P5 Class Notes Sept-Dec 2015 FINAL As at 5 June 2015

ACCA Paper P5
Advanced
Performance
Management
Class Notes
September/December 2015
Interactive World Wide Ltd, May 2015
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without the prior written
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2 w w w . s t ud yi nt e r a c t i ve . o r g
Contents
PAGE
INTRODUCTION TO THE PAPER 5
FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 9
CHAPTER 1: STRATEGIC PLANNING AND CONTROL 13
CHAPTER 2: PERFORMANCE MANAGEMENT AND CONTROL 31
CHAPTER 3: ORGANISATIONAL STRUCTURE AND BUSINESS INTEGRATION 43
CHAPTER 4: RISK AND UNCERTAINTY AS PART OF THE STRATEGIC PLANNING 51
CHAPTER 5: PERFORMANCE EVALUATION 61
CHAPTER 6: DIVISIONALISATION 75
CHAPTER 7: TRANSFER PRICING 83
CHAPTER 8: PERFORMANCE EVALUATION 87
CHAPTER 9: PERFORMANCE SYSTEM ISSUES 103
CHAPTER 10: WHAT IS CORPORATE FAILURE? 113
CHAPTER 11: CURRENT DEVELOPMENTS AND EMERGING ISSUES IN

PERFORMANCE MANAGEMENT 123
ANSWERS TO QUESTIONS 133
w w w . s t ud y i nt e r a c t i v e . o r g 3
Introduction to the
paper
IN T R O D U C T I O N T O T H E P A P E R
AIM OF THE PAPER

To apply relevant knowledge, skills and exercise professional judgement in selecting
and applying strategic management accounting techniques in different business
contexts and to contribute to the evaluation of the performance of an organisation and
its strategic development.
MAIN CAPABILITIES
A Use strategic planning and control models to plan and monitor organisational
performance.
B Assess and identify relevant macroeconomic, fiscal and market factors and key
external influences on organisational performance.
C Identify and evaluate the design features of effective performance management
information and monitoring systems.
D Apply appropriate strategic performance measurement techniques in evaluating
and improving organisational performance.
E Advise clients and senior management on strategic business performance
evaluation and on recognising vulnerability to corporate failure.
F Identify and assess the impact of current developments in management
accounting and performance management on measuring, evaluating and
improving organisational performance.
FORMAT OF THE EXAM PAPER

The examination paper will comprise two sections:
Section A
Section A will comprise a single compulsory question worth 50 marks.
Section B
Section B will contain 3 optional questions worth 25 marks each. Candidates will be
required to answer two of these questions. At least one of the questions in Part B is
usually entirely discursive in nature.
IN T R O D U C T I O N T O T H E P A P ER
ACCA P5 PAST EXAM TOPICS
December 2007 June 2008

Q1 Performance Evaluation Bus Co Q1 EVA, ROI and RI
Q2 EVA and RI Q2 Written Budget Q
Q3 Selling Price, CSF and ERPS Q3 Strategic & Economic Factors
Q4 ABC Q4 NPV and Sensitivity
Q5 5 Forces and Corporate Failure Q5 TQM Cost Analysis

Q1 League Table Performance Q1 Balance Scorecard
Q2 Assess Financial Performance Q2 NPV and Minimax Regret
Q3 Planning Gap, Ansoff and Q3 Agency and Expectancy Theory
Problems Q4 Pricing MR = MC
Q4 Transfer Pricing and TQM Q5 Six Sigma
Q5 ABC and ABM

Q1 Actual and Budget Assess Q1 Balanced Scorecard
Performance Q2 Profit Statement and Expected
Q2 Beyond Budgeting and KPI Value
Q3 Transfer Pricing Q3 VFM
Q4 Financial and Social and Econ Q4 ABC and ABM
Q5 Mission Statements and CSF Q5 Cost Target and Performance

Q1 CSF and EIS Q1 Performance and Transfer Pricing
Q2 ABC and Beyond Budgeting Q2 Balanced Scorecard and
Q3 EVA and Other Measures Stakeholders
Q4 Environmental Strategy Q3 Fitzgerald and Moon
Q5 Z Score Q4 BCG Matrix and Remuneration
Q5 Environmental Strategy

Q1 Risk and Uncertainty Q1 Performance MIRR, EVA & NPV
Q2 Performance Pyramid and KPI Q2 Performance Prism
Q3 Control of Information and IT Q3 Six Sigma
Q4 Performance/Reward Q4 Benchmarking
Q5 Quality/Kaizen and JIT Q5 Difficulties in Performance

Q1 Divisional Performance Q1 Balanced Scorecard
Q2 Budgeting Incremental & Q2 ABC and ABM
Rolling Q3 Porters 5 Forces
Q3 EVA and ROCE Q4 Divisional Performance and
Q4 Gearing and Corporate Failure Transfer Pricing
Q5 Changes in Role of Mgmt A/C
IN T R O D U C T I O N T O T H E P A P E R

Q1 PEST, CSF, KPI and Planning Q1 Evaluate performance, EVA, VBM
Gap & suitable performance
Q2 Performance Pyramid & measures
Performance Problems Q2 Assess the impact of BPR
Q3 RFID Design & Performance financially, culturally and on the
Measurement MIS. Review the appraisal
process.
Q4 Performance & League Tables
Q3 Assess risk appetites, evaluate
the choice of turbines &
problems with managing
performance.
Q4 Assess the influence of plan & op
variances for performance
management. Evaluate the
current budgeting system and
the proposal to move to beyond
budgeting.
Dec 2014
Q1 Explain the Performance
Prism, justify the
management of
stakeholders, approaches
to benchmarking & JIT
Q2 Explain public sector NFIs
and how VFM can be
assessed.
Q3 Assess the environmental
investments & lifecycle
costing
Q4 Evaluation of corporate
failure models & suggest
recommendations to
reduce the possibility of
failure.
Formulae & tables
provided in the
examination paper
F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P ER
Present value table

Present value of 1 ie (1 + r)-n
Where r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
________________________________________________________________________________
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
F O R M U L A E & T A BL ES P R O V ID ED IN T H E E X A M I N A T IO N P A P ER
Annuity table
1 - (1 + r) -n
Present value of an annuity of 1 ie
r
Where r = discount rate

n = number of periods
Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
________________________________________________________________________________
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P ER
Chapter 1
Strategic planning and

control
C H A P T E R 1 S T R A T E G I C P L A N N IN G A N D C O N T R O L
CHAPTER CONTENTS
WHAT IS STRATEGY? ---------------------------------------------------- 15

HOW TO SET A STRATEGY 15
STRATEGIC PLANNING -------------------------------------------------- 17

SETTING A MISSION AND OBJECTIVES 17
EXTERNAL ENVIRONMENTAL ANALYSIS 17
INTERNAL ANALYSIS 17
CORPORATE APPRAISAL 17
STRATEGIC CHOICE 17
REVIEW 17
CRITICAL SUCCESS FACTORS 18
POSITION ANALYSIS ---------------------------------------------------- 19

SWOT 19
BENCHMARKING 20
STAKEHOLDERS 21
ETHICAL AND CULTURE CONSIDERATIONS 22
EXTERNAL INFLUENCES ON PERFORMANCE 22
GAP ANALYSIS ----------------------------------------------------------- 27
WHAT IS ANSOFFS GRID?---------------------------------------------- 28
WHAT IS STRATEGIC MANAGEMENT ACCOUNTING? ----------------- 29

TRADITIONAL MANAGEMENT ACCOUNTING 29
STRATEGIC MANAGEMENT ACCOUNTING 30
C H A P T ER 1 S T R A T E G I C P L A N N IN G A N D C O N T R O L
WHAT IS STRATEGY?
Strategy can be defined as
the direction and scope of an organisation over the long-term, which achieves
advantage in a changing environment through its configuration of resources
and competences with the aim of fulfilling stakeholder expectations.
The above simply means that strategy is how an organisation attempts to meet its
objectives.
How to set a strategy

Stage 1 Strategic Position (Analysis)
1. Identify key stakeholders and their expectations.
2. Develop long-term objectives to satisfy these stakeholder expectations.
3. Calculate financial and non-financial ratios to show position of organisation.
4. Identify core resources and competences within the organisation.
5. Identify key factors changing the environment outside the organisation.
6. Use SWOT analysis to develop strategic position.
Stage 2 Strategic Choices (Closing the gap)

1. Consider possible exit from existing industries.
2. Consider diversification into new industries.
3. Consider how to turnaround underperforming existing competitive advantage.
4. Consider how to extend existing successful competitive advantages.
5. Consider entry into new markets.
6. Consider development of new products.
7. Consider developing new competitive advantages.
Stage 3 Strategy into Action (Implementation)

1. Evaluate above options and choose strategy to be followed.
2. Implement any necessary changes in the organisation.
INTERNAL ANALYSIS EXTERNAL ANALYSIS
Core competencies Strategic tools

Performance models Porters 5
Corporate Appraisal
SWOT
Mission Statement
Objectives
Identify CSFs
Strategic Choice
Strategy to meet CSF
Strategic
Implementation
Formulate
plans/budgets
Target setting KPI
STRATEGIC PLANNING
When formulating a strategic plan the organisation should use a structured model
which breaks the planning process up into a number of stages:
Setting a mission and objectives

The company produce a mission statement and define clear objectives that it wants
to achieve. It will then have a clear purpose in society.
External environmental analysis

Many organisations operate in a dynamic environment and needs to know the current
and future external forces it will face. A continuous study should be undertaken of
the external environment using PEST analysis and competitor analysis.
Internal analysis
Analysis needs to be undertaken to establish internal resources at present and in the
future. Internal strengths and weaknesses will be established during this stage.
Corporate appraisal
A full corporate appraisal will be undertaken using SWOT analysis. This will enable
the organisation to analyse its current and future position.
Strategic choice
The options available will be identified and evaluated at this stage. Each option
indicates a strategic pathway that the organisation can follow.
Develop and implement the strategy.
The best strategy will be agreed and implemented to a long-term timetable.
Review
The strategy implemented must be continuously monitored and updated whenever
the need arises, eg when the external environment changes.
Once introduced strategic planning is a continuous development.
A mission is a broad statement of the overall purpose of the business and should
reflect the core values of the business. It will set out the overriding purpose of the
business in line with the values and expectations of stakeholders.
Johnson and Scholes
There is no one best mission statement for an organisation as the contents of mission
statements will vary in terms of length, format and level of detail from one
organisation to another.
Mission statements are normally brief and address three main questions:
Why do we exist?
What are we providing?
For whom do we exist?

Mission statement translated into a small number of:
Strategic objectives
Tactical objectives
Operational objectives
Critical success factors

These can be defined as those things that must go right if the objectives and goals
are to be achieved.
Critical success factors may be financial or nonfinancial, but they must be high-level.
There are two types of CSF:
Monitoring: keeping abreast of on-going operations.
Building: tracking progress of the programmes for change initiated by the
executive.
Each CSF must have a Key Performance Indicator (KPI) attached to it so as to allow
measurement of progress towards the CSF. Performance indicators are low level and
detailed. They are measures of performance which indicate whether the CSFs have
been achieved or not.
The process is a participative one at management level and the management
accountant would be involved in mapping the above process, developing the KPIs
and monitoring them.
SF analysis is closely linked to the concept of core competences
There are a number of stages. Each of these will be discussed in more detail later in
the notes.
POSITION ANALYSIS
There are various ways in which a company can assess its position and the
environment in which it operates:
SWOT (both internal and external)
BENCHMARKING
PESTLE (external the world in general)
Impact of stakeholders
Porters 5 Forces (external the companys own industry)
SWOT
SWOT analysis is a strategic planning method used to evaluate the Strengths,
Weaknesses, Opportunities, and Threats involved in a project or in a business
venture. This may be incorporated into the strategic planning model.
The purpose of SWOT is to provide a summarized analysis of the companys current
position in the market place and from this it can address the gap between the current
position and where it wants to be. It can be used to help identify CSFs and
performance indicators.
Construct a SWOT for a no frills airline
Strengths Weaknesses
Opportunities Threats
Benchmarking
There are a number of types of benchmarking.
Internal/External
Strategic
Functional
Operational
Again, the above can only be done if the company has adopted appropriate
performance measures.
Benchmarking can benefit the organisation by:
Highlighting which processes need improvement.
Focusing managers on the need for change.
Helping with efficiency and effectiveness.
Helping to prevent failing to meet threshold competences.
Helping to identify that distinctive competences are in advance of rivals.
The disadvantages of benchmarking include:
Implying that there is a single best way to do things which must be copied by
all.
It is not appropriate if the industry is changing radically.
It can mean the company is always behind its rivals.
The wrong activities might be examined.
How accurate are the measurements.
Strategic
Market share
Return on assets
Gross profit margin
Functional
% deliveries on time
Order turnaround time
Order costs per order
Operational
Show reasons for a functional performance gap and enable
identification of corrective actions required
Stakeholders
Stakeholders aspirations and requirements often conflict.
Managers can use Mendelows matrix to help manage stakeholders.
High
4 1
Probability of
exercising
power
3 2
Low
Low High
Stakeholder power
Quadrant
1. Will have to be given most of what they want in short term at least.
2. Will have to be kept satisfied (may become militant).
3. Can be ignored.
4. Should be kept informed (though they have little power).
Stakeholders can influence business performance by:
Control of strategic resources (strike).
Involvement in strategies.
Possession of knowledge or skills.
Joining other groups with more power.
Management seeks to resolve conflicts by:
Prioritisation Exercising power
Negotiation Sequential attention
Ethical and culture considerations
Organisational culture
Values
Attitudes
Norms
Expectations the way we do things round here Handy
Levels of culture
Basic which guides behaviour within the organisation
Overt expressed in the organisation and members
Visible style of office and dress rules etc
Why does the organisation exist?

To maximise shareholder wealth?
CONFLICT!
To benefit all stakeholders?
Ethical codes
Employee-employer relationship
Customer care
Supplier relations
How should these be implemented?

Senior management should support
Followers prosper
Offenders punished
Explained to all staff
Detail provided
Staff have access to detail
External influences on performance
PEST
PEST analysis stands for Political, Economic, Social, and Technological analysis and
describes a framework of macro-environmental factors used in the environmental
scanning component of strategic management.
With PESTEL the key things to consider are:
Is the current environment making it easier or harder for the organisation? In the
exam things are usually getting harder, look for the financial indicators to be getting
worse because of this.
If the environment is making conditions harder, what can the organisation do about
it? Remember that the macro-environment will affect an entire industry in the same
way. This means all the organisations rivals will also be affected.
If the company is going to move into a new industry what will the conditions be like
(different industries will be affected in different ways)?
Economic, fiscal and environmental factors

Economic consider local economic trends, interest and exchange rates, and
inflation.
Inflation is inflation driving up material and labour costs?
Legal impact of local employment law.
Political is govt policy affecting competition?
EU consider product standards and minimum labour costs?
Cultural these issues can affect motivation, and the adaptability of the
organisation.
Business Cycle is there an economic boom or a recession?
Any others?
Political climate
Governments may act as an aid to business performance in the following ways:
A government can increase aggregate demand for goods and services by
increased government spending and/or by reducing taxation so that firms (and
individuals) have more after tax income available to spend.
Government policy may encourage firms to locate to particular areas. This is
particularly the case where there is high unemployment in such areas.
Government policy via the use of quotas and import tariffs might make it more
difficult for overseas firms to compete in domestic markets.
A government can regulate monopolies in particular with regard to the prices
they charge and the quality of their goods and services.
Government policy can regulate the activities of those firms which do not act in
the best interests of the environment.
Question - Speedy Eat

Speedy Eat is the worlds largest and best-known food service retailing group with
more than 30,000 fast-food outlets in over 120 countries. Currently half of its
restaurants are in the USA, where it first began 50 years ago, but up to 1,000 new
restaurants are opened every year worldwide. Restaurants are wholly owned by the
group (it has previously considered, but rejected, the idea of a franchising of
operations and collaborative partnerships).
As market leader in a fiercely competitive industry, Speedy Eat has strategic
strengths of instant global brand recognition, experienced management, site
development expertise and advanced technological systems. Speedy Eats basic
approach works as well in Kandy or Kuala Lumpur as it does in Kansas: although the
products are broadly similar, menus are modified to reflect local tastes. Analysts
agree that it continues to be profitable because it is both efficient and innovative.
The groups vision is to be the worlds favourite through service, cleanliness and
value, and it is following three main strategies:
1 To achieve profitable growth by building on key strengths.
2 To delight every customer in every restaurant.
3 To be a good employer in each community in which it has a restaurant. (Despite
this, some critics claim staff are mainly unskilled and lowly paid.)
Speedy Eats future plans are to maximise global opportunities and continue to
expand markets. Speedy Eat has long recognised that the external environment can
be very uncertain and consequently does not move into new locations or countries
without first undertaking a full investigation.
You are part of a strategy steering team responsible for investigating the key factors
concerning Speedy Eats entry for the first time into the restaurant industry in the
Republic of Borderland.
Required:
(a) Justify the use of a PEST framework to assist your teams
environmental analysis for the Republic of Borderland. (8 marks)
(b) Discuss the main issues arising from applying this framework.
(12 marks)
(20 marks)
Porters 5 Forces
Porters 5 forces model looks at why some industries might be more profitable than
others. In general the more of the forces that are favourable within an industry the
more profits will be earned. Unfortunately if the industry becomes more attractive
then more rivals will want to enter it.
The 5 forces are:
Competitors (new)
Competitors (existing)
Customers
Suppliers
Substitutes
Porters five forces
Threats from potential entrants
Suppliers Buyers
Competitive rivalry
bargaining power bargaining power
Threats from substitutes
Competitors (new)
New entrants always drive down profit margins (as companies have to spend more
on marketing or lower prices to keep customers). New competitors are only kept out
by barriers to entry. These include:
High fixed costs and capital requirements.
Switching costs.
Access to distribution channels.
Competitors (existing)
If there is a lot of rivalry in an industry then profit margins will be lower as companies
constantly fight to retain their customers.
There will tend to be higher rivalry (and lower profits) when:
Market growth is slow.
If capacity can only be increased in large amounts.
If it is difficult to exit the industry.
Customers
Powerful customers prevent companies from putting prices up or implementing other
changes.
Customers will be powerful if:
There is standardisation within the industry.
The customer makes low profits.
Product quality is not particularly important.
Suppliers
Powerful suppliers might put their prices up or impose other changes on the company.
Suppliers will be powerful if:
There are high switching costs.
Where the suppliers product is necessary to the business and is differentiated
from other suppliers.
Substitutes
If there are many substitutes for a product then it becomes harder to raise prices.
There are three main kinds of substitute:
Direct where the customer buys the same product from a different
manufacturer.
Indirect where the customer buys a product from a different industry to meet
the same need.
Monetary where different industries are competing for the same part of a
customers income.
GAP ANALYSIS
A planning gap is the gap between the forecast position based upon an extrapolation
of projected current activities and the forecast of the desired position. The planning
gap is most often measured in terms of demand but may also be reported in terms
of net profit, return on capital employed etc.
Ultimate objective
$
Revenue GAP
Future
projects
Current
operations
Years
An organisation will forecast the likely performance of its existing projects and also
the expected contribution of future projects.
This is far more difficult since future projects are subject to much greater uncertainty
than current operations and therefore forecasts of future projects have a much wider
margin of error.
Where a gap exists, additional strategies are required. Ansoffs matrix identifies
various options that might be considered in order to close the planning gap.
WHAT IS ANSOFFS GRID?

There are a number of ways in which profits could be increased. These include:
Improved cost control (most of F5 is concerned with this)
Increased divisional performance (much of P5 is concerned with this)
Doing something different
Igor Ansoff comes up with four possibilities to do something different:
Market penetration existing products and existing markets
This might include advertising, driving out competition or getting customers to
buy more products.
Market development existing products and a new market
This might include new distribution channels or price discrimination.
Product development new products and an existing market
This will probably involve looking at the profits of a new product versus an
existing one.
Diversification new products to a new market.
Products
Existing New
Protect/ build Product development

Consolidation New products in
existing markets
Existing Market penetration
Use existing
Withdrawal
capabilities or develop
Efficiency gains new ones
Markets
Market development Diversification
New markets for Related
New existing products
Unrelated
New segments of
existing markets
The above strategies are not mutually exclusive. An organisation might well pursue
a penetration strategy whilst seeking to enter new markets.
Other strategies that can be used include efficiency strategies which are designed to
increase profits (or throughput) by making better use of resources in order to reduce
costs. Also it is possible to reduce a planning gap that is measured in terms of profit
by divesting of loss-making business units. This would obviously not be the case
where a planning gap is measured in terms of sales revenue.
WHAT IS STRATEGIC MANAGEMENT ACCOUNTING?
Traditional management accounting

In earlier management accounting papers you will have looked at various topics such
as costing techniques, budgeting and the calculation of variances.
These measures have similar characteristics. They tend to be:
Short-term
Backwards looking
Focused at individual departments
Able to be produced in standard reports
Able to be produced at regular intervals
Produced by junior staff for senior staff to review
Because of this, all of these measures are useful for CONTROL purposes.
We saw earlier that strategy is concerned with big decisions, such as whether:
to acquire a new company
to launch a new product
develop into a new market
close down a division.
Traditional management accounting will not help with these decisions.
Strategic management accounting

Any strategic decision such as those noted above will need to be justified. This means
the accountant will be involved with preparing information to support a decision.
The main features of Strategic management accounting are:
Externally focused.
Forward looking.
Aimed at achieving the goals of the entire organisation.
Produced when needed.
Not in a standard form.
The kind of information that could be provided includes:
Product profitability why is one product making more profit than another
Customer profitability - why are some customers worth more than others
Pricing decisions including looking at customers and competitors
Brand values How much should be invested in a brand
Shareholder wealth What choices will increase it
Possible acquisition targets
Expected synergistic gains
Decisions on entering new industries or markets
Decisions on launching new products
Decisions on whether to expand certain parts of the business
Decisions on whether to close or sell-off various parts of the business.
The last two points are particularly important. Senior management will need to
identify which parts of the business are performing well and which are under-
performing.
To do this senior management will need to introduce a set of performance measures
which can be used to summarise the performance of the business.
Important areas:
What the business is trying to achieve.
What performance measures would be useful.
How these measures can be calculated.
What the results might mean.
The effect of these measures on the behaviour of departmental managers.
Chapter 2
Performance
management and
control
CHAPTER 2 PERFORMANCE MANAGEMENT AND CONTROL
CHAPTER CONTENTS
WHAT TYPES OF BUDGET ARE THERE? -------------------------------- 33

FIXED BUDGET 33
ZERO BASED BUDGETING 33
ROLLING BUDGETS 33
FLEXED BUDGETS 33
INCREMENTAL 34
WHAT IS THE PROBLEM WITH THE TRADITIONAL BUDGETING

SYSTEM? ------------------------------------------------------------------ 35
BEYOND BUDGETING ---------------------------------------------------- 36

THE MAIN PRINCIPLES OF BEYOND BUDGETING 37
THE MAIN DIFFERENCES TRADITIONAL v BEYOND BUDGETING - 38
THE MAIN BENEFITS OF BEYOND BUDGETING ----------------------- 39
SOURCES OF INFORMATION-------------------------------------------- 40
C H A P T E R 2 P ER F O R M A N C E M A N A G E M E N T A N D C O N T R O L
WHAT TYPES OF BUDGET ARE THERE?

There are a number of alternatives to the annual budget that have been developed.
Fixed budget
A Fixed Budget is designed to remain unchanged irrespective of the volume of output
or turnover attained. The budget remains fixed over a given period and does not
change with the change in the volume of production or level of activity attained.
Zero based budgeting

A problem with the annual, incremental budget is that departments are given money
each year because they have been given it in the past. Zero based is designed to
eliminate this wastage.
ZBB starts with the idea that each manager begins with a zero base of resources.
The manager only receives resources if they can be justified.
It would be particularly suitable for a department which pursues different projects
each year (marketing, IT).
The major objection to ZBB is the time and cost involved in preparing the budget
each year.
Rolling budgets
A problem with the annual, incremental budget is that it can quickly become
unrealistic. This leads to the targets becoming unreachable and managers becoming
demotivated.
The rolling budget is regularly updated based on actual performance. This should
lead to more realistic targets.
Flexed budgets
A problem with the annual, incremental budget is that cost centres are given the
same amount of money to spend regardless of activity.
Flexed budgets adjust the target to reflect the amount of work to be carried out.
The major objection to flexed budgets is that it is difficult to motivate managers to
achieve a target if they do not know what the target is until the end of the period.
Incremental
Incremental budgeting is budgeting based on slight changes from the preceding
periods budgeted results or actual results.
Incremental amounts are added to the previous periods budget for the new budget
period. Since this is based on allocations from the previous period and is progressive
it could lead to a spend it or lose it attitude.
This is a common approach in businesses where management does not intend to
spend a great deal of time formulating budgets, or where it does not perceive any
great need to conduct a thorough evaluation of the business.
WHAT IS THE PROBLEM WITH THE TRADITIONAL

BUDGETING SYSTEM?
The annual budget is one of the most fundamental performance measures used in
companies. The starting point is to take last years performance and then to improve.
The annual budget is designed to:
Turn business plans into figures.
Allow co-ordination between divisions.
Motivate managers and measure performance.
BEYOND BUDGETING
In Beyond Budgeting Hope and Fraser argued that:
Annual budgeting adds little value and takes up too much valuable management
time.
Too heavy reliance on budgetary control in managing performance has an
adverse impact on management behaviour.
The use of budgeting as a base for communicating corporate goals, setting
objectives, assisting continuous improvement, etc. is seen as contrary to its
original purpose as a financial control mechanism.
Most budgets are not based on a rational causal model of resource consumption
and are, therefore, of little use in determining strategy.
The process has insufficient external focus from which to derive targets or
benchmarks.
The argument may be put that increased focus on knowledge or intellectual
capital through competent managers, skilled workforce, effective systems, loyal
customers and strong brands is more likely to yield improved business
effectiveness.
They argue that using rolling budgets and non-financial performance indicators
should:
Create a culture based on beating the competition (since goals are related to
external benchmarks) rather than simply gaining more internal resources.
Rewards can be team-based increasing the amount of motivation.
It is easier to judge the performance of people lower down the organisation
(who are closer to the customers).
It empowers more junior managers meaning they can respond more quickly to
changes in the external environment.
The main principles of beyond budgeting

1. Bind people to a common cause.
2. Govern through shared values and sound judgment not detailed rules &
regulations.
3. Make information transparent dont restrict and control it.
4. Have a network of accountable teams not centralised functions.
5. Trust teams to regulate their own performance.
6. Base accountability on holistic criteria.
7. Set ambitious medium term goals not short term.
8. Reward on relative performance not meeting fixed targets.
9. Continuous and inclusive planning not top down.
10. Co-ordinate interactions within the organisation but not through annual
budgets.
11. Make resources available just in time not just in case.
12. Base controls on frequent feedback not variances.
THE MAIN DIFFERENCES TRADITIONAL v BEYOND

BUDGETING
Traditional Beyond budgeting
Target Incremental targets Stretch goals

Fixed incentives Relative rewards
Plan Fixed Continuous planning

Variance controls KPIs
Resources Central co-ordination On demand

Dynamic co-ordination
Culture Central control Value creation

Management of the numbers Front line authority
Rewards Individual departments have their Viewed as one team

own targets and therefore are
Break down barriers with
unwilling to share expertise, skills
emphasis on learning
and information
THE MAIN BENEFITS OF BEYOND BUDGETING

Beyond Budgeting organisations operate with speed and simplicity. Especially
to customer requests.
An open, continuous and adaptive strategy rather than being constrained by a
fixed, outdated and bureaucratic plan.
Trust to share knowledge and best practices.
Rewards based on performance relative to the peers.
Only by removing traditional budgets will people be motivated to question fixed
costs and seek sustainable long term cost reductions.
Ask does it add value to the customer? often ensures that unnecessary work
is eliminated.
Place customer value needs at the centre of their strategy. Respond to
demands for improvement in quality and cost.
Fast response to customer requests is vital. Thus front line people must have
the authority to make quick decisions and manage their own bit of the business.
Examples of organisations that become empowered and adaptive organisations are:
John Lewis Partnership.
Leyland Trucks.
Toyota.
American Express.
SOURCES OF INFORMATION
Internal sources
Formal
Management accounting information
Control procedures, records and general correspondence
Appraisal systems
Informal
Cross-departmental networking
The Grapevine
Social gatherings
External sources
Formal
Commercial data vendors
Government and official authorities
Trade associations and professional bodies
Informal
Suppliers and other intermediaries
Customers and their representatives
Internet
Key points
What data needs to be collected?
How can it be collected efficiently?
What use is to be made of the information?
The environment needs to be monitored.
Summary of actions taken and information that may be required
STRATEGIC TACTICAL OPERATIONAL

Actions Actions Actions
Type of Executive Decision Support Management

system Information System System Information System
used
(EIS) (DSS) (MIS)
Planning Long-term planning Medium term plans Short-term planning

and
New markets and Implementation of Working capital
decision
new products strategic plans management
making
Financing Control Customer service
Corporate structure Resource planning
Information External Mainly internal Almost all internal

features
Obtained ad hoc Obtained routinely Obtained
frequently, on
demand
Summarised Detailed, or in Very detailed
exception format
Expensive Cheap
Relatively inaccurate Accurate Very accurate
Flexible format Standardised form
Information captured in a retail organisation

Vast amounts of quantitative data are collected by EPOS systems through bar codes
and loyalty cards.
Data such as customer complaints and sales visit reports are also vital evidence of
not only how much is spent but also why. This can give accurate profiles of
consumers.
This data needs to be evaluated for accuracy and relevance so should pass through
an analytical system.
Qualitative information is information that cannot normally be expressed in numerical
terms. It is often in the form of opinions, which show the effects of decisions on
people and the community within which the entity operates.
For example: Employees opinions of store layout.
Control of information
Use of standard templates and definitions for all information that has to be collected.
Reports should be examined periodically to ensure that they are actually being used.
The cost of producing the reports should be compared to the benefit that they give.
Regular backups to safeguard data.
Ensuring PCs are not in publicly accessible areas and that they have password
controls.
Anti-virus software is installed and up to date.
Chapter 3
Organisational
structure and business
integration
C H A P T E R 3 O R G A N I S A T IO N A L S T R U C T U R E A N D B U S I N E S S I N T E G R A T IO N
CHAPTER CONTENTS
TYPES OF STRUCTURE--------------------------------------------------- 45
BUSINESS INTEGRATION ----------------------------------------------- 46

PORTERS VALUE CHAIN 46
PROCESS CHANGE 46
MCKINSEY 7S MODEL 46
THE INFLUENCE OF IT --------------------------------------------------- 48

DATABASES AND DATA WAREHOUSING 48
DATA MINING 48
SUMMARY OF THE IMPACT OF IT 49
TYPES OF STRUCTURE
Functional departments are defined by their functions.
Divisional autonomous regions or product businesses.
Network both within and between organisations in the form of virtual organisations
and organisations that have perhaps outsourced.
BUSINESS INTEGRATION
Business integration refers to linkages of various activities and processes to add value
in an organisation.
Porters value chain

This is a more sophisticated model of business integration, looking at how business
activities are organised.
The value chain views the organisation as a set of interlinked activities, rather than
a set of separate departments. Each activity should add value to the product or
service passing through it, so that ultimately value will be added to what the customer
buys.
Primary inbound logistics, operations, outbound logistics, sales & marketing
and after sales.
Secondary procurement, technology development, HRM and firm
infrastructure.
Process change
Process reengineering this is a fundamental rethink of the business processes that
the organisation carries out, usually driven by changes in the external environment.
This involves an organisation focusing attention inwards to consider how processes
can be redesigned ore re-engineered to improve efficiency.
Process re design this focuses on an extensive improvement in current business
processes, and may involve automation of certain processes, and changes in job
descriptions.
Process improvement this means modifying existing processes, but not replacing
them.
McKinsey 7S model
McKinseys 7s model focuses on seven factors that must be considered and aligned
when planning organisational change.
Hard factors easily influenced by management
Strategy How the organisation will build competitive advantage.
Structure How the organisation is structured, who reports to whom.
Systems Daily procedures and technical infrastructure that is used to help

employees achieve their aims.
Soft factors which are more intangible
Shared values The central factor that influences all others. This reflects the
beliefs of the organisation, and would include the mission and
vision.
Staff The employee base, staffing plans and talent management.
Skills The ability to do the organisations work. It is reflected in the

performance of the organisation.
Style The style of management, and the culture of interaction among

staff.
THE INFLUENCE OF IT
It is widely accepted that IT has greatly influenced the way in which businesses are
run.
Databases, networks and the internet all make it possible to directly access and
manipulate information from both internal and external sources.
Databases and data warehousing

A database may be defined as an organised collection of data and information or a
collection of structured data with minimum duplication, which is common to all users
of the system but is independent of programs, which use the data.
A data warehouse is a database that stores current and historical data taken from
various transactions processing systems.
This data is consolidated to provide management reports and analysis using specific
reporting and query tools.
Benefits of a data warehouse system:

It can provide historical information.
Extensive querying and reporting.
Better information delivery.
Future vision from historical trends.
Tools for looking at data in new ways.
Data mining
This is software that looks for hidden patterns in a group of data.
It turns data into information.
The application involves a number of different analytical approaches:
Associations are when a single event is linked purchase of beer & peanuts.
Sequences is when an event leads to another buy new carpet, return to shop
3 months later for curtains.
Classification is looking at patterns in data why we change our credit cards so
often or types of foods?
Clustering is looks for group classifications best product sold in Wigan.
Forecasting is when patters lead to predictions this years sales based on last
two years.
Due to the vast amounts of data now being stored, it is becoming increasingly
necessary to use data warehousing and mining to navigate and browse the data held
by the company.
Summary of the impact of IT

Computerised control systems E-Commerce, JIT etc
Move to service Industries
Globalisation growth in websites
Use of new technologies eg use of video conferencing for meetings
RFID for stock control
New accounting developments throughput accounting
Employment more and more staff are working off site or from home
Skills have changed IT skills are very important, people skills less
Health and safety working longer hours sat at a PC
Organisational changes flatter management structure
Communication less face to face, communication to all levels by email.
Information and accounting systems need to be developed continually otherwise they
will become out of date either because of advances in technology or environmental
changes.
Chapter 4
Risk and uncertainty

as part of the strategic
planning
C H A P T E R 4 R I S K A N D U N C E R T A IN T Y A S P A R T O F T H E S T R A T E G I C
P L A N N IN G
CHAPTER CONTENTS
EXPECTED VALUES------------------------------------------------------- 53
DRAWBACKS OF EXPECTED VALUES 53
EXPECTED VALUES AND THE PAYOFF TABLE 53
DECISION RULES -------------------------------------------------------- 54

MAXIMIN 54
MAXIMAX 54
MINIMAX REGRET 54
LEARNING CURVE ------------------------------------------------------- 57
C H A P T E R 4 R I S K A N D U N C ER T A IN T Y A S P A R T O F T H E S T R A T E G I C
P L A N N IN G
EXPECTED VALUES
Decision-making involves dealing with future events that cannot be predicted with
any certainty.
It may, however, be possible to predict a range of possible costs and revenues and
the likelihood of them arising.
Expected Values (EVs) are weighted average values based on probabilities. EVs are
a useful tool in business.
They can, for Exercise, be used to calculate the likely number of faulty
components in a production batch and the likely sales of a product over a range
of time periods.
They can also be used to calculate the likely profits of a project, together with
the most profitable course of action. Expected values are of most use in longer
term planning though they still have a role in one off decisions.
The general formula for expected values is:
EV = Px
where:
EV is the expected value of x
= the sum of
x = value of x
P = probability of x occurring
Drawbacks of Expected Values

There are a number of drawbacks to expected values:
Expected values are long-term average values.
They may not apply to one off decisions.
They can be values that will never arise.
Probabilities can be hard to determine.
Expected Values and the payoff table

The results from a particular decision or action are often uncertain and depend on
the circumstances prevailing at the time.
Which CONSEQUENCE (or payoff) that arises from each action depends on the
CIRCUMSTANCES operating at the time a decision is made. These circumstances are
independent of the actions themselves, and it is often possible to assign a probability
value to each of them.
It is possible to construct a payoff table which shows all of the possible consequences
of a particular decision. It is customary to display circumstances as rows and actions
as columns. Consequences or payoffs are cells in the table.
P L A N N IN G
DECISION RULES
Depending on a decision-makers attitude to risk a company may adopt different
approaches to deciding which project or course of action to take.
MaxiMin
In this strategy the decision-maker takes the project that has the least worst outcome
in effect playing it safe.
Remember this is a very conservative strategy that can lead to low returns for a
company. It is also one that completely ignores the likelihood of something
happening.
MaxiMax
In this approach the company seeks to maximise the best possible outcome.
Remember this can be a high risk strategy as no account is take of possible losses or
how likely each outcome is.
Minimax regret
In this decision making rule the decision maker tries to minimises the regret from
making the wrong decision. Regret refers to any opportunities lost as a result of
making the wrong decision.
P L A N N IN G
Question Euxton
Euxton Health Centre specialises in the provision of exercise and dietary advice to
clients. The service is provided on a residential basis and clients stay for whatever
number of days suits their needs.
Budgeted estimates for the year ending 30 June 2012 are as follows:
(i) The maximum capacity of the centre is 50 clients per day for 350 days in the
year.
(ii) Clients will be invoiced at a fee per day. The budgeted occupancy level will vary
with the client fee level per day and is estimated at different percentages of
maximum capacity as follows:
Client fee per Occupancy level Occupancy as percentage of

day maximum capacity
$180 High 90%
$200 Most likely 75%
$220 Low 60%
(iii) Variable costs are also estimated at one of three levels per client day. The high,
medium and low levels per client day are $95, $85 and $70 respectively.
The range of cost levels reflects only the possible effect of the purchase prices
of goods and services.
Required:
(a) Prepare a summary which shows the budgeted contribution earned by
Euxton Health Centre for the year ended 30 June 2012 for each of nine
possible outcomes. (6 marks)
(b) State the client fee strategy for the year to 30 June 2012 which will
result from the use of each of the following decision rules: (i) maximax;
(ii) maximin; (iii) minimax regret.
Your answer should explain the basis of operation of each rule. Use the
information from your answer to (a) as relevant and show any
additional working calculations as necessary. (9 marks)
(c) The probabilities of variable cost levels occurring at the high, medium
and low levels provided in the question are estimated as 0.1, 0.6 and
0.3 respectively. Using the information available, determine the client
fee strategy which will be chosen where maximisation of expected
value of contribution is used as the decision basis. (5 marks)
P L A N N IN G
(d) The residents are provided with breakfast and evening meals at no
extra cost. However, they also have an option to buy a lunchtime meal.
Each meal costs $7 to prepare and would be priced at $15 to customers.
All lunches must be prepared in advance. Based on expected occupancy
levels, the restaurant manager has predicted that daily demand will
either be 10 meals (probability 0.2), 20 meals (probability 0.5) or 30
meals (probability (0.3).
Prepare a pay-off matrix showing the outcomes if the restaurant
manager decides to make 10, 20 or 30 lunches in advance. How many
lunches should the restaurant manager make? (5 marks)
(25 marks)
P L A N N IN G
LEARNING CURVE
It has been observed in some industries that there is a tendency for labour time per
unit to reduce as more of the units are produced and thus workers become more
familiar with the task.
From the experience of aircraft production during World War II, aircraft
manufacturers found the rate of improvement was so regular that it could be reduced
to a formula and the labour hours required could be predicted with a high degree of
accuracy from a learning curve.
The first time a new operation is performed, both the workers and the operating
procedures are untried. As the operation is repeated, the workers become more
familiar with the work, labour efficiency increases and the labour cost per unit
declines.
The learning process starts from the point when the first unit comes off the production
line. From then on, each time cumulative production is doubled, the cumulative
average time per unit is a fixed percentage of its previous level. An 80% learning
curve means that each time cumulative output doubles the cumulative average time
per unit falls to 80% of its previous value.
Example 1
A new product will take 100 hours for the first unit. An 80% learning curve applies.
Required:
Complete the table.
Cumulative Incremental
Units Average Total Units Total Average

time per time per
time time
unit unit
The learning curve table shown above is useful if output keeps doubling, but for
intermediate output levels such information could be obtained graphically or by
formula.
P L A N N IN G
Learning curve formula

Y = a.xb GIVEN
where:
y = average labour hours per unit
a = number of labour hours for first unit
x = cumulative number of units
b = the learning coefficient
log learningcurve rate
b =
log 2
For example an 80% learning curve:

Note: the value of b may be given in exam questions.
Example 2 (using Example 1 data also)

The first unit of a new product is expected to take 100 hours. An 80% learning curve
is known to apply.
Calculate:
(a) the average time per unit for the first 16 units
(b) the average time per unit for the first 25 units
(c) the time it takes to make the 20th unit.
Solution to Example 1
Cumulative Incremental
Units Average Total Units Total Average

time p.u. time time time p.u.
1 100 100 1 100 100
2 80 160 1 60 60
4 64 256 2 96 48
8 51.2 409.6 4 153.6 38.4
16 40.96 655.36 8 245.76 30.72
P L A N N IN G
Solution to Example 2
(a) a = 100 b = 0.3219 x = 16
Y = 100. 16 0.3219
= 40.96 hours
(b) x = 25
Y = 100. 25 0.3219
= 35.48 hours
(c) x = 20
Y = 100. 20 0.3219
= 38.12 hours
Total time for 20 units = 38.12 x 20 = 762.42
X = 19
Y = 100. 19 0.3219
= 38.76 hours
Total time for 19 units = 38.76 x 19 = 736.35
Therefore time for the 20th unit = 762.42 736.35
= 26.07 hours
P L A N N IN G
Question Banana
Banana Ltd manufactures and sells computers. It is investigating the financial
viability of a new product, the Leaf. The Leaf is a laptop computer and will be the
thinnest design available on the market. Initial design, development, production set-
up and marketing costs have been significant. However, if the product is launched,
direct labour costs will decrease over time. The product is only expected to have a
life of 18 months, due to the highly competitive and fast moving nature of the
industry.
The following estimated information is available for the Leaf:
1. Sales should be 1,400 units in the 18 month period. The company currently
operates a traditional approach to establish the selling price by calculating the
cost per unit and adding a 25% mark-up.
2. A 75% learning curve will apply for the first 900 units after which a steady state
production time will apply. The labour time per unit after the first 900 units will
be equal to the time for the 900th unit. The cost of the first unit was measured
at $5,000. This was for 500 hours at $10 per hour.
3. Variable overhead is estimated at $3 per labour hour.
4. Direct material will be $600 per unit for the first 300 units produced. The
second 300 units will cost 80% of the cost per unit of the first 300 units. All
units from then on will cost 80% of the unit cost for each of the second 300
units.
5. The Leaf will require additional machines and factory space to be rented, at a
fixed cost of $11,000 per month.
Note: The learning curve formula is given on the formulae sheet. At the learning
rate of 0.75 (75%), the learning factor (b) is equal to -0.4150.
Required:
(a) Explain the impact of the learning effect on budgeting in Banana Ltd.
(3 marks)
(b) What is the minimum price per unit that the company should quote for
each Leaf? Ignore any design, development, set-up and marketing
costs. (12 marks)
(c) Discuss the relevance of the learning curve in a modern manufacturing
environment, such as Banana Ltd. (5 marks)
(20 marks)
Chapter 5
Performance
evaluation
CHAPTER 5 PERFORMANCE EVALUATI ON
CHAPTER CONTENTS
PROFITABILITY, LIQUIDITY AND GEARING -------------------------- 63
RATIOS ------------------------------------------------------------------- 64
RETURN ON INVESTMENT (ROI) 64
RESIDUAL INCOME (RI) 64
EARNINGS PER SHARE (EPS) 64
PRICE EARNINGS (P/E RATIO) 64
DIVIDEND COVER-------------------------------------------------------- 65
RISK----------------------------------------------------------------------- 66
OPERATING GEARING 66
CAPITAL GEARING 66
INTEREST COVER 66
WHAT DO WE MEAN BY DEBT AND EQUITY?-------------------------- 67

DEBT 67
EQUITY 67
WORKING CAPITAL ------------------------------------------------------ 68
LIQUIDITY RATIOS ------------------------------------------------------ 69
OVERTRADING ----------------------------------------------------------- 70
EARNINGS BEFORE INTEREST, TAX AND DEPRECIATION

ADJUSTMENT (EBITDA) ------------------------------------------------- 71
NPV CASHFLOWS -------------------------------------------------------- 74

SENSITIVITY 74
IRR FORMULA 74
MIRR 74
C H A P T ER 5 P ER F O R M A N C E EV A L U A T I O N
PROFITABILITY, LIQUIDITY AND GEARING

In the exam, the simplest benchmarks will be financial ratios that you have seen at
F3 and F7. Look to calculate measures of:
Profitability
Return on Capital Employed & Residual Income
Investor ratios
Gross Profit Margin & Net Profit Margin
Asset Turnover
Liquidity
Current ratio
Acid ratio
Inventory days
Receivables days
Payables days
Gearing
Operational Fixed costs/Total costs
Financial Debt/Equity ratio
Interest cover
Other measures
EVA
NPV
IRR
MIRR
RATIOS
Return on Investment (ROI)

Also known as return on capital employed (ROCE). It is a percentage measure.
Controllable ProfitBeforeInterest& Tax
ROI = 100
Controllable CapitalEmployed
It gives a measure of the underlying performance of the business before finance. It

gives an indication of the health of the business in generating a return on its
investments.
Gearing has no impact on the return and hence this is the most important measure
of profitability to calculate. The ratio is calculated before tax allowing return to be
compared between companies under differing tax regimes.
Note: Capital employed represents the total funds invested in the business, it
includes equity and long-term debt.
Residual Income (RI)

RI = Pre-tax controllable profits Imputed charge for controllable invested capital
It gives an absolute value and is more consistent with the objective of maximising
the profitability of the company.
Earnings Per Share (EPS)

Profit after tax (PAT)
EPS =
Numberof shares
The portion of a companys profit allocated to each outstanding share of common
stock. Earnings per share serves as an indicator of a companys profitability.
Price Earnings ratio (P/E ratio)

The P/E ratio is a measure of future earnings growth, it compares the market value
to the current earnings.
The higher the P/E ratio, the greater the market expectation of future earnings
growth. This may also be described as market potential.
Marketshareprice
PE =
EPS
DIVIDEND COVER
The amount of profits attributable to shareholders that are actually paid out in the
form of dividend.
The level of dividend cover depends on a number of factors:
1 The type of industry
2 The requirements of the specific shareholders
3 The investment opportunities available
4 Tax implications
5 Dividend policy
EP S
Div Cover =
DP S
RISK
There are three measures:
1. Operational Gearing
2. Capital gearing
3. Interest cover
Operational gearing
Operational gearing looks at the risk associated with the level of fixed costs within a
business. The higher the fixed cost the more volatile the profit. The level of fixed
cost is normally determined by the type of industry and cannot be changed.
It is mainly calculated as
FixedCosts
Operational Gearing =
TotalCosts
It is important to note that the level of operating risk will impact on the level of
financial risk that a company is willing to take on.
Capital gearing
Capital gearing may be calculated in a number of different ways and it is likely that
the examiner will specify the method required. The two main measures are as a ratio
or as a proportion.
Ratio measure Proportion measure
Debt Debt
Capital gearing = 100 Capital gearing = 100
Equity Debt+ Equity
Interest cover
A profit and loss account measure that considers the ability of the business to cover
the cost of debt as it falls due.
PBIT
Interest cover =
Interest
WHAT DO WE MEAN BY DEBT AND EQUITY?
Debt
All permanent capital charging a fixed interest may be considered debt. This
includes:
Debentures and loans.
Possibly bank overdraft if significant and considered part of the permanent
financing.
Finally preference share capital may also be included because of its fixed
coupon. Note a company may be able to defer payment of preference share
dividends and hence these are less risky to the company than straight debt.
Equity
All ordinary share capital and share premium together with reserves.
WORKING CAPITAL
The level of working capital required is affected by the following factors:
1 The nature of the business, eg manufacturing companies need more stock than
service companies.
2 Uncertainty in supplier deliveries. Uncertainty would mean that extra stocks
need to be carried in order to cover fluctuations.
3 The overall level of activity of the business. As output increases, receivables,
stock etc, all tend to increase.
4 The companys credit policy. The tighter the companys policy the lower the
level of receivables.
5 The length of the operating cycle. The longer it takes to convert material into
finished goods into cash the greater the investment in working capital.
Calculation of days
Finished goods days = Finished goods stock / Cost of sales * 365
Receivables days = Receivables balance / Credit Sales * 365
Payables days = Payables balance / Credit Purchases (or COS) * 365
LIQUIDITY RATIOS
Current Assets
Current ratio =
CurrentLiabilities
A simple measure of how much of the total current assets are financed by current
liabilities. If, for example the measure is 2:1 this means that only a limited amount
of the assets are funded by the current liabilities.
Current Assets- Inventory

Quick ratio =
CurrentLiabilities
A measure of how well current liabilities are covered by liquid assets. A measure of
1:1 means that we are able to meet our existing liabilities if they all fall due at once.
These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If
a company suddenly finds that it is unable to renew its short term liabilities (for
instance if the bank suspends its overdraft facilities) there will be a danger of
insolvency unless the company is able to turn enough of its current assets into cash
quickly.
OVERTRADING
Overtrading is trading by an organisation beyond the resources provided by its
existing capital.
Overtrading tends to lead to liquidity problems as too much stock is bought on credit
and too much credit is extended to its customers, so that ultimately there is not
sufficient cash available to pay the debts as they arise.
Overtrading is caused by rapid growth.
Indicators:
Rapid increase in turnover
No matching increase in permanent capital (overtrading is sometimes called
under-capitalisation)
Increase in trade creditor balances
Increasing operating cycle
Decrease in cash/increase in overdraft
Remedies:
Cut back trading
Raise further permanent capital
Improve working capital management
EARNINGS BEFORE INTEREST,TAX AND DEPRECIATION

ADJUSTMENT (EBITDA)
This attempts to get to the heart of the organisation.
It omits:
Interest (financing costs)
Tax (not operating performance)
Depreciation and amortisation (P&L charge)
Advantages Disadvantages
It is a measure of underlying It ignores changes in working capital
performance. and the impact on cash flows.
Tax and Interest are externally It fails to consider the amount of fixed
generated and therefore not relevant asset replacement needed.
to underlying performance.
It can easily be manipulated by
It is easy to calculate. aggressive accounting policies.
It is easy to understand
Question Parkside School of Motoring

Parkside Motor School (PMS) provides driving lessons for first time drivers and those
wanting to take an advanced test. Financial data in respect of the two divisions for the
two years ended 31 December 2011 and 2012 are as follows:
Income Statement 2011 2012
Pass Advanced Group Pass Advanced Group
first first
$000 $000 $000 $000 $000 $000
Revenue 4,700 1,395 6,095 5,190 1,525 6,715
Salaries 1,600 649 2,249 1,695 690 2,385

Instruction materials 215 115 330 230 125 355
Other operating costs 1,290 465 1,755 1,456 485 1,941
3,105 1,229 4,334 3,381 1,300 4,681
Marketing 260 80 340 320 92 412

Interest (group) 180 150
Depreciation & 385 95 480 385 100 485
amortisation
645 175 1,000 705 192 1,047
Total cost 3,750 1,404 5,334 4,086 1,492 5,728
Profit 950 (9) 761 1,104 33 987
Summary balance
sheets
Non-current assets 2,815 400 3,215 2,865 420 3,285

Net current assets 425 85 510 438 98 536
3,240 485 3,725 3,303 518 3,821
10% loan stock 1,800 1,500
1,925 2,321
Capital and reserves 1,925 2,321
Further information:
The Pass First division has a block offer 10 lessons for the price of 9. Whilst the
Advanced division takes booking and often invoices after the lessons and exams have
taken place.
Three months after passing with the Pass first division, a student will be contacted by
the Advanced division for further advanced training.
Required:
(a) Provide an assessment of the financial performance of PMS group and
the contributions of the Pass first and Advanced division during the two
years ended 31st December 2012. (11 marks)
(b) Discuss additional information that would be useful in order to provide
a more comprehensive assessment of the financial performance of each
operation. (3 marks)
(c) Explain three advantages and three disadvantages of using Earnings
before Interest, Taxation, Depreciation and Amortisation (EBITDA) as a
performance measure. (6 marks)
(20 marks)
NPV CASHFLOWS
0 1 2 3 4
$ $ $ $ $
Operating Cash-flows
Inflows X X X
Outflows (X) (X) (X)
X X X
Taxation (X) (X) (X)
Initial Investment (X)
Scrap Proceeds X
Capital Allowances X X X/(X)
Working Capital (X) X
(X) X X X (X)
Discount Factors 1 X X X X
Present Value (X) X X X (X)
Net Present Value $X/(X)
Sensitivity
NPV
PV of uncertain cash flow * 100%
IRR formula
IRR represents the discount factor that leads to an NPV equal to zero.
NPVA
IRR A B - A
NPVA NPVB
A = Lower discount rate
B = Higher discount rate
NPVA = NPV calculated at A
NPVB = NPV calculated at B
MIRR
Internal rate of return, or IRR, is used to compare the profitability of various
investments. IRR is most commonly used in corporate capital budgeting analysis.
Modified internal rate of return, or MIRR, is similar to IRR except that it assumes that
all future cash flows are reinvested at a lower rate, such as a risk-free rate or the
firms cost of capital. IRR assumes that all future cash flows are reinvested at the
project rate. MIRR better reflects the true economic benefit of a project.
Chapter 6
Divisionalisation
C H A P T E R 6 D IV I S IO N A L I S A T IO N
CHAPTER CONTENTS
DIVISIONALISATION --------------------------------------------------- 77
SHORT-TERM MEASURES ----------------------------------------------- 78

RETURN ON INVESTMENT (ROI) 78
RESIDUAL INCOME (RI) 78
WHAT IS MEANT BY ECONOMIC VALUE ADDED? --------------------- 80
C H A P T ER 6 D IV I S IO N A L I S A T IO N
DIVISIONALISATION
Usually divisionalisation is accompanied by decentralisation. This means that each of

the divisions will be run by a divisional manager.
Reasons for divisionalisation and decentralisation include:

Greater speed of decision-making by divisional managers.
Divisional managers have a greater understanding of their own markets.
Senior managers (in the centre) are freed up to concentrate on strategic issues
rather than operational ones.
Less experienced staff can be put in charge of small divisions and allowed to
gain experience.
The divisional managers should be motivated to perform better (particularly if
divisions are encouraged to compete with each other).
Problems with divisionalisation and decentralisation include:

Duplication of functions.
Senior managers may not have all the information to make decisions.
Competing with each other might lead divisions to make decisions which are
good for them but not for the company as a whole (this is known as
dysfunctional decision-making).
Senior management may lose track of what is actually happening in each
division.
SHORT-TERM MEASURES?
Three key ratios:
Return on Investment
Residual Income
Economic Value Added
RETURN ON INVESTMENT (ROI)

Controllable Profitbeforeinterestand tax
ROI =
Controllable CapitalEmployed
Advantages of ROI Disadvantages of ROI

Relative measure (%), therefore ROI increases as assets get older if
aids comparisons NBVs are used, thus giving
managers an incentive to hang on
Used externally (ROCE) and
to possibly inefficient obsolete
therefore understood by users
machines
Encourages good use of existing
May lead to dysfunctional decision
capital resources
making, eg a division with an
It can be broken down into current ROI of 30% would not
secondary ratios for more detailed wish to accept a project offering
analysis an ROI of 25% as this would
reduce its current figure
Different accounting policies can
confuse comparisons
RESIDUAL INCOME (RI)

RI = Pre tax controllable profits - imputed charge for controllable invested
capital
Advantages of RI Disadvantages of RI
Reduces the problem of rejecting Does not facilitate comparisons
projects with ROIs greater than between divisions
the group target but less than the
Does not relate the size of a
divisions current ROI
divisions profit to the assets
Possible to use different rates of employed in order to obtain that
interest for different types of asset profit
Cost of financing a division is
brought home to divisional
managers
What measures can be used to assess divisions in the Long-term?

Both RI and ROI have problems when being used to evaluate long-term decisions.
This problem arises because of the way in which depreciation is calculated.
This is potentially a very big problem with using them since most projects undertaken
by managers are for the long-term.
The way round this problem is to use a technique called annuity depreciation.
Class illustration
The company is reviewing investment in an asset for $1.4m. It is expected to
depreciate on a straight line basis over 4 years with a zero residual value. The
forecasted net cash flows are $460,000 per annum and the cost of borrowing is 8%.
Calculate ROI and RI based on opening capital employed.
Calculate ROI and RI using annuity depreciation.
WHAT IS MEANT BY ECONOMIC VALUE ADDED?

EVA is very similar to Residual Income, in fact the calculations look almost identical.
Probably the most widely used approach to measuring value-creation is Economic
Value Added or EVA.
EVA has been popularised by Stern Stewart, a major consulting firm that holds the
registered trademark for EVA.
Many large organisations have adopted EVA, such as Coca-Cola and Whirlpool. EVA
like all value-based metrics departs from the traditional accounting model. The basic
equation for calculating EVA is:
Net operating profit after tax (NOPAT) capital employed x cost of capital
NOPAT CAPITAL EMPLOYED
Accounting profit after XXX Total assets (non current + XXX

tax current) in the Statement of
Financial Position
Add: Add:
Goodwill amortised XX Cumulative amortised goodwill XX
Provision of doubtful XX Allowance for receivables XX

debts (provision for doubtful debts)
Development costs XX Economic value (NBV) of XX

capitalised development costs
Non cash expenses XX Economic value (NBV) of XX

capitalised operating leases
Interest paid net of XX

tax* (*so if tax is at
30%, take interest
payments x 0.70)
Deduct: Deduct:
Economic (XX) Non-interest bearing activities (XX)

depreciation (eg trade payables and tax
payable)
Any impairment in (XX)

the value of goodwill
NOPAT in cash flow XXX Capital invested XXX

terms
The difference between EVA and RI lies in what is included in economic profit and
what is included in net assets.
The advantages of EVA include:

Less distortion by accounting policies since the measure is closer to cashflows.
An absolute value which can easily be understood.
Increasing EVA should result in increase of real wealth for shareholders.
Encouraging expenditure on costs which build up the business by treating them
as an investment rather than an expense.
Disadvantages include:
Focus on short-term performance.
Focus on part performance.
Potentially a large number of adjustments need to be made, making it difficult
to compare different investment centres.
Chapter 7
Transfer pricing
C H A P T E R 7 T R A N S F E R P R I C IN G
CHAPTER CONTENTS
TRANSFER PRICING ----------------------------------------------------- 85
WHAT OTHER METHODS OF TRANSFER PRICING ARE USED? ------- 86
C H A P T ER 7 T R A N S F ER P R I C IN G
TRANSFER PRICING
Divisional managers will be judged on their divisions performance.
The manager of each division knows that if the divisions performance is good they
will receive a bonus and their division might be expanded alternatively if the divisions
performance is poor they will get fired and the division might be closed down
Two common methods of evaluating performance seen earlier include ROI & RI
Both of these measures include a profit figure, so the manager of each division will
try to maximise revenue and or minimise costs
The idea behind transfer pricing is to promote goal congruence. In other words,
managers do what is good for the company because it is also good for their own
division.
In order to promote goal congruence we must ensure that the transfer price
encourages the divisions to trade with each other only when it is appropriate for the
organisation as a whole.
The aim is to set a price that will give a fair measure of performance and to do this
we follow a simple rule:
All goods and services should be transferred at the marginal cost of manufacture
when spare capacity and if not then transfer at marginal plus the opportunity
cost of the lost contribution.
Question Maple
Maple Ltd has been offered supplies of special ingredient Z at a transfer price of $15
per kg by Hexton Ltd, which is part of the same group of companies.
Hexton Ltd processes and sells special ingredient Z to customers external to the
group at $15 per kg. Hexton Ltd bases its transfer price on total cost-plus 25% profit
mark-up. Total cost has been estimated as 75% variable and 25% fixed.
Required:
Discuss the transfer prices at which Hexton Ltd should offer to transfer
special ingredient Z to Maple Ltd in order that group profit maximising
decisions may be taken on financial grounds in each of the following
situations:
(i) Hexton Ltd has an external market for all its production of special
ingredient Z at a selling price of $15 per kg. Internal transfers to Maple
Ltd would enable $1.50 per kg of variable packing cost to be avoided.
(ii) Conditions are as per (i) but Hexton Ltd has production capacity for
3,000kg of special ingredient Z for which no external market is
available.
(iii) Conditions are as per (ii) but Hexton Ltd has an alternative use for
some of its spare production capacity. This alternative use is
equivalent to 2,000kg of special ingredient Z and would earn a
contribution of $6,000.
C H A P T E R 7 T R A N S F E R P R I C IN G
WHAT OTHER METHODS OF TRANSFER PRICING ARE

USED?
In certain cases the company may want to do things slightly differently.
Market price
If there is one single price that the external customer is willing to pay and that the
external supplier is willing to charge then it makes sense to use this as the transfer
price.
Adjusted market price
In some cases there will costs that can be avoided if the goods are transferred
internally (eg packing costs). It makes sense when calculating the transfer price to
deduct these from the market price used above.
Marginal cost plus
Division M will have fixed costs in addition to variable ones. If the marginal cost only
is used there is a danger that M will make a loss. The transfer price might be set as
the marginal cost plus an amount towards these (the same as using a fixed overhead
absorption rate). Alternatively a lump sum could be paid annually to help pay the
fixed costs.
Dual pricing
This is where different prices are recorded in the books of M and A. For example A
would record a cost of $3 (the marginal cost) in its books but M would record a sale
of $6 in its books. This would obviously mean an adjustment would need to be carried
out at the end of the year when the consolidated accounts were being prepared.
There are a number of additional issues when the transfer is between

divisions in different countries:
Exchange rate fluctuation
Taxation rates
Import tariffs
Fund repatriation
Anti-dumping legislation.
Chapter 8
Performance
evaluation
CHAPTER CONTENTS
WHAT IS THE BALANCED SCORECARD APPROACH? ----------------- 89
WHAT IS THE PERFORMANCE PYRAMID APPROACH?---------------- 90

UNDERSTANDING THE PYRAMID 91
WHAT IS THE BUILDING BLOCKS APPROACH? ----------------------- 92
BCG MATRIX-------------------------------------------------------------- 93
PERFORMANCE PRISM -------------------------------------------------- 94
NOT FOR PROFIT ORGANISATIONS ----------------------------------- 95

VALUE FOR MONEY 95
ROLE OF QUALITY IN PERFORMANCE MEASUREMENT SYSTEMS --- 96

TOTAL QUALITY MANAGEMENT (TQM) 96
SIX SIGMA 96
KAIZEN COSTING -------------------------------------------------------- 98
TARGET COSTING -------------------------------------------------------- 99

TRADITIONAL APPROACH TO COSTING 99
TARGET COSTING APPROACH 99
REDUCING THE COST GAP 99
BENEFITS OF TARGET COSTING 99
JUST-IN-TIME (JIT) ---------------------------------------------------- 101

THE TRADITIONAL ENVIRONMENT 101
WHAT IS THE BALANCED SCORECARD APPROACH?

Kaplan and Norton devised a range of measures that assist managers to focus on
what affects the performance of a division.
The four areas to look at are:
Financial perspective how does the division create value for the
organisation?
Customer perspective what do new and existing customers value the
division for?
Innovation and learning how can the division continue to deliver value?
Internal business what processes must the division excel at to meet the
objectives of the organisation and the customers?
Main benefits of using the balanced scorecard include:

Forcing managers to look at internal and external issues.
Focussing on key elements of a companys strategy.
Linking non-financial results with financial ones.
For example highlighting the impact on customers if cheaper materials are
used).
Major drawbacks of using the balanced scorecard include:

Improving in some areas will probably lead to deterioration in others.
It may be hard to come up with measures in all areas.
It may lead to too many things being measured.
There may be too many measures to interpret easily.
WHAT IS THE PERFORMANCE PYRAMID APPROACH?

The idea behind this model is that the entire organisation needs to work together in
order to achieve success. The approach is to try to link the overall strategy of the
company with what is happening on a day-to day level.
1 VISION Corporate vision
2 Market Financial SBUs
Business
3 Customer Flexibility Productivity Operating
satisfaction Systems
4 Quality Delivery Cycle time Waste Depts
Understanding the pyramid

At the top is the vision how it will achieve long-term success and competitive
advantage.
The second level is the business unit, which includes setting CSFs.
The third level is the business operating systems how well we respond to customer
demands.
At the bottom level of the pyramid is what Lynch and Cross label as measuring in the
trenches. Here the objective is to increase quality and delivery and decrease cycle
time and waste. At this level a number of non-financial indicators will be used in
order to measure the operations.
The four levels of the pyramid are seen to fit into each other in the achievement of
objectives. For example, improved quality will assist in the achievement of customer
satisfaction and hence growth and market position.
The left hand side contains the measures which are predominantly externally focused
and non financial. On the right hand side is internally focused, thus improving
efficiency and are mostly financial in nature.
Objectives cascade down, whilst measures and information flow upwards.
WHAT IS THE BUILDING BLOCKS APPROACH?

Fitzgerald and Moon designed a system of non-financial performance indicators
specifically for service industries
There are three aspects to building a performance measurement system:
Standards (KPIs) what the company expects:
Ownership
Achievability
Equity
Rewards what the manager will receive:
Clarity
Motivation
Controllability
Dimensions (Goals / CSFs) what will be measured?
Innovation new product numbers
Quality- product reliability
Resource utilisation - productivity
Flexibility delivery time
Competitive performance market growth
Financial performance - ROCE
The thinking is that getting the top five correct will lead to a strong financial
performance.
BCG MATRIX
The BCG matrix helps a company think about the portfolio of products and services
which it offers and make decisions about which it should keep, which it should let go
and which it should invest further in.
High
STAR QUESTION MARK
(usually at growth (usually at introduction

stage of PLC) stage of PLC
Market
growth
CASH COW DOGS
(usually at maturity (usually towards

stage of PLC) end of PLC)
Low High Low
Relative Market Share
Dogs
These are products, which have low market shares and low market growth rates. The
options for many companies is to phase these products out, however some
organisation do go for the strategy of re-inventing and injecting new life into the
product.
Question Mark/Problem Child

These are products with low market share but operate in high market growth rates.
The company puts a lot of resources in this product in the hope that it will eventually
increase market share and generate cash returns in the future.
Cash Cow
Cash Cows are products at the mature stage of the lifecycle, they generate high
amounts of cash for the company, but growth rate is slowing. There are chances
that the product may slip into decline; appropriate marketing mix strategies should
be employed to try to prevent this from happening.
Star
Stars have high market shares that operate in growing markets. The product at this
stage should be generating positive returns for the company.
PERFORMANCE PRISM
The prism takes an alternative look at performance management, and sets out
explicitly to identify how managers can use measurement data to improve business
performance.
It was developed by the Centre for Business Performance at the Cranfield School of
Management. It aims to take into account all of the stakeholders interests.
The Five Facets of the Performance Prism
Stakeholder Satisfaction
Strategies
Processes
Capabilities
Stakeholder Contribution
Five key questions for measurement design

1. Stakeholder satisfaction Who are they? What do they want?
2. Strategies What strategies do we need to put in place to satisfy the
stakeholders?
3. Processes What do we need to execute the strategies?
4. Capabilities? What capabilities do we need to operate and enhance these
processes?
5. Stakeholder Contribution What contributions do we require from our
stakeholders?
NOT FOR PROFIT ORGANISATIONS
Value for money

The primary objective stated (maximisation of shareholder wealth) and its profit-
based derivatives are not applicable to not-for-profit organisations such as charities
and government bodies.
A more suitable objective in such circumstances would be along the lines of:
Provide benefit to the prescribed group(s) of users.
Examples are:
Public sector medical care, museums, art galleries and some transportation.
Private organisations charity, self-help organisations and environmental
groups.
In the Corporate form agents of the government, co-operatives or clubs.
Value for money (VFM)

As the services of such organisations are very often not expressed in monetary terms,
it is important to ensure that value for money is achieved. In order to do this, the
principle of 3 Es can be applied.
3 Es
Effectiveness Match the service provision to the need.
Economy Source the resource input at the lowest cost.
Efficiency Maximise the output of services for a given level of resource input.
What are the main difficulties in measuring performance in NFP Organisations?
ROLE OF QUALITY IN PERFORMANCE MEASUREMENT

SYSTEMS
Total Quality Management (TQM)

A philosophy of continuous improvement, and where preventing failure is always
more preferable to correcting failure.
Get it right first time
Eliminate non-value adding activities
Communicated to all
Continuous improvement
Quality Costs
Quality costs may be monitored by measuring costs of non-conformance and costs
of conformance.
Costs of non-conformance occur when the product fails to reach the design quality
standards. Such costs may be subdivided into internal failure costs and external
failure costs.
Internal failure costs occur when the failure is detected before the transfer
of the product to the customer.
External failure costs occur when the failure to reach the required standards
is not detected until after the product has been transferred to the customer.
Costs of conformance are those incurred in reducing or eliminating the costs of non-
conformance. Such costs may be subdivided into appraisal costs and prevention
costs.
Appraisal costs are those associated with the evaluation of items such as
purchased material and services in order to ensure that they conform to the
agreed specification.
Prevention costs are those associated with the implementation of a quality
improvement programme. Such costs are planned in advance and their
implementation should lead to continuous improvement.
Six Sigma
The main theory of quality improvement in Paper P5 is the Six Sigma concept. The
idea is to try and reduce the chance of an item failing to be of a good enough quality.
This does not mean having a single standard, there may be a range of values which
are acceptable.
This range is known as the tolerance. For example a hamburger chain may say that
as long as a burger is not too hot or too cold it is acceptable. This would give a range
of acceptable temperatures (the tolerance).
The six sigma approach is about many gradual improvements rather than occasional
large ones.
Six Sigma can be implemented using the DMAIC approach:
Define
Define the problem.
Clarify the purpose of the project.
Develop the project plan.
Measure
Data collection to quantify the problem.
Measure the key processes that are critical to quality.
Analyse
Analyse data to find the root cause of the problem.
Consider the process itself, materials, environmental factors and the activities
of staff involved in the process.
The results from the analysis may lead to modifications in the definition of the
problem.
Improve
Develop solutions.
Implement them.
Control
Monitor changes.
Deal with problems arising.
The control process will focus on key performance measures.
KAIZEN COSTING
Japanese term for Continuous Improvement.
Kaizen budgeting incorporates expectations for continuous improvement into
budgetary estimates. Kaizen costing determines target cost reductions for a
period, such as a month. Thus, variances are the differences between actual and
targeted cost reduction.
The objective is to reduce actual costs below standard costs. The cost-reduction
activities associated with the Kaizen approach minimise costs throughout
the entire product life cycle. Therefore, it has the advantage of being closely
related to the entitys profit-planning procedures
Kaizen is a daily activity whose purpose goes beyond improvement. It is also a
process that, when done correctly, humanises the workplace, eliminates overly hard
work (both mental and physical), and teaches people how to perform experiments
using the scientific method and how to learn to spot and eliminate waste in business
processes.
Kaizen must operate with three principles in place:
1. process and results (not results-only);
2. systemic thinking (ie big picture, not solely the narrow view);
3. and non-judgmental, non-blaming (because blaming is wasteful).
People at all levels of an organisation participate in kaizen, from the CEO down, as
well as external stakeholders when applicable. The format for kaizen can be
individual, small groups or large groups.
Within Toyota it was a local improvement within a local area and involved a small
group in improving their own work environment and productivity.
Whilst Kaizen (in Toyota) usually deliver small improvements the culture of continual
small improvements and standardisation yields large results in a form of compound
productivity improvement.
TARGET COSTING
Traditional approach to costing

1. Estimate the cost of the product.
2. Add a profit mark up or margin.
3. Determine selling price.
Target costing approach

1. Estimate price needed to reach target market share.
2. Estimate a target profit to reach a required return on capital.
3. Determine the cost needed to reach this target profit.
Cost Target
Reduce the cost gap
now cost
Reducing the cost gap

Simplification of design to reduce complexity.
New suppliers to reduce cost of components.
Use of standardised components.
Use of high efficiency machinery.
Training of staff to improve productivity and reduce waste.
Benefits of target costing
Early external focus

The organisation will have an early external focus to its product development.
Businesses have to compete with others (competitors) and an early consideration of
this will tend to make them more successful. Traditional approaches (by calculating
the cost and then adding a margin to get a selling price) are often far too internally
driven.
Value adding features only

Only those features that are of value to customers will be included in the product
design. Target costing at an early stage considers carefully the product that is
intended. Features that are unlikely to be valued by the customer will be excluded.
Early cost control

Cost control will begin much earlier in the process. If it is clear at the design stage
that a cost gap exists then more can be done to close it by the design team.
Traditionally, cost control takes place at the cost incurring stage, which is often far
too late to make a significant impact on a product that is too expensive to make.
Lower costs per unit

Costs per unit are often lower under a target costing environment. This enhances
profitability. Target costing has been shown to reduce product cost by between 20%
and 40% depending on product and market conditions. In traditional cost plus
systems an organisation may not be fully aware of the constraints in the external
environment until after the production has started. Cost reduction at this point is
much more difficult as many of the costs are designed in to the product.
Reduced time to market

It is often argued that target costing reduces the time taken to get a product to
market. Under traditional methodologies there are often lengthy delays whilst a team
goes back to the drawing board. Target costing, because it has an early external
focus, tends to help get things right first time and this reduces the time to market.
JUST-IN-TIME (JIT)
JIT systems are designed to produce or procure products or components as they are
required by the customer or for use, rather than for inventory. A JIT system is a
pull-system, which responds to demand, in contrast to a push-system, in which
inventories act as buffers between the different elements of the systems, such as
purchasing, production and sales.
The main focus of JIT is therefore to reduce stock levels, but to achieve this, there
must be an emphasis on quality.
The traditional environment

The traditional business environment is a push system in which one process supplies
parts to the next process without regard to the ability to continue work on those
parts.
This extends onto producing finished goods inventory ready for sale to customers.
Work in progress, inventory of raw materials and finished goods inventory are an
inherent part of such a traditional system.
JIT Values
described as a philosophy, or approach to management
encompasses a commitment to continuous improvement and the pursuit of
excellence
a pull system.
A JIT system operates in such a way that production and resource acquisition should
be pulled by customer demand rather than being pushed by a planning process.
Responding quickly to customer demand and resources are acquired and utilised only
when needed.
A JIT system operates with little or no inventories and in order to be able to operate
in this manner, an organisation must achieve excellence in the following areas:
Production scheduling
Supplier relations
Information systems
Quality controls
Customer relations.
Chapter 9
Performance system
issues
C H A P T E R 9 P E R F O R M A N C E S Y S T EM I S S U E S
CHAPTER CONTENTS
PRICING ----------------------------------------------------------------- 105
HUMAN RESOURCE MANAGEMENT ISSUES--------------------------- 106

HOW DOES THE ORGANISATION SET REWARDS? 106
TYPES OF REWARD 107
THE ROLE OF THE APPRAISAL SYSTEM IN REWARD SYSTEMS 108
PERFORMANCE MEASUREMENT ISSUES 108
BEHAVIOURAL ASPECTS OF PERFORMANCE EVALUATION 109
ACTIVITY BASED TECHNIQUES --------------------------------------- 111

THE ACTIVITY BASED COSTING PROCEDURE 111
ACTIVITY BASED BUDGETING 111
ACTIVITY BASED MANAGEMENT 112
C H A P T ER 9 P ER F O R M A N C E S Y S T EM I S S U E S
PRICING
What are customers prepared to pay?
What price will cover costs?
What do competitors offer and at what price?
Pricing strategies have to be seen in the light of the generic

competitive strategies:
Cost leadership keep costs low.
Differentiation make products distinct from competition.
Focus specialise in a small section of the market.
Summary of pricing methods:

Cost plus mark up added.
Target pricing find required profit and work back.
MR=MC (see later).
Market skimming enter at high price and skim off customers willing to pay,
then fall to attract more customers.
Penetration pricing start at low price, then raise once established.
Perceived value pricing what are customers willing to pay?
Product range pricing Sell initial item cheap and then follow up parts more
expensive.
Competitive pricing what do competitors charge?
Price differentiation Same product sold at different prices in different markets.
Let us remind ourselves of the traditional method of profit maximization when MR =
MC.
Price as P = a - bQ
Marginal revenue MR = a 2bQ
MC = MR
Insert the quantity back in to get a price.
SEE ILLUSTRATION IN CLASS.
HUMAN RESOURCE MANAGEMENT ISSUES

How does the organisation:
Ensure the recruitment of the correct calibre of employee?
Manage the employee correctly not just daily but through development and
training?
Communicate to them what their role is and how it will be assessed?
Motivate them to work together to achieve the companys objectives?
Reward their staff for any achievements?
How does the organisation set REWARDS?

What is reward?
Reward system refers to all monetary, non-monetary and psychological payments
that an organisation provides for its employees in exchange for the work they
perform.
Objectives of a reward scheme:

Support the goals of the organisation.
Ensure recruitment and retention of employees with the correct skills.
Motivate employees.
Align the risk preferences of managers and employees with those of the
organisation.
Comply with legal regulations.
Be ethical.
Affordable and easy to administer.
Practical problems
The practical problems in implementing a scheme to reward divisional managers will
include the following:
Deciding on acceptable performance measures
Managers will normally be rewarded according to how the division performs on
certain key measures. These measures must be chosen carefully so that the
manager accepts that these measures are a valid test of his performance. The
measures must also ensure goal congruence between the company and the
manager.
Deciding how the results are measured
Most performance measures are accounting ratios or results produced by the
division. Depending on the accounting policies adopted by the company, these
results can be affected, either favourably or unfavourably by transfer pricing
between divisions and dysfunctional behaviour of managers.
Ensuring that the company meets long term objectives

Performance measures must therefore be chosen which adequately reflect the
short term goals of the manager, and the longer term goals of the company.
Difficulty of finding a comprehensive assessment system
It is unlikely that financial results on their own will provide a comprehensive
system of assessment for the company; non-financial indicators may also be
used. Whatever performance system is chosen it will remain important to
provide managers with relevant information about the performance measures.
Action can then be taken in a timely fashion to correct any poor results in the
division.
Remember: improving managerial performance will only work if the organisation can
correctly identify the factors that motivate and de-motivate managers.
Money most people appear to work harder for a higher financial reward.
Esteem companies providing the opportunity for individuals to gain esteem
from others may therefore motivate their managers.
Participation by providing participation in the setting of their performance
measures.
People will react differently depending on their individual situation.
How does the organisation align its reward practices with its
strategy?
The company has to consider:
What to measure? How to measure it?
Is it competitive? Is it equitable?
Types of reward
Basic pay.
Performance-related pay such as:
Piecework
Individual schemes
Group related performance schemes
Knowledge contingent pay
Commissions
Profit related pay
Stock option plans.
Pension scheme.
Benefits in kind.
The role of the appraisal system in reward systems

As employees performance needs to be assessed this usually takes place through the
appraisal process. Staff will be appraised on a regular basis, for example twice a
year.
During this process targets will be set for the next period and rewards agreed if
targets are met.
A good performance related reward system should motivate your employees to work
harder. However designing such reward system is complicated and time consuming
and can easily go wrong.
Performance measurement issues
How do you find the best way to measure managerial

performance?
There are various ways to assess performance some financial and some non financial.
Distinguishing between the mangers performance and that of the division is often
difficult.
Remember deciding on what measures are best for your business and how to
measure them is not easy.
Is the cost controllable or not?

Managers should only be held accountable for costs over which they have some
influence.
Most variable costs are controllable by either a junior or senior manager. However,
some are non-controllable, such as increases in expenditure due to inflation.
Apportioned overheads such as rent and rates would not be controllable by say a
production manager.
Sometimes a particular cost might be the responsibility of two or more managers. A
reporting system must allocate responsibility appropriately. Eg the purchasing
manager would be responsible for an increase in material prices whilst the production
manager for material usage.
Accountancy through management control systems
Hard accountability
Converting activities and outcomes into numbers number/type of warranty
claim.
Ensuring numbers are accounted for numbers of complaints
answered/resolved.
Being held accountable for being held responsible for the complaints.
Soft accountability
This considers the human input to the system such as a managers role in shaping,
evaluating and implementing the goals. Their self-accountability!
Behavioural aspects of performance evaluation

Unfortunately there are a number of problems associated with performance
measurement:
Tunnel vision under focus on performance measures to the detriment of other
areas of the business.
Sub-optimisation focus on a few objectives so that others are not achieved.
Misinterpretation failure to recognise the complexity of the environment in
which the organisation operates.
Myopia short sightedness leading to the neglect of longer term plans.
Measure fixation focusing on the wrong areas.
Misrepresentation creative reporting.
Gaming deliberate distortion of a measure.
Ossification unwillingness to change a measure once it has been set up.
Question BGL
You are the Senior Management Accountant of Better Gardens Ltd (BGL), a well-
established manufacturer of a range of conservatories, summerhouses and large
garden ornaments. The companys turnover and after-tax profits for the year ending
31 May 2012 are forecast to be $100 million and $20 million respectively. The
company has 350 employees in total who are comprised as follows:
Function/level: Number of employees

Directors/Senior managers 20
Sales staff 40
Assembly staff 250
Administrative and support staff 40
BGLs products are sold to specialist Garden Centres by its sales staff, each of whom
is home-based. The forty sales staff work from home and are supported by
administrative and support staff who also undertake telephone-based selling
activities.
The manufacture of conservatories and summer-houses is undertaken by 210
assembly staff, some of whom work in teams and others who work on an individual
basis. The large garden ornaments, each of which is hand-finished, are produced by
40 assembly staff who are responsible for their individual output.
The directors of BGL are considering whether to implement a reward scheme for all
employees within the organisation.
They have approached you for advice with regard to this matter. The production
director recently stated if we implement a reward scheme then it is bound to be
beneficial for BGL.
Required:
(a) As Senior Management Accountant, prepare a memorandum to the
directors of BGL which explains:
(i) the potential benefits to be gained from the implementation of a
reward scheme; (7 marks)
(ii) the factors that should be considered in the design of a reward
scheme for BGL; (10 marks)
(iii) whether you agree or not with the statement of the production
director. (4 marks)
(b) Briefly discuss how stakeholder groups (other than management and
employees) may be rewarded for good performance. (4 marks)
(25 marks)
ACTIVITY BASED TECHNIQUES
The activity based costing procedure

Cooper and Kaplan stated that it was the support activities that were the cause of
many overheads, for example, material handling, quality inspection, setting up
machinery, material acquisition, etc.
Thus a simple three-step philosophy was developed:
support activities cause cost;
the products consume these activities;
cost should, therefore, be charged on the basis of consumption of the activities.
Method
1. Identify the organisations major activities.
Ideally about 30 to 50 activities should be identified. However, over time, some
large firms have been known to develop hundreds of activities. A suitable rule
of thumb is to apply the 80/20 rule: identify the 20% of activities that generate
80% of the overheads, and analyse these in detail.
2. Estimate the costs associated with performing each activity these costs are
collected into cost pools.
3. Identify the factors that influence the cost pools. These are known as the cost
drivers. For example, the number of set-ups will influence the cost of setting
up machinery.
4. Calculate a cost driver rate, for example a rate per set-up, or a rate per material
requisition, or a rate per inspection.
Costpool
Cost driver rate =
Levelof cost drivers
5. Charge the overheads to the products by applying the cost driver rates to the
activity usage of the products.
Activity based budgeting

Activity based budgeting comes from the principles of activity based costing. The
basic ideas are:
The cost of an activity can be calculated accurately.
This can be compared with the value the activity adds to the customer.
If the cost of an activity is larger than its value added, then:
The cost of the activity could be reduced.
The activity could be stopped /outsourced.
The price to the customer could be increased.
Activity based management

Activity-based management (ABM) is a method of identifying and evaluating activities
that a business performs using activity-based costing to carry out a value chain
analysis or a re-engineering initiative to improve strategic and operational decisions
in an organisation.
Activity-based costing establishes relationships between overhead costs and
activities so that overhead costs can be more precisely allocated to products,
services, or customer segments.
Activity-based management focuses on managing activities to reduce costs and
improve customer value.
Kaplan and Cooper (1998) divide ABM into operational ABM and strategic ABM:
Operational ABM is about doing things right, using ABC information to improve
efficiency. Those activities which add value to the product can be identified and
improved. Activities that dont add value are the ones that need to be reduced
to cut costs without reducing product value.
Strategic ABM is about doing the right things, using ABC information to decide
which products to develop and which activities to use. This can also be used
for customer profitability analysis, identifying which customers are the most
profitable and focusing on them more.
A risk with ABM is that some activities have an implicit value, not necessarily reflected
in a financial value added to any product. For instance a particularly pleasant
workplace can help attract and retain the best staff, but may not be identified as
adding value in operational ABM.
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.
ABM can give middle managers an understanding of costs to other teams to help
them make decisions that benefit the whole organisation, not just their activities
bottom line.
Chapter 10
What is corporate
failure?
C H A P T E R 1 0 W H A T I S C O R P O R A T E F A IL U R E?
CHAPTER CONTENTS
INDICATIONS OF CORPORATE FAILURE ----------------------------- 115
QUANTITATIVE MODEL FOR PREDICTING FAILURE ---------------- 116

Z SCORE 116
QUALITATIVE MODEL FOR PREDICTING FAILURE ------------------ 117

ARGENTIS MODEL 117
C H A P T ER 1 0 W H A T I S C O R P O R A T E F A IL U R E?
INDICATIONS OF CORPORATE FAILURE

Performance indicators that an organisation might fail are as follows:
Poor cash flow

Poor cash flow might render an organisation unable to pay its debts as and when
they fall due for payment. This might mean, for example, that providers of finance
might be able to invoke the terms of a loan covenant and commence legal action
against an organisation which might eventually lead to its winding-up.
Lack of new production/service introduction

Innovation can often be seen to be the difference between life and death as new
products and services provide continuity of income streams in an ever-changing
business environment. A lack of new product/service introduction may arise from a
shortage of funds available for re-investment. This can lead to organisations
attempting to compete with their competitors with an out of date range of products
and services, the consequences of which will invariably turn out to be disastrous.
General economic conditions

Falling demand and increasing interest rates can precipitate the demise of
organisations. Highly geared organisations will suffer as demand falls and the weight
of the interest burden increases. Organisations can find themselves in a vicious circle
as increasing amounts of interest payable are paid from diminishing gross margins
leading to falling profits/increasing losses and negative cash flows. This leads to the
need for further loan finance and even higher interest burden, further diminution in
margins and so on.
Lack of financial controls

The absence of sound financial controls has proven costly to many organisations. In
extreme circumstances it can lead to outright fraud (eg Enron and WorldCom).
Internal rivalry
The extent of internal rivalry that exists within an organisation can prove to be of
critical significance to an organisation as managerial effort is effectively channelled
into increasing the amount of internal conflict that exists to the detriment of the
organisation as a whole. Unfortunately the adverse consequences of internal rivalry
remain latent until it is too late to redress them.
Loss of key personnel

In certain types of organisation the loss of key personnel can spell the beginning of
the end for an organisation. This is particularly the case where individuals possess
knowledge which can be exploited by direct competitors, eg sales contacts, product
specifications, product recipes, etc.
QUANTITATIVE MODEL FOR PREDICTING FAILURE
Z Score
Developed in 1968 by Altman. He researched bankrupt manufacturing companies in
the US.
Z score attempts to anticipate strategic and financial failure by examining company
financial statements.
Calculating five ratios generates the Z score. These five ratios, once combined were
considered to be the best predictor of failure.
1. Working capital to total assets: measure of liquidity.
2. Retained earnings to total assets: measure of gearing.
3. EBIT to total assets: measure of productivity.
4. MV Equity (+ MV Pref shares) to total liabilities: extent business can decline
before liabilities exceed assets and company becomes insolvent.
5. Sales to total assets: ability of company assets to generate revenue.
Z score = 1.2x1 + 1.4x2 + 3.3x3 + 0.6x4 + 1.0x5
x1 = Working capital to total assets
x2 = Retained earnings to total assets
x3 = EBIT to total assets:
x4 = MV Equity (+ MV Pref shares) to total liabilities
x5 = Sales to total assets:
What does the score tell us?
If the score is 3 or above they are financially sound
Between 1.81 and 2.99 they need further investigation
Below 1.81 they are in danger of bankruptcy
What to do to prevent failure?

See the signs and take action.
Seek external advice.
Management accept there is a problem.
Make strategic changes as necessary.
Put in more controls and management systems.
QUALITATIVE MODEL FOR PREDICTING FAILURE
Argentis model
Qualitative models such as Argenti use a variety of qualitative and some non-
accounting factors such as management experience, dependence on one or a few
customers or suppliers, a history of qualified audit opinions and the business
environment including the industry and economic situation.
Argenti developed a model, which is intended to predict the likelihood of company
failure based on three connecting areas that indicate likely failure: defects, mistakes
made, and symptoms of failure which are all awarded a specific score.
Defects of the company is split into management and accounting.
Management defects are to do with the characteristics of senior management
for example an autocratic chief executive (8) and a passive board (2).
Accounting defects could be a lack of budgetary control, lack of cash flow
planning and costing systems (all 3 each).
A mark of 10 or less is satisfactory.
Management mistakes are caused by weak management and accounting

systems.
overtrading (expanding faster than cash funding)
gearing (high bank overdrafts/loans)
failure of a large project which jeopardises the company.
All of which are 15.
A pass mark is 15.
The symptoms of failure where the prospects of failure become publicly

clear:
deteriorating ratios in the financial statements
creative accounting (signs of window dressing)
frozen salaries
declining morale
declining quality
Most of which are 4.
The score for all three connected areas is then added together and the overall score
is calculated. If the pass mark is 25 or any more then the company is at the risk
of failing.
Although this model attempts to quantify the causes and symptoms associated with
failure. Its predictive value has not been adequately tested, but a misclassification
rate of 5% has been suggested.
It is also worth noting that there are other reasons why companies fail such as:
Company specific variables such as customer concentration.
General characteristics such as industry type.
External factors such as macroeconomic situation.
Question Lenon
Assume that now is March 2013.
Lenon is a family-owned manufacturer of fashionable comfortable chairs which it sells
via a distribution network to some households but mainly to hairdressers and beauty
salons across Europe. Following a number of years in which the sales revenue has
remained static, the company last year launched a new marketing campaign aimed
at increasing sales in its existing markets. Current plans are to continue with this
campaign to consolidate the increase in sales.
The board of the company are now concerned as poor profits are forecast for the
current financial year to date. Some family members are expressing concern about
the future financial stability of the company. In particular one shareholder, who does
not play a significant part in the running of the business but has a substantial
shareholding, is suggesting that the latest financial accounts indicate that the
company is in danger of bankruptcy in the near future.
The latest summarised accounts of are shown below:
Statement of financial position

31 December 2012 31 December 2011
$m $m $m $m
Non-current assets
Land and buildings (net) 378 338
Other non-current assets (net) 347 311
725 649
Current assets
Inventory 636 690
Receivables 563 404
Cash 97 150
1,296 1,244
Current liabilities
Payables 915 827
Dividend 31 30
Taxation 21 41
(966) (898)
Non-current liabilities
11% loan stock (240) (240)
Floating rate bank term (60) (17)
loans
755 738
Shareholders funds
Ordinary shares (50 cents par) 225 225
Reserves 530 513
755 738
Income statement for the years ending:
31 December 2012 31 December 2011

$m $m
Sales revenue 3,300 2,949
Earnings before interest 98 162

and tax
Interest 30 26
Profit before tax 68 137
Taxation 20 41
Available to 47 96
shareholders
Dividend 30 30
Retained earnings 17 66
The Z score is calculated using the formula:
Z score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
where:
X1 = working capital/total assets
X2 = retained earnings/total assets
X3 = earnings before interest and tax/total assets
X4 = market value of equity/total liabilities
X5 = sales/total assets
It was found that:
Z score <1.81 indicates that the company is in danger and possibly heading
towards bankruptcy.
Z score of 3 or above indicates financially sound.
Companies with scores between 1.81 and 2.99 need further investigation.
Required:
(a) Based on the information given above, is the shareholder correct to be
concerned about the financial health of Lenon? (17 marks)
(b) What are the limitations of your analysis? What further investigation
would you carry out to ascertain whether Lenon is likely to experience
financial distress and/or corporate failure? (6 marks)
(c) Suggest performance indicators which could be used to monitor the
future performance of the business and monitor the success of any
actions which you have suggested. (6 marks)
(d) The Z score has led to the development of other corporate failure
prediction methods. Briefly describe Argentis failure model. (6 marks)
(35 marks)
Chapter 11
Current developments
and emerging issues in
performance
management
C H A P T E R 1 1 C U R R E N T D E V E L O P M E N T S A N D E M E R G I N G IS S U E S IN
PERFORMANCE MANAGEME NT
CHAPTER CONTENTS
CHANGING ROLE OF MANAGEMENT ACCOUNTANTS (BURNS &

SCAPEN) ----------------------------------------------------------------- 125
REVOLUTION OF IT SYSTEMS ----------------------------------------- 126
CHANGE IN MANAGEMENT STRUCTURE ------------------------------ 127
COMPETITION----------------------------------------------------------- 128
ENVIRONMENTAL ACCOUNTING -------------------------------------- 129

ACCOUNTING FOR ENVIRONMENTAL COSTS --------------------------------- 130
C H A P T E R 1 1 C U R R E N T D EV EL O P M E N T S A N D E M E R G I N G IS S U E S IN
P E R F O R M A N C E M A N A G EM E N T
CHANGING ROLE OF MANAGEMENT ACCOUNTANTS

(BURNS & SCAPENS)
The main reasons for this change are:
Elimination of routine jobs
Line managers with accounting knowledge
More forward looking information
A wider role for the management accountants
REVOLUTION OF IT SYSTEMS
Data generated from an IT system.
Changed quality and quantity of information used to make decisions.
Wide variety of reports that can be generated from IT systems.
More analytical and interpretative skills required.
CHANGE IN MANAGEMENT STRUCTURE

Shift in responsibility for budgeting.
Shift in accountability of producing budgets.
Reporting to senior managers.
All changing the information needs for meetings progression of organisation.
COMPETITION
Increasing need to be more responsive to changes from competition.
Being more commercially aware.
Production of a range of measures that looks at all aspects of the business.
There is indeed a broadening of the MAs responsibility and a transformation into
more of a business partner role. However this is not easy and they may meet
problems such as:
Difficulty in interpreting management expectations.
Difficulty in adapting to differential styles in order to be more involved in the
management process.
Conflict with operational managers who may not want them involved.
ENVIRONMENTAL ACCOUNTING
In an ideal world, organisations would reflect environmental factors in their
accounting processes via the identification of the environmental costs attached to
products, processes, and services.
Many existing conventional accounting systems are unable to deal adequately with
environmental costs and as a result simply attribute them to general overhead
accounts.
Consequently, managers are unaware of these costs, have no information with which
to manage them and have no incentive to reduce them.
Many overestimate the cost and underestimate the benefits of improving
environmental practices.
Management accounting techniques can distort and misrepresent environmental
issues, leading to managers making decisions that are bad for businesses and bad
for the environment. The most obvious example relates to energy usage.
Environmental Management Accounting (EMA) is an attempt to integrate best
management accounting thinking and practice with best environmental management
thinking and practice.
EMA is the generation and analysis of both financial and non-financial information in
order to support internal environmental management processes. It is
complementary to the conventional financial management accounting approach, with
the aim to develop appropriate mechanisms that assist in the identification and
allocation of environment-related costs.
The major areas for the application for EMA are:

In the assessment of annual environmental costs/expenditures.
Product pricing.
Budgeting.
Investment appraisal.
Calculating costs.
Savings of environmental projects, or setting quantified performance targets.
EMA is concerned with the accounting information of managers in relation to
corporate objectives. It involves:
Identifying and estimating costs of environmental related activities.
Identifying and monitoring the usage and cost of resources such as water and
fuels.
Ensuring the environment is considered as part of capital investment decisions.
Assessing the likelihood of environmental risks.
Setting environmental related indicators as part of the control and monitoring
process.
Benchmarking activities against environmental best practice.
Classification of costs:
Environmental prevention costs: the costs of activities undertaken to prevent
the production of waste.
Environmental detection costs: costs incurred to ensure that the organisation
complies with regulations and voluntary standards.
Environmental internal failure costs: costs incurred from performing activities
that have produced contaminants and waste that have not been discharged into
the environment.
Environmental external failure costs: costs incurred on activities performed
after discharging waste into the environment.
Identification of costs:
Conventional costs: raw material and energy costs which have environmental
relevance.
Potentially hidden costs: costs captured by accounting systems but then losing
their identity in general overheads.
Contingent costs: costs to be incurred at a future date, eg clean up costs.
Image and relationship costs: costs that, by their nature, are intangible, for
example, the costs of preparing environmental reports.
Accounting for environmental costs:
Input/outflow analysis
This technique records material inflows and balances this with outflows on the basis
that, what comes in, must go out.
So, if 100kg of materials have been bought and only 80kg of materials have been
produced, for example, then the 20kg difference must be accounted for in some way.
It may be, for example, that 10% of it has been sold as scrap and 90% of it is waste.
By accounting for outputs in this way, both in terms of physical quantities and, at the
end of the process, in monetary terms too, businesses are forced to focus on
environmental costs.
Flow cost accounting

This technique uses not only material flows but also the organisational structure. It
makes material flows transparent by looking at the physical quantities involved, their
costs and their value. It divides the material flows into three categories: material,
system and delivery and disposal. The values and costs of each of these three flows
are then calculated. The aim of flow cost accounting is to reduce the quantity of
materials which, as well as having a positive effect on the environment, should have
a positive effect on a business total costs in the long run.
Activity-based costing
ABC allocates internal costs to cost centres and cost drivers on the basis of the
activities that give rise to the costs. In an environmental accounting context, it
distinguishes between environment-related costs, which can be attributed to joint
cost centres, and environmentdriven costs, which tend to be hidden on general

overheads.
Lifecycle costing
Within the context of environmental accounting, lifecycle costing is a technique which
requires the full environmental consequences, and, therefore, costs, arising from
production of a product to be taken account across its whole lifecycle, literally from
cradle to grave.
Problems with EMA

The most significant problem of EMA lies in the absence of a clear definition of
environmental costs. This means it is likely that organisations are not monitoring
and reporting such costs.
The increase in environmental costs is likely to continue, which will result in the
increased information needs of managers and provide the stimulus for the agreement
of a clear definition.
However, whatever the difficulties, the use of EMA will probably increase
with positive effects for both organisations and the environment in which
they operate.
Answers to
questions
ANSWERS TO QUESTIONS
ANSWER TO SPEEDY EAT

(a) Using a PEST analysis to assist the environmental analysis
PEST analysis examines the broad environment in which the organisation is
operating. PEST is a mnemonic which stands for Political/legal, Economic, Social
and Technological factors. These are simply four key areas in which to consider
how current and future changes affect the business. Strategies can then be
developed which address any potential opportunities and threats identified.
In entering a new overseas market, an environmental analysis is important to
help the organisation understand the factors specific to that market so that the
specific opportunities and threats posed can be assessed and appropriate action
taken.
It is a useful tool for the following reasons:
1 It ensures completeness
The majority of issues relevant to an organisation will be covered under
one of the four areas of PEST analysis. By reviewing all four areas, Speedy
Eat can be sure that it has done a full and complete analysis of the broad
environment.
2 All four elements are relevant to examining new markets
Political/legal
Each new country entered will have different political systems and laws.
Speedy Eat will need to understand these differences to ensure that they
operate within the law in Borderland. They will also want to ensure that
there is political stability within the country which will ensure long-term
viability of the new operations.
Economic
Economies are different in different parts of the world. Understanding the
local economy in Borderland and how it is expected to develop enables
Speedy Eat to assess the potential within that market as well as any
economic issues which they need to consider.
Social
Each country will have its own cultural differences, and Speedy Eat can
change how they operate depending on Borderlands culture. Speedy Eat
has already shown its willingness to change for each countrys different
tastes and will want to do so in Borderland too.
Technological
Each country has a different level of technological expertise and
experience. Speedy Eat might need to change processes to accommodate
local systems, or implement training programmes for staff unfamiliar with
their technology.
3 It is a well-known tool which is easy to understand and use
PEST analysis is a very simple tool that does not require detailed
understanding. This means that it is easy to use by the team and simple
for Directors to analyse and understand.
A N S W ER S T O Q U ES T I O N S
(b) Main issues arising from applying the framework

Various issues which Speedy Eat will need to consider include:
Political/legal factors
Government grants
Some countries may have grants available for investment in the country.
Considering the requirements to gain such grants may enable Speedy Eat to
make use of these.
Political stability
Given Speedy Eats worldwide penetration (over 120 countries) it is likely that
Borderland is in a developing region which may be more politically unstable
than many countries in which they currently operate. This may affect the long-
term potential in the market.
Regulation on overseas companies
There may be regulation on how overseas companies can operate in the market.
In China, for instance, it is common for joint ventures with local companies to
be a prerequisite for western companies entering the market.
Employment legislation
Each country will have different employment legislation eg health and safety,
minimum wages, employment rights. Speedy Eat may have to change internal
processes from the US model to stay within this legislation within Borderland.
Being a good employer is also one of Speedy Eats specific strategies.
Tax legislation
Tax laws will impact the profits available for distribution to the group. High tax
levels may discourage Speedy Eat from entering the market.
Tariffs and other barriers to trade
Tariffs may be imposed on imports into Borderland. This may put Speedy Eat
at a significant disadvantage compared with local competitors if they aim to
import a significant number of items (unlikely on food items, more likely on
clothing, fittings etc).
Economic factors
Things to consider include:
Economic prosperity
The more prosperous the nation the more money people will have to invest in
fast-food. Examining the current and likely future prosperity enables the
organisation to understand the potential of this market and the likely future
investment required.
Interest rates
This affects the cost of borrowing within Borderland. If high it may mean
overseas funding is necessary. A big differential between interest rates in
Borderland and the US is also likely to cause instability in the exchange rate
(see below).
Interest rates also affect the availability of money for the people of the country.
Low interest rates mean more disposable income to spend increasing the
potential for Speedy Eat.
Exchange rates
Speedy Eat will be affected by exchange rates for items they export to
Borderland (clothing, fittings). An unfavourable movement in exchange rates
could make exporting to Borderland expensive and reduce profitability. It can
also affect the value of profits when converted back to US dollars.
Position in economic cycle
Different countries are often at different positions in the economic cycle of
growth and recession. The current position of Borderland will affect the current
prosperity of the nation and the potential for business development for Speedy
Eat.
Inflation rates
High inflation rates create instability in the economy which can affect future
growth prospects. They also mean that prices for supplies and prices charged
will regularly change and this difficulty would need to be considered and
processes implemented to account for this.
Social factors
Things to consider include:
Brand reputation/anti-Americanism
As a global brand, the reputation of Speedy Eat might be expected to have
reached Borderland. If not, more marketing will be required. If it has, the
reputation will need to be understood and the marketing campaign set up
accordingly.
This is particularly relevant given the anti-Americanism which is prevalent
currently in some countries. Speedy Eat may have a significant hurdle to climb
to convince people to eat there if this is the case in Borderland.
Cultural differences
Each country has its own values, beliefs, attitudes and norms of behaviours
which means that people of that country may like different foods, architecture,
music and so on, in comparison with US restaurants. By adapting to local needs
Speedy Eat can ensure it wins local custom and improve its reputation.
Different cultures also need to be considered when employing people, especially
given the importance to Speedy Eat of employee relations. People might have
different religious needs to be met or may dislike being given autonomy so the
management style needs changing.
Language problems
Different local languages can create problems, firstly in communication with
staff. Secondly, product names need to be considered to ensure they are
acceptable in the local language. General Motors Nova suggested that it wont
go in Spanish, for example.
Technological factors
Speedy Eat may need to train people in the use of their technologies if the local
population are unfamiliar with them, eg accounting systems or tills. In addition,
technology might have to be adapted to work in local environments, such as

different electrical systems.
ANSWER TO EUXTON
(a) Budgeted Net Profit/Loss outcomes for year ending 30 June 2012
Occupancy Client days = Fee per Var. cost Contribution Total
level 50 clients x client per per client contrib.
350 days x day client day per year
occupancy% day
$ $ $ $
90% 15,750 180 95 85 1,338,750

90% 15,750 180 85 95 1,496,250
90% 15,750 180 70 110 1,732,500
75% 13,125 200 95 105 1,378,125
75% 13,125 200 85 115 1,509,375
75% 13,125 200 70 130 1,706,250
60% 10,500 220 95 125 1,312,500
60% 10,500 220 85 135 1,417,500
60% 10,500 220 70 150 1,575,000
(b) Maximax
The maximax rule looks for the largest contribution from all outcomes.
Fee per client day Best possible contribution ($)
($)
180 1,732,500
200 1,706,250
220 1,575,000
In this case the decision maker will choose a client fee of $180 per day where
there is a possibility of a contribution of $1,732,500.
Maximin
The maximin rule looks for the strategy which will maximise the minimum
possible contribution.
Client fee per day Minimum possible contribution ($)
(S)
180 1,338,750
200 1,378,125
220 1,312,500
In this case the decision maker will choose client fee of $200 per day where the
lowest contribution is $1,378,125.
Minimax regret
The minimax regret rule requires the choice of the strategy which will minimise
the maximum regret from making the wrong decision. Regret in this context is
the opportunity lost through making the wrong decision.
Using the calculations from part (a) we may create an opportunity loss table as
follows:
State of variable cost Client fee per day strategy
$180 $200 $220
High (W1) 39,375 0 65,625

Medium (W2) 13,125 0 91,875
Low (W3) 0 26,250 157,500
Maximum regret 39,375 26,250 157,500
W1 at the high level of variable costs, the best strategy would be a client fee of
$200. The opportunity loss from using a fee of $180 or $220 per day would be
$39,375 (1,378,125 - 1,338,750) or $65,625 (1,378,125 - 1,312,500)
respectively.
W2 at the medium level of variable costs, the best strategy would be a client
fee of $200. The opportunity loss from using a fee of $180 or $220 per day
would be $13,125 (1,509,375 - 1,496,250) or $91,875 (1,509,375 - 1,417,500)
respectively.
W3 at the low level of variable costs, the best strategy would be a client fee of
$180. The opportunity loss from using a fee of $200 or $220 per day would be
$26,250 (1,732,500 $1,706,250) or $157,500 (1,732,500 1,575,000)
respectively.
The minimum regret strategy (client fee $200 per day) is that which minimises
the maximum regret (ie $26,250 in the maximum regret row above).
(c) The expected value of variable cost

= ($95 0.1) + ($85 0.6) + ($70 0.3) = $81.50
For each client fee strategy the expected value of budget contribution for the
year may be calculated:
Fee of $180
15,750 client days x (180 81.50) contribution
= $1,551,375
Fee of $200
= $1,555,313
Fee of $220
= $1,454,250
Conclusion
Hence choose a client fee of $200 per day to give the maximum expected value
contribution of $1,555,313.
Note that there is virtually no difference between this and the contribution
where a fee of $180 per day is used.
(d)
Probability Outcome = Decision =
lunches lunches
demanded made
10 20 30
0.2 10 $80 profit $10 profit ($60) loss
0.5 20 $80 profit $160 profit $90 profit
0.3 30 $80 profit $160 profit $240 profit
1.0 - $80 profit $130 profit $105 profit
Example of working - Decision is made to prepare 20 lunches

If demand is 10 lunches: Sales = 10 lunches x $15 per lunch = $150
Costs = 20 lunches x $7 per lunch = $140
Profit = $150 - $140 = $10
If demand is 20 lunches : Sales = 20 lunches x $15 per lunch = $300
Profit = $300 - $140 = $160
If demand is 30 lunches : Sales = 20 lunches x $15 per lunch = $300
Profit = $300 - $140 = $160
EV of profit if 20 lunches are prepared = ($10 x 0.2) + ($160 x 0.5) +
($160 x 0.3)
= $130
Conclusion = 20 lunches should be prepared in advance since the expected
value of the profit is maximised at this level of output.
ANSWER TO BANANA
(a) The standard cost of a Leaf is the planned unit cost of the product during a
specified period of time.
The leaf enjoys a 75% learning effect. If this effect is ignored, then the
standard costs will be too high, since the fact that each unit will take
progressively less labour will have been ignored.
The budgeted cost of the Leaf must therefore take into account the 75%
expected learning curve when it is formulated.
(b)
$
Direct material (W3) 631,200

Labour (W1) 354,425
Variable overhead (W2) 106,328
Fixed costs (W4) 198,000
________
Cost for 1,400 units 1,289,953
________
Cost per unit 921

Add 25% mark-up 230
________
Minimum selling price to achieve target profit 1,151
________
(W1) Labour
For the first 900 units the average labour cost:
y = axb
= $5,000 900-0.4150
= $297.13880
Total cost for the first 900 units:
= 900units $297.13880
= $267,425
All units after the first 900 will have the same cost as the 900th unit. To
calculate the cost of the 900th unit we need to take the cost of 899 units
from the cost of 900 units.
For the first 899 units the average cost per unit:
y = $5,000 899-0.4150
= $297.27592
Total cost for the first 899 units:
= 899units $297.27592
= $267,251
Therefore, cost of the 900th unit = $267,425 $267,251 = $174
We can now calculate the total labour cost for all 1,400 units:
Total cost for the first 900 units = $267,425 (as above)
Total cost for the next 500 units = 500 units $174 per unit = $87,000
Total cost for 1,400 units = $354,425
(W2) Variable overhead

Variable overhead is $3 per labour hour or 30% of the labour cost of $10
per hour.
Therefore, total variable cost for 1,400 units = $354,425 30% =
$106,328
(W3) Direct material

Cost of first 300 units = 300units $600/unit = $180,000
Cost of next 300 units = 300 units ($600/unit 0.8) = $144,000
Cost of the final 800 units = 800 units ($600/unit 0.82) = $307,200
________
$631,200
________
(W4) Fixed costs

Additional fixed costs = $11,000 per month 18 months = $198,000
(c) The learning curve does still have relevance in a modern manufacturing
environment, such as Banana Ltd:
Short product life

Banana Ltd computers will have short product lives, eg the life of the Leaf is
expected to be just 18 months. Therefore, new products will be released on a
regular basis. This makes it likely that there will be learning effects.
Complex products
Computers are complex products. As a result the learning curve will be
significant and it will take longer for the learning curve to reach a plateau.
However, there are a number of reasons why the learning curve will not be as
relevant in a Company such as Banana Ltd:
Capital intensive production

Production of computers will be capital intensive and as a result the learning
effect cannot apply if machines limit the speed of labour.
Breaks in production
The learning effect requires that production is repetitive with no major breaks
in which the learning effect may be lost. Modern manufacturing companies,
such as Banana Ltd, may use just-in-time production and as a result learning
benefits may be lost.
ANSWER TO PMS
(a) Parkside Motor School (PMS)
2011 2012
ROCE 25.3% 29.0%
EBITDA 1421 1622
Gearing 93.5% 64.6%
2011 2012
Pass Advanced Group Pass Advanced Group
first first
Fixed asset turnover 1.7 3.5 1.9 1.8 3.6 2.0
Sales Margin 20.2% -0.6% 12.5% 21.3% 0.2% 14.3%
Salary cost to
revenue 34% 47% 37% 33% 46% 36%
Instruction materials
to revenue 13% 18% 15% 4% 8% 5%
Operating cost to
revenue 27% 33% 29% 28% 32% 29%
Income Statement Growth % 2011 - 2012
Pass first Advanced Group
Revenue 10% 7% 10%
Salaries 6% 6% 6%
Instruction materials 7% 9% 8%
Other operating costs 13% 4% 11%
Marketing 23% 15% 21%

Interest (group) -17%
Depreciation & amortisation 0% 5% 1%
Total cost 9% 6% 7%
Profit 16% 133% 25.8%
Summary balance sheets

Non-current assets 2% 5%
Net current assets 3% 15%
Sales revenue
Turnover in Pass first has increased by 10% and in the Advanced by 9%. The
overall growth achieved during 2012 was a healthy 10%.
Profits
The increased marketing spend has enabled both divisions to grow.
The profits in Pass first have increased by 16% and moved from a $9,000 loss
to a $3000 profit in the Advanced division, giving a 25.8% increase in overall
group profit from $761,000 to $987,000.
EBITDA rose from $1,421,000 to $1,622,000 an increase of 14%.
Interest payable has fallen by $30,000 which is a direct result of the repayment
of Loan stock.
Costs
The salary costs have increased by 6% in both divisions. If we look at the
salary cost paid compared to revenue generated, there appears to be a problem
in the advanced division as there is approximately 46% salary cost to revenue
generated, compared to 34% in Pass first. This may be due to the fact that we
have to pay premium salaries for the advanced driving instructors.
Spend on Instruction materials has increased by 7% in the Pass first division
and 9% in Advanced. This is less that the increase in turnover. In 2012 the
spend on instruction material as a percentage of revenue generated is
substantially lower. This may due to economies of scale, built up stocks or
more experienced tutors not needing the materials.
Operating costs have increased by 13% in the Pass first division and 4% in the
Advanced division. Overall the operating expenditure as a percentage of
turnover has been maintained by both divisions.
Assets
Fixed asset utilisation ratios remain a similar level to those of 2010. Advanced
is clearly trying to grow and will need investment in fixed assets.
The current assets in the Advanced division have increased to 15% yet the
increase in revenue growth is only 7%. This may be due to the fact that the
advanced lessons are often invoiced after the lessons have been completed and
therefore increase outstanding debtors.
Also in 2010 the instruction manual expenditure to revenue generated was
18%, which indicated a high level of stock was paid for. This may be sitting in
stock until Advance bookings increase.
(b) It would be useful to have data relating to 2010 for both divisions in order to
get a full picture of Parkside Motor School. This would enable a much better
assessment of current performance and the identification of significant factors
that have arisen during the past few years.
It would be extremely useful to have competitor information in order to assess
relative market share and establish how each division is performing compared
with competition.
Future market and financial projections in respect of operations in Parkside
Motor School would be helpful and should reflect the actual results achieved in
2010 and 2011.
(c)
Advantages of EBITDA Disadvantages of EBITDA
It is a proxy for cash flow from It ignores changes in working capital

operations and is therefore a and their impact on cash flow.
measure of underlying
performance.
Tax and interest are externally It fails to consider the amount of

generated and therefore not fixed asset replacement needed by
relevant to the underlying success the business.
of the business.
Easy to calculate and to It can easily be manipulated by

understand. aggressive accounting policies
related to income recognition and
capitalisation of expenses.
ANSWER TO MAPLE
The general rule of transfer pricing to assist in profit maximising decisions is to set
transfer price equal to marginal cost plus net opportunity cost to the group.
If we apply this rule to the three situations given we have:
(i) Since Hexton Ltd has an external market, which is the opportunity foregone,
the relevant transfer price would be the external selling price of $15 per kg.
This will be adjusted to allow for the $1.50 per kg avoided on internal transfers
due to packing costs not required.
The transfer price should be $15 $1.50 = $13.50 per kg.
(ii) In this situation Hexton has no alternative opportunity for 3,000kg of its special
ingredient Z. it should, therefore, offer to transfer this quantity at marginal
cost.
This is variable cost less packing costs avoided =$9 $1.50 = $7.50 per kg.
(Note: Total cost = $15 x 80% = $12, Variable cost = $12 x 75% = $9)
The remaining amount of special ingredient Z should be offered to Maple Ltd at
the adjusted selling price of $13.50 per kg as in (i) above.
(iii) Hexton Ltd has an alternative use for some of its production capacity, which
will yield a contribution equivalent to $3 per kg of special ingredient Z
($6,000/2,000kg). The balance of its square capacity (1,000kg) has no
opportunity cost and should still be offered at marginal cost.
Hexton Ltd should offer to transfer:
2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50per kg (=MC);
and the balance of requirements at $13.50 per kg.
ANSWER TO BGL
(a) Memorandum
To: The board of directors
From: Senior management accountant
Date: 9 June 2012
Subject: Factors to be considered in the design of a reward scheme.
Further to your recent request concerning the above please find detailed below
factors for your consideration:
(i) The potential benefits to be gained from the implementation of a

reward scheme
Rewards and incentives can make a positive contribution to strategy
implementation by shaping the behaviour of individuals and groups.
A well designed reward scheme will be consistent with organisational
objectives and structure.
There is evidence which suggests that the existence of a reward
scheme provides an incentive to achieve a good level of
performance. Moreover, the existence of effective schemes also
helps not only to attract but to retain employees who make positive
contributions to the running of an organisation.
Key values can be emphasised by incorporating key performance
indicators in the performance-rewards mechanisms which underpin
the scheme. This helps to create an understood environment in
which it is clear to all employees what performance aspects
precipitate organisational success.
An effective reward scheme will create an environment in which all
employees are focused upon continuous improvement.
Schemes which incorporate equity share ownership for managers
and employees alike can encourage behaviour which is in the longer-
term interests of the organisation by focusing on actions aimed at
increasing the market value of the organisation.
(ii) The factors that should be considered in the design of a reward

scheme for BGL
Whether performance targets should be set with regard to results or
effort. It is more difficult to set targets for administrative and
support staff since in many instances the results of their efforts are
not easily quantifiable. For example, sales administrators will
improve levels of customer satisfaction but quantifying this is
extremely difficult.
Whether rewards should be monetary or non-monetary. Money
means different things to different people. In many instances people
will prefer increased job security which results from improved
organisational performance and adopt a longer term-perspective.
Thus the attractiveness of employee share option schemes will
appeal to such individuals. Well designed schemes will correlate the
prosperity of the organisation with that of the individuals it employs.
Whether the reward promise should be implicit or explicit. Explicit

reward promises are easy to understand but in many respects
management will have their hands tied. Implicit reward promises
such as the promise of promotion for good performance is also
problematic since not all organisations are large enough to offer a
structured career progression. Thus in situations where not
everyone can be promoted there needs to be a range of alternative
reward systems in place to acknowledge good performance and
encourage commitment from the workforce.
The size and time span of the reward. This can be difficult to
determine especially in businesses such as BGL which are subject to
seasonal variations, ie summerhouses will invariably be purchased
prior to the summer season! Hence activity levels may vary and
there remains the potential problem of assessing performance when
an organisation operates with surplus capacity.
Whether the reward should be individual or group based. This is
potentially problematic for BGL since the assembly operatives
comprise some individuals who are responsible for their own output
and others who work in groups.
Similarly with regard to the sales force then the setting of individual
performance targets is problematic since sales territories will vary in
terms of geographical spread and customer concentration.
Whether the reward scheme should involve equity participation?
Such schemes invariably appeal to directors and senior managers
but should arguably be open to all individuals if perceptions of
inequity are to be avoided.
Tax considerations need to be taken into account when designing a
reward scheme.
(iii) If we implement a reward scheme then it is bound to be beneficial

for BGL
The statement of the manufacturing director is not necessarily correct.
Indeed there is much evidence to support the proposition that the
existence of performance-related reward schemes can encourage
dysfunctional behaviour. This often manifests itself in the form of
budgetary slack which is incorporated into budgets in anticipation of
subsequent cuts by higher levels of management or to make subsequent
performance look better.
(b) Good performance should result in improved profitability and therefore other
stakeholder groups may be rewarded for good performance as follows:
Shareholders may receive increased returns on equity in the form of
increased dividends and/or capital growth.
Customers may benefit from improved quality of products and services,
and possibly lower prices.
Suppliers may benefit from increased volumes of purchases.
Government will benefit from increased amounts of taxation.
ANSWER TO LENON
(a) 2012 2011
Z Z
ratios score ratios score
X1 = working capital/total
assets 1.2 0.163 0.20 0.183 0.22
X2 = retained earnings/
total assets 1.4 0.262 0.37 0.271 0.38
X3 earnings before
interest and tax/total assets 3.3 0.048 0.16 0.086 0.28
X4 = market value of
equity/total liabilities 0.6 0.596 0.36 0.639 0.38
X5 = sales/total assets 1 1.633 1.63 1.558 1.56
2.71 2.82
%
Movements
Sales revenue 11.9%
Non-current assets 11.7%
Inventories -7.9%
Receivables 39.5%
2012 2011
Current ratio 1.34 1.39
Quick ratio 0.68 0.62
Receivables period (days) 62 50
Interest cover 3.27 6.23
Gearing 39.7% 34.8%
The Z score for both years are between 1.81 and 2.99 and therefore under the
cut-off point for companies which need further investigation. The score is also
worsening. Indeed the score for the previous year was also below the cut-off
point and should have been a signal to begin monitoring the situation carefully,
particularly given the plans to expand.
Trends and ratios

There has been a considerable increase in sales revenue over the last year.
However there has also been a proportionate increase in the level of non-
current assets which suggests that the company has invested in additional
manufacturing facilities to meet the new sales target.
Inventories have decreased at the same time as the increase in sales revenue,
which suggests that the company has improved its inventory management.
However working capital requirements have not decreased significantly because
there has been a marked increase in the level of receivables. The receivables
period (already at a fairly high level) is now two months which suggests that
during the time of expansion the company has not paid sufficient attention to
this aspect of its financial control.
Although sales revenue has increased, there has been a decrease in

profitability. It is likely that this is due, at least in part, to an increase in costs
due to the investment in the marketing campaign and associated activities. If
the company continues with its plans for further marketing this may decrease
the companys profitability further.
The company has financed this expansion with an increase in its loans which is
demonstrated by the increase in gearing. The consequent increase in interest
due and the decrease in profitability have led to a considerable worsening in
the interest cover. There has also been a worsening in other liquidity indicators.
All the above suggests that the shareholder does have some cause for concern
over the future of this business.
(b) There are a number of limitations of the Z score and other similar quantitative
failure prediction models, which mean that the Z score alone is not sufficient
to give a conclusive analysis of the likelihood of failure:
The score estimated is a snapshot it gives an indication of the situation
at a given point in time but does not determine whether the situation is
improving or deteriorating. Further analysis is needed to fully understand
the situation.
Scores are only good predictors in the short-term.
Some scoring systems tend to rate companies low and are likely to classify
distressed firms as actually failing.
The financial analysis above indicates that there is a problem, but has been
carried out with limited information. In order to come to a complete
understanding there is further work which needs to be done:
Suggested areas for further investigation:
A more in-depth analysis of the accounting information looking at areas
such as levels of debt, liquidity, payment periods, contingent liabilities,
and post balance sheet events.
An analysis of sales trends, with comparisons for individual products and
customer groups.
Market information, especially an assessment of the success of the
marketing campaign.
Benchmarking against other companies in the same of similar markets.
Actions and strategies of competitors.
Any macro events which have affected the company, including inflation
and foreign exchange rates.
(c) Possible performance indicators

The performance indicators chosen should relate to the problems described in
(a) above and the actions which the company needs to take to address these
areas. They will need to include both financial and non-financial indicators and
include areas related to marketing and internal processes. However it is
important to focus on a small number of key areas.
Suggested indicators:
Profitability, overall and for individual products.
Sales growth at least on a quarterly basis, again overall and for individual
distributors and products.
Operating income.
Levels of receivables.
Market share and pricing, including comparisons with other
manufacturers.
Numbers of new and repeat customers.
Customer feedback, particularly concerning the effect of the marketing
campaign.
Liquidity and gearing.
(d) The development of the ZETA score

In order to address the limitations of the Z score Altman and others carried out
further research and developed the ZETA score. This is a proprietary method
and only available to subscribers to the company which owns the model
therefore it is not possible to give details of the formula here. The approach
taken is similar to the Z score, but the ZETA score is based on seven variables,
with the addition of an assessment of the stability of the companys earnings
over a period of five to ten years, and the size of the company based on its
total assets. Further research showed that the most important factors are the
stability of earnings and the cumulative profitability, that is the ratio of retained
earnings to total assets, also included in the Z score.
Argentis failure model
From historical data on a wide range of actual cases, Argenti developed a model,
which is intended to predict the likelihood of company failure. The model is
based on calculating scores for a company based on:
Defects of the company
eg autocratic chief executive, passive board and lack of budgetary control.
Management mistakes
eg overtrading (expanding faster than cash funding), gearing high bank
overdrafts/loans, failure of large project jeopardises the company.
The symptoms of failure deteriorating ratios, creative accounting signs
of window-dressing, declining morale and declining quality.

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ACCA Paper P5

INTRODUCTION TO THE PAPER 5

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 9

CHAPTER 1: STRATEGIC PLANNING AND CONTROL 13

CHAPTER 2: PERFORMANCE MANAGEMENT AND CONTROL 31

CHAPTER 3: ORGANISATIONAL STRUCTURE AND BUSINESS INTEGRATION 43

CHAPTER 4: RISK AND UNCERTAINTY AS PART OF THE STRATEGIC PLANNING 51

CHAPTER 5: PERFORMANCE EVALUATION 61

CHAPTER 7: TRANSFER PRICING 83

CHAPTER 8: PERFORMANCE EVALUATION 87

CHAPTER 9: PERFORMANCE SYSTEM ISSUES 103

CHAPTER 10: WHAT IS CORPORATE FAILURE? 113

CHAPTER 11: CURRENT DEVELOPMENTS AND EMERGING ISSUES IN

ANSWERS TO QUESTIONS 133

AIM OF THE PAPER

FORMAT OF THE EXAM PAPER

ACCA P5 PAST EXAM TOPICS

December 2007 June 2008

December 2008 June 2009

December 2009 June 2010

December 2010 June 2011

December 2011 June 2012

December 2012 June 2013

December 2013 June 2014

Present value table

Discount rate (r)

Where r = discount rate

Discount rate (r)

Strategic planning and

WHAT IS STRATEGY? ---------------------------------------------------- 15

STRATEGIC PLANNING -------------------------------------------------- 17

POSITION ANALYSIS ---------------------------------------------------- 19

GAP ANALYSIS ----------------------------------------------------------- 27

WHAT IS ANSOFFS GRID?---------------------------------------------- 28

WHAT IS STRATEGIC MANAGEMENT ACCOUNTING? ----------------- 29

How to set a strategy

Stage 2 Strategic Choices (Closing the gap)

Stage 3 Strategy into Action (Implementation)

INTERNAL ANALYSIS EXTERNAL ANALYSIS

Core competencies Strategic tools

Strategy to meet CSF

Target setting KPI

Setting a mission and objectives

External environmental analysis

For whom do we exist?

Critical success factors

Construct a SWOT for a no frills airline

Prioritisation Exercising power

Negotiation Sequential attention

Ethical and culture considerations

Why does the organisation exist?

How should these be implemented?

External influences on performance

Economic, fiscal and environmental factors

Question - Speedy Eat

Porters five forces

Threats from potential entrants

Threats from substitutes

WHAT IS ANSOFFS GRID?

Protect/ build Product development

WHAT IS STRATEGIC MANAGEMENT ACCOUNTING?

Traditional management accounting

Focused at individual departments