Chapter 22 - Performance Measures PDF

# Chapter 22: Performance Measures ## Performance Measures Overview - This chapter describes the performance measurement process, including responsibility accounting, ways to measure performance, and identifying performance measures that can be applied to for-profit and not-for-profit organization...

# Chapter 22: Performance Measures ## Performance Measures Overview - This chapter describes the performance measurement process, including responsibility accounting, ways to measure performance, and identifying performance measures that can be applied to for-profit and not-for-profit organizations. - This lesson includes the following topics: - How performance is measured - Methods to measure individual performance - Analyzing performance and taking action, and unique characteristics for NPO and the public sector - Performance measures - summary problem ### Performance Measurement Steps - **Plan:** The first step is to plan the performance measurement process. This includes identifying the objective, determining who is responsible, and identifying the measures to be used. - **Action:** The second step is to take action, including revising measures and changing performance based on the results. - **Analyze:** Gather data and compile results. The last step is to analyze the results and review them regularly. ### Responsibility Centres - **Revenue Centre:** Has control over revenues only and is responsible for maximizing revenues. Examples include sales departments for service providers. - **Cost Centre:** Has control over costs only and is responsible for providing a level of service at the lowest cost. Examples include a manufacturing facility or IT department. - **Profit Centre:** Has control over revenues and costs and is responsible for maximizing profit. Examples could include a retail location with managers responsible for product selection, pricing, and operating costs. - **Investment Centre:** Has control over revenues, costs, and investments and is responsible for maximizing profit relative to investment. Examples include retail locations with managers responsible for product selection, pricing, operating costs, as well as investment decisions such as capital asset acquisitions and leasehold improvements. ### Negotiated Transfer Prices - **Return on Investment (ROI):** $ROI = \frac{Operating Income}{Average Operating Assets}$ - **Residual Income:** $Residual Income = Operating Income - (Required Rate of Return \times Investment)$ - **Performance Measures:** - **Financial:** Total revenues, profit margin, profit per employee per year, return on investment, residual income, current ratio - **Customer:** Number of high-value customers, customer survey on brand awareness, number of calls, time to resolve complaints - **Internal Business Process:** On-time delivery percentage, defect rates, cost per unit of output, inspection costs, lead times from order to delivery - **Learning and Growth:** Number of patents, new product profits, key staff turnover percentage, number/cost of system outages, de-bugging costs - **Regulatory:** Environmental compliance, number of environmental incidents, corporate social responsibility report card, number of lawsuits - **Social Impact:** Number of green initiatives, days without injuries, public image, number of certified directors and volunteers, number of volunteer days in community ### How Performance is Measured - The performance measurement process is generally an annual cycle and is used to evaluate how the organization is managed from both an efficiency and an effectiveness perspective. ### Planning - The first step in the performance measurement process is planning and setting goals. - Operational measures are derived from the organization's strategic performance measures. - Performance measures help keep track of how the organization is performing compared to expectations, previous years, and industry benchmarks. ### Decentralized and Centralized Organizations - In centralized organizations, major decisions are made at the top of the organizational hierarchy. They are extremely efficient but have a greater impact on the organization's culture. - In decentralized organizations, decision-making is delegated down the organizational hierarchy. Lower-level managers are in a better position than their superiors to take the appropriate course of action. ### Ways to Measure Performance - Organizations have a variety of tools at their disposal to measure and monitor performance. - The management accountant often helps management select organizational and individual performance measures. - **Organization-wide performance measures** - The first step is to determine what measures should be implemented. - Each organization has a unique approach based on its objectives. - Gathering data can be a costly process and may require surveys, interviewing internal and external stakeholders, reviewing existing contracts, data mining of existing information from accounting systems, and extracting information from external agencies. - The data required to assess the measure must be readily available. #### Benefits of a Well-Structured Set of Performance Measures - Provides key information that decision makers can use to analyze and interpret performance. - Helps create a common set of factors that the organization considers most important. - Provides a starting point for planning future performance measures. - Helps communicate and provide direction to employees in terms of fulfilling their duties. - Provides a mix of lead measures, which have a predictive nature and are input based, and lag measures, which summarize past performance and are output based. ### Key Individual Performance Measurement Components - The following are critical components of every individual performance measurement system: - An understanding between the employee and employer on important contractual facets like performance expectations, performance measurement system, and clear standards on what is acceptable and what is not. - A demonstrated link to strategic objectives, such that the employee's contribution is identified and can be measured. - A demonstrated linkage between accountability and controllability (that is, if an employee is to be held accountable for certain results, they must be able to control most or all of the factors determining those results). - Standardization of individual performance measurement for accuracy, objectivity, and fairness across the organization. - Alignment of most individual performance measures with organizational performance measures. ### Responsibility Accounting - This chapter describes how responsibility accounting can be used within an organization to guide decision-making and control. - Responsibility centres are the conventional means to delegate decision-making responsibility in organizations. The objectives assigned to the responsibility centre are monitored through a system of responsibility accounting, which focuses on the responsibility centre's key deliverables/activities. - Responsibility accounting is the accounting system used to measure the plans and outcomes of the responsibility centres within an organization. #### Types of Responsibility Centres - **Cost Centres:** Has control over the level of costs incurred but not the revenue that results. - There are two types of cost centres: - Discretionary (such as research and development or advertising costs) - Engineered (such as volume-driven direct or indirect costs). - Performance is evaluated in terms of how well the manager controlled costs relative to their performance measures. - **Revenue Centres:** Has control only over the revenues generated by the centre. - The manager is evaluated on actual revenue level, revenue level compared to budgeted revenue, growth in revenue, and revenue relative to comparable organizational units. - Non-financial indicators like customer satisfaction, percentage of repeat customers, size and growth of market share can also be used to evaluate the success of the revenue centre. - **Profit Centres:** Has control over both revenues and costs. - The manager is held accountable for the profit the unit contributes to the organization. - Both financial and non-financial performance measures are used to evaluate profit centres. - **Investment Centres:** The manager is able to control both the level of profit and the level of investment. - There are two common means of assessing the profit measure to reflect the level of investment: - ROI and residual income - Other financial and non-financial measures can be used to evaluate the success of the investment centre. #### Benefits and Challenges in Establishing Responsibility Centres - The main benefit is the ability to link the organizational goals with those of the various departments and divisions of the organization. - There are some challenges: - It can be difficult to clearly distinguish responsibilities, as one responsibility centre's decisions can impact the performance of another. - Performance measures can encourage suboptimal decisions. ### Management by Objectives - Every organization should set goals and objectives common to the whole organization. - MBO is a dialogue in which both the subordinate and the manager contribute specific objectives, goals, measures, and time frames. - Employees are evaluated based on their ability to achieve the jointly set objectives. #### Benefits of Management by Objectives - MBO directs managers' and subordinates' attention and allows them to focus on results. - MBO forces everyone in the organization to commit to achieving a specific measurable result. - MBO encourages managers and their staff to think more broadly about how their individual responsibilities and roles fit within the organization and how they can affect the future of the organization and the achievement of its objectives. - MBO can foster greater commitment to the organization because subordinates are personally involved in setting their goals. - MBO can provide better control and co-ordination of activities that work toward goal accomplishment. - MBO can help grow and develop employees who recognize their strengths and weaknesses and who can anticipate and respond to future challenges. #### Challenges in Using Management by Objectives - MBO assumes that a culture of co-operation exists in the organization. - Without proper interpersonal skills, manager and subordinate MBO sessions may degenerate into times for criticism. - If individual objectives are not grounded in organization-wide goals, or if the manager and subordinates do not understand how their roles fit into the organizational goals, misalignment could occur. - MBO cannot solve every management problem. - MBO tends to emphasize individuals even when the work of the organization may be more of a co-ordinated group undertaking. - The processes of MBO require a great deal of time and effort. ### Analyzing Performance - After the planning stage, the organization identifies the objective, area of responsibility, and sets standards for what is a reasonable target to achieve. - The management accountant gathers and analyzes data. - Timely information must be available to the areas responsible for those measures. #### Reviewing Performance - The data must be compared to the expectations. - Both favourable and unfavorable results need to be analyzed. - If the standard that was set was too achievable, it may need to be made more difficult in the future. - If results are unfavorable, the measure may no longer be within the control of the area/person responsible, or the poor results may be due to a lack of effort. - Reasons for the undesirable results are numerous, and could include a change in market conditions, problems with the process, other organizational priorities, or implementation of a measure that wasn't controllable. - When selecting appropriate benchmarks, organizations often use industry standards, budgets, and standards within a standard costing system. ### ROI and Residual Income - **ROI:** Return on investment is computed by dividing the responsibility centre's reported profit by the level of investment in the responsibility centre. - **Residual Income:** Used as a substitute for ROI. Organizations use cost of capital or weighted average cost of capital (WACC) as a substitute for the required rate of return. #### Motivational Problems with ROI - Investment centre managers may reject projects that promise an expected return in excess of the required organization-wide return, lowering their investment centre's average ROI. - Residual income avoids this problem by motivating managers to accept any investment that is expected to return an amount in excess of the required rate of return. - However, residual income may encourage managers to forgo long-term results in favor of improving short-term performance. ### Action - Performance measurement can be thought of as a circle. - Action is the feedback piece that may lead to different plans or revised measurement standards. - Revising measures is the process by which measures are reviewed and reassessed to see if they are a good fit for that position or responsibility centre. - Changing performance means taking action when performance is not meeting expectations. - The measure may be a good fit, but it could be that performance is not at the desired level. - Coaching and guidance can be provided to support the change in behaviors. - Employees are expected to learn from undesirable results and be more motivated for change in the future. ### Aligning Rewards with Performance Measurement - **Intrinsic rewards:** Related directly to performing the job. - Examples include feelings of accomplishment, autonomy, and personal growth. - **Extrinsic rewards:** External to the work itself. - Examples include wages and salaries, fringe benefits, promotions, and recognition and praise from others. - Organizations should emphasize intrinsic rather than extrinsic motivators. - The human resources department is typically responsible for the creation and management of a performance measurement rewards program. ### Unique Characteristics of Not-for-Profit Organizations and the Public Sector - This section describes the performance management process in NPOs. - NPOs do not have a single overriding profit maximization goal. Instead, they measure success based on their ability to meet their stated goals and mission. - It is important to monitor the financial performance and conditions of NPOs regularly. #### Measuring Performance - The amount of profit an organization generates is often used to measure efficiency and effectiveness in the for-profit sector. - If an organization is not efficient, it may not survive in the market. - Profit-oriented organizations can use profit as the main criterion when deciding among alternatives. #### Not-for-Profit Organizations - NPOs typically organize activities by program. The program manager is usually in the best position to identify and explain variances in the budget or in program processes or outcomes. - It's important to remember that the profit motive does not typically apply to NPOs. #### Government Organizations - Government organizations implement policies and deliver services through a variety of entities. - Some are organizational and accounting entities funded mainly through taxation. - Others are separate corporate entities with legislated financial powers and management authority. - Governments are different from business in both their objectives and financing. They provide public services and redistribute wealth for a variety of social and economic purposes. - Measurement of success should relate to stakeholder needs and the mission of the service-delivering organization. - The delivery of a government service does not usually generate direct revenue. Government revenues are generally generated through taxation. - The budgetary process in governments is different from profit-oriented businesses and NPOs. # Chapter 23: Balanced Scorecard - Overview - This chapter introduces the concept of the balanced scorecard in performance measurement and how it relates to an organization's strategic mapping. - This lesson includes the following topics: - Introduction to Strategic Mapping, the BSC and Executive Dashboards - Balanced Scorecard - Overview - Summary Problem