Topic Nine: Performance Measurement Considerations
Performance measures are metrics that monitor our effectiveness in performing an activity and our efficiency in using resources. Efficiency is the attainment of maximum output with minimum resources. Improved efficiency is achieved if fewer inputs are used to produce a given amount of output, or a given level of input leads to increased output. Effectiveness is concerned with ensuring that the output from any given activity is achieving the desired
Responsibility accounting involves classifying financial information into areas of organisational activity that form controllable sets, and then allocating responsibility for the control of each of these areas to individual managers. These areas of organisational activity are known as 'responsibility centres' or strategic business units. There are three main types of responsibility centres:
- a cost centre, where managers are accountable only for the expenses that are incurred
- a profit centre, where managers are accountable for both revenues and expenses incurred
- an investment centre, where managers are accountable for revenues, expenses and capital investment decisions.
In creating responsibility centres, decision-making authority is often decentralised and spread throughout an organisation rather than being confined to senior management. Decentralisation is seen to provide advantages such as more time for managers to devote to planning and decision making, improved control, and greater motivation for managers because they can influence factors that affect their performance. However, its downsides can include an increased need for coordination, the duplication of services, reduced economies of scale in purchasing, and dysfunctional behaviour such as divisional managers being motivated towards actions that benefit their division but not the organisation as a whole. Responsibility accounting is based on the concept of controllability: managers should be made responsible for only those items they can control or influence, and likewise should be rewarded only for those revenues they generate.
If an organisation is decentralised, there is a reasonable likelihood its divisions will need to trade with each other. This creates a need to select a transfer pricing method that will be used to price such transactions. The choice of transfer pricing method is important because it affects the two cornerstones of a successful responsibility accounting system which requires: (a) Goal congruence. The transfer pricing method will affect the operating culture of the organisation and should encourage managers to make decisions that are in the best interests of the organisation as a whole and not just those of their operational division and (b) Performance measurement. Transfer prices will affect the measurement of managerial performance and should be seen as fair in this function.
A number of different transfer pricing methods exist, and these can be grouped into two categories:
- market-based transfer pricing methods
- prevailing market price
- adjusted market price
- negotiated price
- contribution margin
- cost-based transfer pricing methods
- opportunity cost
- marginal cost
- variable cost
- standard cost
- actual full cost
Prevailing market price. This is the price at which significant quantities of a product are bought and sold in arm's-length transactions between independent parties in a perfectly competitive market. However, markets are not always perfectly competitive.
Adjusted market price. This is the prevailing market price adjusted for market imperfections that can be avoided by selling internally; for example, the selling division can avoid bad debt losses, selling expenses and so on. A drawback is that because it is a variation of the prevailing market price, it is useful only in nearly perfect competitive markets. Another difficulty is that the supplying and receiving divisions may not agree on the amount of adjustment necessary to the sales price.
Negotiated price. This is a price that is negotiated using a bargaining process between the supplying and receiving divisions. It is similar to the previous method and has the same disadvantages.
Contribution margin. A contribution margin is the final selling price of a product less total associated variable costs. It represents the amount of money available to cover fixed costs and generate profits. The contribution margin transfer pricing method allocates the contribution margin between
divisions on the basis of proportion using the following formula: Contribution Margin x Divisional Variable Costs / Total Variable Costs
Opportunity cost. The sacrifice incurred in order to pursue a particular course of action is known as the opportunity cost. Its purpose is to help decision makers choose between alternative uses of productive facilities in a way that maximises the profits of the firm.
Marginal cost. This is defined as the change in total cost resulting from a small change in output. Since fixed costs are constant in this situation, the increase in total cost is the change in total variable cost. The optimal output is where marginal cost equals marginal revenue. If a transfer price is set
where marginal cost equals marginal revenue, this will maximise profit.
Variable cost. The transfer price is set to equal variable costs, that is, all costs incurred to produce the product. Divisions will act in the best interests of the company and it encourages cooperation between divisions.
Standard cost. Standard costing was discussed previously in Topic 7. Under this method, the transfer price is based on standard cost, which is a measure of what it should cost to produce the product efficiently.
Actual full cost. Under this method the transfer price comprises all costs—both direct and indirect—related to the product. The supplying division can include extra costs to pass them on and improve its own reported position and performance. If the supplying division is inefficient, these inefficiencies are transferred elsewhere within the company with no corrective action taken to eliminate them.
Both the cost-plus and actual full cost methods can affect decision making by incorrectly including fixed costs in product cost.
Cost-plus. Under this method a mark-up is added to the cost of the product based on either actual or standard cost. This may be simply a flat percentage of the cost arbitrarily determined by management.
Most writers believe that a general rule for a transfer price is that the minimum transfer price is equal to the additional outlay costs per unit incurred up to the point of transfer, plus opportunity costs to the firm as a whole. Outlay represents the cash outflows directly associated with the production and transfer of the products and services. Opportunity costs are the maximum contribution foregone by the company itself if the product or service is transferred internally.
For companies with international operations, setting transfer prices is more complex. The transfer price must take into account tax effects and currency restrictions, and for these reasons will not always be set at market price. Where the tax on profits is higher in an overseas or foreign country, a domestic parent company may set a higher transfer price for a good or service sold to an overseas subsidiary.
Different financial performance measures are typically used to assess each of the three
different types of responsibility centres.
|Responsibility centres and financial performance measures|
|Type of responsibility centre||Financial performance measures|
|Cost centre||Comparing actual and budgeted controllable costs|
|Profit centre||Profit measured in dollar terms, Profitability ratios|
|Investment centre||Return on investment (ROI), Residual income (RI), Economic value added (EVA) ®|
The return on an investment (ROI) is determined by dividing a centre's controllable profit by its controllable assets.
ROI = Controllable Profit/Controllable Assets
Although conceptually simple, ROI is ambiguous. Profit can be defined in a number of ways and this enables the figure to be manipulated. ROI growth and earnings per share growth (EPS) are not necessarily equivalent. ROI targets for a company should not be applied in a blanket fashion across business units with differing risk profiles. When ROI is used as a managerial performance measure, it can lead to decisions that are optimal for individual divisions but sub-optimal for the company. ROI focuses on short-term profitability, looking only at the last quarter or last year for performance evaluation. This time horizon may not be long enough for many projects to be evaluated.
Residual income is calculated as follows: RI = Controllable Profit - (Imputed Charge for Capital x Controllable Assets)
Imputed charge for capital is the desired rate of return on invested assets, usually based on the cost of capital to the company. The concept is based on the idea that if the investment centre were a separate entity it would need to raise capital externally, thus it is reasonable to charge it for the cost of the company providing it with capital.
Residual income overcomes the dysfunctional aspect of ROI and seeks to motivate managers to invest where the expected returns exceed the expected charge for capital. However, it does not overcome the problem of determining the value of assets.
While both ROI and RI appear adequate measures, they also have limitations. The first limitation is related to income. Income can be manipulated on a short-term basis and, because it is based on accrual accounting, it ignores cash flows that can be derived from an investment centre. The second limitation is how to measure the assets employed by the investment centre. By ignoring changing prices, net profit is overstated and investment understated. Finally, both measures focus on the performance of the investment centre and do not consider the performance relative to overall company objectives. This may mean sub-optimal decision making and lead to a company not achieving optimal effectiveness and efficiency.
Economic value added® is after-tax profit minus the total annual cost of capital. If EVA® is positive, the company is creating wealth. If it is negative, then the company is destroying its capital base, which will lead to failure of the company unless reversed. Like residual income, EVA® is a dollar value figure, but its key element is the emphasis on after-tax operating profit and the actual annual cost of capital. This latter aspect differentiates it from the residual income measure, which uses the minimum expected rate of return. Further information on EVA® is available from the website of Stern Stewart, the firm that developed the concept. See http://www.sternstewart.com
A vexed issue for a company's Board of Directors is the remuneration that should be granted to chief executive officers and senior management. Any remuneration package should be designed to encourage managers to adopt the same goals as those of the company. Cash remuneration includes salaries and bonuses, with the bonus linked to satisfactorily achieving specified performance measures. One problem with cash bonuses is that they may encourage a short-term focus. Non-cash forms of remuneration may be even more attractive to managers than cash remuneration, but benefits might result in dysfunctional behaviour. Over the past decade or so, a popular form of non-cash remuneration has been the provision of share options that can be converted into ordinary shares upon payment of a specified amount.
The balanced scorecard is a performance measurement approach developed by Kaplan and Norton to address some of the weaknesses of previous performance measurement approaches. It is a management system that enables organisations to clarify their vision and strategy and translate them into action.
The balanced scorecard approach proposes we view the organisation from four perspectives: (a) financial (b) customer (c) internal business process (d)learning and growth. Metrics should be developed for each of these perspectives to provide key business drivers and criteria for managers to watch. Data is then collected and analysed for each metric and used to assess performance and help future decision-making.
Evaluation and performance measurement has become part of the process of change in government budgeting and financial reporting. Well-designed performance measures will assist in attaining any strategic objectives adopted by a public sector body. Despite difficulties and concerns expressed about the use of performance indicators, some have been developed for government business enterprises including average accounting rate of return, average economic rate of return, average growth in total factor productivity, average growth in labour productivity, labour productivity units and service quality measures (Steering Committee on National Performance Monitoring of Government Trading Enterprises, 1997).