Module 4 · 2020-05-07 · has its own unique characteristics. Organisations today operate in an international and fast-paced business environment, which brings constant change. This

STRATEGIC MANAGEMENT ACCOUNTING

Module 4PROJECT MANAGEMENT

http://www.cpaaustralia.com.au

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260 | PROJECT MANAGEMENT

ContentsPreview 263

IntroductionObjectives

Part A: Project management defined 265What is a project? 265What is project management? 266The project management process 267

Stage 1: Project selectionStage 2: Project planningStage 3: Project implementation and controlStage 4: Project completion and review

Organisational structures for projects 271Project organisations Internal projectsJoint venturesCollaborationsPublic private partnershipsVirtual projects International projects

Part B: Roles in project management 276Project sponsor 276Project manager 276

Project leadership and the management accountant

The project team 280International project teams 282

Project management roles in international project teams

Virtual project teams 284Challenges for virtual project teams

Part C: The management accountant’s role in project selection 286Developing a business case for projects 286Strategic fit 287Stakeholder identification and assessment 290

Ethically informed decision-making and its impact on stakeholders

Risk assessment 295Risk identificationRisk classificationRisk mitigation

Financial analysis—single project 299Net present valueInternal rate of returnProfitability indexPaybackReturn on investmentResidual incomeDeficiencies in accounting-based measuresSensitivity and scenario analysis

Financial analysis—multiple projects 314Equivalent annual cash flow (equivalent annual annuity)

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Part D: The management accountant’s role in project planning 316Project scheduling 317

Gantt chartsPERT: Program evaluation and review techniqueCritical path method—crashing projects

Project budgeting 328Project management software

Supplier contracts 329

Part E: The management accountant’s role in project implementation and control 330Monitoring progress 330Monitoring costs 331

The earned value method: Time versus cost

Monitoring specification and quality 335Quality costs

Measuring performance 337The importance of probity in projects 338Risk management 339Stakeholder management 341

Part F: The management accountant’s role in project completion and review 343The completion decision 343Checklist 343Specification satisfaction consensus 343Strategic fit assessment 344Stakeholder satisfaction assessment 345Financial closure 345

Final costsClosing the cost recordsPost-project expenditure

Resource dispersion 346Final report 346Knowledge management 347

Review 349

Appendices 351Appendix 4.1 351Appendix 4.2 357

Suggested answers 363

References 377Optional reading

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Module 4: Project management

Study guide

Preview

IntroductionThe organisations we work in have many projects. It is easy to see projects in a company whose operations focus on delivering projects, such as the Lend Lease construction company building the new Western Sydney Stadium (Lend Lease 2018), or a software development company such as Microsoft, which develops and delivers new software for your computer. Projects may be focused on improving a current product, such as Toyota upgrading the new Corolla, or a new edition of a mobile phone, such as the latest Apple iPhone. Projects may also be oriented towards the development of a new product line, such as the Apple Watch. Projects can also focus on improving core processes in an organisation (e.g. process mapping and improvement), or be oriented towards support activities (e.g. IT upgrade of enterprise resource planning software), or decision support software.

These examples show that projects are strategically important to organisations. For example, the development of the Apple Watch was central to the company’s strategy to gain competitive advantage in the marketplace by enhancing iPhone use through wearable technologies. To achieve these objectives, project management must be aligned with an organisation’s strategic planning.

Projects are very important and management accountants are likely to be constantly involved in them in the workplace. Projects are also challenging. Typically, each project has a different customer and location, a smaller or larger scope, and so on. These characteristics highlight one of the inherent features of any project—it involves doing something that has not been done before; it is unique. Even when a project has similarities with other projects, each project still has its own unique characteristics.

Organisations today operate in an international and fast-paced business environment, which brings constant change. This presents many challenges, but there are also significant rewards for successful project management. Due to the uncertain nature of projects, a combination of technical tools, coordination and individual judgment is required to make them successful. This module considers these issues from a practical viewpoint.

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Part A of this module considers the definition of project management, including the stages of a project and organisational structures for projects. Part B discusses the roles within project management teams. Part C explores the role of the management accountant in project selection and the range of analytical techniques that are used in this task. Part D examines planning tools that are central to the successful implementation of a project. Part E considers the management accountant’s role in project implementation, risk management and control. Finally, in Part F, the post-completion and review processes are addressed.

The highlighted sections in Figure 4.1 provide an overview of the important concepts in this subject and how they link with this module. This module discusses how the management accountant works to provide management with information for projects and operational decision-making that informs and is informed by strategy.

Figure 4.1: Subject map highlighting Module 4

External environment


VISION

STR

ATE

GY STR

ATE

GY

MANAGEMENT ACCOUNTANT

OPERATIONS

VALUE INFORMATION

VALUE INFORMATION

Source: CPA Australia 2019.

Objectives After completing this module, you should be able to:• Explain the steps and roles in project management and the different types of organisational

structures for projects.• Undertake financial analysis to assess risk and return of a given project. • Evaluate the strategic fit of competing projects or projects as a portfolio.• Apply project management scheduling and budgeting techniques.• Recommend approaches to monitoring and managing a project.• Explain the importance of project post-completion review.

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Part A: Project management defined

What is a project?Projects are everywhere—in the workplace, at home and globally. They can be as large and well known as the construction of the Great Wall of China or the US space shuttle program; or they can be as small as putting together a new entertainment unit at home; or they can be specific to a workplace such as the upgrade of an IT system. Regardless of how large or small the project, or how specific, as shown in Figure 4.2, a number of characteristics are common to all projects.

Figure 4.2: Characteristics common to all projects

1. Unique• Principal characteristic of any

project (Zwikael & Smyrk 2011)• Key distinction between

day-to-day operations and a project

• Leads to another defining characteristic—high level of uncertainty

4. Related activities • Project activities use multiple

resources that need coordination

• Important to understand which activities must occur sequentially and which can proceed concurrently

3. Defined start and finish time • Management focus on the

finishing time is often very high—most projects require considerable investment before the benefits are realised

• The longer the project runs, the longer it is before it generates a return on investment

2. Provides a solution to a problem

• Satisfies an objective within a defined scope

• Could be about generating profit, reducing costs, or improving a specific system or business process

• Objective is commonly set/agreed upon by the business partner

• Any investment in a project should provide recognised added value to the company funding the project

Projects

#1 ?


Examples of these characteristics can be seen in Example 4.1.

Example 4.1: Australian liquefied natural gas (LNG) projects Australia is the fourth largest LNG exporter in the world, with eight operating LNG developments, and two other projects under construction. The existing LNG developments are located in Western Australia (the North West Shelf, Pluto, Gorgon and Wheatstone), Queensland (Queensland Curtis LNG, Gladstone LNG and Australia Pacific LNG) and the Northern Territory (Darwin LNG). Two large Australian LNG development projects are located off the north coast of Western Australia (Prelude and Ichthys). ‘In total, Australia has more than $80 billion of LNG projects under construction’ (Australian Petroleum Production and Exploration Association 2018).

These projects demonstrate the characteristics of projects discussed earlier: • While all are LNG projects, and so share some characteristics, their locations and distinctive geology

make each uniquely challenging in terms of accessing the LNG and transporting the gas to market.• All projects are problem-oriented, being focused on increasing LNG production and associated

revenues.• All projects are time-limited—by the LNG reserves available. When the reserves are depleted,

or their recovery becomes uneconomic, the project will be abandoned.• LNG projects are very complex. Finding suitable gas fields, building offshore gas rigs, and drilling to

access the LNG is only the beginning. When the field is in production, the gas must be transported in ships or by pipelines to ports for shipment.

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➤ Question 4.1Complete the following table by listing six key characteristics of a project and explaining how these make it different from day-to-day operations.

1.

2.

3.

4.

5.

6.

Check your work against the suggested answer at the end of the module.

What is project management?Project management is about planning, controlling and integrating resources and activities so that the objectives of the project can be achieved on time and within budget. This includes trying to foresee all the uncertainties or risks associated with the project.

The Project Management Institute (PMI 2017, s. 1.2.2) defines project management as ‘the application of knowledge, skills, tools and techniques to project activities to meet project requirements’.

Project management is an extremely challenging activity when the level of success and failure in projects is considered. For example, research on 5400 large IT projects found: • Half of all projects had large budget blowouts. These projects, in total, had a cost overrun

of $66 billion.• On average, the projects ran 45 per cent over budget and delivered 56 per cent less value

than predicted.• The longer a project was scheduled to last, the more likely it was that it would run over time

and budget (Bloch, Blumberg & Laartz 2014).

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Not only is project management about trying to deliver what is expected, but good project management requires an understanding of how to maintain control over costs. This is often difficult, as highlighted in Example 4.2.

Example 4.2: Rio 2016 Summer OlympicsAn example of how it is difficult to maintain control over project costs is the Rio 2016 Summer Olympic Games (Matheson et al. 2018). The actual cost of this project is estimated to have been up to USD 20 billion. The budget was used for building the competition venues, the Olympic village, international broadcast centre, media and press centre, road, rail and airport infrastructure, as well as for activities such as transportation, workforce, security, catering, ceremonies and medical services. Although there is no agreement on the exact numbers yet, it is clear that the actual cost was much higher than the expected one; similarly, every Olympic Games since 1968 has finished up with actual costs (AC) exceeding original estimates. How did this happen?

A number of issues affected the project:• All Olympic Games events are complex mega-projects that require the involvement and

collaboration of governments, private contractors, international sports bodies and other influencing stakeholders.

• All Olympic Games projects are led by teams who do not have previous experience in managing an Olympic Games project.

• The Rio 2016 Summer Olympic Games project was more complex for the organisers than originally anticipated.

• There was a tight schedule because Brazil hosted the 2014 FIFA World Cup and the 2016 Summer Olympic Games in Rio—two complex projects that needed high-level attention at the same time.

• Financial irregularities and allegations of bribery in Brazil contributed to the poor project results.

What is interesting is that many of the techniques or tools used in project management were developed during World War II and in the two decades afterwards (Zwikael & Smyrk 2011) as a result of experiences in weapons development and space exploration. The skilful application of these tools has an enormous influence on whether a project is delivered on time and on budget, while satisfying its objectives. Before considering the range of tools used, the next section discusses the basic steps in the project management process.

The project management processThere are four basic stages in the project management process that sometimes overlap. This section provides a brief description of each. These stages are shown in Figure 4.3 and will be discussed in more detail later in the module.

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Figure 4.3: The four stages of a project

Managementaccountantinvolvement

Projectselection

Projectplanning

Project implementationand control

Project completionand review

1

2

3

4


Stage 1: Project selectionThe project selection stage is where project objectives are identified, acceptable levels of performance are made clear and the key deliverables are established. This is also when the initial project team is formed, and the feasibility and justification for the project are established.

The primary objectives of the project need to be identified during project selection. These are typically grouped under:• specification—the technical description of the project’s deliverables (discussed in the

next section)• budget—how to meet the project specifications with the available resources• completion time—the period during which the project is expected to start and finish.

The key criteria in project selection are strategic fit and risk analysis. The project must support organisational strategy, or the investment will likely be wasted. For example, consider a manufacturer pursuing a low-cost strategy. Projects or investments to support this strategy should increase efficiency and reduce labour costs. A project to implement a new quality assurance automated process might increase the products’ quality and reliability, but it would not necessarily support a low-cost strategy—so may not be selected. Such a project would be more useful if the company was pursuing a differentiation strategy, such as a high-quality strategy.

In this stage, the management accountant provides support in:• identifying and quantifying risk(s)• applying an analysis of strategic strengths, weaknesses, opportunities and threats (SWOT)

(see Module 1)• assessing the financial viability of the project.

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Stage 2: Project planningThe project planning stage is where the specific strategy for delivery of the project specifications is developed in detail and where tentative dates for deliverables are established. It is also when schedules and budgets for time and cost are formulated. Planning is usually broken down into five key areas: 1. scheduling—where the activities that need to be performed in the project and the sequence

in which they are to be performed are considered2. optimising cost and time—where the sequence of activities is analysed and optimal trade-

offs are established3. budgeting—where the project budget is prepared in detail to communicate the resource

requirements in terms of people and supplies; and to establish a control framework so that variance analysis can be performed during and after project implementation

4. performance measurement—where the project specifications are converted into a set of performance measures or key performance indicators (KPIs). KPIs are usually set against the key project deliverables and incorporate clearly defined time frames. Critical points in project implementation called ‘milestones’ are also established

5. incentives—which address how the project team (discussed in Part B) will be rewarded for achieving the project’s KPIs.

The management accountant will often have input into the budget and other financial planning aspects of project planning as well as the design of KPIs. Once these five areas of project planning are complete, the project sponsor reconsiders the feasibility of the project and either formally approves commencement of the project or decides to discontinue it.

Part D discusses the tools used in project planning.

Stage 3: Project implementation and controlThe project implementation stage happens when project activities begin.

Progress against the set deliverables’ dates and the budget is monitored, variances are examined and necessary adjustments are made. An important part of monitoring is tracking how the project’s progress compares to the milestones.

Operational or manufacturing variance analysis is well understood by accountants, but new complexities arise in project variance analysis. Many projects extend over a long period of time— sometimes several years. Price variances can arise due to:• inflation—the decline in the purchasing power of the local currency• currency movements when project resources are acquired offshore—changes to the local

currency against foreign currencies.

Project managers (discussed in Part B) need to understand how the cost of work completed differs from the expected cost of this work (the cost variance), and the difference between the budgeted costs of work done and the work planned (the schedule variance). Accordingly, project variance reports can be complex.

The management accountant is typically involved in ongoing budget variance analysis as well as tracking performance against KPIs.

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Stage 4: Project completion and review The final stage of a project is when all the deliverables have been completed and the original objectives achieved. The members of the project team are gradually taken off the project and the project itself shuts down. As each project will have a set of lessons learnt, knowledge management is an important skill to have for this stage. It is important that lessons learnt from the project are documented and fed into new projects where applicable. The management accountant will often be one of the last people taken off the project (along with the project manager), as they are involved in determining final project costs and closing down the related accounts.

➤ Question 4.2 Complete the following table by briefly explaining the role of the management accountant in each project stage.

Project stage Management accountant’s role

Stage 1: Project selection

Stage 2: Project planning

Stage 3: Project implementation and control

Stage 4: Project completion and review


Note: This will be covered in greater depth in Parts C, D, E and F.

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Organisational structures for projectsThe organisational structuring of projects can be done in a number of different ways depending on the requirements and purpose of the project. The six approaches summarised in Figure 4.4 are the main types of project structure. These are discussed further in the following section.

Figure 4.4: Organisational structures for projects

Organisational structures

for projects

Virtual projects

Project organisations

Public privatepartnerships

Internal projects

CollaborationsJoint

ventures (JVs)


Project organisations Project organisations are those that have projects as their core operating activity. Examples of this would be construction companies (see Example 4.3), software companies or professional service organisations.

Example 4.3: Leighton HoldingsAn example of a project-based organisation is Leighton Holdings, an Australian-based international construction company whose core operating activity is building and infrastructure projects. A sample of current projects chosen to demonstrate the scope of the company’s activities includes: • the redevelopment of the Royal North Shore Hospital in New South Wales • the development of the Melak coal mine in Indonesia • the engineering and construction of the Springleaf Station and rail tunnel complex in Singapore • the operation of the North West Rail Link in New South Wales.

Leighton’s involvement in these projects is as principal or, more commonly, as part of a consortium.

More information is available online at: http://www.cimic.com.au/our-business/projects.

http://www.cimic.com.au/our-business/projects

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Internal projectsThis is where a project exists within an organisation whose main business is some other form of product or service provision. In these situations, the project supports the core operating activities of the organisation. For instance, the project might be new product development, implementing new IT systems, asset replacement, cost-reduction programs, or implementing new performance indicator systems. For many management accountants, projects they will be involved in are likely to be internal (within the organisation) ones.

Joint venturesThis structure is used when two or more organisations co-contribute in a form such as capital and technology to undertake a project where the revenue and expenses are also shared. JVs are common in international projects where there are significant risks or where undertaking the project is not possible without a local partner. One of the challenges in JVs is maintaining control of the project, as two or more parties have input and may have different motivations for undertaking the project.

CollaborationsCollaborations are like JVs in that two or more parties contribute towards the achievement of a project outcome. These parties can be different organisations, as well as business units within the same organisation. However, they tend to be less formal or more fluid and flexible than JVs, and do not always have a commercial motive. Instead, collaborative projects build a sense of joint belonging and a culture of cooperation that integrates the diverse skills, knowledge and expertise of people with no experience of working together—an example of this can be seen in Example 4.4.

Example 4.4: Project collaborationAn example of project collaboration involved the Finnish Transport Agency (client organization) and VR Track Ltd. (the main contractor for both design and construction work) partnering in a complex railway project. The railway renovation project aimed to improve the safety, reduce maintenance costs by renewing and repairing structures, and reinforce surface and bench structures. The main goals of the project were rail track usability, undisturbed railway traffic, scheduling, traffic and occupational safety, cost efficiency, and planning and construction quality. The total budget of the project was 106.4 million Euro.

This project identified six key activities supporting the formation of collaborative project identity:

(1) articulating a joint vision for collaborative project identity;

(2) converging on mutual conceptions of collaborative project alliance philosophy;

(3) attaining a shared collaborative mentality;

(4) designing ways of working with multiple identities;

(5) attaining distinctiveness and

(6) legitimizing activities.

Source: Hietajärvi, A. & Aaltonen, K. 2018, ‘The formation of a collaborative project identity in an infrastructure alliance project’, Construction Management and Economics, vol. 36, no. 1, 121.

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Public private partnershipsPublic private partnerships (PPPs) are formed when the government and private sector organisations agree to undertake projects together, often in the public interest. The PPP structure may be used to reduce the risk for the private sector organisations and provide the technical expertise required by the government. While these partnerships are often focused on projects such as infrastructure development (e.g. the Sydney Light Rail), they can also be focused on other areas such as health and welfare development, where the project may be beyond the ability of any one government or private organisation to deliver.

A good example of this type of PPP is the Peter MacCallum Victorian Comprehensive Cancer Centre (VCCC) in Melbourne, Australia, with information available at: https://www.petermac.org/about/partnerships/vccc-partners.

Virtual projects Virtual projects are when project team members are located in different places and the dominant method of communication and operations is via communications technology. A good example of this is software development, where programmers may be based in Bangalore, India, and work on projects for US, European or Asian-based organisations (Lewis 2008). The great advantage of this kind of project approach is that expertise can be employed from the best source and project team members can work independently. One other advantage of virtual teams is that, if it suits the project, there may be significant cost savings in not having to relocate project team members.

➤ Question 4.3Is ‘collaboration’ a type of ‘project organisation’ or a ‘within organisation’ project activity? Explain your answer.

Explanation

Project organisation Within organisation


International projectsAn international project is one that is based in a different country (or at times, multiple countries) to the ‘home’ country of the organisation. As such, the environment of the project is more complex. Figure 4.5 highlights a number of factors that make an international project different from a locally based project.

https://www.petermac.org/about/partnerships/vccc-partners

https://www.petermac.org/about/partnerships/vccc-partners

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Figure 4.5: What makes international projects different?

1. Geographical spread• Projects can be in

multiple locations across different cities and countries

5. Project cost• Costs involved in

coordinating activities, transport and communication are higher

2. Purpose• Often have a more

complex purpose

3. Larger project scope• Typically, have a wider

scope and are more complex

4. Project risk• Much higher uncertainties

and unknowns, which increase the level of risk

Internationalprojects

$


So how can a project manager, or you as the management accountant, deal with this kind of complexity? Ensure that:• You have selected appropriate project team members (see Part B).• All the stakeholders collaborate and that each stakeholder is satisfied (see Part C).• Resources are appropriately allocated to the project (see Part D).• Systems are set up that enable constant monitoring of the project (see Parts C, D, and E).• The lessons learnt and knowledge is captured as the project is progressing, rather than

waiting until the end when it is all over (see Part F).

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A final consideration is to be culturally sensitive or have ‘cultural fluency’ (Turner 2003, p. 153). This is an understanding of how people do business in other parts of the world. To gain cultural fluency, project team members involved in international projects need cultural training and development. This includes three things:• Strategic cultural fluency—this is an understanding of the strategic relationships across

cultures, how business is structured, cultural behaviour at a senior level and how this forms a context for projects.

• Workgroup cultural fluency—work teams that are either formed within a different culture or contain multi-cultures have their own issues and processes that project managers need to understand.

• Personal cultural fluency—individuals have their own social etiquette, language, skills and knowledge. Good project managers understand this and operate within these parameters.

A lack of cultural fluency can mean that while a project may be technically excellent, it may fail due to a lack of understanding of the cultural context that it operates in and how this translates into practice.

The discussion on international project teams is expanded in Part B.

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Part B: Roles in project managementA range of roles exist in project management teams. This part of the module discusses the key roles of the project sponsor, project manager and management accountant and how these project roles fit together. Two basic approaches to project team structures are discussed.

Project sponsorThe project sponsor is a senior executive who should ensure the project’s business case is realised and its goals are met. This means that the sponsor (also referred to as the project owner) represents the project funder (or business partner) during the project (Zwikael & Meredith 2018). Working closely with the project manager, the sponsor provides guidance to the project team in the following three ways: 1. During the project selection stage, the project sponsor establishes the objectives for the

project and its priority, assesses the political environment of the organisation and establishes the make-up of the project team.

2. The project sponsor will also have the responsibility of managing the high-level internal or external stakeholder relationships. A project sponsor may be a key advocate for these stakeholders. If a project has an outside customer as one of the stakeholders, the project sponsor may be the key intermediary for negotiating the contract and ensuring continuing communication over the life of the project.

3. If the project encounters serious problems, the project sponsor may need to become involved in discussions and actions to resolve the problems. Such problems might include non-completion of the project deliverables according to specifications, budget or schedule.

Sometimes, senior executives will sponsor several projects in addition to their regular responsibilities.

A number of other choices exist in relation to project sponsorship: • If a project is not large or complex, there may be no need for a project sponsor, as the

project manager can fulfil all the necessary functions. • At times, the project sponsorship role may be filled by a committee, especially on large

complex projects requiring high levels of commitment and resources. The committee should be composed of different functional representatives.

One of the most difficult issues in project sponsorship is the extent to which the project sponsor should be involved in the project. It is important to ensure that the project manager and project team are empowered to make relevant decisions and that there is no loss of authority through the involvement of the project sponsor. A balance has to be struck between open and visible support, and micro-managing the project. For example, a project sponsor may provide access to resources and maintain a focus on the project meeting its cost, quality and time targets, but they will not interfere in the operational activities of how the targets are being met or the way resources are deployed—they leave that to the project manager and project team.

Project managerA project manager has functional responsibility for the project and has to perform a range of roles. Project managers need to be sufficiently senior so that they can coordinate the activities and resources required to complete the project. Figure 4.6 outlines the duties and challenges for project managers.

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Figure 4.6: Duties and challenges for project managers

Duties Challenges

Project manager

MonitorSpecifications, scope,

budget and cost

Organise and manage Decide on the activities that need to be performed and coordinate personnel and other resources needed to meet project deliverables

Take responsibilityMeeting targets and

deliverables for the project on an ongoing basis and

the final deliverables

UncertaintyOrganisations usually prefer

certainty, but the unique nature of projects makes

this difficult

Schedules and budgetsProject activities are often

uncertain, and planning and target setting often require

frequent readjustmentof targets

AuthorityProject managers have full responsibility for delivering

the project but they are often not given enough

authority or political support to command the

necessary resourcesManageDeal with problems

as they arise


Example 4.5 highlights some of the challenges that can arise for project managers. Part 2 of this example is explored in Example 4.13.

Example 4.5: An IT project in a service-based organisation—Part 1

A service-based organisation undertook an IT project with the aim of making the performance of 4000 front-line employees transparent through an automated performance measurement system. The project was not allocated enough resources for consultation on performance measures with the users of the system, or to train employees adequately in the use of the new system. Furthermore, technical design faults meant that the data in the system was not always accurate. This resulted in compensation inaccuracies for the affected staff. The redesign processes implemented to fix the inherent design problems meant that the project deliverable date was constantly moved back and the project went considerably over budget. Still, the project manager and his team were evaluated on the original project time and cost, and the satisfaction of the users of the system. An impossible situation!

As shown in Table 4.1, project managers need to possess a range of technical and interpersonal skills.

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Table 4.1: Skills required by project managers

Project manager

Technical skills

Interpersonal skills

Process• Possess project management skills (e.g. critical

path analysis, risk analysis and management, and capital budgeting).

Communication• Provide the necessary knowledge and

information to people involved in the project in a clear manner.

• Listen to others.

Project-specific• Possess technical skills that relate to the

objectives of the project (e.g. IT skills in an IT project).

Problem-solving skills• Deal with unexpected opportunities and

problems. • Foresee and detect problems before they arise

or escalate (e.g. if a project needs hard to find technical skills or input materials, this needs to be addressed before it becomes critical to the completion of the project).

General knowledge • Understand all aspects of the project to

discuss the technical work and understand the technical data used.

Insight• Manage significant amounts of data and

establish what is relevant (some project data is incomplete, inaccurate or misleading).

Negotiation• Negotiate for extra resources and other

support in order to deliver the project.

Conflict resolution• Resolve conflicts in areas such as expectations,

level of resources, costs, time, responsibilities and personality clashes.

Leadership• Possess a capacity for leadership for the tasks

and challenges that project managers need to deal with.


Project leadership and the management accountant The management accountant’s role in project management is not as well defined as other roles in project management. As the distinction between many of the techniques used in project management and those used in strategic management accounting starts to disappear, the line between the management accountant’s and the project manager’s responsibilities has become increasingly ambiguous.

The traditional definition of management accounting is the provision of information for management decisions and control. The management accountant’s key role in the project team is to prepare financial and non-financial information for decision-making and control activities.

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In traditional project management, management accountants tended to focus on preparing detailed cost information in the form of budgets and budget variance analysis. This role can extend to capital budgeting and the financing of the project. Much of this financial information influences key aspects of the project, including contract preparation and fulfilment, accountabilities and risk analysis.

The management accountant faces a range of challenges:• Preparing accurate and timely information is a particularly significant issue in a project

environment, as uncertainty is high. In non-project operations, historical data is available to construct meaningful budgets, but in a project situation, historical data is usually not available and many assumptions and estimates need to be made.

• Managers will be making decisions based on the information prepared, so management accountants need to display a high level of ethical behaviour and political sensitivity when communicating this information.

• Realistic project assumptions must be made as the resulting capital budgeting models will be based on realistic assumptions. Care must also be taken that management’s desires to proceed with a project do not unduly influence the assumptions used to evaluate projects.

• Obtaining accurate data can lead to politically difficult situations—such as where a project manager needs data for reporting but also wants to report in a manner that is more (or less) favourable than the data indicates.

Under some circumstances, it could be the management accountant who takes on a leadership role within a project. While leadership is something the project sponsor and the project manager should display, leadership is not their sole domain. All members of a project team, including the management accountant, will have some form of leadership responsibility. The management accountant may be the project manager or a member of the team; in either case, the need for leadership is there, but the way it is demonstrated may be different. A project manager is the person with the title and the responsibility to deliver the project. However, a leader is someone who is able to inspire and motivate team members to get the job done. There is a significant difference between the two and it is important to recognise this. Manager is a formal title and, while they may have authority, they may not be able to succeed if they cannot get the project team to deliver. A leader is someone who can inspire people to deliver, although they may not have the formal authority.

Pinto (2010) outlines four key ways that a project manager exercises leadership.• Acquiring project resources—these are the staff, materials and other support required

to meet the project requirements. Often, the main reason for project failure is inadequate resources.

• Motivating and building teams—a project manager has to take a diverse group and form them into a working team in a short period of time. They then have to ensure that the team delivers in the face of considerable challenges and competing organisational pressures.

• Having a vision and solving problems—a project manager needs to be able to articulate the vision of the project clearly, maintain focus on this and, at the same time, deal with the inevitable crises that occur.

• Communicating—this can be formal or informal and needs to be from the project manager to the team, as well as within the team itself.

Each of these leadership roles can also apply to the management accountant. Consequently, many of the characteristics of a good project manager are also the characteristics of a good management accountant. This includes the previously discussed mix of technical and interpersonal skills. The discussion of the stages of project management (selection, planning, implementation, and review) later in this module highlights the many ways management accountants will display leadership in each of these stages.

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The project teamThere are two basic approaches to organising a project team: 1. the task-force approach 2. the matrix approach.

A task-force approach is when a team is set up specifically for the project and is dedicated to it (as shown in Figure 4.7). The project manager has total authority and responsibility for the members of the team. A matrix approach (as shown in Figure 4.8), on the other hand, occurs when project team members continue to work in their functional areas (in their day-to-day jobs) while also working on the project. This may mean time is spent on operational tasks as well as on the project, or all the team members’ time may be spent on the project, while their position remains situated in a functional department and under the authority of the department manager. Table 4.2 then outlines the advantages and disadvantages of each approach.

Figure 4.7: Task-force project team

Project A

Project manager

Procurement

Engineers

Operations

Finance and accounting

Procurement

General staff

Engineering

General staff

Operations

General staff

Finance andaccounting

General staff

Executivemanagement


Figure 4.8: Matrix project team

Project A

Project manager

Procurement

General staff

Project AProcurement

Engineering

General staff

Project AEngineers

Operations

General staff

Project AOperations

Finance andaccounting

General staff

Project AFinance andaccounting

Executivemanagement


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Table 4.2: Advantages and disadvantages of task-force and matrix approaches

Advantages Disadvantages

Task-force project team Team members focus solely on completing the project.

Team members operate autonomously.

Team members have their own resources.

Team members get to work in cross-functional teams, potentially making their job more interesting and enabling them to gain additional experience outside their primary discipline or area of expertise.

Unless the project is of sufficient size, team members may not be consistently busy.

Unlike in a matrix team, if team members are unavailable, it may be more difficult to cover absences.

Some team members might resist working in a cross-functional team as compared to working in their own departments.

As functions (like that of the management accountant) change, a lack of day-to-day involvement may reduce team members’ exposure to the latest thinking.

If correction is required with some aspect of the project after completion, obtaining prompt action to rectify the problem can be difficult, as the team will have been dispersed.

A role in the workplace might not be available once the project has ended, because project roles are not always on secondment. These roles can involve a job move, especially for long-term projects.

Matrix project team Individuals have a constant employment path, as they work in a stable functional department.

A range of specialist skills can be tapped into, providing the project manager with expertise and flexibility.

During project downtimes, staff can be used on other tasks in their department.

Individuals have multiple responsibilities that can create role uncertainty.

The project manager may not have sufficient authority to ensure that staff do what is required for the project when competing priorities surface for team members.

Team members may have multiple supervisors (e.g. functional and direct), exposing them to political pressures and lack of accountability.


One of the key difficulties encountered in putting together project teams is that functional managers in organisations may not be keen to supply staff for a project. Project teams may not get staff who have the requisite skills, but may be supplied with whoever is available or may be provided with an individual who is less in demand due to skill deficiencies or behavioural problems. The simple fact is that everybody wants to work with the best people, so getting the best people on to the project team is going to be difficult.

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The make-up of the team depends on the functional areas available and what the project demands. A more carefully constructed project specification and definition will make it easier to identify the personnel needed on the project team.

➤ Question 4.4Reflect on a project that you might be familiar with in your organisation. What is your understanding of the three main roles? Explain what each of these roles entails.

Explanation

Project sponsor

Project manager

Project team


International project teams While in standard projects individuals are included mainly for their technical skills, in international project teams individual team members can be included for other reasons (e.g. to ease political pressures). Political issues include the make-up and dynamics of the team, the way a project sits within an organisation, and the broader political context of the country the project is in.

Lientz and Rea (2003) outline a number of ways that international project teams are different from the standard project team:• Collaboration—the need for collaboration between individuals and on tasks is greater due

to the dispersed nature of these projects.• Parallelism—tasks in the project may be done in parallel in multiple locations.• Changing requirements—the turnover of staff is greater, as the variation in skills tends to be

greater over the life of the project. This is often compounded by greater variation in project direction.

• Semi-autonomous work—many parts of the project may be beyond the direct supervision of managers, making the supervision of staff and tasks difficult.

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When you consider these characteristics of international project teams and international projects (discussed earlier), it should be clear that a number of issues are likely to be faced by each member of the team as well as the project manager. The question is: what are the desirable individual characteristics that will help ensure international project teams successfully deliver on projects?

Lientz and Rea (2003) discuss this question as shown in Table 4.3.

Table 4.3: The unique context of international projects and international project teams

Characteristic Explanation

Similar project experience The more experience an individual has with similar projects (in terms of the specific technical nature of the project), the better.

Previous international project experience

Experience in working on international projects is important, as the individual would be more likely to understand the unique problems and issues faced by international projects.

Ability to work with other people As collaboration is even more important on international projects, team members need to know how to work with other team members.

Ability to solve problems Problem-solving is a critical skill for international project work, especially where different legal and social frameworks need to be navigated.

Awareness of potential problems Team members need to have the ability to anticipate problems so as to reduce their impact.

Ability to work with competing demands

International projects often require staff to be able to juggle multiple and conflicting tasks.

Communication skills The ability to communicate with internal and external stakeholders is vital for international projects.

Ambition and energy International projects are demanding, so team members need to have lots of energy and ambition; otherwise, they will not have the drive to achieve the project goals.

Knowledge of the organisation’s business processes

When projects are within an organisation, team members need to have an understanding of the organisation’s business processes.

Knowledge of the methods and tools used on the project

The more the team members know about project software and other tools and techniques (such as PERT [program evaluation and review technique]), the more they will be able to devote their energy and intellect to the more substantive issues.

Ability to understand different cultures

This refers to both the organisation/team culture and the region/country culture in which the project exists. Team members need to be tolerant and sensitive to cultural differences.

Willingness to travel for extended time periods

Team members may have to live overseas for extended periods of time or travel on a regular basis. They need to have the practical circumstances and an almost uncompromising willingness to do it.

Multilingual capability The ability to communicate in the local dialect or language is extremely important, either directly (i.e. by speaking the local language) or through a third party (i.e. a translator).

Source: Lientz, B. P. & Rea, P. R. 2003, International Project Management, Academic Press, Amsterdam.

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Project management roles in international project teamsIn the earlier discussion on project management roles, the roles and characteristics of project sponsors, managers and management accountants were outlined. Table 4.4 outlines how these relate to the more challenging context of international projects.

Table 4.4: Project roles in an international context

Project role Specific challenges for international projects

Project sponsor Clarifying project objectives is even more important—due to the more complex political environment and the increased complexity of coordinating resources.

The make-up of the project team is critical—due to the increased difficulties and specific skill sets required from team members.

Managing the stakeholders is more challenging—as they may be geographically dispersed and have diverse languages and political agendas.

Project manager The task of defining the project budget and managing teams that collaborate over multiple locations and often operate in a semi-autonomous work environment is more difficult.

The need to communicate well, often with people from other cultures, makes this role particularly challenging.

The need to be more proactive and see potential problems before they arise is much greater—because the effects of project problems are so much greater.

Management accountants The collection and presentation of timely information is more difficult. Information may need to be collected in multiple locations and the management accountant may need to rely on other project team members to collect data—so their powers of persuasion may need to be well honed.

There may also be a need to communicate information effectively to managers with different cultural understandings.

The use of budgeting and project planning and performance evaluation techniques becomes even more important in the uncertain environment of international projects.


Virtual project teams A virtual project team works from different geographical locations and often in different time zones. Therefore, it is common for such teams to use collaboration tools to facilitate a project (e.g. file sharing and web conferencing). This is particularly important in international projects because face-to-face meetings are often difficult due to location dispersion and other physical obstacles, as well as time and cost. The idea of working on a project outside its physical location is sometimes described as telecommuting. For example, in a project where team members are located in multiple countries and time zones, they may use electronic communication supplemented with face-to-face meetings (e.g. through the use of videoconferencing) to bring the project together.

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Challenges for virtual project teamsA main challenge for project teams (Pinto 2010) is building trust between members. Trust can be described as having two components:1. goodwill trust—which is established when an individual or organisation delivers what they

say they will deliver (they ‘keep their word’)2. competence trust—which is based on the perception of whether someone has the ability to

deliver what they say they will deliver.

What makes building trust harder in virtual teams is the lack of being in the same room and working alongside other team members where you would normally have the chance to pick up more cues (other than just verbal cues) to establish whether someone has the goodwill or competence to fulfil their obligations. One way to overcome this is to make sure that project team members have enough demonstrated experience so that the risk of competence failure is reduced. Ensuring that delivery dates are clearly understood and adhered to also helps establish goodwill and trust.

Another issue for virtual teams is defining roles and responsibilities. Morris and Pinto (2007) explain that one way to overcome this is to get team members to commit to the tasks that they feel most skilled to do, rather than assigning tasks without consultation. A danger with this approach is that it is unlikely that anyone will volunteer for the difficult tasks. Clearly, careful management of the process is required.

Pinto (2010) has some other suggestions for helping virtual project teams to work:• face-to-face communication whenever possible• maintain constant communication and do not let team members ‘disappear’ for an

extended period• create communication protocols or codes of conduct about what kind of information

needs to be shared and what kind of contact is expected, for how long, and how often• keep all team members informed about what is happening with the project• decide on a protocol for how interpersonal conflict is to be resolved.

One way that virtual project teams are better enabled is through document- management websites (e.g. Google Docs), voice or video telecommunications (e.g. Join Me) and coordination software (e.g. Webex or Gotomeeting).

To summarise, this section has considered the characteristics of a project, the stages in project management, project management roles and the nature of project management teams, including international projects and virtual projects. The next section considers the specific role of the management accountant in project management, taking into account the four stages of project management: 1. project selection2. project planning3. project implementation and control4. project completion and review.

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Part C: The management accountant’s role in project selectionProject selection consists of four main tasks:1. strategic analysis/fit2. stakeholder analysis (stakeholder identification and assessment)3. risk assessment4. financial analysis.

These tasks are complex and there are a number of useful analytical techniques that the management accountant can use. Typically, the outcomes of these key tasks are combined to form the project proposal or business case.

When preparing a business case for a project, it is important to ensure that the key assumptions used to prepare the quantitative data are provided so that decision-makers gain a better understanding of the project. It is also important to provide a discussion of the advantages and disadvantages of a particular option, as well as supplementary information (e.g. qualitative, non-financial information) so that a complete business case can be presented. The next section reviews in more detail the purpose and content of a project’s business case.

Developing a business case for projectsA business case is a document that contains an analysis of the costs, benefits and risks associated with a proposed project. It provides information about the project to enable decision-makers in the funding organisation to choose between proceeding with that project, proceeding with an alternative project, or not proceeding with a project at all. It will often also identify the processes needed to implement the project.

In many organisations, it is the project manager who is responsible for compiling the business case. In large organisations, the management accountant is usually part of a team that develops a project’s business case. Consequently, unless the management accountant has been delegated responsibility for the overall preparation of the case, they will typically only have input into part of the process (often the financial analysis). In this setting, some of the other skills discussed earlier, such as being able to work in teams, become particularly important. In smaller organisations, the management accountant will often be responsible for putting together the whole business case. In this instance, not only will the management accountant need the technical competence and written communication skills to prepare each section of the business case, but they will also need additional soft skills, such as relationship management, negotiation and persuasion, to work with the executive decision-making team.

A good business case:• provides the basis for a clear decision about the project• contains the comparisons of the costs and benefits of the project• identifies a preferred option with a rationale where there are alternative solutions to the

problem that the project needs to address• makes clear the costs of the project beyond its completion.

Example 4.6 highlights the content that is usually included in a business case. The role of the team involved in preparing the business case is to translate this analysis into an understandable format to enable decision-makers to act.

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Example 4.6: Contents of a business case

Section Content

Background and problem This section contains the reason or problem that has triggered the need for a project. In most cases, there is some kind of opportunity or a problem to fix. It is important that there is a clear understanding of the issue to be addressed. Failure to have this understanding may lead to a decision to commence a project that addresses the wrong problem.

Strategic fit This section outlines the extent to which the project fits into the organisation’s strategy. It is important to understand that the business case is not the organisation’s strategy but is there to support or deliver a component of the strategy.

Objective This section states clearly what the objectives of the project are and what ‘success’ looks like in a tangible or measurable way. The objectives of the project will reflect the strategy.

Identifying alternatives This section outlines the options or alternatives to be considered along with supporting analysis. As most problems or opportunities can be addressed in a number of ways, an analysis and a strong argument for how the recommended solution fits the criteria for success are required.

Selected project This section provides detailed analysis of the selected option and will contain:• risk assessment• financial analysis• benefits analysis• cost–benefit analysis• project planning• project budget• project monitoring and performance measurement• project completion and review process.


The next section discusses in more detail what needs to be considered in each of the key areas of analysis.

Strategic fitThe first project selection criterion is the strategic fit between the proposed project and the organisation’s objectives and strategy. Projects need to support organisational strategy and help an organisation achieve its overall objectives. When an organisation has an operating model based around projects (e.g. a company that builds infrastructure projects, such as Leighton Holdings, discussed in Part A), then the strategy of the company is implemented through projects. Clearly, a fit between the project and the company strategy is a central issue. When a project is intended to support an organisation’s operating model, such as a research and development project to improve or introduce a new product (e.g. the Apple Watch example in Part A), then this project must fit within the strategy of the organisation. When a project does not have its origins directly from an organisation’s strategic planning, a strategic fit assessment can be conducted by reviewing strategy documents or assessing how the project supports the initiatives presented in a strategy map.

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Zwikael et al. (2018) claim that project goals should be aligned with the organisation’s current strategy as well as its long-term vision. Strategic fit means that projects should be explicitly linked to the strategy. The role of the sponsor/project owner is therefore crucial to support this important link with strategy. Loch & Kavadias (2011) further suggest to clarify the business strategy by addressing five questions:1. What product (or service) does the organisation offer?2. Who are the organisation’s customers?3. How does the organisation deliver its product or service?4. Why do customers buy from this organisation rather than from somewhere else?5. What will happen if the environment changes?

The answers to these questions are then used to inform the project strategy, where a clear understanding of what the project delivers against the business strategy is developed. This includes what target products or technology the projects will deliver and what it will contribute to the organisation. The business strategy will provide the financial boundary for the project and a direction for what is to be delivered, and the project strategy will provide the kind of constraints and opportunities to be delivered back to the organisation strategy (Loch & Kavadias 2011).

This is a cascading approach to projects and assumes a project is subordinated to the strategy of an organisation overall and that the project should fit the organisation’s objectives, but as outlined earlier, a project will also have its own strategy and objectives. This may be because the project has a set of stakeholders who are not necessarily stakeholders in the organisation. Managing these competing stakeholder interests is one of the real challenges in project management.

Example 4.7 provides a practical example of assessing the strategic fit for projects.

Example 4.7: A mining company’s IT projects A mining company implemented two IT projects. One was an e-business site and the other was an enterprise resource planning (ERP) system. The e-business site fitted directly into the organisational strategy of increasing profitability from the resource sector through creating a transparent market. The ERP investment, on the other hand, did not result in cost savings and did not provide an advantage over the previous IT system.

In evaluating the strategic fit of these projects, the key questions to ask are: • What is the likely long-term impact of this project on key measures used to evaluate business

success (and presented in the strategy map, if one exists)? • Is this project in line with the objectives and actions listed in the organisation’s strategy document?• Does this project address an emerging or existing risk, and/or a new opportunity?

Further analysisE-business siteThe underlying problem for the company was that it was one of only a few companies that sold a particular resource for which there were numerous customers. It had a sense that it was selling the resource too cheaply. Due to the market structure, the resource was not traded regularly on commodity markets, so there was very little external information on the market price to enable comparisons. To remedy this, the company set up an e-business site that enabled it to release certain amounts of the resource at a chosen price to establish how quickly it sold.

If the resource sold quickly—they had likely underpriced it.

If it took a while to sell—they had likely overpriced it.

This information then enabled the company to understand what the actual market price was and thereby increase its revenue and profit.

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Addressing each of the three key questions in evaluating strategic fit:

1. What is the likely long-term impact of this project on key measures used to evaluate business success (and presented in the strategy map, if one exists)?

Like most profit-oriented companies, it had a specific level of profitability as a key project objective. This project had a clear impact on profitability through more effective revenue management from better market pricing. This had longer-term effects as the company previously had very little capacity to gain market intelligence on price, and the project enabled it to create a more transparent market in the long term.

2. Is this project in line with the objectives and actions listed in the organisation’s strategy document?

Yes. The company had objectives centred on ensuring it was in the lowest quartile in terms of cost structures and maximising revenue streams in highly competitive commodity markets.

3. Does this project address an emerging or existing risk, and/or a new opportunity? Yes. While the key risk was that the company was not able to obtain appropriate revenue streams

due to underpricing, it was also able to create a more transparent market, which opened up better opportunities for supplying new customers and servicing its current market more effectively.

Enterprise resource planning systemThe chief information officer (CIO) decided that the company needed an ERP system. At the time, many large companies were considering such systems. Industry observers thought it was becoming a status symbol for companies to have a large ERP system. Senior IT executives in the company were of the opinion that all of the advantages of an ERP system could be gained by integrating the existing software and that this could be done at a fraction of the cost of buying, implementing and operating (over the long term) the proposed ERP system. Notwithstanding these concerns, the CIO made the decision to invest in a new ERP system.

Addressing each of the three key questions in evaluating strategic fit:

1. What is the likely long-term impact of this project on key measures used to evaluate business success (and presented in the strategy map, if one exists)?

The ERP system investment had a negative effect on profitability because depreciation on the assets base increased; the debt capital required to fund the asset increased the company’s interest expense; and the operating costs over the life cycle of the systems were increased.

2. Is this project in line with the objectives and actions listed in the organisation’s strategy document?

No, the company had no strategy in relation to improvements in information provision and more seamless information integration. One of the objectives of an ERP system investment is to improve information flow and reduce human input into data entry and other data processing and conversion processes. As explained earlier, senior IT executives in the company were of the opinion that this could be achieved at a fraction of the cost with alternative IT systems.

3. Does this project address an emerging or existing risk, and/or a new opportunity? One of the risks the company faced at the time was the increasing use of particular types of ERP

systems, which could have made it harder for buyer/supplier relationships to be managed, but this was considered to have a low probability for the company at the time. There were no new market opportunities to be created and very few cost-saving opportunities.

The discussion in Module 1 about strategic analysis (e.g. SWOT) is clearly linked to these three questions.

So, while a project may present a financially viable opportunity with minimal risk, it may not be in line with the current organisational strategy. In the absence of a strategic fit, the decision to proceed with the project should acknowledge this. Such opportunistic project selection should at least be a conscious choice.

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➤ Question 4.5Please now read Parts A and B of Appendix 4.1 on the Sydney Seafood Bar.

Do you think the project is a strategic fit?

Yes No

Explain why or why not?


Note: The concepts covered in this appendix (not the specific details of the case) are examinable.

Stakeholder identification and assessmentRegardless of how well a project fits with organisational strategy or how well time, cost and quality are managed, a project’s success is largely determined by how well stakeholders have been satisfied.

Stakeholders are key individuals, groups or functions that have a stake or interest in the project. They can be categorised as internal and external. Within these two categories, Pinto (2010) and Zwikael and Meredith (2018) identify a number of different types of stakeholders. These are outlined in Table 4.5.

Table 4.5: Internal and external stakeholders

Internal Top management Senior executives who approve the project (e.g. the CEO or a company’s board) are also called the ‘project funder’. Because of their seniority in the organisation, they have control over the project and typically make the final decision on:• whether a project is approved • the level of resources that are devoted to it• whether more funding can be injected during the project• whether, if required, it is terminated early.

Finance and accounting Typically focused on whether a project is within its budget and is using resources efficiently.

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Functional management Members of project teams are often supplied by functional managers and they may either be:• on loan to the project (i.e. in the case of task-force

project teams), or • still working within the functional manager’s area

(i.e. in the case of matrix structures).

Project managers should understand:• Project staff may have divided loyalties.• Functional management may be more interested in their

own function’s success than the project’s success.

Project management office A functional unit that supports all project managers within this business unit in conducting their projects. This support is usually administrative and methodological (e.g. the use of project management methodologies, templates and software packages).

Project team members Have an interest in the success of the project, but may still have loyalty to their functional area.

May be motivated by their own careers/incentives/compensation packages, which—although acceptable—may not always be aligned with project objectives.

External Clients Typically interested in the project being completed on time, within budget and to specifications.

A client may be external to:• the project organisation (e.g. a company developing

software for a manufacturing organisation). • the project team, but within the same organisation

(e.g. the IT project team developing software for the manufacturing department in the same larger organisation).

Project managers should be aware that clients often realise after the project specifications are drawn up that there are complexities or issues they had not considered, requiring an alteration of the project scope.

End users The client entity requires the deliverables (output) from the project to be used by its employees or customers—who are often called ‘end users’.

Although end users do not have a strong voice during the project, it is recommended that the project team involves them during the project in the development of the solution. This is important because if they do not use the deliverables from the project, the project will fail to realise its target benefits (Zwikael & Meredith 2018).

Competitors May be a significant stakeholder through their effect on the project’s successful implementation.

This could be by:• introducing a new product in direct competition• through other competitive and market activities

(e.g. objecting to projects through legal processes or a social media campaign).

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Regulators May be bodies such as local, state or federal government, as well as government agencies and statutory bodies that have legal backing (e.g. standards authorities).

Suppliers Provide the raw materials and other material inputs.

When a project relies on suppliers, the project manager must ensure the reliable and timely delivery of inputs.

Community and society Projects can have a large effect (both positive and negative) on communities. For example, the regular customers of the company, as well as non-customers, may be impacted by the project (e.g. because of the cannibalisation of an existing product).

In such situations, there needs to be extensive consultation with the community to ensure that all those affected have their interests understood and dealt with appropriately.

The environment Although the environment cannot be considered an entity, it is widely recognised as being a stakeholder that needs to be managed carefully in any project (Phillips et al. 2003).

Shareholders As projects can affect share price and the dividends distributed to shareholders, they may also have interest in the project, especially if the project is strategic and can make a major impact on the company (e.g. the building of the Boeing 787 Dreamliner).


Stakeholders will have different interests and these may be incompatible. One of the challenges for project managers is to communicate with these multiple stakeholder groups and attempt to satisfy their needs.

For example, if you worked for a property development company, you may have banks or shareholders who have provided financial resources and who want an adequate return. Part of this return would be to fast track the construction by working weekends and later in the day so that the construction can be completed earlier and start generating positive cash flows. At the same time, the community surrounding the construction site may not want the excessive noise at night and on weekends. This balancing issue will be addressed in more detail later in this section.

When management accountants complete stakeholder identification and assessment, they need to think critically about what the interests of the stakeholders are and what kinds of data and KPIs could be accurately captured and tracked over time to ensure that stakeholder satisfaction is maintained. An interesting research study on using a balanced scorecard (BSC) for signalling information to stakeholders was conducted by Sundin et al. (2010) where they looked at how multiple and competing stakeholder objectives can be reflected in a BSC. One key finding is that managers have to understand who their stakeholders are, what their interests are, and how these can be reflected in the design of performance indicators. This is to enable tracking of the extent to which they deliver stakeholders’ requirements.

The BSC is discussed in detail in Module 5.

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A further insight on this issue that is very useful for management accountants is provided by Malmi and Brown (2008). They make a distinction between information for decision-making versus information for control. Some management systems can be used for control of behaviour—such as a project manager’s need for performance indicators on cost, quality or time to ensure the project is delivered as specified. There are also management systems used by decision-makers, which are not directly related to the behaviour of organisational staff—such as a client who may have technical specification requirements, which are reflected in performance indicators so they can make the decision as to whether the project fits their requirements.

Clearly, the management accountant needs to complete appropriate stakeholder identification and assessment if they are to design appropriate management systems for projects.

Stakeholder assessment and analysis was discussed in Module 2.

➤ Question 4.6Assume that the organisation that you work for, or one that you are familiar with, has won a tender for a project to construct a new shopping centre in a suburban area. List five key external stakeholders and identify the stages of the project when their interests are going to be important to the project.

Stakeholder Stages of the project

1.

2.

3.

4.

5.


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Ethically informed decision-making and its impact on stakeholdersEthical dilemmas often arise in the context of project management, especially when it comes to relationships with stakeholders. When decisions are made and actions taken (whether ethically right or wrong), there will be effects on stakeholders. Projects can significantly affect both internal stakeholders (e.g. through the changes in assets, technology or organisational processes that the project was designed for) and external stakeholders (e.g. shareholder value and through changes to the competitive environment). Two important issues that may make ethical choices in projects more difficult than in the day-to-day operations of typical organisations include the following: 1. Projects are unique, meaning that often there are no previous practices and experiences that

can be used or learnt from. It also means that there may not have been sufficient time elapsed for ethical differences between employees to have emerged or been resolved, and for common ethical practices to have been established. Where appropriate, there should be an alignment between organisational values and project team values.

2. As projects are often finite in terms of time, the results of poor ethical choices may be less apparent in the immediate future. Also, the project team, organisation or team members may complete the project without having to bear the consequences of unethical decisions.

Project sponsors and managers have a critical role to play in the development of ethical practices in projects. Part of their role is to overcome these two key issues. First, they have to ensure that an ethical framework or set of practices is developed that is aligned with the overall organisation. Second, they have to ensure that the long-term effects of decisions are taken into account in addition to the short-term focus. Some responsibilities are important and will help to ensure better outcomes for project stakeholders.

To evaluate whether a project decision is ethical or not, as well as how it will affect project stakeholders, the modified version of the American Accounting Association (AAA) ethical decision-making model that is described in the Ethics and Governance subject of the CPA Program can be used. Some additional questions that can be asked are provided by Drellinger (cited in Turner 2003, p. 170).

1. Which goals or priorities does this solution support or work against?

2. Does the solution reflect the values of the organisation and the decision-makers?

3. What are the consequences (in terms of benefit or harm) and ramifications (effect of time and outside influences) for each of the stakeholders?

4. What qualms would the decision-maker have about the disclosure of a favourable decision to this solution to the CEO, board of directors, family, the public?

5. What is the positive or negative symbolic potential of this solution if understood—or misunderstood—by others? Will it contribute to building and maintaining an ethical environment?

While some of these questions relate to a normative (what ought to be) approach to ethics, there are also real utilitarian aspects (the value is related to the benefits gained or reduction in loss) as well.

Point 4 focuses on the disclosure of decisions to others—this has an effect on the reputation of a project or company, based on the decisions made. For example, if a decision is made that is not seen as ethical by the public, the reputation of the organisation or project can be damaged regardless of whether the decision is normatively right or not. A good example of this is the discussion around the company James Hardie and some of its decisions relating to asbestos compensation, corporate restructuring and location. Regardless of whether these decisions were legal or normatively acceptable from a maximising shareholder wealth perspective, the company’s public reputation was damaged by the disclosure of these choices.

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Ethics is discussed in more detail in the Ethics and Governance subject of the CPA Program.

Risk assessmentProject risk assessment is an integral part of project selection and involves risk identification, classification, prevention and monitoring. At the project selection stage, major sources of risk are identified, evaluated, classified and risk mitigation actions proposed. Typical sources of risk include:• the time to complete the project• the availability of key resources and personnel, and the cost of these resources• the existence of, and solution to, technological problems• macro-economic variables such as finance costs, inflation and foreign currency risk• for project organisations, project variations required by the client and client solvency• that the project will not achieve its deliverables.

Based on identified risks, a decision regarding the acceptable level of risk is made. The cost of removing excess risk needs to be calculated and incorporated into project cost estimates. Typical risk mitigation strategies involve contractually assigning the risk of currency movements, financing costs or resource costs to the client. This is common (and politically controversial) in government infrastructure projects where, because of the large size of projects, governments assume many of the risks more commonly borne by private organisations. Management accountants can help in identifying and quantifying risks, and in finding the most economical way of mitigating or transferring risks.

The management accountant should understand techniques such as calculating expected values and estimating the probability of the occurrence of risk events. Calculating probabilities is particularly important where risk events are interdependent.

Eden, Ackermann and Williams (2005) analysed several large projects that experienced massive cost overruns. The authors attribute these large overruns to interdependencies and conclude that ‘costs combine together in non-linear ways, and accelerating projects can set up vicious cycles that increase costs many more times than expected’.

Risk identificationThere are a number of ways to identify project risk. Organisations undertaking projects regularly develop checklists to help with risk identification. One approach centres on the questions outlined in Table 4.6.

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Table 4.6: Risk identification questions

What? • What is the desired outcome of the project, and will it work (e.g. technical functionality)?

• What skills will be required?

Who? • Who are the stakeholders? • Who will be involved, and are suitable personnel available? • Who will be responsible for what? • To whom is the project a threat?

Why? • Why are they involved?• The purpose here is to identify the aims of different stakeholders involved in the

project (e.g. subcontractors, partners, local government).

How? • How do we ensure that the required actions are completed and required resources are available?

Where? • Where is the project located, or where will the project have an impact? • The purpose here is to identify the risk associated with project location

(e.g. environmental, political).

When? • When will the project take place, and what is the schedule? • What are the main threats to timelines? • What is the impact of missing the deadlines?

How much? • How much is the project likely to cost?• What is the level of uncertainty in project costs? • Can reliable maximum and minimum cost estimates be made?


Risk identification will produce a list of potential risks.

Risk classificationRisk identification is followed by classification. The purpose of classification is to assist in deciding whether a project should be abandoned because it is too risky, or in identifying specific risks that need to be reduced or transferred before starting a viable project. As illustrated in Figure 4.9, probability and financial impact are assessed as high or low for each risk, and risks are assessed on this basis.

Risks that are highly probable and that have a high financial impact if realised are critical and should be considered first. Next in importance are those risks with a low probability of occurrence, but high financial impact. The viability of reducing these risks, including any associated costs, will assist in deciding whether the proposed project is worth pursuing, and what the expected outcomes should be to compensate the organisation for the risks taken.

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Figure 4.9: Risk classification

Financial impact

Low

Low

High

High

Probability

Considerlast

Considersecond

Considerthird

Considerfirst


Applying the 2×2 matrix approach is illustrated in Example 4.8.

Example 4.8: The 2×2 matrix approachA large utilities organisation uses the 2×2 matrix approach when considering the environmental sustainability of projects. After risks are identified, they are assessed first for their likelihood, then for the financial impact should something go wrong. Projects are ranked for selection based on this risk analysis.

Assume you undertake risk assessment for this company and you have four projects to complete. These are:1. a new gas line to an area that has to pass through a relatively geologically unstable parcel of land2. cabling for telecommunications through the same parcel of land 3. cabling for telecommunications in a newly developed area4. installing high-voltage underground electricity cables through a local area in an already

existing path.

Undertaking a risk assessment exerciseThe first thing you will need to do is decide on an appropriate composite index for the analysis. A common approach is to assess the probability and impact on a scale of zero to 10. A rating of zero is a non-existent probability of failure and no financial impact. A rating of 10 is a 100 per cent probability of failure and the maximum financial impact.

The next thing is to assess each of the projects and identify both the probability and financial impact, and then multiply the probability by the impact. This approach is outlined for the four projects as follows:

Project 1 has a high level of probability of failure, as the land is unstable and has been assessed at seven. The financial impact is also high, which may be judged at eight. This will result in a rating of 56.

Project 2 has a high probability of failure, as the cabling is through the same parcel of unstable land and so has been assessed at seven. But it has a low financial impact so it may be assessed at two. The result is a rating of 14.

Project 3 has a low probability of failure, as the cabling is in a newly developed area (a rating of two). It also has a low financial impact, being cabling for telecommunications (a rating of two). This will result in a rating of four.

Project 4 has a low probability of failure, as the underground electricity cabling is through a local area in an already existing path (a rating of three). It has a high financial impact because it relates to high-voltage electricity cables (a rating of seven). This will result in a rating of 21.

From this analysis, you can start to rank the projects and focus on more intensive risk management for the higher risk projects.

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The identification and classification of risks facilitates project selection decisions. Project managers need to make sure that the same risks are not accounted for more than once—for example, when engineers revise their cost estimates to adjust for risk and, at the same time, accountants compensate for the same risk by raising the project’s required rate of return (RRR). A management accountant can assist project managers by designing systematic approaches to managing project risk that ensure that the risk is accounted for just once, such as identifying cost reserves for risks in the project budget.

Risk mitigationWhereas most organisations identify and classify project risks on a regular basis, not all provide effective solutions to mitigate those risks that have been found to be critical. Using the risk classification matrix (Figure 4.9) for these risks needs to be considered first, then effective solutions can be identified to reduce the probability of those risks emerging and their financial impact if they occur.

The project manager can prepare the risk mitigation plan in consultation with the management accountant. Furthermore, the execution and monitoring of the plan will need to involve various staff, including the management accountant.

For example, a risk that ‘a key project team member resigns from the company during the project’ has high probability of happening and, if it occurs, will impact the project’s completion and potentially delay it by a significant time, causing major dissatisfaction to a strategic client of the company. A mitigation plan might include a few potential solutions to choose from: 1. sign a long-term contract with the key team member2. offer the key team member a project completion bonus3. have a deputy trained and ready to step in if required.

A risk mitigation program results in changes to the probability and/or impact of the risk—but it also usually requires additional cost.

A key tool for risk mitigation is the risk register, which is used to document the results of analysis and outline the mitigation program being proposed for each risk. The risk register first appears in the business case and again later in the project plan. It is then updated regularly throughout project implementation. The risk register usually takes the form of a table. Table 4.7 shows a register entry for one risk.

Table 4.7: Example of a risk register entry

Risk attribute Risk entry

Risk number R1

Risk title A key project team member resigns the company during the project

Description David Smiths leaves the company over the next three months to move with his family interstate

Probability High

Financial impact High

Risk mitigation (1) Sign a long-term contract with David Smiths(2) Offer David Smiths a project completion bonus(3) Have a deputy trained and ready to step in if required

Cost of risk mitigation $5000

Risk assigned to Project manager


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It is important to note that risk assessment is different from risk management. As discussed, risk assessment is done before the project starts. Risk management, on the other hand, is done during the project. It is the ongoing process of monitoring and managing the risks of the project—this is discussed in more detail in Part E.

Financial analysis—single project One of the main responsibilities of a management accountant in project selection is to provide an analysis of project financial viability. The following techniques are discussed in this section:• net present value (NPV)• internal rate of return (IRR)• profitability index• payback • return on investment (ROI) • residual income (RI), or economic value added (EVA).

The advantages and disadvantages of these techniques will also be discussed.

Analysing profitability does not complete the management accountant’s financial analysis. There also need to be sufficient funds available to finance a project. Management accountants may assist in project finance analysis, although in large organisations there is usually a separate project finance function. Project finance is beyond the scope of this module, but for the majority of projects, project financing is no different from the financing of other organisational activities.

Net present valueNPV and IRR are both discounted cash flow (DCF) methods used to evaluate projects and investments. In long-term projects (greater than 12 months), DCF methods are superior to methods that do not account for the time value of money and project risk. DCF techniques recognise that the money invested in a project has an opportunity cost—the return forgone from alternative investments.

The NPV method compares the present value (PV) of all project cash inflows and outflows with the initial investment required. Note that for large projects, the investment may span several years.

All project cash flows are discounted using an RRR or discount rate. Often, the discount rate used is the organisation’s cost of capital. The NPV is the sum of the PVs of all project cash flows. An NPV above zero tells us the extent to which the project will yield returns above the organisation’s RRR.

The formula for calculating the PV of future cash flows is:

( )0

1

1

1=

=

= ×+

∑n

t ttt

PV CFi

Where:i = discount raten = project lifeCF = cash flowt = year

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In determining the project’s NPV, a management accountant considers the following key variables: • project costs• forecast cash inflows and outflows• estimated life of the project• residual value• discount rate.

Each of these is discussed in the following sections.

Project costsProject cost is also called the initial investment. Preliminary cost estimates are usually made when alternative project proposals are prepared for consideration. Cost estimates may be revised as project planning proceeds. Final cost estimates are completed only after schedules are agreed to, and major contracts regarding the project are completed. Financial analysis of project costs and budgets should be updated as more detailed and accurate information becomes available.

Large projects are usually broken down into sub-projects, then cost estimates are devised for each sub-project. It is common practice to include a reserve amount to account for risks. This is necessary if risk analysis has not been completed and/or the amount of reduction or transferral of risk is uncertain. Reserves can be based on experience from similar projects. The percentage used depends on the reliability of the cost estimates. Reserves do not account for changes in project content or scope, because those are normally negotiated and priced separately.

Management accountants need to consider whether a project will require an increase in the organisation’s working capital in addition to the funding of direct project costs. Where a project is expected to increase productive capacity and increase sales volume, increases in inventories and accounts receivable (AR) will require additional finance.

Sunk costs should not be included in the project’s profitability analysis. They are cash flows that have already taken place, and so have no effect on future cash flows.

When using DCF methods, finance costs are accounted for in the discount rate used. Therefore, cash flows associated with financing the project (e.g. interest payments) are not separately included in project cash flows.

Forecasting cash flowsOne main problem in using DCF methods is the prediction of future cash flows.

Where revenues need to be estimated, management accountants can analyse market growth, developments in market share, the actions of competitors and trends in price levels. Forecasting is likely to be easier if the project aims to replace an organisation’s resources instead of expanding them.

When a project involves delivery to a customer, cash inflows are contractually determined, and so are more easily forecast. Sometimes contracts make allowance for inflation or currency fluctuations, and so future cash flows, even if contractually determined, can vary depending on economic circumstances.

Future cash flows most often have tax implications and it is important to include these tax effects in any DCF analysis. Most revenues increase taxable income, while expenses decrease it. Of particular note, depreciation and amortisation, like other accruals, are non-cash expenses, so they do not appear in a DCF analysis. Depreciation and amortisation reduce taxable income and in that way, they affect cash flows, so these components need to be included in any NPV calculation.

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One of the challenges faced when a project is being implemented is the reconciliation of forecast cash flows with the actual cash flows (see Example 4.9). While this is discussed in more detail later in the module, the key issue to keep in mind is that the forecast cash flows are going to be based on assumptions that may or may not translate into practice. For example, the expected timing of the cash flow may be different, possibly caused by the rate of completion of the project being slower than expected. A further consideration is that, like any financial reporting, the profit and loss for a project budget will be different to the cash flow statement prepared for reporting and monitoring purposes.

Example 4.9: Forecasting cash flowsWidgetCo undertook a project to purchase new machinery for $8 000 000. Assume the taxation regulations permitted this asset to be written off on a straight-line basis over four years and that the tax rate was 30 per cent.

The annual depreciation charge would have been $2 000 000 with a tax saving of 30 per cent of this, or $600 000 per year (0.3 × 8 000 000 / 4). The cash flows included in the project’s DCF analysis included an immediate outflow of $8 000 000, and for Years 1–4, an inflow (a tax saving) of $600 000. Note that depreciation had no cash flow effect except for the tax saving.

However, the actual cash flow for this project was different from the forecast because by the time the project was implemented, the purchase cost of the machinery was $10 000 000 and the company tax rate had been reduced to 25 per cent. This means that the tax saving was $625 000 (0.25 × 10 000 000 / 4) per year as is illustrated in the following table.

Time period 0 1 2 3 4

Forecast Outflow (8 000 000)

Inflow 600 000 600 000 600 000 600 000

Actual Outflow (10 000 000)

Inflow 625 000 625 000 625 000 625 000

Estimated life of the project Management accountants need to estimate for how long a project (in particular the deliverable or output developed during the project) is expected to generate a cash flow. For example, consider a project to start manufacturing a new car model. The car design may take a year, but sales of new vehicles are expected for five years after the first car has been designed and built, until the next model is introduced. Therefore, costs required to design, build, test and manufacture the new car are expected to last for six years. Estimates involving the very long term (e.g. 10 years or more) are highly uncertain. Despite this, it is important that such estimates are made, as incorporating a highly uncertain estimate in an analysis is preferable to ignoring the issue. Similarly, the tax regulations permit the write-off of assets over set periods. These periods are not indicative of the life of those assets and, while these periods should be used for tax calculations, they have no relevance to project life estimates.

Residual valueThis is the value of the asset at the end of its useful life. It may be either negative or positive. For example, a nuclear power plant project may have a long initial project development phase, decades of power generation and positive cash flows, but a negative residual value at the end due to decommissioning costs and long-term nuclear waste-management costs.

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For projects with long lives (greater than 15 years), residual value usually has little relevance due to the time value of money. For example, the PV of a cash outflow of $1 000 000 in 15 years at a discount rate of 10 per cent is approximately ($239 400); in 30 years it is ($57 300). In contrast, for short-term projects, the residual value can have a significant effect on the project’s NPV.

Tax impacts relating to residual values are often important. When a capital asset is disposed of, a capital gain or loss can result. Tax effects should be incorporated into any DCF analysis.

Discount rateThe selected discount rate has a profound effect on the NPV analysis. For example, consider where a PV of $100.00 to be paid in one year’s time is $86.96 if the ROI is 15 per cent ($100 / (1 + 0.15)). In other words, if you invested $86.96 at a 15 per cent ROI, you would have $100 in one year’s time. If 5 per cent is used as the discount rate for the same future cash flow, the PV is $95.24 ($100 / (1 + 0.05)). The higher the discount rate, the lower the PV of project cash flows. As the discount rate has such a large impact on the PV of future cash flows, selecting an appropriate discount rate is one of the most important steps for increasing NPV accuracy.

15% $100$86.96

FVPV

So how are discount rates set? The first factor to consider in estimating a discount rate is the organisation’s cost of capital. When organisations raise project funding from highly competitive markets, estimating the cost of capital is relatively straightforward because prices are readily observable. For example, if an organisation is going to finance a project using a bank loan, the cost of capital is the interest rate and fees associated with the loan. If the project is funded by an equity raising, then the shareholders’ expected returns from dividends and share price growth can be taken as the project’s cost of capital.

Another factor to consider in setting the discount rate is the opportunity cost of capital or the return the organisation could get from some other project or investment of equal risk. If the next best opportunity is forecast to generate a 15 per cent ROI over the same time frame at the same level of risk, the opportunity cost of capital is 15 per cent. For example, if an organisation chooses to invest in a low-risk project and the next best project is riskier than the one they have chosen, this means that a risk premium needs to be deducted from the opportunity cost of capital. The opposite is also true. This adjustment improves the validity of the discount rate that is applied to the project being evaluated.

Many organisations use their weighted average cost of capital (WACC) to discount project cash flows. The WACC is the cost of the organisation’s present capital structure—the capital for all of the organisation’s existing assets. It is appropriate to use this discount rate, as long as the project under consideration does not differ in its risk profile, or in any other economically significant way, from the organisation’s existing projects. The calculation of the WACC is detailed below.

WACC = Rd × Wd + Re × We

WACC = Rd × (D / (D + E )) + Re × (E / (D + E ))

Where:Rd = after-tax cost of debt capitalD = market value of debtE = market value of equityRe = cost of equity capitalWd = weighting of debt capitalWe = weighting of equity capital

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For example, if a project is financed by 40 per cent debt with an (after-tax) interest rate of 7.5 per cent and the rest is financed using equity with an opportunity cost of 14 per cent, the WACC would be 11.4 per cent (7.5% × 40% + 14% × 60%). Estimation of opportunity cost and the risks associated with future cash flows is usually completed in consultation with each relevant department, including marketing, operations and finance. Estimation of the WACC is usually overseen by the finance department, with most organisations setting clear policies and specifying the WACC (also termed a ‘hurdle rate’).

As mentioned earlier, some organisations use a discount rate that adds an allowance for project risk to their WACC. High discount rates can severely reduce the PV of distant cash flows, because generally the distant project cash flows are the revenues that the project creates. This approach can therefore create a bias against long-term projects. It is preferable to identify and manage each element of project risk than to use an arbitrarily high discount rate for this purpose.

In hierarchical organisations, business units are sometimes required to use high discount rates to ensure large enough returns to cover corporate overheads. In other words, projects returning 15 per cent at the business unit level will return less than 15 per cent at the corporate level (due to the inclusion of corporate overheads).

WACC is also discussed in the Financial Risk Management subject of the CPA Program.

Example 4.10 shows how these concepts can be applied and how calculating the NPV for a project can assist with project selection.

Example 4.10: A project with an expected life of five yearsAn organisation is thinking of investing in a project with an expected life of five years and a cost of capital of 15 per cent. The initial investment is $1 000 000 with expected net cash inflows of $300 000 per year. The cash flows and PVs are presented in the following table.

Time period 0 1 2 3 4 5

Initial investment

–1 000 000

Net cash flow –1 000 000 300 000 300 000 300 000 300 000 300 000

Discount factor calculation (cost of capital = 15%)

= (1 + 15%)1 = (1 + 15%)2 = (1 + 15%)3 = (1 + 15%)4 = (1 + 15%)5

Discount factor 1.0000 1.1500 1.3225 1.5209 1.7490 2.0114

PV calculation –1 000 000 / 1.0000

300 000/ 1.1500

300 000/ 1.3225

300 000/ 1.5209

300 000/ 1.7490

300 000/ 2.0114

PV –1 000 000 260 870 226 843 197 252 171 527 149 150

NPV (sum of row above)

5 642

Note: Taxes have been ignored.

The project has an NPV of $5642, being the PV of all future cash flows less the initial investment ($1 005 642 – $1 000 000). The positive NPV means that, based on forecast cash flows and the cost of the investment, the organisation will recover its cost of capital plus the equivalent of $5642 invested at the cost of capital. Would you accept such a project? It would depend on how confident you are in the forecast net cash flows and whether you had a better project to invest in (your opportunity cost). Given that the NPV is small in relation to the investment, strategic fit and risk factors are critical in project selection or rejection. If this project is a good strategic fit and low risk, it should be selected; otherwise, it should not.

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➤ Question 4.7Big Firm Pty Ltd is considering an IT project that will increase the efficiency of service staff. The old system that it will be replacing has a book value of $100 000 and a present resale value of $70 000. Data on the new system and the projected impact on service operations costs are:

Development cost $700 000Implementation cost $400 000Residual value $100 000Reduction in labour cost per year $180 000Increase in utility costs per year $10 000

Big Firm Pty Ltd has an RRR of 14 per cent and the economic life of the project is expected to be 10 years.

(a) Complete the following table by showing the cash flows and calculating the NPV for the project. Disregard taxes.

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Year

01

23

45

67

89

10

Sale

of o

ld s

yste

m ($

)

Dev

elo

pm

ent

cost

($)

Imp

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tion

cost

($)

Res

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ue ($

)

Red

uctio

n in

lab

our

co

st

per

yea

r ($

)

Incr

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in u

tility

co

st p

er

year

($)

Net

cas

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w ($

)

Dis

coun

t fa

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atio

n (c

ost

of c

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4%)

Dis

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PV w

ork

ing

PV c

ash

flow

s ($

)

NPV

($)

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(b)

On financial grounds, would you recommend the project?

Yes No

Why?

(c) The project manager who prepared this data called to say that there are several errors in the cost calculations. The development cost is actually $760 000, and the reduction in labour cost is $230 000.

Does this affect your recommendation to undertake the project?

Yes No

Show your workings in the following table.

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Year

01

23

45

67

89

10

Sale

of o

ld s

yste

m ($

)

Dev

elo

pm

ent

cost

($)

Imp

lem

enta

tion

cost

($)

Res

idua

l val

ue ($

)

Red

uctio

n in

lab

our

co

st

per

yea

r ($

)

Incr

ease

in u

tility

co

st p

er

year

($)

Net

cas

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w ($

)

Dis

coun

t fa

cto

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lcul

atio

n (c

ost

of c

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l = 1

4%)

Dis

coun

t fa

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r

PV w

ork

ing

PV c

ash

flow

s ($

)

NPV

($)


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Internal rate of returnThe internal rate of return (IRR) is the expected return from a project or an investment. It is defined as the discount rate at which the NPV of project cash flows is equal to zero. In other words, it is the discount rate at which the project breaks even with respect to the PV of its cash flows.

If the project’s IRR is higher than the organisation’s RRR, this indicates a profitable project (i.e. the NPV is positive). Alternatively, if the NPV is negative, the IRR will be lower than the organisation’s RRR. IRR is similar to NPV in that they are both DCF methods that account for the time value of money. They differ rather obviously, because NPV is measured in dollars, while the IRR is a percentage measure. The NPV gives a sense of what a project will add to an organisation’s net assets; the IRR makes it easy to compare different projects and indicates the effect of a project on the organisation’s current ROI. A project with an IRR higher than the organisation’s ROI will increase that ROI if adopted.

Note that without a financial calculator or spreadsheet, the calculation of IRR is typically done by trial and error. It is important to understand the concept of IRR and be aware of how to estimate the IRR using trial and error. For example, if a project has a 10 per cent discount rate and an NPV of $100 000, the IRR will be higher than 10 per cent. The management accountant would continue testing new discount rates (e.g. 12%, 14%, 16%) until they were able to obtain an NPV of zero (and hence determine the IRR for the project).

➤ Question 4.8Assume that you are comparing two projects, only one of which can be undertaken. Your analysis indicates that one project yields a higher NPV than the other, but the one with the lower NPV has the higher IRR.

Given a discount rate of 10 per cent, the project NPVs and IRRs have been calculated as follows:

Project 1$

Project 2$

Initial investment (100 000) (1 000 000)

Net cash flow (Year 1) 220 000 1 320 000

PV of Year 1 cash flow (discount rate = 10%) 200 000 1 200 000

NPV calculation (100 000) + 200 000 (1 000 000) + 1 200 000

NPV 100 000 200 000

IRR† 120% 32%

† Calculated using spreadsheet software. You are not expected to recalculate this figure.

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Which project should you select? Project 1 Project 2

Why?


Profitability indexThe profitability index (PI) is the PV of all future expected cash flows divided by the initial cash investment. When the PI is one, this indicates that the project NPV is zero. Values greater than one indicate an acceptable project.

PaybackPayback is a break-even concept. It is the time it takes a project or an investment to generate a cash amount equal to the initial outlay. Alternatively, payback is the time taken for a project’s cumulative cash flows to equal zero. For projects with regular cash flows, payback can be calculated using the formula:

Payback = Initial investment (project cost) / Annual net cash inflow

If project cash flows are irregular, it is necessary to add annual cash flows for Years 1, 2 and so on, until they equal the original investment.

Payback does not account for the time value of money. To account for this, management accountants can calculate the PV of yearly cash flows using an appropriate discount rate, and so calculate a discounted payback period (DPP). Discounting cash flows leads to longer payback times. The DPP is calculated as follows:• identify the annual cash flows• calculate the discount factor for each period• apply each discount factor to the respective annual cash flow to calculate the PV of the

cash flow• cumulatively sum all the DCFs, starting with Year 0, until the initial investment is fully repaid.

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The payback method will not indicate whether a project is profitable, because it only measures how long the project takes to break even. It is a measure of project risk, not profitability. Potential cash flows after the break-even point are not considered.

The payback method is normally recommended for analysis of small investments. Forecasting cash flows in the near future is likely to be reasonably accurate, and therefore a short payback can be considered a reliable measure of risk. This can be a trap for some organisations. To avoid risk, organisations select short-term projects and avoid long-term projects. Such an approach may allow competitors to implement major projects and achieve significant competitive advantage.

Return on investmentROI is an accounting-based measure, as the ‘return’ referred to is profit. In the context of capital budgeting, ROI is sometimes called the average accounting rate of return (AARR) or accounting rate of return (ARR).

There are many variants of ROI, but the basic idea is simple.

ROI = Return / Invested capital

Average yearly return on the project (profit) is divided by the capital invested. Some variants use yearly operating profit, while others rely on yearly cash flows. Some variants use initial investment, and others use average investment. Average investment may be calculated as the sum of initial investment and residual value divided by two. To illustrate using the data in Question 4.7: the initial investment is $1 030 000 and the residual is $100 000. The average investment is therefore:

($1 030 000 + $100 000) / 2 = $565 000

Note that if there was no residual value, the average investment is $1 030 000 / 2 = $515 000.

Because ROI does not account for the time value of money, it should only be used in conjunction with DCF methods, especially for longer-term projects.

Residual incomeRI is calculated by deducting a notional capital charge from an accounting return. The accounting return used is most often net operating profit after tax (NOPAT). The capital charge is calculated by multiplying either the project initial investment or the project average investment (as described earlier) by the WACC. The best-known application of RI is EVA.

When applied to project evaluation, RI is determined for each year, the PV of each RI is calculated, and the sum of RIs over the project’s life reveal how much value a project is expected to create. So, in this sense, RI combines accounting measures with DCF techniques.

Example 4.11 outlines how these different financial analysis figures are calculated.

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Example 4.11: Calculating the profitability index, payback period, return on investment and residual income

Using the data from Question 4.7†, the PI, payback period, ROI and RI will be calculated. Tax effects are ignored and a WACC of 14 per cent is assumed.

Profitability indexPI = PV of cash flows / Initial cash investmentPI = PV / I PI = $913 715 / $1 030 000 = 0.89

A PI <1 is unacceptable, as it indicates an NPV <0.

† From the suggested answer to Question 4.7, the NPV is –$116 285 and the original investment (Year 0) is $1 030 000. Therefore, the PV of the Years 1 to 10 cash flows is $1 030 000 – $116 285 = $913 715.

Payback periodPayback = Initial investment / Annual cash flow = $1 030 000 / $170 000 per annum‡

= 6.06 years

‡ Exclude residual value

This is a measure of one aspect of project risk. It takes over six years to recover the initial investment. However, payback tells us nothing about the profitability of the project, whether in real economic terms or in accounting terms.

Note that because the project NPV is <0, if a discounted payback was calculated, the payback period would be longer than the 10-year project life (i.e. payback would not be achieved).

Return on investmentROI = Profit (or annual cash flow)§ / Original investment = $170 000 / $1 030 000 = 16.5%

§ Exclude residual value

This result (16.5%) must be considered in relation to: • alternative investment proposals • the organisation’s WACC • the organisation’s overall ROI.

ROI (like other percentage measures and ratios) is mainly useful for comparing projects of different sizes. Also, ROI does not account for the time value of money. For long-term projects, ROI should only be used in conjunction with DCF measures such as NPV.

Note: Other versions of ROI may also be used. For example, the average investment (($1 030 000 + $100 000) / 2 = $565 000) could be used in the denominator.

Residual incomeRI = Profit – Capital charge = $170 000 – 14% ($1 030 000) = $25 800

Note: Other versions of RI can be used. For example, the average investment of $565 000 could be used in place of the initial investment amount of $1 030 000.

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The RI is an estimate of the annual impact on the organisation’s profit if the project proceeds, but NPV is a more economically valid assessment of the increase in the organisation’s value than RI.

Table 4.8 summarises these measures.

Table 4.8: Summary of Example 4.11

Measure

NPV ($116 285)

PI 0.89

Payback 6.06 years

ROI 16.5%

RI $25 800


As can be seen in Table 4.8, payback only measures risk, and so it provides no financial measure of the project. The DCF measures (NPV and PI) indicate that the project is unacceptable—it destroys value. In contrast, the accounting-based measures (ROI and RI) show the project to be acceptable. The difference in the outcomes is attributable to the deficiencies of accounting-based measures.

Deficiencies in accounting-based measuresROI and RI are accounting-based measures and are therefore poor reflections of economic reality. Three core issues exist with accounting-based measures: 1. Accounting profits include accruals such as depreciation that are not economic measures,

but are based on assumptions about limited asset lives, conservatism in accounting estimates, and an inevitable decline in value.

2. The second issue is linked to the first. If accruals are unreliable or economically invalid, then the asset values with which they are associated are equally so.

3. Asset values do not take inflation, or the decline in value of the currency, into account. A property, plant and equipment account will typically include assets purchased over a number of years when the currency had different purchasing power. Yet the value of the account fails to take this into consideration, and the values of assets acquired at different times are simply added together. The resulting balance is, to some extent, meaningless. Asset accounts can be adjusted for inflationary effects, but this adjustment is seldom considered by accountants.

The key message for accountants is that when carrying out financial analysis of projects, DCF methods like NPV, IRR and PI are preferred to accounting-based measures such as ROI and RI. This is because they focus on cash flows rather than accruals, and they distinguish between the PV and the future value of these cash flows. The main use of accounting-based measures is to estimate the effect of a project on the organisation’s financial reports.

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Sensitivity and scenario analysisTwo key methods of evaluating the risk of a project are:1. sensitivity analysis2. scenario analysis.

Sensitivity analysis is where changes in key project assumptions are evaluated against financial returns, such as the effect of a 1 per cent increase in sales growth or cost increases.

Scenario analysis is where the effect of changing a group of assumptions is evaluated, and it usually involves best versus worst-case scenarios. For example, in uncertain economic times, it is prudent to evaluate a recession scenario, which may include lower consumer demand and lower input prices from discounting. Such an analysis will change relevant parameters in the analysis (e.g. consumer demand is 20% lower than in the original analysis) and analyse the impact of such a change on the outcome. If there is no change in the decision being made following the introduction of the change, we can say that the decision is ‘robust’ to the change in this specific scenario, otherwise the decision is ‘sensitive’ to this particular scenario. An advantage of scenario analysis is that key risks and contingencies can be planned for, which has the overall effect of reducing the risk of the project through improved project planning. Worst-case scenario planning also allows projects that have the potential to destabilise the whole organisation to be identified and avoided.

➤ Question 4.9Ideally, the cost of capital used in financial evaluation should reflect the level of project risk, with investors demanding higher returns for projects with greater risk. Hence, it is common to conduct sensitivity analysis on differences in cost of capital. Now read Parts C and D of Appendix 4.1 on the Sydney Seafood Bar.

(a) Do you think the project is financially viable if the managers have 10 years left on the lease of the premises and if the shareholders want an 8 per cent return on their invested capital?

(b) What if the shareholders want 10 per cent return on capital? Would that change the decision?

(c) What if the shareholders want 15 per cent return on capital? Would that change the decision?


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Financial analysis—multiple projectsMost medium-to-large organisations can choose from a range of different projects, which can be a problem if the organisation has more financially viable projects to choose from than it has the capacity to invest into. Also, many projects are mutually exclusive. The management accountant can help decision-makers by preparing reports that compare financial and non-financial rewards and differences in risk and assess the strategic alignment of projects.

Equivalent annual cash flow (equivalent annual annuity)Equivalent annual cash flow (EAC) is a technique that has been devised to compare the financial returns of projects with different lives and different risk profiles. EAC builds on the NPV technique discussed earlier, and therefore it accounts for the time value of money and differences in project risk, and it includes payback of capital invested. EAC converts a project’s NPV into a uniform series of cash flows, enabling the comparison of projects with different lives and risk profiles based on the annual value that they add (or based on being able to repeat the project in perpetuity). From a financial perspective, the project with the highest EAC will be selected.

The formula for calculating the EAC for a project is:

00

tt

NPVEAC

Annuity factor=

= =

Where:NPV = the net present value of a projectAnnuity factor = present value of $1 received annually for n years, where n is the project life.

The formula for calculating an annuity factor is:

( )0

1 1 n

ti

Annuity factori

−

=

− + =

Where:i = discount rate†

n = project lifet = year

† Sometimes referred to as ‘r’

Example 4.12 shows how EAC can be used to choose between projects.

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Example 4.12: An organisation with two mutually exclusive projects

An organisation has two mutually exclusive projects of different life spans to choose between: Project A and Project B. The discount rate for both projects is 10 per cent. The NPV has already been calculated.

Project A Project BInitial investment ($620 000) ($1 100 000) Net cash flows Year 1 $540 000 $610 000 Year 2 $540 000 $610 000 Year 3 $610 000 NPV $317 190 $416 980

When comparing projects with the same lives, Project B would be selected. However, these two projects are mutually exclusive and have different life spans, so the EAC needs to be calculated to determine which project adds the most value.

Step 1: Calculate annuity factors

( )0

1 1n

t

iAnnuity factor

i

−

=

− + =

( ) 2

0

1 1 10%: 1.7355

10%tAnnuity factor Project A−

=

− + = =

( ) 3

0

1 1 10%: 2.48685

10%tAnnuity factor Project B−

=

− + = =

Step 2: Calculate EAC

00

tt

NPVEAC

Annuity factor=

= =

0

317190: 182 766

1.7355tEAC Project A = = =

0

416 980: 167 674

2.48685tEAC Project B = = =

Project A has the higher EAC, which means that it delivers more value per year than Project B. As the capital from Project A will be returned by the end of Year 2, a new project can be started that also has a high EAC. By using EAC, the management accountant can maximise shareholder returns by continually recommending that the organisation invest in projects with a higher EAC.

Capital budgeting techniques—mutually exclusive projects with different lives—is covered in the CPA Program subject Financial Risk Management.

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Part D: The management accountant’s role in project planningThe steps that are central to project planning are outlined in Figure 4.10.

Figure 4.10: Project planning steps

CompleteDescribe DecideDevelop

Describe the activities/ tasks that need to be

done to achieve project objectives—this should

be as detailed as possible and includeall required resources and responsibilities.

Develop a project budget and schedule

from the detailedwork plans.

Decide on how to monitor the project

—that is, when and how often, what form of

reports and to whom the reports are distributed.

Prepare for theproject’s completion.


At the planning stage, the management accountant should assume a leading role in project budgeting and scheduling, and in considering a range of cost optimisation options. Many scheduling techniques combine time and cost information, and hence project cost optimisation must be tightly linked to schedules. Management accountants therefore need to be able to use scheduling tools.

Monitoring and performance measures need to be designed at the project planning stage to ensure proper monitoring is carried out and to make project team members aware of how their performance will be evaluated. Often, the project contract will provide a framework for monitoring and performance measurement systems.

Example 4.13 highlights the importance of project planning tools.

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Example 4.13: An IT project in a service-based organisation—Part 2

This example continues on from Example 4.5 where the service-based organisation that undertook an IT project aimed to make transparent the performance of 4000 front-line employees by using an automated performance measurement system. Consider the problems faced by the company and then how appropriate planning may have either overcome these problems or made them easier to manage.

This highlights the benefits of the tools and techniques in this section:• The project was not allocated enough resources for consultation on performance measures with

the users of the system, or to train employees adequately in the use of the system when it was implemented. Both these problems reflect poor planning and budgeting.

• Technical design faults meant that the data in the system was not always accurate. This resulted in compensation for inaccuracies to the affected staff. This is partly the result of not having a proper description of the various activities or tasks that needed to be done to achieve the project’s objectives. Furthermore, techniques such as PERT and critical path method (CPM) (discussed later) would have helped to get the project back on track when unforeseen problems emerged.

• The project manager and his team were evaluated on the original project time and cost, and the satisfaction of the users of the system. Had proper monitoring and an appropriate plan for the project’s completion been used, the situation may not have been impossible.

Project scheduling Project scheduling is a difficult issue, especially in large, complex projects. A range of methods have been developed to aid this process. The key methods discussed are:• Gantt charts• PERT• CPM.

Gantt chartsOne of the oldest and most widely used methods for presenting schedule information is the Gantt chart. A Gantt chart shows planned and actual progress for project tasks against a horizontal time scale (see Example 4.14). The chart is constructed by listing tasks/activities on a vertical axis, normally in the approximate order of execution. For each scheduled task, the start and end dates are illustrated on the horizontal timeline. Project progress can be monitored by inserting actual start and end times for each task.

Additional information can be added to increase the usefulness of Gantt charts. Project milestones, both scheduled and achieved, can be marked on the horizontal axis. Various colour codes can be used to highlight tasks that are behind schedule or those tasks that form the project’s critical path. The project budget can be related to the Gantt chart by inserting budgeted dollar amounts on the vertical axis (right-hand side), thereby illustrating how much money is budgeted for each time period.

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Example 4.14: Gantt chartsThe manager of Smith’s Embroidery Company has decided to construct a new warehouse on land the company owns on the city’s outskirts. The warehouse has been designed by an architect, and cost estimates have confirmed that it is the best solution to the problem of insufficient finished goods storage space. The following activities have been identified:

Activity Start date Finish date

Obtain planning permission (A) 3 February 3 March

Level land (B) 3 March 10 March

Dig foundations (C) 8 March 15 March

Pour concrete for foundations and floor (D) 16 March 20 March

Construct steel sides and roof (E) 5 April 17 April

Install electric cables (F) 10 April 17 April

Plaster internal walls and ceiling (G) 17 April 30 April

Connect electricity (H) 1 May 1 May

The Gantt chart for the warehouse project is illustrated as follows.

H

G

F

E

D

C

B

A

3 10 17 24 3 10 17 24 31 7 14 21 28 5 February March April May

Activity

Time

The Gantt chart in Example 4.14 shows each activity, and the duration taken to complete the activity, as a horizontal bar. The bar runs from the start date of the activity to the finish date. In this example, most activities need to be completed before the next one is started, except for B and C, and E and F, which overlap. In complex projects, there may be a number of activities that can be done concurrently by different team members. Overlapping horizontal bars show which activities can be performed at the same time.

Gantt charts for complex projects with many activities may be constructed using software packages. These packages help decision-makers to perform sensitivity analyses for scheduling (e.g. what is the impact on Stage B if Stage A is delayed by one week?). In Example 4.14, missing the date for obtaining planning permission (A) by one day would delay the project for a month, as planning permission is only granted by the local authority at its monthly meeting. However, being two days late in installing the electric cables (F) might have no effect on the project completion time, as it may be possible for Stage G to begin while waiting for Stage F to be completed.

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Gantt charts are simple, and are easy to understand, construct and use. Although they require regular updating, this is easily done, as long as there are no changes to task requirements or major alterations to the schedule. They are particularly helpful when expediting, sequencing and reallocating resources among different tasks. All major project management software packages include Gantt charts.

Gantt charts can also describe task interdependencies, identify critical paths, highlight changes in the project schedule and calculate slack time available for project completion. To be able to understand the meaning of this additional information included in Gantt charts, another scheduling tool—PERT—needs to be discussed.

PERT: Program evaluation and review techniquePERT was developed in the late 1950s. It is an approach that represents the tasks required to complete a project. It also enables analysis of what the shortest completion time is and then provides opportunity for analysis of how completion times can be shortened. This is done through the analysis of the CPM. The key elements of PERT and then CPM are described next using the following four steps:Step 1: Draw the network diagram. Step 2: Calculate the expected time (ET). Step 3: Define the critical path. Step 4: Calculate slack.

Note 1: There is a detailed step-by-step example of drawing a PERT diagram available in Appendix 4.2 of this module.

Note 2: The concepts covered in Appendix 4.2 (not the specific details of the case) are examinable.

Step 1: Draw a network diagramPERT is a network diagram that includes all project activities (e.g. replacing the kitchen in the Sydney Seafood Bar case in Appendix 4.1), activity precedence relations (where one activity must be completed before another can start—e.g. removing the old kitchen in Appendix 4.1) and, in some formats, events. An event is the point at which an activity is started or completed (e.g. the start of or the finish of removing the kitchen in the Sydney Seafood Bar).

There are two formats used to prepare a network diagram. One format displays activities as arrows and events as nodes (circles), hence it is entitled ‘activity-on-arrow’ (AOA) network (see Figure 4.11).

Figure 4.11: Activity-on-arrow network diagram

1A 3A

1B 3B

2B

2A


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An alternative format, which is used in this module, is an ‘activity on-node’ (AON) network (see Figure 4.12). In the AON format, nodes represent activities and events are not illustrated. The choice of AOA or AON representation is a matter of personal preference, although some software packages support only one of the two formats. This module uses the AON format, because it is easier to use (e.g. includes real project activities only and does not require events or dummy activities) and is supported by most project management software packages.

Figure 4.12: Activity-on-node network diagram

1A 2A 3A

1B 2B 3B

EndStart


Network diagrams are normally drawn from left to right, reflecting the sequence of activities. Networks can include a time dimension, with the length of the arrows representing the duration of each activity. This can make drawing the diagram difficult. Hence, normally the time of activities is simply noted on the diagram. To draw the diagram, the place to start is with activities that have no predecessors.

Where an activity has no precedent activity, it can start from the start node. For example, if Activity (B) has no precedent activity (i.e. does not need to wait until Activity (A) is complete before it can start), Activity (B) can start immediately after the ‘start’ node.

All activities in the project should be joined or linked so that they eventually connect to an ‘end’ point, which represents project completion. Where an activity is not a precedent activity for another activity, it can be directly linked to the end node. For example, assume there are eight activities (A–H). If Activity (E) is not a precedent activity for another activity, then it can be connected to the end node.

The process of drawing a PERT diagram is explained further in Example 4.15.

Example 4.15: Drawing a PERT diagramConsider a project that starts with the following three activities:

Activity Preceding activity Duration (days)

Activity A N/A 5

Activity B N/A 10

Activity C A and B 3

Activity A has no precedent relationships and is expected to take five days. First draw a node representing Activity A, which is then connected with an arrow from the start node.

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Activity B has no precedent relationships and is expected to take 10 days. Similarly, draw a node representing Activity B, and connect it with an arrow from the start node.

Activity C can only start once both Activities A and B are complete. Therefore, the node representing Activity C is connected to both nodes representing Activities A and B.

Finally, all the activities that are not a precedent activity for another activity (in this case, Activity C only) are connected to the ‘end’ node.

C EndStart

A

B


Step 2: Calculate expected time Once all activities and their precedence relationships have been drawn, activity duration can be calculated. Where schedule uncertainty exists, it is suggested that three duration estimates be made for each activity—O (optimistic), P (pessimistic) and ML (most likely). The ML time is the estimate of the duration that the activity will take—if it is completed as planned. The ET can then be calculated as a weighted average of the three duration estimates according to the following formula:

( )4

6

O ML PET

+ +=

Note for statisticians: The weighting of 1:4:1 assumes that the distribution of possible durations covers six standard deviations and is based on a beta distribution; other weightings might be considered. For a more detailed discussion on the use and assumptions of this formula, see Littlefield and Randolph (1987) or Gallagher (1987).

To highlight scheduling risk, it is useful to estimate the time-related uncertainty (variance) of each activity. The variance will help in understanding the likelihood of completing the project on time. A high variance indicates a high risk of out-of-schedule completion. The variance calculation is:

2

6P O

VAR− =

Some project management software packages provide these calculations.

If you are interested in learning more about this, refer to Meredith and Mantel (2015) listed in the References section at the end of this module.

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Step 3: Define the critical pathFigure 4.13 is a network chart for a project. For each activity, the ET and its variance are given (e.g. for Activity (A), there is an ET of 40 days and a variance (VAR) of eight days (40,8)). Beside each node, the earliest occurrence time (EOT) is displayed. EOT represents the time an activity is expected to be completed. To find the EOT for an activity, all incoming paths need to be evaluated to find out which one takes the longest time to complete. For example, to find the EOT for Activity H in Figure 4.13, note that path A → D takes 70 days (40 + 30), while path B → E takes 60 days (40 + 20). The EOT for Activity H is, therefore, the maximum between these two numbers (70 days) plus the duration of Activity H itself (16 days), hence 70 + 16 = 86.

The EOT for the ‘end’ node (86 days) is the expected project completion time or the ‘project critical time’, calculated as the maximum of all EOT of activities that are not a precedent activity for another activity. In this case, project duration is the maximum of 86 (Activity H), 68 (Activity F) and 84 (Activity I).

The critical path for a project is the path(s) that result(s) in the project critical time—that is, the longest time to completion. In Figure 4.13, the path A → D → H is termed the critical path because this path has the longest duration (86 days). If there are any delays on this path, the whole project is delayed. Conversely, if the duration of activities on this path are shortened, the whole project duration can be reduced.

The critical path is the shortest duration in which you can complete a project. It is also the longest path through the PERT diagram. This is because the project will only be completed when all tasks are finished. This means that the sequence of activities that takes the longest amount of time will determine the total time it takes to complete the project.

Note that all activities, even those not on the critical path, still form part of the overall project and must still be carried out in order to complete the project. What must be determined is the total duration of the project, given that some activities can start immediately, while others have precedent relationships and can only start once another activity has finished. The critical path is usually depicted as a heavy line.

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Figure 4.13: Completed PERT diagram

ET = 40Var = 8

EOT = 40

ET = 30Var = 50

EOT = 70

ET = 16Var = 10

EOT = 86

EOT = 86ET = 28Var = 8

EOT = 68

ET = 20Var = 8

EOT = 60

ET = 40Var = 0

EOT = 40

ET = 44Var = 12

EOT = 44

ET = 8Var = 0

EOT = 48ET = 36Var = 56

EOT = 84

Start B F

G

E

D

H

End

IC

A


Step 4: Calculate slackFrom the network diagram, we can calculate the earliest starting time (ES) and the latest starting time (LST) for each activity. Project managers often want to know the latest time an activity can start without making the entire project late. The answer depends on how much ‘slack’ or ‘float’ there is in any activity or path. The slack time is equal to the LST minus the ES.

The LST can be worked out backwards by starting from the project critical time and deducting activity durations from it (i.e. working from right to left). For example, in Figure 4.13:• The latest day Activity (F) can be started is 58 (86 – 28). As the earliest start time of Activity (F)

is day 40 (i.e. EOT for Activity B), it has slack of 18 days (58 – 40). Where the PERT network is pictured on a time axis (i.e. arrow length is proportional to duration), slack can be indicated by dotted lines.

• The path C → I takes 80 days and the critical path is 86 days. So, there are six days of slack in path C → I. This means that Activity (C) could potentially start after six days and the project would still be completed in 86 days.

• Activity (H) can only start after both Activities (D) and (E) are complete. The EOT for Activity D is 70 days, so unless other preceding activities are reduced in time, this is the ES for Activity (H). As Activity (H) is on the critical path, the LST and ES are the same (i.e. 70 days) and there is no slack available.

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A clear understanding of the slack involved in various activities is essential for project managers who want to ensure that resources are used efficiently. Resources allocated to tasks with some slack can be reallocated to tasks without slack. Smooth distribution of resource usage leads to better economic performance for a project, as there is, for instance, less need for overtime.

For a further explanation of and practice in PERT, please access the ‘Example Network’ and ‘Network Exercise’ learning tasks on My Online Learning.

Critical path method—crashing projectsCPM is a network-scheduling technique based on PERT that provides an additional dimension: the analysis of cost–time trade-offs in meeting or expediting project schedules. This is one of the most difficult tasks faced by the project manager. CPM considers how resources such as labour and machinery can be added to activities to shorten their duration. This is called ‘crashing’ the project.

Define crash duration and costsCPM analysis usually suggests two possible durations for the project. The ‘normal’ duration is the most likely to complete the project. The second one is the ‘crash duration’. Crash duration is the total time the project is expected to take after the project has been crashed. Crash duration is a result of a reduction in the duration of an activity that can be achieved by adding resources such as:• overtime hours• additional staff or machinery• special equipment• expediting subcontractors• paying extra for faster delivery.

For example, if the normal duration is 30 days and by adding resources it would become 25 days, the crash duration would be 25 days. The difference between the normal and the crash duration reflects the number of days that have been crashed (i.e. 30 – 25 = 5).

Similarly, two costs are specified for the project: normal cost (budget) and crash cost. Crash cost is the normal cost together with all the extra costs that are related to expediting one or more activities. Careful planning is essential when trying to shorten a project. The likelihood that a project will need to be expedited is fairly high in situations where duration estimates are uncertain and there is a firm project deadline.

Define financial benefits from crashing a projectThere may be economic incentives for reducing project duration. Faster completion may expedite cash inflows, thus reducing the time that a project employs capital. This may lead to lower interest expenses and increased project ROI. Sometimes, expediting a project may help to avoid late completion penalties, or alternatively, a project might be crashed to free up resources in a multi-project environment.

Crashing project activities is typically done where the cost–time trade-off is feasible—that is, whether it is worthwhile spending more money on additional resources (e.g. labour or machines) to speed up the project. For example, if it costs $50 000 to crash the project by 10 weeks, but the project ends up earning a $100 000 bonus, then the cost-time trade-off is feasible.

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Define the order of activities to crashAfter determining which activities can be crashed, the cost of crashing each activity and the potential benefits due to crashing, the project manager, with the support of the management accountant, determines which of the critical path activities would be optimal to crash. (Note that project duration can only be reduced by crashing activities on the critical path.) This is done by calculating the cost–time slope of an activity. This is the crash cost less normal cost, divided by normal duration less crash duration. The critical activity with the lowest cost–time slope will be the first one to crash. An alternative to the cost–time slope is where the crash costs are identified on a common time basis (e.g. $10 000 per week). When all the crash costs for a project have the same time units (e.g. per day or per week), this information can be used to determine the order of activities to crash (i.e. the lowest cost on the critical path first).

Note that crashing critical path activities may make some other path critical, or create more than one critical path. Therefore, reducing project duration may require the simultaneous crashing of multiple activities.

Refer again to Figure 4.13. The critical path A → D → H has an EOT of 86 days. The second longest path is B → G → I, which is 84 days. If the critical path A → D → H is crashed by two days, the critical path becomes 84 days, and so the duration is equivalent to the path B → G → I. Now there are two critical paths and further crashing must take into account both critical paths. If path A → D → H continues to be crashed, there will be no benefit; if path A → D → H is reduced to 83 days, path B → G → I still remains 84 days. In other words, the duration of the whole project has not changed (84 days). As such, once there are two (or more) critical paths, the duration of all critical paths will need to be reduced simultaneously to have any effect on the project completion time.

Cost optimisingWhere minimising the project cost is being sought, critical path activities continue to be crashed one by one until the point where the additional cost of crashing an activity equals the incremental savings. Figure 4.14 illustrates cost behaviour in cost–time optimisation decisions.

Figure 4.14: Cost behaviour in cost–time optimisation decisions

Cost

Normaltime

Optimumtime/cost

Crashtime

Benefit

Crash cost


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Finding a cost optimum is difficult in practice, especially in large projects that are very complex. A possible way to overcome this problem is to determine a few alternative cost–time points and select the one with the lowest total cost.

A graph illustrating a project cost function such as Figure 4.14 can be drawn based on information about crashing costs and benefits. Such graphs may be useful in communicating with senior managers or customers who may argue for early completion without a clear understanding of the cost implications.

For further practice in the concept of crashing a project, please access the ‘Crashing Exercise’ learning task on My Online Learning.

➤ Question 4.10The managers of the Sydney Seafood Bar (SSB) have decided to use a critical path model to plan the renovation project, as outlined in Appendix 4.1. The table below indicates the activities required to complete the project, plus their durations and precedence relationships.

Duration estimate (days)

ActivityPreceding

activity Optimistic Most likely Pessimistic

1. Remove kitchen 4 7 10

2. Remove toilet block 1 5 10 15

3. Excavate floor for new slab 2 5 15 19

4. Remove mezzanine 2 4 6 14

5. Repair mezzanine 4 6 10 20

6. Lay new slab 3 1 2 9

7. Build toilets 6 5 10 21

8. Fit out toilets 7 9 18 21

9. Build kitchen 6 20 30 46

10. Fit out kitchen 9 5 7 15

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(a) Construct the PERT network for the SSB project using the AON approach (as shown in Figure 4.12).

Note: You will either need to do this separately on a piece of paper, or you may prefer to create the network diagram in a drawing program before adding your response to the answer field.

If you choose to use a drawing program, save your diagram as an image file. Then in the interactive PDF of this Study guide, you can insert your response by selecting the answer field and browsing for the image file that you saved on your device.

(b) Determine the expected completion times for all SSB project activities.

(c) Determine the SSB project’s critical path.


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Project budgeting A project budget has several important functions: • It is a plan to allocate resources to project activities. As senior managers approve a project

budget, they also approve the use of resources determined in the plan. • It facilitates the control of project costs and revenues through variance analysis. • It is the main benchmark used to evaluate a project’s financial success. • When project team members know that costs will be closely monitored, they are less likely

to engage in actions that cause budget overruns.

Project cost estimates are the main input for a project budget. The main difference between a project cost estimate and a project budget is the time dimension. A project budget provides cost estimates on a weekly, monthly or quarterly basis, and should reflect project milestones.

It is often more sensible to budget for activities and milestones rather than time periods that bear no relation to a project’s critical dates, but it is common practice to create project budgets on a monthly and yearly basis. Typically, project budgets contain only project costs. Revenues and cash flows are presented in separate finance and cash flow budgets.

Expenses can be allocated to a project as a whole (i.e. where the project is one cost centre), to different deliverables or to business units within the company. The account coding used varies among companies based on project size, type, complexity and organisational structure, but it is preferable if the accounting system can capture the project as a separate unit to other organisational activities to allow effective project cost control.

There are different ways to treat overheads in project budgets. If overheads are out of the control of the project team, allocation will merely obscure evaluation of project success.

As with other budgets in today’s dynamic business environment, it is unlikely that a budget for a long-term project will remain valid for the entire duration of the project. Therefore, project budgets need updating, at least after major changes in project circumstances or major deviations from plan. A revised budget provides a fairer benchmark to evaluate project management if changes are due to uncontrollable factors. On the other hand, if changes were controllable, the original budget provides a valid benchmark for performance evaluation. In these cases, a revised project budget may still be necessary to plan for cash flows and to control costs.

Budget preparation provides a good opportunity for management accountants to inform project managers about revenue recognition and cost-allocation conventions. This improves the project manager’s understanding of management accounting reports and increases the likelihood of correct decisions being made regarding the project.

Project management softwareProject management software enables the use of effective planning tools such as Gantt charts, PERT and CPM, along with project budgeting and cost control. There are many off-the-shelf packages available, although a number of organisations have also developed in-house applications.

Overviews of different project management software packages are available here: http://www.businessnewsdaily.com/8237-choosing-project-management-software.html.

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Supplier contractsThe project activity contracts with individual suppliers can be designed in many ways. Management accountants should consider the effect that contract terms have on cost control and the AC incurred. For example, fixed-price contracts provide certainty and pass profit risk back to the supplier. In fixed-price contracts, the management accountant works with the project manager mainly to control the quality of work and its timing. Cost control is less important because the supplier has an incentive to keep costs under control and cannot pass on cost overruns.

Another type of contract that is open to negotiation is payment for work done (i.e. hours or days). In this case, the supplier (e.g. a building contractor) has an incentive to work more in order to increase their revenues. The project manager and management accountant must monitor hours and costs in addition to quality and time.

Some contracts are prepared on a cost-plus basis. The supplier is reimbursed for their costs plus a margin for profit. In this case, the management accountant must carefully monitor a supplier’s cost records to ensure that they are prepared in accordance with the contract and that non-reimbursable costs are excluded.

Additionally, various types of bonuses and profit-sharing schemes can be used to achieve desired project targets. One of the ways that management accountants can provide added value for management is in the design of contracts that create the right incentives for suppliers to reduce cost and time, and to minimise administrative costs for the organisation.

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Part E: The management accountant’s role in project implementation and controlAfter the project plan has been developed and approved, project execution starts, when all project activities are undertaken according to the plan. During this time, the role of the management accountant is to monitor the progress of the project, compared with its approved plan.

Monitoring progressThere are three major areas that are considered in the context of monitoring progress, as shown in Figure 4.15.

Figure 4.15: The three critical factors for monitoring progress

Projectcost

Projectspecificationand quality

Projecttime


An important role for management accountants during project implementation is collecting, recording and reporting cost, time and specification/quality-related information (together entitled ‘project iron triangle’) to control the progress of the project. Project control is focused on the project budget, project schedule, and other measures used to establish the achievement of quality and specification.

The main control tools used by management accountants are budget and schedule variances. In reporting variances, the management accountant must keep in mind that because of the unique and uncertain nature of projects, and the difficulty of predicting future costs and activities, significant variances will inevitably arise. These variances will not necessarily reflect the performance of project managers.

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Variance analysis is useful in both providing feedback to project managers about the project’s progress and in helping to revise budgets and schedules to reflect new knowledge about the project and the project environment. In the next section, the discussion on monitoring cost, time and quality/specification is extended to consider two other related issues that have a significant effect on project progress:1. risk management2. stakeholder management.

Monitoring costsProject cost reporting needs to be regular, timely, accurate and relevant. This creates a challenge, as project reporting is usually tied to the invoicing, record-keeping and reporting routines of an organisation (see Example 4.16). Keeping a separate record of committed costs for project purposes will ensure timely and useful information in project reports. A cost is committed when a contract is concluded or a purchase order is issued.

Example 4.16: Controlling project costsA project manager orders a major component required for a project on 1 March. The component is delivered on 30 April. An invoice for $400 000 is received on 15 May. The invoice is processed and payment is made on 14 June.

The company commits to the cost when the order is placed (1 March), but unless a separate record is kept of these committed costs, accounting reports will not recognise these commitments in a timely way. The expenditure might show up in the project report for May, or even as late as June. One may ask how timely and useful this type of reporting is for controlling project costs.

Regular project cost reports should contain incurred costs, committed costs and an estimate of costs still required to complete an activity. These costs are compared against the budget. Deviations from the budget suggest the need for corrective actions. Management accountants should not automatically estimate required costs by subtracting incurred costs from budgeted costs. The key to efficient cost management is accurate budgeting—to produce good estimates of required costs.

Part of the process of managing costs is evaluating the project cash flows against forecast cash flows. Some projects will work with a more traditional budget and use accrual accounting to manage expenses being incurred, while others will run a cash budget. For projects using a cash budget, the schedule of cash flows prepared in the initial project analysis will often form the basis of the cash budget for the project and variance analysis performed against these forecasts.

Many projects are dynamic and constantly changing, so they require the allocation or reallocation of resources to meet a possibly turbulent environment.

The earned value method: Time versus cost A common and simple method for project cost reporting involves comparing actual expenditures against the budget. One major shortcoming of this approach is that it does not account for the amount of work accomplished relative to costs incurred. So a cost report may show that a project is well below budget (favourable variance) without revealing that this is because the project is running late.

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A method called earned value (EV) has been developed to assess cost and time performance simultaneously. The idea behind the method is to break down the usual budget variance (actual – budget) into two parts. The key factor in this breakdown is the EV or the expected cost of project work completed to date.

EV can be estimated for a whole project if it is small. For large projects, EV analysis is applied at the activity level. The EV of work performed is found by multiplying the estimated percentage completion of each activity by the total budgeted cost for that activity. That is:

EV = Estimated percentage completion × Budgeted cost

This gives the amount that should have been spent on the activity so far. For example, if an activity with a budget of $1000 is 25 per cent complete, its EV is $250. This method of calculation is appropriate where activity costs are incurred evenly throughout the activity. Estimating EV can be more difficult if costs are incurred on an irregular basis.

Comparing EV with planned costs and with AC produces two variances. Project (or activity) cost variance is the difference between EV and AC at that point in time. The schedule variance is the difference between the EV and the planned value (PV) at that point in time. That is:

Cost variance = EV – AC

Schedule variance = EV – PV

Although not universal practice, these variances should be defined in such a way that they will be negative when the project is over budget (cost variance) and/or behind schedule (schedule variance). This is the approach taken in this section.

Continuing with the example where EV is $250: if the $350 was actually spent at that point in time (i.e. AC = $350), the cost variance would be ($100) (i.e. $250 – $350), and the project would be over budget. If it was expected that $300 would have been spent at that point in time (i.e. PV = $300), the schedule variance would be ($50) (i.e. $250 – $300), and the project would be behind schedule.

A cost variance would likely lead to a reassessment of the budgeted costs of the project, whereas a schedule variance would likely lead to a reassessment of the estimated completion time of the project.

The magnitude of these variances depends on project dollar values, so they are commonly stated as ratios to make them easier to understand, or when the organisation wishes to compare the performance of multiple projects. The ratios are called the cost performance index and the schedule performance index (SPI).

Cost performance index = EV / AC

SPI = EV / PV

In addition to these variances, two other variances can be calculated. The schedule variance is the (monetary) difference between the EV and PV. The difference between AC and EV is called the cost variance.

The following EV chart (Figure 4.16) shows the tools to be used in reporting project progress and highlights that for the current point in time (‘control point’), the project is behind schedule (EV is lower than PV) and over budget (AC is higher than EV).

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Figure 4.16: Reporting project progress

Schedulevariance = SV

Cost variance = CV

Planned valueEarned valueActual cost

Scheduledcompletion

time

Duration

Cost

Estimatedcompletion

time

Control point

Estimated final cost overrun

Revised budget Estimated delay


Example 4.17 further explains how the EV chart shown in Figure 4.16 can be interpreted.

Example 4.17: WaterSupplyCoWaterSupplyCo is responsible for the main water pipes in a large city and has initiated a project to replace the water pipes that run under the footpath. The total length of the water pipe replacement is 480 metres.

There are three core activities in replacing the water pipes: 1. excavate down to the existing pipes2. replace the existing pipes3. fill in the excavated area and re-concrete the footpath.

WaterSupplyCo engages a contractor (DJ Water) to do the job. DJ Water estimates that it can complete an average of eight metres of piping a day, so the whole project will take 60 days or 12 weeks. Based on this, DJ Water puts together the following project budget for the three activities.

Activity rate Calculation Total activity cost

Excavation—$150 per metre $150 × 480 $72 000

Replace pipe—$200 per metre $200 × 480 $96 000

Fill and concrete—$220 per metre $220 × 480 $105 600

Total—$570 per metre $570 × 480 $273 600

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Within the first week of the project, DJ Water finds a major problem. When excavating the ground where the current water pipes are, they find that it is a type of rock called sandstone. This means that DJ Water needs to widen the channel the pipes sit in, which requires more expense (e.g. hiring additional equipment) and time in excavation.

After the first four weeks (20 days) of the project, DJ Water has provided the following data:• incurred $134 064 in costs:

– $94 584 for excavation– $39 480 for laying the pipes, filling in the hole and re-concreting

• completed 94 metres of water piping.

DJ Water uses a variance approach to understand how it is tracking against budget. The first step is to refer to the original budget for the project. DJ Water originally calculated that at this point, it would have completed 160 metres of the job (i.e. 20 days at a forecast of eight metres per day).

Activity rate Calculation Budget

Total—$570 per metre 570 × 160 $91 200

An initial inspection of the figures suggests that the project is over budget by $42 864 (AC $134 064 – PV $91 200). This is highlighted by the AC being above the PV in Figure 4.16.

The second step to complete is an EV analysis. This shows that the EV to date is $53 580 (94 metres completed × $570 per metre). From this information, DJ Water calculates that the scheduled variance is unfavourable by $37 620 (EV $53 580 – budget $91 200). This is highlighted by the PV being above the EV curve in Figure 4.16.

DJ Water also calculates that the cost variance is unfavourable by $80 484 (EV $53 580 – AC $134 064). This is highlighted by the AC being above the EV curve in Figure 4.16.

The final step is to re-forecast both the time to completion (estimated delay) and the revised budget (cost overrun), both of which are reflected in Figure 4.16.

A standard budget variance analysis would show that the project has real budgetary problems. When the spending and schedule variances are calculated (i.e. based on EV), it highlights just how serious the situation is.

Estimating the percentage completion of activities is sometimes difficult. The EV method suits projects where completion can be measured with reasonable accuracy, such as building a highway (km completed) or dredging a shipping channel (tonnes dredged). Input indicators such as labour hours are not suitable measures of project completion, as they provide no evidence of what has actually been accomplished.

EV cannot replace scheduling techniques such as PERT, because it does not account for critical activities, the critical path or slack. A combination of network analysis techniques and EV analysis provides a useful system for project planning and control. The management accountant can play an important role in implementing such a control system.

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➤ Question 4.11(a) Explain how project managers can benefit from the use of EV analysis.

(b) What are the difficulties in implementing EV analysis?


Monitoring specification and qualityQuality in projects is meeting the customer’s specification. There are three stages to project quality management as outlined in Figure 4.17.

Figure 4.17: The three stages to project quality management

Qualityassurance

Qualitymonitoring

1. At the beginning of the project, the project scope and specifications are established. This needs to happen at the same time as the project budget and time lines are set.

2. A critical task for the management accountant is to establish performance measures to reflect the planned specifications (see Module 5). This is about ensuring that the activities and processes for delivering the project specifications are controlled.

3. This stage is about ensuring that all the outcomes of the project are in accord with the planned specifications and, if they are not, that this is dealt with appropriately.

Qualityplanning


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A significant issue for managing quality is that, unless good performance measurement design is achieved and there is constant monitoring and assurance, specification or quality may be traded off against cost or timeliness. This is because the progress of cost and time is typically easier to recognise and monitor. Not only is quality or specification more difficult to measure, but it may also not be apparent until later in the life of the project. Moreover, it may be difficult to establish who has responsibility for the particular project’s failure to deliver the project specifications (see Example 4.18).

Another important aspect of managing quality is contract management. In cases where there is a contract and an external provider is responsible for some of the project’s deliverables, it is important to ensure compliance with contractual terms and conditions (e.g. time, quality and deliverables). This requires a thorough contract variation regime (e.g. time and cost adjustments due to changes in scope). The management accountant needs to ensure the project critical path is recalculated after every contractual change and the new activity slacks and their effect on the project are well understood.

Example 4.18: Project disputes The Massachusetts Institute of Technology (MIT) sued Frank Gehry, whom many consider to be the world’s greatest living architect, over his design of a USD 300 million building project, due to what they claimed were faults in the design. Alleged problems included cracking masonry, poor drainage in the outdoor amphitheatre, leaks, sliding ice and snow, and mould growth.

MIT argued that poor design led to the problems, while Gehry argued that the problems in the project were due to the workmanship of the subcontractor in the building process.

Gehry is also reported to have argued that his client tried to save construction costs by reducing components of the design, which resulted in some of the problems.

The case was finalised on 5 February 2010. Most of the issues of design and construction cited in the lawsuit were resolved and the case was ‘reported settled’.

Source: Based on Pogrebin, R. & Zezima, K. 2007, ‘M.I.T. sues Frank Gehry, citing flaws in center he designed’, New York Times, 7 November, p. A20; Hawkinson, J. A. 2010, ‘MIT settles with Gehry over

Stata Ctr. Defects’, accessed June 2018, http://tech.mit.edu/V130/N14/statasuit.html.

Quality failure in project organisations not only impedes their ability to deliver quality projects, but can seriously damage their reputation. This contrasts somewhat with quality failure in projects within organisations, which can be harder to quantify, because the projects can be hidden among the many other organisational activities. There may also be fewer or no external stakeholders to hold the organisation accountable.

Quality costsOne way to think about quality management is to consider the four different types of quality costs outlined in Figure 4.18.

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Figure 4.18: Quality costs

Qualitycosts

Incurred in the design of an organisation’s processes and activities to prevent quality failure, by focusing on quality inputs and systems, staff training and equipment maintenance.

Incurred when the customer finds that the project does not meet specifications and the project organisation has to cover the expense of re-working the project. This is the most expensive type of quality cost—it includes the costs of reworking already completed work and reputational costs for the project organisation.

Incurred when incoming supplies and materials are received, and when products are inspected during, and at the completion of, the production process.

Incurred when quality failure is identified in either the quality control or assurance process, and rework is able to be completed before the customer takes control of the project.

1.Prevention

4.Externalfailure

2.Appraisal

3.Internalfailure


These costs are discussed further in Module 6 when total quality management (TQM) is considered.

The international standard ISO 10006:2017, ‘Quality management—Guidelines for quality management in projects’, outlines a number of relevant quality management concepts and assists the management accountant with the application of quality management in projects. It is available online at: https://www.iso.org/standard/70376.html.

Measuring performanceAnalysing performance against the project budget and schedule provides basic control over a project for the project manager—as well as visibility over the project manager for the project sponsor—to ensure that the project is delivered. Other performance measures are required to ensure that the project achieves its deliverables and to ensure project quality.

As projects are inherently uncertain, to evaluate the performance of a project, non-controllable events must be allowed for. Budgets can be adjusted or ‘flexed’ to account for these non-controllable changes.

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There are two major challenges for management accountants in project performance measurement: 1. In many organisations, projects are cross-functional and are organised with a matrix-like

structure, but planning, resource allocation and lines of accountability normally follow functional lines. This means that line managers are responsible for the performance of their own function and their rewards are linked to the success of their function. As staff tend to focus on the performance for which they are rewarded, project work may be given a lower priority when trade-offs are required. This can jeopardise the satisfactory completion of projects. An important contribution that management accountants can make is to design appropriate reward schemes so that line managers are given incentives for successfully completing project milestones under their responsibility.

2. In project organisations (such as construction companies), employees must continue to learn and keep their skills up to date. As a project manager is responsible for completing the project on time and within budget, they may be reluctant to allow their best people to be absent from project activities for extended periods of time (e.g. to attend training). Here, management accountants can design performance measures that encourage project managers to support employees’ learning and development. For example, a simple measure that may be used is the days spent on educational courses. While this measure is limited because it does not convey information about the effectiveness of the training, it highlights the importance of learning and development to project managers. Targets for such measures should allow for learning and skills development.

The importance of probity in projectsProbity means honesty or integrity. The potential for dishonest conduct needs to be monitored in projects. Management accountants have an important role (where they are involved) in probity management through the design of procedures, processes and systems. Independent Commission Against Corruption (ICAC) in New South Wales in Australia has a very useful set of guidelines that provide direction on how to deal with probity issues (ICAC 2005).

A management accountant can draw on five probity fundamentals in the management of project probity:1. Best value for money—the purchase of inputs is in an open and competitive environment,

where the price of the input is balanced against the other characteristics, such as quality and risk. Part of this means ensuring that suppliers do not charge unreasonable prices at the expense of a project or organisation.

2. Impartiality—individuals and organisations should expect impartial treatment in their involvement with a project. If an organisation submits a tender for a public sector contract, it is entitled to impartial treatment at each stage of the process. Suppliers should be able to expect impartial treatment when they submit proposals for supply, especially when the effort and time in the preparation of the proposal are considerable.

3. Conflict of interest—management accountants need to ensure that there is no conflict of interest, such as when individuals may have other private interests that conflict with the interest of the project (e.g. a project team member may have a family member who is a supplier to the project). There is an obligation to ensure that any potential conflict of interest is disclosed and managed.

4. Accountability and transparency—accountability means ensuring that resources are used effectively and that responsibility is taken for performance. Clearly, the accounting systems that management accountants design are central to this process. Transparency means ensuring that the project is open to scrutiny, which involves providing a reason for all decisions made. Again, management accountants are central through preparing reporting mechanisms and constructing decision-making tools.

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5. Confidentiality—while activities in the project need to be accountable and transparent, some information needs to be kept confidential, at least for a particular period of time. Examples of this include proposals, intellectual property and maybe pricing structures (ICAC 2005).

One area in which probity is especially important, and management accountants need to be particularly vigilant, is the procurement of goods and services of high value or goods that are contentious or dangerous. While probity is something that needs to be considered and managed right through the project process, there may be instances where a specific probity adviser or probity auditor needs to be engaged. This is particularly so in the case of government projects and contracts (ICAC 2005).

Risk managementRisk management happens when the project commences. It is about the ongoing process of monitoring and managing the risks of the project while it is being implemented, as shown in Example 4.19.

Example 4.19: Risk managementAssume that your organisation is undertaking an offshore construction project and you identify that material inputs are likely to be unstable, and foreign currency fluctuations are likely to be volatile. Identifying both of these issues is the result of your risk assessment exercise.

Your risk management approach may include establishing a range of suppliers (including some in your own country as a contingency plan) and also hedging against currency fluctuations.

Risk assessment is about clarifying what the risks are, whereas risk management is about trying to manage those risks.

Effective risk management requires a good risk management strategy, which consists of four key areas, as outlined in Figure 4.19.

Figure 4.19: Risk management strategy

Having theright project

team

Monitoringknown risks—diagnostically

Monitoringunknown risks—

interactively

Riskmanagement

strategy

Establishingcontingencyresponses


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Having the right project teamAn effective risk management strategy during project execution is to hire the right project team in the first place—including people who have the necessary technical skills and experience. When you have achieved this, the next challenge is keeping them! Project failures are littered with examples of a good project plan, good people at the start of the project, then poor management of these people during the project, resulting in them leaving and the project failing. A useful exercise is to determine which staff on the project are critical to the project’s success, which staff are difficult to replace and which staff can be replaced relatively easily. From this list, you can establish a strategy of ensuring that your essential staff stay on the project. You also need to create a backup plan for what to do in case those strategies fail.

Monitor known risksIn the risk assessment process prior to project commencement, a list of risks would have been created, including the probability and the impact of those risks. A diagnostic approach to monitoring these risks can be established and, when variances appear, remedial action can be taken. The use of key risk indicators is a useful approach for diagnostic control, as they help to measure risk levels (sometimes against appropriate benchmarks).

Monitor for unknown risksRisk is, by definition, about uncertainty or ambiguity. Consequently, while the probability of some events can be predicted (trying to manage uncertainty), many projects face events that are simply not predictable or may be ambiguous. These are what can be defined as the unknown risks—the events that project managers and teams have no way of knowing in advance. So how can project managers deal with unknown risks?

Robert Simons (1995) provides some thoughts on this in what he calls ‘interactive control’, which can be applied to monitoring unknown risks. In this form of monitoring, the project team stays alert and involved in the ongoing process of risk assessment and risk management. When unforeseen risks appear, project staff are then able to recognise and manage them.

Establish contingency responsesTo manage the known and unknown risks, projects need a contingency response. This should contain a buffer of both time and resources. It should also contain action plans, so that if things go wrong, the project can be still delivered on time, on budget and according to specifications. It is important to be mindful that managers and project staff may use this as a buffer to conceal poor project management or even apathy by project teams towards project deadlines. A solution to this is only to have the contingency response triggered by the project sponsor where particular outcomes or events arise from certain types of known or unknown risks.

The risk–return trade-offOne final issue to keep in mind is that the cost of monitoring and managing risk needs to be balanced against the outcome of the risk eventuating. This is where risk assessment becomes an important and integrated part of risk management, because this enables the costs of failure to be balanced against the costs of monitoring.

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➤ Question 4.12What is the critical difference between project risk assessment and project risk management, and what are the key components of project risk management?


Stakeholder managementStakeholder management is the ongoing process of managing the expectations and influence of stakeholders on a project. While there are a number of different approaches to this, there are a number of common stages that are consistent as shown in Figure 4.20.

Figure 4.20: The stages of stakeholder management

Assess yourcapability tosatisfy their

interests

Identify thestakeholders

Identify theirinterests

Establish a stakeholder register at the project

selection stage. It shouldbe constantly updated

while the project isbeing undertaken.

Are they supportive of the project or are they against it?

Why? If they are against it, is there anything that you can do to accommodate

their interests?

You may need to balancethe interests of different competing stakeholders. If you can’t satisfy their

interests, or if it is prohibitive for you to do so, what ethical responsibilities do you have

to these stakeholders?


Recall the earlier discussion on balancing stakeholder interests (Part C). Stakeholders will often be satisfied if you can demonstrate procedural justice. Moreover, regular communication with stakeholders of what you are doing and why is an essential component of managing them. One aspect of this that is particularly applicable to the client is signalling specification, quality and timeliness. A very useful approach is to design a stakeholder scorecard that contains appropriate performance indicators that can be used by stakeholders to track progress on the project.

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This provides a monitoring mechanism for stakeholders. While it may seem that this enables stakeholders to manage the project, rather than project managers managing the stakeholder, creating transparency and signalling problems before they escalate provides a more proactive approach to ensuring that stakeholders are on side. Within this is appropriate specification of measures to ensure that the stakeholders are satisfied as the project develops.

A word of caution: these kinds of information-signalling approaches need to be carefully managed as they can create opportunities for stakeholders to try to increase functionality or renegotiate the parameters of the project. This is sometime called ‘scope creep’.

Scope creep is when there are changes in a project’s scope that are unplanned. It usually happens when the original project specification is not defined and explained clearly enough and then the processes are not managed adequately.

➤ Question 4.13Refer to Appendix 4.1 on the Sydney Seafood Bar’s renovation project.

(a) What are the most suitable project monitoring and control techniques for this project?

(b) What are the advantages and disadvantages of each technique?



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Part F: The management accountant’s role in project completion and reviewMany activities require the assistance and expertise of the management accountant at the project completion stage. These activities include:• monitoring the project to ensure that completion is the preferred option to abandonment • managing the activities required to complete the project• ensuring stakeholder consensus on project deliverables• financial closure of the project• dispersal of project assets• post-implementation review• preparation of the final project report• knowledge management.

The completion decisionAs the end of the project approaches, and the management accountant has been monitoring its likely success or failure, it is important to consider the potential benefits of walking away from an incomplete project. If the project cannot be completed on time and on budget, it is possible that project completion will result in a loss. Rather than committing further to a bad project, resources would be better used elsewhere and the project should be abandoned or sold in its incomplete state.

ChecklistAt the completion of a project, there will be numerous small tasks that need to be completed prior to official closure. First, a list of final deliverables has to be drawn up by comparing the original project plan with the objectives completed to date. The next stage is to list the activities required to complete the project, then to produce a schedule for those activities and assign responsibility for their completion.

Specification satisfaction consensusAs outlined in Part C, project deliverables are specified at the beginning of the project. Additionally, at various points during the project life cycle, communication with the project’s customer should have taken place to ensure expectations were being met. Consequently, at the end of the project, there should not be any surprises. A project completion meeting should be held with relevant stakeholders to ensure that consensus is reached on the extent to which the project has met its original or adjusted objectives. This part of the process is usually managed by the project sponsor.

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Strategic fit assessmentPart C discussed the need for projects to be aligned with the strategy of the organisation. A review of how a project fits against the strategy of the organisation should not be left until the end of the project. Management accountants need to ensure that there is constant interaction between organisational strategy and project delivery so that alignment is maintained. This tends to help in the process of avoiding scope creep. At the end of the project, there needs to be an analysis of how the project delivered against the original intentions. There are typically three questions that need to be addressed in this analysis.

What was the underlying problem or opportunity that the project was dealing with and did it deliver against this?

In the final review of the project, an analysis needs to be done to determine whether the project addressed the particular problem or opportunity that triggered the project. Sometimes, for projects that operate over long time periods, it becomes more difficult to reconcile what the project was intended to fix or deliver in the first place. This is why making the reason clear at the outset and keeping it on record is so important.

Did the project deliver against the strategy that it was intended to support?

As discussed earlier in this module, the key criteria for project selection is the strategic fit for the project. Unless the project supports the organisation’s strategy, it does not contribute to the central operation of the company and so the effort involved in undertaking the project is likely to be wasted. Consequently, consideration of the extent to which the project was able to support the organisation’s strategy and objectives is central to this analysis. Typically, the strategy of the organisation will give rise to specific objectives for the project that, if met, would signal project success.

Did the project deliver against its objectives and associated performance measures and targets?

At the project selection stage, the project objectives are identified. These should be demonstrated in performance measures and targets reflecting the desired level of performance. These objectives and measures are usually grouped as budget-related, time-related, and specification-related. The key questions to ask when undertaking an analysis at the completion of the project are:• What were the objectives and targets in each of these three areas? • What was the actual performance in each of the three areas (budget, time and specification)? • How much was the variance? • What was the reason for the variance?

There are a number of challenges with analysing the extent to which a project has delivered against its objectives and the organisation’s strategy.

When a project is complete, an assessment against the original strategic fit analysis should be done to see how the project delivered against its original objectives. There are a number of challenges with this analysis: • Strategies in organisations change—while a project may have fitted the original strategy,

strategic change itself may put the project into strategic misalignment. This is why it is important to ensure there is a constant review of alignment between strategy and project delivery.

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• Project outcomes are not always clear and quantifiable—sometimes, benefits feed into operational activities and processes, which may hide obvious outcomes and benefits from projects. The management accountant needs to stay aware of these second-order impacts. Moreover, benefits from projects could be qualitative rather than quantitative, and it is important to identify and explain these benefits. For example, an energy efficiency project may save energy costs for the organisation (a clear measurable outcome) and at the same time create a culture of awareness of environmental issues that may influence employees to reduce their environmental impact in other activities.

• The qualitative benefits from a project may not be obvious—for example, consider the implementation of activity-based costing (ABC) systems. While many companies that implemented ABC did meet their objective of having a more accurate costing system and supported their strategy through better customer profitability analysis, a significant, though unintentional, benefit of ABC was the increased level of communication and understanding they gained of how their companies operated. While this is often unintentional for ABC project designers, it is also one of the hard-to-measure qualitative benefits. In fact, research shows that many companies see this as the outcome that provided them with the greatest benefit.

Stakeholder satisfaction assessment A useful exercise is to establish whether each stakeholder’s requirements have been met, as well as to document any issues that have arisen, or successes that have been achieved, during the project. This is called a stakeholder satisfaction assessment.

To ensure that a stakeholder satisfaction assessment is meaningful, it needs to be an ongoing process throughout the project, rather than something that is left until the end. There are two key reasons for this:1. Stakeholders can have an interest in the project at different stages and may not be interested

in it before, or after, a certain point. 2. By the time the project is finished, the ability to fix any stakeholder concerns may be reduced

significantly, as these may have progressed beyond resolution.

A stakeholder satisfaction assessment is usually led by the project manager, though it can also be conducted by a specialised unit within the organisation, such as the project management office or the marketing department. The frequency of such assessments throughout the project depends, for example, on the importance of the project, its duration and the number of stakeholders. The assessment can be done using various tools, such as a survey, interviews, focus groups and during regular stakeholder meetings. Information about how stakeholders’ needs were met, as well as any problems and successes that arose, should feed into how stakeholders are managed in future projects. This is part of knowledge management, discussed later in this section.

Financial closureFinancial closure has several aspects to it: • determining the final actuals versus budget and schedule variances • closing the cost records• dealing with post-budget expenditures.

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Final costsThe calculation of the project’s final cost and the final budget variance analysis are completed at the end of the project. Analysis of variance size and cause is important, especially if knowledge gained through this analysis can be used to inform future projects. One way that this can be applied is through improving the estimation processes in project budgets. Organisational learning is a key aspect of project completion and review.

Closing the cost recordsThe completion of a project requires closing off the project accounts. If the accounts are not closed, project workers may still bill hours and other non-genuine expenditures. This is a frequent and significant problem with projects.

Post-project expenditureAfter the project is officially complete, there may still be some final costs to be incurred and the management accountant can hold a project account open past the official closing date to deal with such costs. An example of this type of expenditure is invoices from contractors or subcontractors that may not have been issued to the project by the closure date. This is a significant issue in larger projects.

Resource dispersionManagement accountants can be involved in the disposal of excess supplies and capital equipment at the end of the project. Some of the ways of dealing with these include: • The project’s customer may be interested in purchasing the stock.• Materials may be returned to suppliers for a refund.• The stock can be absorbed into the inventory of the organisation to be used in other

projects or in operations.

The last option has to be handled with care as, unless the stock is directly useful, it may be left in storage until it reaches obsolescence. It may be better to disperse such stock promptly to avoid storage costs.

Final reportTypically, a final report is prepared at the end of the project. This usually contains an overview, the major outcomes, how these related to the original specifications, budget and variance analysis data, and an analysis of the administrative and functional performance of those involved in the project. Clearly, this can be a sensitive political exercise, particularly if poor outcomes are identified with the project manager or senior management of the organisation. It is important to clarify the key issue of controllability in relation to budget variances. The final report can also contain the lessons learnt from the project and the way these can be applied in future projects.

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Knowledge managementAlthough each project is unique, there is useful knowledge that can be gained from the process of project management. The management accountant can provide value by ensuring that organisational learning occurs, particularly about cost and budget data, but also about non-financial performance data that might have been collected. Final cost information can provide a useful knowledge resource for estimating the cost of future projects. This applies particularly to the activities or events that caused significant deviations from budget. Questions that the management accountant might ask in this area include:• What problems appeared during the project?• What was the effect of these problems?• What caused them, and why were they not anticipated or detected earlier?

When this knowledge is identified, there are several strategies to ensure that it is not lost.

Some of these lessons can be standardised across the organisation or across projects, and may be reflected in policies or procedures for how activities are to be performed—for example, processes to ensure that probity is maintained for the purchase of input materials are applicable to all projects.

Much of the knowledge gained in projects is based on the experiences of the staff who have worked on them. For projects that occur within organisations, sometimes staff are moved back to operational roles and the lessons from the project may be lost. One solution is to set up a central database of staff and their relevant project-based skills and knowledge, so that when a new project is initiated, staff who fit the new project can be found.

The lessons learnt from projects can be fed back into the strategy of the organisation. Some organisations have training or information sessions where the lessons learnt from the project are communicated back to employees in the organisation. The feedback from project-gained knowledge can also be enabled by involving project staff in the strategy process.

One important thing to keep in mind is that there are inhibitors for project knowledge management including: • Having enough time for staff to record their knowledge is always a challenge, particularly as

time constraints on project delivery are often considerable and time spent recording lessons learnt is not time spent actually getting the project done.

• No incentives for staff to turn their individual knowledge into organisational knowledge. How the organisation manages their culture and incentive structures tends to have a large effect on this.

In summary, project-related knowledge is increasingly useful because many organisations are taking a more project-centric approach to their business. Capturing and codifying knowledge enables similar tasks to be performed more effectively if they are repeated. Knowledge management will help the management accountant, the project sponsor and the project manager to create value in future projects.

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➤ Question 4.14How can a management accountant add value to their organisation in the project completion and review process?


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STUDY GUIDE | 349

ReviewModule 4 discussed that projects are an increasingly important part of any organisation. Whereas some organisations spend most of their effort on projects (e.g. IT and construction companies), in all other organisations different departments conduct projects to enhance their performance (e.g. a marketing department implementing a new customer relationship management information system).

Part A defined projects and how they are different from operations. There are six characteristics that are common to projects and distinguish them from day-to-day operations. Projects:1. are unique2. often have high levels of uncertainty3. relate to solving a problem within a specified scope4. have a specific start and finish time5. have operationally specific relationships6. have multiple resources that need coordination.

Part B discussed the roles in projects. Projects are usually run by teams. The roles within the teams are not usually defined in the same way in all projects, but there are several roles that tend to be consistent—the project sponsor, project manager and project team. Within an organisation, the project team includes functional staff and this is where the management accountant is located. Management accountants provide a key role in supporting the project manager. They provide traditional cost and budget information, perform capital budgeting analysis, carry out network analysis techniques such as PERT, and support and guide management decision-making.

There are four stages in project management:1. Project selection—the objectives of the project are decided on and the project team is

formed. As part of this stage, the management accountant can assist with strategic fit, risk assessment and initial financial analysis (discussed in Part C).

2. Project planning—the project specifications are documented and deliverable dates established. A range of techniques are used to accomplish this, including Gantt charts, PERT, CPM and detailed project budgeting. In each case the management accountant can contribute to these techniques (discussed in Part D).

3. Project implementation and control—the project activities take place and progress against the set deliverable dates and the budget is monitored. A useful tool in this stage is the EV method where cost and time performance are monitored together. The management accountant is central to the process of control (discussed in Part E).

4. Project completion and review—several steps must happen to complete a project. The management accountant can add value through writing the final project report and supporting other knowledge management activities so that lessons learnt in the project can be used in the future (discussed in Part F).

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APPENDIX 4.1 | 351

Appendices

Appendices

Appendix 4.1

Sydney Seafood Bar

A: History and backgroundThis appendix examines a hypothetical company, the Sydney Seafood Bar (SSB).

Figure A1 4.1: Seafood dish at Sydney harbour

Source: iStock.com/mr_focus.

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John Kelly and some other business partners won the tender for a site at Circular Quay in Sydney, Australia. They had an idea to turn a small run-down building into an alfresco dining restaurant/bar. Initially, it was a business that focused on the self-service of fresh seafood, alcohol and other beverages. They opened the business one year later.

As time passed, the original business evolved and the SSB emerged as a more up-market harbour-front dining experience. The SSB still focuses on seafood but now also serves other cuisines. The main factor influencing this change was that public demand and expectations had altered since the original SSB design. Sydney is now a world-class tourist destination and the SSB is part of the Property NSW ‘The Rocks’ precinct and so is part of Sydney’s image to the world.

The contemporary dining experience needs everything from expensive glassware, stylish plates, high-quality wines and a menu that has unique ingredients. Moreover, customers want all of this with great service, at an affordable price.

Over the last 20 years the SSB has become something of a Sydney landmark with its fresh seafood and Harbour Bridge and Opera House views.

Current operations

Current strategy

There does not seem to have been a deliberate choice made in relation to strategy by the SSB management beyond attempting to provide great seafood and great service in a great location. The following would best reflect the strategy that has emerged.

Competitive or business strategy

• The SSB has a ‘differentiation strategy’ (Porter 1985). • This differentiation is focused on high-quality organic seafood dishes in a prime Sydney

Harbour location. • By doing this, the SSB is attempting to do something that is unique.

Operational strategy

• The SSB invests in expert menu and wine advice, obtains the best organic ingredients and constantly focuses on improving kitchen processes (which are particularly important in peak periods).

• In order to maintain high standards of service, staff are proactively trained and every attempt is made to retain good staff.

The premises

Property NSW leases the building and outdoor area to the SSB. Property NSW manages public assets on the harbour foreshore on behalf of the New South Wales state government. As a consequence, the SSB needs to take into account Property NSW’s vision and strategy, including functioning in a caretaker role in relation to the main building which is a ‘state significant site’.

Renovation project

Due to the wear and tear on the building and kitchen, the SSB is about to undergo a major renovation. Project costs will be more than a million dollars (AUD).

The project is estimated to take three to four months during which the business will be closed.

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APPENDIX 4.1 | 353

B: Project proposal

Figure A1 4.2: The kitchen

Source: iStock.com/Lebazele.

The original fit-out for the SSB was completed 30 years ago and, while the SSB has continued to upgrade the facilities, it has now reached the point where major works are required in three areas: 1. a complete removal of the old kitchen, reconfiguration of the floor plan and construction

of a new kitchen2. a complete removal of the toilet and bathroom facilities, a reconfiguration of the floor plan

and then construction of new toilets, including an accessible toilet3. structural improvements to the inside of the building (including the mezzanine level).

Why the project is needed

Amenity, kitchen and structural factors have influenced the requirement for major capital works on the premises. These are so significant that a short-term fix until the end of the current lease does not meet due diligence, stewardship, or fiduciary duty standards (although the option to continue to upgrade the current facilities received thorough consideration). It is unrealistic to expect a ‘world-class’ site with a ‘world-class’ restaurant to undertake a ‘patch-up’. Moreover, the investment will provide permanent improvement and enduring benefit to the site to sustain the operating viability of the SSB. Undertaking the project is in the best interests of Property NSW, customers, staff and stakeholders.

All the requirements issued by the relevant local authorities have been addressed in the submitted plans.

Figure A1 4.3 shows the interrelationship of the project requirements.

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Figure A1 4.3: Interrelationship of requirements for the project

Amenity maintenanceand enabling

disabled access

Kitchen changes1. Regulatory changes2. Changed public expectations3. Kitchen equipment replacement

Structure, fixtureand fitting changesand improvements


Amenity maintenance and enabling disabled access

The toilet facilities need a major upgrade. They are at the end of their useful life, with increasing maintenance costs. Regulations require alteration to install a disabled toilet with wheelchair access. While the SSB could have drawn upon a heritage provision (due to the age and historical significance of the building) to avoid the requirement for disabled toilets, they have, in good faith, worked hard with the architect and the regulators to meet the access requirements while preserving the building. The management of the SSB believes that this is in the spirit of community responsibility and within the principles of Property NSW.

Kitchen changes

Regulatory changes

The initial design of the kitchen layout suited the original operation of the SSB, which centred on the self-service concept of a cold seafood menu. Since then, changes in the liquor licence laws over the last 20 years have specified additional requirements for kitchens. This has ultimately led to two problems:1. The increased kitchen functionality requirements have led to operational problems with the

original design.2. The additional requirements now mean that the SSB needs to address narrow ‘traffic areas’

and improve working conditions to maintain a ‘duty of care’ for staff.

This fundamental design change is of enduring value to the building.

Changed public expectations

A further and very important related issue is that public demand and expectations have changed since the original design. This manifests itself in two relevant ways:1. The current design cannot meet changed and contemporary expectations for service times

in busy periods (this is where it really counts for the city’s reputation). Service throughput improvements are needed so that the SSB experience is more consistent with customers’ needs and expectations.

2. The level and class of presentation of the kitchen (which is visible to customers) needs to be benchmarked against ‘world’s best practice’, as it is in a ‘world’s best location’.

Kitchen equipment replacement

The kitchen equipment has reached the end of its useful life and needs replacing (it cannot be used after this year). This is resulting in increased maintenance and breakdown issues. The reconfiguration of the kitchen will complement the acquisition and replacement of cooking equipment.

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APPENDIX 4.1 | 355

Structure, fixture and fitting changes and improvements

In the engineer’s report required for landholders’ consent, recommendations were made for structural modification of the mezzanine level. The engineers and architects have recommended that the mezzanine level’s structure, fixture and fittings be upgraded and reconfigured. A particular issue to address was ventilation and extraction problems. These changes are of enduring benefit.

C: Project budget

Table A1 4.1

Project construction costs $

Quantity surveyor’s estimate of project construction cost† 625 001

Packing and storing of equipment 10 000

Associated project fees

Consulting costs 77 420

Architect’s design and project management fees 87 932

Legal fees 9 148

Operating costs associated with the project‡

Staff redundancy costs 60 000

New staff costs 40 000

Promotional budget (advertising)§ 100 000

Total project cost 1 009 501

† Estimated cost is from a recent formal quantity survey report. Three tenderers have put in proposals; two are almost the same as this figure and one is 50 per cent more.

‡ Each of these costs is incremental and is a direct result of the project; they have been calculated by the company accountant in consultation with management.

§ As the business will be closed for an estimated four months, marketing advice will be sought and there will be a vigorous marketing campaign to promote the new opening. There will also be consultation with Property NSW about cross promotion and other sponsorship.


D: Financial modelling of the projectCapital budgeting model

Project costs

The details of the project costs and fees are contained in the project budget (Table A1 4.1).

Tax effects of operating costs and depreciation expense

The operating costs associated with the project ($200 000) are paid in Year 0, and are deductible for tax purposes. The tax return for Year 0 is filed after the end of the year and so the cash inflow from the tax reduction is to be recorded in Year 1.

The remainder of the project costs ($809 501) are to be capitalised and depreciated over 10 years. While depreciation expense has no direct effect on cash flows, the expense is tax deductible, and so reduces taxes payable. Assume that these cash inflows occur in each of the Years 1 to 10. The tax rate is 30 per cent.

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Operating cash flows

SSB management assumes that the investment will result in operating efficiencies, which will translate into a steady increase in operating profit and cash flows. To estimate these cash flows, a baseline NOPAT is used and then a growth rate is factored into this over time.

SSB’s accountants believe a baseline NOPAT of $433 913 is sustainable without the investment. A tax rate of 30 per cent has been used to generate this after-tax figure.

The baseline net profit for the first year is reduced by the lost sales for the four months SSB will be closed, and the associated variable costs, totalling $118 995. The first-year net profit is therefore $118 995 lower than the baseline, reflecting an incremental cash outflow associated with the project.

The future increase in NOPAT as a result of the investment is estimated at 7 per cent per annum (compounding). This increase is based on the baseline NOPAT (not the reduced first-year NOPAT) and reflects an incremental cash inflow from Year 2 onwards. This 7 per cent estimate is based on SSB’s historic average increase in NOPAT over the last 10 years.

Discount rate

Three discount rates were used for the analysis:1. a conservative discount rate of 8 per cent—this represents a low-risk investment2. a 10 per cent discount rate—which is close to long-term portfolio stock market returns3. a 15 per cent discount rate—this figure is more realistic, taking into account shareholders’

expected returns from a small unlisted private company.

Residual value

There is an assumption of no residual value in the project. Building fabric changes such as disabled access, amenities reconstruction and mezzanine repairs have no residual value for the business (though these do have long-lasting value for the lessor—Property NSW). The equipment and other fittings only have material value in their current setting and have no disposal value.

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APPENDIX 4.2 | 357

Appendix 4.2

Constructing a network diagram using PERT

Using PERTThis appendix provides a step-by-step example of the process of creating a network (or PERT) diagram and using the CPM to assist with project planning and implementation. It follows the four steps outlined in the Study guide:Step 1: Draw the network diagram. Step 2: Calculate the expected time (ET). Step 3: Define the critical path. Step 4: Calculate slack.

The project has nine activities (as shown in Table A2 4.1). The activity that needs to be completed before the next one can begin is known as the preceding activity. These are shown in the right-hand column. For example, notice that Activities 2, 3 and 4 all need Activity 1 to have been completed before they can start.

Table A2 4.1: Project activity list

Activity Preceding activity

Activity 1 —

Activity 2 1

Activity 3 1

Activity 4 1

Activity 5 2

Activity 6 3

Activity 7 4

Activity 8 5

Activity 9 6


Note: As was the case in the Study guide, for this exercise the activity-on-node (AON) method is used to draw the diagram (remember that AON shows activities as nodes).

Step 1: Draw a network diagramThe project plan can now be transformed into a network diagram. The network diagram includes:• project activities (left-hand column of Table A2 4.1)• activity precedence relationships (right-hand column of Table A2 4.1).

The items from the project activity list (Table A2 4.1) can now be transferred into the diagram.

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(i) Draw the start node

Start

Start 1

(ii) Draw node ‘1’

Activity 1 can start immediately at the start of the project, after the start node.

Start

Start 1

(iii) Draw Activities 2, 3 and 4

Activities 2, 3 and 4 can begin once Activity 1 has been completed.

2

3

4

Start 1

(iv) Draw Activity 5

Note that in the project activity list, Activity 2 precedes Activity 5. That is, Activity 2 must be completed before Activity 5 begins.

So now Activity 5 is added into the diagram, directly after Activity 2.

2 5

3

4

Start 1

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APPENDIX 4.2 | 359

(v) Draw Activity 6

Activity 3 must be completed before Activity 6 begins, so Activity 6 is added to the diagram directly after Activity 3.

2 5

3

4

6Start 1

(vi) Draw Activities 7, 8 and 9

The remaining activities are added to the diagram in the same way:• Activity 7 after Activity 4• Activity 8 after Activity 5• Activity 9 after Activity 6.

2 5

3

4

6

8

9

7

Start 1

(vii) Draw the end node

When all the remaining activities are complete, they meet at the final end node. Activities that are not a precedent activity for another activity (in this case, Activities 7, 8 and 9) are connected to the end node.

2 5

3

4

6

8

9 End

7

Start 1

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Step 2: Calculate expected timeOnce all activities and their precedence relationships have been drawn, it is necessary to calculate the expected activity durations. Recall from the Study guide, three duration estimates are usually made for each activity: optimistic (O—shortest), pessimistic (P—longest) and most likely (ML).

The following formula is used to calculate the ET for each activity.

( )4

6

O ML PET

+ +=

The ET calculated using this formula is a weighted average of the three duration estimates—where the weighting for O is 1 / 6, ML is 4 / 6, and P is 1 / 6.

For example, as per Table A2 4.2, the ET for Activity 1 is:

ET for Activity 1: (20 + 4 × 25 + 30) / 6 = 25 days

The ET for Activity 6 is:

ET for Activity 6: (20 + 4 × 28 + 60) / 6 = 32 days

The ET estimates for the activities of this project are shown in Table A2 4.2.

Table A2 4.2: Expected time estimates

ActivityPreceding

activityOptimistic

duration (days)Most likely

duration (days)Pessimistic

duration (days) ET (days)

Activity 1 — 20 25 30 25

Activity 2 1 10 20 30 20

Activity 3 1 15 20 25 20

Activity 4 1 6 20 40 21

Activity 5 2 6 35 70 36

Activity 6 3 20 28 60 32

Activity 7 4 8 19 24 18

Activity 8 5 10 45 50 40

Activity 9 6 6 9 18 10


Once the ETs have been calculated for each activity, they are added to the network diagram on the arrows (above the activity labels) as shown.

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APPENDIX 4.2 | 361

2 5

3

4

6

8

ET = 20 ET = 36 ET = 40

ET = 20 ET = 32 ET = 10

ET = 21 ET = 18

9 End

7

Start 1

ET = 25

Step 3: Define the critical pathThe next step is to determine how long the overall project will take to complete. As can be seen from the diagram so far, there are three paths. The longest path—the one that has the longest duration—is called the critical path. This path indicates how long it takes to finish the project.

To determine the critical path, add together the ETs for the activities on each path through the network diagram.

Path 1: 1 → 2 → 5 → 8 (25 + 20 + 36 + 40 = 121 days)

Path 2: 1 → 3 → 6 → 9 (25 + 20 + 32 + 10 = 87 days)

Path 3: 1 → 4 → 7 (25 + 21 + 18 = 64 days)

In this case, the critical path is Path 1 and the project duration is 121 days.

Activities on the critical path are the main focus of management attention, because if these activities are not finished on time, the planned project time will be exceeded. Critical path activities must be carefully managed. The critical path is also important for managers, because if they need to finish the project early, this can only be achieved by speeding up the activities on the critical path. Activities on other paths may run ahead or behind schedule—to a degree—and not affect the overall project completion time.

To summarise, the critical path is the longest path through the diagram and it shows the shortest time in which the project can be completed.

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Step 4: Calculate slackIt is now time to calculate the slack for this project. Two paths through the network diagram have slack or float. These are 1 → 4 → 7 and 1 → 3 → 6 → 9. The path 1 → 2 → 5 → 8 is critical so, of course, it has no slack.

Calculating the slack of Activity 4 is provided as an example:

Its earliest start time is day 25, when Activity 1 is complete.

The latest possible start time is the project completion time (121 days) less the time of Activities 4 and 7: 121 – (18 + 21) = 82 days.

The slack in Activity 4 is the difference between its earliest start time and its latest start time:

82 – 25 = 57 days.

Therefore, the project manager has considerable flexibility in deciding when to start Activity 4.

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SUGGESTED ANSWERS | 363

Suggested answers

Suggested answers

Question 4.1

1. Projects are novel or unique—they will not usually be repeated in the same way again.

2. They often have high levels of uncertainty, which may be a result of their unique nature.

3. They are usually focused on providing a solution for some underlying problem.

4. They have a defined start and finish time.

5. Projects typically consist of activities that are related and often have operationally specific relationships (i.e. a particular activity has to be performed before the next one can be started).

6. Finally, they usually have multiple resources that need coordination, and this can be particularly challenging.

While these characteristics set projects apart from day-to-day operations, they are not necessarily all present in each project, but they do provide a guide for helping to distinguish projects from the operational activities present in most organisations.

Return to Question 4.1 to continue reading.

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Question 4.2

Project stage Management accountant’s role

Stage 1: Project selection This stage focuses on the objectives and scope of the project. Included in this is the project feasibility and justification, which often centres on strategic fit, risk assessment, preliminary budgets and completion time. The management accountant is often integrally involved in the application of techniques to deal with these issues, including strategic analysis, risk analysis, budgets and schedules.

Stage 2: Project planning Project planning adds more depth to the project selection analysis. This addresses five key areas:1. scheduling2. optimising cost and time3. budgeting4. performance measurement5. incentives.

Stage 3: Project implementation and control

At the implementation stage, progress against the set deliverables and dates are monitored and variances are examined. This provides information for management to take actions to reduce the variance between actual and budgeted outcomes where necessary. The management accountant is often responsible for this scorekeeping role. Additionally, the project plan deliverable dates and budgets may need adjustment due to the emergence of new information or risks. Finally, analysis of the cost involved in crashing project activities can be done to determine whether the cost–time trade-offs are feasible.

Stage 4: Project completion and review

This is when all the objectives of the project have been delivered. The management accountant is responsible for the final reporting and closing project accounts during this stage. A key aspect of this stage is knowledge management, and the final project report must incorporate this.


Question 4.3

Explanation

Project organisation or within organisation

A collaboration could be either. It depends on whether the project is related to the core activities of the organisation (such as a building project for a construction organisation) or not (such as the development of a new IT solution).


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Question 4.4

Explanation

Project sponsor Usually involved in contract negotiation, customer liaison and ensuring that resources are made available for the project. The project sponsor may also become involved if there is a major crisis.

Project manager Has functional responsibility for the project, including planning, execution and delivery of the project, as well as managing the day-to-day project operations.

Project team Undertakes the functional tasks required. The management accountant is part of the project team and works closely with the project manager in preparing necessary information for decision-making and project control.


Question 4.5

Do you think the project has strategic fit?

Yes

Explain why or why not? Clearly, the managers want to maintain a differentiated approach to the competitive strategy of the business, and the project contributes to this by keeping the building and equipment at an international standard that complements the location.

The kitchen renovation will enable operational efficiencies to be gained that will improve kitchen processes. This has a leveraged effect in that it will enable the employment of experienced staff of higher quality and ability (due to the better standard of facilities) and also improve menu offerings due to the improved functionality of the kitchen. It will also enable better management of throughput times for orders during busy periods, but it goes beyond the basic strategy of the SSB and also addresses legal and regulatory requirements.


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Question 4.6

Stakeholder Stages of the project

1. Client The clients are keenly interested in your ability to complete the project on time, within budget and according to specifications. You will probably have intense involvement with them at the project planning stage, then ongoing involvement reporting on progress, and finally at the end of the project ensuring that the project meets expectations and final payment is received.

2. Regulators Regulators have significant involvement at the project approval and planning stages, while they may be less involved during the construction (as long as compliance is maintained as the project progresses).

3. Suppliers Suppliers of your construction materials and internal fittings are vital throughout the implementation of the project, so detailed planning for these needs to be done prior to commencement.

4. Community and society

As the project takes place in a suburban community, the needs of the community that will use the centre clearly have to be taken into account in the planning stage of the project. Moreover, the way that the completed development affects the community will need to be considered. Furthermore, community inconvenience and dislocation need to be managed during the project—for example, provision of parking bays.

5. The environment The environment needs to be considered in the design of the project to gain an acceptable level of environmental sustainability (e.g. energy efficiency ratings). In addition, suitable environmental sustainability practices need to be implemented in the construction process.


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Question 4.7(a)

Tab

le S

A4.

1: C

ash

flow

and

net

pre

sent

val

ue a

naly

sis

of

Big

Fir

m P

ty L

td’s

IT p

roje

ct

Year

01

23

45

67

89

10

Sale

of o

ld s

yste

m ($

)70

000

Dev

elo

pm

ent

cost

($)

(700

000

)

Imp

lem

enta

tion

cost

($)

(400

000

)

Res

idua

l val

ue ($

)10

0 00

0

Red

uctio

n in

lab

our

co

st

per

yea

r ($

)18

0 00

018

0 00

018

0 00

018

0 00

018

0 00

018

0 00

018

0 00

018

0 00

018

0 00

018

0 00

0

Incr

ease

in u

tility

co

st

per

yea

r ($

)(1

0 00

0)(1

0 00

0)(1

0 00

0)(1

0 00

0)(1

0 00

0)(1

0 00

0)(1

0 00

0)(1

0 00

0)(1

0 00

0)(1

0 00

0)

Net

cas

h flo

w ($

)(1

030

000

)17

0 00

017

0 00

017

0 00

017

0 00

017

0 00

017

0 00

017

0 00

017

0 00

017

0 00

027

0 00

0

Dis

coun

t fa

cto

r ca

lcul

atio

n (c

ost

of

cap

ital =

14%

)

= (1

+

14%

)1

= (1

+

14%

)2

= (1

+

14%

)3

= (1

+

14%

)4

= (1

+

14%

)5

= (1

+

14%

)6

= (1

+

14%

)7

= (1

+

14%

)8

= (1

+

14%

)9

= (1

+

14%

)10

Dis

coun

t fa

cto

r1.

0000

1.14

001.

2996

1.48

151.

6890

1.92

542.

1950

2.50

232.

8526

3.25

193.

7072

PV w

ork

ing

170

000

/ 1.

1400

17

0 00

0 /

1.29

9617

0 00

0 /

1.48

1517

0 00

0 /

1.68

9017

0 00

0 /

1.92

5417

0 00

0 /

2.19

5017

0 00

0 /

2.50

2317

0 00

0 /

2.85

2617

0 00

0 /

3.25

1927

0 00

0 /

3.70

72

PV c

ash

flow

s ($

)(1

030

000

)14

9 12

313

0 80

911

4 74

910

0 65

188

293

77 4

4967

938

59 5

9552

277

72 8

31

NPV

($)

(116

285

)

No

te: D

isco

unt

rate

is 1

4 p

er c

ent.

You

may

get

a s

light

ly d

iffer

ent

answ

er b

ased

on

whe

ther

yo

u us

e a

tab

le, s

pre

adsh

eet

or

finan

cial

cal

cula

tor

to d

isco

unt

the

cash

flo

ws.

Sour

ce: C

PA A

ustr

alia

201

9.

MO

DU

LE 4


(b) No, as the NPV is (116 285). Given the cash flow projections and the discount rate used, the project is not viable.

(c)Ta

ble

SA

4.2:

Cas

h flo

w a

nd N

PV

ana

lysi

s o

f B

ig F

irm

Pty

Ltd

’s IT

pro

ject

(up

dat

ed c

ost

inp

uts)

Year

01

23

45

67

89

10

Sale

of o

ld s

yste

m ($

)70

000

Dev

elo

pm

ent

cost

($)

(760

000

)

Imp

lem

enta

tion

cost

($)

(400

000

)

Res

idua

l val

ue ($

)10

0 00

0

Red

uctio

n in

lab

our

co

st

per

yea

r ($

) 23

0 00

023

0 00

023

0 00

023

0 00

023

0 00

023

0 00

023

0 00

023

0 00

023

0 00

023

0 00

0

Incr

ease

in u

tility

co

st p

er

year

($)

(10

000)

(10

000)

(10

000)

(10

000)

(10

000)

(10

000)

(10

000)

(10

000)

(10

000)

(10

000)

Net

cas

h flo

w ($

)(1

090

000

)22

0 00

022

0 00

022

0 00

022

0 00

022

0 00

022

0 00

022

0 00

022

0 00

022

0 00

032

0 00

0

Dis

coun

t fa

cto

r ca

lcul

atio

n (c

ost

of c

apita

l =

14%

)

= (1

+

14%

)1

= (1

+

14%

)2

= (1

+

14%

)3

= (1

+

14%

)4

= (1

+

14%

)5

= (1

+

14%

)6

= (1

+

14%

)7

= (1

+

14%

)8

= (1

+

14%

)9

= (1

+

14%

)10

Dis

coun

t fa

cto

r1.

0000

1.14

001.

2996

1.48

151.

6890

1.92

542.

1950

2.50

232.

8526

3.25

193.

7072

PV w

ork

ing

220

000

/ 1.

1400

220

000

/ 1.

2996

220

000

/ 1.

4815

220

000

/ 1.

6890

220

000

/ 1.

9254

220

000

/ 2.

1950

220

000

/ 2.

5023

220

000

/ 2.

8526

220

000

/ 3.

2519

320

000

/ 3.

7072

PV c

ash

flow

s ($

)(1

090

000

)19

2 98

216

9 28

314

8 49

813

0 25

511

4 26

210

0 22

887

919

77 1

2367

653

86 3

19

NPV

($)

84 5

22

Sour

ce: C

PA A

ustr

alia

201

9.

MO

DU

LE 4


It seems that the extra development cost and the further reduction of labour costs make the project viable. It now has a positive NPV of $84 522.


Question 4.8

Which project should you select? Project 2

Why? Projects with the highest NPV should be selected because the NPV informs us of the amount by which the net assets of the organisation will increase by undertaking the project. Therefore, you should select Project 2.

Conflicting results between IRR and NPV are due to differences in project size. A large project like Project 2, with a relatively smaller percentage return (but still above the discount rate), will generally return a large NPV in absolute dollar terms. A small project like Project 1, even one with a return that is multiples of the discount rate, will generally only create a relatively small NPV in absolute dollar terms. This is an example of a more general problem of comparing relative measures such as percentages and ratios (e.g. ROI) with absolute measures such as net profit.

In evaluating projects, a range of tools should be used. The management accountant cannot rely on single measures. A range of measures will provide more useful information.


Question 4.9

Sydney Seafood BarProject capital budgeting and net present valueTo establish the financial viability of the project, capital budgeting has been done, involving calculating the project’s NPV using different discount rates.

(a) Over 10 years, with a discount rate of 8 per cent, the project has a positive NPV of $41 612, close to break-even on the project. Therefore, the viability of the project in this case is still positive, although the final decision may depend on alternative project options the company may have.

(b) Over 10 years, with a discount rate of 10 per cent, the project has a negative NPV of ($85 992). While this NPV is negative, because the project sits clearly within the SSB’s strategy and there are good reasons for undertaking the project, it may, under some circumstances, still be viable.

(c) Over 10 years, with a discount rate of 15 per cent, the project has a negative NPV of ($330 092). This indicates that it is not financially viable and the SSB management should think about other options to gain regulatory conformance.

The following tables and commentary further explain the NPV calculations and results.

MO

DU

LE 4


Table SA4.3: Cash flow analysis of Sydney Seafood Bar

Cash outflows in Year 0Year 0

($)

Operating costs (tax reduction in Year 1)

Staff redundancy costs (60 000)

New staff costs (40 000)

Promotional budget (advertising) (100 000)

Total operating costs (tax reduction in Year 1) (200 000)

Other project costs (capitalised and depreciated annually)

Quantity surveyor’s estimate of project construction cost (625 001)

Packing and storing of equipment (10 000)

Consulting costs (77 420)

Architect’s design and project management fees (87 932)

Legal fees (9 148)

Total of capitalised expenses for future depreciation (809 501)

Total project cost = Total cash outflow (i.e. $200 000 + $809 501) (1 009 501)


Table SA4.3 reveals that the total cash outflow in Year 0 is ($1 009 501). This is split between:• operating costs of ($200 000) that are paid in Year 0, resulting in a tax reduction in Year 1

(because the tax return is lodged after the end of Year 0)• other project costs of ($809 501) that are paid in Year 0, capitalised and depreciated

(tax deductible expense) over the life of the project (Years 1–10) using straight-line depreciation.

Table SA4.4: Tax effect of expenses for Sydney Seafood Bar

Cash inflows in Years 1–10Year 1

($)Years 2–10

($)

Total of immediately tax-deductible expenses (200 000)

Tax effect of deductible expense (i.e. $200 000 × 30%) 60 000

Total of capitalised costs for future depreciation (809 501)

Annual depreciation over 10 years (i.e. $809 501 / 10) (80 950)

Annual tax effect of depreciation (i.e. $80 950 × 30%) 24 285 24 285

Total tax effect of expenses 84 285 24 285


MO

DU

LE 4


Depreciation is a non-cash expense and so does not appear directly in the NPV cash flows. However, depreciation leads to a tax-deductible expense (30% of the depreciation amount). This tax deduction leads to a reduction in the amount of tax payable, and this is treated as a cash inflow in NPV calculations. Project construction costs and associated fees (totalling $809 501) are depreciated on a straight-line basis over 10 years. The annual depreciation expense is therefore $80 950 (i.e. $809 501 / 10).

Table SA4.4 shows the tax effect of expenses in Years 1–10. In Year 1, the cash inflow of $84 285 is made up of the:• benefit from tax-deductible operating costs in Year 0 of $60 000 (i.e. $200 000 × 30%)• benefit from tax-deductible depreciation expense in Year 1 of $24 285 (i.e. $809 501 /

10 years × 30%).

The Years 2–10 cash inflows are $24 285, reflecting the benefit from the tax-deductible depreciation expense (i.e. $809 501 / 10 years × 30%).

Note that while the initial decrease in NOPAT due to the project is shown in the tax-effect calculations in Table SA4.4, the ongoing increase in NOPAT due to the project is not shown. This is because the baseline NOPAT provided in this question is after tax, so no adjustment for tax-related cash flows is necessary (see Table SA4.5).

MO

DU

LE 4


Table SA4.5: Net increase/(decrease) in net operating profit after tax for Sydney Seafood Bar

Year

01

23

45

67

89

10

Bas

elin

e N

OPA

T ($

)43

3 91

3(a)

Incr

emen

tal c

ash

out

flow

($)

(low

er N

OPA

T fr

om

lost

sa

les/

varia

ble

co

sts)

(118

995

)(b)

Cal

cula

tion

of b

asel

ine

NO

PAT

gro

wth

(7%

an

nual

gro

wth

in b

asel

ine

NO

PAT

fro

m Y

ear

2)

433

913

×

(1.0

71 – 1

)(c)

433

913

×

(1.0

72 – 1

)43

3 91

3 ×

(1

.073 –

1)

433

913

×

(1.0

74 – 1

)43

3 91

3 ×

(1

.075 –

1)

433

913

×

(1.0

76 – 1

)43

3 91

3 ×

(1

.077 –

1)

433

913

×

(1.0

78 – 1

)43

3 91

3 ×

(1

.079 –

1)

Incr

emen

tal c

ash

inflo

w ($

)(7

% a

nnua

l gro

wth

in

bas

elin

e N

OPA

T fr

om

Ye

ar 2

)

30 3

7462

874

(d)

97 6

4913

4 85

817

4 67

221

7 27

326

2 85

631

1 63

036

3 81

8

No

te: T

able

SA

4.5

reve

als

the

incr

emen

tal c

ash

flow

s fr

om

the

net

incr

ease

/(d

ecre

ase)

in N

OPA

T. N

ote

tha

t w

e ar

e af

ter

the

net

incr

ease

/(d

ecre

ase)

in N

OPA

T fr

om

the

bas

e ye

ar, n

ot

fro

m e

ach

sub

seq

uent

yea

r. Th

is h

elp

s us

to

det

erm

ine

the

actu

al c

ash

inflo

w/(

out

flow

) tha

t is

dire

ctly

rela

ted

to

the

pro

ject

(and

, hen

ce, w

heth

er w

e sh

oul

d p

roce

ed

with

the

inve

stm

ent)

.

(a)

The

bas

elin

e N

OPA

T is

$43

3 91

3.(b

) In

Yea

r 1,

we

are

told

tha

t th

e b

asel

ine

net

pro

fit is

red

uced

by

$118

995

. So

, the

net

dec

reas

e in

op

erat

ing

pro

fit is

($11

8 99

5).

(c)

In Y

ear

2, t

he b

asel

ine

NO

PAT

incr

ease

s b

y 7

per

cen

t to

$46

4 28

7 (i.

e. $

433

913

× 1

.07)

. The

net

incr

ease

in N

OPA

T is

the

refo

re $

30 3

74 (i

.e. $

464

287

– $4

33 9

13).

(d)

In Y

ear

3, t

he b

asel

ine

NO

PAT

agai

n in

crea

ses

by

7 p

er c

ent

to $

496

787

(i.e.

$46

4 28

7 ×

1.0

7). T

he n

et in

crea

se in

NO

PAT

is t

here

fore

$62

874

(i.e

. $49

6 78

7 –

$433

913

).

(Thi

s ca

lcul

atio

n co

ntin

ues

for

Year

s 4–

10.)

Sour

ce: C

PA A

ustr

alia

201

9.

MO

DU

LE 4


Table SA4.6: Net present value analysis of Sydney Seafood Bar

Year

01

23

45

67

89

10To

tal

Tota

l cas

h o

utflo

w

(see

Tab

le S

A4.

3)(1

009

501

) (1

009

501

)

Tota

l tax

effe

ct

of e

xpen

ses

(see

Tab

le S

A4.

4)

84 2

8524

285

24 2

8524

285

24 2

8524

285

24 2

8524

285

24 2

8524

285

302

850

Net

incr

ease

/(d

ecre

ase)

in

NO

PAT

(s

ee T

able

SA

4.5)

(118

995

)30

374

62 8

7497

649

134

858

174

672

217

273

262

856

311

630

363

818

1 53

7 00

9

Tota

l net

cas

h flo

ws

(1 0

09 5

01)

(34

710)

54 6

5987

159

121

934

159

143

198

957

241

558

287

141

335

915

388

103

830

358

8% d

isco

unt

rate

Dis

coun

t fa

cto

r (8

%)

1.00

001.

0800

1.16

641.

2597

1.36

051.

4693

1.58

691.

7138

1.85

091.

9990

2.15

89

PV (T

ota

l net

cas

h flo

w

/ D

isco

unt

fact

or)

(1 0

09 5

01)

(32

139)

46 8

6169

190

89 6

2510

8 31

012

5 37

714

0 94

715

5 13

416

8 04

117

9 76

741

612

NP

V (8

%)

41 6

12

10%

dis

coun

t ra

te

Dis

coun

t fa

cto

r (1

0%)

1.00

001.

1000

1.21

001.

3310

1.46

411.

6105

1.77

161.

9487

2.14

362.

3579

2.59

37

PV (T

ota

l net

cas

h flo

w

/ D

isco

unt

fact

or)

(1 0

09 5

01)

(31

555)

45 1

7365

484

83 2

8398

816

112

306

123

958

133

954

142

461

149

631

(85

992)

NP

V (1

0%)

(85

992)

15%

dis

coun

t ra

te

Dis

coun

t fa

cto

r (1

5%)

1.00

001.

1500

1.32

251.

5209

1.74

902.

0114

2.31

312.

6600

3.05

903.

5179

4.04

56

PV (T

ota

l net

cas

h flo

w

/ D

isco

unt

fact

or)

(1 0

09 5

01)

(30

183)

41 3

3057

308

69 7

1679

122

86 0

1590

811

93 8

6795

488

95 9

33(3

30 0

92)

NP

V (1

5%)

(330

092

)

No

te: P

leas

e no

te t

hat

the

figur

es in

the

thr

ee ro

ws

of P

V (T

ota

l net

cas

h flo

w /

Dis

coun

t fa

cto

r) a

re c

alcu

late

d u

sing

an

MS

Exc

el s

pre

adsh

eet.

The

re w

ill b

e ro

und

ing

d

iffer

ence

s if

the

tota

l net

cas

h flo

ws

are

div

ided

by

the

dis

coun

t fa

cto

r (ro

und

ed t

o fo

ur d

ecim

al p

lace

s).

Sour

ce: C

PA A

ustr

alia

201

9.


MO

DU

LE 4


Question 4.10(a)

ET = 14EOT = 31

ET = 3EOT = 34

ET = 11EOT = 45

ET = 17EOT = 62

ET = 10EOT = 17

ET = 31EOT = 65

ET = 8EOT = 73

ET = 7EOT = 24

ET = 11EOT = 35

ET = 7EOT = 7

Start 1 2

3 6

9 10

End

54

7 8

(b) Calculations of ET†

Activity 1: (4 + 4 × 7 + 10) / 6 = 7 2: (5 + 4 × 10 + 15) / 6 = 10 3: (5 + 4 × 15 + 19) / 6 = 14 4: (4 + 4 × 6 + 14) / 6 = 7 5: (6 + 4 × 10 + 20) / 6 = 11 6: (1 + 4 × 2 + 9) / 6 = 3 7: (5 + 4 × 10 + 21) / 6 = 11 8: (9 + 4 × 18 + 21) / 6 = 17 9: (20 + 4 × 30 + 46) / 6 = 31 10: (5 + 4 × 7 + 15) / 6 = 8

† ET = (O + 4ML + P ) / 6

Where: O = optimistic ML = most likely P = pessimistic

(c) Critical path is 1 → 2 → 3 → 6 → 9 → 10, which is 73 days (7 + 10 + 14 + 3 + 31 + 8). Return to Question 4.10 to continue reading.

MO

DU

LE 4


Question 4.11(a) Explain how project managers can benefit from the use of EV analysis.

Project managers can use EV in projects where a project deliverable (output) or percentage completion can be measured. This is because the key factor in the EV method is the comparison of actual cost incurred to the cost that should have been incurred for the work done.

(b) What are the difficulties in implementing EV analysis?

One of the problems with variance analysis is ensuring that comparisons are made between AC and a meaningful cost estimate or budget. The EV method provides this meaningful base for comparison. This is important because a project may have what seems to be a favourable cost variance due to the fact that the costs incurred are below budget, but when compared to the work completed, there may be a significant cost overrun because the work is behind schedule.


Question 4.12Risk assessment typically happens prior to project commencement and is about identifying and assessing the probability and the financial impact of risk.

Risk management is the ongoing process of managing the risks of the project while the project is being implemented.

The key components of project risk management are:• having the right project team• monitoring known risks• monitoring the emergence of unknown risks• establishing contingency responses so that when things go wrong, the project can still

be delivered on time, on budget and according to specifications.


MO

DU

LE 4


Question 4.13(a) Of the various techniques discussed in Part E, it is necessary to choose those that are most

relevant to the unique characteristics of the renovation project at SSB:1. Quality assurance—the high strategic importance of having a high-quality restaurant in a

prime Sydney Harbour location means that there is an emphasis on ensuring the quality of the renovations is high and the restaurant has the look of an expensive place with high-quality facilities.

2. Stakeholder management—the multiple stakeholders of this project and the changed public expectations suggest stakeholders should be managed carefully in this particular project.

3. Earned value—the project has strict deadlines (no more than four months), as well as an expectation that all scope is delivered with high quality and on budget. This suggests that an integrative technique such as the earned value method should be employed.

(b)


Quality assurance—important for project performance and organisational fit, easy to understand and implement

Stakeholder management—crucial for effective communication and engagement with various internal and external parties

Earned value—an efficient integrative approach that monitors time, cost and scope, all at the same time

Quality assurance—qualitative in nature and difficult to measure during the execution stages of the construction

Stakeholder management—some decisions to engage with certain stakeholders may be difficult to implement

Earned value—requires ongoing data collection about project progress


Question 4.14While the management accountant may be involved in the decision to complete a project, creating the task list, obtaining specification satisfaction consensus and undertaking a stakeholder satisfaction assessment, one key area where the management accountant adds value is in the financial closure of the project.

This includes calculating the final cost of the project and closing the cost records so that expenses can no longer be charged against the project. In addition, the management accountant may be involved in resource dispersion, which can involve negotiating with suppliers for stock returns and selling assets that cannot be absorbed into the organisation.

Finally, the management accountant can add value by documenting the knowledge gained from the project. This includes budget-related information—such as the events that caused deviation from cost estimations, the systematic identification of the problems with a project, and what could be done to reduce their recurrence—which can be useful for planning future projects.


MO

DU

LE 4

REFERENCES | 377

References

References

Australian Petroleum Production and Exploration Association 2018, ‘Australian LNG projects’, accessed September 2018, http://www.appea.com.au/oil-gas-explained/operation/australian-lng-projects.

Bloch, M., Blumberg, S. & Laartz, J. 2012, ‘Delivering large-scale IT projects on time, on budget, and on value’, Insights & Publications, McKinsey & Company, October, accessed September 2018, http://www.mckinsey.com/insights/business_technology/delivering_large-scale_it_projects_on_time_on_budget_and_on_value.

Eden, C., Ackermann, F. & Williams, T. 2005, ‘The amoebic growth of project costs’, Project Management Journal, vol. 36, no. 2, pp. 15–26.

Gallagher, C. 1987, ‘A note on PERT assumptions’, Management Science Quarterly, October.

Independent Commission Against Corruption (ICAC) 2005, Probity and Probity Advising, Sydney, New South Wales.

Lend Lease 2018, ‘Western Sydney Stadium’, accessed September 2018, https://www.lendlease.com/au/projects/western-sydney-stadium/?id=4dd6e4ac-148b-4724-839c-f73922454b95.

Lewis, J. P. 2008, Mastering Project Management, McGraw-Hill, New York.

Lientz, B. P. & Rea, P. R. 2003, International Project Management, Academic Press, Amsterdam.

Littlefield, T. K. & Randolph, P. H. 1987, ‘An answer to Sasieni’s questions on PERT times’, Management Science Quarterly, October.

Loch, C. & Kavadias, S. 2011, ‘Implementing strategy through projects’, The Oxford Handbook of Project Management, Oxford University Press, Oxford.

Malmi, T. & Brown, D. A. 2008, ‘Management control systems as a package: Opportunities, challenges and research directions’, Management Accounting Research, vol. 11, no. 4, December, pp. 287–300.

http://www.appea.com.au/oil-gas-explained/operation/australian-lng-projects

http://www.appea.com.au/oil-gas-explained/operation/australian-lng-projects

http://www.mckinsey.com/insights/business_technology/delivering_large-scale_it_projects_on_time_on_budget_and_on_value

http://www.mckinsey.com/insights/business_technology/delivering_large-scale_it_projects_on_time_on_budget_and_on_value

https://www.lendlease.com/au/projects/western-sydney-stadium/?id=4dd6e4ac-148b-4724-839c-f73922454b95

https://www.lendlease.com/au/projects/western-sydney-stadium/?id=4dd6e4ac-148b-4724-839c-f73922454b95

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Matheson, V. A., Schwab, D. & Koval, P. 2018, ‘Corruption in the bidding, construction and organisation of mega-events: An analysis of the Olympics and World Cup’, in The Palgrave Handbook on the Economics of Manipulation in Sport, Palgrave Macmillan, Cham, pp. 257–78.

Meredith, J. R. & Mantel, J. M. 2015, Project Management: A Managerial Approach, 10th edn, Wiley, New York.

Morris, P. & Pinto, J. K. 2007, The Wiley Guide to Project, Program and Portfolio Management, Wiley and Sons, New Jersey.

Phillips, R., Freeman, R. E. & Wicks, A. C. 2003, ‘What stakeholder theory is not’, Business Ethics Quarterly, vol. 13, no. 4, pp. 479–502.

Pinto, J. K. 2010, Project Management: Achieving Competitive Advantage, Prentice Hall, New Jersey.

Porter, M. E. 1985, Competitive Advantage: Creating and Sustaining Superior Performance, The Free Press, New York.

Project Management Institute (PMI) 2017, A Guide to the Project Management Body of Knowledge, 6th edn, Project Management Institute, Newtown Square, Pennsylvania.

Simons, R. 1995, Levers of Control, Harvard University Press, Boston.

Sundin, H., Granland, M. & Brown, D. 2010, ‘Balancing multiple competing objectives witha balanced scorecard’, European Accounting Review, vol. 19, no. 2, pp. 203–46.

Turner, R. J. 2003, People in Project Management, Gower, Burlington.

Zwikael, O. & Smyrk, J. R. 2011, Project Management for the Creation of Organisational Value, Springer-Verlag, London, UK.

Zwikael, O. & Meredith, J. 2018, ‘Who’s who in the project zoo? The ten core project roles’, International Journal of Operations & Production Management, vol. 38, no. 2, pp. 474–92.

Zwikael, O., Chih, Y. & Meredith, J. 2018, ‘Project benefit management: Setting effective target benefits’, International Journal of Project Management, vol. 36, pp. 650–58.

Optional readingDalal, A. 2011, The 12 Pillars of Project Excellence, CRC Press, Boca Raton, Florida.

Institute of Civil Engineers and the Actuarial Profession 2005, RAMP Risk Analysis and Management for Projects: A Strategic Framework for Managing Project Risks and Its Financial Implications, Thomas Telford, London.

STRATEGIC MANAGEMENT ACCOUNTING

Module 5PERFORMANCE MANAGEMENT

http://www.cpaaustralia.com.au

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ContentsPreview 383

IntroductionObjectives Teaching materials

Part A: The role of performance management 386What is ‘performance’ and ‘performance management’?Performance management and its links to strategy Financial performance managementNon-financial performance managementThe measurability and reporting of performance

The multiple roles of performance management 396Performance—a process of value creationPerformance and sustainabilityIntegrated reportingSignalling Governance, risk and performance managementEthics and performance managementTheories related to performance management

Part B: Strategy, management control and performance management 418

Performance management and control—their role in strategyLimitations of traditional controls

Models of performance management 428Operational and strategic performance Leading and lagging measures of performanceFrameworks for performance managementThe Business Model CanvasThe balanced scorecardDesigning a balanced scorecardPublic sector and not-for-profit performance managementDesigning a strategy map for performance managementCascading performance measuresThe role of information systems in performance managementThe role of performance management in implementing and monitoring strategy

Part C: Determining performance measures and setting performance targets 459

Designing performance measures Measuring efficiency, effectiveness and equityDesigning SMART performance targetsCharacteristics of performance measures and targetsCosts and benefits of performance managementPerformance management, power and culture

Performance management for performance improvement 474The importance of performance improvementTargetsTrendsBenchmarking Organisational learning and performance improvementBehavioural consequences of performance managementPerformance measures and performance targetsThe role of incentives and rewards in performance management

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CONTENTS | 381

Review 488

Appendix 489Appendix 5.1 489

Suggested answers 499

References 521

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Module 5: Performance management

Study guide

Preview

IntroductionThe Strategic Management Accounting subject emphasises the role of the professional accountant in engaging with the organisation’s senior management team to contribute to strategy development and implementation. The aim is to create value and a strong competitive position for the organisation. This subject focuses on developing, implementing and monitoring strategies in order to enhance value for the organisation. Such a focus would not be possible without understanding the key role that performance management plays in strategy and value creation.

The need for sound design and an understanding of the use and implications of strategic performance management and control systems is gaining increasing importance in all organisations. This module sets the context for performance management and control, including the:• characteristics of effective performance measures and control systems • use of performance measures• application of performance management to motivate and reward.

Module 5 is concerned with how performance management helps to achieve goals and objectives through setting targets and measuring performance against those targets through control and feedback systems.

Module 5 builds on Module 1 and emphasises the role of the management accountant in supporting the management team in their strategic role. In particular, this module looks at performance management in the context of value creation and the sustainability of performance over time, as well as sustainability in the sense of corporate social responsibility (CSR).

This module also builds on Module 1 by discussing the role of the management accountant in generating and interpreting information about value chain performance. The focus of Module 2 on information is also relevant as it is the basis of performance management. Similarly, Module 3 looks at variance analysis as one way in which performance can be managed through comparisons between actual and expected performance.

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The links between strategy, management control systems and performance management, and the limitations of some traditional accounting-based controls, are considered. The various models of performance management, emphasising the balanced scorecard and the strategy mapping process, as well as cascading performance measures and the important role of information systems in performance management, will be highlighted.

Module 6 will be previewed by discussing the role of performance management in the creation and management of value. How performance measures and their associated targets are designed and the characteristics that make performance measures useful, including the need to compare the costs and benefits of performance management, will be discussed. This module focuses on improving performance through targets, trends and benchmarking, and the importance of continuous improvement (CI) through organisational learning and knowledge management processes.

This module illustrates concepts with examples from manufacturing, service and retail organisations and the public and not-for-profit sectors.

The highlighted sections in Figure 5.1 provide an overview of the important concepts in this subject and how they link with this module. This module discusses how the management accountant works to provide management with information for monitoring and decision-making that, in turn, informs and is informed by strategy.

Figure 5.1: Subject map highlighting Module 5



VISION

STR

ATE

GY STR

ATE

GY

MANAGEMENT ACCOUNTANT

OPERATIONS

VALUE INFORMATION

VALUE INFORMATION


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Objectives After completing this module you should be able to:• Explain the importance of performance management and the role of a performance

measurement system in value creation, sustainability performance, and strategic implementation.

• Analyse how a properly designed balanced scorecard can implement and monitor strategy.• Identify effective performance measures in a given scenario.• Assess the root causes of performance issues in a given situation.• Evaluate potential behavioural effects resulting from performance evaluation and

reward systems.

Teaching materials • APES 110 Code of Ethics for Professional Accountants• IESBA International Code of Ethics for Professional Accountants (Including International

Independence Standards) April 2018

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Part A: The role of performance managementIn Part A the concepts of performance and performance management are introduced. Financial and non-financial performance and the measurability of performance are considered. The multiple roles of performance management, including its role in value creation and sustainability, are explained. Corporate governance in terms of the links between risk management and performance management, and the role of ethics in performance management, are reviewed. Part A concludes with two theories that help explain differences in how accountants affect and are affected by performance management.

What is ‘performance’ and ‘performance management’?‘Performance’ and ‘performance management’ can mean different things to different people.

Performance Performance may be a discrete event, as in achieving a certain level of profit or customer satisfaction. Performance may be considered quantitatively (i.e. a numeric value)—for example, that profit is $10 million, or that 85 per cent of customers are satisfied. It may also be considered qualitatively (and typically more subjectively)—for example, the quality of a service or an organisation’s reputation. There may be a trade-off between quantitative and qualitative aspects of performance—for example, between achieving a certain level of profitability and the organisation’s reputation. Similarly, there can be a trade-off between short-term performance and longer-term sustainable performance, whether that be financial, societal, environmental or reputational.

Performance may be understood either at the level of the whole organisation, or different business units, products or services, geographic areas, distribution channels or customer segments within the organisation. At each level of analysis, performance may be interpreted differently. For example, the Australian airline Qantas achieves quite different results between its international, domestic and low-cost subsidiary (Jetstar) business segments. Different strategies and measures of performance may apply across each of these different segments.

Further, different stakeholders—for example, investors, lenders, customers, suppliers, employees, local communities—may interpret performance in very different (and sometimes competing) ways. For example, a Qantas customer may see Qantas’s performance in terms of on-time departures or the comfort of the cabin seating. An investor may be more interested in its financial performance. A member of the public living near an airport may be more interested in the airline’s environmental performance.

Performance measurementPerformance measurement implies a scientific technique involving comparison to a specific scale (e.g. a metre in length, a tonne of weight, one thousand dollars). A performance measure is therefore quite specific. Financial performance, such as profit or return on investment, can be readily measured because it is:• specified in a single unit—for example, dollars • clearly defined• based on a clear application of rules—for example, accounting standards or generally

accepted accounting principles.

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A performance indicator is less specific—it is a signal indicating a general direction or trend rather than an exact comparison against a scale. For example, customer satisfaction can be classified as an indicator because it can mean different things to different people and can be judged in different ways, such as sales to returning customers or a survey of a sample of customers. Performance indicators are often presented as a trend or in comparison to targets as ‘traffic lights’: green for acceptable, red for unacceptable and amber for borderline performance.

For a further explanation of performance measurement, please access the ‘Performance Measurement’ video on My Online Learning.

Other aspects of performanceThere are many other functions relevant to the concept of performance:• Performance monitoring involves surveillance of performance.• Performance reporting involves the dissemination and interpretation of information about

performance to those inside and/or outside the organisation (see Module 2).

Performance managementThe management of performance is an active rather than a passive process whereby actions are taken to effect change in behaviour or results. Performance management is far more than collecting or reporting information. It extends to analysing performance with a view to understanding its causes. Only when there is an understanding of causality can change, or recommendations for change, be implemented.

Performance management calls for a wider range of skills for the management accountant. While performance measurement is the starting point, the management accountant needs to synthesise complex data sets from different sources and analyse that data. The management accountant then needs skills of persuasion and communication, backed by evidence, to put in place actions or recommendations for change with the purpose of improving future performance.

Performance improvement implies changing behaviour to improve performance to achieve an absolute or relative target—for example, a return on investment of 12 per cent or a market share that is greater than a particular competitor.

Performance management and its links to strategy The focus of this module is performance management and its links to strategy. As highlighted in Module 1, an organisation’s strategy is concerned with value creation (not only for investors, but also for customers and other stakeholders) that is sustainable over time. The idea of management control to ensure that strategy is achieved is therefore crucial to an understanding of performance management. The performance management process incorporates all of the aspects of performance discussed previously. These are: • defining what the performance is that an organisation needs to achieve • how to measure performance• reporting and monitoring performance• taking deliberate action to improve performance.

Performance can be seen as a method of value creation (‘If we are not creating value, what are we doing?’) in terms of process or the results of a process. Performance is usually interpreted relative to a target, a trend over time or by comparison to a benchmark. Targets, trends and benchmarks are discussed later in this module.

An organisation’s performance should not be viewed from one dimension only (i.e. only from a financial point of view). As shown in Figure 5.2, performance should be seen more holistically.

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Figure 5.2: Performance dimensions

Performance

$ $+%

%

Combination of financial measures (e.g. profit before tax, return on investment)

Non-financial but quantitative (e.g. market share (%), Net Promoter Score (NPS), quality pass rate)

Subjective judgments and opinions (e.g. employee satisfaction, reputation or environmental awareness)

Combination of financial and non-financial quantitative terms (e.g. dollar sales per square metre of floor space, earnings per share (EPS)


Organisations use different terms for their performance measures such as key performance indicators (KPIs) or critical success factors (CSFs). Organisations may call their performance management system a ‘dashboard’ (picture the dials in an aircraft cockpit), a ‘traffic light’ system (discussed previously under ‘Performance measurement’) or a ‘scorecard’. These differences in terminology matter less than understanding what an organisation is trying to measure and how that measurement takes place.

Performance needs to be understood relative to an organisation’s strategy and the particular industry in which it operates, as shown in Example 5.1. All listed companies report their performance to investors and other interested stakeholders.

Example 5.1: Performance reporting by Event Hospitality and Entertainment Ltd

Event Hospitality and Entertainment Ltd (EVT) (formerly Amalgamated Holdings Limited) is an Australian provider of entertainment, hospitality and tourism and leisure services. EVT conducts its operations in Australia, New Zealand and Germany. The company was established in 1910. It had annual revenue of $1.2 billion in the year ended June 2017. EVT is listed on ASX. Its market capitalisation in July 2018 was $2.13 billion.

EVT’s entertainment division operates Event Cinemas in Australia and New Zealand, the State Theatre in Sydney, Moonlight Cinemas across Australia, Cinestar Cinemas in Germany and Edge Digital Technology.

EVT’s hospitality division operates QT Hotels & Resorts, Rydges Hotels & Resorts, Atura Hotels brands as well as the premier Australian ski resort township of Thredbo Alpine Resort. Both the entertainment and hospitality divisions have loyalty programs. Across its owned and managed hotels at June 2017, EVT had 9132 rooms across 58 different locations (EVT 2017a, p. 10).

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EVT’s strategic plan includes future expansion, depending on a number of internal and external factors, including available capital and customer trends.

For the hospitality division, EVT wants to increase the number of hotel rooms through new hotel management agreements and freehold acquisitions. It also aims to grow market share, increase occupancy rates and increase customer spend in all its hotels (EVT 2017a, p. 13).

The most important financial performance aspects for EVT are explained in the annual report as:• revenue• earnings before interest• taxation• earnings before depreciation and amortisation (EBITDA)• normalised profit before interest and taxes (PBIT).

Normalised profit, in many companies called underlying profit, supplements the financial statements, and such figures are unaudited and not comparable to other companies. The underlying profits are based on judgments by the directors as to what is the profit that best reflects the result of operations, unencumbered by transactions that are required by Australian Accounting Standards and that do not reflect ongoing performance.

For each of the divisions, performance is measured based on profit before income tax, which EVT uses to compare to the performance of competitors.

The audited remuneration reports within annual reports provide a good guide as to what aspects of (most commonly, financial) performance are important, as these are the basis for rewarding directors and senior management. These are typically split into short-term incentives (STIs) and long-term incentives (LTIs).

EVT’s remuneration policy aims to reward the CEO and other executives with a level and mix of remuneration commensurate with their position and responsibilities within EVT. The rewards are linked to specific targets, goals and KPIs. Parts of the executive remuneration packages depend on the financial and operational performance of EVT. This element of remuneration is deemed to be ‘at-risk’ because if the performance goals are not achieved, executives do not receive that component of the remuneration package.

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➤ Question 5.1EVT’s Annual Report 2017 and the results presentation for the half year ended 31 December 2017 are available to download at https://www.evt.com/investors/.

Search both documents and identify as many performance measures as you can for the hotel division.


https://www.evt.com/investors/

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Financial performance managementAccountants are familiar with measuring, monitoring, managing, improving and reporting financial performance through the income statement (or statement of profit or loss and other comprehensive income), statement of financial position (balance sheet) and statement of cash flows. Accountants can interpret financial performance through the use of ratio analysis to discover trends and opportunities from the five perspectives provided by ratios, as outlined in Figure 5.3.

Figure 5.3: Ratios for financial performance

Profitability

Activity orefficiency

Gearing

LiquidityShareholder

returns

Ratios


Various approaches to measuring shareholder value from an investor’s perspective are also available. Study of the effect of reported financial performance on capital markets is important to understand stock market expectations and how reported performance influences share price movements over time. Stock markets tend to value shares more on expectations of future cash flows, discounted to present values, than on historical performance. While the analysis of historical, externally reported performance is valuable, it is through a focus on strategy and value-adding activities that management accountants can contribute more to organisations.

While financial statements produced for external parties are governed (in Australia) by the Corporations Act 2001 (Cwlth), International Financial Reporting Standards (IFRS) and the requirements of external audit, these have limited usefulness to managers who are interested in understanding organisational performance at the more detailed level necessary for planning, decision-making and controlling operations. Strategic management accounting, however, provides a more detailed analysis of performance, as shown in Table 5.1.

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Table 5.1: Comparison of approaches to performance between financial accounting and strategic management accounting

Financial accounting Strategic management accounting

Annual figures in external financial statements Monthly figures (or in some cases weekly or even daily—e.g. retail sales) reporting

Consolidated data (even segmental reporting in financial statements is highly aggregated)

Reporting for individual business units and responsibility centres

Highly aggregated data on income and expenses Detailed analysis of individual income and expense line items

Comparison to prior year Comparison to prior year, budget and external benchmarks


Strategic management accounting also provides comparisons to budgets and standard costs, and enables variance analysis, product/service profitability analysis, customer and distribution channel profitability analysis, activity-based cost analysis and a variety of other tools and techniques.

Strategic management accounting information increasingly links the information in the general ledger with other sources of data such as inventory records, labour routings, bills of materials and standard costs.

Strategic management accounting techniques may move beyond the: • financial year to encompass a multi-period, life cycle approach to understand performance • hierarchical organisational structure of reporting to the analysis of its organisational value

chain and business processes, and• organisation to assess the whole supply chain (industry value chain) of which the organisation

is a part, and to provide comparisons with competitor organisations and competitor supply chains.

Increasingly, strategic management accounting can provide managers with increased information about markets, customers, competitors, supply arrangements and production processes, based on formal and informal sources.

Non-financial performance managementStrategic management accounting increasingly links financial data with non-financial data and reports them together to managers. Applying the EVT example (from Example 5.1), it is clear that revenue, the normalised (or underlying) PBIT and EBITDA are the key financial performance measures that are used to manage the performance of the CEO and senior executives. Non-financial data, particularly the average room rate, occupancy rate and revenue per average available room (RevPAR), are key determinants of performance and are metrics used to compare relative profitability in the accommodation industry.

Most organisations maintain comprehensive statistical data to support planning, decision-making and control. This information may come from:• data captured as a by-product of the accounting process—for example, quantities of product

purchased and sold, labour hours worked• data captured by the organisation from non-accounting systems—for example, on-time

delivery, product quality• external surveys—for example, customer satisfaction• published data—for example, Australian Bureau of Statistics or industry associations• stock exchange data—for example, market capitalisation.

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Performance, whether it is financial or non-financial, needs to be interpreted in the contexts of the industry and the organisation’s competitive strategy and business model. For example, measures like occupancy and average room rates are essential in accommodation but not in manufacturing; ‘sales per square metre’ is useful for retail stores, but is meaningless for airlines; while ‘available seat kilometres’ has no relevance to retail stores.

All businesses have a finite capacity, whether it is a production line, a hotel, airline or retail store. To better manage performance, managers need to be able to identify and improve their capacity utilisation, which will reduce the fixed cost per unit of product sold or service supplied.

Performance measures will also reflect differences between the business segments. For example, the entertainment division of EVT will have quite different performance measures compared with the hospitality division. While seasonality may be less important for cinemas (some increase is possible during school holidays), it will be very important for hotels, and weather conditions in particular will have a significant impact on EVT’s Thredbo Alpine Resort. While holiday locations will influence some hotel performance, CBD hotels may be influenced more by Monday to Friday business travel and whether business confidence is rising or falling, as well as by capital city sports and entertainment events.

Of course, hotels do not simply generate revenue from hotel bookings, but from ancillary services, including restaurants and bars, laundry services and room service. One of EVT’s strategies is to increase customer spend in its hotels. Performance measures will need to cascade down (see later in this module) to lower levels of the organisation to be able to manage performance—for example, restaurant utilisation. At the corporate level, EVT must also focus on growth through its pipeline of new hotel management agreements and freehold acquisitions, given its strategy to deliver growth via increased room inventory in key destinations (discussed previously).

The measurability and reporting of performanceA favourite saying in performance management is ‘what gets measured, gets done’. This is because measuring something focuses people’s minds on what is measured, especially if the performance is reported, compared to some target, and where rewards are linked to achieving the desired performance level—for example, sales representatives may receive a commission on the value of sales or managers may receive a bonus on the reported profit. Those things that are not measured or not reported are often deemed to be unimportant. Unfortunately, organisations tend to measure what is easy to measure, rather than what is important to measure (Denton 2005). This raises the issue of whether all performance is measurable.

Some people believe that performance must be ‘measurable’ to be useful. But not everything that is important can be objectively measured. Qantas has long held a reputation for safety. However, safety incidents do occur. For example, in April 2017, 15 people were injured when a Qantas 747 flying from Melbourne to Hong Kong had a ‘stick shaker incident in which the pilots experienced ‘airframe buffeting’ at an altitude of 22 000 feet. The ‘stick shaker’ is a warning system that causes the aircraft’s control stick to vibrate, alerting pilots they may be about to stall. Stalling occurs when the wings stop creating enough lift to hold the aircraft in the sky. The Australian Transport Safety Bureau, the airline safety watchdog, was treating it as a ‘serious incident’, meaning there were indications that an accident causing loss of life or aircraft damage nearly occurred (Hatch 2017).

Example 5.2 illustrates how airline safety ratings are independently assessed as a means of informing travellers about the possible risks involved in travel, a critical area of importance for passengers and airlines alike.

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Example 5.2: Safety indexThe Top 20 Safest Airlines for 2018 rankings by AirlineRatings.com includes Qantas for the fifth year in a row, making the Australian airline a leader in safety standards (Schultz 2018).

Various safety rankings of airlines around the world exist. The Jet Airliner Crash Data Evaluation Center, or JACDEC (JACDEC 2017), calculates its safety index and annual rankings based on accidents and serious incidents (including near-miss accidents) affecting aircraft over the last 30 years. The safety index relates the number of accidents to revenue passenger kilometres.

The safety index is a good example of a performance indicator rather than a performance measure because there is no objective way of measuring Qantas’s actual safety or its reputation for safety. Any trend in passenger numbers or results of surveys of customers may indicate a reputational effect, but could equally be a consequence of other factors, including economic conditions, cost, service or comfort. So Qantas’s performance in terms of safety or reputation is difficult, if not impossible, to objectively measure. But it remains an important element of performance.

Similar difficulties exist with attempts to measure brand image, customer satisfaction or employee morale, where surveys, a common method of evaluating performance in relation to these issues, may provide limited, ambiguous or even biased information.

One development to improve the measurability of customer satisfaction is the Net Promoter Score (NPS). NPS was developed by Bain & Company to measure the loyalty that exists between an organisation providing goods or services (the provider) and a consumer. The focus of the score is the question: ‘How likely is it that you would recommend our company/product/service to a friend or colleague?’ Responses range from customers being complete detractors of the provider to complete promoters of the provider. The measure has been adopted by many Australian companies, including Qantas, where it features as a performance measure in its 2017 annual report. The NPS measures the percentage of promoters minus the percentage of detractors. Promoters are the loyal, enthusiastic customers who love doing business with the organisation.

For an example, see the Australia Post 2017 Annual Report where the company emphasised its overall +1.4 point improvement in the NPS score, available at https://auspost.com.au/content/dam/auspost_corp/media/documents/Annual-Report-2017.pdf?fm=search-organic.

The importance of NPS is that it provides a measure of sustainable customer satisfaction necessary for future financial performance, not only in terms of repeat business for existing customers but also extending to referrals to new customers. This helps the business to focus on keeping profitable customers happy and CI in customer satisfaction. For example, it is quite likely that the NPS results of the four major Australian banks and AMP will suffer from the significant criticism it faced during 2018 at the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

In the public sector, where the primary focus is not on financial results, organisations also communicate the success of their activities by reporting on their performance through a range of non-financial measures, as shown in Example 5.3.

https://auspost.com.au/content/dam/auspost_corp/media/documents/Annual-Report-2017.pdf?fm=search-organic

https://auspost.com.au/content/dam/auspost_corp/media/documents/Annual-Report-2017.pdf?fm=search-organic

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Example 5.3: Performance reporting by Victoria PoliceIn its 2016–17 annual report, Victoria Police describes the role and function of police under five headings:

Preserving the peace.

Protecting life and property.

Preventing offences.

Detecting and apprehending offenders.

Helping those in need of assistance (Victoria Police 2017, p. 4).

Performance is reported against the objectives, objective indicators and outputs agreed by the Chief Commissioner with the Government for 2016–17 in Victorian Budget Paper Number 3: Service Delivery (Budget Paper Number 3).

The annual report lists three broad categories of performance measurement: 1. community feelings of safety2. crime statistics based on reports from the public and crimes detected by police. Each offence

is recorded (e.g. fraud, robbery, drug possession, public nuisance, etc.)3. road fatalities and injuries

The annual report identifies many performance measures, targets and actual results. Some of these are: • based on quantity—for example, number of calls for assistance, number of offences recorded • quality—for example, proportion of the public that has confidence in police, proportion of drivers

tested for alcohol who comply with limits • time-based—for example, proportion of crimes resolved within 30 days.

Financial performance compared with budget is also reported, as are statistics on work health and safety (WHS).

An interesting aspect of police performance is that the management of that performance can be difficult to influence by the police agency alone. The use of the term ‘indicators’ rather than ‘measures’ in the annual report is important, as no police agency has the ability to control behaviours of the public and outcomes, although each has an important role to play in conjunction with other agencies in the criminal justice system—for example, prosecution authorities, courts, prisons and probation services. In addition, many factors affecting police performance are heavily influenced by social factors such as mental health, unemployment and education.

Like other public services, care must be exercised in the extent to which agencies are held accountable for aspects of performance over which they may have little or no control.

Note: Example 5.3 is CPA Australia’s analysis of the performance indicators in the Victoria Police Annual Report 2016–2017 and is illustrative for educational purposes only. It does not represent the official position of Victoria Police.

Source: Based on Victoria Police 2017, Annual Report 2016–2017, accessed May 2018, http://www.police.vic.gov.au/content.asp?a=internetBridgingPage&Media_ID=132934.

Appendix 5.1 explores the case of of Achmea Holdings N.V., the largest insurance provider in the Netherlands, which has been operating since 1811. This is an interesting case because Achmea is a ‘mutual’—that is, an entity not listed on a stock exchange but whose customers are, indirectly, its owners. Appendix 5.1 is included because it provides an example of many of the concepts included in this Study guide, including performance measures, strategy maps and sustainability.

Note: The concepts covered in this appendix (not the specific details of the case) are examinable.

http://www.police.vic.gov.au/content.asp?a=internetBridgingPage&Media_ID=132934

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The multiple roles of performance managementPerformance management has multiple roles that include providing information:• for managers to aid in planning, decision-making and control in pursuit of value creation• on environmental and social sustainability for integrated reporting purposes• for signalling to investors and other stakeholders.

Each of these roles is described in the next section.

Performance—a process of value creationValue creation is a process of turning one thing into something else, with the ‘something else’ having more value than the original. Value-adding may be seen as increasing shareholder value to an investor. Value creation was discussed in Module 1 and will be considered further in Module 6.

A value creation process in production may involve turning wood into paper and paper into a printed book. A value creation process in services may be using knowledge and skill to construct a contract between two parties that will enable them to carry on business together. Value creation may also take place through improved efficiencies—for example, reducing the distance travelled in making a delivery or the time taken to carry out a service.

Performance management can therefore be seen in terms of the value creation process. Porter’s (1985) ‘value chain’ (as discussed in Module 1) shows the primary and support activities that add value to a customer, and the margin that can be achieved as the difference between the cost of providing those value-adding activities and the price the customer is willing to pay. So the value added for which the customer is willing to pay must exceed the cost of performing the activities that lead to the added value; otherwise, the activities should be eliminated. Performance management should focus on the margin in value chain activities.

This idea of value creation is particularly important when considering for-profit organisations whose purpose is to increase shareholder value. Shareholder value can be increased through a combination of dividends and capital gains over time.

There are many ways value creation can be achieved. One is through technological innovation that leads to products that customers want, as Example 5.4 demonstrates.

Example 5.4: Value creation at Apple Inc.The Global Top 100 Companies by Market Capitalisation 31 March 2017 Update by PricewaterhouseCoopers (PwC) lists Apple as the world’s largest company by market capitalisation (USD 754 billion). Apple’s nearest rival is Alphabet (previously known as Google). Both Apple and Alphabet have experienced the largest increases in market capitalisation since the financial crisis of 2009. Apple increased its market capitalisation between 2009 and 2017 by 705 per cent and its ranking from 33 in the Top 100 companies in 2009 to number 1 in 2017 (PricewaterhouseCoopers 2017, p. 32).

Warren Buffett’s Berkshire Hathaway Inc.—long known as an exceptionally successful investor—became Apple Inc.’s second-largest shareholder in May 2018 (Bloomberg 2018).

Apple’s 10-K annual report for 2017 describes its business strategy as designing and developing operating systems, hardware and software to solve customer needs. It achieves this through a continual high-level investment in research and development. In addition to advertising and promotion, Apple’s in-store salesforce provides a high level of advice to customers to attract and retain customers. Apple operates its own retail stores but also has space and sales staff within retail stores (e.g. within JB Hi-Fi in Australia).

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Given its strategy for value-adding, Apple would be expected to measure and manage the following aspects of its performance:• customer satisfaction• customer retention• salesperson knowledge• growth in retail locations• growth in third-party distributors• research and development investment.

However, value creation does not need to come only from innovation. It can also come from more conventional businesses, as Example 5.5 demonstrates.

Example 5.5: Value creation at WoolworthsAlthough there are many ways that market share can be measured (and different methods are supported or disputed by different interest groups), it is reasonably clear that Woolworths and Coles dominate the grocery market in Australia, although more recent entrants such as Aldi have begun to erode the dominance of the ‘Big 2’. While Coles is owned by the Wesfarmers group, Woolworths is listed on ASX in its own right.

Woolworths is best known for its supermarket chain, its Big W department stores and its partnership with Caltex in fuel retailing, but it also owns liquor retailers Dan Murphy and BWS, and the ALH leisure and hospitality group, which owns restaurants, hotels and gaming venues. Woolworths’ strategy for value creation has been to diversify from supermarkets into related retail fields and to expand its range of stores geographically (including online shopping).

Because of the tightly held market share of Woolworths and its competitors, a key strategy is to increase spending by existing customers. Woolworths has consequently expanded its product range, introducing its own-brand products, from the less expensive to the more expensive Woolworths ‘Select’ brand. Woolworths’ supermarket advertising slogan, ‘The fresh food people’, has been successful in creating value for the company, as has its ‘Everyday Rewards’ loyalty cards system (with nearly 8 million members in Australia) that is linked to Qantas Frequent Flyer points and reward points that provide discounts on fuel purchases. One of Woolworths’ strategies is to use the large amount of data gathered on customer buying habits that is available to it through the ‘Everyday Rewards’ card. It uses this example of ‘big data’ (see Module 2) to target customers with specific promotional campaigns. Woolworths is also expanding its multi-channel strategy, including online and social networking channels. Woolworths has also expanded to New Zealand.

In its 2017 Annual Report, Woolworths identified various performance measures linked to its short-term incentive plan (STIP) and long-term incentive plan (LTIP), which are part of the audited remuneration report within the annual report.

Woolworths changed its STIP during the 2016–17 year by setting targets at each level of the business to ensure that all team members ‘from top executives to store managers, were aligned to a common effort but were rewarded for their achievement of business results largely within their own control’ (Woolworths Group 2017, p. 34). Five STIP measures are each equally weighted (i.e. 20% each): sales, EBIT, working capital, customer satisfaction and safety. LTIP measures are relative total shareholder return (TSR), sales per trading square metre and return on funds employed—each weighted at 33 per cent (Woolworths Group 2017, p. 38).

STIP and LTIP are regular features of listed company annual reports and are used by companies to link the performance of the business to the remuneration of directors and senior executives. By focusing on measuring, managing and rewarding performance in areas like working capital management, customer satisfaction and employee safety, managerial behaviour is changed in ways consistent with the company’s strategy. In the longer term, this changed short-term behaviour is more likely to lead to the key financial performance areas of increased shareholder value (i.e. TSR), return on funds employed, and probably the most common measure of retail efficiency, sales per square metre (which measures the effective utilisation of the most expensive retail resource: i.e. rent).

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➤ Question 5.2Please access the Annual Report 2017 of JB Hi-Fi (an Australian consumer electronics and entertainment retailer), available online at: https://www.jbhifi.com.au/General/Corporate/Shareholder-Matters/Financial-Annual-Reports/.

Select ‘Annual Report – 2017 – with Chairman’s & CEO’s Report’ from the list.

(a) Who in the company is responsible for shareholder value creation?

(b) What is the company’s strategy to increase shareholder value?

(c) What performance measures does JB Hi-Fi use to measure the success of its shareholder value creation activities?


The key issue for performance management is to understand the organisation’s strategy for value creation and to measure the success of its value creation activities. As Example 5.5 illustrates, value creation can be viewed from the shareholder financial perspective, or from a more internal, operational perspective, although the two are clearly interrelated.

https://www.jbhifi.com.au/General/Corporate/Shareholder-Matters/Financial-Annual-Reports/

https://www.jbhifi.com.au/General/Corporate/Shareholder-Matters/Financial-Annual-Reports/

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The idea of value creation over time is important, because measuring value creation should not be seen solely in terms of short-term gains such as current year profits or customer satisfaction in a single survey. This highlights the importance of sustainable performance.

➤ Question 5.3Mega Markets Ltd (Mega Markets) is an ASX-listed chain of retail stores with branches in all the major shopping centres in Australia. Mega Markets sells clothing, homewares and toys. Much of Mega Markets’ product range is sourced from South-East Asia, enabling it to offer low prices for a wide range of products. Over many years Mega Markets has become a popular department store for families on a budget with young children.

However, over the past two years, Mega Markets has faced a flattening of sales. Mega Markets has faced out-of-stock situations where customers have asked for a particular style/colour/size combination that is not always available in every store. Market research has revealed that customers are increasingly going online to source similar products from an overseas competitor at even lower prices than Mega Markets can offer. The purchased goods are posted to their home address from a large warehouse in South-East Asia.

Mega Markets has complained in the press that this competition is unfair because the overseas suppliers do not have the high rental costs charged by the large shopping centre owners, nor the high wages and on-costs that Australian retailers have to pay.

The sales director of Mega Markets said:

Our customers can go to our competitor online, choose the product they want, in the colour they like, in any size, and have it delivered to their home within a week, all at a price that is typically 10 to 20 per cent lower than our retail store prices and customers can return or exchange their products if they are dissatisfied. No wonder our sales are suffering.

Mega Markets has suffered from a deteriorating financial position as a consequence of its flat sales, tighter margins and increased overhead costs. The company now faces considerable pressure from investment analysts and institutional investors to improve its sales and earnings. The board of Mega Markets has put pressure on senior management to develop strategies to overcome competition from online sales.

(a) Explain the value creation process for Mega Markets.

(b) Why is its value creation process now facing competition from online sales?

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(c) What can the company do in the face of online competition?


Performance and sustainabilityWhen we use the term ‘sustainability’ in relation to performance, we mean two things, as shown in Figure 5.4.

Figure 5.4: Sustainability in relation to performance

Performance(e.g. financial,

customer satisfaction, quality) mustbe sustained

over time

Meeting the needs of today without

compromising the ability of future

generations to meet their own needs

Performance achieved in one

year, which cannot be achieved in the

following year, is not sustainable

Longer-term perspective (e.g.

avoiding over-fishing, deforestation, global oil supplies pollution, carbon emissions and

waste disposal)


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Most companies listed on ASX now produce a CSR or sustainability report in which they address issues, including sustainability and pollution reduction, and often include performance measures of their effectiveness. This is the so-called ‘triple bottom line’ reporting of economic, environmental and social performance.

Sustainability reporting tends to be distinct from other elements of (mainly financial) reporting and is often addressed in a supplementary statement, rather than being integrated with financial reports or other elements in the annual report. Integrated reporting, which was introduced in Module 2 and is discussed later in this module, is aimed at providing a wider range of stakeholders with reports that integrate the various dimensions of performance, including financial and sustainability performance. While some stakeholders (including ethical investors) are interested in sustainability reporting, others have little or no interest. Boards of directors often see their responsibility, as it is prescribed in the Corporations Act (for Australian companies), to the company and its shareholders, not to broader stakeholder groups. Hence, short-term financial motives often drive out longer-term aspirations for sustainability. The problem is how to convert the long-term benefits of sustainability into current period measures of performance and how to balance these long-term needs with the current financial need to satisfy shareholders.

Consequently, performance measures for financial issues and sustainability issues do not always gain the same exposure and are not always accorded similar importance in annual reports, despite the importance of sustainability in both its meanings. However, reputational issues have increased the importance not just of reporting sustainability performance, but of actually engaging in sustainable practices. Importantly, many organisations now see engaging in sustainable practices as necessary for long-term shareholder value and sustainability reporting as a means for enhancing their reputation.

Increasingly, some investors and some customers expect businesses to be more socially and environmentally responsible. Brand image can be tarnished by companies that use, for example, child labour in developing countries, or source products from factories that have a poor health and safety record for workers. Some customers are even willing to pay a premium price for more ethically sourced products such as clothing and coffee.

Further detail on CSR is presented in the Ethics and Governance subject of the CPA Program.

Returning to Appendix 5.1, we see that Achmea reports its performance against both financial and environmental criteria. Achmea recognises that its success comes from satisfying customers, yet it must operate in a sustainable way in order to balance financial, social and environmental responsibilities.

While one can be cynical and consider that companies engage in sustainability reporting for purely reputational reasons, there can be sound business reasons for engaging in sustainable practices as long-term value creation opportunities can be affected. The mining industry is a good example, as shown in Example 5.6.

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Example 5.6: Sustainability at Newcrest MiningNewcrest Mining is Australia’s leading gold mining company, with operations in Australia, Papua New Guinea and Indonesia.

In addition to its strategy to deliver long-term growth in shareholder value, Newcrest’s annual report discloses that Newcrest recognises the importance of sustainability in its broadest meaning. The opening paragraph of its Chairman’s report begins with the importance of the health and safety of its employees. Its key performance measures for 2017 are safety, earnings, costs per ounce and free cash flow, each with a 25 per cent weighting (Newcrest Mining Limited 2017a, p. 81).

Like many businesses that recognise that a focus on sustainability is not only morally and ethically appropriate but is also necessary for sustained financial performance, Newcrest produces a separate sustainability report in accordance with the Global Reporting Initiative (GRI) (discussed later in this module).

The Sustainability Report identifies Newcrest’s newly developed sustainability objectives to:

have a safe, healthy and diverse workforce; reduce, reuse and recycle resources responsibly to minimise environmental impact; and, work with local communities and other stakeholders, to achieve our vision as Miner of Choice (Newcrest Mining Limited 2017b, p. 8).

The report contains substantial information about People (safety), Economic, Social and Environmental performance and includes 14 pages of data covering these aspects of performance (Newcrest Mining Limited 2017b, pp. 87–100).

The GRI G4 content index is also available at the same website and identifies where data can be found to match the GRI G4 reporting requirements.

The Newcrest example suggests that companies do consider environmental issues in their strategy. GRI G4 Guidelines address the need to adopt a more holistic approach to reporting performance.

The GRI (see http://www.globalreporting.org) is a multi-stakeholder process aimed at developing and disseminating globally applicable sustainability reporting. The GRI Sustainability Reporting Standards (GRI Standards) offer reporting principles, standard disclosures and an implementation manual for the preparation of sustainability reports by organisations, regardless of their size, sector or location. The GRI Standards are required for all reports or other materials published on or after 1 July 2018.

The consolidated PDF of GRI Standards includes the three universal standards—GRI 101, 102 and 103—and the three series of topic-specific standards: 1. 200 (Economic topics)2. 300 (Environmental topics) 3. 400 (Social topics).

It is available at: https://www.globalreporting.org/standards/gri-standards-download-center/consolidated-set-of-gri-standards/.

The GRI argues that ‘sustainability reporting helps organisations to set goals, measure performance, and manage change in order to make their operations more sustainable. A sustainability report conveys disclosures on an organisation’s impacts—be they positive or negative—on the environment, society and the economy’ (GRI 2014, p. 3). GRI sustainability reports under the GRI Standards include the disclosure of the governance approach and the environmental, social and economic performance and effects of organisations. Importantly, the economic dimension of sustainability concerns the effects of the organisation’s activities on the economic conditions of its stakeholders and on economic systems at local, national and global levels, rather than on the financial condition of the organisation.

http://www.globalreporting.org

https://www.globalreporting.org/standards/gri-standards-download-center/consolidated-set-of-gri-standards/

https://www.globalreporting.org/standards/gri-standards-download-center/consolidated-set-of-gri-standards/

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Not all of these have to be disclosed, only those where the organisation deems them to be material. Note that in Example 5.6, Newcrest produced a separate GRI G4 content index that links to where the data in the G4 can be found in the annual report or sustainability report.

Successful companies in the future will need an integrated strategy to achieve strong financial results and create lasting value for the company, its stakeholders and society. The value created by companies in the future cannot be expressed by isolated financial and sustainability reports, with no clear links between the ‘single bottom line’ and the sustainability impacts caused or the value created in order to generate its financial results. Consequently, the GRI co-founded the International Integrated Reporting Council (IIRC) because it believed the future of corporate reporting is the integration of financial and sustainability strategy and reporting. ‘Understanding the links between financial results and sustainability impacts is critical for business managers, and is increasingly connected to long- and short-term business success’ (GRI 2012).

The move towards integrated reporting has important implications for accountants in terms of performance information.

Integrated reportingThe International Integrated Reporting (IR) Framework document (‘the Framework’) was issued by the IIRC in 2013. In relation to performance management:

The Framework takes a principles-based approach … It does not prescribe specific key performance indicators, measurement methods, or the disclosure of individual matters, but does include a small number of requirements that are to be applied before an integrated report can be said to be in accordance with the Framework (IIRC 2013, p. 4).

The Framework refers to a collection of ‘capitals’. ‘The capitals are stocks of value that are increased, decreased or transformed through the activities and outputs’ (IIRC 2013, para. 2.11) of the organisation: • financial capital (funds for use in the business)• manufactured capital (machines)• natural capital (air, water and land)• human capital (skill, experience and motivation)• intellectual capital (the intangibles)• social and relationship capital (community stakeholders).

The ability of an organisation to create value for itself enables financial returns to shareholders. This is interrelated with the value the organisation creates for stakeholders and society at large through the resources and relationships that are used by, and affected by, an organisation.

More information is available online at: http://integratedreporting.org.

While the initial focus of the IIRC is on reporting by larger companies and on the needs of their investors, it may have important implications for organisations and accountants in the longer term.

There are important links between integrated reporting and the GRI.

GRI is supportive of integrated reporting as it develops as an important and necessary innovation of corporate reporting.

GRI advocates for the inclusion of robust sustainability metrics (based on a multi-stakeholder approach) to integrated reporting, in support of its overall vision of a sustainable global economy (GRI 2018).

http://integratedreporting.org

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Integrated reporting provides companies with a broad perspective on risk, and GRI encourages those that want to do integrated reporting to use the GRI Standards. United by the shared vision that businesses should focus on value creation over the short, medium and longer term, GRI and the International Integrated Reporting Council (IIRC) continue to work together, aligning the GRI Standards and the International <IR> Framework to improve corporate reporting.

…

As the global standard setter for sustainability reporting, GRI is committed to supporting integrated reporting – including through the Corporate Leadership Group on integrated reporting 2017 (CLGir) … The CLGir 2017 is exploring how best to leverage the GRI Standards and the International <IR> Framework for integrated thinking and reporting, with the aim of learning together and identifying best practice guidance in reporting (GRI 2017).

CPA Australia believes that bringing together all the strands of corporate reporting will help satisfy the growing demands of investors for information about performance beyond the bottom line.

Integrated reporting is also discussed in the Advanced Audit and Assurance, Contemporary Business Issues and Ethics and Governance subjects of the CPA Program.

XBRLIntegrated reporting takes advantage of new and emerging technologies such as eXtensible Business Reporting Language (XBRL) to link information within the primary report and to facilitate access to further detail online where that is appropriate.

XBRL (‘a language for the electronic communication of business and financial data’) is becoming a standard means of communicating information between businesses and on the internet. ‘Instead of treating financial information as a block of text – as in a standard internet page or a printed document – it provides [a unique, computer-readable] identifying tag for each individual item of data’ (XBRL 2018) (e.g. net profit after tax). Computers can treat XBRL data intelligently. They can recognise the information in an XBRL document, select it, analyse it, store it, exchange it with other computers and present it automatically in a variety of ways for users.

Further information about XBRL is available online at: http://www.xbrl.org.

XBRL is also discussed in the Advanced Audit and Assurance subject of the CPA Program.

Signalling While governance is concerned with conformance and performance, and with making value-adding decisions, signalling is aimed at trying to influence someone else’s decisions. Signalling occurs when a measure is used to communicate information (either a forward goal or an actual achievement). One of the key roles of senior management is to communicate with stakeholder groups. Financial statements, for example, are a signal, prepared by directors for shareholders, about the performance of directors and managers in carrying out the operations of the organisation (the statement of profit or loss and other comprehensive income) and in building the assets of the organisation (the statement of financial position or balance sheet). The key financial performance measures presented in financial reports include various measures of profit, cash flows, assets and liabilities.

Most organisations choose to disclose other financial and non-financial measures to investors and other stakeholders in their annual reports, in investor briefings and through other public communications. However, organisations need to be careful as to how much information they voluntarily disclose (as opposed to disclosing information that is required by law) because competitors will be one of the groups looking for competitively sensitive information that may help them.

http://www.xbrl.org

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As seen in Example 5.5, Woolworths disclosed limited non-financial information in its annual report, at least in part because of the commercially sensitive information this would give to its competitors. Interestingly, a comparison of annual reports over several years reveals that each year Woolworths has disclosed less non-financial performance information, no doubt due to the concern that this information could be advantageous to its main competitor Coles (while Coles, a division of Wesfarmers, had no equivalent practice of disclosing this type of information).

Being given sufficient information to understand and assess investment risk is crucial to the ability of investors to make informed investment decisions (ASX CGC 2014, p. 28). Signalling will be insufficient unless investors understand the risks the company faces and the extent to which future performance may be impacted by those risks. Boards recognise and manage risk through establishing and reviewing the effectiveness of the company’s risk management framework, and annual reports typically disclose the company’s approach to risk management as a form of signalling to the company’s stakeholders. As has been shown in the preceding examples of EVT, Woolworths, JB Hi-Fi and Newcrest, remuneration reports included in annual reports now contain information about how performance is measured for remuneration of directors and senior executives. These reports send an important signal to shareholders that the short-term and long-term remuneration of directors and senior managers is inextricably linked to improving shareholder value, as shown in Example 5.7.

Example 5.7: Risk management and signalling at WestpacLike all Australian banks, Westpac is subject to a large number of regulatory agencies, including the Australian Prudential Regulation Authority (APRA), Reserve Bank of Australia (RBA), Australian Securities and Investments Commission (ASIC), Australian Securities Exchange (ASX), Australian Competition and Consumer Commission (ACCC), Australian Transaction Reports and Analysis Centre (AUSTRAC) as well as the regulatory agencies of the other countries in which it operates.

The Basel Committee on Banking Supervision (BCBS) provides a global regulatory framework known as Basel III. Basel III, among other things, has increased the required quality and quantity of capital held by banks and introduced new standards for the management of liquidity risk.

Westpac’s annual report highlights risk management as a key area that needs to be addressed in order for Westpac to achieve its vision, because risk management affects all aspects of Westpac’s business and its stakeholders.

Westpac has an ‘Operational Risk Management Framework’ and ‘Compliance Management Framework’ it uses to manage risks, and also a ‘Sustainability Risk Management Framework’ it uses to assess and manage CSR-related risks.

Westpac’s annual report notes that the culture in the bank is that all staff are responsible for identifying risk, managing risk and working according to Westpac’s nominated risk profile.

You can access the details of Westpac’s approach to risk management in its annual report, which is available at: https://www.westpac.com.au/about-westpac/investor-centre/. Click on ‘2017 Annual Report’ and navigate to p. 105.

Signalling does not just occur between the organisation and outside stakeholders. Managers in large organisations often devote much time to competing for resources for their business unit, project or team. The need to manage and improve performance can lead to claims by managers for additional resources for their business units. Often, managers who can demonstrate success in achieving their performance goals are more likely to be given increased access to resources in the future.

Organisations need to ensure that the signals they send are accurate. Public relations and marketing are important elements of communication, including investor relations, but a very real risk is when an organisation puts too much faith in its own press releases rather than the underlying reality of performance.

https://www.westpac.com.au/about-westpac/investor-centre/

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At the time of writing, Australian financial institutions, including Westpac and other banks, were facing considerable reputational and potentially financial risks arising from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Criticism of all financial institutions has focused on their STI-driven profit focus possibly directing the behaviour of some employees towards unethical practices. Time will tell what the consequences are of the Royal Commission for banks and other financial institutions. From a signalling perspective, the Royal Commission draws to our attention to the idea that we cannot rely on the statements of any business without considering other relevant factors in the public domain.

Further information about the Royal Commission is available at: https://financialservices.royalcommission.gov.au/Pages/default.aspx.

A historical example, the HIH case (Example 5.8), illustrates the impact on a financial institution of an earlier Royal Commission.

Example 5.8: HIH Insurance The collapse of HIH Insurance Group, placed into provisional liquidation in March 2001, was—and remains—the largest corporate failure in Australian history. The subsequent suspicions about a serious level of corporate mismanagement within HIH saw the appointment of a Royal Commission later that year. The Royal Commission’s report was publicly released in April 2003 and had a significant influence on the ASX’s Principles of Good Corporate Governance and Best Practice Recommendations, from which the ASX’s current (2014) definition of corporate governance was derived.

The ‘Royal Commission did not find fraud or embezzlement to be behind the collapse. HIH’s failure was found to be ‘more the result of attempts to paper over the cracks caused by over-priced acquisitions and too much corporate extravagance’ (Parliament of Australia 2003). There was a misconception in the company that ample funds were available to fund these activities.

According to the Parliament of Australia (2003), ‘The primary reason for the failure was that adequate provision had not been made for insurance claims. Past claims on policies had not been properly priced. HIH was mismanaged in the area of its core business activity’.

The Royal Commission further found that ‘the acquisition of FAI Insurance Ltd in Australia, combined with re-entry into the US market and the expansion of the UK operations’ (Parliament of Australia 2003), were poor commercial decisions. All were afflicted with under-provisioning for mandatory claims reserves.

While HIH had a corporate governance model, the Royal Commission found that HIH had failed to review the model to assess its suitability for changing circumstances in the insurance industry. HIH’s audit committee focused almost exclusively on the financial statements, rather than taking on the function of overall risk identification and assessment.

…

The Royal Commission noted that a culture appeared to have developed within HIH not to question leadership decisions (Parliament of Australia 2003).

Alcock and Bicego (2003) wrote that the Royal Commissioner was:

… frustrated by what he described as the disinclination of HIH middle managers to accept responsibility for undesirable practices. He identified the difficulties for the Royal Commission in considering conduct where middle managers had taken steps that resulted in the falsification of the corporation’s accounts or returns lodged with statutory authorities. In some instances, he observed … someone prepared a report knowing it to be false but did not sign it. The more senior officer who then signed the document would assert as ‘reasonable’ his or her reliance on the more junior employee who prepared the report, to argue that the senior officer’s conduct did not constitute a breach of the law (Alcock & Bicego 2003).

https://financialservices.royalcommission.gov.au/Pages/default.aspx

https://financialservices.royalcommission.gov.au/Pages/default.aspx

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HIH is a clear example of the failure of corporate governance, and the failure to provide appropriate signalling to investors. It is also a clear case of the failure of management controls and risk management, especially in relation to provisions for insurance claims and acquisitions. The performance of HIH was misinterpreted, through a combination of a lack of competence and poor ethical practices.

Corporate failures are a feature of all capitalist economies. In Australia there have been many failures before and after HIH (see Example 5.9 for a more recent case), but there have been no corporate failures since HIH that approach its magnitude.

The role of regulatory bodies and auditors always comes under scrutiny following large-scale and high-profile corporate collapses. This is likely to happen as a result of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in which questions about corporate governance and organisational culture have (at the time of writing in 2018) already been raised.

Example 5.9: Dick Smith Group The Dick Smith Group (DSG) operated consumer electronics retail stores and an online consumer electronics retail business throughout Australia and New Zealand from in excess of 390 locations with in excess of 3000 employees. It was listed on ASX in 2013. In January 2016, DSG and its Australian subsidiaries were placed into voluntary administration by its directors. Banks subsequently appointed receivers and managers to recover the assets over which they held security.

The report to creditors by administrators McGrath Nicol identified the reasons for the failure:

Although DSG reported profits, its growth required considerable financial commitment, during a period where DSG was losing market share. The competitive electronics environment resulted in tightening credit terms, the need for major inventory impairment, and significant cash pressure in late FY16. Increased borrowings and new finance facilities were required and ultimately DSG could not operate within the terms of those facilities (McGrath Nicol 2016, p. 10).

The administrators believed that DSG failed because of its high cost base due to its large network of stores, a loss of market share in a highly competitive market, an expansion plan requiring considerable financial resources and purchase of inventory that was not justified by consumer demand. Ultimately, its cash flows were unable to satisfy the covenants it had made with bank lenders.

Banks were paid a proportion of their secured debt but unsecured creditors and shareholders received nothing. The total shortfall to creditors was about $260 million (McGrath Nicol 2016).

The example of Dick Smith, like HIH, shows the importance of sound risk management as part of governance processes. It also reveals that signalling risk factors to investors is not always as clear as it should be. The suppliers, lenders and customers of Dick Smith are not likely to have understood the risk of rapid expansion, competition and increases in inventory holdings.

Company annual reports require extensive disclosure of risk management information, but rely on the due diligence of investors. Unfortunately, many small investors do not sufficiently understand the nature of risk in their investments and perhaps take too much comfort from audit reports and bank lending (which is typically secured).

While signalling is an important element of understanding performance and the risks associated with performance, the examples of corporate failure here perhaps reveal: • failures in risk management at board level• failures of adequate regulatory body oversight• a lack of understanding of risks of investment by investors.

Further detail on governance is presented in the Ethics and Governance subject of the CPA Program.

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The context in which the accountant operates is dictated by the organisation’s approach to governance and risk management and how these are connected to performance management.

Governance, risk and performance managementIn Australia, the Corporations Act provides the broad legal framework under which companies operate. Two organisations provide regulation for companies and securities in Australia: the Australian Securities and Investments Commission (ASIC) and the Financial Reporting Council. ASIC is Australia’s corporate, markets and financial services regulator. It ensures that Australia’s financial markets are fair and transparent, supported by confident and informed investors and consumers. ASIC administers and enforces the Corporations Act and is required to: • maintain, facilitate and improve the performance of the financial system• promote confident and informed participation by investors and consumers in the

financial system• administer and enforce the law• make information about companies and other bodies available to the public as soon

as practicable.

The ASX Corporate Governance Council has produced corporate governance guidelines for Australian listed entities in the third edition of its Corporate Governance Principles and Recommendations (effective from July 2014). Corporate governance is defined in this publication as ‘the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled within corporations. It encompasses the mechanisms by which companies, and those in control, are held to account’. Further, it defines good corporate governance as promoting ‘investor confidence, which is crucial to the ability of entities listed on the ASX to compete for capital’ (ASX 2014, p. 3).

It is interesting to note that the ASX guidelines have taken the definition of corporate governance from Justice Owen in the Report of the Royal Commission into HIH Insurance, volume 1: ‘The failure of HIH Insurance: A corporate collapse and its lessons’ (HIH Royal Commission 2003, p. xxxiv). HIH focused the minds of regulators and boards of directors on their roles and responsibilities, much of which is now reflected in the ASX publication.

There are eight general principles in the ASX Corporate Governance Principles and Recommendations, which also contains 29 recommendations to give effect to the principles. Listed Australian entities are required to make disclosure in their annual reports regarding the extent to which they do or do not follow the principles and recommendations.

You can access the Corporate Governance Principles and Recommendations at: http://www.asx.com.au/documents/asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf.

Accountants, as significant advisers to the board, play a significant role in contributing to good corporate governance, not only in terms of safeguarding the integrity of financial reports (the fourth principle), but also in contributing to a system of management control that monitors and evaluates performance (the first principle); and establishing and evaluating a risk management framework (the seventh principle).

Corporate governance can be described as constituting the entire accountability framework of the organisation, with two dimensions: 1. conformance, and 2. performance.

http://www.asx.com.au/documents/asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf


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Conformance takes place through assurance (including audit), ensuring that the organisation understands and is managing its risks effectively. While conformance is an essential aspect of corporate governance, it needs to be balanced with performance.

Performance is the need to take risks to achieve objectives, and to do this, risk management needs to be integrated with decision-making at each organisational level. Performance focuses on strategy, resource utilisation and value creation, helping the board to make strategic decisions, understand its appetite for risk and the key performance drivers [in order to achieve shareholder value] (Collier 2009, p. 21).

The board’s role is to set objectives, monitor performance in terms of achieving those objectives and report to shareholders on how well the organisation has performed. Risk management, in this context, is managing the risks of achieving—or not achieving—those organisational objectives. In a positive sense, the risk–return trade-off is that risks need to be taken in order to take advantage of opportunities for the organisation. In its negative sense, the risk is that those objectives will not be achieved. Management controls are put in place to help manage both kinds of risk. Boards will often delegate some of their role to a finance committee (to monitor financial performance), to an audit committee (to monitor the effectiveness of controls) and to a risk committee (to oversee the risk management process), although in practice some of these committees may be combined. These different approaches are recognised in the ASX Corporate Governance Principles and Recommendations (2014).

One of the key roles of the board in determining strategy is to articulate the risk–return trade-off and the organisation’s risk appetite. There is, generally speaking, a relationship between risk and return such that a higher return is expected when there is a higher risk, and a lower return accepted where the risk is lower. To guide management plans and decisions, boards need to be clear about whether the organisation’s strategy is risk averse, risk neutral or risk seeking, and make explicit the expected returns for risk-taking (e.g. minimum payback periods, internal rates of return, hurdle rates).

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) Enterprise Risk Management—Integrated Framework (COSO 2004) defines enterprise risk management as a process, effected by an entity’s board of directors, management and other personnel. It is applied across the enterprise and is designed to identify potential events that may affect the entity, to manage risk within its risk appetite and to provide reasonable assurance regarding the achievement of entity objectives.

COSO updated the framework in 2017 as Enterprise Risk Management—Integrating with Strategy and Performance, which highlights the importance of considering risk in both the strategy-setting process and in driving performance. The updated framework gives explicit focus to performance. The framework ‘Enhances alignment between performance and enterprise risk management to improve the setting of performance targets and understanding the impact of risk on performance’ (COSO 2017, p. iii). It further states that:

Enterprise risk management allows organizations to anticipate the risks that would affect performance and enable them to put in place the actions needed to minimize disruption and maximize opportunity (COSO 2017, p. 4).

The International Standards Organization also produced an updated risk management standard in 2018: ISO 31000:2018 Risk management—Guidelines, which provides principles, a framework and a common process for managing risk of any type. It can be used by any organisation regardless of its size, activity or sector. The new standard is an update of AS/NZS ISO 31000:2009 Risk Management—Principles and Guidelines, the Australian-developed international standard for risk management. Risk is now defined as the ‘effect of uncertainty on objectives’, which focuses on the effect of incomplete knowledge of events or circumstances on an organisation’s decision-making (Tranchard 2018).

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A brief summary of the new standard (which is only available to purchase from ISO) is at: https://www.iso.org/obp/ui#iso:std:iso:31000:ed-2:v1:en.

Performance management is fundamental to helping the board or its committees exercise the function of governance and risk management by monitoring performance information in terms of goal achievement, assessing risks and the effectiveness of management controls. Accounting information is one of the main sources used by boards to support the governance function. Accountants are involved in performance reporting to the board and in establishing and monitoring internal controls.

Management accountants in particular are commonly involved in risk management processes (Collier, Berry & Burke 2007).

Risk management is an important element of performance management because it establishes the boundaries of what is acceptable and unacceptable in terms of the risk appetite set by the board. This function results in the board defining the corporate strategy, the management controls and the performance measures necessary to manage risks and achieve organisational objectives. In particular, the board of directors must balance short-term and long-term expectations about performance—the notion of sustainability (discussed previously)—and also to some extent balance the needs of shareholders and other stakeholders. Finally, actual performance needs to be monitored against performance expectations, thereby satisfying the need for good governance. These relationships are shown in Figure 5.5.

Figure 5.5: Relationship between elements of the management control system

Corporate governance setsobjectives in line with

stakeholder expectationsand competitive situation

Management controls(financial, non-financial;quantitative, qualitative)

Enterprise risk management

Strategies and plans areimplemented and result in

organisational actions

Organisational outcomesFeedback

Performance measuresand targets


https://www.iso.org/obp/ui#iso:std:iso:31000:ed-2:v1:en

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➤ Question 5.4Consider the role of risk management and performance management in your organisation. If your organisation produces a publicly available annual report, do a word search on ‘risk management’, ‘performance’ or ‘KPIs’. If you work for a smaller organisation, you may be able to ask the CEO or chief financial officer (CFO) how they view the relationship between risk management and performance management.

How does risk management relate to performance management?


Ethics and performance managementCPA Australia members must comply with APES 110 Code of Ethics for Professional Accountants (the Code). The standard is based on the previous version of the Code of Ethics for Professional Accountants issued by the International Federation of Accountants (IFAC) (at the time of writing, the APESB had issued an Exposure Draft 02/18 outlining the proposed changes to APES 110, with a proposed effective date of 1 January 2020). The Code applies to members in business as well as members in public practice.

A CPA member’s responsibility is not exclusively to satisfy the needs of an individual client or employer, as the accountancy profession also has a responsibility to act in the public interest. The Code establishes a conceptual framework that requires CPA members to identify, evaluate and address threats to compliance with the fundamental principles. The conceptual framework approach assists a member in complying with the ethical requirements of the code and meeting their responsibility to act in the public interest.

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The fundamental principles in the Code are:

(a) Integrity—to be straightforward and honest in all professional and business relationships

(b) Objectivity—not to compromise professional or business judgments because of bias, conflict of interest or undue influence of others.

(c) Professional competence and due care – to:

i. Attain and maintain professional knowledge and skill at the level required to ensure that a client or employing organization receives competent professional service, based on current technical and professional standards and relevant legislation; and

ii. Act diligently in accordance with applicable technical and professional standards.

(d) Confidentiality—to respect the confidentiality of information acquired as a result of professional and business relationships.

(e) Professional behaviour—to comply with relevant laws and regulations and avoid any conduct that the professional accountant knows or should know might discredit the profession (s. 110.1 A1).

The circumstances in which members operate may create specific threats to compliance with the fundamental principles.

Threats to compliance with the fundamental principles might be created by a broad range of facts and circumstances. It is not possible to define every situation that creates threats. In addition, the nature of engagements and work assignments might differ and, consequently, different types of threats might be created (s. 120.6 A2).

Threats to compliance with the fundamental principles fall into one or more of the following categories:

(a) Self-interest threat—the threat that a financial or other interest will inappropriately influence a professional accountant’s judgment or behavior;

(b) Self-review threat—the threat that a professional accountant will not appropriately evaluate the results of a previous judgment made; or an activity performed by the accountant, or by another individual within the accountant’s firm or employing organization, on which the accountant will rely when forming a judgment as part of performing a current activity;

(c) Advocacy threat—the threat that a professional accountant will promote a client’s or employing organization’s position to the point that the accountant’s objectivity is compromised;

(d) Familiarity threat—the threat that due to a long or close relationship with a client or employing organization, a professional accountant will be too sympathetic to their interests or too accepting of their work; and

(e) Intimidation threat—the threat that a professional accountant will be deterred from acting objectively because of actual or perceived pressures, including attempts to exercise undue influence over the professional accountant (s. 120.6 A3).

Where an ethical conflict exists, a CPA member should determine the appropriate course of action that is consistent with the fundamental principles in the Code. CPAs should also weigh the consequences of each possible course of action. If the matter remains unresolved, a CPA member should consult with other appropriate persons within the employing organisation—particularly the board—for help in obtaining a resolution. A CPA member should also consider obtaining legal advice to determine whether there is a requirement to report the matter to an appropriate authority.

If after exhausting all feasible options, the professional accountant determines that appropriate action has not been taken and there is reason to believe that the information is still misleading, the accountant shall refuse to be or to remain associated with the information (IESBA Code, s. R220.9).

In such circumstances, it might be appropriate for a professional accountant to resign from the employing organization (IESBA Code, s. 220.9 A1).

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Ethics has a great deal of relevance to those responsible for performance management, whether this is reporting performance in an organisation in which an accountant is employed or reporting performance to a client. Accountants may feel under pressure to manipulate or report performance information as a result of any of the threats identified in the Code (some of these behaviours are described in Example 5.10).

Example 5.10: WorldCom, Enron and Arthur Andersen

WorldCom filed for bankruptcy protection in June 2002. At the time, it was the biggest corporate fraud in history. The US Securities and Exchange Commission said WorldCom had committed ‘accounting improprieties of unprecedented magnitude’ (SEC 2002). The company used accounting tricks, largely by treating operating expenses as capital expenditure to conceal a deteriorating financial condition and inflate profits. WorldCom admitted in 2004 that the total amount by which it had misled investors over the previous 10 years was almost USD 75 billion and reduced its stated pre-tax profits for 2001 and 2002 by that amount. Former WorldCom chief executive Bernie Ebbers resigned in April 2002 and is currently serving a 25-year prison term. Scott Sullivan, former chief financial officer, entered a guilty plea and was sentenced to five years in prison as part of a plea agreement in which he testified against Ebbers.

In December 2001, US energy trader Enron collapsed. At the time, it was the largest bankruptcy in US history. Even though the United States was believed by many to be the most regulated financial market in the world, it was evident from Enron’s collapse that investors were not properly informed about the significance of off-balance sheet transactions. US accounting rules may have contributed to this, in that they were more concerned with the strict legal ownership of investment vehicles rather than with their effective control. The failure of Enron highlighted the over-dependence of an auditor (Arthur Andersen) [on one particular client] (Collier 2015, p. 86).

It also highlighted the employment of staff by Enron who had previously worked for their auditors, the process of audit appointments and reappointments, the rotation of audit partners, and how auditors are monitored and regulated.

Before the Big 4 accounting firms, there was a ‘Big 5’, one of which was Arthur Andersen. The firm was found guilty of criminal charges in relation to the audit of Enron and its actions in relation to disguising Enron’s off-balance sheet transactions, with the firm having instructed its employees to destroy documents pursuant to its document retention policy. As a result, the firm surrendered its licence to practise as accountants in the United States. While the criminal verdict was subsequently overturned by the US Supreme Court on the basis that the jury was misdirected as to the law, the damage to Arthur Andersen’s reputation was substantial and the firm ceased to exist, with other accounting firms taking over its client business.

WorldCom’s and Enron’s focus on performance was almost exclusively financial, oriented on short-term profits and share prices. This focus was supported by bonuses and share options to reward executives for short-term profits that resulted in a culture under which ethical principles were largely ignored. The focus on short-term financial performance obscured more fundamental non-financial measures that might have provided signalling to those outside the companies that something was wrong.

The examples of HIH in Australia and WorldCom and Enron in the United States highlight the role of accountants in measuring and reporting performance with integrity, objectivity, competence and due care. Not only is a failure to do so a breach of professional ethics but it can lead to criminal penalties (there is often a fine line between a breach of ethics and a breach of the law). In addition, the practice of auditing was permanently affected by these cases. In particular, audit firms are required to demonstrate independence and clearly separate their audit and non-audit—for example, consulting—services.

Further detail on ethics is presented in the Ethics and Governance subject of the CPA Program.

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Two theories—agency theory and contingency theory—are relevant to gaining a better understanding of how accountants affect and are affected by performance management.

Theories related to performance managementAgency theoryAgency theory is about the relationship between principals (owners of a business) and directors and managers, who act as the agents of the owners. This is particularly relevant where there is a separation between owners and managers, as is most common in listed companies.

Control systems and performance management are used by principals to monitor the actions of their agents. The principals delegate authority to agents, but the agents may act in their own self-interest rather than in the interests of the principals.

A simple example of the agency problem is when selling a property. The real estate agent is the agent of the seller and is expected to obtain the highest price for the property in an open market in return for a commission—typically a percentage of the selling price. But the reward for the agent in obtaining an additional amount—say $5000—on the sale price may not warrant the extra effort, so they may recommend to their principal a lower, but easier to obtain, sale price.

Similarly, managers may award themselves high levels of remuneration, without exercising enough effort. To overcome this potential problem, the ‘sharing rule’ rewards the agent for performance that benefits the principal. So managers will typically receive at least some of their remuneration through, for example, profit-related bonuses and share options. For example, as discussed previously, director and senior executive remuneration is linked to performance management through STIP and LTIP as disclosed in the remuneration reports within annual reports.

Agents may avoid their responsibilities, as principals can never really be sure whether reported performance is the result of the agent’s own efforts or of business conditions generally. One of the criticisms of executives that emerged from the Global Financial Crisis (GFC) of 2007–08 (see Example 5.21) was the level of remuneration paid to executives, even when market conditions in many industries collapsed. The same concern has been raised at hearings of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry in relation to the payment of senior executives of banks that may have led to unethical practices with customers.

Agents may also be tempted to disguise true performance levels to inflate their remuneration packages and their reputations as managers. Financial reporting to shareholders is one way principals can hold agents accountable for their performance. However, the notion of ‘information asymmetry’ is that agents have far greater access to performance information than do principals. This means managers always have access to detailed management accounting information, including non-financial performance reports, that are unseen by shareholders.

Being aware of potential problems in the agency relationship is important in understanding the role of accountants in performance management.

Further detail on agency theory is presented in the Ethics and Governance subject of the CPA Program.

Contingency theoryAnother theory that is relevant to performance management and the role of the accountant is contingency theory, which states that there is no universal best way to measure performance. Each organisation needs to develop an appropriate performance management system that is relevant to its needs. This theory suggests that the performance management system used by an organisation will depend to a large extent on such factors as the size of the organisation, its environment and its technology.

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Table 5.2 provides a hypothetical example of the performance measures that may be used by two businesses in the retail food industry. The technology and systems in place for a large multi-store retail chain and a small local shop reflect the contingency theory approach.

Table 5.2: Comparison of control systems and performance measures for large and small food retailers

Large multi-store food retailer Owner-managed suburban food retailer

Management control system:

Comprehensive performance information by store and product group, which is necessary both for management planning and decision-making and to provide the information needed to report to shareholders

In-store barcode scanner and integrated cash register and electronic funds transfer at point of sale (EFTPOS)

Simple performance reporting system, probably cash-based with sufficient record keeping to satisfy taxation requirements

Simple cash register and separate EFTPOS facility

Likely performance measures:

Daily sales by hour of day—to help with rostering— and by product group

Daily sales

Average revenue per customer—provided by cash register

Average revenue per customer—may be provided by their bank, which provides information on all EFTPOS/credit card transactions

Customer retention—based on loyalty card Customer satisfaction with staff service—approximation based on observation

Sales per square metre and sales per employee

Time to scan customer’s shopping basket—per item scanned

Waiting time for customer—approximation based on observation

Gross margin per day—point of sale (POS) scans barcode and calculates margin

Periodic physical stocktake verifies margin

Stock reordering—POS scans barcode and updates inventory, identifying when to order and may automatically place order on suppliers

Owner/manager orders stock by physical observation and manual reordering

Number of stores and locations based on demographics and competition

Single site—location based on rental cost

Technology investment—percentage of sales Technology cost—dollars

Profit by store location Cash at bank

Number of products—maximise variety and choice Number of products—minimise inventory and wastage

Stock losses—difference between physical stock count and computer inventory record

Stock turnover—financial statement ratio Investment in inventory—dollars

Employee turnover—from human resources (HR) records

Time spent by owner/manager recruiting and training new staff—informal judgment


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➤ Question 5.5Barbara Smith (CPA) works as the CFO of a privately owned company with annual sales of $10 million. Kevin Jones, the CEO, is the main shareholder, who also acts as chair of the board. The only other directors are you and Kevin’s wife.

After producing the draft end-of-year financial statements, Barbara discusses the results with Kevin. His response is that the profit of $250 000 is too high and the tax bill the company will have to pay will prevent the company from repaying its bank loan in the following financial year. As the company does not keep a perpetual inventory system but relies on standard costs of goods sold (COGSs) and periodic stocktakes, Kevin suggests to Barbara that the year-end stocktake figure be reduced in order to reduce the taxable profit to around $150 000.

Barbara responds that such a practice is illegal. Kevin’s reply is that the inventory level at year end was close to $1 million, so any adjustment could be readily disguised. Over Barbara’s further objections, Kevin demands that Barbara adjusts the inventory downwards by $100 000 and that if she is not prepared to make the adjustment, then she might as well resign from the company today.

(a) Discuss the implications of Kevin’s demand in relation to the following:

(i) Governance

(ii) Signalling

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(iii) Ethics

(b) Recommend any actions that Barbara may be able to take.


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Part B: Strategy, management control and performance managementPart A considered the role of performance management (both financial and non-financial) in value creation and sustainability. Performance management was outlined in the broader context of corporate governance and risk management, as well as the importance of ethics. Part B looks in detail at the role of strategy in performance management and how performance management can be seen as an important element in management control. The limitations of some traditional accounting performance measures are considered. The different models of performance management, including the Business Model Canvas, balanced scorecard, the role of strategy mapping and the role of information systems in performance management, are introduced.

Performance management and control—their role in strategyMintzberg and Waters (1985) defined strategy as a pattern in a stream of decisions. They separated the intended from the realised strategy, arguing that deliberate strategies provided only a partial explanation, because some intended strategies were unable to be realised while other strategies emerged over time. As discussed in Module 1, a common description of intended or deliberate strategy formulation is to begin with establishing objectives and goals. This is followed by an internal appraisal of strengths and weaknesses and an external appraisal of opportunities and threats (the SWOT analysis). This leads to a choice from various strategic options of decisions such as diversification or the formulation of a competitive strategy (Ansoff 1988).

Strategy must be implemented after it is formulated, and it is here that performance management is important. Ansoff (1988) established a hierarchy of objectives that were centred on performance measures such as return on investment. Similarly, Galbraith and Nathanson (1976, p. 10) argued that ‘variation in strategy should be matched with variation in processes and systems as well as in structure, in order for organisations to implement strategies successfully’. These variations in processes and systems would include variations in performance management.

As discussed in Module 1, various approaches to strategy have been developed by Michael Porter. Porter (1980) developed his five forces model for analysing an industry’s strategic environment: 1. the threat of new entrants to the market2. the threat of substitutes3. the bargaining power of customers4. the bargaining power of suppliers5. rivalry (competition) within the industry.

Porter (1980) also identified three ‘generic strategies’ for competitive advantage: 1. cost leadership2. differentiation3. focus.

All strategies should contain goals and organisations need to introduce a system of performance management comprising processes for measuring, monitoring, reporting and improving performance to ensure that goals and strategies are achieved. Different strategies require different approaches to performance management. For example, an organisation facing substantial industry competition may measure market share (e.g. the motor vehicle sales and retail supermarkets industries). An organisation facing substantial bargaining power by customers may measure customer profitability (e.g. clothing manufacturers selling to department stores such as Myer and David Jones in Australia). Similarly, if an organisation adopts a cost leadership strategy, we would expect to see performance measures that focus on efficiencies in purchasing and production to achieve cost reduction and competitive pricing (e.g. the manufacture of

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mobile phones). By contrast, an organisation adopting a differentiation or focus strategy (where cost and price are less important) may give more attention to performance measures related to innovation, product features and benefits, advertising effectiveness or brand reputation. For example, the performance measures used by Ford and BMW are likely to be different. Although it is likely that both companies will focus on performance measures for cost and brand reputation, the emphasis they give to those performance measures is likely to be quite different.

The particular performance measures adopted by any organisation will depend on its strategy and objectives. This follows from contingency theory—that is, an organisation will select appropriate performance measures contingent on factors including its strategy and competitive position, as well as its technology and size. These performance measures will then be used to monitor how well the organisation achieves its strategy.

Porter (1985) also introduced the ‘value chain’ as a tool to help create and sustain competitive advantage through recognising the need to add value in each of the organisation’s primary activities.

The concept of creating value was explained in Module 1 and in Part A of this module. Porter argued that customers are prepared to pay for the value created but that organisations need to keep the cost of generating this value lower than the premium customers are willing to pay. This is the margin in the value chain—the difference between the cost of providing the primary and support activities, and the revenue gained from customers.

As for different approaches to strategy, an organisation’s value chain is likely to influence its performance measures. Example 5.11 shows performance measures for a retail store, based on the primary and support activities in the value chain.

Example 5.11: Performance measures and the value chain—a retail store example

Value chain activity Examples of performance measures

Primary activities

Inbound logistics On-time deliveries from suppliers

Operations Out-of-stock products on store shelves

Outbound logistics Queuing time for customers at checkouts

Marketing and sales Store recognition (survey)

Service Customer complaints

Support activities

Procurement Days’ payables outstanding

Technology development Computer downtime

HR management Staff turnover

Firm infrastructure Sales per square metre of floor space


These performance measures might be developed by identifying key value-adding activities for the retail store, on the assumption that sales revenue and margin are affected by each of these aspects of performance. It is important to note that Example 5.11 lists examples of performance measures. Each organisation would develop the performance measures it deems appropriate to achieve its strategic objectives.

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➤ Question 5.6Revisit the information in Question 5.3 about Mega Markets—both the question and suggested answer. Using Porter’s generic strategies, complete the following table.

(a) How would you describe Mega Markets’ strategy?

(b) Compare the value chain for Mega Markets with one of its international online competitors.

Mega Markets Online competitor

Primary activities

Inbound logistics

Operations

Outbound logistics

Marketing and sales

Service

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Support activities

Procurement

Technology development

HR management

Firm infrastructure


Review Appendix 5.1 for a good example of how strategy influences performance management.

Strategy and decision-makingStrategy is concerned with achieving organisational objectives. Objectives are achieved by allocating organisational resources (e.g. property, equipment, people and finances) to activities that are effective (i.e. that generate revenue) and cost-efficient (i.e. the cost of the activity is lower than the revenue generated).

Decision-making is concerned with making choices from alternative courses of action. This requires an understanding of the desired objectives, some knowledge of the alternatives and the ability to estimate the likely results of each alternative.

Often there will be conflicting objectives, including long-term and short-term financial objectives. In the short term, profits and cash flow must satisfy investors, but not at the expense of long-term sustainable profits and cash flow.

There will also be non-financial objectives such as maintaining environmental and social values. When non-financial performance objectives are added (e.g. market share objectives or the need for innovation), the resulting multiple objectives will impact on management decisions.

Alternative courses of action may be imperfectly known as they will require information about customers, markets and suppliers that may be unknown. The results of those alternatives are based on predictive models (the assumed cause-and-effect relationships) that are also imperfect.

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Management control is most commonly seen as a critical element of strategy implementation, which is a process of establishing targets, measuring actual performance and taking corrective action where actual performance differs from the targets. The most common definitions of management control relate to achieving an organisation’s strategic goals and influencing behaviour during environmental change (e.g. Anthony 1965). A management control system implies an integrated set of individual controls that is intended to help accomplish strategy by controlling resource inputs, influencing the production process and monitoring outputs (Daft & Macintosh 1984).

Management controls are focused on objectives set during the organisation’s strategic planning and budgeting cycles. However, market conditions change between these planning and budget cycles as competitors’ strategy and economic conditions alter and customer demand fluctuates. Decision-making needs to consider current circumstances rather than be overly focused on an objective that was set at a different time when conditions were different. So there may be tension between the needs for management control and for more flexible decision-making.

Decision-making by managers will focus on objectives, but it must also consider approaches besides passing on higher costs through increased pricing, and the impact they might have on revenue, market share and profitability.

Strategy and management controlThe most easily recognisable forms of control are ‘cybernetic’ forms of control, based on a feedback cycle. Cybernetics is the science of communication and control processes in both natural and human-made systems. Feedback is the process by which variations between actual and desired performance are fed back into the process to achieve corrective action and bring actual performance in line with expectation. The simplest example of a cybernetic control is a room thermostat. A thermostat has a set standard (the desired room temperature), a method of measuring the temperature (a thermometer), a comparison (between desired and actual temperature) and a means of correction (heating where the room temperature is too low; cooling where the room temperature is too high).

In this simple feedback model, decisions need to be taken about the standard to apply, the method of measurement, a means of comparison and the ability to take corrective action.In the business environment, the cybernetic approach and feedback can be illustrated by a comparison between target and actual sales performance. The target (or budget) performance for a sales department may be a specified level of sales revenue. The accounting system is the method by which the business measures actual sales revenue. Comparison takes place by reporting both the target and actual sales income and calculating the variance. Feedback takes place by using the comparative data to determine corrective action by management to improve future performance relative to target. These actions may include sales force training, additional marketing, incentives or perhaps modifying the target. This is the heart of performance management—using performance information to manage actual performance so that goals and objectives are attained.

➤ Question 5.7 SalesVol Ltd (SalesVol) uses a ‘budget versus actual’ comparison. The company budgets to sell 10 000 units of a product at an average selling price of $3.50. At the end of the period, the accounting system records actual revenue of $33 750 for 9000 units. Three versions of reporting from an accounting system are shown. The first two use a traditional budget approach, while the third uses a flexible (or flexed) budget approach (as discussed in Module 3).

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(i) Traditional budget

Budget Actual Variance

Sales revenue $35 000 $33 750 –$1 250 (Unfavourable)

(ii) Expanded information

Budget Actual Variance

Sales volume 10 000 9 000 –1 000

Average selling price $3.50 $3.75 $0.25

Sales revenue $35 000 $33 750 –$1 250 (Unfavourable)

(iii) Flexible budget

BudgetFlexed budget Actual

Quantity variance

Price variance

Sales volume10 000 9 000 9 000

$3 500(Unfavourable)

$2 250(Favourable)

Average selling price $3.50 $3.50 $3.75

Sales revenue $35 000 $31 500 $33 750 –$1 250 (Unfavourable)

(a) Use the information in each version of the report to explain the elements of cybernetic or feedback control that led to corrective action.

(i) Traditional

(ii) Expanded

(iii) Flexed

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(b) Explain how each report could be useful to management decision-making.

(i) Traditional

(ii) Expanded

(iii) Flexed


Question 5.7 focuses on cybernetic control because it tends to dominate accounting systems. However, there are many ‘informal’ kinds of control that might not always be readily observable, particularly those based on employees’ culture and belief systems.

Internal control is:

the process designed, implemented and maintained by those charged with governance, management and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations (AUASB 2018).

Management control is a much broader concept, covering all the processes used by managers to ensure that organisational goals are achieved and organisations respond to changes in their environment. Performance management is an integral part of management control, and while relevant to internal control, it is more concerned with performance improvement than compliance, which is the greater concern of internal control.

Otley (1999) argued that performance management provides an important integrating framework for the different elements of management control systems, containing both formal and informal kinds of control. A further framework for performance management systems (PMSs), developed by Ferreira and Otley (2009), contains eight core elements: 1. vision and mission2. key success factors3. organisation structure4. strategies and plans5. key performance measures

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6. target setting7. performance evaluation8. reward systems.

These are influenced by four other factors: 1. PMS change2. PMS use3. strength and coherence of the core elements4. information flows, systems and networks.

The PMS exists within a set of broader contextual and cultural influences.

Chenhall (2003) writes that the definition of management control systems has evolved from formal, financially quantifiable information to include: • external information relating to markets, customers and competitors • non-financial information about production processes• predictive information• a broad array of decision support mechanisms and informal personal and social controls.

So management control and performance management, which has financial, non-financial, quantitative and qualitative dimensions (as already discussed), have become almost synonymous.

➤ Question 5.8Reconsider the information in Question 5.7. Apart from the financial controls shown in the various ‘budget versus actual’ reports, what additional formal and informal controls are likely to influence sales behaviour in a company like SalesVol Ltd? (In responding to this question, think about the kinds of controls listed in the previous discussion.)


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Limitations of traditional controls Traditional management controls, especially those that are accounting-based, have been criticised for their limitations.

Return on investment (ROI), for example, is often used to measure financial performance, but it has long been argued that ROI has significant limitations. There are substantial questions around:

• the level of investment that should be used: total capital employed or net assets;

• whether assets should include non-current, current or both; and

• whether assets should be valued at cost or book value (Solomons 1965).

Johnson and Kaplan (1987) pointed out two other limitations: • whether a high rate of return on a small capital investment was better or worse than a lower

return on a larger capital, and • that managers could increase their reported ROI by rejecting investments that yielded returns

in excess of their organisation’s (or division’s) cost of capital, but that were below their current average ROI.

For example, assume that the organisation’s cost of capital was 15 per cent and that Division A is currently operating on an ROI of 25 per cent. However, the manager of Division A rejects an investment that is going to return 20 per cent, because it would lower Division A’s ROI. This is problematic for the organisation as a whole, because the 20 per cent return from that investment is still higher than the organisation’s cost of capital (15%).

As traditional accounting measures are criticised for being less relevant in the modern business environment, non-traditional approaches that are industry- and organisation-specific take on new meaning, while non-financial performance measures take on a greater level of importance in guiding organisations towards their goals. Example 5.12 illustrates how one company (TNA) created a different approach where traditional accounting tools failed to help the organisation’s strategy.

Example 5.12: TNA—a strategic management accounting approach to performance management

TNA is a privately owned engineering company based in Australia, with multinational sales of computer-controlled packaging equipment to large food manufacturers. TNA’s global success was derived from its innovative design, worldwide patent protection, continual investment in research and development (R&D), and the development of export markets. From the start-up of the business, accounting performance was of limited value to TNA’s owners. Accruals accounting on a financial year basis did not take into account the long lead times (often several years) between R&D and export market development expenditure and income from sales. For the same reason, budgets (other than budgeted sales volume) were of limited use. TNA rewarded its marketing and research staff through high salaries and bonuses in order to retain their expertise. The company also expended many millions of dollars in legal fees in patent litigation against much larger companies that were infringing TNA’s patents. It took many years for TNA to win these actions and recover costs and damages. While accounting was necessary for regulatory and taxation purposes, it was not used for management control.

TNA designed its computer numerical control (CNC) equipment but subcontracted manufacture of the components to various suppliers, then assembled the final machines in its Melbourne factory, before delivering them to customers. This avoided the problems of capacity utilisation that are inherent in manufacturing companies.

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TNA had a pricing policy that discouraged discounting because of the technical superiority of its machines. This enabled a high margin between the selling price and the cost of the components. In its early years, TNA’s owners exercised management control through a cash flow based spreadsheet model, where the only real performance measures were the number of machines sold, the percentage of sales reinvested in R&D and the availability of cash to fund business growth. The model used sales volume to drive purchasing of components and assembly planning, included data on outstanding orders and inventory, and cash flow projections over several years. It was updated on an almost daily basis as new orders were received.

As the company grew, a much more sophisticated spreadsheet model was developed that thoroughly documented the industry in which TNA sold its machines, including the customers targeted for future machine sales and the competitors whose customers may be more susceptible due to the financial constraints of their current suppliers. Much of this data was gathered at engineering exhibitions, from websites and from informal conversations with suppliers and employees of TNA’s competitors.

Over a long time period, TNA’s owners developed this spreadsheet model to a point where it became the central management control tool used within the company. TNA’s performance measures now expanded to include a focus on growing market share and reaching what the owners termed a ‘critical mass’. TNA defined critical mass as:

having enough capital to withstand serious fluctuations in general business levels, being able to fund sufficient development to maintain the company’s leading edge in technology, and being able to withstand the onslaught from the competition (Collier 2005, p. 327).

The information in this spreadsheet enabled TNA to target the customers of weaker competitors and win more business than it might otherwise have been able to do.

The second version of the spreadsheet model is a good example of strategic management accounting. It looks beyond the current financial year, applying a life cycle perspective; it looks beyond the organisational boundary to the whole industry; and uses information to drive strategy implementation (Collier 2005).

As a privately owned company, TNA’s owners were unconcerned with short-term profits, seeing longer-term market share growth and reinvestment in research and export market development as far more important. Hence, profit targets and traditional financial performance measures held little importance, although cash flow was critical.

Example 5.12 illustrates the importance of performance management and a very informal kind of management control used to achieve the goals set by the organisation. It also shows that the accountant’s natural focus on financial performance is not always the most appropriate one.

There are other limitations of traditional controls, notably that gaming and biasing accompanies them, the tendency to focus on short-term performance at the expense of sustainable performance, and the masking of cause-and-effect relationships. These behavioural consequences are discussed in more detail later in this module.

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➤ Question 5.9Assume you are the CFO for an organisation with responsibility for financial reporting, accounts payable (AP) and accounts receivable (AR). Make a list of the management controls that could be implemented to help ensure that the organisation’s operations are efficient and effective.


Models of performance management Performance management should not be seen as a list of measures without any underlying framework. Example 5.11 provided a framework, the value chain, which developed performance measures for each of the organisation’s primary and support activities. In the section that follows, alternative models of performance management are discussed.

Operational and strategic performance One of the key elements of performance management is to distinguish operational from strategic performance. All business organisations, particularly listed organisations, need to achieve short-term financial performance that satisfies shareholder expectations. This is a function of agency theory. Each business unit, product, service or geographic segment of the business must contribute to whole-of-organisation performance, which needs to be achieved throughout the financial year in order to meet annual corporate targets. This relies on operational performance management, but there also must be a balance between the needs of short-term shareholders and the sustainability of performance over the longer term—for example, as discussed in Part A where companies report performance-related remuneration through STIPs and LTIPs.

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Strategic performance is concerned with sustainable performance over time at the whole organisational level, over multiple time periods, taking into account strategic goals, economic conditions and the competitive environment. Strategic performance is also concerned with product life cycles (see Module 6) and supply chains, and maintaining or increasing market share through competitive strategy (e.g. cost leadership, differentiation or focus strategies). Strategic performance is linked to risk management through the risk–return trade-off and the organisation’s risk appetite as determined by the board of directors.

Measuring strategic or operational performance requires a different set of key performance measures for each. Operational measures help to measure the short-term performance of an organisation, while strategic measures focus on the implementation of the organisation’s long-term strategy.

What these strategic performance measures are will be determined by the organisation’s strategy. Chenhall (2003) has argued that financial and non-financial measures cover different perspectives which, in combination, provide a way of translating strategy into a coherent set of performance measures. Chenhall (2005) argues that a key element of strategic measures is that they provide integrated information to help managers deliver positive strategic outcomes. He identifies three attributes of strategic measures:1. Strategic and operational linkages: these capture the overall extent of integration

between strategy and operations and across elements of the value chain.2. Customer orientation: linkages to customers including financial and customer measures.3. Supplier orientation: linkages to suppliers and includes business process and innovation

measures (Chenhall 2005).

Example 5.13 highlights the importance of balancing short-term operational performance with longer-term strategic performance, and extending the corporate view of performance beyond the organisation’s own boundary to its supply chain.

Example 5.13: Closure of the Australian automotive manufacturing industry

General Motors Co. closed its Holden factory in South Australia in October 2017, ending more than a century of car manufacturing in Australia. Shortly before, Toyota Motor Corp. had shut its plant in Victoria, where Ford Motor Co. had closed two sites in the previous year. The loss of jobs in the automotive sector was not limited to the big three but extended to the suppliers of automotive parts that fed into the Holden, Ford and Toyota assembly lines.

Over many years, Ford, General Motors (GM) and Toyota have all said they intended to cease their Australian production in the absence of continued government subsidies. In 2014, the Productivity Commission estimated that up to 40 000 people would lose their jobs as a result of the closure of these assembly plants and the resulting effect on other firms in the supply chain (Australian Government 2014, p. 2).

Companies like GM, Ford and Toyota, being listed on global stock exchanges, needed to satisfy short-term stock market expectations. Therefore, there was always an emphasis on financial measures such as ROI, return on capital employed (ROCE), sales growth, profit growth and cash flow—in fact, all the traditional financial ratios used to interpret business performance from the income statement and balance sheet.

Strategically, GM has suffered from falling market share and profits and was effectively saved from bankruptcy by the US Government during the GFC, while Ford narrowly escaped that predicament. Many of the problems faced by both companies have been caused by legacy health insurance and pension-fund contributions for past and present employees in the United States, sales demand that has fallen well short of GM and Ford’s production capacity and the high fixed costs that result from excess capacity. By contrast, Toyota steadily won global market share at the expense of the US companies, largely as a result of its longstanding commitment to quality and its emphasis on lean production,

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which it terms a ‘cost down’ approach. However, Toyota faced increased quality problems in the United States, which caused it some reputational damage, and suffered a major disruption to its supply chain as a result of the 2011 earthquake and tsunami and subsequent nuclear reactor damage in Japan.

Automotive companies like GM, Ford and Toyota are mainly designers and subsequently assemblers of those vehicles, with components sourced, often globally, from multiple suppliers. Automotive companies need to continually invest in new product designs to develop and introduce new model vehicles that meet anticipated economic conditions, market demand and competition. Given the time taken to bring a new product to market in the industry, this can be a complex process, involving identifying what customers may want several years into the future, the efficient design of new models, cost-effective purchasing of components and efficient assembly capacity utilisation.

Despite the needs of short-term financial performance reporting, automotive companies often adopt life cycle costing for their models (see Module 6), recording the profits (or losses) for each model of vehicle over each year of its life from initial design through to abandonment, in order to learn lessons that can be applied in future models. Japanese companies like Toyota appear to have been more effective in applying target-costing approaches (see Module 6) before a new model goes into production, and collaborating with suppliers to achieve the most cost-effective design, purchase cost and assembly processes. Japanese companies have also emphasised kaizen (continual improvement) approaches during production to drive costs down, while Toyota’s emphasis on lean production and ‘cost down’ through the Toyota Production System has been recognised as an important factor in Toyota’s success over its US automotive rivals.

The closure of assembly plants by Ford, GM and Toyota in Australia was a consequence of these companies having an inefficient scale of production due to Australia’s small market size and competition from imported vehicles, exacerbated by the strength of the Australian dollar relative to other currencies (especially the US dollar). The final element in Ford, GM and Toyota’s decision was the reduction, and then cessation, of government financial support for the industry. The Commonwealth Department of Industry has stated that the Australian vehicle manufacturing industry has not returned a profit since 2003. These are measures of strategic performance that these companies are unable to ignore.

As stated in Example 5.13, there is a substantial effect of these closures not just on direct employment but on the automotive component sector that supplies Ford, GM and Toyota. Many of these suppliers would have been aware of repeated press reports about the problems faced by the automotive industry in Australia. However, they may not have incorporated more strategic performance measures into their strategic plans—measures that would likely have addressed the life cycle of automotive products and the profitability of the whole supply chain.

Leading and lagging measures of performanceWhile the pursuit of shareholder value is crucial for listed organisations and for most businesses, performance management based on financial performance has two distinct limitations: 1. Financial measures (as mentioned previously) tend to focus on short-term performance,

sometimes at the expense of longer-term performance. 2. They are lagging rather than leading measures of performance.

Lagging means to follow, come afterwards or occur later on—in other words, lagging measures provide information about what has happened after the event, when it may be too late to take corrective action. A leading measure, on the other hand, provides a more ‘here and now’ view of performance and is likely to help explain, predict or even cause the result of a lagging measure.

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Any accountant will know that by restricting certain expenditures, there is likely to be an improvement in short-term profits, the consequences of which will only be felt in the medium or long term. For example, if an organisation restricts its expenditure on advertising, employee training, repairs and maintenance or R&D, there is not likely to be any significant negative impact on financial performance in the current year, but it is inevitable that financial performance in later years will suffer. Similarly, delaying new capital expenditure will defer higher depreciation charges, but will also delay any efficiencies or volume expansion that rely on capital expenditure. So an emphasis on leading measures (e.g. reducing expenditure on advertising, R&D, etc.) may improve current profits, but the lagging effect will almost certainly be felt on revenue and profits in later years.

Sales revenue (a lagging measure) may fall because of a decline in customer satisfaction, a consequence of performance reflected in a combination of many leading measures, such as quality of the product or service, how well the customer was treated, how fast the customer’s order or query was attended to, and the price of the product.

There are many performance measures available for different functional areas of an organisation. For example, possible measures for the marketing and sales function include: • number of promotional events• number of sales calls• advertising exposures• distribution outlets • products carried per outlet• delivery time• percentage of perfect orders (correct products delivered on time)• average time to resolve customer problems (Clark 2007).

Possible measures for the operations function fall under five broad headings: 1. quality pass rate2. dependability3. speed4. flexibility5. cost (Neely 2007).

Other measures apply to HR management, procurement and supply chains, as we saw in Example 5.11.

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➤ Question 5.10Chocabloc Ltd (Chocabloc) produces a wide range of chocolate bars. The company’s raw materials are mainly cocoa, imported from Brazil, and milk, sourced locally from dairy farms. The chocolate bars are distributed by a national logistics company to retail stores around the country.

Chocabloc has patented the formulas for its range of chocolate bars, many of which have been sold for a decade, while others have been sold for only a few months. The company spends considerable funds on R&D for new chocolate bars, and before each new product launch it engages in an exhaustive and expensive market research program to assess customer demand for the new product. If there is any doubt about the market potential of a new product, it is withdrawn.

Where market research indicates a strong likelihood of success, Chocabloc invests heavily in advertising and has a team of sales representatives in each sales region who visit retail stores and take orders for the chocolate bars. Those orders are processed at Chocabloc’s headquarters and are fulfilled by the logistics supplier. Extensive management attention is given to minimising wastage and ensuring product consistency through quality control.

Based on the information in this scenario, identify the performance measures that might be recommended to the management of Chocabloc. Consider strategic and operational measures (including leading and lagging measures). Include financial and non-financial performance measures in your list.

Strategic performance measures

Operational performance measures

Leading measures

Lagging measures


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Frameworks for performance managementThe use of measures of performance other than financial is not new. One of the earliest was the French tableaux de bord, a kind of instrument panel as would be used by a pilot. It was developed as a set of performance measures used in French factories and relied on the definition of a causal model at each organisational unit level by its manager.

Another interesting framework is the performance pyramid of Lynch and Cross (1991). The pyramid has descending objectives and ascending measures, beginning with corporate vision and cascading through successive layers of business units, core business processes, departments, work groups and individuals. One side of the performance pyramid is concerned with market performance (customer satisfaction, flexibility, quality and delivery) and the other side with financial performance (flexibility, productivity, cycle time and waste).

A framework that was developed specifically for service industries was the Results & Determinants Framework (Fitzgerald, Johnston, et al. 1991). In this framework, results (competitiveness and financial performance) were distinguished from the determinants of results (quality, flexibility, resource utilisation, innovation).

The European Foundation for Quality Management (EFQM) Excellence Model separates five enablers (leadership, people, policy and strategy, partnerships and resources, and processes) and four result areas (people, customer, society and key performance), all underscored by innovation and learning, with performance measures identified for each enabler and result area (see http://www.efqm.org). The EFQM model is used widely in the public and not-for-profit sectors as well as in many business organisations.

‘Six Sigma’ was originally developed by Motorola to reduce variability in manufacturing and business processes. It recognises the cost and impact of failure in any single process on the overall yield using a methodology known as DMAIC: define, measure, analyse, improve, control. Six Sigma relies extensively on statistical techniques. The Six Sigma Business Scorecard has seven elements covering all of the functional business areas: 1. leadership and profitability2. management and improvement3. employees and innovation4. purchasing and supplier management5. operational execution6. sales and distribution7. service and growth.

The performance prism was developed by Cranfield University academics. This framework has five facets: 1. stakeholder satisfaction (what stakeholders want)2. stakeholder contribution (what the organisation needs from its stakeholders) 3. strategies4. processes5. capabilities that an organisation needs to satisfy the wants and needs.

Each of the five facets has its own measures, but the overall focus of the performance prism is on stakeholder satisfaction.

Notably, the performance prism takes a multi-stakeholder approach to performance management, reflecting the importance of CSR, whereas most other models (with the exception of the EFQM) take a predominantly shareholder value focus. Two frameworks are perhaps best known:1. the Business Model Canvas, a marketing-oriented strategic framework2. the balanced scorecard, a more financially oriented approach.

http://www.efqm.org

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The Business Model CanvasThe Business Model Canvas was developed by Alexander Osterwalder as a strategic management template for analysing a business strategy or for designing a new strategy. It comprises a visual representation of nine building blocks centred on a value proposition, as shown in Figure 5.6.

Figure 5.6: The business model canvas

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Source: Strategyzer 2018, ‘The business model canvas’, accessed June 2018, https://strategyzer.com/canvas/business-model-canvas.

https://strategyzer.com/canvas/business-model-canvas

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You can access the Business Model Canvas website and its various resources free by registering at https://strategyzer.com/canvas/business-model-canvas.

The Business Model Canvas template links the value proposition with the business’s customer segments, customer relationships and distribution channels (the right-hand side of the canvas) to key activities, key resources and key partnerships that satisfy customers (the left-hand side). These are all in turn linked to revenue streams and cost structures (occupying the bottom of the canvas). A separate Value Proposition Canvas helps identify what products or services are offered to customers and what motivates them to buy.

The Business Model Canvas approach is that strategies can be developed by focusing on the:• value proposition and its related customer segments, relationships and channels as drivers

of revenue• infrastructure of activities, resources and partnerships that drive costs.

You can try out a Business Model Canvas template either at the Strategyzer website or using a free online template available at https://canvanizer.com/new/business-model-canvas.

This marketing-oriented view of the world focuses on value as perceived by customers, certainly an essential element in creating value for the business. Its weakness lies in the absence of performance measures that determine whether strategy is being achieved. This is the benefit of the second framework, the balanced scorecard.

The balanced scorecardThe balanced scorecard (BSC) was developed by Harvard academic Robert Kaplan and consultant David Norton based on their work with US organisations. Their work on the BSC has been published in the Harvard Business Review and is still widely used (Kaplan & Norton 1992; 1993; 1996a).

The BSC takes four perspectives on performance: 1. financial2. customer3. business process4. innovation and learning.

The customer, business process, and innovation and learning perspectives are considered as leading measures, with financial measures being the lagging measures of performance. Kaplan and Norton (1992; 1993; 1996a) do not prescribe the performance measures that should be used, but suggest that organisations use performance measures and targets linked to their objectives, affirming the clear link between strategy and performance measures. This reflects the contingency approach discussed previously in this module. The BSC ‘translates a company’s strategic objectives into a coherent set of performance measures’ (Kaplan & Norton 1993, p. 134).

Examples of performance measures in the customer perspective include market share, customer satisfaction, customer retention, NPS and brand reputation. Performance measures in the business process perspective may include quality pass rate, on-time delivery, cycle time (from order to delivery) and productivity. In the innovation and learning perspective, performance measures may include employee retention and satisfaction, investment in training, R&D expenditure and new patent registrations.

There is no rule that says a particular measure should go in a particular perspective. Sometimes market share will be in the financial perspective (as it is based on revenues), and other times it will be in the customer perspective (as it reflects how many customers an organisation has).

https://strategyzer.com/canvas/business-model-canvas

https://canvanizer.com/new/business-model-canvas

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Some other examples include the measure of ‘on-time delivery’, which could be classified as either a customer perspective or a business process perspective. It would depend on the purpose of the measure for the organisation (i.e. whether the focus was on customer satisfaction or the organisation’s effectiveness in operations).

Similarly, capital expenditure measures would typically be found in the financial perspective. However, the capital expenditure may appear in other perspectives if it specifically relates to improvements in efficiency (investment in new or improved business processes) or training facilities (investment in innovation and learning).

The important thing is for an organisation to be able to logically explain why an item is placed or classified in a particular perspective. This is a further example of contingency theory. An organisation will determine the performance measure and the perspective that best reflects that measure based on its strategy, competitive position, size, etc. For example, a strategy to improve workforce skills would lead to performance measures being developed in the innovation and learning perspective. A strategy to improve on-time delivery would mean performance measures being developed in the business process perspective. Both strategies would be linked (with others) to the overall business objectives of improving financial objectives such as sales growth, cost reduction and increased profitability.

There is no exact or correct number of measures to include in a BSC. Too few measures will mean the organisation does not have a clear picture of what is going on in the organisation and it may miss detecting issues because it does not have enough leading measures. Too many measures means it may be distracted or unable to focus on the most critical items.

Kaplan and Norton (1992; 1993; 1996a) recommend three or four measures for each of the four perspectives in the BSC (12 to 16 in total). However, this is only at the top level. For lower levels of the organisation there may be many more measures that all link together and are summarised by these final 12 to 16 measures. The cascading of performance measures to business units is discussed further under ‘Cascading performance measures’.

The relative importance of performance measures is addressed to some extent in the BSC by the assumption of a hierarchical relationship between the four perspectives, and hence between the four sets of performance measures. Improving learning and growth (achieving innovation) will transform business processes, which will in turn lead to more satisfied customers and ultimately to improved financial performance. Between each hierarchical level, some value creation is assumed.

Figure 5.7 illustrates the relationships between the elements in the BSC.

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Figure 5.7: Illustration of the balanced scorecard

Financial perspectiveGoals, performance measures and targets

Performance on all dimensions satisfies stakeholders

Customer perspectiveGoals, performance measures and targets

Satisfied customers leads to financial performance

Internal process perspectiveGoals, performance measures and targets

Efficiency of process reduces costs and satisfies customer

Learning and growth perspectiveGoals, performance measures and targets

Leads to continuous improvement

STRATEGY

Source: Based on Kaplan, R. S. & Norton, D. P. 1992, ‘The balanced scorecard: Measures that drive performance’, Harvard Business Review, Jan–Feb 1992; Kaplan, R. S. &

Norton, D. P. 1993, ‘Putting the balanced scorecard to work’, Harvard Business Review, Sept–Oct 1993, pp. 134–47; Kaplan, R. S. & Norton, D. P. 1996, ‘Using the balanced scorecard as a strategic

management system’, Harvard Business Review, Jan–Feb 1996, pp. 75–85.

There has been an almost continuous development of the BSC approach through articles and books, but one of the distinguishing features of the BSC compared with other frameworks is the notion of ‘balance’. Balance in the BSC implies that organisations cannot maximise performance on all four perspectives simultaneously. Rather, there should be balance between these perspectives with optimum overall performance being the result of finding the right balance between performance as measured by all four perspectives.

The following benefits have been identified for the BSC:• It summarises complex information. • It focuses management attention on the most important variables. • It enables management by exception and manages areas of underperformance.• It balances the need for short-term performance with sustainable performance.• It limits the number of performance measures used.

For a further explanation of the BSC please access the ‘R Kaplan explains the Balanced Scorecard’ video on My Online Learning.

Criticisms of the balanced scorecardDespite the undoubted value of the BSC, one criticism of it is the ability to find a true balance between different performance measures, especially when these are measured in very different terms (e.g. a measure of on-time delivery performance is difficult to compare with an employee retention figure). How does an organisation balance, for example, employee satisfaction with customer satisfaction, let alone find the right balance between these and financial measures such as ROI and ROCE?

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Another criticism of the BSC approach is its assumption of cause-and-effect relationships. Norreklit (2000) questioned whether such causal relationships exist.

What is meant by causal relationships is that when you do one particular thing right it will directly lead to or cause an improvement in another item—for example, assuming that increased advertising will cause or lead to more sales revenue, or that high customer satisfaction levels will cause or lead to higher profits.

The measures in each of the BSC’s four perspectives are meant to successfully link together. Figure 5.7 shows this cause-and-effect situation or relationship, but the criticism is that this might not be the case. An example is a monopoly situation where a company is able to increase profits by providing lower levels of service, which would actually annoy customers (and the customers cannot switch to another provider, because there isn’t one). In a different situation, satisfied customers may not lead to higher profits because the organisation may be charging prices that are too low.

Therefore, it cannot be assumed that a change to the leading measure will have a cause-and-effect change on the lagging measure. One of the difficulties in setting objectives and performance measures is the ‘predictive model’ used by the organisation. The predictive model is the set of assumptions that lie behind an organisation’s strategy implementation. It may be useful in developing strategy to start by using the Business Model Canvas and then translate this into a BSC set of performance measures.

Concerns have also been raised by Norreklit (2000) about how effective the goal-setting and performance management process really is. In Otley and Berry’s words:

organisational objectives are often vague, ambiguous and change with time … Measures of achievement are possible only in correspondingly vague and often subjective terms … Predictive models of organisational behaviour are partial and unreliable, and … different models may be held by different participants … The ability to act is highly constrained for most groups of participants, including the so-called ‘controllers’ (Otley & Berry 1980, p. 241).

Otley and Berry’s critique was that organisational goals are often ambiguous (i.e. that different goals are held by different organisational participants). For example, sales managers may prefer sales growth, while operating managers may be pursuing greater efficiencies and economies of scale. This is the case even in a stable environment, while rapidly changing environments can quickly change organisational goals in response to emerging threats and opportunities.

Predictive models are inherently difficult as they assume agreement by organisational participants as to cause-and-effect relationships. For example, the predictive models of Qantas and Jetstar are different, despite their common ownership, because they assume different expectations about frequency of flights, on-time departures, in-flight service, pricing, etc. However, not everyone at Qantas and Jetstar would be likely to share the same assumptions that are contained in those predictive models. Equally, not all Jetstar customers would be likely to accept the different standard of service inherent in those different models (witness, for example, any of the airline documentaries about customer response to late check-ins or flight delays with low-cost airlines).

Finally, Otley and Berry (1980) drew attention to the limited capacity of organisational participants to effect change, either because of budgetary constraints, organisational policies or other formal management controls that are aimed at feedback: reducing the gap between target and actual performance, rather than as tools for learning and CI. To be truly effective, performance measures should lead to organisational learning and improvement. Organisational learning takes place by using performance information to communicate and continually re-evaluate the predictive model used within the business, the appropriateness of the selected performance measures and their associated targets, and the kinds of corrective actions that managers are able to take to reduce performance variations relative to targets.

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Many organisations have additional perspectives to the four in the Kaplan and Norton version. These perspectives may recognise additional stakeholders—for example:• donors to a not-for-profit organisation• social outcomes in the public sector• quality in health services• environmental performance.

Appendix 5.1 shows how Achmea uses a BSC with six perspectives in its strategy implementation.

Designing a balanced scorecardUnderstanding the strategy of the organisation or business unit is essential for the construction of a BSC. The notion of ‘balance’ relies on an understanding of the organisation’s goals and objectives that needs to encompass its approach to its customers/customer segments, distribution channels, activities and resources, etc. (as shown for the Business Model Canvas).

The first question to answer when designing a BSC is: ‘What are the organisation’s goals and objectives that are inherent in its strategy?’

EVT (Example 5.1) showed that its BSC should include aspects of strategy such as market share, room inventory and customer spend. The case of Apple (Example 5.4) shows that continual R&D is an essential strategy and needs to be reflected in a BSC, as do retail store numbers and employee knowledge.

The second question is: ‘Which stakeholders do we need to consider?’ Goals and objectives may well—perhaps should—consider stakeholders other than shareholders. Victoria Police (Example 5.3), because its performance is of so much concern to the public, press and politicians, needs to balance a large number of performance measures to deliver on multiple strategies. The case of Newcrest Mining (Example 5.6) showed the importance of employee safety, environmental protection and relations with local communities in ensuring sustainable financial performance.

These examples highlight that an organisation-specific BSC does not have to be limited to four perspectives. As seen previously in the module under ‘Frameworks for performance management’, the performance prism has facets that include stakeholders. There is no reason why the scorecard cannot include social and environmental aspects of performance.

Where organisational strategy is reflected in director or executive remuneration, as cases including Woolworths (Example 5.5) show, the BSC needs to include short-term measures of sales, EBIT, working capital, customer satisfaction and safety; and long-term measures of TSR, sales per trading square metre and return on funds employed.

Consequently, each organisation’s BSC will be unique to its business, its key stakeholders, the environmental and competitive context in which it operates, its size (see Table 5.2), its goals and objectives and competitive strategy. This is a further example of contingency theory.

Table 5.3 shows how the design of a BSC should proceed. Steps 3, 4 and 5 are covered in more detail later in Part B.

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Table 5.3: Designing a balanced scorecard—a step-by-step approach

Steps Question Tasks

1. Assess the organisation’s strategy

What are the organisation’s overall strategic goal, vision, mission and objectives?

• Source a copy of the organisation’s strategy, usually contained in its annual statements.

• If no accounts are available, consult directly with senior management.

• Identify the most important strategic goals (financial and non-financial; short-term and long-term)

2. Assess the organisation’s stakeholders

Who are the organisation’s key stakeholders and how should the organisation meet their needs?

• List the key customer groups of the organisation.

• How is the organisation currently meeting the needs of each group?

• How can the organisation best meet the needs of its customers?

3. Compile a strategy map How are the various strategic goals interlinked?

• Construct a strategy map, clearly identifying any links that exist.

• Identify any overlap in objectives.

4. Define the key performance measures and SMART targets for each of the four BSC perspectives

How will the strategic goals be aided by each of the four perspectives?

• Construct a list of key performance measures for each of the four perspectives.

5. Cascade the BSC How will the organisation measure its performance at various hierarchical levels?

• Duplicate the previous steps for each business unit and department that contributes to organisational goals and objectives.


An example of how strategy is developed into performance measures for Achmea is given in Appendix 5.1.

Example 5.14 shows how a BSC could be developed for the company TNA.

Example 5.14: Designing a balanced scorecard for TNA Revisiting the TNA case in Example 5.12, a BSC for the company might be developed in the following way. TNA’s strategy was not focused on financial performance but on growing the business to a critical mass. TNA’s strategies were R&D, export market development and growth in market share. A further focus was cash flow to enable the company’s investment in R&D, export development and growth. The following performance measures might be recommended to TNA’s management.

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Perspective Example performance measures

Financial • Cash flow• Gross margin• Sales growth

Customer • New export markets opened• Number of new customers• Number of machines installed• Number of outstanding orders• On-time delivery• NPS

Business process • On-time delivery of components from suppliers• Quality of supplied components• Time to assemble finished machines• Quality pass rate from testing of assembled machines

Innovation and learning • Employee retention• Employee satisfaction• Investment in R&D• New patents• Patent litigation actions won

Strategic • Market share growth• Competition

TNA’s financial goals required sales growth to achieve its business strategy of reaching critical mass (shown in Example 5.12), which was defined as having sufficient capital to enable TNA to withstand general business fluctuations and competition while maintaining its investments in R&D. Cash flow was not only to maintain organisational viability during its high-growth strategy but also to underwrite its obligations to the banks that had lent the company money. As TNA subcontracted the manufacture of all components and assembled the final machines, gross margin was an important measure, but accounting profits were not important to TNA. A focus on short-term profit would likely have detracted from the company’s strategy of long-term market growth and its investments in export market development, patent litigation and R&D.

TNA’s customer goals focused on developing new export markets as those markets it entered became saturated. Within each geographic market, new customers and new machine installations were the key measures of marketing success, with outstanding orders, on-time delivery and customer satisfaction important supporting measures to enable sales to new customers and sales of new machines. NPS is a useful measure of customer satisfaction as it reflects whether a customer would recommend the supplier to a friend or colleague.

TNA’s business process perspective was centred on its strategy of outsourcing the manufacture of components, using its skill base to assemble the components it had designed and retaining its intellectual capital in-house. So performance management was focused on the quality and delivery of components from suppliers, the time taken to assemble those components and the quality pass rate—the quality of assembled machines before delivery to customers.

Innovation and learning were critical to TNA and the measurement of staff retention, staff satisfaction, investment in R&D and the ability to develop new patents from its R&D matched TNA’s strategy of continual development of products ahead of competitors in order to retain a strong market position. Patent litigation measured the success of the company’s court actions against those competitors who had infringed TNA’s patents.

TNA’s overarching strategic goal was market share growth to achieve and maintain its critical mass, linked with its targeting of weaker competitors (explained in Example 5.12).

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Linking performance management with strategy is critical to long-term sustainable performance (compared with a focus on short-term financial results).

For practice in creating a BSC, please access Stage 2 of the ‘Save or close the hotel?’ Business Simulation on My Online Learning.

Questions for strategic planners to ask: the Balanced Scorecard Institute has a series of questions that link performance measures to strategic initiatives, available online at: https://balancedscorecard.org/Resources/Cascading-Creating-Alignment/Metric-Features.

The benefits and challenges of implementing a BSC are highlighted by Balanced Scorecard Australia at: http://www.balancedscorecardaustralia.com/bsa/main/frequently-asked-questions/.

Public sector and not-for-profit performance managementThe public sector and the not-for-profit (NFP) sector have particular challenges in terms of performance management, as shown in the Victoria Police example. First, they have multiple stakeholders and, second, they have multiple objectives, and while financial performance is often a constraint on activities (rather than a goal), non-financial measures of performance (e.g. the quality of health outcomes) are often more important than financial ones.

Charitable organisations may receive funding from government or other bodies tied to achieving specific outcomes, so performance measures need to be developed contingent on the outcomes for specific projects. Within a single organisation with funding for multiple projects, performance measures may be different for each project in line with the outcomes expected for each project. These are further examples of the contingent approach to designing BSCs.

In the Australian public sector, public hospitals are a state government responsibility and performance measures are tied to funding, but funding for specific initiatives comes from both state and federal governments. As a result, hospitals must have performance measures for reporting on actual results and the achievement of targets to the funding agencies to be able to show they are managing the outcomes tied to each different parcel of funding.

Likewise, a not-for-profit organisation such as a charity will have stakeholders, including its donors and the beneficiaries of its services. Compliance with charitable rules will incorporate the regulatory body as a further stakeholder. Because charities rely extensively on volunteers, they are a further stakeholder group.

Appendix 5.1 provides a good example of how the BSC is applied in a mutual, non-profit distributing organisation.

https://balancedscorecard.org/Resources/Cascading-Creating-Alignment/Metric-Features

https://balancedscorecard.org/Resources/Cascading-Creating-Alignment/Metric-Features

http://www.balancedscorecardaustralia.com/bsa/main/frequently-asked-questions/

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➤ Question 5.11Refer again to Questions 5.3 and 5.6, including the suggested answers. Given the different strategies of Mega Markets and its online competitor, identify some possible performance measures (covering each of the four BSC perspectives) for each company, and explain how the performance measures for each company are likely to differ as a result of the different strategies adopted.


Financial perspective

Customer perspective

Business process perspective

Innovation and learning perspective

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Explanation of differences


The need to design an effective BSC for an organisation involves a close relationship with strategy. Kaplan and Norton (2001) have developed the BSC and its relationship with strategy through what they call a ‘strategy mapping’ process.

Table 5.3 showed a step-by-step approach to designing a BSC. Step 3 is compiling a strategy map. This involves deciding how the various strategic goals are interlinked.

Designing a strategy map for performance managementStrategy mapping (Kaplan & Norton 2001) is a development of the BSC. It is driven by strategy and goals. The strategy map for an organisation reflects the assumptions of its predictive model.

Strategy maps are a visual approach that helps to identify assumed cause-and-effect relationships and where critical areas of performance need to be measured. Kaplan and Norton (1996b) describe a simple example of linked performance measures through the four BSC perspectives. In the learning and growth perspective, employee morale leads to employee suggestions. These suggestions lead in the business process perspective to a reduction in rework, while employee morale leads to customer satisfaction in the customer perspective. In the financial perspective, increased customer satisfaction and reduced cost of rework both lead to improved financial performance.

In EVT (see Example 5.1 and solutions to Question 5.1) the design of a strategy map could look something like the example in Figure 5.7, but candidates should note that there is no ‘one best way’ of creating a strategy map. For any organisation, it will be based on the predictive model—that is, the set of cause-and-effect relationships that the manager assumes to be the basis of business success. The logic and relationships in Figure 5.8 are drawn from the EVT annual report.

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Figure 5.8: Event Hospitality and Entertainment Ltd group strategy map (hypothetical)

Grow shareholder valueEPS and TSR growth

ProfitabilityEBITDA and normalised profit before tax

Average roomrevenue

RevPAR andaverage room rate

OccupancyAverage no. of rooms utilised

compared to total available rooms

Salesrevenue

Growth inmarket share

Market share %

Total roomsavailable

Brandpromotion

Increase roominventory byacquisition

Increase hotelmanagementagreements

Cost controlExpenses as

a % of


An important element of strategy mapping and performance management is setting performance measures and targets (see step 4 in Table 5.3). A performance measure is the characteristic that is important to the organisation and its strategy—for example, return on investment or market share. A performance target is the desired level of performance against that measure—for example, a return on investment of 12 per cent or a market share of 10 per cent. Actual performance is measured and compared against the target to identify what corrective action may be needed. The criteria for setting performance measures and targets are discussed in more detail later in this module.

The board sets criteria for financial returns to shareholders, which may be based on past trends, benchmarking with competitors and, for listed companies, the expectations of stock market analysts. These financial targets become the focus for the strategy developed by the board and senior management. To achieve the target returns, the board and senior management agree that it is necessary to increase sales revenue through greater market share and to improve the profitability of those sales through improved cost efficiencies.

In Figure 5.8, performance measures have been included in the strategy map where appropriate, reflecting those performance measures in the EVT annual report and drawn from the solution to Question 5.1.

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Strategy maps are developed through workshops at several levels. They could also be based on what the organisation learns through the Business Model Canvas approach described previously in this module. Customer focus groups can identify those product benefits and elements of the value chain that customers value most and are prepared to pay for. This helps the organisation identify those business processes it should emphasise and measure.

For example, Figure 5.9 shows a strategy map for a manufacturer.

Figure 5.9: Example of a strategy map for a manufacturer

On-timedelivery

Material purchasing(price, quality, delivery)

Return on investment,earnings per share etc.

Market share Net profit after tax

Improve customersatisfaction

Increase sales revenueper customer

Cost efficiencyin production

Quality

Market research,advertising and promotion

Supplyarrangements

Labour skills

Efficient productionscheduling


In Figure 5.9, customer focus groups have been presented with a question as to how the manufacturer can increase its market share. The focus group findings indicate that customer satisfaction is a function of both product quality and on-time delivery. Customer focus groups have also identified that to increase sales revenue from existing customers, quality rather than price is the main motivating factor for customer spending.

This customer-generated information on cause-and-effect relationships is then used in internal management and employee workshops to determine how the best quality and on-time delivery can be achieved. These internal workshops take place across the sales, marketing and production functions. They identify two particular issues: 1. Labour skills are essential to improving quality and delivery.2. Market research, advertising and promotion are key elements in raising customer awareness

and perceptions of quality relative to competitors.

So the strategy mapping process shows that it is not only real product quality, but also customer perceptions of quality that are important. Product quality is the responsibility of the production department, but marketing has the task of improving brand awareness and perceptions of quality.

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Internal workshops are then focused on production and the need for cost efficiencies. Investigations by corporate finance staff have identified that the most significant impact on profitability—other than sales growth—is production cost efficiency relative to competitors. Internal cross-departmental, team-based workshops—which include employees from the manufacturing, distribution and purchasing functions—identify that there are two major impacts on production efficiency and manufacturing costs:1. Labour skills (already identified as a driver of quality and on-time delivery) are also critical

in setting achievable production schedules and meeting those schedules.2. Issues with the price, quality and delivery of raw materials from suppliers.

This internal workshop leads to a project within the purchasing department to work collaboratively with suppliers to improve raw material purchasing, with the aim of obtaining the best mix of price, quality and delivery from suppliers to support the production schedule.

Figure 5.9 is an example of how a strategy map is developed to identify the most significant cause-and-effect relationships to achieve organisational goals. There are elements of a top-down approach, as the board needs to set overall targets and the strategic direction for the business. There is also a bottom-up approach in which employees with first-hand knowledge of the business identify obstacles to performance and develop ways of overcoming those obstacles.

Performance measures and their associated targets would need to be developed for each of the elements in the strategy map. The board can use these measures and targets to monitor strategy implementation. Those measures may include: • financial returns• market share• customer satisfaction (through a combination of customer survey results such as NPS

and measures of spending per customer and customer retention) • quality pass rates• on-time delivery• labour turnover• employee satisfaction• cost reduction per unit of production• compliance with production schedules• material purchase variances• on-time delivery from suppliers• supplier product quality.

Where performance needs to be improved, the strategy mapping process involves making resource reallocations through changing budgets. This approach is challenging to the traditional accounting view of budgets as fixed resource allocations for the year. In practice, budgets are commonly incremental (or decremental) based on the prior year plus or minus a percentage change factor. Budgets are rarely revised mid-year due to performance shortfalls. However, reallocating budgets mid-year is a logical extension of managing performance more flexibly in the strategy mapping process and there is no reason why accountants cannot be more flexible in supporting such a process.

Strategy mapping is a continual learning process whereby learning what works, and what does not, from performance measures should lead to changes to the assumed cause-and-effect relationships, and to the resulting performance measures and targets. This approach should, wherever necessary, continually re-evaluate and modify the assumptions in the relationship between strategy, performance management and budget.

An example of strategy mapping linked to strategy and the BSC can be seen in Appendix 5.1.

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➤ Question 5.12Recommend a set of performance measures (without the associated targets) that would be suitable for a three-partner organisation of CPAs operating in public practice with 40 employees. The organisation has three objectives:

1. to make a satisfactory profit

2. to have a strong cash flow

3. to increase the value of the organisation as measured by billings (i.e. annual professional fees charged to clients).

(a) Using Figure 5.9 as an example, construct a strategy map that shows what might be the key success factors—that is, the cause-and-effect relationships in the business model that the organisation needs to get right in order to achieve its three objectives.

Note: You will either need to do this separately on a piece of paper, or you may prefer to create the strategy map in a drawing program before adding your response to the answer field.

If you choose to use a drawing program, save your strategy map as an image file. Then in the interactive PDF of this Study guide, you can insert your response by selecting the answer field and browsing for the image file that you saved on your device.

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(b) Explain the main features of your strategy map, and why you included each element.

(c) For each of the elements in the strategy map, identify suitable performance measures, keeping a balance between financial and non-financial measures, as well as a balance between each of the four perspectives in the BSC.

BSC perspectiveKey success factors in strategy map Performance measure

Financial or non-financial (N/F)

Financial

Client (customer)

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Business process

Innovation and learning

(d) Explain your thinking behind the performance measures you have selected.


A further feature of the BSC and strategy mapping approach is the cascading of performance measures within the hierarchical organisation structure (step 5 in Table 5.3).

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Cascading performance measuresPerformance measures at the whole-of-organisation level can only be achieved if individual business units, customers/customer segments, and products and services contribute to that performance. For example, an ROI target can only be achieved for the whole organisation if each business unit, product or service and, ultimately, each asset makes a contribution that achieves the target. While business units, products and services and assets will achieve higher and lower levels of ROI, a key management task is to ensure that resources are allocated where the highest (in this example) ROI will be achieved, and to improve the performance of (or dispose of) underperforming business units, products, services or assets.

The Balanced Scorecard Institute (2013) explains the function of cascading:

the enterprise-level scorecard is ‘cascaded’ down into business and support unit scorecards, meaning the organizational level scorecard (the first Tier) is translated into business unit or support unit scorecards (the second Tier) and then later to team and individual scorecards (the third Tier). Cascading translates high-level strategy into lower-level objectives, measures, and operational details. Cascading is the key to organization alignment around strategy. Team and individual scorecards link day-to-day work with department goals and corporate vision. Performance measures are developed for all objectives at all organization levels. As the scorecard management system is cascaded down through the organization, objectives become more operational and tactical, as do the performance measures. Accountability follows the objectives and measures, as ownership is defined at each level. An emphasis on results and the strategies needed to produce results is communicated throughout the organization (Balanced Scorecard Institute 2013).

Performance measures should cascade so that, at each successive organisational level, the measures are different, but lower-level performance on one measure contributes to higher-level performance at the next level. For example, the board may consider ROI as a critical performance measure. At the business unit level, this may be translated into a measure of PBIT. Below this level, sales managers may have measures for the volume (quantity) and value (dollars) of sales as well as the margin achieved on cost. Operations managers may have the same volume (quantity) measure as sales managers, but the measure relevant to them may be cost.

Performance measures and the targets that accompany them must cascade from organisational level through each business unit, to individual products and services and assets and, ultimately, to individual people within the organisation. For example, in a sales department, a contribution to the organisation’s sales target must be achieved by each sales team, within the team by each salesperson, and even within each salesperson’s target this may involve sales targets for each of the salesperson’s customers or products and services. Where targets are set, performance must be measured with performance management involving comparison of actual to expected sales levels and the taking of action aimed at improving performance.

As stated previously, Kaplan and Norton (1992; 1993; 1996a) recommended three to four performance measures for each of their four perspectives. This is at the whole-of-organisation level. Once these high-level performance measures are cascaded, the total in use in an organisation may be very large and, in a complex, multidivisional organisation, may be in the hundreds. However, any one manager will be focused on only those performance measures for which they are responsible, and the total number is unlikely to be more than about 12, for the reasons previously given.

Typically, lower-level employees in an organisation have fewer financial targets and more non-financial ones (i.e. the leading measures) because their role is mainly concerned with tasks such as production, distribution or administration. Senior managers tend to have more targets for the financial performance of their business unit or the whole organisation—the lagging measures.

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Sometimes, targets within business units may be in competition with each other. For example, achieving a sales target may cause difficulties in operations if there is insufficient capacity to fulfil customer orders on time. It is important therefore to ensure the integration of performance targets so that no business unit will be disadvantaged by another achieving its target. A problem faced by complex organisations where there is intra-organisational charging for services is the tendency for each business unit to pursue achievement of performance measures for itself rather than for the organisation as a whole. This is no different to the problems caused by transfer pricing, where business units may be motivated to improve their own profitability even where the overall effect on the organisation may be to worsen performance.

Strategy implementation (rather than formulation) and alignment with organisational goals, coordination across different functions and projects, and across different individuals can only be achieved if goals, measures and targets are effectively cascaded. There are a number of ways cascading can be made more effective: by cascading organisational goals, measures and targets to functional departments, to cross-functional teams, or to particular initiatives or projects.

However, if measures are inconsistent or in competition with each other, individuals, departments, cross-functional teams or projects may be working towards different goals and targets, perhaps even measuring their performance in different ways (see Example 5.15).

In the EVT example, performance measures for all of EVT—for example, average room rate, occupancy, RevPAR, total rooms available, etc.—will cascade down to the separate divisions (QT Hotels, Rydges, Atura & Thredbo) and from there to each individual hotel, where performance management will involve comparing actual performance with targets and taking appropriate corrective action at the individual hotel level.

Appendix 5.1 provides an example of how Achmea cascades its performance measures through the organisation.

Example 5.15: Performance management in a public hospitalHospitals have many performance measures and targets, including waiting lists for elective (non-urgent) surgery and waiting times in the emergency department before admission to a hospital bed. Targets may also exist for minimising hospital-acquired infections and patient complaints. Many of these measures and targets are set by government in response to public expectations and election promises. Because of the need for public accountability, many of these performance measures are audited, to avoid the reality or perception that, for example, waiting lists and times are being manipulated.

Public hospitals also generally operate within a fixed budget that may be unrelated to the actual levels of patient demand on the hospital. Hospital budgets are often an outcome of economic conditions and the government’s spending plans across all sectors of public service delivery.

The role of management—and any board of directors or governing body—is to best allocate and manage resources within the fixed budget allocation to achieve the performance targets set by government. Hospital-wide targets will be cascaded down to each department (e.g. emergency, surgery, medicine) and to clinical directors (e.g. medical specialists) within each department. Ultimately, individual clinicians may be responsible for performance on the days when they are on duty. So the director responsible for the emergency department on a Sunday will be responsible for trying to achieve the target for reducing the time between a patient arriving in emergency and being discharged or admitted to a ward for ongoing treatment.

Hospitals are faced with decisions to open or close wards and to reallocate resources to where they are most needed. These decisions may need to be made on a daily basis in response to patient demand, but closing wards may itself cause performance targets to be missed. The particular problem for public services is that many of their performance measures and targets are politically derived, and not necessarily integrated with each other or with the budgetary resources available.

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An example of the problem of competing performance targets can be seen in a hospital where there is a high number of patients admitted through the emergency department. This can lead to either (or both) the surgery capacity being used up, or a lack of available beds. As a consequence, elective surgery patients can be disadvantaged because their surgery may be cancelled at short notice. This is a difficult problem to manage as the emergency department cannot be closed to people who need urgent treatment.

In the public hospital, there will be conflicts between meeting performance targets for elective surgery and treatment of patients admitted for emergency treatment. There will also be conflicts between the management demand to stay within budget while achieving performance targets and the clinicians’ focus on proper medical treatment, irrespective of the impact on reported performance.

Performance management in hospitals is largely about balancing available funds with performance targets that may not relate to resources or to actual demand for services. This kind of problem is unique to public services and the not-for-profit sector. In this sense, for-profit organisations should find managing performance easier because, generally, higher levels of customer demand will lead to higher revenues. In the absence of politically motivated targets, for-profit organisations have far more scope to change what is measured and how it is measured, and to set specific targets.

One way to address the complexity of modern business and the variety of performance measures is through the use of information technology, which can become critical in a cost-effective performance management system.

The role of information systems in performance managementInformation systems more generally were covered in detail in Module 2. This module discusses information systems from the perspective of performance management.

Balanced scorecard (or similar) performance management systems collate and report information about customers, suppliers, employees and business processes to supplement financial performance measures. Therefore, organisations need to capture information from their marketing, purchasing, production, distribution and HR activities. Information about key factors such as customer satisfaction, cycle times, quality, waste and on-time delivery need to be part of an information system.

Data collection in many organisations takes place as a by-product of transaction recording through computer systems. For example, retailers make extensive use of electronic point of sale (EPOS) technology, including barcode scanning to price goods, printing a cash register listing for the customer, reducing inventory, and calculating and reporting profit margins. Taking advantage of new technologies can improve productivity and reduce the ratio of staff to sales value, a common performance measure in retailing.

The outputs from EPOS include business volume—for example, number of customers, number of items sold—sales analysis, product profitability and inventory reorder requirements. Sales and profitability reporting can be generated by store and time of day. Additional benefits of EPOS include information about:• peak sales times during each day• products that may need to be discounted• sales locations that may need to be expanded• time taken to scan a customer’s basket of goods.

Even small businesses like restaurants can take advantage of modern POS terminals that are relatively inexpensive, enabling them to monitor customer seating by time of day and day of week, generate orders for the kitchen, price goods and calculate bills, and provide detailed management reporting on inventory and sales trends. This information can be used for management accounting purposes to improve inventory management, reduce wastage, enable staff rostering to the busiest times and identify the most profitable products.

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For larger organisations, an enterprise resource planning (ERP) system helps to integrate data flow and access to information over the whole range of a company’s activities. Examples of these systems are the relational databases provided by SAP and Oracle. ERP systems take a whole-of-business approach. They typically capture transaction data for accounting purposes, together with operational data and customer and supplier data, which are then made available through data warehouses from which custom-designed reports can be produced. ERP system data can be used to update performance measures in a BSC and can also be used for:• activity-based costing• shareholder value• strategic planning• customer relationship management• supply chain management.

Cloud computing has enabled access to larger sources of data and made it easier to analyse data from any location. It relies on sharing resources through the internet to achieve economies of scale. With cloud computing, end users access applications through the internet, with both software and data stored on servers at remote locations.

Large volumes of information are now available from public sources. The term ‘big data’ refers to very large and complex data sets, which can be seen in the massive data resources of the internet and the results provided by search engines such as Google or data held on Facebook. Organisations are able to access (for a fee) this information to enable targeted marketing.

According to management consultants McKinsey, big data will become a key basis of competition, underpinning new waves of productivity growth and innovation (McKinsey Global Institute 2012).

The Australian Taxation Office accesses multiple sources of data to identify potential targets for tax audits based on spending patterns. Retail stores such as Woolworths (as mentioned previously) target customers for special promotions based on their individual spending habits recorded through its ‘Everyday Rewards’ card system, which collects data on customer purchases at the POS.

The ability to collect vast amounts of performance information means that it is important but increasingly complex to report management information in a concise and decision-useful way. Approaches to reporting management information include graphical presentation of key performance data. As mentioned, traffic lights (red/amber/green) draw attention to those aspects of performance that:• are meeting their target (green)• are in need of urgent attention (red)• need to be considered because they are borderline (amber).

A ‘drill-down’ facility may also be used to cascade down from highly aggregated performance data to a more specific and detailed level—for example, customer, product or service, or business unit.

Organisations need to determine what performance information is important from the volume and variety of information that is now available. Big data requires specialist computing power and software tools as the volume and variety of data is beyond the capability of relational databases. Examples of such specialist software include Oracle’s ‘Big data appliance’ and ‘Hadoop’, which is an open-source platform for consolidating, combining and transforming large data volumes. Linking platforms to analyse big data and the organisation’s own relational database provides what Oracle refers to as a ‘360-degree view’ of the organisation.

Oracle’s White Paper ‘Integrate for Insight’ on integrating big data is accessible at: http://www.oracle.com/us/technologies/big-data/big-data-strategy-guide-1536569.pdf.

http://www.oracle.com/us/technologies/big-data/big-data-strategy-guide-1536569.pdf

http://www.oracle.com/us/technologies/big-data/big-data-strategy-guide-1536569.pdf

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The role of performance management in implementing and monitoring strategyMarket research carried out by Oracle (2011) comprising almost 1500 interviews in 13 countries found that there was an emphasis on sales growth rather than profits, with 82 per cent of businesses admitting to not having complete visibility of their profits by line of business. This lack of knowledge led to a misallocation of resources, poor decisions and poor pricing policies. Criticisms by respondents included an over-reliance on spreadsheets, working with out-of-date data from multiple ‘silos’ of information and a lack of data sharing between departments. Seventy-one per cent of Oracle’s respondents described the links between strategic goals, operational plans and budgets as ‘fragmented’.

An important implication of Oracle’s research is the finding that, on average, 1.7 months will pass before the finance department becomes aware that operational plans or market circumstances for the company have changed. In terms of performance data, for the 89 per cent of managers with departmental performance measures who responded to the survey, it takes, on average, just under two months for information about departmental performance against targets to filter up to the senior management team or the board of directors.

The lack of reliable, accurate and timely data is compounded by the lack of stability in the organisation’s environment and strategic plans that must be continually updated to stay relevant to the latest business conditions. Turbulence in the business environment is caused by:• economic uncertainty• changing technology• the rapid introduction of new products• changing customer demand• increased regulation and competition.

Strategy&, the strategy consulting group of PwC, argues that execution of strategy is critical to success. It recommends ‘strategic performance management’, an approach that ‘makes an organization’s strategic goals more transparent to line executives and provides an ongoing mechanism to monitor progress toward these goals through simple and intuitive performance measures’. The authors argue that there is often:

a lack of clear linkage between strategic objectives and operational performance measures, limited accountability for outcomes at the operational level, an unmanageable number of sometimes random metrics, fragmented and redundant systems and efforts, and a greater focus on metric analysis than on management decision making (Chandrashekhar et al. 2017).

A key recommendation of the Strategy& report is for senior managers to focus on ’metrics that matter’. This involves becoming more agile in responding to change, changing performance benchmarks and cascading those changes down through the organisation to deliver on strategic goals (Chandrashekhar et al. 2017).

Researchers at UK’s Cranfield University are critical of traditional approaches to performance management, which rely on stability and predictability. They developed a Performance Management for Turbulent Environments (PM4TE) model (Barrows & Neely 2012). They argued that:

many traditional performance management practices do not work well in turbulent environments. In turbulent environments the need for timely information grows significantly. Managers must detect and interpret information much more rapidly. They have to make faster decisions. They have to execute more quickly with a narrower margin for error. And they must embrace new ways of operating versus exclusively focusing on exploiting core businesses (Barrows & Neely 2012, p. 17).

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The PM4TE model comprises:• a performance management cycle• an execution management cycle that explicitly links projects to performance (as it is through

projects that most organisations drive change and improvement)• enablers such as leadership and strategic intelligence.

A key enabler is the recognition that performance management should be used for learning rather than control, as learning is central to success in turbulent environments.

Strategic intelligence and learning are more possible with the advent of technologies to access big data. It is now possible to collect data about every potential customer interaction through a business’s website and social media such as Facebook and Twitter. While this kind of big data can be a powerful tool for business, it does raise issues of access to private information.

Further information about the Facebook and Twitter example is available in a 2018 New York Times article available at: https://www.nytimes.com/interactive/2018/06/03/technology/facebook-device-partners-users-friends-data.html.

A report by McKinsey Analytics argues that most companies are capturing only a fraction of the potential value from data and analytics. Data and analytics can underpin disruptive business models while granular data can be used to personalise offerings of products and services to customers. However, many companies struggle to incorporate data-driven insights into their day-to-day business operations. Large technology investments have been made but organisational changes have not always been in place to take advantage of the technology. The report argues that ‘organizations need to build the capabilities of executives and mid-level managers to understand how to use data-driven insights—and to begin to rely on them as the basis for making decisions’ (McKinsey Global Institute 2016, p. 9). The report concludes that:

Data and analytics have even greater potential to create value today than they did when companies first began using them. Organizations that are able to harness these capabilities effectively will be able to create significant value and differentiate themselves, while others will find themselves increasingly at a disadvantage (McKinsey Global Institute 2016, p. 24).

There is now widespread support for the belief that performance measures should be developed from strategy. Kaplan and Norton’s (1996b) recommendation for a strategy mapping process identified four barriers to implementation of performance management systems in relation to strategy:1. Failure by the senior management team to achieve consensus, leading to different groups

pursuing different agendas not linked to strategy in an integrated way.2. Strategy that is not linked to department, team and individual goals—that is, an absence

of cascading.3. Strategy that is not linked to resource allocation decisions—that is, where budgetary

allocations are incremental/decremental and not linked to strategy.4. Feedback to managers that focuses on short-term financial performance rather than on

a review of measures of strategy implementation and success.

The keys to successful integration of strategy with performance management can be summarised as:• top management commitment to a unified strategic vision, including synthesising the

performance expectations of multiple stakeholders• developing performance measures that are consistent with the vision and that enable

attention to be drawn to whether the strategy is being implemented and is successful. This involves balancing the attention on short-term/operational and long-term/strategic aspects of performance

• ensuring that resource allocations are consistent with strategic priorities• ensuring that individual and team performance measures are linked to organisational

performance measures

https://www.nytimes.com/interactive/2018/06/03/technology/facebook-device-partners-users-friends-data.html

https://www.nytimes.com/interactive/2018/06/03/technology/facebook-device-partners-users-friends-data.html

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• integrating all available sources of information into a single suite of cascaded performance measures that all accountable managers in the organisation have access to and use

• using performance measures as a learning tool, not just as a means of control. Learning facilitates modifications to strategy, resource allocations and what (and how) performance is measured.

Appendix 5.1 provides an example of how Achmea focuses on using strategy mapping and a BSC of performance measures, not just in strategy formulation, but more importantly, in strategy implementation.

➤ Question 5.13Giant Products Ltd (Giant) manufactures ‘triffids’, a product that has many purchased components. The board of directors of Giant has set a goal of 10 per cent reduction in the total cost of components used in manufacturing triffids during the next financial year (assuming constant sales volume). The board believes that the high cost of the components may be due to a combination of poor purchasing practices and/or wastage during production.

Giant has the following organisational structure.

Marketingand sales

Publishing Production

Managingdirector

Finance andadministration

(a) Recommend performance measures that Giant could implement to achieve its goal of a 10 per cent reduction in the cost of components.

(b) Explain how these performance measures could cascade to lower organisation levels in each department.

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(c) What would be the role of Finance and Administration in achieving this goal?

(d) How might information technology—for example, using an ERP system—assist in this process?


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Part C: Determining performance measures and setting performance targetsPart B looked at the role of strategy in performance management and how performance management can be seen as an important element in management control. Part C of this module is concerned with how to design a set of appropriate and meaningful performance measures and, having determined those measures, how to establish SMART (see later in this module) performance targets. This part of the module:• discusses the characteristics that ensure that performance measures are valid and reliable• looks at the costs and benefits of performance measures• reviews how power and culture affect performance management.

Designing performance measures and setting targets has no real value in improving efficiency, effectiveness and equity unless those performance measures are used to improve performance. This part discusses how performance improvement relies on three levels of analysis: 1. targets2. trends3. benchmarks.

It also considers the role of knowledge management and organisational learning in improving performance. This part concludes with a discussion of the behavioural consequences of performance management.

Designing performance measures In considering the BSC framework, while there are many possible performance measures for each of the four perspectives, selecting the most appropriate measures can be a difficult choice.

Given the almost unlimited measures that could be used, the ones that organisations should use are those that are linked to achieving the organisation’s strategic goals. The number of different performance measures needs to be limited to what is manageable, because too many measures may result in none of them being seen as important. As mentioned in Part B, Kaplan and Norton (1992; 1993; 1996a) recommend three or four from each of the four perspectives. Once cascaded down, these broader measures may be replaced by more detailed measures, so in total an organisation may have many more than 12 to 16 measures. The measures may be different at each organisational level, but at any one organisational level the number of measures needs to be manageable.

As was discussed in Part B, the design of a performance management system will be linked to the organisational strategy through the strategy mapping process and will most likely be contingent on the organisation’s competitive environment—for example, size, technology, strategy. It is important to distinguish what should be measured from what is easy to measure. Organisations often avoid measuring performance that is important because measurement is time-consuming or costly (cost–benefit is discussed later in this section). However, it is even worse to measure performance just because it is easy to measure, if it is not critical to business success. This practice leads to too many, often unimportant, performance measures.

The cascading of performance measures reflects the agency relationship between higher- and lower-level managers—an extension of the principal–agent relationship. At the whole organisational level, and at each subsidiary level, the measures that are important to achieving strategy—for that organisational level—need to be determined. This relies on an understanding of the organisation’s predictive model.

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In the EVT example, the entertainment and hospitality divisions have different predictive models, and even for hotels different predictive models will apply because they are influenced by different factors—business travel to CBD locations compared with holiday destinations in resort locations, with seasonality affecting occupancy differently, especially for the skiing season at Thredbo. They are therefore likely to have some performance measures that are different, although there would also be much commonality.

The overall business strategy is cascaded to each business unit, which will develop subsidiary strategies in accordance with the predictive model for that business unit. Once the strategy is understood for each business unit, each department and even each individual employee, performance measures can be defined that monitor whether the strategy is being achieved; as shown in the EVT example, cascading is down to the individual hotel level.

It is important to remember the difference between a performance measure (what is being measured) and a performance target (the desired level of performance). That is, the performance measure may be used as an objective comparison to a predetermined target or an external benchmark—for example, a competitor or industry average.

Many types of performance measures exist. Table 5.4 provides an overview of some of the more common types.

Table 5.4: Types of performance measures

Type of measure Example

Input Resources: human, physical, financial

Activity Processes: number of hours worked, number of material issues, number of deliveries

Output Quantity of goods and services produced, sales revenue

Efficiency Ratios of outputs to inputs, such as process efficiency, wastage

Effectiveness Measures of output conforming to specified characteristics such as absolute quantities, on-time delivery and meeting an agreed quality standard

Impact How outcomes contribute to strategic organisational objectives, such as customer satisfaction, and environmental and CSR goals

Investment Capital expenditure, distribution channel expansion, research and development expenditure


Remember also that some performance measures are used for signalling to external stakeholders as part of an organisation’s accountability. Others are used for planning, decision-making and control, so the purpose of the performance measure needs to be considered.

Example 5.16 reveals the problem of inappropriate performance measures in a changing market. Part 2 of this example is explored in Example 5.17.

Example 5.16: Mammoth Printing—Part 1Mammoth Printing was a large stock exchange–listed printing business in a very competitive market in which most competitors had modern—and expensive—production equipment. As a consequence of high levels of capital investment and price competitiveness to win business, profits across the sector were low.

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Mammoth Printing measured its performance through some common measures: • Sales performance was measured by the level of invoiced sales.• Production performance was measured in terms of:

– printing machine running time as a percentage of total time– wastage– on-time delivery.

Due to pressure from the board to increase profits, Mammoth sought to increase volume, but to achieve its sales targets, sales representatives—who were paid a commission based on sales value—tended to reduce prices and so, while volume was high, margins remained tight.

In this sector of the printing industry, production was based on customers’ orders and a job order manufacturing process was in use. The time taken to produce an order on printing machines was consumed partly in:• set-up—also called make ready (i.e. setting up the machine before the paper is printed) • machine running time—when paper is being printed through the presses.

Market changes had taken place over time, resulting in customers placing orders for smaller volumes more frequently. The effect of this change was that Mammoth’s production capacity was being eroded as more machine time was consumed in set-up rather than running time, which reduced Mammoth’s overall capacity to produce the necessary volume. A further impact of the smaller volume orders was the increased number of non-production employees handling the increased number of sales orders, production orders, deliveries and invoices. The overall effect was declining profits despite increasing sales.

The production department was overwhelmed by the volume of business brought in by the sales department and late deliveries became more common. The production manager argued that too much production time was being used for set-up times for the small-volume orders. He argued that the prices being charged were insufficient to cover the loss of overall production capacity and the administrative burden caused by the small-volume orders.

The following summary of key performance data for Mammoth Printing, comparing its performance over time, reveals substantial changes in financial and non-financial performance.

Three years prior

Prior to implementation

of changesPercentage

change

Sales volume (tonnes of paper) 160 000 220 000 +37.5%

Sales revenue $80 million $100 million +25%

Total costs $72 million $99 million +37%

PBIT $8 million $1 million –87%

Average printing machine set-up time as a percentage of total time

10% 25% +150%

Average printing machine running time as a percentage of total time

90% 75% –17%

Wastage 5% 7.5% +50%

On-time delivery performance 90% 80% –10%

Mammoth’s business model had changed over time but the company realised that its performance measures had not kept up with these changes. Consequently, Mammoth re-evaluated its performance management system. The problem of capacity erosion through set-up times was accepted, and a trial activity-based costing exercise recognised that costs to service small-volume orders were not being passed on to customers through the price. A number of changes were introduced to the performance measures.

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• In the production department, wastage, on-time delivery and machine running-speed performance measures were supplemented by reporting the mix of set-up and running times on each machine, to identify where too much time was being spent on smaller orders with long set-up times.

• Sales performance was judged not only on sales value but on ‘value added per machine hour’. This was a value close to that used under throughput accounting (i.e. sales value less the cost of materials). The value added was divided by the total number of machine hours (set-up and running) to produce the job. The new ‘value added per machine hour’ measure became one of the most important measures in managing Mammoth’s business—it identified those small jobs that had both lower prices and higher set-up times as the value added per machine hour would be very low.

However, Mammoth faced considerable resistance from the sales representatives who were discouraged from accepting orders where the value added per machine hour was too low. Attempts by the CFO to replace the sales representatives’ commission on sales value with a commission based on value added per machine hour failed because of the power of the sales and marketing director. Mammoth failed to move fast enough to change its behaviour or its performance measures, and the company was subsequently taken over by a multinational competitor.

Example 5.16 reveals the need for continual reassessment of the business model and performance measures. It shows the need for management accountants to be able to interpret performance information and recommend appropriate strategies to respond to changes in performance. It also highlights the importance of power and culture, and the behavioural consequences of performance measures (discussed later in this part).

Measuring efficiency, effectiveness and equityOne consideration in designing performance measures is to balance the measures between those concerned with efficiency, effectiveness and equity, as summarised in Figure 5.10.

Figure 5.10: Efficiency, effectiveness and equity

Equity Fairness and equal

treatment—managing differences such that the costs and benefits of

economic activity are spread equally among different customer or other

stakeholder groups

Effectiveness Focus on the end

result of production, on quality and customer

satisfaction—whether the outputs achieve what was intended, or

‘doing the right thing’

Particularly important in the public and not-for-

profit sectors

Efficiency Conversion of inputs or

resources (physical, human and financial) into outputs

(products and services)

Focus on improving productivity and reducing cost—‘doing

more with less’ and ‘doing things right’


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Both efficiency and effectiveness are important. In the Mammoth Printing example, the company was neither efficient (too much time was spent on set-up) nor effective (profits were too low, while customers received late deliveries).

Finding the right balance between efficiency and effectiveness is important, and organisations need to recognise the trade-off between these aspects of performance. For example, a customer needs a service call for some equipment that is not working and wants the service call on Monday, but it is not efficient for the service technician to go to every location on every day of the week. Service calls are grouped to similar areas for set days of the week. The day set for service calls to the customer’s area is Wednesday. There is a trade-off here between the performance measure for service efficiency and the performance measure for customer satisfaction. One may be achieved in this scenario, but not both. Recognition of trade-offs needs to be built into performance measures.

This raises the issue of equity. Should all customers be treated equally? In Example 5.15, there is an equity issue surrounding the treatment of emergency patients and elective (i.e. non-urgent) surgery patients. While it might be unacceptable not to treat an injured person, neither is it equitable for elective surgery patients to wait many months for their treatment. In the Mammoth Printing example, is it equitable for all customers to be treated in the same way, with the risk of late deliveries, when some customers have paid a higher price—generating a higher value added per machine hour—than others for what they have ordered?

Issues of equity also appear in the HR function, where performance measures may exist in relation to gender equality, the treatment of people with disabilities, or those from Indigenous or ethnic backgrounds.

Designing SMART performance targetsOnce performance measures are determined, the target to be achieved also needs to be determined. The targets may be different for different business units or products and services, based on a study of past performance, available resources and capabilities. Targets will, like performance measures, cascade down through the organisational hierarchy to the individual level.

One way of looking at performance measures and targets is through the acronym SMART, as outlined in Figure 5.11.

Figure 5.11: SMART performance targets

SSpecific• Measures and

targets should be clear and unambiguous

MMeasurable• Should be

capable of being accurately measured

• Should be clear whether a target has been achieved, or how close the performance is to target

Achievable and agreed• Targets may

be ‘stretch’ targets rather than easy to achieve but must be achievable and agreed between managers and subordinates

RRelevant• Measures and

targets should be relevant to the strategies in the business model

TTime-based and timely• Targets should

cover a defined time period

• Measures must be produced on a timely basis, so that corrective action can be taken

A


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It is good practice to review all performance targets to ensure they are SMART. If measures are difficult to measure or are ambiguously worded, irrelevant to the organisation’s strategy, too late to lead to action or not agreed between the target setter and the accountable manager, they are unlikely to be helpful in identifying performance gaps or improving performance.

Table 5.5 shows two examples of performance targets that are SMART, as well as two examples of performance targets that do not satisfy the SMART criteria.

Table 5.5: Examples of performance targets

Performance target Analysis

Satisfies SMART criteria

Return on capital employed (ROCE) of 14% in FY 20X4 compared with 13.5% in FY 20X3

The ROCE target is specific, measurable and achievable in comparison to prior year, relevant and time-based (FY 20X4).

Customer satisfaction of 95%, based on survey of products delivered during the month of June

The target is specific, measurable and time-based. It may be achievable provided past customer satisfaction is within a realistic range of the target figure, and is likely to be relevant to most businesses that need satisfied customers to maintain and/or grow sales revenue.

Fails to satisfy SMART criteria

Product quality of 100% The quality target is not specific—it does not say how quality is measured; it may be measurable (if how quality is measured is defined) but is unlikely to be achievable as 100% quality is unrealistic given the costs likely to be incurred to achieve perfect quality; the target may be relevant, but only if it is critical to achievement of organisation goals; it is not time-based as no time period is specified.

Staff turnover less than or equal to 25%—historical staff turnover is 45%

While the target is specific and measurable (although there may be some definitional issues around part-time or casual staff), it may not be achievable given past performance. The target may be relevant if staff continuity is especially important for the business, but the target is not time-based.


Characteristics of performance measures and targetsEffective performance measures are those that achieve what is intended. To be effective, performance measures need to be able to: • help management implement and monitor strategy• support decision-making• motivate managers and other employees• communicate with, or signal to, stakeholders.

To be effective, performance measures need to satisfy several criteria, although it is normally impossible for any single performance measure to satisfy all criteria. Most performance measures have shortcomings or limitations and this is one reason why using multiple performance measures is recommended—each measure captures some important aspect of the performance to be measured and satisfies at least some of the characteristics shown in Figure 5.12 and discussed in the next sections.

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Figure 5.12: Characteristics of performance measures

ValidityHow well a measure

helps evaluate the issueor item of performance

being considered

ReliabilityWhatever is beingmonitored can be

measured consistently and in an objective and

specific manner

ClarityEasy to understand with

little or no ambiguity

TimelinessProvides informationearly enough to allow

corrective action

AccessibilityCan be accessedby all authorisedorganisational

participants who need the information

ControllabilityMust be controllable

by those whoseperformance

is being measured

Characteristicsof performance

measures


Validity Validity (or accuracy) refers to how well a measure helps evaluate the issue or item of performance being considered. If a measure does not accurately describe what it is supposed to, all other attributes are meaningless. A performance measure like operating profit is objectively known from financial statements and is subject to audit, being based on accounting standards. In reality, the practice of accruals and provisioning can influence reported profit. Market share may be measured objectively by reputable and independent industry sources based on sales data reported by each company in the market. This data tends to be accurate, although sales can be misreported by individual companies.

Some concepts are quite difficult to measure directly, so indirect measures are used. The problem is whether or not they accurately capture what is meant to be measured. Customer satisfaction is often measured in a restaurant by asking customers whether or not they were satisfied with their meal. Because customers may be more inclined to say they were satisfied rather than risk offending the restaurant staff, a business can be misled by those responses. A measure of the same customer returning would be more valid, perhaps through a loyalty card scheme. An anonymous ‘tick box’ feedback form left with the customer’s bill may also provide more valid information about customer satisfaction.

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ReliabilityReliability means that whatever is being monitored can be measured in an objective and specific manner. Reliability is concerned with consistency, or the extent to which the reported performance is the same over repeated measurement attempts—for example, does a customer satisfaction survey carried out by different people give the same results no matter who carried out the survey? A reliable measure is one that is trustworthy.

Reliability is sometimes confused with the term ‘validity’ because it is interpreted to mean ‘a measure I can rely on to tell me what I need to know’. However, this is not an accurate understanding or interpretation of what reliability means. Many things can be measured ‘reliably’, but this does not mean they are useful for analysis.

A measure can be highly reliable but completely invalid for decision-making purposes. For example, we could measure growth in company sales revenue to assess customer satisfaction. Sales revenue is both a valid and reliable measure, but it has tenuous links with individual customer satisfaction, so using it to measure customer satisfaction may not be valid. A more valid measure of customer satisfaction may be customer retention—that is, how long the customer stays a customer and whether purchases by the customer are increasing or decreasing. The reliability of this measure can only be gauged if over time customer retention equates to customer satisfaction.

It is often difficult to measure ‘valid’ measures in a reliable way. Consider the restaurant example about measuring customer satisfaction. Reliability of the performance measure will be improved by repeating the method of measurement in a consistent way—for example, using a standard customer feedback form over a long period of time. However, even here, caution must be exercised in interpreting the data because it could be affected by the particular customer or waiting staff on duty or by a variety of other factors such as the level of heating or noise from other customers.

A common performance measure in many service businesses is the time taken to answer an incoming telephone call. The assumption is that customers will be more satisfied when they do not have to wait for long periods. There is a cost in calculating, storing and reporting this information, even though it is largely carried out behind the scenes through communications technology. The performance measure may be reliable because it may be collected as a by-product of the technology used, but may not be valid as a measure of customer satisfaction because the customer may weigh the quality of the answer as being far more important than the time taken to answer the phone. The time taken to answer a telephone is a useful measure because it indicates whether staffing is sufficient to minimise customer queuing, but as a valid measure of customer satisfaction it needs to be supplemented by another measure that focuses on the quality of the contact. For this reason, organisations like Telstra routinely follow up telephone calls with emails asking customers to respond to a short survey to assess customer satisfaction more holistically.

ClarityIf a measure is to be meaningful, it should be easy to understand with little or no ambiguity in interpreting the results. For example, a measure of ‘product quality’ usually has a high level of clarity. It begins with a specification of the product. The final product can then be compared with the specification and tested to see if it meets the specification.

An example of a measure that often has a low level of clarity is a popular measure of shareholder value—economic value added (EVA). This is a valid and sometimes reliable measure, but it is difficult to understand due to its complexity and the number of choices that are made in the construction of the measure. This makes it difficult to use when comparing results between business units or organisations.

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TimelinessTo be useful, performance measures need to provide information early enough to allow corrective action to be taken. If a measure is not available when it is needed for decision-making, then it is of little use. Many financial measures such as profit are not timely. These are lagging measures and inform about what has already happened, but provide little guidance for future action. However, sales data collected daily for a retail chain store is a very timely measure of likely future financial performance. Such data can influence immediate actions such as increasing advertising, purchasing inventory and price discounting.

AccessibilityPerformance measures should be able to be accessed by all authorised organisational participants who need the information. Accessibility refers not only to the measure, but also to the information that drives the measure.

ControllabilityIn order to be effective in motivating behaviour, what is measured must be controllable by those whose performance is being measured. Controllability refers to the ability to influence the quantity or value of the measure through action. Aggregate measures such as the organisation’s profit are normally only partially controllable by any individual in an organisation. On the other hand, production quality is a measure that should be controllable by the process owner.

Costs and benefits of performance managementIn many organisations, much data is collected that is never used. The cost–benefit issue may be difficult to assess, because the benefits of good performance information are rarely received in cash—they come in the form of the characteristics of validity, reliability, clarity and timeliness discussed previously. Performance measures do, however, need to be cost-efficient—that is, the expected benefits of using the measure must exceed the associated cost of undertaking the measurement.

A cost–benefit analysis compares the outputs or outcomes with the costs to produce those outputs or outcomes. Cost–benefit analysis is one method of evaluating performance measures. The measurement of performance, its monitoring, management and reporting is an organisational cost. Data must be collected, summarised, analysed and interpreted, and corrective action must be taken to improve performance where necessary. This often involves both a technology cost (the information system) and a human cost. Therefore, it is important that the design of a performance management system recognises the cost of measuring performance and compares this cost with the benefits that are likely to accrue from it. Performance measures that are very costly but yield little benefit should be avoided or eliminated. Costs here are not just cash costs, but opportunity costs—that is, the alternative use and the benefits from that use to which the resources consumed could be put.

In the TNA example discussed previously (Example 5.12), the owner–manager abandoned most traditional performance measures—including reported profits, except to comply with statutory requirements—because they were not cost-effective. Traditional accounting-based measures did not reflect the reality of TNA’s business model, where the largest costs for R&D, export market development and patent litigation were incurred many years before revenue was earned. TNA saved the cost of comprehensive monthly accounting performance reports that were not useful.

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The lean accounting approach argues that the costs of detailed time recording and material issues against jobs and carrying out price and efficiency variance analyses are prohibitive and yield little benefit compared with the cost. Lean accounting uses backflush costing to record the cost of time and materials based on standard costs once a job is complete. This is a far less costly accounting process. While the argument for lean accounting approaches seems logical, it is contingent to a large extent on how effective other controls are within the organisation.

There may be an opportunity cost in backflush costing if there are variances that are not identifiable. If a physical stocktake at year end results in only minor adjustments, it can be assumed that backflush costing is a cost-effective method and that abandoning time recording, material issues and variance analysis has reduced organisational costs. If there are serious discrepancies at the time of a stocktake, this highlights significant control weaknesses. Whether time recording, material issues and variance analysis may be effective controls is another matter, but this example highlights the need to consider the cost and benefits of performance measures in light of each organisation’s circumstances, as shown in Example 5.17.

Example 5.17: Mammoth Printing—Part 2Returning to the example of Mammoth Printing (see Example 5.16), one of the performance measures used historically was a measure of the length of paper that was produced by the printing machines. Paper is the most significant raw material in printing and this measure was thought to be an important measure of the volume of paper printed. The data was collected at the end of each print job and recorded on the job paperwork, then entered into a computer system and reported along with other data on management reports. However, there was no evidence that the data was used, or had ever been used. Someone had thought it was a good idea to collect the data, and no one had ever questioned whether it was still needed. There was a cost in printing machine operator time to calculate and record this data, which over the number of machines and over time would have amounted to a significant cost.

The questions that can be asked with regard to the value of performance measures are:• Can they be understood?• Can they lead to action to improve reported performance?• Will (and if so, how will) improving performance as reported by a particular measure help

achieve organisational strategy and goals?

If the answer to any of these questions is ‘no’, then it should be asked why that performance is being measured. There is a tendency by some managers and organisations to look for new performance measures, but often insufficient attention is given to abandoning performance measures that may once have been useful, but are no longer useful.

What is important in these examples is that, at the very least, organisations should question taken-for-granted practices and not continue them just because it is ‘the way we have always done things here’.

➤ Question 5.14Review the following 10 performance measures and their associated targets for XYZCo’s latest financial period. Evaluate the performance measures and targets with reference to SMART (specific, measurable, achievable, relevant, time-based) design principles, and the characteristics of effective performance measures and targets (validity, reliability, clarity, timeliness, accessibility and controllability).

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Performance measurePerformance target SMART Characteristics

1. Head office recharge of corporate costs to business units based on a percentage of sales revenue in each business unit

$1 million

2. Survey of brand recognition among members of the public

75%

3. Receivable days 45 days

4. Percentage of incoming telephone calls answered in one minute

90%

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5. Percentage of sales revenue from return customers

80%

6. Dollar value of donations to charities

$100 000 p.a.

7. Reduce employee turnover

Reduce turnover by 10% p.a.

8. Sales revenue growth 15% p.a.

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9. Headcount 120

10. Compliance with legal requirements

Full


For further practice in the concept of effective performance measures, please access the ‘Characteristics associated with performance measures’ learning task on My Online Learning.

Performance management, power and cultureThe preceding examples of unquestioned performance management practices reflect the importance of power and culture within organisations. In describing various approaches to performance management and management control, the role of culture has been highlighted, whether this is a clan culture (Ouchi 1980) or more general belief systems (Simons 1994; 1995). Cultural elements can be seen as part of the control package (Malmi & Brown 2008) but cultural factors also influence the design of performance management systems (Ferreira & Otley 2009). Euske, Lebas and McNair (1993) contrasted the individual performance measures, used to direct short-term attention, with cultural norms as the basis for guiding long-term behaviour.

An organisation’s culture will influence the kind of performance measures used. In a culture where accounting controls are seen as very important, it is more likely there will be time recording, material issues and variance analysis than lean accounting approaches. In an organisation whose culture is focused on short-term profits, then that will dominate the approach to performance management.

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Power is also important in determining what performance measures dominate in an organisation. Markus and Pfeffer (1983, pp. 206–7) argued that accounting and control systems are related to intra-organisational power ‘because they are used to change the performance of individuals and the outcomes of organizational processes’. The most powerful group in an organisation is the ‘dominant coalition’ (i.e. those who are making the choices) (Child 1972). This may not necessarily be the same as shown on the organisational chart of reporting relationships. Dominant coalitions are more subtle centres of power. Some organisations are dominated by the accounting and finance function, others by engineers, others by marketing and sales-focused roles.

Understanding how power influences the design of performance management systems is important because it enables a view of why certain performance measures exist and remain. The power of dominant coalitions also influences the relative importance of performance measures and targets. In a sales-driven organisation, it would be expected that more prominence would be given to measures of sales performance. In an R&D-focused organisation, relative importance might be given to new products or patent registrations. For example, the culture and power at Mammoth Printing was quite different to that at TNA.

Malmi and Brown (2008, p. 291) noted that ‘different systems are often introduced by different interest groups at different times’ and so control systems, including performance management, will be implemented when they are consistent with:

• other sources of power

• the dominant organizational culture in their implications for values and beliefs

• shared judgements about certainty, goals and technology (Markus & Pfeffer 1983, p. 205).

Example 5.18 highlights these issues as they apply to the advertising industry.

Example 5.18: International advertising agency Advertising agencies are dominated by large international conglomerates that are listed on international stock exchanges. As for all listed companies, short-term financial performance—primarily EBIT measures—and sales growth are key success factors.

In the advertising agency business though, creativity is also essential. Agencies recruit creative people who must succeed in designing advertising that works for the agency’s clients. Investing in talent recruitment can conflict with short-term financial pressures. One particular tension is whether to win sales revenue to finance new talent (which causes pressure on existing staff until the talent is recruited) or whether talent is recruited first (which causes pressure to win sales to fund the new talent).

While financial performance is important, advertising agencies measure their performance in terms of employee satisfaction and client satisfaction, and also by winning creative advertising industry awards. These awards enable the agencies to recruit talent, even though they do not necessarily reflect work that is valuable to the client, whose interest is less in the creativity than the ability of the advertising campaign to generate sales revenue.

In one international advertising agency, these different aspects of performance are managed simultaneously. Performance measures for finance, employee satisfaction and client satisfaction, as well as industry awards, are maintained. Attention is paid to both client satisfaction and employee satisfaction so that problems or trends identified through regular surveys of each group result in action to remedy the problem. Although there are no targets to win awards, the agency knows that failure to do so will detract from its ability to attract and retain creative staff. Most importantly, perhaps, creative talent is insulated from financial pressures, with senior managers protecting them from any financial information. Risk-taking by senior managers results in talent recruitment ahead of revenue generation. In the history of this agency, this has proven to be a successful strategy, because newly recruited talent has generated additional client income.

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Creative organisations like advertising agencies need to manage competing priorities in a flexible way to survive—both in terms of satisfying short-term expectations and investing in talent—that reduces profits in the short term, to achieve sustainable performance.

Of course, not all organisations can balance competing demands in an effective way. A contrasting example is the BP and Deepwater Horizons oil rig disaster (see Example 5.19), which demonstrated what can happen when a single aspect of performance is pursued at the expense of all others.

Example 5.19: BP and Deepwater Horizon in the Gulf of Mexico

The world’s largest accidental marine oil spill took place in the Gulf of Mexico when the USD 560 million Deepwater Horizon oil-drilling rig exploded in April 2010. This followed a blowout of the Macondo oil well, resulting in the death of 11 workers and an estimated five million barrels of oil spilling into the gulf.

Reports suggest that the main fault lay with BP and its subcontractors. The well was six weeks behind schedule due to a number of technical drilling problems and the delay was reported to have been costing BP more than half a million dollars a day. Best practice for drilling wells had not been followed and BP had chosen to drill in the fastest possible way. Despite concerns expressed by employees and consultants to BP, a number of shortcuts were taken to reduce costs. Each decision taken by BP, while legal, saved BP time and money yet increased the risk of a blowout (Bourne 2010).

An independent 15-member committee headed by University of Michigan engineering Professor Donald Winter released a report in November 2010, which found that BP’s focus on speed over safety contributed to the accident.

In its final report, the National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling placed most of the blame for the disaster on BP and its partners who placed financial interests before safety.

Following the incident, BP reported a second-quarter loss of USD 17 billion, its first loss in 18 years, which included a one-time USD 32.2 billion charge, including USD 20 billion for the fund created for reparations and USD 2.9 billion in actual costs (AC) incurred at that time. In October 2010, the CEO resigned. The total amount of claims paid or approved for payment by BP as at mid-December 2010 was USD 4.3 billion. In the aftermath of the disaster its market capitalisation fell by about USD 100 billion.

The information available suggests that BP’s culture of cost cutting to achieve short-term profits and the power of dominant coalitions to push ahead despite safety concerns were significant contributors to the accident. As a consequence, the reputational as well as financial cost to BP has been enormous.

Note: Candidates may be familiar with this example from their study of the Ethics and Governance subject of the CPA Program.

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➤ Question 5.15This module has drawn on the difference between performance measurement and performance management. Several examples have suggested that performance measurement needs to be customised to each specific organisation.

Explain why performance measurement needs to be customised and the role of the management accountant in performance management.


Performance management for performance improvement

The importance of performance improvementWhile performance management has been considered in relation to strategy and control, one of the most important aspects of performance management is using the results as part of the feedback cycle (see Part B) to make decisions aimed at improving performance. This is an area where management accountants can add value to their organisations. Such a contribution requires a more ‘soft skills’ approach because management accountants need to move beyond performance reporting.

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There is a significant opportunity for management accountants to collaborate with managers in other functional areas to identify where improved performance is possible. The management accountant has access to information that is not always readily available to non-financial managers. Management accountants can exercise their professional judgment to identify: • problems with performance targets• operational issues that may be leading to sub-optimal performance• data inadequacies.

Management accountants then need the personal skills to be able to use their knowledge to influence senior managers in relation to performance management by: • setting SMART measures and targets consistent with strategy• providing relevant information to support other managers’ decision-making• identifying and recommending potential approaches to performance improvement.

The opportunity for performance improvement through using targets, trends and benchmarking is reviewed in the following section.

TargetsAs outlined previously, at the first level targets need to be set for each performance measure and performance measures should cascade down the organisational hierarchy through each business unit to the individual level. Performance targets need to be SMART and meet the six characteristics of effectiveness.

Targets that are set can range from those that are easy to achieve to those that are difficult or impossible to achieve. The achievement of a target, therefore, is not necessarily a sign of ‘good’ performance because it is relative to the target set. Improving performance is often seen as a process of continually increasing the target and expecting that target to be achieved, but there are three problems with this approach: 1. the cost–benefit trade-off in continually achieving more stretching targets2. the impact of achieving some targets on other targets3. the accuracy of assumptions in the predictive model.

Cost–benefit As discussed previously, the costs and benefits of achieving an ever-increasing target need to be weighed against improving performance.

For example, a student who has a target of 80 per cent in an exam may achieve 82 per cent. The same student may then decide to increase the target to 85 per cent or 90 per cent. However, the student needs to evaluate whether the costs (e.g. time spent studying and its opportunity cost, such as working fewer hours at their part-time job) are worthwhile to achieve the higher mark. It may be that the additional cost to get a mark of 90 per cent (compared to the existing 82%) is not worthwhile and the student could expend their efforts elsewhere.

By contrast, a student who sets a target of 70 per cent and achieves a mark of 60 per cent should be sufficiently motivated to work harder to improve performance, but it may be that the student decides to lower expectations to a revised target of 65 per cent. The actual target will depend on the student’s goals and may be quite different between individual students, depending on their abilities, motivation and aspirations.

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Keeping targets in balance In Part B of this module the balanced scorecard was introduced. One of the key aspects of the BSC is the idea of ‘balance’—that is, it may not be possible to always maximise performance on every measure, but an optimum result should be sought. In the student example, one of the costs of increasing a target for examination performance on one subject and working towards achieving that performance is that performance on other subjects may suffer. Equally, the relentless pursuit of profit may damage customer satisfaction, or the relentless pursuit of customer satisfaction may impact on business process efficiency.

The idea of strategy mapping was that organisations set performance targets based on their strategic goals and then regularly review their performance against those targets. The result of this review may be to reallocate resources, or management attention, to underperforming areas (which may result in a detrimental effect on those areas deemed satisfactory), or to modify the target if it is considered that the target is inappropriate in relation to other targets.

Predictive modelParts A and B discussed the idea of the predictive model. The predictive model is the set of assumptions that drive the business: • why customers buy products and services• how those products and services are produced to fulfil customer orders.

The predictive model suggests that if particular actions are taken, they are likely to lead to defined levels of performance. However, Otley and Berry (1980) argued that predictive models are partial and unreliable. It is not certain that actions (e.g. an increase in advertising expenditure) will lead to performance improvement (e.g. an increase in sales). Organisations work on the basis that assumptions about their predictive model are correct, but they need to continually challenge their assumptions and ask whether the performance targets they have set are still appropriate. Continual poor performance compared to targets may suggest broader problems with the taken-for-granted business model. A good example of the failure of predictive models was the GFC and the purchase of complex financial products like mortgage-backed securities in an overheated housing market.

TrendsThe second level of analysis for performance improvement is trend. Accountants are familiar with trends in the analysis of financial ratios from financial statements. The same principle applies to all performance measures, but organisations will typically monitor non-financial ratios more frequently (monthly, weekly or even daily for some measures) than for many of the ratios calculated from annual financial statements.

Trends show improving or worsening performance over time, and are more reliable measures of performance than comparing performance to targets, which may be set more subjectively. Rather than taking corrective action based on single period comparisons between actual and target, trends can identify short-, medium- and longer-term changes in performance that deserve attention. Performance needs to be sustainable over time, so short-term improvements compared with targets need to be re-evaluated by looking closely at trends over longer time periods.

Benchmarking The third level of analysis for performance improvement is benchmarking—that is, comparing performance to competitors, industry averages, or acknowledged ‘best practice’ or ‘world class’ performance. Benchmarking enables an organisation to see where its performance might be improved relative to others. Figure 5.13 shows the benchmarking process for performance.

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Figure 5.13: Benchmarking performance

1.Decide what

to benchmark

2.Identify

benchmarkingpartners and sources

3.Study the

processes in your ownorganisation and

gather information

4.Obtain

benchmarkingdata

5.Analyse the

information andunderstand it relative

to the benchmark

6.Learn and

implement changeswhere necessary


Benchmarking requires other organisations’ data to benchmark against, and sometimes access to this data can be very difficult. In some industries, performance data is held quite closely—for example, the Big 4 accounting firms or large law firms, where it is difficult to obtain competitively sensitive data. In other industries, data is publicly available, such as the automotive and retail industries, usually because of the economic impact of these industries, which results in a lot of statistical data being published. Much data is collected and reported by industry associations. Industry associations, such as the Master Grocers Association in Australia, provide data (see http://www.mga.asn.au), although detailed information is usually only available to members. Data is collected by government authorities, such as the Australian Bureau of Statistics (http://www.abs.gov.au). Private sector research organisations such as IBIS World (http://www.ibisworld.com.au) produce detailed reports, although the cost of obtaining research reports can be quite high.

Some common areas benchmarked by businesses are:• sales revenue and profitability• products and services• pricing structures, fees and overheads• quality control processes• customer service standards or the number of customers• staff management and turnover.

For example, the Australian Bureau of Statistics reports aggregate data for retail sales per square metre of floor space, labour cost per employee and inventory turnover data. Supermarkets use various data to compare their performance, such as financial results, sales revenue and number of stores. Competitor financial statements will of course be used to compare financial ratios.

Other data shown in some company annual reports includes performance measures of sales per square metre of floor space and sales per employee, both key performance measures in the retail industry. Benchmark comparisons of data such as this are useful in making comparisons of efficiency in use of floor space and staffing levels. Woolworths’ annual report, for example, also shows the number of customers linked to its ‘Everyday Rewards’ accounts and Qantas Frequent Flyer points.

Whereas EPS data is regulated, data on non-financial performance measures is not required under financial reporting standards. So it is often the case that benchmark comparisons cannot be made or can only be made based on estimates derived from data shown in the annual report—for example, using reported sales figures, estimates of supermarket size or employee numbers.

http://www.mga.asn.au

http://www.abs.gov.au

http://www.ibisworld.com.au

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Two kinds of benchmarking are most common: 1. internal2. external (industry), although sometimes benchmarking with organisations in other industries

is also possible.

Internal benchmarksWhere an organisation has multiple business units, especially when those units have similar operations, comparisons between units may be useful. For example, retail stores make extensive use of benchmarking, comparing sales per square metre and sales per employee between store locations and between departments—for example, homewares, clothing, electrical. Internal benchmarks would be particularly valuable to compare hotel performance within EVT’s hospitality division.

Banks have used internal benchmarking of performance measures as a method of introducing internal competition and learning. Each branch receives a report indicating how they score on various measures compared with other branches. Some banks do not allow any branch to stay constantly in the lowest category and low-ranking branches may be closed, or there may be managerial changes or an investigation of the causes of a branch scoring in the lowest category with an aim towards improvement.

External (industry) benchmarksIndustry benchmarking provides a comparison of an organisation’s performance against either industry averages or best practice. The organisations used for comparison are usually in the same market segment and have similar products, processes or technology.

One method of benchmarking is to obtain data directly from the organisation identified as having the best practices, but if this is a competitor, direct access to data is not normally possible. Indirect data may be obtained through business intelligence (BI)—for example, from websites, trade exhibitions or speaking informally with competitors. A common practice in some industries is to hire employees from competitors to obtain first-hand knowledge of competitors’ practices, although this is generally regarded as being unethical; and such employees are often restricted by non-compete and confidentiality clauses in their employment contract and exit package.

One way to have reliable industry benchmarks is to set up a benchmarking consortium that includes a number of organisations operating in the same industry. Universities do this to compare their performance on research, teaching quality and graduate outcomes. Independent organisations are commonly selected to collect the information and provide each organisation with its own results as well as those of other organisations, in a format that does not allow individual organisations to be identified. In many public sector organisations, such as schools and hospitals, government departments benchmark data and make some publicly available, with other data being restricted to the participating organisations.

Increasingly, governments produce data to enable benchmarking of government-funded services. In Australia, some websites include:• ‘My School’ (http://www.myschool.edu.au)• ‘My Hospitals’ (http://www.myhospitals.gov.au).

http://www.myschool.edu.au

http://www.myhospitals.gov.au

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Benchmarks for small businesses can be downloaded from the Australian Taxation Office website at: http://www.ato.gov.au/Business/Small-business-benchmarks.

Sometimes there is an opportunity for benchmarking against best practice organisations outside the organisation’s own industry, but care needs to be exercised as to whether practices can be translated between industries.

Problems with benchmarkingBenchmarking is not without its problems. Many issues need to be considered when benchmarking is undertaken, including:• obtaining the participation of benchmarking partners, all of whom must see some value

in the process• determining why performance is different compared to a benchmark• the sometimes widely different contexts of organisations—for example, regulatory,

technological and historical legacies• non-standardised data—that is, data is measured differently or has a different meaning

between organisations—for example, gross profit may be measured differently• the historical nature of the data itself, which may not reflect more recent changes.

All benchmark data needs to be interpreted carefully. Accountants and managers need to look behind the data provided and try to understand why differences in performance between organisations exist. Sometimes performance may vary due to different strategies or business models, different regulatory regimes, or differences in legacy investments—for example, in technology or infrastructure. In the absence of standardised data, all comparisons need to consider whether the assumptions behind reported data are common between the benchmarked organisations. Finally, the data derived through benchmarking is historical and reflects decisions of the past, not current practices or recent decisions that are yet to be implemented. In relying on past benchmarking comparisons, accountants and managers need to be aware that the pursuit of continual improvement and sustainable competitive advantage by all benchmarked organisations leads to continually evolving processes, and therefore continually changing performance relative to others.

In aiming for performance improvement, targets, trends and benchmarks all provide useful information in learning what works and what does not, but all available information should be used when seeking to improve performance. In comparing actual performance against targets, remember that the variance may lead to a decision to change behaviour to improve performance relative to targets, or to change a target to one that is more realistic. It is also important to recognise that there is a time lag between making changes and when the effect of changes can be seen in performance measures.

http://www.ato.gov.au/Business/Small-business-benchmarks

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➤ Question 5.16(a) Briefly explain the main steps involved in undertaking a benchmarking exercise.

(b) Identify the main problems associated with undertaking a benchmarking exercise.

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(c) Identify at least four benchmarking opportunities for an organisation.


Organisational learning and performance improvementThe process of learning from performance comparisons using targets, trends and benchmarks involves a continual process of improvement through organisational learning or knowledge management. Failure to learn and improve, as reflected in the innovation and learning perspective of the BSC, will likely lead to a loss of competitive advantage and ultimately to organisational decline.

Organisational learning Performance management through improving performance is a learning process. Data is collected, analysed and interpreted by individual organisational members. When behaviours or performance targets (or even what elements of performance are measured) need to change, organisational systems, processes and procedures may prevent these changes from being enacted. Organisations commonly have members who know what needs to be changed, but the organisation can sometimes seem incapable of change because the ‘organisational memory’ is institutionalised (or embedded) in IT systems, procedure manuals, taken-for-granted working practices, budgets and performance targets. Consequently, existing systems, procedures or working practices may need to be ‘unlearned’. This is a process of organisational learning, meaning how organisations as institutions (rather than the individuals within them) are able to learn and improve. This is a distinction between learning in organisations by individuals, and learning by organisations made by Popper and Lipshitz (1998).

Organisational learning is concerned with the acquisition, sharing and utilisation of individual knowledge within organisations (see Nonaka 1991). It is also concerned with how assumptions about cause-and-effect relationships are shared within organisations, as well as how redundant information is unlearned (e.g. Hedberg 1981). Organisational learning is about managing knowledge at the level of the organisation.

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Performance improvement Performance improvement requires a learning process that makes performance comparisons using targets, trends and benchmarks; identifies changes needed to the assumptions about cause-and-effect relationships in the predictive models held by individuals about business models; and changes any or all of:• behaviour• performance measures• targets, where necessary. These are within the domain of the management accountant to influence, as discussed previously. Learning and knowledge management are particularly important in fast-changing markets or technological environments, as Example 5.20 demonstrates.

Example 5.20: Technological change in music and videoThe case of value creation at Apple Inc. highlighted rapid technological change and product innovation. However, many downstream organisations are affected by the pace of change, which is often outside their direct control.

In the music industry, music recordings were originally on gramophone records and subsequently on large reel-to-reel tape recorders. Further innovations were cassette tapes and compact discs (CDs). With computer and internet technology, there is no need to buy music on any particular type of media—it can be purchased and downloaded from e-commerce sites and stored and played on a computer or mobile device. Similar changes have taken place in video with VHS tapes (Betamax tapes failed quickly in competition with VHS) giving way to CDs, DVDs and Blu-ray technology (Blu-ray effectively beating its Toshiba HD-DVD competitor). Movies can now be purchased and downloaded from the internet in the same way as music. Foxtel, which was a major supplier of downloadable content, is facing considerable competition from Netflix. In music streaming, we have seen the failure of Pandora and its replacement by Spotify, which provides features valued more by customers.

These technological changes have had significant impacts on the business models of recording studios, manufacturers of audio and video equipment, and media devices like records, tapes, CDs and DVDs. Performance measures in those industries would likely have focused on numbers of units sold and sales revenue, etc. Without knowledge of rapidly changing upstream technologies, these companies may have been caught unaware by declining sales volume and profitability and may have ultimately failed. Performance measures that are more strategic, such as awareness of patent registrations, collaboration agreements with upstream supply chain partners and environmental scanning of emerging technologies, would serve to avert the effect of such changes.

Similarly, retailers would have had to adapt quickly to new technologies, and the likely impact of downloading music and videos on the types of recording and playing equipment required. As for equipment suppliers, attention to performance measures on sales volume and value, floor space and employee numbers could have led to serious consequences. Retailers who were better informed about technology change could introduce measures for reducing inventories of products that were likely to become obsolete and for expanding the product range to spread the risk, such as the number of new product launches or advertising expenditure on new products. Awareness could lead, for example, to a shift in the business model from retail stores to online sales, something that has become evident in retailers such as JB Hi-Fi; while Amazon’s launch in Australia has generated much discussion about the threat to ‘bricks and mortar’ retailers from its online platform.

Behavioural consequences of performance managementThis section is concerned with how performance management influences the behaviour of managers and individuals within the organisation. Some of the consequences are unintended and some can be quite dysfunctional. Again, it is generally accepted that ‘what is measured by organisations is what gets done’, because management attention to certain aspects of performance focuses the behaviour of individuals on that performance. If particular performance is rewarded, then this is even more likely to result in individual behaviour being directed at meeting targets and achieving the rewards offered.

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Performance measures and performance targetsPerformance measures focus on what is important for the organisation, based on what it has learned about its business model. When performance is measured, it directs attention towards what is measured. Simons (1994, 1995) differentiated diagnostic from interactive forms of control: • Diagnostic controls use feedback to monitor performance and correct deviations from plans. • Interactive control systems are used by managers to involve themselves more directly in the

decision activities of employees.

A performance measure that is used interactively is more likely to influence behaviour than one used diagnostically, because subordinates will be aware that senior managers are paying attention to particular aspects of performance.

In a similar way to compiling budgets, those who determine performance measures and their associated targets derive a considerable source of power in organisations. Targets need to be achievable (the ‘A’ in the ‘SMART’ acronym) but may be on a continuum from ‘stretch’ targets to easy-to-achieve ones. Managers are more likely to accept targets and be motivated to strive to achieve them if they feel that they have participated in the target-setting process, even if the final targets are difficult to achieve. By contrast, if targets are simply imposed without any participation, managers are unlikely to be motivated towards achieving them. The example of Mammoth Printing showed how performance measures—like sales targets—resulted in behaviour that was not necessarily in the organisation’s best interests. In that example, many of the sales achieved were unprofitable due to the impact of smaller orders on production efficiency, but the commissions paid to sales representatives rewarded these unprofitable sales.

Professor David Otley (1999) provided two illustrations of the unintended and dysfunctional consequences of performance measures.

1. Otley, an international expert in performance management, undertook research at British Airways (BA) and observed baggage handlers at Heathrow Airport. As soon as an aircraft landed, one of the baggage handlers unloaded the first available passenger’s suitcase and ran to the baggage conveyor belt. The rest of the baggage was unloaded and stacked on trolleys, which were then driven to the conveyor belt and unloaded. Otley asked what the baggage handler was doing with the first suitcase. The BA manager’s response was that a performance measure for baggage handling was the time taken to put the first suitcase onto the conveyor belt. The performance measure achieved the desired performance, but only for the first suitcase—the others were being unloaded without any change in behaviour.

2. Otley was buying his weekly groceries from Tesco, a major UK supermarket chain. Otley was surprised that the checkout operator waited until the conveyor belt was full of groceries before she commenced scanning and packing. Otley’s interest in performance management led him to ask the operator why she waited before commencing the scan. The checkout operator replied that one of her performance measures was the average time it took to scan a customer’s trolley, based on the time elapsed between the first and last item scanned and the number of items scanned. If the operator had to wait for the customer to take goods out of the trolley it would negatively impact on her performance, which would be seen by everyone on an office chart that ranked the speed of checkout operators.

In both cases, the performance measures were well-intentioned, but resulted in unintended consequences: • an absence of any improvement in the unloading speed of baggage from BA flights• customer dissatisfaction in what, from the customer’s perspective, appeared to be a lazy

checkout operator (Otley 1999).

Efforts to report performance that is desired by senior management can lead to a variety of unintended and dysfunctional consequences, such as those outlined in Table 5.6.

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Table 5.6: Types of unintended and dysfunctional behaviours

Tunnel vision Focusing on a single target to the exclusion of all others

Sub-optimal behaviour Achieving a performance target and failing to try to further improve because the target has already been achieved

Substitution Reducing effort on performance that is not subject to management attention

Being fixated on a performance measure

Rather than the underlying performance, by ignoring the cause-and-effect or action-and-outcome relationships

Gaming and biasing Making performance appear better than it is, either by misrepresenting performance by providing inaccurate reasons for not achieving targets or even falsifying reported performance

Smoothing reported performance

Removing fluctuations between reporting periods


Although they were writing about budgeting, the classic research by Lowe and Shaw (1968) identified several sources of bias that are equally applicable to performance measures. These are the: • reward system• influence of recent practice and norms• insecurity of managers.

The same sources of bias apply to non-financial performance measures where, in a similar way to compiling budgets, there is ‘the desire to please superiors in a competitive managerial hierarchy’ (Lowe & Shaw 1968, p. 312).

These behaviours distort not only target setting and reported performance, but may also result in actions taken by organisations that detrimentally affect performance. Dysfunctional and unintended consequences can easily result from inappropriate performance measures and targets. In these organisations the pressure for short-term financial performance ignored issues of the sustainability of that performance over time, and the associated reputational issues. Often this focus on short-term financial performance is driven by the rewards offered to directors and senior managers.

The role of incentives and rewards in performance managementAs Lowe and Shaw (1968) identified, rewards significantly influence behaviour. The examples of EVT, Woolworths, Newcrest Mining and others highlighted that audited remuneration reports now take up many pages in listed company annual reports. These remuneration reports typically contain STIP and LTIP that reward directors and senior managers for achieving financial and non-financial targets. These targets, particularly in the LTIP, are usually consistent with shareholder value goals. Cascading will result in some of these targets, supplemented by more operational targets as well as sales and cost targets, flowing down to each business unit and often being embedded in individual performance appraisal processes.

Employees can be motivated either through a ‘carrot’ or ‘stick’ approach. ‘Carrots’ are the rewards employees receive for achieving the desired levels of performance. ‘Sticks’ are the sanctions or penalties that result from not achieving desired levels of performance.

Rewards can be financial (e.g. bonuses, profit sharing, share options), but can also be non-financial (e.g. promotion, transfer to desired positions, a better office, a bigger budget, recognition, a better performance appraisal). Sanctions include the loss of financial reward; being identified as a poor performer; a negative personal reputation; or perhaps demotion, transfer or even dismissal.

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Consequently, rewards and sanctions are powerful motivators of behaviour, and can of course lead to the unintended and dysfunctional consequences discussed in the previous section. Rewards should be designed so that the needs for short- and long-term performance are in balance. Short-term (especially financial) results should not be achieved at the expense of sustainable longer-term performance and achievement of the organisation’s goals and strategy. Company LTIPs will often reveal the need for sustainable performance over time before rewards are awarded.

This module has used the example that reducing expenditure on advertising, employee training, repairs and maintenance, or R&D would improve short-term financial results, but would likely detrimentally affect the organisation in the longer term. One impact of rewards for short-term performance is that managers may achieve targets and be rewarded financially and promoted. A replacement manager could then be at a disadvantage. The lack of prior investment makes an incoming manager’s performance appear worse, because they have to remedy the deficiencies of the previous manager who improved short-term performance through failing to invest in the longer term.

The process of tying reward to performance requires two issues to be considered: 1. timing2. group versus individual rewards.

TimingTo reinforce the relationship between performance and reward, rewards need to be timely. If too much time elapses between performance and rewards, the important association between rewards and actions becomes less obvious to people. This suggests that annual bonuses are potentially ineffective and that bonus payments more closely linked in time to the achievement of the desired performance level are likely to be more highly motivating. On the other hand, making bonus payments too soon after performance is achieved can lead to a focus on short-term profits rather than profits that are sustainable in the longer term.

Group versus individual performanceThere is an inherent conflict between the teamwork required for effective organisational performance and the use of individual reward systems. For effective motivation, managers must feel that their effort has a direct impact on their performance and the related performance measure and reward. This is the principle of ‘controllability’ (discussed previously). The choice between individual and group rewards depends to an extent on the interdependencies that exist within the organisation. High levels of interdependency will mean that identifying individual performance, and then paying appropriate compensation, is difficult.

In many organisations, performance rewards are based on aggregate measures such as profit. As has been noted previously, the influence any individual has on corporate profit is likely to be small, so the motivational effect of a profit-based bonus on the individual is likely to be equally small. This approach is popular, because reward systems based on group performance measures, such as profit, enhance teamwork, or at least reduce the potential for dysfunctional conflict, and—as agency theory tells us—they align the goals of managers with those of shareholders. However, the incentive to engage in gaming behaviour to achieve desired performance targets can be a negative influence, and at the extreme, managers and employees may behave dishonestly in their profit-reporting activities, as the examples of Enron and WorldCom revealed.

The most high-profile example of the focus on short-term financial performance affecting longer-term performance has been the GFC. This is explored in Example 5.21.

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Example 5.21: Global Financial CrisisThe GFC, which commenced in 2007 and reached its peak in 2008, had wide-ranging impacts on individual countries, global financial markets and institutions and national economies. A recession affecting most global markets lasted until 2012. Australia has been insulated from any sovereign debt crisis, although there have been corporate failures and severe personal losses as a consequence of the failure of some smaller financial institutions.

Two particular causes of the GFC have been given by commentators.

1. The practice of securitisation, where loans are packaged and resold by banks to other financial institutions, including insurance companies, to raise funds for further lending.

2. A related cause of the GFC was said to be the rewards offered to directors and senior managers, especially in the financial services industry, for continuously improving performance that was unsustainable and did not take into account the risks that were being faced. The initial round of blame in financial institutions that lost billions on subprime mortgage-linked investments focused on their chief executives. CEOs at Citibank, UBS and Merrill Lynch were forced to leave their companies.

There were severe effects from the GFC. The national income and output of the United States fell by about 4 per cent in June 2009. That made it by far the sharpest US recession of the post-war period. In the Eurozone, the peak-to-trough fall in output was even larger at around 6 per cent, and in the United Kingdom it was 7 per cent. Further, in Europe, many countries were affected by a sovereign debt crisis—that is, an unsustainable national debt caused by continual deficits—with Iceland, Greece, Ireland, Portugal, Spain and Italy particularly at risk. The banks in many countries in the Eurozone, in particular in Greece and Spain, faced difficulties in meeting their debt obligations, which caused a downturn in demand and globally depressed stock markets (RBA 2014).

More information on this topic can be found at: http://www.rba.gov.au/speeches/2014/sp-ag-160314.html.

The GFC and its aftermath are at least in part a consequence of the relentless pursuit of short-term financial performance, driven by rewards for measured success, without a real understanding of the predictive model—which effectively collapsed—or a concern for risk or the sustainability of performance over the longer term.

Example 5.22 provides an example of an alternative approach to performance management and sustainability of performance.

Example 5.22: Svenska HandelsbankenSvenska Handelsbanken’s goal was to be the most profitable bank in Sweden, but size was unimportant to its CEO Jan Wallander. The bank’s strategy was to be radically decentralised, with nearly all lending authority independent of head office.

Wallander abandoned budgeting at Handelsbanken but this had no effect on the bank’s performance. Reflecting the contingent nature of performance measures, Wallander said that organisations will use ‘different types of key indicators, ratios, graphs, etc. Modern companies already have myriads of operational, financial and physical measures. The problem is to choose a limited number of those measures which really show if the company and its different units are on the right track or not’ (Wallander 1999, p. 419).

Without a budget, no budget/actual comparisons could be made at Handelsbanken. Instead, the real target was not in absolute monetary terms but a relative one, a return on capital better than other businesses were achieving, not just in the banking industry but in other industries as well. Handelsbanken thus adopted a true shareholder value model.

http://www.rba.gov.au/speeches/2014/sp-ag-160314.html

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STUDY GUIDE | 487

In the absence of targets, the emphasis in performance management was on benchmarking: relative performance compared between Handelsbanken’s branches, but also compared with other Swedish banks. In addition to benchmarks, trends were compared from quarter to quarter, benchmarking from one time period to another.

The final element of Wallander’s strategy at Svenska Handelsbanken was a profit-sharing system for employees, with the profit share dependent on the profitability of the bank relative to other Swedish banks. Interestingly, the employees’ share in the profits of the bank was only paid to them when they retired, which encouraged attention to the sustainability of performance.

➤ Question 5.17After reading Example 5.22, compare what has been learned about performance management throughout this module with the approach that Jan Wallander took in Svenska Handelsbanken.

Critically evaluate the Handelsbanken approach in relation to non-bank organisations, considering:

(a) the type of performance measures used

(b) the reward system.


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ReviewPerformance management focuses on shareholder value through customer value and achieving a strong competitive position for the organisation. Such a focus would not be possible without understanding the key role that performance management plays in strategy and value creation.

Part A looked at the definition of what was meant by performance and performance management and emphasised the importance of balancing financial with non-financial measures. Value creation and the sustainability of performance over time were outlined, as well as sustainability in the sense of CSR. The implications of performance management for accountants and its links with governance and signalling were introduced. Part A also described the importance of ethical responsibilities, and agency and contingency theories that underlie much of the study of performance management.

Part B looked at the links between strategy, management control systems and performance management, and the limitations of some traditional accounting-based controls. The various models of performance management, including the Business Model Canvas, were introduced. The BSC and the strategy mapping process was emphasised, as well as cascading performance measures and the important role of information systems in performance management.

Part C looked at how performance measures and their associated SMART targets are designed and the characteristics that make performance measures useful, including the need to compare the costs and benefits of performance management. This part also briefly introduced the role of power and culture in performance management. It focused on improving performance through targets, trends and benchmarking, and the importance of CI through organisational learning and knowledge management processes. This is a role in which management accountants can use their ‘soft skills’ to add value through interpreting performance and recommending ways to improve performance. Finally, Part C looked at the often unintended and dysfunctional consequences of performance management and how reward systems are implicated in performance management.

Appendix 5.1 explores the case of Achmea including examples of how Achmea develops its performance measures using a BSC linked to strategy through the strategy mapping process. This process is cascaded down through the organisation to enable strategy to be implemented. Achmea reports its performance in financial and non-financial terms and emphasises its commitment to broader sustainability through its GRI index.

The key themes emerging throughout the module were:• the importance of performance being both socially responsible and sustainable• the leadership role of the professional accountant in performance management • the importance of value-adding activities.

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APPENDIX 5.1 | 489

Appendix

Appendix

Appendix 5.1

Achmea Holding N.V.

Achmea Holding N.V. (hereafter Achmea) is a Netherlands based:

insurance company established in 1811 and is the largest insurance provider in the Netherlands. The group was formed by mergers and acquisitions of numerous mutual and cooperative insurance providers over a period of more than two centuries. It operates internationally in selected markets, including Turkey, Greece, Slovakia, Ireland and with partner Rabobank in Australia where it is an insurer of farms.

As a result of its cooperative background and identity, Achmea (a ‘mutual’) is not listed on the stock exchange.

The majority of Achmea’s shares (65%) are held by Vereniging (Association) Achmea, which represents all of Achmea’s customers—so Achmea’s customers are its owners. Partner Rabobank holds 29 per cent of the shares and the remainder is held by like-minded European insurers (Achmea 2015).

Achmea’s Annual Report 2017 can be downloaded at https://www.achmea.nl/en/investors/reports/Paginas/default.aspx.

The annual report comprises three parts:

Part 1 is the ‘Annual Review’. This is aimed at a broader target audience and contains a description of the progress made by Achmea in 2017 and our vision of the future. Part 2 is the ‘Year Report’. This describes the main financial developments. Among other things it contains the financial statements, the report of the Executive Board and a report on our Governance. Part 3 comprising the ‘Supplements’ contains sustainability-reporting information and appendices to the other parts (Achmea 2017, p. 47).

https://www.achmea.nl/en/investors/reports/Paginas/default.aspx


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Achmea makes clear it is a stakeholder-oriented company:

As an insurer, by our very nature we are alert to the long-term interests of all stakeholders. Sustainability is therefore logically of great importance to us. Corporate Social Responsibility forms the foundation for our business operations and strategy (Achmea 2017, p. 9).

The company identifies four main stakeholder groups:

Customers are our most important stakeholders. … Employees are the human capital and beating heart of our company … We have several business partners. Rabobank and the brokers are important distribution partners … Our capital providers (shareholders, bondholders and other equity providers) supply our financial assets (Achmea 2017, p. 11).

Candidates should note that this structure of stakeholders could be aligned with the Business Model Canvas described in Part B of this module.

Achmea identifies five main product groups, or ‘value chains’ as Achmea calls them: Non-Life, Health, Retirement Services, Pension & Life, and International (Achmea 2017, p. 20). Its strategy ‘Delivering Together’ covers the period 2017–19. The business strategy focuses on:

strengthening our current business models and on developing new products, services and business models … evolving from its traditional role as an insurance company … to one that focuses more on services (Achmea 2017, p. 19).

The strategy is described in detail on pp. 19–20. Importantly, the strategic themes Achmea has adopted incorporate sustainability as a leading motive (see below).

The strategy has been developed in the context of a SWOT analysis, shown in Figure A1 5.1.

Figure A1 5.1: Achmea SWOT analysis

Achmea Annual Review 2017 I 16

CONTEXT & STRATEGY OTHER INFORMATIONOBJECTIVES & PROGRESS APPENDICESINTRODUCING ACHMEA

RISKS AND UNCERTAINTY

New and vanishing risks in society All these changes affect the frequency of or potential for risks. The risk of use is declining, e.g. due to the development of driverless cars and home automation. Early signalling of undesirable situations can contribute to a substantial reduction in the cost of claims. Improved insights into health risks can lead to quicker intervention or preventive action.

New risks are emerging. In the short term, these are risks relating to cybersecurity and the sharing economy. In the long term, we also anticipate an increased need for dealing with risks linked to climate change and liability. For some of these risks, the emphasis will be more on prevention and risk mitigation.

Growing uncertainty for customers and businesses Uncertainty in the lives of our customers will continue to be a fact of life. Uncertainty surrounding jobs and income will increase as new technologies can replace the use of human labour. Companies will see new business models and ecosystems emerge that use technology in combinations that do not exist yet. This will change or even disrupt existing business models.

SIGNIFICANCE FOR ACHMEA

The precise direction and speed of change is unknown. A part of the existing propositions will disappear, new propositions will present themselves, market boundaries are fading and competition is changing. Armed with this knowledge and within this context, Achmea has formulated its strategy. We are anticipating the developments mentioned.

We see a dual challenge for ourselves: on the one hand, to strengthen our current business models, and on the other, to develop new products, services and business models.

The way in which we will do this is described in the Delivering Together section.

STRENGTHS WEAKNESSES

OPPORTUNITIES THREATS

• Customer base, brands; customer ratings• Broad portfolio and advantage of diversification• Leading in health and property & casualty insurance• Variety in distribution; strong in banking and direct channels• Broad access to Dutch businesses

• Increase the number of Rabobank customers with an Interpolis insurance policy• Use technology for new services, prevention and cost savings• Expand business model to include services• Convert data into value for customers• Revenue models for new risks (cyber, climate)• Partnering in new ecosystems

• Introduction of new revenue models in existing Achmea markets• Declining risk of use and need for insurance• Vertical integration (reinsurers, car manufacturers)• New ecosystems relating to supply and demand platforms• Changing concept of solidarity• Impact of climate change

• Financial results not yet at target level• Growth of Free Capital Generation required to be able to continue investing in innovation• Restricted scale of international activities• Large market share in mature home market

Source: Achmea 2017, Annual Report 2017, Part 1, p. 16.

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APPENDIX 5.1 | 491

Achmea makes explicit use of a BSC and strategy map:

Achmea’s activities are managed on the basis of six perspectives. The essential elements of the strategy have been translated into a strategy map. Achmea has key performance indicators for each perspective to guide us in achieving our objectives for the planning period 2017-2019 (Achmea 2017, p. 23).

Performance measures are described for each of the perspectives on pp. 22–3 of the annual report, Part 1. Further details of the performance against each of these perspectives is shown on pp. 56–9 of the appendix to the annual report, Part 1. In the 2016 annual report, the performance measures or ‘key performance indicators’ as they were called were shown diagrammatically and are reproduced in Figure A1 5.2.

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Figure A1 5.2: Achmea key performance indicators—2016 annual report

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APPENDIX 5.1 | 493

Achmea’s six perspectives add two to the four standard perspectives in the BSC: society (both in terms of its mutual customers/shareholders and to the wider society); and partners (Rabobank and the businesses that distribute Achmea’s products). It also reflects an employee perspective (rather than learning and growth). Performance on each perspective is described in detail on pp. 24–39 of Part 1 of the 2017annual report.

In particular, candidates should note that Achmea highlights its use of the NPS to measure customer commitment to brands in the customer perspective; and profit before tax as the main measure in the financial perspective.

Achmea’s strategy map, which links the six BSC perspectives, is shown in Figure A1 5.3.

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Figure A1 5.3: Achmea strategy map

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APPENDIX 5.1 | 495

The links between performance management and remuneration are disclosed in the remuneration committee report within the annual report, Part 1:

The process of performance management and variable remuneration was conducted in a balanced manner within Achmea in 2017, while it was also extended to the various organisational levels. In modifying the process, it was decided to opt for greater simplicity and stricter management by restricting the number of Key Performance Indicators (KPIs), while also defining them more precisely, in a manner that matches the company’s risk profile and risk appetite, in a way that aligns the strategy and long term value creation … there is a sound balance in the type of performance indicator, short and long-term performance management and in the criteria used as a basis for variable remuneration (Achmea 2017, p. 43).

Mentioned previously is Achmea’s commitment to sustainability issues. The annual report is:

compiled in line with the G4 Guidelines (Core option) of the Global Reporting Initiative (GRI). The Annual Report’s structure complies in part with the principles of the International Integrated Reporting Framework laid down by the IIRC. Both the IIRC and GRI stress the importance of reporting on material topics … Achmea intends to conduct a completely new materiality analysis next year and use the revised material topics as the starting point for its external reporting (Achmea 2017, p. 47).

Achmea also identifies with the United Nations Social Development Goals (SDGs) under which the United Nations set out, in July 2016, arrangements for monitoring progress and measurement using indicators. Figure A1 5.4 shows the four themes and eight related SDGs (described on p. 45).

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Figure A1 5.4: Achmea social development goals

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Part 2 of Achmea’s annual report focuses on its commitment to socially responsible investment as:

always being able to fulfil our financial obligations to our customers and invest in a socially-responsible manner, with respect for the world around us and for future generations … contributing to a healthier, safer and more future-proof society (Achmea 2017, p. 27).

For example, ‘Achmea does not invest in tobacco producers, as this would be inappropriate for a major health insurer. We also exclude manufacturers of controversial weapons’ (Achmea 2017, p. 27). Achmea’s social themes include energy, paper, waste and corruption (Achmea 2017, p. 31); and employee and gender diversity (Achmea 2017, pp. 33–5).

Part 3 of the 2017 Achmea annual report includes a GRI index (pp. 3–5) that shows where information complying with the GRI G4 reporting guidelines can be found. Part 3 also includes information about Achmea’s corporate social themes linked to the insurance industry’s Principles for Sustainable Insurance (pp. 8–10). There is also a large amount of information about environmental issues (emissions, energy, paper, waste, etc. pp. 17–21).

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Suggested answers

Suggested answers

Question 5.1This question asked you to search both the annual report and results presentation of the 2017 results for EVT and find as many performance measures as you can for the hotel division.

As explained prior to the question, EVT’s most important financial performances measures are revenue, EBITDA and normalised PBIT.

The annual report discloses the managing director’s STI, which is linked to performance targets on p. 19.

Non-disclosure of specific performance measures and targets is often the case for listed companies to avoid the information being available to competitors. For EVT, the annual report also discloses that EPS and TSR (growth over the performance period of the three years to 30 June 2019, with performance measured against the year ended 30 June 2016 (being the base year) (EVT 2017b, p. 20).

You should already be familiar with the most common financial performance measures.

There is very little information in the annual report on non-financial measures. However, there is reference to some important ones. These are: • the number of locations and number of rooms (p. 10) • three key performance measures that are relevant to hotels:

– occupancy – average room rate – RevPAR growth (revenue per room), which are shown for all brands combined (p. 10),

and separately for the two brands: Rydges and QT Hotels (pp. 10–11).

In the Half Year Results Presentation for the first half of the 2018 financial year, information is presented on revenue, EBITDA and normalised PBIT for all hotels (p. 10). Also shown are occupancy percentage, average room rate and RevPAR for all owned hotels (p. 10) and by hotel brand (p. 11).

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The key non-financial performance measures for all hotels are those used by EVT:• occupancy—average number of rooms utilised compared to total average available rooms• average room rate—total average room revenue per occupied room per day • RevPAR—total average room revenue per available room per day.


Question 5.2(a) The 2017 annual report (p. 5) discloses that the primary role of the board is to protect and

enhance long-term shareholder value and recognises that the board is accountable to shareholders for the company’s performance. The table on p. 36 of the annual report shows how shareholder value has been created annually for each of the last five years. JB Hi-Fi defines shareholder value as the increase in the enterprise value, plus cash dividends and share buy-backs paid during the financial year.

(b) JB Hi-Fi’s strategy to create shareholder value is to:

encourage innovation and diversification with new products, technology, merchandising formats, advertising and property locations in a controlled and responsible manner. This approach provides opportunities to increase revenue, margin and productivity (JB Hi-Fi 2017, p. 3).

This strategy clearly shows the goals that are desired (revenue, margin and productivity) but also how those financial goals are achieved. It is only through expanding the product range, improving technology, improving store layouts, effective advertising campaigns and investing in the best retail locations that the desired financial performance can be achieved.

(c) JB Hi-Fi’s performance context during the 2017 year is important because its performance was influenced by the timing of The Good Guys’ acquisition in November 2016 (JB Hi-Fi 2017, p. 2).

A key measure is the number of stores. The Group CEO’s performance involves an assessment against both financial and non-financial performance measures (JB Hi-Fi 2017, p. 15).

The remuneration report discloses that the STIP rewards both financial and non-financial measures (JB Hi-Fi 2017, p. 30) where the main element is statutory EBIT—this annual growth in EBIT is considered the most relevant measure of the Group’s financial performance as it is ‘a key input in driving and growing long term shareholder value’ (JB Hi-Fi 2017, p. 33).

Targets for senior executives, in addition to EBIT, include various store operating metrics, inventory, supply chain and online performance measures. Specific targets are commercially sensitive and are therefore not disclosed but performance management—and the rewards attached to that—is focused on succession planning, investor relations, strategic initiatives, internal process improvements, inventory management, property portfolio, shrinkage control, online initiatives, expenditure control processes, workplace health and safety, risk management, and engagement with key initiatives (JB Hi-Fi 2017, p. 34). The LTIP is based on EPS growth (JB Hi-Fi 2017, p. 35).


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Question 5.3(a) Mega Markets has provided affordable products—sourced from overseas—targeting the

budget-constrained customer. The major benefits of Mega Markets’ historic strategy have been the ease of shopping for customers in major shopping centres, and the affordability and range of its products. However, with the increased availability of low-cost computers in homes and the expansion in online shopping, Mega Markets is now facing global competition, perhaps even from its own suppliers in South-East Asia.

(b) The value previously offered by Mega Markets has been almost completely eroded as customers can order online and receive the equivalent goods in a week at a lower cost. Buying online also avoids the problem of the customer’s choice of style, colour and size being out of stock in their nearest shopping centre. As the kind of products sold by Mega Markets are largely discretionary as to time—that is, the purchase can readily be delayed—there is little advantage in going to a shopping centre when it is more convenient for customers (especially those with young children) to buy online and have the goods delivered to their home.

(c) In the face of strong online competition, the unique factor that Mega Markets can adopt is personal customer service. While this may be expensive, customers often appreciate a friendly and helpful staff member who can advise and assist in selection of products, sizes and colour combinations. Candidates in Australia who have visited some of the larger department stores recently may have noticed that they have reduced staffing to cut costs and, as a consequence, there is often very little customer service available and long queues to pay for goods selected by customers. This has perhaps exacerbated the shift by customers to smaller boutique stores and online purchasing.

Of course, Mega Markets could adopt a strategy of selling its products online as well as in stores, as many Australian retailers have done—for example, JB Hi-Fi, Myer and David Jones. This would enable customers to exercise their shopping preferences by purchasing in store, online or through both channels. This would enable Mega Markets to more effectively compete with other online stores, but there is a substantial investment required to implement this strategy. Information technology needs to be designed and introduced, as does a warehousing, stock picking and distribution function, which would increase the company’s overheads.

It would be difficult to compete with online-only suppliers who do not have the rental and salary costs associated with a chain of retail stores in shopping complexes, and unless Mega Markets opened a warehousing and distribution facility near its suppliers in South-East Asia, it would not be able to take advantage of the cost advantages in those countries.


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Question 5.4There are many possible responses to this question, and it is impossible to cover them all, but you may have identified:• the roles and responsibilities of the board of directors, a chief risk officer (if your organisation

has one), and the CFO in relation to risk management and performance• whether your organisation is risk-averse, or takes managed risks in pursuit of its objectives• whether the internal control systems enable or impede risk-taking• whether performance accountability is centralised, or decentralised to individual managers• whether risk management is centralised, or decentralised to individual managers• whether the accountability for performance and risk management is integrated at the same

organisational level or diverges to different people in the organisation• what performance measures and measurement processes the company has in place.

Some additional information on this topicIFAC (2011) carried out a global survey of risk management. Some of its findings were:• guidelines for risk management tend to be compliance-based and are poorly linked to

performance issues without sufficiently acknowledging the need to make risk-based decisions in pursuit of improved performance

• creating better linkage between risk management, internal control and performance management

• making line managers accountable for overall performance, including risk management and internal controls

• making risk management and internal control part of individual goals and objectives and holding people accountable

• aligning compensation with performance in the area of risk management and internal control, and

• carrying out regular reassessments of risks and controls due to changes in the organisation and its environment, leading to better organisational performance.


Question 5.5(a) Discuss the implications of Kevin’s demand in relation to the following:

(i) Governance As a director, Barbara is responsible for the company’s financial statements, a responsibility that is even more pronounced as the CFO. What has been asked of Barbara is high risk, both for the company and its directors, as it is illegal, with directors and officers facing severe penalties for such action, which also would lead to severe reputational damage for the company and individual perpetrators. Accounting information is one of the main sources of information to support the governance function. As a director and CFO, Barbara is also responsible for a system of internal controls, which includes control over the inventory asset of the company.

In Australia, making a deliberate adjustment to the financial statements is a clear breach of the Corporations Act 2001 (Cwlth), relating to correct financial records (s. 286), compliance with accounting standards (s. 304), and presenting a true and fair view (s. 305). Similar legislation is applicable in many countries. It would be a fraud to mislead the auditors by disguising the true value of inventory by removing stocktake sheets, and the accounts prepared for taxation purposes would be similarly misleading. Barbara should be reminded of the illegalities at WorldCom that resulted in the conviction and imprisonment of the CFO.

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(ii) Signalling Financial statements are not produced just for the owner-manager of a privately owned company. The financial statements provide signals to all shareholders, taxation authorities, banks and financiers, payables, customers and employees. Even from a shareholder perspective, Barbara does not know the position of Kevin’s wife with respect to what Kevin wants her to do. As the company has bank loans, there may also be an undeclared intent to deceive the bank in relation to the loan, and certainly to avoid income taxes.

(iii) Ethics Kevin’s request presents a clear ethical dilemma for Barbara, irrespective of the illegality of what she has been asked to do. The HIH case highlighted the culture in that organisation of not questioning leadership decisions. The fundamental principles in the Code apply not only to public practitioners in relation to clients but also to employee–employer relationships. The Code includes a responsibility to act in the public interest:• the principle of integrity would be breached as the demanded action would

be dishonest• the principle of objectivity would be breached because of the undue

influence of Kevin and the resulting conflict of interest (Barbara is expected to resign if the demand is not met)

• the demand is also a breach of professional behaviour as the action would breach legislation and accounting standards, and would be a behaviour that would discredit the profession.

Inappropriate signalling through the financial statements would be a clear failure of corporate governance, a breach of legislation (in Australia) under the Corporations Act and income tax legislation, and a clear breach of professional ethics.

(b) There are few options available to Barbara. Barbara could wait a couple of days before discussing the matter again with Kevin, in the hope that after further consideration, she could change his mind. The delay could be used to prepare a forward financial plan and cash forecast to show the impact of both the tax payment and debt repayment. Failing this, Barbara could request a board meeting to discuss the matter with Kevin’s wife.

Beyond these actions, Barbara should obtain ethics advice and legal advice in accordance with the Code, but may have no alternative but to resign from the company to avoid being associated with the illegal and unethical act requested.

If the company’s accounts are required to be audited, the auditors may well identify such a material misstatement of the inventory value. In the event of a purposeful misstatement, the auditors may have to report a breach to the authorities.


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Question 5.6(a) Mega Markets is what Porter termed as ‘stuck in the middle’. Mega Markets is not sufficiently

low cost to be adopting a cost leadership strategy and its products are undifferentiated from what can be acquired online. While Mega Markets has focused on the budget-conscious family with young children, the susceptibility of that customer group to online sales at a lower price is a significant weakness.

By comparison, an internationally based online competitor is more likely to have a cost leadership strategy, without the investment in retail stores or a high staffing cost, with a single central warehouse and an investment in technology for the online sales and ordering platform.

(b)


Primary activities

Inbound logistics Sourced from South-East Asia and imported into Australian warehouses

Sourced locally

Operations Distributed from warehouses to shopping centres in various style/colour/size combinations

Distributed from a large central warehouse in South-East Asia direct to customers, avoiding stock holdings in multiple locations

Outbound logistics Customers shop with young children in their nearest store, involving travel, parking, queuing, etc.

Customers shop online, make their product choice and then await delivery to their home

Marketing and sales Significant cost of maintaining and staffing multiple retail stores and marketing the Mega Markets name

Relatively inexpensive online presence with no retail store overhead or retail staffing cost

Service Customers can return or exchange goods in store

Customers can return or exchange goods by post

Support activities

Procurement Identify and contract with suppliers in South-East Asia, place orders for sufficient inventory holdings and monitor quality control

Manufacturer in South-East Asia holds inventory in large central warehouse awaiting online orders

Technology development Not applicable Extensive investment in online ordering system

HR management Large investment in retail staff and training of staff

Relatively low investment in staff for technology support and warehouse staff for picking and delivery of ordered goods

Firm infrastructure Heavy investment in warehousing, distribution and shopping centre rental properties, leasehold improvements, fittings, etc.

Relatively low investment in a single central warehouse


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Question 5.7(a)

(i) Traditional The standard to be applied is the budget of $35 000. The method of measurement is the accounting system that reports sales revenue of $33 750. The comparison is a simple calculation of budget minus actual of $1250 unfavourable variance.

The only means of feedback correction with this information is to hold the sales manager accountable for the shortfall in revenue.

(ii) Expanded There are two standards—the volume of sales quantity and the average selling price. The method of measurement is an accounting system that not only records and reports sales revenue but also records and reports sales volume.

The comparison is of both quantity and sales revenue. The ability to take corrective action is improved because the additional feedback information enables a focus on both unit selling price and volume.

(iii) Flexed While the original budget standard is retained, the standard to be applied is the flexed budget—that is, the actual volume multiplied by the budget selling price per unit.

The method of measurement is as per the expanded information but is enhanced by the additional reporting—in the accounting system or through a spreadsheet—of the flexed budget and the ability to more clearly see the impact of the quantity and price variations.

The comparison enables separation of the selling price variance (actual quantity sold multiplied by the difference between $3.75 and $3.50) and the sales volume variance (the difference between the target of 10 000 units and the actual sales of 9000 multiplied by the budget selling price of $3.50 per unit).

Using the additional feedback, two quite separate pieces of information can lead to two different corrective actions: one volume-related and one price-related, which identifies the likelihood that by increasing price over and above the target price, sales volume has fallen and this has led to a revenue shortfall.

(b)

(i) Traditional Management decision-making is almost impossible because there is no indication of the causes of the variance.

(ii) Expanded Management can see that there is both a volume and a price variance but still has insufficient information other than to question the responsible managers as to why volume is lower than expected but prices higher.

Although it can be assumed that there may be an offsetting factor involved (i.e. that higher prices may have led to lower volume), any trade-off cannot be quantified.

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(iii) Flexed Both the value of the volume variance and the price variance are quantified. More meaningful discussions can take place with sales managers to determine explanations for these variances, the likely effects of higher prices on volume and what corrective action can be taken.

Management decisions may also be taken on the basis of the reports in terms of:• the accuracy of the budget standard—and whether this is in value only, or value

and volume• the validity and reliability of the method of measurement—sales revenue will

be collected by an accounting system, but sales volume may require additional non-financial performance measurement outside the accounting system

• the preferred means of comparison and method of reporting variances in future—traditional budget versus actual reporting, or flexed budget reporting

• the means of investigating variances and seeking feedback to support corrective action—separating price from volume variances, and the likely interaction of each element of sales revenue.


Question 5.8There are many possible controls that could affect sales behaviour at SalesVol, and which could have resulted in the level of sales being below target (remember, volume was lower than targets, but average selling price was higher than targets):• Market controls are exercised through competitive pricing. Prices cannot be increased such

that customers are likely to move their business to competitors unless a price premium can be generated from brand or reputation. In SalesVol’s case, higher pricing may have led to customers moving their business elsewhere.

• Non-financial targets may emphasise sales volume, or the lack of such targets may result in volume being disregarded.

• The absence of a market share target may lead to premium pricing. • Bureaucratic rules may require approval by more senior managers of changes to target

prices, particularly if discounted prices are to be applied.• Incentives and rewards may be based on compensation linked to volume, sales value or even

to premium pricing on particular orders.• The reliance on feedback controls (diagnostic controls) compared with interactive controls

(where managers draw attention to particular areas of performance) may create a financial or non-financial, or a volume/value emphasis.

• The organisational culture—which is built through recruitment, training and socialisation, as well as supervision and performance appraisal processes—may reinforce a particular emphasis on achieving sales volume targets, increasing prices or simply achieving the sales revenue target, irrespective of the combination of price and volume.

• Organisational belief systems may reinforce at employee level that increasing prices will lead to higher revenue.


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Question 5.9The following are examples of the different types of controls that could be introduced, although you may be able to think of others.

Personnel controls: • recruitment (reference checking, qualification checks, assessment centres, in-depth interviews)• training of new employees• performance appraisal on a regular basis• establishing a strong culture to support a work ethic (e.g. towards timeliness and accuracy) • incentives for consistently high levels of performance (e.g. bonus, promotion)• staff turnover.

Financial controls: • cost management within agreed budget.

Planning controls: • annual planning process that is consistent with the organisation’s strategic plan • identifying key success factors with the CEO• developing a service level agreement with internal customers.

Process controls: • standard operating procedures or procedures manual• regular monitoring of staff by managers and supervisors• regular meetings to identify problems and solutions.

Performance measures: • on-time production of reports• quality errors (e.g. journal adjustments to correct errors after close of reporting period)• internal customer satisfaction survey• number of complaints received from internal customers• adjustments required by auditors after end of year (number and value) • days’ sales outstanding• days’ purchases outstanding performance compared to target (and improvements over time).


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Question 5.10

Strategic performance measures

• Sales volume and value for each product bar over the whole product life cycle• Profitability of each product over the whole product life cycle (after deducting

R&D, market research and advertising costs)• On-time deliveries of imported cocoa from Brazil• On-time deliveries of milk from dairy farms• On-time deliveries by logistics supplier• Damaged or returned stock from retail stores• Number of patents• Number of new product launches (and number withdrawn as a result

of market research) over time

Operational performance measures

Leading measures • Advertising spend• R&D spend• Market research spend• Number of sales visits to retail stores• Orders taken by sales team in each region• Number of new product launches• Wastage in production• Quality problems and production faults• Productivity• Time from order to delivery

Lagging measures • Sales volume for each product• Sales value for each product• Profitability of each sales region• Profitability of each product• Customer satisfaction (retail stores)• Customer satisfaction (end user)

Note: This list is based on the information in the scenario question. Some measures may be considered either operational or strategic. The categorisation is less important than developing some performance measures that reflect Chocabloc’s dependence on its upstream and downstream supply chains. Leading measures provide an earlier indication of likely financial performance. Note also the large number of non-financial performance measures compared with financial performance measures. Remember that if non-financial measures are revealing poor performance, this will likely be reflected in financial performance at a later time.


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Question 5.11


Financial perspective

• ROI/ROCE/PBIT• Cost• Total revenue• Gearing/interest cover• Working capital and asset efficiency• Shareholder returns

• ROI/ROCE/PBIT• Cost• Total revenue• Gearing/interest cover• Working capital and asset efficiency• Shareholder returns

Customer perspective

• Number of customers• Sales per customer• Returning customers (e.g. based on

loyalty cards)• Number/percentage/value of returns• Number/percentage of complaints• NPS

• Number of customers• Sales per customer• Returning customers (this will be more accurate

as more accurate customer details will be available for online sales where customer address and payment details are obtained)

• Number/percentage/value of returns• Number/percentage of complaints• Number of website hits, time on website• NPS

Business process perspective

• Sales per square metre• Sales per employee• Out-of-stocks (lost sales due to style/colour/size

combination being out of stock)

• Cycle time (time from receipt of order to despatch)

• Out-of-stocks (less likely as there is one central warehouse holding all style/colour/size combinations)

• Delivery accuracy percentage (returns due to inaccurate picking/delivery)

Innovation and learning perspective

• Employee turnover• Employee training investment• Employee satisfaction/morale

• Employee turnover• Employee satisfaction/morale• Investment dollars in online technology• Number of innovative techniques adopted in

online ordering

Explanation of differences

There is unlikely to be much difference in the lagging financial indicators between both companies, both of which are likely to pursue similar financial outcomes for their shareholders.

There is also likely to be similarity in the measures for the customer perspective, although the online competitor is far more likely to be able to target its customers with special offers because it will have more detailed and accurate information about each customer who places an order. The online competitor will also have more accurate information about prospective customers who visit its website without ordering, than will a retail company that has no information about potential customers who do not make purchases.

The business process perspective is where performance measures are likely to vary most, with the retail store measuring the efficiency of sales for its retail store and staff investment. The online competitor will also need to measure cycle time from order to delivery (where it is most susceptible to competition from the retail store as purchase and delivery are simultaneous) as well as delivery accuracy.

Equally, there will be significant variation in the innovation and learning perspective. The retail store will emphasise staffing measures over systems, whereas the online competitor will place far greater emphasis on the reliability of systems as it is far less dependent on staffing.

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Note: there are some differences between the performance measures of each company based on their different strategies. You may be able to think of others.


Question 5.12(a)

Profit Cash flow

Cost

Debtors’ collections

Revenue

Hours worked

Quality of work

Maintainingup-to-dateknowledge

Recruitmentand retention

of staff

Partner contactwith clients

ProspectingMarketing and

promotion

Hourly charge-out rates

Value of company

Client retention

New client growth

Billing per client


Note: this is an illustration of the kind of things that could be part of a strategy map for a small professional services company. The strategy map may be simple or complex—this is just one example.

(b) The strategy map shows many of the assumed relationships required for a successful accounting practice. Starting from the bottom and moving upwards, the left-hand side reflects the importance of HR: recruitment and retention of staff, and maintaining up-to-date knowledge through continuing professional development (CPD). Staff with knowledge lead to quality work and the ability to charge fair prices—charge-out rates are the rates charged to clients for the work carried out by staff of the company. While staff are usually the most significant cost to the company, it is only through staff that revenue is earned by working hours that are chargeable to clients.

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The right-hand side of the strategy map shows a focus on clients. Marketing is important to develop new business opportunities. Prospecting (making contact with potential clients) is important to winning new business. Partner contact with existing clients is also important to maintain existing client satisfaction. Through these activities, the company can build its new client base, maintain existing clients and increase the revenue earned from clients through value-adding services.

As the main financial asset of any professional services company is its receivables, good billing practices and collection of debts are essential for cash flow. There are many other possible CSFs and cause-and-effect relationships in a strategy map, with many possible variations between companies (even in the same industry). Factors such as information technology and company reputation may be relevant, even though they are not shown in the illustration. The actual strategy map adopted by any one company will be a reflection of its strategy, competitive position and business model.

(c)



Financial Profit, cost and revenue

Net profitNet profit as percentage of revenueRevenue growth year-on-yearDirect salaries as percentage

of revenueIndirect salaries as percentage

of revenueNon-salary costs as percentage

of revenue

All F

Cash flow Free cash flowCash flow as percentage of revenue

Value of company Growth in value as a multiple of average annual billings

Client (customer) Client retention Number of clients lost NF

New client growth Number of new clientsNumber of active prospects

NFNF

Billing per client Growth in billing (calculated for each client)

F

Partner contact with clients

Number of visits by partners to existing clients per annum

NF

Business process Quality of work Number of errors identified by supervisors, managers, partners

NF

Hours worked Chargeable hours as a percentage of paid hours

Write-offs/ons (i.e. hours charged to clients that cannot be recovered in billing, or due to efficiencies resulting in a higher than expected margin)

NF

NF

Hourly charge-out rates

Cost recovery F

Receivables collections

Days billing outstanding (equivalent to days sales outstanding)

NF

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Innovation and learning

Marketing and promotion

Expenditure on marketing and promotion

F

Prospecting Number of activities aimed at winning new clients

Percentage of partner hours spent on marketing and prospecting

NF

NF

Maintaining up-to-date knowledge

Compliance with CPD requirements

Investment in staff training

NF

F

Recruitment and retention of staff

Staff turnover as percentage of total staff employed

NF

(d) The indicative performance measures are shown for each of the key success factors in the strategy map. Different businesses will define different performance measures, based on the business strategy, competitive position and business model. There are 25 performance measures included. These are fairly evenly spread over the four perspectives, although there are a few more measures in the financial perspective. Of the suggested measures, 13 are financial and 12 non-financial. So the scorecard suggested for this company is quite balanced.

Many possible performance measures have not been included. Other measures that could be adopted include: – revenue or profit per partner (or per employee) – the ratio of partners to staff – the office space (in square metres) per employee.

These have not been considered as critical, but they are important measures, and may be particularly useful in benchmarking exercises.


Question 5.13(a) A reduction in the total cost of components can be achieved either through:

– purchasing improvements—reducing the price per component, or – productivity improvement—reducing the quantity of components used, such as reducing

waste or damaged components.

Performance measures should be set for Purchasing—the cost for each component is the most relevant measure for that department. This measure could cascade to individuals or work groups within the department with measures of, for example: – number of alternative suppliers identified – number of quotations sought from suppliers – successful price negotiations with suppliers – number of tender comparisons of suppliers.

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(b) Performance measures could be set for Production—the total number of components used for the number of finished triffids produced is the most relevant measure for that department. This measure could cascade to individuals or work groups within the department with measures of, for example: – number of components received—that is, comparing standard quantities with actual

quantities of components received for the production of triffids – number of out-of-stock notifications requiring special purchasing – number of components wasted – number of components reworked – number of components damaged or lost – number of quality defects.

(c) The Finance and Administration department needs to provide the information required by purchasing, production and the board of directors to enable monitoring of performance.

In addition, the Finance and Administration department must ensure sufficient control exists over goods that are received into inventory (including checking of quantity and quality of received components) to ensure that only components received are paid for. Often, premiums are paid for components ordered due to out of-stock situations, so the number of special purchases due to components being out of stock needs to be reported, together with the price variation.

Care should be taken that the Purchasing department does not achieve a lower cost for each component by simply increasing the ordered amount to take advantage of volume discounts—tying up additional funds in inventory could have disastrous consequences for organisational cash flows and also increase the risk of inventory becoming obsolete, damaged or lost while in storage.

(d) An enterprise resource planning (ERP) system should: – record inventory levels of purchased components – forecast sales demand and production plans – automatically order purchased components based on the organisational plans

(e.g. minimum stock levels, economic order quantities, seasonal demand fluctuations, order to delivery times)

– record approved suppliers and agreed prices – place purchase orders on suppliers at the agreed price – match supplier invoices against purchase orders, highlighting variations in quantity

or price – report actual usage of components (e.g. separating wastage, damage and rework) – report variations between purchased cost and standard cost of components.


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Question 5.14


1. Head office recharge of corporate costs to business units based on a percentage of sales revenue in each business unit

$1 million This measure is not relevant for planning, decision-making or control, because if sales revenue exceeds the target, the head office recharge will be higher than the target.

This measure can be calculated reliably but it is not a valid measure of the business units’ demand for corporate services. It is not controllable by business unit managers.

2. Survey of brand recognition among members of the public

75% This measure is specific and measurable but achievability may depend on the level of advertising. It also may not be relevant in terms of conversion of brand recognition into sales. For example, many consumers are aware of the ‘Coca Cola’ brand but do not buy the product.

This may be a valid measure of the effectiveness of advertising in terms of awareness, but it is not a valid measure of sales. It may be reliable if a standard form of statistical survey is properly carried out.

3. Receivable days 45 days This measure and target satisfies all the SMART criteria, but the achievability of the target depends on the organisation’s trading terms (which in this case might be assumed to be 30 days).

This measure is a valid and reliable method of calculating the level of outstanding receivables, which is clear, can be produced in a timely fashion, is accessible and controllable. It leads to improved activity in collections and approval of credit limits, etc.

4. Percentage of incoming telephone calls answered in one minute

90% This measure and target satisfies all the SMART criteria, but the achievability of the target depends on the organisation’s staffing of positions that involve answering telephone calls.

This performance measure is usually reliable because it is a by-product of telecoms technology. However, it is not valid by itself because it is usually a proxy for customer service and needs to be supplemented by a measure of customer satisfaction with the quality of the service provided.

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5. Percentage of sales revenue from return customers

80% While this measure meets most of the SMART criteria, it is not necessarily time-based (i.e. it does not reveal the elapsed time between customers placing repeat orders, nor the value of their orders compared with their prior orders).

The measure is valid and reliable as it does accurately capture information about customer retention. However, it is not controllable as there are many factors outside managers’ control that influence returning customers.

6. Dollar value of donations to charities

$100 000 p.a. While this measure and target meets most of the SMART criteria, it is not likely to be relevant in terms of something that is important for the organisation, unless it is an organisation whose purpose is to donate to charities.

This measure can be reliably calculated and is valid in terms of measuring financial contributions to charities, but by itself it does not necessarily reflect how well the organisation’s social, environmental or ethical obligations are satisfied.

7. Reduce employee turnover

Reduce turnover by 10% p.a.

This measure meets the SMART criteria. It may be achievable provided managers have authority over remuneration and motivation strategies.

This measure is valid and reliable. It is controllable through a variety of retention strategies including remuneration and motivation. As employee turnover incurs the high cost of recruitment and training, this is likely to be an important measure.

8. Sales revenue growth 15% p.a. This measure meets the SMART criteria, with the possible exception of whether it is achievable based on past performance and economic and competitive conditions in the particular industry.

This is a valid and reliable measure. It is clear and available quickly but many factors affecting revenue growth are outside managers’ control.

9. Headcount 120 The measure may not be relevant as, in many organisations with headcount targets, this is circumvented by appointing casual staff through agencies or consultants where (sometimes higher) costs are incurred even though the payroll headcount target is satisfied.

While this measure is reliable it may not be valid, as headcount does not reflect a number of factors (e.g. the level of business activity, the quality of the workforce, long-term illness, maternity or long service leave being taken).

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10. Compliance with legal requirements

Full This measure and target is not specific and it is difficult to measure, being based on subjective judgments and probably without full knowledge of all requirements and the organisation’s experiences.

It is a valid measure of compliance, but not a reliable one as different people may make different judgments based on different knowledge and experience.

Additional explanation of the answersThe following table outlines the method used to determine whether the performance measures and targets were SMART and effective.

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SMA

RT

crit

eria

Cha

ract

eris

tics

of

effe

ctiv

e p

erfo

rman

ce m

easu

res

Spec

ific

Mea

sura

ble

Ach

ieva

ble

Rele

vant

Tim

ely

Valid

ityRe

liabi

lity

Clar

ityTi

mel

ines

sA

cces

sibi

lity

Cont

rolla

bilit

y

1.

Hea

d o

ffice

re

char

ge

YY

?N

?N

YY

?N

N

2.

Surv

ey o

f bra

nd

reco

gni

tion

YY

?N

N?

??

NN

N

3.

Rec

eiva

ble

day

sY

YY

YY

YY

YY

YY

4.

Inco

min

g

tele

pho

ne c

alls

YY

?Y

YN

YY

YY

Y

5.

Sale

s fr

om

re

turn

cu

sto

mer

s

YY

YY

NY

YY

NY

N

6.

Do

natio

ns t

o

char

ities

YY

YN

YY

YN

YY

Y

7.

Em

plo

yee

turn

ove

rY

YY

YY

YY

YY

YY

8.

Sale

s re

venu

e g

row

thY

Y?

YY

YY

YY

YN

9.

Hea

dco

unt

YY

YN

YN

YN

YY

Y

10.

Co

mp

lianc

eN

NY

Y?

YN

N?

?Y

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It should be clear from these examples that few performance measures are perfect. It may be better to consider most measures as indicators of performance, as they each have their limitations. It is also important to take a contingent view in evaluating measures and targets, as the example of the donations to charity illustrates. Similarly, a measure and target for receivable days is only relevant for a business selling on credit, not for a retail store like Woolworths. It should also be noted that assessment of performance measures and targets can be subjective and requires judgment, and so there may be alternative views or assessments to those described previously. In addition, as no information is given in the question as to current levels of performance or organisational strategies or priorities, you could assume that all elements of performance are achievable.


Question 5.15Different companies have very different approaches to performance measurement. The measures used in retail stores such as Woolworths and JB Hi-Fi are quite different to the measures used in a hotel chain such as EVT, by Apple in its high-tech environment or by Newcrest in the mining industry. Public sector organisations such as policing and hospitals have very different approaches to performance measurement.

The failings of performance measures at Mammoth Printing contrast with the abandonment of most traditional performance measures (including financial ones) at TNA. Public and not-for-profit organisations have quite different needs. The international advertising agency example illustrated how competing priorities need to be balanced, whereas BP in the Gulf of Mexico demonstrated the consequences of a relentless pursuit of short-term profits. These examples illustrate the importance of customising performance measures to the unique position of each organisation.

Despite the differences in what is measured, the focus of performance management should be the same in all organisations, business, not-for-profit or public sector. Management accountants need to be able to add value to their employers or clients by moving beyond the mere reporting of performance against targets, trends and benchmarks and add value by interpreting that information and making appropriate recommendations to senior management.

Despite pressure for short-term financial performance, management accountants need to be able to demonstrate where an excess focus on the short term may detrimentally impact on sustainable financial performance. Management accountants also need to be able to look at financial and non-financial performance holistically, recognising the relationship between lagging and leading performance and identifying the trade-offs between different aspects of performance—for example, high quality and short lead times may not be consistent with low costs.

Management accountants need to focus on performance improvement. They can suggest ways in which performance can be interpreted, and recommend methods of improving performance based on their holistic views of all the available performance information. This means moving away from the desk and computer screen and talking with non-financial managers who will be able to explain the context in which performance reports.


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Question 5.16(a) 1. Decide on the performance measures to be benchmarked

Performance measures are selected for benchmarking where differences in performance can be understood and acted on. Only strategically important measures and processes should be selected for benchmarking.

2. Decide who you are benchmarking against Organisations can select internal measures from different organisational units, industry-

wide benchmarks or benchmarks from outside the industry.

3. Find out how to obtain benchmarking measures Data can be obtained directly from the organisation identified as having the best

practices, perhaps through a benchmarking consortium. Another option is to rely on secondary sources, such as consulting organisations, newspapers and trade journals, or internet materials. Many organisations rely on BI gained from common suppliers or from discussions at exhibitions and conferences, etc.

4. Compare and interpret the data A comparison of the data is what benchmarking really focuses on, but just comparing

the data does not tell us why there are differences. As for all data, it needs to be interpreted sensibly, by not ignoring different contexts. Further investigation is almost always required.

5. Use information for decisions, control and performance evaluation After comparison and interpretation, benchmark data can be used to improve business

practices, motivate behaviour or signal the organisation’s performance relative to others.

(b) – The commitment by other organisations—especially in a consortium—to provide benchmarking data. The level of participation by organisations can be improved if they perceive there is a benefit to be derived from their involvement.

– A lack of knowledge about why there are performance differences. While benchmark figures give an indication of where problems may exist, they are diagnostic. Diagnostics tell us that the problem exists, but not what is causing the problem, and therefore do not tell us how to fix it. Accountants and managers need to go beyond the data provided and understand why the differences exist. Sometimes performance differences may be due to different strategies or business models, different regulations under which organisations operate, or different technologies or investments in infrastructure.

– The standardisation of data. Data may be collected, summarised and interpreted in different ways, leading to performance comparisons that are not appropriate. Questions must therefore be asked about the comparability and usefulness of benchmark data.

– The historical nature of the data. While benchmarking data may give an understanding of what other organisations or business units have done in the past, it does not tell us what they are doing now or in the future. It is no substitute for constant proactive improvement within organisations.

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(c) Every organisation will be different, will have different opportunities for benchmarking and different performance measures will be important. One example is university teaching, where a benchmarking consortium does exist. Some examples of benchmark data for teaching include: – staff–student ratio – student retention—that is, the proportion of students who discontinue studies prior

to completion – student progression—the proportion of students who fail and have to repeat – student satisfaction – graduate outcomes—employment, salary levels.

The last two examples come from standardised surveys of university students.


Question 5.17(a) The need to have a limited number of performance measures is consistent with the proponents

of the BSC, provided there is balance in the range of measures used. The example does not explain the performance measures used, but does mention ‘operational, financial and physical measures’, so it might be assumed that there is balance.

Importantly, the example argues that performance measures are useful in determining whether the organisation is on the right track. If performance measures are not useful in making improvements, then they are unnecessary. The absence of targets—budgetary or otherwise—contrasts with the role of targets in performance management. Despite the absence of targets, the example shows the importance of relative performance, trend—improvement relative to the past—and benchmarking.

(b) The importance of rewards is also emphasised in the example. Importantly, rewards are not for absolute performance but based on relative (to other banks) profitability. This seems a valuable approach to linking performance with rewards and may overcome some of the criticism of financial institutions during the GFC for excessive executive remuneration. Under this approach, if any whole industry improves its performance, this is more likely a consequence of the economy, technology and customer demand than managerial action and should not be rewarded. By contrast, if relative performance in an industry improves, this is more likely due to management actions that are more successful than competitors’. Agency theory would support this kind of relative performance-linked reward.

A further element of the profit share in the example was that it was only payable when an employee retired. This has at least three advantages:1. It prevents a focus on short-term at the expense of long-term performance (i.e. it adheres

to the sustainability principle).2. It encourages employees to remain with the company over the longer term to reap the

benefits of their behaviour. 3. This kind of approach to rewards linked to sustainable performance is likely to have fewer

unintended and dysfunctional consequences than more traditional approaches.


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REFERENCES | 521

References

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http://balancedscorecard.org/?TabId=58