Notes CIMA Paper P2 Management Performance For exams in 2012
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CIMA P2 Performance Management
Contents
Page | 2
About ExPress Notes
3
1.
Pricing and Product Decisions
7
2.
Cost planning and analysis
22
3.
Budgeting and Management Control
31
4.
Control/Performance Measurement of Responsibility Centres
37
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CIMA P2 Performance Management
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CIMA P2 Performance Management
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CIMA P2 Performance Management
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ExPress Notes
CIMA P2 Performance Management
CHAPTER 1
Pricing and Product Decisions
START The Big Picture This chapter examines the key concepts of costs and revenue relevant to product and pricing decisions.
KEY KNOWLEDGE Relevant Decision-making
One of management’s responsibilities involves making decisions affecting the firm in the short- and long-run based on relevant costs. Such decisions typically take the form of:
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•
Accept-Reject
•
Costing projects
•
Make-Buy
•
Shut down
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What is “Relevance”? Each of the above will be illustrated by practical exercises. But first it is necessary to establish the meaning of a relevant cost.
Cash & Incremental A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of taking a decision; cash, because it is the main determinant of value (unlike accounting profit); and unique in the sense that is not common to the alternative choices that are under consideration.
EXAMPLE A company seeking to determine whether to continue to transport its products by truck or to switch to the railroad, discovers that insurance costs are identical in both choices; it that case, insurance costs are not relevant to the decision. If, however, there is a difference in the two insurance costs, then one can speak as the difference between the two choices as being “incremental”; this difference (referred to in some places as the “differential”) is relevant to the decision under consideration.
Future Relevant costs refer to the future, i.e. they can be influenced prospectively by choice. It follows that: •
Sunk costs are not relevant: They have already taken place and cannot be reversed.
•
Committed costs, if they cannot be avoided, are likewise not relevant, even if the timing of their occurrence is in the future. Their “unavoidability” has already been established in the past (making them effectively the equivalent of sunk costs).
In keeping with the above logic, relevant costs therefore involve cash, are incremental and relate to the future. Relevant costs need to be identified with care, as they may include opportunity costs.
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EXAMPLE A company considers building a storage facility on the site of a parking lot. If the parking lot had been generating parking fees which will now be lost, then this foregone revenue is an opportunity cost.
Accept-Reject decisions
EXERCISE A company currently produces fire hydrants with the following per unit data: Selling Price
100
Direct materials
50
Direct labour 1 h
15
Fixed overheads
25
This company has been asked to supply a one-time contract supplying garden ornaments with the following conditions: •
Contract revenue is 750
•
10 hours of labor are required
•
Materials specific to this contract are valued at 200
Required 1. Should the company accept or reject the order? 2. What would be the impact on your decision if labor was at full capacity? Learning Points The relevant cost for labor depends on the capacity utilization of labor:
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•
If there is spare labor capacity, then the relevant cost is zero;
•
If labor is at full capacity, then the relevant cost is either:
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o
its variable market cost, if additional labor can be hired, or
o
the value sacrificed as a result of diverting labor from another activity already performed within the firm
Costing projects It is a standard management accounting practice to determine the relevant costs of a new project in order to come up with a price quotation. Setting a price without having an accurate understanding of costs can put a company at a competitive disadvantage, particularly if there is intense competition.
EXERCISE A proposed contract calls for the use of 200 liters of Agent Q and 50 kg. of Compound P. Additional data: Agent Q Compound P
In stock 150 liters 100 kg
Historical price USD 7 USD 12
Current price USD 5 USD 15
Scrap value USD 1 USD 2
Agent Q is no longer in use. Compound P is in regular use at the company. Required 1. What are the relevant costs of the two materials for the proposed contract? 2. The company discovers that as the result of a change in environmental laws, the residual value of Agent Q has actually become negative, i.e. there is a net cost of USD 1.50/liter disposal cost. How does this affect the relevant cost?
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Learning Points The relevant cost for materials depends on the following: •
If the material is not owned, then it must be bought at the current replacement (market) price;
•
If the material is already in stock, then the relevant cost is either:
•
o
its current replacement cost, if it is to be replaced in the regular course of business, or
o
its current scrap (resale) value, if it is no longer in use, or its value (if greater than scrap) if it can be applied as a substitute for another product.
If the material is scarce (i.e. cannot be purchased externally) and must be diverted from another activity already performed at the company, then its opportunity cost must be ascertained in order to arrive at an accurate relevant cost.
Make-Buy An automotive components producer can buy car heaters from an outside supplier for USD 165 per unit. In considering whether to make these internally, the company calculates that an equivalent unit can be made in 2 labour hours using USD 100 worth of materials. Labor is currently at full capacity producing carburetors which generate contribution of USD 90. A carburetor takes 3 hours to produce. Labor costs USD 6 per hour. The carburetor also absorbs fixed overhead costs at the rate of USD 20 per labour hour. Should the company make or buy the heaters?
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Shut Down decisions
EXERCISE Assume car factory with three locations: Erie Revenues (m)
Huron
Superior
25
30
40
Costs (m)*
(15)
(26)
(44)
Profits (m)
10
4
(4)
* 25% of the costs are fixed costs allocated by H.O. Required Management is considering shutting down the Superior plant. Please advise management. Even if we take allocated costs out of the equation, it is necessary to examine the structure of the costs to determine whether a plant generating a positive contribution should stay open.
The dilemma of short-term decisions and fixed costs Beware of allocated costs; but don’t forget: In the long-run, all costs are variable. In the cases above, we focused on Contribution (Revenue minus Variable Costs). In the short-run, contribution is relevant in decision-making. However, one must not forget that fixed costs have to be covered – they don’t simply vanish! In the long-run, a company’s “business model” must include how fixed costs are to be covered, otherwise the business model lacks long-run viability.
Non-financial factors for investment appraisal Although the financial case for making an investment is a vital part of the decision-making process, non-financial factors can also be important.
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EXERCISE How does one assess non-financial criteria?
KEY KNOWLEDGE Cost-Volume-Profit Analysis (CVP) The breakeven formula Total Costs = Fixed Costs + Unit Variable Cost x Number of Units Total Revenue = Sales Price x Number of Units If TC = Total Costs, FC = Fixed Costs, V = Unit Variable Cost, X = Number of Units, TR = Total Revenue, SP = Selling Price, C = SP – V = Unit Contribution and CM%= C/SP = Contribution Margin, Then the break-even point (the output level at which TR=TC) is: • •
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In units sold: X = FC/C In dollar sales: TR = FC/CM%
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• •
Safety Margin = Budgeted Sales – Break-even point (units/dollars) C is an important indicator, as it shows the contribution of each unit sold towards covering fixed costs. Therefore, in the short run, the firm may prefer to produce/sell below break-even in order to recover some of its fixed costs.
Break-even Analysis Marginal costing is useful in calculating the “break-even” level of sales. The break-even point is the level where the company achieves zero profit (neither gain nor loss). It just manages to cover its fixed costs. •
Contribution per sale – C/S ratio
This is understood as the amount of contribution generated by every dollar sold.
KEY KNOWLEDGE Limiting factors When a single limiting factor is present in a production plan, then it is necessary to identify it and to plan production around it.
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Take the following example: Product Selling price Labour cost per unit ($) Material cost per unit ($)
X 30 10 5
Y 40 16 8
Z 50 20 10
Contribution
15
16
20
It appears that in the face of unlimited demand for all three products, Product Z would be given priority as it maximizes the contribution per unit. Now, assume that labour hours are limited to 500 and that labour costs $2 per hour (demand remains unlimited for all three products). In the above case, Product Labour cost per unit ($) No. of hours per unit Contribution per hour
X 10 5
Y 8 8
Z 20 10
3
2
2
Now it becomes clear that Product X is favoured for the full number of hours available (500). 100 units of X can be produced. If demand for X were limited to, say, 80 units (requiring 400 labour hours), then the remaining available hours (100) could be used to produce either Y or Z (in this case there is indifference between the two). The steps to be followed in working out the optimal production plan are: (1) (2) (3) (4)
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Calculate the contribution per unit of product; Calculate the contribution per unit of limited resource; Rank the products according to Step 2; Produce according to the priority established in Step 3, up to the demand limit of each product or until the limited resource is exhausted
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KEY KNOWLEDGE Multi-limiting factors and the use of linear programming and shadow pricing. When resources are scarce, or other limiting factors are present in a given situation, then management is concerned with achieving the most efficient allocation of available resources. Whereas planning with one limiting factor involves the use of “key factor analysis” (in which typically one seeks to maximize the contribution per unit of the limited, or bottleneck, resource), the presence of several limiting factors requires the use of linear programming. In such cases, linear programming is typically used to either maximise contribution or to minimize costs. The usual steps to be followed are: 1) 2) 3) 4)
Define the variables Define the “objective function” Express the constraints as equations Solve the equations simultaneously as well as feasible values corresponding to the corner points; 5) Determine the combination of specific values that satisfies the objective function.
The answer can also be graphed and Step 5 determined visually. A graph also shows the “feasible region” of value combinations that are consistent with the constraints.
Shadow (dual) price A shadow price is the additional value to be obtained (usually an increase in contribution) by having available one more unit of a scarce resource.
Slack This represents the amount of a resource that has not been exhausted (i.e. its availability does not act as a constraint or limiting factor in a given set of circumstances).
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KEY KNOWLEDGE Linear Programming – Simplex Method Concept: A linear programming algorithm capable of solving optimization problems involving several output variables. The steps involve: •
Formulating the initial tableau;
•
Interpreting the final tableau;
•
Applying tableau information
EXAMPLE Assume a company produces two products (A and B) which pass through three departments (X, Y and Z). Process constraints (S 1 , S 2 and S 3 ) are represented by the number of hours of processing time available in each department. A final tableau could look as follows:
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Variable
A
B
S 1 (x)
S 2 (y)
S 3 (z)
A
1
0
0.3
-0.3
0
200
units (output)
B
0
1
-0.2
0.1
0
300
units (output)
S 3 (z)
0
0
-3.5
2.5
1
2,000
hours avail.
Contribution
0
0
0.5
0
5,500
monetary ($)
0.4
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Solution
expression
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CIMA P2 Performance Management
KEY KNOWLEDGE Pricing strategies External pricing considerations Good businesses do not compete on price alone, but seek to differentiate their products and services. Intelligent pricing nevertheless is a key component of strategy. This is especially true in recessionary economic climates.
Price-Quality Relationship A priori one would expect a positive correlation between price and quality.
High
Skimming
Premium
Price Low Penetration
Economy
Low
Quality
High
The four principal pricing strategies are shown in the above quadrants. The more interesting ones involve High-Low and Low-High combinations. There are a variety of pricing strategies with which one should be familiar: Cost plus: A markup is added to a given cost base (which can be variable or full production cost).
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Skimming: Enter the market at a high price to catch customers willing and able to pay the price; pricing can subsequently be reduced to expand market. Penetration pricing: Go in at a very low price to win market share; pricing can subsequently be increased once share is won. Premium pricing: Maintain a high price due to the nature of the product. Target pricing: Determining the price at which a product will be competitive and working back through required profit to determine the cost limits; this is the “flip side” of the target cost approach. Economy (pricing): This is a no frills low price. Promotional Pricing: These are in support of campaigns to raise customer awareness of a product. Perceived value pricing: Plays on perception of value and what the market is willing to pay. MR = MC: Marginal revenue = Marginal cost. Value Pricing: Increasing the value content of the product so as to defend market share (in times of difficult economic conditions or competition). Product-line pricing: Determining the pricing of particular items in a line of products which are closely linked with one another so as to maximize overall gain. Product range pricing: Sell a “core” product cheaply and price high related products. Volume-discounting pricing: The bigger the order, the lower the price per unit. Discriminatory pricing: Pricing the same product at different levels in different markets (geographical) or market segments (customers). Price differentiation: Pricing the same product at different levels in different markets.
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Geographical Pricing: Similar to price “differentiation”. Psychological Pricing: Plays on the emotion of the consumer. Product Bundle Pricing: Combining products into one pack and pricing it overall. Complementary product pricing: This refers to products that are used in conjunction with other products (e.g. printers and cartridges, razor grips and blades, staplers and staples, automobiles and spare parts). The approach to pricing may be low for the main product and more expensive for the “re-fills”; alternatively, the approach may be a high initial price and cheaper for subsequent products/services. Relevant cost pricing: Basing the price on a keen (accurate) understanding of the real costs of the product or service. Captive Product Pricing: Similar to “product range” but product is more closely tied to the initial product. Competitive pricing: Using competitors as a benchmark. Product Line Pricing: The overall price reflects the benefits provided by the constituent parts. Optional Product Pricing: The pricing of additional products and services once the customer has made the initial purchase. It is important not to fixate on pricing. It is only one of the four components in the marketing mix of a company, the famous 4 P’s of marketing:
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•
Price
•
Product
•
Place
•
Promotion
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KEY KNOWLEDGE Joint Products / By-products Joint products are two or more products that share a common processing path until the point of separation. Until they go their own (separate) ways, the costs of production during the joint processing cannot be physically distinguished. There are different methods used to apportion common costs to such products at the point of separation: •
Market value (based on expected sales price)
•
Number of units (litres, tons, or some other objective physical measurement)
•
Net realizable value = Final sales value – Incremental processing costs
By-products are goods which are incidental to the production process and which generate cash from sales, though the amount is modest in comparison to the overall revenues of the firm. The cash received for by-products can be viewed as a bonus that reduces production costs.
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CHAPTER 2
Cost planning and analysis
START The Big Picture This section looks at cost analysis techniques related to achieving competitive advantage.
KEY KNOWLEDGE Just-In-Time (JIT)
•
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JIT is more than an inventory management model; it is a manufacturing philosophy which puts at its core minimization of inventories on the basis that most of inventory-related activities are non-value-added.
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CIMA P2 Performance Management
KEY KNOWLEDGE Total Quality Management (TQM) Basic objectives are: Customer satisfaction, “get it right first time” and continuous quality improvement, cost savings mainly through complete elimination of waste, promotion of teamwork.
KEY KNOWLEDGE Theory of Constraints (TOC) An “optimised production technology” (OPT) approach to short-term management of “bottlenecks” (sub-processes or operations which restrict the output from the whole process to less than the amount demanded) •
Bottlenecks generate idleness of both prior sub-processes – as soon as waiting line for current sub-process is full - and next sub-process, for which there is shortage of input.
Basic principle
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•
Costs incurred in the business process are all categorized as fixed, except for direct material costs, which are categorized as variable.
•
Throughput contribution is defined as sales minus variable costs, that is, at the level of each sub-process, outputs minus direct material inputs.
•
TOC/OPT states that short-term profits are maximized when throughput contribution by the bottleneck operation is maximized
•
In a production process managed using a Drum-Buffer-Rope (DBR) system, the bottleneck operation is the “drum”, the minimal amount of work units in drum’s waiting line so that the drum never stops is the “buffer”, and the sequence of operations (including the drum) that must be co-ordinated in order not to build-up inventories is the “rope”.
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KEY KNOWLEDGE Kaizen Kaizen refers to the idea of continuous improvement in company operations. It is: •
Consistent with TQM philosophy
•
Requires building-in of costs to improve and improvement effects
•
Budgeted targets cannot be reached if budgeted improvements do not occur
KEY KNOWLEDGE Learning Curves Learning curve effects can be applied to variance analysis, as they allow standards to be adapted to a dynamic situation, i.e. one where the time to produce units declines with the increase in output.
EXAMPLE A product requires 20 hrs of labour per unit at a cost of $6 per hr. A traditional labour standard would expect 4 units to be produced in 80 hrs at a labour cost of $480. If a 90% learning curve effect applies, then one would expect the 4 units to be completed in less time. How long will they require? Utilizing the formula: y = axb Where: y = cumulative time required per unit a = time to produce the first unit (in the example above = 20) x = cumulative number of units produced ( = 4 units) b = log r/log2 r = learning curve ( = 90%)
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We solve for: y = 20 X 4-.1522 = 16
(remember: this is the cumulative time per unit)
Therefore, 4 units will require 64 hrs (16x4) Conclusion: Based on the above, 64 hrs define the standard against which the time required to produce 4 units should be compared when calculating the labour efficiency variance.
KEY KNOWLEDGE Activity-based Management (ABM) Definition ABM is a management system using ABC information to analyse relationships between costs and activities carried out, and to base decisions aimed at (a) reducing costs, (b) improve quality, (c) reduce idle time and eliminate bottlenecks, and (d) enhance process flexibility and promote innovation.
ABM approach to cost measurement •
Focus on activity costs (whether cross-departmental or not) rather than department costs
•
Focus on indirect costs (overheads) and overhead generating areas, given their significance and the fact that their degree of controllability is higher
•
Focus on individual customer profitability
NB that running an ABM programme does not necessarily need an underlying ABC system implemented.
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KEY KNOWLEDGE Target Costing This is a market-oriented approach to costing which starts by identifying the likely price that a product can fetch in the market, deducts the profit that the product is expected to earn, and arrives at the maximum (target) cost of manufacturing the product. Such a method usually requires successive iterations in order to close a “cost gap”, i.e. where the costs are above the targeted level. Product re-design, alternative materials and production processes are examined in order to achieve the desired level of costs.
KEY KNOWLEDGE Product Life Cycle A company’s long term survival is influenced by its ability to bring new products to market. In some cases, such as pharmaceuticals, the lead time (R&D) can be lengthy. Moreover, the financial (and other resource) requirements of a product varies over its life, which will typically extend beyond the next accounting/budgeting period. Consider the following: The conditions in which a product is sold change over its life.
Introduction
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Growth
Maturity
Decline
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Characteristics of each stage Introduction
Product
Potentially unique product. Quality still being “tested”.
Price
Could be high for “skim pricing” or low for penetration pricing.
Place
Limited, specialist locations.
Promotion
Aimed at the “early adopters”.
Growth New entrants arrive. Design improvements. Price can be maintained but pressure on pricing arising due to increased competition Distribution channels increase as demand rises. Expands to the larger market.
Maturity Products start to become similar with few differences.
Decline Product may have minor enhancements to try to “extend the tail” of the lifecycle.
Possibly reduced prices due to increased competition.
Possible further reductions to stimulate sales.
Widespread distribution channels.
Reduced number of distribution channels.
Focus on any differentiating products.
Limited amount of promotion.
KEY KNOWLEDGE Porter’s Value Chain
Support
Strategic Choice to Purchase Some Activities From Outside Suppliers
Support Activities
Firm Infrastructure Human Resource Management Technological Development
Service
Marketing & Sales
Outbound Logistics
Operations
Inbound Logistics
Primary
Procurement
Primary Activities
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The value chain was introduced by Porter and represents an approach to looking at the development of competitive advantage within an organisation. All organisations consist of activities which “link” together to develop the value of a business. Together these activities represent the value chain. The value chain represents a series of activities that both create and build value. Combined they represent the total value delivered by an organisation. The “margin” in the diagram is the added value (the difference between the total value of the activities and the cost of performing them). Primary activities: related with production. Support activities: provide the background for the effectiveness of the organisation (e.g. HRM)
KEY KNOWLEDGE Gain-Sharing The Concept: The process of reviewing and adjusting contracts in a manner that benefits both parties. It is primarily relationship-based, implying that there is a mutual endeavour to achieve cost savings or other benefits which can be shared between the parties. Gain sharing is the antithesis of a zero-sum game or an approach whereby one party leverages its negotiating power to press the other into a corner (“winner take all”).
KEY KNOWLEDGE Activity-Based Costing (ABC) ABC is a method that seeks to group overhead costs according to the activities causing those costs. The activities giving rise to the costs are called “cost drivers”. By linking costs to activities (cost drivers), it becomes possible to charge costs to the agents undertaking those activities.
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ABC -- EXAMPLE A factory clinic with total annual costs of $500,000 serves two Workshops A and B. Workshop A has 200 employees and Workshop B has 300 employees. A conventional way of apportioning the cost would be on the basis of employees: Workshop A: (200/500) x 500,000 = 200,000 Workshop B: (300/500) x 500,000 = 300,000 500,000 An ABC approach might look at the number of visits to the clinic by the employees of A and B. Workshop A: 150 visits p.a. Workshop B: 70 visits p.a. In this case, the apportionment could be: Workshop A: (150/220) x 500,000 = 340,909 Workshop B: ( 70/220) x 500,000 = 159,091 500,000 The different levels of usage may reflect different degrees of occupational hazard present in the two workshops. ABC advantages: provides a more precise way to determine costs per unit of output, especially since not all overhead costs are driven by production volumes. Budgetary planning, pricing decisions and managing performance are all facilitated by ABC. ABC disadvantages: it can be complex and costly to implement. It is not a “plug-in-and-go” system! It is therefore imperative that management carefully weigh the costs against the (expected) benefits from ABC before deciding to implement it.
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The following is a manufacturing illustration which demonstrates the importance of accurate product costing.
Activity classification According to Cooper (1990), product-related overhead costs can be grouped into four categories. They are: •
Unit-level activities;
•
Batch-level activities;
•
Product-sustaining activities; and
•
Facility-sustaining costs
Pareto analysis Pareto analysis is perhaps more popularly known as the “80/20 rule”, whereby (in many cases), a large number of problems can be explained by a small number of causes (in the rough ratio of 80:20. The origin of the theory comes from Pareto’s observation that 80% of the income in Italy (in the ) was earned by 20% of the population. The applications are extensive:
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•
20% of one’s clients accounting for 80% of the profit;
•
20% of one’s sales staff generating 80% of the revenues;
•
80% of customer complaints arising from 20% of the products or services
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CHAPTER 3
Budgeting and Management Control
START The Big Picture Responsibility accounting A system of accounting that attributes costs and/or revenues to individual business units (responsibility centres) for which a particular manager is held responsible.
KEY KNOWLEDGE Alternative budgeting models The strengths and weaknesses of the various models in existence should be considered:
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Fixed •
A fixed budget is not adjusted to the actual volume of output (activity level)
Flexible vs. Flexed The distinction is sometimes overlooked: • Flexible: designed to change according to actual volumes of output; usually done before the start of the budgetary period as a sort of scenario planning; • Flexed: This is done “after the fact” and is based on the actual level of activity achieved.
Rolling A rolling budget is one which is revised on an on-going basis by comparing actual results with the original budget when one period has expired, while simultaneously adding a new period to the budget period.
EXAMPLE
An annual budget which is kept rolling on a quarterly basis, for example, may start with an (original) January – December forecast. At the end of March, the entire budget is revised on the basis of the first quarter, and a new set of forecasts relating to April (current year) – March (next year) are prepared, i.e. always with a 12 month range into the future.
Zero-based (ZBB) • • •
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Each year, budget owners must justify the entire budget (build it from zero) At odds with incremental budgeting (where only changes need justification, hence encouraging the “spend it or lose it” mentality) A three-step approach to ZBB:
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o
o o
Define “decision packages” (i.e. activities that result in costs or revenues), distinguishing between “mutually exclusive packages” (alternative activities to achieve the same result) and “incremental packages” (base level of input needed + additional inputs) Evaluate and rank packages (based on the benefit to the organisation) Allocate resources across packages, considering ranking and seniority of responsible managers
Activity-based (ABB) •
No budget owners (departments, functions), but budgeted activity cost (ABC costing)
•
Budgeted activity cost = demand for activity * unit cost of activity
•
More detailed and accurate than traditional budgets, especially regarding indirect costs
Incremental Such budgets are based on what went on during the period before. Typically, this approach results in modest changes and adjustments to the earlier budget. At worst, they retain and perpetuate inefficiencies and old assumptions. This might be termed the “lazy man’s budget”.
Behavioral aspects of budgeting Budgetary control systems seek to monitor performance against the budget in a timely way so that deviations can be identified and rectified. The system can only work as well as the care and thought that went into defining performance targets to be measured, and the incentives (and sanctions) that follow from achievement (or not) of those targets. Budgets are prepared, implemented/managed and reviewed by people. The following aspects concerning human behavior need to be borne in mind: •
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Goal congruence at all levels of the organization – corporate, divisional and individual – must exist for a budget, and its attendant control systems, to be effective. A lack of congruence leads to organizational dysfunctionality.
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•
To be motivating, budgets/targets should be set at a challenging – but not an impossible – level. If they are too easy to achieve, then organizational/individual complacency result.
•
Participation in the preparation of a budget can be motivating and secure the “buyin” (i.e. commitment) of the employee.
Problems frequently encountered when using conventional budgets: •
They invite “gaming” of the system;
•
They can be inflexible;
•
They are often imposed from the top – “Top Down”;
•
There is an indirect connection with the company’s strategy;
•
They are used for too many different purposes;
•
They reinforce a centralizing tendencies in the company
•
There is a lack of goal congruence between corporate, divisional and individual goals
Key metrics The traditional financial measures used in tracking performance should be familiar; these include:
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•
Profitability ratios,
•
Liquidity ratios; and
•
asset turnover ratios.
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What-if analysis This refers to the process of testing different scenarios regarding volumes, prices and cost structures within a financial model in order to observe the financial consequences of alternative strategies. The use of excel spreadsheets is indispensable in facilitating such analyses and their use is considered a basic working tool for all management professionals.
The scope of performance measurement
KEY KNOWLEDGE Balanced Scorecard The balance scorecard addresses a number of parameters (or “perspectives”) in monitoring business performance by asking the following questions:
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•
Financial perspective: “To succeed financially how should we appear to our shareholders?”
•
Customer perspective: “To achieve our vision how should we appear to our customers?”
•
Internal business processes: “To satisfy our shareholders and customers what business processes must we excel at?”
•
Learning and growth: “To achieve our vision how will we sustain our ability to change and improve?”
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KEY KNOWLEDGE Beyond Budgeting “Beyond” budgeting: The future of budgets and alternatives to budgeting Can you imagine a budget process that takes up to six months and 20 percent of management's time? Numerous proposals have been offered to make budgeting more meaningful. Prof. Bourne (of Cranfield) is one proponent of the sort of measures below: 1. Sever the link between fulfilling budget and compensation Otherwise managers are inclined to set budget targets too low. Some companies link bonuses to the results of competitors. 2. Separate the budgeting from forecasting Budgets are linked to the allocation of resources, while forecasts are subject to more frequent changes, due to external influences (market, etc.) 3. External benchmarking to control costs This offers a better way to control costs and helps avoid the bargaining process that goes on within the company when establishing the budget. 4. Implement financial and non-financial performance measures Some companies are remarkably numbers-obsessed. Perhaps it gives the illusion of control! 5. Understand the connection between major non-financial activities and their financial consequences The above connection has to be managed more directly rather than via the numbers. 6. Make a distinction between operating costs and investments This is a reminder to non-accountants and is frequently overlooked or not appreciated.
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CHAPTER 4
Control/Performance Measurement of Responsibility Centres
START The Big Picture The concept of responsibility accounting introduced earlier is applied and examined in the context of organisational structure.
KEY KNOWLEDGE Responsibility Centres Ensuring goal congruence The system should encourage managers to make the effort to reach common goals, which (a) should be consistent with organization’s objectives and (b) should be specific, objective and verifiable.
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Critical requirements
Responsibility •Assign
responsibility
(obligation to perform) for activities to be performed within the responsibility centre
Authority •Delegate authority to direct and exact performance of assigned activities
Accountability •Establish duty to report performance and accountability for failure to meet obligation
Controllability •Evaluate performance (with consequent feedback ensuring controllability of the responsibility system)
Classification
Cost Centres
Revenue Centres
Profit Centres
Investment Centres
Cost centres •
Responsible for current expenses only
•
Performance measures: standard costs, variance reports, efficiency measures o
Efficiency = Productivity = [Output : Input]
o
Support/service centres are common examples of cost centres
Revenue centres •
Responsible for revenues, but not current expenses other than marketing expenses
Profit centres •
Responsible for revenues and current expenses
•
Performance measures: revenues, costs, output levels, profit
Investment centres •
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Responsible for revenues, current expenses and capital expenditure
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•
Performance measures (refer to sub-section III.6. for more details): ROI, RI, EVA o
ROI = ROCE = [Profit / Capital Employed]
o
RI = PBIT – Capital Employed * Imputed Interest Cost
o
EVA = Adjusted NOPAT – Adjusted Capital Employed Weighted Average Capital Cost
Behavioral aspects of system design Management accounting systems must be designed to take into account the natural tendency of people to “game” the system, i.e. manipulate it so that they can extract results which are most favourable to themselves in terms of recognition, bonuses and career development.
Controllable vs. Uncontrollable costs The distinction above between “controllable” and “uncontrollable” costs is critical insofar as it relates to the idea of “responsibility accounting”, i.e. expecting people who have delegated authority to take responsibility for decisions within their area of control.
Changes in business structure and management accounting Management accounting systems must be appropriate to the structure of the businesses they serve. We have seen that that “beyond budgeting” is based on a recognition of the limitations of traditional management accounting techniques, particularly in rapidly changing business environments. The way in which a business is organized – e.g. a functional, divisional or network form – has implications for the way in which performance is managed and measured.
Functional structures The traditional form of company follows functional lines, these being generally production, marketing, human resources, etc. Specific skills are located within relevant departments and reporting lines and responsibilities rather straightforward. At the same time, this gives rise to
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inflexibility of structure and therefore limited ability to respond and adapt to external circumstances that require inter-disciplinary skills and responses.
Divisional organizations Companies reaching a certain size, with a diversity of product lines and geographic coverage, often find that breaking themselves up along divisional lines enhances their ability to cope with changes in the market. This is because the divisions themselves replicate the original company, this time on a more decentralized basis and with specialization by product or region (meaning domestic regions for a national company, or supra-national regions in the case of a multi-national). The divisional structure motivates division managers to practice more autonomy in decisionmaking across the range of functions located within their business unit. Naturally, a division structure may lose some of the benefits provided by centralization, as for example, global purchasing (and the negotiation power it makes possible). Some organizations decentralize their treasury functions, while others maintain it at the parent company (corporate level).
Networks In an effort to keep fixed costs low, some firms deliberately out-source most of their noncore functions, and even some that are vital to the functioning of their business. A training company, for example, may rely on free-lance tutors so as to minimize the impact of seasonal downswings in demand. In this way, companies may work in alliance with other professionals who can be mobilized according to specialist skill sets and specific client demand when periods of intense activity arise. Virtual organizations are an extreme firm of networks possessing a kind of flexibility that was not possible before the advent of modern communications and transportation. Modern approaches to business structure are “integrative” in nature, as they explicitly take into account the linkages between people, operations, strategy and technology.
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Strategic management accounting in the multinational company context A multi-national company is one that operates in a number of countries, deriving a significant portion of its revenues from abroad (outside its home country). The strategy-making process takes on additional complexity as it must integrate specific factors relating to: •
Products
•
Processes, and
•
Markets
in the various countries of operation, along with their political, economic and fiscal regimes. To achieve strategic coherence across the multinational, important elements of the planning process must essentially be “top-down”, even if the company works on a decentralized basis. Typical conflicts arising between the “group” and the local levels: •
Local management may focus on short-term profits while the group emphasizes the building of market share (long-term);
•
The local company opportunistically wishes to pursue a product/service line which is not supported at group level for a variety of reasons (image/values, lack of strategic fit, technologies or skill sets at variance between the local and international levels;
•
Local decision-making autonomy vs. “across-the-board: hiring freezes or salary cuts;
•
Over time, a divergence in corporate cultures at the local and group levels, particularly when local management is dominated by local staff;
•
To complicate matters, individuals seeking to develop their careers (including the prospect of foreign assignments) may clash with local interests.
Divisional-level Performance measures
KEY KNOWLEDGE Return on Investment (ROI) Earnings can be measured at the divisional level in relation to the financial resources they use. The ROI measure is very similar to ROCE (return on capital employed) with the only exception being the use of profit in the formula:
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ROI
=
Net Profit Capital Employed
ROI as defined above is commonly used for investment appraisal and for business sector (divisional) performance, whereas ROCE is common at the overall corporate level.
EXAMPLE A division head with an actual ROI of 20% may be reluctant to accept a project offering a 15% ROI, especially if his bonus is based on ROI achieved. If the corporate overall ROI target is 12%, then the division head is missing a value-creating opportunity.
KEY KNOWLEDGE Residual Income (RI) Convert results into monetary magnitudes: Residual Income
=
Divisional EBIT (minus) Imputed interest
Where Imputed interest
= Capital Employed X Capital charge (or cost of capital)
A positive result adds profits to the division beyond the incremental capital cost. An investment should be accepted if the RI is positive.
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Drawbacks of RI and ROI
EXAMPLE A division of a corporation currently generating an ROI of 12% is examining a new project which requires an investment of $4.5m. Cash inflows are expected to be $1.5m p.a. and the cost of capital: 10%
ROI and RI computations will be as follows:
Year
1
2
3
4
NBV initial
4500
3375
2250
1125
Net cash inflow
1500
1500
1500
1500
-1125
-1125
-1125
-1125
375
375
375
375
-450
-337.5
-225
-112.5
RI
-75
37.5
150
262.5
ROI
8%
11%
17%
33%
Depreciation Profit Capital charge(10%)
From both RI and ROI points of view, the project does not look favorable to the division, even if it would be from the corporate point of view. (Eg, at a cost of capital of 10%, the project has a positive net present value).
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ExPress Notes
CIMA P2 Performance Management
KEY KNOWLEDGE Economic Value Added (EVA) The EVA method is a complex method to operate, since it involves extensive adjustments to be made to the financial statements of a company in order to determine whether the company has created (or destroyed) value during the year. EVA is arrived at by calculating two values based on a company’s financial statements: (i) The amount of capital employed in a business during the year (or period): Capital Employed = Assets – non-interest bearing current liabilities (ii) The (cash) profits (called “net operating profit after tax” -- NOPAT) that the company is able to generate during the year (or period). The EVA formula also requires the company’s WACC (r) such that: EVA = NOPAT – r x Capital Employed In other words, the formula says: Economic value is created at the firm when the management is able to generate sufficient returns (NOPAT) to cover the charge on capital which represents the expected return by capital providers. If the NOPAT fails to reach the required cost of using the capital employed, then economic value is being destroyed. EVA Adjustments The company’s financial statements need to be adjusted in order to calculate the Capital Employed and NOPAT. Capital Employed The resources that a company uses come from its capital providers – debt and equity. In order to keep track of such resources provided, the following items need to be “capitalized” by including them in the economic book value at the start of each period being measured:
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ExPress Notes
CIMA P2 Performance Management
Items to be included/added back: •
All off-balance sheet debt (e.g. operating leases);
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Cumulative goodwill/(accounting) depreciation (previously written off);
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Provisions for bad debts/deferred taxes;
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Intangibles (e.g. R&D, advertising, training)
Income Statement The income statement needs to be adjusted in order to reveal the actual operating profit of the company. To achieve this, a number of “distortions” caused by the application of accounting conventions need to be removed. The following items (typically) need to be added back to income: •
Goodwill and accounting depreciation written off during the period, net of economic depreciation;
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Provisions for bad debt expenses and deferred taxes (for the period);
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Other non-cash expenses;
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Intangibles (e.g. advertising, R&D, training expenses);
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Interest expense on debt (net of tax)
KEY KNOWLEDGE Transfer Pricing The terms under which units (divisions) within the same company buy and sell from one another must comply within relevant principles of transfer pricing. Basically: •
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It should be in the interests of the divisions to trade with each other as long as the trade does not leave the company as a whole worse off;
© 2012 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.
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ExPress Notes
CIMA P2 Performance Management
•
The interests and motivations of the division managers must be designed to be congruent with the interests of the overall organization; in other words, they must not – for reasons of organizational (or personal) self-interest – reject a deal that would be in the company’s overall best interest.
Basis for transfer price determination •
Market price;
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Outlay cost (standard) + opportunity cost to the seller;
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Outlay cost (actual) + opportunity cost to the seller;
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Outlay cost + notional mark-up;
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Production cost (full absorption);
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Best bargain (negotiation between divisions)
Some challenges concerning transfer prices •
Interim products difficult to value
It may be difficult to determine what the price should be of an interim product if there is no external market to use as a benchmark. •
Covering up production inefficiencies
This can be a problem if a division is required (or entitled) to add a margin to its price in order to book a profit. This profit margin may take the pressure off the selling division to keep its true production costs down. •
Some costs may be difficult to apportion.
There are centralized, or core, activities whose costs are borne by the various companies of a group (e.g. treasury). Apportioning the costs of such activities fairly among the other companies can be tricky. Other factors influencing the transfer pricing policy • • •
Seller’s production capacity; Seller’s cost structure (fixed vs. variable); Tax, if seller and buyer are fiscal subjects in different jurisdictions
(end of ExPress Notes)
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© 2012 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group.
theexpgroup.com
