Hopwood1 identified three distinct ways of using budget information when evaluating

performance:

1.Budget constrained style:

- Here, an employee’s performance is primarily judged on their ability to continuously meet
their budgets on a short-term basis.
- This criterion is held to be more important than all other desirable outcomes.
- So, for example, over-spending to get a machine repaired quickly so that an important order
is shipped would be criticized because the repair budget was exceeded. Not surprisingly, this
approach leads to very poor manager–subordinate relationships and also encourages the
manipulation and misreporting of information.

2 The profit conscious style

- Here, employees are primarily judged on their ability to increase the long-term effectiveness
of their departments.
- Budgets are not ignored, but they are regarded more as guidelines than strict targets and
are interpreted flexibly.
- In the above example, the employee would be more likely to be praised for getting the
machine repaired as that enabled the organization to meet customer requirements

3 Non-accounting style.
- Assess non-financial things
- Here, budgetary information does not play a big part in evaluation.
- . It’s almost impossible to envisage any organization which is not now subject to financial
and therefore budgetary restraints, but from time to time there are elements of an
organization’s where money is relatively unimportant.
- An example might be the budget required by an airline company to meet health and safety
requirements, because the consequences of not doing so would be disastrous.

Management accountant:

- The role of a management accountant combines accounting, finance and

management to prepare internal financial reports and provide insight into
business performance.

- The objective is to help senior management use financial information to inform

business strategy, as well as contributing to decision-making that will ensure
business growth and long-term success

- Management accountants use financial and non-financial data to paint a

complete picture of the business. They may gather information on revenue, cash

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flow and outstanding debts to spot trends, gather stats, write reports that support
day-to-day management decision-making and help drive strategy and planning.

- Professionals in this field will oversee the development of accounting procedures

and financial policies, as well as preparing forecasts, budgets and risk analysis.
They often contribute to efficiency and cost reduction through the identification
and implementation of more effective processes and strategies and may also have
accountability for establishing and maintaining management information systems.

Key responsibilities

 Preparing the monthly management accounts, budgets and forecasts to aid

business planning
 Informing key strategic decisions and formulating business strategies to
generate shareholder value
 Advising on the financial implications of business decisions
 Developing and managing financial systems & policies, and identifying
opportunities for improvement
 Controlling and forecasting income and expenditure, and ensuring
expenditure is in line with the budget
 Recommending strategies to reduce costs
 Analyzing and managing risk
 Negotiating and obtaining finance for major projects
 Offering professional input on financial matters and advising on ways of
improving business performance
 Effectively communicating financial data to non-financial managers

Why are they important?

The analysis of business performance and key financial data provided by

management accountants is highly valued for the important role it plays in
informing senior management

Where financial accountants may focus on preparing reports based on past

performance, management accountants prepare, develop and analyze current
financial information and non-financial data with the objective of allowing
informed decision-making. This can be to help management make decisions in the
present or using budgeting and forecasting to support project assessment and long-
term strategy aimed at securing stability, growth and profitability

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Skills needed for this role

Management accountants must have excellent numerical and analytical skills, along
with strong attention to detail. Critical and strategic thinking skills are key and
these professionals should be highly organized in their approach. A solid
commercial awareness is required, as is the ability to liaise and influence at a senior
level.

Economic Value Added (EVA)

EVA is a performance management measure developed by Stern Stewart and Co.

What is EVA?

The most common objective in decision making scenarios is to maximize

shareholder value. This is because most decisions are made by companies where
the directors have a duty to act in the interests of their shareholders.

Research has found that to develop decision making metrics that maximize
shareholder value, the following factors need to be incorporated:

1 Cash is preferable to profit

Cash flows have a higher correlation with shareholder wealth than profits.

2 Exceeding the cost of capital

 The return, however measured, must be sufficient to cover not just the cost of debt
(for example by exceeding interest payments), but also the cost of equity.

Peter Drucker commented, in a Harvard Business Review article: ‘Until a business

returns a profit that is greater than its cost of capital, it operates at a loss. Never
mind that it pays taxes as if it had a genuine profit. The enterprise still returns less
to the economy than it devours in resources… until then it does not create wealth; it
destroys it.’

3 Managing both long and short-term perspectives

Investors are increasingly looking at long-term value. When valuing a company’s

shares, the stock market places a value on the company’s future potential, not just
its current profit levels.

EVA is an attempt to address the above three issues.

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EVA is a measure of performance similar to residual income, except the profit
figure used is ECONOMIC profit and the capital employed figure used is
ECONOMIC capital employed. It is argued that the profit and capital employed
figures quoted in the financial statements do not give the true picture and that the
accounting figures need to be adjusted to show the true underlying performance.

The basic concept of EVA is that performance should be measured in terms of the
value added during the period. It is a measure of performance that is directly linked
to shareholder wealth.

Basic calculation

Decision rule: accept the project if the EVA is positive.

What is NOPAT?

 Adjustments to PAT

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What is the economic value of capital employed?

The main adjustments to the capital employed figure are as follows:

 an adjustment should be made to reflect the replacement cost of non-

current assets rather than the book value.
 the net book value of any capitalised operating leases should be added
back.
 the net book value of any capitalised development/advertising costs should
be added back.
 the value of amortised goodwill should be added.

What is the WACC?

WACC stands for weighted average cost of capital:

WACC = (proportion of equity × cost of equity) + (proportion of debt × post tax

cost of debt)

For example suppose that a company is 60% financed by equity which has a cost of
10% pa and 40% financed by debt which has an after tax cost of 6%

WACC = (0.60 x 0.10) + (0.40 x 0.06) = 0.084 therefore 8.4%

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Advantages and disadvantages of EVA

Risk: there are a number of possible outcomes and the probability of each

outcome is known.

Uncertainty: there are a number of possible outcomes but the probability of each

outcome is not known.

Expected values (EVs)

An expected value is a weighted average of all possible outcomes. It calculates the

average return that will be made if a decision is repeated again and again. In other
words, it is obtained by multiplying he value of each possible outcome (x), by the
probability of that outcome (p), and summing the results.

The formula for the expected value is EV = Σpx

Advantages:

 Takes uncertainty into account by considering the probability of each possible

outcome and using this information to calculate an expected value.
 The information is reduced to a single number resulting in easier decisions.

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  Calculations are relatively simple.

Disadvantages:

 The probabilities used are usually very subjective.

 The EV is merely a weighted average and therefore has little meaning for a
one-off project.
 The EV gives no indication of the dispersion of possible outcomes about the
EV, i.e. the risk.
 The EV may not correspond to any of the actual possible outcomes.

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