Performance management PM

PERFORMANCE MANAGEMENT PM STUDY NOTES - 2019 Contents CHAPTER 1: MANAGING INFORMATION CHAPTER 2: SOURCES OF INFORMATION 11 CHAPTER 3: INFORMATION SYSTEMS AND DATA ANALYTICS 14 CHAPTER 4: TRADITIONAL COSTING 24 CHAPTER 5: ACTIVITY BASED COSTING (ABC) 29 CHAPTER 6: TARGET COSTING 35 CHAPTER 7: LIFECYCLE COSTING 41 CHAPTER 8: THROUGHPUT ACCOUNTING 47 CHAPTER 9: ENVIRONMENTAL ACCOUNTING 56 CHAPTER 10: COST VOLUME PROFIT (CVP) ANALYSIS 61 CHAPTER 11: LIMITING FACTOR ANALYSIS 70 CHAPTER 12: PRICING DECISIONS 83 CHAPTER 13: SHORT TERM DECISIONS 97 CHAPTER 14: RISK AND UNCERTAINTY 106 CHAPTER 15: BUDGETARY SYSTEMS 120 CHAPTER 16: QUANTITATIVE ANALYSIS 131 CHAPTER 17: STANDARD COSTING AND VARIANCE ANALYSIS 138 CHAPTER 18: MIX AND YIELD VARIANCES 158 CHAPTER 19: PLANNING AND OPERATIONAL VARIANCES 166 CHAPTER 20: PERFORMANCE ANALYSIS 172 CHAPTER 21: PERFORMANCE ANALYSIS – PRIVATE SECTOR 177 CHAPTER 22: DIVISIONAL PERFORMANCE AND TRANSFER PRICING 197 CHAPTER 23: PERFORMANCE ANALYSIS – NOT FOR PROFIT SECTOR 226 PM STUDY NOTES Syllabus Area A INFORMATION, TECHNOLOGIES AND SYSTEMS FOR ORGANISATION PERFORMANCE PM STUDY NOTES CHAPTER 1: MANAGING INFORMATION Introduction Businesses thrive on data – so all businesses; big or small, need systems and procedures that help them collect, process, store and share data In today’s digital world, instead of maintaining paper based records, the collection, processing, storing and sharing of data is also automated Businesses invest in Information systems in order to have data easily accessible in the form required for decision making When used correctly, information system’s can positively impact an organization's overall performance and revenue Information System This comprises of a set of components, namely hardware, software, telecommunications network etc., that work together to deal with the data requirements of the business These requirements include, communication, record-keeping, decision making, data analysis etc Role of Information Systems  Automated systems for data collection and processing, free up employees to focus on more core areas of their work  An effective information system provides users with the ‘information’ they need on a timely basis, supporting the decision making process  While some hardware components are only utilised for data collection, the software and telecommunications network is used to convert the data collected into sensible information, in a format that is best suited to the user  Different users have different information needs and having an effective information system means that users can access the custom information PM STUDY NOTES  The access to an information system means access to real-time or archived data, as and when needed for a particular purpose This is helpful for businesses in need of immediate action as part of their operational strategies  Business Intelligence systems help convert data into valuable insights that aid in data visualisation i.e allows users to interpret large amounts of information, predict future events and find patterns in historical data This is helpful for future decision making and provides businesses with a competitive edge  Enterprise Resource Planning (ERP) software (discussed later) provides users with a bird’s eye view of the business operations Some examples are: NetSuite ERP, PeopleSoft etc Costs and Benefits of Information Systems Normally organisations predict the benefits of an information system expected over its lifetime and estimate the costs of initial development and ongoing operations to compare and identify the worth of the system to the business Some generic benefits and costs associated with the implementation of an Information System are discussed below: Benefits:  Academic studies have proven that Information Systems support operational benefits such as cost reduction and increase competitive capability of businesses  Provided there are no challenges in the data collection phase, the information generated by the systems normally has less chances of ‘human error’  Since information systems rely on software – this can be modified or reprogrammed to meet the changing needs of the users With the advancement in the field of programming, this does not necessarily imply a disruption in all functions of the organisation, when a particular part is being re-programmed Costs:  Normally the major cost associated with a custom Information system is the labour cost – which covers the salaries of the system analysts and programmers PM STUDY NOTES  In such a scenario, another cost impact is the time of the employees with whom the programmers need to work in close collaboration in order to develop software that fulfils the maximum user needs  An alternate to a customised Information System are the ‘off-the-shelf’ software that although cheap may cost the company in terms of unfulfilled information needs, since these are not designed according to the specific business requirements  Regardless of what information system is finalised, there are costs related to the hardware and telecommunications network associated with its use  Additionally businesses have to bear the cost of training employees in the use of the information systems  The business also needs to budget for repairs and maintenance expenses of the system implemented – also taking into account the rapidly changing environment  Although not a tangible cost with immediate impact, a risk associated with automated information systems is that of its security – physical or in the form of virus or malware Some Components of Information Systems Internet and Intranet: Although both terms are used extensively today, the Intranet is only a part of the Internet The Internet is an interconnection of various networks that can be public, private or at the organizational level Global devices are linked together using various technologies to create an internet network These technologies include optical fiber, wired, wireless or electronics circuitry The internet carries huge amounts of data available on World Wide Web Uses:  E-mails – the most common way of communicating the written word across the globe PM STUDY NOTES  Ease of research into factors affecting the business and expanding the business network  E-meetings help away the need for travelling for work  Sharing files, images, videos etc The Intranet is a network of devices which is private and not available to the public In an intranet, the networked computers or devices are available only to a group of authorized users Businesses can set up security policies specific to the user, group or device The users within intranet can connect to the internet, a public network through firewalls Uses:  The major uses of intranet include faster sharing of information within an organization This helps streamline activities  Improved internal communication leads to enhanced collaboration and promotion of corporate culture  Businesses are able to centralise and organise company data into a single database The main differences between the internet and intranet can be summarised as follows: INTERNET INTRANET Available to all across the globe Only the employees of organization can access it Data traveling across the internet or the Intranet is more secure due to presence of web is Less Secure robust security systems No login credentials are required to A user account is must to access the access the information from internet devices of intranet Any number of users can access the There is a limit to the number of users that internet services and documents can access internet resources No rules or policies are defined to access There are certain policies and regulations internet resources which you have to comply within the intranet [Extract from: http://www.it4nextgen.com/difference-between-internet-and-intranet/] PM STUDY NOTES Wireless Technology and Networks: Wireless technology is communication technology that is not dependent upon cables or wires as communication mediums Wireless communications can be available all of the time, almost anywhere They have several advantages including:  Communication has enhanced to convey the information quickly to the consumers  Working professionals can work and access Internet anywhere and anytime without carrying cables or wires wherever they go This also helps to complete the work anywhere on time and improves the productivity  Urgent situation can be alerted through wireless communication  Wireless networks are cheaper to install and maintain Wireless networks are computer networks that are not connected by cables of any kind The use of a wireless network enables enterprises to avoid the costly process of introducing cables into buildings or as a connection between different equipment locations The basis of wireless systems are radio waves, an implementation that takes place at the physical level of network structure There are two main types of wireless networks: Wi-Fi Network: This is a technology that allows smart phones, tablets, printers etc to communicate with the internet Cellular Network: This technology allows electronic devices to communicate over long distances PM STUDY NOTES Using Internal Information When generating information, even if for internal use, as well as when distributing it, businesses should ensure that there are certain controls in place These can vary based on whether the information being generated is routine information or ad-hoc Generating Information – Routine:  Determine if the benefits of the information generated will be higher than the costs incurred to prepare it  Ensure that the desired information will be of use to the decision makers before the information is gathered  Standardised formats for the information to be prepared should be set, especially if there are multiple prepares of the information The formats should ideally focus on being user friendly for the ultimate users  The limitations of the information gathered should be communicated to the users as well as the details of the preparer/ originator, so that any queries can be directly forwarded  The usefulness of the information should be reviewed on a regular basis to assess the need for its continuity Generating Information – Ad-Hoc: Apart from the guidelines above, when dealing with ad-hoc reports, the following should additional measures should be incorporated:  Ensure that information is not being duplicated and that it’s relevant to the user requesting it  Ensure that most up-to-date data is utilised for these reports Distributing Information:  A procedures manual should be in place This would indicate what reports are to be prepared and issued to whom  Confidential information should be highlighted as such and users guided on how to deal with sensitive information PM STUDY NOTES  E-mail policy should be established specifying the do’s and donts’ for on-line communication  Physical computer security  Internal security should be established Senior management should specify which user can have access to which assets and information  External security through firewalls should be established, as they can be used to protect data and databases from being accessed by unauthorised people  Security and confidential information A number of procedures can be used to ensure the security of highly confidential information that is not for external consumption Measures such as passwords, firewalls, database controls, data encryption can be implemented Additionally businesses can ensure that the security of the information stored is maintained by entrusting limited people with its access PM STUDY NOTES  The size of the profit margin or mark-up is likely to be arbitrary Transfer price at variable cost plus or incremental cost plus A transfer price might be expressed as the variable cost of production plus a margin for profit for the selling division Standard variable costs should be used, not actual variable costs This will prevent the selling division from increasing its profit by incurring higher variable costs per unit Variable cost plus might be suitable when there is no external intermediate market It is probably more suitable in these circumstances than full cost plus, because variable cost is a better measure of opportunity cost However, as stated earlier, when transfers are at cot, the transferring division should be a cost centre, and not a profit centre Other methods that maybe used to agree transfer prices include:  Two-part transfer prices  Dual pricing Two-part transfer prices With two-part transfer prices, the selling division charges the buying division for units transferred in two ways:  a standard variable cost per unit transferred, plus  a fixed charge in each period The fixed charge is a lump stun charge at the end of each period The fixed charge would represent a share of the contribution front selling the end product, which the selling/transferring division has helped to earn Alternatively, the charge could be seen as a charge to the buying division for a share of the fixed costs of the selling division in the period PM STUDY NOTES The fixed charge could be set at an amount that provides a 'fair' profit for each division, although it is an arbitrary amount Dual pricing In some situations, two divisions may not be able to agree a transfer price, because there is no transfer price at which the selling division will want to transfer internally or the buying division will want to buy internally However, the profits of the entity as a whole would be increased if transfers did occur These situations are rare However, when they occur, head office might find a solution to the problem by agreeing to dual transfer prices  the selling division sells at one transfer price, and  the buying division buys at a lower transfer price There are two different transfer prices The transfer price for the selling division should be high enough to motivate the divisional manager to transfer more units to the buying division Similarly, the transfer price for the buying division should be low enough to motivate the divisional manager to buy more units from the selling division In the accounts of the company, the transferred goods are:  sold by the selling division to head office and  bought by the buying division from head office The loss from the dual pricing is a cost for head office, and treated as a head office overhead expense However, dual pricing can be complicated and confusing It also requires the intervention of head office and therefore detracts from divisional autonomy Negotiated transfer prices A negotiated transfer price is a price that is negotiated between the managers of the profit centres PM STUDY NOTES The divisional managers are given the autonomy to agree on transfer prices Negotiation might be a method of identifying the ideal transfer price in situations where an external intermediate market does not exist An advantage of negotiation is that if the negotiations are honest and fair, the divisions should be willing to trade with each other on the basis of the transfer price they have agreed Disadvantages of negotiation are as follows:  The divisional managers might be unable to reach agreement When this happens, management from head office will have to act as judge or arbitrator in the case  The transfer prices that are negotiated might not be fair, but a reflection of the bargaining strength or bargaining skills of each divisional manager These profit measures can be used with variance analysis, ratio analysis, return on investment, residual income and non-financial performance measurements to evaluate performance PM STUDY NOTES Return on Investment (ROI) The reason for using ROI as a financial performance indicator  Return on investment (ROI) is a measure of the return on capital employed for an investment centre It is also called the accounting rate of return (ARR)  It is often used as a measure of divisional performance for investment centres because:  the manager of an investment centre is responsible for the profits of the centre and also the assets invested in the centre, and  ROI is a performance measure that relates profit to the size of the investment Profit is not a suitable measure of performance for an investment centre It does not make the manager accountable for his or her use of the net assets employed (the investment in the investment centre) Measuring ROI Performance measurement systems could use ROI to evaluate the performance of both the manager and the division ROI is the profit of the division as a percentage of capital employed Profit ROI = Capital employed (size of investment) Profit This should be the annual accounting profit of the division, without any charge for interest on capital employed This means that the profit is after deduction of any depreciation charges on non-current assets Capital employed/investment This should be the stun of the non-current assets used by the division plus the working capital that it uses Working capital = current assets minus current liabilities, which for a division will normally consist of inventory plus trade receivables minus trade payables PM STUDY NOTES ROI and investment decisions  The performance of the manager of an investment centre may be judged on the basis of ROI  A divisional manager may receive a bonus on the basis of the ROI achieved by the division  When an investment centre manager's performance is evaluated by ROI, the manager will probably be motivated to make investment decisions that increase the division's ROI in the current year, and reject investments that would reduce ROI in the current year  The problem is that investment decisions are made for the longer term, and a new investment that reduces ROI in the first year may increase ROI in subsequent year  An investment centre manager may therefore reject an investment because of its short-term effect on ROI, without giving proper consideration, to the longer term Disadvantages of using ROI  As explained above, investment decisions might be affected by the divisions ROI short term effect and this is inappropriate for making investment decisions  There are different ways of measuring capital employed Comparison of performance between different organisations is therefore difficult  When assets are depreciated, ROI will increase each year provided that annual profits are constant The division's manager might not want to get rid of ageing assets, because ROI will fall if new (replacement) assets are purchased Residual Income (RI) Measuring residual income Residual income = Divisional profit minus Imputed interest charge Divisional profit is an accounting measurement of profit, after depreciation charges are subtracted It is the same figure for profit that would be used to measure ROI PM STUDY NOTES Imputed interest (notional interest) and the cost of capital: The interest charge is calculated by applying a cost of capital to the division's net investment (net assets) Imputed interest (notional interest) is the division's capital employed, multiplied by:  the organisation's cost of borrowing, or  the weighted average cost of capital of the organisation, or  a special risk-weighted cost of capital to allow for the special business risk characteristics of the division A higher interest rate would be applied to divisions with higher business risk Residual income and investment decisions One reason for using residual income instead of ROI to measure a division's financial performance is that residual income has a monetary value, whereas ROI is a percentage value Advantages of residual income  It relates the profit of the division to the capital employed, by charging an amount of notional interest on capital employed, and the division manager is responsible for both profit and capital employed  Residual income is a flexible measure of performance, because a different cost of capital can be applied to investments with different risk characteristics Disadvantages of residual income  Residual income is an accounting-based measure, and suffers from the same problem as ROI in defining capital employed and profit  Its main weakness is that it is difficult to compare the performance of different divisions using residual income  Residual income is not easily understood by management, especially managers with little accounting knowledge PM STUDY NOTES Example At the end of 20X1, an investment centre has net assets of $1m and annual operating profits of $190,000 However,the bookkeeper forgot to account for the following: A machine with a net book value of $40,000 was sold at the start of the year for $50,000 and replaced with a machine costing $250,000 Both the purchase and sale are cash transactions No depreciation is charged in the year of purchase or disposal The investment centre calculates return on investment (ROI) based on closing net assets Assuming no other changes to profit or net assets, what is the return on investment (ROI) for the year? A 18·8% B 19·8% C 15·1% D 15·9% Solution: The correct option is B Revised annual profit = $190,000 + $10,000 profit on the sale of the asset = $200,000 Revised net assets = $1,000,000 – $40,000 NBV + $50,000 cash – $250,000 cash + $250,000 asset = $1,010,000 ROI = ($200,000/$1,010,000) x 100 = 19·8% Example A division is considering investing in capital equipment costing $2·7m The useful economic life of the equipment is expected to be 50 years, with no resale value at the end of the period The forecast return on the initial investment is 15% per annum before depreciation The division’s cost of capital is 7% What is the expected annual residual income of the initial investment? A B C D $0 ($270,000) $162,000 $216,000 PM STUDY NOTES Solution: The correct option is C Divisional profit before depreciation = $2·7m x 15% = $405,000 per annum Less depreciation = $2·7m x 1/50 = $54,000 per annum Divisional profit after depreciation = $351,000 Imputed interest = $2·7m x 7% = $189,000 Residual income = $162,000 PM STUDY NOTES CHAPTER 23: PERFORMANCE ANALYSIS – NOT FOR PROFIT SECTOR Not-For-Profit Organisations and the Public Sector  The public sector refers to the sector of the economy that is owned or controlled by the government in the interests of the general public  Not-for-profit organisations are entities that are not government-owned or in the public sector, but which are not in existence to make a profit They include charitable organisations and professional bodies  A common feature of public sector organisations and not-for-profit organisations is that their main objective is not financial  A not-for-profit organisation will nevertheless have some financial objectives:  State-owned organisations must operate within their spending budget  Charitable organisations may have an objective of keeping running costs within a certain limit, and of raising as much funding as possible for their charity work The need for performance measurement Although the main objective of not-for-profit and public sector organisations is not financial, they need good management, and their performance should be measured and monitored as the directors or senior managers of public sector bodies are accountable to the public In practice, this usually means accountability to the government, which in turn should be accountable to the public The leaders of not-for-profit organisations outside the public sector should also be accountable to the people who provide the finance to keep them in existence More general objectives for not-for-profit organisations include:  Surplus maximisation (equivalent to profit maximisation)  Revenue maximisation (as for a commercial business)  Usage maximisation (as in leisure centre swimming pool usage)  Usage targeting (matching the capacity available, as in the NHS)  Full/partial cost recovery (minimising subsidy)  Budget maximisation (maximising what is offered)  Producer satisfaction maximisation (satisfying the wants of staff and volunteers) PM STUDY NOTES  Client satisfaction maximisation (the police generating the support of the public) Performance measurement should be related to achieving targets that will help the organisation to achieve its objectives, whatever these may be Identifying performance targets in not-for-profit and public sector organisations The selection of appropriate targets will vary according to the nature and purpose of the organisation The broad principle, however, is that any not-for-profit organisation should have:  strategic targets, mainly non-financial in nature  operational targets, which may be either financial (often related to costs and keeping costs under control) or non-financial (related to the nature of operations) To identify suitable performance targets for Not for Profit organisations and Public sector organisations, focus on:  Decide what the objectives of the organisation are  Identify what the managers of the organisation (or area of management responsibility within the organisation) must to achieve those objectives  Identify a suitable way of measuring performance to judge whether those objectives are being achieved Problems with measuring performance in this sector A good performance measurement system seeks to monitor the success of an organisation in achieving its objectives  To this it must have clear objectives  set targets which are linked to objectives  measure performance against these targets However, there are several reasons why the problems with performance measurement in the public sector are greater than those in commercial business organisations PM STUDY NOTES  Multiple objectives: An organisation in the public sector (and also not-for-profit organisations) may have a number of different 'main objectives', and they are required to achieve all these objectives within the constraint of limited available finance This will also lead to conflict and it becomes difficult to prioritise  Measuring outputs: Outputs can seldom be measured in a way that is generally agreed to be meaningful \Data collection can be problematic For example, unreported crimes are not included in data used to measure the performance of a police force  Lack of profit measure: If an organisation is not expected to make a profit, or if it has no sales, indicators such as ROI and RI are meaningless  Nature of service provided: Many not-for-profit organisations provide services for which it is difficult to define a cost unit  Financial constraints: Although every organisation operates under financial constraints, these are more pronounced in not-for-profit organisations  Political, social and legal considerations: Unlike commercial organisations, public sector organisations are subject to strong political influences The public may have higher expectations of public sector organisations than commercial organisations The performance indicators of public sector organisations are subject to far more onerous legal requirements than those of private sector organisations Value for Money How can performance be measured? The performance of not-for-profit organisations or departments of government may be assessed on the basis of value for money 'VFM' Value for money is often referred to as the '3Es':  Economy means spending within limits, and avoiding wasteful spending It also means achieving the same purpose at a lower expense  Efficiency means getting more output from available resources Applied to employees, efficiency is often called 'productivity'  Effectiveness refers to success in achieving end results or success in achieving objectives Whereas efficiency is concerned with getting more outputs from PM STUDY NOTES available resources, effectiveness is concerned with achieving outputs that meet the required aims and objectives Management accounting systems and reporting systems may provide information to management about value for money Value for money audits may be carried out to establish how much value is being achieved within a particular department and whether there have been improvements to value for money VFM as a public sector objective  Value for money is an objective that can be applied to any organisation whose main objective is non-financial but which has restrictions on the amount of finance available for spending It could therefore be appropriate for all organisations within the public sector  The objective of economy focuses on the need to avoid wasteful expenditure on items, and to keep spending within limits It also helps to ensure that the limited finance available is spent sensibly Targets could be set for the prices paid for various items from external suppliers Audits by the government's auditors into departmental spending may be used to identify:  any significant failures to control prices, and  unnecessary expense Quantitative measures of efficiency Efficiency relates the quantity of resources to the quantity of output This can be measured in a variety of ways  Actual output/Maximum output for a given resource x 100%  Minimum input to achieve required level of output/actual input x 100%  Actual output/actual input x 100% compared to a standard or target PM STUDY NOTES External Considerations in Performance Measurement External considerations are factors that arise or exist outside an organisation, and within its external environment, that could have an impact on the objectives that the organisation should try to achieve and the targets that it sets for those objectives, or its actual performance The external factors that affect an organisation vary according to the type of organisation and the environment in which it operates Broad categories of external factors include:  Political and legal developments: new laws may affect what a company is allowed to or is not permitted to do, and this change could affect its performance  Economic conditions and economic developments  Changes in public attitudes and behaviour  Technological changes  Competition in the market Stakeholders:  Stakeholders of a company are any organisations, individuals or groups with an interest in what the company does and how it performs It is often convenient to group stakeholders into categories, such as shareholders, lenders, suppliers, customers, employees, the government and the general public  Public sector entities and not-for-profit organisations also have different stakeholder groups  The interests of each stakeholder group differ, and each group has different expectations about what the organisation should They also judge its performance in different ways  Shareholders in a company have invested money by buying shares Their main expectation is likely to be that the company should provide good returns on investment, in the form of dividends or share price growth  Lenders to a company expect to make a profit or return in the form of interest Lenders will want the company to have a secure business, and will not want the PM STUDY NOTES company to take risks that could threaten its ability to make the interest payments and repay the lending at maturity  Major suppliers to a company may depend on the company for a large proportion of their profits They will expect honest and fair dealing from the company, and they will expect to be paid on time  Customers of a company expect to receive value for the money they pay to buy the goods or services that the company provides If they think they are receiving poor value, they are likely to switch to buying the products of competitors, or to finding an alternative product  Employees are stakeholders in a company because the company provides them with a job and possibly also career opportunities They also have an interest in working conditions  The government and the general public Some large companies can have a major influence on the national economy They provide work for large numbers of people, and they produce the goods or services that many people buy and rely on In addition, companies are major users of natural resources, and are a cause of much pollution in the environment Public expectations of what particular companies should or should not be doing may become quite strong, and in some cases a company may come under severe criticism from protest groups  For each company, some stakeholders are likely to be more influential than others However, when there are several influential stakeholder groups the company may need to take their conflicting interests into consideration, and set their objectives and performance targets accordingly Market conditions Market conditions are any factors that influence the state of the market or markets in which a company operates These include:  the state of the economy  innovation and technological change Companies will usually hope to achieve growth in sales and profits, and economic conditions may be either favourable or adverse PM STUDY NOTES Other financial conditions may affect a company's performance, such as changes in rates of taxation, interest rates or foreign exchange rates Allowance for competitors The targets that a company sets, and the performance that it achieves, are also affected the by nature of competition in the market When the size of a market is fixed, and competition is strong, the rival firms will compete for market share The performance of a company in a competitive market may be measured by the size of market share that it obtains The performance of a company may also be affected by the actions taken by competitors For example if a major competitor has reduced its sales prices, a company may feel obliged to respond by cutting its own prices Example A government is trying to assess schools by using a range of financial and non-financial factors One of the chosen methods is the percentage of students passing five exams or more Which of the three Es in the value for money framework is being measured here? A Economy B Efficiency C Effectiveness D Expertise Solution: The correct option is C Exam success will be a given objective of a school, so it is a measure of effectiveness PM STUDY NOTES ... CHAPTER 20: PERFORMANCE ANALYSIS 172 CHAPTER 21: PERFORMANCE ANALYSIS – PRIVATE SECTOR 177 CHAPTER 22: DIVISIONAL PERFORMANCE AND TRANSFER PRICING 197 CHAPTER 23: PERFORMANCE. .. relationship management  Increased customer loyalty  Increased competitive strength  Increased operational efficiency  The discovery of new sources of revenue PM STUDY NOTES Performance management. .. share and recover the costs incurred over the lifecycle PM STUDY NOTES  Performance management: Understanding the changes in the financial performance of the product as it moves from one stage