ACCA - P5 Study text - Emile Woolf INT - 2010
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Chapter 12: Performance measurement systems
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Information for performance measurement
Classification of costs by cost behaviour
Classification of costs: controllability
Responsibility accounting
Performance reporting and responsibility accounting: problems with the
principle of ‘controllability’
Practical difficulties with responsibility accounting
Non-financial information performance measurement
2 Information for performance measurement
2.1 Classification of costs by cost behaviour
Costs can be classified according to how they change (‘behave’) as the volume of
activity increases or falls. Costs are classified as variable costs, fixed costs, stepped
costs, or semi-fixed and semi-variable costs. Classifying costs in this way is useful
for:
forecasting and budgeting, including cost-volume-profit analysis
budgetary control (flexible budgets and variance analysis)
some decision-making.
It is often assumed that total costs of an activity or operation can be measured by a
linear function:
y = a + bx
where:
y = total costs in a period of time
a = fixed costs in the period
b = variable cost per unit of activity (for example per units sold)
x = volume of activity in the period (for example the number of units sold in the
period).
You might be required in your examination to estimate a variable cost per unit or a
fixed cost per period of time, using a technique such as the high low method or
linear regression analysis. Estimating costs using these techniques was described in
a previous chapter.
2.2 Classification of costs: controllability
Revenues and costs might be classified as controllable or uncontrollable. A cost is
controllable if a manager is able to take action that will alter its amount. Typically, a
cost is controllable if action by a manager may result in a reduction in the cost.
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However, a cost might be controllable by one manager in an organisation, but not
by another. Management information should attribute costs to the managers who
can control them
A performance management system should try to identify costs, revenues and
investments that are:
directly attributable to a division or performance centre within the organisation,
and
controllable by the manager responsible for the division or performance centre.
However, there are some problems with identifying and measuring controllable
costs.
Costs that are directly attributable to a department or cost centre might not be
controllable by the manager of the department or cost centre. For example, the
rental costs of a building used by a department are a directly-attributable fixed
cost of the department, but the manager of the department might have no
control over the decision about whether the department remains in the building
or not. The rental cost is therefore directly attributable, but non-controllable by
the manager.
Some costs are partly-controllable, not fully controllable. For example, the
quantity of materials used by a department might be controllable by its
manager, but their purchase price is not controllable if the materials are
purchased by a separate buying department. Total material costs depend on
both the quantities used and their price. In this situation, quantities would be
controllable by one manager and priced by another.
Example
A business unit employs ten staff who are paid a fixed annual salary. The salary
costs are directly attributable to the business unit, and salaries are decided centrally
by head office. The manager of the unit has no control over salary levels. However,
he should be able to influence the efficiency and effectiveness of the employees who
work for him. It is therefore appropriate that the manager should be held
accountable for the salary costs of the business unit, and the results achieved by
incurring those costs, even though he does not have full control.
Terminology: endogenous variables and exogenous variables
You should note the following terms, which might be unfamiliar to you but might
be used in an examination question.
Endogenous variables: these are factors under the control or influence of
management
Exogenous variables: these are factors that are outside the control or influence of
management.
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2.3 Responsibility accounting
Responsibility accounting is a method of reporting based on measuring the
performance of responsibility centres within an organisation. The manager of a
responsibility centre is responsible and accountable for the performance of the
centre.
Responsibility accounting is based on the principle that managers should be
responsible – and so held accountable – for costs and other aspects of performance
over which they have control. Managers should not be held accountable for costs
and other matters over which they have no control.
The principle of ‘controllability’ is therefore a key issue in any system of
responsibility accounting.
Cost centres, profit centres and investment centres
This is why, for example, reporting units within an organisation may be:
cost centres, where the manager is in a position to control costs, but not sales
revenue
profit centres, where the manager is in a position to control costs and sales
revenue, but is not in a position to control the amount of investment and other
investment decisions
investment centres, where the manager is in a position to control costs and sales
revenue, and also has control over investment decisions affecting the centre.
Within a system for reporting the costs of a centre, a system of responsibility
accounting should also try to make a distinction between:
costs over which the manager should have short-term control: these are often
reported as variable costs and directly-controllable fixed costs (or directly
attributable fixed costs)
costs over which the manager has some control, but over the longer term rather
than the short term
costs over which the manager has no control: in some systems of responsibility
accounting, centres are not charged at all with any share of general overhead
costs that the centre manager cannot control.
There might be a hierarchy of responsibility centres.
A business entity might be divided into several investment centres (strategic
business units or operating subsidiaries).
Within each investment centre there might be several profit centres.
Within each profit centre there might be several cost centres and revenue
centres.
Although the details of a responsibility accounting system may vary between
different entities, the basic principle is consistent: the accounting system should
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identify performance that a manager should be able to control, and for which he or
she should therefore be made responsible and held to account.
2.4 Performance reporting and responsibility accounting: problems with
the principle of ‘controllability’
Management information is provided to each responsibility centre manager, usually
in the form of regular performance reports that the manager uses to:
assess performance
investigate any aspects of performance that seem poor (or very good), and
take any appropriate control measures, depending on what the investigation
reveals.
There are two ways in which the principle of ‘controllability’ may be applied in
management performance reports.
One approach is to include in a performance report only those matters over
which the manager has control.
- This means that many operational performance reports will include non-
financial information, because the operational manager responsible does
not have control over materials prices, or wage rates or salaries for
employees.
- Alternatively, performance reports might report variances by converting
physical variance (materials usage variances in quantities and labour
variances in hours) into a money value, using standard prices for materials
and standard rates per hour for labour.
Another approach is to include controllable costs and non-controllable costs in a
performance report, but to distinguish clearly between these two types of cost. A
profit centre report might therefore be presented as follows:
$000
Profit centre sales revenue 2,000
Cost of sales 600
Gross profit/contribution 1,400
Other controllable costs 500
Controllable profit 900
Non-controllable costs 300
Net profit 600
Problems with the controllability principle
A problem with applying the principle of controllability is that it might be difficult
to decide which costs are controllable and which are uncontrollable.
In practice, many items of cost are partly controllable.
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Some costs that are uncontrollable in the short term (fixed costs) are controllable
in the longer term.
A management information system for responsibility centres should identify
revenues, costs and investment that are directly attributable to each centre, for
which the centre manager is responsible and that the centre manager is in a
position to control.
Type of responsibility centre Performance information required
Cost centre Controllable costs
Revenue centre (for example, a sales
team)
Sales revenue
Profit centre Controllable costs
Revenues
Profits
Investment centre Controllable costs
Revenues
Profit
Controllable investment
Return on investment
An effective management accounting system must be able to supply the managers
of responsibility centres with the information that they need, in a suitable form and
with sufficient regularity. Managers must be able to use the information to help
them with managing their centre, and taking appropriate control decisions so that
actual performance meets (or exceeds) expectations or target.
Example
The manager of an operating division has received the following report about the
performance of the division for the financial year that has just ended.
Current year Previous year
$ $
Sales 800,000 500,000
Operating costs excluding depreciation
600,000 390,000
Depreciation 200,000 80,000
Interest charges
40,000 20,000
Profit/(loss) (40,000) 10,000
The manager is responsible for operations within the division, but has no control
over decisions relating to capital expenditure or borrowing to finance expenditure.
These decisions are taken by senior executives within the company.
The manager has been asked to explain the deterioration in the performance of the
division in the current year. The manager has replied that as far as he is concerned,
there has been a significant improvement in performance.
What is the most appropriate method of assessing performance?
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Answer
This performance report shows that although sales revenue has increased from
$500,000 to $800,000 compared with the previous year, a $10,000 profit has turned
into a $40,000 loss.
However, the division manager has no control over capital expenditure or
borrowing. The decline in performance may be due to the increase in depreciation
costs and interest charges since the previous year. If so, the decline in performance
might be attributable wholly or partly to the buying and borrowing decisions of
senior management.
A suitable measure of performance for the manager of the operating division might
be operating profit, which is sales revenue minus operating costs. Operating profit
may be referred to as:
profit before interest and tax (PBIT), or possibly
earnings before interest, tax, depreciation and amortisation (EBITDA).
Using this measure of performance, a performance report might be presented as
follows:
Current year Previous year
$ $
Sales 800,000 500,000
Operating costs excluding depreciation
600,000 390,000
Operating profit
–
manager’s responsibility
200,000 110,000
Depreciation 200,000 80,000
Interest charges
40,000 20,000
Profit/(loss) for the division (40,000) 10,000
Operating profit/sales ratio 25% 22%
Growth in annual sales revenue 60%
This shows that sales revenue grew by 60% in the current year (presumably helped
by new investment in non-current assets for the division) and the ratio of operating
profit/sales went up from 22% to 25%. This lends support to the division manager’s
claim that performance has improved.
2.5 Practical difficulties with responsibility accounting
The principle of responsibility accounting is valid. In practice, however, it is often
difficult to apply successfully. The main reason for this is that many costs are only
partially controllable.
A cost centre manager may be in a position to control the efficiency of resource
utilisation (for example, materials usage, wastage rates, machine utilisation and
labour efficiency).
However, the centre manager may not be able to control purchase prices for
materials, the effectiveness of machine repairs by maintenance staff or wage
rates to employees under his or her management.
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There is a risk that managers will be held responsible for costs or other aspects of
poor performance over which they did not have effective control, and so were not in
a position to deal with. For example, a production centre manager may be held
responsible for a fall in production output during a month, when the reason for the
fall was a mistake in the purchasing department which ordered the wrong materials
and so caused a hold-up in production.
If managers are held responsible, within a system of responsibility accounting, for
performance that they were unable to control, the reporting system will create
problems of motivation. If so, the system may well have the opposite effect of what
it was designed to achieve – better performance measurement as a means of giving
managers an incentive to improve performance.
Controllability: long-term and short-term
Another serious limitation of responsibility accounting systems is the short-term
nature of the performance that they measure. Managers are usually held
accountable on a monthly, quarterly or annual basis for costs, revenues or return on
investment. By concentrating on specific aspects of short-term performance, the
reporting system encourages managers to ignore other aspects of performance –
including long-term performance.
When a new manager is appointed to manage a responsibility centre, he will inherit
the ‘legacy’ left by his predecessor. For a considerable time, the short-term
performance of the centre will be affected by decisions made by the previous
manager at some time in the past. As a result, the new manager’s performance will
be judged – praised or criticised – partly on the basis of another manager’s decisions
and efforts.
2.6 Non-financial information performance measurement
A performance management system should measure all critical aspects of
performance. For a number of reasons, an exclusive focus on the financial aspects of
performance is normally insufficient.
Many critical success factors for the longer-term are non-financial in nature, and
may relate to issues such as meeting customer needs and innovation.
Intangible assets such as customer goodwill, know-how and intellectual capital
are often essential elements of long-term business success, and financial
measurement systems do not record data about these aspects of performance.
Financial measurements are usually measurements of historical performance.
However, expectations of future financial performance are probably more
important, and performance measurement systems ought to include an element
of future projections.
An exclusive focus on financial performance will often lead to a focus on short-
term performance, to the exclusion of longer-term considerations. Long-term
profit may be sacrificed in order to achieve short-term targets, especially if the
achievement of annual financial targets is used as a basis for the payment of
bonuses. Management may be encouraged to adopt a narrow focus, instead of
considering a wider range of factors that are essential to success.
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Performance should be assessed within the context of the business environment
and competitive environment in which an entity operates. An exclusive focus on
financial aspects of performance is insufficient. Information for the assessment of
performance should come from sources outside the entity as well as from
internal sources (so that comparisons can be made), whereas a financial focus
concentrates on sources of information from within the entity.
Business scorecard approach: focussing on more than one critical aspect of
performance
Some business organisations use a ‘balanced scorecard’ approach to setting
planning targets and measuring performance. The main target is a financial
performance target, but it is also recognised that non-financial performance is also
vitally important for long-term financial success. In a balanced scorecard approach,
targets and performance measurements are therefore established for:
a financial perspective
an internal business perspective
a customer perspective, and
an innovation and learning perspective.
The balanced scorecard approach is described in more detail in a later chapter.
Non-financial performance measurements might also focus on customer
satisfaction, and whether the products or services sold by the organisation meet
customer needs in terms of:
product quality
reliability of service
speed of service or delivery
selling price.
It is also possible to measure performance in terms of ‘value added’, which is the
value of the additional benefits achieved, less the cost of creating these extra
benefits.
Non-financial performance measurements will also be considered in more detail
later.
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Sources of information
Control system theory
Feedback control system
Feed-forward and double loop feedback
Using control system theory
Information from internal sources
Information from external sources
Organising a system for providing external information
Limitations of external information
3 Sources of information
Performance measurement systems, both for planning and for monitoring actual
performance, rely on the provision of relevant, reliable and timely information.
Information comes from both inside and outside the organisation.
Traditionally, management accounting systems have been an information system
providing financial information to managers from sources within the organisation.
In large organisations, management accounting information might be extracted
from a cost accounting system, which records and analyses costs.
With the development of IT systems, management information systems have
become more sophisticated, using large databases to hold data, from external
sources as well as internal sources. Both financial and non-financial data are held
and analysed. The analysis of data has also become more sophisticated, particularly
through the use of spreadsheets and other models for planning and cost analysis
(for example, activity based costing).
3.1 Control system theory
Control system theory can be used to analyse information systems for planning,
measuring performance and control. It is sometimes used to analyse a budgetary
control system, but its general principles are relevant to any systems of planning
and control, or systems of performance measurement.
An information system is a form of control system. It is used to establish planning
targets, and to compare actual performance against targets. When actual
performance is below target, control measures can be taken to improve performance
and bring it up to the target level.
Open systems and closed systems
In control system theory, systems are either open or closed.
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An open system is one that interacts with its environment. It is affected by its
environment, and accepts input from its environment. The system also produces
output that goes into its environment.
A closed system is one that does not interact with its environment. It is ‘shut off’
from its environment, and does not accept any input from the environment.
A business entity, for example is an open system. It interacts with its environment
and is influenced by conditions in the environment. It accepts inputs from the
environment (materials from suppliers, capital from investors, labour) and it
produces output that affects its environment.
The distinction between open and closed systems might seem odd. However, there
is some relevance in the context of management information systems and
management accounting.
A management information system that does not take in data from its
environment can be described as a closed system.
In contrast, a management information system that obtains data from external as
well as internal sources can be described as an open system.
Ideally, management accounting systems should obtain data from external as well
as internal sources. In practice, they might rely on data from internal sources, and
exclude external sources of data.
3.2 Feedback control system
Using control system terminology, a control system might be described as a
feedback control system. For a control system based on feedback, the basic concept
of control system theory is as follows:
1 Aplanortargetisestablished.
2 A manager responsible for the plan or target puts the plan into action, and
commitsresourcestooperations
3 Thereisoutputfromth eprocess.Thingshappenasaresultoftheoperations
thattakeplace.Forexample,outputmightbeproducedandsold.
4 Theoutput(performance)shouldbemeasured.
5 Thesemeas
uresofactualperformancearefedbacktothemanagerconcerned,
ascontrolinformation.(Thisinformationiscalled‘feedback’.)
6 The manager compares actual performance with the target. Where
appropriate,controlactionistakentoimproveperformanceinthefuture.
A feedback
control system consists of several inter-related elements. These are
shown in the diagram below.