i. ROCE

As can be seen in working 1, Cherry’s ROCE is 13.6% and Feather’s ROCE is 14.9%. Feather has apparently performed better than Cherry. One benefit of using ROCE as a performance measure in this benchmarking exercise is that it gives a percentage figure and can compare businesses of different sizes. ROCE does not, however, give the absolute level of return. In this case, Feather has both a higher capital employed and a higher percentage return.

ROCE is easy to calculate and will be familiar to Cherry’s management as it is currently one of Cherry’s main financial performance indicators. The figures required to calculate ROCE are readily available from published data, which makes this a good financial performance measure for benchmarking.

ROCE shows a weak correlation with Cherry’s objective to maximise shareholder wealth, which may limit ROCE’s usefulness as a performance measure in this benchmarking exercise. ROCE may be distorted by accounting policies or where different businesses have different levels of intangible assets. This may lead to drawing incorrect conclusions from the exercise. A big disadvantage of using ROCE in this benchmarking exercise is that it may encourage managers not to invest in new non-current assets, which contradicts Cherry’s strategy of investing in charging points.

Working 1

Cherry:

Tutorial note

In (a)(i), ideally the average capital employed figure should be used to calculate ROCE. However, do not get too distracted and waste time on this. A pass could still be achieved without using the average figure.

(max 6 marks)

ii. EBITDA

Using Cherry’s main financial performance indicators of ROCE, Feather has performed better than Cherry. When depreciation of non-current assets and the write-off of goodwill in Cherry are added back to operating profit to calculate EBITDA, Cherry’s performance, with an EBITDA of $52.0m, is slightly better than that of Feather, which has an EBITDA of $51.0m.

EBITDA as a proxy for cash flow

EBITDA is easy to calculate from published data, and easy to understand. It is a measure of underlying performance, as it is a proxy for cash flow generated from operating profit. As Cherry is having cash flow difficulties following the unsuccessful acquisition, EBITDA would be a relevant measure for this benchmarking exercise. EBITDA does not, however, take into account the cash flow effect of working capital changes, for example, by Cherry negotiating longer payment terms with its suppliers.

Excludes items which are not relevant to underlying performance of the business

Tax and interest are distributions from profits, unrelated to the underlying performance of the business. Excluding them from measures of performance, therefore, gives a better understanding of the underlying performance of Cherry and Feather. This is important for the benchmarking exercise since Feather appears to suffer much lower rates of tax, probably due to the tax incentives given by the Zeeland government. Loans underwritten by the Zeeland government may be at artificially reduced rates of interest and should also be excluded when measuring performance.

Similarly, depreciation, amortisation and write-offs such as goodwill are not relevant to the current year’s underlying performance and may relate to previous years. For example, adding back the write-off of goodwill in Cherry means the two businesses have identical EBITDAs, albeit that Feather has much greater capital employed.

EBITDA affects comparability of benchmarking data

Using EBITDA as a performance measure in the benchmarking exercise makes the data for the two businesses more comparable and removes one element of subjectivity, such as in determining useful economic lives of non-current assets. EBITDA does, however, ignore the replacement costs of these assets. This might limit the usefulness of comparisons between Cherry and Feather if one were to lease non-current assets and the other to purchase them. The introduction of a new accounting standard on the treatment of leases may, however, remove this limitation.

Unlike Cherry’s existing measure of ROCE, which is a percentage measure, EBITDA is an absolute measure and so makes it difficult to compare businesses of different sizes. As a profit based measure, its usefulness is also limited by subjective assumptions made in the calculation of profit, or by inconsistent accounting policies. Development costs may be capitalised in Zeeland, but not in Yorkland, which may make a comparison against the benchmark difficult.

Working 2

(max 10 marks)

Benchmarking the performance of Cherry against a similar business implies that there is a best way to operate. Though Feather may be similar to Cherry, there is no indication that it is best in class and benchmarking against it may be inappropriate.

For example, Feather has taken advantages of tax incentives and loan guarantees to finance new investments. These do not exist in Yorkland, so Cherry may be unable to fund investment in this way. It may have to consider leasing assets instead, or accept a slower rate of growth if it wishes to set up charging points in Yorkland.

Benchmarking is a catching up exercise. The financial data for Feather is 18 months older than that for Cherry and may already be out of date. In 2015, Feather improved operational performance by investment in IT. The effect of this is not reflected in the financial data given. Benchmarking performance against historical data may not be relevant for current or future performance. The electric car market in Zeeland has grown rapidly in the last two years. This growth is not reflected in the financial performance data given for Feather, nor is the falling price of components for the charging points.

Though Feather has agreed to share data, this data may be inaccurate or misleading. Though initially the benchmarking exercise is only against Feather, it may be difficult to find other comparable businesses to benchmark against in the future. The data required for calculation of the three financial performance indicators used in the benchmarking exercise is likely to be readily available and audited, however, which means it is reliable.

A large part of Feather’s business relates to providing charging points for charging electric cars. Though this is a business model Cherry intends to follow in the future, it is very different to its existing business, and so benchmarking against Feather may be misleading unless more detailed data relating to the two activities can be obtained.

Similarly, Feather operates in a different country, where the economy is much stronger. Performance targets set following the benchmarking exercise may be unachievable for Cherry. Feather’s financial data has been converted into $ from its home currency. Movements in exchange rates may make the benchmarking data less comparable, especially if the economies in Yorkland and Zeeland are growing at different rates.

W1 – Fixed overhead cost per unit

= Total fixed overheads/Number of units sold

= $10,000,000/227,000 units = $44.05

1. Target costing

Pitbull currently operates a traditional cost-plus pricing method, where customers pay a fixed mark up on Pitbull’s standard cost. This has been appropriate because the components currently produced have been manufactured in the same way for some time and their cost structure is well understood. Actual costs of production are very close to the standard costs. There is little competition in the market for Pitbull’s current products, as a long-term contract was recently renewed with its biggest customer.

In contrast, for the proposed Booster product, the market price is only estimated. To compete with similar products, the Booster will need to sell at a price reflecting that of competitors’ products, taking into account the different benefits and quality which each product has.

Target costing begins with taking the price which the market will pay for the product for a given market share. From that, the required profit margin is deducted to arrive at a target cost. The difference between the estimated cost for the product and the target cost is the cost gap. Where the estimated costs exceed the target cost, steps are taken to reduce the cost gap. The product can then be sold at a price which the market will accept, and which generates an acceptable profit margin.

Determining the market price

Pitbull’s marketing department has estimated the average market price of competitors’ products and the likely market share over the three years of the scheme. The estimates are based on the success of a similar scheme in Inkland, and the assumptions used could be incorrect. Electricity prices may already be higher in Inkland than in Weeland, meaning consumers there would reduce their energy costs more by installing solar panels. Similarly, consumers in Inkland could save more on energy costs if there is more sunshine there than in Weeland, enabling solar panels to generate more energy. Both factors would, in this case, reduce the take up of subsidies by consumers in Weeland and the amount they would be willing to pay for solar panels.

The domestic solar energy market is new in Weeland, and Pitbull has no experience in estimating market share or price for this type of product. Pitbull’s belief that consumers would be willing to pay a 10% premium for highest quality packaging, or for the Booster to communicate with consumers’ mobile phones, may be incorrect.

Calculating the target cost using the required profit margin

Pitbull charges a 15% profit margin on its existing projects. The shareholders’ financial objective indicates that they require the same profit margin to be earned on Booster.

For its existing products, Pitbull can set a selling price based on its own costs, whereas the Booster’s price must reflect external market conditions more closely. Target costing will focus Pitbull on the external environment by considering prices and relative benefits of competitors’ products.

Estimating total costs of Booster

The total direct costs of Booster have been estimated at $134.00. The fixed overhead per unit relating to Booster for the three years of the scheme is $44.05, making total estimated costs per unit of $178.05. The cost estimates may be incorrect, especially as Booster is new, and different from Pitbull’s existing products. As Booster includes costs which are fixed, estimating sales volumes is also crucial in determining costs per unit.

Pitbull has no recent experience of developing new products or of estimating costs and sales volumes for them. This makes it more likely that the cost estimates for the Booster will be incorrect. Estimating the total costs is needed for the next stage in the target costing process, to identify the cost gap.

Reducing the cost gap

A big advantage for Pitbull of using target costing is that it is often easier to reduce costs of a product at the design stage rather than after it has entered production.

As Boosters are not sold directly to consumers, the buyers of the product, who are professional installers, may not see value in the highest quality packaging. This could be a significant yet unnecessary cost, to be eliminated at the design stage. In deciding what costs to eliminate, Pitbull will have to take into account the effect of these on the quality and perception of the final product.

The features where the Booster can communicate with consumers’ smartphones, and the use of highest quality packaging, are believed to enable Pitbull to charge 10% more than competitors’ products. The $3.8m (W1) of estimated additional total revenue from the packaging and smartphone features may not justify the $2.8m upfront development costs for the smartphone feature alone, especially if the time value of money were to be taken into account. Consumers may not value these two features or be prepared to pay more for them. Eliminating them would therefore have little effect on sales volumes and would enable Pitbull to charge a more competitive price, or obtain higher gross profit margins.

Due to damage of sub-components when assembling the prototype, the estimated assembly labour cost assumes highly skilled labour will be used. This is 30% more expensive than other labour. By providing additional training, lower paid labour could be used to produce the Booster, and hence reduce the cost gap.

Pitbull plans to purchase the four main sub-components in bulk from six different suppliers. Consolidating suppliers, or using suppliers in lower cost countries, could help reduce the cost gap by reducing purchase costs. Moving to a just-in-time production system, rather than buying supplies in bulk, would help reduce costs of holding inventory as suppliers would only deliver sub-components when needed. This may increase other costs such as by requiring investment in information technology. It would also take time to develop the close relationship required with suppliers.

Another source of waste is due to internal transport and handling, which forms over 5% of the total direct cost of the Booster. This will also increase production cycle times, and is an unnecessary process which does not add value. It could be eliminated by changing the layout of the factory, or reorganising production into teams and ensuring all production was done at a single factory, rather than in both of Pitbull’s factories.

W1 – Additional revenue from smartphone feature and highest quality packaging

2018 – 60,000 units x $198 = $11.880m

2019 – 75,000 units x $187 = $14.025m

2020 – 92,000 units x $176 = $16.192m

Total revenue = $42.097m

= $42,097,000 x 10/110 = $3,827,000

(max 12 marks)

Tutorial note

This is a detailed solution. You would not be expected to produce an answer of this length.

Kaizen costing

Unlike target costing, which occurs at the beginning of a product’s life, Kaizen costing is a process of long-term continuous improvement by cost reduction throughout the life of the product.

The Booster will be produced only for the three years during which the Weeland government offers subsidies and tax incentives. Generally, Kaizen costing is used over longer periods, and it is likely the full benefits of this approach will not be achieved in such a short timescale. The target cost is the starting point for Kaizen costing. After production begins, each period’s target is based on the previous period’s reduced costs.

Target costing can achieve large cost reductions at the design stage of the product, e.g. by choosing not to develop the smartphone feature. Kaizen costing, however, reduces costs in much smaller, incremental steps.

The need for continuous improvement

Even though Booster’s share of the market rises over the three years of the project, the market price falls, as does the size of the market. Which means that in order to achieve the shareholders’ financial targets, the direct costs of the Booster must fall over the three years. Continual incremental improvements using Kaizen costing, and measuring these improvements against targets from the previous period rather than the original estimated cost, could help to achieve this.

Ways to reduce waste using Kaizen costing

Traditional costing methods often see employees as the cause of high costs, whereas Kaizen costing sees the employees as a source of ideas on how to reduce costs. The manufacturing director’s comments, that the damage caused by employees to delicate sub-components may mean it may not be possible to produce the Booster, indicates that Pitbull is currently following the traditional approach. Employees are seen as the source of the waste.

To benefit from Kaizen costing, Pitbull must undergo a culture change to encourage employees to suggest ideas, perhaps using quality circles, to reduce costs. That way, improvements could be made in the way sub-components are assembled during production, which would shorten the production cycle and lead to a reduced cost of scrapped items.

Logically, the Force Score (FS) should reflect the aims and objectives of the department. The overall aim has two basic parts: (1) value-for-money service; (2) community safety. The score does use variables associated with community safety but does not measure value-for-money. Value-for-money would be reflected by measures which take account of the economy, efficiency and effectiveness of the police forces. For example, the other indicators given in Appendix 1 allow calculation of the following measures which could be useful in measuring performance of this objective:

The more detailed goals of the police forces are:

• Tackle the underlying causes of crime and achieve long-term sustainable solutions – which is measured by Rank 1 for the number of reported crimes.
• Bring perpetrators to justice – which is measured by Rank 2 which measures the detection rate of crimes.
• Provide protection and support for individuals and communities at risk of harm – which is measured through the user satisfaction score (Rank 3).
• Respond to community needs by being accessible and engaging with their concerns – which is measured through the user satisfaction score (Rank 3) and the responsiveness is measured by call handling speed (Rank 4).

None of these ranks will perfectly measure all aspects of each of the goals but there is a broad coverage present. For example, an improvement might be to include a measure of community engagement through the number of public meetings between police and the community or a measure of community-based policing initiatives.

The choice of weightings used in the FS formula must be considered. Force F is top ranked and Force C is bottom ranked. However, among the four variables used to calculate the score, no one force dominates with three different forces being the best in each of the four variables. Therefore, the weightings are important in determining the final FS.

The formula used is simple as it recognises only four input variables and weights these equally. No explanation of the logic of the choice of variables or weightings has been offered. Different weightings would produce very different results. To illustrate this, if a simple weighting system were used where weighting was given only to Rank 3 (on user satisfaction), then Force D would rank top and Force F would be bottom. Also, relatively small variations can have big impacts on the final FS.

For example, the difference between each force in their call answering is not great with three percentage points separating best and worst but this generates a difference of 0.75 in the forces’ final FS.

There is a danger of over-complicating the formula (with more variables and complex methods of allocating weightings) and thus losing one of its main advantages, which is its simplicity.

The use of league tables effectively benchmarks performance and can have a positive effect on behaviour. The sharing of data on performance can indicate areas of best practice and so improve performance across all forces. Additionally, the use of league tables gives a single figure which gives a clear, immediate answer to questions of performance.

However, the use of league tables only measures relative performance. The best force in the table could still be producing an unacceptable performance in absolute terms. In order to avoid this problem, tables will often try to include comparable bodies from outside the area of control of the government (foreign police forces). However, to get comparable data in order to calculate an FS for a foreign police force will be difficult.

On introduction, if the police staff do not feel that they can affect the FS, then they will not be held accountable by it. They may ignore it or actively undermine it in public through their union. This will present the government with difficulty as the police are considered the experts on this area of public policy and their criticism will carry weight with the electorate.

Once the system is in use, the FS can be used as a target for the leaders of each force; however, it can lead to over-focusing by employees on the variables in the FS to the exclusion of other relevant issues, i.e. only doing what gets measured. This means that the FS must encompass the key variables which will drive desired performance.

The police staff may be demotivated by the league tables if they feel:

1. that the FS does not reflect the valuable work which they do (as noted above, the current FS formula does not take account of the value-for-money aspects of the police force’s efforts); or
2. that the FS is driven by factors outside their control. (For example, there may be a link between the number of crimes reported and the economic conditions in the forces area which they do not have power to affect.)

The use of league tables has stemmed from their introduction for schools. However, the comparison between police forces and schools may not be valid, as school league tables are helpful where parents have some choice in the school to which they send their children while with only four forces covering the country, residents will have to move a long distance to be under the protection of a different police force. The schools’ league table only used the single output of pupils’ performance while the FS is more complex as it tries to encompass a number of different outputs. This will lead to greater debate about the value of the measure for the reasons given above and possibly its reduced effectiveness.

The objectives of a transfer pricing system are as follows:

Performance measurement

The buying and selling divisions will be treated as profit or investment centres. The transfer price is a cost to the receiving division and revenue to the supplying division and should allow the performance of each division to be assessed fairly. Divisional managers will be demotivated if this is not achieved.

Goal congruence

The decisions made by each profit centre manager should be consistent with the objectives of the organisation as a whole, i.e. the transfer price should assist in maximising overall company profits.

A common problem is that a transfer price is set that results in suboptimal behaviour, where the best decision for a division is not necessarily the best for the company or group as a whole.

Autonomy

The system used to set transfer prices should seek to maintain the autonomy of profit centre managers. If autonomy is maintained, managers tend to be more highly motivated but suboptimal decisions may be made.

Recording the movement of goods and services

In practice, an extremely important function of the transfer pricing system is simply to assist in recording the movement of goods and services.

 Tax management

In global companies or groups, the transfer price can effectively move profits from one tax jurisdiction to another. Such companies can thus set transfer prices to minimise global tax liabilities, although there is extensive anti-avoidance legislation in this area.

i.

As regards Quotation 1 in respect of the year ending 31 December 2010, the management of Division B would purchase ankle supports from a local supplier in order to increase the profitability of Division B. An internal transfer price from Division A of $10.50 ($15 less 30%) would appear unattractive in comparison with a locally available price of $9. The management of Division B is encouraged to seek the maximisation of reported profit as its key objective.

Division A has spare production capacity of 10,000 units (Maximum available = 160,000 units and the 2010 budget total demand is 150,000 units). Division A could, therefore, supply 10,000 units of ankle supports at its marginal cost of $7 per unit ($350,000/50,000) i.e., at a total cost of $70,000.

However, the external supplier would charge $9 per unit, giving a total price of $90,000 for the 10,000 units.

In order to have decisions leading to the maximisation of BOD group profit, Division A should, therefore, quote its marginal cost of $7 per unit for each of the 10,000 units required by Division B.

BOD Group profit will then increase by ($9 – $7) × 10,000 = $20,000.

As regards Quotation 2 in respect of the year ending 31 December 2010, the management of Division B would again purchase from a local supplier in order to increase the reported profitability of the division if Division A quotes a transfer price of $10.50 ($15 less 30%).

Division A could potentially have supplied 18,000 ankle supports by using (i) spare capacity for 10,000 units and (ii) switching 8,000 units of production from sales of the type of support that earns the lowest contribution per unit.

The 10,000 units of spare capacity can be supplied at marginal cost of $7 per unit as in Quotation 1.

The additional 8,000 units would have to be diverted from the type of existing support that earns the lowest contribution per unit. The situation is as follows:

Division A should offer to transfer the additional 8,000 ankle supports by diverting production from the least profitable type of support. The wrist support earns the lowest contribution per unit ($5).

Hence Division A should offer to transfer the additional 8,000 ankle supports at marginal cost + contribution foregone = $7 + $5 = $12.

In this case, Division B would reject the offer and would buy externally at $9 per unit. This would ensure that BOD Group profit is not adversely affected by any transfer decision.

ii.

The management of the BOD Group needs to ensure that the management of all divisions takes into consideration all internal and external information relevant to divisional and, much more importantly, group circumstances.

As a starting point, the basic principle which underpins transfer pricing is that transfer prices should be set at a level which covers the marginal costs plus any opportunity cost to the BOD Group. If the basic principle is applied correctly then any subsequent decision made regarding whether to make internal transfers or external sales of products or internal purchases as opposed to external sourcing of products should lead to the most profitable outcome from the standpoint of the group as a whole.

What is best for the BOD Group as a whole is dependent upon the capacity utilisation of its divisions. In this example everything depends on the capacity utilisation of Division A.

What is of vital importance is that the marginal revenues and marginal costs of the BOD Group are known, understood and applied by management.

(8 marks)

(Comments (on merit) 4 marks)

If Division B buys from a local supplier the financial implications for the BOD group are as follows:

If Division B buys internally from Division A the financial implications for BOD group are shown below. The BOD group will be $50,400 – $42,600 = $7,800 worse off if Division B purchases the ankle supports from Division A, as opposed to purchasing an equivalent product from a local supplier.

The costs of quality will probably be hidden in overheads in the standard costing system at Trend. They relate to design, inspection and repair and reworking. The existing system will need to be modified to separate these costs.

The quality costs that will need to be collected will include the following:

• Costs of conformance: ensuring that cars produced are at the acceptable quality standard. This includes prevention costs such as training for staff, building quality into the design of the cars and the design of the business processes in order to avoid quality rejections. It also includes appraisal costs which include the inspection of components from suppliers before they are used and inspection of work-in-progress and finished cars.
• Costs of non-conformance: cost of dealing with cars that do not meet the prescribed quality standards. These costs include internal failure costs when a quality fault is noticed before the car leaves the factory and is rectified. External failure costs also arise when a customer finds a fault with the car which must be handled through customer complaints.

There are quality costs that an accounting system will tend to omit such as the opportunity cost of lost future sales resulting from customer dissatisfaction and the knock-on effects of faulty component purchases in lost time in the rest of the manufacturing process.

The identification and collection of these costs will probably lead to greater management focus on the quality issue as ‘what gets measured, gets done’. This will help Trend to raise the quality of its products in order to compete more effectively with the new imports.

The issues discussed above represent the traditional view of quality costs where there is an optimal effort that minimises but does not eliminate quality faults. There is a trade-off occurring since the reduction of non-conformance costs requires an increase in conformance costs in order to prevent product failures and there comes a point where the cost of reducing the error rate further is greater than the benefit from preventing that additional fault. For a national manufacturer faced with multinational competitors, this may seem an appropriate approach as Trend will not have the resources to be able to drive out all quality faults.

The Kaizen costing process focuses on producing constant, small, incremental cost reductions throughout the production process during the product’s life. Kaizen can be translated as continuous improvement. Kaizen costing applies functional analysis in the design phase to create a target cost for each production function. These are totalled to give a product target cost which, after the first year of production, is used as the baseline for further on-going reductions. These reductions in turn reduce the baseline cost and so on as the production process improves. The cost reduction rate is set as a target and managed by exception throughout an accounting period often on a monthly basis compared to the annual setting of standard costs.

The effect of this on the standard costing system at Trend is significant since, in a process that is continually improving, standard costs have much less value as they are fixed over the relevant period. Therefore, Kaizen costing can respond more easily to a dynamic business environment. Standard costing is used to control costs while Kaizen costing focuses on cost reduction.

The management attitude to employees is different in the two systems, as in continuous improvement systems they are the source of the improvement solutions while in standard costing systems with its analysis of variances of labour rates and efficiencies, the employees are often seen as the source of problems. In the Kaizen system, the employees often work in teams and are empowered to make changes to production that would have to be cleared through a management hierarchy in a more static standard costing system. Changing the costing system would be likely to represent a major cultural change at Trend with its history of bureaucratic control.

The benefit of continuous improvement, which has been successfully followed at many multi-national car manufacturers such as Toyota, is that it will allow the company to address quickly the changing nature of Trend’s competitive environment. It will increase staff motivation through empowerment. However, there may be significant management difficulties initially in getting workers who are used to a command and control structure to change their behaviour and speak out about possible improvements.

Just-in-time (JIT) is a demand-pull system of ordering from suppliers which aims to reduce inventory levels to zero. It can be broken into two parts: purchasing and production. Each part has a similar goal to produce the components for the next stage of the production process only when they are needed (hence demand-pull). The system is often used in conjunction with the continuous improvement methods discussed earlier.

For Trend, this will bring benefits and problems. The benefits will be measured in lower working capital requirements, factory floor space savings and increased flexibility in meeting the customer’s individual needs (faster response times to product specification changes).

There are a number of problems to be overcome. There will be an increased reliance on suppliers as any component quality failures are not necessarily rectifiable by going to inventory to pick a replacement. This can lead to costly stoppages to production. For Trend there could be difficulty in finding local suppliers who are capable of meeting the required component and delivery standards needed in order to run such a system. Quality systems are therefore a driver of the feasibility of JIT and the metrics associated with quality costs (mentioned above) will become important as a result.

Output must be matched to demand and each stage of the production process must match its output speed to the demand level. Teams must be formed to work by component or product rather than by the type of work performed. Staff will require training in order to work in these teams as they will have to be multi-skilled (able to operate and maintain the machinery in use by their team). This means that traditional functional divisions of costs become less appropriate, again requiring cultural change at Trend. Measures of spare capacity and bottlenecks in production will be critical to achieving these aims. Also, the amount and effectiveness of staff training will need to be measured during the implementation of these changes.

Trend’s existing performance reporting system uses standard costing and variance analysis for monitoring and control purposes. This is likely to have been adequate under the old regime when the focus was on production but will not necessarily drive the business forward. As the surrounding markets begin to see the effects of deregulation there is likely to be a greater rate of change in prices and availability of goods and labour and Trend may find it difficult to keep the standard costs up to date and appropriate. This could lead to significant variances being reported and time wasted on analysis and investigation. Trend may find it useful to analyse and report on a wider range of performance measures going forward and will need to consider performance relative to the competition as well as simply comparing against budget. The variance analysis system may also constrain managers as there may be insufficient focus on growing the business and taking advantage of the greater wealth enjoyed by the population. Trend could consider a system which incorporates a range of different measures and takes into account both internal and external factors. A system such as Fitzgerald and Moon’s building blocks would achieve this and could also help the business consider the impact of quality management on performance.

There are a number of broad ways in which the implementation of Six Sigma improves quality in an organisation. These include:

• an increased focus on customers illustrated at Air by the strategic need to improve customer service and the project objective of improving customers’ bills
• management decision-making being driven by data and facts not intuitions such as the use of customer satisfaction scores or numbers of complaints as key performance measures
• the identification of business processes’ improvement as key to success which is exemplified by the mapping of the processes and then their redesign
• the proactive involvement of management such as the CEO championing the billing improvement project. Six Sigma depends on leadership which is provided by various experts who interact with the various Six Sigma projects which will be improving processes in the organisation
• the increased profile of quality issues and the increased knowledge of quality management that comes from the use of different layers of trained experts in the project. There are green belts who will often be line managers, who in additional to their normal work will lead Six Sigma projects. There are black belts who will exclusively specialise on Six Sigma and lead specific projects and there are master black belts who are Six Sigma experts in statistical methods who consult across several Six Sigma projects; and
• Six Sigma implementation requires collaboration across functional and divisional boundaries so bringing the focus of the whole organisation to quality issues as illustrated at Air by the involvement of all the business units in the billing project.

The DMAIC process is as follows:

1. Define customer requirements/problem

Here the problem is the complaints on bills that result in customer dissatisfaction and delayed revenue receipt or potential loss of business. Customer requirements can be divided into those that are the minimum that is acceptable (e.g. billing errors are corrected), those that improve the customer’s service experience (e.g. billing corrections completed swiftly) and those that go beyond the customer’s expectations (e.g. offering additional services as compensation). The customers could be surveyed in order to identify if different customers have different needs (e.g. based on the three business units).

2. Measure existing performance

The number of customer complaints or scores below a threshold level on customer surveys will have to be measured and targets set (e.g. number of complaints per million bills issued or average time to resolve complaints). Measurement should focus on areas where the customer will value improvement. A key issue at this point is ensuring that the measurement system is reliable and this may require redesign of the existing customer survey forms/procedures.

3. Analyse the existing process

This step involves data collection in order to identify the root causes of problems and then techniques such as Pareto analysis will improve the focus of action on the issues that give raise to the majority of complaints based on the idea that 20% of the categories of causes will give rise to 80% of the complaints. For example, the analysis at Air could look at causes of delays in complaint resolution such as staff motivation or processing time for rebilling.

4. Improve the process

This is the implementation stage for any changes that are suggested and it is important at this stage to check on the cost and resource consequences of any suggested improvement.

5. Control the process

The improvement project will be monitored after implementation to ensure that the benefits of reduced complaints are maintained. This can be done through exception reporting if complaint numbers begin to exceed the tolerance set or continued monitoring of the time taken to resolve complaints. The general performance measure of the success of the project will be the retention of customers which is commonly measured through the churn rate of customers (percentage of existing customers lost per year).

One quality practice which Airs could consider is Total Quality Management. TQM is a philosophy of quality management that is applied to the whole organization and aims for continuous improvement and prevention of all errors. In this sense it is consistent with the introduction of Six Sigma. TQM is more frequently used in manufacturing organisations where the impact of quality failures in the production process may be that goods are scrapped. However it is possible to apply the concepts to an organization such as Airs and a focus on improvement to process and minimizing errors in all aspects of the business could enhance the customer experience which is a key aim of Airs. A TQM approach would also provide support to the Six Sigma programme and ensure quality is maintained and improved in all aspects of the business.

Kaizen costing is another quality practice which Airs could introduce. This practice focuses on small, incremental cost reductions throughout the production process. Again it is more commonly found in manufacturing but elements of the concept may be applied to service industries. One key aspect of Kaizen costing is the involvement and empowerment of staff. As Airs is aiming to differentiate with respect to customer service, involving staff could be beneficial. However, Kaizen costing does have the overall aim to make cost reductions which is not considered by the CEO to be the main focus for Airs.

Target costing is something which also may be applied. This concept focuses on the customer and their requirements in terms of quality, service and price and takes into account all costs occurring in the product life-cycle. This is appropriate for Airs in the sense that it starts with external factors and customer needs. However identifying and therefore analysing the appropriate costs may be difficult for Airs due to the nature of the business.

It is recommended that Airs consider a Total Quality Management approach which will support the Six Sigma programme. Kaizen costing and Target costing are not recommended for the reasons given above.

Tutorial note

The solution given is very detailed and candidates would not have to provide an answer of this length to score maximum marks. It is provided to give an idea of the scope of the relevant points which could have been made.

a.

Public sector organisations such as the New York universities receive all their funding from central government and do not have the generation of profit as an objective. Furthermore, their objectives such as ‘improving the standard of education of the citizens of New York’ cannot be measured in financial terms. The value for money of the universities can be assessed using the ‘3Es’ framework of economy, efficiency and effectiveness.

Economy

This involves obtaining the inputs to the service at the lowest possible cost, while still maintaining the quality of the inputs. In practice, this may be difficult to do, and a reduction in cost may lead to a reduction in quality.

From the performance data given, the average annual payroll cost per member of academic staff is highest in Northcity University at $62,286 ($109m/1,750). This is 51% higher than East city University, which has the lowest cost at $41,237 of the four universities given. The high costs in Northcity University may reflect the fact that staff there may be more highly qualified or that highly skilled, trained staff are attracted to work there because of the high standards of teaching and academic research.

A higher payroll cost per member of academic staff may not necessarily mean a particular university is not giving good value for money. The relatively high salary costs in South city University of $62,083 may simply reflect the higher costs of living in the capital city and so comparison between the regions may be inappropriate.

As such, there may be a conflict between this performance measure and the ability of the universities to achieve their objectives, such as to improve educational standards in New York. The politician’s proposal to reduce salary levels for new recruits may reduce the number of appropriately qualified and skilled staff who wish to work there. This may reduce the standard of teaching and academic research, and as a result, the universities’ performance against their stated objectives. This means that focusing solely on economy would not ensure the universities achieve value for money.

Efficiency

Efficiency measures the amount of outputs relative to the amount of inputs. The number of academic staff per student may be a suitable measurement but there may be differences between universities which would make it hard to compare results.

For example, there are 10.1 (17,600/1,750) students per member of academic staff in Northcity University, which is ranked number one in the New York government’s provisional league table. There are 17.9 in West city University which is ranked much lower at 21. It would seem therefore, that increasing the number of students relative to the number of academic staff as per the politician’s proposal may reduce the performance of the universities against their stated objectives and as such will not increase value for money.

The politician’s comparison with the number of students per academic staff in neighbouring Vooland may not be appropriate. Whilst the politician’s assertion that educational standards are higher in Vooland may be correct, the undertaking of high quality academic research may not be a key objective of the universities there, or the quality of research may be lower than in New York.

Effectiveness

Effectiveness measures whether the objectives of the organisation are being met. The stated objectives of the New York universities are to improve the overall standard of education of citizens in New York, to engage in high quality academic research and to provide well-qualified university graduates to meet the needs of the graduate jobs market in New York.

Objective to improve the overall standard of education in New York

Currently, there is no direct measure of the performance of the universities’ stated objectives to increase the level of education of the citizens of New York. The number of graduates entering graduate jobs and the results of the TSOR survey may indirectly measure the effectiveness of the universities in achieving this aim. More direct measures such as the number of students completing their studies, or obtaining good results in university exams may be more appropriate.

The effectiveness of the universities in improving the standard of education should really be related to the entry requirements of each university. West city University is the lowest ranking of the four universities in the provisional league table and has the lowest proportion of graduates entering graduate jobs at 50% (1,750/(11,200/3.2)). It also receives the lowest amount of research funding per student at around $1,250 ($14m/11,200), but it has the lowest entry requirements, which have been relaxed to encourage students from a more diverse range of backgrounds to study there. Therefore, the improvement in educational standards relative to students’ attainment on entry may be higher than the position in the league table may suggest.

Objective to engage in high quality academic research

The stated aim of the universities to engage in high quality academic research is also not currently measured. The amount of research funding received from government and other organisations by each university may indirectly reflect the quality of the research there as providers of funds for research would probably look to fund high quality research.

This measure may, however, equally reflect that some types of research are more expensive than others. South city University, which is successful in science and technology subjects, receives $15,592 per student compared to $5,000 in East city, which specialises in arts and humanities subjects. The funding received may be more indicative of the past quality of academic research rather than future quality, or may not even reflect the quality of the research and may be high due to wastage or inefficiency. The definition of ‘quality’ of research is unclear.

Objective to meet the needs of the graduate jobs market

The number of graduates from each university obtaining graduate jobs each year is an indirect measure how well each university is achieving this objective. However, the number of graduate jobs filled may simply reflect the number of students at each university and demand for graduate jobs in the economy.

Many graduates, including the most talented of them, may take graduate jobs overseas. In which case, the measure of graduate jobs filled may not be a clear measure of the objective to meet the needs of the graduate jobs market in New York. A more precise measure of graduates entering graduate jobs in New York may be more appropriate. Even this may be misleading, if graduates later return from overseas to enter graduate jobs in New York.

The definition of what is a ‘graduate’ job is subjective and likely to change over time, for example, as a result of changes in the economy. This again limits the usefulness of this measure in determining whether universities have met this objective.

The TSOR survey is a measure of effectiveness reflecting a basket of measures, one of which is students’ own perceptions of their future job prospects. The measures in the TSOR survey are, however, highly subjective according to individuals’ personal perceptions, for example, about students’ job prospects and the quality of teaching at the university. Furthermore, the survey also covers a wider range of factors such as their overall satisfaction with university life. As such, this may not reflect the stated aims of the universities in New York. The TSOR score for West city University is considerably higher than for all the other universities, despite it having the lowest overall ranking.

Effect of league tables on the quality of the New York universities

League tables encourage competition between universities

The publishing of league tables of the performance of the universities in New York should stimulate competition for high ranking between them. This should encourage them to find better ways to improve the quality of the service, achieve their performance objectives, and deliver greater value for money.

Sharing of resources may be discouraged

However, this may discourage knowledge or even resource sharing between the universities if they see themselves in competition for the best students and limited research funding. This could particularly be a problem if the university leaders were given performance targets and rewards based on their university’s position in the league table. They may be encouraged to undertake ‘gaming’ and focus solely on their position within the league table to the detriment of other aspects of performance. This may mean the objectives for the universities overall in New York may not be achieved.

University leaders may focus on a narrow range of objectives

Students’ overall experience of university life may be influenced by access to social, pastoral and sporting facilities. Management time and resources may be diverted away from these important areas by focusing on a narrow range of performance objectives such as improving educational standards and high quality research in order to boost the position in the league table.

Use of league table to ensure accountability of the universities

If the performance league tables are made publicly available, for example, on the internet as they are in Vooland, this should ensure the performance of the universities is transparent. This will mean that they are held accountable by the public for the quality of service and value for money which they provide.

League tables give choices to students and staff

To be really effective, league tables should provide users of the performance data, such as the public, with the ability to make choices based on the data given. Prospective students and staff will be able to make choices about which university to study or work at according to their position in the league tables. In addition, providers of funding such as the government will be able to identify where corrective action or additional funding may be required.

This could also be a disadvantage of using league tables, as the best students are likely to be attracted to the best universities, which are in turn likely to attract the most funding for academic research. This may cause a reduction in the overall performance of lower ranking universities, and therefore a failure of the universities as a whole to achieve the stated aim of improving educational standards in New York.

League tables may not reflect variation of standards at each university

There may also be considerable variation of the standards within one university, which a ranking in a league table will not address. For example, South city University offers courses in a variety of subjects and is particularly successful at science and technology subjects. This may mean that it achieves a high overall ranking in a league table, whereas its performance in other subjects may be weaker. For all of these reasons, the provision of league tables or performance data at a lower level, such as by subject area, may therefore be a better way to make the universities accountable to the public.

Regions may not be directly comparable

There may be inherent differences between universities which make comparison using league tables misleading or of limited value. For example, East city University specialises in teaching arts and humanities. It may be inappropriate to compare it to universities offering a wide range of courses or specialising in science and technology subjects. Similarly, it may be misleading to compare universities of different sizes or in locations in different parts of New York. Universities which also attract students from outside New York, for example, those in capital or major cities, are likely to have more access to the most able students.

Due to its capital city location, South city University may incur additional costs of providing facilities and have to pay staff more to reflect the higher cost of living there. It may be more appropriate to produce league tables at a lower level, like within individual cities, to make the comparisons more meaningful and eliminate the effect of regional variations such as this.

There may be differences in the way different universities collect and report performance data. These problems can be reduced by the use of consistent and enforced policies for compiling performance data.

 Resources required to produce league tables

Other problems relate to the targets chosen, external influences on results and cost of collating and measuring performance for the league table.

In Vooland, there is a sizeable government department dedicated to measuring performance. The cost of collecting performance data and compiling the league tables may therefore outweigh the benefits to be gained from doing so. It will use up resources which could be used, for example, in providing additional funding to the universities themselves.

Performance measures used to create league tables may be confusing and conflicting

By having a large number of targets such as in Vooland, this may cause confusion to managers, who may not know which to focus on. Similarly, it may be difficult to decide which performance measures are the most important.

Many performance measures chosen are likely to conflict. Reducing the salaries paid to academic staff may make it harder to recruit and retain experienced and wellqualified staff, which may lead to failing to meet the universities’ key objectives. Similarly, increasing the number of students per member of academic staff is unlikely to help achieve any of the universities’ objectives as staff will have less time available for teaching and for engaging in high quality research.

The use of league tables may demotivate staff and students

The New York politician’s proposed target of a 5% annual increase in the number of students entering graduate jobs sounds very challenging and may be unrealistic. This will be especially so if accompanied by a reduction in the number of academic staff and a reduction of the salaries of new recruits. If the targets are felt to be unachievable by the university leaders, they may become demotivated, and give up on trying to achieve them altogether. This will especially be the case if this is an ‘all or nothing’ target. A more realistic target may at least ensure that some progress is made.

Students may also become demotivated if their university ranks poorly in league tables, even if the students themselves are satisfied with the standard of education they are receiving.

Similarly some performance measures, such as the number of students entering graduate jobs, which may be highly dependent on the economic conditions in New York, are not entirely under the control of the university leaders. The economic conditions in New York will be a key factor in determining the number of graduate jobs available there. University leaders may become demotivated by this measure as well and stop trying to improve.

The relative importance of different performance measures is subjective

The weighting of the different performance measures used by the New York government in arriving at the provisional ranking of the universities is subjective. It is difficult to determine which measures are the most important, and hence how each should be weighted. The opinions of different stakeholders on which are the most important measures will also vary. Academic staff and students may view different measures as important compared to the providers of finance (the New York government) and organisations who recruit university graduates.

Determining the relative importance of different performance measures in order to publish a league table is therefore difficult. Furthermore, the measures chosen, and their relative weightings, could differ from those in other countries. This would make it difficult to benchmark performance against universities in other countries, such as Vooland.

To: The Directors

From: Management Accountant

Subject: The performance of our three health centres

Date: 6 June 20X8

Further to your recent request please find below my detailed responses to the questions you have raised.

A summary of the financial performance of the three centres is shown in the following table:

Which of the three centres is the most successful?

This very much depends on the method used to assess the performance of the three health centres. As requested, I have undertaken calculations based on three performance measures namely, return on investment (ROI), residual income (RI) and economic value added (EVA). I have included the workings for each respective calculation in an appendix to this report.

Using ROI as a measure of financial performance indicates that Aries town is the most successful of the three centres since its ROI was 23.02% compared with the 18.40% achieved by Carls town and the 13.96% achieved by Bens town. However, you should bear in mind that the use of ROI can be grossly misleading since it is a relative measure and ignores absolute returns. In this respect I wish to draw your attention to the fact that Bens town earned $45,000 (11.4%) more operating profit than Aries town and Carls town earned $397,000 (77.5%) more profit than Aries town.

The use of RI as a measure of financial performance indicates that Carls town is the best performing centre, generating $187,000 of residual income. It is worth observing that Aries town was not far behind Carls town in terms of generating residual income of $180,000. However, Bens town only managed to generate $33,000 of residual income.

EVA™ is a specific type of residual income calculation which has attracted a considerable amount of attention during recent years. Economic Value-Added equals after-tax operating profit minus the (after-tax) weighted average cost of capital multiplied by total assets minus current liabilities. EVA™ substitutes the following numbers in residual income calculations:

a. Income is equal to after-tax profits

b. A required rate of return is equal to the after-tax weighted average cost of capital; and

c. Investment is equal to total assets minus current liabilities.

Aries town has the highest EVA. Indeed, it is the only centre which has a positive EVA. In common with RI, EVA charges managers for the cost of making investments in long-term assets and working capital. Value will only be created in circumstances where post-tax operating profit exceeds the cost of investing the required capital.

In order to improve EVA, managers need to earn more operating profit using the same amount of capital, or invest capital in higher-earning projects. The use of EVA is often preferred to RI because it takes into account tax effects of investment decisions whereas pre-tax residual income measures do not.

The ROI of Bens town is currently 13.96%. In order to obtain an ROI of 20%, operating profit would need to increase to (20% × $3,160,000) = $632,000, based on the current level of net assets. Three alternative ways in which a target ROI of 20% could be achieved for the Bens town centre are as follows:

Attempts could be made to increase revenue by attracting more clients while keeping invested capital and operating profit per $ of revenue constant. Revenue would have to increase to $2,361,644, assuming that the current level of profitability is maintained and fixed costs remain unchanged. The current rate of contribution to revenue is $2,100,000 – $567,000 = $1,533,000/ $2,100,000 = 73%. Operating profit needs to increase by $191,000 in order to achieve an ROI of 20%. Therefore, revenue needs to increase by $191,000/0.73 = $261,644 = 12.46%. Or alternatively 632,000 less current level of 441,000 = a 191,000 increase. Contribution is uncertain therefore 191,000/1,533,000 *100 = 12.46%

Attempts could be made to decrease the level of operating costs by, for example, increasing the efficiency of maintenance operations. This would have the effect of increasing operating profit per $ of revenue. This would require that revenue and invested capital were kept constant. Total operating costs would need to fall by $191,000 in order to obtain an ROI of 20%. This represents a percentage decrease of 191,000/1,659,000 = 11.5%. If fixed costs were truly fixed, then variable costs would need to fall to a level of $376,000, which represents a decrease of 33.7%. Or alternatively variable costs are uncertain therefore 191,000/567,000 *100 = 33.7%

Attempts could be made to decrease the net asset base of HFG by, for example, reducing debtor balances and/or increasing creditor balances, while keeping turnover and operating profit per $ of revenue constant. Net assets would need to fall to a level of ($441,000/0.2) = $2,205,000, which represents a percentage decrease amounting to $3,160,000 – $2,205,000 = 955,000/ 3,160,000 = 30.2%. Or alternatively as net assets would need to fall to 2,205,000 this is a decrease of 955,000. Net assets are uncertain therefore 955,000/3,160,000* 100 = 30.2%.

The marketing director is certainly correct in recognising that success is dependent on levels of service quality provided by HFG to its clients. However, whilst the number of complaints is an important performance measure, it needs to be used with caution. The nature of a complaint is, very often, far more indicative of the absence, or a lack, of service quality. For example, the fact that 50 clients complained about having to wait for a longer time than they expected to access gymnasium equipment is insignificant when compared to an accident arising from failure to maintain properly a piece of gymnasium equipment. Moreover, the marketing director ought to be aware that the absolute number of complaints may be misleading as much depends on the number of clients serviced during any given period.

Thus, in comparing the number of complaints received by the three centres then a relative measure of complaints received per 1,000 client days would be far more useful than the absolute number of complaints received. The marketing director should also be advised that the number of complaints can give a misleading picture of the quality of service provision since individuals have different levels of willingness to complain in similar situations.

The marketing director seems to accept the current level of complaints but is unwilling to accept any increase above this level. This is not indicative of a quality-oriented organisation which would seek to reduce the number of complaints over time via a programme of ‘continuous improvement’.

From the foregoing comments one can conclude that it would be myopic to focus on the number of client complaints as being the only performance measure necessary to measure the quality of service provision. Other performance measures which may indicate the level of service quality provided to clients by HFG are as follows:

• Staff responsiveness assumes critical significance in service industries. Hence the time taken to resolve client queries by health centre staff is an important indicator of the level of service quality provided to clients.
• Staff appearance may be viewed as reflecting the image of the centres.
• The comfort of bedrooms and public rooms including facilities such as airconditioning, tea/coffee-making and cold drinks facilities, and office facilities such as e-mail, facsimile and photocopying.
• The availability of services such as the time taken to gain an appointment with a dietician or fitness consultant.
• The cleanliness of all areas within the centres will enhance the reputation of HFG. Conversely, unclean areas will potentially deter clients from making repeat visits and/or recommendations to friends, colleagues etc.
• The presence of safety measures and the frequency of inspections made regarding gymnasium equipment within the centres and compliance with legislation are of paramount importance in businesses like that of HFG.
• The achievement of target reductions in weight that have been agreed between centre consultants and clients.

APPENDIX

 Calculations of ROI:

Calculations of RI

Calculations of EVA

Calculation of weighted average cost of capital (WACC) for use in calculation of EVA is as follows:

Note that the cost of equity is 15% and the after-tax cost of debt is

(100 – 30) / 100 x 10% = 7%

CSFs– Historically, performance measures have tended to focus mainly on aspects of an organisation’s financial performance. This may appear sensible as financial performance indicators play an important role in allowing organisations to measure success.

However, organisations also need to monitor the aspects of performance which ensure success. These aspects which ensure success are an organisation’s CSFs.

Crucially, CSFs are often non-financial in nature:

Quality – For example, it appears that TH’s continuing success is dependent on it continuing to produce high quality clothes. The company has built a strong reputation for quality, and the high quality of its clothes enables TH to charge high prices for them.

Brand loyalty – The competition TH faces has been intensifying for more than ten years, and therefore issues of brand loyalty and brand awareness are likely to become increasingly important for it. The strength of TH’s brand is likely to play an important role in the company’s ability to maintain (or even grow) its market share.

In this respect, ensuring it produces high quality clothes, and ensuring that it develops brand loyalty and brand awareness are likely to be CSFs for TH.

Performance measures – Once TH has identified its CSFs, it then has to develop KPIs to measure how well it is actually performing in these key areas of the business. If TH’s performance is below target in relation to key areas, then performance will need to be improved in order for TH to remain competitive in an increasingly competitive environment.

Because the CSFs are non-financial, it follows that the KPIs used to measure them are also non-financial. For example, TH could use indicators such as the number of garments returned to help measure the quality of its clothes.

Longer-term objectives – Another reason why non-financial aspects of performance are becoming increasingly important is that they tend to have less of a short-term focus than financial performance measures.

Financial performance measurement systems often focus on annual, or short-term, performance against financial targets. However, these may not be directly linked to an organisation’s longer-term objectives. For example, financial performance measures do not assess how well an organisation is meeting customer-related objectives.

However, non-financial objectives (such as achieving customer loyalty or brand loyalty) may be vital in sustaining profitability, competitiveness and other longer-term strategic goals.

Financial control role – The traditional view of accounting is as a mechanism for control, and therefore the focus of the management accountant’s role has traditionally been on financial control within an organisation.

In this traditional model, it was felt that management accountants needed to remain independent from operational managers, in order for accountants to be able to judge performance objectively and then report on it to senior management.

Business support role – However, Burns and Scapens’ studies found that the primary purpose of management accounting has now changed from financial control to business support. The management accountant’s role has also had to change accordingly.

In particular, instead of remaining detached from operating divisions, management accountants now need an understanding of these divisions and the commercial issues they are facing, so that, in effect, accountants can provide an internal consultancy service to the divisions.

Hybrid accountant – Burns and Scapens characterise the management accountant’s new role as being that of a hybrid accountant. As such, an accountant is no longer simply a financial or numbers specialist, but also needs an understanding of the operating functions and commercial processes of their organisation. The accountant acts as a source of business support and advice for operational managers.

Accordingly, management accountants have become increasingly involved with the operations of their business, rather than working in a separate ‘accounting department’.

Burns and Scapens state that there are three main forces for change in the role of the management accountant: changes in technology, management structure and competition.

Technology

In recent decades there have been major changes in the quality and quantity of information technology (IT) resources available in organisations.

Historically, the management accountant was one of the few people in an organisation who had access to the IT system and the information generated, because the outputs from the IT system were usually used to prepare financial reports to management. Data input was strictly controlled, and only a few people were allowed to enter data onto the IT system.

Impact of management information systems (MIS) – Now, however, MIS allow users across an organisation to run reports, providing them with the type of analysis once only provided by the management accountant. Therefore, rather than having exclusive access to information, the management accountant is simply another user of the system, in the same way that operational managers are.

This force for change is evident at TH, because the new management information system has increased the data available to all managers throughout the business.

Management structure

Changes in management structure have also affected the role of the management accountant in organisations.

Responsibility for budgeting – One of the main changes in organisations has been a shift in the responsibility for budgeting. Instead of budgets being produced by head office, and imposed on operational managers, operational managers now have greater responsibility for producing their own budgets.

This force for change is also evident at TH. The SBU managers have taken on greater responsibility for budgeting, whereas this had previously been carried out by the finance team at head office.

The increased autonomy given to the operational managers in organisations also means they have increased responsibility for managing the performance of their operations; for example, by monitoring actual performance against key financial and non-financial performance indicators, and producing revised forecasts based on current performance and trading conditions.

Producing reports – Consequently, whereas in the traditional model, the management accountant was the only person who produced performance reports for senior management, now operational managers will also be producing them.

Therefore, the nature of the reports produced by the management accountant will need to change. For example, the accountant’s reports may have to try to highlight the financial consequences of the information presented in the operational reports, or may have to illustrate how operational performance is affecting the organisation’s progress towards achieving its strategic goals.

Competition

Strategic focus – Burns and Scapens’ project found that the management accountant’s role had an increasingly commercial orientation. This change reflected organisations’ own needs to respond to competition and deploy a more strategic focus to help achieve, and maintain, competitive advantage.

Traditionally, management accountants focused largely on the ‘bottom line’ profit figure. However, this focus on profit has subsequently been associated with a short-term approach to performance management.

A commercial and strategic orientation recognises the importance of an organisation’s future earning capacity as well as its profit in the current period. Therefore, management accountants need to look at a wider range of performance measures to try to capture longer-term trends in performance and future profitability, as well as reporting on current profits.

This strategic orientation also encourages management accountants to assess an organisation’s performance in the context of its wider external environment.

Competitive position at TH – Competition and the competitive environment is having a significant impact on the role of the management accountant at TH.

TH sells its goods across the world and its main goal is to grow the business organically for the next generation of the family. This highlights that TH isn’t solely interested in short-term performance, but also has longer-term goals.

However, TH is also faced with increasing competition in its markets, and it needs to be aware of the threat from large brands which will try to dominate markets using economies of scale to their competitive advantage. Therefore, TH needs to be flexible and innovative in its response to larger competitors, but will also need to ensure it maintains the high quality of its products which could help it differentiate itself from these competitors.

Appropriateness of the changes at TH

The three main forces for change in the management accountant’s role (changes in technology, management structure and competition) are all present at TH.

The changes in organisational structure (leading to SBU managers taking more responsibility for budgeting) would appear to fit particularly well with the concept of the accountant as an internal consultant. For example, the accountant could work with the operational managers to identify ways of improving how the new MIS is used, and tailoring the reports it produces to the managers’ particular needs.

Equally, the accountant can play an important role in ensuring that the aspects of operational performance which the SBU managers measure are properly aligned to, and support, TH’s overall strategic goals and objectives.

Brand identity helps to convey information about the quality or price of a product or service to customers. A strong brand identity can help create customer loyalty to the brand, thereby improving customer retention rates and encouraging repeat purchases, which in turn can be a means of increasing or maintaining sales.

Brand loyalty results in a consumer consistently buying the same brand within a product class, rather than buying a range of different brands. Again, this loyalty helps to maintain sales.

Brand awareness is an indicator of the strength of a product or organisation’s position in the marketplace, and in customers’ minds. Whereas brand loyalty helps to retain existing customers, brand awareness is important for attracting new customers and thereby generating new revenues.

Customer perspective

Competitive advantage – From the customer perspective, TH’s brand is part of its competitive advantage. Customers are attracted to TH by its history and the family story which goes behind its products. In particular, customers are willing to pay high prices because they identify with the company’s values, and because TH’s brand signifies a high quality of manufacturing. In this respect, branding acts as a form of product differentiation which can make it possible for TH to charge premium prices for a luxury product.

Brand loyalty – In this respect, customers’ loyalty to the TH brand can help compensate for the price differential between TH’s products and those of its global competitors who benefit from economies of scale. Equally, since TH’s family story is an important part of its brand, the company will need to ensure that this story is maintained, and customers remain aware of it.

Brand awareness – However, because TH is competing against global brands, awareness of TH’s brand among the public at large may be lower than awareness of some of the competitor brands. This highlights the importance of marketing expenditure within TH to increase public awareness of its brand.

Performance measurement – The management accountant could have an important role in monitoring the effectiveness of TH’s marketing spend; for example, by trying to identify any relationships between marketing and sales growth. In particular, it could be useful to identify which marketing channels are most effective for different campaigns.

A measure such as return on marketing expenditure could be useful here: looking at the incremental revenues which are generated following different marketing campaigns.

Internal business perspective

Quality – In order to sustain the reputation of its brand, TH needs to ensure that it maintains the high quality of both its manufacturing and also its retailing operations.

Quality in production – Since the TH brand promotes the idea of high quality, customers will be disappointed if the products they buy do not live up to their expectations. In this respect, quality assurance and quality control will be very important for TH. Therefore, it could be useful for the management accountant to monitor the expenditure incurred in relation to preventing or detecting faulty goods in the production process. However, it will equally be important to monitor the level of customer complaints about goods which do not meet their quality standards.

Retail quality – The quality of the service customers receive in TH’s shops will also shape their perception of the brand. In this respect, the amount of training given to staff will need to be high in order to ensure a high quality of service is offered to customers in TH’s shops. In addition, there may need to be high capital costs in order to fit out the retail premises to the standards expected of a premium brand such as TH.

Brand loyalty – If customers continue to receive high quality goods and high quality service from TH (which meet, or even exceed their expectations), they are more likely to remain loyal to TH than if they receive products and services which do not meet their expectations.

Suitable measures

Tutorial note.

The marking guide indicates that there are up to four marks available for evaluating suitable measures for brand loyalty and awareness. The solution below includes a range of possible measures which you could have referred to in this context, but you would not have needed to include all of them to score the four marks available.

Brand loyalty

Retention rates – Brand loyalty can be measured through customer retention rates and the level of repeat purchases by customers. We would expect there to be a correlation between brand loyalty and the level of repeat purchases: the higher the proportion of TH’s customers who make repeat purchases from it, the stronger the loyalty to the TH brand would appear to be.

Price elasticity of demand – Another way of measuring brand loyalty could also be to measure price elasticity of demand. If TH’s customers continue to buy its products despite an increase in price, this would suggest they are loyal to the TH brand. A brand’s ability to increase prices with only a relatively small reduction in demand is one of the key benefits of brand loyalty.

Profit margins – Another benefit of branding is that it could help TH charge premium prices for its products, thereby enabling it to earn higher profits than if products had to be sold at a lower price. In this respect, it would be useful to measure the profit margins TH can earn, and compare these to other companies which make similar products to TH but which don’t have such a strong brand.

Brand awareness

Market share – A relatively crude way of trying to gauge customers’ awareness of TH’s brand would be to measure the market share that TH enjoys. If TH’s market share is increasing, this should suggest that customers’ awareness of the brand is also increasing.

Brand awareness surveys – A more detailed way of assessing brand awareness would be through brand awareness surveys; for example, TH could test whether customers can correctly associate the brand associated with its logos or products.

Such an exercise could be particularly useful in assessing the impact that an advertising campaign has had on brand awareness. However, given the segmentation of TH’s markets, it will be important for TH to test its brand awareness in different markets.

BPR involves radical and fundamental changes in the way processes in organisations are designed. A focus on the needs of the customer, and customer satisfaction, are key to BPR. BPR aims to improve key performance measures such as reducing costs, improving quality, service delivery and customer satisfaction.

The proposal is to move away from the existing functional structure where staff are attached to only one stage of the production process, or even to one type of machine within each function, to team working. This is a radical change for Alfred and, as such, is an example of BPR.

Reorganising into teams

Currently, there is very little multi-skilling of production staff at Alfred. This was seen where there were insufficiently trained zip machinists available for the emergency order for the Heeland army, even though there were enough machinists to sew buttons. This led to the emergency order failing to meet the customer’s requirements as it was not delivered on time.

Furthermore, it seems that machinists also prefer to work on one particular type of machine. This is probably because they are currently rewarded according to the speed of production, rather than the quality of production, and can work faster when using just one machine.

A change to team working would imply job enlargement for machinists, who would need to be trained so that they were multi-skilled in different parts of the production process. They could then perform the roles of other members of their team, to ensure that there were no bottlenecks in production.

The cost of reorganisation and the costs of training the machinists should be outweighed by the resulting improved efficiency and flexibility of production. In this way, there is more focus on the outcome (goods of the correct quality produced on time) and less focus on the individual tasks within the process, which is a key principle of BPR.

Production teams are responsible for quality

Alfred’s brand has a strong reputation, and the use of its products for protection in harsh environments and by the armed forces means that quality is a key element of customer satisfaction. Alfred must be able to manufacture goods which are free of defects, unlike the emergency order for the Heeland army. Reorganising the production into teams of machinists, sometimes known as production ‘cells’, would make machinists responsible for decisions about quality of a particular product type. This should lead to improvements in quality and therefore to meeting the needs of the customer.

Reducing the number of processes for checking is typical of a re-engineered process, and the quality checking currently performed by the supervisors would no longer be necessary. The production teams will be managing themselves in this respect, and the distinction between supervisors and machinists will be removed, which is again typical of organisations which have undergone BPR.

Encouraging machinists in each team to suggest improvements in the production process should bring about improvements in both quality and efficiency, and hence a reduction in costs. It is the machinists who are closest to the production process and may be able to see how it can be improved. Alfred could also consider a more formal system of incremental continuous improvements such as Kaizen costing.

Tracking with RFIDs

Typically, organisations with re-engineered processes end up having a flatter hierarchy. It seems that the supervisors’ current roles will no longer be required if the proposal is adopted. Quality checks will no longer be undertaken by them, nor will recording of batches, which will become automated using RFID tags. This should save salary costs and improve lines of communication in the business.

The use of RFID tags would capture the information required to manage the production process at source, and there would be no distinction between the gathering of information and processing it. This is in contrast to the current system of inputting batch data into a spreadsheet, and is a feature in organisations which have undergone BPR.

Practical and cultural aspects of the proposal

New performance measures related to quality rather than just quantity produced will have to be developed and processes and systems developed in order to record and report these. New rewards systems will also have to be developed and introduced as a result of the changes proposed.

The proposal, by definition, represents a significant cultural change for Alfred, and may meet resistance by staff who may perceive it as a threat and a one-off cost-cutting measure rather than a fundamental long-term change in the business. It will also affect the organisational hierarchy, relationships between employees and the roles within Alfred. There will be significant costs with training staff and with the disruption the transition may cause.

The current reward system

The machinists are currently paid a basic hourly wage plus an amount depending on how many items they sew. This will encourage them to work quickly, which will reduce product costs. However, as they are not directly rewarded for the quality of the work which they produce, they may not be motivated to produce high quality work. Furthermore, in order to work quickly, machinists prefer to work on only one type of machine. This reduces Alfred’s overall flexibility to respond to customer needs, as illustrated by the failure to deliver the emergency order for the Heeland army.

The production supervisors also receive a bonus according to how many items machinists in their team are able to sew. This too does not reward the production of high-quality work, and supervisors may also neglect quality in order to increase the speed of production. The machinists in their teams could also see it as unfair that the supervisors obtain a bonus based on what they see as their efforts.

The Production Manager does not receive a bonus for production or quality. It seems that he has currently no direct motivation to improve on either of these two aspects of the process.

At 5% of salary, the bonus related to Alfred’s overall profits is relatively small and it is unclear whether it is a significant motivator to any of the employees. Furthermore, machinists in particular may perceive their own efforts as too remote from the company’s overall profit for them to bother to achieve it. Even if they were to be motivated by this, it is unclear what proportion of the total costs are related to direct labour as Alfred incurs many other costs such as advertising to maintain the brand. If the costs of direct labour were relatively low, even a large improvement in production efficiency by the machinists may have little effect on overall profit.

Changes to reward systems under the new proposal

The existing reward systems would likely need to change if the move to team-based production were to be adopted.

It may still be appropriate to reward machinists with volume-related bonuses but, as they worked in teams, a team-based performance bonus would be more appropriate. In that way the rest of the team would ensure that any underperforming machinists would improve their performance.

Rewards based on other factors such as quality, innovation, on-time delivery and the ability to work as part of a team would also be appropriate and consistent with the machinists’ enlarged job role. This would be a significant change for Alfred, where machinists are now being encouraged for the first time to bring about improvements in the production process. Rewards based on direct costs of production, or for the number of suggestions made by each machinist may be appropriate here.

New performance measures would need to be developed against which to align rewards to ensure that employees work towards the overall objectives of the organisation. New reporting systems will need to be put in place to feedback information regarding quality to each cell. This may incur additional costs in the development of existing or new information technology systems.

The commitment of senior management to these changes would be required, as well as communication and training of employees at all levels. This may again incur additional costs and divert management time away from existing activities.

Unlike commercial organisations which have an underlying objective to maximise the profits they generate for their shareholders; it is often much harder to define the objectives of public sector organisations.

Multiple objectives – The Waste Department’s goal identifies three potential objectives: cleanliness, safety, and environmental friendliness. As such, its performance indicators will need to measure how well it is performing in these three areas. However, as none of the areas are financial, non-financial performance indicators – such as survey scores for how clean residents or tourists feel the area is – are likely to be more relevant than financial ones.

Lack of profit measure – The goal also highlights that generating a profit is not a priority for the department in the way it is for commercial organisations. The Chief Executive’s desire to keep costs under control suggests that financial performance measures (focusing on costs) will still be important. However, if YLA focuses too much on cutting costs (for example, by reducing the frequency of waste collections), this could be detrimental to the primary goal of maintaining cleanliness and safety. As such, YLA needs a range of performance indicators, linked to how clean, safe and environmentally friendly the area is.

Difficulty in selecting financial measures – As with many public sector organisations, the results (output) from the Waste Department’s services are non-financial: for example, clean streets, a safe environment. Therefore it will be difficult to find any financial indicators which measure the outputs of the department’s services in any meaningful way.

Consequently, in any assessment of the department’s services it will be difficult to introduce any direct comparison between cost (financial) and benefits (non-financial). In addition, it could be difficult to define the cost unit against which to measure the department’s performance. For example, should YLA be measuring the cost per tonne of waste collected, or the cost per household?

Value for money

The extent to which YLA provides value for money services should be assessed in relation to:

Economy – the extent to which services of an acceptable quality are provided at the cheapest cost possible

Efficiency – the way YLA’s services are organised, to ensure that the department maximises the benefits and outputs it obtains from its resources

Effectiveness – the extent to which the Waste Services Department’s activities achieve its goals

Possible performance indicators at YLA

Economy

YLA’s staff costs account for 44% of its total costs, and so the extent to which YLA controls its staff costs will have a significant impact on the economy of its services.

The average salary for YLA’s waste collection staff is $31,429 compared to the national average of $29,825. The fact that YLA’s average salary exceeds the national average suggests its services are not being provided as economically as they could be. However, this may reflect the fact that Yorkshire is a wealthy area, so wage levels in general may be higher there than in other parts of the country. Equally, though, by paying above the national average for staff, YLA may be able to recruit more experienced or higher quality staff. As a result, this could improve its efficiency.

Another significant cost driver for YLA is likely to be its fleet of vehicles. Therefore, it could also measure economy in relation to the costs it pays for its vehicles, their fuel and their maintenance.

Efficiency

Benchmarking the performance of YLA’s waste collections against the national figures indicates that YLA is relatively efficient:

This supports the point we made earlier: that although YLA’s average salary is above the national average, YLA benefits from the greater efficiency of its staff.

Effectiveness

Effectiveness needs to be measured against a variety of aspects, linked to the need for waste collection:

Public health concerns – The fact that waste is only collected every 14 days (compared to the national average of 12 days) could suggest that YLA is less effective in maintaining public health. However, the level of public health concerns could also be measured by the number of complaints about vermin or other problems related to waste. If the level of complaints YLA receives is in line with national average (or below it) there would seem to be little reason to increase the frequency of the collections it carries out.

Clean and attractive streets – Finding a way to measure the cleanliness of YLA’s streets could be difficult, because ‘cleanliness’ is inherently subjective, and therefore difficult to quantify. However, YLA could use the number of complaints it receives from residents or businesses as an indirect measure. If the number of complaints is relatively low, this would suggest that the cleanliness of the streets is being maintained at an acceptable level.

Increased recycling – The Government has set a target of 40% of all waste to be recycled, therefore YLA needs to measure the percentage of its total waste it recycles. It currently recycles 43% of all waste collected (950,000/2.2m). As such, YLA has already achieved the target level, and the proportion of waste it recycles is above the national average (41%).

Nonetheless, as the Government is planning to increase the levy charged on landfill, it will be important for YLA to ensure the proportion of waste that it recycles is as high as possible. As such, this remains an important indicator to monitor.

Difficulties of measuring qualitative performance

Subjectivity – One of the main problems in measuring qualitative performance is that it is based on people’s opinions and judgements and therefore is subjective. For example, people’s assessment about what constitutes an acceptable level of cleanliness in YLA’s streets may differ, and this in turn could affect the degree to which the area’s streets are perceived to be ‘clean’.

Equally, as Blueland is currently in a long recession, some people may prefer that waste be collected less frequently to allow the local Government to save money, instead of, for example, increasing local taxes to pay for more frequent collections. In this case, people’s priorities could dictate their willingness to complain about uncollected waste or the frequency of collections.

The fact that the underlying data is qualitative rather than quantitative can, in itself, create problems for measurement. For example, if the Waste Management Department receives a phone call from a resident complaining that some uncollected waste is ‘disgusting’, it will be difficult for the department to gauge whether this is a more serious or less serious problem than the uncollected waste described by another resident as ‘foul’.

Currently, YLA records the number of complaints it receives, but there is no indication of the seriousness of these complaints – possibly due to the subjective nature of the data involved.

Scoring – One way of addressing the problem of subjectivity could be to try to make the data quantitative. For example, the Waste Management Department could introduce a scoring system to judge how satisfied residents are with the cleanliness of their streets. The scoring system could ask residents to rate cleanliness on a scale from 1 to 5, with ‘1’ signifying ‘Very satisfied’ and ‘5’ signifying ‘Very dissatisfied’.

However, scoring systems are still subjective, because the level of cleanliness which one person grades as ‘Very satisfactory’ may only be deemed ‘Satisfactory’ by another person. In general, there is also a tendency to score towards the middle in this type of scoring system: people feel more comfortable selecting scores in the range ‘2’ to ‘4’, rather than using the extreme scores of ‘1’ or ‘5’.

Trends – One way to reduce the subjectivity in non-financial performance measures is by looking at trends over time rather than one-off metrics – for example, monitoring trends in the average scores for cleanliness.

Although individual scores will still be subjective, looking at average scores over time can help to overcome this subjectivity and highlight changes in quality or satisfaction. For example, if the residents are surveyed about the cleanliness of YLA annually, and the average score declines from one year to the next, this should provide a good indication that the quality of the waste collection services is declining.