Budgeting for Better Performance PDF

INSTITUTE OF LEADERSHIP & MANAGEMENT SUPERSERIES Budgeting for Better Performance FOURTH EDITION Published for the Institute of Leadership & Management by O...

INSTITUTE OF LEADERSHIP & MANAGEMENT SUPERSERIES Budgeting for Better Performance FOURTH EDITION Published for the Institute of Leadership & Management by OXFORD AMSTERDAM BOSTON LONDON NEW YORK PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO Pergamon Flexible Learning An imprint of Elsevier Science Linacre House, Jordan Hill, Oxford OX2 8DP 200 Wheeler Road, Burlington, MA 01803 First published 1986 Second edition 1991 Third edition 1997 Fourth edition 2003 Copyright © ILM 1986, 1991, 1997, 2003 All rights reserved. No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0 7506 5880 0 For information on Pergamon Flexible Learning visit our website at www.bh.com/pergamonfl Institute of Leadership & Management registered office 1 Giltspur Street London EC1A 9DD Telephone 020 7294 3053 www.i-l-m.com ILM is part of the City & Guilds Group The views expressed in this work are those of the authors and do not necessarily reflect those of the Institute of Leadership & Management or of the publisher Authors: Clare Donnelly and Bob Foley Editor: Clare Donnelly Editorial management: Genesys, www.genesys-consultants.com Based on previous material by Joe Johnson, Alastair Clelland and Raymond Taylor Composition by Genesis Typesetting Limited, Rochester, Kent Printed and bound in Great Britain by MPG Books, Bodmin  Contents Workbook introduction v 1 ILM Super Series study links v 2 Links to ILM qualifications v 3 Links to S/NVQs in Management vi 4 Workbook objectives vi 5 Activity planner vii Session A What is a budget? 1 1 Introduction 1 2 The purpose of budgets 2 3 Beginning a budget 5 4 Why do we need budgets? 7 5 The advantages of budgets 9 6 Using budgetary control 11 7 Summary 14 Session B Monitoring performance against budget 15 1 Introduction 15 2 Budgetary control 16 3 Flexible budgets and budgetary control 27 4 Non-financial budgets 31 5 Standard costing and budgetary control 33 6 Summary 36 Session C Measuring performance 37 1 Introduction 37 2 What is performance measurement? 37 3 Performance measurement principles 38 4 A range of performance measures 46 5 Financial performance measures 47 iii Contents 6 Non-financial performance measures 49 7 External comparisons 55 8 Stakeholders and their objectives 58 9 Summary 70 Session D Monitoring and improving performance 71 1 Introduction 71 2 Developing performance standards 72 3 Monitoring performance 76 4 Improving performance 81 5 Summary 95 Performance checks 97 1 Quick quiz 97 2 Workbook assessment 100 3 Work-based assignment 101 Reflect and review 103 1 Reflect and review 103 2 Action plan 110 3 Extensions 112 4 Answers to self-assessment questions 113 5 Answers to activities 117 6 Answers to the quick quiz 118 7 Certificate 119 iv  Workbook introduction 1 ILM Super Series study links This workbook addresses the issues of Budgeting for Better Performance. Should you wish to extend your study to other Super Series workbooks covering related or different subject areas, you will find a comprehensive list at the back of this book. 2 Links to ILM qualifications This workbook relates to the following learning outcomes in segments from the ILM Level 3 Introductory Certificate in First Line Management and the Level 3 Certificate in First Line Management. C6.1 Performance Indicators 1 Identify means by which performance levels can be measured 2 Monitor performance against agreed targets 3 Make recommendations for improvement in performance or the adjustment to more realistic targets C6.2 Working to a Budget 1 Explain the importance of operating within a budget 2 Monitor performance against budget v Workbook introduction 3 Links to S/NVQs in Management This workbook relates to the following elements of the Management Standards which are used in S/NVQs in Management, as well as a range of other S/NVQs. A1.3 Make recommendations for improvements to work activities B1.1 Make recommendations for the use of resources B1.2 Contribute to the control of resources D1.1 Gather required information D1.2 Inform and advise others It will also help you to develop the following Personal Competences:  searching for information;  thinking and taking decisions. 4 Workbook objectives You will have plans for your career and your private life. There are things you will want to do today, tomorrow, next week, next year. And because most events and activities cost money, you will know that it’s usually necessary to make financial plans to achieve your aims. The same principles are relevant at work. Your organization has aims and objectives with financial implications and these are identified by using budgets. By preparing budgets which allocate money to specific purposes, an organization seeks to gain more control over its activities. Careful monitoring then helps to ensure that spending is kept within bounds. Budgets are considered an essential tool by organizations in the management of their affairs. vi  Workbook introduction As a first line manager, you are probably expected to meet budgetary targets, expressed in financial terms. But very detailed ‘performance’ targets are often much more practical, such as ‘serve 20 customers per hour’, or ‘inspect five junction boxes per day’. This workbook is intended to help you understand how to meet performance targets, and agree targets that are realistic. 4.1 Objectives When you have completed this workbook you will be better able to:  describe what a budget is;  understand how budgets are used;  use some budgetary control techniques;  identify ways of measuring performance levels;  describe a range of methods for measuring performance;  identify the differing objectives of stakeholders in the organization;  select the ideal performance measure;  monitor performance against agreed targets;  make recommendations for improvement in performance, or adjustments to more realistic targets. 5 Activity planner The following Activities require some planning so you may want to look at these now.  Activity 7 – in which you look at budget deviations.  Activity 10 – which covers budget variances.  Activity 44 – where you use the balanced scorecard to suggest improvement.  Activity 48 – in which you gather information for measuring performance.  Activity 54 – which analyses the systems used, in order to improve work activities and control resources. vii Workbook introduction Some or all of these Activities may provide the basis of evidence for your S/NVQ portfolio. All portfolio activities and the Work-based assignment are sign posted with this icon. The icon states the elements to which the portfolio activities and Work-based assignment relate. The Work-based assignment, on page 101 suggests that you speak to your manager, finance director or to your colleagues in the accounts office about the way in which budgets are used in your organization. You might like to start thinking now about who to approach and arrange to speak with them. viii  Session A What is a budget? 1 Introduction How would you feel if you were never sure if you would be paid on pay-day or not? To ensure that you do get paid on the right day, your organization needs to plan and to control the ways in which it spends and receives money so that enough cash is available to pay wages and salaries when due. The organization draws up a plan indicating how it expects money to flow in and out. This plan is better known as a budget. You probably do the same at home, planning how to use your income. You budget, your employer prepares a budget and, of course, the country as a whole budgets. Each year, the Chancellor of the Exchequer presents a Budget to Parliament. Its aim is to achieve things which are part of the government’s policy on how best to run the country. 3 mins Activity 1 Write down three things the Chancellor might try to achieve through the annual Budget. 1 Session A Typical examples might be to:  improve public services;  reduce inflation;  combat unemployment;  help small businesses;  win the next election! Whatever plans and policies the government has, they all have to be financed. The Budget is all about getting hold of and using money. To achieve this, the Chancellor might introduce policies to:  cut or tighten control over major items of expenditure;  switch expenditure and resources from one item to another;  use a variety of financial incentives and penalties. The national Budget requires a lot of analysis, planning negotiations and juggling with resources. It covers both national income and national expenditure. All budgets work in similar ways; just the amounts involved differ. 2 The purpose of budgets Think about your own workplace for a moment. Your workteam may be earning income through the sales it achieves or the services it supplies. Or it might be contributing to profit (the surplus of income over costs) in one or two other ways. directly, by purchasing, indirectly, by such things as manufacturing or processing designing, controlling, materials, to produce goods maintaining equipment, or that are sold providing services to customers or other workteams Whatever it does, your workteam is certain to incur expenditure (costs), in doing its job. Almost certainly, the organization you belong to will have prepared a budget for its expenditure. If it generates income directly, then there will be a budget for that as well. 2  Session A A budget can be described as: a quantitative plan of action prepared in advance of a defined period of time. Let’s look at this definition more closely.  A budget is quantitative. That means it must be stated in figures; in practice this usually means in sums of money. A general statement of what you intend to do may be useful, but it’s not a budget.  A budget is prepared in advance. A budget must be drawn up before the period to which it refers. Figures produced during or after the period may be important, but they are not part of a budget.  A budget relates to a particular period. Budgets are drawn up for a certain specific period (often, though not always, one year). An open-ended financial plan for the future isn’t a budget.  A budget is a plan of action. This is perhaps the most important point of all. A budget can’t be a definite statement of fact, because it relates to something which hasn’t happened yet. It is what the organization is planning will happen. Conditions may change during the budget period, which means the budget will be inaccurate. Like all plans, budgets seldom turn out to be totally correct predictions of the future. Even so, they can still be useful in guiding the actions of those using them. This guidance role is very important. Of course, you must know what you are trying to achieve before planning. Everything else depends on that. ‘Knowing what to achieve’ is referred to in business as an objective. The objectives of your workplace will depend to some extent on what kind of organization it is and may be short, medium or long term. Manufacturing industries, for example, have to make a profit. Local government services have to provide a certain level of service. A nationalized industry may be required to achieve a planned return on capital invested. Some other examples of objectives are:  to make a profit of 30% on a certain product;  to increase the share of the market by 5% for a certain product;  to improve service to the public in certain areas; 3 Session A  to survive commercially for a financial year (this is particularly relevant to new, small businesses). To achieve any of these objectives needs planning and will probably involve the production of budgets. 3 mins Activity 2 Write down two different kinds of budget that are used in your organization to meet its objectives. One example would be a sales budget. The budgets listed below are all common types. Perhaps your suggestions are among them, though you could well have thought of others too.  Sales budget.  Production budget.  Research and development budget.  Training budget.  Departmental costs budget.  Cash budget. All budgets are important, although it is arguable that the cash budget is most important because without cash a business cannot survive. Let’s look briefly at sales budgets and cash budgets, to make sure we understand what they mean. In a sales budget, a forecast is made of the sales the business will make during the relevant period. This may be broken down by section or department. Knowing how much you plan to sell is essential, in order to decide how much raw materials you will buy, how many employees you will need, and so on. In a cash budget the business will forecast:  what cash will be received and paid out during the budget period;  the timing of receipts and payments;  the bank balance or overdraft for each month. The cash budget is especially important for small, newly established businesses. 4  Session A 2 mins Activity 3 Who do you think would need to see the cash budget of a newly established business? Write down one suggestion. EXTENSION 1 You may have thought of a number of possibilities. The one I had in mind was Assignment 14 in The Business Plan Workbook, by the bank manager who will want to examine the cash forecasts of a new C. Barrow, P. Barrow and business, and will almost certainly insist on a cash budget before authorizing R. Brown, gives a loan for a new business. illustrations of the situations faced by businesses that have and However, I don’t want to give the impression that it is only new, small have not prepared a cash businesses which find cash budgets important. Organizations, large and small, budget. use them, and so do charities and social clubs. Everyone needs cash. 3 Beginning a budget The process of producing a set of budgets is covered in detail in the Controlling Costs workbook. Here, we are going to think about the beginning of the budget process. We’ll start with manufacturing industry – in a business which makes and sells something. We need first to identify the critical factor which influences all the budgets in a certain workplace. The factor influences all other budgets, and is called the key or limiting budget factor. In practice:  the sales budget is the commonest limiting budget factor in established commercial businesses;  the cash budget is the commonest limiting budget factor in newly established small businesses. 5 Session A Sometimes the production budget is the limiting budget factor, although this is less common. In a non-profit organization, the limiting budget factor is likely to be the availability of funds. 4 mins Activity 4 In each of the following situations, the key budget – the one on which other budgets will depend – will have to be produced first. To remind you, in a manufacturing company, this may be a cash, sales or production budget. Look at each situation and decide which is the key budget for each. Key Budget Firm A exists in a highly competitive market and currently sells 500 units Cash  per month. It plans to increase this to 600 units per month in the coming Sales  year and, in fact, has the capacity to produce 750 units per month. Production  Firm B is the sole supplier of a specialist component. It can sell all it Cash  produces and more. Sales  Production  Firm C is a small business with a large overdraft. It is currently owed Cash  a great deal of money, and its bank insists that the overdraft cannot Sales  be extended. Production  Firm D is a haulage contractor with a fleet of ten lorries on the road that has Cash  been offered a contract to transport 12 lorry-loads of goods to Southern Sales  Europe on a weekly basis. The firm cannot afford to purchase additional Production  lorries. Here is what I would say is the key budget, on which all other budgets would depend, for each of these firms.  For Firm A, it’s a sales budget. The firm must sell more. Everything else, including production, will follow from that.  For Firm B, it’s a production budget. The firm has to produce more. If it achieves this then extra sales will follow.  For Firm C, it’s a cash budget. The most important thing is for the firm to earn cash at the moment. This might even mean that the firm would have to refuse a potentially profitable contract if it didn’t bring in cash quickly enough.  For Firm D, the key is the cash budget because the firm does not have enough cash to buy more lorries to provide the transport service offered. 6  Session A 4 Why do we need budgets? Some people think of a budget as something that restricts what we want or need to do. It certainly can be very frustrating when the constraints of a budget, drawn up by accountants who (you may feel) have no under- standing of your problems, prevent you from taking certain actions in your job. See if you recognize any of the following situations or something similar. The training budget of a hospital has been spent. A nursing sister is refused permission to go on a course to learn how to use a new piece of equipment for monitoring heart disease. She is concerned because she feels that patient care may suffer. The entertainments budget of a growing electronics firm is exhaus- ted. The sales manager is unable to offer the kind of hospitality he would like to a visiting trade delegation from Saudi Arabia. No orders are won. The overtime budget of a shipbuilding company is already over- spent. No new overtime is authorized and the ship ends up three months late to the customer. Massive penalties result. The departmental budget in the chemistry department of a university is underspent with one month of the financial year to go. The professor authorizes a spending spree to ensure his budget is not cut next year. Unneeded equipment which is rarely if ever used is purchased. Having a plan, which is all the budget is, can only be a good thing. In these examples, the budgets themselves were not to blame for the unfortunate results. So what went wrong? 7 Session A 6 mins Activity 5 Write down any ideas you have about who or what was responsible for the problems arising in any of the situations described above. A budget is only a plan You may have noted a number of possibilities but perhaps we can narrow and provides guidance. them down to the following. Budgets should not be rigidly kept to as an excuse for not  An over-rigid view of how the budgets should be enforced has been taken – managing. Sometimes this seems likely to be the case in the first and second examples. an adaptation of a plan  The budgets have been badly produced, managed and controlled, particularly is more sensible. the third and fourth examples. If necessary, senior management usually have authority to over-ride a budget if they consider it would be economically worthwhile to do so. For example, it is probably appropriate to intervene to prevent the company having to pay contract penalties for late delivery, because its overtime budget is overspent. They might achieve this by transferring savings made in one budget to another, a process known as virement. After all, budgets are intended to be beneficial. It is when they are badly produced, managed and/or controlled, that they can have undesirable consequences. But what do we mean by this? The easiest way to see how bad production, management and control of budgets have poor effects is to trace through the problems in one of the situations above. Let’s take a look at the hospital training budget example.  The training budget was drawn up at the beginning of the financial year without reference to the equipment budget, which showed that new equipment was being purchased to monitor heart disease.  BAD PRODUCTION – more access to information would have shown the need to budget for this training. 8  Session A  Two key staff left and were not replaced. Instead a series of temporary staff, each of whom had to be trained in certain procedures, were taken on, so using up the training budget.  BAD MANAGEMENT – more effort should have gone into recruiting permanent staff.  A discretionary training course became available which had not been planned at the beginning of the year. All staff were ordered by the human resources department to go on the course, without evaluation of whether it was needed by the departments holding the training budget.  BAD CONTROL – the usefulness of the training course in comparison with the heart disease monitor course should have been evaluated by the managers responsible for the heart disease ward. Having seen the downside of poor practice, let us look at the benefits of good budget practice. 5 The advantages of budgets Organizations benefit in a number of areas through budgeting.  Co-ordination and teamwork The process of budgeting means that management at all levels and in different departments are given the opportunity to meet, discuss and relate their targets to each other. Organizations are most successful if everyone works together to meet common goals rather than each manager acting selfishly to build their own empires. The co-ordination process helps managers get an understanding of how each activity relates to the whole, which is very important for them and for the business. It would be pointless, for example, for the sales manager to plan a 10% increase if the production manager is aiming for a 5% cutback.  Communication In order to work to a budget, people have to know what is possible or impossible in their own workplace. Budgeting encourages management at all levels to talk to one another about the company’s policies and the targets they are aiming for. Again this builds teamwork; people working for each other and for their organizations. 9 Session A  Planning As we’ve seen, planning is at the heart of a budgeting system. Using a budgeting system means that managers and supervisors have to use formal procedures to think about the future, instead of muddling along from one day to the next. It also means that thought is given to the level of performance expected in every part of the organization.  Control and performance evaluation The whole point of a budget is to influence the direction the organization is taking. For a budget to be of value, the actual outcome must be regularly compared with the planned outcome. If the two don’t match up, then controls can be used to take appropriate action. Without a plan there is no yardstick to measure what’s happening; any controls, therefore, are fairly random. The idea of a system of budgets is to get a clearer picture of planned activities and to make departments and individuals responsible for spending and cost control in their own areas. In this way, the strengths of sections and departments can be capitalized on, and ways found to overcome any weaknesses.  Motivation The more people are involved at every level in setting up a budget, and in the planning and control that goes with it, the more they understand and support what the organization is trying to achieve. Involvement is an important motivating factor at any level. All these points are valid, but the two most important purposes of budgets are planning and control. The planning process enables control to be exercised. Let’s explore the idea of budgetary control a little further. 10  Session A 6 Using budgetary control Budgetary control involves drawing up budgets which relate what has to be done to the managers who have to do it, and then comparing actual results against the plan. It is a very useful management tool. It should enable a manager or supervisor to do his or her job more effectively, without detracting from individual skill or flexibility. Control must be an active process. 4 mins Activity 6 Here is an important question for a manager, which budgets should help to provide the answer to. ‘Is my workteam (or section, or department) keeping its spending within agreed limits?’ Can you think of at least one other question to which a manager might want to know the answer, and which budgets should help provide? You may have thought of several possible questions. Perhaps you included the following.  ‘Are we reaching agreed targets?’  ‘If we are not reaching agreed spending limits or agreed targets, where are we falling down, and for what reasons?’  ‘What can I do to try to improve the performance of my team?’  ‘Do events suggest that the budget needs to be modified?’ 11 Session A By monitoring actual results against budgets, control is improved. You should be able to identify problems and take action quickly, and there is less incentive just to let matters slide. No budget is perfect. Unforeseen circumstances do arise. For example, a competitor may suddenly bring out a new product, the bottom may drop out of a market or we may have a strike on our hands. Any number of events can make budgeted figures less accurate, some within the control of managers, some not. 10 mins Activity 7 This Activity may provide the basis of appropriate evidence for your S/NVQ portfolio. If you are intending to take this course of action, it might be better S/NVQ B1.2 to write your answers on separate sheets of paper. Think about your own job. Write down two factors that might make your workteam deviate from its budget, and which are largely within your control. Now write down two factors that might make your workteam deviate from its budget, which are largely outside your control. Your response will be related to your own job.  As factors within your control you might have put down answers such as faulty work, bad timekeeping by employees, inefficient organization of the department, new staff not inducted properly, and so on. 12  Session A  Factors likely to be outside a line manager’s control are the hold-up of supplies, teething problems with new products or systems, shortages of staff and so forth. Because there are many ways in which a budget can become out of line with the plan, an organization must try to obtain the best possible information at the time of preparing the budget. It should look to see, for instance, what it has achieved in the past, and what its costs actually are. 10 mins Self-assessment 1 1 A properly drawn-up budget can be described as having four important features. Identify all four features. 2 Write down two initial uses for budgets at the time when they are drawn up. 3 Fill in the missing words in the following sentences. a Budgets are largely a waste of time unless they are actively in order to see whether the organization is its targets and keeping within its limits. b We use the term to cover the use of budgets to help an organization control its progress towards what it has set out to achieve. c A budget will not be useful to an organization if it is managed so that it does not permit some degree of flexibility. Answers to these questions can be found on page 113. 13  Session A 7 Summary  A budget is a plan, usually described in financial terms, prepared in advance of a defined period of time.  The starting point in producing a budget is to determine the key or limiting factor which influences all other budgets. This will often be the sales budget.  Control is central to the budgeting process. The system of using budgets and comparing actual and budgeted results to control progress towards stated objectives is budgetary control.  Budgeting should never be so inflexible as to prevent sensible decisions being taken.  Budgets can also help to improve:  co-ordination and teamwork;  communication;  motivation.  Good budgeting should help an organization meet its goals and ensure that everyone works together towards those goals. 14  Session B Monitoring performance against budget 1 Introduction Producing a correct and realistic budget takes time. Putting the information together can take you away from your main job of producing or providing a service and make you ask yourself if budgeting is really worth all the expense and effort. We have seen the benefits, but unless budgets really work they are not worth preparing. In this session we look at several ways in which budgets are used, and what makes them important, especially in terms of planning and control. As a first line manager you will be involved in implementing the budget allocation of your section or department in detail. You will monitor operations and ensure that your workteam works within budget as far as is possible, and will report on any differences from budget. In this session you will see what costs you can control and which are uncontrollable. Knowing that will help you understand what actions you can take to make best use of the resources at your disposal and how to monitor those resources. 15 Session B 2 Budgetary control All budgetary control systems follow basically the same steps: EXTENSION 2  establish agreed budgets; Further aspects of  report actual results to departmental managers; budgetary control are  identify where actual performance differs from planned performance (these featured in Budgeting for Non-Financial Managers by differences are called variances); Ian Maitland.  analyse which department and which manager is responsible for the variances;  analyse why the variances have happened. 3 mins Activity 8 Acme Machine Tools Ltd prepared budgets for income from sales of machines (sales revenue) of £2,000,000 in the coming year. In the event, actual sales revenue turns out to be £1,750,000. Identify two possible reasons why you think the variance (the difference between the planned and actual sales revenue) might have arisen, and who you think will be held accountable for the difference from the plan. You may have thought of a number of possible reasons why the variance came about, but your suggestions can probably be grouped into these main areas:  sales price per machine had to be lower than was forecast;  the number of machines sold was fewer than forecast. 16  Session B Of course, these problems would have to be investigated in more depth to find out what was causing them. It might be something like poor delivery dates, low quality or a competitor putting a better or cheaper product on the market. As to who would be held accountable or responsible, it will be whoever was responsible for preparing the sales budget, whether that was the sales director, sales manager or whoever. This person may not be directly to blame for the variance, but he or she carries the responsibility for the problem. Depending on the causes identified, the sales director will wish to discuss the issues with other managers. Poor delivery dates may be down to the distribution manager or the production director; low quality may also be part of the production director’s remit, or that of the research and development director. In order to monitor what is happening, managers need budgetary control reports to be sent to them periodically, highlighting variances for which they are responsible. Regular control is more likely to prevent major problems at the end of the budget period. 2.1 Reporting actual results and variances Here is an extract from a budgetary control report for a manufacturing company. Budget Actual Variance Sales revenue 600,000 700,000 100,000 Favourable Less costs: Materials in factory 250,000 280,000 30,000 Adverse Wages in factory 100,000 120,000 20,000 Adverse Machine running costs 45,000 50,000 5,000 Adverse Salaries in administration 55,000 50,000 5,000 Favourable General administration 20,000 15,000 5,000 Favourable Advertising 15,000 20,000 5,000 Adverse 485,000 535,000 50,000 Adverse Operating profit 115,000 165,000 50,000 Favourable 17 Session B As you can probably see from the figures above, a favourable variance indicates that:  actual sales are greater than budgeted sales, or  actual costs are lower than budgeted costs. An adverse variance indicates that:  actual sales are lower than budgeted sales, or  actual costs are greater than budgeted costs. In the example budgetary control report: Sales – Costs = Operating profit. You read just now that managers responsible for different budgets should periodically receive a budgetary control report, and should then be expected to explain variances. Usually senior management would be concerned with adverse variances of a certain size (some variance either way is almost inevitable), but favourable variances may also need investigation. This is because short cuts may have been taken to arrive at the apparent advantageous situation. Alternatively, managers may simply wish to learn from it for the future. 6 mins Activity 9 Refer back to the budgetary control report for the manufacturing company, shown above. Below is a list of the managers who receive a copy. Against each job title, state the variance which you think each of them would have to explain. Purchasing manager (reports to factory manager) Factory manager Marketing manager 18  Session B You should have identified that the managers would have to explain the adverse variances as follows.  Purchasing manager: materials in factory.  Factory manager: materials and wages in factory, machine running costs.  Marketing manager: advertising. 2.2 Why have the variances happened? As we saw in the budget preparation statement, problems are likely to be interrelated, so that what happens in one area may be the result of a decision made in another area. It is worth investigating the sales variance as something might be gained for other aspects of the business from the successes being achieved here. The same can also be said in the areas of salaries in administration and general administration, where the favourable variances are significant. Managers may not always be able to take action about variances, whether favourable or adverse. This is because:  some costs will be non-controllable;  some costs may arise in the department but the responsibility may lie elsewhere. For example, time wasted in one department may be caused by the failure of another department to supply information or materials. If you want to find out more about investigating the causes of variance, look at the Controlling Costs workbook. 15 mins Activity 10 This Activity may provide the basis of appropriate evidence for your S/NVQ S/NVQs portfolio. If you are intending to take this course of action, it might be better B1.1, B1.2, D1.1, D1.2 to write your answers on separate sheets of paper. Think about your own organization. a To whom do you report variances from budgets and how quickly do you need to report? 19 Session B b Who, if anyone, reports variances to you? c Why is it important for variances to be reported as required by your organization? How well are reports of variances followed up; are the causes always sought? Your response will be related to your own job. You are likely to report variances to your immediate line manager within a period depending on the significance of the variance. A major problem will require immediate reporting. In the same way, others may report to you. The speed and extent of reporting depends on organizational policy and the trust you and your colleagues have in each other to deal with problems. You will presumably be able to take action on variances and take control of appropriate resources under your control, or make recommendations to your manager. 2.3 Non-controllable costs Let’s look a little more closely at what we mean by non-controllable costs. These are costs that are charged to a budget centre, the name given to a section of business on which a budget is built, such as sales or production, but which cannot be influenced by the actions of the people responsible for that budget centre. 20  Session B 2 mins Activity 11 Identify one example of what you think is a non-controllable cost that might be charged to the budget of your work area. Here are some examples which came readily to my mind. I hope you can see that they are outside a manager’s control.  A portion of the rates charged to a departmental budget for the premises it occupies.  Diesel fuel costs charged against the transport manager’s budget where oil shortages cause prices to soar.  Heating costs in a work area where the heating system is controlled centrally. Since these are outside the control of the manager concerned, it’s important to identify them separately. Let’s look at why this is important. 6 mins Activity 12 Margaret Shaw is the manager of a school canteen with a monthly wages budget of £2,000. She receives a budgetary control report which tells her that the wages expenditure in her canteen for January, February and March has been £2,250 for each month. Here are the reasons for overspending.  January: extra staff employed to cover sickness.  February: staff overtime to meet re-arranged schedules during annual school examinations.  March: implementation of a nationally agreed bonus scheme, which was not built into the budget. 21 Session B We usually regard wages as a controllable cost. But is that entirely true in this case? Decide whether the adverse variance in each month has been caused by controllable or non-controllable wages costs, and note briefly the reason for your decision. Controllable Non-controllable Reason January   February   March   Compare your answers with mine.  January’s variance is non-controllable. A reasonable allowance for sickness should be built into the budget, but extra cost caused by excessive sickness could hardly be controlled by the manager.  February’s cost, however, is controllable. The manager should have anticipated this problem. Overtime costs for predictable events would certainly be regarded as being within the manager’s control.  March’s extra costs are clearly non-controllable. National agreements lie outside the manager’s control, and the budget will need to be adjusted to incorporate the extra payment. We’ve said that it’s important to discover who and what is responsible for any budget variance. This isn’t a question of looking for someone to blame. The real issue is finding out why the variance has happened so that corrective action can be taken if necessary. 2.4 Causes of variances At the beginning of this session we looked for reasons why there might be a variance on sales and decided that two of the likely causes are:  the quantity sold is different from the quantity budgeted (volume);  the selling price is different from the price budgeted (price). 22  Session B Let’s see how the variance on sales for the manufacturing company referred to on page 17 would be presented in the budgetary control report for the sales director. First we need a little more detail. Remember that the company budgeted to make £600,000 in revenue and actually made £700,000. Why did this happen? On investigation, we discover that the company budgeted to sell 50,000 units at £12 per unit, but actually sold 56,000 units at £12.50 per unit. How does this information help us? We need to analyse the total sales variance into a volume variance (selling 6,000 more units than expected) and a price variance (selling units at 50p more than expected). This can be presented as follows. (Don’t worry too much about the maths at this point.) Budget Actual Variance Sales volume 50,000 units 56,000 units £72,000 Favourable Selling price £12.00 £12.50 £28,000 Favourable Sales revenue £600,000 £700,000 £100,000 Favourable Having broken down the causes of the sales variance, the company needs to discover the underlying reasons. Perhaps, in this case, the unit price was increased because another supplier went out of business and supplies were scarce, or because less discount was offered to customers. There could be all sorts of reasons. We’ve seen that it’s important to analyse sales variances by:  volume;  price. We can analyse any variance on costs in a similar way. 23 Session B 2 mins Activity 13 Remember our manufacturing company has an adverse variance of £30,000 on the cost of materials in the factory. Jot down the two headings under which you think those cost variances could be analysed. You may not have used the same words as I have but anything on similar lines is acceptable.  Volume Did the business need more materials than budgeted to produce the units?  Expenditure Did it have to pay more for the materials than budgeted? All types of costs can be analysed in this way but we’re just going to concentrate on two:  labour;  materials. 8 mins Activity 14 A job is budgeted to take 50 hours and the labour per hour is £6·00. The actual hours taken are 55 and the hourly rate paid is £6·20. Calculate the labour cost variance and suggest two reasons which you think might have caused the variances in time and the rate. Budgeted cost =  = Actual cost =  = Variance = (A/F) 24  Session B Here are my calculations to compare with yours. Budgeted cost = 50  £6·00 = £300 Actual cost = 55  £6·20 = £341 Total variance = £41·00 (A) We can break down the total variance like this.  For the volume variance, calculate the number of excess hours worked (55 – 50 = 5) and multiply this number by the budgeted hourly rate of pay (£6).  For the rate variance, calculate the difference between the actual rate paid and the budgeted rate (£6·20 – £6·00 = £0·20) and multiply this number by the actual hours paid (55). Labour variance (adverse) £41.00 Volume Rate = 5 hour × £6·00 = 55 × £0 ·20 = £30·00 (A) = £11.00 (A) £41.00 You may have suggested some of the following for the causes of the variances. The volume variance might be caused by:  slack work practices resulting from poor supervision;  machine breakdowns;  technical problems;  bottle-necks, leading to material shortages. The rate variance might be caused by:  overtime or bonus payments  unbudgeted pay award. Now let’s look at the cause of a total materials variance. 25 Session B 5 mins Activity 15 A job is budgeted to use 1000 kilos of material at £3·00 per kilo. The actual usage is 1200 kilos, but the price is £2·50 per kilo. Calculate the total material cost variance, and analyse that into the price and expenditure variances. Write your answers on this diagram. Material variance Expenditure Price The answer to this Activity can be found on page 117. 26  Session B 3 Flexible budgets and budgetary control In what we have said about budgetary control so far, we have assumed that we were using fixed budgets. This means that, before the beginning of the period to which the budget relates, costs are budgeted for, and the budgeted costs remain the standard against which actual costs are compared, regardless of what happens during EXTENSION 3 the budget period. Managing Budgets, a title in the Essential Managers By using a flexible budget, on the other hand, we can make adjustments to series by Dorling costs if circumstances vary from the original budget. Kindersley, describes the usefulness of using spreadsheets in A flexible budget is defined by the Chartered Institute of Management budgeting. By using Accountants as: spreadsheets, a change in level of activity of, say, 5% can quickly and easily ‘a budget which is designed to change in accordance with the level be made. of activity attained’. A flexible budget in fact consists of a series of budgets. Each one is based on a different level of sales or output. As an example, a company might budget for three possible levels of output; costs are then calculated for each level. Despite the extra effort required in preparing these, flexible budgets can be very useful. Software packages certainly enable flexible budgets to be prepared easily and cheaply. The first thing we have to do is to analyse costs into:  fixed costs, which do not vary with the level of production and sales;  variable costs, which do vary with production and sales. Let’s look at the difference this makes in practice. 27 Session B We shall first assume that all costs are variable; that is, that they will vary in line with sales and production volumes. If we predict that production and sales will fall within the range of 2,000–3,000 units, we can work out the costs for both these figures. Suppose each unit costs £5. Then the total costs for 2,000 units will be £10,000, and the total costs for 3,000 units will be £15,000. The flexible budget would then look like this. Budget 1 Budget 2 Production/sales 2,000 units 3,000 units Costs £10,000 £15,000 In this case, the 2,000 units in Budget 1 is the lowest expected production/ sales figure; the 3,000 units in Budget 2 is the highest expected figure. The actual figures are expected to fall somewhere in between these two. Say now that actual performance is to produce and sell 2,500 units. In the budgetary control report, since sales have turned out to be within the expected range, the budget figure written in for sales will be the same as the actual figure. The actual cost can then be compared with the expected costs for that figure. In the case above, the budgetary control report might appear as follows. Budget Actual Variance Production/sales 2,500 units 2,500 units Costs £12,500 £12,000 £500 (F) Here the actual sales turned out to be 2,500 units (which is within the budgeted range), so the ‘new’ expected costs are 2,500  £5 = £12,500. The actual costs were £500 less than this, so the variance is favourable. Of course, not all costs are in practice variable; there are always some fixed costs. 28  Session B 6 mins Activity 16 Let’s assume that we regard 50% of our costs as fixed and 50% as variable. The fixed costs are £5,000. Complete the flexible budget and the budgetary control report in this instance. Flexible budget Budget 1 Budget 2 Production/sales 2,000 units 3,000 units Costs – fixed £5,000 – variable £5,000 Total costs Budgetary control report Budget Actual Variance Production/sales 2,700 units 2,700 units Costs £13,000 As half the costs (£5,000) were fixed, they remain the same in Flexible Budget 2, even though sales are 1,000 more than in the first budget. But for Flexible Budget 2 we must calculate the expected variable costs for 3,000 units, as these do vary. We do this by working out the variable cost per unit from the first budget, and applying that to 3,000 units: £5,000/2,000 units = £2.50 per unit. The variable costs for Flexible Budget 2 are then: £2·50  3,000 units = £7,500. So the total costs for Budget 2 are: £5,000 fixed costs + £7,500 variable costs = £12,500. 29 Session B The completed table is therefore as follows. Flexible budget Budget 1 Budget 2 Production/sales 2,000 units 3,000 units Costs – fixed £5,000 £5,000 – variable £5,000 £7,500 Total costs £10,000 £12,500 Turning to the budgetary control report, the actual sales are 2,700 units and the actual costs are £13,000. We work out the flexible budget costs for 2,700 units as follows. £5,000 fixed + (£2·50  2,700) = £11,750. This gives an adverse variance of £1,250 (£13,000 – £11,750). So the completed table should look like this. Budgetary control report Budget Actual Variance Production/sales 2,700 units 2,700 units Costs £11,750 £13,000 £1,250 (A) 3.1 The advantages of flexible budgets Flexible budgeting is helpful to management in a wide variety of organizations where it is important to be able to take account of changes in circumstances. Flexible budgets are particularly useful at:  the planning stage;  the end of the budget period, in order to revise figures to match reality and to plan for the future. Using flexible budgets at the planning stage lets you consider the consequences of output being greater or less than expected, within a certain range. So, if your planned output and sales are 10,000 units, flexible budgeting will allow you to consider in advance what will be the implications of achieving only 8,000, or what will be the opportunities of achieving 12,000 units. 30  Session B 5 mins Activity 17 The outpatient department of a busy district hospital plans for 25,000 outpatient visits a year. Resources – doctors, nurses, secretarial back-up, waiting rooms, etc. – are geared to cope with 25,000 visits. Management use flexible budgeting to consider in advance the problems associated with there being 20,000 or 30,000 visits. Identify three problems which might be anticipated if there are as many as 30,000 visits. The problems may appear endless. Among these are:  failure to meet agreed service standards;  over-tired doctors and other staff;  overcrowding;  increased litigation. A flexible budget will show what the cost implications are across the board resulting from a change, so that managers can:  think ahead;  anticipate problems;  arrive at possible solutions. 4 Non-financial budgets Let’s look briefly at non-financial budgets. All the budgets we’ve looked at so far have been concerned with money, but we can use the same techniques to help us plan for other key factors. 31 Session B Here, for example, is how they can be used to provide information for management decisions on the allocation of resources in a hospital. Medical specialism Beds available Occupancy (%) Surgery 80 75 Medical 105 80 Geriatric 110 94 Maternity 38 89 Gynaecology 20 80 Now this may not appear like a budget, but the hospital managers are:  planning for bed usage;  recording their resources (beds);  recording the actual outcome (percentage occupancy);  presumably using the information for future plans. 2 mins Activity 18 Take a look at the above table.  Which service is most efficiently managed?  Which service may be worth reducing? Geriatric beds are occupied 94% of the time and are used very efficiently. Compared with this, surgery beds are only 75% occupied and this may indicate that the service could be reduced. Of course, the ‘beds available figure’ is just the tip of the planning iceberg. Allocating new beds implies that more nursing staff, medical staff and back-up 32  Session B resources will need to be allocated to the specialist areas. Percentage occupancy figures do not indicate costs. So, you can see the budget process can help manage in a wide range of areas; it need not be restricted to financial statements. 5 Standard costing and budgetary control Standard costing is really a continuation of budgetary control. Let’s see what it is and how it relates to budgetary control. Here is how the Chartered Institute of Management Accountants defines standard cost. ‘Standard cost is a predetermined calculation of how much costs should be under specified working conditions and standard costing is therefore a system which uses standards for costs (and revenue) to allow detailed control by the use of variances.’ Using standard costs enables us to work out what performance should be under certain conditions, so that we can identify variances and so control actual performance. Perhaps this sounds rather similar to what we have already said about budgeting, particularly using fixed budgets. Both standard costing and budgeting are:  concerned with setting performance standards for the future;  aids to control. They are not, however, the same thing. The important difference is that:  budgets are concerned with totals – such as the costs of an entire department;  standard costs are concerned with individual units; each item of production, for instance, will have a standard cost. 33 Session B 2 mins Activity 19 If standard costing is concerned with individual units, do you think that this involves more or fewer people in budgetary control than in budgeting? Give reasons for your answer. Standard costing takes budgetary control ‘further down the line’, and involves more people in having responsibility for meeting standards in their particular area of work. The advantages of having people involved are:  if unit costs are applied widely and lots of people are monitoring them, it is possible to identify variances on a much wider range of items, so improving control;  the setting of standards gives everybody a target to aim for and is likely to make more people cost conscious. 20 mins Self-assessment 2 1 List five basic steps of budgetary control systems. 2 State what is indicated by favourable and adverse variances. 34  Session B 3 Identify whether the following are controllable or non-controllable costs. Controllable Non-controllable a The produce purchased and sold   by a greengrocer. b The rent of a chair in a   hairdressing salon. 4 Prizewinning Blooms expects to sell 100 bunches of red roses at £8·50 per bunch on Valentine’s day. Sales are hit by a newspaper promotion of chocolates and the business is only able to sell 90 bunches by reducing them to £7·00 per bunch. Calculate the total sales variance and indicate if it is favourable or adverse. 5 Jack Simmons has received an estimate for painting a room of £320, being 16 hours at £20. As the painter was unable to complete the job and a less qualified person completed it, the actual cost was for 24 hours at £13 per hour. Calculate the total labour cost variance and indicate if it is favourable or adverse. 6 Briefly explain why flexible budgeting is useful to management. 7 A local theatre group has fixed costs of £200. It sells tickets for £5·00 each of which £3·00 is taken up by variable costs. How many tickets must the group sell to break even? Answers to these questions can be found on page 114. 35  Session B 6 Summary  Budgets must be put to use to achieve optimum results in organizations, in order to justify the time and effort involved in preparing them.  Budgetary control allocates responsibility to managers who must achieve a plan, and allows for the identification and analysis of variances.  Managers are held responsible for cost variances if these costs are within their control.  Budgetary control can be achieved through fixed or flexible budgets, but flexible budgets are more useful.  Non-financial budgets can provide management with useful information.  Budgetary control is improved by a system of costing such as standard costing. 36  Session C Measuring performance 1 Introduction So far in this workbook we’ve been seeing how the things that first line managers and their workteams do can be monitored against an expected target called a ‘budget’. In this session we’ll be taking a wider perspective, because budgets are not the only yardstick for measurement, and because first line managers are not the only people with a stake in the way an organization performs. So in this session we’ll look at:  a wide range of methods for measuring performance;  how an organization’s performance might be judged by the various people who have a stake in it. 2 What is performance measurement? Suppose you run a 100-metre race in 15 seconds. How did you perform? There are lots of ways you could describe it (and you might be tempted to use the way that makes you look best when describing it to other people). 37 Session C 1 You could compare this performance to your previous attempts to run 100 metres. Were you faster or slower? 2 You could compare it to a target you have set for yourself, such as 100 metres in 12 seconds. 3 You could compare it to the times of other people in the race, or (if you are very ambitious!) to the world record time for running 100 metres. All these descriptions are measurements of your performance. So let’s have a definition. Performance measurement considers how well something per- forms compared with how it performed in the past, or with how it is required to perform in the future, or in comparison with the performance of something else. 3 Performance measurement principles In the 100-metre race we said you ‘performed it’ in 15 seconds, and 15 seconds is a sort of performance measurement. If you usually manage to run 100 metres in 13 seconds we might have said that your performance was ‘below average’. If one person beat you in the race we could have said that you came ‘second out of eight runners’. ’Below average’ and ‘second out of eight’ are both performance measures. 38  Session C 4 mins Activity 20 For each of the three measures we used for your 100-metre race, what were you comparing your performance against? Which do you think is the most useful measure? The first measurement is against the clock: it compares distance travelled with time taken. This is only useful if you happen to know other information, like how long it usually takes people of your age, sex and fitness to run 100 metres. The second is against your own previous performance, and that is useful information for you personally and for people who may compete against you in the near future. The third measurement compares you with other people. Since I don’t know anything else about you, I would say that the third measure is the most useful piece of information you could give me – but I would probably ask you who you were competing against. The point is, the same performance can be presented in lots of different ways. 3 mins Activity 21 Say you had to report your performance in the 100-metre race to your coach, your colleagues at work and your partner. Which measure would you use for each person? 1 Your coach 2 Your colleagues at work 3 Your partner 39 Session C Probably it should be presented in the way that is most helpful to the person who wants the information, but very often information is presented in a way that makes the person presenting it look good. 3.1 Quantitative and qualitative measures Information is quantitative if it can be expressed in numbers (or ‘quantities’). ‘Five apples’ or ‘2 kg of apples’ or ‘a bag of apples costing £1.50’ are all examples of quantitative information. Information is qualitative if it is not expressed in numerical terms (for instance ‘below average’), either because it can’t be, or because it can’t be in a way that has an agreed meaning. 3 mins Activity 22 Describe ‘very delicious apples’ as fully as you can. If you need to describe the quality of something, it’s generally more helpful to give as much detail as possible. This at least gives someone a chance to judge the apples in comparison to things they know about. You may argue that ‘very delicious apples’ could be expressed numerically. You could say ‘apples to which I would give a deliciousness rating of 10 out of 10’. But different people have very different ideas about what they think is a delicious apple. How do you judge? 40  Session C 3 mins Activity 23 If you had to choose between the two performance measures for apples below, which would you choose and why? 1 These apples are green, crisp, hard, juicy and sharp on the tongue. 2 I give these apples a deliciousness rating of 5 out of 10, and so do my three colleagues. I hope you agree that quantitative information (description 2) is the most useful for performance measurement. (This does not mean that qualitative information should never be used, especially if there is a way to express it in a mixture of quantitative (objective) terms and qualitative (subjective) terms.) If you had bought that bag of apples that rated 5 out of 10, and you wanted to increase your colleagues’ apple-eating pleasure, the numbers give you a very clear target to beat: you just have to shop around for apples that rate more highly. In addition, by saying ‘... and so do my three colleagues’, the second measure is much more convincing than the first, purely personal opinion. 41 Session C 3 mins Activity 24 In a supermarket you notice that the label on one of the bottles of organic apple juice you are thinking of buying has ‘Silver Award Winner’ printed on it. Is this an example of performance measurement? If so, why? Look back at the definition of performance measurement at the beginning of this session if you are not sure. The award implies that the apple juice performed well enough to come second overall in an organic apple juice competition (presumably judged by experts) in comparison with other juices, so yes it is certainly a performance measure. Watch out for other examples of attempts to ‘quantify’ qualitative measures. It is a common technique in advertising. 3.2 Comparing numbers: percentages In this workbook we’ve already compared actual performance with budgeted performance, by subtracting one number from the other and calling the difference a variance. There are other ways of looking at numbers in organizations. The most common way in performance measurement is the percentage. 42  Session C 5 mins Activity 25 Jumbo Ltd manufactures pet products. It had sales of £23,500 in January, £19,900 in February and £27,400 in March. By how much did sales fall in February and rise in March? Express you answer as a percentage to two decimal places. In February, sales fell by £(23,500 – 19,900) = £3,600. To express this as a percentage, you divide the difference between the two numbers by the earliest number, and multiply by 100: £(3,600/23,500) × 100% = 15.32%. In March sales rose (compared with February, the earliest number) by £(27,400 – 19,900) = £7,500, or £7,500/£19,900 × 100% = 37.69%. Another way of looking at this is simply to divide one number by the other. For instance you could say that February sales are only 84.68% (£19,900/£23,500) of January sales, while March saw sales of 137.69% of February sales. (Remember: it is the thing that the percentage is ‘of’ that represents 100%.) £ % £ % February 19,900 84.68 February 19,900 100.00 Decrease 3,600 15.32 Increase 7,500 37.69 January 23,500 100.00 March 27,400 137.69 Here are a few examples of how percentages are used in performance measurement.  Market share A company may set a target of 25% share of the total market for its product. The marketing department’s performance will be measured on the difference between this and the actual market share achieved. 43 Session C  Capacity levels ‘The factory is working at 15% below full capacity’ is an example suggesting that the factory is not producing as much as it could, perhaps because of inefficiencies.  Staff turnover If a department has staff turnover of 15% over a year, when the average in the organization is only 5%, there may be some problem in the way that department is performing. 3.3 Comparing like with like 5 mins Activity 26 We have the following additional information about Jumbo Ltd. Sales 2003 2004 January 23,500 34,200 February 19,900 28,900 March 27,400 48,200 Can you see a pattern here? Describe them below, as fully as you can. What reasons can you think of for the pattern? You should be able to see a pattern: sales fall in February and rise in March in both years. There could be a number of reasons for this: perhaps the January figures are boosted by post-Christmas sales, February is about normal and March is the time when the company releases its new Spring range of products. 44  Session C In a case like this, it is not particularly useful to compare a month with the month before, since we already know roughly how sales will rise and fall between January and March. It is not really fair to compare March sales (the new product range) with February sales (the end of the old product range): we are not comparing like with like. A better way of measuring would be to compare sales in 2004 with sales in 2003. Sales 2003 2004 Increase January 23,500 34,200 45.53% February 19,900 28,900 45.23% March 27,400 48,200 75.91% Here we can see that in both January and February, sales are about 45% higher than they were in the previous year. But in March, sales are 75% higher than last year: the Spring 2004 product range has been much more successful on its launch than the Spring 2003 range was when it was first introduced. If you get unexpected results you should always check that the principle of comparing like with like is being applied. Just think of the 100-metre race: if all the other competitors were 30 years older than you, your work colleagues might not be quite so impressed that you came second! 4 mins Activity 27 Company A made a profit in the year to 31 December 2003 of £73,900. In the same period, Company B made a profit of £82,500. What other information would you need to compare the performance of these two companies? 45 Session C On the face of it, Company B did a bit better than Company A, but we have no idea whether we are comparing like with like. If Company A’s sales were £100,000 and Company B’s sales were £500,000, then Company A was actually a lot more successful. We can see this by calculating the profit margin – profit divided by sales – and comparing these. Profit (£) Sales (£) Profit margin Company A 73,900 100,000 73.9% Company B 82,500 500,000 16.5% It would also be useful to know what the two companies actually do. Company A might be a firm of solicitors while Company B might make bathroom accessories, in which case there is little point in comparing their performance. More information about costs would be helpful. Perhaps Company B had unusually large expenses during the year that will not recur in subsequent years. And it would be helpful to know how much profit the companies made in previous years. 4 A range of performance measures In most business organizations, popular ways of measuring performance are profitability, activity and productivity.  Profitability Profit is made up costs and income. All parts of an organization incur costs, and so everyone’s performance can be judged in relation to cost. Only some parts of an organization receive income, and their success should be judged in terms of both cost and income. 46  Session C  Activity All parts of an organization carry out activities. An example of an activity measure is ‘Number of orders received from customers’. This is a measure of the effectiveness of the marketing department. Activities can be measured in terms of physical numbers, monetary value, or time spent.  Productivity This is the quantity of the product or service produced in relation to the resources put in, for example so many units produced per hour, or per employee, or per tonne of material. These are measures of efficiency. 2 mins Activity 28 Circuit Ltd makes circuit boards for the electronics industry. Its production department has two production targets. Identify which is an activity target, and which is a productivity target. 1 At least 15 batches of circuit boards should be produced each week. Activity target  Productivity target  2 At least 1,000 circuit boards should be produced per hour of production time. Activity target  Productivity target  Circuit Ltd produces circuit boards in batches, and in one week it can produce at least 15 batches. We don’t know how many boards there are in each batch, nor how many resources are used in a week, so Target 1 is an activity target. Target 2 measures both factory time and the number of circuit boards produced, so this is a productivity target. 5 Financial performance measures Financial measures are calculated using figures in the organization’s accounting records. Financial measures only tell us something about whether perform- ance is good or bad because they are compared with something else. 47 Session C 4 mins Activity 29 Here are some examples of financial performance measures, accompanied by comments that you might typically read in the financial pages of a newspaper (these are derived from the Financial Times). For each one, try to identify what the performance is being compared with, and what the comparison shows.  Profit: ‘the company made pre-tax profits in 2002 of £1.46m (2001: £1m) on sales of £12.7m (2001: £10.7m)’.  Sales: ‘the aluminium division had sales which accounted for approximately 10% of the group’s total sales’.  Costs: ‘savings from the cost-reduction programme were £30m a quarter’.  Share price: ‘the group’s share price rose 15p to 684p despite the stock market’s overall fall’. You may have expressed your ideas differently but see how they compare with mine.  This year’s profits and sales are compared with last year’s, and are found to be higher.  Sales for one part of the organization are compared with the total for the group. The comparison shows a certain level of sales, but does not indicate whether this is an improvement or a deterioration.  Costs are compared with a previous period. They are at a lower level, in keeping with a planned reduction.  Share price is higher than before and high relative to the performance of the stock market as a whole. Here is a list of yard-sticks against which figures in an organization’s accounts are usually placed so that they become measures.  Budgeted sales, costs and profits, or standards in a standard costing system.  The trend over time (comparing last year to this year, say). 48  Session C  The results of other departments of the organization.  The results of other organizationes, especially competitors.  The market in general.  The economy in general.  The organization’s future potential (for example a promising new organization may make large losses in its first few years, but its performance should be judged in terms of how long it will be before it starts to make large profits). 10 mins Activity 30 See if you can get hold of a copy of your own organization’s latest Annual Report and Accounts and glance through it to see what sort of financial performance measures you can spot. If you’ve studied any accounting you’ll know that there are several ratios that can be calculated to show how an organization is performing. Examples are the current ratio, profit margin and return on capital employed. I logged on to the Internet and tapped ‘Annual Report and Accounts’ into a Another workbook in this series, search engine. Understanding Finance, tells you about The first thing I found was the Annual Report and Accounts of Unilever, which financial ratios in more has a liberal sprinkling of financial performance measures just in the first few detail. pages. Examples I found were: ‘Leading brands account for 84% of total sales...’, ‘In Africa, Middle East and Turkey, overall sales were up by 2%, with profits increasing by 13%’ and many others. 6 Non-financial performance measures Financial measures do not necessarily give the full picture of an organization’s performance, and in any case as a first line manager you may not have access to many accounting figures for your section or department. 49 Session C 3 mins Activity 31 What measures would you prefer to see for judging your workteam’s performance? Does the accounting system measure these? Your team may be best judged by looking at units produced, time taken, product quality, delivery, after-sales service or customer satisfaction, none of which is directly measured by the traditional accounting system. Unlike traditional variance reports, non-financial indicators are more relevant for non-financial managers, who can understand and therefore use them more effectively. We can supplement financial measures in each of the following key areas of an organization:  sales-related activities;  materials;  labour. 6.1 Sales-related activities Traditionally, sales performance is measured in terms of price and volume variances, but other possib