ACCA - P5 Study text - Emile Woolf INT

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Chapter 13: Measuring performance

- Where remuneration is linked to the size of the company rather than its

profits, managers have an incentive to grow the business even if this means

lower profitability. Managers are more likely to want to reinvest profits in

growth rather than to see profits paid out to shareholders as dividends.

- Time horizon. Managers may be more concerned about short-term

performance rather than the longer term, because their future (pay and

promotion) is often linked to short-term performance. Long-term shareholders

are more interested in the longer term.

- Moral hazard. Senior managers are often interested in ‘perks’ that go with the

job, such as a company car or company plane, a company flat, status and so

on. Their interest in these aspects of their job is greater when they do not have

a substantial shareholding in the company.

When there is a principal-agency relationship, the problem is how to minimise the

agency problem for the minimum cost. ‘Agency costs’ consist of three elements:

 Monitoring costs. Principals need to establish systems for monitoring the

performance of their agents. For example, shareholders require the directors of a

company to prepare an annual report and accounts, so that the directors can be

held to account for their stewardship of the company. To improve the reliability

of financial statements, external auditors are appointed report to the

shareholders about whether the financial statements give a true and fair view.

Monitoring costs can be substantial, because performance reporting systems

need to apply throughout the management hierarchy.

 Bonding costs. The principals may try to bring the interests of their agents more

into line with their own interests, by offering incentives based on performance

and achievements. Remuneration schemes offering incentives to senior

management are examples of bonding costs.

 Residual loss. Monitoring systems and bonding schemes will not avoid some

agency costs. For example, management may decide to pursue an expensive

acquisition in order to grow the company and achieve a ‘strategic objective’.

However the acquisition may be over-priced and may lose value for the

company’s owners.

Performance measurement systems and reward systems are therefore linked to

agency theory.

For the purpose of the exam, agency theory may be summarised as follows:

 In large companies there is a separation of ownership from control, and this

creates an agency-principal relationship between the professional managers and

the shareholders. A similar separation of ownership from control occurs in large

not-for-profit entities.

 Individuals are driven by self-interest and this leads to conflicts of interest

between owners and managers. Managers of a company cannot be relied on to

act in the best interests of the shareholders.

 This problem creates costs for the owners, and these costs should be minimised

if possible.

 The potential costs (from ‘residual loss’) can be minimised partly through

monitoring systems (performance measurement systems and accountability) and

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reward/incentive schemes, but monitoring systems and reward systems create

additional costs.

1.2 The nature of the performance hierarchy

The targets for managers throughout an organisation should be consistent with each

other. All managers and employees should be working towards the same goals.

Consistency in setting performance targets can be achieved through a performance

hierarchy, linking the goals of the most senior management with the targets for

operational managers.

 At the top of the hierarchy, an organisation might have a mission statement.

 The mission statement provides a framework for setting strategic objectives, and

for strategic planning.

 Within the framework of a strategic plan, management at the ‘tactical’ level can

prepare plans, such as annual budgets, capital expenditure budgets and

marketing plans.

 Within the framework of tactical plans, operational managers can prepare

operating plans and set operating targets.

Agency theory and the performance hierarchy

This chapter is concerned with the measurement of performance, and accountability

for performance, throughout a business entity or a not-for-profit entity. It may be

useful to consider performance monitoring systems in the context of agency theory.

One way in which the principals try to ensure that the agents are working in their

interests is to make the agents accountable. The agent must be required to give an

account of performance to the principal, and the principal must be able to hold the

agent to account. To make the agents accountable, there should be a reporting

system in which the agents report on those aspects of operations for which they are

responsible and in a position to control. Reporting systems should apply

throughout the management hierarchy and the ‘agents’ at each level in the

hierarchy should be held accountable for their performance.

Within a company, there is a hierarchy of performance evaluation and

accountability.

 Junior managers are accountable to senior managers, and their performance is

measured and evaluated.

 Performance is also measured and evaluated in relation to time: short-term and

long-term performance should be measured.

 Performance should be measured and evaluated at strategic, tactical and

operational levels.

A question in a past P5 examination, for example, asked about the application of

agency theory to lecturers in a university. The theme of the question was that

lecturers can be seen as agents of the university’s principals who should be held

accountable for their performance. A problem with the application of agency theory

Chapter 13: Measuring performance

to not-for-profit entities, however, is that there may be several different groups of

‘principals’. In the example of a university, the principals may be the government

that owns it. Alternatively, the principals may be seen as either the general public

(as the taxpayer and voters) or the students who receive their education at the

university.

1.3 Mission statement

Some organisations have a formal mission statement. The purpose of a mission

statement is to provide a clear expression of the reason why the organisation is in

existence and what it is seeking to achieve.

The content of mission statements varies between different organisations, but

common elements are:

 a statement of the purpose of the organisation

 a statement of its broad strategy for achieving its purpose

 a statement of the values and culture of the organisation.

The purpose of the organisation is usually expressed in terms of its business

purpose, rather than its financial objectives (such as maximising the wealth of its

shareholders). For example, the purpose of a company in the entertainment industry

might be to provide audio-visual entertainment products to customers throughout

the world.

The mission statement might also include a statement of the strategy for achieving

the purpose. For example, the mission statement of company in the entertainment

industry might include a strategy of providing audio-visual entertainment in all

forms and through all media channels.

In contrast, the mission statement of another company in the entertainment industry

might be to produce films for purposes of public entertainment and also education

and training.

The usefulness of a mission statement

A mission statement can have several useful purposes.

 It provides a guide to employees (and other stakeholders such as customers and

suppliers) about what the organisation is in existence to achieve. It may help

employees to identify more readily with their employer.

 More significantly, it can help managers to formulate their business strategy.

Business strategies should be consistent with the mission of the organisation.

Managers should consider new strategies in the context of whether it is

consistent with the organisation’s purpose.

 The mission statement can therefore be used as a screening device, for rejecting

strategies that are inconsistent with the mission of the organisation. For example,

suppose that the mission statement of a company in the entertainment industry

is to produce films for purposes of public entertainment and also education and

training. A proposed strategy to develop a chain of cinemas would be

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inconsistent with this mission, and either the strategy should be rejected or the

mission statement should be amended.

 The mission statement can also be used to establish a corporate culture, such as a

culture of encouraging all employees to develop to their full potential, or a

culture of acting ethically in all dealings with customers and suppliers.

Limitations of mission statements

Mission statements can be of limited practical value, however, especially when they

are worded in vague language that lacks real substance.

When the actual behaviour of an organisation contradicts what is said in its mission

statement, the mission statement may be regarded as cynical and insincere. For

example, a pharmaceuticals company might include in its mission statement the

objective of promoting the improvement in the health of all people throughout the

world. Its management might decide not to allow one of its drugs to be used to

combat a serious epidemic in a developing country, because the country is unable to

afford to pay for the drug. The actual decision of the company would be

inconsistent with its mission statement, making a mockery of the mission statement.

Mission statements do not have a time scale for achievement. Strategies are needed

to establish specific targets and time scales for achievement.

Mission statements may therefore be useful for formulating strategies, but they are

of limited value for monitoring actual performance.

1.4 Corporate vision

Corporate vision is how a company sees itself, and how it wants to be seen by

others, such as its customers, its employees and its shareholders. A corporate vision

statement may set out the future direction that the company will take, and what it

expects to achieve within the next few years. ‘The vision process translates core

values into actions and enables companies to design a desired future rather than

simply letting fate happen’ (PricewaterhouseCoopers).

Ideally a corporate vision:

 should be realistic, and not ‘wishful thinking’.

 should be ‘emotional’, so that it can attract employees, customers and investors

to the company

 should indicate a sense of direction, and what the company wants to achieve.

A corporate vision statement can be used instead of, or in addition to, a mission

statement.

Examples

It might be useful to look at a few corporate vision statements, selected at random

from the internet.

Chapter 13: Measuring performance

Translink, a transport company: ‘To provide a transformed network of co-ordinated

bus and rail services which attracts a growing number of passengers, enjoys public

confidence and is recognised for its quality and innovation.’

Hitachi Chemical Company. ‘Our vision is to contribute to society through the

development of superior technologies and products. By combining and adapting

our wide ranging advanced material and processing technologies, Hitachi Chemical

aims to provide superior technologies, products and services that contribute to the

betterment of human life and society.’

Colt Engineering. ‘The corporate vision of the Colt companies is our primary

objective and the overriding focus of Colt’s activities: Being North America’s

contractor of choice for clients and staff.’

Tylö AB, manufacturer of bathroom equipment. ‘To be perceived as the global

market leader with the most inspiring, innovative bath, shower and sauna

environments.’

1.5 High-level corporate objectives and strategic objectives

An organisation should have high level ‘corporate’ objectives that are consistent

with its mission. For companies, the highest corporate objective is likely to be the

aim of providing benefits to their shareholders. This objective may be expressed in

general terms as ‘maximising the wealth of shareholders over the long term’.

There may be social or ethical constraints or obligations that will be taken into

consideration in the pursuit of the corporate objective. For example, companies may

recognise the need to act in an ethical manner and in accordance with an ethical

code of conduct. Some companies may recognise obligations for the protection of

the environment. Others may recognise an obligation towards employees as well as

shareholders.

High-level corporate objectives must be converted into more specific plans or

strategies, each with its own strategic goal. Strategic objectives are high-level goals,

usually with a long-term time horizon. Achieving the strategic goals should mean

that the corporate objective will also be achieved.

There may be a hierarchy of strategies and strategic objectives. For example:

 There may be a financial objective to achieve targets for growth in profitability,

return on capital and shareholder wealth over a strategic planning period.

 A company should develop strategies for achieving financial success in a

competitive market. This calls for competitive strategies on how to position the

business in its markets. There may be a strategy for growth in the business,

through internal development or through mergers and acquisitions.

 Strategies may be developed for marketing (meeting customer needs), product

innovation and funding/capital expenditure and investment to enable the

company to achieve the financial objective and objectives for competitive

strategy.

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 Strategies may be developed for other aspects of the business, such as IT

systems, human resource planning and the use of new technology. These would

be designed to support the marketing, innovation and finance strategies.

As indicated earlier, strategic objectives should create a framework for subsidiary

objectives, and for tactical and operational planning.

1.6 Critical success factors (CSFs) and key performance indicators (KPIs)

Critical success factors are factors that are critical to the success of an organisation

and the achievement of its overall objectives. They are the key areas where targeted

performance must be achieved. Failure to meet targets for any CSF will mean failure

to achieve long-term targets and objectives. CSFs are therefore vitally important and

an organisation cannot afford to fail in any of these areas.

At a strategic level, there are usually just a small number of CSFs. They might be

expressed in terms of:

 profitability

 market share

 product leadership

 development of human resources

 achieving a balance between long-term and short-term goals.

There may be other CSFs, depending on the nature of the company and its business.

For example, other CSFs may be quality standards, capacity utilisation, the rate of

innovation, and so on.

For each critical success factor, there should be a measure of performance. These

performance measures might be called key performance indicators or KPIs. A

target should be set for each KPI and actual performance can be measured against

the target.

For your examination, you may be asked to suggest what the CSFs or KPIs for a

particular entity may be, given information provided in the question. It is worth

spending time thinking about what you would consider to be the essential

ingredients of success for particular types of business – for example an oil company,

a bank, a television company, a commercial property company, a car manufacturer

and so on.

1.7 The planning gap

The concept of the planning gap can be useful for formulating strategies and other

plans. The planning gap and gap analysis was described in the earlier chapter

introducing strategic management accounting.

A planning gap is the difference between:

 the target or objective that an organisation would like to achieve and

Chapter 13: Measuring performance

 the forecast or expectation of what the actual achievement will be (on the

assumption that there are no new initiatives to improve performance).

Normally, and particularly when objectives are challenging and ambitious, there

will be a large gap between what an organisation wants to achieve and what it

currently expects to achieve.

Having identified the planning gap over the planning period, management should

then consider strategies, and then more detailed tactical and operational plans, for

closing the gap. The planning gap may be closed either by:

 developing strategies for improving performance, or

 if new strategies will not be sufficient to close the gap, lowering the target.

1.8 The characteristics of operational performance

Although the main corporate objective may be expressed in financial terms,

operational performance should be measured by a combination of financial and

non-financial measures.

Performance measurement at an operational level also normally focuses more on

providing information about actual performance for control purposes. Compared

with strategic performance information, there is less emphasis on planning

information at the operational level.

Performance targets should also be set for both the long-term and the short-term.

The strategic aim should be directed towards long-term goals, but the long-term

goals will not be achieved unless intermediate shorter-term goals are also achieved.

Each organisation should therefore develop its own hierarchy of financial and non-

financial objectives, linked through the performance hierarchy and between the

short-term and long-term.

1.9 Accountability

Accountability involves:

 a manager or other individual having to give an account of performance to his or

her boss (or ‘principal’), and

 the boss (or ‘principal’) holding that individual to account.

Accountancy has an important role in systems of accountability, but not an

exclusive role. Control systems and performance reporting systems use a range of

both financial and non-financial quantitative methods and also qualitative methods

for making individuals accountable for their performance. New systems of

accountability have been developed over recent years, such as activity based costing

systems and total Quality Management (TQM) systems.

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1.10 Hard accountability and soft accountability

Systems of accountability based on accounting may require a combination of both

hard accountability and soft accountability.

 Hard accountability means accountability to another person for performance, in

the form of financial reports and other quantitative performance measurements.

 Soft accountability is self-accountability. An individual might be personally

motivated to achieve performance targets, and will judge his or her own

personal performance in relation to those targets. With soft accountability,

control from above by senior management is not required.

Hard accountability requires methods for measuring and reporting actual

performance, using quantitative measures, and comparing actual performance

against the target. A system of hard accountability needs three elements.

 Counting. This means that there must be quantitative aspects of performance

that are capable of being counted and measured. There are different costing

systems for recording and measuring performance, such as standard costing and

variance reporting systems, profit centre reporting systems, activity-based

costing systems, quality cost systems and so on. Quantitative measures may be

non-financial as well as (or instead of) financial measures.

 Accounting for the numbers. This means finding the reasons for the numbers

that were achieved. If performance is accounted for, it is then possible to ask

questions about why or how those figures occurred. For example, why were

actual product costs higher than budgeted or higher than standard cost? Why

did the profit centre report a fall in profit compare dwith the previous year?

 Accountability for the events and circumstances that led to the numbers. The

third aspect of hard accountability is to make individuals accountable for their

contribution to the events or circumstances that have led to the performance

level that has been achieved. For example if there has been a very high adverse

material price variance, the purchasing manager may be asked to explain the

poor performance. If capacity utilisation of machinery is below budget, the

production manager may be asked to explain reasons for poor production

scheduling, or the sales manager may be asked to explain a failure to achieve the

budgeted level of sales demand for production output.

Chapter 13: Measuring performance

Financial performance in the private sector

 The primary performance objective

 Differing primary measures of financial performance

 Other financial measures of performance

 Short-run and long-run financial performance

 Setting financial targets: methods

 Making comparisons of financial performance

2 Financial performance in the private sector

2.1 The primary performance objective

For companies, the primary performance objective should be concerned with the

benefits of their owners, the shareholders. The aim should be to provide benefits to

shareholders over the long term, in the form of dividends from profits and share

price growth.

Share price growth comes mainly from growth in the business and earnings per

share. However, growth should not be achieved if it exposes the company to

excessive risks. The primary objective of financial performance targets should

therefore be consistent with the long-term objectives of both:

 business growth and

 survival

2.2 Differing primary measures of financial performance

There are several measures of financial performance that could be used to assess

success in achieving corporate objectives.

 It is inappropriate to use targets for share price growth and dividend growth as

formal planning targets and measures of actual performance. Share prices can be

volatile, and affected by stock market conditions outside the control of a

company’s management. Dividend policy, on the other hand, is under the

control of the board of directors, but can be manipulated. Dividend payments do

not have to move in line with changes in profitability or longer-term financial

expectations of profit.

 It is therefore more appropriate to measure financial performance in terms of

conditions that should lead to share price growth and dividend growth in the

future.

Discounted cash flow measures of performance

Discounted cash flow is used to assess the value of proposed capital expenditure

projects. (It can also be used to assess the value of companies and their shares.) In

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theory, if a company uses an appropriate cost of capital as the discount rate, projects

that are expected to have a positive net present value (NPV) should add to the value

of the company and its shares. Similarly, projects will add to the company’s value if

they are expected to have an internal rate of return (IRR) in excess of the company’s

cost of capital.

NPV and IRR are therefore used to assess the value of capital expenditure

proposals.

However, although discounted cash flow techniques can be applied to evaluate

forecasts of future cash flows from capital projects, they are not practical methods

for analysing historical performance. This is because management accounting

systems are not designed to identify specific cash flows arising from capital projects,

and some relevant cash flows in DCF analysis, such as opportunity costs, would

also be difficult to measure.

Financial measures of historical performance

Financial measures used to measure historical performance, and assess whether a

company appears to be achieving its corporate objectives, may be:

 return on capital employed (ROCE)

 earnings per share and growth in earnings per share

 earnings before interest, tax, depreciation and amortisation (EBITDA)

 for investment centres, return on investment or residual income

None of these performance measures is ideal for assessing performance and

progress towards achieving the corporate objective.

 Return on capital employed (ROCE) is a useful measure of performance,

because it relates the amount of profit earned to the amount of capital employed

in the business. However, the measurement of ROCE depends on accounting

conventions for the measurement of profit and capital employed.

 Earnings per share growth is also commonly used to assess performance. On the

assumption that in the long term, the ratio of the share price to EPS (the

price/earnings ratio or P/E ratio) remains fairly constant, growth in EPS should

result in a higher share price. However, the P/E ratio does not necessarily

remain constant over the long term, and could change if the perception of

investment risk in the company changed.

 EBITDA (= Earnings before interest tax depreciation and amortisation). EBITDA

is a useful measure of performance only if it is assumed that management have

no control over interest costs or depreciation and amortisation charges. This may

be true for profit centre management, but is unlikely to be the case when

managers have control over investment and financing decisions. EBITDA is a

useful approximation of cash flow from operations before interest and tax, and

can be a useful measurement of financial performance for this reason. (Note: If

you are not sure about this, think about the calculation of operational cash flows

in a statement of cash flows, using the indirect method.)

 The benefits and limitations of ROI and residual income are considered in the

next chapter.

ACCA - P5 Study text - Emile Woolf INT - 2010

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