53124472 acca p5 advanced performance management key notes june 2011

ACCA P5 Exam Support Notes © Pro Active Resolutions - Mahmood Reza

PRO ACTIVE RESOLUTIONS

ACCA P5 EXAM SUPPORT NOTES

Mahmood Reza FRSA, MCMI, ATT, FCCA, DMS, PGCE, BSc (Hons)

www.proactiveresolutions.com

http://www.proactiveresolutions.com

ACCA P5 Exam Support Notes © Pro Active Resolutions - Mahmood Reza 1

ACCA P5 EXAM SUPPORT NOTES: CONTENTS PAGE Page Number Introduction 3

Examiners guidance, approach, syllabus change & exam 4

Exam Reports: examiners comments 9 SYLLABUS SECTION A

• Strategic analysis, choice and implementation 13

• Benchmarking 13

• Budgeting 14

• ABC, ABB, 17

• BPR 18

SYLLABUS SECTION B

• Risk and uncertainty 20

• Activity one: risk 20

• Pricing 21

• Stakeholder analysis 22

• PESTLE and SWOT 23

SYLLABUS SECTION C

• Responsibility Accounting Systems 25

SYLLABUS SECTION D

• Mission and Vision 27

• Aims and Objectives 27

• Rewards and Values 27

• The Strategic Triangle 28

• Divisionalisation and transfer pricing 28

• Activity two: transfer pricing 32

• Porter: industry analysis - the five forces 32

• Boston Box or the BCG Matrix 35

• Ansoff product matrix 35


• Performance measures 36

o Return on investment (ROI) 36

o Residual income 37

o Economic value added 37

o Net present value 38

o Internal rate of return 38

o EPS 39

• Activity three: performance measures 39

• Human resource management 40

o Vrooms Expectancy Theory

o Agency theory

SYLLABUS SECTION E

• Performance management & evaluation 42

• Establishing a performance management system 42

• Criteria for designing performance indicators 43

• Types of performance measures 44

• Performance Pyramid, Lynch and Cross (1991) 44

• Balanced scorecard 46

• Table of potential scorecard measures 49

• ABM 50

SYLLABUS SECTION F

• Target costing 51

• Performance prism 52

• Total Quality Management (TQM) 52

LIST OF RELEVANT ACCA ARTICLES 55

• Activity one: solution 56

• Activity two: solution 57

• Activity three: solution 59


INTRODUCTION These ACCA P5 exam support notes are based on my experience, not only in respect of teaching ACCA P5 but over 25 years of teaching business and management. These notes are not meant to be a comprehensive overview of the syllabus but focus on selected parts. 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. I have adopted a sectional approach to the notes, i.e. notes are provided by syllabus section, some sectional notes being greater than others. 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 support notes are to aid and assist your study programme and to reflect student requirements, any suggestions for future improvements are greatly welcomed. ACCA Qualification The current ACCA Qualification syllabus was first examined in December 2007; a review of the pass rates for the option papers is shown below. Paper Dec 07 Jun 08 Dec 08 Jun 09 Dec 2009 June 2010 P4 31 36 36 30 41 34

P6 28 36 41 37 39 35 P7 33 33 39 37 39 32 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. The strategic planning process was examined in detail in the P3 paper. In P5 the focus is more on the performance management aspects of strategic planning and the role of strategic management accounting.


EXAMINER'S GUIDANCE AND REPORTS Alex Watt is the new ACCA P5 examiner, his first exam diet being December 2010; he wrote an article explaining his approach in Student Accountant August 2010. This guidance was updated in Student Accountant February 2011; in addition Alex Watt also wrote an article in Student Accountant February 2011 outlining the changes to the syllabus and explains the rationale behind them and the effect on the Paper P5 exam. The update article is reproduced in full, a summary of the syllabus changes are included below. The examiner’s exam reports complements the approach article and is very useful when tackling the paper for the first time, giving you a real insight into what the examiner is looking for in terms of exam performance. It covers the main themes of the paper, information on how the exam is structured, advice on exam technique, tips on how to succeed and potential pitfalls to avoid. Examiner’s approach: Paper P5 Alex Watt is the new ACCA P5 examiner, his first exam diet was in December 2010 and he has published his views on the ACCA P5 paper – contained in PDF format, video and podcast and published on ACCAs website. His article is reproduced in full below Updated examiner's approach to Paper P5 As a relatively new examiner and having managed the marking (though not the writing) of the June 2010 paper and both the writing and marking of the December 2010 paper, I felt that it would be helpful to try to give candidates further clarification of the style of questions and skills that will be tested in Paper P5, Advanced Performance Management. Key issues to consider The paper will test a candidate’s ability to assess different approaches to performance management from a variety of perspectives. This will entail the candidate knowing what the approaches are and more importantly being able to compare one with another in the context of a scenario, for example, profit and value approaches, financial and non-financial perspectives, short-term and long-term issues. The questions set in Paper P5 will be based around an organisation. The scenario will describe the organisation, its objectives and its business environment. A good candidate will show how they have taken in this information and then applied it to the performance management of that organisation. For example, when assessing different performance management approaches, a useful question to ask is ‘Does this meet the objectives/needs of the organisation?’ so obviously, the candidate must have identified these from the scenario. Candidates must make sure that they can: 1. Assess the current situation of the organisation (e.g. its existing performance management systems) and then 2. Consider how to apply a new approach to performance management (e.g. value-based or based on one of the many models mentioned in the syllabus such as the performance prism or the building block model) and 3. Assess whether this new approach will be an improvement.


Lists of rote-learned advantages and disadvantages for different approaches will not produce a complete answer as a candidate will be expected to tailor this knowledge to the situation given in the question. So for example, Question 2 of December 2010 asked for an evaluation of two costing systems within a laptop manufacturer. A good answer considered the advantages and disadvantages of the absorption costing and activity-based costing in a dynamic, competitive, bespoke-manufacturing environment. Cover the whole syllabus Remember that, broadly, the exam will test the capabilities listed in the syllabus that are required of a candidate. There are six capabilities and most will feature to some extent in every diet: v Use strategic planning and control models to plan and monitor organisational

performance v Assess and identify relevant macroeconomic, fiscal and market factors and key

external influences on organisational performance v Identify and evaluate the design features of effective performance management

information and monitoring systems v Apply appropriate strategic performance measurement techniques in evaluating

and improving organisational performance v Advise clients and senior management on strategic business performance

evaluation and on recognising vulnerability to corporate failure v Identify and assess the impact of current developments in management

accounting and performance management on measuring, evaluating and improving organisational performance

The paper will aim to address issues at both the strategic and operational levels and will often require a candidate to understand the connections between these levels. For example, the question of how strategic objectives flow through critical success factors to performance indicators as in Question 1 of the December 2010 paper. Another example of the type of question that arises is how does the choice of operational performance measures impact on the strategic performance of the organisation? A phrase that rings true in many situations is Drucker’s dictum ‘What gets measured gets done.’ This phrase succinctly points to the impact that the choice of performance metrics have on the management activity of the firm. Now these points should illustrate why it is a misapprehension that the paper is predominantly about performance measurement, it is a performance management paper. This error often manifests in a candidate’s over-concentration on detailed elements of Section D (strategic performance measurement) of the syllabus. As indicated above, it is important to remember that the ideas contained in the various metrics need to be coherently applied to meet the strategic needs of an organisation and this is where other sections of the syllabus will connect to a question, for example, Section A on how strategic performance fits with the planning and control structures or Section B on external drivers of performance. Create information The candidate is expected to be able to calculate numbers using the various techniques of the paper; however, it is more important that the candidate can explain what their numbers mean and what importance to place on them.


A valuable management accountant will create information from the detailed data given in a question. It is often best to begin by considering the ‘big picture’ (what is the overall objective); next, break down the data into smaller but meaningful (and manageable) chunks; finally, discuss the individual lines of the data table and even then, a candidate should focus on the data that explains the overall picture of emission changes. A good example of this was Question 4 Part b) of the December 2010 paper. 1. Consider the ‘big picture’ – whether the overall target for emission reduction be met. 2. Break down the data into smaller but meaningful (and manageable) chunks – road, rail and air transport 3. Discuss the individual lines of the data table focusing on the data that explains the overall picture of emission changes – the switch from petrol to diesel powered motor vehicles is complete in commercial vehicles and has led to large reductions in emissions but such a change may be more difficult in company cars as employees may resist such a change. Note specifically, this will require answers that go beyond repeating, in sentence form, the data given in (say) a table in that question. There many candidates wasted their time by limiting their comments to only writing out statements such as ‘Commercial Fleet Diesel use has fallen from 105.4 to 70.1’ or even ‘Commercial Fleet Diesel use has gone down’. First, this is stating the obvious to anyone who read the table but also importantly, this is far too detailed for most reporting purposes. Candidates will be expected to analyse not merely calculate numerical data given from a scenario. Overall A candidate would be advised to ask him/herself if the answer they have produced would help the organisation to answer the question requirement. Remember… try to add value with your answers by way of comments relevant to the issue at hand.

Article end

ACCA P5 SYLLABUS CHANGES: SUMMARY Paper P5 syllabus changes for 2011 June 2011 will see an amended syllabus introduced for a number of ACCA papers including Paper P5, Advanced Performance Management. In this article, I will run through these changes explaining the rationale behind them and the effect on the Paper P5 exam. The article begins with an overview of the main changes and concludes with a detailed discussion of the changes to the study guide. Overview The changes to the Paper P5 syllabus are not fundamental. The six learning capabilities that a candidate must be able to demonstrate are unchanged. However, there are a number of changes to the syllabus and detailed Study Guide which are outlined below. Some of the changes were motivated by a requirement to move some of the strategic management accounting topics out of an optional paper and into an essential paper; some of the changes arose from a desire to more clearly differentiate


Paper P5 from Paper F5, Performance Management and Paper P3, Business Analysis and the remainder were made in order to clarify and update the previous syllabus. The substantive changes are: Two new areas have been added to the syllabus from Paper P3. They are quality and human resource management. Questions on these areas will connect to the rest of syllabus by being focused on their impact on the performance of the organisation and its performance management systems. On quality management, the new areas seek to differentiate the different types of activity involved in quality management and the impact of such initiatives on existing performance management systems. For example, a candidate may have to give advice on how quality initiatives require: v The need for new information of a more subjective or qualitative nature v Changes to the key performance measures used in the organisation v The culture and style of management to alter (team working) v Changes to human resources management (staff training, recruitment, and

empowerment). The application of quality management practices is not, in itself, new to Paper P5 having been a current issue for some time and so the extension to cover these other areas is quite natural. On human resource management and reward systems, once again the change is an extension of topics that have already been in the Paper P5 syllabus. The connection between appraisal and reward systems and the motivation of staff to improve the performance of an organisation has been present in the syllabus for some time. The additional elements should be seen as adding greater depth to those points. Appraisal and reward systems have been a topic of current debate with many commentators arguing that they were a significant factor in the recent banking crisis driving managers to take too many risks. An area of greater emphasis in the syllabus is the need to address risk and uncertainty in management decision making. This has appeared in articles and past paper questions such as Question 2 in June 2010. It is not intended to dramatically increase the depth of coverage of this area. However, in line with ACCA’s increased educational focus on risk management, the topic has been given greater prominence in the Study Guide. Two traditional topics from Paper P5 have moved to Paper P3. However, it is important to note that they have not vanished from Paper P5. First, much of the detailed pricing-technique testing has moved into Paper P3 although in Paper P5, it will remain essential that candidates can recognise the impact of their suggestions and changes on the pricing decision as this is a key element of performance management. Second, certain elements of budgeting and costing will now also appear in Paper P3 as it is necessary that these are considered in a compulsory paper. These topics will still have relevance to Paper P5 as can be seen from the coverage in Section A of the syllabus. The focus of Paper P5 questions in this area will be in assessing different financial control systems and their appropriateness for different types of organisation (e.g. profit making and not-for-profit). Extract end


STRUCTURE OF THE EXAM PAPER The exam comprises two sections. Section A includes two compulsory questions usually worth 60 marks in total; a maximum of 40 marks is available for either question in Section A. As Section A is compulsory, candidates must not only attempt it in the exam, but must also allocate an appropriate amount of time. Section B contains three optional questions worth 20 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. P5 ADVANCED PERFORMANCE MANAGEMENT DECEMBER 2010 General Comments General Comments Firstly, I would like to offer my congratulations to all of those candidates who achieved a pass at this diet and my commiserations to those who did not. The examination paper comprised two sections, A and B. Section A consisted of two compulsory questions for 60 marks in total. Section B consisted of three optional questions for 20 marks each from which candidates were required to answer two questions. It was pleasing to see a large number of candidates providing good answers to every question they attempted and consequently achieving high marks. Sadly, the examination revealed a large number of candidates who were either inadequately prepared for the examination or failed to read the question requirements carefully. The performance in this diet was poorer compared to previous diets partly to be due to an inability of some candidates to be flexible in their approach to the examination. As a final level paper, candidates cannot expect there to be one standard answer to all questions on a given topic. The examination is intended to make the candidate apply their knowledge to a given scenario and that scenario will always present new challenges. As in previous diets, in general, candidates are demonstrating good skill at description but are weaker on analysis. This is a lesson that has gone unlearned from previous diets. An example of this was in Q4 (b) where an analysis of a given table of data was required. This is a core skill for any commercially valuable accountant much like being able to read a set of accounts. Therefore, these should be straight-forward marks as this skill is building on those tested at previous levels in the qualification. It is apparent that many candidates believe that because the basic application of this skill has been tested at a lower level, it is thus excluded from later diets. This is wrong! At the professional level, you can expect skills and knowledge obtained at previous levels to be tested but now in a more complex and realistic scenario. Candidates should remember that the examination is intended to be a test of their ability to ‘add value’ in


their work. They can demonstrate that ability by doing things that those they are reporting to cannot – picking out the nuggets of gold from the pile of dirt. Thus, good characteristics to develop in the interpretation of questions are the strength of will to maintain focus on the overall objectives, the keen-sight to identify the driving factors of performance and the breadth of knowledge to be able to suggest methods of performance improvement. Presentation of answers continues to show improvement and more candidates are obtaining higher professional marks as a result. One area that could still be improved is the use of subheadings to break up long answers and in particular, making sure that question sub-parts are all clearly indicated. Candidates should also note that bullet point answers often do not give sufficient detail to earn good marks. As usual, the examination presented a challenge in the efficient use of the candidates’ time. However, well-prepared candidates found this no issue in providing good, complete answers to all questions. It was noticeable that those candidates who failed to complete all of the questions were ones who did not have a clear grasp of the question requirements and the basic knowledge required. As a result they spent considerable time writing irrelevant or vague answers that gained few marks. P5 ADVANCED PERFORMANCE MANAGEMENT JUNE 2010 General Comments Firstly, I would like to offer my congratulations to all of those candidates who achieved a pass at this diet and my commiserations to those who did not. The examination paper comprised two sections, A and B. Section A consisted of two compulsory questions for 60 marks in total. Section B consisted of three optional questions for 20 marks each from which candidates were required to answer two questions. It was pleasing to see a large number of candidates providing good answers to every question they attempted and consequently achieving high marks. Sadly, the examination revealed a large number of candidates who were either inadequately prepared for the examination or failed to read the question requirements carefully. Nevertheless it was pleasing to observe that the improved overall performance of previous diets has been maintained, where there have been few candidates scoring very low marks. In general, candidates are demonstrating good skill at description but are weaker on analysis. This is a lesson that has gone unlearned from previous diets. Many answers often limited themselves to basic comments on trends (e.g. in Q1 (iii) and Q5 and tended to limit their analysis to ‘this has gone up’, ‘this has gone down’ etc. At the professional level, comments should be helpfully quantified where possible and the commercial implications discussed. So ‘prevention costs have increased’ would be improved to ‘the prevention costs have risen by (e.g.) 12% and this should yield benefits by improving production quality and so lowering future rectification costs and improving customer satisfaction.’ This shows the ability to create information and interpret it for the business being analysed. As a further general suggestion to improve candidates’ technique, those who use the scenario to provide illustrations of their general knowledge of a topic score more efficiently and effectively than book-learned definitions supported by vague business examples.


P5 ADVANCED PERFORMANCE MANAGEMENT DECEMBER 2009 Sadly, the examination revealed a large number of candidates who were inadequately prepared for the examination. Nevertheless it was pleasing to observe that there were far fewer candidates scoring very low marks than in recent diets and, in general, the overall performance of candidates was much improved. Many candidates continue to display their answers poorly, with a lack of clear labelling to indicate which questions are being attempted. Hence, many candidates would benefit by giving more thought to the presentation of their answers. This would not only improve the organisation of their answers but would also assist the marker by ensuring that they commence each question on a new page within their answer booklet. Many candidates would clearly benefit from planning their answers to discursive parts of questions. For example, In their answers to Question 5 a number of candidates discussed the mission statement of CFD in part (a)(i) although this was in fact a requirement of part (a)(ii). It was noticeable that many candidates begin their answers to discursive parts of questions by rewriting the requirement of the question and in doing so waste valuable time. Many candidates had clearly memorised solutions to past examination questions and were determined to include them in their answers to questions on the examination paper. Question 5 was the most common place for this to happen e.g. using a past question on hotels as a template for dog kennels and suggesting surveying the dogs on quality of meals and room cleanliness! P5 ADVANCED PERFORMANCE MANAGEMENT JUNE 2009 General Comments However the examination revealed a very large number of candidates who fell well short of achieving a pass. Indeed, there were relatively few marginal candidates at this diet. The overall results suggest that far fewer candidates than expected were adequately prepared for this examination. Sadly, many candidates did not answer all of the question subsections and in not doing so imposed limitations on the marks available to them. Candidates should avoid the temptation to undertake ‘question spotting’. The P5 examination paper continues to examine the full syllabus and as such will continue to reveal those candidates who are poorly prepared. That said there was still much in this examination that was consistent with previous examination papers (Questions 1, 2 and 4) which should have given the more able and prepared candidates a sound foundation for success. Candidates need to be aware whether they have the knowledge to answer discursive questions. If they do not then it is essential that they realise that the quantity of work produced is not a substitute for quality. This was particularly evident from candidates’ answers to Question 3. Workings were generally shown but were at times difficult to follow. Many candidates continue to display their answers poorly, with a lack of clear labelling to indicate which


questions are being attempted. Each question should be started on a new page and candidates must give more thought to the layout and organisation of their answers. This is especially the case given the potential to earn professional marks in this or any other of the professional level examination papers. P5 ADVANCED PERFORMANCE MANAGEMENT DECEMBER 2008 One major problem was candidates ‘memorising’ model answers to past paper questions and attempting to ‘shoehorn’ these answers into questions without even attempting to adapt these answers to the question context. Question 2(d) provided cases of this practice. The question clearly asked for performance measures to assess the quality of service of a software provider, yet there were answers such as ‘the quality of meals, waiting time at reception, staff uniforms and cleanliness, as well as specific mention of hotels. This practice was also evident from candidates’ answers to Question 4(b) with many different organisations mentioned and only the minority of candidates actually referring to BAG. Also evident was the inability of many candidates to interpret the numbers and ratios and translate them into ‘good’ and ‘bad’, even things such as a ‘lost items percentage’ being higher than the target was seen as constituting good performance simply because the number was higher! This suggests that candidates are taking a rote-learning approach which is inappropriate for this level of examination. P5 ADVANCED PERFORMANCE MANAGEMENT JUNE 2008 Many candidates did not answer all of the question subsections and in not doing so imposed limitations on the marks available to them. The consensus of opinion from the marking team was that the paper provided the opportunity to obtain relatively high marks. However, the examination revealed a large number of candidates who performed poorly. The overall results for this diet were not pleasing. P5 ADVANCED PERFORMANCE MANAGEMENT DEC 2007 Sadly, the examination also revealed a large number of candidates who seemed inadequately prepared for the examination. Nevertheless it was pleasing to observe that only a relatively small number of candidates scored very low marks. In general, the overall performance of candidates was good. Many candidates who clearly had knowledge of the areas of the syllabus which featured within the examination questions were unable to achieve a pass at this diet as a consequence of poor examination technique which frequently manifested itself via poor presentation and/or time management or not observing the specific requirements of each question. Well-prepared candidates invariably provided concise workings which arrived at the correct solutions to the computational parts of the examination paper. However, a significant number of candidates produced workings, notably in their answers to part (a) of Question 1, which were and difficult to follow. The need for candidates to give more


thought to the layout and organisation of their answers is of paramount importance. This is especially the case now that ‘professional marks’ might be awarded for well- presented answers. Rather surprisingly, a number of candidates ignored the advice given in previous examiner’s reports that each question should be started on a new page in their answer booklet(s) and that there should be clear labelling to indicate which questions are being attempted. It was pleasing to observe that the vast majority of candidates attempted all four questions. However, there was some evidence of poor time management, particularly affecting Question 1 which a significant number of candidates attempted as their final question. The poor performance of many candidates was exacerbated by a clear failure to carefully read the content and requirements of questions. This contributed to some poor performances in both the computational and discursive parts of questions.


SECTION A Strategic analysis, choice and implementation Johnson and Scholes’ 3stage model of strategic planning is a useful framework for seeing the ‘bigger picture’ of performance management and strategic management accounting issues. 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. v Strategic management accounting gives a financial dimension to strategic

management and control, providing information on the financial aspects of strategic plans and planning financial aspects of their implementation.

v It supports managers throughout the organisation in the task of managing the organisation in the interests of all its stakeholders.

v Strategic management accounting places an emphasis on using information from a wide variety of internal and external sources in order to evaluate performance appraise proposed projects and make decisions.

v It focuses on the external environment, such as suppliers, customers, competitors and the economy in general as much as on the organisation itself.

v Strategic management accounting monitors performance in line with the organisation’s strategic objectives in both financial and nonfinancial terms

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


v 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 v 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 v Competitive: this focuses 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. v Generic: this is 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. Successful and effective benchmarking requires commitment and support from the board and senior management. Managers need to be as specific as possible when identifying areas to benchmark. For example, a company that wishes to benchmark customer service needs to decide what specific aspect of customer service needs to be examined. Customer service encompasses a diverse range of activities, such as dealing with enquiries, handling disappointed customers, issuing refunds and taking payments. Each of these activities is different, each with its own thought processes, techniques and controls.

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. BUDGETING Budgets have multiple functions, namely Planning v Management produce detailed plans for implementation

Coordination v Actions of different parts of organisation are brought together

Communication


v Everyone is informed of the plans and policies; top management communicates to lower level management

Motivation v This influences managerial behaviour, individuals motivated to perform in line

with objectives. This can encourage inefficiency and conflict between managers Control v Assists managers in controlling activities with managements attention

concentrated on deviations from a pre-set plan Performance Evaluation v Measuring success of achieving the budget, rewards like bonuses are given in

some companies and is meant to iinfluence human behaviour Incremental budgeting Indirect cost and support activities are prepared incrementally Zero based budgeting Activities are justified & prioritised before decisions are taken. The approach is that ‘budgeted’ expenditure starts from base zero and description of each activity is included in a decision package, they are evaluated, ranked and resources allocated. The benefits are that the deficiencies of traditional budgeting are avoided, resources are allocated by need or benefit; a questioning attitude is created and the focus is on attention on outputs in relation to value for money Anthony (1965) categorised control into three main types: Strategic Control v The setting of corporate strategy and long term objectives for the organisation.

Operational Control v 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 v 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 session.


Feedback and Feed-forward Controls v Feedback control - occurs where actual outputs are monitored against desired

outputs and corrective action is taken where there is a variance between the two. v Feed-forward control – predictions are made about future outputs and

compared to desired outputs and action is taken where there is a difference between the two.

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. Budgets as feed-forward control In putting budgets together, and submitting them to the budget committee, they are compared against the future expectations of the organisation as outlined in the long term plan. If the budget falls short of these expectations then it may be adjusted and alternatives considered. This process may continue until a budget is agreed that will meet long term expectations. Budgets as feedback control During the budget period actual results are compared to the budget and any deviations from budget identified. Corrective actions are then taken to ensure that future results are in line with the budget. BEYOND BUDGETING Budgets have conflicting roles and a single budget system can’t serve several purposes with planning and motivating roles potentially in conflict. The traditional budgeting model has been criticised for its dysfunctional impact on performance improvement, design and decision making. This was highlighted by Hope and Fraser in their article "Beyond Budgeting" which won the prestigious IFAC award for best management accounting article of 1998. Beyond budgeting is an alternative management model based on the decision-making needs of front line managers. In the model, the nature of performance responsibility is transferred from the centre. Work place culture has a significant impact on the successful implementation of beyond budgeting; it is the participation in decision-making and authority (according to Hope and Fraser) to use their own judgement and initiative that motivates employees to act in the best interests of an organisation and its shareholders. Beyond budgeting requires goal setting, rewarding employees, planning action, resources and co-ordination. Goal setting needs to base targets on KPIs and relative benchmarks to ensure that managers pursue strategic and financial goals. Medium


term goals typically include financial performance expectations, wastage reductions, new product introductions and customer satisfaction ratings. Setting targets based on internal and external benchmarks helps remove internal political negotiations. Managers' performance bonuses can be linked to KPIs both at corporate and business unit level. ACTIVITY BASED COSTING (ABC) Organisations are typically structured hierarchically on a functional basis and costs are typically reported, and control exercised, under commonly recognised general account headings. Within this system, departments are controlled against budget and past performance. This is a well tried and well understood approach but it fails due to 1. Senior management focusing effort on corporate strategies but failing to

communicate them down the organisation to the lower levels. Businesses try to meet their corporate objectives and to meet the needs of their customers. However with each department having its role to play in a cost budget, the departments often allow budgetary targets to dominate. Their contribution to meeting business and customer needs is neglected.

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.

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. ABC is one answer in view of the drawbacks of conventional cost management. The ABC approach recognises the following -

v The need to generate product costs that more accurately reflect the factors which drive them, such as variety and complexity - not just volume.


v The requirement to attribute the cost of differing levels of service to your customers in order to establish true customer profitability.

v The need to be able to measure the cost of failure throughout the organisation, particularly in the overhead functions, so as to focus management attention to the major opportunities for improvement.

v The need to identify the factors that drive costs and helps guide managers as to where they can best direct their efforts in order to control costs.

v The crucial importance of the key business processes. 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:- v What activities are being/need to be carried out? v How efficiently the activities are being carried out and to what quality and

standard. v What is driving the level of resource required to perform this activity (the

activity level volume driver). v The relationships between the activity level volume driver and its root cause. v How the root cause may be changed and how this can affect the activity

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. BUSINESS PROCESS REENGINEERING This is often referred to by the acronym BPR and one of the ways that organisations aspire to become more efficient and effective. Business Process Re-engineering (BPR) is the strategic analysis of business processes and the planning and implementation of improved business processes.


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 BPR is not a universal panacea and criticisms of the approach include v Ineffectiveness of processes is what limits an organisations performance, this is

not necessarily true v The existing way of doing things is disregarded v No real focus is provided for process improvement on organisational constraints v The model (US origin) may be culturally biased towards a US perspective;

cultural differences make it difficult for this approach to be universally applicable.


SECTION B RISK AND UNCERTAINTY Risk management is the process of managing your organisation's exposure to potential liabilities. It gives managers, staff, clients, the board and other stakeholders the confidence to pursue their mission without the fear of legal action or harm, and approaches risk in a structured and calculated manner, rather than being haphazard. 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 infers some level of uncertainty; and some unwanted consequence must exist in one or more of the choices available to the manager. Decisions under uncertainty are effectively where • Outcomes are known • Associated probabilities are unknown Decisions under risk are effectively where • Outcomes are known • Associated probabilities are known 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 Expected Values (EV) This is used where decisions subject to risk EV = Total of probabilities of outcome × returns 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 a) Construct a contingency table b) How many kilos should be bought if the following approach were adopted?

v Maximin v Maximax v Regret

c) Calculate expected contribution (EV) PRICING There are three general approaches to pricing Market based approach, which includes v Target pricing v Market skimming v Price differentiation v Competitive pricing

Cost based v Cost plus

Economic approach v MR = MC

MARKET-BASED PRICING STRATEGIES The actual approach to be adopted will be influenced by the stage in the product life cycle and general market considerations such as Company’s Market Position v The nature of the market & its share v Whether the company is price setter or price taker v The likely competitor reaction

The Macro-Economic Status v Is the economy experiencing boom, recession or confidence?

Other Aspects of the Marketing Mix v The product mix v Any constraints of range v Are there bundling opportunities v Place v Promotion v Product / service attributes


COST STRATEGIES Marginal-Cost v Unit Selling Price = Variable Cost + % contribution v Normally used for short-run tactical or scarce resource situations v A danger that low prices become norm

Full-Cost v Unit Selling Price = Total Cost / Budget Volume + % Profit v This ensures that profits are above break-even volumes v There is a risk of a spiral of declining demand

Minimum-Price v Unit Selling Price = Incremental (cash) Costs only v or opportunity costs in a scarce resource situation

ECONOMIC APPROACH This is considered a theoretical approach to pricing for products exhibiting elastic demand, these being ones that are v Homogenous v Has no distinctive USPs (Unique Selling Proposition) v Product substitutes exist v That there is no perceived value in the product v A strong correlation between price and demand, i.e. a % increase in price causes

a corresponding % decrease in demand (and vice versa). Profit Maximisation occurs where marginal revenue = marginal cost, this can be determined by graphical interpretation, tabulation, or differential calculus 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. Stakeholder Analysis is a process that involves the following stages: v Identify - who are the stakeholders? v Assess and rank - which stakeholders have the most power or influence over the

organisation? v Decide criteria - what are the stakeholders’ expectations? v Decide actions - are we meeting the stakeholders’ expectations? If not, what

should we do?


v Assess performance - are our actions on generating the appropriate outcomes, or should we change?

One analytical tool way to help manage stakeholders is Mendelow’s Matrix.

Stakeholder power Low A B

High C D

A. Minimal effort;

B. Keep informed;

C. Keep satisfied;

D. Key players.

Low High

Probability of exercising power/level of interest

PESTEL AND SWOT 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

YourOrganisation

Suppliers

Substitutes

Competitors

Customers

Political

Economic

Social

Technological

Stakeholders

MacroEnvironment

CompetitiveEnvironment

Entrants

PESTEL ANALYSIS (MACRO ENVIRONMENT)


The figure above shows the range of environmental influences. It is useful to identify what macro environmental factors are affecting an organisation and then to consider which of these are most important (a) at present, (b) in the future. This is known as a PESTEL analysis, i.e. an assessment of how Political, Economic, Social, Technological, Ecological and Legal factors impact, or are likely to impact, on your company. 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. SWOT This is a strategic planning tool which summarises the key issues from the business environment and the strategic capability of an organisation most likely to impact on strategy development. This can be used as a basis against which to generate strategic options and assess future courses of action. v STRENGTHS: What we are good at v WEAKNESSES: What we are not so good at v OPPORTUNITIES: Favourable events trends v THREATS: Unfavourable events trends

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.


SECTION C RESPONSIBILITY ACCOUNTING SYSTEMS Responsibility accounting systems identify individual areas of responsibility in the organisations structure. Each area of responsibility is often referred to as a ‘responsibility centre’. Managers are allocated responsibility centres and held responsible for its performance. There are four types of responsibility centre:

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 In operating a responsibility accounting system a number of issues have to be considered: v Controllable and uncontrollable costs

Managers should only be judged and measured on costs and revenues that they control. If a manager is allocated responsibility for uncontrollable items then no matter what variances occur for that item the manager will not be able to take actions to correct the situation. This only serves to demotivate the manager concerned.

v Problems of dual responsibility It may be for some items an element of shared responsibility exists. For example, direct labour may be the responsibility of the production manager. However, training courses for direct workers, which may require overtime payments for attendance, may be the responsibility of the human resources manager. In these instances a responsibility accounting system should seek to assign and report on cost to the person having ‘primary’ responsibility.

v Guidelines for reporting 1. If a manager can control the quantity and price paid for a service or goods

then the manager is responsible for all of the expenditure incurred for that service or goods.

2. 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.

3. 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.

v 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. However, if managers do not see these costs then they will not understand the costs that are incurred to support their business areas. There is an argument, therefore, that managers should be made aware of arbitrary costs. This would prevent the abuse of services, such as IT support. It should also be borne in mind that they may have some influence on the costs involved.


SECTION D 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 which the organisation aspires, now and in the future, and forces the Board members and staff to align themselves around a specific agenda. 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 Strategic Triangle 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: v Size – a large organisation with centralised management become unpractical v Nature of work – specialists become necessary to deal with the diverse and

complex activities of a business v Motivation – managers need incentives to perform well v Uncertainty – volatile market conditions are better coped with by a manager with

a smaller, closer, sphere of influence v Geographical – it is important to get close to markets and sources of supply v Fiscal – profits can, subject to legal restrictions, be diverted in such a way as to

minimise tax liabilities 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. Two of the main organisational structures are functional or divisionalised, represented as follows:

Vision

Mission Rewards

VALUES


FUNCTIONAL STRUCTURE

DIVISIONAL 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. Adopting a transfer pricing policy will result in: • Total corporate profit to be divided up between divisional profit centres, it may result

in a cost centre being converted into a profit centre • Information becoming available for divisional decision-making • Information being made available to help assess the performance of divisions and

divisional managers 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) Setting the transfer price In the majority of cases the transfer price will be set somewhere between these two extremes. It is important that the criteria used to pick a price are easy to understand and that the impact of the price on the profits of the two segments can be easily evaluated. 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.

Cost-Based Transfer Prices The big problem with cost-based prices is deciding on the cost to be used. Is it to be an actual or standard cost? Will it be fully absorbed cost or variable cost and if so what will be included? Will there be additional elements to cover general and administrative costs for example?


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.

Negotiated Transfer Prices Some companies allow business segments to negotiate the transfer price, usually between the upper and lower limits set out above. There is an implication here that the buying segment has the right to purchase form external sources if it cannot agree a price. Such freedom runs the risk of sub optimisation as segment managers’ fight to gain the lion’s share of the available profit. For this reason the company may specify arbitration processes and for performance management purposes may evaluate managers on the basis of the total profit made by both segments, irrespective of the segment n which they work.

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.


ACTIVITY TWO: PROVIDE INC. AND RECEIVE INC: TRANSFER PRICING Receive Inc. and Provide Inc. are trading subsidiaries of the Happy Group of companies. 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 (i) At their present level, and (ii) At the higher potential level indicated by the market research, subject to a cut in price of 20%. b. Recommend, with supporting calculations, a possible transfer price. PORTER: INDUSTRY ANALYSIS - THE FIVE FORCES The factors that determine the returns that are possible in an industry are known as the Five Forces. This approach to analysis was developed by Prof. Michael Porter (Competitive Strategy, 1980) initially as an investor’s tool. An industry is a group of firms producing products that are close substitutes for each other. According to Porter five forces determine industry structure: 1. Buyer Power 2. Threat of substitutes 3. Supplier Power 4. Rivalry 5. Barriers to Exit and Entry. Competition in an industry continually works to drive down the rate of return towards the competitive floor rate of return.


Threat ofPotentialEntrants

BargainingPower ofBuyers

(customers)

BargainingPower ofSuppliers

Threat ofSubstitutes

CompetitveRivalry

YourOrganisation

(Supply conditions) (Demand conditions– across totalmarket / segments)

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. v A group of buyers is powerful if for example a buyer purchases large amounts

relative to the seller’s total sales. v If the product bought represents a significant portion of the buyers total

purchases the buyer will tend to shop around for lower prices. v If the products are standard and undifferentiated the buyer will have more power

over prices. v If the buyer has few switching costs it will not be locked into a particular seller. v If the buyer has low profitability it will have to press for low prices. v If the product is unimportant to the quality of the buyers products or services. v If the buyer can exercise significant power over which products its customers

purchase as in large retail stores. 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: v It is concentrated with few firms v It does not have to contend with other substitute products for sale to the industry. v The industry is not an important customer. v The suppliers’ product is an important input to the industry. v The supplier group as built up switching costs 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: v Numerous or equally balanced competitors. v Slow industry growth v High fixed or storage costs. The significant cost here is fixed cost relative to

value-added. v Lack of differentiation or switching costs. v Capacity augmented in large increments v Diverse competitors v High strategic stakes v 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: v 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.

v Product differentiation leads to brand identities and customer loyalties. v Capital requirements v Switching costs. v Access to distribution channels which may be difficult if they are controlled by the

industry. v Cost disadvantages to the entrant, not brought about by scale, as a result of

proprietary technology, favourable access to materials, favourable locations, experience curve effects


v Expected retaliations v The entrant will have costs of entry and if the industry price is insufficient to allow

him to recoup these - on other words it is below the ‘Entry Deterring Price’ - he will not enter. Where however the industry price is significantly above these then new entrants will tend to bring the price down to it.

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.

BCG MATRIX

MarketGrowth

High

Low

Stars QuestionMarks

Cash Cows Dogs

High LowMarket Share

(Relative to biggest competitor) ANSOFF PRODUCT MATRIX Apart from competitive advantage and entry barriers the company strategy will also include its decisions on which products to sell in which markets- the so-called product/market decision. This decision is often illustrated by the Ansoff matrix, called after Igor Ansoff who originated it in the 1960s. The matrix plots markets against products giving in each cell the type of strategic decision.


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. A product development strategy is based on selling new products to existing customers. Clearly the strategy is most successful when the customers who are approached are those that are the most profitable to the firm. This will require a soundly based customer profitability information system. 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. PERFORMANCE MEASURES RETURN ON INVESTMENT (ROI) ROI is similar to the ROCE concept; it is the use and application of the measure that is different to ROCE. ROI is more commonly applied at the project or SBU (Strategic Business Unit) level. Advantages and Disadvantages The main advantages are that v Calculations are very simple v The entire life of the project is taken into account v Profit is a well understood concept and easily obtainable v As a relative measure ROI enables comparison against projects or SBUs of

varying sizes

Existing Markets New Markets

Existing Products

New Products

Market Penetration

Exisiting customer strategy

Existing product led strategy

Diversification


The main disadvantages are v The timing of profit flows is completely ignored. v There are a number of different definitions of ROI and various ways of calculating

it which can lead to confusion. v The crucial factor in investment decisions is cash flow and the ROI uses profits. v The technique takes no account of the time value of money. v It takes no account of the incidence of profits; v Averages can be misleading.

RESIDUAL INCOME This is expressed as an absolute figure, it is normnally calculated as Profit (EBIT) - Imputed Interest Charge on Project/SBU Investment 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 and disadvantages of residual income Advantages v It makes divisional managers aware of the cost of financing their divisions. v It is an absolute measure of performance and not subject to the problems of

relative measures such as return on investment. v 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 v In common with most other divisional performance measures, problems exist in

defining controllable and traceable income and investment. v Residual income gives the symptoms not the cause of problems. If residual

income falls the figures give little clue as to why. v Problems exist in comparing the performance of different sized divisions (large

divisions will earn larger residual incomes simply due to their size v 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.

ECONOMIC VALUE ADDED Stern Stewart New York Consultancy Group has ‘trademarked’ the term EVA (Economic Value Added) for what is an extension/refinement of the Residual Income concept. 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.

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.

NOPAT is arrived at by making a number of adjustments to accounting profit, example adjustments being for amortised goodwill, non-cash expenses, provisions and interest charges.

The economic capital is arrived at by making a number of adjustments to the accounting measure of capital, example adjustments being for amortised development costs and goodwill, provisions for doubtful debts.

The financing costs represent the target WACC applied to the economic capital

NET PRESENT VALUE The NPV approach to capital investment appraisal is based on the simple notion that, after discounting the projected cash flows, both in and out, an investment is likely to be worthwhile if the present value of the inflows exceeds the present value of the outflows. This condition is a positive net present value and indicates that the investment as projected will earn more than the interest rate used to discount the cash flows. In economic terms, the NPV represents the change in the value of the firm if the project is adopted. 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 worthwhile, hence the accept/reject approach adopted above where respective positive and negative net present values are achieved. INTERNAL RATE OF RETURN The internal rate of return (IRR) is a technique of investment appraisal which is related to the NPV method. Using the NPV approach it is possible to demonstrate that a project which is discounted at, say, a discount rate of 10% will be feasible because it gives a positive net present value. If the discount rates are successively increased, the net present value will steadily fall, go through zero, and then become negative, illustrating that higher discount rates cause fewer projects to be worthwhile. The IRR is the discount rate which applies when the present value of inflows equals the present value of outflows, that is, the net present value is zero. 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 worth-while. 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.


EPS AND THE MEASUREMENT OF SHAREHOLDER VALUE EPS (earnings per share) is an accounting based measure and is considered, on its own to be a weak measure of shareholder value. Earnings are based on the accounting measurement of post-tax profit; measuring increases in shareholder value using profit based measures are usually weaker than using cash based measures. Some of the reasons cited for the weaknesses of EPS are 1. Alternative accounting methods may be employed, albeit different ways of reporting earnings does not affect underlying economic value, 2. Risk is excluded and is not accounted for in annual reports, 3. Investment requirements are excluded (changes in for example the working capital are not considered in reported earnings), 4. Dividend policy is not considered 5. The time value of money is ignored 6. Intangible assets, such as intellectual property play a greater role in an increasing service and knowledge oriented economy – this is not directly reflected in the EPS figure. Intangibles are generally still not regarded as assets in traditional accounting systems, unless they comply with formal accounting recognition rules. ACTIVITY THREE: PROJECT ASSESSMENT PERFORMANCE MEASURES Global Inc. is currently considering a capital project that will last for three years; the following data has been collected:

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

The cost of capital to be used is 12%. Assumptions and additional information: v All cash flows other than the initial capital and working capital investment occur

at the end of each year. v Use the net book value of the asset at the start of each year to represent the

value of the asset for the year v Ignore taxation.


Required:

a. Prepare a table for each year of the project showing v EBITDA v Net profit v Residual income using straight line depreciation v Return on investment using straight line depreciation v Residual income using annuity depreciation v Return on investment annuity depreciation

b. Calculate the projects Net Present Value (NPV) and Internal Rate of Return

(IRR) 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

Commitment: requires good motivation and leadership.

Competence: requires good recruitment, assessment, training and staff development.

Congruence: requires good job design.

Cost-effectiveness: this normally comes from the achievement of the others.

Theories of HRM

The two theories that may be examined are :

v Vrooms expectancy theory; and

v Agency theory

VROOMS EXPECTANCY 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.

The expectations arising from expectancy theory are that

v Efforts and performance are positively correlated

v Positive performance results in positive rewards

v Then rewards satisfy an important need

v Desire to satisfy outweighs the effort needed to succeed

The foundation of expectancy theory is based on three main beliefs

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.

Instrumentality: There is a difference between employee’s perception of what they actually desire and what they actually receive by way of rewards. Management need to ensure that promises are honoured and the fulfilment by management of these promises is effectively communicated.

The link between the three beliefs can be stated as:

Motivation = Valence × expectancy

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.

Two of the primary agency relationships in a commercial organisation are between (1 shareholders and managers and (2) between employers and employees. These relationships are not necessarily positive; and agency theory deals with these agency conflicts, or conflicts of interest between agents and principals.

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'.


SECTION E PERFORMANCE MANAGEMENT & EVALUATION It has become increasingly important for organisations to develop systems of performance measurement which not only reflect the growing complexity of the business environment but also monitor their strategic response to this complexity. The need for good performance management is an ongoing issue, some of the main issues requiring consideration by management are:

v Setting performance standards and targets v Linking rewards to performance v Considering the potential benefits and problems of performance measures.

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 ESTABLISHING A PERFORMANCE MANAGEMENT SYSTEM The start point is usually an organisation’s underlying mission, vision and strategic direction, in general the approach

1 Identify key objectives – known as Critical Success Factors (CSFs) 2 Establish measures for CSFs – measures are known as Key Performance

Indicators (KPIs), these are driven by CSFs 3 Set target KPIs 4 Establish initiatives and ways to achieve the above 5 Devise methods of capturing the data and processing the information 6 Monitor the above via management reporting

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.


CRITERIA FOR DESIGNING PERFORMANCE INDICATORS Name Clear indicator name Strategic element being assessed

Identification of what strategic element is being assessed (e.g. a specific resource, a core competence, one of the output deliverables)

Purpose Descriptions of the key purpose Data collection method

Short description of how the data is collected

• Formula and/or scale Identification of the scale used to assess performance

• Source of data Identification of where the data comes from

• Frequency How often is the indicator measured?

• Data entry Who is collecting and updating the date?

Ownership

Identification of the person(s) of function(s) responsible for the measured element.

Targets and performance thresholds Identification of targets, benchmarks, and thresholds for traffic lighting

Reporting/notifications

• Audience/access Identifies the audience, outlets, and access rights

• Reporting frequency Identifies how often the indicator is reported

• Reporting formats Identified how the performance is presented (numerical, graphical, narrative formats)

• Notifications/workflows Identifies proactive notifications and workflows

Expiry/revision date Identifies an expirations or revision date Cost estimate

Estimation of the costs incurred by introducing and maintaining this indicator

Confidence level

Evaluation: e.g. good J fair : imperfect L

Written comment

Reproduced from Strategic Performance Management, B Marr, 2006


TYPES OF PERFORMANCE MEASURES Traditionally, three types of performance measures have been encountered in practice. Each is discussed in turn. 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. Inputs are generally the simplest elements to measure, but provide limited information for decision – making and analysis of actual results. 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: v Outcomes demonstrates results, and in today’s environment that is exactly what

everyone, from the general public to the world’s most generous philanthropists, are demanding from public and non-profit organisations.

v Outcomes provide guidance in resource allocations. Funding can be directed in alignment with those actions that produce documented results.

v Focus on outcomes, rather than inputs or outputs, serves to guide the entire organization toward its true aims.

v Accountability is enhanced when the focus shifts to outcomes. Administrators

cannot hide behind data indicating numbers served, but must outline specifically how targeted audiences are better off as a result of their program or service.

There are a number of models of performance measurement which can be used by management.

PERFORMANCE PYRAMID, LYNCH AND CROSS (1991). 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.

These conclusions helped to shape the performance pyramid which can be regarded as a modeling tool that assists in the design of new performance measurement systems, or alternatively the re-engineering of such systems that are already in operation.


The performance pyramid (Lynch and Cross, 1991)

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: Ø Objectives Ø Measures Ø Targets Ø Initiatives


Strategy

Customer Perspective Two key questions need to be asked here: Who are our target customers? What is our value proposition in serving them? Example measures could include v Specifications (customer driven): Product quality (restaurant) & service quality v Service: Responsiveness & customer satisfaction surveys v Market share: Product/service mix & Innovations and competency

Internal Process Perspective What are the key processes which we must excel at in order to continue to add value for customers? Service development and delivery, partnering with the community, and reporting are examples that could be used.

Mission

Customer Whom do we define as

our customer? How do we create value

for our customer?

Employee Learning & Growth

How do we enable ourselves to grow &

change, meeting ongoing demands?

Financial

How do we add value for customers while controlling costs?

Internal Processes

To satisfy customers while meeting budgetary

constraints, at which business processes

must we excel?


Learning and Growth Perspective There will normally be a gap between current organisational infrastructure of employee skills, information systems, and organisational culture and the level necessary to achieve the results that are desired. 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.


TABLE OF POTENTIAL SCORECARD MEASURES

Generic Health care Airlines Banking

Financial Strength (Looking Back)

% of earned income Income growth Operating surplus Cash balances Reserves

Patient census Unit profitability funds raised for capital improvements Cost per care Percent of revenue – new programmes

Revenue/cost per available passenger mile Mix of freight Mix of full fare To discounted Average age of fleet Available seat miles and related yields

Outstanding loan balances Deposit balances Non- interest income

Customer Service & Satisfaction (Looking from the outside in)

Customer Satisfaction Customer retention Quality customer service Income from new products/services

Patient Satisfaction survey Patient retention Patient referral rate Admittance of discharge timeliness Medical plan awareness

Lost bag reports per 10 000 passengers Denied boarding rate Flight cancellation rate Customer complaints filed with the DOT

Customer retention Number of new Customers Number of products per customer Face time spent between loan officers and customers

Internal Operating Efficiency (Looking from the inside out)

Delivery time Cost Process quality Error rates on processes Supplier Satisfaction

Weekly patient complaints Patient loads Breakthroughs in treatments and medicines Infection rates Readmission rate Length of stay

Load factors (percentage of seats occupied) Utilisation factors on aircraft and personnel On-time performance

Sales calls to potential customers Thank You calls or cards to new and existing customers Cross selling statistics

Learning and Growth (Looking ahead)

Employee Skill level Training availability Employee satisfaction Job retention Amount of unpaid overtime worked

Training hours per caregiver Number if peer reviewed papers published Employee turnover rate

Employee absenteeism Worker safety statistics Performance appraisals completed Training programmes hours per employee

Test results from training knowledge of product offerings, sales and service Employee satisfaction survey


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:

v How does the customer perceive the quality of our product versus that of our competitors?

v How can we continuously improve? v Do the activities undertaken by the company produce the value that the customer

requires - activity analysis? v What are the costs of these activities and are they being carried out efficiently? v How well are the activities/processes being performed relative to competitors? v What are the important things that we should be controlling?

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 v Number of hours required to produce a product

Batch level v These are costs such as machine set-up or inspection, these occur once per

batch Processor product level v These cover such items as engineering change orders which refer to a product or

process. Organisation level v They are incurred for supporting the continuing level of operations i.e. building

depreciation, division managers’ salary.


SECTION F TARGET COSTING Target costing should be viewed as an integral part of a strategic profit management system. The initial consideration in target costing is the determination of an estimate of the selling price for a new product which will enable a firm to capture its required share of the market. It is then necessary to reduce this figure to reflect the firm's desired level of profit, having regard to the rate of return required on new capital investment and working capital requirements. The deduction of required profit from the proposed selling price will produce a target price that must be met in order to ensure that the desired rate of return is obtained. The main theme of target costing is, therefore, what a product should cost in order to achieve the desired level of return.

Target costing will necessitate comparison of current estimated cost levels against the target level. This must be achieved if the desired levels of profitability, and hence return on investment, are to be achieved. Where a gap exists between the current estimated cost levels and the target cost, it is essential that this gap is closed.

Target costing overview: Understand Customer Need

Price Sensitivity Value of product Features What What Price Features Set Profit Set Target Cost


PERFORMAMCE PRISM 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. There are five facets to The Performance Prism, namely v Stakeholder satisfaction v Stakeholder contribution v Strategies v Processes v Capabilities

The Performance Prism is distinct from other models in that: It is stakeholder driven, and not strategy driven. The concept of stakeholders is more inclusive, and does not just consider shareholders and customers Success is seen as based on ‘successful’ partnerships and inter-relationships between the organisation and stakeholders Measures can be generated and used for all levels within an organisation When designing the prism, the five facets referred to above prompt specific questions (and answers), namely v Stakeholder satisfaction – Who are the key stakeholders, what do they want and

need? v Strategies – What strategies do we need to put in place to satisfy the wants and

needs of our key stakeholders? v Processes – What critical processes do we need to put in place to enable us to

execute our strategies? v Capabilities – What capabilities do we need to put in place to allow us to operate,

maintain and enhance our processes? v Stakeholder contribution – What contributions do we want and need from our

stakeholders if we are to maintain and develop these capabilities? TOTAL QUALITY MANAGEMENT (TQM) TQM is a philosophy of quality management that originated in Japan in the 1950s, it seeks to integrate the quality management efforts of all groups in an organisation and is considered to be a significant factor in Japanese global business success. 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. There are four categories of TQM costs


Prevention costs Costs incurred in preventing the production of products that do not conform to specification. They include the costs of preventive maintenance, quality planning & training & the extra costs of acquiring high quality raw materials. 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. Internal failure costs Costs associated with materials & products that feel to meet quality standards. They include costs incurred before the product is despatched to the customer, such as the costs of scrap, repair, downtime & work stoppages caused by defects. External failure costs Costs incurred when products or services fail to conform to requirements or satisfy customer needs after they have been delivered. They include the costs of handling customer complaints, warranty replacement, repairs of returned products & the costs arising from a damaged company reputation. Costs within this category can have a dramatic impact on future sales. 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.

TQM and the management of change To ensure successful implementation of a TQM programme it is important to use the tools of TQM in the process. Because TQM is process oriented the best way to change is to set up process-management teams who are tasked with solving real business problems. To do this it is necessary to align the team-roles and responsibilities with the process with which they are dealing. In this way the behaviours and attitudes are changed as a result of doing something practical and not the other way round. This technique of process-alignment has seven distinct steps: 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 of the critical processes is to “Promote, advertise and communicate the company’s business capability”. One of the sub-processes could be “Prepare the company information pack”. One of the activities relating to the sub-process would be “Prepare one of the subject booklets for the pack”. One of the tasks necessary for this is “To prepare the copy for the booklet”.

Processes and teams can be linked as follows: Quality council Mission, CSFs, critical processes Process quality teams critical processes Quality Improvement teams (QITs) Sub-processes and tasks.

Quality circles/individuals Tasks

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.


ACCA ARTICLES: NOT AN EXHAUSTIVE LIST, CHECK THE ACCA SITE

1. Updated examiner’s approach to Paper P5, A Watt, Feb 2011 2. Paper P5 syllabus changes for 2011, A Watt, Feb 2011 3. Examiners approach to paper P5, A Watt, August 2010 4. The risks of uncertainty, M Pogue, October 2009 5. Not-For-Profit Organisations, R Souster, Sept and Oct 2009 6. Transfer Pricing, K Garrett, October 2009 7. The risks of uncertainty, M Pogue, April 2009 8. Accounting And Organisational Cultures, G Morgan, Nov/Dec 2008 9. Business failure, prediction and prevention, M Pogue, June/July 2008 10. Economic Value Added, Creating Value, S Johnson & M Bamber, Oct 2007 11. Critical Success Factors, J Stone, August 2006 12. Defining Managers’ Information Requirements, J Stone, August 2006 13. Business Strategy And Performance Models, S Johnson, April 2006 14. The pyramids & pitfalls of performance measurement, S Johnson, Sept 2005 15. Performance measures to support competitive advantage, G Morgan, Aug 2005 16. Beyond budgeting, S Johnson, Mar 2005 17. Management control - a pre-requisite for survival, S Johnson, Oct 2004 18. Environmental management accounting, S Johnson, Jun 2004 19. Just-in-time operations and Backflush accounting, S Johnson, May 2004 20. Budgetary control - the organisational aspects, M Tayles, Dec 1998


ACTIVITY ONE: SOLUTION Contingency tables Purchased 50 100 150 200 Demand kg 60 30 20 0 -20 100 30 60 40 20 125 30 60 65 45 175 30 60 90 95 Contribution Minimum 30 20 0 -20 Maximum 30 60 90 95 Maximin 30 Maximax 95 Minimax regret Purchased kg 50 100 150 200 Demand kg 60 0 10 30 50 100 30 0 20 40 125 35 5 0 20 175 65 35 5 0 Qty purchased 50 100 150 200 Max regret 65 35 30 50 Minimax 30


ACTIVITY TWO: SOLUTION Provide Inc. and Receive Inc: Transfer Pricing Containers Provide Inc.: Total output 36,000 Sales to Receive Inc. 9,000 Sales outside group 27,000 a. Monthly profit at existing sales level Qty Unit data Sales Containers $ £ Receive Inc. Sales 9,000 30.00 270,000 Costs: Materials 9,000 14.00 (126,000) Costs: Other 9,000 5.00 ( 45,000) Contribution 99,000 Fixed costs ( 60,000) Profit 39,000 Qty Unit data Sales Containers $ £ Provide Inc. Sales 36,000 14.00 504,000 Costs: Materials 36,000 7.00 (252,000) Contribution 252,000 Fixed costs ( 80,000) Profit 172,000 Revised sales levels Existing Change Revised Containers % Containers Total output of Provide Inc. 36,000 42,750 Receive Inc. 9,000 75.0% 15,750 Sales outside group 27,000 0.0% 27,000 b. Monthly profit at revised sales level Qty Unit data Sales Containers $ $ Receive Inc. Sales 15,750 24.00 378,000 Costs: Materials 15,750 14.00 (220,500) Costs: Other 15,750 5.00 ( 78,750) Contribution 78,750 Fixed costs ( 60,000) Profit 18,750 Initial profit b/f 39,000 Profit movement ( 20,250) Qty Unit data Sales Drums $ £ Provide Inc. Sales 42,750 14.00 598,500 Costs: Materials 42,750 7.00 (299,250) Contribution 299,250 Fixed costs ( 80,000) Profit 219,250


Initial profit b/f 172,000 Profit movement 47,250 Total (consolidated) Revised total profit 238,000 Initial total profit b/f 211,000 Total profit movement 27,000 Containers c. Spare capacity of Provide Inc. (52,000 – 36,000) 16,000 Additional output of Provide Inc. 6,750 Receive Inc: loss of profits -$20,250 Receive Inc.: loss of profits/container -$3 Per container Provide Inc.: existing variable cost $7 Set transfer price above $7 per drum and below $14


ACTIVITY THREE: SOLUTION Global Inc.: Project assessment performance measures 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 Sales volume: million 1.8 2.0 2.5 Unit selling price $60.00 $60.00 $60.00 Sales: million $108.0 $120.0 $150.0 Contribution $64.8 $72.0 $90.0 Incremental costs -$40.0 -$45.0 -$50.0 EBITDA: million (Contribution less incremental costs) $24.8 $27.0 $40.0 Working Capital (WC) Inventory -$5.0 $5.0 Receivables -$5.0 $5.0 Payables $3.0 -$3.0 Net operational cash flows (NCF) (EBITDA less WC investment $17.8 $27.0 $47.0 Less: depreciation Profit -$22.0 -$22.0 -$22.0 (NCF minus depreciation) -$4.2 $5.0 $25.0 Imputed interest at 12% on NBV (NBV b/f × cost of capital) -$7.9 -$5.3 -$2.6 Residual income: straight line (Profit minus interest) -$12.1 -$0.3 $22.4 Return on investment: straight line (Profit ÷ NBV b/f) -6.4% 11.4% 113.6% Annuity depreciation approach Initial investment: million $66.0 Annuity factor 12% 2.402 Equivalent annual cost $27.5 Year 1 Year 2 Year 3 $m $m $m Net book value (NBV) b/f 66.0 44.0 22.0 Imputed interest at 12% on NBV (NBV b/f × cost of capital) -7.9 -5.3 -2.6 Annuity depreciation


(EAC minus interest) 19.6 22.2 24.8 Year 1 Year 2 Year 3 $m $m $m Net operational cash flows (NCF) 17.8 27.0 47.0 Annuity depreciation -19.6 -22.2 -24.8 Profit (NCF minus depreciation) -1.8 4.8 22.2 Imputed interest at 12% on NBV (NBV b/f × cost of capital) -7.9 -5.3 -2.6 Residual income: annuity depreciation (Profit minus interest) -9.7 -0.5 19.5 Return on investment: annuity depreciation (Profit ÷ NBV b/f) -2.7% 7.3% 33.6% NPV Year 0 Year 1 Year 2 Year 3 $m $m $m $m Investment -$66.0 Net operational cash flows $17.8 $27.0 $47.0 Total net cash flows -$66.0 $17.8 $27.0 $47.0 Discount factor: 12% 1.000 0.893 0.797 0.712 Present value -$66.0 $15.9 $21.5 $33.5 NPV $4.9 Calculate IRR Discount Discount Cash flow factor PV factor PV $m 12.0% $m 20.0% $m Year 0 -66.0 1.000 -66.0 1.000 -66.0 Year 1 17.8 0.893 15.9 0.833 14.8 Year 2 27.0 0.797 21.5 0.694 18.8 Year 3 47.0 0.712 33.5 0.579 27.2 4.9 -5.2 IRR 12% + (4.9 ) × (20-12)% 15.9% (4.9-(-5.2)

53124472 acca p5 advanced performance management key notes june 2011

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