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Mahmood Reza
FRSA, MCMI, ATT, FCCA, DMS, PGCE, BSc (Hons)
www.knowledgegrab.com
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62
Table of potential scorecard measures 64
Performance Prism 65
Fitzgerald & Moon Building Block 66
Target costing 70
Total Quality Management (TQM) 72
The notes are provided to supplement existing texts and focus on areas that, in my experience,
students find more challenging. Any feedback regarding the notes (positive or negative) would
be greatly welcomed.
ACCA P5, in common with the other option papers does not enjoy significantly high pass rates.
However, people do pass the exam; a structured and focused approach to studying is highly
recommended, as well reading around the subject.
It is worth remembering that are an abundant level of support resources available to assist
you in passing your exams. However, unless you have a photographic memory you will need
to apply conventional techniques to passing your exams, e.g. question practice, question
practice, question practice – you get the picture.
These notes are to aid and assist your study programme and to reflect student requirements,
any suggestions for future improvements are greatly welcomed.
The strategic planning process was examined in detail in the P3 paper. InP5 the focus is more
on the performance management aspects of strategic planning and the role of strategic
management accounting.
This article is available, with many other useful resources on the ACCA website, link being
http://www.accaglobal.com/gb/en/student/acca-qual-student-journey/qual-resource/acca-
qualification.html
The examiner felt that it would be helpful to try to give candidates a consolidated article on his
approach to the exam, the style of questions and the skills that will be tested in Paper
P5, Advanced Performance Management. The new exam format was illustrated with a new
Pilot Paper to give students a feel for what to expect. Older questions are still relevant as the
syllabus topics are not altering materially.
The article considered the syllabus and overall aims of the paper, how it relates to previous
papers and the format of the exam. It then summarised his advice about his approach to the
paper using suitable example questions from recent exams to illustrate points.
The current ACCA Qualification syllabus was first examined in December 2007; a review of
the pass rates since the new examiner is shown below.
The ACCA Professional syllabuses were updated with effect from June 2011, these notes are
based on that syllabus and study guide for the June 2011 exam diet.
Section B contains three optional questions worth 25 marks each; candidates are required to
answer two of these questions.
EXAMINERS COMMENTS
This provides a useful insight into the general problems that students encounter and extracts
have been reproduced below. The original reports are freely available on ACCAs website.
The term ‘strategic management accounting’ refers to the full range of management
accounting practices used to provide a guide to the strategic direction of an organisation.
OBJECTIVE OF STRATEGY
Primary objectives of profit seeking organisations
Survival is the ultimate measure of success of a business. In order to survive in the long-term
a business must be financially successful. Without survival then obviously there will be no
fulfilment of other objectives.
Growth is generally seen as a sign of success, provided it is profitable, and usually results in
improvements in financial performance.
Cost Leader
You must be the cost leader. Being a cost leader is not enough.
You must achieve proximity in the bases of differentiation.
Differentiation
To be unique along some dimensions that are widely valued by buyers.
Price premium > Costs of differentiation
There can be more than one successful differentiation strategy in an industry
Focus
There must be a difference between the focus target market segment and the market.
The segment must be structurally attractive.
Three main strategies
i. Focus on short runs by investing in technology or methods that give
cheaper or quicker turnaround.
ii. Cost focus because the broadly targeted differentiator may be over-
performing I.e. costs are too high.
iii. Differentiate focus because the broadly targeted competitors may not
be meeting the needs of the segment.
The three related to operations and their implementations in the business are as follows:
The two drivers not, in the first place, related to operations are:
Making Choices
· Having chosen a generic strategy it is vital to stick to it:
· Failing to choose between generic strategies - getting stuck in the middle.
· Cost reduction is not the same as cost advantage. Following a differentiation strategy
does not mean maintaining non-value-added costs.
Being both the cost leader and following a differentiation is possible if:
i. Competition is stuck in the middle.
ii. The firm has pioneered an important innovation
iii. Cost leadership is heavily affected by market share.
Competitive Advantage
A competitive advantage is the ability of an organisation to be better at some action, or have
some asset, necessary for being more successful than the other participants in a market place.
Having one or other of these attributes does not turn it into a competitive advantage unless it
is used to create better value for the customer than the competition can produce.
Moreover these advantages have a habit of disappearing unless they are tended. Patents
have a fixed life and unless money is allocated to R & D to create new ones the advantage
will disappear. Low cost products may be superseded by technology and so on. For this
reason the strategic information provided must be forward looking rather than back ward
looking.
Competitive advantage then results from how successfully the firm implements its chosen
generic strategy and how, as a result, it creates value for its buyers. Value is what buyers are
willing to pay and superior value stems from offering lower prices than competitors for
equivalent benefits or for offering unique benefits that more than offset the higher price.
Overview of planning
Planning is to a large extent a continual activity; it should not be confused with the end
document(s) produced such as a strategic or business plan, budget or cash flow, these
documents are merely capturing in words and numbers the results of some clear thinking and
likely outcomes of an organisations business journey.
One of the primary purposes of planning is to demonstrate that we have considered and have
tried to understand the risks involved in our organisational journey, and that we have
considered how we may deal with those risks –all with the primary objective of realising and
ultimately achieving our aspirations.
Mission statements help generate critical success factors (CSFs), CSFs are the cause of our
success, those areas in which we need to perform best if we are to achieve overall success
and ultimately achieve our objectives. For example, CSFs for a theatre company would
typically be audience numbers, audience satisfaction, effective marketing to attract audiences
and cost control. CSFs help us generate measures to monitor and manage the achievement
of those CSFs; these measures are also referred to as Key Performance Indicators
(KPIs). KPIs should normally be a blend of numbers (quantitative) and non-numbers
(qualitative). Targets can be set for these KPIs, and progress measured against these targets,
any variations against these targets prompts investigation and ultimately action taken to rectify
the situation.
There is a general rule of management that you cannot manage what you cannot measure;
we need clues/milestones to identify if we are progressing on our journey. Take the example
of an individual who decides that their aspiration (mission) is to lead a healthier life style; one
identified objective is to reduce their blood pressure to a certain level; a CSF is change of diet;
a KPI to monitor this is blood pressure. If we measure blood pressure against a pre-set target
and required blood pressure is not achieved then we can have a closer look at (say) life style
and then hopefully put this right.
In the example of the retailer quoted above, appropriate KPIs may be levels of occupancy,
ticket sales, customer feedback, repeat visits and spend against budget.
Within the planning process we need to consider the resources, both physical (tangible) and
non-physical (intangible). The ability of any business to perform effectively is determined by
the adequacy and suitability of those resources, whether those resources are physical,
intangible, financial or intellectual. A resource analysis needs to consider how resources are
managed, deployed and used. For example, the impact of an organisation having a good
reputation is minimised if it lacks the skills and expertise to exploit them effectively.
The primary aim of the SWOT analysis is to identify the extent to which the current strengths
and weaknesses are relevant to and capable of dealing with the changes taking place in the
business environment. If the strategic capability of an organisation is to be understood the
SWOT analysis is only considered useful if it is comparative, and not absolute to its
“competitors” or other organisations, i.e. examining strengths, weaknesses, opportunities and
threats relative to competitors.
The expressions Vision and Mission are used to describe aspects of organisational purpose.
They serve to explain the concept of organisational purpose in order that managers may better
understand and be able to apply it.
MISSION
A mission statement is a statement of the overriding direction and purpose of an organisation.
It is the foundation for any strategic plan and expresses its “reason for being”. A mission
statement is the foundation for the entire strategic planning process. It sets the standard to
VISION
A statement of what the organisation will be, or be perceived to be. It often includes references
to products and services, customers, markets, employees, new technology and social
responsibility.
The term vision statement is used by some organisations instead as mission statement, vision
and/or value statements may also be developed alongside the mission statement.
AIMS
These normally flow from the mission statement and are subsequently used to develop
suitable organisational objectives. Organisational and strategic aims represent the link
between mission and objectives and act as a statement of intention. They tend to be positive
in nature and unquantifiable, unlike objectives.
OBJECTIVES
Objectives are statements of specific outcomes that are to be achieved, from the strategic to
operational levels. Objectives are developed and extended from an organisations mission
statement and goals; they can be stated in financial and non-financial terms. Conventional
wisdom is that unless objectives are SMART (Specific Measurable Attainable Relevant Time
Bound) then they are not helpful, however, some organisational objectives are important but
difficult to quantify or convert into measurable terms, such as to be the leader in ones field.
Milestones and indicators of achievements are essential to monitor progress of all objectives.
Rewards
What we can expect as a result of our efforts. Rewards can be either financial or non-financial.
In most instances a mix of both and non-financial rewards will be expected.
Values
Those things that we believe to be important, and if they were not met, or respected, would
cause us to be unhappy.
The term vision statements are used by some organisations instead as mission statements,
vision and/or value statements may also be developed alongside the mission statement.
Aims
These normally flow from the mission statement and are subsequently used to develop
suitable organisational objectives. Organisational and strategic aims represent the link
between mission and objectives and act as a statement of intention. They tend to be positive
in nature and unquantifiable, unlike objectives.
Objectives
Objectives underpin all planning and strategic activities, and serve as the basis for
creating business policy and performance evaluation.
1. Objectives provide a direction for members of the organisation. Employees should know
what their organisation is aiming for so that their efforts can be in line with it.
2. Objectives provide a standard for performance. People know what is expected of them
and what standards they need to achieve in their own work.
3. Objectives provide a basis for planning and control for managers. Managers cannot make
any plans without objectives. If the organisation is not going anywhere in particular then there
is no need to control the activities of the employees. The organisation will become more of a
community and drop-in centre than a company which provides a product or services.
4. Objectives reduce uncertainty in decision making. It is very difficult for managers to take
decisions if they are not sure where the organisation is heading. If they understand that costs
are to be kept low as part of a short term goal, this will help them to decide on such matters
as how to respond to a supplier increasing their prices.
Many writers have argued that objectives are not worthwhile unless they are capable of being
measured and achieved. This is the thinking behind the development of the ‘SMART’ acronym
which argues that an objective is only genuine if it is Specific, Measurable, Attainable, Realistic
and Time-bounded.
To enable an organisation to fulfil its mission, the mission must be translated into long-term,
medium-term and detailed short-term objectives. Ultimately each individual or department
needs to know what is expected of him or it in the coming days and weeks ahead. Such
medium- and shorter-term targets need to be ‘smart’.
Groups and teams within organisations should have clearly defined and well communicated
objectives. Plans should be developed for the achievement of the objectives and the work
should be monitored to ascertain how far the objectives have been achieved. When changes
need to be made, all the team should be informed of the reasons and the nature of the change.
The objectives of every group or team in the organisation should be very clearly linked to the
organisation's mission. Once long and short term objectives have been decided upon, plans
will be drawn up for achieving them. These plans will include all functions or departments in
the organisation and the groups within them. For example:
Resource analysis
Strategic capability is the ability, or otherwise, of the organisation to pursue its chosen
strategy. The are a range of models and techniques used, all of which involve an examination
of the resources and internal features of the organisation.
The first technique used is a Resource Audit. It involves analysing the resources of the
organisation in the following categories:
The next stage is to examine how effectively these resources are being used. This involves
using another analytical model developed by Porter, the Value Chain. The Value Chain
identifies how the activities of the organisation are co-ordinated to support its chosen basis for
competitive advantage. Value Chain Analysis consists of breaking the activities of
organisation down into the following categories:
Value Chain Analysis also forms the basis for identifying Core Competences. From the
activities identified above, management can determine what the organisation does better than
other organisations.
The issues raised by these analyses are carried forward to the SWOT analysis.
The primary aim is to identify the extent to which the current strengths and weaknesses are
relevant to and capable of dealing with the changes taking place in the business
environment. If the strategic capability of an organisation is to be understood the SWOT
analysis is only considered useful if it is comparative, and not absolute to its “competitors” or
other organisations, i.e. examining strengths, weaknesses, opportunities and threats relative
to competitors.
A SWOT analysis should help focus discussion on future choices and the extent to which an
organisation is capable of supporting these strategies. An effective SWOT should be limited
to four to five factors, focus on major and not marginal areas, be open and honest and have a
priority and emphasis
The primary aim is to identify the extent to which the current strengths and weaknesses are
relevant to and capable of dealing with the changes taking place in the business environment.
If the strategic capability of an organisation is to be understood the SWOT analysis is only
considered useful if it is comparative, and not absolute to its “competitors” or other
organisations, i.e. examining strengths, weaknesses, opportunities and threats relative to
competitors.
A SWOT analysis should help focus discussion on future choices and the extent to which an
organisation is capable of supporting these strategies.
EXAMPLES
Strengths and weaknesses
· Resources: Physical and intangible
· Customer care
· Staff
PRODUCT PORTFOLIOS
Because of the inevitability of the eventual decline of all products and services, businesses
seek to reduce their exposure to the risk of a product decline by maintaining a portfolio of
products.
A balanced portfolio will contain products at various stages of the product life cycle.
Conglomerates will seek to minimise the risks found in individual industries by holding
investments in a range of industries.
There are various tools and techniques for analysing a product or Business Unit investment,
portfolio. The most widely used of these is the Boston Consulting Group Matrix, often referred
to either as the Boston Box or the BCG Matrix. This framework allows the product portfolio to
be identified in terms of market share and market growth. Products/ services are placed in
the matrix and identified as question marks, stars, cash cows and dogs.
High
Stars Question
Marks
Market
Growth
Low
High Low
Market Share
(Relative to biggest competitor)
A market penetration strategy is one where the company strategy is to increase its market
share in an existing market with current products. This is particularly successful at developing
super-profits when the market is growing strongly. The key strategic information required is
that on the market, its volumes and prices, by customer segment.
A market development strategy is one where the company seeks to increase its profitability
by selling its existing products to new customers (markets) it has never sold in before. This is
most successful when it is based on the most profitable existing products. The strategic
information required here is the direct profit contribution by unit and an investment strategy
based on incremental/opportunity costing based on future outcomes.
The diversification strategy requires the company to sell new products to new customers. Here
the management accounting system must be able to clearly identify the competitive advantage
by which the company is going to create its super-profit. Sadly the evidence is that this is not
only the most risky strategy but also one which is frequently fails.
STAKEHOLDER ANALYSIS
Stakeholders are normally seen as individuals or groups that are affected by organisations
activities, these consisting of providers of finance, managers, employees, competitors,
government, clients and suppliers.
It is important to conduct a Stakeholder Analysis, as the most powerful stakeholders are the
ones who ultimately determine the purpose and direction of the organisation. It may be easy
to assume that the owners of an organisation as the most powerful stakeholders, however,
this is often not the case and so the leader in an organisation should have a clear view of
where the most powerful influences are likely to come from.
There is often a conflict between differing stakeholder requirements and aspirations; part of
the planning process involves the consideration of stakeholder requirements, power, influence
and ambition. One way to help manage stakeholders is by the use of Mendelow’s Matrix.
Low A B
Stakeholder power
High C D
A. Minimal effort; Low High
Probability of exercising
B. Keep informed;
power/level of interest
C. Keep satisfied;
D. Key players.
BENCHMARKING
Benchmarking is the practice of measuring an organisations products or services against “best
practice”; the primary objective is to improve processes or activities. Through benchmarking,
organisations learn about their own practices and procedures, and the best practices of others.
Benchmarking enables them to identify where they fall short of current best practice and
determine action programmes to help then match and surpass it.
Benchmarking originated in the USA in the 1970s, pioneered by Rank Xerox and was
‘exported’ to Europe and the UK in the 1980s. A number of commercial, public sector and not
for profit organisations have successfully embraced the technique, and it is a popular and
effective management process.
Any activity that can be measured can also be benchmarked. However this is neither feasible
nor practical. The starting point for any benchmarking exercise is to determine the key
performance areas; those are the areas that are critical to the organisation, operationally and
strategically. They should focus on those areas that (a) tie up most of the resources; (b)
significantly improve the relationship with their client groups; (c) impact on the viability of the
organisation. For example a charitable organisation that relies on grant aid as its main source
of income might benchmark fund raising activities.
Once the key performance areas have been decided upon an organisation must then set the
key standards and variables to measure, these are commonly known as “key performance
indicators” (KPIs). Having defined the benchmarks the hunt is on for information to establish
the benchmark performance. There are four types of benchmarking
· Internal: this is done within an organisation arid generally between closely related
divisions, plants or operations. This is an easy way to start benchmarking, but is limited
to internal criteria only
· Functional: this is a comparison of performance and procedures between similar
functions, but in different organisations and industries. It is more likely than internal
benchmarking to generate benefits to the specific function, but it is unlikely to give wide
benefits throughout the organisation
· Competitive: thisfocuses on direct competitors within the same industry and with
specific comparable business operations, or on indirect competitors in related
industries with complementary business operations. There can be practical difficulties
in achieving this.
· Generic: thisis undertaken with external companies in different industries that
represent the "best-in-class" for particular aspects of the selected business operations.
Organisations then need to specify programmes and actions to close the gap. Having
measured one’s actual performance and compared it with some form of target, benchmarking
moves from simple measurement through to performance improvements. Many organisations
forget this stage and therefore miss the real benefit of benchmarking. It is essential that
programmes and actions are implemented and that ongoing performance is monitored.
Once the best practices have been identified, the benchmarking team collects the data,
analyses it, and then plots their performance against best practice to help identify improvement
opportunities.
Finally the team decides what is needed to adapt the best practices to suit their own particular
circumstances, this will a re-evaluation and re-design of existing procedures and approaches.
A cost-benefit exercise will usually be carried out and an implementation timetable with
priorities is established.
Introduction
The government can also take specific measures to regulate businesses through competition
policies, ecological policies and business assistance policies.
Competition Policies
Competition policies ensure that market failures are avoided. Government particularly seek to
regulate private markets. Competition policies are introduced to:
Green Policies
Green (Ecological) policies may not directly benefit the organisation but rather the environment
and society. They include external environmental costs occurring
from production or consumption. The Government policies include:
The Government also has aid policies to assist businesses in the economy in particular small
businesses. These include:
Risk consists of three elements, namely choice, likelihood and consequence. Some choice
is needed in the situation, if there is no choice, a manager does not have a risky situation a
rather a bounded one beyond the manager's control; Likelihood for some level of uncertainty;
and some unwanted consequence must exist in one or more of the choices available to the
manager.
A number of techniques exist for decision making under uncertainty, the more popular being
contingency tables and its associated interpretation:
Contingency Table
This is used for decisions made under uncertainty; it identifies & records all payoffs where
action affects outcomes.
Maximin
This maximises the smallest pay-off, it is indicative of a pessimistic and Risk-averting
approach
Maximax
This has the highest maximum pay-off, it is indicative of an optimistic approach, albeit with the
risk of loss to low returns
Minimax regret
This minimises the maximum possible regret and limits the potential ‘opportunity’ loss. Regret
is seen as the pay-off lost v. not pursuing optimal action
ACTIVITY ONE
A retailer needs to decide how many kilos of fruit he needs to buy from the market and has
assessed the possible daily demand as 60, 100, 125 or 175 kg
He can buy quantities of 50, 100, 150 or 200 kg at a price of $4 per 10 kg. The selling price
is $1 per kg with any unsold apples being scrapped.
Required
PESTEL
One of the key features that differentiated strategic management accounting from traditional
management accounting is the external focus. By looking at the organisation’s competitive
position we will be concentrating on this external focus
The business environment can be thought of as comprising the wider macro-environment and
the competitive (operating) environment
Economic
Substitutes
Suppliers
Customers
Your Social
Political Organisation Entrants
Stakeholders
Competitors
Competitive
Environment
Technological
Macro
Environment
A mere listing of PESTEL influences has little value, it is important to identify the key
opportunities and threats facing the company (a) at present, (b) in the future and how these
are, in effect drivers for change. A PESTEL analysis should also examine the differential
impact of these macro environmental influences by asking how they affect different companies
differently. Some form of impact analysis and scenario planning is especially useful to explore
different possible futures. This exercise allows “what if” questions to be explored.
Competition in an industry continually works to drive down the rate of return towards the
competitive floor rate of return.
Buyer Power
Buyer power is the ability of the buyer to determine the price at which they will buy irrespective
of the decisions of the firm.
· A group of buyers is powerful if for example a buyer purchases large amounts relative
to the seller’s total sales.
· If the product bought represents a significant portion of the buyers total purchases the
buyer will tend to shop around for lower prices.
· If the products are standard and undifferentiated the buyer will have more power over
prices.
· If the buyer has few switching costs it will not be locked into a particular seller.
· If the buyer has low profitability it will have to press for low prices.
· If the product is unimportant to the quality of the buyers products or services.
Substitute Products
Firms in one industry are also competing with firms in another that produce substitute
products. Substitutes limit returns in an industry by setting a ceiling on the prices the industry
can charge. The more attractive the price-performance of alternatives the firmer the lid is on
industry pricing.
Substitute products that need to be closely watched are those with improving price-
performance ratios where the industry that produces them is more profitable than yours.
Supplier Power
Profitable suppliers can squeeze profitability out of an industry if that industry cannot recoup
the cost of higher priced supplies in prices of its own products. The conditions making
suppliers powerful are:
Rivalry
Rivalry takes the form of price competition, advertising battles, product introductions,
increased customer service, improvements to warranties and so on. Price competition can
leave the whole industry worse off while advertising battles may increase demand and hence
wealth of firms. Intense rivalry is the result of a number of factors:
· Numerous or equally balanced competitors.
· Slow industry growth
· High fixed or storage costs. The significant cost here is fixed cost relative to value-
added.
· Lack of differentiation or switching costs.
· Capacity augmented in large increments
· Diverse competitors
· High strategic stakes
· High barriers to exit. Exit barriers can be economic, strategic and emotional. They
consist of specialised assets, fixed costs of exit, strategic interrelationships,
identification with the business, loyalty to the workforce, fear for one’s own career,
government denial or discouragement of exit and so on.
Threats of Entry
New entrants to an industry bring new capacity, the need to gain market share and they can
bring substantial resources. The threat of entry depends on the strength of the barriers to
entry:
· Economies of scale. If these are large then the new entrant has to come in on a large
scale. However these economies of scale must be real. If they are not, as Xerox
discovered when Japanese entrants started following the expiry of patents, the new
entrant may enter at a lower price than the incumbents are manufacturing for. Scale
economies can vary by function, such as selling, or by operation. For example there
are large economies of scale in manufacturing television colour tubes but not in cabinet
making or assembly.
· Product differentiation leads to brand identities and customer loyalties.
· Capital requirements
Incremental budgeting
Indirect cost and support activities are prepared incrementally, say 5% on last year.
Strategic Control
· The setting of corporate strategy and long term objectives for the organisation.
Operational Control
· Operational control is ensuring that specific tasks are carried out. This is primarily
concerned with the processing of inputs and raw materials to get outputs.
Management Control
· Management control is the coordination of the day to day activities in an organisation
to ensure that inputs and raw materials are used efficiently and effectively towards
achieving long term goals. Management control, therefore, links strategic control and
operational control.
Management control utilises regular feedback reporting systems so that corrective action can
taken where variances from plan are identified. The budget plays an important role here in
providing controls to aid management control.
The systematic comparison of planned inputs to actual results made using the budget,
followed by corrective action where deviations from plan exist, is known as a ‘control system’.
The system providing the reports for this control system is known as ‘responsibility
accounting’. This will be discussed in more detail later in the notes.
So, with feed-forward controls any likely errors can be foreseen and actions taken to avoid
them, whereas, with feedback control actual errors against the plan are identified and
corrective actions taken to achieve the remainder of the plan.
The budgeting process is an example of both a feed-forward and feedback control system.
BEYOND BUDGETING
During recent years the business environment has become far more complex,
dynamic, turbulent and uncertain. Shorter product lifecycles coupled with
technological advancement has focused greater attention on innovation as a
determinant of corporate success. Although organisations need to be as adaptive to
change as possible, the rigidity of the budget serves only to stifle innovation and
responsiveness to change. The need to comply with a fixed plan, and to manage with
resources which may have been allocated more than one year earlier, act as
impediments that prevent managers from responding quickly to changes in today's
business environment.
The weaknesses of traditional budgeting processes have been the subject of much
attention and many commentators. Such weaknesses include the following:
· Budgets prepared under traditional processes add little value and require far
too much valuable management time which would be better spent elsewhere.
· Too heavy a reliance on the 'agreed' budget has an adverse impact on
management behaviour, which can become dysfunctional with regard to the
objectives of the organisation as a whole.
· The use of budgeting as a base for communicating corporate goals - setting
objectives, continuous improvement etc. - is seen as contrary to the original
purpose of budgeting as a financial control mechanism.
· Most budgets are not based on a rational, causal model of resource
consumption, but are often the result of protracted internal bargaining
processes.
· Conformance to budget is not seen as compatible with a drive towards
continuous improvement.
· Traditional budgeting processes have insufficient external focus.
In this view of the world, the traditional budget is seen as the fixed plan in accordance
with which all management processes are based and aligned. This determines how
managers behave and the activities and objectives on which they focus. Annual
budgeting is seen as absorbing considerable management time and the monthly
comparisons of actual and budgeted performance are primarily concerned with control
issues. Managers will not exceed their budgets by perhaps spending necessary
resources outside the planned budget cycle to react to events because their bonuses
or even their jobs may be put in jeopardy.
A major problem lies in the fact that circumstances will be different when the budget
was set and when subsequent comparisons are made and management decisions
required. An increasingly competitive global arena further accentuates the problem.
Inflexibility is thus seen as the key failing of traditional budgeting, and companies are
being urged to move towards continuous rolling forecasting to enable speedy and
coordinated adaptations to actual and anticipated changes in the business
environment.
Traditional budgets show the costs of functions and departments (eg staff costs and
establishment costs) instead of the costs of those activities that are performed by
people (e.g. receipt of goods, processing and dispatch of orders).
Thus managers have no visibility of the real 'cost drivers' of their business. In addition,
it is probable that a traditional budget contains a significant amount of non-value-
added costs that are not visible to managers.
The annual budget also tends to fix the capacity for the forthcoming budget period,
thereby undermining the potential of activity-based management (ABM) analysis to
determine required capacity from a customer-demand perspective.
In the private sector, managers are forced to consider current and future opportunities
and threats, particularly where rolling monthly forecasts of financial performance
operate together with a focus on other non-financial 'value drivers'.
The legal framework of public sector organisations would probably prevent such a
system being introduced. As with all alternatives, the success of a particular process
depends on the needs of the individual organisation. The alternative of the beyond
budgeting model places considerable emphasis on the need for organisational,
managerial and cultural changes in order that it may be successfully applied by
organisations.
In the public sector, the budget process inevitably has considerable influence on
organisational processes, and represents the financial expression of policies resulting
from politically motivated goals and objectives.
Yet the reality of life for many public sector managers is an increased pressure to
perform in a resource-constrained environment, while also being subjected to growing
competition.
While these issues may be common with the private sector, a number of issues arise
which are specific to the public sector. For example, UK local authorities are prevented
by law from borrowing funds for revenue purposes or budgeting for a deficit. If the
beyond budgeting model is to allow greater freedom for managers then it will take a
considerable change of mindset in the public sector to achieve the flexible agenda
envisaged, especially where such flexibility would involve considerable and increased
delegation to managers.
Are managers capable of making this change, as it would entail the adoption of a
radically different approach?
Local authority financial regulations also tend to prevent the transfer of funds from one
budget head to another (otherwise known as virement) without compliance with
various rules and regulations. These rules (expressed in the financial regulations of
public sector organisations) will be consistent with the policies of the organisation and
are designed to prevent expenditure on items such as permanent staff where such
costs would go beyond the budget year and represent a commitment of future
resources.
Budgets in the public sector tend to concentrate on planning for one financial year
ahead. Attempts are being made by UK central government, through the
comprehensive spending review, to place an emphasis on the longer-term. However,
considerable difficulties exist within the individual organisations that make up the
public sector when creating a budget system that reflects longer-term objectives and
goes beyond the annual cycle. It also remains to be seen how the relatively new
system of resource accounting in central government will fit into the budgeting
framework.
More advanced approaches are represented within financial planning systems, and
include such concepts as zero-based budgeting and planned programme budgeting
systems with a timeframe greater than one year.
Whether the public sector can adapt to the concept of greater flexibility - which lies at
the heart of beyond budgeting - remains a matter of ongoing debate. Such an
adaptation would require a mindset which not only moves away from control but also
requires a reduction in the internal political power of large departments which has been
at the heart of public sector budgeting for many years. The desire to generate
improved performance - essentially considered the driver for the beyond budgeting
model - is present in the public sector evidenced in initiatives such as key performance
indicators and 'best value' plans.
2. Conventional cost management fails to recognise that corporate success depends on the
effectiveness of its key business processes. Such processes frequently cross
departmental boundaries. Inadequacies, in any department which contributes to a
business process, can affect the entire organisation which is only as strong as the weakest
link. Traditional management accounting and financial control systems reflect the needs
for a hierarchical function in the organising structure. They do not recognise or support
the effectiveness of the key business processes.
ABM
The determination of the cost of a product or service is vital at the strategic planning level, as
it is at the operational level. For example, organisations may need to evaluate the market
profitability and should they remain in it?
However the customer will perceive things from his/her own perspective. Essentially this will
involve making decisions about the value of the service or product to them compared to its
cost. Using a customer perspective for managing the business implies that management will
have to concern itself with some or all of the following issues:
Because the basis of this concern rests on the activities carried out this is called activity based
management.
In order to determine the cost of each activity it is necessary to determine how time is spent
and how costs build up. For example the profitability of a customer will depend not only on the
price and costs of the products purchased, but also on such factors as the number of orders
placed in a year, the number of calls made on the technical service department and so on.
This means that costs will have to be traced to this customer from all over the company, not
just the plant. This is done through cost drivers.
Cost drivers are those elements that give rise to the need for an activity such as the number
of orders for a sales order department, number of complaints for the customer service
department and so on. While there may be many identifiable cost drivers management will
need to identify the minimum set that will allow the costs to be calculated.
Cost drivers apply at different levels:
Unit level
· Number of hours required to produce a product
Batch level
· These are costs such as machine set-up or inspection, these occur once per batch
Processor product level
· These cover such items as engineering change orders which refer to a product or
process.
Organisation level
· They are incurred for supporting the continuing level of operations i.e. building
depreciation, division managers’ salary.
Customer Profitability
The needs of customers can vary radically. In their efforts to retain existing customers and
attract new ones, companies can be drawn into providing widely different levels of service in
respect of many different service elements such as frequency of delivery, number of order
lines, quantity per order line, customer location, discounts given, salesmen's visits and special
orders.
These have one thing in common, they all have associated costs. Conventional cost
accounting techniques rarely recognise them. As a result companies do not know the true
cost of trading with these customers, or even with customer groups. Certain customers may
attract so much cost that they provide no profit contribution at all. In addition, companies may
be unaware of the true value their customers place on the level of service they provide. Under
such circumstances, companies may be trading at a loss with certain customers, giving them
a costly service which they do not actually require.
ABB
The idea behind activity based budgeting is to develop an activity model (or series of linked
cost centre activity models) of resource requirements. This model can then be flexed to affect
different volume assumptions which may need to be evaluated after the first stage of the
budgeting process (external assessment). It can also be used as a basis for identifying and
producing performance improvement. Once the final budget model has been agreed, it then
forms the basis for management control through variance analysis with a more complete
understanding of the impact of changing volumes on activity resource requirements.
In developing the activity based budgeting model it is important to understand and identify:-
· What activities are being/need to be carried out?
· How efficiently the activities are being carried out and to what quality and
o Standard.
· What is driving the level of resource required to perform this activity (the
o Activity level volume driver).
· The relationships between the activity level volume driver and its root cause.
· How the root cause may be changed and how this can affect the activity
o Resource required.
Activity based budgeting can take this a stage further by identifying and modelling a cascade
of activity level volume drivers. For example, in order to achieve a target sales volume, an
organisation needs to process so many orders which will result in so many invoices with so
many complaints and queries to handle before the transactions can be completed. Each of
these activity level volume drivers carries with it a unit cost that can be used to calculate the
total value of the resources required.
Understanding these cost linkages is vital to a good understanding of cost behaviour and this
is at the heart of activity based budgeting. However, this understanding is not fully exploited
unless management can use it to make changes in the way the organisation goes about its
business. The most significant of the cost beneficial changes can only be made if incorporated
into budgets through discussion and performance reviews.
1. Cost Centre – managers are responsible and accountable for costs only
2. Revenue Centre – managers are responsible and accountable for revenue only
3. Profit Centre – managers are responsible and accountable for both revenues and
costs
4. Investment Centre – managers are responsible and accountable for revenue, costs
and capital investment decisions
o If a manager can control the quantity of the service or goods but not the price
paid for that service or goods then only the variance in usage should be
attributed to that manager.
o If a manager cannot control either the quantity or price paid for a service or
goods then both usage and expenditure are uncontrollable and should not be
attributed to the manager.
· Arbitrary costs
Generally costs, such as insurance, heating and rent are apportioned to cost centres
on some sort of arbitrary basis, e.g. floor area. For managers operating in a
responsibility accounting system this would render them uncontrollable. Therefore,
managers should not be held responsible for them.
Human resource management (HRM) refers to the 'strategic and coherent approach to the
management of an organisation's most valued assets: the people working there who
individually and collectively contribute to the achievement of its objectives for sustainable
competitive advantage' (Armstrong).
People are of central importance in most organisations and their recruitment, management
and motivation forms part of the human resource management function.
The definition mentions competitive advantage and this reinforces the link between HRM and
strategy.
HRM goals
If HR strategies are to be effective and successful then HRM must be effective across four
main areas, namely
Theories of HRM
· Agency theory
Vrooms theory deals with management and motivation. It assumes that behaviour is caused
by a making a conscious choice from a number of alternatives, pleasure being maximised and
pain minimised. Vrooms realisation was that an employee’s performance is based on
individual factors such as skills, knowledge, personality, experience and abilities.
In essence the theory says individuals have differing goals, and they can be motivated if they
have certain expectations.
Valence: This refers to the emotional orientations that people have regarding
rewards/outcomes, management need to discover what people (employees) value;
Expectancy: Employees do not share the same levels of expectations and they have differing
levels of confidence in their own abilities. Management needs to identify and provide
employees with resources, training and support.
Agency Theory: Agency theory suggests that an organisation can be seen as agreements
between resource holders. An agency relationship arises whenever one or more individuals,
called principals, hire one or more other individuals, called agents, to perform some service
and then delegate decision-making authority to the agents.
This has implications for, among other things, corporate governance and business ethics.
When agency exists, agency costs are also incurred, for example offering management
performance rewards to encourage managers to act in the best interest of shareholders'.
A key element underlying the BPR philosophy is that one should look at an organisation as a
series of processes, as opposed to functional specialties such as production, and marketing.
The approach advocated by Davenport (1992) is to
1. Develop the business vision and process objectives
2. Identify the business processes to be redesigned
3. Understand and measure the existing processes
4. Identify IT levers
5. Design and build a prototype of the new process
6. Adapt, if appropriate an organisations organisational structure and governance model
Ratio Analysis
We understand how financial statements are prepared and the definitions of the terms used.
Assuming that this information is available in an accurate and timely manner what does it
mean? What is the significance of a particular level of profit or borrowing? How should the
information in the various financial statements be related to one another?
To a large extent this is done by the use of ratios – in effect dividing one number by another.
There are a considerable number of ratios that could be calculated from any one set of
financial statements. We will discuss a few of the more common ones.
With any financial analysis the trend over a number of years is always important since any
number of special factors can distort one year’s figures. It is also important to use financial
information with care. As we have seen many of the numbers in financial statements are
subject to management’s interpretation of future events or can be directly manipulated as a
result of fraud. Therefore when analysing statements of companies it is important to be aware
also of the trend in such things as market share, comments of customers and regulatory
bodies and other organisations.
All external analyses of this sort when carried out on other companies suffer from the fact that
the information is not always available until several months after the end of the financial year.
Finally, remember that there are no systems, whether naturally occurring or brought about by
the hand of man, that continue in a straight line or that grow in a compound fashion forever,
or that carry no risk. Their performance depends on the time scale over which they are being
examined. In the short term and it may be that they can be considered straight line in the long
term, however performance becomes erratic and cyclical.
Characteristics:
Ratios should have a number of characteristics.
· The numerator and the denominator should be linked in some way. The more tenuous the
link, the less useful the ratio. A very common problem in ratio analysis is to find a
numerator and denominator, which are strongly linked from the available data.
· The ratio should be measuring something which is important within or about the
organisation.
· The result of the ratio must be able to be influenced in a positive way by the management
of the organisation so that managerial action which changes the numerator or the
denominator may indicate improvements or worsening in the ratio.
· Because ratios are relative measures, they enable performance in different sized
organisations to be compared
Sales Ratios:
For example the ratio of operating profit or gross profit to sales or the ratio of expenses to
sales, for example selling expenses to sales. The profit to sales ratio is called Return on Sales
(ROS) and is widely used as a measure of how well a company is managed in comparison to
other companies in its sector.
With sales ratios it is important to bear in mind that some of the total costs of operations are
variable, some are fixed and some are semi-variable. Their ratios will respond differently to
different levels of sales.
Efficiency Ratios:
There are some ratios where sales is the numerator in the expression. These important
turnover relationships are calculated by dividing sales by the appropriate balance sheet item,
for example total inventory or debtors, or by total number of employees.
Receivables collection
Yearend receivables divided by sales (credit sales if available) gives the number of times that
the debtors turned over in a year. Divided by 365 it gives the number of days on average it
takes receivables to pay. An increasing trend in this number is a warning signal, especially if
the number of days outstanding is significantly higher than the industry average.
Payable Payments
This is the relationship between trade payables and cost of sales (or credit purchases if
available) multiplied by the number of days in a year (365).
Inventory Turnover
Cost of sales divided by average inventory for the year (opening inventory + closing inventory
divided by 2) multiplied by 365 gives the average age of the inventory. As usual an average
can hide an awful lot of obsolete stock that should have been written off, so comparisons with
prior years or with industry averages will aid in deciding whether inventories are too high.
Price changes over time can also effect this ratio.
Asset Turnover
This is generally calculated as sales to capital employed.
Employee Productivity
Sales divided by the number of employees gives a useful indicator of productivity in the
organisation when compared with industry averages.
Liquidity ratios:
These ratios are particularly important when deciding to extend credit to a customer or to
continue existing credit.
If the present value of the outflows exceeds the present value of the inflows, that is the project
yields a negative net present value, then the investment as projected is earning less than the
discount rate and should be rejected.
The discount rate used represents the rate of return required to make the investment worth-
while, hence the accept/reject approach adopted above where respective positive and
negative net present values are achieved.
Once calculated, the IRR for a project is compared with the target return required by the
organisation. If it is greater than or equal to the latter, the project is likely to be worthwhile. If
it is less than the target return, the project should be rejected. Investments in mutually
exclusive projects are ranked according to the size of the IRR.
Intangibles are generally still not regarded as assets in traditional accounting systems, unless
they comply with formal accounting recognition rules.
Major businesses usually require some sort of divisional structure. If it is to be made to work,
each will have its own performance criteria.
To the accountant, therefore, is bequeathed the problem of measuring how well or badly each
division has been at meeting these criteria.
A number of bases can be used, including profit margin comparisons, return on capital or
economic value added. Whichever is chosen, it is essential that costs, revenue and asset
valuations are adjusted so that ‘like with like’ comparisons are made. Questions of asset and
cost allocation, valuation and apportionment all arise.
Such divisions often have their own management boards, financial targets and strategic plans.
Often at the centre is group management responsible for strategic and financial control and
ensures that management resource is optimised, best practice is adopted and synergies are
realised between operating divisions.
Croda International for example is divided into three major business sectors: Cosmetic and
Toiletries, Coatings and Chemicals. Each business sector sub-divides to divisions. The
surface coatings sector comprises Industrial Paints, Powder Coatings, Printing Inks and
Graphic Supplies.
In a previous financial report the chairman was quoted as “the company will maintain a prudent
financial approach with a decentralised management judged, and rewarded by performance.
Its overall aim “is to achieve long-term growth in earnings per share, by continuing to build a
broadly based speciality chemical group with operations in main market areas of the world”.
It has been said that divisionalisation and decentralisation are sometimes regarded as
synonymous but that in fact divisionalisation adds a new dimension by introducing
performance responsibility to divisional management.
There are three types of ‘responsibility centre’ – expense centres, profit centres, and
investment centres:
Together they form the basis for ‘responsibility accounting’, a system of accounting, ‘that
segregates revenues and costs into areas of personal responsibility in order to assess
performance attained by persons to whom authority has been assigned’.
Historical cost valuations should be converted to current valuations by using index numbers.
Working capital should be included as part of the total assets/capital employed calculation with
stocks valued on a similar basis between divisions.
When measuring the return, it is usual for the average capital employed/total asset figure for
the period to be used (the calculation is earnings times 100, divided by investment
[assets/capital employed]). This can be subdivided into profit margin (profit as a percentage
of sales), and asset turnover (sales divided by investment [assets/capital employed]).
Cost of capital used in residual income calculations should be the cost of financing the
business or division, of which the investment responsibility is being assessed. This may be an
average cost based on group experience or an amalgam of different costs.
Residual income is a concept that has been used by accountants for four or more decades.
Alfred Sloan, of General Motors Corporation, knew and used the principle in the 1920s.
More recently Stern Stewart New York Consultancy Group has ‘trademarked’ the term EVA
(Economic Value Added) for what amounts to the same thing. EVA, according to the book The
Quest for Value – the EVA Management Guide, is simply the net operating profit after tax less
the cost of capital (the weighted average cost of debt and equity) used in the business.
The animal feeds division of Northcliffe Foods Plc, results for year ended 31 December 2000
showed:
$m
Turnover 40.00
Costs:
Materials (arm’s length suppliers) 2.50
Materials (group-transfer price) 7.00
Labour 3.00
Production overhead 2.50
Apportioned group costs 5.00
Net profit 20.00
Profit for the year was $20.00m on a turnover of $40.00m giving a return to sales (profit margin)
of 50%. However it must be noted that the division is only “management responsible” for 40%
of its costs; 60% being transfers and apportioned costs.
$m
Fixed Asset Investment 65.00
Working Capital 15.00
80.00
$m
Capital Structure:
Equity 60.00
Debt 20.00
80.00
The dividend to shareholders had been 15% and interest of 10% was paid on the debt.
Return on Investment:
= Net Profit
Divisional Investment
This is a very good return on capital, to put this in perspective the top five supermarkets over
the past five years have averaged approximately 18.00%.
Asset Turnover:
Turnover
Divisional Investment
The business is generating 0.5 times its capital base in the form of turnover.
Here we can see that the division has achieved earnings of $9.00m in excess of the cost of
financing the division.
Management’s performance would be measured using RI / EVA and often management and
employees would be rewarded based on this performance measure.
DIVISIONALISATION
As a business expands it eventually reaches the stage where it becomes appropriate to split
it up into smaller, more manageable units – to decentralise. Reasons may include:
It may well be the case that some degree of decentralisation arises as a result of the way in
which a business expands. If the expansion is by take-over of companies that then become
subsidiaries within group, a decentralised structure automatically arises.
One condition for a successful decentralisation is that the various divisions should be more or
less interdependent of each other. However, in practice, this is unlikely to be the case and a
certain amount of inter-divisional trading will take place. A transfer pricing policy is needed if
goods and services are passed between divisions.
FUNCTIONAL STRUCTURE
TRANSFER PRICING
Transfer pricing deals with the problem of pricing products or services sold (Transferred
within an organisation). Decisions over suitable transfer prices are needed if a firm has split
itself into autonomous units i.e. it has decentralised or is involved in setting prices between
connected companies in different countries.
The approaches to setting transfer prices are similar to those for external sales, there are cost-
based methods and market based methods. At first sight it would seem that setting prices for
internal transfers is less critical than for external sales; however it has to be appreciated that
the divisions into which a large group will split itself expect to act as self-contained units. The
decision over transfer pricing is even more critical since top management is in a position to
identify whether it is more economical for a product or service to be bought and sold internally
or externally, but at the same time needs to take into account behavioural considerations such
as the motivation of divisional managers.
It might appear that the credit to the supplying division is merely offset by an equal debit to the
receiving division and that therefore, as far as the whole organisation is concerned, it has a
net zero effect. This is true in terms of the physical application of a transfer pricing system
once it has been decided upon and implemented. However, there are important behavioural
and organisational elements associated with transfer pricing and the choice of which method
to adopt. The transfer price does affect the profit of each division separately and, therefore,
can affect the level of motivation of each divisional manager.
The rules for the operation of a transfer pricing policy are the same for any policy in a
decentralised organisation. A system should be reasonably easy to operate and understand
as well as being flexible in terms of a changing organisational structure. In addition there are
four specific criteria which a good transfer pricing policy should meet:
· It should provide motivation for divisional managers
· It should allow divisional autonomy and independence to be maintained
· It should allow divisional performance to be assessed objectively
· It should ensure that divisional managers make decisions that are in the best interests of
the divisions and also of the company as a whole.(goal congruence)
The difference between the upper and lower prices represents the corporate profit/savings
generated by producing the product or service internally. The chosen price “divides” the profit
between the two segments. For external reporting this is irrelevant since the profit element will
be eliminated when the financial statements are consolidated. However this division of profits
may be extremely important for internal reporting since it affects the results of the responsibility
reports and hence the success or failure of the segment.
There are three main methods used to set the transfer price.
If actual costs are used then the cost may vary according to the season or according to the
efficiency of the supplying segment and the receiving segment will have no idea how to set its
sales prices. What additional costs are included and are they reasonable or have they been
inflated?
Market-Based Cost
Market pricing is believed to be an objective arm’s length method of arriving at a transfer price.
If a supplying segment is operating efficiently it should be able to make a profit at this price.
Similarly if the receiving segment is operating efficiently it should be able to make a profit since
it would have to purchase at this price if the item was not manufactured internally.
However several problems may exist in practice. First market price may not be appropriate
because internal production should lead to savings in bad debt, delivery and marketing
expenses. The product or service may not be available on the open market. If the market price
is temporarily depressed or increased due to events beyond the control of either segment
which price should be taken, the normal or the temporary? Finally, in a market, discounts on
price are ordinarily given when volume orders are placed or long-term contracts are signed.
Finally the market price may not equal the LRMC and in this case the company will fail to set
it price/output decisions correctly, although this is less true of commodity products.
Dual Pricing
To overcome these problems companies can adopt the practice of dual pricing. Here the
agreed transfer price is used only for the purposes of financial reporting of individual segment
results. For management evaluation purposes the variable or absorbed cost is applied to the
results of one or both segments. The difference between the “entity” and management price
is called the “mark-up”.
The mark-up is accounted for by assigning it to a different account that is used for
reconciliation purposes. That is to say the amount of mark-up in the buying segment’s
accounts must equal the amount of mark-up in the selling segment’s accounts. This
reconciliation is the same as is done for the purposes of consolidation of the accounts.
Using dual pricing allows a company to get the best of both worlds. The transfer price can be
set to meet the regulatory and corporate finance constraints while the price used by local
management can be based on a close approach to the economist’s long-run marginal costs
so allowing the company’s global operations to optimize their third-party pricing and output
decisions on a decentralized management basis.
Receive Inc. manufactures a branded product sold in containers at a price of $30 per
container; the following cost information has been obtained.
Its direct product costs per container are:
Raw materials from Provide Inc. at a transfer price of $14 per container.
Additional processing costs at of $5 per container.
Receives monthly fixed costs are $60,000, a market research study has indicated that
Receive Inc. could increase their market share by 75% in volume if it were to reduce its price
by 20%.
Provide Inc. produces a standard product which can be converted and used for a number of
final products. It sells one quarter of its output to Receive Inc. and the remainder to
customers outside the group.
The production capacity of Provide Inc. is 52,000 containers per month, but competition is
tough and it plans to sell no more than 36,000 containers per month for the year ending 31st
March. Its variable processing costs are $7 per container and its monthly fixed costs are
$80,000 per month.
The Happy Group’s transfer pricing policy is to use market prices, where known.
Required
a. Calculate the monthly profit position for each of Provide Inc. and Receive Inc. if the
sales Receive Inc. are
RESIDUAL INCOME
This is expressed as an absolute figure, it is normnally calculated as
The interest charge is a notional charge based normally on a risk adjusted cost of capital
applied to the book value of the value of the investment at the start if each year.
Advantages
· It makes divisional managers aware of the cost of financing their divisions.
· It is an absolute measure of performance and not subject to the problems of relative
measures such as return on investment.
· In the long run it supports the net present value approach to investment appraisal (the
present value of a project’s residual income equals net present value of that project).
Disadvantages
· In common with most other divisional performance measures, problems exist in
defining controllable and traceable income and investment.
· Residual income gives the symptoms not the cause of problems. If residual income
falls the figures give little clue as to why.
· Problems exist in comparing the performance of different sized divisions (large
divisions will earn larger residual incomes simply due to their size
· Residual income when applied on a short term basis is a short term measure of
performance and may lead managers to overlook projects whose payoffs are long
term.
EVA is seen to the true economic profit made by an enterprise, the concept being that true
shareholder value is created when an organisation generates economic profits in excess of
the financing costs of the economic capital of an organisation. The economic profits are
described as NOPAT (Net Operating Profits after Tax), this being a proxy measure for net
cash flows.
The financing costs represent the target WACC applied to the economic capital
1. The project will require an investment of $66 million, it will have no residual value and
depreciation is calculated on a straight line basis.
2. The following forecast sales data has been obtained for the project over three years.
Year 1 Year 2 Year 3
Sales volumes 1.8 million 2 million 2½ million
Unit selling price $60 $60 $60
3. Incremental costs $40million $45million $50million
4. The project is forecast to have a contribution to sales ratio of 60% throughout the three
year period.
5. Immediate investment in working capital will be as below; these amounts would be
recovered in full at the end of the three year period.
Inventory $5m
Receivables $5m
Payables $3m
Required:
a. Prepare a table for each year of the project showing
· EBITDA
· Net profit
· Residual income using straight line depreciation
· Return on investment using straight line depreciation
b. Calculate the projects Net Present Value (NPV) and Internal Rate of Return (IRR)
Private or not for profit businesses are not established with the aim of failure but unfortunately
it does occur. It has been suggested that the main reason for business failure is poor
leadership.
According to business commentator 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:
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’.
In this financial planning category, 82% of businesses failed due to poor cash flow
management skills, followed closely by starting out with too little money. 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 and lower priced product, 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.
AVOIDING FAILURE
Perhaps the best way to avoid failure is to look at the many reasons put forward for business
failure and to avoid them - these include
· Having a strategy.
Being aware of the reasons for business failure is one way to take action to try and avoid
and/or mitigate it. Next week I will be taking an alternative way of looking at and evaluating
business failure.
QUALITATIVE MODELS
We have talked about corporate failure and its link that to leadership, however there are
alternative ways of assessing potential failure. Financial measures can provide some insight,
but as sole indicators of organisational performance they have limitations. One way of
assessing potential failure is use a framework, such as the Argenti (1976) approach, weighting
being given to each variable - each variable shown below as underlined .
DEFECTS
Defect can be divided into management weaknesses and accounting deficiencies as follows:
Management weaknesses:
Accounting deficiencies:
· No budgetary control
· No cash flow plans
· No costing system
MISTAKES MADE
1. High gearing – A company allows gearing to rise to such a level that one unfortunate event
can have disastrous consequences
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.
SYMPTOMS OF FAILURE
The final stage of the process occurs when the symptoms of failure become visible. Symptoms
of failure are classified using the following categories:
1. Financial signs
2. Creative accounting – Optimistic statements are made to the public and figures are altered
(inventory valued higher, depreciation lower, etc).
3. Non-financial signs – various signs include frozen management salaries, delayed capital
expenditure, falling market share, rising staff turnover
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
Factors in the external environment – Such as the macroeconomic situation, including interest
rates, the business cycle, and the availability of credit.
An important thing to remember is that action can be taken to reduce and mitigate the impact
of business failure, and thus reduce the emotional and financial consequences attached.
In attempting to establish a clear link between performance and strategy it is vital that
management ensures that the performance measures target areas within the business where
success is a critical factor. The criteria for selecting performance measures for the scorecard
are
The above can be seen as a cascading effect, i.e. CSFs determine KPIs, we then set a target
and then consider ways to achieve the target KPI; the KPIs are then calculated, monitored
and reported to the board and operational managers. If the target KPIs are not being met then
appropriate action can be taken.
Some sense of prioritisation has to occur otherwise we will merely end up calculating and
monitoring a list of KPIs that have no cohesive linkage and can cause us to lose sight of our
main strategic purpose. This methodology, if developed and implemented effectively replaces
the conventional budgetary reporting system where the focus is more on cost control –
important but not the sole determinant of achieving our ultimate mission.
Written comment
a) In terms of its relations with external parties (such as customers, markets, suppliers and
competitors);
A performance indicator is something specific that allows measurement of the objective, i.e.
how will we know when we get there.
An important element of monitoring and review is feedback which, within the context of
planning, is information about the effectiveness of processes and actual achievements.
Feedback is information that is gathered by measuring the outputs of the system itself, where
important information is automatically brought to the attention of the people who need it.
c) By observations;
d) By using questionnaires;
It is important to be clear about the reliability of any particular method of monitoring chosen
and its value as a source of information.
Review involves the analysis of the monitored results so that conclusions can be drawn on the
organisation’s overall performance. These results or conclusions can be used to:
Any lessons drawn from the review exercise should be acted upon. This may require
substantial alterations to existing plans if it is clear that they are no longer realistic.
Input Measures
At the lowest end of the performance measurement spectrum is the tracking of program inputs.
Typical inputs include staff time and budgetary recourses.
Output measures
Results generated from the use of program inputs are the domain of the output measure.
Theses metrics track the number of people served, services provided, or units produced by a
program or service. They may sometimes be referred to as activity measures. Depending on
the nature of the program or services, output measures may provide information on whether
desired results are being achieved.
Outcome measures
Outcomes track the benefit received by stakeholders as a result of the organisation’s
operations. Whereas inputs and outputs tend to focus internally on the program or service
itself, outcomes reflect the concerns of the participants (clients, customers, other
stakeholders). Outcome measures shift the focus from activities to results, from how a
program operates to the good it accomplishes. Outcome measures offer many advantages:
· Performance Pyramid
· Balance Scorecard
· Fitzgerald and Moon Building Blocks
· Performance Prism
The performance pyramid derives from the idea that an organisation operates at different
levels each of which has a different focus. However, it is vital that these different levels support
each other. Thus the pyramid links the business strategy with day-to-day operations.
In proposing the use of the performance pyramid Lynch and Cross suggest measuring
performance across nine dimensions. These are mapped onto the organisation - from
corporate vision to individual objectives.
Within the pyramid the corporate vision is articulated by those responsible for the strategic
direction of the organisation. The pyramid views a range of objectives for both external
effectiveness and internal efficiency. These objectives can be achieved through measures at
various levels as shown in the pyramid. These measures are seen to interact with each other
both horizontally at each level, and vertically across the levels in the pyramid.
At the bottom level of the pyramid is what Lynch and Cross refer to as 'measuring in the
trenches'. Here the objective is to enhance quality and delivery performance and reduce cycle
time and waste. At this level a number of non-financial indicators will be used in order to
measure the operations. The four levels of the pyramid are seen to fit into each other in the
achievement of objectives. For example, reductions in cycle time and/or waste will increase
productivity and hence profitability and cash flow
The strength of the performance pyramid model lies in the fact that it ties together the
hierarchical view of business performance measurement with the business process review. It
also makes explicit the difference between measures that are of interest to external parties -
such as customer satisfaction, quality and delivery - and measures that are of interest within
the business such as productivity, cycle time and waste.
Lynch and Cross concluded that it was essential that the performance measurement systems
adopted by an organisation should fulfil the following functions:
1. The measures chosen should link operations to strategic goals. It is vital that
departments are aware of the extent to which they are contributing - separately and
together - in achieving strategic aims.
2. The measures chosen must make use of both financial and non-financial information
in such a manner that is of value to departmental managers. In addition, the availability
of the correct information as and when required is necessary to support decision-
making at all levels within an organisation.
3. The real value of the system lies in its ability to focus all business activities on the
requirements of its customers.
BALANCED SCORECARD
The Balanced Scorecard was developed by Kaplan and Norton as an attempt to counter a
rather narrow-minded approach to performance management that relied too heavily on
financial measures. The Balanced Scorecard approach relies on the organisation defining
key dimensions of performance for which discreet yet linked measures can be reported. The
following categories, or perspectives, are measured:
Ø Customers
Ø Internal Process
Ø Learning and growth
Ø Financial
The balanced scorecard depicted above is a carefully selected set of quantifiable measures
obtained from an organisation’s strategy. The measures selected represent a communication
tool to employees and external stakeholders the outcomes and performance drivers by which
the organisation will achieve its mission and strategic objectives.
A framework is developed within each of the four perspectives that helps describe the key
elements of strategy; the framework is made up of:
Mission
Customer
How do customers see
us?
Innovation
&Learning
How do we enable
ourselves to improve,
grow &create value?
Customer Perspective
Two key questions need to be asked here:
The measures that are used and designed in this perspective will help close the gap.
Employee skills, employee satisfaction, education training, internal rewards and recognition
are examples of such measures.
Financial Perspective
The measures in this perspective tell us whether our strategy execution and implementation,
detailed through measures in the other perspectives, leads to improved bottom-line results.
Typical examples include shareholder value increase, gearing.
The performance prism was devised by Cranfield University and is one that considers all
organisational stakeholders, without necessarily focusing on one group. The organisation
considers what its stakeholders need and want from the organisation, and consequently what
the organisation needs and wants from its stakeholders.
When designing the prism, the five facets referred to above prompt specific questions (and
answers), namely
· Stakeholder satisfaction – Who are the key stakeholders, what do they want and
need?
· Strategies – What strategies do we need to put in place to satisfy the wants and
needs of our key stakeholders?
· Processes – What critical processes do we need to put in place to enable us to
execute our strategies?
· Capabilities – What capabilities do we need to put in place to allow us to operate,
maintain and enhance our processes?
· Stakeholder contribution – What contributions do we want and need from our
stakeholders if we are to maintain and develop these capabilities?
Fitzgerald and Moon have developed an approach to performance measurement that is based
on the three building blocks of dimensions, standards and rewards.
– Is it going to continue?
• The other four dimensions might be considered to relate to ‘upstream determinants’ in that
they provide indicators for the ability to achieve results in the future.
The list below identifies the generic 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
• 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.
– Although research has been undertaken into how much ‘stretch’ ought to be built into
budgets.
• When setting standards across an organisation, care should be undertaken to ensure that
all managers have equally challenging standards.
• The actual means of motivation may involve performance related salary bonuses, an
assessment scheme point score or access to promotion channels.
• Managers will be better motivated if they actually control the factors contributing to
achievement of the measures and standards on which their rewards are based
Traditional (or cost-plus) costing and target costing are the most commonly used methods for
pricing goods and services. The two methods share some similarities and also exhibit some
differences. Businesses choose the method that is most appropriate for their market, product
mix and position in an industry.
Background
Traditional or cost-plus costing has been around for many decades, much longer than target
costing. Most businesses prefer it.
Target costing was developed in the 1960s by market and cost researchers working for
Toyota. Target costing is still most widely practised in and most closely associated with Japan.
Many of Japan's leading manufacturers, such as Nissan, Toshiba and Toyota, are known for
their devotion to target costing.
Methodology
Traditional costing involves first determining the total cost of the product (adding together
direct, indirect and fixed costs of the total production run, then calculating a per-unit cost and
adding an amount for expected profit (called the profit margin). In target costing, the profit
margin is subtracted from a set market price to determine a target cost. Then the production
procedures are centred on this cost, target costing going in the opposite direction of traditional
costing.
Benefits
Each method has benefits. Businesses like traditional costing for its simplicity. Little data is
required initially for cost-plus pricing, and later adjustments to the price can be made more
easily than with target costing. Target costing is praised for its efficiency and focus on keeping
costs low.
Drawbacks
Drawbacks of traditional costing include its tendency to underestimate costs and overestimate
profits, leading to wasteful spending and unprofitable products. It is also criticised for
inefficiency. Target costing is criticised for its complexity and rigidity. It requires much more
attention to the production life cycle. Traditional costing is better suited to process-oriented
businesses that use continuous production. Target costing is better suited to assembly-
oriented businesses, such as car manufacturing.
Target costing is a modern technique of cost control. It is a reverse costing technique in which
selling price is determined by read the market environment and then the desire profit margin
is deducted from the selling price.
Traditional System
In the traditional system first the budget is prepared and then the production starts. After the
production total cost is calculated. From the calculated cost the desire profit is deducted and
a selling price is determined. The difference is notice by comparing the budgeted and actual
results of cost which is known as variance.
Cost reduction must be in a way that does not affect quality because if quality is damaged
target costing plan will immediately fail.
A 5-step approach is adopted in order to carry out the target costing process.
Step # 1
Deduct the profit margin from the selling price to arrive at target cost.
Step # 4
Calculate the estimate cost of the product and compare it with target costing.
Step # 5
For example, if the selling price of the product is $25 and the desired profit margin is $5. Then,
the target cost would be $25-$5 = $20. The real cost of the product came out to be $22. Now,
the cost gap calculated would be $20-$22 = -$2. This negative $2 or the cost gap of $2 needs
to be reduced as the selling price is less than the real cost of the product.
The basic principle of TQM is that costs of prevention (getting things right first time) are less
than the costs of correction. This is contrasted with the ‘traditional’ approach which takes the
view that that less than 100% quality is acceptable as the costs of reaching 100% outweigh
the benefits.
Appraisal costs
Costs incurred to ensure that materials & products meet quality conformance standards. They
include the costs of inspecting purchased parts, work in process & finished goods, quality
audits & field tests.
Opportunity costs
Advocates of TQM argue that the impact of less than 100% quality in terms of lost potential
for future sales also has to be taken into account.
TQM IMPLEMENTATION
In any implementation there are two things going on. First is the process being implemented,
in this case the TQM process and secondly the process of implementation itself which is a
process of change management. You have already covered the management of change.
1. Gain commitment to change through the organisation of the top team. The top team must
function as a team and if they do not some team-building training via workshops should
be carried out. They should discuss and agree a broad view of what changes are needed,
what must be improved and what the main business problems are.
2. Develop a shared mission of vision of the business of what change is required. This stage
is the development of a mission statement that will help a co-ordinated flow of analysis of
processes that cut across existing organisational boundaries. The mission should consist
of an overarching purpose to which all stakeholders can agree, a set of core values,
overarching strategies and the sorts of behaviours, firmly grounded in TQM philosophy,
based on the purpose, values and strategies.
3. Define the SMART objectives, which must be agreed by the team, as being the quantifiable
indicators of success. They should be tightly bound to the mission statement
4. Develop the mission into its critical success factors (CSFs) to move it forward. The CSFs
are what the organisation must accomplish if it is to achieve its mission. They can include
things such as; motivated, skilled people; right-first-time suppliers; products that meet
market needs; and so on. The CSFs have been achieved when their Key Performance
Indicators (KPI) are met.
5. Break down the CSFs into the key processes and gain process ownership. All the
processes necessary to ensure a CSF is achieved should be listed (using a verb-object
structure i.e. research the market)
6. Break down the critical processes into the sub-processes, activities and tasks and form
improvement teams around these. For example a business services company may have
as part of its mission the objective to “Gain and maintain a position as the UK’s foremost
business service company in the field of management training. One CSF that relates to
this would be “Obtain a high level of awareness of our company in the market place”. One
The next step is to determine measurements of performance for all the elements from
process to task. These measurements should bear in mind the customer for the output.
So for example the leaflet writing task would need to contain clear objectives and benefits
as well as the programme.
-
7. Monitor and adjust the process alignment in response to difficulties in the change process.
Contribution
Minimum 30 20 0 -20
Maximum 30 60 90 95
Maximin 30
Maximax 95
Minimax regret
Max regret 65 35 30 50
Minimax 30
Containers
c. Spare capacity of Provide Inc. (52,000 – 36,000) 16,000
Additional output of Provide Inc. 6,750
Per container
Provide Inc.: existing variable cost $7
Investment
Year 0 Year 1 Year 2 Year 3
$m $m $m $m
Net book value (NBV) 66.0 66.0 44.0 22.0
EBITDA: million
(Contribution less incremental costs) $24.8 $27.0 $40.0
Less: depreciation
Profit -$22.0 -$22.0 -$22.0
(NCF minus depreciation) -$4.2 $5.0 $25.0
4.9 -5.2