F5 – Performance Management

Performance measurement

Every business starts with a vision, which represents where business wants to be in say next 20 to 30
years. To achieve this vision, businesses set a mission that represents the way business intends to
achieve the stated vision. Mission is used to set goals and objectives that business works to achieve. If
these goals and objectives are achieved, business can hope to achieve its vision by working according to
mission.

Strategies are made to achieve these goals and objectives. Goals and objectives do not have a large
difference as they both represent something business wants to achieve. However, goals are relatively
long term and objectives are slightly short term. For example, increasing market share to 40% in 5 years
is an example of goal and objective would be to increase market share by 10% in each year is an
objective.

Once plans are made organizations implement them with the hopes of achieving objectives, goals and
ultimately vision. However, organizations can not afford to sit down and wait for things to happen on
their own. There is a need to evaluate actual performance of the business in relation to plans, objectives
and goals so that in case of any divergence, timely corrective actions can be taken.

Performance measurement is a process of assessing performance of a product, department, division,

subsidiary, individuals or business as a whole in relation to its objectives.

METHODS TO ASSESS PERFORMANCE OF ORGANIZATIONS AS A WHOLE

Organizations have their objectives, however, on the basis of primary objectives; organizations can be
sub-divided into two types.

 Commercial organizations that work to make profits

 Not for profit organizations (nfpo’s)

Performance measurement of private sector or commercial organizations:

Commercial organizations can be sub-divided into two further categories below

 Manufacturing companies or trading products: performance can be measured by using ratio

analysis or Balanced scorecard approach
 Service organizations: performance can be measured by ratio analysis or BUILDING BLOCK
MODEL.

Performance measurement of not-for-profit organizations:

Performance for NFPO’s can be measured on the concept of value for money that is represented by
Economy, efficiency and effectiveness criterion.

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F5 – Performance Management

RATIO ANALYSIS (FINANCIAL PERFORMANCE)

Ratio analysis represents traditional method to assess performance of commercial organizations

developed by organizations in the early days. According to ratios, there are three most important
aspects organizations need to focus upon. If performance is good in these three areas, organizations
are assumed to be doing just fine. These three areas include:

 Profitability
 Liquidity
 Risk

PROFITABILITY:

Commercial organizations work to make profit. They are established with profit being the main motive
behind. Therefore, it is vital to assess how well a business is doing in relation to profitability. Following
financial indicators can be used to assess profitability:

 Gross profit margin = Gross profit/sales * 100 (20%)

 Net profit margin = Net profit/sales *100
 C/s ratio = contribution/sales
 Cost of sales to sales ratio = cost of sales/Sales (80%)
 Net assets turnover = Sales/Net assets (IN TIMES)
 Return on capital employed (roce) = Operating profit/Capital employed * 100
 Residual Income (RI) = Operating profit – Imputed interest
 Earnings per share = Profit after tax/ Number of ordinary shares
 Return on equity (ROE) = Profit after tax/ Equity

LIQUIDITY:

Along with being profitable, organizations need to be able to pay its liabilities as they fall due, this
represents liquidity of an organizations. It can be assessed using:

 Current ratio = Current assets/ Current liabilities

 Quick ratio = (Current assets – inventory) / Current liabilities

RISK:

Risk is the third most important area to look into as organizations need to keep a check on their risk
level to avoid risk being too high. Following indicators can be helpful:

 Financial gearing = Debt/Equity OR Debt/(Debt+Equity) (Financial risk)

 Operational gearing = Contribution/Operating profit (Operational risk)

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These ratios can be calculated if we are provided with income statement and balance sheet. However,
in most cases, questions only include income statement data. In this case, vertical and horizontal
analysis can be used.
Horizontal Analysis: It represents line by line comparison of information provided in income statement
over multiple years. It is one of the most commonly used methods for carrying out financial analysis. For
example, we can calculate %change in sales from year 1 to year 2 with %change in sales from year 2 to
year 3. Comparing the two can be a good indicator of how profitability is being affected.
Vertical analysis: It represents calculating every element of cost as a %age of sale in year 1 and
comparing it with every element of cost as a %age of sale in year 2. For example, if Administration costs
were 40% of sales in year 1 and 20% of sales in year 2, it indicates increase in profitability.

ADVANTAGES:

Ratio analysis has following advantages.

 Information required to calculate ratios or to carry out vertical and horizontal analysis is easily
available in published annual report.
 It is easier to calculate, interpret and explain these ratios.
 They provide organizations with cost savings and time savings.

DISADVANTAGES:

 Ratio analysis focus on only three important factors only that are profitability, liquidity and risk.
However, there are other critical success factors (CSF) too that are equally or more important
than these three. For example, quality, customer satisfaction, innovation etc. Ratio analysis
focuses on few variables only and ignores other aspects. Therefore, it can never present a
complete picture of company’s performance.
 Ratio analysis focuses upon financial performance only and totally ignores non-financial
performance. Financial performance is just an output of good non-financial input. However,
ratios focus only upon financial aspects or financial side making it more of number crunching
rather than performance measurement. Also non-financial performance is determinant of
financial success.
 Ratio analysis promotes a culture of short-termism. Managers are required to show healthy
financial indicator at year end to achieve their bonuses. This might cause dysfunctional behavior
where managers are taking actions to improve their short term performance at the cost of long
term for example, delaying purchasing new machine in order to report high ROCE.
 Financial ratios can be easily manipulated as they include figures from financial statements that
can be manipulated by changing accounting policies.
 Financial ratios provide no guidance about how well a company is doing in relation to its
competitors.

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F5 – Performance Management

 Financial indicators are a measure of past performance they don’t necessarily indicate likely
future performance. Non-financial indicators help to indicate likely future performance.

USE OF FINANCIAL AND NON-FINANCIAL RATIOS:

In order to get a complete picture about performance of a company, it should use a combination of
financial and non-financial indicators covering all or most of critical success factors.

BALANCED SCORECARD APPROACH

This technique was developed by Kaplan and Norton to assess performance of manufacturing
organizations. It uses a matrix combining financial and non-financial aspects to get a complete picture of
company’s performance.

FINANCIAL PERSPECTIVE: CUSTOMER PERSPECTIVE:

The goal of this perspective is to assess The goal of this perspective is to assess quality of
profitability, liquidity and risk. All the ratios listed products and customer satisfaction. Following
in ratio analysis are financial and focus on these indicators can be used:
three aspects. Therefore, organization can choose  Number of complaints
a few from them to determine changes in  Number of sales return
profitability, liquidity and risk.  Number of warranty claims
 Number of customer re-visits
 Number of customers on referral basis
 Number of on-time deliveries
INTERNAL PERSPECTIVE: LEARNING AND GROWTH:
The goal is to assess internal process efficiency The goal is to assess how well in company doing
and how well resources are being utilized. Where with respect to innovation and growing the
resources include material, labor, factory building business. Following indicators can be used:
and machinery.  Number of new products introduced
 % age of material losses  Research and developments costs
 Idle time ratio  Number of new outlets started
 Labor turnover  Sales of new products as a % of total sales
 Time per unit
 Number of machine break-downs
 % age of defected units

TIP:
An important point to remember is that when answering questions do look for maximum marks for
that part before deciding on number of performance indicators to use. Usually 2 marks for one
indicator are a good deal. Therefore, while answering a 16 marks part, 8 indicators should be used.
However, choose indicators wisely that must cover all aspects of balanced scorecard.

KEY PERFORMANE INDICATORS:

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KPI’S is referred to the key performance indicators a company uses to assess performance. Every
business has its own KPI system that it uses to assess performance.

BUILDING BLOCK MODEL

This approach was developed by Fitzgerald and Moon to assess completeness of performance
measurement system and to assess performance of service organizations. According to this model,
performance measurement system of any business must have following three elements:

STANDARDS: (It is a target against which performance of employees is evaluated)

Standard refer to the KPI’s used by company to assess performance of individuals across the business.
According to this model, standards should be well defined and well communicated for a system to work.
Standards must have following characteristics:
 Ownership (Participation of employees in standard setting process)
 Achievability
 Equity
REWARDS:
Standards should be linked with rewards. Employees must be rewarded for achieving standards.
However, rewards must have following characteristics:
 Clarity
 Controllability
 Motivation
DIMENSIONS:
These represent the key areas for which indicators should be used to assess performance. They include:
 Financial performance
 Competitive performance (% AGE CHANGE IN SALES)
 Innovation
 Quality of service
 Resource utilization
 Flexibility (Coping with extra demand, respond to change in customer’s requirement)

TIP:
While assessing performance and making comments as to the reasons behind a certain change, never
use phrases like ‘it is because of this or that’. The best way to write a comment is to use phrases like
‘may be’ or ‘could be’ etc. Never conclude the performance unless otherwise stated.

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F5 – Performance Management

NOT-FOR-PROFIT ORGANISATIONS: (NFPO’s)

METHOD: 3E’s concept/Value for Money (VFM)

 Economy
 Efficiency
 Effectiveness

EDHI:

Economy: Cost of input should be minimum.

Possible KPI’s are:

 Cost per ambulance

 Cost per occupied bed

Efficiency: (Maximum output from a given input)

Possible KPI’S are:

 Number of accidents treated per ambulance

 Number of orphans per volunteer
 Number of occupied beds as compared to total beds available

Effectiveness: (objectives must be achieved)

 % age of injured patients fully recovered after accident

 Number of orphans graduate

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F5 – Performance Management

DIVISIONAL PERFORMANCE MEASUREMENT

Divisions represent an independent and autonomous internal part of any organization. When assessing
the performance of a division, organization is actually assessing the performance of departmental
manager, who controls the department.

Methods:

RETURN ON CAPITAL EMPLOYED (ROI) Residual Income (RI)

It represents annual return expected from the It represents the residue remaining after the
dept. it is expressed in %age. Higher percentage payment of all the expenses and also paying
means higher returns and vice versa. divided. It is expressed as absolute.

ROI = Operating profit/Capital employed * 100 Residual income = operating profit less imputed
interest
Capital employed = Equity + Non-current Imputed interest = Cost of capital * capital
liabilities employed
Capital employed = Total assets – Current
liabilities Advantages:
 It provides returns in absolute form.
ADVANTAGES:  It also incorporates company’s cost of
 Simple to calculate, interpret and explain capital.
 ROCE is particularly useful when
comparing departments with different Disadvantages:
investment sizes.  It is difficult to calculate, interpret and
DISADVANTAGES: explain as it is absolute form.
 ROCE does not provide return in absolute  It cannot be used to assess performance of
form. departments with different investment
 ROCE includes figures mentioned in the sizes.
financial statements and there is a  It uses figures from financial statements
possibility that figures might have been which are easy to manipulate.
manipulated.
 ROCE ignores cost of capital.

DIVISIONAL PERFORMANCE and HEAD OFFICE INTERVENTION:

It is very common for head office to interfere or intervene in divisional matters. It implies that some of
the divisional revenues, costs and assets might not be in control of the division itself.

PRINCIPLE OF CONTROLLABILITY:

According to this principle, individual managers are held accountable only for aspects under their
control. Managers are not responsible or accountable for aspects that are not in their control.

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F5 – Performance Management

Divisional performance measurement, head office intervention and principle of controllability:

Controllable ROI =Controllable operating profit / Controllable capital employed * 100

Controllable RI = Controllable operating profit – Controllable imputed interest

Capital employed = Total assets less current liabilities / Total equity + Non-current liablities

Asses the financial performance (ONLY ON FINANCIAL ASPECTS)

Asses the performance (FINANCIAL ASPECTS AND NON FINANCIAL ASPECTS)

Part a: TIES ONLY / Oliver’s saloon (a,b)

Ratio % age change

Sales 62% (Increase)
Cost of sales 69% (Increase)
Launch marketing 32% (Decrease)
Website development 25% (Decrease)
Administration cost 50% (Increase)

% age change in sales: the sales of TIES only co have shown an outstanding growth of 62% from quarter
1 to quarter 2. This is an extra ordinary achievement considering that business is new and clothing
industry is highly competitive. This could be due to the variety of ties available in different patterns,
styles and colours that attracted customers. Another possible reason could be high quality of the TIES
that resulted in customer satisfaction and increased sales.

% age change in cost of sales: the cost of sales of TIES only has increased by 69% from quarter 1 to
quarter 2. This increase in cost of sales was expected as cost of sales are largely variable and they
change with change in activity. However, alarmingly the change in cost of sales is higher than change in
sales. It could be due to increase in import taxes that resulted in higher cost of sales and it could also be
due to increase in prices by supplier.

% age change in launch marketing cost: there has been a reduction of 32% in the launch marketing cost
from quarter 1 to quarter 2, which is a positive sign as it will result in increase in profits. However, TIES

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F5 – Performance Management

only co has nothing to do with this decline. Launch marketing is supposed to be higher in the early
stages and it reduces with time. This cost will further decline in next quarters.

CRITICAL SUCCESS FACTORS: These are the factors that determine the success of any business.

 Profitability
 Liquidity
 Risk
 Quality of products and services
 Innovation
 Customer satisfaction
 Increasing market share (%age change in sales)
 Expansion or growth
 Internal efficiency

NON FINANCIAL INDICATORS:

QUALITY OF PRODUCTS AND SERVICES / Customer satisfaction:

 % age change in sales

 Number of complaints
 Number of sales return
 Change in market share
 Number of warranty claims
 Number of repeat customers
 Number of customers on referral

INNOVATION:

 Number of new products introduced in a period

 Research and development cost
 Change in market share
 Sales of new products as a percentage of total sales

Expansion and growth:

 % age change in sales

 Number of outlets opened
 Number of new branches started
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F5 – Performance Management

 Increase in capital expenditure

INTERNAL EFFECIENCY/RESOURCE UTILIZATION: Resources? (Material, Labor, Machinery, building)

 Normal loss % age

 Usage of material per unit
 Labor efficiency ratio = (Standard hours/Actual hours) * 100
 Hours per unit
 Idle time ratio
 Labor turnover
 Staff absenteeism
 Repair and maintenance cost
 Number of machine breakdowns
 Number of patients per doctor

Jamair

Part a: Profitability of a business is considered to be one of its top most objectives, which means that
businesses exists for the sole purposes of making profits for the investors/owners to provide them
return over their investment. Financial success is dependent upon non financial success, which implies
that focusing on non financial aspects will help the business to improve its profitability. However,
profitability of a business is an all-encompassing measure as it represents the primary motive or primary
goal, therefore, none of non financial success is worth it if it does not translate into financial success and
higher profitability.

Farrukh Abbas
SKANS School of Accountancy Page 10