ACCA - P5 Study text - Emile Woolf INT - 2010
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Chapter 12: Performance measurement systems
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System
A system can be any operation or activity. It can be an entire business entity. A
system can be anything that is subject to planning and control. In this diagram, the
control information is measure output from the system itself. In this sense it is a
closed system
Inputs
Every system has inputs. In a business operation, inputs include resources –
materials, equipment, labour and cash. Inputs are used within a system to produce
outputs. Some inputs are controllable by management. Other inputs are not
controllable, and may be subject to influence from environmental factors.
For example, raw material prices are inputs to a production system. Materials prices
might be controllable to some extent, by efficient purchasing. However, materials
prices are often outside the control of management, and are affected by
environmental factors such as inflation rates and materials supply shortages.
Outputs
Every system produces outputs. Some outputs are planned. For example, outputs
from a business operation include the volume of production and sales. Some
outputs can be quantified; others are more difficult to quantify. For example, the
outputs from a business operation include the morale and satisfaction of the
workforce, and customer satisfaction.
Sensor
Outputs from a system are measured. However, not all outputs are measured.
Outputs are measured only if:
they are measurable and
if the control system has a procedure for measuring them.
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For example, in the case of a business operation, measured outputs will include
sales, costs and profit. Other measured outputs might include the efficiency of
resource utilisation and capacity utilisation. Outputs that might or might not be
measured include customer satisfaction, the quality of output and employee
satisfaction. Management can decide what measurable outputs should be measured
and fed back as information for the purpose of performance assessment.
Feedback
Feedback is measured information that is reported back to management for control
purposes.
Comparator
A comparator compares measured outputs (feedback) with a target, plan or
standard. Performance has to be measured against expected performance or target
performance, to assess whether it is satisfactory. Where actual performance differs
from the plan, it may be necessary to amend the plan or change the target.
However, the comparison of actual performance with plan might suggest that action
can be taken to improve future performance.
Effector
Control action is taken through an effector mechanism. An effector makes
adjustments to the inputs to the system, so that future outputs will be changed.
An effector might take the form of management instructions to employees. For
example, the quality of output is low and the rate of rejected units in a production
process might be too high. On receiving feedback about the low quality of work,
management might try to take measures to improve the situation – by employing
more people in the work and instructing them to take more time and more care over
their work.
It is important to recognise, however, that the effectors in a control system can only
apply to controllable inputs to the system. Uncontrollable inputs, and inputs that
are subject to environmental influence, cannot be controlled.
3.3 Feed-forward and double loop feedback
Strategic planning and control information is often:
feed-forward control information, or
double-loop feedback information.
Feed-forward
Feed-forward control information is forward-looking control information. It
compares:
the target performance and
the latest forecast of what actual performance will be.
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For example, the directors of a retail store company might obtain control
information in September comparing the targeted sales for the company for the year
to 31st December, and the latest forecast of what sales for the year will be. If the
forecast is below the target, the directors will study the difference (the ‘gap’)
between target and current forecast, and consider measures to close the gap.
A feed-forward system of control information is an alternative to a feedback system.
In management accounting, feedback systems are often associated with budgetary
control. Feed-forward systems are associated with decentralised decision-making,
and techniques such as continuous budgeting.
Double-loop feedback
Feedback is control information reported to the manager responsible, comparing
actual performance in a period with the target or budget for that period. In other
words, feedback compares actual results with a plan for the benefit of the manager
directly responsible for control. Double-loop feedback is control information
comparing actual results with the plan that is reported to a higher level of
management. Senior managers can use double-loop feedback to:
assess the performance of the managers responsible and
where appropriate, consider making changes to the budget or plan.
3.4 Using control system theory
Control system theory can be useful in providing a framework for the analysis of
control systems and performance measurement systems. Each aspect of a control
system can be reviewed, to decide whether it is appropriate or sufficient. For
example, it provides a framework for asking questions such as:
Are the targets or plans for the system suitable? Should there be different targets
or more targets for achievement?
Does the information system currently measure enough, or should it be
measuring other outputs from the system. Are the sensors used to measure the
outputs adequate? Is the feedback provided in an appropriate form?
Is the feedback being sent to the most appropriate individuals?
Are the effectors appropriate? Is enough control action being taken? To what
extent is management able to control the inputs to the system?
3.5 Information from internal sources
A control system such as a management accounting system must obtain data from
within the organisation (from internal sources) for the purposes of planning and
control. The system should be designed so that it captures and measures all the data
required for providing management with the information they need.
It is useful to remember the essential qualities of good information.
It should be relevant to the needs of management. Information must help
management to make decisions. Information that is not relevant to any decision-
making (such as planning and control decisions) is of no value. An important
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factor in the design of information systems should be the purpose of the
information. What decisions should be made, and what information will be
needed to make those decisions.
It should be reliable. This means that the data should be sufficiently accurate for
its purpose. It should also be complete.
It should be available in a timely manner. In other words, it should be available
for when it is needed by management.
The cost of providing the information should not exceed the benefits that it
provides. The key factor that limits the potential size of many information
systems is that the cost of obtaining additional information is not justified by the
additional benefits that the information will provide.
In designing a performance measurement system, and deciding what information is
required from internal sources, these desirable qualities of good information should
influence the design of the system.
Traditionally, management accounting systems have obtained internal data from
the cost accounting system and costing records. In many organisations, IT systems
now integrate costing data with other operational data. This means that data is
available to the management accounting system from non-accounting sources.
Example
An information system might be required to provide information about the
profitability of different types of customer.
The starting point for the design of this information system is the purpose of the
information. Why is information about customer profitability needed? The answer
might be that the company wants to know which of its customers contribute the
most profits, and whether some customers are unprofitable. If some customers are
unprofitable, the company will presumably consider ways of improving
profitability (for example, by increasing prices charged to those customers) or will
decide to stop selling to those customers.
The next consideration is: What data is needed to measure customer profitability?
The answer might be that customers should first be divided into different
categories, and each category of customer should have certain unique
characteristics. Having established categories of customer, information is needed
about costs that are directly attributable to each category of customers. This might
be information relating to gross profits from sales, minus the directly attributable
selling and distribution costs (and any directly attributable administration costs and
financing costs).
Having established what information is required, the next step is to decide how the
information should be ‘captured’ and measured. In this example, a system is needed
for measuring each category of customer, sales revenues, costs of sales and other
directly attributable costs.
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The information should be available for when management intend to review
customer profitability. This might be every three months, six months or even
annually.
3.6 Information from external sources
Managers need information about customers, competitors and other elements in
their business environment. The management information system must be able to
provide this in the form that managers need, and at the time that they need it.
External information is needed for strategic planning and control. However, it is
also often needed for tactical and operational management decisions.
Examples of the external information needed by companies are set out in the table
below.
Information area Examples of information needed
Customers
What are the needs and expectations of customers in the
market?
Are these needs and expectations changing?
What is the potential for our products or services to meet
these needs, or to meet them better?
Competitors
Who are they?
What are they doing?
Can we copy some of their ideas?
How large are they, and what is their market share?
How profitable are they?
What is their pricing policy?
Legal environment
What are the regulations and laws that must be complied
with?
Suppliers
What suppliers are there for key products or services?
What is the quality of their products or services?
What is the potential of new suppliers?
What is the financial viability of each supplier?
Political/
environmental
issues
Are there any relevant political developments or
developments relating to environmental regulation or
environmental conditions?
Economic/
financial
environment
What is happening to interest rates?
What is happening to exchange rates?
What is happening in other financial markets?
What is the predicted state of the economy
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Sources of external information
Sources of external information, some accessible through the Internet, include:
market research
supplier price lists and brochures
trade journals
newspapers and other media
government reports and statistics
reports published by other organisations, such as trade bodies.
3.7 Organising a system for providing external information
If managers are to be provided with external information by a management
information system (MIS), the system must be designed so that it is capable of
providing it:
There has to be a system of data capture. How should information be obtained
from the environment and filed within the MIS? How should the data be held
within the MIS?
How should the information be provided to managers? Should it be e-mailed to
them? Or should managers be expected to search for the information in the MIS
when they need it?
Should the external information be processed into a usable form for managers
when it is captured, or should it be supplied to managers as ‘raw unprocessed
data’?
The external information should be divided into strategic information and
operational information. Which managers should be provided with the strategic
information, and which ones need the operational information?
3.8 Limitations of external information
It is important to recognise the limitations of external information.
It might not be accurate, and it might be difficult to assess how accurate it is.
It might be incomplete.
It might provide either too much or not enough detail.
It might be difficult to obtain information in the form that is ideally required.
It might not always be available when required.
It might be difficult to find.
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Recording and processing methods. Management reports
Recording data
Processing methods
Management reports
4 Recording and processing methods. Management
reports
4.1 Recording data
There are many different ways of ‘capturing’ data, and recording it in an
information system. Methods of recording data will depend on circumstances, and
also on the nature of the data required. For example:
Records of labour time spent on particular tasks or jobs might be recorded on
time sheets or job sheets.
Records of materials used might be recorded in materials requisition notes.
Data about customer satisfaction might be captured as records of customer
complaints. Alternatively, data might be obtained from market research surveys.
The system of recording data should be made as convenient as possible for the
individuals responsible for input of the data to the information system. Where
possible, the information system should be designed to minimise the risk of errors.
Data should also be recorded in a form that will allow it to be processed. As a
simple example, suppose that records of labour costs should provide for an analysis
of these costs into production costs, administration costs and sales and distribution
costs. The data about labour costs will have to be recorded in a way that will enable
the costs to be divided into their different categories.
4.2 Processing methods
Performance measurement systems should be designed so that data can be
processed in a way that meets the requirements of management. There are various
ways of processing data, and IT systems enable managers to obtain large amounts
of information for different purposes.
Data might be needed for planning or forecasting. Many managers use
spreadsheet models and other forecasting models.
Accountancy software packages, including management accounting packages or
modules, can be used to process accounting data.
Data might be used to prepare regular, formal management reports.
Alternatively, managers might want to obtain ‘ad hoc’ reports on demand.
E-mail allows managers to communicate information quickly between each other.
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4.3 Management reports
Entities are able to produce large amounts of information, in formal reports or on
demand. This raises problems of control and security.
There should be controls to ensure that reports are distributed only to individuals
who are authorised to receive it. Much information is confidential, and access to it
should be restricted.
There should be distribution lists for routine reports, and a copy of the report
should be available only to the individuals in the list.
Access to online data files can be restricted by a system of identity codes and
passwords.
IT systems should have safeguards against unauthorised access by external
users. For example, intranet systems should include firewalls (hardware and
software). There should be physical controls over unauthorised access to
computers and computer terminals (such as making sure that office doors are
locked when the manager is away from his desk).
There should be established procedures for preventing unauthorised access to
confidential data. Managers should be required to keep all confidential
information in a secure place. There should be restrictions over the type of
information that can be sent by e-mail.
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Paper P5
Advanced performance management
CHAPTER
13
Measuring performance
Contents
1 Performance hierarchy
2 Financial performance in the private sector
3 Non-financial performance indicators (NFPIs)
4 Performance measurement in not-for-profit
organisations
5 Behavioural aspects of performance reporting:
reward systems
6 Customer profitability
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Performance hierarchy
Agency theory
The nature of the performance hierarchy
Mission statement
Corporate vision
High-level corporate objectives and strategic objectives
Critical success factors (CSFs) and key performance indicators (KPIs)
The planning gap
The characteristics of operational performance
Accountability
Hard accountability and soft accountability
1 Performance hierarchy
1.1 Agency theory
Agency theory is associated with the work of Jensen and Meckling in the 1970s. The
theory considers the separation of ownership in business from its management. The
shareholders are the owners of a company and in a large company the shareholders
are not executive managers. Management is performed by professionals, who are
supposed to act as representatives of the shareholders.
It is therefore possible to describe the shareholders of a company as principals, who
use agents (management) to act on their behalf and in their interests. A similar
situation applies to not for-profit entities. For example, the management of a
government-owned hospital can be described as agents who work on behalf of the
hospital’s owners (the government or the general public) or the representatives of
the owners (say, the hospital’s board of governors).
For the purpose of the P5 examination, agency theory may be summarised briefly as
follows.
There is a conflict of interests between the principals of an entity and their
agents. The principals have their own objectives which they want the entity to
achieve. In a company, the shareholders may want to maximise their return on
investment, and invest in a company whose ‘mission’ they support.
Management on the other hand have personal interests to which they give
priority, such as remuneration and other rewards. The conflict of interests is
always at the heart of the principal-agent relationship.
Conflicts of interest are evident in a number of different ways.
- As a general rule, professional managers work less hard than they would do if
they were owners of the company. The result could be lower sales growth and
lower profits.