ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 16: Performance measurement: external considerations and behavioural aspects
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The interests of each stakeholder group differ, and each group has different
expectations about what the organisation should do. 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. They may expect the
company to achieve annual growth in profits and dividends. Even if the
company is making small profits or even making a loss, the shareholders may
expect the company to maintain the same annual dividend payments.
Lenders to a company expect to make a profit or return in the form of interest.
There is some credit risk in lending, and the rate of interest should provide a
sufficient reward for the risk that the lender is taking. Lenders will want the
company to have a secure business, and will not want the 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, when payment falls due for
goods purchased on credit.
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. For example, commuters using the train services
of a local train company may object to a large increase in rail fares: since the train
company may have a monopoly on the local train routes, some commuters may
respond to the price increase by switching to car, bicycle or bus.
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, such as hours of work.
The government and the general public. Some large companies can have a major
influence on a 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. The
government has an interest in how companies behave, and this is evidenced by
the wide-ranging regulations and laws that are impose on businesses, including
environment regulations, health and safety regulations, employment regulations
and so on.
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.
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1.3 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. When the economy is growing,
demand for goods and services generally should be increasing, and market
conditions are favourable for the development and growth of business. When the
economy is in recession, the opposite is true: companies may even struggle to
survive.
Other financial conditions may affect a company’s performance, such as changes in
rates of taxation, interest rates or foreign exchange rates.
1.4 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. This aspect of performance was described in the
earlier chapter on market size and market share variances.
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. Although there may
be some increase in sales from the price reductions, the net result is likely to be a
reduction in profits.
For the purpose of your examination, it is therefore necessary to understand that
when you assess the performance of a company, it is useful to:
make comparisons with the performance of rival companies and
consider whether the performance of a company has been affected by activities
of competitors.
1.5 Allowing for external considerations
Allowance should be made for external considerations in performance management
in three ways:
In some cases, it may be appropriate to alter objectives to allow for external
considerations. In particular, the objectives of a company should make some
allowance for the conflicting interests of different stakeholder groups.
Performance targets should be set by making assumptions about external
factors such as the state of the economy and probable size of the market. The
Chapter 16: Performance measurement: external considerations and behavioural aspects
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targets for growth may depend on whether the economy is expected to grow
strongly, grow slowly or decline.
Actual performance should be assessed by taking into consideration
unexpected developments in the external environment. As mentioned earlier,
failure to achieve targets for sales revenue may be the result of unexpected
initiatives by a major competitor.
Interpretation of performance in the light of external considerations
When you answer an examination question on performance measurement,
remember the expectations of the examiner.
Calculate suitable measures of performance.
Make an assessment of the performance. Does it appear to be good or bad? Is it
better or worse than the performance target or budget?
Use the background information provided in the question and look for
something that might explain the bad or good performance, and use this
information to express an opinion.
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Behavioural aspects of performance reporting: reward systems
Unintended consequences of performance measurement systems
Performance rewards
Designing reward schemes: factors to consider
Behavioural problems with reward systems
Performance and participation in target-setting
Budget slack
2 Behavioural aspects of performance reporting:
reward systems
2.1 Unintended consequences of performance measurement systems
An aim of performance reporting systems should be to improve performance. In
order to achieve this objective, it is often necessary to consider the behavioural
implications of performance reports.
Performance reports should be used in the way intended. In practice, however,
there may be unintended consequences, particularly when managers receive
rewards for good performance.
Performance measurement systems can suffer from several problems that reduce
their effectiveness.
Tunnel vision. Managers may focus on achieving performance targets to the
exclusion of other aspects of management. When there is a narrow focus on
performance, there is a risk that managers will make decisions that improve
performance in the short term, even if they could be damaging in the long term.
For example an office manager may decide to leave unfilled some job vacancies
in the office, in order to keep labour costs down and meet the expenditure
budget for the office. The shortage of staff may, however, reduce the efficiency
and effectiveness of the office activities.
Sub-optimisation. Sub-optimisation occurs when managers focus on achieving
good performance in one area, but in doing so overlook other aspects of
performance. As a result, overall performance is not as good as it should be. For
example, management may be given performance targets for the sales of new
products: they may focus on sales growth for new products, and in doing so
overlook the need to maintain sales of established products. As a result total
sales and profits might fall.
Myopia. Myopia is short-sightedness. In the context of performance
measurement, it means concentrating on short-term performance measures to
the exclusion of longer-term considerations.
Measure fixation. Measure fixation means taking action to ensure that specific
performance targets are reached without considering the possible consequences.
For example, a department might have a target for labour costs as a maximum
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proportion of its total operating costs. In order to meet this target, management
might recruit and employ inexperienced and untrained staff who are paid less
money than experienced employees. The labour cost target may be met, but the
quality of work may deteriorate.
Misrepresentation. Misrepresentation describes the tendency to give a false but
flattering picture of performance, by disguising actual results. For example, a
sales manager might represent the sales performance for a period in a flattering
light – with some growth in sales volume. However, this could be misleading.
The sales volume growth might have been achieved only as a result of heavy
price discounting and a big reduction in gross profit margins.
Misinterpretation. Misinterpretation occurs when performance measures are
interpreted in an incorrect or over-simplified way. Management might read
something good or something bad in a set of performance figures, when the
actual situation is more complex and the results are not so easy to interpret.
Gaming. Gaming occurs when there is a deliberate distortion of a performance
measure or a performance target, in order to make actual results subsequently
appear much better than they really are. For example, a departmental manager
might argue that productivity in the department has been poor, so that a low
performance target is set for productivity in the department. If the target is set at
a low level, it is relatively easy to achieve, and the department’s performance
will therefore appear better than it really is.
Ossification. Performance measurement systems should be flexible, and new
performance measures should be introduced as appropriate to replace measures
that are no longer appropriate. Ossification refers to an unwillingness that may
exist to change any parts of the measurement system, after it has been
introduced. It therefore demonstrates a lack of flexibility in performance
management.
Lack of consistency. Within an organisation, the performance targets set for
individuals or groups may be inconsistent with each other. For example, a
production manager may be given performance targets relating to keeping costs
under control, and a quality control manager may have performance targets for
ensuring the quality of completed output. The targets of the production manager
and the quality control manager may be inconsistent, if lower costs are
achievable by reducing quality.
These problems need to be recognised and understood. Management should
continually review the performance measurement system and the appropriateness
of the performance targets and performance measurements that are used.
2.2 Performance rewards
Many organisations have systems for linking the achievement of performance
targets with rewards for the successful individual. Rewards may take the form of
higher pay (for example, a cash bonus or a higher salary) or promotion. Individuals
may also feel rewarded by a sense of personal achievement (and possibly also by a
formal recognition of their achievement by senior management). In some cases,
there may be systems of ‘punishment’ for poor performance, such as withholding a
bonus or even dismissal.
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Advantages of reward systems
There are several advantages in having a system of rewards linked to performance:
A well-designed reward scheme should link rewards to performance that
supports strategic objectives. This should help the organisation to implement its
strategies and achieve its strategic objectives.
Rewards can motivate individuals to achieve their performance targets. They
can also help to attract and retain talented individuals.
The payment of rewards for achieving key targets helps to inform managers and
employees about what the critical aspects of performance are.
An effective reward system will encourage employees to focus on continuous
improvement.
Where rewards involve granting shares or share options in the company,
employees who benefit from the rewards may be encouraged to think more
about the long-term prospects of their company and its market value.
2.3 Designing reward schemes: factors to consider
There are several factors to consider and questions to answer when designing a
reward scheme.
Should the rewards for performance be based on results (outputs) or on the
effort that has been put in? A reward scheme for salesmen, for example, can be
based fairly simply on results achieved (volume of sales). It is often much more
difficult however to reward administrative staff for results achieved, because the
results of their efforts might not be easily quantifiable, or measured against clear
targets.
Should rewards be given in a money form (a bonus or higher salary) or in non-
monetary form (such as share options)?
Should rewards be explicit or implicit? Explicit rewards are rewards that will
definitely be given for meeting performance targets, such as a cash bonus.
Implicit rewards are not specific promises, but there is a general understanding
that the rewards will be available for good performance. For example, there is
often an expectation of promotion or a higher salary for good performance, but
these are not explicit promises, only an implicit understanding.
How large should rewards be?
Over what time period should performance be measured before rewards are
given?
Should rewards be given for individual performance, or should there be group
rewards for team performance?
Should the rewards involve equity participation – giving shares or share options
to individuals?
What are the tax implications of different reward schemes? Can a reward
scheme be devised that limit the tax liabilities of the employees receiving the
rewards, without breaching the tax laws?
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2.4 Behavioural problems with reward systems
When individuals are rewarded for performance, some potential behavioural
problems might occur.
It is often difficult to measure the performance of individuals, and the performance
of groups or teams must be measured instead. When group performance is
measured, there may be a problem in the following situations:
Some members of the group or team believe that they have been responsible for
the successful performance of the group, whereas other team members have not
contributed as much as they should have. These individuals may be angered if
rewards are paid to all members of the team, including the undeserving
members.
The reward system provides rewards to some members of a group, but not to
others: for example, a departmental manager may be rewarded, but none of the
departmental staff.
When performance is rewarded, the individuals affected will be inclined to focus on
the measures of performance that set the level of their reward – to the exclusion of
all other aspects of performance. This can have unintended consequences.
For example, a sales manager may be rewarded with a bonus for exceeding a sales
target. The manager might therefore take measures to ensure that the sales target is
achieved, and to do this, the manager might offer attractive terms to customers,
such as large price discounts. As a result, the key performance target – sales revenue
– might be achieved, but with the consequence that profit margins are much lower
than planned.
2.5 Performance and participation in target-setting
You may be familiar already with management theories of motivation. Briefly, there
is an argument that managers and other employees should be allowed to participate
in setting performance targets for themselves, because if they have been involved in
the setting the targets, they will have a stronger motivation to achieve them.
2.6 Budget slack
In contrast, if targets are decided by senior management and subordinates are
‘blamed’ for failing to achieve them, the opposite situation may occur. Managers
may try to blame others for ‘poor performance’. Where possible they will also try to
increase the size of their expenditure budget, so that it becomes easier to keep
within expenditure limits and so achieve the budget targets.
Excessive expenditure allowances within budgeted expenditure limits are
sometimes called budget slack.
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Paper F5
Performancemanagement
Q&A
Practice questions
Contents
Page
Costing systems
1 HEN 406
2 Lardco 407
3 LCC 408
4 Customerprofitability 409
5 Backflush 410
6 Throughput 410
7 Throughputratio 411
Decision making techniques
8 Fourproducts 411
9 Limitingfactors 412
10 Shortages 413
11 Proglin 414
12 Price 415
13 Marginal 416
14 MC=MR 416
15 Snapco 417
16 Bridon 418
17 Materialsandrelevantcosts 418
18 Printingleaflets 419
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19 JB 420
20 ProductB22 421
21 Makeorbuy 423
22 Villaco 424
23 Payofftable 424
24 Grab 424
Budgeting and budgetary control
25 Zerobasedbudgeting 425
26 Learning 426
27 Greenears 426
28 Regression 427
29 Flexedbudget 427
30 Costestimation 428
31 Timeseries 429
Standard costing and variances
32 Reconcile 430
33 Simplevariances 430
34 Manufacturingcostvariance 431
35 Variancesandoperatingstatements 432
36 Standardcosting 433
37 Salesvariances 434
38 Mixandyieldvariances 435
39 Moremixandyield 435
40 Planningandoperationalvariances 436
41 Sizeandshare 436
42 Learningcurvevariance 437