Accounting

MBA INTENSIVE SEMINARS 2004 Page 1

MBA Intensive Seminars 2004

FMA

Revision notes


Definition

Accounting is the process of

•identifying,

•measuring

•and communicating

•financial information about an entity

•to permit informed judgments and decisions

•by users of the information.


The Accounting Equation

Assets minus Liabilities equals Equity

A - L = E

Assets equals Liabilities plus Equity

A = L + E

Equity Capital Ownership claim

Shareholders’ funds


Power of Accounting“Accounting provides a very selective but powerful representation of the corporate identity..”

“The detailed language of assets, liabilities, costs, profits provide a range of corporate imagery and vocabulary …….”

“Accounting provides the categories through which organisational participants perceive both themselves and the organisation.”

Mike Powers


Creative Accounting?“Things may exist independently of our accounts, but they have no human existence until they become accountable. They may not exist, but they take on human significance by becoming accountable..”

“Accounts define reality and at the same time they are that reality….”

“Accounts do not more or less accurately describe things. Instead they establish what is accountable in the setting in which they occur”

“Whether they are ACCURATE OR INACCURATE by some other standards, accounts define reality for a situation in the sense that people act on the basis of what is accountable in the situation of their action.”

Ruth Hines


You will discover

That accounting is subjective, partial and potentially misleadingAccountants use language / numbers in a highly technical way

Accounts are a highly stylised story, representation, description of organisational events

Differences between the ‘Accounting World’ and the ‘Organisational World’

Problematic nature of accounting numbers


And there’s more….

The tribe of accountants takes many forms and lives within all organisations

No such thing as a correct ‘cost’, ‘value’, ‘profit’..it all depends on context

The value of accounting in managing organisations


Roles of AccountingImprove problem solving / decision making

Manage risks

Trust, Assurance

Educational - learn about organisations

Construct, define, measure success/failure

Language of business


Roles of Accountants

Assisting the internal management of organisations

Complying with external financial reporting, controls and with taxation regulations

Expert consultants on financial and organisational performance


Financial Accounting

Accounting concepts

Profit and Cash distinction

Organisational impact

Financial statements


Hierarchy of Accounting QualitiesDecision Makers and their characteristics

Benefits > Costs

Understandability

Decision-Usefulness

Relevance Reliability

Predictive value

Feedback Value

Timeliness

Comparability & consistency

Verifiability

Neutrality

Representational Faithfulness

Materiality


Transactions

Buy materials on credit from suppliers

Sell goods or services on credit to customers

Receive cash

Pay suppliers


When is profit reported?

When goods or services are sold

NOTwhen cash is paid or received


Example: Antiques dealer

Buy 10 chairs for cash $200 each

Sell 6 chairs on credit $300 each

Profit 6 x $100 each = $600

Cash flow = minus $2,000


Profit, not cashMatching Concept – match revenues received with the costs incurred to generate them

Goods received but not paid for –Creditors (Payables)

Prudence concept – providing for known / probable losses – e.g. Doubtful debts, Depreciation of fixed assets

Goods or services supplied but no cash yet - Debtors (Receivables)


Increase in valuation of fixed assets

Company agrees with supplier to buy materials at fixed price for 5 years

Customers pay in advance for services extending beyond the accounting period

Profit, not cash contd

Home currency euros, borrow in dollars


Assets - Liabilities = Equity

Assets - Liabilities = Equity

Profit/loss

Change over a period

start

end

During the period


Contents of annual reportFinancial highlights

Company overview

Chairman’s statementChief Executive’s review

Audit reportFinancial statements

Notes to the accounts


The main financial statements

BalanceSheet 1AS AT

Balance Sheet 2AS AT

Profit and Loss Account

For period

Cash Flow Report

Balance Sheet 3AS AT

Profit and Loss Account

For period

Cash Flow Report

31 Dec Year 1 31 Dec Year 2 31 Dec Year 3


Balance sheet horizontal

• Fixed assets

• Current assets

• Liabilities

• Shareholders’ funds


Balance sheet verticalFixed assets

Current assetsLessCurrent liabilities

Less long term liabilities

EqualsShareholders’ funds


Profit and loss account

Revenue (sales)

Less Expenses (costs)

Equals Profit


Cash flow statement

Operating cash flows

plus

Investing cash flows

plus

Financing cash flows

Equals change in cash and bank loans


Creative accounting

What do we want to create?

More profit? Less profit?

More assets? Fewer assets?

More liabilities? Fewer liabilities?


Creative Accounting Practices

Income smoothing – move profit from one year to another

Changing accounting policies, particularly depreciation, asset valuations

Overstating costs, particularly in regulated industries

Making expenses into Assets - ‘capitalisation’


Corporate takeovers – ACCOUNTING MINEFIELD adjusting policies, fair values, goodwill, brands, reorganisation costs……...

Recognising profits that aren’t really there – foreign exchange rates affecting values of assets and loans

Off-balance sheet financing , e.g leasing, Sale and buyback, special purpose vehicles


Corporate crime / fraud

Directors are responsible for preventing crime and fraud

Who controls executive directors for honesty/? Audit committees, Non-executive Directors, Supervisory Board

They are required to have a system of internal controls


Creating fictitious contracts

Fictitious Assets, inaccurate valuations

Omitting Liabilities, misleading valuations

Raid the employees’ pension fund

Corporate crime/ fraud contd.


Analysis andInterpretation of

Financial Statements


First Steps BC (before calculation)

• Why are you analysing accounts?• Who are you interpreting for?• When are you interpreting?• What are you intending to interpret?• Limitations of Financial Accounts


Always bear in mind

• Preparers of accounts know how people will interpret their accounts

• Be cynical – assume the accounts are the best possible picture

• Analysis only as good as original data –• Never just use accounts – check from many different

sources• Accounting terms are different from general

understandings


However….• Accounts are main source of systematically produced

regulated information• Good as it gets• Usually reliable – 3rd party verified• Follow the same basic rules• Most of the information is there (in the small print)• You can never eliminate the risk of fraud / criminal

misrepresentation


Analyse Accounts to determineIs the company:

•Growing? •Profitable?

•Managing its assets effectively?

•Sufficiently liquid?•Financed properly?

•Able to meet its financial obligations?

•Viewed favourably by financial markets?


Financial ratios

• Quick and simple check on financial health

• Small number of ratios gives a picture of the business. Easy to calculate, harder to interpret.

• Provide a starting point for further investigation.


Key areas for analysis

• Profitability

• Liquidity

• Asset management

• Debt management (financial structure)

• Market value


Success in making profit

Return on capital employed

profit sales Profit

_____ x _______ = __________

sales total assets total assets

profitability x efficiency = ROCE


Managing liquidity

• Can we pay the bills as they fall due?

• Can we pay the wages of employees?

• Buy stock (inventory) on credit

• Sell on credit = accounts receivable

• Pay suppliers = accounts payable

• Ideally, match cash flows in and out


Asset management

• Use fixed assets to earn sales revenue

• Manage working capital

• stocks (inventory)

• debtors (accounts receivable)

• creditors (accounts payable)

• working capital cycle


Financial structure

• Is it a good idea to borrow?

• Creates greater risk - interest payments and capital repayments

• Benefits to shareholders when profits are rising

• Risks to shareholders when profits are falling


Advantages of ratios

• Comparisons are relative to other figures

• Compare businesses of different size

• Gives picture of company strategy

• Financial and trading performance

• Compare with industry averages

• Simple summary of complex information


Reasons for using ratios

• Gives summary statistics

• Helps identify industry benchmarks

• Input to formal decision model

• Standardise for size


Applications of analysis

• Predictions of corporate earnings

• Construct projected financial statements

• Predict corporate failure

• Indicators of financial distress

e.g. Altman’s models, combination of ratios


Problems with ratio analysis

• No agreement on definitions or specific set of ratios

• Accounting estimation

• Data not available

• Timing of data does not match

• Differing accounting policies

• Negative numbers and small divisors


Limitations of ratio analysis

• Diverts attention from the underlying information

• May not give sufficient attention to the notes to the accounts

• Accounting policies may affect comparison

• Industry differences


Creative accounting

Could involve:

• Inflating reported profits and EPS

• Accounting for losses via balance sheet reserves and all profits through P & L

• Reporting profits without generating equivalent cash

• Reporting lower borrowings


Survival Tips for Accounting Jungle

• Read the accounts backwards

• Read the accounting policies and compare

• Screen accounts using filters – e.g. high profit low tax, changing depreciation policies

• Cash is King (or Queen)

• Assess risk: If in doubt, keep out (or get out)


Return on Capital Employed

Profit before interest and taxation x 100

Shareholders’ funds plus long term debt

• Often called ‘Operating profit’

Assets minus Liabilities = Equity

• Total assets minus current liabilities equals

Shareholders’ funds plus long term loans


Return on Capital Employed

Top line questions

• What increases/ decreases profit?

• Sales? Operating Costs?

Bottom line questions

• Recent increases in assets may not yet have created profit

• Is there any debt ‘off balance sheet’?


Return on Shareholders Funds

(also called Return on Equity)

Net profit after taxes x 100



Return on Shareholders Funds

Top line questions

• What increases/ decreases profit?

• Sales? Operating Costs?

• Interest charges? Taxes?


• Is the company high/ low geared?


Net Profit Percentage

Net profit after taxes x 100

Sales

• Often shown as ‘Profit attributable to ordinary shareholders’

• Sales also called ‘turnover’


Net Profit Percentage

Top line questions

• Is gross profit high or low?

• What are the admin and selling costs?

• What are the effects of interest and taxation?


• Is the measurement of sales explained?


Gross Profit Percentage

Gross profit x 100

Sales

Gross profit = Sales minus cost of sales

Cost of sales = making ready for sale


Gross Profit Percentage

Top line questions

• Have sales volumes or prices changed?

• Have costs of sales changed?

• Are costs of sales mainly variable or fixed?


• Is the measurement of sales explained?


Current Ratio

Current Assets

Current Liabilities

Solvency = Ability to meet obligations as they fall due

Working capital = CA minus CL


Current Ratio

Top line questions

• What affects levels of stocks, debtors, cash


• What affects levels of bank borrowing, trade creditors, other short term creditors

Overall - How does the company manage its working capital?


Quick Ratio (Acid Test)

Current Assets less Stock

Current Liabilities

Solvency = Ability to meet obligations as they fall dueCash flow: How does the company manage inflows and outflows of cash?


Quick Ratio (Acid Test)

Top line questions

• How is the company managing debtors and cash?


• How is the company managing trade creditors and bank overdraft?


Stock Holding Period (days)

Stock x 365

Cost of Sales• Change 365 to 12 for a calculation in months.

• Sales minus cost of sales equals gross profit


Stock Holding Period (days)

Top line questions

• Year-end stock or average stock? Use year-end for ease of calculation but check there are no significant changes from start.


• May have to make some approximations to get cost of sales


Debtor Payment Period (days)

Trade Debtors x 365 Sales

• Debtors = Accounts receivable (customers who buy on credit terms)•Use notes to the accounts to find trade debtors.


Debtor Payment Period (days)

Top line questions

• Average or year-end? Year-end is less trouble but check there are no major changes.


• Are all sales made for credit? Think about the nature of the business.


Creditor Payment Period (days)

Trade Creditors x 365Purchases or cost of sales

•Trade creditors = Accounts payable(suppliers who provide goods on credit terms)• Use notes to the accounts for detail.

•


Creditor Payment Period (days)

Top line questions

• Average or year-end? Bottom line questions

• Opening stock + purchases - closing stock = Cost of goods sold.

• Should be Purchases but Cost of goods sold is Ok if stocks are constant.


Gearing

Long Term Debt

Long Term Debt plus Equity

• Look carefully at balance sheet and use notes to accounts.

•Add Preference shares to Debt

•Omit Provisions


Gearing

Top line question

• What are the sources of finance that create fixed commitments to pay interest and repay capital?

Bottom line question

• What is the total long-term financing of the business, based on borrowings and equity?


Interest Cover

Profit before interest and tax

Interest expense

• EBIT = Earnings Before Interest and Taxation

• Interest expense: either in profit and loss account or in detailed notes.


Interest Cover

Top line questions

• What is the amount of profit available to ‘cover’ interest payments?

• Is the company generating sufficient wealth to meet interest payments?


• What is the cost of servicing borrowings?


Concepts, Cost and Costing


Management accounting

• Integral part of management

• identify, present and interpret information

• for strategy, planning and control,

• for decision taking and use of resources

• for disclosure to employees

• to safeguard assets


Management accounting (contd)

• Internal use within organisation

• No regulation by law

• Projections for future

• Analysis of past

• Directing attention, planning and control

• Solving problems


Measuring and analysing performance

Examining future environment

Developing objectives

Formulating strategy

Operating plans

Action plans and budgets

Implementingplans


Importance of costing

• Many organisational decisions rely on costings

• Costing is complex but essential

• “An accountant knows the cost of everything but the value of nothing” Oscar Wilde


Describing costs

• Direct (identified with a saleable unit)

• Indirect (spread across saleable units)

• Indirect costs = Overheads

• How to find a fair way of spreading the overheads?


Confusing terminology

• Allocate = give all cost to one unit or centre

• Apportion = share across units or centres

• Absorb (Absorption) Soak up into the units of output

See page 142 of text book


Terminology (contd)

• What are the direct costs? Allocate these to units of output

• What are the indirect costs? Allocate to cost centres if we know where they belong.

• Otherwise Apportion (share) across cost centres.

• Absorb costs from production centres into products.


Absorption bases

Absorb as

• cost per unit

• cost per labour hour

• cost per £ of labour

• cost per kilo of material

• cost per machine hour

Different bases give different answers


Cost behaviour

Pairs of classifications

• Direct or indirect?

• Fixed or variable?

• Period or product?

Case: Bus company sends buses to 10 schools for taking children home each day. How does the company describe the costs?


Direct or indirect?

Direct for each school:

Driver’s working time, fuel for bus, bridge tolls

Indirect to spread across all journeys:

Insurance, repairs, maintenance, licences, depreciation, driver’s idle time, holiday pay


Fixed or variable?

Variable change with activity level

Fuel, repairs, bridge tolls

Fixed regardless of activity level

Drivers’ wages, Insurance, Licences,

Maintenance checks, Depreciation


Period or product?

What is the product?

A person-mile.

Product costs

Driver’s time, fuel, bridge tolls

Period costs

Insurance, Licences, routine maintenance, depreciation


Examples of decisions• Price setting, tendering for contracts• Product profitability analysis• Product design modifications• R & D management• Value Engineering• General Cost Management• Contracting out / Buying in• Plant / Department Closure


Short-term decisions

In the short term business can continue if the selling price covers variable costs and makes a contribution to fixed costs.

Contribution = Selling price - variable cost


Contribution analysis

Break even point =

Fixed costs

Contribution per unit

Pay £1,000 rent for market stall. Buy toys for £6 each, sell for £8 each. What is breakeven volume?

£1,000/£2 = 500 toys


Contribution analysis (contd)

Sell 500 at £8 = £4,000.

Variable cost 500 x £6 = £3,000

Add fixed costs £1,000

Neither profit nor loss

How many toys to sell for profit of £4,000?

£(1,000 + 4,000)/£2 = 2,500 toys


Scarce resources

Sell gardening services and house cleaning.

Contribution per job £10 and £8.

Gardening needs 2 hours per job, House cleaning needs 1 hour per job.

Shortage of labour. Which has priority?

House cleaning £8 per hour, Gardening £4 per hour.

Contribution per unit of limiting factor


Short term decisions

• Make internally or buy externally

• Hire own staff or pay agency for outsourcing

• Keep a business activity going

• Take on a special order at lower price


Other factors in decisions

Not just an accounting matter. Consider

• organisation’s objectives

• relationship with employees

• marketing

• corporate goodwill/ image

• customer reactions

• government policies


Get the costs wrong and...

•Set prices too high - lose sales; too low - sell products at loss•Lose potentially profitable contracts, win loss making contracts•Don’t know where we are making / losing money•Continue with loss making products, cut profit making products, sub-optimal product mix


Get the costs wrong and...

•R & D to create ‘better’ product when none needed •Product Design Modifications not done when needed•Contracting out production that costs more than internal production•Making products that could be cheaper to buy in•Close profit-making Plant / Keep open loss making plant


Different Costs for Different Purposes

Not a single, universal ‘true’ cost.Appropriate cost is governed by:

Needs of managementSpecific organisational situations

Specific problem to be solvedAvailable information - pragmatics


Different Costs for Different PurposesActivity BasedCost

Failure Cost Planned Cost

Average Cost Full Cost Product CostAvoidable Cost Historic Cost Quality CostBudgeted Cost Incremental

CostRelevant Cost

ControllableCost

Indirect Cost Step Cost

Current Cost Joint Cost Sunk CostDirect Cost Marginal Cost Standard CostEnvironmentalCost

OpportunityCost

Total Cost

EngineeredCost

OverheadCost

Transfer Cost

Fixed Cost Period Cost Variable Cost


Costing Problem

•In contemporary organisations the fixed/variable classification is not relevant•Logical impossibility of attributing all costs to products•Wrong approach to the problem•‘Solution’ based in the ‘accounting world’ not the ‘organisational world’


Activity ‘Solution’

Costs don’t drive activities, activities cause costsOrganisations do things that consume resources and (should) create valueCosting should start with what the firm does - activities in organisational world


Activity Based Costing

• What are the activities of the organisation?

• What resources are used by each activity?

• How much does each resource cost?

• Collect cost in ‘cost pools’

• How does each product or service make use of each activity?

• Share cost from the cost pools.


Activities

consume

Resources

Outputsproduce

cost

Money

creates Value

Collect DataNon-financialPerformanceAnalysis


Benefits of ABC

• Makes visible the activities that drive the costs

• Prevents misallocation of costs

• Links costs more closely to responsibility for causing costs

BUT does not save money or generate profit. It only gives more accurate information


Activity costing is...

•Not based on accounting coding structures•Not based on accounting time frames•Not based on techniques designed to make the accountants life easier•Not based on producing Financial Statements


Short term planning

Budgets and

Budgetary Control


What is a budget?

• Quantified format

• management plans and strategies

• for decision making

• communication medium


Mission/ goals

Corporate objectives

Long term strategy

Long term plans

Financial plans

Assessed market opportunities/ organisationalcapability

Assumptionson criticalfactors


Long term strategy

Long term planning

Short term strategy

Budget/ short termplanning

Forecastingassumptions

Modifyassumptions

Market opportunities

Organisationalcapability


Budget process

• Formalises planning and control

• Defines goals

• Goal congruence - brings goals together

• Authority and responsibility are clear

• Framework to judge performance


Master budgetSales budget

Cost of goods sold budget

Development /design budget

Marketing budget

Distribution budget

Administration budget

Capital budget

Cash budget

Budgeted balance sheet

Budgeted profit and lossaccount

Budgeted statementof cash flow

+

+

+

+

+

financialoperating


Budget preparation

•Start with sales budget (demand driven)

•Then match with cost of sales

•Is this a production organisation?

Plan:

inventories of raw materials, finished goods

purchases to cover sales and inventories


Budget preparation (contd)

• Is this a service organisation?

Plan service programme, labour needs, materials needed

• Plan all other operating expenses

• Plan capital expenditure

• Bring together in cash budget, budgeted profit and loss account, balance sheet.


Cash budget

• Most important part of budget cycle

• Monthly, quarterly?

• Cash receipts from operations

• Cash payments for operations

• Other cash receipts (new finance, sale of fixed assets)

• Other cash payments (tax, dividends, interest)


Fixed and flexible budgets

• Fixed means that budget is not adjusted later if volumes start to vary

• Flexible budgets means that budget is adjusted to take account of change in volumes of activity over the period


Fixed and flexible (contd)

Budget variable costs of £200,000 for 5,000 units of output

Actual variable costs are £195,000 for 4,500 units of output

How has manager performed against budget?


Fixed and flexible (contd)

Appears to have saved £5,000

But budgeted cost = £4 per unit

So flexible budget for 4,500 is £180,000

Performance is £15,000 worse than flexible budget.


Alternative approaches

Easy approach = Last year plus inflation

Zero-based budgeting

• Start with a clean sheet

• Justify every item

• Focus on goals and objectives


Alternative approaches (contd)

Activity based budgeting

• Extension of activity based costing

• Focus on cost of each activity

Kaizen budgeting

• continuous improvement

• budget is achieved if improvements are met


Not-for-profit organisations

• Goals and objectives measured differently

• Need to be cost effective

Planning programming budget system

• Focus on outputs rather than inputs

• ‘joined-up’ government


Behavioural aspects

Budgets can motivate employees to achieve goals of the organisation. What helps?

• degree of difficulty

• top management participation

• perceived fairness

• feeling of ownership

• avoid discontent about preparation


Not foolproof

Why might budgets fail?

• Fail to understand changing environment

• using unsuitable existing structures

• fail to understand business systems

• lack of senior management support

• fail to understand central role of budgeting


Are budgets necessary?

What matters is PLANNING

This does not have to use budgets. Essential:

• Set targets: to maximise long term value

• Strategy: Make development continous

• Growth and improvement: challenge staff

• Resource management: wealth creation


Are budgets necessary?

• Co-ordination: manage cause and effect

• Cost management: challenge all costs

• Forecasting: use rolling forecasts

• Measurement and control: key indicators

• Rewards: unit rewards not individuals

• Delegation: give managers freedom to act


Performance Measurement


Strategic planning

Five year plan, rolling forward.

• Profitability

• Growth of sales, profit

• Market share

• Customer satisfaction

• Rate of innovation

How to measure achievement of strategy?


Accounting-based performance measures

Profit?

• Could compare actual profit against budget, but companies don’t give information

• An absolute measure, needs ratios for comparison.

• Affected by choice of accounting policies

• Measured differently in different countries


Accounting-based performance measures (contd)

Profitability

• A relative measure, better for comparison.

• Calculate for subdivisions of an organisation.

Methods

• Return on capital employed

• Residual income

• Economic value added


Return on capital employed

Profit before interest and taxes

Fixed assets plus current assets less current liabilities

Can be used for divisions of a company if assets and liabilities can be allocated.


Return on shareholders’ funds

Net profit after interest and taxation


Can only be calculated for the company as a whole, not subdivided for divisions of organisation.


Residual income

Ask: What is the income (profit) remaining after deducting a notional interest charge for the use of capital?

X Z £000’s

Operating profit (EBIT) 18 1,500

Capital employed 100 10,000

ROCE 18% 15%


Residual income (contd)

Suppose cost of capital is 10% for both.

X Z £000’sOperating profit (EBIT) 18 1,500Less interest charge (10) (1,000)Residual income 8 500

Company Z gives higher income to shareholders


Economic Value Added (EVA)

Companies should deliver value that exceeds the cost of capital.

X Z

Profit after tax (before interest) 13 1,050

Interest charge (net of tax) (7) (700)

EVA 6 350

Z gives higher EVA than does X


Performance of a division

Divisions are created by decentralisation

• Gives greater responsiveness

• Allows faster decisions

• Motivates managers

• Uses specialist experience of managers

But needs a measure of performance


Performance of a division (contd)

Problems of decentralisation

• Focus on division, not on total organisation

(Called ‘dysfunctional decision making)

• More information is needed, cost involved

• Duplication of activities



Cost centre

• Manager is responsible for costs

Discretionary cost centre

• Manager has some choices in cost budget

Revenue centre

• Manager is responsible for generating planned sales



Profit centre

• Manager is responsible for revenues and costs

• Target profit is set

Investment centre

• Manager is responsible for resources and profit, target return to be achieved


Transfer pricing

What price is charged for transfers between divisions within an organisation?

• Variable cost?

• Variable cost plus a profit margin?

• Variable cost plus portion of fixed cost?

• Variable + fixed + profit margin?

• Negotiated price? Reflect market?


Financial Performance Measurement

• Success / Failure often determined by accounting numbers

• Growth in profit, ROCE, Sales• Reduction in costs, headcount, errors, stock• Financial Ratio Analysis


Financial Performance Measurement (contd)

• Achieving outcome at or under budget• Adverse / Favourable variance analysis• Project NPV – cost overruns• OBJECTIVE APPROACH TO Performance

measurement


Problem with financial measures

A Simple Scenario.

Division in large company enjoyed major growth in profitability over two years ..manager promoted.

New manager ….drop in profits.

WHY ?


Financial measures (contd)Top line answer• Division’s market share dropped• Costs were reduced by reducing maintenance of cutting machine, reducing staff training•build up of stocks (inventory) of unsold goods

Bottom line answer• Reduced investment in new technology

Financial System did not pick up the BAD Events


Problems with financial information

• Complexity /mystery and the method of calculation

• Arbitrary treatment of some cost items

• Time lag between event and the financial ledger

• No direct observable relationship between activities and reported costs

• Irrelevant to managers


Problems with financial information (contd)

• Managers need to convert data into meaningful information.

• Implied assumption that control costs will control activities.

• Focus on cost minimisation, not on effectiveness or value-adding. Could be valid reasons for costs increasing.

• Simplification of organisational activities, by reducing everything into a single £ value.


Value of Financial Performance Measurement

• Managers accept importance of financial outcome of their function (especially if linked to pay / prospects).

• Managers will try to increase their profitability.

• Managers often devise their own budget 'systems’.


Value of Financial Performance Measurement (contd)

• Need information on relationships between activities they control and financial outcome

• Ignore formal budget reports / spend time and effort proving official budget is wrong

• Do not assume that managers can "translate" £s into actual activities


Information Managers Use

US study concluded information used for daily operating control did not come from the budgeting system.

Managers' information needs are affected by:

•the resources most significant to their process, in terms of cost, quality, availability

•the time frame in which this information is needed


Indicators for managers

level of finished goodslevel of orders (demand)key production limiting factors simple counts of output per hour / shift / day, physical quantities of materials / labour used, down-time


Indicators for managers (contd)

scrap quantities, rework rates.capacity utilisationphysical production requirements (long - medium

and short-term)


Non-Financial Measures

Non-financial is any information not valued in £s. It has the following advantages:

• Expressed in terms/language understandable to managers (non-accountants)

• Requires very little "translation" by managers


Non-Financial Measures (contd)

• Potentially quicker, relevant

• Relates to events, activities, actual observable performance

• Can be used to make sense of financial budgets

• Better reflects the "reality" of the situation, not confused by strange accounting rules/conventions


Integrating Non-£ and £ measures

• Activity Based Accounting

• Benchmarking

• Performance Scoring

• Balanced Scorecard

• Strategic Management Accounting

• Many other – multiple criterion decision making, data envelopment analysis, etc…


Balanced Scorecard

Vision and Strategy

Learning & Growth Perspective

Customer Perspective

Internal Business Perspective

Financial Perspective


Balanced Scorecard

• systematic attempt to design performance measurement system that integrates

– organisational objectives,

– co-ordination of individual decision making

– need for organisational learning.

• create an environment that facilitates continual improvement


Balanced Scorecard (contd)

• reflect the organisation’s understanding of the causes of successful performance.

• monitoring performance and what managers believe are drivers of good performance

• performance measure system should measure the most critical aspects of organisational performance.


Balanced Scorecard (contd)BS performance measures should

• be clearly understood by all employees

• link manufacturing performance and financial performance

• be linked to ensure constancy of purpose.


Balanced Scorecard (contd)

BS performance measures should

• be able to identify cause-effect relations to enable employees to deal with poor performance and continue good practices.

• be based on critical success factors

• identify trends and rate of change


Not-for-profit organisations

• Economy

Cost at which resources are acquired

• Efficiency

Compare inputs and outputs

• Effectiveness

How resources are used

Value for Money

Accounting

Business

bottom line

increases

bs performance

000s operating

capital employed

accounts define

balance sheet

financial