ACCA - P5 Advanced Performance Management - Passport ATC 2009
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SUMMARY OF KEY THEORY
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Qualitative signs of corporate failure
Restrictions on dividend policy
Financial engineering
High management turnover/ loss of key personnel
Falling market share
Altman z-score model
Altman’s model is a quantitative model, which attempts
to predict bankruptcy, based on various ratios.
Empirical evidence has shown that the model is good at
predicting corporate failure within 12 months of a
failure- but not so good at predicting corporate failure
longer two years or more before the failure occurs.
Has the advantage of being objective- as it is based on
calculations.
Can’t be used for unquoted companies, because on of
the factors includes the market price of the company’s
equity.
Argenti’s A-score model
Model requires user to assign a score to various
attributes of the company’s corporate governance,
accounting, management and financial performance. A
high score is adverse.
Weakness of the model is that it requires judgement in
applying it.
Corporate recovery strategies
Replacing poor management with strong.
Introduction of tight financial controls
Sale of non core businesses to generate cash
Successful core business required
Restructuring of debt.
DIVISIONAL PERFORMANCE EVALUATION
Return on investment (ROI)
ROI is essentially the same measure as ROCE and ARR
It is important only to only include costs, revenues and
elements of the assets base controlled by the manager
when performing a managerial evaluation.
debt termLong employed Capital
taxationandinterest beforeProfit
+
× 100%
This has the benefit of providing a relative evaluation
for comparative purposes or
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May be used for investment appraisal where the
manager can compare an investment’s ROI with the
target ROI. If the division’s ROI is the same as the
company’s ROI then this will produce goal congruent
behaviour. If not however, then dysfunctional behaviour
may happen (e.g. division’s ROI is 5%, company’s
required rate 20%, project under appraisal 10%. The
manager would accept the project but should reject it).
Residual income (RI)
To overcome this problem, RI calculations may be
used. The calculation is profit – imputed interest
(capital employed multiplied by cost of capital)
If positive the project is accepted, if negative the project
is rejected and as such is an absolute measure like NPV.
Discounted RI indeed reconciles to NPV.
Problems associated with both ROI and RI
Both measures use accounting profits and are short term
i.e. if positive RI or target ROI’s are not met in the first
period then the project may be rejected even though a
positive NPV may be observed over the whole life of
the project. The risk of short-termism may be reduced
through:
the use of annuity based depreciation to smooth
reported performance over the life of the project
relegating the divisional managing director to
profit centre status and make the capital
investment decision at group level based on NPV.
However this could be de-motivating.
Adjust the manager’s target ROI or RI downwards
in the earlier years of the project. This will not be
de-motivating.
Economic value added (EVA)
Economic value is similar in principle to residual
income, and is designed to show if the profits generated
by a division (or even a whole company) exceed the
cost of financing the assets used to generate the profit.
EVA is calculated as: Net Operating Profit after tax –
Finance Charge
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Net operating profit after tax
Profit after tax X
+ Interest charge (net of income tax) X
+ Research & Development expenditure written off during
the year X
+ Non cash expenses (good will written off, etc) X
+ Accounting depreciation X
- Economic depreciation (X)
- Amortisation of cumulative R&D adjustments (X)
–––
= NOPAT X
–––
Finance Charge
Finance charge = Capital employed at the start of the year x
the weighted average cost of capital.
Capital employed
Equity per statement of financial position at start of year X
Debt per statement of financial position at start of year X
Add: Non capitalised leases (Operating leases) X
Add: Cumulative research and development expenses
recognised in income statements X
Less: Amortisation of research and development
expenses (X)
Add: Accumulated Accounting depreciation X
Less: Accumulated economic depreciation (X)
–––
Capital employed for finance charge X
–––
TRANSFER PRICING
Objectives of a good transfer pricing system:
Autonomy
Goal congruence
Fair to both buyer and seller for performance evaluation
purposes.
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Opportunity cost approach to transfer pricing
From the perspective of the selling division, minimum
transfer price is the higher of:
External market price (less any savings due to internal
transfer)
Variable cost + opportunity cost of supplying the goods.
From the perspective of the buying division, the maximum
transfer price acceptable is the lower of:
External market price
Net revenue of the division. Net revenue means
ultimate selling price, less costs incurred in the buying
division. If the transfer price exceeds this, the buying
division will make a loss.
An alternative way of looking at the second criteria is:
Variable cost + shadow price.
If a price exists which meets the criteria above, it will
automatically satisfy the objectives of a good transfer pricing
system.
Practical Approaches to transfer pricing
Cost plus approach
Easy to calculate
Covers all costs of selling division
Setting mark up is arbitrary
Inefficiencies in selling division are passed on to buying
division.
May lead to incongruent decisions.
Market price
Easy to obtain
Fair
May lead to incongruent decisions (e.g. where selling
division has spare capacity, and buying division buys
externally)
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Dual Pricing
Where no transfer price can be found which is
acceptable to both parties, but the head office wants
both divisions to trade internally, dual pricing may be
used. A higher price is credited to the buying division,
and a lower price debited to the buying division- the
head office absorbs the difference.
Transfer Pricing in Multinational companies
Reduce taxation
Multi nationals may try to shift profits from high tax
countries to low tax countries by:
Charging a high price when goods are sold by the
country located in the high tax country
Charging a low price when goods are being sold by the
country located in the low tax country
Using management charges to reduce profits further in
high tax countries.
Reduce import tariffs
If countries impose steep import tariffs, based on the
price of the goods imported, a low price will be charged
by the exporting division of the multinational, thus
reducing the import duty.
Tax authorities in many countries are aware of these
practices, and attempt to curtail them by requiring all
transactions to be performed at the same price that would
occur in an “arms length” transaction.
CURRENT DEVELOPMENTS IN MANAGEMENT
ACCOUNTING
The changing role of the management accountant (Burns
and Scapens)
Factors that changed the role of the management accountant
Technology – management accountant may rely on data
input to the system by other users.
Decentralised management structures – managers often
prepare their own reports without using the formal
management accounts
Competition – means organisations can no longer focus
only on financial performance and require non financial
performance indicators too.
Implications for the management accountant
Management accountant is a “hybrid” accountant, not
just a number cruncher
Will be involved in multi disciplinary teams
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Having a better view of the external commercial view
Deal with non financial as well as financial information.
Total quality management
A continuous improvement in activities involving everyone
in the organisation-managers and workers, in an effort
toward improving performance at every level.
A philosophy which recognises that costs of quality may be
less than costs of failure.
Costs of quality
Measured as the difference between the actual cost of sale
and the equivalent cost without quality failures.
Various types of cost exist in a Total Quality Management
environment:
Cost of conformance- these are the costs of achieving pre-
determined quality standards
Cost of preventing defective products or services being
produced e.g. investing in new processes
Cost of appraisal-costs associated with ensuring our
system ensures output meets required quality standards
e.g. inspection costs
Cost of non-conformance these are the costs of failing to
deliver the required standard of quality
Cost of internal failure- costs associated with
inadequate quality prior to transfer of ownership to
customer e.g. rework costs, scrapping
Cost of external failure -costs associated with
inadequate quality discovered after the transfer of
ownership to customer e.g. warranty claims, loss of
reputation, liability claims.
Just in time
Just in time is a philosophy of organising work flows to
allow high quality, flexible production whilst minimising
waste and inventory levels.
Production is timed to meet customer demand, rather
than producing for inventory.
All the processes in the factory try to work at the same
speed to minimise the wasteful build up of work in
progress throughout the factory.
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Target Costing
Target costing is a method used to ensure required profit
margins are achieved. In traditional cost accounting, the unit
cost of a product is assumed to be given, and profit is the
residual, after deducting the cost of the product from the
revenue. Target costing involves identifying the desired cost
per unit in order to achieve a required level of profit.
$
Selling price per unit X
Required profit per unit (X)
––
Target cost per unit X
––
The required profit is calculated based on required return
on investment required to develop the product.
Target costing may be employed during the design stage
of a product, when designs can be changed to
incorporate cost savings. Steps are then taken to reduce
the gap between the actual cost and the target cost.
Kaizen Costing
Kaizen means continuous improvement. Kaizen costing is a
dynamic approach to target costing, where the initial target
cost is only the starting point. Every year, the target cost will
be reduced further in an attempt to find new ways of
improvement. The cost savings come from
Elimination of waste
Elimination of non value added activities
Improvements in the product cycle time.
Environmental management accounting
Definition
Environmental management accounting is the
generation and analysis of both financial and non
financial information in order to support internal
environmental management processes.
Rationale
Traditional management accounting techniques
underestimate or ignore the costs of bad environmental
behaviour.
Environmental costs
Conventional costs having environmental relevance-
raw materials and energy
Costs that are hidden within overheads
Contingent costs- such as future clean up costs
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Image and relationship costs
Environmental management accounting techniques
Life cycle costing to include environmental costs such
as packaging.
Input output analysis-whereby the physical products
that go into the production process must be accounted
for in the physical outputs- to determine how much of
the output is waste.
Activity based costing, including the environmental
costs.
Value based management
Value based management is an approach to
performance management that attempts to focus the
attention of management onto the objective of
maximising the wealth of the shareholders.
Many traditional approaches to performance
management are based on profits- but maximising
profits does not maximise wealth. Maximising net
present value does.
For senior management, performance will be evaluated
by using Economic value added (see section above on
divisional performance evaluation).
In developing measures for lower levels, managers
should identify the drivers of growth.
Six Sigma
Six sigma is a quality improvement program, similar in
concept to total quality management.
It aims to reduce defects to the statistical six sigma level
(3.4 defects per million).
Six sigma focuses on the business processes, and
variations in them. (For example, the time to make a
product may vary from day to day.)
By analysing past data, the causes of variations are
identified. The program attempt to find new ways of
doing things, to reduce the variations.
Advantages of six sigma
Many organisations have reported huge cost savings as
a result of implementing six sigma programs.
Improvements are based on statistical analysis, rather
than on management’s gut feelings.
Redundant processes may be identified.
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Disadvantages of six sigma
Focus on existing systems can stifle creativity
Time consuming and expensive to perform
Requires supportive culture from the organisation.
The Performance Prism
The performance prism is an approach to performance
management that tries to take into account a wider group of
stakeholders than traditional performance management
systems.
The 6 facets of the prism represent:
Stakeholder satisfaction (top facet) - who are the key
stakeholders and what do they want?
Strategies (side facet) – how do we meet the wants and
needs of the key stakeholders?
Processes (side facet) – what critical processes do we
require if we are to execute these strategies?
Capabilities (side facet) – what capabilities do we need
to operate and enhance these processes?
Shareholder contribution (bottom facet) - what
contributions do we require from our stakeholders if we
are to maintain and develop these capabilities?
ARTICLES
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TECHNICAL ARTICLES
These can be found on the ACCA web site, www.
ACCAglobal.com. The following articles are highly
recommended:
The risks of uncertainty, by Michael Pogue, April 2009
Accounting and organisational cultures, by Graham
Morgan, November 2008.
Business Failure, by Michael Pogue, July 2008
Economic value added, by Shane Johnson, October
2007
Defining managers’ information requirements by Jim
Stone, August 2006
Business strategy and performance models, by Shane
Johnson, April 2006
The pyramids and pitfalls of performance measurement,
by Shane Johnson, Sept 2005
Performance measures to support competitive
advantage, by Graham Morgan, August 2005
Beyond budgeting, by Shane Johnson, March 2005
Management control- a pre requisite for survival, by
Shane Johnson, October 2004
Big brother, by George Bakehouse, August 2004
Environmental management accounting, by Shane
Johnson, June 2004
Just in time operations and backflush accounting* by
Shane Johnson, May 2004
* Backflush accounting is not in the syllabus for paper P5,
but knowledge of just in time operations is.