Chapter 8 Performance management Flashcards
1.1 Performance evaluation
The main functions that management are involved with are planning, decision-making and control.
Planning is one of the main duties of the management account. This involves establishing the objectives of an organisation and formulating relevant strategies that can be used to achieve those objectives. Objectives are the aims or goals that an organisation has. Planning can be either short-term (tactical planning) or long-term (strategic planning).
Decision-making involves considering information that has been provided and making an informed decision. In most situations this involves making a choice between two or more alternatives. The first part of the decision-making process is planning and the second is control.
Control is the second part of the decision-making process. Information relating to the actual results of an organisation is reported to managers. They use information relating to actual results to take control measures and re-assess and amend their original budgets or plans. Internally sourced information, produced largely for control purposes, is called feedback.
Features of effective feedback include:
- Information is provided to management to assist them with planning, controlling operations and making decisions. Management decisions are better when they are provided with better quality information
- Clear and comprehensive
- Exception basis
- Based on controllable costs and revenue
- Produced on regular basis
- Timely
- Accurate
- Communicated
- Irrelevant data excluded
1.2 Behavioural aspects of performance measurement
Budgets and behaviour: individuals react to demands of budgeting and control in different ways and their behaviour can damage the budgeting process. Problems include dysfunctional behaviour and budget slack. Dysfunctional behaviour is when individual managers seek to achieve their own objectives rather than the objectives of the organisation.
Budget bias: budget slack (or bias) is a deliberate over-estimation of expenditure and/or under-estimation of revenues in the budgeting process
Hopwood’s research: research in 1973 involving a sample of 200 managers in a cost centre. He identified three styles of using budgetary information to evaluate management performance:
- Budget-constrained style: main emphasis is the manager’s success in meeting budgets in the short term, with no consideration for other aspects of performance. A manager is criticised for poor results compared to budget, for example if spending exceeds the budget limit. The effect on behaviour is more attention is given to cost and an increase in job-related pressure. This often led to the manipulation of data in accounting reports
- Profit-conscious style: performance is measured in terms of the ability to increase overall effectiveness, in relation to meeting longer term objectives. At cost centre performance is judged in terms of reducing costs over the long term, then short term cost targets. Short term budgetary information needs to be used with care and in a flexible way. The effect on behaviour is there is a high involvement with costs, but less job-related pressure, consequently less manipulation of accounting data. Relationships with managers and colleagues were better than a budget-constrained style
- Non-accounting style: performance evaluation not based on budgetary information and accounting information plays an unimportant role. Non-accounting performance indicators are as important as the budget targets. The effect on behaviour is that the results were similar to profit-conscious style, except for a lower concern with cost information
Hopwood concluded that poor performance was associated with a budget-constrained style and the other two methods were better.
2.1 Responsibility centre - Divisionalisation and decentralisation
As companies grow, they are likely to be split the company into divisions. These can be based on geographical location or product provided. Divisional managers are given the authority to make decisions regarding their division. The more decisions that managers make, the more decentralised the company is. The factors impacting the degree of decentralisation include:
- Management style
- Size of company
- Extent of diversification
- Communication
- Management’s ability
- Technology
- Geographical location
- Extent of local knowledge needed
The advantages of decentralisation include senior managers are freed for strategic issues, better decisions made by local managers, motivation of managers, quicker decisions and good training. The disadvantages include co-ordinating the business, lack of goal congruence, loss of control at senior level, difficult to evaluate managers and duplication of costs.
2.2 Responsibility accounting
This is a system of providing financial information to management, where the structure of the reporting system is based on identifying individual parts of a business which are the responsibility of a single manager. A responsibility centre is an individual part of a business whose manager has personal responsibility for its performance. The main responsibility centres are cost centres, profit centres, investment centres and revenue centres.
2.3 Cost centres
A cost centre is a production or service location, function, activity or item of equipment whose costs are identified and recorded for the purpose of providing management information. Cost centre managers need to have information about costs that are incurred and charged to their cost centres. The performance of a cost manager is judged on the extent to which cost targets have been achieved. They need to distinguish controllable and uncontrollable costs.
2.4 Profit centres
A profit centre is a part of the business for which both costs are incurred, and revenues earned are identified. They are found in large organisations with a divisionalised structure, and each division is treated as a profit centre.
In each profit centre there could be several cost centres and revenue centres. The performance of a manager is measured in terms of the profit made by the centre. The manager must therefore be responsible for both costs and revenues and in a position to plan and control both. Data and information relating to both costs and revenues must be collected and allocated to the relevant profit centres.
2.5 Investment centres
An investment centre is a profit centres with additional responsibilities for investment, financing and whose performance is measured by its return on capital employed. To operate, it is necessary to collect data to provide information on costs, revenues and capital employed (amount invested).
Managers of investment centres are responsible for investment decisions as well as decisions affecting costs and revenues. Managers are therefore accountable for the performance of capital employed as well as profits (costs and revenues). The performance of investment centres can be measured in terms of profit earned and capital invested.
The relative measure is known as return on capital employed. This is calculated as profit divided by capital employed. The absolute measure is known as residual income which is calculated as profit less % (capital employed).
2.6 Revenue centres
A revenue centre is a part of the organisation that earns sales revenue. It is similar to a cost centre, but only accountable for revenues not costs. Associated with selling activities. Each regional manager has sales targets to reach and would be held responsible for reaching these targets. Sales revenues earned must be able to be traced back to individual (regional) revenue centres so that the performance of individual revenue centre managers can be assessed.
2.7 Shared service centres
Common processes are often carried out by a shared service centre, such as HR or IT. The aim is to reduce costs while improving service levels. To aid common processes a company can choose cloud computing, where the software packages and applications are accessible from anywhere. This is cheaper.
Cloud accounting is an example, where accounting software is provided in the cloud by a service provider. This is often managed by an external provider, so small businesses do not have to worry about installing expensive security measures and expensive computers to run the software.
The advantages are reduced headcount due to economies of scale, reduction of floor space, knowledge sharing to improve quality of service and standardisation of approaches and processes. The disadvantages are loss of business and specific knowledge, removing day-to-day running of the business which could lead to mis-informed decisions, weakened relationships and cost inefficiencies.
3.1 Performance measured
Requirements for effective performance measures include promoting goal congruence, controllable factors only and long-term objectives considered. The problems with inappropriate performance measures include manipulation of data, demotivational, stress between staff, short-term verses long-term conflict and division come before company as a whole.
Selection of appropriate measures include:
- Cost centre: cost variances, cost per unit, cost per employee. Also, non-financial measures such as staff turnover and staff absenteeism.
- Revenue centre: revenue variances, revenue per employee, market share and growth in revenue
- Profit centre: all of the above plus gross profit margin and operating profit margin
- Investment centre: all of the above plus liquidity ratios, other working capital ratios, ROI and RI
3.2 Investment centre performance measures (working capital ratios)
Use the following ratios
- Rate of inventory turnover: cost of sales divided by average inventory
- Receivable’s collection period in days: av receivables divided by annual x 365
- Payable’s payment period: av payables divided by annual purchases x 365
The return on investment (ROI/ROCE): controllable divisional profit / controllable divisional investment x 100%
Residual income: controllable profit less imputed interest cost on controllable divisional investment
The advantages of ROI include:
- Enables comparisons made with divisions or companies of different sizes
- Used externally and well understood by users of accounts
- Primary ratio splits into secondary ratios for more detailed analysis
- ROI forces managers to make good use of existing capital resources
- Measure can be improved by increasing profit or reducing capital employed. It encourages reduction in level of assets such as obsolete equipment and excessive working capital
The disadvantages of ROI:
- Disincentive to invest manager will not want to invest if the return reduces the division’s current ROI. Existing assets may be sold, ROI is improved even though the assets are generating a reasonable profit
- Conventional depreciation methods result in ROI improving with the age of an asset. This might encourage divisions to hang on to old assets and deter from investing in new ones. A division may try to improve its ROI by leasing assets. It is suggested gross book value or even replacement cost should be used when evaluating performance
- Corporate objectives of maximising total shareholders’ wealth or the total profit of the company are not achieved by making decisions on the basis of ROI
Residual income overcomes many of the disadvantages of ROI, specifically:
- It reduces problem of under investing or failing to accept projects with ROI’s greater than the group target but less than the division’s current ROI
- As a consequence, it is more consistent with objective of maximising the total profitability of the group
- It is possible to use different rates of interest for different types of assets
- The cost of financing a division is brought home to divisional managers
4.1 The balanced scorecard
Approach to performance management with the idea that the business develops a framework for translating a company’s strategic objectives to a coherent set of goals and performance measures. This approach is constructed using four perspectives:
- Financial – creating value for shareholders
- Customer – customers value
- Internal – processes must excel at to achieve financial and customer objectives
- Innovation and learning – how continue to improve and create future value
In each category a company should seek to identify a series of critical success factors and key performance indicators (financial and non-financial). Targets should be set, and performance monitored. CSFs are things absolutely needed to be right to succeed and KPIs are a way to measure CSFs.
The benefits of a balanced scorecard include providing external and internal information and it focuses on factors enabled to help the company succeed. Problems are the selection of measures, obtaining information, information overload and conflict between measures
5.1 Budgetary control
Involves comparing the plan of the budget with the actual results and investigating differences.
Fixed budgets: compares the original budget against actual. Any differences are variances which can be adverse (decrease profits) or favourable (increase profits).
Flexed/flexible budgets recognises different cost behaviour patterns and is designed to change as the volume of activity changes. When preparing flexible budgets, it is necessary to identify the cost behaviour of the different items in the original budget. In some cases, the high-low method is used to determine the fixed and variable elements of semi-variable costs.
