PM - Budgeting and control

Contents
Performance Analysis .................................................................................................................. 2
VARIANCE ANALYSIS: ............................................................................................................... 2
STANDARD COSTING: .............................................................................................................. 2
JIT AND TQM: ........................................................................................................................... 3
Performance Analysis in Not-For-Profit Organisations and the Public-Sector ........................... 5
OBJECTIVES .............................................................................................................................. 5
PERFORMANCE MEASUREMENT ............................................................................................. 6
PERFORMANCE INDICATORS ................................................................................................... 6
LONG-TERM VIEW ................................................................................................................... 7
Balanced Scorecard ..................................................................................................................... 8
Performance Measures in the Private Sector and NFP and Public Sector .................................. 9
PERFORMANCE MEASURES ..................................................................................................... 9
FINANCIAL PERFORMANCE MEASURES FOR THE PRIVATE SECTOR...................................... 10
NON-FINANCIAL PERFORMANCE MEASURES FOR THE PRIVATE SECTOR ............................ 14
NOT-FOR-PROFIT ORGANISATIONS AND THE PUBLIC SECTOR ............................................. 15

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Performance Analysis
VARIANCE ANALYSIS:

It is crucial to consider variances alongside each other when using them for performance
analysis, as an adverse variance in one area might have also resulted in a favourable variance
elsewhere.

Risk: Appraising management through variance analysis could result in some very demotivated
members of staff and the future performance of the business is likely to suffer.

Solution: By splitting variances into 'uncontrollable' and 'controllable' (planning and

operational), management can then be assessed based on the variances they can control, which
seems fair and should result in a more motivated workforce.

STANDARD COSTING:

Ensuring that the standard cost being used within the initial budget is correct is also crucial to
ensure that:

1) The initial budgets are as accurate as possible;

2) Management is not being assessed against unrealistic targets, costs, and revenues.

If standard costs are to be used to appraise management, we need to ensure that the standards
being set are:

1) Not too high. If they are too high, management will find it difficult to achieve them and
they may be deterred from even trying to achieve them;

2) Not too low. If the standard is too low and is easy to achieve, this is likely to mean that
management will not strive to achieve the best possible results. This can result in staff
and management becoming demotivated;

3) Attainable but challenging. If so, the management and staff can see that they can
achieve the standards, provided they work hard and work to improve the performance
of their department.

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JIT AND TQM:

In a just-in-time production process, materials are only acquired when an order is placed and
the finished goods are immediately shipped to the customer on completion to fulfill the order.
There is no buffer stock and costs are covered quickly through a direct sale to a customer.

Total quality management focuses on the customer and their needs, rather than relying on
predetermined levels of quality, wastage, and so on. There is a strong emphasis on the cost of
producing high quality items and on the idea that all areas of the business need to get things
right the first time.

There is a direct link between this just-in-time process and total quality management:

There are a number of problems that arise if we try to combine standard costs and variance
analysis with total quality management and just-in-time processes:

1) Variance analysis only looks at a narrow range of costs and revenues and it does not pay
any attention to quality or customer satisfaction;

2) Standard costs only apply when we are producing high quantities of the same product
over and over again;

3) There is too much emphasis on labour costs rather than machine costs, and given that
most modern manufacturing environments are highly automated, this isn’t appropriate;

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4) Production overheads are the main cost associated with modern manufacturing and
these are ignored in standard costing;

5) Standard costing cannot cope with the ever changing costs, products, processes, and
business environments.

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Performance Analysis in Not-For-Profit Organisations and the
Public-Sector
OBJECTIVES

The objectives of not-for-profit organisations are often non-quantifiable, so their impact is hard
to measure.

Examples of the objectives of non-profit organisations include:

 Solve a problem or provide support for people in our society;

 Maximise clients’ satisfaction;

 Have job satisfaction among the volunteers and staff;

 Maximise revenues;

 Maximise the organisation's surplus; and

 Value for money (VFM).

It is difficult to measure the performance of an organisation with non-quantifiable objectives. A

not-for-profit organisation can also have many objectives because they have many
stakeholders. This can result in:

 Difficulties assessing performance; and

 Objectives conflicting with each other.

The solution is for the organisation to prioritise their objectives and compromising between
them.

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PERFORMANCE MEASUREMENT

If the performance of not-for-profit organisations is not measured:

 Resources such as time and money would be misallocated; and

 Decisions for allocating funds would be subjective rather than objective.

Performance can be examined under the following headings:

 Economy – are the resources used the cheapest for what is needed?

 Efficiency – is the maximum output being achieved for the resources invested?

 Effectiveness – look and examine the results or the outputs of the project to ensure the
objectives are met.

To assess value for money (VFM) objectives the organisation can:

 Benchmark against other organisations;

 Use performance indicators to measure if value for money has been achieved; or

 Undertake an internal value for money audit.

PERFORMANCE INDICATORS

When assessing a not-for-profit, both financial and non-financial performance indicators should
be used. A performance indicator is a sign that the company is on target for achieving its
objectives.

Examples of non-financial performance indicators include:

 Staff morale;

 Client satisfaction levels; and

 Client engagement.

How can the organisation improve on its performance?

Targets must be set, however, targets of not-for-profits are often qualitative. Qualitative
targets are difficult to set because of these reasons:

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 There is often no scale to measure the target. How can you assess how much of an
improvement there is in the quality of life of somebody with a chronic illness?

 How are benefits and costs measured against each other and traded off against each
other? For example, does the cost of providing certain services equal the benefit of
improving someone’s life?

 Timing – Benefits do not accrue overnight. Often the impact of not-for-profits will be seen
over the years that follow.

 The impact of external events.

When the targets have been set:

 Performance indicators are decided;

 Past performance is assessed using current performance indicators; and

 Current performance is assessed using current performance indicators.

LONG-TERM VIEW

The benefits of not-for-profit organisations are often not visible for many years. So a long-term
view must be adopted.To encourage this:

 Communicate to the public and the volunteers the long-term benefits of the expenditure;
and

 Use performance indicators that reflect a long-term view.

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Balanced Scorecard
The balanced scorecard is a management technique for assessing and communicating the
performance of the business.

It focuses on both financial and non-financial performance indicators and provides a link
between an organisation’s strategy and its short-term operations and performance
measurements across four perspectives:

1) Financial Perspective. It considers how the organisation can create value for its
shareholders. It is measured in terms of net profit margin, ROI or earnings per share;

2) Customer Perspective. It considers how the organisation appears to its customers. It

might be assessed by a reduction in the number of customer complaints, increase in the
number of customer visits or increase in the number of on-time deliveries;

3) Internal Perspective. The organisation must identify the internal business processes
that are critical to the implementation of its strategy. It is assessed in terms of reducing
staff turnover, reducing the number of mistakes or increasing the organisation’s IT
capability;

4) Innovation Perspective. The aim here is constant learning and growth. Increasing staff
training or enhancing research and development expenditure might result in less staff
mistakes (internal perspective), increased customer satisfaction (customer perspective)
increased organisation’s profit (financial perspective).

Note: The balanced scorecard provides a valuable link between the short-term business
operations and the long-term goal or strategy of that business. It can be considered a dynamic
and efficient tool used in delivering the organisation’s strategy.

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Performance Measures in the Private Sector and NFP and
Public Sector
PERFORMANCE MEASURES

Performance measurement aims to establish how well a company or individual is doing in

relation to a given plan. It is a vital part of the planning and control process.

At a high-level, performance measures can be divided into two types:

1. Financial performance indicators: These measures will typically relate to figures from
financial statements (e.g., revenue, profits, return on capital, cash flows, etc.). The
actual performance is usually measured against a financial plan, a previous time period,
a similar business, or an industry average.

2. Non-financial performance indicators: These measures will vary from one organisation
to another but can include measures around the quality of the goods or service
provided, customer feedback, achieving deadlines, or capacity utilisation for a
manufacturing company.

Whether performance measures are financial or non-financial, there are several factors that
organisations should consider:

A. Any form of performance measurement will require some type of resource to collect
and analyse the information (e.g., staff time, equipment).

B. All measures must be measured in relation to "something". Overall, this will be the
company’s objectives and the plans that will cascade from those objectives.

C. The measures should be "fair". If managers are targeted or incentivised for achieving
certain targets, the measure should only include areas that the manager is responsible
for and has direct control over.

D. A mixture of both long-term and short-term achievements should be measured. Too

much emphasis on short-term targets can lead to short-termism, where decisions are
taken for the "here and now" with little regard to the long-term future of a company.

Note: Once suitable performance measures have been identified, they should be monitored on
a regular basis to ensure that they are relevant and provide meaningful information.

Performance measures can be:

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 1. Quantitative: These measures are expressed in numbers and by measurements. This
will include all financial performance measures and measures that are numerical (e.g.,
number of units, number of hours, or cost per unit).

2. Qualitative: These measures are not numerical. However, they are subjective and
judgemental, and may relate to the quality of a product or service, customer loyalty, or
employee morale.

FINANCIAL PERFORMANCE MEASURES FOR THE PRIVATE SECTOR

Financial performance measures for the private sector can be grouped into three categories:

1. Profitability ratios: This category includes the following ratios:

a. Gross profit margin: This ratio is calculated using the following formula:

Gross profit
Gross profit margin = ———————— x 100%
Sales revenue

To improve this measure, a company will need to either increase its revenue or
decrease the cost of sales. This measure can be used for comparisons against
previous periods within the same company, similar-sized companies within the
same industry, or against an industry average.

b. Net profit margin: This ratio considers all costs of the company, including
administrative and distribution costs. It is only meaningful when compared to
previous periods within the same company, or performance of similar-sized
companies within the same industry. It is calculated using the following formula:

PBT
Net profit margin = ———————— x 100%
Sales revenue

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c. Return on capital employed (ROCE): The capital employed is the shareholder
funds plus any non-current liabilities. This is also the equivalent of the total
assets less the current liabilities. High return on capital employed ratios generally
indicate a high rate of return for investors. ROCE is calculated using the following
formula:

PBT
ROCE = —————————— x 100%
Capital employed

d. Asset turnover: Asset turnover is a measure of how well a business is using its
assets to generate sales. The ratio is calculated as follows:

Revenue
Asset turnover ratio = —————————
Capital employed

The asset turnover ratio is linked to the return on capital employed and the net
profit margin in the following way:

Return on capital employed = Net profit margin x Asset turnover

PBT
Return on capital employed = ————————— x 100%
Capital employed

Revenue
Asset turnover ratio = —————————
Capital employed

PBT
Net profit margin = —————
Revenue

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 e. Earnings per share (EPS): A company must be able to generate sufficient
earnings in order to firstly pay a dividend to the shareholder, and then re-invest
any surplus back into the business to support future growth. It is calculated as
follows:

Profit after tax

EPS = —————————————————————
Weighted average number of ordinary shares

2. Liquidity and cash flow ratios: A company may be financially profitable, but it will
struggle if it does not have sufficient liquidity (i.e., cash to pay its debts). Liquid assets
include cash, trade receivables, deposits with the bank, and any short-term investments
which can be readily converted into cash (e.g., shares). This category includes the
following ratios:

a. Current ratio: This ratio gives an indication as to whether the organisation has
enough cash to meet its short-term liabilities over the coming year. A current
ratio of one is the most desirable current ratio value for most organisations. The
ratio is calculated as follows:

Current assets
Current ratio = ——————————
Current liabilities

b. Quick ratio (acid test): This ratio is very similar to the current ratio, but it takes
into account the fact that the conversion of inventory into cash may take a long
time. Ideally, this ratio should still be greater than one for companies with a slow
inventory turnover. For companies that have a rapid inventory turnover, a quick
ratio may be less than one without suggesting that the company is having any
cash flow difficulties.

Current assets - Inventory

Quick ratio = ——————————————
Current liabilities

c. Receivables payment period: This measure allows a company to calculate the

average length of time it takes for customers to pay them. Close monitoring of
this is essential for companies to avoid a high receivables figure and cash flow
difficulties. It is calculated as follows:

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 Trade receivables
Receivables payment period = —————————— x 365
Credit sales

d. Payables payment period: This measure allows a company to calculate the

average length of time it takes to pay its suppliers. From a cash flow perspective,
companies will normally take full advantage of any credit period offered.
However, it is important for companies not to abuse the agreed terms, as this
could lead to loss of goodwill, and ultimately, a restriction on supply. The ratio is
calculated as follows:

Trade payables
Payables payment period = ————————— x 365
Cost of sales

e. Inventory turnover period. This measure indicates the average period that a
company holds its inventory. An increasing inventory days calculation suggests
slow moving inventory, which can lead to a build-up or excessive holdings. In
addition to potential cash flow problems, too much inventory can lead to loss
through obsolescence or damage, and there may be associated related costs
such as warehousing and insurance. The ratio is calculated as follows:

Closing inventory
Inventory turnover period = —————————— x 365
Cost of sales

3. Gearing ratio: There are different ways that a company can be financed, and this is
known as the capital structure of a business. At a high level there are two options open
to a business for long-term finance:

a. They can raise capital from shareholders (equity); or

b. They can borrow funds (debt).

Gearing ratio looks at the relationship between the shareholders' funds (equity) and debt.
Generally, any ratio greater than 50% would denote that a company is highly geared. It is
calculated as follows:

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 Non-current liabilities Debt

Capital gearing ratio = —————————————— x 100% = ————— x 100%

Ordinary shareholders' funds Equity

The higher the percentage of capital financed through debt, the higher the financial risk
associated with the company. It is important for companies to keep their debt under control,
otherwise, banks or other lenders would likely refuse to lend funds in the future.

NON-FINANCIAL PERFORMANCE MEASURES FOR THE PRIVATE SECTOR

Non-financial performance indicators are generally a useful guide to future financial

performance, unlike financial indicators. They vary significantly between different types of
businesses, dependent on what is important for the organisation.

As a general guide, non-financial performance measures could include:

 Quality of goods or service: This could be formulated by the number of rejects within the
production process, the number of customer returns, or warranty claims.

 Delivery: This could be calculated by the average time between taking and delivering an
order.

 Reliability: This could be expressed as the percentage of equipment failures or

"downtime".

 Innovation: This could be calculated as the number of new products launched over a given
time period, or the value invested in development of new products.

 Customer satisfaction: This may include the number of repeat orders, the number of new
accounts opened, the percentage of on-time deliveries, or the number of customer
complaints as a percentage of total sales volume.

 Employee morale: This can be measured by survey results.

Once all suitable performance measures have been identified, it is important to monitor them,
analyse performance, and identify any reasons for unexpected performance.

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NOT-FOR-PROFIT ORGANISATIONS AND THE PUBLIC SECTOR

Not-for-profit organisations and the public sector are likely to have significantly different goals
in comparison to a private sector business as profit is not their primary goal and they do not
have to be successful against the competition.

Normally, performance will be judged in terms of input and output, which ties in with the value
for money criteria of economy, efficiency, and effectiveness:

1. Economy: This will focus on the inputs for an organisation and obtaining them at the
lowest acceptable cost possible for the level of service to be provided. Economy does
not necessarily mean straightforward cost cutting, as the resource needs to be of a
suitable quality.

2. Efficiency: This means getting the greatest output possible for the level of inputs.
Efficiency would mean ensuring that the staff is fully utilised, equipment is fully
operational and running to the maximum, and inventory is not wasted.

3. Effectiveness: This is concerned with achieving the end result or objective. There is
always a "trade-off" between economy and effectiveness. Organisations usually have
the ability to plan their inputs at a lower cost. However, if the cost cutting is too severe,
then the organisation will struggle to achieve its end objectives.

Typically, management may be subjected to value for money audits to ensure services are
being delivered in the most economical, efficient, and effective way. The audits can be
conducted by an internal audit department or may be carried out by an outside specialist
organisation.

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