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Chapter 8
Performance Management
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Topic
1. Performance evaluation

2. Responsibility centres

3. Performance measures

4. The balanced scorecard

5. Budgetary control
 1. Performance evaluation
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Feedback control
• The term “feedback” is used to describe both the process of reporting back
control information to management and control information itself.

Input
resources
Feedback loop in the control
Plan, target or
cycle Operations
budget Compare
actual result Control action
with plan

Output (eg, actual

Measure
Feedback of output revenues,
outputs
information costs)
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Control cycle
• Step 1: Plans and targets are set for the future
• Step 2: Plans are put into operation
• Step 3: Actual results are recorded and analysed
• Step 4: Information about actual results is fed back
• Step 5: The feedback is used by management to compare actual
results with plans or targets
• Step 6: By comparing actual and planned results, management
can:
- Can take control action
- Can decide to do nothing
- Can alter the plan or target
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Features of effective feedback
• Clear and comprehensive
• Apply 'exception principle': highlight the significant differences
between target and the actual results for
• Controllable costs and revenues should be separately identified
• Report should be produced on a regular basis
• Reports should be made available to managers in a timely fashion
• Feedback information should be sufficiently accurate
• Irrelevant detail should be excluded
• Report should be communicated to the manager who has
responsibility and authority to act on the information
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The behavioral impact of performance measurement

• Budget constrained
- Actual cost vs. budget
• Profit conscious
- Ability to increase the general effectiveness in relation to long-
term purposes
• Non-accounting
- The budgetary information is unimportant in performance
evaluation
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Summary of evaluation styles

Budget Profit Non -
constrained conscious accounting

Involvement with costs HIGH HIGH HIGH

Job-related tension HIGH MEDIUM MEDIUM

Manipulation of the accounting EXTENSIVE LITTLE LITTLE

reports

Relation with supervisor POOR GOOD GOOD

Relation with colleagues POOR GOOD GOOD

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Budget bias

Budget bias or manipulation of accounting reports is more likely to

occur if the manager is under pressure to achieve short-term budget targets.

Managers might introduce budget slack into their estimates => when a
manager deliberately overestimates costs and/or underestimates revenues, so
that they will not be blamed in the future for overspending and/or poor results.
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2. Responsibility centres
Divisionalisation

A large organisation can be structured in one of two ways:

- functionally (all activities of a similar type within a company, such
as production, sales, research, are under the control of the appropriate
departmental head)
- divisionally (split into divisions in accordance with the products or
services made or provided).
Divisional managers are then given the authority to make decisions
concerning the activities of their divisions.
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Factors affecting the degree of decentralisation

» Management style

» Size of the organization

» Extent of activity diversification

» Effectiveness of communication

» Ability of management

» Speed of technological advancement

» The geography of locations and the extent of local knowledge needed

 Adv vs. Dis adv of decentralisation 12

• Advantages
- Senior managers are freed from detailed involvement
- The quality of decisions is likely to improve
- Motivate managers
- Decisions should be taken more quickly
- Training for future senior managers
• Disadvantages
- Difficult to coordinate activities of the organisation
- Lack of goal congruence in decision making
- Lose control over day to day activities
- Difficult to evaluate performance of managers and their area of
responsibility .
- Duplication of some roles (i.e. administrative)
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Responsibility accounting

Responsibility accounting describes decentralisation of authority, with

the performance of the decentralised units or responsibility centres measured
in terms of accounting results.

• Cost centres

• Profit centres

• Revenue centres

• Investment centres
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Responsibility centre summary

Type of Manager has control over Principal performance
responsibility measures
centre
Cost centre • Controllable costs • Variance analysis
• Efficiency measures
Revenue centre • Revenue only • Revenues

Profit centre • Controllable costs • Profit

• Sales prices (including transfer • Profit margins
prices)
Investment • Controllable costs • Return on investment
centre • Sales prices (including transfer • Residual income
prices) • Other financial ratios
• Output volumes
• Investment in non-current assets and
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Cost centre
• A cost centre acts as a collecting place for certain costs before they are
analysed further
• A cost centre manager is responsible for, and has control over, the costs
incurred in the cost centre.
• Costs of the cost centres should be divided into:
- Controllable costs
- Uncontrollable costs
• Example:
- Production departments
- Personnel departments
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Revenue and Profit centre

• The manager of a revenue centre is responsible only for raising revenue

but has no responsibility for forecasting or controlling costs.
Example: Sales centre
• A profit centre is any unit of an organisation to which both revenue and
costs are assigned, so that the profitability of the unit may be measured.
- Key performance measure of a profit centre is Profit
Example:
Sale persons
Sale department
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Investment centres

• An investment centre is a profit centre whose performance is measured by

its return on capital employed (ROCE) and other subsidiary ratios, or by
residual income (RI).

• Example:
- Investment division
- A subsidiaries or branches (standing at parent company)
 Share services centres (SSC) 18

Advantages:
(a) reduced headcount
(b) associated reduction in premises and other overhead costs
(c) knowledge sharing should lead to an improvement in quality of the service
provided
(d) allows standard approaches to be adopted across the organisation
Disadvantages:
(a) loss of business specific knowledge
(b) removed from decision making
(c) weakened relationships
(d) cost inefficiencies
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Cloud accounting
• Cloud computing: 'ls a model for enabling ubiquitous, convenient, on-
demand network access to a shared pool of configurable computing resources
(e.g, networks, servers, storage, applications, and services) that can be rapidly
provisioned and released we minimal management effort or service provider
interaction'. (US Department of Commerce. National Institute of Standards and
Technology)

• Cloud accounting: An application of cloud computing where accountancy

software is provided in the cloud by a service provider.
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Cloud accounting
Benefits of cloud accounting
• Accounting information can be accessed from anywhere, at any time, as long as
internet access is available => Information can therefore be accessed quickly.
• The security systems in place will often be better than a small business can provide.
• The software updates are managed by the cloud accounting supplier.
• Back ups are made automatically by the cloud accounting supplier.
• Applications are usually rented rather than purchased => there are no upfront costs.
• Overhead costs can be reduced
• The software is running in the cloud => no need to worry about whether PCs are
powerful enough
• Files can shared via invitations rather than physically exchanging files => Collaboration
between users is easier .
• More cloud accounting licences can be purchased
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Cloud accounting
Risks of cloud accounting

• The supplier could fail and so a contingency plan is required

• There is a permanent need for internet access

• There is a risk of security breaches

• Legislation risks

• Unannounced changes or upgrades to software could be disruptive.

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3. Performance measures
The features of effective performance measures:
• They should promote goal congruence
• The measures should incorporate only those factors over which the
responsibility centre manager has control.
• They should encourage the pursuit of longer term objectives as well as
short-term.
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Potential problems with inappropriate performance measures

• Managers may manipulate information in order to ensure achievement of
the KPIs.
• The measures might cause demotivation and stress
• The measures might promote excessive concern for the control of short-
term costs
• They may lead to the assessment of a responsibility centre as an isolated
unit
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Performance measures
revenue
cost centre profit centre investment centre
centre
- Gross
- Cost - Revenue profit - Liquidity measures
variances variances margin
- Cost per - Revenue - Operating - Rate of inventory
unit earned per profit margin turnover
employee
- Cost per - % market share - Receivables and
employee achieved payables periods

- Other non- - Return on investment

financial - Growth in
revenue (ROI)
measures

- Residual income (RI)

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Return on investment (ROI)

ROI shows how much profit has been earned in relation to the amount of
capital invested in the centre.

Controllable divisional profit

ROI = X 100%
Divisional capital employed
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Residual Income

RI = Pre tax controllable profits –

imputed interest cost of the
Advantages of RI capital invested
(a) RI will increase when
investments earning above the
cost of capital are undertaken and
investments earning below the
cost of capital are eliminated. Disadvantages of RI
(b) Residual income is more • Does not facilitate comparisons
flexible between divisions of different sizes
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4. The balanced scorecard

The balanced scorecard involves the 5 steps:
 Identify the critical success factors for the business
 Identify the core competences and resources required to achieve them
 Develop the key performance indicators (financial and non-financial) to
best measure progress towards achieving the necessary competences and
resources
 Set targets
 Monitor performance
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The critical success factors

Financial perspective
How do we look to shareholders
and lenders?

Innovation & learning

Customer perspective VISION &
Can we continue to
How do customers see us? STRATEGY
improve and create value?

Internal business processes

What must we excel at?
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Non-financial performance measures

Non-financial performance measures include:

 the number of new products developed
 the rate of employee turnover
 customer praise/complaints
 the number of outstanding orders
 the number of warranty claims
 health and safety incident statistics
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Potential measures
FINANCIAL PERSPECTIVE
Goals Measures
Survival Cash flow
CUSTOMER PERSPECTIVE
Growth Sales revenue
Goals Measures
Cost reduction Unit costs
Time Product delivery lead times
Asset utilisation Working capital ratios
Risk Order books Quality Defect rates
Price compared with the prices of
competitors

Satisfaction Repeat purchases

 Potential measures
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INNOVATION & LEARNING PERSPECTIVE

Goals Measures
Employees The rate of staff turnover
Learning The number of days spent on staff training
Products and services The percentage of revenue generated by
new products and services

INNOVATION & LEARNING PERSPECTIVE

The number or percentage of quality control rejects

The average set-up time

The speed of producing management information
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Problems
Conflicting
measures

Too many
measures Selecting
measures

Problems

Interpretation Expertise
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5. Budgetary control

• the actual results should be compared with a

Budgetary control realistic budget for the actual activity level
achieved.

FIXED
VS FLEXIBLE
BUDG
ET BUDGET
 Budgetary control
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Fixed budget

• Fixed budgets prepared before beginning of budget period

• The budget is prepared on the basis of an estimated volume of production
or output and an estimated volume of sales
• Fixed budgets remain unchanged regardless of level of activity

Flexible budget

• Flexible budget changes as volume of activity changes

• Useful at planning stage
• Necessary for control
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Preparation of flexible budgets

• Step 1: Determine cost behaviour (fixed, variable or semi-variable)

• Step 2: Calculate the budget cost allowance for each cost item

Budget cost allowance = Budgeted fixed cost + (number of units x variable

cost per unit)
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Flexible budget and control

The correct approach to control is as follows:

- Identify fixed and variable costs
- Produce a flexible budget based on the actual activity level