Chapter 15 Monitoring Performance, Cost Reduction and Value Enhancement
Performance measures in manufacturing organisations
• Profitability, activity, liquidity and gearing
These will be the main financial key performance indicators that the organisation will
be interested in, and they look at the overall performance of an organisation.
• Resource utilisation
This can be measured by calculating non-financial indicators such as activity, efficiency
and capacity ratios.
• Variance analysis
Variances are an essential measure of performance.
• Quality
Quality is how well a product or service meets the customer’s needs. It involves
applying various standards and measurement and monitoring of quality costs.
• Customer satisfaction
Customer satisfaction is essential for the long-term growth and profitability of
companies.
• There are several ways that it can be measured. For example, customer survey results
and the number of new customers recommended by current customers are measurement
methods.
Measuring performance in service industries
• Service industry organisations provide services and do not produce physical products
as manufacturing industries do. Examples of places where services are provided are
hairdressers, restaurants, hospitals, hotels and accountancy firms.
• Services have several characteristics that make them different from products. For
example, services are intangible, perishable, inconsistent and simultaneous.
• These characteristics make measuring performance in service industry organisations
more complicated than in other industries.
• There would be a focus on non-financial performance measures specifically related to
delivering the service.
Example
Some examples of performance measures for service industries include:
Example company Service performance measure
Arrival on time %
Seat capacity utilisation %
Cost per passenger-kilometre
Revenue per passenger kilometre
Aircraft availability rates
Route market share %
Emissions per passenger-kilometre
Airline Baggage loss rate %
Cost per megawatt-hour supplied
Uninterrupted supply %
Electricity utility Revenue per megawatt hour supplied
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Example
Sustainable generation %
Generation efficiency %
Emissions per megawatt-hour generated %
Complaint resolution period
Complaint resolution date
Cost per square foot
Service availability period %
Building management Number of security incidents
Measuring performance in non-profit and public sector organisations
• Non-profit seeking organisations include charities, government bodies, educational
establishments and public sector organisations. Let’s look at these in a bit more detail:
o Charities and other voluntary organisations do not look to make a profit. Instead,
donations from donors fund these organisations.
o Public sector organisations, for example, hospitals and schools. These
organisations are controlled and funded by the government (which receives the
money in taxes paid by the taxpayers).
• Taxpayers who fund public sector organisations are interested in value for money: they
want low taxes but high public service levels from what they have paid.
• Donors who make charitable donations will want to ensure the maximum amount of
their contributions will be spent on its intended purpose (the charity’s beneficiaries)
rather than on administration charges. The donors will therefore want to see that their
donations are being put to good use.
• Most public sector organisations aim to provide value for money or the best possible
service for a limited budget. Therefore, in most cases, financial performance measures
will not suit public sector organisations.
Example: Stakeholders' Conflicting Objectives
Stakeholders in a state-funded university:
• The university's management board is accountable to multiple principals.
• However, the requirements of the principals may conflict:
• Students may desire small class sizes, an extensive library, etc.
• Government wants to minimise the costs per student.
• Designing a performance measurement system with multiple and conflicting objectives
is tricky.
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Example: Stakeholders' Conflicting Objectives
• Management must try to rank its principals/stakeholders and prioritise objectives.
• One of the difficulties in measuring performance in such organisations is how to value
their outputs because the outputs are not usually in financial terms. This problem has
led to the development of the VFM or Value for Money concept.
Value for Money (VFM) concept
• The Value for Money concept revolves around the 3E approach – the three Es are:
o Economy – Inputs
This is a measure of inputs-related costs (the aim is to minimise costs for a set
quality or a set amount of inputs). Inputs are the resources input, for example,
time, money, materials and labour.
o Efficiency – Process
This is a measure of how the inputs and outputs are related, with the aim being
to achieve the maximum output from the actual input (resources) used in a
process.
o Effectiveness – Outputs.
This relates the outputs of a process to the objectives of an organisation.
Example
A government wants to measure the performance of the state schools in its country and is
looking at both financial and non-financial performance indicators.
The government wishes to assess the average class sizes of state schools. Which of the three
Es would be the best description of the measure of class sizes?
A school will generally consist of many students taught by several teachers.
The teachers can be thought of as the ‘input’; they are the resources that cost money to employ
(in the form of wages), and the students can be considered as the ‘output’ – an educated pupil
is the result of a state-run school education.
Efficiency is a measure of how the inputs and outputs are related, with the aim being to achieve
the maximum output from the actual input (resources) used in a process. The efficiency =
outputs/inputs = pupils/teachers, the result of which is the average class size in a school.
The government wishes to assess the pass rates of the state schools. Which of the three Es
would be the best description of the measure of pass rates?
A school will generally consist of many students taught by several teachers.
Schools will aim to prepare students to the required standard so that they will be able to pass
their exams.
The students can be thought of as the ‘output’ – an educated pupil is the result of a state-run
school education, and ‘pass rates’ are one of the school’s objectives. The VFM measure that
links output to objectives is effectiveness – how well does the school’s output relate to its
purpose (pass rate) – the answer is ‘effectiveness’.
The government wishes to assess the average cost of employing one full-time teacher in
each state school. Which of the three Es would be the best description of the measure of
hiring one full-time teacher?
The teachers can be considered the ‘input’; they are the resources that cost money to employ
(in the form of wages). Therefore, the teachers’ wages are the cost (the amount spent on the
inputs).
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Example
The measure of employing one full-time teacher can therefore be described as ‘economy’
because this is the measure that relates cost to input.
Example University Objectives – Conflicting 3Es
High effectiveness is likely to conflict with economy and efficiency.
Multiple and conflicting objectives also may exist due to the various stakeholders involved.
Assessment of managerial performance and problems involved
• It is not easy to monitor the individual performance of a division or department manager
within an organisation. This is because sometimes there are factors that may affect a
division but are not under the direct control of the manager of that division. Therefore,
it would be unfair to assess the division manager based only on a single performance
measure of his division.
• As well as ensuring the measures represent a fair reflection of the manager’s
responsibilities and area of influence, it is also essential to ensure the criteria used are
aligned with the organisation’s strategy and long-term goals. This is not easy to achieve.
• For example, if client or customer satisfaction and long-term customer retention are
vital to the organisation’s long-term success, it would not be appropriate to judge
management performance based only on short-term profitability. A focus on
profitability may lead to managers taking a commercially aggressive stance when
dealing with customers and reducing resources dedicated to customer service, which in
the long term may lead to customers switching to competitors.
• Specific targets can be set for managers. For example, a manager could be assigned an
increase in sales target for a period. It would also be fair to assess a divisional manager
based on costs and revenues within their control.
• Therefore,
o It would be fair to assess cost centre managers on controllable costs
o It would be fair to assess revenue centre managers on controllable revenues
o It would be fair to assess profit centre managers on controllable costs and
revenues
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o It would be fair to assess investment centre managers on controllable costs,
revenues and investments.
• Controllable costs and revenues result in a controllable profit, and this is commonly
used in the calculation of two performance measures that can be used to assess
managerial performance in divisions that are investment centres:
o Return on investment ratio (ROI)
o Residual income ratio (RI).
Imputed interest
• The imputed interest (which is sometimes known as the notional interest rate) is
calculated as follows:
Imputed interest = Capital employed (or net assets) × imputed interest rate or cost of capital
• An exam question might give information relating to imputed/notional interest rates.
Return on investment (ROI)
Return on Investment = Controllable profit/controllable capital employed
or
Return on Investment = Operating profit/Net assets
• The return on investment is a similar ratio to the ROCE. It is commonly used when
assessing the managerial performance of an individual department or responsibility
centre when profit and capital employed (net assets) can be controlled by the manager
in charge.
• ROI is a relative measure (expressed in %)
Residual Income (RI)
Residual Income = Controllable profit − Imputed interest on capital employed
or
Residual income = operating profit − (net assets × imputed interest rate)
• A manager has exceeded the profit level required to satisfy the investors if residual
income is positive. Residual income is an absolute measure (expressed in $).
Application of RI and ROI
Example
A division currently earns an ROI of 25%.
It is considering investing in a project with a RI of $2,000 at an imputed interest charge of 25%.
What is the project’s effect on the division’s ROI if undertaken?
Activity 1
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The following information is available on a company’s two departments:
Department 1 Department 2
$000 $000
Capital employed 1,000 100
Profits Year 1 200 20
Year 2 220 40
Target ROI = 20%
Determine which department is performing better using the following:
(a) Residual income; and
(b) Return on investment.
Activity 2
The following information is available on a division and its possible investment in a project:
Division Project
$000 $000
Capital employed 1,000 100
Controllable profit 300 25
Target ROI 20%
Required
(a) Calculate ROI and RI for the division:
(i) Pre-project; and
(ii) Post-project.
(b) Explain whether or not the divisional manager would accept the project if they were
paid a bonus based on the following:
(i) ROI; and
(ii) RI.
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Advantages and Disadvantages of ROI
• Advantages
o It is similar to the ROCE ratio, so it is widely known.
o It uses operating profit/controllable profit and capital employed/net assets to
calculate the ratio – this information can be easily obtained from accounting
information.
o The ROI is a relative measure (percentage) and will provide meaningful
comparisons between different-sized divisions.
o ROI is a commonly used ratio, and so it can be used to make comparisons
between different organisations as well as different divisions within an
organisation.
• Disadvantages
o Identifying the controllable costs and revenues (which impact profit) in ROI
calculations can be challenging.
o The single results of ROI calculations are unlikely to be the 'full story' of how
well divisional managers have performed.
o ROI may lead to managers making decisions that will be best for their
performance measure rather than for the organisation as a whole. For example,
managers may reject projects that have a positive RI if they lower the manager's
ROI.
o ROI values may give a false impression of being high when old non-current
assets are valued at their net book value.
Advantages and Disadvantages of RI
• Advantages
o It uses operating profit/controllable profit and capital employed/net assets to
calculate the ratio – this information can be easily obtained from accounting
information.
o The RI is stated as an absolute value and can be useful when information about
an actual value rather than a relative value (such as ROI) is needed.
• Disadvantages
o Identifying the controllable costs and revenues (which impact profit) in RI
calculations can be challenging.
o The single results of RI calculations are unlikely to be the 'full story' of how
well divisional managers have performed.
o The RI calculation requires an imputed interest charge which must be estimated.
Benchmarking
• Benchmarking compares an organisation’s performance measures to the best in the
organisation’s industry (or to internal departments or divisions) or the best practices
from other companies in a different sector.
• Comparisons can help improve performance, and this is important for benchmarking as
the information indicates an organisation’s strengths and weaknesses against its
competition.
• The process of external benchmarking involves an organisation identifying the best
companies in their industry or in another industry where similar processes exist. The
organisation then compares its results with those of other organisations. The benefit of
this process is that the organisation carrying out the benchmarking process learns how
well the other organisations are performing and what they are doing that makes them
successful.
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• There are four main types of benchmarking.
With internal benchmarking, an organisation compares the performance of
its different divisions or departments.
This is more commonly used in larger organisations which have similar
divisions or departments operating within them.
For example, a large multi-national organisation with offices in many
Internal countries might compare how its accounts receivable departments operate
benchmarking worldwide to help share best practices and promote efficiency.
With competitive benchmarking, organisations look to their industry's
most successful organisations to see how they compare with their
competitors' performances and make changes where improvement can be
achieved.
For example, an organisation may wish to improve the performance of its
accounts receivable department by comparing its processes to those of the
Competitive organisation in its industry with the best-run accounts receivable
benchmarking department.
With functional benchmarking, an organisation will compare its processes’
performance with a top-performing organisation in another industry which
performs a similar function.
For example, a credit card company would be a good industry for an
organisation to look to when it is aiming to improve the performance of its
accounts receivables department. This is because credit card companies
Functional collect monies that are owed to them on a large scale, the same function
benchmarking performed by an organisation’s accounts receivable department.
Strategic benchmarking compares performance measures like an
Strategic organisation's market share in its industry and its profitability ratios with
benchmarking other organisations to improve its strategic or long-term plans.
• Benchmarking enables organisations to learn more about how best-performing
divisions within themselves or the organisations within their industry operate. An
organisation can improve its performance with this information (where it is available).
• Benchmarking exercises are carried out by following the benchmarking process.
1. Select the activity to be benchmarked
Where the organisation appears to be underperforming in a particular activity, it may
select this activity as an area to be benchmarked. An organisation identifies areas of
poor performance by comparing its performance measures with those of the following:
• Other departments or divisions within its organisation
• Other organisations within its industry
• Other organisations in different industries.
2. Carry out the benchmarking process.
Obtain detailed information by looking at the following:
• Publically available information
• Observation
• By arranging with other organisations to interview their employees.
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3. Identify improvements
The organisation may look to see how improvements can be made, which may include:
• Identifying whether new processes could be developed to improve performance
• Reviewing methods used by other organisations to see whether methods
employed by them could lead to improvements.
4. Act on improving performance
Once organisations have decided which activities they would like to improve upon and
how to bring about this improvement, they must make plans to bring about these
improvements and then act on them.
5. Monitor performance progress
Once a programme to improve performance has been set up, it should be monitored and
reviewed to identify how it is doing. If necessary, this process should be repeated if the
results planned have not been achieved.
Total Quality Management (TQM)
• Quality can be defined as the standard of something as measured against other things
of a similar kind.
• Total quality management (TQM) is a management process that focuses on two main
things:
o Getting it right the first time
o Continual improvement of products or services.
• TQM’s elements are:
o Total – every part of the organisation is involved in the TQM process:
employees, customers and suppliers.
o Quality – products and services must be provided at the standard expected by
the customer to meet their needs. Quality does not mean perfection. It means
meeting the customer’s expectations and delivering a product or service that is
fit for purpose.
o Management – prevent faulty products from being produced or bad service from
being provided. This is achieved by managing the quality of an organisation’s
products and services
TQM: Costs of Quality
• Specific costs will be involved in producing products and services that meet quality
standards. These costs are known as the costs of quality.
• There are four main groups of costs of quality:
• Internal failure costs - these are the costs that are incurred when faulty products
or poor services are discovered while they are still in the organisation. They are
usually found by the quality assurance team.
o Cost of correcting faulty products or improving poor quality services
o Cost of scrapping poor-quality materials
o Production delays.
• For example, at Winston’s Football Factory, footballs made that don’t meet
production standards must be scrapped or reworked, costing the company money.
• External failure costs - these are the costs that are incurred when faulty products
or poor services are discovered after they have left the organisation. They are
usually found by the customer.
o Cost of repairing defective products
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o Cost of replacing defective products and poor services
o Loss of customer goodwill.
• For example, at Winston’s Football Factory, dissatisfied customers may return
poor-quality footballs or claim a warranty repair. As a result, there might also be a
sales decline due to a reputation for poor quality.
• Prevention costs - these are the costs that arise because an organisation is trying
to prevent producing faulty products and providing poor services.
• Examples of prevention costs
o Product design improvements
o Maintenance of quality control equipment
o Wages of quality control staff
o Training of quality control staff
• For example, at Winston’s Football Factory, a quality assurance process in monitoring
materials and the manufacturing process is implemented. This costs money and time,
as machines need to be calibrated, employees need to be trained, materials need to be
sourced and inspected, etc.
• Appraisal costs - these are the costs that arise because an organisation is appraising or
assessing the quality of its goods or services.
o Inspection costs of materials received from suppliers
o Inspection costs of finished goods
o Costs of appraising the services provided to customers.
• For example, at Winston’s Football Factory, footballs are subjected to a series of quality
tests and may only be sold to the customer after passing.
• Expenses of using TQM
o In organisations using TQM, the prevention and appraisal costs will be higher
than in organisations not using TQM. This is because these types of cost
increase as more money is spent on preventing faults and assessing the quality
of goods and services.
o In organisations using TQM, the internal and external failure costs will be lower
than those not using TQM. This is because organisations using TQM will
provide fewer faulty goods and better quality services.
o If using a TQM cost management system is to be beneficial, the costs of quality
(prevention and appraisal costs) should be less than the costs of failure (internal
failure and external failure costs).
Application of TQM
• Change of work culture from the pursuit of the minimum cost to that of satisfying
customers.
• Understanding that poor quality costs money.
• Total involvement of all employees in the pursuit of quality.
• Pursuing continuous improvement and accepting that it is a never-ending process.
• Use benchmarking and other quality tools to understand the true costs of activities and
the value they generate.
Cost reduction
• Cost control identifies areas where costs are higher than expected (for example, higher
than budget) and aims to bring them back in line with expectations.
• Cost reduction aims to reduce the unit cost of a product to one that is below the
standard cost by looking at ways in which individual cost elements of a product can be
reduced.
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• Cost reduction should be carried out through a planned cost reduction programme.
Cost reduction programmes should be ongoing processes that continually look for areas
where there may be opportunities to reduce costs.
• Ideally, costs would be minimised and ‘designed out’ of a product or process at the
product or process design stage, and unnecessary costs would be avoided.
• In reality, inefficiencies and higher-than-necessary costs can become established within
organisations. Eventually, a cost reduction programme may be introduced. But,
unfortunately, some cost reduction programmes are rushed and relatively unplanned,
mainly when there is pressure to cut costs straightaway.
• Such arbitrary programmes can result in an immediate reduction in costs, although the
steps taken may not be in the organisation’s long-term interests. For example, the
programme may lead to employee redundancies, resulting in the inability to meet orders
due to insufficient staff.
• The main differences between cost reduction and cost control are summarised in the
table below.
Cost reduction Cost control
Broad focus: aims to reduce the unit cost of Narrower focus: focuses on costs that are
producing and delivering a product or service higher than expected
Rather than accepting standards and budgets, Uses standards and budgets as a way of
cost reduction programmes challenge them planning and controlling costs
Attempts to achieve genuine savings in the cost Involves a comparison of actual costs with
of production, distributing, selling and the standard or budget, and an investigation
administration of variances
• Cost reduction may involve work study techniques, which consist of observing and
analysing current working methods and looking for efficiency improvements. How the
people and departments are organised may also be reviewed to establish whether a more
efficient way of working is possible.
Areas for cost reduction
• Materials
The cost of materials could be reduced by:
o Reducing wastage levels (one way of achieving this is to buy higher quality
materials which are easier to work with)
o Seeking to purchase materials from different suppliers whose prices are lower
o Purchasing materials in bulk to take advantage of quantity discounts which may
be available
o Investigating the use of substitute materials that are cheaper to buy that will do
the same job (and are of the same quality).
• Labour
o If the employees work more productively, they will produce more output for the
same wages, reducing the labour cost per product unit.
o Labour productivity can be increased by:
▪ Introducing incentive schemes to encourage workers to work more
efficiently and to produce more output
▪ Regular maintenance of machinery to reduce idle (non-productive)
hours that employees are paid for whether they can work or not.
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• Machinery
o If machinery works more efficiently, it will enable the organisation to produce
more output during the same operating hours, reducing the overheads per unit
associated with running the machinery.
o Regular maintenance can improve machinery efficiency to ensure it runs at its
most efficient level.
• Production Overheads
o Variable and fixed production overheads are often based on labour hours or
machine hours. Therefore, improving labour and machine efficiency will affect
the overheads charged to a product unit.
• Non-Production Overheads
o Non-production overheads include administration and finance costs, for
example. One way an organisation can look to reduce finance costs is to make
sure that it is paying the lowest interest rate for any finance (bank loan or
overdraft) that it might have.
Activity 3
The following table shows the resources involved in making one football at Winston’s Football
Factory:
Standard cost per football Units Cost per kg ($) Cost per unit ($)
Direct materials – Plastic F 1 kg $3 3.00
Direct labour 2 Hours $6 12.00
Variable overheads 2 Hours $1 2.00
Fixed overheads 2 Hours $2 4.00
Total cost per football 21.00
Winston’s Football Factory is planning a cost reduction programme to look into possible areas
where costs might be reduced without any reduction in the quality of each football.
The following options have been identified:
• A replacement material to Plastic F called Plastic L, which has identical properties but
only costs $2.50 per kg
The material composition of Plastic L is slightly different to that of Plastic F. Even though it is
of the same quality, the difference in its composition means there is less wastage, so the
standard usage of Plastic L would be 0.9 kg per football.
Plastic L is slightly easier to work with, saving five minutes in labour time for each football
manufactured.
• Plans are being made to introduce a bonus scheme, and results have shown that
productivity will increase, resulting in a saving of ten minutes per football produced.
The quality of the footballs will be unchanged, and the standard selling price will remain at
$35 per football.
Calculate the revised cost card and standard profit per football if the suggested options
are implemented (using the absorption costing template below)
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Standard cost per football $ per unit
Direct materials – Plastic L
Direct labour
Variable overheads
Fixed overheads
Total cost per football
Selling price
Revised standard profit
Value analysis
• Value analysis is a cost reduction method that looks at a product’s or service’s
components and considers how each one affects its unit cost. Value analysis also looks
at how the design of a product or service can be changed without affecting its value.
• The main aims of value analysis are:
o To produce a product or cost at a given standard for the most economical cost
o To look closely at each product or service feature and ask how necessary each
feature is.
• Types of Value
o Four types of value are used when considering how necessary the features of a
product or service are.
Value type Description
The value of the product or service from the point of view of its use.
Utility value The utility value is also known as the use value.
Esteem The value of a product or service from the point of view of what it
value means to the customer (its prestige).
The value of a product or service from the point of view of how much
Cost value it costs to produce and sell.
Exchange The value of a product or service from the point of view of its market
value value.
Value analysis method of cost reduction
• Two assumptions are associated with the value analysis method of cost reduction:
o Consumers will have a standard of quality that they require for each product or
service, and organisations will work towards this required standard
o The organisation tries to achieve the desired objective for a product or service
for the lowest possible cost.
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• There are six main steps involved in carrying out a value analysis.
1. Select an item for value analysis
It is common for the product or service that incurs the highest costs (which therefore
represents the greatest possibility of saving costs) to be selected for value analysis.
2. Record information relating to the selected item
When recording the information that relates to the item chosen for value analysis,
consider the following questions:
• Does the product or service carry out its intended function?
• What are the costs associated with producing this product or service?
• Are there any alternative methods of making the product or service, and what
are the associated costs?
3. Analyse product/service information
Analysis of the product/service includes:
• How essential are all of the elements of the product/service?
• Can each individual cost element be purchased or manufactured at a lower cost?
• Are all of the features of the product/service necessary?
• Is it possible to substitute one of the items of cost for a cheaper alternative (of
the same quality and functionality)?
4. Consider alternatives
This stage considers the alternative ways of producing a product/delivering services
that are available to an organisation. It is a good idea to gather information about each
alternative’s cost at this stage.
5. Select the option that costs the least
Evaluate each of the alternatives available and consider their associated costs. Then
select the best option from those available.
6. Recommend the best option
Recommend the best option and begin planning the cost reduction programme.
Value analysis and activity-based costing
• Value analysis reflects aspects of activity-based costing (ABC).
• ABC measures activities’ cost and performance level, including how activities
contribute to the organisation’s success. ABC and value analysis aims to ensure that the
things the organisation does are necessary, are done well, and ‘add value’.
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