measures of performance ch-3

8/4/2019 Measures of Performance Ch-3

1/54

Designing the Management

Control System


2/54

An important component of Management Controls

Assigning responsibility for executing strategy

Implementing strategies is not

adequate if individuals whomust execute them fall short.

3-2


3/54

Therefore, management controls

must include

How responsibility is assigned and measured

How tasks are measured (not necessarily tasks done

by humans but also by machines; e.g. units

produced)

Task controls such as when to order inventory, why

the actual differ from budgeted (the causes)

And, not easy to measure or quantify items such asimpact on behaviors, intangible assets, and so on.

3-3


4/54

Factors influencing Design

Size of organization

Organizational philosophy of delegation anddecentralization

Types of responsibility centers

Perception of people

3-4


5/54

Process of designing control system

and required constraints

3-5


6/54

RESPONSIBILITY CENTERS

3-6


7/54

What is a responsibility center?

In simple words: an organizational unit for which a

manager is made responsible.

Examples: A specific store in a chain of grocery

stores.

A work-station in a production line manufacturing

automobile batteries.

The payroll data processing center within a firm.


8/54

Attributes of a responsibility center

It is like a small business, and its manager is

Asked to run that small business and preserve the

interests of the larger organization.

Goals for the center should be specific and

measurable, and

Should promote the long terms interests of the

organization and should be compatible with otherresponsibility center activities.


9/54

Example: A courier service (DHL)

Courier operations dispatch trucks to pick up or deliver

shipments from local terminals.

It could be sent to one or more central terminals and then

sorted and redirected. Success of this service would depend on:

Service commitment to customers (on time, without damage) and

Controlling costs

Let us suppose that each terminal is treated as a responsibilitycenter.

How should the company measure the performance of each

terminal, its mangers, and its employees?


10/54

Measuring the performance of the

courier-terminal responsibility center

To focus on efficiency: we could measure no. of parcels picked

up, sorted or delivered, per route, per employee, per vehicle,

per hour or per shift.

To focus on customer service, we could measure each groupscontribution to customers: proportion of the time the terminal

met its deadlines, when terminals are required to sort

shipments, what the sorting error rate was.

We could also measure customer service by: no. of complaints

operations group receives, average time taken by the

operation group to respond to complaints, and no. of

complaints of poor, or impolite service.


11/54

Measuring inputs and outputs

In the courier example, the inputs are causal and

direct: e.g. no. of packets received to time taken to

deliver them.

But, such causal and direct relationships are not

always possible. For example, how does

advertising contribute to increase in revenues?

Or, how would you measure the contribution of R &D to product innovation, revenue generation, or cost

reduction?


12/54

Converting the inputs into monetary units

Most organizations would convert the physical inputs

into monetary units when evaluating a responsibility

center.

No. of units x cost of production, labor hours x per

hour rate, etc.


13/54

Measuring outputs

Measuring outputs is more difficult. This is because:

Input may be extended this year but outputs

(benefits) may be received over several years (e.g.

employee training).

It would be difficult to make the causal relationship

e.g. marketing expenses, IT investments,

accountants and generation of revenue and profits.


14/54

The input-output attributes

Most organizations use financial controls cost,

revenue, and profits, etc.

However, such measures are not applicable to all

units within an organization.

For example, how would you measure the

contribution of a production department? It can

only be done on a cost measurement basis. How would you measure the contribution of a sales

department only by revenue generated.


15/54

Why does an organization

relate input to outputs?

Because they inherently measure efficiency and effectiveness.

Efficiency: ratio of output to inputs;

Caution: Do not use ratio of output to input in an absolute

sense; but, only in a comparative sense. If Dept. A is more efficient than Dept. B, do not rush to

conclusions; examine why Dept. B is less efficient and what can

be done about it.

Also, comparisons are possible only if Dept. B and Dept. A usecomparable outputs and comparable inputs. You cannot

compare advertising to accounting.


16/54

Efficiency

Efficiency is generally measured by comparing

actual costs to standard costs.

Issues:

Standard costs do not remain stationery.

Recorded costs are often different from actual

resources (costs) consumption.

Lesson: Establishing a responsibility center is easy;

Measuring its efficiency in a reasonable manner is

difficult.


17/54

Effectiveness

Relationship between a responsibility centers output

and its objectives (what it was intended to do or

perform or deliver).

If the output contributes to satisfying the objectives,

the more effective it is.

The new advertising and marketing efforts has

increased awareness and recognition of ourproduct. Advertising and marketing has been

effective.


18/54

Efficiency-Effectiveness

Not a compromise

A responsibility center must both be efficient and

effective.

It must use the least amount of inputs to get the

maximum amount of output and yet deliver on the

goals.

A sales department was efficient in growing the

sales by 10% without adding additional salespeople or marketing expenses (efficient); however,

many of the credit sales could not be collected (bad

debts). It is ineffective.


19/54

Role of Profit

The goal of every for-profit organization is earn profits

(effectiveness).

If the organization could use the least input to get the

maximum earnings, profits will be high (efficiency). Therefore, profit is an indicator of both efficiency and

effectiveness.

However, not every unit within an organization earns profit

and therefore, this measure cannot be used for allresponsibility centers.

Therefore, an organization must establish various types of

responsibility centers.


20/54

Types of Responsibility Centers

Revenue Centers

Cost Centers or Expense Centers

Profit Centers and Investment Centers

Financial performance center

Strategic business unit (SBU)


21/54

Revenue Centers

Responsibility Centers whose members control

revenues but,

Not the manufacturing or acquisition cost of the

products or service they sell, or

The level of investment in the responsibility center.

In other words, you cannot link the input to the

output.


22/54

Revenue Centers (continued)

Most revenue centers may not set selling prices

They definitely have no control over the costs ofinput acquired (service manager of an automobile

workshop does not control gasoline costs) These centers are generally not allocated costs of

the goods that they market (there are exceptions).Manager is responsible only for costs directly

incurred by his/her unit. They are evaluated on the basis of actual sales or

orders booked against budgets or quotas and

Example: a unit of a chain store in a mall.


23/54

Expense/Cost Centers

Responsibility centers whose employees control costs, but

Do not control their revenues or investment level.

Examples: Production department in a manufacturing unit, a

dry cleaning business Two types of costs:

Engineered: those costs that can be reasonably associated with a cost

center direct labor, direct materials, telephone/electricity consumed,

office supplies.

Discretionary: where a direct relationship between a cost unit and

expenses cannot be reasonably made; Management allocates them on

a discretionary basis (e.g. depreciation expenses for machines utilized).


24/54

Engineered costs

Should be measurable in monetary terms, outputs inphysical quantities.

Works well in units such as production, distribution,

accounting receivables, payables where repetitivetasks are performed.

Developing standard costs for such activities is morereliable than in other cases.

Multiply standard cost per unit x no. of unitsproduced or processed = this is the ideal cost.

Compare it to actual costs and the difference isindicative of efficiency or lack thereof.


25/54

Engineered costs

Important to remember

The fundamental purpose of all responsibility

centers is accountability; evaluating performance.

And a engineered cost center,

Does not merely compare costs but also

Holds the managers accountable for

obtaining/producing right quality of product

Volume of production, speed of processing.


26/54

Discretionary costs

Mostly administrative and support service costs

More difficult to measure in physical quantities or precisely onmonetary terms (e.g. customer relations or even R & D).

Discretionary means, management allocates them based on

established polices (not arbitrarily). More caution is required while using discretion cost numbers.

Difference between budgeted expenses and actual expensesdoes not indicate efficiency.

Suppose if the actual cost is less than budget, does it mean

good or bad? Suppose if the actual cost is higher than budget, does it mean

good or bad?


27/54

Expense centers (continued)

Comparing Budgeted and Actual Costs

Budgeted costs are target estimates.

It points to a goal to be achieved.

But, it is not written in concrete.

Actual costs are that were incurred during a given period.

The difference between the two could be either positive or

negative variances.

However, making conclusions on the basis of positive or

negative variances must be done carefully. See the next set slides and the example.


28/54

Morton Carpets Master Budget (Fixed)

Prod. 1 Prod. 2 Prod. 3 Prod. 4 Total

Units made 245,000 385,000 636,000 1,250,000

Units per batch 500 2,500 1,500 5,000

No. of batches 490 154 424 250

Cost per unit $ 5.40 $3.20 $4.25 $1.45

Cost per batch $325.00 $680.00 $400.00 $135.00

Unit-related costs

(245,000x$5.40)

$1,323,000 $1,232,000 $2,703,000 $1,812,500 $7,070,500

Batch-related costs

(490x$325)

159,250 104,720 169,600 33,750 467,320

Prod.-sustaining costs 125,000 168,000 256,000 355,000 904,000

Facility costs 1,450,000

Total cost center costs $9,891,820


29/54

Morton Carpets Actual Costs


Units made 2,945,000 345,000 675,000 950,000

Units per batch 600 2,300 1,800 6,000

No. of batches 492 150 375 159

Cost per unit $ 5.43 $3.18 $4.33 $1.40

Cost per batch $335.00 $670.00 $387 $144.00

Unit-related costs $1061,850 $1,097,100 $2,922,750 $1,330,000 $6,951,700

Batch-related costs 164,820 100,500 145,125 22,896 433,341

Prod.-sustaining costs 133,000 163,000 259,000 362,000 917,,000




30/54

Budget Actual VarianceUnrelate d costs

Product 1 1,323,000.00 1,601,850.00 278,850.00

Product 2 1,232,000.00 1,097,100.00 -134,900.00Product 3 2,703,000.00 2,922,750.00 219,750.00Product 4 1,812,500.00 1,330,000.00 -482,500.00

Total 7,070,500.00 6,951,700.00 -118,800.00Batch related costs

Product 1 159,250.00 164,820.00 5,570.00

Product 2 104,720.00 100,500.00 -4,220.00Product 3 169,600.00 145,125.00 -24,475.00Product 4 33,750.00 22,896.00 -10,854.00

Total 467,320.00 433,341.00 -33,979.00Prod. sus. Costs

Product 1 125,000.00 133,000.00 8,000.00

Product 2 168,000.00 163,000.00 -5,000.00Product 3 256,000.00 259,000.00 3,000.00Product 4 355,000.00 362,000.00 7,000.00

Total 904,000.00 917,000.00 13,000.00Fac. Sus. Costs 1,450,000.00 1,650,000.00 200,000.00

Total 9,891,820.00 9,952,041.00 60,221.00

Variance Analysis


31/54

What do we learn from the variance analysis of

Morton Carpets?

The variance analysis presents a mix of positive and

negative variances.

Example: Product 1 and 3, unit-related costs were

higher than planned, and

For products 2 and 4 they were lower than planned.

In total, the unit-related costs and batch-related

costs were lower than planned and the product-sustaining and facility-sustaining costs were higher

than planned.


32/54

What can we conclude about

Morton Carpets?

Based on initial analysis, manufacturing is able to control unit-related and batch-related costs, but

Did not do so well controlling product-sustaining and facility-sustaining costs.

A closer examination, however, casts doubts on theseconclusions.

If you look at slides 24 and 25, you will notice that the no. ofunits actually made differed from budgeted for all fourproducts.

Similarly, no. of units per batch actually produced differedfrom budgeted units per batch.

Because of these volume differences, it is inappropriate tocompare the cost targets in the master budget with actual costresults.


33/54

What can managers do to make the numbers

comparable and meaningful?

Use a flexible budget (the text does not use this

term but discusses the same concepts within cost

variability and incremental budgeting sections). The

objectives are the same. Flexible budget recasts cost targets in the planned

or budget to reflect the achieved level of

production.

The flexible budget develops cost target levels

based on actual level of activity.

See the next set of slides.


34/54

Morton Carpets Flexible Master Budget


Units made 295,000 345,000 675,000 950,000

Units per batch 500 2,500 1,500 5,000

No. of batches 590 138 450 190

Cost per unit $ 5.40 $3.20 $4.25 $1.45

Cost per batch $325.00 $680.00 $400.00 $135.00

Unit-related costs $1,593,000 $1104,000 $2,868,750 $1,337,500 $6,943,250

Batch-related costs 191,750 93,840 180,000 25,650 491,240

Prod.-sustaining costs 125,000 168,000 256,000 355,000 904,000




35/54

Budget Fl. Budget Actual

Planning

variance

Fl. Bud.

Variance

Unrelated costs (slide) (B-Fl.B) (Act.-F.B)

Product 1 1,323,000.00 1,593,000.00 1,601,850.00 270,000.00 8,850.00

Product 2 1,232,000.00 1,104,000.00 1,097,100.00 -128,000.00 -6,900.00

Product 3 2,703,000.00 2,868,750.00 2,922,750.00 165,750.00 54,000.00

Product 4 1,812,500.00 1,377,500.00 1,330,000.00 -435,000.00 -47,500.00

Total 7,070,500.00 6,943,250.00 6,951,700.00 -127,250.00 8,450.00Batch related costs

Product 1 159,250.00 191,750.00 164,820.00 32,500.00 -26,930.00

Product 2 104,720.00 93,840.00 100,500.00 -10,880.00 6,660.00

Product 3 169,600.00 180,000.00 145,125.00 10,400.00 -34,875.00

Product 4 33,750.00 25,650.00 22,896.00 -8,100.00 -2,754.00

Total 467,320.00 491,240.00 433,341.00 23,920.00 -57,899.00

Prod. sus. Costs

Product 1 125,000.00 125,000.00 133,000.00 0.00 8,000.00

Product 2 168,000.00 168,000.00 163,000.00 0.00 -5,000.00

Product 3 256,000.00 256,000.00 259,000.00 0.00 3,000.00

Product 4 355,000.00 355,000.00 362,000.00 0.00 7,000.00

Total 904,000.00 904,000.00 917,000.00 0.00 13,000.00

Fac. Sus. C 1,450,000.00 1,450,000.00 1,650,000.00 200,000.00 200,000.00Total 9,891,820.00 9,788,490.00 9,952,041.00 -103,330.00 163,551.00

Variance Analysis

Flexible Budget Cost Analysis


36/54

What did we infer from the

flexible budget slides?

Cost standards are the same as in the case of the fixed budget.Why?

Difference: volume levels are adjusted to reflect achieved level ofactivity (e.g. Product 2 was 345,000 and std. batch size of 2,500

or 345/2.5 = 138 batches). Using std. unit cost of $3.20 and std. batch cost of $680, unit-

related and batch-related costs for Prod. 2 should have been$1,104,000 (345,000 x $3.20) and $93,840 ($680 x 138).

Planned variance reflect cost adjustment needed to show the

differences in production volume between master budget andflexible budget. Negative variance means a cost reduction due to lower volume and

a positive variance means a cost increase because of a highervolume.

Flexible budget variances are the focus of cost control in a costcenter.


37/54

Cost/Expense center variances

A few pointers

Dont rush to conclusions based on positive or

negative variances.

Find the cause behind the variances.

Decompose the flexible budget variances for unit-

related costs into price and quantity components.

Since analysis of variances for batch-related,

product-sustaining, and facility-sustaining costs is notformalized and proceeds on an ad hoc basis,

Use your common sense and rationale as a neutral

evaluator.


38/54

Profit Centers

Managers of profit centers control both the

revenues and costs of the product or service they

deliver.

It is like an independent business except it is part ofa larger organization (e.g. departmental stores of

larger chains Wal Mart, restaurants, corporate

hotels such as Hilton, Holiday Inn).

The store manager would have responsibility for

pricing, product selection, and promotion.


39/54

Profit Centers (continued)

Cost for these units vary depending on ability to

control labor, waste, and hours.

Revenues also will vary depending on the units

service level, location, etc.

In other words, local discretion would affect

revenues and costs.

Investments and some costs (e.g. centralizedpurchasing).

Therefore, profits represent a broader index of

both corporate and local decisions.


40/54

Profit Centers (continued)

If performance is poor, it may reflect poor

conditions that no one in the organization could

control as well as poor local conditions.

For this reason, organizations should not evaluateperformance only based on costs and profits, but

Perform detailed evaluations that include quality,

material use, labor use, and service measures thatthe local unit can control.


41/54

Investment Centers

Responsibility centers whose managers and

employees control revenues, costs, and the level of

investment.

It is also like an independent business (commonwhen an organization acquires another organization

e.g. Sears financial centers).


42/54

Administrative Centers (support centers)

One of the most difficult to evaluate because

neither the input nor the output is easy to measure

(e.g. accounting services, marketing), and

Linking units input and output to organizationalobjectives.

But, with a little careful approach, the costs of such

centers can be reasonably computed.

Since most of these centers are treated somewhat

like cost centers, an approach based on costs would

be helpful.


43/54

A simple summary of the

responsibility centers

Revenue CenterOutput measured in

monetary terms

Input measured inmonetary terms

Output measured in

monetary terms

Output measured in

monetary terms

Expense/Cost Centers

Profit Centers

Investment Centers


44/54

What did we learn from these

control system illustrations?

All responsibility centers evolve from the concept of

controllability.

Controllability principle states a manager should be assigned

responsibility for the revenue, costs, or investment that he/shecould control.

Revenues, costs, or investments that do not fall under a managers

control must be excluded when evaluating the manager or his/her

center.

Problem with this concept: In most organizations, many revenues

and costs are jointly earned or incurred and differentiation the

controllable from the uncontrollable is difficult.


45/54

An alternative to Controllability

Some argue that performance measures should be

chosen to influence decision-making behavior.

For example, if market prices for raw material is

increasing, what can a manager do?

Perhaps, enter into long term contract for fixed

prices for raw materials.

If electricity consumption cost is going up, find outhow consumption can be economized (better

machines, lighting, reduce waste).


46/54

MEASURES OF PERFORMANCE


47/54

Measures of performance

Financial measures

Expenses incurred

Revenuesearned

profit

ROI/ROCE

EVA

other

Nonfinancial measures

customers

operations

suppliers

HR & safety

Environment


48/54

Financial measures of performance

1 Expenses center measure the actual cost with standard cost

2

Revenues cannot measure effectively so performance of organization

can be analyzed on the basis of regional performance

3 Organizations established for only profit making

4 Rate on capital employed=EBIT/cost of investment

5 Economic value added =net operating after tax-economicvalue of

assetsin place * weighted cost of capital


49/54

Nonfinancial measures of performance

Measures ofperformance

Environment

HR&safty

OperationsCustomers

Suppliers


50/54

Monitoring and reporting results

Monitoring is needed to analyse or review the

progress of project or task of organisation

Helps in getting information about techanical

progress ,manpower deployment,financial

expenditures,constraints,remedial actions,task

completion,etc


51/54

Need .?

Helps in identifying the ,decision,actions for

avoiding damages and losses

Helps to find what actualy goes wrong,for better

prevention

Helps in determining the accountability for where

goes wrong


52/54

Requisites of good management system

Long term and short term objectives

Compilences to the all levels of mgt and user friendly

Facts and figures

Operations and accounting oriented

Behavioral aspects

Detail report

Constant review of plans and schedules

Review of reports yearly


53/54

Management control &reporting system

for Commertial banks

Long run plan&stratagic

control

Operational

controlsystem

Performancebudgeting &

controlsystem


54/54

Is Anything in your brain..?

measures of performance ch-3

Documents