The performance pyramid covers not only financial performance but also performance relating to a wide range of underlying processes which drive financial performance. As such, it helps to set financial and non-financial performance measures, such as on-time stops. Non-financial measures are leading indicators which can help to achieve long-term future financial performance. This would be useful to Zoris, which has had excessive focus on financial objectives and inadequate systems to measure and manage performance of the underlying processes driving financial performance. It is unclear exactly what the current financial objectives are.

The elements of the pyramid are interrelated, and each level in the pyramid supports the one above it. For example, on-time stops will increase customer satisfaction, which will eventually lead to greater market share, one element of the corporate vision.

Objectives cascade down the pyramid from the strategic to the operational level. The vision to increase shareholder wealth can be supported by financial objectives such as EVA™ at the level below. Measures flow up the pyramid, so that measurement of on-time stops can help determine whether Zoris is achieving customer satisfaction.

The pyramid ensures that all aspects, both internal and external, of performance are measured. The right-hand side of the pyramid covers internal efficiency, such as flexibility and productivity, while the left-hand side covers external effectiveness, such as customer satisfaction. Using on-time stops again as an example, which relates to the quality (external effectiveness) element of the pyramid, will lead to improved performance up the left hand side of the pyramid.

Operational performance is represented by the four elements at the bottom level of the performance pyramid, which are quality, delivery, cycle time and waste. It is unclear what quality means in the context of the corporate vision, though the measure of on-time stops could be interpreted as a measure of quality, which is valued by customers. There is no direct measure of cycle time, for example, the time taken between collecting a parcel and delivering it. Also, there is no direct measure for delivery, which in this context would be the amount of time needed to arrange a collection or delivery.

Vehicle utilisation

This is a good way to measure waste. The greater the utilisation of vehicle capacity, the lower the waste, for example, of vehicle running costs. In the long run, higher vehicle utilisation would mean the number of vehicles operated could be reduced for the same level of activity. This would lead to increased productivity and financial performance, so helping to achieve the corporate vision.

Vehicle utilisation will vary, according to location, time of year and type of vehicle used, and is also measured inconsistently, according to the type of vehicle. Vehicle utilisation may be too broad a measure, making it difficult to manage performance. Areas of poor performance may mask other areas of good performance. Similarly, measuring utilisation as an average between that at the beginning and end of each day may not actually represent the average utilisation during the day.

Fuel consumption

Reducing fuel consumption would lead to a significant increase in financial performance at Zoris. Measuring average fuel consumption per kilometre travelled does not, however, relate directly to activity, for example, to the number of parcels delivered.

Average fuel consumption will vary between type of vehicle and between rural and urban areas. A large vehicle may have high fuel consumption per kilometre travelled, but will also carry a large number of parcels. Average fuel consumption per kilometre is not a good measure of waste, or any other aspect of operational performance. To be useful in managing operational performance, this measure should be changed to average fuel consumed per parcel delivered. In this case, this would be a suitable measure for waste.

On-time stops

Customers are likely to value on-time stops very highly, and along with value for money, this will be one of the main reasons they will choose to use Zoris. This is reflected in the corporate vision. The proportion of on-time stops is a measure of operational performance which relates to the quality element of the performance pyramid and is a key driver of customer satisfaction.

Tutorial note

Answers structured on the basis of the four operational elements of the pyramid would be acceptable.

The DMAIC acronym stands for define, measure, analyse, improve and control. These are the five phases by which the six-sigma methodology is implemented. To be suitable for use in the DMAIC method, measures defined must have certain characteristics.

Percentage of stops made within 10 minutes of the booked time

According to the six-sigma method, only those measures which are valued by the customer should be measured. On-time stops will be valued by customers, and contribute to customer satisfaction.

Currently, however, of all complaints which Zoris receives from customers relating to stops not made on time, less than around 1 per million of these relate to those made within 30 minutes of the booked time. This level of complaints is so low that this would already achieve the very low number, 3.4 per million, of failures targeted by implementation of the six sigma methodology.

It seems that customers will not value stops made within 10 minutes of the booked time, any more than they would value those within 30 minutes. Another principle of six sigma methodology is not to measure what customers are already satisfied with. They are already satisfied with stops made within 30 minutes of the booked time.

The percentage of stops made within 10 minutes of the booked time is not a suitable measure. The time and costs of making the measurements will exceed the benefits of doing so.

Failed deliveries

Failed deliveries will represent a considerable cost to Zoris in terms of wasted fuel and driver time. It may also reduce flexibility by using up vehicle capacity which could be used to carry more parcels. Even though deliveries may fail due to traffic congestion, they will still reduce customer satisfaction.

The percentage of failed deliveries is currently 5%, well above the target rate for failures under the six sigma methodology (which is better than 3.4 per million accuracy), and in this respect would be a suitable measure.

According to the six-sigma method, only those measures which can be improved should be measured. Failed deliveries arising from customers being unavailable to take the delivery is completely out of Zoris’ control. Deliveries failing due to incorrectly addressed parcels could be reduced to some extent, for example, by the use of information technology to check the correct address, but most failures due to this are outside Zoris’ control. As failed deliveries cannot be significantly improved, this is not a suitable measure.

The extent to which the Argenti A Score indicates corporate failure in ML

The Argenti A Score assigns scores to management defects and accounting defects, which are effectively weaknesses which can lead to failure, mistakes, and symptoms. Symptoms are indications that the business is actually failing. The resulting score indicates whether or not ML is or is not at risk of corporate failure. Between these two extremes, there is a grey area where further analysis is required to reach a conclusion. An A Score of 25 or above indicates a high risk of corporate failure. As ML’s A Score is 47, it is at high risk of failure.

Defects

The chief executive appears to be an autocrat, which is a management defect under the Argenti A Score model. ML prepared bids for work in areas it had little track record in, which was the strategy preferred by the chief executive, even though the rest of the board wanted to reduce the workforce to reduce operating gearing after the start of the recession. This suggests that the chief executive has a dominant influence over the rest of the board and that the board of directors is passive, which is another management defect.

The submission of the bid was done when most of the board members were on holiday, so in this respect too, the board was passive as it had no opportunity to discuss or review the bid. Similarly, the bid was made when the finance director was on long-term absence. An ineffective finance director is a management defect which increases the risk of corporate failure.

The fact that the amount of staff resources, and therefore cost, required to perform the work on the housing development was greater than anticipated was an accounting defect which increases the risk of failure.

Mistakes

ML undertook a large project in an area where it has little experience, and at a fixed fee. This was a high-risk venture, particularly as ML failed to set clear milestones for the project or put in place adequate performance management systems. This is a management mistake which, in the absence of suitable insurance cover, may mean ML is unable to meet any legal claims brought against it.

ML has an operational gearing ratio which is 50% higher than its nearest rival. Failing to address this high level of fixed cost, for example, by reducing the workforce for the duration of the recession, is also a management mistake which increases the risk of corporate failure.

Symptoms

Any symptoms of impending problems would indicate a high risk of corporate failure, even if ML’s A Score were to be below the maximum acceptable score of 25. The low staff morale, and staff leaving the firm due to working long hours with unclear individual performance targets, is a symptom that the firm is at risk of failure.

Mistakes

The failure of the big project for the design work for the housing development, and the high operational gearing, are management mistakes which increase the risk of corporate failure. To improve performance in these areas, ML needs effective performance management systems.

Failure of the big project for the design work for the housing development

ML should identify critical success factors (CSFs) for improvement in performance. Big projects, especially those which are outside ML’s usual activities should be fully scrutinised by the board, and the risks of the project thoroughly assessed. This would help prevent ML taking on projects for a fixed fee, where the costs of performing the work are poorly understood. The use of realistic budgets and clear project milestones would have helped identify that the major project was failing and allowed corrective action to be taken. Clear budgets and project milestones should be key performance measures to identify failure of the major project.

Operational gearing

From the CSFs ML must develop key performance indicators (KPIs). The operating gearing is an obvious KPI to help reduce the firm’s high operating gearing. Cash forecasts would also help to identify and correct high operating gearing. Performance targets such as these should be clearly communicated and linked to employee rewards.

Symptoms

Clear milestones and performance targets were not set for the housing development project and the project has fallen behind schedule. This has led to low staff morale and to staff leaving the firm. All of these are symptoms of corporate failure.

Performance against the targets should be regularly monitored, for example, by using staff appraisals and surveys to monitor staff satisfaction. This could indicate where additional training or support is required.

Measuring staff turnover would help measure this symptom of corporate failure so that ML could try to identify why staff were leaving.

Advantages of using qualitative models in predicting corporate failure

The subjectivity of the A Score can be an advantage over quantitative indicators of corporate failure, as it allows the person calculating the A Score to use their own professional judgement in considering individual circumstances.

It also recognises factors which have been observed in failing companies and which often can be seen in organisations before they reach a terminal state.

The A Score model incorporates financial (such as the operating gearing ratio), and non-financial factors, which give a more holistic assessment of whether failure is likely than just looking at financial or non-financial factors alone.

Disadvantages of using qualitative models in predicting corporate failure

Calculating the A Score is subjective and requires experience and professional judgement, for example, in determining whether ML’s board is passive. In reality, passive will be on a scale rather than just passive or not, which also makes it difficult to compare the score between organisations.

The A Score focuses on internal factors, which limits its usefulness. The economic recession has had a serious impact on ML, which calculating the A Score alone would not consider. Further analysis of the external environment, such as using a PEST analysis, or calculation of competitors’ A Scores, would consider external factors in determining whether ML is at risk of corporate failure.

A limitation of the A Score model is that it is only a snapshot at a particular time and does not indicate when corporate failure may occur. Defects and management mistakes may take a long time before they lead to corporate failure. In ML, corporate failure may occur if it is subject to legal action for the delay of the housing project. Conversely, the recession may end and ML may no longer be at risk.

The fact that the A Score does not give a definitive indication of whether failure will happen may mean inappropriate decisions are taken as a result of the analysis. It must be considered whether the time and cost in calculating the score are justified by the benefit of doing so. The results of the A Score may be inconclusive and indicate that the subject is in the ‘grey area’. This will require yet further analysis before a conclusion can be reached. This does not appear to apply to ML which is currently clearly at risk of corporate failure using the A Score model.

Board briefing

The concept of the Balanced Scorecard was introduced by Kaplan & Norton in the early Nineties to recognise what they considered to be two primary deficiencies in the implementation phase of many corporate plans.

First, they recognised that, although many organisations measure performance ratios these are primarily focused on historical figures and may have little to do with future success. Although such ratios are important they do not address important aspects of future strategy, particularly those concerned with the satisfaction of customers and their loyalty, organisational learning and the commitment of employees.

Additionally, they believed that, although strategic initiatives were formulated, these often-had little impact on organisational behaviour or performance since they were not translated into measures which management and staff could understand and use. Moving away from purely financial measures they claimed that what really mattered was the strategy implementation process and described three processes:

1. Management – how the leader runs the organisation, how decisions are made and implemented
2. Business – how products are designed, orders fulfilled, customer satisfaction achieved, for example
3. Work – how work is operationalised, purchased, stored, and manufactured.

The Balanced Scorecard was developed to address any deficiencies in these areas and encompasses four key principles:

1. Translating the vision through clarifying and gaining consensus
2. Communicating and linking by setting goals and establishing rewards for success
3. Business planning to align objectives, allocate resources and establish milestones
4. Feedback and learning to review the subsequent performance against the plan.

They recognised that there should be, on every scorecard, four perspectives:

1. Financial perspective – ‘To succeed financially, how should we appear to our shareholders?’
2. Customer perspective – ‘To achieve our vision, how should we appear to our customers?’
3. Internal perspective – ‘To satisfy our shareholders and customers, what business processes must we excel at?’
4. Future – the innovation and learning perspective. ‘To achieve our vision, how will we sustain our ability to change and improve?’

For each perspective, a number of objectives, appropriate measures and target levels of performance together with initiatives for their achievement, would be defined. Thus, the measures chosen under each perspective would reflect the strategic imperatives under which the organisation operates at the time.

Although the Balanced Scorecard was originally developed for commercial organisations, over the last few years it has found increasing use in the not-for-profit sector, where the same perspectives are equally important, but measured in a different way.

The Royal Botanical Gardens would benefit from the introduction of a Balanced Scorecard by:

• Placing the whole organisation in a learning process, aligning everyone to strategy in a single framework. The Balanced Scorecard has potential to improve itself over time by testing cause – effect hypotheses, refinement of the metrics selected, the measurement processes employed, resource allocation and identification of suitable initiatives.
• Encouraging more rational budgeting in a world of rapid change where resource allocations are based on performance and systematic, fact-based management replaces intuition.
• Encouraging and facilitating the anticipation of future outcomes and their impact on the organisation.
• Raising the visibility of what is happening, prioritising what most needs to be changed and helping to identify best practices.

In addition to the internal, managerial, benefits that the balanced scorecard can bring to the organisation it has the potential to demonstrate to external stakeholders that their mandates and objectives are being met. In this particular case, where the Government will need to be convinced to maintain, or even increase, the grant in aid, the measures incorporated can demonstrate that objectives over and above value for money are being achieved. It would make it easier for the Garden’s negotiators to demonstrate the achievements in terms of assistance to education, industry, tourism and national prestige. However, it must be recognised that it requires sustained effort to implement fully and requires a high level of organisational commitment. Its introduction may create fear and uncertainty since it raises both visibility and accountability. As with all other performance measurement techniques it will not solve problems – only strategy and initiatives and their successful implementation can do that.

It is important that the Balanced Scorecard is developed by a team of individuals and the commitment of the senior management is obtained. The team should be cross organisational and contain representatives of all functional groups within the Gardens.

The main tasks of the teams are as follows:

• Identify strategic themes
• Define perspectives and desired outcomes
• Create a strategy map
• Define performance measures and targets
• Develop strategic initiatives to achieve targets.

Once the team has been established the mission statement should be analysed to identify the strategic themes that are encompassed by the statement. This will provide a more specific focus for planning. For instance, the following themes, among others, might be distilled from the mission statement:

• Knowledge and understanding through research
• Knowledge and understanding through display
• Conservation by living and preserved collections
• Belonging to the Nation.

The next task will be to define the perspectives – the diverse ways of looking at the organisation from the perspective of different stakeholders. Also, to define the meaning of mission success for each perspective and strategic theme.

The different stakeholders for The Royal Botanical Gardens are many and would include, for example:

1. Financial perspective – government and research foundations that fund some of the work
2. Customer perspective – universities who use the facilities
3. Internal perspective – botanists using the facilities for research
4. Future – the innovation and learning perspective – educationalists attached to the Gardens.

Within the strategic theme of knowledge and understanding through research, these perspectives might lead to the following desired outcomes:

1. Financial perspective – government funders would look for value for money in the collection of novel plants and materials and the production of research papers.
2. Customer perspective – universities who deal with the Gardens would look for seamless access to any plants and materials they required in a cost-effective way.
3. Internal perspective – the botanists who work within the Gardens would look for support in their research so that they can work productively and advance the boundaries of science.
4. Future – the innovation and learning perspective – the educationalists might wish to raise the profile of the facilities and attract people to this area of study and would look to find innovative ways to bring people in.

For each strategic theme, the team would need to develop a chain of causes and effects that would be expected to lead to the desired outcomes. Each of these chains would be mapped onto a strategy map. Systems dynamics techniques would help in this area.

For instance, considering the provision of samples to Universities from a future perspective would mean enhancing information management, improving the employee climate and changing the skills gap. The botanists who work in the Gardens might see themselves in competition with the Universities. A co-operative approach would improve relationships, while seeking citation or acknowledgement in any research published. From the internal perspective looking for process efficiencies in picking and despatch would lead to more cost effective operations satisfying the financial perspective, while the enhanced service levels would, from the customer perspective, make them more likely to acknowledge assistance in research publications.

The definition of performance measures and targets would be achieved by answering the question ‘how will we know if this theme/desired outcome is being achieved?’ and deciding how each goal should be measured for example surveys or other means of data collection. If available, baseline data should be examined to set schedules and targets for improvement.

For instance, measures for the theme/outcome of provision of samples to Universities might include:

• Financial – cost per sample provided, revenue generated from advice and consultancy
• Customer – satisfaction surveys, amount of repeat business
• Internal – citations in published research, published research
• Future – new universities seeking samples; reduction in number of unsatisfied requests.

MCJ

Financial performance and competitiveness

Summary Income Statement for the year ended 31 May 20X6

It is clear that MCJ performed well during the year ended 31 May 20X6. Fee income was 13.8% above budget, in spite of the fact that other operating costs were 25% higher than budget.

The management of MCJ should investigate what caused this significant overspend and therefore it would be extremely useful to have a more detailed breakdown of other operating costs.

Consultants earned an aggregate bonus of (($11,235,000 – $9,870,000) – (450 × 2 × $700)) × 40% = $294,000 in respect of activity above budgeted levels. Actual net profit was $1,441,000 against a budgeted net profit of $1,270,000. In spite of the overspend on other operating costs, MCJ is achieving rapid growth in levels of net profit. In 20X5 (its second year of trading) net profit was 50% higher than in its first year. In 20X6 net profit has increased by 60.1% over 20X5 net profit.

MCJ could measure its competitiveness in terms of sales growth and the relative success in obtaining business from enquiries made by customers.

In assessing sales growth, it needs to be borne in mind that this is the ‘start-up’ phase of MCJ. However, MCJ increased sales revenue from $4,000,000 in its first year to $11,235,000 in its third year of operation, which is very impressive. MCJ’s success in obtaining business from enquiries made by customers for the year ended 31 May 20X6 is shown in the following table.

60% of enquiries from existing clients resulted in additional chargeable consultancy days for MCJ. This may well indicate that MCJ is starting to build customer loyalty despite the fact that the organisation has only been in existence for three years. With regard to enquiries from potential ‘first time’ clients, MCJ achieved a conversion ratio of 30.0%, against a budgeted conversion ratio of 35% that was budgeted. However, in absolute terms new business was approximately 7.1% above budget whilst existing business was 16.7% business above budget.

As regards the nature of the chargeable activities undertaken by the consultants it can be seen that Distribution software implementation was 20.6% below budget, whereas Accounting and Manufacturing implementations were 26.2% and 33.3% respectively above budget.

MCJ provided 300 consultations on a no-fee basis with a view to gaining new business. Also, during the year MCJ consultants provided non-chargeable ‘remedial’ consultations. Both of these non-chargeable activities might be viewed as initiatives aimed at increasing future levels of competitiveness. However, each remedial consultation could be viewed as inefficiency.

External effectiveness

In order to achieve ‘external effectiveness’ MCJ has to satisfy its customers. Customer satisfaction may be defined as meeting customer expectations. The quality-of-service provision and delivery are operational criteria that can be used to monitor levels of customer satisfaction. To some extent, the increase in the number of complaints and non-chargeable consultations associated with the remedying of those complaints is indicative of a quality problem that must be investigated and addressed. In particular the number of chargeable days for implementation of distribution applications is significantly below budget and it might well be the case that poor service ‘delivery’ is giving rise to the need for remedial consultations.

Assuming consultants could otherwise have undertaken chargeable work at a rate of $700, revenue amounting to $630,000 was lost as a consequence of having to undertake remedial consultations. It would appear that MCJ does not budget for complaints.

A summary of client complaints received by MCJ is shown in the following table:

Whilst it can be seen that the complaint: client ratio is improving, it should be recognised that this may be due to the fact that the size of the client base is increasing very rapidly. Such a trend might be expected during the first few years of operation, especially in a business such as MCJ.

The harsh fact is that the number of complaints is increasing in absolute terms. In order to be able to better assess customer satisfaction, complaints need to be analysed since the nature of complaints may well be of far more relevance than the number of complaints!

The number of customer support desk queries resolved is improving; i.e., 20X4 (85%); 20X5 (95%) and 20X6 (99%). This will further enhance the level of customer satisfaction. The fact that the number of accounts in dispute is falling whilst the number of clients is increasing significantly on a year-on-year basis may also be an indication of improved customer satisfaction. The increase in the number of new customers and the increased revenues generated per customer are probably indicators of increasing levels of customer satisfaction.

Internal efficiency

Internal efficiency may be assessed by reference to flexibility and productivity. Flexibility relates to the business operating system as a whole whilst productivity relates to the management of resources such as, in the case of MCJ, consultants time.

Flexibility might be substantiated by looking at the mix of work undertaken by the consultants during the year. The following table gives a comparison of actual and budgeted consultations by category of consultant.

Consultations by category of consultant:

flexibility to meet increasing demand. The delivery speed will be increased as a consequence of the retention of consultants. It would appear that a change has occurred in the mix of consultants which may well be a response to changing market requirements. Again, it would be useful to see recent year’s statistics in order to consider trends.

Productivity can be measured by the ratio of output achieved from those resources input. In this scenario the average number of chargeable days per consultant may be used as a guide.

The implementation of distribution application software was more than 20% below budget. Chargeable distribution consultancy days based on the original budget of 168 days per consultant would produce a total of 4,200 chargeable days which is 200 more than the actual levels. Again, this might be indicative of a quality problem.

‘Cycle time’ would appear to be improving as evidenced by the increasing number of on-time implementations as well as the reduction in the implementation time of each application. In this respect MCJ needs to be certain that the reduction in implementation time has not caused a diminution in the quality of service delivery. Consequently an aggregate bonus amounting to $294,000 was paid in respect of the year ended 31 May 2006. MCJ needs to ensure that the incentive provided by the bonus is not causing a loss of ‘internal efficiency’.

With regard to the bonus paid to consultants then it is questionable whether the bonus should be shared equally by consultants since chargeable activity levels clearly vary between categories of consultant.

Tutorial note

Such a detailed analysis of performance is not representative of the current examiner’s style. However, this requirement does serve as useful practise of such analysis and this may form a smaller part of an exam question.

Particularly at higher levels of management, non-financial information is often not in numerical terms, but qualitative, or soft, rather than quantitative. Qualitative information often represents opinions of individuals and user groups. Decisions often appear to have been made on the basis of quantitative information; however qualitative considerations often influence the final choice, even if this is not explicit. In both decision making and control, managers should be aware that an information system may provide a limited or distorted picture of what is actually happening. In many situations, sensitivity has to be used in interpreting the output of an information system.

Conventional information systems are usually designed to carry quantitative information and are sometimes less able to convey qualitative issues. However the impact of a decreased output requirement on staff morale is something that may be critical but it is not something that an information system would automatically report.

The following difficulties in measurement and interpretation mean that qualitative factors are often ignored:

• Information in the form of opinions is difficult to measure and interpret. It also requires more analysis.
• Qualitative information may be incomplete.
• Qualitative aspects are often interdependent and it can be difficult to separate the impact of different factors.
• Evaluating qualitative information is subjective, as it is not in terms of numbers – there are no objective formulae as there are with financial measures.
• The cost of collecting and improving qualitative information may be very high.

Despite the challenges it presents, there may be ways of improving the use of qualitative information. Where it is important to make use of qualitative information, it is essential to ensure that users are aware of any assumptions made in analysis and of the difficulties involved in measuring and counting it. It is sometimes possible to quantify issues which are initially qualitative, by looking at its impact. For example when looking at service quality it is possible to consider the cost of obtaining the same quality of service elsewhere. Even if it is not possible to quantify issues precisely, attempting to do so is likely to improve decision making as the issues are likely to have been thought through more thoroughly.

i.

The differences in the reported cost estimates calculated under each of the two costing systems are significant. This is especially the case with regard to Job order 973. The management accountant’s calculations for the cost estimates produce the following increase/(decrease) in reported costs:

Job order 973 shows an increase in reported cost of 37.54% [(1,612 – 1,172)/1,172] whereas Job order 974 shows a decrease in reported cost of 5.02% [(88.89 – 620)/620].

A common occurrence when activity-based costing is implemented is that low-volume products show an increase in their reported costs while high-volume products show decreases in their reported costs. This is very much the case with regard to the products which are the subjects of Job orders 973 and 974. The reported costs also differ due to the following:

• Job orders 973 and 974 differ in the way they consume activities in each of the five activity areas within SS’s premises
• The activity areas differ in their indirect cost allocation bases. In particular no activity area uses direct labour hours as the basis of allocating indirect costs.

Two areas where the differences in reported product costs might be important to SS are as follows:

Product design – since it is more probable that those involved in the design of products will find the results produced by the activity-based approach to be much more credible. This is especially the case in a machine oriented environment where direct labour hours are unlikely to be the major costdriver. Activity-based costing can be of more assistance to product designers and may signal areas where cost reductions can be achieved, for example using fewer cuts on the lathe and/or reducing the number of machine hours required in the milling area.

Product pricing – The application of activity-based costing shows that the cost of Job order 973 is being understated while the cost of Job order 974 is being overstated. The management of SS should be aware of the danger of failing to recover the costs incurred on Job order 973. Conversely, they may well be overpricing Job order 974 which might well entail losing business to its competitors.

(max 8 marks)

ii.

Two problems SS would have had to deal with in the successful implementation of an activity-based costing system are as follows:

1. initially it would be very time consuming to collect a large amount of data concerning the activities relating to each job undertaken by SS. Hence the cost of buying, implementing and maintaining a system of activity-based costing is likely to be significant
2. it would be vital to identify the real ‘cost-drivers’ within the activity-based costing system of SS otherwise results given by the ABC system would be inaccurate leading to incorrect decisions by management.

Tutorial note

Additional credit was available for staff/culture issues which would be resolved by adequate training and motivation to change.

Operational ABM is about ‘doing things right’. Those activities which add value to products can be identified and improved. Activities that do not add value should be reduced in order to cut costs without reducing product value. Where for example a product or service has been estimated to require a longer activity time than other products or services then every effort should be made to find ways of reducing the number of hours required.

Strategic ABM is about ‘doing the right things’ using the ABC information to decide which products to develop and which activities to use. It can focus on profitability analysis, identifying which products/customers are the most profitable and for which sales volume should be developed.

An activity may have implicit value not necessarily reflected in the financial value added to any service or product. SS might decide to cut back on the level of expenditure involved in servicing customers. This may lead to a poorer perceived value by customers of the service provided by SS with a consequent fall in demand.

There are risks attaching to the use of ABM insofar as ABM can give the wrong signals. For example, a particularly pleasant work environment can help attract and retain the best staff, but may not be identified as adding value in operational ABM. By the same token, a customer that represents a loss based on committed activities, but that opens up leads in a new market, may be identified as a low value customer by a strategic ABM process.

Tutorial note

Other risks or potential problems were also accepted such as pricing errors arising or the cost/benefit of such an expensive system.

ABM can be used alongside performance management improvement strategies, such as Total Quality Management, Six Sigma and Business Process Reengineering, where the information provided can support the projects.

TQM

In TQM, costs are analysed into costs of conformance (appraisal and prevention costs) and costs of non-conformance (internal and external failure costs). The aim of TQM is to reduce the costs of non-conformance.

ABM enables organisations to more accurately calculate these quality related costs by identifying the appropriate cost drivers and then monitoring improvements.

Six Sigma and Business Process Reengineering

Six Sigma and BPR typically involve projects to achieve large one-off improvements in particular business processes relating to efficiency and better customer satisfaction. ABM can support these approaches in several ways:

• Identifying processes that need improvement and establishing priorities
• Providing cost justification for proceeding with the project, for example by enabling more useful cost-benefit analysis
• Monitoring the benefits of the projects.

Fitzgerald and Moon’s building block approach

The building block model is an analysis that aims to improve the performance measurement systems of service businesses such as ARO. It suggests that the performance system should be based on three concepts of dimensions, standards and rewards.

Dimensions fall into two categories: downstream results (competitive and financial performance) and upstream determinants (quality of service, flexibility, resource utilisation and innovation) of those results. These are the areas that yield specific performance metrics for a company.

Standards are the targets set for the metrics chosen from the dimensions measured. These must be such that those being measured take ownership of them, possibly by participating in the process of setting the standard. The standard must be achievable in order to motivate the employee or partner. The standards must be fairly set, based on the environment for each business unit so that those in the lower growth areas of, say, audit do not feel prejudiced when compared to the growing work in business advisory.

Rewards are the motivators for the employees to work towards the standards set. The reward system should be clearly understood by the staff and ensure their motivation. The rewards should be related to areas of responsibility that the staff member controls in order to achieve that motivation.

The current system

ARO’s performance management system does not cover all the areas that the building block model would suggest are necessary. The downstream dimensions appear to be covered as the competitive performance (market share) and financial performance (revenue growth and profit margin) can be measured. However, the determinants of this performance appear less well covered with only the quality-of-service aspect handled by the customer satisfaction rating.

The standards are unclear from the information provided. It appears that the industry averages can be used to compare competitive performance but there are no figures for the industry on profitability. The measure must therefore be internal, comparing practice areas to each other. This may breach the fairness criterion as it is likely that business advisory can negotiate better fees than audit or tax due to market conditions being favourable from that area. No standard is mentioned on the document for quality of service.

The non-partner reward system at ARO is related to performance as assessed by the line manager but this will be compromised by the limited measurement of the dimensions of performance. The partner reward system appears to be based on the level of responsibility of the partner and the performance of the whole firm rather than that individual’s contribution to performance. Therefore, there is a strong probability that the reward level is not controllable by the partner and this may affect their motivation.

For example, a tax partner may view the growth in recovery work as sufficient to merit reward to all partners and so not optimise the performance of their own area of the practice.

Main building block improvements

The first improvement obtained by using this model will be to ensure that all the key determinants of success in performance are being measured. The next benefit will be that the targets set for each measure are set in such a way as to engage the staff. Finally, the reward system will operate in a way to optimally motivate the individual staff members.

Improvements to existing performance measurement system

The existing performance measurement system requires measures for flexibility which address the speed of delivery of the service (e.g. a punctuality measure of percentage of jobs delivered on time), the customer’s attitude (e.g. the existing customer service survey could be broken down to include the customer’s perception of whether objectives were achieved) and the degree to which the practice handles busy periods (e.g. amount of overtime worked).

It is surprising that ARO does not seem to measure resource utilisation, for example, by considering the percentage of billable hours worked to the total working hours of the firm. This is a commonly used measure of the productivity of staff in accounting practices. Finally, the dimension of innovation is not measured. Innovation is an important source of competitive advantage. The efficiency of the innovation process can be measured by the time it takes to launch a new service once the initial customer need is identified. The outputs of innovation process within ARO could be measured by the number of new customer initiatives launched or by the revenue that they generate.

Performance measurement problems at Emerald

In a virtual organisation such as Emerald, performance measurement can be difficult due to the fact that key players in the business processes and in the supply chain are not ‘on site’. Emerald has the problem of collecting and monitoring data about its employees working from home and the outsourcing partners.

At Emerald, there is a reliance placed on information technology for handling these remote contacts. Collecting and monitoring performance should therefore be done automatically as far as possible. A large database would be required that can be automatically updated from the activities of the remote staff and suppliers. This will require the staff and supplier systems to be compatible.

The employees can be required to use software supplied by Emerald and in fact, at Emerald, they use the internet to log in remotely to Emerald’s common systems. Although this solution requires expenditure on hardware and software, it is within the control of Emerald’s management. Even with reviews of system logs to identify the hours that staff spend logged in to the systems, there are still the difficulty of measuring staff outputs in order to ensure their productivity. These outputs must be clearly defined by Emerald’s managers, otherwise there will be disputes between staff and management.

One further outstanding issue is the need to ensure that such communication is over properly secured communication channels, especially if it contains customer or financial data.

The strategic partners, such as SLS, will have their own systems. A problem for Emerald is that there is disagreement over the measurement of the key SLAs. In order to resolve such disputes, lengthy reconciliations between Emerald’s and SLS’s systems will have to be undertaken otherwise there are no grounds for enforcement of the SLAs and the SLAs represent Emerald’s key control over the relationship. The solution would be for the partners to agree a standard reporting format for all data that relates to the SLAs which would remove the need for such reconciliations.

Finally, there is the problem that Emerald and the partner organisation may have differing objectives – the obvious conflict over price between supplier and customer being one. However, at Emerald, this is being addressed by the use of detailed SLAs which both organisations can use to develop performance measures such as inventory levels and delivery times.

(Max 9 marks)

Performance management problems at Emerald

The performance management of employees is complicated due to the inability of management to ‘look over their shoulder’ since they are not present in the same building. However, employees will enjoy the advantages of home-working, such as lower commuting times, more contact with family and greater flexibility in working hours.

The disadvantages are the difficulties in measuring outputs mentioned above and ensuring motivation and commitment. The motivation and commitment can be addressed through suitable reward schemes which would have to be tied to agreed outputs and targets for each employee. Work could be divided into projects where the outputs are more easily identified and pay and bonuses related to these.

The performance management issues of handling the strategic partners include:

• confidentiality where the partners will have access to commercially sensitive information about customers’ locations and suppliers’ names and lead times
• reliability where the partner is supplying a business critical role (as for SLS with Emerald) such that it would take considerable time to replace such a relationship and affect customer service while this happened
• relationship management where the interface between the organisations can create wasteful activity if there is not an atmosphere of trust. At Emerald, this is illustrated by the problem of reconciliation of performance data
• profit sharing where given the collaborative nature of the relationship and the difficulty of breaking it combine to imply that it will be in the interest of both parties to negotiate a contract that is motivating and profitable for both sides. For Emerald, the business aim is to increase volume and this will require customer loyalty so the quality of service is important.

(Max 8 marks)

Performance measures

It is important that performance measures used for Emerald are in line with the overall business objectives.

Employees

There are likely to be a wide range of roles performed by employees across the functions of production, finance and supplier relationship management and the chosen measures need to reflect these differences.

Volume based measures could be used to assess those working in video clip production, for example the number of minutes of video produced. However the videos produced are not part of the physical product being sold by Emerald and so an increase in volume will not have any positive impact on the level of complaints which are received, a key concern for the company. Measures applied to these employees should concentrate more on the quality of the video produced and its ability to attract customers to the site. Web based measures relating to the number of ‘hits’ each video has and the number of purchases that then result would be more appropriate. This information should be readily available through the company’s website.

Finance employees should be measured according to the quality and timeliness of the information they provide such as the number of deadlines met within a period of time. This should prove relatively easy to monitor through a review of the reports produced each period.

In order to accurately measure the performance of those employees involved in supplier relationship management, Emerald should consider the quality of communication between employees and strategic partners. From the employees perspective this can be measured by looking at the number of breaches in an SLA although this may be difficult due to the way the information is currently gathered. Regular reviews of the SLAs should allow this information to be collated.

Strategic partners

Performance of the strategic partners working with Emerald should be measured through delivery of the SLAs. Each of these agreements will have different terms depending on the nature of the supplier. So, for example, a suitable measure for SLS may be that 90% of orders are despatched within 3 working days of receipt. Customer receipt documentation will ensure this can be tracked and regular reviews of the SLA should identify any areas of concern.

The performance pyramid is based on the belief that each level of an organisation has different concerns but they must support each other in order to achieve the overall objective of the organisation. The aim is to produce a set of performance measures which cover the outputs and drivers of the outputs of the organisation. The pyramid shape is to emphasise that the measures from the operational up to the strategic levels should support the corporate vision.

A general criticism of the system at Brandix could be that it is suffering from tunnel vision which is over-focusing on those areas which are actually measured. This can be managed by ensuring that the set of performance measures are comprehensive in examining the results and the determinants of those results for the organisation. The performance pyramid is a systematic method which tries to achieve this goal. Tunnel vision may explain why, although revenue is rising rapidly, the operating profit is fairly static. There is a danger that the company is focusing on making more sales to the exclusion of making higher profits. This may result from the measuring of revenue growth but not of cost related metrics or profit margins. It is notable that there are no variances from budget given in the performance report.

The pyramid diagram is:

The pyramid begins with the corporate vision. At Brandix, the company objective is to maximise shareholder wealth by being flexible in response to market demand and controlling the production chain closely. The current performance measures as illustrated in the example report do measure all of these factors in some way but may not be comprehensive.

• Return on capital employed (ROCE) is reported but this is not directly measuring shareholder wealth and it is surprising that there is no mention of measures such as total shareholder return which will cover dividends and share price growth. The failure to provide a dividend measure may be a reason why the dividend growth has been allowed to slip.
• Flexibility in manufacturing is measured through the time to market for new designs. The design awards won indicate the innovative abilities of the employees at Brandix. The ability of the manufacturing chain to replenish successful lines and so take advantage of a fast-selling product is not measured.
• Close control of production is not evident as the problems with quality of clothes (durability complaints by customers) demonstrate. There may be a lack of cost control which explains the disconnection between growing revenue and the operating profits performance.

The next level of the pyramid is the driving of the vision by satisfying the market and performing well financially. As noted above, the financial measures are lacking a focus on costs through profit margins (such as gross margin) or key cost headings such as labour costs which would highlight the higher costs of designers. Therefore, the danger exists at Brandix that profitability is being sacrificed for revenue growth. Productivity measures of waste are likely to be important as designs become obsolete in this market quickly and the manufacturing process for clothes can lead to waste of materials in production. The problem of obsolescence can be significant in a fashion-driven industry since it is important to get the right garments in the right place at the right time. Inventory write-offs would measure such waste.

Market satisfaction is driven by customer satisfaction and flexibility. Brandix measures flexibility through time to market and delivery and these are obviously given a high priority in order to meet this objective in the corporate vision. Customer satisfaction can be considered to be measured through the revenue growth and indirectly through the winning of design awards but the failure to address quality may detract from this in the long term. (There is also evidence of short-term thinking at factory site 2 where the reason for the excess equipment repairs could be the failure to invest in new equipment which may be driven by the desire to keep the capital employed figure low to enhance ROCE.) An exercise should be undertaken to identify how strongly customers value the durability of Brandix’s products and if this is significant, then measures of quality such as level of complaints should be made. It is possible that in a fast-changing, trend-driven industry such as Brandix’s, there is little interest from customers in the durability of their garments, as they will be purchasing new ones on a regular basis to keep up with fashion.

Myopia is prioritising short-term issues over long-term ones and is evident here in factory site 2. The variance in repairs expenditure could be due to a failure to invest in new machinery and so having excess repair work to do on old machinery. This could be exacerbated by using ROCE as a performance measure, since continuing to use old machinery (possibly written off) will require little or no capital employed. The use of longer term measures rather than those over just one accounting period might help to capture the effect of such behaviour.

Gaming is dysfunctional behaviour (from the organisation’s perspective) where an individual manager is trying to meet their individual targets while ignoring the good of the whole organisation. There is evidence at factory site 1 of this behaviour where a manager is manipulating revenue and profit across the accounting cut-off. This behaviour can be dealt with by emphasising a culture of honesty in the organisation and by ensuring that the manager is rewarded for average gains over long periods rather than block payments for hitting simple profit-triggers in a single period.

Ossification is the unwillingness to change from an existing performance system, especially when it shows adequate or good results are being achieved. The board is clearly exhibiting this problem in resisting change at Brandix. The CEO will need to persuade them that there are issues in the omissions from the current set of performance measures which will lead to long-term difficulties in achieving their overall goal of enhancing shareholder wealth. The targets and remuneration of the board should be set so that the board is rewarded if current good performance is sustainable in the future.

The balanced scorecard consists of four perspectives: customer, internal, innovation and learning and financial. It requires an organisation to have a number of goals supported by performance measures in each perspective. The customer perspective measures what it is that customers value from the business; internal looks at what processes does the organisation need to be successful; innovation and learning considers how future value can be created and financial measures whether performance is acceptable to investors.

It is useful because it uses both internal and external information to assess performance and measures financial and non-financial aspects of a business to ensure long-term future success, rather than just focusing on historic results. It can also be used as a mechanism to link KPIs into the CSFs which are vital to deliver strategy.

Harvard currently uses return on capital employed (ROCE) as its key financial performance measure, but this does not correlate directly with the objective to maximise shareholder wealth and could encourage short-term decisions to be taken at the expense of long-term success. This is the case at Harvard which purchased old trains and subsequently failed to reinvest, meaning that Harvard’s ROCE is probably higher than its rivals. However, the trains are becoming unreliable and their condition is deteriorating. In the long term this will reduce customer satisfaction and financial performance.

Using the scorecard, Harvard should have a broader range of financial measures which encourage managers to take decisions, such as investment decisions, consistent with the objective to maximise shareholder wealth in the long term. EVA^TM would be a suitable measure to help achieve this, and would be preferable to the current focus on ROCE.

Harvard does measure growth in passenger numbers which could be a measure of customer satisfaction. However, it is a limited, quantitative measure. Though Harvard does have rivals and is likely to be required to operate a specified level of service under the terms of the licence from the government, some passengers may be forced to travel on Harvard trains, rather than those of another operator because of where they live or the times they need to travel. The number of operators (competitors) is limited by the capacity of the railway infrastructure as well as by passenger demand. This means that the level of repeat customers may not be appropriate for Harvard.

Passenger numbers are also externally focused but again this fails to fully consider the environment in which Harvard operates.

Within the customer perspective Harvard could use a range of performance measures. This will be beneficial as where passengers are able, they are likely to choose to use Harvard if they provide a good service. This can be easily measured by surveying or asking passengers’ opinions. This will give Harvard more qualitative information about their customers and their expectations, which will vary, for example, passengers will have different perceptions of overcrowding, or what is an acceptable delay. Certain groups may be more affected by overcrowding like frequent travellers and the elderly. Passengers who are unable to find a seat will probably be the most dissatisfied, though this will depend on how long their journey is. Other aspects of Harvard’s service may be less valued than reliability and occupancy, like wireless access and the on-board cafe, but will be important to certain groups.

Another key element of customer satisfaction will relate to the amount of fare paid. Fares are regulated in Flowland so the interaction between fares and other aspects of the service is unknown. Many customers while valuing a particular aspect of the service may be unwilling to pay more for it; some may accept a reduction in the level of service if fares were reduced.

This detailed information about customers will allow Harvard to focus performance improvements on key areas using more external data to make decisions.

Measures of the internal processes are likely to be closely linked to customer satisfaction. Harvard apparently neglects this area in its performance management system. The scorecard could be used to help to address reliability, overcrowding and environmental factors.

Reliability will be highly valued by customers especially those who travel frequently and who rely on rail travel to get to work. The number of trains arriving late would be a suitable measure of reliability, as would the number of train services cancelled, though the length of the delay is also critical and should be carefully defined. The scorecard would allow more detailed measures as some of the factors affecting reliability will be within Harvard’s direct control but others such as failures in the railway infrastructure are controlled by the government. This is useful information for Harvard to effectively assess their controllable performance and feedback as necessary to external parties.

Seat occupancy, the number of passengers on a train compared to the number of available seats on different routes and at different times, is a suitable measure of train overcrowding and is important for passenger safety. To fully utilise its trains and achieve its objective of maximising shareholder wealth, Harvard must try and maximise both the seat occupancy and the amount of time its trains are actually running. These internal measures would then help to support financial targets.

Harvard’s licence to operate rail services in Regions A and B expires in three years’ time, and as with the operator from whom Harvard purchased the trains, it may not be renewed. Harvard must balance the needs of shareholders for short-term increases in dividends and share price with the long-term need to renew to its operator’s licence.

The creation of long-term future value can be addressed by the innovation and learning perspective. The immediate scope to innovate the service experienced by the passenger is limited, but there are some quick wins available in the choice in the on-board cafe and improving the reliability of the internet access. Also time spent training staff may improve customer satisfaction and reduce maintenance time. Fundamental innovation like the use of faster or environmentally less harmful trains requires long-term planning and large capital investment. The scorecard will encourage Harvard to be forward looking, unlike the present system which is limited to historic performance.

To measure the extent of overcrowding, some measure of occupancy is needed. The number of passengers per available seat can be used as a measure of occupancy.

Seats available per train is 490 (7 coaches × 70 seats) in Region A and 420 (7 coaches × 60 seats) in Region B.

Total seat occupancy = 82.5% (8,200/9,940)

Overall occupancy is below 100% which means on average there are more seats available than passengers, which is not consistent with the government’s claims that the trains are overcrowded. However, these averages may be misleading as trains running on certain days or at certain times may be relatively overcrowded. This may generate customer dissatisfaction even on services which are on average not fully occupied. The total number of passengers without seats would be a better measure.

There are significant variations between regions and times travelled with only the trains in Region A travelling at peak times being over occupied. This affects only 18% (4/22) of all services.

Most affected by this will be the 28% of the passengers travelling at peak times in Region A who are unable to obtain a seat. This represents only 9% (28% × 2,500/8,200) of total passengers per day. There is some overcrowding but the claim that Harvard’s trains are overcrowded seems exaggerated given the data provided. However, certain routes or specific times or sections of the trains may be more affected and more analysis is needed.

The impact of overcrowding on passengers also depends on journey times, with passengers being less satisfied by not obtaining a seat on longer journeys rather than on short ones. Assuming trains are available for 14 hours per day and there are 22 services, each service is on average almost 1.5 hours which may be a significant length of time for passengers to stand on a train.

When applying the balanced scorecard in Harvard, the measures need to be chosen carefully. A balance needs to be struck and only measures which help Harvard to achieve its objectives should be chosen. Currently Harvard focuses on short-term financial measures such as return on capital employed, whereas the balanced scorecard considers more long-term measures.

Some measures are more important than others, so prioritising measures will be difficult. Customers may value some aspects of the service more than others, for example, the choice available in the on-board cafe is probably unimportant to most passengers provided they can obtain some food and drink. The punctuality of Harvard’s trains or whether they even run at all is fundamental to achieving customer satisfaction and needs careful measurement. Harvard must have measures for regulatory or safety reasons too.

Some aspects of the business may be harder to measure than others. For example, it may be relatively easy to measure seat occupancy as a measure of overcrowding, but passengers’ perceptions of overcrowding may differ. Non-financial aspects such as customer satisfaction may be subjective and any surveys done may not reflect the experience of the majority of passengers. Performing and analysing surveys would also be time consuming and resource intensive.

Measures chosen may conflict. Overcrowding may be unwelcomed by passengers but making them less crowded conflicts with Harvard’s presumed objective of fully occupied trains. Time spent maintaining trains to reduce their impact on the environment or ensure reliability will mean they are not operational for periods of time, though safety will be a key factor here. C

are must be taken to avoid overloading with too many performance measures. The current objective to maximise shareholder wealth is very broad. Having a clearer strategy would enable Harvard to determine suitable performance measures so it is not overloaded with KPIs which do not contribute towards achieving this strategy.

What VBM involves and how it can focus the company on shareholder interests

The VBM approach starts with the primary objective of the business as shareholder wealth maximisation and develops a performance approach based on this. At the strategic level the primary measure of performance is EVA™ because this EVA™ is equivalent to discounted cash flow in the long term which is a widely used method of valuing shares by equity analysts.

EVA™ is used as the sole measure of performance by management and even throughout the organisation (at strategic, tactical and operational levels) thereby avoiding the conflict between multiple objectives and resulting measures. The variables within EVA™ that drive performance such as PBIT can be used by management to achieve value-based targets set down from the strategic value-based goal.

An assessment of the financial performance of KAP using EVA™. Evaluate this against EPS and share price performance

EPS has fallen by 23.4% (21.88 in 20X9 ($35m/$160m) compared with 16.75% in 20Y0 ($26.8m/$160m)) which suggests the company is not favoured by investors but the average share price has only fallen from $12.20 to $10.70 over the same period which doesn’t suggest the company is out of favour as much. Indeed this is against a sector fall of 26% (907.1/1,225.6) over the same period and a main market index decline of 34.9% (1,448.90/2,225.40) thus inferring KAP has actually outperformed its sector and the main market.

The sector comparison is more relevant to KAP’s performance as this includes only comparative companies. The view of the market that KAP is outperforming its sector is confirmed by the calculation of EVA™. This remains positive at $22.6m in 20YO compared with $29.6m in 20X9. Calculations are in Appendix 1. Thus, KAP continues to create value for shareholders even in difficult conditions.

Evaluate VBM against traditional profit-based measures of performance

Value measures take into account capital employed and the cost of capital and are therefore considered superior to profit measures which capture these less clearly. They are adjusted to take out accounting adjustments so they arrive at cash flow measures which are less affected by accounting adjustments. In the case of KAP, the accounting and economic depreciation are assumed to be the same but may differ if additional information becomes available.

However, EVA™ and other value-based measures are complex and unfamiliar to calculate and so may be off-putting to management used to profit measures. They also contain assumptions on the capital asset pricing model (used to calculate the cost of capital) and data is historic and so may change in the future. For instance, share values are calculated based on dividend flows in the future. However, provided users are aware of the assumptions and become familiar with the process of calculating EVA™ it could be a useful measure.

EVA™ can be manipulated by choosing projects with low set-up costs to massage the initial EVA™ figure which then falls in later years. It also fails to recognise the increase in shareholder wealth over the life of the project better captured by the use of net present value.

Traditional cost allocation systems

Traditional costing systems, notably absorption costing, assume that all products consume resources in proportion to their production volumes. While this may be true for overheads such as power costs, it does not necessarily hold for all overheads, especially those connected with support services.

The amount of overhead allocated to individual products by absorption costing therefore bears very little resemblance to the amount of overhead actually incurred by the products and hence gives management minimal understanding of the behaviour of overhead costs. Consequently management also only have a limited ability to control/reduce overhead costs.

ABC/ABM approach

Activity-based costing (ABC) attempts to overcome this problem by identifying the activities or transactions (cost drivers) which underlie an organisation’s activities and which cause the incidence of the activity, and hence the cost of the activity (overheads) to increase. Costs can then be attributed to products according to the number of cost drivers they cause/consume using cost driver rates.

ABM is the term given to those management processes that use the information provided by an activity-based cost analysis to improve organisational profitability.

ABM and cost reduction

Because ABM analyses costs on the basis of what causes them, rather than on the basis of type of expense/cost centre, it provides management with vital information on why costs are being incurred. If management can reduce the incidence of the cost driver, they can reduce the associated cost.

ABM involves a variety of cost reduction techniques.

• Ensuring activities are performed as efficiently as possible
• Reducing or eliminating the need to perform activities that do not add value for customers
• Improving the design of products
• Developing better relationships with customers and suppliers

In short, it aims to ensure that customer needs are met while fewer demands are made on organisational resources.

Appendix 1

Workings: EVA^TM calculation

EVA™ calculations for the periods given are:

Assumptions:

Economic and accounting depreciation are equivalent.

There are no non-cash expenses to adjust in the profit figure.

There are no additional adjustments to make regarding goodwill.

Cost of capital

Cost targets and platinum status

UEG is aiming for platinum status and has been advised to focus on effectiveness in its services. This refers to operations meeting any objectives set. One way of measuring whether objectives have been achieved is through quantitative measures such as costs.

The Managing Director has asked for an analysis of manufacturing cost targets and quality costs. Cost targets have advantages in that they can be compared with competitors using benchmarking which then enables targets to be set based on market leaders. This does require the cost measures to be comparable or else like with like is not being measured. They can also be used as an internal comparative to monitor performance year on year and set stretch targets against which current profitability and hence return on investment is measured. The outcome of the comparison is that a gap may exist and UEG will need to act to close this gap.

The statement shows variable costs increasing 25% ($8.4m to $10.5m) from 20X1 to 20X2 and another 20% to 20X3 ($12.6m). Sales revenues are projected to increase by 50% over the total period from $24m to $36m so variable costs as a percentage of sales have remained stable at 35% and the increase here is down to volume. Fixed manufacturing costs are expected to increase 13% year on year to 20X2 and remain static at $3.4m thereafter.

Costs of quality are made up of conformance costs (prevention costs and appraisal costs) and non-conformance costs (internal and external failure costs). Internal and external failure costs are the difference or gap between current expected cost levels and cost targets regarding the application for platinum status for quality. Internal failure costs arise before the goods or services pass to the customer and are a failure to meet design quality standards. They include manufacturing flaws and incorrect processing of orders. External failure costs arise after sale and include warranty claims and costs of rectification. These can be compared to the manufacturing cost target in each year as a means of setting a projection. Internal failure costs are expected to fall from 21.9% (2,500/(8,400 + 3,000)) of the cost target to 7.5% from 20X1 to 20X3. External failure costs are expected to decline from 27.2% of the cost target to 6.1% from 20X1 to 20X3.

In a traditional manufacturing approach to quality, management spend more on conformance costs to reduce non-conformance costs but, as costs of conformance are high, especially to secure zero defects, there is an acceptable level of defects. However, in a total quality management (TQM) system, management would aim for zero defects and spend on conformance costs to reduce total quality costs over time. The emphasis is on getting things right first time and designing in quality.

UEG is projecting a decrease in all categories of quality cost over the three years which suggests a TQM approach is being taken. Prevention costs are the costs of management acting to achieve quality standards before and during manufacture and include the costs of training sales staff taking customer enquiries. These are predicted to fall by 50% in the first year from $4.2m to $1.32m by 20X3. Appraisal costs are incurred when ensuring compliance with quality standards and performance testing. These are projected to decrease by 12% from 20X1 to 20X2 and remain static to 20X3. These projections are quite ambitious and come on top of a reputation established for high quality. It would be useful for UEG to obtain some data on costs of quality from the competition in the hotel and catering industry to get a benchmark for what reasonable costs of quality are.

Forecast performance of UEG

The headings come from the performance pyramid, a model that links the overall strategic view of management with day-to-day operations. The application for platinum status may be measured in financial and marketing terms.

i. Financial performance and marketing

UEG is aiming for an increase in sales of 50% to $36m from 20X1 to 20X3. This is allied to an overall fall in costs from $22m to $20.2m in the same period which can be attributed to the fall in costs of quality seen in the statement produced by the Management Accountant. The net margin has gone up from $2m or 8.33% to $15.8m or 43.89% over the 3 years but this large increase is due to the 2 trends just mentioned and is from a small base of $2m. The sales target is ambitious and may be unrealistic in a market with a number of significant competitors.

A less ambitious target of 8% rising to 11% is predicted for market share although the basis for this calculation is not stated especially as this is a new market for UEG. Presumably the data for the market share calculation and that of growth in the market from $300m to $340m is based on the market research analysis. Nonetheless the market does have a number of significant competitors, although there is no quantification of their market shares such as a BCG analysis would illustrate.

ii. External effectiveness

This is measured through customer satisfaction for example. There are four measures that capture how satisfied customers are through measuring the quality of services provided and delivery. The external effectiveness of the business relies on all stages of the business cycle from design through to delivery and involving quality.

The first of the measures is the percentage of products accepted as meeting design quality standards without rectification. This appears to refer to the Institute’s verification and it is predicted to rise from 92% to 99% over the 3 years to 20X3. This high-quality standard aligns with the fall in the costs of quality suggesting a TQM approach to manufacture. Allied to this is a measure showing a fall in rectification claims from $0.96m to $0.1m over the period and another showing the cost of rectifying goods sold after sales decreasing from $1.8m to $0.8m.

These reveal that the business intends to build in quality before sale rather than relying on repairing goods sold (external failure costs).

Finally, a measure of sale service is projected to rise from 88.5% of sales meeting delivery dates to 99.5% doing so over the 3 years.

All of these measures are ambitious, especially the first and last where the percentages are near 100% perfection. It would be useful to have comparatives in the industry if this data is available. Nonetheless these targets suggest a quality-led approach to manufacture which may be achieved by setting stretch targets.

iii. Internal efficiency

This is captured through measures such as productivity and flexibility.

Productivity is the management of resources whilst flexibility is the responsiveness of the business as a whole. The average time from customer enquiry to product delivery is a measure of flexibility and is projected to fall from 49 days in 20X1 to 40 days in 20X3. This has added cash flow benefits as inventory is being converted to receivables and cash faster. A non-conversion rate of enquiries to sales (%) is planned to fall from 10.5% of all enquiries to 3% over the 3 years. The idle time measure and this measure are both productivity indicators and measures of waste. They also relate to costs of conformance preventing failure before it arises.

The final measure in this part is idle capacity of manufacturing staff which is also projected to fall, from 12% (which seems high) to 1.5%. However, this may mean that if any unanticipated changes in production arise the company may not be flexible enough to absorb these and may have to bring in outworkers. It would be a good idea to obtain comparable data on competitors if possible.

We don’t know the precise standards required to obtain platinum status. Nonetheless, UEG is clearly setting ambitious targets for improvements in performance during the three years reviewed.

Performance pyramid

The Marketing Director has stressed that UEG needs to focus on increasing the effectiveness of all operations as part of its application for platinum status.

The performance pyramid should encourage it to do this because it focuses on a range of objectives looking at both external effectiveness and internal efficiency. Of the areas which the director mentions, product design will be addressed through looking at internal efficiency, while after-sales services is likely to be addressed through looking at external effectiveness, specifically in relation to customer satisfaction.

Operational criteria – The statistics which are relevant for the platinum status application correspond to the operational criteria in the pyramid, which are: quality, product delivery, process time and waste. For example, the cost of rectification claims could be a reflection of quality; the percentage of sales meeting planned delivery dates will reflect the effectiveness of UEG’s product delivery; while the idle capacity of staff is an indicator of waste.

Importance of processes – Using the pyramid will also highlight the importance of understanding the processes which drive UEG’s costs and financial performance, rather than simply looking at costs and sales figures. However, the pyramid also highlights that UEG’s business level strategies and day to day operations need to come together to enable it to achieve its financial objectives, such as increase sales by 50% over 2 years.

Developing strategies – The pyramid also highlights the way that different levels within an organisation support each other and relate to each other. UEG appears to have some fairly ambitious performance targets in relation to its application, and so it will be important that it develops a coherent set of objectives and performance measures across the organisation which will give it the best chance of being able to achieve those targets.

An organisation’s mission statement reflects its underlying purposes. By doing so, the mission statement can also help to identify the aspects of performance which the organisation considers to be important in helping it to achieve its corporate vision, and therefore which need to be measured and managed.

Pod’s mission statement identifies a number of areas which are important for its competitive success: competitive pricing, high quality, excellent customer service, product development (innovation) and staff training.

However, while the mission statement identifies areas which are important, the way they are presented is too high level and open-ended for the board to be able to measure Pod’s actual.

performance against them. Therefore, the mission statement needs to be translated into more specific objectives and targets against which performance can be measured.

As their name suggests, KPIs should focus on factors which are central to a company’s success or failure. Critically, however, Pod’s current KPIs focus solely on financial performance, meaning there is no obvious alignment between them and the key aspects of performance identified in the mission statement. For example, despite the mission statement identifying quality, customer service and product development as important to Pod, none of the KPIs reflect this. Consequently, at a strategic level, Pod is not measuring how well it is performing in any of the areas which the mission has suggested are important.

In turn, this lack of integration between the KPIs and the mission statement might also explain why the employees view the mission statement as being merely a public relations exercise. Since none of the elements of the mission statement are measured – via the KPIs – this could lead to a perception amongst the staff that these elements are not actually very important after all. Equally, the perception could be that the only elements of performance which management are really interested in are the financial measures (profit, cash flow and return on capital employed (ROCE)).

The importance of KPIs being aligned to the mission statement is also reinforced by the adage ‘What gets measured, gets done’. If the aspects of performance in the mission statement are those which are important for Pod then, in order to ensure that employees focus on them, then those aspects of performance also need to be reflected in the KPIs and related performance targets.

Lynch and Cross’s performance pyramid stems from an acknowledgement that traditional performance measures based on financial indicators such as profitability, cash flow and ROCE do not address the driving forces that guide an organisation’s ability to achieve its strategic objectives. This appears to be the problem with Pod’s current performance measures.

Range of objectives – By contrast, instead of focusing purely on financial objectives, the pyramid focuses on a range of objectives for both external effectiveness (e.g., customer satisfaction) and internal efficiency (e.g., flexibility and productivity).

Performance hierarchy – The pyramid also highlights the way that different levels in an organisation support each other and relate to each other. This will allow Pod to develop a coherent set of objectives which are derived from the overall corporate vision.

The nine dimensions of the pyramid link strategic objectives (market satisfaction, financial measures) to operational objectives (quality, delivery, cycle – or process – time, and waste) through the themes of external effectiveness and internal efficiency.

Linkages and support – In order for Pod to develop a coherent set of performance measures it is important the objectives and measures at each level of the organisation (strategic, tactical and operational) support each other. The performance pyramid highlights the importance of these linkages between the different levels of the organisation, and the overall link between Pod’s vision and mission and its day to day operations.

Appreciating these linkages will help Pod devise a coherent set of performance measures. For example, increasing quality should increase customer satisfaction, and in turn increase Pod’s market share.

Customer satisfaction, flexibility and productivity – The performance pyramid suggests that the strategies developed to achieve an organisation’s financial and market objective should focus on three key driving forces: customer satisfaction, flexibility and productivity.

Currently, Pod’s KPIs do not address any of these three areas, although the performance information already available means that Pod could develop non-financial KPIs for each of the three areas (see below).

It could be argued that some of these non-financial measures are more appropriate to the tactical and operational levels of the management hierarchy rather than the strategic (board) level. However, the existing performance information does not appear to be linked to the current KPIs, which suggests the board is right to be concerned about the current KPI system.

Additional KPIs

Customer satisfaction

Complaints – Customer satisfaction levels could be measured by the percentage of orders with complaints against them.

Preferred supplier status – The number of customers who have awarded a preferred supplier status could also be seen as an indicator of customer satisfaction.

Flexibility

Products launched – The number of new products launched in a year can be seen as an indicator of innovation.

Productivity

Quality costs – Failure costs (internal + external) can act as an indicator of inefficient production. Failure costs have increased from $3.46 million in 20X0 to $4.35 million in 20X1.

Operational performance measures

The operational performance measures suggested by the pyramid will relate to the four areas of quality, delivery, process time and waste.

Quality

Failure costs – Pod’s additional performance information already shows failure costs and these could be used as a measure for quality. However, they would be improved as measures if actual costs were compared to budgeted costs.

Customer complaint numbers could also be used as a measure for quality, in particular those relating to product quality. However, there could be problems with using the information as it stands because there is no indication about the seriousness of the complaint or the consequences of it (for example, discounts or refunds offered).

Equally, the number of complaints being classified as ‘Other’ is also a concern. These need to be broken down into further subcategories to help identify the causes of the complaint more accurately, and therefore identify which aspects of operational performance need improving.

Delivery

Customer complaint numbers – It is important for Pod to become (and remain) a preferred supplier for as many manufacturers as possible. Customer satisfaction is vital to achieving this, so again customer complaint numbers will be important here. If complaints relating to product quality are used as a measure of quality, then complaints relating to late delivery and customer service can be used as measures of delivery.

Staff measures – The number of training days and the number of vacant posts could also be used as measures relating to delivery. An increase in the number of training days should help improve quality and delivery, while posts remaining vacant are likely to have a detrimental impact on them. However, Pod’s current performance information on training days could be improved by comparing them to benchmarking, for example, to see how they compare to competitor organisations.

Cycle time (or Process time)

The performance information which Pod currently collects does not appear to be useful for measuring process time. It is possible that the number of new products being developed in a year could give an indication of the time to market. However, the performance measure would be improved if Pod specifically measured the time to market for each new product developed, and possibly then also compared this to an industry benchmark.

Waste

The current performance information does not appear to be useful for measuring waste in production. Variance analysis (comparing actual performance to budget) of idle time for employees and materials usage would be instructive measures here.