ACCA Paper P5 Advanced performance management (APM) Essential text British library cataloguinginpublication data A catalogue record for this book is available from the British Library Published by: Kaplan Publishing UK Unit 2 The Business Centre Molly Millars Lane Wokingham Berkshire RG41 2QZ ISBN 978 1 84710 552 3 © Kaplan Financial Limited, 2008 Printed and bound in Great Britain Acknowledgements We are grateful to the Association of Chartered Certified Accountants and the Chartered Institute of Management Accountants for permission to reproduce past examination questions. The answers have been prepared by Kaplan Publishing All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Kaplan Publishing ii KAPLAN PUBLISHING Contents Page Chapter Introduction to strategic management accounting Chapter Approaches to budgets Chapter Changes in business structure and management 77 accounting Chapter The impact of information technology 101 Chapter Environmental influences 117 Chapter Performance measurement systems and design 153 Chapter Financial performance measures in the private sector 183 Chapter Divisional performance appraisal and transfer pricing 207 Chapter Performance management in notforprofit organisations 251 Chapter 10 Nonfinancial performance indicators 277 Chapter 11 Current developments in performance management 315 Chapter 12 Questions & Answers 361 KAPLAN PUBLISHING 45 iii iv KAPLAN PUBLISHING chapter Intro Paper Introduction v How to Use the Materials These Kaplan Publishing learning materials have been carefully designed to make your learning experience as easy as possible and to give you the best chances of success in your examinations The product range contains a number of features to help you in the study process. 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Value for money audits can be undertaken in order to assess whether value for money has in fact been achieved. In order for such an audit to be effective the objectives of AV would need to be clearly understood by those undertaking the audit The management of AV could attempt to measure the value for money of its operating activities in terms of economy, efficiency and effectiveness. Economy is only concerned with inputs acquired by AV, and is achieved by obtaining those inputs at the lowest acceptable cost. For example, the prices at which with the replacement fitted kitchens are purchased ($2,610) could be compared with those obtainable from other vendors in order to assess whether the lowest acceptable cost is being achieved for the required level of quality. It is important that the management of AV realise that economy is measured by reference to quality of resource inputs. They need to recognise that the purchase of poor quality materials and inferior services represents ‘false economy’. Efficiency is focussed upon output, for example, maximising output for a given level of input. For example with regard to the replacement fitted kitchens, AV could use the tendering process in an attempt to maximise the number of fitted kitchens that would be installed for a given amount of money by the contractor awarded the tender. Efficiency is measured by the ratio of output to input. The ratio is not used in an absolute sense but in a relative sense and can be improved in four ways: – By increasing output for the same input – By increasing output by a greater proportion than the proportionate increase in input – By decreasing input for the same output; and – By decreasing input by a greater proportion than the decrease in output The denominator (input) is often measured in monetary terms whilst the numerator (output) can be measured in either monetary amounts or physical units, e.g. per property Effectiveness is focussed upon the achievement of objectives. A not for profit organisation will invariably have a number of objectives. For example AV may have the following objectives: 410 KAPLAN PUBLISHING chapter 12 – To meet housing needs – To provide quality wellmanaged homes – To provide the services that clients want – To provide an effective care and repair service – To support the communities within which it operates The management of AV should be mindful that the three performance measures require individual consideration since for example, the degree to which effectiveness is achieved gives no indication about how much was spent to achieve it The management of AV should also recognise that these performance measures may conflict with one another. For example, during the year AV incurred expenditure amounting to $234,900 in respect of 90 replacement fitted kitchens. If AV had purchased the same replacement kitchen units as BW, then AV would only have been able to refit 45 properties ($234,900/$5,220). Hence, the efficiency ratio of inputs to outputs would have been halved. However, the purchase of replacement kitchen units at a cost of $5,220 might have resulted in a higher level of effectiveness being achieved through factors such as the longer life of the replacement kitchen units, higher quality fixtures and fittings, and enhanced aesthetic ‘appeal’ to residents. The management of AV should also give consideration to benchmarking against other similar charities whose primary objective is the provision of accommodation to the communities in which they operate. Benchmarking is probably the most significant recent development in measuring the performance of notforprofit organisations. The management of charities such as AV would be far more willing to share information about performance with similar organisations for their mutual benefit, than the management of many profitseeking organisations who often view the sharing of information as a commercial threat. For example, the management of AV could attempt to establish whether $2,610 is the ‘norm’ in respect of the cost of a replacement fitted kitchen incurred by similar non profitseeking organisations. B I Service quality The time required in order to undertake repairs of an emergency nature, after notification of the requirement by a tenant The friendliness of staff employed by AV which could be measured via the completion of questionnaires by tenants KAPLAN PUBLISHING 411 Questions & Answers Flexibility Mean waiting time for a house to become available to a tenant Mean waiting time to rehouse a tenant in a different sized house after receipt of a request from a tenant II The management of AV could use the following performance measures: Cost and efficiency (1) The mean cost, per week per house on management (2) The mean cost per week, per house on general repairs (3) Percentage of rent available that was collected AV BW $9.61 $29.81 ––––– ––––– $10.22 $6.13 ––––– ––––– 98.5% 100% ––––– ––––– Notes/ comments: (1) The mean cost per week per house is calculated by dividing the amount of staff and management costs by the number of properties held by each of the respective organisations. Although the same number of staff, (25), are employed by each organisation, staff costs incurred by BW are 37.7% higher than those of AV. This could result from different pay structures and management policies regarding remuneration that are likely to be employed within a profit seeking organisation such as BW (2) AV currently pays, on average, $140 for each emergency repair, $120 for each urgent repair and $116 for each non urgent repair. BW has benefited from the fact that each repair undertaken by BW costs the same (i.e. $100), irrespective of the classification of repair. This might be a result of a contractual arrangement with a subcontractor that each repair undertaken is charged at the same fee in return for guaranteed business volumes for the subcontractor. If this were the case, then AV would benefit from entering into such an arrangement for the supply of repair services 412 KAPLAN PUBLISHING chapter 12 (3) BW did not have any unoccupied properties at any time during the year. This would seemingly indicate a high level of demand for its properties. AV had potential gross rents receivable during the year of $2,423,200. Unoccupied properties resulted in lost revenues of $36,348. which amounted to 1.5% of gross rents receivable. Further information is required to in order to assess whether the lost revenue is attributable to ‘void periods’, i.e. properties becoming vacant or perhaps due to tenants who have defaulted Note: other ratios and relevant comments would have been acceptable C The primary objective of any commercial organisation such as BW is to maximise profit. Management may take a short or longterm view regarding the ways in which they seek to achieve this objective. Management may have to choose between available options, each of which might help them to achieve this objective. However, whilst many decisions may have to be made, the objective remains clear and identifiable The management of BW will most probably be concerned with the provision of high quality accommodation in order to generate higher revenues and profits. The management of BW are probably trying to appeal to those who are willing to pay high rents for high quality accommodation. The fact that replacement fitted kitchens and replacement windows and doors purchased by BW cost 100% and 50% respectively, more than those purchased by AV may be an indication of this The objectives of notforprofit organisations such as AV can vary significantly. AV’s primary objective is ‘to meet the accommodation needs of persons within its locality’. This might distil down to ensuring that any person, who is in need of accommodation, is in fact provided for. The absence of a profit measure makes it more difficult to measure whether objectives are in fact being achieved. It is difficult to judge whether nonquantitative objectives such as meeting accommodation needs of people have been met. This does not mean however, that such an assessment should be placed on the ‘too difficult pile’ and left unattended. A number of suitable measures need to be devised by the management accountant in order to assess the extent to which nonquantitative objectives have been met The management of AV would probably be better served in comparing the performance of their organisation with a similar non profit seeking organisation that provides accommodation to meet the needs of society KAPLAN PUBLISHING 413 Questions & Answers Additional information that would assist in appraising the performance of BW during the year ended 31 May 2004 includes the following: – Estimates of the financial effects of changes in demand for different levels of rents charged – Estimates of the financial effects of changes in demand for different costs/quality levels of accommodation provision – A detailed analysis of net interest payable – $750,000 – A detailed analysis of sundry operating costs – $235,000 – Management accounts for the current and prior years – Budget information for 2004, 2005 and, if available, 2006 It would also be useful to have details regarding the location of the properties held by BW. It is quite conceivable that the houses held by BW are situated in a sought after area. Benchmarking with a ‘best practice’ organisation from within the private sector would be of much assistance in the appraisal of the operating and financial performance of BW Ears’n’eyes Inc Answer Briefing document for Ears’n’eyes Inc: A The Z” scores may be estimated as follows At 1 April 20X6: 6.56X1 6.56*223/1358 = Weighted score 1.08 3.26X2 3.26*371/1358 = 0.89 W1 6.72X3 6.72*87/1358 = 0.43 W1 1.05X4 1.05*324/837 = 0.41 W3, W4 Total Z’’ score See working W1, W2 2.81 At 1 April 20X5: 414 6.56X1 6.56*231/1261 = Weighted score 1.20 3.26X2 3.26*342/1261 = 0.88 See working W1, W2 W1 KAPLAN PUBLISHING chapter 12 6.72X3 6.72*108/1261 = 0.58 W1 1.05X4 1.05*399/769 = 0.54 W3, W4 Total Z’’ score 3.20 In addition, it is useful to consider some ratios and trends over the two years: Selected trends: % growth 4.2 12.2 11.1 10.7 (19.4) Turnover Noncurrent assets Inventories Trade payables EBIT Selected ratios: Current ratio Quick ratio Gearing Profitability – EBIT/ total assets Inventory to turnover ratio – sales/inventory 1 April 20X6 1 April 20X5 1.34 1.38 0.21 0.28 36% 35% 6.4% 8.6% 2.80 2.98 Workings W1 Total assets $m 1 April 20X6: 1 April 20X5: Noncurrent assets 485 432 Current assets 873 829 Total assets 1358 1261 W2 Working capital $m 1 April 20X6: 1 April 20X5: Current assets 873 829 Current liabilities (650) (598) Working capital 223 231 W3 Market value of equity Number of 50c shares = 150/0.5 = 300m Market value of equity at 1 April 20X6 is 108c * 300m shares = $324m KAPLAN PUBLISHING 415 Questions & Answers Market value of equity at 1 April 20X5 is 133c * 300m shares = $399m W4 Book value of total liabilities $m Current liabilities Loan stock Long term loan Total Liabilities 1 April 20X6: 650 160 27 837 1 April 20X5: 598 160 11 769 Comments: The Z” scores The Z” score for year to 31 March 20X6 is below 3 and therefore under the cutoff point for companies which need further investigation. The score is also worsening. Although the score for the previous year was above 3, it was still low and should have been a signal to begin monitoring the situation carefully Trends and ratios There has been a considerable investment in noncurrent assets over the year as now stores have been opened. However the low growth in turnover suggests that the increase in store space has not led to a proportionate increase in turnover – in fact if the number opened over the last year is similar to the plan for the coming year (an increase of 10%), a growth in turnover of 4% suggests that sales could have actually dropped in the existing stores There has been a decrease in profitability which is likely to be a result of an increase in expenses through opening new stores which has not been matched by an increase in sales of a similar level There has also been an increase in inventory levels over the last year. The inventory turnover is also low and indicates that on average inventory remains on shelves for several months, which seems a poor performance for a retailer There has also been a worsening in other ratios All the above suggests that there is cause for concern over the future of this business B 416 The financial analysis above indicates that there is a problem. However in order to come to a complete understanding there is further work which needs to be done: KAPLAN PUBLISHING chapter 12 Suggested areas for further investigation: C – A more indepth analysis of the accounting information looking at areas such as levels of debt, liquidity, payment periods, contingent liabilities, and post balance sheet events – An analysis of sales trends by sector (both geographical and comparing internet sales with storebased purchases), with comparisons for individual stores and types of store – Market information, especially an assessment of the current purchasing methods of consumers such as the use of the internet – Benchmarking against other companies in the same of similar markets – Actions and strategies of competitors – Any macro events which have affected the company, including inflation and foreign exchange rates Recommendations for action Other issues to consider At this stage, without having carried out the further investigation above it is difficult to comment on the nonfinancial issues. However one point which can be made at this stage is that the market for books, CDs and DVDs has changed significantly over the last few years, in part due to changes in computer technology. There has been a move towards purchasing such goods over the internet, with online retailers (such as Amazon) gaining a substantial share of the market. There is no reason to suppose that this will not continue. In addition, more and more customers are downloading music from the internet instead of purchasing CDs. This is likely to be followed by downloading of films from the internet replacing DVD purchases. There is also a competitive market for DVD rental for which prices are decreasing. These changes in the market are particularly significant when looking at the poor performance of Ears’n’eyes Inc in the context of its current strategy of opening new stores Recommended actions: The company should stop its store expansion programme. This is expensive and is not resulting in increased sales, as customers are moving away from storebased purchasing. Consideration should also be given to closing stores which are not profitable. Further analysis may also show whether there are particular types of store which are more profitable than others and which should form the focus for the future strategy (for example airport and station stores may be more successful than the superstores due to the high level of impulse purchases) KAPLAN PUBLISHING 417 Questions & Answers The two actions above should release resources to focus on increasing sales from the existing stores. This will probably only be achieved by enhancing the stores to improve the experience of visiting a store. With internet shopping becoming so easy customers need another reason to purchase there. Store prices will also need to be competitive Ears’n’eyes Inc should also examine the possibility of establishing its own internet shopping service alongside the stores rather than using a third party. As the company has a good reputation and an existing customer base it will be important to ensure that those customers who want to buy online purchase from Ears’n’eyes Inc rather than a competitor Inventory management must be improved. The current level is much too high. Again, reducing inventory carried will release resources The loyalty programme which seems to be popular with customers should be continued and could be used for internet purchases as well as in store. However as well as being used to encourage repeat purchases it should also be used to provide data for analysis of sales and to improve the company’s understanding of its customers, their interests and buying habits D Possible performance indicators The performance indicators chosen should relate to the actions described in (c) above. They will need to include both financial and nonfinancial indicators and include areas related to marketing and internal processes. However it is important to focus on a small number of key areas Suggested indicators: – Profitability, overall and for individual stores – Sales growth at least on a quarterly basis, again overall and for individual stores and internet – Operating income – Inventory levels in stores and warehouses – Market share and pricing, including comparisons with internet based retailers – Numbers of new and repeat customers – Customer feedback, particularly concerning their experience of visiting stores 418 KAPLAN PUBLISHING chapter 12 SAPU Co Answer I Absorptionbased unit product cost for A and B Direct costs Direct material Direct labour Variable overheads Materials Labour Total variable cost Product A $ Product B $ 16.00 8.00 ––––– 24.00 30.00 10.00 ––––– 40.00 4.00 9.00 ––––– 37.00 ––––– 7.50 11.25 ––––– 58.75 ––––– Workings Materials overhead 40% × $1,500,000 = $600,000 Labour overhead 60% × $1,500,000 = $900,000 Absorption rate Material ($600,000/$2,400,000) × 100 = 25% i.e. materialsrelated overheads are absorbed at 25% of direct materials cost Labour ($900,000/$800,000) × 100 = 112.5% i.e. labourrelated overheads are absorbed at 112.5% of direct labour cost KAPLAN PUBLISHING 419 Questions & Answers II Activitybased unit product cost for A and B Direct costs Direct material Direct labour Overheads Materials Labour Total variable cost Product A $ Product B $ 16.00 8.00 ––––– 24.00 30.00 10.00 ––––– 40.00 26.67 45.00 ––––– 95.67 ––––– 6.67 7.50 ––––– 54.17 ––––– Workings Materialsrelated overhead Overhead: $600,000 Cost driver: Materials bulk Total bulk: (4 × 5,000) + (1 × 10,000) +(1.5 × 40,000) = 90,000 Overhead per unit of $600,000/90,000 = $6.67 bulk: Overhead per product Product A $6.67 × 4 = $26.67 Product B $6.67 × 1 = $6.67 Labourrelated overhead Overhead: $900,000 Cost driver: Number of labour operations Total operations: (6 × 5,000) + (1 × 10,000)+ (40,000 × 2) = 120,000 Overhead per $900,000/120,000 = $7.50 operation: Overhead per product Product A $7.50 × 6 = $45 Product B $7.50 × 1 = $7.50 420 KAPLAN PUBLISHING chapter 12 Part (b) From Head of Management Accounting To: Sapu Management Team Concerning: Forthcoming Sales and Production Mix for ProductsA and B Currently Sapu has a policy of not manufacturing and selling products that fail to meet a minimum sales contribution (C/S) ratio of 40%. On the basis of information presented below concerning variable production costs, recommendations are made regarding production mix The current market prices of A and B are $75 and $95 respectively on sales volumes of 5,000 and 10,000 units. At present Sapu uses absorption costing to calculate variable cost of production.These figures are presented below together with recalculation of costs using activity based costing (ABC) Sales price Direct costs Variable overheads Total variable cost Contribution C/S ratio Product A Absorption ABC costing costing $ $ 75.00 75.00 _ _ 24.00 24.00 13.00 71.67 Product B Absorption AB costing costing $ $ 95.00 95.00 _ _ 40.00 40.00 18.75 14.17 _ 37.00 _ 95.67 _ 58.75 _ 54.17 _ 38.00 _ 50.7% _ (20.67) _ – _ 36.25 _ 38.2% _ 40.83 _ 43.0% Using absorption costing only Product A exceeds the 40% C/S threshold set by the company and on this basis production of B should be discontinued However, if ABC is used a different picture emerges with only B exceeding the 40% threshold Under ABC product A actually makes a loss KAPLAN PUBLISHING 421 Questions & Answers Of the two costing methods ABC is the more advanced and the costs it produces are a fairer reflection of the degree of effort required to produce an item. On the basis of this production of B is recommended Part (c) Sapu has all of the information necessary to apply target costing. Market information suggests demand of 5,000 and 10,000 for A and B at prices of $75 and $95 respectively. At the same time, the company has set a target C/S ratio of 40%. Currently costings, established using ABC, indicate that only product B meets these requirements. Using this information Sapu should pursue two courses of action I It should monitor costs of Product B carefully to ensure it maintains its 40% + C/S ratio. Where possible it should seek cost savings to improve the ratio further II ABC clearly identifies the cause of cost generation (cost drivers).Using this information Sapu should seek cost savings to bring the C/S ratio of Product A up to the 40% target set by the company. From the analysis of costs prepared earlier it is clear that indirect costs associated with labour are very high and in the first instance methods to reduce these should be explored Part (d) If spare production capacity can be used to manufacture products that generate a positive contribution, Sapu would be advised to drop their criterion and manufacture the products. This contribution could be set against fixed costs. However, on the basis of the ABC analysis completed earlier, Product A should not be manufactured, as it does not make a positive contribution. It may, however, be possible to increase production of other products manufactured by the company New manufacturing environment Answer A 422 The traditional management accounting performance measures are best suited to a stable environment which is programmable.These measures include budgetary control measures and standard costing. Standards and budgets are often based on past performance – on the assumption that what has happened in the past is a good guide to what might happen in the future KAPLAN PUBLISHING chapter 12 With the increase in competition in world markets and the increasing rate of technological change, manufacturing has had to become more flexible in order to survive. Rather than being able to have long batch runs of the same product, companies have to place an emphasis on tailoring customised products and producing in small quantities. Quality of product and service has become vital Traditional management accounting measures do not provide any impression of flexibility or quality. For example, a traditional costing system provides little information concerning the cost of quality in both its financial and nonfinancial forms. Such a system does not therefore provide the information needed by management in order to control this critical area in the business operation It is therefore true to say that the modern business environment requires a more comprehensive approach to performance measurement than that provided by a traditional accounting system B One of the major developments in management accounting in recent years has been the development of performance measurement systems which are not based solely on simple financial metrics A modern performance measurement system seeks to develop a range of indicators which relate to the strategic objectives and mission of the business. In particular, measures should be adopted which relate to: The customer perspective, specific measures being: – market share – customer turnover – new customer acquisition – image and reputation (possibly worked using a points score system) The internal business perspective: – Number of product innovations – Production cycle time (time between customer order and delivery) – Quality measures including reject rates and customer returns KAPLAN PUBLISHING 423 Questions & Answers The learning and growth perspective: – Employee training and ability (employee numbers achieving particular competencies) – IT system capability – Staff motivation and empowerment (possibly worked using benchmark or points score systems The most important consideration is that these indicators should be aligned with the strategic objectives of the business to ensure that managers are motivated to move towards the maximisation of shareholder value 424 KAPLAN PUBLISHING ... often examined Expandable Text Expandable text provides you with additional information about a topic area and may help you gain a better understanding of the core content. Essential text users can access this additional content online (read it ... (2) Description of the examination (3) Study skills and revision guidance (4) Complete text or essential text (5) Question practice The sections on the study guide, the syllabus objectives, the... examination and give you tips on how to best to approach your learning. The complete text or essential text comprises the main learning materials and gives guidance as to the importance of topics and where other related resources can be found.