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CPA-Australia - SMA
CPA-Australia - SMA
STRATEGIC
MANAGEMENT
ACCOUNTING
2ND EDITION
BE HEARD.
BE RECOGNISED.
CPA PROGRAM
STRATEGIC
MANAGEMENT
ACCOUNTING
2ND EDITION
Published by Deakin University, Geelong, Victoria 3217, on behalf of CPA Australia Ltd, ABN 64 008 392 452
First edition published January 2010, reprinted with amendments July 2010, updated January 2011,
reprinted July 2011, updated January 2012, reprinted July 2012, updated January 2013, July 2013,
January 2014, revised edition January 2015, updated January 2016
Second edition published January 2019
© 2010–2019 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is owned or
licensed by CPA Australia and is protected under Australian and international law. Except for personal and
educational use in the CPA Program, this material may not be reproduced or used in any other manner
whatsoever without the express written permission of CPA Australia. All reproduction requests should be
made in writing and addressed to: Legal, CPA Australia, Level 20, 28 Freshwater Place, Southbank, VIC 3006,
or legal@cpaaustralia.com.au.
Authors
Brian Clarke Consultant
Paul Collier Consultant
Rahat Munir Head of Department and Professor, Department of Accounting and
Corporate Governance, Macquarie University
Gary Oliver Senior Lecturer, University of Sydney Business School, University of Sydney
Peter Robinson Senior Lecturer, UWA Business School, University of Western Australia
Natasja Steenkamp Senior Lecturer in Accounting, School of Business and Law, CQUniversity
Ofer Zwikael Associate Professor, College of Business and Economics,
Australian National University
2019 updates
Brian Clarke Consultant
Paul Collier Consultant
Rahat Munir Head of Department and Professor, Department of Accounting and
Corporate Governance, Macquarie University
Gary Oliver Senior Lecturer, University of Sydney Business School, University of Sydney
Paul Shantapriyan Consultant
Natasja Steenkamp Senior Lecturer in Accounting, School of Business and Law, CQUniversity
Ofer Zwikael Associate Professor, College of Business and Economics,
Australian National University
Acknowledgments
Karen Drutman Consultant
Vladimir Malcik Praxtra Pty Ltd
Ann Sardesai Senior Lecturer in Accounting, School of Business and Law, CQUniversity
CPA Australia acknowledges the contributions of David Brown, Courtney Clowes and Teemu Malmi to
previous versions of this Study guide.
Advisory panel
Assoc. Prof. Albie Brooks University of Melbourne
Nicolas Diss CPA Australia
Assoc. Prof. Ralph Kober Monash University
Vladimir Malcik Praxtra Pty Ltd
Alastair Mckenzie Devondale Murray Goulburn
Sarah Scoble Solution Underwriting
Prof. Naomi Soderstrom University of Melbourne
Dr Gillian Vesty RMIT
Learning designer
Jan Williams DeakinCo.
Acknowledgment
All legislative material is reproduced by permission of the Office of Parliamentary Counsel, but is not the official or authorised version. It is
subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth
legislation. In particular, s. 182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction
or publication beyond that permission by the Act, permission should be sought.
IFAC extracts are from the 2017 Handbook of International Education Pronouncements of the IAESB, published by the International
Federation of Accountants (IFAC) in February 2017; the 2018 Handbook of the International Code of Ethics for Professional Accountants
(including International Independence Standards) of the IESBA, published by the International Federation of Accountants (IFAC) in April
2018; and the International Guidance Document: Environmental Management Accounting (“Excerpts”), published by the International
Federation of Accountants (IFAC) in July 2005. All extracts are used with permission of IFAC. Contact permissions@ifac.org for permission
to reproduce, store or transmit, or to make other similar uses of this document.
This publication contains copyright material from the ASX Corporate Governance Council. © Copyright 2018 ASX Corporate Governance
Council. Association of Superannuation Funds of Australia Ltd, ACN 002 786 290, Australian Council of Superannuation Investors,
Australian Financial Markets Association Limited ACN 119 827 904, Australian Institute of Company Directors ACN 008 484 197, Australian
Institute of Superannuation Trustees ACN 123 284 275, Australasian Investor Relations Association Limited ACN 095 554 153, Australian
Shareholders’ Association Limited ACN 000 625 669, ASX Limited ABN 98 008 624 691 trading as Australian Securities Exchange, Business
Council of Australia ACN 008 483 216, Chartered Accountants Australia and New Zealand, CPA Australia Ltd ACN 008 392 452, Financial
Services Institute of Australasia ACN 066 027 389, Group of 100 Inc, The Institute of Actuaries of Australia ACN 000 423 656, ABN 50 084
642 571,The Institute of Internal Auditors – Australia ACN 001 797 557, Financial Services Council ACN 080 744 163, Governance Institute
of Australia Ltd ACN 008 615 950, Law Council of Australia Limited ACN 005 260 622, National Institute of Accountants ACN 004 130 643,
Property Council of Australia Limited ACN 008 474 422, Stockbrokers Association of Australia ACN 089 767 706. All rights reserved 2015.
This publication contains copyright material from the International Integrated Reporting Council (IIRC). Copyright © December 2013
by the International Integrated Reporting Council (‘the IIRC’). All rights reserved. Used with permission of the IIRC. Contact the IIRC
(info@theiirc.org) for permission to reproduce, store, transmit or make other uses of this document.
These materials have been designed and prepared for the purpose of individual study and should not be used as a substitute for
professional advice. The materials are not, and are not intended to be, professional advice. The materials may be updated and amended
from time to time. Care has been taken in compiling these materials, but they may not reflect the most recent developments and have
been compiled to give a general overview only. CPA Australia Ltd and Deakin University and the author(s) of the material expressly exclude
themselves from any contractual, tortious or any other form of liability on whatever basis to any person, whether a participant in this subject
or not, for any loss or damage sustained or for any consequence that may be thought to arise either directly or indirectly from reliance on
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Any opinions expressed in the study materials for this subject are those of the author(s) and not necessarily those of their affiliated
organisations, CPA Australia Ltd or its members.
STRATEGIC MANAGEMENT ACCOUNTING
Contents
Subject outline 1
Subject outline
2 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Contents
Before you begin 3
Strategic Management Accounting 3
Study guide
My Online Learning
Study plan
Study map 6
Detailed study session planning
Your exam information 16
Authors 17
SUBJECT OUTLINE | 3
OUTLINE
Before you begin
The purpose of this subject outline is to:
• provide important information to assist you in your studies
• define the aims, content and structure of the subject
• outline the learning materials and resources provided to support learning
• provide information about the exam and its structure.
The CPA Program is designed around five overarching learning objectives to produce future
CPAs who will:
• Be technically skilled and solution driven
• Be strategic leaders and business partners in a global environment
• Be aware of the social impacts of accounting
• Be adaptable to change
• Be able to communicate and collaborate effectively.
For information on dates, fees, rules and regulations, and additional learning support, please refer
to the CPA Australia website: cpaaustralia.com.au/cpaprogram.
This subject examines the management accountant’s role in dynamic organisations operating
in the global business environment. In this role, the professional accountant engages with the
organisation’s management team and contributes to strategy development and implementation,
with the aim of creating customer and shareholder value and a strong competitive position for
the organisation. The subject highlights the management accounting tools and techniques
of value chain analysis and project management that have become increasingly important in
contemporary operating environments.
The subject includes discussions on the professional accountant’s responsibilities and judgment
as introduced in Ethics and Governance. Also discussed are investment evaluation and strategic
business analysis in the context of assessing and responding to risk, as covered in the Financial
Risk Management and Advanced Audit and Assurance subjects. Candidates are introduced to
strategic management concepts that are expanded on in Global Strategy and Leadership.
Study guide
The Study guide is your primary examinable resource and contains all the knowledge you need
to learn and apply to pass the exam. The Strategic Management Accounting Study guide is
divided into six modules, plus a Case study, and includes a number of features to help support
your learning. These include:
• Objectives—to describe what you are expected to know and be able to do after completing
the module, as well as identify what you’ll be assessed on in the exam.
• Examples—to demonstrate how concepts are applied to real-world scenarios.
• Questions (and suggested answers)—to provide you with an opportunity to assess your
understanding of the key learning points. These questions are an integral part of your study
and should be fully utilised to support your learning of the module content.
• Case studies (and suggested answers)—to help you apply theoretical knowledge to real-life
scenarios, requiring a deep understanding of the module content.
• Teaching materials—this section of your Study guide will inform you of any additional
resources and readings to be referred to in conjunction with the module. Any material
that is listed under ‘Readings’ in this section will be examinable. Any readings that are
listed as ‘optional’ will not be examined; they are provided if you wish to explore a particular
topic in more detail.
Case study
The Case study consolidates your understanding of strategic management accounting
through completion of various tasks that require you to apply the concepts, tools and
techniques covered in Modules 1 to 6. The Case study is not weighted for assessment
purposes (i.e. it is not examinable). However, in order to gain the most benefit from your
study of Strategic Management Accounting, it is important that you allocate time to complete
the Case study, including attempting the Case study tasks and reviewing the suggested
answers. Completing the Case study and Case study tasks will help you prepare for the
written section of the Strategic Management Accounting exam.
My Online Learning
My Online Learning is CPA Australia’s online learning platform, which provides you with
access to a variety of resources to help you with your study. We suggest you view the video
‘Insights for a great semester of study’ on My Online Learning, which will provide you with
some insights on how to plan your semester. It will also take you on a guided tour of My Online
Learning to show you how (and when) to access the range of resources available.
You will find a wide range of subject-level and module-level resources on My Online Learning.
Subject-level resources are those that apply to the entire subject. These resources can be used
at any time but are most useful when you’ve completed all the modules for the entire subject—
whereas module-level resources should be used while you work through a particular module in
the Study guide.
OUTLINE
You should refer to the journey map located on My Online Learning to see what module
resources you can access and in what order you should use them.
You can access My Online Learning from the CPA Australia website: cpaaustralia.com.au/
myonlinelearning.
Help desk
For help when accessing My Online Learning, either:
• email memberservice@cpaaustralia.com.au, or
• telephone 1300 73 73 73 (Australia) or +61 3 9606 9677 (international) between 8.30 am
and 5.00 pm (AEST) Monday to Friday during the semester.
Study plan
Total hours of study for this subject will vary depending on your prior knowledge and experience
of the course content. Your individual learning pace and style and your work commitments will
need to be taken into consideration. You will need to work systematically through the Study guide
and readings and attempt all the in-text questions, Case studies and online Knowledge checks.
The workload for this subject is the equivalent of that for a one-semester postgraduate unit.
An estimated 15 hours of study per week through the semester is recommended, but additional
time may be required for revision.
The ‘Weighting’ column in the following table provides an indication of the emphasis placed on
each module in the exam, while the ‘Recommended proportion of study time’ column is a guide
for you to allocate your study time for each module.
With our flexible study options, you can complete the CPA Program in your own time with access
to national support if you need it. Please refer to the CPA Australia website: cpaaustralia.com.au/
cpaprogram_support.
Recommended
proportion Recommended
of study time Weighting study
Module (%) (%) schedule
100 100
You can see an overview of all the learning resources for this subject in the Study map on the
next page.
The Study map is then followed by a detailed Study planner, which will help you allocate your
study time per module/week.
6 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Study map
BEFORE YOU BEGIN
BYB
of study
• Strategic Management
Accounting: An overview
MODULE 1
• Study and Exam information
• Study Companion and Exam Study guide
Mark Allocations
Knowledge checks
• Frequently Asked Questions
• General My Online Learning
M1
Value chain
administration queries
Knowledge checks
Stakeholder management M2
Week 2
Ask the expert forum
MODULE 3
Study time proportion: 14%
Study guide
Knowledge checks
M3
Weeks 3, 4
Zero-based budgeting
Knowledge checks
•
•
•
Network Exercise
Crashing Exercise
Example Network
M4
Week 5
MODULE 5
Study guide
Ask the expert forum Knowledge checks
Study time proportion: 13% Characteristics associated with
performance measures
MODULE 6 M5
Weeks 6, 7
•
•
Performance Measurement
R Kaplan explains the
Balanced Scorecard
Study guide
Save or close the hotel?—Stage 2
Knowledge checks
Ask the expert forum
• Activity-based costing
• Time-driven activity-based Study time proportion: 21%
M6
costing
• Target costing
• Customer profitability analysis Weeks 8, 9
Save or close the hotel?—Stage 3
CASE STUDY
Ask the expert forum
Study guide
Study time proportion: 17%
Extended-response knowledge
EXAM PREPARATION
CS
Week 10
checks
OUTLINE
Detailed study session planning
Recommended
study time Done
— Topic finder
Total 1 hr
Notes:
8 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Recommended
study time Done
Study
session Module 1—Week 1
Total 15 hrs
Notes:
SUBJECT OUTLINE | 9
OUTLINE
Recommended
study time Done
Study
session Module 2—Week 2
Total 15 hrs
Notes:
10 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Recommended
study time Done
Study
session Module 3—Weeks 3 and 4
Total 29 hrs
Notes:
SUBJECT OUTLINE | 11
OUTLINE
Recommended
study time Done
Study
session Module 4—Week 5
Total 15 hrs
Notes:
12 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Recommended
study time Done
Study
session Module 5—Weeks 6 and 7
Total 30 hrs
Notes:
SUBJECT OUTLINE | 13
OUTLINE
Recommended
study time Done
Study
session Module 6—Weeks 8 and 9
Total 30 hrs
Notes:
14 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Recommended
study time Done
Study
session Case study—Week 10
Notes:
SUBJECT OUTLINE | 15
OUTLINE
Recommended
study time Done
Exam preparation—Revision
— Topic finder —
Total 13 hrs
Notes:
16 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
The Study guide is your central examinable resource. Where advised, relevant sections of the
CPA Australia Members’ Handbook and legislation are also examinable.
This is an open-book exam, so you may bring any reference material into the exam that you
believe to be relevant and that may assist you in undertaking the exam. This may include,
for example, the Study guide, additional materials from My Online Learning, readings and
prepared notes.
You will have access to an on-screen calculator within the computer-based exam environment.
If you are sitting a paper-based exam, we recommend that you bring your own calculator.
Please ensure that the calculator is compliant with CPA Australia’s guidelines. The calculator
must be a silent electronic calculating device the primary purpose of which is calculation.
Calculators with text-storing abilities are not permitted in the exam.
As this exam forms part of a professional qualification, the required level of performance is high.
You are required to achieve a passing scaled score of 540 in all CPA Program exams. Further
information about scaled scores and exam results is available at: cpaaustralia.com.au/cpaprogram.
SUBJECT OUTLINE | 17
OUTLINE
Authors
Brian Clarke PhD, CA, MBA
Brian began his career as a CA and auditor with Deloitte in
Vancouver. After moving to Australia, he worked in higher
education at Monash and Deakin Universities, and as a business
consultant. At Monash, he taught management accounting and
was awarded the Monash prize for team-based educational
development for his work on the Multi-disciplinary Industrial
Project. At Deakin, he obtained his PhD and taught auditing.
He also initiated Deakin’s successful Certificate program
in Chartered Accounting. Brian has published auditing,
management accounting and education research, and has
presented at numerous conferences. He currently works as
an education consultant to the accounting profession.
His early career in industry saw him move from financial into
general management roles. He subsequently moved into
academia, where he has worked as Director of Executive
Education with Aston Business School in the United Kingdom,
and as Associate Dean (Research Training) and head of discipline
for management accounting and accounting information
systems at Monash University in Melbourne.
OUTLINE
Gary R Oliver PhD, MComm, MEdH, BSc Hons, BA,
GradDipSocSci, GradCertHEd, FCPA, FCIMA
Gary researches and teaches at the University of Sydney,
Darlington campus, in Sydney, NSW. Prior appointments include
the University of New South Wales and the Australian Graduate
School of Management. Before joining academia in mid-2000,
Gary was Chief Information Officer in a stock-exchange-listed
corporation and a consultant at the federal and state levels
of government. His earlier industry experience includes inner
city retailing and suburban services.
Module 1
INTRODUCTION TO
STRATEGIC MANAGEMENT ACCOUNTING
22 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Contents
Preview 23
Introduction
Objectives
Subject map
MODULE 1
Part A: Value 26
Shareholder value
Customer value
Stakeholder value
Which viewpoint should be taken when determining ‘value’?
Review 82
Suggested answers 83
References 89
Study guide | 23
Module 1:
Introduction to
strategic management
MODULE 1
accounting
Study guide
Preview
Introduction
Contemporary organisations face significant internal and external challenges that must be
addressed in order to operate and function effectively. It is essential for them to create value
for multiple stakeholders, including customers, employees, management, regulators and their
shareholders or owners. This must be achieved in a global environment that is continuously
changing and becoming more competitive. This subject focuses on the role strategic
management accounting plays in creating, managing and protecting value.
For the purposes of this subject, strategic management accounting is defined as follows:
Creating sustainable value by:
• supporting the formation, selection, implementation and evaluation of organisational strategy
• synthesising information that captures financial and non-financial perspectives for both the
internal and external environments, to enable effective resource allocation.
Strategic management accounting requires that management accountants embrace new skills
that extend beyond their traditional practices. They must collaborate with general management
(operational departments), corporate strategists (senior management team) and product
development, in creating, managing and protecting value. Fostering organisational capabilities
leads to value creation.
24 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Value creation is essential in contemporary organisations. One way of thinking about commercial
organisations, government bodies and not-for-profit entities is as ‘linked chains’ of resources
and activities. These chains produce products and services of value to consumers and end users.
The essential requirements for successful performance are:
• to generate products and services with value that consumers are willing to pay for
• to constantly develop and improve the resources, activities and processes used to generate
MODULE 1
This module first considers management accounting and its role in supporting management.
It then describes the key changes that have led to the development of strategic management
accounting. The module also identifies the challenges that management accountants face and
describes the skills required to perform their role, at present and in the future.
The ability to support managers at a strategic level has become critically important for
organisational survival, and management accountants must broaden their role from traditional
scorekeeping tasks to business advisory positions. Advances in technology and information
systems now help with capturing and processing the routine events within an organisation.
This allows management accountants to spend more time understanding the organisation’s
external environment and work on non-routine, complex decisions.
This module concludes with an examination of the various analytical techniques available to
management accountants that will assist them to support management in their decisions about
strategic direction.
For a visual overview of Strategic Management Accounting, please access the ‘Strategic Management
Accounting: An overview’ video on My Online Learning.
Objectives
After completing this module, you should be able to:
• Explain what is involved in a strategic management process and its various stages.
• Identify the role of management accounting in strategic management and the mindset and
values required to transit from a management accountant to a competent business partner.
• Assess the key challenges facing management accountants in today’s business environment.
• Identify various analysis techniques used in strategic management and their functions.
Subject map
Figure 1.1 provides an overview of the important concepts in this subject and how they link
together. The highlighted sections show the concepts that are the focus of Module 1.
Study guide | 25
rnal environment
Exte
MODULE 1
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
MANAGEMENT ACCOUNTANT
VALUE INFORMATION
OPERATIONS
Exte
rnal environment
An organisation decides on a strategic direction, where it believes value can be created. This value
may be shareholder value, customer value or broader stakeholder value—depending on the
type of organisation involved. Creating value for organisations helps sell products and services,
increases the share price, and ensures the future availability of capital to fund operations.
For value creation to occur there must be a clear strategy, based on a vision and mission that
combine resources (including people, technology and time) and their effective use to achieve
goals and objectives.
The day-to-day activities and projects that are performed must be linked to the organisation’s
overall strategy to drive towards its desired outcomes. It is important to perform the work
required, but it is also necessary to continuously review, monitor and improve activities
and processes. As shown in Figure 1.1, while there must be an information flow from the
strategic level to the operational level, there must also be clear feedback and reporting from
the operational level. This can be used as a control mechanism to ensure the organisation’s
day‑to‑day activities stay in agreement with its vision and mission.
The organisation must also be aware of the external environment in which it operates. Competitor
activity, the broader economic and regulatory environment, technological advancements, alliances,
management capabilities, employee and customer relations, and social changes may all affect
the organisation. So, monitoring these influences and adapting to change are critical activities.
The management accountant is at the centre of all these activities. Understanding what
creates value helps management accountants focus capital and talent on the most profitable
opportunities for survival and growth of an organisation.
26 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Part A: Value
The main theme of this part of the module is value. The analysis and activities, the tools and
techniques, the reporting and evaluation—all of these take place in the pursuit of value.
Value is a broad concept and has a major influence on an organisation’s behaviour and drive to
MODULE 1
achieve its vision, mission and goals. It can be described as combining resources in a manner
that creates desirable outcomes. Examples of value creation include growing food, generating
energy, providing health care and building new machines, software programs and infrastructure.
Shareholders
Community
Lenders
groups
Stakeholders
Regulators Customers
Employees Suppliers
Each group has its own interests and desires and therefore its own definition of the ‘value’ it
wishes to receive from an organisation. Failure to consider stakeholder needs and desires will
make it difficult to maintain and increase shareholder wealth.
Value creation is just as relevant in the not-for-profit and public sectors. For example, national
infrastructure, education, health and social welfare need to be managed just as effectively
as privately run organisations. In the not-for-profit and public sectors, value is created for the
members, citizens or residents (or taxpayers) of the nation, instead of wealth being increased
for shareholders.
Value creation in contemporary organisations is based on creativity and innovation. This includes
the innovative ways that management adapt to take advantage of new materials, technologies
and processes, as compared to value creation in the past, which was based on economies of
scale and mass production.
Study guide | 27
Shareholder value
The ultimate outcome for many organisations is to generate wealth for the owners. The owners
have either started or invested in the organisation to obtain appropriate returns for the risk
involved. As such, many measures of value focus on shareholder value. However, pursuit of
shareholder value while ignoring other areas of value creation is not sustainable. To ensure that
an organisation is able to create shareholder value over a prolonged period, its actions and use
MODULE 1
of resources need to be sustainable. For example, if the impact on the natural environment is not
acknowledged or minimised, long-term sustainable shareholder value is unlikely to be achieved.
Customer value
The primary task for an organisation is to create an output that has customer value. A key
requirement is to produce this output at a cost that is lower than the price the customer is willing
to pay, which leads to profitability and creates shareholder value.
Figure 1.3 shows a simple version of the organisational value chain. This provides an overview
of how the organisation performs a sequence of activities to provide outputs or outcomes to
create customer value.
Business cycle
Operations (obtaining/producing goods or services) Sales Distribution After-sales service
Support activities
Research and development, accounting, human resources, information technology and infrastructure
For a further explanation of and practice in the concept of value chains, please access the ‘Value chain’
learning task on My Online Learning.
Stakeholder value
Shareholder wealth is a by-product of generating value in other areas. To create products or
services, an organisation will require community permission to operate, infrastructure, customers
and employees—who will only supply their effort if the wages and conditions are adequate.
So, consideration of stakeholders is critical to organisational success.
Unemployment,
Cost cutting—reducing
financial pressure on
the number of staff
communities and additional
MODULE 1
by 10% to increase
stress for employees who
profitability
remain employed
Switching production
Local unemployment,
to cheaper offshore
environmental degradation,
locations with lower
and an increase in injuries
standards of employee
and incidents among employees
and environmental
who receive little protection
protections
The development of corporate social responsibility (CSR) indicates that people are interested
in more than just the pure economic value that organisations create. They are also interested in
‘how’ that economic value is created, and they assess the impact of those actions (or inactions).
CSR reporting has increased to help people understand the sustainable value or effect of an
organisation’s activities from a social and environmental perspective. Such reporting aims to
increase the level of ethics and accountability demonstrated by organisations when making
value-based decisions.
Value is either created or destroyed by management through the business model they use.
The business model is highly dependent on a broad range of relationships and activities that
take place in the market, in a societal and environmental context within which the organisation
operates. Therefore, to be truly valuable, something must offer economic value to the
organisation and provide sustainable value to other stakeholders within society.
Study guide | 29
MODULE 1
• the direction it will take
• the industry it will operate within
• the types of products or services it will provide
• its structure, systems and processes
• its goals and objectives.
Throughout Part B, the strategic management process is presented as a continuous process that
evaluates the business and the environment within which the organisation operates, evaluates/
re‑evaluates its competitors, and defines its objectives and strategy.
Strategic management
The strategic management process involves:
• addressing key issues, including determining the vision, mission and purpose of an organisation
• setting specific objectives
• creating and implementing the strategies to achieve these objectives.
Important phases in the strategic management process are shown in Figure 1.5.
Strategic analysis—
both internal and
external
Strategy evaluation—
performance Strategy planning
measurement, and choice
feedback and review
Strategy
implementation
This strategic management process shown in Figure 1.5 is continuous, and the phases are closely
interwoven rather than being clearly separate events. The stages are critically useful in evaluating
an organisation’s planning systems and processes and for indicating ways of improving their
effectiveness. Significant amounts of information are required to successfully complete each
of the stages.
MODULE 1
The stages in the process are briefly discussed below.
Strategic analysis
The strategic management process begins with strategic analysis, which is undertaken through
scanning the internal and external organisational environment. It is important for the organisation
to know itself and its competitors.
Organisations must continuously analyse the external environment to understand trends and
changes that affect the industry and the economy. For instance, Apple redefined the smartphone
technology, and its decision to create the iPhone shows its ability to analyse the traditional
industry and create a product that distinguished Apple in the mobile phone industry.
Organisations must also analyse their own resources and capabilities to understand how they
might react to changes in the environment. For instance, changes in the global economic
environment have influenced the development of business models where intellectual property
(IP) has become an important resource for many contemporary organisations, such as Google,
Apple, Louis Vuitton and Mercedes-Benz, for establishing value and potential growth.
Organisations use various management tools and techniques to scan the organisational
environment. A well-established tool that captures the idea of scanning the environment both
external and internal to the organisation is strengths, weaknesses, opportunities and threats
(SWOT) analysis (discussed later in this module) (Saylor 2012).
Strategy implementation
The next step of the strategic management process is strategy implementation, which entails
crafting an effective organisational structure, organisational processes and culture. For
example, the rate of Amazon’s innovations in supply chain management (SCM) has been
significant, with investment in supply chain automation lessening the overall product delivery
time, and increasing the number of warehouses. Its unique supply chain strategies and
continuous technological innovations have changed the way SCM works. This helped Amazon
to successfully implement its Amazon Prime service in 2005 providing guaranteed two-day
shipping of products.
Strategy evaluation
The final stage of the process is strategy evaluation. This involves measuring performance,
providing feedback and undertaking continuous review for improvement. The focus of
every organisation is to lead strategically in order to attain long-term goals. Consequently,
how managers understand and interpret the performance of their organisations is critical to
evaluating strategy.
32 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Operational management
The relationship between senior strategic managers and operational managers is usually
drawn as a pyramid. The senior management team is at the top and focuses on strategic tasks.
Underneath this are the operational managers who focus on the medium- to short-term tasks
of running an organisation. There should be a strong link between these levels via the strategic
implementation phase. However, strategy often fails at the implementation phase due to poor
MODULE 1
integration of the strategic and operational levels. Formal strategies are often ignored or
postponed as day-to-day issues receive all the attention.
There is a direct and impactful relationship between strategic and operations management.
The success of an organisation depends on both the strategic and operational elements.
As described earlier, strategic management is the process of understanding the business
environment and developing and implementing strategies, while operational management
involves executing those strategies on a day-to-day basis to achieve the outcomes in the
long run.
Table 1.1 summarises the broad difference between strategic management and operational
management.
Directly linked to survival of an organisation Not directly related, but indirectly influences
organisational survival
➤➤Question 1.1
Will the role of strategic management accounting change if the roles and functions of management
identified so far in Part B of this module change in any way?
MODULE 1
Check your work against the suggested answer at the end of the module.
Example 1.1 highlights how strategic management accounting information can support
operational management.
Example 1.1: S
upporting operational management with
management accounting information
Planning
Alpha Pty Ltd (Alpha) sells educational toys for children aged one to four years. One of its products is
an electronic reading support toy that is expected to have good sales before the start of the school
year at the end of January. The budget for the next quarter (January–March) is set in mid December—
it includes a sales revenue target of $165 000 for January. A bonus will be paid to sales staff in mid
April if both revenue and profit targets are achieved for this product.
The planning phase is supported by the use of previous sales figures, consumer confidence in the
economy and required profit targets to achieve a minimum return above the cost of capital. The plan
and expected levels of performance are then communicated to staff.
Evaluating
On 5 February, the results for January are reported, and actual sales for the toy are $130 000. Not only
are January’s figures short of the target, but there is also doubt about achieving the sales target for
the whole quarter. The cost of producing each unit has risen because of raw material price increases
caused by unfavourable foreign exchange fluctuations. It appears that there will be no bonuses for
the sales staff for quite some time.
Evaluation occurs continuously, and in this situation, it was supported by the use of actual versus
budgeted figures to identify current performance and establish whether bonus criteria were being
achieved.
34 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Analysing
An analysis of the sales revenue variance uncovers two major issues:
1. An external issue was caused by Alpha’s main competitor, Zeta Pty Ltd (Zeta). During the Christmas
period, Zeta heavily discounted a similar toy to successfully attract market share away from Alpha.
This had a flow-on effect on January’s sales.
2. An internal problem was caused by a delay in the product being delivered to several large retailers
who had sold out. Several days’ worth of sales was lost as a result.
MODULE 1
Analysis of the causes of the variance indicates that coordination within the organisation needs to be
examined and decisions must be made about how to take control of the situation.
Control
Alpha decides to reduce the selling price by 15 per cent and increase advertising to generate additional
sales. Sales estimates for February and March are also slightly reduced. A series of meetings are
arranged between sales, purchasing and logistics personnel to ensure that the company has enough
stock and that it is being distributed to retailers on time.
Variance to be controlled
Actual result
The company is off target. Several approaches to control the situation are made:
• changing the target—reduced sales target
• changing the course to the target—reduced sales price and increased target sales volumes
• attempting to improve coordination within the company.
In Example 1.1, the decisions made at each stage needed to be based on rigorous financial and
qualitative analysis. This required an understanding of different cost concepts, as well as various
tools and techniques to support the analysis. For example, the original variances would have
been identified by variance analysis, and the decision to reduce the price by 15 per cent and
increase advertising to increase market share could have been modelled using cost-volume-profit
(CVP) analysis.
A range of operational support techniques are regarded as assumed knowledge for this subject,
including:
• cost classifications
• CVP analysis
• product costing
• marginal costing
• working capital management.
If you are unsure about your knowledge in these areas, please access the ‘Assumed Knowledge
Exercise’ available on My Online Learning.
Instead of merely recording and providing the information, management accountants are
required to provide support and training to assist line managers and employees to undertake
these tasks. An advantage of this approach is that it transfers routine tasks to other employees to
allow time to be devoted to more complex, non-routine and strategic-level tasks.
MODULE 1
Many management accounting examples involve the manufacture of products. These products
are tangible, easy to visualise, and often produced systematically, so costs can be easily identified
and allocated to each element of the product. However, service industries also require the
support of management accounting tools and techniques.
The detailed Case study at the end of this subject demonstrates this by considering the Australian
domestic airline industry.
The same approaches and tools are used to analyse services, but the main characteristics of
services can make this analysis more difficult. Services differ from products in the following ways:
• A service is intangible, so it can be more difficult to define or measure systematically.
• Once a service is provided, it cannot be consumed or used again in the same way as a
product. This means there is no ability to store a service as inventory, which makes it more
difficult to manage supply and demand levels.
• A service is more of a unique offering than a product. So providing it in a systematic and
identical way is much more difficult.
• Unused capacity is lost forever. It cannot be used to create something that is stored for
later—that is, inventory cannot be created.
Other important issues include measuring and maintaining quality, which can be difficult
because providing a service can be more individual or unique than producing identical products.
Therefore, accurately costing the provision of services to different customers is challenging.
The key questions to consider are: what decisions do public sector managers need to make and
how does strategic management accounting support these choices? For instance, in performance
assessment, strategic management accounting can help establish metrics for measuring:
• economy—the extent to which resources of a given quality were acquired at the lowest cost
• efficiency—the maximisation of outputs for a given set of inputs
• effectiveness—the extent to which an organisation achieved its objectives.
36 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
➤➤Question 1.2
Read this extract from a local government planning document.
STRATEGIC OBJECTIVES
STRONG LEADERSHIP
Council will lead our changing city using strategic foresight, innovation, transparent decision
MODULE 1
Source: Maribyrnong City Council 2018, Council Plan 2017–21, Maribyrnong, Victoria, Australia, p. 1,
accessed June 2018, https://www.maribyrnong.vic.gov.au/About-us/Our-plans-and-performance/
Council-plan.
Study guide | 37
What strategic management accounting information may be used to support these objectives?
Strong leadership
MODULE 1
Healthy and inclusive communities
Check your work against the suggested answer at the end of the module.
38 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
The term ‘strategic management accounting’ captures this new and broader role. The focus
is now on assisting the formation, selection and operational implementation of strategies.
This has led to operational management being viewed as strategic implementation, rather than
something that is separate from the strategic process. A key part of the strategic management
accounting concept is its focus on the organisation’s internal and external environments.
By collecting information on internal operations, as well as competitors, customers and suppliers,
and gaining an appreciation for the broader economic environment—including political, social
and environmental factors— an organisation is assisted to respond more quickly to change.
The emphasis on the external environment can be seen in many ways. For example, internal
information (e.g. product costing) is more useful when it is compared with industry and
competitor information. Likewise, evaluating the operating efficiency and profitability of an
organisation can no longer be limited to internal results, but must be compared to external
benchmarks. Therefore, management accountants must focus on obtaining and using this
external information, which is not always easily available. This approach brings the strategic
management accounting function in much closer alignment with both the marketing function—
with its focus on customers—and the strategic planning function of the organisation.
This places greater pressure on people working in these roles to increase their levels of skill.
A variety of techniques have been linked together under the banner of strategic management
accounting. These include target costing, life cycle costing, competitor cost analysis, activity-
based costing and management, and strategic performance measurement systems (Langfield-
Smith 2008). These techniques are discussed in detail in Modules 5 and 6.
Study guide | 39
Table 1.2 provides a summary of the expanded level of work and responsibility that is expected
from management accountants for strategic management accounting compared to traditional
management accounting.
Table 1.2: T
raditional management accounting compared to strategic
management accounting
MODULE 1
Traditional management accounting Strategic management accounting
Job costing and process costing Product costing and activity-based costing and management
Most roles are split into several areas including technical tasks, working with internal stakeholders
such as sales and marketing teams, and project or team management. This will include managerial
work such as supervision, running meetings and ensuring timelines are met.
The move to providing strategic support is combined with the traditional cost management
services that management accountants have always provided. Management accountants are
often placed in different areas of the organisation or within project teams, to provide other
employees with greater access to their capabilities. This also helps management accountants
develop a much greater understanding of the organisation’s products, services, customers and
suppliers, as well as the issues faced by different parts of the organisation.
Risk management and mitigation is another important part of enhancing overall performance.
In addition to financial risk management, operational risk throughout the organisation needs to
be assessed and managed effectively. The effective use of controls to manage risk is a valuable
role that is often performed by management accountants (Cooper 2002).
Accountants bring unique skills to the business adviser role. They are traditional information providers,
understand financial information and are disciplined in the use of control mechanisms. This brings a
seriousness and an analytical approach that can help control risk during the pursuit of new opportunities.
Accountants are also perceived to bring an independent, objective and credible approach.
To maintain this advisory position, accountants must provide a valuable service in areas such as
strategic business planning, customer profitability management, revenue generation strategies,
cost management, information management, competitive intelligence, forecasting, decision analysis,
productivity improvements and cash flow maximisation. When possible, accountants should move
away from their own department and join project teams and other business units to work closely on
specific activities and issues.
Another risk is the possible tension that arises in the ability to switch between encouraging and pursuing
new opportunities, and also ensuring that effective controls and oversight are put in place. Having the
same person attempt to perform both these roles may lead to difficulty, hence, could adversely impact
the quality of the task performed and/or the product. Providing oversight on top of deep involvement
may involve conflicts of interest or time pressures that make it difficult to perform either role effectively.
It may, therefore, be worth considering whether specific and different roles are developed within an
organisation for different accountants—some with a focus on compliance and control, and others who
are more engaged in performance improvement and strategy.
Increased pressure and perceived or actual loss of objectivity are some of the biggest issues facing
accountants as they become more heavily involved in the decision-making process (Chartered Institute
of Management Accountants (CIMA) 2010).
Do you agree with the arguments presented for the business partner or the overseer in relation to
the role of accountants within an organisation?
At more senior levels within the accounting function, accountants must do more than just be
familiar with the numbers. Financial skills need to be coupled with:
• detailed knowledge of the specific business and industry
• the ability to manage team members and the accounting function
• the ability to negotiate and communicate with other executives and external stakeholders.
A matrix of skills has been prepared by the International Accounting Education Standards Board
(IAESB). It details what is required of today’s professional accountant in business. The main
categories include:
• intellectual skills
• interpersonal and communication skills
• personal skills
MODULE 1
• organisational skills (IAESB 2017).
A report by the International Federation of Accountants (IFAC 2011) looked at how management
accountants drive sustainable organisational success. It identified four specific ways in which
management accountants support an organisation:
1. creators of value—developing the plans and strategies that set the direction of
the organisation
2. enablers of value—supporting management decision-making and implementation
3. preservers of value—protecting value through effective risk management,
controls and compliance
4. reporters of value—providing clear and detailed reporting.
A summary of some of the specific types of skill required within each category is presented
in Table 1.3.
Competence Area
(Level of proficiency) Learning Outcomes
(a) Intellectual (i) Evaluate information from a variety of sources and perspectives through
(Intermediate) research, analysis, and integration.
(b) Interpersonal and (i) Display cooperation and teamwork when working towards
communication organizational goals.
(Intermediate)
(ii) Communicate clearly and concisely when presenting, discussing and
reporting in formal and informal situations, both in writing and orally.
Competence Area
(Level of proficiency) Learning Outcomes
(d) Organizational (i) Undertake assignments in accordance with established practices to meet
(Intermediate) prescribed deadlines.
(ii) Review own work and that of others to determine whether it complies
with the organization’s quality standards.
Source: IAESB 2017, 2017 Handbook of International Education Pronouncements, ‘Table A: Learning
outcomes for professional skills’, accessed June 2018, https://www.ifac.org/publications-resources/2017-
handbook-international-education-pronouncements.
MODULE 1
accountants. As discussed earlier in this module, in the rapidly changing business environment,
management accountants are experiencing significant changes in their role and responsibilities.
Therefore, to be competent, management accountants should adapt to the changes, to remain
relevant in the future. Generally, factors such as globalisation, advancements in technology,
and competition have impacted organisational structures, inventory costs and the value chain.
This part of the module also highlights how these changes have prompted the introduction
of various management accounting tools.
Challenges
Some of the key challenges facing management accountants include:
• using technology effectively while guiding others to effectively use management accounting
systems (MASs)
• managing resources
• promoting innovation.
All this is occurring at a time when globalisation and technological advances are changing the
structure and culture of organisations, with many roles now being outsourced. With an increasing
focus on environmental and social outcomes, management accountants are facing challenges
from other information providers who are skilled in capturing and reporting physical information,
including engineers, who will be competing to provide this type of service to organisations.
Technology
There are technology-linked challenges at both the day-to-day operational level and the strategic
level. These include keeping information secure and maintaining customer privacy (Gelinas and
Sutton 2002; Munir et al. 2013). Establishing new and secure sales and distribution channels to
customers over the internet are opportunities that must be managed carefully.
Maintaining records and audit trails for data verification in a computerised environment is also
a significant issue. Effective implementation of major information system projects presents
both a challenge and an opportunity. Technology has allowed the automation of traditional
number-crunching activities and provides the tools to improve the quality of information
provided to management. This, in turn, has increased management’s expectations of
management accountants.
Viewed from a broader perspective, technology is transforming how people compete within an
industry, which is forcing rapid change and innovation—this is highlighted in Example 1.3.
44 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
recorded music sales (unit measure) more than doubled between the early 1980s and the end of the
1990s. It was with this backdrop that the first peer-to-peer file sharing service was developed and
released to the mainstream music market in 1999 by the college student Shawn Fanning. The service
was named Napster and it marks the beginning of an era that is now a classic example of how an
innovation is able to disrupt an entire industry and make large swathes of existing industry competences
obsolete. File sharing services such as Napster, followed by a range of similar services in its path,
reduced physical unit sales in the music industry to levels that had not been seen since the 1970s.
The severe impact of the internet on physical sales shocked many music industry executives who spent
much of the 2000s vigorously trying to reverse the decline and make the disruptive technologies go
away. At the end, they learned that their efforts were to no avail and the impact on the music industry
proved to be transformative, irreversible and, too many music industry professionals, also devastating.
But as always during periods of disruption, the past 15 years have also been very innovative, spurring a
plethora of new music business models. These new business models have mainly emerged outside
the music industry and the innovators have been often been required to be both persuasive and
persistent in order to get acceptance from the risk-averse and cash-poor music industry establishment.
Apple was one such change agent that in 2003 was the first company to open up a functioning and
legal market for online music. iTunes Music Store was the first online retail outlet that was able to offer
the music catalogues from all the major music companies; it used an entirely novel pricing model,
and it allowed consumers to de-bundle the music album and only buy the songs that they actually
liked. Songs had previously been bundled by physical necessity as discs or cassettes, but with iTunes
Music Store, the institutionalized album bundle slowly started to fall apart. The consequences had an
immediate impact on music retailing and within just a few years, many brick and mortar record stores
were forced out of business in markets across the world.
The transformation also had disruptive consequences beyond music retailing and redefined music
companies’ organizational structures, work processes and routines, as well as professional roles. iTunes
Music Store in one sense was a disruptive innovation, but it was at the same time relatively incremental,
since the major labels’ positions and power structures remained largely unscathed. The rights holders
still controlled their intellectual properties and the structures that guided the royalties paid per song
that was sold were predictable, transparent and in line with established music industry practices.
Source: Wikström, P. & DeFillippi, R. 2016, ‘Introduction’, Business Innovation and Disruption
in the Music Industry, Edward Elgar, Cheltenham, pp. 1–2. Reproduced with permission of
the Licensor through PLSclear.
Managing resources
Effective use and control of assets are required for superior results. Mastering areas such as
cash flow management and SCM is essential. Using forecasting and scheduling tools, achieving
reductions in inventory levels and maintaining effective links with suppliers are necessary.
In addition to the tangible assets base, it is important to improve in the areas of recognising,
developing and managing intangible assets, including knowledge (Massingham 2014). It is
more difficult to deal with organisational knowledge, customer and employee loyalty, and brand
management than to focus on traditional cash flow and inventory issues. However, with such
intangibles being a significant contributor to the value of organisations, their management is an
essential task for protecting and improving business value (EY 2018).
Study guide | 45
Innovation
One factor that leads to strong performance is innovation. It drives competitiveness by creating
efficiencies and new and better products. Innovation is both an outcome—that is, a new product or
service—and a process—a combination of decisions, structures, resources and skills that produce
outputs and outcomes. In a more competitive environment, constant innovation is required to
achieve objectives. This can often be incremental innovation—small, minor improvements—but it
MODULE 1
may also involve radical changes (Dodgson 2004). Consistently generating new and improved
products, services and processes (e.g. Apple) is essential to creating customer value. Investment in
research and development (R&D) requires significant cash outlays, but is necessary to maintain
superior performance as shown in Example 1.4.
In 2009, FPB had over 200 employees and a turnover of up to $40 million per annum. It successfully
reduced its carbon output by re-using the heat generated from the baking process for cake and pastry
production. The estimated saving was approximately 5000 tonnes of emission per annum and a more
than 75 per cent reduction in gas per square metre as a result of turning a waste by-product into a
useful input.
It also implemented a real-time monitoring system for energy consumption, and rainwater was used
for flushing toilets. Over 95 per cent of waste was recycled—including plastic, tin, wood and food.
With an estimated $300 000 investment in green initiatives at the time, the financial cost was paid back
just from annual electricity savings of $290 000.
Since then FPB has embraced ‘ethical & sustainable ingredient sourcing’ including ‘premium Victorian
chicken & eggs, hormone free beef’ and committed to ‘continue to reduce our carbon & water footprint
and where necessary offset emissions via tree planting’ (Ferguson Plarre 2018b).
Source: Based on McKeith, S. 2009, ‘Emission magician’, Business Review Weekly, 5–11 November,
p. 50, accessed June 2018, https://www.fergusonplarre.com.au/blog/wp-content/uploads/2017/06/BRW-
Emission-Magician.pdf; Ferguson Plarre 2018a, ‘FAQ’, accessed June 2018, https://www.fergusonplarre.
com.au/about/faq; Ferguson Plarre 2018b, ‘Our history’, accessed June 2018,
https://www.fergusonplarre.com.au/about/history.
For management accountants to remain effective in their role, they must understand the
causes of change in the business environment that affect organisations. This is discussed in
the next section.
46 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
A large number of external factors have led to changes in the contemporary business
environment and, therefore, to management accounting.
External factors include significant upheavals in the global economy, the effects of globalisation
and increased competition, as well as rapidly developing technology. An increasing focus on
corporate governance and a broader stakeholder perspective of corporate accountability
have also had an impact. Sustainability and the need to capture and report a wider range of
information have had an influence. Management accounting has also been affected by internal
factors—for example, structures within organisations have become less hierarchical and more
decentralised in their decision-making.
Economic
turmoil Capital
equipment
Structural Global
Technology
change economy Information
communication
technology
Globalisation
Changing
business Flatter
environment hierarchies
Environmental
management Outsourcing/
accounting offshoring
Internal Joint
Stakeholders Sustainability ventures
structures
Virtual
Ethics
offices
Management
reporting
MODULE 1
for many organisations. In a similar way to illness or disease, we talk about global ‘contagions’
such as potential bank defaults and collapses combined with fear and panic, sending share
markets tumbling.
Years after the start of the Global Financial Crisis (GFC) in 2008, the damaging effects are still
visible at the national level in many countries (e.g. Greece) as well as on individual industries
and organisations. It appears that many underlying issues have been deferred but not resolved.
Difficult times in most economies have led to lower demand and lower prices for many goods
and services. This has increased the focus of management on key areas such as cash flows,
access to funding and ensuring that supply chains are able to continue delivering products or
services. Risk management, forecasting and rapid adaptation to new circumstances are now
critical to successful management of organisations. Cost control and efficiency are also critical
as organisations deal with an extended period of stagnant or declining growth.
At the time of writing, the global economy is more deeply indebted than before the GFC and
countries need to take immediate action to improve their finances before the next downturn.
The International Monetary Fund (IMF) indicated that a prolonged period of low interest rates
had stimulated a build-up of debt worth 225 per cent of world gross domestic product (GDP)
in 2016, which is 12 points above the previous record level, reached in 2009. So it is important to
build a buffer now that will help protect the economy by reducing the risk of financing difficulties
if global financial conditions tighten (Elliot 2018).
Structural change
Many economies are experiencing significant change in terms of:
• average growth rates
• government philosophy on spending
• government, company and individual debt levels
• consumer spending habits
• new regulations.
Table 1.4 reveals actual and forecast GDP growth rates. Before the GFC, economic growth rates
around the world were strong (in 2005) but there was a considerable slump by 2009. Despite some
improvement since then, the high growth levels have not yet returned.
48 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Table 1.4: Actual and forecast gross domestic product growth rates
Source: Based on World Bank 2007, Global Economic Prospects, accessed August 2015, http://www.
worldbank.org/content/dam/Worldbank/GEP/GEParchives/GEP2007/381400GEP2007.pdf; World Bank
2011, Global Economic Prospects, vol. 3, June, accessed August 2015, http://www.worldbank.org/
content/dam/Worldbank/GEP/GEParchives/GEP2011b/GEP2011bFullReport.pdf; World Bank 2014,
Global Economic Prospects, vol. 9, June, accessed August 2015, http://www.worldbank.org/content/
dam/Worldbank/GEP/GEP2014b/GEP2014b.pdf; World Bank 2018, Global Economic Prospects:
The Turning of the Tide?, accessed June 2018, http://www.worldbank.org/en/publication/global-
economic-prospects.
There has been a focus on government austerity, which involves significant reductions in
spending so that government debt may be reduced. This has been combined with individuals
and organisations trying hard to reduce their spending and debt to more manageable levels,
as they are uncertain about the future. Although these are worthy economic approaches,
the flow-on effect for many companies is reduced demand and limited expected growth in the
future. To be more competitive, companies have to reduce prices, cut costs and keep employee
numbers down. As such, many economies are still experiencing slow or negative growth, and so
there is little hope for significant improvement in the next few years for these economies.
To minimise this risk, banks must hold an appropriate level of capital in reserve (capital adequacy),
but this of course will reduce the amount of lending they do, resulting in lower revenues and profits.
An additional problem for banks is the types of lending they undertake. Mortgage based lending,
where residential property is provided as security, is much safer than higher-risk lending secured by
commercial property or where there is no security at all.
Lending with higher risks should be done at higher interest rates to reflect that risk. However, high risk-
taking banks and lenders may do the opposite in an attempt to capture market share. They may
offer customers low interest rate loans without the need to provide security and also lend a higher
amount (e.g. 100% of the purchase price of a house instead of a safer level such as 80%). If too many
of these higher-risk loans default on their obligations—that is, borrowers default on their repayment
obligations—the bank may be severely affected or even collapse. Holding additional capital to adjust
for higher-risk loans is a suitable solution, but it comes at a cost.
Study guide | 49
The Basel Accords (Basel I in 1988, Basel II in 2004, Basel III in 2010) are an attempt by central bankers
to address these problems. The Basel Accords aim to create a robust and stable international banking
system to minimise banking problems and to avoid an international collapse of the financial system—
which nearly occurred during the GFC.
MODULE 1
enable the banking sector to absorb shocks. Other aims include improving risk management and
transparency. The following requirements for banking institutions are to be implemented by 2019,
and each of these has relevant numerical or ratio measures to demonstrate that it has been achieved.
Capital Increasing the level of capital held (as a percentage of risk-weighted assets)
Counter-cyclical buffers are put in place when credit grows too quickly.
This means that rather than encouraging the growth cycle with extra credit
and lending (pro-cyclical), changes are made to slow credit growth (to counter
or reduce the growth cycle).
Leverage Ensuring leverage (use of debt) does not reach dangerous levels
Effect on business
The most likely impact of Basel III on business will be a reduction in credit availability, especially for
higher-risk activities, such as trade credit financing. The cost of borrowing will also increase, although
this is expected to be quite small in most circumstances. The extra cost is estimated to be 5 to 10 basis
points (i.e. 0.05% to 0.10%), which equates to between $50 and $100 per annum on every $100 000
borrowed.
In summary, there will be a dampening effect, where excessive credit growth is tempered, and borrowing
costs are slightly higher. This will lead to (slightly) slower growth and (slightly) lower profits in the short
term. The positive trade-off from a broader economic perspective is a decreased chance of a bank
collapse and a more stable economic environment in which to operate. This should lead to higher
long-term growth and profits.
The Basel III Accord is also discussed in the Financial Risk Management and Contemporary Business
Issues subjects of the CPA Program.
In addition to the cyclical events of the global economy that follow a boom-bust cycle, there are
structural changes in the size and types of industries. This is often caused by new technology,
and these changes also have an effect on organisations. Electronic commerce is accelerating
these changes, and specific examples of structural change include the rapid growth of the
services sector and the decline of manufacturing in many developed countries as shown in
Table 1.5 and Figure 1.7.
50 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
†
The figures in the table are not meant to total 100 per cent.
Source: Based on IBISWorld 2016, ‘Australia’s growth industries’, accessed June 2018,
https://www.ibisworld.com.au/media/2016/08/10/australias-growth-industries/.
Figure 1.7: T
he decline of agriculture and manufacturing and the rise in services
in Australia
Changing importance of industry divisions
Shares of GDP by industry division, 1800−2050
100
Agriculture
Primary
Sector
Mining
90 Manufacturing
Secondary
Sector Utilities
80 Construction
Tertiary
Sector Wholesale trade
70 Retail trade
Transport, Postal
Percentage
1880
1900
1920
1940
1960
1980
2000
2020
2050
Year
Note: At market prices to 1940, at factor cost thereafter Source: N.G. Butlin, ABS and IBISWORLD 01/06/17
Source: Ruthven, P. 2017, ‘Ages of progress’, IBISWorld, 23 June, accessed June 2018,
https://www.ibisworld.com.au/media/2017/06/23/ages-of-progress/.
Study guide | 51
The data in Table 1.5 must be interpreted with care. Although Australian agricultural activity as a
percentage of GDP has declined from 23 per cent to 2.2 per cent, this does not mean that there
has been a physical or monetary decline in terms of activity, produce or output. Rather, this data
indicates that the rest of the Australian economy has grown even more rapidly.
Despite the decline of Australian manufacturing starting over 50 years ago, this structural change
MODULE 1
has caused significant difficulty for many organisations. For example, at the time of writing,
car makers that have stopped producing vehicles in Australia include Mitsubishi, Nissan and
Renault. By 2016 there were only three car makers remaining in Australia (Ford, Holden and
Toyota Australia). Ford stopped manufacturing cars in Australia in 2016, Holden closed its
Australian operations on 20 October 2017 and Toyota ceased plant production on 3 October
2017. The economic impact for the hundreds of suppliers and thousands of employees as
well as the general community has been significant, and this will continue as this industry
slowly disappears.
These changes are not limited to Australia. Even many Chinese manufacturing organisations are
struggling to stay profitable because of rising labour costs and an inability to pass higher costs
on to consumers.
Globalisation
Globalisation can be described as the integration of international economic activity and the
creation of global production systems to service global markets. Significant reductions in trade
barriers, lower transport costs, increasing competition across national borders, large multinational
corporations, unrestricted capital flows and faster information transfers have all had a significant
effect on organisations.
As organisations have been exposed to an increasingly tough business environment, they have
struggled to survive or even failed. However, as a result of globalisation, many opportunities
have also arisen. Organisations that are flexible have been able to take advantage of these
opportunities and take sales and profits away from those who have been too slow or unable
to adapt.
Globalisation creates difficult issues that must also be addressed. These include:
• taxation
• protection of IP
• cross-border money laundering
• financing of illegal activities.
Such issues often arise because of different cultures, rules and levels of enforcement in different
countries and regions.
Global competition
Organisations have a variety of reasons for expanding globally:
• The local market for their products may be saturated or in decline.
• They may be pursuing rapid growth.
• They may be focusing on obtaining lower-cost raw materials and labour.
• It may be a defensive strategy because low-cost competitors have entered their
MODULE 1
domestic market.
• It may be a strategy to avoid trade barriers such as quotas, which limit the level of goods
one country is allowed to export to or import from another.
The internet has also enabled smaller organisations to immediately compete globally, rather than
spending years developing a local market before expanding into new countries.
Example 1.6 provides some historical context for how globalisation developed.
The current wave of globalisation has seen these global leaders fall behind, as powerful new
organisations set the benchmark. For example, combined losses for Sony, NEC and Panasonic have
been in the tens of billions of dollars over the last few years, and newer competitors are taking over.
At the same time as the cost of shipping goods by air or sea has fallen substantially, advances in
telecommunications have dramatically reduced the cost of international business communication.
Technological changes, such as the use of wireless communications for phone calls and internet
use throughout Africa and India, have meant that many areas previously cut off from the global
economy are now able to participate without the need for significant infrastructure expenditure.
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Example 1.7: The US tariffs
In 2018 the US administration announced steel and aluminium tariffs that:
are necessary to protect national security and the intellectual property of US businesses.
Source: Bryan, B. 2018, ‘Trump’s tariffs are starting a trade war with Europe, Mexico, and Canada:
Here’s what tariffs are, and how they could affect you’, Business Insider, accessed July 2018, https://www.
businessinsider.com.au/trump-tariffs-what-is-a-tariff-meaning-for-prices-consumer-2018-3.
International political forces have responded with a progressive series of negotiations intended to
reduce tariffs and create greater liberalisation of trade. The World Trade Organization (WTO) has
proved central to this effort. In addition, regional economic and trade organisations, such as the
European Union, the North American Free Trade Agreement (NAFTA) and Asia Pacific Economic
Cooperation (APEC), have become increasingly prominent in recent years. Many countries are
also harmonising their commercial law and accounting practices, increasing uniformity and
making international business more accessible and less risky. However, the US administration
has been taking a more protectionist stance on global trade since President Trump came into
office, withdrawing from the Trans-Pacific Partnership, demanding a renegotiation of NAFTA
and generally taking a tougher stance on global trade deals.
For management accountants, as globalisation increases, the ability to obtain relevant information
and evaluate decisions across a wider level of issues becomes important. For example, issues such
as transfer pricing, insurance, political risk, IP risk and foreign currency management all arise in
the global context and add complexity to management accounting roles.
54 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
➤➤Question 1.3
Identify three competitor-related issues that an organisation might face as a result of the local
currency becoming stronger.
1.
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2.
3.
Check your work against the suggested answer at the end of the module.
➤➤Question 1.4
Consider your organisation or one that you are familiar with and describe how this organisation
has been affected by globalisation.
Check your work against the suggested answer at the end of the module.
Technology
Two areas in which technology is having a significant effect are capital equipment and information
and communications technology (ICT). Capital equipment transforms organisations and industries
by allowing faster and cheaper production and by accelerating product life cycles. ICT is changing
how information is collected and analysed as well as interaction with clients and suppliers.
Study guide | 55
Capital equipment
Rapid development has meant that current technologies are significantly advanced compared
to technologies of earlier generations, and future technologies will only accelerate this
advancement. Physical systems and processes allow organisations to convert raw materials
into outputs faster, with more efficiency and less waste.
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A recent example is additive manufacturing. Figure 1.8 provides an example of powder-based
laser sintering technology, which is an industrial 3D printing process:
The system starts by applying a thin layer of the powder material to the building platform.
A powerful laser beam then fuses the powder at exactly the points defined by the computer-
generated component design data. The platform is then lowered and another layer of powder
is applied. Once again the material is fused so as to bond with the layer below at the predefined
points (EOS 2018).
However, the cost associated with these technologies, and the cash requirements to purchase
and support them, are also increasing rapidly. Many industries now have significant barriers to
entry due to capital infrastructure costs. A further impact on costs that needs to be managed
effectively occurs because a large proportion of funding is often committed when the product
and production process are designed.
Products are developed faster but superseded quickly, as current forms become obsolete at
a rapid rate. Therefore, investments need to be recovered or recouped in a shorter period.
The solar power industry highlights some difficulties in pursuing successful and profitable
strategies. Significant capital investment is required to build solar power facilities, which often
require several years to generate a suitable return. However, during that time, technology will
improve so rapidly that new competitors can enter the market with lower cost structures,
meaning that the initial capital investment may never be realised.
56 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
There are constant developments in the ICT area. Many of these affect the management
accounting role in terms of cost control, risk management, data capture and analysis,
and communications within the organisation and with stakeholders.
Some important trends that have arisen and need to be managed carefully are described in
the following section.
Cloud computing
Faster internet access has enabled the development of internet-based storage, software
applications and programs, including whole IT platforms—including operating systems—
provided from the ‘cloud’. Key services include:
• SaaS—software as a service
• IaaS—infrastructure as a service
• PaaS—platform as a service.
This creates many benefits including reduced costs in purchasing capital items such as storage,
reduced need for in-house technical knowledge and the ability to deploy employees globally
with instant access to organisational information. Risks of this approach include exposure to
data loss, theft, privacy issues and jurisdictional issues. These risks increase and are of particular
concern when the data or information is stored or hosted in a different country than where it is
being used. Privacy and jurisdictional issues overlap here because the privacy or other laws in
the hosting country may differ from those in the user country.
Big data
The amount of data that is now being collected and stored is growing exponentially. The data
is often in unstructured or difficult-to-analyse formats, but the ability to analyse this information
provides significant insights into customer behaviour and business activity. Developing the
ability to analyse and interpret this data is an important requirement for improving performance.
Big data is discussed further in Module 2.
Study guide | 57
➤➤Question 1.5
Identify four technological developments and the effect they have had on management accounting.
1.
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2.
3.
4.
Check your work against the suggested answer at the end of the module.
58 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Sustainability
Long-term sustainability is a significant area of discussion and business activity that has been
gradually gaining momentum over the past 20 years. A short-term approach to decision-making
can often have undesirable long-term consequences. For example, the news media is often filled
with discussion about dwindling natural resources, toxic outputs from commercial processes,
food security and access to water. Considering sustainability when conducting strategic
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analysis and making decisions places the focus on taking action that is not only beneficial
now, but beneficial or at least not harmful in the future.
Despite a trust being set up to manage funds earned during the mining period, mismanagement
meant that once the phosphate reserves were exhausted there was little left to provide for the
population. The island now has significant environmental damage, unemployment is estimated to
be 90 per cent and there are many health issues—for example, nearly three-quarters of Nauruans
are obese with 10 per cent having type 2 diabetes due to dietary changes that came with increasing
wealth. The economic, environmental and social issues that have arisen are all closely intertwined and
demonstrate that a lack of sustainable action can have devastating consequences (Asian Development
Bank 2007; LoFaso 2014).
From an economic sustainability perspective, a useful example is the banking crisis that arose
during the 2000s as a result of unsustainable lending practices. Easy access to credit resulted in
loans to many people and businesses that were not in a position to service or repay their loans
over the long term. The consequence of so many people and countries living beyond their
means was a contributing factor to the GFC.
Examples of unsustainable social activities include sweatshops in the textiles industry, which use
extremely poorly paid labour in dangerous working conditions to produce low-cost clothes and
shoes. Similar examples exist in the electronics assembly industry, where employee deaths have
led to greater awareness and monitoring of working conditions. At a broader level, demographic
changes, such as increased population growth and migration from rural to urban areas, are also
having a significant impact on sustainable living.
Industries that have seen, or may see, significant decline due to unsustainable environmental
practices include fishing, where fish stocks have been overfished and are not reproducing at an
adequate rate, and agricultural production, where soil nutrients have been completely eroded.
Organisations within those industries therefore need to adapt or change to assure their longer-
term, sustainable future. The most obvious example of this adaptation is in the energy industry,
where clean energy and sustainable technologies, such as wind and solar power, are replacing
fossil fuels and non-renewable resources, such as coal and oil.
Study guide | 59
MODULE 1
accountable for more than just economic results.
Organisations are no longer just accountable to their owners. There is a growing body of opinion
that argues for greater accountability of organisations to a broader body of stakeholders.
This growing focus on a wider range of stakeholders has also led to significant change within
organisations, especially with regard to how they report and what information is reported.
Important non-financial information is now presented, and in many cases, environmental data
is legally required to be measured and reported. Accountability for financial performance has
been expanded to consider both the social impact and environmental impact, based on ever-
increasing amounts of regulation.
This broadening focus on stakeholders is not limited to business. Governments, the public
sector and not-for-profit organisations are being held to greater levels of accountability as the
community becomes more informed and demands more information. For instance, government
departments and agencies are subjected to performance auditing with a strong focus on outputs
and outcomes, rather than just an account of the income received and expenses incurred.
The concept of EMA has been in existence for many years, and has been defined as:
The management of environmental and economic performance through the development and
implementation of appropriate environment-related accounting systems and practices. While this
may include reporting and auditing in some companies, environmental management accounting
typically involves life cycle costing, full cost accounting, benefits assessment, and strategic planning
for environmental management (IFAC 2005, p. 19).
60 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
The Expert Working Group of the United Nations Division for Sustainable Development (UNDSD)
emphasised both the physical and monetary aspects of EMA in its definition:
… the identification, collection, estimation, analysis and use of physical flow information
(i.e., materials, water, and energy flows), environmental cost information, and other monetary
information for both conventional and environmental decision-making within an organization
(UNDSD 2002, p.11).
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EMASs have developed over the past decade. Standard accounting information systems (AISs)
typically capture financial transactions. EMASs do more much more than this by also recording
the physical flows of resources, including volumes and weights of inputs, outputs, waste,
recycling and emissions. Having access to this information often leads to increased incentives
to change and improve as people become more aware of the unnecessary cost and waste
associated with poorly managed resources. As more organisations adopt external sustainability
reporting approaches, such as the GRI Standards, this functionality will become expected
and normal.
Ethics
Ethics and its relationship with strategic management accounting should be considered in
several ways. It is important to incorporate ethical implications in organisational decision-making.
Management accountants provide significant input into these decisions, so it is important to
be aware of such non-financial issues and ensure they are properly considered in the decision-
making process. Sometimes, choosing the most profitable or cost-effective approach may have
significant ethical implications. For example, consider the decision to terminate the employment
of a workforce in one country and replace it with a new workforce in another, cheaper location.
The cheaper location may have limited safeguards for employees for work health and safety
(WHS) (as highlighted in Example 1.9) and minimum wages that reflect local standards.
The management accountant should ensure that these ethical issues are included in the
organisation’s decision-making process.
Example 1.9: O
utsourcing in the textiles and garment-
making industry
In Bangladesh there have been many terrible incidents including fires and building collapses because
of poor safety standards. In 2013 a building called the Rana Plaza in the capital city of Dhaka collapsed,
and over 1100 workers died. Over 2500 workers were rescued from the building alive, but some suffered
dreadful injuries and now have permanent disabilities. As a result, there have been changes in how
the industry operates, although there is still a lot of improvement required.
CPA Australia members are expected to act ethically at an individual level when performing their
roles. Members are expected to comply with the Code of Ethics for Professional Accountants,
published by the Accounting Professional and Ethical Standards Board (APESB), which has
an overarching requirement to act in the public interest. The fundamental principles that a
member is required to abide by are integrity, objectivity, professional competence and due care,
confidentiality and professional behaviour. In Example 1.9, the accountant may not be considered
to have acted in the public interest or in accordance with the fundamental principles of ethics
if they were to ignore serious WHS issues.
A detailed examination of different stakeholders, CSR and ethics is provided in the Ethics and
Governance subject of the CPA Program.
Study guide | 61
The term ‘organisational structure’ describes how an organisation is organised. This may involve
having different departments that work on:
• specific functions—for example, sales, marketing, accounting, customer service
• particular product lines—for example, mortgages, credit cards, personal loans.
Some organisations have many managers, senior managers and executives. There may be several
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levels in the hierarchy from the lowest level employees up to the CEO. In other organisations,
there may be only one level of management that directly interacts with employees. This is known
as a flat hierarchy.
An organisational structure includes all the people, tasks and responsibilities given to different
areas and the authority delegated to different positions within an organisation. A traditional
functional structure separates the organisation into distinct groups based on the functions they
perform. Each of these functions is a centre of responsibility for individual managers, who may
be held accountable for performance in their specific area. For example, the general manager of
sales is usually in charge of the sales department, and the chief financial officer (CFO) is in control
of the accounting department.
Organisations that are structured in a functional way usually create accounting systems that
match this. This type of accounting system is called a responsibility accounting system (RAS).
The RAS collects revenues and costs and also measures the performance of these responsibility
centres. This enables the organisation to hold managers of these centres accountable for their
performance. Figure 1.9 outlines what managers of the various responsibility centres are held
accountable for.
Responsibility
centres
Flatter hierarchies
As a response to external changes, and to generate improvements in efficiency and effectiveness,
the structure of many organisations has undergone significant change. Hierarchies have
become flatter, with fewer levels of management and reduced bureaucracy between senior
management and the lowest level of employees. A key influence on this change has been an
attempt to eliminate costs by reducing the number of middle managers and replacing them
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with IT. Another influence has been the attempt to create organisations that are more flexible
as information and decisions move rapidly between the layers of the organisation. Less middle
management has resulted in the transfer or delegation of authority to lower levels of the
organisation (often described as employee empowerment) and a greater need to attract and
develop highly skilled staff.
As part of the move towards flatter structures, significant changes have occurred to the traditional
organisational structure, including:
• offshoring and outsourcing
• virtual offices and global teams
• joint ventures (JVs) and alliances.
Outsourcing, on the other hand, is when an organisation pays another organisation to perform
work that was previously done internally. Work may be outsourced locally or to companies based
overseas. This has altered the traditional hierarchical structure of organisations.
Traditionally, organisations have focused on shifting low-skilled work from high-labour-cost areas
to low-cost locations. Over time, organisations have also been able to shift large parts of their
highly paid, highly skilled work (e.g. computer programming) to low-cost economies (e.g. in
India) where technical skills are available.
Viewing organisations as a chain of activities and processes that flow across departments has also
led to structural change. Instead of thinking of an organisation in terms of its final product, it is
viewed in terms of the activities that add value and those that do not. Many organisations have
found they are very capable in one activity, but poor or mediocre in other areas. This has led to
an increasing trend of outsourcing non-core activities, which allows an organisation to focus its
attention on the areas where it generates value most effectively.
Examples of outsourced activities include warehousing and logistics, data processing, payroll,
and information systems installation and maintenance. A further expansion of this concept is a
franchising relationship, where the whole business model is outsourced. Franchising has become
a popular way for the original creators of businesses to accelerate their growth and for other
entrepreneurs to develop a business faster through the use of an existing brand name and
business process (IBM 2004; Walker 2004a; Child 2015).
Management accountants have a variety of roles to perform as a result of this change. These
include evaluating choices of whether to make or buy an item and where production should
occur. Once these decisions are made, it is also important to develop performance measurement
systems and control mechanisms to protect assets and ensure accountability.
Study guide | 63
Offshoring and outsourcing are also discussed in the Contemporary Business Issues subject of the
CPA Program.
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or videoconferencing technology. The benefits of this include using the best qualified people
for the job regardless of location, work being carried out 24 hours a day (due to time zone
differences) and using lower-cost labour locations. Some negative outcomes include language
barriers, cultural differences and difficulties in supervision. Virtual offices provide similar benefits,
where the employees of an organisation from the same region or location may not be fixed to
a specific office location.
All but one of the world’s 20 biggest full-service network airlines are now signed up to one of the
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There are a number of reasons for the emergence of global airline alliances:
• More people want to fly to more places more easily and for greater value – but government
restrictions and business economics make it impossible for any one airline to serve all these markets
by itself. Allying with like-minded partner airlines enables carriers to provide their customers with
global travel solutions.
• In the drive to reduce costs, airlines can achieve substantial efficiencies through working more
closely together.
• Alliances help boost airlines’ revenues and provide opportunities to maintain more routes and
frequencies, by transferring passengers between members’ networks.
• Individual passengers and corporate customers are increasingly recognising the value and benefits
which alliances can offer them.
Source: Qantas 2018, ’Introduction to oneworld: An alliance of the world’s leading airlines working
as one’, accessed July 2018, https://www.oneworld.com/news-information/oneworld-fact-sheets/
introduction-to-oneworld.
➤➤Question 1.6
List three advantages and three disadvantages of outsourcing business operations.
Advantages Disadvantages
1. 1.
2. 2.
3. 3.
Check your work against the suggested answer at the end of the module.
Study guide | 65
Management reporting
In response to the significant changes that are happening with internal structures and externally,
there has been significant development in how management reporting occurs. In the past,
organisations may have produced a monthly management report 10 to 15 days after month-
end. Now, many organisations are able to perform month-end processes in only a few days and
sometimes within a few hours. The management reporting role has also expanded from just
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producing the numbers, to analysing and interpreting the numbers that are generated from the
information systems.
Beyond this, the opportunity to have ongoing access to real-time data means that it is possible to
report on critical performance indicators in real time. Weekly summaries and constant monitoring
have replaced monthly meetings, leading to rapid identification of issues and opportunities,
as well as faster response times.
Management reports need to convey much more than just financial performance. They should
also include many of the items shown in Figure 1.10. These items are discussed in Modules 4 to 6.
Leading
Projects
indicators
Management
Non-
reports
financial
performance Competitor
activity
Industry
• Physical volumes and flows,
analysis • Estimates of competitor
including throughput,
emissions and waste cost structures and pricing
• Employee performance, • Analysis of competitor
satisfaction and strategies and potential
engagement • Growth and profitability responses
• Efficiency and quality results including life cycle and
business cycle analysis
• Impact of current or
potential regulations or
political changes
Designing and implementing effective MASs that capture and report this data in a quick and
efficient manner is an important role for management accountants.
➤➤Question 1.7
Apart from the factors described in this section, can you identify other factors that have affected
MODULE 1
Check your work against the suggested answer at the end of the module.
Study guide | 67
MODULE 1
tools and techniques include the organisational and industry value chain analysis, SWOT analysis,
the Boston Consulting Group (BCG) growth/share matrix, Porter’s five forces model and PEST
analysis. The challenge is not in selecting the best tool, but in using the most relevant tool and
technique given the business issue or opportunity.
Table 1.6 and Table 1.7 outline a variety of ways management accountants can support managers
both at the strategic and operation levels.
Table 1.6: Strategic management accounting and the strategic management process
Strategic tasks Tools, techniques and accounting information that may be useful
Internal analysis Examine BSC results, product life cycle costing, market share, product
profitability, activity evaluation and costing. Create and report on financial
and non-financial (quality, time, innovation, customer satisfaction)
performance measures and customer profitability analysis.
External analysis Estimate competitor costs and capital investment projects. Conduct
industry life cycle growth and profitability analysis. Obtain supplier
and customer intelligence to identify their bargaining strengths
and weaknesses.
Strategic planning and choice Evaluate and rank the feasibility and profitability of strategies, considering
both capital budgeting (discounted cash flow measures) and strategic
costs/benefits.
Strategic implementation Provide accurate and timely costings as well as financial and non-financial
performance results during the implementation process.
Strategic evaluation Provide accurate key performance indicators that measure the success
achieved by the strategy. Review the effectiveness of the strategic
management process in terms of accurate estimates and costings,
and the appropriate use of performance measures and incentives.
Table 1.7: G
eneric operational management tasks and strategic management
accounting support
Many of these approaches are discussed in later modules, and some are discussed in greater
detail in the Global Strategy and Leadership subject of the CPA Program.
The following section provides an overview of some of the tools and techniques most relevant
for this subject.
Value analysis
Value and the value chain were introduced in Part A of this module. A value chain is a network
of interrelated activities that provides value to customers and other stakeholders.
Organisations exist to create value. Organisational objectives identify each stakeholder group
and how to create and deliver value to that group. Strategies are plans for delivering this value
through value chains. Value chains achieve the strategic objectives through their activities.
Activities and value chains must be continually analysed to optimise the design of the activities,
and of the value chain itself. The organisation and its environment are dynamic, and optimisation
is a moving target.
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• identifying primary or support activities that either do not add value or actually destroy
value—non-value-adding activities should be minimised or, if possible, eliminated
• using substitute—less costly—inputs for activities
• conceiving new ways to conduct activities, like designing new processes or implementing
new technologies
• linking the activities within its value chain in a more effective way than competitors do.
A ‘non-value-adding activity’ means that customers do not compensate the organisation for the
costs incurred in carrying it out—for example, storage of inventory. Organisations can reduce
the total cost of their value chains by eliminating or reducing activities that customers do not
value. This may also help them to shorten the duration of innovation and production cycles,
and reduce the time it takes to bring new products to market or fill customer orders; this, in turn,
may lead to improved competitive advantage.
Understanding an organisation’s competitive position in its industry value chain has significant
strategic implications. If some value chain roles in an industry are relatively unprofitable, it may
be wise for an organisation that operates across the entire industry value chain to outsource or
divest itself of less profitable activities. Alternatively, an organisation may secure a competitive
advantage by better managing the linkages it has with its suppliers (and customers) up and
down the industry value chain. As mentioned earlier, linkages can take the form of, for example,
outsourcing, JVs or alliances. An alternative to increasing upstream and downstream linkages
in the value chain is vertical integration—that is, acquisition of suppliers (upstream or backward
integration) or customers (downstream or forward integration).
An organisation must carefully consider the value chains of its suppliers and customers before
introducing any performance-improvement initiative targeted at its own value chain. Simply
shifting costs to suppliers or customers will not change the overall value created in the industry
value chain, and customers will have an incentive to shift their business to lower-cost (higher-
value) supply chains.
One other factor important to competitive advantage is the ability of an organisation to develop
and display its value-adding capabilities through reputation and branding. The greater and more
unique the organisation’s value-adding activities, the greater the reliance other parties are likely
to place on the organisation, and the stronger the organisation’s position becomes in the value
chain (Pfeffer and Salancik 1978). This is highlighted in Example 1.11.
The main lesson for management accountants is that knowledge of both organisational and
industry value chains is essential to strategic analysis. If an organisation does not know how it
provides value to its customers, and does not understand its role in the industry value chain,
it cannot develop a meaningful strategy.
The introduction of a just in time (JIT) system provides an example of how competitive advantage
can be gained from the development of close linkages between an organisation and its suppliers
and customers. A JIT system is an inventory strategy that aims to reduce the stockpiling of goods by
supplying them only when required for use.
In order for a JIT system to be successful, customers must cooperate by providing reliable long-
term purchase orders for the organisation’s products, and suppliers must be able to reliably deliver
required quantities of high-quality inputs at regular intervals. The successful linking of an organisation’s
operations with those of its suppliers and customers through adoption of a JIT system throughout the
supply chain should reduce the cost of raw materials, work in progress and finished goods inventories
for all supply chain participants and increase total industry value.
Consider a car manufacturer who wants to increase customer value by cutting inbound logistics costs.
A value analysis of activities suggests that inventory carrying costs are significant and the cost of this
activity would be reduced by the introduction of a JIT system for the delivery of parts.
Example 1.12 illustrates how value analysis within an organisation is complemented by value
analysis of the linkages between organisations in the supply chain.
View the mini-lecture presented by Eugene O’Loughlin on value analysis, where O’Loughlin shows
how to analyse the value provided by a simple product. As he notes, however, this value analysis
process can be applied to any unit of analysis: a business, a product, an activity or an individual:
http://www.youtube.com/watch?v=TT6tVH6cDMM.
For practice in value analysis, please access Stage 1 of the ‘Save or close the hotel?’ Business
Simulation on My Online Learning.
Figure 1.11 illustrates how an organisation’s strategy should be framed by factors present in
the organisation’s external and internal environments.
Study guide | 71
• Political External
• Economic environment
• Social
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• Technological
Internal
Strategic framework
environment
• Vision
• Mission
• Values
• Goals and objectives
In the following two sections, four tools that support SWOT analysis are presented:
1. product life cycle analysis
2. the BCG matrix
3. Porter’s five forces model
4. PEST analysis.
The first two are tools for analysing an organisation’s product portfolio, Porter’s five forces model
is a tool for industry analysis, and PEST analysis addresses the external environment.
View the video on SWOT analysis by Erica Olsen (2008a) on YouTube: ‘SWOT analysis: How to
perform one for your organization’. Olsen summarises the basic parts of a SWOT analysis and
provides practical illustrations: http://www.youtube.com/watch?v=GNXYI10Po6A.
For practice in completing a SWOT analysis please access Stage 1 of the ‘Save or close the hotel?’
Business Simulation on My Online Learning.
Internal analysis
The purpose of the internal part of a SWOT analysis is to identify the organisation’s strategically
relevant strengths and weaknesses. As each organisation is unique, what is relevant for any one
organisation cannot be generalised.
An accepted approach to understanding how organisations can draw on their inner strengths
to create a sustainable competitive advantage is generically referred to as resource-based
theory. In this approach, each organisation is seen as having a set of distinctive capabilities and
reproducible capabilities. Only distinctive capabilities can lead to a sustainable competitive
advantage—for example, patents, strong brands, supplier relationships and government
licences. Reproducible capabilities can be copied by other organisations—most technical
capabilities are reproducible.
72 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Prahalad and Hamel (1990) introduced a similar idea of the ‘core competency’. They showed the
importance of understanding the core competencies that an organisation has—those things that
the organisation is able to do better than the competition.
Figure 1.11 identified some general categories that should be considered in an internal strategic
analysis:
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A product’s life cycle can be divided into four distinct stages as shown in Figure 1.12
Study guide | 73
1. Introduction
• Organisation introduces a
new product into the market.
• Risky stage—prices tend to
be high and demand low.
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• No guarantee marketplace
will accept the new product.
4. Decline 2. Growth
• Market is saturated. • Market has accepted the
• Sales volumes decline. Product new product.
• Intense competition. • Rapid increase in market size.
• Cash flows might be
life cycle • Competitors enter the market.
negative. • Prices drop.
3. Maturity
• Sales volumes increase
at a lower rate.
• New investment is low.
• Cash flows increase.
• Profits start to decline.
• Competition increases.
Product life cycle analysis holds that each stage of a product’s life cycle has different cash
flow and profit implications. Products in the early stages of their life cycle, introduction and
growth, require high levels of cash investments in design, and for new manufacturing plant and
marketing. In the maturity stage of the product life cycle, little investment is required and cash
inflows increase dramatically. In the decline stage, revenues are reduced while service obligations
must be met.
A strategically balanced product portfolio is one that contains both new and old products.
Mature products provide cash inflow for investment in the development of new products,
which will in turn provide cash flow for the next generation of products.
Introduction
At the introduction stage, the organisation may be able to take advantage of barriers that
restrict immediate entry by competitors to the new product market—a ‘first mover’ advantage.
This temporary monopoly position may enable the organisation to charge a high price before
rivals enter the marketplace. Such a pricing policy can recoup the costs of product R&D quickly.
Alternatively, the organisation may opt for a low-price strategy to build a dominant market
position. This latter form of pricing is known as penetration pricing. As market dominance is
established, the organisation can then increase its prices.
74 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Growth
In the growth stage, the market has accepted the new product. A rapid increase in market size
is expected. Seeing the success of the product, competitors enter the market. A consequence
of increasing competition is that prices drop. This is caused partly by organisations engaging in
price competition to gain market share, and partly by the cost savings manufacturers achieve
through economies of scale and learning. If entry to the market is expensive, the growth stage
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To meet demand at this stage, the organisation will need to invest in new manufacturing capacity
and new marketing, promotion and distribution capacity. However, this stage can generate the
highest level of profits in the product life cycle.
Maturity
Although sales volumes might still increase in the maturity phase, they increase at a lower rate.
New investment is low and cash flows increase while profits start to decline. Product promotion
activity may fall as consumers adopt a brand. The number of suppliers is reduced as some
leave the market or merge to obtain greater economies of scale in production, marketing or
distribution. As growth slows, competition increases and competitors seek to maintain market
share through price reductions.
Decline
The market is saturated and sales volumes decline due to technological obsolescence and
substitute products. Intense competition takes place, with price promotion and advertising
forcing unsuccessful suppliers to exit the market. Cash flows might be negative at this stage
due to warranty, parts supply or other ongoing service commitments.
The stages of the product life cycle are further explained in Example 1.13.
Another example is the ‘tablet’ device first popularised by Apple’s iPad. Following Apple’s introduction
of a high-priced tablet, several manufacturers rushed new products to market and a strong growth
phase began. Subsequently, prices fell dramatically. Apple is now challenged to introduce new models/
features and stimulate further market growth. If this is not possible, the product will become mature
and some manufacturers will inevitably drop the product from their portfolio.
High Low
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High
Rate of market growth
Source: Adapted from Smith, M. 1997, Strategic Management Accounting Issues and Cases, 2nd edn,
Butterworths, Sydney, p. 119. Reproduced and adapted with permission of LexisNexis.
Market growth is important. Even though high-growth markets require significant investments
of cash, it is easier and less costly for products to gain market share in growth markets than
in mature markets. An organisation’s competitive position, as measured by market share,
is indicative of the profitability and cash-generating ability of the product. The stronger the
organisation’s market share, the more likely it is able to control its profit through reducing input
costs, low-cost production through economies of scale, and control of prices.
The BCG approach to product analysis differs from product life cycle analysis because it
disregards the time element and it does not assume that all products will grow and mature.
Some products will never enter the growth phase (dogs). Others will grow but never achieve
market dominance (question marks). However, the two techniques together provide a good
understanding of an organisation’s product portfolio, and form an important part of an
organisation’s internal analysis.
76 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
For practice in completing a BCG matrix, please access Stage 1 of the ‘Save or close the hotel?’
Business Simulation on My Online Learning.
External analysis
The business environment is dynamic and, to succeed, organisations must be dynamic and
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responsive. Prahalad (2001) argued that the strategic space available to organisations is
expanding and provides unlimited opportunities to the strategist. Opportunities arise from
many sources, including:
• changes in the national and international regulatory environments
• the emergence of new products, markets, industries and economies
• new technologies—for example, new distribution channels made possible by the
digitisation of products like music, film, TV and education
• the convergence of technologies—for example, cameras, phones, computers and
navigation systems.
Organisations need to understand where they are situated within their industry. For example,
a profit-making organisation must be aware of its competitors’ strengths and weaknesses so as
to identify threats to its own position, and opportunities for growth and profitability. Without an
understanding of the competitive environment, an organisation is unable to plan effectively or
develop a meaningful strategic position.
The aim of industry analysis is to understand how competitive forces create the profitability
(prices, costs, investments) of the industry. An understanding of competitive forces can help to
identify new strategies that shift competitive forces and create a higher return on investment.
For example, if industry profitability is driven by price competition, it might be possible to shift
the basis of competition by introducing a new customer value proposition based on provision
of additional services like stock management or fast delivery.
Industry analysis should start by defining the industry. Errors can arise from a focus on the
wrong industry, or from defining the industry too broadly or narrowly. A narrow viewpoint
might overlook potential linkages across products and markets. A broad viewpoint might miss
important distinctions between products and markets. For example, does the local market for
petroleum have unique and important characteristics, or is the industry global in its scope?
Are cars and motorcycles in the same industry, or in two separate industries?
To answer these questions in a way that is useful for strategic analysis, it is necessary to look
at the industry’s suppliers, buyers, competitors, barriers to entry and so on. In the petroleum
industry example, if the local industry is the appropriate unit of analysis, a local strategy is
needed. If not, then a national or global strategy is required. In the second example, if we
conclude that cars and motorcycles are in different industries, then an organisation will need
a separate strategy for competing in each product category. Porter (2008) explained that,
if differences between products or between geographic markets are large, then different
industries might be present.
A second important factor in industry analysis is the chosen time frame. Strategic analysis should
not be overly concerned with temporary fluctuations in prices or demand, but should focus on
the industry’s business cycle, whether in the short term/run (e.g. mobile phones) or in the long
term/run (e.g. mining).
Study guide | 77
Industry analysis should be quantified, and this is a key responsibility for the management
accountant. For example, in assessing buyer power, it is important to determine how many
buyers exist, and the market share of each buyer. For example, if you are a supplier to the
Australian retail food industry, buyer power is high because just two large organisations,
Coles and Woolworths, sell between 60 and 70 per cent of Australian groceries between them.
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Porter’s five forces model
According to Porter (1985, 2006), the strategic environment of an industry is shaped by five forces.
Not all industries are susceptible to the threat of new entrants. Significant economic disincentives
may act as barriers to entry. These could include:
• legal constraints in the form of limited licences—for example, the television, radio or
telecommunication industries—or patents
• technological barriers in the form of secret or innovative production processes or product
formulations that cannot be readily copied—for example, pharmaceuticals
• availability of financial resources for investment in the industry
• economies of scale that enable existing industry members to decrease unit costs to a level
that a competitor cannot match in the short term
• brand reputation barriers give established industry members a strong reputation in the
market and high customer loyalty.
Force 3: Customers
When an organisation has powerful customers, its strategic position is weakened. Alternatively,
when the organisation has power over its customers, this is a source of strategic advantage.
A customer may have some power over the prices at which sales are made because
the customer:
• purchases large quantities, so is an important customer
• might attempt to take over the organisation—backward, or upstream, integration
• can switch to alternative products or suppliers at little incremental cost.
78 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Force 4: Suppliers
Supplier power is the opposite side of customer power. Powerful suppliers have a strong effect
on an organisation’s sustainable competitive advantage because they can drive up the price
of business inputs. A supplier may have power because:
• The supplier is significantly larger than the organisation it is selling to.
• The supplier might attempt to take over the organisation—forward, or downstream,
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integration.
• Alternative products or suppliers are not available to the buyer.
• The product provided by the supplier is important to the organisation in terms of the value
of its own products.
Intense competition through price discounting in the airline industry provides a good example
of the marginal profitability that competitors in this industry will accept in their efforts to protect
market share.
View the video on YouTube by Michael Porter: ‘The five competitive forces that shape strategy’.
In this video, Porter explains his model and provides practical examples of the five forces:
http://www.youtube.com/watch?v=mYF2_FBCvXw.
PEST analysis
While industry factors are important to strategic analysis, the external environment is much
broader in scope than the industry. PEST analysis offers a tool for examination of these additional
factors. PEST stands for:
• political
• economic
• social
• technological.
Other versions of PEST exist that further broaden the frame of analysis:
• SLEPT (adds ‘legal’ to PEST)
• PESTEL (adds ‘environmental’ to SLEPT)
• STEEPLED (adds ‘education and demographics’ to PESTEL).
While a multitude of issues arise in a PEST analysis, three that are commonly included are:
1. regulation—an important aspect of the political and legal dimensions
2. CSR—an important aspect of the socio-cultural dimension
3. the business cycle—an important aspect of the economic dimension.
Study guide | 79
Regulation
National regulatory frameworks and international treaties and trade agreements can affect an
organisation’s strategic position. Regulatory constraints may limit the type of products that
can be offered to consumers and can reduce or increase the level of competition or prices.
For example, tobacco and alcohol cannot be sold to minors.
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In a similar vein, the loosening of regulatory constraints in the insurance, telecommunication
and civil aviation industries has changed the competitive positions of many organisations in
these industries. Prior to airline market deregulation, a profitable duopoly existed in Australia—
Ansett Airlines and Qantas. After deregulation, Ansett ultimately failed and several new entrants
attempted to enter the industry to compete with Qantas. Some have done so successfully
(e.g. Virgin Australia and Tiger Airlines), while others have failed (e.g. Compass Mark I and II,
and Strategic Airlines).
The progressive reduction of interstate and international trade barriers, and the adoption of
international (e.g. the General Agreement on Tariffs and Trade) and bilateral (e.g. Australia–
United States) trade agreements have had a strong influence on the globalisation of business
opportunities and competitive threats.
In a similar vein, Smith (2007) argued the importance of strategically leveraging social responsibility
in a way that provides a sustainable competitive advantage. This is achieved by developing a
culture capable of simultaneously executing a combination of relevant activities successfully.
Governments, activists, the media, shareholder associations and other stakeholders have
become adept at holding organisations to account for the social consequences of their actions.
In response, CSR has emerged as a priority for business leaders. Perceiving social responsibility
as a strategic opportunity, rather than as damage control or a public relations matter, requires a
mindset that is increasingly important for competitive success (Porter and Kramer 2006, p. 78).
Moulang and Ferreira (2009) investigated the environmental awareness of Australian businesses.
They found only one organisation in eight had environmental strategies within their overall
business strategy, and that there was a very low level of integration of environmental management
systems with business management systems. Existing environmental management systems
were mainly compliance oriented rather than strategically oriented. Management accountants
should grasp this opportunity to enhance the CSR information provided to the strategic
management process.
Upadhaya et al. (2018) and Carroll and Shabana (2010) summarised the arguments that provide
rational justification for CSR initiatives from a primarily economic and financial perspective,
concluding that firms that engage in CSR activities will be rewarded by the market in economic
and financial terms.
View the following video, which is about an IBM study that addressed the importance of CSR to the
leaders of 250 businesses: http://www.youtube.com/watch?v=PdkYieDuVvY.
80 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Business cycle
Business cycles are fluctuations in local, national or international economic activity evidenced
by changes in GDP, inflation, interest rates, unemployment rates and other macroeconomic
variables.
Predicting the turning points in the business cycle is difficult, as is predicting the extent of the
rises and falls, and the differential effects of the business cycle on different countries. All that is
known for sure is that business cycles recur. A brief overview of the effects of the business cycle
since 2002 is shown in Example 1.14.
In 2007, the GFC was triggered by the collapse of Lehman Brothers, a large US merchant bank and,
as the bubble burst and prices declined, many banks holding devalued assets failed. This led in turn
to a significant reduction in the availability of credit, which caused many organisations to become
insolvent when they were unable to refinance their debts.
A recovery appeared underway in 2010–11, but in 2011 some countries in the eurozone were unable
to refinance their debts and fund their budgets, leading to a European recession.
By 2014, evidence of a US recovery was continuing—with the US stock market hitting all-time highs—
though US interest rates were at very low levels. European countries varied widely, with some in
depression and others in recovery. Throughout, China’s economic growth continued to be strong.
However, in mid 2015 two events occurred:
1. The Shanghai Stock Exchange (which had risen by more than 30 per cent in the previous 12 months)
suffered a correction.
2. Greece defaulted on a loan repayment to its European creditors, mainly German and French banks.
Since then (at the time of writing), global markets have remained volatile.
Many business decisions have long-term implications. Management accountants should use their
understanding of the business cycle to ensure that unreasonable assumptions are challenged—
for example, constant growth in the world economy is frequently, and inaccurately, assumed.
Those organisations that ignore the business cycle, and that base their business strategies and
value chain configurations on an assumption of continuous growth, are less likely to survive the
onset of a recession. An understanding of the business cycle allows an organisation to better
manage risks and to explore a range of different investment scenarios. Organisations that are
successful in the long run consider both positive and negative scenarios—for example, negative,
zero, low and high growth.
The management accountant must try to understand the existing industry and economic
situation, and how the economic situation and the structure of the industry are likely to change
over the strategic horizon. An understanding of economic history is useful in this regard.
Study guide | 81
➤➤Question 1.8
Consider your own organisation, or one with which you are familiar—like your supermarket or your
bank. Examine the competitive forces at work in the industry. What is the competitive position
of your selected organisation? Is it strong? Is it sustainable?
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Check your work against the suggested answer at the end of the module.
82 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Review
This module has provided an introduction to strategic management accounting and the role
of the management accountant.
Part A defined strategic management accounting and examined the contemporary environment
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and its impact on organisations and on management accounting. This part of the module also
introduced the concept of value.
Part B described the strategic management process and the role of strategic management
accounting in supporting managers. The strategic management process is taken as a continuous
process that evaluates the business and the environment within which the organisation operates,
evaluates/re-evaluates its competitors and defines its objectives and strategy.
Part C detailed the role of management accountants in the strategic management process.
Management accountants are seen as information providers for the business process,
organisational planning and control, resource management and utilisation, and creation
of value through effective use of financial and non-financial resources. As a trusted business
partner, new challenges facing management accountants mean they must constantly advance
their knowledge in diverse areas and improve their soft skills to effectively communicate with
the internal and external stakeholders.
Part D explained key challenges faced by management accountants. The focus was on three
questions: how these challenges affect them, what the consequences are, and what skills are
needed by management accountants to deal with such challenges.
Part E described the most common analytical techniques available to management accountants,
and how these techniques are applied in a practical setting.
Suggested answers | 83
Suggested answers
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Suggested answers
Question 1.1
The overall role of strategic management accounting is to support management with useful
information, so at a broad level, it is doubtful that this role will change. Even if the basic
functions—for example, planning and controlling—of management do change over time,
or managers pursue new and innovative responses to address contemporary challenges,
it is unlikely that this support role will change.
However, the way this support is provided may change. The management accounting role
has continued to expand, and the way it supports management has changed drastically over
time. From pure financial information delivery to provision of a broader range of non-financial
measures, business support and involvement, the role continues to change and develop to
stay relevant.
Question 1.2
Goal Strategic management accounting information
Quality places and spaces Establish maintenance budgets to keep facilities in good working
condition, including playgrounds, community centres, parks
and gardens.
84 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Growth and prosperity Provide budgets and forecasts in relation to the availability
of resources to fund community activities and developments.
Measure the actual outcomes, compare them to the desired
outcomes and identify reasons for any discrepancies. Help develop
action plans to fix any problems that have occurred. Measure the
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Mobile and connected city Cost various traffic management systems, including new roads,
traffic lights and road infrastructure (e.g. roundabouts and bicycle
lanes). Set prices for things such as car parking that encourage
pedestrians and bicycles and discourage cars in particular
areas. Calculate the cost of transport incidents, and establish
benchmarks and benefits for improving transportation options.
Question 1.3
1. An organisation will be able to purchase imported raw materials, or manufacturing parts at a lower
cost, because its currency is able to purchase more foreign currency than before. Having lower costs
may enable the organisation to pass on price cuts that solely domestic competitors might not be
able to match. If the price cuts are not passed on to customers, then profits will increase.
2. If an organisation exports products or services, the price for foreign-based buyers will be higher
than it was previously. This may make prices higher relative to foreign-based competitors, which may
make it difficult to remain competitive.
3. Some organisations believe they are not affected by changes in currency rates because they do not
import or export their products or services. This is not always correct, because even in this situation
problems may arise. Costs or prices may not change, but the local prices of foreign competitors’
imported products will be lower than they were previously. This might also encourage new foreign
competitors to enter the marketplace.
Note: Other issues may also exist and the opposite is typically true if the local currency becomes weaker.
Question 1.4
The answer to this question will depend on the organisation chosen.
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because the local market is becoming full of low-priced competitors. Meanwhile, its customers
are becoming attracted to new imported brands of soup noodles from another country.
Restrictions on trade and transport costs are no longer an impediment, as both road and
air freight have improved considerably.
In addition, just as the company’s customers are becoming interested in foreign brands,
the resistance of overseas customers to the company’s brand of soup noodles is likely to be
replaced with receptiveness, as television and online advertising conveys the brand’s distinctive
qualities. People in neighbouring countries may have more disposable income to try out
new products and are developing the curiosity to do this. As international competition is
consolidating in the region, the choice is to join this regional competition or remain a smaller,
domestic brand facing erosion of local market share by overseas competitors.
Question 1.5
Technological development Effect on management accounting
1. Capital intensive investment. Investment in Accurate cash flow planning and management is
technology often requires significant amounts essential to ensure stability.
of cash.
2. Shorter product life cycles. Products exist Appropriate pricing, product characteristics
for a much shorter period than in the past, and life cycle costing are essential to ensure
as they are superseded by technological an appropriate return.
developments. At the same time, greater
investments in technology are required to keep
up with the competition and ensure that returns
on investment are recouped in the shortest
time possible.
3. Automated sales, production and farming Project estimations and evaluations must be
methods. Technologies are reducing the amount more accurate, and effective allocation of
of manual labour required, which changes the overhead is essential.
nature of costs from variable to fixed. This is
because labour is usually a variable cost that is
linked to sales volume or production levels.
Question 1.6
Advantages Disadvantages
1. Risks may be shared with, or transferred to, 1. Anticipated cost savings are often not
another organisation. realised—this can occur because of the
extra time and cost required to manage the
outsourcing relationship and because of
inaccurate estimates.
2. Using outside specialists may be more efficient 2. Outsourced organisations may not be able
and more cost-effective. to provide an acceptable level of service or
performance.
3. Managers no longer have to spend time 3. Organisations may lose core business
directly managing the parts of the organisation knowledge, intellectual capital or property
that have been outsourced—this will give or control of their value-generating activities.
them more time to focus on generating value
in the areas where they are most competent
and comfortable.
Question 1.7
While this list is not exhaustive, additional factors that have affected organisations and driven
change include the following:
• Quality. In today’s environment, quality is no longer an extra to help attain a premium price
for your product. It is an essential characteristic of not only the outputs of an organisation,
but of the individual processes that link together to produce the final product.
• Customer focus. The power of today’s customers is growing as strong competition provides
them with choice and lower prices. The need to make products and deliver services that
customers desire is essential. Instead of pushing products towards them, organisations are
now expected to understand customers’ needs and then develop and sell solutions for those
needs. This has led to a major reorientation within organisations.
• Changing political structures around the world. Wars, shifts towards Western-style
capitalism and the development of new major economic powers, including China and India,
may all affect organisations.
Question 1.8
Your answer to this question should cover the five forces that are present in the selected
organisation’s industry, as well as regulatory and CSR factors that may be specific to the industry
chosen. As noted in this module, it is perhaps an easier task to see the competitive forces at
work in industries where a profit motive is present. Nevertheless, public-sector and not-for-profit
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organisations are also confronted with similar competitive forces in their industries. For many
organisations, the future promises greater competition rather than less, and the competitive
position your selected organisation achieves over the next five years depends on how well
it is able to develop and execute the strategies that obtain superior performance from the
organisation’s value chain.
In drafting your response to this question, these are some of the considerations that you would
need to make. Please be aware that this is a suggested response based on conditions prevailing
in an industry at a particular point in time.
Consider a large telecommunications provider. In addition to providing fixed line, mobile and
internet services, the organisation owns and operates most of the country’s telecommunications
infrastructure. These two parts of the organisation’s business are subject to very different forces
and follow different strategies. A Porter’s five forces analysis would need to focus on these
strategic business units separately.
The organisation was for many years a monopoly provider of telecommunications services and was
owned by the government. Today, it is a private organisation and faces competition from major
and minor telecommunications providers, as well as significant regulatory challenges. Regulatory
issues include the cost of the provision of its network to other telecommunications organisations,
the provision of services to unattractive markets—for example, regional, less populated areas—
and the introduction of a national broadband network. All of these issues also have significant
CSR implications.
• New entrants—Experience has shown that the retail segment of the telecommunications
industry value chain is easy to enter. Other aspects of the organisation’s business have high
barriers to entry due to the massive investment required to build a network.
• Existing competitors—No significant competitors for the organisation exist in the provision
of telecommunications infrastructure. In the retail area, competitors are active in the
regulatory process and, as a result, are likely to have significant power through this route.
• Customers—Buyers of the organisation’s retail services would have little power if each
made a relatively small purchase. Customers for the organisation’s infrastructure—other
telecommunications retailers—are likely to have more power due to the regulatory issues
noted above. Large-scale customers like governments and large corporations have more
than insignificant power because switching providers is an option.
88 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
• Suppliers—Due to the organisation’s size and buying power, and the existence of a number
of competing suppliers, supplier power is a moderate threat. It is not low because the
main suppliers include some other very large organisations. Due to the complexity of the
organisation’s business and the number of different suppliers involved, an analysis of supplier
power needs to take into account the differential importance of various suppliers in the
organisation’s value chain.
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Note: A hypothetical organisation in the telecommunications industry was chosen, because it provides
a ready basis for illustrating the competitive forces at work and information is easily sourced in the
public arena.
References
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References
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MODULE 1
STRATEGIC MANAGEMENT ACCOUNTING
Module 2
INFORMATION FOR DECISION-MAKING
94 | INFORMATION FOR DECISION-MAKING
Contents
Preview 97
Introduction
Objectives
Review 167
MODULE 2
Suggested answers 169
References 177
MODULE 2
Study guide | 97
Module 2:
Information for
decision-making
Study guide
MODULE 2
Preview
Introduction
This module looks at the information that management accountants work with and provide
to satisfy a wide variety of stakeholders including investors, financiers, the organisation’s
managers and other interested parties who need to make judgments and decisions. There are
many methods, techniques and tools that a management accountant can use to satisfy the
information needs of stakeholders. The aim of this module is to provide an understanding of
alternative approaches that are available so that the management accountant can apply the
most appropriate method, technique or tool in any particular situation.
At the outset there are a few terms that need to be clarified. The module uses the expression
‘information’ as an umbrella term—it can mean data, which are numbers, words or symbols,
or it can mean coherent sets of numbers and commentary in combination.
The terms ‘data’, ‘information’ and ‘knowledge’ are often confused. Hislop (2005) makes a
useful distinction. He defines data as raw numbers, images, words or sounds derived from
observation or measurement. Information is data arranged in a meaningful pattern and where
some intellectual input has been added. Knowledge emerges from the application, analysis and
productive use of data and/or information with a further layer of intellectual analysis whereby it
is structured and linked with existing systems of beliefs and bodies of knowledge. Knowledge
provides beliefs about causality and the basis for meaningful action and thought (Hislop 2005,
pp. 15–16)
Knowledge may be explicit or tacit. You should be aware if you read academic literature
on knowledge management that these competing definitions exist. Furthermore, they are
sometimes not defined, and sometimes they are used interchangeably, but not always correctly.
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The American Institute of Certified Public Accountants (AICPA) and the Chartered Institute of
Management Accountants (CIMA) produced the Global Management Accounting Principles.
The principles are based on the premise that management accounting is at the heart of quality
decision-making, because it brings to the fore the most relevant information and analysis to
generate and preserve value. There are four Global Management Accounting Principles:
1. Communication provides insight that is influential.
2. Information is relevant.
3. Impact on value is analysed.
4. Stewardship builds trust (AICPA and CIMA 2014, p. 3).
In its broadest sense, management accounting encompasses both financial and non-financial
information that comes from sources that may begin with but move far beyond the financial
accounting system. The information produced by management accountants is far more granular
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than that contained in financial statements. The management accountant, in assembling various
sources of information, must be careful to faithfully represent that information to management.
This involves recognising and reconciling sources of information that may be inconsistent
or ambiguous.
The final introductory point about this module is that it shows many of the reasons why the
management accountant has to work closely with the financial accountant. The current reporting
obligations for a listed entity mean that internal events which may affect market price or company
valuation require timely market disclosure. The management accountant is likely to possess or
generate some of this information. Understanding who the external stakeholders are can help
to understand how the stakeholders are affected by the entity. Of course, financial accounting
systems are a critical source for the management accountant’s work, even though they are
supplemented by other sources—for example, non-financial performance measures and
operational information sourced from enterprise resource planning (ERP) systems.
The management accountant may have multiple internal stakeholders who rely on the information
they provide. This may be to use financial accounting reports to help non-financial managers
interpret monthly budget versus actual variance reports. However, where these internal
stakeholders are making future-oriented decisions, the management accountant will need to
provide additional information to support capital expenditure proposals, process improvements,
cost savings, etc.
This module is concerned with information, management accounting and the systems that unite
them. The management accountant prepares information for different stakeholders, both internal
and external to the organisation. This is explored in Part A, which suggests that stakeholders
have different information needs—management accountants should not attempt to treat all
stakeholders as the same.
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The idea of dimensions of information is introduced in Part B. The management accountant works
with a large volume of information, from various sources and of varying quality. The stakeholders
who need information to make judgments and decisions can include investors, financiers,
the organisation’s managers and other interested parties. This means that the management
accountant must be mindful that this information needs to be assessed and differentiated in terms
of its validity and reliability to ensure that the information provided is fit for the stakeholders’
purposes (the characteristics of validity and reliability are defined in Module 5).
An important point about this module is that information provided to stakeholders by management
accountants can also be used to build trust and confidence in their analyses and advice.
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when making an assessment of an information system and this is particularly the case when
identifying its shortcomings.
Part D consolidates concepts from the previous parts of this module and considers situations where
the management accountant has found deficiencies in an information system. These deficiencies
can arise from limitations of the information system itself, using inappropriate information to make
decisions, or a lack of suitable information.
The management accountant needs to carefully consider the approach to be taken (and the tools
and techniques to be used) to provide information that best meets the needs of the stakeholder
for whom the information is provided. This involves:
1. Judgment—the management accountant needs to consider the time and resources that are
available in terms of the scope and depth of the analysis. Any limitations of the management
accountant’s analysis need to be made clear when the information is provided.
2. Analysis and interpretation—the management accountant needs to decide what tools and
techniques to apply, which will depend on the circumstances. Any limitations of specific
tools and techniques need to be made clear with the interpretation that the management
accountant provides.
3. Flexibility and a focus on risk—the management accountant needs to be flexible in searching
out sources of information that are useful, but especially where information is externally
sourced; where there are ambiguities between the information generated from different
sources, the user must be aware of the risks of relying on any source of data that cannot be
verified or triangulated.
The highlighted sections in Figure 2.1 show that the external environment influences the
information that the management accountant provides to managers to focus their attention
on strategic decision-making. It also shows the central role of management accountants in
translating strategy into operational activities and recognising the impact that actual operations
have on achieving goals and objectives.
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rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
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MANAGEMENT ACCOUNTANT
VALUE INFORMATION
OPERATIONS
Exte
rnal environment
Objectives
After completing this module, you should be able to:
• Identify the types of information required to support various stakeholders’ decision-making.
• Examine the characteristics of different types of information and the functions they play in
the process of decision-making.
• Evaluate the roles of management accountants in collecting, analysing and presenting
information to influence stakeholders’ decision-making.
• Provide recommendations to an existing information system to meet the decision-making
needs.
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in providing relevant information to stakeholders is to determine who the stakeholders are and
what information they need.
External stakeholders
Table 2.1 identifies various stakeholders and their key information needs.
Source: Based on Donaldson & Preston 1995, ‘The stakeholder theory of the corporation: Concepts,
evidence, and implications’, Academy of Management Review, vol. 20, no. 1, pp. 65–91.
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Internal stakeholders
Internal stakeholders can be categorised by considering their roles and the information they
routinely need—as shown in Table 2.2.
Since internal stakeholders have familiarity with the operations of the business, the management
accountant can seek to understand the impact of:
• priorities—for example, current concerns, strategies, initiatives
• plans—for example, budgets
• performance objectives.
This will enable them to communicate in the most relevant and useful way for the given situation
of the particular internal stakeholder.
How are the different information needs and requirements of stakeholders reconciled?
The management accountant is the ideal person to identify potentially useful information and
make it available to stakeholders—both internal and external.
Information may also be required for organisations engaged in reporting under the Global
Reporting Initiative (GRI), which is a reporting structure that provides a great deal of economic,
environmental and social information not commonly found in annual reports (the GRI is discussed
in Module 5). This also relates to corporate social responsibility (CSR) and integrated reporting,
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which are discussed in the next section.
The management accountant is best placed to provide the information that is assembled
into a CSR/integrated report because it is not just financial information that is being provided.
Much of this financial and non-financial information is prepared or encountered by management
accountants in their day-to-day work. An important skill for management accountants is the
ability to summarise a large amount of detail into a succinct yet accurate description of business
achievements and prospects from more than one perspective (i.e. financial, environmental
and social).
You can view a report commissioned by CPA Australia on the views of stakeholders regarding
integrated reporting. It is available via the CPA Australia website at: cpaaustralia.com.au/~/media/
corporate/allfiles/document/professional-resources/sustainability/report-exploration-stakeholder-
needs-integrated-reporting.pdf?la=en.
The next section discusses how the different information needs of stakeholders can be identified
and managed.
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Stakeholder management
As discussed earlier, management accountants should always be able to identify who the
stakeholders are and strive to satisfy the information needs of these stakeholders. The objectives
of stakeholder management are to:
• anticipate the information needs of stakeholders
• determine the likely value the management accountant can contribute
• assess stakeholders’ importance to the functions and performance of the organisation and
its organisational sub-units
• assess the power wielded by a particular stakeholder.
The stakeholder grid or matrix shown in Figure 2.2 is a useful tool for this analysis. It combines
two dimensions:
1. interest in the matter under consideration
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2. power.
Low
Low Interest High
Source: Based on Mendelow, A. L. 1981, ‘Environmental scanning: The impact of the stakeholder
concept Stakeholder Mapping’, Proceedings of the International Conference on Information Systems,
Paper 20, pp. 407–18, accessed July 2018, https://aisel.aisnet.org/icis1981/20/.
• employees and their unions—some will be affected by the change because they may become
redundant, while others may not be impacted
• customers—these are high risk to Boots-4-All because they still need to be satisfied as to delivery
and quality if production is moved offshore
• existing suppliers who may lose their ability to supply Boots-4-All.
A stakeholder grid drawn by the management accountant to show relevant internal and external
stakeholders may look like the following:
High
Keep satisfied Key players
• Sales and marketing employees who are • Board of directors
largely unaffected other than needing • Senior management
to keep customers satisfied • Stock exchange
• Shareholders
• Financiers
• Customers who need to be reassured
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about continuity of supply
Power
Low
Low Interest High
Inspection of this grid suggests that maximum effort will be directed to stakeholders in the upper right
quadrant because they are the key players for whom management accountants provide information
and analysis. On the other hand, minimal effort will be directed towards stakeholders in the bottom
left quadrant. The top left quadrant contains stakeholders who will need to be kept satisfied in terms
of their particular interests, while the bottom right contains the stakeholders to be kept informed and
supported because they often have highly valuable insights into organisational functioning but little
power to enact improvements.
In some cases it is necessary to drill down further to identify the particular concern of
the stakeholder.
Stakeholder power shows the extent of influence the stakeholder has over the work and
projects of management accountants. Organisational studies of power emphasise that
stakeholder power should not be underestimated. A typology of stakeholders based on their
power was developed by Mitchell et al. (1997). According to this typology, stakeholder power
is based on three factors:
1. the extent to which a stakeholder can influence an organisation
2. how legitimate the stakeholder is seen to be by the organisation
3. how time critical the stakeholder’s support is to the organisation.
For example, a stakeholder who does not have immediate, high power may have indirect power
through their contacts or expertise in the management accountant’s work or projects.
The stakeholder interest level shows the expected attention the stakeholder will give to the work
or projects. However, the interest of stakeholders can change quite quickly in a dynamic business
where day-to-day attention is focused on meeting targets, satisfying customers and improving
quality. Depending on the stakeholder’s perception of whether a management accountant’s
analysis is useful, the stakeholder may become attentive and motivated to share in its success,
or become less interested in order to avoid being associated with the analysis.
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An example at the time of writing is the Australian Royal Commission into Misconduct in the
Banking, Superannuation and Financial Services Industry. While banks and other financial services
organisations have routinely been regulated, there has been a significant shift in the power
of stakeholders—particularly indirect stakeholders—throughout 2018 as a result of increased
scrutiny by the media and politicians. This has brought into sharp focus the practice of banks.
As a result of this exposure, the focus of banks on their shareholders, often seen as the primary
stakeholder, has been called into question.
A potential role for management accountants is to draw the attention of senior management
away from the profitability of banking products and towards the long-term effects of a higher
degree of regulation by government agencies and the potential loss of business due to the
severe reputational impact on the major banks.
Therefore, conclusions drawn from the stakeholder grid should always be provisional and subject
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to continuous review.
For a further explanation of stakeholder management, please access the ‘Stakeholder management’
video on My Online Learning.
The outcome of this analysis should be a clear list of actions that can optimise the management
accountant’s work. The information collection and analysis work of management accountants
should be prioritised in terms of immediate, high pay-off/return activities.
Risk management requires the consumption of resources and this should always be evaluated
in terms of opportunity cost—that is, whether the resources may be better spent on alternative,
more profitable activities.
Example 2.2 shows how the stakeholder management process could be used by an online retail
company.
DRC has a board of directors comprising three independent members and three senior executives.
The board has only ever been interested in monitoring financial results for reporting to shareholders.
DRC has always been a sales and marketing-driven company with territory managers located in six
different regions. While the business is profitable, sales growth has been lower than target. The central
purchasing, warehousing and logistics function is expected to satisfy customer orders within 24 hours
of receiving the order. The human resources (HR) department recruits and trains a large number of
casual employees who are mainly unskilled. These staff take customer orders, pick the goods and
assemble them for dispatch, awaiting transport to customers. However, absenteeism and staff turnover
are problems.
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DRC’s business is suffering because of the emergence of Amazon, whose business model is more
sophisticated than that of DRC. The sales and marketing director, who sits on the board with the
CEO and chief financial officer (CFO) is constantly critical of the company’s ability to compete due to
out-of-stock products, picking errors (incorrect goods dispatched) and delivery delays, all of which
contribute to an NPS that has reduced over the last two years.
Dingxiang, the management accountant at DRC, wants to provide the most relevant information for
management to assist them in dealing with these issues. To do this, Dingxiang will:
• perform the stakeholder grid analysis
• use the grid as a tool to provide relevant information to different functional managers
• use the grid to make recommendations to management.
The following stakeholder grid classifies DRC’s stakeholders into four groups. For each group, different
information needs to be provided.
High
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Sales and marketing Board of directors
Geographic business unit managers Senior management
(Keep satisfied: Protect) (Key players)
Power
Purchasing, warehousing
Employees
and logistics HR
(Minimise effort)
(Keep informed: Show consideration)
Low
Low Interest High
The stakeholder grid categorises the four groups by their power and interest in the organisational
problem. Further detail of this categorisation is shown in the following list.
The stakeholder grid enables Dingxiang to direct his own resources to provide information to the
responsible departments to enable those departments to carry out their functions.
In completing the analysis, it is likely Dingxiang will be able to make some recommendations.
For example:
1. Can the sales and marketing function provide more accurate sales forecasts to enable better
purchasing and stock-holding practices? Dingxiang may be able to assist by producing data on
sales trends by product group and by territory, and evaluating minimum stock levels.
2. Would regional warehouses be a more effective means by which customer orders could be satisfied?
Dingxiang may be able to undertake a cost–benefit analysis of this.
3. Would improved staff retention and staff training lead to better results for the business? Dingxiang
could work with the HR function to calculate the cost of staff turnover, recruitment and absenteeism
and undertake an analysis of whether permanent employment of more skilled staff would generate
benefits exceeding the cost.
4. Should the board receive more operationally focused performance information to enable it to
identify problems that give rise to a lower NPS and impact on financial performance? This could
help to redress the power imbalance between the business functions.
Example 2.3 highlights the management accountant’s role in providing useful information for
management decision-making.
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A review of information for management was conducted for the company by its management
accountant. This revealed that the board of directors was receiving reports containing information
about sales and receivables with a one to two year time horizon. This showed information by branch,
produced by the accounting system. The accounting system calculated aggregate gross margin and
the ageing of accounts receivable (AR) as an exception report for debtors over 90 days.
However, the board does not receive any information about the external environment such as
socioeconomic factors.
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Question
What recommendations should the management accountant make to improve the information provided
to the board of ElectricThingz?
Possible recommendations
The management accountant should recommend that the board be provided with information that
has a strategic horizon of two to five years to help the board to set a clearer strategic direction.
Although there may be very good reasons for the short-term information the board currently receives—
for example, it may have discovered that debtors were not being carefully managed and bad debts
were unacceptably high—once it ensures that receivables management is under control, it should
readdress its priorities and move towards focusing on the future.
Specifically, the information should separately identify the primary customer groups—electricians and
defence contractors—each group likely having a different strategic focus and information requirements.
If the management accountant believes the board has a good understanding of the business,
they should ask the board what information it thinks it needs to support strategy and control—
for example, information about socioeconomic trends and government plans, the level of immigration,
housing construction, level of spending on defence, etc.
This board is currently taking a reactive role in relation to a current problem of large outstanding
receivables. Alternatively, a more proactive approach is for the management accountant to consider
the wide variety of information that the business has and provide reports to the board that the
management accountant considers may inform and assist the board. The management accountant
may also recommend obtaining a specific report from a consultant with expertise in other areas, to give
the board information on which to base its strategic plan, if there is no expert available in house.
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➤➤Question 2.1
Kim Koelski has just been hired as the management accountant at Pinewood Timbers Ltd
(Pinewood Timbers), a manufacturer of timber veneers and laminated beam building products
that has been recently listed on the stock exchange.
On Kim’s first day she meets with her manager, the CFO and the CEO. They are concerned about
whether the six new board members have adequate information to provide adequate governance
for the business (this has been the reason why some major competitors have failed).
What advice should Kim provide the CEO and CFO about the kind of information the new board
members should routinely receive?
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Check your work against the suggested answer at the end of the module.
Study guide | 111
➤➤Question 2.2
Following on from Question 2.1, it is now Kim’s second day. Kim has found that there are two
new managers (logistics and sales) who are still learning their operational job roles. Since Kim is
investigating the information needs of the new board members, she realises that the information
needs of the new managers may overlap with some of the information she needs to provide to
the board members. So she plans to approach the two new managers.
(a) What advice should Kim provide the CEO and CFO about the kind of information that the
new managers should routinely receive?
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(b) What are the soft skills that Kim will need to display in approaching the new managers?
Check your work against the suggested answer at the end of the module.
This part of the module has identified the ways in which information is oriented to different
groups known as stakeholders, both external and internal to the organisation. The next part of
the module examines the types of information the management accountant can prepare and use.
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This future orientation means that the management accountant needs to draw information from
multiple sources, such as:
• the financial accounting system
• operational information on purchasing, production, distribution, sales, etc., which will
comprise detailed and current financial costs and non-financial performance information
• external data that can be used for benchmarking purposes (benchmarking is described in
detail in Module 5)
• other external data—for example, economic and industry trends, competition.
Due to these costs, information gathered and analysed should always be directly related to the
decisions for which it is used (discussed in more detail in Part D of this module).
Much of the information used in organisations is the product of information systems that organise
and analyse information. The system may be manual, semi-automated (e.g. spreadsheets) or
automated. Table 2.3 summarises the common functions of an information system. It shows how
information is produced and used.
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Processing Converts the input data into output— Analysing sales to inform inventory decisions
usually in the form of a report based on whether seasonal factors apply
Output The particular purpose, format and Sales reports on daily transactions provide
frequency of the report information on product groups to determine
sales trends by territory or customer group
Feedback When outputs of a system become inputs Where sales of inventory reach a certain
level, a reorder is triggered that may need
managerial approval
Decision
support system
The major limitation of a TPS is that it is focused on historical transactions and so is incapable
of providing little more than trend analysis to managers.
The MAS goes further than the general ledger-based system used for external financial reporting.
It is an organised process or system that identifies, collects, processes and communicates
financial and non-financial information to relevant stakeholders, based on their entitlement to
receive the information. Ideally, the MAS will use information from all relevant business functions.
This is difficult if the MAS is simply an extension of the accounting system centring on the general
ledger. A test to check whether the MAS is sufficiently broad is to ask the following questions:
• Does it capture revenues and allow them to be detailed through drill-down?
• Does it capture costs and allow them to be detailed through drill-down?
• Does it enable the analysis of revenue and cost by important business segments?
Examples of business segments include product/service group, geographic area, business
unit, customer group or distribution channel.
• Does it capture process efficiency and effectiveness measures that are non-financial and allow
them to be detailed through drill-down?
• Does it capture quality measures that are non-financial and allow them to be detailed
through drill-down?
• Does it include benchmarks and apply them against the listed measures?
• Does it capture customer satisfaction measures that are non-financial and allow them to be
detailed through drill-down?
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Answers to these questions can reveal whether the MAS is receiving input information from other
systems including:
• sales and marketing
• production
• logistics
• warehousing
• HR
• project management.
MASs will vary in their usefulness for strategy formulation and implementation depending on
how well they integrate information from financial and non-financial sources, and from different
functional areas. These systems tend to capture and report different information, but in the
absence of a more sophisticated database may be unable to integrate or reconcile data from
different sources. They also tend to be hierarchical, following the organisational structure,
rather than process-driven, reflecting the through-organisation way in which businesses are
typically carried on.
The usefulness of MASs for strategy formulation and implementation will depend on how well
those systems are designed and integrated.
Separate systems have been developed by software suppliers to attempt to solve the problems
of production and marketing. These are:
• production planning and control systems
• customer relationship management (CRM) systems.
Production planning and control systems can provide powerful data to support decision-
making and strategy formulation and implementation by providing accurate information
about, for example, standard cost revisions, waste and rework of products, and employee
unproductive time.
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This helps the organisation to improve and deepen customer relationships, promote customer
retention and maximise the value of the customer to the entity.
CRM systems synthesise customer related information from many different sources to inform the
organisation about, for example:
• customers’ product and service needs
• customer communication preferences
• customer socioeconomic and demographic profile
• buying history—for example, what, where, how much, how frequently
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Modern CRM systems extend ‘customer’ data to include sales leads and prospects. CRM systems
like Salesforce facilitate sales forecasting, centralise contact management information, track sales
history and help a business focus on targeting new customers and increasing sales to existing
customers.
ERP systems take a whole-of-business approach. They help to integrate data flow and access
to information across the whole range of business activities. They typically capture transaction
data for accounting purposes together with other data ‘modules’ such as customer, supplier,
production and distribution data. This data is made available through data warehouses from
which custom designed reports can be produced (Collier 2015, p. 191).
High-end ERP systems should operate in real time, provide all the previously identified functions,
provide a consistent look and feel across functions, and use a central database. The management
accountant should therefore be able to rely on the ERP system to provide up-to-date information—
as at the time it was retrieved; however, this is not always the case.
The benefit of ERP systems is that they overcome the limitations of MASs by integrating data
from different modules (different business functions) into a single database—so, there is no
duplication of data (leading to inconsistency) and a single master file that can be updated.
For example, customer contact details will be accessed by AR, by the sales department, and for
CRM purposes.
The ERP system provides wide-ranging information to support decision-making and strategy
formulation and implementation—including the ability to track and manage actual performance
compared to plan.
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DSSs are the most powerful system for supporting strategy formulation and implementation
because they provide not only a wide variety of the organisation’s data and externally available
data, but also remove human biases by finding patterns and projections that support senior
management decision-making.
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Knowledge management systems
Although not really an information system in the sense of a technology, knowledge management
is important because it encompasses technology-based systems, formal systems and procedures,
and the informal ‘way we do things here’ that is often embedded in an organisation’s history
and culture. Other than the information systems described in this module, the organisation’s
corporate memory is contained in manuals (such as standard operating procedures), standard
costing systems and training programs (reflecting the ‘lessons learned’).
Knowledge management systems (KMSs) enable the acquisition, capture, distribution and
application of knowledge and expertise gained by an organisation. KMSs are at times referred
to as ‘corporate memory’; they assist with the retention of vital knowledge from key employees
and often contain information about lessons learned.
KMSs are vital sources of information during periods of rapid change and high staff turnover;
assist with learnings in complex project management; and, if used well, can be a key strategic
tool for developing and protecting an organisation’s sustainable competitive advantage.
Knowledge management is discussed in more detail from the perspective of projects in Module 4.
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➤➤Question 2.3
ERP systems have now been around for such a long time that they are fully featured and extremely
reliable. Should most large and medium organisations (except family corner store businesses)
install them?
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Check your work against the suggested answer at the end of the module.
➤➤Question 2.4
Thaddeus & Smart (T&S) is a medium-sized chain of retail clothing stores with a sales growth over
the last 10 years that has averaged 5 per cent per annum. The company has recently experienced
significant competition from online sellers whose prices are lower than those of T&S. Despite their
considerable investment in technology, the competitors do not face the same store rental and
staffing costs incurred by T&S.
The board of directors of T&S is considering investing in an online ordering system for its
customers, and replacing half of the retail stores with a central warehouse from which to dispatch
customer orders. T&S has had an ERP system incorporating a CRM system for several years
and has asked Tim Smith, the management accountant, what information might be available to
support the board’s strategic plan.
(a) What type of good quality information could be available for Tim to inform the board of
from T&S’s ERP and CRM systems?
Study guide | 119
(b) What other useful information might Tim research that might not be in the ERP or CRM
systems?
MODULE 2
Check your work against the suggested answer at the end of the module.
External Internal
Credit ratings—e.g. Standard & Poor’s, Dun & Reports from operations—e.g. sales, costs,
Bradstreet profitability—financial information and
commentary from managers on performance
Industry information provided by major employer Non-financial information on, for example,
associations—e.g. chambers of commerce— cycle time (order to delivery), on-time delivery,
and specific industry associations such as the quality, productivity and customer satisfaction
Minerals Council of Australia measures such as NPS
Stock exchanges and commodity exchanges The strategy of the organisation as reported in
the approved strategy document
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External Internal
Publications of international bodies and countries— Specific analyses—e.g. to identify and assess
e.g. United Nations, World Bank, US Treasury, the resources of the organisation; or the capital
Australia China Business Council budget, with its analyses and supporting
documentation
Having the information available from different systems creates richer, more complex and
therefore potentially more useful information, as suggested by the examples in the Table 2.5.
Integrated information
Source system #1 Source system #2 to support
Sales demand by season and + Production costs to allow → Setting product prices,
any effects of advertising target pricing monitoring actual
or promotion versus standard costs of
production over time,
determining product
profitability
Sales of existing products + Fixed costs and other → Deciding whether to close
with margins commitments a factory
It should be noted that there are also many occasions where information needs to be integrated
and the sources are not systems. For example, discussions with managers or employees may
elicit information they possess from experience or reflection on operations. The experience of
non-financial managers should always be considered by the management accountant when
analysing and interpreting non-financial information.
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Table 2.6: Common forms of aggregation
Aggregating to get the This may occur where totals Imported volumes may be
‘bigger picture’ are lacking or are unreliable. added to internal production
Estimates may be formed from volume and estimated
proxy data. competitor volume to
estimate market size.
Combining existing information This may use existing data or A company that decides to
to create new measures be the prelude for advanced use the DuPont return on
statistical analysis. equity measure will assemble
information for its three
different dimensions—operating
efficiency, asset use efficiency
and financial leverage.
Aggregating to produce new, Typically these are averages, The average customer order
high-level summary measures indexes or ratios. value in dollars or the gross sales
per employee.
Aggregating where different Many summary reports contain For example, Kaplan and
information is presented together line items that do not have an Norton (2001) suggest that
arithmetic relationship but are the BSC should be connected
simply presented together for with strategic objectives in a
convenience and ease of review. cause and effect relationship.
This leads to a hierarchical BSC
that is cascaded down through
the levels of the organisation
so that managers are all being
measured in relation to the
highest level strategic objectives.
Example 2.4 illustrates how sales data can be ‘drilled down’ to a granular level to enable
managers to make decisions about strategic choices.
For management purposes to support strategy formulation and to manage performance, this total
figure can be drilled down, depending on the information that is required:
• by month
• by product group
• by territory.
April … December
(these would be separate columns,
January February March each with a monthly figure) Total for year
Product group A Product group B Product group C Product group D Total all products
$1 200 000 $800 000 $500 000 $1 500 000 $4 000 000
North region East region South region West region Total all regions
$300 000 $1 600 000 $600 000 $1 500 000 $4 000 000
More detailed analysis could drill down even further, for example to the sales of Product group B in the
South region in the month of March. This would provide far more granular performance management
information for decision-making to support strategy formulation, implementation and control.
The kind of information in Example 2.4 might also be supplemented by non-financial information.
For example, information on customer satisfaction (e.g. NPS), on-time delivery and product
quality could be used to enhance interpretation of the financial information. A BSC approach
could also be used.
The BSC (discussed in more detail in Module 5) integrates information in three ways:
1. It combines financial with non-financial information and stratifies that information in
four perspectives:
–– financial
–– customer
–– business process
–– learning and growth.
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The management accountant can add value to information by aggregating and integrating
information if they also consider its attributes. This is discussed in the next section.
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section summarises common characteristics before considering limitations.
Dimensions of information
It is always useful to consider a broader view of information when initially gathering or being
given new data. This helps to identify any limitations or lack of balance. One approach is to
examine information across three dimensions:
1. domain—external versus internal (discussed earlier)
2. type—financial versus non-financial
3. source—primary versus secondary.
Non-financial information is expressed in non-dollar terms. Often, there are vast quantities of
information held by organisations, such as the number of products sold, hours worked (in a
factory or a professional service firm), cartons delivered to customers, etc. Wherever possible
and cost effective to do so, this information should be captured (see the earlier discussion
about ERP systems) to provide a more holistic picture of the organisation than is provided
by financial information alone. This kind of information is invaluable in strategy formulation
and implementation.
There are many measures of non-financial information—these can include measures of customer
satisfaction such as NPS and customer retention. Other measures include on-time delivery,
cycle time (from order to delivery) and product or service quality.
Primary sources generally come directly from the original transactions. They are controlled by
the organisation and are therefore readily verifiable.
The accounting transactions of a business are primary sources, as are non-financial records under
the organisation’s control, such as quality and on-time delivery.
Secondary sources of information are from sources external to the organisation. The organisation
has no control over this information and is unable to verify its accuracy. Information from some
sources, such as the ABS, can be relied on because they have a reputation for accuracy and
high-quality information. Reports from management consulting firms will also come with a high
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reputational element. By contrast, information from newspapers, magazines and books is less
reliable although these sources may still provide some useful information.
Considering these various limitations, it is important to remember that there may be risks when
comparing or aggregating information.
A related concern is the ethics of information regarding the creation, organisation, dissemination
and utilisation of information. The ethical management accountant will therefore be concerned
with preserving privacy and confidentiality of information—for example, by keeping it secure,
using only authorised media to transmit it, and not discussing it with third parties.
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Characteristics of information
Management accountants use the characteristics of information to judge the suitability of the
information they gather and use. They must take into consideration the limitations of information,
whether it is financial or non-financial, whether it is internally or externally derived, and whether
it is primary or secondary source.
These characteristics, together with those of clarity, timeliness, accessibility and controllability,
are discussed in detail in Module 5. However, it is important to recognise here that validity and
reliability are key characteristics that must be considered when information is used to support
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strategy formulation and implementation and subsequently used for control purposes.
Validity, sometimes called accuracy, is how well information describes what it is meant to
describe. Information about a particular customer’s level of sales in a period is valid. However,
information about the cost of products sold to that customer may not be valid, because different
overhead allocation methods can lead to different costs. Validity may be called into question
because different management accountants may calculate the cost in different ways.
Reliability is about consistency, or whether information from different sources tells the same story;
in other words, whether we can rely on or trust that information.
Information about rework to faulty products in a factory is a valid measure of product quality,
although it would need to be supplemented by additional information about quality issues that
were not found in the factory but were raised by customers. This highlights the importance of
triangulation—comparing, integrating and reconciling information from different sources to
provide a full picture so that reliable judgments can be made.
Some information is valid but not reliable. So information from the ABS about retail sales trends
has high validity. However, it is not reliable for any one business to assume it will apply to them.
For this, a business would need to look at its own sales trend over time and determine what
factors influenced it.
Some information is reliable but may not be valid for a particular purpose. NPS is a reliable
measure of customer satisfaction but would not be valid if we are considering a price increase
and using the NPS to predict customer retention.
Where information comprises performance measures, an important characteristic is that these are
SMART performance measures (Doran 1981). SMART refers to specific, measurable, achievable,
relevant and time-based.
Characteristics Description
Comparability Examines how two or more pieces of information resemble each other. For example,
the information may be from different years (to identify trends) or from another
company (to juxtapose performance).
Any use of similar information should be checked to ensure that the accounting
methods are similar—e.g. they use the same depreciation method.
Verifiability Refers to independent observers reaching consensus (but not necessarily 100%)
without simplifying the information.
Timeliness The degree to which older information ceases to be relevant. This encourages
efficient capture/collection and preparation. Decisions should be based on up-to-
date information but what is meant by the latest information is dependent upon the
specific task.
Some information is timely long after the period in which it is reported. For example,
information about seasonal trends can be useful despite the current weather pattern
being an anomaly because the trend information allows this judgment to be made.
Understandability Refers to the interpretation of the information by a proficient user: that is,
someone who has reasonable knowledge of business and economic activities.
Understandability begins with classifying, characterising and presenting information
clearly and concisely. Excluding information to make it less complex may
potentially mislead.
Quality of information
Wang and Strong (1996) propose four elements for analysing information quality, as outlined in
Figure 2.4.
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• Accuracy
• Objectivity
Intrinsic • Believability
• Reputation
• Relevance
• Value-added
Contextual • Timeliness
• Completeness
• Amount of information
Classifications
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• Interpretability
Represen- • Format
tational • Coherence
• Compatibility
• Access
Accessibility • Security
This classification requires accuracy to be weighed up against the other dimensions. It allows
a user to describe information relevant to a particular task as good or poor by making judgments
about each of the dimensions.
Information quality is a measure of the value the information provides to the user of that
information. However, quality can be subjective in how it is perceived by users such that different
users ascribe a different quality to the information.
Each stakeholder is a customer and their needs must be satisfied by the information they receive.
These issues are explored further in Example 2.5.
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EventArama has eight full-time employees (including six event managers) and numerous casual and
part-time employees who work on particular events. The event managers have high integrity and can
handle about 25 events simultaneously—because so much of the work is outsourced.
Since the company was founded three years ago, the business model has been that each event is
managed using a custom application in a database. The first-year turnover was $5 million. Four years
later, the turnover is forecast to be $45 million. The profit margin is around 9 per cent after deducting
all expenses except tax.
1. Amandev, an IT manager, to develop and modify the database. He will replace the outsourced
service provided by a small group in the United States
2. Suyin, a management accountant, whose brief is to improve the profit margin and ensure that the
six event managers no longer operate as information silos. Competition has developed among
the event managers because they are responsible for arranging all their own resources for the
events they manage.
Consider how Suyin should approach the event managers and the kind of information she would be
seeking to discover.
Since Suyin knows the event managers operate as information silos, she can begin by asking them about
the information they need and why it is important from a customer (meaning their client) perspective.
Suyin’s findings are summarised in the following table.
Information feature
Information needs
Dimension, attribute Finding assessment
Source
External versus internal Information about the client Many informal external sources
is sourced from them and of information are used and
third parties. there are difficulties when
they are contradictory—
Prior event information is e.g. creditworthiness.
available internally if done by
the same event manager.
Primary versus secondary Most external information is Some major disputes over
secondary. payment from the client could
be resolved by better controls.
Most internal information is
primary because it originates The classification of some
from source documents. information should be more
detailed to allow easier
identification.
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Information feature
Information needs
Dimension, attribute Finding assessment
Dimension
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Aggregation There is no aggregation Aggregation is used for the
across events, but for the client’s number of attendees,
accounts used for each event use of suppliers and costs.
the individual transactions
are aggregated.
Integration Source data for event planning Some sources are outside the
is matched to actual event accounting information system
instances. (AIS)—e.g. long-range weather
forecast, industry performance
incentives and rewards,
proven sustainable supplies
and resources, more efficient
ways to use fixed assets.
Qualitative characteristics
Relevance The majority of decisions for The budget system works well
the event are based on the but there is a problem that
budget set by the client and it is more detailed than the
the specification for the event resulting invoice as the budget
agreed with the client. uses a greater number of items.
Faithful representation Some opinions are involved Because there have been
in deciding whether to previous disputes with
accept a new client, as this is clients, Suyin will need to
a decision of the individual be involved at several stages
event manager. to create a process that
properly and legitimately
Otherwise, most expenditure ensures arrangements follow
falls within the budget. best practice.
Information feature
Information needs
Dimension, attribute Finding assessment
Understandability Some issues arise from clients Suyin will need to create
misunderstanding quotes and a contingency for events,
raising complaints that they and evaluate the capabilities
know the same products and and pricing of other suppliers.
services can be obtained from
other suppliers at lower prices.
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sources and the data model that stores data. A data warehouse is distinguished from a traditional
database in two ways:
1. The data warehouse may have redundant information—for example, former addresses
of customers that were current at the time the data was collected.
2. Once accepted into the data warehouse, the information is not updated. The data warehouse
is therefore programmed to aggregate data over a period of time—usually in predefined
structures.
The data warehouse then becomes the repository for all enterprise data and is used for data
mining. For example, in a retail chain using loyalty cards, data mining may be used to learn more
about a customer’s purchasing preferences and habits to improve the effectiveness of marketing
strategies, as well as increase sales and decrease costs.
Data mining techniques include common statistical analyses (e.g. correlation) as well as advanced
computational techniques (e.g. cluster analysis). In addition, data integrity checks are conducted
for anomalies and dependencies.
Big data
Big data is a large dataset that can comprise both structured (e.g. spreadsheet information)
and unstructured data (e.g. a collection of web pages). Traditionally, ‘big data’ was thought to
be solely defined by its volume. Large volumes of data were originally created as a by-product
of e‑commerce. Laney (2001) proposed the 3V model. He began with ‘volume’ to refer to the
amount of data that arrives via a TPS, but then added ‘variety’, because there are different types
of data (e.g. text, html, images, audio, video), and ‘velocity’, which refers to the rate at which data
arrives and which therefore implies a processing speed.
Analysis of data may use either the large volumes or selected extracts. Both are facilitated by the
classification system to ensure data is properly protected (e.g. for privacy reasons) and to ensure
appropriate legal compliance (e.g. legal discovery). Software vendors have developed databases
and analytical methods that can computationally reveal patterns, trends and associations. Initially
these were aimed at products and services, but recent developments allow human behaviour
and interaction to be analysed and predicted.
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Big data may be stored by the organisation as part of its data warehouse or managed by third
parties who collect data on the organisation’s behalf. A common example is the expansion
of loyalty cards from the parent organisations’ products and services to multiple vendors.
The Australian supermarket chain Coles created the FlyBuys card to promote customer loyalty
towards its supermarket sales. It has expanded its use by partnering with organisations who
offer other products—for example, eBay, Garmin, National Australia Bank Ltd—and services—
for example, AGL, Medibank.
Issues with ‘big data’ and personal data used for profiling
Recently, technology companies such as Facebook and Google have been found to capture and
use personal data from their customers in ways that were unrelated to the personal transactions
for which the data was collected.
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In at least one case (Cambridge Analytica) where permission was given, the information on
each user’s friends was included. There is also the issue of using this data to target advertising
to individuals for products and services they had not expressed interest in receiving marketing
information about. This raises both legal and ethical issues. There is no doubt that permission
was sought and given by users to obtain access to selected tools and services, although the
wording did not detail the potential uses and consequences—for example, extraction of
keywords from email (Popkin 2018).
The issue appears to be that while users would never have given the government or a corporation
permission to monitor their activities and locations, this has occurred with Google and Facebook.
Of course, data can be deleted but this affects the efficacy of searches, and based on Facebook
testimony, absolute deletion may not be possible (Curran 2018).
Management accountants should be mindful of the legal and ethical issues associated with the
use of big data. Misuse of data, or even the perception of misuse, can lead to a loss of reputation
and may have a significant financial impact on an organisation, as evidenced by the shareholder
value loss of $US119 billion experienced by Facebook in July 2018 (Chau 2018).
Business intelligence
BI is a combination of the strategies and technologies used by organisations to analyse their
information to improve their operational and strategic decision-making. Although BI is related
to big data, which uses analysis to determine interrelationships among data, big data primarily
supports implementing existing decisions. BI may use the same statistical methods (correlation,
cause and effect analysis, prediction) but with the aim of developing computer-aided models for
decision-making.
A number of terms have been used in conjunction with BI, including data discovery, executive
information systems (EISs) and online analytical processing (OLAP).
Data discovery features visual tools—e.g. pivot tables, geographical maps, heat maps. It aims to
make patterns or specific items immediately visible.
An EIS facilitates and supports senior executive information and decision-making needs by its
orientation to defined organisational goals. A major EIS function is to combine internal and
external information and present it in an easy-to-use, convenient format.
➤➤Question 2.5
Tina Macto is the newly appointed management accountant for OutbackRail Pty Ltd (ORPL). ORPL
provides rail services to regional centres. Tina is responsible for producing a weekly financial report
for the regional managers, which is currently sent to them as an email attachment about four days
after the weekend (to allow for weekend services to be included). The report covers sales of past
travel bookings actually completed, and projected journeys based on sales for the next week.
When she was initially introduced to the regional managers, Tina was told by them that they did
not use the report for their decision-making. They explained that the two main kinds of decision
they need to make are:
1. whether to add carriages to the trains to cater for higher demand
2. when buses replace trains due to trackwork—what number and sizes of buses should
be ordered.
However, the regional managers told Tina that they tended to keep the train length standard.
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Also, instead of being able to just use buses to cover the distance between major towns where
trackwork was occurring, they tended to replace the entire trip because this avoids the combined
train/bus logistics.
Suggest what Tina should do to discover the information needs of managers that would allow
her to improve the report. State how she should evaluate the information attributes.
Check your work against the suggested answer at the end of the module.
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➤➤Question 2.6
Bono Musk is the management accountant at StreemMov Pty Ltd (StreemMov), a start-up
organisation that offers an online music and movie download and streaming service. To use the
service, it is necessary to either buy a membership or pay for individual downloads. Memberships
are divided into three categories:
1. music
2. movies
3. volume of use.
StreemMov have decided that they will host the service themselves so that they can better know
their customers and their customers’ preferences. So far, they have concentrated on giving the
customer a smooth and reliable service. For example, when there is a disruption to the service it
automatically reconnects and resumes at the point where transmission was broken.
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StreemMov have selected an ERP system and have purchased the transaction product distribution
module and billing system that connects seamlessly to the data warehouse that stores all
the transactions.
Consider big data and BI.
What should Bono recommend with regard to how big data could be used by StreemMov to
make a difference to its business strategy and decisions?
Check your work against the suggested answer at the end of the module.
Study guide | 135
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information delivery
Time, for management accountants, is a scarce resource, so they need to balance stakeholder
expectations for information with their ability to search for or produce the expected information
to an acceptable quality. Stakeholders have different needs (as discussed earlier) and the
management accountant will, as a result, provide them with different kinds of information
in terms of delivery, format and impact. Table 2.8 summarises the key issues for stakeholder
expectations and the management accountant’s actions.
Table 2.8: K
ey issues for information delivery—stakeholders and management
accountants
Impact of information • Immediate or near term • Deliver tangible and visible beneficial
• Clear message regarding information
the action to be taken • Follow up with stakeholders to
determine whether they find the
information useful and track that back
to the systems to ensure they are useful
and usable for stakeholders
Before working ‘behind the scenes’ on information system improvements (e.g. improved
taxonomy for information in the data warehouse) or making changes to deliver more visible
benefits for stakeholders, the management accountant should validate the feasibility of
suggested systems improvements with stakeholders.
Given the differing needs and behaviours of stakeholders, when intending to change the
information provided to them it may be necessary to conduct a pilot project to resolve any issues.
The reasons for this lie in the possibility that the management accountant is actually seeking
organisational and cultural change, and this requires the support of strong leaders at all levels in
the organisation.
Senior
managers
(e.g. CEO, CFO)
(strategic information
needs)
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Lower-level managers
(e.g. sales team leaders, production planners)
(operational information needs)
Source: Based on Lumen 2018, ‘Management levels: Hierarchical view of management in organizations’,
accessed July 2018, https://courses.lumenlearning.com/boundless-business/chapter/types-of-
management/.
Strategic information
Strategic information is forward looking and assists the organisation with planning. Typically,
the planning horizon is three to five or more years, depending on the industry and technology.
This information is gathered to identify and improve the organisation’s competitive advantage—
it is an amalgamation of different sources, much of which may be sourced externally from
the organisation.
According to Drucker (1964), strategic information is necessary to answer key questions such as:
1. Who will be the future customers?
2. How will those customers be reached? (What channels will be used?)
3. What needs to be done now to be ready for a new business direction?
4. What is likely to go wrong with current plans?
Management accountants closely link the time horizon of information with the timing of
decisions. One reason for this is their concern with cause and effect. Many outputs or
outcomes—for example, growth, increased shareholder value and greater market share—
result from improved products and services for customers. Therefore, management accountants
need to gather as wide a range of information available as possible to get early signals about
looming problems and opportunities—so that they can inform decision-making at the right time.
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In any organisation, strategy must cascade downward to lower organisational levels such as
business unit managers responsible for profit centres, or functional managers responsible for
their cost centres. Equally, as shown in Figure 2.5, information flows upward from operational
information that may be aggregated and interpreted by these managers, often with the advice
and assistance of management accountants.
Tactical information
Tactical information has a shorter time horizon than strategic information. Tactical information is
more focused on day-to-day operations and aims to assist management with effective execution
of strategy. Its role is informed by the guidelines set by the strategic plan.
Tactical information has the following characteristics:
• It is mainly used by middle management.
• It is focused at the business unit level, rather than at the whole of organisation.
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• Typically, it is functionally oriented, with specific goals and objectives and performance
targets.
• It contains more detail than strategic information, in terms of project plans, timetables,
resource plans, human resource requirements and budgets.
• It plays a vital role in the coordination of organisational activities, often ranking activities in
terms of their relative importance and urgency.
The importance of the interplay of tactical and strategic information cannot be overestimated.
The best laid strategy will be rendered useless by poor tactical implementation and, conversely,
tactical excellence will not suffice in light of poor strategy. The management accountant has an
important role in the provision of both types of information.
Middle managers need to interpret strategy, and for effective execution they need to translate
this into detailed tasks and instructions for operational staff such as supervisors of sales
representatives, production operatives, etc. It is at the ‘grass roots’ of organisations (e.g. where
there is day-to-day contact with customers, or where goods and services are produced) that
strategic plans succeed or fail.
Operational information
Operational information is produced from, or used by, the day-to-day transactions of an
organisation. For example, the information may relate to the following functions:
• production—manufacturing or service delivery
• logistics—including purchasing and warehousing of finished goods and distribution
of finished goods to wholesalers and retailers
• marketing
• sales
• after-sales service
• information and communications technology (ICT)
• finance
• accounting.
Operational information has a shorter time horizon and deals with ‘today’ or ‘this period’.
It is used to answer key questions such as:
• How can we satisfy customer orders?
• How can we obtain raw materials for manufacturing, mining or construction; inventory for
merchandising; and labour for production and services?
• How can we improve efficiency?
• How can we reduce costs?
• How can we maximise profitability?
• How can we outperform our immediate and emerging competitors?
Level of Type of information Level in the
information system organisation Perspective Type of decision Impact Activities
key features
Budgeting
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Table 2.9 shows that managers at different levels require different kinds of information and will
use different sources of information for their decisions, which have different time horizons.
Functional requirements
To understand the different functional requirements for information, it is useful to consider some
examples. Table 2.10 identifies four major functional areas of an organisation and their different
needs for information.
Balancing strategic, tactical and operational decisions is difficult. The management accountant
will be guided by the circumstances of the organisation and the urgency and importance of its
immediate problems.
In beginning with strategic decisions, which are future oriented and affect the external positioning
of the organisation, the management accountant will take into account tactical decisions associated
with initiatives to achieve its strategy. For example, a strategy of becoming number one in a market
will require tactics concerning pricing, marketing, deployment of resources, and responses to
anticipated and unanticipated reactions by competitors. The operational decisions to conduct
activities will be guided by the tactical initiatives that are being resourced. As noted earlier,
one means of ensuring synergies between these levels is with the BSC (see Module 5).
Figure 2.6 provides a summary of the types of questions that can be asked at the three levels to
ensure that the right information is gathered and provided to assist decision-making.
Study guide | 141
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• How can we remain profitable?
In summary, different organisations allocate activities and processes to different levels in the
organisation because they believe that is where they can gain competitive advantage. Each of
the levels of planning has different information requirements, and the management accountant
must identify the best source and best method of aggregating and presenting information to
each level.
Senior management plays an important role in setting the vision and mission of the organisation.
Vision is an aspirational description of where an organisation wants to be in the future. Mission is
a declaration of an organisation’s core purpose and focus. Senior management must therefore
make many decisions over current and future courses of action, and the management accountant
can assist them do so by providing useful information that directly links to strategy.
Linking information to strategy requires a clear understanding of the strategic goals and
objectives to be achieved at the tactical and operational levels, and the projects or tasks that
are necessary to deliver these goals and objectives. The strategy needs to be elaborated in terms
of strategic priorities that are funded and with clear milestones and end-deliverables. Only when
this has been established can the strategy be cascaded down through the organisation for its
accomplishment. Traditionally, the following two approaches have been taken:
1. the financial approach
2. the performance management approach.
The financial approach involves framing budgets that extend down through the organisation and
include lower-level organisational units and their sub-units. Budgets are frequently used to align
resources to strategy because they require each organisational unit to prioritise and allocate its
available resources between key initiatives allocated to it and its existing programs. Usually any
projects are separately resourced as part of the project plan.
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Budgets are discussed in detail in Module 3 and project management is discussed in Module 4.
The performance management approach considers the allocated resources and achievements
of organisational units against non-financial standards and outcomes. Performance management
encompasses CI of current processes and the accomplishment of transformational breakthroughs.
CI is the ongoing effort to improve service effectiveness or process efficiencies to achieve either
best practice or benchmarks—for example, process improvements measured as faster delivery of
services or less resource utilisation.
Management accountants can link information to strategy by obtaining stakeholder and market
knowledge and building relationships with stakeholders (as discussed later in this module).
This will enable them to determine stakeholder satisfaction and suggest the financial and
performance information to be collected and analysed. This information will then be used to
review organisational performance in overall terms as well as by organisational unit. In many
cases, the analysis will reveal shortcomings in performance that require investigation. This is
where the relationships with organisation unit managers will make both the investigation and
recommendations for continuous and transformational improvements easier.
The management accountant can take a strategic view of the information by considering the
contribution that it makes to understanding customers, markets and end users of products and
services (Drucker 1964, p. 104). Drucker offers a simple approach to simplifying these quite large
issues. He suggests asking four key questions:
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Taking Drucker’s approach means that decision-making should always be converting information
(knowledge) into results for stakeholders. This places an obligation on management accountants
to ensure they do not just gather and analyse the information—they must also provide the
information to managers and employees to help them improve the efficiency and effectiveness
of their recommendations and decisions—as shown in Example 2.6.
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Acme Enterprises Ltd (Acme) is a bricks and mortar retailer with an online retail presence that has
been quite successful (profitable) for almost 10 years. It specialises in luxury fashion and has its own
shopper card to track purchases. Acme conducts an annual strategy retreat where senior managers
and the board discuss strategy. The management accountant is usually asked to provide supporting
documentation on the business and often attends to make a presentation.
Initially, Danh Nguyen, the management accountant for Acme, provided aggregate information about
revenue, cost of sales, expenses and the capital budget for investment, for both budget and actual for
the last five years as well as the estimates for the current year. The board found this information useful
because there were supporting documents for each, which gave breakdowns and a commentary on
major issues encountered during the year. For example, for expenses that year, the report noted that
winter sales of men’s and women’s coats were very low, because the winter was quite warm and the
spring sale of the surplus stock reduced margin by 11 per cent.
The next year, Danh applied the questions provided by Drucker. He worked with the sales department
to produce sales by customer ranked from top to bottom. Cash sales and sales to individual customers
were simply put into two groups. The list allowed board members and senior managers to see that the
majority of sales had been in Western Australia to fly-in fly-out staff who were either ordering things
online because their work sites were too remote to allow shopping in person, or sending gifts home
to family members as a way of staying in touch.
The list also showed that while some stores were easily covering costs, only a very small proportion
of the number of inventory lines they carried were being purchased. This led to a small project to
investigate whether to continue carrying the lines. The lines were originally stocked to ensure Acme’s
slogan—‘we stock what you need’—was credible.
The additional information obtained during the investigation allowed Danh to support the advertising
expense incurred by the branch managers and sales manager to run product promotion nights.
These events were to inform selected customers about other products that they did not buy but that
may be suitable alternatives or additions to their shopping purchases.
This example illustrates the importance of information when allocating organisational resources.
Consider the damage that could be done to shareholder value by incorrect information and analysis
being provided to management, or, as often is the case, what could have happened in the absence
of information and management having to rely on uninformed guesses.
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The management accountant may have difficulty with some of these guidelines when evaluating
strategy, providing information associated with strategy, or being the recipient of sensitive
information. For example, management accountants may need to:
• make highly technical or complex information available to senior management in a short
time frame
• respond in a highly competitive work environment where other managers are hostile
• overcome a culture where expertise and mastery are dominant
• reduce boundaries between the job and their personal life to be transparent
• put at risk their own bonus and job.
Maister et al. (2001) suggest working through the following five-step process:
1. Engage
2. Listen
3. Frame
4. Envision
5. Commit to improve communication.
This way, management accountants can build a foundation for assisting senior management.
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Management accountants can offer their insights by connecting information they have gathered
or produced with the broader organisational strategy. In discussions with management,
the management accountant may become aware of new information or potential directions
for the organisation. The test for the management accountant is whether they can use
this information to propose new options and identify the related strength and weakness,
opportunities and threats of each option. For example, a senior manager may reveal the board
is thinking about splitting off part of the organisation into a publicly listed company, to improve
shareholder value. The management accountant can offer suggestions on the proposal’s effect
on the remaining organisation in terms of costs, losses of synergy from dealing with the unit
at arm’s length and likely implementation issues.
Custodian of information
Another important role for the management accountant is as a custodian of information. This role
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should not be confused with the governance roles of either data steward or data custodian.
A data steward is responsible for the information content, context and application of business
rules. They achieve this through good systems design that validates input data and provides
output for verification.
Data custodians are responsible for the authorised access and acceptable integrity of the stored
data, including its transport or communication.
The management accountant, therefore, is concerned with ensuring that any technology deployed
to automate business processes and maximise productivity creates the required accounting
information and non-financial performance management information. They will also check
that the technology chosen is aligned with the business decision-making needs of managers,
senior management and stakeholders. This includes contemplating how disruptions to business
continuity might diminish the relevance or faithful representation of accounting information.
Their custodian role also extends to recruiting, developing and retaining high-performing
accounting staff who maintain high engagement with the business of the organisation by ensuring
they are provided with quality information and clearly understand the organisation’s strategy.
Example 2.7 uses all the points from this part of the module to show how information has wide
effect in the organisation.
AS selectively buys unique cars, after verifying they are in reasonable condition. It then sells them
either at fixed prices or at auctions. The lowest value for a car was $100 000 for a mint condition 1972
Fiat X1/9 serial number 001. The most expensive was a 1960s Ferrari 250 GTO (in showroom condition)
for $50 million.
AS has a very close relationship with courier companies and airlines so the item is packed and sent
with no chance of damage. Buyers are located around the world and include individuals and also
clubs and organisations. Turnover is currently $100 million, which is down from previous years when
it was around $125 million.
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The former owner has sold the business to a syndicate who want to hold sales around the world.
Their strategy is to replace well-known national sales (e.g. Goodwood in the United Kingdom,
Pebble Beach in the United States) with their brand. Their vision is to offer a better car sales environment
by selecting major cities that the famous and wealthy are already likely to visit (e.g. New York, London,
St Tropez). They have tasked the management accountant with benchmarking their operations
against the best practices found at the existing national car sales events. They have also advised the
management accountant to form close relationships with each of the managers to ensure the planning
for the new arrangements is comprehensive. The new managers are responsible for marketing, sales,
logistics and maintenance/repairs. AS offers a car restoration and repair service that has a second-
to-none reputation among car collectors. Most of the managers and employees have worked there
since the 1990s. None of the employees belong to a union.
The management accountant is aware that AS is quite an old-fashioned organisation. It uses hard-copy
documentation for most of its operations, although there is some use of email. Managers justify this
approach by claiming that it is what the clients want.
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In this scenario, the management accountant could either begin with the internal stakeholders
(as outlined in Part A) or focus on the information. This example uses the information approach
discussed earlier, showing some of the stakeholder expectations to highlight the information and the
management accounting actions that are needed.
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sells and whether managers would be
able to persuade sellers and buyers
of its value
Impact Owners—realise that the edge AS Discuss what decisions they expect
has over its competitors is their to make and whether they have
‘old‑fashioned service’ ethic sufficient information to make
informed decisions.
➤➤Question 2.7
Ally Green, the management accountant for LQ Iron Ore Ltd (LQ), receives numerous requests
for information from shareholders, creditors and suppliers as well as members of the public.
Ally has kept a diary of how she spent the last fortnight and it shows that:
• Forty-five per cent of her time involved responding to LQ’s external stakeholders.
• Twenty-five per cent was spent with senior management in strategy related meetings and
planning workshops.
• Fifteen per cent was spent in discussion with line managers.
• Fifteen per cent was spent with staff, giving guidance and supervision.
Ally realises that although she spends about 55 per cent of her time with internal stakeholders,
answering their management accounting questions, she feels that this is not building rapport.
She also knows that in the past when she has tried to spend time with line managers, they have
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Check your work against the suggested answer at the end of the module.
Study guide | 149
➤➤Question 2.8
GoodsFast Pty Ltd (GoodsFast) is a small company that quickly grew into a large company by
challenging the dominance of larger parcel companies. GoodsFast specialises in transporting
large and heavy parcels, but will carry any size or weight. It is very customer oriented and known
for its reliable tracking and delivery. Its organisational chart is as follows:
Strategic level Tactical level Operational level
Senior manager—
marketing
Senior manager—
transport
Senior manager—
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Middle managers Supervisors
warehousing and
(12) (30)
administration
CEO
Senior management
Senior manager—
accountant
accounting and finance
(Tom Patton)
Senior manager—
HR
Senior manager—
information technology
The CEO has overall responsibility for the business while senior managers are responsible for
considering the future sales expectations of customers, the delivery technologies that GoodsFast
should be adopting, and the partners they should use.
The middle managers are responsible for logistics, that is pickup of parcels received for delivery
and making arrangements for redelivery (e.g. customer not home), contract negotiation to ensure
there are couriers covering the delivery locations, advertising the parcel service, recruiting and
timetabling the truck fleet and truck driver work allocation, ensuring there is sufficient warehouse
storage available, approving expedited deliveries and providing customer after-sales service
where there have been delivery delays. In addition, they ensure that stores have sufficient
packing materials (e.g. boxes, bubble wrap) for sale to customers who simply bring in the item
they want to send.
The supervisors are responsible for accepting customer orders to consign their parcels, arranging
day-to-day deliveries and receipting payments made by customers. Their workload is allocated
by family name and delivery location.
Tom Patton has recently been promoted to senior management accountant at GoodsFast and
from his knowledge of the company realises that its information flows are quite poor and
no‑one has taken responsibility for the quality of information that is being produced and used
for decision-making.
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Identify the information needs for each of the three levels of manager at GoodsFast.
Strategic
Tactical
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Operational
Check your work against the suggested answer at the end of the module.
Study guide | 151
MODULE 2
Stimulus for a new or updated system
The stimulus to initiate a review or propose a new or replacement system often originates with
general observations about the system, such as:
• The functions performed by the current system are no longer suited to the goals the
organisation has for it.
• The technology used with the current system appears out of date.
• The current system appears too inflexible compared to current or future needs.
• The current system is expensive to maintain compared with alternatives.
The design of a new information system, or major changes to an existing system, require a robust
project management methodology, which is described in detail in Module 4. The following
sections relate to specific aspects of planning for information systems.
The preliminary assessment uses interviews with staff members and observation of business
processes and asks three simple questions:
1. What is satisfactory about the current system?
2. What is unsatisfactory that external and internal stakeholders see as weaknesses?
3. What improvements have been requested and what is their status—for example, in progress,
approved and awaiting development, rejected, ignored?
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The results of these interviews and observations are compiled and cross-checked for
consistency. Inconsistencies are investigated and resolved. The output from this assessment
is an independent assessment of current arrangements that can be referred to after obtaining
information from managers about their information needs.
Although this approach might appear to be unnecessary when a completely new system is being
installed, this is not the case. A comparable new system should be examined in the same way.
This can be done by asking what existing business processes would receive outputs or send
inputs to the new information system.
Some managers may complain that this activity causes a delay or is unproductive, however the
management accountant should defend the time and effort for the preliminary assessment as
worthwhile planning. This is shown in Example 2.8.
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On the first day, six managers made unannounced drop-in visits to his office asking whether their
preferred software package could now be purchased and the project to install and commission it be
completed before the next financial year. Gary replied, ‘As it has to be signed off by the board, I can
do the preliminary assessment myself but I expect it will take about a fortnight’. The managers went to
the CEO to complain. The CEO asked for an explanation. Gary reminded the CEO that the board had
to approve the expenditure of about $2 million and funds were a scarce resource. The CEO agreed
the time was reasonable.
Gary could understand the managers’ frustration. They had found a software package they believed
was better than the one they had and that was offered by a small but reputable supplier. They had
also experienced difficulties with their large IT department, which preferred a mainstream software
package supplier and wanted to have that supplier do all the work including interfacing with the
existing systems (production, accounting, and marketing).
At the conclusion of the preliminary analysis, a round table meeting was held with all managers.
They were asked: If you could get what you want from the existing system, would you want to keep
it? They were unanimous they would keep it.
The happy ending (about a year later) was that the improved system did everything the managers
wanted at a cost of about 40 per cent of the budget for the replacement.
The preliminary assessment does not preclude assessing the information needs of stakeholders,
and this is discussed in the next section.
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The ‘what’ can become a project in its own right if it is allowed to examine everything. The
management accountant has the choice of establishing information needs by starting with the
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senior managers (top down) or first-line supervisors (bottom up). The advantage of a top-down
approach is that senior managers should know what they expect lower managers to be doing
and can identify their own needs as well as those of subordinate managers. The requirements
of senior managers can be checked with subordinate managers and any discrepancies can be
resolved with the senior managers.
This issue that inevitably arises with the top-down method is its lack of detail. Senior managers
will use key performance indicators (KPIs) or critical success factors (CSFs), and the subordinate
managers will say they make many more decisions—and hence need more detailed information—
than those envisaged by the CSFs. This occurs even when hierarchical methods such as the BSC
are used.
Lack of information
A lack of information suggests the need for data analysis. A proven method that management
accountants can use is a data flow diagram (DFD) (DeMarco 1979). A DFD highlights processes
and visually illustrates what data is the input to and output from a particular system or process.
A DFD starts with an overview that contains a single process (the entire system) that is then
broken down into components. So for example, a system might have five individual component
processes that are identified, of which number 5 is ‘accounting’. Accounting would then be
broken down into its ‘child processes’ (as shown in Figure 2.7).
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Diagram 5: Accounting
CC-statement
Bulk-claim
5.2
Accept
funds Deposit
Payment
Credited-payment
5.1
Record
5.3
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payment
Commission-note Pay Commission
commission
Mail-payment
Invoice file
5.4
Dun Delinquent-invoice
deadbeats
Source: DeMarco, T. 1979, Figure 45, Structured Analysis and System Specification, Prentice Hall, p. 101.
The advantage of a DFD is that the technique is simple to learn, widely applicable and, most
importantly, independent of any hardware or software. After a short period of analysis, the data
needs of managers become visible and the scope of the system is easily determined.
12. If you had been isolated on a desert island for three months, what would be the three
questions you would ask about your role and responsibilities?
13. Do your subordinates complain about receiving performance information that
is unsatisfactory?
The major weaknesses of this approach are that executives may incorrectly identify the CSFs,
or the CSFs may change without the executive realising it.
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• Made by senior managers
• Concerned with the vision, mission, structure and resources of
the organisation
• Mainly unstructured
Strategic • Require searching the external environment
• Occur infrequently
• Longer and broader consequences than management or operational
decisions
Studying decisions requires attention. Some decisions are made consciously, deliberately and at
slow pace. These are often linked to organisational activities such as strategic planning. Or they
may be initiated when external forces (e.g. government regulators) force the organisation to act
in certain ways or respond to an issue. Other decisions have to be made in the moment without
careful deliberation. Kahneman (2012) points out that these decisions use heuristics and may be
subject to biases. So particular attention needs to be paid when making a quick decision.
A second reason for giving attention to the decision process is that it is difficult to know what
issues will be strategically important for the organisation in the future. One heuristic that is often
used is to look at previous planning efforts—but the past is not necessarily a guide to the future.
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A systematic approach is to ask each manager when making a decision to answer the following
introductory questions:
1. What information do I need?
2. Why do I need this information?
3. Where do I obtain this information?
4. Do I need to obtain the information from one or more other systems?
5. Are those other systems manual, semi-automated or computer-based information systems?
6. Who else uses the same information?
7. How do I rate the information I am provided with in terms of content, volume and quality?
8. Who do I send the information I produce to (one or many recipients)?
9. How does the information I produce support any individual, team/group and company goals?
10. Is the flow of information disrupted by inadequate tools, processes and procedures?
11. What changes in workflow, tools, processes, policies or procedures are desirable to improve
the quality of information I receive or provide?
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After these questions are answered, the results are summarised in a matrix (table) similar to
Table 2.11.
Table 2.11: Matrix of analysis for information needed and information produced
Information needed
The disadvantage of this approach is the effort required—which is intensive since every decision
has to be examined and checked with the decision-maker. It is cumbersome because once the
matrix is completed it can result in a large document. In some cases, the recipient of information
may be a committee where different understandings may exist. However, the advantage is that
this can be used to build rapport with managers and then provides an opportunity for review
checks in the future—which should be less time consuming, allowing more time for discussion.
The assumption with this initial establishing of information is that the decision is significant,
stable and made repeatedly. A practical example of this approach is shown in Example 2.9.
Decision What info Why Source Content Volume Quality Destination Goal Disruptions
Range of Number To Inventory Covered Monthly High CEO Increase Requires New
items of existing compete system accuracy but also some hand product
lines by with online reduce analysis grouping
product retailers some in more
group than one
dimension
(e.g. size
and colour)
Inventory Current Working Inventory Within Monthly Low Purchasing Better — Real-time
level stock level capital KPI system budget accuracy stock and ad hoc
The following table is an extract of the matrix.
turnover availability
It can be used as part of the cost justification for change because it shows that making this information
Chenglei decides to meet with the managers and use the ‘identify and analyse decisions’ approach
The table crystallises the information analysis and indicates that there are common information needs.
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157
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dynamic one
Ask the decision- Detailed interviews Focuses on a single issue, Huysmans 1970
maker about task or decision assuming
their needs it is major and repetitive Ross and Schoman 1977
Strategic goals Investigate goals top down The decision-makers’ Checkland 1981
and concerns personal goals may be
inconsistent with the
organisational goals
Process analysis of Detailed systems analysis Observes users’ behaviour Lundeberg 1979
inputs and outputs without seeking their
insight or helping them
examine their expertise
to assess needs more
creatively
Use an expert Panel identifies strategic The experts also classify Gustafson et al. 1992
panel issues that the organisation the information into
will face within the next essential, periodic and
2–5 years. The related low value, and then discard
information is then sought the low value so it is still
for high priority issues possible to miss a future
information need
These options are not explored in detail in this module because they do not involve employees
in the detail, and we know from psychological studies (including the Hawthorne effect) that
when employees participate in their workplace design, it is more likely they will be motivated
to support the system (or project) and then use it.
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↓ software package
Programming
Testing
Testing Implementation
Migration
Conversion ↓
Installation
Installation
Post implementation
Maintenance Upgrades of software package
↓
Source: Based on Oliver, G. R. 2012, Foundations of the Assumed Business Operations and Strategy
Body of Knowledge (BOSBOK), Darlington Press, Darlington, Australia, pp. 261–4.
One important benefit of the SDLC approach is that it allows the management accountant to
estimate how long it will take to introduce a new or updated information system and to estimate
the costs of each phase of software development or software package implementation.
Prior to investing significant resources in a new or updated information system, the organisation
needs to make an assessment of its life expectancy and whether an investment should be made
in a system approaching obsolescence.
The management accountant will always make enquiries about the original implementation
date of a system or software package and the extent to which it has been updated previously.
This gives an indication of where the system or software is in terms of its whole-of-life expectancy.
Systems become obsolete technically, but also because new software developments and new
packages may be a preferred option, compared with continually updating an underperforming
system. This is only a guide to assessing the expected life of the system, and attention will be
needed to determine what new requirements there are and whether those requirements can be
handled by changes to the existing system or software, or acquisition of a replacement system or
software. This is further explored later in this module.
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Answers to these questions allow the management accountant to more fully explore the
stakeholder’s information needs.
Once stakeholder responses have been obtained, their information needs can be collated and
tabulated. This may lead to additional small group meetings for confirmation and to explore the
kind of information that needs to be provided.
The first step is known as the tests of feasibility (see Table 2.14). Feasibility assessment occurs
after the requirements have been established, and is the decision whether to pursue design
or selection of a software package. The tests are simple yet decisive and encompass any
technology change.
Technical Is this application possible within the limits of available technology and our
resources?
Economic Will this application return more in monetary benefits than it will cost to develop?
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Source: Based on McKinsey Consulting Organization 1968, ‘The 1968 McKinsey Report on computer
utilization’, in T. W. McRae, Management Information Systems, p. 104, Penguin, Harmondsworth, UK.
If the tests of feasibility are completed and judged as passed then the second step can be
commenced by applying some more detailed criteria. Any organisation looking to evaluate a
new information system needs to assess the criteria it will use, which will depend on its own
circumstances. Table 2.15 describes criteria that could apply to an ERP system.
Adaptability As new business needs arise or changes to business processes occur, will it be
adaptable to change?
Fit Is the system specific to the business situation or problem? Or will the business
need to change its processes to fit the new system?
Operational skills How many people are required to support the operations and what level of skill and
experience do they need?
Big data capability Is there a capability to extract and analyse internal and externally sourced data for
strategy formulation, implementation and control?
Separate to the criteria are the organisation’s goals and objectives. Table 2.16 highlights
possible tangible and intangible goals for an ERP system. The achievement of these goals
by implementing a new ERP system should then be compared with the costs, to justify the
acquisition of the system.
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Table 2.16: Key objectives for ERP system—tangible and intangible goals
Goals
Since the 1980s, total quality management (TQM) has advocated making improvements to
accounting systems by promoting improved performance measures (Kanatsu 1990). It offers
a holistic approach by beginning with information capture and considering the adequacy of
information in reports. In this way it is possible to discover whether reports are inadequate
because of:
• the existing content—which may be capable of improvement, or
• the lack of desirable content.
Management accountants can consider stakeholder views on monthly budget reports; these
can often overwhelm managers by providing intricate detail that makes detecting trends and
patterns difficult. As a result, managers spend their time looking for unfavourable variances
and decomposing them. This is desirable if the organisation is pursuing a major cost reduction
program, but not a wise use of time if the priority is attention to products.
There are various ways the information flow to stakeholders can be improved. Data can be
exported to spreadsheets for analysis. Exception reports rather than detailed reports can
be produced. The ability to drill down from summary data to transaction level data can be
implemented. All these changes can be made to existing information systems.
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These simple changes can be justified by the increased attention paid to reports, and can stand
alone—that is, they do not necessarily need to be situated in a project. Once it is known that
the management accountant can improve report formats to provide better information for
stakeholders, management accountants will quickly find they are appreciated and sought out
for advice.
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retaining the existing system (e.g. no new system installation costs) and some intangible
benefits (e.g. no business disruption).
2. They can show that making limited changes to the existing system is preferred over making
a major change now. For example, user requirements may not be stable or cannot be
satisfactorily established. Establishing requirements could be time consuming or unreliable,
and thus retaining the existing system for a further period is a rational choice.
The issue with tangible benefits is the method of measurement. There is no agreement on the
best method and there are a considerable number of reasonable alternatives:
• One view is the derived value method. It considers how a system is intended to be used.
Soh and Markus (1995) recommend that information system success be judged on its actual
achievement of the objectives or goals for which it was implemented. They distinguish
this from judgment about how well the system operates. For example, if the goal is better
customer service then evidence should be sought on whether better customer service
occurred, not whether revenue increased.
• There are alternative views of the value of the system to the organisation. A wholly economic
criterion is the decision pay-off (Schell and Cocoma 1986). It requires careful analysis of
the proposal and agreement between stakeholders on the tangible costs and benefits.
It frequently shows deficiencies in the calculation of these, and focuses attention only on
proposals with high potential.
• Peters (1990) recommended using the value chain to determine which activities produced
value.
• Another view combines weights with ratings to produce a numeric index that indicates
the total business value of the proposed system (Parker et al. 1988). Parker et al. describe
this as an information economics method that provides a broader view of value, allowing
prioritisation of individual IT projects or a portfolio.
So, the management accountant not only has to choose the method they will use to evaluate
benefits, but also whether they will include intangible benefits.
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If we continue with the same example of a business seeking to implement an ERP system, we can
consider the major costs and benefits.
Costs include:
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Traditionally, these costs are also grouped as one-off or recurrent costs. A thorough approach is
necessary to discover, capture and quantify all possible costs to avoid them occurring during the
project where they are unbudgeted.
When considering benefits, there is a possibility that managers may seek to quantify benefits
identified as intangible and thus convert them to tangible benefits. Table 2.17 provides examples
of tangible and intangible benefits that can be compared with costs.
As far as possible, tangible benefits will need to be quantified for comparison with costs.
Quantifying the benefits is far more problematic than estimating costs, and so the assumptions
behind the dollar values allocated to benefits will need to be clearly explained by the
management accountant.
Study guide | 165
Tangible Intangible
Ability to deliver the business strategy, which may be Easier communication—e.g. managers,
expansion of sales revenue and/or cost reduction, department heads and employees are all sharing
entering a new market or introducing a new product common information
or service
Improved output at reduced cost—e.g. faster Higher productivity—e.g. employees avoid wasting
customer service and order fulfilment, improved time gathering information for management
quality
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Elimination of activities and resources in processes— Improved efficiency—e.g. managers have new
e.g. inventory reduction, waste reduction information to identify strengths and weaknesses
Analysing costs and benefits also requires an analysis of the risks involved in any change to
information systems. These risks may include, for example:
• poor design of the new system (or changes to an existing system) due to inadequate
consultation with users
• availability and cost of resources to complete the project
• failure of project management to ensure delivery of the new/changed system within time
and budget constraints
• failure to recognise emerging technological or legal changes such as cloud computing
developments and privacy legislation
• poor changeover planning leading to loss of data
• poor implementation training.
As with any other aspect of risk management (covered in detail in Module 4), risks need to be
identified, assessed (in terms of impact and probability), and risk mitigation put in place to
reduce the risk to an acceptable level.
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➤➤Question 2.9
Anna Field is the management accountant at Homemade Biscuits Pty Ltd (HB). She has been
asked by the CEO to examine their AIS. The CEO was recently hired from a large manufacturing
business that used a database and software including a complex financial module.
The CEO wants to know why the accounting reports that he receives are so poor and why he
cannot drill down to find details about revenues and expenses. He complains that the reports
he receives are hard to read and leave him to do basic calculations such as trend comparison
and some ratios.
How should Anna go about this investigation? Make clear what she should be looking for and
whether a new AIS is the best option.
MODULE 2
Check your work against the suggested answer at the end of the module.
Study guide | 167
Review
This module comprises four parts that are linked together by their common theme of information
for decision-making.
Part A reminded the management accountant that they should not initially try to identify the
individual information needs of managers and employees. Instead, they should consider all
stakeholders—both external and internal. External stakeholders are featured in the conceptual
framework and play an important role where financial accountants provide them with general
purpose and special purpose reports. Internal stakeholders may be the primary customers of
the management accountant because they require far more detailed information about business
performance, including both more detailed and disaggregated financial statements as well as
a wide range of non-financial performance information.
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Part B examined in detail the types of information and their role in decision-making. It outlined
how information is used in the most common systems found in organisations (TPSs, DSSs
and ERP systems). It also discussed that an important role for the management accountant is
to integrate the wide variety of information that is available and present this to managers in
a meaningful way, accompanied by a comprehensive analysis and interpretation to support
management decision-making.
Part B also focused on security. While privacy and confidentiality are among the most important
reasons for security, the increasing prevalence of industrial intelligence means that information
has value to competitors.
Next, Part B discussed the attributes of information—that is, its qualitative and qualitative
characteristics. This included the conceptual framework approach and the four-way classification
approach.
Part B then discussed big data. With big data, it has become common to work with very
large sets of information and these present new challenges for the management accountant.
Data warehousing and data mining are the two most common techniques that allow the analysis
of information, usually to make predictions or uncover hitherto hidden trends or relationships.
For these reasons, the management accountant will be interested in big data, but this will
necessitate building predictive models and ensuring storage is compliant with emerging
government concerns.
Part C was concerned with the role of management accountants in influencing stakeholder
decision-making. Having looked at stakeholders in Part A and taken a detailed look at
information in Part B, this part showed how the management accountant can address the
requirements stated by stakeholders and yet deliver the information they need.
Part C also discussed how there have traditionally been three levels of information needed in
the organisation:
1. At the top is strategic information, which is used by the board and senior executives.
2. In the middle is tactical information, which is used by middle managers for decisions about
sales and production and the support activities.
3. Finally, there is operational information, used by employees and first-line supervisors who are
responsible for the routine activities of the organisation.
Part D required the management accountant to analyse existing information systems. This may
occur through them receiving a demand for a new or revised system. Criteria for analysis are
suggested, together with the steps involved in making a preliminary assessment.
One of the responsibilities of the management accountant is to initially establish the system
information needs of stakeholders.
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There are three tests of feasibility (technical, economic and operational) that can be applied to
any system. A system that passes these tests can then be assessed against criteria that are likely
to reveal whether costs are understated because functions are omitted.
A second check is provided by the key objectives. Often, the result is the realisation that the
existing system should be retained and changed, so this possibility is also discussed.
There may be instances where stakeholders are proposing to invest in a new system but this can
be shown to be premature. Sometimes this can be achieved by a ‘hard line’ economic analysis
that examines payback from better decisions, or by ensuring the costs and benefits have been
fully calculated.
In summary, this module shows the management accountant has an important role in:
• identifying useful information for decision-making
• ensuring that the information they provide is of suitable quality
• managing the information needs of stakeholders, both external and internal
• obtaining useful information by improving the systems and processes or assisting in
the selection of new accounting systems
• assisting in decision-making by not only interpreting accounting information but by
becoming a trusted adviser to managers.
Suggested answers | 169
Suggested answers
Suggested answers
MODULE 2
Question 2.1
Kim has two issues to resolve:
1. identify whether all the new board members are in the same stakeholder group
2. consider how to determine their information needs.
To identify whether all the board members should be treated as equivalent stakeholders, Kim will
want to discover whether any of the board members are executive directors (i.e. attend the
office from 9.00 am to 5.00 pm each day), and whether any of the board members have special
committee responsibilities that require them to have additional information—for example,
for audit committee, remuneration committee. It is likely that as internal stakeholders,
the members on committees will require additional information, but as members of the board,
they can be treated as a stakeholder group. This is consistent with the stakeholder grid in
Figure 2.2, which places them in the high power/high interest quadrant.
To determine the main kinds of information they will need, Kim should first consider the
information needs in Table 2.1. This suggests that all board directors will require information
about financial performance, strategy, competitive position and issues of concern. The stakeholder
approach is incomplete and there may be adequate information already available and routinely
provided to previous directors, so this can be separately considered. There will be some specific
additional information based on board committee roles, and these can be investigated separately
(using methods discussed in Part C and D of this module).
Question 2.2
(a) In respect of the two new managers, Kim should find out what their roles responsibilities are
and what information would be of value to them. Unlike the directors, whose information
needs will cover tactical and strategic information, the two managers (assuming they are mid-
level management) are likely to require tactical information dealing with goals and objectives,
detailed performance targets, budgets and organisational priorities.
Finally, Kim will want to use the stakeholder grid and risk analysis to determine whether there
are any communication or risk factors that should receive attention.
MODULE 2
(b) The soft skills that the management accountant should develop are around working with the
new managers. To do this, the management accountant will have the ability to collaborate by
developing and managing relationships with the new managers to understand their needs
and ensure information is available to help the new managers settle into their new roles.
However, to be able to do this the management accountant will need to show the ability to
apply professional judgment to help the new managers to anchor their business decisions
taking into account the information available to them.
The management accountant will assist the new managers to have the ability to influence
decision-making by being a trusted partner.
So developing a trusted adviser position with managers is the soft skill goal.
Question 2.3
It is true that ERP systems have now been around for such a long time, and over the past 10 years
they have become fully featured and extremely reliable. However, the decision to install an ERP
system requires careful analysis. Just because they are reliable and proven does not mean they
are suitable for most organisations.
There are many ERP systems. Large-scale ERP systems such as Oracle and SAP are designed for
large organisations—that is, organisations that have many sites, usually in many countries, and a
business with a large number of products or services. These systems have high purchase costs,
high installation costs and high maintenance costs. So, to ensure benefits exceed costs, it is
necessary that they are used for most if not all the business processes in the organisation.
Suggested answers | 171
There are also ERP systems for smaller organisations. It is more likely that a smaller organisation
will not select all the modules, and it is also likely that the smaller ERP system will not have the
same amount of functionality as the large-organisation ERP packages. In part, this is due to
the fact that the smaller ERP packages are often specific to different industries. For example,
there are small-to-medium ERP packages for universities, which focus on their student admission,
enrolment and progression. There is no reason for a small-to-medium business to have an
ERP system. The managers are more likely to know the intricacies and details of the business
outside their own department and so will receive little value from having to standardise their
business processes.
Question 2.4
MODULE 2
(a) The most important information that the ERP system should be able to provide is the sales
and profits by store location. This will help to identify the least profitable stores that might be
closed and the potential savings in rental costs and staffing.
Sales by product information would also be available from the ERP system. This would
enable judgments to be made about which were the highest volume and/or most profitable
products that could be sold online.
In addition, the CRM system should have information on customers including their lifetime
value, satisfaction, buying trends and location. This information could provide information
to support decision-making about the location of the central warehouse, ideally in proximity
to the largest number of (or largest number of most profitable) customers. Customer buying
behaviour could also inform decision-making about the product range to be carried online.
(b) Broad-ranging research from available statistical and industry sources might provide a
‘big picture’ of the growth of online sales relative to in-store sales to inform a long-term
view for the board of the continued viability of the retail stores.
Tim would need to undertake a price comparison between the prices charged by the existing
online competitors and estimate by how much T&S prices would need to be reduced in
order to compete.
Tim would then need to undertake a study to determine an estimated cost to develop an
appropriate IT system to enable online purchasing by customers. An estimate of costs to
acquire or build a warehouse would also have to be carried out, together with an estimate of
the necessary staffing, marketing and promotion costs and means of distribution of ordered
products to customers. This would require a detailed capital expenditure evaluation to be
carried out.
Note: Much of the information sourced externally by the management accountant could be
available if T&S had a DSS.
Question 2.5
Tina needs to conduct further discussion with the managers to discover:
1. whether the policy on train length allows the length of the train to be increased or reduced
by changing the number of carriages
2. the relationship between the number of carriages, passenger numbers and revenues
3. how important revenue measures are to the managers in providing strategic management
accounting
4. what is the extent of forward planning in the TPS.
Tina could apply Drucker’s four questions (Drucker 1964) to strategic management accounting to
discover what information managers believe they are missing that would allow them to improve
the efficiency of operations—both for trains and bus substitution.
MODULE 2
One approach Tina could suggest is attending the next meeting with the regional managers to
understand their concerns and the ways they use the existing information. This may result in the
need to source information from different sources and/or integrate it. For example, costs change
when buses are running but there is no change to the revenue (fares). Tina needs to consider
the possibility that the managers are concerned about the qualitative attributes of information,
so she may explore the four-way classification of information (see Figure 2.4) with managers.
Question 2.6
Big data uses large data sets for analysis. StreemMov offers a subscriber service where membership
entitles the member to access programs by logging on through their account that acts as the
identification and billing method, which will generate considerable information about customer
buying preferences.
Bono may also make suggestions that BI could be used to improve StreemMov’s own decision-
making, if it is felt that improvement is warranted.
Question 2.7
(a) How could Ally deal with the ad Ally has been quite diligent in understanding how she spends
hoc requests from stakeholders? her time, and it shows that about 55 per cent of her time is spent
helping managers. Ally has also recognised that much of this
time spent with managers is responding to their specific ad hoc
requests and has not been developing relationships with them.
They are reluctant to speak with her when she attempts to book
time with them.
(b) How could Ally approach the There are two possible approaches Ally could take, based on
line managers and improve the information in this part of the module. The first is to embark
her professional relationship on an information needs analysis, which would take up the time
with them? of managers who are already reluctant to assist. One possibility
is that Ally uses the time spent with managers on answering
MODULE 2
their ad hoc queries to identify ways in which she can gain a
better understanding of their information needs, which may
then enable her to provide more useful information in the
first place. If the majority of the managers’ queries relate to
making decisions, then Ally could ask whether the managers are
interested in completing the log on decisions they make and
information needed.
Question 2.8
Identify the information needs for each of the three levels of manager at GoodsFast.
Strategic This level is concerned with long-term issues of the business direction, which will assure
its revenues and allow it to manage costs. Strategic revenue questions involve what will
ensure the competitive advantage of GoodsFast in the future in terms of its customers,
delivery arrangements and changes in technology that may create challenges or
opportunities. Tom will recognise that external information will be required in addition
to the information he can provide to ensure that strategic management of costs is
concerned with improving performance and containing costs so that the strategic
position of the firm is improved overall.
Tactical These are primarily logistics decisions covering arrangements for pickup and delivery
of the parcels. There are some that ensure there are contracts with couriers to pick up
MODULE 2
and ship parcels to the destination state and suburb. These arrangements depend on
having sufficient drivers and trucks available for the number and volume of materials.
Other middle manager decisions include staffing each location (branch, shopfront,
warehouse) and ensuring adequate supplies. GoodsFast, like most shopfront packing
services, makes additional revenue out of selling packing boxes and packing material
(e.g. bubble wrap) because their clients bring in the package for wrapping as otherwise
any breakage becomes their responsibility. So, having sufficient supplies in stock is
essential, otherwise they incur costs when they have to upgrade the packing to a higher
level as a result of a stock-out.
Operational These are primarily the decisions about accepting orders from customers to consign
their parcels, and determining the method of transport, pickup and delivery.
Question 2.9
This will be a difficult assignment for Anna because the CEO is biased towards the AIS that he
previously used, and it is likely that Anna will begin by suggesting amendments to the reports.
To meet the CEO’s needs, it should not be overly difficult to provide a drill-down facility so that
the CEO can trace from report totals down to individual transactions; every accounting system
is comprised of transactions, so drilling down should not be a problem. Minor modifications to
reporting should also be fairly easy to accommodate the CEO’s need for ratio calculations and
trends, without making significant changes to the information system as these needs are no
more than manipulations of data that already exists in the accounting system.
Generally speaking, before recommending a new system it is wise to try and improve the existing
system. Anna should sit with the CEO to understand the deficiencies in the reports that he
receives. She can then check with the other recipients of the same reports and see whether they
too have found deficiencies. Anna can synthesise the information needs of all the managers and
go back to the CEO with a mock-up of a better designed report. She may have to repeat this
several times to get a suite of reports that are acceptable to the CEO.
In doing so, Anna may determine that the required data is either not input or not calculated—
so some programming changes may also be necessary. It will be necessary to establish the
budget for making the changes, and ensure that the CEO agrees to it otherwise the CEO may
perceive her as not following systems development protocols.
Suggested answers | 175
There may be several iterations of these improvements. Eventually, Anna will be able to make
a judgment whether the existing system is still capable of being improved, or whether she has
reached its limits and it is time to consider a replacement. The important thing is that the costs
of these refinements and enhancements are small but the payback in terms of better reporting is
high. If Anna is able to improve these reports in the short term so they are satisfactory, then they
can become the baseline for any new system (should one be proposed). This will encourage
Anna and the managers to consider what new level of functionality for the business should be
delivered by any new system.
Depending on what additional reports are called for by the CEO, it may be possible for her to
visit the CEO’s former firm (depending on the circumstances) and see examples of the reports
to get a comparison. This is known as benchmarking. If it is not possible then the CEO may be
able to use his contacts to find another organisation that uses the software and that Anna can
visit. The reason this is suggested is that if Anna believes the CEO is unlikely to give up pushing
MODULE 2
for the larger system, it would be wise for her to start to understand it now, even though any
decision may be two or more years in the future.
References
References
MODULE 2
American Institute of Certified Public Accountants (AICPA) and Chartered Institute of Management
Accountants (CIMA) 2014, Global Management Accounting Principles: Effective Management
Accounting: Improving Decisions and Building Successful Organisations, accessed August 2018,
https://www.cgma.org/content/dam/cgma/resources/reports/downloadabledocuments/global-
management-accounting-principles.pdf.
Bullen, C. V. & Rockart, J. F. 1981, ‘A primer on critical success factors’, CISR No. 69. Sloan WP
No. 1220-81, Massachusetts Institute of Technology, Sloan School of Management, Centre for
Information Systems Research, Cambridge, Massachusetts.
Chau, D. 2018, ‘Facebook share price drop wipes $US119b from company’s value, $15b from
Mark Zuckerberg’s net worth’, ABC News, 27 July, accessed August 2018, http://www.abc.net.au/
news/2018-07-27/facebook-share-price-drop-wipes-$us119-billion-company-value/10042404.
Checkland, P. 1981, Systems Thinking, Systems Practice, John Wiley, New York.
Collier, P. M. 2015, Accounting for Managers: Interpreting Accounting Information for Decision
Making, 5th edn, Wiley, West Sussex, United Kingdom.
Curran, D. 2018, ‘Are you ready? Here is all the data Facebook and Google have on you’,
The Guardian, 28 March, accessed July 2018, https://www.theguardian.com/commentisfree/2018/
mar/28/all-the-data-facebook-google-has-on-you-privacy.
Deloitte & Touche, cited in Byard, S. 2018, ‘Top ten criteria for selecting accounting software’,
accessed June 2018, https://blog.bestbusinessstrategies.net/top-ten-criteria-for-selecting-
accounting-software.
DeMarco, T. 1979, Structured Analysis and System Specification, Prentice Hall, New Jersey.
Donaldson, T. & Preston, L. E. 1995, ‘The stakeholder theory of the corporation: Concepts,
evidence, and implications’, Academy of Management Review, vol. 20, no. 1, pp. 65–91.
Doran, G. T. 1981, ‘There’s a S.M.A.R.T. way to write management’s goals and objectives’,
Management Review, AMA Forum, vol. 70, no. 11, pp. 35–6.
178 | INFORMATION FOR DECISION-MAKING
Gelinas, U. J., Dull, R. B. & Wheeler, P. R. 2012, Accounting Information Systems, 9th edn,
South‑Western, Mason, Ohio.
Gustafson, D. H., Cats-Baril, W. L. & Alemi, F. 1992, Systems to Support Health Policy Analysis:
Theory, Models, and Uses, Health Administration Press, Ann Arbor, Michigan.
Kanatsu, T. 1990, TQC for Accounting: A New Role in Company-wide Improvement, Productivity
Press, Cambridge, Massachusetts.
Kaplan, R. S. & Norton D. P. 2001, The Strategy-Focused Organization: How Balanced Scorecard
Companies Thrive in the New Business Environment, Harvard Business School Press, Boston.
International Integrated Reporting Council (IIRC) 2013, The International <IR> Framework,
accessed August 2018, http://integratedreporting.org/wp-content/uploads/2015/03/13-12-08-
THE-INTERNATIONAL-IR-FRAMEWORK-2-1.pdf.
Laney, D. 2001, ‘3D data management: Controlling data volume, velocity, and variety’,
Meta Group Application Delivery Strategies, 6 February, file 949, pp. 1–2.
Lundeberg, M. 1979, ‘An approach for involving users in the specifications of information
systems’, in H. J. Schneider (ed.), Formal Models and Practical Tools for Information Systems
Design, Amsterdam.
Maister, D., Green, C. H. & Galford, R. 2001, The Trusted Advisor, new edn, Simon and Schuster,
New York.
McKinsey Consulting Organization 1968, ‘The 1968 McKinsey Report on computer utilization’,
in T. W. McRae (ed.), Management Information Systems, Penguin, Harmondsworth,
United Kingdom.
Mintzberg, H. 1975, ‘The manager’s folklore and fact’, Harvard Business Review, vol. 53, no. 4,
pp. 49–61.
Mitchell, R., Agle, B. & Wood, D. 1997, ‘Toward a theory of stakeholder identification and
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Parker, M., Benson, R. & Trainor, E. H. 1988, Information Economics: Linking Business Performance
to Information Technology, Prentice-Hall, Englewood Cliffs, New Jersey.
Peters, G. 1990, ‘Beyond strategy: Benefits identification and the management of specific IT
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your-personal-data-n870501.
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2018, https://searchitchannel.techtarget.com/essentialguide/IT-channel-sales-and-marketing-
strategy-for-the-digital-era.
MODULE 2
Valusek, J. R. 1985, ‘Information requirements determination: An empirical investigation of obstacles
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MODULE 2
STRATEGIC MANAGEMENT ACCOUNTING
Module 3
PLANNING, BUDGETING AND FORECASTING
182 | PLANNING, BUDGETING AND FORECASTING
Contents
Preview 185
Introduction
Objectives
Review 247
References 257
MODULE 3
MODULE 3
Study guide | 185
Module 3:
Planning, budgeting
and forecasting
Study guide
MODULE 3
Preview
Introduction
The business environment is constantly changing, resulting in many challenges. One such
challenge is how an organisation can sustain itself in an uncertain future. The governing board
of organisations typically considers the organisation’s sustainability in their strategic plan and
managers implement the strategic plan through operational plans. Budgets form a part of the
operational plan.
Budgets are an accounting tool that helps managers plan to meet the organisation’s goals.
During this planning, they anticipate and consider the challenges posed by an uncertain future
and predict the possible effects of these challenges and uncertainties on their organisation’s
limited resources. This culminates in setting targets that make best use of the organisation’s
limited resources and that would achieve the organisation’s goals. Once targets are set in the
budgets, they are used to gauge the performance of the organisation and the managers.
This module focuses on budgeting as a planning and control mechanism. The role of budgets
and their relationship to the organisation’s strategy is discussed. The module also describes
the various components of budgets and demonstrates how financial forecasts addressing
uncertainties are developed.
Variance analyses are then considered as a means to monitor and evaluate the organisation’s
and managers’ performance compared with targets set in the budgets.
The module then discusses the human behavioural issues that typically result when using
budgets as a control mechanism. Finally, the module concludes with a discussion of proposed
alternative approaches to alleviate the limitations of traditional annual budgets.
186 | PLANNING, BUDGETING AND FORECASTING
The highlighted sections in Figure 3.1 provide an overview of the important concepts in this
subject and how they link with this module. This module discusses how the management
accountant works to provide management with information for budgets and operational
decision-making that, in turn, informs and is informed by strategy.
rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
MODULE 3
MANAGEMENT ACCOUNTANT
VALUE INFORMATION
OPERATIONS
Exte
rnal environment
Objectives
After completing this module, you should be able to:
• Identify the roles of operational plans, budgets and forecasts and the relationship between
these elements and strategy.
• Develop a master budget based on operational plans, previous financial results, and forecasts.
• Perform variance analysis to monitor and evaluate performance.
• Prepare a financial forecast that addresses uncertainty.
• Analyse the behavioural impacts that may result from budgeting
• Discuss the usage of alternative approaches to budgeting.
Study guide | 187
Note: This links with the financial analysis and performance measures discussed later in
Modules 4 and 5.
The choice the organisation makes about which course of action to pursue, and the direction
for their future activities over the long term, are set out in broad terms in their strategic plan.
Strategic plans normally cover three or more years, with most being for at least five years.
A budget is a means to operationalise strategic plans, create value and shape the future of
an organisation (Eldenburg et al. 2017).
Once the strategic plan is in place, organisations focus on short-term decisions that shape their
day-to-day activities for the chosen course of action. These are set out in the operational plan,
which is normally for a one-year period—corresponding to the financial year of the organisation.
MODULE 3
Although budgets are plans of how the organisation is going to achieve its goals for the next
year only, they are set within the context of the organisation’s strategic plan, and are therefore
linked with how the organisation is going to achieve its long-term goals.
Since the future is unknown and uncertain, organisations make predictions about the financial
outcomes of their planned activities. Forecasts in the strategic plan are set out in broad terms,
while estimates in the operational plan are done in much greater detail. A budget is therefore an
outcome of the planning process.
Time period involved Long-term, at least five years Short-term, usually one year
Amount of detail presented Broad plan, much less detail Very detailed
‘Budgeting is used to assist in strategic planning’ (Kleiner & Wilhelmi 1995, p. 78). Budgets are
most useful when they are integrated with an organisation’s strategy (Horngren et al., 2011).
Ideally, the development of a budget should begin with the organisation’s strategy. Budgets set
benchmarks for how an organisation is going to achieve its goals over the short term, so they
are useful tools to gauge if an organisation is on target in meeting its operational plan and
hence its strategic plan. If used properly, budgets can signal if managers need to revise their
plans and possibly even the organisation’s strategy. Consequently, budgets are used as a
control mechanism to evaluate managers’ and the organisation’s performance.
MODULE 3
Strategic plan
(long-term plan)
Operational plan
Long-term objectives
(short-term plan)
Master budget
Operational budget
Financial budget
Budgets are financial plans, setting out managers’ and owners’ expectations about financial
aspects such as sales prices and operational costs for the next year. However, budgets also
include non-financial aspects of the organisation’s proposed plan. These include, for example,
the quantities of units that need to be manufactured and sold, and the number of labour hours
and number of employees. The management accountant is uniquely placed to add value to an
organisation’s budgeting process by analysing and including non-financial information in the
budgets. Budgets are a useful means to monitor and control the organisation’s performance
when they are used to compare what actually happened with initial expectations.
MODULE 3
A master budget is a comprehensive initial plan of what the whole organisation intends to
accomplish in the budget period. In preparing a master budget, managers make decisions about:
• how best to use the limited financial and non-financial resources in the operating activities
• how to obtain funds to acquire those resources.
These decisions are formalised in the operating budget and the financial budget.
The operating budget is associated with the operating activities or income-producing activities
of an organisation and always precedes the financial budget. In the operating budget,
an organisation’s sales, cost of goods sold (COGS), and selling and administration expenses
are forecast. Thus, the end result (outcome) of the operating budget is a budgeted income
statement, although the latter is part of the financial budget. To derive the budgeted income
statement, the operating budget consists of numerous budgets prepared in a specific sequence
(discussed later in the module). Developing budgets for the coming year usually starts a few
months before the end of the current financial year.
The financial budget is a set of budgeted financial statements, providing forecasts about the
organisation’s income statement, balance sheet and cash budget for the next financial year.
In addition, the financial budget also contains a plan for acquiring assets beyond the next
12 months, namely the capital expenditure budget. This budget shows the purchase of assets
in the next operating period and beyond.
Operating budgets are developed within the constraints of limiting factors such as demand or
capacity, and therefore based on a limited level of activity. If market demand is the limiting factor,
then the defined level of activity will be expected sales revenue. In a manufacturing organisation,
if production capacity is the limiting factor, then the defined level of activity will be production
capacity, as shown in Example 3.1.
190 | PLANNING, BUDGETING AND FORECASTING
SprocketCo Ltd (SprocketCo), on the other hand, has a production capacity of 30 000 units but their
forecast sales is only 10 000 units, so their budget will based on the 10 000 units demand level. There is
no point in developing a budget for what SprocketCo can supply if there is no demand for the products.
It is often useful to have either a moving 12-month or quarterly budget, or use a combination
of both. This is made possible by continually adding a month or a quarter to the period that
just ended so that the business always has a 12-month period budget. This budget is referred
to as a rolling or continuous budget. For example, the global appliance company, Electrolux,
has a three- to five-year strategic plan and a four-quarter rolling budget (Horngren et al. 2011).
The purpose of a rolling budget is to allow managers to plan a full year ahead constantly,
and not only once a year when budgets are prepared. Constant future planning is important
to all organisations, but more so when organisations operate in rapidly changing environments.
Purposes of a budget
According to Roosli and Kaduthanam (2018, p. 21), ‘a budget represents a financial plan and
MODULE 3
Traditionally, budgets are used to help managers and owners plan for the future and to formalise
goals. To do this they need to think about what courses of action to take to create value, to achieve
their goals, satisfy their customers and succeed in the marketplace. Further, they need to make
decisions about what courses of action to take in allocating scarce resources. When managers
make decisions about allocating scarce resources, they will typically rank competing projects or
programs or products. The ranking of these is done in Module 4. The emphasis in Module 3 is to
illustrate how budgets help managers in making decisions about scarce resources.
In essence, a budget is a planning instrument for resource allocation and a yardstick for
performance evaluation (Roosli & Kaduthanam 2018). Example 3.2 illustrates how budgets can
assist with allocating scarce resources.
Study guide | 191
Business case A
Currently the academic staff in the nursing department have an open plan office structure. Due to
overall noise, it is very difficult for these academics to do their jobs to the best of their ability. Further,
they experience ongoing challenges due to privacy issues and the nature of discussing learning and
teaching issues with students. The Dean of the nursing department submitted a plan to renovate
this space so that staff can have their own offices. The estimated cost for this project is $1.2 million.
Business case B
Due to the success of the nursing department, there was a huge increase in the student numbers.
However, the university’s carpark is too small to provide off-road parking for these students.
They protested and threatened to study at other universities in a nearby metropolitan area. The Deputy
Vice-Chancellor of the campus submitted a business plan to extend the carpark. The estimated cost
for this project is $1 million.
Business case C
The Student Social Network Association has seen that there are not a lot of activities and social events
that attract students on campus. They argue better student life will result in satisfied students and attract
more students in the future. They propose to build a theatre in which art and music performances and
exhibitions can be held. The projected cost for this theatre is $750 000.
MODULE 3
To fund all three business cases, $2.95 million is required, but the budget is limited to $2 million.
The Campus Growth Committee has to make decisions about what causes of action to take to create
value, satisfy staff and students, and succeed in the marketplace. After deliberating the three cases,
the Committee decided to allocate the limited resource of funds as follows.
Note: As the decision-making process that the Committee followed is outside the scope of Module 3,
you may assume that the Campus Growth Committee has validated these three business cases against
the University’s key performance indicators (KPIs), perceived risk tolerance and stakeholder importance.
The latter is discussed in Module 2: Information for decision-making).
Justification:
Business case A
The growth in the nursing students will result in an increase in the university’s revenue and perhaps
also enhance the university’s reputation, which may ensure ongoing growth. Such growth depends
on satisfied staff and students. Although there are many factors contributing to their satisfaction,
having their own offices will certainly impact staff job satisfaction. Students may also feel more
comfortable to consult their lecturers when they have the own offices in which private and sensitive
issues related to the teaching can be discussed. The Committee therefore decided to fully fund
this project.
192 | PLANNING, BUDGETING AND FORECASTING
Business case B
Providing off-road parking to students is important as this will enable students to attend lectures and
study on the premises of the university without worrying about their cars. It may also encourage students
to attend lectures. Further, students already threatened to leave the university due to not having off‑road
parking. Not only is it important to retain these students, but providing off-road parking may also result
in satisfied students in the future which should enhance the credibility of the university and may result
in growth of student numbers and ultimately increased revenue. Although these benefits were pointed
out in the business plan, the Committee proposed that the Campus Coordinator meet with Council and
to negotiate better public transport facilities. Consequently, the Committee decided to partly fund this
business case with the remaining $800 000.
Business case C
The Committee decided not to fund this project because, compared to the other two projects that will
affect the revenue of the university directly, this project is the least critical at this moment—although
it is an important issue for the future.
The procedures and activities that are undertaken to develop the budget are referred to
as the budgeting process. The budgeting process provides a formal mechanism to ensure
organisational objectives and activities are planned effectively. During the execution period,
budgets can serve as a benchmark and provide guidelines for operations. As mentioned earlier,
it also allows comparison against actual financial results at all levels of a business, enabling
managers to measure and evaluate the performance of individuals, departments, divisions or
the entire organisation. Care should be taken to not make the budget the target that needs
MODULE 3
Revenue
Responsibility
Investment Cost
centres
Profit
MODULE 3
Source: CPA Australia 2019.
‘These classifications indicate the degree of responsibility the manager has for the performance
of the centre’ (Weygandt et al. 2012b, pp. 1109–10).
Revenue centres
For a revenue centre, the manager is only responsible for activities generating revenue (e.g. sales).
The sales department is therefore a revenue centre and the sales manager is responsible for
preparing the sales budget.
Cost centres
In a cost centre, costs and expenses are incurred but the centre does not directly generate
revenues. Since managers in cost centres have the ‘authority to incur costs’, they are responsible
and accountable for meeting the budget targets. Consequently, they are ‘evaluated on their ability
to control’ these costs (Weygandt et al. 2012b, pp. 1109–10). Typical examples of cost centres
are support departments such as accounting, research and development, human resources (HR)
and maintenance departments. For example, the maintenance department of a hotel is a cost
centre as the maintenance manager is accountable for the costs of maintenance. Production
departments are also cost centres. For example, in an automobile plant, the production
departments such as welding, painting, and assembling are separate cost centres.
Profit centres
In addition to incurring costs and expenses, a profit centre generates revenues. Here managers
are judged on the profitability of their centres. For example, the hotel manager is in charge of
the profit for the specific hotel and is therefore accountable for both revenues and costs. In a
retail store, for example a hardware store, each department (e.g. building materials, gardening,
and tools) might be cost centres. Although the sales, operating expenses and costs budgets may
be developed by other managers within the unit, ultimately, the manager of the profit centre is
responsible for the profit centre’s budget.
194 | PLANNING, BUDGETING AND FORECASTING
Investment centres
In addition to being responsible for generating revenues and incurring costs and expenses,
the manager of an investment centre has the responsibility and control over the centre’s available
assets. Managers in investment centres significantly influence decisions related to investments
(e.g. expansion of a manufacturing plant or entry into new markets). They are therefore
‘evaluated on both the profitability of the centre and on the rate of return’ (Weygandt et al.
2012b, p. 1112) (using return on investment (ROI)) earned on invested funds. The ROI shows
the manager’s effectiveness in utilising the assets at their disposal. To use a hotel example,
investment centres in this case would be subsidiary companies and the regional manager of
hotels within a region.
Responsibility accounting
‘Responsibility accounting can be used at every level of management’ (Weygandt et al. 2012b,
p. 1109). However, it is important that when responsibility accounting is used in performance
evaluation, that only revenue and costs that meet the following conditions are included:
• those that can be directly associated with the specific level of management responsibility
• those that can be controlled by management at the level of responsibility with which
they are associated.
To ensure this, costs are split between controllable and non-controllable, separating direct cost
from indirect cost in budgets. This is important due to the potential impact on the behaviour
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of managers during both the preparation of and assessment against budgets. For example,
being held accountable for costs they cannot control could be perceived as unfair and may
demotivate managers. Behavioural aspects are discussed further in Part D of this module.
An example of a controllable cost of a profit centre is the supervisor’s salary. This direct fixed cost
‘relates specifically to one centre and is incurred for the sole benefit of that centre’ (Weygandt et
al. 2012b, p. 1115). Further, this cost is directly associated as the manager of that responsibility
centre can control this cost because they can influence the costs and these costs can be traced
directly to a centre. On the other hand, indirect fixed costs are common corporate-level costs
pertaining to the organisation’s ‘overall operating activities and are incurred for the benefit of
more than one’ (Weygandt et al. 2012b, p. 1115) centre. Such costs are non-controllable by
divisional managers and are allocated to responsibility centres on some sort of equitable basis.
Examples of indirect fixed cost is property taxes on a building, research and development costs,
and salaries of top management. These costs can be allocated to various centres, for example
based on the square metres of floor space each centre uses. These costs are neither associated
nor can be controlled by revenue and by cost responsibility centre managers and therefore
need to be separated from controllable cost in budgets.
Applying responsibility accounting, first the effectiveness of the individual’s performance for the
specified activity is measured, followed upward throughout the organisation to top management.
Since top management has a broad range of authority, all costs are controllable by them.
However, as one moves down to each lower level of responsibility, fewer costs are directly
associated with the specified level, and due to the individual’s decreasing authority, fewer costs
are controllable at each lower level (Weygandt et al. 2012b).
‘Budgets, coupled with responsibility accounting, provide feedback to top management about
the performance relative to the budget of different responsibility centre managers’ (Horngren
2011, p. 435).
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‘Budgeting is the cornerstone of the management control process’ (Hansen et al. 2003, p. 95).
Since budgets set standards and benchmarks, it is common practice to use budgets as a
means to monitor and to control the use of an organisation’s use of resources and to evaluate
its performance (Mowen et al. 2016). This is done by frequent and timely (usually monthly)
comparison of actual results with budgeted forecasts—referred to as variance analyses.
The purpose of variance analyses is to understand the magnitude of the differences between
planned (budgeted) and realised (actual) performance, for both the monetary values and the
quantities of related costs and revenues. Once these are known, the causes of the differences
can be investigated.
Variance analyses show how successful managers have been in their execution of the operational
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plan, and as a consequence the implementation of the organisation’s strategies. It may also
provide warning signs of potential problems or events that may otherwise not be easily or
immediately evident and may also signal that strategies are ineffective. Variance analyses enable
managers to learn, evaluate the organisation’s strategies, take corrective actions and change
operational plans accordingly.
The financial budgets help management to ensure the organisation remains solvent and
sustainable. For example, it helps to ensure enough cash is available to pay creditors, normal
operating expenses and taxes. It also helps ensure ‘sufficient raw materials are available to
meet production requirements’, and that ‘adequate finished goods will be available to meet
expected sales’ (Weygandt et al. 2012b, p. 1054) and ultimately satisfy customers.
Using budgets as a means to control the performance of managers and employees can be
challenging. Ideally, budgets should neither be too rigid nor too slack. For example, if top
management sets budgets that are too difficult to achieve, employees will be discouraged.
Budgets should also not be too rigidly administered—not meeting the set budget does not
necessarily mean the employees did not perform optimally. Budgets are prepared based on
predicted information about an uncertain future—in the intervening period, conditions and
markets may have changed. Consequently, to best assess the performance of individuals and
the organisation, budgets are ‘updated’ during the year. This is referred to as a flexed budget
(discussed later in this module).
Now that the relationship between strategic and operational planning, the role and purposes
of budgets, and their relationship with responsibility accounting have been discussed, the next
section elaborates on developing master budgets.
196 | PLANNING, BUDGETING AND FORECASTING
Many organisations use financial planning models to reduce the computational burden and
time required in preparing budgets. These models ‘are mathematical representations of the
relationships among operating activities, financing activities and other factors that affect the
master budget’ (Horngren 2011, p. 432). Computer-based systems, such as enterprise resource
planning (ERP) systems, store a huge amount of data required for preparing budgets. An ERP
system therefore allows quick calculation of budgeted costs, for example to manufacture
products. This includes, for example, information about manufacturing different products
such as:
• the direct manufacturing costs—for example, materials and labour
• the indirect manufacturing overhead costs—for example, power and machine maintenance
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Further, most financial planning model software packages have a module on sensitivity analysis
to test alternative ‘what-if’ scenarios. For example, what will be the impact on the budget if the
assumptions change, or what will be the outcome for the organisation’s worst-case, best-case
and most likely-case scenario?
In developing plans about the organisation’s future activities, managers use estimates to
determine the resources the organisation is going to need, including the number of employees
and specific skill sets required, the quantities of raw materials and supplies, cash and anything
else necessary to the future operations. To make these decisions, managers consider many
internal and external factors that may impact the organisation’s future. This is discussed in the
next section. Later in this part, the development of operational budgets is discussed, separating
those of manufacturing organisations from non-manufacturing organisations. This is followed by
a discussion of the development of financial budgets, budgeting for various departments and
flexible budgets.
Just as important is getting the forecasts of the raw materials and finished goods inventories
as accurate as possible:
• Inadequate raw material inventories ‘could result in temporary shutdowns of production’
while inadequate inventories of finished goods inventories may result either in ‘added costs
for overtime work’ to produce more goods or ‘in lost sales’ (Weygandt et al. 2012b, p. 1061).
• Stockpiling of both raw material and finished goods may result in additional costs such as
storage, insurance, and handling costs, increase the risk that the inventory may become
obsolete, and if the prices of the raw materials drop, the organisation may be stuck with
overpriced raw material. If the economy slows down, excessive finished goods in one period
‘may lead to cutbacks in production and even employee layoffs’ (Weygandt et al. 2012b,
p. 1061) in subsequent periods.
To mitigate this, careful consideration of internal and external factors is extremely important
when planning and developing budgets.
Table 3.2 provides a summary of the internal and external factors that affect business
environments that should be considered in both strategic and operational plans and budgets.
Table 3.2: Internal and external factors that affect business environments
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Demand for the goods or services Supply and capacity constraints
Suppliers of resources such as raw materials, labour, Anticipated advertising and sales promotions
supplies, and everything that impacts them and their
existence—e.g. a short supply of raw materials may
result in increased prices
General economic climate and past trends of a Policies of organisation (e.g. sales prices,
country—e.g. is it growing, is there an economic inventory levels)
slowdown, or a recession?
General economic climate worldwide New products and services planned by the
organisation, which may be the outcome
of research and development
Technological developments
198 | PLANNING, BUDGETING AND FORECASTING
Source: Based on Eldenburg, L. G., Brooks, A., Oliver, J., Vesty, G., Dormer, R. & Murthy, V. 2017,
Management Accounting, 3rd edn, Wiley, Milton; Mowen, M., Hansen, D., Heitger, D., Sands, J.,
Winata, L. & Su, S. 2016, Managerial Accounting, Asia-Pacific edn, Cengage Learning, Australia, p. 328;
Horngren, C. T., Wynder, M., Maguire, W., Tan, R., Datar, S. M., Foster, G., Rajan, M. V. & Ittner, C.
2011, Cost Accounting: A Managerial Emphasis, rev. edn, Pearson, French Forest, p. 422; Langfield-
Smith, K., Smith, D., Andon, P., Hilton, R. & Thorne, H. 2018, Management Accounting: Information for
Creating and Managing Value, 8th edn, McGrawHill Education, Sydney; Weygandt, J. J., Kimmel, P. D.
& Kieso, D. E. 2012a, Managerial Accounting: Tools for Business Decision Making,
6th edn, Wiley, USA, p. 385.
Although the information in Table 3.2 is not exhaustive, it clearly indicates that setting budgets
requires elaborate information gathering, and a considerable amount of discussion among
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managers. It also demonstrates that developing budgets can be time consuming. Managers
setting budgets must have detailed knowledge, understanding and appreciation of the
organisation, its products and services, the markets it operates in and its competitors.
Step 1
Sales budget
Step 2
Production budget
Step 3
Direct materials cost budget
Step 4
Direct manufacturing labour costs budget
Step 5
Manufacturing overhead costs budget
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Step 6
Finished goods inventory budget
Step 7
COGS budget
Step 8
Period costs budgets
In the following discussion, the links between the various operating budgets are highlighted to
explain the sequence in which operating budgets are prepared.
In some organisations, production managers may participate in the forecasting of sales. This is
because both supply and demand influence the sales budget. A sales budget set at demand levels
that an organisation cannot supply will be unrealistic and useless, as explained in Example 3.3.
200 | PLANNING, BUDGETING AND FORECASTING
Example 3.3: S
upply and demand influence on the
sales budget
Assume that the expected demand for the organisation’s products is 30 000 units. Usually, forecast sales
will be based on the 30 000 units. However, assume that the organisation has constraints such as
production capacity or short supply of inputs—for example, materials and labour. These constraints
in supply limit the demand level. Consequently, the sales budget will be set on 10 000 units.
➤➤Question 3.1
Kabuki Ltd imports electrical equipment used in the mining industry from Japan and converts the
equipment so that it is suitable for the Australian environment. Kabuki has been very successful
and operated at full capacity and sold all the products in the past. The organisation has a capacity
to convert 15 000 pieces of the imported electrical equipment per year.
The success of Kabuki Ltd attracted competitors to the market. One competitor also imports the
product from Japan, does the conversion in India, and then imports the final product to Australia.
Consequently, they are able to sell the final product at a significantly reduced price. Another
competitor manufactures the entire product in Australia. It is expected that this organisation
may dominate the market in future as they meet the recent changes in the Australian regulation
of imported electrical equipment. Further, there has been an outcry to buy locally manufactured
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Check your work against the suggested answer at the end of the module.
Study guide | 201
The next three budgets are prepared to estimate the cost of goods manufactured: direct
materials, direct labour, and manufacturing overhead costs budgets.
The purchasing manager has the responsibility to determine the costs of the direct materials
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purchased. The production manager is responsible for the effective use of raw materials, so also
participates in developing this budget.
If an organisation uses different components of raw material to manufacture the finished product,
separate budgets are prepared for each component for both cost of materials used and materials
purchased. For example, an organisation that manufactures running shoes will prepare separate
budgets for the materials used to manufacture the soles of the shoes and for materials used to
manufacture the upper part of the shoes. These separate budgets are then integrated into one
aggregated direct materials costs budget.
To determine the quantity of direct material that will be used in manufacturing the finished
goods, this budget is linked to the number of finished goods that need to be purchased,
forecast for each period in the production budget. These numbers are multiplied by the
quantities of each raw material component used in the finished product to determine the
direct materials that will be used. This is shown in Example 3.4.
To determine how much (quantity) raw materials to purchase, GadgetCo uses the number of finished
MegaGadgets to be produced (5000 units) plus the closing inventory of raw material minus the opening
raw material inventory.
To calculate the cost of raw materials to purchase, the quantity of each direct materials component
to be purchased is multiplied by the cost per unit of that specific component of direct material used
to manufacture the finished MegaGadget.
202 | PLANNING, BUDGETING AND FORECASTING
Depending on the inventory levels, the figures of raw material purchased will not necessarily be
the same as the figures of raw material used for any period. Both figures are essential though.
The purchasing manager requires information about the quantity and costs of raw material to be
purchased. The cost of direct materials used for the period is required to calculate the COGS.
The reason why there is a difference between the cost of direct materials purchased and the cost
of direct materials used is because of direct material inventory. For example, if an organisation
uses the first in, first out (FIFO) method to value its raw material inventory, the goods that were
manufactured first will be sold first. If the costs of direct materials change (which is very likely),
then there will be a difference between the costs of direct materials used in different periods. It is
therefore important to pay attention to the period when the finished goods were manufactured
when valuing finished goods inventory.
It is important to distinguish between costs of direct materials purchased and used when using
budgets in performance evaluations. The purchasing manager must explain any difference
between budgeted and actual costs (AC) to purchase raw materials. The production manager is
responsible for the efficient use of raw material in manufacturing the finished product. However,
this can sometimes be tricky, as shown in Example 3.5.
Example 3.5: E
xplaining variances in budgeted and actual
costs of raw materials
ManufacturingCo purchased a batch of raw material that was inferior in quality. This resulted in
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increased waste. This resulted in the inefficient use of raw material, for which the production manager
was held responsible. But the decision to purchase the inferior raw materials was actually made by the
purchasing department, so although the production manager should explain the inefficient use of raw
materials, they are not responsible for the purchase. This shows the importance of coordination and
communication during the budgeting process as well as the actual day-to-day operating activities.
Since the opening finished goods inventory of one period is the closing finished goods inventory
of the previous period, both opening and closing finished goods inventory figures are available
automatically in this budget. However, the opening balance of finished goods inventory for the
start of the budgeted financial year needs to be estimated. This is because many organisations
prepare budgets a few months before the end of the financial year and therefore have to
estimate the cost of closing finished goods inventory for the current period.
➤➤Question 3.2
To which operating budgets are the finished goods inventory budget linked, directly and indirectly?
Check your work against the suggested answer at the end of the module.
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COGS, the budgeted costs of manufacturing need to be determined. This is the sum of the
total cost of direct materials used, plus the direct labour costs plus the total manufacturing
overhead costs. The budgeted opening finished goods inventory is added to the budgeted
cost of manufacturing to get the cost of goods available for sale. Then, the ending finished
goods inventory is subtracted to determine the budgeted COGS. This figure will appear in the
budgeted income statement, which is part of the financial budget.
The budgets prepared in Steps 2 to 7 cover budgeting for an organisation’s production function
of the value chain. Budgets for other parts of the value chain, for example product design,
research and development, marketing and distribution, and administration, are prepared in
the next step.
Many service organisations, ‘such as a public accounting firm, a law office, or a medical practice’
(Weygandt et al. 2012b, p. 1073), provide only services. These organisations will only prepare
budgets to forecast the revenue, and the costs and expenses relevant to their activities in
rendering the services. An accounting firm would for example prepare the following budgets:
• a revenue budget of planned hours and rates that will be charged to clients
• labour costs budgets for staff—including hours of professional staff that will be charged
and the cost of administrative staff
• an overhead budget—including other costs and expenses related to the operations of
the organisation.
Service organisations normally have large labour cost budgets and extensive selling and
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administrative costs budgets. However, some service organisations also sell goods (e.g. a dentist
or a veterinary practice). Therefore, these organisations will also prepare a purchases budget
similar to those prepared by retail and wholesale organisations.
In preparing the budgeted income statement though, no regard is given to when the money
will flow in and out of the organisation. For example, making a credit sale (and a profit for that
matter) in say February does not necessarily mean that the cash will flow into the business in
February. It is important to know when the cash for credit sales in February will be collected as an
ethical organisation always aims to pay its debts and expenses on time. The inflow and outflow
of money is considered in the cash budget.
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Cash budget
Cash management is essential for the success of any business, which makes the cash budget
the most important financial budget (Weygandt et al. 2012a) and one of the most important
budgets in the master budget. The cash budget also shows when there will be cash shortages
(deficiencies) and excess cash (surpluses). This will enable management to make plans about
when to borrow money and when to spend money (e.g. buying assets, repaying loans or even
making short-term investments).
Further, the principal source of revenue and cash inflow should be from the core business of an
organisation, namely its sales. However, for many organisations, a large proportion of sales is on
account. It is therefore important to prepare a schedule for cash sales and collections from credit
sales. This schedule is based on past experience of what percentage of credit sales are paid in
the month of and months following sales. Similarly, a schedule for cash purchases and payments
of credit purchases is prepared in developing the cash budget. In addition to preparing
schedules to indicate the periods in which cash will be collected from credit sales and when
cash will be paid for credit purchases, schedules are also prepared for other inflows and outflows
of cash (e.g. when cash will be received from sources such as interest and dividends (where these
are receivable), and proceeds from selling investments and assets). Examples of other payments
are income taxes, acquisition of assets and interest and dividends (where these are payable).
The latter will be identified from the capital expenditure budget.
At its simplest, a cash budget shows the cash balances at the beginning and at the end of
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the period, cash inflows, and cash outflows for the period. The cash budget shows how much
money will be available for each period (opening balance plus cash receipts) to finance the
cash disbursements for the period. In developing a cash budget, cash flows from all activities,
thus operating, investing and financing activities are considered.
➤➤Question 3.3
How and in which budget is the figure ‘cash in bank’ in the budgeted balance sheet determined?
Check your work against the suggested answer at the end of the module.
Normally, in preparing budgets for decentralised organisations, the sales managers and
representatives of a specific unit or region or town (in short referred to as a department) prepare
the sales budget. Thus the bottom-up approach is applied. The department for which a budget
is prepared may be for example within a large retail hardware store chain (e.g. gardening
supplies) or one of the stores in the chain in a town or region. Senior management will then
aggregate these departmental budgets, which will form the sales budget for the organisation
as a whole. In responsibility accounting, the individual sales representatives and sales managers
are accountable for their centre’s revenue budget only. This is shown in Example 3.6.
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Example 3.6: P
reparing budgets for decentralised
organisations
RunGear manufactures running gear (e.g. shoes, clothes and accessories) and has developed a sales
budget. RunGear has sales representatives in each state in Australia, and each state is divided into a
north, south, east and west region.
The sales representatives responsible for the sales in the north Queensland region will prepare a sales
budget for north Queensland. The sales representatives responsible for the south, east and west
Queensland regions will do the same.
The sales manager for Queensland will then aggregate these budgets for the four regions and be held
responsible for the sales budget for Queensland. A similar process will be followed in the other states.
Ultimately, in developing the sales budget for RunGear as a whole, the sales budgets for all the states
will be aggregated and sales forecasts through other means, such as the internet, will be added.
For planning purposes, flexible budgets are used to study the sensitivity of budgeted revenues
and costs for various activity levels. Large organisations typically use software packages to develop
flexible budgets, while spreadsheets are sufficient for small organisations. ‘Flexible budgets can be
prepared for each … of the budgets … in the master budget’ (Weygandt et al. 2012b, p. 1101).
Example 3.7 provides an illustration of a flexible sales budget, using sales volume ranging from
24 000 units to 32 000 units and a selling price of $50 per unit.
Study guide | 207
Budgeted sales revenue $1 200 000 $1 300 000 $1 400 000 $1 600 000 $1 800 000
The relevant range for fixed costs is 8000 to 12 000 units. ExampleCo uses labour hours as the cost
driver for variable costs. ExampleCo’s production budget indicated that 8000, 9000, 10 000, 11 000,
and 12 000 labour hours will be required to manufacture the finished goods required to meet the sales
volume (including the required inventory levels).
Using the information in the following table to prepare a flexible manufacturing overhead cost budget
in the planning phase illustrates the sensitivity of the budgeted costs.
$ $
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Manufacturing overhead cost budget for various levels of activity
$ $ $ $ $
Variable costs
Fixed costs
Calculations:
†
8000 × $1.50
‡
8000 × $2.00
§
8000 × $0.50
The complete master budget will be prepared for various activity levels as shown in the two tables.
Source: Adapted from Weygandt, J. J., Kimmel, P. D. & Kieso, D. E. 2012a,
Managerial Accounting: Tools for Business Decision Making, 6th edn, Wiley, USA, p. 443.
208 | PLANNING, BUDGETING AND FORECASTING
Using flexible budgets in the planning phase is a useful means to determine a worst case, a best
case, a most likely case and a few alternatives in between, of expected results for the next
financial year. Having budgets for different scenarios provides valuable information for making
decisions about the allocation of resources and also about the most realistic budget.
Although one budget will be approved and adapted, flexible budgets may be useful in the
coming year, because they indicate the outcome of various activity levels that may be a useful
reference of probable outcomes if the planned activity levels are not achieved. When the master
budget is formalised, approved and accepted, it is then used to monitor and evaluate the
organisation’s and individuals’ performances. One way of doing this is comparing the budget
forecasts with the actual results, referred to as variance analysis. This is discussed in the next part
of this module.
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Study guide | 209
It is sometimes complicated to determine the underlying causes of a variance. This may be due
to the flow-on effects of decisions made and actions taken in other departments or functional
units of the value chain. For example, sales staff may promise a rush delivery to a customer,
forcing employees to work overtime and increasing the labour costs—which will probably result
in an unfavourable variance. Consequently, in analysing variances, the management accountant
must have a thorough understanding of and insight into the connections, interdependencies
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and interrelatedness of activities in the organisation, and the effect of one decision and action
on other aspects. Management accountants have to ensure that the managers of responsibility
centres provide sensible explanations for actual results deviating from forecast budgets.
The static budget is only used as a starting point in doing variance analysis. Due to the limitations
of the static budget, flexible budgets are developed to perform variance analyses (discussed in
the next section). Later in this part, the usefulness of variance analyses of revenue and several
cost components is discussed.
When using variance analysis to monitor and control the organisation’s and managers’
performance, two aspects are analysed to investigate the underlying causes:
1. quantities—both sales and production
2. prices—both selling prices and costs.
The difference between actual and budgeted prices is known as the price variance, and the
difference between actual and budgeted quantities (volumes) as the efficiency variance.
However, comparing actual results with the static budget will not show either of these variances.
Consequently, to interpret variances appropriately, a flexible budget is developed, as illustrated
in Examples 3.8 to 3.13.
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Example 3.8: C
omparing actual results with the static
budget forecast—budgeted quantities
exceed actual quantities
StarCo has a budget production level of 5000 units (finished goods) and an actual production level of
4500 units for flagship product ‘Starz’. The raw material required (budget and actual) to manufacture
one unit of Starz is 1.5 kg. Both budgeted and actual cost of the raw material is $2 per kg.
Using a static budget to determine the variance of direct material will result in a favourable variance,
calculated as follows:
Should the production manager receive a bonus for this favourable variance? The answer is
no, because the reason for the favourable variance is simply because they produced less units.
The operations were not more efficient, because the production manager budgeted to use 1.5 kg of
raw material per unit and the actual usage was 1.5 kg per unit. Further, the purchasing manager did not
deviate from the budgeted cost of $2 per kg of raw material. So there are no favourable performances
that warrant any awards. Although simplistic, this example illustrates that the difference between the
static budget and actual results is purely because of the difference in volume.
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Care should be taken in analysing and interpreting variances between a static budget and actual
results. It only indicates if more or less units have been sold or more or less units have been
produced. To understand the underlying causes of variances between actual results and budgeted
forecasts, the static budgets are therefore flexed and described as flexible budgets. In developing
a flexible budget, the actual quantities are used instead of the budgeted quantities.
Example 3.9: D
eveloping a flexible budget—actual and
budgeted prices are equal
Using the figures in Example 3.8, the flexible budget is determined as follows:
Flexing the static budget clearly shows that the only reason why the difference between the actual
result and the static budget showed a favourable variance is because fewer units were produced.
The production manager certainly should not be rewarded with a bonus. On the other hand,
an unfavourable variance will result if more units have been produced than budgeted. This would
not mean that the production manager underperformed and should be reprimanded, as illustrated
in Example 3.10.
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Example 3.10: C
omparing actual results with the static
budget—actual quantities exceed
budgeted quantities
Assume now that 5500 units of Starz were produced (everything else remain the same). Logically,
comparing the actual results with the static budget will result in an unfavourable variance, calculated
as follows:
Example 3.11: D
eveloping a flexible budget—actual and
budgeted prices are different
Using the information in Example 3.8, assume that the actual cost per kg of raw material is $2.10. Using a
static budget, the variance is calculated as follows:
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= $825 favourable.
Again, this does not make sense as the actual cost (price) is higher than the budget so one would
have expected that the variance would be unfavourable. In fact, the purchasing manager should be
asked to explain why the price increased.
Example 3.12: D
eveloping a flexible budget—actual
and budgeted quantities used per unit
are different
Assume that the actual cost is the same as the budgeted cost but that the actual quantity of raw
material used per unit is 1.6 kg. Using the static budget, the variance is calculated as follows:
Again, this does not look correct because Steve, the production manager, was less efficient in using
1.6 kg as opposed to the budgeted 1.5 kg per unit. Steve should explain why more materials were
used than planned.
Examples 3.8 to 3.12 illustrate that the causes of variances between actual results and flexible
budgets relate to differences in price as well as differences in quantities used (both number
of units produced and input per unit). Therefore, flexible budgets are developed so that two
variances can be determined: price variance and efficiency variance. Example 3.13 illustrates
how an efficiency variance is determined.
212 | PLANNING, BUDGETING AND FORECASTING
Example 3.13: D
eveloping a flexible budget—budgeted
and actual quantity per unit are different
To determine the efficiency of Steve, the quantities that should have been consumed (based on
the budgeted consumption) for the actual activity level is determined in the flexible budget. In this
example, the budgeted quantity per output unit was 1.5 kg of the raw material. To determine the
figure for raw material that should have been used to produce the 4500 units in the flexible budget,
the following formula is applied:
This formula will be further expanded later in the discussion, as in this example, the actual and
budgeted prices are the same ($2). Examples 3.8 to 3.13 illustrate why using a static budget in
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performance evaluation to analyse and interpret variances is not useful. Static budgets hide
variances due to efficiencies and inefficiencies, and also due to changes in prices and costs.
To expose these hidden variances, the static budget is flexed. In a flexible budget, the data is
based on the actual activity levels such as sales and production attained.
Sales-volume variance for operating profit = (Actual quantity sold – budgeted quantity sold)
× budgeted contribution margin per unit sold
†
cm = contribution margin
Study guide | 213
The sales volume variance indicates that the variance in the profit (or contribution margin) of the
organisation is solely because of the decrease in the number of units sold.
Applying responsibility accounting, the sales volume variance is useful to evaluate the
performance of the manager of a profit or investment centre. Although the variance is referred
to as the sales volume variance, the sales manager is not entirely responsible to explain this
variance as it is based on the contribution margin. The sales manager is only responsible for
the performance of the revenue responsibility centre.
To understand the causes of the sales volume variance and to evaluate the performance of the
appropriate responsible managers in the revenue and costs responsibility centres, the sales
volume variance is separated between sales and various costs components. This is normally done
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by analysing each line item in the income statement and calculating a variance. It is important to
remember though that the sales volume variance is calculated using only budgeted prices and
costs and budgeted quantities. The reality is that actual prices and costs, and actual quantities
used are seldom the same as budgeted. Consequently, flexible budgets are developed as
explained in the previous section.
To evaluate the performance of the sales manager, the variation in revenue (sales) is determined,
referred to as the selling-price variance. This variance is the difference between actual and
budgeted selling prices, calculated in the following formula and applied in Example 3.15:
Selling-price variance = (Actual selling price – Budgeted selling price) × Actual units sold
(AP – BP) × AQ
= ($110 – $120) × 4500
= $45 000 unfavourable
Selling prices are likely to affect the sales demand. Consequently, in evaluating the performance
of the revenue centre, the selling-price variance should be considered in conjunction with the
sales volume variance. The sales manager is responsible for both the price and volume of sales
and hence the revenue centre’s performance and will therefore be responsible for providing
explanations for these two variances.
Figure 3.5 outlines possible explanations for increases and decreases in selling prices.
214 | PLANNING, BUDGETING AND FORECASTING
Figure 3.5: Possible explanations for increases and decreases in selling prices
Possible explanations
• Shortage of supply in the market
• Increase in market demand
Increased • Increase in competitors’ prices
selling • Organisation may use a superior quality
prices of raw material
• Improved quality of the product
• Added features to the product
Possible explanations
Decreased • Decreased selling prices in the
selling industry/market/competitors
prices • Decrease in the demand for the product
• New competitors may have entered
the market
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However, the sales managers’ decisions to increase or decrease the selling prices will have flow-
on effects on other functional units in the value chain, particularly the production department.
For example, a decrease in the selling price may force the purchasing manager to buy cheaper
raw material and probably of an inferior quality. Further, using raw material of an inferior quality
may affect the efficiency of the production operations and may also result in an inferior quality
product being produced, which may ultimately result in a decrease in the demand for the
product. This illustrates the connectivity and interdependence of various managers’ decisions
and the consequential impact these decisions may have on other managers’ performance
evaluation. Therefore, understanding the connectivity between variances and their causes
is essential when using variance analysis to evaluate the performance of departments and
managers. This also emphasises the importance of open communication and coordination
between managers of various departments.
Variable direct manufacturing costs, such as direct material, direct labour and manufacturing
overhead costs, are generally incurred directly by production departments. Consequently,
in responsibility accounting, analysing variances of these costs is useful to evaluate the
performance of managers of cost centres. The production and purchasing managers will be
held accountable for variances between the actual results and the budgeted allowance for
variable costs. The next three sections illustrate how variances of direct material, direct labour
and variable manufacturing overhead costs are calculated and used as mechanisms to evaluate
the performance of relevant managers.
Study guide | 215
BQ allowed for AQ × BP
= 4500 × 1.5 × $2
= $13 500
Using the actual quantity direct material used per unit of Example 3.12, and actual cost of Example 3.11,
the actual results of direct material is calculated as follows:
AQ × AP
= 4500 × 1.6 × $2.10
= $15 120
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= $1620 unfavourable
However, it is not always obvious in the flexible variance how much of the variance relates to inefficient
consumption of the raw material and how much is related to the increased price.
To address the situation outlined in Example 3.16, flexible budgets are further subdivided to
show the price variance separate to the efficiency variance. Figure 3.6 illustrates how the price
and the efficiency variances are determined—for all variable cost components: direct material,
direct labour, and variable manufacturing overhead costs.
AQ × AP AQ × BP BQ allowed for AQ × BP
As shown in Figure 3.6, the term ‘flexed’ budget is used to determine the price variance—
the difference between actual results and flexed budget. Further, to determine the efficiency
variance—the difference between flexed budget and flexible budget. The formulas for calculating
the price and efficiency variances are illustrated in Examples 3.17 and 3.18 respectively.
Price variance = (Actual Quantity of input × Actual price) – (Actual Quantity of input × Budgeted price)
Applying this formula, and using the information provided in Examples 3.8, 11 and 12, the price variance
of direct material can be determined as follows:
= $720 unfavourable
Example 3.18: C
alculating the direct material efficiency
variance
The formula for determining efficiency variances of direct material, direct labour and variable
manufacturing overhead is as follows:
Efficiency variance = (Actual quantity of input × Budgeted price) – (Budgeted quantity allowed
for actual quantity of input × Budgeted price)
Using this formula and the information provided in Examples 3.8 and 12, the efficiency variance for
direct material can be determined as follows:
Adding the price and efficiency variances shows the flexible budget variance as determined in
Example 3.16: $720 + $900 = $1620 unfavourable.
Separating the flexible budget into a price and an efficiency variance enables effective analyses
and interpretation of variance analysis, to evaluate the performance of appropriate managers.
The purchasing manager is responsible for the price variance of direct material and the
production manager is responsible for the efficiency variance of direct material.
Study guide | 217
Example 3.19: C
alculating the direct labour flexible
budget variance
Use the information provided in Example 3.8 and assume the following direct labour information:
The flexible budget variance for direct labour costs will be determined as follows:
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= $5625 favourable (F)
To understand the causes of the variance in Example 3.19, it is subdivided into the price and the
efficiency variances, calculated as shown in Examples 3.20 and 3.21.
The total of the direct labour price and efficiency variances equals the flexible budget variance as
determined in Example 3.19: $3750 (U) + $9375 (F) = $5625 favourable.
Since the production manager is responsible for monitoring and controlling the labour rate and
efficiency of workers, the direct labour price and efficiency variances are used to evaluate the
performance of the production manager.
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Further, to simplify record keeping, many organisations use standard costing to allocate
overhead costs to the various manufacturing departments. These standards may be derived
from either actual or budgeted costs. To calculate these standards, variable manufacturing
overhead costs may be grouped into one cost pool or a few appropriate cost pools, depending
on the complexity of the organisation. For example, the AC of all variable overhead costs may
be accumulated in one cost pool. In determining how to allocate these costs, managers make
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decisions about which factor drives these costs. Cost drivers can be for example:
• labour hours
• machine hours
• floor space
• kilometres driven
• number of employees.
The standard overhead-cost allocation rate is determined as follows: total costs for the cost pool
/ the driver (also known as the cost-allocation base) of the cost.
These standards are typically calculated at the start of the budget period and used when setting
the budgets. Although line managers often do not have direct control over actual variable
overhead costs incurred (as it is allocated), they help the control of these costs by budgeting for
each variable overhead cost separately, deciding about the cost driver and hence determining
the standard allocation rate. Therefore, line managers have shared responsibility for variable
manufacturing overhead costs variances. To investigate possible causes for variable manufacturing
overhead costs variances, variance analyses can be done for each cost item or in total, depending
on the complexity of the organisation, and how standard costs are determined and allocated.
So, in responsibility accounting, variance analyses of variable manufacturing overhead costs are
useful to evaluate the performance of the profit and investment centres. Although these variances
are not directly related to the performance of line managers, they are responsible for monitoring
and controlling these costs and hence have a shared responsibility to explain the causes of
these variances.
Similar to direct material and direct labour costs, a price and an efficiency variance is calculated
for variable overhead costs. Here, the price variance is referred to as the spending variance.
Example 3.22 demonstrates how the flexible budget variance is calculated for variable
overhead costs.
Study guide | 219
Example 3.22: C
alculating the flexible budget variance
for variable overhead costs
Assume that the variable overhead cost driver is labour hours and the following standard rates are applied:
Using the actual quantity of 4500 from the Example 3.8, the flexible budget variance for variable
overhead costs will be determined as follows:
Subdividing the flexible variance into the spending and efficiency variance for the variable overhead
costs are calculated in Examples 3.23 and 3.24 respectively:
Example 3.23: C
alculating the variable overhead costs
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spending variance
Spending variance = Difference between actual results and flexed budget
= (AQ × AP) – (AQ × BP)
= (4500 × 10 / 60 × $7) – (4500 × 10 / 60 × $8)
= $5250 – $6000
= $750 favourable
Example 3.24: C
alculating the variable overhead costs
efficiency variance
Efficiency variance = Difference between flexed budget and flexible budget
= (AQ × BP) – (BQ allowed for AQ × BP)
= (4500 × 10 / 60 × $8) – (4500 × 15 / 60 × $8)
= $6000 – $9000
= $3000 favourable
The total of the spending and efficiency variances equals the flexible budget calculated in Example 3.22:
The aim of organisations should not necessarily be to achieve favourable variances. A favourable
variance in one cost component is not always desirable, as it may result in unfavourable variances
in other cost components. These are illustrated in Example 3.25.
220 | PLANNING, BUDGETING AND FORECASTING
The decision of Sunil, however, affected the performance of Diego, the production manager of
Acropolis, adversely. Using lower quality material resulted in more materials being used and wasted,
which resulted in unfavourable efficiency variances of direct material and of variable overhead costs.
The lower priced materials also impacted the labour price and efficiency variances of Acropolis
unfavourably because more time was needed to work with the poor-quality material and to rework jobs.
As more time was required, the actual direct labour costs increased and compared to the budgets,
the labourers were less efficient. These unfavourable direct labour price and efficiency variances will
impact the performance evaluation of Diego negatively, although he is not entirely responsible for
these, as they are a direct consequence of the lower quality of materials purchased.
Further, assume that later in the year, Acropolis hired several less skilled workers at a lower pay rate
than usual. Although this resulted in a favourable labour price variance, these workers were slower to
complete tasks. This increased the total labour hours and resulted in an unfavourable direct labour
efficiency variance.
If Acropolis had hired more skilled workers later in the year, they might have been more efficient
and completed the tasks more quickly, using less total direct labour hours, and consequently would
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have had a favourable efficiency variance. However, as they are more skilled, hiring them would have
resulted in an unfavourable direct labour price variance. In making decisions about which workers to
employ, managers have to offset the price and efficiency variances.
Knowledge of how to calculate these variable cost variances is important for management
accountants in analysing and interpreting how variances are derived. However, more important
is that the management accountant can apply this knowledge in analysing and interpreting the
possible causes of the variances. It is essential that management accountants understand the
correlations between possible causes of variances, the interrelatedness and interdependencies
within and across business functions in the value chain, and between activities, decisions and
actions, and their flow-on effects.
Figure 3.7 provides some possible causes of variances in variable cost. In addition, remember
that one possible reason why actual results will deviate from budgeted forecasts is because of an
‘incorrect’ budget, either being too high or too low. Although this is a plausible reason as to why
AC will deviate from the budgeted forecasts, be cautious in accepting an ‘incorrect’ budget as
a cause for variances year after year.
Study guide | 221
Reasons
for
variances
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• Sales staff promised a rushed delivery, that prevented skilled workers doing
so overtime had to be worked, paid at the job
higher rates • Inefficient scheduling of jobs resulting
• Staff underwent training, obtained in more machine-hours used than
qualifications or got promoted, so had budgeted
an increase in their wages • Machines not maintained, so not in
• Short supply of raw materials in the good operating condition
market resulting in an increase in • Machine breakdown
the price • Using lower quality raw material and
indirect materials
Actual fixed overhead costs are also accumulated to cost pools with the same cost driver to
determine a predetermined allocation rate—Total fixed costs / cost driver. This rate is then used
in developing the master budget. Examples of fixed manufacturing overhead costs that will be
allocated are:
• depreciation on plant and equipment
• leasing cost on plant and equipment
• plant manager’s salary.
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Similar to the variable overhead costs, a spending variance is calculated, but not in the same
way. First, no flexible budget is calculated and second, the spending variance is the difference
between the AC and the static budget for fixed costs. In essence, the static budget becomes
the flexible budget for fixed costs. Examples 3.26 and 3.27 illustrate how the spending and
production volume variances for fixed manufacturing overhead costs are determined,
Example 3.26: C
alculating the spending variance for fixed
manufacturing overhead costs
Continuing on from the previous example, assume the following additional information:
Fixed manufacturing overhead costs are allocated to finished products based on the labour hours used.
Standard fixed overhead cost rate for allocating fixed overhead costs to finished products:
Four units are made per hour, therefore the rate per unit is $6.
The formula for determining the spending variance of fixed manufacturing overhead is as follows:
It is important to remember that the $30 000 budgeted fixed cost will only be fully allocated if all 5000
budgeted goods are produced. Therefore, this predetermined rate of $6 per unit will only be accurate
if 5000 units are produced. However, in this example, only 4500 units are produced. Therefore, not all
fixed costs will be allocated, which is the production volume variance.
The production volume variance is the difference between budgeted fixed overhead and fixed
overhead allocated on the basis of the actual number of finished goods produced. To determine
the fixed costs allocated, the following formula is used:
BQ allowed for AQ × BP
Example 3.27: C
alculating the production volume variance
for fixed overhead costs
Static budget – (BQ allowed for AQ × BP)
= $30 000 – (15 / 60 × 4500 × $24) or (4500 × $6)
= $30 000 – $27 000
= $3000 unfavourable or under-allocated
This production-volume variance is the fixed costs of units that were not produced (i.e. 500 units
× $6 = $3000) and could not be allocated (i.e. under-allocated). If more goods are produced than
forecast then the production volume variance will be favourable, which means too much fixed costs
were allocated (i.e. over-allocated). Over-allocated fixed costs is also referred to as over-applied and
under-allocated as under-applied.
It is important to understand the production volume variance so that it can be accounted for in the
accounting records. In accordance with AASB 102 Inventories, manufacturing fixed overhead costs
is considered an inventoriable cost. Using standard costing, fixed costs are viewed as if they had a
variable cost behaviour and are consequently allocated to finished goods accordingly.
In this case, only the fixed overhead costs that are allocated to the actual number of finished goods
produced ($27 000) are recorded in the accounting records. The master budget forecast fixed costs
as $30 000 but only $27 000 will be allocated. This will result in $3000 not being allocated to finished
goods. But remember, the actual fixed costs will eventually have to be recorded in the accounting
records and presented in the income statement, so the unfavourable production volume variance
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calculation of $3000 will also have to be recorded in the accounting records.
However, be cautious and remember that there is a vast difference between the actual behaviour
of fixed overhead costs (not affected by level of activities) and how fixed overhead costs are
allocated to finished goods (applying a predetermined rate to level of activity). When forecasting
fixed overhead costs to develop a master budget, always use the total lump sum costs (which are
based on their behaviour) and never use the fixed costs per unit.
Although fixed overhead costs are part of the manufacturing costs, they are not under direct
control of the managers of cost centres. In responsibility accounting, managers of the profit and
investment centres are responsible for these costs, and analysing these variances is useful in their
performance evaluation.
Analysing the production volume variance is important in making decisions about resource
allocation. Fixed costs are only fixed within a relevant range. The relevant range typically
depends on the available resource capacity. For example, the size of the plant and the number
of machines it contains, dictates how many units will be produced and hence the number of
labourers required. Returning to the Acropolis example (see Example 3.25), assume the relevant
range is between 4000 and 6000 units. The budgeted fixed cost of $30 000 is only appropriate
if Acropolis manufactures between 4000 and 6000 units. Now, assume there is an indication
of a sustained increase in the demand of 2000 of Acropolis’s products over the long term.
The relevant range will then change to between 6000 and 8000 units. To enable Acropolis to
increase its production, they will have to review their strategic plan and make decisions about
expanding resources, such as:
• buying or leasing additional plant and machinery
• employing more workers, including an additional supervisor for the plant.
The production volume variance may also indicate that not all fixed costs are allocated—meaning
that there is idle capacity. This may be an early warning sign of a decrease in the demand of
the organisation’s products, and may signal that the resources need to be downsized and
capacity curtailed.
224 | PLANNING, BUDGETING AND FORECASTING
Analysing the spending and the production volume variances of the fixed overhead costs is
therefore important for the profit and investment centres’ managers to monitor the resource
allocations. Further, the production volume variance may provide signals and warning signs that
may trigger a chain reaction of issues that require further investigation. Important questions to
ask when analysing fixed overhead costs variances are:
• Why did the organisation not produce at the capacity forecast in the budget?
• Was there a decrease in demand?
• Did the quality of the product deteriorate, which resulted in customers buying less or
from competitors?
• Are there gaps or weaknesses in the product and marketing strategies?
• Do competitors have aggressive product and marketing strategies?
• Were there new entrants to the market?
• Are the selling prices too high?
• Are competitors selling their goods at a lower price?
Answering these questions will help with understanding the organisation’s environment and may
help managers to make decisions about possible future courses of action.
reprimanded or punished for poor performance. Variance analyses should only be regarded
as a starting point to understand what really happened in the organisation, and to dig deeper
and behind the measured results in order to reveal the underlying performance. The purpose
of setting budgets and doing variance analyses is to improve performance, monitor the
implementation of the operational plan and provide information for management to change
the strategy if needed. So, variance analyses are best used to provide suggestions for further
investigation and future improvements.
Variance analyses are therefore a means that enable management to take appropriate actions
and make more precise predictions in order to achieve improved budgets as well as actual results
in future, as illustrated in Example 3.28.
➤➤Question 3.4
Leap Ltd (Leap) uses standard costing in planning and flexible budgets in controlling its
manufacturing. It has two direct-cost categories (direct material and direct labour) and two
overhead–cost categories (variable and fixed manufacturing overhead).
The cost driver for both overhead-cost categories is direct manufacturing labour hours. For the
previous period:
• total variable overhead costs $720 000
• total fixed costs $2 568 000.
The fixed costs are incurred equally per month and is for a factory large enough to meet Leap’s
capacity to supply the current demand.
The total direct labour hours forecast for the current year was 80 000 hours.
During May, 17 000 saleable units were produced. Of these, 14 000 units were sold. There was
no beginning inventory of direct materials and no beginning or ending work in process for May.
Due to a natural disaster, there was a short supply of raw material from its current supplier during
April. Consequently, Leap had not been able to meet the demands of customers in April, causing a
backlog of 5000 units in sales. To satisfy these customers, the sales manager promised that the
goods would be produced in May, and offered a discount of $20 per unit on the budgeted selling
price of $150 per unit.
For the May budget:
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• sales volume 10 000 units
• number of units to be manufactured 12 000 units
• standard usage of raw material 1.2 kg per unit
• standard labour hours per unit 30 minutes.
To meet the demand for both the backlog of April sales and the planned sales of May, Leap
appointed casual labourers at a pay rate of $20 per hour. The budgeted and actual pay rate for its
permanent labourers is $25 per hour. However, due to the inexperience of the casual labourers,
they had to redo 1000 jobs. It took them 30 minutes to make each of the 1000 units the first
time and another 30 minutes to redo each one. Fortunately, Leap ended their contracts within
two weeks to avoid any further waste.
However, to meet the sales demand, permanent labourers had to work overtime to manufacture
2000 units. It took them 30 minutes per unit to manufacture the units, for which they were
paid time and a half. The permanent labourers also manufactured 12 000 units that took them
20 minutes each to make.
Leap’s purchasing manager found and purchased a substitute raw material that was superior
compared to the raw material they purchased before, but it cost $44 per kilogram (compared to
the budgeted raw material of $40 per kilogram). Leap started to purchase the substitute material
on 1 May. Due to the superior quality, less raw materials were used in the manufacturing process.
In addition, the finished product was of a better quality, so the sales manager increased the
selling price to $160 per unit on 1 May. Unfortunately, some customers were not satisfied with
the increased price and bought from Leap’s competitors instead. Due to this, Leap lost 1000 of
the forecast sales volume for May, although these units were produced.
Due to the improved quality of the raw material purchased in May, the permanent labourers
only used 1.1 kg per unit manufactured. The actual variable manufacturing overhead cost was
$60 000 and fixed manufacturing overhead cost was $220 000 for May.
During the planning of the budget, management wanted to increase the finished goods inventory
levels. The budgeted inventory of finished goods as at 31 May was 2000 units.
226 | PLANNING, BUDGETING AND FORECASTING
Sales volume
Sales
Operating profit
(b) Calculate each of the following variances so that you can communicate effectively with the
appropriate managers and ask appropriate questions to investigate possible causes for
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each variance.
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Direct labour efficiency variance
(c) Analyse each of the variances you calculated in (b) and discuss sensible and plausible causes
to explain these variances.
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Causes for variances in fixed
manufacturing overhead
230 | PLANNING, BUDGETING AND FORECASTING
(d) Consider each of these variances as a control mechanism to evaluate the responsible managers’
performance. Discuss which variance relates to which manager and whether any of these
managers will be eligible for a bonus or whether anyone needs to be reprimanded.
Sales manager
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Production manager
Study guide | 231
Purchasing manager
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Check your work against the suggested answer at the end of the module.
232 | PLANNING, BUDGETING AND FORECASTING
Budgets are often used to judge managers’ performance, so they can have a significant
behavioural effect. When setting budgets, it is best if there is ‘goal congruence’—when an
individual’s goals coincide with the organisation’s goals. Goal congruence motivates individuals
and drives each manager to achieve the set goals. However, this is one of the greatest challenges
in managing large organisations. Negative (or dysfunctional) behaviour may occur if budgets
are poorly administrated—resulting in a conflict between individual goals and those of
the organisation.
The next section discusses participative budgeting, including resulting behavioural aspects,
and how negative behaviour can be avoided when setting budgets.
Participative budgeting
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Research has shown that the top-down approach to planning and control is not the best way to
create order in complex adaptive systems (Roosli & Kaduthanam 2018). When top management
sets the budgets too tightly, using the top-down approach, it often frustrates and demotivates
the individuals who have to execute the budget. Not only may this result in poorer performance,
but managers may be inclined to manipulate data. Targets and budgets are more likely to
be accepted and achieved if they are considered to be achievable. Therefore, managers of
responsibility centres should have direct input into the process of establishing budget goals
Study guide | 233
of their area of responsibility. If this is not the case, they may adopt an ‘it’s not my budget’ view
and consider the goals set by top management as unrealistic or arbitrary. For these reasons,
it is argued that budgets should be developed with the participation of lower-level management,
referred to as the bottom-up approach. The idea is that the bottom-up plan should inform the
top-down plan.
Advantages
The bottom-up approach encourages coordination and communication between managers by
allowing subordinate managers considerable say in setting budgets. Giving people individual
freedom to make decisions and team autonomy creates a sense of responsibility and fosters
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creativity. Further, budgets developed using the bottom-up approach may lead to increased
goal congruence because the budgets may then become the manager’s personal goal.
This approach may also provide greater understanding and appreciation of the organisation’s
objectives and wider strategy when top management communicates strategic goals and
targets to division and department managers, who then incorporate these into the budgeted
operating plans. Although top managers approve the final budget, they rely on the knowledge,
insight and expertise of lower-level management and operational staff to help establish realistic
departmental budgets.
Disadvantages
However, using the bottom-up approach can also result in dysfunctional behaviour, including
internal corporate political issues (e.g. power struggles and refusing to cooperate), protracted
negotiation games, ‘horse-trading’ tactics, empire building, and eventually blame shifting.
Managers associate resources under their control as power and status, which may lead to a ‘game’
between leaders and would-be leaders. To avoid these political struggles, top management
should foster a culture of cooperation rather than competition among employees and ensure
there is transparency and involvement in budget setting.
The bottom-up approach may also result in potential problems with setting targets and budgets,
such as ‘pseudo participation’ and ‘budgetary slack’ (referred to as padding the budget).
Pseudo participation occurs when top management only appears to seek input from lower-level
managers, but they really assume total control of the budgeting process and only seek superficial
participation from lower-level managers. In essence, top management only seeks lower-level
managers’ formal acceptance of the budget and not real input.
Budgetary slack (or padding the budget) exists when a manager deliberately underestimates
revenues or overestimates costs in an effort to make the future period budgets appear less
attractive in the budget than they think it will be in reality (Mowen et al. 2016, p. 352).
234 | PLANNING, BUDGETING AND FORECASTING
Some managers may pad budgets because they know it will be easy to achieve and so they will
be entitled on incentives. In essence, they drain the budget in an attempt to ensure sufficient
funds are available in future budgets. In padding the budget, managers believe they build in
a buffer and therefore reduce the risk of receiving an unfavourable performance evaluation for
not meeting their goals. Budgetary slack is also used as a means to cope with uncertainties
and unforeseen or unanticipated events. It is also common for top management or the budget
committee to cut budgets, so managers pad budgets, and because budgets are likely to be
padded, they are cut.
Budgetary slack may be the result of poor budgeting administration, where budgets are used
as a control mechanism of performance. For example, if a regional sales manager received a
poor performance evaluation in the previous period, they may be inclined to set a conservative
budget. On the other hand, managers of cost centres may inflate the budget. When this budget
is used in their performance evaluation, comparing AC with the overestimated costs in the
budget will appear as if the manager managed the cost centre in a cost-effective way.
It is understandable and sensible to build in a buffer in a budget and to estimate some costs
slightly higher than what is really expected so as to factor in uncertainty. However, deliberate
excessive padding of costs and revenue is misrepresentation and is a questionable ethical
professional practice. Not only is this is a violation of credibility standards but it is doubtful if
managers applying such behaviour demonstrate integrity. The challenge is for top management
to carefully review participative budgets in an attempt to reduce the effects of budgetary slack,
and to set budgets that are realistic and achievable (this is discussed in the next section).
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➤➤Question 3.5
Ariel Ltd (Ariel) uses the bottom-up approach in developing budgets and uses standard costing.
It manufactures a variety of outdoor furniture and equipment in numerous departments. Ariel uses
variance analysis to evaluate the performance of each department and the responsible manager.
In the past, the production department of the Akimo dining chairs and tables has achieved mostly
favourable variances. Consequently, the manager of the Akimo production department has
received excellent performance evaluations and considerable bonuses. Managers receive a bonus
if they either meet the budget or do not deviate from the budget by 10 per cent. The bonus is
based on a fixed percentage of actual profits of the organisation. No bonus is awarded if Ariel’s
actual profit is less than the budgeted profit.
On average, 144 tables of the Akimo dining table and chairs set are produced per day.
The production manager, Martin Steen, provided the following monthly data to be used to
prepare the budget for the next financial year:
Actual results to manufacture 144 tables for April of the following year are:
There are seven labourers each working 7.5 hours per day.
Due to an economic slowdown, Ariel’s top management wants to tighten the budget for the
following year as a means to challenge and encourage employees to improve their performance,
and to reduce costs.
As Ariel’s management accountant, you ask Martin Steen to provide you with challenging yet
achievable data to be used to develop next years’ budget. In response, Martin provided you
with the following input quantities per table:
Martin also informed you that the reductions in the input quantities will only be possible if the
labourers are more efficient. To become more efficient, they will have to receive training in how
to use less time and materials. This will make them more skilled, which will entitle them to a
pay increase.
(a) Why has Martin Steen chosen these figures for the new budget? Are they challenging
and realistic?
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(b) What aspects would you consider when communicating with Martin in challenging him about
the proposed figures?
236 | PLANNING, BUDGETING AND FORECASTING
(c) What steps can top management take to encourage Martin to provide budgeted data that
will ensure goal congruence?
Check your work against the suggested answer at the end of the module.
• One way is to avoid using the budget as a means to rigidly evaluate performance, but instead
to allow some discretion when comparing actual performance with the expectations set
out in the budget. For example, consider the situation when the actual maintenance costs
of machinery exceed the budget, but this is due to a breakdown that was not foreseen—
these mitigating circumstances should be taken into account.
• Since incentives for achieving the budget have the potential to lead to negative behaviour and
practice, another way is to give rewards for consistently providing accurate budget estimates.
• To ensure that everyone makes decisions in the interest of meeting organisation-wide targets,
align goals and incentives giving everyone who achieves their goals an incentive.
To achieve goal congruence, budgets should be based on realistic conditions and expectations.
Setting realistic budgets requires coordination, transparency, communication, cooperation and
commitment on all levels of management. It requires an attitude of ‘us’ and not one of ‘us and
them’ or ‘what’s in it for me’. This is closely related to human behaviour and psychological
issues—controlling issues such as greed, ego and fear is clearly outside the scope of the
accounting discipline. No budget will ever be able to completely prevent this negative behaviour.
According to Horngren et al., most employees will ‘work more intensely to avoid failure than to
achieve success’ (2011, p. 421). From this perspective, top management may set challenging
targets but targets that, in their view, are achievable. However, as discussed earlier, overly ambitious
targets and budgets may be viewed as unachievable and therefore discourage staff because they
see very little chance of avoiding failure. On the other hand, lowering standards and setting targets
and budgets that are too easy to achieve may result in employees not being challenged enough.
This may result in them becoming complacent. It is argued that having a challenging budget,
but one that employees believe they can achieve, will encourage and motivate them—so the
trick is to find the balance between a ‘too easy’ and a ‘too hard’ budget. This is referred to as a
realistic budget.
Setting realistic budgets is important when budgets are linked to incentive schemes to reward
managers’ performance. This is discussed in the next section.
Study guide | 237
Monetary incentives are used to motivate managers to be productive, work efficiently and
reduce waste. Good performance is rewarded with, for example, salary increases, bonuses
and promotions. Poor performance on the other hand may lead to dismissal. While monetary
incentive schemes are important, linking individual bonuses to targets will only increase
dysfunctional behaviour (Bogsnes 2018), and overemphasising monetary incentives can
lead to a form of dysfunctional behaviour referred to as ‘myopia’ or ‘milking the firm’. In this
case, managers take action to improve short-term performance but at the expense of the
long-term performance of the organisation. They simply disregard or overlook the fact that
concentrating only on short-term goals may have a harmful effect on the organisation’s long-
term sustainability. Further, ‘money loses its motivating power to purpose, mastery, autonomy
and belonging’ especially ‘when we move to more complex and team-based “knowledge” work’
(Bogsnes 2018, p. 12)
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In addition to monetary incentives, most people are also motivated by intrinsic psychological and
social factors, including non-monetary incentives such as responsibility, challenges, the freedom
of not being micro-managed or the simple acknowledgement and recognition of a job well
done. As Bogsnes states, many people ‘are much more fired up by the right words, igniting our
hearts and minds in a very different way than those clinical and decimal-loaded numbers ever
could’ (Bogsnes 2018, p. 9). Intrinsic factors may boost people’s self-esteem and give them
a feeling of job satisfaction. Consequently, some organisations use non-monetary incentives
such as job enrichment, increased responsibility and autonomy, and recognition programs in
budgetary control.
➤➤Question 3.6
Following on from the information provided in Question 3.5, the following standards were used
in developing the budget for the Akimo production department of the dining chairs and tables
for the following year:
These standards were made possible due to careful negotiation and coordination. Top management
agreed to provide training so that the employees could improve their efficiency, but due to the
downturn in the economy, they did not agree on an increased pay rate. The employees were
happy with this decision because they retained their jobs and had an opportunity to upskill.
Due to a redesign in the table, a different type of material is now being used, which requires
less material and fewer machine hours. Further, a new supplier for the material has been found.
Due to the tighter budget, the Akimo production department received a few unfavourable
variances in the first month of the new year. Martin Steen is concerned about the effect this may
have on his performance evaluation and bonus this year. A few months later, Martin also begins
to doubt that Ariel will achieve its budgeted profit. Due to these concerns, he deliberately works
on a plan to prove that the standards were set too high.
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• He convinces the employees that the quality of the tables is not as good as previously and
this encourages them to work more slowly.
• He also convinces the purchasing manager that the quality of the tables is not as good as
previously and to purchase the material from the previous supplier—which is of inferior
quality compared to the material currently used.
Martin knows that these proposed changes will increase the quantities input per table and he
plans to use these more generous standards in setting the budget for the following year. He is
convinced that if this budget gets approved, he will be able to convince the purchasing manager
to purchase the better quality material again and also the labourers to be more efficient.
(a) Comment on Martin Steen’s behaviour and what the potential drivers behind this might be.
Study guide | 239
(c) Assume that Martin is successful in convincing the labourers and the purchasing manager
and that he develops a budget which is quite obviously padded.
Discuss how you will be able to point out budgetary slack to Martin by discussing which
variances you will analyse and what the expected outcomes of these variances will be.
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Check your work against the suggested answer at the end of the module.
240 | PLANNING, BUDGETING AND FORECASTING
method, stifle initiative, impede empowered employees from making the best decisions for the
organisation, and restrict organisations’ ability to act and react. Due to digitalisation, globalisation
or mobility, the business environment is becoming more and more demanding, causing a VUCA
world: volatile, uncertain, complex and ambiguous (Roosli & Kaduthanam 2018). The unexpected
is becoming the norm and organisations need to cope with unforeseen events. Traditional
budgeting methods are too unresponsive in this VUCA environment (Neely et al. 2003).
Further, traditional budgets are not focused on value creation but merely on reducing costs.
Research has found that responsibility-centre-focused budgets are not compatible with value-
chain-based organisations. ‘Traditional budgeting is fundamentally mismatched to today’s
rapidly changing and uncertain environments’ (Hansen et al. 2003, p. 98). Another criticism is
that traditional budgeting creates budgets for silo functional units such as sales, production,
and administration departments, and then allocates (or pushes) these functional budgets
to products.
Hansen et al. list the following most cited weaknesses of budgetary control:
1. Budgets are time-consuming to put together;
2. Budgets constrain responsiveness and are often a barrier to change;
3. Budgets are rarely strategically focused and often contradictory;
4. Budgets add little value, especially given the time required to prepare them;
5. Budgets concentrate on cost reduction and not value creation;
6. Budgets strengthen vertical command-and-control;
7. Budgets do not reflect the merging network structures that organisations are adopting;
8. Budgets encourage gaming and perverse behaviour;
9. Budgets are developed and updated too infrequently, usually annually;
10. Budgets are based on unsupported assumptions and guesswork;
11. Budgets reinforce departmental barriers rather than encourage knowledge sharing; and
12. Budgets make people feel undervalued (Hansen et al. 2003, p. 96).
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Neely et al. (2003) also identify 12 significant weaknesses of traditional planning and budgeting
practices, which they categorise into three principal categories:
1. competitive strategy
2. business process
3. organisational capability.
Overall, they state, traditional planning and budgeting processes are failing to deliver results,
as ‘they tend to promote an inward-looking, short-termist culture that focuses on achieving a
budget figure rather than on implementing business strategy and creating shareholder value
over the medium to long term’ (Neely et al. 2003, p. 25).
Despite the shortcomings of traditional budgets, the vast majority of organisations around the
world are still using them in planning and control. Three principal approaches and techniques
that have been proposed to improve budgeting and planning processes are discussed next.
Incremental budgeting
Incremental budgeting involves the common practice of projecting next year’s budget by adding
an adjustment (e.g. a percentage increase due to inflation) to either the actual results or the
previous budget. This is a quick and easy way to develop a budget and may be useful in small
businesses—especially service organisations—with simple business models. However, using this
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approach to develop a budget for large organisations with complex business models may not
be appropriate.
This approach does not force managers to manage resources more efficiently and effectively.
Further, using the previous year’s budget only to plan the next year’s budget may result in
complacency and dysfunctional behaviour and waste of resources. For example, some managers
have the belief and attitude that they should spend the money in a budget even though there is
no real need to do so. This dysfunctional behaviour can be characterised as the ‘if you don’t use
it, you will lose it’ mentality—resulting in some managers spending money unnecessarily simply
to avoid cutbacks.
To make these budgets more useful, it is recommended that the organisation use an incremental
budget simply as the starting point and, in addition, consider the internal and external factors
that may affect the organisation in future.
Zero-based budgeting
Zero-based budgeting was developed and used widely in the 1970s and 1980s (Langfield-Smith
2018, p. 441). Zero-based budgeting is designed to reduce problems associated with incremental
budgeting. As the name indicates, using this approach, virtually every activity is set to zero. It is
argued that this forces managers to rethink each phase of the operations and to justify each
activity and budgeted figure in order for them to receive an allocation of resources. Under zero-
based budgeting, managers prepare a budget as if no information about revenue and costs from
previous budget cycles is available—the budgets are developed from scratch. It forces managers
to carefully consider the effects of internal and external factors (discussed earlier in this module).
242 | PLANNING, BUDGETING AND FORECASTING
Although rethinking each phase of an organisation’s operations and developing a budget from
scratch has advantages, it is very time consuming and expensive—because it requires extensive
in-depth analysis of expenditures.
Zero-based budgeting is also criticised as being too introspective. It is argued that managers
can overlook the interactions with other departments and the relevance of their own part of
the operations to the overall business objectives and strategies. Consequently, this approach
may not be useful for managing costs or improving an organisation’s performance. Zero-based
budgeting has also been criticised as not being useful to identify ‘areas of waste, redundant
activities, communication barriers or opportunities for more effectively deploying resources to
support business needs’ (Langfield-Smith 2018 p. 441).
For a further explanation of zero-based budgeting, please access the ‘Zero-based budgeting’
Case study on My Online Learning.
Activity-based budgeting
Activity-based budgeting (ABB) was developed by consultants Coopers and Lybrand Deloitte
(Kleiner & Wilhelm 1995). This approach primarily focuses on the problems with using traditional
budgets as a planning tool. ABB is a participative management process for control and continuous
improvement (CI) of performance and costs, operating at the activity level. It focuses on developing
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a budget explicitly from activities and resources. In essence, ABB aims to make budgeting more
meaningful to operational managers.
In this approach, organisations apply the analytical operational model of activity-based costing
(discussed in Module 6) with a detailed financial model. Opposed to traditional budgeting that
is primarily based on outputs and only use a few cost drivers, ABB uses a considerable amount
of cost drivers. In essence, activity-based and capacity management concepts are expanded
into budgeting. In ABB, the traditional budgeting process is modified to better reflect the
operational processes in the organisation. Various activity cost pools and their related cost
drivers are used to forecast the costs for individual activities. This approach allows managers
to identify the resources consumption of each activity separately and to prepare a budget for
that activity accordingly.
Similar to traditional budgeting, the ABB process starts with forecasting future market demand
for the organisation’s products and services. The sales forecast drives the quantities of products
to be manufactured (and the product mix), which then drives the expected production activities.
Using a range of activity drivers (as opposed to the limited drivers of sales and production used
in traditional budgeting), ABB helps managers to estimate the resources that will be needed for
each activity. Managers then analyse the resource capacity of the organisation to conduct the
required activities and compare this with the resources necessary to produce the products. If the
activity plan is not feasible, they adjust the budget loop until they achieve a balance between
the required resources and available resource capacity.
In using this approach, a feasible operating budget is developed before generating the financial
budget. Doing this avoids unnecessary calculations of financial effects until the operational plan
is feasible. The financial plan is typically broken down into information by resources, activities,
products or other cost objects (Hansen et al. 2003). In ABB, the product decisions, activity costs
and resource costs are reviewed until the targeted financial results are met (for further details,
see Hansen et al. 2003).
Study guide | 243
Prominent organisations such as Boeing, Emerson Electric, IBM Business Consulting Services,
SAS Institute and the US Marine Corps support the ABB approach. However, at the time of
writing, it is still an open question whether the higher complexity costs of the ABB approach
can earn back the credibility of the budgeting process.
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The components of the master budget in ABB is illustrated in the Figure 3.8.
244 | PLANNING, BUDGETING AND FORECASTING
Strategic plan
Sales forecast
Production activities
Activity budget
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Financial plan
Source: Based on Groot, T. & Selto, F. 2013, ‘Figure 5.3 Master budget components’,
Advanced Management Accounting, Pearson, Harlow, UK, p. 151.
In ABB, the operating budget implements the organisation’s strategy by forecasting the expected
levels of activities, for example sales, production, purchasing, maintenance, marketing and
distribution (and other overhead activities).
However, according to Neely et al., none of these three alternative approaches and techniques to
planning and budgeting processes provides a complete solution. A criticism that ABB and zero-
based budgeting share ‘is that they tend to involve even more work than traditional budgets so
they are best used on a ‘one-off’ basis rather than a regular one’ (Neely et al. 2003, p. 25).
A radical re-engineering proposal to banish budgeting altogether, called Beyond Budgeting (BB),
is discussed next.
Study guide | 245
It is argued that in planning and preparing an annual budget, there are too many uncertainties
that cannot be foreseen. Consequently, this makes annual budgets risky and even dangerous.
Advocates of the BB model argue that traditional ‘fixed’ contract budgets should be eliminated.
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making is in the hands of empowered local managers, having responsibility for their units. It is
based on principles of employee empowerment, assuming that employees enjoy contributing
to the organisation they work for and they take pride in their work. This model therefore ‘relies
heavily on high levels of trust among employees with a strong commitment to customer focus’
(Eldenburg et al. 2017, p. 178). The core of this movement rests with extreme decentralisation
of decision-making, with minimal influence from centralised functions. Other important issues
of this model is its transparent accounting and reward systems with relative performance
evaluation. Further, this model uses rolling forecasts as a form of benchmarking, in which plans
are adapted and evolved over time, enabling managers to adapt quickly to changing conditions.
It is important to keep in mind that rolling forecasts are not equivalent to rolling budgets.
‘Rolling forecasts as the prediction of key values that may or may not be budget related for a
period of time into the future, while rolling budgets specifically link these updates to the budget’
(Bhimani et al. 2018, p. 308). It is argued that this approach to forecasting can be used as a means
to evaluate ‘relative performance assessment with hindsight’(Hansen et al. 2003) and motivates
employees towards CI.
To avoid the dysfunctional behaviour of traditional budgeting when used as a tool to evaluate
performance, BB uses ‘relative performance contracts with hindsight’ (Hansen et al. 2003, p. 101).
The relative component is because financial compensation is attached to the organisation’s
overall financial results and not relative to the unit’s performance. The hindsight component
means that the performance is evaluated against targets with hindsight. Thus, the performance
’level is not set inflexibly in advance, but will be established when the evaluation takes place and
is equal to the benchmarked performance’(Groot & Selto 2013, p. 147). BB therefore aims to
achieve goal congruence and ‘a philosophy of doing what is best for the firm in light of current
circumstances and to improve teamwork (Hansen et al. 2003, p. 102).
Although budgets are still developed in the BB approach, these budgets will not be used as
targets that must be achieved in performance evaluation. Thus, the planning and the performance
evaluation functions of budgets are separated. It is argued that, in future, less attention should
be given to managing performance through targets, budgets and bonuses, and more on creating
conditions to enable great performance (Bogsnes 2018). So the BB approach will encourage
cooperation, make local managers feel responsible for the performance of the entire organisation
and discourage internal rivalry among units.
246 | PLANNING, BUDGETING AND FORECASTING
BB applies a more decentralised model of management control, which is consistent with strong
clan control (Groot & Selto 2013). BB relies on managers to make more strategy-focused planning
and control decisions, but without budgets. This ‘requires authority to be developed through
the hierarchical layers to lower level branches, teams and individual employees’ (Eldenburg
et al. 2017, p. 178), giving individuals autonomy and allowing them to quickly respond to,
for example, customers. BB focuses on radically decentralising organisations. It is argued that
radical decentralisation gives employees responsibilities and power to make decisions that
affect their activities and operations they are responsible for. For example, when decentralising
an organisation, the sales managers may have the authority to make decisions about the best
product or service for a local region, and local teams will have the authority to set prices,
offer discounts and make decisions about local marketing and advertising. This decentralisation
allows employees to be innovative and creative. Support units, such as accounting, HR and
information technology departments, will still be maintained as centralised functions.
While the BB approach sounds like a sensible approach for performance evaluation, not all
organisations will necessarily benefit from decentralisation. Further, the principles of the BB
approach have not been taken up widely across the globe. Only a cluster of Scandinavian
companies have taken up the principles of the BB approach and operate without targets and
budgets (Neely et al. 2003). The Swedish bank Svenska Handelsbanken prepared their last
budget in 1970. Skandia, a Swedish financial services organisation, uses a highly slimmed-
down budgeting process that only includes high-level budget figures. To manage their
business, they apply a ‘navigator’ scorecard framework. Another company, Borealis, prepared
their last budget in 1995. They use rolling forecasts to manage the future and a balanced
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scorecard to keep track of the organisation’s performance, and motivate staff through target
setting. Volvo abandoned budgets in 1994. They use quarterly forecast planning and monthly
reporting to manage their business.
Another organisation with a radical reengineering approach to improve the process of planning
and budgeting is Hilcorp Energy (Lalicker & Lambert 2018). McKinsey & Company undertook an
interview with the CEO of Hilcorp Energy, Greg Lalicker, about Hilcorp’s practices in planning
and control. Hilcorp has four practices:
1. Commitment to a flat organisation with no more than five layers above any employee.
2. Delegate decision-making, pushing decision-making as close to the front line as is practical.
3. Align goals and incentives. To ensure everyone makes decisions in the interests of meeting
company-wide targets, everyone gets the same amount, and all employees who achieve their
goals receive an incentive.
4. Have just enough process and control. Start the planning with a bottom-up plan that informs
the top-down plan.
A possible reason why the BB approach has not been widely implemented across the world is
because it lends itself towards a coaching management style, so requires a radical change in
mindset or a new management philosophy. Managing organisations without targets and budgets
requires trust, autonomy, transparency, helping each other, and accountability for creating value.
Managers and employees have to leave the safety of their comfort zones and move into a stretch
zone (Heupel & Schmitz 2015). In these stretch zones, ‘managers have to be ambitious, accept
risks and deal with uncertainty’ (Heupel & Schmitz 2015, p. 734). BB is an approach positioning
organisations to continuous development so that they can stay viable for the future (Roosli &
Kaduthanam 2018). Giving people the freedom to make their own decisions develops greater
coherence and strength.
Study guide | 247
Review
This module provided an overview of budgets and how they are developed and used to evaluate
performance. It also discussed negative behavioural issues related to using budgets as a control
mechanism and alternative approaches that have been proposed consequently.
Part A discussed the roles and purposes of budgets and their relationship with an organisation’s
strategy and responsibility centres.
Part B detailed the various components of a master budget and developed operational budgets
for an example manufacturing organisation. It also described how financial and flexible budgets
are developed. Internal and external factors that should be considered in developing budgets
were provided.
Part C described why and how static budgets are flexed into flexible budgets. It then illuminated
how flexible budgets are used to analyse variances with actual results for manufacturing
organisations. Possible causes for variances are proposed.
Part D discussed participative budgeting and behavioural issues that result from budgetary control.
A discussion of monetary and non-monetary incentive schemes used to motivate performance
was provided.
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Part E detailed criticisms against traditional annual budgets and alternative approaches
proposed to alleviate these shortcomings.
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Suggested answers | 249
Suggested answers
Suggested answers
Question 3.1
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Although Kabuki Ltd has the capacity to convert 15 000 units per year, the forecast demand is
only 5000 units. Therefore, the forecast sales should be set at 5 000 units. In making this decision,
the following factors were considered:
It is not sensible to supply 15 000 units if there is only a demand for 5000. The market has
changed significantly and there is no guarantee that Kabuki will achieve its past success. If the
organisation produces 15 000 units and is not be able to sell them, this will result in significant
losses. They will incur unnecessary costs in producing the final product that they will not be able
to recoup from selling the products. If such products are produced, they will end up in inventory,
which will cost Kabuki Ltd more money as they will have to store the inventory and incur many
other costs related to inventory. Further, there is the risk that the inventory may be damaged or
become obsolete and has to be written off. Also, they may try to sell the products at a reduced
price, but that is also very risky.
Therefore, Kabuki should not budget to manufacture to full capacity but only to the sales
demand. Should it become apparent in the next year that they are able to sell more units than
budgeted for, they will be able to manufacture and sell it as they have the capacity.
Question 3.2
The finished goods inventory budget will be linked directly to the direct materials, direct labour,
and the manufacturing overheads costs budgets and indirectly to the production and sales
budgets. These are linked because the direct materials costs budget is linked to the production
budget, which in turn is linked to the sales budget.
Question 3.3
The closing balance of cash at bank in the budgeted balance sheet is the closing cash figure
in the cash flow budget as at the end of the forecast period. This balance is determined by
adding the cash inflows for the period to the opening cash figure in the beginning of the
period, and subtracting the cash outflows for the period.
Question 3.4
(a)
$
(b)
Sales price variance (AP – BP) × AQ
April sales: ($130 – $150) × 5000 = $100 000 U
May sales: ($160 – $150) × 9000 = $90 000 F
Total sales volume variance = $10 000 U
Sales volume variance Budgeted quantity is 5000 for April and 10 000 for May
Direct material efficiency variance (AQ × BP) – [(BQ allowed AQ) × BP]
= (17 800 × $40) – [(1.2 × 16 000) × $40]
= $712 000 – $768 000
= $56 000 F
Direct labour efficiency variance (AQ × BP) – [(BQ allowed AQ) × BP]
= (6000 × $25) × [(30 / 60 × 16 000 units manufactured) × $25]
= $150 000 – 8000 hours × $25
= $150 000 – $200 000
= $50 000 F
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spending variance
Cost driver is direct labour hours.
Total cost / cost driver
= $720 000 / 80 000 hours
= $9 per hour
(c)
Causes for variances in sales The sales price variance will be negatively affected by
the $20 discount per unit for the 5000 backlogged April
units, thus there is an unfavourable variance of $100 000.
On the other hand, selling 9000 units at $10 per unit more
than budgeted will result in a favourable price variance
of $90 000. However, it is questionable whether the sales
manager should have increased the selling price due to
the increased price of the raw materials. The organisation
has a large enough contribution margin that it could be
argued that they should not pass the increased cost on
to the customers. Due to this, 1000 units have not been
sold, and are now part of the inventory, which may cost the
organisation additional costs to carry. Further, customers
were lost and it is uncertain whether the organisation will
be able to win them back.
Causes for variances in direct material The purchasing and use of a superior quality of raw material
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Causes for variances in direct labour The direct labour price variance has a few explanations.
First, casual labourers were paid $5 per unit less than
the permanent labourers, resulting in a favourable price
variance. However, they had to redo all 1000 units they
made, and therefore $20 for 1000 cost was a waste,
contributing to an unfavourable price variance.
Causes for variances in variable The actual variable overhead cost rate is $10 per labour hour
manufacturing overhead ($60 000 / 6000 hours). As this exceeds the budgeted rate by
$1, the spending variance is unfavourable. Variable overhead
costs consist of all the indirect overhead costs incurred
such as indirect material and labour, and any other
common variable manufacturing costs that are not directly
under the control of any particular production manager.
Consequently, these costs are allocated. To understand
the variable manufacturing overhead spending variance,
the management accountant could break these costs up
and investigate each line item. It is possible that some items
will exceed the budgeted costs while other will beat the
budgeted costs.
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Causes for variances in fixed The fixed manufacturing overhead spending variance
manufacturing overhead could be due to renting or leasing storage for the
increase inventory.
(d)
Sales manager Sales price and sales volume variance.
The unfavourable sale price variance is due to the reduced price applied
to the 5000 units not able to be manufactured and sold in April. It is
understandable that the sales manager would have offered a reduced
price in order to retain the customers. However, the decrease is 13.333%
(20 / 150) and it could be argued that this is too high. Perhaps 5% would
have been sufficient. The sales manager should ‘know’ these customers
and in theory should be best to judge if this would have convinced
them to stay with the organisation.
In summary, the unfavourable variances are both due to the sales manager’s
decision to change the selling price per unit. Unless they can provide
plausible and sensible reasons to justify their decision, the sales manager
should not receive any bonus.
254 | PLANNING, BUDGETING AND FORECASTING
Production manager Direct material, direct labour efficiency and the direct labour price variance.
The casual labourers caused the organisation to lose profit, as they had
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to redo 1000 jobs, wasting material and labour costs. Thus, the process
of their appointment needs to be investigated. Who was responsible
for their appointment—the production manager or the HR department?
Were they appointed due to poor or hasty decisions? The organisation
can learn from this to ensure better communication and coordination
in the future. Perhaps it would have been better to negotiate with the
customers—for example, by informing them that the products would
not be manufactured on time and offering them a reduced price.
Question 3.5
(a) The figures Martin provided are not challenging and realistic. The Akimo production
department has already achieved these levels, as demonstrated in the April actual results.
Total kilograms direct materials used: 2736 / 144 units = 19 kg per table
Total direct labour hours spent: 52.5 hours / 144 units = 21.875 minutes per table
Total machine hours used: 110 hours / 144 units = 45.83 minutes.
Martin probably chose these figures so that the Akimo department will be able to
achieve the budget easily, resulting in favourable variances, which will give him a positive
performance evaluation and ultimately a bonus.
(b) The following ways may be considered to illustrate to Martin that the budgeted figures he
provided are easy to achieve.
–– Since Akimo is only one department of Ariel’s operations, there might be other
departments that may be used as benchmarks.
–– If available, industry averages may be used.
Further, Martin needs to be made aware that his actions are not ethical.
If Martin does not respond well to these suggestions, the situation may be escalated up
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the hierarchy.
(c) Top management may appoint an independent person, such as a consultant, to conduct
studies on the efficiency of the Akimo department, so as to better understand the operations.
If it is found that the figures Martin provided are indeed too lenient, they could use these
studies to encourage him to improve his management of the Akimo department.
They could also reward the performance of the Akimo department (and consequently
Martin’s bonus) only if it increases productivity and not when it beats the budget.
Further, they could also find out what intrinsic factors motivate Martin so as to make decisions
whether to award Martin with monetary or non-monetary incentive schemes or both.
They could award Martin’s performance only if he sets accurate budgets.
Question 3.6
(a) The standards set for the following year’s budget are considerably higher than those used
in the previous year (in Question 3.5). Further, due to the changes in the design of the table,
use of different material and reduction of material quantities and machine hours, Martin may
feel unsure as to whether those standards will be met, even though employees will receive
training. This is further escalated by Martin’s belief that the company will not achieve the
budgeted profit. It is therefore likely that Martin may think it will be challenging to meet the
standards and he may be concerned that he will lose his bonus.
From this perspective, it appears that Martin’s behaviour could be viewed as deceptive—he
lowered the standard to meet the budget, have a favourable performance evaluation and
receive a bonus. He has misrepresented the Akimo department’s capabilities.
Potential drivers of Martin’s behaviour and decisions could include self-interest and fear of
losing his bonus. Martin’s goal (to lower the standards so that he can get a bonus) is not
aligned with that of the organisation (to have realistic standards to ensure the company
remains sustainable)—so there appears to be an absence of goal congruence.
(b) This is not an easy issue to deal with, because as it has potential to create a challenging
internal political situation of power and game playing. If the purchasing manager suspects
dysfunctional behaviour, he could refuse to change suppliers. If, however, the purchasing
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manager coheres with Martin, the management accountant may detect budgetary slack when
analysing the direct material price and efficiency variances. The labourers may report Martin’s
leadership. First, he instructed them to improve their efficiency, work harder and ensured they
received adequate training. They would have learned new skills that could have given them
intrinsic rewards such as job satisfaction and knowing that they are capable of performing
at a higher level. However, then Martin instructed them again to work slower. They may feel
undervalued and criticised, which may encourage them to report Martin’s expectations to
a higher hierarchy.
(c) Due to the redesign of the Akimo table, less raw material is required. This will be represented
in the standards set in the budget. However, the budget will be based on buying material
with a superior quality from the new supplier at an increased price. Therefore, if the cheaper
and inferior material is purchased, the direct material price variance will be favourable but
the direct material efficiency variance will be unfavourable. Further, the inferior quality of
raw material will result in an unfavourable efficiency variance. Since the labourers received
a pay increase, the direct labour price variance will be unfavourable, but it can be expected
that they will be more efficient and hence that the direct labour efficiency variance should
be favourable. But if they used the inferior material, there may be waste and hence an
unfavourable direct labour efficiency variance.
References
References
Bhimani, A., Sivabalan, P. & Soonawalla, K. 2018, ‘A study of the linkages between rolling
budget forms, uncertainty and strategy’, The British Accounting Review, vol. 50, pp. 306–23,
MODULE 3
https://doi.org/10.1016/j.bar.2017.11.002.
Bogsnes, B. 2018, ‘Hitting the target but missing the point’, Controlling & Management Review,
vol. 62, no. 5, pp. 8–13.
Collier, P. 2015, Accounting For Managers: Interpreting Accounting Information for Decision-
Making, 4th edn, Wiley, West Sussex, United Kingdom.
Covaleski, M., Evans III, J., Luft, J. & Shields, M. 2003, ‘Budgeting research: Three theoretical
perspectives and criteria for selective integration’, Journal of Management Accounting Research,
vol. 15, no. 1, December, pp. 3–49.
Eldenburg, L. G., Brooks, A., Oliver, J., Vesty, G., Dormer, R. & Murthy, V. 2017, Management
Accounting, 3rd edn, Wiley, Milton.
Eldenburg, L. G., Brooks, A., Oliver, J., Vesty, G. & Wolcott, S. 2011, Management Accounting,
2nd edn, Wiley, Milton.
Hansen, S. C., Otley, D. T. & Van der Stede, W. A. 2003, ‘Practice developments in budgeting:
An overview and research perspective’, Journal of Management Accounting Research, vol. 15,
pp. 95-116.
Horngren, C. T., Wynder, M., Maguire, W., Tan, R., Datar, S. M., Foster, G., Rajan, M. V. & Ittner, C.
2011, Cost Accounting: A Managerial Emphasis, rev. edn, Pearson, French Forest.
Kleiner, B. & Wilhelmi, M. 1995, ‘New developments in budgeting’, Management Research News,
vol. 18, no. 3/4/5, pp. 78–87.
258 | PLANNING, BUDGETING AND FORECASTING
Lalicker, G. & Lambert, P. 2018, ‘Digging deep for organizational innovation’, McKinsey Quarterly,
accessed September 2018, https://www.mckinsey.com/business-functions/organization/our-
insights/digging-deep-for-organizational-innovation.
Langfield-Smith, K., Smith, D., Andon, P., Hilton, R. & Thorne, H. 2018, Management Accounting:
Information for Creating and Managing Value, 8th edn, McGrawHill Education, Sydney.
Mowen, M., Hansen, D., Heitger, D., Sands, J., Winata, L. & Su, S. 2016, Managerial Accounting,
Asia-Pacific edn, Cengage Learning, Australia.
Neely, A., Bourne, M. & Adams, C. 2003, ‘Better budgeting or beyond budgeting?’, Measuring
Business Excellence, vol. 7, no. 3, pp. 22–8, doi:10.1108/13683040310496471.
Roosli, F. & Kaduthanam, S. 2018, ‘Beyond Budgeting as a mindset and a framework for action’,
Management Journal, vol. 4, May/June, pp. 20–22.
Strathern, M. 1997, ‘“Improving ratings”: Audit in the British University system’, European Review,
vol. 5, no. 3, pp. 305–21.
Weygandt, J. J., Kimmel, P. D. & Kieso, D. E. 2012a, Managerial Accounting: Tools for Business
Decision Making, 6th edn, Wiley, USA.
Weygandt, J. J., Kimmel, P. D. & Kieso, D. E. 2012b, Accounting Principles, 10th edn, Wiley, USA.
MODULE 3
STRATEGIC MANAGEMENT ACCOUNTING
Module 4
PROJECT MANAGEMENT
260 | PROJECT MANAGEMENT
Contents
Preview 263
Introduction
Objectives
MODULE 4
Closing the cost records
Post-project expenditure
Resource dispersion 346
Final report 346
Knowledge management 347
Review 349
Appendices 351
Appendix 4.1 351
Appendix 4.2 357
References 377
Optional reading
MODULE 4
Study guide | 263
Module 4:
Project management
Study guide
Preview
Introduction
The organisations we work in have many projects. It is easy to see projects in a company whose
operations focus on delivering projects, such as the Lend Lease construction company building
the new Western Sydney Stadium (Lend Lease 2018), or a software development company
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such as Microsoft, which develops and delivers new software for your computer. Projects may
be focused on improving a current product, such as Toyota upgrading the new Corolla, or a
new edition of a mobile phone, such as the latest Apple iPhone. Projects may also be oriented
towards the development of a new product line, such as the Apple Watch. Projects can also focus
on improving core processes in an organisation (e.g. process mapping and improvement), or be
oriented towards support activities (e.g. IT upgrade of enterprise resource planning software),
or decision support software.
These examples show that projects are strategically important to organisations. For example,
the development of the Apple Watch was central to the company’s strategy to gain competitive
advantage in the marketplace by enhancing iPhone use through wearable technologies. To achieve
these objectives, project management must be aligned with an organisation’s strategic planning.
Projects are very important and management accountants are likely to be constantly involved
in them in the workplace. Projects are also challenging. Typically, each project has a different
customer and location, a smaller or larger scope, and so on. These characteristics highlight one
of the inherent features of any project—it involves doing something that has not been done
before; it is unique. Even when a project has similarities with other projects, each project still
has its own unique characteristics.
Part A of this module considers the definition of project management, including the stages of
a project and organisational structures for projects. Part B discusses the roles within project
management teams. Part C explores the role of the management accountant in project selection
and the range of analytical techniques that are used in this task. Part D examines planning tools
that are central to the successful implementation of a project. Part E considers the management
accountant’s role in project implementation, risk management and control. Finally, in Part F,
the post-completion and review processes are addressed.
The highlighted sections in Figure 4.1 provide an overview of the important concepts in this
subject and how they link with this module. This module discusses how the management
accountant works to provide management with information for projects and operational
decision‑making that informs and is informed by strategy.
rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
MANAGEMENT ACCOUNTANT
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VALUE INFORMATION
OPERATIONS
Exte
rnal environment
Objectives
After completing this module, you should be able to:
• Explain the steps and roles in project management and the different types of organisational
structures for projects.
• Undertake financial analysis to assess risk and return of a given project.
• Evaluate the strategic fit of competing projects or projects as a portfolio.
• Apply project management scheduling and budgeting techniques.
• Recommend approaches to monitoring and managing a project.
• Explain the importance of project post-completion review.
Study guide | 265
#1 ?
• Key distinction between profit, reducing costs, or
day-to-day operations and improving a specific system
a project or business process
• Leads to another defining • Objective is commonly
characteristic—high level set/agreed upon by the
of uncertainty business partner
• Any investment in a project
should provide recognised
4. Related activities Projects added value to the company
• Project activities use multiple funding the project
resources that need
coordination 3. Defined start and finish time
• Important to understand • Management focus on the
which activities must occur finishing time is often very
sequentially and which can high—most projects require
proceed concurrently considerable investment
before the benefits are realised
• The longer the project
runs, the longer it is before
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it generates a return
on investment
➤➤Question 4.1
Complete the following table by listing six key characteristics of a project and explaining how
these make it different from day-to-day operations.
1.
2.
3.
4.
5.
6.
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Check your work against the suggested answer at the end of the module.
The Project Management Institute (PMI 2017, s. 1.2.2) defines project management as ‘the
application of knowledge, skills, tools and techniques to project activities to meet project
requirements’.
Project management is an extremely challenging activity when the level of success and failure in
projects is considered. For example, research on 5400 large IT projects found:
• Half of all projects had large budget blowouts. These projects, in total, had a cost overrun
of $66 billion.
• On average, the projects ran 45 per cent over budget and delivered 56 per cent less value
than predicted.
• The longer a project was scheduled to last, the more likely it was that it would run over time
and budget (Bloch, Blumberg & Laartz 2014).
Study guide | 267
Not only is project management about trying to deliver what is expected, but good project
management requires an understanding of how to maintain control over costs. This is often
difficult, as highlighted in Example 4.2.
What is interesting is that many of the techniques or tools used in project management were
developed during World War II and in the two decades afterwards (Zwikael & Smyrk 2011) as a
result of experiences in weapons development and space exploration. The skilful application of
these tools has an enormous influence on whether a project is delivered on time and on budget,
while satisfying its objectives. Before considering the range of tools used, the next section
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discusses the basic steps in the project management process.
Project
1 selection
Project
2 planning
Management
accountant
involvement
Project implementation
3 and control
Project completion
4 and review
The primary objectives of the project need to be identified during project selection. These are
typically grouped under:
• specification—the technical description of the project’s deliverables (discussed in the
next section)
• budget—how to meet the project specifications with the available resources
• completion time—the period during which the project is expected to start and finish.
The key criteria in project selection are strategic fit and risk analysis. The project must support
organisational strategy, or the investment will likely be wasted. For example, consider a
manufacturer pursuing a low-cost strategy. Projects or investments to support this strategy
should increase efficiency and reduce labour costs. A project to implement a new quality
assurance automated process might increase the products’ quality and reliability, but it
would not necessarily support a low-cost strategy—so may not be selected. Such a project
would be more useful if the company was pursuing a differentiation strategy, such as a high-
quality strategy.
The management accountant will often have input into the budget and other financial planning
aspects of project planning as well as the design of KPIs. Once these five areas of project
planning are complete, the project sponsor reconsiders the feasibility of the project and either
formally approves commencement of the project or decides to discontinue it.
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Progress against the set deliverables’ dates and the budget is monitored, variances are examined
and necessary adjustments are made. An important part of monitoring is tracking how the
project’s progress compares to the milestones.
Project managers (discussed in Part B) need to understand how the cost of work completed
differs from the expected cost of this work (the cost variance), and the difference between
the budgeted costs of work done and the work planned (the schedule variance). Accordingly,
project variance reports can be complex.
The management accountant is typically involved in ongoing budget variance analysis as well as
tracking performance against KPIs.
270 | PROJECT MANAGEMENT
➤➤Question 4.2
Complete the following table by briefly explaining the role of the management accountant in
each project stage.
Check your work against the suggested answer at the end of the module.
Project Virtual
organisations projects
Organisational
structures
for projects
Joint
Collaborations
ventures (JVs)
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Project organisations
Project organisations are those that have projects as their core operating activity. Examples of
this would be construction companies (see Example 4.3), software companies or professional
service organisations.
Leighton’s involvement in these projects is as principal or, more commonly, as part of a consortium.
Internal projects
This is where a project exists within an organisation whose main business is some other form of
product or service provision. In these situations, the project supports the core operating activities
of the organisation. For instance, the project might be new product development, implementing
new IT systems, asset replacement, cost-reduction programs, or implementing new performance
indicator systems. For many management accountants, projects they will be involved in are likely
to be internal (within the organisation) ones.
Joint ventures
This structure is used when two or more organisations co-contribute in a form such as capital
and technology to undertake a project where the revenue and expenses are also shared.
JVs are common in international projects where there are significant risks or where undertaking
the project is not possible without a local partner. One of the challenges in JVs is maintaining
control of the project, as two or more parties have input and may have different motivations
for undertaking the project.
Collaborations
Collaborations are like JVs in that two or more parties contribute towards the achievement of a
project outcome. These parties can be different organisations, as well as business units within
the same organisation. However, they tend to be less formal or more fluid and flexible than JVs,
and do not always have a commercial motive. Instead, collaborative projects build a sense of
joint belonging and a culture of cooperation that integrates the diverse skills, knowledge and
expertise of people with no experience of working together—an example of this can be seen in
Example 4.4.
An example of project collaboration involved the Finnish Transport Agency (client organization) and
VR Track Ltd. (the main contractor for both design and construction work) partnering in a complex
railway project. The railway renovation project aimed to improve the safety, reduce maintenance costs
by renewing and repairing structures, and reinforce surface and bench structures. The main goals of
the project were rail track usability, undisturbed railway traffic, scheduling, traffic and occupational
safety, cost efficiency, and planning and construction quality. The total budget of the project was
106.4 million Euro.
This project identified six key activities supporting the formation of collaborative project identity:
(1) articulating a joint vision for collaborative project identity;
(2) converging on mutual conceptions of collaborative project alliance philosophy;
(3) attaining a shared collaborative mentality;
(4) designing ways of working with multiple identities;
(5) attaining distinctiveness and
(6) legitimizing activities.
Source: Hietajärvi, A. & Aaltonen, K. 2018, ‘The formation of a collaborative project identity in an
infrastructure alliance project’, Construction Management and Economics, vol. 36, no. 1, 121.
Study guide | 273
A good example of this type of PPP is the Peter MacCallum Victorian Comprehensive Cancer Centre
(VCCC) in Melbourne, Australia, with information available at: https://www.petermac.org/about/
partnerships/vccc-partners.
Virtual projects
Virtual projects are when project team members are located in different places and the dominant
method of communication and operations is via communications technology. A good example
of this is software development, where programmers may be based in Bangalore, India, and work
on projects for US, European or Asian-based organisations (Lewis 2008). The great advantage
of this kind of project approach is that expertise can be employed from the best source and
project team members can work independently. One other advantage of virtual teams is that,
if it suits the project, there may be significant cost savings in not having to relocate project
team members.
➤➤Question 4.3
Is ‘collaboration’ a type of ‘project organisation’ or a ‘within organisation’ project activity? Explain
your answer.
Explanation
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Project organisation
Within organisation
Check your work against the suggested answer at the end of the module.
International projects
An international project is one that is based in a different country (or at times, multiple countries)
to the ‘home’ country of the organisation. As such, the environment of the project is more
complex. Figure 4.5 highlights a number of factors that make an international project different
from a locally based project.
274 | PROJECT MANAGEMENT
International
projects
So how can a project manager, or you as the management accountant, deal with this kind
of complexity? Ensure that:
• You have selected appropriate project team members (see Part B).
• All the stakeholders collaborate and that each stakeholder is satisfied (see Part C).
• Resources are appropriately allocated to the project (see Part D).
• Systems are set up that enable constant monitoring of the project (see Parts C, D, and E).
• The lessons learnt and knowledge is captured as the project is progressing, rather than
waiting until the end when it is all over (see Part F).
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A final consideration is to be culturally sensitive or have ‘cultural fluency’ (Turner 2003, p. 153).
This is an understanding of how people do business in other parts of the world. To gain cultural
fluency, project team members involved in international projects need cultural training and
development. This includes three things:
• Strategic cultural fluency—this is an understanding of the strategic relationships across
cultures, how business is structured, cultural behaviour at a senior level and how this forms
a context for projects.
• Workgroup cultural fluency—work teams that are either formed within a different culture
or contain multi-cultures have their own issues and processes that project managers need
to understand.
• Personal cultural fluency—individuals have their own social etiquette, language, skills and
knowledge. Good project managers understand this and operate within these parameters.
A lack of cultural fluency can mean that while a project may be technically excellent, it may fail
due to a lack of understanding of the cultural context that it operates in and how this translates
into practice.
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276 | PROJECT MANAGEMENT
Project sponsor
The project sponsor is a senior executive who should ensure the project’s business case is
realised and its goals are met. This means that the sponsor (also referred to as the project owner)
represents the project funder (or business partner) during the project (Zwikael & Meredith 2018).
Working closely with the project manager, the sponsor provides guidance to the project team
in the following three ways:
1. During the project selection stage, the project sponsor establishes the objectives for the
project and its priority, assesses the political environment of the organisation and establishes
the make-up of the project team.
2. The project sponsor will also have the responsibility of managing the high-level internal
or external stakeholder relationships. A project sponsor may be a key advocate for these
stakeholders. If a project has an outside customer as one of the stakeholders, the project
sponsor may be the key intermediary for negotiating the contract and ensuring continuing
communication over the life of the project.
3. If the project encounters serious problems, the project sponsor may need to become
involved in discussions and actions to resolve the problems. Such problems might include
non-completion of the project deliverables according to specifications, budget or schedule.
Sometimes, senior executives will sponsor several projects in addition to their regular
responsibilities.
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One of the most difficult issues in project sponsorship is the extent to which the project sponsor
should be involved in the project. It is important to ensure that the project manager and project
team are empowered to make relevant decisions and that there is no loss of authority through
the involvement of the project sponsor. A balance has to be struck between open and visible
support, and micro-managing the project. For example, a project sponsor may provide access
to resources and maintain a focus on the project meeting its cost, quality and time targets,
but they will not interfere in the operational activities of how the targets are being met or the
way resources are deployed—they leave that to the project manager and project team.
Project manager
A project manager has functional responsibility for the project and has to perform a range of
roles. Project managers need to be sufficiently senior so that they can coordinate the activities
and resources required to complete the project. Figure 4.6 outlines the duties and challenges for
project managers.
Study guide | 277
Project manager
Duties Challenges
Monitor Uncertainty
Specifications, scope, Organisations usually prefer
budget and cost certainty, but the unique
nature of projects makes
this difficult
Take responsibility
Meeting targets and Authority
deliverables for the project Project managers have full
on an ongoing basis and responsibility for delivering
the final deliverables the project but they are
often not given enough
authority or political support
to command the
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Manage necessary resources
Deal with problems
as they arise
Example 4.5 highlights some of the challenges that can arise for project managers. Part 2 of this
example is explored in Example 4.13.
Example 4.5: A
n IT project in a service-based organisation—
Part 1
A service-based organisation undertook an IT project with the aim of making the performance of
4000 front-line employees transparent through an automated performance measurement system.
The project was not allocated enough resources for consultation on performance measures with the
users of the system, or to train employees adequately in the use of the new system. Furthermore,
technical design faults meant that the data in the system was not always accurate. This resulted in
compensation inaccuracies for the affected staff. The redesign processes implemented to fix the
inherent design problems meant that the project deliverable date was constantly moved back and the
project went considerably over budget. Still, the project manager and his team were evaluated on the
original project time and cost, and the satisfaction of the users of the system. An impossible situation!
As shown in Table 4.1, project managers need to possess a range of technical and
interpersonal skills.
278 | PROJECT MANAGEMENT
Project manager
Process Communication
• Possess project management skills (e.g. critical • Provide the necessary knowledge and
path analysis, risk analysis and management, information to people involved in the project
and capital budgeting). in a clear manner.
• Listen to others.
Negotiation
• Negotiate for extra resources and other
support in order to deliver the project.
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Conflict resolution
• Resolve conflicts in areas such as expectations,
level of resources, costs, time, responsibilities
and personality clashes.
Leadership
• Possess a capacity for leadership for the tasks
and challenges that project managers need
to deal with.
Under some circumstances, it could be the management accountant who takes on a leadership
role within a project. While leadership is something the project sponsor and the project manager
should display, leadership is not their sole domain. All members of a project team, including the
management accountant, will have some form of leadership responsibility. The management
accountant may be the project manager or a member of the team; in either case, the need for
leadership is there, but the way it is demonstrated may be different. A project manager is the
person with the title and the responsibility to deliver the project. However, a leader is someone
who is able to inspire and motivate team members to get the job done. There is a significant
difference between the two and it is important to recognise this. Manager is a formal title and,
while they may have authority, they may not be able to succeed if they cannot get the project
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team to deliver. A leader is someone who can inspire people to deliver, although they may not
have the formal authority.
Pinto (2010) outlines four key ways that a project manager exercises leadership.
• Acquiring project resources—these are the staff, materials and other support required
to meet the project requirements. Often, the main reason for project failure is inadequate
resources.
• Motivating and building teams—a project manager has to take a diverse group and form
them into a working team in a short period of time. They then have to ensure that the team
delivers in the face of considerable challenges and competing organisational pressures.
• Having a vision and solving problems—a project manager needs to be able to articulate
the vision of the project clearly, maintain focus on this and, at the same time, deal with the
inevitable crises that occur.
• Communicating—this can be formal or informal and needs to be from the project manager
to the team, as well as within the team itself.
Each of these leadership roles can also apply to the management accountant. Consequently,
many of the characteristics of a good project manager are also the characteristics of a
good management accountant. This includes the previously discussed mix of technical and
interpersonal skills. The discussion of the stages of project management (selection, planning,
implementation, and review) later in this module highlights the many ways management
accountants will display leadership in each of these stages.
280 | PROJECT MANAGEMENT
A task-force approach is when a team is set up specifically for the project and is dedicated to
it (as shown in Figure 4.7). The project manager has total authority and responsibility for the
members of the team. A matrix approach (as shown in Figure 4.8), on the other hand, occurs
when project team members continue to work in their functional areas (in their day-to-day jobs)
while also working on the project. This may mean time is spent on operational tasks as well as
on the project, or all the team members’ time may be spent on the project, while their position
remains situated in a functional department and under the authority of the department manager.
Table 4.2 then outlines the advantages and disadvantages of each approach.
Executive
management
Procurement
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Engineers
Operations
Finance and
accounting
Executive
management
Advantages Disadvantages
Task-force project team Team members focus solely on Unless the project is of sufficient
completing the project. size, team members may not be
consistently busy.
Team members operate
autonomously. Unlike in a matrix team, if team
members are unavailable, it may be
Team members have their own more difficult to cover absences.
resources.
Some team members might resist
Team members get to work in working in a cross-functional team
cross-functional teams, potentially as compared to working in their own
making their job more interesting departments.
and enabling them to gain additional
experience outside their primary As functions (like that of the
discipline or area of expertise. management accountant) change,
a lack of day-to-day involvement may
reduce team members’ exposure to
the latest thinking.
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can involve a job move, especially for
long-term projects.
A range of specialist skills can be The project manager may not have
tapped into, providing the project sufficient authority to ensure that staff
manager with expertise and flexibility. do what is required for the project
when competing priorities surface for
During project downtimes, staff team members.
can be used on other tasks in
their department. Team members may have multiple
supervisors (e.g. functional and
direct), exposing them to political
pressures and lack of accountability.
One of the key difficulties encountered in putting together project teams is that functional
managers in organisations may not be keen to supply staff for a project. Project teams may not
get staff who have the requisite skills, but may be supplied with whoever is available or may
be provided with an individual who is less in demand due to skill deficiencies or behavioural
problems. The simple fact is that everybody wants to work with the best people, so getting the
best people on to the project team is going to be difficult.
282 | PROJECT MANAGEMENT
The make-up of the team depends on the functional areas available and what the project
demands. A more carefully constructed project specification and definition will make it easier
to identify the personnel needed on the project team.
➤➤Question 4.4
Reflect on a project that you might be familiar with in your organisation. What is your understanding
of the three main roles? Explain what each of these roles entails.
Explanation
Project sponsor
Project manager
Project team
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Check your work against the suggested answer at the end of the module.
Lientz and Rea (2003) outline a number of ways that international project teams are different from
the standard project team:
• Collaboration—the need for collaboration between individuals and on tasks is greater due
to the dispersed nature of these projects.
• Parallelism—tasks in the project may be done in parallel in multiple locations.
• Changing requirements—the turnover of staff is greater, as the variation in skills tends to be
greater over the life of the project. This is often compounded by greater variation in project
direction.
• Semi-autonomous work—many parts of the project may be beyond the direct supervision
of managers, making the supervision of staff and tasks difficult.
Study guide | 283
When you consider these characteristics of international project teams and international projects
(discussed earlier), it should be clear that a number of issues are likely to be faced by each
member of the team as well as the project manager. The question is: what are the desirable
individual characteristics that will help ensure international project teams successfully deliver
on projects?
Lientz and Rea (2003) discuss this question as shown in Table 4.3.
Table 4.3: T
he unique context of international projects and international
project teams
Characteristic Explanation
Similar project experience The more experience an individual has with similar projects (in terms
of the specific technical nature of the project), the better.
Ability to work with other people As collaboration is even more important on international projects,
team members need to know how to work with other team members.
Ability to solve problems Problem-solving is a critical skill for international project work,
especially where different legal and social frameworks need to
be navigated.
Awareness of potential problems Team members need to have the ability to anticipate problems so
as to reduce their impact.
Ability to work with competing International projects often require staff to be able to juggle multiple
demands and conflicting tasks.
Communication skills The ability to communicate with internal and external stakeholders
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is vital for international projects.
Ambition and energy International projects are demanding, so team members need to
have lots of energy and ambition; otherwise, they will not have the
drive to achieve the project goals.
Knowledge of the organisation’s When projects are within an organisation, team members need to
business processes have an understanding of the organisation’s business processes.
Knowledge of the methods and The more the team members know about project software and other
tools used on the project tools and techniques (such as PERT [program evaluation and review
technique]), the more they will be able to devote their energy and
intellect to the more substantive issues.
Ability to understand different This refers to both the organisation/team culture and the region/
cultures country culture in which the project exists. Team members need to
be tolerant and sensitive to cultural differences.
Willingness to travel for extended Team members may have to live overseas for extended periods of
time periods time or travel on a regular basis. They need to have the practical
circumstances and an almost uncompromising willingness to do it.
Source: Lientz, B. P. & Rea, P. R. 2003, International Project Management, Academic Press, Amsterdam.
284 | PROJECT MANAGEMENT
Project sponsor Clarifying project objectives is even more important—due to the more
complex political environment and the increased complexity of coordinating
resources.
Project manager The task of defining the project budget and managing teams that collaborate
over multiple locations and often operate in a semi-autonomous work
environment is more difficult.
The need to communicate well, often with people from other cultures, makes
this role particularly challenging.
The need to be more proactive and see potential problems before they
arise is much greater—because the effects of project problems are so
much greater.
Management accountants The collection and presentation of timely information is more difficult.
Information may need to be collected in multiple locations and the
management accountant may need to rely on other project team members
to collect data—so their powers of persuasion may need to be well honed.
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What makes building trust harder in virtual teams is the lack of being in the same room and
working alongside other team members where you would normally have the chance to pick
up more cues (other than just verbal cues) to establish whether someone has the goodwill or
competence to fulfil their obligations. One way to overcome this is to make sure that project
team members have enough demonstrated experience so that the risk of competence failure is
reduced. Ensuring that delivery dates are clearly understood and adhered to also helps establish
goodwill and trust.
Another issue for virtual teams is defining roles and responsibilities. Morris and Pinto (2007)
explain that one way to overcome this is to get team members to commit to the tasks that they
feel most skilled to do, rather than assigning tasks without consultation. A danger with this
approach is that it is unlikely that anyone will volunteer for the difficult tasks. Clearly, careful
management of the process is required.
Pinto (2010) has some other suggestions for helping virtual project teams to work:
• face-to-face communication whenever possible
• maintain constant communication and do not let team members ‘disappear’ for an
extended period
• create communication protocols or codes of conduct about what kind of information
needs to be shared and what kind of contact is expected, for how long, and how often
• keep all team members informed about what is happening with the project
• decide on a protocol for how interpersonal conflict is to be resolved.
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One way that virtual project teams are better enabled is through document- management
websites (e.g. Google Docs), voice or video telecommunications (e.g. Join Me) and coordination
software (e.g. Webex or Gotomeeting).
To summarise, this section has considered the characteristics of a project, the stages in project
management, project management roles and the nature of project management teams,
including international projects and virtual projects. The next section considers the specific
role of the management accountant in project management, taking into account the four stages
of project management:
1. project selection
2. project planning
3. project implementation and control
4. project completion and review.
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These tasks are complex and there are a number of useful analytical techniques that the
management accountant can use. Typically, the outcomes of these key tasks are combined to
form the project proposal or business case.
When preparing a business case for a project, it is important to ensure that the key assumptions
used to prepare the quantitative data are provided so that decision-makers gain a better
understanding of the project. It is also important to provide a discussion of the advantages and
disadvantages of a particular option, as well as supplementary information (e.g. qualitative,
non-financial information) so that a complete business case can be presented. The next section
reviews in more detail the purpose and content of a project’s business case.
In many organisations, it is the project manager who is responsible for compiling the business
case. In large organisations, the management accountant is usually part of a team that develops
a project’s business case. Consequently, unless the management accountant has been delegated
responsibility for the overall preparation of the case, they will typically only have input into part of
the process (often the financial analysis). In this setting, some of the other skills discussed earlier,
such as being able to work in teams, become particularly important. In smaller organisations,
the management accountant will often be responsible for putting together the whole business
case. In this instance, not only will the management accountant need the technical competence
and written communication skills to prepare each section of the business case, but they will also
need additional soft skills, such as relationship management, negotiation and persuasion, to work
with the executive decision-making team.
Example 4.6 highlights the content that is usually included in a business case. The role of the
team involved in preparing the business case is to translate this analysis into an understandable
format to enable decision-makers to act.
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Background and problem This section contains the reason or problem that has triggered the
need for a project. In most cases, there is some kind of opportunity
or a problem to fix. It is important that there is a clear understanding
of the issue to be addressed. Failure to have this understanding
may lead to a decision to commence a project that addresses the
wrong problem.
Strategic fit This section outlines the extent to which the project fits into the
organisation’s strategy. It is important to understand that the business
case is not the organisation’s strategy but is there to support or
deliver a component of the strategy.
Objective This section states clearly what the objectives of the project are
and what ‘success’ looks like in a tangible or measurable way.
The objectives of the project will reflect the strategy.
Selected project This section provides detailed analysis of the selected option
and will contain:
• risk assessment
• financial analysis
• benefits analysis
• cost–benefit analysis
• project planning
• project budget
• project monitoring and performance measurement
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• project completion and review process.
The next section discusses in more detail what needs to be considered in each of the key areas
of analysis.
Strategic fit
The first project selection criterion is the strategic fit between the proposed project and the
organisation’s objectives and strategy. Projects need to support organisational strategy and help
an organisation achieve its overall objectives. When an organisation has an operating model
based around projects (e.g. a company that builds infrastructure projects, such as Leighton
Holdings, discussed in Part A), then the strategy of the company is implemented through
projects. Clearly, a fit between the project and the company strategy is a central issue. When a
project is intended to support an organisation’s operating model, such as a research and
development project to improve or introduce a new product (e.g. the Apple Watch example
in Part A), then this project must fit within the strategy of the organisation. When a project does
not have its origins directly from an organisation’s strategic planning, a strategic fit assessment
can be conducted by reviewing strategy documents or assessing how the project supports the
initiatives presented in a strategy map.
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Zwikael et al. (2018) claim that project goals should be aligned with the organisation’s current
strategy as well as its long-term vision. Strategic fit means that projects should be explicitly
linked to the strategy. The role of the sponsor/project owner is therefore crucial to support
this important link with strategy. Loch & Kavadias (2011) further suggest to clarify the business
strategy by addressing five questions:
1. What product (or service) does the organisation offer?
2. Who are the organisation’s customers?
3. How does the organisation deliver its product or service?
4. Why do customers buy from this organisation rather than from somewhere else?
5. What will happen if the environment changes?
The answers to these questions are then used to inform the project strategy, where a clear
understanding of what the project delivers against the business strategy is developed. This
includes what target products or technology the projects will deliver and what it will contribute to
the organisation. The business strategy will provide the financial boundary for the project and a
direction for what is to be delivered, and the project strategy will provide the kind of constraints
and opportunities to be delivered back to the organisation strategy (Loch & Kavadias 2011).
Example 4.7 provides a practical example of assessing the strategic fit for projects.
enterprise resource planning (ERP) system. The e-business site fitted directly into the organisational
strategy of increasing profitability from the resource sector through creating a transparent market.
The ERP investment, on the other hand, did not result in cost savings and did not provide an advantage
over the previous IT system.
In evaluating the strategic fit of these projects, the key questions to ask are:
• What is the likely long-term impact of this project on key measures used to evaluate business
success (and presented in the strategy map, if one exists)?
• Is this project in line with the objectives and actions listed in the organisation’s strategy document?
• Does this project address an emerging or existing risk, and/or a new opportunity?
Further analysis
E-business site
The underlying problem for the company was that it was one of only a few companies that sold a
particular resource for which there were numerous customers. It had a sense that it was selling the
resource too cheaply. Due to the market structure, the resource was not traded regularly on commodity
markets, so there was very little external information on the market price to enable comparisons.
To remedy this, the company set up an e-business site that enabled it to release certain amounts of
the resource at a chosen price to establish how quickly it sold.
This information then enabled the company to understand what the actual market price was and
thereby increase its revenue and profit.
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1. What is the likely long-term impact of this project on key measures used to evaluate business
success (and presented in the strategy map, if one exists)?
Like most profit-oriented companies, it had a specific level of profitability as a key project objective.
This project had a clear impact on profitability through more effective revenue management
from better market pricing. This had longer-term effects as the company previously had very
little capacity to gain market intelligence on price, and the project enabled it to create a more
transparent market in the long term.
2. Is this project in line with the objectives and actions listed in the organisation’s strategy
document?
Yes. The company had objectives centred on ensuring it was in the lowest quartile in terms of cost
structures and maximising revenue streams in highly competitive commodity markets.
3. Does this project address an emerging or existing risk, and/or a new opportunity?
Yes. While the key risk was that the company was not able to obtain appropriate revenue streams
due to underpricing, it was also able to create a more transparent market, which opened up better
opportunities for supplying new customers and servicing its current market more effectively.
1. What is the likely long-term impact of this project on key measures used to evaluate business
success (and presented in the strategy map, if one exists)?
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The ERP system investment had a negative effect on profitability because depreciation on the
assets base increased; the debt capital required to fund the asset increased the company’s interest
expense; and the operating costs over the life cycle of the systems were increased.
2. Is this project in line with the objectives and actions listed in the organisation’s strategy
document?
No, the company had no strategy in relation to improvements in information provision and more
seamless information integration. One of the objectives of an ERP system investment is to improve
information flow and reduce human input into data entry and other data processing and conversion
processes. As explained earlier, senior IT executives in the company were of the opinion that this
could be achieved at a fraction of the cost with alternative IT systems.
3. Does this project address an emerging or existing risk, and/or a new opportunity?
One of the risks the company faced at the time was the increasing use of particular types of ERP
systems, which could have made it harder for buyer/supplier relationships to be managed, but this
was considered to have a low probability for the company at the time. There were no new market
opportunities to be created and very few cost-saving opportunities.
The discussion in Module 1 about strategic analysis (e.g. SWOT) is clearly linked to these
three questions.
So, while a project may present a financially viable opportunity with minimal risk, it may not be
in line with the current organisational strategy. In the absence of a strategic fit, the decision to
proceed with the project should acknowledge this. Such opportunistic project selection should
at least be a conscious choice.
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➤➤Question 4.5
Please now read Parts A and B of Appendix 4.1 on the Sydney Seafood Bar.
Check your work against the suggested answer at the end of the module.
Note: The concepts covered in this appendix (not the specific details of the case) are examinable.
Stakeholders are key individuals, groups or functions that have a stake or interest in the project.
They can be categorised as internal and external. Within these two categories, Pinto (2010) and
Zwikael and Meredith (2018) identify a number of different types of stakeholders. These are
outlined in Table 4.5.
Internal Top management Senior executives who approve the project (e.g. the CEO
or a company’s board) are also called the ‘project funder’.
Because of their seniority in the organisation, they have
control over the project and typically make the final
decision on:
• whether a project is approved
• the level of resources that are devoted to it
• whether more funding can be injected during the project
• whether, if required, it is terminated early.
Finance and accounting Typically focused on whether a project is within its budget
and is using resources efficiently.
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Project management office A functional unit that supports all project managers within
this business unit in conducting their projects. This support
is usually administrative and methodological (e.g. the use
of project management methodologies, templates and
software packages).
Project team members Have an interest in the success of the project, but may still
have loyalty to their functional area.
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organisation).
End users The client entity requires the deliverables (output) from the
project to be used by its employees or customers—who are
often called ‘end users’.
Community and society Projects can have a large effect (both positive and negative)
on communities. For example, the regular customers of
the company, as well as non-customers, may be impacted
by the project (e.g. because of the cannibalisation of an
existing product).
Stakeholders will have different interests and these may be incompatible. One of the challenges
for project managers is to communicate with these multiple stakeholder groups and attempt to
satisfy their needs.
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For example, if you worked for a property development company, you may have banks or
shareholders who have provided financial resources and who want an adequate return. Part of
this return would be to fast track the construction by working weekends and later in the day so
that the construction can be completed earlier and start generating positive cash flows. At the
same time, the community surrounding the construction site may not want the excessive noise at
night and on weekends. This balancing issue will be addressed in more detail later in this section.
When management accountants complete stakeholder identification and assessment, they need
to think critically about what the interests of the stakeholders are and what kinds of data and
KPIs could be accurately captured and tracked over time to ensure that stakeholder satisfaction
is maintained. An interesting research study on using a balanced scorecard (BSC) for signalling
information to stakeholders was conducted by Sundin et al. (2010) where they looked at how
multiple and competing stakeholder objectives can be reflected in a BSC. One key finding is that
managers have to understand who their stakeholders are, what their interests are, and how these
can be reflected in the design of performance indicators. This is to enable tracking of the extent
to which they deliver stakeholders’ requirements.
A further insight on this issue that is very useful for management accountants is provided
by Malmi and Brown (2008). They make a distinction between information for decision-
making versus information for control. Some management systems can be used for control of
behaviour—such as a project manager’s need for performance indicators on cost, quality or time
to ensure the project is delivered as specified. There are also management systems used by
decision-makers, which are not directly related to the behaviour of organisational staff—such as
a client who may have technical specification requirements, which are reflected in performance
indicators so they can make the decision as to whether the project fits their requirements.
➤➤Question 4.6
Assume that the organisation that you work for, or one that you are familiar with, has won a
tender for a project to construct a new shopping centre in a suburban area. List five key external
stakeholders and identify the stages of the project when their interests are going to be important
to the project.
1.
2.
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3.
4.
5.
Check your work against the suggested answer at the end of the module.
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Project sponsors and managers have a critical role to play in the development of ethical practices
in projects. Part of their role is to overcome these two key issues. First, they have to ensure that
an ethical framework or set of practices is developed that is aligned with the overall organisation.
Second, they have to ensure that the long-term effects of decisions are taken into account in
addition to the short-term focus. Some responsibilities are important and will help to ensure
better outcomes for project stakeholders.
To evaluate whether a project decision is ethical or not, as well as how it will affect project
stakeholders, the modified version of the American Accounting Association (AAA) ethical
decision-making model that is described in the Ethics and Governance subject of the
CPA Program can be used. Some additional questions that can be asked are provided by
Drellinger (cited in Turner 2003, p. 170).
1. Which goals or priorities does this solution support or work against?
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2. Does the solution reflect the values of the organisation and the decision-makers?
3. What are the consequences (in terms of benefit or harm) and ramifications (effect of time
and outside influences) for each of the stakeholders?
4. What qualms would the decision-maker have about the disclosure of a favourable decision
to this solution to the CEO, board of directors, family, the public?
5. What is the positive or negative symbolic potential of this solution if understood—or
misunderstood—by others? Will it contribute to building and maintaining an ethical
environment?
While some of these questions relate to a normative (what ought to be) approach to ethics,
there are also real utilitarian aspects (the value is related to the benefits gained or reduction in
loss) as well.
Point 4 focuses on the disclosure of decisions to others—this has an effect on the reputation of
a project or company, based on the decisions made. For example, if a decision is made that is
not seen as ethical by the public, the reputation of the organisation or project can be damaged
regardless of whether the decision is normatively right or not. A good example of this is the
discussion around the company James Hardie and some of its decisions relating to asbestos
compensation, corporate restructuring and location. Regardless of whether these decisions
were legal or normatively acceptable from a maximising shareholder wealth perspective,
the company’s public reputation was damaged by the disclosure of these choices.
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Ethics is discussed in more detail in the Ethics and Governance subject of the CPA Program.
Risk assessment
Project risk assessment is an integral part of project selection and involves risk identification,
classification, prevention and monitoring. At the project selection stage, major sources of risk
are identified, evaluated, classified and risk mitigation actions proposed. Typical sources of
risk include:
• the time to complete the project
• the availability of key resources and personnel, and the cost of these resources
• the existence of, and solution to, technological problems
• macro-economic variables such as finance costs, inflation and foreign currency risk
• for project organisations, project variations required by the client and client solvency
• that the project will not achieve its deliverables.
Based on identified risks, a decision regarding the acceptable level of risk is made. The cost
of removing excess risk needs to be calculated and incorporated into project cost estimates.
Typical risk mitigation strategies involve contractually assigning the risk of currency movements,
financing costs or resource costs to the client. This is common (and politically controversial) in
government infrastructure projects where, because of the large size of projects, governments
assume many of the risks more commonly borne by private organisations. Management
accountants can help in identifying and quantifying risks, and in finding the most economical
way of mitigating or transferring risks.
Eden, Ackermann and Williams (2005) analysed several large projects that experienced massive
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cost overruns. The authors attribute these large overruns to interdependencies and conclude that
‘costs combine together in non-linear ways, and accelerating projects can set up vicious cycles
that increase costs many more times than expected’.
Risk identification
There are a number of ways to identify project risk. Organisations undertaking projects regularly
develop checklists to help with risk identification. One approach centres on the questions
outlined in Table 4.6.
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What? • What is the desired outcome of the project, and will it work (e.g. technical
functionality)?
• What skills will be required?
How? • How do we ensure that the required actions are completed and required resources
are available?
Where? • Where is the project located, or where will the project have an impact?
• The purpose here is to identify the risk associated with project location
(e.g. environmental, political).
When? • When will the project take place, and what is the schedule?
• What are the main threats to timelines?
• What is the impact of missing the deadlines?
Risk classification
Risk identification is followed by classification. The purpose of classification is to assist in deciding
whether a project should be abandoned because it is too risky, or in identifying specific risks that
need to be reduced or transferred before starting a viable project. As illustrated in Figure 4.9,
probability and financial impact are assessed as high or low for each risk, and risks are assessed
on this basis.
Risks that are highly probable and that have a high financial impact if realised are critical and
should be considered first. Next in importance are those risks with a low probability of occurrence,
but high financial impact. The viability of reducing these risks, including any associated costs,
will assist in deciding whether the proposed project is worth pursuing, and what the expected
outcomes should be to compensate the organisation for the risks taken.
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Consider Consider
Low
last second
Probability
Consider Consider
High
third first
Assume you undertake risk assessment for this company and you have four projects to complete.
These are:
1. a new gas line to an area that has to pass through a relatively geologically unstable parcel of land
2. cabling for telecommunications through the same parcel of land
3. cabling for telecommunications in a newly developed area
4. installing high-voltage underground electricity cables through a local area in an already
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existing path.
The next thing is to assess each of the projects and identify both the probability and financial impact,
and then multiply the probability by the impact. This approach is outlined for the four projects as follows:
Project 1 has a high level of probability of failure, as the land is unstable and has been assessed at
seven. The financial impact is also high, which may be judged at eight. This will result in a rating of 56.
Project 2 has a high probability of failure, as the cabling is through the same parcel of unstable land
and so has been assessed at seven. But it has a low financial impact so it may be assessed at two.
The result is a rating of 14.
Project 3 has a low probability of failure, as the cabling is in a newly developed area (a rating of two).
It also has a low financial impact, being cabling for telecommunications (a rating of two). This will
result in a rating of four.
Project 4 has a low probability of failure, as the underground electricity cabling is through a local
area in an already existing path (a rating of three). It has a high financial impact because it relates to
high-voltage electricity cables (a rating of seven). This will result in a rating of 21.
From this analysis, you can start to rank the projects and focus on more intensive risk management
for the higher risk projects.
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The identification and classification of risks facilitates project selection decisions. Project
managers need to make sure that the same risks are not accounted for more than once—for
example, when engineers revise their cost estimates to adjust for risk and, at the same time,
accountants compensate for the same risk by raising the project’s required rate of return (RRR).
A management accountant can assist project managers by designing systematic approaches
to managing project risk that ensure that the risk is accounted for just once, such as identifying
cost reserves for risks in the project budget.
Risk mitigation
Whereas most organisations identify and classify project risks on a regular basis, not all provide
effective solutions to mitigate those risks that have been found to be critical. Using the risk
classification matrix (Figure 4.9) for these risks needs to be considered first, then effective
solutions can be identified to reduce the probability of those risks emerging and their financial
impact if they occur.
The project manager can prepare the risk mitigation plan in consultation with the management
accountant. Furthermore, the execution and monitoring of the plan will need to involve various
staff, including the management accountant.
For example, a risk that ‘a key project team member resigns from the company during the
project’ has high probability of happening and, if it occurs, will impact the project’s completion
and potentially delay it by a significant time, causing major dissatisfaction to a strategic client
of the company. A mitigation plan might include a few potential solutions to choose from:
1. sign a long-term contract with the key team member
2. offer the key team member a project completion bonus
3. have a deputy trained and ready to step in if required.
A risk mitigation program results in changes to the probability and/or impact of the risk—but it
also usually requires additional cost.
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A key tool for risk mitigation is the risk register, which is used to document the results of analysis
and outline the mitigation program being proposed for each risk. The risk register first appears
in the business case and again later in the project plan. It is then updated regularly throughout
project implementation. The risk register usually takes the form of a table. Table 4.7 shows a
register entry for one risk.
Risk number R1
Risk title A key project team member resigns the company during the project
Description David Smiths leaves the company over the next three months to move with
his family interstate
Probability High
It is important to note that risk assessment is different from risk management. As discussed,
risk assessment is done before the project starts. Risk management, on the other hand, is done
during the project. It is the ongoing process of monitoring and managing the risks of the
project—this is discussed in more detail in Part E.
Analysing profitability does not complete the management accountant’s financial analysis.
There also need to be sufficient funds available to finance a project. Management accountants
may assist in project finance analysis, although in large organisations there is usually a separate
project finance function. Project finance is beyond the scope of this module, but for the majority
of projects, project financing is no different from the financing of other organisational activities.
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recognise that the money invested in a project has an opportunity cost—the return forgone
from alternative investments.
The NPV method compares the present value (PV) of all project cash inflows and outflows
with the initial investment required. Note that for large projects, the investment may span
several years.
All project cash flows are discounted using an RRR or discount rate. Often, the discount rate
used is the organisation’s cost of capital. The NPV is the sum of the PVs of all project cash
flows. An NPV above zero tells us the extent to which the project will yield returns above the
organisation’s RRR.
n
1
=
PVt =0 ∑ 1 + i t × CFt
t =1
Where:
i = discount rate
n = project life
CF = cash flow
t = year
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In determining the project’s NPV, a management accountant considers the following key variables:
• project costs
• forecast cash inflows and outflows
• estimated life of the project
• residual value
• discount rate.
Project costs
Project cost is also called the initial investment. Preliminary cost estimates are usually made when
alternative project proposals are prepared for consideration. Cost estimates may be revised as
project planning proceeds. Final cost estimates are completed only after schedules are agreed
to, and major contracts regarding the project are completed. Financial analysis of project costs
and budgets should be updated as more detailed and accurate information becomes available.
Large projects are usually broken down into sub-projects, then cost estimates are devised for
each sub-project. It is common practice to include a reserve amount to account for risks. This is
necessary if risk analysis has not been completed and/or the amount of reduction or transferral
of risk is uncertain. Reserves can be based on experience from similar projects. The percentage
used depends on the reliability of the cost estimates. Reserves do not account for changes in
project content or scope, because those are normally negotiated and priced separately.
Management accountants need to consider whether a project will require an increase in the
organisation’s working capital in addition to the funding of direct project costs. Where a project
is expected to increase productive capacity and increase sales volume, increases in inventories
and accounts receivable (AR) will require additional finance.
Sunk costs should not be included in the project’s profitability analysis. They are cash flows that
have already taken place, and so have no effect on future cash flows.
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When using DCF methods, finance costs are accounted for in the discount rate used. Therefore,
cash flows associated with financing the project (e.g. interest payments) are not separately
included in project cash flows.
Where revenues need to be estimated, management accountants can analyse market growth,
developments in market share, the actions of competitors and trends in price levels. Forecasting
is likely to be easier if the project aims to replace an organisation’s resources instead of
expanding them.
When a project involves delivery to a customer, cash inflows are contractually determined,
and so are more easily forecast. Sometimes contracts make allowance for inflation or currency
fluctuations, and so future cash flows, even if contractually determined, can vary depending on
economic circumstances.
Future cash flows most often have tax implications and it is important to include these tax
effects in any DCF analysis. Most revenues increase taxable income, while expenses decrease
it. Of particular note, depreciation and amortisation, like other accruals, are non-cash expenses,
so they do not appear in a DCF analysis. Depreciation and amortisation reduce taxable
income and in that way, they affect cash flows, so these components need to be included in
any NPV calculation.
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One of the challenges faced when a project is being implemented is the reconciliation of forecast
cash flows with the actual cash flows (see Example 4.9). While this is discussed in more detail later
in the module, the key issue to keep in mind is that the forecast cash flows are going to be based
on assumptions that may or may not translate into practice. For example, the expected timing
of the cash flow may be different, possibly caused by the rate of completion of the project being
slower than expected. A further consideration is that, like any financial reporting, the profit and
loss for a project budget will be different to the cash flow statement prepared for reporting
and monitoring purposes.
The annual depreciation charge would have been $2 000 000 with a tax saving of 30 per cent of this,
or $600 000 per year (0.3 × 8 000 000 / 4). The cash flows included in the project’s DCF analysis included
an immediate outflow of $8 000 000, and for Years 1–4, an inflow (a tax saving) of $600 000. Note that
depreciation had no cash flow effect except for the tax saving.
However, the actual cash flow for this project was different from the forecast because by the time the
project was implemented, the purchase cost of the machinery was $10 000 000 and the company tax
rate had been reduced to 25 per cent. This means that the tax saving was $625 000 (0.25 × 10 000 000
/ 4) per year as is illustrated in the following table.
Time period 0 1 2 3 4
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Inflow 625 000 625 000 625 000 625 000
Residual value
This is the value of the asset at the end of its useful life. It may be either negative or positive.
For example, a nuclear power plant project may have a long initial project development phase,
decades of power generation and positive cash flows, but a negative residual value at the end
due to decommissioning costs and long-term nuclear waste-management costs.
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For projects with long lives (greater than 15 years), residual value usually has little relevance due
to the time value of money. For example, the PV of a cash outflow of $1 000 000 in 15 years at
a discount rate of 10 per cent is approximately ($239 400); in 30 years it is ($57 300). In contrast,
for short-term projects, the residual value can have a significant effect on the project’s NPV.
Tax impacts relating to residual values are often important. When a capital asset is disposed of,
a capital gain or loss can result. Tax effects should be incorporated into any DCF analysis.
Discount rate
The selected discount rate has a profound effect on the NPV analysis. For example, consider
where a PV of $100.00 to be paid in one year’s time is $86.96 if the ROI is 15 per cent ($100 /
(1 + 0.15)). In other words, if you invested $86.96 at a 15 per cent ROI, you would have $100 in
one year’s time. If 5 per cent is used as the discount rate for the same future cash flow, the PV
is $95.24 ($100 / (1 + 0.05)). The higher the discount rate, the lower the PV of project cash
flows. As the discount rate has such a large impact on the PV of future cash flows, selecting an
appropriate discount rate is one of the most important steps for increasing NPV accuracy.
PV FV
So how are discount rates set? The first factor to consider in estimating a discount rate is the
organisation’s cost of capital. When organisations raise project funding from highly competitive
markets, estimating the cost of capital is relatively straightforward because prices are readily
observable. For example, if an organisation is going to finance a project using a bank loan,
the cost of capital is the interest rate and fees associated with the loan. If the project is funded
by an equity raising, then the shareholders’ expected returns from dividends and share price
growth can be taken as the project’s cost of capital.
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Another factor to consider in setting the discount rate is the opportunity cost of capital or the
return the organisation could get from some other project or investment of equal risk. If the
next best opportunity is forecast to generate a 15 per cent ROI over the same time frame at the
same level of risk, the opportunity cost of capital is 15 per cent. For example, if an organisation
chooses to invest in a low-risk project and the next best project is riskier than the one they
have chosen, this means that a risk premium needs to be deducted from the opportunity cost
of capital. The opposite is also true. This adjustment improves the validity of the discount rate
that is applied to the project being evaluated.
Many organisations use their weighted average cost of capital (WACC) to discount project cash
flows. The WACC is the cost of the organisation’s present capital structure—the capital for all of
the organisation’s existing assets. It is appropriate to use this discount rate, as long as the project
under consideration does not differ in its risk profile, or in any other economically significant way,
from the organisation’s existing projects. The calculation of the WACC is detailed below.
WACC = Rd × Wd + Re × We
Where:
Rd = after-tax cost of debt capital
D = market value of debt
E = market value of equity
Re = cost of equity capital
Wd = weighting of debt capital
We = weighting of equity capital
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For example, if a project is financed by 40 per cent debt with an (after-tax) interest rate of
7.5 per cent and the rest is financed using equity with an opportunity cost of 14 per cent,
the WACC would be 11.4 per cent (7.5% × 40% + 14% × 60%). Estimation of opportunity cost
and the risks associated with future cash flows is usually completed in consultation with each
relevant department, including marketing, operations and finance. Estimation of the WACC is
usually overseen by the finance department, with most organisations setting clear policies and
specifying the WACC (also termed a ‘hurdle rate’).
As mentioned earlier, some organisations use a discount rate that adds an allowance for project
risk to their WACC. High discount rates can severely reduce the PV of distant cash flows,
because generally the distant project cash flows are the revenues that the project creates.
This approach can therefore create a bias against long-term projects. It is preferable to identify
and manage each element of project risk than to use an arbitrarily high discount rate for
this purpose.
In hierarchical organisations, business units are sometimes required to use high discount rates
to ensure large enough returns to cover corporate overheads. In other words, projects returning
15 per cent at the business unit level will return less than 15 per cent at the corporate level
(due to the inclusion of corporate overheads).
WACC is also discussed in the Financial Risk Management subject of the CPA Program.
Example 4.10 shows how these concepts can be applied and how calculating the NPV for a
project can assist with project selection.
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Time period 0 1 2 3 4 5
Net cash flow –1 000 000 300 000 300 000 300 000 300 000 300 000
PV calculation –1 000 000 / 300 000 300 000 300 000 300 000 300 000
1.0000 / 1.1500 / 1.3225 / 1.5209 / 1.7490 / 2.0114
PV –1 000 000 260 870 226 843 197 252 171 527 149 150
The project has an NPV of $5642, being the PV of all future cash flows less the initial investment
($1 005 642 – $1 000 000). The positive NPV means that, based on forecast cash flows and the cost of
the investment, the organisation will recover its cost of capital plus the equivalent of $5642 invested
at the cost of capital. Would you accept such a project? It would depend on how confident you are in
the forecast net cash flows and whether you had a better project to invest in (your opportunity cost).
Given that the NPV is small in relation to the investment, strategic fit and risk factors are critical in
project selection or rejection. If this project is a good strategic fit and low risk, it should be selected;
otherwise, it should not.
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➤➤Question 4.7
Big Firm Pty Ltd is considering an IT project that will increase the efficiency of service staff.
The old system that it will be replacing has a book value of $100 000 and a present resale value
of $70 000. Data on the new system and the projected impact on service operations costs are:
Development cost $700 000
Implementation cost $400 000
Residual value $100 000
Reduction in labour cost per year $180 000
Increase in utility costs per year $10 000
Big Firm Pty Ltd has an RRR of 14 per cent and the economic life of the project is expected to
be 10 years.
(a) Complete the following table by showing the cash flows and calculating the NPV for the
project. Disregard taxes.
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Year 0 1 2 3 4 5 6 7 8 9 10
Discount factor
PV working
NPV ($)
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(b)
Why?
(c) The project manager who prepared this data called to say that there are several errors in
the cost calculations. The development cost is actually $760 000, and the reduction in labour
cost is $230 000.
Discount factor
Check your work against the suggested answer at the end of the module.
PV working
NPV ($)
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308 | PROJECT MANAGEMENT
If the project’s IRR is higher than the organisation’s RRR, this indicates a profitable project (i.e. the
NPV is positive). Alternatively, if the NPV is negative, the IRR will be lower than the organisation’s
RRR. IRR is similar to NPV in that they are both DCF methods that account for the time value
of money. They differ rather obviously, because NPV is measured in dollars, while the IRR is a
percentage measure. The NPV gives a sense of what a project will add to an organisation’s net
assets; the IRR makes it easy to compare different projects and indicates the effect of a project
on the organisation’s current ROI. A project with an IRR higher than the organisation’s ROI will
increase that ROI if adopted.
Note that without a financial calculator or spreadsheet, the calculation of IRR is typically done by
trial and error. It is important to understand the concept of IRR and be aware of how to estimate
the IRR using trial and error. For example, if a project has a 10 per cent discount rate and an NPV
of $100 000, the IRR will be higher than 10 per cent. The management accountant would continue
testing new discount rates (e.g. 12%, 14%, 16%) until they were able to obtain an NPV of zero
(and hence determine the IRR for the project).
➤➤Question 4.8
Assume that you are comparing two projects, only one of which can be undertaken. Your analysis
indicates that one project yields a higher NPV than the other, but the one with the lower NPV
has the higher IRR.
Given a discount rate of 10 per cent, the project NPVs and IRRs have been calculated as follows:
Project 1 Project 2
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$ $
PV of Year 1 cash flow (discount rate = 10%) 200 000 1 200 000
NPV calculation (100 000) + 200 000 (1 000 000) + 1 200 000
†
Calculated using spreadsheet software. You are not expected to recalculate this figure.
Study guide | 309
Why?
Check your work against the suggested answer at the end of the module.
Profitability index
The profitability index (PI) is the PV of all future expected cash flows divided by the initial cash
investment. When the PI is one, this indicates that the project NPV is zero. Values greater than
one indicate an acceptable project.
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Payback
Payback is a break-even concept. It is the time it takes a project or an investment to generate
a cash amount equal to the initial outlay. Alternatively, payback is the time taken for a project’s
cumulative cash flows to equal zero. For projects with regular cash flows, payback can be
calculated using the formula:
If project cash flows are irregular, it is necessary to add annual cash flows for Years 1, 2 and so on,
until they equal the original investment.
Payback does not account for the time value of money. To account for this, management
accountants can calculate the PV of yearly cash flows using an appropriate discount rate, and so
calculate a discounted payback period (DPP). Discounting cash flows leads to longer payback
times. The DPP is calculated as follows:
• identify the annual cash flows
• calculate the discount factor for each period
• apply each discount factor to the respective annual cash flow to calculate the PV of the
cash flow
• cumulatively sum all the DCFs, starting with Year 0, until the initial investment is fully repaid.
310 | PROJECT MANAGEMENT
The payback method will not indicate whether a project is profitable, because it only measures
how long the project takes to break even. It is a measure of project risk, not profitability.
Potential cash flows after the break-even point are not considered.
The payback method is normally recommended for analysis of small investments. Forecasting
cash flows in the near future is likely to be reasonably accurate, and therefore a short payback can
be considered a reliable measure of risk. This can be a trap for some organisations. To avoid risk,
organisations select short-term projects and avoid long-term projects. Such an approach may
allow competitors to implement major projects and achieve significant competitive advantage.
Return on investment
ROI is an accounting-based measure, as the ‘return’ referred to is profit. In the context of capital
budgeting, ROI is sometimes called the average accounting rate of return (AARR) or accounting
rate of return (ARR).
There are many variants of ROI, but the basic idea is simple.
Average yearly return on the project (profit) is divided by the capital invested. Some variants use
yearly operating profit, while others rely on yearly cash flows. Some variants use initial investment,
and others use average investment. Average investment may be calculated as the sum of initial
investment and residual value divided by two. To illustrate using the data in Question 4.7: the
initial investment is $1 030 000 and the residual is $100 000. The average investment is therefore:
Note that if there was no residual value, the average investment is $1 030 000 / 2 = $515 000.
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Because ROI does not account for the time value of money, it should only be used in conjunction
with DCF methods, especially for longer-term projects.
Residual income
RI is calculated by deducting a notional capital charge from an accounting return. The accounting
return used is most often net operating profit after tax (NOPAT). The capital charge is calculated
by multiplying either the project initial investment or the project average investment (as described
earlier) by the WACC. The best-known application of RI is EVA.
When applied to project evaluation, RI is determined for each year, the PV of each RI is calculated,
and the sum of RIs over the project’s life reveal how much value a project is expected to create.
So, in this sense, RI combines accounting measures with DCF techniques.
Example 4.11 outlines how these different financial analysis figures are calculated.
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Example 4.11: C
alculating the profitability index,
payback period, return on investment
and residual income
Using the data from Question 4.7†, the PI, payback period, ROI and RI will be calculated. Tax effects
are ignored and a WACC of 14 per cent is assumed.
Profitability index
PI = PV of cash flows / Initial cash investment
PI = PV / I
PI = $913 715 / $1 030 000
= 0.89
†
From the suggested answer to Question 4.7, the NPV is –$116 285 and the original investment (Year 0)
is $1 030 000. Therefore, the PV of the Years 1 to 10 cash flows is $1 030 000 – $116 285 = $913 715.
Payback period
Payback = Initial investment / Annual cash flow
= $1 030 000 / $170 000 per annum‡
= 6.06 years
‡
Exclude residual value
This is a measure of one aspect of project risk. It takes over six years to recover the initial investment.
However, payback tells us nothing about the profitability of the project, whether in real economic
terms or in accounting terms.
Note that because the project NPV is <0, if a discounted payback was calculated, the payback period
would be longer than the 10-year project life (i.e. payback would not be achieved).
Return on investment
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ROI = Profit (or annual cash flow)§ / Original investment
= $170 000 / $1 030 000
= 16.5%
§
Exclude residual value
ROI (like other percentage measures and ratios) is mainly useful for comparing projects of different
sizes. Also, ROI does not account for the time value of money. For long-term projects, ROI should
only be used in conjunction with DCF measures such as NPV.
Note: Other versions of ROI may also be used. For example, the average investment (($1 030 000 +
$100 000) / 2 = $565 000) could be used in the denominator.
Residual income
RI = Profit – Capital charge
= $170 000 – 14% ($1 030 000)
= $25 800
Note: Other versions of RI can be used. For example, the average investment of $565 000 could be
used in place of the initial investment amount of $1 030 000.
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The RI is an estimate of the annual impact on the organisation’s profit if the project proceeds,
but NPV is a more economically valid assessment of the increase in the organisation’s value
than RI.
Measure
PI 0.89
ROI 16.5%
RI $25 800
As can be seen in Table 4.8, payback only measures risk, and so it provides no financial measure
of the project. The DCF measures (NPV and PI) indicate that the project is unacceptable—
it destroys value. In contrast, the accounting-based measures (ROI and RI) show the project to
be acceptable. The difference in the outcomes is attributable to the deficiencies of accounting-
based measures.
1. Accounting profits include accruals such as depreciation that are not economic measures,
but are based on assumptions about limited asset lives, conservatism in accounting
estimates, and an inevitable decline in value.
2. The second issue is linked to the first. If accruals are unreliable or economically invalid,
then the asset values with which they are associated are equally so.
3. Asset values do not take inflation, or the decline in value of the currency, into account.
A property, plant and equipment account will typically include assets purchased over a
number of years when the currency had different purchasing power. Yet the value of the
account fails to take this into consideration, and the values of assets acquired at different
times are simply added together. The resulting balance is, to some extent, meaningless.
Asset accounts can be adjusted for inflationary effects, but this adjustment is seldom
considered by accountants.
The key message for accountants is that when carrying out financial analysis of projects, DCF
methods like NPV, IRR and PI are preferred to accounting-based measures such as ROI and RI.
This is because they focus on cash flows rather than accruals, and they distinguish between the
PV and the future value of these cash flows. The main use of accounting-based measures is to
estimate the effect of a project on the organisation’s financial reports.
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Sensitivity analysis is where changes in key project assumptions are evaluated against financial
returns, such as the effect of a 1 per cent increase in sales growth or cost increases.
Scenario analysis is where the effect of changing a group of assumptions is evaluated, and it
usually involves best versus worst-case scenarios. For example, in uncertain economic times, it is
prudent to evaluate a recession scenario, which may include lower consumer demand and lower
input prices from discounting. Such an analysis will change relevant parameters in the analysis
(e.g. consumer demand is 20% lower than in the original analysis) and analyse the impact of
such a change on the outcome. If there is no change in the decision being made following the
introduction of the change, we can say that the decision is ‘robust’ to the change in this specific
scenario, otherwise the decision is ‘sensitive’ to this particular scenario. An advantage of scenario
analysis is that key risks and contingencies can be planned for, which has the overall effect of
reducing the risk of the project through improved project planning. Worst-case scenario planning
also allows projects that have the potential to destabilise the whole organisation to be identified
and avoided.
➤➤Question 4.9
Ideally, the cost of capital used in financial evaluation should reflect the level of project risk,
with investors demanding higher returns for projects with greater risk. Hence, it is common
to conduct sensitivity analysis on differences in cost of capital. Now read Parts C and D of
Appendix 4.1 on the Sydney Seafood Bar.
(a) Do you think the project is financially viable if the managers have 10 years left on the lease
of the premises and if the shareholders want an 8 per cent return on their invested capital?
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(b) What if the shareholders want 10 per cent return on capital? Would that change the decision?
(c) What if the shareholders want 15 per cent return on capital? Would that change the decision?
Check your work against the suggested answer at the end of the module.
314 | PROJECT MANAGEMENT
NPVt =0
EACt =0 =
Annuity factor
Where:
NPV = the net present value of a project
Annuity factor = present value of $1 received annually for n years, where n is the project life.
1 − (1 + i )−n
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Annuity factort =0 =
i
Where:
i = discount rate†
n = project life
t = year
†
Sometimes referred to as ‘r’
Example 4.12 shows how EAC can be used to choose between projects.
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Example 4.12: A
n organisation with two mutually
exclusive projects
An organisation has two mutually exclusive projects of different life spans to choose between: Project A
and Project B. The discount rate for both projects is 10 per cent. The NPV has already been calculated.
Project A Project B
Initial investment ($620 000) ($1 100 000)
Net cash flows
Year 1 $540 000 $610 000
Year 2 $540 000 $610 000
Year 3 $610 000
NPV $317 190 $416 980
When comparing projects with the same lives, Project B would be selected. However, these two projects
are mutually exclusive and have different life spans, so the EAC needs to be calculated to determine
which project adds the most value.
1 − (1 + i ) − n
Annuity factort = 0 =
i
1 − (1 + 10% )−2
=
Annuity factor : Project At = 0 = 1.7355
10%
1 − (1 + 10% )−3
=
Annuity factor : Project Bt = 0 = 2.48685
10%
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NPVt = 0
EACt = 0 =
Annuity factor
317 190
=
EAC : Project At = 0 = 182 766
1.7355
416 980
=
EAC : Project Bt = 0 = 167 674
2.48685
Project A has the higher EAC, which means that it delivers more value per year than Project B. As the
capital from Project A will be returned by the end of Year 2, a new project can be started that also
has a high EAC. By using EAC, the management accountant can maximise shareholder returns by
continually recommending that the organisation invest in projects with a higher EAC.
Capital budgeting techniques—mutually exclusive projects with different lives—is covered in the
CPA Program subject Financial Risk Management.
316 | PROJECT MANAGEMENT
At the planning stage, the management accountant should assume a leading role in project
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budgeting and scheduling, and in considering a range of cost optimisation options. Many
scheduling techniques combine time and cost information, and hence project cost optimisation
must be tightly linked to schedules. Management accountants therefore need to be able to use
scheduling tools.
Monitoring and performance measures need to be designed at the project planning stage
to ensure proper monitoring is carried out and to make project team members aware of how
their performance will be evaluated. Often, the project contract will provide a framework for
monitoring and performance measurement systems.
Example 4.13: A
n IT project in a service-based organisation—
Part 2
This example continues on from Example 4.5 where the service-based organisation that undertook
an IT project aimed to make transparent the performance of 4000 front-line employees by using an
automated performance measurement system. Consider the problems faced by the company and then
how appropriate planning may have either overcome these problems or made them easier to manage.
This highlights the benefits of the tools and techniques in this section:
• The project was not allocated enough resources for consultation on performance measures with
the users of the system, or to train employees adequately in the use of the system when it was
implemented. Both these problems reflect poor planning and budgeting.
• Technical design faults meant that the data in the system was not always accurate. This resulted
in compensation for inaccuracies to the affected staff. This is partly the result of not having a
proper description of the various activities or tasks that needed to be done to achieve the project’s
objectives. Furthermore, techniques such as PERT and critical path method (CPM) (discussed
later) would have helped to get the project back on track when unforeseen problems emerged.
• The project manager and his team were evaluated on the original project time and cost, and the
satisfaction of the users of the system. Had proper monitoring and an appropriate plan for
the project’s completion been used, the situation may not have been impossible.
Project scheduling
Project scheduling is a difficult issue, especially in large, complex projects. A range of methods
have been developed to aid this process. The key methods discussed are:
• Gantt charts
• PERT
• CPM.
Gantt charts
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One of the oldest and most widely used methods for presenting schedule information is
the Gantt chart. A Gantt chart shows planned and actual progress for project tasks against a
horizontal time scale (see Example 4.14). The chart is constructed by listing tasks/activities on
a vertical axis, normally in the approximate order of execution. For each scheduled task, the start
and end dates are illustrated on the horizontal timeline. Project progress can be monitored by
inserting actual start and end times for each task.
Additional information can be added to increase the usefulness of Gantt charts. Project milestones,
both scheduled and achieved, can be marked on the horizontal axis. Various colour codes can
be used to highlight tasks that are behind schedule or those tasks that form the project’s critical
path. The project budget can be related to the Gantt chart by inserting budgeted dollar amounts
on the vertical axis (right-hand side), thereby illustrating how much money is budgeted for each
time period.
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Activity
A
B
C
D
E
F
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G
H
Time
3 10 17 24 3 10 17 24 31 7 14 21 28 5
February March April May
The Gantt chart in Example 4.14 shows each activity, and the duration taken to complete the
activity, as a horizontal bar. The bar runs from the start date of the activity to the finish date.
In this example, most activities need to be completed before the next one is started, except for
B and C, and E and F, which overlap. In complex projects, there may be a number of activities
that can be done concurrently by different team members. Overlapping horizontal bars show
which activities can be performed at the same time.
Gantt charts for complex projects with many activities may be constructed using software
packages. These packages help decision-makers to perform sensitivity analyses for scheduling
(e.g. what is the impact on Stage B if Stage A is delayed by one week?). In Example 4.14,
missing the date for obtaining planning permission (A) by one day would delay the project for
a month, as planning permission is only granted by the local authority at its monthly meeting.
However, being two days late in installing the electric cables (F) might have no effect on the
project completion time, as it may be possible for Stage G to begin while waiting for Stage F
to be completed.
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Gantt charts are simple, and are easy to understand, construct and use. Although they require
regular updating, this is easily done, as long as there are no changes to task requirements or
major alterations to the schedule. They are particularly helpful when expediting, sequencing and
reallocating resources among different tasks. All major project management software packages
include Gantt charts.
Gantt charts can also describe task interdependencies, identify critical paths, highlight changes
in the project schedule and calculate slack time available for project completion. To be able
to understand the meaning of this additional information included in Gantt charts, another
scheduling tool—PERT—needs to be discussed.
Note 2: The concepts covered in Appendix 4.2 (not the specific details of the case) are examinable.
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Sydney Seafood Bar case in Appendix 4.1), activity precedence relations (where one activity
must be completed before another can start—e.g. removing the old kitchen in Appendix 4.1)
and, in some formats, events. An event is the point at which an activity is started or completed
(e.g. the start of or the finish of removing the kitchen in the Sydney Seafood Bar).
There are two formats used to prepare a network diagram. One format displays activities as
arrows and events as nodes (circles), hence it is entitled ‘activity-on-arrow’ (AOA) network
(see Figure 4.11).
2A
1A 3A
1B 3B
2B
An alternative format, which is used in this module, is an ‘activity on-node’ (AON) network
(see Figure 4.12). In the AON format, nodes represent activities and events are not illustrated.
The choice of AOA or AON representation is a matter of personal preference, although some
software packages support only one of the two formats. This module uses the AON format,
because it is easier to use (e.g. includes real project activities only and does not require events
or dummy activities) and is supported by most project management software packages.
1A 2A 3A
Start End
1B 2B 3B
Network diagrams are normally drawn from left to right, reflecting the sequence of activities.
Networks can include a time dimension, with the length of the arrows representing the
duration of each activity. This can make drawing the diagram difficult. Hence, normally the
time of activities is simply noted on the diagram. To draw the diagram, the place to start is with
activities that have no predecessors.
Where an activity has no precedent activity, it can start from the start node. For example,
if Activity (B) has no precedent activity (i.e. does not need to wait until Activity (A) is complete
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before it can start), Activity (B) can start immediately after the ‘start’ node.
All activities in the project should be joined or linked so that they eventually connect to an
‘end’ point, which represents project completion. Where an activity is not a precedent activity
for another activity, it can be directly linked to the end node. For example, assume there are
eight activities (A–H). If Activity (E) is not a precedent activity for another activity, then it can be
connected to the end node.
Activity A N/A 5
Activity B N/A 10
Activity C A and B 3
Activity A has no precedent relationships and is expected to take five days. First draw a node
representing Activity A, which is then connected with an arrow from the start node.
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Activity B has no precedent relationships and is expected to take 10 days. Similarly, draw a node
representing Activity B, and connect it with an arrow from the start node.
Activity C can only start once both Activities A and B are complete. Therefore, the node representing
Activity C is connected to both nodes representing Activities A and B.
Finally, all the activities that are not a precedent activity for another activity (in this case, Activity C
only) are connected to the ‘end’ node.
Start C End
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O + ( 4ML ) + P
ET =
6
Note for statisticians: The weighting of 1:4:1 assumes that the distribution of possible durations
covers six standard deviations and is based on a beta distribution; other weightings might
be considered. For a more detailed discussion on the use and assumptions of this formula,
see Littlefield and Randolph (1987) or Gallagher (1987).
To highlight scheduling risk, it is useful to estimate the time-related uncertainty (variance) of each
activity. The variance will help in understanding the likelihood of completing the project on time.
A high variance indicates a high risk of out-of-schedule completion. The variance calculation is:
2
P −O
VAR =
6
If you are interested in learning more about this, refer to Meredith and Mantel (2015) listed in the
References section at the end of this module.
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The EOT for the ‘end’ node (86 days) is the expected project completion time or the ‘project
critical time’, calculated as the maximum of all EOT of activities that are not a precedent activity
for another activity. In this case, project duration is the maximum of 86 (Activity H), 68 (Activity F)
and 84 (Activity I).
The critical path for a project is the path(s) that result(s) in the project critical time—that is,
the longest time to completion. In Figure 4.13, the path A → D → H is termed the critical
path because this path has the longest duration (86 days). If there are any delays on this
path, the whole project is delayed. Conversely, if the duration of activities on this path are
shortened, the whole project duration can be reduced.
The critical path is the shortest duration in which you can complete a project. It is also the
longest path through the PERT diagram. This is because the project will only be completed
when all tasks are finished. This means that the sequence of activities that takes the longest
amount of time will determine the total time it takes to complete the project.
Note that all activities, even those not on the critical path, still form part of the overall project
and must still be carried out in order to complete the project. What must be determined is the
total duration of the project, given that some activities can start immediately, while others have
precedent relationships and can only start once another activity has finished. The critical path
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ET = 40
Var = 0 ET = 28
EOT = 40 Var = 8 EOT = 86
EOT = 68
Start B F End
ET = 8
Var = 0
EOT = 48
G
ET = 44 ET = 36
Var = 12 Var = 56
EOT = 44 EOT = 84
C I
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time (LST) for each activity. Project managers often want to know the latest time an activity can
start without making the entire project late. The answer depends on how much ‘slack’ or ‘float’
there is in any activity or path. The slack time is equal to the LST minus the ES.
The LST can be worked out backwards by starting from the project critical time and deducting
activity durations from it (i.e. working from right to left). For example, in Figure 4.13:
• The latest day Activity (F) can be started is 58 (86 – 28). As the earliest start time of Activity (F)
is day 40 (i.e. EOT for Activity B), it has slack of 18 days (58 – 40). Where the PERT network is
pictured on a time axis (i.e. arrow length is proportional to duration), slack can be indicated
by dotted lines.
• The path C → I takes 80 days and the critical path is 86 days. So, there are six days of slack in
path C → I. This means that Activity (C) could potentially start after six days and the project
would still be completed in 86 days.
• Activity (H) can only start after both Activities (D) and (E) are complete. The EOT for Activity D
is 70 days, so unless other preceding activities are reduced in time, this is the ES for Activity (H).
As Activity (H) is on the critical path, the LST and ES are the same (i.e. 70 days) and there is no
slack available.
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A clear understanding of the slack involved in various activities is essential for project managers
who want to ensure that resources are used efficiently. Resources allocated to tasks with some
slack can be reallocated to tasks without slack. Smooth distribution of resource usage leads to
better economic performance for a project, as there is, for instance, less need for overtime.
For a further explanation of and practice in PERT, please access the ‘Example Network’ and
‘Network Exercise’ learning tasks on My Online Learning.
For example, if the normal duration is 30 days and by adding resources it would become 25 days,
the crash duration would be 25 days. The difference between the normal and the crash duration
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reflects the number of days that have been crashed (i.e. 30 – 25 = 5).
Similarly, two costs are specified for the project: normal cost (budget) and crash cost. Crash cost
is the normal cost together with all the extra costs that are related to expediting one or more
activities. Careful planning is essential when trying to shorten a project. The likelihood that a
project will need to be expedited is fairly high in situations where duration estimates are uncertain
and there is a firm project deadline.
Crashing project activities is typically done where the cost–time trade-off is feasible—that is,
whether it is worthwhile spending more money on additional resources (e.g. labour or machines)
to speed up the project. For example, if it costs $50 000 to crash the project by 10 weeks, but the
project ends up earning a $100 000 bonus, then the cost-time trade-off is feasible.
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Note that crashing critical path activities may make some other path critical, or create more than
one critical path. Therefore, reducing project duration may require the simultaneous crashing
of multiple activities.
Refer again to Figure 4.13. The critical path A → D → H has an EOT of 86 days. The second
longest path is B → G → I, which is 84 days. If the critical path A → D → H is crashed by two
days, the critical path becomes 84 days, and so the duration is equivalent to the path B → G → I.
Now there are two critical paths and further crashing must take into account both critical paths.
If path A → D → H continues to be crashed, there will be no benefit; if path A → D → H is
reduced to 83 days, path B → G → I still remains 84 days. In other words, the duration of the
whole project has not changed (84 days). As such, once there are two (or more) critical paths,
the duration of all critical paths will need to be reduced simultaneously to have any effect on the
project completion time.
Cost optimising
Where minimising the project cost is being sought, critical path activities continue to be crashed
one by one until the point where the additional cost of crashing an activity equals the incremental
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savings. Figure 4.14 illustrates cost behaviour in cost–time optimisation decisions.
Benefit
Crash
Normal Optimum time
time time/cost
Finding a cost optimum is difficult in practice, especially in large projects that are very complex.
A possible way to overcome this problem is to determine a few alternative cost–time points and
select the one with the lowest total cost.
A graph illustrating a project cost function such as Figure 4.14 can be drawn based on information
about crashing costs and benefits. Such graphs may be useful in communicating with senior
managers or customers who may argue for early completion without a clear understanding of
the cost implications.
For further practice in the concept of crashing a project, please access the ‘Crashing Exercise’
learning task on My Online Learning.
➤➤Question 4.10
The managers of the Sydney Seafood Bar (SSB) have decided to use a critical path model to
plan the renovation project, as outlined in Appendix 4.1. The table below indicates the activities
required to complete the project, plus their durations and precedence relationships.
Preceding
Activity activity Optimistic Most likely Pessimistic
1. Remove kitchen 4 7 10
4. Remove mezzanine 2 4 6 14
5. Repair mezzanine 4 6 10 20
7. Build toilets 6 5 10 21
9. Build kitchen 6 20 30 46
(a) Construct the PERT network for the SSB project using the AON approach (as shown in
Figure 4.12).
Note: You will either need to do this separately on a piece of paper, or you may prefer
to create the network diagram in a drawing program before adding your response to the
answer field.
If you choose to use a drawing program, save your diagram as an image file. Then in the
interactive PDF of this Study guide, you can insert your response by selecting the answer
field and browsing for the image file that you saved on your device.
(b) Determine the expected completion times for all SSB project activities.
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Check your work against the suggested answer at the end of the module.
328 | PROJECT MANAGEMENT
Project budgeting
A project budget has several important functions:
• It is a plan to allocate resources to project activities. As senior managers approve a project
budget, they also approve the use of resources determined in the plan.
• It facilitates the control of project costs and revenues through variance analysis.
• It is the main benchmark used to evaluate a project’s financial success.
• When project team members know that costs will be closely monitored, they are less likely
to engage in actions that cause budget overruns.
Project cost estimates are the main input for a project budget. The main difference between a
project cost estimate and a project budget is the time dimension. A project budget provides cost
estimates on a weekly, monthly or quarterly basis, and should reflect project milestones.
It is often more sensible to budget for activities and milestones rather than time periods that
bear no relation to a project’s critical dates, but it is common practice to create project budgets
on a monthly and yearly basis. Typically, project budgets contain only project costs. Revenues and
cash flows are presented in separate finance and cash flow budgets.
Expenses can be allocated to a project as a whole (i.e. where the project is one cost centre),
to different deliverables or to business units within the company. The account coding used
varies among companies based on project size, type, complexity and organisational structure,
but it is preferable if the accounting system can capture the project as a separate unit to other
organisational activities to allow effective project cost control.
There are different ways to treat overheads in project budgets. If overheads are out of the control
of the project team, allocation will merely obscure evaluation of project success.
As with other budgets in today’s dynamic business environment, it is unlikely that a budget for
a long-term project will remain valid for the entire duration of the project. Therefore, project
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budgets need updating, at least after major changes in project circumstances or major deviations
from plan. A revised budget provides a fairer benchmark to evaluate project management if
changes are due to uncontrollable factors. On the other hand, if changes were controllable,
the original budget provides a valid benchmark for performance evaluation. In these cases,
a revised project budget may still be necessary to plan for cash flows and to control costs.
Budget preparation provides a good opportunity for management accountants to inform project
managers about revenue recognition and cost-allocation conventions. This improves the project
manager’s understanding of management accounting reports and increases the likelihood of
correct decisions being made regarding the project.
Supplier contracts
The project activity contracts with individual suppliers can be designed in many ways.
Management accountants should consider the effect that contract terms have on cost control
and the AC incurred. For example, fixed-price contracts provide certainty and pass profit
risk back to the supplier. In fixed-price contracts, the management accountant works with
the project manager mainly to control the quality of work and its timing. Cost control is less
important because the supplier has an incentive to keep costs under control and cannot pass
on cost overruns.
Another type of contract that is open to negotiation is payment for work done (i.e. hours or days).
In this case, the supplier (e.g. a building contractor) has an incentive to work more in order to
increase their revenues. The project manager and management accountant must monitor hours
and costs in addition to quality and time.
Some contracts are prepared on a cost-plus basis. The supplier is reimbursed for their costs plus
a margin for profit. In this case, the management accountant must carefully monitor a supplier’s
cost records to ensure that they are prepared in accordance with the contract and that non-
reimbursable costs are excluded.
Additionally, various types of bonuses and profit-sharing schemes can be used to achieve desired
project targets. One of the ways that management accountants can provide added value for
management is in the design of contracts that create the right incentives for suppliers to reduce
cost and time, and to minimise administrative costs for the organisation.
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Monitoring progress
There are three major areas that are considered in the context of monitoring progress, as shown
in Figure 4.15.
Project
cost
Project
Project
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specification
time
and quality
The main control tools used by management accountants are budget and schedule variances.
In reporting variances, the management accountant must keep in mind that because of the
unique and uncertain nature of projects, and the difficulty of predicting future costs and
activities, significant variances will inevitably arise. These variances will not necessarily reflect
the performance of project managers.
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Variance analysis is useful in both providing feedback to project managers about the project’s
progress and in helping to revise budgets and schedules to reflect new knowledge about the
project and the project environment. In the next section, the discussion on monitoring cost,
time and quality/specification is extended to consider two other related issues that have a
significant effect on project progress:
1. risk management
2. stakeholder management.
Monitoring costs
Project cost reporting needs to be regular, timely, accurate and relevant. This creates a challenge,
as project reporting is usually tied to the invoicing, record-keeping and reporting routines of
an organisation (see Example 4.16). Keeping a separate record of committed costs for project
purposes will ensure timely and useful information in project reports. A cost is committed when
a contract is concluded or a purchase order is issued.
The company commits to the cost when the order is placed (1 March), but unless a separate record is
kept of these committed costs, accounting reports will not recognise these commitments in a timely
way. The expenditure might show up in the project report for May, or even as late as June. One may
ask how timely and useful this type of reporting is for controlling project costs.
Regular project cost reports should contain incurred costs, committed costs and an estimate
of costs still required to complete an activity. These costs are compared against the budget.
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Deviations from the budget suggest the need for corrective actions. Management accountants
should not automatically estimate required costs by subtracting incurred costs from budgeted
costs. The key to efficient cost management is accurate budgeting—to produce good estimates
of required costs.
Part of the process of managing costs is evaluating the project cash flows against forecast cash
flows. Some projects will work with a more traditional budget and use accrual accounting to
manage expenses being incurred, while others will run a cash budget. For projects using a cash
budget, the schedule of cash flows prepared in the initial project analysis will often form the basis
of the cash budget for the project and variance analysis performed against these forecasts.
Many projects are dynamic and constantly changing, so they require the allocation or reallocation
of resources to meet a possibly turbulent environment.
A method called earned value (EV) has been developed to assess cost and time performance
simultaneously. The idea behind the method is to break down the usual budget variance (actual –
budget) into two parts. The key factor in this breakdown is the EV or the expected cost of project
work completed to date.
EV can be estimated for a whole project if it is small. For large projects, EV analysis is applied at
the activity level. The EV of work performed is found by multiplying the estimated percentage
completion of each activity by the total budgeted cost for that activity. That is:
This gives the amount that should have been spent on the activity so far. For example, if an
activity with a budget of $1000 is 25 per cent complete, its EV is $250. This method of calculation
is appropriate where activity costs are incurred evenly throughout the activity. Estimating EV can
be more difficult if costs are incurred on an irregular basis.
Comparing EV with planned costs and with AC produces two variances. Project (or activity) cost
variance is the difference between EV and AC at that point in time. The schedule variance is the
difference between the EV and the planned value (PV) at that point in time. That is:
Cost variance = EV – AC
Schedule variance = EV – PV
Although not universal practice, these variances should be defined in such a way that they will
be negative when the project is over budget (cost variance) and/or behind schedule (schedule
variance). This is the approach taken in this section.
Continuing with the example where EV is $250: if the $350 was actually spent at that point
in time (i.e. AC = $350), the cost variance would be ($100) (i.e. $250 – $350), and the project
would be over budget. If it was expected that $300 would have been spent at that point in time
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(i.e. PV = $300), the schedule variance would be ($50) (i.e. $250 – $300), and the project would
be behind schedule.
A cost variance would likely lead to a reassessment of the budgeted costs of the project,
whereas a schedule variance would likely lead to a reassessment of the estimated completion
time of the project.
The magnitude of these variances depends on project dollar values, so they are commonly
stated as ratios to make them easier to understand, or when the organisation wishes to compare
the performance of multiple projects. The ratios are called the cost performance index and the
schedule performance index (SPI).
SPI = EV / PV
In addition to these variances, two other variances can be calculated. The schedule variance is
the (monetary) difference between the EV and PV. The difference between AC and EV is called
the cost variance.
The following EV chart (Figure 4.16) shows the tools to be used in reporting project progress
and highlights that for the current point in time (‘control point’), the project is behind schedule
(EV is lower than PV) and over budget (AC is higher than EV).
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Cost variance = CV
Schedule
variance = SV
Duration
Control point Scheduled Estimated
completion completion
time time
Planned value
Earned value
Actual cost
Example 4.17 further explains how the EV chart shown in Figure 4.16 can be interpreted.
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Example 4.17: WaterSupplyCo
WaterSupplyCo is responsible for the main water pipes in a large city and has initiated a project to
replace the water pipes that run under the footpath. The total length of the water pipe replacement
is 480 metres.
WaterSupplyCo engages a contractor (DJ Water) to do the job. DJ Water estimates that it can complete
an average of eight metres of piping a day, so the whole project will take 60 days or 12 weeks. Based on
this, DJ Water puts together the following project budget for the three activities.
Within the first week of the project, DJ Water finds a major problem. When excavating the ground
where the current water pipes are, they find that it is a type of rock called sandstone. This means
that DJ Water needs to widen the channel the pipes sit in, which requires more expense (e.g. hiring
additional equipment) and time in excavation.
After the first four weeks (20 days) of the project, DJ Water has provided the following data:
• incurred $134 064 in costs:
– $94 584 for excavation
– $39 480 for laying the pipes, filling in the hole and re-concreting
• completed 94 metres of water piping.
DJ Water uses a variance approach to understand how it is tracking against budget. The first step is to
refer to the original budget for the project. DJ Water originally calculated that at this point, it would
have completed 160 metres of the job (i.e. 20 days at a forecast of eight metres per day).
An initial inspection of the figures suggests that the project is over budget by $42 864 (AC $134 064
– PV $91 200). This is highlighted by the AC being above the PV in Figure 4.16.
The second step to complete is an EV analysis. This shows that the EV to date is $53 580 (94 metres
completed × $570 per metre). From this information, DJ Water calculates that the scheduled variance
is unfavourable by $37 620 (EV $53 580 – budget $91 200). This is highlighted by the PV being above
the EV curve in Figure 4.16.
DJ Water also calculates that the cost variance is unfavourable by $80 434 (EV $53 580 – AC $134 064).
This is highlighted by the AC being above the EV curve in Figure 4.16.
The final step is to re-forecast both the time to completion (estimated delay) and the revised budget
(cost overrun), both of which are reflected in Figure 4.16.
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A standard budget variance analysis would show that the project has real budgetary problems.
When the spending and schedule variances are calculated (i.e. based on EV), it highlights just how
serious the situation is.
EV cannot replace scheduling techniques such as PERT, because it does not account for critical
activities, the critical path or slack. A combination of network analysis techniques and EV analysis
provides a useful system for project planning and control. The management accountant can
play an important role in implementing such a control system.
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➤➤Question 4.11
(a) Explain how project managers can benefit from the use of EV analysis.
Check your work against the suggested answer at the end of the module.
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project, the project scope
and specifications are
established. This needs to
Quality happen at the same time as
planning the project budget and
time lines are set.
Quality Quality
monitoring assurance
A significant issue for managing quality is that, unless good performance measurement design is
achieved and there is constant monitoring and assurance, specification or quality may be traded
off against cost or timeliness. This is because the progress of cost and time is typically easier to
recognise and monitor. Not only is quality or specification more difficult to measure, but it may
also not be apparent until later in the life of the project. Moreover, it may be difficult to establish
who has responsibility for the particular project’s failure to deliver the project specifications
(see Example 4.18).
Another important aspect of managing quality is contract management. In cases where there
is a contract and an external provider is responsible for some of the project’s deliverables, it is
important to ensure compliance with contractual terms and conditions (e.g. time, quality and
deliverables). This requires a thorough contract variation regime (e.g. time and cost adjustments
due to changes in scope). The management accountant needs to ensure the project critical path
is recalculated after every contractual change and the new activity slacks and their effect on the
project are well understood.
MIT argued that poor design led to the problems, while Gehry argued that the problems in the project
were due to the workmanship of the subcontractor in the building process.
Gehry is also reported to have argued that his client tried to save construction costs by reducing
components of the design, which resulted in some of the problems.
The case was finalised on 5 February 2010. Most of the issues of design and construction cited in the
lawsuit were resolved and the case was ‘reported settled’.
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Source: Based on Pogrebin, R. & Zezima, K. 2007, ‘M.I.T. sues Frank Gehry, citing flaws in center he
designed’, New York Times, 7 November, p. A20; Hawkinson, J. A. 2010, ‘MIT settles with Gehry over
Stata Ctr. Defects’, accessed June 2018, http://tech.mit.edu/V130/N14/statasuit.html.
Quality failure in project organisations not only impedes their ability to deliver quality projects,
but can seriously damage their reputation. This contrasts somewhat with quality failure in projects
within organisations, which can be harder to quantify, because the projects can be hidden among
the many other organisational activities. There may also be fewer or no external stakeholders to
hold the organisation accountable.
Quality costs
One way to think about quality management is to consider the four different types of quality
costs outlined in Figure 4.18.
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Quality
costs
4. Incurred when the customer finds that the project does not meet
External specifications and the project organisation has to cover the expense of
failure re-working the project. This is the most expensive type of quality cost—
it includes the costs of reworking already completed work and
reputational costs for the project organisation.
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These costs are discussed further in Module 6 when total quality management (TQM)
is considered.
The international standard ISO 10006:2017, ‘Quality management—Guidelines for quality management
in projects’, outlines a number of relevant quality management concepts and assists the management
accountant with the application of quality management in projects. It is available online at:
https://www.iso.org/standard/70376.html.
Measuring performance
Analysing performance against the project budget and schedule provides basic control over a
project for the project manager—as well as visibility over the project manager for the project
sponsor—to ensure that the project is delivered. Other performance measures are required to
ensure that the project achieves its deliverables and to ensure project quality.
There are two major challenges for management accountants in project performance
measurement:
1. In many organisations, projects are cross-functional and are organised with a matrix-like
structure, but planning, resource allocation and lines of accountability normally follow
functional lines. This means that line managers are responsible for the performance of their
own function and their rewards are linked to the success of their function. As staff tend to
focus on the performance for which they are rewarded, project work may be given a lower
priority when trade-offs are required. This can jeopardise the satisfactory completion of
projects. An important contribution that management accountants can make is to design
appropriate reward schemes so that line managers are given incentives for successfully
completing project milestones under their responsibility.
2. In project organisations (such as construction companies), employees must continue to
learn and keep their skills up to date. As a project manager is responsible for completing
the project on time and within budget, they may be reluctant to allow their best people
to be absent from project activities for extended periods of time (e.g. to attend training).
Here, management accountants can design performance measures that encourage project
managers to support employees’ learning and development. For example, a simple measure
that may be used is the days spent on educational courses. While this measure is limited
because it does not convey information about the effectiveness of the training, it highlights
the importance of learning and development to project managers. Targets for such measures
should allow for learning and skills development.
One area in which probity is especially important, and management accountants need to be
particularly vigilant, is the procurement of goods and services of high value or goods that are
contentious or dangerous. While probity is something that needs to be considered and managed
right through the project process, there may be instances where a specific probity adviser or
probity auditor needs to be engaged. This is particularly so in the case of government projects
and contracts (ICAC 2005).
Risk management
Risk management happens when the project commences. It is about the ongoing process
of monitoring and managing the risks of the project while it is being implemented, as shown
in Example 4.19.
Your risk management approach may include establishing a range of suppliers (including some in your
own country as a contingency plan) and also hedging against currency fluctuations.
Risk assessment is about clarifying what the risks are, whereas risk management is about trying to
manage those risks.
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Effective risk management requires a good risk management strategy, which consists of four key
areas, as outlined in Figure 4.19.
Risk
management
strategy
Robert Simons (1995) provides some thoughts on this in what he calls ‘interactive control’,
which can be applied to monitoring unknown risks. In this form of monitoring, the project
team stays alert and involved in the ongoing process of risk assessment and risk management.
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When unforeseen risks appear, project staff are then able to recognise and manage them.
➤➤Question 4.12
What is the critical difference between project risk assessment and project risk management,
and what are the key components of project risk management?
Check your work against the suggested answer at the end of the module.
Stakeholder management
Stakeholder management is the ongoing process of managing the expectations and influence of
stakeholders on a project. While there are a number of different approaches to this, there are a
number of common stages that are consistent as shown in Figure 4.20.
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Assess your
Identify the Identify their capability to
stakeholders interests satisfy their
interests
Recall the earlier discussion on balancing stakeholder interests (Part C). Stakeholders will often
be satisfied if you can demonstrate procedural justice. Moreover, regular communication with
stakeholders of what you are doing and why is an essential component of managing them.
One aspect of this that is particularly applicable to the client is signalling specification, quality and
timeliness. A very useful approach is to design a stakeholder scorecard that contains appropriate
performance indicators that can be used by stakeholders to track progress on the project.
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This provides a monitoring mechanism for stakeholders. While it may seem that this enables
stakeholders to manage the project, rather than project managers managing the stakeholder,
creating transparency and signalling problems before they escalate provides a more proactive
approach to ensuring that stakeholders are on side. Within this is appropriate specification of
measures to ensure that the stakeholders are satisfied as the project develops.
Scope creep is when there are changes in a project’s scope that are unplanned. It usually
happens when the original project specification is not defined and explained clearly enough
and then the processes are not managed adequately.
➤➤Question 4.13
Refer to Appendix 4.1 on the Sydney Seafood Bar’s renovation project.
(a) What are the most suitable project monitoring and control techniques for this project?
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Advantages Disadvantages
Check your work against the suggested answer at the end of the module.
Study guide | 343
Checklist
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At the completion of a project, there will be numerous small tasks that need to be completed
prior to official closure. First, a list of final deliverables has to be drawn up by comparing the
original project plan with the objectives completed to date. The next stage is to list the activities
required to complete the project, then to produce a schedule for those activities and assign
responsibility for their completion.
What was the underlying problem or opportunity that the project was dealing with and did
it deliver against this?
In the final review of the project, an analysis needs to be done to determine whether the
project addressed the particular problem or opportunity that triggered the project. Sometimes,
for projects that operate over long time periods, it becomes more difficult to reconcile what the
project was intended to fix or deliver in the first place. This is why making the reason clear at
the outset and keeping it on record is so important.
Did the project deliver against the strategy that it was intended to support?
As discussed earlier in this module, the key criteria for project selection is the strategic fit for
the project. Unless the project supports the organisation’s strategy, it does not contribute to
the central operation of the company and so the effort involved in undertaking the project is
likely to be wasted. Consequently, consideration of the extent to which the project was able to
support the organisation’s strategy and objectives is central to this analysis. Typically, the strategy
of the organisation will give rise to specific objectives for the project that, if met, would signal
project success.
Did the project deliver against its objectives and associated performance measures
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and targets?
At the project selection stage, the project objectives are identified. These should be demonstrated
in performance measures and targets reflecting the desired level of performance. These objectives
and measures are usually grouped as budget-related, time-related, and specification-related.
The key questions to ask when undertaking an analysis at the completion of the project are:
• What were the objectives and targets in each of these three areas?
• What was the actual performance in each of the three areas (budget, time and specification)?
• How much was the variance?
• What was the reason for the variance?
There are a number of challenges with analysing the extent to which a project has delivered
against its objectives and the organisation’s strategy.
When a project is complete, an assessment against the original strategic fit analysis should be
done to see how the project delivered against its original objectives. There are a number of
challenges with this analysis:
• Strategies in organisations change—while a project may have fitted the original strategy,
strategic change itself may put the project into strategic misalignment. This is why
it is important to ensure there is a constant review of alignment between strategy and
project delivery.
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• Project outcomes are not always clear and quantifiable—sometimes, benefits feed into
operational activities and processes, which may hide obvious outcomes and benefits from
projects. The management accountant needs to stay aware of these second-order impacts.
Moreover, benefits from projects could be qualitative rather than quantitative, and it is
important to identify and explain these benefits. For example, an energy efficiency project
may save energy costs for the organisation (a clear measurable outcome) and at the same
time create a culture of awareness of environmental issues that may influence employees to
reduce their environmental impact in other activities.
• The qualitative benefits from a project may not be obvious—for example, consider the
implementation of activity-based costing (ABC) systems. While many companies that
implemented ABC did meet their objective of having a more accurate costing system
and supported their strategy through better customer profitability analysis, a significant,
though unintentional, benefit of ABC was the increased level of communication and
understanding they gained of how their companies operated. While this is often
unintentional for ABC project designers, it is also one of the hard-to-measure qualitative
benefits. In fact, research shows that many companies see this as the outcome that
provided them with the greatest benefit.
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2. By the time the project is finished, the ability to fix any stakeholder concerns may be reduced
significantly, as these may have progressed beyond resolution.
A stakeholder satisfaction assessment is usually led by the project manager, though it can also
be conducted by a specialised unit within the organisation, such as the project management
office or the marketing department. The frequency of such assessments throughout the
project depends, for example, on the importance of the project, its duration and the number
of stakeholders. The assessment can be done using various tools, such as a survey, interviews,
focus groups and during regular stakeholder meetings. Information about how stakeholders’
needs were met, as well as any problems and successes that arose, should feed into how
stakeholders are managed in future projects. This is part of knowledge management,
discussed later in this section.
Financial closure
Financial closure has several aspects to it:
• determining the final actuals versus budget and schedule variances
• closing the cost records
• dealing with post-budget expenditures.
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Final costs
The calculation of the project’s final cost and the final budget variance analysis are completed at
the end of the project. Analysis of variance size and cause is important, especially if knowledge
gained through this analysis can be used to inform future projects. One way that this can be
applied is through improving the estimation processes in project budgets. Organisational
learning is a key aspect of project completion and review.
Post-project expenditure
After the project is officially complete, there may still be some final costs to be incurred and
the management accountant can hold a project account open past the official closing date
to deal with such costs. An example of this type of expenditure is invoices from contractors
or subcontractors that may not have been issued to the project by the closure date. This is a
significant issue in larger projects.
Resource dispersion
Management accountants can be involved in the disposal of excess supplies and capital
equipment at the end of the project. Some of the ways of dealing with these include:
• The project’s customer may be interested in purchasing the stock.
• Materials may be returned to suppliers for a refund.
• The stock can be absorbed into the inventory of the organisation to be used in other
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projects or in operations.
The last option has to be handled with care as, unless the stock is directly useful, it may be left
in storage until it reaches obsolescence. It may be better to disperse such stock promptly to
avoid storage costs.
Final report
Typically, a final report is prepared at the end of the project. This usually contains an overview,
the major outcomes, how these related to the original specifications, budget and variance
analysis data, and an analysis of the administrative and functional performance of those involved
in the project. Clearly, this can be a sensitive political exercise, particularly if poor outcomes are
identified with the project manager or senior management of the organisation. It is important
to clarify the key issue of controllability in relation to budget variances. The final report can also
contain the lessons learnt from the project and the way these can be applied in future projects.
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Knowledge management
Although each project is unique, there is useful knowledge that can be gained from the
process of project management. The management accountant can provide value by ensuring
that organisational learning occurs, particularly about cost and budget data, but also about
non‑financial performance data that might have been collected. Final cost information can
provide a useful knowledge resource for estimating the cost of future projects. This applies
particularly to the activities or events that caused significant deviations from budget.
Questions that the management accountant might ask in this area include:
• What problems appeared during the project?
• What was the effect of these problems?
• What caused them, and why were they not anticipated or detected earlier?
When this knowledge is identified, there are several strategies to ensure that it is not lost.
Some of these lessons can be standardised across the organisation or across projects, and may
be reflected in policies or procedures for how activities are to be performed—for example,
processes to ensure that probity is maintained for the purchase of input materials are applicable
to all projects.
Much of the knowledge gained in projects is based on the experiences of the staff who have
worked on them. For projects that occur within organisations, sometimes staff are moved back to
operational roles and the lessons from the project may be lost. One solution is to set up a central
database of staff and their relevant project-based skills and knowledge, so that when a new
project is initiated, staff who fit the new project can be found.
The lessons learnt from projects can be fed back into the strategy of the organisation. Some
organisations have training or information sessions where the lessons learnt from the project
are communicated back to employees in the organisation. The feedback from project-gained
knowledge can also be enabled by involving project staff in the strategy process.
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One important thing to keep in mind is that there are inhibitors for project knowledge
management including:
• Having enough time for staff to record their knowledge is always a challenge, particularly as
time constraints on project delivery are often considerable and time spent recording lessons
learnt is not time spent actually getting the project done.
• No incentives for staff to turn their individual knowledge into organisational knowledge.
How the organisation manages their culture and incentive structures tends to have a large
effect on this.
➤➤Question 4.14
How can a management accountant add value to their organisation in the project completion
and review process?
Check your work against the suggested answer at the end of the module.
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Study guide | 349
Review
Module 4 discussed that projects are an increasingly important part of any organisation. Whereas
some organisations spend most of their effort on projects (e.g. IT and construction companies),
in all other organisations different departments conduct projects to enhance their performance
(e.g. a marketing department implementing a new customer relationship management
information system).
Part A defined projects and how they are different from operations. There are six characteristics
that are common to projects and distinguish them from day-to-day operations. Projects:
1. are unique
2. often have high levels of uncertainty
3. relate to solving a problem within a specified scope
4. have a specific start and finish time
5. have operationally specific relationships
6. have multiple resources that need coordination.
Part B discussed the roles in projects. Projects are usually run by teams. The roles within the teams
are not usually defined in the same way in all projects, but there are several roles that tend to
be consistent—the project sponsor, project manager and project team. Within an organisation,
the project team includes functional staff and this is where the management accountant is located.
Management accountants provide a key role in supporting the project manager. They provide
traditional cost and budget information, perform capital budgeting analysis, carry out network
analysis techniques such as PERT, and support and guide management decision-making.
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established. A range of techniques are used to accomplish this, including Gantt charts,
PERT, CPM and detailed project budgeting. In each case the management accountant can
contribute to these techniques (discussed in Part D).
3. Project implementation and control—the project activities take place and progress against
the set deliverable dates and the budget is monitored. A useful tool in this stage is the
EV method where cost and time performance are monitored together. The management
accountant is central to the process of control (discussed in Part E).
4. Project completion and review—several steps must happen to complete a project.
The management accountant can add value through writing the final project report and
supporting other knowledge management activities so that lessons learnt in the project can
be used in the future (discussed in Part F).
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Appendix 4.1 | 351
Appendices
Appendices
Appendix 4.1
Sydney Seafood Bar
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Figure A1 4.1: Seafood dish at Sydney harbour
Source: iStock.com/mr_focus.
352 | PROJECT MANAGEMENT
John Kelly and some other business partners won the tender for a site at Circular Quay in Sydney,
Australia. They had an idea to turn a small run-down building into an alfresco dining restaurant/
bar. Initially, it was a business that focused on the self-service of fresh seafood, alcohol and other
beverages. They opened the business one year later.
As time passed, the original business evolved and the SSB emerged as a more up-market
harbour-front dining experience. The SSB still focuses on seafood but now also serves other
cuisines. The main factor influencing this change was that public demand and expectations had
altered since the original SSB design. Sydney is now a world-class tourist destination and the SSB
is part of the Property NSW ‘The Rocks’ precinct and so is part of Sydney’s image to the world.
The contemporary dining experience needs everything from expensive glassware, stylish plates,
high-quality wines and a menu that has unique ingredients. Moreover, customers want all of this
with great service, at an affordable price.
Over the last 20 years the SSB has become something of a Sydney landmark with its fresh
seafood and Harbour Bridge and Opera House views.
Current operations
Current strategy
There does not seem to have been a deliberate choice made in relation to strategy by the SSB
management beyond attempting to provide great seafood and great service in a great location.
The following would best reflect the strategy that has emerged.
Operational strategy
• The SSB invests in expert menu and wine advice, obtains the best organic ingredients and
constantly focuses on improving kitchen processes (which are particularly important in
peak periods).
• In order to maintain high standards of service, staff are proactively trained and every attempt
is made to retain good staff.
The premises
Property NSW leases the building and outdoor area to the SSB. Property NSW manages public
assets on the harbour foreshore on behalf of the New South Wales state government. As a
consequence, the SSB needs to take into account Property NSW’s vision and strategy, including
functioning in a caretaker role in relation to the main building which is a ‘state significant site’.
Renovation project
Due to the wear and tear on the building and kitchen, the SSB is about to undergo a major
renovation. Project costs will be more than a million dollars (AUD).
The project is estimated to take three to four months during which the business will be closed.
Appendix 4.1 | 353
B: Project proposal
Figure A1 4.2: The kitchen
Source: iStock.com/Lebazele.
The original fit-out for the SSB was completed 30 years ago and, while the SSB has continued
to upgrade the facilities, it has now reached the point where major works are required in
three areas:
1. a complete removal of the old kitchen, reconfiguration of the floor plan and construction
of a new kitchen
2. a complete removal of the toilet and bathroom facilities, a reconfiguration of the floor plan
and then construction of new toilets, including an accessible toilet
3. structural improvements to the inside of the building (including the mezzanine level).
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Why the project is needed
Amenity, kitchen and structural factors have influenced the requirement for major capital works
on the premises. These are so significant that a short-term fix until the end of the current lease
does not meet due diligence, stewardship, or fiduciary duty standards (although the option to
continue to upgrade the current facilities received thorough consideration). It is unrealistic to
expect a ‘world-class’ site with a ‘world-class’ restaurant to undertake a ‘patch-up’. Moreover,
the investment will provide permanent improvement and enduring benefit to the site to sustain
the operating viability of the SSB. Undertaking the project is in the best interests of Property
NSW, customers, staff and stakeholders.
All the requirements issued by the relevant local authorities have been addressed in the
submitted plans.
Amenity maintenance
and enabling
disabled access
Kitchen changes
Structure, fixture
1. Regulatory changes
and fitting changes
2. Changed public expectations
and improvements
3. Kitchen equipment replacement
Kitchen changes
Regulatory changes
The initial design of the kitchen layout suited the original operation of the SSB, which centred on
the self-service concept of a cold seafood menu. Since then, changes in the liquor licence laws
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over the last 20 years have specified additional requirements for kitchens. This has ultimately led
to two problems:
1. The increased kitchen functionality requirements have led to operational problems with the
original design.
2. The additional requirements now mean that the SSB needs to address narrow ‘traffic areas’
and improve working conditions to maintain a ‘duty of care’ for staff.
C: Project budget
Table A1 4.1
†
Estimated cost is from a recent formal quantity survey report. Three tenderers have put in proposals;
two are almost the same as this figure and one is 50 per cent more.
‡
Each of these costs is incremental and is a direct result of the project; they have been calculated by
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the company accountant in consultation with management.
§
As the business will be closed for an estimated four months, marketing advice will be sought and there
will be a vigorous marketing campaign to promote the new opening. There will also be consultation
with Property NSW about cross promotion and other sponsorship.
The remainder of the project costs ($809 501) are to be capitalised and depreciated over
10 years. While depreciation expense has no direct effect on cash flows, the expense is tax
deductible, and so reduces taxes payable. Assume that these cash inflows occur in each of the
Years 1 to 10. The tax rate is 30 per cent.
356 | PROJECT MANAGEMENT
SSB’s accountants believe a baseline NOPAT of $433 913 is sustainable without the investment.
A tax rate of 30 per cent has been used to generate this after-tax figure.
The baseline net profit for the first year is reduced by the lost sales for the four months SSB
will be closed, and the associated variable costs, totalling $118 995. The first-year net profit is
therefore $118 995 lower than the baseline, reflecting an incremental cash outflow associated
with the project.
The future increase in NOPAT as a result of the investment is estimated at 7 per cent per annum
(compounding). This increase is based on the baseline NOPAT (not the reduced first-year NOPAT)
and reflects an incremental cash inflow from Year 2 onwards. This 7 per cent estimate is based on
SSB’s historic average increase in NOPAT over the last 10 years.
Discount rate
Three discount rates were used for the analysis:
1. a conservative discount rate of 8 per cent—this represents a low-risk investment
2. a 10 per cent discount rate—which is close to long-term portfolio stock market returns
3. a 15 per cent discount rate—this figure is more realistic, taking into account shareholders’
expected returns from a small unlisted private company.
Residual value
There is an assumption of no residual value in the project. Building fabric changes such as
disabled access, amenities reconstruction and mezzanine repairs have no residual value for the
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business (though these do have long-lasting value for the lessor—Property NSW). The equipment
and other fittings only have material value in their current setting and have no disposal value.
Appendix 4.2 | 357
Appendix 4.2
Constructing a network diagram using PERT
Using PERT
This appendix provides a step-by-step example of the process of creating a network (or PERT)
diagram and using the CPM to assist with project planning and implementation. It follows the
four steps outlined in the Study guide:
Step 1: Draw the network diagram.
Step 2: Calculate the expected time (ET).
Step 3: Define the critical path.
Step 4: Calculate slack.
The project has nine activities (as shown in Table A2 4.1). The activity that needs to be completed
before the next one can begin is known as the preceding activity. These are shown in the right-
hand column. For example, notice that Activities 2, 3 and 4 all need Activity 1 to have been
completed before they can start.
Activity 1 —
Activity 2 1
Activity 3 1
Activity 4 1
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Activity 5 2
Activity 6 3
Activity 7 4
Activity 8 5
Activity 9 6
Note: As was the case in the Study guide, for this exercise the activity-on-node (AON) method
is used to draw the diagram (remember that AON shows activities as nodes).
The items from the project activity list (Table A2 4.1) can now be transferred into the diagram.
358 | PROJECT MANAGEMENT
Start
Start
Start 1
Start 1 3
4
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(iv) Draw Activity 5
Note that in the project activity list, Activity 2 precedes Activity 5. That is, Activity 2 must
be completed before Activity 5 begins.
2 5
Start 1 3
4
Appendix 4.2 | 359
(v) Draw Activity 6
Activity 3 must be completed before Activity 6 begins, so Activity 6 is added to the diagram
directly after Activity 3.
2 5
Start 1 3 6
2 5 8
Start 1 3 6 9
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4 7
2 5 8
Start 1 3 6 9 End
4 7
360 | PROJECT MANAGEMENT
O + ( 4ML ) + P
ET =
6
The ET calculated using this formula is a weighted average of the three duration estimates—
where the weighting for O is 1 / 6, ML is 4 / 6, and P is 1 / 6.
The ET estimates for the activities of this project are shown in Table A2 4.2.
Activity 1 — 20 25 30 25
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Activity 2 1 10 20 30 20
Activity 3 1 15 20 25 20
Activity 4 1 6 20 40 21
Activity 5 2 6 35 70 36
Activity 6 3 20 28 60 32
Activity 7 4 8 19 24 18
Activity 8 5 10 45 50 40
Activity 9 6 6 9 18 10
Once the ETs have been calculated for each activity, they are added to the network diagram on
the arrows (above the activity labels) as shown.
Appendix 4.2 | 361
ET = 20 ET = 36 ET = 40
2 5 8
ET = 25 ET = 20 ET = 32 ET = 10
Start 1 3 6 9 End
ET = 21 ET = 18
4 7
To determine the critical path, add together the ETs for the activities on each path through the
network diagram.
In this case, the critical path is Path 1 and the project duration is 121 days.
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Activities on the critical path are the main focus of management attention, because if these
activities are not finished on time, the planned project time will be exceeded. Critical path
activities must be carefully managed. The critical path is also important for managers, because if
they need to finish the project early, this can only be achieved by speeding up the activities on
the critical path. Activities on other paths may run ahead or behind schedule—to a degree—and
not affect the overall project completion time.
To summarise, the critical path is the longest path through the diagram and it shows the shortest
time in which the project can be completed.
362 | PROJECT MANAGEMENT
The latest possible start time is the project completion time (121 days) less the time of
Activities 4 and 7: 121 – (18 + 21) = 82 days.
The slack in Activity 4 is the difference between its earliest start time and its latest start time:
82 – 25 = 57 days.
Therefore, the project manager has considerable flexibility in deciding when to start Activity 4.
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Suggested answers | 363
Suggested answers
Suggested answers
Question 4.1
1. Projects are novel or unique—they will not usually be repeated in the same way again.
2. They often have high levels of uncertainty, which may be a result of their unique nature.
3. They are usually focused on providing a solution for some underlying problem.
5. Projects typically consist of activities that are related and often have operationally specific relationships
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(i.e. a particular activity has to be performed before the next one can be started).
6. Finally, they usually have multiple resources that need coordination, and this can be particularly
challenging.
While these characteristics set projects apart from day-to-day operations, they are not necessarily
all present in each project, but they do provide a guide for helping to distinguish projects from
the operational activities present in most organisations.
Question 4.2
Project stage Management accountant’s role
Stage 1: Project selection This stage focuses on the objectives and scope of the project.
Included in this is the project feasibility and justification, which often
centres on strategic fit, risk assessment, preliminary budgets and
completion time. The management accountant is often integrally
involved in the application of techniques to deal with these issues,
including strategic analysis, risk analysis, budgets and schedules.
Stage 2: Project planning Project planning adds more depth to the project selection analysis.
This addresses five key areas:
1. scheduling
2. optimising cost and time
3. budgeting
4. performance measurement
5. incentives.
Stage 3: Project implementation At the implementation stage, progress against the set deliverables
and control and dates are monitored and variances are examined. This provides
information for management to take actions to reduce the variance
between actual and budgeted outcomes where necessary. The
management accountant is often responsible for this scorekeeping
role. Additionally, the project plan deliverable dates and budgets
may need adjustment due to the emergence of new information
or risks. Finally, analysis of the cost involved in crashing project
activities can be done to determine whether the cost–time
trade‑offs are feasible.
Stage 4: Project completion This is when all the objectives of the project have been delivered.
and review The management accountant is responsible for the final reporting
and closing project accounts during this stage. A key aspect of this
stage is knowledge management, and the final project report must
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incorporate this.
Question 4.3
Explanation
Question 4.4
Explanation
Project sponsor Usually involved in contract negotiation, customer liaison and ensuring that
resources are made available for the project. The project sponsor may also become
involved if there is a major crisis.
Project manager Has functional responsibility for the project, including planning, execution and
delivery of the project, as well as managing the day-to-day project operations.
Project team Undertakes the functional tasks required. The management accountant is part of
the project team and works closely with the project manager in preparing necessary
information for decision-making and project control.
Question 4.5
Do you think the project Yes
has strategic fit?
Explain why or why not? Clearly, the managers want to maintain a differentiated approach to the
competitive strategy of the business, and the project contributes to this
by keeping the building and equipment at an international standard that
complements the location.
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(due to the better standard of facilities) and also improve menu offerings
due to the improved functionality of the kitchen. It will also enable better
management of throughput times for orders during busy periods, but it
goes beyond the basic strategy of the SSB and also addresses legal and
regulatory requirements.
Question 4.6
Stakeholder Stages of the project
1. Client The clients are keenly interested in your ability to complete the project on
time, within budget and according to specifications. You will probably have
intense involvement with them at the project planning stage, then ongoing
involvement reporting on progress, and finally at the end of the project
ensuring that the project meets expectations and final payment is received.
2. Regulators Regulators have significant involvement at the project approval and planning
stages, while they may be less involved during the construction (as long as
compliance is maintained as the project progresses).
3. Suppliers Suppliers of your construction materials and internal fittings are vital throughout
the implementation of the project, so detailed planning for these needs to be
done prior to commencement.
4. Community and As the project takes place in a suburban community, the needs of the
society community that will use the centre clearly have to be taken into account in
the planning stage of the project. Moreover, the way that the completed
development affects the community will need to be considered. Furthermore,
community inconvenience and dislocation need to be managed during the
project—for example, provision of parking bays.
5. The environment The environment needs to be considered in the design of the project to gain
an acceptable level of environmental sustainability (e.g. energy efficiency
ratings). In addition, suitable environmental sustainability practices need to
be implemented in the construction process.
Year 0 1 2 3 4 5 6 7 8 9 10
Reduction in labour cost 180 000 180 000 180 000 180 000 180 000 180 000 180 000 180 000 180 000 180 000
per year ($)
Increase in utility cost (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000)
per year ($)
Net cash flow ($) (1 030 000) 170 000 170 000 170 000 170 000 170 000 170 000 170 000 170 000 170 000 270 000
Discount factor = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 +
calculation (cost of 14%)1 14%)2 14%)3 14%)4 14%)5 14%)6 14%)7 14%)8 14%)9 14%)10
capital = 14%)
Discount factor 1.0000 1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV working 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 270 000 /
1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV cash flows ($) (1 030 000) 149 123 130 809 114 749 100 651 88 293 77 449 67 938 59 595 52 277 72 831
You may get a slightly different answer based on whether you use a table, spreadsheet or financial calculator to discount the cash flows.
MODULE 4
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368
Table SA4.2: Cash flow and NPV analysis of Big Firm Pty Ltd’s IT project (updated cost inputs) (c)
Year 0 1 2 3 4 5 6 7 8 9 10
Reduction in labour cost 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000
per year ($)
Increase in utility cost per (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000)
year ($)
Net cash flow ($) (1 090 000) 220 000 220 000 220 000 220 000 220 000 220 000 220 000 220 000 220 000 320 000
Discount factor = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 +
calculation (cost of capital 14%)1 14%)2 14%)3 14%)4 14%)5 14%)6 14%)7 14%)8 14%)9 14%)10
= 14%)
Discount factor 1.0000 1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV working 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 320 000 /
1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV cash flows ($) (1 090 000) 192 982 169 283 148 498 130 255 114 262 100 228 87 919 77 123 67 653 86 319
It seems that the extra development cost and the further reduction of labour costs make the
project viable. It now has a positive NPV of $84 522.
Question 4.8
Which project should you select? Project 2
Why? Projects with the highest NPV should be selected because the NPV
informs us of the amount by which the net assets of the organisation
will increase by undertaking the project. Therefore, you should select
Project 2.
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Question 4.9
Sydney Seafood Bar
Project capital budgeting and net present value
To establish the financial viability of the project, capital budgeting has been done, involving
calculating the project’s NPV using different discount rates.
(a) Over 10 years, with a discount rate of 8 per cent, the project has a positive NPV of $41 612,
close to break-even on the project. Therefore, the viability of the project in this case is still
positive, although the final decision may depend on alternative project options the company
may have.
(b) Over 10 years, with a discount rate of 10 per cent, the project has a negative NPV of ($85 992).
While this NPV is negative, because the project sits clearly within the SSB’s strategy and
there are good reasons for undertaking the project, it may, under some circumstances,
still be viable.
(c) Over 10 years, with a discount rate of 15 per cent, the project has a negative NPV of
($330 092). This indicates that it is not financially viable and the SSB management should
think about other options to gain regulatory conformance.
The following tables and commentary further explain the NPV calculations and results.
370 | PROJECT MANAGEMENT
Year 0
Cash outflows in Year 0 ($)
Total project cost = Total cash outflow (i.e. $200 000 + $809 501) (1 009 501)
Table SA4.3 reveals that the total cash outflow in Year 0 is ($1 009 501). This is split between:
• operating costs of ($200 000) that are paid in Year 0, resulting in a tax reduction in Year 1
(because the tax return is lodged after the end of Year 0)
• other project costs of ($809 501) that are paid in Year 0, capitalised and depreciated
(tax deductible expense) over the life of the project (Years 1–10) using straight-line
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depreciation.
Annual depreciation over 10 years (i.e. $809 501 / 10) (80 950)
Annual tax effect of depreciation (i.e. $80 950 × 30%) 24 285 24 285
Depreciation is a non-cash expense and so does not appear directly in the NPV cash flows.
However, depreciation leads to a tax-deductible expense (30% of the depreciation amount).
This tax deduction leads to a reduction in the amount of tax payable, and this is treated as a cash
inflow in NPV calculations. Project construction costs and associated fees (totalling $809 501) are
depreciated on a straight-line basis over 10 years. The annual depreciation expense is therefore
$80 950 (i.e. $809 501 / 10).
Table SA4.4 shows the tax effect of expenses in Years 1–10. In Year 1, the cash inflow of $84 285
is made up of the:
• benefit from tax-deductible operating costs in Year 0 of $60 000 (i.e. $200 000 × 30%)
• benefit from tax-deductible depreciation expense in Year 1 of $24 285 (i.e. $809 501 /
10 years × 30%).
The Years 2–10 cash inflows are $24 285, reflecting the benefit from the tax-deductible
depreciation expense (i.e. $809 501 / 10 years × 30%).
Note that while the initial decrease in NOPAT due to the project is shown in the tax-effect
calculations in Table SA4.4, the ongoing increase in NOPAT due to the project is not shown.
This is because the baseline NOPAT provided in this question is after tax, so no adjustment for
tax-related cash flows is necessary (see Table SA4.5).
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372
Year 0 1 2 3 4 5 6 7 8 9 10
sales/variable costs)
Calculation of baseline 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 ×
NOPAT growth (7% (1.071 – 1)(c) (1.072 – 1) (1.073 – 1) (1.074 – 1) (1.075 – 1) (1.076 – 1) (1.077 – 1) (1.078 – 1) (1.079 – 1)
annual growth in baseline
NOPAT from Year 2)
Incremental cash 30 374 62 874(d) 97 649 134 858 174 672 217 273 262 856 311 630 363 818
Sydney Seafood Bar
inflow ($)
(7% annual growth in
baseline NOPAT from
Year 2)
Note: Table SA4.5 reveals the incremental cash flows from the net increase/(decrease) in NOPAT. Note that we are after the net increase/(decrease) in NOPAT from the base
year, not from each subsequent year. This helps us to determine the actual cash inflow/(outflow) that is directly related to the project (and, hence, whether we should proceed
with the investment).
Total tax effect 84 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 302 850
of expenses
(see Table SA4.4)
Net increase/(decrease) (118 995) 30 374 62 874 97 649 134 858 174 672 217 273 262 856 311 630 363 818 1 537 009
in NOPAT
(see Table SA4.5)
Total net cash flows (1 009 501) (34 710) 54 659 87 159 121 934 159 143 198 957 241 558 287 141 335 915 388 103 830 358
8% discount rate
Discount factor (8%) 1.0000 1.0800 1.1664 1.2597 1.3605 1.4693 1.5869 1.7138 1.8509 1.9990 2.1589
Discount factor (10%) 1.0000 1.1000 1.2100 1.3310 1.4641 1.6105 1.7716 1.9487 2.1436 2.3579 2.5937
PV (Total net cash flow (1 009 501) (31 555) 45 173 65 484 83 283 98 816 112 306 123 958 133 954 142 461 149 631 (85 992)
/ Discount factor)
Discount factor (15%) 1.0000 1.1500 1.3225 1.5209 1.7490 2.0114 2.3131 2.6600 3.0590 3.5179 4.0456
PV (Total net cash flow (1 009 501) (30 183) 41 330 57 308 69 716 79 122 86 015 90 811 93 867 95 488 95 933 (330 092)
/ Discount factor)
Note: Please note that the figures in the three rows of PV (Total net cash flow / Discount factor) are calculated using an MS Excel spreadsheet. There will be rounding
differences if the total net cash flows are divided by the discount factor (rounded to four decimal places).
Suggested answers |
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374 | PROJECT MANAGEMENT
Question 4.10
(a)
ET = 14 ET = 3 ET = 11 ET = 17
EOT = 31 EOT = 34 EOT = 45 EOT = 62
3 6 7 8
ET = 7 ET = 10
EOT = 7 EOT = 17
ET = 31 ET = 8
EOT = 65 EOT = 73
Start 1 2 End
9 10
ET = 7 ET = 11
EOT = 24 EOT = 35
4 5
ET = (O + 4ML + P ) / 6
†
Where:
O = optimistic
ML = most likely
P = pessimistic
Question 4.11
(a) Explain how project managers can benefit from the use of EV analysis.
Project managers can use EV in projects where a project deliverable (output) or percentage
completion can be measured. This is because the key factor in the EV method is the
comparison of actual cost incurred to the cost that should have been incurred for
the work done.
One of the problems with variance analysis is ensuring that comparisons are made between
AC and a meaningful cost estimate or budget. The EV method provides this meaningful
base for comparison. This is important because a project may have what seems to be a
favourable cost variance due to the fact that the costs incurred are below budget, but when
compared to the work completed, there may be a significant cost overrun because the work
is behind schedule.
Question 4.12
Risk assessment typically happens prior to project commencement and is about identifying and
assessing the probability and the financial impact of risk.
Risk management is the ongoing process of managing the risks of the project while the project
is being implemented.
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The key components of project risk management are:
• having the right project team
• monitoring known risks
• monitoring the emergence of unknown risks
• establishing contingency responses so that when things go wrong, the project can still
be delivered on time, on budget and according to specifications.
Question 4.13
(a) Of the various techniques discussed in Part E, it is necessary to choose those that are most
relevant to the unique characteristics of the renovation project at SSB:
1. Quality assurance—the high strategic importance of having a high-quality restaurant in a
prime Sydney Harbour location means that there is an emphasis on ensuring the quality
of the renovations is high and the restaurant has the look of an expensive place with
high‑quality facilities.
2. Stakeholder management—the multiple stakeholders of this project and the changed
public expectations suggest stakeholders should be managed carefully in this particular
project.
3. Earned value—the project has strict deadlines (no more than four months), as well as an
expectation that all scope is delivered with high quality and on budget. This suggests
that an integrative technique such as the earned value method should be employed.
(b)
Advantages Disadvantages
Earned value—an efficient integrative approach Earned value—requires ongoing data collection
that monitors time, cost and scope, all at the about project progress
same time
Question 4.14
While the management accountant may be involved in the decision to complete a project,
creating the task list, obtaining specification satisfaction consensus and undertaking a
stakeholder satisfaction assessment, one key area where the management accountant adds
value is in the financial closure of the project.
This includes calculating the final cost of the project and closing the cost records so that expenses
can no longer be charged against the project. In addition, the management accountant may be
involved in resource dispersion, which can involve negotiating with suppliers for stock returns and
selling assets that cannot be absorbed into the organisation.
Finally, the management accountant can add value by documenting the knowledge gained from
the project. This includes budget-related information—such as the events that caused deviation
from cost estimations, the systematic identification of the problems with a project, and what
could be done to reduce their recurrence—which can be useful for planning future projects.
References
References
Australian Petroleum Production and Exploration Association 2018, ‘Australian LNG projects’,
accessed September 2018, http://www.appea.com.au/oil-gas-explained/operation/australian-lng-
projects.
Bloch, M., Blumberg, S. & Laartz, J. 2012, ‘Delivering large-scale IT projects on time, on budget,
and on value’, Insights & Publications, McKinsey & Company, October, accessed September
2018, http://www.mckinsey.com/insights/business_technology/delivering_large-scale_it_projects_
on_time_on_budget_and_on_value.
Eden, C., Ackermann, F. & Williams, T. 2005, ‘The amoebic growth of project costs’, Project
MODULE 4
Management Journal, vol. 36, no. 2, pp. 15–26.
Independent Commission Against Corruption (ICAC) 2005, Probity and Probity Advising, Sydney,
New South Wales.
Lend Lease 2018, ‘Western Sydney Stadium’, accessed September 2018, https://www.lendlease.
com/au/projects/western-sydney-stadium/?id=4dd6e4ac-148b-4724-839c-f73922454b95.
Lientz, B. P. & Rea, P. R. 2003, International Project Management, Academic Press, Amsterdam.
Littlefield, T. K. & Randolph, P. H. 1987, ‘An answer to Sasieni’s questions on PERT times’,
Management Science Quarterly, October.
Loch, C. & Kavadias, S. 2011, ‘Implementing strategy through projects’, The Oxford Handbook
of Project Management, Oxford University Press, Oxford.
Malmi, T. & Brown, D. A. 2008, ‘Management control systems as a package: Opportunities,
challenges and research directions’, Management Accounting Research, vol. 11, no. 4, December,
pp. 287–300.
378 | PROJECT MANAGEMENT
Matheson, V. A., Schwab, D. & Koval, P. 2018, ‘Corruption in the bidding, construction and
organisation of mega-events: An analysis of the Olympics and World Cup’, in The Palgrave
Handbook on the Economics of Manipulation in Sport, Palgrave Macmillan, Cham, pp. 257–78.
Meredith, J. R. & Mantel, J. M. 2015, Project Management: A Managerial Approach, 10th edn,
Wiley, New York.
Morris, P. & Pinto, J. K. 2007, The Wiley Guide to Project, Program and Portfolio Management,
Wiley and Sons, New Jersey.
Phillips, R., Freeman, R. E. & Wicks, A. C. 2003, ‘What stakeholder theory is not’, Business Ethics
Quarterly, vol. 13, no. 4, pp. 479–502.
Pinto, J. K. 2010, Project Management: Achieving Competitive Advantage, Prentice Hall,
New Jersey.
Porter, M. E. 1985, Competitive Advantage: Creating and Sustaining Superior Performance,
The Free Press, New York.
Project Management Institute (PMI) 2017, A Guide to the Project Management Body of
Knowledge, 6th edn, Project Management Institute, Newtown Square, Pennsylvania.
Sundin, H., Granland, M. & Brown, D. 2010, ‘Balancing multiple competing objectives with
a balanced scorecard’, European Accounting Review, vol. 19, no. 2, pp. 203–46.
Zwikael, O. & Smyrk, J. R. 2011, Project Management for the Creation of Organisational Value,
Springer-Verlag, London, UK.
MODULE 4
Zwikael, O. & Meredith, J. 2018, ‘Who’s who in the project zoo? The ten core project roles’,
International Journal of Operations & Production Management, vol. 38, no. 2, pp. 474–92.
Zwikael, O., Chih, Y. & Meredith, J. 2018, ‘Project benefit management: Setting effective target
benefits’, International Journal of Project Management, vol. 36, pp. 650–58.
Optional reading
Dalal, A. 2011, The 12 Pillars of Project Excellence, CRC Press, Boca Raton, Florida.
Institute of Civil Engineers and the Actuarial Profession 2005, RAMP Risk Analysis and
Management for Projects: A Strategic Framework for Managing Project Risks and Its Financial
Implications, Thomas Telford, London.
STRATEGIC MANAGEMENT ACCOUNTING
Module 5
PERFORMANCE MANAGEMENT
380 | PERFORMANCE MANAGEMENT
Contents
Preview 383
Introduction
Objectives
Teaching materials
Review 488
Appendices 489
Appendix 5.1 489
References 521
MODULE 5
MODULE 5
Study guide | 383
Module 5:
Performance management
Study guide
Preview
Introduction
The Strategic Management Accounting subject emphasises the role of the professional
accountant in engaging with the organisation’s senior management team to contribute to strategy
development and implementation. The aim is to create value and a strong competitive position
for the organisation. This subject focuses on developing, implementing and monitoring strategies
in order to enhance value for the organisation. Such a focus would not be possible without
understanding the key role that performance management plays in strategy and value creation.
The need for sound design and an understanding of the use and implications of strategic
performance management and control systems is gaining increasing importance in all
organisations. This module sets the context for performance management and control,
including the:
MODULE 5
• characteristics of effective performance measures and control systems
• use of performance measures
• application of performance management to motivate and reward.
Module 5 is concerned with how performance management helps to achieve goals and
objectives through setting targets and measuring performance against those targets through
control and feedback systems.
Module 5 builds on Module 1 and emphasises the role of the management accountant in
supporting the management team in their strategic role. In particular, this module looks at
performance management in the context of value creation and the sustainability of performance
over time, as well as sustainability in the sense of corporate social responsibility (CSR).
This module also builds on Module 1 by discussing the role of the management accountant in
generating and interpreting information about value chain performance. The focus of Module 2
on information is also relevant as it is the basis of performance management. Similarly, Module 3
looks at variance analysis as one way in which performance can be managed through comparisons
between actual and expected performance.
384 | PERFORMANCE MANAGEMENT
The links between strategy, management control systems and performance management,
and the limitations of some traditional accounting-based controls, are considered. The various
models of performance management, emphasising the balanced scorecard and the strategy
mapping process, as well as cascading performance measures and the important role of
information systems in performance management, will be highlighted.
Module 6 will be previewed by discussing the role of performance management in the creation
and management of value. How performance measures and their associated targets are
designed and the characteristics that make performance measures useful, including the need
to compare the costs and benefits of performance management, will be discussed. This module
focuses on improving performance through targets, trends and benchmarking, and the
importance of continuous improvement (CI) through organisational learning and knowledge
management processes.
This module illustrates concepts with examples from manufacturing, service and retail
organisations and the public and not-for-profit sectors.
The highlighted sections in Figure 5.1 provide an overview of the important concepts in this
subject and how they link with this module. This module discusses how the management
accountant works to provide management with information for monitoring and decision-making
that, in turn, informs and is informed by strategy.
rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
MODULE 5
MANAGEMENT ACCOUNTANT
VALUE INFORMATION
OPERATIONS
Exte
rnal environment
Objectives
After completing this module you should be able to:
• Explain the importance of performance management and the role of a performance
measurement system in value creation, sustainability performance, and strategic
implementation.
• Analyse how a properly designed balanced scorecard can implement and monitor strategy.
• Identify effective performance measures in a given scenario.
• Assess the root causes of performance issues in a given situation.
• Evaluate potential behavioural effects resulting from performance evaluation and
reward systems.
Teaching materials
• APES 110 Code of Ethics for Professional Accountants
• IESBA International Code of Ethics for Professional Accountants (Including International
Independence Standards) April 2018
MODULE 5
386 | PERFORMANCE MANAGEMENT
Performance
Performance may be a discrete event, as in achieving a certain level of profit or customer
satisfaction. Performance may be considered quantitatively (i.e. a numeric value)—for example,
that profit is $10 million, or that 85 per cent of customers are satisfied. It may also be considered
qualitatively (and typically more subjectively)—for example, the quality of a service or an
organisation’s reputation. There may be a trade-off between quantitative and qualitative
aspects of performance—for example, between achieving a certain level of profitability
and the organisation’s reputation. Similarly, there can be a trade-off between short-term
performance and longer-term sustainable performance, whether that be financial, societal,
environmental or reputational.
Performance may be understood either at the level of the whole organisation, or different
business units, products or services, geographic areas, distribution channels or customer
segments within the organisation. At each level of analysis, performance may be interpreted
differently. For example, the Australian airline Qantas achieves quite different results between its
international, domestic and low-cost subsidiary (Jetstar) business segments. Different strategies
and measures of performance may apply across each of these different segments.
departures or the comfort of the cabin seating. An investor may be more interested in its financial
performance. A member of the public living near an airport may be more interested in the
airline’s environmental performance.
Performance measurement
Performance measurement implies a scientific technique involving comparison to a specific
scale (e.g. a metre in length, a tonne of weight, one thousand dollars). A performance measure
is therefore quite specific. Financial performance, such as profit or return on investment, can be
readily measured because it is:
• specified in a single unit—for example, dollars
• clearly defined
• based on a clear application of rules—for example, accounting standards or generally
accepted accounting principles.
Study guide | 387
For a further explanation of performance measurement, please access the ‘Performance Measurement’
video on My Online Learning.
Performance management
The management of performance is an active rather than a passive process whereby actions
are taken to effect change in behaviour or results. Performance management is far more
than collecting or reporting information. It extends to analysing performance with a view
to understanding its causes. Only when there is an understanding of causality can change,
or recommendations for change, be implemented.
Performance management calls for a wider range of skills for the management accountant.
While performance measurement is the starting point, the management accountant needs to
synthesise complex data sets from different sources and analyse that data. The management
accountant then needs skills of persuasion and communication, backed by evidence, to put in
place actions or recommendations for change with the purpose of improving future performance.
MODULE 5
but also for customers and other stakeholders) that is sustainable over time. The idea of
management control to ensure that strategy is achieved is therefore crucial to an understanding
of performance management. The performance management process incorporates all of the
aspects of performance discussed previously. These are:
• defining what the performance is that an organisation needs to achieve
• how to measure performance
• reporting and monitoring performance
• taking deliberate action to improve performance.
Performance can be seen as a method of value creation (‘If we are not creating value, what are we
doing?’) in terms of process or the results of a process. Performance is usually interpreted relative
to a target, a trend over time or by comparison to a benchmark. Targets, trends and benchmarks
are discussed later in this module.
An organisation’s performance should not be viewed from one dimension only (i.e. only from a
financial point of view). As shown in Figure 5.2, performance should be seen more holistically.
388 | PERFORMANCE MANAGEMENT
$+%
investment) per square metre of floor
%
Source: CPA Australia 2019.
Organisations use different terms for their performance measures such as key performance
indicators (KPIs) or critical success factors (CSFs). Organisations may call their performance
management system a ‘dashboard’ (picture the dials in an aircraft cockpit), a ‘traffic light’ system
(discussed previously under ‘Performance measurement’) or a ‘scorecard’. These differences in
terminology matter less than understanding what an organisation is trying to measure and how
that measurement takes place.
Example 5.1: P
erformance reporting by Event Hospitality
and Entertainment Ltd
Event Hospitality and Entertainment Ltd (EVT) (formerly Amalgamated Holdings Limited) is an Australian
provider of entertainment, hospitality and tourism and leisure services. EVT conducts its operations in
Australia, New Zealand and Germany. The company was established in 1910. It had annual revenue
MODULE 5
of $1.2 billion in the year ended June 2017. EVT is listed on ASX. Its market capitalisation in July 2018
was $2.13 billion.
EVT’s entertainment division operates Event Cinemas in Australia and New Zealand, the State Theatre
in Sydney, Moonlight Cinemas across Australia, Cinestar Cinemas in Germany and Edge Digital
Technology.
EVT’s hospitality division operates QT Hotels & Resorts, Rydges Hotels & Resorts, Atura Hotels brands
as well as the premier Australian ski resort township of Thredbo Alpine Resort. Both the entertainment
and hospitality divisions have loyalty programs. Across its owned and managed hotels at June 2017,
EVT had 9132 rooms across 58 different locations (EVT 2017a, p. 10).
Study guide | 389
EVT’s strategic plan includes future expansion, depending on a number of internal and external factors,
including available capital and customer trends.
For the hospitality division, EVT wants to increase the number of hotel rooms through new
hotel management agreements and freehold acquisitions. It also aims to grow market share,
increase occupancy rates and increase customer spend in all its hotels (EVT 2017a, p. 13).
The most important financial performance aspects for EVT are explained in the annual report as:
• revenue
• earnings before interest
• taxation
• earnings before depreciation and amortisation (EBITDA)
• normalised profit before interest and taxes (PBIT).
Normalised profit, in many companies called underlying profit, supplements the financial statements,
and such figures are unaudited and not comparable to other companies. The underlying profits are
based on judgments by the directors as to what is the profit that best reflects the result of operations,
unencumbered by transactions that are required by Australian Accounting Standards and that do not
reflect ongoing performance.
For each of the divisions, performance is measured based on profit before income tax, which EVT uses
to compare to the performance of competitors.
The audited remuneration reports within annual reports provide a good guide as to what aspects of
(most commonly, financial) performance are important, as these are the basis for rewarding directors
and senior management. These are typically split into short-term incentives (STIs) and long-term
incentives (LTIs).
EVT’s remuneration policy aims to reward the CEO and other executives with a level and mix of
remuneration commensurate with their position and responsibilities within EVT. The rewards are linked
to specific targets, goals and KPIs. Parts of the executive remuneration packages depend on the
financial and operational performance of EVT. This element of remuneration is deemed to be ‘at‑risk’
because if the performance goals are not achieved, executives do not receive that component of the
remuneration package.
MODULE 5
390 | PERFORMANCE MANAGEMENT
➤➤Question 5.1
EVT’s Annual Report 2017 and the results presentation for the half year ended 31 December
2017 are available to download at https://www.evt.com/investors/.
Search both documents and identify as many performance measures as you can for the hotel
division.
MODULE 5
Check your work against the suggested answer at the end of the module.
Study guide | 391
Profitability
Shareholder
Liquidity
returns
Ratios
Activity or
Gearing
efficiency
Various approaches to measuring shareholder value from an investor’s perspective are also
available. Study of the effect of reported financial performance on capital markets is important
to understand stock market expectations and how reported performance influences share
price movements over time. Stock markets tend to value shares more on expectations of future
cash flows, discounted to present values, than on historical performance. While the analysis
of historical, externally reported performance is valuable, it is through a focus on strategy and
value‑adding activities that management accountants can contribute more to organisations.
While financial statements produced for external parties are governed (in Australia) by the MODULE 5
Corporations Act 2001 (Cwlth), International Financial Reporting Standards (IFRS) and the
requirements of external audit, these have limited usefulness to managers who are interested
in understanding organisational performance at the more detailed level necessary for planning,
decision-making and controlling operations. Strategic management accounting, however,
provides a more detailed analysis of performance, as shown in Table 5.1.
392 | PERFORMANCE MANAGEMENT
Table 5.1: C
omparison of approaches to performance between financial accounting
and strategic management accounting
Annual figures in external financial statements Monthly figures (or in some cases weekly or even
daily—e.g. retail sales) reporting
Consolidated data (even segmental reporting in Reporting for individual business units and
financial statements is highly aggregated) responsibility centres
Highly aggregated data on income and expenses Detailed analysis of individual income and expense
line items
Strategic management accounting also provides comparisons to budgets and standard costs, and
enables variance analysis, product/service profitability analysis, customer and distribution channel
profitability analysis, activity-based cost analysis and a variety of other tools and techniques.
Strategic management accounting information increasingly links the information in the general
ledger with other sources of data such as inventory records, labour routings, bills of materials
and standard costs.
Increasingly, strategic management accounting can provide managers with increased information
about markets, customers, competitors, supply arrangements and production processes,
based on formal and informal sources.
Strategic management accounting increasingly links financial data with non-financial data and
reports them together to managers. Applying the EVT example (from Example 5.1), it is clear
that revenue, the normalised (or underlying) PBIT and EBITDA are the key financial performance
measures that are used to manage the performance of the CEO and senior executives. Non-
financial data, particularly the average room rate, occupancy rate and revenue per average
available room (RevPAR), are key determinants of performance and are metrics used to compare
relative profitability in the accommodation industry.
All businesses have a finite capacity, whether it is a production line, a hotel, airline or retail store.
To better manage performance, managers need to be able to identify and improve their capacity
utilisation, which will reduce the fixed cost per unit of product sold or service supplied.
Performance measures will also reflect differences between the business segments. For example,
the entertainment division of EVT will have quite different performance measures compared with
the hospitality division. While seasonality may be less important for cinemas (some increase is
possible during school holidays), it will be very important for hotels, and weather conditions in
particular will have a significant impact on EVT’s Thredbo Alpine Resort. While holiday locations
will influence some hotel performance, CBD hotels may be influenced more by Monday to Friday
business travel and whether business confidence is rising or falling, as well as by capital city
sports and entertainment events.
Of course, hotels do not simply generate revenue from hotel bookings, but from ancillary
services, including restaurants and bars, laundry services and room service. One of EVT’s
strategies is to increase customer spend in its hotels. Performance measures will need to
cascade down (see later in this module) to lower levels of the organisation to be able to
manage performance—for example, restaurant utilisation. At the corporate level, EVT must
also focus on growth through its pipeline of new hotel management agreements and freehold
acquisitions, given its strategy to deliver growth via increased room inventory in key destinations
(discussed previously).
MODULE 5
Some people believe that performance must be ‘measurable’ to be useful. But not everything
that is important can be objectively measured. Qantas has long held a reputation for safety.
However, safety incidents do occur. For example, in April 2017, 15 people were injured when a
Qantas 747 flying from Melbourne to Hong Kong had a ‘stick shaker incident in which the pilots
experienced ‘airframe buffeting’ at an altitude of 22 000 feet. The ‘stick shaker’ is a warning
system that causes the aircraft’s control stick to vibrate, alerting pilots they may be about to
stall. Stalling occurs when the wings stop creating enough lift to hold the aircraft in the sky.
The Australian Transport Safety Bureau, the airline safety watchdog, was treating it as a ‘serious
incident’, meaning there were indications that an accident causing loss of life or aircraft damage
nearly occurred (Hatch 2017).
Example 5.2 illustrates how airline safety ratings are independently assessed as a means of
informing travellers about the possible risks involved in travel, a critical area of importance for
passengers and airlines alike.
394 | PERFORMANCE MANAGEMENT
Various safety rankings of airlines around the world exist. The Jet Airliner Crash Data Evaluation Center,
or JACDEC (JACDEC 2017), calculates its safety index and annual rankings based on accidents and
serious incidents (including near-miss accidents) affecting aircraft over the last 30 years. The safety
index relates the number of accidents to revenue passenger kilometres.
The safety index is a good example of a performance indicator rather than a performance
measure because there is no objective way of measuring Qantas’s actual safety or its reputation
for safety. Any trend in passenger numbers or results of surveys of customers may indicate a
reputational effect, but could equally be a consequence of other factors, including economic
conditions, cost, service or comfort. So Qantas’s performance in terms of safety or reputation
is difficult, if not impossible, to objectively measure. But it remains an important element
of performance.
Similar difficulties exist with attempts to measure brand image, customer satisfaction or
employee morale, where surveys, a common method of evaluating performance in relation
to these issues, may provide limited, ambiguous or even biased information.
One development to improve the measurability of customer satisfaction is the Net Promoter
Score (NPS). NPS was developed by Bain & Company to measure the loyalty that exists between
an organisation providing goods or services (the provider) and a consumer. The focus of the score
is the question: ‘How likely is it that you would recommend our company/product/service to a
friend or colleague?’ Responses range from customers being complete detractors of the provider
to complete promoters of the provider. The measure has been adopted by many Australian
companies, including Qantas, where it features as a performance measure in its 2017 annual
report. The NPS measures the percentage of promoters minus the percentage of detractors.
Promoters are the loyal, enthusiastic customers who love doing business with the organisation.
For an example, see the Australia Post 2017 Annual Report where the company emphasised its
overall +1.4 point improvement in the NPS score, available at https://auspost.com.au/content/dam/
auspost_corp/media/documents/Annual-Report-2017.pdf?fm=search-organic.
that the NPS results of the four major Australian banks and AMP will suffer from the significant
criticism it faced during 2018 at the Royal Commission into Misconduct in the Banking,
Superannuation and Financial Services Industry.
In the public sector, where the primary focus is not on financial results, organisations also
communicate the success of their activities by reporting on their performance through a range
of non-financial measures, as shown in Example 5.3.
Study guide | 395
Performance is reported against the objectives, objective indicators and outputs agreed by the Chief
Commissioner with the Government for 2016–17 in Victorian Budget Paper Number 3: Service Delivery
(Budget Paper Number 3).
The annual report identifies many performance measures, targets and actual results. Some of these are:
• based on quantity—for example, number of calls for assistance, number of offences recorded
• quality—for example, proportion of the public that has confidence in police, proportion of drivers
tested for alcohol who comply with limits
• time-based—for example, proportion of crimes resolved within 30 days.
Financial performance compared with budget is also reported, as are statistics on work health and
safety (WHS).
An interesting aspect of police performance is that the management of that performance can be difficult
to influence by the police agency alone. The use of the term ‘indicators’ rather than ‘measures’ in
the annual report is important, as no police agency has the ability to control behaviours of the public
and outcomes, although each has an important role to play in conjunction with other agencies in the
criminal justice system—for example, prosecution authorities, courts, prisons and probation services.
In addition, many factors affecting police performance are heavily influenced by social factors such
as mental health, unemployment and education.
Like other public services, care must be exercised in the extent to which agencies are held accountable
for aspects of performance over which they may have little or no control.
Note: Example 5.3 is CPA Australia’s analysis of the performance indicators in the Victoria Police
MODULE 5
Annual Report 2016–2017 and is illustrative for educational purposes only. It does not represent the
official position of Victoria Police.
Source: Based on Victoria Police 2017, Annual Report 2016–2017, accessed May 2018,
http://www.police.vic.gov.au/content.asp?a=internetBridgingPage&Media_ID=132934.
Appendix 5.1 explores the case of of Achmea Holdings N.V., the largest insurance provider in the
Netherlands, which has been operating since 1811. This is an interesting case because Achmea is
a ‘mutual’—that is, an entity not listed on a stock exchange but whose customers are, indirectly,
its owners. Appendix 5.1 is included because it provides an example of many of the concepts
included in this Study guide, including performance measures, strategy maps and sustainability.
Note: The concepts covered in this appendix (not the specific details of the case) are examinable.
396 | PERFORMANCE MANAGEMENT
A value creation process in production may involve turning wood into paper and paper into a
printed book. A value creation process in services may be using knowledge and skill to construct
a contract between two parties that will enable them to carry on business together. Value creation
may also take place through improved efficiencies—for example, reducing the distance travelled
in making a delivery or the time taken to carry out a service.
Performance management can therefore be seen in terms of the value creation process.
Porter’s (1985) ‘value chain’ (as discussed in Module 1) shows the primary and support activities
that add value to a customer, and the margin that can be achieved as the difference between
the cost of providing those value-adding activities and the price the customer is willing to pay.
So the value added for which the customer is willing to pay must exceed the cost of performing
the activities that lead to the added value; otherwise, the activities should be eliminated.
Performance management should focus on the margin in value chain activities.
This idea of value creation is particularly important when considering for-profit organisations
whose purpose is to increase shareholder value. Shareholder value can be increased through a
combination of dividends and capital gains over time.
There are many ways value creation can be achieved. One is through technological innovation
that leads to products that customers want, as Example 5.4 demonstrates.
MODULE 5
Apple’s 10-K annual report for 2017 describes its business strategy as designing and developing
operating systems, hardware and software to solve customer needs. It achieves this through a continual
high-level investment in research and development. In addition to advertising and promotion,
Apple’s in-store salesforce provides a high level of advice to customers to attract and retain customers.
Apple operates its own retail stores but also has space and sales staff within retail stores (e.g. within
JB Hi-Fi in Australia).
Study guide | 397
Given its strategy for value-adding, Apple would be expected to measure and manage the following
aspects of its performance:
• customer satisfaction
• customer retention
• salesperson knowledge
• growth in retail locations
• growth in third-party distributors
• research and development investment.
However, value creation does not need to come only from innovation. It can also come from
more conventional businesses, as Example 5.5 demonstrates.
Woolworths is best known for its supermarket chain, its Big W department stores and its partnership
with Caltex in fuel retailing, but it also owns liquor retailers Dan Murphy and BWS, and the ALH leisure
and hospitality group, which owns restaurants, hotels and gaming venues. Woolworths’ strategy for
value creation has been to diversify from supermarkets into related retail fields and to expand its range
of stores geographically (including online shopping).
Because of the tightly held market share of Woolworths and its competitors, a key strategy is to
increase spending by existing customers. Woolworths has consequently expanded its product range,
introducing its own-brand products, from the less expensive to the more expensive Woolworths ‘Select’
brand. Woolworths’ supermarket advertising slogan, ‘The fresh food people’, has been successful
in creating value for the company, as has its ‘Everyday Rewards’ loyalty cards system (with nearly
8 million members in Australia) that is linked to Qantas Frequent Flyer points and reward points that
provide discounts on fuel purchases. One of Woolworths’ strategies is to use the large amount of data
gathered on customer buying habits that is available to it through the ‘Everyday Rewards’ card. It uses
this example of ‘big data’ (see Module 2) to target customers with specific promotional campaigns.
Woolworths is also expanding its multi-channel strategy, including online and social networking
channels. Woolworths has also expanded to New Zealand.
In its 2017 Annual Report, Woolworths identified various performance measures linked to its short-term
incentive plan (STIP) and long-term incentive plan (LTIP), which are part of the audited remuneration
report within the annual report.
Woolworths changed its STIP during the 2016–17 year by setting targets at each level of the business MODULE 5
to ensure that all team members ‘from top executives to store managers, were aligned to a common
effort but were rewarded for their achievement of business results largely within their own control’
(Woolworths Group 2017, p. 34). Five STIP measures are each equally weighted (i.e. 20% each): sales,
EBIT, working capital, customer satisfaction and safety. LTIP measures are relative total shareholder
return (TSR), sales per trading square metre and return on funds employed—each weighted at
33 per cent (Woolworths Group 2017, p. 38).
STIP and LTIP are regular features of listed company annual reports and are used by companies to link
the performance of the business to the remuneration of directors and senior executives. By focusing
on measuring, managing and rewarding performance in areas like working capital management,
customer satisfaction and employee safety, managerial behaviour is changed in ways consistent with
the company’s strategy. In the longer term, this changed short-term behaviour is more likely to lead to
the key financial performance areas of increased shareholder value (i.e. TSR), return on funds employed,
and probably the most common measure of retail efficiency, sales per square metre (which measures
the effective utilisation of the most expensive retail resource: i.e. rent).
398 | PERFORMANCE MANAGEMENT
➤➤Question 5.2
Please access the Annual Report 2017 of JB Hi-Fi (an Australian consumer electronics and
entertainment retailer), available online at: https://www.jbhifi.com.au/General/Corporate/
Shareholder-Matters/Financial-Annual-Reports/.
Select ‘Annual Report – 2017 – with Chairman’s & CEO’s Report’ from the list.
(a) Who in the company is responsible for shareholder value creation?
(c) What performance measures does JB Hi-Fi use to measure the success of its shareholder
value creation activities?
MODULE 5
Check your work against the suggested answer at the end of the module.
The key issue for performance management is to understand the organisation’s strategy for value
creation and to measure the success of its value creation activities. As Example 5.5 illustrates,
value creation can be viewed from the shareholder financial perspective, or from a more internal,
operational perspective, although the two are clearly interrelated.
Study guide | 399
The idea of value creation over time is important, because measuring value creation should not
be seen solely in terms of short-term gains such as current year profits or customer satisfaction in
a single survey. This highlights the importance of sustainable performance.
➤➤Question 5.3
Mega Markets Ltd (Mega Markets) is an ASX-listed chain of retail stores with branches in all the
major shopping centres in Australia. Mega Markets sells clothing, homewares and toys. Much of
Mega Markets’ product range is sourced from South-East Asia, enabling it to offer low prices for
a wide range of products. Over many years Mega Markets has become a popular department
store for families on a budget with young children.
However, over the past two years, Mega Markets has faced a flattening of sales. Mega Markets
has faced out-of-stock situations where customers have asked for a particular style/colour/
size combination that is not always available in every store. Market research has revealed that
customers are increasingly going online to source similar products from an overseas competitor
at even lower prices than Mega Markets can offer. The purchased goods are posted to their
home address from a large warehouse in South-East Asia.
Mega Markets has complained in the press that this competition is unfair because the overseas
suppliers do not have the high rental costs charged by the large shopping centre owners, nor the
high wages and on-costs that Australian retailers have to pay.
The sales director of Mega Markets said:
Our customers can go to our competitor online, choose the product they want, in the
colour they like, in any size, and have it delivered to their home within a week, all at a
price that is typically 10 to 20 per cent lower than our retail store prices and customers
can return or exchange their products if they are dissatisfied. No wonder our sales
are suffering.
Mega Markets has suffered from a deteriorating financial position as a consequence of its flat
sales, tighter margins and increased overhead costs. The company now faces considerable
pressure from investment analysts and institutional investors to improve its sales and earnings.
The board of Mega Markets has put pressure on senior management to develop strategies to
overcome competition from online sales.
(a) Explain the value creation process for Mega Markets.
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(b) Why is its value creation process now facing competition from online sales?
400 | PERFORMANCE MANAGEMENT
Check your work against the suggested answer at the end of the module.
Performance Longer-term
achieved in one perspective (e.g.
year, which cannot avoiding over-fishing,
be achieved in the deforestation, global
following year, is not oil supplies pollution,
sustainable carbon emissions and
waste disposal)
Most companies listed on ASX now produce a CSR or sustainability report in which they
address issues, including sustainability and pollution reduction, and often include performance
measures of their effectiveness. This is the so-called ‘triple bottom line’ reporting of economic,
environmental and social performance.
Sustainability reporting tends to be distinct from other elements of (mainly financial) reporting
and is often addressed in a supplementary statement, rather than being integrated with financial
reports or other elements in the annual report. Integrated reporting, which was introduced
in Module 2 and is discussed later in this module, is aimed at providing a wider range of
stakeholders with reports that integrate the various dimensions of performance, including
financial and sustainability performance. While some stakeholders (including ethical investors)
are interested in sustainability reporting, others have little or no interest. Boards of directors often
see their responsibility, as it is prescribed in the Corporations Act (for Australian companies),
to the company and its shareholders, not to broader stakeholder groups. Hence, short-term
financial motives often drive out longer-term aspirations for sustainability. The problem is how to
convert the long-term benefits of sustainability into current period measures of performance and
how to balance these long-term needs with the current financial need to satisfy shareholders.
Consequently, performance measures for financial issues and sustainability issues do not always
gain the same exposure and are not always accorded similar importance in annual reports,
despite the importance of sustainability in both its meanings. However, reputational issues
have increased the importance not just of reporting sustainability performance, but of actually
engaging in sustainable practices. Importantly, many organisations now see engaging in
sustainable practices as necessary for long-term shareholder value and sustainability reporting
as a means for enhancing their reputation.
Increasingly, some investors and some customers expect businesses to be more socially and
environmentally responsible. Brand image can be tarnished by companies that use, for example,
child labour in developing countries, or source products from factories that have a poor health
and safety record for workers. Some customers are even willing to pay a premium price for more
ethically sourced products such as clothing and coffee.
Further detail on CSR is presented in the Ethics and Governance subject of the CPA Program.
Returning to Appendix 5.1, we see that Achmea reports its performance against both financial
and environmental criteria. Achmea recognises that its success comes from satisfying customers,
yet it must operate in a sustainable way in order to balance financial, social and environmental
responsibilities.
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While one can be cynical and consider that companies engage in sustainability reporting for
purely reputational reasons, there can be sound business reasons for engaging in sustainable
practices as long-term value creation opportunities can be affected. The mining industry is a
good example, as shown in Example 5.6.
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In addition to its strategy to deliver long-term growth in shareholder value, Newcrest’s annual
report discloses that Newcrest recognises the importance of sustainability in its broadest meaning.
The opening paragraph of its Chairman’s report begins with the importance of the health and safety
of its employees. Its key performance measures for 2017 are safety, earnings, costs per ounce and free
cash flow, each with a 25 per cent weighting (Newcrest Mining Limited 2017a, p. 81).
Like many businesses that recognise that a focus on sustainability is not only morally and ethically
appropriate but is also necessary for sustained financial performance, Newcrest produces a separate
sustainability report in accordance with the Global Reporting Initiative (GRI) (discussed later in this module).
The Sustainability Report identifies Newcrest’s newly developed sustainability objectives to:
have a safe, healthy and diverse workforce; reduce, reuse and recycle resources responsibly
to minimise environmental impact; and, work with local communities and other stakeholders,
to achieve our vision as Miner of Choice (Newcrest Mining Limited 2017b, p. 8).
The report contains substantial information about People (safety), Economic, Social and Environmental
performance and includes 14 pages of data covering these aspects of performance (Newcrest Mining
Limited 2017b, pp. 87–100).
The GRI G4 content index is also available at the same website and identifies where data can be found
to match the GRI G4 reporting requirements.
The Newcrest example suggests that companies do consider environmental issues in their
strategy. GRI G4 Guidelines address the need to adopt a more holistic approach to reporting
performance.
The consolidated PDF of GRI Standards includes the three universal standards—GRI 101, 102 and
103—and the three series of topic-specific standards:
1. 200 (Economic topics)
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The GRI argues that ‘sustainability reporting helps organisations to set goals, measure
performance, and manage change in order to make their operations more sustainable.
A sustainability report conveys disclosures on an organisation’s impacts—be they positive or
negative—on the environment, society and the economy’ (GRI 2014, p. 3). GRI sustainability
reports under the GRI Standards include the disclosure of the governance approach and the
environmental, social and economic performance and effects of organisations. Importantly,
the economic dimension of sustainability concerns the effects of the organisation’s activities
on the economic conditions of its stakeholders and on economic systems at local, national and
global levels, rather than on the financial condition of the organisation.
Study guide | 403
Not all of these have to be disclosed, only those where the organisation deems them to be
material. Note that in Example 5.6, Newcrest produced a separate GRI G4 content index that
links to where the data in the G4 can be found in the annual report or sustainability report.
Successful companies in the future will need an integrated strategy to achieve strong financial
results and create lasting value for the company, its stakeholders and society. The value created
by companies in the future cannot be expressed by isolated financial and sustainability reports,
with no clear links between the ‘single bottom line’ and the sustainability impacts caused or the
value created in order to generate its financial results. Consequently, the GRI co-founded the
International Integrated Reporting Council (IIRC) because it believed the future of corporate
reporting is the integration of financial and sustainability strategy and reporting. ‘Understanding
the links between financial results and sustainability impacts is critical for business managers,
and is increasingly connected to long- and short-term business success’ (GRI 2012).
The move towards integrated reporting has important implications for accountants in terms
of performance information.
Integrated reporting
The International Integrated Reporting (IR) Framework document (‘the Framework’) was issued
by the IIRC in 2013. In relation to performance management:
The Framework takes a principles-based approach … It does not prescribe specific key
performance indicators, measurement methods, or the disclosure of individual matters, but does
include a small number of requirements that are to be applied before an integrated report can be
said to be in accordance with the Framework (IIRC 2013, p. 4).
The Framework refers to a collection of ‘capitals’. ‘The capitals are stocks of value that are
increased, decreased or transformed through the activities and outputs’ (IIRC 2013, para. 2.11)
of the organisation:
• financial capital (funds for use in the business)
• manufactured capital (machines)
• natural capital (air, water and land)
• human capital (skill, experience and motivation)
• intellectual capital (the intangibles)
• social and relationship capital (community stakeholders).
The ability of an organisation to create value for itself enables financial returns to shareholders.
This is interrelated with the value the organisation creates for stakeholders and society at large
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through the resources and relationships that are used by, and affected by, an organisation.
While the initial focus of the IIRC is on reporting by larger companies and on the needs of
their investors, it may have important implications for organisations and accountants in the
longer term.
There are important links between integrated reporting and the GRI.
GRI is supportive of integrated reporting as it develops as an important and necessary innovation
of corporate reporting.
GRI advocates for the inclusion of robust sustainability metrics (based on a multi-stakeholder
approach) to integrated reporting, in support of its overall vision of a sustainable global economy
(GRI 2018).
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Integrated reporting provides companies with a broad perspective on risk, and GRI encourages
those that want to do integrated reporting to use the GRI Standards. United by the shared vision
that businesses should focus on value creation over the short, medium and longer term, GRI and
the International Integrated Reporting Council (IIRC) continue to work together, aligning the GRI
Standards and the International <IR> Framework to improve corporate reporting.
…
As the global standard setter for sustainability reporting, GRI is committed to supporting integrated
reporting – including through the Corporate Leadership Group on integrated reporting 2017 (CLGir)
… The CLGir 2017 is exploring how best to leverage the GRI Standards and the International <IR>
Framework for integrated thinking and reporting, with the aim of learning together and identifying
best practice guidance in reporting (GRI 2017).
CPA Australia believes that bringing together all the strands of corporate reporting will help
satisfy the growing demands of investors for information about performance beyond the
bottom line.
Integrated reporting is also discussed in the Advanced Audit and Assurance, Contemporary Business
Issues and Ethics and Governance subjects of the CPA Program.
XBRL
Integrated reporting takes advantage of new and emerging technologies such as eXtensible
Business Reporting Language (XBRL) to link information within the primary report and to facilitate
access to further detail online where that is appropriate.
XBRL (‘a language for the electronic communication of business and financial data’) is becoming
a standard means of communicating information between businesses and on the internet.
‘Instead of treating financial information as a block of text – as in a standard internet page or a
printed document – it provides [a unique, computer-readable] identifying tag for each individual
item of data’ (XBRL 2018) (e.g. net profit after tax). Computers can treat XBRL data intelligently.
They can recognise the information in an XBRL document, select it, analyse it, store it,
exchange it with other computers and present it automatically in a variety of ways for users.
XBRL is also discussed in the Advanced Audit and Assurance subject of the CPA Program.
Signalling
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While governance is concerned with conformance and performance, and with making value-
adding decisions, signalling is aimed at trying to influence someone else’s decisions. Signalling
occurs when a measure is used to communicate information (either a forward goal or an actual
achievement). One of the key roles of senior management is to communicate with stakeholder
groups. Financial statements, for example, are a signal, prepared by directors for shareholders,
about the performance of directors and managers in carrying out the operations of the
organisation (the statement of profit or loss and other comprehensive income) and in building
the assets of the organisation (the statement of financial position or balance sheet). The key
financial performance measures presented in financial reports include various measures of
profit, cash flows, assets and liabilities.
Most organisations choose to disclose other financial and non-financial measures to investors
and other stakeholders in their annual reports, in investor briefings and through other public
communications. However, organisations need to be careful as to how much information they
voluntarily disclose (as opposed to disclosing information that is required by law) because
competitors will be one of the groups looking for competitively sensitive information that may
help them.
Study guide | 405
As seen in Example 5.5, Woolworths disclosed limited non-financial information in its annual
report, at least in part because of the commercially sensitive information this would give to its
competitors. Interestingly, a comparison of annual reports over several years reveals that each
year Woolworths has disclosed less non-financial performance information, no doubt due to the
concern that this information could be advantageous to its main competitor Coles (while Coles,
a division of Wesfarmers, had no equivalent practice of disclosing this type of information).
Being given sufficient information to understand and assess investment risk is crucial to the
ability of investors to make informed investment decisions (ASX CGC 2014, p. 28). Signalling will
be insufficient unless investors understand the risks the company faces and the extent to which
future performance may be impacted by those risks. Boards recognise and manage risk through
establishing and reviewing the effectiveness of the company’s risk management framework,
and annual reports typically disclose the company’s approach to risk management as a form
of signalling to the company’s stakeholders. As has been shown in the preceding examples of
EVT, Woolworths, JB Hi-Fi and Newcrest, remuneration reports included in annual reports now
contain information about how performance is measured for remuneration of directors and
senior executives. These reports send an important signal to shareholders that the short-term
and long-term remuneration of directors and senior managers is inextricably linked to improving
shareholder value, as shown in Example 5.7.
The Basel Committee on Banking Supervision (BCBS) provides a global regulatory framework known
as Basel III. Basel III, among other things, has increased the required quality and quantity of capital
held by banks and introduced new standards for the management of liquidity risk.
Westpac’s annual report highlights risk management as a key area that needs to be addressed in order
for Westpac to achieve its vision, because risk management affects all aspects of Westpac’s business
and its stakeholders.
Westpac has an ‘Operational Risk Management Framework’ and ‘Compliance Management Framework’
it uses to manage risks, and also a ‘Sustainability Risk Management Framework’ it uses to assess and
manage CSR-related risks.
MODULE 5
Westpac’s annual report notes that the culture in the bank is that all staff are responsible for identifying
risk, managing risk and working according to Westpac’s nominated risk profile.
You can access the details of Westpac’s approach to risk management in its annual report, which is
available at: https://www.westpac.com.au/about-westpac/investor-centre/. Click on ‘2017 Annual
Report’ and navigate to p. 105.
Signalling does not just occur between the organisation and outside stakeholders. Managers in
large organisations often devote much time to competing for resources for their business unit,
project or team. The need to manage and improve performance can lead to claims by managers
for additional resources for their business units. Often, managers who can demonstrate success
in achieving their performance goals are more likely to be given increased access to resources in
the future.
Organisations need to ensure that the signals they send are accurate. Public relations and
marketing are important elements of communication, including investor relations, but a very
real risk is when an organisation puts too much faith in its own press releases rather than the
underlying reality of performance.
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At the time of writing, Australian financial institutions, including Westpac and other banks, were
facing considerable reputational and potentially financial risks arising from the Royal Commission
into Misconduct in the Banking, Superannuation and Financial Services Industry. Criticism of all
financial institutions has focused on their STI-driven profit focus possibly directing the behaviour
of some employees towards unethical practices. Time will tell what the consequences are of
the Royal Commission for banks and other financial institutions. From a signalling perspective,
the Royal Commission draws to our attention to the idea that we cannot rely on the statements
of any business without considering other relevant factors in the public domain.
A historical example, the HIH case (Example 5.8), illustrates the impact on a financial institution
of an earlier Royal Commission.
The ‘Royal Commission did not find fraud or embezzlement to be behind the collapse. HIH’s failure was
found to be ‘more the result of attempts to paper over the cracks caused by over-priced acquisitions
and too much corporate extravagance’ (Parliament of Australia 2003). There was a misconception in
the company that ample funds were available to fund these activities.
According to the Parliament of Australia (2003), ‘The primary reason for the failure was that adequate
provision had not been made for insurance claims. Past claims on policies had not been properly
priced. HIH was mismanaged in the area of its core business activity’.
The Royal Commission further found that ‘the acquisition of FAI Insurance Ltd in Australia, combined with
re-entry into the US market and the expansion of the UK operations’ (Parliament of Australia
2003), were poor commercial decisions. All were afflicted with under-provisioning for mandatory
claims reserves.
While HIH had a corporate governance model, the Royal Commission found that HIH had
failed to review the model to assess its suitability for changing circumstances in the insurance
industry. HIH’s audit committee focused almost exclusively on the financial statements,
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Alcock and Bicego (2003) wrote that the Royal Commissioner was:
… frustrated by what he described as the disinclination of HIH middle managers to accept
responsibility for undesirable practices. He identified the difficulties for the Royal Commission
in considering conduct where middle managers had taken steps that resulted in the falsification
of the corporation’s accounts or returns lodged with statutory authorities. In some instances,
he observed … someone prepared a report knowing it to be false but did not sign it. The more
senior officer who then signed the document would assert as ‘reasonable’ his or her reliance
on the more junior employee who prepared the report, to argue that the senior officer’s
conduct did not constitute a breach of the law (Alcock & Bicego 2003).
Study guide | 407
HIH is a clear example of the failure of corporate governance, and the failure to provide
appropriate signalling to investors. It is also a clear case of the failure of management controls
and risk management, especially in relation to provisions for insurance claims and acquisitions.
The performance of HIH was misinterpreted, through a combination of a lack of competence
and poor ethical practices.
Corporate failures are a feature of all capitalist economies. In Australia there have been many
failures before and after HIH (see Example 5.9 for a more recent case), but there have been no
corporate failures since HIH that approach its magnitude.
The role of regulatory bodies and auditors always comes under scrutiny following large-scale and
high-profile corporate collapses. This is likely to happen as a result of the Royal Commission into
Misconduct in the Banking, Superannuation and Financial Services Industry in which questions
about corporate governance and organisational culture have (at the time of writing in 2018)
already been raised.
The report to creditors by administrators McGrath Nicol identified the reasons for the failure:
Although DSG reported profits, its growth required considerable financial commitment,
during a period where DSG was losing market share. The competitive electronics environment
resulted in tightening credit terms, the need for major inventory impairment, and significant
cash pressure in late FY16. Increased borrowings and new finance facilities were required and
ultimately DSG could not operate within the terms of those facilities (McGrath Nicol 2016, p. 10).
The administrators believed that DSG failed because of its high cost base due to its large network of
stores, a loss of market share in a highly competitive market, an expansion plan requiring considerable
financial resources and purchase of inventory that was not justified by consumer demand. Ultimately,
its cash flows were unable to satisfy the covenants it had made with bank lenders.
Banks were paid a proportion of their secured debt but unsecured creditors and shareholders received
nothing. The total shortfall to creditors was about $260 million (McGrath Nicol 2016).
MODULE 5
The example of Dick Smith, like HIH, shows the importance of sound risk management as part
of governance processes. It also reveals that signalling risk factors to investors is not always as
clear as it should be. The suppliers, lenders and customers of Dick Smith are not likely to have
understood the risk of rapid expansion, competition and increases in inventory holdings.
Company annual reports require extensive disclosure of risk management information, but rely on
the due diligence of investors. Unfortunately, many small investors do not sufficiently understand
the nature of risk in their investments and perhaps take too much comfort from audit reports and
bank lending (which is typically secured).
While signalling is an important element of understanding performance and the risks associated
with performance, the examples of corporate failure here perhaps reveal:
• failures in risk management at board level
• failures of adequate regulatory body oversight
• a lack of understanding of risks of investment by investors.
Further detail on governance is presented in the Ethics and Governance subject of the CPA Program.
408 | PERFORMANCE MANAGEMENT
The context in which the accountant operates is dictated by the organisation’s approach to
governance and risk management and how these are connected to performance management.
The ASX Corporate Governance Council has produced corporate governance guidelines
for Australian listed entities in the third edition of its Corporate Governance Principles and
Recommendations (effective from July 2014). Corporate governance is defined in this publication
as ‘the framework of rules, relationships, systems and processes within and by which authority
is exercised and controlled within corporations. It encompasses the mechanisms by which
companies, and those in control, are held to account’. Further, it defines good corporate
governance as promoting ‘investor confidence, which is crucial to the ability of entities listed
on the ASX to compete for capital’ (ASX 2014, p. 3).
It is interesting to note that the ASX guidelines have taken the definition of corporate
governance from Justice Owen in the Report of the Royal Commission into HIH Insurance,
volume 1: ‘The failure of HIH Insurance: A corporate collapse and its lessons’ (HIH Royal
Commission 2003, p. xxxiv). HIH focused the minds of regulators and boards of directors on
their roles and responsibilities, much of which is now reflected in the ASX publication.
There are eight general principles in the ASX Corporate Governance Principles and
Recommendations, which also contains 29 recommendations to give effect to the principles.
Listed Australian entities are required to make disclosure in their annual reports regarding
the extent to which they do or do not follow the principles and recommendations.
You can access the Corporate Governance Principles and Recommendations at: http://www.asx.com.
MODULE 5
au/documents/asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf.
Conformance takes place through assurance (including audit), ensuring that the organisation
understands and is managing its risks effectively. While conformance is an essential aspect
of corporate governance, it needs to be balanced with performance.
Performance is the need to take risks to achieve objectives, and to do this, risk management
needs to be integrated with decision-making at each organisational level. Performance focuses
on strategy, resource utilisation and value creation, helping the board to make strategic decisions,
understand its appetite for risk and the key performance drivers [in order to achieve shareholder
value] (Collier 2009, p. 21).
The board’s role is to set objectives, monitor performance in terms of achieving those objectives
and report to shareholders on how well the organisation has performed. Risk management,
in this context, is managing the risks of achieving—or not achieving—those organisational
objectives. In a positive sense, the risk–return trade-off is that risks need to be taken in order to
take advantage of opportunities for the organisation. In its negative sense, the risk is that those
objectives will not be achieved. Management controls are put in place to help manage both
kinds of risk. Boards will often delegate some of their role to a finance committee (to monitor
financial performance), to an audit committee (to monitor the effectiveness of controls) and to
a risk committee (to oversee the risk management process), although in practice some of these
committees may be combined. These different approaches are recognised in the ASX Corporate
Governance Principles and Recommendations (2014).
One of the key roles of the board in determining strategy is to articulate the risk–return trade-
off and the organisation’s risk appetite. There is, generally speaking, a relationship between
risk and return such that a higher return is expected when there is a higher risk, and a lower
return accepted where the risk is lower. To guide management plans and decisions, boards
need to be clear about whether the organisation’s strategy is risk averse, risk neutral or risk
seeking, and make explicit the expected returns for risk-taking (e.g. minimum payback periods,
internal rates of return, hurdle rates).
COSO updated the framework in 2017 as Enterprise Risk Management—Integrating with Strategy
and Performance, which highlights the importance of considering risk in both the strategy-setting
process and in driving performance. The updated framework gives explicit focus to performance.
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The framework ‘Enhances alignment between performance and enterprise risk management to
improve the setting of performance targets and understanding the impact of risk on performance’
(COSO 2017, p. iii). It further states that:
Enterprise risk management allows organizations to anticipate the risks that would affect
performance and enable them to put in place the actions needed to minimize disruption and
maximize opportunity (COSO 2017, p. 4).
The International Standards Organization also produced an updated risk management standard
in 2018: ISO 31000:2018 Risk management—Guidelines, which provides principles, a framework
and a common process for managing risk of any type. It can be used by any organisation
regardless of its size, activity or sector. The new standard is an update of AS/NZS ISO 31000:2009
Risk Management—Principles and Guidelines, the Australian-developed international standard for
risk management. Risk is now defined as the ‘effect of uncertainty on objectives’, which focuses
on the effect of incomplete knowledge of events or circumstances on an organisation’s decision-
making (Tranchard 2018).
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A brief summary of the new standard (which is only available to purchase from ISO) is at:
https://www.iso.org/obp/ui#iso:std:iso:31000:ed-2:v1:en.
Management controls
Performance measures
(financial, non-financial; Enterprise risk management
and targets
quantitative, qualitative)
Feedback
Organisational outcomes
➤➤Question 5.4
Consider the role of risk management and performance management in your organisation. If your
organisation produces a publicly available annual report, do a word search on ‘risk management’,
‘performance’ or ‘KPIs’. If you work for a smaller organisation, you may be able to ask the CEO
or chief financial officer (CFO) how they view the relationship between risk management and
performance management.
How does risk management relate to performance management?
Check your work against the suggested answer at the end of the module.
MODULE 5
the APESB had issued an Exposure Draft 02/18 outlining the proposed changes to APES 110,
with a proposed effective date of 1 January 2020). The Code applies to members in business as
well as members in public practice.
A CPA member’s responsibility is not exclusively to satisfy the needs of an individual client
or employer, as the accountancy profession also has a responsibility to act in the public
interest. The Code establishes a conceptual framework that requires CPA members to identify,
evaluate and address threats to compliance with the fundamental principles. The conceptual
framework approach assists a member in complying with the ethical requirements of the
code and meeting their responsibility to act in the public interest.
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The circumstances in which members operate may create specific threats to compliance with
the fundamental principles.
Threats to compliance with the fundamental principles might be created by a broad range of facts
and circumstances. It is not possible to define every situation that creates threats. In addition,
the nature of engagements and work assignments might differ and, consequently, different types
of threats might be created (s. 120.6 A2).
Threats to compliance with the fundamental principles fall into one or more of the following
categories:
(a) Self-interest threat—the threat that a financial or other interest will inappropriately influence a
professional accountant’s judgment or behavior;
(b) Self-review threat—the threat that a professional accountant will not appropriately evaluate the
results of a previous judgment made; or an activity performed by the accountant, or by another
individual within the accountant’s firm or employing organization, on which the accountant will
rely when forming a judgment as part of performing a current activity;
(c) Advocacy threat—the threat that a professional accountant will promote a client’s or employing
organization’s position to the point that the accountant’s objectivity is compromised;
(d) Familiarity threat—the threat that due to a long or close relationship with a client or employing
organization, a professional accountant will be too sympathetic to their interests or too
accepting of their work; and
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(e) Intimidation threat—the threat that a professional accountant will be deterred from acting
objectively because of actual or perceived pressures, including attempts to exercise undue
influence over the professional accountant (s. 120.6 A3).
Where an ethical conflict exists, a CPA member should determine the appropriate course of
action that is consistent with the fundamental principles in the Code. CPAs should also weigh
the consequences of each possible course of action. If the matter remains unresolved, a CPA
member should consult with other appropriate persons within the employing organisation—
particularly the board—for help in obtaining a resolution. A CPA member should also consider
obtaining legal advice to determine whether there is a requirement to report the matter to an
appropriate authority.
If after exhausting all feasible options, the professional accountant determines that appropriate
action has not been taken and there is reason to believe that the information is still misleading,
the accountant shall refuse to be or to remain associated with the information (IESBA Code,
s. R220.9).
In such circumstances, it might be appropriate for a professional accountant to resign from the
employing organization (IESBA Code, s. 220.9 A1).
Study guide | 413
Ethics has a great deal of relevance to those responsible for performance management,
whether this is reporting performance in an organisation in which an accountant is employed
or reporting performance to a client. Accountants may feel under pressure to manipulate
or report performance information as a result of any of the threats identified in the Code
(some of these behaviours are described in Example 5.10).
It also highlighted the employment of staff by Enron who had previously worked for their auditors,
the process of audit appointments and reappointments, the rotation of audit partners, and how
auditors are monitored and regulated.
Before the Big 4 accounting firms, there was a ‘Big 5’, one of which was Arthur Andersen. The firm was
found guilty of criminal charges in relation to the audit of Enron and its actions in relation to disguising
Enron’s off-balance sheet transactions, with the firm having instructed its employees to destroy
documents pursuant to its document retention policy. As a result, the firm surrendered its licence to
practise as accountants in the United States. While the criminal verdict was subsequently overturned
by the US Supreme Court on the basis that the jury was misdirected as to the law, the damage to
Arthur Andersen’s reputation was substantial and the firm ceased to exist, with other accounting firms
taking over its client business.
WorldCom’s and Enron’s focus on performance was almost exclusively financial, oriented on short-term MODULE 5
profits and share prices. This focus was supported by bonuses and share options to reward executives
for short-term profits that resulted in a culture under which ethical principles were largely ignored.
The focus on short-term financial performance obscured more fundamental non-financial measures
that might have provided signalling to those outside the companies that something was wrong.
The examples of HIH in Australia and WorldCom and Enron in the United States highlight the role
of accountants in measuring and reporting performance with integrity, objectivity, competence
and due care. Not only is a failure to do so a breach of professional ethics but it can lead to
criminal penalties (there is often a fine line between a breach of ethics and a breach of the law).
In addition, the practice of auditing was permanently affected by these cases. In particular,
audit firms are required to demonstrate independence and clearly separate their audit and
non‑audit—for example, consulting—services.
Further detail on ethics is presented in the Ethics and Governance subject of the CPA Program.
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Control systems and performance management are used by principals to monitor the actions
of their agents. The principals delegate authority to agents, but the agents may act in their own
self-interest rather than in the interests of the principals.
A simple example of the agency problem is when selling a property. The real estate agent is the
agent of the seller and is expected to obtain the highest price for the property in an open market
in return for a commission—typically a percentage of the selling price. But the reward for the
agent in obtaining an additional amount—say $5000—on the sale price may not warrant the extra
effort, so they may recommend to their principal a lower, but easier to obtain, sale price.
Similarly, managers may award themselves high levels of remuneration, without exercising
enough effort. To overcome this potential problem, the ‘sharing rule’ rewards the agent for
performance that benefits the principal. So managers will typically receive at least some of their
remuneration through, for example, profit-related bonuses and share options. For example,
as discussed previously, director and senior executive remuneration is linked to performance
management through STIP and LTIP as disclosed in the remuneration reports within
annual reports.
Agents may avoid their responsibilities, as principals can never really be sure whether reported
performance is the result of the agent’s own efforts or of business conditions generally. One of
the criticisms of executives that emerged from the Global Financial Crisis (GFC) of 2007–08 (see
Example 5.21) was the level of remuneration paid to executives, even when market conditions in
many industries collapsed. The same concern has been raised at hearings of the Royal Commission
into Misconduct in the Banking, Superannuation and Financial Services Industry in relation to the
payment of senior executives of banks that may have led to unethical practices with customers.
Agents may also be tempted to disguise true performance levels to inflate their remuneration
packages and their reputations as managers. Financial reporting to shareholders is one
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way principals can hold agents accountable for their performance. However, the notion of
‘information asymmetry’ is that agents have far greater access to performance information than
do principals. This means managers always have access to detailed management accounting
information, including non-financial performance reports, that are unseen by shareholders.
Being aware of potential problems in the agency relationship is important in understanding the
role of accountants in performance management.
Further detail on agency theory is presented in the Ethics and Governance subject of the CPA Program.
Contingency theory
Another theory that is relevant to performance management and the role of the accountant is
contingency theory, which states that there is no universal best way to measure performance.
Each organisation needs to develop an appropriate performance management system that is
relevant to its needs. This theory suggests that the performance management system used by
an organisation will depend to a large extent on such factors as the size of the organisation,
its environment and its technology.
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Table 5.2 provides a hypothetical example of the performance measures that may be used by two
businesses in the retail food industry. The technology and systems in place for a large multi-store
retail chain and a small local shop reflect the contingency theory approach.
Table 5.2: C
omparison of control systems and performance measures for large
and small food retailers
In-store barcode scanner and integrated cash Simple cash register and separate EFTPOS facility
register and electronic funds transfer at point of
sale (EFTPOS)
Time to scan customer’s shopping basket—per Waiting time for customer—approximation based
item scanned on observation
Gross margin per day—point of sale (POS) scans Periodic physical stocktake verifies margin
barcode and calculates margin
Stock reordering—POS scans barcode and updates Owner/manager orders stock by physical
inventory, identifying when to order and may observation and manual reordering
automatically place order on suppliers
Number of stores and locations based on Single site—location based on rental cost
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demographics and competition
➤➤Question 5.5
Barbara Smith (CPA) works as the CFO of a privately owned company with annual sales of
$10 million. Kevin Jones, the CEO, is the main shareholder, who also acts as chair of the board.
The only other directors are you and Kevin’s wife.
After producing the draft end-of-year financial statements, Barbara discusses the results with
Kevin. His response is that the profit of $250 000 is too high and the tax bill the company will
have to pay will prevent the company from repaying its bank loan in the following financial year.
As the company does not keep a perpetual inventory system but relies on standard costs of goods
sold (COGSs) and periodic stocktakes, Kevin suggests to Barbara that the year-end stocktake
figure be reduced in order to reduce the taxable profit to around $150 000.
Barbara responds that such a practice is illegal. Kevin’s reply is that the inventory level at year
end was close to $1 million, so any adjustment could be readily disguised. Over Barbara’s further
objections, Kevin demands that Barbara adjusts the inventory downwards by $100 000 and that if
she is not prepared to make the adjustment, then she might as well resign from the company today.
(a) Discuss the implications of Kevin’s demand in relation to the following:
(i) Governance
(ii) Signalling
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Study guide | 417
(iii) Ethics
Check your work against the suggested answer at the end of the module.
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418 | PERFORMANCE MANAGEMENT
Strategy must be implemented after it is formulated, and it is here that performance management
is important. Ansoff (1988) established a hierarchy of objectives that were centred on performance
measures such as return on investment. Similarly, Galbraith and Nathanson (1976, p. 10) argued
that ‘variation in strategy should be matched with variation in processes and systems as well as
in structure, in order for organisations to implement strategies successfully’. These variations in
processes and systems would include variations in performance management.
As discussed in Module 1, various approaches to strategy have been developed by Michael Porter.
Porter (1980) developed his five forces model for analysing an industry’s strategic environment:
1. the threat of new entrants to the market
2. the threat of substitutes
3. the bargaining power of customers
4. the bargaining power of suppliers
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Porter (1980) also identified three ‘generic strategies’ for competitive advantage:
1. cost leadership
2. differentiation
3. focus.
All strategies should contain goals and organisations need to introduce a system of performance
management comprising processes for measuring, monitoring, reporting and improving
performance to ensure that goals and strategies are achieved. Different strategies require
different approaches to performance management. For example, an organisation facing
substantial industry competition may measure market share (e.g. the motor vehicle sales and
retail supermarkets industries). An organisation facing substantial bargaining power by customers
may measure customer profitability (e.g. clothing manufacturers selling to department stores
such as Myer and David Jones in Australia). Similarly, if an organisation adopts a cost leadership
strategy, we would expect to see performance measures that focus on efficiencies in purchasing
and production to achieve cost reduction and competitive pricing (e.g. the manufacture of
Study guide | 419
The particular performance measures adopted by any organisation will depend on its strategy
and objectives. This follows from contingency theory—that is, an organisation will select
appropriate performance measures contingent on factors including its strategy and competitive
position, as well as its technology and size. These performance measures will then be used to
monitor how well the organisation achieves its strategy.
Porter (1985) also introduced the ‘value chain’ as a tool to help create and sustain competitive
advantage through recognising the need to add value in each of the organisation’s primary
activities.
The concept of creating value was explained in Module 1 and in Part A of this module. Porter
argued that customers are prepared to pay for the value created but that organisations need
to keep the cost of generating this value lower than the premium customers are willing to pay.
This is the margin in the value chain—the difference between the cost of providing the primary
and support activities, and the revenue gained from customers.
As for different approaches to strategy, an organisation’s value chain is likely to influence its
performance measures. Example 5.11 shows performance measures for a retail store, based on
the primary and support activities in the value chain.
Example 5.11: P
erformance measures and the value
chain—a retail store example
Value chain activity Examples of performance measures
Primary activities
These performance measures might be developed by identifying key value-adding activities for
the retail store, on the assumption that sales revenue and margin are affected by each of these
aspects of performance. It is important to note that Example 5.11 lists examples of performance
measures. Each organisation would develop the performance measures it deems appropriate to
achieve its strategic objectives.
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➤➤Question 5.6
Revisit the information in Question 5.3 about Mega Markets—both the question and suggested
answer. Using Porter’s generic strategies, complete the following table.
(a) How would you describe Mega Markets’ strategy?
(b) Compare the value chain for Mega Markets with one of its international online competitors.
Primary activities
Inbound logistics
Operations
Outbound logistics
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Service
Study guide | 421
Support activities
Procurement
Technology development
HR management
Firm infrastructure
Check your work against the suggested answer at the end of the module.
Review Appendix 5.1 for a good example of how strategy influences performance management.
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than the revenue generated).
Decision-making is concerned with making choices from alternative courses of action. This requires
an understanding of the desired objectives, some knowledge of the alternatives and the ability to
estimate the likely results of each alternative.
Often there will be conflicting objectives, including long-term and short-term financial objectives.
In the short term, profits and cash flow must satisfy investors, but not at the expense of long-term
sustainable profits and cash flow.
There will also be non-financial objectives such as maintaining environmental and social values.
When non-financial performance objectives are added (e.g. market share objectives or the need
for innovation), the resulting multiple objectives will impact on management decisions.
Alternative courses of action may be imperfectly known as they will require information about
customers, markets and suppliers that may be unknown. The results of those alternatives are
based on predictive models (the assumed cause-and-effect relationships) that are also imperfect.
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Management controls are focused on objectives set during the organisation’s strategic planning
and budgeting cycles. However, market conditions change between these planning and budget
cycles as competitors’ strategy and economic conditions alter and customer demand fluctuates.
Decision-making needs to consider current circumstances rather than be overly focused on
an objective that was set at a different time when conditions were different. So there may be
tension between the needs for management control and for more flexible decision-making.
Decision-making by managers will focus on objectives, but it must also consider approaches
besides passing on higher costs through increased pricing, and the impact they might have on
revenue, market share and profitability.
In this simple feedback model, decisions need to be taken about the standard to apply,
the method of measurement, a means of comparison and the ability to take corrective action.
In the business environment, the cybernetic approach and feedback can be illustrated by a
comparison between target and actual sales performance. The target (or budget) performance
for a sales department may be a specified level of sales revenue. The accounting system is
the method by which the business measures actual sales revenue. Comparison takes place
by reporting both the target and actual sales income and calculating the variance. Feedback
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takes place by using the comparative data to determine corrective action by management
to improve future performance relative to target. These actions may include sales force
training, additional marketing, incentives or perhaps modifying the target. This is the heart
of performance management—using performance information to manage actual performance
so that goals and objectives are attained.
➤➤Question 5.7
SalesVol Ltd (SalesVol) uses a ‘budget versus actual’ comparison. The company budgets to
sell 10 000 units of a product at an average selling price of $3.50. At the end of the period,
the accounting system records actual revenue of $33 750 for 9000 units. Three versions of
reporting from an accounting system are shown. The first two use a traditional budget approach,
while the third uses a flexible (or flexed) budget approach (as discussed in Module 3).
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Sales revenue $35 000 $31 500 $33 750 –$1 250 (Unfavourable)
(a) Use the information in each version of the report to explain the elements of cybernetic or
feedback control that led to corrective action.
(i) Traditional
(ii) Expanded
(i) Traditional
(ii) Expanded
(iii) Flexed
Check your work against the suggested answer at the end of the module.
Question 5.7 focuses on cybernetic control because it tends to dominate accounting systems.
However, there are many ‘informal’ kinds of control that might not always be readily observable,
particularly those based on employees’ culture and belief systems.
Management control is a much broader concept, covering all the processes used by managers
to ensure that organisational goals are achieved and organisations respond to changes in
their environment. Performance management is an integral part of management control,
and while relevant to internal control, it is more concerned with performance improvement
than compliance, which is the greater concern of internal control.
Otley (1999) argued that performance management provides an important integrating framework
for the different elements of management control systems, containing both formal and informal
kinds of control. A further framework for performance management systems (PMSs), developed
by Ferreira and Otley (2009), contains eight core elements:
1. vision and mission
2. key success factors
3. organisation structure
4. strategies and plans
5. key performance measures
Study guide | 425
6. target setting
7. performance evaluation
8. reward systems.
The PMS exists within a set of broader contextual and cultural influences.
Chenhall (2003) writes that the definition of management control systems has evolved from
formal, financially quantifiable information to include:
• external information relating to markets, customers and competitors
• non-financial information about production processes
• predictive information
• a broad array of decision support mechanisms and informal personal and social controls.
➤➤Question 5.8
Reconsider the information in Question 5.7. Apart from the financial controls shown in the various
‘budget versus actual’ reports, what additional formal and informal controls are likely to influence
sales behaviour in a company like SalesVol Ltd? (In responding to this question, think about the
kinds of controls listed in the previous discussion.)
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Check your work against the suggested answer at the end of the module.
426 | PERFORMANCE MANAGEMENT
Return on investment (ROI), for example, is often used to measure financial performance, but it
has long been argued that ROI has significant limitations. There are substantial questions around:
• the level of investment that should be used: total capital employed or net assets;
• whether assets should include non-current, current or both; and
• whether assets should be valued at cost or book value (Solomons 1965).
For example, assume that the organisation’s cost of capital was 15 per cent and that Division A
is currently operating on an ROI of 25 per cent. However, the manager of Division A rejects an
investment that is going to return 20 per cent, because it would lower Division A’s ROI. This is
problematic for the organisation as a whole, because the 20 per cent return from that investment
is still higher than the organisation’s cost of capital (15%).
As traditional accounting measures are criticised for being less relevant in the modern business
environment, non-traditional approaches that are industry- and organisation-specific take on
new meaning, while non-financial performance measures take on a greater level of importance
in guiding organisations towards their goals. Example 5.12 illustrates how one company
(TNA) created a different approach where traditional accounting tools failed to help the
organisation’s strategy.
Example 5.12: T
NA—a strategic management accounting
approach to performance management
TNA is a privately owned engineering company based in Australia, with multinational sales of
computer-controlled packaging equipment to large food manufacturers. TNA’s global success was
derived from its innovative design, worldwide patent protection, continual investment in research
and development (R&D), and the development of export markets. From the start-up of the business,
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accounting performance was of limited value to TNA’s owners. Accruals accounting on a financial year
basis did not take into account the long lead times (often several years) between R&D and export market
development expenditure and income from sales. For the same reason, budgets (other than budgeted
sales volume) were of limited use. TNA rewarded its marketing and research staff through high salaries
and bonuses in order to retain their expertise. The company also expended many millions of dollars
in legal fees in patent litigation against much larger companies that were infringing TNA’s patents.
It took many years for TNA to win these actions and recover costs and damages. While accounting
was necessary for regulatory and taxation purposes, it was not used for management control.
TNA designed its computer numerical control (CNC) equipment but subcontracted manufacture of
the components to various suppliers, then assembled the final machines in its Melbourne factory,
before delivering them to customers. This avoided the problems of capacity utilisation that are inherent
in manufacturing companies.
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TNA had a pricing policy that discouraged discounting because of the technical superiority of its
machines. This enabled a high margin between the selling price and the cost of the components.
In its early years, TNA’s owners exercised management control through a cash flow based spreadsheet
model, where the only real performance measures were the number of machines sold, the percentage
of sales reinvested in R&D and the availability of cash to fund business growth. The model used sales
volume to drive purchasing of components and assembly planning, included data on outstanding
orders and inventory, and cash flow projections over several years. It was updated on an almost daily
basis as new orders were received.
As the company grew, a much more sophisticated spreadsheet model was developed that thoroughly
documented the industry in which TNA sold its machines, including the customers targeted for future
machine sales and the competitors whose customers may be more susceptible due to the financial
constraints of their current suppliers. Much of this data was gathered at engineering exhibitions,
from websites and from informal conversations with suppliers and employees of TNA’s competitors.
Over a long time period, TNA’s owners developed this spreadsheet model to a point where it became
the central management control tool used within the company. TNA’s performance measures now
expanded to include a focus on growing market share and reaching what the owners termed a ‘critical
mass’. TNA defined critical mass as:
having enough capital to withstand serious fluctuations in general business levels, being
able to fund sufficient development to maintain the company’s leading edge in technology,
and being able to withstand the onslaught from the competition (Collier 2005, p. 327).
The information in this spreadsheet enabled TNA to target the customers of weaker competitors and
win more business than it might otherwise have been able to do.
The second version of the spreadsheet model is a good example of strategic management accounting.
It looks beyond the current financial year, applying a life cycle perspective; it looks beyond the
organisational boundary to the whole industry; and uses information to drive strategy implementation
(Collier 2005).
As a privately owned company, TNA’s owners were unconcerned with short-term profits, seeing longer-
term market share growth and reinvestment in research and export market development as far more
important. Hence, profit targets and traditional financial performance measures held little importance,
although cash flow was critical.
Example 5.12 illustrates the importance of performance management and a very informal kind
of management control used to achieve the goals set by the organisation. It also shows that the
accountant’s natural focus on financial performance is not always the most appropriate one.
There are other limitations of traditional controls, notably that gaming and biasing
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accompanies them, the tendency to focus on short-term performance at the expense of
sustainable performance, and the masking of cause-and-effect relationships. These behavioural
consequences are discussed in more detail later in this module.
428 | PERFORMANCE MANAGEMENT
➤➤Question 5.9
Assume you are the CFO for an organisation with responsibility for financial reporting, accounts
payable (AP) and accounts receivable (AR). Make a list of the management controls that could
be implemented to help ensure that the organisation’s operations are efficient and effective.
Check your work against the suggested answer at the end of the module.
Performance management should not be seen as a list of measures without any underlying
framework. Example 5.11 provided a framework, the value chain, which developed performance
measures for each of the organisation’s primary and support activities. In the section that follows,
alternative models of performance management are discussed.
Strategic performance is concerned with sustainable performance over time at the whole
organisational level, over multiple time periods, taking into account strategic goals, economic
conditions and the competitive environment. Strategic performance is also concerned with
product life cycles (see Module 6) and supply chains, and maintaining or increasing market
share through competitive strategy (e.g. cost leadership, differentiation or focus strategies).
Strategic performance is linked to risk management through the risk–return trade-off and the
organisation’s risk appetite as determined by the board of directors.
What these strategic performance measures are will be determined by the organisation’s
strategy. Chenhall (2003) has argued that financial and non-financial measures cover different
perspectives which, in combination, provide a way of translating strategy into a coherent set
of performance measures. Chenhall (2005) argues that a key element of strategic measures is
that they provide integrated information to help managers deliver positive strategic outcomes.
He identifies three attributes of strategic measures:
1. Strategic and operational linkages: these capture the overall extent of integration
between strategy and operations and across elements of the value chain.
2. Customer orientation: linkages to customers including financial and customer measures.
3. Supplier orientation: linkages to suppliers and includes business process and innovation
measures (Chenhall 2005).
Example 5.13 highlights the importance of balancing short-term operational performance with
longer-term strategic performance, and extending the corporate view of performance beyond
the organisation’s own boundary to its supply chain.
Example 5.13: C
losure of the Australian automotive
manufacturing industry
General Motors Co. closed its Holden factory in South Australia in October 2017, ending more than
a century of car manufacturing in Australia. Shortly before, Toyota Motor Corp. had shut its plant
in Victoria, where Ford Motor Co. had closed two sites in the previous year. The loss of jobs in the
automotive sector was not limited to the big three but extended to the suppliers of automotive parts
that fed into the Holden, Ford and Toyota assembly lines.
Over many years, Ford, General Motors (GM) and Toyota have all said they intended to cease their
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Australian production in the absence of continued government subsidies. In 2014, the Productivity
Commission estimated that up to 40 000 people would lose their jobs as a result of the closure of these
assembly plants and the resulting effect on other firms in the supply chain (Australian Government
2014, p. 2).
Companies like GM, Ford and Toyota, being listed on global stock exchanges, needed to satisfy
short-term stock market expectations. Therefore, there was always an emphasis on financial measures
such as ROI, return on capital employed (ROCE), sales growth, profit growth and cash flow—in fact,
all the traditional financial ratios used to interpret business performance from the income statement
and balance sheet.
Strategically, GM has suffered from falling market share and profits and was effectively saved from
bankruptcy by the US Government during the GFC, while Ford narrowly escaped that predicament.
Many of the problems faced by both companies have been caused by legacy health insurance and
pension-fund contributions for past and present employees in the United States, sales demand that has
fallen well short of GM and Ford’s production capacity and the high fixed costs that result from excess
capacity. By contrast, Toyota steadily won global market share at the expense of the US companies,
largely as a result of its longstanding commitment to quality and its emphasis on lean production,
430 | PERFORMANCE MANAGEMENT
which it terms a ‘cost down’ approach. However, Toyota faced increased quality problems in the
United States, which caused it some reputational damage, and suffered a major disruption to its supply
chain as a result of the 2011 earthquake and tsunami and subsequent nuclear reactor damage in Japan.
Automotive companies like GM, Ford and Toyota are mainly designers and subsequently assemblers
of those vehicles, with components sourced, often globally, from multiple suppliers. Automotive
companies need to continually invest in new product designs to develop and introduce new model
vehicles that meet anticipated economic conditions, market demand and competition. Given the
time taken to bring a new product to market in the industry, this can be a complex process, involving
identifying what customers may want several years into the future, the efficient design of new models,
cost-effective purchasing of components and efficient assembly capacity utilisation.
Despite the needs of short-term financial performance reporting, automotive companies often adopt
life cycle costing for their models (see Module 6), recording the profits (or losses) for each model
of vehicle over each year of its life from initial design through to abandonment, in order to learn
lessons that can be applied in future models. Japanese companies like Toyota appear to have been
more effective in applying target-costing approaches (see Module 6) before a new model goes into
production, and collaborating with suppliers to achieve the most cost-effective design, purchase cost
and assembly processes. Japanese companies have also emphasised kaizen (continual improvement)
approaches during production to drive costs down, while Toyota’s emphasis on lean production and
‘cost down’ through the Toyota Production System has been recognised as an important factor in
Toyota’s success over its US automotive rivals.
The closure of assembly plants by Ford, GM and Toyota in Australia was a consequence of these
companies having an inefficient scale of production due to Australia’s small market size and competition
from imported vehicles, exacerbated by the strength of the Australian dollar relative to other currencies
(especially the US dollar). The final element in Ford, GM and Toyota’s decision was the reduction,
and then cessation, of government financial support for the industry. The Commonwealth Department
of Industry has stated that the Australian vehicle manufacturing industry has not returned a profit
since 2003. These are measures of strategic performance that these companies are unable to ignore.
As stated in Example 5.13, there is a substantial effect of these closures not just on direct
employment but on the automotive component sector that supplies Ford, GM and Toyota.
Many of these suppliers would have been aware of repeated press reports about the problems
faced by the automotive industry in Australia. However, they may not have incorporated more
strategic performance measures into their strategic plans—measures that would likely have
addressed the life cycle of automotive products and the profitability of the whole supply chain.
Lagging means to follow, come afterwards or occur later on—in other words, lagging measures
provide information about what has happened after the event, when it may be too late to take
corrective action. A leading measure, on the other hand, provides a more ‘here and now’ view of
performance and is likely to help explain, predict or even cause the result of a lagging measure.
Study guide | 431
Any accountant will know that by restricting certain expenditures, there is likely to be
an improvement in short-term profits, the consequences of which will only be felt in the
medium or long term. For example, if an organisation restricts its expenditure on advertising,
employee training, repairs and maintenance or R&D, there is not likely to be any significant
negative impact on financial performance in the current year, but it is inevitable that financial
performance in later years will suffer. Similarly, delaying new capital expenditure will defer higher
depreciation charges, but will also delay any efficiencies or volume expansion that rely on capital
expenditure. So an emphasis on leading measures (e.g. reducing expenditure on advertising,
R&D, etc.) may improve current profits, but the lagging effect will almost certainly be felt on
revenue and profits in later years.
Sales revenue (a lagging measure) may fall because of a decline in customer satisfaction,
a consequence of performance reflected in a combination of many leading measures, such as
quality of the product or service, how well the customer was treated, how fast the customer’s
order or query was attended to, and the price of the product.
There are many performance measures available for different functional areas of an organisation.
For example, possible measures for the marketing and sales function include:
• number of promotional events
• number of sales calls
• advertising exposures
• distribution outlets
• products carried per outlet
• delivery time
• percentage of perfect orders (correct products delivered on time)
• average time to resolve customer problems (Clark 2007).
Possible measures for the operations function fall under five broad headings:
1. quality pass rate
2. dependability
3. speed
4. flexibility
5. cost (Neely 2007).
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432 | PERFORMANCE MANAGEMENT
➤➤Question 5.10
Chocabloc Ltd (Chocabloc) produces a wide range of chocolate bars. The company’s raw materials
are mainly cocoa, imported from Brazil, and milk, sourced locally from dairy farms. The chocolate
bars are distributed by a national logistics company to retail stores around the country.
Chocabloc has patented the formulas for its range of chocolate bars, many of which have been
sold for a decade, while others have been sold for only a few months. The company spends
considerable funds on R&D for new chocolate bars, and before each new product launch it engages
in an exhaustive and expensive market research program to assess customer demand for the
new product. If there is any doubt about the market potential of a new product, it is withdrawn.
Where market research indicates a strong likelihood of success, Chocabloc invests heavily in
advertising and has a team of sales representatives in each sales region who visit retail stores
and take orders for the chocolate bars. Those orders are processed at Chocabloc’s headquarters
and are fulfilled by the logistics supplier. Extensive management attention is given to minimising
wastage and ensuring product consistency through quality control.
Based on the information in this scenario, identify the performance measures that might be
recommended to the management of Chocabloc. Consider strategic and operational measures
(including leading and lagging measures). Include financial and non-financial performance measures
in your list.
Strategic performance
measures
Leading measures
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Lagging measures
Check your work against the suggested answer at the end of the module.
Study guide | 433
Another interesting framework is the performance pyramid of Lynch and Cross (1991).
The pyramid has descending objectives and ascending measures, beginning with corporate
vision and cascading through successive layers of business units, core business processes,
departments, work groups and individuals. One side of the performance pyramid is concerned
with market performance (customer satisfaction, flexibility, quality and delivery) and the other
side with financial performance (flexibility, productivity, cycle time and waste).
A framework that was developed specifically for service industries was the Results & Determinants
Framework (Fitzgerald, Johnston, et al. 1991). In this framework, results (competitiveness and
financial performance) were distinguished from the determinants of results (quality, flexibility,
resource utilisation, innovation).
The European Foundation for Quality Management (EFQM) Excellence Model separates five
enablers (leadership, people, policy and strategy, partnerships and resources, and processes)
and four result areas (people, customer, society and key performance), all underscored by
innovation and learning, with performance measures identified for each enabler and result area
(see http://www.efqm.org). The EFQM model is used widely in the public and not-for-profit
sectors as well as in many business organisations.
‘Six Sigma’ was originally developed by Motorola to reduce variability in manufacturing and
business processes. It recognises the cost and impact of failure in any single process on the
overall yield using a methodology known as DMAIC: define, measure, analyse, improve, control.
Six Sigma relies extensively on statistical techniques. The Six Sigma Business Scorecard has seven
elements covering all of the functional business areas:
1. leadership and profitability
2. management and improvement
3. employees and innovation
4. purchasing and supplier management
5. operational execution
6. sales and distribution
7. service and growth.
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The performance prism was developed by Cranfield University academics. This framework
has five facets:
1. stakeholder satisfaction (what stakeholders want)
2. stakeholder contribution (what the organisation needs from its stakeholders)
3. strategies
4. processes
5. capabilities that an organisation needs to satisfy the wants and needs.
Each of the five facets has its own measures, but the overall focus of the performance prism
is on stakeholder satisfaction.
This work is licensed under the Creative Commons Attribution-Share Alike 3.0 Unported License. To view a copy of this license, visit:
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https://strategyzer.com/canvas/business-model-canvas.
Source: Strategyzer 2018, ‘The business model canvas’, accessed June 2018,
Study guide | 435
You can access the Business Model Canvas website and its various resources free by registering at
https://strategyzer.com/canvas/business-model-canvas.
The Business Model Canvas template links the value proposition with the business’s customer
segments, customer relationships and distribution channels (the right-hand side of the canvas)
to key activities, key resources and key partnerships that satisfy customers (the left-hand side).
These are all in turn linked to revenue streams and cost structures (occupying the bottom of the
canvas). A separate Value Proposition Canvas helps identify what products or services are offered
to customers and what motivates them to buy.
The Business Model Canvas approach is that strategies can be developed by focusing on the:
• value proposition and its related customer segments, relationships and channels as drivers
of revenue
• infrastructure of activities, resources and partnerships that drive costs.
You can try out a Business Model Canvas template either at the Strategyzer website or using a free
online template available at https://canvanizer.com/new/business-model-canvas.
This marketing-oriented view of the world focuses on value as perceived by customers, certainly
an essential element in creating value for the business. Its weakness lies in the absence of
performance measures that determine whether strategy is being achieved. This is the benefit
of the second framework, the balanced scorecard.
The customer, business process, and innovation and learning perspectives are considered
as leading measures, with financial measures being the lagging measures of performance.
Kaplan and Norton (1992; 1993; 1996a) do not prescribe the performance measures that should
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be used, but suggest that organisations use performance measures and targets linked to their
objectives, affirming the clear link between strategy and performance measures. This reflects
the contingency approach discussed previously in this module. The BSC ‘translates a company’s
strategic objectives into a coherent set of performance measures’ (Kaplan & Norton 1993, p. 134).
Examples of performance measures in the customer perspective include market share, customer
satisfaction, customer retention, NPS and brand reputation. Performance measures in the business
process perspective may include quality pass rate, on-time delivery, cycle time (from order to
delivery) and productivity. In the innovation and learning perspective, performance measures may
include employee retention and satisfaction, investment in training, R&D expenditure and new
patent registrations.
There is no rule that says a particular measure should go in a particular perspective. Sometimes
market share will be in the financial perspective (as it is based on revenues), and other times it will
be in the customer perspective (as it reflects how many customers an organisation has).
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Some other examples include the measure of ‘on-time delivery’, which could be classified
as either a customer perspective or a business process perspective. It would depend on the
purpose of the measure for the organisation (i.e. whether the focus was on customer satisfaction
or the organisation’s effectiveness in operations).
Similarly, capital expenditure measures would typically be found in the financial perspective.
However, the capital expenditure may appear in other perspectives if it specifically relates to
improvements in efficiency (investment in new or improved business processes) or training
facilities (investment in innovation and learning).
The important thing is for an organisation to be able to logically explain why an item is placed
or classified in a particular perspective. This is a further example of contingency theory.
An organisation will determine the performance measure and the perspective that best reflects
that measure based on its strategy, competitive position, size, etc. For example, a strategy to
improve workforce skills would lead to performance measures being developed in the innovation
and learning perspective. A strategy to improve on-time delivery would mean performance
measures being developed in the business process perspective. Both strategies would be linked
(with others) to the overall business objectives of improving financial objectives such as sales
growth, cost reduction and increased profitability.
There is no exact or correct number of measures to include in a BSC. Too few measures will mean
the organisation does not have a clear picture of what is going on in the organisation and it may
miss detecting issues because it does not have enough leading measures. Too many measures
means it may be distracted or unable to focus on the most critical items.
Kaplan and Norton (1992; 1993; 1996a) recommend three or four measures for each of the four
perspectives in the BSC (12 to 16 in total). However, this is only at the top level. For lower levels
of the organisation there may be many more measures that all link together and are summarised
by these final 12 to 16 measures. The cascading of performance measures to business units is
discussed further under ‘Cascading performance measures’.
The relative importance of performance measures is addressed to some extent in the BSC
by the assumption of a hierarchical relationship between the four perspectives, and hence
between the four sets of performance measures. Improving learning and growth (achieving
innovation) will transform business processes, which will in turn lead to more satisfied customers
and ultimately to improved financial performance. Between each hierarchical level, some value
creation is assumed.
Figure 5.7 illustrates the relationships between the elements in the BSC.
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Study guide | 437
Financial perspective
Goals, performance measures and targets
Customer perspective
Goals, performance measures and targets
Source: Based on Kaplan, R. S. & Norton, D. P. 1992, ‘The balanced scorecard:
Measures that drive performance’, Harvard Business Review, Jan–Feb 1992; Kaplan, R. S. &
Norton, D. P. 1993, ‘Putting the balanced scorecard to work’, Harvard Business Review, Sept–Oct
1993, pp. 134–47; Kaplan, R. S. & Norton, D. P. 1996, ‘Using the balanced scorecard as a strategic
management system’, Harvard Business Review, Jan–Feb 1996, pp. 75–85.
There has been an almost continuous development of the BSC approach through articles and
books, but one of the distinguishing features of the BSC compared with other frameworks
is the notion of ‘balance’. Balance in the BSC implies that organisations cannot maximise
performance on all four perspectives simultaneously. Rather, there should be balance between
these perspectives with optimum overall performance being the result of finding the right
balance between performance as measured by all four perspectives.
For a further explanation of the BSC please access the ‘R Kaplan explains the Balanced Scorecard’ MODULE 5
video on My Online Learning.
What is meant by causal relationships is that when you do one particular thing right it will
directly lead to or cause an improvement in another item—for example, assuming that increased
advertising will cause or lead to more sales revenue, or that high customer satisfaction levels
will cause or lead to higher profits.
The measures in each of the BSC’s four perspectives are meant to successfully link together.
Figure 5.7 shows this cause-and-effect situation or relationship, but the criticism is that this might
not be the case. An example is a monopoly situation where a company is able to increase profits
by providing lower levels of service, which would actually annoy customers (and the customers
cannot switch to another provider, because there isn’t one). In a different situation, satisfied
customers may not lead to higher profits because the organisation may be charging prices that
are too low.
Therefore, it cannot be assumed that a change to the leading measure will have a cause-
and-effect change on the lagging measure. One of the difficulties in setting objectives and
performance measures is the ‘predictive model’ used by the organisation. The predictive model
is the set of assumptions that lie behind an organisation’s strategy implementation. It may be
useful in developing strategy to start by using the Business Model Canvas and then translate this
into a BSC set of performance measures.
Concerns have also been raised by Norreklit (2000) about how effective the goal-setting and
performance management process really is. In Otley and Berry’s words:
organisational objectives are often vague, ambiguous and change with time … Measures of
achievement are possible only in correspondingly vague and often subjective terms … Predictive
models of organisational behaviour are partial and unreliable, and … different models may be held
by different participants … The ability to act is highly constrained for most groups of participants,
including the so-called ‘controllers’ (Otley & Berry 1980, p. 241).
Otley and Berry’s critique was that organisational goals are often ambiguous (i.e. that different
goals are held by different organisational participants). For example, sales managers may prefer
sales growth, while operating managers may be pursuing greater efficiencies and economies of
scale. This is the case even in a stable environment, while rapidly changing environments can
quickly change organisational goals in response to emerging threats and opportunities.
Predictive models are inherently difficult as they assume agreement by organisational participants
as to cause-and-effect relationships. For example, the predictive models of Qantas and Jetstar are
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different, despite their common ownership, because they assume different expectations about
frequency of flights, on-time departures, in-flight service, pricing, etc. However, not everyone at
Qantas and Jetstar would be likely to share the same assumptions that are contained in those
predictive models. Equally, not all Jetstar customers would be likely to accept the different
standard of service inherent in those different models (witness, for example, any of the airline
documentaries about customer response to late check-ins or flight delays with low-cost airlines).
Finally, Otley and Berry (1980) drew attention to the limited capacity of organisational participants
to effect change, either because of budgetary constraints, organisational policies or other formal
management controls that are aimed at feedback: reducing the gap between target and actual
performance, rather than as tools for learning and CI. To be truly effective, performance measures
should lead to organisational learning and improvement. Organisational learning takes place by
using performance information to communicate and continually re-evaluate the predictive model
used within the business, the appropriateness of the selected performance measures and their
associated targets, and the kinds of corrective actions that managers are able to take to reduce
performance variations relative to targets.
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Many organisations have additional perspectives to the four in the Kaplan and Norton version.
These perspectives may recognise additional stakeholders—for example:
• donors to a not-for-profit organisation
• social outcomes in the public sector
• quality in health services
• environmental performance.
Appendix 5.1 shows how Achmea uses a BSC with six perspectives in its strategy implementation.
The first question to answer when designing a BSC is: ‘What are the organisation’s goals and
objectives that are inherent in its strategy?’
EVT (Example 5.1) showed that its BSC should include aspects of strategy such as market share,
room inventory and customer spend. The case of Apple (Example 5.4) shows that continual
R&D is an essential strategy and needs to be reflected in a BSC, as do retail store numbers and
employee knowledge.
The second question is: ‘Which stakeholders do we need to consider?’ Goals and objectives
may well—perhaps should—consider stakeholders other than shareholders. Victoria Police
(Example 5.3), because its performance is of so much concern to the public, press and
politicians, needs to balance a large number of performance measures to deliver on multiple
strategies. The case of Newcrest Mining (Example 5.6) showed the importance of employee
safety, environmental protection and relations with local communities in ensuring sustainable
financial performance.
These examples highlight that an organisation-specific BSC does not have to be limited to
four perspectives. As seen previously in the module under ‘Frameworks for performance
management’, the performance prism has facets that include stakeholders. There is no reason
why the scorecard cannot include social and environmental aspects of performance.
Consequently, each organisation’s BSC will be unique to its business, its key stakeholders,
the environmental and competitive context in which it operates, its size (see Table 5.2), its goals
and objectives and competitive strategy. This is a further example of contingency theory.
Table 5.3 shows how the design of a BSC should proceed. Steps 3, 4 and 5 are covered in more
detail later in Part B.
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1. Assess the organisation’s What are the organisation’s • Source a copy of the
strategy overall strategic goal, vision, organisation’s strategy,
mission and objectives? usually contained in its
annual statements.
• If no accounts are available,
consult directly with senior
management.
• Identify the most important
strategic goals (financial and
non-financial; short-term and
long-term)
2. Assess the organisation’s Who are the organisation’s key • List the key customer groups
stakeholders stakeholders and how should the of the organisation.
organisation meet their needs? • How is the organisation
currently meeting the needs
of each group?
• How can the organisation
best meet the needs of its
customers?
3. Compile a strategy map How are the various strategic • Construct a strategy map,
goals interlinked? clearly identifying any links
that exist.
• Identify any overlap in
objectives.
4. Define the key performance How will the strategic goals • Construct a list of key
measures and SMART targets be aided by each of the four performance measures
for each of the four BSC perspectives? for each of the four
perspectives perspectives.
5. Cascade the BSC How will the organisation • Duplicate the previous steps
measure its performance at for each business unit and
various hierarchical levels? department that contributes
to organisational goals
and objectives.
An example of how strategy is developed into performance measures for Achmea is given in
Appendix 5.1.
Example 5.14 shows how a BSC could be developed for the company TNA.
TNA’s financial goals required sales growth to achieve its business strategy of reaching critical mass
(shown in Example 5.12), which was defined as having sufficient capital to enable TNA to withstand
general business fluctuations and competition while maintaining its investments in R&D. Cash flow was
not only to maintain organisational viability during its high-growth strategy but also to underwrite its
obligations to the banks that had lent the company money. As TNA subcontracted the manufacture
of all components and assembled the final machines, gross margin was an important measure,
but accounting profits were not important to TNA. A focus on short-term profit would likely have
detracted from the company’s strategy of long-term market growth and its investments in export
market development, patent litigation and R&D.
TNA’s customer goals focused on developing new export markets as those markets it entered became
saturated. Within each geographic market, new customers and new machine installations were the key
measures of marketing success, with outstanding orders, on-time delivery and customer satisfaction
important supporting measures to enable sales to new customers and sales of new machines. NPS is
a useful measure of customer satisfaction as it reflects whether a customer would recommend the
supplier to a friend or colleague.
TNA’s business process perspective was centred on its strategy of outsourcing the manufacture MODULE 5
of components, using its skill base to assemble the components it had designed and retaining its
intellectual capital in-house. So performance management was focused on the quality and delivery
of components from suppliers, the time taken to assemble those components and the quality pass
rate—the quality of assembled machines before delivery to customers.
Innovation and learning were critical to TNA and the measurement of staff retention, staff satisfaction,
investment in R&D and the ability to develop new patents from its R&D matched TNA’s strategy of
continual development of products ahead of competitors in order to retain a strong market position.
Patent litigation measured the success of the company’s court actions against those competitors who
had infringed TNA’s patents.
TNA’s overarching strategic goal was market share growth to achieve and maintain its critical mass,
linked with its targeting of weaker competitors (explained in Example 5.12).
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For practice in creating a BSC, please access Stage 2 of the ‘Save or close the hotel?’ Business
Simulation on My Online Learning.
Questions for strategic planners to ask: the Balanced Scorecard Institute has a series of questions that
link performance measures to strategic initiatives, available online at: https://balancedscorecard.org/
Resources/Cascading-Creating-Alignment/Metric-Features.
The benefits and challenges of implementing a BSC are highlighted by Balanced Scorecard Australia
at: http://www.balancedscorecardaustralia.com/bsa/main/frequently-asked-questions/.
Charitable organisations may receive funding from government or other bodies tied to achieving
specific outcomes, so performance measures need to be developed contingent on the outcomes
for specific projects. Within a single organisation with funding for multiple projects, performance
measures may be different for each project in line with the outcomes expected for each project.
These are further examples of the contingent approach to designing BSCs.
In the Australian public sector, public hospitals are a state government responsibility and
performance measures are tied to funding, but funding for specific initiatives comes from both
state and federal governments. As a result, hospitals must have performance measures for
reporting on actual results and the achievement of targets to the funding agencies to be able
to show they are managing the outcomes tied to each different parcel of funding.
Likewise, a not-for-profit organisation such as a charity will have stakeholders, including its
donors and the beneficiaries of its services. Compliance with charitable rules will incorporate
the regulatory body as a further stakeholder. Because charities rely extensively on volunteers,
they are a further stakeholder group.
Appendix 5.1 provides a good example of how the BSC is applied in a mutual, non-profit
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distributing organisation.
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➤➤Question 5.11
Refer again to Questions 5.3 and 5.6, including the suggested answers. Given the different
strategies of Mega Markets and its online competitor, identify some possible performance
measures (covering each of the four BSC perspectives) for each company, and explain how
the performance measures for each company are likely to differ as a result of the different
strategies adopted.
Financial perspective
Customer perspective
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Explanation of differences
Check your work against the suggested answer at the end of the module.
The need to design an effective BSC for an organisation involves a close relationship with
strategy. Kaplan and Norton (2001) have developed the BSC and its relationship with strategy
through what they call a ‘strategy mapping’ process.
Table 5.3 showed a step-by-step approach to designing a BSC. Step 3 is compiling a strategy
map. This involves deciding how the various strategic goals are interlinked.
Strategy maps are a visual approach that helps to identify assumed cause-and-effect
relationships and where critical areas of performance need to be measured. Kaplan and
Norton (1996b) describe a simple example of linked performance measures through the four
BSC perspectives. In the learning and growth perspective, employee morale leads to employee
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In EVT (see Example 5.1 and solutions to Question 5.1) the design of a strategy map could look
something like the example in Figure 5.7, but candidates should note that there is no ‘one best
way’ of creating a strategy map. For any organisation, it will be based on the predictive model—
that is, the set of cause-and-effect relationships that the manager assumes to be the basis of
business success. The logic and relationships in Figure 5.8 are drawn from the EVT annual report.
Study guide | 445
Figure 5.8: E
vent Hospitality and Entertainment Ltd group strategy map
(hypothetical)
Growth in
Sales Profitability
market share
revenue EBITDA and normalised profit before tax
Market share %
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what corrective action may be needed. The criteria for setting performance measures and
targets are discussed in more detail later in this module.
The board sets criteria for financial returns to shareholders, which may be based on past trends,
benchmarking with competitors and, for listed companies, the expectations of stock market
analysts. These financial targets become the focus for the strategy developed by the board and
senior management. To achieve the target returns, the board and senior management agree
that it is necessary to increase sales revenue through greater market share and to improve the
profitability of those sales through improved cost efficiencies.
In Figure 5.8, performance measures have been included in the strategy map where appropriate,
reflecting those performance measures in the EVT annual report and drawn from the solution
to Question 5.1.
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Strategy maps are developed through workshops at several levels. They could also be based on
what the organisation learns through the Business Model Canvas approach described previously
in this module. Customer focus groups can identify those product benefits and elements of the
value chain that customers value most and are prepared to pay for. This helps the organisation
identify those business processes it should emphasise and measure.
Return on investment,
earnings per share etc.
In Figure 5.9, customer focus groups have been presented with a question as to how the
manufacturer can increase its market share. The focus group findings indicate that customer
satisfaction is a function of both product quality and on-time delivery. Customer focus groups
have also identified that to increase sales revenue from existing customers, quality rather than
price is the main motivating factor for customer spending.
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So the strategy mapping process shows that it is not only real product quality, but also customer
perceptions of quality that are important. Product quality is the responsibility of the production
department, but marketing has the task of improving brand awareness and perceptions
of quality.
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Internal workshops are then focused on production and the need for cost efficiencies.
Investigations by corporate finance staff have identified that the most significant impact on
profitability—other than sales growth—is production cost efficiency relative to competitors.
Internal cross-departmental, team-based workshops—which include employees from the
manufacturing, distribution and purchasing functions—identify that there are two major
impacts on production efficiency and manufacturing costs:
1. Labour skills (already identified as a driver of quality and on-time delivery) are also critical
in setting achievable production schedules and meeting those schedules.
2. Issues with the price, quality and delivery of raw materials from suppliers.
This internal workshop leads to a project within the purchasing department to work collaboratively
with suppliers to improve raw material purchasing, with the aim of obtaining the best mix of price,
quality and delivery from suppliers to support the production schedule.
Figure 5.9 is an example of how a strategy map is developed to identify the most significant
cause-and-effect relationships to achieve organisational goals. There are elements of a top-down
approach, as the board needs to set overall targets and the strategic direction for the business.
There is also a bottom-up approach in which employees with first-hand knowledge of the
business identify obstacles to performance and develop ways of overcoming those obstacles.
Performance measures and their associated targets would need to be developed for each of the
elements in the strategy map. The board can use these measures and targets to monitor strategy
implementation. Those measures may include:
• financial returns
• market share
• customer satisfaction (through a combination of customer survey results such as NPS
and measures of spending per customer and customer retention)
• quality pass rates
• on-time delivery
• labour turnover
• employee satisfaction
• cost reduction per unit of production
• compliance with production schedules
• material purchase variances
• on-time delivery from suppliers
• supplier product quality.
Where performance needs to be improved, the strategy mapping process involves making
resource reallocations through changing budgets. This approach is challenging to the traditional
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accounting view of budgets as fixed resource allocations for the year. In practice, budgets are
commonly incremental (or decremental) based on the prior year plus or minus a percentage
change factor. Budgets are rarely revised mid-year due to performance shortfalls. However,
reallocating budgets mid-year is a logical extension of managing performance more flexibly in
the strategy mapping process and there is no reason why accountants cannot be more flexible
in supporting such a process.
Strategy mapping is a continual learning process whereby learning what works, and what does
not, from performance measures should lead to changes to the assumed cause-and-effect
relationships, and to the resulting performance measures and targets. This approach should,
wherever necessary, continually re-evaluate and modify the assumptions in the relationship
between strategy, performance management and budget.
An example of strategy mapping linked to strategy and the BSC can be seen in Appendix 5.1.
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➤➤Question 5.12
Recommend a set of performance measures (without the associated targets) that would be
suitable for a three-partner organisation of CPAs operating in public practice with 40 employees.
The organisation has three objectives:
1. to make a satisfactory profit
2. to have a strong cash flow
3. to increase the value of the organisation as measured by billings (i.e. annual professional fees
charged to clients).
(a) Using Figure 5.9 as an example, construct a strategy map that shows what might be the key
success factors—that is, the cause-and-effect relationships in the business model that the
organisation needs to get right in order to achieve its three objectives.
Note: You will either need to do this separately on a piece of paper, or you may prefer to
create the strategy map in a drawing program before adding your response to the answer
field.
If you choose to use a drawing program, save your strategy map as an image file. Then in
the interactive PDF of this Study guide, you can insert your response by selecting the answer
field and browsing for the image file that you saved on your device.
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Study guide | 449
(b) Explain the main features of your strategy map, and why you included each element.
(c) For each of the elements in the strategy map, identify suitable performance measures,
keeping a balance between financial and non-financial measures, as well as a balance between
each of the four perspectives in the BSC.
Financial or
Key success factors non‑financial
BSC perspective in strategy map Performance measure (N/F)
Financial
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Client (customer)
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Financial or
Key success factors non‑financial
BSC perspective in strategy map Performance measure (N/F)
Business process
Innovation and
learning
(d) Explain your thinking behind the performance measures you have selected.
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Check your work against the suggested answer at the end of the module.
A further feature of the BSC and strategy mapping approach is the cascading of performance
measures within the hierarchical organisation structure (step 5 in Table 5.3).
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Performance measures should cascade so that, at each successive organisational level, the
measures are different, but lower-level performance on one measure contributes to higher-level
performance at the next level. For example, the board may consider ROI as a critical performance
measure. At the business unit level, this may be translated into a measure of PBIT. Below this
level, sales managers may have measures for the volume (quantity) and value (dollars) of sales as
well as the margin achieved on cost. Operations managers may have the same volume (quantity)
measure as sales managers, but the measure relevant to them may be cost.
Performance measures and the targets that accompany them must cascade from organisational
level through each business unit, to individual products and services and assets and, ultimately,
to individual people within the organisation. For example, in a sales department, a contribution
to the organisation’s sales target must be achieved by each sales team, within the team by each
salesperson, and even within each salesperson’s target this may involve sales targets for each
of the salesperson’s customers or products and services. Where targets are set, performance
must be measured with performance management involving comparison of actual to expected
sales levels and the taking of action aimed at improving performance.
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As stated previously, Kaplan and Norton (1992; 1993; 1996a) recommended three to four
performance measures for each of their four perspectives. This is at the whole-of-organisation
level. Once these high-level performance measures are cascaded, the total in use in an
organisation may be very large and, in a complex, multidivisional organisation, may be in
the hundreds. However, any one manager will be focused on only those performance measures
for which they are responsible, and the total number is unlikely to be more than about 12,
for the reasons previously given.
Typically, lower-level employees in an organisation have fewer financial targets and more non-
financial ones (i.e. the leading measures) because their role is mainly concerned with tasks such
as production, distribution or administration. Senior managers tend to have more targets for the
financial performance of their business unit or the whole organisation—the lagging measures.
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Sometimes, targets within business units may be in competition with each other. For example,
achieving a sales target may cause difficulties in operations if there is insufficient capacity to
fulfil customer orders on time. It is important therefore to ensure the integration of performance
targets so that no business unit will be disadvantaged by another achieving its target. A problem
faced by complex organisations where there is intra-organisational charging for services is the
tendency for each business unit to pursue achievement of performance measures for itself rather
than for the organisation as a whole. This is no different to the problems caused by transfer
pricing, where business units may be motivated to improve their own profitability even where
the overall effect on the organisation may be to worsen performance.
Strategy implementation (rather than formulation) and alignment with organisational goals,
coordination across different functions and projects, and across different individuals can only be
achieved if goals, measures and targets are effectively cascaded. There are a number of ways
cascading can be made more effective: by cascading organisational goals, measures and targets
to functional departments, to cross-functional teams, or to particular initiatives or projects.
However, if measures are inconsistent or in competition with each other, individuals, departments,
cross-functional teams or projects may be working towards different goals and targets, perhaps
even measuring their performance in different ways (see Example 5.15).
In the EVT example, performance measures for all of EVT—for example, average room rate,
occupancy, RevPAR, total rooms available, etc.—will cascade down to the separate divisions
(QT Hotels, Rydges, Atura & Thredbo) and from there to each individual hotel, where performance
management will involve comparing actual performance with targets and taking appropriate
corrective action at the individual hotel level.
Appendix 5.1 provides an example of how Achmea cascades its performance measures through
the organisation.
Public hospitals also generally operate within a fixed budget that may be unrelated to the actual levels
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of patient demand on the hospital. Hospital budgets are often an outcome of economic conditions
and the government’s spending plans across all sectors of public service delivery.
The role of management—and any board of directors or governing body—is to best allocate and
manage resources within the fixed budget allocation to achieve the performance targets set by
government. Hospital-wide targets will be cascaded down to each department (e.g. emergency,
surgery, medicine) and to clinical directors (e.g. medical specialists) within each department. Ultimately,
individual clinicians may be responsible for performance on the days when they are on duty. So the
director responsible for the emergency department on a Sunday will be responsible for trying to achieve
the target for reducing the time between a patient arriving in emergency and being discharged or
admitted to a ward for ongoing treatment.
Hospitals are faced with decisions to open or close wards and to reallocate resources to where they are
most needed. These decisions may need to be made on a daily basis in response to patient demand,
but closing wards may itself cause performance targets to be missed. The particular problem for
public services is that many of their performance measures and targets are politically derived, and not
necessarily integrated with each other or with the budgetary resources available.
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An example of the problem of competing performance targets can be seen in a hospital where there
is a high number of patients admitted through the emergency department. This can lead to either
(or both) the surgery capacity being used up, or a lack of available beds. As a consequence, elective
surgery patients can be disadvantaged because their surgery may be cancelled at short notice. This is
a difficult problem to manage as the emergency department cannot be closed to people who need
urgent treatment.
In the public hospital, there will be conflicts between meeting performance targets for elective surgery
and treatment of patients admitted for emergency treatment. There will also be conflicts between the
management demand to stay within budget while achieving performance targets and the clinicians’
focus on proper medical treatment, irrespective of the impact on reported performance.
Performance management in hospitals is largely about balancing available funds with performance
targets that may not relate to resources or to actual demand for services. This kind of problem is
unique to public services and the not-for-profit sector. In this sense, for-profit organisations should
find managing performance easier because, generally, higher levels of customer demand will lead
to higher revenues. In the absence of politically motivated targets, for-profit organisations have far
more scope to change what is measured and how it is measured, and to set specific targets.
One way to address the complexity of modern business and the variety of performance measures
is through the use of information technology, which can become critical in a cost-effective
performance management system.
Balanced scorecard (or similar) performance management systems collate and report
information about customers, suppliers, employees and business processes to supplement
financial performance measures. Therefore, organisations need to capture information from
their marketing, purchasing, production, distribution and HR activities. Information about key
factors such as customer satisfaction, cycle times, quality, waste and on-time delivery need
to be part of an information system.
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of new technologies can improve productivity and reduce the ratio of staff to sales value,
a common performance measure in retailing.
The outputs from EPOS include business volume—for example, number of customers, number
of items sold—sales analysis, product profitability and inventory reorder requirements. Sales and
profitability reporting can be generated by store and time of day. Additional benefits of EPOS
include information about:
• peak sales times during each day
• products that may need to be discounted
• sales locations that may need to be expanded
• time taken to scan a customer’s basket of goods.
Even small businesses like restaurants can take advantage of modern POS terminals that
are relatively inexpensive, enabling them to monitor customer seating by time of day and
day of week, generate orders for the kitchen, price goods and calculate bills, and provide
detailed management reporting on inventory and sales trends. This information can be used
for management accounting purposes to improve inventory management, reduce wastage,
enable staff rostering to the busiest times and identify the most profitable products.
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For larger organisations, an enterprise resource planning (ERP) system helps to integrate data
flow and access to information over the whole range of a company’s activities. Examples of these
systems are the relational databases provided by SAP and Oracle. ERP systems take a whole-of-
business approach. They typically capture transaction data for accounting purposes, together
with operational data and customer and supplier data, which are then made available through
data warehouses from which custom-designed reports can be produced. ERP system data can be
used to update performance measures in a BSC and can also be used for:
• activity-based costing
• shareholder value
• strategic planning
• customer relationship management
• supply chain management.
Cloud computing has enabled access to larger sources of data and made it easier to analyse
data from any location. It relies on sharing resources through the internet to achieve economies
of scale. With cloud computing, end users access applications through the internet, with both
software and data stored on servers at remote locations.
Large volumes of information are now available from public sources. The term ‘big data’ refers
to very large and complex data sets, which can be seen in the massive data resources of the
internet and the results provided by search engines such as Google or data held on Facebook.
Organisations are able to access (for a fee) this information to enable targeted marketing.
According to management consultants McKinsey, big data will become a key basis of
competition, underpinning new waves of productivity growth and innovation (McKinsey Global
Institute 2012).
The Australian Taxation Office accesses multiple sources of data to identify potential targets
for tax audits based on spending patterns. Retail stores such as Woolworths (as mentioned
previously) target customers for special promotions based on their individual spending habits
recorded through its ‘Everyday Rewards’ card system, which collects data on customer purchases
at the POS.
The ability to collect vast amounts of performance information means that it is important but
increasingly complex to report management information in a concise and decision-useful
way. Approaches to reporting management information include graphical presentation of key
performance data. As mentioned, traffic lights (red/amber/green) draw attention to those
aspects of performance that:
• are meeting their target (green)
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A ‘drill-down’ facility may also be used to cascade down from highly aggregated performance
data to a more specific and detailed level—for example, customer, product or service,
or business unit.
Organisations need to determine what performance information is important from the volume
and variety of information that is now available. Big data requires specialist computing power and
software tools as the volume and variety of data is beyond the capability of relational databases.
Examples of such specialist software include Oracle’s ‘Big data appliance’ and ‘Hadoop’, which is
an open-source platform for consolidating, combining and transforming large data volumes.
Linking platforms to analyse big data and the organisation’s own relational database provides
what Oracle refers to as a ‘360-degree view’ of the organisation.
Oracle’s White Paper ‘Integrate for Insight’ on integrating big data is accessible at: http://www.
oracle.com/us/technologies/big-data/big-data-strategy-guide-1536569.pdf.
Study guide | 455
An important implication of Oracle’s research is the finding that, on average, 1.7 months will pass
before the finance department becomes aware that operational plans or market circumstances
for the company have changed. In terms of performance data, for the 89 per cent of managers
with departmental performance measures who responded to the survey, it takes, on average,
just under two months for information about departmental performance against targets to filter
up to the senior management team or the board of directors.
The lack of reliable, accurate and timely data is compounded by the lack of stability in the
organisation’s environment and strategic plans that must be continually updated to stay relevant
to the latest business conditions. Turbulence in the business environment is caused by:
• economic uncertainty
• changing technology
• the rapid introduction of new products
• changing customer demand
• increased regulation and competition.
Strategy&, the strategy consulting group of PwC, argues that execution of strategy is critical
to success. It recommends ‘strategic performance management’, an approach that ‘makes an
organization’s strategic goals more transparent to line executives and provides an ongoing
mechanism to monitor progress toward these goals through simple and intuitive performance
measures’. The authors argue that there is often:
a lack of clear linkage between strategic objectives and operational performance measures,
limited accountability for outcomes at the operational level, an unmanageable number of
sometimes random metrics, fragmented and redundant systems and efforts, and a greater focus
on metric analysis than on management decision making (Chandrashekhar et al. 2017).
A key recommendation of the Strategy& report is for senior managers to focus on ’metrics that
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matter’. This involves becoming more agile in responding to change, changing performance
benchmarks and cascading those changes down through the organisation to deliver on strategic
goals (Chandrashekhar et al. 2017).
A key enabler is the recognition that performance management should be used for learning
rather than control, as learning is central to success in turbulent environments.
Strategic intelligence and learning are more possible with the advent of technologies to access
big data. It is now possible to collect data about every potential customer interaction through a
business’s website and social media such as Facebook and Twitter. While this kind of big data can
be a powerful tool for business, it does raise issues of access to private information.
Further information about the Facebook and Twitter example is available in a 2018 New York Times
article available at: https://www.nytimes.com/interactive/2018/06/03/technology/facebook-device-
partners-users-friends-data.html.
A report by McKinsey Analytics argues that most companies are capturing only a fraction
of the potential value from data and analytics. Data and analytics can underpin disruptive
business models while granular data can be used to personalise offerings of products and
services to customers. However, many companies struggle to incorporate data-driven insights
into their day‑to-day business operations. Large technology investments have been made but
organisational changes have not always been in place to take advantage of the technology.
The report argues that ‘organizations need to build the capabilities of executives and mid-level
managers to understand how to use data-driven insights—and to begin to rely on them as the
basis for making decisions’ (McKinsey Global Institute 2016, p. 9). The report concludes that:
Data and analytics have even greater potential to create value today than they did when companies
first began using them. Organizations that are able to harness these capabilities effectively will
be able to create significant value and differentiate themselves, while others will find themselves
increasingly at a disadvantage (McKinsey Global Institute 2016, p. 24).
There is now widespread support for the belief that performance measures should be developed
from strategy. Kaplan and Norton’s (1996b) recommendation for a strategy mapping process
identified four barriers to implementation of performance management systems in relation
to strategy:
1. Failure by the senior management team to achieve consensus, leading to different groups
pursuing different agendas not linked to strategy in an integrated way.
2. Strategy that is not linked to department, team and individual goals—that is, an absence
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of cascading.
3. Strategy that is not linked to resource allocation decisions—that is, where budgetary
allocations are incremental/decremental and not linked to strategy.
4. Feedback to managers that focuses on short-term financial performance rather than on
a review of measures of strategy implementation and success.
• integrating all available sources of information into a single suite of cascaded performance
measures that all accountable managers in the organisation have access to and use
• using performance measures as a learning tool, not just as a means of control. Learning
facilitates modifications to strategy, resource allocations and what (and how) performance
is measured.
Appendix 5.1 provides an example of how Achmea focuses on using strategy mapping and a
BSC of performance measures, not just in strategy formulation, but more importantly, in strategy
implementation.
➤➤Question 5.13
Giant Products Ltd (Giant) manufactures ‘triffids’, a product that has many purchased components.
The board of directors of Giant has set a goal of 10 per cent reduction in the total cost of
components used in manufacturing triffids during the next financial year (assuming constant sales
volume). The board believes that the high cost of the components may be due to a combination
of poor purchasing practices and/or wastage during production.
Giant has the following organisational structure.
Managing
director
(a) Recommend performance measures that Giant could implement to achieve its goal of a
10 per cent reduction in the cost of components.
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(b) Explain how these performance measures could cascade to lower organisation levels in
each department.
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(c) What would be the role of Finance and Administration in achieving this goal?
(d) How might information technology—for example, using an ERP system—assist in this process?
Check your work against the suggested answer at the end of the module.
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Study guide | 459
Designing performance measures and setting targets has no real value in improving efficiency,
effectiveness and equity unless those performance measures are used to improve performance.
This part discusses how performance improvement relies on three levels of analysis:
1. targets
2. trends
3. benchmarks.
It also considers the role of knowledge management and organisational learning in improving
performance. This part concludes with a discussion of the behavioural consequences of
performance management.
Given the almost unlimited measures that could be used, the ones that organisations should use
are those that are linked to achieving the organisation’s strategic goals. The number of different
performance measures needs to be limited to what is manageable, because too many measures
may result in none of them being seen as important. As mentioned in Part B, Kaplan and Norton
(1992; 1993; 1996a) recommend three or four from each of the four perspectives. Once cascaded
down, these broader measures may be replaced by more detailed measures, so in total an
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organisation may have many more than 12 to 16 measures. The measures may be different at
each organisational level, but at any one organisational level the number of measures needs to
be manageable.
As was discussed in Part B, the design of a performance management system will be linked
to the organisational strategy through the strategy mapping process and will most likely be
contingent on the organisation’s competitive environment—for example, size, technology,
strategy. It is important to distinguish what should be measured from what is easy to measure.
Organisations often avoid measuring performance that is important because measurement is
time-consuming or costly (cost–benefit is discussed later in this section). However, it is even
worse to measure performance just because it is easy to measure, if it is not critical to business
success. This practice leads to too many, often unimportant, performance measures.
The cascading of performance measures reflects the agency relationship between higher-
and lower-level managers—an extension of the principal–agent relationship. At the whole
organisational level, and at each subsidiary level, the measures that are important to achieving
strategy—for that organisational level—need to be determined. This relies on an understanding
of the organisation’s predictive model.
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In the EVT example, the entertainment and hospitality divisions have different predictive models,
and even for hotels different predictive models will apply because they are influenced by different
factors—business travel to CBD locations compared with holiday destinations in resort locations,
with seasonality affecting occupancy differently, especially for the skiing season at Thredbo.
They are therefore likely to have some performance measures that are different, although there
would also be much commonality.
The overall business strategy is cascaded to each business unit, which will develop subsidiary
strategies in accordance with the predictive model for that business unit. Once the strategy
is understood for each business unit, each department and even each individual employee,
performance measures can be defined that monitor whether the strategy is being achieved;
as shown in the EVT example, cascading is down to the individual hotel level.
Many types of performance measures exist. Table 5.4 provides an overview of some of the more
common types.
Activity Processes: number of hours worked, number of material issues, number of deliveries
Remember also that some performance measures are used for signalling to external stakeholders
as part of an organisation’s accountability. Others are used for planning, decision-making and
control, so the purpose of the performance measure needs to be considered.
Example 5.16 reveals the problem of inappropriate performance measures in a changing market.
Part 2 of this example is explored in Example 5.17.
Due to pressure from the board to increase profits, Mammoth sought to increase volume, but to achieve
its sales targets, sales representatives—who were paid a commission based on sales value—tended
to reduce prices and so, while volume was high, margins remained tight.
In this sector of the printing industry, production was based on customers’ orders and a job order
manufacturing process was in use. The time taken to produce an order on printing machines was
consumed partly in:
• set-up—also called make ready (i.e. setting up the machine before the paper is printed)
• machine running time—when paper is being printed through the presses.
Market changes had taken place over time, resulting in customers placing orders for smaller volumes
more frequently. The effect of this change was that Mammoth’s production capacity was being eroded
as more machine time was consumed in set-up rather than running time, which reduced Mammoth’s
overall capacity to produce the necessary volume. A further impact of the smaller volume orders
was the increased number of non-production employees handling the increased number of sales
orders, production orders, deliveries and invoices. The overall effect was declining profits despite
increasing sales.
The production department was overwhelmed by the volume of business brought in by the sales
department and late deliveries became more common. The production manager argued that too
much production time was being used for set-up times for the small-volume orders. He argued that
the prices being charged were insufficient to cover the loss of overall production capacity and the
administrative burden caused by the small-volume orders.
The following summary of key performance data for Mammoth Printing, comparing its performance
over time, reveals substantial changes in financial and non-financial performance.
Prior to
implementation Percentage
Three years prior of changes change
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PBIT $8 million $1 million –87%
Mammoth’s business model had changed over time but the company realised that its performance
measures had not kept up with these changes. Consequently, Mammoth re-evaluated its performance
management system. The problem of capacity erosion through set-up times was accepted, and a
trial activity-based costing exercise recognised that costs to service small-volume orders were not
being passed on to customers through the price. A number of changes were introduced to the
performance measures.
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• In the production department, wastage, on-time delivery and machine running-speed performance
measures were supplemented by reporting the mix of set-up and running times on each machine,
to identify where too much time was being spent on smaller orders with long set-up times.
• Sales performance was judged not only on sales value but on ‘value added per machine hour’.
This was a value close to that used under throughput accounting (i.e. sales value less the cost of
materials). The value added was divided by the total number of machine hours (set-up and running)
to produce the job. The new ‘value added per machine hour’ measure became one of the most
important measures in managing Mammoth’s business—it identified those small jobs that had
both lower prices and higher set-up times as the value added per machine hour would be very low.
However, Mammoth faced considerable resistance from the sales representatives who were discouraged
from accepting orders where the value added per machine hour was too low. Attempts by the CFO
to replace the sales representatives’ commission on sales value with a commission based on value
added per machine hour failed because of the power of the sales and marketing director. Mammoth
failed to move fast enough to change its behaviour or its performance measures, and the company
was subsequently taken over by a multinational competitor.
Example 5.16 reveals the need for continual reassessment of the business model and
performance measures. It shows the need for management accountants to be able to interpret
performance information and recommend appropriate strategies to respond to changes in
performance. It also highlights the importance of power and culture, and the behavioural
consequences of performance measures (discussed later in this part).
Efficiency Effectiveness
Conversion of inputs or Focus on the end
resources (physical, human result of production,
and financial) into outputs on quality and customer
(products and services) satisfaction—whether the outputs
achieve what was intended, or
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Equity
Fairness and equal
treatment—managing differences
such that the costs and benefits of
economic activity are spread equally
among different customer or other
stakeholder groups
Both efficiency and effectiveness are important. In the Mammoth Printing example, the company
was neither efficient (too much time was spent on set-up) nor effective (profits were too low,
while customers received late deliveries).
Finding the right balance between efficiency and effectiveness is important, and organisations
need to recognise the trade-off between these aspects of performance. For example,
a customer needs a service call for some equipment that is not working and wants the service
call on Monday, but it is not efficient for the service technician to go to every location on every
day of the week. Service calls are grouped to similar areas for set days of the week. The day
set for service calls to the customer’s area is Wednesday. There is a trade-off here between
the performance measure for service efficiency and the performance measure for customer
satisfaction. One may be achieved in this scenario, but not both. Recognition of trade-offs needs
to be built into performance measures.
This raises the issue of equity. Should all customers be treated equally? In Example 5.15, there is
an equity issue surrounding the treatment of emergency patients and elective (i.e. non-urgent)
surgery patients. While it might be unacceptable not to treat an injured person, neither is it
equitable for elective surgery patients to wait many months for their treatment. In the Mammoth
Printing example, is it equitable for all customers to be treated in the same way, with the risk of
late deliveries, when some customers have paid a higher price—generating a higher value added
per machine hour—than others for what they have ordered?
Issues of equity also appear in the HR function, where performance measures may exist in
relation to gender equality, the treatment of people with disabilities, or those from Indigenous
or ethnic backgrounds.
One way of looking at performance measures and targets is through the acronym SMART,
as outlined in Figure 5.11.
S M A R T MODULE 5
Specific Measurable Achievable Relevant Time-based
• Measures and • Should be and agreed • Measures and and timely
targets should capable of • Targets may targets should • Targets should
be clear and being be ‘stretch’ be relevant to cover a
unambiguous accurately targets rather the strategies defined time
measured than easy to in the business period
• Should be achieve but model • Measures
clear whether must be must be
a target has achievable produced on
been and agreed a timely basis,
achieved, or between so that
how close the managers and corrective
performance subordinates action can
is to target be taken
It is good practice to review all performance targets to ensure they are SMART. If measures are
difficult to measure or are ambiguously worded, irrelevant to the organisation’s strategy, too late
to lead to action or not agreed between the target setter and the accountable manager, they are
unlikely to be helpful in identifying performance gaps or improving performance.
Table 5.5 shows two examples of performance targets that are SMART, as well as two examples
of performance targets that do not satisfy the SMART criteria.
Return on capital employed (ROCE) The ROCE target is specific, measurable and achievable in
of 14% in FY 20X4 compared with comparison to prior year, relevant and time-based (FY 20X4).
13.5% in FY 20X3
Customer satisfaction of 95%, The target is specific, measurable and time-based. It may be
based on survey of products achievable provided past customer satisfaction is within a realistic
delivered during the month of June range of the target figure, and is likely to be relevant to most
businesses that need satisfied customers to maintain and/or
grow sales revenue.
Product quality of 100% The quality target is not specific—it does not say how quality
is measured; it may be measurable (if how quality is measured
is defined) but is unlikely to be achievable as 100% quality is
unrealistic given the costs likely to be incurred to achieve perfect
quality; the target may be relevant, but only if it is critical to
achievement of organisation goals; it is not time-based as no
time period is specified.
Staff turnover less than or equal to While the target is specific and measurable (although there may be
25%—historical staff turnover is 45% some definitional issues around part-time or casual staff), it may not
be achievable given past performance. The target may be relevant
if staff continuity is especially important for the business, but the
target is not time-based.
Reliability
Controllability
Whatever is being
Must be controllable
monitored can be
by those whose
measured consistently
performance
and in an objective and
is being measured
specific manner
Characteristics
of performance
measures
Accessibility
Can be accessed
Clarity
by all authorised
Easy to understand with
organisational
little or no ambiguity
participants who need
the information
Timeliness
Provides information
early enough to allow
corrective action
Validity
Validity (or accuracy) refers to how well a measure helps evaluate the issue or item of performance
being considered. If a measure does not accurately describe what it is supposed to, all other
attributes are meaningless. A performance measure like operating profit is objectively known from
financial statements and is subject to audit, being based on accounting standards. In reality, the
practice of accruals and provisioning can influence reported profit. Market share may be measured
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objectively by reputable and independent industry sources based on sales data reported by each
company in the market. This data tends to be accurate, although sales can be misreported by
individual companies.
Some concepts are quite difficult to measure directly, so indirect measures are used. The problem
is whether or not they accurately capture what is meant to be measured. Customer satisfaction
is often measured in a restaurant by asking customers whether or not they were satisfied with
their meal. Because customers may be more inclined to say they were satisfied rather than
risk offending the restaurant staff, a business can be misled by those responses. A measure
of the same customer returning would be more valid, perhaps through a loyalty card scheme.
An anonymous ‘tick box’ feedback form left with the customer’s bill may also provide more valid
information about customer satisfaction.
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Reliability
Reliability means that whatever is being monitored can be measured in an objective and
specific manner. Reliability is concerned with consistency, or the extent to which the reported
performance is the same over repeated measurement attempts—for example, does a customer
satisfaction survey carried out by different people give the same results no matter who carried
out the survey? A reliable measure is one that is trustworthy.
Reliability is sometimes confused with the term ‘validity’ because it is interpreted to mean
‘a measure I can rely on to tell me what I need to know’. However, this is not an accurate
understanding or interpretation of what reliability means. Many things can be measured
‘reliably’, but this does not mean they are useful for analysis.
A measure can be highly reliable but completely invalid for decision-making purposes.
For example, we could measure growth in company sales revenue to assess customer
satisfaction. Sales revenue is both a valid and reliable measure, but it has tenuous links with
individual customer satisfaction, so using it to measure customer satisfaction may not be valid.
A more valid measure of customer satisfaction may be customer retention—that is, how long
the customer stays a customer and whether purchases by the customer are increasing or
decreasing. The reliability of this measure can only be gauged if over time customer retention
equates to customer satisfaction.
It is often difficult to measure ‘valid’ measures in a reliable way. Consider the restaurant example
about measuring customer satisfaction. Reliability of the performance measure will be improved
by repeating the method of measurement in a consistent way—for example, using a standard
customer feedback form over a long period of time. However, even here, caution must be
exercised in interpreting the data because it could be affected by the particular customer or
waiting staff on duty or by a variety of other factors such as the level of heating or noise from
other customers.
A common performance measure in many service businesses is the time taken to answer an
incoming telephone call. The assumption is that customers will be more satisfied when they
do not have to wait for long periods. There is a cost in calculating, storing and reporting this
information, even though it is largely carried out behind the scenes through communications
technology. The performance measure may be reliable because it may be collected as a
by‑product of the technology used, but may not be valid as a measure of customer satisfaction
because the customer may weigh the quality of the answer as being far more important than
the time taken to answer the phone. The time taken to answer a telephone is a useful measure
because it indicates whether staffing is sufficient to minimise customer queuing, but as a valid
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Clarity
If a measure is to be meaningful, it should be easy to understand with little or no ambiguity in
interpreting the results. For example, a measure of ‘product quality’ usually has a high level of
clarity. It begins with a specification of the product. The final product can then be compared with
the specification and tested to see if it meets the specification.
An example of a measure that often has a low level of clarity is a popular measure of shareholder
value—economic value added (EVA). This is a valid and sometimes reliable measure, but it is
difficult to understand due to its complexity and the number of choices that are made in the
construction of the measure. This makes it difficult to use when comparing results between
business units or organisations.
Study guide | 467
Timeliness
To be useful, performance measures need to provide information early enough to allow
corrective action to be taken. If a measure is not available when it is needed for decision-making,
then it is of little use. Many financial measures such as profit are not timely. These are lagging
measures and inform about what has already happened, but provide little guidance for future
action. However, sales data collected daily for a retail chain store is a very timely measure of
likely future financial performance. Such data can influence immediate actions such as increasing
advertising, purchasing inventory and price discounting.
Accessibility
Performance measures should be able to be accessed by all authorised organisational
participants who need the information. Accessibility refers not only to the measure, but also
to the information that drives the measure.
Controllability
In order to be effective in motivating behaviour, what is measured must be controllable by
those whose performance is being measured. Controllability refers to the ability to influence the
quantity or value of the measure through action. Aggregate measures such as the organisation’s
profit are normally only partially controllable by any individual in an organisation. On the other
hand, production quality is a measure that should be controllable by the process owner.
A cost–benefit analysis compares the outputs or outcomes with the costs to produce those
outputs or outcomes. Cost–benefit analysis is one method of evaluating performance
measures. The measurement of performance, its monitoring, management and reporting
is an organisational cost. Data must be collected, summarised, analysed and interpreted,
and corrective action must be taken to improve performance where necessary. This often
involves both a technology cost (the information system) and a human cost. Therefore, it is
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important that the design of a performance management system recognises the cost of
measuring performance and compares this cost with the benefits that are likely to accrue
from it. Performance measures that are very costly but yield little benefit should be avoided or
eliminated. Costs here are not just cash costs, but opportunity costs—that is, the alternative
use and the benefits from that use to which the resources consumed could be put.
In the TNA example discussed previously (Example 5.12), the owner–manager abandoned most
traditional performance measures—including reported profits, except to comply with statutory
requirements—because they were not cost-effective. Traditional accounting-based measures
did not reflect the reality of TNA’s business model, where the largest costs for R&D, export
market development and patent litigation were incurred many years before revenue was earned.
TNA saved the cost of comprehensive monthly accounting performance reports that were
not useful.
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The lean accounting approach argues that the costs of detailed time recording and material
issues against jobs and carrying out price and efficiency variance analyses are prohibitive and
yield little benefit compared with the cost. Lean accounting uses backflush costing to record the
cost of time and materials based on standard costs once a job is complete. This is a far less costly
accounting process. While the argument for lean accounting approaches seems logical, it is
contingent to a large extent on how effective other controls are within the organisation.
There may be an opportunity cost in backflush costing if there are variances that are not
identifiable. If a physical stocktake at year end results in only minor adjustments, it can
be assumed that backflush costing is a cost-effective method and that abandoning time
recording, material issues and variance analysis has reduced organisational costs. If there are
serious discrepancies at the time of a stocktake, this highlights significant control weaknesses.
Whether time recording, material issues and variance analysis may be effective controls is another
matter, but this example highlights the need to consider the cost and benefits of performance
measures in light of each organisation’s circumstances, as shown in Example 5.17.
The questions that can be asked with regard to the value of performance measures are:
• Can they be understood?
• Can they lead to action to improve reported performance?
• Will (and if so, how will) improving performance as reported by a particular measure help
achieve organisational strategy and goals?
If the answer to any of these questions is ‘no’, then it should be asked why that performance
is being measured. There is a tendency by some managers and organisations to look for new
performance measures, but often insufficient attention is given to abandoning performance
measures that may once have been useful, but are no longer useful.
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What is important in these examples is that, at the very least, organisations should question
taken-for-granted practices and not continue them just because it is ‘the way we have always
done things here’.
➤➤Question 5.14
Review the following 10 performance measures and their associated targets for XYZCo’s latest
financial period. Evaluate the performance measures and targets with reference to SMART
(specific, measurable, achievable, relevant, time-based) design principles, and the characteristics
of effective performance measures and targets (validity, reliability, clarity, timeliness, accessibility
and controllability).
Study guide | 469
Performance
Performance measure target SMART Characteristics
4. Percentage of 90%
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incoming telephone
calls answered in
one minute
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Performance
Performance measure target SMART Characteristics
Performance
Performance measure target SMART Characteristics
9. Headcount 120
Check your work against the suggested answer at the end of the module.
For further practice in the concept of effective performance measures, please access the
‘Characteristics associated with performance measures’ learning task on My Online Learning.
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Cultural elements can be seen as part of the control package (Malmi & Brown 2008) but cultural
factors also influence the design of performance management systems (Ferreira & Otley 2009).
Euske, Lebas and McNair (1993) contrasted the individual performance measures, used to direct
short-term attention, with cultural norms as the basis for guiding long-term behaviour.
An organisation’s culture will influence the kind of performance measures used. In a culture where
accounting controls are seen as very important, it is more likely there will be time recording,
material issues and variance analysis than lean accounting approaches. In an organisation
whose culture is focused on short-term profits, then that will dominate the approach to
performance management.
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Malmi and Brown (2008, p. 291) noted that ‘different systems are often introduced by different
interest groups at different times’ and so control systems, including performance management,
will be implemented when they are consistent with:
• other sources of power
• the dominant organizational culture in their implications for values and beliefs
• shared judgements about certainty, goals and technology (Markus & Pfeffer 1983, p. 205).
Example 5.18 highlights these issues as they apply to the advertising industry.
In the advertising agency business though, creativity is also essential. Agencies recruit creative people
who must succeed in designing advertising that works for the agency’s clients. Investing in talent
recruitment can conflict with short-term financial pressures. One particular tension is whether to win
sales revenue to finance new talent (which causes pressure on existing staff until the talent is recruited)
or whether talent is recruited first (which causes pressure to win sales to fund the new talent).
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While financial performance is important, advertising agencies measure their performance in terms of
employee satisfaction and client satisfaction, and also by winning creative advertising industry awards.
These awards enable the agencies to recruit talent, even though they do not necessarily reflect work
that is valuable to the client, whose interest is less in the creativity than the ability of the advertising
campaign to generate sales revenue.
In one international advertising agency, these different aspects of performance are managed
simultaneously. Performance measures for finance, employee satisfaction and client satisfaction,
as well as industry awards, are maintained. Attention is paid to both client satisfaction and employee
satisfaction so that problems or trends identified through regular surveys of each group result in action
to remedy the problem. Although there are no targets to win awards, the agency knows that failure
to do so will detract from its ability to attract and retain creative staff. Most importantly, perhaps,
creative talent is insulated from financial pressures, with senior managers protecting them from any
financial information. Risk-taking by senior managers results in talent recruitment ahead of revenue
generation. In the history of this agency, this has proven to be a successful strategy, because newly
recruited talent has generated additional client income.
Study guide | 473
Creative organisations like advertising agencies need to manage competing priorities in a flexible way
to survive—both in terms of satisfying short-term expectations and investing in talent—that reduces
profits in the short term, to achieve sustainable performance.
Of course, not all organisations can balance competing demands in an effective way. A contrasting
example is the BP and Deepwater Horizons oil rig disaster (see Example 5.19), which demonstrated
what can happen when a single aspect of performance is pursued at the expense of all others.
Example 5.19: B
P and Deepwater Horizon in the
Gulf of Mexico
The world’s largest accidental marine oil spill took place in the Gulf of Mexico when the USD 560 million
Deepwater Horizon oil-drilling rig exploded in April 2010. This followed a blowout of the Macondo oil
well, resulting in the death of 11 workers and an estimated five million barrels of oil spilling into the gulf.
Reports suggest that the main fault lay with BP and its subcontractors. The well was six weeks behind
schedule due to a number of technical drilling problems and the delay was reported to have been
costing BP more than half a million dollars a day. Best practice for drilling wells had not been followed
and BP had chosen to drill in the fastest possible way. Despite concerns expressed by employees
and consultants to BP, a number of shortcuts were taken to reduce costs. Each decision taken by BP,
while legal, saved BP time and money yet increased the risk of a blowout (Bourne 2010).
In its final report, the National Commission on the BP Deepwater Horizon Oil Spill and Offshore
Drilling placed most of the blame for the disaster on BP and its partners who placed financial interests
before safety.
Following the incident, BP reported a second-quarter loss of USD 17 billion, its first loss in 18 years,
which included a one-time USD 32.2 billion charge, including USD 20 billion for the fund created for
reparations and USD 2.9 billion in actual costs (AC) incurred at that time. In October 2010, the CEO
resigned. The total amount of claims paid or approved for payment by BP as at mid-December 2010 was
USD 4.3 billion. In the aftermath of the disaster its market capitalisation fell by about USD 100 billion.
The information available suggests that BP’s culture of cost cutting to achieve short-term profits and
the power of dominant coalitions to push ahead despite safety concerns were significant contributors
to the accident. As a consequence, the reputational as well as financial cost to BP has been enormous.
Note: Candidates may be familiar with this example from their study of the Ethics and Governance
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subject of the CPA Program.
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➤➤Question 5.15
This module has drawn on the difference between performance measurement and performance
management. Several examples have suggested that performance measurement needs to be
customised to each specific organisation.
Explain why performance measurement needs to be customised and the role of the management
accountant in performance management.
MODULE 5
Check your work against the suggested answer at the end of the module.
Management accountants then need the personal skills to be able to use their knowledge to
influence senior managers in relation to performance management by:
• setting SMART measures and targets consistent with strategy
• providing relevant information to support other managers’ decision-making
• identifying and recommending potential approaches to performance improvement.
The opportunity for performance improvement through using targets, trends and benchmarking
is reviewed in the following section.
Targets
As outlined previously, at the first level targets need to be set for each performance measure
and performance measures should cascade down the organisational hierarchy through each
business unit to the individual level. Performance targets need to be SMART and meet the six
characteristics of effectiveness.
Targets that are set can range from those that are easy to achieve to those that are difficult or
impossible to achieve. The achievement of a target, therefore, is not necessarily a sign of ‘good’
performance because it is relative to the target set. Improving performance is often seen as a
process of continually increasing the target and expecting that target to be achieved, but there
are three problems with this approach:
1. the cost–benefit trade-off in continually achieving more stretching targets
2. the impact of achieving some targets on other targets
3. the accuracy of assumptions in the predictive model.
Cost–benefit
As discussed previously, the costs and benefits of achieving an ever-increasing target need to
be weighed against improving performance.
For example, a student who has a target of 80 per cent in an exam may achieve 82 per cent.
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The same student may then decide to increase the target to 85 per cent or 90 per cent. However,
the student needs to evaluate whether the costs (e.g. time spent studying and its opportunity
cost, such as working fewer hours at their part-time job) are worthwhile to achieve the higher
mark. It may be that the additional cost to get a mark of 90 per cent (compared to the existing
82%) is not worthwhile and the student could expend their efforts elsewhere.
By contrast, a student who sets a target of 70 per cent and achieves a mark of 60 per cent should
be sufficiently motivated to work harder to improve performance, but it may be that the student
decides to lower expectations to a revised target of 65 per cent. The actual target will depend on
the student’s goals and may be quite different between individual students, depending on their
abilities, motivation and aspirations.
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The idea of strategy mapping was that organisations set performance targets based on their
strategic goals and then regularly review their performance against those targets. The result of
this review may be to reallocate resources, or management attention, to underperforming areas
(which may result in a detrimental effect on those areas deemed satisfactory), or to modify the
target if it is considered that the target is inappropriate in relation to other targets.
Predictive model
Parts A and B discussed the idea of the predictive model. The predictive model is the set
of assumptions that drive the business:
• why customers buy products and services
• how those products and services are produced to fulfil customer orders.
The predictive model suggests that if particular actions are taken, they are likely to lead to
defined levels of performance. However, Otley and Berry (1980) argued that predictive models
are partial and unreliable. It is not certain that actions (e.g. an increase in advertising expenditure)
will lead to performance improvement (e.g. an increase in sales). Organisations work on the basis
that assumptions about their predictive model are correct, but they need to continually challenge
their assumptions and ask whether the performance targets they have set are still appropriate.
Continual poor performance compared to targets may suggest broader problems with the
taken-for-granted business model. A good example of the failure of predictive models was the
GFC and the purchase of complex financial products like mortgage-backed securities in an
overheated housing market.
Trends
The second level of analysis for performance improvement is trend. Accountants are familiar
with trends in the analysis of financial ratios from financial statements. The same principle
applies to all performance measures, but organisations will typically monitor non-financial ratios
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more frequently (monthly, weekly or even daily for some measures) than for many of the ratios
calculated from annual financial statements.
Trends show improving or worsening performance over time, and are more reliable measures
of performance than comparing performance to targets, which may be set more subjectively.
Rather than taking corrective action based on single period comparisons between actual
and target, trends can identify short-, medium- and longer-term changes in performance that
deserve attention. Performance needs to be sustainable over time, so short-term improvements
compared with targets need to be re-evaluated by looking closely at trends over longer
time periods.
Benchmarking
The third level of analysis for performance improvement is benchmarking—that is, comparing
performance to competitors, industry averages, or acknowledged ‘best practice’ or ‘world class’
performance. Benchmarking enables an organisation to see where its performance might be
improved relative to others. Figure 5.13 shows the benchmarking process for performance.
Study guide | 477
3.
2.
1. Study the
Identify
Decide what processes in your own
benchmarking
to benchmark organisation and
partners and sources
gather information
5.
4. 6.
Analyse the
Obtain Learn and
information and
benchmarking implement changes
understand it relative
data where necessary
to the benchmark
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For example, the Australian Bureau of Statistics reports aggregate data for retail sales per square
metre of floor space, labour cost per employee and inventory turnover data. Supermarkets use
various data to compare their performance, such as financial results, sales revenue and number
of stores. Competitor financial statements will of course be used to compare financial ratios.
Other data shown in some company annual reports includes performance measures of sales
per square metre of floor space and sales per employee, both key performance measures
in the retail industry. Benchmark comparisons of data such as this are useful in making
comparisons of efficiency in use of floor space and staffing levels. Woolworths’ annual report,
for example, also shows the number of customers linked to its ‘Everyday Rewards’ accounts
and Qantas Frequent Flyer points.
Whereas EPS data is regulated, data on non-financial performance measures is not required
under financial reporting standards. So it is often the case that benchmark comparisons
cannot be made or can only be made based on estimates derived from data shown in the
annual report—for example, using reported sales figures, estimates of supermarket size or
employee numbers.
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Internal benchmarks
Where an organisation has multiple business units, especially when those units have similar
operations, comparisons between units may be useful. For example, retail stores make extensive
use of benchmarking, comparing sales per square metre and sales per employee between
store locations and between departments—for example, homewares, clothing, electrical.
Internal benchmarks would be particularly valuable to compare hotel performance within EVT’s
hospitality division.
One method of benchmarking is to obtain data directly from the organisation identified as
having the best practices, but if this is a competitor, direct access to data is not normally possible.
Indirect data may be obtained through business intelligence (BI)—for example, from websites,
trade exhibitions or speaking informally with competitors. A common practice in some industries
is to hire employees from competitors to obtain first-hand knowledge of competitors’ practices,
although this is generally regarded as being unethical; and such employees are often restricted
by non-compete and confidentiality clauses in their employment contract and exit package.
One way to have reliable industry benchmarks is to set up a benchmarking consortium that
includes a number of organisations operating in the same industry. Universities do this to
compare their performance on research, teaching quality and graduate outcomes. Independent
organisations are commonly selected to collect the information and provide each organisation
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with its own results as well as those of other organisations, in a format that does not allow
individual organisations to be identified. In many public sector organisations, such as schools
and hospitals, government departments benchmark data and make some publicly available,
with other data being restricted to the participating organisations.
Benchmarks for small businesses can be downloaded from the Australian Taxation Office website at:
http://www.ato.gov.au/Business/Small-business-benchmarks.
Sometimes there is an opportunity for benchmarking against best practice organisations outside
the organisation’s own industry, but care needs to be exercised as to whether practices can be
translated between industries.
All benchmark data needs to be interpreted carefully. Accountants and managers need to
look behind the data provided and try to understand why differences in performance between
organisations exist. Sometimes performance may vary due to different strategies or business
models, different regulatory regimes, or differences in legacy investments—for example,
in technology or infrastructure. In the absence of standardised data, all comparisons need to
consider whether the assumptions behind reported data are common between the benchmarked
organisations. Finally, the data derived through benchmarking is historical and reflects decisions
of the past, not current practices or recent decisions that are yet to be implemented. In relying
on past benchmarking comparisons, accountants and managers need to be aware that the
pursuit of continual improvement and sustainable competitive advantage by all benchmarked
organisations leads to continually evolving processes, and therefore continually changing
performance relative to others.
In aiming for performance improvement, targets, trends and benchmarks all provide useful
information in learning what works and what does not, but all available information should be
used when seeking to improve performance. In comparing actual performance against targets,
remember that the variance may lead to a decision to change behaviour to improve performance
relative to targets, or to change a target to one that is more realistic. It is also important to
recognise that there is a time lag between making changes and when the effect of changes
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can be seen in performance measures.
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➤➤Question 5.16
(a) Briefly explain the main steps involved in undertaking a benchmarking exercise.
(b) Identify the main problems associated with undertaking a benchmarking exercise.
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Study guide | 481
Check your work against the suggested answer at the end of the module.
Organisational learning
Performance management through improving performance is a learning process. Data is
collected, analysed and interpreted by individual organisational members. When behaviours
or performance targets (or even what elements of performance are measured) need to change,
organisational systems, processes and procedures may prevent these changes from being
enacted. Organisations commonly have members who know what needs to be changed, but the
organisation can sometimes seem incapable of change because the ‘organisational memory’
is institutionalised (or embedded) in IT systems, procedure manuals, taken-for-granted working
practices, budgets and performance targets. Consequently, existing systems, procedures or
working practices may need to be ‘unlearned’. This is a process of organisational learning,
meaning how organisations as institutions (rather than the individuals within them) are able
to learn and improve. This is a distinction between learning in organisations by individuals,
and learning by organisations made by Popper and Lipshitz (1998).
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Organisational learning is concerned with the acquisition, sharing and utilisation of individual
knowledge within organisations (see Nonaka 1991). It is also concerned with how assumptions
about cause-and-effect relationships are shared within organisations, as well as how redundant
information is unlearned (e.g. Hedberg 1981). Organisational learning is about managing
knowledge at the level of the organisation.
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Performance improvement
Performance improvement requires a learning process that makes performance comparisons
using targets, trends and benchmarks; identifies changes needed to the assumptions about
cause-and-effect relationships in the predictive models held by individuals about business
models; and changes any or all of:
• behaviour
• performance measures
• targets, where necessary.
These are within the domain of the management accountant to influence, as discussed
previously. Learning and knowledge management are particularly important in fast-changing
markets or technological environments, as Example 5.20 demonstrates.
In the music industry, music recordings were originally on gramophone records and subsequently on
large reel-to-reel tape recorders. Further innovations were cassette tapes and compact discs (CDs).
With computer and internet technology, there is no need to buy music on any particular type of media—
it can be purchased and downloaded from e-commerce sites and stored and played on a computer
or mobile device. Similar changes have taken place in video with VHS tapes (Betamax tapes failed
quickly in competition with VHS) giving way to CDs, DVDs and Blu-ray technology (Blu-ray effectively
beating its Toshiba HD-DVD competitor). Movies can now be purchased and downloaded from the
internet in the same way as music. Foxtel, which was a major supplier of downloadable content, is facing
considerable competition from Netflix. In music streaming, we have seen the failure of Pandora and
its replacement by Spotify, which provides features valued more by customers.
These technological changes have had significant impacts on the business models of recording studios,
manufacturers of audio and video equipment, and media devices like records, tapes, CDs and DVDs.
Performance measures in those industries would likely have focused on numbers of units sold and
sales revenue, etc. Without knowledge of rapidly changing upstream technologies, these companies
may have been caught unaware by declining sales volume and profitability and may have ultimately
failed. Performance measures that are more strategic, such as awareness of patent registrations,
collaboration agreements with upstream supply chain partners and environmental scanning of emerging
technologies, would serve to avert the effect of such changes.
Similarly, retailers would have had to adapt quickly to new technologies, and the likely impact of
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downloading music and videos on the types of recording and playing equipment required. As for
equipment suppliers, attention to performance measures on sales volume and value, floor space and
employee numbers could have led to serious consequences. Retailers who were better informed about
technology change could introduce measures for reducing inventories of products that were likely to
become obsolete and for expanding the product range to spread the risk, such as the number of new
product launches or advertising expenditure on new products. Awareness could lead, for example,
to a shift in the business model from retail stores to online sales, something that has become evident
in retailers such as JB Hi-Fi; while Amazon’s launch in Australia has generated much discussion about
the threat to ‘bricks and mortar’ retailers from its online platform.
A performance measure that is used interactively is more likely to influence behaviour than
one used diagnostically, because subordinates will be aware that senior managers are paying
attention to particular aspects of performance.
In a similar way to compiling budgets, those who determine performance measures and their
associated targets derive a considerable source of power in organisations. Targets need to be
achievable (the ‘A’ in the ‘SMART’ acronym) but may be on a continuum from ‘stretch’ targets
to easy-to-achieve ones. Managers are more likely to accept targets and be motivated to strive
to achieve them if they feel that they have participated in the target-setting process, even if
the final targets are difficult to achieve. By contrast, if targets are simply imposed without any
participation, managers are unlikely to be motivated towards achieving them. The example
of Mammoth Printing showed how performance measures—like sales targets—resulted in
behaviour that was not necessarily in the organisation’s best interests. In that example, many
of the sales achieved were unprofitable due to the impact of smaller orders on production
efficiency, but the commissions paid to sales representatives rewarded these unprofitable sales.
Professor David Otley (1999) provided two illustrations of the unintended and dysfunctional
consequences of performance measures.
2. Otley was buying his weekly groceries from Tesco, a major UK supermarket chain. Otley was
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surprised that the checkout operator waited until the conveyor belt was full of groceries
before she commenced scanning and packing. Otley’s interest in performance management
led him to ask the operator why she waited before commencing the scan. The checkout
operator replied that one of her performance measures was the average time it took to scan
a customer’s trolley, based on the time elapsed between the first and last item scanned and
the number of items scanned. If the operator had to wait for the customer to take goods
out of the trolley it would negatively impact on her performance, which would be seen by
everyone on an office chart that ranked the speed of checkout operators.
In both cases, the performance measures were well-intentioned, but resulted in unintended
consequences:
• an absence of any improvement in the unloading speed of baggage from BA flights
• customer dissatisfaction in what, from the customer’s perspective, appeared to be a lazy
checkout operator (Otley 1999).
Efforts to report performance that is desired by senior management can lead to a variety of
unintended and dysfunctional consequences, such as those outlined in Table 5.6.
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Sub-optimal behaviour Achieving a performance target and failing to try to further improve because
the target has already been achieved
Being fixated on a Rather than the underlying performance, by ignoring the cause-and-effect or
performance measure action-and-outcome relationships
Gaming and biasing Making performance appear better than it is, either by misrepresenting
performance by providing inaccurate reasons for not achieving targets or
even falsifying reported performance
Although they were writing about budgeting, the classic research by Lowe and Shaw (1968)
identified several sources of bias that are equally applicable to performance measures.
These are the:
• reward system
• influence of recent practice and norms
• insecurity of managers.
The same sources of bias apply to non-financial performance measures where, in a similar way to
compiling budgets, there is ‘the desire to please superiors in a competitive managerial hierarchy’
(Lowe & Shaw 1968, p. 312).
These behaviours distort not only target setting and reported performance, but may also result
in actions taken by organisations that detrimentally affect performance. Dysfunctional and
unintended consequences can easily result from inappropriate performance measures and
targets. In these organisations the pressure for short-term financial performance ignored issues
of the sustainability of that performance over time, and the associated reputational issues.
Often this focus on short-term financial performance is driven by the rewards offered to directors
and senior managers.
As Lowe and Shaw (1968) identified, rewards significantly influence behaviour. The examples of
EVT, Woolworths, Newcrest Mining and others highlighted that audited remuneration reports
now take up many pages in listed company annual reports. These remuneration reports typically
contain STIP and LTIP that reward directors and senior managers for achieving financial and non-
financial targets. These targets, particularly in the LTIP, are usually consistent with shareholder
value goals. Cascading will result in some of these targets, supplemented by more operational
targets as well as sales and cost targets, flowing down to each business unit and often being
embedded in individual performance appraisal processes.
Employees can be motivated either through a ‘carrot’ or ‘stick’ approach. ‘Carrots’ are the rewards
employees receive for achieving the desired levels of performance. ‘Sticks’ are the sanctions or
penalties that result from not achieving desired levels of performance.
Rewards can be financial (e.g. bonuses, profit sharing, share options), but can also be non-financial
(e.g. promotion, transfer to desired positions, a better office, a bigger budget, recognition, a better
performance appraisal). Sanctions include the loss of financial reward; being identified as a poor
performer; a negative personal reputation; or perhaps demotion, transfer or even dismissal.
Study guide | 485
Consequently, rewards and sanctions are powerful motivators of behaviour, and can of course
lead to the unintended and dysfunctional consequences discussed in the previous section.
Rewards should be designed so that the needs for short- and long-term performance are in
balance. Short-term (especially financial) results should not be achieved at the expense of
sustainable longer-term performance and achievement of the organisation’s goals and strategy.
Company LTIPs will often reveal the need for sustainable performance over time before rewards
are awarded.
This module has used the example that reducing expenditure on advertising, employee training,
repairs and maintenance, or R&D would improve short-term financial results, but would likely
detrimentally affect the organisation in the longer term. One impact of rewards for short-term
performance is that managers may achieve targets and be rewarded financially and promoted.
A replacement manager could then be at a disadvantage. The lack of prior investment makes an
incoming manager’s performance appear worse, because they have to remedy the deficiencies
of the previous manager who improved short-term performance through failing to invest in the
longer term.
Timing
To reinforce the relationship between performance and reward, rewards need to be timely. If too
much time elapses between performance and rewards, the important association between
rewards and actions becomes less obvious to people. This suggests that annual bonuses are
potentially ineffective and that bonus payments more closely linked in time to the achievement
of the desired performance level are likely to be more highly motivating. On the other hand,
making bonus payments too soon after performance is achieved can lead to a focus on short-
term profits rather than profits that are sustainable in the longer term.
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performance, and then paying appropriate compensation, is difficult.
In many organisations, performance rewards are based on aggregate measures such as profit.
As has been noted previously, the influence any individual has on corporate profit is likely to be
small, so the motivational effect of a profit-based bonus on the individual is likely to be equally
small. This approach is popular, because reward systems based on group performance measures,
such as profit, enhance teamwork, or at least reduce the potential for dysfunctional conflict,
and—as agency theory tells us—they align the goals of managers with those of shareholders.
However, the incentive to engage in gaming behaviour to achieve desired performance targets
can be a negative influence, and at the extreme, managers and employees may behave
dishonestly in their profit-reporting activities, as the examples of Enron and WorldCom revealed.
The most high-profile example of the focus on short-term financial performance affecting longer-
term performance has been the GFC. This is explored in Example 5.21.
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1. The practice of securitisation, where loans are packaged and resold by banks to other financial
institutions, including insurance companies, to raise funds for further lending.
2. A related cause of the GFC was said to be the rewards offered to directors and senior managers,
especially in the financial services industry, for continuously improving performance that was
unsustainable and did not take into account the risks that were being faced. The initial round
of blame in financial institutions that lost billions on subprime mortgage-linked investments
focused on their chief executives. CEOs at Citibank, UBS and Merrill Lynch were forced to leave
their companies.
There were severe effects from the GFC. The national income and output of the United States fell by
about 4 per cent in June 2009. That made it by far the sharpest US recession of the post-war period.
In the Eurozone, the peak-to-trough fall in output was even larger at around 6 per cent, and in the
United Kingdom it was 7 per cent. Further, in Europe, many countries were affected by a sovereign
debt crisis—that is, an unsustainable national debt caused by continual deficits—with Iceland, Greece,
Ireland, Portugal, Spain and Italy particularly at risk. The banks in many countries in the Eurozone,
in particular in Greece and Spain, faced difficulties in meeting their debt obligations, which caused a
downturn in demand and globally depressed stock markets (RBA 2014).
The GFC and its aftermath are at least in part a consequence of the relentless pursuit of
short-term financial performance, driven by rewards for measured success, without a real
understanding of the predictive model—which effectively collapsed—or a concern for risk or
the sustainability of performance over the longer term.
Svenska Handelsbanken’s goal was to be the most profitable bank in Sweden, but size was unimportant
to its CEO Jan Wallander. The bank’s strategy was to be radically decentralised, with nearly all lending
authority independent of head office.
Wallander abandoned budgeting at Handelsbanken but this had no effect on the bank’s performance.
Reflecting the contingent nature of performance measures, Wallander said that organisations will
use ‘different types of key indicators, ratios, graphs, etc. Modern companies already have myriads
of operational, financial and physical measures. The problem is to choose a limited number of
those measures which really show if the company and its different units are on the right track or not’
(Wallander 1999, p. 419).
In the absence of targets, the emphasis in performance management was on benchmarking: relative
performance compared between Handelsbanken’s branches, but also compared with other Swedish
banks. In addition to benchmarks, trends were compared from quarter to quarter, benchmarking from
one time period to another.
The final element of Wallander’s strategy at Svenska Handelsbanken was a profit-sharing system for
employees, with the profit share dependent on the profitability of the bank relative to other Swedish
banks. Interestingly, the employees’ share in the profits of the bank was only paid to them when they
retired, which encouraged attention to the sustainability of performance.
➤➤Question 5.17
After reading Example 5.22, compare what has been learned about performance management
throughout this module with the approach that Jan Wallander took in Svenska Handelsbanken.
Critically evaluate the Handelsbanken approach in relation to non-bank organisations, considering:
(a) the type of performance measures used
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Check your work against the suggested answer at the end of the module.
488 | PERFORMANCE MANAGEMENT
Review
Performance management focuses on shareholder value through customer value and achieving
a strong competitive position for the organisation. Such a focus would not be possible without
understanding the key role that performance management plays in strategy and value creation.
Part A looked at the definition of what was meant by performance and performance management
and emphasised the importance of balancing financial with non-financial measures. Value creation
and the sustainability of performance over time were outlined, as well as sustainability in the
sense of CSR. The implications of performance management for accountants and its links with
governance and signalling were introduced. Part A also described the importance of ethical
responsibilities, and agency and contingency theories that underlie much of the study of
performance management.
Part B looked at the links between strategy, management control systems and performance
management, and the limitations of some traditional accounting-based controls. The various
models of performance management, including the Business Model Canvas, were introduced.
The BSC and the strategy mapping process was emphasised, as well as cascading performance
measures and the important role of information systems in performance management.
Part C looked at how performance measures and their associated SMART targets are designed
and the characteristics that make performance measures useful, including the need to compare
the costs and benefits of performance management. This part also briefly introduced the role of
power and culture in performance management. It focused on improving performance through
targets, trends and benchmarking, and the importance of CI through organisational learning
and knowledge management processes. This is a role in which management accountants can
use their ‘soft skills’ to add value through interpreting performance and recommending ways
to improve performance. Finally, Part C looked at the often unintended and dysfunctional
consequences of performance management and how reward systems are implicated in
performance management.
Appendix 5.1 explores the case of Achmea including examples of how Achmea develops its
performance measures using a BSC linked to strategy through the strategy mapping process.
This process is cascaded down through the organisation to enable strategy to be implemented.
Achmea reports its performance in financial and non-financial terms and emphasises its
commitment to broader sustainability through its GRI index.
Appendix
Appendices
Appendix 5.1
Achmea Holding N.V.
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represents all of Achmea’s customers—so Achmea’s customers are its owners. Partner Rabobank
holds 29 per cent of the shares and the remainder is held by like-minded European insurers
(Achmea 2015).
Candidates should note that this structure of stakeholders could be aligned with the Business Model
Canvas described in Part B of this module.
Achmea identifies five main product groups, or ‘value chains’ as Achmea calls them: Non-Life,
OBJECTIVES
Health, Retirement Services, Pension & Life, and International (Achmea 2017, p. 20). Its strategy
CONTEXT & STRATEGY & PROGRESS OTHER INFORMATION APPENDICES
‘Delivering Together’ covers the period 2017–19. The business strategy focuses on:
strengthening our current business models and on developing new products, services and business
models … evolving from its traditional role as an insurance company … to one that focuses more
on services (Achmea 2017, p. 19).
SIGNIFICANCE
The strategyFOR ACHMEA
is described We see a dual challenge
in detail on pp. 19–20. Importantly, for ourselves:
the strategic themes on the one hand,
Achmea hasto
strengthen our current business models, and on the other, to
adopted incorporate sustainability as a leading motive (see below).
The precise direction and speed of change is unknown. A part develop new products, services and business models.
f or potential of the existing propositions will disappear, new propositions
due to the The strategy
will present has been
themselves, marketdeveloped infading
boundaries are the context
and of a way
The SWOT analysis,
in which shown
we will do in FigureinA1
this is described the 5.1.
me automation. competition is changing. Armed with this knowledge and Delivering Together section.
can contribute within this context, Achmea has formulated its strategy. We
claims. Improved are anticipating
Figure A1 the
5.1:developments
Achmeamentioned.
SWOT analysis
cker intervention or
STRENGTHS WEAKNESSES
m, these are risks
g economy. In the • Customer base, brands; customer ratings • Financial results not yet at target level
ed need for dealing • Broad portfolio and advantage of diversification • Growth of Free Capital Generation required to be
iability. For some of • Leading in health and property & casualty insurance able to continue investing in innovation
n prevention and risk • Variety in distribution; strong in banking and direct • Restricted scale of international activities
channels • Large market share in mature home market
• Broad access to Dutch businesses
nd businesses
s will continue to
g jobs and income OPPORTUNITIES THREATS
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Performance measures are described for each of the perspectives on pp. 22–3 of the annual
report, Part 1. Further details of the performance against each of these perspectives is shown on
pp. 56–9 of the appendix to the annual report, Part 1. In the 2016 annual report, the performance
measures or ‘key performance indicators’ as they were called were shown diagrammatically and
are reproduced in Figure A1 5.2.
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MODULE
PROFILE AND STRATEGY 5
OF ACHMEA - STRATEGY 492
SOCIETAL PERSPECTIVE
Implementation of innovative
ideas which promote safety and
health as part of the revenue At least 2 per brand1
model
EMPLOYEE PERSPECTIVE
Indicator of availability Minimum of 722
PARTNER PERSPECTIVE
Level of market penetration of
Interpolis Insurance
Private More than 25%
Commercial More than 29%
PROCESS PERSPECTIVE
Reduction in number of letters sent More than 25%; down from 2016
FINANCIAL PERSPECTIVE
S&P Rating Rating for insurance entities
Reduction in operating expenses,
€200 million
2016-2019
Figure A1 5.2: Achmea key performance indicators—2016 annual report
Achmea’s six perspectives add two to the four standard perspectives in the BSC: society (both
in terms of its mutual customers/shareholders and to the wider society); and partners (Rabobank
and the businesses that distribute Achmea’s products). It also reflects an employee perspective
(rather than learning and growth). Performance on each perspective is described in detail on
pp. 24–39 of Part 1 of the 2017annual report.
In particular, candidates should note that Achmea highlights its use of the NPS to measure
customer commitment to brands in the customer perspective; and profit before tax as the main
measure in the financial perspective.
Achmea’s strategy map, which links the six BSC perspectives, is shown in Figure A1 5.3.
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OBJECTIVES
INTRODUCING ACHMEA CONTEXT & STRATEGY & PROGRESS OTHER INFORMATION APPENDICES
494
Together with Vereniging Achmea we strengthen the Based on our expertise we contribute to a healthier,
Society perspective cooperative foundation of Achmea safer and a more future-proof society
Partner perspective With our (distribution) partners we improve and innovate Insurance is successful for Rabobank
our insurances and services
We optimise our portfolio and We ensure a robust balance and We realise a competitive
Financial perspective realise profitable growth effective capital and below market cost level
liquidity management
Additional information strategy map 2017-2019 can be found in the appendix (p.56).
The links between performance management and remuneration are disclosed in the
remuneration committee report within the annual report, Part 1:
The process of performance management and variable remuneration was conducted in a balanced
manner within Achmea in 2017, while it was also extended to the various organisational levels.
In modifying the process, it was decided to opt for greater simplicity and stricter management
by restricting the number of Key Performance Indicators (KPIs), while also defining them more
precisely, in a manner that matches the company’s risk profile and risk appetite, in a way that aligns
the strategy and long term value creation … there is a sound balance in the type of performance
indicator, short and long-term performance management and in the criteria used as a basis for
variable remuneration (Achmea 2017, p. 43).
Mentioned previously is Achmea’s commitment to sustainability issues. The annual report is:
compiled in line with the G4 Guidelines (Core option) of the Global Reporting Initiative (GRI).
The Annual Report’s structure complies in part with the principles of the International Integrated
Reporting Framework laid down by the IIRC. Both the IIRC and GRI stress the importance of
reporting on material topics … Achmea intends to conduct a completely new materiality analysis
next year and use the revised material topics as the starting point for its external reporting
(Achmea 2017, p. 47).
Achmea also identifies with the United Nations Social Development Goals (SDGs) under which
the United Nations set out, in July 2016, arrangements for monitoring progress and measurement
using indicators. Figure A1 5.4 shows the four themes and eight related SDGs (described on
p. 45).
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OBJECTIVES
INTRODUCING ACHMEA CONTEXT
MODULE 5 & STRATEGY & PROGRESS OTHER INFORMATION APPENDICES
496
Good health Clean, safe and Safe home and (Financial) solutions for
closer to everyone smart mobility working environments today, tomorrow and later
Figure A1 5.4: Achmea social development goals
Part 2 of Achmea’s annual report focuses on its commitment to socially responsible investment as:
always being able to fulfil our financial obligations to our customers and invest in a socially-
responsible manner, with respect for the world around us and for future generations …
contributing to a healthier, safer and more future-proof society (Achmea 2017, p. 27).
For example, ‘Achmea does not invest in tobacco producers, as this would be inappropriate for
a major health insurer. We also exclude manufacturers of controversial weapons’ (Achmea 2017,
p. 27). Achmea’s social themes include energy, paper, waste and corruption (Achmea 2017, p. 31);
and employee and gender diversity (Achmea 2017, pp. 33–5).
Part 3 of the 2017 Achmea annual report includes a GRI index (pp. 3–5) that shows where
information complying with the GRI G4 reporting guidelines can be found. Part 3 also includes
information about Achmea’s corporate social themes linked to the insurance industry’s Principles
for Sustainable Insurance (pp. 8–10). There is also a large amount of information about
environmental issues (emissions, energy, paper, waste, etc. pp. 17–21).
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Suggested answers | 499
Suggested answers
Suggested answers
Question 5.1
This question asked you to search both the annual report and results presentation of the 2017
results for EVT and find as many performance measures as you can for the hotel division.
As explained prior to the question, EVT’s most important financial performances measures are
revenue, EBITDA and normalised PBIT.
The annual report discloses the managing director’s STI, which is linked to performance targets
on p. 19.
Non-disclosure of specific performance measures and targets is often the case for listed
companies to avoid the information being available to competitors. For EVT, the annual report
also discloses that EPS and TSR (growth over the performance period of the three years to
30 June 2019, with performance measured against the year ended 30 June 2016 (being the base
year) (EVT 2017b, p. 20).
You should already be familiar with the most common financial performance measures.
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There is very little information in the annual report on non-financial measures. However, there is
reference to some important ones. These are:
• the number of locations and number of rooms (p. 10)
• three key performance measures that are relevant to hotels:
–– occupancy
–– average room rate
–– RevPAR growth (revenue per room), which are shown for all brands combined (p. 10),
and separately for the two brands: Rydges and QT Hotels (pp. 10–11).
In the Half Year Results Presentation for the first half of the 2018 financial year, information
is presented on revenue, EBITDA and normalised PBIT for all hotels (p. 10). Also shown are
occupancy percentage, average room rate and RevPAR for all owned hotels (p. 10) and by hotel
brand (p. 11).
500 | PERFORMANCE MANAGEMENT
The key non-financial performance measures for all hotels are those used by EVT:
• occupancy—average number of rooms utilised compared to total average available rooms
• average room rate—total average room revenue per occupied room per day
• RevPAR—total average room revenue per available room per day.
Question 5.2
(a) The 2017 annual report (p. 5) discloses that the primary role of the board is to protect and
enhance long-term shareholder value and recognises that the board is accountable to
shareholders for the company’s performance. The table on p. 36 of the annual report shows
how shareholder value has been created annually for each of the last five years. JB Hi-Fi
defines shareholder value as the increase in the enterprise value, plus cash dividends and
share buy-backs paid during the financial year.
This strategy clearly shows the goals that are desired (revenue, margin and productivity) but
also how those financial goals are achieved. It is only through expanding the product range,
improving technology, improving store layouts, effective advertising campaigns and investing
in the best retail locations that the desired financial performance can be achieved.
(c) JB Hi-Fi’s performance context during the 2017 year is important because its performance
was influenced by the timing of The Good Guys’ acquisition in November 2016 (JB Hi-Fi 2017,
p. 2).
A key measure is the number of stores. The Group CEO’s performance involves an
assessment against both financial and non-financial performance measures (JB Hi-Fi 2017,
p. 15).
The remuneration report discloses that the STIP rewards both financial and non-financial
measures (JB Hi-Fi 2017, p. 30) where the main element is statutory EBIT—this annual growth
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in EBIT is considered the most relevant measure of the Group’s financial performance as it is
‘a key input in driving and growing long term shareholder value’ (JB Hi-Fi 2017, p. 33).
Targets for senior executives, in addition to EBIT, include various store operating metrics,
inventory, supply chain and online performance measures. Specific targets are commercially
sensitive and are therefore not disclosed but performance management—and the rewards
attached to that—is focused on succession planning, investor relations, strategic initiatives,
internal process improvements, inventory management, property portfolio, shrinkage
control, online initiatives, expenditure control processes, workplace health and safety,
risk management, and engagement with key initiatives (JB Hi-Fi 2017, p. 34). The LTIP is
based on EPS growth (JB Hi-Fi 2017, p. 35).
Question 5.3
(a) Mega Markets has provided affordable products—sourced from overseas—targeting the
budget-constrained customer. The major benefits of Mega Markets’ historic strategy have
been the ease of shopping for customers in major shopping centres, and the affordability and
range of its products. However, with the increased availability of low-cost computers in homes
and the expansion in online shopping, Mega Markets is now facing global competition,
perhaps even from its own suppliers in South-East Asia.
(b) The value previously offered by Mega Markets has been almost completely eroded as
customers can order online and receive the equivalent goods in a week at a lower cost.
Buying online also avoids the problem of the customer’s choice of style, colour and size being
out of stock in their nearest shopping centre. As the kind of products sold by Mega Markets
are largely discretionary as to time—that is, the purchase can readily be delayed—there is
little advantage in going to a shopping centre when it is more convenient for customers
(especially those with young children) to buy online and have the goods delivered to
their home.
(c) In the face of strong online competition, the unique factor that Mega Markets can adopt
is personal customer service. While this may be expensive, customers often appreciate
a friendly and helpful staff member who can advise and assist in selection of products,
sizes and colour combinations. Candidates in Australia who have visited some of the larger
department stores recently may have noticed that they have reduced staffing to cut costs
and, as a consequence, there is often very little customer service available and long queues
to pay for goods selected by customers. This has perhaps exacerbated the shift by customers
to smaller boutique stores and online purchasing.
Of course, Mega Markets could adopt a strategy of selling its products online as well as
in stores, as many Australian retailers have done—for example, JB Hi-Fi, Myer and David
Jones. This would enable customers to exercise their shopping preferences by purchasing
in store, online or through both channels. This would enable Mega Markets to more
effectively compete with other online stores, but there is a substantial investment required
to implement this strategy. Information technology needs to be designed and introduced,
as does a warehousing, stock picking and distribution function, which would increase the
company’s overheads.
It would be difficult to compete with online-only suppliers who do not have the rental and
salary costs associated with a chain of retail stores in shopping complexes, and unless Mega
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Markets opened a warehousing and distribution facility near its suppliers in South-East Asia,
it would not be able to take advantage of the cost advantages in those countries.
Question 5.4
There are many possible responses to this question, and it is impossible to cover them all,
but you may have identified:
• the roles and responsibilities of the board of directors, a chief risk officer (if your organisation
has one), and the CFO in relation to risk management and performance
• whether your organisation is risk-averse, or takes managed risks in pursuit of its objectives
• whether the internal control systems enable or impede risk-taking
• whether performance accountability is centralised, or decentralised to individual managers
• whether risk management is centralised, or decentralised to individual managers
• whether the accountability for performance and risk management is integrated at the same
organisational level or diverges to different people in the organisation
• what performance measures and measurement processes the company has in place.
Question 5.5
(a) Discuss the implications of Kevin’s demand in relation to the following:
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(i) Governance As a director, Barbara is responsible for the company’s financial statements,
a responsibility that is even more pronounced as the CFO. What has been asked
of Barbara is high risk, both for the company and its directors, as it is illegal,
with directors and officers facing severe penalties for such action, which also
would lead to severe reputational damage for the company and individual
perpetrators. Accounting information is one of the main sources of information
to support the governance function. As a director and CFO, Barbara is also
responsible for a system of internal controls, which includes control over the
inventory asset of the company.
(ii) Signalling Financial statements are not produced just for the owner-manager of a privately
owned company. The financial statements provide signals to all shareholders,
taxation authorities, banks and financiers, payables, customers and employees.
Even from a shareholder perspective, Barbara does not know the position of
Kevin’s wife with respect to what Kevin wants her to do. As the company has bank
loans, there may also be an undeclared intent to deceive the bank in relation to
the loan, and certainly to avoid income taxes.
(iii) Ethics Kevin’s request presents a clear ethical dilemma for Barbara, irrespective of the
illegality of what she has been asked to do. The HIH case highlighted the culture
in that organisation of not questioning leadership decisions. The fundamental
principles in the Code apply not only to public practitioners in relation to clients
but also to employee–employer relationships. The Code includes a responsibility
to act in the public interest:
• the principle of integrity would be breached as the demanded action would
be dishonest
• the principle of objectivity would be breached because of the undue
influence of Kevin and the resulting conflict of interest (Barbara is expected
to resign if the demand is not met)
• the demand is also a breach of professional behaviour as the action would
breach legislation and accounting standards, and would be a behaviour that
would discredit the profession.
(b) There are few options available to Barbara. Barbara could wait a couple of days before
discussing the matter again with Kevin, in the hope that after further consideration, she could
change his mind. The delay could be used to prepare a forward financial plan and cash
forecast to show the impact of both the tax payment and debt repayment. Failing this,
Barbara could request a board meeting to discuss the matter with Kevin’s wife.
Beyond these actions, Barbara should obtain ethics advice and legal advice in accordance
with the Code, but may have no alternative but to resign from the company to avoid being
associated with the illegal and unethical act requested.
If the company’s accounts are required to be audited, the auditors may well identify such
a material misstatement of the inventory value. In the event of a purposeful misstatement,
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the auditors may have to report a breach to the authorities.
Question 5.6
(a) Mega Markets is what Porter termed as ‘stuck in the middle’. Mega Markets is not sufficiently
low cost to be adopting a cost leadership strategy and its products are undifferentiated from
what can be acquired online. While Mega Markets has focused on the budget-conscious
family with young children, the susceptibility of that customer group to online sales at a lower
price is a significant weakness.
(b)
Mega Markets Online competitor
Primary activities
Outbound logistics Customers shop with young Customers shop online, make
children in their nearest store, their product choice and then
involving travel, parking, await delivery to their home
queuing, etc.
Support activities
Question 5.7
(a)
(i) Traditional The standard to be applied is the budget of $35 000. The method of measurement
is the accounting system that reports sales revenue of $33 750. The comparison is
a simple calculation of budget minus actual of $1250 unfavourable variance.
The only means of feedback correction with this information is to hold the sales
manager accountable for the shortfall in revenue.
(ii) Expanded There are two standards—the volume of sales quantity and the average selling
price. The method of measurement is an accounting system that not only records
and reports sales revenue but also records and reports sales volume.
The comparison is of both quantity and sales revenue. The ability to take corrective
action is improved because the additional feedback information enables a focus
on both unit selling price and volume.
(iii) Flexed While the original budget standard is retained, the standard to be applied is the
flexed budget—that is, the actual volume multiplied by the budget selling price
per unit.
The comparison enables separation of the selling price variance (actual quantity
sold multiplied by the difference between $3.75 and $3.50) and the sales volume
variance (the difference between the target of 10 000 units and the actual sales of
9000 multiplied by the budget selling price of $3.50 per unit).
Using the additional feedback, two quite separate pieces of information can lead
to two different corrective actions: one volume-related and one price-related,
which identifies the likelihood that by increasing price over and above the target
price, sales volume has fallen and this has led to a revenue shortfall.
(b)
(i) Traditional Management decision-making is almost impossible because there is no indication
of the causes of the variance.
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(ii) Expanded Management can see that there is both a volume and a price variance but still has
insufficient information other than to question the responsible managers as to why
volume is lower than expected but prices higher.
Although it can be assumed that there may be an offsetting factor involved (i.e. that
higher prices may have led to lower volume), any trade-off cannot be quantified.
506 | PERFORMANCE MANAGEMENT
(iii) Flexed Both the value of the volume variance and the price variance are quantified.
More meaningful discussions can take place with sales managers to determine
explanations for these variances, the likely effects of higher prices on volume and
what corrective action can be taken.
Management decisions may also be taken on the basis of the reports in terms of:
• the accuracy of the budget standard—and whether this is in value only, or value
and volume
• the validity and reliability of the method of measurement—sales revenue will
be collected by an accounting system, but sales volume may require additional
non-financial performance measurement outside the accounting system
• the preferred means of comparison and method of reporting variances in
future—traditional budget versus actual reporting, or flexed budget reporting
• the means of investigating variances and seeking feedback to support
corrective action—separating price from volume variances, and the likely
interaction of each element of sales revenue.
Question 5.8
There are many possible controls that could affect sales behaviour at SalesVol, and which could
have resulted in the level of sales being below target (remember, volume was lower than targets,
but average selling price was higher than targets):
• Market controls are exercised through competitive pricing. Prices cannot be increased such
that customers are likely to move their business to competitors unless a price premium can
be generated from brand or reputation. In SalesVol’s case, higher pricing may have led to
customers moving their business elsewhere.
• Non-financial targets may emphasise sales volume, or the lack of such targets may result in
volume being disregarded.
• The absence of a market share target may lead to premium pricing.
• Bureaucratic rules may require approval by more senior managers of changes to target
prices, particularly if discounted prices are to be applied.
• Incentives and rewards may be based on compensation linked to volume, sales value or even
to premium pricing on particular orders.
• The reliance on feedback controls (diagnostic controls) compared with interactive controls
(where managers draw attention to particular areas of performance) may create a financial or
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Question 5.9
The following are examples of the different types of controls that could be introduced, although
you may be able to think of others.
Personnel controls:
• recruitment (reference checking, qualification checks, assessment centres, in-depth
interviews)
• training of new employees
• performance appraisal on a regular basis
• establishing a strong culture to support a work ethic (e.g. towards timeliness and accuracy)
• incentives for consistently high levels of performance (e.g. bonus, promotion)
• staff turnover.
Financial controls:
• cost management within agreed budget.
Planning controls:
• annual planning process that is consistent with the organisation’s strategic plan
• identifying key success factors with the CEO
• developing a service level agreement with internal customers.
Process controls:
• standard operating procedures or procedures manual
• regular monitoring of staff by managers and supervisors
• regular meetings to identify problems and solutions.
Performance measures:
• on-time production of reports
• quality errors (e.g. journal adjustments to correct errors after close of reporting period)
• internal customer satisfaction survey
• number of complaints received from internal customers
• adjustments required by auditors after end of year (number and value)
• days’ sales outstanding
• days’ purchases outstanding performance compared to target (and improvements over time).
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508 | PERFORMANCE MANAGEMENT
Question 5.10
Strategic performance • Sales volume and value for each product bar over the whole product life cycle
measures • Profitability of each product over the whole product life cycle (after deducting
R&D, market research and advertising costs)
• On-time deliveries of imported cocoa from Brazil
• On-time deliveries of milk from dairy farms
• On-time deliveries by logistics supplier
• Damaged or returned stock from retail stores
• Number of patents
• Number of new product launches (and number withdrawn as a result
of market research) over time
Note: This list is based on the information in the scenario question. Some measures may be
considered either operational or strategic. The categorisation is less important than developing
some performance measures that reflect Chocabloc’s dependence on its upstream and
downstream supply chains. Leading measures provide an earlier indication of likely financial
performance. Note also the large number of non-financial performance measures compared with
financial performance measures. Remember that if non-financial measures are revealing poor
performance, this will likely be reflected in financial performance at a later time.
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Question 5.11
Mega Markets Online competitor
Financial perspective
• ROI/ROCE/PBIT • ROI/ROCE/PBIT
• Cost • Cost
• Total revenue • Total revenue
• Gearing/interest cover • Gearing/interest cover
• Working capital and asset efficiency • Working capital and asset efficiency
• Shareholder returns • Shareholder returns
Customer perspective
• Sales per square metre • Cycle time (time from receipt of order to
• Sales per employee despatch)
• Out-of-stocks (lost sales due to style/colour/size • Out-of-stocks (less likely as there is one
combination being out of stock) central warehouse holding all style/colour/size
combinations)
• Delivery accuracy percentage (returns due
to inaccurate picking/delivery)
Explanation of differences
There is unlikely to be much difference in the lagging financial indicators between both companies,
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both of which are likely to pursue similar financial outcomes for their shareholders.
There is also likely to be similarity in the measures for the customer perspective, although the online
competitor is far more likely to be able to target its customers with special offers because it will have more
detailed and accurate information about each customer who places an order. The online competitor will
also have more accurate information about prospective customers who visit its website without ordering,
than will a retail company that has no information about potential customers who do not make purchases.
The business process perspective is where performance measures are likely to vary most, with the retail
store measuring the efficiency of sales for its retail store and staff investment. The online competitor will
also need to measure cycle time from order to delivery (where it is most susceptible to competition from
the retail store as purchase and delivery are simultaneous) as well as delivery accuracy.
Equally, there will be significant variation in the innovation and learning perspective. The retail store will
emphasise staffing measures over systems, whereas the online competitor will place far greater emphasis
on the reliability of systems as it is far less dependent on staffing.
510 | PERFORMANCE MANAGEMENT
Note: there are some differences between the performance measures of each company based
on their different strategies. You may be able to think of others.
Question 5.12
(a)
Debtors’ collections
Cost Revenue
Client retention
Quality of work
Maintaining Recruitment
up-to-date and retention
knowledge of staff
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Note: this is an illustration of the kind of things that could be part of a strategy map for a
small professional services company. The strategy map may be simple or complex—this is
just one example.
(b) The strategy map shows many of the assumed relationships required for a successful
accounting practice. Starting from the bottom and moving upwards, the left-hand side
reflects the importance of HR: recruitment and retention of staff, and maintaining up-to-date
knowledge through continuing professional development (CPD). Staff with knowledge lead
to quality work and the ability to charge fair prices—charge-out rates are the rates charged
to clients for the work carried out by staff of the company. While staff are usually the most
significant cost to the company, it is only through staff that revenue is earned by working
hours that are chargeable to clients.
Suggested answers | 511
The right-hand side of the strategy map shows a focus on clients. Marketing is important to
develop new business opportunities. Prospecting (making contact with potential clients) is
important to winning new business. Partner contact with existing clients is also important to
maintain existing client satisfaction. Through these activities, the company can build its new
client base, maintain existing clients and increase the revenue earned from clients through
value-adding services.
As the main financial asset of any professional services company is its receivables, good
billing practices and collection of debts are essential for cash flow. There are many other
possible CSFs and cause-and-effect relationships in a strategy map, with many possible
variations between companies (even in the same industry). Factors such as information
technology and company reputation may be relevant, even though they are not shown in
the illustration. The actual strategy map adopted by any one company will be a reflection
of its strategy, competitive position and business model.
(c)
Financial or
Key success factors non‑financial
BSC perspective in strategy map Performance measure (N/F)
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Partner contact Number of visits by partners to NF
with clients existing clients per annum
Financial or
Key success factors non‑financial
BSC perspective in strategy map Performance measure (N/F)
(d) The indicative performance measures are shown for each of the key success factors in the
strategy map. Different businesses will define different performance measures, based on
the business strategy, competitive position and business model. There are 25 performance
measures included. These are fairly evenly spread over the four perspectives, although there
are a few more measures in the financial perspective. Of the suggested measures, 13 are
financial and 12 non-financial. So the scorecard suggested for this company is quite balanced.
Many possible performance measures have not been included. Other measures that could be
adopted include:
–– revenue or profit per partner (or per employee)
–– the ratio of partners to staff
–– the office space (in square metres) per employee.
These have not been considered as critical, but they are important measures, and may be
particularly useful in benchmarking exercises.
Question 5.13
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(a) A reduction in the total cost of components can be achieved either through:
–– purchasing improvements—reducing the price per component, or
–– productivity improvement—reducing the quantity of components used, such as reducing
waste or damaged components.
Performance measures should be set for Purchasing—the cost for each component is the
most relevant measure for that department. This measure could cascade to individuals
or work groups within the department with measures of, for example:
–– number of alternative suppliers identified
–– number of quotations sought from suppliers
–– successful price negotiations with suppliers
–– number of tender comparisons of suppliers.
Suggested answers | 513
(b) Performance measures could be set for Production—the total number of components used
for the number of finished triffids produced is the most relevant measure for that department.
This measure could cascade to individuals or work groups within the department with
measures of, for example:
–– number of components received—that is, comparing standard quantities with actual
quantities of components received for the production of triffids
–– number of out-of-stock notifications requiring special purchasing
–– number of components wasted
–– number of components reworked
–– number of components damaged or lost
–– number of quality defects.
(c) The Finance and Administration department needs to provide the information required by
purchasing, production and the board of directors to enable monitoring of performance.
In addition, the Finance and Administration department must ensure sufficient control
exists over goods that are received into inventory (including checking of quantity and
quality of received components) to ensure that only components received are paid for.
Often, premiums are paid for components ordered due to out of-stock situations, so the
number of special purchases due to components being out of stock needs to be reported,
together with the price variation.
Care should be taken that the Purchasing department does not achieve a lower cost for
each component by simply increasing the ordered amount to take advantage of volume
discounts—tying up additional funds in inventory could have disastrous consequences
for organisational cash flows and also increase the risk of inventory becoming obsolete,
damaged or lost while in storage.
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–– report variations between purchased cost and standard cost of components.
Question 5.14
Performance
Performance measure target SMART Characteristics
1. Head office recharge $1 million This measure is not This measure can be
of corporate costs to relevant for planning, calculated reliably but it is
business units based decision-making or not a valid measure of the
on a percentage of control, because if sales business units’ demand
sales revenue in each revenue exceeds the for corporate services.
business unit target, the head office It is not controllable by
recharge will be higher business unit managers.
than the target.
Performance
Performance measure target SMART Characteristics
6. Dollar value of donations $100 000 p.a. While this measure and This measure can be
to charities target meets most of reliably calculated
the SMART criteria, it is and is valid in terms
not likely to be relevant of measuring financial
in terms of something contributions to charities,
that is important for the but by itself it does not
organisation, unless it is necessarily reflect how
an organisation whose well the organisation’s
purpose is to donate social, environmental
to charities. or ethical obligations
are satisfied.
7. Reduce employee Reduce This measure meets the This measure is valid and
turnover turnover by SMART criteria. It may reliable. It is controllable
10% p.a. be achievable provided through a variety of
managers have authority retention strategies
over remuneration and including remuneration
motivation strategies. and motivation.
As employee turnover
incurs the high cost of
recruitment and training,
this is likely to be an
important measure.
8. Sales revenue growth 15% p.a. This measure meets This is a valid and reliable
the SMART criteria, measure. It is clear and
with the possible available quickly but many
exception of whether factors affecting revenue
MODULE 5
it is achievable based growth are outside
on past performance managers’ control.
and economic and
competitive conditions in
the particular industry.
Performance
Performance measure target SMART Characteristics
10. Compliance with legal Full This measure and target It is a valid measure
requirements is not specific and it of compliance, but
is difficult to measure, not a reliable one
being based on subjective as different people
judgments and probably may make different
without full knowledge judgments based on
of all requirements different knowledge
and the organisation’s and experience.
experiences.
Specific Measurable Achievable Relevant Timely Validity Reliability Clarity Timeliness Accessibility Controllability
1. Head office Y Y ? N ? N Y Y ? N N
recharge
2. Survey of brand Y Y ? N N ? ? ? N N N
recognition
3. Receivable days Y Y Y Y Y Y Y Y Y Y Y
4. Incoming Y Y ? Y Y N Y Y Y Y Y
telephone calls
5. Sales from Y Y Y Y N Y Y Y N Y N
return
customers
6. Donations to Y Y Y N Y Y Y N Y Y Y
charities
7. Employee Y Y Y Y Y Y Y Y Y Y Y
turnover
8. Sales revenue Y Y ? Y Y Y Y Y Y Y N
growth
9. Headcount Y Y Y N Y N Y N Y Y Y
10. Compliance N N Y Y ? Y N N ? ? Y
Suggested answers |
517
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518 | PERFORMANCE MANAGEMENT
It should be clear from these examples that few performance measures are perfect. It may
be better to consider most measures as indicators of performance, as they each have their
limitations. It is also important to take a contingent view in evaluating measures and targets,
as the example of the donations to charity illustrates. Similarly, a measure and target for
receivable days is only relevant for a business selling on credit, not for a retail store like
Woolworths. It should also be noted that assessment of performance measures and targets
can be subjective and requires judgment, and so there may be alternative views or assessments
to those described previously. In addition, as no information is given in the question as to
current levels of performance or organisational strategies or priorities, you could assume that
all elements of performance are achievable.
Question 5.15
Different companies have very different approaches to performance measurement. The measures
used in retail stores such as Woolworths and JB Hi-Fi are quite different to the measures used
in a hotel chain such as EVT, by Apple in its high-tech environment or by Newcrest in the
mining industry. Public sector organisations such as policing and hospitals have very different
approaches to performance measurement.
The failings of performance measures at Mammoth Printing contrast with the abandonment
of most traditional performance measures (including financial ones) at TNA. Public and not-for-
profit organisations have quite different needs. The international advertising agency example
illustrated how competing priorities need to be balanced, whereas BP in the Gulf of Mexico
demonstrated the consequences of a relentless pursuit of short-term profits. These examples
illustrate the importance of customising performance measures to the unique position of
each organisation.
Despite the differences in what is measured, the focus of performance management should be
the same in all organisations, business, not-for-profit or public sector. Management accountants
need to be able to add value to their employers or clients by moving beyond the mere reporting
of performance against targets, trends and benchmarks and add value by interpreting that
information and making appropriate recommendations to senior management.
Despite pressure for short-term financial performance, management accountants need to be able
to demonstrate where an excess focus on the short term may detrimentally impact on sustainable
MODULE 5
Management accountants need to focus on performance improvement. They can suggest ways
in which performance can be interpreted, and recommend methods of improving performance
based on their holistic views of all the available performance information. This means moving
away from the desk and computer screen and talking with non-financial managers who will be
able to explain the context in which performance reports.
Question 5.16
(a) 1. Decide on the performance measures to be benchmarked
Performance measures are selected for benchmarking where differences in performance
can be understood and acted on. Only strategically important measures and processes
should be selected for benchmarking.
MODULE 5
–– The standardisation of data. Data may be collected, summarised and interpreted in
different ways, leading to performance comparisons that are not appropriate. Questions
must therefore be asked about the comparability and usefulness of benchmark data.
–– The historical nature of the data. While benchmarking data may give an understanding
of what other organisations or business units have done in the past, it does not tell
us what they are doing now or in the future. It is no substitute for constant proactive
improvement within organisations.
520 | PERFORMANCE MANAGEMENT
(c) Every organisation will be different, will have different opportunities for benchmarking and
different performance measures will be important. One example is university teaching,
where a benchmarking consortium does exist. Some examples of benchmark data for
teaching include:
–– staff–student ratio
–– student retention—that is, the proportion of students who discontinue studies prior
to completion
–– student progression—the proportion of students who fail and have to repeat
–– student satisfaction
–– graduate outcomes—employment, salary levels.
The last two examples come from standardised surveys of university students.
Question 5.17
(a) The need to have a limited number of performance measures is consistent with the proponents
of the BSC, provided there is balance in the range of measures used. The example does not
explain the performance measures used, but does mention ‘operational, financial and physical
measures’, so it might be assumed that there is balance.
Importantly, the example argues that performance measures are useful in determining
whether the organisation is on the right track. If performance measures are not useful in
making improvements, then they are unnecessary. The absence of targets—budgetary or
otherwise—contrasts with the role of targets in performance management. Despite the
absence of targets, the example shows the importance of relative performance, trend—
improvement relative to the past—and benchmarking.
(b) The importance of rewards is also emphasised in the example. Importantly, rewards are not
for absolute performance but based on relative (to other banks) profitability. This seems
a valuable approach to linking performance with rewards and may overcome some of the
criticism of financial institutions during the GFC for excessive executive remuneration.
Under this approach, if any whole industry improves its performance, this is more likely a
consequence of the economy, technology and customer demand than managerial action
and should not be rewarded. By contrast, if relative performance in an industry improves,
this is more likely due to management actions that are more successful than competitors’.
MODULE 5
A further element of the profit share in the example was that it was only payable when an
employee retired. This has at least three advantages:
1. It prevents a focus on short-term at the expense of long-term performance (i.e. it adheres
to the sustainability principle).
2. It encourages employees to remain with the company over the longer term to reap the
benefits of their behaviour.
3. This kind of approach to rewards linked to sustainable performance is likely to have fewer
unintended and dysfunctional consequences than more traditional approaches.
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Module 6
TOOLS FOR CREATING AND MANAGING VALUE
528 | TOOLS FOR CREATING AND MANAGING VALUE
Contents
Preview 529
Introduction
Objectives
Review
MODULE 6
648
References 683
Study guide | 529
Module 6:
Tools for creating and
managing value
Study guide
Preview
Introduction
This module draws together the material in Modules 1, 2 and 5 by examining specific ways that
management accountants are able to contribute to the enhancement of an organisation’s value
chain. Managers must be able to identify, evaluate and implement strategies that, while leading
to improvements in business performance, also address important social and environmental
issues such as human rights and the effect of climate change. Management accountants play a
pivotal role in developing systems that provide information that business managers must access
and use to carry out these tasks. This module illustrates how strategic management accounting
techniques assist with the growth of business value.
The module contains an extended Case study that shows how specific strategic management
accounting concepts and tools can be used to manage development of a new product and to
grow organisational value. It covers the following strategic management accounting concepts
and tools:
• activity-based costing (ABC)
• life cycle, target and kaizen costing
• activity-based management (ABM)
MODULE 6
The module also identifies performance measures for assessing the effect of these concepts
and tools on an organisation’s value chain.
It is assumed that you have some prior knowledge of the tools and techniques in this module.
For this reason, the limited background material provided before the practical application of
the concept or tool should be sufficient. If you wish to read beyond this background material,
most recently published management accounting textbooks provide comprehensive coverage
of these topics.
Your tasks
In this module, you will work through the Case study for the company HZ Electrical Pty Ltd (HZ).
You will complete a series of tasks for the company as it manages the design and introduction of
two new products—the Solarheat 1 and Solarpower 2. You will be required to provide relevant
information to the management of HZ’s household products division (HPD) so that they can:
• use ABC to allocate indirect manufacturing costs
• determine life cycle costs for redesigning the product
• re-engineer the Solarheat 1 manufacturing facility
• analyse their value chain activities
• evaluate supplier-related costs
• determine the impact of a total quality improvement initiative
• decide whether to outsource distribution
• assess the profitability of different customer segments
• determine customer profitability at the individual customer level.
Throughout the Case study there are tasks presented in tables that require you to fill in missing
data. To complete the task, work through each table by using the data provided in the Case study
and enter your answers in the editable table cells.
Notes:
1. You will often require answers from earlier parts of the Case study to complete tasks that
come later.
2. You may find differences in the rounding for some of your calculations, depending on
whether you manually calculate the answers or use a spreadsheet program. However,
these should be only minor, so if you see a large discrepancy, please check your calculations.
The highlighted sections in Figure 6.1 provide an overview of the important concepts in this
subject and how they link with this module. This module discusses how the management
accountant works to provide management with information for operational decision-making
that, in turn, informs and is informed by strategy.
MODULE 6
Study guide | 531
rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
MANAGEMENT ACCOUNTANT
VALUE INFORMATION
OPERATIONS
Exte
rnal environment
Objectives
After completing this module you should be able to:
• Explain the benefits of using value chain analysis and activity-based management
to create and manage value
• Apply appropriate cost management techniques for strategic costing decisions.
• Determine the appropriate pricing strategy to enhance organisational value.
• Apply supplier management methods to evaluate supplier’s performance.
• Apply customer profitability analysis to evaluate different market segments.
MODULE 6
532 | TOOLS FOR CREATING AND MANAGING VALUE
Local community Impact on quality of life (Impact of production plants on air quality (e.g. increased
higher living standards as a result of more local jobs)
Advocacy groups Focus on safeguarding the industry value chain from sourcing products that might
use child labour. (Refer to the industry value chain (Figure 6.2).)
Michael Porter (1985; 1996) introduced the concept of the organisational value chain
(see Example 6.1). Porter’s work focused on the customer as the key stakeholder because the
revenue provided by customers is the source of value for most other stakeholders. Value created
by an organisation is measured by the margin—that is, the excess of revenues over costs—
generated by a product or service.
Example 6.1 is an example of a value chain. It can be seen that value is created through both
primary and support activities. Primary activities are those required to create the organisation’s
product. Support activities facilitate the primary activities. Example 6.1 shows the main
activities required to produce an Apple iPad.
MODULE 6
Study guide | 533
Technology
Product and process design, production engineering, market testing and R&D
Porter’s generic value chain diagram presented in Module 1 (Figure 1.2) is reconfigured in
Figure 6.2 to include the important supplier, channel and customer value chains. These upstream
and downstream parts of the industry value chain are those of most concern to an organisation.
MODULE 6
534 | TOOLS FOR CREATING AND MANAGING VALUE
Support activities
Firm infrastructure
HR management
Value chains:
Technology development
s
sale
s
istic
s
istic
and
log
log
und
ting
tion
d
vice
oun
tbo
rke
era
Ser
Inb
Ma
Op
Ou
Primary activities
Value added
Value system
In the downstream part of the value chain, first is the organisation’s distribution channels and
then its customers. An organisation must have an in-depth understanding of the activities
carried out in its distribution channels, so that its own activities can be integrated with those
of distributors in the most efficient and effective way. Similarly, a clear understanding of the
customers’ value creation process—in the case of industry participants—or of the end user’s
value proposition, will enable an organisation to efficiently provide a product offering that will
maximise customer value and so the organisation’s profit. The downstream channel and customer
value chains inform all of the organisation’s strategic revenue management initiatives. This is
discussed in more detail in Part C of this module.
of an organisation’s cost initiatives. Strategic cost management issues are discussed in Parts D,
E and F of this module.
Study guide | 535
Before moving to the discussion of an organisation’s strategic revenue and cost management
initiatives, Part B of this module introduces some key management accounting tools used in
the planning and implementation of strategy: activity analysis, activity-based costing (ABC) and
time‑driven activity-based costing (TDABC).
Activities are defined as the actions that organisations take in order to create value. In ABC
and TDABC, activities are the cost pools used in the allocation of costs to products or other
cost objects. ABC should be clearly distinguished from activity-based management (ABM),
which is discussed in Part D of this module. Like ABC, ABM is based on activity analysis, but it
is concerned with enhancing organisational value through improving the efficiency of activities
and improving the structure of the organisation’s value chain.
MODULE 6
536 | TOOLS FOR CREATING AND MANAGING VALUE
Product costing
Organisations need to have accurate costs for the goods or services they supply so they can
ensure that prices are high enough to generate profits. An organisation may often have products
or services that are unprofitable but may not have enough information to realise that this is the
case. Too often, inaccurate costing systems have led organisations to set prices that are not
profitable (i.e. too low) or are not attractive to customers (i.e. too high).
The traditional approach to allocating indirect manufacturing costs and other overhead costs
to an organisation’s products is to use a volume-based driver linked to production—but this
method has been criticised for causing inaccurate costing. This will be discussed further under
‘Activity‑based costing’.
In the first part of the Case study, we see that HPD currently uses this approach.
After this Case study, this traditional approach is compared to ABC, which is one of the
most important tools available to management accountants to help them to understand an
organisation’s value chain properly.
For many years, the FC101 was the only food processor made by the HPD and was highly regarded
for its quality. Unfortunately, demand has steadily fallen over the past two years.
William Prout, HPD’s production manager, suspected the reason for the decline in sales was increasing
competition from overseas suppliers who appeared to be using their spare capacity to supply product
to the Australasian market at less than cost, a process known as ‘dumping’.
FC202 and FC303 have been added to the product line over the past six years. Both are more advanced
and technologically sophisticated than the FC101. As a result, they are significantly more complex to
manufacture and require special materials handling, tooling and setting up for each batch produced.
Given the complexity of manufacturing the FC202 and FC303, HPD charges what it believes is a
premium price for both of these products.
Overheads
Indirect manufacturing costs are budgeted to be $810 000 and these are currently allocated across
the three product lines on the basis of direct labour hours (DLHs), as shown in the following table.
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538 | TOOLS FOR CREATING AND MANAGING VALUE
➤➤Task
Use the current indirect manufacturing cost allocation method based on direct labour hours
(DLHs) to calculate the budgeted:
(a) indirect manufacturing cost rate
(b) indirect manufacturing cost for each product
(c) total manufactured cost per unit for each product.
Some of this information is found in the Case study data, and the rest is found by performing
calculations with the data in the following tables. To assist you in understanding how to begin,
some data for FC303 has already been inserted in the tables.
(a) Calculate the indirect manufacturing cost rate per DLH
FC101
FC202
DLHs
(c) Calculate the total manufactured cost per unit for each product
Check your work against the suggested answer at the end of the module.
Activity-based costing
An organisation must have a good understanding of what ‘drives’ its indirect costs. Indirect costs
are related to complexity and diversity of production, rather than to the volume of output. ABC is
a technique designed to assist organisations to classify and allocate indirect costs properly.
For example, costs for pre-production activities such as machine set-ups, and support services
such as stock handling and scheduling, do not increase with the volume of output. There are also
many costs that are fixed in the short term, but that may vary in the long term, depending on
changes that may occur within the organisation. The greater the degree of variation in the range
of products manufactured by a company, the more complex and diverse its support activities
become. This, in turn, increases the need for and importance of a costing system that allocates
costs as accurately as possible.
ABC emerged from the work of Cooper and Kaplan (1991). ABC draws on a hierarchy of costs:
facility sustaining (or organisation sustaining), product sustaining, batch level and unit level.
Activities in the unit level are easily traced to an individual product, such as ice cream and,
therefore, costs are accurate, traced on labour hours (or costs), material used (or material cost)
and machine hours (or machine costs).
In the next level, batch, activities are not as directly traced to individual products. When a batch
of a product is made, the set-up of the machine (pre-start up diagnostics, start-up configurations,
flushing of pipes and tubes to make vanilla ice cream after chocolate ice cream is made) is costly.
What drives these costs needs to be understood.
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For product sustaining costs, the hierarchy indicates that these costs are further removed from an
individual product type. Some of the drivers of product sustaining costs are shown for ice-cream
manufacturing in Example 6.2.
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Product sustaining costs New flavour design and introduction (avocado ice cream)
Now the contentious area—how are facility or organisation sustaining costs traced? Consider
the costs of a corporate headquarters—for example, CEO salaries and expensive office rental
in metropolitan cities. How are these costs traced to a product manufactured in a plant in an
outer suburb? Is there a cause-and-effect relationship? This is the danger of allocation. The total
corporate office costs can be divided by the number of litres of ice cream made, to the nearest
two decimal places—an arbitrary precision that does not accurately capture the cost of making
ice cream. All this will do is allocate a semi-related overhead that increases the cost of making
ice cream to the point that competitors appear cheaper, and the organisation will not be in a
sustainable or value-adding position.
This is one reason why ABC is an expenditure model—to inform strategic decision-making.
The choice to drop a product or product line needs to be made on the basis of the strategy of
the business. For example, if the business has a differentiation strategy, reducing price is not
a viable strategic decision. A company with a differentiation strategy will focus on charging a
premium price for a unique product. Cost is always a significant factor, but for a differentiator,
cost is a secondary issue. A variety of organisational approaches to product pricing are discussed
in Part C of this module (‘Strategic revenue management’).
Value engineering
Value engineering (VE) is a customer-focused cost management technique. VE improves the
value of products by examining a product’s functions to ensure only functions of value to the
customer—its basic functions—are included in the product offering, and that the cost of these
basic functions is minimised. For example, many consumer products, like the iPhone, have a
short life cycle, after which they become practically or stylistically obsolete. These products
could be built to last many years, but through using VE they are not, because this would create
unnecessary cost. A manufacturer will use the least expensive components that satisfy the
product’s lifetime projections.
Cost drivers
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Activities consume resources and incur costs, so it is necessary to identify what drives these costs.
Traditional volume-based allocation methods usually rely on a small number of cost drivers,
such as direct labour hours, direct labour cost or machine hours. The problem is that not all costs
are clearly linked by cause and effect to these measures—that is, they do not actually ‘drive’
all the costs. ABC separates different types of costs into different cost groups or pools. These
groupings are based on what activity actually causes or drives this cost to be incurred. Table 6.2
shows a range of potential cost groupings (activity cost pools) and possible causes (drivers)
of these costs. By allocating costs based on these drivers, cost estimates are more accurate,
especially when there are complex products that consume significant amounts of ‘extra’ activities
that were not previously noticed or were not accounted for properly.
Study guide | 541
While the cost drivers in Table 6.2 are straightforward, as business processes become more
complex, it becomes more important to trace costs from the cost pool to the products, as
explained in Example 6.3.
Example 6.3: W
hen activity-based costing is useful—
capturing complexity
Products
Vanilla Pty Ltd (Vanilla) produces 500 000 litres of vanilla ice cream packaged in 1 L tubs. In contrast,
Flavour Pty Ltd (Flavour) produces 500 000 litres of 30 different flavours of ice cream packaged in
MODULE 6
250 mL cups, 1 L tubs and 5 L catering packs. Flavour obviously has a more complex manufacturing
process and will have significantly more machine set-ups, product-testing, packaging, storage and
order-filling costs than Vanilla. To cope with these indirect costs, Flavour should consider the use of
ABC. On the other hand, Vanilla may be better served by a simple process costing system.
Services
Pensioner Insurance Ltd (Pensioner) provides car insurance for drivers over 50. Pensioner only insures
customers over 50 years of age who have had no accidents or claims over the last five years. EV Insurance
Ltd (EV) offers insurance for cars, boats, homes and businesses. This insurance is available to everyone.
542 | TOOLS FOR CREATING AND MANAGING VALUE
The cost, time and effort for providing insurance services for Pensioner will follow a more predictable
pattern and be more easily traced to a particular product or customer. The complexity of having many
different product types and different types of customer will make cost allocation much harder for EV.
The time to evaluate customers with completely different risk profiles and for multiple products will
be less predictable and less systematic. Therefore, EV should consider ABC.
Some potential cost pools and drivers that may be useful for cost allocation in such service businesses
are shown in the following table.
Studies indicate that a majority of businesses still are yet to implement ABC, due in part to the
complexity of understanding activities, tracing costs as well as the time line of around 18 months
to implement a well thought-out ABC. The benefits of ABC remain persuasive, especially when
cost drivers are mapped out and linked to performance scorecards. This is revisited later in
this module when the health care industry is highlighted in the discussion on structural and
executional cost drivers.
In this module, the generic term ‘product’ is used to mean both products and services.
This usage reflects the way that many banks identify their services as being financial ‘products’.
Accurate costing is necessary for pricing decisions. It also guides cost-reduction efforts,
special projects such as launching a new product, and analysing customer and product
profitability. Accurate costs are also very useful when competition increases, because this may
lead to more aggressive pricing strategies in the industry and more innovation of products
and services—which must be carefully monitored and managed.
1. Activity analysis
Identify each activity in a process
1. Activity analysis
For many organisations, this stage is the most challenging part of an ABC system
implementation. Even with apparently simple processes, many different types of activities
are performed. A comprehensive understanding of what activities are involved is necessary.
This stage is called process mapping or activity mapping—an activity map shows all the
main activities and, importantly, their interrelationships.
One frequently used way of identifying activities is by asking personnel what they do
and having them keep a diary of all the activities they perform. Typical answers might
include purchasing supplies, moving products throughout the factory, running machinery,
inspecting products and reporting on performance.
is, form cost pools. For example, there may be a ‘running machinery’ activity cost pool.
Almost all activities involve labour costs or wages. Other costs, such as rent, maintenance of
machinery, depreciation, electricity, computer equipment and maintenance, can be estimated
and assigned to activities as appropriate.
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This generates the cost per transaction in a similar way to the development of an allocation
rate per direct labour hour or per machine hour using traditional costing methods.
Number of cost driver transactions per product line × ABC transaction cost rate
These steps may also be used to apply ABC in a service-based organisation. Example 6.4
provides an example of the allocation of indirect costs to day care service of a local council.
The council runs five-day care centres with a total enrolment of 600 children. Steps 1 to 7
(as discussed) show how the ABC information is created and how costs are allocated.
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Study guide | 545
Example 6.4: A
ctivity-based costing indirect cost allocation
to council day care services
Step 1 Step 4 Step 5 Cost
Council Step 2 Step 3 Total cost Allocation driver Step 6
activities Cost pools Cost drivers drivers rate transactions Allocation
Debtors $74 095 Number of 108 582 $0.68 17 207 $11 742
invoices
Step 7 Calculate indirect cost per unit (per child) $315 509 / 600 = $525
Source: Based on Victorian Auditor-General’s Office 2010, Fees and Charges—Cost Recovery by Local
Government, Victorian Government Printer, Melbourne, p. 15. Please note that this table has been
printed with minor omissions. For the original table that includes the full set of data, please refer to:
https://www.audit.vic.gov.au/report/fees-and-charges-cost-recovery-local-government.
These same seven steps will now be applied to the next part of the HZ Case study, which uses
ABC to recalculate the product costs for HPD’s food processor product range.
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Given the diversity in the range of electrical household products manufactured, HPD has contemplated
switching the allocation of indirect manufacturing costs to an ABC system. Therefore, you decide to
prepare an analysis on the usefulness of an ABC system for HPD by applying this approach to the
three different food processor models.
Analysis of the $810 000 of indirect manufacturing costs indicates that they can be classified into four
broad cost pools, with four different cost drivers. The budgeted indirect manufacturing costs for the
food processor product line for next year are shown in the following table.
Annual
Indirect manufacturing cost pool Cost driver budgeted costs
Budgeted production details for the food processor product line for next year are summarised in the
next table.
➤➤Task
(a) Calculate the budgeted indirect manufacturing cost rate for the four ABC cost pools.
DLHs
MHs
FC101
FC202
FC303 200
FC101
FC202
FC303 350
(b) Use the ABC method to calculate the budgeted indirect manufacturing cost per unit for each
product range. Calculate the difference in costs between the ABC method and the traditional
approach in Case study 6.1.
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Study guide | 549
FC101
Indirect
Cost pool Number of manufacturing
Cost pools rates cost drivers cost %
2. Machine-related
$ $ %
3. Scheduling set-up
$ $ %
4. Materials handling
$ $ %
FC202
Indirect
Cost pool Number of manufacturing
Cost pools rates cost drivers cost %
1. Labour-related
$ $ %
2. Machine-related
$ $ %
3. Scheduling set-up
$ $ %
4. Materials handling
$ $ %
FC303
Indirect
Cost pool Number of manufacturing
Cost pools rates cost drivers cost %
1. Labour-related
$ $ %
2. Machine-related
$ $ %
3. Scheduling set-up
$ $ %
4. Materials handling
$ $ %
Check your work against the suggested answer at the end of the module.
years ago HPD stopped marketing the FC101 food processor to overseas markets, because international
orders had decreased significantly.
You have been asked to prepare a comparison of the product costs you have calculated using the
traditional volume-based allocation method based on direct labour hours and costs using the ABC
method. The following table comprises data calculated in Case study 6.1.
Study guide | 551
Total indirect costs allocated to each food processor product line using traditional method
Indirect
% of Cost per manufacturing
DLHs total DLHs DLH cost
In the next table, the difference between the traditional volume-based approach and the ABC approach
for the three products is compared. The table combines data from Case Studies 6.1 and 6.2.
Total manufactured cost per unit: Traditional versus ABC allocation methods
Total prime costs per unit (see the answers for $95.00 $115.00 $130.00
Case study 6.1)
Indirect manufacturing cost per unit (see the answers $60.00 $45.00 $37.50
for Case study 6.1)
Total manufactured cost per unit using traditional $155.00 $160.00 $167.50
approach
ABC indirect manufacturing cost per unit (see the $36.40 $80.67 $102.00
answers for Case study 6.1)
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➤➤Task
(a) Using the traditional DLH approach, the FC101 receives 74 per cent of all the overhead,
while the FC303 receives less than 10 per cent (see the total indirect costs table in the
case facts).
(i) Complete the following comparison table and use it to help explain why the indirect
manufacturing charge per unit has changed for FC303 when applying the ABC model.
The data in the following tables is from your calculations in Case study 6.2.
FC101
20 000 74.07% 10 000 % 50 % 90 %
FC202
4 500 16.67% 9 000 % 150 % 260 %
FC303
2 500 9.26% 6 000 % 200 % 350 %
(b) Under what circumstances would you recommend that HPD adopt an ABC system to replace
its current costing system? Give reasons to support your recommendations.
(c) Explain how ABC will help the management of HPD with:
(d) HPD has a standard wholesale price for the FC101 food processor of $180.00 per unit.
Complete the following table and then identify what information obtained from the ABC
product-costing model helps HPD understand its lost sales to BigShop, which is purchasing
an equivalent product for 15 per cent less from HPD’s competitors.
(i) Comparison of budgeted profit margins for FC101 using the traditional and ABC product
costing systems
(ii) What information obtained from the ABC product-costing model helps HPD understand
its lost sales to BigShop?
(e) Explain to your fellow HPD senior managers the likely effect of the introduction of ABC on
the allocation of indirect manufacturing costs for all (existing and proposed) HPD product
lines.
Check your work against the suggested answer at the end of the module.
For a further explanation of ABC, please access the ‘Activity-based costing’ video on
My Online Learning.
For further practice in ABC, please access Stage 3 of the ‘Save or close the hotel?’
MODULE 6
TDABC is a simplification of the conventional ABC approach with a focus on ‘time’ as a reflection
of resource capacity, although other measures of capacity may be used. In its simplest form,
TDABC requires only a few key calculations. As shown in Example 6.5, the two key input
calculations are the:
1. cost per time unit of capacity
2. unit time of the activity.
Example 6.5: U
sing time-driven activity-based costing
to allocate costs
The membership department of a large professional sporting team performs three main activities:
1. processing membership applications
2. handling membership inquiries
3. performing membership seating checks.
There are on average 10 staff working in the membership department, who work an average of 20 days
per month, eight hours per day.
Theoretical capacity refers to the total amount of time available in an ideal or theoretical situation.
20 days per month × 8 hours per day × 60 minutes per hour = 9600 minutes per employee ×
10 employees = 96 000 minutes.
It is obviously not possible for all employees to spend every available minute working on activities that
form a specific part of the production process. People take breaks, have training sessions and attend
staff meetings—all of which are considered non-productive activities from a TDABC perspective.
To improve the accuracy of cost estimates, it is therefore useful also to identify the practical capacity of
the department. This is a more realistic or practical assessment of the amount of time that people will
be able to work productively. Identifying the amount of productive time available can be accomplished
through detailed analysis or, possibly, by using an estimate such as 80 per cent.
The practical capacity—allowing for other work activities taking 20 per cent of time—would therefore
be calculated as:
The cost per minute of supplying capacity can now be calculated as:
The average time it takes to conduct one unit of each activity can then be estimated:
• 15 minutes to process membership applications
• 12 minutes to handle membership inquiries
• five minutes to perform membership seating checks.
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The cost driver rate (per unit of activity) is then calculated based on the cost per minute and average
unit times. This is shown in the following table.
These cost driver rates are then used to allocate costs for each activity based on actual quantities of
the resource used (i.e. units of activity). This is shown in the following table.
Total cost
Cost driver allocated
Activity Quantity (a) rate (b) (c = a × b)
One of the main benefits of TDABC is the identification of unused capacity and its cost. Unused capacity
does not represent the difference between theoretical and practical capacity. Unused capacity is the
difference between the practical capacity available and the actual capacity used.
In this example, the total theoretical capacity was 96 000 minutes. It was estimated that the practical
capacity, or actual time available to be used on productive work, was 80 per cent of this amount—
that is, 76 800 minutes. To determine unused capacity, the actual time used is compared to practical
capacity of 76 800 minutes.
The total time actually used in the month was 68 320 minutes, resulting in 8480 minutes of unused
capacity (i.e. 76 800 – 68 320) and costing $7208 (i.e. $65 280 – $58 072). Note that the cost of unused
capacity can also be calculated by multiplying the unused capacity in minutes by the cost driver rate
(i.e. 8480 × $0.85 = $7208). The calculations that demonstrate this are shown in the following table.
Total
time in Cost Total cost
Quantity Unit minutes driver allocated
Activity (a) time (b) (c = a × b) rate (d) (e = a × d)
What management chooses to do with this information may vary. For example, in this organisation,
reducing the resources supplied (i.e. reducing staff levels) may not be the best option because
members who contact the club will expect their query to be dealt with in a timely manner. However,
if the level of unused capacity remains consistent over a longer period, management may consider
reducing the resources supplied—to reduce costs. Of course, this should be balanced against the
need for quality service provision.
TDABC uses time equations to accommodate these types of variations (Kaplan & Anderson
2007). For such complex activities, the time equation is:
Standard activity unit time + Variation activity unit time = Complex activity unit time
This process combines the generic or standard way of completing the activity (e.g. 20 minutes
to receive a standard shipment) with the more complex variation (e.g. 10 additional minutes
to receive a fragile shipment) to determine a total time estimate for the complex activity
(e.g. 30 minutes in total to receive a fragile shipment). The variation time is in addition to the
standard time, so the two must be added together to obtain the total time for the complex
activity. The variation time therefore does not represent the total time it takes to perform the
more complex activity.
Each additional element of activity complexity attracts an incremental cost based on the
additional time it takes to perform that additional activity element.
MODULE 6
To show how TDABC would determine the time taken to carry out a particular activity,
Example 6.6 details some hypothetical time drivers for HPD. It shows the estimated time
the division will take for processing orders from two different customers.
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The following table demonstrates how the time equation for complex activities functions. For item 1
(Order receipt), the standard time is two minutes (using EDI). The total time to receipt an order for
Customer A is therefore two minutes. The manual variation for an order receipt takes an additional five
minutes, which must be added to the standard task time of two minutes. The total time to receipt an
order for Customer B is therefore seven minutes. The time equations for order receipt are as follows:
Order receipt (complex) = 2 minutes (EDI) + 5 minutes (manual variation) = 7 minutes [Customer B]
Variation to Additional
Generic activity Minutes generic activity minutes Customer A Customer B
If HPD has estimated that the customer order processing capacity cost rate is $2.00 per minute,
the order processing costs incurred for:
• Customer A would be 43 minutes × $2.00 per minute = $86
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This information is valuable because it highlights that the cost of doing business with each of these two
customers is quite different. This will also help the business to identify inefficient areas of the business
and make better decisions about what special services (i.e. variations) to offer and what prices might
need to be charged for these extra services.
Study guide | 559
The total annual budgeted cost for the materials handling function is $1 504 000. The food processor
product range is expected to account for $70 000 of this cost.
Rather than focusing on the number of materials movements on the production floor as the sole transaction
driver for the materials handling function, HPD has identified four generic areas of resource capacity:
• materials requisitions
• materials received into storage
• sourcing materials for production
• materials movements on the production floor.
Estimated time for a standard transaction activity, as well as the additional time required for more
complex versions of the activity are shown in the following table and the total number of activities for
the materials handling function is shown in the next table.
Budgeted standard and complex task performance times for the materials handling function
Standard activity
Materials handling performance time Time unit Nature of complexity leading
resource categories unit (minutes) (minutes) to increased time demand
To help to calculate the total time for each materials handling activity, it is necessary to consider the
following formulas:
Standard time = Standard activity unit time × Total number of activities performed
Additional time = Variation activity unit time × Number of variation activities performed
Total time = Standard time + Additional time
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Keeping these formulas in mind, the preceding two tables have been combined to calculate the total
budgeted time for the materials handling function.
Budgeted standard 828 000 Budgeted additional 122 000 950 000
time time
To explain this table further, note that the total number of standard activity transactions for the
‘Requisition’ activity is 4200 (not the 3440 transactions listed under the standard activities heading
in the preceding table). This matches the formula for ‘Standard time’, which uses ‘Total number of
activities performed’. It also matches the time equation approach described earlier.
There are 3440 transactions that only require the standard amount of time. The other 760 more
complex transactions are a combination of both the standard time of 10 minutes and the additional
variation (complex) time of five minutes. This means that all 4200 transactions will require at least the
standard amount of time, with 760 transactions needing extra time. The total time for requisitions can
be reconciled by performing the following calculation:
➤➤Task
(a) For the coming year, calculate the following for the materials handling function:
− Theoretical capacity (total time available) in minutes.
− Practical capacity (total productive time available) in minutes.
− The cost rate per minute, based on practical capacity.
Theoretical capacity (total time available) in minutes
Total budgeted costs of the materials handling function to be allocated $1 504 000
Total budgeted costs to be allocated / Budgeted total practical capacity $1 504 000
$
$
(b) (i) Use the TDABC cost rate per minute to allocate costs to each activity in the materials
handling function. Then, calculate the total budgeted costs and the unused capacity.
Requisition
45 800 $ $
Production movements
$ $
Unused capacity
(Total practical capacity and
costs – Total time and cost) $ $
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(ii) What does a difference between the total practical capacity and budgeted usage times
for the materials handling resource represent, and how should HPD account for it?
(c) The following transaction data has been extracted from the budget for the coming year for
the FC303 food processor model.
Requisition 65 60 125
Note: The number of standard activities performed is equal to the total number of activities—
for example, 125 for requisitions. All 125 requisition transactions will require the standard time,
with additional or extra time being added for the number of complex activities performed—for
example, 60 for requisitions. This follows the time equation format mentioned previously, so the
total time for requisitions can be reconciled as follows:
65 standard requisitions × 10 minutes = 650 minutes
Add: 60 complex requisitions × (10 minutes + 5 minutes extra) = 900 minutes
1550 minutes
(i) Using the time data from the case facts and the activities data budget extract, calculate the
total time required for the materials handling activity for the FC303.
Receipt into
storage
MODULE 6
Sourcing for
production
Production
movements
(d) Using the total budgeted activity times calculated in task (c), calculate the materials handling
costs that would be charged to the FC303 using TDABC.
Requisition
$ $
Production movements
$ $
Total times
17 700 $
(e) Compare the materials handling costs allocated to the FC303 food processor model for the
materials handling resource using:
Check your work against the suggested answer at the end of the module.
For a further explanation of TDABC, please access the ‘Time-driven activity-based costing’
video on My Online Learning.
For further practice in TDABC, please access Stage 3 of the ‘Save or close the hotel?’
Business Simulation on My Online Learning.
MODULE 6
Study guide | 565
In taking a broad view of value created, it would be reasonable to assume that organisations
that achieve significant and sustainable increases in their profitability are better placed to deliver
greater value to their stakeholders than are those that do not. Furthermore, as our measure of
value is the amount remaining after deducting the costs incurred from the revenue generated
from the organisation’s activities, two strategic levers for increasing the amount of value created
can be identified:
1. strategic revenue management, and
2. strategic cost management (discussed in Part D of this module).
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566 | TOOLS FOR CREATING AND MANAGING VALUE
Soft functions The image of the product By making minor By creating an image in
and include attributes— modifications to: the mind of customers
i.e. appearance, aesthetics, • the product that the product is a brand
prestige and effect. formulation— worth paying more for,
e.g. better-quality the company is able to
ingredients charge a higher price.
• Packaging—e.g. a
more exclusive and
expensive appearance,
Specified Augmented
Generic
Product Value received in Above average hard
features Basic hard functions,
conformity to contract functions and a range
no soft functions
specifications of soft functions
Price at
Price Price at cost plus Price at value to client
competitive parity
Pricing role of
Estimate
management Reduce cost Estimate customer value
competitor’s price
accountant
Surplus value
As already stated, customer value exists if the customer is willing to pay for a product or service,
but this does not mean that customer value is a single amount or point value. Rather than being
a single point value, a customer will usually have a range of values that they are willing to pay
for an item. The upper limit of those values is the maximum price they are prepared to pay for
an item. A simple example can be made with a quality cup of coffee. A customer may be willing
to pay within an expected range of values—for example, from $3 per cup, up to a maximum of
$5 per cup. This concept is highlighted further in Example 6.7.
From a supplier’s perspective, knowing the upper limit of customer value is important,
because the difference between the maximum price that a customer would be willing to pay
and the supplier’s cost represents the maximum profit they might be able to secure from a
sale. The lower limit or price of $3 indicates the minimum profit, given the supplier cost, that a
business can make in a competitive market. The range of between $3 and $5 for setting a price
sets the parameters for revenue management for a business.
However, this does not mean that a customer will be just as willing to pay the maximum price as
the middle of the range (e.g. $4.95 for a cup of coffee compared to $3.50 per cup). The closer the
selling price is set to the customer’s upper limit, the lower the likelihood of the customer making
the purchase.
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The greater the gap (or saving) between the customer’s upper limit and the price asked by a
supplier, the more likely a customer would be to proceed with the purchase—but the lower the
profit received by the supplier.
Identifying and understanding the value customers place on products or services is therefore an
essential part of strategic revenue management. Prices need to be set to maximise the level of
purchases and the return on each purchase for each customer or customer segment, as shown
in Example 6.8.
Company A’s phone provides a higher level of functionality than Company B’s. The differences in
functionality between the two products may relate to hard and/or soft functions. Where the difference
is attributable to hard functions—that is, added features—these are easy to identify. If the difference
is due to soft functions (e.g. the product’s image), the differences may be more subjective.
The surplus value for the customer is $20 greater for Company A’s product. So, in this situation, even
though Company B’s product is $10 cheaper than Company A’s, the customer is likely to choose
Company A’s product.
If Company B is to compete in terms of surplus value, it would need to provide the customer with a
greater surplus value than Company A—that is, more than $60. It could do this by setting the price
more than $60 below the upper limit of $170 that the customer is prepared to pay—that is, below $110.
Company B will have a problem with this strategy. It costs $110 to produce this unit, so there will be
no profits in this situation. Company B could focus on strategic revenue management by increasing
the quality and functionality of its product. This would increase the amount the customer is willing to
pay. If this is not possible, it will need to pursue strategic cost reductions to reduce the total unit cost
so that it is profitable.
Pricing strategies
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Price is the amount a customer is willing to pay for a product or service. There are products for
which a customer will pay a premium—a high price—while for other products, the customer will
be price sensitive and pay a low price.
The map of pricing strategies in Figure 6.5 shows how promotion or marketing expenditure
(high or low) is aligned to price.
Study guide | 569
High Low
Figure 6.5 illustrates two product attributes, price and quality, that influence pricing strategy.
The ability of a business to be a price leader, when compared to rivals, shapes the understanding
of price and promotion.
iPhone X A$1579
iPhone 8 A$1079
iPhone 7 A$849
iPhone 6s A$699
iPhone SE A$549
Source: Mac Prices Australia, 2018, ‘Apple iPhone prices’, accessed August 2018,
https://www.macpricesaustralia.com.au/iphone/cheapest/.
570 | TOOLS FOR CREATING AND MANAGING VALUE
Example 6.9: P
ricing strategies for the household
products division
Recall the following information about HPD’s new food processors from Part B:
FC202 and FC303 have been added to the product line over the past six years. Both are more
advanced and technologically sophisticated than the FC101. As a result, they are significantly
more complex to manufacture and require special materials handling, tooling and setting
up for each batch produced. Given the complexity of manufacturing the FC202 and FC303,
HPD charges what it believes is a premium price for both of these products.
As the company has adopted a high price strategy for its high-quality products, the indicated pricing
strategy is ‘rapid penetration’. As noted earlier, however, a rapid penetration strategy depends on
customer brand loyalty (e.g. the iPhone). No such customer loyalty is likely to exist for HPD food
processors and the pricing strategy is inappropriate.
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The alternative strategy presented for a high-quality product is ‘rapid penetration’. The key to
rapid penetration is high investment in promotion to create customer awareness of product value.
As noted, however, success depends on economies of scale and it is unlikely that HPD can achieve
such economies.
Study guide | 571
Part C of this module has introduced strategic revenue management, an approach to value
creation with a focus on revenue initiatives. The following Parts D, E and F discuss strategic cost
management, an approach to value creation based on cost initiatives.
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572 | TOOLS FOR CREATING AND MANAGING VALUE
The problem was that many of these cost reductions have been achieved by the imposition
of across-the-board spending cuts (e.g. every manager was required to achieve a 10% cut in
operational costs). While this is decisive, easy and fair in spreading the financial pain, it does
not address the ability of individual managers to deliver targeted cost savings in a sustainable
manner. Across-the-board cost reduction initiatives often rely on short-term cuts in non-essential
expenditure such as:
• travel, training and other labour-related costs
• minimisation of inventory holdings
• postponing scheduled maintenance activity
• deferring planned capital investment projects and new product launches
• renegotiating the terms of existing service contracts with external vendors.
Although such measures usually meet the desired cost-cutting targets, opportunities for sustainable
cost reductions often fail to be pursued. McKinsey in Dolan et al. (2010) revealed that 40 per cent
of respondents, predominantly those who have used an across-the-board spending cut approach,
as opposed to a targeted or differentiated approach, believe that some of the cost reductions
achieved since September 2008 have not continued. This fear has been realised, with respondents
to a Deloitte (2013) survey indicating that a significant obstacle to successful cost reduction was
the erosion of savings. This was because the cost improvements that were undertaken were, in the
longer term, not feasible or sustainable. Blind cost cutting does not last. A 2010 study by McKinsey
argued that cost reduction programs do not identify the true drivers of costs or are simply too
difficult to maintain over time (Agrawal, Nottebohm & West 2010). This stickiness of costs needs a
focus on how to cut and not by how much. By understanding or digging for new drivers, the focus
on how to cut is pivotal for an organisation.
Many organisations also find that they must continually achieve a reduction in the cost of
their products or services for competitive purposes—if an organisation fails to match the
cuts in product cost achieved by its competitors, it will inevitably lose market share. Similarly,
every organisation that launches a new product may be confronted with the challenge of
closing the gap between the product’s target average cost and expected average cost per unit.
Such cuts must be secured in a sustainable manner and implemented in a way that does not
compromise the organisation’s ability to secure future reductions in costs.
Often, significant and sustainable improvements in cost performance come from an examination
of the organisation’s own value chain. For example, an organisation might be able to reduce
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costs by targeting non-value-adding activities and eliminating them along with their associated
costs. As well as managing its own value chain, a company can improve its own cost performance
through better management of its supplier and customer linkages and relationships. Such options
for achieving improvement in the cost performance of an organisation can be grouped together
as strategic cost management. These approaches are more complex and difficult to implement,
but often generate more sustainable cost reductions.
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When efficiency gains are made, the use of fixed resources, such as machines or full-time
employees, is often reduced. This will usually lead to an increase in unused fixed capacity.
The problem is that it is not always easy, or possible, to reduce or eliminate the spare fixed
capacity in the short term. There are typically fixed or committed costs attached to these items.
These may include long-term rental agreements and employee contracts that cannot easily be
changed or ended.
For example, if ABC analysis helps reduce inventory levels by 30 per cent, this will not necessarily
lead to an immediate reduction in fixed rental costs for a warehouse, even if only two-thirds of
the space is now being used. The rest of the space becomes unused capacity until the warehouse
rental is renegotiated, which may be several years away. Fewer staff members will also be needed
to manage the lower levels of inventory; but if current staff have permanent full time positions
this will lead to unused labour capacity, unless they are reassigned to new work or the workforce
can be reduced.
This unused capacity may be used in new ways—for example, leasing out the spare space
to other companies requiring storage facilities—but where it is not possible to achieve an
improvement in resource usage or to reduce the unused capacity, planned cost reductions
may not occur. Having a conceptual understanding of cost drivers in a business model is
important. The following section maps out a conceptual framework and applies that to the
health care industry.
Shank and Govindarajan (1992) suggest that two different types of drivers are the basis for
strategic cost management, as outlined in Table 6.5.
An organisation may initially focus its cost-reduction initiatives on structural cost drivers and,
having successfully secured a shift in the manner of production, then try to obtain further cost
reductions by examining its executional cost drivers. Despite these efforts, success is not easy.
One reason for difficulty in cost cutting is the intransigence of costs, particularly sales, general
and administrative (Agrawal et al. 2010). The focus should be on how to cut and not how much.
The complexity of understanding cost drivers is illustrated by the challenges in the health care
industry. The structural cost drivers include the high costs of hospitals, medical technology and
e-records while the executional cost drivers include the salaries of highly qualified HR, training
and delivery of health care services across primary health care centres and hospitals.
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The National Health System in the United Kingdom has a target of increasing general practitioner
numbers by 5000 by 2020. In 2016, ‘Health Education England (HEE), the employment and
training arm of the NHS, has signed a “memorandum of understanding” with Apollo Hospitals
in India which could see hundreds more doctors coming to Britain if they pass rigorous tests’
(Knapton 2016). Apollo Hospital has emerged since 1991 as a business case demonstrating
successful management of executional and structural cost drivers. Investments in structural cost
drivers such as hospitals and medical technology arose from investments by the International
Study guide | 575
Finance Corporation (an arm of the World Bank). A high standard of care and training of
HR coupled with driving down infection rates saw the executional cost drivers reduce.
Apollo Hospitals is part of an ecosystem with an aim of keeping individuals out of hospitals,
thus reducing costs and increasing efficiency. An integrated value chain perspective is needed
to manage the structural and executional cost drivers.
Figure 6.6 provides a series of five questions that, once addressed, might identify opportunities
for achieving sustainable reductions in costs.
No
No
No
No
Ideally, an organisation’s product portfolio should include products at each stage. Mature
products generate the cash flows required to fund investment in new products and support
the service commitments associated with declining products. If an organisation has a large
proportion of its products entering the decline phase, it may face difficulty in getting new
products to market in sufficient time to ensure continued viability. This relationship is explained
further in Figure 6.7.
Source: Andrew, J. P. & Sirkin, H. L. 2004, ‘Making innovation pay’, Strategic Finance, vol. 86, no. 1, p. 7.
(Figure 1. ‘The cash curve’ republished with the permission of the Institute of Management Accountants;
permission conveyed through the Copyright Clearance Center Inc.)
Figure 6.7 shows that in the early stages of the product life cycle, the cumulative cash curve
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is negative. As the market for the new product develops and matures, the accumulated cash
surplus becomes positive and continues to grow. At some future point, the cumulative cash flow
from the product will start falling and, in the absence of any compelling strategic reason—for
example, to augment other product lines—it would be withdrawn from the market. So, life cycle
management views any new product as an investment which, over its entire economic lifetime,
should recover the initial and subsequent cash costs of investment and generate sufficient returns
to justify the risk taken in developing that product.
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The shape of the cash curve can be modified by decisions taken by the organisation.
For example, a manufacturing company may decide to speed up the product design and
development stage of a new product’s life cycle by employing more production designers
and engineers. The initial investment cost will be increased by the salaries of the additional
designers and engineers and this will add depth to the negative section of the cumulative cash
flow. However, the company hopes that, in getting the product to market more quickly, the time
taken before cumulative positive cash flows appear will be reduced. Other initiatives, such as
collaborating with suppliers and/or customers, may be helpful in bringing about a favourable
change in the shape of a new product’s cash curve.
At each stage in the life cycle of a product or service, opportunities for achieving improved cost
performance are available. As illustrated in Figure 6.8, 85 to 90 per cent of the total cost of a
product is committed at the time of product design, prototype manufacture and the construction
of production facilities (Raffish 1991). So, a focus on cost reduction during production is unlikely
to yield significant economies, because the main scope for improvement exists in respect to the
yet to be committed costs.
Target costing deals with the pre-production stages of the product life cycle and promises the
greatest opportunity for improving product cost performance. Kaizen costing (discussed later
in this module) is primarily associated with the manufacturing and distribution stages (maturity)
of the product life cycle and provides a more restricted opportunity for improving the cost
performance of a product.
75
66%
Strategic cost Traditional cost-
management focus accounting focus
50
25
Cost incurrence
0
Product
planning Design and Production Marketing
and concept manufacture preparation Production and logistics
design of prototype support
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Source: Adapted from Raffish, N. 1991, ‘How much does that product really cost?’,
Management Accounting, vol. 72, no. 9, p. 37.
Figure 6.8 shows that in the manufacturing process, a high level of cost is committed and cannot
be avoided before production begins—for example, capital expenditure, long-term contracts.
This is shown by the dotted cost commitment line. This shows that by the time the product is
ready for production, close to 95 per cent of all costs have already been committed.
578 | TOOLS FOR CREATING AND MANAGING VALUE
The rate of cost incurrence is shown by the dashed cost incurrence line. This refers to the actual
payments of costs, which may have been committed (but not paid) at a much earlier stage. By the
time production starts, only 25 per cent of total costs may have been paid out, even if 95 per cent
of them have been committed.
Up to the time before production begins, a strategic cost management focus is required to
ensure that the outcomes of the manufacturing project are in line with the strategic plan.
The activities of the project are then carried out according to the proposed project schedule
to ensure that manufacturing activities begin on time. Once manufacturing begins, a traditional
cost accounting-focused approach can be adopted to measure the efficiency of inputs and
outputs of the manufacturing process, as shown in Example 6.10.
Once manufacturing begins, the focus will be more on making the production line run efficiently, rather
than large-scale decisions about which vehicles to produce or equipment to install.
It is important to gain control of costs at an early stage—when they are committed. This highlights
the importance of early planning. A useful tool to support this work is target costing, which is
discussed in the next section.
Target costing
Organisations must be able to determine realistically what price a new product is likely to
command, given the:
• specific market conditions
• total costs of developing, manufacturing and supplying that particular product
• profit margin that is desired.
Target costing is a strategic management accounting technique that helps this type of analysis.
Target costing initially focuses on what the market is prepared to pay for the product—that is,
it identifies the likely target price. Knowing the accepted market price enables the organisation
to determine the cost that can be incurred in manufacturing the product after allowing for the
desired (or target) profit. The target selling price is the price the market is prepared to pay for
a product and is determined by the:
• functionality of a product relative to alternative products, or
• volume of sales—that is, market penetration—that an organisation wishes to achieve.
For example, if an organisation wanted to sell two million units of a product to build an
adequate market position in a competitive market, the selling price would need to be set
lower than if it only wanted to sell one million units.
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Target costing supports value engineering and embraces the total cost of the product
throughout the product life cycle, including:
• research and development
• product design
• manufacturing processes, including supply chain management
• marketing
• distribution systems
• customer service.
In summary, if, after the organisation completes the target costing analysis of a proposed
product, it decides to proceed to production, then the product can be manufactured at a cost
that enables the organisation to make an acceptable profit when it is sold at the estimated
market-determined price.
If an organisation is using target costing, the steps outlined in Figure 6.9 should be completed
before a product launch.
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580 | TOOLS FOR CREATING AND MANAGING VALUE
• Identify the target selling price for the product. The target selling price is established
after market research that also takes into account the business strategy that will be
employed to market the product (e.g. cost leadership, focus or differentiation).
Step 1
• Determine the profit margin the organisation requires to achieve its objectives
(e.g. maximise shareholder wealth).
Step 2
• Determine the target cost for the planned product by subtracting Step 2 from Step 1.
Step 3
• Determine whether the product can be produced at or below the target cost—the
target cost must incorporate life cycle costs, so the organisation will include design,
engineering, manufacturing and distribution costs within the total target cost.
Step 4
• Compare the estimated cost determined in Step 4 with the target cost in Step 3. If the
estimated life cycle cost is less than the target cost, the organisation should proceed
with production. If the estimated life cycle cost is greater than the target cost, the
organisation could:
Step 5 – produce the product and derive a profit margin lower than considered acceptable
in Step 2
– produce the product and attempt to reduce costs now, or over an acceptable time
period, by redesigning the product, revising production process technologies,
or changing the quality and/or mix of inputs. The intention is to achieve either an
immediate or planned reduction in actual costs to a level at or below the target cost
– attempt to increase the functionality of the product (e.g. more features) while
keeping costs constant, to enable the organisation to increase the price to a level
that customers are willing to pay
– decide not to manufacture the product.
Target costing is usually applied to products that have clearly defined inputs (raw materials
and labour) and outputs that can be more carefully analysed, managed and changed. It is also
possible to apply these principles to service industries, but it is more challenging because
services are less tangible and unique compared to mass-produced products. Nonetheless
significant improvements are still available, as shown in Example 6.11.
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Burgeoning medical tourism in Singapore, Malaysia, Thailand and India are examples of target costing.
The case of Apollo Hospitals used earlier is evidence of the growing business model of strategic
cost management.
The combination of advanced, custom-built facilities and well-trained specialised employees working
in lower-cost countries has created a whole new industry where patients travel to another country and
receive treatment, and often have a holiday as well—hence the ‘tourism’ descriptor.
The target-costing-based approaches that have enabled this enormous cost reduction started with
a focus on providing a service at well below the current market price to draw customers from other,
more developed and high-cost countries. The largest costs are the facilities and the specialists needed
to perform the procedures and operations.
Careful design of hospitals that allow for effective flow of patients and ensure high levels of utilisation
lead to lower costs per procedure being achievable. Training specialists from countries with lower wage
levels also helps keep prices down. Training specialists who become experts in a single procedure,
which is then repeated many times per day, creates high levels of patient throughput or efficiency.
Careful work has been done to make sure each procedure or operation is performed in a similar or
routine way every time. This leads to better-quality, more consistent results. By increasing the volume
of patients for a particular procedure, the provider is able to specialise their treatment. Operations
and treatment lose their unique features and work is scheduled in a similar way to a production line.
This reduces excess capacity and ensures specialist staff are used solely on productive effort—that is,
performing procedures on patients. This leads to faster, higher-quality and lower-cost treatment.
Specific examples linked to the insurance, banking and telecommunications industries include being
available for help or customer service 24/7 and being able to perform tasks immediately, rather than
taking days or weeks. Customers want to open accounts, withdraw or transfer funds, lodge insurance
claims, receive prompt claim payments and access a variety of telecommunication services with ease.
The highest cost in many situations will be the cost of employee time required to perform particular
activities. Therefore, attention is devoted to redesigning activities and work processes (rather than
physical products or components). By identifying areas that can be automated or streamlined,
an organisation can reduce labour costs and also significantly improve the speed of service.
Automated processing of repetitive activity combined with systematic checklists for approvals and
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processing events can both lead to reduced costs. When this is coupled with greater authority given
to front-line staff, faster decisions and quicker responses are made and costs are reduced.
582 | TOOLS FOR CREATING AND MANAGING VALUE
Kaizen costing
Kaizen costing is based on the concept of achieving incremental reductions in product costs
through a continuous program of small improvements. This is a different perspective to
target costing, which is usually seeking significant reductions in product costs, prior to the
commencement of production.
In practice, organisations will set a target specifying by how much they expect costs to be
reduced in a subsequent control period—for example, a 2 per cent reduction in production costs
per year. This improvement may be achieved through:
• better utilisation of existing technologies and resources—for example, a telephony service
provider increasing the customer load that can be carried on its mobile telephone system
• elimination of waste—for example, idle employee time, material scrap, material handling and
excessive inventory levels
• increased productivity from operational personnel—for example, from staff development and
technical training or having multi-skilled employees who can perform different roles, such as
where employee headcount is kept to a minimum, or
• reducing business activities and costs by outsourcing services that can be provided at the
desired standard at a lower cost by an outside supplier.
Figure 6.10 links the strategic cost management tools of target and kaizen costing to the activity-
analysis approaches of business-process management and CI programs. ABM and BPM will be
discussed later in this module.
Low High
Continuous Business process
Extent of changes made in
improvement management
business processes
Life-cycle costing
Figure 6.11 provides a product life cycle flow chart for a manufacturing company, illustrating how
target and kaizen costing help to answer questions such as ‘Should this product be manufactured?’
and ‘At what point should this product be withdrawn from the market?’.
Product and
Target selling price • Product specifications formulated
process design
established • Manufacturing process designed
changes
Target profit
determined
No
Are product life-cycle costs acceptable? Do not manufacture
Yes
Production phase (Kaizen costing)
Commence production
Continue
Yes production
Product and process improvements
Yes
Is the product still ‘profitable’?
No
Abandon production phase
Cease manufacturing
The following section of the Case study shows how a range of tools is used to analyse and
evaluate various options for the planned introduction of two new products and, in particular,
improving the expected profitability of a new solar hot water product.
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584 | TOOLS FOR CREATING AND MANAGING VALUE
For some products, the combined market share of HPD’s largest rivals is now over 85 per cent. HPD is
therefore investigating alternative manufacturing opportunities, hoping they will provide the division’s
growth over the next decade.
Solar products
Recognising the growing worldwide consumer interest in renewable energy products, such as solar hot
water and solar power systems, HPD has decided to focus on expanding into this area. The worldwide
market for such renewable energy products is expected to become one of the fastest-growing product
markets over the next 30 to 40 years.
Fuelling the demand for renewable energy products are rising electricity costs and a desire to pursue
more sustainable methods, combined with the introduction in many countries of greenhouse gas
reduction initiatives such as emission trading schemes (ETSs) and establishing a price for carbon
emissions (commonly referred to as a carbon tax).
Government support—for example, solar credits or rebates—for renewable energy make the purchase
and installation of renewable energy products more affordable to both industrial and consumer
users. This is coupled with increased community interest in achieving reductions in greenhouse gas
emissions. As a result, HPD believes that entry into this market will provide it with a growing domestic
and international market for these types of products.
30 per cent net profit margin on the selling price of products in highly competitive markets.
Study guide | 585
The following sales and manufacturing data for the expected five-year product life of the Solarheat 1
have been developed.
Total sales revenue $24 000 000 is forecast to be earned on total sales of 30 000 units.
Total life cycle costs of $22 500 000 are expected to be incurred for a total production volume
of 30 000 units. Total forecast life cycle costs have been analysed into:
➤➤Task
In your role as the management accountant for HPD, and in preparation for your first management
meeting on the development of Solarheat 1, you need to perform some calculations for discussion.
(a) Calculate the average selling price per unit of the Solarheat 1 over its expected five-year
product life.
Total sales revenue Total units to be sold Average selling price per unit
$ units $
(b) Calculate the expected average total cost per unit of the Solarheat 1.
$ units $
(c) Calculate the target average total cost per unit of the Solarheat 1 if HPD is to achieve a
30 per cent net profit on the average selling price per unit sold. Use this information to
determine the difference between the target and the expected average cost per unit.
Details Amounts
Expected average cost below (above) the target average cost per unit
($)
586 | TOOLS FOR CREATING AND MANAGING VALUE
(d) At the meeting, Martin Emmitt, HPD’s divisional manager, states that he is interested in
identifying performance measures that he could use to evaluate how well the division has
managed the pre-production activities of research and development, and product and
process design. Prepare a one-page explanation that identifies and briefly discusses three
financial and three non-financial measures that Martin might use to evaluate the research
and development, and product and process design activities.
(e) Martin is contemplating whether target costing would be required for the planned
Solarpower 2 product. Given the significant increase in global interest in the use of renewable
energy sources, he knows that there are in excess of 100 solar power system manufacturers
worldwide. Martin’s research suggests that the prices set by the leading solar power system
manufacturers in individual markets (e.g. Australia and New Zealand) are influenced by such
local environmental factors as:
– the amount of energy that would be generated by the manufacturer’s solar power product
– cost savings that customers will obtain from using self-generated power as opposed to
mains-supply power
– the availability and amount of government subsidies and rebates made available for the
purchase and installation of solar power systems.
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Study guide | 587
Advise Martin on whether HPD will need to undertake a target costing exercise for the
proposed Solarpower 2.
Check your work against the suggested answer at the end of the module.
For a further explanation of target costing, please access the ‘Target costing’ video on My Online
Learning.
For further practice in Target costing, please access Stage 3 of the ‘Save or close the hotel?’
Business Simulation on My Online Learning.
After further investigation of the conventional and TDABC models, analysis of the initial activity and
cost data for HPD reveals that six cost pools will be sufficient. The following cost pools and cost pool
rates have been estimated and the number of transactions to be carried out in manufacturing the
Solarheat 1 has been forecast.
Solarheat 1 indirect
Cost pool Cost pool rate manufacturing activities
➤➤Task
Martin Emmitt has asked you to review the activity and cost data provided and has also requested
that you complete the following tasks.
(a) (i) Calculate for each cost pool the total indirect manufacturing costs that would be allocated
to the Solarheat 1 using the ABC model.
Solarheat 1 indirect
manufacturing ABC indirect
Cost pool Cost pool rate activities manufacturing costs
(ii) Determine the difference between the total indirect manufacturing costs that would
be allocated to the Solarheat 1 using the ABC model in comparison to the traditional
labour-based allocation model (both in total and per unit).
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Study guide | 589
(iii) Comment on how Solarheat 1’s total average cost per unit now compares to the target
average cost per unit.
Check your work against the suggested answer at the end of the module.
Source: Millar, L. 2012, ‘Toyota rocked by faulty accelerator recalls’, ABC News, accessed July 2018,
http://www.abc.net.au/news/2010-02-02/toyota-rocked-by-faulty-accelerator-recalls/317798.
Figure 6.12 illustrates reverse value chain flows that begin with the recovery of a product from the
customer at the end of its economic life and the ultimate fate of the reclaimed product.
Social impacts
Raw material
harvesting or
extraction and Procurement
Product Product Product Product
processing, (e.g. of raw
manufacturer distribution use reclamation
including materials)
reprocessed
materials
Product re-use
(e.g. printer cartridges)
Environmental impacts
Including energy usage and the type and potency of effects caused by compounds
and other contaminants released during the manufacture and consumption of products.
Harvesting or Consumption
Transportation
extraction and Transportation Manufacturing Transportation and/or
and recycling
processing energy costs energy costs energy costs operation
energy costs
energy costs energy costs
In some cases, the recovered product can be re-used repeatedly—for example, printer toner
cartridges that are refilled for re-use. A reclaimed product may also be put to an alternative
purpose—for example, the conversion of used polyethylene terephthalate (PET) bottles into hard
plastic cases for notebook computers. Alternatively, a reclaimed product might be broken down
and the recovered materials or components either used to manufacture the same product again
or in the making of a different product—for example, repurposing computer crystalline silicon
semi-conductor wafers in the manufacture of silicon-based solar panels.
Finally, where no other economically viable use can be found for a reclaimed product, or any of
its parts, it may need to be disposed of in a landfill or a high temperature treatment incineration
system. Many organisations, both manufacturers and retailers, are taking responsibility for the
cost of properly disposing of products (e.g. car tyres, batteries, and, increasingly, smart phones
and personal computers) that have been recovered from their customers. A growing awareness
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of the economic cost and opportunities for realising an economic benefit from reversals in an
organisation’s value chain is now generating managerial interest in making upstream changes
to the design of products. Such changes are directed at lowering total life cycle costs when the
costs and benefits of recovery, re-use, recycling and/or disposal are considered.
Study guide | 591
Figure 6.12 also illustrates the social and environmental context of an organisation’s value chain.
In particular, the environmental impact of an organisation’s value chain activities can be very
extensive and include:
• Energy usage, which can occur during:
–– harvesting or extracting raw materials
–– processing raw materials
–– manufacturing products
–– consuming and/or operating a product
–– transporting procured raw materials
–– distributing finished products
–– reclaiming used products.
• Potency of effects caused by compounds and other contaminants released during
the manufacture and consumption of products. For example:
–– global warming
–– air quality (e.g. smog formation)
–– depletion of the ozone layer
–– acidification of oceans
–– aquatic and terrestrial toxicity
–– human carcinogens.
Example 6.13 reports how Apple Inc. seeks to reduce the environmental effects that result
from its products.
In 2018, Apple reached a major milestone: 100 per cent of the electricity used at all facilities is from
renewable sources (Apple Inc. 2018). The new corporate headquarters was opened in 2016 and
expected to save over 6 692 000 kilowatt hours.
In terms of materials, Apple uses a single, solid piece of recyclable aluminium to enclose the iMac
computer and recyclable glass is used for the display. The iMac’s aluminium and glass materials are
economically valuable to recyclers, so these materials can then be re-used in other products.
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592 | TOOLS FOR CREATING AND MANAGING VALUE
At this point, it is useful to clarify the relationship between ABM and ABC.
ABM focuses on managing activities along the organisation’s value chain to reduce costs. ABM is
focused on strategic decision-making and aims to improve customer value through business
process improvements. It is focused on strategic planning and performance.
Activity-based management
The ABM process begins in a way similar to ABC.
1. The first step is an activity analysis and drawing an activity map. Next, the management
accountant must identify inputs, drivers and outputs for each activity. As in ABC, the inputs
comprise the cost of all the resources used in the activity and the driver—the item that
creates or ‘drives’ the cost of the activity.
2. ABM then differs from ABC with its focus on outputs. All activities should produce valuable
outputs. Activities that do not produce valued outputs are called non-value-adding activities
and need to be eliminated or reduced as much as possible. The management accountant
must determine the nature of the outputs for each activity and appropriate ways of measuring
them. For some activities, outputs are clearly defined. For the activity ‘running machinery’,
units of product are the likely output; for other activities like ‘purchasing supplies’, the output
might be the number of purchase orders generated, or the dollar value of purchases.
3. Having determined the inputs, outputs and drivers for each activity, the management
accountant is in a position to analyse and improve both individual activities and the broader
activity map to increase the overall productivity and efficiency of the organisation or specific
business process. The analysis should start at the strategic level with the activity map.
The most complex aspect of ABM is analysing groups of interrelated activities in the activity map
to see if they can be reorganised in a more efficient or strategically relevant manner. This often
occurs in manufacturing companies when traditional, functionally oriented (output) manufacturing
systems are replaced by customer- and product-focused manufacturing cells—for example,
flexible manufacturing system cells. Similarly, major changes to business processes need to be
considered for every part of the organisation’s value chain. It is critically important to ensure that
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any significant new investment in process change is consistent with the strategic direction of the
organisation (see Module 4 for more detail on managing major investment projects).
To determine the cost savings that may be realised from ABM, it is necessary to understand the
factors that determine the economics of the organisation’s value chain. Factors to be analysed
are outlined in Table 6.6
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Table 6.6: A
ctivity-based management—factors to be analysed for activity-
based management
Factor Definition
Scale The extent to which the organisation has sufficient production capacity and volume
of output to achieve economies of scale and, with it, a significant market share.
Scope The extent of vertical integration influences control over the industry value chain.
Highly integrated organisations have more control over the prices paid for inputs and
revenues received for outputs.
Experience The benefit of that experience should be reflected in higher levels of productivity
and lower wastage and rework rates.
Complexity A highly complex product or service portfolio has costs that are likely to be significantly
higher than an organisation with a relatively simple range of products or services.
This additional cost must be balanced against the desirability of offering a full
product range.
Channels The channels used to distribute products can have a significant effect on value chain
costs and benefits. For example, Google maps uses location ‘pins’ for drivers who plan
their journey. The pins for McDonald’s not only allow the customer to schedule their
trip but have become a channel for McDonald’s to connect to their customers, who can
drill down into the food menu. These non-traditional channels, in the Internet of Things
(IOT), show how businesses can leverage disruptive technologies.
Quality of Competent operational management results in the best capacity utilisation, improved
operational product and process design, a continuing stream of learning opportunities flowing from
management total quality management and CI programs and well-exploited external linkages with
suppliers and customers.
Management efforts to make major changes to the way business processes are carried out are
often referred to as BPM. This is akin to the business process re-engineering approach to process
improvement adopted by engineers, and both approaches are very similar to the strategic
analysis of ABM.
The BPM approach assumes a value chain perspective and examines business processes from the
viewpoint of the organisation’s customers. BPM can result in the organisation being restructured
around business processes rather than functions, as shown in Example 6.14.
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Suncorp
Suncorp, an Australian financial conglomerate, conducted a study that focused on process
improvements to reduce the length of time it took for processing insurance claims. Through this
analysis and by redesigning processes, the company was able to reduce the time it took to process
claims—from one to two months to between one and five days. This extraordinary improvement shows
that process analysis is just as important in service industries (Suriadi et al. 2013).
Mary Johnson, the assistant production manager for HPD, has suggested that part of the Solarheat 1
manufacturing line be reorganised into five production cells. Instead of one long production line, all of
the production activities from start to finish would be contained within these cells—groups of people
and equipment that have multiple roles. Mary believes this would minimise handovers and create a
greater level of responsibility and accountability for time, quality and efficiency.
Furthermore, as a result of BPM achieving a leaner manufacturing process through the permanent
reduction in direct labour requirements for the production of the Solarheat 1, the forecast direct labour
cost is expected to decrease by $30 per unit.
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➤➤Task
Mary Johnson has asked for your help to look into the possible BPM exercise.
(a) (i) If the cost of reorganising the Solarheat 1 manufacturing facility into a cellular format
is $300 000, calculate the indirect manufacturing cost allocations and savings in direct
labour costs for the functional versus cellular manufacturing layout.
Machine set-
ups (see the $ $ $
answers to set-ups set-ups
Case study 6.6)
Materials
moves (see $ $ $
the answers to moves moves
Case study 6.6)
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(b) With the ABC model now being used for allocating indirect manufacturing costs, the expected
product cost for Solarheat 1 has been revised down to $725 per unit (i.e. $750 – $25)—
see Case study 6.6.
(c) Write a response for Mary Johnson that identifies and briefly explains two financial and two
non-financial performance measures that she could recommend to Martin Emmitt to evaluate
the success of the BPM exercise.
Check your work against the suggested answer at the end of the module.
Organisations engage in many activities when producing the goods or services they sell
to customers. Some activities directly or indirectly contribute to increasing the value of
the organisation’s products to customers and increase the level of customer satisfaction—
for example, through improved product design and manufacturing processes. As discussed in
Module 1, these activities are termed ‘value-adding’, because they increase the attractiveness
or saleability of the organisation’s products or services. The organisation should strive to carry
out these activities as efficiently as possible.
There are also other non-value-adding activities—for example, process set-up time, storage,
inspection and movement of items—that do not increase the attractiveness or saleability of
the products and, if eliminated, allow the organisation to reduce its costs without affecting its
revenue. Where activities that are not inherently required in supplying a product are reduced,
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Figure 6.13 provides a series of questions that will assist in identifying if a particular activity
is value-adding or not. By undertaking a rigorous approach to activity value analysis,
an organisation is more likely to achieve a sustainable reduction in operating and support
costs by eliminating or reducing non-value-adding activities.
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expected total sales and production volume of 30 000 units, a further total cost saving of $3 450 000
must be achieved ($115 × 30 000 units).
You now need to prepare for the next HPD senior management meeting and you decide to undertake
an activity value analysis of HPD’s value chain.
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➤➤Task
(a) Activities involved in the production of the Solarheat 1 have been determined and are shown
in the following table. In your checklist, classify each activity as more likely to be value-adding
or non-value-adding.
Non-value-
Nature of activity or event Value-adding adding
1. Designing a product
9. Processing products
(b) HPD’s functional activities and life cycle costs are presented in the following table. The total
costs for each function incorporate the ABC and BPM projections made earlier. For each
functional activity, classify the related costs as more likely to be value-adding or non-value-
adding.
Research and
development work $900 000 $ $
Prototype design
$250 000 $ $
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Rework of prototypes
$150 000 $ $
BPM—cellular facility
layout costs $300 000 $ $
Design work
$1 500 000 $ $
Issue patterns
$700 000 $ $
Rework patterns
$300 000 $ $
Production costs (made up of direct materials and labour and indirect manufacturing costs)
Direct materials
Inbound logistics costs
$1 500 000 $ $
Direct labour
Direct labour
manufacturing activity $1 100 000 $ $
On-the-job inspection
activity $250 000 $ $
Quality control
$375 000 $ $
Rework
$600 000 $ $
Materials movement
$600 000 $ $
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Total indirect
manufacturing $3 150 000 $ $
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Distribution
$950 000 $ $
After-sales service
Warranty claims
$600 000 $ $
Customer complaints
$150 000 $ $
(c) Martin Emmitt is interested in understanding how the division will determine which of the
non-value-adding activities should be eliminated. Write an explanation for Martin, covering the
factors that would need to be considered before deciding if a particular non-value-adding
activity is to be eliminated.
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(d) Explain why some of the costs associated with the non-value-adding activities cannot be totally
eliminated by stopping them immediately. Illustrate your answer by using the ‘$600 000 of
rework’ indirect manufacturing cost as an example.
(e) You establish a business case to eliminate many non-value-adding activities. While it is desirable
to eliminate them all, it may be too difficult and costly. Further, you have been advised that
the following activities and costs are to be excluded from the analysis as they are currently
considered unavoidable in the short to medium term:
You initially identify two levels of elimination: partial and total. The table in the case facts
shows the benefit (in cost savings) and cost for the partial or total elimination of the relevant
non-value-adding activities.
To determine whether to pursue partial or total elimination you need to complete the following
table, by:
(i) Identifying the:
– net saving of partial elimination
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Total costs
$1 320 000 ($240 000) $ $1 645 000 ($480 000) $ Total savings $
(ii) Identifying the preferred BPM initiative for each activity—total or partial elimination—and
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(iii) Calculate the total amount of savings expected for the Solarheat 1 product by performing
the preferred elimination option for each activity. What is the revised expected cost per
unit and the gap to the target average cost per unit?
Check your work against the suggested answer at the end of the module.
Continuous improvement
Once activities have been rearranged, non-value-adding activities eliminated, value-adding
activities replaced with other more efficient activities, and management is generally satisfied
with their revised activity map, individual activities can be analysed to identify ways of improving
them. This aspect of ABM is often called CI and was originally developed by Japanese motor
vehicle manufacturers. It has a strong focus on teamwork and worker empowerment. CI is
focused on existing activities and aims to engage all personnel involved in that activity in an
ongoing improvement process. An important incentive often associated with CI implementation
is ‘gainsharing’. Workers involved in the CI process share a portion (say 10%) of any cost
improvements they are able to achieve.
While both BPM and CI seek to improve process performance, they approach the task differently,
as shown in Figure 6.14 and explained further in Example 6.15.
Low High
Continuous Business process
Extent of changes made in
improvement management
business processes
Example 6.15: P
roductivity measures for continuous
improvement initiatives
The output–input ratio for the activity ‘running machinery’ is:
Units of product
Activity cost
If the activity results in 10 000 units of product in a time period where activity costs are $5000, then the
ratio is 10 000 units / $5000 = 2 units per dollar of input. To improve the performance of this activity,
the ratio must increase. To achieve this increase, managers must focus on the activity’s inputs, outputs
and cost driver.
• An input focus might lead managers to reduce the wages of machine operators or have one
operator supervise multiple machines.
• An output focus might lead managers to add a second shift to produce more product. This would
also increase cost, but the net change in the ratio is what is important.
• A driver focus might lead managers to reduce machine hours by running the machines at faster
speeds.
The success or failure of management initiatives is measured by the effect of management’s actions
on the activity ratio.
Having established the inputs and outputs for each main activity at the beginning of the ABM
process, the management accountant can support CI by providing management information
in relation to efficiency or productivity ratios (i.e. output/input or, alternatively, input/output).
The first approach, output/input, should be adopted for consistency’s sake, and when the ratio
has output in the numerator, any increase in the ratio can be interpreted as a positive outcome.
This approach to measuring improvements in productivity obtained from a CI initiative is
generally more easily understood.
These activity ratios are also known as efficiency or productivity ratios. Performance is enhanced
for an efficiency ratio when inputs (the denominator) are reduced. Performance can be enhanced
for a productivity ratio by increasing the output level (the numerator). Return on investment
(ROI) is an output/input ratio. ROI can be improved by decreasing the denominator (net assets)
and/or increasing the numerator (profit). Both actions have a positive impact on the ratio.
Example 6.16: E
stablishing the social and environmental
impact of the Solarheat 1
To illustrate how social and environmental factors might be recognised, consider HPD’s Solarheat 1.
Establishing the social impact of Solarheat 1 should include reviewing where materials or components
might be sourced from low-labour-cost developing countries. A question to ask may be: How can
HPD be assured that its suppliers are behaving in socially responsible ways towards their employees,
their families and the broader community?
When reviewing the environmental factors, the inputs and processes, as well as the outcomes from
using the product, should be considered. From an inputs perspective, consider the:
• types of materials used to make the Solarheat 1
• effect of the manufacturing processes employed, including the creation of any toxic by-products
• potential for recycling materials at the end of its economic life.
From an outcomes perspective, based on usage of the product, the benefits of using this renewable
energy product should be considered.
BMW plans to invest more than €300 million in body and paint facilities (Boeriu 2018). While
increasing capacity, the new plant would be filler free, reduce energy by 30 per cent and
waste water by 45 per cent. From an environmentally conscious customer’s perspective,
these environmental improvements make BMW more attractive.
Part E, following, continues the theme of strategic cost management begun in Part D. Part E
focuses on supplier management—management of the upstream portion of the industry value
chain. Key issues discussed include:
• the complexity of the global supply chain
• supplier codes of conduct relating to ethical treatment of employees and the environment
• supplier selection
• TQM
• outsourcing.
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The financial cost associated with procuring raw materials and components is not simply the
visible supplier invoice cost. The relationship with a supplier imposes other costs. For example,
an organisation may incur costs like those outlined in Figure 6.15.
These supplier-related expenses are not usually explicitly recorded in inbound logistics-related
overheads and, depending on the performance of a particular supplier, can be significant. Of the
total cost structure for companies involved in manufacturing, purchased goods and services
might account for between 20 and 60 per cent of total costs.
For organisations involved in wholesaling or retailing, purchased goods and services can account
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for between 80 and 90 per cent of their total cost structure. Besides the invoice cost of purchased
goods and services, a thorough review of other supplier-related costs can potentially lead to
significant cost reductions. However, a single focus on supplier-related cost reduction needs to
be balanced against the risks involved. Risks (which were explained in Module 4) can be classified
in different ways.
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There are two broad risks (Ho et al. 2015) in the supply chain:
1. macro risk—for example, natural disasters, war, economic downturns, social and cultural
grievances and legal and regulatory risks
2. micro risks or operational risks (Sodhi et al. 2012), which include:
(i) demand risk—for example, inaccurate forecasts, customer expectations change,
short life cycles, competition changes
(ii) manufacturing risks—for example, labour disputes, product obsolescence, insufficient
maintenance as well as production capacity shortages or excess
(iii) supply risk—for example, inability to meet demand changes, failure to deliver on time or
to requirements, supplier bankruptcy or suppliers have unethical or poor management
(iv) infrastructure risk—for example, information infrastructure breakdown, transportation
risk factors due to excessive handling at border crossings, fragmentation of logistics
and supply chain complexity
(v) financial risks—for example, exchange rate risk, interest rate risk, low profit margins,
credit risks.
These risks are not mutually exclusive and may on their own or in combination not only cause
damage within the particular risk category, but also significantly affect the brand value or
reputation of the organisation. The risk associated with supply chain management needs to be
handled carefully, with appropriate steps being undertaken to try to reduce the risk exposure
of the organisation. For example, poor supplier selection processes may result in inferior raw
materials, lower-quality products or problems within the local facility of the supplier. Any of these
may ultimately affect the performance of the organisation, but more importantly they pose a
threat to the reputation of the organisation, resulting in a longer-term effect (see Example 6.17
in the next section).
Supplier management
Organisations typically spend considerable time interacting with customers to find out how
to serve them better and meet their needs. Generally speaking, this is not the case with
the organisation’s suppliers—because suppliers rely on the organisation to place orders—
so organisations are generally less interested in meeting their suppliers’ needs. However,
devoting attention to building long-term supplier relationships will help minimise risks and build
stronger partnerships within the value chain. Suppliers are often able to point out opportunities
for improvements within the organisation that they supply. An effective relationship with a
supplier can lead to improvements that are to both organisations’ benefit, by providing higher-
quality goods and services to customers and possibly also reducing costs in the value chain.
Meetings with suppliers to discuss and explain the organisation’s strategic direction, types of
products, future product strategies and other relevant information may be risky. The more
information a supplier has about an organisation, the more power it has when it comes to
negotiations, and this may be used against the organisation. But sharing information may
also lead to useful contributions from suppliers at the design and development stage of
new strategies that avoid major mistakes or lead to better options being considered and
implemented. Suppliers may be more willing to make changes in their organisation to
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provide better service. This may include the appropriate selection of particular raw materials
or determining the most suitable location to set up operations for a particular item to
be supplied.
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Attention also needs to be focused carefully on suppliers of services, because it is often more
difficult to evaluate the quality and ensure the timeliness of the work. Services are often provided
in an ongoing manner, which means that clear terms, expected outputs and time frames need to
be agreed. Dealing with issues or differing expectations requires careful negotiation and clear
communication to ensure requirements are met, while at the same time maintaining harmonious
and constructive working relationships.
Building these relationships also provides further opportunity to work on reducing the
hidden costs highlighted earlier within the supplier’s business that are flowing through to the
organisation. Helping suppliers improve the quality of their products or services will lead to
greater efficiency and less double-checking, saving additional time and money.
Global suppliers
As shown in Example 6.17, many organisations source their required materials and components
from global suppliers. By choosing an overseas supplier, an organisation may hope to obtain
a price reduction because of the supplier’s lower production costs. Cost advantages that an
overseas supplier may have over a domestic supplier could include cheaper labour costs,
the benefit of lower taxes, greater access to required commodities at lower prices and/or
better operational competencies.
A range of factors will therefore influence the decision to contract with specific global suppliers.
The evaluation and audit of potential global suppliers is an important part of the selection
process. One key characteristic is whether the potential global supplier has achieved accreditation
status for one or more of the international standards. These voluntary standards are developed
by the International Organisation for Standards (ISO). The more popular standards include:
• ISO 9001 Quality Management
• ISO 14001 Environmental Management
• ISO 26000 Social Responsibility
• ISO 31000 Risk Management
• ISO 22000 Food and Safety Management.
Organisations wanting to secure global supply contracts will commonly seek accreditation—
which is conducted by external certification agencies—for one or more of the standards, even if
not explicitly required to do so by the customer.
Example 6.17: W
alMart consolidates its global sourcing
structure and upgrades its risk management
United States retailer WalMart is consolidating its global sourcing structure in a bid to reduce costs
and accelerate its speed to market. The global sourcing strategy involves the creation of global
merchandising centres, a change in leadership and structure, and an alliance with global sourcing
organisation Li & Fung. The moves are considered to be ‘important elements in the organisation’s
strategy to deliver even greater value to its customers and shareholders’. The new structure leverages
the organisation’s global scale across both general merchandise categories and global food sourcing.
The core of the organisation’s strategy will be to continue increasing direct sourcing for the
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organisation’s private brands. Furthermore, Li & Fung, which will form a new organisation to manage
the WalMart account, is expected to build capacity that would enable it within the first year to act as
a buying agent for goods valued around $2 billion.
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WalMart has been forced to review its risk management practices within its global sourcing portfolio.
The building collapse in 2013 at a Bangladesh factory, which killed more than 1100 workers, triggered a
review of risk management practices by many organisations that use garment factories in Bangladesh
as part of their supply network. WalMart planned to use outside auditors to inspect nearly 280 factories
and where safety concerns are not met, remove those factories from its list of approved suppliers.
Source: Based on WalMart 2010,‘WalMart leverages global scale to lower costs of goods, accelerate
speed to market, improve quality of products’, accessed August 2012, http://news.walmart.com/news-
archive/investors/walmart-leverages-global-scale-to-lower-costs-of-goods-accelerate-speed-to-market-
improve-quality-of-products-1380021; Banjo, S. & Zimmerman, A. 2013, ‘WalMart goes it alone on
Bangladesh garment factory safety pact’, The Australian Wall Street Journal, Supplement, 16 May.
Offsetting the cost savings that might be obtained from sourcing globally, rather than domestically,
is the possible increase in the length of an organisation’s supply chain. There might also be
costs and risks associated with international trade. As well as additional inbound freight costs
(including insurance), the lead time from order placement to order fulfilment will also increase.
The organisation may also need to consider exchange rate movements and relevant international
freight regulations, including any customs and duties. Another risk of a global sourcing strategy is
the negative impact of business and/or political practices in the international supplier’s country.
Beyond these business practice risks, other more qualitative issues may emerge from a global
sourcing strategy, such as:
• cultural and language differences
• legal and political system differences
• a lack of immediate interpersonal engagement—for example, with long distances and
different time zones, it may be difficult to maintain regular interpersonal contact.
Many global manufacturers choose to have their components produced and assembled in low
labour-cost developing countries. Such labour-cost savings emerge because the employment
environment and conditions for many workers—for example, health and safety, human rights,
hours of work and rates of pay—are significantly lower than those in place in more developed
economies. Using these suppliers may expose an organisation to a level of criticism that could
damage the organisation’s reputation and the value of its brand and products. In the past,
both Nike (Nisen 2013) and Apple (Cooper 2013) have been severely criticised for the poor
working conditions of employees in companies located in less developed economies where
they have subcontracted manufacturing.
recruitment and a prohibition on hiring under-age employees), limits on work hours, minimum
rates of pay, and work health and safety (WHS) policies and practices. They may also specify
minimum standards of environmental management practices.
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Just as important as having a code of conduct is monitoring the suppliers’ actual compliance
with the terms of the code. An organisation may use its own personnel, supplemented where
required with local third-party experts, to audit the supplier’s manufacturing and related
facilities—for example, residential accommodation, sporting and recreational facilities,
and transport, health and educational services. It is also important that any detected violations
of a supplier code of conduct are dealt with appropriately. This may include corrective action
plans to remedy the situation (and prevent it from occurring in the future) or, for more serious
breaches, termination of the supplier agreement.
You can see Apple’s view of its own supplier code of conduct on p. 41 of its Supplier Responsibility:
2018 Progress Report, available at: https://www.apple.com/au/supplier-responsibility/pdf/Apple_
SR_2018_Progress_Report.pdf.
Another example is Levi Strauss & Co. (Levi Strauss), which works with the Better Cotton Initiative
(BCI). In 2013, BCI set out to conserve water and reduce the impacts of fertilisers, and this led to
a 23 per cent reduction of water used by cotton farmers in China (Levi Strauss 2014).
Suppliers are not the only focus for shared value creation at Levi Strauss. Levi Strauss Foundation
set up a Worker Wellbeing initiative and found that for every dollar of investment in worker
wellbeing, there was $4 generated in productivity (Levi Strauss 2016). The company plans that
by 2020, 80 per cent of its production facilities will have Worker Wellbeing programs in place.
JIT is not just focused on lower inventory levels but also on having the right inventory levels,
the right quality of inventory and an effective inventory management system. Together, these are
likely to contribute to better product quality, faster set-up times and less waste.
Within the organisation’s own value chain activities, excess inventories can be eliminated by:
• better control over material flows from an inbound logistics perspective—for example,
materials being delivered by suppliers in small batches, on time, in full and to specification
• better management of material flows throughout the manufacturing process by:
–– ensuring preventative maintenance reduces unscheduled downtime
–– reducing the build-up of work-in-process inventories by removing production
bottlenecks.
While much of the success of a JIT initiative relies on the changes a manufacturing company
makes within its own value chain, the suppliers’ ability to deliver raw materials and components
on time, in full and as specified is also very important. In some cases, manufacturing companies
have entered vendor managed inventory (VMI) arrangements where the supplier takes full
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responsibility for ensuring that raw materials and components are delivered exactly where and
when they are required by the production process.
Despite the benefits of a JIT approach to minimising inventories, it is also important to remember
that a major potential issue that arises with having minimal inventory is supply chain disruption.
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Supplier failure
(e.g. the supplier cannot deliver because
their manufacturing facilities have been
damaged or they have been liquidated)
Logistics failure
(e.g. workers at the inbound port take
industrial action over a safety issue and
the freight cannot be unloaded)
Disruptions
Natural disasters
(e.g. earthquakes, tsunamis and
cyclones may affect the functioning
of the supply chain)
Geopolitical events
(e.g. trade sanctions)
Another supply chain consideration is deciding whether to have single or multiple suppliers.
Having more than one supplier addresses several supply chain risks. The organisation is not
dependent on just one vendor, so a more competitive supply-side market is created. This means
that there are alternative sources of supply available, should one vendor be unable to fulfil its
contractual obligations.
From another perspective, by having a single supplier an organisation may be able to establish
a deeper and more sustainable relationship with the vendor that is to the mutual benefit of
both. Through a long-established trading relationship, greater levels of trust may develop.
The willingness of the supplier to offer exemplary service and support may increase, along with
the vendor’s capability to readily innovate and adjust to the changing procurement needs
of the organisation.
Ultimately, the selection of a supplier not only depends on its pricing, but also on its past and
expected future supply performance—for example, a supplier’s reliability in delivering on
time, in full and to specification. These non-financial measures relating to a supplier’s delivery
performance are important. While the economic cost of a supplier’s performance failure in any
of these areas cannot always be readily determined, non-financial delivery performance metrics
provide a leading measure of the economic cost that would ultimately be incurred if a supplier’s
performance deteriorated.
Areas that would be thoroughly examined when initially selecting a supplier include their ability,
expertise and experience. Although suitable, accurate and timely supplier performance measures
can be limited in their coverage of these criteria, they cannot be neglected. Careful consideration
of all supply chain factors ensures that the suitability of fit is maximised between the organisation
and the suppliers it selects.
After a supply contract with a vendor is entered into, other factors will emerge that influence
how the supplier’s performance is monitored. When a vendor always fulfils its obligations under
the supply contract and establishes a reputation for always dealing promptly and equitably with
any problems that arise, the organisation may find that, after more informal and interpersonal
exchanges in this procurement relationship, a level of trust develops that leads to less emphasis
on written contractual requirements.
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Such a progression from behavioural compliance (i.e. where the terms of the procurement
contract dictate the interactions between the supplier and the organisation when resolving a
supply problem) to attitudinal compliance (i.e. where both parties willingly collaborate to resolve
a supply problem jointly) is an important ingredient for long-term and mutually sustainable
supply arrangements.
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Three potential suppliers (Componentz, ElectricalPartz and Parts100), who have been used before by
HPD, are being evaluated for the supply of raw materials for the Solarheat 1.
Jane extracts some representative data that she has been compiling on the three suppliers.
The following table reveals the invoiced cost of recent materials purchased. Jane notes that:
• Parts100 is typically the cheapest supplier with whom she has been ordering the greatest volume
of materials, leading to a greater dollar value of invoiced costs.
• ElectricalPartz is the most expensive supplier, costing about 3 per cent more than Parts100, and is
given the least business in both volume and dollar value terms.
• Componentz is about 2 per cent more expensive than Parts100, with both volume of ordered
materials and dollar value of orders sitting in between the other two suppliers.
While both Componentz and Parts100 make deliveries every week to HPD, ElectricalPartz prefers to
make deliveries every fortnight. Total costs relating to each supplier are a function of the invoice cost
of the raw materials and additional supplier-related costs. Management finds that the supplier cost
performance ratio is a useful measure (this ratio is a function of supplier-related costs as a proportion
of the invoice cost).
➤➤Task
Martin Emmitt has asked you to review the current purchasing practices.
(a) Complete the following tables by calculating the:
(i) total supplier-related costs for each supplier (based on activities performed)
(ii) total procurement costs
(iii) supplier cost performance ratio.
Note that Jane estimates that the ratio of supplier-related costs to invoice costs over all HPD
purchases is 1:5—that is, an additional 20 per cent of the cost of the average purchase order is
spent on supplier-related activities. Accordingly, she estimates that if the raw materials for the
Solarheat 1 product line were sourced from Parts100 at an invoice cost of $7.5 million, an additional
$1.5 million would be spent on supplier-related activities.
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Total activities
Cost per Electrical and total
Activity type activity Componentz Partz Parts100 costs
Order materials
Receive orders
Inspect deliveries
Costs $120 $18 000 $10 800 $21 600 $50 400
Return materials
Activities 15 6 30 51
Account queries
Activities 15 6 30 51
Process payments
Activities 36 75 36 147
Total supplier-
related costs $ $ $ $135 780
Invoice cost of
raw materials $ $ $ $678 900
(see table in
case facts)
Total
procurement $ $ $ $814 680
costs
(Total supplier-
related costs +
Invoice cost of
raw materials)
supplier-
related costs /
Invoice cost of
raw materials)
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(b) (i) Using the following table, calculate the expected Solarheat 1 total procurement costs
that would be incurred for each of the three potential preferred suppliers if they were
chosen as the preferred supplier.
Suppliers
Estimated
Details Componentz ElectricalPartz Parts100 costs
Expected invoice cost of direct ($7 500 000 ($7 500 000) ($7 500 000)
materials (calculation) × (1.02) × (1.03) × (1.00)
†
From the introduction in Case study 6.9, Parts100 is the cheapest supplier and so has
been selected as the base against which all other suppliers are analysed. So Parts100 has
been assigned a supplier invoice cost index of 1.00. Since the cost of materials supplied
by Componentz is 2 per cent more expensive than Parts100’s, it has a supplier invoice cost
index of 1.02 (1.00 + 0.02). Similarly, as the cost of materials supplied by ElectricalPartz is
3 per cent more expensive than Parts100’s, the supplier invoice cost index for ElectricalPartz
is 1.03 (1.00 + 0.03).
(ii) Explain your calculations.
MODULE 6
Check your work against the suggested answer at the end of the module.
Study guide | 617
A draft report has been prepared which, with respect to the lean manufacturing model, has made
several recommendations that the cross-functional team believes will deliver improvements in both
manufacturing efficiency and product quality. The team recommends that the product be redesigned,
the manufacturing process refined and employees given increased training. As a result of these
investigations and the greater customer value provided through improved quality, the average selling
price of the Solarheat 1 can be increased by $10 per unit (from $800 to $810).
The following table details some of the changes that will occur for the broad-level manufacturing
activities undertaken and costs incurred as a result of this recommendation. For example, by increasing
expenditure in research and development and design work, HPD believes it can save a greater amount
in activities such as prototype design, pattern issue and quality control.
Production costs
Direct materials
Direct labour
➤➤Task
As leader of the cross-functional team, you will need to provide information to Martin Emmitt
regarding the product redesign:
(a) Calculate the target and expected costs per unit of the Solarheat 1 and the difference between
the two costs if HPD is able to lift the selling price from $800 to an average of $810 per unit.
Assume that HPD still wants a profit margin of 30 per cent on the Solarheat 1.
Details Amounts
Expected average cost above (below) the target average cost per unit
($)
Study guide | 619
(b) Write an explanation for Martin that identifies and briefly explains two financial measures
and two non-financial measures that could be used to assess the success of the product and
production design changes that your team has proposed.
MODULE 6
Check your work against the suggested answer at the end of the module.
620 | TOOLS FOR CREATING AND MANAGING VALUE
Quality can be defined as conformance to standards. This concept sits well with accounting
notions of standard costs and variance analysis. Any variance from a standard is a quality
problem. Quality services or products are those that are suitable for their function or purpose
and which conform to the needs of customers. TQM means that an organisation will attempt
to produce quality products at a reasonable cost in all its operations. So, for a production
department, the quality of inputs as well as outputs must be monitored. Other support
departments, such as accounts or planning, will all be expected to provide quality inputs in
terms of service and back-up support to production activities.
Juran (1962), a quality cost pioneer, separated the costs of controlling quality (e.g. prevention
and appraisal) from the costs of failing to control quality (e.g. internal and external failure).
These are summarised in Table 6.7, and highlighted in Example 6.18 and Example 6.19.
Costs of failing Internal failure Incurred before products are • Corrective action
to control sent to customers, and relate • Rework and scrap
quality to products that fail to meet • Process
quality standards • Expediting
• Re-inspection and retest
unsatisfactory products
• Customer ill-will
Example 6.20 demonstrates the costs of controlling and of failing to control quality costs.
The Takata airbag recall that caused car recalls across the world shows that costs of quality, particularly
the cost of external failures, can be huge.
Example 6.21: C
ategorising quality costs in the household
products division
Assume that HPD has three types of appraisal activity:
1. initial appraisal of potential suppliers in terms of their ability to deliver raw materials and
components at or above quality specifications
2. appraisal of raw materials and components delivered by a supplier who has not been certified
as being quality assured
3. appraisal of work-in-progress and finished products as a result of plant and equipment and machine
operators not always being able to manufacture to exact product specifications.
Clearly, the initial supplier quality accreditation (1) falls into the prevention classification of quality
costs, as the desired outcome is to ensure that only those suppliers who will deliver raw materials and
components meeting HPD’s requirements will be selected. The inspection of inbound raw materials
and components (2) is an appraisal cost, since it is intended to detect and remove defective materials
and components before they are issued to production.
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The inspection of work-in-progress and finished products (3) is less clear-cut. This activity and cost
occurs during production, but it could be considered to fall into either the appraisal cost or internal
failure cost category. The typical classification of this quality cost is by its nature, rather than by its place
within the product life cycle—that is, it is an appraisal rather than an internal failure cost. However,
it could be argued that the need to inspect work-in-progress and finished products is attributable
to HPD’s inability to have manufacturing equipment and operators always achieve desired product
specifications, meaning that this type of appraisal activity could be an internal failure quality cost.
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Typically, reworking defective products would be classified as an internal failure cost. Furthermore,
since rework costs are additional costs incurred to bring a defective product up to a predetermined
commercially acceptable level—for example, to factory ‘seconds’ standard—and customers are not
prepared to pay for rectifying production errors, the rework costs would be viewed as being non-
value-adding. This is from the viewpoint that they should not have been incurred in the first place.
Keep in mind that while rework is not considered to be value-adding, it may still be worth doing in
some cases. This is because the organisation may recover more money than the cost of rework from
the proceeds realised from the sale of the reworked product, as shown in Example 6.22.
1. Totally scrap the defective unit at a cost of $10. If HPD decided to scrap all defective FC101 food
processors, then, in addition to the costs incurred to date in manufacturing the defective units,
a further $10 per unit would need to be added to calculate the total wastage cost.
2. Scrap the defective unit and recover re-usable materials and components at a cost of $25 per unit.
The recovered materials and components have an economic value of $18 per unit. If the re-usable
materials and components are recovered and the defective unit scrapped, the total wastage
cost would be $3 lower than if the unit was totally scrapped. This is because there is a net cost of
$7 per unit realised from the decision to recover the re-usable materials and components from the
scrapped defective unit (i.e. $18 of economic value recovered – $25 cost of recovery and eventual
scrapping).
3. Rework and repackage the defective unit at a cost of $40 per unit so that it can be sold as a factory
‘second’ to a discount electrical retailer for $70 per unit.
While the option to rework and repackage a defective FC101 model food processor results in the
highest rework cost of $40 per unit, it also provides HPD with a product that it can sell for $70 per
unit. In this situation, the rework is still not regarded as a value-adding activity, because it should
never have occurred—but it is still a best option because it generates a net economic benefit of
$30 (i.e. $70 for factory seconds – $40 rework and repackaging costs).
In general, it can be expected that a $1 expenditure on prevention saves $10 in appraisal and
internal and external failure costs. Similarly, increased expenditure on appraisal activities will
reduce external failure costs, through shifting external failures to internal failures—for example,
by increasing the cost of scrap and rework and decreasing customer returns and warranty claims.
So, managers should invest their quality dollars in prevention and appraisal activities so that
failure costs are decreased and overall value increased.
significant improvements are forecast. Market research indicates that the improved Solarheat 1 will
be very competitive relative to the leading solar hot water system currently available in the market.
To achieve the same volume of product sales (i.e. 30 000 units), a $60 increase in the selling price per
unit (from $810 to $870) will now be possible.
The following table shows the changes that will occur in the manufacturing activities undertaken and
costs incurred as a result of the TQM recommendations.
Study guide | 623
Rework of prototypes $0 $0
Rework patterns $0 $0
Production costs
Direct materials
Direct materials invoice costs $7 725 000 $8 265 900
Direct labour
After-sales service
†
As a result of better-quality materials being acquired and used in the manufacture of the
Solarheat 1, a higher direct materials cost is forecast to be incurred. While it might be expected
that the absolute dollar value of supplier-related costs should not increase, particularly given
the total quality focus of the initiatives being implemented, it is assumed that the supplier cost
ratio for ElectricalPartz of 14.93 per cent is still relevant. So, forecast supplier-related costs are
$1 234 100, rounded up (i.e. $8 265 900 × 14.93%).
➤➤Task
As leader of the cross-functional team, you need to provide information to Martin Emmitt
regarding the TQM initiative:
(a) (i) Calculate the target and expected costs per unit of the Solarheat 1, if HPD is able to lift
the selling price to an average of $870 per unit. Assume that HPD still wants a profit
margin of 30 per cent on the Solarheat 1.
Details Amounts
Price increase per unit due to improved product quality: TQM initiative
$
Expected average cost below (above) the target average cost per unit
($)
Study guide | 625
(ii) Write a paragraph to include in your report to Martin Emmitt that outlines whether HPD
managed to achieve the target cost per unit for the Solarheat 1.
(b) Quality is often perceived as an important characteristic desired by the purchasers of electronic
products such as cordless telephones. Ken Lee, the quality engineer for HPD, was so persuaded
by the perceived importance of product quality that he made the following comment:
‘Quality goals are always superior to the profit maximisation objective’. Critically evaluate
Ken’s comment. Do you believe that Ken has identified the correct relationship between
quality goals and the profit maximisation objective? Write a short explanation outlining
your views.
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(c) Write an explanation for Martin that identifies and briefly explains two financial measures
and two non-financial measures that could be used to assess the success of the total quality
improvements your team has proposed.
Check your work against the suggested answer at the end of the module.
It is important to note that an investment in upstream quality initiatives, such as the redesign to a
defect-free production system or employee training and development, may not yield immediate
improvements in downstream quality costs. In the short term, total quality costs may increase
before the improvements from the TQM initiative are realised and the quality costs of appraisal
and internal and external failures decline.
Offshoring
In offshoring, the company moves some of its activities to subsidiaries in overseas locations
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where labour costs are lower than those prevailing in the company’s domestic market. By locating
such facilities offshore, the company seeks to obtain the economic benefit of reduced operating
costs that may be derived from such things as economies of scale or differences in resource costs
that would not be available if the good or service were to be procured from a domestic source.
Furthermore, some companies not only choose to procure from overseas but also to outsource
this activity to specialist external suppliers.
Study guide | 627
Offshoring presents its own unique costs and benefits. Many of the potential risks with international
suppliers have already been discussed, including longer supply chains and other international trade
risks. These factors introduce additional costs and make it difficult for organisations to respond
quickly to changes in their product markets or the competitive environment.
Outsourcing
The extent to which it is necessary for an organisation to retain activities in-house as opposed
to outsourcing them is an essential strategic choice. Outsourcing is the process of switching the
supply of goods and services from an internal supplier to an outside vendor.
In deciding to outsource, a main consideration is cost. Many organisations fail in their outsourcing
programs because they are unable to follow up with effective internal cost reduction strategies that
deliver the expected cost savings. Care must also be exercised in assessing the long-run supply
cost of external service provision, as life cycle costs for the outsourced function might end up being
greater than if the function had been retained in-house. For example, costs typically increase as an
organisation becomes more dependent on outside suppliers.
Decisions about the source of goods or services will not only be influenced by the relative costs
of internal versus external supply, but also by differences in the level of quality, on-time delivery,
data quality and data security risk and after-sales service provided. The organisation also needs
to consider its capacity to manage outsourcing contracts, as well as the loss of business-critical
knowledge that may take place once a decision to outsource is implemented.
Inevitably, there are also labour-related issues that arise with outsourcing. Apart from the
displacement of employees and the potential for industrial action, there can also be an adverse
impact on the morale of remaining employees. Unless the labour-related consequences of a
decision to outsource are thoroughly examined and dealt with to the satisfaction of all parties,
the forecast cost savings may fail to materialise.
Another factor that influences the outsourcing decision is the strategic importance of the function
that is to be outsourced. Figure 6.17 illustrates the types of activities or functions that may be the
subject of an outsourcing decision where factors, other than cost, may influence the decision.
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Strategic
Never outsource
direction
Rarely is the information required to make the outsourcing decision available from existing
strategic management accounting reports. While the total cost of providing goods or services
internally may be estimated with some accuracy, the costs that will be avoided with the decision
to outsource are less clear. The presence of unavoidable fixed costs (e.g. administrative
overheads) or other costs that must be met following a decision to outsource (e.g. employee
redundancies or redeployment) can often be underestimated and lead to an incorrect decision
being made.
Similarly, the decision to outsource may provide benefits to the organisation in the form of
freeing up scarce resources formerly used for internal supply. The opportunity costs of these
alternative uses of the resources are also rarely known, nor can they be reliably quantified.
Further, if information about the supplier’s environmental and social performance is important,
this can be difficult to obtain, and the organisation may have to rely on data that is incomplete
or not independently verified.
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Once the decision has been made to outsource, the organisation must identify the criteria it will:
• initially use in selecting the external provider
• subsequently use in monitoring the external supplier’s delivery performance
• include in periodic audits of the supplier.
Study guide | 629
Apart from a typical financial performance measure such as cost, performance indicators may
include the percentage of services not supplied to specification, services supplied late or the
time taken to respond to a dispute. Wherever possible, these performance measures might be
supplemented with data about the broader environmental and social impact of the supplier.
Both financial and non-financial performance measures will provide managers with an indication
of how successful the outsourcing decision has been. These measures are typically in the form of
a service-level agreement (SLA). Through SLAs, both parties document what is expected of each
other and identify the measures that will be used to monitor the performance of both parties in
meeting those expectations.
The decision to use outside vendors for the supply of goods and services is said to provide many
advantages and some disadvantages, as outlined in Figure 6.18.
Disadvantages
• Increase in long-run operating costs
• Loss of specialised skills and knowledge
• Dependence on third parties
• Risk of security breaches
• Quality problems
Advantages
• Cost reduction
• Reduction in the use of assets
• Increased expertise
• Access to resources
• Greater flexibility
• Opportunity to focus on managing core activities
In many respects, the problems that outsourcing can create may have more to do with the way
outsourcing decisions are initially evaluated and then negotiated, rather than being intrinsic
to the use of external suppliers. Contract management, project management and supplier
management skills are critical.
Outsourcing and offshoring are also covered in the ‘Contemporary Business Issues’ subject of the
CPA Program.
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➤➤Task
(a) Martin Emmitt has asked you to determine the financial effect of moving the distribution of
the Solarheat 1 to Supersonic on the life cycle cost per unit of the product.
Details Amounts
Expected average cost per unit after implementation of cross-functional team’s $615.00
lean manufacturing and TQM initiative
Target average total cost per unit (see the answers to Case study 6.11)
$
Expected average cost below (above) the target average cost per unit
$
(b) From a purely financial perspective, should HPD recommend that the Solarheat 1 product
line be manufactured? What qualitative issues should be considered before accepting the
outsourcing proposal? Does this influence or change your recommendation as to whether
HPD should manufacture the Solarheat 1?
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Study guide | 631
(c) HZ senior management are contemplating forcing HPD to use the services of the organisation’s
freight division for distributing the Solarheat 1 at any cost. Prepare some notes for
Martin Emmitt, outlining how HPD should respond to a potential ultimatum from senior
management not to outsource the distribution of the Solarheat 1 to Supersonic.
(d) Assume that your recommendation to outsource the distribution of all HPD’s product lines
to Supersonic was accepted. Write a response for Martin Emmitt that identifies and briefly
explains two financial and two non-financial measures that he could incorporate into the
contract for monitoring the performance of Supersonic.
MODULE 6
Check your work against the suggested answer at the end of the module.
632 | TOOLS FOR CREATING AND MANAGING VALUE
Part E of this module has discussed two key strategic cost management issues—supplier
management and TQM.
For many organisations, suppliers are a key stakeholder group. Supplier management requires
the management accountant to understand the upstream activities in the industry value chain,
particularly those activities in what is called the ‘supply chain’. Collaboration with suppliers can
lead to increased value for both the organisation and its suppliers.
TQM is a cost analysis technique focusing on value chain improvements through investment in
prevention and appraisal activities, in order to reduce failure costs.
Part F, which follows, deals with another key strategic cost management issue—customer
profitability. The focus in Part F is on understanding the full cost of servicing an organisation’s
customers—that is, all of the costs that contribute to the customer net margin. A limited focus
on the cost of goods sold (COGS) and the customer gross margin is shown to be inadequate in
managing customer profitability. An ABC approach to analysing customer costs is demonstrated.
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Study guide | 633
Customer profitability analysis moves the focus of strategic management accounting to the
customer. Understanding who an organisation’s customers are and what contribution they make
to profits is important in determining the strategic approach to adopt in dealing with customers.
Customer profitability analysis focuses on the profits generated by each customer or class of
customer—for example, differentiated by location, demographics or purchasing behaviour.
It does not automatically assume that the biggest customer, in terms of sales volume or growth
in sales orders, is the organisation’s best or most profitable customer.
While customer service has become a key tool for enhancing an organisation’s competitive
position as it battles for sales volume and profit margins, it comes at a cost. In seeking to satisfy
customers, an organisation may overlook whether it is actually profiting from the business it does
with a particular customer or group of customers. It may be that only a small group of customers
contributes the greatest proportion of profits, effectively subsidising a large number of marginal
or unprofitable customers.
Traditionally, revenue analysis has been limited to customer gross margins—sales less COGS.
The profitability of an individual customer is not only influenced by the gross margin realised
on the sales made, but also on the magnitude of the other costs associated with the provision
of customer service. It is necessary to focus on the net margin earned. This is the net price
(gross selling price less all sales discounts and other allowances) minus the cost of the goods
supplied and all other customer-related costs.
The profitability of customers can be influenced by differences in revenues and costs. These are
summarised in Figure 6.19. MODULE 6
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Possible causes
of revenue
differences
• Not all of an organisation’s products will have the same revenue
Product per unit.
mix • As the mix of products purchased by customers varies, so too will
the amount of total revenue generated from each customer.
Online sales may be cheaper and more time efficient than using a field-based
Distribution channel
sales force to market the organisation’s products and services.
After-sales service Some customers may require more ongoing service support.
Some customers may require an intensive marketing effort, whereas others buy
Marketing approach
the product simply on the basis of quality and price.
The costs of quality control can vary between customers, as some customers may
Quality
demand higher quality than others.
Variations in order type and size and in delivery locations can affect the costs
Delivery
of delivery.
Financing Some customers may demand more liberal credit policies than others.
Adopting an ABC approach and systematically allocating customer-related costs will enable
a more accurate analysis to be obtained of the costs the organisation incurs in servicing each
customer. Figure 6.21 illustrates how ABC supports customer profitability analysis. As in ABC
for products, customer-related costs can relate to a number of different categories. These
could be volume based (i.e. related to the volume of sales) or non-volume related cost drivers.
For example, a cost driver could be the number of orders placed, regardless of the size of
each order.
An organisation may not be able to assign some customer-related costs to individual customers
meaningfully because there is no clear cause–effect relationship between the cost being
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incurred and the particular customer—for example, sales administration salaries and overheads.
Apart from having no plausible cause–effect relationship, most of these costs are likely to be
fixed in the short term and are unlikely to change with the addition of new customers or the loss
of old customers.
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Is customer profitable?
Improve customer
profit margins by
Increasing revenues
Classify, analyse and allocate Cost reduction strategies
customer costs. (e.g. fewer orders and
ABC approach? larger order sizes)
Table 6.8 provides a summary of where differences can arise in the cost of servicing individual
customers. The objective of customer profitability analysis is to relate these cost differences to
individual customers. Managers can use this information to check whether certain customers are
too costly to sell to and should be abandoned, and to assess whether strategies for reducing
costs or improving revenues can improve the profitability of a customer.
Analysing the relationship between the net margin earned from sales and customer-service
costs enables the organisation to obtain an understanding of the profitability of customers and
to identify strategies for increasing the level of profits made. Figure 6.22 examines the four-way
relationship between the net margin earned from sales and customer-service costs.
Figure 6.22: Interaction between customer net margin and cost to serve
Customer type
Profits
High
Passive A Costly to service B
• Product crucial to customer • Pay top prices
• Good match to supplier
Net margin
realised Inexpensive to service Aggressive
• Price sensitive • Customer leverages buying power
• Few special • Low price and highly customised
demands specifications
C D
Low
Low High
Cost to serve Losses
The dashed diagonal line indicates the demarcation between the more profitable customers
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and the less profitable (or loss-making) customers. Ideally, an organisation would like all
customers to fall in quadrant A, where each sale results in a high net margin but requires low
customer-service costs. Unfortunately, these types of customers are rare and susceptible to being
poached by competitors. If an organisation has customers exhibiting this type of net-margin
and customer-service cost profile, it should ensure they receive priority service and appropriate
incentives (e.g. modest discounts) or other inducements (e.g. hospitality at major sporting and
cultural events) to retain their loyalty and continued patronage. Of course, these efforts will
increase customer-related costs, so they need careful management.
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Many organisations have customers who fall in quadrant D, where the customer generates low
net margins, yet demands a high level of customer service.
The low margins may arise from the customer requiring products that have to be:
• manufactured to the customer’s specifications
• in small production batch sizes
• in shorter production cycle times.
Some customers are relentless in pushing for lower prices. They may also require suppliers
to make substantial investments in new technology to service their needs. In this latter case,
customer profitability analysis needs to focus on the long-term costs and benefits of the
relationship. Some large retail organisations are famous for this type of behaviour.
Customer profitability analysis, supported by ABC, highlights the specific costs of servicing a
particular customer and can motivate an organisation to:
• share this information with the low net margin and high service-cost customer in an attempt
to modify the buying behaviour of the customer to a less costly style
• give more explicit recognition to the net margin realised. This should prompt a change
in the pricing policy towards low net-margin customers, by removing discounts and other
allowances or incorporating a charge for the ‘special’ services in the price.
In each case, it is important to ensure that the net margin achieved aligns with the characteristics
of the product supplied (e.g. a standard versus a customised product) and the service-level
requirements of the customer (e.g. pre- and post-sale support). In this situation, an organisation
may adopt a menu-based pricing policy where the price of the product supplied is influenced by
both product characteristics and customers’ service-level requirements.
If an organisation knows how much it costs to serve each customer, it can become more
discriminating in the customers it chooses and then focus on its most profitable customers.
But should an organisation view its unprofitable customers in a totally negative light? Kaplan
(1992) notes that an organisation may retain currently unprofitable customers for one of
three reasons:
1. New and growing customers who are currently loss-making may be retained as they could
provide profitable business in the future, or they currently help enter new but eventually
lucrative markets.
2. Customers who provide qualitative rather than financial benefits may be worthy of being
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retained. An unprofitable customer may possess strengths (e.g. being at the leading edge
of technology or marketing). By maintaining the relationship with the unprofitable customer,
an organisation may draw on these strengths to the benefit of its relationships with other
customers who are profitable.
3. Association with highly reputable but unprofitable customers provides the credibility to
do business with other profitable customers.
Study guide | 639
The steps to be followed in performing customer profitability analysis are shown in Figure 6.23.
2. 3.
1.
Measure the revenue Measure the full service
Identify the customers
from each customer costs of each customer
6.
4. 5.
Take action—increase
Determine customer Evaluate customer
revenues, reduce costs—
profitability profitability
and continue to monitor
Unlike the planned Solarheat 1 product range, Martin knows that HPD has an extensive set of financial
and non-financial data for the division’s existing food processors product range. Although this data
is available for the last five years, Martin decides that he will confine his analysis to the data for the
latest year ending 31 December. In doing so, he hopes to ensure that he accounts for any seasonal
influences that may affect the analysis of customer-segment profitability.
For many years, HPD has used the gross margin percentage as the measure of the profitability of the
different customer segments. The gross margin percentage is calculated as:
(Sales revenue – Cost of sales) / Sales revenue
Sally Greene, HPD’s assistant management accountant, reports the following data for the latest year
ending 31 December:
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Total sales revenue $15 000 000 $3 000 000 $1 200 000
Total cost of sales $12 000 000 $2 100 000 $720 000
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After extensive discussions, Sally and the other HPD managers agree that there are five key activity
areas performed by HPD in serving the three different customer segments. The following table
details each cost pool and the relevant driver anticipated to provide the best measure of the total
cost behaviour for that item.
Each order placed consists of one or more food processor product line items. A line item represents a
single product (e.g. FC101 or FC202). Each delivery requires one or more cartons or pallets of product
to be sent to each customer. Each delivery of cartons or pallets may involve separate packaging
(i.e. smaller cartons) for individual product lines ordered by the customer. Each customer receives
a certain level of customer relations activity, but over 60 per cent of the customer support activity is
directed to the nationwide retailers.
The total indirect service costs (i.e. excluding the cost of sales) for the latest year ending 31 December
amount to $1 380 000. The division of this cost into the five cost pools and the transactions carried
out in each pool are shown in the following table.
The number of transactions in each cost pool by the three types of customers during the latest year
ending 31 December is shown in the following table.
3. Total line items ordered (1) × (2) 12 000 13 500 27 000 52 500
MODULE 6
➤➤Task
Martin Emmitt has asked you to provide information to management to help it make decisions
regarding customer profitability.
(a) Calculate the gross margin for each customer market segment and confirm each segment’s
gross margin percentage.
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
% % % 22.81%
(b) Determine the pool rate for each of the five cost pools.
1. Order processing
$50.00 600 $ 6.7% 900 $ 21.4% 4 500 $ 31.2%
3. Distribution
$100.00 300 $ 6.7% 300 $ 14.3% 3 000 $ 41.7%
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4. Cartons/pallets shipping
$5.00 45 000 $ 50.0% 6 000 $ 14.3% 15 000 $ 10.4%
5. Customer relations
$200.00 585 $ 26.0% 255 $ 24.3% 60 $ 1.7%
Total cost
$ 100.0% $ 100% $ 100.0%
(c) Determine the total customer service costs for each of the three market segments.
Study guide | 643
(d) Determine the most profitable market segment in dollars and by net margin. Compare the
results to those in task (a) and comment on any findings.
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Net margin $2 550 000 $690 000 ($240 000) $3 000 000
% % % 15.63%
Comments:
(e) Identify and describe at least two major problems that would confront Sally in allocating the
customer service costs to the activity areas and customer segments.
MODULE 6
Check your work against the suggested answer at the end of the module.
644 | TOOLS FOR CREATING AND MANAGING VALUE
Sally Greene, the assistant management accountant for HPD, decides to use the ABC data to further
examine the profitability of individual customers in the small local electrical retailer market segment.
Sally randomly selects two small electrical retailers (Mini-Electrical and Home Appliances). The following
data for these two customers for the year ending 31 December is extracted from HPD’s sales database.
Sally then decides to complete the customer profitability analysis for all individual customers within
the small local electrical retailer market segment and ranks those customers on the basis of their dollar
contribution to the division’s profit. The cumulative net margin for the top 20 per cent of the local
electrical retailer market segment for the year ending 31 December is a profit of $180 000.
MODULE 6
Study guide | 645
➤➤Task
After seeing the customer profitability information, Martin Emmitt has asked for further
information.
(a) Calculate the total line items, total cartons/pallets and gross margin.
4. Total deliveries 30 30
Cost driver
transaction
(see the
answers Number Number
to Case of cost Customer of cost Customer
Cost pools study 6.13) drivers service costs drivers service costs
1. Order processing
$50.00 45 $ 30 $
3. Distribution
$100.00 30 $ 30 $
4. Cartons/pallets shipped
$5.00 240 $ 120 $
5. Customer relations
$200.00 0 $ 6 $
MODULE 6
Total costs
$ $
646 | TOOLS FOR CREATING AND MANAGING VALUE
(c) Calculate the profitability of the two local retailers. Comment on your findings.
Gross margin
$ $
Net margin
$ ($)
$ $
Comments:
(d) Identify and describe two strategies that could be recommended to HPD for managing its
relationship with individual customers.
Check your work against the suggested answer at the end of the module.
information as it:
• helps to identify unprofitable customers as well as unprofitable products
• helps to identify whether poorly performed customer service activities cause some customers
to become unprofitable
• directs managerial attention to different options for improving profitability, both for individual
customers and for products.
Study guide | 647
Customer profitability analysis has disadvantages that are primarily attributable to the problems
of allocating certain types of customer support costs, including:
• the allocation of common costs (e.g. advertising) is arbitrary. While an advertising
campaign might be intended to attract new customers, it may also have a positive impact
on the amount of business that existing customers do with the organisation. To allocate
all advertising campaign costs to new customers would appear unreasonable. Similarly,
advertising specific products may have flow-on effects for other products
• the treatment of unavoidable or committed costs (e.g. a sales manager’s salary) as not
being attributable to any particular customer ignores the need for these costs to be
recovered from all sales made.
Customer profitability analysis can also strengthen the impact of an organisation’s customer
relationship management (CRM) initiatives. CRM seeks to develop and foster long-term customer
commitment by ensuring that the customer’s needs are identified and satisfied. For example,
CRM initiatives by financial institutions have resulted in the development of tailored financial
products that meet the needs of individual customers, thereby helping to gain a greater share
of each customer’s total spending on financial products and services.
In many industries, a key driver of business value is the retention of the existing customer base.
A study of banks and other financial institutions suggested that acquiring a new customer
is anywhere from five to 25 times more expensive than retaining an existing one and that
increasing customer retention rates by 5 per cent increases profits by 25 per cent to 95 per cent.
Yet, businesses that seek to grow often target new customers and fail to address the retention
of existing customers (Gallo 2014).
For a further explanation of customer profitability analysis, please access the ‘Customer profitability
analysis’ video on My Online Learning.
For further practice in customer profitability analysis, please access Stage 3 of the ‘Save or close the
hotel?’ Business Simulation on My Online Learning.
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648 | TOOLS FOR CREATING AND MANAGING VALUE
Review
Module 6 focused on how an organisation can manage its value chain more effectively.
For superior performance, managers must have access to information about their own internal
activities, and about the suppliers and customers who comprise their industry value chain.
With this greater understanding, opportunities for reconfiguring and improving value chain
activities can be identified, analysed and implemented.
The management accountant provides information to support the strategic decisions that
managers must make about their organisation’s value chain. The issues discussed in this module
are summarised in the following list.
• For managers to effectively develop and manage the competitive position that their
organisation’s value chain provides, they must have a sound understanding of the business
model that underlies their value chain. In particular, managers must identify and effectively
manage those core competencies or capabilities that provide their organisation with its
unique sustainable competitive advantage (discussed in Part A).
• Value is a function of revenue and cost. Strategic revenue initiatives focus on price and
pricing strategies like skimming and penetration (discussed in Part C). Strategic cost
initiatives focus on cost reduction and the efficient use of resources (discussed in
Part D). While each of these strategic levers can be understood independently, they are
interdependent as both impact on profit. Any cost-saving or revenue-enhancing initiative
must be assessed for its impact on both cost and revenue, and therefore on profit.
• The Case study covered the practical application of the following strategic cost management
concepts and tools.
–– Two techniques based on activity analysis—ABM and ABC—help to develop
organisational understanding about the sequencing and cost of value chain activities,
and to develop targeted strategies for improving the performance of the value chain.
Where it is operationally and economically feasible for non-value-adding activities to be
eliminated, or for the efficiency of value-adding activities to be improved, an organisation
should be able to reduce its total value chain costs (discussed in Part B).
–– Strategies for improving the performance of an organisation’s value chain can involve
either the major re-design of activities (BPM) or fine-tuning of existing activities (CI)
(discussed in Part D).
–– Understanding the behaviour of product life cycle costs is important for determining
when and where the most significant cost-reducing opportunities occur. Greater
opportunities for achieving better cost performance typically exist within pre-production
activities (discussed in Part D).
–– Target costing assumes selling prices for new products are set by the market and
that to achieve desired profit margins, product costs must be at or below a target cost
(discussed in Part D).
–– Kaizen costing provides the focus for achieving in-production cost improvements and
can be beneficial in ensuring that standard cost targets are continually challenged.
–– In knowing the nature and magnitude of supplier-related costs, managers can identify
MODULE 6
and evaluate different strategies for obtaining required inputs at a lower overall cost
(discussed in Part D).
–– Outsourcing examines the relative costs and benefits of using an external supplier to
provide goods or services instead of creating them internally. It also assists in identifying
those few critical competencies that must be retained and effectively managed
(discussed in Part E).
Study guide | 649
–– Knowing where the organisation spends its resources on quality can be important
to delivering not only better-quality products but also improved cost-performance
outcomes. By having information about where the costs of quality are incurred
(i.e. in the categories of prevention, appraisal, internal failure and external failure),
an organisation is able to identify and implement those total quality management
initiatives that are likely to achieve improved strategic outcomes (e.g. greater customer
satisfaction and/or lower product cost) (discussed in Part E).
–– Customer profitability analysis measures the profit or loss from each customer or
customer segment and identifies the various customer-related activities that have a
significant impact on the net margin of each sale. It also guides the selection of strategies
that ensure profitable customers are retained and unprofitable customers are managed in
a manner consistent with the long-term goals of the organisation (discussed in Part F).
This module has demonstrated the contribution that each of these strategic management
accounting concepts and tools can make to improving the performance of an organisation’s
value chain.
The overall objective of this module has been to demonstrate how strategic management
accounting helps an organisation to manage its competitive position and ensure that value is
continually created from its activities.
MODULE 6
MODULE 6
Suggested answers | 651
Suggested answers
Suggested answers
Total DLHs for the food processor product line 27 000
(b)
Indirect manufacturing cost FC101 FC202 FC303
(c)
Total manufactured cost per unit FC101 FC202 FC303
25 000 MHs
Cost pool 3—production scheduling and other set-up costs $120 000
FC101 50
FC202 150
FC303 200
Total production scheduling and other set-up related costs / $120 000
Total budgeted production runs 400 production runs
Production scheduling and other set-up cost pool rates $300.00 per production run
FC101 90
FC202 260
FC303 350
(b)
FC101
Indirect
Cost pool Number of manufacturing
Cost pools rates cost drivers cost %
FC202
Indirect
Cost pool Number of manufacturing
Cost pools rates cost drivers cost %
FC303
Indirect
Cost pool Number of manufacturing
Cost pools rates cost drivers cost %
(ii) The FC101 food processor consumes 74 per cent of the number of DLHs and 40 per cent
of machinery-related activities, but it only uses 12.50 per cent of production scheduling
and set-up activities, and 12.86 per cent of materials handling activities.
The labour-related cost pool is only 33.33 per cent of the total budgeted overhead costs
(i.e. $270 000 / $810 000) (see Case study 6.2). The FC101 food processor would therefore
be allocated a significantly disproportionate share of the total indirect manufacturing
costs where DLHs are used as the sole basis for allocating overhead to the three
product lines.
On the other hand, the FC303 is less intensive in its consumption of labour-related
activities (9.26%) yet is a more intensive consumer of machinery-related activities (24%),
production scheduling and set-up activities (50%) and materials handling activities (50%).
So where indirect manufacturing costs are allocated on the basis of DLHs, the FC303
model will be significantly under-costed.
The indirect manufacturing costs for the FC303 have increased from $37.50 to $102.00
(see Case study 6.2) by using ABC. This increase in costs allocated to the FC303 reflects:
|| capital intensive production requirements relative to the other two products. The FC303
is absorbing a greater amount of machine costs than it was previously allocated
|| that it is a low-volume product with short production runs, so is receiving a greater
allocation of production scheduling costs
|| that being a low-volume product with a large number of materials movements,
it is receiving a greater allocation of materials handling costs.
In light of the greater allocation of indirect manufacturing costs to the FC303 model
and the small production volume relative to the other two food processor product lines,
these costs are being spread over a smaller number of units and result in a significant
increase in indirect manufacturing costs per unit.
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656 | TOOLS FOR CREATING AND MANAGING VALUE
This has been clearly demonstrated in relation to the FC range of products. If the same issues
were shown to exist for other HPD product lines, then an ABC system may be much more
appropriate for obtaining product costings.
(c)
(i) External strategy ABC will help the management of HPD to:
• undertake customer profitability analysis where retailers purchase
different product mixes—i.e. where retailers may be ordering more of
the FC101 than of the other two models. Information about customer
requirements could be used to revise the product/service offering.
(ii) Internal strategy ABC will help the management of HPD to:
• understand the real economic cost of its products and the real cost
of servicing its customers. An understanding of the actual costs
(AC) should enable management to create product and customer
strategies that deliver value for customers and other stakeholders.
(d) (i)
Details Traditional costing ABC costing Difference
(ii) Based on the information given, BigShop appears to be able to buy an equivalent
product to the FC101 from overseas suppliers at 15 per cent less than $180.00, which is
a cost of $153.00 per unit (i.e. $180.00 × (1 – 15%)). This is 85 per cent of HPD’s standard
wholesale price of $180.00 per unit. This appears to be lower than the $155.00 cost that
HPD can make the product, based on the traditional product costing approach. Based on
this data, William’s suspicion that overseas suppliers are dumping their spare capacity
on the Australasian market at less than full cost appears to have some merit.
The more accurate ABC product-costing approach indicates that the budgeted
manufactured cost of the FC101 model is only $131.40 per unit and the anticipated
profit margin with a standard wholesale price of $180.00 per unit is really $48.60 and not
the previously assumed $25.00 per unit.
If HPD’s management team was prepared to drop the wholesale price of the FC101 to,
say, $150.00 per unit—a profit margin of $18.60 based on the ABC system (i.e. $150.00
– $131.40)—not only might it win back the business it has lost with BigShop, but it
MODULE 6
might also retain other retailers who perhaps have contemplated a switch to equivalent
imported food processors. HPD’s profits would be expected to increase as a result of
the greater number of units manufactured and sold.
Suggested answers | 657
ABC is a potential solution to the under- and over-costing problem faced by HPD.
The introduction of ABC on the allocation of indirect manufacturing costs for all HPD
product lines will help ensure that low-volume, high-complex products are not under-costed,
and that high-volume low-complexity products are not over-costed.
Less: Time spent by materials handling personnel in professional development, (104 000)
training activities, staff meetings and similar events
Budgeted total practical capacity (or productive time) in minutes 1 000 000 mins
Total budgeted costs of the materials handling function to be allocated $1 504 000
Total budgeted costs to be allocated / Budgeted total practical capacity $1 504 000 /
1 000 000
TDABC cost rate per minute (rounded to three decimal places) $1.504
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658 | TOOLS FOR CREATING AND MANAGING VALUE
(b) (i)
Budgeted total Cost rate per Budgeted
Materials handling activity time (minutes) minute costs
Unused capacity
(Total practical capacity and
costs – Total time and cost) 50 000 $1.504 $75 200
(ii) The planned usage time for the four materials handling tasks is 950 000 minutes out of
a total practical capacity level of 1 000 000 minutes, indicating 50 000 minutes of unused
or idle capacity. This unused capacity has a cost of $75 200.
By highlighting both the time and dollar value of the difference between available
capacity and the capacity that is planned to be used, Kaplan and Anderson (2007,
p. 12) suggest that the TDABC approach will encourage managers to explore options
for reducing the cost of supplying unused resources or allocating these to more
productive uses.
(c) (i)
Standard activity performance Complex activity performance
(ii) The total time required for the materials handling activity for the FC303 is 17 700 minutes.
MODULE 6
Notice that all 200 transactions for sourcing for production are regarded as a complex
activity for FC303. This means that all 200 transactions will require 15 minutes of standard
time (3000 minutes) with an additional 10 minutes of variation (complex) time (2000
minutes) to complete the activity, for a total of 25 minutes each (5000 minutes in total).
The same situation has also occurred in the fourth materials handling activity, production
movements. All 350 transactions require 15 minutes of standard time plus five minutes
of additional variation time.
Suggested answers | 659
(d)
Budgeted activity Cost rate per Materials handling
Materials handling activity time (minutes) minute costs allocated
(e)
(i) the conventional ABC approach The conventional ABC approach would allocate
($35 000—see Case study 6.1) $35 000 in budgeted materials-handling costs to the
FC303. This amount was calculated in the answers to
Case study 6.2 as 350 materials-handling transactions
multiplied by $100 per materials movement. This is
equivalent to $17.50 per unit for the planned
production of 2000 units (i.e. $35 000 / 2000).
(ii) the TDABC approach (calculated in The budgeted materials-handling costs that would
part (d)). be allocated by the TDABC approach to the FC303
is $26 621. This amount was calculated in part (d) of
this answer and effectively represents 17 700 minutes
(total across four activities) multiplied by $1.504 per
minute. This is equivalent to $13.31 per unit for the
planned production of 2000 units (i.e. $26 621 / 2000).
Comment on any differences in the materials- The difference of $8379 in the total allocated costs
handling costs that would be allocated to is explained by the fact that the ABC and TDABC
the FC303 food processor as a result of using calculations use different assumptions. In the
either ABC method. ABC calculation, the assumption is that the cost is
$100 per move and in the TDABC calculation the
assumption is $1.504 per minute. A key message is
that TDABC only allocates used time and separates
out unused capacity such that management can take
appropriate action.
(b)
Total costs Total units to be manufactured Average cost per unit
(c)
Details Amounts
Less: The net profit margin expected per unit (30% × $800) ($240)
Expected average total cost per unit (from task (b)) $750
Expected average cost below (above) the target average cost per unit ($190)
(d) Martin is targeting activities that comprise the pre-production stage of HPD’s value chain
and would want to be provided with performance measures that reflect how well the division
has managed the activities related to R&D, product design and process design. Financial
measures include:
–– Comparisons of various revenue, expense and asset categories with historical
performance and with budget, including:
|| R&D spending (in total and by individual R&D project)
|| product design expenditures, including the cost of product prototypes
|| the cost of designing and testing alternative manufacturing processes and
technologies
|| the proportion of sales revenue derived from new products.
–– Non-financial measures can also be compared to expectations. Examples include the:
|| time taken from R&D and product development to product launch
|| number of R&D projects currently being undertaken
|| number of product launches as a proportion of product development projects
|| number of new product launches compared to prior years or to rival organisations
|| market share generated from new products.
|| number of workplace incidents, accidents and improvements to health and wellbeing.
Measures focusing on R&D activities show how committed HPD is to undertaking R&D.
For example, if HPD is spending more on R&D in absolute dollar terms and/or as a
percentage of sales revenue, this indicates a greater divisional commitment to innovation.
The number of product design projects or product launches indicates how successful HPD
has been in converting its R&D activities into commercially exploitable products. Similarly,
the time taken from R&D project initiation to product launch provides a time-to-market
measure of the success of innovation activities. Finally, the ultimate success of HPD’s
innovation activities might be reflected in the proportion of sales revenue generated by
new products or in the market share commanded by new product sales.
(e) Given that HPD is a late entrant to the renewable energy product market, it is highly likely
that it will need to undertake a target-costing exercise for the proposed Solarpower 2
product line. As there are well-established and leading solar power systems already trading
in the markets likely to be served by HPD (e.g. Australasia), the division is likely to be a price
taker rather than a price maker. While HPD’s design of the Solarpower 2 will have some
effect on how efficient the solar power system will be, and the dollar value of energy savings
realised by customers, the price it will be able to achieve will be strongly influenced by the
MODULE 6
Solarheat 1 indirect
manufacturing ABC indirect
Cost pool Cost pool rate activities manufacturing costs
Quality control $125 per inspection hour 3 000 hours $375 000
Repair and maintenance $200 per maintenance hour 2 400 hours $480 000
Hazardous waste disposal $50 per kilogram disposed 3 900 kilograms $195 000
Excess indirect manufacturing costs allocated to the Solarheat 1 product line $750 000
(iii) The original estimated cost per unit was $750 (see the answers to Case study 6.5). Each unit
has been over-costed by $25 ($750 000 / 30 000 units). So, the switch to ABC indicates that
the expected average total cost per unit should be decreased to $725 ($750 – $25).
Refer to the answers to Case study 6.5, where there was an original gap of $190 between
the expected average cost of $750 and the target average cost per unit of $560. Under
ABC, this gap will also fall by $25, from $190 to $165 (representing the difference between
average total cost of $725 per unit and target average cost per unit of $560).
Net benefit realised from BPM implementation per unit $50 per unit
(Net benefit realised from BPM implementation / Number of units)
(ii) Yes
(iii) Machine set-ups will fall from five to three per batch. This is 3/5 or 60 per cent of the
3000 original machine set-ups (i.e. 60% × 3000 = 1800 set-ups). The reduction in machine
set‑ups is therefore 1200, saving $600 000 (i.e. 1200 × $500 per set-up).
Material moves will decrease from six to four per batch. This is 4/6 or 66.67 per cent of
the 3600 original movements, which is 2400 moves. The reduction in material moves
is therefore 1200, saving $300 000 (i.e. 1200 × $250 per move).
In addition to this, there will be a direct labour saving of $900 000 (i.e. 30 000 units ×
$30 per unit). Note that the budget of 30 000 units is provided in Case study 6.5.
The total cost reduction is therefore expected to be $1 800 000 (i.e. $900 000 + $900 000).
This will be offset by the cost of implementing the BPM initiative ($300 000), so the net
benefit is expected to be $1 500 000.
Suggested answers | 663
Because total costs will fall by a net amount of $1 500 000 or $50 per unit (i.e. $1 500 000
/ 30 000 units) as a result of moving the Solarheat 1 manufacturing facility to a cellular
layout, Mary should proceed with the recommendation that HPD undertake the
BPM exercise.
(b)
(i) If HPD undertakes the BPM exercise The original expected average cost of Solarheat 1
for the Solarheat 1 manufacturing was $750 (see Case study 6.5) and in Case study 6.6
facility, what will be the expected the expected average cost of the Solarheat 1 had
product cost per unit? been reduced to $725. This cost will now fall again by
$50 per unit to $675 ($725 – $50).
(ii) How much will the expected cost In Case study 6.6 the gap between the expected
per unit be above the target cost average cost and the target average cost per unit for
for the Solarheat 1 as a result of the the Solarheat 1 had been reduced from $190 to $165.
BPM exercise being undertaken? This should now fall again by the $50 saving per unit to
$115 ($165 – $50)—representing the difference between
average total cost of $675 per unit and target average
cost per unit of $560.
(c) The BPM initiative changes the layout of HPD’s manufacturing facility from a functional to a
cellular layout. Through achieving reductions in the number of machine set-ups and material
movements, the BPM initiative is intended to reduce the costs incurred for (or allocated to)
the Solarheat 1.
Martin would want to know that the BPM initiative was delivered on time and within budget.
Failure to achieve either of these BPM targets may weaken the financial benefits that the
initiative actually delivers. Similarly, Martin will want to know that what was promised in the
business case for the BPM initiative has actually been achieved. If planned improvements have
not eventuated, Martin may be able to take action that improves the post-implementation
performance of this particular initiative. He can also draw on the experience provided by this
project to improve the planning for and execution of subsequent BPM exercises.
While the BPM exercise is about how HPD hopes to improve the performance of its own
MODULE 6
value chain, the value chain activities of HPD’s suppliers and customers may also be worthy
of examination.
7. Returning materials Customers will not pay a premium for the errors
and components made by suppliers.
to suppliers
8. Storing raw materials This does not transform or change the materials,
and components so does not increase value for customers.
10. Incomplete products This does not transform or change the materials,
waiting for further so it does not increase value for customers.
processing
11. Moving product This does not transform or change the materials,
through the so it does not increase value for customers.
MODULE 6
production facility
Non-
Nature of activity or Value- value-
event adding adding Explanation
15. Storing inspected This does not transform or change the materials,
products so it does not increase value for customers.
16. Delivering products The customer will often pay an additional amount
to customers for this, indicating its value. Alternatively, this value
is included in the price of the product.
Non-
Nature of activity or Value- value-
event adding adding Explanation
18. Dealing with These are likely to occur because of a quality failure
customer complaints in an activity performed earlier in the value chain
and do not add customer value (as customers
would perceive making complaints as annoying).
Please note that this subject follows a particular philosophy towards value-adding activities.
You may be able to present alternative arguments for particular items or have reached a
different conclusion. For the purpose of this subject, the following discussion is the correct
application of value analysis based on this philosophy.
Value-adding activities—philosophy
When looking at whether an activity is value-adding, it is necessary to ask: ‘In an ideal world,
when planning or designing a value chain, would this activity need to happen?’ In practice,
it is hard to set a clear rule to categorise activities as either value-adding or non-value-
adding. There is likely to be a continuum where part of the activity is required, and part can/
should be eliminated. Further, it may be that a non-value-adding activity (e.g. warranties)
costs less in the short term than making changes and fixing activities in the value chain to
ensure that there are zero defects in the products produced. In such cases, with access to
all available information, it may be decided not to eliminate the non-value-adding activity
because to do so would be too costly (i.e. the cost outweighs the benefit).
(b)
Function and activities Total costs Value-adding Non-value-adding
Production costs (made up of direct materials and labour and indirect manufacturing costs)
Direct materials
Inbound logistics costs $1 500 000 $1 500 000
Direct labour
Direct labour manufacturing $1 100 000 $1 100 000
activity
After-sales service
Warranty claims $600 000 $600 000
Total cost of Solarheat 1 $20 250 000 $15 650 000 $4 600 000
(c) Once you have worked through the flow chart in Figure 6.13 to classify items as value-adding
or non-value-adding, the next step is to rank or prioritise which non-value-adding activities
you will focus on eliminating.
Using this information, Martin would hope to improve the design of the Solarheat 1—for
example, through using fewer components—and reduce the complexity of the manufacturing
process. This will enable HPD to deliver the product that customers want, and at a lower total
cost to the organisation.
While this task appears to focus on the value chain activities of HPD itself, Martin may also
be interested in the effect of the non-value-adding activities of the division’s suppliers and
customers of HPD. Communication with both suppliers and customers may therefore be
a useful strategy prior to making radical changes here.
(d) Non-value-added activities often exist to fix mistakes. So, efforts to eliminate the causes
of the mistakes must be made (i.e. perform earlier activities better) in order for this cost to
be eliminated over time. If you eliminate the non-value-added cost by ceasing the activity,
the mistake itself (or underlying cause) will not be fixed. This will likely lead to greater costs,
as shown in the following discussion of the $600 000 of rework.
By stopping the rework, you will save $600 000 in costs, but this must be weighed against
the benefit that will be obtained by the rework. While the amount of rework will reduce by
$600 000, it is likely that scrap/wastage costs will increase as more items are scrapped rather
than fixed and sold. So, there is a range of alternatives. The first and best is to make the
product without mistakes, rework or scrap.
If there is a mistake, the rework should be done as long as it costs less than the additional
benefit to be received. If the rework cost is greater than the additional benefit to be received,
then the item should be scrapped.
So, it can be assumed that the cost of reworking defective Solarheat 1 products generates
an economic benefit greater than $600 000 and the net benefit of reworking these defective
units is greater than any other alternative—for example, scrapping or recycling.
MODULE 6
Partial elimination of non-value-adding activities Total elimination of non-value-adding activities
Preferred Net saving
Net BPM from preferred
(e) (i) and (ii)
Function and activities Benefit Cost saving Benefit Cost Net saving initiative BPM initiative
Rework of prototypes $115 000 ($30 000) $85 000 $150 000 ($40 000) $110 000 Total $110 000
Rework patterns $220 000 ($25 000) $195 000 $300 000 ($50 000) $250 000 Total $250 000
On-the-job inspection activity $205 000 ($30 000) $175 000 $250 000 ($65 000) $185 000 Total $185 000
Repair and main- tenance $70 000 ($10 000) $60 000 $120 000 ($40 000) $80 000 Total $80 000
Hazardous waste disposal $50 000 ($20 000) $30 000 $75 000 ($35 000) $40 000 Total $40 000
Warranty claims $550 000 ($80 000) $470 000 $600 000 ($150 000) $450 000 Partial $470 000
Customer complaints $110 000 ($45 000) $65 000 $150 000 ($100 000) $50 000 Partial $65 000
Total costs $1 320 000 ($240 000) $1 080 000 $1 645 000 ($480 000) $1 165 000 Total savings $1 200 000
Suggested answers |
669
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670 | TOOLS FOR CREATING AND MANAGING VALUE
(iii) Successfully implemented, this initiative will reduce the estimated total costs of the
Solarheat 1 by $1 200 000. This is a saving of $40 per unit (i.e. $1 200 000 / 30 000 units).
The revised expected cost per unit was already down to $675 (explained in Case study 6.7).
This expected cost per unit will decrease by $40 to $635.
The gap between the expected average cost and the target average cost per unit for the
Solarheat 1 was already down to $115 (as explained in Case study 6.7). This should now
fall again by the $40 cost saving per unit to $75 ($115 – $40)—representing the difference
between average total cost of $635 per unit and target average cost per unit of $560.
Total activities
Cost per Electrical and total
Activity type activity Componentz Partz Parts100 costs
Order materials
Receive orders
Inspect deliveries
Costs $120 $18 000 $10 800 $21 600 $50 400
Return materials
Activities 15 6 30 51
Account queries
Activities 15 6 30 51
Process payments
Activities 36 75 36 147
Total supplier- $47 490 $31 350 $56 940 $135 780
related costs
Invoice cost of raw $222 900 $210 000 $246 000 $678 900
materials (see table
in case facts)
Suggested answers | 671
Total activities
Cost per Electrical and total
Activity type activity Componentz Partz Parts100 costs
Total procurement $270 390 $241 350 $302 940 $814 680
costs
(Total supplier-
related costs +
Invoice cost of
raw materials)
Supplier cost $47 490 / $31 350 / $56 940 / $135 780 /
performance ratio $222 900 = $210 000 = $246 000 = $678 900 =
(Total supplier- 21.31% 14.93% 23.15% 20.00%
related costs /
Invoice cost of
raw materials)
(b) (i)
Suppliers
Estimated
Details Componentz ElectricalPartz Parts100 costs
Relative supplier invoice cost index† 1.02 1.03 1.00 $135 780
Expected invoice cost of direct ($7 500 000 ($7 500 000) ($7 500 000)
materials (calculation) × (1.02) × (1.03) × (1.00)
Expected invoice cost $7 650 000 $7 725 000 $7 500 000 $7 500 000
Expected supplier-related costs $1 630 215 $1 153 343 $1 736 250 $1 500 000
(Expected invoice cost × Supplier ($7 500 000
cost performance ratio) × 20.00%)
Total procurement cost (Expected $9 280 215 $8 878 343 $9 236 250 $9 000 000
invoice cost + Expected supplier- ($7 500 000
related costs) + $1 500 000)
†
From the introduction in Case study 6.9, Parts100 is the cheapest supplier and so has been selected
as the base against which all other suppliers are analysed. So Parts100 has been assigned a supplier
invoice cost index of 1.00. Since the cost of materials supplied by Componentz is 2 per cent
more expensive than Parts100’s, it has a supplier invoice cost index of 1.02 (1.00 + 0.02). Similarly,
as the cost of materials supplied by ElectricalPartz is 3 per cent more expensive than Parts100’s,
the supplier invoice cost index for ElectricalPartz is 1.03 (1.00 + 0.03).
(ii) The expected invoice cost of direct materials to be sourced from ElectricalPartz is
$225 000 more expensive than Parts100 (i.e. 3% × $7 500 000). However, the hidden
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supplier-related costs for ElectricalPartz are $582 907 lower than the costs that would be
incurred if Parts100 was the selected vendor (i.e. $1 736 250 – $1 153 343). So, the net
benefit from selecting ElectricalPartz over Parts100 as the supplier of direct materials for
the Solarheat 1 product is $357 907 (i.e. $9 236 250 – $8 878 343).
672 | TOOLS FOR CREATING AND MANAGING VALUE
In determining the expected cost for the Solarheat 1, the effect of the hidden supplier
costs on the total cost of direct materials procured was not fully understood. The direct
materials total costs were estimated to be only $9 000 000, so the anticipated cost
reduction from choosing ElectricalPartz as the vendor is only $121 657 (i.e. $9 000 000
– $8 878 343). A further reduction in the expected cost of $4.06 per Solarheat 1 unit
(i.e. $121 657 / 30 000 units) is now achieved.
In Case study 6.8, the revised expected cost had been reduced to $635.
The gap between the expected average cost and the target average cost per unit for the
Solarheat 1 will also fall by the $4.06 cost saving per unit to $70.94 (i.e. $75.00 – $4.06)—
representing the difference between average total cost of $630.94 per unit and target
average cost per unit of $560.
Price increase per unit due to improved product quality: Lean manufacturing initiative $10.00
Less: Net profit margin expected per unit (30% × $810.00) ($243.00)
Expected average total cost per unit ($18 093 343 / 30 000 units) (see the table in the $603.11
case facts)
Expected average cost below (above) the target average cost per unit ($567.00 – $603.11) ($36.11)
(b) The financial and non-financial measures that could be reported can be categorised in
two ways:
1. the success of the product and production design changes as a project itself (i.e. was the
project delivered on time, within budget and to the required scope and specifications)
2. the benefits delivered ultimately from the redesigned product.
In the short term, Martin might want to know how the cost of making the necessary design
changes is tracking (e.g. has the change in actual spending on R&D been kept within the
planned increase of $100 000?) or the time taken to redesign the Solarheat 1 (e.g. has the
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time taken to redesign the Solarheat 1 been in line with the revised time plan?). Martin would
want to know that the redesign initiative was delivered on time and within budget. Failure to
achieve either of these targets may weaken the financial benefits that the redesign initiative
actually delivers to HPD.
Suggested answers | 673
Martin will want to know in the longer term that what was promised in the business case for
the redesign initiative has been achieved. Therefore, he will be more interested in quantifying
the benefits that have actually been realised. If the planned improvements in pre-production,
production and post-production activities have not eventuated, Martin may be able to act to
improve the post-implementation performance of the redesign initiative. He can also draw on
the experience provided by this project to improve the planning for and execution of similar
projects in the future.
As the benefits have been split into three separate areas (i.e. pre-production, production and
post-production activities), the non-financial and financial measures could be reported to
Martin as follows:
1. Pre-production activities
Non-financial measures include reductions in the time and savings in the physical resources
used in designing the prototypes and patterns (e.g. the reductions in the quantities of
materials and other physical inputs consumed in pre-production).
Financial measures include R&D and production design activities against budget (net increase
in costs of $100 000).
2. Production activities
Non-financial measures include reductions in manufacturing labour time and the savings in
physical resources used in quality control, rework, repair and maintenance and hazardous
waste disposal (e.g. quantities of materials that no longer have to be reworked, scrapped
and/or disposed of as being hazardous waste).
Financial measures include the actual cost savings realised in production costs and indirect
manufacturing overheads. These would be compared against the total budgeted cost savings
of $810 000 (i.e. DLHs ($220 000), on-the-job training (–$200 000), quality control ($250 000),
rework ($400 000), repair and maintenance ($80 000) and hazardous waste disposal ($60 000)).
3. Post-production activities
Non-financial measures include ‘customer’ response to the improved product (e.g. improved
ratings as to product performance given by independent consumer advocate bodies or
internet-based, product-sourcing websites), change in market share generated from the
redesigned product, and the number and type of warranty claims and customer complaints
(e.g. expectations would be that the number of customer complaints will decrease
and the nature of the customer complaints submitted would shift away from product
performance concerns).
Financial measures include the actual cost savings realised in marketing campaigns,
warranty claims and handling of customer complaints (e.g. were the reductions in the AC
of post-production activity greater than $125 000?).
Revised market price per unit (see the answers to Case study 6.10) $810.00
Price increase per unit due to improved product quality: TQM initiative $60.00
Less: Net profit margin expected per unit (30% × $870.00) ($261.00)
Expected average total cost per unit ($18 450 000 / 30 000 units) (see the table $615.00
in the case facts)
Expected average cost below (above) the target average cost per unit ($6.00)
(ii) HPD is now very close ($6) to achieving the target average total cost per unit. Based on
the calculations in part (i), the new target average total cost per unit is $609, while the
expected average total cost per unit is $615.
(b) Organisations such as HPD will not pursue quality goals in isolation from considerations
of profit. Rather, quality is the means by which they seek to maximise long-term profits.
Organisations that produce high-quality products and have a significant reputation for quality
may be able to command higher prices and/or sell greater volumes of their products.
Certainly, HPD hopes to increase its selling price by an additional $60 per unit as a result
of the TQM initiative. This increase in sales revenue may lead to higher profits, but at
times, the pursuit of quality goals and long-term profitability may conflict with short-term
profitability. For example, the redesign of a production facility or increased training of
manufacturing personnel to ensure improved product quality may incur costs that initially
are greater than the immediate benefits they generated.
However, as noted in the section dealing with value chain analysis, the pursuit of quality
is only optimal to the extent that the long-term benefits of reduced internal and external
failures exceed the costs of prevention and appraisal. So, an organisation may not want to
eliminate all internal and external failures, because it would reduce its overall profitability.
Note: There will be some regulatory circumstances (e.g. product safety) where quality
considerations will outweigh the profit outcome.
(c) As shown in the case facts, while the TQM program results in higher raw material and labour
costs, these are expected to translate into reduced costs for such things as:
–– quality control
–– rework
MODULE 6
The financial measures will focus on whether spending in support of the TQM initiatives is
incurred as planned and whether lower costs do actually eventuate. Furthermore, given the
higher product quality resulting from the TQM initiative, Martin will want to see if the
expected price increase of $60 per unit has been achieved.
As for the non-financial measures, Martin will want to examine such things as the:
–– number of suppliers meeting quality-assurance standards
–– number and value of defective parts and components returned to suppliers
–– hours devoted to TQM training courses
–– hours devoted to preventative maintenance activities
–– number of defective products detected during and at the end of production
–– number of customer complaints or defective-product returns
–– number of warranty claims
–– number of on-site service calls made by HPD’s customer-service personnel.
These financial and non-financial measures help HPD to determine whether the investment
in the TQM initiative achieves improvements in the cost performance of the Solarheat 1
and ultimately delivers better overall financial returns.
Expected average cost per unit after implementation of cross-functional team’s lean $615.00
manufacturing and TQM initiative
Revised expected average cost per unit after outsourcing distribution $605.00
Target average total cost per unit (see the answers to Case study 6.11) $609.00
Expected average cost below (above) the target average cost per unit $4.00
(b) The expected average cost per unit ($605) is now below the target average cost per unit
($609). From a purely financial perspective, the product line should be manufactured because
it has achieved the desired profit margin. However, this analysis has ignored the freight costs
that may still be incurred outside HPD, but within the HZ group, as a result of excess capacity
that would arise because of HPD’s outsourcing.
Several qualitative issues need to be considered prior to the outsourcing proposal. While the
cost is lower, the organisation must also ensure that an identical or better level of service
MODULE 6
is achieved. This includes delivery reliability, ensuring all deliveries are in good condition
and limited on-costs of managing the outsourcing arrangement—for example, contract
negotiations, reviews and regular interactions.
Some potential risks to consider include the possibility that an unsustainable low price has
been quoted, which could mean that poor-quality service is provided or that, once HPD
has become reliant on Supersonic, it may increase its fees and charges to more realistic
levels—when HPD is in a weaker negotiating position.
676 | TOOLS FOR CREATING AND MANAGING VALUE
An analysis of these qualitative issues (i.e. service, ongoing low price, unused capacity) will
determine whether the recommendation to outsource should be accepted, which in turn
will lead to the appropriate cost structure to commence manufacture.
(c) The following points are relevant to the insourcing/outsourcing decision faced by HPD:
–– It seems that a specialised freight company can distribute the products at a significantly
lower cost than HZ’s own distribution division. Whether the same level of distribution
service can be delivered by Supersonic is questionable, but it could be expected that
there would not be a dramatic difference in the quality of service between internal and
external supply.
–– The difference in costs should be examined. Investigating the cost difference might pose
the following questions:
|| Does the lower price quoted by Supersonic reflect an initial ‘low-ball’ below cost
tender price that is intended to capture the distribution business from HPD? If so,
as HPD becomes more dependent on Supersonic for distribution support, the
distributor might then opportunistically increase costs to levels above the long run
cost of internal supply.
|| Does the lower price quoted by Supersonic reflect the specialised freight company’s
use of new or advanced freight moving technology, the more effective management
of existing distribution infrastructure or simply greater economies of scale?
|| Is the higher price quoted by HZ’s freight division based on the incremental variable
cost (marginal cost) or full cost? If the $950 000 was the full cost, then this would
include fixed costs that are going to be incurred regardless of whether this work was
performed. Since it appears that the freight division expects to have idle capacity as a
result of HPD’s intention to outsource the distribution of the Solarheat 1, perhaps the
price quoted should not include these fixed costs and only be based on the division’s
out-of-pocket (or variable) costs. If this were the case, a quote based on the freight
division’s marginal cost of supply (only those costs directly related to providing this
additional piece of work) would be significantly less than the initially quoted $950 000,
and HPD may be more inclined to use the internal distribution function.
–– Finally, as the use of a multi-divisional structure by HZ is intended to achieve the many
benefits that come from decentralised decision-making (e.g. greater use of local
knowledge, quicker and more appropriate responses to changing operational conditions
and improved motivation and commitment), a direction from HZ’s head office to HPD
that it use the internal freight division ‘at any cost’ may be counterproductive. Provided
appropriate performance measures are in place, HZ should afford HPD the freedom to
make operational decisions as to how the division chooses to distribute its products.
(d) The decision to allow HPD to outsource the distribution of all its product lines addresses
issues about which set of competencies HZ should retain. Where an external supplier is
contracted to provide a previously internally supplied function, it may be assumed that HZ
has carefully examined the costs and benefits of outsourcing and decided that the external
supplier provides net benefits greater than can be achieved by using the internal supplier.
So, the external supplier has a core competency that HZ currently does not possess or wish
to acquire.
In terms of financial performance measures, Martin would want to ensure that the life cycle
MODULE 6
distribution costs charged by Supersonic for the Solarheat 1 are as quoted (i.e. $650 000) and
that there is also a reduction in the distribution costs for all other HPD product lines that are
now to be distributed by the specialist freight company. Martin might also wish to monitor
the cost of damages that occur during distribution, as these might reveal the superior (or
inferior) freight handling practices of Supersonic.
Suggested answers | 677
The financial and non-financial measures used to monitor the performance of Supersonic
are intended to give Martin some assurance that HPD’s distribution needs are being well
serviced by the specialist freight company in a cost-effective manner.
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Gross margin % on sales $3 000 000 $900 000 $480 000 $4 380 000
$15 000 000 $3 000 000 $1 200 000 $19 200 000
(b)
Cost per driver
Total cost driver transaction in year
Customer service activity Total costs transactions ending 31 December
2. Line item ordering $210 000 52 500 line items $4 per line item
(c)
1. Order processing $50.00 600 $30 000 6.7% 900 $45 000 21.4% 4 500 $225 000 31.2%
2. Line item ordering $4.00 12 000 $48 000 10.6% 13 500 $54 000 25.7% 27 000 $108 000 15.0%
3. Distribution $100.00 300 $30 000 6.7% 300 $30 000 14.3% 3 000 $300 000 41.7%
4. Cartons/pallets shipping $5.00 45 000 $225 000 50.0% 6 000 $30 000 14.3% 15 000 $75 000 10.4%
5. Customer relations $200.00 585 $117 000 26.0% 255 $51 000 24.3% 60 $12 000 1.7%
Total cost $450 000 100% $210 000 100% $720 000 100%
| TOOLS FOR CREATING AND MANAGING VALUE
Suggested answers | 679
(d)
Nationwide State-wide Small local
Details retailers retailers retailers Total
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Customer service indirect costs ($450 000) ($210 000) ($720 000) ($1 380 000)
Net margin $2 550 000 $690 000 ($240 000) $3 000 000
Net margin % on sales $2 550 000 ( $690 000 ) ( $240 000 ) $3 000 000
$15 000 000 $3 000 000 $1 200 000 $19 200 000
Comments:
As shown in the case facts, the most profitable market segment in absolute dollar terms
is the nationwide market segment ($2 550 000). However, the state-wide retailers are the
most profitable market segment when measured on a net margin basis (23%). Interestingly,
the small local retailer market segment incurs an overall loss of $240 000 and has a negative
net margin of 20 per cent. This is a significant turnaround from the gross margin figures
identified in the case facts. Net margin therefore provides a more accurate assessment of
the profitability of customers.
(e) The main problems in allocating the customer service costs to the activity areas and customer
groups in the year ending 31 December include:
–– Choosing the appropriate cost driver for each area of activity. While the cost driver
for each activity seems to be an economically plausible base on which to allocate the
total indirect costs in that cost pool, it may need refinement over time.
–– Developing a reliable database for the chosen cost drivers. For some cost drivers,
the information required to compile the cost driver database is likely to be readily
available—for example, the number of individual product lines ordered. However,
the data on the hours spent in customer-support activities will rely on the manual diary
entries made by each HPD sales representative.
–– Deciding how costs that may be common across a number of functions or activities
are to be handled. A similar cost allocation problem occurs in the costs of filling
each order where the order and items ordered activities share some common costs.
Accuracy will be uncertain and data collection expensive.
–– Assessing likely adverse reaction of the division’s sales representatives to the new
cost-allocation model. This adverse reaction may be even more pronounced if HPD
changes the method of determining sales commissions from a gross to a net customer
profit margin.
4. Total deliveries 30 30
(b)
Mini-Electrical Home Appliances
Cost driver
transaction
(see the
answers Number Number
to Case of cost Customer of cost Customer
Cost pools study 6.13) drivers service costs drivers service costs
(c)
Details Mini-Electrical Home Appliances
Comments:
As indicated by the customer profitability analysis, Mini-Electrical, returning a net margin of
$5250 in the year ending 31 December, generates a net margin on sales of 17.50 per cent.
This net margin on sales places Mini-Electrical marginally above the average return made
by HPD from the nationwide customer market segment (of 17%). Home Appliances made a
loss of $3600 for the year ending 31 December, generating a negative net margin on sales
of 30 per cent.
(d) The following strategies could be recommended to HPD for managing its relationship with
individual customers:
–– Refocus sales force—pay increased attention to the top 20 per cent of customers.
HPD may wish to educate its workforce as to the importance of its customers so that the
employees always strive to meet, if not surpass, their expectations of product quality,
on‑time delivery and after-sales service.
–– Inform—seek to educate HPD’s customers about the ‘costs’ they will bear as a result of
unprofitable orders. The approach to customers could seek to reduce both the number
of orders placed (i.e. increase the order size per delivery) and decrease the complexity
of the order (i.e. the number of line items ordered).
–– Remuneration and commissions—offer bonuses to the division’s sales representatives
based on each customer’s net margin rather than the gross margin. The previous
remuneration system would need to be phased out over time in a manner that does not
adversely affect the level of compensation paid to the division’s sales representatives.
While it might be suggested that it would be profitable for HPD to cease trading with
the bottom 40 per cent of its small local electrical-retailer market segment, this decision
should only be taken after all other avenues for improving customer profitability have been
exhausted. In particular, it may be that a currently unprofitable small local electrical retailer
such as Home Appliances will become profitable to HPD once the customer’s market has
grown. Surrendering a relationship with this type of customer to a rival supplier may appear
to make economic sense in the short term, but it may result in the permanent loss of a
very profitable customer in the long term. So, customer profitability analysis needs to be
undertaken in the context of the long-term strategic plans that HPD has about the markets
it wishes to compete in.
MODULE 6
MODULE 6
References | 683
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and trends in the Fortune 1000’, March, Deloitte Consulting LLP, accessed October 2018,
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MODULE 6
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MODULE 6
MODULE 6
STRATEGIC MANAGEMENT ACCOUNTING
Case study
688 | STRATEGIC MANAGEMENT ACCOUNTING
Contents
Preview 689
Introduction
Concepts, tools and techniques 689
Introduction to WattleJet 690
Company background
Mission, vision and strategy
Business operations
Performance
Australian domestic airline industry 696
Industry history
Industry economics
Value drivers
Industry cost structure
Industry factors
Industry competitors 700
Porter’s five forces model and the Australian domestic airline industry
WattleJet strategic initiatives 702
Strategic cost and profit management
Project analysis, selection and implementation
Conclusion 704
Case study tasks 704
References 731
CASE STUDY
Case study | 689
Case study
Case study
Preview
Introduction
Completing this Case study helps you to revise and consolidate your understanding of strategic
management accounting. This is done through completion of various tasks and practice questions
that require you to apply the concepts, tools and techniques covered in Modules 1 to 6. The Case
study is ‘WattleJet’ and focuses on a service environment—the Australian domestic airline industry.
This hypothetical company is trying to establish a niche alongside established competitors
including Qantas, Jetstar, Tigerair and Virgin Australia.
At the end of the Case study is a set of tasks that you are expected to complete by referring to
Modules 1 to 6 and applying the necessary knowledge. These tasks are your focus:
• analysing the airline industry
• analysing the strategic approaches of WattleJet
• measuring and assessing the performance of WattleJet
• analysing the WattleJet value chain
• project analysis, evaluation and planning.
Please note that while the Case study is not examinable, the concepts, tools and techniques covered
in Modules 1 to 6 and used in the Case study are examinable.
Traditional management accounting techniques include budgeting, variance analysis and product
costing. As the management accountant’s role has developed to include being a business adviser,
additional techniques have emerged.
CASE STUDY
690 | STRATEGIC MANAGEMENT ACCOUNTING
The first main tool described is industry and organisational value chain analysis. This is used to
gain an overall perspective of the organisation and its place within its industry value chain.
Once a clear picture of the organisation and industry is obtained, the organisation and its
environment can be analysed using SWOT analysis, product life cycle analysis and Porter’s five
forces analysis.
Providing feedback and control mechanisms is another crucial role. The use of both financial and
non-financial measures helps to achieve this. Integrating measures into scorecards and strategy
maps is a powerful way of making sure that all critical aspects of an organisation are properly
monitored to enable corrective action to be taken if necessary.
In contrast to the concepts, tools and techniques that focus on a broader organisational view,
it can also be necessary to focus very specifically on individual products and activities within the
value chain. Activity-based costing (ABC), life cycle costing and target costing are all examples of
this. Understanding customer profitability and managing value chains are valuable approaches
for improving performance.
Management accountants often perform a role in the selection and implementation of projects
to achieve organisational objectives. Financial and risk analyses, combined with project
scheduling techniques, are essential for successful strategy implementation.
Introduction to WattleJet
This Case study examines a hypothetical Australian company called WattleJet Ltd (WattleJet),
which is competing in the Australian domestic airline industry.
An important theme in this Case study is the role of the management accountant in a service
environment. The service provided involves flying people and freight from one destination to
another. Strategic management accounting case studies are often focused on manufacturing or
product-based businesses, but this Case study demonstrates the importance of supporting value
creation in a service industry. In this industry, for example, there is no physical inventory produced
or managed, but there is an inventory of available seats that must be filled by travellers. If these
seats are not filled, then the opportunity to sell that service disappears.
It is much easier to achieve efficiency. For example, flights may be filled by offering low fares.
However, this may not be effective, because prices may be below cost. Achieving both objectives
is very difficult in a highly competitive environment.
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Company background
WattleJet was formed in 2006 and is based in Perth, the capital city of Western Australia (WA).
It chartered small aircraft that were used to fly employees from Perth to mines and other
worksites around Australia.
A mining boom started in 2005 following a significant rise in the demand for energy and minerals
by fast-growing developing countries. This led to very high minerals prices and so encouraged
mining companies to make significant investments to expand capacity and output.
Many Australian mining sites are in remote areas, and due to this, many employees are engaged
on fly-in fly-out contracts. Under this type of arrangement, employees commute to their
workplace by air, and stay on-site temporarily. The decision to commute by air is often made
because there is only a small amount of local accommodation or infrastructure close to the
mine site.
In the last two years, WattleJet has started to compete on major routes across Australia,
flying between Perth and the cities of Adelaide, Melbourne, Sydney and Brisbane.
More than a decade after the mining boom began, most analysts believe that the boom is
now over, even though demand and prices are still reasonably strong.
Its mission focused on providing safe, reliable and cost-effective commuting for workers
employed on remote mining sites. With low overhead and a specific focus on the fly-in fly-out
market, WattleJet offered a viable alternative to the larger, established airlines.
However, the company does not presently have a formal approach to strategic management and
has no strategic plan, objectives, timelines or data collection and analysis process. There is also
no established approach for dealing with environmental or corporate social responsibility (CSR)
issues. WattleJet’s overarching goals have been simplified to:
• remain profitable
• grow successfully
• maintain a perfect safety record.
At monthly management meetings, strategic issues are raised and discussed in an ad hoc
manner. The company currently reacts and responds to changes in the marketplace intuitively
and spontaneously, rather than following a formal or structured long-range action plan.
The company’s decision to expand beyond the original fly-in fly-out market evolved over time
and was not formally planned. Accordingly, the company’s operations do not reflect its vision
or mission statements.
Business operations
WattleJet has a single office based near Perth Airport. It has a fleet of 12 aircraft.
WattleJet mainly flies to the Kimberley, Pilbara and Goldfields–Esperance regions in WA, as shown
in Figure CS1. As mentioned earlier, it also flies to the major capital cities within Australia.
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KIMBERLEY
PILBARA
GASCOYNE
MID WEST
GOLDFIELDS–ESPERANCE
WHEATBELT
PERTH
PEEL
SOUTH WEST
GREAT SOUTHERN
WattleJet has many fixed-rate medium-term contracts in place with companies based throughout
regional WA. Many bookings for flights to regional centres are made by employers—rather than
individual employees—directly with the head office call centre. Individuals may also book directly
with the airline via the call centre or online by using the WattleJet website. The company has no
relationships with any travel agencies. For interstate travel to capital cities, most bookings are
made by individuals online or via the call centre.
Staff in the head office are involved in route planning, capacity analysis, marketing, purchasing
and human resources (HR), as well as regulatory compliance.
Sales staff spend a considerable amount of time working with companies involved in the mining
industry. They focus on developing suitable pricing strategies and winning longer-term contracts
to ensure that flights carry enough passengers to be profitable.
Most operational staff are based at Perth Airport, and aircraft maintenance is outsourced to
providers who are also located there.
The ground crew prepare the aircraft so that they are ready to fly. This includes passenger check-
in, baggage handling and aircraft preparation (e.g. fuel, safety checks and catering). The flight
schedules are planned to minimise costs—including crew accommodation, employee allowances
and leasing space. To help to achieve this, the schedules ensure that all staff and aircraft finish
each day back at Perth Airport.
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Primary activities
Support activities
Performance
WattleJet has a very simple performance measurement system that captures the following
financial results and some operational measures:
• total revenue
• employee costs
• fuel costs
• flight expenses.
Flight expenses are sometimes called ‘aircraft operating variable’, and are a combination of costs
that are incurred as a result of each flight, including:
• route navigation fees
• landing fees
• maintenance expenses
• crew expenses
• passenger expenses.
Operational measures include capacity availability, usage and efficiency; on-time performance;
and safety—as shown in Table CS2.
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For example, the RPK for a flight from Perth to Newman Airport
(1021 km) with 54 paying passengers would be:
Incidents and near misses Measures the effectiveness of safety and control systems
Incidents and near misses is a count of the number of safety and risk
incidents that occur, and any near misses. It provides a picture of
activities that may be dangerous or processes that need attention.
These must also be immediately reported to the Australian Transport
Safety Bureau (ATSB).
Monthly management reports include a statement of profit or loss, and of operational indicators.
The financial and operating results for the last four years are shown in Table CS3.
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Expenses
NPAT ‡
5.688 2.352 1.133 (0.947)
†
Earnings before interest, tax, depreciation and amortisation
‡
Net profit after tax
Industry history
Trans Australia Airlines (TAA) and Ansett dominated the domestic airline industry for 40 years
because of the Two Airlines Policy that was established by the Australian federal government
in 1952. Regulations promoted a duopoly over major routes within Australia. In 1992, TAA was
absorbed into Qantas, which had been operating solely international routes. Several small
airlines operated in regional areas.
Deregulation of the industry in 1990 allowed new entrants to the industry. The first attempt at a
low-cost start-up was Compass Airlines, which was established in 1990 and failed in 1991.
In 2000, Virgin Blue Airlines (now Virgin Australia) entered the market. This competition led to
significant fare reductions and opened air travel to tourists. When Ansett collapsed a year later,
Virgin Australia captured significant market share, and low fares continued.
To compete with Virgin Australia, Qantas launched a low-cost airline called Jetstar in 2003.
This initiative was designed to assist Qantas to compete against Virgin Australia without
sacrificing the traditional full-service, high-price model offered by the main Qantas brand.
In 2007, Tigerair, another low-cost competitor, started operations. Tigerair’s low fares meant
that the company struggled to be profitable throughout its existence. It was taken over by
Virgin Australia in 2017.
Over the last few decades, the industry has changed from a highly regulated, uncompetitive
duopoly with high prices, to an intensely competitive duopoly offering a range of options and
prices to suit both low- and high-fare-paying travellers.
Industry economics
Volume growth
Passenger growth was rapid from 2004 to 2008 (from below 40 million to over 50 million). As shown
in Figure CS2, demand between 2008 and 2009 faltered during the Global Financial Crisis (GFC).
After this period, growth continued, but at a slower pace. In 2017 (latest information available at
time of writing), passenger growth was 1.7 per cent and 60 million domestic flights took place,
a decrease of 0.5 per cent. Other relevant statistics (see Figure CS3) from 2017 include:
• RPK was up 1 per cent.
• ASK was down 1 per cent.
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Figure CS2: D
omestic regular public transport passenger traffic—moving
annual totals
65
Total passengers carried (millions)
60
55
50
45
7
7
-0
-0
-0
-1
-1
-1
-1
-1
-1
-1
-1
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
D
D
Year ending
Source: Australian Government 2018, Australian Domestic Aviation Activity, p. 2, accessed June 2018,
https://bitre.gov.au/publications/ongoing/files/domestic_airline_activity_2017.pdf.
90
ASKs/RPKs (billions)
80
70 80
75
60
Available seat kilometres (ASKs)
70
Revenue passenger kilometres (RPKs)
Load factors (%)
50 65
7
10
12
15
17
-0
-0
-0
-1
-1
-1
-1
-
-
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
D
Year ending
Source: Australian Government 2018, Australian Domestic Aviation Activity, p. 2, accessed June 2018,
https://bitre.gov.au/publications/ongoing/files/domestic_airline_activity_2017.pdf.
Profit
The increase in passenger numbers and competition for market share came at a cost as airlines
reduced fares. Operating profit margins were dramatically reduced, from around 8 per cent
before the GFC to around 1 per cent, slowly recovering to about 2 per cent. For the past five
years (2013–17), however, average growth has been –2.8 per cent. The whole industry currently
generates revenues of approximately $12 billion, with overall profits of nearly $1700 million
(2017). Table CS4 shows how the profit is distributed across the different services in the industry.
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Freight 3
Reward programs 31
Business travel
The business or ‘full-fare’ segment is mainly used by business travellers and employees working
in the public sector. While this segment offers a higher-quality experience, it has been under
pressure due to business and government cost-control policies. The unit value of a sale per
passenger for the business segment is approximately double that of the leisure segment.
In addition to business-class tickets, this segment includes ‘fully flexible’ fares in economy class
that allow booking and flight changes at short notice, and provide similar services to business
class like lounge access, entertainment, baggage allowances and meals. Flexible economy seats
achieve premium prices.
Leisure travel
The leisure or ‘low-fare’ segment is mainly provided to travellers on holidays or for other personal
reasons. Only limited services are provided with low-cost fares. Self-service is often required for
booking, checking in and baggage drop-off. Additional services may be purchased separately,
and the revenues for this segment are a combination of ticket price and the price of services that
have been purchased with the ticket or on-board the aircraft.
Freight
Items that are time sensitive or that have a high value-to-weight ratio are often transported by
air rather than by road or rail. The boom in online shopping has led to a significant growth in this
industry segment.
Value drivers
RPK and ASK are driven by the key industry value drivers, which include:
• links with travel agents, international airlines (RPK) and road and rail freight handlers
• optimum aircraft capacity utilisation (Passenger load = RPK / ASK)
• ability to expand and reduce aircraft capacity in line with demand (ASK)
• fuel price fluctuations (international oil price)
• domestic tourist visitor nights (RPK)
• real household discretionary income (RPK)
• on-time performance—predictably, Qantas is the best on-time performer, and Tigerair
is the least punctual.
Airports
Aircraft Tourism
Pre- In-flight Arrival
Departure
departure services and exit
Fuel Freight
Catering
Industry factors
Environment
Factors like carbon emissions and carbon pricing pressure airlines to become more efficient and
environmentally focused and lead to significant capital investment in efficient and lighter aircraft.
Noise is another factor. Curfews on flying at night (between 11.00 pm and 6.00 am) exist at
Sydney Airport, which makes additional growth difficult. Attempts to develop a new airport
in Sydney or to add another runway to the existing airport meet with fierce opposition from
local communities.
Technology
Videoconferencing may reduce demand for air travel. The possibility of high-speed trains linking
major capital cities is also a threat.
Technology is helping airlines with cost management and pricing. Software tools for the
efficient scheduling of aircraft and flight crews are becoming more powerful. Ticket pricing
can be adjusted in real time to reflect small changes in demand, helping to ensure that aircraft
are not only filled but also have the highest possible revenue per seat. The use of technology
to enable flight bookings, web check-in and self-service baggage drop-off has also led to
cost improvements.
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Regulation
A combination of regulatory change and new technology is also likely to affect the industry.
Automatic Dependent Surveillance–Broadcast (ADS–B) is a system for broadcasting information
about aircraft during flight. Linked to GPS networks, the data that is transmitted includes the
position, speed and identity of the aircraft. The ADS–B system is currently being introduced
into Australia.
Benefits include more direct flight routes and aircraft operating in closer proximity to each
other, facilitating more take-offs and landings and reduced time spent in holding patterns and
at airports. Another benefit will be the ability to perform a continuous descent—rather than a
stepped descent—which reduces fuel costs and emissions.
Industry competitors
Competition within the domestic airline industry is unique because of the Qantas/Virgin duopoly.
Between them, they have four major brands (Qantas, Jetstar, Virgin and Tigerair), and they
control several minor brands focused on regional areas. So, instead of a protected duopoly
with high prices as was the case before 1990, prices have remained comparatively low as the
airlines fight for market share, especially in the high-price business segment.
Qantas
Qantas primarily targets and is the market leader in the business/full-fare segment. For nearly
10 years, it was the only participant in this market because of the collapse of Ansett Airlines
in 2001. Its domination is also linked to having the largest network across Australia and
internationally, including code-sharing arrangements with other airlines.
Historically, the business segment was uncompetitive—however, since Virgin Australia started
providing business class, there has been greater competition. Qantas has reacted strongly to
maintain its market share by adding extra capacity and reducing prices.
QantasLink is the largest regional airline and flies to over 50 destinations. It uses smaller aircraft
to provide both metropolitan and regional services. It provides links to Qantas rewards and
provides for baggage connections for onward Qantas travel.
The company initially started as a low-cost provider in the leisure segment. However, faced with
competition in the low-cost leisure segment, it later focused on market share in the business
segment.
Jetstar provides low-cost fares with a focus on the leisure market. Creating Jetstar made it easier
for Qantas to compete effectively against Virgin Australia without harming the Qantas brand.
Jetstar’s low-cost structure was facilitated by having a single type of aircraft. This minimised
complexity (e.g. with maintenance and pilot certification). Services such as checked luggage
and preferred seating are provided on a user-pays model.
Virgin Australia
Virgin Australia originally focused on the leisure travel segment and grew its market share
through low prices, branding and cost control. It became the market leader. The introduction
of Jetstar curtailed Virgin Australia’s strong growth. The later entry of Tigerair, an ultra-low-cost
airline, created even more pressure. In response, Virgin entered the business segment to attract
higher-yield customers. By 2010, Virgin Australia had secured about 10 per cent of business
CASE STUDY
In May 2013, Skywest became part of Virgin Australia. Skywest Airlines was a regional airline that
provided services mainly in regional WA as well as to Darwin in the Northern Territory of Australia.
Tigerair launched in 2007. Tigerair introduced extremely low fares matched with a simple service
offering. Flying out of peripheral airports and terminals, only basic services were provided.
In July 2013, Virgin Australia took control of Tigerair. As part of Virgin’s change in strategic
direction towards becoming a full-fare provider, it needed some mechanism for competing
against Jetstar and maintaining its market share in the leisure segment. Having a separate
brand—in a similar manner to the use of Jetstar by Qantas—allows the company to provide two
very different experiences for customers. It also helped to eliminate Tigerair as a competitor
as it was undercutting Virgin’s prices.
Other players
A number of small regional airlines serve diverse regional areas—like WattleJet, which serves
mainly regional WA. Only 2 million of the current 60 million domestic flights depart from or
arrive in regional towns.
Applying these five forces to the Australian domestic airline industry, it is noted that:
1. The threat of new competitors is reasonably low because of the high start-up capital
costs and the regulatory approvals required to start a new domestic airline in Australia.
2. The threat of direct substitutes, such as road and train travel, is low—with the possible
introduction of high-speed ‘bullet trains’ being a distant threat. The low ticket prices,
especially for leisure travel, make flying a valuable alternative because travel times
using other means of transportation are so lengthy. The threat of indirect substitutes,
especially in the business segment, is low but is starting to increase. Video communication
technology is becoming increasingly powerful, while its costs are decreasing rapidly,
making it an increasingly affordable way to communicate with staff, customers and suppliers
across the country. In many situations, companies may decide to replace air travel with
electronic communications.
3. Customers are powerful because they have a range of choices between very similar products
in both the business and leisure segments. Therefore, pricing becomes a key differentiator
between competitors, and leads to very low fares and reduced margins. This power is
reduced on some regional routes that are serviced by only one airline.
4. Suppliers of fuel are powerful because these prices are set globally and are very difficult to
influence. Aircraft suppliers are less powerful and are willing to negotiate lower prices to
ensure that they have full order books to maintain production.
5. The intensity of competition is high, and this is shown by the decline in ticket prices in both
the leisure and business segments. Despite constantly increasing passenger numbers,
total revenues across the whole industry have been flat, indicating that volume growth has
not led to revenue growth.
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Total costs in the sales and marketing area for 2018 were $1.879 million. Marketing and
advertising costs were $1.1 million. The costs of ticketing ($0.779 million) are split between
four main activities:
1. maintenance of the sales website
2. staffing of the bookings call centre
3. resolution of complaints and disputes
4. distribution of physical tickets.
Of the approximately 300 000 passengers per annum, 190 000 passengers purchased tickets
online, while 110 000 used the call centre. WattleJet has decided that the best way of
differentiating its customer groups is by how they purchase their tickets (i.e. online versus
call centre), and that the remaining $0.779 million in overhead costs should be properly allocated
between these two customer groups to determine the profitability (or otherwise) of each group.
Table CS5 shows the activities and costs within the ticketing component of the sales and
marketing function.
4. Physical ticket Number of physical $105 000 42 000 tickets 4 000 38 000
distribution tickets distributed
The estimated up-front costs for implementing ADS–B are $235 000. Additional ongoing training,
testing and implementation costs of $75 000 will be incurred during the first year of the project.
Table CS6 contains a probability analysis of the estimated fuel and other efficiency savings from
an early upgrade to ADS-B, compared to waiting until 2021.
Probability $ $ $
Table CS7 details the activities required and the time estimates for implementing the ADS-B
system. The first activity involves WattleJet requesting information from potential suppliers about
the new technology and infrastructure. At the same time, the second activity requires quotes to
be obtained for various types of technology systems.
Once a supplier is chosen, the equipment will need to be obtained, installed and tested.
At the same time as the technology is being implemented, the planning department will be
reconfiguring routes and take-off and landing methods to reduce fuel usage. An additional
benefit will be an improvement in on-time arrivals and departures. This could potentially
generate more ASKs per day per available aircraft, thus increasing the level of capacity without
additional aircraft leasing or purchase costs.
Preceding
Activity Activity description Time estimates (working days) activity
Conclusion
This Case study is designed to provide you with some appreciation of the complex challenges
and issues that managers face. WattleJet typifies a company that has experienced turbulent
conditions in a mature, competitive market with high entry costs and significant operational,
economic and environmental risks.
The tasks below require you to apply strategic management accounting concepts and tools as
you analyse the key issues facing WattleJet and the implications of these for management.
(b) How may strategic management accounting support management decision-making and help
to create and manage value for WattleJet?
(c) What are the types of information that will be useful for the management of WattleJet?
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706 | STRATEGIC MANAGEMENT ACCOUNTING
(d) What are the requirements for an effective management accounting system (MAS) for
WattleJet?
Check your work against the suggested answer at the end of the module.
➤➤Task 2: Decision-making
(a) Use the conceptual framework approach introduced in Module 2 to identify WattleJet’s
stakeholders.
(b) Based on the results of (a), prepare a stakeholder grid (see Module 2) to assess stakeholder-
related risk (Interest × Power).
High
Power
Low
(c) Based on the results of (b), identify the stakeholders’ information needs.
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Check your work against the suggested answer at the end of the module.
➤➤Task 3: Budgeting
(a) Using the following template (column B), prepare a budget for 2019. The budget should be
based on the following assumptions.
(i) Ignore inflation.
(ii) Ticket sales and sales and marketing expenses are based on an estimated RPK increase
of 1 per cent over 2018 figures.
(iii) Freight will not change.
(iv) Cost saving measures in the ticketing system will reduce sales and marketing expenses
by $0.3 million and increase IT costs by $0.4 million.
(v) All expenses other than property and IT and sales and marketing vary with APK.
APK growth is estimated at –0.5 per cent below 2018 figures.
(vi) Property and IT are fixed costs except as noted in (iv).
(b) Using the same template below (column C – B), calculate budget variances.
A B C C–B
Revenues
Freight 8.213 10
Expenses
Wages 37.690 38
Fuel 28.725 34
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A B C C–B
Flight 8.637 9
Aircraft 9.121 10
EBITDA 9.019 4
(c) Prepare a report to management explaining the significance of the 2019 budget variances.
Check your work against the suggested answer at the end of the module.
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Probability $ $ $
30%
50%
20%
$ $ $ $ $
Investment outlay
Estimated fuel
efficiency savings
Discount factor
calculation (14%)
Discount factor
Discount calculation
Estimated present
value
Worst-case
cash flow
Worst-case NPV
Best-case
cash flow
Best-case NPV
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(b) (i) Construct a PERT network diagram for the ADS-B project based on the data in Table CS7.
(ii) Calculate the expected time (ET) for each activity.
(iii) Define the critical path and calculate the estimated duration of the project.
Expected
Activity Description Optimistic Most likely Pessimistic Calculation time
1 Review 30 50 90
and select
technology and
infrastructure
2 Obtain quotes 15 20 30
from various
suppliers
3 Choose supplier 10 14 25
and prepare
formal contracts
4 Installation of 65 90 185
equipment
Draw the completed network diagram, including the expected times and critical path.
Note: You will either need to do this separately on a piece of paper, or you may prefer
to create the network diagram in a drawing program before adding your response to the
answer field.
If you choose to use a drawing program, save your diagram as an image file. Then in the
interactive PDF of this Study guide, you can insert your response by selecting the answer
field and browsing for the image file that you saved on your device.
Check your work against the suggested answer at the end of the module.
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Case study | 715
(b) Create a full BSC for WattleJet that includes a fifth perspective—environmental.
Customer perspective
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Financial perspective
Environmental perspective
Check your work against the suggested answer at the end of the module.
(b) Prepare an ABC estimate using the data in Table CS5 for ticket-purchasing costs of the two
main customer groups—those who purchase tickets online and those who purchase tickets
using the call centre. To do this:
(i) Calculate the ABC transaction cost rate.
(ii) Allocate the cost of each activity (cost pool) to the customer groups based on the number
of driver transactions used by each customer group.
(iii) Calculate the total cost for each customer group, as well as the cost per ticket for each
customer group.
(iv) Analyse the results.
(i) Calculate the ABC transaction cost rate.
Cost driver
Activity area Total costs transactions Transaction cost rate
(ii) Allocate the cost of each activity (cost pool) to the customer groups based on the number
of driver transactions used by each customer group.
(iii) Calculate the total cost for each customer group, as well as the cost per ticket for each
customer group.
Difference
Overall average
Check your work against the suggested answer at the end of the module.
Suggested answers | 719
Suggested answers
Suggested answers
WattleJet creates shareholder value when the prices obtained from customers are higher
than the costs of providing the service. These profits will be sustainable if value is also
created for other stakeholders, such as employees (in terms of appropriate wages and
working conditions) and suppliers (in terms of pricing and payment terms).
From a more specific point of view, examples of how WattleJet creates value include:
–– providing flights to regional and remote areas
–– offering fixed rates and medium-term contracts to companies flying staff to mine sites
–– minimising costs by returning crew to Perth after each flight.
Management accounting has traditionally supported the different levels of internal decision-
making of organisations. In its early history, the emphasis of the management accounting role
was on planning and control with a focus on budgeting and cost management. Organisations
and their environments were typically stable and decisions were made under conditions of
relative certainty. However, strategic management accounting goes beyond this and helps to
create and manage value.
Strategic management accounting provides a wide range of tools and techniques that
support these decisions, including:
–– BSCs for supporting the analysis of organisational performance and guiding
strategy choice
–– ABC and activity analysis to identify and cost non-value-adding activities that may
be eliminated or reduced
–– capital budgeting tools, such as NPV, that enable project evaluation
–– project scheduling and budgeting tools to manage both the time and cost of
implementation
–– customer profitability analysis to identify which segments the organisation should
focus on.
To compete effectively in the domestic airline industry, WattleJet will need to make
decisions based on a sound analysis of both financial and qualitative characteristics.
Capturing enough customers, including the right types of customers, controlling
costs and implementing efficiency improvements will all be essential for developing
a successful and sustainable business.
(c) The types of information that will be useful for WattleJet may be split into internal and
external data.
Internal data
This will be needed across a range of categories, including financial performance, customer
satisfaction, employee efficiency, operational effectiveness and environmental impact.
This information will also need to be able to be segregated easily by customer, route and
aircraft type to support detailed analysis.
External data
One of the important aspects of strategic management accounting is its focus on areas that
are external to the organisation—especially competitors and customers. Data on competitor
performance, market share, customer demographics and preferences, cost structures and
approaches to things such as fuel-cost management and selection of aircraft will be very
useful when developing strategic plans. Broader economic data will also be essential in
terms of Australian economic growth rates, consumer sentiment, and the performance of
the mining industry, which drives a lot of the fly-in fly-out customer segment.
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Suggested answers | 721
(d) WattleJet will need a MAS that considers performance across the value chain, rather than
just the financial results. It will need to capture operational statistics quickly and easily
including ASK, RPK, on-time performance and load factor for each route. It will also need to
be extended to capture physical flows (e.g. fuel usage) and environmental data (e.g. carbon
emissions) which will aid both efficiency and environmental improvements by providing a
baseline for current performance.
The ability to identify and assess costs that are often hidden in overhead (e.g. by using ABC
approaches) will also help to ensure that efficiencies are obtained, and that waste is reduced
or eliminated. The MAS will therefore need to capture data on the various types of activities
performed, how often they are performed (the cost drivers) and the costs of those activities.
As well as effective data capture and analysis, the system must provide quick and timely
reports that are easily understood by managers and staff throughout the organisation.
Task 2: Decision-making
(a)
Primary users Other users
(b)
High ATO Debt holders
ASIC • 2018 interest payment $1.6 million
• Suppliers of fuel, aircraft and airport
facilities
• Airline regulator
• Safety and systems
Power
• Management
Public Customers
Environmental issues • Regional customers have few options
regarding carrier or price
• Shareholders
• Employees
Low
(c)
Stakeholder Key information requirements or needs
Community • WattleJet should ensure that its environmental credentials remain high
with a number of in-house programs to prevent waste and contamination
• The local community should be kept informed about company changes
and initiatives like schedule changes or service interruptions
Government • Tax, superannuation and goods and services tax (GST) returns as required
• Pay amounts due
• Provide reports as required to airline regulators
Management • Revenue
• Costs
• Efficiency
• Profitability
• Assets
• Cash flows
• Economy
• Industry
Task 3: Budgeting
(a) and (b)
Profit and loss
budget 2019 2018 actual 2019 budget 2019 actual Budget variance
A B C C–B
Revenues
Expenses
Notes:
1 Ticket sales 99 371 × 1.01 = 100 364
2 Sales and marketing 1898 × 1.01 – 300 = 1616
3 Property and IT 12 494 + 400 = 12 894
4 Other expenses × 0.995
(c) Revenue
Budget RPK growth was 1 per cent, but the actual achieved was 2 per cent.
This higher than expected volume growth could not be converted into revenue growth,
however. Revenue from ticket sales was below budget due to price discounting. The ticket
sales variance was –$364 000.
On a more positive note, freight revenue was well above budget, and delivered a favourable
revenue variance of $1.787 million.
Costs
Total cost variance was $7.721 million. Cost variances were dominated by a fuel cost blow-
out of $5.419 million. Other cost categories were over budget, ranging from 1.3 per cent
for wages to 32 per cent for sales and marketing.
Sales and marketing expense was $383 000 higher than expected because RPK increased,
and because cost savings from the new ticketing system were not realised. A saving
of $0.3 million was budgeted but actual savings were only $0.2 million. The related IT
ticketing project was $0.2 million over budget.
CASE STUDY
(i)
Year 1 Year 2 Year 3
Probability $ $ $
(ii)
Year 1 Year 2 Year 3
30% × $45 300 $13 590 30% × $111 800 $33 540 30% × $145 300 $43 590
50% × $86 800 $43 400 50% × $152 000 $76 000 50% × 178 000 $89 000
20% × $114 000 $22 800 20% × $165 000 $33 000 20% × $190 000 $38 000
(iii)
Year 0 Year 1 Year 2 Year 3 Total
$ $ $ $ $
Net cash flow ($235 000) $4 790 $142 540 $170 590
Estimated present ($235 000) $4 202 $109 680 $115 147 ($5 971)
value
CASE STUDY
Suggested answers | 725
(vi) The estimated up-front costs (investment outlay) for implementing this system are $235 000,
to be spent at the start of the project (Year 0), with additional ongoing training, testing and
implementation costs of $75 000 spent in Year 1 of the project.
The weighted average of the fuel efficiency savings is inserted as cash savings over the three
years of the project. The net cash flow for each year and the total for the project can then be
established. As can be seen in part (iii), the total net cash flow is a positive result of $82 920.
However, these cash flows need to be discounted to their present value to evaluate the
project properly.
To do this, a discount factor of 14 per cent is applied. Remember that the initial investment is
not discounted, because this occurs at the start of the project (Year 0) and is regarded as the
present value already.
(v)
Worst-case ($235 000) 45 300 – 111 800 145 300
cash flow 75 000
Worst-case NPV ($235 000) –26 052 86 026 98 076 (76 950)
Best-case NPV ($235 000) 34 210 126 962 128 248 54 420
(vi) The NPV for this project is negative $5971. From a financial perspective, this suggests that
the project will not add value to the organisation—although the amount is immaterial
because of the size of the business.
The quantitative risk analysis presented in part (v) shows that the worst-case scenario for
the project is a negative NPV of $76 950. The best-case scenario is a positive NPV of 54 420.
Given the negative NPV of the most likely scenario, the project shows a high risk of a
negative return.
The qualitative risk factors must be considered before deciding whether to proceed. It would
also be worthwhile to check all the assumptions and cash flow estimates, as a small change
may lead to a different result.
(vii) This is where the qualitative risk factors need to be identified. There are a variety of benefits
in addition to fuel savings to be achieved by implementing the system. As it will eventually
become a legal requirement, early action may lead to a more efficient and effective
implementation, with a longer transition, fewer mistakes and lower prices in the short
term—because costs will likely rise as the compulsory implementation date approaches.
More accurate positioning of aircraft in the air is likely to reduce the chance of a mid-air
collision or other incidents, which provides an enormous safety benefit. It will also enable
faster routing of aircraft around airports, leading to better on-time departure and arrival
performance. This will provide additional customer and operational efficiency benefits.
In terms of risks, there is the potential for faulty implementation and the small chance that
the government may change the regulations again. Faulty implementation may be addressed
by running the current system simultaneously for a considerable period to test accuracy.
The technology that is being implemented should be carefully selected to ensure that,
if regulations change, the capabilities of the system will match the new requirements or
will be at least able to be adapted to do so.
CASE STUDY
726 | STRATEGIC MANAGEMENT ACCOUNTING
(b) (i)
1 4 5
Start 3 End
2 6
Both Activity 1 and Activity 2 can start at the same time. This is shown by having two arrows
flow from the start node. However, both activities must be completed before you can start
Activity 3, as they are listed as preceding activities.
From Activity 3, both Activity 4 and Activity 6 can be started at the same time, because
these both list Activity 3 as a preceding activity. Activity 5 can start once Activity 4 is finished.
Once Activity 5 and Activity 6 are completed, there are no more tasks to be done, so these
are linked by an arrow to the end node.
(ii)
Expected
Activity Description Optimistic Most likely Pessimistic Calculation time
1 Review 30 50 90 30 + (4 × 50) + 90 53
and select 6
technology and
infrastructure
So, the critical path is 1 → 3 → 4 → 5. This is the longest time in days, but it is also the
shortest amount of time required to complete the whole project. The project is forecast to
take 257 days.
CASE STUDY
Suggested answers | 727
ET = 53 ET = 102 ET = 87
EOT = 53 EOT = 170 EOT = 257
1 4 5
ET = 15
EOT = 68
Start 3 End
EOT = 257
2 6
ET = 21 ET = 108
EOT = 21 EOT = 176
The following environmental measures are sourced from competitors’ annual reports.
Note that additional measures may be relevant, such as those provided by the Global
Reporting Initiative (GRI) Standards as well as sustainability indices (e.g. FTSE4Good or
the Dow Jones Sustainability Index).
The first two measures are a numerical count, so they are a useful starting point in
measuring performance but are not very useful in establishing efficiency or improvement
over time. Thus, the measures are reliable (may be measured objectively and accurately)
and have clarity and timeliness, but they are not as valid as other measures in capturing
‘environmental performance’.
To address this issue, total fuel use and total emissions can be converted into a ratio linked
to RTK. RTK is the total number of passengers and the amount of freight carried, multiplied
by the number of kilometres flown, measured in tonnes. This enables us to obtain data that is
comparable over time and with competitors. As such, it has greater validity than the first two
measures, and may still be measured in a reliable manner.
(b)
Area Performance measures
Note: The example BSC in part (b) is presented to demonstrate the type of analysis that
needs to be undertaken. There may be a variety of other measures (financial or non-financial,
leading or lagging) to include in the BSC. In addition, it would be ideal to include targets for
each measure that meet the SMART criteria—namely, specific, measurable, achievable and
agreed, relevant, time-based and timely.
Traditional BSCs have financial, customer, business process, and learning and growth as
their four categories, but it is possible to add an extra perspective such as an environmental
perspective. The BSC also emphasises cause-and-effect relationships, and so it is important
to ensure that the BSC that you have designed has cause-and-effect relationships present
and has both leading and lagging indicators.
2. Call centre queries, Value-adding and Staffing the call centre is likely to be a
bookings and changes non‑value-adding combination of value-adding and non-value-
adding activity. The website is a lower-cost
alternative, so it can be argued the call
centre is mainly a non-value-adding cost.
However, if certain customers desire this
service and are willing to pay a premium
for it, this would demonstrate that it is
a valuable activity. The important thing
here would be to minimise the number of
customers using the call centre and transfer
them to the website. This might be achieved
through additional communication and
lower prices for web-based bookings.
(b) (i)
Cost driver
Activity area Total costs transactions Transaction cost rate
1. Website design $167 200 2 200 hours $167 200 / 2 200 = $76 per hour
and maintenance
2. Call centre queries, $464 000 32 000 calls $464 000 / 32 000 = $14.50 per call
bookings and
changes
3. Complaint and $42 400 800 complaints $42 400 / 800 = $53 per complaint
dispute resolution
4. Physical ticket $105 000 42 000 tickets $105 000 / 42 000 = $2.50 per ticket
distribution
CASE STUDY
730 | STRATEGIC MANAGEMENT ACCOUNTING
(ii)
Online ticket Call centre ticket
purchasers purchasers
1. Website $76 per $167 200 2 150 hours $163 400 50 hours $3 800
design and hour
maintenance
2. Call centre $14.50 per $464 000 5 800 calls $84 100 26 200 calls $379 900
queries, call
bookings
and changes
3. Complaint $53 per $42 400 635 $33 655 165 $8 745
and dispute complaint complaints complaints
resolution
4. Physical $2.50 per $105 000 4 000 $10 000 38 000 $95 000
ticket ticket tickets tickets
distribution
(iii)
Number of Average cost
Customer group Total cost customers per ticket
Call centre ticket purchase customers $487 445 110 000 $4.43
Difference $2.90
(iv) From the table in part (iii), it can be seen that the cost of servicing online ticket purchasers
($1.53 per ticket) is considerably less than that for call centre ticket purchasers ($4.43 per
ticket). The difference is $2.90 per ticket. WattleJet should ensure that prices are set
accordingly (i.e. menu-based pricing), so that call centre purchasers pay a premium for
the additional service. This ticketing cost information can also be used in assessing the
profitability of customer segments and the types of flights and routes that they book.
References
References
Australian Government 2018, Australian Domestic Aviation Activity, accessed June 2018,
https://bitre.gov.au/publications/ongoing/files/domestic_airline_activity_2017.pdf.
Porter, M. E. 1985, Competitive Advantage: Creating and Sustaining Superior Performance,
The Free Press, New York.
CASE STUDY
CASE STUDY