(77)---PERFORMANCE MEASUREMENT - THE BALANCE SCORECARD

Performance measures-The balance scorecard.

Although segment of a business may be measured by a single performance indicator such as Return on Investment (ROI), Profit or Cost variance, it might be more appreciate to use multiple measures of performance where each measure reflects a different aspect of achievement. Where multiple measures are used, several may be non-financial.

The most popular approach in current management thinking is the use of what is called a “balance scorecard” consisting of a variety of indicators both financial and non-financial.

As CIMA official terminology the balance scorecard is an approach to the provision of information to management to assist strategic policy formulate and achievement. It empresses the need to provide the users with a set of information which addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both financial and non-financial elements, and areas such as profitability, customer satisfaction, internal efficiency and innovation.

(76)---INFORMATION SYSTEM AND PERFORMANCE MEASURES.

Information system and performance measures.

Traditional information systems hold historic information of quantitative and monetary nature which has usefully been produced internally. To deal with the type of performance measures describe above, information system must be capable of holding descriptive results from a customer survey, for example, This type of information may come from external consultancies or from internal sources, service businesses being in a good position for collecting survey information because the customer is often at the point of delivery of the service and is therefore easily accessible for data collection.

In addition to adapting to collection and storing descriptive data, information systems must be capable of monitoring non-monetary data, such as customer waiting time and the speed of service delivery. To be most effective this type of information must be instantly available. Therefore the speed with which the data is processed into management information is likely to have to increase.

(75)---PERFORMANCE APPRAISAL SERVICE INDUSTRIES & NON-PROFIT MAKING ORGANIZATION.

Performance appraisal in service industries.

Service businesses do not produce any tangible output and, as it is difficult to measures performance, the tendency has been to concentrate on the easily quantifiable aspects of cost and productivity.

However, the non-tangibility of output makes even productivity difficult to measure. Fitzgerald et al advocate the use of a range of performance measures covering six “dimensions”

(a). Competitive performance, focusing on factors such as sales growth and market share.
(b). Financial performance, concentrating on profitability, liquidity and market ratios.
(c). Quality of service, looks at matters like reliability, courtesy, competence and availability.
(d). Flexibility, is an apt heading for organization’s to deliver at the right speed, to respond to process customer specifications, and to cope with fluctuations in demand.
(e). Resource utilization, considers how efficiently resources are being utilized. This can be problematic because of the complexity of the inputs to a service and the outputs from it.
(f). Innovation, is assessed in terms of both the innovation process and the success of individual innovations. In a modern environment in which product quality, product differentiation and continues improvement are the order of the day, a company that can find innovative ways of satisfying customers wants has an important competitive advantage.

Performance measurement for Non-Profit Making Organization (NPMO).

Commercial organizations generally have market competition and the profit motive to guide the process of managing resources economically, efficiently and effectively. However, non-profit making organization (NPMOs) cannot by definition be judged by profitability nor do they generally have to be successful against competition, so other methods of assessing performance have to be used.

Performance is usually judge in terms of inputs and outputs and this tie in with the “value for money” criteria that an often used to assess NPMOs.

• Economy (spending money frugally)
• Efficiency (getting out as much as possible for what goes in)
• Effectiveness (getting done, by means, by means of (a)and (b) what was supposed to be done)

More formally, effectiveness is the relationship between an organization outputs and its objectives, efficiency is the relationship between inputs and outputs, and economy equates to cost control in the commercial sector.

The problems with measuring the performance of NPMOs are therefore as follows.

• For many NPMOs, particularly government bodies, it is extremely difficult to define their objectives at all, let alone fine one which can serve a yardstick function in the way that profit does for commercial bodies.
• NPMOs tend to have multiply objectives, so that even if they can all be clearly identified it is impossible to say which the overriding objective is.
• Outputs can seldom be measured in a way that is generally agreed to be meaningful. (For example, are good exam results alone an adequate measure of the quality of teaching?)

(74)---PERFORMANCE MEASURES.

Many of the measures that are being suggested combine elements from the chart shown below. The chart is not intended to be prescriptive or exhaustive,

Traditional measures derived from these lists like kg (of material) per unit produced’ or ‘units produced per hour’ are fairly obvious, but what may at first seem a fairly unlikely combination may also be very.

(73)---PERFORMANCE MEASURES.

Performance measures.

Non-financial indicators.

Financial measures of not convey the full picture of a company’s performance, especially in a modern business environment.
Many companies are discovering the usefulness of quantitative and quantitative non- financial indicators (NFIs) such as the following.

• Quality
• Number of customer complaints and warranty claims
• Lead times
• Delivery to time
• Non-productive hours
• System (machine)down time, and so on
• Rework

Unlike traditional variance reports, measures such as these can be provide quickly for managers, per shift per daily or even hourly. They are likely to be easy to calculate, and easier for non- Financial managers to understand and therefore to use effectively.

Reveling.

• Absenteeism per customer, for example, may be of no significance at all or it may reveal that a particularly difficult customer is avoided, and hence that some action is needed.
• Miscalculations per 1,000 invoices’ would show how accurately the invoicing clerk was working.
• Defects per return may show that customers are very fussy about quality or (if there are no defects in returned goods) that their real needs are not being properly identified.

There are problems associated with applying NFIs.

• There is a danger that too many such measures could be reported, overloading managers with information that is not truly useful, or that sends conflicting signals.
• Arguably, non- Financial measures are less likely to be manipulated than Traditional profit-related measures and they should, therefore, offer a means of counteracting short-terms, since short-term profit any (non monetary) expense is rarely an advisable goal. However, that ultimate foal of commercial organizations in the long run is likely to remain the maximization of profit and so the financial aspect cannot be ignored.
• A further detail of non- Financial measures is that they lead managers to pursue detailed operational goals and become blind to the overall strategy in which those goals are set.
  A combination of Financial and non- Financial indicators is likely to be most successful.

(72)---THE ADVANTAGE AND WEAKNESSES OF RESIDUAL INCOME-COMPARED WITH RETURN ON INVESTMENT.

The advantage and weakness of Residual Income (RI) compared with Return on Investment (ROI).

The advantages of using Residual Income (RI) are as follows.

• Residual income will increase when investment earning above the cost of capital are undertaken and investments earning below the cost of capital are eliminated.
• Residual income is more flexible since a different cost of capital can be applied to investments with different risk characteristics.

The weakness of RI is that it does not facilitate comparisons between investment centers nor does it relate the size of a centre’s income to the investment.

Residual Income (RI) versus Return on Investment (ROI): Marginally profitable investment.

Residual income (RI) will increase if a new investment is undertaken which earns a profit in excess of the imputed interest charge on the value of the asset acquired. Residual income (RI) will go up even if the investment only just exceeds the imputed interest charge, and this means that “marginally profitable” investment are likely to be undertaken by the investment centre manager.

Conclusion.

Residual income should not be used as a means of making asset purchasing decisions; nevertheless, it may be a useful alternative to ROI where there is a conflict between investment decisions indicated by a positive NPV in discounted cash flow, and the resulting reduction in divisional ROI which “reflects badly” on management performance.

Incompatible signals – Solutions to the problems.

As we have seen, ROI and RI do not always point to the right decision and so, whenever possible, a Discounted Cash Flow (DCF) approach to decision making should be adopted. Two possible refinements to the normal approach to calculating ROI and RI exist.
However, and these can be adopted if it is not possible to calculate an NPV or an IRR.

(71)---RETURN ON INVESTMENT (ROI) AND DECISION MAKING.

Return On Investment(ROI) and decision making.

New investment.


If investment centre performance is judged by ROI, should expect that the managers of investment centre will probably decide to undertake new capital investment only if these new investment are likely to increase the ROI of their centre.

The target returns for a group of companies.


If a group of companies sets a target return for the group as a whole, it might be group policy that investment projects should only go ahead if the promises to earn at least the target return.


Discounted Cash Flows(DCF) Vs ROI.


In spite of the superiority of DGF yield over accounting ROI as a means of evaluating investment, and in spite of the wisdom of taking a longer term view rather than a short term view with investment, it is nevertheless an uncomfortable fact that the consideration of short-run accounting ROI does influence investment decisions.
A similarly misguided decision would occur where a divisional manager is worried about the low ROI of his decision, and decides to reduce his investment by scrapping some machinery which is not currently in use. The reduction in both depreciation charge and assets would immediately improve the ROI. When the machinery is eventually required the manager would then be obliged to buy new equipment. Such a situation may seem bizarre, but does occur in real life.
ROI should not be used to guide management decisions but there is a difficult motivational problem. If management performance is measured in term of ROI, any decisions which benefit the company in the long term but which reduce the ROI in the immediate short term would reflect badly on the manager’s reported performance. In other words, good investment decisions would make a manager’s performance seem worse than if the wrong investment decision were taken instead.

Residual Income (RI)


An alternate way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre’s profits after deducting or imputed interest cost.

• The centre’s profit is after deducting depreciation on capital equipment.
• The imputed cost of capital might be the organization’s cost of borrowing or its weighted average cost of capital.

Residual income (RI) is “pretax profits less an imputed interest change for invested capital” Used to assess divisional performance.

(70)---RETURN ON ON INVESTMENT (ROI).

Return on investment (ROI)

The performance of an investment center is usually monitored using either or both of return on investment (ROI) also known as return on capital employed (ROCE) and residual income (RI)
ROI is generally regarded as the key performance measure. There are two main reasons for its widespread use.
(a) It ties in directly with the accounting process, and is identifiable from the profit and loss account and balance sheet.
(b) Even more importantly, ROI is the only measure of performance available (apart from residual income) by which the return on investment for a division or company as a single enter unit (or collection of assets) can be measured.

Return on investment (ROI) as return on capital employed (ROCE) shows how much profit has been made in relation to the amount of capital invested is calculated as profit / capital employed) x100%

Measuring ROI

ROI can be measured in different ways,

Profit after depreciation as a % of net asset employed.
This is probably by the most common method, but it does present a problem. If an investment center maintains the same annual profit, and keeps the same asset without a policy of regular fixed asset replacement, its ROI will increase year by year as the asset get older. This can give a false impression over time.

Profit after depreciation as a % of gross assets employed.
Instead of measuring ROI as return on net assets, we could measure it as return gross assets. This would remove the problem of ROI increasing over time as fixed assets get older.

However, using book values to measure ROI has it disadvantages.

Most important of these is that measuring ROI as return on gross assets ignores the age factor, and does not distinguish between old and new assets.

• Older fixed assets usually cost more to repair and maintain, to keep them running. An investment centre with old assets may therefore have its profitability reduced by repair costs, and its ROI might fall over time as its assets get older and repair costs get bigger.
• Inflation and technological change alter the cost of fixed assets. If one investment centre has fixed assets bought ten years ago with a gross cost of $1 million, and another investment centre, in the same area of business operations, has fixed assets bought very recently for $1 million, the quantity and technological character of the fixed assets of the two investment centre are likely to very different.

Tangible and intangible assets

The management account is free to capitalize or expense intangible assets. When significant expenditure on an intangible asset (such as an advertising campaign) which is expected to provide future benefits is expenses, profit will be reduced and ROI/RI artificially depressed. In the further, investment should produce significant cash inflows and the ROI/RI will be artificially inflated. Such expenditure should therefore be capitalized so as to smooth out performance measures and to eradicate the risk of drawing false conclusions from them.

A comparison of the performance of manufacturing division and service divisions should be treated with caution. The majority of manufacturing division assets will be tangible and therefore are automatically capitalized whereas the treatment of a service division’s mostly intangible assets is open interpretation.

(69)---CONTROLLABLE COSTS AND UNCONTROLLABLE COSTS.

Controllable cost and uncontrollable costs.

A Controllable cost is "a cost which can be influenced by its budget holder"
Responsibility accounting attempts to associate costs, revenues, assets and liabilities with the manager most capable of controlling them. As a system of accounting, it therefore distinguishes between controllable and incontrollable costs.

• Most variable costs within a department are thought to be controllable in the short term because manager can influence the efficiency with which resources are used, even if they cannot do anything to rise or lower price levels.
• Many fixed costs are uncontrollable (or committed) in the short term, although some fixed costs may be discretionary.
• Many fixed costs are directly attributable to a department or profit center in that although they are fixed (in the short term) within the relevant range of output, a drastic reduction in the of the department‘s output, or closure of the division entirely, would reduce or remove these costs.
• Assets and liabilities are only controllable to the extent that the investment centers Manager has authority to increase or reduce them.

Responsibility centers, Management control tools and Principal performance measurements.

(1).Cost centre.
Controllable costs, Can measure through Variance analysis and Efficiency measures.
(2).Revenue centre.
Controllable Revenue, Measure by revenues.
(3).Profit centre.
Controllable costs, Sales prices (Including transfer prices), Measure through Profits.
(4).Contribution centre.
As a profit centre except that expenditure is reported on a marginal cost basis, it can measure through Contribution.
(5).Investment centre.Controllable costs, sales prices, output volumes, Investment in fixed and current assets, it can measure the Return on investment, Residual income, and other financial ratios.

(68)---RESPONSIBILITY ACCOUNTING AND INVESTMENT CENTERS.

Responsibility Accounting.

The creation of divisions allows for the operation of a system of responsibility accounting. Responsibility accounting is a system of accounting that segregates revenues and costs into areas of personal Responsibility in order to monitor and asses the performance of each part of an organization.
A Responsibility center is a department or organizational function whose performance is the direct responsibility of a specific manager.
In the weakest form of decentralization a system of cost centers might be used. As decentralization becomes stronger the responsibility accounting framework will be based around profit centers. In its strongest form investment centers are used.

Investment centers.

Where a divisional manger of a company is allowed some discretion about the amount of investment undertaken by the division, assessment of results by profit alone (as for a profit centre) is clearly inadequate. The profit earned must be related to the amount of capital invested. Such divisions are sometimes called investment centers for this reason. Performance is measured by Return on Capital Employed (ROCE), often referred to as Return on Investment (ROI) and other subsidiary ratios, or by Residual Income (RI).
An investment center is a profit centre with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment.
Managers of subsidiary companies will often be treated as investment centers Managers, accountable for profits and capital employed. Within each subsidiary, the major divisions might be treated as profit centers with each divisional manger having the authority to decide the process and output volumes for the products or services of the division. Within each division, there will be departmental Managers section Managers and so on, who can all be treated as cost center Managers. All Managers should receive regular, periodic Performance reports for their own areas of responsibility.
The amount of capital employed in an investment center should consist only of directly attributable fixed assets and working capital.

• Subsidiary companies are often required to remit spare cash to the central treasury department at group head office. And so directly attractable working capital would normally consist of stocks and less creditors, but minimal amounts of cash.
• If an investment center is apportioned a share of head office fixed assets, the amount of capital employed in these assets should be recorded separately because it is not directly attractable to the investment centre.

(67)---INVESTMENT CENTERS AND PERFORMANCE APPRAISAL.

Investment Centers and Performance Appraisal.

1. What is Divisional isation?In general a large organization can be structured in one or two ways: functionally (all activities of a similar type within a company, such as production, sales, research, are placed under the control of the appropriate departmental head) or divisional (split into divisions in accordance with the products which are made).
Divisional managers are therefore responsible for all operations (production, sales and so on) relating to his or product, the functional structure being applied to each division. It is quite possible, of course, that only part of a company is divisionalised and activities such as administration are structured centrally on a functional basis with the responsibility of providing services to all divisions.
Decentralization.
In general a divisional structure will lead to decentralization of the decision- marking process and Divisional managers may have the freedom to set selling prices, choose suppliers, make product mix and output decision and so on. Decentralization is however, a matter of degree, depending on how much freedom - Divisional managers are given.
Advantages of divisionalisation.

• Divisionalisation can improve the quality of decisions made because divisional managers (those taking the decisions) have good knowledge of local conditions and should therefore be able to make more informed judgments. Moreover, with the personal incentive to improve the division’s performance, they ought to take decisions in the division’s best interests.
• Decisions should taken more quickly because information close not have to pass along the chain of command to and from top management. Decisions can be made on the spot by those who are familiar with the product lines and production processes and who are able to react to changes in local conditions quickly and efficiently.
• The authority to act to improve performance should motivate divisional managers.
• Divisional organization frees top management from detailed involvement in day-to-day operations and allows them to above more time to strategic planning.
• Decisions provide valuable training grounds for future members of top management from by giving them experience of managerial skills in a less complex environment than that faced by top management.
• In a large business organization, the central head office will not have the management resources or skills to direct operations closely enough itself. Some authority must be delegated to local operational managers.

Disadvantage of divisionalisation.

• A danger with divisional accounting is that the business organization will divide into a number of self-interested, each acting at times against the wishes and interests of other segments. Decisions might be taken by a divisional manager in the best interests of his own part of the business, but against the best interests of other Decisions and possibly against the best interests Of the Organization as the whole.
• A task of head office is therefore to try to prevent dysfunctional decision making by individual divisional managers. To do this, head office must reserve some power and authority for itself so that divisional managers cannot be allowed to make entirely independent Decisions. A balance ought to be kept between decentralization of authority to provide incentives and motivation, and retaining centralized authority to ensure that the Organization’s Decisions are all working towards the same target, the benefit of the Organization as a whole (in other words, retaining goal congruence among the Organization’s separate divisions).
• It is claimed that the costs of activities that are common to all divisions such as running the accounting department may be grater for a divisionalised structure than for centralized structure.
• Top management, by delegation decision making to divisional managers, may lose control since they are not aware of what is going on in the organization as a whole. (With a good system of performance evaluation and appropriate control information, however, top management should be able to control operations just as effectively).

(66)---The pros and cons of different transfer pricing bases.

The pros and cons of different transfer pricing bases.

A transfer price at market value is usually encouraged by the tax and customs authorities. Of the host and home countries as they will received a fair share of the profits made but there are problems with its use.
Prices for the same product may very considerably from one country to another.
Changes in exchange rates, local taxes and so on can result in large variations in selling price.
A division will want to set its prices in relation to the supply and demand conditions present in the country in question to ensure that it can complete in that country.

• A transfer price at cost is usually acceptable to tax and customs authorities since it provides some indication that the transfer price approximates to the real cost of supplying the item and because it indicates that they will therefore received a fair share of tax and tariff revenue. Cost-based approaches do not totally remove the suspicion that the figure may have been massaged because the choice of the type of cost (full actual, full standard, actual variable, marginal) can later the size of the transfer price.

• In a multinational organization, negotiated transfer price may result in overall sub-optimization because on account is taken of factors such as differences in tax and tariff rates between countries.