INTRODUCTION monitoring of management budgets and targets

INTRODUCTION

Performance Evaluation deals
with measurement and monitoring of management budgets and targets against
actual results to establish how well the organization and its staffs are
functioning as whole and as individual.

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Performance Evaluation can
relate to short term objectives e.g. Cost Control or long term objectives e.g.
Customer Satisfaction. The short term objectives will enable the organization
to monitor progression towards the ultimate long term objectives and to enable performance
of employees to be measured along the way.

However the objectives or goals to measure performance may vary
depending on the type of the organization that is being operated. Example;-

a)     
A Profit Making Organization the overall goals is for
shareholders wealth maximization, therefore such company will monitor the
Profitability and Market share compare to competitors.

b)     
For Non Profit Making Organization e.g. Government; the
overall objectives is to provide better services to the public.

Performance measurement aims to establish how well an organization or
its personnel is doing. It is about how organizations measure the quality of
their activities and services, and is a vital part of the control process. As a
management accountant, you have to be able to identify a suitable performance
measure for a department, a person or an organization.

Performance measure is termed as a key performance indicator (KPI). KPI
can be separated into Financial Performance Indicators and Non-Financial
Performance Indicators.

SUITABLE FINANCIAL PERFORMANCE
MEASURES

An organization should set a
suitable financial performance measures in order to monitor the achievement of
each objectives. These suitable performance measures may include;

(a)   
Strategic – Measurement of overall
profitability of the organization and return made on investing surplus funds.
Return on Investment (ROI), Return on Sales etc.

(b)  
Tactical – Comparison of actual costs
and revenues with the budgeted costs and revenues for each business division or
department. Actual profit with the budgeted produced monthly.

(c)   
Operational – Measurement of day to day
targets such as meeting production requirements, meeting sales targets and
reducing wastage. Quality of rejects, number of customer complaints produced
daily.

 

EXTERNAL FACTORS AFFECTING
PERFORMANCE MEASUREMENT

External factors may be an important influence on the ability of the
organization to achieve objectives. Particularly, market condition and
government policy are the factors that the organization’s management will not
be able to control and will need to be carefully monitored to ensure forecasts
remain accurate.

Economics and Market
conditions

The economics and market conditions may led to the deteriorated or
improvement of the management performance. Also the action of competitors
sometimes may be considered, for example; demand of the company’s products may
decrease if a competitor reduces its prices or launches a successful
advertising campaign.

Government regulation

The government regulation has a direct impact to the management’s
performance by introducing regulations or by having agencies that monitor
organization activity may led to the deteriorated or improvement of the
management performance. Example, Fines and Quota – maximum quota are set to
limit production or importation and if exceed fines are imposed. E.g. the
government has set the quota on importation of sugar so that to protect local
industries, by exceeding the authorized quantity then fines are imposed.

If the organization is
affected by government regulation then the performance measures should be
taken.

The measurement and evaluation
of financial performance are central to control the affairs of an organization.
Performance measurement can be sub-divided into financial measures and
non-financial measures.

FINANCIAL PERFORMANCE MEASURES

Financial measures used to
monitor revenues and costs and overall management of funds in the organization.
These measures focus on information available from Income statement and
Statement of financial position of an organization.

It can be used to records the performance of Cost centres, Profit
centres and Investment Centres within a responsibility accounting system but it
can also be used to assess the overall performance of the organization.

Profitability Measures

The primary objective of
Profit Making Organization is to maximize profitability. A business needs to
generate profits to be able to provide returns to investors and to be able to
grow and made expansion of its operation by re-investing into the business.

 

 

 

The major ratios used to monitor the achievements of this objective are;

a)      Return on Capital Employed (ROCE)

= Earnings before interest
and tax x 100%

           Capital Employed

 

b)     Return on Sales (ROS)

= Net profit x 100%

       Sales

 

c)      Gross Profit Margin

= Gross profit x 100%

        Sales

 

d)     Return on shareholder’s equity (ROE)

= Earnings after tax x
100%

Total shareholder’s funds

 

Liquidity
Measures

An organization can be
profitable but at the same time may face liquidity problems. The liquidity
measures ability of the company to meet short term obligation as the fall due.
There are two major liquidity ratios that used to measure ability of the
company to meet short term financial obligation.

a)      Current ratio

=    Current Assets

    Current Liabilities

 

The ratio that being equal or exceed 2:1 is desirable
but the expected ratio varies depending on the type of the industry. E.g.
Banking Industry should be more liquidity as the customer may demand his saving
at any time.

 

b)     Acid test (Quick ratio)

=    Liquid Assets

    Current liabilities

 

The liquid Assets are those current assets that are
near to cash money or quick to pay liability by cash without losing the
original value. Liquid assets are total current assets excluding Inventories
and Prepayments. If the ratio is 1:1 or above then the liquidity position of
the company is said to be desirable.

 

Activity Measures

Activity measures the
efficiency of the company to generate returns. It looks on how well a business
manages to convert statement of financial position items into cash.

a)      Assets Turnover

=     Total Assets

     Sales Revenue

 

It measures the contribution of assets to generate
revenue. It answers the question; Does the company’s assets managed efficiently
to generate revenue.

 

b)     Inventories Days

= Average Inventories x
365 Days

       Cost of sales

 

Measure number of days has
taken to sale the inventories.

 

c)      Receivables Days

= Average Receivables x
365 Days

         Credit sales

 

Risk Measures

It is important for the company to manage risks as it manages
profitability, liquidity and efficiency. How ‘geared’ a company is can be
determined to assess financial risk. Gearing/Leverage indicates how well the
company will be able to meet its long term debts.

a)      Debt Ratio

=   Total Debts x 100%

     Total Assets

 

b)     Debt to Equity Ratio

=           Total Debts x 100%

     Total Shareholder’s funds

 

NON
FINANCIAL PERFORMANCE MEASURES

Although profit cannot be ignored as the first objectives of Profit
Making Organization, critical success factors (CSFs) and Key Performance
Indicators (KPIs) should not focus only on profit alone. The view is that a
range of performance indicators should be used and these should be a mix of
financial and non financial measures.

Example
of Non Financial Performance Measures includes;

a)     
Measurements of customers’ satisfaction e.g. returning
customers, reduction in complaints.

b)     
Resource utilization e.g. the machine being operated
for all available hours and producing outputs as efficiently as possible.

c)     
Measurements of quality e.g. reduction of conformance
and non-conformance costs.

 

The large variety in types of
businesses means that there are many Non financial performance indicators. Each
business will have its own set of non financial performance indicators that
provides relevant measures of the success of the business. However non
financial performance measures can be grouped together into two broad groups;

1)     
Productivity

2)     
Quality

Productivity

A productivity measure is a measure of efficiency of an operation; it is
also referred to as resource utilization. It relates the goods or services
produced to the resources used, and therefore ultimately the cost incurred to
produce the output. The most productive operation is one that produce the
maximum output for any given set of resources inputs or alternatively uses the
minimum inputs for any given quantity or quality of output.

Type
of Productivity Measures

Productivity measures are usually given in term of labour efficiency.
However productivity measures are not restricted to labour and can also be
expressed in terms of other resource input of the organization such as the
machine hours used for production.

Productivity
measures often analyzed using three control ratios;

a)     
Production – Volume Ratio

This ratio assesses the overall
production relative to the budget. A ratio is excess of 100% indicates that
overall production is above budgeted levels and below 100% indicates a
shortfall compared to budget.

Formula:

            = Actual Output Measured in Standard Hours x 100%

                        Budgeted Production Hours

 

b)    
Capacity Ratio

This provides information in
terms of hours of working time that has been possible in the period. A ratio in
excess 100% indicates that more hours have been worked than were in the budget and
below 100% fewer hours have been worked than in the budget.

Formula:

            = Actual Production Hours Worked x 100%

                  Budgeted
Production Hours

 

c)     
Efficiency Ratio

This is useful indicator of
productivity based on output compared with inputs. A ratio in excess 100%
indicates that the workforce have been more efficient than the budget predicted
and below 100% less efficient than in the budget predicted.

 

 

Formula:

            = Actual Output Measured in Standard Hours x 100%

                        Actual
Production Hours Worked

 

 

Quality

Quality is an issue whether
manufacturing products or providing a service. Poor quality products or
services will leads to a loss of business and damage to the businesses
reputation. Targets of an appropriate level need to be set. Example of Non
Financial Performance Indicators that could be used to monitor quality both
from an internal and external perspective include:

a)     
Customer complaints

b)     
Speed of delivery

c)     
Accuracy of delivery

d)    
Staff absences

e)     
Overtime working

f)      
Cleanliness

EVALUATION OF RESULTS BASED ON
BUSINESS OBJECTIVES

Business Objectives

Business objectives should be
in line with the mission statement of the organization.  The major business objectives of most of
organizations include;

a)     
Profitability

b)     
Survival

c)     
Customer Satisfaction

d)    
Employees Retention

e)     
Maximization of Shareholder Value

An organization may develop various strategies to achieve business
objectives. At the time that objectives are identified, the following stage is
to break down each objective into action plans. Action plans must be small and
manageable projects so that they can be accomplished in time.

Evaluation of Business Results

Evaluation of performance of
any organization is the fundamental practice to assist in early identification
of potential problems and used to determine both positive and negative trends
in company’s operations. When the evaluation process is completed then the
management needs to focus on improving business performance to ensure that the
business is in line with the recommendations from the evaluation.

 

 

 

Generally, the financial
business results can be measured by;

a)     
Profitability measures

b)     
Cash flow, liquidity and solvency measures

c)     
Efficiency measures

d)    
Risk measures

 

Action
taken by management to achieve business objective

Based on the evaluation of
business results, the management may be required to take action to achieve
their objectives. This is mostly required especially where objectives are
changing. Normally, taking action is not as easy as in theories. Therefore the
first step the management has to ensure that the approaches used is in the
right place. They should know what they want to achieve and how will be
achieved. Other steps to be followed include:

i.       
Setting goals and deadlines

ii.     
Structuring time frame to achieve the goal, and

iii.   
Being flexible to adopt changes

THE BALANCED SCORECARD METHOD

To ensure an effective system
of performance appraisal a business should use a combination of financial and
non financial measures. One of the major developments in performance
measurement techniques that have been widely adopted is the balanced scorecard.

The concept of Balanced
Scorecard was developed by Kaplan and Norton in 1994 at Harvard. Balanced
Scorecard is the device for planning that enables managers to set the range of
budgets linked with appropriate objectives and performance measures. It defines
the mission, outlining the strategies to achieve the mission, understanding the
major customer requirement, defines the internal business process and assessing
the organizational infrastructure needed to achieve the objectives.

The balanced scorecard is a useful approach for a complete strategic
performance evaluation is to include both financial and non financial factors
for the organization. It measures an organization’s performance in four (4)
major key areas;-

a)     
Customer Satisfaction

This is an attempt to measures the customers view of the organization by
measuring customer satisfaction.

b)    
Financial Performance

This focuses on satisfying shareholders value. Appropriate performance
measures include; Return on Capital Employed (ROCE) and Return on Shareholders’
Funds.

c)     
Internal Business Process

This aimed to measure the organization’s output in term of technical
excellence and customer needs.

d)    
Learning and Growth

This focuses on the need for
continual improvement of existing products and techniques and developing new
ones to meet customers’ changing needs.

 

Sources: Lean Management Programme: A management
System Built for Purpose (lean.org.za)

EVALUATION ON THE USES OF
VALUE FOR MONEY (VFM) TECHNIQUES IN PERFORMANCE MANAGEMENT

Generally value for money (VFM) signifies the following three elements
relating to the internal operations of an organization and its use for money;

a)     
Economy (Input)

This implies the principle of prudence.

b)    
Efficiency (Process)

This is concerned with the relationship between the input and output of
goods, services or other outcomes.

c)     
Effectiveness (Output)

This is concerned with the relationship between the planned outcomes and
actual outcomes of projects, programmes or other activities.

It is very important to note
that, regardless of the type and nature of the organization, the basic
assessment techniques of Economy, Efficiency and Effectiveness remain the same.
These three measures may sometimes conflicts each other but may also complement
each other.

 

STAKEHOLDER BASED MEASURES OF PERFORMANCE THAT MAY BE USED TO
EVALUATE SOCIAL OR ENVIRONMENTAL PERFORMANCE OF THE BUSINESS

Stakeholders are the people
who have an interest on the operation of a particular company. Any decisions
made by the organization are likely to affect their interest either positively
or negatively. The major stakeholders of any organization include;

i.       
Board of Directors

ii.     
Existing and Prospective Shareholders

iii.   
Money Lenders

iv.   
Customers

v.     
Competitors, and

vi.   
Suppliers

 

Stakeholders based measure of
performance

The stakeholders’ approach of
developing the model of performance measurement captures strategic planning
issues. They can determine the organization’s performance through measures like
Balanced Scorecard, Economic Value Added (EVA), Shareholder Value Added (SVA)
and the environmental and social reporting of such organization.

 

How the transfer prices can
distort the performance evaluation of divisions and decision made

Transfer pricing is the set of mechanisms which is used to attach prices
to the goods or services which are traded between two divisions of the same
company. The transfer price is the price one division charges for a product or
services supplied to another division of the same organization. The goods which
are transferred in this way are called the intermediate product.

In order to make performance
evaluation of the divisions useful, the ‘Selling Division’ should be credited
with the revenue for the products and services transferred. By the same amount
the ‘Buying Division’ needs to be charged with the expense of using the goods
or service supplied by the ‘Selling Division’. Where interdivisional transfers
represent a large part of the total sales or purchases of a division, transfer
pricing is a very important issue. Any small change in the transfer price of
the product transferred may result into large changes in profits for the
division concerned.

The performances of divisional
managers are often assessed according to the profits generated by the division concerned.
Accordingly, setting transfer price can become a sensitive issue between
divisional managers to make decisions which are in the interest of their
division but which are not in the interest of the business as a whole.

 

 

Effect of Transfer pricing
methods on the divisional performance

1.     
Cost-Based Method

Under this method, management needs to be careful in determine the
efficiency of the transferor division. If the transferor division works less
efficiently, this inefficiently will be transferred to the transferee division
and will ultimately affect its performance.

2.     
Market Price Method

This method achieve most of the objectives of transfer pricing such as
goals congruence, divisional autonomy etc. This method does not favour any
division. The transfer division has the freedom either to sell the product to
the transferee division or in the external market. On other hand, the
transferee division has the freedom either to purchase from outside or from the
transferor division.

3.     
Negotiated Price Method

Under this method, division
which have good bargaining skills will be at an advantage. Accordingly, this
method does not present a rational transfer price and leads to distorted
performance levels for the division involved in the transfer of products.