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M10_ATRI3622_06_SE_C10.QXD 394 CHAPTER 10 5/29/09 10:41 AM Page 394 MEASURING PERFORMANCE Activity 10.20 continued For Devon, the budgeted profit under each transfer pricing policy will be: Revenue 200,000 × £75 Variable cost £000 Full cost £000 Market price £000 15,000 15,000 15,000 Costs Fabric (200,000 × 1.1) × £11 × £24 × £30 Other costs (200,000 × £35) Budgeted profit (2,420) (5,280) (7,000) 5,580 (7,000) 2,720 (6,600) (7,000) 1,400 We can see that Cornwall will make a significant loss under the variable cost policy. Most of the division’s output must be sold to Devon and, whilst the surplus sold to the external market makes a contribution, it is not enough to cover the fixed cost. Cornwall manages to make a small profit under the full cost policy, which is entirely due to the sales to the outside market. If there were no external sales, the division would simply break even. When, however, transfer prices are set at market price, Cornwall makes a significant profit. For Devon, the situation is reversed. It makes a significant profit under the variable cost policy but when fabric prices are increased under the full cost policy, and then further increased under the market price policy, so the budgeted profit declines. Devon’s profits, of course, are unaffected by Cornwall’s sales to outside businesses. Differential transfer prices There is no reason why, in respect of a particular inter-divisional transaction, there cannot be two different transfer prices. It may be that setting the buying price, for the buying division, at one value and the selling price, for the selling division, at a different value, could lead to both divisions being encouraged to act in the best interests of the business as a whole. This would mean that the overall profit for the business would not equal the sum of the profits of the individual divisions, but this is not necessarily a problem. Real World 10.7 sets out transfer pricing guidelines for businesses operating in the water industry. M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 395 TRANSFER PRICING 395 REAL WORLD 10.7 Thinking water To protect the interests of customers, the UK government regulates the activities of water and sewerage businesses. Many of these businesses are part of a large group with diversified operations, some of which are not regulated. The government regulator, Ofwat, must therefore be assured that any transactions between the regulated water and sewerage activities and other unregulated businesses are not to the disadvantage of customers of the regulated activities. If, for example, water or sewerage services were charged to other unregulated businesses at a price below cost, or services bought in from other businesses were charged at a price above their market value, customers of the regulated water and sewerage services might have to bear an unfair share of the costs of the business as a whole. To prevent this problem from occurring, the following transfer pricing guidelines are in place: l l l transfer prices for goods and services transferred from unregulated businesses to regulated ones should be at market price or less; regulated businesses should market test to determine the market prices for works or services to be transferred to unregulated businesses; transfer prices for transfers from unregulated to regulated businesses should be based on full cost (direct costs plus indirect costs) for specialised services where no market exists. It is interesting to note that transfers of goods and services at cost may, at times, be appropriate, as this can protect the interests of water customers. Source: Guidelines for transfer pricing in the water industry: Regulatory accounting guideline 5.04, ofwat.gov.uk, March 2005. Real World 10.8 provides detail about the use of transfer pricing in UK manufacturing businesses. This survey evidence is now quite old, but there is no more recent evidence of UK practice. REAL WORLD 10.8 Transfer pricing in practice A survey by Drury and others of UK manufacturing businesses found that, amongst divisionalised businesses, the approaches to setting transfer prices were as follows: Approach used Variable cost Full cost Variable cost plus a profit mark-up Full cost plus a profit mark-up Market price Negotiated price Other methods % of divisionalised respondents 37 (2) 42 (22) 30 (11) 52 (27) 52 (33) 70 (30) 9 (1) ‘ M10_ATRI3622_06_SE_C10.QXD 396 CHAPTER 10 5/29/09 10:41 AM Page 396 MEASURING PERFORMANCE Real World 10.8 continued It is clear from the table that, on average, businesses use more than one method. Some of these percentages include ‘used rarely’ and ‘sometimes’. The bracketed figures are percentages of businesses that use the approach ‘often’ or ‘always’. For example, variable cost is used by 37 per cent of respondents, but of those only 2 per cent of total respondents used it ‘often’ or ‘always’. Full cost, which has not too much credibility in theory, seems widely used. The more theoretically respectable variable cost and the market-price-based approaches also seem popular, as do negotiated prices. Source: Drury, C., Braund, S., Osborne, P. and Tayles, M., A Survey of Management Accounting Practices in UK Manufacturing Companies, Chartered Association of Certified Accountants, 1993. Transfer pricing and service industries There is absolutely no reason why the item being transferred inter-divisionally need be a physical object. A water company, for example, may have separate divisions for services such as IT, scientific testing and customer relations, which then charge the division providing water services for any work undertaken. The transfer pricing issues raised above will equally apply under these circumstances. Non-financial measures of performance For both divisions and businesses overall, managers increasingly use non-financial measures to help assess performance. Non-financial measures can help managers to cope with an uncertain environment: the greater the uncertainty of the environment, the greater the extent to which non-financial measures are likely to be of value. This is because they contribute to a broader and more complete range of information for managers, which should, in turn, contribute to a more balanced assessment of performance. It is, therefore, not surprising that these measures have taken on increasing importance in recent years. The reporting of non-financial measures can provide a useful counterweight to the reporting of financial information. It is often the case that ‘the things that count are the things that get counted’. That is, the degree of importance given to items will depend on whether they are reported, irrespective of their real significance. Thus, where managers receive reports based exclusively on short-term financial performance measures, such as sales revenues and profits, these measures become the main focus of attention. As a result, decisions may be made to enhance these reported performance measures, and other aspects of the business may be ignored. The result is likely to be to the detriment of the business. For example, to increase annual profit a decision may be made to cut back on research and development costs, which may be vital to longterm survival. In this kind of situation, reporting non-financial measures concerning the quality and success of research and development would help to provide a more complete picture. Non-financial measures can also provide managers with insights that are difficult or impossible to gain with purely financial ones. For example, customer satisfaction is difficult to assess simply on the basis of financial values. M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 397 NON-FINANCIAL MEASURES OF PERFORMANCE We saw in Chapter 9 that financial measures are normally ‘lag indicators’ that tell us about the outcomes of management decisions. Thus, sales revenues and profits are both examples of lag indicators. Some non-financial measures are also lag indicators, but others may be ‘lead indicators’ that provide an insight to the elements that drive performance such as product quality, delivery times and innovation levels. It is, therefore, important to identify and measure the non-financial factors that are critical to future success. Real World 10.9 provides an example of a non-financial measure that is used by one large business. This measure not only serves as a useful measure of customer satisfaction, but is a vital lead indicator. REAL WORLD 10.9 Is everybody happy? FT Enterprise (see Real World 10.2) is a car rental business that is committed to high standards of service to its customers. To monitor performance it has developed an Enterprise service quality index (ESQI) that measures customer satisfaction. Experience has shown that those customers who express themselves to be ‘completely satisfied’ with the service provided are three times more likely to come back. Thus, the index is seen as a key indicator of future growth and success. To demonstrate to staff how seriously the ESQI is taken by the business, no manager can be promoted from a network office where the ESQI score is below average, no matter how impressive the financial performance of that office may be. According to Andy Taylor, chairman and chief executive, rising ESQI scores give him greater confidence about the future than Enterprise’s strong cash flow or increase in market share: ‘ESQI doesn’t mean we can ignore other things but it will keep us on track.’ Source: Based on information from ‘Enterprise drives home the service ethic’, Financial Times, 2 June 2003. What is measured? Some of the main areas covered by non-financial measures include: l Research and development (R&D) expenditure. For some businesses, R&D may be vital to long-term success. Developing suitable measures relating to the quality and success of the R&D effort may therefore be useful. These might include the number of innovations successfully launched, the percentage of total sales revenue arising from new products, and the time taken to bring a new product to market. l Staff training and morale. It is a modern-day mantra that the employees are the most valuable assets of a business. If this is the case, it is useful to know how the managers are cultivating this resource. Staff training may be measured directly by such means as the number of training days per employee, or indirectly through measures of customer satisfaction. Staff morale may be revealed by staff turnover, absenteeism levels and attitude surveys. l Product/service quality. In a competitive environment, the quality of the products and services offered is of vital importance. Measures such as number of product defects, percentage of scrap, number of warranty claims and number of customer complaints may be important. l Market share. The percentage share of total sales generated within a particular market can help to assess the success of the product range. 397 M10_ATRI3622_06_SE_C10.QXD 398 CHAPTER 10 5/29/09 10:41 AM Page 398 MEASURING PERFORMANCE l Environmental and social concerns. In highly industrialised societies, there is increas- ing pressure on businesses to acknowledge their responsibility towards the environment and to assess the impact of their activities on the communities in which they are based. An assessment of the policies on such matters as pollution, wildlife protection and employment of minorities can be carried out to see whether the business is being a good ‘corporate citizen’. Although this is not an exhaustive list of areas, it nevertheless provides a flavour of what non-financial measures can cover. Activity 10.21 Bling plc operates a chain of high street shops selling costume jewellery to those in the 18 to 30 age range. The business aims to sell products that are both highly fashionable and of good quality, and tries to ensure that customers are provided with a wide range from which to choose. Suggest four non-financial measures that may help the business to assess its performance in achieving these aims. Possible non-financial measures include: l l l l l l l l l the percentage of new products that were ‘first to market’; the percentage of sales revenue from new products; the percentage of returned items; the number of customer complaints concerning quality; customer satisfaction scores; the number of different types of product available for sale; the percentage of items unable to be supplied due to insufficient inventories; the average inventories turnover period; and the percentage share of the market in which the business competes. You may have thought of others. Real World 10.10 provides some insight into the kind of non-financial measures that are regarded as important by management accountants in manufacturing businesses. REAL WORLD 10.10 Rank-and-file measures A study by Abdel-Maksoud and others asked management accountants employed in 313 UK manufacturing businesses to assess the importance of 19 ‘shop floor’ non-financial measures. The accountants were asked to rank the measures on a scale ranging from 1 (low) to 7 (high). The mean importance accorded to each of the 19 measures is set out in Figure 10.7. We can see that the first three measures relate to customers. This is followed by four measures relating to cost control and the efficiency of processes. Source: Abdel-Maksoud, A., Dugdale, D. and Luther, R., ‘Non-financial performance measurement in manufacturing companies’, The British Accounting Review, 37, 2005, pp. 261–297. M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 399 NON-FINANCIAL MEASURES OF PERFORMANCE Figure 10.7 Importance attached to various non-financial measures by management accountants We can see that the degree of importance attached to the 19 ‘shop floor’ financial measures identified varies, but all are located at the upper end of the scale. 399 M10_ATRI3622_06_SE_C10.QXD 400 CHAPTER 10 5/29/09 10:41 AM Page 400 MEASURING PERFORMANCE Choosing non-financial measures Although there is an almost infinite number of non-financial measures that may be reported, it would not be sensible to report too many. Managers would become overloaded, which would undermine rather than improve the quality of decision making. It would also add significantly to the costs of gathering and reporting information. Choices must be made and the measures chosen must demonstrate some logic and coherence. What is needed is a set of non-financial measures that deal with the factors that really matter and fit into a logical framework. Activity 10.22 Can you suggest how this might be done? (Hint: Think back to a particular approach that we discussed in Chapter 9.) A useful approach would be to employ the balanced scorecard. We may recall that this provides a coherent framework and attempts to translate the aims and objectives of the business into a series of key performance measures and targets. In this way, strategy is linked more closely to particular measures. The choice of measure (either financial or non-financial) would then be determined according to its value in achieving the agreed strategy. Real World 10.11 provides some evidence of the popularity of the balanced scorecard among UK divisionalised businesses. REAL WORLD 10.11 A question of balance The study by Drury and El-Shishini mentioned earlier asked senior financial managers of divisionalised businesses about the approaches used to incorporate non-financial measures. Of the 97 respondents, 55 per cent adopted the balanced scorecard approach for the business as a whole; 43 per cent of the 97 respondents also used this approach to evaluate divisional performance. Source: Drury, C. and El-Shishini, E., ‘Divisional performance measurement: an examination of potential explanatory factors’, CIMA Research Report, August 2005, p. 31. Who should report? We saw in Chapter 1 that management accounting embraces both financial performance and non-financial measures. Indeed, reporting non-financial measures, such as budgeted units of production, can be traced back to the early years of the development of the subject. However, the scale and importance of non-financial measures have increased dramatically in recent years and this has raised questions as to whether it should be the management accountant’s responsibility to report such measures. Although many see it as a natural development of the management accountant’s role, M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 401 SUMMARY some believe that it will lead to unbalanced reports. It is feared that financial measures will dominate, resulting in an emphasis on lag indicators rather than lead indicators. Real World 10.12 provides some evidence to support the view that management accountants consider financial measures to be more important than non-financial measures. REAL WORLD 10.12 Finance matters The study by Drury and El-Shishini mentioned earlier asked senior financial managers about the relative importance of financial and non-financial measures for assessing divisional performance. To do this, a seven-point scale was used where 1 represented the view that financial measures were considerably more important than non-financial measures, 7 represented the view that non-financial measures were considerably more important than financial ones, and 4 represented a midpoint which reflected the view that they were of about the same importance. The managers’ scores were as follows: Financial measures more important (scores 1 to 3) Financial and non-financial measures of equal importance (score 4) Non-financial measures more important (scores 5 to 7) % 71 18 11 100 Source: Drury, C. and El-Shishini, E., ‘Divisional performance measurement: an examination of potential explanatory factors, CIMA Research Report, August 2005, pp. 31–32. Whilst this may provide support for those who would like others to report nonfinancial measures, it is worth remembering that, over time, management accountants have strengthened their position at the heart of decision making. This can only have been achieved by responding to the changing needs of business. We should not, therefore, assume that they are unwilling or unable to confront new challenges. SUMMARY The main points of this chapter may be summarised as follows: Divisionalisation l Many large businesses operate through relatively independent divisions. l Divisions are typically either: – Profit centres, which have responsibility for most aspects except investment. – Investment centres, which have responsibility for most aspects including investment. l Divisionalisation is usually made according to: – Product or service. – Geographical location. l Benefits of divisionalisation are said to include: – Better access to market information. – Motivating middle and junior managers. 401 M10_ATRI3622_06_SE_C10.QXD 402 CHAPTER 10 5/29/09 10:41 AM Page 402 MEASURING PERFORMANCE – Developing managers through experience. – Better use of specialised knowledge. – Allowing senior managers to deal with strategic issues. – Enabling timely decision making. l Problems of divisionalisation are said to include: – Goal conflict between divisions. – Excessive avoidance of risky courses of action. – Excessive management ‘perks’. – Costly duplication of facilities and other losses of economies of scale. – Divisions competing with each other to the detriment of the business as a whole. Divisional performance measurement l There are various measures of divisional profit. The most suitable measure must take account of the purpose for which the measure will be used. l Return on investment (ROI) = (divisional profit/divisional investment) × 100%. l l l l l – Resembles the return on capital employed ratio, which seems to be widely used. – Can be broken down into a profit margin and an asset turnover element. – Problems of definition of the divisional profit and investment – need to be consistent. ROI is a comparative (percentage) measure that can mislead. – Can lead to the rejection of beneficial activities because they lower the ROI despite generating wealth. – Tends to focus on the short term. Residual income (RI) = divisional profit less a capital charge (investment × cost of capital). – Relates to wealth generated. – An absolute measure (£s), not a percentage. – Tends to focus on the short term. RI is generally considered a better performance indicator than ROI. Assessing divisional performance requires some basis for comparison. A particular division can be compared with that for: – Other divisions of the same business. – Previous performance of the same division. – Performance of businesses in the same industry as the division. – Budgeted performance – probably the best basis of comparison. EVA® may also be used to measure divisional performance. Transfer pricing l Involves setting prices for transfers (sales and purchases) between divisions of the same business. l An important issue because transfer prices (TPs) have a direct effect on divisional profit and therefore on ROI and RI. l Transfer pricing has the following objectives: – Promoting divisional independence, by allowing divisions to act as if they are independent businesses. – Providing a basis for measuring the effectiveness of divisions through, for example, ROI and RI. – Promoting the objectives of the business as a whole. – Allocating resources provided for individual divisions. – Minimising tax charges by moving profits to low-tax countries. l The best TPs are based on the opportunity cost for both divisions. M10_ATRI3622_06_SE_C10.QXD 5/29/09 10:41 AM Page 403 FURTHER READING l In practice, the following are found: – Market prices – these are usually best because they tend to represent the opportunity cost; however, a market may not exist in practice. – Variable cost – will represent the opportunity cost to a supplying division with spare capacity. – Full cost, usually plus a profit loading – rarely reflects the opportunity cost and tends to pass on inefficiencies. – Negotiated prices – enable the divisions to act as independent businesses but can be unfair. Non-financial measures l Non-financial measures have increased in importance due to environmental uncertainty. l Possible areas for measurement include: – Research and development. – Staff training and morale. – Product/service quality. – Market share. – Environmental and social concerns. l Non-financial measures should be integrated with financial measures into a logical framework, such as the balanced scorecard. l Management accountants usually take responsibility for reporting non-financial measures, although this has raised some concern. ‘ Key terms Divisions p. 367 Profit centre p. 367 Investment centre p. 367 Controllable costs p. 374 Non-controllable costs p. 374 Return on investment (ROI) p. 376 Residual income (RI) p. 379 Transfer pricing p. 386 Market prices p. 389 Negotiated prices p. 391 Further reading If you would like to explore the topics covered in this chapter in more depth, we recommend the following books: McWatters, C., Zimmerman, J. and Morse, D., Management Accounting: Analysis and Interpretation, FT Prentice Hall, 2008, chapter 7. Drury, C., Management and Cost Accounting, 7th edn, Thomson Learning Business Press, 2008, chapters 19 and 20. Bhimani, A., Horngren, C., Datar, S. and Foster, G., Management and Cost Accounting, 4th edn, FT Prentice Hall, 2008, chapter 18. Hilton, R., Managerial Accounting, 6th edn, McGraw-Hill Irwin, 2005, chapter 13. 403