ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 11: Advanced variance analysis
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The adverse sales price variance could be explained largely by the fact that in a
competitive market that is affected by recession, all companies might be reducing
their selling prices in an attempt to achieve sales.
The market size variance is $290,000(A), indicating that there has been a large fall in
the size of the market due to the adverse economic conditions. However, the
company has succeeded to some extent in reducing the damaging effect of the fall in
market size by gaining a larger share of the market (market share variance
$110,000(F)).
It is not clear, however, whether the improvement in market share is due to
management effort (good performance) or due to the fact that a competitor went
into liquidation – so that the competitor’s share of the market is taken up by the
companies that remain.
This example illustrates the level of analytical ability that you might be required to
show in your examination. The examiner has stated (Student Accountant, May 2008)
that:
Calculating a variance or ratio alone is not enough to pass the exam
Some interpretation or analysis is required, and you should use any background
information given in the question
You should hypothesise – suggest reasons – for the performance indicated by the
variance or ratio: why might a variance be favourable or adverse?
You will be expected to express an opinion. Comments such as: ‘I recommend
that management should investigate the cause of the variance…’ will not be
good enough.
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Behavioural aspects of standard costing
The effect of variances on staff motivation and action
Behavioural aspect of variances in a TQM or JIT environment
Standard costs in a rapidly changing environment
4 Behavioural aspects of standard costing
This section considers briefly some behavioural aspects of variance reporting. The
behavioural issues to consider are:
Whether managers and the staff in the entity respond to reported variances, and
If they do respond, whether their response benefits the entity or might be
harmful.
4.1 The effect of variances on staff motivation and action
In principle, when variances are reported the staff responsible should investigate
the causes of variances that appear to be significant, and if it is discovered on
investigation that the cause of the variance can be controlled, suitable control action
should be taken.
This response by staff is only likely to happen under certain conditions:
Senior managers should indicate the importance they attach to variance reports,
and should demand explanations from their subordinates about significant
variances and what has been done to investigate them. Subordinates are unlikely
to treat variances seriously unless their boss does.
Reported variances must be realistic and reliable. Staff will be reluctant to
investigate variances if they do not trust the reported figures and consider the
variances to be unrealistic.
The standard cost or budget should be realistic and achievable.
The possible causes of a variance should be controllable by the person who is
made responsible and accountable for the variance. If the cause of a variance is
unlikely to be controllable, it would be a waste of time to investigate its cause.
Variances should be fairly current. If variance reports are not provided to
management until several weeks after the control period, the variances might be
considered ‘out of date’ and so ‘no longer relevant’.
If managers and other staff are given incentives for achieving favourable
variances – for example if an annual cash bonus depends partly or entirely on
achieving favourable variances – the individuals concerned should be motivated
by performance and variance reports.
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4.2 Behavioural aspect of variances in a TQM or JIT environment
Variances and a TQM environment
The concept of Total Quality Management (TQM) was first developed in Japan. As
its name suggests, TQM is an approach to management based on the principle that
all aspects of quality in an entity’s operations should be managed so as to improve
value for the customer.
One aspect of TQM is the concept of ‘continuous improvement’. This is a view that
in order to manage quality it is essential to keep looking for and identifying ways of
improving quality in procedures, systems, products and services. Most
improvements will be fairly small, but they should be happening all the time. Over
time, a large number of small quality improvements will result in significant total
improvements.
It has been suggested that variance analysis and variance reporting is inconsistent
with TQM. This is because:
Variances are calculated by comparing actual results with a fixed standard:
performance is considered ‘good’ if actual results are better than the standard
In a system of TQM, it is inappropriate to think in terms of a fixed standard,
because the aim should be to improve continually. In a TQM environment, it
would be disappointing if actual results are ever worse than standard (assuming
that a current standard as at the start of the year is used for measuring
variances).
Variance reporting in a TQM environment may lead to dysfunctional behaviour if
managers ignore aspects of performance where the variance is close to $0, because
in TQM any aspect of performance should be considered capable of improvement.
Variances and a JIT environment
Just in time (JIT) management involves purchasing raw materials and producing
output ‘just in time’ for when they are needed.
With JIT purchasing, the aim should be to obtain raw materials from suppliers
only when the materials are needed for production.
With JIT production, the aim should be to produce output only when there is a
customer for the finished output.
In principle, in a JIT environment there will be no inventory of raw materials or
finished goods. (In practice the aim should be to keep these inventories as low as
possible).
This approach to management may possibly be inconsistent with some variance
reporting, especially if a system of absorption standard costing is used.
In a system of absorption costing, there will be favourable fixed production
overhead variances if actual output exceeds budgeted output. In other words,
favourable variances are obtained and profit is improved by increasing finished
goods inventory levels.
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A consequence of JIT purchasing and production is that sometimes the purchase
price for raw materials or the production cost for finished goods may be higher
than they might otherwise be, because a supplier may charge a higher unit price
for a small quantity. Production costs per unit may also be higher when batch
sizes are smaller. With variance reporting, the aim would be to reduce material
price variances and production cost variances; however in a JIT environment, it
is considered that other benefits – not measured in variances – are greater.
Variance reporting could therefore be inconsistent with JIT.
4.3 Standard costs in a rapidly-changing environment
Some business entities operate in a business environment where change is continual
and fast. The life cycle of products may be short because of rapidly-changing
technologies, and products may be developed or re-designed regularly, with new
production methods. As new technologies develop and become popular, the market
size might grow but sales prices are likely to fall.
There are many examples of industries in a rapidly-changing environment; for
example mobile phone technology has changed enormously within a relatively
small number of years, so that we now have touch screen technology and small
handsets. Over time, the materials content of mobile phones has diminished, sales
volumes have rocketed and sales prices have fallen substantially.
Standard costs may be incompatible with rapid change, for similar reasons to those
explained for TQM.
With variance analysis, actual results are compared with a fixed standard and a
budget, and variances arise when actual results differ from the standard or
budget.
In a rapidly-changing environment, it should be expected that the original
standard or budget may get out of date, and action to try to eliminate an adverse
variance may in fact be inappropriate because operating conditions have now
changed.
In conclusion, it may be argued that standard costing and variance analysis are now
much less important for budgetary control than they may have been in the past.
Standard costing and variances are most useful in conditions where standard
products are made and sold. However, many companies now produce non-
standard products, and try to adjust their products to the individual needs of
particular customers. Even where companies do not customise products for
individual customers, there is extensive fragmentation of markets into segments
or niches, with different product designs manufactured for each separate
segment.
As suggested above, variance reporting and budgetary control based on
variances may not be appropriate for many modern manufacturing
environments, such as those where TQM or JIT methods are applied.
Similarly, variance reporting may be inappropriate in a rapidly-changing
business environment.
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Paper F5
Performancemanagement
CHAPTER
12
The scope of performance
measurement
Contents
1 Measuring performance
2 Financial performance indicators (FPIs)
3 Non-financial performance indicators (NFPIs)
4 Balanced scorecard approach
5 Performance pyramid
6 Performance measurement in service industries:
the building block model of Fitzgerald and Moon
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Measuring performance
Reasons for measuring performance
Responsibility and controllability
Long-term, medium-term and short-term performance
Financial and non-financial performance measures
Performance measurement and the F5 examination
Benchmarking
1 Measuring performance
1.1 Reasons for measuring performance
Performance in business should be measured and reported back to:
the individuals most directly responsible for the performance
their boss or bosses.
The purpose of measuring performance is to:
inform individuals whether the planning targets or standards (for which they
are responsible) are being met
inform senior managers about the performance of each of their subordinates, as
well as their own performance
indicate the risk that targets will not be met, so that action to correct the situation
can be considered
indicate poor performance, so that individuals and their managers can take
whatever corrective action seems appropriate
reward the successful achievement of targets or standards, for example by
means of cash bonuses or other incentives.
A business entity must have management information systems that are capable of
providing reliable and relevant information about all the important aspects of
performance.
1.2 Responsibility and controllability
Two essential features of an effective performance reporting system are:
Responsibility. Performance reports should be provided to the individuals (and
their managers) who are actually responsible for the performance. Performance
reports are irrelevant if they are sent to individuals with no responsibility.
Controllability. Performance reports should distinguish between aspects of
performance that should be controllable by the individual who is made
responsible and accountable. There is no sensible purpose in judging the
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performance of an individual by looking at factors that are outside the
individual’s control.
1.3 Long-term, medium-term and short-term performance
Performance measurement should cover the long-term, medium-term and short-
term.
Long-term performance
Long-term performance measures should be linked to the long-term objectives and
the strategies of the organisation. The most significant long-term objectives might be
called critical success factors or CSFs. In order to achieve its long-term and strategic
objectives, the critical success factors must be achieved.
For each critical success factor, there should be a way of measuring performance, in
order to check whether the CSF targets are being met. Performance measurements
for CSFs might be called key performance indicators (KPIs) or possibly key risk
indicators (KRIs).
Medium-term performance
Medium-term performance measurement is perhaps most easily associated with the
annual budget, and meeting budget targets. Targets, whether financial or non-
financial, can be set for a planning period such as the financial year, and actual
results should be compared against the planning targets.
Short-term performance
Short-term performance should be monitored by means of operational performance
measures. For example, quality might be measured by the percentage of rejected
units in production, or the rate of customer returns or customer complaints. Speed
might be measured by the average time required to meet a customer order.
1.4 Financial and non-financial performance measures
Performance measures can be financial or non-financial. Accountants tend to think
about the performance of a business in financial terms, such as sales, costs and
profits. Traditionally, performance reporting by management accountants was
restricted to financial performance measures, or ‘financial performance indicators’
(FPIs).
However, the performance of a business in both the short term and the longer term
depends on factors other than financial results. Profits are earned by delivering
products or services to customers that customers want to buy, and by operating in
an efficient and effective manner. Non-financial aspects of performance are the main
reason why a business is financially successful (or performs badly in financial
terms) and profits follow on from ‘getting the business right’.
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It is therefore recognised that non-financial aspects of performance are important
and that these should also be measured and monitored (using non-financial
performance indicators or NFPIs).
In many organisations, management accountants have taken on responsibility for
measuring and reporting non-financial performance, as well as financial
performance. There is no obvious reason why management accountants should do
this (because they are not ‘experts’ in non-financial aspects of operations) except
that performance reporting should be an integrated management information
system. Management accountants are best placed within an entity to report on
financial performance. Since they report on financial performance, it is sensible to
make them responsible for reporting on aspects of non-financial performance too.
1.5 Performance measurement and the F5 examination
Previous chapters have already explained variance analysis and the assessment of
performance using standard costs, budgetary control and variances.
You may also be required to calculate and comment on a number of financial and
non-financial performance ratios, which will be described in later sections of this
chapter. Before studying ratios in any detail, however, it is important to understand
how you might be expected to use ratios in the examination. The F5 examiner has
given some guidelines (Student Accountant, May 2008).
A question may involve a ‘case study’ and provide information from which you
will be required to calculate one or more ratios. The question may indicate
which ratios to calculate. On the other hand you may be asked simply to
comment on performance, and identify one or more ratios that you consider
important or significant. These may be financial or non-financial ratios, or a
combination of both.
Calculating a ratio will not be good enough on its own to earn a pass mark. You
will also be required to provide some comments about performance, based on
the ratio or ratios that you have calculated. To help with the assessment of
performance, the question may provide some background information that you
should use. Make use of this background information. It may indicate reasons
why performance has been better or worse than expected, or may provide
information that enables you to decide whether performance has been ‘good’ or
‘bad’.
You will be expected to ‘hypothesise’ and explain why performance has been
better or worse than expected, and you are encouraged to express an opinion.
Your opinion should be sensible and demonstrate ‘business common sense’. The
F5 examiner commented (in the article referred to) that ‘Candidate must be
brave and commit themselves. You must express an opinion. It is not acceptable
to suggest that management investigate. Although in the real world this may
well happen, in the exam hall you have to demonstrate that you know where to
look.’
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1.6 Benchmarking
It may be useful to be aware of benchmarking as a method of assessing
performance. Benchmarking involves comparing performance with the performance
of another, similar organisation or operation. In other words, another organisation
or department is used as a ‘benchmark for comparison’.
Performance can be assessed in terms of whether it has been better or worse than
the selected benchmark. By making such comparisons, it should be possible to
identify strengths and weaknesses in performance.
There are three main types of benchmarking.
Internal benchmarking. An entity may have many similar operations, such as
regional or area branches. For example, a bank may have a network of branches,
and a retail company may have a network of retail stores. The best-performing
branches or departments can be used as a benchmark, and the performance of
other branches compared against it.
Competitive benchmarking. This involves comparing the performance of the
organisation against the performance of its most successful competitors. In this
way, the areas of performance where the competitor is better can be identified,
and measures can then be planned for reducing the gap in performance.
The practical difficulty with competitive benchmarking is that the competitor
will not willingly act as a benchmark, and allow its competitors to make a
detailed study of its operations. Competitive benchmarking is therefore usually
done without the competitor’s knowledge. For example, a company might buy a
product of a successful competitor and analyse its qualities and features in
detail, perhaps by taking it apart in a laboratory and investigating its structure
and components.
Operational benchmarking. A company might use benchmarking to assess the
performance of a particular aspect of its operations, such as customer order
handling, handling e-commerce orders from the Internet, or warehousing and
despatch operations. It might be able to identify a company in a completely
different industry that carries out similar operations successfully. The other
company might be prepared to act as a benchmark, and allow its operations to
be studied and its staff interviewed. The benefit of this type of benchmarking is
that a business is able to learn from world-class companies how to improve its
operations and raise its performance levels.
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Financial performance indicators (FPIs)
Aspects of financial performance
Using financial ratios: comparisons
FPIs for measuring profitability
FPIs for measuring liquidity
FPIs for measuring financial risk
The limitations of financial ratios
2 Financial performance indicators (FPIs)
2.1 Aspects of financial performance
A common method of analysing and measuring the financial performance of an
organisation is by means of ratio analysis. Although profitability is a very important
aspect of business performance, it is not the only aspect of financial performance
that should be monitored. The main aspects of financial performance are usually:
profitability
liquidity
financial risk.
Information for measuring financial performance is obtained largely from internal
sources – financial statements produced by the entity and its accounting systems.
Each financial ratio should be a potential significance. Remember that it is not good
enough simply to know how to calculate a ratio. You need to understand what the
ratio might tell you about financial performance.
2.2 Using ratios: comparisons
Financial ratios can be used to make comparisons:
Comparisons over a number of years. By looking at the ratios of a business entity
over a number of years, it might be possible to detect improvements or a
deterioration in the financial performance or financial position. For example,
changes over time can be used to measure rates of growth or decline in sales or
profits. Ratios can therefore be used to make comparisons over time, to identify
changes or trends, and (perhaps) to assess whether the rate of change is ‘good’
or ‘bad’.
Comparisons with the similar ratios of other, similar companies for the same
period.
In some cases, perhaps, comparisons with ‘industry average’ ratios.