Week 9-performance measurement

Question 1

What is a centralised and a decentralised organisation?

Answer 1

• Centralised organisations restrict authority for decision making to senior executive teams at the centre of the organisation.
• Decentralised organisations allocate responsibility to managers at lower levels of the organisation to make key operating decisions.

Divisional structures are a typical example of decentralised structures.
Such as geographical location or product line.

Question 2

What is a responsability centre?

Answer 2

• A responsibility centre is a part, segment, or a sub-unit of an organisation whose manager is accountable for a specified set of activities.
– Cost centre (responsible for costs of the sub-unit only e.g. a bank’s back office departments)
– Revenue centre (responsible for revenues only e.g. hotel restaurant; pharmacy of a hospital)
– Profit centre (responsible for costs and revenues e.g.
sales department with sales staff salaries)
– Investment centre (responsible for all of the above and to make capital expenditure; therefore responsible for assets also)

Question 3

How should responsabiloty centre established?

Answer 3

•Responsibility centres should be established in
accordance with controllability principle (i.e. degree of
influence a manager has over costs, revenues etc.)

• Problem: In practice, controllability is often difficult to pinpoint.
• Performance reports for responsibility centres may include uncontrollable items.

Question 4

What are the advantages of decentralisation in organisations?

Answer 4

• timely decisions
• specialist knowledge
• exploiting market information
• strategic role for top managers
• management development
• management motivation

Question 5

What are the disadvantages of decentralisation in organisations?

Answer 5

•Dysfunctional decision making. Serving
individual segment, but harming the organisation
as a whole. E.g. service providing department
compromising on quality to save costs and
therefore the service receiving department does
not get what it should

•Diseconomies of scale. duplication of services

•Loss of control. Senior management may lose
control of the organisation, being far removed
from the detail

Question 6

What is performance measurement?

Answer 6

• The process of quantifying the efficiency and
effectiveness of action (Neely et al., 2005) .
• Performance measurement is a process used to
determine the status of an attribute or attributes of the
measurement objects (Lönnqvist, 2004).
• Radnor and Barnes (2007) quantifying the input, output,
or level of activity of an event or process.

Question 7

What is performance management? Why does it matter?

Answer 7

• Performance management is based on performance
measurement, which results in improvements in
behaviour, motivation, and processes.
• Performance management builds on performance
measurement and is concerned with effectiveness and
a broader, more holistic, even qualitative view of
operations and the organisation (Radnor and Barnes,
2007) .

Evidence suggests that measurement-managed companies
outperform non-measurement companies.

Question 8

What are the main components of perf. magament systems?

Answer 8

• Financial and non-financial measures

- Responsibility centres

Question 9

What do profit measures ignore?

Answer 9

Profit measures ignore differences in the size of the investments in each hotel.

Investments are the resources or assets used to generate profits.

Question 10

What is ROI?

Answer 10

Measure of the amount of return on an investment relative to the
cost of that investment (assets employed).
ROI can be compared with rate of return opportunities elsewhere
both inside and outside the company.

FM sheet

ROI is a percentage measure of divisional profitability
• It relates divisional profits to the size of the
investment made in the division
• It allows for comparison across divisions

ROI can appear more palatable if investment is reduced. i.e. ROI may induce short-term perspective (e.g. averting long-term investment); may therefore be harmful to the company in the long-run.

Divisions performing above average could reject an investment even if its ROI is good from the company’s perspective.

Question 11

What are the issues with ROI?

Answer 11

Percentage return or the size of investment: What is better? A return of 10 per cent on £1m, or an 8 percent return on £2m?

Short term against long-term returns: Generally speaking a business has to invest now in order to obtain positive cash flows and profits in the future

Different ROIs are for different businesses and
industries: Traditional manufacturing organisations tend to have a large number of physical assets – tangible fixed assets.

ROI and earnings management: Open to manipulation.

Intra-group transfers:
Growing business with high asset base may be faced with a conundrum. They would want to charge high internally to look profitable

higher ROI than target is motivating managers ti act, but this can lead them to act in a non-goal congruent manner.

Question 12

What is RI?

Answer 12

RI relates the measure of divisional income to a pre-defined minimum acceptable level (required rate of return) of income.

• The required minimum rate of return on investment is a risk adjusted measure

• Required Rate of return is the minimum acceptable return on investment. Required rate of return could be the cost of
capital of the firm (or a specific project)

• RI focuses managerial efforts on maximising the difference (the “residual”)

RI looks better if cost of capital is low or revenues rise

With RI, better goal congruence arises. All investments whose rate of return exceeds the organisational minimum will be accepted

• RI removes manager’s temptation to increase gearing through excess borrowing. Because the
required rate of return will have to be adjusted
upwards for the higher risk. Also interest would
leave low profits.

• RI cannot be used to compare the performance of
divisions of different sizes

RI cannot solve ‘short-termism’. Because of income
(accounting profit) still remains an important
component of the performance measure.

The RI will always be positive if the ROI of a
proposed project is higher than the percentage
capital charge.

Question 13

Describe the industry age and the information age

Answer 13

1) industry age: stable business environment, tangible assets, hierarchical organisations = financially-focused perf. measurement
2) information age: dynamic business environment, intangible assets, decentralised organisations = combine financial, strategic and operating measures

Question 14

What is an ultimate incicator of performance measure? What measures could be used toe measure intrinsic value for shareholders?

Answer 14

Assumption: Measuring and rewarding activities that create shareholder value will ultimately increase shareholder wealth.

Shareholder value as ultimate indicator of business performance in capital market oriented environments

– Shareholder wealth creation is not simple earning per share.
– Should include cost of capital employed (debt and equity)

measures:
Economic Value Added (EVA®)
Shareholder Value Added (SVA)

Question 15

EVA

Answer 15

Variation of RI looking at economics of the firm rather than
traditional accounting model.

For EVA generally the capital figure is charged to the
replacement cost of the assets (or capital employed); or could
even be based on the estimated sales value of the entire division.

Replacement cost of assets or how much the entire division could be sold for (like market value)

Question 16

fre cash flows calculation

Answer 16

FM sheet

Question 17

How to deliver sharholder value?

Answer 17

FM sheet

Question 18

What are the two approaches to determine shareholder value?

Answer 18

FM sheet

Question 19

improved financial measure of shareholder Shareholder value

Answer 19

shareholder value= business value - MV of debt

Market based approach
 Business value = discounted free cash flows
 Free cash flows measure the amount of cash
generated by the business that is available to
shareholders

Benefits: Familiar accounting
numbers
 Consideration of
intangibles
 Focus on cost of
capital

Limitations:
• Complex accounting
adjustments
• Still purely financial (incomplete)

Question 20

What are the limits of financial accounting based perf measures?

Answer 20

• lack of timeliness (reporting date is after decisions)
• backward orientiation: we need leading inficators (future perf.) and not lagging indicators (past perf.)
• failure to incororate non-financial items (skilss, culture, relationships, ideas,…)
• internal focus: focuses on accounting (not environment, society, customers, competitors)

-behavioural implications: real earnings managment: REM (Real earnings management) occurs when managers
undertake actions that change the timing or structuring of
an operation, investment, and/ or financing transaction in an
effort to influence the output of the accounting system.

There are situations in which the manager may benefit by
decreasing earnings.
Firms prior to a management buyout, during the award date
of stock options (option to buy stock at a predetermined price
on a specified date), for income smoothing, avoid antitrust
investigation, or seek import (or other government relief) may
have incentives to lower reported earnings (e.g., Perry and
Williams 1994; Watts and Zimmerman 1978; Jones 1991)

Question 21

What is transfer pricing?

Answer 21

Transfer price is the price one sub-unit charges for
an intermediate product or service supplied to another sub-unit of the same organisation. (for example: intellectual property, licenses, etc)

Creates revenues for the selling sub-units and
purchase costs for the buying sub-unit, affecting each of the two sub-units’ operating profit. For example: buyings sub units has to pay 35% tax rate. But if it “buys” IP from the selling sub-unit situated in a country where tax rate is 5%, it can avoid excessive payment of the 35% tax rate.

Can have an effect on the business as a whole; can
also have opportunity cost implications

Objectives of transfer pricing: allocating divisional ercourses, tax minimisation, independence of divisions, assessment of performance, optimism profits of the business

Question 22

What are the common approaches to transfer pricing?

Answer 22

Common approaches to transfer pricing

1) Market-based transfer prices: market value of the product
2) Cost-based transfer prices: variable cost of the product, or full cost
3) Negotiated transfer prices: negotiate the price between the divisions

Question 23

What is the mnimum price to be charged? (transfer pricing)

Answer 23

Minimum price to be charged:

The sum of the selling division’s marginal cost and the opportunity cost of the resources used. Or a price at which it could sell outside.

Note that in many practical circumstances, the opportunity cost of the resources used in making a transfer is ‘nil’. Hence it is often stated in management literature that the minimum limit for a transfer price is marginal cost.

Question 24

What is the maximum price to be paid? (transfer pricing)

Answer 24

Maximum Price to be paid:
The lowest market price at which the buying division could
acquire the goods or services externally, less any internal
cost savings in packaging and delivery (because if goods
are internally transferred without packaging; buying division
will need to do it themselves.)

Question 25

What is a two-part tariff?

Answer 25

Price discrimination technique: Selling division transfers at marginal cost (including any opportunity cost), plus a fixed annual fee to the buying division for the privilege of receiving transfers at that price. As each unit has no incentive to be sold as a priority to the transferee therefore could be delayed in passing the units on. A profit is only made when the fixed fee is transferred. -lump sum + unit cost

Question 26

What are market-based prices?

Answer 26

•Market-based prices: Comparable price of product or service in the open market has a potential of being viewed as a fair price between divisions but a comparable product might not be available on the market. Also different vendors may charge different amounts and quality. Similarly what about early payment discounts or even savings on bulk purchases.

Question 27

Transfer pricing: some of high profile scandals

Answer 27

Starbucks sales as seen above were all in the UK but paid no corporation tax. It transferred some money to a Dutch sister company in royalty payments, bought coffee beans from Switzerland and paid high interest rates to borrow from other parts of the business. (Task avoidance is not task evasion they argued)

Question 28

What are critical success factors?

Answer 28

Few key areas of a business performance which must succeed in order to achieve its strategic objectives such as: * profitability * market share * productivity * product leadership * personnel development * employee attitudes * public responsibility * balance between short and long-term goals

Question 29

What is a key performance indicator? (KPI)

Answer 29

A KPI is used to measure performance. CSF helps us in finding the areas that are needed for succeeding. KPIs should be used to measure CSFs. eg: ``` Manufacturing: -Capacity utilisation • Customer complaints • Percentage of correct demand forecasting • Faults detected prior to failure • First aid visits (injuries) • Standard Costing Variances • Percentage reduction in downtime • Percentage reduction in inventory levels ``` ``` Financial: -Number and amounts of budget deviations • Average insurance policy size • No. of new claims • Percentage of accuracy of periodic financial reports • Accounting ratios ```

Question 30

What is a balance scorecard like?

Answer 30

Balanced scorecard is a strategy performance management tool – a semi-standard structured report, that can be used by managers to keep track of the execution of activities by the staff within their control and to monitor the consequences arising from these actions. Integrates financial and non-financial measures Areas covered include, profitability, customer satisfaction, employee satisfaction, internal efficiency and innovation four perspectives (Kaplan and Norton): Financial, Internal business process, customer, learning and growth Questions: - To succeed financially how should we appear to our customers? - To satisfy our shareholders and customers what business processes must we excell off? To achieve our vision, how ill we sustain our ability to change and improve? To achieve our vision, how should we appear to our customers Internal: what processes must we excel at, to achieve our financial and customer objectives? . Innovation and learning: can we continue to improve and create value? (Think of Google and Apple) Financial: how do we create value for our shareholders? Customer: what do existing customers and targeted new customers value from us?

Question 31

What are customer measures (BSC)?

Answer 31

``` Market share • Customer profitability • Attracting new customers • Retaining existing customers • Customer satisfaction • On-time delivery ```

Question 32

BSC: internal perspective measures?

Answer 32

Success rate in winning contract orders • Production time cycle • Level of re-works

Question 33

BSC: Learning and growth measures

Answer 33

``` -% of total sales revenue generated by new products • Time to develop new products • Employee productivity • Employee satisfaction • Employee retention • Revenue per employee ``` (Training and development can do a lot in meeting many of these)

Question 34

Financial measures (BSC)

Answer 34

``` Return on investment • Economic value added • Profitability • Sales revenue growth/revenue mix • Cost reduction/productivity • Cash flow ```

Question 35

What is the connection etween Learning and Growth, Internal business process, customer and financial?

Answer 35

Investment is staff development => improvment in level of after-sales service => increase in customer satisfaction =>increase in sales and profits

Question 36

BSC benefits and limitations

Answer 36

Benefits: ``` •Implementation forces strategic clarity •Focus on value drivers •Alignment between operating units •Thought process =behavioural tool ``` Limitations ``` •Not validating the causality of links (e.g. sales not down because of poor customer service) •Not setting the right performance target •Measuring incorrectly = Paralysis without analysis ```

Question 37

What is benchmarking?

Answer 37

By the adoption of identified best practice, it is hoped that performance will improve. • Formalisation of comparing performance with that of similar organisations • Achieve competitive advantage by learning from others’ successes and failures • Finding best practice (As best will remain a moving target!) External benchmarking: • competitive benchmarking: with the best in the same industry or business type. • functional benchmarking: an internal function with the best practitioners, irrespective of industry Internal (functional) benchmarking: compare performance of one part of the business with another part of the business

Question 38

Advantages of benchmarking

Answer 38

-Focusing on improvement which are challenging but practically achievable. * Focus remains on gaining competitive advantage * Assists with team working and cross-functional learning • Openness to change can be encouraged and therefore culture becomes less rigid; something that is a pre-requisite in the current business world

Question 39

Disadvantages of benchmarking

Answer 39

-Can take up a lot of time and money * May face resistance to change and therefore output may not be as effective as planned. * Data may be difficult to access especially regarding back office processes.