ACCA – APM
ADVANCED PERFORMANCE
MANAGEMENT
STUDY NOTES
CONTENTS
Chapter #
Chapter Name
Page #
Tips to Pass the Exam
1
Introduction to Strategic Management
01
2
Environmental Influences
11
3
Performance Hierarchy and Budgeting
20
ACCA Questions Part 1 (Solution key provided by ACCA)
48
4
Business Structure and Management Accounting
61
5
The Environment Issue & Risk and Uncertainty
73
6
Management Accounting Information
100
7
Management Report
116
ACCA Questions Part 2
132
8
Financial Performance Measure in the Private Sector
138
9
Divisional Performance Appraisal
155
10
Performance Management in Not-For-Profit Organisation
173
ACCA Questions Part 3
179
11
Non-Financial Performance Measurement
191
12
The Role of Quality in Performance Measurement
193
13
Human Resource Management Issues
206
14
Balance Scorecard and Performance Issues
224
15
Corporate Failure
237
ACCA Questions Part 4
248
TIPS TO PASS THE EXAM
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Start the preparation early. Ideally plan to spend 2 hours daily on reading the notes and
study text .Otherwise you will be really frustrated and exhausted during exam days.
Try to understand the concepts and understand how they are applied
There is no substitute for practice. Need to be able to solve at least 5 past papers so that
you are able to comprehend the exam easily.
Try to solve the questions in exam room condition and record the time you are taking to
solve each question. Time Management is the key.
Never try to study on the last day before exam. This is your day to relax your brain before
the BIG DAY.
DO NOT WORRY, ALWAYS BE HAPPY! YOU HAVE THE POTENTIAL TO PASS THE EXAM
Intro to Strategic Management Accounting
APM – Study Notes
INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Learning Objectives
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Explain the role of strategic performance management in strategic planning and control
Discuss the role of performance measurement in checking progress towards the corporate objectives.
Compare planning and control between the strategic and operational levels within a business entity.
Discuss the scope for potential conflict between strategic business plans and short‐term localised
decisions.
Evaluate how models such as SWOT analysis, Boston Consulting Group, balanced scorecard, Porter’s
generic strategies and 5 Forces may assist in the performance management process.
Apply and evaluate the methods of benchmarking performance.
Assess the changing role of the management accountant in today’s business environment as outlined by
Burns and Scapens.
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Intro to Strategic Management Accounting
APM – Study Notes
Strategic Management Accounting
Strategic management accounting is a form of management accounting in which emphasis is placed on
information about factors external to the organisation as well as on nonfinancial and internally‐generated
information.
Traditional management accounting is more concerned with the achievement of internal financial performance
targets (e. g. budget).
The aim of strategic management accounting is to provide information that is relevant to the process of strategic
planning and control.
The Strategic Planning Process
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External analysis involves consideration of developments and circumstances outside the organisation which
may affect the organisation in the future. Relevant external factors include the law, politics, economics,
culture, technology and competition.
Internal analysis involves consideration of the strengths and weaknesses within the organisation. Relevant
internal factors include technical skills, know‐how, market reputation and liquidity.
SWOT analysis involves systematic consideration of the strengths and weaknesses of the organisation against
the background of the opportunities and threats it faces.
Gap analysis involves consideration of the difference between “where we are” and “where we want to be”
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Intro to Strategic Management Accounting
APM – Study Notes
Level Of Management
 Strategic management
 Tactical management
 Operational management
Management accounting system should provide information for strategic management, tactical management and
operational management
In many respects, strategic information, tactical information and operational information are concerned with the
same things (business plans and actual performance) but are provided in different amounts of detail and with
differing frequency. IT systems are used to provide this information
Strategic management is concerned with the development and execution of long term plans. Strategic
information needs are typically:
 About the whole organisation and are summarised
 Relevant to long term and forward looking
 Likely to be prepared on an ad hoc basis and may be taken from external sources
Tactical management is concerned with efficient and effective use of resources in the implementation of medium
term plans. Tactical information needs are typically:
 About individual departments and detailed
 Relevant to medium term and a mix of backward and forward looking material
 Likely to be prepared on a systematic and regular basis
Operational management is concerned with the day to day running of the business. Operational information
needs are typically:
 ‘task specific’ and very detailed, down to transaction level
 Relevant to the very short term period and they are backward looking
 Likely to be prepared regularly or continuously available on‐line
Role of Performance in Checking Progress
Vigilant and effective management systems ensure how well a business and its investment and expansion plans
succeed but many managers experience that as a business grows, they become more isolated from its operations.
Thus it is necessary to set up a system which can effectively manage the progress of a business. Here, performance
measurement systems play a major role.
A performance measurement system keeps track and updates the managers with all crucial information regarding
the current performance of the business. The system also facilitates in important task of setting up targets that
shape the strategies required by the business to grow.
Calculated measurements and target development may not be vital for small businesses, but for businesses that
are looking to expand and grow, these performance measurements provide essential controls. Good measurement
systems not only update on how different sectors of a business are working, but also equips managers to assess
factors that may affect the performance in any way, which in turn helps in managing performance more efficiently.
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Intro to Strategic Management Accounting
APM – Study Notes
It is important to carefully select what exactly the system needs to measure. The priority here is to focus on
quantifiable factors that are clearly linked to the drivers of success in your business and your sector. These factors
are known as Key Performance Indicators (KPIs). The factors selected for assessment should preferably be
quantitative but not necessarily financial as even though financial measures seem decisive about the progress of a
business, some non‐financial factors are too important to ignore. E.g. If the success and performance of a business
depends on customer service, then the performance measurement system should assess the number of
complaints received instead of financial measurement.
Once the key indicators are identified, a way to measure them should be set up. Following this, performance
targets should be set up to present goal clarity for everyone. Businesses have strategic visions but it is not easy to
make them clear for everyone so it is more suitable to break down the vision into understandable yet crucial
targets so that it is easier for everyone to manage and achieve them. Through this strategy, daily operations
throughout the business are focused on the set targets.
It is of equal importance to effectively manage all the information being received through the system. Better
managed information about KPIs will be a more effective management tool that unorganized data.
Planning and Control between Strategic and Operational Level
One of the most underlying and important activities of any business is the planning. When planning all different
aspects of a business are taken into consideration including the vision, goals and objectives of the company. It
requires careful thinking and analyzing according to the predicted future of the business. Strategic planning occurs
at corporate level while operational planning includes all planning processes taking place at the functional level.
Strategic planning focuses on the long‐term objectives of the company while operational planning focuses on the
short‐term objectives. This definition of roles helps use resources in a better way to achieve all company goals.
Strategic control assesses whether the strategies set are being implemented and whether they are working out as
expected. Strategic control is “the critical evaluation of plans, activities, and results, thereby providing information
for the future action”. Operational control on the other hand assesses the daily operations and whether they are
in accordance to the set objectives. Wherever performance fails to meet the set standards, actions to correct them
are taken instantly. These actions usually involve training, motivation, leadership, discipline, or termination.
Conflict Between Strategic Business Plans and Short Term Decisions
 Top‐down approaches to management may lead to conflict in decision making in organisations where
divisional autonomy & employee empowerment is practiced.
 Routine Strategic planning is normally made annually or for a longer period while localised decision cannot
wait for subsequent strategic plan even if inconsistent with it
 Decision flexibility of an organisation may become limited due to imposition of strategic business
plans. Organisation may not able to respond to changes in environment at the right time.
 Rigid strategic plans discourages creativity in employee decisions
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Intro to Strategic Management Accounting
APM – Study Notes
SWOT Analysis
The SWOT analysis combines the results of the environmental analysis and the internal appraisal into one
framework for assessing the firm's current and future strategic fit.
BCG matrix to assess business performance:
The Boston Consulting Group Matrix
There is a fundamental need for management to evaluate existing products and services in terms of their market
development potential, and their potential to generate profit. The Boston Consulting Group matrix, which
incorporates the concept of the product life cycle (PLC), is a useful tool which helps management teams to assess
existing and developing products and services in terms of their market potential. More importantly, the model can
also be used to assess the strategic position of SBUs, and in this respect it is particularly useful to those
organisations which operate in a number of different markets.
The matrix offers an approach to product portfolio planning. It has two controlling aspects, namely relative market
share (meaning relative to the competition) and market growth. Management must consider each product or
service that is marketed, and then position it on the matrix. This should be done for every product manufactured
or service provided, and management should then plot the position of competitors’ products and services on the
matrix in order to determine relative market share.
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Intro to Strategic Management Accounting
APM – Study Notes
Stars
Stars are products which have a good market share in a strong and growing market. As a product moves into this
category it is commonly known as a ‘rising star’. While a market is strong and still growing, competition is not yet
fully established. Since demand is strong, and market saturation and over‐supply is not an issue, the pricing of such
products is relatively unhindered, and therefore these products generate very good margins. At the same time,
manufacturing overheads are minimised due to high volumes and good economies of scale. These are great
products, and worthy of continuing investment for as long as they have the potential to achieve good rates of
growth. In circumstances where this potential no longer exists, these products are likely to fall vertically in the
matrix into the ‘cash cow’ quadrant (‘fallen stars’), and their cash characteristics will change. It is therefore vital
that a company has ‘rising stars’ developing from its ‘problem children’ in order to fill the void left by the fallen
stars.
Problem children
‘Problem children’ have a relatively low market share in a high‐growth market, often due to the fact that they are
new products, or that they are yet to receive recognition by prospective purchasers. In order to realise the full
potential of problem children, management needs to develop new business prudently, and apply sound project
management principles if it is to avoid costly disasters. Gross profit margins are likely to be high, but overheads are
also high, covering the costs of research, development, advertising, market education, and low economies of scale.
As a result, the development of problem children can be loss‐making until the product moves into the rising star
category, which is by no means assured. This is evidenced by the fact that many problem children products remain
as such, while others become tomorrow’s ‘dogs’.
Cash cows
A cash cow has a relatively high market share in a low growth market, and should generate significant cash flows.
This somewhat crude metaphor is based on the idea of ‘milking’ the returns from a previous investment that
established good distribution and market share for the product. Activities to support products in this quadrant
should be aimed at maintaining and protecting their existing position, together with good cost management,
rather than aimed at growth. This is because there is little likelihood of additional growth being achieved.
Dogs
A‘dog’ has a relatively low market share in a low growth market. It might be loss making, and therefore have
negative cash flow. A common belief is that there is no point in developing products or services in this quadrant.
Many organisations discontinue ‘dogs’, but businesses that have been denied adequate funding for development
may find themselves with a high proportion of their products or services in this quadrant.
Limitations of the Boston Consulting Group matrix
The popularity of the matrix has diminished as more comprehensive models have been developed. Management
should exercise a degree of caution when using the matrix. Some of its limitations are detailed below:
 The rate of market growth is just one factor in an assessment of industry attractiveness, and relative market
share is just one factor in the assessment of competitive advantage. The matrix ignores many other factors
that contribute towards these two important determinants of profitability.
 There can be practical difficulties in determining what exactly ‘high’ and ‘low’ (growth and share) can mean in
a particular situation.
 The focus upon high market growth can lead to the profit potential of declining markets being ignored.
 The matrix assumes that each SBU is independent. This is not always the case, as organisations often take
advantage of potential synergies.
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Intro to Strategic Management Accounting
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APM – Study Notes
The use of the matrix is best suited to SBUs as opposed to products, or to broad markets (which might
comprise many market segments).
The position of ‘dogs’ is frequently misunderstood, as many of them play a vital role in helping SBUs achieve
competitive advantage. For example, dogs may be required to complete a product range and provide a
credible presence in the market. Dogs may also be retained in order to reduce the threat from competitors.
Notwithstanding these limitations, the Boston Consulting Group matrix provides a useful starting point in the
assessment of the performance of products and services and, more importantly, of SBUs.
EXAMPLE
Domestic Appliances Ltd (DAL) commenced trading in 1955, when it started to manufacture semi‐automatic
washing machines. From 1965, DAL expanded its product portfolio. Core products now include fully automatic
washing machines, dishwashers, and cookers. The market in domestic appliances is extremely competitive. DAL’s
principal competitor is the Jarvis Electrical Group (JEG), which has achieved the position of market leader in many
similar areas of the market. Other information is as follows:
1. JEG is the market leader in dishwashers, having 48% of the market. DAL has only 30% of the market.
Environmentalist pressure groups, concerned about water consumption, have caused a significant diminution
in the size of the market for dishwashers. However, the market remains profitable and this is expected to
continue.
2. DAL continues to manufacture washing machines using a process which uses new materials for each unit.
Legislation now requires that 35% of all materials used comprise recycled materials, which means that DAL will
no longer be able to sell its washing machines in certain markets.
3. Both DAL and JEG have invested very heavily in the manufacture of steam ovens. DAL has 12% of the new
market, while JEG has an 18% share of the new market.
4. DAL has recently produced a new washing machine, the Celeribus, which washes three times faster than any
other machine on the market. Market awareness of this machine is growing. The development costs of the
Celeribus were significant. At present the company is making heavy losses on production of this product.
Analyse the product portfolio of DAL using the Boston Consulting Group matrix.
Answer: Domestic Appliances Ltd
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Intro to Strategic Management Accounting
APM – Study Notes
The steam oven appears to be a star at the moment since it has a relatively large market share in what is a high
growth market. The Celeribus is a problem child as it has generated losses to date, and has a relatively low market
share in a high‐growth market. The challenge facing the management of DAL is to convert the product into a star.
The dishwashers are cash cows as even though the rate of market growth is low, DAL has a relatively high market
share. Cash generated can be used not only to further develop stars but also problem children where it is deemed
appropriate. The washing machines will soon become dogs as they are no longer able to be sold in certain markets.
Porter’s Five Forces
Porter's Five Forces
1.
Power of suppliers
This force includes the ability of suppliers to change the cost of materials provided by them. It depends on the
number of accessible suppliers, how easily the business can shift between them and the power of control that
the suppliers have over the company.
2.
Power of buyers
This includes the power the buyers may exercise to lower the cost of a company’s products. It mainly depends
on the number of buyers and their importance for the company. It is also affected by the risk that the buyers
may face in switching to another company. The distribution and homogeneity of buyers are also important.
3.
Power of Competitive rivalry
The amount of competition that a company has is also important. This force expresses what a company’s own
standing is amongst rivals in the market.
4.
Power of Threat of substitution
This force highlights how easily the services or products of a company may be substituted or replaced by other
items or other brands. The more difficult it is to substitute the products, the stronger a company’s power is
while the easier it may be for buyers to access substitutes, the weaker a company’s position will be.
5.
Power of Threat of new entry
This aspect of the model focuses on how easy or difficult it is for a new company to enter the market as
competition. If it is easy, then existing businesses are at threat but if strong obstacles have been placed for
new competition, then the business has established a strong position.
Power of suppliers, power of buyers and power of competitive rivalry mainly discuss the existing position of the
company while power of threat of substitution and power of threat of new entry are associated with how strong a
business has kept itself against possible competition. The first three forces define how much progressive the
company can be while the other forces define how well that company can sustain itself in the long run.
Benchmarking
Benchmarking is:
‐ Data gathering of targets and comparators;
‐ Identifying relative levels of performance (and particularly include underperformance);
‐ Adopting the best practices that were identified to improve performance.
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Intro to Strategic Management Accounting
APM – Study Notes
Benchmarking the reference enables a firm to:
‐ Meet industry standards by copying others,
‐ Challenge existing ways of doing things
‐ Assess current resources and competences
Advantages of benchmarking
‐ Assess existing resources
‐ Manager involvement
‐ Focus on improvement
‐ Sharing information
Disadvantages of benchmarking
‐ Too much focus on efficiency rather than effectiveness
‐ Assesses the present, not the future
‐ Targets and comparisons may not reveal the best practice (i.e. what, not why!)
‐ Useful information not freely available
Types of Benchmarking:
Internal benchmarking. Here performance is compared to an internally generated target. There has to be some
reference point f o r that target and it could be a target based o n last year‘s achievements or a target
based on another branch or subsidiary. It could be relatively easy to generate that target, but the problem is that
there is no guarantee that the target is appropriate. It could be either too hard or too easy; some sort of external
reference is needed.
External benchmarking. Here the performance is compared to that seen in other similar organisations. This gives
a better reference point, but the problem in implementing this is that often other organisations will be secretive
about their performance as their performance is commercially sensitive. They are therefore unlikely to cooperate
in providing internal data and only data from published financial statements will be available.
Best practice. This is more preferable as rather than randomly choosing an external, similar organisation, one
may choose the best one and build comparisons with the performance there. This causes ones organisational
ways to strive to get better as it seeks to match the performance found in the best practice. Once again the best
performing organisation may not cooperate in providing measurement data.
Burns and Scapen
The role of a managing accountant has effectively changed with progress in time and development of systems.
From a previous focus on financial control it is now more directed towards business support. Burns while studying
these changes noticed that previously accountants and operation managers were two separate entities who
reported to one senior manager but with progress in system, a new role of hybrid accountant who is also involved
in the operations while providing consultancy to managers is more commonly seen in companies. Scapens believes
that this change exists only because of the need for change.
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Intro to Strategic Management Accounting
APM – Study Notes
There are three main forces for change: technology, management structure and competition.
1.
Technology:
There have been significant developments in information technology throughout the world in the past two
decades. Previously only the accountants were equipped with the ability to access, input data, manage and
interpret the IT systems and from the information develop financial reports for the management. Recently
with the advancement in management information systems (MIS), multiple users throughout the organisation
may perform all these tasks that previously only the accountant had the knowledge to handle. The value of
the management accountant has therefore reduced to just another user of the MIS.
2.
Management Structure:
The progression in management systems has also changed the responsibilities of an accountant. Due to the
increased autonomy of SBUs, the SBU managers are now more responsible for taking decisions that were
previously taken by the management accountant. The SBU managers are more associated with assessing
financial and non‐financial data and producing forecasts. The accountant however provides reports which link
and assess operational reports, financial consequences and the strategic outcomes desired alongside the SBU
reports.
3.
Competition:
As markets and knowledge have increased with time, businesses have started to focus strategically on the
competitive environment they are a part of. Competitive advantage is an important aspect for the progress of
businesses. This change has also altered the role of a management accountant. An accountant’s focus on
profit figures is now termed as short‐term while organisations now pay more attention to other measures that
may affect their long‐term performance. New and expanding companies pose a market threat for the old
companies, thus it is necessary that to survive in the competitive environment, companies make themselves
flexible, creative and more innovative to respond strongly to the increasing competitive threats.
Even though the role of the managing accountant has altered in these aspects, it is still beneficial and important.
The accountant now assists the SBU managers in retrieving more information effectively from the MIS, extracting
crucial information from the prepared reports and in developing performance measures assessing financial and
non‐financial aspects. The accountant now plays the role of a guide to the SBU managers ensuring that maximum
and efficient performance management is done which complements the goals and objectives of the company.
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Environmental Influences
APM – Study Notes
ENVIRONMENTAL INFLUENCES
Learning objectives
Discuss the need to consider the environment in which an organisation is operating when assessing its
performance using models such as PEST and Porter's 5 forces, including areas:
 Political climate
 Market conditions
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Environmental Influences
APM – Study Notes
Environmental Influences on Performance of Businesses
Once the objectives of the business are set, the organisation then needs to decide how to meet the objectives and
define the strategy. For that, it is important that the organisation considers what is going on in the outside world.
The business environment is the world in which the organisation operates.
This area will cover the following:
1. Macro Environment
2. The industry environment
3. Stakeholder’s Influence
4. Ethics
5. Corporate Social Responsibility (CSR)
6. Government Influences
7. Risk & Uncertainty in external environment and How to manage it
Macro Environment
PEST ANALYSIS
It considers the following external factors:
1. Political Factors: e.g. change in government policy, tax incentives, instability of government etc.
2. Economic Factors: e.g. disposable income, inflation rates, employment rates, international trade etc.
3. Social Factors: Demography (average age, ethnicity, family structure, geography, culture, lifestyle etc.
4. Technological Factors: e.g. awareness of stakeholders about technology, new products and services become
available, new media for communication with customers etc.
 All above factors are interlinked
 All PEST factors help an organisation to identify its threats and opportunities in the external environment
which can impact performance
ILLUSTRATION
Speedy Eat is the world’s largest and best‐known food service retailing group with more than 30,000 ‘fast‐food’
outlets in over 120 countries. Currently half of its restaurants are in the USA, where it first began 50 years ago,
but up to 1,000 new restaurants are opened every year worldwide. Restaurants are wholly owned by the group
(it has previously considered, but rejected, the idea of a franchising of operations and collaborative
partnerships).
As market leader in a fiercely competitive industry, Speedy Eat has strategic strengths of instant global brand
recognition, experienced management, site development expertise and advanced technological systems.
Speedy Eat’s basic approach works as well in Kandy or Kuala Lumpur as it does in Kansas: although the products
are broadly similar, menus are modified to reflect local tastes. Analysts agree that it continues to be profitable
because it is both efficient and innovative.
The group’s vision is to be ‘the world’s favourite’ through service, cleanliness and value, and it is following three
main strategies:
a. To achieve profitable growth by building on key strengths.
b. To ‘delight’ every customer in every restaurant.
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Environmental Influences
c.
APM – Study Notes
To be a good employer in each community in which it has a restaurant. (Despite this, some critics claim
staff are mainly unskilled and lowly paid.)
Speedy Eat’s future plans are to maximize global opportunities and continue to expand markets. Speedy Eat has
long recognized that the external environment can be very uncertain and consequently does not move into new
locations or countries without first undertaking a full investigation.
You are part of a strategy steering team responsible for investigating the key factors concerning Speedy Eat’s
entry for the first time into the restaurant industry in the Republic of Borderland.
Required:
(a)
Justify the use of a PEST framework to assist your team’s environmental analysis for the Republic of
Borderland.
(8 marks)
(b)
Discuss the main issues arising from applying this framework.
(12 marks)
(20 Marks)
Answer
(a) Using a PEST analysis to assist the environmental analysis
PEST analysis examines the broad environment in which the organisation is operating. PEST is a mnemonic
which stands for Political, Economic, Social and Technological factors. These are simply four key areas in
which to consider how current and future changes affect the business. Strategies can then be developed
which address any potential opportunities and threats identified.
In entering a new overseas market, an environmental analysis is important to help the organisation
understand the factors specific to that market so that the specific opportunities and threats posed can be
assessed and appropriate action taken.
It is a useful tool for the following reasons:
1. It ensures completeness
The majority of issues relevant to an organisation will be covered under one of the four areas of PEST
analysis. By reviewing all four areas, Speedy Eat can be sure that it has done a full and complete
analysis of the broad environment.
2.
All four elements are relevant to examining new markets
Political/legal
Each new country entered will have different political systems and laws. Speedy Eat will need to
understand these differences to ensure that they operate within the law in Borderland. They will also
want to ensure that there is political stability within the country which will ensure long‐term viability of
the new operations.
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Environmental Influences
APM – Study Notes
Economic
Economies are different in different parts of the world. Understanding the local economy in Borderland
and how it is expected to develop enables Speedy Eat to assess the potential within that market as well
as any economic issues which they need to consider.
Social
Each country will have its own cultural differences, and Speedy Eat can change how they operate
depending on Borderland’s culture. Speedy Eat has already shown its willingness to change for each
country’s different tastes and will want to do so in Borderland too.
Technological
Each country has a different level of technological expertise and experience. Speedy Eat might need
to change processes to accommodate local systems, or implement training programs for staff
unfamiliar with their technology.
3.
It is a well‐known tool which is easy to understand and use
PEST analysis is a very simple tool that does not require detailed understanding. This means
that it is easy to use by the team and simple for Directors to analyse and understand.
(b) Main issues arising from applying the framework
Various issues which Speedy Eat will need to consider include:
Political/legal factors
 Government grants
Some countries may have grants available for investment in the country. Considering the requirements
to gain such grants may enable Speedy Eat to make use of these.
 Political stability
Given Speedy Eat’s worldwide penetration (over 120 countries) it is likely that Borderland is in a
developing region which may be more politically unstable than many countries in which they currently
operate. This may affect the long‐term potential in the market.
 Regulation on overseas companies
There may be regulation on how overseas companies can operate in the market. In China, for instance,
it is common for joint ventures with local companies to be a prerequisite for western companies
entering the market.
 Employment legislation
Each country will have different employment legislation e.g. health and safety, minimum wages,
employment rights. Speedy Eat may have to change internal processes from the US model to stay
within this legislation within Borderland. Being a good employer is also one of Speedy Eat’s specific
strategies.
 Tax legislation
Tax laws will impact the profits available for distribution to the group. High tax levels may discourage
Speedy Eat from entering the market.
 Tariffs and other barriers to trade
Tariffs may be imposed on imports into Borderland. This may put Speedy Eat at a significant
disadvantage compared with local competitors if they aim to import a significant number of items
(unlikely on food items, more likely on clothing, fittings etc.).
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Environmental Influences
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APM – Study Notes
Economic factors
Things to consider include:
Economic prosperity
The more prosperous the nation the more money people will have to invest in ‘fast‐food’. Examining
the current and likely future prosperity enables the organisation to understand the potential of this
market and the likely future investment required.
Interest rates
This affects the cost of borrowing within Borderland. If high it may mean overseas funding is
necessary. A big differential between interest rates in Borderland and the US is also likely to cause
instability in the exchange rate (see below).
Interest rates also affect the availability of money for the people of the country. Low interest rates
mean more disposable income to spend increasing the potential for Speedy Eat.
Exchange rates
Speedy Eat will be affected by exchange rates for items they export to Borderland (clothing, fittings).
An unfavorable movement in exchange rates could make exporting to Borderland expensive and
reduce profitability. It can also affect the value of profits when converted back to US dollars.
Position in economic cycle
Different countries are often at different positions in the economic cycle of growth and recession. The
current position of Borderland will affect the current prosperity of the nation and the potential for
business development for Speedy Eat.
Inflation rates
High inflation rates create instability in the economy which can affect future growth prospects. They
also mean that prices for supplies and prices charged will regularly change and this difficulty would
need to be considered and processes implemented to account for this.
Social factors
Things to consider include:
Brand reputation/anti‐Americanism
As a global brand, the reputation of Speedy Eat might be expected to have reached Borderland. If not,
more marketing will be required. If it has, the reputation will need to be understood and the
marketing campaign set up accordingly.
This is particularly relevant given the anti‐Americanism which is prevalent currently in some countries.
Speedy Eat may have a significant hurdle to climb to convince people to eat there if this is the case in
Borderland.
Cultural differences
Each country has its own values, beliefs, attitudes and norms of behaviours which means that people of
that country may like different foods, architecture, music and so on, in comparison with US
restaurants. By adapting to local needs Speedy Eat can ensure it wins local custom and improve its
reputation.
Different cultures also need to be considered when employing people, especially given the importance
to Speedy Eat of employee relations. People might have different religious needs to be met or may
dislike being given autonomy so the management style needs changing.
Language problems
Different local languages can create problems, firstly in communication with staff. Secondly, product
names need to be considered to ensure they are acceptable in the local language. General Motor’s
Nova suggested that ‘it won’t go’ in Spanish, for example.
Page | 15
Environmental Influences

APM – Study Notes
Technological factors
Speedy Eat may need to train people in the use of their technologies if the local population is
unfamiliar with them, e.g. accounting systems or tills. In addition, technology might have to be adapted
to work in local environments, such as different electrical systems.
The Industry Environment
Porter’s Five Forces Model
The use of Porter’s Five Forces Model (see Figure 1) helps identify the sources of competition in an industry or
sector.
The model has similarities with other tools for environmental audit, such as political, economic, social, and
technological (PEST) analysis, but should be used at the level of the strategic business unit, rather than the
organisation as a whole. A strategic business unit (SBU) is a part of an organisation for which there is a distinct
external market for goods or services. SBUs are diverse in their operations and markets so the impact of
competitive forces may be different for each one.
Five Forces analysis focuses on five key areas: the threat of entry, the power of buyers, the power of suppliers, the
threat of substitutes and competitive rivalry.
Page | 16
Environmental Influences
APM – Study Notes
THE THREAT OF ENTRY
This depends on the extent to which there are barriers to entry. These barriers must be overcome by new entrants
if they are to compete successfully. Johnson et al (2005), suggest that the existence of such barriers should be
viewed as delaying entry and not permanently stopping potential entrants. Typical barriers are detailed below.
Economies of scale
For example, the benefits associated with volume manufacturing by organisations operating in the automobile and
chemical industries. Lower unit costs result from increased output, thereby placing potential entrants at a
considerable cost disadvantage unless they can immediately establish operations on a scale that will enable them
to derive similar economies.
The capital requirement of entry
These vary according to technology and scale. Certain industries, especially those which are capital intensive
and/or require very large amounts of research and development expenditure, will deter all but the largest of new
companies from entering the market.
Access to supply or distribution channels
In many industries, manufacturers enjoy control over supply and/or distribution channels via direct ownership
(vertical integration) or, quite simply, supplier or customer loyalty. Potential market entrants may be frustrated by
not being able to get their products accepted by those individuals who decide which products gain shelf or floor
space in retailing outlets. Retail space is always at a premium and untried products from a new supplier constitute
an additional risk for the retailer.
Supplier and customer loyalty
A potential entrant will find it difficult to gain entry to an industry where there are one or more established
operators with a comprehensive knowledge of the industry, and with close links with key suppliers and customers.
Cost disadvantages independent of scale
Well‐established companies may possess cost advantages which are not available to potential entrants irrespective
of their size and cost structure. Critical factors include proprietary product technology, personal contacts,
favourable business locations, learning curve effects, favourable access to sources of raw materials, and
government subsidies.
Expected retaliation
In some circumstances, a potential entrant may expect a high level of retaliation from an existing firm, designed to
prevent entry – or make the costs of entry prohibitive.
Government regulation
This may prevent companies from entering into direct competition with nationalised industries. In other scenarios,
the existence of patents and copyrights afford some degree of protection against new entrants.
Differentiation
Differentiated products and services have a higher perceived value than those offered by competitors. Products
may be differentiated in terms of price, quality, brand image, functionality, exclusivity, and so on. However,
differentiation may be eroded if competitors can imitate the product or service being offered and/or reduce
customer loyalty.
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Environmental Influences
APM – Study Notes
THE POWER OF BUYERS
The power of the buyer will be high where:
 There are a few, large players in a market. For example, large supermarket chains can apply a great deal of
price pressure on their potential suppliers. This is especially the case where there are a large number of
undifferentiated, small suppliers, such as small farming businesses supplying fresh produce to large
supermarket chains
 The cost of switching between suppliers is low, for example from one haulage contractor to another
 The buyer’s product is not significantly affected by the quality of the supplier’s product. For example, a
manufacturer of foil and cling film will not be affected too greatly by the quality of the spiral‐wound paper
tubes on which their products are wrapped
 Buyers earn low profits
 Buyers have the potential for backward integration, for example where the buyer might purchase the supplier
and/or set up in business and compete with the supplier. This is a strategic option which might be selected by
a buyer in circumstances where favourable prices and quality levels cannot be obtained
 Buyers are well informed. For example, having full information regarding availability of supplies.
THE POWER OF SUPPLIERS
The power of the seller will be high where (this tends to be a reversal of the power of buyers):
 There are a large number of customers, reducing their reliance upon any single customer
 The switching costs are high. For example, switching from one software supplier to another could prove
extremely costly
 The brand is powerful (BMW, McDonalds, Microsoft). Where the supplier’s brand is powerful then a retailer
might not be able to operate a particular brand in its range of products
 There is a possibility of the supplier integrating forward, such as a brewery buying restaurants
 Customers are fragmented so that they have little bargaining power, such as the customers of a petrol station
situated in a remote location.
THE THREAT OF SUBSTITUTES
The threat of substitutes is higher where:
 There is product‐for‐product substitution, e.g. for fax and postal services
 There is substitution of need. For example, better quality domestic appliances reduce the need for
maintenance and repair services. The information technology revolution has made a significant impact in this
particular area as it has greatly diminished the need for providers of printing and secretarial services
 There is generic substitution competing for disposable income, such as the competition between carpets and
flooring manufacturers.
COMPETITIVE RIVALRY
Competitive rivalry is likely to be high where:
 There are a number of equally balanced competitors of a similar size. Competition is likely to intensify as one
competitor strives to attain dominance over another
 The rate of market growth is slow. The concept of the life cycle suggests that in mature markets, market share
has to be achieved at the expense of competitors
 There is a lack of differentiation between competitor offerings because, in such situations, there is little
disincentive to switch from one supplier to another
Page | 18
Environmental Influences


APM – Study Notes
The industry has high fixed costs, perhaps as a result of capital intensity, which may precipitate price wars
and hence low margins. Where capacity can only be increased in large increments, requiring substantial
investment, then the competitor who takes up this option is likely to create short‐term excess capacity and
increased competition
There are high exit barriers. This can lead to excess capacity and, consequently, increased competition from
those firms effectively ‘locked in’ to a particular marketplace.
In summary, the application of Porter’s Five Forces model will increase management understanding of an industrial
environment which they may want to enter.
EXAMPLE 1
Kleen‐up plc, which provides factory cleaning services, is considering a strategic decision to set up industrial
launderettes in order to enter the market for cleaning industrial work‐wear in the country of Eajland. Map the
following eight points onto the five forces model:
1. A government grant, equal to 95% of the start‐up costs, will be paid to any organisation setting up an
industrial launderette.
2. Disposable work‐wear is available on a nationwide basis from a distributor of imported products.
3. A large number of businesses spend large amounts of money on cleaning employees’ work‐wear each
week.
4. There are very few high quality launderettes capable of cleaning industrial work‐wear to a satisfactory
standard.
5. Health and Safety legislation in Eajland encourages the use of launderettes by businesses.
6. Other launderettes within the community regularly offer free cleaning, or high discounts on the cleaning of
clothing items.
7. The number of industrial firms setting up in Eajland is increasing by 10% per annum.
8. The market in the cleaning of industrial work‐wear in Eajland is relatively new, and is projected to grow
rapidly.
Answer
1. A government grant, equal to 95% of the start‐up costs, will be paid to any organisation setting up an
industrial launderette. threat of entry – low barriers to entry
2. Disposable work‐wear is available on a nationwide basis from a distributor of imported products. product‐
for‐product substitution
3. A large number of businesses spend large amounts of money on cleaning employees’ work‐wear each
week. high bargaining power of buyers
4. There are very few high quality industrial launderettes capable of cleaning industrial work‐wear to a
satisfactory standard. high bargaining power of suppliers
5. Health and Safety legislation in Eajland encourages the use of industrial launderettes by businesses. Threat
of entry reduced by legislation
6. Other launderettes within the community regularly offer free cleaning, or high discounts on the cleaning of
clothing items. Threat of entry – differentiation
7. The number of industrial firms setting up in Eajland is increasing by 10% per annum. bargaining power of
buyers
The market in the cleaning of industrial work‐wear is relatively new, and is projected to grow rapidly.
Page | 19
Performance Hierarchy & Budgets
APM – Study Notes
PERFORMANCE HIERARCHY & BUDGETS
Learning objectives







Discuss how the purpose, structure and content of a mission statement impacts on performance
measurement and management.
Discuss how strategic objectives are cascaded down the organisation via the formulation of subsidiary
performance objectives.
Apply critical success factor analysis in developing performance metrics from business objectives.
Identify and discuss the characteristics of operational performance.
Discuss the relative significance of planning activities as against controlling activities at different levels in
the performance hierarchy.
Evaluate the strengths and weaknesses of alternative budgeting models and compare such techniques as
fixed and flexible, rolling, activity based, zero based and incremental.
Evaluate different types of budget variances and how these relate to issues in planning and controlling
organisations.
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Performance Hierarchy & Budgets
APM – Study Notes
Performance Hierarchy
1. At the top of the hierarchy is the mission statement
2. The mission statement provides a framework for the setting of strategic objectives
3. Strategic objectives form a basis for the setting of tactical plans such as annual budgets
4. Operating plans and targets derived from tactical plans
Mission Statement
Mission statement
 A clear expression of the reason why an organisation is in existence and what it is seeking to achieve
 Not all organisations have formal statements
The Content varies – common elements are:
 A statement of the purpose of the organisation
 A statement of its broad strategy for achieving its purpose
 A statement of the values and culture of the organisation.
Usefulness of a mission statement
 It provides a guide to stakeholders
 Aids formulation of business strategy (can be used to screen proposed strategies)
 Can establish corporate culture
Strategic Objective And Cascading Down The Organisation
Every business needs to have set strategic objectives to develop a proper framework of plan which supports the
vision of each area of an organisation. Strategic objectives include a vision ranging from3 to 5 years which would
have long term effect of the performance of the company. They have a broad perspectives which include financial,
customer, operational processes, and staff development.
When developing strategic objectives, there are a few perspectives that should be kept in mind to help lay a more
efficient framework. The financial perspective guides according to the shareholders’ and stakeholders’
expectations for financial and social outcomes of the company. The customer perspective helps the planners
decide what value should be provided to the customers. The operations perspective involves the processes that
must be made efficient to provide and deliver value products and services. The people perspective helps define
the processes, skills, structures and expertise an organisation must have.
A framework plan should preferably consist of 4‐6 objectives as less than 4 objectives give the impression of an
incomplete plan while greater than 6 objectives give the impression of unachievable tasks.
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Performance Hierarchy & Budgets
APM – Study Notes
Cascading to Create Annual Aligned Goals
Following strategic objective development, it is necessary to be able to communicate them to the rest of the
organisation in order to achieve them. For this purpose, aligned annual goals are formulated to help all areas
accomplish the yearly requirements and in turn long‐term objectives efficiently. It is important to communicate to
the employees that the aligned annual goals are of the highest priority at the present and should be achieved
actively in order to reach the actual long‐term objectives.
They aligned annual goals of a company might look something like:
 150K in unrestricted grants and $1M total funding
 Always have at least 90 days of cash on hand
 25% of sales from outside of California and 15% growth in California
 Quality control process for our services
 Meaningful employee recognition program in place
 All departments know the “customer” they serve
When constructing goals, it is important to make sure that the goal is clear and easily communicated. The goal
should clearly explain what it aims to achieve, who is responsible for achieving it and what the deadline is to
achieve it.
Once strategic objectives have been constructed and aligned annual goals are formulated in accordance to those
objectives, it is required that they are brought together and a framework of the strategic plan is defined using
them. Through this strategy, long term objectives can be achieved by fulfilling the annual goals which can further
be supported by short term goals.
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Performance Hierarchy & Budgets
APM – Study Notes
Critical Success Factor (CSF)
 Factors that are critical to the success of an organisation and the achievement of its overall objectives
 Key areas where targeted performance must be achieved;
 Failure to meet targets for any CSF will mean failure to achieve long‐term targets and objectives
 Each CSF requires a performance measure (key performance indicators or KPIs)
 Critical success factors must be in line with the mission or corporate strategy of the business
Managing Critical Success Factors
1. Identify CSF
2. Measure CSF using (KPIs‐ Key performance indicators)
3. Target setting (Benchmark)
4. Identify the problem areas
5. Take corrective actions
6. Re‐measure KPI
Characteristics of Operational Performance
There are five main operational performance objectives: speed, quality, costs, flexibility, and dependability.
Speed
Page | 23
Performance Hierarchy & Budgets
APM – Study Notes
This objective assesses the speed with which a company can provide services and products to the consumers. It
includes all concerns that involve time e.g. how fast research can be done and products developed and how much
time it is taken from the start of the manufacturing process to the delivery of the products.
Quality
Quality of a product measures how well a product falls within the general requirements expected of the product. It
also assesses the reliability, durability and performance of the products. The amount of trust customers put into
the value of the products and how easily it can be repaired also define its quality.
Costs
This part of operational performance measures how much the cost of one unit may differ with respect to different
factors which may include volume and variety of the manufactured products. Products that feature a greater
variety tend to sport lower volumes and higher unit costs and vice versa. Through this, the costs and profits of the
products are decided.
Flexibility
Flexibility means how well product lines and products adjust to new demands. A flexible product adjusts in
accordance to the speed objective as well adapting to the market demands and delivery demands. To be able to
produce varying quality products in accordance to all requirements is the true meaning of flexibility.
Dependability
This objective includes assessing how much customers can depend on a company with respect to quality, service,
delivery time and costs. When a company provides good quality and services over a long period of time, it
becomes accepted as dependable.
BUDGETING (PURPOSE)
Purpose
Planning
Control
Communication
Co‐ordination
Explanation
A business needs to map ahead how it intends to operate in its environment. By
planning, management are forced to think and plan ahead as to how their business
is to operate, compete and grow.
By setting up a budget, a business uses standard cost cards. These set out the
expected sales price to achieve for goods sold, the expected resources that each
unit should consume and at what cost.
The budget is a formal part of the businesses reporting channels, often reflecting the
hierarchy of responsibility in the business. The budget may reflect and indeed
dictate the intended activities of the business. E.g. Senior management may set
targets for junior management to achieve better in terms of sales volume and
activity through the budget.
In large organisations especially, it is hard to ensure that all departments are
working towards common aim and objectives. For example, it is critical that if the
sales department is aiming to sell 1,000 units, it must be communicated through the
budget to the production department so that it knows how many units they are
expected to make. The production department will need (via budgets) to
communicate with the purchasing department to ensure that enough components
are purchased to cope with the production of 1,000 units and so on.
Page | 24
Performance Hierarchy & Budgets
Evaluation
Motivation
Authorisation
APM – Study Notes
Budgeting can allow the business to have a benchmark in order to assess the
performance of individual departments, functions or indeed managers within a
business.
If a departmental manager is given a budget, it acts as a target for that manager to
aspire to. If by achieving that budget the manager is rewarded, the budget acts as an
incentive to the manager. If all managers achieve their targets (and are rewarded for
doing so) then the business as a could efficiently achieve its aims and objectives.
Budgets can act as a tool to authorise junior management to undertake a particular
action. For example if Manager X has $45,000 included in their budget to recruit two
new members of staff, then the manager has in essence been authorised to
undertake the recruitment and spend a set amount of money doing so.
Participation in budget
Top‐down approach
It is a budget, which is set without allowing the ultimate budget holders to have the opportunity to participate in
the budgeting process. It is also called ‘imposed’ budget or non‐participative.
Features
 Senior management prepares budgets
 It is imposed on junior management
 It is quicker than bottom up approach
 Time saving
The time when imposed budgets are effective
 New organisation
 Small businesses
 In period of economic hardship
 At a time when operational personnel have a lack of budgeting skills
 At a time when different organisation’s units require precise coordination
Advantages
 Strategic plans are incorporated in budgets
 Increased coordination between plans and long‐term objectives of the division
 Involvement of senior management in operational decisions
 Decreased input from inexperienced employees
 Time saving
Disadvantages
 Low employees morale (hard for people to be motivated to achieve targets set by someone else)
 Acceptance of organisational goals & objectives could be limited
 Operational managers are likely to have a better understanding of day by day operations
 Unachievable budgets (may be for local operations)
Page | 25
Performance Hierarchy & Budgets
APM – Study Notes
Method of budgets
Fixed budget
A Fixed Budget is designed to remain unchanged irrespective of the volume of output or turnover attained.
Flexible budget
A flexible budget is a budget which is prepared at the start of the year at more than one activity level and can be
flexed to the actual activity level for variance analysis. For preparing flexible budget cost behaviour of all elements
should be known and all cost should be classified as fixed or variable.
Example
Zenith Ltd. manufactures and sells a single product; Alpha. Operational capacity of plant is 100,000 units of
Alpha a year but due to plant deterioration it is now expected that it can only produce 80,000 units of Alpha a
year. A budget is prepared at 80% and 90% plant capacity.
Sales
Costs:
Direct material
Direct labour
Production overheads
Selling & distribution overheads
Net income
80%
$
640,000
90%
$
720,000
96,000
128,000
210,000
50,000
________
156,000
________
108,000
144,000
230,000
50,000
________
188,000
________
Actual production for the period was 68,000 units of Alpha. Actual costs and revenue for the period were as
follows:
$
Sales
680,000
Costs:
Direct material
105,400
Direct labour
132,600
Production overheads
213,200
Selling & distribution overheads
60,000
________
Net income
168,800
________
There was no opening and closing stock. Sales price is fixed.
Required:
You are required to prepare a flexed budget and compare the actual results with the flexed budget.
Page | 26
Performance Hierarchy & Budgets
APM – Study Notes
Incremental budgets
 An incremental budget starts with the previous period’s budget or actual results and adds (or subtracts)an
incremental amount to cover inflation and other known changes.
 It is suitable for stable businesses, where costs are not expected to change significantly. There should be good
cost control and limited discretionary costs.
Advantages
Disadvantages
Quickest and easiest method.
Builds in previous problems and inefficiencies
Suitable if the organisation is stable and historic figures
are acceptable since only the increment needs to be
justified.
Uneconomic activities may be continued. E.g. the firm
may continue to make a component in‐house when it
might be cheaper to outsource.
Managers may spend unnecessarily to use up their
budgeted expenditure allowance this year, thus
ensuring they get the same (or a larger) budget next
year.
Zero Based Budgeting
ZBB are an improvement of incremental budgets.
ZBB involves the simple idea of preparing a budget from a ‘zero base’ each period (like a ‘clean sheet of paper’!).
There is no expectation that current activities should continue from one period to the next. ZBB is unlikely to be
used frequently in manufacturing industries where the manufacturing processes are likely to be identical or very
similar year‐on‐year. Therefore, there is little point in redrafting the entire budget from scratch. The
manufacturing process largely dictates how costs are incurred.
ZBB is normally found in service industries where costs are more likely to be discretionary. There is more flexibility
to adapt the service provided from one period to the next to better fit in with customer expectation.
Suitability
 Fast moving businesses and industries
 Public sector organisations such as local authorities
 Discretionary costs such as research and development (R&D).
Explanation
SKANS could in one year provide students with:
 Tuition Days
 Revision Days
 Study Text Book
 Revision Kit
 Study Notes
 Revision Notes
 Practice Exams
Page | 27
Performance Hierarchy & Budgets
APM – Study Notes
All of these products and services will have their own associated costs. If however student demand is such, or
there is a major selling opportunity, SKANS can undertake ZBB and decide to alter their course structure and
provision dramatically.
For example SKANS can alter course structure in length and timings, change its course material, run courses
from new locations, offer new products (such as video lectures and discussion board) etc. As a service business
it is much easier to adapt the mode of delivery of its ‘product’ and previous budgets will bear little resemblance
to future activities (i.e. there is little scope for incremental budgeting).
Organisations considering using ZBB would need to consider the four basic steps to follow:
1. Prepare decision packages
Identify all possible services (e.g. courses offered by SKANS) and levels of service (e.g. length of course) that
may be provided and then cost each service or level of service. These are known individually as decision
packages.
Explanation
SKANS can consider a wide variety of methods of delivering courses. Each possible service or level of service
(decision package) needs to be included in the cost (e.g. printing cost of a textbook) and assessed for the likely
benefit (e.g. number of students attracted to SKANS courses) it will bring to the organisation.
2.
Rank the decision packages
Each decision packages is ranked in order of importance, starting with the mandatory requirements of a
department.
Explanation
SKANS has to provide a tuition and revision course for each paper. These are essential services which must be
funded by the business. Other decision packages can then be considered. SKANS may then consider updating its
course study notes as being the next most ‘value‐added’ activity. After that the next most important decision
packages are ranked. This forces the management to consider carefully what their aims are for the coming year
and importantly their priorities.
3.
Funding
Identify the level of funding that will be available to the business. This may relate to the amount of cash SKANS
has available, its lines of credit with its bankers etc.
4.
Utilise
These funds are then used up in the order of the ranking at step 2, until exhausted. The highest ranked
decision packages are financed. Allocation of funding continues until it is exhausted (say at the 12th ranked
decision package). Any lower ranking decision packages, being less of a priority to the business may not be
funded and are ‘shelved’ (e.g. the 13th ranked decision package onwards). If however more funding becomes
available, then the business can select the next decision package (the 13th) and undertake that decision
package.
The key with ZBB is that it focuses the business’s attention on where its money must be spent to the best effect. It
helps the business to prioritise where it should invest, without being dependent on a previous year’s budget (as
with incremental budgeting). It is a considered allocation of resources.
Page | 28
Performance Hierarchy & Budgets
APM – Study Notes
Advantages of Zero Based Budgets (ZBB) (as opposed to incremental budgeting)
1. Emphasis on future need instead of past actions. ZBB focuses on future plans and is not ‘swayed’ by what was
in last year’s budget. The strategies that worked well in the past are no guarantee of future success.
2. Eliminates past errors that may be perpetuated in an incremental analysis. Any inefficiencies or mistakes in
previous budgets under incremental budgeting are perpetuated (and often magnified) in future budgets. ZBB
eliminates these errors (although the possibility of new errors being introduced cannot be eliminated).
3. A considered allocation of resources. The business does not automatically carry on the projects that they have
always performed in the past.
4. Encourages cost reduction. The business may continue projects that it has undertaken in the past, but a close
review of costs will have been undertaken.
Disadvantages of Zero Based Budgets (ZBB)
1. Can be costly and time consuming. ZBB techniques will take a lot of time in terms of training managers in the
required techniques and more time and effort in preparing each decision package.
2. May lead to increased stress for management. Managers may become nervous that their decision packages
may not be accepted. It is possible that the manager may worry about redundancy if they have too few
decision packages that are approved. It is conceivable that managers may put forward unrealistic decision
packages to ensure that they are accepted.
3. Only really applicable to a service environment. It is not applicable in a manufacturing environment where the
production process dictates how the production is undertaken.
4. May ‘re‐invent’ the wheel each year. It is quite conceivable that if ZBB is undertaken each year, the same
decision packages are accepted. This is an inefficient approach to budgeting.
5. May lead to lost continuity of action and short‐term planning. The business may alter its activities and plans
year by year, causing a lack of consistency and possible drift from its strategic aims. For example if SKANS
decided one year to run its courses entirely online and the next year purely in the classroom, it would
antagonise students and have serious repercussions for resource allocation and usage (e.g. having to find and
kit out premises and recruit tutors at a very short notice).
Rolling Budget
A rolling budget is one that is kept continually up‐to‐date by revising at the end of each month and also adding a
further month.
For example, on 1 January 2008 prepare a budget for the whole year upto 31 December 2008.
At the end of January 2008, revise the budget for the remaining 11 months of 2008 (in the light of what happened
in January), and also prepare a budget for January 2009.
In this way there is always a budget for the coming 12 month period.
The benefits of rolling budgets are that they are likely to be more accurate, and also the work‐load of budgeting is
spread throughout the year and becomes part of the normal job – again leading to more accurate budgeting.
Page | 29
Performance Hierarchy & Budgets
APM – Study Notes
Example
A company uses rolling budgeting and has a sales budget as follows:
Q1
Q2
Q3
($)
($)
($)
Sales
125,750
132,038
138,640
Q4
($)
145,572
Total
($)
542,000
Actual sales for Quarter 1 were $123,450. The adverse variance is fully explained by competition being more intense
than expected and growth being lower than anticipated.
The budget committee has proposed that the revised assumption for sales growth should be 3% per quarter for Quar
ters 2, 3 and 4.
Required:
Update the budget figures for Quarters 2–4 as appropriate
Solution
ANSWER
The revised budget should incorporate 3% growth starting from the actual sales figure of Q1.
Sales
Q2 ($)
127,154
Q3 ($)
130,969
Q4 ($)
134,898
Workings
 Q2: Budget = $123,450 × 103%
 Q3: Budget = $127,154 × 103%
 Q4: Budget = $130,969 × 103%
Example
ABC is a high growth non‐alcoholic drinks company, currently it uses a system of incremental budgeting. ABC
has been receiving complaints from customers about late deliveries and poor quality control. ABC's managers
have explained that they are working hard within the budget and capital constraints imposed by the board and
have expressed a desire to be less controlled. ABC's incremental budget for the current year is given below. You
can assume that cost of sales and distribution costs are variable and administrative costs are fixed.
Revenue
Cost of sales
Gross profit
Distribution costs
Administration costs
Operating profit
Q1
$'000
8,760
4,818
3,942
789
2,107
1,046
Q2
$'000
8,979
4,939
4,040
808
2,107
1,125
Q3
$'000
9,204
5,062
4,142
829
2,107
1,206
Q4
$'000
9,434
5,189
4,245
849
2,107
1,289
Total
$'000
36,377
20,008
16,369
3,275
8,428
4,666
Page | 30
Performance Hierarchy & Budgets
APM – Study Notes
The actual figures for Quarter 1 (which has just completed) are:
$'000
Revenue
8,966
Cost of sales
4,932
Gross profit
4,034
Distribution costs
807
Administration costs
2,107
Operating profit
1,120
On the basis of the Q1 results, sales volume growth of 3% per quarter is now expected.
Required
Recalculate the budget for ABC using rolling budgeting and assess the use of rolling budgets in this context.
ANSWER
A rolling budget is one where the budget is kept up to date by adding another accounting period when the most
recent one expires. The budget is then rerun using the new actual data as a basis.
For ABC, with its quarterly forecasting, this would work by adding another quarter to the budget and then
rebudgeting for the next four quarters.
Rolling budgets are suitable when the business environment is changing rapidly (which is likely to be the case
here) or when the business unit needs to be tightly controlled (which may not be valid here since managers are
complaining about control).
The new budget at ABC would be:
Revenue
Cost of sales
Gross profit
Distribution costs
Administration costs
Operating profit
Q1
$000
8,966
4,932
4,034
807
2,107
1,120
Current year
Q2
Q3
$000
$000
9,235
9,512
5,080
5,232
4,155
4,280
831
856
2,107
2,107
1,217
1,317
Q4
$000
9,797
5,389
4,408
882
2,107
1,419
Total
$000
37,510
20,633
16,877
3,376
8,428
5,073
Next year
Q1
$000
10,091
5,551
4,540
908
2,107
1,525
Based on the assumptions that cost of sales and distribution costs increase in line with sales and that
administration costs are fixed as in the original budget.
The budget now reflects the rapid growth of the division. Using rolling budgets like this will avoid the problem of
managers trying to control costs using too small a budget and as a result, choking off the growth of the
business. This may explain some of the quality issues that ABC is experiencing.
The rolling budgets will require additional resources as they now have to be done each quarter rather than
annually but the benefits of giving management a clearer picture and more realistic targets more than outweigh
this.
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Performance Hierarchy & Budgets
APM – Study Notes
Poor budgeting is probably at the core of the managers' desire to be less controlled. Rolling budgets could be
seen as a tightening of control, so it may also be worth considering changing the style of control being used (see
Hopwood later).
Advantages
Disadvantages
Planning and control will be based on a more
accurate budget
Rolling budgets reduce the element of uncertainty in
budgeting since they concentrate on the short‐term
when the degree of uncertainty is much smaller
Rolling budgets are more costly and time consuming
than incremental budgets
May de‐motivate employees if they feel that they
spend a large proportion of their time budgeting or if
they feel that the budgetary targets are constantly
changing
There is a danger that the budget may become the last
budget 'plus or minus a bit'
An increase in budgeting work may lead to less control
of the actual results
There is always a budget that extends into the future
(normally 12 months)
It forces management to reassess the budget
regularly and to produce budgets which are more up
to date
Issues with version control, as each month the full year
numbers will change
Confusion in meetings as to each numbers the
business is working towards; this can distract from the
key issues as managers discuss which numbers to
achieve
Activity Based Budgeting
Before Activity Based Budgeting, it is useful to review the Activity Based Costing.
Activity based costing (ABC)
The aim of ABC is to calculate the full production cost per unit. It is an alternative to absorption costing in a
modern business environment.
Reason for the development of ABC
1. Complex production and increase in product range where all products are consuming different amounts of
overheads
2. Falling cost of information processing
3. Increase in non‐volume related support activities e.g. Machine set up etc.
4. Absorption costing allocates a greater portion of overheads to high volume products and smaller portion of
overheads to low volume products
Steps in ABC
1) Group production overheads into activities (cost pools), according to how they are driven.
2) Identify cost drivers for each activity, i.e. what causes the activity costs to be incurred.
3) Calculate an overhead absorption rate (OAR) for each activity.
4) Absorb the activity costs into the product.
5) Calculate the full production cost and/or the profit or loss.
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Performance Hierarchy & Budgets
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Practice Question
Hensau Ltd has a single production process for which the following costs have been estimated for the period
ending 31 December 2010:
$
Material receipt and inspection costs
15,600
Power costs
19,500
Material handling costs
13,650
Three products ‐ X, Y, and Z are produced by workers who perform a number of operations on material blanks
using hand held electrically powered drills. The workers are paid £4 per hour.
The following budgeted information has been obtained for the period ending 31 December 2009:
Product X
Product Y
Product Z
Production quantity (units)
2,000
1,500
800
Batches of Material
10
5
16
Data per product unit:
Direct material (square metres)
4
6
3
Direct material per square metre(£)
1.25
0.50
2
Direct labour (minutes)
24
40
60
No. of power drill operations
6
3
2
Overhead costs for material receipt and inspection, process power and material handling are presently each
absorbed by product units using rates per direct labour hour.
An activity based costing investigation has revealed that the cost drivers for the overhead costs are as follows:
Material receipt and inspection:
Number of batches of material
Process power:
Number of power drill operations
Material handling:
Quantity of material (square metres) handled
Required
Prepare a summary which shows the budgeted product cost per unit for each product of X, Y, and Z for the
period ending 31 December 2010 detailing the unit costs for each cost element using:
i.
The existing method for the absorption of overhead costs and
i.
An approach which recognises the cost drivers revealed in the activity based costing investigation.
(15 marks)
Solution
(i)
Cost per unit using absorption costing.
Direct materials
Direct labour
Production Overheads
X
5
1.6
‐‐‐‐‐‐‐
6.6
7.5
Y
3
2.7
‐‐‐‐‐‐‐‐
5.7
12.5
Z
6
4
‐‐‐‐‐‐
10
18.75
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Performance Hierarchy & Budgets
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‐‐‐‐‐‐‐
14.1
‐‐‐‐‐‐‐
Total Cost per unit
(ii)
‐‐‐‐‐‐‐‐
18.2
‐‐‐‐‐‐‐‐
‐‐‐‐‐‐‐
28.75
‐‐‐‐‐‐‐‐
Cost driver calculation
Cost Drivers Calculation:
Number of batches
10
5
16
‐‐‐‐‐‐‐‐
31
=====
X
Y
Z
Total
Number of operation drills
X
2,000 x 6
Y
1,500 x 3
Z
800 x 2
=
=
=
12,000
4,500
1,600
‐‐‐‐‐‐‐‐‐‐‐‐
18,100
=======
=
=
=
8,000
9,000
2,400
‐‐‐‐‐‐‐‐‐‐‐
19,400
=======
Total
Quantity of materials:
X
2,000 x 4
Y
1,500 x 6
Z
800 x 3
Total
Cost Driver rate Calculation:
Material receipts and inspections
Power
Material Handling
$15,600 / 31
$19500 / 18100
$13,650 / 19400
$503.23 / batch
$1.08 / drill ops
$0.70 / sq. Meter
Cost Per Unit ($)
Prime Costs
Overheads:
Material receipts
Power
Material Handling
Cost per unit
X
6.6
2.52
Y
5.7
1.68
Z
10
10.06
6.48
2.8
‐‐‐‐‐‐‐‐‐
18.4
======
3.24
4.20
‐‐‐‐‐‐‐‐‐
14.82
======
2.16
2.10
‐‐‐‐‐‐‐‐‐
24.32
======
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Performance Hierarchy & Budgets
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Advantages of activity based costing
 Provides a more accurate cost per unit leading to better pricing, decision making and performance
management.
 It provides a better insight into what drives overhead costs resulting in better control of costs.
 It recognises that overhead costs are not all related to production and sales volumes.
 It can be applied to all overhead costs, not just production overheads.
 It can be used just as easily in service costing as product costing.
Disadvantages of activity based costing
 Limited benefit if overheads are primarily volume related or a small proportion of total costs.
 It is impossible to allocate all overheads to specific activities.
 The choice of activities and cost drivers might be inappropriate.
 The benefits might not justify the costs since a large amount of data must be collected.
Activity based budgeting
Use of activity based costing principles to provide better overhead cost data for budgeting purposes.
The advantages of using such a technique accrue from better cost allocation.
ABB is used in an environment with the following criteria:
1. Complex manufacturing environment.
2. Wide range of products.
3. High proportion of overhead costs.
4. Competitive market.
Benefit of ABB
1. Better understanding of overhead costs.
2. Identifies the accurate relationship between product and activity.
3. Each activity more accurately describes where costs are incurred.
Each and every benefit allows for better control of costs together with the opportunity to reduce the costs using
other management accounting techniques.
Disadvantages of ABB
1. Identifying appropriate cost drivers may be subjective and therefore accuracy depends on the judgment of
management.
2. The implementation and maintenance of an ABB system will be expensive and time consuming.
Activity based management
During the 1980s, many businesses started to introduce activity‐based costing (ABC) systems. The aim of these was
to achieve a more accurate calculation of product costs. However, it soon became apparent that the information
that had been produced for activity based costing had much wider use than just calculating the cost per unit of a
product or service.
Activity‐based management (ABM) can be defined as the entire set of actions that can be taken on a better
informed basis using ABC information. The aim is to achieve the same level of output with lower costs.
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Performance Hierarchy & Budgets
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Stages in activity based management (ABM)
The initial stages in ABM are the same as for ABC:
1. Identify the activities that the organisation performs
2. Calculate the cost of each activity
3. Identify the activity cost driver for each activity.
Identify the activities
Organisations perform hundreds, if not thousands, of different activities. It would not be feasible, or even
beneficial, to identify every activity that the organisation performs – so judgment will need to be used to identify
the significant activities based on the amount of time that is spent performing them or based on the expected cost.
Some organisations may try to define only high‐level activities to keep the number of activities defined to less than
30, while other organisations may define much more detailed activity lists. These activities may be summarised in
an activity dictionary.
The following list shows examples of some of the activities that may take place in a manufacturing organisation:
 Schedule production jobs
 Set up machines
 Receive materials
 Run machines
 Support existing products
 Introduce new products
 Calculate the cost of the activities
All indirect costs must be apportioned to the particular activities that they relate to using an appropriate basis.
Staff may be asked, for example, to estimate how much time they spend on each of the activities above so that
factory staff costs can be apportioned to the relevant activities. Other costs such as rent and heating and lighting
will also have to be apportioned. This is similar to the principle of allocating and apportioning costs to cost centres
in traditional absorption costing.
As far as ABM is concerned, simply having the information about the cost of each activity may be all that is
required. In the case of ABC however, it is then necessary to apportion the costs of each activity to the products
using the cost driver information.
Identify cost driver
The cost driver is the factor that causes the cost of an activity to vary. In traditional costing, it was always assumed
that the cost driver was the volume of production, measured either in terms of the number of units, or a proxy,
such as the number of labour hours or the number of machine hours. In ABM however, it is recognised that the
cost of a particular activity may depend on something other than volume of output. In the case of sales order
processing, the cost driver may be the number of orders processed; so whether a sales order contains 5 line items,
or 10 line items, the amount of time to process it will be the same.
The cost drivers for the activities listed above may be as follows:
Activity
Driver
Schedule production jobs
Number of production runs
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Performance Hierarchy & Budgets
APM – Study Notes
Set up machines
Receive materials
Run machines
Support existing products
Introduce new products
Number of setups
Number of receipts
Machine hours
Number of products
Number of new products introduced
ABC then apportions the costs of each activity among the different products that use them, based on the use of
the drivers by each product.
There are two main types of activity‐based management:
1. Operational activity based management (doing things right) – this relates to making the organisation more
efficient by reducing the cost of the activities and eliminating those activities that do not add value.
2. Strategic activity based management (doing the right thing) – which essentially involves deciding which
products to make, and which customers to sell to, based on the more accurate analysis of product and
customer profitability that activity based costing allows.
Operational activity based management
One of the greatest advantages of ABM is that costs are categorised by activities rather than by traditional cost
categories. A simplified analysis of expenses from a traditional costing system may look something like this:
Cost of sales
Staff costs
Rent of factory
Maintenance
Depreciation
Total costs
X
X
X
X
X
‐‐‐‐‐‐
X
‐‐‐‐‐‐
ABM analyses costs by activity. For example:
Direct materials costs
X
Direct labour costs
Schedule production jobs
Set‐up machines
Receive materials
Support existing products
Introduce new products
Total costs
X
X
X
X
X
X
‐‐‐‐‐‐‐
X
‐‐‐‐‐‐‐
Having costs analysed by activity provides much more relevant information to managers. There may be activities
that are being performed that do not add value, so these can be stopped. Management may also identify activities
that cost more than expected, and can investigate these. Management might decide that the cost of setting up
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Performance Hierarchy & Budgets
APM – Study Notes
machines is too high. Using their knowledge of the drivers of that activity, management would realise that having
longer production runs could reduce the cost of this activity as the number of set ups would be reduced.
Many writers discuss using ABM to eliminate non‐value added activities. Cooper and Kaplan claim that it is not
always clear whether an activity is value added or not. It might be argued for example that setting up the machines
is a non‐value added activity, as customers do not value it. However, without setting up machines, there can be no
production. Instead, Kaplan and Cooper suggest discussing how efficient an activity currently is, and therefore how
much opportunity there is for improvement.
Use of ABM with other performance improvement strategies
ABM does not have to be used in isolation, and can be used alongside performance management improvement
strategies, such as Total Quality Management, Six Sigma and Business Process Reengineering, where the
information provided can support the projects.
In Total Quality Management, costs are analysed into costs of conformance (appraisal and prevention costs) and
costs of non‐conformance (internal and external failure costs). The aim of TQM is to reduce the costs of non‐
conformance. Activity‐based management enables organisations to more accurately calculate these quality related
costs and to monitor improvements.
Six Sigma, Business Process Improvements and Business Process Reengineering aim to achieve large one off
(discontinuous) improvements in particular business processes relating to efficiency and better customer
satisfaction. ABM can support these methodologies in several ways:
1. Identifying processes that need improvement and establishing priorities
2. Providing cost justification for proceeding with the project
3. Monitoring the benefits of the projects.
As far as establishing priorities is concerned, ABM enables management to identify which activities or processes it
is spending the most on, and where the biggest financial savings can be made. It can also identify activities where
management believe big improvements can be made. Typically, these are the processes that are highly
fragmented, and involve people from many different departments.
Many business improvement projects may require considerable capital expenditure, and it will be necessary
therefore to do a cost benefit analysis to establish whether it is worthwhile going ahead. ABM can provide more
accurate information about the potential savings from a particular project, therefore leading to a more accurate
assessment.
After completion of a business process improvement project, many businesses do not measure the benefits
achieved by the project, and in some cases fail to take full advantage of them. For example, the project may have
reduced the amount of time spent on dealing with customer complaints, but have the excess staff members whose
time has now been freed up been re‐deployed to other departments?
ABM models also provide information about cost incurred on various activities, so it is easier to monitor how much
the costs of an activity have been cut by a particular project.
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Performance Hierarchy & Budgets
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Example
A case described by Kaplan and Cooper related to a producer of technical manuals for the computer industry.
The company had run out of storage space in their main factory in South Street, due to a large amount of slow
moving inventory for their biggest customer, IBM. So additional storage space was rented in Elmore Street,
several kilometres away from South Street. After production, the manuals for all other customers were
transported to Elmore Street for storage. They would then be returned to South Street for dispatch to the
customer when required. This was only for two or three weeks later.
The management knew that this movement of finished goods to and from Elmore Street was inefficient.
However, since the company used a traditional cost accounting system, the only visible cost relating to this was
the cost of transport – this was $200,000 per year. A solution to redesign the storage process in the South Street
factory for the fast moving goods, and to move the slow moving inventory to Elmore Street (or destroy it
entirely) was estimated to cost $600,000. It did not seem worth investing in this, given that the annual saving
would be only $200,000.
Activity based management was then introduced, and this identified the fact that the actual costs of operating
the inefficient system were much higher than expected. The annual savings of the proposed solution analysed
by activity were:
$
Reduced rental expense
Reduced transport costs
Reduced costs of moving WIP within factory
Reduced costs of moving finished goods within factory
Reduced costs of finding materials
Equipment savings
Reduced cost of managing WIP
Reduced cost of managing finished goods
Eliminated use of outside warehouses
Total annual savings
128,000
271,000
38,000
91,000
88,000
27,000
44,000
68,000
53,000
‐‐‐‐‐‐‐‐‐‐
808,000
‐‐‐‐‐‐‐‐‐‐‐
This activity based information clearly gave management a much more accurate idea of the savings that could be
made by going ahead with the proposed solution, and since the required investment was $600,000, it was clearly
worthwhile.
Strategic activity based management
The first application of strategic ABM is to help decide which products to make or services to provide. The use of
ABC enables the cost per unit of a product or service to be measured accurately and therefore the profit per unit
can be predicted. Many organisations find that when they rank their products according to total profit, it is typical
that 20% of their products generate 300% of the company’s profits. [1] This means that between them, the
remaining 80% of products lose 200% of the company’s profits. The loss making products are normally those that
are produced in low volumes, or require a high level of customisation.
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Performance Hierarchy & Budgets
APM – Study Notes
While it may be tempting to suggest that all such loss making products should be stopped, there are two possible
dangers to such a simplistic decision. First, if 80% of the products were stopped, demand for the remaining 20%
might fall, as many customers prefer to buy all their requirements from one supplier. A second danger is that even
if the business were to stop producing the loss making products, the costs associated with them would not all be
saved.
A more realistic approach that can be used is to adjust the price of the loss‐making products, or to employ tools
such as target costing to reduce the cost.
A second application of ABM is customer profitability analysis where overheads are allocated to customers using
activity based management processes to obtain a more accurate analysis of the profit or loss generated by each
customer. In traditional costing it is assumed that if a customer generates positive contribution, then servicing that
customer must increase the profits of the company. This ignores the fact that many 'fixed' overhead costs are
customer specific – such as the time spent by customer service departments.
Using ABM, overhead costs are also apportioned to customers using appropriate cost drivers, giving a more
accurate picture of how profitable each customer is. Such exercises have produced surprising results for many
businesses, where the 'best' customers have often turned out to generate losses when ABM is employed.
Example
In Hometown, there are several providers of electricity, and domestic consumers can easily switch from one
provider to another.
One of the providers of electricity is First Electric. The company recently had an aggressive advertising campaign
and increased its customer base from 30,000 users to 40,000. Management was surprised to discover that this led
to a fall in profits.
The company introduced customer profitability analysis, using activity‐based principles. The analysis identified the
following activities, along with their cost per unit of driver.
Activity
Driver
Cost per unit of
driver
Meter reading
Number of visits
$20
Customer service
Number of calls
$30
Invoicing
Number of invoices
$10
Customer complaints
Number of complaints
$25
The meter reading took place every three months, after which an invoice was issued.
For an 'easy' customer, the overhead cost per quarter was $30, the cost of reading the meter and issuing the
invoice. More difficult customers could cost much more. Many customers were out when the meter reader came,
so a second visit was necessary. Sometimes the customer was not home the second time either, so was requested
to read his own meter and inform the customer service centre.
Using this information, First Electric was able to analyse accurately the profit per customer. The company was
surprised to learn that it made a loss on 20% of its customers and only broke even on a further 30%.
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Performance Hierarchy & Budgets
APM – Study Notes
In order to remedy the situation, the company made a number of changes. First, it reduced the number of meter
readings to once per year, and issued invoices based on estimated consumption for the other quarters of the year.
It introduced a website where customers could enter their own meter readings if they were not home at the date
of the reading, thus reducing the amount of time used by the customer service department. These actions are
examples of operational activity‐based costing as they relate to reducing the cost of existing activities.
The company also made attempts to stop supplying loss making customers by increasing prices above those of
competitors, encouraging loss making customers to switch to other providers, while offering big discounts to
profitable customers, encouraging them to remain loyal. This is an example of strategic activity‐based costing, as it
focuses on which customers the company should supply to.
Evaluation of ABM
The benefits of ABM (and ABC) are greatest in organisations that have high indirect costs. A major reason for the
increase in the use of ABC in the last 30 years has been the fact that as manufacturing processes have become
more IT based and sophisticated, overhead costs have increased, while direct costs, particularly labour, have fallen.
ABC is most useful in organisations with a wider range of products, as it is these organisations that will have the
most difficulty in allocating overhead costs among different products.
ABM can be criticised for being too inwardly focused. It aims to increase profits by reducing the cost of the
activities that it already performs. It does not consider external factors, such as changes in consumer demand for
its product.
Users of ABM and ABC often assume that all overhead costs are variable. This is not the case, and some overhead
costs will be fixed and will not be saved if activities are reduced.
ABM is also complex and is expensive to implement. For small businesses, or businesses with narrow product
ranges, the benefits of implementing ABM may not justify the costs.
Question
Note – this question is an abridged version of a question that appeared in the June 2013 Paper APM exam.
Navier Aerials Co (Navier) manufactures satellite dishes for receiving satellite television signals. Navier supplies
the major satellite TV companies who install standard satellite dishes for their customers. The company also
manufactures and installs a small number of specialised satellite dishes to individuals or businesses with specific
needs resulting from poor reception in their locations.
The CEO wants to initiate a programme of cost reduction at Navier. His plan is to use activity‐based
management (ABM) to identify non‐value adding activities. The first department to be analysed is the customer
care department, as management believe that the costs of this department are too high. The costs for the most
recent year from the existing accounting system are shown in Table 1.
TABLE 1: EXISTING COST DATA
Computer time
Telephone
Stationary and sundries
$000
165
79
27
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Performance Hierarchy & Budgets
APM – Study Notes
Depreciation and equipment
36
707
The cost accountant has gathered information for the customer care department in Table 2 from interviews
with the finance and customer care staff. She has used this information to correctly calculate the total costs of
each activity.
TABLE 2: ACTIVITY‐BASED DATA
Activities of department
Handling enquiries and preparing
quotes for potential orders
Receiving actual orders
Customer credit checks
Supervision of orders through
manufacturing to delivery
Complaints handling
Staff
time
40%
Total cost
% ($)
282,800
10%
10%
70,700
70,700
15%
106,050
25%
176,750
Comments
relates to 35,000
enquiries/orders
relates to 16,000 orders
done once an order is
received
relates to 3,200
complaints
707,000
The CEO wants you to consider the implications for management of the customer care process of the costs of
each activity in that department. The CEO is especially interested in how this information may impact on the
identification of non‐valued added activities and quality management at Navier.
Required:
Assess how the information on each activity can be used and improved upon at Navier in assisting cost
reduction and quality management in the customer care department.
(12 marks)
Solution
The information in Table 2 shows that the main cost activities of the CC department are pre‐sale preparation
(handling enquiries and quotes) and post‐sale complaints handling. Together, these activities consume 65% of
the resources of the customer care department.
The pre‐sale work is essential for the organisation and the department converts 46% (16,000/35,000) of
enquiries to orders. It would be beneficial to try to benchmark this ratio to competitor performance although
obtaining comparable data will be difficult, due to its commercially sensitive nature.
However, the complaints handling aspect is one, which would be identified as non‐value; adding in an activity‐
based management analysis. Non‐value adding activities are those that do not increase the worth of the
product to the customer; common examples are inspection time and idle time in manufacturing. It is usually not
possible to eliminate these activities but it is often possible to minimise them. Complaints handling is not value
adding as it results from failure to meet the service standards expected (and so is already included in the price
paid).
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Performance Hierarchy & Budgets
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Complaints handling links directly to issues of quality management at Navier as improved quality of products
should reduce these costs. These costs are significant at Navier as complaint numbers are 20% (3,200/16,000) of
orders. Complaints may arise in many ways and these causes need to be identified. As far as the operation of
the CC department is concerned, it may cause complaints through poor work at the quotation stage where the
job is improperly understood or incorrectly specified to the manufacturing or installation teams. This leads to
non‐conformance costs as products do not meet expected standards and, in this case, complaints imply that
these are external failure costs as they have been identified by customers
Quality of the end product could also be affected by the supervision activity and in order to ensure that this is
functioning well, the CC department will need to have the authority to intervene with the work of other
departments in order to correct errors – this could be a key area for prevention of faults and so might become a
core quality activity (an inspection and prevention cost).
The other activities in the department are administrative and the measures of their quality will be in the
financial information systems. Order processing quality would be checked by invoice disputes and credit note
issuance. Credit check effectiveness would be measured by bad debt levels.
Variances




Targets and standards are set reflecting what should happen.
Actual performance is then measured.
Actual results are then compared with the standards, using variance analysis.
Significant variances can then be investigated and appropriate action taken.
This process thus facilitates "management by exception”.
Planning and operational variance
Planning variance is a comparison of original planning and revised planning.
Operational planning is a comparison of actual result and revised planning.
Advantages of revising the budget
(a) Highlights those variances which are controllable and those which aren't.
(b) Ensures that operational performance is appraised by reference to realistic targets.
(c) Should ensure that future budgets are more realistic.
Disadvantages of revising the budget
(a) Determination of revised budget:
 May be biased
 May need external information
(b) Use of revised budget may undermine original budget as a target and as a motivator.
(c) Employees may use this system to their advantage by excusing operating problems as poor planning if this
method is used.
A budget should only be revised for items that are beyond the control of the organisation.
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Performance Hierarchy & Budgets
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Learning curve
It costs more to produce the first unit of a product than it does to produce the one hundredth unit. In part, this is
due to economies of scale since costs usually fall when products are made on a larger scale. This may be due to
bulk quantity discounts received from suppliers, for example.
The learning curve, effect, however, is not about this; it is not about cost reduction. It is a human phenomenon
that occurs because of the fact that people get quicker at performing repetitive tasks once they have been doing
them for a while. The first time a new process is performed, the workers are unfamiliar with it since the process is
untried. As the process is repeated, however, the workers become more familiar with it and better at performing
it. This means that it takes them less time to complete it.
The specific learning curve effect is that the cumulative average time per unit decreased by a fixed percentage
each time cumulative output doubled.
The learning process starts as soon as the first unit or batch comes off the production line. Since a doubling of
cumulative production is required in order for the cumulative average time per unit to decrease, it is clearly the
case that the effect of the learning rate on labour time will become much less significant as production increases.
Eventually, the learning effect will come to an end altogether. You can see this in Figure 1 below. When output is
low, the learning curve is really steep but the curve becomes flatter as cumulative output increases, with the curve
eventually becoming a straight line as the learning effect ends.
Figure 1
The learning curve effect will not always apply. It flourishes where certain conditions are present. It is necessary
for the process to be a repetitive one. Also, there needs to be a continuity of workers and they must not be taking
prolonged breaks during the production process.
Importance of learning curve
Learning curve models enable users to predict how long it will take to complete a future task. Management
accountants must therefore be sure to take into account any learning rate when they are carrying out planning,
control and decision‐making. If they fail to do this, serious consequences will result
Page | 44
Performance Hierarchy & Budgets
1.
2.
3.
APM – Study Notes
As regard to its importance in decision‐making, there is a need to assess the example of a company that is
introducing a new product into the market. The company wants to make its price as attractive as possible to
customers but still wants to make a profit, so it prices it based on the full absorption cost plus a small 5%
mark‐up for profit. The first unit of that product may take one hour to make. If the labour cost is $15 per
hour, then the price of the product will be based on the inclusion of that cost of $15 per hour. Other costs may
total $45. The product is therefore released onto the market at a price of $63. Subsequently, it becomes
apparent that the learning effect has been ignored and the correct labour time per unit should is actually 0.5
hours. Without crunching through the numbers again, it is obvious that the product will have been launched
into the market at a price which is far too high. This may mean that initial sales are much lower than they
otherwise would have been and the product launch may fail. Worse still, the company may have decided not
to launch it in the first place as it believed it could not offer a competitive price.
Here, consider its importance in planning and control. If standard costing is to be used, it is important that
standard costs provide an accurate basis for the calculation of variances. If standard costs have been
calculated without taking into account the learning effect, then all the labour usage variances will be
favourable because the standard labour hours that they are based on will be too high. This will make their use
for control purposes pointless.
Finally, it is worth noting that the use of learning curve is not restricted to the assembly industries it is
traditionally associated with. It is also used in other less traditional sectors such as professional practice,
financial services, publishing and travel. In fact, research has shown that just under half of the users are in the
service sector.
Assumption of learning curve
1. When Product is made largely by labour effort
2. Brand new product
3. Short life products (will have more effect of learning curve)
4. Complex products made in small quantities for special orders (modern business environment)
5. Applied on homogenous products
Learning curve approaches
Tabular approach
*The learning curve applies when output is doubled
The following example to shows how tabular approach works:
Example:
Time to make first unit=50 hours and learning curve is 90%
Cumulative
output(units)
1
2*
4*
8*

Cumulative average
time per unit
50
45 (50x90%)
40.50(45x90%)
36.45(40.50x90%)
Total time (hours)
50(50x1)
90(45x2)
162(40.50x4)
291.6(36.45x8)
Incremental total
time
Hours/unit
40(90‐50)
72(162‐90)
129.6(291.6‐162)
40(40/1)
36(72/2)
32.4(129.6/4)
So one needs to calculate the time it took to make the 8th unit, it will be 32.4 as seen in the table
Page | 45
Performance Hierarchy & Budgets

APM – Study Notes
And the time it took to make 8 units, it will be 291.6
Formula approach
Where Y = cumulative average time per unit to produce x units
a = the time taken for the first unit of output
x = the cumulative number of units produced
b = the index of learning (log LR/log2)
LR = the learning rate as a decimal
Example
A firm's workforce experiences a 75% learning rate.
The budgeted cost for the first batch is 100 Hours
Required
Using the formula Y= aXb , calculate the cost of producing:
(a) the first 10 batches in total
(b) the 10th batch only
Solution
a) Steps
- First calculate ‘Cumulative Average time per Unit’ (Y)
- Calculate Total time (Hours) by multiplying total no. of units with ‘Y’
Y
= 100 x 10 – 0.415 = 38.459 hrs
Total time taken to produce 10 batches: 10 × 38.459 = 384.59 hrs
b)
-
Steps
Calculate Total time (Hours) of which you have to find (i.e. 10 batches) as calculated above
Calculate Total time (Hours) of which you have to find less 1 (i.e. 10 – 1 = 9 batches)
Difference of step 2 and step 1 is the time taken to produce a specific unit (i.e. 10th batch)
Total time taken to produce 10 batches: 384.59 hrs
(from part ‘a’)
Total time taken to produce 9 batches: 361.60 hrs
(Working)
Time to produce the 10th batch only(total cost of 10 batches minus total cost of 9 batches) =384.59‐361.60
=22.99 hrs
Working
Y
= 100 x 9 – 0.415
= 40.1781 hrs
Total time to produce 9 batches = 9 x 40.1781 = 361.60 hrs
Page | 46
Performance Hierarchy & Budgets
APM – Study Notes
Cessation of learning
A time will be reached when the learning effect no longer applies and steady state of production will reach for a
product.
When a steady state point is reached, a standard time and labour cost for the product can be established.
For example if learning ceases at 30 units. The time it takes to make the 30thunit, will be time required to make the
rest of the units
Page | 47
Question Paper
APM – Study Notes
ACCA PAST PAPER QUESTION 1
1.
Framiltone is a food manufacturer based in Ceeland, whose objective is to maximise shareholder wealth.
Framiltone has two divisions: Dairy division and Luxury division. Framiltone began manufacturing dairy foods 20
years ago and Dairy division, representing 60% of total revenue, is still the larger of Framiltone’s two divisions.
Dairy division
This division manufactures cheeses and milk‐based desserts. The market in Ceeland for these products is
saturated, with little opportunity for growth. Dairy division has, however, agreed profitable fixed price
agreements to supply all the major supermarket chains in Ceeland for the next three years. The division has
also agreed long‐term fixed volume and price contracts with suppliers of milk, which is by far the most
significant raw material used by the division.
In contrast to Luxury division, Dairy division does not operate its own fleet of delivery vehicles, but instead
subcontracts this to a third party distribution company. The terms of the contract provide that the distribution
company can pass on some increases in fuel costs to Framiltone. These increases are capped at 0∙5% annually
and are agreed prior to the finalisation of each year’s budget.
Production volumes have shown less than 0∙5% growth over the last five years. Dairy division managers have
invested in modern production plant and its production is known to be the most efficient and consistent in
the industry.
Luxury division
This division was set up two years ago to provide an opportunity for growth which is absent from the dairy
foods sector. Luxury division produces high quality foods using unusual, rare and expensive ingredients, many
of which are imported from neighbouring Veeland. The product range changes frequently according to
consumer tastes and the availability and price of ingredients. All Luxury division’s products are distributed using
its own fleet of delivery vehicles.
Since the company began, Framiltone has used a traditional incremental budgeting process. Annual budgets for
each division are set by the company’s head office after some consultation with divisional managers, who
currently have little experience of setting their own budgets. Performance of each division, and of divisional
managers, is appraised against these budgets. For many years, Framiltone managed to achieve the budgets set,
but last year managers at Luxury division complained that they were unable to achieve their budget due to
factors beyond their control. A wet growing season in Veeland had reduced the harvest of key ingredients in
Luxury’s products, significantly increasing their cost. As a result, revenue and gross margins fell sharply and the
division failed to achieve its operating profit target for the year.
Framiltone has just appointed a new CEO at the end of Q1 of the current year. He has called you as a
performance management expert for your advice.
‘In my last job in the retail fashion industry, we used rolling budgets, where the annual budget was updated to
reflect the results of every quarter’s trading. That gives a more realistic target, providing a better basis on which
to appraise divisional performance. Do you think we should use a similar system for all divisions at Framiltone?’,
he asked.
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Question Paper
APM – Study Notes
You have obtained the current year budget for Luxury division and the division’s Q1 actual trading results
(Appendix 1) and notes outlining expectations of divisional key costs and revenues for the rest of the year
(Appendix 2).
Appendix 1
Luxury division current year budget
C$’000
Revenue
Cost of sales
Gross profit
Distribution costs
Administration costs
Operating profit
Q1
10,000
(6,100)
–––––––
3,900
(600)
(2,300)
–––––––
1,000
–––––––
Q2
12,000
(7,120)
–––––––
4,880
(720)
(2,300)
–––––––
1,860
–––––––
Q3
11,000
(6,460)
–––––––
4,540
(660)
(2,300)
–––––––
1,580
–––––––
Q4
7,000
(4,720)
––––––
2,280
(420)
(2,300)
––––––
(440)
––––––
Total
40,000
(24,400)
–––––––
15,600
(2,400)
(9,200)
–––––––
4,000
–––––––
Q1 Actual
10,400
(6,240)
–––––––
4,160
(624)
(2,296)
–––––––
1,240
–––––––
Appendix 2
Expected key costs and revenues for remainder of the current year
1.
Sales volumes are expected to be 2% higher each quarter than forecast in the current budget.
2.
Average selling price per unit is expected to increase by 1∙5% from the beginning of Q3.
3.
The exchange rate between the Ceeland Dollar (C$) and the Veeland Dollar (V$) is predicted to change at the
beginning of Q2 to C$1∙00 buys V$1∙50. For several years up to the end of Q1, C$1∙00 has been equivalent to
V$1∙40 and this exchange rate has been used when producing the current year budget. Food produced in the
Luxury division is despatched immediately upon production and Framiltone holds minimal inventory. The cost
of ingredients imported from Veeland represents 50% of the division’s cost of sales and suppliers invoice goods
in V$.
4.
The rate of tax levied by the Ceeland government on the cost of fuel which Luxury uses to power its fleet of
delivery vehicles is due to increase from 60%, which it has been for many years, to 63% at the beginning of
quarter 3. 70% of the division’s distribution costs are represented by the cost of fuel for delivery vehicles.
5.
The CEO has initiated a programme of overhead cost reductions and savings of 2∙5% from the budgeted
administration costs are expected from the beginning of Q2. Q3 administration costs are expected to be a
further 2∙5% lower than in Q2, with a further 2∙5% saving in Q4 over the Q3 costs.
Page | 49
Question Paper
APM – Study Notes
Required:
(a) Using the data in the appendices, recalculate the current year budget to the end of the current year and
(12 marks)
briefly comment on the overall impact of this on the expected operating profit for the year.
(b) Evaluate whether a move from traditional incremental budgeting to a system of rolling budgets would be
(13 marks)
appropriate for Dairy and Luxury divisions.
(25 marks)
Page | 50
Question Paper
APM – Study Notes
1 (a) Recalculate the budget for Luxury division to the end of the current year
C$’000
Q1 (Actual)
Q2
Q3
Q4
Total
Revenue (W1)
10,400
12,240
11,388
7,247
41,275
Cost of sales (W2)
(6,240)
(7,020)
(6,370)
(4,654)
(24,284)
Gross profit
Distribution costs (W3)
Administration costs (W4)
Operating profit
–––––––
–––––––
–––––––
––––––
–––––––
4,160
5,220
5,018
2,593
16,991
(624)
(734)
(682)
(434)
(2,474)
(2,296)
(2,243)
(2,186)
(2,132)
(8,857)
–––––––
–––––––
–––––––
––––––
–––––––
1,240
2,243
2,150
27
5,660
–––––––
–––––––
–––––––
––––––
–––––––
Recalculating Luxury division’s budget for the year to reflect current conditions gives a more realistic target for
the division managers. For the coming year, the effect of this is very significant and represents a much more
challenging target for managers as it increases the expected total annual operating profit by 42% (5,660/4,000)
over the original budget.
Workings (C$’000)
W1 – Revenue
Original budget
Q1 (Actual)
Q2
Q3
Q4
Total
10,400∙0
12,000∙0
11,000∙0
7,000∙0
40,400∙0
240∙0
220∙0
140∙0
600∙0
168∙3
107∙1
275∙4
2% sales volume
1∙5% sales price
Total
–––––––––
–––––––––
–––––––––
––––––––
–––––––––
10,400∙0
12,240∙0
11,388∙3
7,247∙1
41,275∙4
–––––––––
–––––––––
–––––––––
––––––––
–––––––––
W2 – Cost of sales
Original budget
Q1 (Actual)
Q2
Q3
Q4
Total
6,240∙0
7,120∙0
6,460∙0
4,720∙0
24,540∙0
142∙4
129∙2
94∙4
366∙0
(242∙2)
(219∙7)
(160∙6)
(622∙5)
2% sales volume
6∙67% Exchange rate*
––––––––
––––––––
––––––––
––––––––
–––––––––
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Question Paper
APM – Study Notes
Total
6,240∙0
7,020∙2
6,369∙5
4,653∙8
24,283∙5
––––––––
––––––––
––––––––
––––––––
–––––––––
Q2
Q3
Q4
Total
720∙0
660∙0
420∙0
2,424∙0
14∙4
13∙2
8∙4
36∙0
8∙8
5∙6
14∙4
*6∙67% = 1 – (1∙4/1∙5), applied to 50% of COS.
W3 – Distribution costs
Q1 (Actual)
Original budget
624∙0
2% sales volume
1∙31% Fuel tax increase*
––––––
––––––
––––––
––––––
–––––––––
624∙0
734∙4
682∙0
434∙0
2,474∙40
––––––
––––––
––––––
––––––
–––––––––
Q1 (Actual)
Q2
Q3
Q4
Total
2,296∙0
2,300∙0
2,300∙0
2,300∙0
9,196∙0
(57∙5)
(113∙6)
(168∙3)
(339∙4)
Total
* 1∙31% = 70% x (3/160)
W4 – Administration costs
Original budget
2∙5% compound savings
––––––––
––––––––
––––––––
––––––––
––––––––
2,296∙0
2,242∙5
2, 186∙4
2,131∙7
8,856∙6
––––––––
––––––––
––––––––
––––––––
––––––––
Total
Workings for savings in administration costs
Q2 2,300∙0 x 2∙5% = 57∙5
Q3 57∙5 + (2,242∙5 x 2∙5%) = 113∙6
Q4 113∙6 + (2,186∙40 x 2∙5%) = 168∙3
Page | 52
Question Paper
APM – Study Notes
(b) Incremental budgeting
Framiltone currently uses this type of budgeting, the starting point of which is usually the previous year’s actual
performance or budget. This is then updated for any known changes in costs, or for inflation. The budget would
normally remain unchanged for the remainder of the year.
Incremental budgeting is suitable for use in organisations which are stable and not undergoing significant
changes. This is the case for Dairy division, which operates in a saturated market and has little opportunity to
grow.
Production volumes in Dairy division have only increased by 0∙5% over a full five years, so it is a very stable
business. Dairy division has stability of both revenues and costs. It has long‐term fixed cost and volume supply
agreements with its supermarket customers. It also has similar fixed contracts with its suppliers of milk, the
most significant raw material ingredient used in its products.
Though the third party distribution company is able to pass on some increases in fuel costs to Dairy division,
these are capped at only 0∙5% per year. This is significantly less than the tax increases which will increase Luxury
division’s fuel costs after the start of Q3. It appears that Dairy division has relatively little exposure to rising fuel
prices.
Furthermore, these increases are agreed prior to the setting of the current year budget, so there is no need to
update these costs on an ongoing basis throughout the year.
As the dairy foods market is saturated and stable, there is little opportunity for the division to incur
discretionary costs such as research and development of new products.
Incremental budgeting is only suitable for business where costs are already well controlled. This is because a
big disadvantage of incremental budgeting is that it perpetuates inefficient activities by often simply building
inflation into previous year results or budgets. It appears that Dairy division, having been in existence for a
relatively long time, does have good cost control as it has modern production plant and is recognised as having
the most efficient production processes in the industry.
Incremental budgeting may, however, build in budget slack. Managers may spend up to their budgeted amounts
in one year, so that their budget is not cut the next, which may affect their appraisal and reward in the future.
It is unclear whether this is occurring at Dairy division, though for many years (while Dairy division was the only
division at Framiltone), the budgets set following consultation with divisional managers have just been
achieved. This may be consistent with the stability of the division, but could also indicate that budgets were not
set at a challenging enough level, even though Dairy division had the best performance of the two divisions last
year.
It is not therefore advisable that rolling budgets are introduced in Dairy division, as the current incremental
process appears satisfactory. This is especially so since divisional managers have little experience of setting their
own budgets, and the time and cost of using rolling budgets would exceed the value of them to the division.
Page | 53
Question Paper
APM – Study Notes
Rolling budgets
Rolling budgets are continually updated to reflect current conditions and are usually extended by budgeting for
an additional period after the current period, for example, a quarter, has elapsed. That way, the budget always
reflects the most up to date trading conditions and best estimates of future costs and revenues, usually for the
next four quarters.
Rolling budgets are suitable for businesses which change rapidly or where it is difficult to estimate future
revenues and costs.
Luxury division was only set up two years ago, and is therefore a relatively new business. It also operates in
quite a different sector of the industry to that in which Dairy division operates and where Framiltone has most
experience. There is likely to be considerable uncertainty as to future costs and revenues as Framiltone has little
direct experience on which to base its forecasts.
Whereas Dairy division operates in a saturated and stable market, Luxury division uses rare ingredients which
are subject to variations in availability and cost, for example, as a result of poor harvests. There is no indication
that Luxury division has fixed price and volume contracts with its customers or suppliers and is therefore likely
to suffer from instability of supply as well as demand resulting from changes in consumer tastes.
The frequent changes in the product range are also likely to make forecasting for a year ahead difficult. The fact
that a large proportion of ingredients are imported from Veeland, makes costs susceptible to changes in the
C$:V$ exchange rates which can quickly make an annual budget out of date, though managers may use methods
such as forward contracts to reduce these movements. If managers are appraised on a budget which is out of
date or unrealistic, they are likely to give up trying to achieve the budget, which will negatively affect the
performance of Framiltone.
Rolling budgets will provide a more accurate basis on which to appraise managers at Luxury division as they
incorporate the best known estimates of future costs and revenues. It can be seen by the recalculation following
Q1 results that Luxury division’s revised budgeted operating profit for the year has increased significantly by
42% (5,660/4,000), most of which is due to exchange rate changes. Where costs and revenues are likely to
change during the period, rolling budgets give a much more realistic basis on which to appraise divisional
performance and appraise and reward divisional managers. Budgets are likely to be achievable, which will
motivate managers to try and achieve them.
Though the regular updating of the budget required in rolling budgeting is costly, time consuming and possibly
a distraction for divisional managers, it does seems that rolling budgets are more suitable for Luxury division
than the current incremental approach, particularly as being realistic and achievable, they will increase
managers’ motivation to achieve the budget and so improve the performance of the business.
Page | 54
Question Paper
2
APM – Study Notes
The Drinks Group (DG) has been created over the last three years by merging three medium‐sized family
businesses. These businesses are all involved in making fruit drinks. Fizzy (F) makes and bottles healthy, fruit‐
based sparkling drinks. Still (S) makes and bottles fruit‐flavoured non‐sparkling drinks and Healthy (H) buys fruit
and squeezes it to make basic fruit juices. The three companies have been divisionalised within the group
structure. A fourth division called Marketing (M) exists to market the products of the other divisions to various
large retail chains. Marketing has only recently been set up in order to help the business expand. All of the
operations and sales of DG occur in Nordland, which is an economically well‐developed country with a strong
market for healthy non‐alcoholic drinks.
The group has recruited a new finance director (FD), who was asked by the board to perform a review of the
efficiency and effectiveness of the finance department as her first task on taking office. The finance director has
just presented her report to the board regarding some problems at DG.
Extract from finance director’s Report to the Board:
‘The main area for improvement, which was discussed at the last board meeting, is the need to improve profit
margins throughout the business. There is no strong evidence that new products or markets are required but
that the most promising area for improvement lies in better internal control practices.
Control
As DG was formed from an integration of the original businesses (F, S, H), there was little immediate effort put
into optimising the control systems of these businesses. They have each evolved over time in their own way.
Currently, the main method of central control that can be used to drive profit margin improvement is the budget
system in each business. The budgeting method used is to take the previous year’s figures and simply increment
them by estimates of growth in the market that will occur over the next year. These growth estimates are
obtained through a discussion between the financial managers at group level and the relevant divisional
managers. The management at each division are then given these budgets by head office and their personal
targets are set around achieving the relevant budget numbers.
Divisions
H and S divisions are in stable markets where the levels of demand and competition mean that sales growth is
unlikely, unless by acquisition of another brand. The main engine for prospective profit growth in these divisions
is through margin improvements. The managers at these divisions have been successful in previous years and
generally keep to the agreed budgets. As a result, they are usually not comfortable with changing existing
practices.
F is faster growing and seen as the star of the Group. However, the Group has been receiving complaints from
customers about late deliveries and poor quality control of the F products. The F managers have explained that
they are working hard within the budget and capital constraints imposed by the board and have expressed a
desire to be less controlled.
The marketing division has only recently been set up and the intention is to run each marketing campaign as an
individual project which would be charged to the division whose products are benefiting from the campaign.
The managers of the manufacturing divisions are very doubtful of the value of M, as each believes that they
have an existing strong reputation with their customers that does not require much additional spending on
marketing. However, the board decided at the last meeting that there was scope to create and use a marketing
budget effectively at DG, if its costs were carefully controlled. Similar to the other divisions, the marketing
Page | 55
Question Paper
APM – Study Notes
division budgets are set by taking the previous year’s actual spend and adding a percentage increase. For M,
the increase corresponds to the previous year’s growth in group turnover.’
End of extract
At present, the finance director is harassed by the introduction of a new information system within the finance
department which is straining the resources of the department. However, she needs to respond to the issues
raised above at the board meeting and so is considering using different budgeting methods at DG. She has asked
you, the management accountant at the Group, to do some preliminary work to help her decide whether and
how to change the budget methods. The first task that she believes would be useful is to consider the use of
rolling budgets. She thinks that fast‐growing F may prove the easiest division in which to introduce new ideas.
F’s incremental budget for the current year is given below. You can assume that cost of sales and distribution
costs are variable and administrative costs are fixed.
Q1
$’000
17,520
Q2
$’000
17,958
Q3
$’000
18,407
Q4
$’000
18,867
Total
$’000
72,752
Cost of sales
9,636
9,877
10,124
10,377
40,014
Gross profit
7,884
8,081
8,283
8,490
32,738
Distribution costs
Administration costs
1,577
4,214
1,616
4,214
1,657
4,214
1,698
4,214
6,548
16,856
Operating profit
2,093
2,251
2,412
2,578
9,334
Revenue
The actual figures for quarter 1 (which has just completed) are:
Revenue
$’000
17,932
Cost of sales
9,863
Gross profit
8,069
Distribution costs
Administration costs
1,614
4,214
Operating profit
2,241
On the basis of the Q1 results, sales volume growth of 3% per quarter is now expected.
The finance director has also heard you talking about bottom‐up budgeting and wants you to evaluate its use
at DG.
Required:
(a) Evaluate the suitability of incremental budgeting at each division.
(8 marks)
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Question Paper
APM – Study Notes
(b) Recalculate the budget for Fizzy division (F) using rolling budgeting and assess the use of rolling budgeting
at F.
(8 marks)
(c) Recommend any appropriate changes to the budgeting method at the Marketing division (M), providing
justifications for your choice.
(4 marks)
(d) Analyse and recommend the appropriate level of participation in budgeting at Drinks Group (DG).
(6 marks)
Page | 57
Question Paper
2
APM – Study Notes
(a) The current method of budgeting at all divisions is incremental budgeting. The advantages of incremental
budgeting are that it is simple and easy; therefore, it does not take up much time and resources in the
finance department, which is constrained by the new information system implementation. It is suitable in
organisations where the business is stable and so historic figures represent a solid base from which to
consider small changes. The problems associated with incremental budgeting are that it consolidates
existing practices into the targets and so tends to stifle innovation. As a result, inefficient and uneconomic
activities will not be challenged and opportunity for cost savings may be missed. Also, managers may
deliberately spend up to their budget limits in order to ensure that they get an increment from the highest
possible base figure in the next budget.
At the different divisions
As S and H are stable businesses, it makes sense to continue to use incremental budgeting at these divisions.
Change at these divisions may not seem necessary as it would create resistance from the divisional
managers. However, incremental budgeting is not consistent with continuous improvement which may be
required to reduce costs and improve profit margins in these divisions.
At F, the incremental budgets will be rapidly out of date in such a growing business. The current problems
of management dissatisfaction and poor quality control may be resulting from divisional management
trying to meet their targets with a budget that is not suitable for the growth occurring. They may be cutting
corners to meet budget and so buying poorer materials or failing to increase capacity and so not making
deliveries.
At M, incremental budgeting is intensifying complaints from the other divisions, who already see M as an
unnecessary expense. Incremental budgeting is insufficiently critical of the existing spending and it can lead
to unjustified increases.
(b) A rolling budget is one where the budget is kept up to date by adding another accounting period when the most
recent one expires. The budget is then rerun using the new actual data as a basis. At Drinks Group, with its
quarterly forecasting, this would work by adding another quarter to the budget and then rebudgeting for the
next four quarters.
Rolling budgets are suitable when the business environment is changing rapidly or when the business unit needs
to be tightly controlled.
The new budget at F would be:
Revenue
Current year
Q1
$’000
17,932
Q2
$’000
18,470
Q3
$’000
19,024
Q4
$’000
19,595
Total
$’000
75,021
Next year
Q1
$’000
20,183
Cost of sales
9,863
10,159
10,464
10,778
41,264
11,101
Gross profit
8,069
8,311
8,560
8,817
33,757
9,082
Distribution costs
Administration costs
1,614
4,214
1,662
4,214
1,712
4,214
1,764
4,214
6,752
16,856
1,817
4,214
Operating profit
2,241
2,435
2,634
2,839
10,149
3,051
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Based on the assumptions that cost of sales and distribution costs increase in line with sales and that
administration costs are fixed as in the original budget.
The budget now reflects the rapid growth of the division. Using rolling budgets like this will avoid the problem
of managers trying to control costs using too small a budget and as a result, choking off the growth of the
business. The rolling budgets will require additional resources as they now have to be done each quarter rather
than annually but the benefits of giving management a clearer picture and more realistic targets more than
outweigh this.
However, it may also be worth considering going beyond budgeting altogether in order to avoid this
constraint problem.
(c) At M, as noted in part (a), incremental budgeting may not be a suitable choice of budget method. A more
appropriate budgeting system for such a project‐based function is zero‐based budgeting (ZBB). Marketing
operates around campaigns that often run for fixed periods of time and do not fit neatly into accounting periods
which further undermines the use of incremental budgeting. It can be seen as a series of projects. This type of
operation is best controlled by having individual budgets for each campaign that the divisional managers must
justify to senior management at the start. ZBB requires each cost element to be justified, otherwise no
resources are allocated. This approach would please the manufacturing divisional managers, as they will see
tight control. It will not hobble M as there are few fixed overheads in marketing as it mainly involves human
capital. ZBB is often used where spending is discretionary in areas such as marketing and research and
development.
(d) The management style currently used at DG is top‐down, budget‐based with some degree of participation by
divisional managers. Given the irritation being expressed by the divisional managers, the senior management
could consider making the control process more participatory. This would involve shifting to more bottom‐up
setting of control targets. This could involve the divisions preparing budgets or else dropping budgeting
altogether.
Bottom‐up control involves the divisional managers at DG having an opportunity to participate in the setting of
their budgets/targets. It is also known as participative control for that reason. It has the advantages of
improving motivation of the divisional managers by creating a greater sense of ownership in the budget/targets.
It increases the manager’s understanding, which has additional benefits if personal targets are then set from
the budget. Bottom‐up processing frees up senior management resource as the divisional managers do more
of the work. It can also improve the quality of decision making and budgeting as divisional managers are closer
to their product markets.
Bottom‐up control can be contrasted with top‐down budgeting. A top‐down budget is one that is imposed on
the budget holder by the senior management. It is controlled by senior management and avoids budgets that
are not in line with overall corporate objectives or that are too easily achieved.
At DG, the current approach does have involvement from the budget holders and so is participatory. This is
important as the managers are set targets based on budgets, although the finance department involvement
should help to avoid the issues of lack of strategic focus and slack that are noted above. The introduction of
rolling budgets could be delegated to the F managers as they will be happy to take on the solution to their
constraint problems. It would be wise to keep some involvement by senior finance staff in reviewing the budget
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– particularly, the key growth assumptions. The introduction of ZBB at M will require the involvement of budget
holders as they will prepare the original proposal. These suggestions will have the advantage of encouraging
innovation although it will loosen central control. Senior management will need to assess whether the
managers of the stable divisions (H and S) can be relied on to drive down costs without the close oversight of
the head office that is provided by a top‐down approach.
Thus, some level of bottom‐up budgeting fits well with both the current and future plans for financial control
at Drinks Group. Although, the senior management will have to decide on the different level of central control
to exercise, based on the skills of the divisional management and the degree of latitude that they require in
order to improve their operations.
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Business Structure & Management Accounting
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BUSINESS STRUCTURE AND MANAGEMENT ACCOUNTING
Chapter Learning Objectives






Identify and discuss the particular information needs of organisations adopting a functional, divisional or
network form and the implications for performance management.
Assess the changes to management accounting systems to reflect the needs of modern service orientated
businesses compared with the needs of a traditional manufacturing industry.
Assess the influence of Business Process Re‐engineering on systems development and improvements in
organisational performance.
Analyse the role that performance management systems play in business integration using models such as
the value chain and McKinsey’s 7S’s.
Discuss how changing an organisation’s structure, culture and strategy will influence the adoption of new
performance measurement methods and techniques.
Assess the need for businesses to continually refine and develop their management accounting and
information systems if they are to maintain or improve their performance in an increasingly competitive
and global market.
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Introduction
This chapter looks at the different types of business structure, and the effect the structure has on the information
needed. It also looks at the types of changes that business might implement to improve their performance.
The information need of different structure
Functional structure
One of the common structures found in medium‐sized organisations is the functional structure. This means that
people within an organisation are organised by function. So, for example, there is a finance department, a
manufacturing department, a sales department, and so on.
Main board
Production
Finance
Administration
Sales
Distribution
Advantages of functional structure
 The organisation gains economies of scale
 Each of these departments is likely to be large enough to be headed by a well‐qualified manager
 Staff within each department is dealing with like‐minded individuals with similar skills and motivation.
Disadvantages of functional structure


As the organisation grows, each of the functional departments can become very powerful and can begin to
concentrate on their own interests rather than those of the organisation as a whole. This is sometime known
as a solo mentality in which departments do not wish to share information with others in the same company.
This type of mentality will reduce efficiency, morale and company performance.
It is not easy to identify where profits and losses are made e.g. Are production costs too high, sales too low or
has not enough been spent on research and development.
Information needs of functional structure
Each functional manager needs information about the performance of their department and senior management
need to know how the business is performing overall.
Budgets are set for each individual function and amalgamated into an overall budget for the business. Actual
results for each function are collected and compared to budget on a periodic basis. The comparison of actual
results to budget is made available to functional managers so that they can take corrective action. Again the
results are amalgamated for senior management.
Potential issues include:
 Functional managers making dysfunctional decisions as they do not get to see the big picture
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

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Performance of managers must be judged based only on controllable costs.
Performance of departments must be judged on costs and revenues traceable to the department.
Divisional structure
As organisations grow they will often develop a divisional structure, where each division has its own functional
departments and where the divisional manager has a degree of autonomy.
Divisions can be on the basis of:
 Products.
 Geography.
 Type of customer
Advantages of divisional structure
 Divisional managers are more motivated as they are provided with performance targets that are easier to
define, measure and evaluate.
 Decisions are made ‘closer to the action’ so that faster decisions can be made.
 Divisions can specialize. For example, the North American division can concentrate making goods to suit that
market, pricing them competitively and countering the competition there.
 Junior managers have more responsibility and get training for more senior positions in the future
Disadvantages of divisional structure
 Head office management may need to restrict the autonomy of divisional managers, which can reduce
motivation and cause dissatisfaction
 Divisional managers are concerned about their own division’s performance rather than that of the
organisation as a whole, which can lead to a loss of goal congruence.
 Poorer coordination.
 There can be transfer pricing issues.
 There can be some duplication of service departments e.g. to finance departments.
Information needs of divisional structure
Each divisional manager needs information about the performance of his division – aggregating the data from each
department within the division. This aggregated information is then passed upwards to head office.
Head office does however need to aggregate the information received from each division in order to assess the
overall performance of the organisation.
Network (matrix) structure
An example of this may be found in firms of accountants, where there may be managers responsible for each
individual office within a country, but at the same time there may be managers responsible for different activities
in all offices throughout the country.
As a result, an employee working in the tax department of an office in one town will be reporting both to the
manager of that office, and to the nationwide tax manager.
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Another example is that of employees being assigned to a project.
Engineering
Finance
Quality control
Purchasing
Project A
Project B
Project C
These employees are responsible to both the project leader of project B and to the quality control manager.
Advantages of network structure
 Communication is encouraged between various departments and activities
 Employees are encouraged to be more concerned for the organisation as a whole instead of simply their
geographical division
Disadvantages of network structure
 There can be conflicting pressures put on employees by the different managers to whom they report.
 There can be confusion over which boss has the ultimate say.
Information needs for network structure
Data needs to be aggregated in two ways – both for the manager of the division and for the manager of the
activity.
As with a divisional structure, the aggregated information is passed upwards to the head office, and the head
office needs to be able to aggregate it in order to assess the performance of the organisation as a whole.
Complex business structure
Businesses increasingly rely on relationships with external partners to perform critical business processes.
Relationships such as outsourcing and collaboration allow business processes to be performed better or more cost
effectively, or without the need for investment in expensive production capacity. Various terms have been used to
describe the complex relationships that have developed, such as virtual organisations, hollow organisations and
network organisations.
In Virtual Organisations and Beyond (1), Hedberg, Dahlgren, Hansson and Olve describe how the Swedish clothes
retailer GANT operates. The centre of operations is a Swedish company, Pyramid Sportswear AB, which has eight
employees. Pyramid Sportswear owns the rights to use the brand name, selects the designers, performs quality
control of production, arranges advertising, and organises the shipping of clothes from the factories to the
retailers. Design and production of the clothes are outsourced, and the clothes are sold through independent
retailers. To the customer it appears that there is one organisation, the GANT Company, which performs all these
activities but in reality no such organisation exists. This group of independent companies, working together,
coordinated by Pyramid Sportswear is described as an ‘imaginary organisation’ by Hedberg et al., although the
term ‘hollow organisation’ has been used by others to describe similar arrangements. Pyramid Sportswear is the
core of this imaginary organisation, and it coordinates the other organisations; the partners.
A virtual organisation is one that has little or no physical premises, but where employees and managers work
remotely (typically from home) and are connected using IT, such as emails, video conferencing, extranet and
intranets. The organisation appears to the outside world to be just like any traditional style organisation.
Customers and suppliers are linked using IT systems which adds to the impression that they are all part of the
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organisation. The classic example is Amazon, the online retailer. Most orders placed on Amazon’s website are
forwarded to suppliers, who then send the goods directly to the customer.
Collaboration is also an important element in many business chains. Organisations such as Apple rely on a network
of independent programmers who develop apps for their products. While these programmers work independently,
they rely on Apple sharing technical information with them about its operating systems, and through Apple’s
developer conference, they become part of the Apple family.
Performance management in complex business structure
In complex business structures the core enterprise needs to manage the performance not only of its own activities,
but also those of the partners to some extent. The obvious problem is that the core enterprise does not usually
own the partners, so has no legal right to try to manage them. Performance management issues must therefore be
agreed with each partner as part of the terms of business.
Typically a contract or service level agreement will specify what activities are expected of each partner, what the
minimum standards are in terms of quality, and the price that will be paid. These agreements may also describe
reporting requirements, whereby partners are required to report their own performance using agreed metrics,
such as percentage of late deliveries and number of customer complaints. There may also be fines for repeated
failure to achieve some of the standards.
Planning
In traditional organisations, planning and control is based on the budget. The process of preparing the budget
requires the different parts of the organisation to coordinate their activities for the following year and this requires
some central coordination. Budgets also aim to ensure that costs of production are controlled. At the end of each
accounting period, actual results are compared with budgets and action taken to remedy any significant variances.
In a complex business structure, the core organisation does not need to have a detailed analysis of costs incurred
by the business partners. From a financial point of view, the core is only interested in the prices that partners will
charge, and these will already have been agreed in the service level agreement. The core needs to be sure that
suppliers will have the capacity to meet its demand on time, even though it may not be possible to specify how
much that demand will be at the start of the year. Some type of planning will therefore be required to ensure that
all parts of the structure have the flexibility and capacity to meet the potential demand from the core organisation.
Control
The core is mainly interested in non‐financial aspects of the performance of the partners. Quality of goods or
services are obvious areas. Other aspects may include delivery times, quality of customer service and ethical
behaviour. Several large multinational companies have had their reputations damaged by the behaviour of
partners in third world countries who employ child labour for example, or operate sweat shop style operations
where employees are paid subsistence wages, and made to work long hours. Poor ethical behaviour of such
partners can harm the reputation of the whole structure.
Expected standards must be specified in service level agreements. If a partner is required to fulfil sales orders to
customers for example, there may be requirements about the minimum period within which such orders must be
completed. The service level agreement may also require compliance with a corporate code of ethics. Partners will
be expected to provide performance reports showing appropriate measures of performance and must allow
inspections and audits to be performed by the core organisation.
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Monitoring the work force
Where the structure makes use of freelance workers and employees who work from home, traditional methods of
control over the work force become less useful. It is not possible to clock employees each morning when they work
from home, for example, and they cannot be watched to ensure that they are working diligently. One solution is to
simply pay by results. Remuneration may be based on quantitative measures of the output such as number of
customer queries dealt with. Trust is likely to be a key factor in any such relationship, and the use of cultural
controls, which involves employing people who are self‐motivated.
Information technology can also be used to keep tabs on employees. System logs can record what time employees
log onto and off the system, although there is no guarantee that they are being productive all the time they are
logged in.
Performance management problems in complex structure
While performance measures and expected targets will be specified in the service level agreements, there can still
be disagreements when things go wrong. Disagreements can arise about the value of metrics calculated. In the
exam question Callisto Retail (June 2012), there was a disagreement about the amount of days the inventory was
held by one of the wholesalers, and this required detailed reconciliation to be performed. Disagreement may also
arise over who is to blame when things go wrong. If customers are not happy about the service they receive, there
could be a number of partners who are potentially to blame.
Confidentiality of information becomes a risk, due to the fact that the core organisation is sharing key information
with its partners. This may include commercially sensitive information such as production methods, or names and
addresses of customers. Procedures need to be in place to ensure that such information is secure. This would
include requirements relating to the security surrounding the information systems.
Motivation can also be an issue. Where all business processes are carried out in house, it can be easier to motivate
employees using reward systems. Where the processes are carried out by an outside partner, it may not be so easy
to motivate them. It is essential therefore that all partners share the same objectives and understand how they
contribute to the success of the whole organisation. In some relationships, there is an element of profit share or
bonus paid to the partners to motivate them to perform well.
Role of IT
Information systems often play a crucial role in complex business structures. The core organisation may invest in
the development of an information system that it requires all partners to use. This can mitigate many of the
challenges relating to the performance management discussed above. Its role in monitoring the work of
employees has already been noted. Having one system used by all partners means that everyone is using the same
data. There should be less difficulty collecting information about the performance of partners since the
information will all be stored in one system. The core party has greater control over the security of data, and
communication between the parties will be much more fluid allowing greater coordination.
Conclusion
The greater use of business partners to perform crucial business processes may lead to lower costs and greater
specialisation. However, the reliance on external partners can lead to additional challenges for performance
management. These must be considered in drafting of contracts with the partners. The use of shared IT systems
can also assist in many of the challenges.
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Performance management in service industry
It has been argued that performance management for modern service based firms create extra challenges for
performance management (compared to traditional manufacturing) because services have the following
characteristics:
Heterogeneity:
Manufacturing often produces many identical units; service industries often produce tailored products e.g. an
audit. Costing information and efficiency measurement will be quite different. Pricing will be very different as
customer (or clients) will find it more difficult to judge prices.
Perishability:
Many services are perishable i.e. they lose their value after a certain time. An example is airline seats. Once the
aircraft departs the seats have no value. Again, this presents interesting pricing challenges. Performance will be
improved by attracting each extra passenger at the maximum marginal price, but if everyone knows that prices will
fall near the departure date, passengers will be encouraged to postpone booking until prices reduce.
Intangibility:
It is difficult to show potential customers what they will get for their money. Auditing firms cannot show clients an
audit or audit file so it is difficult for potential clients to judge value for money?
Simultaneity:
In manufacturing, production and sale can be separated. This allows products to be quality checked before
dispatch and allow flexibility in timing. For example, production can be carried out steadily throughout the year
and inventory can be stored until busy sales periods. Services cannot be stored and are often instantly delivered.
This places additional demands on scheduling, pricing and quality control information
No transfer of ownership.
Often services or the use of a service provider is for a limited period of time. Pricing and demand information has
to reflect this. For example, the pricing of hotel rooms will vary from weekdays to weekends. In addition, because a
service is being provided for a limited period only, consumers are likely to be very demanding during that period.
These differences mean that the performance management will need to adapt, for example it could be argued
that:
 Information requirements of service businesses will be broader than that of manufacturers.
 More qualitative information will be required concerning customer satisfaction and employee morale.
 Most of the expenses in service businesses are overheads, making activity based cost information more
valuable.
Business Process Re‐engineering (BPR)
Business process reengineering involves re‐thinking and radically re‐designing of the way an organisation’s
processes operate.
It is not simply attempting to improve the existing way of doing things, but starting almost with a blank piece of
paper and designing how best to operate the business. The starting point is to determine what the desired
outcome is of the organisation and then to design how best to achieve it.
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It focuses on maximising customer value and removing non‐value adding work.
A leading advocate of business process reengineering – Michael Hammer – claimed that most of the work being
done does not add any value for customers, and that this work should be removed, rather than simply speeded up,
using technology. Information technology in particular has been used primarily for automating existing processes
whereas it should be used as a way of making non‐value added work obsolete.
Business process reengineering opportunities can be identified by the following approaches:
 Zero‐based: how to organize a business if it were being started just now?
 Simplification – eliminate duplication and redundant steps
 Value‐added analysis – remove non‐value adding activities
 Gaps and disconnects – check flows between departments
Business integration
Business integration is about linking an organisation’s systems together to streamline processes that will lead to
greater efficiency.
For example, "you’ll streamline operations and gain a competitive edge by integrating your accounting, business
intelligence, CRM, supply chain and human resource management applications,". BI is mostly applicable to
manufacturers that deal in large quantities of inventory. With a warehouse management B2B integration solution.
A company should be careful about choosing the implementation strategy, because If the most effective
integration strategy is not adopted, it runs the risks of deploying standalone systems and applications that only
lead to more silos.
Performance management can be enhanced by the use of the value chain (Porter) to enhance the linkages
between activities within (and outside) the organisation.
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Value chain analysis
This model represents organisations by setting out the activities they carry out.
Firm infrastructure, technology development, human resources and procurement are known as support activities.
The other activities are primary activities.
By carrying out these activities, organisations can manage to make profits. However, it is essential for the
organisation to know what gives the right (or ability) to make profits.
Why do customers pay enough to allow a profit to be made? It might be because:
 The organisation possesses the knowhow that customers pay for
 The organisation offers flexibility
 The organisation offers economies of scale
 The organisation takes on risks
Whatever it is that customers value, is the key to an organisation’s success and its performance needs to be
carefully managed. The organisation also has to be careful about changing or removing activities or performance
that its customers value. It is difficult for an organisation to survive if it carries out tasks that are not valued by
customers. Short term performance improvements in one area might lead to longterm performance decreases in
another.
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McKinsey’s 7s Model
This model represents organisations using the following inter‐related elements. To carry out a strategy
successfully, consideration has to be given to getting each element:
Structure
Strategy
System
Shared
values
Style
Skills
Staff
Strategy
Plans on how to reach identified goals and for dealing with the environment, competition, customers, new
technology etc.
Structure
This is the way the organisation’s units relate to each other: centralized, functional divisions, divisionalisation,
tall/narrow or wide/flat, decentralized (the trend in larger organisations); matrix etc.
Systems
The procedures, processes and routines define how work is to be done: financial systems, quality control systems,
recruitment, promotion and performance appraisal systems, information systems, safety procedures.
Skills
Distinctive competences of personnel or of the organisation as a whole.
Staff
Numbers and types of personnel within the organisation.
Style
Cultural style of the organisation and how key managers behave in achieving the organisation’s goals. For example
an organisation could adopt a role culture or a task culture.
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Shared Values
This includes what the organisation stands for and what it believes in. Central beliefs and attitudes.
The upper three elements on the dark background are the ‘hard Ss’. These are relatively easy to describe and
define. Many organisations focus too much on these because they are easy to define and describe.
The lower three on the white background and the central element are the ‘soft Ss’ and are less easy to describe
and define. Therefore, these tend to be ignored.
Additionally, all the elements are all inter‐dependant so that changing one will affect others. For example, the
introduction of a new production system will probably affect skills structure, style and staff. It could even have an
impact on strategy if allowed, for example, more flexible production.
Structure and Performance Measurement
Structure:
Performance depends on the organisational structure; it can improve or deteriorate performance. The better
synchronized structure, the better will be the management and employee coordination thus leaving a positive
effect on the productivity. Performance management includes setting of goals for the employees, and the regular
submission of review reports to the managers. Policies, goals, requirements and methods should be in an
organized structure in order to help achieve the objectives for good quality and improved products and services, in
turn satisfying customers successfully.
Purpose
The need for performance management is vital to keep a check on the productivity of organisations. Performance
management includes developing goals and plans, setting targets, defining priorities, setting up small goals and
tasks for employees complementing the company’s key objectives and helping achieve them in the long‐term. The
work of employees is then reviewed and rated and exemplary performance may even be rewarded to encourage
goals to be achieved efficiently and timely.
Entrepreneurial
An entrepreneurial organisation is usually unstructured and thus has more of a flat flow. As the structure is
informal, the management should also be according to it. In such set ups, there is a threat that if employees drop
out or leave, there is no trained backup and as a result this would leave the strategic goals of the organisation
unfulfilled.
Bureaucratic
A bureaucratic organisation has a very formal work environment. There is a set pattern, fixed responsibilities and
defined protocols and standards. Organized and well described jobs and levels give a clear career path to
employees. This organisation has a vertical structure so good performance of employees result in promotion and
rewards but only within their existing departments, thus defining limits to career growth.
Professional
Professional organisations have trained staff that has the expertise to work and achieve goals independently which
leads them to have complete control over their responsibility, progress and performance. As many individuals have
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authority, the performance may become haphazard. It may even be difficult to streamline, control the overall work
and introduce changes.
Divisional
In divisional organisations, many independent divisions and departments work in such a way that they have their
own set of goals, procedures and rules, but they are all connected to one central unit where they all report. When
companies have many products and services or they exist in different locations or provide to different sets of
customers, a divisional organisation set up is more convenient and flexible to match the requirements. The major
drawback of such a set up is that departments and employees may feel that they are not being equally treated
thus leading to a conflicting environment in the workplace.
Innovative
Organisations with an innovative set up are not bound by many rules and regulations. The setup is flexible in a way
that the organisation adjusts its structure according to the ongoing project or along the demand of the market.
Management is informal in such an organisation. Such organisations have a fixed set of unchanging employees but
a few conditional employees may be hired in accordance to different projects.
The performance and strategy of an organisation are determined mainly by senior managers. Having an efficient
strategy, helps an organisation to perform successfully and compete in the market actively and prominently. There
is a difference between the managers’ and shareholders’ perspectives. Shareholders are more focused on huge
profits, expansion and prosperity while managers are focused on reaching goals successfully with minimum effort
applied. Organisations prosper more when these differing views are aligned together and the shareholders and
managers work together keeping each other’s perspective in mind.
Continous Development and Improvement of Accounting and Information Systems
Continuous development of information and accounting systems is needed in order to keep them updated with
the latest advances in technology keeping in mind the various environmental and trend changes as well.
Reasons for change in systems:
1. Advancement in technology requires all prospering businesses to be up to date
2. Expansion of business and progress requires better systems
3. To become a successful and prominent competitor in the market, ample knowledge and information is
required
4. Revised and latest methodology needs to be learnt and applied
5. With latest developments in accounting, it is necessary to be familiar with them e.g. ABC, throughput, black‐
flush etc.
6. If organisations apply JIT, they should be well equipped with knowledge about orders, supplies and processes.
7. With the increase in new products and a developed global market, latest systems are required to produce
creative and new quality products in minimum time.
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Environmental Issues
APM ‐ Study Notes
ENVIRONMENTAL ISSUES & RISK AND UNCERTAINITY
Learning Objectives






Discuss the ways in which stakeholder groups operate and how they influence an organisation and its
performance measurement and performance management systems (e.g. using Mendelow’s matrix).
Discuss the social and ethical issues that may impact on strategy formulation, and consequently, business
performance.
Discuss, evaluate and apply environmental management accounting using for example lifecycle costing and
activity‐based costing.
Assess the impact of the different risk appetites of stakeholders on performance management.
Evaluate how risk and uncertainty play an important role in long term strategic planning and
decisionmaking that relies upon forecasts of exogenous variables.
Apply different risk analysis techniques in assessing business performance such as maximin, maximax,
minimax regret and expected values.
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Stakeholder’s Influence
Stakeholder’s Influence
Stakeholders:
Group or individuals whose interests are directly affected by activities of an organisation. e.g.
Internal:
Connected:
External:
Interacts daily with the organisation
Frequent interaction with the company
Occasional interaction with organisation
Mendelow’s stakeholder’smodel:
To identify and manage stakeholders according to their expectations.
Power: In an influential position?
Interest: Is a stakeholder affected by the decision made in the organisation?
The Detailis:
Key players:
Stakeholders who have high power and high interest are known as key players.
Management really needs to keep those people happy. They have the power and they
have the willingness to do something about it if they are upset. These stakeholders can
stop any strategy in its tracks.
Keep satisfied:
Some stakeholders have high power but they are unlikely to take action even if
management does something which they dislike. They may be unwilling to take because
of professional or ethical reasons. For example, medical staff in hospitals are very unlikely
to take industrial action.
Keep informed:
Minimal effort:
Management doesn‘t have to be quite as careful with these people as with the key
players. However, they have to be kept satisfied otherwise they could be provoked to
take action and turn into key players.
People with low power but high interest have to be kept informed. They can‘t do much
about it themselves but they might be able to influence key players to take action on their
behalf.
These stakeholders have low power and low interest. Management can almost ignore
these people. After all, what are they going to do if they don‘t like what‘s happening?
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Ethical influence:
Ethics are ideas about right and wrong that set standards for conduct. Ethics are important to business because
society considers such things important. There are also rules of professional conduct to consider. Ideas of right
and wrong have become more fluid and less absolute. As a result there is a greater scrutiny of an organisation‘s
behavior since it is likely to be less subject to definitive internal rules.
Ethical stance: The extent to which an organisation will exceed its minimum obligation to stakeholders.
 Short term stakeholder interest: obey the letter of the law
 Long term stakeholder interest: behave ethically to enhance image and reduce pressure for regulation
 Multiple stakeholder obligations: the expectations of other groups of stakeholders may be considered, as
well as any right they may have
 Shaper of society: really restricted to public sector organisations; businesses should not sacrifice their
commercial viability
Ethical Dilemmas:
Conflicting views of the organisation‘s responsibilities create ethical dilemmas for managers at all levels.
Examples are;
 Dealing with corrupt or unpleasant regimes
 Honesty in disclosing information
 Employees‐cost or opportunity for them?
 Corrupt payments to officials‐bribery or gift?
The local culture must be considered
Social Issues:
Society and its values include many things. Heritage, values, traditions, the way people think, what acts are
accepted as normal or offensive, the way people react to change, how a traditional buyer thinks and spends etc.
are all part of social trends. A social environment focuses on some major factors including ecology, demographics,
non‐economic activities and quality of life such as healthcare, education, safety etc. Social issues can quickly
become political and even legal issues.
The behavior and consumer perspective and thinking are all important thing that may be altered by social factors.
The way consumers behave and think is very important for organisations to understand to make sure its products
are accepted by the people. Consumer behaviors as well as employee behavior both affect organisations externally
and internally.
It is important to assess, understand and stay updated with consumer’s changing behavior affected by social issues
in order to determine relevant goals and objectives to succeed in the market.
ENVIRONMENTAL ACCOUNTING
In an ideal world, organisations would reflect environmental factors in their accounting processes via the
identification of the environmental costs attached to products, processes and services.
Many existing conventional accounting systems are unable to deal adequately with environmental costs and as a
result simply attribute them to general overhead accounts.
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Consequently, managers are unaware of these costs, have no information with which to manage them and have
no incentive to reduce them.
Many overestimate the cost and underestimate the benefits of improving environmental practices.
Management accounting techniques can distort and misrepresent environmental issues, leading to managers
making decisions that are bad for businesses and bad for the environment. The most obvious example relates to
energy usage.
Environmental Management Accounting (EMA) is an attempt to integrate best management accounting with the
best environmental practices and thinking.
EMA is the generation and analysis of both financial and non‐financial information in order to support internal
environmental management processes. It is complementary to the conventional financial management accounting
approach, with the aim to develop appropriate mechanisms that assist in the identification and allocation of
environment‐related costs.
The major areas for the application for EMA are:
 In the assessment of annual environmental costs/expenditures.
 Product pricing.
 Budgeting.
 Investment appraisal.
 Calculating costs.
 Savings of environmental projects, or setting quantified performance targets.
EMA is concerned with the accounting information of managers in relation to corporate objectives. It involves:
 Identifying and estimating costs of environmental related activities.
 Identifying and monitoring the usage and cost of resources such as water and fuels.
 Ensuring the environment is considered as part of capital investment decisions.
 Assessing the likelihood of environmental risks.
 Setting environmental related indicators as part of the control and monitoring process.
 Benchmarking activities against environmental best practices
Classification of costs:
 Environmental prevention costs: the costs of activities undertaken to prevent the production of waste.
 Environmental detection costs: costs incurred to ensure that the organisation complies with regulations and
voluntary standards.
 Environmental internal failure costs: costs incurred from performing activities that have produced
contaminants and waste that have not been discharged into the environment.
 Environmental external failure costs: costs incurred on activities performed after discharging waste into the
environment.
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Identification of costs:
 Conventional costs: raw material and energy costs which have environmental relevance.
 Potentially hidden costs: costs captured by accounting systems but then losing their identity in ‘general
overheads’.
 Contingent costs: costs to be incurred at a future date, e.g. clean up costs.
 Image and relationship costs: costs that, by their nature, are intangible, for example, the costs of preparing
environmental reports.
Accounting for environmental costs:
Input/outflow analysis
This technique records material inflows and balances this with outflows on the basis that, what comes in, must go
out.
So, if 100kg of materials have been bought and only 80kg of materials have been produced, for example, then the
20kg difference must be accounted for in some way. It may be, for example, that 10% of it has been sold as scrap
and 90% of it is waste. By accounting for outputs in this way, both in terms of physical quantities and, at the end
of the process, in monetary terms too, businesses are forced to focus on environmental costs.
Flow cost accounting
This technique uses not only material flows but also the organisational structure. It makes material flows
transparent by looking at the physical quantities involved, their costs and their value. It divides the material flows
into three categories: (i) material, (ii) system and (iii) delivery and disposal. The values and costs of each of these
three flows are then calculated. The aim of flow cost accounting is to reduce the quantity of materials which, as
well as having a positive effect on the environment, should have a positive effect on a business’ total costs in the
long run.
Activity‐Based Costing
ABC allocates internal costs to cost centers and cost drivers on the basis of the activities that give rise to the costs.
In an environmental accounting context, it distinguishes between environment‐related costs, which can be
attributed to joint cost centers, and environment‑driven costs, which tend to be hidden on general overheads.
Lifecycle costing
Within the context of environmental accounting, lifecycle costing is a technique which requires the full
environmental consequences. Costs arising from production of a product to be taken account of, across its whole
lifecycle, literally ‘from cradle to grave’.
Problems with EMA
The most significant problem of EMA lies in the absence of a clear definition of environmental costs. This means it
is likely that organisations are not monitoring and reporting such costs.
The increase in environmental costs is likely to continue, which will result in the increased information needs of
managers and provide the stimulus for the agreement of a clear definition.
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However, whatever the difficulties, the use of EMA will probably increase with positive effects for both
organisations and the environment in which they operate.
Risk and uncertainty
INTRODUCTION
Risk and uncertainty is a topic on which you have been examined previously, but is deemed knowledge and
therefore is repeated here for revision.
Decision making involves making decisions now which will affect future outcomes which are unlikely to be known
with certainty.
Risk exists where a decision maker has knowledge that several possible outcomes are possible – usually due to
past experience. This past experience enables the decision maker to estimate the probability or the likely
occurrence of each potential future outcome.
Uncertainty exists where the future is unknown and where the decision maker has no past experience on which to
base predictions.
Whatever the reasons for the uncertainty, the fact that it exists means that there is no rule as to how to make
decisions. For the examination you are expected to be aware of, and to apply, several different approaches that
might be useful.
Risk preference
A RISK SEEKER will be interested in the best possible outcome, no matter how small the probability of success.
Someone who is RISK NEUTRAL will be concerned with the most likely or ‘average’ outcome.
A RISK AVOIDER makes decisions on the basis of the worst possible outcomes that may occur.
EXPECTED VALUES
Decision‐making involves dealing with future events that cannot be predicted with any certainty.
It may, however, be possible to predict a range of possible costs and revenues and the likelihood of them arising.
Expected Values (EVs) are weighted average values based on probabilities. EVs are a useful tool in business.
 They can, for Exercise, be used to calculate the likely number of faulty components in a production batch and
the likely sales of a product over a range of time periods.
 They can also be used to calculate the likely profits of a project, together with the most profitable course of
action. Expected values are of most use in longer term planning though they still have a role in one off
decisions.
The general formula for expected values is: EV = ∑Pxwhere:
 EV is the expected value of x
 ∑ = the sum of
 x = value of x
 P = probability of x occurring
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Drawbacks of Expected Values
There are a number of drawbacks to expected values:
 Expected values are long‐term average values.
 They may not apply to one off decisions.
 They can be values that will never arise.
 Probabilities can be hard to determine.
Expected Values and the payoff table
The results from a particular decision or action are often uncertain and depend on the circumstances prevailing at
the time.
The CONSEQUENCE (or payoff) that arises from each action depends on the CIRCUMSTANCES operating at the time
when the decision is made. These circumstances are independent of the actions themselves, and it is often
possible to assign a probability value to each of them.
It is possible to construct a payoff table which shows all of the possible consequences of a particular decision. It is
customary to display circumstances as rows and actions as columns. Consequences or payoffs are cells in the
table.
DECISION RULES
Depending on a decision‐maker’s attitude to risk a company may adopt different approaches to deciding which
project or course of action to take.
MaxiMin
In this strategy the decision‐maker takes the project that has the least bad outcome – in effect playing it safe.
Remember this is a very conservative strategy that can lead to low returns for a company. It is also one that
completely ignores the likelihood of something happening.
MaxiMax
In this approach the company seeks to maximize the best possible outcome.
Remember this can be a high risk strategy as no account is taken of possible losses or how likely each outcome is.
Minimax regret
In this decision making rule, the decision maker tries to minimize the regret from making the wrong decision.
Regret refers to any opportunities lost as a result of making the wrong decision.
ILLUSTRATION 1
Exton Health Centre specializes in the provision of exercise and dietary advice to clients. The service is
provided on a residential basis and clients stay for whatever number of days suits their needs.
Budgeted estimates for the year ending 30 June 2012 are as follows:
(i)
The maximum capacity of the center is 50 clients per day for 350 days in the year.
(ii)
Clients will be invoiced at a fee per day. The budgeted occupancy level will vary with the client fee level
per day and is estimated at different percentages of maximum capacity as follows:
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APM ‐ Study Notes
Client fee per Occupancy level Occupancy as percentage of day maximum capacity
$180
High
90%
$200
Most likely
75%
$220
Low
60%
Variable costs are also estimated at one of three levels per client day. The high, medium and low levels
per client day are $95, $85 and $70 respectively.
The range of cost levels reflects only the possible effect of the purchase prices of goods and services.
Required:
(a) Prepare a summary which shows the budgeted contribution earned by Exton Health Centre for the year
ended 30 June 2012 for each of nine possible outcomes.
(6 marks)
(b) State the client fee strategy for the year to 30 June 2012 which will result from the use of each of the
following decision rules: (i) maximax; (ii) maximin; (iii) minimax regret.
Your answer should explain the basis of operation of each rule. Use the information from your answer to
(a) as relevant and show any additional working calculations as necessary.
(9 marks)
(c) The probabilities of variable cost levels occurring at the high, medium and low levels provided in the
question are estimated as 0.1, 0.6 and 0.3 respectively. Using the information available, determine the
client fee strategy which will be chosen where maximization of expected value of contribution is used as
the decision basis.
(5 marks)
(d) The residents are provided with breakfast and evening meals at no extra cost. However, they also have
an option to buy a lunchtime meal. Each meal costs $7 to prepare and would be priced at $15 to
customers. All lunches must be prepared in advance. Based on expected occupancy levels, the restaurant
manager has predicted that daily demand will either be 10 meals (probability 0.2), 20 meals (probability
0.5) or 30 meals (probability (0.3).
Prepare a pay‐off matrix showing the outcomes if the restaurant manager decides to make 10, 20 or 30
lunches in advance. How many lunches should the restaurant manager make? (5 marks)
(25 marks)
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ANSWER
(a) Budgeted Net Profit/Loss outcomes for year ending 30 June 2012
Occupancy Client days = Fee per Var. cost Contribution Total level 50 clients x client per per client contrib.
350 days x day client day per year occupancy% day
$
$
$
90%
90%
90%
75%
75%
75%
60%
60%
60%
15,750
15,750
15,750
13,125
13,125
13,125
10,500
10,500
10,500
180
180
180
200
200
200
220
220
220
95
85
70
95
85
70
95
85
70
85
95
110
105
115
130
125
135
150
$
1,338,7
1,496,2
1,509,3
1,417,50
1,575,00
(b) Maximax
The maximax rule looks for the largest contribution from all outcomes.
Fee per client day
180
200
220
Best possible contribution ($) ($)
1,732,500
1,706,250
1,575,000
In this case the decision maker will choose a client fee of $180 per day where there is a possibility of
a contribution of $1,732,500.
Maximin
The maximin rule looks for the strategy which will maximize the minimum possible contribution.
Client fee per day
Minimum possible contribution ($) (S)
180
1,338,750
200
1,378,125
220
1,312,500
In this case the decision maker will choose client fee of $200 per day where the lowest contribution
is $1,378,125.
Minimax regret
The minimax regret rule requires the choice of the strategy which will minimise the maximum
regret from making the wrong decision. Regret in this context is the opportunity lost through
making the wrong decision.
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Using the calculations from part (a) we may create an opportunity loss table as follows:
State of variable cost
Client fee per day strategy
$180
$200
$220
High (W1)
Medium (W2)
Low (W3)
Maximum regret
39,375
13,125
0
39,375
0
0
26,250
26,250
65,625
91,875
157,500
157,500
W1 at the high level of variable costs, the best strategy would be a client fee of $200. The
opportunity loss from using a fee of $180 or $220 per day would be $39,375 (1,378,125 ‐
1,338,750) or $65,625 (1,378,125 ‐ 1,312,500) respectively.
W2 at the medium level of variable costs, the best strategy would be a client fee of $200. The
opportunity loss from using a fee of $180 or $220 per day would be $13,125 (1,509,375 ‐
1,496,250) or $91,875 (1,509,375 ‐ 1,417,500) respectively.
W3 at the low level of variable costs, the best strategy would be a client fee of $180. The
opportunity loss from using a fee of $200 or $220 per day would be $26,250 (1,732,500 –
$1,706,250) or $157,500 (1,732,500 – 1,575,000) respectively.
The minimum regret strategy (client fee $200 per day) is that which minimizes the maximum
regret (i.e. $26,250 in the maximum regret row above).
(c) The expected value of variable cost
= ($95 0.1) + ($85 0.6) + ($70 0.3) = $81.50
For each client fee strategy, the expected value of budget contribution for the year may be calculated:
Fee of $180
15,750 client days x (180 – 81.50) contribution
= $1,551,375
Fee of $200
13,125 client days x (200 – 81.50) contribution
= $1,555,313
Fee of $220
10,500 client days x (220 – 81.50) contribution
= $1,454,250
Conclusion
Hence choose a client fee of $200 per day to give the maximum expected value contribution of $1,555,313.
Note that there is virtually no difference between this and the contribution where a fee of $180 per day is
used.
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(d)
Probability
0.2
0.5
0.3
1.0
Outcome = lunches
demanded
10
20
30
‐
10
$80 profit
$80 profit
$80 profit
$80 profit
Decision = lunches
made
20
$10 profit
$160 profit
$160 profit
$130 profit
30
($60) loss
$90 profit
$240 profit
$105 profit
Example of working ‐ Decision is made to prepare 20 lunches
 If demand is 10 lunches: Sales = 10 lunches x $15 per lunch = $150
Costs = 20 lunches x $7 per lunch = $140
Profit = $150 ‐ $140 = $10

If demand is 20 lunches : Sales = 20 lunches x $15 per lunch = $300
Costs = 20 lunches x $7 per lunch = $140
Profit = $300 ‐ $140 = $160

If demand is 30 lunches : Sales = 20 lunches x $15 per lunch = $300
Costs = 20 lunches x $7 per lunch = $140
Profit = $300 ‐ $140 = $160

EV of profit if 20 lunches are prepared = ($10 x 0.2) + ($160 x 0.5) + ($160 x 0.3)
= $130
Conclusion = 20 lunches should be prepared in advance since the expected value of the profit is
maximized at this level of output.
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Technical Article part A
Clearly, risk permeates most aspects of corporate decision making (and life in general), and few can predict with
any precision what the future holds in store
Risk can take myriad forms – ranging from the specific risks faced by individual companies (such as financial risk, or
the risk of a strike among the workforce), through the current risks faced by particular industry sectors (such as
banking, car manufacturing, or construction), to more general economic risks resulting from interest rate or
currency fluctuations, and, ultimately, the looming risk of recession. Risk often has negative connotations, in terms
of potential loss, but the potential for greater than expected returns also often exists.
Clearly, risk is almost always a major variable in real‐world corporate decision‐making, and managers ignore itl.
Similarly, trainee accountants require an ability to identify the presence of risk and incorporate appropriate
adjustments into the problem‐solving and decision‐making scenarios encountered in the exam hall. While it is
unlikely that the precise probabilities and perfect information which feature in exam questions can be transferred
to real‐world scenarios, a knowledge of the relevance and applicability of such concepts is necessary.
In this first article, the concepts of risk and uncertainty will be introduced together with the use of probabilities in
calculating both expected values and measures of dispersion. In addition, the attitude to risk of the decision maker
will be examined by considering various decision‐making criteria, and the usefulness of decision trees will also be
discussed. In the second article, more advanced aspects of risk assessment will be addressed, namely the value of
additional information when making decisions, further probability concepts, the use of data tables, and the concept
of value‐at‐risk.
The basic definition of risk is that the final outcome of a decision, such as an investment, may differ from that which
was expected when the decision was taken. We tend to distinguish between risk and uncertainty in terms of the
availability of probabilities. Risk is when the probabilities of the possible outcomes are known (such as when tossing
a coin or throwing a dice); uncertainty is where the randomness of outcomes cannot be expressed in terms of
specific probabilities. However, it has been suggested that in the real world, it is generally not possible to allocate
probabilities to potential outcomes, and therefore the concept of risk is largely redundant. In the artificial scenarios
of exam questions, potential outcomes and probabilities will generally be provided, therefore a knowledge of the
basic concepts of probability and their use will be expected.
PROBABILITY
The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with potential values
ranging from 0 (the event will not occur) to 1 (the event will definitely occur). For example, the probability of a tail
occurring when tossing a coin is 0.5, and the probability when rolling a dice that it will show a four is 1/6 (0.166).
The total of all the probabilities from all the possible outcomes must equal 1, i.e. some outcome must occur.
A real world example could be that of a company forecasting potential future sales from the introduction of a new
product in year one (Table 1).
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From Table 1, it is clear that the most likely outcome is that the new product generates sales of £1,000,000, as that
value has the highest probability.
INDEPENDENT AND CONDITIONAL EVENTS
An independent event occurs when the outcome does not depend on the outcome of a previous event. For example,
assuming that a dice is unbiased, then the probability of throwing a five on the second throw does not depend on
the outcome of the first throw.
In contrast, with a conditional event, the outcomes of two or more events are related, i.e. the outcome of the
second event depends on the outcome of the first event. For example, in Table 1, the company is forecasting sales
for the first year of the new product. If, subsequently, the company attempted to predict the sales revenue for the
second year, then it is likely that the predictions made will depend on the outcome for year one. If the outcome for
year one was sales of $1,500,000, then the predictions for year two are likely to be more optimistic than if the sales
in year one were $500,000.
The availability of information regarding the probabilities of potential outcomes allows the calculation of both an
expected value for the outcome, and a measure of the variability (or dispersion) of the potential outcomes around
the expected value (most typically standard deviation). This provides us with a measure of risk which can be used to
assess the likely outcome.
EXPECTED VALUES AND DISPERSION
Using the information regarding the potential outcomes and their associated probabilities, the expected value of
the outcome can be calculated simply by multiplying the value associated with each potential outcome by its
probability. Referring back to Table 1, regarding the sales forecast, then the expected value of the sales for year
one is given by:
Expected value
= ($500,000)(0.1) + ($700,000)(0.2) + ($1,000,000)(0.4) + ($1,250,000)(0.2) + ($1,500,000)(0.1)
= $50,000 + $140,000 + $400,000 + $250,000 + $150,000 = $990,000
In this example, the expected value is very close to the most likely outcome, but this is not necessarily always the
case. Moreover, it is likely that the expected value does not correspond to any of the individual potential outcomes.
For example, the average score from throwing a dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.5, and the average family (in
the UK) supposedly has 2.4 children. A further point regarding the use of expected values is that the probabilities
are based upon the event occurring repeatedly, whereas, in reality, most events only occur once.
In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the potential
actual outcomes around the expected value. The most common measure of dispersion is standard deviation (the
square root of the variance), which can be illustrated by the example given in Table 2 above, concerning the
potential returns from two investments.
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In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the potential
actual outcomes around the expected value. The most common measure of dispersion is standard deviation (the
square root of the variance), which can be illustrated by the example given in Table 2 above, concerning the
potential returns from two investments.
To estimate the standard deviation, we must first calculate the expected values of each investment:
Investment A
Expected value = (8%)(0.25) + (10%)(0.5) + (12%)(0.25) = 10%
Investment B
Expected value = (5%)(0.25) + (10%)(0.5) + (15%)(0.25) = 10%
The calculation of standard deviation proceeds by subtracting the expected value from each of the potential
outcomes, then squaring the result and multiplying by the probability. The results are then totaled to yield the
variance and, finally, the square root is taken to give the standard deviation, as shown in Table 3.
In Table 3, although investments A and B have the same expected return, investment B is shown to be more risky by
exhibiting a higher standard deviation. More commonly, the expected returns and standard deviations from
investments and projects are both different, but they can still be compared by using the coefficient of variation,
which combines the expected return and standard deviation into a single figure.
COEFFICIENT OF VARIATION AND STANDARD ERROR
The coefficient of variation is calculated simply by dividing the standard deviation by the expected return (or mean):
Coefficient of variation = standard deviation / expected return
For example, assume that investment X has an expected return of 20% and a standard deviation of 15%, whereas
investment Y has an expected return of 25% and a standard deviation of 20%. The coefficients of variation for the
two investments will be:
Investment X = 15% / 20% = 0.75
Investment Y = 20% / 25% = 0.80
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The interpretation of these results would be that investment X is less risky, on the basis of its lower coefficient of
variation. A final statistic relating to dispersion is the standard error, which is a measure often confused with
standard deviation. Standard deviation is a measure of variability of a sample, used as an estimate of the variability
of the population from which the sample was drawn. When we calculate the sample mean, we are usually
interested not in the mean of this particular sample, but in the mean of the population from which the sample
comes. The sample mean will vary from sample to sample and the way this variation occurs is described by the
‘sampling distribution’ of the mean. We can estimate how much a sample mean will vary from the standard
deviation of the sampling distribution. This is called the standard error (SE) of the estimate of the mean.
The standard error of the sample mean depends on both the standard deviation and the sample size:
SE = SD/√(sample size)
The standard error decreases as the sample size increases, because the extent of chance variation is reduced.
However, a fourfold increase in sample size is necessary to reduce the standard error by 50%, due to the square
root of the sample size being used. By contrast, standard deviation tends not to change as the sample size
increases.
DECISION‐MAKING CRITERIA
The decision outcome resulting from the same information may vary from manager to manager as a result of their
individual attitude to risk. We generally distinguish between individuals who are risk averse (dislike risk) and
individuals who are risk seeking (content with risk). Similarly, the appropriate decision‐making criteria used to make
decisions are often determined by the individual’s attitude to risk.
To illustrate this, we shall discuss and illustrate the following criteria:
1. Maximin
2. Maximax
3. Minimax regret
An ice cream seller, when deciding how much ice cream to order (a small, medium, or large order), takes into
consideration the weather forecast (cold, warm, or hot). There are nine possible combinations of order size and
weather, and the payoffs for each are shown in Table 4.
The highest payoffs for each order size occur when the order size is most appropriate for the weather, i.e. small
order/cold weather, medium order/warm weather, large order/hot weather. Otherwise, profits are lost from either
unsold ice cream or lost potential sales. We shall consider the decisions the ice cream seller has to make using each
of the decision criteria previously noted (note the absence of probabilities regarding the weather outcomes).
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1.
Maximin
This criteria is based upon a risk‐averse (cautious) approach and bases the order decision upon maximising the
minimum payoff. The ice cream seller will therefore decide upon a medium order, as the lowest payoff is £200,
whereas the lowest payoffs for the small and large orders are £150 and $100 respectively.
2.
Maximax
This criteria is based upon a risk‐seeking (optimistic) approach and bases the order decision upon maximising
the maximum payoff. The ice cream seller will therefore decide upon a large order, as the highest payoff is
$750, whereas the highest payoffs for the small and medium orders are $250 and $500 respectively.
3.
Minimax regret
This approach attempts to minimise the regret from making the wrong decision and is based upon first
identifying the optimal decision for each of the weather outcomes. If the weather is cold, then the small order
yields the highest payoff, and the regret from the medium and large orders is $50 and $150 respectively. The
same calculations are then performed for warm and hot weather and a table of regrets constructed (Table 5).
The decision is then made on the basis of the lowest regret, which in this case is the large order with the maximum
regret of $200, as opposed to $600 and $450 for the small and medium orders.
DECISION TREES
The final topic to be discussed in this first article is the use of decision trees to represent a decision problem.
Decision trees provide an effective method of decision‐making because they:
 Clearly lay out the problem so that all options can be challenged
 Allow us to fully analyse the possible consequences of a decision
 Provide a framework in which to quantify the values of outcomes and the probabilities of achieving them
 Help us make the best decisions on the basis of existing information and best guesses.
A comprehensive example of a decision tree is shown in Figures 1 to 4, where a company is trying to decide
whether to introduce a new product or consolidate existing products. If the company decides on a new product,
then it can be developed thoroughly or rapidly. Similarly, if the consolidation decision is made then the existing
products can be strengthened or reaped. In a decision tree, each decision (new product or consolidate) is
represented by a square box, and each outcome (good, moderate, poor market response) by circular boxes.
The first step is to simply represent the decision to be made and the potential outcomes, without any indication of
probabilities or potential payoffs, as shown in Figure 1 below.
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The next stage is to estimate the payoffs associated with each market response and then to allocate probabilities.
The payoffs and probabilities can then be added to the decision tree, as shown in Figure 2 below.
The expected values along each branch of the decision tree are calculated by starting at the right hand side and
working back towards the left, recording the relevant value at each node of the tree. These expected values are
calculated using the probabilities and payoffs. For example, at the first node, when a new product is thoroughly
developed, the expected payoff is:
Expected payoff = (0.4)($1,000,000) + (0.4)($50,000) + (0.2)($2,000) = $420,400
The calculations are then completed at the other nodes, as shown in Figure 3 below.
We have now completed the relevant calculations at the uncertain outcome modes. We now need to include the
relevant costs at each of the decision nodes for the two new product development decisions and the two
consolidation decisions, as shown in Figure 4 below.
The payoff we previously calculated for ‘new product, thorough development’ was $420,400, and we have now
estimated the future cost of this approach to be $150,000. This gives a net payoff of $270,400.
The net benefit of ‘new product, rapid development’ is $31,400. On this branch, we therefore choose the most
valuable option, ‘new product, thorough development’, and allocate this value to the decision node.
The outcomes from the consolidation decision are $99,800 from strengthening the products, at a cost of $30,000,
and
$12,800
from
reaping
the
products
without
any
additional
expenditure.
By applying this technique, we can see that the best option is to develop a new product. It is worth much more to us
to take our time and get the product right, than to rush the product to market. And it’s better just to improve our
existing products than to botch a new product, even though it costs us less.
In the next article, we will examine the value of information in making decisions, the use of data tables, and the
concept of value‐at‐risk.
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Written by a member of the Paper APM examining team
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Technical Article part 2
In this second article on the risks of uncertainty, we build upon the basics of risk and uncertainty addressed in
the first article published in April 2009 to examine more advanced aspects of incorporating risk into decision
making
In particular, we return to the use of expected values and examine the potential impact of the availability of
additional information regarding the decision under consideration. Initially, we examine a somewhat artificial
scenario, where it is possible to obtain perfect information regarding the future outcome of an uncertain variable
(such as the state of the economy or the weather), and calculate the potential value of such information.
Subsequently, the analysis is revisited and the more realistic case of imperfect information is assumed, and the
initial probabilities are adjusted using Bayesian analysis.
Some decision scenarios may involve two uncertain variables, each with their own associated probabilities. In such
cases, the use of data/decision tables may prove helpful where joint probabilities are calculated involving possible
combinations of the two uncertain variables. These joint probabilities, along with the payoffs, can then be used to
answer pertinent questions such as what is the probability of a profit/(loss) occurring?
The other main topic covered in the article is that of Value‐at‐Risk (VaR), which has been referred to as 'the new
science of risk management'. The principles underlying VaR will be discussed along with an illustration of its
potential uses.
EXPECTED VALUES AND INFORMATION
To illustrate the potential value of additional information regarding the likely outcomes resulting from a decision,
we return to the example given in the first article, of the ice cream seller who is deciding how much ice cream to
order but is unsure about the weather. We now add probabilities to the original information regarding whether the
weather will be cold, warm or hot, as shown in Table 1.
TABLE 1: ASSIGNING PROBABILITIES TO WEATHER
Warm
Order/weather
Cold
0.2
0.5
Probability
Small
$250
$200
Medium
$200
$500
Large
$100
$300
Hot
0.3
$150
$300
$750
We are now in a position to be able to calculate the expected values associated with the three sizes of order, as
follows:
 Expected value (small) = 0.2 ($250) + 0.5 ($200) + 0.3 ($150) = $195
 Expected value (medium) = 0.2 ($200) + 0.5 ($500) + 0.3 ($300) = $380
 Expected value (large) = 0.2 ($100) + 0.5 ($300) + 0.3 ($750) = $395
On the basis of these expected values, the optimal decision would be to order a large amount of ice cream with an
expected value of $395. However, it may be possible to improve upon this value if better information regarding the
weather could be obtained. Exam questions often make the assumption that it is possible to obtain perfect
information, i.e. to predict exactly what the outcome of the uncertain variable will be.
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THE VALUE OF PERFECT INFORMATION
In the case of the ice cream seller, perfect information would be certainty regarding the outcome of the weather.
If this was the case, then the ice cream seller would purchase the size of order which gave the highest payoff for
each weather outcome ‐ in other words, purchasing a small order if the weather was forecast to be cold, a medium
order if it was forecast to be warm, and a large order if the forecast was for hot weather. The resulting expected
value would then be:
Expected value =; 0.2 ($250) + 0.5 ($500) + 0.3 ($750) = $525
The value of the perfect information is the difference between the expected values with and without the
information, i.e.
Value of information = $525 ‐ $395 = $130
However, the concept of perfect information is somewhat artificial since, in the real world, such perfect certainty
rarely, if ever, exists. Future outcomes, irrespective of the variable in question, are not perfectly predictable.
Weather forecasts or economic predictions may exhibit varying degrees of accuracy, which leads to the concept of
imperfect information.
THE VALUE OF IMPERFECT INFORMATION
With imperfect information we do not enjoy the benefit of perfect foresight. Nevertheless, such information can be
used to enhance the accuracy of the probabilities of the possible outcomes and therefore has value. The ice cream
seller may examine previous weather forecasts and, on that basis, estimate probabilities of future forecasts being
accurate. For example, it could be that when hot weather is forecast past experience has suggested the following
probabilities:
 P (forecast hot but weather cold)‐ 0.3
 P (forecast hot but weather warm);‐ 0.4
 P (forecast hot and weather hot)‐ 0.7
The probabilities given do not add up to 1 and so, for example, P (forecast hot but weather cold) cannot mean P
(weather cold given that forecast was hot), but must mean P (forecast was hot given that weather turned out to be
cold).
We can use a table to determine the required probabilities. Suppose that the weather was recorded on 100 days.
Using our original probabilities, we would expect 20 days to be cold, 50 days to be warm, and 30 days to be hot.
The information from our forecast is then used to estimate the number of days that each of the outcomes is likely
to occur given the forecast (see Table 2).
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TABLE 2: LIKELY WEATHER OUTCOMES
Warm
Outcome/forecast
Cold
Hot
6**
20
Other
14
30
20*
50
From past data, cold weather occurs with probability of 0.2
Other percentages are also derived from past data.
APM ‐ Study Notes
Hot
21
9
30
i.e. on 0.2 of the
Total
47
53
100
100 days in the sample = 20 days.
** If the actual weather is cold, there is a 0.3 probability that hot weather had been forecast. This will occur on 0.3
of the 20 days on which the weather was poor = 6 days (0.3 x 20). Similarly, 20 = 0.5 x 40 and 21 = 0.7 x 30.
The revised probabilities, if the forecast is hot, are therefore:
 P (Cold)=6/47=0.128
 P (Warm) = 20/47 = 0.425
 P (Hot) = 21/47 = 0.447
The expected values can then be recalculated as:
 Expected value (small) = 0.128 ($250) + 0.425 ($200) + 0.447 ($150) = $184
 Expected value (medium) = 0.128 ($200) + 0.425 ($500) + 0.447 ($300) = $372
 Expected value (large) = 0.128 ($100) + 0.425 ($300) + 0.447 ($750) = $476
 Value of imperfect information = $476 ‐ $395 = 81
The estimated value for imperfect information appears reasonable, given that the value previously calculated for
perfect information was $130.
BAYES' RULE
Bayes' rule is perhaps the preferred method for estimating revised (posterior) probabilities when imperfect
information is available. An intuitive introduction to Bayes' rule was provided in The Economist, 30 September
2000:
'The essence of the Bayesian approach is to provide a mathematical rule explaining how you should change your
existing beliefs in the light of new evidence. In other words, it allows scientists to combine new data with their
existing knowledge or expertise. The canonical example is to imagine that a precocious newborn observes his first
sunset, and wonders whether the sun will rise again or not. He assigns equal prior probabilities to both possible
outcomes, and represents this by placing one white and one black marble into a bag. The following day, when the
sun rises, the child places another white marble in the bag. The probability that a marble plucked randomly from
the bag will be white (i.e. the child's degree of belief in future sunrises) has thus gone from a half to two‐thirds.
After sunrise the next day, the child adds another white marble, and the probability (and thus the degree of belief)
goes from two‐thirds to three‐quarters. And so on. Gradually, the initial belief that the sun is just as likely as not to
rise each morning is modified to become a near‐certainty that the sun will always rise'.
In mathematical terms, Bayes' rule can be stated as:
Posterior probability =likelihood x prior probabilitymarginal likelihood
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For example, consider a medical test for a particular disease which is 90% accurate, i.e. If you test positive then
there is a 90% probability that you have the disease and a 10% probability that you have been misdiagnosed. If we
further assume that 3% of the population actually have this disease, then the probability of having the disease
(given that you have tested positive) is shown by:
P(Disease|Test = +) =
P(Test = +|Disease) x P(Disease)
P(Test = +|Dis) x P(Dis) + P(Test= +|No Dis) x P(No Dis)
= 0.90 0.03; 0.027;
0.90 x 0.03 + 0.10 x 0.97 0.027 + 0.097
= 0.218
This result suggests that you have a 22% probability of having the disease, given that you tested positive. This may
seem a low probability but only 3% of the population have the disease and we would expect them to test positive.
However, 10% of tests will prove positive for people who do not have the disease. Therefore, if 100 people are
tested, approximately three out of the 13 positive tests will actually have the disease.
Bayes' rule has been used in a practical context for classifying email as spam on the basis of certain key words
appearing in the text.
DATA TABLES
Data tables show the expected values resulting from combinations of uncertain variables, along with their
associated joint probabilities. These expected values and probabilities can then be used to estimate, for example,
the probability of a profit or a loss.
To illustrate, assume that a concert promoter is trying to predict the outcome of two uncertain variables, namely:
1. The number of people attending the concert, which could be 300, 400, or 600 with estimated probabilities of
0.4, 0.4, and 0.2 respectively.
2. From each person attending, the profit on drinks and confectionary, which could be $2, $4, or $6 with
estimated probabilities of 0.3, 0.4 and 0.3 respectively.
As each of the two uncertain variables can take three values, a 3 x 3 data table can be constructed. We shall
assume that the expected values have already been calculated as follows:
Number/spend
$2
$4
$6
300
(2,000)
(750)
1,000
400
(1,000)
3,000
5,000
600
3,000
4,000
7,000
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The probabilities can be used to calculate joint probabilities as follows:
300
400
600
Number/spend
$2
0.12
0.12
0.06
$4
0.16
0.16
0.08
$6
0.12
0.12
0.06
The two tables could then be used to answer questions such as:
1. The probability of making a loss? = 0.12 + 0.12 + 0.16 = 0.40
2. The probability of making a profit of more than $3,500? = 0.08 + 0.12 + 0.06 = 0.26
VALUE‐AT‐RISK (VaR)
Although financial risk management has been a concern of regulators and financial executives for a long time,
Value‐at‐Risk (VaR) did not emerge as a distinct concept until the late 1980s. The triggering event was the stock
market crash of 1987 which was so unlikely, given standard statistical models, that it called the entire basis of
quantitative finance into account.
VaR is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio,
probability, and time horizon, VaR is defined as a threshold value such that the probability that the mark‐to‐market
loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading) is the
given probability level. Such information can be used to answer questions such as 'What is the maximum amount
that I can expect to lose over the next month with 95%/99% probability?'
For example, large investors, interested in the risk associated with the FT100 index, may have gathered information
regarding actual returns for the past 100 trading days. VaR can then be calculated in three different ways:
1. The historical method
This method simply ranks the actual historical returns in order from worst to best, and relies on the assumption that
history will repeat itself. The largest five (one) losses can then be identified as the threshold values when identifying
the maximum loss with 5% (1%) probability.
2. The variance‐covariance method
This relies upon the assumption that the index returns are normally distributed, and uses historical data to estimate
an expected value and a standard deviation. It is then a straightforward task to identify the worst 5 or 1% as
required, using the standard deviation and known confidence intervals of the normal distribution – i.e. ‐1.65 and ‐
2.33 standard deviations respectively.
3. Monte Carlo simulation
While the historical and variance‐covariance methods rely primarily upon historical data, the simulation method
develops a model for future returns based on randomly generated trials.
Admittedly, historical data is utilised in identifying possible returns but hypothetical, rather than actual, returns
provide the data for the confidence levels.
Of these three methods, the variance‐covariance is probably the easiest as the historical method involves crunching
historical data and the Monte Carlo simulation is more complex to use.
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VaR can also be adjusted for different time periods, since some users may be concerned about daily risk whereas
others may be more interested in weekly, monthly, or even annual risk. We can rely on the idea that the standard
deviation of returns tends to increase with the square root of time to convert from one time period to another. For
example, if we wished to convert a daily standard deviation to a monthly equivalent then the adjustment would be:
σ monthly = σ daily x √T where T = 20 trading days
For example, assume that after applying the variance‐covariance method we estimate that the daily standard
deviation of the FT100 index is 2.5%, and we wish to estimate the maximum loss for 95 and 99% confidence
intervals for daily, weekly, and monthly periods assuming five trading days each week and four trading weeks each
month:
95% confidence
Daily = ‐1.65 x 2.5% = ‐4.125%
Weekly = ‐1.65 x 2.5% x √5 = ‐9.22%
Monthly = ‐1.65 x 2.5% x √20 = ‐18.45%
99% confidence
Daily = ‐2.33 x 2.5% = ‐5.825%
Weekly = ‐2.33 x 2.5% x √5 = ‐13.03%
Monthly = ‐2.33 x 2.5% x √20 = ‐26.05%
Therefore we could say with 95% confidence that we would not lose more than 9.22% per week, or with 99%
confidence that we would not lose more than 26.05% per month.
On a cautionary note, New York Times reporter Joe Nocera published an extensive piece entitled Risk
Mismanagement on 4 January 2009, discussing the role VaR played in the ongoing financial crisis. After
interviewing risk managers, the author suggests that VaR was very useful to risk experts, but nevertheless
exacerbated the crisis by giving false security to bank executives and regulators. A powerful tool for professional
risk managers, VaR is portrayed as both easy to misunderstand, and dangerous when misunderstood.
CONCLUSION
These two articles have provided an introduction to the topic of risk present in decision making, and the available
techniques used to attempt to make appropriate adjustments to the information provided. Adjustments and
allowances for risk also appear elsewhere in the ACCA syllabus, such as sensitivity analysis, and risk‐adjusted
discount rates in investment appraisal decisions where risk is probably at its most obvious. Moreover in the current
economic climate, discussion of risk management, stress testing and so on is an everyday occurrence.
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MANAGEMENT ACCOUNTING INFORMATION
Learning Objectives












Discuss, with reference to performance management, ways in which the information requirements of a
management structure are affected by the features of the structure.
Evaluate the compatibility of management accounting objectives and the management accounting
information systems.
Discuss the integration of management accounting information within an overall information system, for
example the use of enterprise resource planning systems
Evaluate whether the management information systems are lean and the value of the information that they
provide (e.g. using the 5 Ss).
Evaluate the external and internal factors (e.g. anticipated human behaviour) which will influence the design
and use of a management accounting system.
Discuss the principal internal and external sources of management accounting information, their costs and
limitations.
Demonstrate how the information might be used in planning and controlling activities e.g. benchmarking
against similar activities.
Demonstrate how the type of business entity will influence the recording and processing methods.
Discuss how IT developments e.g. unified corporate databases, RFIDs, cloud and network technology may
influence management accounting systems.
Explain how information systems provide instant access to previously unavailable data that can be used for
benchmarking and control purposes and help improve business performance (for example, through the use
of enterprise resource planning, knowledge management and customer relationship management systems
and also, data warehouses).
Discuss the difficulties associated with recording and processing data of a qualitative nature.
Discuss the development of big data and its impact on performance measurement and management,
including the risks and challenges it presents.Discuss the impact of big data and data analytics on the role of
the management accountant.
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Size Of The Organisation and Information Requirements
Small Organisations
Small organisations have a very basic management setup and in turn do not require much detailed information
systems. The management includes very few people who are responsible for all decision making tasks within the
organisation. These are top managers thus lower level employees are not involved in any decisions. Due to limited
number of people involved in making final decisions, information is easily retrieved and not many performance
reviews and documents are required. Due to such a simple set up, easy information systems are enough to keep the
organisation running smoothly.
Examples of Information requirements of Small Organisations
Day to day transactions
Daily Sale
Cash management
Receivables and Payables
Medium Sized Organisations
These type of organisations include businesses run by different members of one family. Even though many people
like keeping their company in their own control, informal organisation management may affect the need for
information systems, as the family would require information reporting only from external factors. Usually such set
ups do not have formal roles and duties defined either, as authority is shared and decisions are made together.
Information systems that are enough to relate to customers are needed by such organisations. Such a structure
rarely changes with complexity and dynamism of environments.
Information Requirements of Medium Sized Organisations
As size of the organisation increases, the importance of planning for information also increases. The planning on
long‐term basis also helps in monitoring of information against planning
Usually such organisations are characterized by large scale of operations. Various criteria can be used for this
purpose.
Number of employees
Amount of turnover
Number of branches
Profit size
Value of assets
Number of businesses the organisation is working in
Large Size Organisations
With large size of organisations, management structure needs to be multi‐ tiered for efficient and strong control.
This leads to formulation of many departments, management levels, designations, promotional opportunities and
salary increments
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Information Requirements of Large Sized Organisations
Large Organisations require information for effective coordination of similar activities across various geographical
locations.
e.g.
Value Chain Coordination Reports
Revenue Reports of Subsidiary and Head Office
Compatibility of management accounting objectives and management accounting information systems
Management Information Systems facilitate managers to have a complete review of the whole company, its
operations, functioning and outcomes. It is easier for organisations to overcome competition when they are well
equipped with knowledge requiring their organisation, products and the market as well. It is easier to make timely
decisions and implement them by communicating them clearly to all people involved in achieving the goal. MIS
therefore makes a company more synchronized and manages all departments efficiently.
A good management accounting system should be able to produce management information that is consistent with
the objective of the management accountant. Management accounting information is used for:
 Planning
 Controlling
 Decision making
 Performance evaluation
 Stock valuation
Attributes of good management information
Accurate:
Sufficient for its purpose. At higher managerial levels, information does not normally
need to be as accurate as at lower levels
Complete:
Incomplete information is likely to mislead
Cost‐beneficial:
Benefits should exceed costs
User‐targeted:
It should provide the information needed by the user to make the decision and perform
the job
Irrelevant information distracts and wastes people’s time.
Relevant:
Authoritative:
Some web‐site data is unreliable: sometimes deliberately misleading, sometimes
sloppy, sometimes out‐of‐date.
Timely:
Information should be received quickly enough to enable better decisions. There is no
need for all information to be ‘instantly’ available and speed often has a cost.
Easy to use:
Well‐set out and annotated.
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Management information system
A Management information system (MIS) is: 'a system to convert data from internal and external sources into
information and to communicate that information, in an appropriate form, to managers at all levels in all functions
to enable them to make timely and effective decisions for planning, directing and controlling the activities for which
they are responsible'.
An effective management information system will define the areas of control within the organisation and the
individuals who are responsible for those areas and ensure that the relevant information is communicated and flows
to the managers in charge of those areas.
Information and management accounting systems need to be developed continually otherwise they will become out
of date either because of advances in technology or because of environmental changes.
Types of Management Information System (MIS)
Type of MIS
Executive
Systems (EIS)
Decision
(DSS)
Information
Support
Expert Systems (ES)
System
Explanation
Used by top management. Flexible with the ability to ‘drill down’ to more and
more detailed information. Access to external information is essential at this
level.
A DSS helps management to make decisions. An example of a DSS is a database
management system which uses data mining software to look for patterns and
relationships in large pools of data.
These can make decisions that replicate the decisions an expert would make.
They rely on extracting knowledge from the expert and storing this in a
knowledge base. Situations can then be presented to the system which uses the
knowledge base to come to a conclusion or recommendation. The type of data
needed depends on the management level:
Management level
Characteristics of the information
Strategic
Highly summarized. Often using estimates about
the future. Often non‐routine. High need for
external information
Tactical
A mix of the characteristics of strategic and
operational
Operational
Very detailed Usually historical Routine Mostly
internal
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STRATEGIC
Actions
Executive Information
System (EIS)
Type of system used
Planning and decision
making


Information features
APM ‐ Study Notes




TACTICAL
Actions
Decision Support System
(DSS)
OPERATIONAL
Actions
Management
Information System
(MIS)
Enter New markets and
new products.
Financing
Corporate
structure

Medium term plans:
Implementation
of
strategic plans Control
Resource planning


Externally Obtained ad
hoc
Expensive
Relatively inaccurate
Flexible format

Mainly
internal
Obtained routinely
Detailed,
or
in
exception format
Accurate Standardised
form






Short‐term planning
Working
capital
management
Customer service
Almost all internal
Obtained
frequently,
on
demand
Very
detailed
Cheap Very accurate
ERP (Enterprise Resource Planning):
A system that integrates internal and external management information across an entire organisation, including:
finance/accounting, manufacturing, sales and services, customer relationship management, etc. ERP systems
automate these activities with an integrated software application and they facilitate the flow of information
between all business functions of the organisation.
An ERPS can also be used to produce customised reports and can support performance measures such as the
balanced scorecard.
An ERPS can result in:
 Lower costs (for example, through workforce redeployment), and
 Increased flexibility and efficiency of production, because sales, production and purchasing are closely
integrated.
Disadvantages of an ERPS include cost, implementation time and lack of scope for adaptation to the demands of
specific businesses. In addition, a problem with one function can affect all the other functions. An ERPS that
automates poorly designed and inconsistent business processes is unlikely to add any value.
Lean Information system
Features of a lean information system are:
 only useful reports and documents that help in decision making should be formulated
 reports generated should only reach the people that require them
 there should be no delay in the processing of reports so that information is available to respective persons in
minimum time
 Repetition of generated information should be avoided by making only a single entry of data in the system
 regular improvements should be made to review and make the most use of the information
 Information systems should be adapt efficiently to meet special ad hoc needs or changing needs of managers
over time. An information system that equips managers to make their own specialized repots rather than a
typical set standard of reports is a lean system
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The Five S Model
Most organisations that adopt the lean system methodology using The Five S Model. The model minimizes waste,
enhances productivity and eliminates variation (in output).It is necessary to eradicate variation as it leads to errors
in production.
The Fives Ss are:
 sort (provide structure)
 simplify (systemize)
 scan
 standardise
 sustain (self‐discipline)
Sort
To sort means to organise the work area by removing things that are not needed and putting things away that are
not required regularly. Sorting should be done twice yearly in order to make the work area convenient for use.
Simplify
This includes organizing and setting up things in preferable places. Everything should be easily accessible but the
items required often should be placed up front while the ones rarely needed should be put at the back or in labeled
storage.
Scan
Scanning means to identify which items are unorganised and require sorting or attending to. It also includes paying
attention to all items that need tuning, fixing and maintenance.
Standardise
Once the workplace is well organised through sorting and simplifying, rules and protocols are needed to be set up
to standardize the way it should remain that way. E.g. Labeling and colour coordinated organizing may be applied to
set a standard for organizing the storage area.
Sustain
The procedures implemented to sort, simplify, scan and standardize the workplace should be maintained regularly.
They should be repeated regularly and implemented as a part of the office routine in order to sustain the effort
made.
The Relationship Between People Management And Organisational Success
An organisation’s workforce and staff are its fundamental assets. They are significant for the organisation in many
ways.
 Strategic Significance
All strategies developed in an organisation for its functioning depend on the knowledge, expertise, skills and
innovations of the people involved.

Operational Significance
The successful implementation and completion of all the defined goals depends on the abilities of the company
employees to carry out instructions and fulfill the requirements of their appointed tasks.
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APM ‐ Study Notes
Organisational success also depends on how well the human work force is managed as well. For this purpose, the
human behavior must be understood.
1.
Learning Curves:
As time passes, labour understands the methods of production better to the extent that they become experts
in handling the work they have been taught. This automatically reduces the time of the production as the learnt
behavior helps workers complete their tasks much quicker. This should be considered when planning including
standardization, costing, scheduling and budgeting are being done.
2.
Learning Styles:
Human nature, aptitude and abilities differ from person to person. People learn and understand things in
different ways. Some people learn theoretically while some people are able to understand better when taught
practically. This should be considered when selecting how communication will be done with the workforce to
ensure that the information is understood completely by all.
Sources of management information
Managers need internal and external information which is used for planning, decision making and for controlling the
organisation effectively.
Internal source of management information
Source
Sales ledger system
Purchase ledger system
Payroll system
Fixed asset system
Production
Sales and marketing
Information
 Number and value of invoices
 Volume of sales
 Value of sales, analysed by customer
 Value of sales, analysed by product
 Number and value of invoices
 Value of purchases, analysed by supplier
 Number of employees
 Hours worked
 Output achieved
 Wages earned
 Tax deducted
 Date of purchase
 Initial cost
 Location
 Depreciation method and rate
 Service history
 Production capacity
 Machine breakdown times
 Output achieved
 Number of rejected units
 Types of customer
 Market research results
 Demand patterns, seasonal variations etc
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Sources of external information
Source
Suppliers
Newspapers, journals
Government
Customers
Employees
Banks
Business enquiry agents
Internet
Information
 Product prices
 Product specifications
 Share price
 Information on competitors
 Technological developments
 National and Market surveys
 Industry statistics
 Taxation policy
 Inflation rates
 Demographic statistics
 Forecasts for economic growth
 Product requirements

Price sensitivity
 Wage demands
 Working conditions
 Information on potential customers
 Information on national markets
 Information on competitors

Information on customers
 Almost everything via databases (public and private), discussion groups and
mailing lists.
IT DEVELOPMENTS
There have been great IT developments in recent years. These include:
 Data warehouses: a data warehouse includes:
 Database: data in a database is a cumulative representation of all the data collected from different sources
so that a unified data is available to all the users at the same time.
 Data extraction tool: it is easier for users to extract whatever data and information they need from the
database
 A decision support system: data mining is used to analyse the data and unearth unknown patterns or
correlations in data.
Illustration ‐ Data mining relationships
Data mining results may include:
 Associations ‐ when one event can be correlated to another, e.g. beer purchasers buy peanuts a certain
percentage of the time.
 Sequences ‐ one event leading to another event, e.g. a rug purchase followed by a purchase of matching
curtains.
 Classifications ‐ profiles of customers who make purchases can be set up.
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




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APM ‐ Study Notes
Networks ‐ most organisations connect their computers together in local area networks (LANs), enabling them
to share data (e.g. via email) and to share devices such as printers. Wide area networks (WANs) are used to
connect LANs together, so that computer users in one location can communicate with computer users in
another location. Improvements in broadband speed and security have eased communication across sites and
from home.
Intranet ‐ this is a private network contained within an organisation. It allows company information and
computing resources to be shared among employees.
Extranet ‐ this is a private, secure extension of an Intranet. It allows the organisation to share information with
suppliers, customers and other business partners.
Internet ‐ a global system of interconnected networks carrying a vast array of information and resources.
Enterprise resource planning system (ERPS) ‐ this is a way of integrating the data from all operations within
the organisation, e.g. operations, sales and marketing, human resources and purchasing, into one single system.
It ensures that everyone is working off the same system and includes decision support features to assist
management with decision making. Software companies like SAP and Oracle have specialised in the provision
of ERP systems across many different industries.
Radio frequency identification (RFID) ‐ organisations use small radio receivers to tag items and hence to keep
track of their assets. It can be used for a variety of purposes, for example:
 to track inventory in retail stores
 to tag livestock after the BSE crisis in 2002
 to track the location of doctors in a hospital.
RFID Example
Many clothing retailers began the phased rollout of item‐level radio frequency identification (RFID) tags in 2007
following extensive testing of the technology. Stock accuracy has improved and stores and customers have
commented on the more consistent availability of sizes in the pilot departments.
The tags allow staff to carry out stocktaking 20 times faster than bar code scanners by passing an RFID reader
over goods. At the end of each day, stock on the shop floor will be scanned and the data collected will be
compared with information in a central database containing each store's stock profile, to determine what
products need to be replaced. This has led to improved sales through greater product availability.

CLOUD TECHNOLOGY
Cloud computing offers advantages for decision making
 Cloud computing delivers cost savings and eases systems administration
 The collaborative advantage of cloud technology is less than expected, or not yet realised by finance
 The primary reason for not adopting cloud technology in finance processes is data security concerns
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Benefits of ERP,CRM & Knowledge Management
•
ERP
Enterprise Resource Planning systems help organise information and keep it safe. It automates processes and
develops simpler solutions. ERP has proven to be useful in daily operations and long term planning of an
organisation thus helping an organisation run smoothly.
•
CRM
Advantage of using CRM is that Customer data is well managed which enables employees to easily assess all
customer records including setting up reminders for customer sales, calls and meetings. Database growth is
quicker and well managed .Data is all automated and centralized which enables efficient communications with
customers via email and SMS etc.
It also facilitates in developing long term sustainable relations with customers e.g. sending them wishes on their
birthday etc. Moreover it also identifies the problem areas which require focus and makes improvements in
them. For example, you can evaluate your business strategy integration with other CRM services and third‐
party apps.
•
Knowledge Management
Knowledge management prevents staff from constantly reinventing the wheel, provides a baseline for progress
measurement, reduces the burden on expert attrition, makes visual thinking tangible, and manages effectively
large volumes of information to help employees serve their clients better and faster.
Knowledge management facilitates businesses and organisations by:
Safeguarding their intellectual capital
Focusing on human capital which is the most crucial asset of a company.
Connecting people by setting collaborations between them
Developing a culture of its own by for an optimal knowledge sharing strategy
With the increasing global environment it is necessary for people to be more connected with each other and work
together to stay updated and connected with people abroad as well. Employees should be able to promptly respond
to queries and work efficiently with everyone. Social media is also an important tool which enables employees to
access people and information conveniently and informally express themselves and in turn building a trusting and
knowledge sharing environment with everyone.
Difficulties Associated With Recording And Processing Data Of A Qualitative Nature
Limited Sample Size
Sample size of quantitative data contains a sufficient amount of data whereas qualitative data has a limited sample
size. There is no set sample size requirement for qualitative research as it is expensive to conduct qualitative
researches with a large number of participants. Often, qualitative feedback from 10‐20 or maybe 30 people is enough
to help optimize the questions in mind.
When doing qualitative research, it is more convenient to avoid setting the number of participants in the beginning
as it may be changed once research starts. As long as new data and information is being added to the data with the
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entry of each new participant, more participants will continue to be added to the sample size till increment in
information ceases
Sampling Bias
In statistics, sampling bias is a bias in which a sample is collected in such a way that some members of the intended
population are less likely to be included than others.
This means that it is highly likely that the sample drawn may exclude some people and result in not being a true
representative of the whole population.
Self‐Selection Bias
Qualitative researches let people choose whether they want to be a part of the sample or not while in quantitative
researches most data of people is available whether they like it or not. Self‐selection bias limits the worth of
qualitative data.
Observation Biases
Other concerns associated with qualitative data include observational biases.
Hawthorne Effect
The Hawthorne Effect can best be described as:
“Participants in behavioral studies change their behavior or performance in response to being observed.”
People behave differently when they realize they are being assessed or watched. E.g. People would use the internet
differently if they know they have privacy, while their choices will be altered if they know their browsing is being
monitored.
Observer‐Expectancy Effect
The observer‐expectancy effect is the unconscious effect a researcher has on the participants when they seem to
believe what expectations the researcher may have from the study being done on them.
Artificial Scenario
In some experiments and scenario, focus and goals are already decided. The participants only respond to the
questions asked as a researcher only focuses on pre‐determined areas of research. Through this only information
regarding those objectives is gathered ignoring all other information that the participant may want to add.
Conclusively, there are many issues associated with qualitative data and qualitative research which may lead to
improper representation and generation of biased results.
4. Data analytics
a)
Discuss the development of big data and its impact on performance measurement and management, including
the risks and challenges it presents
Big data
There are many definitions of the term ‘big data’ but most suggest something like the following:
'Extremely large collections of data (data sets) that may be analysed to reveal patterns, trends, and associations,
especially relating to human behaviour and interactions.'
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In addition, many definitions also state that the data sets are so large that conventional methods of storing and
processing the data will not work.
In 2001 Doug Laney, an analyst with Gartner (a large US IT consultancy company) stated that big data has the
following characteristics, known as the 3Vs:
 Volume
 Variety
 Velocity
These characteristics, and sometimes additional ones, have been generally adopted as the essential qualities of big
data
The commonest fourth 'V' that is sometimes added is: Veracity. This indicates if the data is true and if its accuracy
can be relied upon?
VOLUME
The volume of big data held by large companies such as Walmart (supermarkets), Apple and EBay is measured in
multiple petabytes. What is a petabyte? It is 1015 bytes (characters) of information. A typical disc on a personal
computer (PC) holds 109 bytes (a gigabyte), so the big data depositories of these companies hold at least the data
that could typically be held on 1 million PCs, perhaps even 10 to 20 million PCs.
These numbers probably mean little even when converted into equivalent PCs. It is more instructive to list some of
the types of data that large companies will typically store.
Retailers
Via loyalty cards being swiped at checkouts: details of all purchases made, when, where, how one pays, use of
coupons.
Via websites: every product one has ever viewed, every page visited, every product bought.
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Social media (such as Facebook and Twitter)
Friends and contacts, postings made, location when postings are made, photographs (that can be scanned for
identification), any other data one might choose to reveal to the universe.
Mobile phone companies
Numbers dialed, text sent (which can be automatically scanned for key words), every location a phone has ever been
to whilst switched on (to an accuracy of a few metres), browsing habits. Voice mails.
Internet providers and browser providers
Every site and every page visited. Information about all downloads and search terms entered.
Banking systems
Every receipt, payment, credit card information (amount, date, retailer, location), location of ATM machines used.
VARIETY
Some of the variety of information can be seen from the examples listed above. In particular, the following types of
information are held:
 Browsing activities: sites, pages visited, membership of sites, downloads, searches
 Financial transactions
 Interests
 Buying habits
 Reaction to advertisements on the internet or to advertising emails
 Geographical information
 Information about social and business contacts
 Text
 Numerical information
 Graphical information (such as photographs)
 Oral information (such as voice mails)
 Technical information, such as jet engine vibration and temperature analysis
This data can be both structured and unstructured:
Structured data: This data is stored within defined fields (numerical, text, date etc) often with defined lengths, within
a defined record, in a file of similar records. Structured data requires a model of the types and format of business
data that will be recorded and how the data will be stored, processed and accessed. This is called a data model.
Designing the model defines and limits the data which can be collected and stored, and the processing that can be
performed on it.
An example of structured data is found in banking systems, which record the receipts and payments from your
current account: date, amount, receipt/payment, short explanations such as payee or source of the money.
Structured data is easily accessible by well‐established database structured query languages.
Unstructured data: Refers to information that does not have a pre‐defined data‐model. It comes in all shapes and
sizes and it is this variety and irregularity which makes it difficult to store it in a way that will allow it to be analysed,
searched or otherwise used. An often quoted statistic is that 80% of business data is unstructured, residing in word
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processor documents, spreadsheets, PowerPoint files, audio, video, social media interactions and map data. For
example: just walking round a store can generate a vast quantity of data which will be very different in size and
nature for every individual.
VELOCITY
Information must be provided quickly enough to be of use in decision‐making and performance management. For
example, in the above store scenario, there would be little use in obtaining the price‐comparison information and
texting customers once they had left the store. If facial recognition is going to be used by shops and hotels, it has to
be more or less instant so that guests can be welcomed by name.
Volume and variety conspire against velocity and, so, methods have to be found to process huge quantities of non‐
uniform, awkward data in real‐time.
Software for big data
Without getting too technical on this issue, a library of software known as Apache Hadoop is specifically designed to
allow for the distributed processing of large data sets (i.e. big data) across clusters of computers using simple
programming models. (Clusters of computers are needed to hold the vast volume of information.) Hadoop IT is
designed to scale up from single servers to thousands of machines, each offering local computation and storage.
The processing of big data is generally known as big data analytics and includes:
 Data mining: analysing data to identify patterns and establish relationships such as associations (where several
events are connected), sequences (where one event leads to another) and correlations.
 Predictive analytics: a type of data mining which aims to predict future events. For example, the chance of
someone being persuaded to upgrade a flight.
 Text analytics: scanning text such as emails and word processing documents to extract useful information. It
could simply be looking for key‐words that indicate an interest in a product or place.
 Voice analytics: same as text analytics but with audio.
The analytical findings can lead to:
 Better marketing
 Better customer service and relationship management
 Increased customer loyalty
 Increased competitive strength
 Increased operational efficiency
 The discovery of new sources of revenue.
OTHER EXAMPLES OF THE USE OF BIG DATA
Netflix: this company began as a DVD mailing service and developed algorithms to help it to predict viewers’
preferences and habits. Now it delivers films over the internet and can easily collect information about when movies
are watched, how often films might be stopped and restarted, where they might be abandoned, and how users rate
films. This allows Netflix to predict which films will be popular with which customers. It is also being used by Netflix
to produce its own TV series, with much greater assurance that these will be hits.
Amazon: the world’s leading e‐retailer collects huge amounts of information about customers’ preferences and
habits which allow it to market very accurately to each customer. For example, it routinely makes recommendations
to customers based on books or DVDs previously purchased.
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Airlines: they know where you’ve flown, preferred seats, cabin class, when you fly, how often you search for a flight
before booking, how susceptible you are to price reductions, probably which airline you might book with instead,
whether you are returning with them but didn’t fly out with them, whether car hire was purchased last time, what
class of hotel you might book through their site, which routes are growing in popularity, seasonality of routes. They
also know the profitability of each customer so that, for example, if a flight is cancelled they can help the most
valuable customers first.
This information allows airlines to design new routes and timings, match routes to planes and also to make
individualised offers to each potential passenger.
Disease epidemic identification: In 2009, Google was able to track the spread of influenza across the USA faster than
the government’s Center for Disease Control and Prevention. This is because they monitored users entering terms
like ‘Flu symptoms’, ‘Flu remedies’, High temperature’. This connection was uncovered by web analytics looking at
popular search terms then finding a correlation with other information confirming influenza infections. Of course,
you have to be careful drawing conclusions about correlations: the association between the use of search terms and
the outbreak of flu might be driven by news articles on the spread of the epidemic rather than the epidemic itself.
Target: Target is the second largest discount retailer in the USA. There is an often quoted story about their ability to
predict when a customer is pregnant – frequently before the customer has informed her family. By looking at about
25 products it is claimed that they can create a pregnancy predictor. For example, early pregnancy often causes
morning sickness so consumers would perhaps change to blander food and less perfumed shower gel. Why would
Target be interested in knowing whether a consumer is pregnant? Well that person will require different products
during the pregnancy then in a few months the baby will have its own product needs: nappies, baby shampoo and
clothes. Early identification of pregnancy can allow Target to establish the shopping habits of the mother and
perhaps even the preferences of the child.
DANGER/RISKS OF BIG DATA
Despite the examples of the use of big data in commerce, particularly for marketing and customer relationship
management, there are some potential dangers and drawbacks.
Cost: It is expensive to establish the hardware and analytical software needed, though these costs are continually
falling.
Regulation: Some countries and cultures worry about the amount of information that is being collected and have
passed laws governing its collection, storage and use. Breaking a law can have serious reputational and punitive
consequences.
Loss and theft of data: Apart from the consequences arising from regulatory breaches as mentioned above,
companies might find themselves open to civil legal action if data were stolen and individuals suffered as a
consequence.
Incorrect data (veracity): If the data held is incorrect or out of date, incorrect conclusions are likely. Even if the data
is correct, some correlations might be spurious leading to false positive results.
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The Impact Of Big Data And Data Analytics On The Role Of The Management Accountant
Management accountants have the potential to make a business develop to its maximum capacity. Data scientists
are mainly responsible for meeting the challenges of advanced data but due to the shortage of data scientists,
management accountants may play this role as well. With the advancement in technology, many high skilled roles
are threatened as computers can now identify problems and run solutions without much skilled human input. But,
management accountants who are prepared to gain more skills and expertise in advanced analytical techniques to
add to their existing accounting knowledge can be assets to organisations. An important message for management
accountants is that they do not need to feel that the only way to survive in a new era of digital data is to become a
data scientist. This is a highly specialised and technical area that is not necessarily in the management accounting
space.
Data manager
Management accountants who also have the knowledge of information systems can contribute structure and
credibility to data projects and they are often best placed to articulate the needs of the business and determine the
data necessary to inform decisions or manage performance. Some management accountants may choose to develop
their careers in this area as project managers, change managers or IT professionals.
Data champion
Due to the professional advice management accountants provide in making well informed decisions which are also
beneficial for stakeholders, they are considered data champions. They are well equipped to extract the most value
from the data and develop efficient strategies for the business.
Finance business partner
Management accountants and business managers can easily be partnered as they are connected with each other in
all aspects of the business regularly. Finance accountants provide quantitative credibility in information while
business professionals have a better objective understanding. Together with their skills, they can carry out better
and more challenging projects and make the available data more valuable for the organisation.
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MANAGEMENT REPORTS
Learning Objectives



Evaluate the output reports of an information system in the light of.
i)
best practice in presentation;
ii)
the objectives of the report/organisation;
iii)
the needs of the readers of the report; and
iv)
avoiding the problem of information overload
Advise on common mistakes and misconceptions in the use of numerical data used for performance
measurement.
Explore the role of the management accountant in providing key performance information for integrated
reporting to stakeholders
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Reports for performance management
Performance means different things to different organisations so there is no single correct way of measuring or
presenting performance. For example, profit‐seeking organisations will certainly be interested in sales and profits,
but charitable organisations have neither sales nor profit. Furthermore, even within a single organisation different
aspects of performance may have to be examined in more detail at different times and for different audiences.
The following approach is suggested as one that may give guidance for a good performance report design. Decide
on:
 Purpose. What is the fundamental purpose of the report?
 Audience. For whom is the report produced?
 Information. What information is needed? This ties back to the first two considerations.
 Layout. The important information and conclusions must be easy to see.
Purpose
An organisation’s mission should define its purpose, and any judgment of the performance report must report on
the extent to which the mission is being achieved.
Accountants are prone to thinking that the measurement of profit is vital. However, none of these missions, aims
or goals mentioned ‘profit’, and only the last one mentioned ‘money’ at all. Therefore, successful performance
cannot simply be rooted in profit. It mainly depends on achieving the factors mentioned in the organisations’
missions, aims or goals.
Remember, performance can be judged only with respect to an organisation’s purpose and the ways it has chosen
to achieve its purpose.
Audience
The audience for performance reports will normally be managers, owners, government and all those charged with
governance. Often the audience will be sophisticated enough to understand the information presented without
much explanation. However, sometimes the audience will have fewer skills and might need fuller explanations.
Care has to be taken to assess the appropriate level of detail, layout and terminology used in reports so that users
will properly understand the information that is provided.
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Information
Information can be classified as follows:
Examples are:
 Financial: sales, profits, costs, GP%, return on capital employed.
 Non‐financial quantitative: percentage of product rejects, volume of sales, number of complaints.
 Non‐financial qualitative: reputation, effectiveness, customer satisfaction, staff morale.
The information provided must match the purpose of the performance report. In particular, non‐financial
performance is a very important determinant of the long term success of any enterprise. For a business, short‐
term financial performance can often be improved by reducing quality, innovation and training. However, a
business pursuing these approaches is likely to suffer financially in the long term. A business is not interested in
making high quality products for its own sake but to position itself as a high quality manufacturer. It must deliver
high quality and, therefore, quality needs to be monitored. If the business were known as a low cost supplier, the
measurement of quality would be much less important but costs per unit would become more important. It is a
common theme of questions for reports to display only financial information; this allows the opportunity for
candidates to criticise the lack of relevant non‐financial information.
It is important to understand about the balanced scorecard in this context. The four perspectives are:
 Financial perspective
 Customer perspective
 Internal business perspective
 Innovation and learning perspective
The need for non‐financial information is more obvious in not‐for‐profit organisations and, indeed, in those
organisations non‐financial performance is often an end in itself, rather than an enabler of profitability. If reporting
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on the success of the school described in December 2011 Q3 which has the ethos ‘to promote learning, citizenship
and self‐confidence among the pupils’, then the following might be suitable:
Quality
Learning
Citizenship
(participating in and
contributing to the well‐
being
of
their
community)
Self‐confidence
Possible measures
Details of exam marks, grades and exams passed together with comparatives from
previous years and neighbouring schools.
Explanations about differences in performance
Numbers of students involved in community service.
Records students’ behaviour to document the percentage of students engaged in
positive behaviours and/or a decline each year in negative behaviours.
Documentation of the students’ ability to discuss a significant social issue.
This is a difficult area. There are technical psychological approaches to measuring self‐
confidence, but something simple would be expected here. For example:
Participation in class discussions and debates.
Questionnaires
Non‐financial qualitative information is likely to be as important as quantitative information, but is harder to pin‐
down. Technically, qualitative information is known as a ‘construct’ i.e. an attribute that cannot be measured
directly. Examples of constructs are enthusiasm and empathy. Both are very important in business, but there is no
direct way in which they can be measured. Usually, for communication, assessment and comparative purposes, an
effort has to be made to try to turn qualitative information into quantified information. For example, in a hospital
it would be important for patients to feel that they were treated sensitively and with dignity. Assuming
management feels that these are important qualities, targets need to be set for them and performance assessed.
Inevitably this will be done by setting up some type of numerical assessment system so that qualitative becomes
quantitative.
The transition from qualitative to quantitative can introduce distortions to the information. For example, is what is
measured truly reflect what the undertaking wants to assess? In an effort to measure enthusiasm an organisation
might measure when staff arrives in the morning. However, the person who always arrives early might simply be a
victim of an hourly train service: arrive 40 minutes early or 20 minutes late.
Question 4 in the December 2013 exam is as an excellent example of how performance measure information can
be distorted. In summary, divisional raw scores were translated into rankings and performance was judged on
average ranking. However, this approach would change very similar scores of, say, 65, 64, 63 and 62 (perhaps well
within measurement error) into rankings of 1, 2, 3, and 4. The effect is to greatly magnify the differences.
Another way in which information can be distorted is to use proportional or percentage changes without regard to
absolute values. This is often seen in health scares where research claims that consumption of a product doubles
the chance of succumbing to a disease. What the headlines might well leave out is the absolute chance in
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increasing from 1 in 5,000,000 to 2 in 5,000,000. One might worry about it, but it is insignificant compared to, say,
the danger arising from crossing the road.
Graphical presentation is another way in which information can either be exaggerated or played down. For
example, here is a graph of the €/£ exchange rate for 30 days:
It looks very volatile until the y‐axis on scale is observed and it is understood that the rate moves between only
1.191 and 1.214, with a percentage change of about 2%.
Narrative explaining the information is also needed. For example, even something as simple as adverse material
prices variance needs an explanation about what caused it. If no explanation is given, it will simply mean that
questions will be raised later. Explanations may be accepted or challenged, but simply to report a variance without
stating how it might have arisen is too vague to be accepted.
Layout
Layout must help users to understand the information presented and to quickly observe the important amounts,
trends, results and explanations.
One of the most common criticisms of reports is that they present too much information and are much too
cluttered. There might be valuable information there but it is almost impossible to find and interpret it. There is
always the suspicion that large volumes of information have been deliberately provided to obfuscate the facts and
to blunt the message.
Although there is great misuse of graphical information, graphical displays can be used to greatly enhance
performance information.
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For example, Question 3 of the December 2011 exam and Question 1 of the June 2012 exam both provide good
examples of too detailed, cluttered and badly explained performance reports. It might be right to provide high
levels of detail, but that should be in appendices. The main body of any performance report should be immediately
understandable by users and easy to follow.
For Question 1 of the June 2012 exam, a bar chart of the 2010 revenue and costs of sales figures would look as
follows:
The relative performance of the different sectors is now much more obvious.
Similarly, the addition of narratives can be very important in drawing attention to important matters and
explaining their significance or causes. A much more satisfactory presentation of this report would be to have the
detailed information in an appendix and the body of the report explaining how each sector was performing – both
financially and in terms of important non‐financial performance measures.
Conclusion
Note: When drafting or criticizing a performance report, consider:
 Purpose. The organisations purpose determines what is meant by good performance.
 Audience. Make the report suitable for the interests, responsibilities and ability of the audience.
 Information. Above all, remember the importance of non‐financial information and beware of measurement
distortion.
 Layout. Not too cluttered; allow the important information to be easily seen and understood.
Common Mistakes And Misconceptions in The Use Of Numerical Data Used For Performance Measurement
Introduction
The mistakes and misconceptions can be divided into two causes:
 The quality of the data: what measures have been chosen and how has data been collected?
 How has the data been processed and presented to allow valid conclusions to be drawn?
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Inevitably, these two causes overlap because the nature of the data collected will influence both processing and
presentation.
The collection and choice of data
What to measure?
What to measure is the first decision and the first place where wrong conclusions can innocently or deliberately be
generated?
For example:
 A company boasts about impressive revenue increases but downplays or ignores disappointing profits.
 A manager wishing to promote one of two mutually exclusive projects might concentrate on its impressive IRR
whilst glossing over which project has the higher NPV.
 A production manager measures the quantity of units produced but not their quality.
 An investment company with 20 different funds advertises only the five most successful ones.
Not only might inappropriate amounts be measured, but they might be deliberately undefined as well. For
example, a marketing manager in a consumer products company might claim that the company’s new toothbrush
is reported by users to be 20% better.
But what’s meant by that statement? What is ‘better’? Even if that quality could be defined, is the toothbrush 20%
better than: using nothing, competitors’ products, the company’s previous products, or better than using a tree
twig?
Another potential way to confuse readers is to report relative rather than absolute changes. For example, one may
occasionally come across reports claiming that eating a particular type of food will double the risk of getting a
disease. Doubling sounds serious but what if told that consumption would change the risk from 1 in 10m to 1 in
5m? For most people doubling the risk does not look quite so serious now. The event is still rare and the risk
remains very low.
Similarly, if told that using a new material would halve the number of units rejected by quality control, one might
be tempted to switch to using it. But if the rate of rejections is falling from 1 in 10,000 to 1 in 20,000, the switch
does not look so convincing – though it would depend on the consequences of failure.
Sampling
Many statistical results depend on sampling. The characteristics of a sample of the population are measured and
based on them, conclusions are drawn about the characteristics of the population. There are two potential
problems:
1) For the conclusions to be valid, the sample must be representative of the population. This means that random
sampling must be used so that every member of the population has an equal chance of being selected in the
sample. Other sorts of sampling are liable to introduce bias so that some elements of the population are over
or under represented and false conclusions are likely to be drawn. For example, a marketing manager could
sample customer satisfaction only at outlets known to be successful.
2) Complete certainty can only be obtained by looking at the whole population and there are dangers in relying
on samples which are too small. It is possible to quantify these dangers and, in particular, one needs to know
information like “to a 95% confidence level, average salaries are $20,000 ± 2,300". This means that, based on
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the sample, there is 95% confidence that the population mean salary is between $17,700 and $22,300 (the
confidence interval). Of course, there is a 5% chance that the true mean salary lies outside this range.
Conclusions based on samples are meaningless if confidence intervals and confidence levels are not supplied.
The larger the sample, greater is the reliance that can be placed on the conclusions drawn. In general, the
confidence interval is inversely proportional to the square size of the sample. So, to halve the confidence interval,
the sample size has to be increased four times – often requiring a significant amount of work and expense.
More on small samples
Consider a company that has launched a new advertisement on television. The company knows that before the
advertisement 50% of the population recognises its brand name. The marketing director is keen to show to the
board that the ad has been effective in raising brand recognition to at least 60%. To support this contention, a
small survey has been quickly conducted by stopping 20 people at ‘random’ in the street and their brand
recognition was tested. (Note that this methodology can introduce bias: which members of the population are out
and about during the survey period? Which street was used? What are the views of people who refuse to be
questioned?)
Even if the ad were completely ineffective and only 50% of the population recognises the brand it can be shown
that there is a 25% chance that at least 12 out of the 20 selected will recognise the brand. So, if the director didn’t
get a favourable answer in the first sample of 20, another small sample could be quickly organised. There is a good
chance that by the time about four surveys have been carried out one of the results will show the improved
recognition that the marketing director wants. (Note: these results make use of the binomial distribution, which
you do not need to be able to use.)
It’s rather like flipping a coin 20 times – you intuitively know that there is a good chance of getting an 8:12 split in
the results.
If instead of just 20 people being surveyed, 100 were asked, then the chance of getting a recognition rate of at
least 60% would be only 1.8%. In general, small samples:
 Increase the chance that results are false positives.
 Increased chance that important effects will be missed. Always be suspicious of survey results that do not tell
you how many items were in the sample.
Another example of a danger arising from small samples is that of seeing a pattern where there is none of any
significance.
Imagine a small country of 100 km x 100 km. The population is evenly distributed and that four people will suffer
from a specific disease. In the graphs below, the locations of the sufferers have been generated randomly using
Excel and plotted on the 100 x 100 grid. These are actual results from six consecutive recalculations on the
spreadsheet data and represent the six possible scenarios.Now imagine you are a researcher who believes that the
disease might be caused high‐speed trains. The dark diagonal line represents the railway track going through the
country.
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Have a look at the position of the dots (sick people) compared to the rail‐tracks. If you wanted to see a clustering
of disease close to the railway tracks you could probably do so in several of the charts. Yet the data has been
generated randomly.
I didn’t have to do many more recalculations before the following pattern emerged:
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For people predisposed to believing what they want to believe, this graph presents them with a pattern they will
interpret as conclusive evidence of the effect.
The problem is that if dealing with only four pieces of data then there is a good chance that they will often cluster
around any given shape. The negative results such as seen in Graph C are easily dismissed and researchers
concentrate on the patterns they want to see.
Now think about the following business propositions: ๏A business receives very few complaints about its level of
service in one year but it all relates to one branch. Does that indicate that the branch is performing poorly or is it
just an artefact of chance? ๏In a year a business tenders for 1000 contracts but only three are won – all by the
same sales team. Does that really mean that the winner sales team is exceptionally good or is it simply the result of
chance?
The processing and presentation of data
Averages
The term ‘average’ refers to the arithmetic mean. This is calculated by adding up all results and dividing by the
number of results. So, for example:
Person
Height (cm)
A
B
C
D
E
Total
175
179
185
179
176
894
So the arithmetic mean of these 5 people is 894/5 = 178.8.
This is a natural way to describe an important measurement about the data. However, it can lead you astray at
times.
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The arithmetic mean is one measure of the data’s location. The other common measures are:
Mode: The most commonly occurring value. In the table above, the mode is 179. This measure would be more
useful than the mean to a mobile phone manufacturer who needs to know customer preferences for phones of 8,
16, 32 or 64 GB. It will identify which one is the most popular.
Median: This is the value of the middle ranking item. So, the data should be arranged in an ascending order and
the height of the person at the mid‐point, will be the median of the data.
Person
Height (cm)
A
E
B
D
C
175
176
179
179
185
As the height of the mid‐ranking person is 179 and this is the median
Unless the distribution of the data is completely symmetrical, the mean, mode and median will generally not have
the same values. In particular, the arithmetic mean can be distorted by extreme values that give rise to its
misinterpretation.
To demonstrate this, the following example sets up a theoretical symmetrical distribution of the annual income of
a population:
Number of people (000)
10
20
30
40
50
40
30
20
10
Annual income $ 000
15
25
35
45
55
65
75
85
95
The mean, median and mode are all $55,000. The one who earned that will feel that he is on ‘average’ pay, with an
equal number of many people earning more and less than him.
Now let’s say that into this population comes the founder of a hi‐tech internet company called Mark Gutenberg
who invented a social medium service called U‐Face. Mr. Gutenberg has a very high income ‐ $10m/year. The
salary distribution now looks like:
Number of people (000)
10
20
30
40
50
40
30
20
10
Annual income $000
15
25
35
45
55
65
75
85
95
M
Gutenberg
1
10000
The arithmetic mean of this distribution is $55,400, so now earning only $55,000, the employee will feel that he is
earning less than average. In fact over 50% of the population is earning less than ‘average’ – something that at first
glance would seem impossible.
This distortion could allow a government to claim that people are now better off because average earnings are
higher. In fact, even if all the salary bands were reduced by 5%, the arithmetic mean including Gutenberg would be
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around $55,380. So the government could claim that on average the population is better off when, in fact, almost
everyone is worse off.
In situations where the data is not symmetrical, the median value will often provide a more useful measure. The
inclusion of Gutenberg does not change the median value and if everyone’s income fell by 5%, so would the
median.
False positives and false negatives: Bayes’ theorem
This will first be demonstrated using a medical example, then it will be applied to a more business‐related area.
Assume there is a serious medical condition called ‘lurgy’ suffered by 5% of the population. There is a diagnostic
test available, but it is not perfect. If the test result is positive there is a 90% chance that it is correct, and a 10%
chance that it is wrong (false positive). If the test is negative, there is an 80% chance that the result is correct, but a
20% chance that the disease was missed (false negative).
If you are tested and the result is positive, what is the probability that you have lurgy? The answer is 90%, but that
is far from the truth.
The easiest way to solve this is to construct a table, based on 10,000 people.
Suffers from lurgy
Does not suffer
Total
from lurgy
Positive test result
Negative test result
Total
500
9,500
10,000
First, put in the true number of the 10,000 who suffer from the disease: 5% and 95% of 10,000.
So, of the 500 who have the disease, the test will report correctly on 90% of them and incorrectly on 10%. In
numbers this will be 90% x 500 = 450 who have the disease and who are correctly reported on, and 10% x 500 = 50
who have the disease but are not reported on.
Similarly, of the 9,500 non‐sufferers, the test will correctly report on 80% of them. The numbers are 80% x 9,500 =
7,600. The remainder will be reported as having the disease, 20% x 9,500 = 1,900
The table can now be shown as:
Suffers from lurgy
Positive test result
Negative test result
Total
450
50
500
Does not suffer
from lurgy
1,900
7,600
9,500
Total
2,350
7,650
10,000
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So, if one finds his test results as positive, he is in the top line of this table (where the positive results are). From
the population of 10,000 there are 2,350 positive results, but only 450 are true positives. Therefore the chance of
that person actually having the disease is 450/2,350 = 19% which is very different from the 90% calculated at the
start.
Now let’s look at a business‐orientated example.
Maxter Software Co creates software and web‐sites for clients. They prefer to recruit employees with no
programming experience and train them. It is believed that 1% of the population has the aptitude to become a
programmer. The company asks each applicant to undergo an aptitude test. If someone has the proper aptitude
the test will identify them correctly on 80% of occasions, but 20% are missed. If a recruit does not have aptitude,
there is only a 5% chance that they will pass the test.
If someone is identified as having aptitude, what is the chance that they actually do?
Has aptitude
Does not have
Total
Aptitude
Passes test
80
475
555
Does not pass test
20
9,525
9,545
Total
100
9,900
10,000
So the chance that a person who passes the test actually has aptitude is 80/555 = 14.4. This is not a great way to
recruit successful staff.
3.3 Correlation
One of the most common misuses of data is to assume that good correlation between two sets of data implies
causation (that one causes the other). This is a fallacy and one that needs to be constantly fought against.
For example, consider this data set:
Sales of smartphones in
UK2 (m)
2012
2013
2014
2015
1 Diabetes
UK 2 Statista/eMarketer
Diabetes in UK1(m)
3.04
3.21
3.33
3.45
26.4
33.2
36.4
39.4
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On a graph the data looks like:
The two sets of data follow one another closely and indeed the coefficient of correlation between the variables is
0.99, meaning very close association.
It is unlikely that one may believe that owning a smart phone causes diabetes or vice versa and will easily prefer to
believe that the high correlation is spurious. However, with other sets of data showing high correlation it is easier
to assume that there is causation. For example:
 Use of MMR vaccines and incidence of autism. Almost no doctors now accept there is any causal connection.
In addition the whole study was later discredited and the doctor responsible was struck off the UK medical
register.
 Cigarette smoking and lung cancer. A causal effect is well‐established, but it took more than correlation to do
so.
 Concentration of CO2 in the atmosphere and average global temperatures. Not universally accepted (but
increasingly accepted).
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Graphs and pictograms
Here’s a graph of the £/€ exchange rate for September to October 2015.
However, the effect has been magnified because the y‐axis starts at 1.3, not 0. The whole graph only stretches
from 1.3 to 1.44. If the graph is redrawn starting at the y‐axis 0, then the graph will look a follows:
Note that a board of directors that wants to accentuate profit changes could easily make small increases look
dramatic, simply by starting the y‐axis at a high value.
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Pictograms are often used to make numerical results more striking and interesting. Look at the following set of
results:
Year
Profit ($m)
2013
2014
100
110
2015
120
The increase has been a relatively modest 10% per year and on a bar chart would appear as:
A pictogram could show this as:
Look at the first and last bag of money and think about how much you could fit into each. I would suggest the
capacity of the third one looks at least 50% greater than the first one. That’s because the linear dimensions have
increased by 20%, but that means that the capacity has increased by 1.23 = 1.73, flattering the results.
So it is important to consider how data is collected, processed and presented as it can be used to indicate that
performance of an organisation is better or worse than it actually is.
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ACCA PAST PAPER QUESTION 2
Stokeness Engineering (Stokeness) is developing hydrogen fuel cells for use in powering large motor vehicles such
as buses and trucks. They will replace standard petrol/diesel engines. The fuel cells have a clear advantage over
these older technologies in having lower carbon dioxide (a greenhouse gas) emissions. The governments of many
developed countries are keen to see cuts in such emissions and are supportive of a variety of possible technological
solutions to this issue (such as fuel cells, electrical batteries and compressed natural gas).
These alternate power technologies would be fitted by the major international vehicle manufacturers into their
vehicles for sale to their customers. The vehicle manufacturers will need to form a close partnership with any engine
producer in order to make their technologies compatible and this has already begun to happen, with two of the
major manufacturers signing deals with other engine makers recently.
Stokeness’ mission is to provide world‐leading, reduced‐emission, fuel‐efficient power products for the motor
industry in order to optimise shareholder returns. Stokeness has existed for only five years and is owned by its
management and venture capitalists (VCs). The management were all engineers who had been working on the basic
research associated with new fuel technologies and saw the opportunity to commercialise their expertise. Stokeness
is highly regarded in the industry for its advanced, efficient fuel cell designs. As a result, the VCs were eager to invest
in Stokeness and have assisted by placing experienced managers into the business to aid the original engineering
team.
It takes five to ten years to develop a viable product for sale in this motor market. Thus, the VCs have stressed the
need to analyse competition and competitive advantage in order to understand how to make the business profitable
in the long term. A major problem that needs to be overcome with any of these new technologies is that there must
be an infrastructure accessible to the end users for refuelling their vehicles (as the petrol station chains do for petrol
engine vehicles at present). Governments have indicated their desire to support the development of such
technologies to address environmental issues and to try to establish new, high‐value industries in their jurisdiction.
They may do this through tax breaks and investment to support the development of the refuelling infrastructure.
Production of Stokeness’ fuel cells uses a special membrane that requires rare and expensive elements. Also, it has
partnered with two other engineering firms to subcontract the production of certain components in the fuel cell.
Stokeness has had to share much of its fuel cell design with these firms in order to overcome certain engineering
difficulties.
There are a number of companies developing fuel cells but Stokeness is believed to have a two‐year lead over them
and to be only three years away from commercial launch. Also, there are a number of start‐up companies developing
the other technologies mentioned above, as well as large, existing diesel and petrol engine manufacturers who are
constantly reducing the emissions from their existing engines.
The chief executive officer (CEO) of Stokeness wants to understand the external business environment and its effect
on performance management. She has used Porter’s five forces model herself in the past for strategic decision‐
making but here she wants it focused on performance management. In particular, she wants your analysis of the
current competitive environment to result in advice about performance management and a properly justified
recommendation of one performance measure for each of the five force areas. Stokeness already uses market share
to measure its competitive position but the CEO is worried about the way this is calculated, in particular the
definition of the market. She has asked for your comments on this as you are a performance management expert.
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Required:
(a) Using Porter’s five forces model, assess the impact of the external business environment on the performance
management of Stokeness and give a justified recommendation of one new performance measure for each
of the five force areas at Stokeness.
(16 marks)
(b) Discuss how the problems of defining the market in measuring a market share apply for Stokeness.
(4 marks)
(c) Assess the risk appetite of the venture capitalists and discuss how this might impact on performance
measurement at Stokeness.
(5 marks)
(Total marks 25)
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APM – Study Notes
Quality of the end product could also be affected by the supervision activity and in order to ensure that this is
functioning well, the CC department will need to have the authority to intervene with the work of other
departments in order to correct errors – this could be a key area for prevention of faults and so might become
a core quality activity (an inspection and prevention cost).
The other activities in the department are administrative and the measures of their quality will be in the financial
information systems. Order processing quality would be checked by invoice disputes and credit note issuance.
Credit check effectiveness would be measured by bad debt levels.
Workings:
Customer care (CC) department
Standard absorption cost per dish
Salaries
Computer time
Telephone
Stationery and sundries
Depreciation of equipment
Total CC cost
Number of dishes (5∙5 x 16,000)
$’000
400
165
79
27
36
––––
707
––––
$707,000
88,000
Standard absorption cost per dish
$8∙03
Finance director’s adjusted cost per specialised
$108∙03
dish
Activity‐based costs
Total
$
282,800
70,700
70,700
Handling enquiries and preparing quotes
Receiving actual orders
Customer credit checks
Supervision of order through manufacture to
delivery
106,050
Complaints handling
176,750
––––––––
Total
707,000
––––––––
Average dishes per order
No of orders
Total number of dishes
ABC absorption cost per dish
Standard
$
226,240
63,630
63,630
Specialised
$
56,560
7,070
7,070
95,445
88,375
––––––––
537,320
––––––––
6
14,400
86,400
$6∙22
10,605
88,375
––––––––
169,680
––––––––
1
1,600
1,600
$106∙05
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Question Paper
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(a) Porter’s five forces analysis
Threat of new entrants
The threat of new entrants will be dictated by barriers to entry into the fuel cell market. These appear to be
high, given the long timescale and the high levels of technical expertise required to develop a viable product.
Also, the developer will need to have cultivated a strong relationship with the major vehicle manufacturers who
will be the customers for the product.
A suitable performance measure would be percentage of revenue derived from patented products to measure
the legally protected revenues of the business and so indicate the barrier to entry. Stokeness will need to ensure
that all technology developments are written up and assessed for their patent possibility.
[Other measures could include ratio of fixed cost to total cost (measures capital required) or customer loyalty
(through long‐term contracts to supply fuel cells to manufacturers).]
Threat of substitutes
The substitutes mentioned in the question are electrical batteries, compressed natural gas and improved
existing diesel/petrol engines. However, it is clear that improved diesel/petrol engines would potentially have
many lower barriers to cross as the technology is known to the car industry and the infrastructure exists to
deliver the fuel to the end‐users of the cars.
The threat of each of these substitutes would be measured by an analysis of the comparative cost of creating a
viable alternative to the fuel cell. The performance in terms of power output of the engine and emissions
reductions compared to price would be critical. Management of this aspect will entail monitoring fuel prices in
the market, reviewing the appropriate technical journals and attending conferences in order to identify these
threats and their progress. This will require the input of both finance and engineering staff at Stokeness.
Power of suppliers
The suppliers have considerable power. There are rare raw materials used in production and the price and
availability of these will dictate possible output levels for fuel cell producers. This is especially important, given
the possibility of increased production that could flow if fuel cells become the dominant way to power vehicles
in the future. There is a danger that the market in these materials is controlled by a few suppliers who can then
dictate price. The engineering subcontractors will also have power through their knowledge of the design
elements of Stokeness’ product. It will be important for Stokeness to protect this by legally enforceable non‐
disclosure agreements. There is a danger that this knowledge will lead the suppliers to consider pre‐emptive
forward integration by taking over Stokeness.
The power of suppliers could be measured by estimating the cost of shifting to an alternative supplier, which
could be considerable, given the innovative nature of the technology. These costs would have to include the
damage to value from the delay that such a shift would cause.
[Other measures could include cost of suppliers’ product compared to total cost of the fuel cell, which indicates
the importance of this component in production, and the number of suppliers as it indicates the level of
competition in that market.]
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Power of customers
The customers are the major bus and truck manufacturers. Again, the customers will have a large degree of
influence, given their size and limited numbers if Stokeness wants to access the world market. There will need
to be a partnership between the fuel cell maker and the vehicle manufacturer in order to ensure that the
technologies are compatible. There is the threat that these powerful customers will seek to take over Stokeness
if its products prove successful; however, this may be an attractive exit for the shareholders depending upon
the price offered.
The power of customers can be measured by estimating their switching costs which are likely to be high, given
the technological compatibility issue. However, these costs will only occur once the vehicle manufacturer has
agreed to source from a particular supplier (e.g. Stokeness) and until an agreement is reached, the fuel cell
supplier will be in the weaker position. The vehicle manufacturer will also have the commercial power to be
able to become a new entrant to the market if it appears more profitable to do so.
Stokeness could seek to manage these problems in two ways:
(a) quickly enter into an exclusive arrangement with one partner by emphasising the technological lead that
they hold over the competition. This will be lower risk but will cut returns as the partner will then have
pricing power; or
(b) seek to develop a product that will be attractive to multiple vehicle manufacturers and then maximise
price by playing them against each other. This appears less plausible in this scenario, given the limited
number of large manufacturers.
[Other measures could be the number of alternative customers, the level of discounts customers demand and
the number of alternative suppliers customers can chose from.]
Power of existing competition
The power of existing competition appears low as Stokeness has a two‐year lead in development. It will be
important to protect this legally by patenting innovations as soon as possible and, also, ensuring the strictest
commercial confidentiality is maintained within Stokeness and their commercial partners.
The power of existing competitors can be measured by market share once the market forms. However, at this
development stage of the industry, a measure such as time to market (the expected commercial launch date of
a viable fuel cell) would be more appropriate. This will aid management focus on delivering the product as
rapidly as possible, thus maintaining Stokeness’ competitive advantage and avoiding time over‐runs in
development which will strain the cash flows of the company and may lead to unwelcome further calls for
funding from the VCs.
[Other measures could be partnership agreements (with car manufacturers) signed or projected
revenues/volumes under such agreements.]
[Tutor note: The use of ideas such as patent protection, time to market and partnering with a vehicle
manufacturer are relevant under several of the headings and credit is given provided the point is suitably
justified to the particular force being discussed at that point of the answer.]
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(b) Market definition
The CEO’s concerns over the definition of market in market share are justified, as there are a variety of
possibilities.
If Stokeness were to take an ambitious view, then they could measure the market as the total commercial
vehicle market and measure the number of vehicles powered by Stokeness’ fuel cell compared to the total
number of vehicles. This would be a measure of competitive performance against all existing engine
technologies including existing petrol/diesel. It would be more realistic to use the number of new vehicles sold
rather than all vehicles in existence in this measure.
A second possibility exists in this scenario for comparing the number of vehicles with Stokeness’ fuel cell
compared to the number using any of the alternative engine technologies (fuel cells, electrical, compressed
natural gas).
However, Stokeness could take an even less ambitious view and consider just the market for fuel cells, therefore
measuring Stokeness’ performance against only other fuel cell makers.
The board must make a choice as to the market they are competing in or maybe decide the firms that they see
as their main competitors, and then use this to define the market and so the performance measure.
(c) Venture capitalists
The VCs are likely to be rational investors seeking maximum return for minimum risk. However, they will have
invested in a number of companies and so are prepared for investments to fail, provided that some of their
investments perform very well. Therefore, they will be risk seeking in technology start‐ups such as Stokeness.
The VCs have placed employees within the management team and so have a high degree of influence on
Stokeness. They will be looking at medium/long‐term returns, given the nature of the project, through net
present value based on projected revenues. Of more immediate concern will be the worry that Stokeness runs
out of cash before it has a viable product to sell and so cost control measures (variances from budget) and cash
outflow will be key measures at present. They will have stated a rough timescale to exit the investment on
provision of the initial funds and they will monitor performance to plan on this basis. Progression towards an
exit will require Stokeness to pass various milestones (e.g. to file patents, to sign contracts with customers);
timely achievement of these would be useful performance indicators, as well as purely financial ones such as
meeting the cash flow projections.
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FINANCIAL PERFORMANCE MEASURES IN THE PRIVATE SECTOR
Learning Objectives





Demonstrate why the primary objective of financial performance should be mainly concerned with the
benefits to shareholders.
Discuss the appropriateness of, and apply the following as measures of performance:
 Return on capital employed (ROCE)
 Earnings per share (EPS)
 Earnings before interest, tax & depreciation adjustment (EBITDA)
 Residual Income
 Net present value (NPV)
 Internal rate of return and modified internal rate of return (IRR, MIRR)
 Economic Value Added
Discuss why indicators of liquidity and gearing need to be considered in conjunction with profitability D1c)
Compare and contrast short and long run financial performance and the resulting management issues.
Asses the appropriate benchmarks to use in assessing performance.
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Financial performance measures in
the private sector
Benefits to
shareholders
Profitability Ratios
Measures
Investors Ratios
Gearing and
Liquidity Ratios
Advantages and
Disadvantages of
Ratios
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INTRODUCTION
It is clearly important in practice to have measures in order to determine whether or not a company is performing
well. It is crucial to measure both financial and non-financial performance, but in this chapter we will consider only
financial performance. You will be given extracts from the company’s accounts for several years and be expected
to analyse and interpret this information.
OBJECTIVE OF PROFIT MAKING ORGANISATIONS
 The primary objective of a profit making organisation is to maximise shareholder wealth because shareholders
are legal owners of the company, so their interest should be priortised.
 Shareholders are mainly concerned with the current and future earnings of the company, dividend policy and
relative risk of their investment.
Objective according to Peter Drucker
Relation between shareholder value and profits
Research has suggested the following important points.
 There is a poor correlation between shareholder return and profit, EPS.
 There is no correlation between shareholder return and return on equity (ROE).
 Investors usually looks for long term value.
 There is a strong relationship between shareholder value and future cash flows.
 Total shareholder return is equal to dividend received and capital gain/loss.
Approach of performance measurement
Although there are several key measures of financial performance, it is important that one does not make the
mistake of simply calculating every ratio imaginable for every year available. What the examiner is after is much
more of an over-view and being able to determine the key measures and to comment adequately.
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Financial Performance
APM – Study Notes
The following points should be considered:
What is it that you are being asked to comment on?
If one is looking at the information from the shareholders’ perspective, then growth (or otherwise) in the share
price will be of great interest.
However, if one is looking at how well the managers are performing, the growth (or otherwise) in the profit (to the
extent to which they control it) is perhaps of more importance.
Growth
The level of growth should always be a major focus. The amount of detail required depends on the information
available and the number of marks allocated, but growth in turnover, profit and share price are all potentially
relevant.
It is better to assess the overall level of growth and look for any trends instead of wasting time doing detailed yearby-year analysis.
Basis of comparison
Most measures mean little on their own, and are only really useful when compared with something. Depending on
the information given in the question, any comparison is likely to be with one of the following:
 Previous years for the same company
 Other similar companies
 Industry averages
 Against budget
 Against other performance measures.
Profitability ratios
Return on capital employed (ROCE)
𝑃𝑟𝑜𝑓𝑖𝑡 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥
𝑅𝑂𝐶𝐸 =
𝑋 100%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
It gives a measure of the underlying performance of the business before finance as well as an indication of the
health of the business in generating a return on its investments.
Note: Capital employed represents the total funds invested in the business, it includes equity and long-term debt.
There are three comparisons that can be made:
(a) The change in ROCE from year to year
(b) Comparison to other similar businesses
(c) Comparison to the market borrowing rate.
Net profit margin
𝑷𝑩𝑰𝑻
𝑵𝑷 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑿𝟏𝟎𝟎
𝑺𝑨𝑳𝑬𝑺
A high profit margin indicates that either sales prices are high or total costs are being kept well under control.
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Financial Performance
APM – Study Notes
Gross profit margin
𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕
𝑷 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝒙𝟏𝟎𝟎
𝒔𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆
A high gross profit margin indicates that either sales prices are high or production costs are being kept well under
control.
Asset turnover
𝑨𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝒔𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆
𝒙 𝟏𝟎𝟎
𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
A measure that considers the level of sales in relation to the capital employed. The asset turnover will depend very
much on the type of industry, manufacturing would be likely to have more assets relative to sales than a retail
operation. (where there is no production and only stock in trade). When used to compare one company with
another within the same industry, the measure may highlight the difference between a wholesaler or high volume
retailer with high turnover rather than a specialist retailer with relatively low turnover.
Return on equity (ROE)
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔
𝑹𝑶𝑬 =
𝒔𝒉𝒂𝒓𝒆 𝒉𝒐𝒍𝒅𝒆𝒓 𝒇𝒖𝒏𝒅𝒔
Companies can manipulate ROE by using high levels of debt finance.
Investors ratios
Earning per shares (EPS)
𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 (𝑃𝐴𝑇)
𝐸𝑃𝑆 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠
The portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves
as an indicator of a company’s profitability.
EPS must be used with care when measuring performance.
(a) Must be compared over time.
(b) Possible dilution in the future due to existence of share options or convertible debt (which influence
ownership percentage share).
(c) Cannot be used to compare companies with different equity structures.
(d) Cannot be easily used if a company changes its equity structure during the year.
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Financial Performance
APM – Study Notes
Price Earnings ratio (P/E ratio)
The P/E ratio is a measure of future earnings growth; it compares the market value to the current earnings.
The higher the P/E ratio, the greater the market expectation of future earnings growth. This may also be described
as market potential.
𝑃𝐸 𝑅𝑎𝑡𝑖𝑜 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
𝐸𝑃𝑆
P/E ratios are deemed to reflect the future prospects of a company. A high P/E ratio indicates that investors
believe the company will have:
(a) Higher future earnings; or
(b) Lower risk than others in its market.
P/E ratios of quoted companies are often used as starting points for valuing unquoted companies in the same
sector.
Dividend cover
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑐𝑜𝑣𝑒𝑟 =
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
The dividend cover indicates:
 The proportion of distributable profit for the year that is being retained by the company
 The level of risk that the company will not be able to maintain the same dividend payments in future years,
should earning fall.
 A high dividend cover means that a high proportion of profit is being retuned, which might indicate that the
company is investing to achieve earning growth in the future.
Interest cover
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟 =
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑜𝑓𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
The interest cover ratio shows whether company is earning enough profit before interest to pay its interest costs
comfortably, or whether its interest costs are high in relation to the size of its profit, so that a fall in profit before
interest and tax would then have a significant effect on profits available for ordinary shareholders. An interest
cover of 2 times or less would be low, although benchmarks are different for each industry.
Risk ratios
Gearing ratio
Capital gearing may be calculated in a number of different ways
𝐷𝑒𝑏𝑡
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑒𝑎𝑟𝑖𝑛𝑔 =
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦
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Financial Performance
APM – Study Notes
WHAT DO WE MEAN BY DEBT AND EQUITY?
Debt
This includes:
 Debentures and loans.
 Possibly bank overdraft if significant and considered part of the permanent financing.
 Finally, preference share capital may also be included because of its fixed coupon. Note a company may be
able to defer payment of preference share dividends hence these are less risky to the company than straight
debt.
Equity
All ordinary share capital and share premium together with reserves
Operating gearing ratio
Operational gearing looks at the risk associated with the level of fixed costs within a business. The higher the fixed
cost the more volatile the profit. The level of fixed cost is normally determined by the type of industry and cannot
be changed. It is mainly calculated as
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐺𝑒𝑎𝑟𝑖𝑛𝑔 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
It is important to note that the level of operating risk will impact on the level of financial risk that a company is
willing to take on.
Liquidity ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A simple measure of how much of the total current assets are financed by current liabilities. If, for example, the
measure is 2:1, it means that only a limited amount of the assets are funded by the current liabilities.
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A measure of how well current liabilities are covered by liquid assets. A measure of 1:1 means that one is able to
meet existing liabilities if they all fall due at once.
These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company suddenly finds
that it is unable to renew its short term liabilities (for instance if the bank suspends its overdraft facilities), there
will be a danger of insolvency unless the company is able to turn enough of its current assets into cash quickly.
OVERTRADING
Overtrading is trading by an organisation beyond the resources provided by its existing capital.
Overtrading tends to lead to liquidity problems as too much stock is bought on credit and too much credit is
extended to its customers which ultimately leads to insufficient cash available to pay the debts as they arise.
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Financial Performance
APM – Study Notes
Overtrading is caused by rapid growth.
Indicators:
 Rapid increase in turnover
 No matching increase in permanent capital (overtrading is sometimes called under-capitalization)
 Increase in trade creditor balances
 Increasing operating cycle
 Decrease in cash/increase in overdraft
Remedies:
 Cut back trading
 Raise further permanent capital
 Improve working capital management
Working capital ratio
The level of working capital required is affected by the following factors:
 The nature of the business. e.g. manufacturing companies need more stock than service companies.
 Uncertainty in supplier deliveries. Uncertainty means that extra stocks need to be carried in order to cover
fluctuations.
 The overall level of activity of the business. As output increases, receivables, stock etc., all tend to increase.
 The company’s credit policy. The tighter the company’s policy the lower the level of receivables.
 The length of the operating cycle. The longer it takes to convert material into finished goods and into cash,
the greater the investment required in working capital.
Calculation of days
𝐹𝑖𝑛𝑠𝑖𝑠ℎ𝑒𝑑 𝑔𝑜𝑜𝑑 𝑠𝑡𝑜𝑐𝑘
𝑥 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠 =
𝑥 365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠 =
𝑥365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒
𝐹𝑖𝑛𝑠𝑖𝑠ℎ𝑒𝑑 𝑔𝑜𝑜𝑑𝑠 𝑑𝑎𝑦𝑠 =
EARNINGS BEFORE INTEREST, TAX AND DEPRECIATION ADJUSTMENT (EBITDA)
EBITDA is a financial performance measure that has appeared relatively recently. It stands for ‘Earnings, Before,
Interest, Taxes, Depreciation and Amortisation’ and is particularly popular with high-tech startup businesses.
Consideration of earnings before interest and tax has long been common. Before interest, in order to measure the
overall profitability before any distributions to providers of capital, and before tax on the basis that this is not
under direct control of management.
The reason that EBITDA additionally considers the profit before depreciation and amortisation is in order to
approximate to cash flow, on the basis that depreciation and amortisation are non-cash expenses.
A major criticism, however, of EBITDA is that it fails to consider the amounts required for fixed asset replacement.
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Financial Performance
Advantages
1. It is a measure of underlying performance.
2. Tax and Interest are externally generated and therefore
not relevant to underlying performance.
3. It is easy to calculate.
4. It is easy to understand
APM – Study Notes
Disadvantages
1. It ignores changes in working capital and
the impact on cash flows.
2. It fails to consider the amount of fixed
asset replacement needed.
3. It can easily be manipulated by aggressive
accounting policies
Practice questions
Web Co is an online retailer of fashion goods and uses a range of performance indicators to measure the
performance of the business. The company’s management have been increasingly concerned about the lack of
sales growth over the last year and, in an attempt to resolve this, made the following changes right at the start of
quarter 2
Advertising: Web Co placed an advert on the webpage of a well-known online fashion magazine at a cost of
$200,000. This had a direct link from the magazine’s website to Web Co’s online store.
Search engine: Web Co also engaged the services of a website consultant to ensure that, when certain key words
are input by potential customers onto key search engines, such as Google and Yahoo, Web Co’s website is listed on
the first page of results. This makes it more likely that a customer will visit a company’s website. The consultant’s
fee was $20,000.
Website availability: During quarter 1, there were a few problems with Web Co’s website, meaning that it was not
available to customers at some of the time. Web Co was concerned that this was losing them sales and the IT
department therefore made some changes to the website in an attempt to correct the problem.
The following incentives were also offered to customers:
Incentive 1: A free ‘Fast Track’ delivery service, guaranteeing delivery within two working days, for all continuing
customers who subscribe to Web Co’s online subscription newsletter. Subscribers are thought by Web Co to
become customers who place further orders.
Incentive 2: A $10 discount to all customers spending $100 or more at any one time.
The results for the last two quarters are shown below, quarter 2 being the most recent one. The results for quarter
1 reflect the period before the changes and incentives detailed above took place and are similar to the results of
other quarters in the preceding year.
Quarter 1
Quarter 2
Total sales revenue
$2,200,000
$2,750,000
Net profit margin
25%
16·7%
Total number of orders from customers
40,636
49,600
Total number of visits to website
101,589
141,714
Conversion rate – visitor to purchaser
40%
35%
The percentage of total visitors accessing website through magazine link
0
19·9%
Website availability
95%
95%
Number of customers spending more than $100 per visit
4,650
6,390
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Financial Performance
Number of subscribers to online newsletter
APM – Study Notes
4,600
11,900
Required:
Assess the performance of the business in Quarter 2 in relation to the changes and incentives that the company
introduced at the beginning of this quarter. State clearly where any further information might be necessary,
concluding as to whether the changes and incentives have been effective.
(20 marks)
Solutions
Web Co has made three changes and introduced two incentives in an attempt to increase sales. Using the
performance indicators given in the question, it is possible to assess whether these attempts have been
successful.
Total sales revenue
This has increased from $2·2 million to $2·75m, which is an increase of 25% (W1). This is a substantial increase,
especially considering the fact that a $10 discount has been given to all customers spending $100 or more at any
one time. However, because a number of changes and incentives have been introduced, it is not possible to assess
how effective each of the individual changes/incentives has been in increasing sales revenue without considering
the other performance indicators.
Net profit margin (NPM)
This has decreased from 25% to 16·7%. In $ terms this means that net profit was $550,000 in quarter 1 and
$459,250 in quarter 2 (W2). If the 25% NPM had been maintained in quarter 2, the net profit would have been
$687,500 for quarter 2. It is therefore $228,250 lower than it would have been. This is mainly because of the
$200,000 paid out for advertising and the $20,000 paid to the consultant for the search engine work. The
remaining $8,250 difference could be a result of the cost of the $10 discounts given to customers who spent more
than $100, depending on how these are accounted for. Alternatively, it could be due to the costs of providing the
Fast Track service. More information would be required on how the discounts are accounted for (whether they are
netted off sales revenue or instead included in cost of sales) and also on the cost of providing the Fast Track
service.
Whilst it is not clear how long the advert is going to run for in the fashion magazine, $200,000 does seem to be a
very large cost. This expense is largely responsible for the fall in NPM.
Number of visits to website
These have increased dramatically from 101,589 to 141,714, an increase of 40,125 visits (39·5% W3). The reason
for this is a combination of visitors coming through the fashion magazine’s website (28,201 visitors W5), with the
remainder of the increase most probably being due to the search engine consultants’ work. Both of these changes
can therefore be said to have been effective in improving the number of people who at least visit Web Co’s online
store. However, given that the search engine consultant only charged a fee of $20,000 compared to the $200,000
paid for magazine advertising, in relative terms, the consultant’s work provided value for money. Web Co’s sales
are not really high enough to withstand a hit of $200,000 against profit, hence the fall in NPM.
Number of orders/customers spending more than $100
The number of orders received from customers has increased from 40,636 to 49,600, an increase of 22% (W4). This
shows that, whilst most of the 25% sales revenue increase is due to a higher number of orders, 3% of it is due to
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Financial Performance
APM – Study Notes
orders being of a higher purchase value. This is also reflected in the fact that the number of customers spending
more than $100 per visit has increased from 4,650 to 6,390, an addition of 1,740 orders. If each of these 1,740
customers spent exactly $100 rather than the $50 they might normally spend, it would easily explain the 3%
increase in sales that is not due to increased order numbers. It depends partly on how the sales discounts of $10
each are accounted for. As stated above, further information is required on these.
An increase in the number of orders would also be expected, given that the number of visitors to the site has
increased substantially. This leads on to the next point.
Conversion rate – visitor to purchaser
The conversion rate of visitors to purchasers has gone down from 40% to 35%. This is not surprising, given the
advertising on the fashion magazine’s website. Readers of the magazine may well have clicked on the link out of
curiosity and may come back and purchase something at a later date. It may be useful to have a breakdown of the
visitor to purchaser rate, showing one statistic for visitors who have come from the online magazine and one for
those who have not. This would help clarify the position.
Website availability
Rather than improving after the work completed by Web Co’s IT department, the website’s availability has stayed
the same. This means that the IT department’s changes to the website have not corrected the problem. Lack of
availability is not good for business, although its exact impact is difficult to ascertain. It may be that visitors have
been halfway through making a purchase only to find that the website has become unavailable. More information
would need to be available about aborted purchases before any further conclusions could be drawn.
Subscribers to online newsletter
These have increased by a massive 159%. It is not clear what impact this has had on the business as we do not
know whether the level of repeat customers has increased. This information is needed. Surprisingly, it seems that
there has not been an increased cost associated with providing Fast Track delivery, as the whole fall in net profit
has been accounted for, so one can only assume that Web Co managed to offer this service without incurring any
additional cost itself.
Conclusion
With the exception of the work carried out to make the system more available, all of the other measures seem to
have increased sales or, in the case of Incentive 1, increased subscribers. More information is needed in relation to
a couple of areas, as noted above. The business has therefore been responsive to changes made and incentives
implemented but the cost of the advertising was so high that, overall, profits have declined substantially. This
expenditure seems too high in relation to the corresponding increase in sales volumes.
Workings
1. Increase in sales revenue $2·75m – $2·2m/$2·2m = 25% increase.
2. NPM: 25% x $2·2m = $550,000 profit in quarter 1. 16·7% x $2·75m = $459,250 profit in quarter 2.
3. No. of visits to website: increase = 141,714 – 101,589/101,589 = 39·5%.
4. Increase in orders = 49,600 – 40,636/40,636 = 22%.
5. Customers accessing website through magazine line = 141,714 x 19·9% = 28,201.
6. Increase in subscribers to newsletter = 11,900 – 4,600/4,600 = 159%.
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Financial Performance
APM – Study Notes
Example 1
Summary financial information for Repseplc is given below, covering performance over the last four years.
$ thousands
Year 1
Year 2
Year 3
Year 4
Turnover
43,800
48,000
56,400
59,000
Cost of sales
16,600
18,200
22,600
22,900
Salaries and Wages
12,600
12,900
11,900
11,400
Other costs
5,900
7,400
12,200
13,400
Profit before interest and tax
Interest
Tax
Profit after interest and tax
Dividends payable
8,700
1,200
2,400
5,100
2,000
9,500
1,000
2,800
5,700
2,200
9,700
200
3,200
6,300
2,550
11,300
150
Average debtors
Average creditors
Average total net assets
Shareholders’ funds
Long term debt
8,800
3,100
33,900
22,600
11,300
10,000
3,800
35,000
26,000
9,000
11,100
5,000
47,500
44,800
2,700
11,400
5,200
50,300
48,400
1,900
Number of shares in issue (‘000)
P/E ratio (average for year)
Repseplc
Industry
9,000
9,000
12,000
12,000
17.0
18.0
18.0
18.2
18.4
18.0
19.0
18.2
7,550
3,600
The increase in share capital was as a result of a rights issue.
Review Repse’s performance in light of its objective being to maximise shareholder wealth.
Solution
Begin with a review of the summary information
 Growth in turnover
 Growth in PBIT
 Growth in PAT
 Growth in total assets, debtors approximately in line with turnover, creditors at a higher rate.
 Reduction of gearing and reduced interest charge
 Dividend growth
 P/E ratio has overtaken industry average.
Profitability
ROCE
Profit Margin
Asset Turnover
Gearing
Gearing (book values)
Year 1
26%
19.9%
1.3
Year 2
27%
19.8%
1.4
Year3
20%
17.2%
1.2
Year 4
22%
19.2%
1.2
50%
34.6%
6%
3.9%
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Financial Performance
APM – Study Notes
Interest cover (times)
7.25
9.5
48.5
Working capital
Debtor days
73
76
71
Creditor days
68
76
81
Investor ratios Share Price* $
9.63
11.40
9.66
Market Capitalisation $m
86.67
102.60
115.92
Divi per share (p)
22.2
24.4
21.65
Divi yield
2.3%
2%
2.2%
* EPS = 5,100,000/9,000,000 = $0.5666; P/e = 17. Therefore price = 17 x 0.5666 = $9.63
75.3
70
83
11.95
143.4
30.0
2.5%
DISCOUNTED CASH FLOW TECHNIQUES
Introduction
It is important to be familiar with Modified Internal Rate of Return and the techniques involved.
Net present value (NPV)
There are a few important aspects to remember when performing a net present value calculation.
 One needs to consider only cash flows. Non-cash items (such as depreciation) are irrelevant. ๏It is only future


cash flows that one should be interested in. Any amounts already spent (such as market research already
done) are sunk costs and are irrelevant.
There is very likely to be inflation in the question, in which case the cash flows should be adjusted in your
schedule in order to calculate the actual expected cash flows. The actual cash flows should be discounted at
the actual cost of capital (the money, or nominal rate). (Note: alternatively, it is possible to discount the cash
flows ignoring inflation at the cost of capital ignoring inflation (the real rate).
Tax is a cash flow and needs bringing into schedule. It is usually easier to deal with tax in two stages – to
calculate the tax payable on the operating cash flows (ignoring capital allowances) and then to calculate
separately the tax saving on the capital allowances. ๏Cash is needed to finance additional working capital
necessary for the project. These are cash flows in your schedule, but they have no tax effects and, unless told
otherwise, you assume that the total cash paid out is received back at the end of the project.
Performa for Net Present Value
Years
0
1
2
3
4
X
X
X
X
Variable Cost
(X)
(X)
(X)
(X)
Incremental Fixed Cost
(X)
(X)
(X)
(X)
Operating Cash flows
X
X
X
X
Tax Expense
(X)
(X)
(X)
(X)
X
X
X
X
(X)
(X)
(X)
X
Sales
Tax Savings on Capital Allowances
Change in Working Capital
(X)
Initial Investment
(X)
Scrap Value
X
Page | 150
Financial Performance
APM – Study Notes
Net Cash flows
X Discount Factor
Present Values
Net Present Value
(X)
X
X
X
X
X
X
X
X
X
(X)
X
X
X
X
X
Example 1
Rome plc is considering buying a new machine in order to produce a new product.
The machine will cost $1,800,000 and is expected to last for 5 years at which time it will have an estimated
scrap value of $1,000,000.
They expect to produce 100,000 units p.a. of the new product, which will be sold for $20 per unit in the first
year.
Production costs p.u. (at current prices) are as follows:
Materials: $8
Labour: $7
Materials are expected to inflate at 8% p.a. and labour is expected to inflate at 5% p.a..
Fixed overheads of the company currently amount to $1,000,000.
The management accountant has decided that 20% of these should be absorbed into the new product.
The company expects to be able to increase the selling price of the product by 7% p.a..
An additional $200,000 of working capital will be required at the start of the project.
Capital allowances: 25% reducing balance, Tax: 25% payable immediately, Cost of capital: 10%
Calculate the NPV of the project and advise whether or not it should be accepted.
Solution
0
Sales
Materials
Labour
Net operating flow
Tax on operating flow
Cost
Scrap
Tax on saving on capital
allowed
Working Capital
1
2,000
(864)
(735)
401
(100)
2
2,140
(933)
(772)
435
(109)
3
2,290
(1,008)
(810)
472
(118)
4
2,450
(1,088)
(851)
511
(128)
5
2,622
(1,175)
(893)
554
(139)
47
1,000
(107)
(1,800)
113
(200)
84
63
200
Page | 151
Financial Performance
Net cash flow
d.f. @ 10%
P.V.
APM – Study Notes
(2,000)
1
(2,000)
414
0.909
376
410
0.826
339
NPV = $258
417
0.751
313
430
0.683
294
1,508
0.621
936
Sensitivity
A technique that considers a single variable at a time and identifies by how much that variable has to change for
the decision to change (from accept to reject).
Formula to calculate sensitivity of a particular variable:Sensitivity =
Net present value
100%
After-tax Present value of particular variable
It indicates which variables may impact most upon the net present value (critical variables) and the extent to which
those variables may change before the investment results in a negative NPV.
Internal Rate of Return (IRR)
IRR is the total rate of return offered by an investment over its life. Calculative, The rate of return at which the NPV
equals zero.
Formula to calculate
Modified internal rate of return (MIRR)
A criticism of the IRR method is that in calculating the IRR, an assumption is that all cash flows earned by the
project can be reinvested to earn a return equal to the IRR.
Modified internal rate of return is a calculation of the return from a project, as a percentage yield, where it is
assumed that cash flows earned from a project will be reinvested to earn a return equal to the company’s cost of
capital.
Using MIRR for project appraisal
It might be argued that if a company wishes to use the discounted return on investment as a method of capital
investment appraisal, it should use MIRR rather than IRR, because MIRR is more realistic as it is based on the cost
of capital as the reinvestment rate.
Page | 152
Financial Performance
APM – Study Notes
Calculating MIRR
The MIRR of a project is calculated as follows:
 Take the negative net cash flows in the early years of the project and discount these to a present value. The
total PV of these cash flows is the PV of the investment phase of the project.
 Take the cash flows from the year that the project cash flows start to turn positive and compound these to an
end-of-project terminal value, assuming that cash flows are reinvested at the cost of capital.
 The MIRR is then calculated as follows:
𝑃𝑉𝑅 1
𝑀𝐼𝑅𝑅 = {
}𝑛 (1 + 𝑟𝑒 ) − 1
𝑃𝑉𝐼
Where
 n = the project life in years
 PVR = the end-of-year investment returns during the recovery phase of the project (as calculated in Step 2)
 PVI = the present value of the capital investment in the investment phase (as calculated in Phase 1).
The MIRR is usually lower than the IRR, because it assumes that the proceeds are re-invested at the Cost of Capital.
However, in practice, the proceeds are often re-invested elsewhere within the firm. It does however have the
advantage of being much quicker to calculate than the IRR.
Residual Income
Residual income is the amount of net income generated in excess of the minimum rate of return. Residual income
concepts have been used in a number of contexts, including as a measurement of internal corporate performance
whereby a company's management team evaluates the return generated relative to the company's minimum
required return. Alternatively, in personal finance, residual income is the level of income that an individual has
after the deduction of all personal debts and expenses have been paid.
Economic Value Added
Economic value added (EVA) is a measure of a company's financial performance-based on the residual wealth
calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also
be referred to as economic profit, as it attempts to capture the true economic profit of a company. This measure
was devised by management consulting firm Stern Value Management, originally incorporated as Stern Stewart &
Co.
NOPAT - (Total Assets - Current Liabilities) * WACC.
Short term and long term financial performance
Generally, companies use short term performance measures for assessing the quality of the past decision or
assessing the impact of decision yet to be made. Companies also use short term performance measures for
rewarding managers and employees as the rewards may be linked with achievement of short term targets. Last
company uses short term performance measures for control purpose, e.g. variance analysis.
Page | 153
Financial Performance
APM – Study Notes
Problem of using short-term performance measures
When a company focuses on short term performance measure to evaluate the manager’s performance, then there
is a risk that the company might not be able to create a long-term value to its shareholder value. Manager will be
more motivated to achieve short term target as his performance will be evaluated on the basis of achievement of
those short term targets and as a result, long term performance may be compromised. For examples
 Delay of labour training to increase current year profit
 Delay of research of development to increase current year profit.
 Reluctant in Non-Current Asset investment.
Step to resolve short termism
 Use a balance scorecard and the building block model
 Company should give share option plans to its management so management will try to improve share prices of
the company.
 NPV and IRR should be used for investment appraisal. Discounted cash flow technique recognizes the future
economic benefit of current investment.
 Switch from budget-constrained style to non-accounting style or profit-conscious style.
Page | 154
Divisional Performance Appraisal
APM – Study Notes
DIVISIONAL PERFORMANCE APPRAISAL
Learning Objectives





Describe, compute and evaluate performance measures relevant in a divisionalised organisation structure
including ROI, RI and economic value added (EVA)
Discuss the need for separate measures in respect of managerial and divisional performance
Discuss the circumstances in which a transfer pricing policy may be needed and discuss the necessary
criteria for its design
Demonstrate and evaluate the use of alternative bases for transfer pricing
Explain and demonstrate issues that require consideration when setting transfer prices in multinational
companies
Page | 155
Divisional Performance Appraisal
APM – Study Notes
Introduction
In this chapter we will consider the situation where an organisation is divisonalised (or decentralised) and the
importance of proper performance measurement in this situation.
We will also consider the possible problems that can result from the use of certain standard performance
measures.
Meaning of Divisionlisation
Divisionalisation is a term for the division of an organisation into divisions. Each divisional manager is responsible
for the performance of the division. A division may be a cost centre (responsible for its costs only), a profit centre
(responsible for revenues and profits) or an investment centre or Strategic Business Unit (responsible for costs,
revenues and assets).
There are a number of advantages and disadvantages to divisionalisation.
Advantages
a) Divisionalisation can improve the quality of decisions made because divisional managers know local conditions
and are able to make more informed judgements. Moreover, with the personal incentive to improve the
division's performance, they ought to take decisions in the division's best interests.
b) Decisions should be taken more quickly because information does not have to pass along the chain of
command to and from top management. Decisions can be made on the spot by those who are familiar with
the product lines and production processes and who are able to react to changes in local conditions quickly
and efficiently.
c) The authority to act to improve performance should motivate divisional managers.
d) Divisional organisation frees top management from detailed involvement in day-to-day operations and allows
them to devote more time to strategic planning.
e) Divisions provide valuable training grounds for future members of top management by giving them experience
of managerial skills in a less complex environment than that faced by top management.
f) In a large business organisation, the central head office will not have the management resources or skills to
direct operations closely enough itself. Some authority must be delegated to local operational managers.
Disadvantages
a) Divisional managers may make dysfunctional decisions (decisions that are not in the best interests of the
organisation).
b) There is a need for a performance appraisal system to assess the performance of individual managers.
c) Top management may lose control by delegating decision making to divisional managers since they are not
aware of what is going on in the whole organisation.
d) Lack of economies of scale. For example, efficient cash management can be achieved much more effectively if
all cash balances are centrally controlled.
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.
Page | 156
Divisional Performance Appraisal
APM – Study Notes
Types of responsibility centers
Responsibility Centre
Cost Centre
Profit Centre
Investment Centre
Description
 Division which incurs only cost.
 Manager has responsibility and
authority for cost only.
 Manager’s performance will be
evaluated on the basis of cost only.
 Division which has both cost and
revenue.
 Manager has responsibility and
authority for both cost and revenue.



Division which has both cost and
revenue.
Manager has responsibility and
authority for both cost and revenue.
Manager have additional authority to
invest in new asset or dispose of
existing assets.
Possible metric
 Total cost
 Cost variances
 Cost per unit
 Productivity
 Quality of product etc
 Sales revenue
 Sales volume
 Cost
 Profit margins
 Sales variances
 Market share
 Customer satisfaction
 All measures used for cost
Centre and Revenue Centre
will be used for the Investment
Centre as well.
 Additional
measure
for
investment centre are:
o Return on Investment
(ROI)
o Residual Income (RI)
o Economic value added
(EVA)
Use of performance measure to control divisional manager
If managers are to be given autonomy in their decision making, it becomes impossible for senior management to
‘watch over’ them on a day-to-day basis. This would remove the whole benefit of having divisionalised.
The way to control their performance is to establish a set of measures in advance that will be used to evaluate
their performance at the end of each year. These measures provide a way of determining whether or not they are
managing their division well, and also communicate to the managers how they are expected to perform.
It is of critical importance that the performance measures are designed well.
For example, a manager was simply given one performance measure i.e. to increase profits. This may seem
sensible as in any normal situation the company will want the division to become more profitable. However, if the
manager expects to be rewarded on the basis of how well he achieves the measure; all his actions will be focused
on increasing profit to the exclusion of everything else. This would not however be beneficial to the company if the
manager were to achieve it by taking actions that reduced the quality of the output from the division. (In the longterm it may not be beneficial for the manager either, but managers tend to focus more on the short-term
achievement of their performance measures.)
Page | 157
Divisional Performance Appraisal
APM – Study Notes
It is therefore necessary to have a series of performance measures for each division manager.
Maybe one measure will relate to profitability, but at the same time have another measure relating to quality. The
manager will be assessed on the basis of how well he has achieved all of his measures.
The performance measures should be goal congruent to encourage the manager to make decisions that are not
only good for him but end up being good for the company as a whole as well.
Controllable profits
The most important financial performance measure is profitability.
However, if the measure is to be used to assess the performance of the divisional manager it is important that any
costs outside his control should be excluded.
For example, it might be decided that pay increases in all divisions should be fixed centrally by human resources
staff at Head Office. In this case it would be unfair to penalise (or reward) the manager for any effect on the
division’s profits in respect of this cost. For these purposes, a profit and loss account would be prepared ignoring
wages and it would be on the resulting controllable profit that the manager would be assessed.
Investment Centre and problem with measuring profitability
As stated earlier, divisionalisation implies that the divisional manager has some degree of autonomy.
In the case of an investment centre, the manager is given decision-making authority not only over costs and
revenues, but additionally over capital investment decision.
In this situation it is important that any measure of profitability is related to the level of capital expenditure. Simply
to assess on the absolute level of profits would be dangerous – the manager might increase profits by $10,000 and
be rewarded for it, but this would hardly be beneficial to the company if it had required achieving a capital
investment of $1,000,000.
The most common way of relating profitability to capital investment is to use Return on Investment as a measure.
However, this can lead to a loss of goal congruence and a measure known as Residual Income is theoretically
better.
Return on investment (ROI)
Return on investment =
controllable profit
x100
controllable capital employed
Page | 158
Divisional Performance Appraisal
Return on investment
Advantages
1. It is easy to understand and easy to calculate.
2. ROCE is still the most common way in which
business unit performance is measured and
evaluated, and is certainly the most visible to
shareholders.
3. Managers may be happy in expressing project
attractiveness in the same terms in which their
performance will be reported to shareholders, and
according to which they will be evaluated and
rewarded.
4. The continuing use of the ROCE method can be
explained largely by its utilisation of balance sheet
and income statement magnitudes familiar to
managers, namely profit and capital employed.
5. It is a relative measure.
APM – Study Notes
Disadvantages
1. It fails to take account of the project life or the
timing of cash flows and time value of money
within that life.
2. When assets are valued at net book value,
reported performance improves with time as the
assets get old. In this case there is a disincentive
to invest in new assets.
3. It uses accounting profit and capital employed,
hence is subject to manipulation due to various
accounting conventions.
4. Performance measurement based on ROCE
encourages short-termism in decision making.
Failure to invest in new assets could be harmful
to the long term interest of the division and the
organisation as a whole.
5. It is difficult to assess the significance of ROI.
There is no definite investment signal. The
decision to invest or not remains subjective in
view of the lack of objectively set target ROI
6. ROI is sometime confused with internal rate of
return (IRR)
Residual income (RI)
Residual income = controllable profit – (capital employed x imputed interested)
Residual income
Advantages
Residual income overcomes many of the problems of
ROI:
 It encourages investment centre managers to
undertake new investments if they add to residual
income.
 As a consequence, it is more consistent with the
objective of maximizing the total profitability of
the company.
 It is possible to use different rates of interest for
different types of assets.
 It makes managers more aware about cost of
financing their division.
Disadvantages
 Like ROI, residual income is also based on
accounting profit and capital employed which can
be manipulated.
 It encourages investment center managers to
think in the short-term about how to increase
next year’s residual income for the centre and
does not encourage decision making for longterm.
 Residual income is not as widely used as the ROI
despite overcoming some of the problems in ROI
Page | 159
Divisional Performance Appraisal
APM – Study Notes
Question 1
There are two divisions with the following performance for the current year
Division
X
Y
Investment ($m)
10
30
Controllable Profit
2
3
Required rate of return 15%
Required:
Calculate the performance of each division based using:
a) ROI
b) RI
Which division has superior performance?
Solution
(a) ROI
X = $2 m / $10 m = 20% Y = $3m / $30m = 10%
(b) RI = NOPAT – internal cost of capital
X $2m - $1.5m = $0.5m Y $3m - $4.5m = -$1.5m
Hence division A has performed better currently on both yardsticks.
Question 2
Continuing from the previous example each division has the opportunity to invest in a new project.
Division
X
Y
Investment ($000s)
500
1,000
Controllable Profit
80
120
Required rate of return is 15%.
Required:
Using the measures of performance above, assess the decisions that would be made by:
(a) The divisional managers;
(b) Head office;
Solution
X ROI = $80,000/$500,000 = 16% RI = $80,000 - $75,000 = $5,000
Y ROI = $120,000/$1,000,000 = 12% RI = $120,000 - $150,000 = -$30,000
a) X would accept the project on the basis of both measures. Y can accept the project on the basis of ROI as it
is higher than current one, but overall they would resist as it still not meeting the requirements of the head
office.
b) Head office should go for both projects. Clearly X is acceptable. But Y can also be accepted on the basis of
ROI as it will improve the results, and may motivate the managers of Y in the long run.
Page | 160
Divisional Performance Appraisal
APM – Study Notes
Residual income vs Return on investment
Note that both RI and ROI favour divisions with older assets because those divisions will:
(1) Probably have bought the assets more cheaply than new divisions which buy at inflated prices.
(2) The assets are more heavily depreciated so that the capital employed figures are less in the division with older
assets – and this affects both the denominator in ROI and the notional interest charge in RI
(3) Both methods can also suffer distortions because of assets leased on operating leases and also if head office
accounts for some ‘divisional’ assets (for example HO holding all receivables).
Economic value added
In theory, if a company makes a profit, the value of its shares ought to increase by the amount of the profit (unless
any dividends are paid to shareholders). In practice, this does not happen.
One reason for this is that in order to make a profit, capital is invested. Capital is a resource which has a cost. The
actual creation of extra value should therefore be the profit less the cost of capital invested. Residual income is the
accounting profit earned by a division less a notional charge for capital employed. In theory, there is a connection
between residual income and the expected increase in the value of a business.
Suppose for example that a company has $10 million in cash and keeps it in a bank deposit account earning 2% per
year interest. The cash will earn interest of $200,000 less tax in one year, and this will be reported as income.
Although keeping money in a low-interest account adds to accounting profit, it does not ’add value’ to the
company (or ‘create value’), because the cost of capital needed to finance the cash is probably higher than 2%. The
management writer Peter Drucker once wrote that: ‘until a business returns a profit that is greater than its cost of
capital, it operates at a loss.’
There is a more important reason why profits are not a good measure of the expected increase in the value of a
business. This is that profit measured by accounting conventions is not a proper measure of ‘real’ economic profit.
It can be argued that if economic profit is measured, instead of accounting profit, there will be a better
measurement of the increase in the value of a business during a given period of time.
A management consultancy firm, Stern Stewart, devised a method of measuring economic profit, which they have
called economic value added or EVA. The term ‘EVA’ is a trademark of the Stern Stewart organisation.
Advantages of Economic Value Added
1. It measures the creation of value by a company, and is a more ‘accurate’ measurement of performance than
accounting profit.
2. Economic value can be created when expectations of future profitability improve, because economic value can
be measured as the net present value of future profits. EVA recognises the benefit of activities such as new
investments that add to longer-term profitability. Unlike accounting measures of profitability, EVA is not
focused exclusively on the short term.
3. Management is encouraged to focus on the creation of value (EVA), which is in the long-term interest of
shareholders.
4. Management reward schemes based on EVA are likely to align the interests of management and shareholders
more closely than a bonus system linked to annual accounting profits.
5. It is a simple measure, like profit, and one that line managers (including those with limited financial
understanding) can understand.
Page | 161
Divisional Performance Appraisal
APM – Study Notes
Computation of economic value added (EVA)
Economic value added (EVA) for a financial period is the economic profit after deducting a cost for the value of
capital employed.
The formula for EVA is as follows:
EVA = Net operating profit after tax – (Capital employed × Cost of capital)
or
EVA = NOPAT – (Capital employed × WACC).
In practice the computation of EVA involves making adjustments to accounting profit and the accounting value
(book value) of assets. These adjustments can be complex, and although you are not required to know them in
detail, an examination question may ask you to calculate EVA from a given set of simplified data.
Net Operating Profit After Tax (NOPAT)
The net operating profit after tax is calculated by making adjustments to the accounting profit in order to arrive at
an estimate of economic profit. NOPAT is similar to ‘free cash flow’ and is an estimate of economic profit before
deducting a cost for the capital employed. The calculation of NOPAT requires a number of different adjustments to
the figure for accounting profit.
A few of the problems are as follows:
(1) Interest costs. In calculating NOPAT, interest costs of debt capital should not be deducted from profit. This is
because debt capital is included in the capital employed. NOPAT should be the profit before deducting interest
costs but after deducting tax. There is tax relief on interest, so to reach a figure for NOPAT, the amount of
interest charges in the period less relief on the interest cost should be added back to the figure for profit after
tax.
NOPAT = Profit after tax + [Interest costs less tax relief on the interest]
(2) Depreciation. Non-cash expenses should not be deducted from profit. The main item of non-cash expense is
usually depreciation of non-current assets. There should be a charge for non-current assets, to allow for the
economic consumption of value that occurs when the assets are used.
NOPAT = Profit after tax + Post-tax interest cost + [Accounting depreciation –Economic depreciation]
If it can be assumed that accounting depreciation charges are similar to the loss of economic value in noncurrent assets, the two items cancel out, and:
NOPAT = Profit after tax + [Interest costs less tax relief on the interest]
(3) Other non-cash expenses. Other non-cash expenses should also be added back in order to measure NOPAT.
These include additional provisions for irrecoverable debts and other provisions.
(4) Investments in intangible items. Investments in intangible items include spending on promotion activities,
investing in a brand name, research and development expenditure and spending on employee training (to
increase the economic value of the work force). In conventional accounting systems, these items of expense
are usually written off as expenses in the year that they occur. However, they are items of discretionary
spending by management that add to the value of the business.
Page | 162
Divisional Performance Appraisal
APM – Study Notes
To measure NOPAT, these items of expense that have been written off in the conventional accounts should be
added back.
(They should also be added to the value of the company’s capital. Economic depreciation charges will be
applied as appropriate to this economic capital, in subsequent years.)
Charge of capital
Charge of capital = capital employed x weighted average cost of capital (WACC)
Always use adjusted opening capital employed
Adjustment in opening capital employed
 Investments in intangibles. Spending on intangible items should be added back in calculating NOPAT. In
addition, the net book value of intangible items should be included in capital employed, and so an estimate of
the net book value of the intangibles should be added to the accounting value of the company’s net assets.
 Provisions and allowances. Additions during the year to allowances for irrecoverable debts and additions to
provisions should be added back to profit in calculating NOPAT. The total amount of allowances for
irrecoverable debts, provisions for deferred tax and other provisions should also be added to capital
employed.
 Off-balance sheet financing and operational leases. Some companies keep items of capital off their balance
sheet. A notable example is assets held on operating leases. The acquisition of leased assets is a form of debt
finance, because the lessor (provider of the leased asset) has provided the financing for the assets that the
company is leasing. The estimated value of assets held under operating lease agreements (and the value of
any other assets financed ‘off balance sheet’) should be added to capital employed.
Cost of capital. The capital charge is calculated by applying the weighted average cost of capital (WACC) to the
value of capital employed.
WACC is the weighted average of equity capital and debt capital in the company’s target debt structure.
 If the current debt structure of the company is close to the long-term target debt structure of the company,
the weighted average cost of capital can be calculated from the current value of equity and debt capital.
 However, if the target capital structure is different from the current capital structure, the weighted average
cost of capital is calculated using the target proportions of equity and debt.
 The cost of equity and the cost of debt can vary from one year to the next. A new WACC may therefore be
calculated each year, with appropriate costs for equity and debt in each year.
Example (ECONOMIC VALUE ADDED)
A company’s income statement and statement of financial position for the year just ended, and the previous
year are as follows.
Income statement
Year just ended
Previous year
Year 2
Year 1
$000
$000
Profit before interest and tax
80,000
62,000
Interest cost
8,000
6,000
__________
__________
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Divisional Performance Appraisal
Profit before tax
Tax at 25%
Profit after tax
Dividends paid
Retained profit
Income statement
Non-current assets
Net current assets
Shareholders’ funds
Long-term and medium-term debt
APM – Study Notes
72,000
18,000
56,000
14,000
__________
__________
54,000
29,000
__________
25,000
___________
42,000
24,000
__________
18,000
__________
Year just ended
Year 2
$000
280,000
200,000
___________
480,000
___________
370,000
110,000
___________
480,000
____________
Previous year
Year 1
$000
265,000
170,000
____________
435,000
___________
345,000
90,000
___________
435,000
___________
Notes
1. Capital employed at the beginning of Year 1 was $410 million.
2. The company had non-capitalised leased assets of $18 million in each of the past three years. These assets
are not subject to depreciation.
3. The estimated cost of equity in Year 2 was 12% and the cost of debt was 8%. The estimated cost of equity in
Year 1 was 10% and the cost of debt was 7%
4. The company’s target capital structure is 50% equity and 50% debt.
5. It should be assumed that accounting depreciation was equal to economic depreciation, in each of the two
years, and this was also the amount used for the calculation of the tax charge in each year. (The purpose of
this assumption is to remove the need to make an adjustment to get from accounting depreciation and to
economic depreciation, and to remove the need for adjustments to capital employed.)
6. Other non-cash expenses were $16 million in Year 2 and $14 million in Year 1.
Required
Use the information provided to calculate a figure for EVA in each of the two years,
Year 2 and Year 1.
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Divisional Performance Appraisal
Solution
Net operating profit after tax
Profit after tax
Add: Interest cost less tax: (8,000 less 25%)
Add: Non-cash expenses
APM – Study Notes
Year just ended
Year 2
$000
54,000
6,000
16,000
_________
(6,000 less 25%)
NOPAT
76,000
_________
Capital employed
Year just ended
Year 2
$000
435,000
18,000
____________
Previous year
Year 1
$000
410,000
18,000
____________
453,000
____________
____________
428,000
___________
Book value of total assets less current liabilities
Non-capitalised leased assets
Previous year
Year 1
$000
42,000
4,500
14,000
_________
60,500
_________
WACC
Year 2: (12% × 50%) + [8% (1 – 0.25) × 50%] = 9%.
Year 1: (10% × 50%) + [7% (1 – 0.25) × 50%] = 7.625%.
Year 1 EVA = 60,500 – (428,000 x 7.625%) = $27,865
Year 2 EVA = 76,000 – (453,000 x 9%) = $35,230
These figures suggest that in each year the company created value, because the EVA was positive.
 Financial performance in Year 2 was better than in Year 1 because the EVA is higher.
 Allowing for the payment of dividends ($29 million in Year 2 and $24 million in Year 1) some of this created
value was retained within the company each year.
Problems with economic value added
There are several potential problems with the use of EVA.
 It is not easy to use EVA for inter-firm comparisons or inter-divisional performance comparisons, because it is
an absolute measure (in $) rather than a comparative measure (such as a ratio).
 The adjustments required to get from accounting profit to NOPAT and from accounting capital employed to
economic capital employed can be complex. In particular, it may be very difficult to estimate economic
depreciation.
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Divisional Performance Appraisal
APM – Study Notes
Transfer price
Transfer prices are almost inevitably needed whenever a business is divided into more than one department or
division
In accounting, many amounts can be legitimately calculated in a number of different ways and can be correctly
represented by a number of different values. For example, both marginal and total absorption cost can
simultaneously give the correct cost of production, but which version of cost should be used depends on what one
is trying to do.
Similarly, the basis on which fixed overheads are apportioned and absorbed into production can radically change
perceived profitability. The danger is that decisions are often based on accounting figures, and if the figures
themselves are somewhat arbitrary, so will be the decisions based on them. One should always be careful when
using accounting information, not just because information could have been deliberately manipulated and
presented in a way which misleads, but also because the information depends on the assumptions and the
methodology used to create it. Transfer pricing provides excellent examples of the coexistence of alternative
legitimate views, and illustrates how the use of inappropriate figures can create misconceptions and can lead to
wrong decisions.
WHEN ARE TRANSFER PRICES NEEDED
Transfer prices are almost inevitably needed whenever a business is divided into more than one department or
division. Usually, goods or services flow between the divisions and each report its performance separately. The
accounting system usually records goods or services leaving one department and entering the next, and some
monetary value must be used to record this. That monetary value is the transfer price. The transfer price
negotiated between the divisions, or imposed by head office, can have a profound, but perhaps arbitrary, effect on
the reported performance and subsequent decisions made.
Example 1
Take the following scenario shown in Table 1, in which Division A makes components for a cost of $30, and
these are transferred to Division B for $50. Division B buys the components in at $50, incurs own costs of $20,
and then sells to outside customers for $90.
As things stand, each division makes a profit of $20/unit, and it should be easy to see that the group will make a
profit of $40/unit. This can be calculated either by simply adding the two divisional profits together ($20 + $20 =
$40) or subtracting both own costs from final revenue ($90 – $30 – $20 = $40).
For every $1 increase in the transfer price, Division A will make $1 more profit, and Division B will make $1 less.
Mathematically, the group will make the same profit, but these changing profits can result in each division
making different decisions, and as a result of those decisions, group profits might be affected.
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Divisional Performance Appraisal
APM – Study Notes
Knock-on effects that different transfer prices and different profits might have on the divisions:
Performance evaluation.
The success of each division, whether measured by return on investment
(ROI) or residual income (RI) will be changed. These measures might be
interpreted as indicating that a division’s performance was unsatisfactory
and could tempt management at head office to close it down.
Performance-related pay.
If there is a system of performance-related pay, the remuneration of
employees in each division will be affected as profits change. If they feel
that their remuneration is affected unfairly, employees’ morale will be
damaged.
If the transfer price is very high, the receiving division might decide not to
buy any components from the transferring division because it becomes
impossible for it to make a positive contribution. That division might decide
to abandon the product line or buy-in cheaper components from outside
suppliers.
Everyone likes to make a profit and this ambition certainly applies to the
divisional managers. If a transfer price is such that one division found it
impossible to make a profit, then the employees in that division would
probably be demotivated. In contrast, the other division would have an
easy ride as it would make profits easily, and it would not be motivated to
work more efficiently.
New investment should typically be evaluated using a method such as net
present value. However, the cash inflows arising from an investment are
almost certainly going to be affected by the transfer price, so capital
investment decisions can depend on the transfer price.
If the divisions are in different countries, the profits earned in each country
will depend on transfer prices. This could affect the overall tax burden of
the group and could also affect the amount of profits that need to be
remitted to head office.
Therefore, transfer prices can have a profound effect on group
performance because they affect divisional performance, motivation and
decision making.
Make/abandon/buy-in
decisions.
Motivation.
Investment appraisal.
Taxation and profit remittance.
The characteristic of a good transfer price
Although not easy to attain simultaneously, a good transfer price should:
Preserve divisional autonomy:
Divisionalisation is accompanied by a degree of decentralisation in decision making so that specific managers and
teams are put in charge of each division and must run it to the best of their ability. Divisional managers are
therefore likely to resent being told by head office which products they should make and sell. Ideally, divisions
should be given a simple, understandable objective such as maximising divisional profit.
Be perceived as being fair for the purposes of performance evaluation and investment decisions.
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APM – Study Notes
Permit each division to make a profit:
Profits are motivating and allow divisional performance to be measured using positive ROI or positive RI.
Encourage divisions to make decisions which maximise group profits:
The transfer price will achieve this if the decisions which maximise divisional profit also happen to maximise group
profit – this is known as goal congruence. Furthermore, all divisions must want to do the same thing. There’s no
point in transferring divisions being very keen on transferring out, if the next division doesn’t want to transfer
in.wants to transfer in
POSSIBLE TRANSFER PRICES
In the following examples, assume that Division A can sell only to Division B, and that Division B’s only source of
components is Division A. Example 1 has been reproduced but with costs split between variable and fixed. A
somewhat arbitrary transfer price of $50 has been used initially and this allows each division to make a profit of
$20.
Example 2
See Table 2. The following rules on transfer prices are necessary to get both parties to trade with one another:
For the transfer-out division, the transfer price must be greater than (or equal to) the marginal cost of
production. This allows the transfer-out division to make a contribution (or at least not make a negative one).
In Example 2, the transfer price must be no lower than $18. A transfer price of $19, for example, would not be
as popular with Division A as would a transfer price of $50, but at least it offers the prospect of contribution,
eventual break-even and profit.
For the transfer-in division, the transfer in price plus its own marginal costs must be no greater than the
marginal revenue earned from outside sales. This allows that division to make a contribution (or at least not
make a negative one). In Example 2, the transfer price must be no higher than $80 as:
$80 (transfer-in price) + $10 (own variable cost) = $90 (marginal revenue)
Usually, this rule is restated to say that the transfer price should be no greater than the net marginal revenue of
the receiving division, where the net marginal revenue is marginal revenue less own marginal costs. Here, net
marginal revenues = $80 = $90 – $10.
So, a transfer price of $50 (transfer price ≥ $18, ≤ $80), as set above, will work in so far as both parties will find it
worth trading at that price.
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Divisional Performance Appraisal
APM – Study Notes
THE ECONOMIC TRANSFER PRICE RULE
The economic transfer price rule is as follows:
Minimum (fixed by transferring division)
Transfer price ≥ marginal cost of transfer-out division
Maximum (fixed by receiving division)
Transfer price ≤ net marginal revenue of transfer-in division
As well as permitting interdivisional trade to happen at all, this rule will also give the correct economic decision
because if the final selling price is too low for the group to make a positive contribution, no operative transfer
price is available.
So, in Example 2, if the final selling price were to fall to $25, the group could not make a contribution because $25
is less than the group’s total variable costs of $18 + $10. The transfer price that would make both divisions trade
must be no less than $18 (for Division A) but no greater than $15 (net marginal revenue for Division B = $25 – $10),
so clearly no workable transfer price is available.
If, however, the final selling price were to fall to $29, the group could make a $1 contribution per unit. A viable
transfer price has to be at least $18 (for Division A) and no greater than $19 (net marginal revenue for Division B =
$29 – $10). A transfer price of $18.50, say, would work fine.
Therefore, all that head office needs to do is to impose a transfer price within the appropriate range, confident
that both divisions will choose to act in a way that maximises group profit. Head office therefore gives each
division the impression of making autonomous decisions, but in reality each division has been manipulated into
making the choices that the head office wants.
Note, that although the range of transfer prices that would work correctly in terms of economic decision making
have been established, there is still plenty of scope for argument, distortion and dissatisfaction. Example
1 suggested a transfer price between $18 and $80, but exactly where the transfer price is set in that range vastly
alters the perceived profitability and performance of each sub-unit. The higher the transfer price, the better
Division A looks and the worse Division B looks (and vice versa).
A transfer price range as derived in Example 1 and 2 will often be dynamic. It will keep changing as both variable
production costs and final selling prices change, and this can be difficult to manage. In practice, management
would often prefer to have a simpler transfer price rule and a more stable transfer price – but this simplicity runs
the risk of poorer decisions being made.
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Divisional Performance Appraisal
APM – Study Notes
PRACTICAL APPROACHES TO TRANSFER PRICE FIXING
In order to address these concerns, some common practical approaches to transfer price fixing, exist:
1. Variable cost:
A transfer price set equal to the variable cost of the transferring division produces very good economic
decisions. If the transfer price is $18, Division B’s marginal costs would be $28 (each unit costs $18 to buy in
then incurs another $10 of variable cost). The group’s marginal costs are also $28, so there will be a goal
congruence between Division B’s wish to maximise its profits and the group maximising its profits. If marginal
revenue exceeds marginal costs for Division B, it will also do so for the group.
Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain
drawbacks:
Division A will make a loss as its fixed costs cannot be covered. This is demotivating.
Performance measurement is distorted. Division A is condemned to making losses while Division B gets an
easy ride as it is not charged enough to cover all costs of manufacture. This effect can also distort investment
decisions made in each division. For example, Division B will enjoy inflated cash inflows.
There is little incentive for Division A to be efficient if all marginal costs are covered by the transfer price.
Inefficiencies in Division A will be passed up to Division B. Therefore, if marginal cost is going to be used as a
transfer price, it should be made a standard marginal cost, so that efficiencies and inefficiencies stay within
the divisions responsible for them.
2.
Full cost/full cost plus/variable cost plus/market price
Example 3
See Table 3.
A transfer price set at full cost as shown in Table 3 is slightly more satisfactory for Division A as it means that it
can aim to break even. It is a big drawback, that it can lead to dysfunctional decisions because Division B can
make decisions that maximise its profits but which will not maximise group profits. For example, if the final
market price fell to $35, Division B would not trade because its marginal cost would be $40 (transfer-in price
of $30 and own marginal costs of $10). However, from a group perspective, the marginal cost is only $28 ($18
+ $10) and a positive contribution would be made even at a selling price of only $35. Head office could instruct
Division B to trade but then divisional autonomy is compromised and Division B managers will resent being
instructed to make negative contributions which will impact on their reported performance. Imagine you are
Division B’s manager, trying your best to hit profit targets, make wise decisions, and move your division
forward by carefully evaluated capital investment.
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Divisional Performance Appraisal
APM – Study Notes
The full cost plus approach would increase the transfer price by adding a markup. This would now motivate
Division A, as profits can be made there and may also allow profits to be made by Division B. Again, this may lead
to dysfunctional decisions as the final selling price falls.
A transfer price set to the market price of the transferred goods (assuming that there is a market for the
intermediate product) should give both divisions the opportunity to make profits (if they operate at normal
industry efficiencies), but again such a transfer price runs the risk of encouraging dysfunctional decision making as
the final selling price falls towards the group marginal cost. Market price has the important advantage of providing
an objective transfer price not based on arbitrary mark ups. Market prices will therefore be perceived as being fair
to each division and will also allow important performance evaluations to be carried out by comparing the
performance of each division to outside, stand-alone businesses. More accurate investment decisions will also be
made.
The difficulty with full cost, full cost plus, variable cost plus and market price is that they all result in fixed costs and
profits being perceived as marginal costs, as goods are transferred to Division B. Division B therefore has the wrong
data to enable it to make good economic decisions for the group – even if it wanted to. In fact, once you get away
from a transfer price equal to the variable cost in the transferring division, there is always the risk of dysfunctional
decisions being made unless an upper limit – equal to the net marginal revenue in the receiving division – is also
imposed.
VARIATIONS ON VARIABLE COST
There are two approaches to transfer pricing which try to preserve the economic information inherent in variable
costs while permitting the transferring division to make profits and allowing better performance evaluation.
However, both methods are somewhat complicated.
Variable cost plus lump sum. In this approach, transfers are made at variable cost. Then, periodically, a transfer is
made between the two divisions (Credit Division A, Debit Division B) to account for fixed costs and profit. It is
argued that Division B has the correct cumulative variable cost data to make good decisions, yet the lump sum
transfers allow the divisions ultimately to be treated fairly with respect to performance measurement. The size of
the periodic transfer would be linked to the quantity or value of goods transferred.
Dual pricing: In this approach, Division A transfers out at cost plus a markup (perhaps market price), and Division B
transfers in at variable cost. Therefore, Division A can make a motivating profit, while Division B has good
economic data about cumulative group variable costs. Obviously, the divisional current accounts won’t agree, and
some period-end adjustments will be needed to reconcile those and to eliminate fictitious interdivisional profits.
MARKETS FOR THE INTERMEDIATE PRODUCT
Consider Example 1 again, but this time assume that the intermediate product can be sold to, or bought from, a
market at a price of either $40 or $60. See Table 4.
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APM – Study Notes
(i)
Intermediate product bought/sold for $40
Division A would rather transfer to Division B, because receiving $50 is better than receiving $40. Division
B would rather buy in at the cheaper $40, but that would be bad for the group because there is now a
marginal cost to the group of $40 instead of only $18, the variable cost of production in Division A. The
transfer price must, therefore, compete with the external supply price and must be no higher than that. It
must also still be no higher than the net marginal revenue of Division B ($90 – $10 = $80) if Division B is to
avoid making negative contributions.
(ii)
Intermediate product bought/sold for $60:
Division B would rather buy from Division A ($50 beats $60), but Division A would sell as much as possible
outside at $60 in preference to transferring to Division B at $50. Assuming Division A had limited capacity
and all output was sold to the outside market, that would force Division B to buy outside and this is not
good for the group as there is then a marginal cost of $60 when obtaining the intermediate product, as
opposed to it being made in Division A for $18 only. Therefore, Division A should be encouraged to supply
to Division B and this can be done by setting a transfer price that is high enough to compensate for the
lost contribution that Division A could have made by selling outside. Therefore, Division A has to receive
enough to cover the variable cost of production plus the lost contribution caused by not selling outside:
Minimum transfer price = $18 + ($60 – $18) = $60
Basically, the transfer price must be as good as the outside selling price to get Division B to transfer inside
the group.
The new rules can therefore be stated as follows:
ECONOMIC TRANSFER PRICE RULE
Minimum (fixed by transferring division)
Transfer price ≥ marginal cost of transfer-out division + any lost contribution
Maximum (fixed by receiving division)
Transfer price ≤ the lower of net marginal revenue of transfer-in division and the external purchase price
CONCLUSION
One might have thought that transfer prices were matters of little importance: debits in one division, matching
credits in another but with no overall effect on group profitability. Mathematically this might be the case, but only
at the most elementary level. Transfer prices are vitally important when motivation, decision making, performance
measurement and investment decisions are taken into account. These are the factors which so often separate
successful from unsuccessful businesses.
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Performance Management
APM – Study Notes
PERFORMANCE MANAGEMENT IN THE NOT‐FOR PROFIT
ORGANISATIONS
Learning Objectives





Highlight and discuss the potential for diversity in objectives depending on organisations type.
Discuss the difficulties in measuring outputs when performance is not judged in terms of money or an easily
quantifiable objective
Discuss the use of benchmarking in public sector performance (league tables) and its effects on operational
and strategic management and behaviour..
Discuss how the combination of politics and the desire to measure public sector performance may result in
undesirable service outcomes‐e.g. the use of targets
Assess 'value for money' service provision as a measure of performance in not‐for‐profit organisations and
the public sector
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Performance Management
APM – Study Notes
Performance management in the
not‐for‐profit organisations
What is a not‐for‐
profit
organisation?
Problems with
performance
measurement in
NFP organisation.
The use of league
table and target
in a public sector.
Introduction
Non‐profit seeking organisations are those whose prime goal cannot be assessed by economic means. Examples
would include charities and state bodies such as the police and the health service.
For this sort of organisation, it is not possible or desirable to use standard profit measures. For example the case of
the health service) the objective is to ensure that the best service is provided at the best cost.
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Performance Management
APM – Study Notes
Problems with performance measurement in NFP organisation.
Multiple objectives
The
difficulty
measuring outputs
Financial constraints
Even if all objectives can be clearly identified, it may be impossible to identify an
overriding objective or to choose between competing objectives
of
Political, social and legal
considerations
Little market competition
and no profit motive
Identification of cost unit
An objective of the health service is obviously to make ill people better. However,
how can one measure how much better they are?
Public sector organisations have limited control over the level of funding they
receive and the objectives that they can achieve.
The public have higher expectations from public sector organisations than from
commercial ones and such organisations are subject to greater scrutiny and more
onerous legal requirements.
Measures such as ROI and RI cannot be used to gain an overall measure of
performance
The cost unit is likely to be relatively complex and there is likely to be more than
one cost unit. For example what is a cost unit for a hospital? It is possible for such
multiple cost units being used by a single patient.
Identifying performance targets for not‐for‐profit organisations
You may be required in your examination to suggest quantitative targets for a not for‐profit organisation. The
selection of appropriate targets will vary according to the nature and purpose of the organisation. The broad
principle of suggesting quantitative targets, that any not‐for‐profit organisation should have include:
 Strategic targets, mainly non‐financial in nature
 Operational targets, which may be either financial (often related to costs and keeping costs under control) or
non‐financial (related to the nature of operations)
A useful approach for setting performance targets and performance measures in a not‐for‐profit entity is to define
performance indicators into three groups:
 Financial measurements, which indicate the efficiency in using available financial resources and economy in
spending
 Non‐financial measurements, which indicate whether the entity has achieved its strategic objectives
(measurements of effectiveness)
 Qualitative indicators, which also indicate effectiveness in achieving objectives, but which cannot be
measured in quantifiable terms.
Example
The performance targets and performance measurements for a hospital might include the following items:
Financial measures Budgeted annual expenditure. Comparison of actual spending with the budget.
(efficiency,
Costs per selected units of activity, such as average costs per treatment, average costs
economy)
per operation, average annual cost per hospital bed. Benchmarking costs against
costs in other hospitals. Major items of cost as a percentage of total costs: for
example, administration and management costs as a percentage of total running
costs.
Non‐financial
Units of service delivered, such as the number of patients treated each year, and the
measures
number of operations performed. The speed of delivery of services, such as the speed
(effectiveness)
of an ambulance service, average waiting time for treatment, average time between
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Performance Management
Qualitative
APM – Study Notes
start and completion of treatment.
Quality of service, measured in terms of successful treatments, number of serious
errors in treatment. Utilisation of resources, such as ‘bed occupancy rates’
(percentage of beds occupied on average by patients each day).
Public confidence and satisfaction with the services provided. Morale of the work
force. Standards of cleanliness in the hospital.
The Impact of Politics on Performance Measurment
The combination of politics and performance measurement in the public sector may result in undesirable
outcomes. The public focus on some sectors, such as health and education, make them a prime target for political
interference. Long‐term organisational objectives are sacrificed for short‐term political gains.
Politicians may promise 'increased funding' and 'improved performance' as that is what voters want to hear, but it
may result in undesirable outcomes.
Increased funding:
 May be available only to the detriment of other public sector organisations
 May be provided to organisations in political hot‐spots, not necessarily the places that need more money
 May not be used as efficiently or effectively as it could be
 May only be available in the short‐term, as a public relations exercise.
Improved performance:
 May be to the detriment of workers and client's
 May come about as the result of data manipulation, rather than real results
 May be a short‐term phenomenon
 May result in more funds being spent on performance measurement when it might better be used on
improvements, e.g. hospitals under increasing pressure to compete on price and delivery in some areas may
result in a shift of resources from other, less measurable areas, such as towards elective surgery and away from
emergency services.
Value for money
As the services of such organisations are very often not expressed in monetary terms, it is important to ensure that
value for money is achieved. In order to do this, the principle of 3 E’s can be applied.
Economy
Economy means to keep spending within limits and avoiding wasteful spending. It also means achieving the same
purpose at a lower expense. A simple example of economy is found in the purchase of supplies. Suppose that an
administrative department buys items of stationery from a supplier and pays $2 each for pens. It might be possible
to buy pens of the same quality to fulfil exactly the same purpose for $1.50 each. Economy would be achieved by
switching to buying the $1.50 pens, saving $0.50 per pen with no loss of operating efficiency or effectiveness.
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Performance Management
APM – Study Notes
Efficiency
Efficiency means getting more output from available resources. Applied to employees, efficiency is often called
‘productivity’. Suppose that a sales order clerk processes 50 customer orders each day. Efficiency would be
improved if a sales order clerk increases the rate of output, and processes 60 orders each day, without any loss of
effectiveness.
Effectiveness
Effectiveness refers to success in achieving end results or in achieving objectives. While efficiency is concerned
with getting more outputs from available resources, effectiveness is concerned with achieving outputs that meet
the required aims and objectives. For example, the efficiency of sales representatives will be improved if they
increase their calls to customers from eight to ten each day but their effectiveness will not be increased if they do
not achieve any more sales from the extra calls.
Management accounting systems and reporting systems may provide information to management about value for
money. Has VFM been achieved, and if so, how much and in what ways?
Value for money audits may be carried out to establish how much value is being achieved within a particular
department and whether there have been improvements to value for money. Internal audit departments may
carry out occasional VFM audits, and report to senior management and the manager of the department they have
audited.
VFM budgeting can be particularly useful in not‐for‐profit organisations, whose purpose is to achieve a stated
objective as closely as possible, with the resources available.
Example
State‐owned schools may be given a target that their pupils (of a specified age) must achieve a certain level of
examination grades or ‘passes’ in a particular examination.
A VFM audit could be used to establish spending efficiency within a school.
 Economy. Was there any unnecessary spending? Could the same value have been obtained from lower
spending?
 Efficiency. Have the school’s resources been used efficiently? Could more output have been obtained from
the available resources? Could the same results have been achieved with fewer resources? A study of
efficiency might focus on matters such as teaching time per teacher per week, and the utilisation of
resources such as science equipment and computer‐based training materials.
 Effectiveness. The most obvious measurements of effectiveness are the number or percentage of pupils
achieving the required examination ‘passes’, or the grades of pass marks that they have achieved.
Effectiveness is improved by increasing the pass rate.
Benchmarking (league table)

Benchmarking can be especially relevant to not‐for‐profit organisations because it can help to create a
discipline to encourage high standards of performance.
 If organisations are prepared to collaborate with each other than benchmarking can produce extremely useful
data for performance management.
 Benchmarked measures are often presented in league tables.
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Performance Management


APM – Study Notes
A league table is a chart or list which compares one organisation with another by ranking them in order of
ability or achievement.
For example, in the UK, university league tables are produced based on selected aspects of the universities'
performance, with weightings attached to each aspect of performance. For example, the Guardian's league
table uses the following (with weightings in brackets):
 'Entry score' (17%);
 'Feedback' – as rated by graduates of the course (5%);
 'Job prospects' (17%)
 'Spending per student' (17%);
 'Staff/student ratio' (17%);
 'Teaching quality' – as rated by graduates of the course (10%)
 'Value added' (17%).
Advantages of league table
 Implementation stimulates competition and the adoption of best practice. As a result, the quality of the
service should improve.
 Monitors and ensures accountability of the providers.
 Performance is transparent.
 League tables should be readily available and can be used by consumers to make choices.
Problems with league table
 Organisations are likely to focus mainly on improving their performance in these areas of activity, and less
attention will be given to other areas. This highlights the statement that, 'What gets measured, gets done.'
 If an organisation feels that the performance measure is not controllable, (e.g. 'job prospects' may be largely
determined by economic conditions in the local region) then league tables could serve to demotivate.
 League tables are less useful where consumers of the service do not have the choice of which organisation to
use e.g. choice of police force.
 If a ranking system is used this fails to show whether the differences between organisations are major or
minor.
Page | 178
Question Paper
APM – Study Notes
ACCA PAST PAPER QUESTION 3
Alpha Division, which is part of the Delta Group, is considering an investment opportunity to which the following
estimated information relates:
(1) An initial investment of $45m in equipment at the beginning of year 1 will be depreciated on a straight‐line
basis over a three‐year period with a nil residual value at the end of year 3.
(2) Net operating cash inflows in each of years 1 to 3 will be $12∙5m, $18∙5m and $27m respectively.
(3) The management accountant of Alpha Division has estimated that the NPV of the investment would be
$1∙937m using a cost of capital of 10%.
(4) A bonus scheme which is based on short‐term performance evaluation is in operation in all divisions within
the Delta Group.
Required:
(a)
(i) Calculate the residual income of the proposed investment and comment briefly (using ONLY the
above information) on the values obtained in reconciling the short‐term and long‐term decision views
likely to be adopted by divisional management regarding the viability of the proposed investment.
(6 marks)
(ii) A possible analysis of divisional profit measurement at Alpha Division might be as follows:
$m
Sales revenue
xxx
Less: variable costs
xxx
–––
1. Variable short run contribution margin
xxx
Less: controllable fixed costs
xxx
–––
2. Controllable profit
xxx
Less: non‐controllable avoidable costs
xxx
–––
3. Divisional profit xxx
–––
Required:
Discuss the relevance of each of the divisional profit measures 1, 2 and 3 in the above analysis as an acceptable
measure of divisional management performance and/or divisional economic performance at Alpha Division.
You should use appropriate items from the following list relating to Alpha Division in order to illustrate your
discussion:
(i) Sales to customers external to the Delta Group
(ii) Inter‐divisional transfers to other divisions within the Delta Group at adjusted market price
(iii) Labour costs or equipment rental costs that are fixed in the short term
(iv) Depreciation of non‐current assets at Alpha Division
(v) Head office finance and legal staff costs for services provided to Alpha Division.
(8 marks)
Page | 179
Question Paper
APM – Study Notes
(b) Summary financial information for the Gamma Group (which is not connected with the Delta Group) is as
follows:
Income statements/financial information:
Revenue
2006
$m
400
––––
2007
$m
450
––––
Profit before tax
Income tax expense
96
(29)
––––
117
(35)
––––
Profit for the period
Dividends
67
(23)
––––
44
––––
82
(27)
––––
55
––––
2006
$m
160
180
––––
2007
$m
180
215
––––
––––
––––
340
270
70
––––
340
––––
395
325
70
––––
395
––––
Retained earnings
Balance Sheets:
Non‐current assets
Current assets
Financed by:
Total equity
Long‐term debt
Other information is as follows:
(1) Capital employed at the end of 2005 amounted to $279m.
(2) The Gamma Group had non‐capitalised leases valued at $16m in each of the years 2005 to 2007 which were
not subject to amortisation.
(3) Amortisation of goodwill amounted to $5m per year in both 2006 and 2007. The amount of goodwill written
off against reserves on acquisitions in years prior to 2006 amounted to $45m.
(4) The Group’s pre‐tax cost of debt was estimated to be 10%.
(5) The Group’s cost of equity was estimated to be 16% in 2006 and 18% in 2007.
(6) The target capital structure is 50% equity, 50% debt.
(7) The rate of taxation is 30% in both 2006 and 2007.
(8) Economic depreciation amounted to $40m in 2006 and $45m in 2007. These amounts were equal to the
depreciation used for tax purposes and depreciation charged in the income statements.
(9) Interest payable amounted to $6m per year in both 2006 and 2007.
(10) Other non‐cash expenses amounted to $12m per year in both 2006 and 2007.
Page | 180
Question Paper
APM – Study Notes
Required:
(i) Stating clearly any assumptions that you make, estimate the Economic Value Added (EVA™) of the
Gamma Group for both 2006 and 2007 and comment briefly on the performance of the Group.
(8 marks)
(ii) Briefly discuss THREE disadvantages of using EVA™ in the measurement of financial performance.
(3 marks)
(25 marks)
Page | 181
Question Paper
1
APM – Study Notes
(a) (i)
Profit/(loss)
Less: cost of capital (at 10% of wdv)
Year
1
$m
12∙5
15∙0
–––––
(2∙5)
(4∙5)
–––––
RI
(7∙0)
Net cash inflow
Less: Depreciation
$m
Year 2
$m
18∙5
15∙0
–––––
3∙5
(3∙0)
––––
–
0∙5
Year
3
$m
27∙0
15∙0
–––––
12∙0
(1∙5
)
–––––
10∙5
A positive NPV of $1∙937m indicates that the performance is acceptable over the three‐year life of
the proposal.
The RI shows a negative value of $7m in year 1. This is likely to lead to its rejection by the
management of Alpha
Division because they participate in a bonus scheme that is based on
short‐term performance evaluation.
The short‐term focus on performance evaluation might lead to the rejection of investment
opportunities such as the one under consideration which would be detrimental to the Delta Group.
Management of the Delta Group should give immediate consideration to changing the focus of the
bonus scheme.
(ii)
Measures of divisional profitability may be viewed as evaluating managerial performance and/or
economic performance of the division. Management are likely to take the view that any contribution
value used as a measure of their performance should only contain revenue or cost elements over
3 shown in the question are considered
which they have control. If each of the measures 1 to
the following analysis may be made:
1. Variable short run contribution margin:
This measure may be viewed as unacceptable to divisional management where it contains inter‐
divisional transfers. In this case this should not be a problem since the use of adjusted market
price is in effect equivalent to external selling price after the deduction of cost elements (e.g.
special packaging) that are not appropriate to inter‐divisional transfers.
2. Controllable profit:
This measure will be calculated by deducting controllable fixed costs from the variable short‐run
contribution. These costs may include labour costs and/or equipment rental costs that are fixed
in the short term but are subject to some influence by divisional management. For example,
divisional management action may enable efficiency gains to be achieved in order to reduce the
level of fixed labour or equipment rental costs that are incurred. In addition, it will be relevant to
determine whether divisional management is free to source such items as they wish or if there is
some direction for them to use, for example, a Delta Group Service Division for equipment
rental requirements.
Page | 182
Question Paper
APM – Study Notes
The inclusion of depreciation of fixed assets as a charge in evaluating controllable contribution
may be debated depending on the extent to which divisional management has control over
investment decisions.
3. Divisional profit:
Depending on the extent to which investment decisions relating to Alpha Division are ultimately
authorised at Delta Group level, depreciation may be viewed as a non‐controllable cost,
chargeable in arriving at the divisional profit and hence as part of divisional economic
performance measurement.
Other non‐controllable costs attributed to the division may be a share of Group finance and legal
staff costs for services provided to the division. Such costs are non‐controllable by divisional
management and may be viewed as avoidable only if the division was closed.
The divisional profit figure is useful in evaluating the economic performance of the division in that
it represents the contribution made by Alpha Division towards the overall profitability of the Delta
Group.
(b)
(i) In order to compute EVA, adjustments must be made to the conventional after tax profit measures of
$67m and $82m shown in the summary income statements. Since we know that financial accounting
depreciation is equal to economic depreciation then no adjustment is required to take into account the
fact that economic depreciation differs from financial accounting depreciation. In calculating EVA the
calculation of adjusted profit represents an attempt to approximate cash flow after taking into account a
charge in respect of economic depreciation. Hence non‐cash expenses are added back
to the profit
reported in the income statement. Net interest is also added back to the reported profit because the
returns required by the providers of funds are reflected in the cost of capital adjustment. It is the net
interest i.e. interest after tax that is added back to reported profit because interest will already have
been allowed as an expense in the computation of the taxation liability.
In computing EVA, the calculation of capital employed should be based on adjustments which seek to
approximate economic value at the commencement of each period. Due to the lack of sufficient
information the book value of shareholders’ funds plus long‐term capital loans at the end of 2005 is used
as a basis for the determination of economic capital employed at the commencement of 2006.
Goodwill is a measure of the price paid for a business in excess of the current cost of the net separable
assets of the business. Payments in respect of goodwill may be viewed as adding value to the company.
Therefore any amounts in respect of goodwill amortisation appearing in the income statement are added
back to reported profit since they represent part of the intangible asset value of the business.
By the same token, the cumulative write off of $45 million is added back to capital employed in order to
show a more realistic value of the capital base realistic value of the capital employed. This is because
goodwill represents an element of the total value of a business. The value placed on goodwill should be
regularly reviewed and any diminution in its value should be recognised immediately in the income
statement.
Page | 183
Question Paper
APM – Study Notes
The calculation of EVA in respect of the two years under consideration is as follows:
2006
Adjusted profit:
$m
Profit after tax
67
Amortisation of goodwill
5
Other non‐cash expenses 12
Interest expense
4.2
Adjusted profit
88.2
2007
$m
82
5
12
4.2
103.2
Adjusted capital employed:
Year beginning
Non‐capitalised leases
Goodwill
$m
279
16
45
––––
$m
340
16
50
–––––
Adjusted capital employed
340
406
The weighted average cost of capital should be based on the target capital structure of 50% Debt: 50%
Equity.
The calculations are as follows:
WACC 2006: (16% x 50%) + (10% x 0∙7 x 50%) = 11∙5%
WACC 2007: (18% x 50%) + (10% x 0∙7 x 50%) = 12∙5%
Therefore EVA in respect of both years can be calculated as follows:
EVA 2006 = 88∙2 – (340 x 11∙5%) = $49∙1
million EVA 2007 = 103∙2 – (406 x 12∙5%)
= $52∙45 million
The EVA measures indicate that the Gamma Group has added significant value during each year under
consideration and thereby achieved a satisfactory level of performance.
(ii)
Disadvantages of an EVA approach to the measurement of financial performance include:
(i) The calculation of EVA may be complicated due to the number of adjustments required.
(ii) It is difficult to use EVA for inter‐firm and inter‐divisional comparisons because it is not a ratio
measure.
(iii) Economic depreciation is difficult to estimate and conflicts with generally accepted accounting
principles. Note: Other relevant discussion would be acceptable.
Page | 184
Question Paper
APM – Study Notes
2. Landual Lamps (Landual) manufactures and delivers floor and table lamps for homes and offices in Beeland. The
company sells through its website and uses commercial logistics firms to deliver their products. The markets for its
products are highly competitive. The company has traditionally relied on the high quality of its designs to drive
demand for its products.
The company is divided into two divisions (components and assembly), plus a head office that provides design,
administrative and marketing support. The manufacturing process involves:
1. the components division making the housing components and electrical components for the lamp. This is an
intricate process as it depends on the specific design of the lamp and so serves as a significant source of
competitive advantage for Landual;
2. the assembly division assembling the various components into a finished lamp ready for shipment. This is a
simple process.
The finance director (FD) of Landual is currently overloaded with work due to changes in financial accounting
policies that are being considered at board level. As a result, she has been unable to look at certain management
accounting aspects of the business and has asked you to do a review of the transfer pricing policy between the
components and assembly divisions.
The current transfer pricing policy at Landual is as follows:
(a) market prices for electrical components are used as these are generic components for which there is a
competitive external market; and
(b) prices for housing components based on total actual production costs to the components division are used as
there is no external market for these components since they are specially designed for Landual’s products.
Currently, the components division produces only for the assembly division in order to meet overall demand
without the use of external suppliers for housing and electrical components. If the components division were to
sell its electrical components externally, then additional costs of $269,000 would arise for transport, marketing
and bad debts.
The FD is considering two separate changes within Landual: one to the transfer pricing policy and a second one to
the divisional structure.
First, the transfer pricing policy for housing components would change to use variable cost to the components
division. The FD wants to know the impact of the change in transfer pricing policy on the existing results of the two
divisions and the company. (No change is proposed to the transfer price of the electrical components.)
Second, as can be seen from the divisional performance report below, the two divisions are currently treated as
profit centres. The FD is considering splitting the components division into two further separate divisions: an
electrical components division and a housing components division. If the board agrees to this proposal, then the
housing components division will be treated as a cost centre only, charging its total production cost to the assembly
division. The electrical components and assembly divisions will remain as profit centres.
The FD needs to understand the impact of this proposed new divisional structure on divisional performance
assessment and on the company as a whole. She has asked that, in order to keep the discussion on the new
divisional structure simple, you use the existing transfer pricing policy to do illustrative calculations. She stated that
she would reallocate head office costs to the two new components divisions in proportion to their cost of sales.
Page | 185
Question Paper
APM – Study Notes
You are provided with the following financial and other information for Landual Lamps.
Note:
1 The components division has had problems meeting budgets recently, with an adverse variance of $575,000
in the last year. This variance arises in relation to the cost of sales for housing component production.
Required:
(a) Evaluate the current system of transfer pricing at Landual, using illustrative calculations as appropriate.
(10 marks)
(b) Advise the finance director (FD) on the impact of changing the transfer pricing policy for housing
components as suggested by the FD and comment on your results, using illustrative calculations as
appropriate.
(6 marks)
(c) Evaluate the impact of the change in proposed divisional structure on the profit in the divisions and the
company as directed by the FD.
(9 marks)
(25 marks)
Page | 186
Question Paper
APM – Study Notes
2 (a) Current transfer pricing policy
A good transfer pricing system will ensure goal congruence and fair performance measurement between the
divisions and maintain a suitable level of managerial autonomy within each division. Generally, the use of variable
costs is helpful as it
leads to optimal decisions for the company as a whole. The use of fixed production costs
obscures these marginal costs and can lead to sub‐optimal decisions by the divisions.
Electrical components
The use of a market price basis for electrical components makes sense, as these are generic products for which
there is a ready external market. Therefore, the performance of the components division in their production can
be readily compared to this market and the assembly division will accept such a price, as this is its alternative to
sourcing internally. This activity
does return a small contribution to head office costs, currently $383k (1,557 –
804 – 370). This small contribution reflects
the generic nature of the products.
However, the assembly division could reasonably argue that the market price is too high, since an internal transfer
of components does not require a number of costs (transport, marketing and bad debts). These should be deducted
from the market price in order to get an adjusted market price. If this is done, then the contribution to head office
costs from electrical components within the components division falls to $114k (1,288 – 804 – 370 or 383 – 269),
as shown below.
Housing components
The housing components are currently priced using actual production costs. This makes sense, as these
components are uniquely produced for the assembly division and there is no external market since this would
give away Landual’s competitive advantage. It could be argued that the unique work in housing components
should be rewarded with greater divisional profit. The components division only covers its actual production
costs and gets no contribution towards the allocated head office costs from these components. Thus, since
housing represents the bulk of the division’s revenue (84% = 8,204/9,761), it will be difficult for the
components division to ever earn a significant profit. A mark‐up on actual total production costs of 30% (say)
would not seem unusual for such unique products and would lead to additional divisional profit of $2,461
(30% of $8,204k). This would significantly shift the location of the divisional profit from assembly to housing.
However, by using actual rather than budget costs, this means that there is no incentive to reduce on costs by the
components division, as it will always receive these back from the assembly division. This lack of incentive could
explain the failure to meet budget by $575,000 caused in the production of the housing components.
Applying all of these changes, divisional reports would be:
Page | 187
Question Paper
APM – Study Notes
Data for the year ended 31 March 2013
1.
Transfer price for electrical components is reduced by additional costs of external sales.
Previous market price for electricals
Less: additional costs for external sales
Adjusted market price
$’000
1,557
(269)
––––––
1,288
2.
The transfer price for housing is now budgeted total production cost (7,629 = 6,902 + 1,302 – 575),
marked up by 30%.
(b)
The change in transfer policy has the effect of reducing the revenue/cost of sales of the components/assembly
divisions by the fixed production costs of the housing components ($1,302k). It shifts this amount of divisional
profit from the components to the assembly division. This change seems unusual since the competitive
advantage of the business lies in the housing designs, and yet this change is further emphasising the importance
of the assembly division which does not seem to be the value‐adding element of the business.
There is a danger, here, that the company focuses on the work of the division with higher profits and so
downgrades the unique work done by the components division. However, the clarity of using variable costs
only in transfer pricing may assist the company overall in achieving optimal pricing and profit.
There is no change to the company’s profit from such a change.
Page | 188
Question Paper
APM – Study Notes
Working:
Note:
Only change is that housing is now c harged to assembly on variable cost only.
(c)
Housing division
The housing division is now a cost centre and so it will be easier for it to focus on cost control (avoiding adverse
budget variances) and quality of its output (as it makes the key components for the company’s products).
However, there may be an adverse effect on the motivation of divisional managers through losing profit centre
status and this must be countered by altering their reward packages to focus them on costs.
Electrical division
The electrical division can be seen to be making a small divisional profit ($335k). Its treatment as a profit
centre makes sense, as it can be compared to similar companies for benchmarking purposes and also so that
Landual can consider easily the ‘make or buy’ decision for such generic components. Obviously, at present,
electrical is making a contribution to HO costs which means that it should continue to obtain the business
from the assembly division.
Assembly division
The assembly division is unaffected by the changes, although the greater clarity of results in the electrical
division will allow the managers of the division to ensure that the electrical division remains competitive.
Landual Lamps
The change has no effect on the company profit reported but it would be hoped that the change would bring
the benefits noted above (cost savings in housing and greater motivation to compete in electrical) and so
improve profits in the future.
Page | 189
Question Paper
APM – Study Notes
Page | 190
Non – Financial Performance Measurement
APM ‐ Study Notes
NON‐FINANCIAL PERFORMANCE MEASUREMENT
Learning Objectives




Discuss the interaction of non‐financial performance indicators with financial performance indicators
Identify and discuss the significance of nonfinancial performance indicators in relation to product/service
quality, e.g. Customer satisfaction reports, repeat business ratings, access and availability
Discuss the difficulties in interpreting data on qualitative issues
Discuss the significance of brand awareness and company profile and their potential impact on business
performance
Page | 191
Non – Financial Performance Measurement
APM ‐ Study Notes
Difficulties in interpreting data on qualitative issues









Particularly at higher levels of management, non‐financial information is often not in numerical terms, but
qualitative, or soft, rather than quantitative. Qualitative information often represents opinions of individuals
and user groups. However there are issues related to its use.
Decisions often appear to have been made on the basis of quantitative information; however qualitative
considerations often influence the final choice, even if this is not explicit.
Conventional information systems are usually designed to carry quantitative information and are sometimes
less able to convey qualitative issues. However the impact of a decreased output requirement on staff morale
is something that may be critical but it is not something that an information system would automatically
report.
In both decision making and control, managers should be aware that an information system may provide a
limited or distorted picture of what is actually happening. In many situations, sensitivity has to be used in
interpreting the output of an information system.
Information in the form of opinions is difficult to measure and interpret. It also requires more analysis.
Qualitative information may be incomplete. They are often interdependent and it can be difficult to separate
the impact of different factors.
Evaluating qualitative information is subjective, as it is not in terms of numbers ‐ there are no objective
formulae as there are with financial measures.
The cost of collecting and improving qualitative information may be very high.
Difficulties in measurement and interpretation mean that qualitative factors are often ignored.
Brand Awareness
Brand awareness defined as the “extent to which consumers are familiar with the distinctive qualities or image of a
particular brand of goods or services.” It is important when launching new products and services, and it drives
consumers’ decisions when differentiating between competing companies. It encourages repeat purchases and
leads to an increase in market share and incremental sales. Brand awareness is also very important to businesses
that are marketing proactively through social media sites.
By building brand awareness, you can also increase your market share. If you are the first to the punch in getting
your brand fused into customers’ minds, you will raise the barrier to other companies that are trying to enter the
market. According to the Strategic Planning Institute, “Aggressive marketing and advertising, are the key factors in
increasing brand awareness and converting awareness into market share.” Brand awareness does not have a
financial value on its own, but it is part of the collective marketing effort that drives incremental sales.
There are many ways you can go about boosting brand awareness amongst consumers, and making a brand mean
something to consumers when they look at it is just as important as a sales pitch. Your marketing strategies may
vary year‐to‐year, but a consistent brand message will help make your business top‐of‐mind when your target
market is comparison shopping.
Page | 192
The Role of Quality in Performance Management
APM ‐ Study Notes
THE ROLE OF QUALITY IN PERFORMANCE MANAGEMENT
Learning Objectives




Discuss and evaluate the application of Japanese business practices and management accounting
techniques, including:
 Kaizen costing
 Target costing
 Just‐in‐time,
 Total Quality Management
Assess the relationship of quality management to the performance management strategy of an
organisation including cost of quality
Justify the need and assess the characteristics of quality in management information systems
Discuss and apply Six Sigma as a quality improvement method using tools such as DMAIC for
implementation
Page | 193
The Role of Quality in Performance Management
APM ‐ Study Notes
Importance of quality
Success in business depends on satisfying the needs of customers and meeting the requirements of customers. An
essential part of meeting customer needs is to provide the quality that customers require. Quality is therefore an
important aspect of product design and marketing.
Quality is also important in the control of production processes. Poor quality in production will result in losses due
to rejected items and wastage rates, sales returns by customers, repairing products sold to customers (under
warranty agreements) and the damaging effect on sales of a loss of reputation.
A company or a not‐for‐profit entity may have a strategic target for quality:
 It may adopt a Total Quality Management (TQM) approach and look for continuous improvements in quality.
Improvements in quality do not mean higher costs. Improvements can be found that will lower costs by
improving efficiency and eliminating waste.
 It may have a strategic target for quality. For example, a company might set a target of a maximum of only 1%
of goods sold being returned as unsatisfactory.
If there is a strategic target for quality, the aim should be to achieve the target for a minimum total of quality‐
related costs.
Even if an entity does not have a specific quality target, it should seek to minimise quality‐related costs. In order to
do this, quality‐related costs should be measured, analysed and controlled.
Quality management
Quality management involves planning and controlling activities to ensure the
product or service is fit for purpose, meets design specifications and meets the
needs of customers. Quality management should lead to improvements in
performance.
Quality control
Quality control involves a number of routine steps which measure and control the
quality of the product/service as it is developed.
Quality assurance involves a review of the quality control procedures, usually by
an independent third party, such as ISO (see section 3). It aims to verify that the
desired level of quality has been met.
Quality assurance
Quality management systems and certification
Quality standards
Total Quality Management is a philosophy of management. It includes statistical quality measurement and control,
but it does not provide a specific statement of what an entity should do to achieve an acceptable quality standard
in its processes, products and services.
The recognition of quality as an important factor in business planning and performance has led to the
development of specific quality management standards.
Page | 194
The Role of Quality in Performance Management
APM ‐ Study Notes
Companies and other entities might establish their own quality standards. However, external quality standards
have been developed for a wide range of business activities, including:
 Quality standards in specific industries or products
 More general quality standards for management
ISO9000 quality standards
External quality standards were developed in the UK by the British Standards Institute, now called the BSI Group.
There are also some organisations in the EU that establish external standards.
Standards set by the BSI influence the development of international quality standards by the International
Organisation for Standardisation (ISO) which is based in Switzerland.
Like the BSI, ISO has a range of quality standards for specific industries and products, but also has a series of
standards for quality management. This is called the ISO9000 series, or sometimes the ISO9000:2000 series,
because the standards were revised in 2000.
The ISO9000 series includes:
 ISO9000:2000 ‘Quality management systems: fundamentals and vocabulary’. This provides definitions for the
terms used in the ISO9000 series.
 ISO9001:2000 ‘Quality management system – requirements’. This specifies the requirements that must be met
by an entity wishing to meet the ISO9000 quality standards and obtain certification for having done so.
 ISO9004:2000 ‘Quality management systems – guidelines for performance improvements’. As the title
indicates, this provides guidelines on how an entity can continue to improve its quality management system.
The purpose of the ISO9000 series
The International Organisation for Standardisation has stated that the ISO9000 series is concerned with quality
management and what an entity should do to:
 Meet the quality requirements of its customers
 Meet applicable regulatory requirements for quality, and at the same time, enhance customer satisfaction
 Achieve continued improvement in performance in pursuit of these quality objectives.
The ISO9000 series specifies the requirements for a generic management system and the same standards can be
applied to all types of entities, large and small, business and non‐business.
ISO9000 and the eight principles of quality management
Principal
Customer focus
Explanation
Entities depend on their customers. They should understand the current and future
needs of their customers and should meet these requirements while trying to exceed
customer expectations. The benefits of meeting this requirement are:
 More sales revenue and a bigger market share achieved through flexible responses
to market opportunities
 Increased effectiveness in using the resources of the entity to increase customer
satisfaction
 Improved customer loyalty, leading to repeat business in the future.
Page | 195
The Role of Quality in Performance Management
Leadership
Involvement
people
of
Process approach
System approach to
management
Continual
improvement
Factual approach to
decision‐making.
Mutually beneficial
supplier
relationships
APM ‐ Study Notes
The leaders of an entity provide purpose and a sense of direction. Leaders should create
and maintain an ‘internal environment’ in which individuals can become fully involved in
achieving the entity’s objectives. The benefits of meeting this requirement are:
 Motivating individuals towards the entity’s goals and objectives
 Improved communications between different levels of the organisation structure.
Individuals at all levels within the organisation are the ‘essence’ of the organisation.
Getting them fully involved will enable the entity to make the best use of their abilities.
The benefits of meeting this requirement are:
 A motivated and committed work force
 The encouragement of innovation and creativity
 Individuals willing to be accountable for their own performance
 Individuals wanting to participate and find ways of achieving continual
improvement.
A desired result is achieved more efficiently when activities and related resources are
managed as a process. The benefits of meeting this requirement are:
 Lower costs and shorter cycle times through the more efficient use of resources
 Improved and consistent results
 An ability to focus on and prioritise opportunities for improvement.
Interrelated processes should be identified, understood and managed as an integrated
system. This will improve the efficiency and effectiveness of the entity in achieving its
objective
Continual improvement in performance should be a permanent objective of the entity.
Effective decisions are based on the analysis of data and information – facts, not
opinions or guesswork. The key benefits are
 Informed decision‐making,
 An ability to question the rationale for decisions
 Change opinions and decisions if appropriate.
An entity and its suppliers are interdependent. A mutually beneficial relationship helps
both to create value. The benefits of meeting this requirement are:
 A better ability to improve value in the supply chain
 More flexibility and speed of joint response to changing markets and customer
needs and expectations
 Better uses of resources and lower costs
ISO9000 and certification
The ISO9000 quality management standards are voluntary standards. However, entities may apply for ISO9000
certification if they believe that they comply with the ISO9000 standards.
Certification means obtaining a certificate of compliance from an external auditing/inspecting body. An
independent, external body (recognised by ISO) audits the entity’s quality management system and verifies that it
conforms to the requirements specified in the standard.
The auditing body then records the certification in its client register. The entity’s management system is therefore
both certified and registered.
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Advantages of ISO9000 compliance
If an entity complies with the requirements of ISO9000, it will benefit from a high standard of quality management.
Many of the benefits are set out in the eight principles of quality management.
In addition, if an entity is certified under ISO9000, this provides independent ‘evidence’ that the entity has an
excellent system of quality management and is in control of its processes and is focused on customer satisfaction.
This can have marketing benefits.
Some large companies and governments insist that their suppliers should have ISO9000 certification. This provides
a specific commercial reason for achieving and maintaining ISO9000 certification.
Impact of quality management system on performance management
The adoption of a QMS should complement an organisation's strategy and help it in achieving its quality objectives.
An effective QMS should:
 Minimise the overall costs of quality
 Improve customer satisfaction due to higher levels of quality
 Improve staff morale and productivity due to the involvement and pride taken in the work done.
Quality related costs
Non‐conformance cost
Internal failure costs:
External failure costs:
Conformance cost
Appraisal costs:
Prevention costs:
These costs arise from inadequate quality where the problem is discovered before
the transfer of ownership from supplier to buyers.
 Rework costs
 Down time or idle time due to quality problem
 Disposal of defective products
 Re‐inspection cost
 Cost of reviewing product after failure
The cost arising from poor quality discovered after the transfer of ownership from
suppliers to buyers.
 Warranty claims
 Cost of lost sales
 Cost of customer service section
 Complaint, investigation and processing costs
It is a cost incurred in ascertaining the product to quality requirement
 Inspection and tests
 Product quality audits
 Process control monitoring
 Test equipment expense
Cost of any action taken to prevent or reduce defects of failures
 Customer surveys
 research of customer needs
 quality education and training programs
 supplier reviews
 investment in improved production equipment
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Quality practices
Target costing
Introduction:
When a new product is launched, traditionally profit was added to cost i.e. cost plus pricing considering internal
factors to get to the selling price but, TARGET COSTING involves setting a target cost by subtracting a desired profit
margin from a target selling price.
In a modern environment with shortening product lifecycles, organisations have to continually redesign their
products. It is essential that they try to achieve a target cost during the product’s development.
TARGET COST is the cost at which a product must be produced and sold in order to achieve the required amount
of profit at the target selling price. When a product is first planned, its estimated cost will often be higher than its
target cost. The aim of target costing is then to find ways of closing this target cost gap and producing and selling
the product at the target cost.
Target costing
As product life cycles have become much shorter, the planning, development and design stage of a product is
critical to an organisation's cost management process. Cost reduction must be considered at this stage of a
product’s life cycle, rather than during the production process.
Target costing involves setting a selling price for the product by reference to the market.
From this, the desired profit margin is deducted leaving us with a target cost.
Implementing Target Costing‐The Steps:
1. Determine a product specification of which an adequate sales volume is estimated
2. Decide a target selling price at which the organisation will be able to sell the product successfully and achieve
a desired market share.
3. Estimate the required profit, based on required profit margin or return on investment
4. Calculate: Target cost
Target cost = Target selling price – Target profit.
5. Prepare an estimated cost for the product, based on the initial design specification and current cost levels.
6. Calculate: Target cost gap = Estimated cost – Target cost.
7. Make efforts to close the gap. This is more likely to be successful if efforts are made to 'design out' costs prior
to production, rather than to 'control out' costs after ‘live’ production has started.
Cost
now
Reduce the cost gap
Target
cost
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Example:
A company manufactures digital watches and is in the process of introducing a new watch into the market. Their
research shows the following;
Competitive Selling price
$ 60
Cost Estimates
Direct material
Direct labour
Machinery
Ordering and Receiving
Quality Assurance
Marketing
Distribution
After Sales Service
Target Profit Margin
$
3.21
24.03
1.12
0.23
4.60
8.15
3.25
1.30
30%
Requirement:
a) Calculate Target Cost
b) Calculate Cost gap
Solution
Solution:
Competitive Selling price
$
60
Target profit margin(30% of selling price)
Target cost(60‐18)
Projected cost per unit(add all costs)
COST GAP
18
42
(45.89)
3.89
The projected cost exceeds the target cost by $3.89. This is target cost gap. This company will have to find out
the ways to reduce this gap by controlling costs.
Possible Ways to close a Cost Gap:








Value analysis to determine which features are adding value to the product and which will not affect it at all.
Reducing the number of components.
Using cheap labour/staff.
Using standard components wherever possible.
Acquiring new more efficient technology.
Training staff in more efficient techniques
Cutting out non value added activities
Using different materials(identified using activity analysis)
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The most effective stage to reduce non value added feature is the product design and development stage and most
costs are determined at this stage.
Benefit of target costing
Benefits
Early external focus
Value
adding
features only
Early cost control
Lower
unit
costs
per
Reduced time to
market
Explanation
The organisation will have an early external focus to its product development.
Businesses have to compete with others (competitors) and an early consideration of this
will tend to make them more successful. Traditional approaches (by calculating the cost
and then adding a margin to get a selling price) are often far too internally driven.
Only those features that are of value to customers will be included in the product design.
Target costing at an early stage considers carefully the product that is intended.
Features that are unlikely to be valued by the customer will be excluded.
Cost control will begin much earlier in the process. If it is clear at the design stage that a
cost gap exists, then more can be done to close it by the design team. Traditionally, cost
control takes place at the ‘cost incurring’ stage, which is often far too late to make a
significant impact on a product that is too expensive to make.
Costs per unit are often lower under a target costing environment. This enhances
profitability. Target costing has been shown to reduce product cost by between 20% and
40% depending on product and market conditions. In traditional cost plus systems an
organisation may not be fully aware of the constraints in the external environment until
after the production has started. Cost reduction at this point is much more difficult as
many of the costs are intermixed in the product.
It is often argued that target costing reduces the time taken to get a product to market.
Under traditional methodologies there are often lengthy delays whilst a team goes ‘back
to the drawing board’. Target costing, because it has an early external focus, tends to
help get things right the first time and this reduces the time to market.
Kaizen costing
Kaizen is a Japanese term for continuous improvement in all aspects of an entity's performance at every level.
Often associated with total quality management, many firms limit Kaizen to improving production.
Characteristic
 Kaizen involves setting standards and then continually improving these standards to achieve long‐term
sustainable improvements.
 The focus is on eliminating waste, improving processes and systems and improving productivity.
 Involves all employees and all areas of the business.
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Illustration – Kaizen
Many Japanese companies have introduced a Kaizen approach:
 In companies such as Toyota and Canon, a total of 60‐70 suggestions per employee are written down and
shared every year.
 It is not unusual for over 90% of those suggestions to be implemented.
 In 1999, in one US plant, 7,000 Toyota employees submitted over 75,000 suggestions, of which 99% were
implemented.
What is continuous improvement?
Continuous improvement is the continual examination and improvement of existing processes and is very different
from approaches such as business process re‐engineering (BPR), which seeks to make radical one‐off changes to
improve an organisation's operations and processes. The concepts underlying continuous improvement are:
 The organisation should always seek perfection. Since perfection is never achieved, there must always be
scope for improving on the current methods.
 The search for perfection should be ingrained into the culture and mindset of all employees. Improvements
should be sought all the time.
 Individual improvements identified by the work force will be small rather than far‐reaching.
Eliminating waste
Kaizen costing has been developed to support the continued cost reduction of existing components and products.
Cost reduction targets are set on a regular, e.g. monthly basis and variance analysis is carried out at the end of
each period to compare the target cost reduction with the actual cost.
One of the main ways to reduce costs is through the elimination of the seven main types of waste:
 Over‐production ‐ produce more than customers have ordered.
 Inventory ‐ holding or purchasing unnecessary inventory.
 Waiting ‐ production delays/idle time when value is not added to the product.
 Defective units ‐ production of a part that is scrapped or requires rework.
 Motion ‐ actions of people/equipment that do not add value.
 Transportation ‐ poor planning or factory layout results in unnecessary transportation of materials/work‐in‐
progress.
 Over‐processing ‐ unnecessary steps that do not add value.
Kaizen costing vs standard costing
Standard costing
 It is used for cost control.
 It is assumed that current manufacturing
conditions remain unchanged.
 The cost focus is on standard costs based on
static conditions.
 The aim is to meet cost performance standards.
 Standards are set every 6 or 12 months.
Kaizen costing
 It is used for cost reduction.
 It assumes continuous improvement.
 The cost focus is on actual costs assuming dynamic
conditions.
 The aim is to achieve cost reduction targets.
 Cost reduction targets are set and applied
monthly.
 Costs are controlled using variance analysis  Costs are reduced by implementing continuous
based on standard and actual costs.
improvement (Kaizen) to attain the target profit or
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APM ‐ Study Notes
to reduce the gap between target and estimated
profit.
 Management should investigate and respond  Management should investigate and respond
when standards are not met.
when target Kaizen amounts are not attained.
Total quality management (TQM)
Total quality management (TQM) is the process of applying a zero defects philosophy to the management of all
resources and relationships within an organisation as a means of developing and sustaining a culture of continuous
improvement which focuses on meeting customers' expectations.
Features of total quality management (TQM)
Customer focus:
Organisation‐wide there must be acceptance that the only thing that matters is the
customer. Organisations depend on their customers and so must strive to
understand and meet customer needs and expectations.
Internal customers and
internal suppliers:
All parts of the organisation are involved in quality issues and need to work
together. Every person and every activity in the organisation affects the work done
by others. The work done by an internal supplier for an internal customer will
eventually affect the quality of the product or service to the external customer.
Instead of relying on inspection to a predefined level of quality, the cause of the
defect in the first place should be prevented.
Every person within an organisation has an impact on quality and it is the
responsibility of all employees to get quality right. Each employee or group of
employees must be personally responsible for defect‐free production or service in
their area of the organisation.
There should be a move away from 'acceptable' quality levels. Any level of defects
must be unacceptable.
All departments should try obsessively to get things right the first time; this applies
to misdirected phone calls and typing errors as much as to production.
Quality certification programmes should be introduced.
Identify
causes
defects:
Quality culture:
of
Zero defects:
Right first time:
Quality
certification
programmes
Costs of poor quality:
The cost of poor quality should be emphasised; good quality generates savings (for
example, though not having to rework items with defects, or through a reduction in
the level of refunds or replacement products given to customers).
Just in time
JIT aims for zero inventory and perfect quality and operates by demand‐pull. It consists of JIT purchasing and JIT
production and results in lower investment requirements, space savings, greater customer satisfaction and
increased flexibility.
Just‐in‐time (JIT)
A JIT system is a "pull" system, which responds to demand, in contrast to a "push" system, in which inventories act
as buffers between the different elements of the system, such as purchasing, production and sales.'
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Just‐in‐time production is 'A production system which is driven by demand for finished products, whereby each
component on a production line is produced only when needed for the next stage.'
Just‐in‐time purchasing is 'A purchasing system in which material purchases are contracted so that the receipt and
usage of material, to the maximum extent possible, coincide.'
(Chartered Institute of Management Accountants (CIMA), Official Terminology)
Essentials of JIT
JIT purchasing
Parts and raw materials should be purchased as near as possible to the time they are
needed, using small frequent deliveries against bulk contracts. Inventory levels are
therefore minimised.
Close
relationship
with suppliers
In a JIT environment, the responsibility for the quality of goods lies with the supplier. A
long‐term commitment between supplier and customer should therefore be
established. If an organisation has confidence that suppliers will deliver material of
100% quality on time such that there will be no rejects or returns and hence no
consequent production delays, usage of materials can be matched with delivery of
materials and inventories can be kept at near zero levels. However, flexibility and
establishing good communication channels are also important aspects of the
relationship with suppliers.
All parts of the productive process should be operated at a speed which matches the
rate at which the final product is demanded by the customer. Production runs will
therefore be shorter and there will be smaller inventories of finished goods because
output is being matched more closely to demand (through this, storage costs will be
reduced).
No value is added during set‐up times, so set‐ups are non‐value added activities.
Consequently, time spent setting up machinery should be minimised.
There is a constant focus on the simplification of products and processes in order to
maximise the utilisation of available resources.
Machines or workers should be grouped by product or component instead of by the
type of work performed. Products can flow from machine to machine without having
to wait for the next stage of processing or returning to stores. Lead times and work in
progress are thus reduced.
Production management should seek to eliminate scrap and defective units during
production, and to avoid the need for reworking of units since this stops the flow of
production and leads to late deliveries to customers. Product quality and production
quality are important 'drivers' in a JIT system. Also, note that the fundamental
requirement in relation to quality is that the level of quality satisfies the customer.
Products/components are only produced when needed by the next process. Nothing is
produced in anticipation of need, to then remain in inventory, consuming resources.
Production systems must be reliable and prompt without unforeseen delays and
breakdowns.
Workers within each machine cell should be trained to operate each machine within
that cell and to be able to perform routine preventive maintenance on the cell
Uniform loading
Set‐up time reduction
Simplification
Machine cells
Quality
Pull system ('kanban')
Preventive
maintenance
Employee
involvement
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The Role of Quality in Performance Management
Continuous
improvement
('Kaizen')
APM ‐ Study Notes
machines (i.e. to be multi‐skilled and flexible). Employee involvement in JIT
programmes is also important at a more general level. The successful operation of JIT
requires workers to possess a flexibility of both attitude and aptitude.
The ideal target is to meet demand immediately with perfect quality and no waste. In
practice, this ideal is never achieved. However, the JIT philosophy is that an
organisation should work towards the ideal and therefore continuous improvement is
both possible and necessary.
JIT and Service Organisations
Although it originated with manufacturing systems, the JIT philosophy can also be applied to some service
operations.
 Whereas JIT in manufacturing seeks to eliminate inventories, JIT in service operations will seek to eliminate
internal or external queues of customers.
 Other concepts of JIT, such as eliminating wasteful motion and seeking ways of achieving continuous
improvement are also applicable to services as much as to manufacturing activities.
Benefits of Just In Time
 There should be minimal amounts of inventory obsolescence, since the high rate of inventory
turnover keeps any items from remaining in stock and becoming obsolete.
 Since production runs are very short, it is easier to halt production of one product type and switch to a
different product to meet changes in customer demand.
 The very low inventory levels mean that inventory holding costs (such as warehouse space) are
minimized.
 The company is investing far less cash in its inventory, since fewer inventories are needed.
 Fewer inventories can be damaged within the company since it is not held long enough for storage‐
related accidents to arise. Also, having fewer inventories gives material handlers more room to
maneuver, so they are less likely to run into any inventory and cause damage.
 Production mistakes can be spotted more quickly and corrected, which results in fewer products being
produced that contain defects.
Problems of Just In Time
Despite the magnitude of the preceding advantages, there are also some disadvantages associated with just‐
in‐time inventory, which are:
 A supplier that does not deliver goods to the company exactly on time and in the correct amounts could
seriously impact the production process.
 A natural disaster could interfere with the flow of goods to the company from suppliers, which could
halt production almost at once.
 An investment should be made in information technology to link the computer systems of the company
and its suppliers so that they can coordinate the delivery of parts and materials.
 A company may not be able to immediately meet the requirements of a massive and unexpected order
since it has few or no stocks of finished goods.
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Six sigma
The main theory of quality improvement is the Six Sigma concept. The idea is to try and reduce the chance of an
item failing to be of a good enough quality. This does not mean having a single standard, there may be a range of
values which are acceptable.
This range is known as the tolerance. For example a hamburger chain may say that as long as a burger is not too
hot or too cold it is acceptable. This would give a range of acceptable temperatures (the tolerance).
The six sigma approach is about many gradual improvements rather than occasional large ones.
Six Sigma can be implemented using the DMAIC approach:
Define
 Define the problem.
 Clarify the purpose of the project.
 Develop the project plan.
Measure
 Data collection to quantify the problem.
 Measure the key processes that are critical to quality.
Analyze
 Analyze data to find the root cause of the problem.
 Consider the process itself, materials, environmental factors and the activities of staff involved in the process.
 The results from the analysis may lead to modifications in the definition of the problem.
Improve
 Develop solutions.
 Implement them.
Control
 Monitor changes.
 Deal with problems arising.
 The control process will focus on key performance measures.
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Human Resource Aspects of Performance Management
APM ‐ Study Notes
HUMAN RESOURCE ASPECTS OF PERFORMANCE MANAGEMENT
Learning Objectives






Advice on the relationship of HR management to performance measurement (performance rating) are
suitable remuneration methods.
Discuss and evaluate different methods of reward practices
Assess the potential beneficial and adverse consequences of linking reward schemes to performance
measurement, for example how it can affect the risk appetite of employees.
Assess the statement 'What gets measured gets done’
Discuss the accountability issues that might arise from performance measurement systems
Demonstrate how management style needs to be considered when designing an effective performance
measurement system.
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Introduction
This chapter looks at the nature of human resource management and observes the link between human resource
management and performance management. It then examines aspects of the staff appraisal system and considers
the impact of these on the performance of an organisation.
Nature of human resource management
Human resource management is defined by Bratton as ‘a strategic approach to managing employment relations,
which emphasises that leveraging people’s capabilities is critical to achieving competitive advantage.’
From this definition, we can see that human resource management has grown in importance from the traditional
view of the personnel department. Previously its role was seen as that of hiring and firing employees but now it
has evolved into a much broader role. Human resource management includes the recruitment of employees, the
development of policies relating to human resources and the management and development of employees.
It also follows that human resource management is not carried out exclusively by the HR department. Line
managers are involved in managing the human resources in their departments.
Importance of human resource
The modern terms ‘human resources’ and ‘human capital’ reflect the increasing recognition of the strategic
importance of employees. The terms actually refer to the traits that people bring to the workplace, such as
knowledge, intelligence, enthusiasm, an ability to learn etc. Employees are seen less and less as an expensive
necessity and more and more as a strategic resource that may provide an organisation with competitive
advantage.
In service industries such as restaurants where employees have direct contact with customers, having employees
that are friendly and helpful has a large impact on how customers will view the business. In IT industries, having
staff with good technical knowledge is essential.
The problem with human resources is that they require more management than other factors of production.
Humans are complex and emotional creatures so it can be challenging to ensure that they behave in the right way,
remain motivated and give the best to the employer. William James, the 19th century American sociologist, once
remarked that most people only use 15% of their combined intelligence, skills and aptitudes in their employment.
Whether this still remains the case or not, it is clearly a challenge to get employees to contribute more of their
abilities at the workplace.
Strategic human resource management
Given that human resources are a strategic capability, many human resource practitioners talk about ‘strategic
human resource management’. This means aligning the human resource management of organisations with the
organisations’ strategy.
The human resources management process should support the corporate strategy by ensuring that:
 The organisation has the right number of qualified employees
 Employees have the right skills and knowledge to perform efficiently and effectively
 Employees exhibit the appropriate behaviours consistent with the organisation’s culture and values
 Employees meet the organisation’s motivational needs.
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A low‐cost supermarket, for example, may have an HR policy of recruiting unskilled staff, who are prepared to
work for low wages, but would not provide customers with excellent service. A more high‐end supermarket on the
other hand would want to provide excellent customer care. HR strategies would include the recruitment of
individuals who have excellent personal skills and the training of all staff in customer care.
Recruitment and selection
‘Recruitment is the process of generating a pool of capable people to apply to an organisation for employment.
Selection is the process by which managers and others use specific instruments to choose from a pool of applicants
the person or persons most likely to succeed in the job given management goals and legal requirements.'
Recruitment is the first stage in the process of human resource management. The organisation needs to recruit
individuals with the right skills and attitudes to contribute to the strategic goals of the organisation. Employees
should also have the personality that would fit well into the culture of the organisation.
From the point of view of potential employees, the recruitment process provides them with the opportunity to see
if the organisation matches their expectations. The organisation should provide honest information about the
position so that the potential employee forms the right expectations about the role that they are applying for. If
not, this may lead to disappointment and high staff turnover.
When recruiting, the amount of time and effort spent in selecting the right employee depends on the amount of
responsibility that the position requires. Managerial or problem‐solving positions where employees would be
required to have deeper skills, a higher level of responsibility and greater commitment thus contributing to the
strategy of the organisation, would merit a much greater effort in the selection process. The selection process will
need to ensure that candidates possess the ability to acquire the skills needed and the attitude that fits the culture
of the organisation. Organisations may use psychometric tests to assess candidates for such positions.
Lower level employees would be employed if they have the right skills. Less screening would take place for this
group of employees.
Competency framework
In many organisations, competency frameworks may be developed prior to the recruitment stage. A competency
framework shows a set of behaviour patterns and skills that the candidate needs in order to perform a job with
competence.
ACCA has developed a comprehensive competency framework for ACCA students to help plan careers in different
roles. In ACCA's competency frameworks, competencies are categorised into exams, experience, ethics, job
profiles, technical competencies and behavioural competencies.
Appraisal system
An appraisal is the analysis of the performance of an individual, which usually includes assessment of the
individual’s current and past work performance. Broadly speaking, there are two main reasons for the appraisal
process. The first is the control purpose, which means making decisions about pay, promotions and careers. The
second is about identifying the development needs of individuals.
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Control objective of appraisal
In recent years, there has been a drive towards linking the appraisal of employees to the strategic objectives of an
organisation. The idea is that the organisation sets its own goals and performance measures. These goals are then
translated into goals for managers and employees. Measurable targets are identified and set for employees and
their performance against the targets is used as part of their appraisal.
Appraisal is therefore seen as part of management control. By measuring the performance of employees against
targets, management is seen to proactively control the performance of employees and therefore improve the
performance of the organisation.
While such an approach may appear rational, in practice, it is very unpopular with employees, who do not like to
feel they are being controlled. It can also be criticised for trying to make a complex relationship between
employees and managers appear to be too simple. It is not something very easy to evaluate someones
performance that incorporates all the factors .In practice, however, such control models are the most popular
models of assessment.
Developmental objectives of appraisal
A second way in which the appraisal system can support performance management is by identifying the
development needs of staff and managers. Some organisations use a development centre where an individual is
assessed, often by a qualified occupational psychologist, against the required competencies for his role. Personal
development plans are then made to develop the individual in areas where weaknesses are recognised.
Difficulties in appraisal
In assessing employees, managers are required to make judgments about an employee’s performance and
capabilities. Such judgments are naturally subject to potential bias in favour of some and against others. There are
many statistics showing how prejudice may affect the promotional prospects of some groups. In the UK, for
example, 40% of the workforce are women, but only 30% of managers are women.
Another difficulty is the effect that negative criticism can have on performance. A study carried out in the 1960s by
Meyer, Kay and French investigated the impact of the appraisal process at a factory in the US. The study concluded
that where staff are given criticism, they react defensively to the criticism and try to blame others for their
shortcomings. They also become demotivated. Interestingly, praise given during the process had little impact on
performance.
One potential solution to these difficulties in relation to appraisal is to be aware that in addition to the formal
appraisal process, employees receive continuous informal feedback from their managers on the job. Employees
generally accept this informal feedback more readily and it is more likely to lead to improvement in their
performance. Placing more emphasis on this informal type of assessment and less on the formal appraisal process
may improve the overall performance of employees.
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Measure of input
When measuring the performance of employees for the purpose of appraisal, three different approaches can be
used:
 Measurement of inputs
 Behaviour in performance
 Measurement of results and outcomes.
Measurement of inputs
Measurement of inputs means attempting to assess the traits of an individual. Traits are those skills, knowledge
and attitudes that the employee possesses. Assessment aims to identify whether the staff member has the
competencies (or traits) for a job, perhaps with reference to a competency framework. Attributes such as
leadership, commitment, ability to work within a team and loyalty are traits that are typically desired.
Where assessment is performed by the line manager, the subjectivity of the exercise may well lead to real or
perceived bias in the assessment. As a result of this, many organisations now use professionally designed
psychometric tests.
Psychometric testing aims to ‘measure’ the abilities and personal skills of an individual. An example of an ability
would be the number of words per minute that the individual can type on a keyboard. Personal skills focus on
areas such as emotional stability of the individual, whether the individual is an introvert or extrovert, and how
flexible the employee is.
Some organisations hold ‘moderation meetings’ for bigger teams. The purpose of these meetings is to ensure that
the various managers involved in assessing the different members of staff within a team, are doing the job
consistently.
Behaviour in performance
This type of appraisal looks at the behaviour of the employee during work and at how the employee applies his or
her skills. Both quantitative and qualitative data is collected on a continuous basis relating to how the employee
displays the expected behaviour for the A common method for assessing behaviour in performance is the use of
behaviour‐anchored rating scales (BARS). Descriptions of desired (and undesirable) behaviour are listed, and the
appraiser gives a score for each one. A good example of BARS is the course assessment forms used by many ACCA
tuition providers, where students are asked to rate the tutor on various attributes, such as ‘clarity of explanations’
and ‘approachability’. Students then give the tutor a grade for each of these attributes mostly from 1 to 5, where 5
is excellent and 1 is poor.
Behavioural observation scales (BOS) are where specific actions are listed and the appraise is judged on how many
times he performs that action. For example, how often does a supervisor provide constructive feedback to
colleagues?
An obvious problem with BARS and BOS is the subjectivity involved. BOS are designed to be slightly less subjective
as they are based on the number of times a behaviour is observed which is more factual.
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Measurement of behaviour in performance generally is beneficial because not only is information about the
employee’s performance obtained, but more detailed understanding of the requirement of the job can be
ascertained, and this can be used for defining standards in future.
Measurement of result and outcomes
Under these types of appraisals, individuals are assessed on quantifiable outcomes – for example, the amount of
sales achieved by a salesman, the volume of production achieved, the number of customer complaints. Where
competency frameworks are used, it may also be possible to measure the number of competencies achieved
during a period.
Frequently, targets may be set for individuals and their performance judged against those targets. In setting such
targets, it is appropriate to consider the principles relating to the setting of standards from the Fitzgerald and
Moon building blocks model. In particular, standards should be achievable or staff will become demotivated.
Measurement of results and outcomes is usually easy to perform but suffers from the problem that it does not
take into account the differing external factors that may have occurred. It may also lead to measure fixation
among staff, such as the famous example in call centres, where the performance of call centre staff was measured
based on the number of calls per day. It was quite common for call centre staff to keep this high by simply hanging
up when presented with difficult customers.
Fitzgerald and Moon Building Block
Fitzgerald and Moon have developed an approach to performance measurement in business services that is based
on the three building blocks of dimensions, standards and rewards.
Dimensions
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The dimensions are the goals, i.e. the CSFs for the business and suitable measures must be developed to measure
each performance dimension.
For example:
The table above identifies the dimensions of performance. The first two of these relate to downstream results, the
other four to upstream determinants. For example, a new product innovation will not impact on profit, cash flow
and market share achieved in the past ‐ but a high level of innovation provides an indicator of how profit, cash flow
and market share will move in the future. If innovation is the driver or determinant of future performance, it is a
key success factor.
Standards
The standards set, i.e. the KPIs, should have the following characteristics:
 Ownership: Managers who participate in the setting of standards are more likely to accept and be motivated
by the standards than managers on whom standards are imposed.
 Achievability: An achievable, but challenging, standard is a better motivator than an unachievable one.
 Fairness: When setting standards across an organisation, care should be undertaken to ensure that all
managers have equally challenging standards.
Rewards
To ensure that employees are motivated to meet standards, the standards need to be clear (e.g. the target is to
'achieve four product innovations per year' rather than to simply 'innovate') and linked to controllable factors. The
actual means of motivation may involve performance related pay, a bonus or a promotion.
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Illustration ‐ Fitzgerald and Moon applied to a Washing Machine Manufacturer:
Advantages of the building block model
 All key determinants of success in performance will be measured.
 Targets are set in such a way to engage and motivate staff, i.e. through ownership, achievability and fairness.
Control mechanism for employees
Ouchi developed a model for helping to determine what types of controls are most appropriate for employees in
different situations:
 Personnel controls, also known as clan controls, are based on fostering a sense of solidarity in the people who
work for an organisation. If personnel believe in the objectives that the organisation is trying to achieve, then
they will be motivated to work towards those objectives and will not require detailed supervision or control.
Personnel controls include recruitment of people with the right attitudes, training and job design. These are
closely related to appraisal systems based on inputs.
 Behavioural controls involve observing the employee – for example, the foreman on a production line watches
the employees to ensure that the work is done as prescribed. Such controls are consistent with appraisal
systems that focus on the behaviour of employees.
 Output or result controls focus on measuring some aspect of the work performed. Examples could include
measuring the number of defective products. Appraisal systems based on results or outcomes are examples of
output controls.
The type of control system that is appropriate depends on two variables – the ability to measure output and the
knowledge of the transformation process. Ouchi forms a matrix from these two that helps to determine what
types of control systems are most appropriate for a particular organisation:
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Knowledge of the transformation process is low in situations where there is no obvious way to do a task. Those
performing the task may have to learn on the job, rather than be provided with a detailed instruction manual
showing them how to do it. This may occur in project‐based work where each project brings new tasks and
challenges to the project team.
In manufacturing industries, it is likely that it is easy to measure output, and knowledge of the transformation
process is high – the tasks have been performed many times before. So behavioural or output controls are
appropriate, and appraisal will focus on the behaviour of employees or on results and outcomes.
A situation where the knowledge of the transformation system is imperfect but measurement is easy might be a
sales department. Management may not be aware of the exact processes involved by the sales team and there
may not be one ‘right way’ of making sales but measurement of sales is easy to do, so output controls may be
used. The problem with this approach, however, is that it does not take into account external factors. It may be
difficult to make sales in some markets and thus appraising employees on results alone might be deemed unfair.
The ability to measure output may be difficult in certain activities such as research work. Where people work in
teams, measuring the output of the individuals within the team may be difficult. Some individuals may put in more
effort than others. If knowledge of the transformation process is also low, then the organisation may have to rely
on personnel and clan controls. In such situations, the appraisal process may focus on traits.
Reward schemes for employees and manager
Meaning of reward schemes
A broad definition of reward schemes is provided by Bratton:
‘Reward system refers to all the monetary, non‐monetary and psychological payments that an organisation
provides to its employees in exchange for the work they perform.’
Rewards schemes may include extrinsic and intrinsic rewards. Extrinsic rewards are items such as financial
payments and working conditions that the employee receives as part of the job. Intrinsic rewards relate to
satisfaction that is derived from actually performing the job such as personal fulfilment and a sense of contributing
something to society. Many people who work for charities work for much lower salaries than they might achieve if
they worked for commercial organisations. In doing so, they are exchanging extrinsic rewards for the intrinsic
reward of doing something that they believe is good for society.
Objectives of reward system
The following are among the most important objectives:
1. To support the goals of the organisation by aligning the goals of employees with these.
2. To ensure that the organisation is able to recruit and retain sufficient number of employees with the right
skills.
3. To motivate employees.
4. To align the risk preferences of managers and employees with those of the organisation.
5. To comply with legal regulations.
6. To be ethical.
7. To be affordable and easy to administer.
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Aligning the goal of organisation and employees
The reward scheme should support the organisation’s goals. At the strategic level, the reward scheme must be
consistent with the strategy of the organisation. If a strategy of differentiation is chosen, staff may receive more
generous benefits, and these may be linked to achieving certain skills or achieving pre‐determined targets. In an
organisation that has a strategy of cost leadership, a simple reward scheme offering fairly low wages may be
appropriate as less skilled staff are required, new staff are easy to recruit and need little training, so there is less
incentive to offer generous rewards. The US supermarket group Walmart competes on low cost. It recruits
employees with low skills, and pays low wages. It discourages staff from working overtime, as it wishes to avoid
paying overtime rates.
To recruit and retain sufficient number of employees with right skills
If rewards offered are not competitive, it will be difficult to recruit staff since potential employees can obtain
better rewards from competitors. Existing staff may also be tempted to leave the organisation if they are aware
that their reward system is uncompetitive.
High staff turnover can lead to higher costs of recruitment and training of new staff. Losing existing employees
may also mean that some of the organisation’s accumulated knowledge is lost forever. For many knowledge‐based
organisations, the human capital may be one of the most valuable assets they have. High technology companies
such as Microsoft are companies that trade on knowledge so they offer competitive remuneration to key staff.
To motivate employees
Motivation of employees is clearly an important factor in the overall performance of an organisation.
Organisations would like their employees to work harder and be flexible. The link between reward schemes and
motivation is a complex issue that is hotly debated in both accounting and human resource‐related literature.
A well‐known theory relating to motivation is Maslow’s hierarchy of needs. Maslow stated that people’s wants and
needs follow a hierarchy. Once the needs of one level of the hierarchy are met, the individual will then focus on
achieving the needs of the next level in the hierarchy. The lower levels of the hierarchy are physiological, relating
to the need to survive (e.g. eating and being housed); once these have been met, humans then desire safety,
followed by love and esteem, and finally at the top of the hierarchy is self actualisation or self fulfilment.
Applying Maslow’s hierarchy of needs to reward schemes suggests that very junior staff, earning very low wages
will be motivated by receiving higher monetary rewards, as this will enable them to meet their physiological needs.
As employees become progressively more highly paid, however, monetary rewards become relatively less
important as other needs in the hierarchy, such as job security, ability to achieve one’s potential and feeling of
being needed become more important.
Herzberg argued that increasing rewards only motivates employees temporarily. Once they become de‐motivated
again, it is necessary to ‘recharge their batteries’ with another increase. A far better way to motivate employees is
to ‘install a generator in an employee’ so they can recharge their own batteries. This means that it is essential to
find out what really motivates them. According to Herzberg, it is the intrinsic factors in a job that motivate
employees, such as ‘achievement, recognition for achievement, the work itself, responsibility and growth or
advancement.’ Giving greater responsibility to employees can increase motivation.
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Perhaps the conclusion to be gained from this is that monetary rewards alone are insufficient to motivate
employees. Other factors such as giving greater recognition and greater responsibility may be equally important
such as giving praise at company meetings, promoting staff and involving staff more in decision making.
Aligning the risk preference of managers and employees with those of the organisation
Managers and senior employees make decisions on behalf of the company and acting as agents of the company. It
is desirable that the risk preferences of these employees should match the risk preferences of the organisation and
its stakeholders. One problem with many reward schemes is that managers are too risk averse and do not make
investments that may risk their targets not being met.
The events leading up to the financial crisis of 2008 are a good example of the opposite situation, where the risk
appetites of employees at investment banks did not match the risk appetites of the owners. During this period,
individuals working in the banks were paid large commissions for selling mortgage loans to customers. The
problem was that the employees were selling loans to customers that posed a large risk to the banks, due to their
low credit worthiness.
The problem was confounded by the fact that in many cases, the employees of the banks were paid commissions
on the date that the loan agreements were signed, while the loans lasted for 25 years. In situations where the
borrower defaulted, however, there was no claw back, so the employee would not be required to repay the
commission.
Share options may also create a miss‐match between the risks faced by the organisation and the risks faced by the
holders of the options as the holders benefit if share prices increase but do not bear any losses if the share price
falls.
Complying with legal regulations
Rewards should comply with legal regulations. Typically, employment laws include areas such as minimum pay and
equal pay legislation to ensure that no groups are being prejudiced against. There have been high profile cases of
female investment bankers winning legal cases against their employers because their bonuses were far less than
those paid to male colleagues.
Ethics and rewards
In recent decades there has been a move away from fixed remuneration systems towards reward systems where
at least part of an employee’s rewards are based on performance of the individual and the business as a whole.
Some writers claim that this is unethical for two reasons. First, such systems tend to place increased business risk
onto employees. Second, such systems undermine collective bargaining systems, and reduce the power of unions.
This leads to a situation where collectively employees have less bargaining power.
The size of total remunerations paid to directors of large public companies has also become a hot political issue,
with a perception that the gap between top earners and average earners is becoming larger. In the US, the average
directors of S&P 500 companies earn 200 times more than the average household income in the US. Defenders of
such large differences in pay, point out that this difference has actually declined in recent years. In the year 2000,
directors of S&P 500 companies earned 350 times the average household income. According to some research,
such high packages are justified as they do reflect the performance of those directors.
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Affordable and easy to administer
It is a fact that there is an inherent conflict of interest in the relationship between employer and employee. The
employee’s rewards represent a cost to the employer, which the employer wants to minimise. Clearly whatever
reward scheme is in place, it must be affordable to the employer.
Target setting
Many reward schemes are based on employees achieving pre‐determined targets, so some consideration of target
setting is required.
In Fitzgerald and Moon’s building block’s model, three principles are given when setting standards or targets:
equity, ownership and achievability. Equity in this context means fairness meaning that when setting targets for
the various managers, those targets should be equally challenging. Ownership means that the targets should be
accepted and agreed by those managers for whom they are set. This can usually be achieved by participation.
Finally targets must be achievable otherwise the employees for whom they were set will become demotivated.
Hope and Fraser warn against the use of linking rewards to fixed performance targets as this leads to gaming. In
particular, managers whose rewards depend on fixed targets may be tempted to ‘always negotiate lowest targets
and highest rewards,’ which suggests that management plans will understate the potential that the organisation
can make. ‘Always make the bonus, whatever it takes,’ is another example of gaming suggested by Hope and
Fraser, which suggests that managers may indulge in unethical behaviour such as fraudulent accounting in order to
ensure that targets are met.
Hope and Fraser suggest divorcing the planning process and the target setting process and basing rewards on
relative targets and benchmarks. A relative target might be market share where rather than setting an absolute
target for a sales manager, a market share (%) target is provided. If the market rises, then more is expected in
absolute terms. This adds to controllability, since the sales manager could not be held responsible for a rise (or fall)
in the overall market, which is outside of his control, but would be able to control whether or not he achieves the
expected share of the market.
Types of rewards schemes
Basic pay
Base pay, or basic pay, is the minimum amount that an employee receives for working in an organisation. For
example, the employee may be paid $10 per hour for a minimum of 40 hours per week. The employee will
therefore earn at least $400 per week. This will be paid regardless of how many of those 40 hours the employee is
actually working. A fixed annual salary is also an example of basic pay.
Basic pay may be supplemented by other types of remuneration. A blue collar worker may be paid overtime if he
works more than 40 hours per week, and a manager may receive some form of performance pay in addition to the
base pay.
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Performance related pay
Performance‐related pay is a generic term for reward systems where payments are made based on the
performance, either of the individual (individual performance‐related pay) or a team of employees (group
performance‐related schemes).
In recent decades there has been a move toward performance‐related pay schemes in many organisations. This
has lead to a situation where a higher portion of the employees pay is dependent on performance. This rationale
for performance‐related pay is that it motivates employees to work harder and rewards those who make a greater
contribution to the organisation’s goals. This should lead to efficiency savings. There are many types of
performance‐related pay and the most popular ones are described below:
Piece‐work scheme
Under Piece‐work schemes, a price is paid for each unit of output. Piecework
schemes are the oldest form of performance pay and were used in organisations
such as the textile industries in Great Britain during the industrial revolution. Piece‐
work schemes are appropriate where output can be measured easily in units. They
are typically used for paying freelance creative people. Freelance writers are often
paid based on the number of words.
The benefit of piece‐work schemes is their inherent fairness. The higher the output,
the more the employee (or subcontractor) receives. From the employer’s
perspective, the employer does not have to pay for idle time or inefficiencies.
From the employee’s perspective, such schemes mean that the employee bears
commercial risk if demand for their product falls.
A further disadvantage of piece‐work schemes is that the payment is not based on
the quality of output. However, some sort of quality control is likely and if the
quality is not of a required standard, the employee or subcontractor will not be paid.
Individual performance
related pay scheme
Individual performance‐related pay schemes are where the employee receives
either a bonus or an increase in the base pay on meeting previously agreed
objectives or based on assessment by their manager, or both. They are typically
used for middle managers in private sector organisations and for professional staff.
The advocates of individual performance‐related pay schemes claim that they are an
obvious way to align the objectives of middle managers with the goals of the
organisation. If performance targets set are based on the goals of the organisation,
it appears obvious that making part of the rewards of employees’ contingent on
achieving those targets will mean that employees are motivated to achieve the goals
of the organisation.
Individual performance‐related schemes also have the advantage as compared to
group schemes that the employee has control over the rewards, as they do not
depend on the effort (or lack of) of other members of the team.
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Critics of such schemes point out that the link between rewards and motivation is
far from clear, as discussed above. It is also argued that performance‐related
schemes lead a situation of tunnel vision whereby if something is not measured, and
then rewarded, it won’t get done.
Individual reward schemes may lead to a lack of teamwork and may lead to
variances in pay among individuals, which can lead to ill feeling.
An example of an individual performance‐related pay scheme is one that is operated
by a UK bank. Under the scheme, a bonus pool is allocated to each region based on
the performance of that region. From this pool, individual rewards are made based
on assessment of performance, taking into account the rating on a five‐point scale.
Those with scores of 1 to 3 qualify for a discretionary bonus. The assessment
depends on how much new business the individuals have brought in, or how much
efficiency savings they have generated. The rewards are usually paid in cash,
although senior employees receive a portion as deferred stock.
Group
performance
related pay schemes
Group‐related performance‐related schemes are similar to individual in the aspect
that rewards are paid based on the achievement of targets. However, the targets
are set for a group of employees, such as a particular department, or branch of a
company, rather than for an individual. Since the rewards apply to a group, they are
likely to be based on a pre‐determined quantitative formula, rather than on
assessment of staff.
A bonus pool is calculated based on the performance of the team and this is shared
among the members of the team. Bonuses may be paid up at the end of the year, or
may be deferred and paid at a later date, as this may encourage staff and managers
to take a longer term view, rather than simply focusing on the current year’s bonus.
The advantage claimed for group schemes is that they encourage teamwork. The
disadvantage is that the lazier members of the team benefit from the hard work of
the more dedicated.
Hope and Fraser give the example of a scheme operated by Svenska Handelsbanken,
where each year, a portion of the bank’s profits are paid to a profit sharing pool for
employees, provided that certain conditions are made. The main conditions are that
the Handelsbanken Group must have a higher return on shareholder’s equity than
the average of its peer group. The upper limit of the amount paid into the scheme is
25% of the total dividends paid to shareholders. Employees do not actually receive
anything from the pool until they reach the age of 60, at which point they receive a
pay out based on the number of years that they have worked for the bank. The CEO
of Handlesbanken claimed that employees are not motivated by financial targets,
but by the challenge of beating the competition. The reward scheme is designed to
be a dividend on their intellectual capital.
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Human Resource Aspects of Performance Management
Knowledge
pay
contingent
Commissions
APM ‐ Study Notes
Knowledge contingent pay is where an employee will receive a pay rise or a bonus,
or both, for work‐related learning. An ACCA candidate may receive a higher salary
once he has passed all the knowledge level papers and an even higher salary after
passing all of his exams.
Commissions are a form of remuneration normally used for sales staff. The staff may
receive a low basic pay, but will then receive commission, based on a percentage of
the amount of their sales.
The advantages of commission are that they should motivate sales staff to achieve
higher sales, as their rewards depend on it. This also means that the large part of the
salesman’s salary becomes variable. If sales are low, the organisation will have to
pay less.
Profit‐related pay
The disadvantage of commission is that it may lead to dysfunctional behaviour. Sales
staff may indulge in window dressing, for example, to meet the year’s sales target,
by selling on a ‘sale and return basis’ in the final month of the year, with the
inherent understanding that the goods will be returned in the following month of
next year. They may also lead to short termism, where sales staff ‘never put the
customer above the sales target’ to quote Hope and Fraser.
Profit‐related pay is a type of group performance‐related pay scheme where a part
of the employee’s remuneration is linked to the profits of the organisation. If the
company’s profits hit a pre‐determined threshold, a bonus will be paid to all
members of the scheme. Typically the bonus will be a percentage of the basic pay.
The bonus may be paid during the year in question; for example, quarterly, or it may
be deferred until some later date, such as the retirement of the staff.
Advocates of profit‐related pay argue that it motivates employees to become more
interested in the overall profitability and therefore become more motivated to ‘do
their bit’ to improve it. It may also encourage loyalty in cases where staff may lose
their bonus if leaving the organisation means that they lose the right to it.
The obvious disadvantage with profit‐related pay is that it does not match the
primary objective of commercial organisations, which is to maximise the wealth of
the shareholders. Managers may be motivated to increase profits by taking short‐
term actions that will harm the business in the long run or destroy wealth by
investing in projects that increase the profits of the organisation, but produce a
return that is below the cost of capital of the organisation.
Stock option plans
Profit‐related pay might not be a motivator for junior employees, who may fail to
see the link between their effort and the overall profits of the organisation.
Stock option plans have become very popular since the 1990s when greater
emphasis started to be given to shareholder value. Under stock option plans, staff
receives the right to buy shares in their company at a certain date in the future, at a
price agreed in the present.
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For example, Alpha Co is listed on the stock exchange of Homeland. Today, shares in
Alpha Co are trading at $100 each. The company has just awarded the CEO of Alpha
Co the option to buy 1 million shares for $100 each in exactly ten years time. These
options have no intrinsic value at the granting date.
If the share price rises to say $200 in 10 years time, the CEO could exercise his
option of buying 1 million shares at a price of $100 each. Since the shares would be
worth $200 each by then the CEO would make a gain of $100 per share or $100m in
total.
Stock option plans are most appropriate for the senior management of
organisations as they are the people who have the most influence over its share
price. The rational for using stock option plans is that they align the objectives of the
directors with the objectives of shareholders. If the share price rises, the senior
management benefit because their options increase in value. Thus senior managers
will start to think like investors.
The big weakness of stock option plans is that share prices may depend on external
factors as much as on the performance of the directors. During the bull markets of
the 1990s and 2000s, many companies share prices rose simply because the market
rose.
Another weakness is risk misalignment. Share options reward managers if the share
price goes up. If the share price falls, however, there is no difference in reward
between the share price remaining the same ($100) and falling to ($1) so managers
may be motivated to take extreme risks where the exercise price may not be met.
What shareholders really want is the performance of their company to be better
than the market. One solution to this is to use an indexed exercise price, where the
price at which the director can buy the shares is equal to the current market price,
plus the increase in the stock market index during the period the options are issued
and the exercise date. This means that the share option reflects the controllability
principle more closely as directors would not be rewarded for rises in the stock
market in general.
Pensions scheme
Defined benefit pension schemes used to be a popular form of reward. Under such schemes, the employee pays a
pension to former employees based on their final salary and the number of years that the employee worked for
the organisation. A typical example is that the former employee receives 1/60ths of their final salary for every year
of service. An employee who works for 40 years for the same organisation would therefore receive a pension equal
to 40/60ths of their final salary from the date of retirement to the date of death.
Defined benefit schemes leave organisations with an uncertain, often a large liability, and for this reason, many
organisations have now discontinued such schemes.
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Defined contribution schemes are another form of pension scheme where the employer pays a certain percentage
of the employee’s salary into an account for the employee which is called a pension ‘pot.’ The employee may also
have the option of making additional voluntary contributions into this pension pot. The pension pot is then
invested, and the employee receives whatever is in their account on retirement.
Many countries offer tax incentives for such pension schemes, such as allowing employees to reduce their taxable
income by the value of contributions made to the schemes.
Benefit in kinds
Benefits in kind (or indirect pay) are paid to employees in addition to their base salary and performance‐related
pay. Benefits in kind include items such as health insurance and meal vouchers. They are usually provided to more
junior staff in order to provide additional incentives at a lower cost. They are often used as a form of recognition,
so the employee of the month for example will be given a benefit rather than a cash payment.
The advantage of benefits in kind is that greater flexibility can be given in designing a reward scheme for an
individual.
‘Cafeteria’ schemes have also become popular, whereby employees are told that they may select benefits from a
menu up to a certain value. The advantage of this is that employees will select the benefits that they value most.
Benefits from which the employees can choose typically include such items as health insurance, holiday vouchers,
company cars or sports vouchers.
Cafeteria schemes may be difficult to administer. Staff may also find them complex to understand, as they will
have to select a number of benefits that have a value that is within the agreed limit.
Establishing the level of benefiting
How much should employees be paid? Two factors need to be taken into account here; competitiveness and
internal equity.
Unless the level of pay is competitive, it will be difficult to recruit and retain the right number of skilled employees.
If it is too much, the cost to the organisation will be too high. Here the organisation will compare its pay levels with
competitors. Such information may be available from job adverts in newspapers, the Internet or from recruitment
consultants.
Internal equity relates to the pay differentials within the organisation itself. Staff will become demotivated if they
feel that the remuneration system is ‘unfair’ and that other people are being paid more generously. Job evaluation
techniques are used that try to determine the value of a specific job to the organisation. Based on this, the level of
rewards for that particular position will be determined.
Role of appraisal in rewards system
Many of the performance‐related reward schemes depend on the performance of the employees. As such, the
employees’ performance has to be assessed. This usually takes place during the appraisal process. Staff will be
assessed on a regular basis, for example twice a year. During the appraisal, targets will be set for the next period,
and rewards agreed if the targets are met.
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Specific behavioural problems
Tunnel vision
Undue focus on performance measures to the detriment of other areas (‘What you
measure you change’)
Sub‐optimisation
Ceasing effort when acceptable performance is achieved (e.g. when budgeted sales have
been achieved), even though better performance might be achievable.
Focusing on the short‐term which results in the ignoring of the long‐term
Behaviour and activities to achieve specific performance measure that may not be
effective. For example, measuring behaviour or results that are not important
Using creative reporting to suggest that performance measures have been achieved
Behaviour designed to achieve some strategic advantage. For example, not passing on
sales leads to a colleague so that your sales are comparatively higher.
The unwillingness to change a performance measure scheme once it has been set up.
Myopia
Measure fixation
Misrepresentation
Gaming
Ossification
Suggested ways of addressing the problems
 Involve staff at all levels in the development and implementation of the scheme
 Be flexible in the use of performance measures
 Keep the performance measurement system under constant review
Management style
Hopwood identified three distinct management styles.
Style
Budget‐constrained
Content
Meeting budget
Profit‐conscious
General effectiveness
Non‐accounting
Budgets not important
factors considered)
(other
Effect
 High tension
 High manipulation
 Poor staff relations
 Medium tension
 Little manipulation
 Good staff relations
 Medium tension
 Little manipulation
 Good staff relations
Hopwood believed that the profit‐conscious style was often optimal, but appreciated that style could be
contingent on the organisation and activity undertaken.
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Balanced Scorecard & Performance Issues
APM ‐ Study Notes
BALANCED SCORECARD & PERFORMANCE ISSUES
Learning Objectives







Apply and evaluate the ‘balanced scorecard’ approach as a way in which to improve the range and linkage
between performance measures
Apply and evaluate the ‘performance pyramid’ as a way in which to link strategy, operations and
performance
Apply and evaluate the work of Fitzgerald and Moon that considers performance measurement in business
services using building blocks for dimensions, standards and rewards.
Discuss and evaluate the application of activity‐based management.
Evaluate and apply the value‐based management approaches to performance management
Discuss the problems encountered in planning, controlling and measuring performance levels, e.g.
productivity, profitability, quality and service levels, in complex business structures.
Discuss the impact on performance management of the use of business models involving strategic alliances,
joint ventures and complex supply chain structures.
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Introduction
In the previous two chapters we were looking at measures of financial performance. However, as we stated, it is
important to have a range of performance measures considering non‐financial as well as financial matters.
In general, financial performance is easy to measure (earning per share, profit, dividends, EVA etc.) but these
measurements do not tell managers why financial performance has improved. For example, sales might have
increased either because prices have been lowered or the company has spent money developing a new, innovative
product. In this chapter we will consider the various areas where performance measures are likely to be needed.
Although we might all like to think that customer service is a foundation for company success, it is not necessarily
so. Some low‐cost airlines have been very successful despite giving poor customer service. Good customer service
and other non‐financial qualities are not ends in themselves. They become important in profit seeking
organisations only if they enable financial success.
WHAT IS THE BALANCED SCORECARD APPROACH?
The balanced scorecard approach is an approach to measuring performance in relation to long‐term objectives.
This approach to target setting and performance measurement was developed by Kaplan and Norton in the 1990s.
The most important objective for business entities is a financial objective, but to achieve long‐term financial
objectives, it is important to achieve goals or targets that are nonfinancial in nature as well as financial
The reason for having a balanced scorecard is that by setting targets for several key factors, managers will take a
more balanced and long‐term view about what they should be trying to achieve. A balanced scorecard approach
should remove the emphasis on financial targets and short‐term results.
In a balanced scorecard, critical success factors are identified for four aspects of performance, also known as four
‘perspectives’:
 Customer perspective
 Internal perspective
 Innovation and learning perspective
 Financial perspective.
Perspective
Customer
perspective
Internal
perspective
Innovation
learning
and
The key question
What do customers value? By recognising what customers value most from the
organisation, it can focus performance on satisfying the customer more effectively. Targets
might be developed for performance such as cost (value for money), quality or place of
delivery. Having established targets for performance, actual achievements should be
monitored. Actual performance will help to answer another key question: How do
customers see the organisation?
What must the organisation excel at? To achieve it’s financial and customer objectives,
what processes must the organisation perform with excellence? Management should
identify the key aspects of operational performance and seek to achieve or maintain
excellence in this area. Targets should be established and compared with actual
performance.
How can the organisation continue to improve and create value? The focus here is on the
ability of the organisation to maintain its competitive position, through the skills and
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perspective
knowledge of its work force and through developing new products and services.
Financial
perspective
How does the organisation create value for its owners? Financial measures of performance
in a balanced scorecard system might include share price growth, profitability and return
on investment. Financial performance is likely to be the main perspective that shareholders
will use to assess how well the business has performed.
Using the balanced scorecard
The focus is on strategic objectives and the critical success factors necessary for achieving them. In a balanced
scorecard approach, targets are set for a range of critical financial and non‐financial areas covering these four
perspectives. The main performance report for management each month is a balanced scorecard report, not
budgetary control reports and variance reports.
Examples of measures of performance for each of the four perspectives are as follows:
Perspective
Possible measures
Critical financial measures
 Return on investment
 Profitability
 Economic value added (EVA)
 Revenue growth
 Productivity and cost control
 Cash flow
Critical customer measures
 Market share
 Customer profitability
 Attracting new customers
 Retaining existing customers
 Customer satisfaction
 On‐time delivery
Critical internal measures
 Success rate in winning contract orders
 Production cycle time/throughput time
 Amount of re‐working of defective units
 Capacity utilisation of a key resource
Critical innovation and learning measures
 Revenue per employee
 Employee productivity
 Percentage of total revenue earned from sales of new
products
 Time to develop new products
 Number of new products developed to market launch stage
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Example
Kaplan and Norton described the example of Mobil in the early 1990s, in their book The Strategy‐focused
Organisation. Mobil, a major supplier of petrol, was competing with other suppliers on the basis of price and the
location of petrol stations. Its strategic focus was on cost reduction and productivity, but its return on capital
was low.
The company’s management re‐assessed their strategy, with the aim of increasing market share and obtaining
stronger brand recognition of the Mobil brand name. They decided that the company needed to attract high‐
spending customers who would buy other goods from the petrol station stores, in addition to petrol.
As its high‐level financial objective, the company set a target of increasing return on capital employed from its
current level of about 6% to 12% within three years.
 From a financial perspective, it identified key success factors as productivity and sales growth. Targets were
set for productivity (reducing operating costs per gallon of petrol sold) and ‘asset intensity’ (ratio of
operational cash flow to assets employed).
 From a customer perspective, Mobil carried out market research into who its customers were and what
factors influenced their buying decisions. Targets were set for providing petrol to customers in a way that
would satisfy the customer and differentiate Mobil’s products from rival petrol suppliers. Key issues were
found to be having petrol stations that were clean and safe, offering a good quality branded product and a
trusted brand. Targets were set for cleanliness and safety, speedy service at petrol stations, helpful
customer service and rewarding customer loyalty.
 From an internal perspective, Mobil set targets for improving the delivery of its products and services to
customers, and making sure that customers could always buy the petrol and other products that they
wanted, whenever they visited a Mobil station.
Main benefits of using the balanced scorecard include:
 Forcing managers to look at internal and external issues.
 Focusing on key elements of a company’s strategy.
 Linking non‐financial results with financial ones. For example highlighting the impact on customers if cheaper
materials are used).
Major drawbacks of using the balanced scorecard include:
 Improving in some areas will probably lead to deterioration in others.
 It may be hard to come up with measures in all areas.
 It may lead to too many things being measured.
 There may be too many measures to interpret easily.
The performance pyramid
Another approach to structuring the performance evaluation system is the performance pyramid. The concept of a
performance pyramid is based on the idea that an organisation operates at different levels. Each level has different
concerns, but these should support each other in achieving the overall business objectives.
Performance can therefore be seen as a pyramid structure, with a large number of operational performance
targets supporting higher‐level targets, leading to targets for the achievement of overall corporate objectives at
the top.
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The pyramid structure: linking performance targets throughout an organisation
The performance pyramid was developed by Lynch and Cross (1991). They argued that traditional performance
measurement systems were not as effective as they should be, because they had a narrow financial focus –
concentrating on measures such as return on capital employed, profitability, cash flow and so on. They argued that
in a dynamic business environment, achieving strategic business objectives depends on good performance with
regard to:
 Customer satisfaction (a ‘marketing’ objective: here, the focus is on external/market effectiveness)
 Flexibility (the flexibility objective relates to both external effectiveness and internal efficiency within the
organisation)
 Productivity (resource utilisation: here, the focus is on internal efficiency, much of which can be measured by
financial performance)
These key ‘driving forces’ can be monitored at the operational level with performance measures relating to quality,
delivery, cycle time and waste.
Lynch and Cross argued that within an organisation, there are different levels of management and each has its own
focus. However, there must be consistency between performance measurements at each management level, so
that performance measures at the operational level support the corporate strategy.
They presented these ideas in the form of a pyramid of targets and performance that links operations to corporate
strategy.
A performance pyramid can be presented as follows:
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Interpreting the pyramid
The performance pyramid links strategic objectives with operational targets and internally‐focused with externally‐
focused objectives.
 Objectives and targets are set from the top level (corporate vision) down to the operational level.
Performance is measured from an operational level upwards. If performance targets are achieved at the
operational level, targets should be achieved at the operating systems level. Achieving targets for operating
systems should help to ensure the achievement of marketing and financial strategy objectives, which in turn
should enable the organisation to achieve its corporate objectives.
 A key level of performance measurement is at the operating systems level which involves achieving targets for
customer satisfaction, flexibility and productivity. To achieve performance targets at this level, operational
targets must be achieved for quality, delivery, cycle time and waste.
 With the exception of flexibility, which has both an internal and an external aspect, performance measures
within the pyramid (and below the corporate vision level) can be divided between:
o Market measures, or measures of external effectiveness, and
o Financial measures or measures of internal efficiency.
 The measures of performance are inter‐related, both at the same level within the pyramid and vertically,
between different levels in the pyramid. For example:
o New product development in a business operating system. When a new product is introduced to the
market, success depends on meeting customer needs (customer satisfaction), adapting to customer
attitudes and production systems in order to make the changes (flexibility) and delivering the product to
the customer at the lowest cost for the required quality (productivity).
o Achieving improvements in productivity depends on reducing the cycle time (from order to delivery) or
reducing waste.
Lynch and Cross argued that the performance measures that are chosen should link operations to strategic goals.
 All operational departments need to be aware of how they are contributing to the achievement of strategic
goals.
 Performance measures should be a combination of financial and non‐financial measures that are of practical
value to managers. Reliable information about performance should be readily available to managers whenever
it is needed.
Performance measurement in service industries
The characteristics of services and service industries
Many organisations provide services rather than products. There are many examples of service industries: hotels,
entertainment, holiday and travel industries, professional services, banking, recruitment services, cleaning services
etc.
Performance measurement for services may differ from performance measurement in manufacturing in several
ways:
Feature
Explanation
Simultaneity
When providing the service (‘production’) and receiving the service (‘consumption’ by the
customer) happen at the same time. With production, the product is sold to the customer
after it has been manufactured.
Perishability
It is impossible to store a service for future consumption. Unlike manufacturing and
retailing, there is no stock or inventory of unused services. The service must be provided
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Heterogeneity
Intangibility
APM ‐ Study Notes
when the customer wants it.
A product can be made to a standard specification. With a service provided by humans,
there is variability in the standard of performance. Each provision of the service is different.
For example, even if they perform the same songs at several concerts, the performance of a
rock band at a series of concerts will be different each time. Similarly, a call centre operator
answering telephone calls from customers will be unable to deal with each call in exactly the
same way.
With a service, there are many intangible elements of service that the customer is given, and
that individual customers might value. For example, a high quality of service in a restaurant
is often intangible, but noticed and valued by the customer.
Fitzgerald and moon building blocks model
Fitzgerald and Moon (1996) suggested that a performance management system in a service organisation can be
analysed as a combination of three building blocks:
 Dimensions
 Standards, and
 Rewards.
These are shown in the following diagram.
Building blocks for performance measurement systems (Fitzgerald and Moon 1996)
Dimension






Financial performance
Competitive performance
Quality
Flexibility
Resource utilization
Innovation
Standards



Ownership
Achievability
Equity
Rewards



Clarity
Motivation
Controllability
Dimensions of performance
Dimensions of performance are the aspects of performance that are measured. A critical question is: What are the
dimensions of performance that should be measured in order to assess performance?
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Research by Fitzgerald and others (1993) and by Fitzgerald and Moon (1996) concluded that there are six aspects
to performance measurement that link performance to corporate strategy.
These are:
 Profit (financial performance)
 Competitiveness
 Quality
 Resource utilisation
 Flexibility
 Innovation.
Some performance measures that might be used for each dimension are set out in the following table:
Performance area
Financial performance
Competitive performance
Quality
Flexibility
Resource utilization
Innovation
Possible measures
 Profitability
 Sales growth
 ROI
 Cash flow/liquidity
 EVA
 Sales growth
 Proportion of contracts won
 Customer assessment/feedback
 Market share
 Rejects/reworks
 Customer complaints/feedback
 Claims for compensation
 Peer review assessments
 Spare capacity
 Time order to delivery
 Set‐up time
 % of work declined
 Idle time
 Non‐chargeable time
 Machine utilization
 Wastage
 New products brought to market
 Patents files
 R&D spend
The dimensions of performance should also distinguish between:
 ‘Results’ of actions taken in the past, and
 ‘Determinants’ of future performance.
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Performance: results of past actions
Some dimensions of performance measure the results of decisions that were taken in the past that have now had
an effect. Fitzgerald and Moon suggested that results of past actions are measured by:
 Financial performance and
 Competitiveness.
Determinants of future performance
Other dimensions of performance will not have an immediate effect nor do they measure the effects of decisions
taken in the past. Instead they measure progress towards achieving strategic objectives in the future. The ‘drivers’
or ‘determinants’ of future performance are:
 Quality
 Flexibility
 Resource Utilisation
 Innovation.
Measuring performance in these dimensions ‘is an attempt to address the short‐termism criticism frequently
leveled at financially‐focused reports’ (Fitzgerald). This is because they recognise that by achieving targets now,
future performance will benefit. Improvements in quality might not affect profitability in the current financial
period, but if these quality improvements are valued by customers, this will affect profits in the future.
Standards
The second part of the framework for performance measurement suggested by Fitzgerald and Moon relates to
setting expected standards of performance, once the dimensions of performance have been selected.
There are three aspects to setting standards of performance:
 To what extent do individuals feel that they own the standards that will be used to assess their performance?
Do they accept the standards as their own or do they feel that the standards have been imposed on them by
senior management?
 Do the individuals held responsible for achieving the standards of performance consider that these standards
are achievable, or not?
 Are the standards fair (‘equitable’) for all managers in all business units of the entity?
It is recognised that individuals should ‘own’ the standards that will be used to assess their performance, and
managers are more likely to own the standards when they have been involved in the process of setting the
standards.
It has also been argued that if an individual accepts or ‘owns’ the standards of performance, better performance
will be achieved when the standard is more demanding and difficult to achieve than when the standard is easy to
achieve. This means that the standards of performance that are likely to motivate individuals are standards that
will not be achieved successfully all the time. Budget targets should therefore be challenging, but not impossible to
achieve.
Finding a balance between standards that the company thinks are achievable and standards that the individual
thinks are achievable can be a source of conflict between senior management and their subordinates.
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Standards should also be fair for everyone in all business units and should not be easier to achieve for some
managers than others. To achieve fairness or equity, it is often necessary to assess performance by relying on
subjective judgement rather than objective financial measurements.
Rewards
The third aspect of the performance measurement framework of Fitzgerald and Moon is rewards. This refers to the
structure of the rewards system and how individuals will be rewarded for the successful achievement of
performance targets.
One of the main roles of a performance measurement system should be to ensure that strategic objectives are
achieved successfully, by linking operational performance with strategic objectives.
According to Fitzgerald, there are three aspects to consider in the reward system.
 The system of setting performance targets and rewarding individuals for achieving those targets must be clear
to everyone involved. Provided that managers accept their performance targets, motivation to achieve the
targets will be greater when the targets are clear (and when the managers have participated in the target‐
setting process).

Employees may be motivated to work harder to achieve performance targets when they are rewarded for
successful achievements, for example with the payment of a bonus.

Individuals should only be held responsible for aspects of financial performance that they can control. This is a
basic principle of responsibility accounting. A common problem, however, is that some costs are incurred for
the benefit of several divisions or departments of the organisation. The costs of these shared services have to
be allocated between the divisions or departments that use them. The principle that costs should be
controllable therefore means that the allocation of shared costs between divisions must be fair. In practice,
arguments between divisional managers often arise because of disagreements as to how the shared costs
should be shared.
Value based management
Management decisions designed to lead to higher profits do not necessarily create value for shareholders. Often
long term value is sacrificed to meet short term profit targets. VBM starts with the view that companies only
create value when they create returns in excess of their cost of capital.
There are four essential management processes involved in the implementation of VBM
Step 1
Step 2
A company or business unit develops a strategy to maximise value. Critical success factors are
identified.
This strategy translates into short‐term and long‐term performance targets defined in terms of the
key value drivers.
These targets are likely to involve a structured mix of financial and non‐financial KPIs (e.g. balanced
scorecard, performance pyramid, building blocks models).
A key financial measure is likely to be EVA® (because this embeds the WACC into the performance
measure).
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Balanced Scorecard & Performance Issues
Step 3
Step 4
APM ‐ Study Notes
Plans are drawn up to define the steps that will be taken to achieve these targets.
Finally performance metrics and incentive systems are cascaded through the organisation that are
compatible with these targets.
Complex Business Structures and Performance Issues
This is an article from ACCA GLOBAL website.
Businesses increasingly rely on relationships with external partners to perform critical business processes.
Relationships such as outsourcing and collaboration allow business processes to be performed better or more cost
effectively, or without the need for investment in expensive production capacity. Various terms have been used to
describe the complex relationships that have developed, such as virtual organisations, hollow organisation and
network organisations.
In Virtual Organisations and Beyond (1), Hedberg, Dahlgren, Hansson and Olve describe how the Swedish clothes
retailer GANT operates. The centre of operations is a Swedish company, Pyramid Sportswear AB, which has eight
employees. Pyramid Sportswear owns the rights to use the brand name, selects the designers, performs quality
control of production, arranges advertising, and organises the shipping of clothes from the factories to the
retailers. Design and production of the clothes are outsourced, and the clothes are sold through independent
retailers. To the customer it appears that there is one organisation, the GANT Company, which performs all these
activities but in reality no such organisation exists. This group of independent companies, working together,
coordinated by Pyramid Sportswear is described as an ‘imaginary organisation’ by Hedberg et al although the term
‘hollow organisation’ has been used by others to describe similar arrangements. Pyramid Sportswear is the core of
this imaginary organisation, and it coordinates the other organisations; the partners.
A virtual organisation is one that has little or no physical premises, but where employees and managers work
remotely (typically from home) and are connected using IT, such as emails, video conferencing, extranet and
intranets. The organisation appears to the outside world to be just like any traditional style organisation.
Customers and suppliers are linked using IT systems which adds to the impression that they are all part of
the organisation. The classic example is Amazon, the online retailer. Most orders placed on Amazon’s web site are
forwarded to suppliers, who then send the goods directly to the customer.
Collaboration is also an important element in many business chains. Organisations such as Apple rely on a network
of independent programmers who develop apps for their products. While these programmers work independently,
they rely on Apple sharing technical information with them about its operating systems, and through Apple’s
developer conference, they become part of the Apple family.
For the rest of this article, all these different arrangements will be referred to as complex business structures. They
include a core enterprise (such as Pyramid Sportswear) that coordinates the activities of the partners in the
structure.
Performance Management
In complex business structures the core enterprise needs to manage the performance not only of its own activities,
but also those of the partners to some extent. The obvious problem is that the core enterprise does not usually
own the partners, so has no legal right to try to manage them. Performance management issues must therefore be
agreed with each partner as part of the terms of business.
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Typically a contract or service level agreement will specify what activities are expected of each partner, what the
minimum standards are in terms of quality, and the price that will be paid. These agreements may also describe
reporting requirements, whereby partners are required to report their own performance using agreed metrics,
such as % of late deliveries, and number of customer complaints. There may also be fines for repeated failure to
achieve some of the standards.
Planning
In traditional organisations, planning and control is based on the budget. The process of preparing the budget
requires the different parts of the organisation to coordinate their activities for the following year, and this
requires some central coordination. Budgets also aim to ensure that costs of production are controlled. At the end
of each accounting period, actual results are compared with budgets and action taken to remedy any significant
variances.
In a complex business structure, the core organisation does not need to have a detailed analysis of costs incurred
by the business partners. From a financial point of view, the core is only interested the prices that partners will
charge, and these will already have been agreed in the service level agreement. The core does need to be sure that
suppliers will have the capacity to meet its demand on time, even though it may not be possible to specify how
much that demand will be at the start of the year. Some type of planning will therefore be required to ensure that
all parts of the structure have the flexibility and capacity to meet the potential demand from the
core organisation.
Control
The core is mainly interested in non‐financial aspects of the performance of the partners. Quality of goods or
services are obvious areas. Other aspects may include delivery times, quality of customer service and
ethical behaviour. Several large multinational companies have had their reputations damaged by the behaviour of
partners in third world countries who employ child labour for example, or operate sweat shop style operations
where employees are paid subsistence wages, and made to work long hours. Poor ethical behaviour of such
partners can harm the reputation of the whole structure.
Expected standards must be specified in service level agreements. If a partner is required to fulfil sales orders to
customers for example, there may be requirements about the minimum period within which such orders must be
completed. The service level agreement may also require compliance with a corporate code of ethics. Partners will
be expected to provide performance reports showing appropriate measures of performance and must allow
inspections and audits to be performed by the core organisation.
Monitoring the workforce
Where the structure makes use of freelance workers and employees who work from home, traditional methods of
control over the work force become less useful. It is not possible to clock employees in each morning when they
work from home, for example, and they cannot be watched to ensure that they are working diligently. One
solution is to simply pay by results. Remuneration may be based on quantitative measures of the output such as
number of customer queries dealt with. Trust is likely to be a key factor in any such relationship, and the use of
cultural controls, which involves employing people who are self‐motivated.
Information technology can also be used to keep tabs on employees. System logs can record what time employees
log onto and off the system, although there is of course no guarantee that they are being productive all of the time
they are logged in.
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Performance management problems
While performance measures and expected targets will be specified in the service level agreements, there can still
be disagreements when things go wrong. Disagreements can arise about the value of metrics calculated. In the
exam question Callisto Retail (June 2012 – see 'Related links'), there was disagreement about the amount of days
inventory held by one of the wholesalers, and this required detailed reconciliation to be performed. Disagreement
may also arise over who is to blame when things go wrong. If customers are not happy about the service they
receive, there could be a number of partners who are potentially to blame.
Confidentiality of information becomes a risk, due to the fact that the core organisation is sharing key information
with its partners. This may include commercially sensitive information such as production methods, or names and
addresses of customers. Procedures need to be in place to ensure that such information is secure. This would
include requirements relating to the security surrounding the information systems.
Motivation can also be an issue. Where all business processes are carried out in house, it can be easier to motivate
employees using reward systems. Where the processes are carried out by an outside partner, it may not be so easy
to motivate them. It is essential therefore that all partners share the same objectives and understand how they
contribute to the success of the whole organisation. In some relationships, there is an element of profit share or
bonus paid to the partners to motivate them to perform well.
Role of IT
Information systems often play a crucial role in complex business structures. The core organisation may invest in
the development of an information system that it requires all partners to use. This can mitigate many of the
challenges relating to performance management discussed above. Its role in monitoring the work of employees
has already been noted above. Having one system used by all partners means that everyone is using the same
data. There should be less difficulty collecting information about the performance of partners since the
information will all be stored on one system. The core party has greater control over the security of data, and
communication between the parties will be much more fluid allowing greater coordination.
Conclusion
The greater use of business partners to perform crucial business processes may lead to lower costs and
greater specialisation. However, the reliance on external partners can lead to additional challenges for
performance management. These must be considered in drafting of contracts with the partners. The use of shared
IT systems can also assist in many of the challenge
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Corporate Failure
APM ‐ Study Notes
CORPORATE FAILURE
Learning Objectives





Discuss how long‐term survival necessitates consideration of lifecycle issues
Assess the potential likelihood of corporate failure, utilizing quantitative and qualitative performance
measures and models (such as Z‐scores and Argenti)
Assess and critique quantitative and qualitative corporate failure prediction models
Identify and discuss performance improvement strategies that may be adopted in order to prevent
corporate failure
Identify and discuss operational changes to performance management systems required to implement the
performance improvement strategies.
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Corporate Failure
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Introduction
This chapter considers the reasons for companies failing, and various suggestions as to how corporate failure might
be predicted.
Why do companies Fail?
Businesses can fail as a result of wars, recessions, high taxation, high interest rates, excessive regulations,
poor management decisions, insufficient marketing, inability to compete with other similar businesses or a lack of
interest from the public in the business's offerings. Some businesses may choose to shut down prior to an
expected failure. Others may continue to operate until they are forced out by a court order.
General reasons of business failure
 Fail to adapt change
 Lack of experience
 Un‐trusted sales representative
 Insufficient capital
 Poor inventory management
 Over‐investment in fixed assets
 Business's finance mismanagement
 Poor business location
 Poor credit arrangement management
 Unexpected growth
 Engaging in the wrong business niche
 Inability to recover from a major business interruption
 Strategic drift, i.e. Strategy is developed in accordance with unchanged assumption which may have proved
unsuccessful in the past and may drift away from environment fit.
Other symptoms of failure
Many other lists of symptoms of failure exist. For example, there is a list of 65 reasons on the UK Insolvency
website which include:
1. Failure to focus on a specific market because of poor research.
2. Failure to control cash by carrying too much stock, paying suppliers too promptly and allowing customers too
long to pay.
3. Failure to control costs ruthlessly.
4. Failure to adapt products to meet customer needs.
5. Failure to carry out decent market research.
6. Failure to build a team that is compatible and has the skills to finance, produce, sell and market.
7. Failure to pay taxes (insurances and VAT).
8. Failure of businesses’ need to grow. Merely attempting stability or having even less ambitious objectives,
businesses which did not try to grow didn’t survive.
9. Failure to gain new markets.
10. Under‐capitalisation.
11. Cash flow problems.
12. Tougher market conditions.
13. Poor management.
14. Companies diversifying into new, unknown areas without a clue about costs.
15. Company directors spending too much money on frivolous purposes thus using up all available capital.
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Corporate Failure
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Ultimate reason of failure
It has been suggested that the ultimate reason for business failure is poor leadership. According to business guru,
Brian Tracy, ‘Leadership is the most important single factor in determining business success or failure in our
competitive, turbulent, fast‐moving economy.’ Based on a study by the US Bank, the main reasons why businesses
fail are:
 Poor business planning
 Poor financial planning
 Poor marketing
 Poor management.
Proper application of these key factors is a function of good leadership. According to the study, in the business
planning category, 78% of businesses fail due to the lack of a well‐developed business plan. Remember the old
saying: ‘If you fail to plan, you plan to fail.’
Leadership is about planning for success before it happens. Sun Tzu, the 6th century Chinese philosopher, in his
epic work ‘The Art of War’, gave some sound advice that still applies to business today: ‘When your strategy is
deep and far‐reaching, then what you gain by your calculations is much, so you can win before you even fight.
When your strategic thinking is shallow and near‐sighted, then what you gain by your calculations is little, so you
lose before you do battle.’
In the financial planning category, 82% of businesses failed due to poor cash flow management skills, followed
closely by starting with low startup investment. Business leadership is about taking financial responsibility,
conducting sound financial planning and research and understanding the unique financial dynamics of one’s
business. Half of the UK’s small businesses fail within the first three years because of cash flow problems. They
either run out of money or run out of time. Consumer debt, personal bankruptcies and company insolvencies are
all now on the increase.
The third business failure factor profiled in the study, and a critical one, was marketing. Over 64% of the businesses
surveyed in the marketing category failed because their owners ignored the importance of properly promoting
their business and then ignored their competition. Again, as a business leader, you must be able to effectively
communicate your idea to the right people and understand their unique needs and wants. Leadership is all about
taking initiative, taking action, getting things done, and making decisions. If you are not doing anything of
significance to market and promote your business, you are most likely headed for business failure.
You must also know your competition. Leadership is about providing value to customers; if your main competitors
are all providing a better quality at a lower price, how can you possibly create any value? Either you harness your
strengths to provide different benefits (such as speed, convenience or better service), lower your price and
improve quality, create a different product for an unmet demand, or get out of the game.
Finally, one of the most important reasons why businesses fail is due to poor management. In the management
category, 70% of businesses failed due to owners not recognising their failings and not seeking help, followed by
insufficient relevant business experience. Not delegating properly and hiring the wrong people were additional
major contributing factors to business failure in this category.
An interesting, alternative method of classifying reasons for failure is provided by Richardson et al., (1994), who
used the analogy of frogs and tadpoles:
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Corporate Failure
APM ‐ Study Notes
1.
Boiled frog failures
These are long‐established organisations which exhibit the often observed organisational characteristics of
introversion and inertia in the presence of organisational change.
2.
Drowned frog failures
Less to do with management complacency and more to do with managerial ambition and hyperactivity. In the
smaller company context, this is the failed ambitious entrepreneur, whereas in the bigger context this is the
failed conglomerate kingmaker, perhaps typified by Robert Maxwell.
3.
Bull frogs
Expensive show‐offs who need to adorn themselves with the trappings of success. The bullfrog exists on a
continuum from the ‘small firm flash’ to the ‘money messing megalomaniac’. The behaviour of bullfrogs often
raises ethical issues due to a failure to separate business expenditure from personal expenditure (for example,
Conrad Black).
4.
Tadpoles
Tadpoles never develop into frogs and represent the failed business start‐up in the small business setting. In
the large business context, the tadpole is typified by the business which is dragged down by a big new project
which turns out to be such an expensive failure that it destroys its parent. New products and services often
fail, such as the Sinclair home computer. Small tadpoles usually fail to become frogs because of over‐
optimism, a failure to make contingency plans and a lack of interest in overall success as a result of too much
focus on the product.
INDICATIONS OF CORPORATE FAILURE
Poor cash flow
Poor cash flow might render an organisation unable to pay its debts when they fall
due for payment. This might mean that providers of finance might be able to invoke
the terms of a loan covenant and commence legal action against an organisation
which might eventually lead to its winding‐up.
Lack of new
production/service
introduction
Innovation can often be seen to be the difference between ‘life and death’ as new
products and services provide continuity of income streams in an ever‐changing
business environment. A lack of new product/service introduction may arise from a
shortage of funds available for re‐investment. This can lead to organisations
attempting to compete with their competitors with an out of date range of products
and services, the consequences of which will invariably turn out to be disastrous.
General
conditions
Falling demand and increasing interest rates can precipitate the demise of
organisations. Highly geared organisations will suffer as demand falls and the weight
of the interest burden increases. Organisations can find themselves in a vicious circle
as increasing amounts of payable interest are paid from diminishing gross margins
leading to falling profits/increasing losses and negative cash flows. This leads to the
need for further loan finance and even higher interest burden and further diminution
in margins etc
economic
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Corporate Failure
Lack
of
controls
financial
APM ‐ Study Notes
The absence of sound financial controls has proven costly to many organisations. In
extreme circumstances it can lead to outright fraud (e.g. Enron and WorldCom).
Internal rivalry
The extent of internal rivalry that exists within an organisation can prove to be of
critical significance to an organisation as managerial effort is effectively channeled
into increasing the amount of internal conflict that exists to the detriment of the
organisation as a whole. Unfortunately, the adverse consequences of internal rivalry
remain latent until it is too late to readdress them.
Loss of key personnel
In certain types of organisations, the loss of key personnel can ‘spell the beginning of
the end’ for an organisation. This is particularly the case where individuals possess
knowledge which can be exploited by direct competitors e.g. sales contacts, product
specifications, product recipes etc.
Corporate failure prediction model
There are two types of corporate failure models: quantitative models, which are based largely on published
financial information; and qualitative models, which are based on an internal assessment of the company
concerned.
Quantitative models
Beaver
Beaver looked at various financial ratios and concluded that the best predictor was the ratio of cash flow to total
debt.
The approach is simple, but suffers as a result because in reality many factors are likely to result in failure and not
just one factor (a univariate approach).
Altman’s Z score
Developed in 1968 by Altman. He researched bankrupt manufacturing companies in the US.
Z score attempts to anticipate strategic and financial failure by examining company financial statements.
Calculating five ratios generates the Z score. These five ratios, once combined were considered to be the best
predictor of failure.
Z score = 1.2x1 + 1.4x2 + 3.3x3 + 0.6x4 + 1.0x5
Factor
X1
X2
X3
X4
X5
Ratios
working capital/total assets
retained earnings/total assets
earnings before interest and tax/total assets
market value of equity/book value of total debt
revenue/total assets
Measure of
Liquidity
Profitability
Solvency
Gearing
Activity
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Corporate Failure
APM ‐ Study Notes
What does the score tell us?
If the score is 3 or above, they are financially sound
Between 1.81 and 2.99, they need further investigation
Below 1.81, they are in danger of bankruptcy
Altman also adapted this quantitative model to allow relative scoring from 0 to 100. A score of 75, for example,
would indicate that 25% of companies have higher Z‐scores than the company under consideration. Relative
measurement over time permits trends to be identified more easily
Weaknesses of the model
(a) Based on a sample.
(b) Requires a market value for equity which limits its use to quoted companies.
(c) Based on visible factors, so fails to include post balance sheet events, creative or fraudulent accounting or
internal weakness which is not apparent in financial information.
Example
ABC is a manufacturer of fancy dress costumes. It has expanded rapidly in the last few years under the
leadership of its autocratic chairman and chief executive officer, Sally Maysmith.
The company has developed a major new product range linked to the relaunch of a major film franchise, which
has necessitated a large investment in new equipment. However, the recent share price performance has
caused concern at board level and there has been comment in the financial press about the increased gearing
and the strain that this expansion is putting on the company.
A junior analyst in the company has correctly prepared a spreadsheet calculating the Z‐scores as follows
20X8
20X9
20Y0
X1 WC/TA
–0.28
–0.25
–0.20
X2 RE/TA
0.12
0.21
0.21
X3 PBIT/TA
0.16
0.09
0.05
X4 MVE/Total long‐term debt
1.62
0.95
0.60
X5 revenue/TA
1.50
0.72
0.84
Z
2.832
1.581
1.419
Required
Comment on the results in the junior analyst's spreadsheet.
Solution
The Z‐score for ABC in 20Y0 is 1 .41 9 which is below the danger level of 1.8 and suggests a likelihood of
insolvency in the next two years. It has fallen over the past three years between 2.832 and 1.419.
During this period the variables making up the model have been mostly static or declining. Roughly half the
decline in the Z‐score arises from variable X4 which has fallen from 1.62 to 0.60 or 63%. This represents the
market value of equity to total long term debt. This is due to the increase in gearing and may also be due to
recent falls in the share price.
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Corporate Failure
APM ‐ Study Notes
The other variable that has seen most decline is variable X3 (PBIT/TA) falling from 0.16 to 0.05 which is likely to
reflect a sharp fall in profits and an increase in total assets. The company has failed to extract profit from
available assets. Maybe this will improve in future periods as revenue from the new investments is earned.
It is likely at the early stage of the project that costs will be high and revenues low. So a longer‐term view needs
to be taken before concluding the company is definitely failing.
Qualitative Model
Argenti’s A‐score
This category of model rests on the premise that the use of financial measures as sole indicators of organisational
performance is limited. For this reason, qualitative models are based on non‐accounting or qualitative variables.
One of the most notable of these is the A‐score model attributed to Argenti (1976), which suggests that the failure
process follows a predictable sequence:
Defects
Mistakes
Symptoms
Failure
Defects can be divided into management weaknesses and accounting deficiencies as follows:
Management weaknesses:
 Autocratic chief executive (8)
 Failure to separate role of chairman and chief executive (4)
 Passive board of directors (2)
 Lack of balance of skills in management team – financial, legal, marketing, etc (4)
 Weak finance director (2)
 Lack of ‘management in depth’ (1)
 Poor response to change (15).
Accounting deficiencies:
 No budgetary control (3)
 No cash flow plans (3)
 No costing system (3).
Each weakness/deficiency is given a mark or given zero if the problem is not present. The total mark for defects is
45 and Argenti suggests that a mark of 10 or less is satisfactory.
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Corporate Failure
APM ‐ Study Notes
If a company’s management is weak, then Argenti suggests that it will inevitably make mistakes which may not
become evident in the form of symptoms for a long period of time. The failure sequence is assumed to take many
years, possibly five or more. The three main mistakes likely to occur are:
1. High gearing – a company allows gearing to rise to such a level that one unfortunate event can have disastrous
consequences (15)
2. Overtrading – this occurs when a company expands faster than its financing is capable of supporting. The
capital base can become too small and unbalanced (15)
3. The big project – any external/internal project, the failure of which would bring the company down (15).
The suggested pass mark for mistakes is a maximum of 15.
The final stage of the process occurs when the symptoms of failure become visible. Argenti classifies such
symptoms of failure using the following categories:
1. Financial signs – in the A‐score context, these appear only towards the end of the failure process, in the last
two years (4).
2. Creative accounting – optimistic statements are made to the public and figures are altered (inventory valued
higher, depreciation lower, etc). Because of this, the outsider may not recognise any change, and failure, when
it arrives, is therefore very rapid (4).
3. Non‐financial signs – various signs include frozen management salaries, delayed capital expenditure, falling
market share, rising staff turnover (3).
4. Terminal signs – at the end of the failure process, the financial and non‐financial signs become so obvious that
even the casual observer recognises them (1).
The overall pass mark is 25. Companies scoring above this show many of the signs preceding failure and should
therefore cause concern. Even if the score is less than 25, the sub‐score can still be of interest. If, for example, a
score over 10 is recorded in the defects section, this may be a cause for concern, or a high score in the mistakes
section may suggest an incapable management. Usually, companies not at risk have fairly low scores (0–18 being
common), whereas those at risk usually score well above 25 (often 35–70).
The A‐score has therefore attempted to quantify the causes and symptoms associated with failure. Its predictive
value has not been adequately tested, but a misclassification rate of 5% has been suggested. While Argenti’s
model is perhaps the most notable, a large number of non‐accounting or qualitative variables have been included
in other studies. These include:
 Company‐specific variables – such as management experience, customer concentration, dependence on one
or a few suppliers, level of diversification, qualified audit opinions, etc
 General characteristics – such as industry type
 Factors in the external environment – such as the macroeconomic situation, including interest rates, the
business cycle and the availability of credit.
Weaknesses of the model
a) Subjective scores chosen
b) Lack of formal testing to prove the model's validity
c) Lack of PESTEL factors incorporated
d) Lack of industry considerations.
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Corporate Failure
APM ‐ Study Notes
Avoiding failure
One of the more significant earlier works was done by Ross and Kami (1973); they gave ‘Ten Commandments’
which, if broken, could lead to failure:
1. You must have a strategy.
2. You must have controls.
3. The Board must participate.
4. You must avoid one‐man‐rule.
5. There must be management in depth.
6. Keep informed of, and react to, change.
7. The customer is king.
8. Do not misuse computers.
9. Do not manipulate your accounts.
10. Organise to meet employees’ needs.
Performance management system
Company’s performance management system should reflect performance improvement strategies. Company
should develop a link between its goals, critical success factors and key performance indicators. Company should
set performance target at all levels and these targets should be linked to the achievement of strategic objectives
and actual performance should be reviewed against these targets. Company should fulfill the needs of additional
training and development.
Life cycle costing and long term survival
Basic life cycle costing
Introduction:
Life cycle costing aims to cost a product, service, customer or project over its entire lifecycle with the aim of
maximizing the return over the total life while minimizing costs.
Traditionally the costs and revenues of a product are assessed on a financial year or period by period basis.
Product life cycle costing considers all the costs that will be incurred from design to abandonment of a new
product and compares these to the revenues that can be generated from selling this product at different target
prices throughout the product's life.
Product Life cycle: there are 5 stages;
Stages
Cost
 R&D
Development
 Testing cost
stage
 Training cost
 Sampling cost
 Manufacturing cost
 Distribution cost
Introduction
 High Marketing cost
 Inventory
Demand
Revenue
Profit
Nil
Nil
Loss
Low
Revenue
Loss
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Corporate Failure
Growth
Maturity
Decline
APM ‐ Study Notes













Manufacturing cost
Distribution cost
Marketing cost
Inventory
Manufacturing cost
Distribution cost
Inventory
Marketing cost if long life
cycle product.
Manufacturing cost
Distribution cost
Marketing cost
Inventory
Disposal
Growing
Growing
Profit
High
(Maximum)
High
(maximum)
High profits
Decreasing
Decreasing
Low profits
Long‐term survival necessitates consideration of lifecycle issues:
Issue 1: There will be different CSFs at different stages of the life cycle. In order to ensure that performance is
managed effectively KPIs will need to vary over different stages of the life cycle.
Issue 2: The stages of the life cycle have different intrinsic levels of risk:
 The development and introduction periods are clearly a time of high business risk as it is quite possible that
the product will fail. Revenues will be low and expenditure high.
 The risk is still quite high during the growth phase because the ultimate size of the industry is still unknown
and the level of market share that can be gained and retained is also uncertain.
 During the maturity phase the risk decreases. Revenues will be high and total assets will be static or
decreasing.
 The final phase should be regarded as low risk because the organisation knows that the product is in decline
and its strategy should be tailored accordingly. However, costs such as decommissioning costs may be
incurred during this stage.
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Corporate Failure
APM ‐ Study Notes
Understanding and responding to these risks is vital for the future success of the organisation. If there is an
analysis of the developing risk profile, it should be compared with the financial risk profiles of various strategic
options, making it much easier to select appropriate combinations and to highlight unacceptably high or low total
risk combinations. Thus for an organisation to decide to finance itself with debt during the development stage
would represent a high total risk combination.
It will be the scale of financial resources which the organisation calls on over the life of its products which will
dictate its survival.
Page | 247
Question Paper
APM – Study Notes
ACCA PAST PAPER QUESTION 4
Q1.Soup operates passenger rail services in Deeland, a technologically advanced country, with high demand for
fast reliable rail travel from business and leisure passengers. Many passengers choose train travel because they
see it as less harmful to the environment than other forms of transport.
Soup’s main objective is to maximise shareholder wealth. Since becoming licensed to operate routes in Regions A
and B by the Deeland government five years ago, Soup has consistently delivered increased dividends and share
prices
for investors. In its initial appraisal of the licensing opportunity, Soup expected to operate the routes for
at least
15 years, however, their licence may not be renewed when it expires in three years’ time. The
government has warned Soup it ‘is unhappy about high returns to shareholders while there are many reports of poor
passenger service, overcrowded trains and unreliable services on certain routes and at busy times’.
Soup owns its fleet of diesel powered trains. Each train in Region A has seven coaches with 70 passenger seats
available per coach. In the less busy Region B, each train has six coaches each with 70 seats. As a condition of the
licence, Soup runs a set number of services at both busy and quieter times in both regions. Soup has two larger rivals,
both operating electric trains, which cause less harm to the environment than diesel powered trains. They run on
the same routes in both regions.
The government regulates fares charged to passengers, which are the same per distance travelled for every operator
in that region. The railway track, stations and other infrastructure are managed by the government which charges
the operators a fee. There are several stations along the route which are only used by Soup trains and others where
Soup trains do not stop at all.
Soup’s trains are 25 years old, originally purchased cheaply from an operator whose licence was withdrawn by the
government. Soup believes the low price it paid is a key competitive advantage enabling them to steadily increase
their return on capital employed, the company’s main performance measure, to a level well in excess of their rivals.
The shareholders are pleased with the growth in passenger numbers over the last five years, which is the other
performance measure Soup uses.
Soup’s ageing trains spend increasing time undergoing preventative maintenance, safety checks or repairs. A recent
television documentary also showed apparently poor conditions on board, such as defective heating and washroom
facilities and dirty, torn seating. Passengers complained in the programme of difficulties finding a seat, the
unreliability of accessing wireless internet services and even that the menu in the on‐board cafe had not changed
for five years.
Soup’s CEO responded that unreliable internet access arose from the rapid growth in passengers expecting to access
the internet on trains. She said Soup had never received any formal complaints about the lack of choice in the on‐
board cafe, nor had she heard of a recent press report that Soup’s trains were badly maintained, so causing harm
to the environment.
The CEO has asked you, as chief management accountant, for your advice. ‘In view of the government’s warning, we
must develop performance measures balancing the needs of passengers with the requirements of the shareholders’,
she has said. ‘I don’t want to know how to improve the actual performance of the business; that is the job of the
operational managers, nor do I just want a list of suggested performance measures. Instead I need to know why
these performance measures will help to improve the performance of Soup.’
Page | 248
Question Paper
APM – Study Notes
The following data applies to Soup:
Number of services per day
Peak times
Other times
Number of passengers per day
Peak times
Other times
Region A
Region B
4
6
4
8
2,500
2,450
1,400
1,850
Required:
(a) Advise the CEO on how the use of the balanced scorecard could improve the performance management
system of Soup.
(10 m a r k s )
(b) Using the performance data given, evaluate the comments of the Deeland government that Soups trains are
overcrowded.
(7 marks)
(c) Assess the problems Soup may encounter in selecting and interpreting performance measures when applying
the balanced scorecard to its performance management system.
(8 marks)
(25 marks)
Page | 249
Question Paper
APM – Study Notes
(a) The balanced scorecard consists of four perspectives: customer, internal, innovation and learning and financial.
It requires an organisation to have a number of goals supported by performance measures in each perspective.
The customer perspective measures what it is that customers value from the business; internal looks at what
processes does the organisation need to be successful; innovation and learning considers how future value
can be created and financial measures whether performance is acceptable to investors.
It is useful because it uses both internal and external information to assess performance and measures financial
and non‐financial aspects of a business to ensure long‐term future success, rather than just focusing on historic
results. It can
also be used as a mechanism to link KPIs into the CSFs which are vital to deliver strategy.
Soup currently uses return on capital employed (ROCE) as its key financial performance measure, but this does
not correlate directly with the objective to maximise shareholder wealth and could encourage short‐term
decisions to be taken at the expense of long‐term success. This is the case at Soup which purchased old trains
and subsequently failed to reinvest, meaning that Soup’s ROCE is probably higher than its rivals. However, the
trains are becoming unreliable and their condition is deteriorating. In the long term this will reduce customer
satisfaction and financial performance.
Using the scorecard, Soup should have a broader range of financial measures which encourage managers to
take decisions, such as investment decisions, consistent with the objective to maximise shareholder wealth in
the long term. EVA would be
a suitable measure to help achieve this, and would be preferable to the
current focus on ROCE.
Soup does measure growth in passenger numbers which could be a measure of customer satisfaction. However,
it is a limited, quantitative measure. Though Soup does have rivals and is likely to be required to operate a
specified level of service under the terms of the licence from the government, some passengers may be forced
to travel on Soup trains, rather than those of another operator because of where they live or the times they
need to travel. The number of operators (competitors) is limited by the capacity of the railway infrastructure as
well as by passenger demand. This means that the level of repeat customers may not be appropriate for Soup.
Passenger numbers are also externally focused but again this fails to fully consider the environment in which
Soup operates.
Within the customer perspective Soup could use a range of performance measures. This will be beneficial as
where passengers are able, they are likely to choose to use Soup if they provide a good service. This can be
easily measured by surveying or asking passengers’ opinions. This will give Soup more qualitative information
about their customers and their expectations, which will vary, for example, passengers will have different
perceptions of overcrowding, or what is an acceptable delay. Certain groups may be more affected by
overcrowding like frequent travellers and the elderly. Passengers who are unable to find a seat will probably be
the most dissatisfied, though this will depend on how long their journey is. Other aspects of Soup’s service
may be less valued than reliability and occupancy, like wireless access and the on‐board cafe, but will be
important to certain groups.
Another key element of customer satisfaction will relate to the amount of fare paid. Fares are regulated in
Deeland so the interaction between fares and other aspects of the service is unknown. Many customers while
valuing a particular aspect of the service may be unwilling to pay more for it; some may accept a reduction
in the level of service if fares were reduced.
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Question Paper
APM – Study Notes
This detailed information about customers will allow Soup to focus performance improvements on key areas
using more external data to make decisions.
Measures of the internal processes are likely to be closely linked to customer satisfaction. Soup apparently
neglects this area in its performance management system. The scorecard could be used to help to address
reliability, overcrowding and environmental factors.
Reliability will be highly valued by customers especially those who travel frequently and who rely on rail travel
to get to work. The number of trains arriving late would be a suitable measure of reliability, as would the number
of train services cancelled, though the length of the delay is also critical and should be carefully defined. The
scorecard would allow more detailed measures as some of the factors affecting reliability will be within Soup’s
direct control but others such as failures in the railway infrastructure are controlled by the government. This
is useful information for Soup to effectively assess their controllable performance and feedback as necessary
to external parties.
Seat occupancy, the number of passengers on a train compared to the number of available seats on different
routes and at different times, is a suitable measure of train overcrowding and is important for passenger safety.
To fully utilise its trains and achieve its objective of maximising shareholder wealth, Soup must try and maximise
both the seat occupancy and the amount of time its trains are actually running. These internal measures would
then help to support financial targets.
Soup’s licence to operate rail services in Regions A and B expires in three years’ time, and as with the operator
from whom Soup purchased the trains, it may not be renewed. Soup must balance the needs of shareholders
for short‐term increases in dividends and share price with the long‐term need to renew to its operator’s
licence.
The creation of long‐term future value can be addressed by the innovation and learning perspective. The
immediate scope to innovate the service experienced by the passenger is limited, but there are some quick wins
available in the choice in the on‐board cafe and improving the reliability of the internet access. Also time spent
training staff may improve customer satisfaction and reduce maintenance time. Fundamental innovation like
the use of faster or environmentally less harmful trains requires long‐term planning and large capital
investment. The scorecard will encourage Soup to be forward looking, unlike the present system which is
limited to historic performance.
(b)
To measure the extent of overcrowding, some measure of occupancy is needed. The number of passengers
per available seat can be used as a measure of occupancy.
Seats available per train is 490 (7 coaches x 70 seats) in Region A and 420 (7 coaches x 60 seats) in
Region B.
Page | 251
Question Paper
APM – Study Notes
Total seat occupancy = 82∙5% (8,200/9,940)
Overall occupancy is below 100% which means on average there are more seats available than passengers,
which is not consistent with the government’s claims that the trains are overcrowded. However, these averages
may be misleading as trains running on certain days or at certain times may be relatively overcrowded. This may
generate customer dissatisfaction even on services which are on average not fully occupied. The total number
of passengers without seats would be a better measure.
There are significant variations between regions and times travelled with only the trains in Region A travelling
at peak times being over occupied. This affects only 18% (4/22) of all services.
Most affected by this will be the 28% of the passengers travelling at peak times in Region A who are unable to
obtain a seat. This represents only 9% (28% x 2,500/8,200) of total passengers per day. There is some
overcrowding but the claim that Soup’s trains are overcrowded seems exaggerated given the data provided.
However, certain routes or specific times or sections of the trains may be more affected and more analysis is
needed.
The impact of overcrowding on passengers also depends on journey times, with passengers being less satisfied
by not obtaining a seat on longer journeys rather than on short ones. Assuming trains are available for 14 hours
per day and there are 22 services, each service is on average almost 1∙5 hours which may be a significant length
of time for passengers to
stand on a train.
(c) When applying the balanced scorecard in Soup, the measures need to be chosen carefully. A balance needs to
be struck and only measures which help Soup to achieve its objectives should be chosen. Currently Soup focuses
on short‐term financial measures such as return on capital employed, whereas the balanced scorecard
considers more long‐term measures.
Some measures are more important than others, so prioritising measures will be difficult. Customers may value
some aspects of the service more than others, for example, the choice available in the on‐board cafe is probably
unimportant to most passengers provided they can obtain some food and drink. The punctuality of Soup’s trains
or whether they even run at all is fundamental to achieving customer satisfaction and needs careful
measurement. Soup must have measures for regulatory or safety reasons too.
Some aspects of the business may be harder to measure than others. For example, it may be relatively easy to
measure seat occupancy as a measure of overcrowding, but passengers’ perceptions of overcrowding may differ.
Non‐financial aspects such as customer satisfaction may be subjective and any surveys done may not reflect the
experience of the majority of passengers. Performing and analysing surveys would also be time consuming
and resource intensive.
Measures chosen may conflict. Overcrowding may be unwelcome by passengers but making them less crowded
conflicts with Soup’s presumed objective of fully occupied trains. Time spent maintaining trains to reduce their
impact on the environment or ensure reliability will mean they are not operational for periods of time, though
safety will be a key factor here.
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Question Paper
APM – Study Notes
Care must be taken to avoid overloading with too many performance measures. The current objective to
maximise shareholder wealth is very broad. Having a clearer strategy would enable Soup to determine suitable
performance measures so it is not overloaded with KPIs which do not contribute towards achieving this strategy.
Page | 253
Question Paper
APM – Study Notes
1 Kolmog Hotels is a large, listed chain of branded hotels in Ostland. Its stated mission is: ‘to become the No. 1 hotel
chain in Ostland, building the strength of the Kolmog brand by consistently delighting customers, investing in
employees, delivering innovative products/services and continuously improving performance’. The subsidiary aims
of the company are to maximise shareholder value, create a culture of pride in the brand and strengthen the brand
loyalty of all stakeholders.
The hotels in the Kolmog chain include a diverse range of buildings and locations serving different customer groups
(large conference venues, city centre business hotels and country house hotels for holidays). For reporting purposes,
the company has divided itself into the four geographical regions of Ostland as can be seen in a recent example of
the strategic performance report for the company used by the board for their annual review (see appendix 1). At
the operational level, each hotel manager is given an individual budget for their hotel, prepared in the finance
department, and is judged by performance against budgeted profit.
Kolmog is planning a strategic change to its current business model. The board has decided to sell many of the hotels
in the chain and then rent them back. This is consistent with many other hotel companies who are focusing on the
management of their hotels rather than managing a large, property portfolio of hotels.
In order to assist this strategic change, the chief executive officer (CEO) is considering introducing the balanced
scorecard (BSC) across Kolmog. He has tasked you, as a management accountant in the head office, with reviewing
the preliminary work done on the development of the scorecard in order to ensure that it is consistent with the goal
of meeting the strategic objectives of the company by tying operational and strategic performance measurement
into a coherent framework.
The CEO is worried that the BSC might be perceived within the organisation as a management accounting technique
that has been derived from the manufacturing sector. In order to assess its use at Kolmog, he has asked you to explain
the characteristics that differentiate service businesses from manufacturing ones.
Senior executives at the head office of Kolmog have drawn up a preliminary list of perspectives and metrics as an
outline of the balanced scorecard in table 1:
The history of rewards at Kolmog has not been good, with only 1% of staff receiving their maximum possible bonus
in previous years and 75% of staff receiving no bonus. This has led to many complaints that targets set for the reward
system are too challenging.
Under a new performance reward system, employee targets are to be derived from the above BSC strategic
measures depending on the employee’s area of responsibility. The new system is for hotel managers to be given
challenging targets based on their hotel’s performance against budgeted profit, industry wide staff turnover and the
company’s average customer satisfaction scores. The hotel managers will then get up to 30% of their basic salary as
a bonus, based on their regional manager’s assessment of their performance against these targets. The CEO wants
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you to use Fitzgerald and Moon’s building block model to assess the new system. He is happy with the dimensions
of performance but wants your comments on the standards and rewards being applied here.
Appendix 1
Strategic performance report for review Kolmog Hotels Year to 31 Mar 2013
Revenue
Cost of sales
Gross profit
Staff costs
Other operating costs
hotels
head office
Operating profit
Financing costs
Profit before tax
East
Region
$m
235
28
––––
207
West
Region
$m
244
30
––––
214
North
Region
$m
313
37
––––
276
South
Region
$m
193
21
––––
172
Total
61
65
78
54
258
245
26∙19%
68
70
97
54
289
158
––––
164
270
150
––––
151
29∙34%
16∙04%
73
7∙92%
78
8∙73%
––––
78
––––
––––
79
––––
––––
101
––––
––––
64
$m
985
116
––––
869
78
––––
86
––––
Total
2012
$m
926
110
As % of
revenue
for 2013
11∙78%
816
16∙60%
Growth
Capital employed
EPS
Share price
ROCE
$1,132m
$1∙36
$12∙34
14∙49%
$1,065m
$1∙27
$11∙76
14∙18%
Year on Year
6∙29%
7∙09%
4∙93%
Required:
Write a report to the CEO to:
(i) explain the characteristics that differentiate service businesses from manufacturing ones, using Kolmog to
illustrate your points;
(5 marks)
(ii) evaluate the current strategic performance report and the choice of performance metrics used (Appendix
1);
(8 marks)
(iii) evaluate the outline balanced scorecard (Table 1) at Kolmog, suggesting suitable improvements;
(12 marks)
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(iv) describe the difficulties in implementing and using the balanced scorecard at Kolmog;
(7 marks)
(v) explain the purpose of setting targets which are challenging, and evaluate the standards and rewards for
the hotel managers’ performance reward system as requested by the CEO.
(14 m a r k s )
Professional marks will be awarded for the format, style and structure of the discussion of your answer.
(4 marks)
(50 marks)
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Report
To: CEO
From: A. Accountant
Date: June 2013
Subject: Balanced scorecard and targets at Kolmog Hotels
Introduction
This report explains the differences between service and manufacturing industries and evaluates the current board
performance information. Next, it evaluates the proposed balanced scorecard and describes the difficulties in
implementing and using it. Finally, the purpose of setting challenging targets is explained and the hotel managers’
standards and rewards are evaluated using the building block model.
(i)
Characteristics differentiating service from manufacturing businesses
The service nature of the hotel business can be analysed as:
–
simultaneous in that the service is created as it is consumed during the customer’s stay;
–
heterogeneous (variable) in that it is hard to standardise the service since each hotel and city stayed in
is different;
–
intangible in that there is no physical product, only nights’ stay in the hotel. This is a cause of the low cost
of sales at 12% of revenue;
–
perishable in that hotel nights cannot be stored as they are used that night. Thus, in the hotel industry
room occupancy is often a key performance measure; and
–
there is no transfer of ownership as the guest’s stay only gives them right of access to use the hotel facilities
for a limited period.
(ii) Current strategic performance information
The current information used by the board is purely financial in nature and, as a result, it omits to measure
many of the elements mentioned in the mission. It covers the shareholder value aspects through EPS growth,
share price performance
and ROCE, although there are arguably better measures of shareholder value in
total shareholder return and economic value added. However, it does not quantify customer and employee
loyalty nor product innovation, which are the routes by which the primary mission is to be achieved.
Most strikingly, there is also no attempt to measure the goal of being the No. 1 hotel chain in Ostland. An obvious
way to measure this would be market share but there is no external data given in the report. The use of ratios
comparing to revenue is a helpful communication tool in showing how resources/costs generate sales but,
again, no external comparators are given which would aid in judging competitive position.
The breakdown of results into geographical areas is only helpful if these are comparable. A breakdown of the
results by hotel type may be a more useful management tool, as luxury hotels will use a higher staff to guest
ratio than budget ones and the geographical results will be distorted unless each geographical area has the
same mix of these different product types. Year on year growth figures are given but no inflation figure is
given which might explain growth as a non‐management achievement.
There is limited information on fixed and variable costs in the report which is relevant to Kolmog, as hotels
naturally have high operational gearing since many costs (financing, property, staff and administration) are
fixed and so profit is sensitive to small changes in revenues. There are a number of traditional measures of hotel
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performance that would improve the report by helping to capture this issue, such as occupancy rates and
revenue per available room.
Finally, the report does not link to the budget which appears to be the main operational control tool. Summary
budget figures and variances may aid the board in their role of overseeing performance.
(iii) BSC proposal
Generally, the BSC will aid in communicating, implementing and controlling the strategy of the company. It
aims to help achieve coherence between the stated goals and the measures used at Kolmog.
The proposed scorecard has the advantage of using only a limited number of measures and so should avoid the
danger of information overload. Taking each perspective in turn:
The financial perspective is covered by the measures of strategic financial performance (share price and ROCE).
This fits with the objective of maximising shareholder value. It is also common to use dividend per share as well
as share price to reflect total shareholder return. Return on capital employed is a standard measure of overall
performance but this may now have less value for Kolmog. The change in strategy in no longer owning the
hotels that it operates will reduce the capital dependence of the business. It may be more appropriate to use
a measure such as operational gearing (fixed costs/total costs) that reflects the returns against fixed costs
(especially rental payments). Revenue growth will also be an important measure of the achievement of being
the leading hotel chain in Ostland.
The customer perspective is addressed by the customer survey scores. This addresses the objective of delighting
customers. However, there is no direct attempt to measure the objective of improving brand loyalty. The
customers are a major stakeholder whose loyalty Kolmog will want to improve. Growth in returning customers
(i.e. repeat business) would be better measured, for example, through growth in customer account revenues.
The internal process perspective is addressed through the hotel budget variance analysis. This analysis will need
to be broken down into detailed areas for each hotel. It may be necessary to have different areas of emphasis
depending on the hotel type, for example, country house hotels will have different occupancy levels from city
centre ones due to the seasonality of this trade. Benchmarking performance against these internal comparators
should assist in spreading best practice within the chain. This communication of best practice may help to
instil brand loyalty among employees if they feel that other members of the chain are helping to improve
their own hotel’s performance.
The learning and growth perspective would appear to be an obvious area to address, given the objective on
product innovation. Yet there is no measure given for this. A possible metric would be percentage of revenue
generated from new hotel types or hotel services. Hotels are a fairly mature business and so this may be a
difficult objective to realise.
Instead, the objective of employee loyalty is addressed by measuring staff turnover. The happiness and
motivation of staff is likely to be a key driver of the customer experience and so it has been highly prioritised.
This can be measured through surveys of staff attitudes.
In relation to all the measures proposed, Kolmog should benchmark their performance against their
competitors. This will measure whether they are achieving the ‘No. 1’ status that is the primary objective.
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(iv) Difficulties of implementing and using the BSC
The first difficulty is in selecting the metrics for use in the scorecard. It is important that the BSC does not
become a long list of metrics that obscure the truth with information overload. It is important to measure
what is needed to be measured, not just what can be measured. There is often difficulty with measuring
the innovation and learning perspective and other qualitative/non‐financial areas. There is also the need
to translate the strategic measures down to the operational level, for example, breaking down general
customer satisfaction into specific areas of customer interaction such as reception and room service.
The second difficulty is that some of the perspectives and their metrics will naturally conflict with each
other. For example, reducing employee turnover may require increasing their pay but this will conflict with
profit targets. These conflicts may be required to be resolved at board level by looking at what will achieve
the overall mission of the company.
The third difficulty is that the use of many metrics requires managers to be capable of interpreting each
metric and also handling the volume of metrics presented. This expertise is less common among non‐
financial staff.
The final difficulty is the need for senior management to be committed to use of the BSC, otherwise staff
will fall back on the traditional financial performance measures. The use of the BSC can be emphasised by
tying the individual’s performance appraisal into measures derived from the BSC.
(v)
Hotel manager targets Challenging targets
Target setting is a difficult task. The targets must be challenging enough to push employees, in order to
motivate them to maximum effort, without being perceived to be so improbable to achieve that they
demotivate the employees. The proposal here is to use so‐called stretch targets that aim beyond the
easily achievable but fall short of the improbable.
At Kolmog, there is a history of setting targets that have been too difficult to achieve, so that many
employees will never expect a bonus and so make no effort beyond the minimum acceptable to keep
their job. The new targets will need to be perceived as more difficult but achievable in order to
motivate employees.
Standards
Standards are the measures of employee performance. Employees must take ownership so they need to
participate, accept and be motivated by the targets. Targets must be achievable and so challenge the
manager without being demotivating. They must take account of expected market conditions that will be
beyond the control of the hotel manager. Targets must be fair, for example, different types of hotels
must be measured against similar standards (e.g. city centre hotels v other city centre ones and not
country houses).
Rewards
Rewards must be
–
clear, that is, understood by the managers;
–
motivating, that is, of value to the employee; and
–
controllable, that is, related to their area of responsibility.
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The system proposed at Kolmog suffers from a number of potential problems. The basic measures are
considered acceptable by the CEO but the detailed system conflicts with the building block principles
given above.
–
–
–
–
The performance against budgeted profit may fail to be participative since the finance department
at head office sets the budget. Hotel managers will need to be involved in budget setting.
The use of an industry wide standard for staff turnover would not be fair if staff wages are not
controllable by the manager and set at a level that is not reasonably attractive in the industry. It may
be better to compare staff turnover to the company average (or even the average within the
company’s product range) in order to get a fair comparison between hotel managers.
The use of company average customer satisfaction does not stretch staff to meet competitor
performance. This area is much more in the control of the hotel manager and should be externally
compared in order to generate competitive advantage.
The reward offered is valuable at up to 30% of salary. It would need to be compared to competitor
offerings in order to judge the effect in retaining employees. It may not be clearly understood, as
the precise level is based on the regional manager’s assessment but this should be dealt with by
explanation at the annual appraisal.
The company is already collecting data about the number of staff receiving different levels of bonus and
this should be continued as it represents a way of quantifying the achievability of the targets.
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Q3.
Culam Mining (Culam) is a mineral ore mining business in the country of Teeland. It owns and operates four mines.
A mine takes on average two years to develop before it can produce ore and the revenue from the mine is split
(25:75) between selling the ore under fixed price contracts over five years and selling on the spot market. The bulk
of the business’s production is exported. A mine has an average working life of about 20 years before all the
profitable ore is extracted. It then takes a year to decommission the site and return the land to a useable form for
agriculture or other developments.
Recently, one of Culam’s foreign competitors surprised the market by becoming insolvent as a result of paying too
much to acquire a competitor when the selling price of their minerals dipped as the world economy went into
recession. As a result, the chief executive officer (CEO) wanted to know if this was likely to happen to Culam. She
had read about the Altman Z‐score as a way of predicting corporate failure and had a business analyst prepare a
report calculating the Z‐score for Culam. The report is summarised below:
Analyst’s Report (extract)
The Altman Z‐score model is:
Z = 1∙2X1 + 1∙4X2 + 3∙3X3 + 0∙6X4 + X5
Another quantitative model (Q‐score model) has been produced by academics working at Teeland’s main university
based on recent data from listed companies on the small Teeland stock exchange. It is:
Q = 1∙4X1 + 3∙3X3 + 0∙5X4 + 1∙1X5 + 1∙7X6
Where for both models:
X1 is working capital/total assets;
X2 is retained earnings reserve/total assets;
X3 is profit before interest and tax/total assets;
X4 is market value of equity/total long‐term debt (MVe/total long‐term debt);
X5 is revenue/total assets;
and
X6 is current assets/current liabilities.
Using the most recent figures from Culam’s financial statements (year ending September 2014), Culam’s Altman
Z‐score is 3∙5 and its score from the other model (Q) is 3∙1.
For both models, a score of more than 3 (for Z or Q) is considered safe and at below 1∙8, the company is at risk of
failure in the next two years.
The analyst had done what was asked and calculated the score but had not explained what it meant or what action
should be taken as a result. Therefore, the CEO has turned to you to help her to make sense of this work and for
advice about how to use the information and how Culam should proceed into the future.
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Required:
(a) Evaluate both the result of the analyst’s calculations and the appropriateness of these two models for Culam.
(10 marks)
(b) Explain the potential effects of a mine’s lifecycle on Culam’s Z‐score and the company’s probability of failure.
Note: You should ignore its effect on the Q‐score.
(7 marks)
(c) Give four detailed recommendations to reduce the probability of failure of Culam, providing suitable
justifications for your advice.
(8 marks)
(25 marks)
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The results from both models indicate that Culam is not likely to become insolvent in the next two years. However,
there are good reasons to question the applicability of these models to Culam’s business and so it would be
dangerous to place too much reliance on these results.
A quantitative model such as those presented here identifies financial ratios which significantly differ in value
between surviving and failing companies. Statistical analysis is then used to choose the weightings for these ratios
in a formula for a score which can be used to identify companies which exhibit the features of previously failing
companies. Obviously, the company being analysed must be similar to those being used to build the model for the
results to be relevant.
The Altman Z‐score was originally developed in the late 1960s and was based on data from US companies, primarily
in the manufacturing sector. Therefore, there are three reasons to question the applicability of such data to Culam.
1.
2.
3.
The world economy has changed significantly since Altman’s original work. The data for this model is now nearly
50 years old.
The economy of the USA may not reflect the market in which Culam works.
The mining sector is not like general manufacturing, for example, it is highly capital intensive with long periods
of no revenue generation.
The Q‐score model was based on recent data from Teeland businesses. As for the Z‐score, Culam is not likely to be
appropriately modelled by such data. The problems are:
1.
2.
The Q‐score is based on data for Teeland listed companies and Culam is a mining company with an unusual
pattern of revenue and costs supplying a global market. It is therefore unlikely to be similar to the companies
on the small Teeland exchange, both in its markets and its business model.
If Teeland’s exchange is small, there may not be much data from failing companies on which to base the model.
Neither of the models addresses factors which may have a large impact on Culam’s survival such as world
commodity prices and foreign exchange rates.
(b) The lifecycle issues for Culam relate to the long timescale (23 years) for development and use of a mine and the
uneven cashflows over this lifecycle.
The initial development phase of two years will require large capital investments with no revenue being generated.
There is then a 20‐year revenue‐generating phase followed by a final year of decommissioning costs with no revenue.
This will impact on the Z‐score by making the score very volatile as the mines go through the three phases of their
lives.
–
–
–
During the development phase, total assets are growing while revenue is zero. This will mean that the X5
variable will be zero and the X1 and X3 variables will be falling, thus lowering the score.
During the working phase of the mine, the total assets will be static or falling (depending on the accounting for
reserves) while the revenue is high.
Finally, during the decommissioning phase, the assets will be falling and again there will be no revenue, so a
low Z‐score could be expected.
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The fact that Culam has only four mines will mean that the phase of any one mine will have a significant impact on
the score. If two mines are in development at the same time, then there is likely to be a large effect in lowering the
Z‐score. It will be the scale of the financial resources which Culam can call on over the life of the mines which will
dictate its survival
(c) The type of action which Culam’s board can take to reduce the risk of collapse of the business is to grow the
business by buying or developing many more mines, so that the failure of any one project does not bring down the
business. Staggering the development of the mines would also help to address this issue.
The board could also seek to alter the proportion of revenues generated from long‐term contracts rather than the
more volatile spot market. By signing over more of the production to contracts of fixed revenues, the business’s
cashflows will be more reliable.
The board could learn from the mistakes of their competitors by avoiding over‐priced acquisitions or other large
project failures by performing suitable due diligence and risk analysis in advance of the investment.
The board could be proactive in managing other major risks by using hedging techniques in order to reduce volatile
revenues due to:
–
–
foreign exchange rate changes when the costs of the mines will all be denominated in local currency; and
commodity prices on the spot market.
Although the use of such techniques will be limited by the availability of long‐term hedging contracts.
[Tutor note: This solution may look short (of ink) but it is an illustration of how a good compact answer can look.
More work in description and justification would have to be done to gain credit for more obvious advice such as
‘increase revenue’ or ‘reduce costs’.]
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