PART E: PERFORNMANCE MEASUREMENT AND CONTROL.

Topic to be covered:

1. Performance Measurement in private sector organizations.

2. Divisional Performance and Transfer pricing.

3. Further Aspects of Performance Management.

 Performance Measurement in private sector organizations

The following topics will be covered in this chapter.

1) Performance measurement

2) Financial and non-financial performance indicators

3) Short-termism and manipulation

4) Improving performance

5) The balanced scorecard

6) Building block model

Performance measures may be divided into two types.

1) Financial performance indicators
2) Non-financial performance indicators

FINANCIAL AND NON-FINANCIAL PERFORMANCE MEASURES

Measures of performance may be either financial or non-financial.

 Financial measures are typically measures relating to revenues, costs, profits, return
on capital, asset values or cash flows. Actual performance is often measured against
a financial plan, such as a budget.

 Non-financial measures may relate to a number of different aspects of performance,

such as: Product or service quality, Reliability, Speed of performance, Risk, Flexibility,
Customer attitudes, Innovation, Capability, and Pollution etc.

 Non-Financial aspects of performance are often good indicators of future financial

performance.

 Performance Measurement is vital for planning and control.

 Some performance measurement combines financial and Non-financial e.g.:

Efficiency of resource allocation.
Performance Measurement

 Performance measures used will vary between organizations.

 Factors influencing the design of performance measurement system are:

1. Cost and benefit of resources (People, equipment, and time) to collect and
analyze data.
2. Performance measured in relation to something ie objectives and plans of
organization. If organization has no such objective then
 Set objective.
 Identify factors critical to success.
3. Measures must be relevant.
4. Measure short term and long term achievements.
5. Measures must be fair ie include only factors which managers can control by
their decisions and held responsible.
6. Variety of measures should be used to prevent from distortion.
7. Respond to the measurement ie take decisions and actions in best interest of
organization

Quantitative and Qualitative performance Measure.

 Quantitative information is information that is expressed in numbers and by

measurements.
 Qualitative information is not numerical, and may relate to issues such as customer
loyalty, employee morale and capability etc.
 Qualitative values can be converted to quantitative. (e.g. 1= Good, 2 = Avg, 3 = Poor).
 E.g.
 Quantitative: 1000 unit produced in 50 hours at $ 15 each.
 Qualitative: Market research indicates very strong and positive
customer response to new product.
 Qualitative measures are subjective, will be derived from several source.
 E.g. 7 out of 10 say they enjoy our service.

Financail Performance Indicators (FPI`s)

(1) Financial indicators include:
 Profit.
 Revenue.
 Cost.
 Ratios. (GP Ratio, ROCE etc.) etc.
 (2) Common ways of using financial measures are:
 Comparing actual with budget (or financial plan)
 Comparing performance in recent period with previous time period

Note: Comparison with budget, standard, other part of business, other business are common
used benchmarks.
Firms can use ratio analysis to compare budgets, for control purposes last year’s figures to
identify trends competitors’ results and/or industry averages to assess performance

I. MEASURING PROFITABILITY

 Most important measure. The primary objective of a company is to maximise

profitability
 Check on profitability include:
 Whether profit made ordinary activities of business.
 Profit is more or less than last year.

1) Sales Margin (Gross Profit) = Sales – Cost of Sales.

2) The profit margin indicates how much of the total revenue remains to provide for
taxation and to pay the providers of capital, both interest and dividends. This return to
sales can be directly affected by the management’s ability to control costs and
determine the most profitable sales mix.

Gross Profit Margin or Ratio = Gross Profit x 100

Turnover

Note: It is not useful or meaningless to compare profitability using the above measures
because it cannot be used to compare different industry.

Net Profit Margin or Ratio = Net Profit x 10

Turnover
Note: Meaningful when compared with performance of previous period or performance of
similar companies in same industry
A high gross profit margin is desirable. It indicates that either sales prices are high or that
production costs are being kept well under control
Sales Growth = Sales in current year - Sales in previous year
Sales in previous year

Cost /Sales Ratio: (cost / Sales)*100

Useful to identify main cause of change from previous periods in net profit. Fall in NP Ratio
can be due to fall in GP or Increase in:
(1) Selling and distribution cost.
(2) Administration cost.
(3) Other cost like R&D.

Example:1
A company has the following summarized income statements for two consecutive years
Year 1 ($) Year 2 ($)

Turnover 70,000 100,000

Less: cost of sales 42,000 55,000

Gross profit 28,000 45,000

Less: expenses 21,000 35,000
Net profit 7,000 10,000
Although the net profit margin (net profit/sales) is the same for both years at 10%, the gross
profit margin is not.
Year 1 = 28,000/70,000 Year 2 = 45,000/1,00,000

= 40% = 45%
Is this good or bad for the business or not ?

Solution:
An increased profit margin must be good because this indicates a wider gap between selling
price and cost of sales. Given that the net profit ratio has stayed the same in the second
year, however, expenses must be rising. In Year 1 expenses were 30% of turnover, whereas
in Year 2 they were 35% of turnover. This indicates that administration, selling and
distribution expenses or interest costs require tight control.
 Percentage analysis of profit between year 1 and year 2
Year 1 Year 2
% %
Cost of sales as a % of sales 60 55

Gross profit as a % of sales 40 45

100 100

Expenses as a % of sales 30 35
Net profit as a % of sales 10 10
Gross Profit as a % of sales 40 45

II. Earning based Measure

1) Earnings per Share (EPS)

1. It is the Measure related to profitability of shareholders. ie EPS defined as profit
attributable to equity share holders

2. EPS = PAT (and Preference dividend)

[Link] equity shares in issue.
3. Comparison is made over a period of several years.

Example:2
Walter Wall Carpets made profits before tax in 20X8 of $9,320,000. Tax amounted to
$2,800,000. The company's share capital is as follows.

($)

Ordinary share (10,000,000 shares of $1) 10,000,00

0

8% preference shares
2,000,000
 12,000,00
0

Calculate the EPS for 20X8

($)

Profits before tax 9,320,000

Less: tax 2,800,000

Profits after tax 6,520,000

Less: preference dividend (8% of $2,000,000) 160,000

Earnings 6,360,000

Number of ordinary shares 10,000,000

EPS 63.6c

Concept of EPS
EPS must interpret in context:
I. Compare results over time and check whether
Is EPS growing ??
Rate of growth ??
2. Number of shares issued or Change in share capital should be considered while
comparing with previous year EPS or with other company
3. Can manipulate EPS easily by change in accounting policy.

2) Return on Capital Employed (ROCE)

1. Profit on fund employed in business.
2. It is the operating profit as a percentage of the capital employed.
3. ROCE = PBIT or Net Profit or Operating Profit
Capital Employed.
4. ROCE is also = Operating Profit Margin * Asset Turnover
 5. Capital Employed = Shareholders fund + Long term Liability.
OR
Total Asset – Current Liability.

6. Possible Comparison:
 Change in ROCE from one year to next.
 ROCE earned by other company.
 ROCE with current market borrowing rate:
 Company must earn high earnings to make borrowings worth

Note:
Operating Profit Margin : Operating profit/sales *100
Operating profit means sales less all expense

3.) Asset Turnover:

The asset turnover is a measure of utilisation and management efficiency. It
indicates how well the assets of a business are being used to generate sales or how
effectively management have utilised the total investment in generating income.

Asset Turnover = Turnover Capital Employed

Capital employed
 II. MEASURING LIQUIDITY
1. Liquidity is the ability of an organization to pay its current liability when they
fall due.
2. A Company can be profitable but may face cash flow problems.
3. Liquidity Ratio, Working Capital Ratio gives idea of company’s ability to
generate cash.
4. Liquidity is the amount of cash a company can obtain quickly to settle debt
and other demand of cash.
5. Liquid Asset:
Liquid funds are:
Cash.
Short term investment (not subsidiary or associate).
Trade receivables.
Bill of exchange.
 More Liquid assets:
o Inventory of finished products are more liquid than of RM.
 Non-current asset (unless no longer needed) are not liquid asset. Selling non-current
asset is not a solution for cash needs.
 Liquid assets are current asset that can soon convert to cash and cash itself.

A. Current Ratio:
1. Current Ratio = Current Asset
Current Liability
2. Ratio in excess of “1” is expected.
3. If current assets exceed current liabilities, then the ratio will be greater than 1 and
indicates that a business has sufficient current assets to cover demands from
creditors.
[Link] Ratio /Acid Test Ratio:
1. All current asset cannot convert into cash quickly like inventory of RM, inventory
of FG with lengthy credit schemes
2. Quick Ratio/Acid Test Ratio =
Current asset – Inventory
Current Liability
3. Ideal Quick Ratio = 1
 4. If this ratio is 1:1 or more, then clearly the company is unlikely to have liquidity
problems. If the ratio is less than 1:1 we would need to analyse the structure of
current liabilities, to those falling due immediately and those due at a later date.

C. Accounts Receivable Payment Period (Debtors Collection period)

Rough measure of average length of time it takes for a company’s accounts receivable to
pay their Due
Accounts receivable days/Accounts receivable payment period:
= Trade Receivable *365
Credit Sales Turnover
Trade receivable do not include prepayments, Non-trade accounts receivables.
It is only approximate because:
Value of accounts receivable on statement of financial position may be high/low compared
what usually had.
An increase in the receivables collection period could indicate that the company is struggling
to manage its debts. Possible steps to reduce the ratio include: • Credit checks on customers
to ensure that they will pay on time • Improved credit control, e.g. invoicing on time,
chasing up bad debts.

D. Inventory Turnover Period/Inventory Days

 Inventory Days = Inventory * 365
Cost of sales
 It is also approximate figure
 Lengthening inventory turnover period indicates
o Slowdown in Trading.
o Inventory investment is high (building in inventory)
 A decrease in the inventory holding period could be desirable as the company's
ability to turn over inventory has improved and the company does not have excess
cash tied up in inventory.

Inventory days + Accounts receivable day’s gives how soon inventory converted to cash
E. Accounts Payable Payment Period

Accounts payable payment period = Average Trade Payable * 365

Credit Purchase

 Increase in account payable days indicated lack of long term finance or poor
management of current asset etc.
 Comparison should be with companies in same industry.
 This is the average period it takes for a company to pay for its purchases.

Example:3
Calculate liquidity and working capital ratios from the accounts of a manufacturer of
products for the construction industry, and comment on the ratios

20X8 20X7
$m $m

Turnover 2,065.0 1,788.7

Cost of sales 1,478.6 1,304.0

Gross profit 586.4 484.7

Current assets: Inventories 119.0 109.0

Receivables (note 1) 400.9 347.4

Short-term investments 4.2 18.8

Cash at bank and in hand 48.2 48.0

572.3 523.2

Payables: amounts falling due within one year 49.1 35.3

Loans and overdrafts

Corporation taxes 62.0 46.7

Dividend 19.2 14.3

Payables (note 2) 370.7 324.0

501.0 420.3

Net current assets $m 71.3 $m 102.9

Notes

Trade receivables 329.8 285.4

Trade payables 236.2 210.8

Solution:

20X8 20X9

Current ratio 572.3/501.0 = 1.14 523.2/420.3 = 1.24

Quick ratio 453.3/501.0 = 0.90 414.2/420.3 = 0.99

Receivables payment 329.8/2,065.0 * 365 = 58 285.4/1,788.7 * 365 = 58

period days days

Inventory turnover 119.0/1,478.6 * 365 = 29 109.0/1,304.0 * 365 = 31

period days days

Payables turnover period 236.2/1,478.6 * 365 = 58 210.8/1,304.0 * 365 = 59

days days

As a manufacturing group serving the construction industry, the company would be

expected to have a comparatively lengthy receivables turnover period, because of the
relatively poor cash flow in the construction industry. It is clear that the company
compensates for this by ensuring that they do not pay for raw materials and other costs
before they have sold their inventories of finished goods (hence the similarity of receivables
and payables turnover periods).
The company's current ratio is a little lower than average but its quick ratio is better than
average and only slightly lower than the current ratio. This suggests that inventory levels are
strictly controlled, which is reinforced by the low inventory turnover period. It would seem
that working capital is tightly managed, to avoid the poor liquidity which could be caused by
a high receivables turnover period and comparatively high payables.
Notes:
 Work-in-progress period = Value of WIP
------------------ * 365
Cost of Sales

Value of Finished Goods

 Finished goods period = ----------------------------- * 365
Cost of Sales

III. Gearing Ratio

1. Financial Gearing Ratio:

1. Asset must be financed by capital.
2. Two main reason why company should keep debt burden under control:
(1) When company is heavily in debt, lenders likely to refuse further
borrowings.
(2) When company earn modest PBIT, and has heavy debt burden, there will
be very less profit left for shareholders.
(3) When company goes into liquidation creditors cannot recover in full ie
cannot pay when full due if company build up debt.
2. Gearing Ratio:
Gearing Ratio measure financial risk of company’s capital structure. (Relationship between
equity and debt).
Gearing Ratio = Debt *100
Debt + Equity
OR
Debt *100
Equity
(Overdraft not form part of debt)

 No absolute limit to what gearing ratio ought to be, generating over 50 % indicates
high.
  A high level gearing indicated company relies heavily on debt to finance for long
term needs. This increase risk of business since interest and principal repayment is
must on debt whereas no such obligation for equity.

3. Operating Gearing

Fixed Costs
(1) Operating Gearing (Operating leverage) = Contribution
Or --------------
PBIT
Total Costs

(2) Interpretation:

 High Indicates -- Fixed cost is high and is somehow covered by contribution.

 Low indicates --- Fixed cost is low and easily covered by contribution.

4. Interest Cover = Profit before interest and tax

--------------------------------------- ( Number of times)
Interest paid

This ratio represents the number of times that interest could be paid out of profit before
interest and tax.

Earnings after tax and preference dividends

5. Dividend Cover = ---------------------------------------------------- ( Number of times)
Ordinary dividend

This is an indication of dividend policy – whether profits tend to be distributed or reinvested

Issues surrounding the use of financial performance indicators to monitor

performance:
All of the ratios reviewed so far have concentrated on the financial performance of the
business. Many of these ratios, e.g. ROCE, gross profit margin, may be used to assess the
performance of a division and of the manager's in charge of that division.
Achievement of these target ratios (financial performance indicators) may be linked to a
reward system in order to motivate managers to improve performance.
Problems associated with the use of financial performance indicators to monitor
performance:
Non-Financial Performance Indicators [NFPI`s]
 Importance of NFPI`s
1. Concentrates on few variables if focus only on items expresses in monetary terms.
2. Lacks information on quality.
3. Change in structure.
a. Greater portion of cost are sunk, planned, designed before production.
b. Therefore too late to control cost.
4. Financial measures does not convey full picture of performance in modern
environment.
5. NFPS`s are indicators of future financial performance.
E.g. falling quality ultimately damage profitability.

Aspects used in NFPI`s

1. Quality of production, wastage ratio.
2. Speed or efficiency such as output per hour.
3. Delivery: Time between taking order and delivery.
4. Customer satisfaction/ [Link] complaints.
5. Innovation: New product developed and launched

NFPI`s on Employees
Employee’s attitude, morale, education, skill, promotion, training, absenteeism, labour
turnover etc. need to be measured.

Total Quality Management (TQM)

1. Modern concept of TQM demands every activity of business (not only production
process) like selling and distribution department, effect of external suppliers,
reduction of customers etc. need to get measured to improve Quality.
2. It divided into three:
A. Measuring quality of inward supplied and measure rejections.
 B. Monitoring work done as it proceeds
o Amount of scrap, reworking in relation to good production etc.
o Measurement can be made by product, by worker, by machine, by
department etc.
C. Measuring Customer Satisfaction:
o Letter of complaint, return of goods, claims under guarantee etc are
used to measure
o Surveying customer on regular basis is an advanced technique

Measure of Customer Satisfaction:

1. Questionnaires.
2. Market research information on customer preference.
3. Number of defective units supplied to customer.
4. Number of customer complaints.
5. On time delivery.
6. Repeat business from existing customers.
7. New customer.

 Areas to measure should relate to an organisation's critical success factors. Critical

success factors (CSFs) are performance requirements which are fundamental to an
organisation's success (for example innovation in a consumer electronics company)
and can usually be identified from an organisation's mission statement, objectives
and strategy.
 Key performance indicators (KPIs) are measurements of achievement of the chosen
critical success factors. Key performance indicators should be:
o Specific (i.e. measure profitability rather than 'financial performance', a term
which could mean different things to different people)
o Measurable (i.e. be capable of having a measure placed upon it, for example,
number of customer complaints rather than the 'level of customer
satisfaction')
o Relevant, in that they measure achievement of a critical success factor.
 The following table demonstrates critical success factors and key performance
indicators
Perspective Critical success Key performance indicators
factor

financial shareholder dividend yield; % increase in share

success wealth price

cash flow actual vs budget debtor days

customer exam success college pass rate vs national average

satisfaction premier college status
tutor grading by students

flexibility average number of course variants

per subject (e.g. full-time, day
release, evening)

process resource % room occupancy average class size

efficiency utilisation average tutor teaching load (days)

growth innovation % of sales from < 1-year-old number

products of online enrolments
information
technology

Short Termism and Manipulation.

Short-termism is when there is a bias towards short-term rather than long-term
performance. Decisions which involve the sacrifice of longer-term objectives include the
following.

 Postponing or abandoning capital expenditure projects, which would eventually

contribute to growth and profits, in order to protect short term cash flow and
profits?

 Cutting R&D expenditure to save operating costs, and so reducing the prospects for
future product development.

 Reducing quality control, to save operating costs (but also adversely affecting
reputation and goodwill).
Methods to encourage Long Term View
1. Set quality based target along with financial target.
2. Link manager rewards with share price which will reflect long term achievements.
3. Evaluate manager performance based on long term and short term objectives.
4. Providing management information about both short term and long terms targets.

Step of Performance Measurement.

Performance is measured to asses show well or badly an organisation has performed over a
given period of time. When performance is measured, the objectives should be to:

 identify aspects of performance that may be a cause for concern

 explain differences between actual performance and the plan or expectation, or

deteriorating performance over time

 consider ways of taking control measures to improve performance.

Three steps which is helpful in improving performance of an organisation

1) Analyse performance
The purpose of analysing performance in this way is to identify whether there are any
aspects of performance that are worse than the target or worse than the previous year,
where there may be some cause for concern.
2) Identify reasons for unexpected performance or poor performance
To identify possible reasons for disappointing performance, you may need to apply your
judgement and common sense to the facts in an examination ‘case study’.
Reasons for Unexpected Performance

Aspect of performance Possible reasons

Increase in rejection rates for faulty Using relatively inexperienced staff to do

products the
work Using cheaper materials (to ‘save
money’)

Increase in time between taking a customer Administrative delays in processing

customer
order and delivering the product to the orders
customer

Increase in frequency of machine Reduction on amount of routine

breakdowns maintenance work

Customer dissatisfaction with on-line sales Poor web site design

service

Longer average time to answer customer Reduction in number of call centre staff
calls in a call centre

Declining labour productivity Failure to train staff

Increase in complexity of the work Use of
inexperienced staff

3) Improving performance
Having identified reasons for poor performance, whether financial or non-financial
performance, the final step is to consider and implement methods of improving
performance.

Aspect of performance Possible reasons Possible measures to improve

performance

Increase in rejection Using relatively inexperienced Hire more experienced staff

rates
staff to do the work Provide training
for faulty products
Using cheaper materials (to Switch back to better-quality
materials
‘save money’)

Increase in time between Administrative delays in Set a maximum time limit for
taking a customer order processing customer orders processing orders and monitor
and delivering the performance continually
product to the customer

Increase in frequency of Reduction on amount of Increase routine maintenance of

machine breakdowns routine maintenance work machines

Customer dissatisfaction Poor web site design Re-design the web site. Hire
with on-line sales service web site design specialists if
necessary

Longer average time to Reduction in number of call Employ more staff

centre staff
answer customer calls in
a call centre

Declining labour Failure to train staff Hire more experienced staff

productivity Increase in complexity of the Provide training
work
Give the most complex tasks to
Use of inexperienced staff specialist staff
Building Block Model (Fitzgerald and Moon Model)

 Attempt to overcome problems associated with performance measurement of

service business.

 Performance measurement in service is combination of

 Dimensions of performance.
 Standards.
 Rewards.

I. Dimensions of Performance:
Six aspects to performance measurement that link strategy

Dimension of Possible measure of performance

performance

Financial performance Profitability Profits growth

Gross profit margin, net profit margin
Growth in Profit.

Competitiveness Growth in sales

Retention rate for customers
Success rate in converting enquiries into sales

Service quality Number of complaints

Customer satisfaction, as revealed by customer
opinion surveys

Flexibility Mix of different types of work done by employees

Speed in responding to customer requests
Resource utilisation Efficiency/productivity measures Capacity utilisation
rates

Innovation Number of new services offered within the previous

year or two years

2) STANDARD
The second part of Fitzgerald and Moon’s framework for performance measurement
concerns setting the standards or targets of performance, once the measures for the
dimensions of performance have been selected.
There are three aspects to setting standards of performance:

 Individuals need to feel that they ‘own’ the standards and targets for which
they will be made responsible. ( ownership)

 Individuals also need to feel that the targets or standards are realistic and
achievable.

 The standards and targets should be seen as ‘fair’ and equitable for all the
managers in the organisation.
3) REWARD
The third aspect of Fitzgerald and Moon’s performance measurement framework is
rewards. This refers to the structure of the rewards system, and how individuals will be
rewarded for the successful achievement of performance targets.
There are three aspects to consider in a reward system.

 The system of setting targets and rewarding individuals for achieving the
targets should be clear. Clarity will improve the motivation to achieve the
targets

 Achievement of performance targets should be suitably rewarded.

(Motivation)

 Individuals should be made responsible only for aspects of performance that

they are in a position to control.
Balanced Score Card
 The balanced scorecard approach to performance measurement focuses on four
different perspectives of performance, and uses both financial and non-financial
indicators to set performance targets and monitor performance.

 The balanced scorecard focuses on four different perspectives, as follows.

Perspective Basic question Identifying performance targets

Customer What do existing and new Gives rise to targets that matter to
customers value from us? customers: cost, quality, delivery,
inspection, handling and so on.

Internal What processes must we excel Aims to improve internal processes

at to achieve our financial and and decision making.
customer objectives?
Innovation and learning Can we continue to improve Considers the business's capacity to
and create future value? maintain its competitive position through
the acquisition of new skills and the
development of new products.

Financial How do we create value for Covers traditional measures such as

our shareholders? growth, profitability and shareholder value
but set through talking to the shareholders
directly.

Important features of this approach are as follows.

(a) It looks at both internal and external matters concerning the organisation.
(b) It is related to the key elements of a company's strategy.
(c) Financial and non-financial measures are linked together.

Steps

(1) Small number of target for each four perspective should be determined.

(2) Target for 4 perspective should be consisted each other.

(3) Actual performance measured regularly and compared with target.

(4) Differences are investigated and appropriate measures taken.