P5 Advanced Performance Management

Okey Umeano ACCA FRM

Aim
To apply relevant knowledge and skills and to exercise professional judgment in selecting and applying strategic management accounting techniques in different business contexts, and to contribute to the evaluation of the performance of an organization and its strategic development

Core Areas
Strategic planning and control External influences on organisational performance Performance measurement systems and design Strategic performance measurement Performance evaluation and corporate failure Current developments and emerging issues in performance management.

Planning & Control

Planning is about: - where an organization wants to be, and - how it will get there Control is concerned with monitoring the achievement of objectives and suggesting corrective action.

The Performance Hierarchy

Mission Strategic plans and objectives Tactical plans and objectives Operational plans and targets

Strategic Management Accounting

The Strategic planning process includes strategic analysis, strategic choice, and strategic implementation.

Strategic management accounting

- provides information on the financial aspects of strategic planning using information from internal and external sources, monitoring performance in line with organisational objectives.

 Critical Success Factors (CSF)s are areas in which the business must do well to achieve its objectives
The achievement of CSFs is measured by establishing Key Performance Indicators (KPIs).

Tools used in strategic analysis

Benchmarking use of a best-in-class yardstick to compare performance. Things to know: - types of benchmarking - the process - benefits and problems of benchmarking SWOT analysis Gap analysis
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Environmental Influences
External Analysis - can be analysed using PESTEL and Porters 5forces. Impact of Stakeholders & Stakeholder conflict - Mendelows matrix - managing conflicting objectives by prioritisation, negotiation and satisficing, sequential attention, side payments and exercise of power
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Environmental Influences contd.

Impact of ethical issues - corporate social responsibility (CSR)
Impact of government policy - fiscal and monetary policy - legislation and regulation - competition policy Risk and uncertainty - tools for incorporating risk and uncertainty: 1. scenario planning
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Environmental Influences contd.

2. computer simulations 3. sensitivity analysis 4. expected values 5. maximin, maximax, and minimax regret
Expected Values - Calculated by multiplying the value of each possible outcome (x), by the probability of that outcome (p), and summing the results. EV = px
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Environmental Influences contd.

Maximin, Maximax, and Minimax Regret The risk tolerance of management will determine which of the 3 will be used. Maximin rule- selects the alternative that maximises the minimum payoff achievable pessimist. Maximax rule- selects the alternative that maximises the minimum payoff achievable optimist. Minimax regret- selects the strategy that minimises the maximum regret (opportunity loss from making the wrong decision) sore loser.
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Environmental Influences contd. Classwork maximin,etc

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Approaches to Budgets
A budget is a financial plan prepared for a specific time period. Purposes of budgeting include planning, control, communication, co-ordination, evaluation, motivation, authorisation, delegation.

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Approaches to Budgets contd.

Methods of Budgeting
Note: Know all the methods, their advantages/disadvantages.

a. Fixed budget budget prepared at a single level of

activity.

b. Flexible budget budget prepared with the cost behaviour of all cost elements known and classified as either fixed or variable. May be prepared at a number of activity levels and can be flexed.

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Approaches to Budgets contd.

c. Incremental budget starts with the previous periods budget or actual results, and adds (or subtracts) an incremental amount to cover inflation and other known changes. d. Zero-based budget (ZBB) requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. e. Rolling budget one that is kept continuously up to date by adding another accounting period (e.g. month or quarter) when the earliest period has expired.
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Approaches to Budgets contd.

f. Activity-based budget uses principles of activity based costing to estimate the firms future demand for resources and hence can help the firm to acquire these resources more efficiently. Beyond budgeting This is a leadership philosophy that relates to an alternative approach to budgeting which should be used instead of traditional annual budgeting.

Budgeting in Not-For-Profit Organisations Considerations include: no profit motive, non-quantifiable benefits, no revenue generated, multiple stakeholders, objectives.
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Approaches to Budgets contd.

Forecasting Recall the methods from F5: - high-low method - regression analysis - time series analysis - the learning curve model Wrights Law as output doubles, the average time per unit falls to a fixed percentage of the previous average time. The learning curve effect is calculated using: y=axb
where: y= average time per unit/batch; a= time for the first unit/batch x= output in units/batches; b= log r (r = rate of learning) log 2

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Approaches to Budgets contd.

Classwork

Ammy Ltd. wants to estimate the labour costs of a new product. The product, DSC, will have a life of 12months. Sales are budgeted to be 110,000 in the year, in batches of 100 units. An 75% learning curve will apply for the first 500 batches, after which a steady state production time will apply, with the labour time per batch after the first 500 batches being equal to the 500th batch. The labour cost of the first batch was measured at $1,800. This was for 300hours at $6 per hour. Required: Calculate the labour cost for production of DSC. Note: At a learning rate of 75%, learning factor b is -0.415. Limitations: For the learning curve effect to work; there must be no breaks in production, the product should be new, and the process should be complex, labour-intensive, and repetitive.
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Changes in Business Structure

Business Integration
- means that all aspects of the business must be aligned to secure the most efficient use of the organisations resources so that is can achieve its objectives effectively. - Four aspects that need to linked include: people, operations, strategy, and technology. - Tools that can be used here include Porters Value Chain and the McKinseys 7s model.

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Business Process Re-engineering

This is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical, contemporary measures of performance, such as cost, quality, service, and spread. BPR is aimed at improved customer satisfaction.

Staff Empowerment
- the delegation of certain aspects of business decisions to those lower down in the hierarchy.
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Information
Important Issues Sources: Internal and External Costs of information Quantitative & Qualitative data Qualities of good information ACCURATE accurate, complete, cost<benefit, understandable, relevant, adaptable to user needs, timely, easy to use.
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Behavioural Aspects of Performance Management

Performance Measures & Human Resource Mgt (HRM) HRM is the strategic and coherent approach to the management of the people working in an organisation, who individually and collectively contribute to the achievement of its objectives for sustainable competitive advantage.

Theories of HRM: a. The Vroom expectancy model force = valence x expectancy b. Agency theory

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Behavioural Aspects of Performance Management

Important Issues: - Relationship between performance management and performance measurement - Performance measurement and reward systems Methods of Reward: 1. Basic pay 2. Performance-related pay 3. Benefits

- Wrong signals and inappropriate action misrepresentation, gaming, misinterpretation, shorttermism, measure fixation, tunnel vision, suboptimisation, ossification.
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Behavioural Aspects of Performance Management

Management styles of performance appraisal- Budget constrained style - Profit-conscious style - Non-accounting style

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Financial Performance Measures in the Private Sector

The primary objective of profit-seeking organisations is maximisation of shareholder wealth. This further broken down into profit, survival, and growth. Growth can be identified in the following ways: Financial: profitability, revenue, return on investment, cash flow

Non-Financial: market share, number of employees, number of products

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Financial Performance Measures in the Private Sector ROCE - EPS EBITDA - NPV IRR - MIRR Liquidity & Gearing Ratios

ROCE is a measure of profitability ROCE = Net profit x 100 Capital employed Merits Demerits
-Easily understood by shareholders. -Figures are readily available. -Measures how well a business is using investors funds -Research shows poor correlation between ROCE and shareholder value. -Care must be taken to compare like with like -Can be gamed using certain accounting treatments.
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Financial Performance Measures in the Private Sector EPS is a measure of the profit attributable to each ordinary share. EPS = profit after tax less preference dividends
weighted average number of ordinary shares outstanding Classwork: ABC Ltd. share capital is as follows: ordinary shares ($1 each) 6% preference shares

$2,000,000 $ 500,000

ABCs profits before tax were $1,800,000. Tax rate is 32%. Required: Calculate ABCs EPS.
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Financial Performance Measures in the Private Sector EPS contd. Merits

-Easily understood by shareholders. -Figures are readily available.

Demerits
-Research shows poor correlation between EPS and shareholder value. -Can be gamed using certain accounting treatment.

-Calculation precisely defined, avoiding ambiguity.

EBITDA Earnings before interest, tax, depreciation and amortization Merits Demerits
-Easy to calculate and understand.
-It is a proxy for cash flow from operations -Ignores changes in working capital and its impact on cash flow -Can be gamed using certain accounting treatment.
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Financial Performance Measures in the Private Sector

Liquidity ratios: - Current ratio - Quick ratio (acid test) - Raw material period = (ave. value of raw materials/purchases) x 365 - WIP period = (ave. value of WIP/cost of sales) x 365 - Receivables period = (ave. receivables/sales) x 365 - Payables period = (ave. payables/purchases) x 365

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Financial Performance Measures in the Private Sector

Gearing ratios: - Gearing = (long-term debt/shareholder funds) x 100% or - Gearing = long-term debt x 100% long-term debt + shareholder funds Interest cover = PBIT/interest charges

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Financial Performance Measures in the Private Sector

Ways to reduce short termism: - Use both financial and non-financial measures - Switch from a budget-constrained style to a profitconscious or non-accounting style - Use share options - Use bonuses linked to profits - Use NPV to appraise investments - Reduce decentralisation - Use value-based techniques.

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Divisional Performance Appraisal and Transfer Pricing

Problems associated with a divisional structure: - Co-ordination difficulties - Goal congruence - Inter-dependence of divisions - Head office costs - Transfer prices - Controllability
Types of divisions - Cost centre incurs costs, no revenue stream - Profit Centre incurs costs, has revenues, manager has no investment authority - Investment Centre has costs, revenues, and investment authority

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Divisional Performance Appraisal and Transfer Pricing

- Return on Investment (ROI) ROI = PBIT x 100 capital employed ROI is the divisional equivalent of ROCE. Decision rule: If ROI > cost of capital (required return), accept the project. Advantages 1. Widely used & accepted Disadvantages

1. May lead to dysfunctional decision making 2. Relative measure can be 2. Different accounting used for divisions of diff sizes policies can distort comparisons
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Divisional Performance Appraisal and Transfer Pricing

Residual Income PBIT less imputed interest (capital employed x cost of capital) RI
Decision Rule: accept the project if RI is positive

x (x) x

Advantages 1. Reduces problems of ROI

Disadvantages

1. Difficult to decide right cost of capital 2. Divisional managers are made 2. Not relative and so sizeaware of the cost of financing dependent

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Divisional Performance Appraisal and Transfer Pricing

Economic Value Added (EVA) EVA = NOPAT less (capital employed x WACC)
Advantages 1. Should not lead to dysfunctional behaviour because it is consistent with NPV. 2. Based on cash flows, and so, less distorted by chosen accounting policies. Disadvantages 1. Many assumptions 2. Ignores items such as brands and goodwill
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Divisional Performance Appraisal and Transfer Pricing

Classwork:
Division XYZ of a company has a PBIT of $25m. This PBIT is after a $5m charge for the launch of a new product expected to have a life of 5 years. XYZs non-current assets (NCAs) are valued at $75m and net current assets $28m. The replacement cost of NCAs is estimated to be $80m. The companys WACC and tax rate are 10% and 30%, respectively.

Required: Calculate XYZs WACC.

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Divisional Performance Appraisal and Transfer Pricing

Models used in divisional performance appraisal

Ansoffs matrix:
Existing Products Protect/Build Existing Markets New Products Product devt.

Mkt. developmnt Diversification New Markets

BCG matrix:
High Market Growth

Relative market share High Low Star Problem child

Cash cow Low

Dog

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Divisional Performance Appraisal and Transfer Pricing

Transfer Pricing: 3 scenarios Scenario 1: perfectly competitive market for product/service Transfer price = market price less any cost saving due to transfer (e.g. packaging & carriage costs)
Scenario 2: the selling division has surplus capacity Transfer price = marginal cost (less any savings), so long as the total is less than the external purchase price Scenario 3: the selling division has no surplus capacity Transfer price = marginal cost (less any savings) + lost contribution from other product, so long as the total is less than the external purchase price
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Divisional Performance Appraisal and Transfer Pricing

Treatment of fixed costs: In transfer pricing, standard costs are best used and fixed costs are treated as lump sums. This is to prevent the selling division from transferring the cost of slack to the buying division.
In summary, fairness has to be maintained in fixing transfer prices.

Classwork:

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Performance Management in Not-For-Profit Organisations (NFPO)

Problems associated with performance measurement in NFPOs
1. Non-quantifiable costs and benefits - no readily available scale exists - time scale problems - how to trade off cost & benefits measured differently - externalities solution = cost-benefit analysis Assessing the use of funds solution = assess value for money use the 3Es in the VFM assessment

2.

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Performance Management in Not-For-Profit Organisations (NFPO)

3. Multiple and diverse objectives Solution = problem can be overcome by prioritizing objectives or making compromises between objectives. 4. Impact of politics on performance measurement

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Non-financial performance indicators and corporate failure

Know typical NFPIs for
Competitiveness Activity Productivity Quality of service Customer satisfaction Quality of working life Innovation
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Non-financial performance indicators and corporate failure

Models for evaluating financial and non-financial performance - Balanced Scorecard - Performance pyramid - Building Block Model

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Balanced Scorecard: - Customer perspective - Financial perspective - Internal business process - Innovation & learning Within each of these perspectives a business should seek to identify a series of goals (CSFs) and measures (KPIs).

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Performance Pyramid
Corporate Vision

Market
Customer Satisfaction

Financial

Divisions/SBUs

Flexibility
Productivity Cycle

Business operating systems Departments Waste

Quality

Delivery

time

External effectiveness

Internal efficiency

- One drawback of the performance pyramid is that it does tend to concentrate on two groups of stakeholders shareholders and customers.
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Building Block Model

Dimension
Competitiveness Financial performance Quality of service

Flexibility
Resource utilization Innovation

Standards
Ownership

Measures
Clarity

Achievability
Fairness

Motivation
Controllability

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Corporate Failure
Reasons for corporate failure: - Failing to adapt to changes in the environment - Strategic drift Assessing the likelihood of failure: Red flags- poor cash flow - lack of financial controls - internal rivalry - general economic conditions - loss of key personnel - lack of new production/service introduction
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Corporate failure prediction models

Altmans Z-score:
z-score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 where: X1 = working capital/total assets X2 = retained earnings/total assets X3 = EBIT/total assets X4 = market value of equity/total liabilities X5 = sales/total assets
Decision rule:

Less than 1.81 :- impending failure 1.81 2.99 :need further investigation 3.0 and above:- financially sound
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Argentis A score - Defects management weaknesses - Mistakes high gearing, overtrading, failure of big project - Symptoms of failure deteriorating ratios or creative accounting
Decision rule: If the overall score is more than 25, the company has many of the signs preceding failure and is therefore a cause for concern. Know: Limitations of qualitative & quantitaive models for predicting corporate failure.
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Current developments in performance management

Six sigma Kaizen costing Target costing Just-in-time Total quality management Quality assurance, control and management
- Quality-related costs prevention, internal & external failure costs, and appraisal costs

Performance prism
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