F5 Performance Management

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F5Performance Management
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The exam

• Five compulsory questions 20 marks each
• Time allowed 3hours plus 15 minutes reading time
• Balance typically 5050 between calculations and
  discussion aspects

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The examiners key concerns

• Students need to be able to interpret any numbers
  they calculate and see the limitations of their
  financial analysis.
• In particular financial performance indicators
  may give a limited perspective and NFPIs are
  often needed to see the full picture.
• Questions will be practical and realistic, so
  will not dwell on unnecessary academic
  complications.
• Many questions will be designed so discussion
  aspects can be attempted even if students have
  struggled with calculation aspects.

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1. Advanced costing methods

• ABC.
• Target costing.
• Lifecycle costing.
• Throughput accounting.
• Environmental Accounting

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Activity Based Costing (ABC)

• Steps
• Identify major activities.
• Identify appropriate cost drivers (note you may
  have to justify your choice here in the exam).
• Collect costs into pools based upon the
  activities.
• Charge costs to units of production based on cost
  driver volume.

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Activity Based Costing (ABC)

• Cost driver rate total driver pool cost
• cost driver volume

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Advantages of ABC

• More realistic costs.
• Better insight into cost drivers, resulting in
  better cost control.
• Particularly useful where overhead costs are a
  significant proportion of total costs.
• ABC recognises that overhead costs are not all
  related to production and sales volume.
• ABC can be applied to all overhead costs, not
  just production overheads.
• ABC can be used just as easily in service costing
  as in product costing.

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Criticisms of ABC

• It is impossible to allocate all overhead costs
  to specific activities.
• The choice of both activities and cost drivers
  might be inappropriate.
• ABC can be more complex to explain to the
  stakeholders of the costing exercise.
• The benefits obtained from ABC might not justify
  the costs.

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Implications of ABC

• Pricing - more realistic costs improve cost-plus
  pricing.
• Sales strategy - more realistic margins can help
  focus sales strategy.
• Decision making for example, research and
  development can be directed at products with
  better margins.

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Target Costing

• Steps
• Estimate a market driven selling price for a new
  product. (E.g. to capture a required market
  share).
• Reduce this figure by the firms required level
  of profit. (E.g. based on target ROI).
• Produce a target cost figure for product
  designers to meet.
• Reduce costs to provide a product that meets that
  target cost.

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Closing the target cost gap

• Value analysis
• Focus is on reducing cost without compromising
  perceived value.
• Can labour savings be made?
• Can productivity be improved?
• What production volume is needed to achieve
  economies of scale?

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Closing the target cost gap cont.

• Could cost savings be made by reviewing the
  supply chain?
• Can any materials be eliminated?
• Can a cheaper material be substituted without
  affecting quality?
• Can part-assembled components be bought in to
  save on assembly time?
• Can the incidence of the cost drivers be reduced?

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Implications of target costing

• Pricing might identify sufficient cost savings
  to reduce the target price.
• Cost control target cost motivates managers to
  find new ways of saving costs.

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Lifecycle costing

• Life cycle costing
• Is the profiling of cost over a products life,
  including the pre-production stage.
• Tracks and accumulates the actual costs and
  revenues attributable to each product from
  inception to abandonment.
• Enables a products true profitability to be
  determined at the end of its economic life.

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Implications of lifecycle costing

• Pricing decisions can be based on total lifecycle
  costs rather than simply the costs for the
  current period.
• Decision making - a timetable of life cycle costs
  helps show what costs need to be recovered.
• Control - Lifecycle costing reinforces the
  importance of tight control over locked-in costs,
  such as RD.
• Performance reporting - Life cycle costing costs
  to products over their entire life cycles, to aid
  comparison with product revenues generated in
  later periods.

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Throughput

• Background
• Application of key factor analysis to production
  bottlenecks.
• The only totally variable costs are the purchase
  cost of raw materials / components
• Direct labour costs are not wholly variable.

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Throughput

• Multi-product decisions
• Rank products by looking at the throughput per
  hour of bottleneck resource time
• Throughput Revenue Raw Material Costs

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Throughput

• Throughput accounting ratio (TPAR)
• Throughput per hour of bottleneck resource
• Operating expenses per hour of bottleneck resource

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Throughput

• How to improve the TPAR
• Increase the sales price to increase the
  throughput per unit.
• Reduce total operating expenses, to reduce the
  cost per hour.
• Improve productivity, reducing the time required
  to make each unit of product.

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ACCOUNTING FOR ENVIRONMENTAL COSTS
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Management Accounting Techniques
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Break-even analysis
The Break-even chart
Breakeven point The point where total costs
total sales revenue and Where there is neither a
profit or loss
Breakeven Point
Sales Revenue
Total Costs

Fixed Costs
Output (units)
B/E Point (units) Fixed Costs
Contribution per Unit
Chapter 4
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The Margin of Safety
The Margin of Safety represents the level by
which output can fall before the organisation
makes a loss
Margin of safety
Breakeven Output
Budgeted Output
Margin of Safety Budgeted Output Breakeven
Output
X 100
Budgeted Output
Chapter 4
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Contribution to Sales ratio
Contribution to Sales Ratio (C/S ratio)
(Contribution per unit) / Unit Sales Price
Breakeven Point in Sales Value Fixed Costs /
C/S ratio
Sales for a certain level of profit Fixed
Costs Required Profit
Contribution per Unit
Chapter 4
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Basic Breakeven chart
Sales Revenue
Profit
000
Breakeven point
Total Costs
40
30
Loss
Fixed Costs
20
0
10
20
40
50
60
70
30
Number of units
Chapter 4
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Contribution Breakeven chart
Sales Revenue
Profit
000
Breakeven point
Contribution
Total Costs
Fixed Costs
Loss
Variable Costs
10
20
40
50
60
70
30
Number of units
Chapter 4
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The Profit-Volume Chart
The profit-volume chart presents information in a
way that clearly shows the change in the level of
profit using data from the previous data table
5000
0
Profit
Output
1000
1500
-10000
Chapter 4
Page 30
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2. CVP Analysis
Profit (Contribution per unit x units) - Fixed
Costs
Contribution Sales Value All Variable Costs
A product has a sales price of 20 and a variable
cost of 10 per unit
Units 0 100 500 1000 1500
Contribution() 0 1000 5000 10000 15000
Fixed Costs() (10000) (10000) (10000) (10000) (10000)
Profit() (10000) (9000) (5000) 0 5000
Contribution per unit 10 10 10 10
Profit per unit 0 (90) (10) 50
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Multi-product breakeven analysis
Fixed Costs
BE Point (Revenue)

C/S Ratio
Weighted Average C/S Ratio
Fixed Costs Required profit
Required Revenue

Weighted Average C/S Ratio
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Limitations/Assumptions of CVP

• Costs behaviour is assumed to be linear
• Revenue is assumed to be linear
• Volume Produced Volume Sold
• Ignores inflation
• Assumes a constant sales mix

Chapter 4
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3. Planning with limited factors

• Key factor analysis one resource in short
  supply
• Linear Programming two or more scarce resources

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Key factor analysis

1. Calculate contribution per unit.
2. Calculate contribution per unit of the limiting
   factor.
3. Rank in order.
4. Allocate resources make first up to max demand,
   then second,...

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Linear programming

1. Define variables
2. Define the objective
3. Set out constraints
4. Draw graph showing constraints and identify the
   feasible region
5. Identify optimal point
6. Solve for optimal solution
7. Answer the question

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Linear programming

• Assumptions
• A single quantifiable objective.
• Each product always uses the same quantity of the
  scarce resources per unit.
• The contribution per unit is constant.
• Products are independent e.g. sell A not B.
• The scenario is short term.

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Linear programming

• Slack
• Slack is the amount by which a resource is under
  utilized. It will occur when the optimum point
  does not fall on the given resource line.

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Linear programming

• Shadow (or dual) prices
• The extra contribution that results from having
  one extra unit of a scarce resource.
• The max premium (i.e. over the normal cost) that
  the firm should be willing to pay for one extra
  unit of each constraint.
• Non-critical constraints will have zero shadow
  prices as slack exists already.

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Linear programming

• Calculating dual prices
• Add one unit to the constraint concerned, while
  leaving the other critical constraint unchanged.
• Solve the revised equations to derive a new
  optimal solution.
• Calculate the revised optimal contribution. The
  increase is the shadow price

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Linear programming

• Range of applicability of dual prices
• The dual price only applies as long as extra
  resources improve the optimal solution
• i.e. the constraint line concerned moves out
  increasing the size of the feasible region and
  moving the optimal point.
• Eventually other constraints become critical.

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4. Pricing

• Factors to consider when pricing.
• Calculation aspects.
• Pricing approaches.

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Factors to consider when pricing

• Costs
• Competitors
• Corporate objectives
• Customers

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Calculation aspects

• Price elasticity of demand (PED)
• PED change in demand / change in price.
• PED gt1 (elastic) revenue increases if the price
  is cut.
• PED lt1 (inelastic) revenue increases if the price
  is raised.

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Calculation aspects

• Equation of a straight line demand curve
• P a bQ
• a the price at which demand would fall to
  zero
• b gradient change in price/change in
  demand
• Calculate b first

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Calculation aspects

• Equation of a cost curve
• C F vQ
• Volume based discounts

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Pricing approaches

• Cost plus pricing
• Price skimming
• Penetration pricing
• Linking pricing decisions for different products
• Volume discounts
• Price discrimination
• Relevant cost pricing

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Cost plus pricing

• Establish cost per unit options include MC,
  TAC, prime cost
• Calculate price using target mark-up or margin
• Often used as a starting point even when using
  other methods

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Cost plus pricing

• Advantages
• Widely used and accepted.
• Simple to calculate if costs are known.
• Selling price decision may be delegated to junior
  management.
• Justification for price increases.
• May encourage price stability.

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Cost plus pricing

• Disadvantages
• Ignores link between price and demand.
• No attempt to establish optimum price.
• Which absorption method?
• Does not guarantee profit
• Which cost?
• Inflexibility in pricing.
• Circular reasoning.

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Price skimming

• Set a high initial price to skim off customers
  who are willing to pay extra.
• Prices fall over time.
• Suitability?

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Penetration pricing

• Set a low initial price to gain market share
• If a high volume is achieved, the low price could
  be sustainable.
• Suitability?

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Linking pricing decisions for different products

• Basic idea product A is cheap to attract
  customers who then also buy the higher margin
  product B.
• Key issue is the extent to which customer must
  buy the other products.
• Suitability?

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Volume discounts

• Discount for individual large order.
• Cumulative quantity discounts.
• Suitability?

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Price discrimination

• Have different prices in different markets for
  the same product.
• Suitability?

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Relevant cost pricing

• Price net incremental cash flow.
• Suitability?

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5. Make v buy and other shortterm decisions

• Relevant costing principles.
• Make v buy decisions.
• Shut down decisions.
• Joint products the further processing decision.

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Relevant costing principles

• Include
• Future incremental cash flows.
• Opportunity costs
• Exclude
• Depreciation.
• Sunk costs.
• Unavoidable costs.
• Apportioned fixed overheads.
• Financing cash flows (e.g. interest).

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Make v buy

• Decision
• Look at future incremental cash flows.
• Watch out for opportunity costs especially
  whether or not spare capacity exists and
  alternative uses for capacity.
• Practical factors?

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Shut down decisions

• Decision
• Look at future incremental cash flows.
• Apportioned overheads not relevant
• Closure costs e.g. redundancies.
• Alternative uses for resources?
• Practical factors?

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Joint products

• The further processing decision
• Look at future incremental cash flows
• sell at split off v process further and then
  sell.
• Pre-separation (joint) costs not relevant
• only include post split-off aspects.

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6. Risk and uncertainty

• Basic concepts.
• Research techniques.
• Scenario planning.
• Simulation.
• Expected values.
• Sensitivity.
• Payoff tables.

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Basic concepts

• Risk variability in future returns.
• Investors risk aversion
• Upside v downside
• Risk v uncertainty
• Risk probability x impact

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Research techniques

• Desk research
• Company records.
• General economic intelligence.
• Specific market data.
• Field research
• Opinion v motivation v measurement
• Questionnaires, experiments, observation.
• Group interviews, triad testing, focus groups.

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Scenario planning

• 1 Identify high-impact, high-uncertainty factors.
• 2 Identify different possible futures.
• 3 Identify consistent future scenarios.
• 4 Write the scenario.
• 5 For each scenario identify and assess possible
  courses of action for the firm.
• 6 Monitor reality.
• 7 Revise scenarios and strategic options

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Simulation

• 1 Apply probabilities to key factors in scenario
  analysis.
• 2 Use random numbers to select a particular
  scenario and calculate outcome.
• 3 Repeat until build up a picture of possible
  outcomes
• 4 Make decision based on risk aversion.

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Expected values

• EV S outcome probability.
• Make decision based on best EV.

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Expected values

• Advantages
• Recognises that there are several possible
  outcomes.
• Enables the probability of the different outcomes
  to be taken into account.
• Leads directly to a simple optimising decision
  rule.
• Calculations are relatively simple.

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Expected values

• Disadvantages
• probabilities used are subjective.
• EV is the average payoff. Not useful for one-off
  decisions.
• EV gives no indication of risk
• Ignores the investors attitude to risk.

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Sensitivity

• Identify key variables by calculating how much an
  estimate can change before the decision reverses.
• Can only vary one estimate at a time.

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Payoff tables

• Prepare table of profits based on different
  decision choices and different possible
  scenarios.
• Four different ways of making a decision.
• 1 Expected values
• 2 Maximax
• 3 Maximin
• 4 Minimax regret

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Decision Trees
A diagrammatic representation of a multi-decision
problem, where all possible courses of action are
represented, and every possible outcome of each
course of action is shown. Decision trees
should be used where a problem involves a series
of decisions being made and several outcomes
arise during the decision-making process.
Decision trees force the decision maker to
consider the logical sequence of events. A
complex problem is broken down into smaller,
easier to handle sections. The financial
outcomes and probabilities are shown separately,
and the decision tree is rolled back by
calculating expected values and making decisions.

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7. Budgeting I

• The purposes of budgeting.
• Budgets and performance management.
• The behavioural aspects of budgeting.
• Conflicting objectives.

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The purpose of budgets

• Forecasting
• Planning
• Control
• Communication
• Co-ordination
• Evaluation
• Motivation
• Authorisation and delegation

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Budgets and performancemanagement

• Responsibility accounting
• Responsibility accounting divides the
  organisation into budget centres, each of which
  has a manager who is responsible for its
  performance.
• The budget is the target against which the
  performance of the budget centre or the manager
  is measured.

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Management by exception

• 1 Set up standard costs, prepare budgets and set
  targets.
• 2 Measure actual.
• 3 Compare actual to budget (e.g. via variances).
• 4 Investigate reasons for differences and take
  action.

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Behavioural aspects of budgeting

• Key issues
• Dysfunctional behaviour want goal congruence.
• Budgetary slack.
• Management styles (Hopwood)
• Budget constrained
• Profit conscious
• Non-accounting

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Target setting and motivation

• Expectations v aspirations
• Ideal target?
• Targets should be
• communicated in advance
• dependent on controllable factors
• based on quantifiable factors
• linked to appropriate rewards
• chosen to ensure goal congruence.

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Participation

• Advantages of participative budgets
• Increased motivation
• Should contain better information,
• Increases managers understanding and commitment
• Better communication
• Senior managers can concentrate on strategy.

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Participation

• Disadvantages of participative budgets
• Loss of control
• Inexperienced managers
• Budgets not in line with objectives
• Budget preparation slower and disputes can arise
• Budgetary slack
• Certain environments may preclude participation

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Conflicting objectives

• Company v division
• Division v division
• Short-termism
• Individualism

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8. Budgeting II

• Rolling v periodic.
• Incremental budgeting.
• Zero based budgeting (ZBB).
• Activity based budgeting (ABB).
• Feedforward control.
• Flexible budgeting.
• Selecting a budgetary system.
• Dealing with uncertainty.
• Use of spreadsheets.

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Rolling v periodic budgeting

• Periodic budgets
• The budget is prepared for typically one year at
  a time. No alterations once the budget has been
  set.
• Suitable for stable businesses where forecasting
  is easy and where tight control is not necessary.

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Rolling v periodic budgeting

• Rolling (continuous) budgets
• A budget kept continuously up to date by adding
  another accounting period when the earliest
  period has expired.
• Aim to keep tight control and always have an
  accurate budget for the next 12 months.
• Suitable if accurate forecasts cannot be made, or
  if need tight control.

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Incremental budgeting

• Start with the previous periods budget or actual
  results and add (or subtract) an incremental
  amount to cover inflation and other known
  changes.
• Suitable for stable businesses where costs are
  not expected to change significantly. There
  should be good cost control and limited
  discretionary costs.

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Zero based budgeting

• Preparing a budget from a zero base, justifying
  all expenditure.
• 1 Identify all possible services and then cost
  each service (decision packages)
• 2 Rank the decision packages
• 3 Identify the level of funding that will be
  allocated to the department.
• 4 Use up the funds in order of the ranking until
  exhausted.

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Activity based budgeting

• Use ABC for budgeting purposes
• 1 Identify cost pools and cost drivers.
• 2 Calculate a budgeted cost driver rate
• 3 Produce a budget for each department or product
  by multiplying the budgeted cost driver rate by
  the expected usage.

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Feed forward control

• Feed-forward control is defined as the
  forecasting of differences between actual and
  planned outcomes and the implementation of
  actions before the event, to avoid such
  differences.
• E.g. using a cash-flow budget to forecast a
  funding problem and as a result arranging a
  higher overdraft well in advance of the problem.

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Flexible budgeting

• Fixed Budgets
• Flexible Budgets
• Flexed Budgets

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Selecting a budgetary system

• Determinants
• Type of organisation.
• Type of industry.
• Type of product and product range.
• Culture of the organisation.

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Changing a budgetary system

• Factors to consider
• Time consuming
• Are suitably trained staff are available to
  implement the change successfully?
• Management time
• Training needs.
• Cost v benefits for the new system

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Incorporating risk and uncertainty

• Flexible budgeting.
• Rolling budgets.
• Scenario planning.
• Sensitivity analysis.
• What if analysis using spreadsheets

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9. Quantitative analysis

• High-low.
• Regression and correlation.
• Time series analysis.
• Learning curves.

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High-low

• 1 Select the highest and lowest activity levels,
  and their costs.
• 2 Find the variable cost/unit.
• 3 Find the fixed cost, using either level.
• Fixed cost Total cost at activity level total
  variable cost.

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Regression and correlation

• y a bx

r
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Time series analysis

• Four components
• 1 the trend
• 2 cyclical variations
• 3 seasonal variations
• 4 residual variations.
• Additive model
• Actual Trend Seasonal Variation
• Multiplicative model
• Actual Trend x Seasonal Variation

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Learning curves

• As cumulative output doubles, the cumulative
  average time per unit falls to a fixed (the
  learning rate) of the previous average.
• Y axb
•  y average cost per batch
• a cost of first batch
• x total number of batches produced
• b learning factor (log LR/log 2)

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10. Standard costing and basic variances

• Standard costing.
• Recap of basic variances from F2.
• Labour variances with idle time.
• Variance investigation.

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Standard costing

• A pre-determination of what a product is expected
  to cost under specific working conditions.

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Standard costing

• Advantages
• Annual detailed examination
• Performance appraisal
• Management by exception
• Simplifies bookkeeping
• Disadvantages / problems
• Standards not updated
• Cost
• Unrealistic standards can demotivate staff

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Types of standard

• Attainable
• Ideal
• Basic
• Current

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Sales variances
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Material variances
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Labour variances (basic)
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Variable overhead variances
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Fixed overhead variances
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Labour variances with idle time
No idle time budgeted for
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Idle time budgeted for
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Variance investigation
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11. Advanced variances

• Materials mix and yield variances.
• Other targets for controlling production.
• Planning and operational variances.
• Modern manufacturing environments.

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Materials mix and yield variances

• Only use where materials can be substituted for
  each other.

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Other targets for controlling production processes

• Detailed timesheets, idle time.
• Productivity, yield, waste.
• Quality measures e.g. reject rate.
• Average cost of inputs, output.
• Average margins.
• on-time deliveries.
• Customer satisfaction ratings.

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Planning and operationalvariances
111
Market size and market shares variances
112
Planning and operating cost variances
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Modern manufacturingenvironments

• Total Quality Management (TQM)
• TQM is the continuous improvement in quality,
  productivity and effectiveness through a
  management approach focusing on both process and
  the product.

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Modern manufacturingenvironments

• Just-intime (JiT)
• JIT is a pull-based system of planning and
  control.
• Pulling work through the system in response to
  customer demand.
• Goods are only produced when they are needed.
• This eliminates large inventories of materials
  and finished goods.

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12. Performance measurement and control

• Ratio analysis.
• NFPIs.
• Behavioural considerations.

116
Ratio analysis

• Preliminaries
• Ratios may not be representative of the position
  throughout a period.
• Need a basis for comparison.
• Ratios can be manipulated
• Ratios indicate areas for further investigation
  rather than giving answers.

117
Profitability ratios

• ROCE Operating Profit x 100
• Capital Employed
• Gross margin Gross profit x 100
• Sales
• Net margin Net profit x 100
• Sales
• Asset turnover Sales / capital employed
• ROCE asset turnover x net margin

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Liquidity / working capital ratios

• Current ratio current assets / current
  liabilities
• Quick ratio quick assets/ current liabilities
• Quick assets current assets inventory
• Receivables days receivables / sales x 365
• Payables days payables / purchases x 365
• Inventory days inventory / cost of sales x 365

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Ratios to measure risk

• Financial gearing debt/equity
• Financial gearing debt / (debt equity)
• Dividend cover PAT / total dividend
• Interest cover PBIT / interest
• Operating gearing fixed costs / variable costs
• Operating gearing contribution / PBIT

120
Non-financial performanceindicators

• Financial performance appraisal often reveals the
  ultimate effects of operational factors and
  decisions but non-financial indicators are needed
  to monitor causes.
• Critical success factors often non-financial
• Stakeholder objectives may also be non-financial

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The balanced scorecard(Kaplan and Norton)
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The building block model (Fitzgerald et al)
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Behavioural aspects

• Measures designed to assess performance should
• provide incentives to promote goal congruence.
• only incorporate factors for which the manager
  can be held responsible.
• recognise both financial and non financial
  aspects of performance.
• recognise longer-term, as well as short term,
  objectives.

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Behavioural aspects

• Potential problems with inappropriate measures
• manipulation of information provided by managers
• demotivation and stress-related conflict
• excessive concern for control of short term
  costs, possibly at the expense of longer-term
  profitability.

125
13. Transfer pricing and divisional Performance
measurement

• Transfer pricing.
• Divisional performance measurement.

126
Transfer pricing

• Objectives
• Goal congruence
• Performance measurement.
• Autonomy.
• Minimising global tax liability.
• To record the movement of goods and services.
• Fair split of profit between divisions.

127
Transfer pricing - Exam questions

• Will often be given a TP and asked to comment.
  Look at the following.
• Implications for divisional performance e.g. is
  a target ROI achieved?
• Resulting manager behaviour - does it give
  dysfunctional decision making e.g. will a
  manager reject a new product that is acceptable
  to the company as a whole?

128
Transfer pricing - General rule

• TP marginal cost opportunity cost
• In a perfectly competitive market,
• TP market price.
• If spare capacity exists,
• TP marginal cost.
• With production constraints,
• TP marginal cost opportunity cost of not
  using those resources elsewhere.

129
Practical transfer pricing systems

• Market price
• Production cost mark-up
• Negotiation

130
Divisional performancemeasurement

• Key considerations
• Manager or division?
• Type of division.
• Cost centre
• Profit centre
• Investment centre

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Return on Investment (ROI)
132
Residual Income (RI)

• RI Pre tax controllable profits imputed
  charge for controllable invested capital

133
14. Performance measurement in not-for-profit
organisations

• Objectives.
• Performance Measurement.

134
Objectives

• Planning for NFPs usually more complex.
• Multiple objectives
• Difficult to quantify objectives
• Conflicts between stakeholders
• Difficult to measure performance
• Different ways to achieve the same objective
• Objectives may be politically driven

135
Performance measurement

• Value for money (VFM)
• Effectiveness
• Efficiency
• Economy