PERFORMANCE

MEASUREMENT & CONTROL

Performance Measurement  Profitability ratios (ROCE, profit margins, asset
turnover)
 Profitability ratios relationship
 Liquidity ratios (current, quick, receivable collection,
payable payment, inventory holding)
 Gearing (operating, financial, interest cover, dividend
cover)
 Derive figure from: Ratio, Numerator-Denominator,
SOFP/SOPL
 Performance analysis
o FPI
o Percentage comparison of FS figures
o Balance scorecard
o Building block
o Value for money
Divisional Performance &  ROI
Transfer Pricing  RI
 Divisional performance analysis
 Optimal transfer price
o Minimum price
o Maximum price
Performance Measurement
Performance measurement aims to show how successfully the organisation achieves
its objectives. Therefore, performance indicators are part of the organisation's control
system.

Financial Performance Indicators

A particular indicator is very little of use in isolation. Indicators will add benefit if it is:

● Compared with a budget

● Set in a trend

● Compared against a best practice benchmark

● Compared with last year’s figure

● Compared with the industry average.

Profitability ratios:

1. Returns on Capital Employed: Measures returns to the various providers of capital.

Return on Capital Employed = Profit Before Interest and Tax / Capital employed ×
100

[Capital employed = Total Assets - Current Liabilities

= Total Equity + Non-current Liabilities]

Return on Equity = Profit after tax / (Share capital + Reserves) × 100

[Higher is desirable]

If profit is after interest, divide by equity. If profit is before interest, divide by equity
plus long-term debt, because that profit will be shared between providers of debt and
equity finance.

This can be compared with other companies in the same industry sector or to the
company's cost of capital. Comparing companies in other sectors does not provide
valid information.

Improved by investing in projects that generate a higher return on capital.

Other methods of increasing ROCE that are not actually improvements include:

● The use of different accounting policies may affect profits and capital employed.

● Delaying or reducing investment in new non-current assets. As the existing non-

current assets depreciate, their carrying amount (net book value) falls, reducing
the capital employed and improving ROCE.

2. Gross Profit Margin:

Gross profit margin = Gross profit / Revenue × 100

[Higher is desirable]

A falling gross profit margin over time means that either:

● the selling price declining, or

● the cost of making or buying those goods is increasing.

Gross profit margins may be improved by:

● Introducing new products that are popular with customers. These can be sold for a
higher margin.

● Using target costing to reduce the cost of sales.

Reclassifying direct expenses as administrative would increase the gross profit

margin but not improve overall profitability.

3. Net Profit Margin:

Net profit margin = Net profit after tax / Revenue × 100

[Higher is desirable]

Ways to Improve the Net Profit Margin:

● Introduce new products that are popular with customers. These can be sold for a
higher margin.

● Use target costing to reduce the cost of sales.

 ● Increasing sales volume should increase net profit margins if a high portion of the
company's costs are fixed (e.g. in a training company).

● Better control over administrative expenses (e.g. salaries).

● Using less debt finance (less interest cost).

4. Asset Turnover Ratio: It indicates whether or not the capital invested is generating
enough revenue.

Asset Turnover Ratio = Revenue / Capital employed

[Higher is desirable]

The asset turnover ratio can be improved by:

● Selling non-current assets that are surplus to requirements.

● Recognizing impairments and writing down the value of the assets. (Arguably,
this is merely financial engineering as it does not improve actual performance.)

● Improving working capital management, for example by collecting receivables

more quickly or reducing inventory levels through better inventory management.

Relationship:

ROCE = Operating profit margin × Asset turnover

Liquidity ratios: Liquidity ratios measure the ability of the organisation to meet its
liabilities as they become due (e.g. suppliers, interest on bank loans, overdrafts).

1. Current Ratio: measures the adequacy of current assets to meet current liabilities
(without having to raise additional finance).

Current ratio = Current assets at period end / Current liabilities at period end

[>2:1 is desirable]

A ratio of less than 1 means current liabilities exceed current assets.

2. Quick Ratio (Acid Test Ratio): measures immediate liquidity (by eliminating the
least liquid asset, inventory, from current assets).

Quick ratio = (Current assets -Inventory at period end) / Current liabilities at period
 end

[>1 is desirable]

3. Inventory Holding Period: measure the amount of time inventory is held before it is
sold, measured in days.

Inventory Holding Period (days) = 365 × Average Inventory / Cost of Sales

[Lower is desirable]

The shorter the period, the lower the holding costs of inventory and the faster inventory
can be converted into cash.

4. Receivables Collection Period: measure the amount of time receivables are held
before they are collected, measured in days.

Receivables Collection Period (days) = 365 × Average Receivables / Total Credit

Sales

[Lower is desirable]

The shorter the period, the lower the financing costs of receivables, and the faster
receivables can be converted into cash. Shorter periods also indicate a lower risk of
bad debt.

5. Payables Payment Period: measure the amount of time payables are held before
they are paid, measured in days.

Payables Payment Period (days) = 365 × Average Payables / Total Credit Purchase

[Higher is desirable]

The longer the period, the lower the financing cost. Longer periods also indicate more
cash retention. Payables can be used as a form of interest-free financing. However, this
needs to be balanced against the risk of losing access to payables financing from
suppliers.

Ways to Increase Liquidity Ratios:

Acceptable ways of increasing (i.e. improving) liquidity ratios include:

● Using long-term finance (loans and equity) to finance acquisitions of non-

current assets. This is usually done to match the financing period with the useful
life of the non-current asset.
● Better control over receivables.
 ● Delaying payable payments.

Liquidity ratios may also be increased by adjusting year-end balances (“window

dressing”); however, this is not a genuine improvement.

Gearing ratios: Gearing (or "leverage") measures the portion of a company's finance
provided by debt. The advantage of debt is that it is a relatively cheap source of
financing (lower cost than equity; tax deductible). However, companies with too much
debt (gearing) increase the risk of being unable to repay the debt's interest and principal.

1. Operating gearing: measures the extent to which a firm’s operating costs are fixed
rather than variable.

Operating gearing = Fixed cost / Variable cost

Or, Fixed cost / Total cost

Or, Contribution / Profit Before Interest and Tax

[High operating gear means fall in sales revenue would cause even larger fall in
operating profit]

2. Financial gearing: measures the long-term debt as a percentage of equity.

Financial gearing = Debt / Equity × 100

Or, Debt / (Debt + Equity) × 100

Gearing ratio is only useful if the gearing of the organization is compared with industry
averages of other companies in the same business area to determine whether or not
the gearing is too high.

● In industries with stable profits, companies can sustain higher gearing levels.
● An increase in gearing over time may reflect changes in the level of debt
acceptable to the finance director. Alternatively, it may indicate that
insufficient cash flows cause the company to borrow money to finance short-
term operations.

3. Interest Cover: Interest cover shows how much the return on debt (interest) is
covered by profit. Lenders use this measure to determine the vulnerability
(sensitivity) of interest payments to a fall in profit.

Interest cover = Profit before interest and tax / Interest

[Higher is desirable]

A decrease in the ratio indicates that the company is facing an increased risk of not
being able to meet its interest payments as they fall due.

4. Dividend cover: It shows how much the dividend is covered by net profit.

Dividend cover = Net Profit / Dividend

Weaknesses of FPIs:

FPIs ignore the drivers of business success:

● Quality;
● Delivery;
● Customer satisfaction;
● After-sales service.

Short termism (myopia): managers may take a short-term view and concentrate on
achieving the next set of financial targets, ignoring the longer term.

Financial manipulation: Short-termism may also increase the risk of financial

manipulation, which can take many forms of earnings management (e.g., the recognition
of revenue and expenses), profit smoothing or manipulation of key accounting ratios
(e.g., misclassification of debt or equity).

● Accelerating revenue: including next year's revenue to the current year.

● Delaying cost: including current years costs to next year.

● Understating provisions

● Manipulation of accounting policies.

Non-financial Performance Indicators

Many companies identify critical success factors (CSFs) at the strategic level.

Critical success factors – an area where an organisation must perform well if it is to

succeed.
Key performance indicator (KPI) – a quantifiable metric that measures the
achievement of a goal or objective.

Key performance indicators (KPIs) measure how well an organization meets its critical
success factors.

Balance scorecard: The objective of the balanced scorecard is to provide top

management with an integrated set of performance measures of all relevant areas.

The balanced scorecard looks at performance from four different perspectives:

1. Customer perspective – how do our customers see us?

2. Internal business process perspective – at what process must we excel?

3. Learning (or innovation) and growth perspective – how can we continue to grow and
change in the modern dynamic business environment?

4. Financial perspective – how do we look to shareholders?

Perspective Goal/Objective
Customer perspective  To increase the number of new customers and
returning customers
 To reduce customer complaints/satisfaction
Internal business  To reduce the time taken between order and delivery
process perspective  To reduce staff turnover
 To reduce defect rate
 To increase productivity
 To increase efficiency [resource used/unit]
 To reduce wastage/idle time
Learning and  To increase the proportion of revenue from new
growth perspective product/service
 To increase % staff training time
 To improve methods
 R&D
Financial perspective  To increase revenue per customer
 To increase gross profit margin

The four perspectives should complement each other. If customers are satisfied, for
example, this should lead to increased revenues and profits, which improve the
financial perspective.

For each perspective, management needs to identify:

1. Objectives – what are the main objectives?

 2. Measures – how can the performance be measured against the objectives?
3. Targets – what targets should be set for each measure?
4. Initiatives – what actions could be taken to improve performance?

Advantages Disadvantages

● It leads to a wider view of ● Introducing the balanced scorecard

performance rather than would require training and a culture
concentrating on the financial change. Managers and staff may
aspects of performance. initially be sceptical.

● Managers are unlikely to be able to ● Identifying the most appropriate

distort the performance measure as measures may be difficult.
poor performance is difficult to hide
using multiple measures. ● Obtaining the data to determine
whether some measures have been
● It takes a long-term perspective of achieved may be problematic.
business performance and links
performance measurement to the ● The balanced scorecard focuses only
organization’s objectives and on the needs of two stakeholders –
strategy. owners and customers; it ignores
the needs of other groups, such as
● Using only a small number of KPIs employees.
ensures that management can
concentrate on the most critical ● Managers may have to analyse
aspects (i.e. “what gets measured many KPIs, some of which may
gets done”) and avoid confusion conflict with each other, and
arising from having too many determine which gives the most
performance indicators. significant results.

● Financial performance indicators

are ‘lagging’ indicators. This means
that the events and decisions which
caused these indicators occurred
long ago. The balanced scorecard
includes ‘leading’ indicators. For
example, the learning and growth
perspective may encourage spending
on training or techniques which will
depress profits or increase costs in
 the short term, but will have much
greater benefits in the future.

● Not all organisations have profit or

financial return as the main objective.
Many non-profit bodies have
multiple stakeholders, each with
potentially conflicting objectives.
Balanced scorecard considers
multiple perspective rather than
just shareholder.

Building block model: A framework for service companies to use in developing a

performance evaluation system linked to reward schemes for managers.

There are three "blocks" – dimensions, standards and rewards.

Dimensions: Dimensions are the aspects of performance which must be measured.

There are six dimensions in the Fitzgerald and Moon model. Organizations need to
identify performance measures based on these six dimensions. (Similar to the four
perspectives in the balanced scorecard model.) The six dimensions are:

Dimensions Examples of measures

1. Financial  Profitability
performance  Liquidity
 Risk
2. Competitiveness  Market share
 Sales growth
 Customer attraction
 3. Quality  Customer satisfaction/complaint
 Customer repeat
 Defect rate/return/refund
 Reliability
 Responsiveness
 Competence
4. Resource  Productivity [sales/output per resource
utilization (staff/hour/machine)]
 Efficiency [resource used/unit]
 Wastage/idle time
 Occupancy
5. Flexibility  Time taken per unit
 Volume flexibility
 Resource (staff/hour/machine) flexibility
 Staff multi-task
 Delivery speed
 Changeover time
6. Innovation.  New products
 Proportion of revenue from new product/service
 Improve methods
 R&D

Financial performance and competitiveness are the results, while quality, resource
utilization, flexibility and innovation are the determinants. If the organization performs
well in the determinants, this will lead to good performance in the results.

Standards: standard block sets the target for the performance indicator chosen for
each dimension.

Three principles should be applied in setting targets for managers:

1. Ownership – managers should take ownership of (believe in) the targets.

Managers who participate in setting targets will be more likely to believe in
them.

2. Achievability – targets should be challenging but achievable; otherwise,

managers will dismiss them rather than be motivated to achieve them. Owing to
the principal-agent problem, those responsible for results will always push for
easier targets.

3. Equity – the organization should maintain a realistic level of difficulty for its
standards across all business areas and be fair and unbiased in its performance
assessment.
Reward Schemes: Rewards blocks motivate the employees to achieve the standards.
Reward schemes may be linked to performance by paying managers bonuses if they
achieve targets. Three principles apply:

1. Clarity – employees must understand the performance measurement scheme.

2. Motivation – bonuses should motivate staff to achieve the targets.

3. Controllability – managers' performance evaluations should only measure factors

that they control.

Performance Measurement for Not-for-Profit

Organizations & Public Sector
Objectives of NFP organizations are more difficult to measure and rank because:

● They are challenging to quantify. How can a hospital's aim "to improve health in
the area" be measured? Information from several sources may be required (e.g.
hospital admissions, rates of specific diseases, ultimately life expectancy).
Charities may find it challenging to measure the alleviation of suffering or raise the
level of public awareness.

● The achievement of some objectives may be simpler to measure than others.

Therefore, there is a risk that the organization will focus on what can be easily
measured rather than what is most important to its long-term future.

● Achievement of some objectives may be subjective. For example, the objective

“to provide a good quality of education” may mean different things to different
people.

● Many non-profit bodies have multiple stakeholders, each with potentially

conflicting objectives.

● There may be no clear primary objective (like commercial companies with profit
maximization as their primary objective to which all other goals are assessed).

Setting qualitative targets can be difficult in NFP organizations because:

● Identifying measures for qualitative areas can be challenging enough, even

before consideration of setting the target.
 ● Determining the appropriate level of difficulty for the target is difficult. A target
that is too difficult may demotivate. A target that is too easy may encourage
inefficiency.

● Meaningful targets need to take into account differences in the external

environment. For example, a school's demographics may significantly influence
exam results. It may not be appropriate to set the same targets for all schools.

● Targets are often based on results rather than effort. In many organizations, the
hard work of staff may not always be reflected in the results (e.g. mortality rates in
hospitals may reflect many factors, not just the efforts of the medical staff).

● Managers judged by the performance measures need to be involved into the

targets set. Managers may be more willing to accept targets if they have been
involved in developing them.

Value for Money Objectives: The value for money (VFM) framework attempts to
evaluate the performance of NFP and other non-commercial organizations. VFM focuses
on how well the organization has achieved its objectives given the funding it received.

Three performance indicators (the "3Es”) measure VFM:

1. Economy: minimizing inputs cost for the quality required (i.e. the lowest cost
option may not necessarily be chosen if it does not provide sufficient quality).

2. Efficiency: how efficiently the input is utilised, maximizing the output/input

ratio;

3. Effectiveness: achievement of objectives.

High effectiveness may conflict with economy and efficiency.

External Considerations
Performance evaluations should consider external factors that management cannot
control. Performance measurement should be flexible enough to consider external
factors.

Stakeholders: A stakeholder is defined as any person or group that has an interest in or

is affected by an organisation.

Ignoring stakeholder objectives may result in adverse implications for an organization.

Different stakeholders have different objectives. Management needs to consider the
most critical stakeholders, consider their objectives, and identify ways to measure how
these objectives are being met.

Market conditions: An organization's market conditions will affect its economic

performance and may affect various parts of the organization differently. For example,
performance analysis should consider market differences when comparing two divisions.

Competitors: Competitor performance will directly affect organizational performance.

Price competition within a market, for example, will likely lead to price cuts of the
organization's products and have a financial impact.

Sustainability: meeting the needs of the present without compromising the ability of
future generations to meet their own needs.

There are numerous ways in which poor environmental behaviour may damage an
organization:

● fines (e.g. for pollution or other breaches of regulations);

● increased liability to environmental taxes (e.g. carbon taxes);
● reputational damage;
● loss of sales or consumer boycotts;
● inability to secure finance;
● loss of insurance cover.

However, reducing material, energy and water usage should not only reduce
environmental impact but may also reduce operating costs. Similarly, a focus on
reducing waste could, in turn, improve process efficiency and reduce the amount (and
therefore the cost) of materials used.

Equally, although health and safety measures might not add value directly, they can
help to protect an organization from the cost of accidents which might otherwise occur.

Divisional Performance
Decentralization: Delegation of authority to make decisions.

Decentralisation requires the creation of autonomous business units or divisions to

align responsibility with Decentralized authority. These units can be:
 ● Revenue centres – managers are responsible for decisions about revenue
generation (usually including selling costs);

● Cost centres – managers are responsible for decisions about costs;

● Profit centres – managers are responsible for decisions about costs and
revenues;

● Investment centres – managers are responsible for cost, revenues, and asset
investment decisions.

Benefits Problems

● Senior management can concentrate ● Lack of goal congruence − the risk

on strategy − delegating routine that divisional managers will make
decisions free senior management for decisions inconsistent with overall
long-term corporate planning. organizational objectives.

● Faster decision-making − divisional ● Increased information requirements

managers are "on the spot" and can − reporting systems must be
react quickly to changes. introduced to monitor divisional
performance.
● Better decision-making − specialist
managers will likely understand their ● Lost economies of scale − costs may
part of the business better than rise through duplication of common
senior management. activities. A central purchasing
department may achieve better prices
● Motivation − divisional managers are and lower overall overhead than
given responsibility and status and may divisional purchasing departments.
increase effort.
● Loss of central control − top
● Training and career progression − management loses control to divisional
divisional managers acquire skills managers. Conflict may occur if top
and experience which may prepare management disagrees with the
them for senior management (e.g. decisions of divisional managers.
managers may be "rotated" between
divisions).

● Tax advantages − locating divisions in

certain areas which enjoy tax
 incentives or government grants.

Measurement Characteristics: A significant risk of decentralisation is that managers

may make decisions that are not in the best interests of the overall company
(“dysfunctional decisions”). Therefore, a good performance measurement system
should provide for the following:

● Goal congruence − performance measures should encourage decisions consistent with

company objectives.

● Timeliness − performance reporting must be fast enough to allow any required

corrective action.

● Controllability − evaluation should assess only divisions and divisional managers on

performance under their control.

Measures:

● variance analysis − taking care to identify controllability

● ratio analysis
● non-financial measures
● return on investment
● residual income

Division Type Financial Measures Non-Financial Measures

- Sales volume per employee

- Sales variances (volume, price,
Revenue - Customer satisfaction
mix)
Centre rating
- Selling costs ratio
- Customer retention

- Cost variances
Cost Centre - Labor turnover
- Cost per unit produced

Profit Centre - Controllable profit (for manager - Customer returns

assessment)
- Traceable profit (for division)
- Sales variances
- Profit margins
 Division Type Financial Measures Non-Financial Measures

- Contribution margins

- Return on Investment (ROI)

- Residual Income (RI)
Investment - Number of new products
- Liquidity ratios:
Centre developed
• Current ratio
• Receivables days

[Controllable profit is used to assess the manager's performance.

Traceable profit is used to assess the division's performance.]

Return on investment (ROI): A return on capital employed which compares income

with the operational assets used to generate that income. It is used to appraise
decisions of individual departments.

ROI = Controllable or Traceable profit / Capital employed × 100

[Profit is before interest and tax because interest is affected by financing decisions]

[Decision rule − Divisional performance is favourable if; ROI > cost of capital]

Capital investment usually has two components:

ROI is the divisional version of company ROCE. It is a measure of divisional

performance. It is NOT an investment appraisal method. In practice, however,
divisional managers often use ROI for investment appraisal.
Advantages Disadvantages

● As a relative measure, it is easy to ● Risk of dysfunctional decision-

compare divisions. making.

● Similar to ROCE used externally by ● The definition of capital employed

analysts. is subjective. For example, should
non-current assets be valued
● Focuses attention on scarce capital using:
resources.
o carrying amount (i.e. net
● Encourages reduction in non- book value);
essential investment by: o historical cost; or
o selling off unused non-current o replacement cost?
assets; and
● If net book value is used, ROI will
o minimizing the investment in
working capital. increase over time because of
depreciation.
● Easily understood percentages
● Risk of window-dressing; boosting
(especially by non-financial
managers). reported ROI by cutting
discretionary costs.
● Can be further analysed (i.e.
● Risk of short termism by not
between profit margin and asset
turnover). investing in non-current asset to
keep the ROI high.
Residual income (RI): pre-tax profit less imputed interest charge for capital invested.
Residual income focuses on wealth creation.

Residual Income = Controllable or Traceable Profit - Imputed Interest charge

Imputed interest = Capital employed × Interest rate

[Decision rule − accept a project/investment if residual income is positive.]

Advantages Disadvantages

● Residual income overcomes some of ● Definition of capital employed.

the problems associated with ROI
(dysfunctional behaviour and holding ● Effect of depreciation.
on to old assets).
● Window dressing.
● It can be linked to net present value.
The present value of an investment's ● It is challenging to compare divisions
residual income equals the of different sizes. The manager of the
investment's net present value. In the larger division will generally show a
long run, companies that maximize higher residual income because of
residual income will also maximize the size of the division rather than
net present value and shareholder superior managerial performance.
wealth.
● Less easily understood than a
● A risk-adjusted cost of capital can percentage.
reflect different risk positions of
different divisions.

Transfer Pricing
Transfer price – the price at which one division transfers goods or services to another
division within a company or from one subsidiary to another within a group.

A transfer pricing policy is needed when:

 ● An organization has been decentralized into divisions; and

● Inter-division trading of goods or services occurs.

Transfers between divisions must be recorded in monetary terms as revenue for

supplying divisions and costs for receiving divisions.

Objectives:

● Goal congruence:
Transfer prices should encourage divisional managers to make decisions in the
best interests of the organization as a whole. Any organization with divisions
faces a risk of dysfunctional decision-making. Where inter-division trading
occurs, this risk is particularly high, for example, divisional managers purchasing
from external sources because of the high transfer price. Achievement of goal
congruence must be the primary objective of a transfer pricing system.
● Divisional autonomy:
Head office must be mindful when one of the divisions has a much stronger
negotiating position than the other. This can result in a transfer price that is
unduly beneficial to the performance of the stronger division and detrimental to
the performance of divisions in a weaker position.
● Divisional performance evaluation:
Transfer prices should be "fair" and allow an objective assessment of divisional
performance. The transfer price used should permit each division to make a
profit.

Market Price Method

A market price may be used as transfer price if buying and selling divisions can
buy/sell externally at market price. However, it may need to be adjusted downwards if
internal sales incur lower costs than external sales (e.g. due to lower delivery costs).
 Advantages Disadvantages

● Optimal for goal congruence if the ● Only possible if a perfectly

selling division is at full capacity. competitive external market
exists.
● Encourages efficiency − the
supplying division must compete ● Market prices may fluctuate.
with external competition.

Full Cost Plus Method

Under the full cost-plus method, the supplying division charges full absorption cost
plus a mark-up. Standard costs should be used rather than actual costs to avoid
selling divisions transferring inefficiencies to buying divisions.

Advantages Disadvantages

● Easy to calculate if a standard ● The markup is arbitrary.

costing system exists.
● May lead to dysfunctional
● Covers all costs of the selling decision making:
division.
o Selling division may not reduce
● May approximate the market cost because it will reduce
price. mark-up profit also.

o If the trade is loss making for

the buying division, it may buy
from external sources.

o The fixed costs of the selling

division become the variable
costs of the buying division −
which increases cost per unit for
buying division while for selling
division it stays the same.

Opportunity Cost Approach

The transfer price should be between the minimum price acceptable by selling division
and the maximum price acceptable by buying division.

Otherwise, there may be dysfunctional decision making (i.e. selling division only
selling externally if they don’t get the minimum price and buying division buying from
external source if they have to pay more than the maximum price; where inter-division
trade is of the company’s best interest.)

Minimum price acceptable by Selling division:

Minimum Transfer price = Marginal (variable cost) + Opportunity cost

[The opportunity cost is usually the lost contribution from external sales, either of:
● The product subject to the transfer price; or
● other products which the supplying division makes.

Opportunity cost arises if:

● external market exists

● but no spare capacity of production

So, external sales have to be sacrificed for internal sales.]

Maximum price acceptable by Buying division: The maximum transfer price

acceptable to the buying division will be the LOWER OF:

● the external market price (if buying division can buy from external market);
Or,
● the net revenue of the buying division.

[The net revenue of the buying division means the ultimate selling price of the
goods/services sold by the buying division, less the cost of those goods incurred by
the buying division.]