Controllable profit X
Apportioned general overheads (X)
Net profit X
The profit performance of divisional managers should be based on the controllable profit.
Manufacturing costs last year were 53% of sales revenue, but sales and distribution costs (17% of sales revenue) were also quite high. The responsibility accounting system should ensure that sales and distribution costs for which each division is directly responsible are included within the variable costs or directly attributable fixed costs of each division.
In the same way, the assets that are accounted for as divisional assets should be assets over which the divisional managers have some control. This may be difficult in practice, especially when a division occupies a building that is shared with staff from other divisions or head office staff.
Learning curve
The design of a responsibility accounting system should also recognise the implications of the learning curve in one division, and its potential impact on transfer pricing arrangements.
The existence of a learning curve in one division means that expected average production times will get shorter as new products are produced in (cumulatively) larger quantities. The division should therefore benefit from improving efficiency but these improvements will come 'naturally' and should not be attributed to effective management. The reporting system should therefore be capable of including the expected
production times with expectation. The divisional manager should not be credited with the efficiency improvements that come from the learning curve.
Transfer prices
When investment centres transfer goods or services between each other, the transfers add to the revenue and profits of the transferring division and add to the costs of the receiving division. This creates potential for disagreements about what the transfer prices should be. Since there is no external market for most transferred items, transfer prices for these items at cost plus would seem to be appropriate. However, the transfer prices should be fixed periodically at a negotiated price based on expected cost plus a profit margin.
Actual cost plus should not be used for transfer pricing, because inefficiencies and overspending in the transferring division would be passed on and charged to the receiving division in the transfer price. This would be inconsistent with the principle of responsibility accounting.
(b) It should be assumed that if divisional managers are rewarded on the basis of the performance of their division, they will be motivated to optimise the performance by which they are rewarded. They will be much less concerned about aspects of performance that do not affect their reward.
Short vs long term performance
The board currently believes that divisional managers should be rewarded on the basis of financial performance only – profitability and return on investment. It is likely that rewards would also be based on annual financial performance rather than longer-term financial performance. This would be inappropriate, because long-term performance is an important consideration, and non-financial aspects of performance as well as short-term financial measures will affect longer-term performance. The new performance reporting system should be designed in a way that motivates divisional managers to recognise the longer-term aspects of performance.
Financial and non-financial performance
An appropriate performance reporting system may therefore be one based on a balanced scorecard of performance targets, with annual bonuses based on the achievement of non-financial as well as financial targets. A balanced scorecard would include performance measures from customer, internal efficiency and innovation and learning perspectives.
Goal congruence – Performance measures could still include short-term performance measures. For investment centres, an important aspect of performance is financial return on investment. The performance measurement system should encourage managers to make capital investment decisions that are in the best interests of the company. Ignoring issues such as risk, investment decisions should be taken if they will be expected to achieve a positive net present value.
However, if divisional performance is based on accounting return on investment, there will be a possibility that divisional managers will choose not to make new investments because, in the early years of the investment, the effect will be to reduce the division's ROI. The performance reporting system should therefore be designed in a way that encourages desirable capital investment. The use of residual income, or even economic value added (EVA™), should therefore be considered as alternatives to ROI as measures of short-term financial performance.
(c) There are three broad categories of control mechanism which KLP might use to cope with the problem of organisational control: action control; personnel control; and results control.
Action control
The aim of action controls is to ensure that only those actions which are desirable occur, and actions which are undesirable do not occur.
Action accountability involves defining actions that are acceptable or unacceptable, observing the actions and then rewarding acceptable (or punishing unacceptable) actions. In this way, action accountability sets limits on employee behaviour. For example, setting budgets for different categories of expenditure in each division makes the divisional managers accountable if they exceed the budget limit, such that they have to explain or justify their actions.
Personnel control
The aim of personnel controls is to help employees do a good job, by ensuring they have the capabilities and the resources needed to do that job. This is through appropriate recruitment and selection (finding the right people to do a specified job); training and job design (where job design includes making sure that jobs are not too complex, onerous or badly designed so that employees do not know what is expected of them); and providing the necessary resources for people to do their jobs.
Cultural control – These represent a set of values or social norms that are shared by members of an organisation and influence their actions. The Board of KLP could introduce codes of conduct, or group based rewards schemes, such as annual bonuses based on how well staff perform against objectives (rather than simply based on profitability and return on investment).
Results control
The focus of results control is on collecting and reporting information about the outcomes of work effort.
The key value of results controls for KLP would be to identify deviations from desired performance measures (eg variances to budget) and then allow corrective actions to be taken to try to improve performance.
24 Racer deliveries
Text reference. Recording and processing methods, including the recoding of qualitative information, is covered in Chapter 8 of the BPP study text. Issues around interpreting qualitative data are covered in Chapter 12.
Top tips. Performance measurement systems need to provide information of a qualitative nature to management, although quantitative measures should be used even for qualitative issues, where this is achievable.
Qualitative aspects of performance can be particularly useful in service businesses, and this appears to be the case here. However, the question is whether these qualitative factors do actually contribute to RACER's competitive advantage, or whether the directors have just assumed they have.
In part (a) you need to identify what aspects of performance are perceived to contribute to RACER's competitive advantage, and then think how qualitative information could help assess the impact they are actually having on the company's performance.
In part (b) you then need to think about the practical problems associated with trying to capture qualitative information. It is often subjective, so how can it be measured?
Part (c) picks up on this point. The surveys which the management accountant will could enable RACER to quantity qualitative data, but are there any potential issues with such a process? For example, will all customers give the same level of service the same score?
(a) The board of directors of RACER believes that its competitive advantage is based on reputation, brand recognition, reliability, experience and personalised service by its call centre staff. This belief appears to have made the directors decide that RACER should not copy its rivals and introduce an automated ordering system, even though this may be less expensive to operate.
Information for decision-making – The directors would probably benefit from information about these aspects of the company's service, because their views currently seem to be based on opinion rather than firm evidence. In this respect, it seems probable that the board is basing decisions about the company's future strategy on its views of RACER's competitive advantage, rather than any firm evidence.
If the directors believe that these qualitative aspects of performance are the reason why RACER is successful in the market, they will probably base the company's future strategy on preserving the factors that create this advantage. Therefore it would be valuable to obtain information about whether these qualitative aspects of performance really do create value for RACER; for example, by establishing whether they affect
customer's choice of which delivery service to use.
Competitive advantage – If qualitative aspects of performance are strategically significant, then it is also important that Information about them is reported regularly so that the board can monitor any change in circumstances that might create a threat to competitive advantage.
The most significant qualitative aspects of performance that appear to be significant for RACER may be those that have been identified by the board.
(i) Brand recognition – The board believe that RACER has a good reputation for service and that it benefits from strong brand recognition. Information about the strength of the company's reputation and brand recognition by customers would help the company to develop its marketing strategies. For example an advertising campaign might promote the brand name and image.
(ii) Service reliability – The board believes that the company's reputation is based largely on its service reliability. Reliability probably means on-time collections and deliveries, or possibly speed of delivery.
Information about on-time services and speed of services would help management to monitor this aspect of performance, and try to ensure that the service standard is maintained.
(iii) Customer service – The board also believes that customers value the experience and personal service of its call centre operators. As a result, it has taken the important decision to retain a personal calls system for customer orders, when rival companies have chosen to cut costs and use automated voice recognition ordering systems. Information about the value of this service to customers would enable the board to confirm their view – or prove it wrong.
(iv) Customer needs – Information about the quality of the telephone ordering service and reliability of service are important only if they are significant to customers. RACER does not seem to have obtained reliable information about customer needs and whether RACER's services are meeting them sufficiently well. Information about how much extra customers would be willing to pay for additional features in the service would also be of value.
(b) One of the distinctions between qualitative and quantitative information is that it can be harder to measure qualitative information and qualitative aspects of performance. For quantifiable aspects of performance, it is possible to set specific targets for achievement; whereas often qualitative aspects targets can only be expressed in more general terms. When targets are not measurable and performance is not measured, it can be difficult to assess whether the targets are being achieved.
There is a risk that monitoring qualitative aspects of performance can become self-delusional.
Management may decide that actual performance is what they would like it to be, not necessarily what it actually is. Strength of reputation is one such qualitative aspect of performance. Others may be employee loyalty, team spirit and quality of strategic leadership.
Since qualitative information is not currently measured at RACER, there are problems in gathering and analysing information, and in accessing and retrieving qualitative information that is held on file. The information provided by a reporting system may also be of limited value, because management may not know what to do about it.
Information must have a purpose, but qualitative information may not be sufficiently specific and its purpose may therefore be unclear.
It may be argued that qualitative information may be of value for strategic planning rather than performance management and control. Information about the strengths and weaknesses of the company, and about threats and opportunities in the industry and the business environment, may be largely qualitatively in nature, but this information is used to assess strategic options and make strategic choices.
SWOT analysis, however, is unlikely to be made part of a regular performance reporting system for management.
The importance of non-financial information is now widely recognised: much qualitative information is non- financial in nature, but many aspects of non-financial performance can be measured quantitatively.
If RACER's board wants to obtain information of a qualitative nature, an appropriate approach may be to convert as many qualitative aspects of performance as possible into quantifiable aspects. Customer satisfaction, for example and aspects of service quality may be measured by means of regular customer surveys or market research surveys.
(c) Quantifying data – The surveys which the management accountant has suggested will provide RACER with a means of converting qualitative data into quantitative data. RACER's performance in key areas of the
the scores it receives for them, and for example, taking an average score for a given period. For example, this could be useful for quantifying the impact on customer service of introducing the automated calling system, and in turn allowing the directors to assess how successful the new system has been.
Subjectivity – One of the major problems in interpreting qualitative data is that it based on people's opinions and judgements, and is therefore it is subjective. For example, the quality of service which one of RACER's customers might rate as 'Excellent' (and score '5') another customer might simply rate as 'Average' (and score '3').
Equally, when people complete surveys there is a tendency to score towards the middle. In general, respondents are likely to feel more comfortable selecting scores in the range 2 – 4, rather than using the extremes of 1 or 5.
Trends – Because of this subjectivity, the surveys may be more useful for looking at trends in RACER's performance rather than looking at one-off performance. For example, RACER could monitor how their average score for customer service varies over a period of time, as an indication of whether customer service is improving, remaining at much the same level, or getting worse over time.
Equally, if there are significant variations in the scores over time, this should prompt the Directors to investigate the reasons for these variations.
25 Forion Electronics
Text reference. Enterprise Resource Planning Systems (ERPS) are discussed in Chapter 8 of the BPP Study Text.
Non-financial performance indicators are discussed in Chapter 12.
Top tips.
Part (a). As is the case with a number of P5 questions, note that there are two elements to this requirement: first, you need to discuss the integration of information systems in an ERPS; then, second, you need to discuss how the ERPS at Forion may affect performance management issues there.
The first element doesn't specifically require any application to Forion. However, you could use the issues which Forion is facing, and the different departments mentioned in the scenario, to illustrate the way an ERPS could integrate information from different systems.
The marking guide indicates that six out of the 10 marks for this requirement are available for the second element – discussing how the ERPS can affect the performance management issues at Forion.
Even if you didn't know much about an ERPS, you should have been able to identify how deficiencies in the information sharing between departments could lead to the problems identified in the scenario. There are six marks available for three problems; so two marks per problem. If, for each problem, you provide a brief discussion of the likely causes of each problem, and then indicate how better information sharing could help to avoid that problem, this should help you earn the majority of the marks available for this part of the requirement.
Part (b). An important factor to consider here is the relationship between Forion and BAS. BAS is a supplier to Forion, and Forion has chosen BAS because of its reputation for quality and new product development. This suggests Forion consider these aspects of performance to be important (and Forion has previously identified it needs to have high-visibility, durable screens in order to be competitive – so visibility and durability could be considered as aspects of 'quality').
A useful way to answer the question would be to consider how well the performance measures chosen allow Forion to assess BAS's performance in the areas which it has identified as important.
In this respect, don't just think about the aspects of performance selected, but also think about the practicalities of measuring the performance. How easy will it be to measure whether or not BAS achieves the desired levels of performance?
Part (c). Note that the question requires you to make two separate comparisons: financial vs non-financial data; and internal vs external data. Also, it is important that you discuss the issues specifically in the context of the service level agreement between Forion and BAS. For example, will BAS be happy to use internal performance data prepared by Forion given that it (BAS) could be liable for a financial penalty if it fails to achieve the target performance levels?
Examining team's comments (for part (c)) – Evaluating the reliability of data has been a common topic in part exams, yet candidates answers to this question were unexpectedly poor. Many candidates seemed unaware of what constitutes internal and external sources, and – surprisingly – many considered audited, financial data to be amongst the least reliable source. In addition, many candidates discussed the type of information that both parties to the alliance would need, without discussing its reliability (which is what the requirement actually asked for).
Marking scheme
Marks (a) For general description of an ERPS and how it integrates information:
1 mark per relevant point – up to 5 marks
For specific discussion of the impact an ERPS could have on the problems at Forion:
1 mark per relevant point – up to 6 marks:
Total for part (a): up to 10 10
(b) For relevant points about the usefulness of the three areas for measuring performance – 1 mark per point
Note. In order to score a clear pass, all three issues must be addressed
Total for part (b): up to 12 8
(c) For relevant points about the relative reliability about the different types of data – 1 mark per point
Note. In order to score a clear pass, both issues (financial/non-financial; and internal/external must be addressed
Total for part (c): up to 7 7
Total = 25
(a) An Enterprise Resource Planning System (ERPS) is a software system which supports and automates the business processes in an organisation. An ERPS can assist in identifying and planning the resources needed to perform many different activities in different departments across the whole organisation – including inventorying management, manufacturing, distribution, invoicing and accounting. An ERPS can incorporate support functions such as human resource management and marketing.
As such, an ERPS enables the performance information from all departments that are involved in operations or production to be integrated into one system, thereby assisting the flow of information between the departments and across the organisation as a whole. Integrating performance information in this way would seem very useful to Forion, given the problems it has encountered to date.
As well as improving the flow of information between the department in an organisation, ERPSs can also help to improve linkages with outside stakeholders – for example, by incorporating customer relationship management (CRM) and supply chain management (SCM) software.
Again, this would seem very useful to Forion, given the high number of customer and supplier relationships it has to manage.