BA2 - Fundamentals of Management Accounting

Chapter 9 – Performance Measurement

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Performance Measurement :
Performance measurement
• Performance measurement is the monitoring of budgets or targets against actual results to establish how well the business and its
employees are functioning as a whole and as individuals.
• Performance measurement is a very important aspect of management accounting. Management accountants get involved in
setting targets, measuring the actual performance against those targets and providing information to management regarding the
outcome. This information will be used by management to make decisions about the organisation.
• Performance measurement is very important as it can affect behaviour, so it is crucial when setting performance targets that we
consider what behaviour we are looking to encourage. Setting poor performance targets can lead to dysfunctional behaviour which
is behaviour that is not in the best interests of the organisation as a whole.
• Performance can be measured at an individual, departmental or organisation level and the types of measurements used will
depend on the area being measured and the nature of the organisation.

The needs of different organisations:

• Objectives and goals of a business or business area will vary depending on the type of business that is being operated. For
example:
• A commercial organisation's overall goal will be to maximise their shareholders wealth so they will want to monitor profitability
(based on increasing sales and reducing costs) and growth of market share compared to competitors.
• A not-for-profit organisation, for example a government department, will want to provide the best service possible for the lowest
cost so that the residents being cared for achieve value for money from the taxes they pay.

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Within organisations, the objectives and goals in a production centre would be different to those in a call centre. For example:
•A production centre manager will be interested in maximising volume of output or reducing the level of wastage.
•A call centre manager will be interested in answering as many calls as possible or minimising the percentage of calls unanswered.

Responsibility accounting
• When considering the types of reports to produce and the performance measurements to include, some considerations must be
given to the type of organisation, the nature of the department, what aspects the manager of the department can control and the
information required by the manager.

• Before looking at performance measurements, we should first recap on responsibility centres.

• Organisations are often split into responsibility centres. Each centre will have a manager responsible for managing the centre and
controlling the performance of the centre. There are four types of responsibility centre:

Cost centre: The cost centre manager is responsible for managing the level of operating costs. To have responsibility for the costs,
the manager should be able to exercise control over the costs.
Revenue centre: The revenue centre manager is responsible for generating revenue. To have responsibility for the revenue, the
manager should be able to exercise control over the revenue generated.
Profit centre: The profit centre manager is responsible for operating costs and revenue and for the resulting profit. To have
responsibility for the profit, the manager should be able to exercise control over both costs and revenue. So a profit centre manager
can exercise control over revenue, but a cost centre manager cannot. Likewise an profit centre manager can exercise control over
costs, but a revenue centre manager cannot.

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Investment centre: The investment centre manager is responsible for profit and the return on any investment made. To have
responsibility for the return, the manager should be able to exercise control over costs, revenue and investment. So an investment centre
manager can exercise control over investments but cost, revenue and profit centre managers cannot.

This type of responsibility centre will affect the information supplied to the manager of the centre

Q1.
Match the information required by each responsibility centre manager, by dragging the boxes to show if the information would be
required. Boxes can be dragged more than once to indicate an item that would be of interest to multiple managers.

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Performance Measurement :

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Performance Measurement :
• Financial performance measures are used to monitor the inflows (revenue) and outflows (costs) and the overall management of
money in the business. These measures focus on information available from the statement of profit or loss and statement of
financial position of a business.
• Financial measures can be used to record the performance of cost centres, profit centres and investment centres within a
responsibility accounting system but they can also be used to assess the overall performance of the organisation as a whole. For
example, if cost reduction or cost control is important to an organisation, cost based performance measures might be appropriate
performance indicators to use.
• Cost based performance measures can be calculated as a simple cost per unit of output. The organisation will have to determine
its policy for establishing cost per unit for performance measurement purposes.
There are a number of common financial performance measures:
• gross revenue
• contribution
• gross margin
• operating (net) margin
• return on capital

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Performance Measurement :
Gross revenue
• The total sales achieved by a company is known as gross revenue. This is the total of all sales transactions made by the
company. This is a useful figure for the sales director of a company who needs to know how many customers their products or
services have reached.

• However, for various reasons, not all sales are successful and companies can experience returns from customers or goods could
be lost in transit. It is important that these deductions are made from the gross revenue figure to give another meaningful
measure called sales revenue.

Contribution
• Contribution was looked at in detail in the Marginal and Absorption costing unit. Contribution is a useful measure in management
reports as it is aids decision making.

To recap:
Contribution = sales revenue – variable costs

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Performance Measurement :
Gross margin
• Another measure which may be useful to managers is gross margin. This is also referred to as gross profit. Gross margin is
calculated as follows:

Gross margin = sales revenue – direct production or purchasing costs incurred

• This is a useful measure which shows how effective the company’s trading activity is. It shows if the sales revenue is enough to
cover the direct cost of the item sold.
Net margin can then be calculated by deducting indirect costs or overheads from the gross margin.
Gross margin percentage is also a useful measure in reporting. It is calculated as follows:

• This measure helps to highlight the relationship between sales revenues and production/purchasing costs.
• A high gross profit margin is desirable. It indicates that either sales prices/volumes are high or that production costs are being kept
well under control.

• As it is a % measure, it can be used to compare the performance of different areas of the business or different products.

Example – a gross margin analysis

The following extract is taken from the monthly managerial report of a manufacturing company.

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Performance Measurement :

• This gross margin analysis focuses managers' attention on the relationship between the sales value and the direct cost of sales,
before indirect costs or overheads are taken into account. This analysis reveals the following:
-Although the gross sales revenue is steadily increasing, the gross margin is relatively constant each year.
-The gross margin percentage is steadily decreasing each year. If the gross margin percentage could have been maintained at 22%
the total gross margin earned would have been higher.
-Perhaps selling prices are being increased but the reduction in the gross margin percentage might be the result of a failure to
increase selling prices sufficiently in line with increasing direct costs.
-Alternatively, the sales volume might be increasing but direct costs are not being contained as the sales increase.

Operating (net) margin

• Another measure which may be useful to managers is operating or net margin. Operating (net) margin is also called earnings
before interest and tax in the financial statements. This is a useful measure which shows how much profit the company has
generated in the period. It shows if the sales revenue is enough to cover the direct cost of the item sold and all expenses.

• The operating margin percentage is also a useful measure in reporting. It is calculated as follows:
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• It can be useful to compare the gross margin and operating margin as it helps to see how well the business is controlling its
expenses

Return on capital employed (ROCE)

• Capital is the investment in an entity, it is often referred to as capital employed.
Capital employed is calculated as total assets less current liabilities.
There are a number of measures which can be used to calculate the return on capital, the main one is return on capital employed
(ROCE). It is calculated as follows:

This measure helps to highlight the productivity of the capital employed.

Problems with financial performance measures

• While the above performance measures are useful there are some problems with financial performance measures.

• A focus on financial measures can lead to a more short-term focus by managers. In addition, financial measures can be easy to
manipulate, for example costs can be delayed in order to show a more favourable position.

• The main problem with financial measures is that they do not convey the full picture regarding the performance of the manager,
department or company.
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Non-financial performance measures
• Information provided by management accountants needs to be both financial and non-financial. Financial information is important
for management because many objectives of an organisation are financial in nature, such as making profits. While profit cannot be
ignored as it is the main objective of commercial organisations, performance measures should not focus on profit alone. Managers
also need information of a non-financial nature.
Examples of non-financial measures include:
-measurements of customer satisfaction e.g. returning customers or reduction in complaints
-resource utilisation e.g. are the machines being operated for all the available hours and producing output as efficiently as possible?
•measurement of quality e.g. reduction in conformance and non-conformance costs.

• While financial measures tend to be backward looking and report what has happened in the past, non-financial measures have the
advantage of being ‘forward looking’. That is, they are likely to address factors that relate to how well or badly the business will
perform in the future.

• Different types of companies and different functions within companies will all require different types of non-financial measures which
would be relevant to their operation. There are therefore a large range of potential non-financial measures which could be used in
management reporting. Most non-financial measures cover the headings of productivity and quality. These are not really able to be
measured by using financial measures alone.

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Performance Measurement :
Examples of non-financial measures
Non-financial measures vary depending on the area being reported measured and on. Click on the following departments to get some
examples of suitable performance measurements for that area.
Production department: wastage levels, number of units produced, hours of idle time
Sales department: reapeat sales, number of new customers, average spend per customer
Customer services department: number of calls answered, average length of call, number of calls answered per member of staff
Distribution centre: customer complaints, number of orders dispatched, miles travelled by delivery vehicles

Problems with non-financial measures

• Non-financial measures can offer a wider, more complete view of the performance of an area and cannot be as easily manipulated
as financial measures. The also tend to be easier for managers to understand and help to focus on potential problem areas.

• Non-financial measures, however also have some problems.

• Setting up a system to measure and report on all of the non-financial measures can be very time consuming and costly. As we
have seen above, each area will require its own specific measures which can add up to a huge number of items requiring
measuring each period. It is also difficult to decide on what to measure and some aspects, such as customer satisfaction, can be
very difficult to measure.

• It can be easy to get carried away and start to measure everything which can cause an overload for managers.
• We can see from this that that the important thing when producing management reports is to consider the area being reported on
and what the most important measures would be for that area.

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Performance Measurement :
Q1.
Consider a large chain of hotels. Suggest some non-financial measure which could be used to measure customer satsfaction.

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Performance Measurement :
The balanced scorecard
• To get an effective system of performance appraisal a business should use a combination of financial and non-financial
measures.
• One of the major developments in performance measurement techniques in recent years that has been widely adopted is the
balanced scorecard.

• The concept was developed by Kaplan and Norton, 1993 at Harvard. It is a device for planning that enables managers to set a
range of targets linked with appropriate objectives and performance measures.

The four perspectives

• The framework looks at the strategy and performance of an organisation from four points of view, known in the model as four
perspectives:
Financial - This focuses on traditional financial measures.
Customer - This attempts to measure customers' view of the organisation by measuring customer satisfaction.
Internal business processes - This aims to measure the organisation's output in terms of technical excellence and consumer
needs.
Learning and growth - This focuses on the need for continual improvement of existing products and techniques and developing
new ones to meet customers' changing needs.

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Performance Measurement :
Financial Perspective:
• Operating profit margin
• return on capital employed
• return on shareholders’ funds

Customer Perspective:
• number of customer complaints
• % of returning customers
• new customers as a % of total customers

Learning & Growth Perspective:

• % of revenue attributable to new products
• number of new products launched in the period
• number of staff training days undertaken

Internal Business Processes Perspective:

• unit costs
• capacity utilisation %
• number of units rejected

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Performance Measurement :
• Performance measurements in service industrie
In many western economies, one of the major changes that has taken place in recent years has been a change in the structure of
those economies – the manufacturing sector has declined in size and significance and the service sector has grown in importance.
The service sector consists of banks, airlines, transport companies, accountancy and consultancy firms and service shops.

• Measurement of performance for a service provider can be difficult due to the nature of services.

Features of service organisations

• Intangibility. Services are activities undertaken by the organisation on behalf of its customers and therefore cannot be packaged
for the customer to take away with them. They often have few, if any, physical aspects. For example, a taxi driver provides a
service, carrying customers from one location to another. The customers do not have a permanent, tangible product they can
keep.

• Variability. Each service is unique and cannot usually be repeated in exactly the same way, making offering a standardised service
to customers very difficult.

• Simultaneous production and consumption. Services are often created by the organisation at the same time as they are
consumed by the customer. For example, a restaurant meal is cooked as it is ordered by the customer. This brings with it
particular management problems of planning and control but it does mean that the incidence of work in progress is very low,
that is, it is rarely necessary to value part-finished units of service at the end of an accounting period.

• Perishability. Services cannot be stored for later. For example, if a cinema seat is vacant when a film is showing it cannot be
stored in inventory for a later sale. Therefore, capacity utilisation becomes a very important issue for managers in many service
organisations.
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Performance Measurement :
Establishing a cost unit
• While there are many types of service organisations, one aspect of service organisations that can present difficulties for all types is
establishing a suitable cost unit. Many service organisations produce an intangible ‘output’, that is: their output has no physical
substance and it cannot be physically seen and touched. In order to maintain effective cost control it is essential to establish a
measurable cost unit for which we can ascertain and monitor the costs.

• In the cost identification and classification unit we saw how composite cost units are often used to monitor and control the costs
in service operations.

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Performance measurements in a service organisation
• We shall consider two main aspects of performance in relation to service organisations:
-Financial performance
-Service quality
• Quality is seen to be a particularly important non-financial performance indicator in the service sector.

Financial performance
• Conventional financial analysis as looked at earlier can be used in service organisations and can be useful as long as it involves
comparisons with past trends and/or competitors' ratios. Typical ratios that could be used by a service organisation include:
-gross revenue
-revenue per 'service’
-revenue per 'principal' or partner in, say, a management consultancy
-staff costs as a % of revenue
-space costs as a % of revenue
-training costs as a % of revenue
-operating (net) margin.

• Financial ratio analysis is of limited use due to the 'human' nature of a service provider. The quality of the service also needs to be
considered.

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Performance Measurement :
Service quality
• Service quality is going to be critical in a service company as there is no tangible product, the company will be judged on that
service.
• Consider a large hotel chain. Customer satisfaction is critical if the hotel is going to survive in the long-term. The hotel chain could
use the following measures to assess customer satisfaction.
• Examples of suitable quality measures could be:
-the length of time at reception
-the facilities in the hotel
-the cleanliness of the rooms
-the quality of the food
-the helpfulness of its staff.

• Many of these could be measured using customer comment cards, or using mystery shoppers. Mystery shopping involves getting
another member of staff, or an independent party to use the facilities as if they were a customer and report back on their findings.
• Cleanliness and condition of service facilities can be measured by the regular completion of detailed checklists showing when
each area has been cleaned.
• Inspection and monitoring of the inputs to the service process is also crucially important for service organisations.
• Many service companies use internal mechanisms to measure service quality during the process of service delivery.
• The quality of the service may be measured after the event that is by measuring the results by outputs of the service.
• We can see that for service organisations, quality performance measurements are more useful than financial measures.

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Patient care cost per night =

$1,602,100/4,750 = $337.28

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 Closing session

Source : Mr. Lalith De Silva, FCMA, CGMA, FCPA (Aust.), MBA (Aust.)
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