ACCA Paper P5 Advanced Performance Management Mock Exam

Commentary, Marking scheme and Suggested solutions

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Commentary Tutor guidance on improving performance on the exam paper The key to success in P5 is application of wide and varied syllabus knowledge, both flexibly and in enough depth in the time allowed.

Section A

Question 1 Part (i) of this question provides you with actual and budgeted figures for a quoted company (Crown Oak), together with selected information an unquoted competitor (Henderson). Although you need to calculate some KPIs in part (a), the main focus of this question is an evaluation of the appropriateness of the CSFs and KPIs Crown Oak has chosen to measure, rather than detailed calculations.

In parts (ii) and (iii) you are required to assess the relationship between CSFs and KPIs, but also how changing environmental and competitive conditions could affect the aspects of performance which are critical to Crown Oak's continuing success. In this respect, the calculations from part (i) could help to highlight some of the issues that Crown Oak is facing.

Part (iv) requires you to consider whether comparing financial performance against Henderson (given the different strategies being pursued by the two companies, and in the context of the changing competitive conditions) is still worthwhile for Crown Oak.

Part (v) requires a discussion of the potential problems the directors face in trying to manage short-run results and long-run results (for example, in relation to the expenditure needed to enable Crown Oak to move into a new market). Finally part (vi) requires you to consider the likely reaction of shareholders to the results that you have been working on.

Section B

Question 2 This question considers the importance of non-financial performance indicators in modern performance measurement systems. In part (a) you need to consider why there is growing emphasis on NFPIs for service businesses such as GA. You are also provided with data which you must use in part (b) to create NFPIs. Explanation of usefulness and levels of performance must relate to the critical success factors and strategies of GA. Part (c) links back to part (a), but here the focus is specifically on the non-financial indicators within integrated (or 'multi-dimensional') performance measurement systems, such as the performance pyramid. The requirement doesn't specifically mention GA so you don't have to relate your answer to the scenario, but it could be helpful to use your answer to part (b) to provide some context.

Question 3 This question concerns decision-making in divisions, and the potential for dysfunctional behaviour. Part (a) requires some simple calculations to illustrate the problems of ROI and RI and EVA. Part (b) requires four reasons to separate the assessment of a divisional manager from assessment of the division itself. Part (c) considers the problems of comparing the performance of divisions in different countries and requires little application to GA to score well. Part (d) asks about the relevance of liquidity and gearing measures to divisional performance measurement.

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Question 4 This question looks at two different aspects of human resource management, in the context of an accountancy firm. Part (a) considers staff appraisals, and requires a practical application to the scenario to score high marks. Identifying the problems in G&C's current appraisal process should help you to think how a successful appraisal scheme should be organised and operated.

Part (b) looks at the relationship between human resource management and corporate strategy – specifically in relation to the Building Block model. Again, it is important to relate your answer specifically to the scenario, rather than simply discussing the model in general terms. For example, what aspects of performance would be considered in the Building Block model which aren't considered under G&C's current performance management system? Finally, part (c) requires practical suggestions about how a firm of professional accountants may use performance measures to assess aspects of performance such as client service and productivity.

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SECTION A

Question 1 Marking scheme Marks (a)

Note: The verb requirement for part (i) was 'calculate' so marks are for calculation only. No analysis or evaluation was required for part (i), and no marks are available for them.

Calculation of gross profit (contribution) and GP margins 2 Average sales price per unit 1 Contribution per unit 1 Quality costs per unit 1 Operational gearing (fixed vs variable costs) 2 Return on capital employed 2 9 (b) For evaluating how well the KPIs fit with the CSF to improve

production rates – Up to 5 marks

For evaluating how well the KPIs fit with the CSF to maximise profits within acceptable levels of risk – Up to 4 marks

For evaluating how well the KPIs fit with the CSF to maintain customer satisfaction – Up to 3 marks

Up to 11

11 (c) For identifying relevant environmental issues in the scenario

(economic factors; new competitors; technology; social responsibility) – 1 mark for each relevant issue

For evaluating the relevance of the CSFs to the environmental factors – Up to 2 marks for each environmental factor

For general conclusion about the validity of the CSFs and possible dangers of ossification – 1 mark

Up to 10

10 (d) For relevant comments about the potential benefit to Crown Oak of

competitor benchmarking (with Henderson) – Up to 2 marks

For relevant comments about the limitations and drawbacks of the

current financial benchmarking – Up to 6 marks

Up to 7

7 (e) General comments regarding short v long term – up to 3 Application to Crown Oak – up to 3 Up to 5 5 (f) Importance of information available 1 Importance of dividend signal 2 Belief in long term growth 1 4 Professional marks – for style and structure of the report 4 50

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Suggested solution REPORT

To: Board of Crown Oak From: Accountant Date: [today's date] Subject: Performance and performance measurement in Crown Oak

Introduction

This report calculates the KPIs used by the board for measuring Crown Oak's performance, and then evaluates the effectiveness of the company's KPIs and CSFs in measuring the company's performance and addressing the issues it faces in its competitive environment. At summary level, the report compares Crown Oak's performance against Henderson's, although the report also raises some concerns about the value of that comparison.

The report concludes on the potential issues facing the board in relation to managing both the short-term and longer-term performance of the company.

(a) Revenue and profitability

The analysis which follows is based on the key performance indicators which the Board used to assess performance. The figures relate to the full year 20X5.

Crown Oak Crown Oak Henderson Actual Budget Actual Units sold in year 40,360 41,000 n/a Gross profit % 23.2% 30.5% 31.8% See Appendix 1 Average sales price per unit ($) 10,877 11,024 n/a Contribution per unit ($) 2,527 3,366 n/a See Appendix 1 Quality costs per unit ($) 248 195 n/a Ratio of fixed: variable costs 0.23:1 0.23:1 0.19:1 See Appendix 1 Return on capital employed (%) 4.5 13.3 22.0 See Appendix 1 Average customer satisfaction score 3.7 4.0 n/a

Details of calculations are given in Appendix 1.

(b) Value of performance report in addressing links between CSFs and KPIs

Improved production rates

Units sold – The number of units sold in a month provides some indication of Crown Oak's productivity, because the 'build to order' model means that Crown Oak needs to build each unit before it can sell it.

However, there are several limitations with using 'Units sold' as a performance measure:

The number of units sold will be influenced by customer demand as well as Crown Oak's own productivity.

The measure does not taken account of the different types of unit being built, although a smaller unit (such as a car port) should take less time to build than a larger unit (such as a barn).

In this respect, a potential alternative measure of productivity might be to compare the number of units built to the number of employees (ie units built per employee). This could indicate how productive Crown Oak's staff are, and what impact new equipment and new construction techniques are having on labour productivity. The actual number of employees for 20X5 (2,200) is higher than the budgeted number (2,000) despite the number of units sold in the year being below budget. It is not clear how many additional employees have been taken on in connection with the new development (pre-assembled housing), but nonetheless, falling revenues alongside increasing staff numbers may be an indicator of falling labour productivity.

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Nonetheless, these performance measures do not provide any information about the construction techniques being used. The fact that Crown Oak is moving into the pre-assembled house market, and is acquiring new assets to support this suggests that it is receptive to new ideas. However, it is difficult to assess how far these correspond to developments in construction techniques, or the impact those techniques are having on productivity.

Gross profit % – It is possible that the gross profit margin obtained on each building could provide an indication of the effectiveness with which Crown Oak uses its resources in production. Again, however, there are potential limitations with using margin as an indicator of productivity: for example, Crown Oak may not be able to control raw material costs per unit, such as the price of timber used. Also it is not clear if any quality control work, for example, is undertaken by Crown Oak's permanent staff (whose costs are treated as fixed costs) as opposed to the work undertaken by the staff and sub-contractors, whose costs are included within gross profit percentage.

Time periods – The Board report also only shows actual figures against budget. Whatever KPIs are chosen, in order to assess whether production rates are improving over time, it would be useful to compare actual performance against a prior period (for example, the equivalent month last year).

Maximise profits within acceptable risk

Gross Profit % – Including gross profit % as KPI, should encourage a focus on profits. Again, however, using a single figure across all products means the figure could be affected by product mix, rather than the underlying profitability of different products. Moreover, in terms of maximising profits, it may be more useful for the Board to monitor gross profit as an absolute value, rather than as a margin %.

Contribution per unit – Although this indicator provides monetary values (rather than a %), it is providing very little additional information to that provided by the gross profit %. The way Crown Oak's figures are reported (revenue, less variable costs, less fixed costs) means that gross profit and contribution are the same thing; therefore there seems little value in including both of them as KPIs.

Return on capital employed (ROCE) – ROCE indicates how efficiently Crown Oak is using its capital in order to generate profits. As such, this KPI should also encourage profit maximisation, although there could be concerns that using ROCE as a profit measure may encourage short-termist behaviour at the expense of longer term decisions. However, at the moment, the Board still appears willing to take decisions on the basis of the longer term (eg investing in the pre-assembled wooden house market) even though those decisions may reduce ROCE in the short term.

Operational gearing – Although Crown Oak doesn't monitor financial gearing (which could be an indicator of financial risk), monitoring operating gearing should help it ensure the company keeps its level of business risk to an acceptable level. Using sub-contractors to do work which might otherwise be done by permanent full time staff helps to reduce the level of fixed to variable costs.

Maintaining customer satisfaction and providing excellent customer service

Customer satisfaction score – The customer satisfaction score, obtained through the customer survey, provides a good way of measuring how satisfied customers are with Crown Oak's products. Again, however, in order to judge whether satisfaction levels are being maintained, comparative figures from previous periods should be provided, to compare against the scores for the current period.

Moreover, it is not clear exactly what customers are being asked to score – for example, whether it is the quality and design of their building itself, or the whole customer experience they have received throughout their dealings with Crown Oak. Both of these will be important in maintaining Crown Oak's position as a quality brand.

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Quality costs – Crown Oak appears to be pursuing a differentiation strategy based on the quality of its products, and the 'cost of quality' KPI gives an indication of how much the company has spent on quality management. However, it is not clear whether these costs are due to preventative actions (which should help to improve customer satisfaction) or whether they are the result of having to correct defective products (which could be the cause of customer dissatisfaction).

In this respect, it could be useful to monitor the number of customer complaints received as well as the summary customer satisfaction score.

(c) Extent to which the CSFs reflect the competitive pressures Crown Oak is facing

New entrants – Crown Oak's performance measures appear to have been designed when the market was relatively stable – with itself and Henderson sharing a large proportion of the market. However, recently, the dynamics of the market have changed, following the entry of the new, foreign competitor.

Between 20X4 and 20X5 Crown Oak's market share fell from 27.4% (434/1,585) to 26.2% (439/1,670), and if the new entrant is successful, their presence could reduce Crown Oak's market share. However, currently, the CSFs do not directly refer to maintaining market share – or growing sales.

Brand strength – As an established player in the market, Crown Oak's brand should hopefully be relatively well known. However, Crown Oak needs to ensure that it uses its brand strength so that potential customers choose one of its products in preference to the new competitor's products.

The reference to customer satisfaction in the current CSFs could be seen as relevant here, but it could be useful to refer directly to the importance of developing brand loyalty in sustaining Crown Oak's competitive position.

Technology and innovation – The new entrant appears to be taking advantage of new production techniques (eg pre-built housing), and Crown Oak appears to have responded to this by moving into the 'pre-built' market itself.

Moreover, Crown Oak appears to have acknowledged the importance of technology and development, by identifying the need to use leading edge construction techniques as a CSF.

Quality or cost – Historically, Crown Oak's business strategy appears to have been to compete on the basis of quality. However, the recent increase in interest rates, and uncertainty over the strength of the economy, mean that customers are becoming more price sensitive. (We have already seen evidence of this in the variances in the product mix for 20X5 compared to budget).

If customers are becoming more price sensitive, then controlling costs (while maintaining quality) is likely to become a vital element of the company's future success. However, the CSFs do not directly mention anything about cost control, or quality.

Sustainability – Another factor which distinguishes Crown Oak's products from the new competitor is that Crown Oak uses timber from sustainable sources, while its competitor doesn't. In this respect, Crown Oak might be able to use social responsibility as a means of differentiating itself from the competitor. Again, however, there is currently nothing about social responsibility in the company's CSFs.

Conclusion – It is not clear when the current CSFs and KPIs were established, but given the changes in the external and competitive environment, it could be useful to re-assess whether Crown Oak's CSFs still truly reflect the aspects of performance which are critical to its competitive success. If not, there is a danger that Crown Oak's performance measurement system could suffer from ossification – an unwillingness to change a performance measure system once it has been set up.

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(d) Benchmarking

Financial benchmarking – By comparing its performance against Henderson's, Crown Oak is benchmarking its financial performance against a competitor. As with any benchmarking exercise, the benefit of this comparison is that it can help Crown Oak identify how well it is performing, with a view to improving performance in any areas in which it currently appears to be under-performing.

More generally, comparing financial performance with a competitor can serve to remind management that external factors (competitors, and the wider external environment) can have an impact on the company's own performance, so it is important to consider these external factors as well as assessing internal performance.

Limitations of the benchmarking

However, despite the potential benefits of benchmarking in general, there are some significant limitations in the current comparisons we make between Crown Oak's performance and Henderson's.

Compatability of companies – Crown Oak is looking to diversify its product portfolio and has been investing in new equipment and recruiting additional staff to help support its future growth. By contrast, Henderson's strategy is to focus only on its existing market, but to control costs and operate as efficiently as possible. As such, the two companies appear to be pursuing different competitive strategies, which means that comparing financial performance for a single year may have limited value.

The fact that the current report only looks at summary financial data rather than any non-financial management information also limits its usefulness. For example, we don't know how many units Henderson sold in a year (or what mix of units they sold), which means the current comparison doesn't really provide any insight into why the two companies are performing as they are.

Choice of competitor – In addition, the current benchmarking exercise only compares Crown Oak's performance against Henderson's. However, given the threat from the new competitor, and the fact that Crown Oak is starting to build pre-assembled houses in response to that threat, there is an argument that it might actually be more useful to compare Crown Oak's performance against the new competitor, rather than against Henderson.

Market share – One useful way of assessing the relative performance of all three companies could also be to look at market share. We already record the total market size (in Note 1 to Appendix 1) and by obtaining the total revenue figure for the new competitor we could show a summary performance indicator comparing the market share of all three companies. Monitoring changes in market share over time would potentially provide the directors with more useful management information than the current comparison.

We have already noted (in part iii) that Crown Oak's CSFs don't currently refer to market share or sales growth, although it could be instructive for them to do so. In this respect, including market share data in the monthly report could then provide management with an indicator to assess how well Crown Oak is performing against that CSF.

(e) Short vs long-term performance

In general terms, it could be argued that the directors of a company have a short-term interest in their company, in terms of their employment and remuneration, whereas the equity investors have a longer-term interest as they have made an investment in the shares in order to secure a return over time.

However, it can also be argued that the directors of a company need to produce results in the short-term in order satisfy the requirements of the investors in terms of earnings per share each year. Crown Oak's earnings before interest and tax only equate to $0.12 per share, so the earnings per share figure (after interest and tax) will be lower still. The shareholders may well have reasons to be concerned over short-term performance, particularly if Crown Oak's results for 20X5 are significantly worse than the equivalent results for 20X4. (It is unlikely that the shareholders will be aware of the budgeted figures for 20X5 in order to compare the actual figures to them.)

As we noted earlier, the use of ROCE as a performance measure can also discourage long-term strategic investments by an organisation, because investing in new capital leads to a decline in ROCE in the short term. This appears likely to be the case in relation to the new pre-assembled house business.

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However, the directors believe that the pre-assembled housing market is a growing market and therefore it can be a source of profitable growth for Crown Oak in the future. In this respect, it appears that the directors have invested with the aim of generating growth in the longer term, and generating value for the shareholders in the longer term.

(f) Shareholders' reaction

The likely reaction of the shareholders in Crown Oak will depend upon the amount of information that is available to them, and their attitude to risk. Clearly the results for the year are worse than the directors had hoped, and it is possible they are worse than 20X4's results. The results (particularly profits before interest and tax) are also significantly worse than Crown Oak's acknowledged direct competitor, Henderson.

However, the directors have decided to maintain the dividend payment for 20X5 at the level which had originally been budgeted, despite the reduced profitability. Maintaining the dividend should indicate to the shareholders that the directors of are confident in the long term future of the company, despite the short-term downturn in results.

Conversely, some shareholders might have preferred Crown Oak's retained earnings are used for invested in the future growth of the company, rather than being distributed as dividends.

It is often advisable for the chief executive of a company to meet with key shareholders, particularly institutional shareholders on a regular basis, in order to keep them informed of major developments such as this move into a new line of business.

If the shareholders are informed of what is going on at Crown Oak, and believe the directors' assertions of future levels of profitability, backed up by the dividend payment, then there should be little effect on the company's share price. However, if the shareholders are not informed or do not believe in the return to profitability levels then these results may lead to a fall in the company's share price.

Conclusion

Although Crown Oak is a well-established player in the market for timber-framed buildings, with a significant market share, its performance in 20X5 has been worse than expected.

A number of the factors which have contributed to this relate to changes in the company's external and competitive environments, but Crown Oak's current performance measurement system doesn't focus on these issues as clearly as it could. For example, current performance indicators focus predominantly internal aspects of performance rather than external ones (such as market share).

However, the board appear to have responded to the threats (and opportunities) in the environment by looking to develop a new product range. Although this move has come too late to generate any additional profits for the current year, the new product range has the potential to do so in future years.

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Appendix 1

Crown Oak Henderson Actual

($m) Budget ($m)

Actual ($m)

Revenue 439 452 550 Less: variable costs Materials and labour 275 272 331 Sub-contractor costs 52 34 39 Quality costs 10 8 5 Gross profit = contribution 102 138 175 % (contribution %) 23.2% 30.5% 31.8% Units 40,360 41,000 n/a n/a Contribution per unit 2,527 3,366 Fixed costs 78 71 73 Variable costs 337 314 375 Fixed/Variable costs 0.23 0.23 0.19 PBIT 24 67 102 Capital employed (shares + loan) 533 504 464 ROCE 4.5% 13.3% 22.0%

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Section B

Question 2

Marking scheme Marks (a) Weakness of traditional measures 1 Widen manager's focus 1 Importance of other areas of performance 1 Application to service industry 1 4 (b) 3 marks per NFPI

Produce an indicator ie measure Explain the importance to GA, ie why chosen Assess GA's performance ie improving/worsening Max per indicator For each of: (i) Competitiveness (ii) Resource utilisation (iii) Quality

1 1 1 3

Max 6 Max 6 Max 6

Max 16 (c) Explanation of pyramid as an integrated, hierarchical system which

puts non-financial measures into context in relation to organisational objectives. (Diagram of pyramid = 1 mark only)

Max 3

Discuss competitiveness, resource utilisation and quality in the context of the performance pyramid - 1 mark per relevant point

Max 3

Max 5 25

Suggested solution (a) It is now fairly widely recognised that concentration on financial performance indicators alone is too

narrow a focus for businesses and means that important goals and factors may be ignored. Financial performance measures are historic, often out of date when reported and short term in nature.

Further, managers are more likely to narrow their thinking if only financial performance indicators are considered. Non-financial performance indicators will tend to make managers consider external factors, such as customers and competitors. This in turn can result in managers thinking more strategically about the business and making decisions to improve service rather than increase short run profit or profitability.

In the current business environment, factors such as quality, delivery, reliability, after sales service and customer satisfaction are vital to continued success of any business. Such elements of a business cannot be quantified and reported using the traditional financial performance indicators such as profit margins and return on capital employed.

This is particularly true of service industries such as that of GA, where the quality and flexibility of service that they provide to their customers is of extreme importance in a competitive market.

GA's reputation relies upon not only the reliability of the product that it supplies, the security system, but also the service that it provides in terms of the speed and quality of installation and emergency response, and its reliability in terms of servicing the security systems.

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(b) Competitiveness

Percentage of enquiries turned into contracts:

New business (3,005/4,230) 71.0% Repeat business (1,510/1,840) 82.1%

This indicates how competitive GA is at winning new contracts from both new business customers and existing customers. In particular, the percentage of new business is a useful indicator due to strategic objective of increasing the customer base.

Increase in number of contracts:

Service (18,890 – 15,890)/15,890 18.9% Installations (9,635 – 8,120)/8,120 18.7%

This gives an indication of growth in the business rather than simply considering growth in turnover. The break down between service and installation contracts provides management with information about which section of the business is more competitive. It is surprising that service business has increased at a greater rate than installations as it is expected that new installations lead to an increase in service contracts thereafter. GA should see the service percentage rise in future periods or may be incorrect in believing that service business automatically follows from an installation.

Resource utilisation

Number of service call outs per engineer:

(14,320/95) 150.7 per engineer

This indicates the productivity of the service engineers. Productivity is an important aspect of cost control as the salaries of the engineers will be fixed costs of the business. The more service call-outs made by each engineer will reduce the salary costs per call out and increase profit per call out.

Percentage of chargeable hours to total hours:

Installations (62,830/68,300) 92.0% Service (166,790/213,750) 78.0%

Again this indicates the productivity of each type of engineer. As above, the greater the productivity of the engineers the lower will be the cost per installation and cost per service. GA has a strategic objective to control costs in order to encourage sales without increasing prices. It is not possible to assess this completely, as no comparisons are available, other than to suggest that control seems to be more tightly enforced on installations than on service. Given the need for emergency cover and to maintain flexibility, GA will need to accept some spare capacity and this may be greater in the service part of the business. Care must be taken when setting standards in this area to ensure that over-efficiency does not impact quality.

Quality

Customer complaints as percentage of contracts:

Installations (934/9,635) 9.7% Service contracts (1,250/18,890) 6.6%

This shows the level of customer satisfaction with the work carried out, and indicates the quality of the work of the engineers. In a service industry such as this, quality of both the product and the service provided is of vital importance in retaining and attracting customers, and the directors of GA recognise this as part of their overall strategy.

These measures can also be linked to repeat business and growth, as measured in (i) above. Installations have slightly lower growth, higher productivity and higher complaints than service. The directors may need to prioritise these objectives as they appear to be in conflict.

Time to reach client 3.2 hours on average

Time between enquiry and installation 5 days on average

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Both of these indicators are important factors as customers will assess GA not only on the quality of their product and of their engineers but also on the speed of dealing with problems and getting a new installation in place. Again, as above, this ties in with the strategic objective of providing the highest quality of service. These indicators may also suffer if too much pressure is applied to resource utilisation.

(c) It may be assumed that the overall objective of a commercial organisation is to achieve a suitable financial return for its owners. If so, financial measures of performance may be considered directly relevant to this objective. Non-financial measures of performance, such as quality measures, are not so clearly relevant to an organisation's objectives. An integrated system of performance measurements helps to set non-financial performance in the context of achieving the organisation's overall objectives.

Lynch & Cross's performance pyramid is an integrated system that highlights the hierarchy and linkages extending from the strategic aspects of performance, through layers of management, down to the operational level. It also specifically combines financial and non-financial measures, on the basis that the external effectiveness and internal efficiency of an organisation's operations will ultimately be critical in determining whether or not it achieves its objectives. The diagram of the performance pyramid highlights how the performance of operational and business processes underpins an organisation's financial performance.

Market Financial

ProductivityCustomersatisfaction

Corporatevision

Cycle timeDelivery WasteQuality

Operations

Internal efficiencyExternal effectiveness

Objectives

Measures

Business

operating

systemsFlexibilty

Departm

ent

and work

centres

Business

Although it is not specifically included as an element of the pyramid, 'competitiveness' is likely to have a key influence on 'customer satisfaction' and an organisation's ability to achieve its 'market' objectives (such as business growth in GA's case).

Similarly, quality is one of the aspects of performance at an operational level which contribute to customer satisfaction and, in turn, would help GA to retain existing customers and acquire new ones.

'Resource utilisation' – or productivity in the pyramid – is one of the aspects which can be measured when assessing the internal efficiency of an organisation's processes and operations.

As such, the pyramid helps to illustrate how measuring, and monitoring, the different aspects of performance considered in the answer to part (b) can help an organisation to achieve its vision and its corporate objectives.

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Question 3 Marking scheme Marks (a) ROI – calculation 2 RI – calculation 2 Explanation of manager's reaction 2 Board reaction 2 EVA – calculation 3

EVA commentary 1 12

(b) 1 mark per reason 4

(c) 1 mark per relevant issue 4 (d) Failure of the performance measures to take account of liquidity

and gearing – 1 mark per relevant point – up to 4 Suggestions for monitoring liquidity and gearing – up to 2

Max 5 25

Suggested solution

(a) (i) Return on investment = investment capital Average

tax andinterest beforeProfit 100

Opening capital investment = $1,000,000 Closing capital investment (1,000,000 ¾) = $750,000

Average capital investment = ($1,000,000 + 750,000)/2 = $875,000

Return on investment = $875,000

$120,000

= 13.7% Residual income

Profit before interest and tax $120,000

Interest cost on average investment $875,000 10% $87,500

Residual income $32,500

The return on investment of the project in the first year is only 13.7% which is lower than the current return on investment for TT of 15.8%. Therefore the manager of TT is unlikely to invest in this project as it will reduce his division's return on investment in the short term and therefore affect the amount of bonus which he will be paid for this year.

However the project has an overall positive net present value of $0.35 million and has a positive residual income in this first year of $32,500. Both of these measures mean that the investment would be suitable for the company overall and therefore the Board of directors of EI would want TT to invest in this project.

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(ii) Economic value added

EVA = Net operating profit after tax – capital charge Capital charge = Weighted average cost of capital economic value of net assets

$'000 Profit after tax per question 90 Add back advertising cost 40 NOPAT 130 Value of net assets at start of period 1,000 At 10% charge (100) EVA 30

As the economic value added of the investment is positive the manager of TT should conclude that the investment will add to the wealth of the shareholders and therefore should be undertaken. The board should concur, given the net present value (as above).

(b) The performance of a division must be assessed separately from that of a manager for the following reasons:

An astute manager may have been put in charge of a poorly performing division. He may have improved the division's performance due to his own ability but if the division is still performing poorly then divisional measurements will not reflect the performance of the manager.

Many strategic decisions take time to affect results. A manager should be assessed on the value added to a division rather than on reported profits. Strategic decisions may not always be available if capital budgets are set by head office.

Managers have skills and attributes that cannot be assessed by considering divisional returns. Managerial ability will require separate measurement.

Managers may not have control over all costs. The manager of a division should only be held accountable for costs over which he has some influence. However it is not always easy to determine controllable and non-controllable costs in practice. Some costs may be under the control of a senior manager but not a junior manager. Some costs may be under joint control of two or more managers.

In a divisionalised business such as EI, some costs are controlled by a manager in another division. Costs and revenues may be created by a system of transfer prices, which may have been determined by higher levels of management rather than the manager being assessed.

Many divisions are also charged with costs from head office. These may be apportioned to divisions irrespective of use, in a manner that the divisional manger cannot control.

(Note: Only four reasons required. Additional reasons are provided here for tutorial purposes.)

(c) The problems of comparing divisional performance when divisions are in different countries include:

Market conditions

The economic climate in different countries will affect the reported performance of divisions within those countries. Economic factors may include different inflation rates, changing exchange rates, the state of the economic cycle in the country, interest rates and local taxation policy.

Political climate

Political factors that may affect performance include the attitude of the local government to that particular industry, incentives or grants which may be allowed, effects on competition or regulations and controls in that particular industry.

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Funding

The availability of funds for investment from country to country may differ and this is likely to affect the ability to invest and also the cost of investment if the funds are available.

Legal factors

Different countries may have different laws and regulations in areas such as health and safety, minimum wages, consumer protection, pollution control and waste disposal. All of these are likely to affect the performance of a division.

(d) Residual income and economic value added are both measures of financial position. Both can be used to assess the value created by an organisation during a period, and can be used to measure historical performance or to budget or forecast future performance. Similarly, both are measures of the success of the organisation in achieving the overall financial objectives of the organisation, which are generally related to profits and return.

Liquidity and gearing are measures of financial condition. Sufficient liquidity and an appropriate level of financial gearing are necessary conditions for survival and financial security, but they do not contribute directly to overall financial objectives.

Although liquidity and gearing can be measured retrospectively using historical data, they are more useful as forward-looking measures. An organisation needs to be satisfied that it will have adequate liquidity and suitable gearing in the future.

There are several ways of measuring liquidity. Historically, liquidity can be measured by a quick ratio, current ratio and cash cycle. Looking forward, liquidity is perhaps best measured by free cash or by means of a cash budget or cash flow forecast.

Operational gearing can be measured by the contribution/sales ratio, which indicates the rate of change in contribution or gross profit as a result of a given change in sales revenue. TT Division has volatile annual sales revenue, and operational gearing is therefore significant as a measure of change in profitability resulting from a change in revenue.

Financial gearing is not a useful measure of financial condition at divisional level unless specific amounts of long-term debt are attributable to the division. Financial gearing measures changes in after-tax profit in response to a change in operating profit, but is usually measured at the level of the organisation as a whole.

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Question 4 Marking scheme Marks (a) Problems with current appraisal process – up to 2 marks per problem – up to 6 Up to 6 Problems could include (but are not limited to): conflict between control (assessment) and development; lack of time; lack of assessment criteria Suggestions for organising and operating an appraisal scheme: 1 mark per relevant point: Up to 7 Maximum for part (a) Max 10 (b) General description of the Building Block model in relation to G&C's

current system – up to 2 marks

Up to 2

Evaluation of G&C's system in relation to 'Results' aspect of model – up to 2 marks

Up to 2

Evaluation of G&C's system in relation to 'Determinants' aspect of model – up to 3 marks

Up to 3

Evaluation of G&C's system in relation to 'Standards' aspect of model – up to 3 marks

Up to 3

Evaluation of G&C's system in relation to 'Rewards' aspect of model – up to 5 marks

Up to 5

Max 11 (c) Suggestions for performance measures, discussion of merits and

limitations:

Maximum of 2 marks each for client service, and employee productivity

Max 4 25

Suggested solution (a) G&C's current staff appraisal scheme is not operating successfully. The problems seems to begin at the

outset with the design and implementation of the formal scheme. Because the partners lack the expertise in scheme design, the model that they are using is likely to be difficult to work with. Had they employed an experienced agency to help them design their appraisal system, for example, they could still have tailored the system to suit themselves but the basic structure would have been sound.

(i) Problems

Too many conflicting purposes. Although the partners refer to the scheme as an appraisal scheme, it is used for staff development, performance assessment and reward (annual bonus). If the staff are unclear about the purpose of the appraisal, this may explain why they either do not contribute anything to the interviews, or else see them as an opportunity to complain.

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(1) Performance vs development

If an individual is assessed on past performance, the assessment will not show whether the individual will be capable of handling a more senior job with a demand for different skills. Appraisal for promotion should therefore be based on a person's potential skills – those required by the new post.

There is an inherent conflict in the appraisal process between judgement about past performance and development in relation to future performance.

(2) Performance vs reward

There is also a problem in linking past performance with future reward, or a bonus in this case. Unless the connection between performance and reward is a real one, it is damaging.

(ii) Too little time. There are too many employees for Gibson and Chew to appraise without help. They will need to involve other partners and managers in the process. A 360 degree appraisal is when people at all levels contribute to the appraisal.

(iii) Poor identification of criteria for assessment, meaning that staff will not be clear about how they are being assessed or what aspects of their performance are most important.

(iv) A disregard for action plans to achieve improvements and changes agreed.

All of these shortcomings mean that it will be difficult, if not impossible, for the partners to evaluate the benefits of the present system.

Good appraisal schemes

A successful appraisal scheme could be operated by the firm if they follow certain guidelines.

(i) Everyone should understand the purpose and objectives of the appraisal scheme, the uses that will be made of it and the method of operation.

(ii) The scheme should have full support at all management levels. As wide a range of staff as possible should be involved in the formulation of the scheme.

(iii) It should be objective and constructive, helping the appraisee to improve performance. Destructive appraisals have been shown to lead to resentment and a worsening of relations.

(iv) It should be systematic in that all the relevant personnel should be appraised using the same criteria.

(v) Training of appraisers is vital, as is the constant monitoring of their performance, so that standards are maintained.

(vi) All aspects of the appraisal should be made known to the job holder, who is then given full feedback of has every opportunity to contribute to the process.

(vii) The system should be simple to operate with the minimum of form filling but ensuring the facts are recorded.

(viii) Follow up action plans should be agreed and there must be a willingness to monitor progress.

(b) The building block model (which was designed for use in service businesses, such as G&C) highlights that non-financial factors (such as quality of service) are key determinants of an organisation's competitive and financial success. G&C's current performance management system appears to focus on only a few aspects of financial performance, and therefore does not focus on any of the determinants of performance highlighted by the building block model.

Results – Financial performance is one of the 'results' in the model, and the metrics for revenue growth and profit margin in the current system allow this to be measured. However, the current system does not provide any way of measuring competitive performance –for example, comparing growth rates (particularly for planning and advisory services) to market growth rates.

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Determinants – The management information provided does not provide any scope to measure the four determinants of performance identified in the model (quality of service, flexibility, resource utilisation and innovation). Charles Chew has already highlighted the importance of client service for G&C, and this is also likely to have an impact on G&C's ability to contribute to client's success – particularly for the planning and advice sector of the business. Therefore, the fact that the current system provides no way of measuring client service levels (for example, through customer satisfaction scores) could be seen as a particular weakness.

Standards

Fitzgerald & Moon suggest that in order to be effective, performance targets must be fair and achievable, and employees must take ownership of them. The current management reports only show actual figures; so for example, there are no budget figures to compare actual performance to. As such, we cannot tell whether any targets are fair or achievable.

One area which could raise issues in relation to achievability and fairness would be performance targets (and entitlement to bonuses) in the two different business streams. The market conditions for the planning and advisory service business appear more favourable than those for audit services, so we would expect the former to achieve higher growth and margins. As such, simply comparing the results for the two areas has limited value for assessing how well the staff (and partners) in each area have performed.

Rewards

The building block model suggests that, in order for reward systems to encourage staff to work towards the performance standards set, they need to have three key properties: clarity, motivation and controllability.

Clarity – The amount of bonus which non-partners receive depends on feedback from their line managers and their annual appraisal. We have already identified the weaknesses with the appraisal process in part (a) – including the fact that staff are not clear about how they are being assessed or which aspects of performance are most important. This lack of clarity could serve to demotivate staff, which could be a major problem for G&C since staff excellence is seen as a key component of its competitive success.

Controllability – Since the performance management system only looks at financial indicators this might suggest that financial measures are used as a factor when deciding bonus entitlements. However, non-partners have relatively little scope to influence revenue or profit margins at a corporate level. In this respect, the feedback from line managers could be important, if it focuses on aspects of performance which staff can control (for example, their productivity and efficiency when carrying out client engagements).

Basis of assessment – There could be similar controllability issues in relation to the partners' reward system. Although the partners currently receive a share of profit, it is not clear if the profit-share is based purely on G&C's profit as a whole, or if it also reflect the profits for the areas they are responsible for. If the partners feel their rewards are being based on measures they cannot control, this is likely to adversely affect their motivation. For example, if rewards are based on group profits, then partners in the audit division have little incentive to maximise their performance, because they know they will benefit from the stronger performance of the advisory division (regardless of their own division's performance).

(c) Client service

Client service might be assessed in relation to the increase (or decrease) in total fee income from individual clients, and the average rate of growth (or decline) in fee income per client. This would have to be adjusted for any changes in hourly fee rates charged.

This might be a suitable measure on the basis that clients will only ask an accountancy firm to do more work if they are satisfied with the work that the firm has done so far.

However, there may be reasons why fee income per client rises for some clients that are not connected to client service and client satisfaction. For example, if a client is successful and its business grows in size, the annual audit may involve more work and so generate more income for Gibson & Chew.

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Productivity

Employee costs are likely to be a significant cost in a professional firm of accountants, and measures of productivity should therefore be concerned mainly with labour productivity.

A suitable measure of performance may be chargeable hours worked per professional employee, or chargeable hours as a proportion of total hours worked, in the case of accounting technicians. This assumes that an individual is productive only when directly earning income for the firm.

There are several problems with this performance measure. Individuals may be productive when they are not doing chargeable hours of work. In addition, using this measure for control purposes can bring unnecessary pressure to bear on employees, who may feel that they are underperforming if they are not continually working long hours on income-earning work.

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