ACCA - P5 Study text - Emile Woolf INT

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Chapter 18: Developments in management accounting and performance management

 environmental-related costs: these are costs that are attributable to cost centres

involved in environmental-related activities, such as an incinerator or a waste

recycling plant

 environmental-driven costs: these are overhead costs resulting from

environment-related factors, such as higher costs of labour or depreciation.

The cost drivers for environment-related costs may be:

 the volume of emissions or waste

 the toxicity of emissions or waste

 ‘environmental impact added’ (units multiplied by environmental impact per

unit)

 the volume of emissions or waste treated.

Environmental life cycle costing

Life cycle costing is a method of costing that looks at the costs of a product over its

entire life cycle. Life cycle costing can help a company to establish how costs are

likely to change as a product goes through the stages of its life (introduction,

growth, maturity, decline and withdrawal from the market). This analysis of costs

should include environmental costs.

Xerox provides a good example of the environmental aspect of life cycle costing.

Xerox manufactures photocopiers, which it leases rather than sells. At the end of a

lease period, the photocopiers are returned from the customer to Xerox. At one time,

photocopiers were delivered to customers in packaging that could not be re-used for

sending the machines back at the end of the lease period. Customers disposed of the

old packaging and had to provide their own new packaging to return the machines

to Xerox. Xerox then disposed of this packaging. The company therefore incurred

two costs: the cost of packaging to deliver machines and the cost of disposal of the

packaging for returned machines.

By looking at the costs of photocopiers over their full life cycle, Xerox found that

money could be saved by manufacturing standard re-usable packaging. The same

packaging could be used to deliver and return machines, and could also be re-used.

At the same time, the company created benefits for the environment by reducing

disposals of packaging materials.

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Six Sigma

 Seeking ‘near perfection’

 The basic approach in Six Sigma

 Process improvement and process design

 Process improvement: DMAIC

 New process design or radical improvement: DMADV

6 Six Sigma

6.1 Seeking ‘near perfection’

Six Sigma is an approach to eliminating defects from products and operations, and

achieving near perfection. Although it was originally applied to manufacturing

operations and defects in products, it can also be applied to any product, process or

transaction.

The term ‘Six Sigma’ comes from statistical analysis, but it is now generally accepted

as meaning that there should be no more than 3.4 defects in every 1 million items,

for any product or process to which the Six Sigma methodology is applied. The limit

of 3.4 defects per 1 million items can be seen as a target, and improvements in

existing products and processes and designs of new products and processes should

aim towards this target.

Six Sigma was originated in the US in the 1980s, by Motorola. (Although the term

‘Six Sigma’ is widely used, it is a registered trademark of Motorola.) Modern

technology was becoming more complex, and it was becoming apparent in some

manufacturing industries that old ideas about quality standards and quality control

no longer applied. Unless quality standards could be improved in component

production, for example, the quality of complex end-products would be much lower

than customers had a right to expect. In 1989, having experimented for several years

with its approach to quality by improvements, Motorola announced that within five

years it intended to achieve a defect rate of no more than 3.4 parts per million in its

products.

Examples

A company might establish target specifications for the manufacture of a product,

and products should be manufactured to this exact specification, or within

acceptable tolerance limits. A Six Sigma approach should be to ensure that no more

than 3.4 items per 1 million produced will fail to meet the specification, or will be

manufactured outside the acceptable tolerance limits.

The IT department of a company that writes software for other departments might

set a target for the programs that it writes of no more than 3.4 coding errors per 1

million lines of software code.

Chapter 18: Developments in management accounting and performance management

6.2 The basic approach in Six Sigma

A definition of Six Sigma will help to explain its key features. Six Sigma has been

defined as ‘a data-driven method for achieving near-perfect quality. Six Sigma

analysis can focus on any element of production or service, and has a strong

emphasis on statistical analysis in design, manufacturing and customer-oriented

activities’ (UK Department of Trade and Industry).

The basic objective with Six Sigma is to focus on improvements in processes and a

reduction in variations. Perfection is achieved by reducing the amount of

variations in processes. For example, if a product is designed with a length of

exactly one metre, Six Sigma improvements might be aimed at reducing the

variation in the length of products actually manufactured to acceptable tolerance

limits of, say, plus or minus one millimetre.

The aim of Six Sigma is to improve customer satisfaction. Its approach is to apply a

standard approach (a structured methodology) to reduce and control the causes of

variation in a process, and to focus on reducing the standard deviation of actual

performance from the target specification.

The Six Sigma approach relies heavily on statistical measurements. Actual

performance is measured and compared with the target, and the number of ‘defects’

– products or processes that fail to meet acceptable standards – can be established,

to see whether the required quality standards have been achieved.

Another feature of Six Sigma is that project teams are established to achieve the

required improvements in processes or products. These project teams should consist

of representatives from every department or aspect of operations that might

contribute towards making the required improvements. The projects teams should

be led by individuals who are specially trained in Six Sigma methods, who are

commonly called Master Black Belts, Black Belts and Green Belts, according to their

level of skill and knowledge of Six Sigma.

General Electric Company, another US company that adopted Six Sigma methods,

has stated that Six Sigma is based on the following key concepts:

 ‘Critical to quality’. These are attributes or characteristics of a product or service

that are the most important to customers.

 Defect. This is failing to deliver what the customer wants.

 Process capability. This is the level of quality or performance that a process is

capable of achieving.

 Variation. This refers to variations in quality that the customer can see or feel in

a product or service.

 Stable operations. This means consistent and predictable processes and

operations that improve what customers see and feel.

 Design for Six Sigma. This refers to designing a product or process that meets

customer needs and achieves the level of process capability for doing this.

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6.3 Process improvement and process design

The Six Sigma approach differs slightly between:

 making improvements in existing processes, where the required changes in the

process are fairly small (‘incremental improvements’), and

 the design of a new process, or major re-design of an existing process.

Process improvements

The Six Sigma approach to making incremental improvements in existing processes

is in five steps, known as DMAIC.

 Define an opportunity

 Measure performance

 Analyse the opportunity

 Improve performance

 Control performance.

New process design/process re-design

The Six Sigma approach to designing a new process or the major re-design of an

existing process is also in five steps, known as DMADV.

 Define the goals for the new process

 Match performance requirements with these goals

 Analyse these performance requirements and produce an outline design (a

design, but not in detail) of a new process that will meet these requirements

 Design and implement the process

 Verify performance.

6.4 Process improvement: DMAIC

The five steps in process improvement using the Six Sigma method are explained in

more detail below. You should try to learn the DMAIC approach: it has been

examined in P5 in the past, and may well be examined again.

D = Define

A serious problem with the quality of an existing process is identified.

 A problem statement is then prepared. This describes the nature of the problem,

which must be defined in specific, measurable terms. What is the visible

evidence of the problem? What are the symptoms of the problem? (A ‘symptom’

is something that is going wrong in the process, expressed as a quantified

measurement of output from the process).

 Having defined the problem, a ‘mission statement’ is drawn up, which states

what will be done to deal with the problem. Like the problem statement, the

mission statement should be expressed in specific and quantified terms, using

the same units of measurement that have been used in the problem statement.

Chapter 18: Developments in management accounting and performance management

For example, the problem statement may be that the number of defects in a

particular process is 1 in 1,000. The mission statement may then be that the aim

should be to reduce the number of defects to no more than 1 in 100,000

A project team is set up. This team is given the responsibility and the resources

to solve the problem and make an improvement. It should be a ‘cross-functional’

team consisting of members from all the departments or functions that will be

affected by the project.

M = Measure

The project team should begin with preliminary analysis of the process and the

quality problem. The aim is to obtain a measure of how the process is working and

to gather data that can be studied in order to arrive at a conclusion about what the

problem seems to be. If there appears to be more than one cause to the problem, the

team should concentrate on the factor that appears to be the biggest contributor.

Data is obtained about the current process, and the ‘symptoms’ of the problem are

measured in detail. At this stage in the project, the project team should measure

how the process is working, and obtain data that can be analysed in order to

identify what seems to be causing the problem. Where there are several causes of a

‘symptom’, the project team should concentrate on those problems that are the main

causes.

This is a preliminary analysis. The project team will not make a final decision about

the main causes of the problem until it has carried out a more extensive analysis.

The mission statement should be verified, and if necessary amended.

A = Analyse

The project team should then investigate in greater detail the matter than, on

preliminary analysis, appears to be the cause of the quality problem. The aim is now

to identify what the actual cause of the problem is. Different theories will be

formulated and tested, with a view to confirming or discovering what the main

cause (or causes) of the problem seems to be. Theories that cannot be correct are

rejected. Through this process of testing different theories, the main cause of the

problem is identified.

Different theories are tested, until the project team believes that it has discovered

the main cause (or causes) of the problem.

 The project team formulate different theories about the main causes of the

problem, and documents these theories.

 Each theory is then tested, to establish whether it might be correct. Theories are

rejected when it is decided that they cannot be correct.

 The ‘root’ cause (or causes) of the problem is identified when the testing of the

theories has been completed.

I = Improve

The cause (or causes) of the problem are removed by means of re-designing and

improving the process that is causing the problem.

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 Several different alternative methods of improving the process should be

evaluated, to decide which will be the most effective in achieving the ‘mission

statement’ for the project.

 The chosen improvement is then designed in detail.

 If the improvements are likely to meet resistance to change from some

employees, plans should be developed for overcoming the expected resistance.

 Before the improvement is implemented, it should be tested to prove that it will

be effective.

 The improvement is then implemented.

C = Control

New controls are designed and implemented to prevent the problem from returning

and to make sure that the improvements are sustained.

Controls will include regular measurements of output from the process, and a

comparison of actual performance with the target.

The controls should be audited from time to time, to make sure that they are

effective.

6.5 New process design or radical improvement: DMADV

Sometimes, making improvements in existing processes is not sufficient to achieve

the required quality standard, and a completely different process must be designed.

The five steps in new process design using the Six Sigma method are explained in

more detail below.

 Define. The goals and target quality standards of the new process must be

defined. Customer requirements and expectations should be taken into

consideration when defining these goals.

 Match. The next step is to develop a set of performance measurements

(quantified performance targets) that will enable the goals for the process to be

achieved.

 Analyse. These performance standards for the new process must be analysed.

Based on this analysis, a preliminary design for a new process is developed.

 Design. The preliminary design for the new process is developed into a more

detailed design, and the new process is then implemented.

 Verify. After the new process has been implemented, controls and checks

should be introduced to confirm that the required performance targets are met,

and that the goals of the process are successfully achieved.

Chapter 18: Developments in management accounting and performance management

Performance prism

 Origins of the performance prism

 Five sides to the performance prism

 Stakeholder satisfaction

 Strategies

 Processes and capabilities

 Stakeholder contribution

 Performance prism: a summary

7 Performance prism

7.1 Origins of the performance prism

The performance prism is a model of performance management that has been

developed by the Centre for Performance at Cranfield Business School. It is an

attempt to overcome the limitations of earlier models or frameworks of performance

measurement, such as the balanced scorecard, shareholder value added, activity

based costing and competitive benchmarking.

These other performance management models have a variety of limitations.

 The balanced scorecard is used to set targets on four key areas: financial

performance, the customer, internal processes and innovation and learning. In

doing so, it fails to recognise the potential importance of other stakeholders in

the business, particularly suppliers and employees.

 Shareholder value added also focuses on returns and value for shareholders, and

gives no consideration to any other stakeholders in the business.

 Activity based costing is concerned with analysing business processes, to

identify cost drivers and eliminate activities that fail to add value. This focus on

improving the efficiency of processes ignores the opinions of all stakeholders –

such as shareholders, customers and employees.

 Competitive benchmarking is often used as a ‘one off’ exercise to identify

improvements that can be made in processes, and it is normally used to

introduce short-term improvement measures. It does not provide a long-term

and formal system of performance measurement.

Note: The term ‘stakeholder’ may not be familiar to you. Every company or other

entity has a number of different stakeholders. ‘Stakeholder’ is a term for any

individual, entity or group of similar individuals or entities that has an interest (or

‘stake’) in what the company does. The stakeholder groups for a company include

its shareholders, lenders (banks and bondholders), suppliers, customers, the

government and the general public (or sections of the general public).

P5: Advanced performance management

Each of the performance measurement models listed above looks at a different

aspect of performance and each model can be very useful in particular

circumstances. However, none of them provide a performance measurement

framework that considers all aspects of performance and the full significance of all

stakeholders. The performance prism has been developed as a framework for

performance measurement that considers all aspects of performance and all

significant stakeholders.

7.2 Five sides to the performance prism

The performance prism can be shown in diagram form as a solid block of glass with

five sides, a top, a bottom and three vertical sides. The five sides of the prism

represent:

 stakeholder satisfaction

 strategies

 processes

 capabilities

 stakeholder contribution.

Performance prism

Stakeholder

satisfaction

Strategies

Processes

Capabilities

Stakeholder

contribution

There are five aspects to successful performance in the long term.

 The entity must have a very clear picture of who its key stakeholders are, and

what they want. The key stakeholders of a company will include the

shareholders, but other stakeholders might also be significant. (Stakeholder

satisfaction)

 The entity must have defined the strategies it will select and pursue in order to

ensure that ‘value’ is given to all the key stakeholders. (Strategies)

Chapter 18: Developments in management accounting and performance management

 They must understand the processes that will be necessary in order to achieve

the strategic targets. (Processes)

 They must have defined the resources that they need to perform these processes

effectively, and must be capable of providing these required resources.

(Capabilities)

 The most successful entities will also have identified what they want to obtain

from their stakeholders, such as loyalty from their employees and profitability

from their customers. (Stakeholder contribution).

7.3 Stakeholder satisfaction

An entity must satisfy the needs and expectations of its key stakeholders. According

to the performance prism framework, the starting point for a performance

management system should be the satisfaction of key stakeholders.

 Who are the most influential stakeholders?

 What do they need and want?

The starting point should not be to establish performance targets for strategies.

‘Performance measures are designed to help people track whether they are moving

in the direction they want to. They help managers establish whether they are going

to reach the destination they set out to reach. Strategy, however, is not about

destination. Instead, it is about the route you choose to take – how to reach the

desired destination’ (Neely and Adams).

A criticism of the balanced scorecard model for performance measurement is that it

begins by establishing strategic targets, on the assumption that the aim should be to

satisfy shareholders and maximise shareholder value. The approach in the

performance prism framework is that although shareholders are key stakeholders

for a company, other stakeholders might be just as important.

 Some manufacturing companies rely heavily on suppliers, and should not

establish a performance management system without considering the needs and

expectations of those suppliers. In an article of the performance prism, Neely

and Adams mention the example of Boeing, which manufactures only three of

the components in a 777 aircraft. All the other components are manufactured by

external suppliers.

 Some entities rely heavily on key employees, and the performance targets they

set cannot ignore their needs and expectations. An extreme example is a

professional football club, which must consider the needs and expectations of its

star players.

 The government or government agencies can be powerful stakeholders in

companies. In some countries, services such as the supply of water, gas and

electricity are provided by commercial companies, but because of their

monopoly position (and because of public concern about these services)

companies are subject to regulation by a government-appointed regulatory

body. This ‘stakeholder’ might have the power to instruct companies to reduce

prices or improve the quality of their service, and companies failing to comply

with the regulator’s demands might have to pay heavy fines. In many other

P5: Advanced performance management

industries, companies might have to consider the risk of punishment (often in

the form of fines or legal settlements) for failing to comply with various

government regulations.

 In some industries, pressure groups might have a significant influence on the

activities of companies. Pressure groups are sometimes able to organise action

against a company, using the internet as their method of communication. For

example, a few years ago, public pressure in some European countries

successfully forced Monsanto to remove its genetically-modified food products

from the market.

7.4 Strategies

When an entity has identified its key stakeholders, and their needs and wants, the

next step is to select strategies that will satisfy these needs and wants. For each

strategy, performance measures are needed. Performance measures are needed for

four reasons.

 Managers need performance measures for strategic targets so that they can

monitor whether the strategies are being implemented.

 Performance measures can also be used to communicate strategies to others

within the organisation, so that they have a clear understanding of strategic

objectives.

 Performance measures are used to encourage the achievement of strategic

objectives, for example by paying bonuses for the successful achievement of

targets.

 Actual data about performance can be used to assess whether strategic objectives

are being achieved (and if they are not being achieved, to find out why not).

However, it is essential that performance targets should be consistent with the

entity’s strategies. Individuals respond to performance measures, and will often do

anything to succeed in meeting their targets, even if their actions are damaging and

harmful. An example used by Neely and Adams is a telephone call centre that had a

target of dealing with customer calls within one minute. In order to achieve this

target, staff at the call centre would often cut off a customer in the middle of a call,

to make it appear that the call had been dealt with on time. In this example, the

objective of answering calls within one minute was not properly aligned with the

company’s strategic objectives.

Neely and Adams comment: ‘Measures send people messages about what matters

and how they should behave. When the measures are consistent with organisation’s

strategies, they encourage behaviour that is consistent with strategy. The right

measures then not only offer a means of tracking whether strategy is being

implemented, but also a means of communicating strategy and encouraging

implementation.’

ACCA - P5 Study text - Emile Woolf INT - 2010

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