Performance Evaluation Study Unit

APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2021
CHARTERED ACCOUNTANTS ACADEMY
MANAGEMENT ACCOUNTING & FINANCE DEPARTMENT
CERTIFICATE OF THEORY IN ACCOUNTING
STUDY UNIT 2: PERFORMANCE EVALUATION
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Contents
1. Introduction ................................................................................................................... 3
2. Learning objectives under Performance Evaluation ........................................................ 3
3. Study material................................................................................................................ 3
4. Competence Framework expectation............................................................................. 4
5. Examination possibilities ................................................................................................ 5
6. Assumed Knowledge ...................................................................................................... 6
7. Integration ..................................................................................................................... 6
8. Course Notes ................................................................................................................. 7
8.1. Goals of Performance Evaluation ................................................................................ 7
8.2. Responsibility accounting ........................................................................................... 7
8.3. Financial performance measures ................................................................................ 8
8.4. Return on Investment (ROI) ...................................................................................... 10
8.5. Residual income (RI) ................................................................................................. 12
8.6. Economic Value Added (EVA) ................................................................................... 13
8.7. Accounting-based measures and a company-wide WACC ......................................... 14
8.8. Ways of over-coming the disadvantages................................................................... 14
8.9. Financial statement Analysis and Ratios ................................................................... 15
8.10. Non-financial performance measures ................................................................... 17
8.11. The Balanced Scorecard ........................................................................................ 18
8.12. Tips and examination technique ........................................................................... 19
8.13. Performance evaluation: Guidelines ..................................................................... 19
9. Practice Question ......................................................................................................... 21

1. Introduction
This unit provides guidance on the principles behind performance
evaluation. Performance evaluation can be noted as an effective
communication tool between the employee and employer and a
method used to analyse and document the execution of actions by
an employee against set organisational goals and standards. A
performance measurement system should provide in detail what is
being measured, how it is going to be measured, what performance
measurement indicators are going to be used and how the data
obtained through performance evaluation is going to be used to
produce some meaningful intended outcomes.
2. Learning objectives under Performance Evaluation

After studying this unit, one should be able to:
• Understand why performance measurement is important;
• Distinguish between functional and divisionalised organisation structures, and
between management performance and division performance;
• Calculate Return on Investment (ROI), Residual Income (RI) and Economic Value
Added (EVA) and how they tie into Net Present Value;
• Understand EVA and EVA adjustments;
• Understand the different strategies a firm can adopt;
• Understand the Balanced Scorecard, and its link to financial outcomes;
• Understand the integration of the Balanced Scorecard with other syllabus areas.
3. Study material
• Colin Drury (2012). "Management and Cost Accounting". 8th South African Edition,
South – Western Cengage Learning.
• CAA Applied Management Accounting and Finance MAF 401/2 Module 2

4. Competence Framework expectation
COMPETENCE AREA: MANAGEMENT DECISION MAKING AND CONTROL
VI-1.1 Identifies management’s information needs and the entity’s key

performance indicators
− Determines what information is relevant and useful to both management and

the governing body for the purposes of decision making and control based on
the entity’s mission, vision and strategies and competitive position, economic,
competitive and operating environments, products and governance structure
− Identifies key performance indicators, including any sector-specific tracking
needs
− Describes and gives examples of non-financial key performance indicators that
might be suitable for evaluating the entity’s effectiveness, such as – market
share, customer satisfaction, health and safety record, sales (or other) volume
comparisons, impact of economic, environmental, social and governance
factors, service delivery, economic, efficient and effective use of the limited
resources.
− Considers the applicability of the following performance measurement and
control techniques and tools, including – activity-based costing, activity-based
management, balanced score card and benchmarking
VI-1.2 Evaluates the design of the entity’s responsibility accounting system
− Gains an understanding of the arrangement of an entity’s governance

structure and responsibility accounting centres.
− Evaluates the impact of the structures on performance evaluation and
incentivisation, in the context of the entity’s strategies and enhancement of
shareholder wealth and fulfilment of stakeholder expectations or mandate.
− Evaluates the effectiveness and appropriateness (including strengths,
weaknesses and effect of accounting distortions) of the performance incentive
mechanisms (including measures of profit, return on investment, residual
income and economic value added) and makes suggestions for improvement.
− Considers the creation of medium- to long-term value for stakeholders or
fulfilment of mandate.

VI-1.3 Analyses the financial performance of an entity and makes and/or

evaluates recommendations for improvement
− Analyses, evaluates and explains the financial performance of the entity, or

division, branch, department, etc., in the context of the entity’s product,
competitive position, strategic plans, operations and activities during the
period(s) and with consideration to cash flows, business risks, other financial
risks, working capital policies, financial management principles, and
management control mechanisms in place, where appropriate.
− Identifies and uses financial analysis tools and methods appropriate to the
purpose of the evaluation, including – ratio and trend analysis, CVP and
sensitivity analysis and appropriate categorisation, allocation and
presentation of financial information.
− Identifies, determines, explains and excludes the effect of any distortions
resulting from the application of IFRS or the entity’s internal or external
accounting policies on the financial performance of the entity.
− Identifies reasons for any areas of strength or concern in performance,
including management control over the entity and decision making, as well as
the nature of the entity’s product, competitive position, operations, activities
and operating environment.
− Identifies areas and makes and/or evaluates suggestions for potential
improvement in profitability, management of resources, enhancement of the
value of the entity or fulfilment of a mandate (or maximisation of service
delivery outcomes).
− Conducts further analysis of recommendations, utilising decision-making
techniques, and identifies further relevant financial considerations and
appropriate cost management techniques (including, but not limited to, cost
driver identification and analysis, the behaviour and relevance of costs to long-
term decision making and control and control mechanisms
5. Examination possibilities
Performance evaluation has been examined frequently in the ITC. However, you
should be aware of the behavioural implications of performance evaluation systems.

6. Assumed Knowledge
The following is assumed knowledge which you should have to tackle Performance
Evaluation.
1. Corporate Strategy
2. Governance structure, linking with compensation structure
3. Activity-based costing and Activity-based management
4. CVP and sensitivity analysis
5. Working capital management
6. Financial statement and ratio analysis
7. Integration
This topic can be integrated with Relevant Costing (decision making), Transfer Pricing,
Standard Costing, Sustainability and Corporate Governance linking with compensation
structure.
Transfer Pricing
Standard Costing
Performance
Evaluation
Ratio analysis
Compensation
schemes
(governance)

8. Course Notes
In the transfer pricing section, we highlighted the advantages and disadvantages of
decentralisation. Decentralisation highlights the problems of goal congruence, managerial
effort, and sub-unit autonomy. Thus, we need to consider the measurement of segment
performance in developing management motivation toward the achievement of
organisational goals. Performance evaluation is closely linked to the incentives and
rewards offered to management thus, it is important to select a performance evaluation
system that does not encourage mischievous behaviour.
8.1. Goals of Performance Evaluation

• Encourage cost control;
• Fairness in terms of only holding managers accountable for results within their
control;
• Encourage goal congruence;
• Hold managers accountable for resources/assets under their control; and
• Penalise mangers for actions that are not in the best interest of the company.
8.2. Responsibility accounting

Responsibility accounting is the term used to describe decentralisation of authority,
with the performance of the decentralised units measured in terms of accounting
results.
With a system of responsibility accounting there are five types of responsibility

centre: cost centre; revenue centre; profit centre; contribution centre; and
investment centre.
Type of Principal performance

Manager has control over…
responsibility measures
centre
Cost centre Controllable costs

• Variance analysis
• Efficiency measures
Revenue centre Revenues only • Revenues
Profit centre − Controllable costs • Profit

− Sales prices (including
transfer prices)
Contribution As for-profit centre except that • Contribution
centre expenditures reported on a
marginal cost basis

Type of Principal performance

Manager has control over…
responsibility measures
centre
Investment − Controllable costs • Return on

centre − Sales prices (including investment
transfer prices) • Residual income
− Output volumes • Other financial ratios
− Investment in non-
current assets and
working capital
There are strong arguments for producing two measures of divisional profitability —
one to evaluate managerial performance and the other to evaluate the economic
performance of the division.
Controllable profit is the most appropriate measure of a divisional manager’s

performance (should be measured relative to budget performance).
Looking at how the Invested Capital should be measured for performance evaluation:
a) If a manager's performance is being evaluated, only those assets which can be

traced directly to the division and are controllable by the manager should be
included.
b) If it is the performance of the investment centre that is being appraised, a

proportion of the investment in head office assets would need to be included
because an investment centre could not operate without the support of head
office assets and administrative backup. A similar point of view is that, these costs
would be incurred had the division been a stand-alone company.
8.3. Financial performance measures
a) Return on investment (ROI)

b) Residual income (RI)

c) Economic value added (EVA™)
Notes
ROI Profit Profit is usually NOPAT + [i x (1-t)
If NPBT is given, the adjustment for interest is (NPBT + i) x
Net Investment 74.25%
When evaluating an individual, allocated costs, such as
head
office costs are excluded from profit, as these are not
controllable by the manager. They can be included for the
evaluation of a division as they are costs that would be
incurred
had the division been a stand-alone company.
Profit - WACC x Net Investment = Total Assets - Current Liabilities or
RI Net
Investment Net Investment = Equity + Long Term Liabilities.
Only permanent sources of finance must be used when
calculating the net investment, i.e. the current portion of a
long
term liability is excluded from current liabilities.
Whether or not a source of finance is permanent depends
on the nature of the business. For example in a large
EVA (Profit ± adjustments) – retailer,
[WACC x (Net investment Trade payables could be a permanent source of finance if
± they
adjustments)] always make all purchases on credit, compared to a smaller
business where trade payables might just be bridging
form of finance.
The assets that are included in net investment are those that
are
controllable by the manager/division. Assets managed
centrally
are not included. Take note of whether the division is a profit
or
Investment
centre.

Net book value is often used to reflect the investment

although
this is often conceptually incorrect. It is preferable to
ascertain the
assets present value or replacement cost less
depreciation.
8.4. Return on Investment (ROI)

Return on investment (ROI) shows how much profit has been made in relation to the
amount of capital invested and is calculated as (profit/capital employed) x 100%.
The profit figure for ROI should always be the amount before any interest is charged.
Profit is usually - NOPAT + [interest x (1 – t)]
- If NPBT is given, the interest adjustment is (NPBT + interest) x 74.25%
ROI can have behavioural implications and lead to dysfunctional decision-making

when used as a guide to investment decisions. It focuses attention on short-run
performance whereas investment decisions should be evaluated over their full life.
Therefore, profit can be evaluated using either net assets or gross assets employed:
- NOPAT/Net Assets employed

- NOPAT/Net Assets + Accumulated Depreciation (Gross Assets)
- Net Assets employed = Total Assets – Current Liabilities
Note: Only permanent sources of finance must be used when calculating Net Assets.
Idle assets and assets acquired for future use (not employed in current year) are
omitted from the calculation.
Profit after depreciation as a % of net assets employed

This is probably the most common method, but it does present a problem. If an
investment centre maintains the same annual profit and keeps the same assets
without a policy of regular replacement of non-current assets, its ROI will increase
year by year as the assets get older. This can give a false impression of improving
performance over time. Therefore, there could be a disincentive to investment centre
managers to reinvest in new or replacement assets.
Profit after depreciation as a % of gross assets employed
This would remove the problem of ROI increasing over time as non-current assets
get older.
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The ROI based on gross book value suggests that the asset will perform consistently
in each of the years they are employed, which is probably a more valid conclusion.
However, using gross book values to measure ROI has its disadvantages. Most
important of these is that measuring ROI as return on gross assets ignores the age
factor and does not distinguish between old and new assets.
• Older non-current assets usually cost more to repair and maintain

• Inflation and technological change alter the cost of non-current assets
The theoretical solution to the problem is to value assets at their economic cost (i.e.
the present value of future net cash inflows) but this presents serious practical
difficulties.
An alternative calculation of ROI is the Du Pont model:
ROI = [Sales/Invested Capital = (Asset turnover) ] x [Net Income/Sales = (N.P margin)]

= Net Income/Invested Capital
8.4.1. Massaging the ROI
If a manager's large bonus depends on ROI being met, the manager may feel
pressure to massage the measure. The asset base of the ratio can be altered
by increasing/decreasing payables and receivables (by speeding up or delaying
payments and receipts).
8.4.2. ROI and new investments
If investment centre performance is judged by ROI, we should expect that the

managers of investment centres will probably decide to undertake new capital
investments only if these new investments are likely to increase the ROI of
their centre and thus the required rate of return(WACC) of the company might
be disregarded.
8.4.3. Advantages of using ROI

• As it is a relative measure (%), therefore comparisons with other divisions,
companies and available investments are possible;
• It reveals information about cost control and asset management; and
• It is simple to calculate and easily understood by managers.
• External stakeholders (analysts/investors) usually use ROI as a measure of
overall company performance.

8.4.4. Disadvantages of using ROI

• It encourages management to either not replace assets or inappropriately
sell assets. This decreases the denominator and increases ROI;
• ROI does not support goal congruence. The acceptable return on a new
project for the company is WACC. If WACC< Project A < ROI, such a project
will not be accepted as it will reduce the ROI of the division, but it would
have created value for the company. If Project A is an existing project, a
manager might discontinue it in order to boost ROI resulting in shrinkage
of the business;
• ROI can result in acceptance of value destroying projects. If ROI < Project
A< WACC, Project A will be accepted, as it will boost the ROI of the division,
but since the return is less than WACC, value is being destroyed; and
• ROI encourages management to target percentage returns and not to
maximise returns in absolute terms i.e. they will rather accept a R5m
investment that returns 30% (R1.5m) rather than a R10m investment that
returns 20% (R2m). As long as WACC is less than 20% the second
investment should be accepted.
• It is easily manipulated (i.e. increasing/decreasing payables and
receivables, by speeding up or delaying payments and receipts, alters the
Net Assets).
8.5. Residual income (RI)

An alternative way of measuring the performance of an investment centre, instead of
using ROI, is residual income (RI). Residual income is a measure of the centre's profits
after deducting a notional or imputed interest cost.
Formula = Profit – (WACC x Net Investment)
Only permanent sources of finance must be used when calculating the net investment
(i.e. the current portion of a long-term liability is excluded from current liabilities)
The imputed cost of capital might be the organisation's/division’s cost of borrowing

or its weighted average cost of capital.

8.5.1. Advantages of RI
a) It is claimed that RI is more likely to encourage goal congruence
Residual income will increase if a new investment is undertaken which earns
a profit in excess of the imputed interest charge on the value of the asset
acquired. In contrast, when a manager is judged by ROI, a marginally
profitable investment would be less likely to be undertaken because it would
reduce the average ROI earned by the centre as a whole.
b) Aligned with NPV principles, this encourages long-term based decisions.
c) Residual income is more flexible since it enables different cost of capital
percentages to be applied to different investments that have different levels
of risk.
8.5.2. Disadvantages of RI
a) It is an absolute measure and therefore comparisons are difficult; and
b) It encourages cutting of discretionary expenditure that could have long-
term benefit, for example training costs.
If RI is used it should be compared with budgeted/target levels which reflect

the size of the divisional investment.
8.6. Economic Value Added (EVA)

EVA is based on the residual income concept. It incorporates adjustments to the
divisional financial performance measure for distortions introduced by GAAP. EVA is
designed to measure the value added to shareholder wealth and to motivate
managers to maximise shareholder value.
EVA = (Profit ± adjustments) – [WACC x (Net Investments ± adjustments)]
a) Managers can increase shareholders value by:

i. Increasing the return on existing assets;
ii. Investing in new assets which generate a return which is higher than the
WACC; and
iii. Selling assets where the return on capital is below the WACC. This happens
when the present value of the future economic cash flows (economic
value) is less than the disposal value.
b) Adjustments are intended to convert historic accounting profit to an
approximation of economic profit. Certain accounting adjustments typically made
are:
c) Expenditure that has the potential for enduring benefit. For example, the costs of
a major marketing campaign would be expensed in the year incurred, but from an
EVA perspective, these costs would be capitalised and impaired over the period
that the benefits were expected to accrue.

d) Operating leases are capitalised and expensed over the life of the asset. This is
because the asset base would otherwise be understated. The opening balance of
the leases that is included is the present value of the lease commitments. The pre-
tax cost of debt is used as the discount rate. The net profit is adjusted by adding
back the lease expense and replacing this with the depreciation of the capitalised
lease.
e) The profit must be adjusted from the absorption costing to variable costing basis.
8.6.1. Advantages of EVA

i. It considers risk (WACC)
ii. Flexible measure (i.e. WACC can be adjusted for divisional specific risk)
iii. Avoids accounting manipulation
iv. It is based on NPV and working capital management principles
v. It motivates decisions in the interest of the business.
8.6.2. Disadvantages of EVA

i. It is an absolute measure (i.e. difficult to compare organisations which are
different in size).
ii. Complex calculation
iii. Accounting based measure
8.7. Accounting-based measures and a company-wide WACC

Disadvantages of using accounting-based measures and a company-wide WACC
include:
• Managers are encouraged to reduce potentially beneficial discretionary

expenditure;
• Accounting figures can be manipulated;
• Accounting measures do not represent free cash flow; and
• The company WACC might not be representative of the risk of the division being
evaluated, which could make results look artificially poor or impressive.
8.8. Ways of over-coming the disadvantages

Ways of over-coming the disadvantages using accounting-based measures and a
company-wide WACC :
• More than one measure should be used;

• Some non-financial measures should also be used to evaluate performance
(consider the use of a balanced score card);
• Accounting figures can be adjusted in a similar manner to calculating EVA;
• Discounted EVA can be applied.

8.9. Financial statement Analysis and Ratios

This is a common method which is used to measure performance particularly
between companies, different departments or comparing with prior years.
SUMMARY OF COMMON FINANCIAL RATIOS
RATIO CALCULATION INTERPRETATION
Profitability ratios
Gross profit Sales − Cost of sales Indication of the

margin Sales margin available to
cover non-production
expenses
Operating profit Profit before interests and taxes Indication of the firm’s
margin Sales profitability without
regard to the interest
charges resulting from
the capital structure
Net profit Profit after taxes Shows after tax profit
margin Sales per dollar of sales.
Unacceptably low
margins could indicate
relatively low sales
prices or relatively high
costs (or both)
Return on total Profit before tax + interest Measure of return on
assets Sales total
investment in the
enterprise (from both
shareholders and
lenders)
Return on equity Profit after tax Measures return on
Shareholders equity investment by ordinary
shareholders
Earnings per Profit after tax − pref div Measures earnings
share Weighted Ave Number Of Shares available for each
ordinary share in issue
Liquidity ratios

Current ratio Current assets Measures extent to

Current liabilities which short-term
creditors are covered
by short-term assets
(payable/ realisable
within a year)
Quick ratio (acid Current assets − inventory Measures ability to pay
test) Current liabilities short term obligations
without relying on sale
of inventories
Inventory to net Inventory Measures extent to
working capital Current assets − Current liabilities which the firm’s
working capital is tied
up in stock
Solvency ratios
Debt to assets Total debt Measures extent to

(Gearing ratio) Total assets which operations have
been financed by
borrowed funds
Debt to equity Total debt Measures funds

Shareholders equity provided by lenders
versus funds provided
by owners
Interest cover Profit before interest and tax Measures extent to

Total interest expense which earnings can
decline without the
firm defaulting on
finance costs
Efficiency ratios
Inventory Sales Indicates

turnover Finished goods on hand appropriateness of
inventory of finished
goods held
Accounts Accounts receivable Measures average

× 365
receivable Credit sales length of time for the
collection period

firm to collect its credit

sales
Fixed assets Sales Measures utilisation of

turnover Fixed assets the firm’s assets
Other
P/E ratio Current market price per share Measures market

After tax earnings per share expectations of future
earnings
Dividend pay-out Annual dividend per share Indicates the

ratio After tax earnings per share percentage of profits
paid out as dividends
Dividend cover Profit after tax − pref div Measures the capacity
Dividend paid to ordinary shareholders of an organisation to
pay dividends out of
the profit attributable
to shareholders
8.10. Non-financial performance measures

Non-financial performance measures are important if the available financial
performance measures not completely reflect the manager’s contribution to the
firm’s total value. Again, non-financial performance measures serve as an indicator for
the firm’s long-term performance. From a motivation point of view, non-financial
measures can be helpful because any combination of performance measures that
reduces the risk imposed on the agent through a contract is beneficial to the principal.
Furthermore, combining different performance measures may help the principal in
inducing specific activities, and thereby to reduce managerial short-sightedness.
Generally, non-financial measures have no intrinsic value for the director. Rather, they
are leading indicators that provide information on future performance not contained
in accounting measures.

8.11. The Balanced Scorecard

The need to integrate financial and non-financial measures of performance and
identify key performance measures that link measurements to strategy led to the
emergence of the balanced scorecard. The balanced scorecard was devised by Kaplan
and Norton in 1992. According to Kaplan and Norton, previous performance
measurement systems that incorporated non-financial measurements used ad hoc
collections of such measures, more like checklists of measures for managers to keep
track of and improve than a comprehensive system of linked measurements. The
balanced scorecard philosophy creates a strategic focus by translating an
organization’s vision and strategy into operational objectives and performance
measures for the following four perspectives.
Strategy is implemented by specifying the major objectives for each of the four
perspectives and translating them into specific performance measures, targets and
initiatives. There may be one or more objectives for each perspective and one or more
performance measures linked to each objective. Only the critical performance
measures are incorporated in the scorecard.
8.11.1. Four components of the balanced scorecard

a. The Learning and Growth Perspective - improve and create value?
To ensure that an organization will continue to have loyal and satisfied
customers in the future and continue to make excellent use of its resources,
the organization and its employees must keep learning and developing. Hence
there is a need for a perspective that focuses on the capabilities that an
organization needs to create long-term growth and improvement. This
perspective stresses the importance of organizations investing in their
infrastructure (people, systems and organizational procedures) to provide the
capabilities that enable the accomplishment of the other three perspectives’
objectives.
b. The Internal Business Process Perspective - where must we excel?
The internal business perspective requires that managers identify the critical
internal processes for which the organization must excel in implementing its
strategy. Critical processes should be identified that are required to achieve
the organization’s customer and financial objectives.
c. The Customer Perspective - how do customers see us?

The customer perspective should identify the customer and market segments
in which the business unit will compete. The customer perspective underpins
the revenue element for the financial perspective objectives. Typical generic
objectives in this quadrant increasing market share, increasing customer

retention, increasing customer acquisition, increasing customer satisfaction

and increasing customer profitability.
d. The Financial Perspective - how do we look to shareholders?
The financial perspective specifies the financial performance objectives
anticipated from pursuing the organization’s strategy and the economic
consequences of the outcomes expected from achieving the objectives
specified from the other three perspectives. Therefore, the objectives and
measures from the other perspectives should be selected to ensure that the
financial outcomes will be achieved. Three core financial themes that drive the
business strategy include revenue growth and mix, cost reduction and asset
utilization.
Examples
Internal business Process – internal measures of efficiency, variances, quality and time
Learning and growth – innovation, new products
Customer – new customers, customer satisfaction
Financial – RI, ROI, focus on cost reduction, asset utilisation, revenue growth
8.12. Tips and examination technique

It is important to identify that the appropriate type of responsibility centre will depend
on the degree of autonomy given to the manager. Managers cannot be held
responsible for issues beyond their control.
With investment centres there are two generally accepted measurement techniques,
Return on Investment and Residual Income. While these two performance
measurement methods are very similar, the residual income is regarded as being
conceptually superior as it sets managers the correct hurdle rate for decision-making.
8.13. Performance evaluation: Guidelines

How to approach a question:
− Make sure you understand how to analyse Income statement and Balance sheet –
− Go through the financial statements and identify unusual items, or big changes
between current and preceding years.
− Go through ratios to identify problem areas (Traditional, Line-by-line = common
size, Non-financial ratios)
− Understand information in question:
• What has been provided: internal management accounts (Variable costing
analysis, good for breakeven point and capacity analysis)/ external Annual

Financial Statements (IFRS) – good for seeing if company has even made a
profit or if there is a positive cash balance
• Ensure the problem areas identified in ratios tie into information about
company eg, poor debtors collection ties into high debtors; huge restructuring
in current period ties into a large increase in fixed costs, working capital
management issues etc.
− Structure:
− General comments from scenario – issues identified through reading through
question, for example:
• Sales decreasing
• High debtors: now selling more on credit
• High stock, short shelf life
• Ratio analysis focusing on problem areas
− Discuss working capital management (if applicable)
− Discuss profitability and sustainability issues
− Break Even Point, capacity and borrowings (Debt/Equity) – especially if the company
has made a loss, can it ever break even!
− If possible, discuss Economic Value Added

9. Practice Question
Background
Zip Bottling Co. Ltd has been in business for five hectic years. During this time the business
has grown enormously. The reason for this is the drink called Zip which has taken a small but
profitable share of the market for low alcohol drinks. Zip Bottling Co. Ltd obtained the
franchise for the drink in Japan at the beginning of 2005 and has manufactured in a single
manufacturing facility ever since then. Expansion of the facility commenced in 2008 and was
completed in May 2009. Expansion consisted of additional fermentation, packaging and
pasteurising facilities. The plant had been considered too large when it was completed but it
is now well utilised even to the extent of sometimes working double shifts. No revaluation of
plant and machinery is put through the books and the figure shown in the balance sheet is
cost less accumulated depreciation. The property on which the business is situated, has
appreciated over the years and the company has re-valued the land and buildings each year.
Of late, the growth in volume sales has slipped somewhat, as the price of the product has
increased over the five years to the point that it is now creating some market resistance. The
main cause of the increase in selling price is considered by management to be the increase in
raw material costs.
The key ingredient in Zip is a base supplied by Japan which defies all analysis but smells like a
mixture of cream soda and yeast. It causes the fermentation of the basic mix of rice mash and
fruit juices and adds some flavour as well. As this is an imported component, it is subject to
exchange rate fluctuations as well as normal price increases and is now becoming very
expensive. The problem is that the drink cannot be made without the base. The company uses
a variable costing system and, as these are internal management financial statements, stocks
are valued at variable cost. The company has a stable labour force and treats all labour costs
as fixed costs. Thus, variable costs are primarily raw materials.
Zip was originally marketed through bottle stores but in later years has been marketed
through supermarkets as well. The supermarkets have had their effect on the credit terms
granted. Most of the volume is now through the supermarket chains.
Zip has an alcohol level of 1.5% and is slightly fizzy. It has a sweetish taste and is considered
to appeal to the younger set. Because of this the company has recently launched a massive
TV and radio advertising campaign. The bulk of this cost is still to be incurred in the coming
year. The management are a little concerned as they have stocked up with the product in
anticipation, but the shelf life of the product is only eight weeks. After eight weeks it starts to
go sour and darkens unacceptably.
The company only sells Zip in a non-returnable 500ml bottle which is shrink wrapped in a six
pack. The storage of the finished product is on pallets. The company has started on a

programme to replace the pallets as many of them are five years old and are starting to break
up. (Note that there are 200 bottles in a hectolitre - hl).
Set out below are the balance sheet, income statement and cash flow statement prepared by
the accountant. He has also calculated some ratios.
ZIP Bottling Company Limited

Statement of Financial Position as at 31 2008 2009 2010
March
Capital
Share capital 2 000 000 2 000 000 2 000 000
Non-distributable reserve 485 490 629 100 754 510
Retained earnings 1 935 160 4 322 390 7 007 070
4 420 650 6 951 490 9 761 570
Interest bearing debt
Bank overdraft 6 450 562 640 1 509 850
Long term loans 0 476 630 1 813 620
6 450 1 039 270 3 323 470
Capital employed 4 427 100 7 990 760 13 085 040
Non-current assets
Land and buildings 1 528 600 1 672 210 1 797 620
Plant and machinery 952 800 1 644 300 2 393 600
Motor vehicles 286 000 339 000 691 000
Returnable containers and pallets 193 400 283 800 419 000
2 960 800 3 939 310 5 301 220
Current assets
Bank and cash 6 800 9 400 1 160
Debtors - Trade 1 253 790 3 182 290 5 487 640
- Other 32 770 52 830 79 230
Stocks - Finished goods 303 030 719 790 1 458 930
- Work in progress 71 960 133 690 310 330
- Raw materials 977 390 2 018 130 3 829 690
- Other 38 650 101 660 237 670
2 684 390 6 217 790 11 404 650
Current liabilities
Creditors - Trade 517 900 922 100 1 859 930

- Excise 373 800 644 800 975 470

- Accruals & Prov. 12 710 21 680 42 330
Receiver of Revenue 313 680 577 760 743 100
1 218 090 2 166 340 3 620 830
Net working capital 1 466 300 4 051 450 7 783 820
Employment of capital 4 427 100 7 990 760 13 085 040
Income Statement for year ended 31

March 2008 2009 2010
SALE VOLUME hls 107 100 154 300 188 600

PRODUCTION VOLUME hls 108 500 165 100 214 400
GROSS SALES INCOME 21 094 900 35 563 570 51 998 730
Excise duty 4 772 100 8 231 370 12 452 800
Promotional discount 772 600 1 163 400 2 197 430
NET SALE INCOME 15 550 200 26 168 800 37 348 500
Variable cost of sales 4 908 540 8 443 170 13 071 820
GROSS MARGIN 10 641 660 17 725 630 24 276 680
Fixed costs 7 082 350 12 253 620 18 103 320
Depreciation 274 340 361 640 595 610
3 284 970 5 110 370 5 577 750
Interest received 3 800 5 500 5 800
Miscellaneous income 7 440 9 140 15 280
OPERATING PROFIT 3 296 210 5 125 010 5 598 830
Interest - Long term loan 0 88 970 340 960
- Other 850 60 130 283 850
PROFIT BEFORE TAX 3 295 360 4 975 910 4 974 020
Taxation 1 614 730 2 338 680 2 039 350
PROFIT AFTER TAX 1 680 640 2 637 230 2 934 670
Dividends paid 200 000 250 000 250 000
1 480 640 2 387 230 2 684 670
ZIP BOTTLING COMPANY LTD CASH FLOW STATEMENT FOR YEAR ENDED 31 MARCH
2008 2009 2010
Cash generated from operating activities: $000's $000's $000’s

Operating profit 3 296 210 5 125 010 5 598 830

Add: Depreciation 274 340 361 640 595 610

Cash generated from operations 3 570 550 5 486 650 6 194 440
Cash utilised/generated - working capital
- Stock 554 320 1 582 240 2 863 350

- Debtors 443 970 1 948 560 2 331 750
- Creditors & accruals (156 440) (684 170) (1 289 150)
Cash generated from operating activities 2 728 700 2 640 020 2 288 490
Finance costs 850 149 100 624 810
Taxation paid 1 386 910 2 074 600 1 874 010
Cash available from operating activities 1 340 940 416 320 (210 330)
Dividends 200 000 250 000 250 000
Cash retained from operating activities 1 140 940 166 320 (460 330)
Cash utilised in investment activities:

Additions to fixed assets
- Capital cost of:
- Maintaining operations 197 140 437 930 1 327 200
- Expanding operations 960 280 758 610 504 910
Net cash invested 1 157 420 1 196 540 1 832 110
Funding requirement 16 480 1 030 220 2 292 440
Cash injected from financing activities

Bank overdraft 6 450 556 190 947 210
Long term loan 0 476 630 1 336 990
Increase/(Decrease) in borrowings 6 450 1 032 820 2 284 200
Decrease/(Increase) in cash on hand 10 030 (2 600) 8 240
Total financing 16 480 1 030 220 2 292 440
Ratios at 31 March 2008 2009 2010
GROSS MARGIN % 68.4% 67.7% 65.0%

Gross margin x 100
Net sales income
OPERATING PROFIT TO SALES 21.2% 19.6% 15.0%

Operating profit x 100
Net sales income

SALES TO CAPITAL EMPLOYED 3.51 3.27 2.85

Net sales income
Capital employed
DEBTORS DAYS 22.3 33.2 39.1

Total debtors x 365
Gross sales
STOCK DAYS (TOTAL STOCK) 103.4 128.5 163.0

Total stock x 365
Cost of sales
STOCK DAYS (FINISHED GOODS STOCK) 22.5 31.1 40.7

Finished goods stock x 365
Cost of sales
STOCK DAYS (RAW MATERIAL STOCK) 72.7 87.2 106.9

Raw material stock x 365
Cost of sales
CREDITORS DAYS 38.5 39.9 51.9

Trade creditors x 365
Cost of sales
(in the absence of a purchases figure)
TRADE CYCLE 87.2 121.8 150.2

RETURN ON CAPITAL EMPLOYED 74.5% 64.1% 42.8%
Operating profit x 100
Capital employed
RETURN ON EQUITY 38.0% 37.9% 30.1%

Net profit after tax x 100
Shareholders' equity

Required
Management has asked you to analyse and report on the reasons for the poor results for
the year and to suggest any ways to improve profitability in both the short and the long
term. If insufficient information is supplied for full comment, indicate what further
information you would call for.

Suggested Solution
Analyse and report on the reasons for the poor results for the year and to suggest any
ways to improve profitability in both the short and the long term.
• If insufficient information is supplied for full comment, indicate what further

information you would call for.
This is an internal set of financial statements and thus they do not have the same format as
published statements. The intention is for the analysis to be on the company’s performance
from a managerial accounting point of view.
This is further emphasised by the ratios supplied (mostly focusing on operating profit and
asset management) and by the low gearing (interest bearing debt to share capital and
reserves is 34% in 2010).
The company has made some poor strategic decisions, and this has placed the company in
danger of not continuing its profitability in the long term. For this reason, the headings
chosen are:
• Profitability
• Asset management
• Liquidity and cash flow management
• Risk
Profitability:
Operating profit generated from sales:
This ratio depends on selling prices, volumes, variable cost management and fixed cost
management.
Selling prices and contribution:
As the company manufactures and sells one product, it is possible to analyse its pricing
strategy. The selling prices and contributions for the respective years are:
2008 2009 2010

Gross selling price per hl 196.96 230.48 275.71
Gross selling price per bottle 0.98 1.15 1.38
Percentage increase 17.0% 19.6%
Excise per hl 44.56 53.35 66.03
Net selling price per hl 145.19 169.60 198.03
Variable cost per hl 45.83 54.72 69.31


Contribution per unit 99.36 114.88 128.72
It is evident that the management was unable to pass the excise increase on to the
customer. This is evidenced by the fact that even with this lower selling price increase, the
increase was met with resistance from the market.
The excise per hl increased by 19.7% in 2009 yet the gross selling price increased by only
17%.
In 2010 the excise increased by 23.8% yet the gross selling price increased by only 19.6%.
The gross selling price per unit has been calculated to compare to the prices charged by
similar products per bottle.
This is the wholesale price and the bottle store or supermarket will need to add its mark
up. The price does not seem excessive but a comparison to cider, beer etc. is needed.
It seems that the management consider the product to be price sensitive. There are four
clues that this may be so:
• The comment in the details of the case that the selling price is creating some
resistance.
• The reluctance of management to pass on all the excise cost increase.
• The change to marketing through supermarkets to endeavour to gain more sales
with a lower retail mark up
• The high promotional discounts offered to attempt (presumably) to generate
additional sales volume.
This pricing policy had an effect on the net income per unit which is increasing by 16.8%
year on year.
When this net income per unit is compared to the variable cost per unit, it is evident that
the pricing policy has not taken cost increases into account.
Variable costs have increased by 19.4% in 2009 and a huge 26.7% in 2010.
The net effect of this is the poor contribution per unit. This combined with the huge
increases in fixed costs makes the break-even units higher each year:
The break-even units on these fixed costs, using the contribution per unit calculated above,
would be:
2008 2009 2010

Calculation $7 356 690/$99.36 $12 615 260/$114.88 $18 698

930/$128.72
BEP units = 74 041 = 109 813 = 145 269
For a product, such as this, which could have a short life cycle, it seems foolish to increase
the fixed costs by 71.5% in 2009 and 48.2% in 2010.
It appears the company is increasing capacity and operating gearing in the assumption that
volume will continue to increase year after year.
If inflation is assumed at 15% and 2008 is taken as a base, the fixed costs (including
depreciation) for the three years should have been:
2008 2009 2010
Fixed costs $7 356 690 $8 460 194 $9 729 223
It is no wonder that the operating profit to sales ratio has declined from 21.2% to 19.6% to
15% over the three years.
Taking the above into account the company should consider several actions which include:
− Investigate the pricing of the product to ensure that the maximum cost is passed
onto the consumer without affecting the volume and the total sales
− Forecast the volume anticipated with that volume and ensure that the facilities are
not expanded if not required.
− Consolidate and make full use of the current infrastructure without incurring any
additional fixed costs. The use of activity-based costing could be of benefit to
identify value added and non-value-added costs in the operating areas and
discretionary and fundamental costs in the support areas. It should be possible to
manage the fixed costs down as it is likely that there is excessive spending.
− Implement a variable cost management programme to ensure that there is

minimum wastage. A part of the variable cost increase is the imported base. An
analysis of this cost should be undertaken to ensure that there is minimum loss.
Perhaps negotiations can be instituted with the supplier to reduce the price.
Asset management:
Sales generated from assets:
The sales to capital employed ratio has declined from 3.51 to 3.27 to 2.85. This could either
be viewed as reducing the number of times fixed assets plus working capital has turned

over or a reduction in the rand sales generated by the asset base. Either way, there is a
problem.
In analysing the problem, it is useful to separate working capital from fixed assets and
calculate the ratio for these separately. (Net sales are used as the company does not benefit
from the gross sales). Note that as assets are not re-valued, the net book value of fixed
assets may give a distorted picture.
2008 2009 2010
Net sales to fixed assets: 5.25 6.64 7.05
Net sales to working capital: 10.61 6.46 4.80
Despite the substantial increases in fixed assets, the problem clearly lies in working capital
management.
This conclusion is supported by the increase in the net trade cycle which has increased from
87.2 days to 121.8 days to 150.2 days.
Looking at the individual elements of working capital:
− Debtors days have extended from 22.3 days to 33.2 days to 39.1 days. Much of this
is due to the change in policy where sales are being made through supermarkets.
− These organisations usually take longer credit terms. The carrying cost of these
debtors is increasing each year and is placing pressure on the company to borrow
to finance these debtors. In addition, problems with bad debts could arise.
− Stock days reflect a major problem in the company. Production seems to have
delusions about the possible sales and each year are manufacturing more than is
being sold (see income statement volumes).
− There is clearly a problem with forecasting and producing to anticipated demand
rather than to actual demand. There is excessive stock in all categories of stock
particularly finished goods and raw materials.
− With a shelf life of 8 weeks, the company is facing possible large stock write offs.
Further, the carrying cost of this excessive stock is placing pressure on the company
to finance its working capital.
− Creditors days have been estimated using cost of sales. This is not an accurate figure
but does reflect that the company is taking an increasingly long time to pay its
accounts.
− The result is either a loss of discounts or an increase in price from the supplier to
cover the longer terms taken. The company may be losing its good relationships
with its suppliers.

Clearly the company is overtrading. Actions that management should consider include:
Formulation of a credit policy and the institution of credit management to ensure that the
laid down terms are adhered to.
A major drive on both production costs and stock levels is required. This points to the need
to institute JIT principles. The company needs have a good look at its production process to
ensure minimum non-value-added time such as wait, set up, inspection, move times etc.
They need to set up controls over variable costs. Production should be changed to the pull
system with quantities geared to actual demand rather than anticipated demand.
Liquidity and cash flow management:
Because of poor operating management, i.e. cost and working capital management, there
has been a decrease in profitability and an increase in working capital.
As a result, the company has been forced to fund operating costs and working capital from
borrowings.
The problem is not serious as yet, but the cash flow statement shows cash retained from
operating activities to have declined from 1 140 940 in 1988 to 166 320 in 2009 and a
negative 460 330 in 2010.
The company has invested in fixed assets consistently over the three years, both to
maintain operations and to expand operations.
This has resulted in an increase in borrowings and in turn in the interest on those
borrowings. Interest cover (using cash generated from operating activities) has declined
from 17.7 times [$2640020/($88970+$60130)] in 2009 to 3.7 times
[$2288490/$340960+$283850)] in 2010.
The average time take to pay total liabilities, using cash generated from operations
(operating profit plus non-cash items), is still low and has increased as follows:
2008 2009 2010
Total liabilities $1 224 540/$3 570 $3 205 610/$5 486 $6 944 300/$6 194
550 650 440
= 0.34 = 0.58 = 1.12
There are no specific management actions that need to be directed toward liquidity
management.

If the overall stock level is reduced by, say, 40 days, this would release approximately
$ 1.4 million (based on 40 times the daily cost of sales) into the business.
Similarly, if debtors were reduced by, say, 5 days this would release approximately
$700 000 (based on 5 times the daily gross sales) into the business.
Some of this would be used to reduce creditors days but will still have a considerable impact
on the interest-bearing debt.
Risk
The return on equity of this business has declined considerably in 2010.
Several factors need to be considered when assessing whether the 30.1% return is still
acceptable.
This appears to be a high after-tax return, but fixed assets have not been revalued. If this
were done, the return would decline.
One also must take into consideration, the likelihood of the return continuing in future
years and the vulnerability of the company to fluctuations in economic activity.
The company is reliant on a single product which may have a short product life cycle.
Despite this, the company has invested considerable amounts in anticipation of future
growth in sales.
If the product goes out of favour with the group who are currently buying it, the company
will not be able to generate sufficient sales to be profitable.
The company should be investigating entering the market in similar product such as cider.
The low alcohol market is very competitive, and the company is faced with tough
competitor action if it grows too big.
The company is reliant on an overseas supplier who is the only supplier of a key ingredient.
This adds to the risk as this source of supply can be removed at any time unless there is a
contract.
The high level of working capital and fixed costs makes it difficult for the company to reduce
its scale of operations quickly if volumes change downwards.
The huge increases in fixed costs coupled with the decline in contribution per unit has
resulted in an ever-increasing break even.
Any change in the economic climate could place the company in a non-profitable situation.

Conclusion
The company should stop expanding with immediate effect and instead determine demand
for Zip in the current market. This may require them to undertake market research to
establish this. This may result in the company having to reduce capacity in the most cost-
effective way.
The company should look for new customers to sell their product to as well as opportunities
to differentiate their product in order to stimulate sales demand.
The company should improve working capital management by introducing a new working
capital policy (benchmarked with other companies selling to supermarkets), as well as a
new working capital system to manage working capital more efficiently.
This will resolve to a large extent the liquidity problems. The company should introduce JIT
to reduce the large quantities of the different types of inventory on hand.

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APPLIED MANAGEMENT ACCOUNTING AND FINANCE STUDY PACK 402 – MODULE 2 2021

CHARTERED ACCOUNTANTS ACADEMY

MANAGEMENT ACCOUNTING & FINANCE DEPARTMENT

CERTIFICATE OF THEORY IN ACCOUNTING

STUDY UNIT 2: PERFORMANCE EVALUATION

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2. Learning objectives under Performance Evaluation

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4. Competence Framework expectation

COMPETENCE AREA: MANAGEMENT DECISION MAKING AND CONTROL

VI-1.1 Identifies management’s information needs and the entity’s key

− Determines what information is relevant and useful to both management and

VI-1.2 Evaluates the design of the entity’s responsibility accounting system

− Gains an understanding of the arrangement of an entity’s governance

4|P ag e ©PROPERTY OF CAA LEARNING MEDIA 2021

VI-1.3 Analyses the financial performance of an entity and makes and/or

− Analyses, evaluates and explains the financial performance of the entity, or

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8.1. Goals of Performance Evaluation

8.2. Responsibility accounting

With a system of responsibility accounting there are five types of responsibility

Type of Principal performance

Cost centre Controllable costs

Revenue centre Revenues only • Revenues

Profit centre − Controllable costs • Profit

7|P ag e ©PROPERTY OF CAA LEARNING MEDIA 2021

Type of Principal performance

Investment − Controllable costs • Return on

Controllable profit is the most appropriate measure of a divisional manager’s

a) If a manager's performance is being evaluated, only those assets which can be

b) If it is the performance of the investment centre that is being appraised, a

8.3. Financial performance measures

a) Return on investment (ROI)

8|P ag e ©PROPERTY OF CAA LEARNING MEDIA 2021

b) Residual income (RI)

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Net book value is often used to reflect the investment

8.4. Return on Investment (ROI)

Profit is usually - NOPAT + [interest x (1 – t)]

- If NPBT is given, the interest adjustment is (NPBT + interest) x 74.25%

ROI can have behavioural implications and lead to dysfunctional decision-making

- NOPAT/Net Assets employed

Profit after depreciation as a % of net assets employed

Profit after depreciation as a % of gross assets employed

10 | P a g e ©PROPERTY OF CAA LEARNING MEDIA 2021

• Older non-current assets usually cost more to repair and maintain

An alternative calculation of ROI is the Du Pont model:

ROI = [Sales/Invested Capital = (Asset turnover) ] x [Net Income/Sales = (N.P margin)]

8.4.1. Massaging the ROI

8.4.2. ROI and new investments

If investment centre performance is judged by ROI, we should expect that the

8.4.3. Advantages of using ROI

11 | P a g e ©PROPERTY OF CAA LEARNING MEDIA 2021

8.4.4. Disadvantages of using ROI

8.5. Residual income (RI)

Formula = Profit – (WACC x Net Investment)

The imputed cost of capital might be the organisation's/division’s cost of borrowing

12 | P a g e ©PROPERTY OF CAA LEARNING MEDIA 2021

If RI is used it should be compared with budgeted/target levels which reflect

8.6. Economic Value Added (EVA)

EVA = (Profit ± adjustments) – [WACC x (Net Investments ± adjustments)]

a) Managers can increase shareholders value by: