Professional Documents
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These study materials are copyright CPA Australia. They have been provided for your personal use only to
review or proof the study material. You should not reproduce or distribute the materials without permission
from CPA Australia.
CPA PROGRAM
STRATEGIC
MANAGEMENT
ACCOUNTING
Version 16a
Published by Deakin University, Geelong, Victoria 3217 on behalf of CPA Australia Ltd,
ABN 64 008 392 452
First published January 2010, reprinted with amendments July 2010, Updated January 2011,
reprinted July 2011, Updated January 2012, reprinted July 2012, Updated January 2013, July 2013,
January 2014, Revised edition January 2015, updated January 2016.
© 2010–2016 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is owned or
licensed by CPA Australia and is protected under Australian and international law. Except for personal and
educational use in the CPA Program, this material may not be reproduced or used in any other manner
whatsoever without the express written permission of CPA Australia. All reproduction requests should be
made in writing and addressed to: Legal, CPA Australia, Level 20, 28 Freshwater Place, Southbank, VIC 3006
or legal@cpaaustralia.com.au.
Authors
David Brown University of Technology, Sydney
Brian Clarke Consultant
Courtney Clowes KnowledgEquity
Paul Collier Consultant
Teemu Malmi Aalto University, Finland; and University of Technology, Sydney
Peter Robinson Curtin University
2016 updates
Robert Cornick Monash University
Rahat Munir Macquarie University
Ofer Zwikael Australian National University
Acknowledgments
Albie Brooks University of Melbourne
Mandy Cheng University of New South Wales
Russell Clowes KnowledgEquity
Lyndal Drennan James Cook University
Karen Drutman Consultant
Advisory panel
Daniel Langelaan Australian Drug Foundation
Desley Ward CPA Australia
Eileen Foo Pacific Brands
Jacquetta Griggs Sturrock & Robson Group
Kerry Humphreys University of New South Wales
Kylie Walsh Ford
Robert Inglis RMIT University
Sarah Scoble CPA Australia
Educational designer
Jan Williams DeakinPrime
Acknowledgment
All legislative material is reproduced by permission of the Office of Parliamentary Counsel, but is not the official or authorised version. It is
subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth
legislation. In particular, s. 182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction
or publication beyond that permission by the Act, permission should be sought.
These materials have been designed and prepared for the purpose of individual study and should not be used as a substitute for
professional advice. The materials are not, and are not intended to be, professional advice. The material may be updated and amended
from time to time. Care has been taken in compiling these materials but may not reflect the most recent developments and have been
compiled to give a general overview only. CPA Australia Ltd and Deakin University and the author(s) of the material expressly exclude
themselves from any contractual, tortious or any other form of liability on whatever basis to any person, whether a participant in this
subject or not, for any loss or damage sustained or for any consequence which may be thought to arise either directly or indirectly from
reliance on statements made in these materials.
Any opinions expressed in these study materials for this subject are those of the author(s) and not necessarily those of their affiliated
organisations, CPA Australia Ltd or its members.
STRATEGIC MANAGEMENT ACCOUNTING
Contents
Subject outline 1
Subject outline
2 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Contents
Introduction 3
Before you begin 3
Important information
Subject description 3
Strategic Management Accounting: The CPA as a value driver
Subject aims
Subject overview 4
General objectives
Module descriptions
Module weightings and study time requirements
Exam structure
Learning materials 6
Module structure
My Online Learning
General exam information 9
Authors 10
SUBJECT OUTLINE | 3
OUTLINE
Introduction
The purpose of this subject outline is to:
• provide important information to assist you in your studies;
• define the aims, content and structure of the subject;
• outline the learning materials and resources provided to support learning; and
• provide information about the exam and its structure.
Subject description
Strategic Management Accounting: The CPA as a value driver
Strategic management accounting is a key component of the overall skills base of today’s
professional accountant.
This subject examines the management accountant’s role in dynamic organisations operating
in the global business environment. In this role, the professional accountant engages with the
organisation’s management team and contributes to strategy development and implementation,
with the aim of creating customer and shareholder value and a strong competitive position for
the organisation. The subject highlights the management accounting tools and techniques
of value chain analysis and project management that have become increasingly important
in contemporary operating environments.
The subject includes discussions on the professional accountant’s responsibilities and judgment
as introduced in Ethics and Governance. Also discussed are investment evaluation and strategic
business analysis in the context of assessing and responding to risk, as covered in the Financial Risk
Management and Advanced Audit and Assurance subjects. Candidates are introduced to strategic
management concepts which are expanded on in Global Strategy and Leadership.
Subject aims
The aims of this subject are:
• to develop the skills of the professional accountant in creating, managing and enhancing
sustainable value to the organisation through the use of various strategic management tools
and techniques; and
• to examine techniques for developing, implementing, measuring and monitoring the
performance of an organisation to provide feedback for improving strategies.
4 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Subject overview
General objectives
On completion of this subject, candidates should be able to:
• explain the role of strategic management accounting in supporting strategy development
and the day-to-day operations of an organisation;
• explain and apply the strategic management process and organisational and industry value
analysis to understand value drivers, cost drivers and the reconfiguring of value chains;
• explain the role of performance measurement and control systems in value creation,
strategy implementation and monitoring performance to improve strategies;
• apply strategic management accounting tools and techniques to improve the contribution
and sustainability of value-creating activities; and
• discuss the role of project selection, planning, monitoring and completion in strategy
implementation.
Module descriptions
The subject is divided into five modules and a case study. A brief outline of each module
and the case study is provided below.
OUTLINE
Module 4: Techniques for creating and managing value
This module shows how, through the use of a variety of strategic management accounting
concepts, tools and techniques, the professional accountant is able to assist with the growth of
organisational value. The module uses a case study to illustrate the implementation of strategies
to enhance value. Module 4 focuses on managing the value chain and discusses the key
components of strategic cost management and strategic profit management.
Case study
The case study consolidates your understanding of strategic management accounting through
completion of various tasks that require you to apply the concepts, tools and techniques covered in
Modules 1 to 5. The case study is not weighted for assessment purposes (i.e. it is not examinable).
However, in order to gain the most benefit from your study of Strategic Management Accounting,
it is important that you allocate time to complete the case study, including attempting the case
study tasks and reviewing the suggested answers. Completing the case study and case study tasks
will help you prepare for the written section of the Strategic Management Accounting exam.
Please note that the specific financial and operational details of the organisations discussed in the
case study will change over time and may not be current. However, the purpose of the case study is
to provide you with an opportunity to apply strategic management accounting concepts, tools and
techniques to a given set of data. That is, whether the specific ‘numbers’ are current is less important
than applying the concepts, tools and techniques to a nominated set of information.
Do not underestimate the amount of time it will take to complete the subject.
The ‘weighting’ column in the following table provides an indication of the emphasis placed
on each module in the exam, while the ‘proportion of study time’ column is a guide for you to
allocate your study time for each module and the case study.
6 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Recommended
proportion Recommended
of study time Weighting study
Module (%) (%) schedule
Case study 5 — †
Week 10
100 100
†
Please refer to the module descriptions for the Case study.
Exam structure
The Strategic Management Accounting exam is comprised of a combination of multiple-
choice and extended response questions. Multiple-choice questions include knowledge,
application and problem-solving questions that are designed to assess the understanding
of Strategic Management Accounting principles. Extended response questions can include
a combination of short-answer and case scenario based questions. All extended response
questions focus on the application of concepts and theories from the study materials to solve
a given problem. An extended response question may require candidates to apply concepts
and theories from more than one module to provide the required solution. Table 1 of this
subject outline provides details of the weighting of each module in your exam, together with
an indication of the approximate proportion of your study time which should be allocated
to each of the modules.
Learning materials
Module structure
These study materials form your central reference in the Strategic Management Accounting
subject.
Contents
Each module has a detailed contents list. This list indicates the sequence of the educational
content in the module.
Preview
Each module begins with a preview containing the following sections.
Introduction: The introduction outlines what will be covered in the module and how it relates
to other modules in the subject.
Objectives: A set of objectives is included in the study guide for each module. These objectives
provide a framework for the learning materials and identify the main focus of the module.
The objectives also describe what candidates should be able to do after completing the module.
SUBJECT OUTLINE | 7
OUTLINE
Teaching materials: This section alerts you to the required teaching material (if any) to which you
should have ready access. It also includes a list of readings which are to be used in conjunction
with the module study material.
Study material
The study material is divided into sections and subsections that will help you conceptualise the
content and study it in manageable portions. It is also important to appreciate the cumulative
nature of the subject and to follow the given sequence as closely as possible.
The purpose of the questions and case studies is to provide you with the opportunity, as you
progress through the subject, to assess your understanding of significant points and to stimulate
further thinking on particular issues. The self-assessment activities are an integral part of your
study and they should be fully utilised to support your learning of the module content throughout
the semester. You are encouraged to spend time reviewing and analysing the module content.
Utilising the self-assessment activities should form one part of your revision for the exam. It is
evident that candidates who achieve good results in the program and in their careers are those
who are able to think, review and analyse situations, and solve problems.
Where applicable, sample answers are included at the end of each module. These provide
immediate feedback on your performance in comprehending the material covered. Your answers
to these questions do not contribute to your final result, and you are not required to submit
your answers for marking.
Revision questions. These require you to prepare answers and to compare those answers with
the suggested answers before continuing with the study material. These questions test your
comprehension of specific sections of a module.
Reflective questions. These require you to reflect on an issue. They are not numbered,
and are set in bold italics. No suggested answers are provided for these questions.
Case studies. These are much broader in scope than revision and reflective questions.
They illustrate practical problems that accountants might face. The case studies require you
to apply the theoretical knowledge you studied in the module to a particular situation. To be
able to adequately address issues raised in case studies, a deep understanding of the module
content is required. Simply memorising definitions and lists of technical details is insufficient.
While issues may be relatively clear in some case studies, it is important to realise that often
the case studies will have no correct/incorrect outcomes. The outcomes are quite possibly best
expressed as different viewpoints on problem situations, where viewpoints are supported by
reference to relevant theoretical principles. Moreover, the essence of the case may depend
on interpretation of the relevant concept rather than a simple restatement of that principle
or concept. For this reason, no ‘solutions’ to case studies are provided. Instead, responses to
cases are included in comprehensive case notes. To obtain maximum benefit from your case
study work, and to provide the best preparation for the case scenario section of the exam, it is
important to allow adequate time for in-depth analysis of case studies and to thoroughly work
through case materials and prepare a written response to case issues before you check your
responses against the notes/answers provided.
8 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Review
The review section places the module in context of other modules studied and summarises the
main points of the module.
References
The reference list details all sources cited in the study guide. You are not expected to follow up
this source material.
Optional reading
The resources in the ‘Optional reading’ list are useful if you wish to explore a particular topic in
more detail.
Required readings
Readings are provided to assist in the clarification and application of concepts from the study
materials. The content of readings is not directly examinable. However, the concepts covered by
the readings are examinable.
Suggested answers
These provide important feedback on the numbered revision questions and case studies
included in the module learning materials. Consider them as a model for your reference.
To assess how well you have understood and applied the material supplied in the text, it is
important to write your answer before you compare it with the suggested answer.
Internet references
At various points in the subject materials you may be directed to references located on the
internet and many of these are on external websites. All the URL addresses cited are tested
prior to the start of the semester to ensure their currency; however, this does not guarantee that
changes have not been made to the websites since the tests were performed. CPA Australia
provides links to external websites as a service to candidates in the CPA Program. CPA Australia
does not own, operate, sponsor or endorse these external websites and makes no warranties or
representations regarding the source, quality, accuracy, merchantability or fitness for purpose of
the content of these external websites; nor warrants that the content of these external websites is
free from any computer virus or other defect or error.
SUBJECT OUTLINE | 9
OUTLINE
My Online Learning
CPA Australia offers additional study material through My Online Learning to assist candidates
in their study. Your study guide forms your central reference for examinable material. You must
also check My Online Learning for any study guide updates that will be posted there, as these
are considered part of the study guide.
There are many learning resources available to you in My Online Learning, such as self-
assessment questions and online activities. We recommend that you take the time to look
through these resources and become familiar with them.
You can access My Online Learning from the CPA Australia website:
cpaaustralia.com.au/myonlinelearning
CPA Program exams are open book. This means that candidates may bring any reference
material into the exam that they believe to be relevant and that may assist them in undertaking
the exam. This may include, for example, the study guide, additional materials from My Online
Learning, readings and prepared notes.
It is highly recommended that all candidates have access to a calculator in the exam. Candidates
will have access to an on-screen calculator within the computer-based exam environment.
We recommend candidates sitting paper-based exams bring their own calculator. Please ensure
that the calculator is compliant with CPA Australia’s guidelines. The calculator must be a silent
electronic calculating device whose primary purpose is as a calculator. Calculators with text-
storing abilities are not permitted in the exam.
The exam is based on the whole subject, including the general objectives, module objectives and
all related content and required readings. Where advised, relevant sections of the CPA Australia
Members’ Handbook and legislation are also examinable.
As this exam forms part of a professional qualification, the required level of performance is high.
Candidates are required to achieve a passing scaled score of 540 in all CPA Program exams.
Further information about scaled scores and exam results is available at: cpaaustralia.com.au/
cpaprogram.
10 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Authors
David Brown
David is a Professor of Management Accounting in the School
of Accounting at the University of Technology Sydney. His PhD
research examined how management-control packages operate
as loosely coupled systems. Prior to pursuing an academic
career, he had extensive industry experience. David has been
involved in winning a number of industry research grants and
has numerous publications and conference papers, including the
Peter Brownell Manuscript award for the best paper in Accounting
and Finance in 2004. He has undertaken a range of projects
with CPA Australia, including projects on the use of activity-
based costing, the balanced scorecard and predictive business
analysis in Australia. He also has a strong interest in accounting
education research.
Brian Clarke
Brian began his career as a CA and auditor with Deloitte,
Haskins and Sells in Vancouver. After moving to Australia he
worked in higher education and as a consultant. At Monash
University he obtained his MBA and taught management
accounting. He was awarded the Monash prize for team-based
educational development for his work on the Multi-disciplinary
Industrial Project. At Deakin University he obtained his PhD and
taught auditing. Brian has published auditing, management
accounting and education research, and has presented his
research at numerous conferences. Brian currently works as
an education consultant to the accounting profession.
OUTLINE
Paul Collier CPA, PhD Warwick, BBus UTS, MComm NSW,
GradDipEd UTS
Paul is an active business investor and consultant whose interests
are in management control systems, including accounting-
based controls and non-financial performance measurement,
governance and risk management.
His early career in industry saw him move from financial into general
management roles. He subsequently moved into academia,
where he has worked as Director of Executive Education with
Aston Business School in the UK, and as Associate Dean (Research
Training) and head of discipline for management accounting and
accounting information systems at Monash University in Melbourne.
Paul has retired from full-time academic work but remains an active
consultant and investor.
Teemu Malmi
Teemu is a visiting Professor at the University of Technology
Sydney and a Professor at Aalto University, Finland. Teemu’s
teaching and research focus is mainly on managerial control
systems, strategy implementation and cost and profitability
accounting. He regularly teaches in a number of executive
education programs and has served as a consultant to a wide
range of private and public organisations. He has served as a
chairman of the board for a listed company and currently holds
board memberships in two information technology companies.
He holds a PhD from the Helsinki School of Economics.
12 | STRATEGIC MANAGEMENT ACCOUNTING
OUTLINE
Peter Robinson
Peter is a sessional lecturer in accounting at the University of
Western Australia. He was a full-time academic in accounting
at Curtin University until 1990 and again from 2011 to 2013,
and at the University of Western Australia from 1990 to 2011.
Peter first began his academic career in 1971 and he has taught
the breadth of financial and management accounting curriculum
at both the undergraduate and postgraduate levels. Peter has an
active research and teaching interest in strategic management
accounting. He also presents professional development courses
for CPA Australia on the development and application of
comprehensive performance measurement frameworks (in the
for-profit, not-for-profit and public sectors) and on strategic
management accounting issues. Peter has also developed and
delivered many professional development courses to private,
public and not-for-profit organisations. Courses have been
delivered to the National Australia Bank, Telstra, Peters and
Brownes, Georgiou Group, the Departments of Agriculture
and Food, Child Protection, Commerce, Corrective Services,
Indigenous Affairs, Planning and Infrastructure, Mining and
Resources, Regional Development and Lands, Water and Landgate
(WA), Public Sector Commission (WA), the Royal Automobile Club
of Western Australia, Senses Foundation, St John of God Health
and the Institute of Public Administration Australia. He has also
delivered courses and workshops to professional groups such
as the Local Government Managers Association.
STRATEGIC MANAGEMENT ACCOUNTING
Module 1
INTRODUCTION TO
STRATEGIC MANAGEMENT ACCOUNTING
COURTNEY CLOWES*
Contents
Preview 15
Introduction
Objectives
Subject map
Value 17
Shareholder value
MODULE 1
Customer value
Stakeholder value
Which viewpoint should be taken when determining ‘value’?
Review 66
Appendix 69
Appendix 1.1 69
Appendix 1.1 Suggested answers 94
References 109
Study guide | 15
Module 1:
Introduction to
strategic management
MODULE 1
accounting
Study guide
Preview
Introduction
Contemporary organisations face significant challenges. It is essential for them to create
value for a variety of stakeholders, including customers, employees, management and their
shareholders or owners. This must be achieved in a global environment that is constantly
changing and becoming more competitive. In this subject, we focus on the role that strategic
management accounting plays in creating, managing and protecting value.
In this module we consider accounting and its role in supporting management. We then describe
the key changes that have led to the development of strategic management accounting. We also
identify the challenges that management accountants face and describe the skills required
to perform their role. This module concludes with an examination of the role of management
accounting systems. At the end of the module, there is an appendix that covers traditional
accounting support tools for operational management, including budgeting.
The ability to support managers at a strategic level has become essential, and management
accountants must broaden their role from traditional scorekeeping tasks to business advisory
positions. Technology and information systems now capture and process the routine events
within an organisation. This allows management accountants to spend more time understanding
the organisation’s external environment and work on non-routine, complex decisions. In this
module, we introduce concepts and skills that help management accountants create, manage
and protect value in the contemporary business environment.
In this module we will introduce and use a hypothetical case study—HZ Electrical Pty Ltd—
to illustrate strategic management accounting concepts, tools and techniques. We will revisit
this case in Modules 2 and 4.
Objectives
After completing this module, you should be able to:
• explain the role of strategic management accounting;
• analyse the key challenges facing the management accountant;
• apply accounting techniques that support operational management; and
• discuss the role and structure of the management accounting system and explain how
strategy underpins its design.
Subject map
Figure 1.1 provides an overview of the important concepts in this subject and how they link
together. An organisation pursues a particular direction, where it believes value can be created.
This value may be shareholder value, customer value or broader stakeholder value—depending
on the type of organisation involved. The concept of value is explored in Module 1 and in further
detail in Module 2.
Study guide | 17
E E
n n
v v
i i
r r
o Value o
n n
m m
MODULE 1
e Vision/Mission e
n n
t Goals and objectives t
a a
l Strategy—Creation l
RESOURCES SYSTEMS
a a
n Strategy—Implementation n
a PROJECTS a
l l
y Strategy—Implementation y
s VALUE CHAIN s
i i
s Control and feedback systems s
Underlying value creation is the need to put in place a clear strategy, based on a vision and
mission that combine resources effectively (including people, technology and time) to achieve
goals and objectives.
The foundation of any business involves the implementation of broader strategic ideas and
concepts. As such, the day-to-day activities and projects that are performed provide a solid base
that allows the organisation to drive towards its desired outcomes. It is important to perform the
work required, but it is also necessary to review, monitor and improve activities and processes.
The need for clear feedback and reporting is highlighted to enable the organisation to stay in
line with its vision and mission.
At all times, the organisation must be aware of the external environment in which it operates.
Competitor activity, the broader economic and regulatory environment, and social changes may
all impact on the organisation, and so monitoring and adapting to change are critical activities.
Value
The main theme of this subject is value. The analysis and activities, the tools and techniques,
the reporting and evaluation—all of these take place in the pursuit of value.
The role of management is to create, manage and protect value. Value is usually described
as increasing shareholder wealth. However, this is both narrow and simplistic. A focus purely
on shareholders is often too limited, as it ignores other important and interested parties or
stakeholders. These include:
• lenders;
• customers;
• suppliers;
• employees; and
MODULE 1
• community groups.
Each group has its own interests and desires and therefore its own definition of the ‘value’ that
it wishes to receive from an organisation. Failure to consider stakeholder needs and desires will
make it difficult to maintain and increase shareholder wealth.
Value creation is just as relevant in the not-for-profit and public sectors. For example, national
infrastructure, education, health and social welfare need to be managed just as effectively
as privately run organisations. In the not-for-profit and public sectors, value is created for the
members, citizens or residents (or taxpayers) of the nation instead of wealth being increased
for shareholders.
Shareholder value
The ultimate outcome for many organisations is to generate wealth for the owners. The owners
have either started or invested in the organisation to obtain appropriate returns for the risk
involved. As such, many measures of value focus on shareholder value. However, pursuit of
shareholder value while ignoring other areas of value creation is not sustainable. To ensure that
an organisation is able to create shareholder value over a prolonged period, its actions and use
of resources need to be sustainable. For example, if the impact on the natural environment is not
acknowledged or minimised, long-term sustainable shareholder value is unlikely to be achieved.
Customer value
The primary task for an organisation is to create an output that has customer value. A key
requirement is to produce this output at a cost that is lower than the price the customer is willing
to pay, which leads to profitability and creates shareholder value.
Figure 1.2 shows a simple version of the organisational value chain. This provides an overview of
how the organisation performs a sequence of activities to provide outputs or outcomes to create
customer value. A more detailed version of the value chain is outlined in Module 2.
Business cycle
Operations (obtaining/producing goods or services) Sales Distribution After-sales service
Support activities
Research and development, accounting, human resources, information technology and infrastructure
Stakeholder value
Shareholder wealth is a by-product of generating value in other areas. To create products
or services, an organisation will require community permission to operate, infrastructure,
customers and employees—who will only supply their effort if the wages and conditions
are adequate. That is, the organisation must provide suitable value to its stakeholders.
So, consideration of stakeholders is critical to organisational success.
The primary focus of this subject is on generating customer value by improving activities in the
MODULE 1
organisational value chain. This, in turn, is expected to generate shareholder value for private
sector organisations as a result of increased profitability and growth.
Massive price discounting of key items by A small price reduction for individual consumers
supermarkets to gain market share, forcing suppliers but at the expense of producers who are unable to
to reduce prices remain viable
Selling addictive products or services including Social issues in communities and an increase in
gambling, alcohol and cigarettes health-related costs
The development of corporate social responsibility (CSR) indicates that people are interested
in more than just the pure economic value that organisations create. They are also interested in
‘how’ that economic value is created, and they assess the impact of those actions (or inactions).
CSR reporting has increased to help people understand the sustainable value or impact of an
organisation’s activities from a social and environmental perspective. Such reporting aims to
increase the level of ethics and accountability demonstrated by organisations when making
value-based decisions.
Therefore, to be truly valuable, something must offer economic value to the organisation and
provide sustainable value to other stakeholders within society. This collaborative approach is
discussed further in Module 2. Module 2 also provides useful tools for analysing value to ensure
it is occurring.
20 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
The following case study provides an opportunity to consider the idea of value for different
stakeholders.
founded 40 years ago. It distributes consumer products to the South Pacific market under licence from
European and North American electrical appliance manufacturing organisations. It also manufactures
its own range of electrical appliances through a joint venture with a manufacturer in southern China.
HZ had experienced a significant level of annual growth, but as a result of increased competition,
the growth rate of both sales and profits has slowed.
The board of directors comprises the founder of the company, Bronwyn Jones, three members of
her immediate family, and the chief executive officer (CEO), Cynthia Grey. Ninety-five per cent of
the shares in HZ are owned by members of the Jones family. Bronwyn Jones is rarely seen by the
organisation’s senior management team, as she is involved with various charitable organisations and
prefers to leave her two eldest sons in charge. Unfortunately, the two sons frequently clash, and as
Bronwyn is unwilling to take the side of one son over the other, the organisation’s management team
feels that it has to serve two masters.
Bronwyn Jones’ eldest son, Stephen, championed the development of HZ’s own product range.
He established connections with the Chinese joint venture partner and regularly travels to China for
meetings. Although the venture has been reasonably successful in terms of revenue, the profit margins
on these sales have been lower than those from the sale of licensed products because the products
do not have a well-known brand name. Nevertheless, Stephen is recommending to the board that
they make a greater investment in new product development and manufacturing.
➤➤Task
Using the table below, provide examples of what would be considered as value for each of
the following stakeholder groups of HZ.
Owners
Lenders
Customers
Suppliers
Employees
Community groups
A suggested answer to the Case Study 1.1 task is provided at the end of the ‘Suggested answers’
for Module 1.
Study guide | 21
MODULE 1
There is a clear outcome here—the creation of sustainable value. While some areas of accounting,
such as financial reporting and auditing, may have a regulatory compliance focus to inform
and protect external stakeholders, strategic management accounting is aimed specifically at
improving organisational outcomes.
Strategic management accounting provides a wide range of tools and techniques that support
each stage of the strategic management process. So, strategic management accounting
becomes an enabler, or a catalyst, that helps initiate and drive strategic management activity.
Strategic management accounting helps organisations in their desire to create long-term,
sustainable value that is of benefit to all stakeholders.
22 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
of accounting. Then consider how the role of strategic management accounting developed
over time and what factors currently influence it.
There is a wide range of titles used to describe the accountants who perform strategic
management accounting. These include:
• management accountant;
• business analyst;
• senior analyst;
• commercial manager;
• planning specialist; and
• profit analyst.
For the remainder of this subject the title ‘management accountant’ will be used.
With strategic management accounting, the focus is on providing useful information that supports
both the day-to-day and strategic decisions of management. Examples of these decisions are
shown in the table below.
Resource allocation Allocating time, employees, physical capital and cash to various activities within
an organisation
MODULE 1
External user groups Decisions supported by accounting information
Lenders Should I lend money? Will the principal be repaid with interest?
Suppliers Will credit purchases be repaid? What is the likelihood of future orders?
Government and Should the organisation’s actions and performance be monitored to see if extra
interest groups accountability or intervention is required?
Figure 1.3 shows the main differences between financial reporting and strategic management
accounting. It is important to be aware that strategic management accounting does not
have the direct guidance that exists for financial reporting. External reporting is guided by a
conceptual framework and governed by specific standards and rules, whereas the structure
of and information contained in internal reports are decided by management to suit its needs.
This subject focuses on internal reporting and decision-making.
These definitions suggest that the key focus of management accounting is on planning and
controlling. Over time, the role of management accounting has developed and broadened.
More contemporary definitions expand the role to consider strategic activities, competitor
activities and the broader economic environment. The focus now goes beyond planning and
controlling towards value creation and sustainable interactions with stakeholders.
Stage 5:
Stage 4: Strategic and
Stage 3: Value
Stage 2: Increasing externally focused
Stage 1: creation
Management efficiency
Technical activity
activity
Stage 1: Prior to 1950 Management accounting was considered to be a technical activity. The two
major areas of focus were determining costs and providing financial
control. This was achieved through techniques including cost accounting
and budgeting.
Stage 3: 1965–1985 In addition to the previous information provision role, attention was focused
on increasing the efficiency of business processes in an attempt to reduce and
eliminate wasted resources. This expansion was aided by the reduced cost of
technology and the availability of real-time information.
Study guide | 25
Stage 4: 1985–2000s The scope of management accounting expanded even further to include
improving the effective use of resources to create value. Essential to achieving
this was an understanding of the cause and drivers of customer value and
shareholder value, as well as the effective use of technology. Management
accounting moved from just providing information to becoming actively
involved in improving strategic and operational decision-making and resource
allocation (IFAC 1998).
Stage 5: 2000s to now Management accounting has become more strategic with an increasingly
MODULE 1
external outlook and has focused on a broader range of stakeholders.
Social, environmental and ethical issues continue to grow as do competitive
pressures due to increasing levels of globalisation. The emphasis is now on
creating value in a responsible and sustainable manner.
It is evident that management accountants have expanded their role from recording and
reporting information to providing analysis and recommendations. They have moved into
the position of being strategic business advisers.
The main activities now performed by management accountants are summarised as follows:
• providing useful information combined with analysis and interpretation to support
management in the tasks of setting strategy and making operational decisions;
• developing and implementing performance measurement systems;
• costing products and services;
• designing processes and systems that reduce errors, wastage and control costs;
• improving the effective use of resources by understanding the drivers of value for the major
stakeholders of an organisation; and
• providing risk management, internal control and assurance-type services (IFACb 2005).
➤➤Question 1.1
Why is strategic management accounting relevant in the public sector and not-for-profit sector
if these organisations are not manufacturing products or pursuing a profit?
A large number of external factors have led to changes in the contemporary business environment
and, therefore, to management accounting.
External factors include significant upheavals in the global economy, the effects of globalisation
and increased competition, as well as rapidly developing technology. An increasing focus on
corporate governance and a broader stakeholder perspective of corporate accountability
have also had an impact. Sustainability and the need to capture and report a wider range of
information have had an influence. Management accounting has also been affected by internal
factors—for example, structures within organisations have become less hierarchical and more
decentralised in their decision-making.
26 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Global
Technology
economy
MODULE 1
Economic
turmoil
Structural Capital
change Information equipment
communication
Globalisation technology
Changing
business
Environmental MA environment
Flatter
Outsourcing/
hierarchies
Stakeholders offshoring
Ethics Joint
Virtual ventures
offices
Management
reporting
Internal
Sustainability
structures
Years after the start of the Global Financial Crisis (GFC) in 2008, the damaging effects are still
visible at the national level in many countries (e.g. Greece) as well as on individual industries and
organisations. It appears that many underlying issues have been deferred but not resolved.
Difficult times in most economies have led to lower demand and lower prices for many goods
and services. This has increased the focus of management on key areas such as cash flows,
access to funding and ensuring that supply chains are able to continue delivering products or
services. Risk management, forecasting and rapid adaptation to new circumstances are now
critical to successful management of organisations. Cost control and efficiency are also critical
as organisations deal with an extended period of stagnant or declining growth.
Structural change
Many economies are experiencing significant change in terms of:
• average growth rates;
• government philosophy on spending;
• government, company and individual debt levels;
• consumer spending habits; and
• new regulations.
Study guide | 27
Table 1.4 reveals actual and forecast gross domestic product (GDP) growth rates. Before the GFC,
economic growth rates around the world were strong (in 2005) but there was a considerable slump
by 2009. Despite some improvement since then, the high growth levels have not yet returned.
MODULE 1
2005a 2009a 2013a 2015f
There has been a focus on government austerity, which involves significant reductions in
spending so that government debt may be reduced. This has been combined with individuals
and organisations trying hard to reduce their spending and debt to more manageable levels,
as they are uncertain about the future. Although these are worthy economic approaches,
the flow-on effect for many companies is reduced demand and limited expected growth in
the future. To be more competitive, companies have to reduce prices, cut costs and keep
employee numbers down. As such, many economies are still experiencing slow or negative
growth, and so there is little hope for significant improvement in the next few years for
these economies.
To minimise this risk, banks must hold an appropriate level of capital in reserve (capital adequacy),
but this of course will reduce the amount of lending they do, resulting in lower revenues and profits.
An additional problem for banks is the types of lending they undertake. Mortgage-based lending,
where residential property is provided as security, is much safer than higher-risk lending secured by
commercial property or where there is no security at all.
Lending with higher risks should be done at higher interest rates to reflect that risk. However, high‑risk
taking banks and lenders may do the opposite in an attempt to capture market share. They may offer
customers low interest rate loans without the need to provide security and also lend a higher amount
(e.g. 100% of the purchase price of a house instead of a safer level such as 80%). If too many of these
higher risk loans go bad (i.e. borrowers default on their repayment obligations), the bank may be
severely affected or even collapse. Holding additional capital to adjust for higher-risk loans is a suitable
solution, but it comes at a cost. Different banks will approach this issue differently.
28 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
The Basel Accords (Basel I in 1988, Basel II in 2004, Basel III in 2010) are an attempt by central bankers
to address these problems. The Basel Accords aim to create a robust and stable international banking
system to minimise banking problems and to avoid an international collapse of the financial system
(which nearly occurred during the GFC).
and each of these has relevant numerical or ratio measures to demonstrate that it has been achieved.
Capital Increasing the level of capital held (as a percentage of risk-weighted assets)
Counter-cyclical buffers are put in place when credit grows too quickly.
This means that rather than encouraging the growth cycle with extra credit
and lending (pro-cyclical), changes are made to slow credit growth (to counter
or reduce the growth cycle).
Leverage Ensuring leverage (use of debt) does not reach dangerous levels
Effect on business
The most likely impact on business will be a reduction in credit availability, especially for higher-risk
activities, such as trade credit financing. The cost of borrowing will also increase, although this is
expected to be quite small in most circumstances. The extra cost is estimated to be 5 to 10 basis points
(i.e. 0.05% to 0.10%), which equates to between $50 and $100 per annum on every $100 000 borrowed.
In summary, there will be a dampening effect, where excessive credit growth is tempered, and borrowing
costs are slightly higher. This will lead to (slightly) slower growth and (slightly) lower profits in the short
term. The positive trade-off from a broader economic perspective is a decreased chance of a bank
collapse and a more stable economic environment in which to operate. This should lead to higher
long-term growth and profits.
The Basel III Accord is also discussed in the ‘Financial Risk Management’ and ‘Contemporary Business
Issues’ subjects of the CPA Program.
In addition to the cyclical events of the global economy that follow a boom-bust cycle, there are
structural changes in the size and types of industries. This is often caused by new technology,
and these changes also have an impact on organisations. Electronic commerce is accelerating
these changes, and specific examples of structural change include the rapid growth of the services
sector and the decline of manufacturing in many developed countries as shown in Table 1.5.
Study guide | 29
MODULE 1
Mining 14.6% 1.8% 7.3%
†
The figures in the table are not meant to total 100 per cent.
Figure 1.6: T
he decline of agriculture and manufacturing and the rise in services
in Australia
60.00%
50.00%
40.00% Agriculture
Share of GDP
Manufacturing
30.00%
Property and
20.00% business services
10.00%
0.00%
1860 1960 2011
The data in the table above must be interpreted with care. Although Australian agricultural
activity as a percentage of GDP has declined from 23 per cent to 2.2 per cent, this does not
mean that there has been a physical or monetary decline in terms of activity, produce or output.
Rather, this data indicates that the rest of the Australian economy has grown even more rapidly.
30 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Despite the decline of Australian manufacturing starting over 50 years ago, this structural change
has caused significant difficulty for many organisations. For example, at the time of writing,
car makers that have stopped producing vehicles in Australia include Mitsubishi, Nissan and
Renault. By 2010 there were only three car makers remaining in Australia (Ford, Holden and
Toyota). Ford has indicated it will stop manufacturing cars in Australia in 2016, and Holden and
Toyota have also stated they will withdraw from making cars in Australia in 2017. The economic
impact for the hundreds of suppliers and thousands of employees as well as the general
community has been significant, and this will continue as this industry slowly disappears.
MODULE 1
These changes are not limited to Australia. Even many Chinese manufacturing organisations
are struggling to stay profitable because of rising labour costs and an inability to pass higher
costs on to consumers.
Globalisation
Globalisation can be described as the integration of international economic activity and the
creation of global production systems to service global markets. Significant reductions in trade
barriers, lower transport costs, increasing competition across national borders, large multinational
corporations, unrestricted capital flows and faster information transfers have all had a significant
effect on organisations.
Globalisation creates difficult issues that must also be addressed. These include:
• taxation;
• protection of intellectual property;
• cross-border money laundering; and
• financing of illegal activities.
Such issues often arise because of different cultures, rules and levels of enforcement in
different countries and regions.
Global competition
Organisations have a variety of reasons for expanding globally. The local market for their
products may be saturated or in decline; they may be pursuing rapid growth; or alternatively they
may be focusing on obtaining lower-cost raw materials and labour. It may even be a defensive
strategy because low-cost competitors have entered their domestic market. It may also be a
strategy to avoid trade barriers such as quotas, which limit the level of goods one country is
allowed to export to or import from another. The internet has also enabled smaller organisations
to immediately compete globally, rather than spending years developing a local market before
expanding into new countries.
Study guide | 31
MODULE 1
they realised they had to become globally competitive if they were to survive.
The current wave of globalisation has seen these global leaders fall behind, as powerful new
organisations set the benchmark. For example, combined losses for Sony, NEC and Panasonic have
been in the tens of billions of dollars over the last few years, and newer competitors are taking over.
Technology changes, such as the use of wireless communications for phone calls and internet
use throughout Africa and India, have meant that many areas previously cut off from the global
economy are now able to participate without the need for significant infrastructure expenditure.
International political forces have responded with a progressive series of negotiations intended
to reduce tariffs and create greater liberalisation of trade. The World Trade Organization
(WTO) has proved central to this effort. In addition, regional economic and trade organisations,
such as the European Union (EU), the North American Free Trade Agreement (NAFTA) and the
Asia‑Pacific Economic Cooperation (APEC), have become increasingly prominent in recent years.
Many countries are also harmonising their commercial law and accounting practices, increasing
uniformity and making international business more accessible and less risky.
MODULE 1
As globalisation increases, the ability to obtain relevant information and evaluate decisions
across a wider level of issues becomes important. For example, issues such as transfer pricing,
insurance, political risk, intellectual property risk and foreign currency management all arise in
the global context and add complexity to management accounting roles.
➤➤Question 1.2
Identify three competitor-related issues that an organisation faces as a result of changing foreign
currency levels.
➤➤Question 1.3
Consider your organisation or one that you are familiar with and list how this organisation has
been affected by globalisation.
Technology
Two areas in which technology is having a significant effect are capital equipment and information
and communication technology (ICT). Capital equipment transforms organisations and industries
by allowing faster and cheaper production and by accelerating product life cycles. ICT is changing
how information is collected and analysed as well as interaction with clients and suppliers.
Capital equipment
Rapid development has meant that current technologies are significantly advanced compared to
technologies of earlier generations, and future technologies will only accelerate this advancement.
Physical systems and processes allow organisations to convert raw materials into outputs faster,
with more efficiency and less waste.
Source: De Angelis, S. F. 2011, ‘3D printing and the supply chain’, Enterra Insights, 25 March, accessed
July 2015, http://enterpriseresilienceblog.typepad.com/enterprise_resilience_man/2011/03/3d-printing-
and-the-supply-chain.html. © WithinLab.com.
Study guide | 33
Additive manufacturing can create significant savings because specific moulds and tools are not
needed to produce a product; there is no ‘excess’ to be cut off and machined; and small batch
sizes can be generated, with no need to produce substantial inventory during each production run.
However, the cost associated with these technologies, and the cash requirements to purchase
and support them, are also increasing rapidly. Many industries now have significant barriers to
entry due to capital infrastructure costs. A further impact on costs that needs to be managed
effectively occurs because a large proportion of funding is often committed when the product
MODULE 1
and production process are designed.
Products are developed faster but superseded quickly, as current forms become obsolete at
a rapid rate. Therefore, investments need to be recovered or recouped in a shorter period.
The solar power industry highlights some difficulties in pursuing successful and profitable
strategies. Significant capital investment is required to build solar power facilities, which often
require several years to generate a suitable return. However, during that time, technology
will improve so rapidly that new competitors can enter the market with lower cost structures,
meaning that the initial capital investment may never be realised.
There are constant developments in the ICT area. Many of these affect the management
accounting role in terms of cost control, risk management, data capture and analysis,
and communications within the organisation and with stakeholders.
Some important trends that have arisen and need to be managed carefully are described below.
Cloud computing
Faster internet access has enabled the development of internet-based storage, software
applications and programs, including whole information technology platforms (including
operating systems), provided from the ‘cloud’. Key services include SaaS (software as a service),
IaaS (infrastructure as a service) and PaaS (platform as a service).
This creates many benefits including reduced costs in purchasing capital items such as storage,
reduced need for in-house technical knowledge and the ability to deploy employees globally
with instant access to organisational information. Risks of this approach include exposure to
data loss, theft, privacy issues and jurisdictional issues. These risks increase and are of particular
concern when the data or information is stored or hosted in a different country than where it is
being used. Privacy and jurisdictional issues overlap here because the privacy or other laws in
the hosting country may differ from those in the user country.
Big data
The amount of data that is now being collected and stored is growing exponentially. The data
is often in unstructured or difficult-to-analyse formats, but the ability to analyse this information
provides significant insights into customer behaviour and business activity. Developing the ability
to analyse and interpret this data is an important requirement for improving performance. This is
discussed further in Module 3 in relation to performance measurement.
MODULE 1
➤➤Question 1.4
Discuss the impact that technological developments have had on management accounting.
Sustainability
Long-term sustainability is a significant area of discussion and business activity that has been
gradually gaining momentum over the past 20 years. A short-term approach to decision-making
can often have undesirable long-term consequences. For example, the news media is often
filled with discussion about dwindling natural resources (e.g. oil), toxic outputs from commercial
processes, food security and access to water. Considering sustainability when conducting
strategic analysis and making decisions places the focus on taking action that is not only
beneficial now, but beneficial or at least not harmful in the future.
Despite a trust being set up to manage funds earned during the mining period, mismanagement meant
that once the phosphate reserves were exhausted there was little left to provide for the population.
The island now has significant environmental damage, unemployment is estimated to be 90 per cent
and there are many health issues (e.g. nearly three-quarters of Nauruans are obese with 10 per cent
having type 2 diabetes due to dietary changes that came with increasing wealth). These economic,
environmental and social issues that have arisen are all closely intertwined and demonstrate that a lack
of sustainable action can have devastating consequences (Asian Development Bank 2007; LoFaso 2014).
From an economic sustainability perspective, a useful example is the banking crisis that arose
during the 2000s as a result of unsustainable lending practices. Easy access to credit resulted in
loans to many people and businesses that were not in a position to service or repay their loans
over the long term. The consequence of so many people and countries living beyond their
means was a contributing factor to the GFC.
Examples of unsustainable social activities include sweatshops in the textiles industry, which use
extremely poorly paid labour in dangerous working conditions to produce low-cost clothes and
shoes. Similar examples exist in the electronics assembly industry, where employee deaths have
led to greater awareness and monitoring of working conditions. At a broader level, demographic
changes, such as increased population growth and migration from rural to urban areas, are also
having a significant impact on sustainable living.
Study guide | 35
Industries that have seen, or may see, significant decline due to unsustainable environmental
practices include fisheries, where fish stocks have been overfished and are not reproducing at an
adequate rate, and agricultural production, where soil nutrients have been completely eroded.
Organisations within those industries therefore need to adapt or change to assure their longer-
term, sustainable future. The most obvious example of this adaptation is in the energy industry,
where clean energy and sustainable technologies, such as wind and solar power, are replacing
fossil fuels and non-renewable resources, such as coal and oil.
MODULE 1
Corporate social responsibility—a stakeholder focus
The focus on sustainability is causing several changes in the business environment, which in turn
affects strategic management accounting. First, there is a broader consideration of qualitative
and non-financial factors when making decisions about long-term projects. Second, there is a
much stronger focus on reporting a broader range of information and being held accountable for
more than just economic results.
Organisations are no longer just accountable to their owners. There is a growing body of opinion
that argues for greater accountability of organisations to a broader body of stakeholders.
This growing focus on a wider range of stakeholders has also led to significant change within
organisations, especially with regard to how they report and what information is reported.
Important non-financial information is now presented, and in many cases, environmental data is
legally required to be measured and reported. Accountability for financial performance has been
expanded to consider both the social impact and environmental impact based on ever-increasing
amounts of regulation.
This broadening focus on stakeholders is not just limited to business. Governments, the public
sector and not-for-profit organisations are being held to greater levels of accountability as the
community becomes more informed and demands more information. For instance, government
departments and agencies are subjected to performance auditing with a strong focus on outputs
and outcomes, rather than just an account of the income received and expenses incurred.
The concept of EMA has been in existence for many years, and has been defined as:
The management of environmental and economic performance through the development and
implementation of appropriate environment-related accounting systems and practices. While this
may include reporting and auditing in some companies, environmental management accounting
typically involves life cycle costing, full cost accounting, benefits assessment, and strategic planning
for environmental management (IFAC 2005a, p. 19).
The Expert Working Group of the United Nations Division for Sustainable Development (UNDSD)
MODULE 1
emphasised both the physical and monetary aspects of environmental management accounting
in its definition of EMA:
… the identification, collection, estimation, analysis and use of physical flow information
(i.e., materials, water, and energy flows), environmental cost information, and other monetary
information for both conventional and environmental decision-making within an organization
(UNDSD 2002, p.11).
EMASs have developed over the past decade. Standard accounting information systems typically
capture financial transactions. EMASs do more much more than this by also recording the
physical flows of resources, including volumes and weights of inputs, outputs, waste, recycling
and emissions. Having access to this information often leads to increased incentives to change
and improve as people become more aware of the unnecessary cost and waste associated
with poorly managed resources. As more organisations adopt external sustainability reporting
approaches such as the Global Reporting Initiative (GRI) guidelines, this functionality will become
expected and normal.
Ethics
Ethics and its relationship with strategic management accounting should be considered in several
ways. First, it is important to incorporate ethical implications in organisational decision-making.
As management accountants provide significant input into these decisions, it is important to
be aware of such non-financial issues and ensure they are properly considered in the decision-
making process. Sometimes choosing the most profitable or cost-effective approach may have
significant ethical implications. For example, consider the decision to terminate the employment
of a workforce in one country and replace it with a new workforce in another, cheaper location.
The cheaper location may have limited safeguards for employees for occupational health and
safety (OHS) and minimum wages that reflect local standards.
The management accountant should ensure that these ethical issues are included in the
organisation’s decision-making process.
Example 1.5: O
utsourcing in the textiles and garment-
making industry
In Bangladesh there have been many terrible incidents including fires and building collapses because
of poor safety standards. In 2013 a building called the Rana Plaza in the capital city of Dhaka collapsed,
and over 1100 workers died. Over 2500 workers were rescued from the building alive, but some suffered
dreadful injuries and now have permanent disabilities. As a result, there have been changes in how
the industry operates, although there is still a lot of improvement required.
CPA Australia members are expected to act ethically at an individual level when performing their
roles. Members are expected to comply with the Code of Ethics for Professional Accountants,
published by the Accounting Professional and Ethical Standards Board (APESB), which has
an overarching requirement to act in the public interest. The fundamental principles that a
member is required to abide by are integrity, objectivity, professional competence and due care,
confidentiality and professional behaviour. In the above example, the accountant may not be
considered to have acted in the public interest or in accordance with the fundamental principles
of ethics if they were to ignore serious OHS issues.
Study guide | 37
The term ‘organisational structure’ describes how an organisation is organised. This may involve
having different departments that work on specific functions (e.g. sales, marketing, accounting,
customer service) or on particular product lines (e.g. mortgages, credit cards, personal loans).
Some organisations have many managers, senior managers and executives. There may be several
levels in the hierarchy from the lowest level employees up to the CEO. In other organisations,
MODULE 1
there may be only one level of management that directly interacts with employees. This is known
as a flat hierarchy.
An organisational structure includes all the people, tasks and responsibilities given to different
areas and the authority delegated to different positions within an organisation. A traditional
functional structure separates the organisation into distinct groups based on the functions they
perform. Each of these functions is a centre of responsibility for individual managers, who may
be held accountable for performance in their specific area. For example, the general manager of
sales is usually in charge of the sales department, and the chief financial officer (CFO) is in control
of the accounting department.
Organisations that are structured in a functional way usually create accounting systems that
match this. This type of accounting system is called a responsibility accounting system (RAS).
The RAS collects revenues and costs and also measures the performance of these responsibility
centres. This enables the organisation to hold managers of these centres accountable for their
performance. The following examples describe what managers of the various responsibility
centres are held accountable for:
• Cost centres—the ability to control and reduce costs are the primary responsibilities.
• Revenue centres—performance measurement is focused on increasing revenues.
• Profit centres—successful performance requires the ability to control costs and increase
revenues simultaneously.
• Investment centres—controlling costs, increasing revenues and investing in assets
appropriately and efficiently are the main responsibilities. These are the most autonomous
of the responsibility centres, as they have more authority to make a wide range of decisions.
Flatter hierarchies
As a response to external changes, and to generate improvements in efficiency and effectiveness,
the structure of many organisations has undergone significant change. Hierarchies have become
flatter, with fewer levels of management and reduced bureaucracy between senior management
and the lowest level of employees. A key influence on this change in hierarchy has been an
attempt to eliminate costs by reducing the number of middle managers and replacing them
with information technology. Another influence has been the attempt to create organisations
that are more flexible as information and decisions move rapidly between the layers of the
organisation. Less middle management has resulted in the transfer or delegation of authority to
lower levels of the organisation (often described as employee empowerment) and a greater need
to attract and develop highly skilled staff.
As part of the move towards flatter structures, significant changes have occurred to this traditional
organisational structure, including:
• offshoring and outsourcing;
• virtual offices and global teams; and
• joint ventures and alliances.
38 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Outsourcing, on the other hand, is when an organisation pays another organisation to perform
work that was previously done internally. Work may be outsourced locally or to companies based
overseas. This has altered the traditional hierarchical structure of organisations.
MODULE 1
Traditionally, organisations have focused on shifting low-skilled work from high-labour cost areas
to low-cost locations. Over time, organisations have also been able to shift large parts of their
highly paid, highly skilled work (e.g. computer programming) to low-cost economies (e.g. in
India) where technical skills are available.
Viewing organisations as a chain of activities and processes that flow across departments has also
led to structural change. Instead of thinking of an organisation in terms of its final product, it is
viewed in terms of the activities that add value and those that do not. Many organisations have
found they are very capable in one activity, but poor or mediocre in other areas. This has led to
an increasing trend towards outsourcing non-core activities, which allows an organisation to focus
its attention on the areas where it generates value most effectively.
Examples of outsourced activities include warehousing and logistics, data processing, payroll,
and information systems installation and maintenance. A further expansion of this concept is a
franchising relationship, where the whole business model is outsourced. Franchising has become
a popular way for the original creators of businesses to accelerate their growth and for other
entrepreneurs to develop a business faster through the use of an existing brand name and
business process (IBM 2004; Walker 2004a).
Management accountants have a variety of roles to perform as a result of this change. These
include evaluating choices of whether to make or buy an item and where production should
occur. Once these decisions are made, it is also important to develop performance measurement
systems and control mechanisms to protect assets and ensure accountability.
Offshoring and outsourcing are also discussed in the ‘Contemporary Business Issues’ subject of the
CPA Program.
MODULE 1
new subsidiary from scratch in a new market. Of course, blending the culture and operational
practices of the purchased organisation into the parent organisation may take considerable
time and effort.
➤➤Question 1.5
List three advantages and three disadvantages of outsourcing business operations.
Management reporting
In response to the significant changes that are happening with internal structures and externally,
there has been significant development in how management reporting occurs. In the past,
organisations may have produced a monthly management report 10 to 15 days after month-
end. Now, many organisations are able to perform month-end processes in only a few days
and sometimes within a few hours. The management reporting role has also expanded from
just producing the numbers, to analysing and interpreting the numbers that are generated
from the information systems.
Beyond this, the opportunity to have ongoing access to real-time data means that it is possible to
report on critical performance indicators in real-time. Weekly summaries and constant monitoring
have replaced monthly meetings, leading to rapid identification of issues and opportunities,
as well as faster response times.
Management reports need to convey much more than just financial performance. They should
also include many of the items below, which are discussed in detail throughout Modules 2 to 5.
40 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Competitor activity
• Estimates of competitor cost structures and pricing
• Analysis of competitor strategies and potential responses
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Industry analysis
• Growth and profitability including life cycle and business cycle analysis
• Impact of current or potential regulations or political changes
Non-financial performance
• Physical volumes and flows, including throughput, emissions and waste
• Employee performance, satisfaction and engagement
• Efficiency and quality results
Projects
• Core criteria including cost, quality and time
• Business cases, approvals and post-implementation reviews
Designing and implementing effective management accounting systems that capture and report
this data in a quick and efficient manner is an important role for management accountants.
➤➤Question 1.6
Apart from the factors described above, can you identify other factors that have affected
organisations and driven change?
The term ‘strategic management accounting’ captures this new and broader role. The focus
is now on assisting the formation, selection and operational implementation of strategies.
This has led to operational management being viewed as strategic implementation, rather than
something that was separate or divorced from the strategic process. A key part of the strategic
management accounting concept is its focus on the organisation’s external environment.
By collecting information on competitors, customers and suppliers, and gaining an appreciation
for the broader economic environment (including political, social and environmental factors),
an organisation is able to respond more quickly to change.
For these reasons, it is important to revisit the definition of strategic management accounting:
Creating sustainable value by:
• supporting the formation, selection, implementation and evaluation of organisational
strategy; and
• providing information that captures financial and non-financial perspectives for both the
internal and external environments to enable effective resource allocation.
Study guide | 41
The emphasis on the external environment can be seen in many ways. For example, internal
information (e.g. product costings) is more useful when it is compared against industry and
competitor information. Likewise, evaluating the operating efficiency and profitability of an
organisation can no longer be limited to internal results, but must be compared to external
benchmarks. Therefore, management accountants must focus on obtaining and using this
external information, which is not always easily available. This approach brings the strategic
management accounting function in much closer alignment to both the marketing function
(with its focus on customers) and the strategic planning function of the organisation.
MODULE 1
This places greater pressure on people working in these roles to increase their level of skills.
You should review Table 1.6 and consider the expanded level of work and responsibility that is
expected from management accountants.
A variety of techniques have been linked together under the banner of strategic management
accounting. These include target costing, life cycle costing, competitor cost analysis,
activity based costing and management, and strategic performance measurement systems
(Langfield-Smith 2008).
Table 1.6: T
raditional management accounting compared to strategic
management accounting
Job costing and process costing Product costing and activity-based costing
Most roles are split into several areas including technical tasks, working with internal stakeholders
such as sales and marketing teams, and project or team management. This will include managerial
work such as supervision, running meetings and ensuring timelines are met.
The move to providing strategic support is combined with the traditional cost management
services that management accountants have always provided. Management accountants are
often placed in different areas of the organisation or within project teams, to provide other
employees with greater access to their capabilities. This also helps management accountants
develop a much greater understanding of the organisation’s products, services, customers and
suppliers, as well as the issues faced by different parts of the organisation.
42 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Helping design and manage information systems and develop effective reporting methods is
often incorporated into the management accounting role. This will typically involve showing
others how to access information themselves rather than being an information gatekeeper.
MODULE 1
Accountants bring unique skills to the business adviser role. They are traditional information providers,
understand financial information and are disciplined in the use of control mechanisms. This brings a
seriousness and analytical approach that can help control risk during the pursuit of new opportunities.
Accountants are also perceived to bring an independent, objective and credible approach.
To maintain this advisory position, accountants must provide a valuable service in areas such as
strategic business planning, customer profitability management, revenue generation strategies,
cost management, information management, competitive intelligence, forecasting, decision analysis,
productivity improvements and cash flow maximisation. When possible, accountants should move
away from their own department and join project teams and other business units to work closely on
specific activities and issues.
Another risk is the possible tension that arises in the ability to switch between encouraging and
pursuing new opportunities, and also ensuring that effective controls and oversight are put in place.
Having the same person attempt to perform both these roles may lead to difficulty. Providing oversight
on top of deep involvement may involve conflicts of interest or time pressures that make it difficult to
perform either role effectively.
It may therefore be worth considering whether specific and different roles are developed within an
organisation for different accountants—some with a focus on compliance and control, and others who
are more engaged in performance improvement and strategy.
Increased pressure and perceived or actual loss of objectivity are some of the biggest issues facing
accountants as they become more heavily involved in the decision-making process (CIMA 2010).
Study guide | 43
Do you agree with the arguments presented for the business partner or the overseer in relation
to the role of accountants within an organisation?
At more senior levels within the accounting function, accountants must do more than just be
familiar with the numbers. Financial skills need to be coupled with:
• detailed knowledge of the specific business and industry;
• the ability to manage team members and the accounting function; and
• the ability to negotiate and communicate with other executives and external stakeholders.
MODULE 1
Contemporary skills and techniques
Accountants are often in high demand, but many senior accounting roles are often left unfilled
for a considerable amount of time. This is sometimes because potential employees are missing
‘soft skills’ (including negotiation, presentation and communication skills). The ability to analyse
information, present arguments and influence people, speak and give presentations to the
board, senior managers or employees is very important. Written communication skills, such as
writing concise and understandable reports, and sending appropriate emails and letters,
are essential. For these reasons, traditional skills must be supplemented with better personal
and behavioural skills.
A matrix of skills has been prepared by the International Accounting Education Standards Board
(IAESB). It details what is required of today’s professional accountant in business. The main
categories include:
• intellectual skills;
• technical skills;
• personal and interpersonal skills;
• communication skills; and
• organisational or business management skills (IAESB 2004).
A report by IFAC (2011) looked at how management accountants drive sustainable organisational
success. It identified four specific ways in which management accountants support an organisation:
1. Creators of value—developing the plans and strategies that set the direction of the
organisation
2. Enablers of value—by supporting management decision-making and implementation
3. Preservers of value—protecting value through effective risk management, controls and
compliance
4. Reporters of value—clear and detailed reporting.
A summary of some of the specific types of skill required within each category is presented
in Figure 1.8.
44 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Management accountant
Challenges
Some of the key challenges facing management accountants include:
• using technology effectively while guiding others to effectively use management
accounting systems;
• managing resources; and
• promoting innovation.
All this is occurring at a time when globalisation and technological advances are changing the
MODULE 1
structure of organisations, with many roles now being outsourced. With an increasing focus on
environmental and social outcomes, accountants are facing challenges from other information
providers who are skilled in capturing and reporting physical information, including engineers,
who will be competing to provide this type of service to organisations.
Technology
There are technology-linked challenges at both the day-to-day operational level as well as
at the strategic level. These include keeping information secure and maintaining customer
privacy (Gelinas & Sutton 2002). Establishing new and secure sales and distribution channels
to customers over the internet are opportunities that must be managed carefully.
Maintaining records and audit trails for data verification in a computerised environment is also
a significant issue. Effective implementation of major information system projects presents both
a challenge and an opportunity. Technology has allowed the automation of traditional number-
crunching activities and provides the tools to improve the quality of information to management.
This, in turn, has increased management’s expectations of management accountants.
Viewed from a broader perspective, technology is transforming how people compete within an
industry, which is forcing rapid change and innovation.
A wide range of skills are required of management accountants working in this industry, in both the
‘old’ organisations as well as the ‘new’ competitors. Surviving a decline in the industry life cycle involves
both specific operational action and strategic plans. Trying to streamline operations, cut costs and
move into new distribution channels such as digital downloads is critical for the ‘old’ organisations if
they are to successfully transition to the new industry structure.
Things are also difficult for the new competitors. Capturing market share, setting prices that lead to
profitability in a fiercely competitive market, managing technology and gaining customer confidence
are essential. Therefore, management accountants need a strong mix of general business skills,
as well as research, analysis, scenario-modelling and numerical skills to effectively advise and guide
companies through this period.
46 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Managing resources
Effective use and control of assets is required for superior results. Mastering areas such as cash
flow management and supply chain management is essential. Using forecasting and scheduling
tools, achieving reductions in inventory levels and maintaining effective links with suppliers
are necessary. In addition to the tangible assets base, it is important to improve in the areas of
recognising, developing and managing intangible assets, including knowledge (Carlin 2004).
It is more difficult to deal with organisational knowledge, customer and employee loyalty,
MODULE 1
and brand management than to focus on traditional cash flow and inventory issues.
However, with such intangibles being a significant contributor to the value of organisations,
the management of intangibles is an essential task for protecting and improving business value
(James 2004).
Innovation
One factor that leads to strong performance is innovation. It drives competitiveness by creating
efficiencies and new and better products. Innovation is both an outcome (i.e. a new product or
service) and a process (a combination of decisions, structures, resources and skills that produce
outputs and outcomes). In a more competitive environment, constant innovation is required to
achieve objectives. This can often be incremental innovation (small, minor improvements), but it
may also involve radical changes (Dodgson 2004). Consistently generating new and improved
products, services and processes (e.g. Apple Inc.) is essential to creating customer value.
Investment in research and development requires significant cash outlays, but is necessary to
maintain superior performance.
With over 200 employees, the organisation has a turnover of up to $40 million per annum. It has
successfully reduced its carbon output by reusing the heat generated from the baking process for cake
and pastry production. The estimated saving is approximately 5000 tonnes of emission per annum
and over 75 per cent reduction in gas per square metre as a result of turning a waste by-product into
a useful input.
It has also implemented a real-time monitoring system for energy consumption, and rainwater is
used for flushing toilets. Over 95 per cent of waste is recycled (including plastic, tin, wood and food).
With an estimated $300 000 investment on green initiatives, the financial cost has already been paid
back just from annual electricity savings of $290 000 (McKeith 2009; Ferguson Plarre 2014).
MODULE 1
What managers do—creating and
managing value
The role of management is often described as planning and controlling. Strategies and plans
are developed and then monitored closely when implemented to ensure they stay on track.
While this is accurate, the role of management encompasses more than this. The overarching role
of management is to guide the organisation in attempts to create, manage and protect value.
Leading organisations
Managing is not an exact science of planning and controlling, as it involves coordinating physical
resources and the actions of people. Treating people as resources without consideration of their
needs and desires is likely to end in dysfunctional management. There is a need to be able to
lead people effectively—to provide them with a sense of purpose and direction, clear goals and
develop an appropriate culture in which to perform their work. The ability to lead groups, teams,
departments or whole organisations will make achieving goals easier.
Value creation is just as applicable in the not-for-profit and public sectors. For instance,
national infrastructure, education, health and social welfare need to be managed just as
effectively as privately run organisations. In the not-for-profit and public sectors, instead of
maximising shareholder wealth, value is created for the citizens/residents of the nation (and/or
taxpayers). Leading these types of organisations with less quantifiable objectives may be even
more difficult than leading a profit-driven organisation.
Most assessments of an organisation are relative. For example, an acceptable level of profit is
usually relative and a combination of a specified return on assets or sales (internal focus), but it is
also determined by a comparison against competitors or industry benchmarks. Customer service,
levels of quality and cost leadership are important when conducting comparisons against
competitors. Therefore, it is important for those within an organisation to have a comprehensive
understanding of the key parts that interact within the industry they are in. In addition to
understanding the industry, managers also need to consider the state of the economy in their
analysis. This will have a significant effect on product demand, prices, wages and the predicted
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An organisation that is poorly run may still be successful in times of positive economic growth.
But, even the best run organisations may fail when faced with a prolonged period of decline
or recession.
Strategic management
The strategic process involves addressing key issues, including determining the vision, mission or
purpose of an organisation; setting specific objectives; and creating and implementing the
strategies to achieve these objectives. Important phases in the strategic management
process include:
• strategic analysis—both internal and external;
• strategy planning and choice;
• strategy implementation; and
• strategy evaluation (performance measurement, feedback and review).
Study guide | 49
This strategic process is continuous, and the phases are closely interwoven rather than clearly
separate events. Significant amounts of information are required to successfully complete each
of these stages. Table 1.7 outlines a variety of ways management accountants can support
managers. Many of these approaches are described in detail in later modules.
Table 1.7: S
trategic management accounting and the strategic
management process
MODULE 1
Strategic tasks Tools, techniques and accounting information that may be useful
Internal analysis Examine balanced scorecard results, product life cycle costing, market
share, product profitability, activity evaluation and costing. Create and
report on financial and non-financial (quality, time, innovation, customer
satisfaction) performance measures and customer profitability analysis.
External analysis Estimate competitor costs and capital investment projects. Conduct
industry life cycle growth and profitability analysis. Obtain supplier
and customer intelligence to identify their bargaining strengths and
weaknesses.
Strategic planning and choice Evaluate and rank the feasibility and profitability of strategies, considering
both capital budgeting (discounted cash flow measures) and strategic
costs/benefits.
Strategic implementation Provide accurate and timely costings as well as financial and non-financial
performance results during the implementation process.
Strategic evaluation Provide accurate key performance indicators that measure the success
achieved by the strategy. Review the effectiveness of the strategic
management process in terms of accurate estimates and costings,
and the appropriate use of performance measures and incentives.
Operational management
The relationship between senior strategic managers and operational managers is usually
drawn as a pyramid. The senior management team is at the top and focuses on strategic tasks.
Underneath this are the operational managers who focus on the medium- to short-term tasks
of running an organisation. There should be a strong link between these levels via the strategic
implementation phase. However, strategy often fails at the implementation phase due to poor
integration between the strategic and operational levels. Formal strategies are often ignored or
postponed as day-to-day issues receive all the attention.
Table 1.8: G
eneric operational management tasks and strategic management
accounting support
➤➤Question 1.7
Will the role of strategic management accounting change if the roles and functions of management
identified so far in Part B—or the factors that have caused change in the business environment
outlined in Part A—change in any way?
The example below highlights how strategic management accounting information can support
operational management.
Example 1.10: S
upporting operational management with
management accounting information
Planning
Alpha Pty Ltd (Alpha) sells educational toys for children aged 1–4. One of its products is an electronic
reading support toy that is expected to have good sales before the start of the school year at the
end of January. The budget for the next quarter (January–March) is set in mid-December; it includes
a sales revenue target of $165 000 for January. A bonus will be paid to sales staff in mid-April if both
revenue and profit targets are achieved for this product.
The planning phase is supported by the use of previous sales figures, consumer confidence in the
economy and required profit targets to achieve a minimum return above the cost of capital. The plan
is then communicated to staff about expected levels of performance.
Study guide | 51
Evaluating
On 5 February, the results for January are reported and actual sales for the toy are $130 000. Not only
are January’s figures short of the target, but there is also doubt about achieving the sales target for
the whole quarter. The cost of producing each unit has risen because of raw material price increases
due to unfavourable foreign exchange fluctuations. It appears that there will be no bonuses for the
sales staff for quite some time.
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Evaluation occurs continuously, and in this situation, it was supported by the use of actual versus budgeted
figures to identify current performance and establish whether bonus criteria were being achieved.
Analysis
An analysis of the sales revenue variance uncovers two major issues. The first, an external issue,
was caused by Alpha’s main competitor, Zeta Pty Ltd (Zeta). During the Christmas period, Zeta heavily
discounted a similar toy to successfully attract market share away from Alpha. This had a flow-on effect
on January’s sales. The second issue was an internal problem caused by a delay in the product being
delivered to several large retailers who had sold out. Several days’ worth of sales was lost as a result.
Analysis of the causes of the variance indicates that coordination within the organisation needs to be
examined and decisions must be made about how to take control of the situation.
Control
Alpha decides to reduce the selling price by 15 per cent and increase advertising to generate sales and
maintain market share. Sales estimates for February and March are also slightly reduced. A series of
meetings are arranged between sales, purchasing and logistics personnel to ensure that the company
has enough stock and that it is being distributed to retailers on time.
Variance to be controlled
Actual result
The company is off target. Several approaches to control the situation are made: changing the target
(reduced sales target), changing the course to the target (reduced sales price) and attempting to
improve coordination within the company.
In the above example, the decisions made at each stage needed to be based on rigorous
financial and qualitative analysis. This required an understanding of different cost concepts,
as well as various tools and techniques to support the analysis. For example, the original
variances would have been identified by variance analysis, and the decision to reduce the price
by 15 per cent and increase advertising to increase market share could have been modelled
using cost-volume-profit analysis.
52 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Appendix 1.1 examines cost classifications, cost-volume-profit analysis, product costing, budgeting
and working capital management. It provides a review of operational support techniques that are
regarded as assumed knowledge for the ‘Strategic Management Accounting’ subject. Use this as
an opportunity to review these techniques, including the ability to perform relevant calculations,
analyse scenarios and make recommendations.
Instead of merely recording and providing the information, management accountants are
required to provide support and training to allow line managers and employees to undertake
these tasks for themselves. Advantages of this approach include transferring routine tasks to other
employees to allow time to be devoted to more complex, non-routine and strategic-level tasks.
The same approaches and tools are used to analyse services, but the main characteristics of
services can make this analysis more difficult. Services differ from products in the following ways:
• A service is intangible, so it can be more difficult to define or measure systematically.
• Once a service is provided, it cannot be consumed or used again in the same way as a
product. This means there is no ability to store a service as inventory, which makes it more
difficult to manage supply and demand levels.
• A service is more of a unique offering than a product. So providing it in a systematic and
identical way is much more difficult.
• Unused capacity is lost forever. It cannot be used to create something that is stored for later
(i.e. inventory cannot be created).
Other important issues include measuring and maintaining quality, which can be difficult
because providing a service can be more individual or unique than producing identical products.
Therefore, accurately costing the provision of services to different customers is challenging.
Study guide | 53
MODULE 1
The key question to consider is: what decisions do public sector managers need to make and
how does strategic management accounting support these choices? For instance, in performance
assessment, strategic management accounting can help establish metrics for measuring:
• economy—the extent to which resources of a given quality were acquired at the lowest cost;
• efficiency—the maximisation of outputs for a given set of inputs; and
• effectiveness—the extent to which an organisation achieved its objectives.
➤➤Question 1.8
Read this extract from a local government planning document. What strategic management
accounting information may be used to support these themes and goals?
Theme Objective
Source: Maribyrnong City Council 2013, Council Plan 2013–17, Maribyrnong, Victoria, Australia, p. 16,
accessed July 2015, http://www.maribyrnong.vic.gov.au/files/Council_Plan_2013-17sm.pdf.
54 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
If management accountants are to support managers and, more specifically, provide strategic
support, accounting systems must be robust and capable. Supporting managers requires an
understanding of:
• what managers do and the decisions they make;
• what information they require; and
• how to capture, analyse and transform organisational data into the appropriate information.
Part C focuses on the second and third points—identifying the information that managers
need and then capturing the relevant data and turning it into useful information. Accounting
involves identifying, analysing, classifying and then recording data. This requires a systematic
process and is often a combination of manual and electronic systems. In many organisations,
the manual parts of the process often include the use of paper-based source documents,
including invoices, receipts, delivery dockets, purchase orders and statements. These documents
are physically moved between activities or functions, and data from these documents is then
generally recorded in electronic format. More recently, virtually all stages of a transaction may be
automated, including the generation and transmission of electronic invoices, receipts, payments
and statements.
An MAS should help managers create, manage and protect value by capturing data relating to
activities and assist in identifying whether those activities are adding value. This should include
costs, revenues, efficiency, quality, benchmarks and satisfaction. But, many MASs are based on
financial accounting reporting systems, so this is not always easy. Traditional classification of costs
may not enable easy tracking of, or focus on, value-adding activities.
Study guide | 55
Operations Research/
Sales/ and logistics development Human
marketing system system resources
MODULE 1
system system
Accounting
system
General ledger and reporting — AR/AP — Costing systems — Order entry/sales — Purchasing
A significant level of complexity arises when trying to capture all the relevant data from
organisational transactions and processes. The following example shows that even a simple
business activity, such as reordering stock to be sold in a retail store, has many small tasks and
data requirements that must all be carefully sequenced.
Automatic notifications from the information system should be able to advise the right time to order
and also the right amount of stock to order. For this to occur, the following information is required.
Forecast and actual sales level of the stock item Sales forecasts
Sales results by stock item
Minimum order quantity that supplier is willing Supplier contract, vendor information
to provide
From this information, it can be established that the store has three weeks’ worth of stock and that it
takes two weeks to replenish stock. Once stock levels drop to 400 units (which will occur in one week’s
time), the store must place an order to avoid a stock out. The order size will depend on whether the store
prefers to order small quantities on a weekly basis, or make a large order to obtain a volume discount.
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Not only must data be captured, but it must also be analysed and presented in a variety of ways
to determine how costs are being incurred and how activities are being performed.
Consider an electricity bill that arrives as a supplier invoice. In the first instance, the important
data will be the amount due and the date it must be paid by. But other pieces of data include
the electricity usage, where that usage was incurred within the business, how much of that
usage was wasted or unnecessary, and the level of emissions that arose as a result of the usage.
This data can then provide a foundation for improvement (i.e. energy efficiencies and cost
reductions) throughout the business.
When management accounting goes beyond reporting on a particular department or product and
starts to focus on tasks and activities, it creates a whole new way of understanding the organisation.
This focus helps identify which activities are worthwhile and which are not adding any value. It shows
where resources are being consumed and helps evaluate efficiency in these areas. Waste is highlighted
and links between departments are analysed—which may also reveal inefficiencies caused by confused
communication or different departmental objectives or strategies.
By considering alternative ways of structuring work, many opportunities exist to produce the same
services in a better way, or make products more effectively (e.g. with fewer parts and with less toxic
raw materials).
This activity-based costing and activity-based management approach is linked to the value chain
concept. It is also holistic in that it encourages an overall view of the organisation and the needs of
customers. Individual tasks are not viewed as ends in themselves, but rather as part of the overall
chain to produce valuable outputs. The aim should be to develop higher levels of interaction between
employees as well as integration between different work areas. This shifts the focus from managing
cost to improving performance based on improved cost, quality and flexibility.
A significant difficulty in achieving this approach is that many MASs are not able to provide the relevant
information in a timely manner. Management accountants must work creatively to ensure the systems
that are in place can support this type of analysis.
As strategic management accounting shifts from cost determination to the provision of information
that helps analyse activities and create value, management accountants are expected to operate
as managers of business value. This requires a greater understanding of the areas they will support,
including procurement and logistics, human resource management, financial management,
knowledge management and information technology (Sharma 1998). Specific areas that the MAS
will be required to support include those outlined in Table 1.9.
Study guide | 57
People management Measuring productivity and efficiency, revenues and profits per person,
costing of employee turnover and hiring; reward and bonus systems
Marketing and sales Profitability analysis, helping determine prices, returns on particular
marketing campaigns
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shareholder and customer value creation.
Financial management Activity-based costings and activity management, and measuring and
managing risk
Intellectual capital Measuring and managing customer and employee satisfaction and
management levels of information technology (IT) literacy, and maintaining strict
controls on intellectual property such as patents and licences
Information management Ensuring data security and controls; implementing and generating
value from e-commerce and electronic data interchange (EDI),
and using IT to support ‘just in time’ inventory management
Quality management Performance measures and costings to implement and manage total
quality management (TQM)
Management accounting systems should clearly distinguish between two types of information:
1. strategic profitability (costing) information; and
2. administrative control information.
The first type of information relates to the strategic variables that create value for an organisation.
This requires identifying what each product or service contributes to profitability over the long
term. The strategic support tools are outlined in Module 4, which includes detailed descriptions
of what information is required for target costing, customer profitability analysis and activity-
based costing and analysis.
The second type of information relates to generating relevant information for controlling
operational activities and processes. This component must also provide a control feature
that can protect assets, document transactions and provide a reliable source of verification.
The following section examines the role of the MAS in ensuring internal controls are
implemented and effective.
58 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Risk management
Management accounting systems are devised to help streamline operations, make activity more
efficient and minimise risk. The term ‘risk’ is used to describe the chance of potential losses or
problems arising from particular actions. Organisations face a large variety of risks—including
financial, administrative and operational risks.
Without structure and systems, it is very easy for mistakes to happen. Some obvious financial risks
MODULE 1
Invoices for private expenses, including work on his own personal home, were channelled through
the company. The invoices were modified to look as if they were related to work done on company
properties, and they involved collusion by multiple people within and outside the organisation.
Source: Director of Public Prosecutions 2007, The Pursuit of Justice: 25 Years of the DPP in Victoria,
p. 27, accessed July 2015, http://www.opp.vic.gov.au/Home/Resources/The-Pursuit-of-Justice-25-
years-of-the-DPP-in-Vict.
Because of the variety of risks and the significant amount of damage that may arise from poor
management of these risks, it is essential that management accounting systems form a core part
of the organisation’s risk management systems.
Risk management is required as a day-to-day operational activity, but it also holds a much
broader and strategic role. It is now expected that the overarching corporate governance
systems for the organisation include systems that address risk in a structured manner.
This includes the creation of suitable policies for the identification, disclosure and mitigation
of risks, as well as the design and implementation of a system of risk management and sound
internal controls (ASX CGC 2014).
Operational risk
Linking together all the tasks and activities that happen within organisations is essential for value
creation. However, at each stage in these processes, there is the risk that mistakes or errors may
occur, resulting in significant financial, environmental or social issues. Cost control is an important
part of the management accounting function, but when pressure to contain cost leads to risky
actions or behaviour, this can create more issues than are solved.
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Environmental risk
Complex production processes within organisations and environmental issues throughout the
supply chain (e.g. suppliers who use toxic materials in their manufacturing processes) lead to
risks of increased emissions and long-term damage to a physical location.
Reputational risk
The reputation of an organisation and its brand are often important drivers of revenue growth
and successful value creation. Consumers trust established brand names and are willing to pay
a premium for them, so developing and protecting reputation is important.
Quality risk
Failing to design things appropriately, not following designated policies and procedures,
or failing to support customers with their issues are all problems that can harm an organisation.
There are many ways of managing quality, and comprehensive data collection and analysis
form the foundation of techniques such as total quality management and quality costing.
Management accounting systems, which are already used to capture and report internal
information, are well-suited to capturing information in many of these areas and providing
appropriate disclosure and identification of issues.
60 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
• redesigning the way activities are performed, including new checks and reviews;
• building safer and more reliable infrastructure; and
• using protective equipment.
A risk classification matrix is a useful tool for determining when to initiate risk management and
mitigation. The matrix helps classify risks by both their probability of occurring (e.g. low, medium,
high or certain) and their severity if the event occurs (e.g. low, medium, high or catastrophic).
Tables 1.10 and 1.11 provide example classifications of likelihood or probability as well as
severity or the consequences. Note that it is common to use quantitative figures to describe the
severity or consequence of an event (e.g. the dollar impact or the number of injuries sustained).
Identifying and classifying risks in this way makes it clear which risks should receive the highest
priority and which may be deferred.
Probability Description
Severity Description
Major Significant impact on the organisation or its employees, but the organisation
is able to survive
Catastrophic Severe impact likely to mean the organisation will not continue to operate
These two classifications are combined into a particular risk rating (see Figure 1.10). For example,
if the probability of an event occurring is unlikely, but the severity will involve major consequences,
then this is classified as high risk. This event should be immediately reviewed and plans should be
devised to eliminate or mitigate the risk.
MODULE 1
Severity
One specific area of risk management is the creation and implementation of internal accounting
controls to minimise or eliminate unwanted issues and problems.
Internal controls
Management accounting systems provide valuable internal controls to support risk management.
This involves the use of procedures and mechanisms to ensure that mistakes and fraud do not
occur. Process controls are required for most organisational activities, but the focus of the MAS
is chiefly on accounting controls. These accounting controls are necessary to minimise or prevent
fraud and theft of assets, unacceptable accounting methods, and mistakes during data entry.
Documented policies and procedures, combined with well-programmed computer systems,
are quick and effective ways of making these controls part of everyday activity that cannot be
avoided. Helping avoid the loss of valuable assets—both physical and intangible (IP, data)—
is another important way of protecting value (Gelinas & Sutton 2002).
Internal controls are discussed in greater depth in the ‘Advanced Audit and Assurance’ and
‘Financial Risk Management’ subjects of the CPA Program.
62 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
➤➤Question 1.9
Describe how each of the procedures listed above is used to provide internal control.
➤➤Question 1.10
Describe how the internal controls listed above may be useful in the following situation.
Beta Pty Ltd is a computer hardware wholesaler. There are two office staff (Jan and Simon) and
MODULE 1
three workers in the warehouse (Peter, Paul and Mary). Jan is in charge of customer accounts and
administration, and Simon takes care of purchasing. Jan receives customer orders, enters them
into the computer system and ensures the warehouse dispatches them with an invoice attached.
She collects and opens the mail, and processes all the customer payment cheques before taking
them to the bank and depositing them every second day.
Once stock in the warehouse reaches a minimum level, Simon calls up the relevant supplier and
places an order. The goods are received in the warehouse, and the delivery docket and invoice
are given to Jan who processes the invoice, writes the cheque and sends it to the supplier.
Strategic risks often occur when the management team pays too little attention to the
external environment. Ignoring or failing to notice important trends, such as new technology,
economic decline or a change in the industry life cycle, can cause problems to escalate until they
are unmanageable. Companies that were once large and powerful often refuse to acknowledge
that the market has changed and that they will need to behave differently in the future to
continue successfully.
To help ensure these types of strategic risks are carefully monitored and managed, the risk
management system needs to be seen as part of the top-level decision-making processes of an
organisation. This approach is supported by ASX CGC’s ‘Corporate Governance Principles and
Recommendations’ (2014), which emphasises that boards of listed organisations in Australia are
responsible for ensuring a sound risk management framework is in place.
The strategic management accounting function becomes an important source of data for
ensuring strategic risks are properly considered. By carefully analysing broad economic
data, combined with industry trends and financial and strategic analysis of competitors,
management accountants are able to help make sure that strategic decisions are not made in
a vacuum that ignores reality. Having a detailed understanding of internal activities and processes
will also lead to more informed decision-making. Knowing the organisation’s areas of strength
and competence, and those where it is lacking resources and ability, should also help guide
decisions to avoid undertaking overly ambitious projects that are not feasible.
Study guide | 63
MODULE 1
promising opportunities and greatest weaknesses.
A related issue with an MAS is that the structure it is designed to represent may not match the
organisational reality. If the MAS is designed on a departmental basis, it may be very difficult to
evaluate processes, products or services that flow through different departments from a value
chain perspective. As value is created when products or services move through an organisation,
it is imperative that the MAS tracks how products or services move through the organisation.
However, this task is hindered when costs are allocated to departments, and interlinkages and
transfers are ignored.
One possible solution is to deploy more powerful and integrated organisational software that
is now available. ERP software allows for the development of activity-based management
accounting systems, but the cost of these packages and implementation challenges are
two very important considerations.
Other useful features of these systems include the ability to automate workflows and decision-
making processes. For example, leave application forms for employees may be created within
the ERP system and automatically submitted to managers. Failure of a manager to approve
or decline a request in time will automatically route the electronic document to a designated
alternative, and once approved, the leave form will be routed to payroll to update the relevant
employee records. This eliminates manual handling and delays, and reduces errors in payroll.
The same approach can be used for other activities such as approving purchasing requisitions.
In operational areas, bills of materials (lists of raw materials and components for products) may
automatically be rolled into requests for quotes from suppliers or purchase orders, which should
automatically link to job and process costing sheets to keep track of individual product costs
within the organisation.
64 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
ERP systems can become very expensive and complex, especially once they have been
customised, and management of these systems often falls to the accounting team. Management
accountants must therefore have considerable skills in areas such as understanding systems,
databases, data integrity and software management.
(CSR) increases the requirements being placed on MASs. Over time, the focus of MASs has
transformed from producing simple financial costings, to also include non-financial information
such as quality and timeliness. However, this is no longer enough. It is essential for the MAS to
support management to act in an ethical, responsible and sustainable manner.
However, there is evidence that many managers are largely unsure or unaware of how CSR and
environmental analysis should be addressed within their organisations. One reason behind
this lack of internal information is that the accounting systems are not structured to provide it.
It is therefore crucial that MASs be capable of supporting CSR through the appropriate capture
of both financial and non-financial information relating to items such as emissions, waste and
consumption of raw materials.
In addition to reporting resource usage, it is necessary to expand the role of the MAS to perform
value-added analysis. This requires a consideration of not only the financial implications of
products and services, but also their physical impact and sustainability.
Techniques for project evaluation and capital budgeting also need to capture the total cost of
ownership and overall impact of business activities, including the types of raw materials used,
the pollution generated and the sustainability of the approach used.
A management accounting system should be able to assess the financial costs and benefits of each
alternative, and should also be able to include the environmental impact of the raw materials and the
pole’s end-of-life treatment. Transportation, installation and the environmental impact of the installed
poles should also be able to be reviewed and analysed (Deegan 2008).
Study guide | 65
Example 1.15: M
easuring and capturing economic and
environmental benefits
Each year the airline Virgin Australia prepares an Energy Efficiency Opportunities report. This report
describes its improvement projects that have had environmental benefits and cost savings.
Two examples are:
1. Changing from two engines to a ‘single engine taxi inbound’ when moving the aircraft from the
runway to the arrival gate has saved nearly half a million dollars, while reducing energy usage by
MODULE 1
19 990 GJ and CO2-e emissions by 1390 tonnes (Virgin Australia 2012).
2. A project to upgrade the way flight plans and routes are determined is expected to take nearly
two and a half years to generate a positive return. However, it will lead to expected cost savings of
over $6 million and save over 250 000 GJ of energy and nearly 18 000 tonnes of CO2-e emissions.
Changes are being made to flight paths to take advantage of winds at higher altitudes combined
with altering the speed of aeroplanes to operate in the most fuel-efficient way (Virgin Australia 2013).
New product design must carefully consider the types of raw materials used, the energy used in
the production, the impact of product packaging and the ability to recycle the product after it is
no longer required. The focus on sustainability also needs to extend throughout the supply chain.
For example, a consideration of the social and environmental performance of suppliers should
be included in any assessment and selection of appropriate suppliers.
A related and significant issue is the development of a more appropriate and detailed approach
to overhead cost allocation. In many circumstances, waste items (such as excess or scrapped raw
material) are actually allocated to the product cost or placed into an overhead account and then
allocated over the whole range of products. This ‘hides’ the cost of waste, leading to overstated
product costs and impacts on pricing and performance. It also hinders a detailed examination as
this information is not easily brought to the attention of management. This shows that despite
the benefits that strategic management accounting brings to the organisation, there are still
many areas where improvement is needed.
66 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Review
This module provided an introduction to strategic management accounting and the role of the
management accountant.
Part A defined strategic management accounting and examined the contemporary environment
and its impact on organisations and on management accounting. It also explored the development
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of management accounting over time into its current strategically focused role.
Part B described the various roles that managers perform and how strategic management
accounting supports those roles. It also discussed a variety of techniques that are available to
support operational management.
Part C detailed the role of the management accounting system. It explored the link between this
system, the value chain and risk, as well as the need for effective internal controls. Additionally,
Part C discussed problems associated with management accounting systems, links with ERP
software, as well as extending these systems to consider environmental data and issues.
Study guide | 67
MODULE 1
subject. The objective of the following modules is to help equip you with the skills required in
management accounting roles. We can see from the subject concept map that there are a wide
range of activities and concepts that need to be carefully interwoven to successfully achieve value.
As we progress through the following modules, which expand on the increased strategic focus
that strategic management accounting is taking, we will consider each of these areas in detail.
E Module 2 E
n n
v v
i Module 1 i
r r
o Module 3 o
Value
n n
m Module 2 m
e Vision/Mission e
n n
t Goals and objectives t
a a
l Strategy—Creation l
Module 5
RESOURCES SYSTEMS
a a
n Strategy—Implementation n
a Module 4 a
PROJECTS
l l
y Strategy—Implementation y
s VALUE CHAIN s
i i
s Control and feedback systems s
In Module 2 we explore the concept of value in more detail and examine how organisations
create and manage value. This includes a specific focus on how strategy is developed
and important parts of strategy, including a vision, mission, clear goals and objectives,
and competitive strategic approaches. We also provide a detailed examination of the
value chain and external analysis.
We consider control and feedback systems in Module 3 and explore the essential role of
measuring performance. As multifaceted performance metrics are required, management
accountants have the dual role of helping to design performance measures and collect and
analyse results. We discuss techniques including the balanced scorecard and benchmarking,
which can be used to enhance both operational and strategic performance measurement.
68 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
In Module 4 we expand on the concept of how value is created through the linked activities of
the value chain, by demonstrating a variety of techniques that help organisations manage value.
By combining these techniques with appropriate performance measurement, both management
accountants and managers perform an essential role in developing an organisation’s sustainable
competitive advantage.
Our focus in Module 5 is on the importance of managing projects as part of successful strategy
implementation. These unique events must be carefully integrated into the organisation so that
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they enhance the day-to-day value-creating activities. It is therefore essential that we accurately
evaluate, select and implement projects.
It is important for you to understand how to apply the skills and techniques covered in this
subject, and so at the end of the subject we introduce an in-depth case study. This provides an
overall synthesis of the subject. You will need a good understanding of the material covered in
Modules 1 to 5 and be able to apply this knowledge to the specific information contained in the
case study to successfully complete the case study tasks.
Appendix 1.1 | 69
Appendix
Appendix
MODULE 1
Appendix 1.1
Accounting techniques for supporting operational
management
Introduction
This appendix provides a review of operational support techniques that are assumed knowledge
for the Strategic Management Accounting subject. You should use this as an opportunity to
refresh your knowledge and familiarity with these techniques, including the ability to perform
relevant calculations, analyse scenarios and make recommendations.
Cost classifications
Costs exhibit different types of behaviour. This means that when activity levels change,
different types of cost respond differently, depending on the circumstances. For example,
some may increase or decrease, while some may remain unchanged, and the impact of these
behaviours needs to be understood. These costs can be classified in a variety of ways to support
different types of decisions. For example, when cost-volume-profit analysis or sensitivity analysis
is conducted, there should be a clear separation of fixed and variable costs. Or, when preparing a
list of performance measures for a management team bonus plan, it is important to clearly identify
controllable versus non-controllable costs. Different types of cost classification are described below.
Direct/indirect
A direct cost is capable of being directly traced to a specific cost object such as a product.
Indirect costs, often called overheads, are not capable of being traced directly in a cost-efficient
or accurate manner and are allocated in a more arbitrary way. A cost object is any item for
which cost information needs to be obtained. This may be a job, product or service, or even
a department, customer or the whole organisation. When more costs are directly linked to
products or services, the accuracy and usefulness of costing information is significantly improved,
which supports efforts such as determining which product lines are profitable and setting prices.
70 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Fixed/variable
A cost is either fixed, and therefore stays the same regardless of volume, or is variable, meaning
the cost varies with changes in volume. Costs may exhibit both fixed and variable characteristics,
including step-fixed costs and semi-variable (mixed) costs. Consider the costs of a telephone
that include the monthly line rental (fixed) and the cost of each call made (variable). This is very
important in making short-term decisions, such as pricing a special order, and determining break-
even points.
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Variable costs do not just include those items used in the production of goods or services.
They may also include other expense items such as selling or transportation. Each cost needs
to be assessed to determine if it varies with volume or if it stays fixed.
An important concept to use when describing costs as fixed is the ‘relevant range’. This is the
range of activity or volume within which the pattern of behaviour (i.e. being fixed) still occurs.
Consider the rental of a warehouse that can hold between 0 and 5000 storage pallets. The rent
is fixed and any number of pallets being stored within this relevant range will not alter the fixed
cost. But, if the organisation needs to store 6000 pallets, then this will be outside the relevant
range, and additional storage costs will be incurred (e.g. by renting another warehouse).
Outlay/opportunity
Actual expenditures or payments may be described as outlay costs, while opportunity costs
represent the cost of an alternative that has been foregone. In many situations, analysis only
focuses on the physical amount paid. However, this ignores important costs and potential
benefits that should be included in the analysis. For example, if an asset is purchased with cash
rather than through a lease agreement, part of the analysis must include the opportunity cost of
deploying the cash elsewhere—possibly in a term deposit—or purchasing an alternative asset.
If this up-front cash payment is treated as ‘cost-free’, then the analysis will be inaccurate.
Relevant/sunk
Relevant costs include those that will occur in the future and differ between alternative decisions.
Some costs should not be included when making decisions about particular issues or projects.
These are costs that are irrelevant because they either:
• will be incurred regardless of the choice made; or
• have already been incurred and cannot be avoided.
While no-one would argue against the need to exclude irrelevant costs, this area needs attention
because decisions often mistakenly consider costs that have already been incurred and are not
recoverable. Including such sunk costs in the analysis can lead to incorrect decisions. This can
involve incurring even greater costs, which is sometimes described as ‘throwing good money
after bad’.
Appendix 1.1 | 71
When management needs to make a decision on whether to proceed with the mining project
(i.e. whether the mine will be profitable), the costs incurred during the feasibility study are considered
‘sunk’. Examples of such costs include wages, hiring equipment, drilling holes and testing samples.
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That is, the initial costs are irrelevant to the decision of whether to proceed with the mine as there is
no opportunity cost involved and their inclusion may distort the analysis by requiring a very high return
on investment. It means sunk costs are irrelevant because they are the outcome of past decisions and
should therefore be excluded from future decisions. Managers should not say, ‘We have spent this
much money already—we really should go ahead’, because those costs cannot be retrieved, regardless
of whether the mining company goes ahead with the project.
The mining company’s decision to proceed should be made by determining the expected future
profits (i.e. future revenues and future costs) from the mine. The company should not include these
sunk costs in its evaluation.
Value-added/non-value-added
Examining each activity in a process and determining whether it is adding value to the end
product or service help effective management of value. Those activities that add value should be
improved and enhanced, while activities that do not add value should be reduced or eliminated.
This concept is explored in Modules 2 and 4.
Committed/discretionary
Some costs are committed or locked in. This may be the result of contracts already in place
that cannot be avoided (e.g. for long-term lease of land, property, plant and equipment).
Some costs are committed because a particular design of an item may require certain raw
materials or components that cannot be avoided. Discretionary costs are those that can be
avoided at the discretion of a manager. These include items such as training, preventative
maintenance, advertising and bonuses.
Controllable/uncontrollable
When evaluating and rewarding performance, assess only outcomes and costs that are
under the control of the particular individual or department. This is because the person or
department under assessment cannot influence uncontrollable costs. The inclusion of such
costs in performance evaluation may produce unjustified negative performance results that can
have the undesirable effect of causing demotivation and disillusionment. Therefore, identifying
the controllable versus uncontrollable costs provides the foundations for holding managers
accountable for performance in a responsibility accounting system.
It is important to recognise the degree of influence managers have over certain revenues and
costs. Where a manager does not have direct control but may influence other departments’
costs, there may be an argument for evaluating their performance in relation to these costs.
This may encourage a team environment and cross-functional decision-making that leads to
better organisational outcomes.
72 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
There are two problems that arise when considering the concept of controllability:
• It is difficult to pinpoint controllability as there is often more than one factor affecting a
particular cost/outcome.
• Performance evaluation is often focused on the short term, while the effect of some current
actions may only be evident in the longer run (i.e. beyond one financial period).
Methods for ensuring systematic collection include making sure credit terms (e.g. 30 days from sale)
are properly explained, doing credit checks on customers, setting credit limits and using stop supply
(refusing to sell any more goods or services) when a customer is late with a payment.
It is expected that AR managers will be held accountable for any issues or costs from slow collections
because they are in charge. But, uncontrollable costs (from the AR manager’s perspective) may arise
without careful management of the end-to-end function, from sales to cash collection.
When strict credit terms and cash collection methods are used, it can make it difficult for the sales team
to reach its sales targets. If there are bonuses available, then the sales team will have an incentive to
provide payment flexibility to customers in order to win a sale. A salesperson may offer an extended
payment period (60 days instead of 30) or try to sell goods above the customer’s credit limit. In more
extreme circumstances, they may collude with the customer to avoid the stop supply being put in
place by the accounts team.
This creates conflict between the sales manager and the AR manager. The sales team’s actions will
lead to costs that are outside the control of the AR manager if the team continues to overrule the
company processes and procedures.
Potential solutions in this situation are to give the AR manager authority over any sale that deviates from
the policy or to not link the manager’s performance to cash collections. A more beneficial approach
may be to link sales bonuses to the prompt collection of cash rather than winning the sale itself.
Sportz Watch Pty Ltd (Sportz Watch) is a fictitious company that is used in this appendix to help
you apply concepts. Sportz Watch is a company that produces a variety of watches. Special sport
related features of these watches include:
• stopwatch capability for timing activities;
• heart rate monitor function;
• GPS function that provides speed, distance covered and inclines/declines over terrain;
and database that stores records of fitness sessions.
Appendix 1.1 | 73
➤➤Question A1.1
Identify the appropriate cost description for each of the following items:
(a) Raw material (plastic) for the watchband is imported and costs USD 3000 per kilogram
(b) Advertising expenditure of AUD 50 000 has been incurred to market the product.
MODULE 1
Direct or indirect
Fixed or variable
Outlay or opportunity
Relevant or sunk
Value-added or non-value-added
Committed or discretionary
Controllable or uncontrollable
Cost-volume-profit analysis
One benefit of having an understanding of different types of costs is the ability to forecast
different scenarios. It is necessary to know the fixed and variable costs when performing cost-
volume-profit (CVP) analysis. This type of analysis is useful in making decisions about volume
and pricing, as well as decisions about whether to accept customer orders that are below the
full cost of a product.
A company will usually set a desired or target profit level based on a set level of return on
assets (ROA) or a similar measure. For many organisations the current estimated level of profit
may not be high enough to achieve the profit target. This may be because costs are too high,
sales volumes are too low or prices are not high enough. For example, a company with $10 million
in assets may want an ROA of 20 per cent. This would be an ROA of $2 million ($10 million × 20%).
However, after preparing its budget, the company finds that the estimated profit based on current
sales levels and costs is only going to be $1.5 million. It can then try and cut costs or increase the
volume of sales to increase the estimated profit from $1.5 million to the desired level of $2 million.
CVP analysis often helps work out effective ways of successfully reaching the target (budgeted or
desired level) profits. For example, it will help an organisation to decide to increase prices or cut
costs, and by how much.
With this information, we are able to model the results of a variety of possible options that relate
to changes in sales price, volume sold and the level of variable or fixed costs. For example,
if all the fixed costs for a period have already been covered by previous sales, a reduced sales
price that is above the variable cost may still be beneficial to the company.
In its basic form, CVP analysis uses some assumptions that may limit its usefulness, including
assuming that selling prices are constant and that variable costs are also linear, which means
they stay at the same level per unit rather than decreasing as volumes get larger. This may not
MODULE 1
match reality, where larger purchases will often receive price reductions and higher volumes will
also lead to lower variable costs per unit. However, CVP analysis is still a useful starting point for
considering sales and relevant production and purchasing estimates. Financial models can be
developed to conduct more advanced forms of CVP analysis and to remove the need for the
assumptions mentioned above. Table A1.1 details some of the formulas required for CVP analysis.
Contribution margin per unit (CMU) = Sales price per unit – Variable cost per unit
Units to achieve a specific profit level = (Fixed costs + Target profit) / CMU
Revenue to achieve a specific profit level = (Fixed costs + Target profit) / CMR
MODULE 1
Break-even point in dollars (BP$)
Fixed costs / CMR $300 000 / 20% $1 500 000
Estimated profit
(Unit sales × CMU) – Fixed costs (12 000 × $30) – $300 000 $60 000
or
(Unit sales – BPU) × CMU (12 000 – 10 000) × $30 $60 000
Target profit
Total assets × Target return on assets $750 000 × 20% $150 000
Units to achieve target profit
(Fixed costs + Target profit) / CMU ($300 000 + $150 000) / $30 15 000 units
Source: Adapted from Crowe, D. 2004, ‘Manoeuvring to get out of the slow lane’,
Australian Financial Review—Special Report, 13 May, p. 2.
Product costing
Product costing information is essential for service organisations as well as manufacturing and
retailing companies. It is useful for both internal decision-making and for compliance purposes
in terms of reporting various inventory figures and cost of sales. To cost a product or service,
the direct costs need to be traced and recorded. Indirect costs (overhead) may then be allocated
to the item to provide an overall cost. There are several useful methods for costing, including:
• job costing—for larger, specific tasks or where unique products or services are produced; and
• process costing—for when large amounts of a similar (homogeneous) product or service
are produced.
There are four points in traditional product costing when recording (i.e. journal entries),
are required. These are when:
1. resources are obtained;
2. resources are used in the production process;
3. the production process is completed and there are finished goods; and
4. the finished goods are sold.
76 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
When the finished goods are sold, the asset value (Inventory – Finished goods) is transferred
to an expense account (Cost of sales) to reflect that these assets are no longer in the business.
An entry for the sale is also required, which reflects an increase in revenue and a corresponding
increase in assets (either cash or accounts receivable).
Job costing
Job costing is used if the product or service being costed is a clearly identifiable task or job.
MODULE 1
The main journal entry required, which relates to point 2 (in the previous list) when resources are
used in the production process, provides an overall total for transfers of direct and overhead
(indirect) costs across all jobs. Control accounts are then used to trace all of the direct costs and
allocate overheads to each particular job.
This use of control accounts is similar to the use of control accounts and subsidiary ledgers for
accounts receivable. For example, if a company makes a sale on credit, the journal entry will
increase accounts receivable and sales revenue. The journal entry does not reflect who the
customer is, which products were sold and other specific information. When payment is received,
it is just as important to make sure that the correct customer’s debt is updated in the system.
Control accounts make this achievable. Note that in a computerised environment this is done
automatically, but it is still important to understand the underlying principles.
The same process is required for job costing. While the main ledger will record the total amounts
going in and out of the accounts, the control account (job sheet) for each job will contain the
amounts relevant to a specific job. Budgeted estimates for each part of the job could then be
compared to the actual results to determine variances and identify potential problems.
Process costing
Process costing is used in situations when there are a large number of similar products or services
being produced. Instead of each individual unit being costed, the total amount of costs incurred
is collated and averaged across the total units produced.
The focus of cost accumulation is usually on the departments that the product or service
passes through. The work-in-process (WIP) is allocated to specific departments. This process of
performing additional processes and transferring costs to WIP continues until all processes are
complete and the WIP costs (i.e. direct materials, direct labour and overhead) are converted into
finished goods. At this stage, the cost of finished goods can be divided by the volume of units
produced to calculate the product cost per unit.
Overhead allocation
A large number of costs are not directly traceable to a cost object—for example, the final
product or service that is created. These indirect costs are called ‘overhead’, and it is necessary
to find a way to allocate these costs to the specific object to be costed. Overhead costs include
all of the business’s running costs (not including direct labour and direct materials).
Overhead costs are allocated to products using an ‘overhead allocation base ’ in order to
determine the ‘true’ cost of manufacture. So even though direct labour and direct materials are
direct costs, they can be used as a foundation (or ‘allocation base’) for allocating overhead costs
that cannot be easily traced to a cost object. Other allocation bases, such as ‘machine hours’,
can also be used.
Appendix 1.1 | 77
A process is then needed to determine how much overhead is allocated. A brief summary of the
overhead allocation process is shown below.
1. Collect or estimate all relevant overhead costs (this is often called a cost pool). There may be
more than one cost pool because of the different types of overhead (indirect manufacturing
costs, indirect departmental costs—for instance, marketing and administration costs).
2. Select an allocation base for each cost pool. The allocation base should be determined on
the basis of the cause–effect relationship between the overhead costs incurred and the cost
object. Examples of allocation bases include:
MODULE 1
(a) direct labour hours
(b) direct labour dollars
(c) machine hours
(d) direct materials dollars.
This does not mean that these allocation bases are the overhead cost. Rather, the costs or
time incurred in these areas will be used as a foundation for allocating other overhead costs
that cannot be easily traced.
3. Collect or estimate the total quantity of the allocation base.
4. Determine the cost allocation rate by dividing the cost pool by the total quantity of the
allocation base.
5. Allocate overhead costs to a particular job or process based on this rate.
➤➤Question A1.2
A manufacturing organisation has three jobs planned for the next financial year.
Its manufacturing overhead is expected to be $350 000.
Estimated operating data is provided below.
(a) Using each of the four allocation bases above, calculate for each job the:
(i) overhead application rate.
(ii) overhead allocation.
Complete your answer in the tables below.
(i) Overhead application rate
Total Application
Allocation base Job 1 Job 2 Job 3 quantity rate
Direct labour costs
Machine hours
Overhead allocated
Overhead Application
allocation base rate Job 1 Job 2 Job 3 Total
Direct labour costs
Machine hours
(b) Using machine hours as the allocation base, prepare control accounts for each job. Complete
your answer in the table below.
Control accounts
Manufacturing
Job number Direct materials Direct labour overhead Total
1.
2.
3.
Total
(c) How would switching from machine hours to direct material dollars as the allocation base
affect the profitability of Job 1?
Appendix 1.1 | 79
Budgeting
A short-term master budget is required to help turn long-term strategic objectives into
operational short-term plans. The master budget may be for a period of weeks, months,
quarters or even a year and combines the relevant information into a short-term operational
plan. The budgeting process helps management to allocate resources (time, people and money)
to a coherent set of financial and numerical plans. The starting point of the budgeting process
is the organisational goals and strategic plan. These are combined with a detailed assessment
of the financial position and integrated with external and internal projections about how the
MODULE 1
organisation will operate in the future environment. Information required will include sales
forecasts, production capacity and costs, and employee data.
A series of short-term budgets not only assists in planning, but is also useful for coordinating and
integrating the variety of activities within an organisation. It also communicates to staff what is
expected to be achieved, and the allocation of resources to key areas informs employees about
the relative importance of activities and areas.
There are many different approaches to budgeting, some of which are more flexible than others.
Flexible budgets are commonly used and are updated during a period based on changing
events. Another popular method is the use of a rolling forecast. This is where, instead of an
organisation forecasting in calendar or financial year blocks, new budgets or forecasts are
continuously created, and the organisation continues to look 12 to 18 months ahead at all times.
For example, as a three- or six-month period passes, that period drops off the budget and
another three- or six-month period is then added.
Forecasts, or dynamic budgets, are now common in most organisations and allow for increased
control over costs and short-term planning. These forecasts use actual costs incurred during
the financial period to date, in addition to the remaining budget for the period, to enable
more accurate forecasts of revenues, expenditures and cash flows for the full financial period.
These forecasts do not take the place of the original budget, but provide an additional tool that
may be used to adjust or refocus planning where variations to budgets occur.
= Revenue
80 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Important things to consider when creating a sales budget include external factors such as
market demand at different price levels and internal factors such as production and storage
capacity. Failure to integrate these factors may create unachievable budgets and, in turn,
lead to decreases in employee motivation. The cash collections from the sales budget will be
incorporated into the cash budget.
To determine the amount of goods to be produced in a particular period, first determine the
level of sales and then consider the current and required levels of inventory. Setting sales and
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production budgets is usually an iterative process in which the sales and production teams need
to communicate to ensure that the number of units expected to be sold can be produced.
Forecast sales
If goods or services are being produced, a direct labour budget and a raw materials purchases/
usage budget are required. The final data from the production budget (production requirements)
becomes the starting point for both of these budgets.
A raw materials budget is created by combining the production requirements identified earlier
with the required levels of raw materials inventory. From this, the amount of raw materials to
purchase as well as the cost can be calculated. The cost information from the direct labour
budget and raw materials budget will be fed into the cash budget, which will project when
payments will be required.
Raw materials (RM) purchases and usage budget July August September
= Usage of RM
= RM purchases volume
× RM cost
= Total RM cost
Appendix 1.1 | 81
➤➤Question A1.3
Twinkle Toes Ltd is a company that makes and sells shoes for women. A new shoe made from
recycled materials is being considered, and the following estimates have been made:
Expected selling price: $220 per pair of shoes
To make each pair of shoes, the following items are required:
• 800 grams of raw material that costs $50 per kilogram;
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• direct labour of two hours, at $17 per hour; and
• variable overhead of $24.
Expected unit sales for the second half of 20Y1 are as follows:
July 1300
August 1900
September 2200
October 2300
November 2500
December 3200
To ensure there are no shortages of stock or production bottlenecks, the following are required:
• Finished goods (FG) inventory at the end of each month should be 20 per cent of the following
month’s estimated sales. Note that Twinkle Toes will require inventory to be built up in June
for July sales.
• Raw materials inventory at the end of each month should be 35 per cent of the following
month’s estimated raw material usage needed to meet the production requirements.
Prepare the following for Twinkle Toes Ltd for the period July–September 20Y1:
(a) sales budget
(b) production budget
(c) direct labour budget
(d) raw materials budget.
Notes: The production budget will need to include October so that raw materials purchases for
September are identified, and ending June inventory for both raw material and finished goods
is required to determine July starting balances.
The first type of variance examined is the difference between a budgeted level of activity and the
actual level. The second type of variance is the difference between the consumption of resources
that should be incurred for a ‘given level of activity’ as compared to what is actually consumed.
For example, if production of 1500 units is budgeted but, because of a large sales order,
2000 units are actually produced and sold during the period, there are two variance issues.
The first issue revolves around why there is a 500 unit variance in units produced. The second
issue relates to the amount of resources used to produce 2000 units. The actual resources used
must be compared with the budgeted estimates to ensure resources are being used effectively.
82 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
However, if the amount of resources actually consumed (to produce 2000 units) is compared
with the amount expected to be consumed (based on a sales estimate of 1500), there will be
a significant difference that has nothing to do with inefficiency. Rather, 33 per cent more direct
material or labour may have been required to produce the extra 500 units. Unless the budgets
are adjusted or ‘flexed’ to reflect the increased levels of production before the variances are
calculated, the analysis will be inaccurate.
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Cash budgets
Managing cash flows is an important issue. A crucial area that often causes problems is customer
collections. Slow collections can make it difficult to pay suppliers on time and to plan for longer-
term and strategic investments, such as hiring new staff or capital expenditure. Clearly identifying
when large outflows such as loan repayments are to arise is also essential.
The inputs for a cash budget are mainly found in the general budgets that have already been
considered, including the sales budget and the purchases and labour budgets. For example,
based on the total revenue estimates, it is possible to try to identify when these funds will
be collected. This can be done by examining the accounts receivable ageing data, and an
organisation should be able to determine the usual time periods when revenue is collected as
cash. For example, a possible structure may be as follows:
• 20 per cent of sales received under 30 days;
• 60 per cent between 30 and 60 days;
• 15 per cent between 60 and 90 days; and
• 5 per cent over 90 days.
A schedule of cash receipts can be prepared to map out how revenue is collected over time.
For example, if a company had $100 000 in sales in the month of January, based on the
percentages outlined above, this would be collected as follows:
April/May/June 5% $5 000
The accounts payable ageing data shows when invoices are due for payment.
Effective cash budgeting ensures that an organisation highlights any cash issues well before they
arise (see Table A1.2 for a monthly cash budget template). If an organisation is going to require
extra cash in line with its operating cycle, from purchasing raw materials up until the collection
of cash from sales, then this needs to be organised promptly. Note that organisations with strict
bank overdraft credit limits, or those experiencing cash flow problems, may prepare weekly or
daily cash budgets, with a running cash balance calculated after each cash transaction.
Appendix 1.1 | 83
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– direct labour
– raw materials
– variable and fixed overheads
− general expenses (e.g. selling and admin.)
− Tax payments
➤➤Question A1.4
Based on the following estimates for Zeta Ltd, prepare:
(a) a schedule of cash receipts (in April 20Y1) from sales;
(b) a schedule of cash payments (in April 20Y1) from material purchases; and
(c) a cash budget for April 20Y1.
Working capital is the difference between current assets and current liabilities. This difference will
be funded by long-term debt or equity capital. It is described as ‘working’ because this capital is
constantly being converted from cash into inventory, accounts receivable and back to cash again.
Effective management of each of these parts is essential. Not collecting accounts receivable
on time creates cash flow problems that, if left unsolved, may lead to insolvency. Not paying
creditors on time can harm business relationships, and holding too much inventory ties up capital
that could be used elsewhere in the organisation or repaid to lenders. However, finding a balance
is important. While an organisation can suffer from undercapitalisation (where there is too little
long-term finance to support operations), it can also experience overcapitalisation (where funds
are not fully used, providing a lower return to investors).
This section discusses the operating cycle and cash cycle, and provides an overview on each of
the parts of working capital. It concludes with a summary of working capital formulas for creating
ratios to benchmark and assess the effectiveness of working capital management.
Appendix 1.1 | 85
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The operating cycle represents the time taken for an entity’s purchased inventory to be converted
into cash through sales (see Figure A1.1).
As inventory is often purchased on credit, the cash outflow does not always take place when
the raw materials are acquired. The cash cycle represents the net time taken from obtaining and
paying for resources, to selling goods and receiving cash.
1 2
Acquire materials Convert materials
or resources to goods or resources
or services
4
Collect payment for 3
goods or services Sell goods
or services
Inventory days—The average number of days inventory is held. The fewer days the better,
otherwise it indicates slow-moving stock.
Receivable days—The average number of days customers hold accounts receivable balances.
The fewer days the better, otherwise it indicates risk of bad debts.
Payable days—The average number of days creditors have to wait to be paid. The more days
the better, taking into account supplier relationships and availability of discounts.
Inventory cycle
For the inventory part of the operating cycle length, determine the ratio ‘inventory days’.
One way to determine the average time that inventory is held within an organisation is to
determine inventory turnover.
Cost of sales
Inventory turnover =
Average inventory
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Inventory turnover identifies the average number of inventory cycles occurring in one year
(the more the better). This can also be expressed in terms of inventory days.
365
Inventory days =
Inventory turnover
Average inventory
Inventory days = × 365
Cost of sales
Sales
Receivables turnover =
Average receivables
Receivables turnover identifies the number of times debtors pay their accounts in full during the
year. This can also be expressed in terms of receivable days.
365
Receivable days =
Receivables turnover
Average receivables
Receivable days = × 365
Sales
Cost of sales
Payables turnover =
Average payables
Appendix 1.1 | 87
Payables turnover identifies the number of times creditors are paid their accounts in full during
the year. This can also be expressed in terms of payable days.
365
Payable days =
Payables turnover
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Average payables
Payable days = × 365
Cost of sales
Sale Collection
Purchase Payment
Sale Collection
Purchase Payment
88 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Cash management
Having an adequate supply of cash is essential for paying debts and being able to take
advantage of business opportunities. Cash refers to an organisation’s actual cash and near-
cash holdings at a given point in time. Near-cash holdings include highly liquid investments
such as at-call money market instruments and bank deposits, bank bills and promissory notes.
Also included in cash is the bank overdraft balance, which forms an integral part of a company’s
cash management process.
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Although cash itself is essential for the operation of a business, it can be described as an idle
asset. That is, it rarely generates the returns that other business assets or investments would be
expected to achieve. As such, there is a trade-off between having enough liquid assets to fund
the operations of the organisation and having excess cash, which leads to lower returns for the
organisation. It is therefore important that cash balances be managed effectively.
1 2 3 4 5 6
Forecasting Daily cash Intercompany Investment of Cash Performance
and planning procedures flows surplus funds disbursements measures
These steps are discussed in more detail in the ‘Financial Risk Management’ subject of the CPA Program.
The simplest form of cash management is investing surplus funds into an interest-bearing
deposit account. Listed below are four factors that need to be taken into consideration when
investing cash.
Maturity The time taken to realise the investment. ‘At-call’ accounts and ‘term deposits’ are the
most common way of investing surplus cash, with term deposits typically having one-,
three-, six- or 12-month durations. Usually, the longer the maturity, the higher the yield.
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Liquidity How easily the organisation can access its cash from the investment. Usually, the longer
the term of the investment (i.e. 12-month term deposits), the less liquidity there is and
the higher the interest rate or yield.
Risk The chances of losses or gains on the investment, primarily gauged by the financial
institution’s credit rating (e.g. ‘investment grade’ status) by ratings agencies. With cash,
investors generally seek a lower-risk investment, as a key objective is to protect the
value of the asset. A higher risk will generally provide a higher yield.
Yield The yield or rate of return is determined by the other three factors, namely maturity,
liquidity and risk. Generally speaking, the longer the term to maturity on the investment,
the less liquid the investment, the higher the risk, and the higher the yield.
6. Performance measures
Performance of managers is often biased towards the measures on which they are to be
appraised or evaluated. Where these performance measures do not include a benefit
(or penalty) for the efficient (or inefficient) use of cash resources, it will invariably lead to a
lack of resolve in that area. Cash-based measures should apply to all managers who have a
significant impact on the company’s cash cycle.
The cash generated by a business unit is the simplest performance measure that can be used.
It is easy to measure and assess, and is directly related to the overall group objective of cash
maximisation. We discuss performance measures in more detail in Module 3.
Credit sales may help an organisation to grow sales, but granting credit can mean that
administration and funding costs will increase, as will bad debts if there is poor management
of accounts receivable.
The formula to determine the return generated from paying an invoice early and obtaining
a discount is:
(1 + D/P)(365 / d) – 1
A simple example demonstrates the power of paying invoices early and obtaining an associated
discount. Consider an invoice that requires a $500 payment in 30 days. There is an opportunity of
receiving a 5 per cent discount ($25) if the invoice is paid immediately. One way to consider the
benefit of paying early is to see the return you would normally get by investing these funds. If you
invested $475 in a term deposit for 30 days that pays 5 per cent per annum, you would receive
$1.95 in interest ($475 × 5% × 30 / 365). So, getting a $25 return (in money saved) by paying
immediately may be a much better investment than keeping your funds in the bank and paying
the supplier in 30 days.
The equivalent annual return from paying the invoice early and obtaining the discount is
calculated as:
This means that the 5 per cent discount over 30 days actually equates to an annual rate of return
of nearly 87 per cent. An organisation may save hundreds or thousands of dollars each year by
taking advantage of such discounts, and it would be unlikely that the organisation could find such
a return elsewhere. The following table provides further examples (assuming an invoice amount
of $500) of the annualised rate of return achieved for different levels of discount.
Inventory management
For organisations involved in selling merchandise (e.g. retail shops) or manufacturing goods,
management of cash flows associated with inventory is essential. Inventory can take many forms,
from raw materials, to partially completed goods on the production line (work-in-progress),
to finished goods or merchandise ready for sale.
There are two important tasks associated with inventory management: controlling inventory
(knowing where it is and what has been transported) and managing the costs. Constantly
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recording the inflow and outflow of inventory (using perpetual systems of inventory management)
combined with either continuous (cycle) counting of stock or monthly/quarterly stock takes will
provide stronger control.
The key tasks of inventory management include balancing the costs related to:
• acquisition costs, which include the price paid, ordering costs and consideration of possible
discounts for larger quantity orders;
• storage (and transfer) costs; and
• opportunity costs because of stopped production (if no raw materials are available) or lost
sales (if no finished goods are available).
The intuitive approach to avoiding the third set of costs generally involves holding a vast quantity
of inventory. But this will lead to holding too much inventory, which decreases efficiency, increases
overall costs and makes managing cash more difficult. Balancing these costs effectively is a
useful skill. One model for supporting decisions is the economic order quantity (EOQ) model,
which helps to determine the order quantity that minimises total cost.
EOQ = 2aD /c
= (2aD/c)0.5
Where:
a = acquisition cost per order placed;
D = demand over a period; and
c = carrying cost per unit.
A simple example of this formula is shown in the following scenario. Calculating the EOQ formula
can determine how many orders should be placed annually. Assume an organisation purchases
8000 bottles per year. The cost of processing each order is $4.00 and carrying costs are $0.10 per
bottle. Therefore:
a = 4.0
D = 8000
c = 0.1
EOQ = ((2aD)/c)0.5
= ((2 × 4.0 × 8000) / 0.1)0.5
= 800 bottles
This shows that the order quantity that minimises costs is 800 bottles. Once the EOQ has been
calculated, it is possible to determine how many orders need to be placed over the time period
of estimated demand. In this situation, the ideal number of orders per year is 8000 / 800, which is
10 orders per year. Therefore, any more than 10 orders per year will mean that the acquisition costs
outweigh any savings achieved by reducing the carrying cost per unit. Larger order sizes might lead
to a reduction in total acquisition costs, but because inventory is being held for longer periods,
the carrying costs will outweigh these savings. This model can also be extended to consider issues
such as maintaining a buffer of stock to avoid running out (this is also called ‘safety stock’).
92 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
A detailed explanation of this formula is found in most management accounting and business
finance textbooks.
Many companies do not record the cost of lost sales. These costs are not directly incurred by the
company. Rather, they are opportunity costs—the cost of missing out on the sale as a result of
holding lower levels of inventory. By capturing this information, companies can assess whether it
is worthwhile increasing their inventory holdings. Estimating the opportunity cost incurred from a
stock-out involves calculating the ratio of actual stock available to stock demanded. For example,
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if 950 units were available, but there was demand for 1000 units, the ratio would be 950 / 1000;
that is, 95 per cent of customer orders would be satisfied.
Efficiency and liquidity are two important areas to consider when evaluating working capital.
1. Efficiency focuses on how quickly the organisation moves through the operating cycle,
the inventory cycle and the cash cycle (discussed earlier).
2. Liquidity is the ability to convert current assets into cash and is often used to describe the
organisation’s ability to pay its debts as and when they fall due. This is because cash will
be needed to pay debts. Measuring the level of current assets (which are usually able to be
converted reasonably quickly into cash) against the level of current liabilities (which must
be paid relatively quickly) will provide an indication of the organisation’s ability to pay debts
as and when they fall due.
Current assets (the numerator in the working capital ratio shown below) are typically made up of
cash, accounts receivable and inventory. If the working capital ratio is less than one, it means the
company has fewer current assets than current liabilities. This is usually an undesirable situation
as it may be difficult for the company to pay its debts on time, which places the company in a
weak position.
If the working capital ratio is close to two, then this means current assets are close to twice the
size of current liabilities. This places the company in a position to be able to pay its debts on
time. This may be referred to as a strong position. However, if the working capital ratio is above
three, the company’s current assets level is too high (e.g. it may have too much inventory), as the
company may not be generating a sufficient return on those assets.
The quick asset ratio gives an even better indication of the organisation’s ability to pay its
debts promptly. This is because the quick asset ratio excludes inventory from the calculation,
as inventory can be difficult to turn or convert into cash rapidly, especially in difficult trading
times. A ratio of less than one indicates the organisation has difficulty paying its short-term debts
immediately. The higher the ratio, the stronger the liquidity position.
Appendix 1.1 | 93
Quick asset ratio = (Current assets – Inventory) / (Current liabilities – Bank overdraft)
MODULE 1
Evaluating efficiency
➤➤Question A1.5
Sportz Watch operates in a highly competitive industry. The following items were extracted from
its financial statements.
Accounts payable $100 000 Net profit after interest and tax $50 000
Fixed or variable Variable cost. Although the cost per kilogram may be set,
the kilograms required will depend on the number of units
produced. So, the cost of the plastic will vary with the volume
of production.
Relevant or sunk Relevant cost. This cost is incurred each time the product is
made, and it would be required for any decisions to produce
the product in a different manner.
Value-added or non-value-added Value-added cost. This cost is necessary for the product to be
made.
Committed or discretionary Committed cost. This cost cannot be avoided as, based on the
product design, it requires this raw material.
Controllable or uncontrollable This can be viewed from two perspectives or stages in time.
(b) Advertising
Direct or indirect Direct cost. This cost can be directly traced to the watch.
Advertising is often an indirect or overhead cost, especially
when it is done for a whole range of an organisation’s products
or services. However, it is not automatically classified as an
indirect cost in all situations. Just because a cost is not part of
making the product, it is not automatically an indirect cost.
Fixed or variable Fixed cost. The amount of $50 000 will be spent regardless
of the volume of watches produced or sold.
Relevant or sunk Sunk cost. Once the money has been spent, then it is sunk.
This means that any future decisions should not consider this
spending (e.g. whether to continue manufacture and sale of
the product).
Committed or discretionary Discretionary cost. This cost could have been avoided at the
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manager’s discretion.
Controllable or uncontrollable Controllable cost. The managers of the company had full
control over whether this expenditure was incurred.
Question A1.2
(a) Overhead allocation
(i) To calculate the amount of manufacturing overhead to be allocated to each job, we first
need to calculate the overhead application rate.
Total Application
Allocation base Job 1 Job 2 Job 3 quantity Formula rate
Direct labour costs $50 000 $60 000 $90 000 $200 000 ($350 000 / $200 000) $1.75
Direct material dollars $35 000 $25 000 $40 000 $100 000 ($350 000 / $100 000) $3.50
Direct labour hours 1 250 2 000 3 000 6 250 ($350 000 / 6 250) $56.00
Machine hours 150 450 650 1 250 ($350 000 / 1 250) $280.00
(ii) Once the application rate has been calculated, apply overhead to each job. For example,
if direct labour costs are used as the allocation base:
|| the application rate for direct labour costs is $1.75
|| the direct labour cost for Job 1 is $50 000
|| the overhead to be applied to Job 1 would be 1.75 × $50 000 = $87 500.
Overhead allocated
Direct labour costs $1.75 $87 500 $105 000 $157 500 $350 000
Direct material dollars $3.50 $122 500 $87 500 $140 000 $350 000
Direct labour hours $56.00 $70 000 $112 000 $168 000 $350 000
Machine hours $280.00 $42 000 $126 000 $182 000 $350 000
Manufacturing
Job number Direct materials Direct labour overhead Total
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This means that the overhead cost using direct materials dollars is $80 500 higher than the
cost when using machine hours. As such, the profitability of Job 1 should fall by $80 500
if direct materials dollars were used as the overhead allocation base instead of machine
hours (i.e. $122 500 – $42 000). The table below shows the difference in total estimated cost
(and hence profit) between these two overhead allocations bases.
Question A1.3
(a)
Sales budget July August September
(b)
Production budget June July August September October† November
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= Production 1 420 1 960 2 220 2 340
requirements (units)
†
October’s figures are needed to calculate the raw materials budget in part (d).
‡
June’s ending FG inventory of 260 is calculated as 20 per cent of July sales of 1300. This number
then becomes the starting FG inventory for July.
(c)
Direct labour budget July August September
= Total direct labour cost $48 280 $66 640 $75 480
(d) (i) To create a raw materials (RM) budget, do not start with the estimated sales figure.
Base this budget on the production requirements that were identified in the production
budget (see answer (b) above). Production requirements are in number of units (pairs of
shoes). That is why the production requirements for July are 1420 units, not 1300 units.
(ii) We need to convert the number of shoes into RM inventory volume (kg) to meet the
production requirements. This is done by multiplying production requirements (units) by
the RM per unit (0.8 kg). That is, each pair of shoes uses 800 grams or 0.8 kilograms of raw
material, which equates to $40 per pair of shoes (0.8 kilograms × $50 per kilogram).
(iii) Once the RM usage (kg) required for production is known, consider the ending and starting
RM inventory levels (in kilograms). This gives the total RM kilograms to be purchased.
(iv) The final step is to multiply the RM (kg) by the RM cost per kilogram ($50).
Production requirements (shoes) 1 420 units 1 960 units 2 220 units 2 340 units
†
October’s raw material usage figures are needed to calculate the ending raw materials inventory
for September.
‡
Ending raw material for June is calculated as 35 per cent of July’s raw material usage of 1136 kg.
This number then becomes the starting raw material figure for July.
98 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Question A1.4
(a) Schedule of cash receipts (in April 20Y1) from sales
April cash sales 20% of April sales of $565 000 are 20% × $565 000 $113 000
collected in April.
MODULE 1
April credit sales (i) 80% of April sales of $565 000 are 80% × $565 000 = $452 000 $316 400
collected on credit; 70% × $452 000 = $316 400
(ii) 70% of the credit sales are
collected within April, the month
of sale.
March credit sales (i) 80% of March sales of $500 000 are 80% × $500 000 = $400 000 $80 000
collected on credit; 20% × $400 000 = $80 000
(ii) 20% of the March credit sales are
collected in April, the month after
the sale.
February credit sales (i) 80% of February sales of $300 000 80% × $300 000 = $240 000 $16 800
collected are on credit; 7% × $240 000 = $16 800
(ii) 7% of the February credit sales are
collected in April, two months after
the sale.
(b) Schedule of cash payments (in April 20Y1) from material purchases
Key items:
(i) Raw materials costs are 20 per cent of sales revenue.
(ii) Raw materials are purchased in the month before they are converted into final
products and sold.
(iii) 50 per cent of these RM purchases are paid for immediately with cash.
(iv) 50 per cent of these RM purchases are paid in the month after they are bought.
March credit – March purchases are 20% of April 20% × $565 000 = $113 000 –$56 500
purchases sales of $565 000 50% × $113 000 = $56 500
– 50% of this is paid for in March, and
50% is bought on credit and paid
for in April, one month later.
April cash purchases – April purchases are 20% of May 20% × $600 000 = $120 000 –$60 000
sales of $600 000. 50% × $120 000 = $60 000
– 50% of this is paid with cash
immediately in April (the remainder
is settled in May)
MODULE 1
Payments to suppliers and employees
$234 700
$3 000
Question A1.5
Some items to note when answering Question A1.5:
• Capital is part of equity.
• Net cash from operations is from the statement of cash flows. It represents the sum of all
operating cash inflows (e.g. sales revenue) and all operating cash outflows (e.g. payments
to employees and suppliers).
(b)
Efficiency ratios
(c) The company appears to be falling short in its working capital management in several areas.
Sportz Watch’s inventory and accounts receivable are relatively high and are contributing to
the high working capital ratio result. Its inventory levels may be too high, as they are being
held for too long (111 days). Issues that may arise from this delay are obsolete and damaged
stock and increased holding costs. Without further information, it is difficult to determine
whether accounts receivable turnover is too slow (i.e. if normal credit terms with customers
are 30 days) or if turnover is good (i.e. if credit terms are 60 days).
The business cycle is taking approximately 168 days from purchase of inventory (day 0) to
payment (92 days), to sale of goods (111 days—an additional 19 days) to cash collections
(57 days after sale). The cash cycle is taking approximately 76 days (111 days—92 days +
57 days) from payment of credit purchases to collection of credit sales. This shows that there
is scope for improvement to reduce this length and reduce the need for additional cash to
support the business through this period.
Sportz Watch has a working capital ratio of 2.9, which indicates a very strong or even excessive
short-term liquidity position. This means for every dollar of current liabilities, the company
has almost three times as much in current assets. This could indicate the company has too
many liquid assets that do not generate a sufficient return. Another way of describing this is
that Sportz Watch has too much working capital tied up in inventory and accounts receivable.
Appendix 1.1 Suggested answers | 101
An assessment of Sportz Watch’s ability to immediately pay off short-term debts shows a
quick asset ratio of 1.7. This means that it has a sufficient amount of liquid current assets to
pay off its current liabilities, so this is a reasonably strong position.
Accounts payable present another set of issues. Although late payments (averaging 92 days)
may help a company’s cash position, delaying payment over 60 days may affect relationships
with suppliers, who may refuse to continue supplying, increase prices or demand shorter
credit terms before supplying in the future. This is a strong indicator that the company has
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efficiency issues that need to be carefully managed.
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Suggested answers | 103
Suggested answers
Suggested answers
MODULE 1
Question 1.1
The not-for-profit sector often provides services for less than they cost. Funding to provide these
services is often difficult to obtain and can come from the government, grants, donations or
membership subscriptions. It is essential that these organisations demonstrate accountability
for resources employed and the successful attainment of objectives for their operations to
remain sustainable in the long term. Strategic management accounting supports this through
developing effective performance measures, as well as detailed accounting of resource
allocation, consumption and outcomes.
The public sector has a responsibility to provide services and be accountable to citizens
(taxpayers). This requires the allocation of resources (billions of dollars annually for the public
sector and hundreds of thousands of employees), which need to be measured, controlled and
allocated. Both cost and effectiveness must be considered, and it is essential that detailed
performance measurement systems are in place to ensure plans are implemented successfully.
The public and not-for-profit sectors often have a broader role as a result of their service
objectives, which are often difficult to quantify in financial terms. For management accountants,
this requires an even greater level of effort to effectively combine non-financial information and
performance measures.
Strategic management accounting is much more than just product costing and overhead
allocation. For organisations to be successful (i.e. meet their goals and objectives), they require
resources, strategies, action and control. Strategic management accounting provides useful
information in each of these areas to enable organisations to achieve their goals and objectives.
Even though they are not focused on making profits, the public sector and not-for-profit sectors
must still work hard to achieve their strategic outcomes with the resources they have available.
This requires financial discipline and clever and sound decision-making.
104 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Services also need to be costed to ensure resources are being allocated and used appropriately.
Often, it is more difficult to cost services because they are intangible compared to physical
products made from combinations of raw materials.
Question 1.2
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2. If an organisation exports products or services, the price for foreign-based buyers will
be higher than it was previously. This may make prices higher relative to foreign-based
competitors, which may make it difficult to remain competitive.
3. Some organisations believe they are not affected by changes in currency rates because they
do not import or export their products or services. This is not always correct, because even
in this situation problems may arise. Costs or prices may not change, but the local prices of
foreign competitors’ imported products will be lower than they were previously. This might
also encourage new foreign competitors to enter the marketplace.
The opposite is typically true if the local currency becomes weaker. Note that other issues may
also exist.
Question 1.3
The answer to this question will depend on the organisation chosen.
In addition, just as the company’s customers are becoming interested in foreign brands,
the resistance of overseas customers to the company’s brand of soup noodles is likely to be
replaced with receptiveness, as television and online advertising conveys the brand’s distinctive
qualities. People in neighbouring countries may have more disposable income to try out
new products and are developing the curiosity to do this. As international competition is
consolidating in the region, the choice is to join this regional competition or remain a smaller
domestic brand facing erosion of local market share by overseas competitors.
Suggested answers | 105
Question 1.4
Some examples of changes to management accounting as a result of technological
developments include the following:
• Capital intensive. Investment in technology often requires significant amounts of cash.
As a result, accurate cash flow planning and management is essential to ensure stability.
• Shorter product life cycles. Products exist for a much shorter period than in the past, as they
are superseded by technological developments. At the same time, greater investments
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in technology are required to keep up with the competition and ensure that returns on
investment are recouped in the shortest time possible. Appropriate pricing, product
characteristics and life cycle costing are essential to ensure an appropriate return.
• Automated sales, production and farming methods. Technologies are reducing the
amount of manual labour required, which changes the nature of costs from variable to fixed.
This is because labour is usually a variable cost that is linked to sales volume or production
levels. Automating a process by implementing new technology (e.g. self-scanning of
shopping by customers in supermarkets) or purchasing a large piece of machinery at a fixed
price and removing the manual labour element shifts a greater proportion of a business’s
costs to fixed costs. It also changes when costs are committed to and incurred very early
in the development stages as opposed to during production. Project estimations and
evaluations must be more accurate, and effective allocation of overhead is essential.
• Information. Vast amounts of information may now be stored, tracked, analysed and
communicated across multiple locations in a short time. Management accountants have
had to give up their role as information gatekeepers and transfer the power to access this
information to other employees throughout the organisation.
Question 1.5
Possible advantages of outsourcing business operations include the following:
1. risks may be shared with, or transferred to, another organisation;
2. using outside specialists may be more efficient and more cost-effective; and
3. managers no longer have to spend time directly managing the parts of the organisation that
have been outsourced—this will give them more time to focus on generating value in the
areas where they are most competent and comfortable.
Question 1.6
While this list is not exhaustive, additional factors that have affected organisations and driven
change include the following:
• Quality. In today’s environment, quality is no longer an extra to help attain a premium price
for your product. It is an essential characteristic of not only the outputs of an organisation,
but of the individual processes that link together to produce the final product.
• Customer focus. The power of today’s customers is growing as strong competition provides
MODULE 1
them with choice and lower prices. The need to make products and deliver services that
customers desire is essential. Instead of pushing products towards them, organisations are
now expected to understand customers’ needs and then develop and sell solutions for those
needs. This has led to a major reorientation within organisations.
• Changing political structures around the world. Wars, shifts towards Western-style
capitalism and the development of new major economic powers, including China and India,
may all affect organisations.
Question 1.7
The overall role of strategic management accounting is to support management with useful
information, so at a broad level, it is doubtful that this role will change. Even if the basic functions
(e.g. planning and controlling) of management do change over time, or managers pursue new
and innovative responses to address contemporary challenges, it is unlikely that this support role
will change.
However, the way this support is provided may change. The management accounting role has
continued to expand, and the way it supports management has changed drastically over time.
From pure financial information delivery to a broader range of non-financial measures, business
support and involvement, the role continues to change and develop to stay relevant.
Question 1.8
Strategic management accounting information may be used as follows (note that this list
is not exhaustive):
• Urban growth. Establish capital budgets for new buildings and infrastructure.
• Transport. Cost various traffic management systems, including new roads, traffic lights
and road infrastructure (e.g. roundabouts and bicycle lanes). Set prices for things such
as car parking that encourage pedestrians and bicycles and discourage cars in particular
areas. Calculate the cost of transport incidents, and establish benchmarks and benefits
for improving transportation options.
Suggested answers | 107
MODULE 1
Question 1.9
Separating tasks between employees and requiring independent verification of key activities
help to reduce internal control problems by reducing the possibility of fraud or mistakes and by
increasing the chance of detecting problems.
Appropriate measures to protect both tangible and intangible assets are essential to reduce not
only fraud, but also accidents and mishaps that cause damage to assets or injury to employees.
Documents that capture information that is both accurate and complete are essential to
organisational systems and as a point of authentication and verification of key tasks and activities.
Documents provide an audit trail of actions that allow the examination of past events.
Effective reconciliations and other cash control measures, such as requiring joint signatures
on cheques, banking all cash daily or using only cheques and electronic funds transfers (EFTs),
are essential for protecting cash resources.
Question 1.10
Several internal control issues arise with Jan’s position performing the combined roles of
receiving customer orders and processing customer payments. Jan also processes invoices,
writes cheques and mails them.
Simon appears to be in charge of both initiating the purchasing process and raising the purchase
orders. This gives Simon several opportunities to commit fraud without being detected and
enables his mistakes to go unnoticed.
It may be useful to separate the roles and spread the responsibilities more clearly between
Jan and Simon and, possibly, other workers. In addition, independent verification of orders and
receipts of payments would be essential.
Additionally documents that collect relevant data for each task (e.g. purchase requisitions,
purchase orders, customer orders, customer receipts and delivery dockets) must be created,
verified for accuracy and stored accordingly. These documents should be pre-numbered in
sequential order to account for the completeness of transactions and to check for errors or fraud.
The security of physical assets would be a high priority, as many computer parts are very small
and valuable.
108 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Cash control measures that may be useful include: dual signatures on cheques and frequent bank
reconciliations to check for errors or fraud. Jan should not be given the task of opening the mail
as well as processing customer payments. These two tasks should be segregated. Preferably,
two staff members should be present when the mail is opened, and a listing of the customer
payments received should be made. All customer payments should be deposited into the bank
on the same day they are received as opposed to every second day.
MODULE 1
Owners The Jones family own 95 per cent of HZ. In addition to financial returns, they are
likely to gain value from receiving employment, career opportunities and the
ability to guide the direction of the company. Owners of the other 5 per cent
would probably be focused on seeing solid returns that compensate for the risk
and the level of investment they have made.
Lenders Being able to lend appropriate levels of money that will generate interest while
ensuring the company is able to repay them over time. Things that will destroy
value include insufficient cash flows or profits to repay the interest or principal.
Customers Electrical products that comply with safety standards are of high quality and
reasonable price, with good services attached including warranty support.
Suppliers Contracts that generate sufficient revenue for the costs involved as well as strong
and reliable working relationships.
Employees Appropriate reward for the effort contributed to the company in terms of both
monetary returns and qualitative items, such as recognition and job satisfaction.
Value would be destroyed by having conflicting management requests (i.e. having
to serve two masters).
Community groups Ensuring that products are safe to use, sustainable in terms of their raw materials
and recycled at the end of their life would all be seen as valuable to different
groups within the community.
References | 109
References
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MODULE 1
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110 | INTRODUCTION TO STRATEGIC MANAGEMENT ACCOUNTING
Dodgson, M. 2004, ‘Most admired traits: The Big Six—Innovate or die’, Business Review Weekly,
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emirates-tieup-but-silent-on-benefits-20140401-35vlh.html.
Gelinas, U. J. & Sutton, S. G. 2002, Accounting Information Systems, 5th edn, South-Western,
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IBM Corporation 2004, Your Turn: The Global CEO Study 2004, IBM, Sydney.
International Federation of Accountants (IFAC) 2005b, ‘The roles and domain of the professional
accountant in business’, Information Paper, Professional Accountants in Business Committee,
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publications/files/the-roles-and-domain-of-the.pdf.
International Federation of Accountants (IFAC) 2011, ‘Competent and versatile: How professional
accountants in business drive sustainable organizational success’, IFAC, New York, accessed
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professional-accountants-business-drive-sustainab.
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LoFaso, J. 2014, ‘Destroyed by fertilizer, A tiny island tries to replant’, 3 March, Modern Farmer,
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BRW-Emission-Magician.pdf.
MODULE 1
Sharma, R. 1998, ‘Management accounting: Where to next?’, Australian CPA, December, pp. 24–5.
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GEP2014b.pdf.
MODULE 1
STRATEGIC MANAGEMENT ACCOUNTING
Module 2
CREATING ORGANISATIONAL VALUE
BRIAN CLARKE*
* The author acknowledges the use in this module of some of the content previously prepared
by Peter Robinson. Updated by Robert Cornick.
114 | CREATING ORGANISATIONAL VALUE
Contents
Preview 115
Introduction
Objectives
Teaching materials
Review 190
Reading 191
Reading 2.1 191
References 231
Optional reading
Study guide | 115
Module 2:
Creating organisational
value
Study guide
MODULE 2
Preview
Introduction
The ability of any organisation to thrive depends on a variety of factors, but fundamentally,
an organisation must develop and maintain a sustainable competitive advantage. Competitive
advantage is often misunderstood. According to Magretta’s analysis of Michael Porter’s influential
work, achieving a sustainable competitive advantage ‘is not about beating rivals; it’s about
creating superior customer value’ (Magretta 2011).
Another common misunderstanding is that only private sector organisations must secure
a sustainable competitive advantage. However, in the public and not-for-profit sectors,
the continued support offered by government funding, donations or membership fees is
generally conditional upon an organisation’s ability to achieve desired goals and outcomes in
an efficient and effective manner. All organisations compete for resources and customers.
Sustainable competitive advantage and the efficient and effective delivery of outcomes flow
from an organisation’s ability to develop and display its value-adding capabilities. The more an
organisation creates value for stakeholders, the greater its ability to attract ongoing investment
and support.
Understanding how an organisation creates value is important for the organisation’s managers
and other stakeholders. The contribution of CPAs to the development of this understanding
cannot be overestimated. In this module, Part A examines the concept of the value chain and
the role of the management accountant in generating information for management and other
stakeholders about value-creating activities and value chain performance. This introduction
provides the foundation for a more detailed examination, presented in Module 4, of the strategic
management accounting tools used to increase organisational value in a sustainable way.
116 | CREATING ORGANISATIONAL VALUE
The ability to deliver long-term value and secure a competitive position depends on how
well an organisation develops and executes its strategy. Part B of this module provides an
overview of the strategic management process. It illustrates how organisations collect and
analyse strategically relevant information to develop an achievable set of objectives centred
on stakeholder value. Having developed objectives, organisations then consider alternative
strategies and choose the best strategies for implementation. Implementation is supported by
the development of management accounting systems that monitor key performance measures
and provide feedback for timely revision of the objectives and strategic plan, thus completing the
strategic management cycle. Measuring the performance of business units and their managers,
in terms of their success in achieving strategic objectives, is discussed in Module 3.
You will recall from Module 1 that HZ Electrical Pty Ltd (HZ) is a hypothetical case study used to
illustrate strategic management accounting issues. In this module, you are required to evaluate
the strategic planning processes employed by HZ.
E E
n n
v v
i i
r r
o Value o
n n
m m
e Vision / Mission e
n n
t Goals and objectives t
a a
l Strategy—Creation l
RESOURCES SYSTEMS
a a
n Strategy—Implementation n
a PROJECTS a
l l
y Strategy—Implementation y
s VALUE CHAIN s
i i
s Control and feedback systems s
Objectives
After completing this module, you should be able to:
• explain and apply organisation and industry value analysis in understanding value drivers
and in reconfiguring value chains;
• apply the strategic management framework to develop and implement organisational strategy;
• apply tools for internal and external strategic analysis; and
• identify strategies that organisations can adopt to deliver value to stakeholders.
Teaching materials
• Reading
Reading 2.1
‘Strategic cost management and the value chain’
J. Shank and V. Govindarajan
• Links to resources
In this module, links to websites with podcasts and videos are provided. These are optional
supplementary resources, which are included to assist you in understanding the concepts
contained in this module. The content of these optional supplementary resources is
not examinable.
Study guide | 117
Organisations exist to provide value to stakeholders, and this is achieved through the process
of corporate governance. Corporate governance is the set of processes by which business
corporations are directed and controlled, and includes both a conformance element and a
performance element.
MODULE 2
The conformance element of corporate governance refers to compliance with corporate policy
and outside regulation.
Two analytical tools for understanding and enhancing value creation are introduced in
Part A—the organisation value chain and the industry value chain. The organisation’s value
chain comprises the input-transformation-output processes carried out by an organisation to
provide value to customers and other recipients of the organisations’ products and/or services.
The industry value chain comprises the chain of separate organisations operating in a particular
industry. In a manufacturing setting, this would begin with raw material acquisition, followed by
the production process itself, sales to the final customer and, where appropriate, the provision
of after-sales support.
The final section of Part A discusses the impact of the value chain concept on management
accounting practice. It highlights that management accountants—by identifying and measuring
activities, their inputs and outputs, and their value drivers—can generate relevant data to achieve
and enhance organisational value creation. The importance of managing linkages with suppliers
and customers within the industry value chain is also emphasised.
Organisations
Why do we have organisations? Because organisations are an efficient means of organising the
production of goods and services.
A market is a location (either virtual or real) where resources are bought and sold. The most familiar
markets are consumer markets where people buy food, clothing and services. Other markets
exist where business or government organisations purchase goods and services from each
other, and there are markets that are internal to large corporations (e.g. Shell with exploration,
refining and distribution) or to networks of organisations where related business units deal among
themselves (e.g. the One World Alliance—a group of airlines).
118 | CREATING ORGANISATIONAL VALUE
Economics tells us that the interaction of demand and supply in a market (i.e. the interaction
between buyers and sellers) determines the quality, quantity and price of resources exchanged.
However, this is a simplified view and market failure does occur. In fact, the concept of a
‘perfect market’ is an ideal. No real market is perfectly efficient and competitive. In real markets,
the relationship between demand and supply is affected by several factors, including monopolies,
available information, timing issues and price and demand elasticity.
The demand elasticity for some goods is low. For example, demand for consumer staples
(like milk, bread or petrol) is relatively fixed and does not respond greatly to price changes.
In contrast, demand for other goods like consumer electronics is highly elastic; demand can
fluctuate rapidly in response to consumer sentiment, virtually regardless of price.
Another drag on markets is the mismatch between the timing of production and consumption.
As the supply of most goods depends on long-term investments in manufacturing, farming
or mining capacity, markets are frequently unable to respond in a timely way to demand
fluctuations, and price bubbles or price collapses often occur. An example is the US housing
market collapse that contributed to the global financial crisis (GFC) of 2008. Housing prices
MODULE 2
So, if markets are not always efficient, how should transactions be organised? According to
Coase (1937), business organisations exist because they offer an efficient alternative way
of organising transactions.
Transaction costs
A transaction cost is a cost ‘incurred in making a bargain, over and above the benefit exchanged’
(Law 2009). In other words, it is a cost on top of the price of products or services, but that is often
needed in order to ‘do business’. Transaction costs occur in every transaction—whether within
a business, between businesses, or in consumer markets. Examples of transaction costs include
the costs of writing contracts, collecting information and negotiating. Transaction costs are not
value adding and should be minimised.
Where transactions are simple and transaction costs are low—for instance, buying an apple—
buyers and sellers will trade in the market and there will be many small businesses engaged in
this sort of trade. For example, think of the many small fruit and vegetable shops that exist.
However, when transaction costs are high and transactions can be more economically
performed within an organisation than an external market, the large business organisation
emerges. Large organisations are more efficient at organising complex transactions than are
markets because the people within the organisation are more likely to cooperate to complete
transactions, and have greater cause to trust each other.
Examples of activities normally performed within large organisations (in order to minimise the
substantial transaction costs involved) include banking, car manufacturing and power generation.
To enter these industries, a high level of investment in both tangible assets and human capital is
required. Significant economies of scale and scope, and information advantages are available to
these large organisations, and these advantages can significantly reduce transaction costs.
Study guide | 119
While these costs may not seem significant at first glance, consider a major project: the purchase of
a light rail system for Vancouver by the provincial government of British Columbia. This was a multi
billion dollar project and the contract document ran to several volumes (thousands of pages). In order
to negotiate and write such a contract, a team of lawyers, engineers, accountants and top level
government personnel were busy for over a year—an enormously expensive exercise. Following the
signing of the contract, teams of accountants and other professionals were involved in guiding its
implementation and ensuring that the contractor fulfilled its obligations.
MODULE 2
to employees for their work are not transaction costs, there are ‘employment-related costs’ that are
necessary for the continuing operation of the organisation. These costs are not incurred as a result of
creating products and/or services, but they do add to the overall cost of employment. Examples include:
• advertising;
• interviewing and gathering information about potential employees;
• selecting employees;
• writing contracts;
• training;
• paying incentives or bonuses to employees; and
• monitoring the performance of employees.
Professional associations (like CPA Australia) and unions exist to reduce transaction costs for members
and employers by providing assurance about the competence and trustworthiness of current and
potential employees. This assurance reduces transaction costs for all labour market participants.
Transaction costs are important because they form a very significant and, as the size of
organisations in our society increases, a continually increasing part of the value chain.
The increase in transaction costs raises questions for organisations and for management
accountants, including the following:
• How can transaction costs be identified, measured and managed effectively (i.e. minimised
or eliminated)?
• How are these costs to be shared within a value chain?
• Can an organisation successfully transfer some of its transaction costs to its suppliers,
customers or other stakeholders?
A typical transaction cost problem confronting many organisations is the ‘make or buy’ decision
that arises when organisations consider outsourcing some of their activities to reduce costs or
to access the expertise of other organisations. Careful analysis of the costs and benefits of each
option is a critical role for the management accountant.
120 | CREATING ORGANISATIONAL VALUE
Unfortunately, the business failed to appreciate the complexity of managing the contractual relationship
with the overseas manufacturer. Quality was poor and all product that arrived in Australia had to be
unpacked, checked and re-packed. The additional quality-control costs exceeded the savings, and the
business came near to bankruptcy before solving its problems.
Corporate governance
MODULE 2
Organisations are controlled through the process of corporate governance (CG). Key elements
of CG are shown in Figure 2.2.
The two dimensions of CG shown in Figure 2.2 are conformance (which is historical in its
orientation) and performance, (which is forward-looking). The conformance element is achieved
through codes and standards imposed and monitored up by audit and assurance. The International
Federation of Accountants (IFAC) notes that the key conformance components are:
• culture and tone at the top;
• the Chief Executive Officer (CEO);
• the board of directors; and
• internal controls (IFAC 2004, p. 9).
Corporate
governance
Conformance Performance
(accountability (strategy and
and assurance) value creation)
Source: Adapted from International Federation of Accountants (IFAC) 2004, Enterprise Governance:
Getting the Balance Right, accessed July 2015, https://www.ifac.org/publications-resources/
enterprise-governance-getting-balance-right.
Please note that a discussion of corporate governance, with a specific focus on conformance,
is contained in the ‘Ethics and Governance’ subject of the CPA program.
Study guide | 121
The performance element is focused on helping the board of directors to make strategic
decisions. Strategic planning, risk management and performance measurement are fundamental
features. IFAC (2004, p. 10) notes that the performance element depends mainly on the:
• choice and clarity of strategy;
• strategy execution;
• ability to respond to changes; and
• ability to undertake successful mergers and acquisitions (according to IFAC, this is the most
common cause of strategy-related failure).
The purpose of CG is to control organisations, but to what end? According to IFAC (2011),
organisations should achieve financial, social and environmental goals—a ‘triple bottom line’.
Together, the triple bottom line goals define sustainable practice. In short, the purpose of
organisations and of CG is sustainability.
MODULE 2
and productivity are conserved, the flow of energy and matter is moderated, and the economy is
converted to rely on renewable resources and resilient technologies … [with respect to people]
… A sustainable society democratises its political and workplace environments, humanises capital
creation and work, and vitalises human need fulfilment, ensuring sufficiency in meeting basic needs.
Source: Gladwin, T. N. 2000, ‘A call for sustainable development’, in T. Dickinson (ed.),
Mastering Strategy, Financial Times, Prentice Hall, Harlow, p. 97.
Friedman (1970) was an influential economist who is often cited because he argued that the sole
responsibility of a business’s management is to ‘increase profits and maximise the value provided
to shareholders’. Some people interpret this statement to mean that business managers need
not concern themselves with ethical, social or environmental matters outside of what is required
by the law, or with any stakeholder other than the shareholder. This is an incorrect interpretation.
In order to increase profit and maximise shareholder value in a sustainable way, managers must
act ethically and responsibly. If they do not, the organisation is put at risk. Breaking the law
through fraud or anti-competitive actions is one obvious source of risk, but reputation effects are
also critically important. Development of a culture of ethical and responsible behaviour is one
of the most important risk management practices that can be introduced by a board of directors
to ensure an organisation’s success.
Responsibilities to ‘other’ stakeholders are increasingly being defined more broadly in our
society. They include responsibilities to the:
• workforce, including the employees of suppliers and customers (see Example 2.5);
• community, including both the local community where the business operates, and the
global community (community values address health, education, poverty, recreational,
and spiritual and aesthetic values); and
• environment, both local and global environmental values include values relating
to air and water quality, climate stability, prevention of erosion, animal and plant
species conservation, preservation of genetic resources and control of biochemicals
(e.g. carcinogens like diesel exhaust).
These responsibilities are broadly termed corporate social responsibility (CSR), or alternatively,
corporate citizenship.
CSR can be defined as the extent to which an organisation accepts the economic, legal,
ethical and discretionary responsibilities expected by stakeholders. Discretionary responsibilities
are those that extend beyond economic, legal and ethical responsibilities, and that exist
for the betterment of society. For example, a discretionary responsibility might arise when a
corporation provides support for a community health facility or a sporting club.
122 | CREATING ORGANISATIONAL VALUE
Along with the business case for CSR, it can be argued that CSR is important because it links CG
with business ethics. Ethics are the belief systems that people use to judge behaviour; they deal
with what is ‘right’ and ‘wrong’ and how people ought to act when faced with a particular
situation. Systematic support or structured approaches to making ethical decisions are important
for good governance. A business actively pursuing a heightened CSR strategy will be more likely
to have these supports and approaches in place, increasing the likelihood that the business
and its employees will operate in an ethical manner. Organisations that are socially responsible
typically show a high level of awareness of legitimate stakeholder demands, and are responsive
to these demands.
The commitment and approach to Social Responsibility is further demonstrated in the company’s
2014 comprehensive (36 page) Sustainability Review, which details how the sustainability strategy is
delivered through the following five broad domains:
1. Environment;
2. Community;
3. Workplace;
4. Market place; and
5. Economy.
To ensure that information allows for benchmarking against various international standards and
corporate peers, reporting is in accordance with the Global Reporting Initiative (GRI) Sustainability
Reporting G4 Guidelines, AccountAbility’s AA1000 Assurance Standard (2008) and the Australian
Standard on Assurance Engagements ASAE3000.
MODULE 2
• 16 per cent in water use intensity.
Source: Adapted from Amcor 2014, Amcor Sustainability Review 2014, accessed September 2015,
http://www.amcor.com/getmedia/c79e9ca5-3f4e-4907-9af6-fe1dfbccac31/SR-review-2014.
Management accountants need to develop high-quality CSR systems. Such systems identify
stakeholder groups and the financial, social and environmental requirements of these stakeholders.
CSR systems then contribute to the formation of goals and objectives, and report on progress
towards achievement of these objectives.
Example 2.5 highlights the importance of CSR and what can occur when there is a negative
perception of an organisation.
The US Constitution states that child labour is an illegal and inhumane practice, and any US organisation
found guilty of practising or encouraging it will be prosecuted.
Although Apple did not directly control production in China, the adverse media attention generated
by these events resulted in significant protests by human rights activists across North America and
elsewhere.
124 | CREATING ORGANISATIONAL VALUE
As a result of this and other incidents of unsatisfactory work practices at some its subcontracted
manufacturers, Apple has subsequently vowed to completely eliminate child labour from its supply
chain. While Apple’s audit reports show improved conditions, there are still some problematic issues
in this regard within Apple’s supply chain. This highlights the complexity of effectively dealing with
these matters in an increasingly global business environment.
If Apple had an appropriate CSR management system in place earlier, these problems might have
been identified and avoided. Unfortunately CSR issues persist and Apple is still in the public eye
(Meyers 2014).
MODULE 2
➤➤Question 2.1
Examine your own organisation, or one with which you are familiar (such as the university you
attended). Identify the key stakeholder groups who have an interest in the organisation, and the
corporate social responsibilities (environmental and social goals) that are demanded of the
organisation by the stakeholder groups. Use the following table to organise your answer.
Organisation
The IFAC framework makes it clear that sustainability requires an organisation to take full account
of its impact on the planet and its people. This means:
• promoting ethical responsibility and sound corporate governance;
• providing a safe working environment;
• promoting cultural diversity and equity;
• minimising adverse environmental impacts; and
• providing opportunities for social and economic development of communities.
You can see an example of the requirements and guidelines for social impact assessments from
the Department of State Development, Infrastructure and Planning (in Queensland, Australia) at:
http://www.dip.qld.gov.au/assessments-and-approvals/social-impact-assessment.html.
Creating value
What do organisations do? Organisations create value in a sustainable way.
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Porter (1985) focuses on the importance of customer value:
Value is what buyers are willing to pay, and superior value stems from offering lower prices than
competitors for equivalent benefits, or providing unique benefits that more than offset a higher
price (Porter 1985, p. 3).
Kaplan and Norton (1992) focus on customer value as a leading indicator of shareholder value:
A company’s ability to innovate, improve, and learn ties directly to the company’s value. That is,
only through the ability to launch new products, create more value for customers, and improve
operating efficiencies continually can a company penetrate new markets and increase revenues
and margins—in short, grow and thereby increase shareholder value (Kaplan & Norton 1992, p. 76).
Thakor (2000) suggests that it is most important to focus on shareholder value because
shareholders are the residual claimants on the organisation’s resources. That is, other stakeholders,
like suppliers, customers and employees, will receive their share of organisational value before
shareholders receive theirs.
An organisation creates value for stakeholders when the revenue it receives for the products or
services it supplies to customers is greater than the direct costs and opportunity costs of the
resources used. For any production process or activity:
If you are familiar with the calculation of Economic Value Added or Residual Income you should
recognise this formula. In the residual income calculation, the opportunity cost is represented by
a ‘notional’ capital charge. Clearly, value can be increased by increasing benefits or by decreasing
direct costs or opportunity costs. Table 2.1 illustrates in a simple way how value can be measured
at different levels.
126 | CREATING ORGANISATIONAL VALUE
Business unit (BU) Total BU revenue Costs traceable to the Cost of capital employed
BU by the BU
Product line Product revenue Costs traceable to the Cost of capital assets
product traceable to the product
Activity—e.g. quality Reduced failure costs— Costs traceable to QC Cost of capital assets
control (QC) spoilage and warranty activity—prevention traceable to QC activity;
cost and monitoring cost of lost business
While there are many differences between organisations, all successful organisations create
value by:
• competing for resources;
• processing or transforming the resources in a value chain; and
• supplying a product or service that meets the needs of their customers.
Understanding, measuring and managing the value creation process are critical strategic
management accounting activities. The value creation process is shown in Figure 2.3 and
illustrated in Example 2.7.
The activities that transform inputs into outputs create customer value. In order to maximise
value creation, the management accountant must answer three questions:
What are the key value drivers of the activity?
How do these value drivers affect some measure of value?
What innovations in the management of these drivers can be introduced?
The model described in Figure 2.3 can also be applied to the not-for-profit sector.
Example 2.7 shows how the model can be applied to a not-for-profit organisation that
is a charity for the homeless.
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Value drivers
It is the management accountant’s job to identify and measure value drivers as well as measure
the inputs and outputs of value-creating activities in order to plan for, control, and maximise
value creation.
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According to Thakor and DeGraff et al. (2001), for example, there are four main types of strategic
value drivers:
• collaboration;
• innovation;
• efficiency; and
• market awareness.
These four value drivers sometimes require trade-offs to be made, especially between efficiency
and the other three, and each organisation will be positioned differently with respect to the four
value drivers.
The chosen value drivers, or the organisation’s value proposition, have a determining effect on
the organisation in:
• the way that resources are allocated;
• the way performance is measured and rewarded; and
• the organisational culture and leadership style.
For example, in a factory, the main value drivers might relate to efficiency and include employee
training, employee talent, the factory layout and the complexity of the manufacturing process.
Innovations in these value drivers should lead to outcomes like shorter cycle times or reduced
waste, which lead in turn to a lower product cost and increased value.
➤➤Question 2.2
Examine your own organisation or choose a familiar organisation like McDonald’s or Toyota.
Describe the goals and the input-transformation-output-outcomes model (i.e. the value chain)
of the organisation.
128 | CREATING ORGANISATIONAL VALUE
Consider the following questions about your organisation or an organisation you are familiar with.
Does the organisation:
• reward employees for under-spending their budget and decreasing the use of resources in
order to create additional value?
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• seek out and eliminate competitive activities within the organisation that destroy value?
• reward cross-functional collaboration?
• reward employees for identifying activities that could be performed more efficiently outside
their own functional area, whether by another functional area, or by outsourcing?
• encourage job rotation to ensure that employees understand the capabilities and
requirements of other functional areas?
Stakeholder value
As noted earlier, the goal of all organisations is sustainable value creation. In order to understand
the nature of the value that is to be created, and how this can be achieved, the management
accountant must understand the organisation’s stakeholders.
A useful way to think about an organisation is as a coalition of stakeholder groups who are
simultaneously competing for resources and collaborating to make the organisation successful.
In order for the organisation to survive and prosper, each stakeholder must make a contribution
to the organisation, and each stakeholder must get something they value in return for their
contribution. Table 2.2 shows how different organisations offer different value propositions
to stakeholders.
Community Land and workers Employment opportunities, taxes, clean air and water
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As can be seen from Table 2.2, delivering value to stakeholders requires organisational
resources. Because all value delivery requires some economic outlay, all stakeholder groups
are in competition for scarce resources. No stakeholder group will ever get everything that
they want, yet they must all get enough to ensure their continuing cooperation, and so ensure
the sustainability of the organisation. Finding an acceptable balance for all of the competing
claims of stakeholders is a key responsibility of top management and is an essential part of
strategic thinking.
Example 2.8 shows Origin Energy’s Value Distribution schedule from their 2014 GRI Disclosures.
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Community 7 0.3
Source: Adapted from Origin Energy 2014b, GRI: Economic, p. 1, accessed October 2015, http://www.
originenergy.com.au/content/dam/origin/about/our-approach/sustainability-gri-economic-2014.pdf.
Understanding and balancing the claims of stakeholders is a particularly challenging task for
not-for-profit organisations. Donors are the main source of revenue for many not-for-profit
organisations, yet donors do not receive a product or service for their contribution. The value
donors receive is intangible, and largely invisible. People must be convinced that a real need
exists and the not-for-profit organisation, as opposed to a competing charity or a government
service, is the best hope for addressing the need. The not-for-profit organisation needs to
demonstrate that what donors value is consistent with its mission and accomplishments.
When organisations fail to satisfy the needs of their stakeholders, in this case the governments/
communities of the countries where Apple operates, then the coalition of stakeholders breaks
down and the organisation risks large penalties or even failure. Similarly, when governments
are unable to collect taxes, they cannot provide the physical and administrative infrastructure
necessary to support a modern economy, and the sustainability of the national economy is
brought into question. Professional accounting associations like CPA Australia contribute to
the sustainability of organisations and of national economies by developing and enforcing the
Code of Ethics for Professional Accountants.
130 | CREATING ORGANISATIONAL VALUE
In the longer term, the relationship between employee, customer, supplier and shareholder value
is not one where benefits and costs completely offset each other. There are always opportunities to
create additional value throughout the organisation’s value chain by effective employment of the
value drivers noted above; that is, collaboration among stakeholders, innovation, efficiency and
market awareness. Good strategic planning and execution can deliver this overall increase in value.
Example 2.9 demonstrates the approach taken by Shell to ensure that strategic initiatives are
aligned with the overall objective of value creation.
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The company was early to recognise the benefits of incorporating sustainability as an integral element
of its value creation strategy—the 1998 Shell Annual Report introduced a number of new terms linked to
sustainable development, including the (then) relatively new concept of the ‘triple bottom line’ (TBL)†.
†
This term was first coined in 1994 by John Elkington, the founder of a British consultancy called SustainAbility
who argued that companies should be preparing three different (and quite separate) bottom lines. One is
the traditional measure of corporate profit—the ‘bottom line’ of the profit and loss account. The second is
the bottom line of a company’s ‘people account’—a measure of how socially responsible an organisation has
been throughout its operations. The third is the bottom line of the company’s ‘planet’ account—a measure
of how environmentally responsible it has been.
The TBL thus consists of three Ps: profit, people and planet. It aims to measure the financial, social and
environmental performance of the corporation over a period of time.
Nearly 20 years later, Shell continues to remain true to this philosophy, as evidenced by the following
statements from the 2014 Annual Report:
… The company strives to create competitive returns for shareholders by continually reinforcing
its position as a leader in the oil and gas industry while helping to meet global energy demand
in a responsible way. Safety, environmental and social responsibility have long been at the
heart of the company’s activities …
… Our approach to sustainability starts with running a safe, efficient, responsible and profitable
business. We also work to share benefits with the communities where we operate. And we’re
helping to shape a more sustainable energy future, by investing in low-carbon technologies
and collaborating with others on global energy challenges …
Sources: Shell Global 2015a, ‘Shell global homepage’, accessed October 2015, http://www.shell.com/.
Shell Global 2015b, ‘Environment & society’, accessed October 2015,
http://www.shell.com/global/environment-society.html.
Shell 2014, Sustainability Report, Royal Dutch Shell plc, accessed October 2015,
http://reports.shell.com/sustainability-report/2014/servicepages/downloads/files/entire_shell_sr14.pdf.
Study guide | 131
Since the value an organisation creates is not endless, the share of the value given to some
stakeholders (e.g. customers in the form of lower prices) cannot also be given to others
(e.g. better pay for employees). It is possible that Coles delivered superior value to customers
and shareholders at the expense of employees and suppliers. Downsizing the workforce or
using market power to pressure suppliers (for lower prices) are strategies commonly employed
by large and powerful organisations. One has to question, however, whether an aggressive
approach to extracting value from some stakeholders is sustainable. A collaborative approach to
value creation and organisational sustainability implies a sharing of the gains from value creation
initiatives amongst stakeholders. It also implies increasing available organisational value through
effective strategic management.
➤➤Question 2.3
In your own words provide a definition and a relevant performance measure† for:
(a) organisation value;
(b) shareholder value;
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(c) customer value;
(d) employee value;
(e) community value; and
(f) supplier value.
†
For example, a relevant measure for shareholder value is return on investment (ROI).
➤➤Question 2.4
BikeCo is a family-owned company that has been manufacturing bicycles in Australia for 40 years.
The company manufactures eight models including children’s bikes, road racers and mountain
bikes, and has an above-average quality reputation. BikeCo distributes its products through 500
independent bicycle shops and has a 10 per cent market share. BikeCo’s most recent income
statement is shown below.
Income statement for the year ended 30 June 20Y1
$(000)
Sales (100 000 bicycles × $200) 20 000
Variable cost 12 000
Contribution margin 8 000
Fixed manufacturing costs 4 000
Fixed selling and administration expenses 4 000
Net profit 0
Recently, BayMart (a discount department store chain) offered BikeCo an exclusive three-year
contract for 40 000 bicycles per year. BayMart wants BikeCo to provide private label (house-
brand) bicycles to be sold as the BayMart ‘Charger’ brand. Under the terms of the contract,
BayMart would require BikeCo to hold a two-month inventory of bicycles and would pay BikeCo
an average of $180 per unit, which is 10 per cent less than BikeCo’s current average unit selling
price of $200.
The Australian bicycle market has grown steadily over the past decade and many Australians
prefer to purchase locally manufactured products. However, due to a strong Australian dollar
and high local labour costs, most bicycles sold in Australia are now imported. Automation of
BikeCo’s production process would reduce unit cost, but retooling the factory would be expensive.
Currently, BikeCo is operating its factory at 80 per cent capacity.
132 | CREATING ORGANISATIONAL VALUE
(a) Calculate the factory’s unused capacity and contribution margin per unit.
(b) Using the figures calculated in (a), calculate the total contribution available, and the increase
to BikeCo’s profit, if the full capacity of the factory were to be achieved and sold.
(c) Based on the case facts provided above, identify the value proposition that the company
offers to five stakeholder groups.
Owners
Employees
Bicycle shops
BayMart/Department stores
Consumers
Activities are the means by which an organisation creates value in its products or services.
An activity is any task that an organisation engages in with the intention of achieving a specified
goal. A simple way of understanding activities is that they are ‘what people do’. An accountant,
for example, might engage in activities like bookkeeping, reporting, training, communicating
with clients, and advising. Activities use resources and so incur costs. In combination with other
activities in a value chain, activities provide a product or service that can earn revenue from
customers. In a not-for-profit organisation, activities provide products or services, but these
are focused on providing stakeholder value in less-tangible forms (like the satisfaction a donor
receives when giving to a worthy cause, or the improved health of a hospital patient).
➤➤Question 2.5
Prepare a list of activities for a restaurant and identify the different ways these activities can
create value for customers.
Remember that activities are what people do, so start by identifying the restaurant employees and
their roles. Do not forget the support activities.
Porter (1985) studied the activities of several organisations and developed a generic model of
an organisation value chain (Figure 2.4).
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Porter’s model shown below depicts how a typical ‘push based’ organisation might organise
primary and support activities to procure inputs, add value to the inputs by processing them,
and generate outputs of value to its customers. Primary activities transform resources into
finished products that are then sold to the customer, but primary activities cannot be successfully
undertaken without support activities.
Tables 2.3 and 2.5 provide examples of activities associated with each part of the value chain.
FIRM INFRASTRUCTURE
MA
SUPPORT
RG
ACTIVITIES TECHNOLOGY DEVELOPMENT
IN
PROCUREMENT
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N
INBOUND OPERATIONS OUTBOUND MARKETING SERVICE
GI
LOGISTICS LOGISTICS & SALES
AR
M
PRIMARY ACTIVITIES
Source: Porter, M. E. 1985, Competitive Advantage: Creating and Sustaining Superior Performance,
The Free Press, New York, p. 37. Reprinted with the permission of The Free Press,
a division of Simon & Schuster, Inc. Copyright © 1985, 1998 by Michael E. Porter.
In Figure 2.4 the primary activities, which are shown sequentially at the bottom of the diagram,
are the activities that transform raw materials or resources into finished product. Support
activities, which are shown at the top of the diagram, are indirect activities and––although they
are not directly related to ‘transformation’––without them, the direct transformation process
may not occur.
You should study Table 2.3 to ensure you fully understand that the value chain is a series of linked
and strategically relevant activities providing a competitive advantage to the organisation.
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Inbound logistics Locating, ordering, receiving, handling, storing and controlling the inputs to
the production system.
Marketing and sales Marketing and sales are those activities that inform customers about the
product, persuade them to buy it, and enable them to do so. Activities include
brand development, advertising, promotion, sales order processing and
customer account management.
Service After-sale service augments the value of the product in the hands of the
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Source: Adapted from Viljoen, J. & Dann, S. 2000, Strategic Management: Planning and Implementing
Successful Corporate Strategies, 3rd edn, Longman, Melbourne, pp. 268–9.
You should also consider how value is created and destroyed in the primary activities in your
organisation, or an organisation with which you are familiar.
Table 2.4 provides some examples of how value is created and destroyed in primary activities.
Source: Adapted from Thakor, A. V. 2000, Becoming a Better Value Creator, Jossey-Bass, San Francisco.
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Table 2.5: Support activities in the value chain of a manufacturing organisation
Procurement Acquiring the inputs required for production. Procurement activities include
the purchase of plant, parts and equipment.
Human resource Human resource management activities ensure that the right people,
management with the right skills, abilities and motivation are made available to each activity.
Human resource management activities include the recruitment, training,
development and rewarding of people.
Firm infrastructure Systems. Systems activities ensure that efficient and effective information
management, reporting, planning and control systems operate within and
between each activity. Planning, finance and quality control activities are crucially
important to the performance of an organisation’s activities.
†
Research and development activities might sometimes be considered to be primary activities in
organisations where product upgrades are an important part of the business strategy—like the car
manufacturing or telecommunications industries.
Source: Adapted from Viljoen, J. & Dann, S. 2000, Strategic Management: Planning and Implementing
Successful Corporate Strategies, 3rd edn, Longman, Melbourne, pp. 268–9.
You should also consider how value is created and destroyed in the support activities in your
organisation, or an organisation with which you are familiar.
Table 2.6 provides some examples of how value is created and destroyed in support activities.
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Technology Reducing wait time and move time in Incrementally improving out-of-date
development manufacturing processes systems
Source: Adapted from Thakor, A. V. 2000, Becoming a Better Value Creator, Jossey-Bass, San Francisco.
At Woolworths, despite the growing use of self-service checkout facilities, a large number of staff
members still operate the checkout counters. It is important that these personnel understand how
to operate their terminals, deal with the pricing and other exceptions that often arise, and deal with
customers in a positive fashion. Woolworths’ human resources activity therefore has a critical role in
selecting personnel who have the ability to carry out these primary activities, and in training them to
operate in accordance with the Woolworths system. In fact, human resources has a role in supporting
every one of Woolworths’ primary and support activities.
In addition, some of the activities that appear in Porter’s value chain might not appear in the
value chain of a business.
For example, consider the value chain of a bakery. The primary activities include:
• purchasing raw materials; and
• transforming these into bread through
–– mixing and cooking;
–– packing;
–– storage; and
–– shipment.
For the primary activities to occur effectively and efficiently, the bakery requires support
activities including:
• hiring and training people to bake;
• purchase of plant, equipment and other infrastructure (ovens, mixing machines,
warehouses); and
• information technology (IT) to track products through the system, provide quality control
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and process customer orders.
When drawing value chains, we focus on the activities that create or maintain value along the
input–transformation–output pathway; that is, activities that customers will be willing to pay for.
Note that, as previously mentioned, there may be several ways of presenting a value chain diagram.
The key is to ensure that it reflects the main activities in the value chain of the organisation.
In order to draw the restaurant value chain, primary activities are sequentially presented, from left
to right, according to their place in the input–transformation–output chain. Support activities
are presented in parallel with the chain of primary activities. Figure 2.4 provides an illustration
for a generic manufacturing company and Figure 2.5 below illustrates the restaurant value chain
constructed on the basis of information collected in Question 2.5.
Primary activities
Receive/store
Sell Serve food/
food and Cook
food/drinks drinks
drinks
should consider whether to focus on managing procurement at the business level rather than at
a departmental level. Taking a whole-of-business approach to procurement is likely to increase
its efficiency and effectiveness. The same can be said of other activities like quality control and
systems development.
In addition to the primary and support activities shown in Figure 2.4, Porter (1985) identifies
quality assurance activities as important. Quality assurance activities ensure that other activities
are performed appropriately. Examples of quality assurance activities include:
• the inspection of work in progress or fully finished inventories;
• the review of an activity (e.g. procurement) or business function (e.g. administration); and
• auditing (e.g. the quality of the accounting records and managerial reports).
For example, many banks have made large investments in IT and automation, and simultaneously
reduced the scale of their branch networks. The value chain of personal banking is steadily
moving from being based on personal service and tangible assets to a virtual space where
self‑service is the norm. Arguably, a bank’s use of IT should result in lower fees and charges—
hence a more attractive price to customers—than if the bank were to provide its financial services
through a physical branch network. Larger banks will be the best positioned to exploit the scale
of their technology investments and so achieve the lowest unit costs.
In Reading 2.1, Exhibits 6 and 7, Shank and Govindarajan (1992) describe the value chains for a low
cost and a full-service airline. You should read Reading 2.1 now.
Study guide | 139
➤➤Question 2.6
Describe the value chain, including both primary and support activities, using a format like
Tables 2.3 and 2.5, for a:
(a) manufacturing organisation;
(b) financial services organisation;
(c) charity organisation (e.g. Oxfam: www.oxfam.org.au/about-us); and
(d) public hospital.
By the early 2000s the management of Sara Lee had formed the view that the company really only
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had one core competency that created competitive advantage, namely managing the Sara Lee brand.
Essentially, this competency was built on marketing expertise and a good understanding of customer
needs. Operationally, however, it was evident that the company had no particular advantage in actually
producing and distributing their products.
Because of this Sara Lee adopted a strategy of outsourcing the preparation and distribution of its
products through entering into manufacturing and distribution contracts with various external suppliers.
As long as Sara Lee could ensure the quality of its product through effective and efficient management
of the contracts with its suppliers, the company was able to focus on its key competency—increasing
the value of its brand.
Coca-Cola has adopted a similar strategy. Production and distribution of its soft drinks are licensed
to independent bottlers who purchase the flavouring syrup from Coca-Cola. The business strategy is
focused on the brand.
Sources: Adapted from ‘Sara Lee: Playing with the recipes’ and Reich, R. ‘Brand name knowledge’,
both cited in Hilton, R. and Maher, M. et al. 2000, Cost Management Strategies for Business
Decisions, Irwin, Toronto, p. 14. Encyclopedia of Chicago, accessed September 2015,
http://www.encyclopedia.chicagohistory.org/pages/2623.html
➤➤Question 2.7
Consider Sara Lee’s value chain before and after the outsourcing strategy:
(a) Draw a diagram of Sara Lee’s value chain before and after it outsourced its activities.
(b) What changes are there between the two value chains?
(c) What problems might you see for an organisation that has outsourced most of its value chain?
The industry value chain begins with the production of raw materials and ends with the retail
distribution of products and services. Whether or not an organisation can develop a successful
strategy depends on how it manages its value chain relative to that of its competitors. To do this
well, the organisation must understand the entire value delivery system of its industry, not just the
portion of the value chain in which it participates.
The industry value chain is like a river. Upstream activities occur at the start and flow downstream.
Consider the bread industry. At the start, wheat and other grains are grown. Once the wheat is
planted, grown and harvested, it moves through the industry value chain (flows downstream)
for further processing into flour. Next, the flour is packaged, sold and distributed to bakers who
produce the bread. Once baked, the bread is packaged and distributed to retailers and finally
sold to the end consumer. Also note the importance of the various interlinking activities including
baking, packaging, transportation and retailing, which are all parts of the industry value chain.
Figure 2.6 presents an industry value chain for a manufactured product that identifies six
discrete roles. While larger more complex organisations can sometimes fulfil a number of
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roles with an industry value chain, for the purpose of analysis it is common for each step to
be separately identified.
Raw
Retailer materials
6 1
2
Primary manufacturing
Distributor 5
4
3
Product producer
Fabrication
†
Note that in this simple industry value chain, the activities flow in a circle. Other representations of
industry value chains might show a vertical flow or a horizontal flow of activities. There is no ‘correct’
format. A format should be chosen that is most appropriate to the level of detail that needs to be shown.
Role 1: Production of raw materials. An important material in the automotive industry is steel,
so a mining company that extracts iron ore from a mineral deposit could fill this role.
Role 2: Primary-level manufacturing, where the iron ore is processed into steel.
Role 3: Fabrication of automotive parts, such as car body panels, from the steel.
Role 4: Assembly of cars.
Role 5: Distribution of the cars to dealers.
Role 6: Retail sales.
A seventh role in the automotive industry might be after-sales service, where extended warranties
and servicing are provided by other companies.
It should be clear that industry value chains often overlap. In the auto industry value chain just
described, Role 1 is the production of raw materials. This role would encompass the steel making
industry, the plastics (petroleum) industry and others. The extent to which an organisation needs
to understand the full complexity of its industry value chain depends on its size and place in
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the chain. For example, a steel manufacturer would have little interest in a rubber manufacturer.
On the other hand, a plastics manufacturer would be very interested in the rubber manufacturer as
the two industries often compete with substitute products (natural rubber versus synthetic rubber).
Vertical integration within an industry value chain occurs when one organisation expands to
take on multiple roles within an industry. The purposes of vertical integration are to eliminate
inter-organisational transaction costs (with suppliers or customers) and to enter profitable
segments of the industry value chain. Vertical integration within an industry value chain can flow
upstream or downstream. Upstream (or backwards) integration is movement towards the raw
materials end of the industry value chain. Downstream (or forwards) integration is movement
closer to the end-use customer.
Horizontal integration is also possible. This involves acquiring competitors that occupy the
same role in the value chain. The objective of horizontal integration is to create value through
economies of scale and, of course, through the removal of a competitor from the industry.
If Mercedes was to move to fabricate all its parts, that would be upstream integration. If the company
established its own retail distribution network, that would be downstream integration.
In Reading 2.1, Shank and Govindarajan (1992) describe the paper products industry value chain.
You should review Reading 2.1 now.
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As shown by Shank and Govindarajan (1992), in the paper products industry, six roles are
carried out before the main product, newsprint, is sold to the final customer (the publisher of a
newspaper). The six roles are:
1. growing timber;
2. logging and wood chipping;
3. manufacturing pulp;
4. manufacturing paper;
5. processing paper products; and
6. distributing them to end-use customers.
Figure 2.7 shows how different organisations take on differing roles in an industry value
chain. A fully integrated organisation, Competitor A, competes with six other organisations
(B through G) that occupy one, two, three or four roles within the industry value chain.
Forestry and
timber
plantations
Logging and
Competitor B
chipping
Competitor C
Pulp
manufacturing
Competitor D
Paper
manufacturing
Competitor A
Competitor G
Converting
operations
Competitor F
Competitor E
Distribution
End-use customer
Source: Shank, J. K. & Govindarajan, V. 1992, ‘Strategic cost management and the value chain’,
Journal of Cost Management, vol. 5, no. 4, p. 6.
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Industry value chains are most efficient and effective when the organisations that make up the
value chain collaborate (Manzoni & Islam 2009). Trust, shared values and aligned goals are
critical factors in collaboration. Of course, obstacles exist to effective collaboration. Managing
collaborative relationships is a high-level skill that is most effective within long-term relationships.
Sharing risks and rewards, and determining the best way to measure performance, are important
and challenging aspects of this management role. Measurement is particularly challenging,
as management accountants must learn to measure performance across organisational
boundaries and, at the same time, assess and reward the contribution of each participant
to the joint outcome.
Collaboration enables organisations to more effectively plan their operations, minimise waste,
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and generally reduce transaction costs. In the past, decoupled organisations had to forecast and
then plan operations around these forecasts. Forecast errors led to waste and inventory build-up.
In contrast, the modern organisation, by working collaboratively with suppliers and customers in
the industry value chain, can coordinate activities by sharing information. Waste, inventories and
transaction costs are minimised, and supply chain management can be significantly improved.
As a result of increasingly competitive global markets and the perceived benefits of vertical
and horizontal integration within industry value chains, organisations have found it beneficial to
adopt new organisational forms, such as strategic alliances and joint ventures. Alliances and joint
ventures are types of integration that, unlike mergers and acquisitions, do not involve a transfer
of ownership rights. An alliance can be defined as:
a co-operative arrangement between two or more organisations that forms part of, and is
consistent with, their overall strategy, and contributes to the achievement of their major goals
and objectives (Howarth, Gillin & Bailey 1995, p. 2).
An effective alliance is designed to reduce overall transaction costs (the costs of negotiating and
enforcing the terms and conditions of various contracts) and to create extra value for the members
of the alliance by providing members with access to broader markets and new resources.
You will recall that, earlier in this module, the shortcomings of markets were noted, and the
organisation was proposed as a viable alternative for carrying out transactions. The term ‘mode
of control’ refers to how an organisation is owned, structured and controlled, and how it engages
with the industry value chain (i.e. whether it focuses on one area, or across the whole chain).
The market is at one end of the ‘mode of control’ continuum (see Figure 2.8), reflecting an
organisation’s need to frequently transact with other market participants. Hierarchical organisations
are at the other end of the continuum, reflecting their ability to conduct operations (e.g. product
design, marketing, manufacturing, transportation and accounting) internally. Alliances and joint
ventures are a third mode of control, sitting between the market and the hierarchical organisation.
An alliance is therefore a useful way for an organisation to manage transaction costs without
becoming a completely hierarchical organisation (i.e. doing everything internally).
Alliance
Mode of control
Stand-alone business
Market demand
Per cent of market-based transactions
As ‘stand-alone’ airlines are not part of an alliance, they have to compete with each other in the
marketplace. They have to develop their own systems, and can offer customers relatively limited
travel options. At the other extreme one airline could horizontally integrate, taking over a number
of regional airlines in order to develop a global presence and benefit from the efficiencies
inherent in major IT systems and large-scale operations. While this latter approach may be
attractive, the airline industry is similar to many others in that national governments frequently
restrict foreign ownership. Alliances are, for this reason, an attractive approach to organisational
design in this and many other industries.
The value chain has significant implications for management accounting systems (MAS).
In the past, MAS delivered accounting information that met the decision-making needs of the
managers of vertically controlled (hierarchical) organisational units. The main focus of the MAS
was on internal cost centres (i.e. departmental budgets, standard costs and variance analysis).
These MAS limited the competitive effectiveness of organisations and potentially destroyed
value (e.g. when managers spent time and resources attempting to achieve out-of-date or
inaccurate budgets, and uncompetitive standard costs).
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As modern-day organisations are increasingly organised and managed with reference to activities
that cut horizontally across departmental boundaries, and even across organisation boundaries,
MAS have also been reorganised around activities to enhance the value creation process.
These new MAS focus on product- and market-oriented information flowing horizontally from
supplier to customer—not on internal cost centres.
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and manage its value chain and that of its industry, and hence establish a coherent strategy
(Porter 1985).
Shank and Govindarajan (1992) suggest that value analysis must focus on how organisations
create value and, particularly, how they can exploit linkages with suppliers and customers up
and down the industry value chain. Similarly, Munday (1992) says that management accountants
must consider how cost reductions can be achieved and value created in both the organisational
and the industry value chains.
While value analysis can be done as a special project to enhance stakeholder value in the
short term, in reality it is a holistic approach to visualising and managing an organisation.
Organisations, and the industries in which they operate, are dynamic. For example:
• stakeholder needs change over time; and
• organisational and industry value chains change in response to:
–– innovation;
–– economic conditions; and
–– competitive pressures.
Value analysis is best approached as an ongoing cycle designed to support the continuous
development of organisational strategy.
Value analysis creates a view of the organisation and its industry as a complex web of interrelated
activities. Effective management of the organisation entails extracting the most value from each
activity, and organising the value chains of each product and market in the most effective way.
This requires:
• reconfiguring existing value chains;
• eliminating non-value adding activities;
• introducing new activities; and
• enhancing the efficiency of existing activities.
Having collected this basic data, the management accountant is in a position to provide
management with performance measures and advice to aid in the management of strategically
important activities, value drivers and linkages.
Such a cooperative approach is commonly used in the automotive industry. For example, it is common
for engineers from Toyota or Ford to spend much of their time working with supplier organisations to
improve their manufacturing processes, and so better integrate the supplier into the buyer’s value chain.
The value chain also has implications for the type of investments that organisations make,
and how investment decisions are made. Investments in new technology have strategic and
economic implications for organisations, as well as for an organisation’s suppliers and customers.
Investment decisions must take into account the impact on the industry rather than just the
organisation. Module 5 discusses the capital investment decision.
The management accountant’s role must focus on the value chain. Table 2.7 summarises the
differences between traditional and strategic management accounting views. The traditional
view of the value chain has a short-term, internal and functional focus, where improving the
cost performance of parts of the organisation is seen as the key to improving profitability and
return on investment. In contrast, the strategic view of the value chain is focused on internal and
external linkages. It encourages the creation of value through the development of partnerships
that cross departmental or organisational boundaries. This requires a broad view of what creates
organisational value, and it requires a long-term view of what constitutes a successful and
sustainable organisation.
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interdependencies • Alliances
• Win/lose relationship with • Collaboration
suppliers and customers and
other departments
➤➤Question 2.8
Debits and Credits Ltd (DCL) develops and sells accounting software packages. Figure 2.9 shows
the value chain of DCL.
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1
New 2 4 6
Procurement 3 5
product Production Marketing Distribution After-sales
research of resources and sales service
and design
(a) Assign each of the costs listed below to the appropriate section of DCL’s organisational value
chain.
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In the year ending 30 June 20X0, DCL incurred the following costs:
1. Purchase of blank DVDs to be used for burning accounting software packages for sale
to DCL’s customers.
2. Payments made to an internet service provider for bandwidth for the delivery of software
packages to licence holders.
3. Costs of developing new user-friendly screen layouts for existing accounting software
packages.
4. Fees paid to graphic designers for the design and construction of display units to be
used in major retail stores that sell computer software.
5. Costs of development and delivery of sales training packages to the staff of customers
that stock and sell DCL software.
6. Legal and related consulting costs incurred in the purchase of a new subsidiary, Payroll
Software Ltd (PSL). PSL has developed software that DCL believes will improve the payroll
functionality in its top-selling accounting software package.
7. The costs of staff employed to operate DCL’s customer help desk.
8. The cost of the feasibility study for the development of a new e-store for DCL’s software
packages.
9. Burning software onto DVDs and packing for sale.
(b) Construct an industry value chain for DCL modelled on Figure 2.7, the paper products industry
value chain. As DCL is a service business, the value chain will be significantly different. Consider
the industry DCL operates in, its suppliers (upstream) and its customers (downstream).
Study guide | 149
Strategy
A strategy is a road map for getting to a goal. It shows how resources will be allocated and
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provides guidance on which activities to undertake. A good strategy provides a match between
the internal capabilities of an organisation and its external environment, and meets the goals of
the organisation’s stakeholders. Strategy is focused on the future; it is goal-oriented, long-term
and outward-looking.
The last observation requires some explanation. As an example, low cost may be very important
to some customers. If an organisation has successfully differentiated its product, it should be
able to charge a premium price and so will choose not to satisfy price-sensitive customers.
Dropping the price would mean abandoning the strategy.
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Qantas has a corporate strategy of focusing on the airline industry. Within this corporate strategy,
Qantas pursues two main lines of business—air travel and airfreight. Within the air travel business,
Qantas has developed three strategic business units: the frequent flyer program, Jetstar and Qantas.
The Jetstar business unit offers relatively minimal service and pursues an essentially low-cost strategy,
while the Qantas business unit pursues a full-service and high-price strategy. Qantas has been careful
in identifying the routes, flight times and market segments that each business unit serves to ensure
that they do not compete with each other, and that both compete effectively with other carriers.
Qantas has also separated its profitable domestic business from its loss-making international business.
In 2013, Qantas’ international business unit entered into a partnership agreement with another
international carrier in order to direct passengers into their domestic business.
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You will recall the comparison of the People Express and United Airlines value chains in Reading 2.1.
These value chains clearly show the differences between a budget and a full service airline.
Strategic management
The goal of strategic management is to achieve a sustainable competitive advantage evidenced
by a superior return on invested capital (ROIC). Emerging competitive forces (e.g. new competitors
or substitute products) continually challenge the commercial viability of an organisation’s existing
product range and marketing strategies. If an organisation focuses solely on existing products and
markets, it is likely to lose market share and profitability. To remain competitive, organisations must
defend their products and markets, but also continually reinvent themselves. This is the essence of
the strategic management process.
Competitive advantage can be defined as anything that gives an organisation an edge over
its industry rivals in the products it sells or the services it offers. Ideally, organisations seek to
achieve and maintain sustainable competitive advantage (Porter 1985). Unless advantage can
be sustained, profitability will, over time, be eroded as competitors seek to share in the benefits.
Strategic management is therefore about creating unique and superior customer value.
Practically speaking, strategic management is a set of techniques for understanding, and therefore
influencing, an organisation’s strategic position in existing and future markets. While differing views
exist about the functions that comprise strategic management, as mentioned previously, most
suggest that a strategic management framework includes:
• strategic analysis;
• strategic planning;
• strategy choice; and
• strategy implementation.
Johnson and Scholes (2002, pp. 4–9) suggest that strategic management should:
• establish the scope of the organisation’s activities (draw boundaries);
• match the organisation’s activities to its capabilities (strengths);
• allocate resources;
• facilitate strategy implementation by setting a framework for operational decisions;
• reflect the values and expectations of senior managers and other key stakeholders;
and affect the long-term direction of the organisation.
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Strategic management processes are undertaken by the board of directors and senior
executives when they:
• set goals and objectives for the organisation.
• formulate and implement strategies that
–– are consistent with the organisation’s environment;
–– aim to achieve the organisation’s goals; and
–– reinforce one another (strategic fit).
• Implement appropriate strategic management accounting control systems to
–– identify and manage risks;
–– formulate and evaluate strategies; and
–– control strategy implementation.
Management accounting systems collect strategically relevant information about the organisation
and its environment, establish performance measures and targets for organisational objectives,
and monitor performance through variance analysis and other methods of performance evaluation.
Figure 2.10 highlights the key elements of the strategic management framework described above.
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Figure 2.10: Strategic management framework
and objectives
Strategic plan/Choice
Implementation
Assumptions
When examining strategic management, it is important to be aware that it is based on three
assumptions:
1. the environment is predictable;
2. organisations and people are controllable; and
3. decision-makers act rationally.
First, it is obvious that it is not usually possible to reliably predict the future. Predictions about
asset lives, the productivity of assets and employees, market demand, interest rates, exchange
rates, future revenue streams and future resource costs all require the use of subjective judgment.
In order to cope with the unreliability of predictions, techniques such as scenario analysis and
sensitivity analysis have been developed to minimise the level of uncertainty.
Sensitivity analysis involves exploring ranges, rather than point estimates, for key variables
such as interest rates, prices, demand, etc. Scenario analysis involves exploring a range of
scenarios such as ‘pessimistic’, ‘most likely’ and ‘optimistic’. For example, in an optimistic
scenario, financing costs would be low, prices would be high and demand would grow strongly.
Both scenario analysis and sensitivity analysis are important tools of risk management.
Sensitivity analysis and scenario analysis are discussed further in Module 5. Sensitivity analysis
and scenario analysis do not have universal acceptance because of the subjectivity of the analysis
and the range of results that are obtained. However, as it is not possible to accurately predict the
future, understanding the range of possible outcomes is far more useful than any point estimate
is likely to be. The process of analysis, and the learning that arises from this, is likely to be more
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valuable in improving decision-making than the use of a so-called ‘accurate’ estimate. In fact, it is
important to remember that any estimate of future outcomes may be wrong, and that the extent
of the error, and as a consequence its effect on organisational performance, is unknowable.
Second, control systems, and particularly remuneration systems, may be unreliable because they
often encourage unintended or dysfunctional behaviours, such as fraudulent financial reporting
or the maximisation of short-term profits at the expense of long-term return on investment.
Accounting control systems can be highly motivational, and this is both a great strength and a
great weakness. People will often focus on target achievement regardless of any detrimental
effect on themselves or their organisations (the behavioural consequences of performance
measures and performance targets are discussed in Module 3).
Another factor contributing to the unreliability of accounting control systems is the proxy
nature of most performance measures (see Module 3 ‘Performance indicators’). For example,
profit is said to measure the economic performance of a business unit, but profit is affected
by depreciation charges and other accruals, some of which are necessarily quite arbitrary.
Similarly, net asset value is said to provide a measure of the economic value of an organisation,
but frequently the market value of an organisation is a multiple of net asset value. Net profit and
net assets are therefore problematic indicators of true economic value.
Third, psychologists have for many years studied human decision-making and have identified a
multitude of common and persistent factors that compromise the process. Decision-makers are
subject to poorly understood biases, and are able to reason only imperfectly. People are said
to be ‘creatures of habit’. They seldom question common assumptions or the way that things
have been done in the past. As recommended by IFAC, it is very important that management
accountants question common assumptions, accepted practices and their own biases.
So why invest resources in strategic management? Because some long-term and external analysis
is better than none, and executive teams that engage in strategic management have been shown
to outperform those who do not. In a study of larger Australian organisations, Bedford and
Malmi (2009) reported that greater formality in strategic planning enhances organisational
performance. Performance is improved when:
• strategic goals are specific, detailed and quantified;
• strategic plans are highly detailed;
• strategic plans are tightly followed; and
• strategy is developed through formalised processes.
Formalised strategic planning processes provide greater focus, clarity and consensus on strategic
objectives, and on the actions required to realise these objectives.
Managers and management accountants can help to overcome the shortcomings of their
systems and the nature of human biases by doing their best to understand them. Ultimately,
organisational success is not measured in absolute terms, but is defined in relation to competitors
who are faced with similar difficulties with their own strategic management processes.
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Organisations exist in the for-profit and the not-for-profit sectors, the private and public
sectors, and in many different industries. All organisations are defined by their value chains,
their stakeholders, and the strategies they employ to fulfil their goals. While the discussion of
strategic management in this module makes reference mainly to profit-making organisations,
all of the concepts introduced are also broadly applicable because all organisations engage in
competition. For example:
• In the public sector, competitive rivalry exists between political parties, government
departments and levels of government.
• In the not-for-profit sector, charities compete for donations, and sporting clubs for members.
• In health care and education, public and private providers (e.g. hospitals and schools) are in
direct competition. Additionally, components of public institutions’ value chains (e.g. support
activities like catering and cleaning) are often outsourced to private-sector providers.
• A public transport authority must plan for the competition that its trains and buses receive
from privately owned cars and taxis.
You will recall that Bronwyn Jones’ eldest son Stephen had championed HZ’s development of its own
product range and established connections with a Chinese joint venture partner. While the initiative
had been reasonably successful in terms of revenue, the profit margins on these sales were lower than
that realised on the sale of licensed products because the products did not have a well-known brand
name. Nevertheless, Stephen was recommending to the board of directors that they make a greater
investment in the China joint venture.
HZ’s focus on the development, manufacture and sale of its own product range meant that the
licensed products were neglected and sales were stagnating. Some suppliers of licensed products
were concerned about the decline in their sales, and also the competition provided by HZ’s own line
of electrical appliances.
Another strategy adopted by HZ was the opening of factory outlet stores in a number of capital
cities in Australia for the clearance of outdated products. The factory outlet stores had added to the
organisation’s bottom line by increasing the margins generated from these sales. However, two of
HZ’s customers had expressed concern about the competitive impact of the factory outlet stores on
their retail stores.
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Bronwyn Jones’ other son, John, thought HZ should expand its retail offering by opening a chain of
retail stores to sell the entire product range.
Cynthia Grey, the CEO of HZ, was recently appointed to her position. She was surprised to find that
HZ had little in the way of a formal strategic plan. She arranged for the senior management team and
the board of directors to spend two days at a resort to plan the organisation’s future. The meeting
was a disaster.
While Cynthia had developed a well-structured agenda and her management team presented
comprehensive and thorough reviews of the various operations of HZ, the directors continually
argued among themselves about what direction the organisation should take. Cynthia was dismayed
by the tone of the planning meeting and by the fact that two directors criticised every proposal the
executives put forward.
Other senior managers were not as dismayed as Cynthia, as the planning meeting simply confirmed
their long-held belief that the directors were in conflict about the direction of the organisation. It was
believed that the former CEO had been fired because he had continually challenged the board of
directors about the lack of a coherent organisational strategy.
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The strategy planning meeting did, however, result in a plan being prepared by the board, which was
passed to Cynthia Grey for implementation. The plan did not incorporate any of the senior management
team’s proposals. Since the planning meeting, a number of strategic proposals had been submitted
to the Jones family board members by management, but only one had been approved. All other
proposals were put aside by the Jones family without any explanation. It appeared that the Jones
family had decided to keep private any debate about the direction of the organisation. At the monthly
board meetings, the Jones family’s attention was focused primarily on financial performance and the
20 per cent return on investment target.
➤➤Task
After reviewing the above background information, consider each of the evaluation statements
presented in Table 2.8 below. Using the table, rate the quality of the strategic planning process
followed by HZ.
8. Sufficient board time and resources are made available for strategic
planning and review.
Study guide | 155
MODULE 2
16. Directors and managers routinely engage in informal dialogue
about strategic issues.
A suggested answer to the Case Study 2.1 task is provided at the end of the ‘Suggested answers’
for Module 2.
Strategic analysis
Strategic analysis underpins the strategic management framework. Strategic analysis is
concerned with understanding the internal and external environments of an organisation.
Two common approaches to strategic analysis are discussed below:
• value analysis; and
• strengths, weaknesses, opportunities and threats (SWOT) analysis.
The concepts of internal and external analysis are expanded on in the ‘Global Strategy and
Leadership’ subject of the CPA Program.
Value analysis
Value and the value chain were introduced in Part A of this module. A value chain is a network
of interrelated activities that provides value to customers and other stakeholders.
Organisations exist to create value. Organisational objectives identify each stakeholder group
and how to create and deliver value to that group. Strategies are plans for delivering this value
through value chains. Value chains achieve the strategic objectives through their activities.
Activities and value chains must be continually analysed to optimise the design of the activities,
and of the value chain itself. The organisation and its environment are dynamic and optimisation
is a moving target.
A ‘non-value adding activity’ means that customers do not compensate the organisation for
the costs incurred in carrying it out (e.g. storage of inventory). Organisations can reduce the
total cost of their value chains by eliminating or reducing activities that customers do not value.
This may also help them to shorten the duration of innovation and production cycles, reduce the
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time it takes to bring new products to market or fill customer orders and, in turn, lead to improved
competitive advantage.
Understanding an organisation’s competitive position in its industry value chain has significant
strategic implications. If some value chain roles in an industry are relatively unprofitable,
it may be wise for an organisation that operates across the entire industry value chain to
outsource or divest less profitable activities. Alternatively, an organisation may secure a
competitive advantage by better managing the linkages it has with its suppliers (and customers)
up and down the industry value chain. As mentioned earlier, linkages can take the form of,
for example, outsourcing, joint ventures or alliances. An alternative to increasing upstream
and downstream linkages in the value chain is vertical integration—i.e. acquisition of suppliers
(upstream or backward integration) or customers (downstream or forward integration).
An organisation must carefully consider the value chains of its suppliers and customers before
introducing any performance-improvement initiative targeted at its own value chain. Simply
shifting costs to suppliers or customers will not change the overall value created in the industry
value chain, and customers will have an incentive to shift their business to lower-cost (higher-
value) supply chains.
Shank and Govindarajan (1992, p. 3) describe a US automobile manufacturer that, for every dollar
of manufacturing cost saved as a result of introducing a just-in-time (JIT) inventory control system,
increased its suppliers’ manufacturing costs by more than a dollar. Not surprisingly, the suppliers
demanded price increases that more than offset the savings that had been achieved from the
JIT initiative, and the overall value produced by the industry decreased.
One other factor important to competitive advantage is the ability of an organisation to develop
and display its value-adding capabilities through reputation and branding. The greater and more
unique the organisation’s value-adding activities, the greater the reliance other parties are likely
to place on the organisation, and the stronger the organisation’s position becomes in the value
chain (Pfeffer & Salancik 1978).
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The main lesson for management accountants is that knowledge of both organisational and
industry value chains is essential to strategic analysis. If an organisation does not know how it
provides value to its customers, and does not understand its role in the industry value chain,
it cannot develop a meaningful strategy.
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supplying them only when required for use.
In order for a JIT system to be successful, customers must cooperate by providing reliable long-
term purchase orders for the organisation’s products, and suppliers must be able to reliably deliver
required quantities of high-quality inputs at regular intervals. The successful linking of an organisation’s
operations with those of its suppliers and customers through adoption of JIT throughout the supply
chain should reduce the cost of raw materials, work-in-progress and finished goods inventories for all
supply chain participants and increase total industry value.
Consider a car manufacturer who wants to increase customer value by cutting inbound logistics costs.
A value analysis of activities suggests that inventory carrying costs are significant and the cost of this
activity would be reduced by the introduction of a JIT system for the delivery of parts.
This example illustrates how value analysis within an organisation is complemented by value
analysis of the linkages between organisations in the supply chain.
View the mini-lecture presented by Eugene O’Loughlin on value analysis, where O’Loughlin shows
how to analyse the value provided by a simple product. As he notes, however, this value analysis
process can be applied to any unit of analysis: a business, a product, an activity or an individual:
http://www.youtube.com/watch?v=TT6tVH6cDMM. For quick access, copy TT6tVH6cDMM
(case sensitive) into the YouTube search box.
Figure 2.11 illustrates how an organisation’s strategy should be framed by factors present in the
organisation’s external and internal environments.
Internal environment
Industry
• Assets and resources
Strategy • Customers
• People and management
• Competitors
• Systems and processes
• Suppliers
• Capabilities
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Strategic framework
Internal • Vision
environment • Mission
• Values
• Goals and objectives
In the following two sections, we present four tools that support SWOT analysis:
1. product life cycle analysis;
2. the Boston Consulting Group (BCG) matrix;
3. Porter’s five forces model; and
4. ‘PEST’ analysis.
The first two are tools for analysing an organisation’s product portfolio, the five forces model is
a tool for industry analysis, and PEST analysis addresses the external environment in its broadest
sense.
View the video on SWOT analysis by Erica Olsen (2008a) on YouTube: ‘SWOT Analysis: How to
perform one for your organization’. Olsen summarises the basic parts of a SWOT analysis and
provides practical illustrations: http://www.youtube.com/watch?v=GNXYI10Po6A. For quick access,
copy GNXYI10Po6A (case sensitive) into the YouTube search box.
Internal analysis
The purpose of the internal part of a SWOT analysis is to identify the organisation’s strategically
relevant strengths and weaknesses. As each organisation is unique, what is relevant for any one
organisation cannot be generalised.
An accepted approach to understanding how organisations can draw on their inner strengths
to create a sustainable competitive advantage is generically referred to as resource-based
theory. In this approach, each organisation is seen as having a set of distinctive capabilities and
reproducible capabilities. Only distinctive capabilities can lead to a sustainable competitive
advantage; examples of distinctive capabilities include patents, strong brands, supplier
relationships and government licences. Reproducible capabilities can be copied by other
organisations; most technical capabilities are reproducible.
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Prahalad and Hamel (1990) introduced a similar idea of the ‘core competency’. They showed the
importance of understanding the core competencies that an organisation has—those things that
the organisation is able to do better than the competition.
Figure 2.11 identified some general categories that should be considered in an internal
strategic analysis:
• Assets—include working capital, plant and equipment, and intangible assets.
• Resources—unique sources of supply or special relationships with suppliers.
• People and management—the human capital of the organisation.
• Systems and processes—support systems like core manufacturing systems and IT systems,
value analysis systems, or the MAS.
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You should note that the product life cycle is also discussed in Module 4.
Product life cycle analysis helps managers to improve their understanding of and ability to manage
these product-specific risks. Product life cycle theory is particularly useful for understanding the
dynamics of consumer-product industries like electronics and cars, which typically have relatively
short–medium life cycles. It is less useful for commodity-based industries. For example, iron ore
and oil are two commodity products for which product life cycle analysis may not be as useful,
or perhaps only useful over the longer term.
Product life cycle theory holds that each stage of a product’s life cycle has different cash
flow and profit implications. Products in the early stages of their life cycle, introduction and
growth, require high levels of cash investments in design, and for new manufacturing plant and
marketing. In the maturity stage of the product life cycle, little investment is required and cash
inflows increase dramatically. In the decline stage, revenues are reduced while service obligations
must be met.
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A strategically balanced product portfolio is one that contains both new and old products.
Mature products provide cash inflow for investment in the development of new products,
which will in turn provide cash flow for the next generation of products.
Introduction
The ‘Introduction’ phase is when a new product is introduced to the market by the organisation.
This is a risky stage when prices tend to be high and demand low. There is no guarantee that
the marketplace will accept the new product. In the case of a novel product, if the product and
marketing strategies are inadequate, the new product may fail.
At the introduction stage, the organisation may be able to take advantage of barriers that
restrict immediate entry by competitors to the new product market—a ‘first mover’ advantage.
This temporary monopoly position may enable the organisation to charge a high price before
rivals enter the marketplace. Such a pricing policy can recoup the costs of product research and
development quickly. Alternatively, the organisation may opt for a low-price strategy to build a
dominant market position. This latter form of pricing is known as penetration pricing. As market
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Growth
In the growth stage, the market has accepted the new product. A rapid increase in market size
is expected. Seeing the success of the product, competitors enter the market. A consequence
of increasing competition is that prices drop. This is caused partly by organisations engaging in
price competition to gain market share, and partly by the cost savings manufacturers achieve
through economies of scale and learning. If entry to the market is expensive, the growth stage
might see a strengthening of an organisation’s competitive position.
To meet demand at this stage, the organisation will need to invest in new manufacturing capacity
and new marketing, promotion and distribution capacity. However, this stage can generate the
highest level of profits in the product life cycle.
Maturity
Although sales volumes might still increase in the maturity phase, they increase at a lower rate.
New investment is low and cash flows increase while profits start to decline. Product promotion
activity may fall as consumers adopt a brand. The number of suppliers is reduced as some
leave the market or merge to obtain greater economies of scale in production, marketing or
distribution. As growth slows, competition increases and competitors seek to maintain market
share through price reductions.
Decline
The market is saturated and sales volumes decline due to technological obsolescence and
substitute products. Intense competition takes place, with price promotion and advertising
forcing unsuccessful suppliers to exit the market. Cash flows might be negative at this stage
due to warranty, parts supply or other ongoing service commitments.
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Another example is the ‘tablet’ device first popularised by Apple’s iPad. Following Apple’s introduction
of a high-priced tablet, several manufacturers rushed new products to market and a strong growth
phase began. Subsequently, prices fell dramatically. Apple is now challenged to introduce new models/
features and stimulate further market growth. If this is not possible, the product will become mature
and some manufacturers will inevitably drop the product from their portfolio.
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portfolios. The matrix has an external (market growth) and an internal (market share) dimension,
and so contributes to both the internal and external aspects of strategic analysis. Figure 2.12
shows the four quadrants of the BCG matrix.
High Low
High
Rate of market growth
Source: Adapted from Smith, M. 1997, Strategic Management Accounting Issues and Cases, 2nd edn,
Butterworths, Sydney, p. 119. Reproduced and adapted with permission of LexisNexis.
Market growth is important. Even though high-growth markets require significant investments
of cash, it is easier and less costly for products to gain market share in growth markets than
in mature markets. An organisation’s competitive position, as measured by market share,
is indicative of the profitability and cash-generating ability of the product. The stronger the
organisation’s market share, the more likely it is able to control its profit through reducing input
costs, low-cost production through economies of scale, and control of prices.
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as ‘dogs’ are unlikely to generate enough cash to support investment in other products.
The BCG approach to product analysis differs from product life cycle analysis because it
disregards the time element and it does not assume that all products will grow and mature.
Some products will never enter the growth phase (dogs). Others will grow but never achieve
market dominance (question marks). However, the two techniques together provide a good
understanding of an organisation’s product portfolio, and form an important part of an
organisation’s internal analysis.
In his keynote address at the World Wide Developers Conference held in San Francisco in June 2015,
CEO Tim Cook announced some staggering statistics. For example:
• 100 billion apps have been downloaded from the App Store.
• 850 apps are downloaded every second.
• 600 million iOS† devices have been sold to date.
• There are more than 1.5 million apps now available in the App Store.
July 22 2015
Apple’s main physical products are the iPhone, iPad and MacBook. The iPod, once a star performer,
is in decline. Apple TV and, more recently, the Apple Watch are emerging products. Non-physical
products such as digital download and streaming services, particularly of music and apps, are also
increasingly important. The following statistics from Apple’s Q3 financial results website illustrate that
the company’s star products are iPhones and iPads, which is where market growth remains significant.
Apple’s market share is high.
Application of the BCC matrix suggests that iPhones, IPads and iMacs are probably cash cows. The iPod
would still likely be considered a cash cow by applying the definitions in the BCG matrix, but this may
change in the near future. Apple TV and the Apple Watch are question marks at this relatively early
stage of their life cycle.
†
Apple’s mobile operating system.
Sources: Allsop, A. (2015) ‘Apple Q3 2015 financial results: 47.5 million iPhones, 10.9 million iPads,
4.8 million Macs’, Macworld, accessed October 2015, http://www.macworld.co.uk/news/apple/
apple-q3-2015-financial-results-how-many-iphones-ipads-macs-sold-revenue-update-3581769/.
Viticci, F. (2015) ‘The Numbers from Apple’s WWDC 2015 Keynote’, MacStories, accessed October 2015,
https://www.macstories.net/news/the-numbers-from-apples-wwdc-2015-keynote/
Please note that while product portfolio analysis is an important aspect of an organisation’s internal
analysis, there are other aspects of an internal analysis designed to identify an organisation’s
strengths and weaknesses that are not discussed here. Strategically important internal capabilities
that should be analysed include the workforce, management, technology, access to resources,
intangible assets, access to finance, and governance structures. Some of these issues are noted by
Erica Olsen in the SWOT Analysis video mentioned earlier. If you have not viewed this video yet,
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go to http://www.youtube.com/watch?v=GNXYI10Po6A.
➤➤Question 2.9
Consider your own organisation, or one with which you are familiar. Examine the products or
services of this organisation.
(a) Where are these products or services positioned within the product life cycle and within the
BCG growth/share matrix?
(b) Is the organisation’s product portfolio high or low risk? What changes would you recommend?
External analysis
The business environment is dynamic and, to succeed, organisations must be dynamic and
responsive. Prahalad (2001) argued that the strategic space available to organisations is
expanding and provides unlimited opportunities to the strategist. Opportunities arise from
many sources, including:
• changes in the national and international regulatory environments;
• the emergence of new products, markets, industries and economies;
• new technologies (e.g. new distribution channels made possible by the digitisation of
products like music, film, TV and education); and
• the convergence of technologies (e.g. cameras, phones, computers and navigation systems).
The purpose of the external part of a SWOT analysis is to identify opportunities and threats.
First, organisations need to understand where they are situated within their industry. For example,
a profit-making organisation must be aware of its competitors’ strengths and weaknesses so as
to identify threats to its own position, and opportunities for growth and profitability. Without an
understanding of the competitive environment, an organisation is unable to plan effectively or
develop a meaningful strategic position.
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The aim of industry analysis is to understand how competitive forces create the profitability
(the prices, costs, and investments) of the industry. One approach to industry analysis introduced
previously is industry value chain analysis. An understanding of competitive forces can help to
identify new strategies that shift competitive forces and create a higher return on investment.
For example, if industry profitability is driven by price competition, it might be possible to shift
the basis of competition by introducing a new customer value proposition based on provision of
additional services like stock management or fast delivery.
Industry analysis should start by defining the industry. Errors can arise from a focus on the wrong
industry, or from defining the industry too broadly or narrowly. A narrow viewpoint might overlook
potential linkages across products and markets. A broad viewpoint might miss important
distinctions between products and markets. For example, does the local market for petroleum
have unique and important characteristics, or is the industry global in its scope? As a second
example, are cars and motorcycles in the same industry, or in two separate industries?
To answer these questions in a way that is useful for strategic analysis, we need to look at the
industry’s suppliers, buyers, competitors, barriers to entry, and so on. In the petroleum industry
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example, if the local industry is the appropriate unit of analysis, a local strategy is needed. If not,
then a national or global strategy is required. In the second example, if we conclude that cars
and motorcycles are in different industries, then an organisation will need a separate strategy for
competing in each product category. Porter (2008) explains that, if differences between products
or between geographic markets are large, then different industries might be present.
A second important factor in industry analysis is the chosen timeframe. Strategic analysis should
not be overly concerned with temporary fluctuations in prices or demand, but should focus on
the industry’s business cycle, whether short (e.g. mobile phones) or long (e.g. mining).
Industry analysis should be quantified, and this is a key responsibility for the management
accountant. For example, in assessing buyer power, it is important to determine how many buyers
exist, and the market share of each buyer. For example, if you are a supplier to the Australian retail
food industry, buyer power is high because just two large organisations, Coles and Woolworths,
sell between 60 and 70 per cent of Australian groceries between them.
Five forces
According to Porter (1985, 2006), the strategic environment of an industry is shaped by five forces
(see Figure 2.13). Porter’s five forces are the:
1. threat of new entrants to the industry;
2. threat of substitute products;
3. power of customers;
4. power of suppliers; and
5. intensity of competition.
View the video on YouTube by Michael Porter: ‘The five competitive forces that shape strategy’.
In this video, Porter explains his model and provides practical examples of the five forces:
http://www.youtube.com/watch?v=mYF2_FBCvXw. For quick access, type mYF2_FBCvXw
(case sensitive) in the YouTube search box.
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Suppliers Customers
Existing competitor
Threat of forward Threat of backward
pressure
integration integration
Alternative products
New ways of
satisfying the same
Physical customer
Sociological
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environment environment
Reprinted with the permission of The Free Press, a Division of Simon & Schuster Inc.,
from Competitive Advantage: Creating and Sustaining Superior Performance.
Copyright © 1985 by Michael E. Porter. All rights reserved.
Not all industries are susceptible to the threat of new entrants. Significant economic disincentives
may act as barriers to entry. These could include:
• legal constraints in the form of limited licences (e.g. the television, radio or
telecommunication industries) or patents;
• technological barriers in the form of secret or innovative production processes or product
formulations that cannot be readily copied (e.g. pharmaceuticals);
• availability of financial resources for investment in the industry;
• economies of scale that enable existing industry members to decrease unit costs to a level
that a competitor cannot match in the short term; and
• brand reputation barriers give established industry members a strong reputation in the
market and high customer loyalty.
With the ongoing deregulation of many industries (e.g. banking, telecommunications, civil aviation,
and power generation and distribution) and the elimination of global trade barriers, the threat of
new entrants arises from both domestic and international sources. Many local markets have been
overtaken by global markets.
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Example 2.20: F
ree trade agreements between Australia and
other countries
The free trade agreements established between Australia and other countries—including the United
States, South Korea, Japan and China—make it easier for organisations in each of those countries to
compete in some Australian markets, and vice versa. As an example, in the Australian pharmaceutical
industry, the competitive position of Australian manufacturers and suppliers of generic drugs has
been weakened as a result of the free trade agreement with the United States. On the positive
side, an Australian pharmaceutical distributor may enter into an alliance with a US pharmaceutical
manufacturer who is able to supply products to its Australian partner at low cost because of the large
scale of its operations or the access it has to cheaper inputs (e.g. materials and labour).
Force 3: Customers
When an organisation has powerful customers, its strategic position is weakened. Alternatively,
when the organisation has power over its customers, this is a source of strategic advantage.
A customer may have some power over the prices at which sales are made because the customer:
• purchases large quantities, so is an important customer;
• might attempt to take over the organisation (backward, or upstream, integration); or
• can switch to alternative products or suppliers at little incremental cost.
Toyota is another powerful organisation that has sought to control the price and quality of the
components and parts it purchases by holding an equity stake in its suppliers.
Force 4: Suppliers
Supplier power is the opposite side of customer power. Powerful suppliers have a strong impact
on an organisation’s sustainable competitive advantage because they can drive up the price of
business inputs. To understand the importance of supplier power, simply reverse the arguments
made above about buyer power. A supplier may have power because:
• the supplier is significantly larger than the organisation it is selling to;
• the supplier might attempt to take over the organisation (forward or downstream integration);
• alternative products or suppliers are not available to the buyer; or
• the product provided by the supplier is important to the organisation in terms of the value of
its own products.
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Intense competition through price discounting in the airline industry provides a good example
of the marginal profitability that competitors in this industry will accept in their efforts to protect
market share.
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➤➤Question 2.10
Porter’s five forces model is focused on organisations operating in the for-profit private sector.
However, a five forces analysis is equally applicable to not-for-profit and public sector entities.
Consider the Australian higher education industry. The industry has been very profitable, but more
recently profitability has declined. Each of the five forces is relevant:
• ‘new entrants’ in the form of private education providers;
• ‘substitute’ job training programs like apprenticeships;
• ‘customer power’ from international and local student groups;
• ‘supplier power’ from academics and governments; and
• ‘competition’ among existing universities and TAFEs, both locally and internationally.
Using the five forces model, analyse the Australian higher education industry and assess its
strategic environment. Aspects you should consider in your response are:
• stakeholders; and
• the level of power held.
PEST
While industry factors are important to strategic analysis, the external environment is much
broader in scope than the industry. PEST analysis offers a tool for examination of these additional
factors. PEST stands for:
• Political.
• Economic.
• Socio-cultural.
• Technological.
Other versions of PEST exist that further broaden the frame of analysis:
• SLEPT (adds ‘Legal’ to PEST).
• PESTEL (adds ‘Environmental’ to SLEPT).
• STEEPLED (adds ‘Education and Demographics’ to PESTEL).
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While a multitude of issues arise in a PEST analysis, three that are commonly included are
discussed below:
1. Regulation is an important aspect of the political and legal dimensions.
2. Corporate social responsibility (CSR) is an important aspect of the socio-cultural dimension.
3. The business cycle is an important aspect of the economic dimension.
Regulation
National regulatory frameworks and international treaties and trade agreements can affect an
organisation’s strategic position. Regulatory constraints may limit the type of products that
can be offered to consumers and can reduce or increase the level of competition or prices.
For example, tobacco and alcohol cannot be sold to minors.
attempted to enter the industry to compete with Qantas. Some have done so successfully
(e.g. Virgin Australia and Tiger Airlines), while others have failed (e.g. Compass Mark I and II,
and Strategic Airlines).
The progressive reduction of interstate and international trade barriers, and the adoption of
international (e.g. the General Agreement on Tariffs and Trade) and bilateral (e.g. Australia/US)
trade agreements have had a strong influence on the globalisation of business opportunities and
competitive threats.
In a similar vein, Smith (2007) argued the importance of strategically leveraging social responsibility
in a way that provides a sustainable competitive advantage. This is achieved by developing a
culture capable of simultaneously executing a combination of relevant activities successfully.
Governments, activists, the media, shareholder associations and other stakeholders have
become adept at holding organisations to account for the social consequences of their actions.
In response, CSR has emerged as a priority for business leaders. Perceiving social responsibility
as a strategic opportunity, rather than as damage control or a public relations matter, requires a
mindset that is increasingly important for competitive success (Porter & Kramer 2006, p. 78).
Study guide | 169
Moulang and Ferreira (2009) investigated the environmental awareness of Australian businesses.
They found only one organisation in eight had environmental strategies within their overall
business strategy, and that there was a very low level of integration of environmental management
systems with business management systems. Existing environmental management systems
were mainly compliance oriented rather than strategically oriented. Management accountants
should grasp this opportunity to enhance the CSR information provided into the strategic
management process.
In a review paper, Carroll and Sharbana (2010) summarise the arguments that provide rational
justification for CSR initiatives from a primarily economic and financial perspective, concluding that
firms that engage in CSR activities will be rewarded by the market in economic and financial terms.
CSR is discussed in Part A of this module.
View the following video, which is about an IBM study that addressed the importance of CSR to
the leaders of 250 businesses: http://www.youtube.com/watch?v=PdkYieDuVvY. For quick access,
type PdkYieDuVvY (case sensitive) in the YouTube search box.
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Business cycle
A third important aspect of the external environment discussed here is the business cycle.
Business cycles are fluctuations in local, national or international economic activity evidenced
by changes in gross domestic product (GDP), inflation, interest rates, unemployment rates and
other macroeconomic variables.
A business cycle generally comprises four phases: boom, recession, depression and recovery:
1. A boom is a rise in economic activity that lasts until a peak is reached.
2. A recession is the fall from the peak of economic activity back to the mean (normally
a recession is defined by two quarters of negative GDP growth).
3. A depression is the slide from the mean down to a prolonged and low level of
economic activity.
4. A recovery is the rise from the trough of economic activity back to the mean.
Predicting the turning points in the business cycle is difficult, as is predicting the extent of the
rises and falls, and the differential effects of the business cycle on different countries. All that is
known with certainty is that business cycles recur.
In 2007, the global financial crisis (GFC) was triggered by the collapse of Lehman Brothers, a large US
merchant bank and, as the bubble burst and prices declined, many banks holding devalued assets failed.
This led in turn to a significant reduction in the availability of credit, which caused many organisations
to become insolvent when they were unable to refinance their debts.
A recovery appeared underway in 2010–11, but in 2011 some countries in the eurozone were unable
to refinance their debts and fund their budgets, leading to a European recession.
By 2014, evidence of a US recovery was continuing (with the US stock market hitting all-time highs),
though US interest rates were at very low levels. European countries varied widely, with some in
depression and others in recovery. Throughout, China’s economic growth continued to be strong.
However, in mid-2015 two events occurred which could potentially impact global growth. Firstly,
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the Shanghai stock market (which had risen by more than 30 per cent in the previous 12 months)
suffered a correction. Secondly, Greece defaulted on a loan repayment to its European creditors,
mainly German and French banks. While it is too early to assess the long-term impact of these events,
it is evident that global markets have become more volatile as a result.
Many business decisions have long-term implications. One example is Woodside Petroleum’s
$43 billion investment in liquefied gas processing in north-western Australia, a project which is
expected to last for decades. Management accountants should use their understanding of the
business cycle to ensure that unreasonable assumptions are challenged (e.g. constant growth
in the world economy is frequently, and inaccurately, assumed). Those organisations that ignore
the business cycle, and who base their business strategies and value chain configurations
on an assumption of continuous growth, are less likely to survive the onset of a recession.
An understanding of the business cycle allows an organisation to better manage risks and to
explore a range of different investment scenarios. Organisations that are successful in the long
run consider both positive and negative scenarios (e.g. negative, zero, low and high growth).
The management accountant must try to understand the existing industry and economic
situation, and how the economic situation and the structure of the industry are likely to change
over the strategic horizon. An understanding of economic history is useful in this regard.
This section introduced two tools for carrying out the external (opportunities and threats)
aspect of a SWOT analysis. Porter’s (1985) five forces model identifies the main competitive
forces that determine an organisation’s strategic position in its industry. The performance
of an organisation’s value chain is influenced by the challenges or threats posed by existing
competitors, new competitors, substitute products, suppliers and customers. PEST analysis is
a framework for carrying out a broader environmental analysis. Political, economic, socio-cultural
and technological factors have a significant effect on an industry and the competitive position
of an organisation.
Strengths and • Are margins strong? • Are value propositions clearly stated and
weaknesses • Are revenues reliable? aligned with stakeholder needs?
• Are revenue streams • Are brands strong?
diversified? • Are customer relationships strong?
• Are costs predictable? • Are channels for value delivery efficient
and effective?
• Do channels match customer segments?
• Are operations efficient?
• Do we achieve economies of scale?
• Do unused intellectual property or other
valuable assets exist?
• Do synergies exist between products?
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for the product or service? • Are customers clearly segmented?
• Can we replace one off • Would finer segmentation clarify the value
transactions with a revenue proposition?
stream (e.g. rental or • Do customers have high switching costs?
licensing)? • How can switching costs be increased?
• Which costs are growing • Are substitute products threats?
fastest? • Are our important resources or partnerships
available to competitors?
• Are partnership linkages reliable and
sustainable?
• Should additional activities be outsourced?
• Are our main activities easy to imitate?
• Do competitors threaten our market share?
➤➤Question 2.11
Consider your own organisation, or one with which you are familiar (like your supermarket or your
bank). Examine the competitive forces at work in the industry. What is the competitive position
of your selected organisation? Is it strong? Is it sustainable?
➤➤Question 2.12
(a) Refer to the information provided about BikeCo in Question 2.4. Prepare a SWOT analysis
for BikeCo. Clearly differentiate the strengths, weaknesses, opportunities and threats you
identify (i.e. do not include any item in more than one category).
(b) In relation to BikeCo’s existing strategy of differentiation on the basis of manufacturing a
quality Australian-made bicycle, how do BikeCo’s strengths, weaknesses, opportunities and
threats affect its ability to achieve a sustainable strategic position? Provide numerical analysis
where appropriate.
(c) Assume that BikeCo accepts the BayMart contract and decides to follow a new strategy
of manufacturing low-cost generic bicycles. How do BikeCo’s strengths, weaknesses,
opportunities and threats impact on its ability to achieve a sustainable strategic position?
Provide numerical analysis where appropriate.
Strategic planning
After managers have obtained a thorough understanding of the organisation’s internal
and external environments through strategic analysis, they are in a position to reassess the
organisation’s existing strategic management framework and strategic plan, and to revise them
as necessary. Strategic planners aim to improve existing organisational objectives or identify
new organisational objectives, then improve on existing strategies or invent new strategies to
achieve those objectives.
Strategic planning is discussed in greater depth in the ‘Global Strategy and Leadership’ subject of the
CPA Program.
Vision
The vision states why society is better off due to the existence of the organisation. The vision is a
guiding principle or the core value of the organisation.
For example, Amazon’s vision is ‘to be Earth’s most customer-centric company for four primary
customer sets: consumers, sellers, enterprises, and content creators’ (Amazon 2013).
Mission
The mission identifies the organisation’s stakeholders, commercial rationale and target market.
Ideally, mission statements should refer to the:
• identity of key stakeholders (e.g. shareholders, customers and employees);
• stakeholder value to be delivered;
• nature of the organisation’s business (e.g. its outputs and the markets it services);
• competencies and competitive advantages by which the organisation will prosper;
• ways the organisation will compete (e.g. reliance on quality, innovation or low prices;
commitment to customer care; policies on acquisition versus organic growth and the
geographical spread of operations); and
• CSR principles (e.g. commitment to maintaining good working relationships with suppliers
and employees; social policies such as equal opportunity or energy conservation; and
commitment to after-sales service and customer satisfaction).
In practice, however, many companies tend to release shorter and less specific statements in their
annual reports.
Example 2.25 highlights extracts from the 2014 annual reports of three well-known and highly
regarded companies. Each includes some, but not all, of the points listed above in their reported
mission statements.
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Amcor Limited:
By being dynamic and seeking innovation, Amcor will globally offer cost effective, differentiated
products for environmental purposes that have high quality and added value to customers
(Amcor Limited 2014).
Apple Inc:
Apple designs Macs, the best personal computers in the world. Apple leads the digital music
revolution with its iPods and iTunes online store. Apple has reinvented the mobile phone
with its revolutionary iPhone and App Store, and is defining the future of mobile media and
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computing devices with iPad (Apple 2015).
Goals should express the organisation’s mission in detail—the ‘what’, ‘how’ and ‘when’ of
delivering value to stakeholders. Objectives are similar in content to goals, but offer quantitative
measures of the goals against which performance can be assessed. Performance measures
should include time-based measures.
For goals and objectives to be effective, they must be consistent. That is, objectives set for
different parts and levels of the organisation should not be in conflict. The organisational goals
and objectives provide the framework for strategy development.
The key aspect of an effective strategic framework is that it provides guidance for the
development of strategy and a way to judge whether a strategy is appropriate. In developing
strategy, each goal should be addressed. Strategies that do not address specific organisational
goals are probably counterproductive.
The following example illustrates the corporate mission and goals of Wesfarmers, a prominent
Australian organisation (owner of Coles, Bunnings and other businesses).
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(Note how this expands on the mission statement shown above, and covers most of the points listed.)
➤➤Question 2.13
(a) Review CPA Australia’s vision and mission.
(Go to cpaaustralia.com.au and click on ‘About us’.)
How does CPA Australia contribute to society?
(b) Consider your own organisation or another one with which you are familiar (like the university
you attended). What is its vision and mission? If your organisation does not have a stated
vision and mission, consider how it contributes to society and work out what its vision and
mission could be.
Hambrick and Fredrickson (2001) suggest that the following SWOT-oriented questions should be
answered in order to test the quality of an organisation’s existing strategy. Obviously, the answers
depend on completing a thorough strategic analysis:
1. Strengths. Does the organisation’s strategy exploit its resources and capabilities?
Given the organisation’s particular mix of resources and capabilities, does its strategy offer it an
advantage over its competitors? Can the organisation pursue its strategy more economically
than its competitors?
2. Weaknesses. Does the organisation have sufficient resources to pursue its strategy?
Does the organisation have the money, managerial time and talent, and other essential
capabilities required to achieve what it envisages? Is the organisation spreading its resources
too thinly, which means that its competitive position is under-resourced and feeble?
3. Opportunities. Is the organisation’s strategy consistent with its environment?
Does the organisation’s strategy align with the key success factors of the chosen environment?
Are there healthy value-creating opportunities in the direction the organisation wishes to head?
4. Threats. Will the organisation’s differentiators be sustainable?
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Will the organisation’s competitors have difficulty in matching the organisation’s capacities?
If not, does the organisation have a strategy that explicitly requires a ceaseless regimen of
innovation and opportunity creation?
5. Fit. Are the elements of the organisation’s strategy internally consistent?
Has the organisation made a choice of arenas, vehicles, differentiators, staging and economic
logic? Do these elements fit and mutually reinforce each other?
6. Reality check. Is the organisation’s strategy capable of being implemented?
(Hambrick & Fredickson 2001, p. 59.)
Because of the dynamic business environment and the five forces of industry competition,
an organisation’s existing strategy is unlikely to satisfy all of its goals and objectives, and provide
sustainable competitive advantage in the long term. Even where an existing strategy is successful,
it is still important for the organisation to seek new strategies that can achieve these outcomes
in ways that provide greater value now and in the future.
Consider your own organisation, or one with which you are familiar. Identify the organisation’s
strategy or strategies. (Strategy documents are often available on an organisation’s website.)
➤➤Question 2.14
Refer to Case Study 2.1 on HZ. For each of the six strategy evaluation questions proposed
by Hambrick and Fredrickson shown above, provide an answer for HZ. How would you rate
HZ’s strategy?
While it is difficult to generalise about strategies that an organisation might adopt, the following
are characteristics of strategies formulated by many innovative organisations.
• Focus on core competencies.
• Use joint ventures, alliances and acquisitions to access resources and competencies.
• Acquire other organisations to achieve horizontal or vertical integration.
• Reduce layers of management to enhance organisational responsiveness.
• Increase the use of project- and team-based forms of organising to increase horizontal
knowledge and resource-sharing.
• Invest in team building, mission building and training to provide the skills to make flatter
structures work.
• Invest in new forms of IT.
• Increase market share through the introduction of new or improved products or services.
• Develop new export markets to improve economies of scale.
• Focus on those activities that generate the greatest value by disposing of, or outsourcing,
non-core or lower value-adding competencies.
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Partner strategically
The organisation chooses from a number of options for collaborating with others to achieve
strategic goals. The spectrum of collaboration ranges from the minimalist level of partnering,
where the partnering organisations simply exchange information, to the extreme level where
the organisations formally integrate their activities through acquisition. Partnering options also
include such avenues as market transactions, outsourcing, co-branding ventures, alliances and
joint ventures, all of which allow the organisation to focus on its own core competencies, while at
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Communicate strategically
An organisation’s strategy cannot be successful if it is not communicated. Organisational
communications must ensure that all stakeholders, internal and external, are aware of the
organisation’s business strategy. For example, effective strategic communication should build
employee engagement and direct their attention to activities that help realise the overall
organisational strategy.
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called the Business Model canvas (see Figure 2.14). They recommend that, as a first step
in business design, strategists should carry out a strategic analysis including a SWOT analysis.
Only after developing a thorough understanding of the internal and external environments can
the Business Model canvas be employed for strategic planning.
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178
4. Delivery—How do we deliver a
• Convenience/usability value proposition to customers?
Types of resources 5. After sales—How do we provide
• Physical post-purchase customer support?
• Intellectual (brand patents, copyrights, data)
• Human
• Financial
In their book, Business Model Generation, Osterwalder and Pigneur (2010) identify the nine
building blocks of a business model, and illustrate the business models of a number of innovative
modern organisations (e.g. Lego, Wii, Apple, Skype, Gillette).
The Business Model canvas has a value side (right-hand side: building blocks 1–5) and a cost side
(left-hand side: building blocks 6–9). The interaction between these two sides (cost and value)
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is the primary determinant of a business model’s success. Business model value is maximised
when customer value is maximised and cost is minimised.
In the FREE business model, one customer segment receives their value proposition free of
charge (e.g. Google, Skype, or free-to-air television and radio). Unsurprisingly, a free value
proposition is popular and attracts high customer numbers. Other customer segments
(advertisers) provide a revenue stream for access to this group. Not-for-profit organisations use
the FREE model too. For example, the Fred Hollows Foundation provides free eye cataract
surgery to the poor. Another customer segment (donors) is attracted to this free service and
provides a revenue stream to the foundation.
View the following video which provides a brief introduction to the Business Model canvas:
http://www.youtube.com/watch?v=QoAOzMTLP5s. For quick access, type QoAOzMTLP5s
(case sensitive) into the YouTube search box.
➤➤Question 2.15
Refer to the information in Question 2.4 about BikeCo.
Using the Business Model canvas in Figure 2.14 as a guide, construct a canvas for BikeCo, assuming
that BikeCo accepted the BayMart contract. You will need to identify key elements of each of
the nine building blocks. Start with building block 1, ‘Customer Segments’.
Narrow target
Cost focus Differentiation focus
Source: Porter, M. E. 1985, Competitive Advantage: Creating and Sustaining Superior Performance,
The Free Press, New York, p. 12. Reprinted and adapted with the permission of The Free Press,
a division of Simon & Schuster Inc. Copyright © 1985, 1998 by Michael E. Porter.
3. Focus When an organisation pursues a focus strategy, the organisation restricts its
activities to a market niche (or market segment) by providing products or services:
• at the lowest cost to that segment (cost-focus); or
• that are differentiated for that segment (differentiation-focus).
For the global airline industry, consider a small domestic-only operator (focus) that
aims to achieve the lowest cost.
In adopting a differentiation strategy, the organisation offers a unique product or service to the
whole industry or market. In adopting a differentiation-focus strategy, the organisation offers a
unique product or service in a particular market niche or segment, rather than the whole industry.
So, both involve a unique product or service and the difference between the two lies in their
target market—broad or narrow.
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Ferrari, Rolls Royce and Lamborghini are also examples of unique or differentiated products. However,
they are priced at the very high end of the market, often at several hundred thousand dollars each.
There are also very few of them made or available for purchase. As such, there is only a very small
customer group that can afford these vehicles. They have a differentiation-focus strategy on a very
narrow or niche segment of the market within the industry.
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• The use of the latest manufacturing technology. Organisations using the most efficient
methods of production should be able to secure improved cost performance and
product quality.
• Learning. All activities are associated with learning effects. By producing more items than
any other competitor, an organisation maximises its learning and achieves the lowest costs.
• Access to economical resources. If the organisation can gain favourable access to the
sources of its raw materials or labour because of the scale of its purchasing, its location,
or through vertical integration, the lower prices paid for these inputs can contribute towards
overall cost leadership.
• Focus on operational productivity. If the organisation seeks out productivity improvements
and cost reductions, lower product cost will result.
• Ensure value is created by support activities. Unless continually examined and subjected
to suitable cost-minimisation strategies, indirect activities (e.g. research and development,
sales force administration, promotion and distribution) can add significant costs to an
organisation’s value chain without delivering commensurate benefits. Leveraging greater
value per dollar spent on support activities reduces the organisation’s value chain costs.
In the 1960s, Toyota and other Japanese automobile makers entered the North American market with
small, inexpensive cars—a cost-leadership strategy. Over time these organisations grew to dominate
the North American automotive industry, producing a full range of cars known for their high quality.
182 | CREATING ORGANISATIONAL VALUE
Sources of differentiation
Porter (1996) explained that unique strategic positions emerge from three sources: variety,
needs and access.
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Variety
Strategic position can be based on producing a subset of an industry’s products or services.
This is variety-based positioning because it is based on the choice of product or service
varieties, rather than customer segments (Porter 1996, pp. 65–6). Examples of variety-based
organisations include those automobile manufacturers who concentrate on luxury cars, like BMW,
Mercedes or Audi.
Needs
Needs-based positioning is based on serving most or all the needs of a particular group of
customers. It arises when there are groups of customers with differing needs, and when a tailored
set of activities can serve those needs best. IKEA’s customers are a good example of such a
group. IKEA seeks to meet all the home-furnishing needs of its target customers.
Access
The third basis for positioning is that of segmenting customers who are accessible in different
ways. Access can be a function of customer geography or customer scale—or of anything that
requires a different set of activities to reach customers in the best way. For example, fast food
restaurants must have an excellent location in relation to their customers. An increasingly
important customer group to access is smartphone owners who engage with social media like
Twitter and Instagram.
The following table highlights some advantages and disadvantages of cost leadership and
differentiation strategies.
Study guide | 183
Barriers to new entrants Economies of scale raise barriers Brand loyalty and perceived
to entry. uniqueness are barriers to entry.
Suppliers Flexibility to deal with cost increases High margins can offset vulnerability
from suppliers, given the greater to price rises.
value-added margin. Large scale
may increase power over suppliers
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Industry rivalry Organisation remains profitable Brand loyalty lowers buyer price
when rivals fail through excessive sensitivity.
price competition.
Profitability A cost leader can choose to achieve High margins can be achieved as long
higher margins by matching the as the product is clearly differentiated
prices of its competitors. and provides value.
Product characteristics Cost concerns ignore product Customers may no longer require the
feature and marketing issues. differentiating factor.
Branding is essential.
Price Increase in input costs can reduce Eventually customers become price
price advantages. sensitive.
Organisation
infrastructure Minimal corporate headquarters and decentralised store management
Organisation
infrastructure Central control of operations and credit control
Organisation
infrastructure Central control of operations and credit control
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Focus (narrow target)
The third type of competitive strategy identified by Porter (1980) is a focus strategy where
an organisation concentrates its attention on one or more market niches or segments.
An organisation pursuing a focus strategy will not sell its products industry wide but focuses its
value chain on a particular customer demographic, geographical area or a limited product range.
There are two forms of focus strategy.
Strategy choice
As mentioned above in the introduction to Part B, strategic management is an iterative process
with many feedback loops. Accordingly, strategy choice does not follow strategic analysis and
strategic planning in a linear fashion as might be thought. Rather, strategies evolve in the process
of strategic analysis and strategic planning.
The notion of strategic choice might be thought to imply that one best strategy should be
(or can be) determined. This is incorrect. As noted, strategic management is inherently uncertain.
A risk-based management approach means that a number of potentially successful strategies
are developed, and one (or more) preferred strategies are implemented. This is done with the
understanding that alternative strategies might then be adopted on the basis of new information,
or changes in the external environment.
186 | CREATING ORGANISATIONAL VALUE
A strategic business unit (SBU) is a unit within a corporation that serves a defined external market
with a distinct family of products. An SBU has unique stakeholders, unique objectives relating to
providing stakeholder value, and unique strategies to achieve these objectives.
Porter (1980) argues that a strategic business unit must pursue only one of the three generic
strategies. Organisations that fail to select a single strategy for a business unit will be ‘stuck in
the middle’ and will be unprofitable. According to Porter (1980), an organisation pursuing a stuck
in-the-middle strategy:
lacks the market share, capital investment and resolve to play the low-cost game; the industry-
wide differentiation necessary to obviate the need for a low-cost position, or the focus to create
differentiation or low cost in a more limited sphere
Source: Porter, M. E. 1980, Competitive Strategy: Techniques for Analyzing Industries and Competitors,
The Free Press, New York. p. 41.
In practice, it is not easy to draw hard and fast distinctions between generic strategies, or for
an organisation to choose to follow one strategy exclusively. Today, technology such as flexible
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manufacturing systems (i.e. robots) enable mass customisation. Organisations adopting such
technology can offer customers differentiation and low cost (although robotic machinery is very
expensive). Many organisations have successfully pursued strategies involving elements of cost
leadership and differentiation.
Business Model Generation, by Osterwalder and Pigneur (2010), recommends that an effective
strategy is one that increases customer value at the same time as it reduces costs. This idea
does not contradict Porter’s approach, but provides alternative criteria for evaluating a
strategy’s effectiveness.
Organisations encounter difficulties when they fail to develop any strategy at all, when their
strategy is based on inadequate strategic analysis, or when their strategy is poorly designed or
incoherent. A business unit might pursue multiple strategies, as long as there are no inherent
conflicts and the strategies are clearly articulated.
While management’s commitment to, and accountability for, strategy implementation is critical,
over-commitment to any one strategy is highly risky. On the other hand, Porter warns that too
much flexibility means you will never stand for anything or become good at anything, and that
too much change can be just as disastrous for strategy as too little (Magretta 2011).
In choosing a strategy, those criteria for a good strategy noted at the beginning of the Strategic
Planning section of Part B should be considered. Briefly, these criteria suggest that a good strategy:
• promotes organisational values;
• shows how to compete;
• incorporates product and market strategies;
• creates linkages, both internal and external;
• creates inspiration and guidance for managers;
• provides discretion for management action;
• provides a common language;
• exploits strengths and opportunities;
• manages weaknesses and threats;
• complements existing strategies;
• meets stakeholders expectations; and
• provides sustainable competitive advantage.
Study guide | 187
If a strategy ‘ticks all of these boxes’, it is probably a good strategy. These questions cannot,
however, be asked after a strategy has been developed. They are fundamental guidelines to be
applied during the strategic planning process. When the planning process is complete, all of
these questions should have been discussed, and a consensus achieved.
Strategy selection is discussed in detail in the ‘Global Strategy and Leadership’ subject of the
CPA Program.
Strategy implementation
The aim of strategy implementation is to achieve the organisation’s strategic objectives.
Implementation demands action and requires the creation of tangible outputs. Strategy
implementation seeks to:
• unite the organisation behind its agreed strategy;
• ensure that organisational activities lead to realisation of the strategic objectives;
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• generate a commitment from all levels of the organisation to implement the strategy;
• hold managers accountable for, and reward them for, successful implementation; and
• provide regular feedback on the practicality and success of strategic plans so that those
plans can be reconfigured as required.
The next three modules (3, 4 and 5) focus on aspects of strategy implementation.
Two well-known tools used to control the implementation of strategic plans are the strategy
map and the balanced scorecard (BSC). These tools focus the organisation on its strategy,
ensure strategic objectives are realised, generate strategic commitment, provide for accountability
and reward, and provide feedback to the strategic planning process. These tools are discussed
further in Module 3.
Module 4 is also concerned with issues of strategy implementation. The main topics addressed
are activity analysis, activity-based costing, activity-based management and customer profitability
analysis. At a detailed level, these tools are focused on the control of costs and revenues, and on
the delivery of value.
Module 5 addresses project management with a particular focus on long-term and large-scale
projects. Strategies are projects. They are unique, future-oriented and large scale. All of the
recommendations in Module 5 about project management, including organisational structure,
project teams, scheduling, budgeting and monitoring of results, are relevant to strategy
implementation.
➤➤Question 2.16
Consider your own organisation, or one with which you are familiar (like the HZ case study).
Examine the approach that the organisation employs in implementing its strategy. Does the
approach achieve the five objectives of strategy implementation noted in this section? What
particular weaknesses can you identify in your organisation’s strategy implementation process?
View Erica Olsen’s video (2008b) on strategy implementation on YouTube: ‘The Secret to
Strategic Implementation’. Olsen stresses the importance of a) appointing a strategic manager,
b) communications, c) accountability and d) frequent reporting: http://www.youtube.com/
watch?v=ndCexCPLNdA. For quick access, type ndCexCPLNdA (case sensitive) in the YouTube
search box.
188 | CREATING ORGANISATIONAL VALUE
Implementation problems
Many organisations fail to successfully implement strategic change. Understanding how
new systems work takes time, and the learning process is often unexpectedly drawn out and
expensive. This is especially a problem when the training needs of employees are improperly
assessed. Research has shown that as much as 50 per cent of the cost of new systems is required
for training, and that these costs are often significantly underestimated, or it is assumed that
employees will learn how to use new systems on their own, and in their own time.
Due to the complexity of strategic change, it is difficult for managers to envisage how changes
in strategy should be supported by changes in organisational structure, processes and systems.
Often there is a significant time lag before appropriate structures and processes can be worked
out and implemented. It is always easier for organisations to remain with a suboptimal system,
as any change is likely to result in short-term performance declines and confusion. Old systems
possess inertia because people have become used to them and have learned to operate them
relatively efficiently in spite of their inadequacies.
The important thing to understand about strategy implementation is that implementation involves
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significant learning. As learning takes place, the original strategic plan will invariably need to be
modified. Planning and implementation are not separate activities, but part of a circular process
where feedback from implementation leads to the revision of plans and fresh approaches to
implementation. Similarly, strategic planning and implementation are not one off activities,
but are ongoing. Business organisations and their environments are dynamic, and the planning
and implementation activities required to adapt to a changing environment are continuous.
Strategy implementation is also discussed in the ‘Global Strategy and Leadership’ subject of the
CPA Program.
The CPA’s role in strategic management is not unfamiliar. Tasks like information gathering,
analysis and reporting are fundamental to CPAs. Clearly, the CPA has the professional skills to
gather and report information that is quantitative and objective, especially financial information.
This information plays an important role in determining which strategies will create the greatest
organisational value. However, financial and quantitative data can only meet part of the strategic
decision-making needs of an organisation’s managers.
During all stages of strategic management (i.e. strategy analysis, planning, choice and
implementation), much of the information gathered and reported by the CPA will be forward
looking, external and subjective rather than historical, internal and objective. For example,
information on the business cycle has these characteristics and, consequently, it will be difficult
to forecast or quantify reliably. However, the existence of such uncertainties does not reduce
the need to understand these issues—if anything, uncertainties increase the importance of
gathering, analysing and reporting relevant information.
Study guide | 189
Some forecast of the future, however uncertain, is always preferable to failing to include an
important factor in a strategic analysis. In any case, accountants have always had to deal with
uncertain future events, like estimating the expected life and salvage value of depreciable
assets or estimating doubtful debts, so long-term forecasting presents a familiar challenge.
Where point estimates are likely to be misleading, scenario analysis and sensitivity analysis
provide useful alternatives.
While CPAs cannot eliminate the subjectivity in strategic management, they can challenge
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the assumptions underlying forward estimates (e.g. economic growth, population growth,
interest rates) and they can provide some understanding of the risks involved (e.g. the
organisational consequences if the strategy fails or sales targets are not met). By challenging
key assumptions and carrying out scenario analysis, a CPA can increase the objectivity and
substance of the strategic management process and direct their organisation to sustainability.
190 | CREATING ORGANISATIONAL VALUE
Review
In this module, we examined value creation in Part A and strategic management in Part B.
In Part A we showed that organisations exist because they provide an efficient way to organise
economic activities, especially in the presence of significant transaction costs. Control of
organisations is accomplished through corporate governance. Effective corporate governance
ensures that the financial, social and environmental requirements of an organisation’s stakeholders
are met. Successful organisations achieve sustainable value creation where value is measured in
terms of stakeholder requirements.
Understanding how an organisation creates stakeholder value is critical for managers and
their advisers. Through an understanding of the organisation value chain, managers are better
able to appreciate how the organisation provides value, and how this value can be enhanced.
An understanding of the industry value chain enables managers to identify opportunities to
enhance value through linkages with other organisations in the industry value chain.
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Having completed a strategic analysis of the business and its environment, the management
accountant must engage in strategic planning. Porter’s framework for understanding available
strategic alternatives—cost leadership, differentiation and focus—was illustrated, as was the
Business Model Generation approach. Strategy must be developed on the basis of sound
assumptions, and the testing of assumptions is a critical task for the management accountant.
Also important is the examination of an organisation’s strategy for internal consistency.
Successful organisations are those that are able to develop and execute effective strategies
responsive to a dynamic environment. This strategic management activity must be supported by
accounting information systems that:
• monitor stakeholders to determine their requirements;
• analyse the inputs, outputs and value drivers of activities to build effective value chains and
create value;
• collect and communicate strategically relevant information about the organisation, the
industry, and the macro-economic environment;
• set targets for strategic initiatives; and
• measure performance and provide feedback on strategic initiatives.
Reading 2.1 | 191
Reading
Reading
MODULE 2
Reading 2.1
Strategic cost management and the value chain
John K. Shank and Vijay Govindarajan
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Suggested answers | 211
Suggested answers
Suggested answers
MODULE 2
Question 2.1
The answer to this question has been prepared for a university and an electronics retailer.
The emphasis here is on corporate social responsibilities.
Stakeholder Responsibilities
Stakeholder Responsibilities
Question 2.2
This question requires you to draw on your knowledge of an organisation that you work for or
are familiar with. Your nominated organisation may be a for-profit, private-sector organisation,
a public-sector agency or a not-for-profit organisation.
As all organisations are created to realise a particular purpose, they should all have readily
identifiable goals. However, in the case of public-sector and not-for-profit organisations, the goals
may be far more complex and less precise than those of their private-sector counterparts. Thus, it
would be more difficult to have described the goals of a public-sector or not-for-profit organisation.
The concept of the value chain is one that applies to all types of organisations. In some settings,
such as a manufacturing organisation like McDonald’s or Toyota, the properties of the value
chain are tangible and fairly well defined. Here, the value chain typically has a deterministic
character, where a given amount of inputs can be transformed into a given amount of outputs
under specified manufacturing or transformation conditions. The value of many of the inputs and
outputs are easily measurable, and the calculation of value created is not difficult.
The value chains of organisations providing services rather than tangible products (e.g. professional
accounting organisations and public-sector and not-for-profit agencies) are complex and are more
difficult to describe. Furthermore, the input-transformation-output-outcome model of a service
organisation is less deterministic than its product-supplying counterpart. The following illustrates
these issues.
Suggested answers | 213
Public-sector agencies are expected, through the delivery of outputs, to realise agency-level
objectives such as:
• enhancing the quality of life and wellbeing of the community;
• creating the conditions required for the investment and growth that helps to build a strong
economy and deliver more jobs, more opportunities and greater wealth for the community; and
• ensuring that biological diversity is preserved and habitats protected through the sustainable
management, development and use of environmental resources.
For example, a public-sector or not-for-profit agency that has a goal of improving the quality
of life of severely disabled clients will perform a complex chain of activities directed at realising
this goal. Measuring the outputs of the process will be difficult because success in achieving
objectives is difficult to measure. On the input side, in some instances, extensive resources may
be required to achieve a given outcome, while in other instances the inputs might be minimal.
Given the labour intensive nature of the production process and the diversity of customer needs,
the transformation process must be flexible and, in this situation, specifying the input/output
relationship and measuring the value provided might be difficult.
MODULE 2
An agency with responsibilities for severely disabled people will provide a range of training,
accommodation, health care and employment services for its clients. Measuring the value of
these activities to clients could be carried out with a quality-of-life survey, or from mortality
statistics that perhaps reveal an improvement in the life expectancy of the disabled. Measures—
such as the number of clients in care, the number of clients engaged in training programs or
placed into the paid workforce—provide an indication of how active the agency has been,
but do not directly address whether the agency has created value.
Question 2.3
(a) Organisational value has different meanings and these meanings depend on the context
within which the term is used. In a broader sense, organisational value is the total net value
that is created for all stakeholders, including society as a whole, and is measured as the
total benefit generated by the organisation’s activities minus the resources that have been
consumed in carrying out those activities.
The emergence of the triple bottom line (TBL) reporting framework is consistent with this
concept of organisational value creation. In TBL reporting, the organisation calculates
measures of economic value added, social value added and environmental value added to
arrive at a total organisational value.
(b) When one refers to shareholder value, it is the value that remains for shareholders after all
other legitimate claims. It might be simply measured as residual income, return on equity
(ROE) or return on investment (ROI). Shareholders ultimately receive value through dividends
and the capital growth of their investments.
(c) Customer value is the value that a customer derives from the product or service they acquire.
Customer value is a complex concept, as products are typically conceived as a bundle of
complementary features. For example, cars provide transport, but also safety, prestige,
comfort and entertainment. Many measures exist, including the percentage of customers
willing to refer your product or service to others. The ultimate measure of customer value
from the organisation’s perspective is revenue.
214 | CREATING ORGANISATIONAL VALUE
(d) Employee value is the benefit employees obtain from the employment contract. Value for
employees comes in the form of pay and job security, and also includes intrinsic benefits such
as interesting and challenging work. Two possible measures of employee value are employee
satisfaction and employee turnover.
(e) Community value is the benefit obtained by the local community from the presence of
the organisation. Employees and managers will be members of the local community and
their wages contribute to the wealth of the other businesses in the community, as well as
to public infrastructure and services. These individuals will also support the community in
many non-monetary ways. One possible measure might be the amount that the organisation
contributes to the community directly by providing resources to local health, educational,
or environmental programs.
(f) Supplier value is the benefit, largely economic in character, obtained from trading with the
organisation. Thus, supplier value could be measured as being the profit or revenue realised
on the sale of goods or services.
Question 2.4
MODULE 2
(a) BikeCo is operating its factory at 80 per cent capacity with sales of 100 000 units. So full
capacity is 100 000 / 80% = 125 000 units. Unused capacity is therefore 25 000 units
(i.e. 125 000 – 100 000).
From the income statement, the contribution ratio is $8 000 000 / $20 000 000 or 40%.
The unit selling price is $200 per bike, so the unit contribution margin is 40% × $200 = $80.
This calculation is confirmed by dividing the total contribution margin by the number of
bicycles (i.e. $8 000 000 / 100 000 = $80).
(b) For the unused capacity of 25 000 bicycles, the total contribution available is therefore
$2 000 000 (i.e. 25 000 × $80). Note that this reflects the contribution of the additional sales
towards fixed costs and profits.
Assuming all selling and administration expenses are fixed as noted, the increased
contribution would improve the profit by $2 million.
(c)
Table SA2.3
Owners Profit
Survival/sustainability
Growth
Question 2.5
Activities are what people do. In order to understand the activities in a restaurant, we start with a
list of restaurant personnel and then identify activities performed (as shown in Table SA2.4).
Head cook Order, receive and inspect Maître d’ Order, receive and inspect drinks
food; cook from suppliers; greet and seat clients;
sell and serve drinks; collect money
Assistant cooks Cook Waiters Sell food; serve food; prepare bill
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A customer dining in the restaurant is prepared to pay for these activities. The ultimate value
an organisation creates is measured by the amount customers are willing pay for its products or
services above the cost of carrying out its activities. An organisation is profitable if the realised
value to customers exceeds the collective cost of performing the activities.
Some ways that a restaurant can create value include the following.
• It can become more efficient by automating the production of meals, for instance, a fast-
food chain. Customers value the economy, speed, convenience and consistency of the meals
served by a fast-food restaurant.
• It can develop long-term commercial relationships with suppliers so that the chef always has
access to the best quality fresh produce. Customers value the quality of the meals served by
a restaurant that uses the best fresh produce.
• It can specialise in a particular type of cuisine (e.g. Thai, Italian or Japanese). Customers value
the style of cuisine because they do not have skills to cook such food at home.
• It can be sumptuously decorated for those customers who not only value the restaurant’s
food, but also wish to dine in a venue that has ‘atmosphere’ or ‘ambience’. Customers value
the sense of occasion provided by dining in a five-star restaurant.
• It can serve a particular type of customer (e.g. celebrities). Customers value the experience of
dining with like-minded patrons.
Each of these options for a restaurant to organise the activities of buying, cooking and serving
food is a way for it to increase customer value.
216 | CREATING ORGANISATIONAL VALUE
Question 2.6
Table SA2.5
Primary activities
Support activities
Firm infrastructure: Systems. Might include the Systems. Might include the installation
installation and maintenance of an and maintenance of an on-line
enterprise resource planning (ERP) brokerage system
system
Value chain stage (c) Charity (Oxfam is primarily (d) Public hospital
concerned with famine relief)
Primary activities
Inbound logistics Identifying areas of need and Scheduling and assessing patients
negotiating access referred by doctors or arriving in
ambulances
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Service Follow-up of training activities Return visits for follow-up of treatment.
In-home nursing visits
Support activities
Human resource Recruitment and training of staff and Recruitment and training of medical
management volunteers and support staff
Firm infrastructure: Systems. Website for donors Systems. Patient management systems
Distribution system for food and Medicare records
equipment Pharmacy management
Question 2.7
(a) Prior to outsourcing production and distribution, one would expect that the primary activities
in Sara Lee’s value chain would have comprised inbound supply logistics, production,
marketing, distribution and customer service. Support activities would be similar to those
in other manufacturing organisations, and would have included company infrastructure,
human resource management, technology development and procurement (see Panel A in
Figure SA2.1 below).
Following the outsourcing decision, Sara Lee’s value chain would have been simplified
to one of contract management (of the various tasks now contracted out) and marketing.
The support activities would likely remain relatively unchanged. Research and development
would remain in-house; however, it is likely that product design would now be coordinated
between Sara Lee and an external provider.
218 | CREATING ORGANISATIONAL VALUE
Figure SA2.1: Sara Lee’s value chain before and after reconfiguration
Panel A: Before value chain reconfiguration
Inbound Customer
Production Marketing Distribution
supply logistics service
Management of
Management of product design and distribution and
Marketing
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(b) The major change in the value chain of Sara Lee was the replacement of the activities of
inbound raw materials acquisition, production, distribution and customer service with a
‘single’ value chain activity of contract management. The activity of contract management
will call on many human resource skills and competencies across the different types of
contracts that need to be managed. For example, Sara Lee employees managing contracts
with product design partners will need to take knowledge from Sara Lee’s own research
and development activities, have the skills to analyse trends and innovations in the
bakery and convenience foods industry and be able to work successfully with the external
provider to develop new products. It is important, in the context of Sara Lee retaining a
strong competitive position, that it has access to a continuing supply of new bakery and
convenience-food products that do not erode the quality (and value) of the Sara Lee brand.
On the other hand, Sara Lee employees involved in managing the organisation’s contracts
with bakeries need the skills to monitor the quality of products manufactured under the
Sara Lee brand and be able to promptly identify and offer solutions to production problems
(e.g. poor-quality output).
(c) The major threat to Sara Lee from the decision to outsource to other parties, product design,
inbound-raw-materials acquisition, production, distribution and customer service is that the
organisation loses direct managerial control over these operations. In this situation, the viability
of the outsourcing arrangements for Sara Lee depends on how well the organisation’s partners
perform. While KPIs related to factors such as product quality, time to market, delivery
performance and after-sales service will be specified in the various contracts that Sara Lee
enters into with its suppliers, these measures will be incomplete, less accurate and lagging
when compared to the observation of performance that accompanies direct managerial control.
For example, in attempting to improve the cost performance of its own manufacturing
operations, a bakery partner might be inclined to ‘shave’ product quality by using slightly
inferior and cheaper ingredients. The inability to ensure that product quality standards are
maintained in the manufacturing process may result in irreparable harm being done to the
Sara Lee brand.
Over time, as Sara Lee develops a long-term arrangement with a particular supplier,
trust may be developed. This can lead to an open and transparent relationship between
the organisations, with less concern about potentially opportunistic behaviour of a partner
(e.g. a bakery using low-cost and inferior materials in the manufacture of Sara Lee-branded
products), which would reduce Sara Lee’s risks from outsourcing some of its operations.
Suggested answers | 219
Question 2.8
(a) The costs incurred by DCL during the year ending 30 June 20X0 would be classified as follows.
Table SA2.6
Assigning DCL’s expenditures to different sections of the value chain is the first step in the analysis of how
DCL provides customer value. Value is the difference between the cost of carrying out the activities and
the revenue gained from customers. Value can be increased by reducing the costs of a single activity, or by
combining new or old activities to achieve new synergies. Value can also be improved by initiatives that
increase revenues more than they increase costs.
1. Purchase of blank DVDs Procurement of resources—the costs are for a product related
primary activity.
2. Payments to internet service Distribution—the costs are incurred specifically to enable delivery
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provider of software to customers.
3. Costs of new user-friendly New product research and design—the costs are for a product-
screen related primary activity rather than general IT development.
4. Fees paid to graphic designers Marketing and sales—the costs are incurred to market and sell the
products in retail stores.
5. Customer training Marketing and sales—the costs are incurred to market and sell the
products in retail stores
6. Legal and consulting costs Organisational enabling structures—while the new subsidiary will
improve the functionality of an existing DCL, the costs relate more
so to firm infrastructure.
7. Costs of customer help desk After-sales service—the costs are specifically incurred in helping
staff customers with products.
9. Burning and packing DVDs Production—the costs are for a product-related primary activity
(b) Defining the boundaries of the industry in which DCL operates depends on the detail of
analysis required. DCL is in the IT industry or the accounting industry. The industry value chain
below includes only those participants identified in the case.
The inputs purchased from upstream industry participants by DCL include media (DVDs and
broadband) and graphic design. Downstream industry participants include the retailers who
sell their software and the accountants who use it to service their clients.
220 | CREATING ORGANISATIONAL VALUE
• DVDs
• Broadband
Media • Graphic design
• Programming
Software • Training
• Marketing
Distributor • Sales
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• Book keeping
Accountant • Tax
Question 2.9
(a) Your answer to this question requires you to analyse products in terms of their progress
through the product life cycle (i.e. introduction, growth, maturity and decline) and their
position in the BCG market growth/share matrix (i.e. stars, cash cows, question marks or
dogs). Your response will depend on the example you have used.
Consider Apple Inc., which sells desktop computers, notebook computers, iPhones, iPods,
iPads, Apple TVs, apps and watches. While the classification of these products is debatable,
and is based on the assumption that the personal computer market is saturated, at least in
Western countries the following might be appropriate.
Table SA2.7
(b) Continuing with the Apple Inc. example, Apple’s product portfolio is very low risk as it
includes many mature cash-generating products. The risk in the portfolio is the lack of new
growth products to replace the maturing products.
Suggested answers | 221
Question 2.10
Table SA2.8
New entrants Private providers Private providers are willing to offer Medium
low priced products. Most have
developing reputations.
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Government Government funding is dependent High
on political party policy.
Existing competitors Universities and TAFEs Local competition is well-organised Rivalry: Medium
in an oligopoly.
Based on the brief analysis above, the main threat to the industry is government policy. Funding
cutbacks are a significant and unpredictable threat to the number of places available to students,
the level of student fees, and to the funding of staff and facilities. Secondary threats are found in
competition from new private providers and international universities. Other industry factors are
less significant. While the industry is experiencing short-term difficulties, the long-term trend for
the industry would appear to be profitable.
Question 2.11
Your answer to this question should cover the five forces that are present in the selected
organisation’s industry, as well as regulatory and CSR factors that may be specific to the industry
chosen. As noted in this module, it is perhaps an easier task to see the competitive forces at
work in industries where a profit motive is present. Nevertheless, public-sector and not-for-profit
organisations are also confronted with similar competitive forces in their industries. For many
organisations, the future promises greater competition rather than less, and the competitive
position your selected organisation achieves over the next five years depends on how well
it is able to develop and execute the strategies that obtain superior performance from the
organisation’s value chain.
In drafting your response to this question, these are some of the considerations that you
would need to make. Please be aware that this is a suggested response based on conditions
prevailing in an industry at a particular point in time. Consider a large telecommunications
provider. In addition to providing fixed line, mobile and internet services, the organisation owns
and operates most of the country’s telecommunications infrastructure. These two parts of the
organisation’s business are subject to very different forces and follow different strategies. A five
forces analysis would need to focus on these strategic business units separately.
222 | CREATING ORGANISATIONAL VALUE
The organisation was for many years a monopoly provider of telecommunications services and
was owned by the government. Today, it is a private organisation and faces competition from
major and minor telecommunications providers, as well as significant regulatory challenges.
Regulatory issues include the cost of the provision of its network to other telecommunications
organisations, the provision of services to unattractive markets (e.g. regional, less populated
areas) and the introduction of a national broadband network. All of these issues also have
significant CSR implications.
• New entrants—Experience has shown that the retail segment of the telecommunications
industry value chain is easy to enter. Other aspects of the organisation’s business have high
barriers to entry due to the massive investment required to build a network.
• Existing competitors—No significant competitors for the organisation exist in the provision
of telecommunications infrastructure. In the retail area, competitors are active in the
regulatory process and, as a result, are likely to have significant power through this route.
competitors but by some industry organisations that have adopted alternative technologies,
or by organisations operating in other industries. The organisation operates a copper or wire
network. Other network technologies exist, like optical fibre and wireless communications,
and these provide a threat to its infrastructure business. Other communications technologies,
such as Skype (computer-to-computer telephony over the internet), are also relevant in the
retail sector. Other substitutes for telephone services include mail, email and texts.
• Customers—Buyers of the organisation’s retail services would have little power if each
makes a relatively small purchase. Customers for the organisation’s infrastructure—other
telecommunications retailers—are likely to have more power due to the regulatory issues
noted above. Large-scale customers like governments and large corporations have more than
insignificant power because switching providers is an option.
• Suppliers—Due to the organisation’s size, buying power, and the existence of a number
of competing suppliers, supplier power is a moderate threat. It is not low because the
main suppliers include some other very large organisations. Due to the complexity of the
organisation’s business and the number of different suppliers involved, an analysis of supplier
power needs to take into account the differential importance of various suppliers in the
organisation’s value chain.
Question 2.12
Table SA2.9
(a)
Strengths Established market share, production facility, product range and distribution network
Quality reputation
Unused factory capacity
MODULE 2
Threats High Australian dollar/Low cost imported bicycles
Buyer power (large chain stores like BayMart)
(b) Strengths
(i) From the suggested answer to Question 2.4, unused capacity is currently 25 000 bicycles.
For the unused capacity of 25 000 bicycles, the total contribution available is $2 million.
(ii) The ‘Australian made’ differentiator is clearly sustainable.
Weaknesses
The current low level of profit ($0) prohibits new investment in the machinery required to reduce
unit cost (i.e. by reducing labour costs) and improve the company’s competitive position.
Opportunities
Bicycle market growth will support the existing strategy and exploit the unused factory
capacity. Unused capacity is currently 25 000 bicycles. See Strength 1 for a calculation of the
profit potential. The increased profitability would permit investment in the new machinery
required to improve the company’s manufacturing cost profile.
Threats
(i) The Australian industry is increasingly based on imported products and the consolidation
of retailers. An Australian manufacturer selling through independent retailers does not fit
the industry trend.
(ii) BikeCo’s quality reputation will be increasingly difficult to sustain in the face of cheaper
imports. Prices of comparable (equal quality) bikes will continue to decline as Australian
wages rise and competitors mechanise their production processes.
(c) Strengths
(i) The new strategy builds on 40 years’ experience of building quality bikes in Australia.
(ii) Unused capacity—the factory is operating at 80 per cent capacity, implying a full capacity
of 125 000 units (i.e. 100 000 bicycles / 80% = 125 000).
Weaknesses
(i) Assuming retention of existing customer demand, the new strategy requires expansion
(or outsourcing) of capacity: existing demand 100 000 + BayMart demand 40 000 =
140 000 bikes per annum versus 100 per cent capacity of 125 000 bikes. If BikeCo pursues
a cost-leadership strategy, investment in machinery will be required and the company’s
profitability is not adequate for this purpose.
(ii) Additional warehouse capacity may be required as per the BayMart contract terms.
The company’s current profitability is not adequate to support this investment.
224 | CREATING ORGANISATIONAL VALUE
Opportunities
(i) BikeCo is responding to the emergence of powerful buyers and competing more
effectively with foreign imports through price reductions based on economies of scale
(lower per unit fixed costs).
(ii) The BayMart contract (also a strength relating to unused capacity). Accepting the BayMart
contract would mean capacity of 125 000 bicycles could be achieved, with 40 000 sold
to BayMart and 85 000 to existing customers. This would mean a profit contribution
of 40 000 × $60 = $2.4 million per annum from BayMart, in addition to 85 000 × $80 =
$6.8 million from existing customers; a total contribution of $9.2 million. Assuming the
$4 million fixed manufacturing costs and the $4 million selling and administration
expenses are fixed over the relevant time frame, this increased contribution would
improve BikeCo’s net margin by $1.2 million (i.e. $9.2m – $8.0m); from 0 to 5 per cent
(i.e. $1.2 million / (40 000 × $180 + 85 000 × $200)). The increased profitability would
permit investment in new machinery required to improve the company’s manufacturing
cost profile.
(iii) BikeCo could consider outsourcing bicycles from other manufacturers in the short
(or long) term in order to provide the additional capacity required. This would mean
MODULE 2
BikeCo could continue selling 100 000 bikes to existing customers, plus the 40 000 bikes
to BayMart, increasing total sales to 140 000 bikes. Such an outsourcing arrangement
would provide for an additional 15 000 units (i.e. 140 000 total sales – 125 000 factory
capacity) at a contribution of up to $80 per unit, depending on the cost of outsourcing
(potentially adding $1.2 million).
(iv) The new strategy provides a new distribution channel accessing consumers who prefer
Australian manufactured products as well as low prices.
Threats
(i) BikeCo’s entry into the BayMart distribution network is a direct threat to its existing
customers. The company may increase its low margin business at the expense of its high
margin business.
(ii) The strategy is not sustainable unless major economies of scale are achieved through
market expansion (exporting) or increasing market share.
Question 2.13
(a) CPA Australia functions, like other professional organisations, to train, accredit and monitor
its members. These activities provide a social benefit, as consumers or employers who hire
a CPA have confidence that a CPA will be both technically competent and ethical. This also
reduces transaction costs in the labour market (the cost of employment and training for
employers), and reduces any losses that might be caused by incompetent or unethical
people providing accounting services.
(b) In considering the contribution of your own organisation, focus on key stakeholder groups
and the benefits they derive from the organisation.
Presented below is the ‘one-page’ strategy document of Deakin University, which clearly
illustrates its mission and vision, as well as its objectives and strategic performance measures.
Here, the vision is called the ‘Deakin Offer’ and the mission is the ‘Deakin Promise’.
DEAKIN OFFER
Deakin University offers you a borderless and personalised relationship, creating the power and opportunities to
live the future in a new world.
Deakin will be Australia’s premier university in driving the digital frontier to enable globally connected education
for the jobs of the future, and research that makes a difference to the communities we serve.
Deakin Response Deakin will achieve its Promise through integrated strategies:
1. Provide premium cloud and located learning 1. Grow research capacity, depth and quality 1. Create innovative environments both located and 1. Optimise our services and support to meet the
2. Deliver globally connected education 2. Develop targeted commercial research partnerships in the cloud prioritised needs of students
3. Welcome, support and retain committed and 3. Develop a strategic international research footprint 2. Build employee capacity, capability and productivity 2. Deliver services, resources and environments to enable
capable learners 3. Progress a sustainable and competitive enterprise an engaged, inclusive, productive and satisfied staff
4. Empower learners for the jobs and skills of the future 3. Strengthen connections with, and add value to,
governments, industry, alumni and the communities
that Deakin serves
• Premium enhanced courses • Research capability • Deliver ICT and Infrastructure projects • Student engagement
• Globally connected learning experiences • Innovation impact • Workforce productivity • Staff and student satisfaction
Table SA2.10: Live the future—the Deakin plan
MODULE 2
226 | CREATING ORGANISATIONAL VALUE
Question 2.14
Your answer to this question requires you to be familiar with the case facts and strategy of
HZ Electrical (HZ) (see Case Study 2.1). You need to:
• answer Hambrick and Fredrickson’s (2001) six questions; and
• evaluate HZ’s strategy.
1. Strengths (internal). Does the organisation’s strategy exploit its resources and capabilities?
All of HZ’s strengths are employed in the organisation’s strategy. HZ’s strengths are:
–– new CEO—the CEO is instrumental in forwarding the strategy;
–– licence agreements with suppliers—these provide well-known branded products;
–– growth in sales and product range—this supports the growth of the business;
–– HZ’s own product range—this also supports the growth of the business; and
–– factory outlet stores—these provide a new distribution channel to support growth.
2. Weaknesses (internal). Does the organisation have sufficient resources to pursue its strategy?
HZ’s weaknesses prevent it from pursuing a meaningful strategy. It’s weaknesses include:
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–– no strategic plan—lack of a strategic plan means that HZ lacks strategic planning skills; and
–– board in conflict—this will prevent the development and implementation of any strategy.
3. Opportunities (external). Does the organisation’s business strategy fit with what’s going on
in the environment?
The lack of a coherent strategy means that HZ is failing to exploit its opportunities as
effectively as it might. HZ has opportunities to:
–– expand product range; and
–– expand retail chain.
Question 2.15
Please note, the letters (A or B) in the table relate to the two customer segments (A—existing
customers; B—BayMart contract). For example, in the ‘Key activities’ building block, the bike
factory is A/B. This indicates it is important to both customer segments.
MODULE 2
and distribution workers wages B Low cost
channel as
well as bicycle
manufacturing
Question 2.16
The study materials identify the following guidelines for strategy implementation. Your answer
to this question requires you to be sufficiently aware of your own organisation’s strategy
implementation process to determine whether the guidelines are followed. The following
analysis applies the guidelines to HZ (see Case Study 2.1).
8. Sufficient board time and resources are made available for strategic
planning and review
11. Strategic issues and updates receive strong coverage at board meetings
and meetings of the board with management
12. Proposals considered by the board and senior management are linked back
to an agreed mission, goals and objectives
13. The board and senior management monitor a broad range of financial and
non-financial KPIs relevant to the strategy
15. Risk assessment is carried out for every strategic proposal considered by
the board
How did you rate the strategic planning process employed by HZ? Hopefully, you have allocated
mostly ‘Poor’ to each of the evaluation criteria.
The broad conclusion that can be drawn from the case study is that the members of HZ’s board
of directors and the senior executives do not have a clear and strongly shared view about the
organisation’s business model. Furthermore, there is some confusion among the directors and
senior executives about the strategic initiatives the organisation should employ to maintain a
competitive position in the Australasian consumer-products industry.
Specifically, HZ uses few relevant tools in its strategic planning process and the board is poorly
equipped to carry out this function. In spite of this, the board dominates the process and
excludes management from its discussions. Little relevant information is provided to the board
to support its discussions. No strategic planning framework is agreed, strategic KPIs are not
tracked, and no risk assessment takes place. As a consequence, it is not possible to connect
senior management rewards to strategic goals.
HZ must start the strategic management process by carrying out a strategic analysis of the
MODULE 2
organisation and its operating environment. Following this, they should draw on the strategic
analysis to develop a corporate vision and mission to guide the development of organisational
objectives, and then develop strategies to accomplish those objectives.
In developing the strategies, the board and management must create a shared understanding of
how HZ creates value for its stakeholders (e.g. shareholders, creditors, employees, customers and
suppliers). Without this understanding, the future for HZ is bleak.
MODULE 2
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Wesfarmers 2011, ‘2011 full-year results teleconference: 18 August 2011’, accessed October 2015,
http://www.wesresources.com.au/sites/default/files/announcements/2011%20Full-Year%20
Results%20Presentation_0.pdf.
Optional reading
businessmodel tv. 2011, ‘Business Model canvas’, accessed October 2015, http://www.youtube.
com/watch?v=QoAOzMTLP5s.
Kaplan, R. S. & Norton, D. P. 1996, ‘Using the balanced scorecard as a strategic management
system’, Harvard Business Review, vol. 74, no. 1, January/February, pp. 75–86.
Murphy, P. R. & Chan, Y. E. 2014, ‘The CFO competency map’, CPA Magazine, accessed October
2015, http://www.cpacanada.ca/en/CPA-magazine/Articles/the-cfo-competency-map.
Pohle, G. 2008, ‘IBM study: Corporate social responsibility’, accessed October 2015, http://www.
youtube.com/watch?v=PdkYieDuVvY.
STRATEGIC MANAGEMENT ACCOUNTING
Module 3
PERFORMANCE MEASUREMENT
PAUL M. COLLIER*
Contents
Preview 237
Introduction
Objectives
Teaching materials
Review 320
Appendix 321
Appendix 3.1 321
References 351
Study guide | 237
Module 3:
Performance measurement
Study guide
Preview
MODULE 3
Introduction
The Strategic Management Accounting subject promotes ‘the CPA as a value driver’. It emphasises
the role of the professional accountant in engaging with the organisation’s senior management
team to contribute to strategy development and implementation. The aim is to create customer
value and a strong competitive position for the organisation. This subject focuses on developing,
implementing and monitoring strategies in order to enhance value for the organisation. Such a
focus would not be possible without understanding the key role that performance measurement
plays in strategy and value creation.
The need for sound design and an understanding of the use and implications of strategic
performance measurement and control systems is gaining increasing importance in all
organisations. This module sets the context for performance measurement and control
including the:
• characteristics of effective performance measures and control systems;
• use of performance measures; and
• application of performance measurement to motivate and reward.
Module 3 is concerned with how performance measurement helps to achieve goals and
objectives through setting targets and measuring performance against those targets through
control and feedback systems.
Module 3 builds on Module 1 and emphasises the role of the management accountant in
supporting the management team in their strategic role. In particular this module looks
at performance measurement in the context of value creation and the sustainability of
performance over time, as well as sustainability in the sense of corporate social responsibility.
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This module also builds on Module 2 by discussing the role of the management accountant
in generating and interpreting information about value chain performance. The links between
strategy, management control systems and performance measurement, and the limitations of
some traditional accounting-based controls are considered. The various models of performance
measurement, emphasising the balanced scorecard and the strategy mapping process, as well as
cascading performance measures and the important role of information systems in performance
measurement will be highlighted.
Modules 4 and 5 will be previewed by discussing the role of performance measurement in the
creation and management of value and in project management. How performance measures
and their associated targets are designed and the characteristics that make performance
measures useful, including the need to compare the costs and benefits of performance
measurement will be discussed. This module focuses on improving performance through
targets, trends and benchmarking, and the importance of continuous improvement through
organisational learning and knowledge management processes.
This module illustrates concepts with examples from manufacturing, service and retail
organisations and the public and not-for-profit sectors.
E E
n n
v v
i i
r r
o o
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Value
n n
m m
e Vision / Mission e
n n
t Goals and objectives t
a a
l Strategy—Creation l
RESOURCES SYSTEMS
a a
n Strategy—Implementation n
a PROJECTS a
l l
y Strategy—Implementation y
s VALUE CHAIN s
i i
s Control and feedback systems s
Objectives
After completing this module you should be able to:
• explain performance and performance measurement;
• examine the role of performance measurement in value creation and sustainability;
• discuss the role of performance measurement in implementing and monitoring strategy;
• design alternative frameworks for performance measurement;
• evaluate the characteristics of different types of performance measures;
• analyse techniques for performance improvement; and
• explain the behavioural effects of performance measurement and reward systems.
Teaching materials
• Learning task
A learning task for this module is available in ‘My Online Learning’.
MODULE 3
240 | PERFORMANCE MEASUREMENT
Performance may be understood at the level of the whole organisation, or different business
units, products or services, geographic areas, or customer segments within the organisation.
At each level of analysis, performance may be interpreted differently. For example, if you
follow the news reports about the Australian airline Qantas, you will know that the results the
organisation achieves are quite different between its international, domestic, and low-cost
subsidiary (JetStar) business segments, and different strategies and measures of performance
may apply across each of these different segments.
A performance indicator is less specific in nature—it is more like a signal (like a traffic light)
indicating a general direction or trend rather than an exact comparison against a scale.
For example, judging customer satisfaction would be more of an indicator because it can
mean different things to different people and can be judged in different ways (e.g. sales
to returning customers, a survey of a sample of customers). Performance indicators are
often presented as a trend or as ‘traffic lights’: green for acceptable, red for unacceptable,
and amber for borderline performance.
Study guide | 241
An organisation’s performance should not be viewed from one dimension only (i.e. only from a
financial point of view). Performance should be seen more holistically through:
• financial dimensions—via a combination of financial measures (e.g. profit before tax,
return on investment);
• non-financial dimensions—in non-financial but quantitative terms (e.g. market share (%),
net promoter score, quality pass rate, patent registrations (number));
• quantitative dimensions—via combinations of financial and non-financial quantitative terms
(e.g. dollar sales per square metre of floor space, earnings per share); and
• qualitative dimensions—via subjective judgments and opinions (e.g. employee satisfaction,
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reputation or environmental awareness).
Organisations use different terms for their performance measures such as key performance
indicators (KPIs) or critical success factors (CSF). Organisations may call their performance
measurement system a ‘dashboard’ (picture the dials in an aircraft cockpit) or a ‘scorecard’.
These differences in terminology matter less than understanding what an organisation is
trying to measure and how that measurement takes place.
Financial performance is highlighted in the annual report to shareholders. Qantas draws particular
attention in its annual reports to profit before tax, revenue, operating cash flow, and cash held at year
end. Qantas reports its results for its major business segments, where it focuses on underlying earnings
before income tax (before interest costs). These segments are:
• Qantas domestic;
• Qantas international;
• Qantas loyalty (Frequent Flyers);
• Qantas freight;
• Jetstar; and
• corporate/unallocated.
While you would expect that financial performance through the financial statements would be a
central part of the annual report, Qantas also includes a broad range of measures of performance in
its annual report.
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➤➤Question 3.1
The Qantas Annual Report 2014 is available online at: http://www.qantas.com.au/travel/airlines/
investors-annual-reports/global/en. Click the ‘Annual Report’ link for 2014.
Search the 2014 Qantas annual report and identify as many performance measures as you can.
Various approaches to measuring shareholder value from an investor’s perspective are also
available. The study of the impact of reported financial performance on capital markets is an
important one in order to understand stock market expectations and how reported performance
influences share price movements over time.
International Financial Reporting Standards (IFRS) and the requirements of external audit,
these have limited usefulness to managers who are interested in understanding organisational
performance at the more detailed level necessary for planning, decision-making and controlling
operations. Strategic management accounting, however, provides a more detailed analysis of
performance as shown in Table 3.1.
Table 3.1: C
omparison of approaches to performance between financial accounting
and strategic management accounting
Annual figures in external financial statements Monthly figures (or in some cases weekly or even
daily—e.g. retail sales) reporting
Consolidated data (even segmental reporting in Reporting for individual business units and
financial statements is highly aggregated) responsibility centres
Highly aggregated data on income and expenses Detailed analysis of individual income and expense
line items
Increasingly, strategic management accounting can provide managers with increased information
about markets, customers, competitors, supply arrangements and production processes,
based on formal and informal sources.
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make decisions and exercise control by reference to:
• financial data;
• business operating data (e.g. passenger numbers, seat utilisations, available seat kilometres
(ASK), revenue passenger kilometres (RPK)); and
• performance measures for the safety and health, environment, customer, people and
community perspectives.
Individual managers of business units will be responsible for various measures of performance
within their areas of responsibility. The Qantas Remuneration Report discloses how many of these
measures are incorporated into executive and director remuneration packages.
In the Qantas example, its two-brand strategy means that performance measures across
the organisation are unlikely to be applied in the same way. Qantas may have performance
measures for onboard sales of duty-free items on international flights, but does not sell food and
alcohol for onboard consumption as it is built into the ticket price. Jetstar by contrast emphasises
onboard sales of food and drink as an important source of additional revenue, as these are not
always built into the ticket price. While on-time arrivals and departures are important measures
for both Qantas and Jetstar, the actual turnaround time between arrivals and departures is
likely to be very different for the two airlines. On the other hand, safety would have the same
importance for both airlines (because the detrimental reputational impact of poor safety
practices is very high). Qantas and Jetstar have different ‘business models’. The model defines
the assumptions that managers use about how the business achieves success.
Some people believe that performance must be ‘measurable’ to be useful. But not everything
that is important can be objectively measured. Qantas has long held a reputation for safety.
However, during the period 2011–13 Qantas experienced a range of aircraft faults and moved
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to offshore maintenance, which may have damaged its reputation. But how is this measured?
In 2013, Fairfax reported that Qantas had dropped in place to 13th in the world, despite the fact
that it has had a clean record (defined as no aircraft loss or serious incident) since 1983. The Center
director explained that this was because Qantas ‘had experienced multiple incidents where a serious
accident had nearly occurred in recent years.’ Qantas has since improved its position and was listed
at 7th in the 2015 rankings.
Source: Adapted from Mace W. & Olivieri N. 2013, ‘Qantas downgraded on Safety Index’
Sydney Morning Herald, 12 January, accessed September 2015,
http://www.traveller.com.au/qantas-downgraded-on-safety-index-2cm44.
The Safety Index is a good example of a performance indicator rather than a performance
measure because there is no objective way of measuring Qantas’ actual safety or its reputation
for safety. Any trend in passenger numbers or results of surveys of customers may indicate a
reputational effect, but could equally be a consequence of other factors including economic
conditions, cost, service or comfort. So Qantas’ performance in terms of safety or reputation
is difficult, if not impossible to objectively measure. But it remains an important element
of performance.
Similar difficulties exist with attempts to measure brand image, customer satisfaction or employee
morale, where surveys, a common method of evaluating performance in relation to these issues,
may provide limited, ambiguous or even biased information.
Study guide | 245
One development to improve the measurability of customer satisfaction is the Net Promoter
Score (NPS). NPS measures the loyalty that exists between an organisation providing goods or
services (the provider) and a consumer. The focus of the score is the question: ‘How likely is it that
you would recommend our company/product/service to a friend or colleague?’, which can be
answered on a scale of one to 10. Responses range from customers being complete detractors
of the provider to complete promoters of the provider. The measure has been adopted by many
Australian companies, including Qantas (Bradley & Hatherall 2013).
In the public sector, where the primary focus is not on financial results, organisations also
communicate the success of their activities by reporting on their performance through a range
of non-financial measures.
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The quantity, quality, timeliness and cost of the delivery of policing services are measured through
18 key performance measures (as published in the Victoria Police Annual Report 2013–14 and Victorian
Government’s Budget Paper 3). The measures comprise for example:
• Quantity measures: reduction in property crime and crimes against the person; number of
responses to events (calls to police); crime prevention checks;
• Quality measures: the proportion of the community who are satisfied with police services and
confident in police; the proportion of drivers who comply with alcohol limits and speed limits;
and successful prosecution outcomes;
• Timeliness measures: the proportion of crimes against the person and property crimes resolved
within 30 days; and
• Cost: measured by total output cost of policing services.
Source: Adapted from Victoria Police 2014, Victoria Police Annual Report 2013–2014, accessed July
2015, http://www.police.vic.gov.au/content.asp?a=internetBridgingPage&Media_ID=105393.
Appendix 3.1 contains a case study of Western Water, located in Victoria, Australia, which reports
its performance in both financial and non-financial terms. This is an interesting case study because
Western Water is a government-owned corporation, yet it has local residents (both individuals
and organisations) as its customers, and operates in a highly regulated market. The case study is
intended as an aid to learning as it provides a detailed example of the concepts included in this
Study Guide. Read the Western Water case now.
Note: The concepts covered in this appendix (not the specific details of the case) are examinable.
246 | PERFORMANCE MEASUREMENT
A value creation process in production may involve turning wood into paper and paper into a
printed book. A value creation process in services may be using knowledge and skill to construct
a contract between two parties that will enable them to carry on business together. Value creation
may also take place through improved efficiencies (e.g. reducing the distance travelled in making
a delivery, or the time taken to carry out a service).
Performance measurement can therefore be seen in terms of the value creation process. Porter’s
(1985) ‘value chain’ (as discussed in Module 2) shows the primary and support activities that add
value to a customer, and the margin that can be achieved as the difference between the cost
of providing those value-adding activities and the price the customer is willing to pay. Hence,
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the value added for which the customer is willing to pay must exceed the cost of performing the
activities that lead to the added value, or else the activities should be eliminated.
This idea of value creation is particularly important when we consider for-profit organisations
whose purpose is to increase shareholder value. Shareholder value can be increased through a
combination of dividends and capital gains over time.
There are many ways value creation can be achieved. One is through technological innovation
that leads to products that customers want—as the example of Apple Inc. demonstrates.
Prior to 2003, Apple had sluggish growth and achieved mediocre financial performance and shareholder
returns. Some argued at the time that it faced collapse. However, under Steve Jobs (now deceased),
the company implemented a strategy of giving customers what they wanted by investing in innovation
that added value to customers and building intellectual property within Apple. This led to vastly
improved financial returns.
Apple has been successful by manufacturing in relatively low-cost countries such as China which has
enabled it to improve its profits far more than if manufacturing had taken place in the US. However,
this strategy has required focused management attention on sourcing, supply chain logistics,
and quality control. As a result, the company has faced criticism for the poor labour practices of some
of its subcontractors, and for Apple’s own environmental and business practices. It is undergoing long
running law suits with South Korean electronics giant Samsung and other companies over alleged
patent infringements.
Study guide | 247
Apple’s focus would be on continually expanding market share by introducing new products.
Although the information is not publicly available, Apple’s internal performance measures would likely
include new patents, new product launches, new store openings and market share, as well as the more
usual financial measures such as sales growth and profitability.
However, value creation does not need to come only from innovation. It can also come from
more conventional businesses, as the example of Woolworths demonstrates.
Woolworths is best known for its supermarket chain, its Big W department stores and its partnership
with Caltex in fuel retailing, but it also owns the home improvement retailer Masters, liquor retailers
Dan Murphy and BWS, and the ALH leisure and hospitality group which owns restaurants, hotels and
gaming venues. Woolworths’ strategy for value creation has been to diversify from supermarkets into
related retail fields, and to expand its range of stores geographically (including online shopping).
Because of the tightly held market share of Woolworths and its competitors, a key strategy is to
increase spending by existing customers. Woolworths has consequently expanded its product range,
introducing its own-brand products, from the less expensive to the more expensive Woolworths ‘Select’
brand. Woolworths’ supermarket advertising slogan, ‘The fresh food people’, has been successful
in creating value for the company, as has its ‘Everyday Rewards’ loyalty cards system (with nearly
8 million members in Australia) that is linked to Qantas Frequent Flyer points, and reward points that
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provide discounts on fuel purchases. One of Woolworths’ strategies is to use the large amount of data
gathered on customer buying habits that is available to them through the ‘Everyday Rewards’ card.
It uses this to target customers with specific promotional campaigns. Woolworths is also expanding
its multi-channel strategy including online and social networking channels. Woolworths has also
expanded to New Zealand.
In its 2014 Annual Report, Woolworths identified some performance measures, mainly financial (sales,
gross margin, and ‘cost of doing business’—the largely fixed costs of their stores) as well as closing
inventory days (a measure of inventory holding). The limited disclosure of non-financial performance
measures is no doubt because of the advantage this could give to its competitors, notably Coles.
Woolworths’ value creation strategy is to improve its value to shareholders, rather than out of any
altruistic motivation towards its customers. Nevertheless, if customers are dissatisfied with store
locations, product range, quality or price, they will go to its competitors. The consequence will be
reduced shareholder value, as lower market share and profits will lead to lower dividends and a lower
share price.
Woolworths would be focused both on geographic and product expansion, by opening new stores,
improving existing stores, and growing its ‘Everyday Rewards’ program to identify customer purchasing
habits to increase the spend per customer. Internal performance measures would probably focus on
new store openings, sales per employee, sales per square metre and market share (especially market
share relative to Coles). Measures of Woolworths own ‘Select’ brand sales compared with other
branded products would also be likely.
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➤➤Question 3.2
Please access the Annual Report 2014 of JB Hi-Fi (an Australian consumer electronics and
entertainment retailer), available online at: https://www.jbhifi.com.au/Documents/Annual%20
Reports/JB%20Hi_Fi%20Limited_Annual_Report_2014.pdf.
(a) Who in the company is responsible for shareholder value creation?
(b) What is the company’s strategy to increase shareholder value?
(c) What performance measures does JB Hi-Fi use to measure the success of its shareholder
value creation activities?
The key issue for performance measurement is to understand the organisation’s strategy for
value creation and to measure the success of its value creation activities. As the JB Hi-Fi example
illustrates, we can look at value creation from the shareholder perspective, or from the internal
business perspective, although the two are clearly interrelated.
The idea of value creation over time is important, because the measurement of value creation
should not be seen solely in terms of short-term gains such as current year profits or customer
satisfaction in a single survey. This highlights the importance of sustainable performance.
➤➤Question 3.3
Mega Markets Ltd (Mega Markets) is an ASX listed chain of retail stores with branches in all the
major shopping centres in Australia. Mega Markets sells clothing, homewares and toys. Much of
Mega Markets’ product range is sourced from South East Asia, enabling it to offer low prices for
a wide range of products. Over many years Mega Markets has become a popular department
store for families on a budget with young children.
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However, over the last two years, Mega Markets has faced a flattening of sales. Mega Markets
has faced out-of-stock situations where customers have asked for a particular style/colour/size
combination, which is not always available in every store. Market research has revealed that
customers are increasingly going online to source similar products from an overseas competitor
at even lower prices than Mega Markets can offer. The purchased goods are posted to their
home address from a large warehouse in South-East Asia.
Mega Markets has complained in the press that this competition is unfair as the overseas suppliers
do not have the high rental costs charged by the large shopping centre owners, nor the high
wage and on-costs that Australian retailers have to pay.
The sales director of Mega Markets said:
Our customers can go to our competitor online, choose the product they want, in the
colour they like, in any size, and have it delivered to their home within a week, all at a
price that is typically 10 to 20 per cent lower than our retail store prices and customers
can return or exchange their products if they are dissatisfied. No wonder our sales
are suffering.
Mega Markets has suffered from a deteriorating financial position as a consequence of its flat
sales, tighter margins and increased overhead costs. The company now faces considerable
pressure from investment analysts and institutional investors to improve its sales and earnings.
The board of Mega Markets has put pressure on senior management to develop strategies to
overcome competition from online sales.
(a) Explain the value creation process for Mega Markets.
(b) Why is its value creation process now facing competition from online sales?
(c) Can the company do anything in the face of online competition?
Study guide | 249
2. Meeting the needs of today without compromising the ability of future generations to
meet their own needs. This longer-term perspective has arisen for example, in relation
to over-fishing, deforestation and global oil supplies. It is also relevant to pollution of the
environment through carbon emissions and waste disposal.
Most companies listed on the ASX now produce a corporate social responsibility (CSR)
or sustainability report in which they address issues including sustainability and pollution
reduction, and often include performance measures of their effectiveness. This is the so-
called ‘triple bottom line’ reporting of economic, environmental and social performance.
Sustainability reporting tends to be distinct from other elements of (mainly financial) reporting
and is often addressed in a supplementary statement, rather than being integrated with financial
reports or other elements in the annual report. While some stakeholders (including ethical
investors) are interested in sustainability reporting, others have little or no interest. Boards of
directors often see their responsibility, as it is prescribed in the Corporations Act (for Australian
companies), to the company and its shareholders, not to broader stakeholder groups. Hence,
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short-term financial motives often drive out longer-term aspirations for sustainability. The problem
is how to convert the long-term benefits of sustainability into current period measures of
performance and how to balance these long-term needs with the current financial need to
satisfy shareholders.
Consequently, performance measures for financial issues and sustainability issues do not always
gain the same exposure and are not always accorded similar importance in annual reports,
despite the importance of sustainability, in both its meanings. However, reputational issues
have increased the importance, not just of reporting sustainability performance, but of actually
engaging in sustainable practices. Importantly, many organisations now see engaging in
sustainable practices as necessary for long-term shareholder value, and sustainability reporting
as a means for enhancing their reputation.
Further detail on CSR is presented in the ‘Ethics and Governance’ subject of the CPA Program.
Returning to Appendix 3.1, we see that Western Water reports its performance against both
financial and environmental criteria. Western Water recognises that its success comes from satisfying
regulators, customers and government, yet it must operate in a sustainable way in order to ensure
water quality and the health of the population it services.
While one can be cynical and consider that companies engage in sustainability reporting for
purely reputational reasons, there can be sound business reasons for engaging in sustainable
practices as long-term value creation opportunities can be affected. The mining industry is a
good example.
250 | PERFORMANCE MEASUREMENT
Newcrest has strong technical capabilities in deep underground block caving, shallow targeted
underground mines, large open pits and a variety of metallurgical processing skills. The company’s
mines are located in Australia, Papua New Guinea, Indonesia, and in West Africa.
In its Sustainability Report 2014 (the 13th consecutive report produced by the company), Newcrest Mining
describes the importance it attaches to sustainability:
Over the coming years, Newcrest aims to remain focused on our key priorities of safety and
operating discipline, cash generation and profitable growth within a culture of accountability
and personal ownership. For sustainability, this means maintaining a strong focus on the
safety and health of our employees; regularly engaging with our stakeholders, including
neighbouring communities, to maintain our social licence to operate; applying robust
environmental management through application of our policies and standards to meet
regulatory requirements and manage risks; and managing all-in sustaining costs of the business
to be able to respond to changes in market conditions and progress growth opportunities
(Newcrest 2015b, p. 1).
The report covers the company’s practices and performance under the headings of economic,
environmental, social and employee performance. The sustainability report is supplemented
by a comprehensive set of data tables and a separate set of performance measures under the
Global Reporting Initiative (GRI) G3 Guidelines (the GRI for sustainability reporting is explained below).
Source: Newcrest Mining 2015b, Sustainability Report 2014, accessed September 2015,
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http://www.newcrest.com.au/media/sustainability_reports/newcrest_sustain_2014_72dpi_web.pdf.
Research in Australia by Ferreira Moulang et al. (2010) pointed out that environmental strategies
are often poorly integrated with overall business strategy. This results (among other things)
in failure to incorporate environmental impact assessments into capital investments which
leads to problems with managing future cost structures. Over half the organisations surveyed
had no performance measures addressing environment-related matters. The Newcrest case
study suggests that companies do consider environmental issues in their strategy; however,
there remains only a small amount of research concerning the integration of environmental
concerns into overall business strategy formulation or implementation. The Global Reporting
Initiative (GRI) G4 Guidelines (discussed below) address the need to adopt a more holistic
approach to reporting performance.
The GRI argues that sustainability reporting helps organisations to set goals, measure
performance, and manage change in order to make their operations more sustainable.
A sustainability report conveys disclosures on an organisation’s impacts—be they positive or
negative—on the environment, society and the economy. GRI Sustainability Reports under
G4 include the disclosure of the governance approach and the environmental, social and
economic performance and effects of organisations. Importantly, the economic dimension
of sustainability concerns the effects of the organisation’s activities on the economic conditions
of its stakeholders and on economic systems at local, national, and global levels rather than on
the financial condition of the organisation.
Study guide | 251
In addition, there are specific standard disclosures on management approach and performance
indicators (note: ‘indicators’ rather than ‘measures’ is the term used in the GRI). There are three
categories of specific standard disclosures with the social category being subdivided into four
sub-categories:
1. economic;
2. environmental; and
3. social:
(a) labour practices;
(b) human rights;
(c) society; and
(d) product responsibility.
However, not all of these have to be disclosed, only those where the organisation deems them
to be material.
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Although the G4 Guidelines have only recently been released, Australia has become one of the
fastest growing countries in the world for sustainability reporting. The Global Reporting Initiative
reports that:
Australia saw a remarkable 25 percent increase in sustainability reporting, between 2011 and 2013
with 82 percent of the top 100 companies now disclosing sustainability impacts and performance.
This makes Australia the fourth fastest climber internationally when it comes to growth in sustainability
reporting, rising from the 23rd to 12th most prolific reporting country in just two years (GRI 2014, p. 4).
An earlier GRI G3 version adopted by Newcrest Mining Limited is available in a separate document.
Candidates may wish to consult this document following their review of Example 3.6. See:
http://www.newcrest.com.au/media/sustainability_reports/newcrest_gri_content_2014_web.pdf).
Successful companies in the future will need an integrated strategy to achieve strong financial
results and create lasting value for the company, its stakeholders and society. The value created
by companies in the future cannot be expressed by an isolated financial and a sustainability
report, with no clear links between the ‘single bottom line’ and the sustainability impacts caused
or the value created in order to generate its financial results. Consequently, the Global Reporting
Initiative co-founded the International Integrated Reporting Council (IIRC) because it believed
the future of corporate reporting is the integration of financial and sustainability strategy and
reporting. Understanding the links between financial results and sustainability impacts is critical
for business managers, and is increasingly connected to long- and short-term business success.
The move towards integrated reporting has important implications for accountants in terms of
performance information.
252 | PERFORMANCE MEASUREMENT
Integrated reporting
Integrated reporting is an emerging and evolving trend in corporate reporting. It offers providers
of financial capital to an organisation with an integrated representation of the key factors that are
material to that organisation’s present and future value creation.
Integrated reports build on sustainability reporting foundations and disclosures. Through the
integrated report, an organisation provides a concise communication about how its strategy,
governance, performance and prospects lead to the creation of value over time.
Therefore, the integrated report is not intended to be an extract of the traditional annual report,
nor a combination of the annual financial statements and the sustainability report. The integrated
report interacts with other reports and communications by making reference to additional detailed
information that is provided separately.
The International Integrated Reporting (IR) Framework document (‘the Framework’) was issued
by the International Integrated Reporting Council in 2013 (please see http://integratedreporting.
org/wp-content/uploads/2013/12/13-12-08-THE-INTERNATIONAL-IR-FRAMEWORK-2-1.pdf).
In relation to performance measurement:
The Framework takes a principles-based approach… It does not prescribe specific key performance
indicators, measurement methods, or the disclosure of individual matters, but does include a small
number of requirements that are to be applied before an integrated report can be said to be in
accordance with the Framework (IIRC 2013, p. 4).
The Framework refers to a collection of ‘capitals’. ‘The capitals are stocks of value that are
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increased, decreased or transformed through the activities and outputs’ (IIRC 2013, para. 2.11)
of the organisation:
• financial capital (funds for use in the business);
• manufactured capital (machines);
• natural capital (air, water and land);
• human capital (skill, experience and motivation);
• intellectual capital (the intangibles); and
• social and relationship capital (community stakeholders).
The ability of an organisation to create value for itself enables financial returns to shareholders.
This is interrelated with the value the organisation creates for stakeholders and society at large
through the resources and relationships that are used by, and affected by, an organisation.
While the initial focus of the IIRC is on reporting by larger companies and on the needs of
their investors, it may have important implications for organisations and accountants in the
longer term.
CPA Australia believes that bringing together all the strands of corporate reporting will help
satisfy the growing demands of investors for information about performance beyond the
bottom line.
Integrated reporting is also discussed in the ‘Advanced Audit and Assurance’, ‘Contemporary
Business Issues’ and ‘Ethics and Governance’ subjects of the CPA Program.
Study guide | 253
XBRL
Integrated reporting takes advantage of new and emerging technologies such as eXtensible
Business Reporting Language (XBRL) to link information within the primary report and to facilitate
access to further detail online where that is appropriate.
XBRL (a language for the electronic communication of business and financial data) is becoming a
standard means of communicating information between businesses and on the internet. Instead
of treating financial information as a block of text (as in a standard internet page or a printed
document) it provides a unique computer-readable identifying tag for each individual item of
data (e.g. net profit after tax). Computers can treat XBRL data intelligently. They can recognise
the information in an XBRL document, select it, analyse it, store it, exchange it with other
computers and present it automatically in a variety of ways for users.
XBRL is also discussed in the ‘Advanced Audit and Assurance’ subject of the CPA Program.
Signalling
While governance is concerned with conformance and performance, and with making value
adding decisions, signalling is aimed at trying to influence someone else’s decisions. Signalling
occurs when a measure is used to communicate information (either a forward goal or an
actual achievement). One of the key roles of senior management is to communicate with
stakeholder groups. Financial statements, for example, are a signal, prepared by directors for
shareholders, about the performance of directors and managers in carrying out the operations of
the organisation (the statement of profit or loss and other comprehensive income) and in building
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the assets of the organisation (the statement of financial position or balance sheet). The key
financial performance measures presented in financial reports include various measures of profit,
cash flows, assets and liabilities.
Most organisations choose to disclose other financial and non-financial measures to investors
and other stakeholders in their annual reports, in investor briefings and through other public
communications. However, organisations need to be careful as to how much information they
voluntarily disclose (as opposed to disclosing information that is required by law) because
competitors will be one of the groups looking for competitively sensitive information that may
help them. Hence, in the example of Woolworths above, limited non-financial information was
disclosed in its annual report, at least in part because of the commercially sensitive information
this would give to their competitors. Interestingly, a comparison of annual reports over
several years reveals that each year Woolworths has disclosed less non-financial performance
information—no doubt due to the concern that this information could be advantageous to
its main competitor Coles (while Coles, a division of Wesfarmers, had no equivalent practice of
disclosing this type of information).
Being given sufficient information to understand and assess investment risk is crucial to the
ability of investors to make informed investment decisions (ASX CGC, 2014, p. 28). Signalling will
be insufficient unless investors understand the risks the company faces and the extent to which
future performance may be impacted by those risks. Boards recognise and manage risk through
establishing and reviewing the effectiveness of the company’s risk management framework
and annual reports typically disclose the company’s approach to risk management as a form
of signalling to the company’s stakeholders.
254 | PERFORMANCE MEASUREMENT
Westpac’s approach to risk management considers both negative risks (i.e. those to be avoided) and
positive risks (i.e. those opportunities that involve a risk/return trade-off). We discuss this further in
the next section.
Westpac manages the risks that affect our business as they influence our performance,
reputation and future success. Effective risk management involves taking an integrated
approach to risk and reward, and enables us to both increase financial growth opportunities
and mitigate potential loss or damage. We adopt a Three Lines of Defence approach to risk
management which reflects our culture of ‘risk is everyone’s business’ and that all employees
are responsible for identifying and managing risk and operating within the Group’s desired
risk profile (Westpac 2014, p. 36).
Review Westpac’s approach to risk management in its 2014 annual report in the ‘Corporate
governance statement’ (pages 24–42) and the ‘Risk and risk management’ section (commencing
on p. 112). The report can be accessed online at: http://www.westpac.com.au/docs/pdf/aw/
ic/2014WestpacGroupAnnualReport.pdf.
Signalling does not just occur between the organisation and outside stakeholders. Managers
in large organisations often devote much time to competing for resources for their business
unit, project or team. Performance measures can be used internally in organisations to support
claims by managers for additional resources for their business units. Often, managers who can
demonstrate success in achieving their performance goals are more likely to be given increased
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Organisations do, however, need to ensure that the signals they send are accurate. Public
relations and marketing are important elements of communication, including investor relations,
but a very real risk is when an organisation puts too much faith in its own press releases rather
than the underlying reality of performance, as the HIH case illustrates.
The Royal Commission did not find fraud or embezzlement to be behind the collapse. HIH’s failure was
found to be ‘more the result of attempts to paper over the cracks caused by over-priced acquisitions
and too much corporate extravagance’. There was a misconception in the company that ample funds
were available to fund these activities.
According to the Parliament of Australia (2003), ‘The primary reason for the failure was that adequate
provision had not been made for insurance claims. Past claims on policies had not been properly
priced. HIH was mismanaged in the area of its core business activity’.
Study guide | 255
The Royal Commission further found that the acquisition of FAI Insurance Ltd in Australia, combined
with re-entry into the US market and the expansion of the UK operations, were poor commercial
decisions. All were afflicted with under-provisioning for mandatory claims reserves. While HIH had a
corporate governance model, the Royal Commission found that HIH had failed to review the model
to assess its suitability for changing circumstances in the insurance industry. HIH’s audit committee
focused almost exclusively on the financial statements, rather than taking on the function of overall
risk identification and assessment.
The Royal Commission noted that a culture appeared to have developed within HIH not to question
leadership decisions. Alcock and Bicego (2003) wrote that the Royal Commissioner was:
frustrated by what he described as the disinclination of HIH middle managers to accept
responsibility for undesirable practices. He identified the difficulties for the Royal Commission
in considering conduct where middle managers had taken steps that resulted in the falsification
of the corporation’s accounts or returns lodged with statutory authorities. In some instances,
he observed … someone prepared a report knowing it to be false but did not sign it. The more
senior officer who then signed the document would assert as ‘reasonable’ his or her reliance
on the more junior employee who prepared the report, to argue that the senior officer’s
conduct did not constitute a breach of the law (Alcock & Bicego 2003).
HIH is a clear example of the failure of corporate governance, and the failure to provide
appropriate signalling to investors. It is also a clear case of the failure of management controls
and risk management, especially in relation to provisions for insurance claims and acquisitions.
The performance of HIH was misinterpreted, through a combination of a lack of competence
and poor ethical practices.
Corporate failures are a feature of all capitalist economies. In Australia there have been many
failures before and after HIH, but there has been no corporate failure since HIH approaching
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its magnitude.
The role of regulatory bodies and auditors always comes under scrutiny following large-scale
and high profile corporate collapses.
These videos can be viewed on the CPA Australia YouTube channel starting with Part 1 at:
http://www.youtube.com/watch?v=YYF6JW9vJKo. For quick access, type YYF6JW9vJKo
(case sensitive) into the YouTube search box.
256 | PERFORMANCE MEASUREMENT
The examples of Storm Financial and ABC Learning, like HIH, show the importance of sound
risk management as part of governance processes. They also reveal that signalling risk factors to
investors is not always as clear as it should be. For clients of Storm Financial, they may not have
adequately understood the risk of margin lending and may have taken comfort in the lending to
the company by a large bank. In the case of ABC Learning, there was little signalling to investors
as to whether the company’s acquisitions were over-valued, although an astute investor may have
questioned this and the high levels of debt.
Company annual reports require extensive disclosure of risk management information but rely on
the due diligence of investors. Unfortunately, many small investors do not sufficiently understand
the nature of risk in their investments and perhaps take too much comfort from audit reports and
bank lending (which is typically secured).
While signalling is an important element of understanding performance and the risks associated
with performance, the examples of corporate failure here perhaps reveal:
• failures in risk management at board level;
• failures of adequate regulatory body oversight; and
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Further detail on governance is presented in the ‘Ethics and Governance’ subject of the CPA Program.
The context in which the accountant operates is dictated by the organisation’s approach to
governance and risk management and how these are connected to performance measurement
and management.
The ASX Corporate Governance Council has produced corporate governance guidelines
for Australian listed entities in the third edition of its Corporate Governance Principles and
Recommendations (effective from July 2014). Corporate governance is defined in this publication
as ‘the framework of rules, relationships, systems and processes within and by which authority is
exercised and controlled within corporations. It encompasses the mechanisms by which companies,
and those in control, are held to account.’ Further it defines good corporate governance as
promoting ‘investor confidence, which is crucial to the ability of entities listed on the ASX to
compete for capital’ (ASX 2014, p.3).
It is interesting to note that the ASX guidelines have taken the definition of corporate governance
from Justice Owen in the Report of HIH Royal Commission, Volume 1: ‘The failure of HIH Insurance:
A corporate collapse and its lessons’, Commonwealth of Australia, April 2003 at page xxxiv.
HIH focused the minds of regulators and boards of directors on their roles and responsibilities,
much of which is now reflected in the ASX publication.
There are eight general principles in the ASX Corporate Governance Principles and
Recommendations that also contains 29 recommendations to give effect to the principles.
Listed Australian entities are required to make disclosure in their annual reports regarding the
extent to which they do or do not follow the principles and recommendations. The principles are:
1. Lay solid foundations for management and oversight, in particular defining the roles of and
responsibilities of the board and management and how their performance is monitored
and evaluated;
2. Structure the board to add value through appropriate size, composition and commitment
to its role;
3. Act ethically and responsibly;
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4. Safeguard integrity in corporate reporting;
5. Make timely and balanced disclosure of matters that would likely have a material effect on the
price or value of its securities;
6. Respect the rights of security holders by providing appropriate information;
7. Recognise and manage risk by establishing and evaluating a sound risk management
framework;
8. Remunerate directors and executives fairly and responsibly to attract and retain and motivate
high quality people.
The board’s role is to set objectives, and monitor performance in terms of achieving those
objectives and to report to shareholders on how well the organisation has performed. Risk
management, in this context, is managing the risks of achieving—or not achieving—those
organisational objectives. In a positive sense, the risk-return trade-off is that risks need to be
taken in order to take advantage of opportunities for the organisation. In its negative sense,
risk is that those objectives will not be achieved. Management controls are put in place to help
manage both kinds of risk. Boards will often delegate some of their role to a finance committee
(to monitor financial performance), to an audit committee (to monitor the effectiveness of controls)
and to a risk committee (to oversee the risk management process), although in practice some
of these committees may be combined. These different approaches are recognised in the
ASX Corporate Governance Principles and Recommendations (2014).
One of the key roles of the board in determining strategy is to articulate the risk/return trade-
off and the organisation’s risk appetite. There is generally speaking a relationship between
risk and return such that a higher return is expected when there is a higher risk, and a lower
return accepted where the risk is lower. In order to guide management plans and decisions,
boards need to be clear about whether the organisation’s strategy is risk averse, risk neutral,
or risk seeking, and make explicit the expected returns for risk-taking (e.g. minimum payback
periods, internal rates of return, hurdle rates).
In 2013, COSO updated the Framework to reflect changes in the business environment since
its release in 1992. The 2013 Framework retains its five components (i.e. control environment,
risk assessment, information and communication, control activities and monitoring activities);
however it adds 17 principles related to these five components that are essential for effective
internal control. Upon adoption of the 2013 Framework, organisations need to assess the
extent to which each of the 17 principles are relevant and, to the extent a principle is relevant,
whether the entity’s controls are operating effectively to achieve the principle. In addition to
the 17 principles, the updated Framework contains more guidance on how technology relates
to an organisation’s internal control structure. The 2013 Framework includes greater emphasis
on technology within the components of internal control as well as a broader focus on the
impacts of the technology on the internal control structure (COSO 2013).
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Management controls
Performance measures
(financial, non-financial Enterprise risk management
and targets
quantitative; qualitative)
Feedback
Organisational outcomes
➤➤Question 3.4
Consider the role of risk management and performance measurement in your organisation. If your
organisation produces a publicly available annual report, do a word search on ‘risk management’
and ‘performance measurement’. If you work for a smaller organisation, you may be able to ask the
CFO how he/she views the relationship between risk management and performance measurement.
How does risk management relate to performance measurement?
Appendix 3.1 shows how Western Water’s performance measurement is integrated with its approach
to risk management.
A CPA member’s responsibility is not exclusively to satisfy the needs of an individual client
or employer, as the accountancy profession has a responsibility to act in the public interest.
The Code establishes a conceptual framework that requires CPA members to identify, evaluate
and address threats to compliance with the fundamental principles. The conceptual framework
approach assists a member in complying with the ethical requirements of the code and meeting
their responsibility to act in the public interest.
The circumstances in which members operate may create specific threats to compliance
with the fundamental principles. Threats may be created by a broad range of relationships
and circumstances. When a relationship or circumstance creates a threat, such a threat
could compromise, or could be perceived to compromise, a member’s compliance with
the fundamental principles of the Code (s. 110.10). Threats fall into one or more of the
following categories:
(a) Self-interest threat—the threat that a financial or other interest will inappropriately influence
the member’s judgment or behaviour.
(b) Self-review threat—the threat that a member will not appropriately evaluate the results of a
previous judgment made or service performed by the member, or by another individual within
the member’s firm or employing organisation, on which the member will rely when forming a
judgment as part of providing a current service.
(c) Advocacy threat—the threat that a member will promote a client’s or employer’s position to
the point that the member’s objectivity is compromised.
(d) Familiarity threat—the threat that due to a long or close relationship with a client or employer,
a member will be too sympathetic to their interests or too accepting of their work.
(e) Intimidation threat—the threat that a member will be deterred from acting objectively
because of actual or perceived pressures, including attempts to exercise undue influence over
the member.
Where an ethical conflict exists, a CPA member should determine the appropriate course of
action that is consistent with the fundamental principles in the Code. CPAs should also weigh
the consequences of each possible course of action. If the matter remains unresolved, a CPA
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member should consult with other appropriate persons within the employing organisation—
particularly the board—for help in obtaining a resolution. A CPA member should also consider
obtaining legal advice to determine whether there is a requirement to report the matter to an
appropriate authority. If, after exhausting all relevant possibilities, the ethical conflict remains
unresolved, a CPA should, where possible, refuse to remain associated with the matter creating
the conflict. A CPA may conclude that, in the circumstances, it is appropriate to resign altogether
from the employing organisation or from further dealings with the client.
Ethics has a great deal of relevance to those responsible for performance measurement.
Whether this is reporting performance in an organisation in which an accountant is employed,
or reporting performance to a client. Accountants may feel under pressure to manipulate
or report performance information as a result of any of the threats identified in the Code
(some of these behaviours are described below). This kind of pressure may well have been
behind poor management practices, as it was found to be in the failures of Enron and WorldCom.
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In December 2001, US energy trader Enron collapsed. At the time, it was the largest bankruptcy in
US history. Even though the United States was believed by many to be the most regulated financial
market in the world, it was evident from Enron’s collapse that investors were not properly informed
about the significance of off-balance sheet transactions. US accounting rules may have contributed
to this, in that they were more concerned with the strict legal ownership of investment vehicles rather
than with their effective control. The failure of Enron highlighted the over-dependence of an auditor
(Arthur Andersen) on one particular client, the employment of staff by Enron who had previously
worked for their auditors, the process of audit appointments and re-appointments, the rotation of
audit partners, and how auditors are monitored and regulated.
Before the ‘Big Four’ accounting firms, there was a ‘Big Five’, one of which was Arthur Andersen.
The firm was found guilty of criminal charges in relation to the audit of Enron and its actions in relation
to disguising Enron’s off-balance sheet transactions, with the firm having instructed its employees to
destroy documents pursuant to its document retention policy. As a result, the firm surrendered its
licence to practice as accountants in the US. While the criminal verdict was subsequently overturned
by the US Supreme Court on the basis that the jury was misdirected as to the law, the damage to
Arthur Andersen’s reputation was substantial and the firm ceased to exist, with other accounting firms
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WorldCom’s and Enron’s focus on performance was almost exclusively financial, oriented on short-term
profits and share prices. This focus was supported by bonuses and share options to reward executives
for short-term profits that resulted in a culture under which ethical principles were largely ignored.
The focus on short-term financial performance obscured more fundamental non-financial measures
that might have provided signalling to those outside the companies that something was wrong.
The examples of HIH in Australia and WorldCom and Enron in the US highlight the role of
accountants in measuring and reporting performance with integrity, objectivity, competence
and due care. Not only is a failure to do so a breach of professional ethics but it can lead to
criminal penalties (there is often a fine line between a breach of ethics and a breach of the law),
as was the case with directors of HIH, WorldCom and Enron. In addition, the practice of auditing
was permanently affected by these cases. In particular, audit firms are required to demonstrate
independence and clearly separate their audit and non-audit (e.g. consulting) services.
Further detail on ethics is presented in the ‘Ethics and Governance’ subject of the CPA Program.
Control systems and performance measurement are used by principals to monitor the actions
of their agents. The principals delegate authority to agents, but the agents may act in their own
self-interest rather than in the interests of the principals. Hence, managers may award themselves
high levels of remuneration, without exercising enough effort. To overcome this potential
problem, the ‘sharing rule’ rewards the agent for performance that benefits the principal.
So managers will typically receive at least some of their remuneration through, for example,
profit-related bonuses and share options.
However, agents may avoid their responsibilities, as principals can never really be sure whether
reported performance is the result of the agent’s own efforts or of business conditions generally.
One of the criticisms of executives that emerged from the GFC (see Example 3.23) was the level
of remuneration paid to executives, even when market conditions in many industries collapsed.
Agents may also be tempted to disguise true performance levels in order to inflate their
remuneration packages and their reputations as managers. Financial reporting to shareholders
is one way in which principals can hold agents accountable for their performance. However,
the notion of ‘information asymmetry’ is that agents have far greater access to performance
information than do principals. So managers always have access to detailed management
accounting information, including non-financial performance reports, that are unseen
by shareholders.
One of the main ways in which the agency problem is addressed in business organisations
is through remuneration strategies. The annual report of Qantas, as for many other listed
companies, reveals the ways in which executive remuneration is linked to both short-term and
long-term financial (and often non-financial) performance.
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Table 3.2: Qantas remuneration of senior executives
Base pay Short-term incentive plan (STIP) Long-term incentive plan (LTIP)
A guaranteed salary level, This comprises a cash bonus and LTIP provides rights that can be
inclusive of superannuation shares if performance conditions exchanged for shares based on
set with reference to external are achieved. performance over a three-year
benchmark market data including period.
comparable roles in other listed Underlying PBT is the primary
Australian companies and performance measure (with a LTIP is based on Total
international airlines. 50 per cent weighting). Shareholder Return (TSR)
Performance compared to the
Other performance measures S&P/ASX100 Index and Qantas
are explicitly aligned to the TSR Performance compared to a
execution of the Qantas Group peer group of global airlines.
strategy, including delivering on
the transformation agenda.
Examples of these measures
include operating cash flow to
net debt, market share, unit
cost reductions, punctuality
(on-time departures and arrivals),
customer experience (measured
by Net Promoter Score),
Frequent Flyer membership
growth and safety (lost time
due to injuries and serious
injury rates).
Source: Qantas 2014, Qantas Annual Report 2014, accessed July 2015,
http://www.qantas.com.au/infodetail/about/investors/agms/2014DirectorsReport.pdf.
264 | PERFORMANCE MEASUREMENT
Being aware of potential problems in the agency relationship is important in understanding the
role of accountants in performance measurement. At least to some extent, the agency problem
was evident in the cases of HIH, WorldCom and Enron.
Further detail on agency theory is presented in the ‘Ethics and Governance’ subject of the
CPA Program.
Contingency
Another theory that is relevant to performance measurement and the role of the accountant is
contingency theory. This theory states that there is no universal best way to measure performance.
Each organisation needs to develop an appropriate performance measurement system that is
relevant to its needs. This theory suggests that the performance measurement system used by
an organisation will depend to a large extent on such factors as the size of the organisation,
its environment or technology.
For example (as seen in Table 3.3), while Woolworths (a large Australian food retailer) and a
small food retailer are both in the retail food industry, the control systems and performance
measures used by each are likely to be very different.
Table 3.3: C
omparison of control systems and performance measures for large and
small food retailers
Competes on price and range of goods with other Narrowly defined market, usually based on
large supermarket chains like Coles for weekly its location.
grocery shopping in high volume locations.
Commonly sells a large number of items to any Commonly sells a small number of items to any
single customer. single customer.
Customer requires a lower price in exchange for Customer prepared to pay a higher price in
purchasing higher volume. exchange for convenience.
Needs more formal and comprehensive controls Few, if any, employees to control.
for employees.
Uses far more technology (e.g. cash registers, May use a simple cash register with manually
barcode scanners, automated ordering). applied price stickers and ordering based on visual
inspection.
➤➤Question 3.5
You are a CPA, working as the chief financial officer (CFO) of a privately owned company with
annual sales of $10 million. The chief executive officer (CEO) is the main shareholder who also
acts as chairman of the board. The only other directors are you and the chairman/CEO’s wife.
After producing the draft end-of-year financial statements, you discuss the results with the CEO.
His response is that the profit of $250 000 is too high and the tax bill the company will have to
pay will prevent the company from repaying its bank loan in the following financial year. As the
company does not keep a perpetual inventory system but relies on standard costs of goods sold
and periodic stocktakes, the CEO suggests to you that the year-end stocktake figure be reduced
in order to reduce the taxable profit to around $150 000.
You respond that such a practice is illegal. The CEO’s reply is that the inventory level at year end
was close to $1 million, so any adjustment could be readily disguised. Over your further objections,
the CEO demands that you adjust the inventory downwards by $100 000 and that if you are
not prepared to make the adjustment, then you might as well resign from the company today.
1. Discuss the implications of the CEO’s demand in relation to:
(i) governance;
(ii) signalling; and
(iii) ethics.
2. Recommend any actions that you, the CFO, may be able to take.
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266 | PERFORMANCE MEASUREMENT
Strategy must be implemented after it is formulated, and it is here that performance measurement
is important. Ansoff (1988) established a hierarchy of objectives that were centred on performance
measures such as return on investment. Similarly, Galbraith and Nathanson (1976, p. 10) argued
that ‘variation in strategy should be matched with variation in processes and systems as well as
in structure, in order for organisations to implement strategies successfully’. These variations in
processes and systems would include variations in performance measurement.
Porter (1980) also identified three ‘generic strategies’ for competitive advantage:
1. cost leadership;
2. differentiation; and
3. focus.
All strategies should contain goals and organisations need to introduce processes for measuring,
monitoring, managing, improving and reporting performance to ensure that goals and strategies
are achieved. Different strategies require different approaches to performance measurement.
For example, an organisation facing substantial industry competition may measure market share
(e.g. the motor vehicle assembly and retail supermarkets industries). An organisation facing
substantial bargaining power by customers may measure customer profitability (e.g. clothing
Study guide | 267
manufacturers selling to department stores such as Myer and David Jones in Australia). Similarly,
if an organisation adopts a cost leadership strategy, we would expect to see performance
measures that focus on efficiencies in purchasing and production to achieve cost reduction and
competitive pricing. By contrast, an organisation adopting a differentiation or focus strategy
(where cost and price are less important) may give more attention to performance measures
related to innovation, product features and benefits, advertising effectiveness, or brand
reputation. Hence, the performance measures used by Ford and BMW, for example, are likely
to be different. Although it is likely that both companies will focus on performance measures for
cost and brand reputation, the emphasis they give to those performance measures is likely to be
quite different.
The particular performance measures adopted by any organisation will depend on its strategy
and its objectives. This follows from contingency theory, that is, an organisation will select
appropriate performance measures contingent on factors including its strategy and competitive
position, as well as its technology and size. These performance measures will then be used to
monitor how well the organisation achieves its strategy.
Porter (1985) also introduced the ‘value chain’ as a tool to help create and sustain competitive
advantage through recognising the need to add value in each of the organisation’s primary
activities.
The concept of creating value was explained in Module 2 and in Part A of this module. Porter
argued that customers are prepared to pay for the value created but that organisations need
to keep the cost of generating this value lower than the premium customers are willing to pay.
This is the margin in the value chain—the difference between the cost of providing the primary
and support activities, and the revenue gained from customers.
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As for different approaches to strategy, an organisation’s value chain is likely to influence its
performance measures. Example 3.12 below shows performance measures for a retail store,
based on the primary and support activities in the value chain.
Example 3.12: P
erformance measures and the value
chain—a retail store example
Value chain activity Examples of performance measures
Primary activities
Support activities
These performance measures might be developed by identifying key value-adding activities for
the retail store, on the assumption that sales revenue and margin are affected by each of these
aspects of performance. It is important to note that Example 3.12 lists examples of performance
measures. Each organisation would develop the performance measures it deems appropriate to
achieve its strategic objectives.
➤➤Question 3.6
Revisit the information in Question 3.3 (both the question and suggested answer). Using Porter’s
generic strategies:
(a) How would you describe Mega Market’s strategy?
(b) Compare the value chain for Mega Markets with one of its international online competitors.
Review Appendix 3.1 for a good example of how strategy influences performance measurement.
Decision-making is concerned with making choices from among alternative courses of action.
This requires an understanding of the desired objectives, some knowledge of the alternatives,
and the ability to estimate the likely results of each alternative.
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Often there will be conflicting objectives including long-term and short term financial objectives.
In the short-term, profits and cash flow must satisfy investors, but not at the expense of long-term
sustainable profits and cash flow.
There will also be non-financial objectives such as maintaining environmental and social values.
When non-financial performance objectives are added (e.g. market share objectives or the need
for innovation), the resulting multiple objectives will impact on management decisions.
Alternative courses of action may be imperfectly known as they will require information about
customers, markets and suppliers that may be unknown. The results of those alternatives are
based on predictive models that are also imperfect.
Management controls are focused on objectives set during the organisation’s strategic planning
and budgeting cycles. However, market conditions change between these planning and budget
cycles as competitors’ strategy and economic conditions alter, and customer demand fluctuates.
Decision-making needs to consider current circumstances rather than be overly focused on an
objective that was set at a different time when conditions were different. Hence, there may be
tension between the needs for management control and for more flexible decision making.
Decision-making by managers will focus on objectives but it must also consider approaches
besides passing on higher costs through increased pricing, and the impact they might have on
revenue, market share and profitability.
In this simple feedback model, decisions need to be taken about the standard to apply,
the method of measurement, a means of comparison and the ability to take corrective action.
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In the business environment, the cybernetic approach and feedback can be illustrated by a
comparison between target and actual sales performance. The target (or budget) performance
for a sales department may be a specified level of sales revenue. The accounting system is
the method by which the business measures actual sales revenue. Comparison takes place by
reporting both the target and actual sales income and calculating a variance. Feedback takes
place by using the comparative data to determine corrective action by management to improve
future performance relative to target. These actions may include sales force training, additional
marketing, incentives, or perhaps modifying the target.
➤➤Question 3.7
Consider the following example of feedback in a ‘budget versus actual’ comparison for
SalesVol Ltd. The company budgets to sell 10 000 units of a product at an average selling price
of $3.50. At the end of the period, the accounting system records actual revenue of $33 750 for
9000 units. Three versions of reporting from an accounting system are shown below. The first two
use a traditional budget approach, while the third uses a flexible (or flexed) budget approach.
Sales revenue $35 000 $31 500 $33 750 –$1 250
(Unfavourable)
(a) Use the information in each version of the report to explain the elements of cybernetic or
feedback control that lead to corrective action.
(b) Explain how each report could be useful to management decision-making.
Question 3.7 focuses on cybernetic control because it tends to dominate accounting systems.
However, there are many ‘informal’ kinds of control that might not always be readily observable,
particularly those based on employees’ culture and belief systems.
Otley (1999) argued that performance management provides an important integrating framework
for the different elements of management control systems, containing both formal and
informal kinds of control. A further framework for performance management systems (PMSs),
developed by Ferreira and Otley (2009), contains eight core elements:
1. vision and mission;
2. key success factors;
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3. organisation structure;
4. strategies and plans;
5. key performance measures;
6. target setting;
7. performance evaluation; and
8. reward systems.
The PMS exists within a set of broader contextual and cultural influences.
Chenhall (2003) writes that the definition of management control systems has evolved from formal,
financially quantifiable information to include:
• external information relating to markets, customers, and competitors;
• non-financial information about production processes;
• predictive information; and
• a broad array of decision support mechanisms and informal personal and social controls.
Hence, management control and performance measurement, which we have already defined
as having financial, non-financial, quantitative and qualitative dimensions, have become
almost synonymous.
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➤➤Question 3.8
Reconsider the information in Question 3.7. Apart from the financial controls shown in the various
‘budget versus actual’ reports, what additional formal and informal controls are likely to influence
sales behaviour in a company like SalesVol Ltd? (In responding to this question, think about the
kind of controls listed above.)
Return on investment (ROI), for example, is an often used measure of financial performance.
However, it has long been argued that ROI has significant limitations. There are substantial
questions around:
• the level of investment that should be used: total capital employed or net assets;
• whether assets should include non-current, current or both; and
• whether assets should be valued at cost or book value (Solomons 1965).
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For example, assume that the organisation’s cost of capital was 15 per cent and that Division A
is currently operating on an ROI of 25 per cent. However, the manager of Division A rejects an
investment that is going to return 20 per cent, because it would lower Division A’s ROI. This is
problematic for the organisation as a whole, as the 20 per cent return from that investment is still
higher than the organisation’s cost of capital (15%). This highlights a limitation of using ROI as a
sole financial measure of performance.
Beyond Budgeting is based on 12 principles. The first six principles are concerned with taking the
right leadership actions to address the drivers of change, and the second six align management
processes with leadership actions. Importantly for an understanding of performance
measurement, the Beyond Budgeting approach:
• abandons fixed targets in favour of relative goals for continuous improvement;
• makes resources available as needed, not through annual budget allocations;
• rewards shared success based on relative performance, not fixed targets; and
• bases controls on relative indicators and trends, not variances against a plan.
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Hope and Fraser (2003), who promote the Beyond Budgeting approach, suggested that budgets
should be replaced with a combination of financial and non-financial measures, with performance
being judged against world-class benchmarks.
A more recent development has been that of ‘lean accounting’, a development from the concept
of ‘lean thinking’ in manufacturing, which is described in detail by Womack and Jones (2003).
Lean thinking is a management philosophy that focuses on customer value and results in the
use of fewer resources, a reduction of waste, and improved outputs from existing resources.
The redesign of end-to-end processes, as well as individual activities, helps to make the
organisation more efficient in generating that customer value. A ‘lean’ approach focuses on
only doing activities that add value and eliminating those that do not. While this concept
of removing non-value adding activities is often applied to the actual production of goods,
it can also be applied to the work done by accountants.
Lean accounting is a contemporary vision of how the accounting function should be run in
organisations. It challenges the need for many of the traditional accounting tools and outputs,
which are deemed to be complex, untimely and wasteful of resources. Lean accounting focuses
on simplifying processes, reducing waste and speeding up the accounting function to improve
decision making, reduce errors, and add greater value to the organisation. This involves a detailed
review of the work done by accountants in an organisation and a search for ways to reduce errors
and mistakes, and complete work in faster ways. However, it also involves using some simpler
techniques such as direct costing of items (rather than including overheads—which is a difficult,
time-consuming and often confusing activity), eliminating activities such as standard costing and
variance analysis and introducing simplified management reporting to improve decision-making.
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Lean accounting abandons detailed time recording and material issues to production in favour
of backflush costing, or backflushing, which refers to a type of automated measurement or
costing system. Instead of itemising the inventory and manufacturing costs throughout the
whole production process, a backflushing system waits until a product is finished and then
simply assigns standard costs for materials and labour to the product.
In this way, backflushing simplifies the costing process (as opposed to detailed costing and
variance analysis). A backflush costing system is based on standard costs or estimates of the
inventory values. At the end of a period, a stocktake identifies the number of inventory items
physically in storage and assigns or confirms the cost of that inventory. If the stocktake reveals
inventory values that are close to the backflush costing estimates, then backflush costing is
assumed to be cost-effective and worthwhile.
As traditional accounting tools are criticised for being less relevant in the modern business
environment, non-traditional approaches that are industry- and organisation-specific take on
new meaning, while non-financial performance measures take on a greater level of importance
in guiding organisations towards their goals. The example of TNA, which follows, illustrates
how one company created a new approach where traditional accounting tools failed to help
the organisation’s strategy.
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Example 3.13: T
NA—a strategic management accounting
approach to performance measurement
TNA is a privately owned engineering company based in Australia, with multinational sales of
computer-controlled packaging equipment to large food manufacturers. TNA’s global success was
derived from its innovative design, worldwide patent protection, continual investment in research and
development, and the development of export markets. From the start-up of the business, accounting
performance was of limited value to TNA’s owners. Accruals accounting on a financial year basis did
not take into account the long lead times (often several years) between research and development
and export market development expenditure and income from sales. For the same reason, budgets
(other than budgeted sales volume) were of limited use. TNA rewarded its marketing and research
staff through high salaries and bonuses in order to retain their expertise. In addition, the company
expended many millions of dollars in legal fees in patent litigation against much larger companies
which were infringing TNA’s patents. It took many years for TNA to win these actions and recover
costs and damages. While accounting was necessary for regulatory and taxation purposes, it was not
used for management control.
TNA designed its computer numerical control (CNC) equipment but subcontracted manufacture of the
components to various suppliers, then assembled the final machines in its Melbourne factory before
delivering them to customers. This avoided the problems of capacity utilisation that are inherent in
manufacturing companies.
TNA had a pricing policy that discouraged discounting because of the technical superiority of its
machines. This enabled a high margin between the selling price and the cost of the components.
In its early years, TNA’s owners exercised management control through a cash flow based spreadsheet
model, where the only real performance measures were the number of machines sold, the percentage
of sales reinvested in research and development, and the availability of cash to fund business growth.
The model used sales volume to drive purchasing of components and assembly planning, included
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data on outstanding orders and inventory, and cash flow projections over several years. It was updated
on an almost daily basis as new orders were received.
As the company grew, a much more sophisticated spreadsheet model was developed that thoroughly
documented the industry in which TNA sold its machines, including the customers targeted for future
machine sales and the competitors whose customers may be more susceptible due to the financial
constraints of their current suppliers. Much of this data was gathered at engineering exhibitions, from
websites and from informal conversations with suppliers and employees of TNA’s competitors.
Over a long time period, TNA’s owners developed this spreadsheet model to a point where it became
the central management control tool used within the company. TNA’s performance measures now
expanded to include a focus on growing market share and reaching what the owners termed a ‘critical
mass’. TNA defined critical mass as ‘having enough capital to withstand serious fluctuations in general
business levels, being able to fund sufficient development to maintain the company’s leading edge in
technology, and being able to withstand the competition’ (Collier 2005, pp. 321–39). The information in
this spreadsheet enabled TNA to target the customers of weaker competitors and win more business
than it might otherwise have been able to do.
The second version of the spreadsheet model is a good example of strategic management accounting.
It looks beyond the current financial year, applying a life cycle perspective; it looks beyond the
organisational boundary to the whole industry; and uses information to drive strategy implementation
(Collier 2005, pp. 321–39).
As a privately owned company, TNA’s owners were unconcerned with short-term profits, seeing longer
term market share growth and reinvestment in research and export market development as far more
important. Hence profit targets and traditional financial performance measures held little importance,
although cash flow was critical.
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The TNA case illustrates the importance of performance measurement in management control,
and the role that management control plays in achieving the goals set by the organisation.
However, the example also shows that the accountant’s natural focus on financial performance
is not always the most appropriate one.
There are other limitations of traditional controls, notably that gaming and biasing
accompanies them, the tendency to focus on short-term performance at the expense of
sustainable performance, and the masking of cause and effect relationships. These behavioural
consequences are discussed in more detail below.
➤➤Question 3.9
Assume that you are the chief financial officer for an organisation with responsibility for financial
reporting, accounts payable and accounts receivable. Make a list of the management controls that
could be implemented to help ensure that the organisation’s operations are efficient and effective.
Strategic performance is concerned with sustainable performance over time at the whole
organisational level, over multiple time periods, taking into account strategic goals, economic
conditions and the competitive environment. Strategic performance will be concerned with
product life cycles (see Module 4) and supply chains, and maintaining or increasing market
share through competitive strategy (e.g. cost leadership, differentiation or focus strategies).
Strategic performance will be linked to risk management through the risk–return trade-off and
the organisation’s risk appetite as determined by the board of directors.
What these strategic performance measures are will be determined by the organisation’s
strategy. Chenhall (2003) has argued that they are designed to present managers with financial
and non-financial measures covering different perspectives which, in combination, provide a way
of translating strategy into a coherent set of performance measures. Chenhall (2005) argues that
a key element of strategic measures is that they provide integrated information to help managers
deliver positive strategic outcomes. He identifies three attributes of strategic measures:
1. strategic and operational linkages: these capture the overall extent of integration between
strategy and operations and across elements of the value chain;
2. customer orientation: linkages to customers including financial and customer measures; and
3. supplier orientation: linkages to suppliers and includes business process and innovation
measures (Chenhall 2005).
Example 3.14: C
losure of the Australian automotive
manufacturing industry
Companies like General Motors (GM), Ford and Toyota, being listed on global stock exchanges, need to
satisfy short-term stock market expectations. Therefore, there is an emphasis on financial measures
such as ROI, return on capital employed (ROCE), sales growth, profit growth and cash flow. In fact,
all the traditional financial ratios used to interpret business performance from the income statement
and balance sheet.
However, strategically, GM has suffered from falling market share and profits and was effectively
saved from bankruptcy by the US Government during the GFC, while Ford narrowly escaped that
predicament. Many of the problems faced by both companies have been caused by legacy health
insurance and pension-fund contributions for past and present employees in the US, sales demand
that has fallen well short of GM and Ford’s production capacity and the high fixed costs which result
from excess capacity. By contrast, Toyota has steadily won global market share at the expense of the
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US companies, largely as a result of its longstanding commitment to quality and its emphasis on lean
production, which it terms a ‘cost down’ approach. However, Toyota faced quality problems in the US
which caused it some reputational damage, and suffered a major disruption to its supply chain as a
result of the 2011 earthquake and tsunami and subsequent nuclear reactor damage in Japan.
Automotive companies like GM, Ford and Toyota are mainly designers and subsequently assemblers
of those vehicles, with components sourced, often globally, from multiple suppliers. Automotive
companies need to continually invest in new product designs to develop and introduce new model
vehicles that meet anticipated economic conditions, market demand and competition. Given the
time taken to bring a new product to market in the industry, this can be a complex process, involving
identifying what customers may want several years into the future, the efficient design of new models,
cost-effective purchasing of components and efficient assembly capacity utilisation.
Despite the needs of short-term financial performance reporting, automotive companies often adopt
life cycle costing for their models, recording the profits (or losses) for each model of vehicle over
each year of its life from initial design through to abandonment, in order to learn lessons that can
be applied in future models. Japanese companies like Toyota appear to have been more effective
in applying target-costing approaches (see Module 4) before a new model goes into production,
and collaborating with suppliers to achieve the most cost-effective design, purchase cost and assembly
processes. Japanese companies have also emphasised kaizen (continual improvement) approaches
during production to drive costs down, while Toyota’s emphasis on lean production and ‘cost down’
through the Toyota Production System has been recognised as an important factor in Toyota’s success
over its US automotive rivals.
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In Australia, Ford, GM and Toyota have all announced closure of their assembly operations by 2016–17.
There are several causes of these decisions, which are more strategic than operational. These companies
have an inefficient scale of production due to Australia’s small market size and competition from
imported vehicles, exacerbated by the strength of the Australian dollar relative to other currencies
(especially the US dollar). The final element in Ford, GM and Toyota’s decision was the reduction and
projected cessation of government financial support for the industry.
A report by the National Australia Bank revealed that production and sales of vehicles has almost halved
between 2004 and 2012, while imports have doubled (NAB 2014). The Commonwealth Department
of Industry has stated that the Australian vehicle manufacturing industry has not returned a profit
since 2003. These are measures of strategic performance that these companies are unable to ignore.
There is a substantial effect of these closures not just on direct employment but on the automotive
component sector which supplies Ford, GM and Toyota. Many of these suppliers would have been
aware of repeated press reports about the problems faced by the automotive industry in Australia.
However, they may not have incorporated strategic performance measures in to their strategic plans—
measures that would likely have addressed the life cycle of automotive products and the profitability
of the whole supply chain.
This example highlights the importance of balancing short-term operational performance with
longer-term strategic performance, and extending the corporate view beyond the organisation’s
own boundary to its supply chain.
(as mentioned earlier) tend to focus on short-term performance, sometimes at the expense
of longer-term performance. Second, they are lagging rather than leading measures of
performance. Lagging means to follow, come afterwards, or occur later on—in other words,
lagging measures provide information about what has happened after the event, when it may
be too late to take corrective action. A leading measure on the other hand, provides a more
‘here and now’ view of performance and is likely to help explain or predict or even cause the
result of a lagging measure.
Any accountant will know that by restricting certain expenditures, there is likely to be an
improvement in short-term profits, the consequences of which will only be felt in the medium or
long term. So, for example, if an organisation restricts its expenditure on advertising, employee
training, repairs and maintenance or research and development (R&D), there is not likely to
be any significant negative impact on financial performance in the current year. However, it is
inevitable that financial performance in later years will suffer. Similarly, delaying new capital
expenditure will defer higher depreciation charges, but will also delay any efficiencies or
volume expansion that rely on capital expenditure. Hence, an emphasis on leading measures
(e.g. reducing expenditure on advertising, R&D, etc.) may improve current profits, but the
lagging effect will almost certainly be felt on revenue and profits in later years.
Sales revenue (a lagging measure) may fall because of a decline in customer satisfaction,
a consequence of performance reflected in a combination of many leading measures—such as
quality of the product or service, how well the customer was treated, how fast the customer’s
order or query was attended to, and the price of the product.
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There are many performance measures available for different functional areas of an organisation.
For example, possible measures for the marketing and sales function include:
• number of promotional events;
• number of sales calls;
• advertising exposures;
• distribution outlets;
• products carried per outlet;
• delivery time;
• percentage of perfect orders (correct products delivered on time); and
• average time to resolve customer problems (Clark 2007).
Possible measures for the operations function fall under five broad headings:
1. quality pass rate;
2. dependability;
3. speed;
4. flexibility; and
5. cost (Neely 2007).
Other measures apply to human resource management, procurement and supply chains.
➤➤Question 3.10
Chocabloc Ltd (Chocabloc) produces chocolate bars. The company’s raw materials are mainly
cocoa, imported from Brazil, and milk, sourced locally from dairy farms. Chocabloc produces a
wide range of chocolate bars that are distributed by a national logistics company to retail stores
around the country.
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Chocabloc has patented the formulas for its range of chocolate bars, many of which have been
sold for a decade, while others for only a few months. The company spends considerable funds on
research and development for new chocolate bars, and before each new product launch, it engages
in an exhaustive and expensive market research program to assess customer demand for the
new product. If there is any doubt about the market potential of a new product, it is withdrawn.
Where market research indicates a strong likelihood of success, Chocabloc invests heavily in
advertising and has a team of sales representatives in each sales region who visit retail stores
and take orders for the chocolate bars. Those orders are processed at Chocabloc’s headquarters
and are fulfilled by the logistics supplier. Extensive management attention is given to minimising
wastage and ensuring product consistency through quality control.
Based on the information in this scenario, identify the performance measures that might be
recommended to the management of Chocabloc. Consider strategic and operational measures,
as well as leading and lagging measures, and financial and non-financial performance measures.
Note: Categorise the selected measures under the headings of strategic performance measures,
leading performance measures and lagging performance measures.
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Another interesting framework is the performance pyramid of Lynch and Cross (1991).
The pyramid has descending objectives and ascending measures beginning with corporate
vision, cascading through successive layers of business units, core business processes,
departments, work groups and individuals. One side of the performance pyramid is concerned
with market performance (customer satisfaction, flexibility, quality and delivery) and the other
side to financial performance (flexibility, productivity, cycle time and waste).
A framework that was developed specifically for service industries was the Results & Determinants
Framework (Fitzgerald, Johnston, et al. 1991). In this framework, results (competitiveness and
financial performance) were distinguished from the determinants of results (quality, flexibility,
resource utilisation, innovation).
The European Foundation for Quality Management (EFQM) Excellence Model separates five
enablers (leadership, people, policy and strategy, partnerships and resources, and processes)
and four result areas (people, customer, society, and key performance), all underscored by
innovation and learning, with performance measures identified for each enabler and result
area (see http://www.efqm.org). The EFQM model is used widely in the public and not-for-profit
sectors as well as in many business organisations.
‘Six Sigma’ was originally developed by Motorola to reduce variability in manufacturing and
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business processes. It recognises the cost and impact of failure in any single process on the
overall yield using a methodology known as DMAIC: de fine, measure, analyse, improve, control.
Six Sigma relies extensively on statistical techniques. The Six Sigma Business Scorecard has
seven elements covering all of the functional business areas:
1. leadership and profitability;
2. management and improvement;
3. employees and innovation;
4. purchasing and supplier management;
5. operational execution;
6. sales and distribution; and
7. service and growth.
The performance prism was developed by Cranfield University academics. This framework has
five facets:
1. stakeholder satisfaction (what stakeholders want);
2. stakeholder contribution (what the organisation needs from its stakeholders);
3. the strategies;
4. processes; and
5. capabilities that an organisation needs to satisfy the wants and needs.
Each of the five facets has its own measures but the overall focus of the performance prism is on
stakeholder satisfaction.
The customer, business process, and innovation and learning perspectives are considered
as leading measures with financial measures being the lagging measures of performance.
Kaplan and Norton (1992, 1993, 1996a) do not prescribe the performance measures that should
be used, but suggest that organisations use performance measures and targets linked to their
objectives, affirming the clear link between strategy and performance measures. This reflects the
contingency approach discussed earlier in this Module. The BSC ‘translates a company’s strategic
objectives into a coherent set of performance measures’ (Kaplan & Norton 1993, p. 134).
Examples of performance measures in the customer perspective include market share, customer
satisfaction, customer retention, net promoter score and brand reputation. Performance measures
in the business process perspective may include quality pass rate, on-time delivery, cycle time
(from order to delivery) and productivity. In the innovation and learning perspective, performance
measures may include employee retention and satisfaction, investment in training, research and
development expenditure, and new patent registrations.
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There is no rule that says a particular measure should go in a particular perspective. Sometimes
you will see market share in the financial perspective (as it is based on revenues), and other times
it will be in the customer perspective (as it reflects how many customers an organisation has).
Some other examples include the measure of ‘on-time delivery’ which could be classified as a
customer perspective, or a business process perspective. It would depend on the purpose of
the measure for the organisation (i.e. whether the focus was on customer satisfaction, or the
organisation’s effectiveness in operations).
Similarly, capital expenditure measures would typically be found in the financial perspective.
However, the capital expenditure may appear in other perspectives if it specifically relates to
improvements in efficiency (investment in new or improved business processes), or training
facilities (investment in innovation and learning).
The important thing is for an organisation to be able to logically explain why an item is placed
or classified in a particular perspective. This is a further example of contingency theory.
An organisation will determine the performance measure and the perspective that best reflects
that measure based on its strategy, competitive position, size, etc. So for example, a strategy
to improve workforce skills would lead to performance measures being developed in the
innovation and learning perspective. A strategy to improve on-time delivery would mean
performance measures being developed in the business process perspective. Both strategies
would be linked (with others) to the overall business objectives of improving financial objectives
such as sales growth, cost reduction and increased profitability.
There is no exact or correct number of measures to include in a balanced scorecard. Too few
measures will mean you do not have a clear picture of what is going on in the organisation and
you may miss out on detecting issues because you do not have enough leading measures.
Too many measures means you may be distracted or unable to focus on the most critical items.
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Kaplan and Norton (1992; 1993; 1996a) recommend three or four measures for each of the four
perspectives in the balanced scorecard (12 to 16 in total). This is only at the top level though.
For lower levels of the organisation there may be many more measures which all link together
and are summarised by these final 12 to 16 measures. The cascading of performance measures
to business units is discussed further below.
The relative importance of performance measures is addressed to some extent in the BSC
by the assumption of a hierarchical relationship between the four perspectives, and hence
between the four sets of performance measures. Improving learning and growth (achieving
innovation) will transform business processes, which will in turn lead to more satisfied customers
and finally to financial performance. Between each hierarchical level, some value creation
is assumed.
Figure 3.3 illustrates the relationships between the elements in the BSC.
Financial perspective
Goals, performance measures and targets
Customer perspective
Goals, performance measures and targets
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There has been an almost continuous development of the BSC approach through articles and
books, but one of the distinguishing features of the BSC compared with other frameworks is the
notion of ‘balance’. Balance in the BSC implies that organisations cannot maximise performance
on all four perspectives simultaneously. Rather, there should be balance between these
perspectives with optimum overall performance being the result of finding the right balance
between performance as measured by all four perspectives.
Appendix 3.1 shows how Western Water uses the balanced scorecard as a key element of its
strategy implementation.
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What we mean by causal relationships is that when you do one particular thing right it will
directly lead to or cause an improvement in another item. For example, assuming that increased
advertising will cause or lead to more sales revenue, or that high customer satisfaction levels will
cause or lead to higher profits.
The measures in each of the balanced scorecard’s four perspectives are meant to successfully
link together. Figure 3.3 shows this cause-effect situation or relationship. However, the criticism
is that this might not be the case. An example is a monopoly situation where a company is able
to increase profits by providing lower levels of service, which would actually annoy customers
(and the customers cannot switch to another provider—as there isn’t one). In a different situation,
satisfied customers may not lead to higher profits because you may be charging prices that
are too low.
Therefore, we cannot assume that a change to the leading measure will have a cause-effect
change on the lagging measure. One of the difficulties in setting objectives and performance
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measures is the ‘predictive model’ used by the organisation. The predictive model is the set of
assumptions that lie behind an organisation’s strategy implementation.
Concerns have also been raised by Norreklit (2000) about how effective the goal-setting and
performance measurement process really is. In Otley and Berry’s words:
organisational objectives are often vague, ambiguous and change with time … Measures of
achievement are possible only in correspondingly vague and often subjective terms … Predictive
models of organisational behaviour are partial and unreliable, and … different models may be held
by different participants … The ability to act is highly constrained for most groups of participants,
including the so-called ‘controllers’ (Otley & Berry 1980, p. 241).
Otley and Berry’s critique was that organisational goals are often ambiguous (i.e. that different
goals are held by different organisational participants). For example, sales managers may prefer
sales growth, while operating managers may be pursuing greater efficiencies and economies of
scale. This is the case even in a stable environment, while rapidly changing environments can
quickly change organisational goals in response to emerging threats and opportunities.
Predictive models are inherently difficult as they assume agreement by organisational participants
as to cause–effect relationships. For example, the predictive models of Qantas and Jetstar are
different, despite their common ownership, because they assume different expectations about
frequency of flights, on-time departures, in-flight service, pricing etc. However, not everyone in
Qantas and Jetstar would be likely to share the same assumptions that are contained in those
predictive models. Equally, not all Jetstar customers would be likely to accept the different
standard of service inherent in those different models (witness for example, any of the airline
documentaries about customer response to late check-ins or flight delays with low-cost airlines).
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Finally, Otley and Berry (1980) drew attention to the limited capacity of organisational participants
to affect change, either because of budgetary constraints, organisational policies or other formal
management controls that are aimed at feedback: reducing the gap between target and actual
performance, rather than as tools for learning and continuous improvement. To be truly effective,
performance measures should lead to organisational learning and improvement. Organisational
learning takes place by using performance information to communicate and continually
re‑evaluate the predictive model used within the business, the appropriateness of the selected
performance measures and their associated targets, and the kinds of corrective actions that
managers are able to take to reduce performance variations relative to targets.
The organisation’s strategy will also determine the performance measures. A strategy based on
innovation, such as Apple’s strategy (see Example 3.4) will determine many of its performance
measures, whereas Woolworth’s strategy (see Example 3.5) on new stores and sales revenue
growth will dictate different performance measures. Part of strategy is identifying the relevant
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performance measures, which will determine the most important areas of success for the
organisation’s predictive model, whether that be new patents for Apple, or sales per square
metre of floor area for Woolworths.
Once these measures have been identified, the final aspect of designing a performance
measurement system is to balance strategic and operational measures, leading and lagging
measures, financial and non-financial measures, and the perspectives on performance that are
relevant to the organisation. These perspectives may be the four perspectives in Kaplan and
Norton’s (1992; 1993; 1996a) BSC, or the five facets in the performance prism or another relevant
framework for performance measurement.
An example of how strategy is developed into performance measures is given in Appendix 3.1.
TNA’s financial goals required sales growth to achieve its business strategy of achieving critical
mass (which as we saw in Example 3.13 was defined as having sufficient capital to enable TNA to
withstand general business fluctuations and competition while maintaining its investments in R&D).
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Cash flow was not only to maintain organisational viability during its high growth strategy but also to
underwrite its obligations to the banks which had lent the company money. As TNA subcontracted
the manufacture of all components and assembled the final machines, gross margin was an important
measure. However accounting profits were not important to TNA as a focus on short-term profit would
likely have detracted from the company’s strategy of long-term market growth and its investments in
export market development, patent litigation and research and development (R&D).
TNA’s customer goals focused on developing new export markets as those markets it entered became
saturated. Within each geographic market, new customers and new machine installations were the key
measures of marketing success, with outstanding orders, on-time delivery and customer satisfaction
important supporting measures to enable sales to new customers and sales of new machines.
Net promoter score is a useful measure of customer satisfaction as it reflects whether a customer
would recommend the supplier to a friend or colleague.
TNA’s business process perspective was centred on its strategy of outsourcing the manufacture of
components, and using its skill base to assemble the components it had designed and retaining
its intellectual capital in-house. Hence, performance measurement was on the quality and delivery
of components from suppliers, the time taken to assemble those components and the quality pass
rate—the quality of assembled machines before delivery to customers.
Innovation and learning were critical to TNA and the measurement of staff retention, staff satisfaction,
investment in R&D and the ability to develop new patents from its R&D matched TNA’s strategy of
continual development of products ahead of competitors in order to retain a strong market position.
Patent litigation measured the success of the company’s court actions against those competitors who
had infringed TNA’s patents.
TNA’s overarching strategic goal was market share growth to achieve and maintain its critical mass,
linked with its targeting of weaker competitors (which was explained in Example 3.13).
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The Balanced Scorecard Institute has a series of questions that link performance measures to
strategic initiatives, available online at: https://balancedscorecard.org/Resources/Cascading-Creating-
Alignment/Metric-Features.
The benefits and challenges of implementing a balanced scorecard are highlighted by Balanced
Scorecard Australia at: http://www.balancedscorecardaustralia.com/frequently-asked-questions.
In the Australian public sector, public hospitals are a state government responsibility and
performance measures are tied to funding. However, funding for specific initiatives also comes
from both State and Federal governments and so hospitals must have performance measures
to be able to report on actual and target to the funding agencies in relation to the outcomes
tied to each different parcel of funding.
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Australian public sector organisations that have successfully adopted the BSC include the
Australian National Audit Office, the Department of Human Services and the Department of
Defence. Public sector performance measures are contingent on the organisation’s purposes.
For example, the Department of Human Services delivers payments to people who qualify for
various levels of income support. Its stakeholders include government (as the funder), and client
groups (people who receive financial assistance) as well as the professional staff who carry out
the organisation’s functions.
In addition, there are various qualitative judgments, including Government stakeholder assessment
of the organisation’s agility, flexibility and responsiveness.
Likewise, a not-for-profit organisation such as a charity will have stakeholders including its donors
and the beneficiaries of its services. Compliance with charitable rules will incorporate the regulatory
body as a further stakeholder. Because charities rely extensively on volunteers, they are a further
stakeholder group.
Study guide | 285
Example 3.16: T
he balanced scorecard at the National Library
of Australia
The library’s role, as defined by the National Library Act 1960 (Cwlth), is:
to ensure that documentary resources of national significance relating to Australia and the
Australian people, as well as significant non-Australian library materials, are collected, preserved
and made accessible, either through the library or through collaborative arrangements with
other libraries and information providers.
The National Library of Australia’s objective is to ensure that all Australians can access,
enjoy and learn from a national collection that documents Australian life and society. Through
open access to the national collection and online services, Australians should be able to easily
discover and obtain the information they are seeking and to engage with rich digital content
to support their lifelong learning.
The library has been using the Balanced Scorecard for number of years. Its website explains its approach
to performance measurement:
The Balanced Scorecard is a strategically focussed performance management system.
It provides a framework that translates the library’s vision and strategy … into a comprehensive
set of performance measures. Performance is measured in five areas:
• customer;
• stakeholder;
• financial;
• process; and
• learning and growth.
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[It] moves the Library beyond the traditional performance measures of cost, accuracy and timeliness.
Through the balanced scorecard the Library is better able to:
• focus on implementation of strategic directions
• focus on achieving longer term objectives
• link strategic directions with the budget process
• measure achievement of strategic directions.
As such, it is the primary tool used to inform the Library’s Council on performance and is paramount
in enabling Library managers to identify areas where resources should be focussed. It provides a
consistent measure of the Library’s success in meeting strategic goals.
The library sets out its ‘service standards’—its target levels of performance—in its Service Charter,
which is monitored and reported in the annual report. The service standards are:
• deliver 90% of items stored onsite within 45 minutes
• deliver 90% of items requested from rare or secure collections within two hours of
designated cut-off times
• deliver 90% of items requested from offsite store within two hours of designated cut-off
times
• respond to 90% of information and research enquiries within one week of receipt—more
complex enquiries may take up to four weeks
• dispatch items or copies of documents requested through a local library within four
working days of receipt of request for the standard service or within two hours to one
day, depending on the level of the priority service required
• dispatch 75% of copies directly to individuals through the Copies Direct Service within
five working days for standard requests and within three days for priority service
• ensure that the Library’s website at www.nla.gov.au is available 99.5% of time (24 hours
a day, seven days a week).
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To measure satisfaction with its services, feedback from library users is sought, whether access is in
the library or through the website. Both compliments and complaints are reported in the library’s
annual report.
As a further example of the implementation of this approach, the library’s ‘Strategic directions
2012–2014’ document identified the changing focus from printed materials to digital forms, and a
commitment to expanding its digitisation program.
Aligned to this strategic direction and as part of the library’s balanced scorecard approach, statistics
relating to the use of web services are generated by Web Trends software, which measures the use of
all of its online services. The library has discontinued counting the number of website hits, and now
counts the number of user sessions. The library argues that counting a hit is misleading. It does
not equate to an action by the client, rather it counts the number of graphic files such as the logo,
buttons and thumbnail images loaded into each page separately.
Using the balanced scorecard approach enables the National Library to report against the performance
standards in its service charter, while the use of Web Trends enabled the library to measure and monitor
the effectiveness of its strategy of moving further into digital access for users. These performance
measures, together with user feedback, are directly related to the library’s role of collecting, preserving
and making accessible documentary resources of national significance.
The Library has now implemented its corporate plan for 2015-2019, which again emphasises the use
of a number of qualitative and quantitative measures to assess performance.
Sources: National Library of Australia ‘Balanced Scorecard’, accessed July October 2015,
https://web.archive.org/web/20140306103058/http://www.nla.gov.au/policy-and-planning/balanced-
scorecard; ‘Service Charter’, accessed November 2015, http://www.nla.gov.au/service-charter;
accessed October July 2015, https://web.archive.org/web/20150501105004/http://www.nla.gov.au/
corporate-documents/directions.
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Appendix 3.1 provides a good example of how the balanced scorecard is applied in a public
sector setting.
➤➤Question 3.11
Refer again to Questions 3.3 and 3.6 (including the suggested answers). Given the different
strategies of Mega Markets and its online competitor, identify some possible performance
measures (covering each of the four balanced scorecard perspectives) for each company,
and explain how the performance measures for each company are likely to differ as a result of
the different strategies adopted.
The need to design an effective BSC for an organisation involves a close relationship
with strategy. Kaplan and Norton (2001) have developed the BSC and its relationship with
strategy through what they call a ‘strategy mapping’ process.
Strategy maps are a visual approach that helps to identify assumed cause–effect relationships
and where critical areas of performance need to be measured. Kaplan and Norton (1996b)
describe a simple example of linked performance measures through the four BSC perspectives.
In the learning and growth perspective, employee morale leads to employee suggestions.
These suggestions lead in the business process perspective to a reduction in re-work,
while employee morale leads to customer satisfaction in the customer perspective. In the
financial perspective, increased customer satisfaction and reduced cost of rework both lead to
improved financial performance.
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The board sets criteria for financial returns to shareholders, which may be based on past trends,
benchmarking with competitors and, for listed companies, the expectations of stock market
analysts. These financial targets become the focus for the strategy developed by the board and
senior management. To achieve the target returns, the board and senior management agree
that it is necessary to increase sales revenue through greater market share and to improve the
profitability of those sales through improved cost efficiency in production.
Return on investment,
earnings per share etc.
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Improve customer Increase sales revenue Cost efficiency
satisfaction per customer in production
Market research,
Supply
advertising and Labour skills
arrangements
promotion
Strategy maps are developed through workshops at several levels. Customer focus groups
can identify those product benefits and elements of the value chain that customers value
most and are prepared to pay for. This helps the business identify those business processes
it should emphasise and measure. In Figure 3.4, customer focus groups have been presented
with a question as to how the manufacturer can increase its market share. The focus group
findings indicate that customer satisfaction is a function of both product quality and on-time
delivery. Customer focus groups have also identified that in order to increase sales revenue from
existing customers, quality rather than price is the main motivating factor for customer spending.
288 | PERFORMANCE MEASUREMENT
Hence, the strategy mapping process shows that it is not only real product quality, but also
customer perceptions of quality that are important. Product quality is the responsibility of
the production department, but marketing has the task of improving brand awareness and
perceptions of quality.
Internal workshops are then focused on production and the need for cost efficiencies.
Investigations by corporate finance staff have identified that the most significant impact on
profitability (other than sales growth) is production cost efficiency relative to competitors.
Internal cross-departmental, team-based workshops (which include employees from the
manufacturing, distribution and purchasing functions) identify that there are two major impacts
on production efficiency and manufacturing costs:
1. labour skills (already identified as a driver of quality and on-time delivery) are also critical in
setting achievable production schedules and meeting those schedules; and
2. issues with the price, quality and delivery of raw materials from suppliers.
This internal workshop leads to a project within the purchasing department to work collaboratively
with suppliers to improve raw material purchasing, with the aim of obtaining the best mix of
price, quality and delivery from suppliers to support the production schedule.
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Figure 3.4 is an example of how a strategy map is developed to identify the most significant
cause-effect relationships to achieve organisational goals. There are elements of a top-down
approach, as the board needs to set overall targets and the strategic direction for the business.
However, there is also a bottom-up approach in which employees with first-hand knowledge of
the business identify obstacles to performance and develop ways of overcoming those obstacles.
Performance measures and their associated targets would need to be developed for each of the
elements in the strategy map. The board can use these measures and targets to monitor strategy
implementation. Those measures may include:
• financial returns;
• market share;
• customer satisfaction (through a combination of customer survey results such as net
promoter score and measures of spending per customer and customer retention);
• quality pass rates;
• on-time delivery;
• labour turnover;
• employee satisfaction;
• cost reduction per unit of production;
• compliance with production schedules;
• material purchase variances;
• on-time delivery from suppliers; and
• supplier product quality.
Study guide | 289
Where performance needs to be improved, the strategy mapping process involves making
resource reallocations through changing budgets. This approach is challenging to the traditional
accounting view of budgets as fixed resource allocations for the year. Budgets are commonly
incremental (or decremental) based on the prior year plus or minus a percentage change factor.
Rarely are budgets revised mid-year due to performance shortfalls. However, reallocating
budgets mid-year is a logical extension of managing performance more flexibly in the strategy
mapping process and there is no reason why accountants cannot be more flexible in supporting
such a process.
Strategy mapping is a continual learning process whereby learning what works, and what
does not, from performance measures should lead to changes to the assumed cause–effect
relationships, and to the resultant performance measures and targets. This approach should,
wherever necessary, continually re-evaluate and modify the assumptions in the relationship
between strategy, performance measurement and budget.
An example of strategy mapping linked to strategy and the balanced scorecard can be seen in
Appendix 3.1.
➤➤Question 3.12
Recommend a set of performance measures (without the associated targets) that would be
suitable for a three-partner organisation of CPAs operating in public practice with 40 employees.
The organisation has three objectives:
1. to make a satisfactory profit;
2. to have a strong cash flow; and
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3. to increase the value of the organisation as measured by billings (i.e. annual professional fees
charged to clients).
(a) Using Figure 3.4 as an example, construct a strategy map that shows what might be the
key success factors (i.e. the cause and effect relationships in the business model that the
organisation needs to get right in order to achieve its three objectives).
(b) For each of the elements in the strategy map, identify suitable performance measures, keeping a
balance between financial and non-financial measures, as well as a balance between each of
the four perspectives in the BSC.
A further feature of the BSC and strategy mapping approach is the cascading of performance
measures within the hierarchical organisation structure.
Performance measures and the targets that accompany them must cascade from organisational
level through each business unit, to individual products and services and assets, and ultimately to
individual people within the organisation. So, for example, in a sales department, a contribution
to the organisation’s sales target must be achieved by each sales team, within the team by each
salesperson, and even within each salesperson’s target this may involve sales targets for each
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of the salesperson’s customers or products and services. Where targets are set, performance
measurement and comparison of actual to expected sales levels must be carried out.
As stated earlier, Kaplan and Norton (1992; 1993; 1996a) recommended three to four performance
measures for each of their four perspectives. This is at the whole-of-organisation level.
Once these high level performance measures are cascaded, the total in use in an organisation
may be very large and, in a complex, multi-divisional organisation, may be in the hundreds.
However, any one manager will be focused on only those performance measures for which
they are responsible, and the total number is unlikely to be more than about 12, for the
reasons previously given.
Typically, lower-level employees in an organisation have fewer financial targets, but more non
financial ones (i.e. the leading measures), as their role is mainly concerned with tasks such as
production, distribution or administration. Senior managers tend to have more targets for the
financial performance of their business unit or the whole organisation (the lagging measures).
Targets within business units may be in competition with each other. For example, achieving a
sales target may cause difficulties in operations if there is insufficient capacity to fulfil customer
orders on time. It is important therefore to ensure the integration of performance targets so
that no business unit will be disadvantaged by another achieving its target. A problem faced by
complex organisations where there is intra-organisational charging for services is the tendency
for each business unit to pursue achievement of performance measures for itself rather than
for the organisation as a whole. This is no different to the problems caused by transfer pricing,
where business units may be motivated to improve their own profitability even where the overall
effect on the organisation may be to worsen performance.
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Strategy implementation (rather than formulation) and alignment with organisational goals,
coordination across different functions and projects, and across different individuals can only be
achieved if goals, measures and targets are effectively cascaded. There are a number of ways
in which cascading can be made more effective: by cascading organisational goals, measures
and targets to functional departments, to cross-functional teams, or to particular initiatives or
projects. However, if measures are inconsistent or in competition with each other, individuals,
departments, cross-functional teams or projects may be working towards different goals and
towards different targets, perhaps even measuring their performance in different ways.
Appendix 3.1 provides an example of how Western Water cascades its performance measures
through the organisation.
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Because of the need for public accountability, many of these performance measures are audited, to
avoid the reality or perception that for example, waiting lists and times are being manipulated.
Public hospitals also generally operate within a fixed budget that may be unrelated to the actual levels
of patient demand on the hospital. Hospital budgets are often an outcome of economic conditions
and the government’s spending plans across all sectors of public service delivery.
The role of management (and any board of directors or governing body) is to best allocate and manage
resources within the fixed budget allocation to achieve the performance targets set by government.
Hospital-wide targets will be cascaded down to each department (e.g. emergency, surgery, medicine)
and to clinical directors (i.e. medical specialists) within each department. Ultimately, individual clinicians
may be responsible for performance on the days when they are on duty. So the director responsible
for the emergency department on a Sunday will be responsible for trying to achieve the target for
reducing the time between a patient arriving in emergency and being discharged or admitted to a
ward for ongoing treatment.
Hospitals are faced with decisions to open or close wards and to reallocate resources to where they
are most needed, and these decisions may need to be made on a daily basis in response to patient
demand. However, closing wards may itself cause performance targets to be missed. The particular
problem for public services is that many of their performance measures and targets are politically
derived, and not necessarily integrated with each other or with the budgetary resources available.
An example of the problem of competing performance targets can be seen in a hospital where there
is a high number of patients admitted through the emergency department. This can lead to either
(or both) the surgery capacity being used up, or a lack of available beds. As a consequence, elective
surgery patients can be disadvantaged because their surgery may be cancelled at short notice. This is
a difficult problem to manage as the emergency department cannot be closed to people who need
urgent treatment.
In the public hospital, there will be conflicts between meeting performance targets for elective surgery
and treatment of patients admitted for emergency treatment. There will also be conflict between the
management demand to stay within budget while achieving performance targets and the clinician’s
focus on proper medical treatment, irrespective of the impact on reported performance.
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One way to address the complexity of modern business and the variety of performance measures
is through the use of information technology—which can become critical in a cost-effective
performance measurement system.
Data collection in many organisations takes place as a by-product of transaction recording through
computer systems. For example, retailers make extensive use of electronic point of sale (EPOS)
technology including bar-code scanning to price goods, printing a cash register listing for the
customer, reducing inventory, and calculating and reporting profit margins. Taking advantage of
new technologies can improve productivity and reduce the ratio of staff to sales value, a common
performance measure in retailing.
The outputs from EPOS include business volume (e.g. number of customers, number of items
sold), sales analysis, product profitability and inventory re-order requirements. Sales and
profitability reporting can be generated by store and time of day. Additional benefits
of EPOS include:
• information about peak sales times during each day;
• products that may need to be discounted;
• sales locations that may need to be expanded; and
• time taken to scan a customer’s basket of goods.
Even small businesses like restaurants can take advantage of modern point of sale terminals
that are relatively inexpensive enabling them to monitor customer seating by time of day and
day of week, generate orders for the kitchen, price goods and calculate bills, and provide
detailed management reporting on inventory and sales trends. This information can be used
for management accounting purposes to improve inventory management, reduce wastage,
enable staff rostering to the busiest times, and identify the most profitable products.
Study guide | 293
For larger organisations, an enterprise resource planning (ERP) system helps to integrate data
flow and access to information over the whole range of a company’s activities. Examples of
these systems are the relational databases provided by SAP and Oracle. ERP systems take a
whole-of-business approach. They typically capture transaction data for accounting purposes,
together with operational data, and customer and supplier data which are then made available
through data warehouses from which custom-designed reports can be produced. ERP system
data can be used to update performance measures in a BSC and can also be used for:
• activity-based costing;
• shareholder value;
• strategic planning;
• customer relationship management; and
• supply chain management.
Cloud computing has enabled access to larger sources of data and made it easier to analyse
data from any location. It relies on sharing resources through the internet to achieve economies
of scale. With cloud computing, end users access applications through the internet, with both
software and data stored on servers at remote locations.
Large volumes of information are now available from public sources. The term ‘big data’ refers
to very large and complex data sets, which can be seen in the massive data resources of the
internet and the results provided by search engines such as Google, or data held on Facebook.
Organisations are able to access (for a fee) this information to enable targeted marketing.
According to IBM, 90 per cent of the data in the world today has been created in the last two
years. This data comes from, for example, sensors used to gather climate information, posts to
social media sites, digital pictures and videos, purchase transaction records, and mobile phone
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signals (IBM 2015). This provides what Oracle call ‘a potential treasure trove of less structured
data: weblogs, social media, email, sensors, and photographs that can be mined for useful
information’ (Oracle 2015).
According to management consultants McKinsey, big data will become a key basis of competition,
underpinning new waves of productivity growth and innovation (McKinsey Global Institute 2012).
The Australian Taxation Office accesses multiple sources of data to identify potential targets for
tax audits based on spending patterns. Retail stores such as Woolworths (as mentioned earlier)
target customers for special promotions based on their individual spending habits recorded
through its ‘Everyday Rewards ’ card system, which collects data on customer purchases at the
point of sale.
The ability to collect vast amounts of performance information means that it is important but
increasingly complex to report management information in a concise and decision-useful
way. Approaches to reporting management information include graphical presentation
of key performance data. Traffic lights (red/amber/green) draw attention to those aspects of
performance which:
• are meeting their target (green);
• are in need of urgent attention (red);
• need to be considered as they are borderline (amber).
A ‘drill down’ facility may also be used to cascade down from highly aggregated performance
data to a more specific and detailed level (e.g. customer, product or service, or business unit).
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Organisations need to determine what performance information is important from the volume and
variety of information that is now available. Big data requires specialist computing power and
software tools as the volume and variety of data is beyond the capability of relational databases.
Examples of such specialist software include Oracle’s ‘Big data appliance’ and ‘Hadoop’, which is
an open-source platform for consolidating, combining, and transforming large data volumes.
Linking platforms to analyse big data and the organisations’ own relational database provides
what Oracle refers to as a ‘360-degree view’ of the organisation.
Market research carried out by Oracle (2011) comprising almost 1500 interviews in 13 countries
found that there was an emphasis on sales growth rather than profits, with 82 per cent of
businesses admitting to not having complete visibility of their profits by line of business. This lack
of knowledge led to a misallocation of resources, poor decisions and poor pricing policies.
Criticisms by respondents included an over-reliance on spreadsheets, working with out of-date
data from multiple ‘silos’ of information, and a lack of data sharing between departments.
Seventy-one per cent of Oracle’s respondents described the links between strategic goals,
operational plans and budgets as ‘fragmented’.
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An important implication of Oracle’s research is the finding that, on average, 1.7 months will pass
before the finance department becomes aware that operational plans or market circumstances
for the company have changed. In terms of performance data, for the 89 per cent of managers
with departmental performance measures who responded to the survey, it takes, on average,
just under two months for information about departmental performance against targets to filter
up to the senior management team or the board of directors.
The lack of reliable, accurate and timely data is compounded by the lack of stability in the
organisation’s environment and strategic plans that must be continually updated to stay relevant
to the latest business conditions. Turbulence in the business environment is caused by:
• economic uncertainty;
• changing technology;
• the rapid introduction of new products;
• changing customer demand; and
• increased regulation and competition.
A key enabler is the recognition that performance measurement should be used for learning
rather than control, as learning is central to success in turbulent environments.
Strategic intelligence and learning are more possible with the advent of technologies to access
‘Big data’. It is now possible to collect data about every potential customer interaction through
their interaction with a business’s website and through interaction with social media such as
Facebook and Twitter. Parise and Iyer et al. (2012) distinguish social analytics (non-transactional,
social data) from performance management (business intelligence using transactional data).
They use the example of BizTech, an information technology services company in the US using
Oracle’s Customer Relationship Management On Demand (CRM OD) business intelligence
application to improve its opportunities for sales growth through generating, reviewing and
acting on leads. In non-transactional data, Parise and Iyer et al. (2012) describe the use of social
metrics to help inform managers about the success of their external and internal social marketing
campaigns and the ability to calculate a ‘digital footprint’.
However, big data faces the problem of how to analyse multiple pictures to devise
the optimum strategy. Buytendijk (2010) has emphasised the limitations of analytics in
performance measurement, because, as he explains, strategy is concerned with satisfying
the often differing expectations of different stakeholders. Developing strategy is full of
dilemmas and analytical thinking is only partly helpful in dealing with these dilemmas. Rather
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than analysis, Buytendijk (2010) emphasises the importance of synthesis, the process of taking
multiple, sometimes contradictory ideas and bringing them together to create a single picture.
He identifies dilemmas, including:
• customer value versus profit maximisation;
• exploitation or exploration strategy;
• innovation by listening to customers versus creating new demand; and
• long-term versus short-term performance.
He argues that both can be achieved, not as either/or choices but as a genuine synthesis of both.
There is now widespread support for the belief that performance measures should be developed
from strategy. However, Kaplan and Norton’s (1996b) recommendation for a strategy mapping
process identified four barriers to implementation of performance measurement systems in
relation to strategy:
• Failure by the senior management team to achieve consensus leading to different groups
pursuing different agendas not linked to strategy in an integrated way.
• Strategy that is not linked to department, team and individual goals.
• Strategy that is not linked to resource allocation decisions (i.e. where budgetary allocations
are historical and not linked to strategy).
• Feedback to managers that focuses on short-term financial performance rather than on a
review of measures of strategy implementation and success.
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➤➤Question 3.13
Giant Products Ltd (Giant) manufactures ‘triffids’, a product which has many purchased
components. The board of directors of Giant has set a goal of 10 per cent reduction in the total
cost of components used in manufacturing ‘triffids’ during the next financial year (assuming
constant sales volume). The board believes that the high cost of the components may be due to
a combination of poor purchasing practices and/or wastage during production.
Giant has the following organisational structure.
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Managing
Director
(a) Recommend performance measures that Giant could implement to give effect to its goal
(10% reduction in the cost of components), and explain how these performance measures
could cascade to lower organisation levels in each department.
(b) What would be the role of Finance and Administration in achieving this goal?
(c) How might information technology (e.g. using an ERP system) assist in this process?
Study guide | 297
The design of performance measures and the setting of targets have no real value in improving
efficiency, effectiveness and equity unless those performance measures are used to improve
performance. This part looks at how performance improvement relies on three levels of analysis:
targets; trends; and benchmarks. It also looks at the role of knowledge management and
organisational learning in improving performance. This part concludes with a discussion of the
behavioural consequences of performance measurement.
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business processes, customers and financial—selecting the most appropriate measures
can be a difficult choice.
Given the almost unlimited measures that could be used, the ones that organisations should
use are those that are linked to achieving the organisation’s strategic goals. The number of
different performance measures needs to be limited to what is manageable, as too many
measures may result in none of them being seen as important. As mentioned earlier, Kaplan
and Norton (1992; 1993; 1996a) recommend three or four from each of the four perspectives.
As the performance measures are cascaded down an organisation, broader measures may be
replaced by more detailed measures, so in total an organisation may have many more than 12 to
16 measures, but the measures may be different at each organisational level, as we saw above.
However, at any one organisational level, the number of measures needs to be manageable.
The design of a performance measurement system will be linked to the organisational strategy
and will most likely be contingent on the organisation’s competitive environment (e.g. size,
technology, strategy, etc.). It is important to distinguish what should be measured from what is
easy to measure. Organisations often avoid measuring performance that is important because
measurement is time-consuming or costly (cost–benefit is discussed below). However, it is even
worse to measure performance just because it is easy to measure, when what is easy to measure
may not be critical to business success. This practice leads to too many, often unimportant,
performance measures.
The cascading of performance measures reflects the agency relationship between higher-
and lower-level managers (an extension of the principal–agent relationship). At the whole
organisational level, and at each subsidiary level, the measures that are important to achieving
strategy—for that organisational level—need to be determined. This relies on an understanding
of the organisation’s predictive model. As discussed previously, Qantas and Jetstar have different
predictive models and are therefore likely to have some performance measures that are different,
although there would also be some commonality.
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The overall business strategy is cascaded to each business unit, which will develop subsidiary
strategies in accordance with the predictive model for that business unit. Once the strategy
is understood for each business unit, each department and even each individual employee,
performance measures can be defined that monitor whether the strategy is being achieved.
However, we should be mindful about the difference between a performance measure
(what we want to measure) and a performance target (the desired level of performance). That is,
the performance measure may be used as an objective comparison to a predetermined target
or an external benchmark (e.g. a competitor or industry average).
We also need to be mindful that some performance measures are used for signalling to external
stakeholders as part of an organisation’s accountability. Others are used for planning, decision-
making and control, so the purpose of the performance measure needs to be considered.
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Example 3.18 reveals the problem of inappropriate performance measures in a changing market.
Due to pressure from the board to increase profits, Mammoth sought to increase volume, but in order
to achieve its sales targets, sales representatives (who were paid a commission based on sales value)
tended to reduce prices and so while volume was high, margins remained tight.
In this sector of the printing industry, production was based on customers’ orders and so a job order
manufacturing process was in use. The time taken to produce an order on printing machines was
consumed partly in set-up (also called make ready, i.e. setting up the machine before the paper is
printed) and machine running time (when paper is being printed through the presses).
Market changes had taken place over time, resulting in customers placing orders for smaller volumes
more frequently. The impact of this change was that Mammoth’s production capacity was being eroded
as more machine time was consumed in set-up rather than running time, which reduced Mammoth’s
overall capacity to produce the necessary volume. A further impact of the smaller volume orders
was the increased number of non-production employees handling the increased number of sales
orders, production orders, deliveries and invoices. The overall effect was declining profits despite
increasing sales.
Study guide | 299
The production department was overwhelmed by the volume of business brought in by the sales
department and late deliveries became more common. The production manager argued that too
much production time was being used for set-up times for the small volume orders. He argued that
the prices being charged were insufficient to cover the loss of overall production capacity and the
administrative burden caused by the small-volume orders.
The following summary of key performance data for Mammoth Printing, comparing its performance
over time reveals substantial changes in financial and non-financial performance.
Prior to
Three implementation Percentage
years prior of changes change
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Mammoth’s business model had changed over time but the company realised that its performance
measures had not kept up with these changes. Consequently, Mammoth re-evaluated its performance
measurement system. The problem of capacity erosion through set-up times was accepted, and a trial
activity-based costing exercise recognised that costs to service small volume orders were not being
passed on to customers through the price. A number of changes were introduced to the performance
measures.
• In the production department, wastage, on-time delivery and machine running-speed performance
measures were supplemented by reporting the mix of set-up and running times on each machine,
to identify where too much time was being spent on smaller orders with long set-up times.
• Sales performance was judged not only on sales value but on ‘value added per machine hour’.
This was a value close to that used under throughput accounting (i.e. sales value less the cost of
materials). The value added was divided by the total number of machine hours (set-up and running)
to produce the job. The new ‘value added per machine hour’ measure became one of the most
important measures in managing Mammoth’s business—it identified those small jobs which had
both lower prices and higher set-up times as the value added per machine hour would be very low.
However, Mammoth faced considerable resistance from the sales representatives who were discouraged
from accepting orders where the value added per machine hour was too low. Attempts by the chief
financial officer to replace the sales representatives’ commission on sales value with a commission
based on value added per machine hour failed because of the power of the sales and marketing
director. Mammoth failed to move fast enough to change its behaviour or its performance measures,
and the company was subsequently taken over by a multinational competitor.
The Mammoth Printing example reveals the need for continual reassessment of the business
model and performance measures. It also highlights the importance of power and culture,
and the behavioural consequences of performance measures (discussed later in this part).
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Both efficiency and effectiveness are important. In the Mammoth Printing example, the company
was neither efficient (too much time was spent on set-up) nor effective (profits were too low,
while customers received late deliveries).
Finding the right balance between efficiency and effectiveness is important, and organisations
need to recognise the trade-off between these aspects of performance. For example, a customer
requires a service call for some equipment that is not working and wants the service call on
Monday. However, it is not efficient for the service technician to go to every location on every
day of the week. Service calls are grouped to similar areas for set days of the week. The day
set for service calls to the customer’s area is Wednesday. There is a trade-off here between
the performance measure for service efficiency and the performance measure for customer
satisfaction. One may be achieved in this scenario, but not both. Recognition of trade-offs
needs to be built into performance measures.
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This raises the issue of equity. Should all customers be treated equally? In the example of the
public hospital above, there is an equity issue surrounding the treatment of emergency patients
and elective (i.e. non-urgent) surgery patients. While it might be unacceptable not to treat an
injured person, neither is it equitable for elective surgery patients to wait many months for their
treatment. In the Mammoth Printing example, is it equitable for all customers to be treated in
the same way, with the risk of late deliveries, when some customers have paid a higher price
(generating a higher value added per machine hour) than others for what they have ordered?
Issues of equity also appear in the human resource function, where performance measures
may exist in relation to gender equality, the treatment of people with disabilities, or those from
indigenous or ethnic backgrounds.
One way of looking at performance measures and targets is through the acronym SMART—
which stands for:
• S—specific. Performance measures and targets should be clear and unambiguous.
• M—measurable. Performance should be capable of being accurately measured and it should
be clear whether a target has been achieved, or how close actual performance is to target.
• A—achievable and agreed. While performance targets may be ‘stretch’ targets rather
than easy to achieve, they do need to be achievable, and agreed between managers and
subordinates as they cascade down through each organisational level.
• R—relevant. Performance measures and targets should be relevant to the strategies in the
business model.
• T—time-based and timely. Performance targets should be established to cover a defined
time period to determine whether the performer has achieved the target. Performance
measures also need to be produced on a timely basis (i.e. so that corrective action can
be taken).
It is good practice to review all performance targets to ensure they are SMART. If measures are
difficult to measure or are ambiguously worded, irrelevant to the organisation’s strategy, too late
to lead to action or are not agreed between the target setter and the accountable manager,
they are unlikely to be helpful in identifying performance gaps or improving performance.
Table 3.4 shows two examples of performance targets that are SMART, as well as two examples
of performance targets that do not satisfy the SMART criteria.
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Performance target Analysis
Return on capital employed (ROCE) The ROCE target is specific, measurable, achievable in comparison
of 14% in FY 20X4 compared with to prior year, relevant and time-based (FY 20X4).
13.5% in FY 20X3
Customer satisfaction of 95%, The target is specific, measurable and time-based. It may be
based on survey of products achievable provided past customer satisfaction is within a realistic
delivered during the month of June range of the target figure, and is likely to be relevant to most
businesses that need satisfied customers to maintain and/or grow
sales revenue.
Product quality of 100% The quality target is not specific—it does not say how quality
is measured; it may be measurable (if how quality is measured
is defined); but is unlikely to be achievable as 100% quality is
unrealistic given the costs likely to be incurred to achieve perfect
quality; the target may be relevant, but only if it is critical to
achievement of organisation goals; it is not time-based as no
time period is specified.
Staff turnover less than or equal to While the target is specific and measurable (although there may be
25%—historical staff turnover is 45% some definitional issues around part-time or casual staff), it may not
be achievable given past performance. The target may be relevant
if staff continuity is especially important for the business; however,
the target is not time based.
Appendix 3.1 includes an example of how Western Water’s performance measures comply with the
SMART criteria.
Validity
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Validity (or accuracy) refers to how well a measure helps evaluate the issue or item of performance
being considered. If a measure does not accurately describe what it is supposed to, all other
attributes are meaningless. A performance measure like operating profit is objectively known
from financial statements, and is subject to audit, being based on accounting standards. However,
we know in reality that the practice of accruals and provisioning can influence reported profit.
Market share may be measured objectively by reputable and independent industry sources
based on sales data reported by each company in the market. This data tends to be accurate
although sales can be misreported by individual companies.
Some concepts are quite difficult to measure directly, so we use indirect measures. The problem
is whether or not they accurately capture what we are trying to measure. Customer satisfaction
is often measured in a restaurant by asking customers whether or not they were satisfied with
their meal. Because customers may be more inclined to say they were satisfied rather than
risk offending the restaurant staff, a business can be misled by those responses. A measure
of the same customer returning would be more valid, perhaps through a loyalty card scheme.
An anonymous ‘tick box’ feedback form left with the customer’s bill may also provide more valid
information about customer satisfaction.
Reliability
Reliability means that whatever is being monitored can be measured in an objective and
specific manner. Reliability is concerned with consistency, or the extent to which the reported
performance is the same over repeated measurement attempts (e.g. Does a customer
satisfaction survey carried out by different people give the same results no matter who
carried out the survey?). A reliable measure is one that is trustworthy.
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It is sometimes confused with the term ‘validity’ because it is interpreted to mean ‘a measure
I can rely on to tell me what I need to know’. But, this is not an accurate understanding or
interpretation of what reliability means. Many things can be measured ‘reliably’ but this does
not mean they are useful for analysis.
A measure can be highly reliable but completely invalid for decision-making purposes.
For example, we could measure growth in company sales revenue to assess customer
satisfaction. Sales revenue is both a valid and reliable measure, but it has tenuous links with
individual customer satisfaction, so using it to measure customer satisfaction may not be valid.
A more valid measure of customer satisfaction may be customer retention (i.e. how long the
customer stays a customer and whether purchases by the customer are increasing or decreasing).
The reliability of this measure can only be gauged if over time customer retention equates to
customer satisfaction.
It is often difficult to measure ‘valid’ measures in a reliable way. Consider the restaurant
example above about measuring customer satisfaction. Reliability of the performance measure
will be improved by repeating the method of performance measurement in a consistent way,
for example, using a standard customer feedback form over a long period of time. However,
even here, caution must be exercised in interpreting the data as it could be affected by the
particular customer or waiting staff on duty or on a variety of other factors such as the level of
heating or noise from other customers.
A common performance measure in many service businesses is the time taken to answer an
incoming telephone call. The assumption is that customers will be more satisfied when they
do not have to wait for long periods. There is a cost in calculating, storing and reporting this
information, even though it is largely carried out behind the scenes through communications
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technology. The performance measure may be reliable as it may be collected as a by-product
of the technology used, but may not be valid as a measure of customer satisfaction because the
customer may weigh the quality of the answer as being far more important than the time taken
to answer the phone. The time taken to answer a telephone is a useful measure as it indicates
whether staffing is sufficient to minimise customer queuing, but as a valid measure of customer
satisfaction it needs to be supplemented by another measure that focuses on the quality of the
contact. For this reason, organisations like Telstra routinely follow up telephone calls with emails
asking customers to respond to a short survey to assess customer satisfaction more holistically.
Clarity
If a measure is to be meaningful, it should be easy to understand with little or no ambiguity in
interpreting the results. For example, a measure of ‘product quality’ usually has a high level of
clarity. It begins with a specification of the product. The final product can then be compared with
the specification and tested to see if it meets the specification.
An example of a measure that often has a low level of clarity is a popular measure of shareholder
value—Economic Value Added (EVA). This is a valid and sometimes reliable measure. However,
it is difficult to understand due to its complexity and the number of choices that are made in
the construction of the measure. This makes it difficult to use when comparing results between
business units or organisations.
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Timeliness
To be useful, performance measures need to provide information early enough to allow corrective
action to be taken. If a measure is not available when it is needed for decision-making, then it is
of little use. Many financial measures such as profit are not timely. These are lagging measures
and inform about what has already happened, but provide little guidance for future action.
However, sales data collected daily for a retail chain store is a very timely measure of likely
future financial performance. Such data can influence immediate actions such as increasing
advertising, purchasing inventory, and price discounting.
Accessibility
Performance measures should be able to be accessed by all authorised organisational
participants who need the information. Accessibility refers not only to the measure, but also to
the information that drives the measure.
Controllability
In order to be effective in motivating behaviour, what is measured must be controllable by
those whose performance is being measured. Controllability refers to the ability to influence the
quantity or value of the measure through action. Aggregate measures such as the organisation’s
profit are normally only partially controllable by any individual in an organisation. On the other
hand, production quality is a measure that should be controllable by the process owner.
difficult to assess, as the benefits of good performance information are rarely received in cash—
they come in the form of the characteristics of validity, reliability, clarity, and timeliness discussed
earlier. However, performance measures need to be cost-efficient (i.e. the expected benefits of
using the measure must exceed the associated cost of undertaking the measurement).
A cost–benefit analysis compares the outputs or outcomes with the costs to produce those
outputs or outcomes. Cost–benefit analysis is one method of evaluating performance
measures. The measurement of performance, its monitoring, management, and reporting
is an organisational cost. Data must be collected, summarised, analysed and interpreted,
and corrective action must be taken to improve performance where necessary. This often
involves both a technology cost (the information system) and a human cost. Therefore, it is
important that the design of a performance measurement system recognises the cost of
measuring performance and compares this cost with the benefits that are likely to accrue from
it. Performance measures which are very costly but yield little benefit should be avoided or
eliminated. Costs here are not just cash costs, but opportunity costs (i.e. the alternative use—
and the benefits from that use—to which the resources consumed could be put).
In the TNA example discussed earlier, the owner-manager abandoned most traditional
performance measures (including reported profits, except to comply with statutory
requirements) because they were not cost effective. Traditional accounting-based measures
did not reflect the reality of TNA’s business model, where the largest costs for research and
development, export market development and patent litigation were incurred many years
before revenue was earned. TNA saved the cost of comprehensive monthly accounting
performance reports that were not useful.
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We have already discussed the usefulness of labour and materials costing and variance analysis,
and its alternative, lean accounting. The lean accounting approach argues that the costs of
detailed time recording and material issues against jobs and carrying out price and efficiency
variance analyses are prohibitive and yield little benefit compared with the cost. Lean accounting
uses backflush costing to record the cost of time and materials based on standard costs
once a job is complete. This is a far less costly accounting process. While the argument for
lean accounting approaches seems logical, it is contingent to a large extent on how effective
other controls are within the organisation.
There may be an opportunity cost in backflush costing (discussed earlier) if there are variances
that are not identifiable. If a physical stocktake at year end results in only minor adjustments,
it can be assumed that backflush costing is a cost-effective method and that abandoning time
recording, material issues and variance analysis has reduced organisational costs. However,
where serious discrepancies exist at the time of a stocktake, this highlights significant control
weaknesses. Whether time recording, material issues and variance analysis may be effective
controls is another matter, but this example highlights the need to consider the cost and benefits
of performance measures in light of each organisation’s circumstances.
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had thought it was a good idea to collect the data, and no one had ever questioned whether it was
still needed. There was a cost in printing machine operator time to calculate and record this data,
which over the number of machines and over time would have amounted to a significant cost.
The questions that can be asked with regard to the value of performance measures are:
• Can they be understood?
• Can they lead to action to improve reported performance?
• Will (and if so, how will) improving performance as reported by a particular measure help
achieve organisational strategy and goals?
If the answer to any of these questions is ‘no’, we need to ask why we are measuring that
performance. There is a tendency by some managers and organisations to look for new
performance measures, but often insufficient attention is given to abandoning performance
measures that may once have been useful, but are no longer useful.
What is important in these examples is that, at the very least, organisations should question
taken-for-granted practices and not continue them just because it is ‘the way we have always
done things here’.
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➤➤Question 3.14
Listed below are ten performance measures and their associated targets for the latest financial
period. Evaluate the performance measures and targets with reference to SMART design
principles (specific, measurable, achievable, relevant, time-based), and the characteristics of
effective performance measures and targets (validity, reliability, clarity, timeliness, accessibility
and controllability).
9. Headcount 120
An organisation’s culture will influence the kind of performance measures used. In a culture
where accounting controls are seen as very important, we are more likely to see time recording,
material issues and variance analysis than lean accounting approaches. In an organisation
whose culture is focused on short-term profits then that will dominate the approach to
performance measurement.
Malmi and Brown (2008, p. 291) noted that ‘different systems are often introduced by different
interest groups at different times’ and so control systems, including performance measurement,
will be implemented when they are consistent with:
• other sources of power;
• the dominant organisational culture in their implications for values and beliefs; and
• shared judgments about certainty, goals and technology (Markus & Pfeffer 1983).
However, in the advertising agency business, creativity is essential. Agencies recruit creative people
who must succeed in designing advertising that works for the agency’s clients. Investing in talent
recruitment can conflict with short-term financial pressures. One particular tension is whether to win
sales revenue in order to finance new talent (which causes pressure on existing staff until the talent is
recruited) or whether talent is recruited first (which causes pressure to win sales to fund the new talent).
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While financial performance is important, advertising agencies measure their performance in terms of
employee satisfaction and client satisfaction, and also in the winning of creative advertising industry
awards. These awards enable the agencies to recruit talent, even though they do not necessarily
reflect work that is valuable to the client, whose interest is less in the creativity as in the ability of the
advertising campaign to generate sales revenue.
In one international advertising agency, these different aspects of performance are managed
simultaneously. Performance measures for finance, employee satisfaction and client satisfaction, as
well as industry awards, are maintained. Attention is paid to both client satisfaction and employee
satisfaction so that problems or trends identified through regular surveys of each group result in action
to remedy the problem. Although there are no targets to win awards, the agency knows that failure
to do so will detract from the agency’s ability to attract and retain creative staff. Most importantly
perhaps, creative talent is insulated from financial pressures, with senior managers protecting them
from any financial information. Risk-taking by senior managers results in talent recruitment ahead of
revenue generation, which in the history of this agency, has proven to be a successful strategy, as newly
recruited talent has generated additional client income.
Creative organisations like advertising agencies need to manage competing priorities in a flexible
way in order to survive, both in terms of satisfying short-term expectations and investing in talent,
that reduces profits in the short-term, to achieve sustainable performance.
Of course, not all organisations can balance competing demands in an effective way. A contrasting
example is the BP and the Deepwater Horizons oil rig disaster, which demonstrated what can
happen when a single aspect of performance is pursued at the expense of all others.
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Example 3.21: B
P and Deepwater Horizon in the
Gulf of Mexico
The world’s largest accidental marine oil spill took place in the Gulf of Mexico when the USD 560 million
Deepwater Horizon oil-drilling rig exploded in April 2010. This followed a blowout of the Macondo oil
well, resulting in the death of 11 workers and an estimated five million barrels of oil spilling into the gulf.
Reports suggest that the main fault lay with BP and its subcontractors. The well was six weeks behind
schedule due to a number of technical drilling problems and the delay was reported to have been
costing BP more than half a million dollars a day. Best practice for drilling wells had not been followed
and BP had chosen to drill in the fastest possible way. Despite concerns expressed by employees and
consultants to BP, a number of shortcuts had been taken to reduce costs. Each decision taken by BP,
while legal, saved BP time and money yet increased the risk of a blowout (Bourne 2010).
In its final report, the National Commission on the BP Deepwater Horizon Oil Spill and Offshore
Drilling placed most of the blame for the disaster on BP and its partners who placed financial interests
before safety.
Following the incident, BP reported a second-quarter loss of USD 17 billion, its first loss in 18 years,
which included a one-time USD 32.2 billion charge, including USD 20 billion for the fund created
for reparations and USD 2.9 billion in actual costs incurred at that time. In October 2010, the CEO
resigned. The total amount of claims paid or approved for payment by BP as at mid-December 2010 was
USD 4.3 billion. In the aftermath of the disaster its market capitalisation fell by about USD 100 billion.
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The information available suggests that BP’s culture of cost cutting to achieve short-term profits and
the power of dominant coalitions to push ahead despite safety concerns were significant contributors
to the accident. As a consequence, the reputational as well as financial cost to BP has been enormous.
Note: Candidates would be familiar with this example from their study of the ‘Ethics and Governance’
subject of the CPA Program. For further reading on this issue, please refer to the ‘Drilling into
disaster: BP in the Gulf of Mexico’ corporate governance case study edited by Mak Yuen Teen.
➤➤Question 3.15
Several examples in this module have suggested that performance measurement needs to be
customised to each specific organisation.
Use the examples (Qantas, Jetstar, Newcrest, Apple, Woolworths, Mammoth Printing, TNA,
National Library and BP) from this module to explain why performance measurement needs to
be customised.
Improving performance
While performance measurement has been considered in relation to strategy and control,
one of the most important aspects of performance measurement is using the results as
part of the feedback cycle (see Part B) to make decisions aimed at improving performance.
The opportunity for performance improvement through targets, trends and benchmarks can
be assessed.
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Targets
As outlined above, targets, at the first level, need to be set for each performance measure and
that performance measures cascade down the organisational hierarchy through each business
unit to the individual level. How performance targets need to be SMART, and meet the six
characteristics of effectiveness has also been discussed. The following section focuses on the
relationship between targets and improving performance.
Targets that are set can range from those that are easy to achieve to those that are difficult
or impossible to achieve. The achievement of a target therefore is not necessarily a sign of
‘good’ performance as it is relative to the target set. Improving performance is often seen as a
process of continually increasing the target and expecting that target to be achieved. However,
there are three problems with this approach:
• the cost–benefit trade-off in continually achieving more stretching targets;
• the impact of achieving some targets on other targets; and
• the accuracy of assumptions in the predictive model.
Cost–benefit
As discussed earlier, the costs and benefits of achieving an ever-increasing target need to be
weighed against improving performance.
For example, a student who has a target of 80 per cent in an examination may achieve 82 per cent.
The same student may then decide to increase the target to 85 per cent or 90 per cent. However,
the student needs to evaluate whether the costs (e.g. time spent studying and its opportunity
cost—such as working fewer hours at their part-time job) are worthwhile to achieve the higher
mark. It may be that the additional cost to get a mark of 90 per cent (compared to the existing
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82%) is not worthwhile and the student could expend their efforts elsewhere.
By contrast, a student who sets a target of 70 per cent and achieves a mark of 60 per cent should
be sufficiently motivated to work harder to improve performance. However, it may be that the
student decides to lower expectations to a revised target of 65 per cent. The actual target
will depend on the student’s goals and may be quite different between individual students,
depending on their abilities, motivation and aspirations.
The idea of strategy mapping was that organisations set performance targets based on their
strategic goals and then regularly review their performance against those targets. The result of
this review may be to reallocate resources, or management attention, to under–performing areas
(which may have a resulting detrimental impact on those areas deemed satisfactory), or to modify
the target if it is considered that the target is inappropriate in relation to other targets.
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Predictive model
Parts A and B discussed the idea of the predictive model (recall the example of the different
predictive models used by Qantas and Jetstar). The predictive model is the set of assumptions
that drive the business:
• why customers buy products and services; and
• how those products and services are produced to fulfil customer orders.
The predictive model suggests that if particular actions are taken, they are likely to lead to
defined levels of performance. However, Otley and Berry (1980) argued that predictive models
are partial and unreliable. We do not know for certain that actions (e.g. an increase in advertising
expenditure) will lead to performance improvement (e.g. an increase in sales). Organisations work
on the basis that assumptions about their predictive model are correct. However, organisations
need to continually challenge their assumptions and ask whether the performance targets they
have set are still appropriate. Continual poor performance compared to target may suggest
broader problems with the taken-for-granted business model. A good example of the failure of
predictive models was the GFC and the purchase of complex financial products like mortgage
backed securities in an overheated housing market.
Trends
The second level of analysis for performance improvement is trend. Accountants are familiar with
trends in the analysis of financial ratios from financial statements. The same principle applies
to all performance measures. However, organisations will typically monitor non-financial ratios
more frequently (monthly, or weekly or even daily for some measures) than for many of the ratios
calculated from annual financial statements.
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Trends determine improving or worsening performance over time and are more reliable measures
of performance than comparing performance to targets which may be set more subjectively.
Rather than taking corrective action based on single period comparisons between actual
and target, trends can identify short-, medium- and longer-term changes in performance that
deserve attention. Performance needs to be sustainable over time, so short-term improvements
compared with targets need to be re-evaluated by looking closely at trends over longer
time periods.
Appendix 3.1 includes an example of how Western Water’s performance measures are assessed
against both targets and trends.
Benchmarking
The third level of analysis for performance improvement is benchmarking—that is, comparing
performance to competitors, industry averages, or acknowledged ‘best practice’ or ‘world class’
performance. Benchmarking enables an organisation to see where its performance might be
improved relative to others. Figure 3.5 shows the benchmarking process for performance.
Study guide | 311
3.
2.
1. Study the
Identify
Decide what processes in your own
benchmarking
to benchmark organisation and
partners and sources
gather information
5.
4. 6.
Analyse the
Obtain Learn and
information and
benchmarking implement changes
understand it relative
data where necessary
to the benchmark
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produce detailed reports, although the cost of obtaining research reports can be quite high.
For example, the Australian Bureau of Statistics reports aggregate data for retail sales
per square metre of floor space, labour cost per employee, and inventory turnover data.
Supermarkets will use various data to compare their performance, such as financial results,
sales revenue and number of stores. Competitor financial statements will of course be used
to compare financial ratios.
Other data shown in some company annual reports includes performance measures of sales
per square metre of floor space and sales per employee, both key performance measures
in the retail industry. Benchmark comparisons of data such as this are useful in making
comparisons of efficiency in use of floor space and staffing levels. Woolworths’ annual report,
for example, also shows the number of customers linked to its ‘Everyday rewards’ accounts and
Qantas Frequent Flyer points.
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Whereas earnings per share data are regulated, data on non-financial performance measures
is not required under financial reporting standards. Hence, it is often the case that benchmark
comparisons cannot be made or can only be made based on estimates derived from data
shown in the annual report (e.g. using reported sales figures, estimates of supermarket size or
employee numbers).
Two kinds of benchmarking are most common: internal and external (industry), although sometimes
benchmarking with organisations in other industries is also possible.
Internal benchmarks
Where an organisation has multiple business units, especially when these units have similar
operations, comparisons between units may be useful. For example, retail stores make extensive
use of benchmarking, comparing sales per square metre and sales per employee between store
locations and between departments (e.g. homewares, clothing, electrical).
Industry benchmarks
Industry benchmarking provides a comparison of an organisation’s performance against either
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industry averages or best practice. The organisations used for comparison are usually in the
same market segment and have similar products, processes or technology.
One method of benchmarking is to obtain data directly from the organisation identified as
having the best practices. If this is a competitor, direct access to data is not normally possible.
Indirect data may be obtained through ‘business intelligence’; for example, from websites,
trade exhibitions or speaking informally with competitors. A common practice in some industries
is to hire employees from competitors in order to obtain first-hand knowledge of competitors’
practices, although this is generally regarded as being unethical; and such employees are
often restricted by non-compete and confidentiality clauses in their employment contract and
exit package.
Benchmarks for small businesses can be downloaded from the Australian Taxation Office website at:
http://www.ato.gov.au/Business/Small-business-benchmarks.
Industry profile data can be purchased online from the Australian Taxation Office at:
http://www.benchmarking.com.au/shop/business-benchmarking/industry-profiles.
Sometimes there is an opportunity for benchmarking against best practice organisations outside
the organisation’s own industry, but care needs to be exercised as to whether practices can be
translated between industries.
All benchmark data needs to be interpreted carefully. Accountants and managers need to look
behind the data provided and try to understand why differences in performance between
organisations exist. Sometimes performance may vary due to different strategies or business
models, different regulatory regimes, or differences in legacy investments (e.g. in technology or
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infrastructure). In the absence of standardised data, all comparisons need to consider whether
the assumptions behind reported data are common between the benchmarked organisations.
Finally, the data derived through benchmarking is historical and reflects decisions of the past,
not current practices or recent decisions that are yet to be implemented. In relying on past
benchmarking comparisons, accountants and managers need to be aware that the pursuit of
continual improvement and sustainable competitive advantage by all benchmarked organisations
leads to continually evolving processes, and therefore continually changing performance relative
to others.
In aiming for performance improvement, targets, trends and benchmarks all provide useful
information in learning what works and what does not. However, all available information should
be used when seeking to improve performance. In comparing actual performance against target,
we should always remember that the variance may lead to a decision to change our behaviour
to improve performance relative to target, or to change the target to one that is more realistic.
It is also important to recognise that there is a time lag between making changes and when the
effect of changes can be seen in performance measures.
➤➤Question 3.16
(a) Briefly explain the main steps involved in undertaking a benchmarking exercise.
(b) Identify the main problems associated with undertaking a benchmarking exercise.
(c) Identify at least four benchmarking opportunities for an organisation.
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Organisational learning processes enhance or impede the acquisition, sharing and utilisation
of individual knowledge within organisations (see Nonaka 1991). It is concerned with assumption
sharing and the construction of mental maps, as well as unlearning redundant information
(e.g. Hedberg 1981). In other words, the assumptions in cause–effect or action–outcome
relationships are implicit in the organisation’s predictive model. The distinction has been made
between learning in organisations, by individuals, and learning by organisations (Popper &
Lipshitz 1998), the latter involving the organisational processes that enhance or impede learning.
In the music industry, music recordings were originally on gramophone records and subsequently
on large reel-to-reel tape recorders. Further innovations were cassette tapes and compact discs
(CDs). With computer and internet technology, there is no need to buy music on any particular type
of media; it can be purchased and downloaded from e-commerce sites and stored and played on
a computer, MP3 player, smartphone or tablet computer. Similar changes have taken place in video
with VHS tapes (Betamax tapes failed quickly in competition with VHS) giving way to CDs, DVDs,
and Blu ray technology (Blu-ray effectively beating its Toshiba HD-DVD competitor). Movies can now
be purchased and downloaded from the internet in the same way as music.
These technological changes have had significant impacts on the business models of the recording
studios, manufacturers of audio and video equipment, and media devices like records, tapes, CDs and
DVDs. Performance measures in those industries would likely have focused on numbers of units sold,
sales revenue, etc. Without knowledge of rapidly changing upstream technologies, these companies
may have been caught unaware by declining sales volume and profitability and may have ultimately
failed. Performance measures that are more strategic, such as awareness of patent registrations,
collaboration agreements with upstream supply chain partners and environmental scanning of emerging
technologies, would serve to avert the effect of such changes.
Study guide | 315
Similarly, retailers would have had to adapt quickly to new technologies and their likely impact of
downloading on the types of recording and playing equipment required. Hence, as for equipment
suppliers, attention to performance measures on sales volume and value, floor space, and employee
numbers could have led to serious consequences. Retailers who were better informed about technology
change could introduce measures for reducing inventories of products that were likely to become
obsolete and for expanding the product range to spread the risk, such as the number of new product
launches, or advertising expenditure on new products. Awareness could lead, for example, to a shift in
the business model from retail stores to online sales, something that has become evident in retailers
such as JB Hi-Fi.
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measured. Simons (1994, 1995) differentiated diagnostic from interactive forms of control.
Diagnostic controls use feedback to monitor performance and correct deviations from plan.
Interactive control systems are used by managers to involve themselves more directly in the
decision activities of employees. A performance measure that is used interactively is more likely
to influence behaviour than one used diagnostically, as subordinates will be aware that senior
managers are paying attention to particular aspects of performance.
In a similar way to compiling budgets, those who determine performance measures and their
associated targets derive a considerable source of power in organisations. Targets need to be
achievable (the ‘A’ in the ‘SMART’ acronym) but may be on a continuum from ‘stretch’ targets
to easy-to-achieve ones. Managers are more likely to accept targets and be motivated to strive
to achieve them if they feel that they have participated in the target-setting process, even if
the final targets are difficult to achieve. By contrast, if targets are simply imposed without any
participation, managers are unlikely to be motivated towards achieving them. The example of
Mammoth Printing showed how performance measures (like sales targets) result in behaviour
that is not necessarily in the organisation’s best interests. In that example, many of the sales
achieved were unprofitable due to the impact of smaller orders on production efficiency.
However, the commissions paid to sales representatives rewarded these unprofitable sales.
Professor David Otley of Lancaster University in the UK has provided two illustrations of the
unintended and dysfunctional consequences of performance measures. Otley, an international
expert in performance measurement, undertook research in British Airways (BA) and observed
baggage handlers at Heathrow Airport. As soon as an aircraft landed, one of the baggage
handlers unloaded the first available passenger’s suitcase and ran to the baggage conveyor
belt. The rest of the baggage was unloaded and stacked on trolleys which were then driven
to the conveyor belt and unloaded. Otley asked what the baggage handler was doing with
the first suitcase. The BA manager’s response was that a performance measure for baggage
handling was the time taken to put the first suitcase onto the conveyor belt. The performance
measure achieved the desired performance, but only for the first suitcase—the others were
being unloaded without any change in behaviour.
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In a second example, Otley was purchasing his weekly groceries from Tesco, a major UK
supermarket chain. Otley was surprised that the checkout operator waited until the conveyor
belt was full of groceries before she commenced scanning and packing. Otley’s interest in
performance measurement led him to ask the operator why she waited before commencing
the scan. The checkout operator replied that one of her performance measures was the average
time it took to scan a customer’s trolley, based on the time elapsed between the first and last
item scanned and the number of items scanned. If the operator had to wait for the customer to
take goods out of the trolley it would negatively impact on her performance, which would be
seen by everyone on an office chart that ranked the speed of checkout operators.
In both cases, the performance measures were well-intentioned, but resulted in unintended
consequences:
• an absence of any improvement in the unloading speed of baggage from BA flights; and
• customer dissatisfaction in what, from the customer’s perspective, appeared to be a lazy
checkout operator (Otley 1999).
Efforts to report performance that is desired by senior management can lead to a variety of
unintended and dysfunctional consequences, including:
• tunnel vision: focusing on a single target to the exclusion of all others;
• sub-optimal behaviour: achieving a performance target and failing to try to further improve
because the target has already been achieved;
• substitution: reducing effort on performance that is not subject to management attention;
• being fixated on a performance measure: rather than the underlying performance,
by ignoring the cause–effect or action–outcome relationships;
• gaming and biasing: making performance appear better than it is, either by misrepresenting
performance by providing inaccurate reasons for not achieving targets, or even falsifying
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Although they were writing about budgeting, the classic research by Lowe and Shaw (1968)
identified several sources of bias that are equally applicable to performance measures:
• the reward system;
• the influence of recent practice and norms; and
• the insecurity of managers.
The same sources of bias apply to non-financial performance measures where, in a similar way to
compiling budgets, there is ‘the desire to please superiors in a competitive managerial hierarchy’
(Lowe & Shaw 1968, p. 312).
These behaviours distort not only target setting and reported performance, but may also
result in actions taken by organisations that detrimentally affect performance. Dysfunctional
and unintended consequences can easily result from inappropriate performance measures
and targets. In these organisations the pressure for short term financial performance ignored
issues of the sustainability of that performance over time, and the associated reputational
issues. Often this focus on short-term financial performance is driven by the rewards offered
for directors and senior managers.
Reward systems
Employees can be motivated either through a ‘carrot’ or ‘stick’ approach. ‘Carrots’ are the rewards
employees receive for achieving the desired levels of performance. ‘Sticks’ are the sanctions or
penalties that result from not achieving desired levels of performance.
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Rewards can be financial (e.g. bonuses, profit sharing, share options), but can also be non financial
(e.g. promotion, transfer to desired positions, a better office, a bigger budget, recognition, and a
better performance appraisal). Sanctions include the loss of financial reward, being identified as a
poor performer, a negative personal reputation, perhaps demotion, transfer or even dismissal.
Consequently, rewards and sanctions are powerful motivators of behaviour, and can of course
lead to the unintended and dysfunctional consequences discussed in the previous section.
Rewards should be designed so that the needs for short-, medium- and long-term performance
are in balance. Short-term (especially financial) results should not be achieved at the expense of
sustainable longer-term performance and achievement of the organisation’s goals and strategy.
The Qantas example showed how that company split its senior executive remuneration over a
fixed salary, a short-term incentive plan and a long-term incentive plan to balance the needs for
performance over multiple time periods.
This module has shown that reducing expenditure on advertising, employee training, repairs
and maintenance, or research and development would improve short-term financial results,
but would likely detrimentally affect the organisation in the longer term. One impact of rewards
for short-term performance is that managers may achieve targets, and be rewarded financially
and promoted. A replacement manager could then be at a disadvantage because the lack
of prior investment makes them look like a poor manager, because they have to remedy the
deficiencies of the previous manager who was perceived as a better manager because of a short
term reported performance.
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Timing
In order to reinforce the relationship between performance and reward, rewards need to be timely.
If too long a period elapses between performance and rewards, the important association
between rewards and actions becomes less obvious to people. This suggests that annual
bonuses are potentially ineffective and that bonus payments more closely linked in time to the
achievement of the desired performance level are likely to be more highly motivating. However,
on the other hand, making bonus payments too soon after performance is achieved can lead to
a focus on short-term profits rather than profits that are sustainable in the longer term. Hence in
the Qantas example, the airline separated its short-term incentive plan (STIP) from its long-term
incentive plan (LTIP).
In many organisations, performance rewards are based on aggregate measures such as profit.
As has been noted previously, the influence any individual has on corporate profit is likely to
be small; therefore, the motivational effect of a profit-based bonus on the individual is likely
to be equally small. This approach is popular, however, because reward systems based on group
performance measures, such as profit, enhance teamwork, or at least reduce the potential for
dysfunctional conflict, and—as agency theory tells us—they align the goals of managers with
those of shareholders. However, the incentive to engage in gaming behaviour to achieve desired
performance targets can be a negative influence, and, at the extreme, managers and employees
may behave dishonestly in their profit-reporting activities (as the examples of Enron and
WorldCom revealed).
The most high-profile example of the focus on short-term financial performance impacting on
longer-term performance has been in the GFC.
Two particular causes of the GFC have been given by commentators. The first was the practice of
securitisation, where loans are packaged and resold by banks to other financial institutions, including
insurance companies, to raise funds for further lending.
The second and related cause of the GFC was said to be the rewards offered to directors and senior
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managers, especially in the financial services industry, for continuously improving performance that
was unsustainable and did not take into account the risks that were being faced. The initial round of
blame in financial institutions that lost billions on subprime mortgage-linked investments focused on
their chief executives. CEOs at Citibank, UBS and Merrill Lynch were forced to leave their companies.
There were severe effects from the GFC. The national income and output of the US fell by about
4 per cent in June 2009. That made it by far the sharpest US recession of the post-war period. In the
Eurozone, the peak-to-trough fall in output was even larger at around 6 per cent, and in the UK it
was 7 per cent. Further, in Europe, many countries were affected by a sovereign debt crisis (i.e. an
unsustainable national debt caused by continual deficits), with Iceland, Greece, Ireland, Portugal,
Spain and Italy particularly at risk. The banks in many countries in the Eurozone, in particular in Greece
and Spain, faced difficulties in meeting their debt obligations, which caused a downturn in demand
and globally depressed stock markets (RBA 2014).
The GFC and its aftermath are at least in part a consequence of the relentless pursuit
of short-term financial performance, driven by rewards for measured success, without a real
understanding of the predictive model (which effectively collapsed), or a concern for risk
or the sustainability of performance over the longer term.
One way organisations have found to combat ‘short termism’ is to link some financial rewards
to sustainable performance. Increasingly, we see senior managers receiving the rights to
benefits such as share options that can only be cashed-in by them if performance is sustained
over a longer period of time.
Study guide | 319
Wallander abandoned budgeting at Handelsbanken but this had no effect on the bank’s performance
(see the limitations of traditional accounting performance measures, including the Beyond Budgeting
movement discussed earlier).
Reflecting the contingent nature of performance measures, Wallander said that organisations will
use ‘different types of key indicators, ratios, graphs, etc. Modern companies already have myriads
of operational, financial and physical measures. The problem is to choose a limited number of
those measures which really show if the company and its different units are on the right track or not’
(Wallander 1999, p. 419).
In the absence of targets, the emphasis in performance measurement was on benchmarking: relative
performance compared between Handelsbanken’s branches, but also compared with other Swedish
banks. In addition to benchmarks, trends were compared from quarter to quarter, a benchmarking
from one time period to another.
The final element of Wallander’s strategy at Svenska Handelsbanken was a profit-sharing system for
employees, with the profit share dependent on the profitability of the bank relative to the other Swedish
banks. Interestingly, the employees’ share in the profits of the bank was only paid to them when they
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retired, which encouraged attention to the sustainability of performance.
➤➤Question 3.17
After reading the above example of Svenska Handelsbanken, compare what has been learned
about performance measurement throughout this module with the approach that Jan Wallander
took in his bank.
Critically evaluate the Handelsbanken approach in relation to non-bank organisations, considering:
• abandoning budgeting;
• the type of performance measures used; and
• the reward system.
320 | PERFORMANCE MEASUREMENT
Review
Performance measurement focuses on customer value and achieving a strong competitive position
for the organisation. Such a focus would not be possible without understanding the key role that
performance measurement plays in strategy and value creation.
Part A looked at the definition of what was meant by performance and performance measurement
and emphasised the importance of balancing financial with non-financial measures. Value creation
and the sustainability of performance over time were outlined, as well as sustainability in the
sense of corporate social responsibility. The implications of performance measurement for
accountants and its links with governance and signalling were introduced. Part A also described
the importance of ethical responsibilities, and agency and contingency theories that underlie
much of the study of performance measurement.
Part B looked at the links between strategy, management control systems and performance
measurement, and the limitations of some traditional accounting-based controls. The various
models of performance measurement, emphasising the balanced scorecard and the strategy
mapping process, as well as cascading performance measures and the important role of
information systems in performance measurement were reviewed.
Part C looked at how performance measures and their associated targets are designed and
the characteristics that make performance measures useful, including the need to compare
the costs and benefits of performance measurement. This part also briefly introduced the role
of power and culture in performance measurement. It focused on improving performance
through targets, trends and benchmarking, and the importance of continuous improvement
through organisational learning and knowledge management processes. Finally, Part C looked
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Appendix 3.1 provided a case study of Western Water (WW) including examples of how WW
develops its performance measures using a balanced scorecard linked to strategy through the
strategy mapping process. This process is cascaded down through the organisation to enable
strategy to be implemented. WW reports its performance in financial and non-financial terms
and emphasises long-term sustainability.
Appendix
Appendix
Appendix 3.1
Western Water Case Study
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Introduction
Western Region Water Corporation (trading as Western Water—hereafter WW) is located in
Australia in the state of Victoria. It is one of Victoria’s 13 regional urban water corporations,
providing water, recycled water and sewerage services to 58 200 properties over an area of 3000
square kilometres and servicing a population of 158 300. WW has significant responsibilities to
its customer base to provide water and sewerage treatment, as well as operating in a financially,
socially and environmentally responsible way.
WW operates in a highly regulated environment. It is responsible to the Minister for Water via
the Department of Sustainability and Environment, which agrees performance standards for each
water corporation.
The Department of Treasury and Finance also has a shareholder governance role. The Department
of Health sets and supervises water quality standards, while the Environment Protection Authority
governs environmental standards. Essential Services Commission, the Victorian Government’s
economic regulator for essential utility services, also regulates Western Water prices, service
standards and market conduct. The Energy and Water Ombudsman Victoria receives, investigates
and resolves enquiries and complaints against water suppliers across Victoria (Western Water
2014, p. 1).
WW’s vision is ‘To be recognised as a successful water business that is valued by our community’
(Western Water 2015).
Balanced scorecard
WW’s Corporate Report 2011/12 explains the role of the balanced scorecard (BSC) as a strategic
management tool:
Having been in implementation for over a decade, Western Water utilises the tool to monitor key
actions and outcomes to ensure all facets of the business are aligned and progressing toward our
vision (Western Water 2012, p. 15).
Importantly, with its long experience of the scorecard, WW has moved from its use as a monitoring
and reporting tool to using the BSC as a key tool for strategy execution.
WW develops its strategy through a series of workshops with the board, customers and managers.
This is shown diagrammatically in Figure A.3.1. This is followed by a board strategic planning
workshop which develops BSC objectives. The board then sets the direction for the strategic
plan (and monitors the results). A risk review identifies the risks that prevent strategies from
being achieved and ensures regulatory compliance.
BALANCED SCORECARD
Objectives Measures BSC rating Initiatives
Source: Wilkinson, J. 2010, ‘Using the balanced scorecard for effective strategy execution:
The Western Water approach’, Presentation to the Australian Institute of Company Directors,
Directors Briefing, April 2010.
Appendix 3.1 | 323
Risk management
Risk management is an important part of setting goals, strategies and targets. Risks and returns
are commonly associated, so risk is an unavoidable aspect of any business. Risk has been defined
as the inability to achieve objectives and can be seen in both positive terms (risk taking is part of
taking advantage of opportunities) and in negative terms (avoiding threats). Risk management is
the process of:
• identifying these risks;
• assessing their importance in terms of their likelihood of eventuating, and the consequences
of those risks; and
• putting in place methods of evaluating, managing and monitoring those risks, adopting
appropriate risk treatments, from insurance and management controls to avoiding the risk
altogether.
The strategic plan and risk review lead to the development of initiatives that are designed to
bridge the gap between actual and desired performance, with measures identified to monitor
the effectiveness of strategy implementation. These initiatives and measures are matched with
the board’s objectives in the BSC. The final step in the planning process is the development
of corporate plans in which there is an allocation of resources to fund the initiatives consistent
with the objectives and performance measures.
Strategy mapping
To build accountability in any organisation, accountability for performance and the implementation
of initiatives is assigned to the appropriate department, teams, project groups or to individual
employees. The approach used by WW is a good example of the use of strategy mapping.
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The importance of a strategy map is in strategy implementation. There is little point in formulating
detailed strategies if they are unable to be implemented. Implementation is achieved through
cascading roles, responsibilities, initiatives or projects, performance measures and targets for
each organisational goal. When measures are inconsistent or even competing across different
functional areas, the organisation will likely suffer sub-optimum performance, as different
individuals, teams or projects will be working towards different targets. Cascading measures
and targets at each level of the organisation supports both alignment with organisational
goals and coordination between departments, teams, projects and individual efforts.
WW’s approach to translating strategy into initiatives is a good example of strategy implementation
using cascading performance measures. Without cascading, strategies and plans are likely to
remain just that. Execution of strategy requires the allocation of tasks, and their associated
performance measures, to departments, teams and individuals. In WW, ‘initiatives’ are
the organisation’s strategic priorities. In other organisations these may be called projects.
The discussion in Module 5 ‘Project management’ is important here as projects and initiatives
need to be managed effectively to ensure that milestones of budget, time and quality are
satisfied in order to achieve the targets for those initiatives and projects and so contribute to
overall organisational performance.
Given its focus on strategy execution rather than mere strategy formulation, WW adopts a
cascading approach beginning with the strategic direction of the business, then describing
three-five key strategic themes, utilising the strategy mapping approach to describe how
strategy will be achieved by defining key outcome objectives, measures and targets. These are
in turn cascaded to key initiatives which are prioritised through the BSC process and are
cascaded further to team and individual employee goals.
324 | PERFORMANCE MEASUREMENT
The WW strategy map is a hierarchical structure that starts with people drivers, leading to
sustainable process drivers, financial outcomes and stakeholder (regulators, government
and community) outcomes, and finally to customer outcomes in each of the three pathways
(see the ‘Introduction’ above). The pathways and drivers within the strategy map are shown
in Figure A.3.2.
CUSTOMER OUTCOMES
C1 C2 C3
Water Water Quality
SMART supply customer Pathway 1:
customers SECURITY SERVICE To drive an environmentally
sustainable future
STAKEHOLDER OUTCOMES
S1 S2 S3
Influence and meet Influence policy Enhance
REGULATORS and satisfy our
requirements GOVERNMENT COMMUNITY
Pathway 2:
To proactively manage
FINANCIAL OUTCOMES our destiny
F1 F2
Manage Sustainable
RISK financial
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Effectively PERFORMANCE
I1 I2 I4
I3
Implement Create OPTIMISE
Pursue
SUSTAINABILITY effective systems and
INNOVATION
principles PARTNERSHIPS processes Pathway 3:
To be a valued and innovative
service provider as judged
PEOPLE DRIVERS by our customers and the
P2 wider community
P1
Improve P3
Develop
workforce Excel at
LEADERSHIP
ENGAGEMENT OH&S
capabilities
and planning
Source: Wilkinson, J. 2010, ‘Using the balanced scorecard for effective strategy execution:
The Western Water approach’, Presentation to the Australian Institute of Company Directors,
Directors Briefing, April 2010.
The strategy map contains performance measures and targets that are used by the board to
monitor performance using a ‘traffic light’ approach (green are on-target results; yellow are
near target; and red off-target results) to guide board discussion. Importantly, WW’s board
focuses on questioning the logic and rationale of strategy rather than on the day-to-day
operational detail. A (fictitious) sample of the cascaded performance measures within each
pathway with their green/yellow/red indicators is shown in Figure A.3.3.
Appendix 3.1 | 325
Figure A3.3: E
xample strategy map—tracking strategy performance—strategy map
with traffic-lights guides board discussion
STRATEGIC PERFORMANCE REPORT JULY 2009
To be a leading service provider working with our
community towards a sustainable future
CUSTOMER OUTCOMES
C1 C2 C3
Water Water Quality
SMART supply customer
customers SECURITY SERVICE
STAKEHOLDER OUTCOMES
S1 S2 S3
Influence and meet Influence policy Enhance
REGULATORS and satisfy our
requirements GOVERNMENT COMMUNITY
FINANCIAL OUTCOMES
F1 F2
Manage Sustainable
RISK financial
Effectively PERFORMANCE
I1 I2 I3 I4
Implement Create Pursue OPTIMISE
SUSTAINABILITY effective INNOVATION systems and
principles PARTNERSHIPS processes
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PEOPLE DRIVERS
P2 P3
P1 Improve Excel at
Develop workforce OH&S
LEADERSHIP ENGAGEMENT
capabilities and planning
Off-target (red)
Near-target (yellow)
On-target (green)
No data
Source: Wilkinson, J. 2010, ‘Using the balanced scorecard for effective strategy execution:
The Western Water approach’, Presentation to the Australian Institute of Company Directors,
Directors Briefing, April 2010.
326 | PERFORMANCE MEASUREMENT
Performance reporting is used extensively by WW. WW’s Annual Report 2011/12 provides a
comprehensive list of financial as well as service and environmental performance indicators,
with comparisons against the prior year and variances against target being shown for each
indicator. WW also included in its annual report further performance measures using the
GRI G3 Guidelines.
The annual report shows the following ‘service and environmental’ indicators:
• water-supply interruptions;
• duration of interruptions;
• restoration of supply within five hours;
• reliability of sewerage collection;
• containment of sewer spillages; and
• customer complaints:
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–– water-quality complaints;
–– sewerage complaints;
–– billing complaints; and
–– sewage odour complaints.
In addition, there are sewage reuse indicators for each of WW’s seven treatment plants.
These are summary measures reported externally each year but are supplemented by many
more internal management performance measures.
WW measures customer service performance on a weekly basis to ensure all essential service
functions are performed in accordance with agreed standards. These performance measures
follow the Specific, Measureable, Achievable and Agreed, Relevant, Time-based and Timely
(SMART) principles. For example, the three performance indicators for water supply show
the following:
1. number of customers receiving greater than five unplanned interruptions during the year;
2. average duration of those interruptions in minutes;
3. percentage of unplanned water-supply interruptions;
Conclusion
The WW case is an interesting one as it is a state-owned corporation subject to extensive oversight
from various government departments and agencies. While it has no shareholders in the listed
company sense, there are equivalent financial expectations as the regulator sets prices and WW
needs to operate within a tight budgetary framework. This can be a very difficult balancing act for
public authorities who must not only carry out their operations in the short-term but must reinvest
in significant assets for the future and balance their financial and environmental accountabilities
in both the short and long terms. Much of the performance reporting of state-owned enterprises
such as WW is in non-financial terms as financial measures are overly restrictive in holding the
organisation accountable to its multiple stakeholders.
Sources: Western Water 2014, Annual Report 2013/14, accessed October 2015,
http://www.westernwater.com.au/files/assets/public/documents/reports/annual-reports/annual-
report-2014.pdf; Adapted from Western Water 2012a, Corporate Report 2011/12,
accessed June 2013, http://www.westernwater.com.au/About/Reports?BestBetMatch=Annual
report|ead053fc-a57c-4fff-b653-f023722b18ed; Western Water 2012b, Annual Report 2011/12,
accessed June 2013, http://www.westernwater.com.au/About/Reports?BestBetMatch=Annual
report|ead053fc-a57c-4fff-b653-f023722b18ed; Wilkinson, J. 2010, ‘Using the balanced scorecard for
effective strategy execution: The Western Water approach’, Presentation to the Australian Institute
of Company Directors, Directors Briefing, April 2010.
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Suggested answers | 329
Suggested answers
Suggested answers
Question 3.1
The Qantas Annual Report 2014 reports performance for each of its business segments by:
• available seat kilometres (ASKs—a measure of airline capacity defined as the total number
of seats available for passengers multiplied by the number of kilometres flown);
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• revenue passenger kilometres (RPKs—the total number of passengers carried, multiplied by
the number of kilometres flown);
• passengers carried;
• revenue seat factor—seat utilisation (percentage of available seats booked);
• yield (passenger revenue divided by RPK);
• net underlying unit cost (as defined by Qantas); and
• revenue tonne kilometres (RTKs—the total number of tonnes of paying passengers,
freight and mail carried, multiplied by the number of kilometres flown).
In the Qantas Annual Report 2014 a section on ‘Sustainability statistics and notes’ identifies
performance measures across six dimensions:
1. Finance—Underlying profit before tax; net underlying unit cost; free cash flow; and average
fleet age.
2. Safety and health—Injury frequency; lost work frequency; absenteeism.
3. Customer—On-time departures and arrivals; cancellations.
4. People—Gender and age diversity; part-time employees; indigenous Australians employed;
full time equivalent employees.
5. Environment—Aviation fuel consumption; CO2 emissions; fuel and CO2 emissions per
revenue tonne kilometre (RTK); electricity and water usage; waste to landfill.
6. Community—National export revenue; domestic travel expenditure.
Note that many of the performance measures are specific to the airline industry and to Qantas.
It is also important to note that in reporting these performance measures, Qantas defines each
and discloses how the measures are calculated.
330 | PERFORMANCE MEASUREMENT
Question 3.2
(a) JB Hi-Fi’s Annual Report 2014 reveals that the primary role of JB Hi-Fi’s board is ‘to protect
and enhance long-term shareholder value’ (JB Hi-Fi 2014, p. 5) and it is accountable to
shareholders for that performance.
In its annual report, JB Hi-Fi reports that its focus has been on a national expansion,
expanding its product range into home appliances, and development of its online store.
(c) The company views its main financial measure of performance as annual growth in EBIT
(JB Hi-Fi 2014, p. 33).
There are also a number of specific performance measures used to assess the performance
of senior executives (see page 34 and 35 of the 2014 Annual Report).
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Question 3.3
(a) Mega Markets has provided affordable products, sourced from overseas, targeting the
budget-constrained customer. The major benefits of Mega Markets’ historic strategy have
been the ease of shopping for customers in major shopping centres, and the affordability
and range of its products. However, with the increased availability of low-cost computers in
homes and the expansion of the internet, Mega Markets’ is now facing global competition,
perhaps even from its own suppliers in South-East Asia.
(b) The value previously offered by Mega Markets’ has been almost completely eroded as
customers can order online and receive the equivalent goods in a week, at a lower cost.
Buying online also avoids the problem of the customer’s choice of style, colour and size being
out of stock in their nearest shopping centre. As the kind of products sold by Mega Markets’
are largely discretionary as to time (i.e. the purchase can readily be delayed), there is
little advantage in going to a shopping centre when it is more convenient for customers
(especially those with young children) to buy online and have the goods delivered to
their home.
(c) In the face of strong online competition, the unique factor that Mega Markets can adopt
is personal customer service. While this may be expensive, customers often appreciate
a friendly and helpful staff member who can advise and assist in selection of products,
sizes and colour combinations. Candidates in Australia who have visited some of the larger
department stores recently may have noticed that they have reduced staffing to cut costs
and, as a consequence, there is often very little customer service available and long queues
to pay for goods selected by customers. This has perhaps exacerbated the shift by customers
to smaller boutique stores and online purchasing.
Suggested answers | 331
Of course, Mega Markets could adopt a strategy of selling its products online as well
as in stores, as many Australian retailers have done (e.g. JB Hi-Fi, Myer, David Jones,
etc.). This would enable customers to be able to exercise their shopping preferences by
purchasing in store, online, or through both channels. This would enable Mega Markets to
more effectively compete with other online stores. However, there is a substantial investment
required to implement this strategy. Information technology needs to be designed and
introduced, as does a warehousing, stock picking and distribution function, which would
increase the company’s overheads.
It would be difficult to compete with online-only suppliers who do not have the rental and
salary costs associated with a chain of retail stores in shopping complexes, and unless
Mega Markets opened a warehousing and distribution facility near its suppliers in South East
Asia, it would not be able to take advantage of the cost advantages in those countries.
Question 3.4
There are many possible responses to this question, and it is impossible to cover them all.
However, you may have identified:
• the roles and responsibilities of the board of directors, a chief risk officer (if your organisation
has one), and the chief financial officer in relation to risk management and performance;
• whether your organisation is risk-averse, or takes managed risks in pursuit of its objectives;
• whether the internal control systems enable or impede risk-taking;
• whether performance accountability is centralised, or decentralised to individual managers;
• whether risk management is centralised, or decentralised to individual managers;
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• whether the accountability for performance and risk management is integrated at the same
organisational level, or diverges to different people in the organisation; and
• what performance measures and the measurement processes the company has in place.
Source: IFAC Professional Accountants in Business Committee (2011), Global Survey on Risk
Management and Internal Control: Results, Analysis, and Proposed Next Steps, accessed July 2015,
http://www.ifac.org/sites/default/files/publications/files/global-survey-on-risk-manag.pdf.
332 | PERFORMANCE MEASUREMENT
Question 3.5
1. (i) Governance
As a director, you are responsible for the company’s financial statements, a responsibility
that is even more pronounced as the chief financial officer (CFO). What has been
asked of you is high risk, both for the company and its directors, as it is illegal with
directors and officers facing severe penalties for such action, which also would lead to
severe reputational damage for the company and individual perpetrators. Accounting
information is one of the main sources of information to support the governance function.
As a director and CFO, you are also responsible for a system of internal controls,
which includes control over the inventory asset of the company.
Signalling
(ii)
Financial statements are not produced just for the owner–manager of a privately
owned company. The financial statements provide signals to all shareholders, taxation
authorities, banks and financiers, payables, customers and employees. Even from a
shareholder perspective, you do not know the position of the CEO/chairman’s wife
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with respect to what the CEO/chairman wants you to do. As the company has bank
loans, there may also be an undeclared intent to deceive the bank in relation to the
loan, and certainly to avoid income taxes.
Ethics
(iii)
The request by the CEO/chairman presents a clear ethical dilemma for you, irrespective
of the illegality of what you have been asked to do. The HIH case study highlighted the
culture in that organisation of not questioning leadership decisions. The fundamental
principles in the Code apply not only to public practitioners in relation to clients but
also to employee/employer relationships. The Code includes a responsibility to act in
the public interest:
|| the principle of integrity would be breached as the demanded action would be
dishonest;
|| the principle of objectivity would be breached because of the undue influence of
the CEO/chairman and the resulting conflict of interest (you are expected to resign
if the demand is not met); and
|| the demand is also a breach of professional behaviour as the action demanded
would breach legislation and accounting standards, and would be a behaviour that
would discredit the profession.
2. Recommendations
There are few options available to the CFO. The CFO could wait a couple of days
before discussing the matter again with the CEO/chairman, in the hope that after further
consideration, the CFO could change the mind of the CEO/chairman. The delay could be
used to prepare a forward financial plan and cash forecast to show the impact of both the tax
payment and debt repayment. Failing this, the CFO could request a board meeting to
discuss the matter with the CEO/chairman’s wife.
Beyond these actions, the CFO should obtain ethics advice and legal advice in accordance
with the Code, but may have no alternative but to resign from the company to avoid being
associated with the illegal and unethical act requested.
If the company’s accounts are required to be audited, the auditors may well identify such
a material misstatement of the inventory value. In the event of a purposeful misstatement,
the auditors may have to report a breach to the authorities.
Question 3.6
(a) Mega Markets is what Porter termed as ‘stuck in the middle’. Mega Markets is not sufficiently
low cost to be adopting a cost leadership strategy and its products are undifferentiated
from what can be acquired online. While Mega Markets has focused on the budget-conscious
family with young children, the susceptibility of that customer group to online sales at a lower
price is a significant weakness.
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By comparison, an internationally based online competitor is more likely to have a cost
leadership strategy, without the investment in retail stores or a high staffing cost, with a
single central warehouse and an investment in technology for the online sales and
ordering platform.
(b) The value chain comparison in Table SA3.1 shows the susceptibility of Mega Markets to
online competition.
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Table SA 3.1: Value chain comparison between Mega Markets and an online
competitor
Primary activities
Outbound logistics Customers shop with young Customers shop online, make their
children in their nearest store, product choice and then await
involving travel, parking, delivery to their home
queuing, etc.
Support activities
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Human resource management Large investment in retail staff and Relatively low investment in
training of staff staff for technology support and
warehouse staff for picking and
delivery of ordered goods
Margin in the value chain refers to the difference between the cost of providing the primary and
†
Question 3.7
(a) In the traditional budget example, the standard to be applied is the budget of $35 000.
The method of measurement is the accounting system that reports sales revenue of $33 750.
The comparison is a simple calculation of budget minus actual of $1250 unfavourable
variance. The only means of feedback correction with this information is to hold the sales
manager accountable for the shortfall in revenue.
In the expanded version of the traditional budget versus actual report, there are two standards
(the volume of sales quantity and the average selling price). The method of measurement is
an accounting system that not only records and reports sales revenue but also records and
reports sales volume. The comparison is of both quantity and sales revenue. The ability to
take corrective action is improved because the additional feedback information enables a
focus on both unit selling price and volume.
In the flexible budget version, while the original budget standard is retained, the standard
to be applied is the flexed budget (i.e. the actual volume multiplied by the budget selling
price per unit). The method of measurement is as per the expanded information but is
enhanced by the additional reporting (in the accounting system or through a spreadsheet)
of the flexed budget and the ability to more clearly see the impact of the quantity and price
variations. The comparison enables separation of the selling price variance (actual quantity
sold multiplied by the difference between $3.75 and $3.50) and the sales volume variance
(the difference between the target of 10 000 units and the actual sales of 9000 multiplied by
the budget selling price of $3.50 per unit). Using the additional feedback, two quite separate
pieces of information can lead to two different corrective actions: one volume-related and
one price-related, which identifies the likelihood that by increasing price over and above the
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target price, sales volume has fallen and this has led to a revenue shortfall.
(b) Management decision-making is almost impossible in the first version of the report that shows
the variance between sales budget and actual, as there is no indication of the causes of
the variance.
In the second, expanded version, management can see that there is both a volume and a
price variance but still has insufficient information other than to question the responsible
managers as to why volume is lower than expected but prices higher. Although it can
be assumed that there may be an offsetting factor involved (i.e. that higher prices may
have led to lower volume), any trade-off cannot be quantified.
The third, flexible budget format is the most useful for management decisions as both
the value of the volume variance and the price variance are quantified. More meaningful
discussions can take place with sales managers to determine explanations for these
variances, the likely effects of higher prices on volume, and what corrective action can
be taken.
Management decisions may also be taken on the basis of the reports in terms of:
–– the accuracy of the budget standard (and whether this is in value only, or value and volume);
–– the validity and reliability of the method of measurement (sales revenue will be collected by
an accounting system, but sales volume may require additional non-financial performance
measurement outside the accounting system);
–– the preferred means of comparison and method of reporting variances in future
(traditional budget versus actual reporting, or flexed budget reporting); and
–– the means of investigating variances and seeking feedback to support corrective
action (separating price from volume variances, and the likely interaction of each
element of sales revenue).
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Question 3.8
There are many possible controls that could affect sales behaviour at SalesVol Ltd (SalesVol),
and which could have resulted in the level of sales being below target (remember, volume was
lower than target, but average selling price was higher than target):
• Market controls are exercised through competitive pricing. Prices cannot be increased such
that customers are likely to move their business to competitors unless a price premium can
be generated from brand or reputation. In SalesVol’s case, higher pricing may have led to
customers moving their business elsewhere.
• Non-financial targets may emphasise sales volume (or the lack of such targets may result in
volume being disregarded).
• The absence of a market share target may lead to premium pricing.
• Bureaucratic rules may require approval by more senior managers of changes to target
prices, particularly if discounted prices are to be applied.
• Incentives and rewards may be based on compensation linked to volume, sales value,
or even to premium pricing on particular orders.
• The reliance on feedback controls (diagnostic controls) compared with interactive controls
(where managers draw attention to particular areas of performance) may create a financial
or non-financial, or a volume/value emphasis.
• The organisational culture (which is built through recruitment, training and socialisation,
as well as supervision and performance appraisal processes) may reinforce a particular
emphasis on achieving sales volume targets, increasing prices, or simply achieving the sales
revenue target, irrespective of the combination of price and volume.
• Organisational belief systems may reinforce at employee level that increasing prices will
lead to higher revenue.
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Question 3.9
The following are examples of the different types of controls that could be introduced,
although you may be able to think of others.
Personnel controls:
• recruitment (reference checking, qualification checks, assessment centres, in-depth interviews);
• training of new employees;
• performance appraisal on a regular basis;
• establishing a strong culture to support a work ethic (e.g. towards timeliness and accuracy);
• incentives for consistently high levels of performance (e.g. bonus, promotion); and
• staff turnover.
Financial controls:
• cost management within agreed budget.
Planning controls:
• annual planning process that is consistent with the organisation’s strategic plan;
• identifying key success factors with the chief executive officer (CEO); and
• developing a service level agreement with internal customers.
Process controls:
• standard operating procedures or procedures manual;
• regular monitoring of staff by managers and supervisors; and
• regular meetings to identify problems and solutions.
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Performance measures:
• on-time production of reports;
• quality errors (e.g. journal adjustments to correct errors after close of reporting period);
• internal customer satisfaction survey;
• number of complaints received from internal customers;
• adjustments required by auditors after end of year (number and value);
• days’ sales outstanding; and
• days’ purchases outstanding performance compared to target (and improvements over time).
Question 3.10
The list below is based on the information in the scenario question. Some measures may
be considered either operational or strategic. The categorisation is less important than
developing some performance measures that reflect Chocabloc’s dependence on its upstream
and downstream supply chain. Leading measures provide an earlier indication of likely financial
performance. Note also the large number of non-financial performance measures compared
with financial performance measures. Remember that if non-financial measures are revealing
poor performance, this will likely be reflected in financial performance at a later time.
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• on-time deliveries of imported cocoa from Brazil;
• on-time deliveries of milk from dairy farms;
• on-time deliveries by logistics supplier;
• damaged or returned stock from retail stores;
• number of patents; and
• number of new product launches (and number withdrawn as a result of market research)
over time.
Question 3.11
Table SA 3.2 shows some differences between the performance measures of each company
based on their different strategies. You may be able to think of others.
Financial perspective
Customer perspective
• Number/percentage/value of returns
• Number/percentage of complaints
• Number of website hits, time on website
• Net promoter score
• Sales per square metre • Cycle time (time from receipt of order
• Sales per employee to despatch)
• Out-of-stocks (lost sales due to style/colour/ • Out-of-stocks (less likely as there is one
size combination being out of stock) central warehouse holding all style/colour/
size combinations)
• Delivery accuracy percentage (returns due to
inaccurate picking/delivery)
As Table SA3.2 shows, there is unlikely to be much difference in the lagging financial indicators
between both companies, both of which are likely to pursue similar financial outcomes for
their shareholders.
Suggested answers | 339
There is also likely to be similarity in the measures for the customer perspective, although the
online competitor is far more likely to be able to target its customers with special offers because
it will have more detailed and accurate information about each customer who places an order.
The online competitor will also have more accurate information about prospective customers
who visit its website without ordering, than will a retail company which has no information about
potential customers who do not make purchases.
The business process perspective is where performance measures are likely to vary most, with the
retail store measuring the efficiency of sales for its retail store and staff investment. The online
competitor will also need to measure cycle time from order to delivery (where it is most
susceptible to competition from the retail store as purchase and delivery are simultaneous) as
well as delivery accuracy.
Equally, there will be significant variation in the innovation and learning perspective. The retail
store will emphasise staffing measures over systems, whereas the online competitor will place
far greater emphasis on the reliability of systems as it is far less dependent on staffing.
Question 3.12
What follows is an illustration of the kind of things that could be part of a strategy map for a small
professional services company. The strategy map may be simple or complex; this is just one
example. Some companies will have fewer performance measures and some will have more than
those shown below.
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(a)
Figure SA 3.1: Example strategy map
Debtors’ collections
Cost Revenue
Client retention
Quality of work
Maintaining Recruitment
up-to-date and retention Partner contact Marketing and
knowledge of staff Prospecting
with clients promotion
The strategy map shows many of the assumed relationships required for a successful
accounting practice. Starting from the bottom and moving upwards, the left-hand side
reflects the importance of human resources: recruitment and retention of staff, and
maintaining up-to-date knowledge through continuing professional development (CPD).
Staff with knowledge lead to quality work and the ability to charge fair prices (charge-out
rates are the rates charged to clients for the work carried out by staff of the company).
While staff are usually the most significant cost to the company, it is only through staff
that revenue is earned by working hours that are chargeable to clients.
The right-hand side of the strategy map shows a focus on clients. Marketing is important to
develop new business opportunities. Prospecting (making contact with potential clients) is
important to winning new business. Partner contact with existing clients is also important to
maintain existing client satisfaction. Through these activities, the company can build its new
client base, maintain existing clients and increase the revenue earned from clients through
value-adding services.
As the main financial asset of any professional services company is its receivables, good
billing practices and collection of debts are essential for cash flow. There are many other
possible critical success factors and cause–effect relationships in a strategy map, with many
possible variations between companies (even in the same industry). Factors such as
information technology and company reputation may be relevant, even though they are
not shown in the illustration above. The actual strategy map adopted by any one company
will be a reflection of its strategy, competitive position and business model.
factors in the strategy map. Different businesses will define different performance
measures, based on the business strategy, competitive position and business model.
There are 25 performance measures shown below. These are fairly evenly spread over the
four perspectives (although there are a few more measures in the financial perspective).
Of the suggested measures, 13 are financial and 12 non-financial. So the scorecard
suggested for this company is quite balanced.
Suggested answers | 341
Financial
(F) or non-
Key success factors financial
BSC perspective in strategy map Performance measure (NF)
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Hours worked Chargeable hours as a percentage of NF
paid hours
Write-offs/ons (i.e. hours charged to clients NF
that cannot be recovered in billing,
or due to efficiencies result in a higher
than expected margin)
Many possible performance measures have not been included in the above table. One issue
for any organisation is how many different performance measures it should have. It is
usually accepted that any more than 12 to 16 measures (balanced between each of the
four perspectives) becomes difficult to monitor and manage. Hence organisations need to
choose which are the most important, and will generally cascade these measures down,
with different organisational units possibly having different measures.
In the above example these have not been considered as critical, but they are important
measures, and may be particularly useful in benchmarking exercises.
Question 3.13
(a) A reduction in the total cost of components can be achieved either through purchasing
improvements (reducing the price per component), or through productivity improvement
(reducing the quantity of components used, e.g. by reducing waste or damaged components).
Performance measures should be set for Purchasing—the cost for each component is the
most relevant measure for that department. This measure could cascade to individuals or
work groups within the department with measures of, for example:
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Performance measures could be set for Production—the total number of components used
for the number of finished triffids produced is the most relevant measure for that department.
This measure could cascade to individuals or work groups within the department with
measures of, for example:
–– number of components received (i.e. comparing standard quantities with actual
quantities of components received for the production of triffids);
–– number of out-of-stock notifications requiring special purchasing;
–– number of components wasted;
–– number of components reworked;
–– number of components damaged or lost; and
–– number of quality defects.
Suggested answers | 343
(b) The Finance and Administration department needs to provide the information required by
purchasing, production, and the board of directors to enable monitoring of performance.
In addition, the Finance and Administration department needs to ensure sufficient control
exists over goods that are received into inventory (including checking of quantity and
quality of received components) to ensure that only components received are paid for.
Often, premiums are paid for components ordered due to out of-stock situations, hence the
number of special purchases due to components being out of stock needs to be reported,
together with the price variation. In addition, care should be taken that the Purchasing
department doesn’t achieve a lower cost for each component by simply increasing the
ordered amount to take advantage of volume discounts—tying up additional funds in
inventory could have disastrous consequences for organisational cash flows and also
increase the risk of inventory becoming obsolete, damaged or lost while in storage.
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344 | PERFORMANCE MEASUREMENT
Question 3.14
Table SA 3.4: SMART performance measures and targets
Performance
Performance measure target SMART Characteristics
1. Head office recharge $1 million This measure is not relevant This measure can be
of corporate costs to for planning, decision- calculated reliably but it is
business units, based making or control, because not a valid measure of the
on a percentage of if sales revenue exceeds business units’ demand for
sales revenue in each the target, the head office corporate services. It is not
business unit recharge will be higher than controllable by business
the target. unit managers.
2. Survey of brand 75% This measure is specific This may be a valid measure
recognition among and measurable but of the effectiveness of
members of the achievability may depend advertising in terms
public on the level of advertising. of awareness, but it is
It also may not be relevant not a valid measure of
in terms of conversion of sales. It may be reliable
brand recognition into if a standard form of
sales. For example, many statistical survey is properly
consumers are aware of the carried out.
‘Coca Cola’ brand but do
not buy the product.
3. Receivable days 45 days This measure and target This measure is a valid
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5. Percentage of sales 80% While this measure meets The measure is valid
revenue from return most of the SMART criteria, and reliable as it does
customers it is not necessarily time- accurately capture
based (i.e. it does not reveal information about customer
the elapsed time between retention. However, it is
customers placing repeat not controllable as there
orders, nor the value of are many factors outside
their orders compared with managers’ control that
their prior orders). influence returning
customers.
Suggested answers | 345
Performance
Performance measure target SMART Characteristics
6. Dollar value of $100 000 p.a. While this measure and This measure can be reliably
donations to charities target meets most of calculated and is valid in
the SMART criteria, it is terms of measuring financial
not likely to be relevant contributions to charities,
in terms of something but by itself it does not
that is important for the necessarily reflect how well
organisation (unless it is an the organisation’s social,
organisation whose purpose environmental or ethical
is to donate to charities). obligations are satisfied.
7. Reduce employee Reduce This measure meets the This measure is valid and
turnover turnover by SMART criteria. It may reliable. It is controllable
10% p.a. be achievable provided through a variety of
managers have authority retention strategies
over remuneration and including remuneration and
motivation strategies. motivation. As employee
turnover incurs the high
cost of recruitment and
training, this is likely to be
an important measure.
8. Sales revenue growth 15% p.a. This measure meets the This is a valid and reliable
SMART criteria, with the measure. It is clear and
possible exception of available quickly but
whether it is achievable many factors affecting
based on past performance revenue growth are outside
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and economic and managers’ control.
competitive conditions in
the particular industry.
10. Compliance with legal Full This measure and target It is a valid measure of
requirements is not specific and it compliance, but not a
is difficult to measure, reliable one as different
being based on subjective people may make different
judgments and probably judgments based on
without full knowledge of different knowledge and
all requirements and the experience.
organisation’s experiences.
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346
Specific Measurable Achievable Relevant Timely Validity Reliability Clarity Timeliness Accessibility Controllability
1. Head office Y Y ? N ? N Y Y ? N N
recharge
2. Survey of brand Y Y ? N N ? ? ? N N N
recognition
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3. Receivable days Y Y Y Y Y Y Y Y Y Y Y
4. Incoming telephone Y Y ? Y Y N Y Y Y Y Y
calls
6. Donations to Y Y Y N Y Y Y N Y Y Y
charities
7. Employee turnover Y Y Y Y Y Y Y Y Y Y Y
8. Sales revenue Y Y ? Y Y Y Y Y Y Y N
growth
9. Headcount Y Y Y N Y N Y N Y Y Y
10. Compliance N N Y Y ? Y N N ? ? Y
It should be clear from these examples that few performance measures are perfect. It may
be better to consider most measures as indicators of performance, as they each have their
limitations. It is also important to take a contingent view in evaluating measures and targets,
as the example of the donations to charity illustrates. Similarly, a measure and target for
receivable days is only relevant for a business selling on credit, not for a retail store like
Woolworths. It should also be noted that assessment of performance measures and targets
can be subjective and requires judgment, and so there may be alternative views or assessments
to those described above. In addition, as no information is given in the Question as to current
levels of performance or organisational strategies or priorities, you could assume that all
elements of performance are achievable.
Question 3.15
The notion that there is a single performance measurement system applicable to all organisations
or even to all industries should by now have been dismissed. Each organisation, even in the
same industry, has different goals, a different strategy for reaching those goals, and a different
competitive position as its starting point. Contingency theory was briefly introduced in Part A
to show that the design of a performance measurement system is often contingent on factors
such as the environment in which the organisation operates, its size, or its technology.
We saw that Qantas and Jetstar, despite being not only in the same (airline) industry, but owned
by the same company, have different business models (ways of operating) that result in many
common but also many different performance measures. The need for long-term sustainability
in mining was shown in the Newcrest example. Value creation strategies were quite different at
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Apple and Woolworths. Product and service life cycles are an important aspect of measuring
performance, so the approaches taken by Apple with its short life cycle contrasts with the
multi-year automotive industry and with the current year focus of a public hospital. Competitive
position is also important. The failings of performance measures at Mammoth Printing contrast
with the abandonment of most traditional performance measures (including financial ones)
at TNA. Public and not-for-profit organisations have quite different needs, as the National
Library example showed. The international advertising agency example illustrated how
competing priorities need to be balanced, whereas BP in the Gulf of Mexico demonstrated
the consequences of a relentless pursuit of short-term profits. These examples illustrate the
importance of customising performance measures to the unique position of each organisation.
348 | PERFORMANCE MEASUREMENT
Question 3.16
(a) The main steps involved in benchmarking are given below.
(b) Some of the problems associated with benchmarking are given below.
–– The commitment by other organisations (especially in a consortium) to provide
benchmarking data. The level of participation by organisations can be improved if
they perceive there is a benefit to be derived from their involvement.
–– A lack of knowledge about why there are performance differences. While benchmark
figures give an indication of where problems may exist, they are diagnostic. Diagnostics
tell us that the problem exists, but not what is causing the problem, and therefore do not
tell us how to fix it. Accountants and managers need to go beyond the data provided and
understand why the differences exist. Sometimes performance differences may be due to
different strategies or business models, different regulations under which organisations
operate, or different technologies or investments in infrastructure.
–– The standardisation of data. Data may be collected, summarised and interpreted
in different ways, leading to performance comparisons that are not appropriate.
Questions must therefore be asked about the comparability and usefulness of
benchmark data.
–– The historical nature of the data. While benchmarking data may give an understanding
of what other organisations or business units have done in the past, it does not tell
us what they are doing now or in the future. It is no substitute for constant proactive
improvement within organisations.
Suggested answers | 349
(c) Every organisation will be different and will have different opportunities for benchmarking
and different performance measures will be important. One example is university teaching
(where a benchmarking consortium does exist).
The last two examples come from standardised surveys of university students.
Question 3.17
Abandoning budgeting is a risky thing. While many of the arguments of the Beyond Budgeting®
movement seem valid, one problem is that an organisation (other than a bank) that does not
budget is likely to appear badly managed. There is a degree of legitimacy associated with
budgeting that cannot be ignored. Furthermore, organisations that need access to finance
need cash flow forecasts, which are dependent on budgets.
Of course the case study does not suggest that planning is abandoned, merely the tool of
budgeting. Planning is still evident in the case, through the idea of the business model that is
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the foundation of the whole management control system, in which performance measurement
has a central place. The business model, exemplified in the automotive analogy in the example
and reflected in the strategy map, is crucial in deciding what performance measures are important.
Strategy is also crucial, with the aim of achieving a better shareholder performance, relative not
only to competitors but also relative to alternative investments.
The need to have a limited number of performance measures is consistent with the proponents
of the balanced scorecard, provided there is balance in the range of measures used. The example
does not explain the performance measures used, but does mention ‘operational, financial and
physical measures’, so it might be assumed that there is balance.
Importantly, the example argues that performance measures are useful in determining whether
the organisation is on the right track. If performance measures are not useful in making
improvements, then they are unnecessary. The absence of targets, (budgetary or otherwise)
contrasts with the role of targets in performance measurement. However, despite the absence
of targets, the example shows the importance of relative performance, trend (improvement
relative to the past) and benchmarking.
350 | PERFORMANCE MEASUREMENT
The importance of rewards is also emphasised in the example. Importantly, rewards are not for
absolute performance but based on relative (to other banks) profitability. This seems a valuable
approach to linking performance with rewards and may overcome some of the criticism of
financial institutions during the global financial crisis for excessive executive remuneration.
Under this approach, if any whole industry improves its performance, this is more likely a
consequence of the economy, technology and customer demand than managerial action
and should not be rewarded. By contrast, if relative performance in an industry improves,
this is more likely due to management actions which are more successful than competitors.
Agency theory would support this kind of relative performance-linked reward.
A further element of the profit share in the example was that it was only payable when an
employee retired. This has at least three advantages:
1. It prevents a focus on short term at the expense of long-term performance (i.e. it adheres
to the sustainability principle).
2. It encourages employees to remain with the company over the longer term to reap the
benefits of their behaviour.
3. This kind of approach to rewards linked to sustainable performance is likely to have fewer
unintended and dysfunctional consequences than more traditional approaches.
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References | 351
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STRATEGIC MANAGEMENT ACCOUNTING
Module 4
TECHNIQUES FOR CREATING AND
MANAGING VALUE
PETER ROBINSON (REVISED BY COURTNEY CLOWES)*
Contents
Study guide
359
Preview 359
Introduction
Objectives
Review 448
References 483
Optional reading
Study guide | 359
Module 4:
Techniques for creating
and managing value
Study guide
Preview
Introduction
In this module, we draw together the material in Modules 2 and 3 by examining specific ways that
management accountants are able to contribute to the enhancement of an organisation’s value
chain. Managers must be able to identify, evaluate and implement strategies that, while leading
to improvements in business performance, also address important social and environmental
issues such as human rights and the impact of climate change. Management accountants play
MODULE 4
a pivotal role in developing systems that provide information that business managers must
access and use to carry out these tasks. In this module, we illustrate how strategic management
accounting techniques assist with the growth of business value.
The module contains an extended case study that shows how specific strategic management
accounting concepts and tools can be used to manage development of a new product and to
grow organisational value. We cover the following strategic management accounting concepts
and tools:
• activity-based costing;
• life cycle, target and kaizen costing;
• activity-based management;
• business process management;
• continuous improvement;
• value chain analysis;
• supply chain management;
• total quality management;
• downsizing, outsourcing and offshoring; and
• customer-profitability analysis.
360 | TECHNIQUES FOR CREATING AND MANAGING VALUE
We also identify performance measures for assessing the impact of these concepts and tools on
an organisation’s value chain.
It is assumed that you have some prior knowledge of these topics. For this reason, the limited
background material provided before the practical application of the concept or tool should be
sufficient. However, if you wish to read beyond this background material, most recently published
management accounting textbooks provide comprehensive coverage of these topics.
Your tasks
You will work through the case study for the company HZ Electrical Pty Ltd (HZ) (previously
introduced in Modules 1 and 2). You will complete a series of tasks for the company as it
manages the design and introduction of two new products—the Solarheat 1 and Solarpower
2. You will be required to provide relevant information to the management of HZ’s Household
Products Division so that they can:
• use activity-based costing to allocate indirect manufacturing costs;
• determine life cycle costs for redesigning the product;
• re-engineer the Solarheat 1 manufacturing facility;
• analyse their value chain activities;
• evaluate supplier-related costs;
• determine the impact of a total quality improvement initiative;
• decide whether to outsource distribution;
• assess the profitability of different customer segments; and
• determine customer profitability at the individual customer level.
Throughout the case study there are tasks presented in tables that require you to fill in missing
data. The first task is presented in Table 4.4. To complete the task, work through each table by
using the data provided in the case study and write your answers in the grey shaded table cells.
For example, the first answer that you are required to complete in Table 4.4 is to insert the
Total budgeted indirect manufacturing costs into the table. The answer for this task is $810 000.
This is provided in the case study in the paragraph headed ‘Overheads’ that appears directly
under Table 4.2. To start completing the case study, write the required amount in the first grey
shaded cell.
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Next, you are required to calculate the Total direct labour hours for the FC101. The amount is
found by multiplying the budgeted volume of FC101 of 10 000 by the DLHs per unit of 2.00.
Simply fill in the grey shaded cells with the calculations as follows.
Continue to work through all the case study components in the same way.
Note: You will often require answers from earlier parts of the case study to complete tasks that
come later.
Study guide | 361
E E
n n
v v
i i
r r
o Value o
n n
m m
e Vision/Mission e
n n
t Goals and objectives t
a a
l Strategy—Creation l
RESOURCES SYSTEMS
a a
n Strategy—Implementation n
a PROJECTS a
l l
y Strategy—Implementation y
s VALUE CHAIN s
i i
s Control and feedback systems s
Strategy—Implementation—VALUE CHAIN:
The different concepts, tools and techniques used to assess the costs and redesign
our value chain to reach our objectives.
Objectives
After completing this module you should be able to:
• identify and analyse activities for an organisation;
• explain and apply activity-based costing techniques; and
• use cost and profit management techniques to improve activities and the value chain
to enhance organisational value.
MODULE 4
362 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Organisations need to have accurate costs for the goods or services they supply so they can
ensure that prices are high enough to generate real profits. An organisation may often have
products or services that are unprofitable but may not have enough information to realise that
this is the case. Too often, inaccurate costing systems have led organisations to set prices
that are not profitable (i.e. too low) or are not attractive to customers (i.e. too high).
The traditional approach to allocating indirect manufacturing costs and other overhead costs
to an organisation’s products is to use a volume-based driver linked to production. However,
this method has been criticised for causing inaccurate costing.
In the first part of the case study, we see that HPD currently uses this approach.
The steps involved in the volume-based approach were outlined in Appendix 1.1, and you may find
it helpful to review this prior to completing Case Study 4.1.
After this case study, we will compare this traditional approach to activity-based costing,
which is one of the most important tools available to management accountants to help them
to understand an organisation’s value chain properly.
For many years, FC101 was the only food processor made by the HPD and was highly regarded for its
quality. Unfortunately, demand has steadily fallen over the past two years.
William Prout, HPD’s production manager, suspected the reason for the decline in sales was increasing
competition from overseas suppliers who appeared to be using their spare capacity to supply product
to the Australasian market at less than cost, a process known as ‘dumping’.
FC202 and FC303 have been added to the product line over the past six years. Both are more advanced
and technologically sophisticated than the FC101. As a result, they are significantly more complex to
manufacture and require special materials handling, tooling and setting up for each batch produced.
Given the complexity of manufacturing the FC202 and FC303, HPD charges what it believes is a
premium price for both of these products.
Table 4.2: Prime costs for HPD’s food processor product line
Overheads
Indirect manufacturing costs are budgeted to be $810 000 and these are currently allocated across
the three product lines on the basis of direct labour hours (DLHs), as shown in Table 4.3.
Table 4.3: Indirect manufacturing activity for HPD’s food processor product line
➤➤Task
Use the current indirect manufacturing cost allocation method based on direct labour hours
(DLHs) to calculate the budgeted:
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• indirect manufacturing cost rate;
• indirect manufacturing cost for each product; and
• total manufactured cost per unit for each product.
Some of this information is found in the case study data, and the rest is found by performing
calculations with the data in the tables. To assist you in understanding how to begin, some data
for FC303 has already been inserted in the tables.
To complete tasks, you will need to fill in the shaded cells in the following tables.
364 | TECHNIQUES FOR CREATING AND MANAGING VALUE
FC101
FC202
Table 4.6: Total manufactured cost per unit for each product
Activity-based costing
An organisation must have a good understanding of what ‘drives’ its indirect costs. Indirect
costs are related to complexity and diversity of production, rather than to the volume of output.
Activity-based costing (ABC) is a technique designed to assist organisations to classify and
allocate indirect costs properly.
For example, costs for pre-production activities such as machine set-ups, and support services
such as stock handling and scheduling do not increase with the volume of output. There are also
many costs that are fixed in the short term, but that may vary in the long term depending on
changes that may occur within the organisation. The greater the degree of variation in the range
of products manufactured by a company, the more complex and diverse its support activities
become. This, in turn, increases the need for and importance of a costing system that allocates
costs as accurately as possible.
Traditional volume-based allocation methods usually rely on a small number of cost drivers—
such as direct labour hours, direct labour cost or machine hours. The problem is that not
all costs are clearly linked by ‘cause and effect’ to these measures (i.e. they do not actually
‘drive’ the costs). ABC separates different types of costs into different cost groups or pools.
These groupings are based on what activity actually causes or drives this cost to be incurred.
The following table shows a range of potential cost groupings (activity cost pools) and possible
causes (drivers) of these costs. By allocating costs based on these drivers, cost estimates are
more accurate, especially when there are complex products that consume significant amounts
of ‘extra’ activities that were not previously noticed or were not accounted for properly.
MODULE 4
366 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Services
Pensioner Insurance Ltd (Pensioner) provides car insurance for older drivers. Pensioner only insures
customers over 55 years of age who have had no accidents or claims over the last five years. Everyone
Insurance Ltd (EV Insure) offers insurance for cars, boats, homes and businesses. This insurance is
available to anyone.
The cost, time and effort for providing insurance services for Pensioner will follow a more predictable
pattern, and be more easily traced to a particular product or customer. The complexity of having
many different product types and different types of customer will make cost allocation much harder
for EV Insure. The time to evaluate customers with completely different risk profiles and for multiple
products will be less predictable and less systematic. Therefore, EV Insure should consider ABC.
Study guide | 367
Some potential cost pools and drivers that may be useful for cost allocation in such service businesses
are shown below.
While the initial applications of ABC were primarily in the manufacturing sector, organisations
engaged in the services sector (e.g. banks, hospitals and universities) have also found ABC a
useful approach for allocating indirect costs to the different types of services they offer. In this
module, rather than specifically discussing the use of ABC for making decisions in service
settings, the generic term ‘product’ is used to mean both products and services. This usage
reflects the way that many banks identify their services as being financial ‘products’.
Accurate costing is necessary for product-pricing decisions. It also guides the identification
of cost-reduction efforts, special projects such as launching a new product, and analysing
customer and product profitability. Accurate costs are also very useful when competition
increases, because this may lead to more aggressive pricing strategies in the industry and
more innovation of products and services—which must be carefully monitored and managed.
Steps in ABC
1. Activity analysis
The first step in ABC is to undertake an activity analysis. Activity analysis involves listing,
or drawing a map of the significant activities that make up the business process in question.
For many organisations, this stage represents the most challenging part of an ABC system
implementation. Even with apparently simple processes, many different types of activities
are performed. A comprehensive understanding of what activities are involved is necessary.
MODULE 4
This stage is called process mapping or activity mapping. An activity map shows all the main
activities and, importantly, their interrelationships.
One frequently used way of identifying activities is by asking personnel what they do
and having them keep a diary of all the activities they perform. Typical answers might
include purchasing supplies, moving product throughout the factory, running machinery,
inspecting products and reporting on performance.
This generates the cost per transaction in a similar way to the development of an allocation
rate per direct labour hour or per machine hour using traditional costing methods.
Number of cost driver transactions per product line × ABC transaction cost rate
2. Create cost pools—classify indirect costs into activity groups that have similar characteristics
4. Identify the number of cost driver transactions for each product line and in total
5. Determine the ABC transaction cost rate for each cost pool. The formula for this is:
Cost pool / Total number of cost driver transactions
6. Allocate cost pools to each product line. The formula for this is:
Number of cost driver transactions per product line × ABC transaction cost rate
7. Calculate the indirect cost per unit. The formula for this is:
Indirect cost allocated to a product line / Number of units produced
These steps may also be used to apply ABC in a service-based organisation. There has been
significant use of ABC in local government in both Australia and the United Kingdom. Instead of
applying ABC to a product, Table 4.9 provides an example of the allocation of indirect costs to
one of the services of a local council. The service being provided here is family day care. Steps 1
to 6 outlined above have been highlighted to show how the ABC information is created and how
costs are allocated.
Study guide | 369
Table 4.9: Indirect costs allocated to a local government service: Family daycare
Step Step 6:
2: Cost Step 4: Total Step 5: Daycare Indirect
Step 1: Council to be Step 3: cost driver Transaction cost driver costs
activity allocated Cost drivers transactions cost rate transactions allocated
Debtors $74 095 Number of 108 582 $0.68 17 207 $11 742
invoices
Total indirect costs allocated to a specific service: family daycare service $57 930
MODULE 4
For the original table that includes the full set of data, please refer to:
http://www.audit.vic.gov.au/publications/2009-10/LG-Fees-and-Charges-full-report.pdf.
These steps will now be applied to the next part of the HZ case study, which uses ABC to
recalculate the product costs for HPD’s food processor product range.
Given the diversity in the range of electrical household products manufactured, HPD has contemplated
switching the allocation of indirect manufacturing costs to an ABC system. Therefore, you decide to
prepare an analysis on the usefulness of an ABC system for HPD by applying this approach to the three
different food processor models.
Analysis of the $810 000 of indirect manufacturing costs indicates that they can be classified into four
broad cost pools, with four different cost drivers. The budgeted indirect manufacturing costs for the
food processor product line for next year are shown in Table 4.10.
370 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table 4.10: Indirect manufacturing cost pools for HPD’s food processor
product range
3. Production scheduling and other set-up costs Production runs $120 000
Budgeted production details for the food processor product line for next year are summarised
in Table 4.11.
Table 4.11: Indirect manufacturing activity for HPD’s food processor product range
➤➤Task
(a) Calculate the budgeted indirect manufacturing cost rate for the four ABC cost pools.
MODULE 4
Table 4.12: Indirect manufacturing cost rates for HPD’s food processor product
range using ABC
FC101
FC202
FC303 200
FC101
FC202
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FC303 350
materials movements
(b) Use the ABC method to calculate the budgeted indirect manufacturing cost per unit for each
product range. Calculate the difference in costs between the ABC method and the traditional
approach in Case Study 4.1.
372 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table 4.13: Indirect manufacturing cost per unit for each product range using ABC
FC101
Indirect
Number of cost manufacturing
Cost pools Cost pool rates drivers cost %
2. Machine-related $ $
3. Scheduling set-up $ $
4. Materials handling $ $
Traditional indirect manufacturing cost per unit (from Table SA4.3) $60.00
FC202
Number of cost
Cost pools Cost pool rates drivers Overhead %
1. Labour-related $ $
2. Machine-related $ $
3. Scheduling set-up $ $
4. Materials handling $ $
Traditional indirect manufacturing cost per unit (from Table SA4.3) $45.00
FC303
Number of cost
Cost pools Cost pool rates drivers Overhead %
1. Labour-related $ $
2. Machine-related $ $
3. Scheduling set-up $ $
4. Materials handling $ $
Traditional indirect manufacturing cost per unit (from Table SA4.3) $37.50
The traditional volume bases for indirect cost allocation gave no real insight into what caused
these costs to be incurred. ABC focuses on understanding activities and how they cause
costs to be incurred. This supports strategic and tactical decision-making on cost control,
setting prices, choosing the product mix and arranging production, which should result in
improved organisational efficiency and, ultimately, profitability.
MODULE 4
Case Study 4.3: Comparing the two costing systems
John Foster, the marketing manager for HPD, has advised William (the production manager) that
BigShop, a long-standing and major retail customer, had stopped sourcing the FC101 food processor
model from the division. According to John, BigShop claimed they were able to buy a foreign equivalent
for a price 15 per cent below the standard wholesale price of $180 quoted by HPD. In fact, about three
years ago HPD stopped marketing the FC101 food processor to overseas markets, as international
orders had decreased significantly.
You have been asked to prepare a comparison of the product costs you have calculated using
the traditional volume-based allocation method based on direct labour hours and costs using
the ABC method. The data in Table 4.14 comprise data calculated in Tables 4.4 and 4.5 (see also
Tables SA4.1 and SA4.2).
374 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table 4.14: T
otal indirect costs allocated to each food processor product line using
traditional method
Indirect
DLHs % of total DLHs Cost per DLH manufacturing cost
In Table 4.15, the difference between the traditional volume-based approach and the ABC approach
for the three products is compared. The table combines data from Case Studies 4.1 and 4.2.
Table 4.15: T
otal manufactured cost per unit: Traditional versus ABC allocation
methods
Total prime costs per unit (Table SA4.3) $95.00 $115.00 $130.00
Indirect manufacturing cost per unit (Table SA4.2) $60.00 $45.00 $37.50
Total manufactured cost per unit using traditional $155.00 $160.00 $167.50
approach (Table SA4.3)
ABC indirect manufacturing cost per unit (Table SA4.5) $36.40 $80.67 $102.00
(Total prime costs + ABC indirect manufacturing cost $131.40 $195.67 $232.00
MODULE 4
per unit)
Difference in total manufactured cost per unit between ($23.60) $35.67 $64.50
the two systems
➤➤Tasks
(a) Using the traditional DLH approach, the FC101 receives 74 per cent of all the overhead,
while the FC303 receives less than 10 per cent (see Table 4.14).
Complete the following comparison table and use it to help explain why the indirect
manufacturing charge per unit has changed for FC303 when applying the ABC model. The data
in Table 4.16 are from your calculations in Table 4.12 (see also Table SA4.4).
Study guide | 375
Table 4.16: Cost pool consumption percentages across the HPD FC product series
(b) Under what circumstances would you recommend that HPD adopt an ABC system to replace
its current costing system? Give reasons to support your recommendations.
(c) It has been argued that ABC systems can be designed to lead to modifications in both the
external strategy and the internal strategy of an organisation. Explain the substance of these
arguments and evaluate their strengths.
(d) HPD has a standard wholesale price for the FC101 food processor of $180.00 per unit.
Complete Table 4.17 and then identify what information obtained from the ABC product-
costing model helps HPD understand its lost sales to BigShop—which is purchasing an
equivalent product for 15 per cent less from HPD’s competitors.
Table 4.17: C
omparison of budgeted profit margins for FC101 using the traditional
and ABC product costing systems
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Source: CPA Australia 2015.
(e) Explain to your fellow HPD senior managers the likely effect of the introduction of ABC on the
allocation of indirect manufacturing costs for all (existing and proposed) HPD product lines.
TDABC is a simplification of the conventional ABC approach with a focus on ‘time’ as a reflection
of resource capacity (although other measures of capacity may be used). In its simplest form,
TDABC requires only a few key calculations. The two key input calculations are:
1. the cost per time unit of capacity; and
2. the unit time of the activity.
376 | TECHNIQUES FOR CREATING AND MANAGING VALUE
There are on average 10 staff working in the membership department, who work an average of 20 days
per month, eight hours per day.
Theoretical capacity refers to the total amount of time available in an ideal or theoretical situation.
20 days per month × 8 hours per day × 60 minutes per hour = 9600 minutes per employee
× 10 employees = 96 000 minutes.
It is obviously not possible for all employees to spend every available minute working on activities that
form a specific part of the production process. People take breaks, have training sessions and attend
staff meetings—all of which are considered non-productive activities from a TDABC perspective.
To improve the accuracy of cost estimates, it is therefore useful also to identify the practical capacity of
the department. This is a more realistic or practical assessment of the amount of time that people will
be able to work productively. Identifying the amount of productive time available can be accomplished
through detailed analysis or, possibly, by using an estimate such as 80 per cent.
The practical capacity (allowing for other work activities taking 20% of time) would therefore be
calculated as:
The cost per minute of supplying capacity can now be calculated as:
The average time it takes to conduct one unit of each activity can then be estimated:
• 15 minutes to process membership applications;
• 12 minutes to handle membership inquiries; and
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The cost driver rate (per unit of activity) is then calculated based on the cost per minute and average
unit times. This is shown in Table 4.18.
Table 4.18: TDABC cost driver calculations for the membership department
These cost driver rates are then used to allocate costs for each activity based on actual quantities of
the resource used (i.e. units of activity). This is shown in Table 4.19.
Study guide | 377
Table 4.19: Cost allocations for each activity based on actual quantities
One of the main benefits of TDABC is the identification of unused capacity and its cost. Unused capacity
does not represent the difference between theoretical and practical capacity. Unused capacity is the
difference between the practical capacity available and the actual capacity used.
In this example, the total theoretical capacity was 96 000 minutes. It was estimated that the practical
capacity, or actual time available to be used on productive work, was 80 per cent of this amount
(i.e. 76 800 minutes). To determine unused capacity, the actual time used is compared to practical
capacity of 76 800 minutes.
The total time actually used in the month was 68 320 minutes, resulting in 8480 minutes of unused
capacity (i.e. 76 800 – 68 320) and costing $7208 (i.e. $65 280 – $58 072). Note that the cost of unused
capacity can also be calculated by multiplying the unused capacity in minutes by the cost driver rate
(i.e. 8480 × $0.85 = $7208). The calculations that demonstrate this are shown in Table 4.20.
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Handle membership inquiries 1 960 12 23 520 $10.20 $19 992
What management chooses to do with this information may vary. For example, in this organisation,
reducing the resources supplied (i.e. reducing staff levels) may not be the best option as members
who contact the club will expect their query to be dealt with in a timely manner. However, if the level
of unused capacity remains consistent over a longer period of time, management may consider
reducing the resources supplied (to reduce costs). Of course, this should be balanced against the
need for quality service provision.
378 | TECHNIQUES FOR CREATING AND MANAGING VALUE
TDABC uses time equations to accommodate these types of variations (Kaplan & Anderson 2007).
For such complex activities, the time equation is:
Standard activity unit time + Variation activity unit time = Complex activity unit time
This process combines the generic or standard way of completing the activity (e.g. 20 minutes
to receive a standard shipment) with the more complex variation (e.g. 10 additional minutes
to receive a fragile shipment) to determine a total time estimate for the complex activity
(e.g. 30 minutes in total to receive a fragile shipment). The variation time is in addition to the
standard time, so the two must be added together to obtain the total time for the complex
activity. The variation time therefore does not represent the total time it takes to perform the
more complex activity.
Each additional element of activity complexity attracts an incremental cost based on the
additional time it takes to perform that additional activity element.
To show how TDABC would determine the time taken to carry out a particular activity,
Table 4.21 in Example 4.3 details some hypothetical time drivers for processing a customer
order by HPD. It shows the estimated time the division will take for processing orders from two
different customers.
Study guide | 379
Table 4.21 demonstrates how the time equation for complex activities functions. For item 1 (Order
receipt), the standard time is two minutes (using EDI). The total time to receipt an order for Customer
A is therefore two minutes. The manual variation for an order receipt takes an additional five minutes,
which must be added to the standard task time of two minutes. The total time to receipt an order for
Customer B is therefore seven minutes. The time equations for order receipt are as follows:
Order receipt (complex) = 2 minutes (EDI) + 5 minutes (manual variation) = 7 minutes [Customer B]
1. Order receipt
Electronic data interchange 2 Manual (by mail or 5 2 mins 7 mins
(EDI) phone)
2. Customer history
Existing customer of good 3 New customer 15 3 mins 18 mins
credit standing credit history check
3. Order fulfilment
Standard 5 Expedited 8 13 mins 5 mins
4. Packaging
Standard 4 Fragile 7 4 mins 11 mins
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5. Order shipment
Standard 3 Express 12 15 mins 3 mins
If HPD has estimated that the customer order processing capacity cost rate is $2.00 per minute,
the order processing costs incurred for:
• Customer A would be 43 minutes × $2.00 per minute = $86; and
• Customer B would be 57 minutes × $2.00 per minute = $114.
380 | TECHNIQUES FOR CREATING AND MANAGING VALUE
This information is valuable because it highlights that the cost of doing business with each
of these two customers is quite different. This will also help to identify inefficient areas of the
business and help to make better decisions about what special services (i.e. variations) to offer
and what prices might need to be charged for these extra services.
The total annual budgeted cost for the materials handling function is $1 504 000. The food processor
product range is expected to account for $70 000 of this cost.
Rather than focusing on the number of materials movements on the production floor as the sole
transaction driver for the materials handling function, HPD has identified four generic areas of resource
capacity:
• materials requisitions;
• materials received into storage;
• sourcing materials for production; and
• materials movements on the production floor.
Estimated time for a standard transaction activity, as well as the additional time required for more
complex versions of the activity are shown in Table 4.22. The total number of activities for the materials
handling function is shown in Table 4.23.
Table 4.22: B
udgeted standard and complex task performance times for the
materials handling function
Material receipt into storage 20 +10 High-value and/or fragile stock item
Table 4.23: Budgeted activity levels for the materials handling function
To help to calculate the total time for each materials handling activity, it is necessary to consider the
following formulas:
Standard time = Standard activity unit time × Total number of activities performed
Additional time = Variation activity unit time × Number of variation activities performed
Total time = Standard time + Additional time
Keeping these formulas in mind, the two tables above have been combined to calculate the total
budgeted time for the materials handling function.
Budgeted standard time 828 000 Budgeted additional time 122 000 950 000
To explain this table further, note that the total number of standard activity transactions for the
‘Requisition’ activity is 4200 (not the 3440 transactions listed under the standard activities heading in
Table 4.23). This matches the formula for ‘Standard time ’ above the table, which uses ‘Total number
of activities performed’. It also matches the time equation approach described earlier.
There are 3440 transactions that only require the standard amount of time. The other 760 more
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complex transactions are a combination of both the standard time of 10 minutes and the additional
variation (complex) time of five minutes. This means that all 4200 transactions will require at least the
standard amount of time, with 760 transactions needing extra time. The total time for requisitions can
be reconciled by performing the following calculation:
➤➤Tasks
(a) For the coming year, calculate the following for the materials handling function:
• Theoretical capacity (total time available) in minutes.
• Practical capacity (total productive time available) in minutes.
• The cost rate per minute, based on practical capacity.
Table 4.25: Practical capacity and the cost rate per minute for materials handling
Number of eight-hour
days worked per annum
Number of personnel per person Number of minutes
Total budgeted costs of the materials handling function to be allocated $1 504 000
Total budgeted costs to be allocated / Budgeted total practical capacity $1 504 000
(b) Use the TDABC cost rate per minute to allocate costs to each activity in the materials handling
function. Then, calculate the total budgeted costs and the unused capacity.
What does a difference between the total practical capacity and budgeted usage times for
the materials handling resource represent, and how should HPD account for it?
Table 4.26: Budgeted costs and unused capacity for the materials handling function
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Requisition 45 800 $ $
Production movements $ $
Unused capacity $ $
(Total practical capacity and costs –
Total time and cost)
(c) The following transaction data has been extracted from the budget for the coming year for
the FC303 food processor model.
Using the time data from Table 4.22 and the activities data from Table 4.27, complete
Table 4.28 and calculate the total time required for the materials handling activity for the
FC303.
Table 4.27: Budgeted number of standard and complex activities for the FC303
Requisition 65 60 125
Note: As with Table 4.24, the number of standard activities performed is equal to the total number
of activities (e.g. 125 for requisitions). All 125 requisition transactions will require the standard time,
with additional or extra time being added for the number of complex activities performed (e.g. 60
for requisitions). This follows the time equation format mentioned previously. In Table 4.28, we can
reconcile the total time for requisitions as follows:
Table 4.28: Budgeted time for the materials handling activity for the FC303
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Requisition 10 125 1 250 5 60 300 1 550
Receipt into
storage
Sourcing for
production
Production
movements
(d) Using the total budgeted activity times calculated in task (c), calculate the materials handling
costs that would be charged to the FC303 using TDABC.
384 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table 4.29: B
udgeted materials handling costs allocated to the FC303 food
processor model
Requisition $ $
Production movements $ $
(e) Compare the materials handling costs allocated to the FC303 food processor model for the
materials handling resource using:
(i) the conventional ABC approach ($35 000—see Table SA4.5); and
(ii) the time-driven ABC approach ($26 621).
Comment on any differences in the materials handling costs that would be allocated to the FC303
food processor as a result of using either ABC method.
In taking a broad view of value created, it would be reasonable to assume that organisations
that achieve significant and sustainable increases in their profitability are better placed to deliver
greater value to their stakeholders than are those who do not. Furthermore, as our value measure
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of profitability is the amount remaining after deducting the costs incurred from the revenue
generated from the organisation’s activities, two strategic levers for increasing the amount of
value created can be identified:
1. strategic revenue management; and
2. strategic cost management.
While each strategic lever can be discussed individually, they are in fact interdependent.
For example, it may be feasible for the organisation to redesign or value engineer a product
to increase its overall profitability by including features that are so valued by customers that
they are prepared to pay more for the product than it costs to incorporate these features.
Figure 4.2 shows how the level of product features could be expected to affect the price
charged for a product.
Study guide | 385
Price at
Cost plus Price at value to client
competitive parity
Pricing role of
management
accountant
Estimate
Reduce cost Estimate customer value
competitor’s price
There are two forms of product functionality of interest to customers: hard functions and
soft functions.
1. Hard functions refer to the technical and economic use of the product and include attributes
such as operational performance (e.g. economic life, production capacity and cost of operation)
and the ease of use (e.g. minimal training required in product use). For example, by using
better quality components or improved product design, greater value may be provided for
customers as a result of the product having a longer economic life, better environmental
performance (e.g. zero greenhouse gas emissions), lower costs of operation and maintenance
or improved after-sales customer support (e.g. extended warranty period). Since functionality
improvements are not cost-free, low cost should not be the pricing strategy of an organisation
if it is providing a product that offers greater value or functionality to the customer than its
competitors ’ products.
2. Soft functions reflect the image of the product and include attributes such as appearance,
aesthetics, prestige and effect. For example, by making minor modifications to the product
formulation (e.g. better quality ingredients) and packaging (e.g. a more exclusive and
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expensive appearance), a company may be able to charge a higher price for a product
by positioning it at the premium end of the market. By creating an image in the mind
of customers that the product is a brand worth paying more for, the company is able to
charge a higher price.
While both types of function affect the selling price of a product, as hard functions are more
objectively determined than the more subjective soft functions, a company will usually find it
easier to quantify the effect of the hard functions on the price charged for a product.
386 | TECHNIQUES FOR CREATING AND MANAGING VALUE
From a supplier’s perspective, knowing the upper bound of customer value is important, as the
difference between the maximum price that a customer would be willing to pay and the supplier’s
cost represents the maximum profit they might be able to secure from a sale.
However, this does not mean that a customer will be just as willing to pay the upper bound as
the middle of the range (e.g. $4.95 for a cup of coffee compared to $3.50 per cup). The closer
the selling price is set to the customer’s upper bound, the lower the likelihood of the customer
making the purchase.
The greater the gap (or saving) between the customer’s upper bound and the price asked by a
supplier, the more likely a customer would be to proceed with the purchase (but the lower the
profit received by the supplier).
Identifying and understanding the value customers place on your products or services is therefore
an essential part of strategic revenue management. Prices need to be set to maximise the level
of purchases and the return on each purchase.
The differences in functionality between the two products may relate to either hard or soft functions,
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or both. Where a difference in price is attributable to hard functions (e.g. where the higher-priced
product possesses added features), these should be easier to identify. The impact of such enhanced
hard functionality on product cost should also be readily determinable.
If the difference is due to ‘soft functions’ (e.g. a product’s image), the drivers of such differences in
customer value may be more difficult to isolate and measure. Thus, for the supplier of the product
with inferior soft functionality, the task of reliably quantifying the cost of matching the features of a
superior product may be more challenging and subject to error.
Now assume:
• Company A quotes a minimum price of $140 per unit—this is $60 below the customer’s upper
limit of $200; and
• Company B quotes $130 per unit, which is $40 below the upper limit of $170.
Study guide | 387
The surplus value for the customer is $20 greater for Company A’s product. This is because the customer
is purchasing the product for $60 less than they are willing to pay, but would only purchase Company
B’s product for $40 less than they would pay ($60 – $40 = $20 greater benefit to the customer).
So, in this situation, even though Company B’s product is $10 cheaper than Company A ($140 – $130),
the customer is likely to choose Company A’s product.
If Company B is to compete in terms of surplus value, it would need to provide the customer with
a greater surplus value than Company A (i.e. more than $60). It could do this by setting the price
more than $60 below the upper limit of $170 that the customer is prepared to pay (i.e. below $110).
Company B will have a problem with this strategy. It costs $110 to produce this unit, so there will be
no profits in this situation. Company B could focus on strategic revenue management by increasing
the quality and functionality of its product. This would increase the amount the customer is willing to
pay. If this is not possible, it will need to pursue strategic cost reductions to reduce the total unit cost
so that it is profitable.
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388 | TECHNIQUES FOR CREATING AND MANAGING VALUE
The problem was that many of these cost reductions have been achieved by the imposition of
across-the-board spending cuts (e.g. every manager was required to achieve a 10 per cent cut
in operational costs). While this is decisive, easy and fair in spreading the financial pain, it does
not address the ability of individual managers to deliver targeted cost savings in a sustainable
manner. Across-the-board cost reduction initiatives often rely on short-term cuts in non-essential
expenditure such as:
• travel, training and other labour-related costs;
• minimisation of inventory holdings;
• postponing scheduled maintenance activity;
• deferring planned capital investment projects and new product launches; and
• renegotiating the terms of existing service contracts with external vendors.
Although such measures usually meet the desired cost-cutting targets, opportunities for
sustainable cost reductions often fail to be pursued. McKinsey in Dolan & Murray et al.
(2010) revealed that 40 per cent of respondents, predominantly those who have used
an across-the-board spending cut approach, as opposed to a targeted or differentiated
approach, believe that some of the cost reductions achieved since September 2008 will not
continue. This fear has been realised, with respondents to a Deloitte (2013) survey indicating
that a significant obstacle to successful cost reduction was the erosion of savings. This was
because the cost improvements that were undertaken were, in the longer term, not feasible
or sustainable.
Many organisations also find that they must continually achieve a reduction in the cost of
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their products or services for competitive purposes. For example, if an organisation fails to
match the cuts in product cost achieved by its competitors, it will inevitably lose market share.
Similarly, every organisation that launches a new product may be confronted with the challenge
of closing the gap between the product’s target average cost and expected average cost per
unit. Again, such cuts must be secured in a sustainable manner and implemented in a way that
does not compromise the organisation’s ability to secure future reductions in costs.
Often, the source of significant and sustainable improvements in cost performance comes
from an examination of the organisation’s own value chain. For example, an organisation might
be able to reduce costs by targeting non-value adding activities and eliminating them along
with their associated costs. As well as managing its own value chain, a company can improve its
own cost performance through better management of its supplier and customer linkages and
relationships. Such options for achieving improvement in the cost performance of an organisation
can be grouped together as strategic cost management. These approaches are more complex
and difficult to implement, but often generate more sustainable cost reductions.
Study guide | 389
When efficiency gains are made, the use of fixed resources, such as machines or full-time
employees, is often reduced. This will usually lead to an increase in unused fixed capacity.
The problem is that it is not always easy, or possible, to reduce or eliminate the spare fixed
capacity in the short term. There are often fixed or committed costs attached to these items.
These may include long-term rental agreements and employee contracts that cannot easily
be changed or ended.
For example, if ABC analysis helps reduce inventory levels by 30 per cent, this will not necessarily
lead to an immediate reduction in fixed rental costs for a warehouse—even if only two-thirds
of the space is now being used. The rest of the space becomes unused capacity until the
warehouse rental is renegotiated, which may be several years away. Fewer staff members will
also be needed to manage the lower levels of inventory. However, if current staff have permanent
full‑time positions this will lead to unused labour capacity, unless they are reassigned to new
work or a reduction in the workforce is able to be achieved.
This unused capacity may be used in new ways, such as leasing out the spare space to
other companies requiring storage facilities. However, where it is not possible to achieve
an improvement in resource usage or to reduce the unused capacity, planned cost
reductions may not occur.
Shank and Govindarajan (1992) suggest that two different types of drivers are the basis for
strategic cost management:
1. structural cost drivers that reflect the organisation’s decisions about its structure
(e.g. centralised versus decentralised), its investments (e.g. acquisition of advanced
manufacturing technologies), and mode of operations (e.g. fixed versus variable cost
structure); and
2. executional cost drivers that relate to how economically and efficiently the organisation
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executes its strategy.
For structural cost drivers, an organisation may decide, for example, to invest in up to date
automated manufacturing equipment that will enable it to achieve significant improvements in
material usage (e.g. lower wastage and rework rates) and a reduction in labour cost. Such an
investment re-engineers the organisation’s cost structure into a form that enables more successful
competitive strategies to be formulated and implemented (e.g. cost leadership).
For executional cost drivers, an organisation may decide that while its existing manufacturing
facilities still provide a competitive base for its activities, it can improve its cost performance:
• by entering into a long-term procurement contract with a supplier of raw materials, thereby
securing a significant reduction in the price paid for those materials; or
• by providing additional on-the-job training for operational personnel where improvements
in manufacturing yields (e.g. labour efficiency) will be obtained and a lower average cost per
unit produced achieved.
390 | TECHNIQUES FOR CREATING AND MANAGING VALUE
It should be noted that an organisation may initially focus its cost-reduction initiatives on
structural cost drivers and, having successfully secured a shift in the manner of production,
then try to obtain further reductions in costs by examining its executional cost drivers.
Despite these efforts, success is not easy. Research by Deloitte (2013) indicated that nearly
half of all cost-reduction initiatives failed to achieve their goals. This level of failure has been
growing since 2008 when only 14 per cent of projects were unsuccessful.
Figure 4.3 provides a series of five questions that, once addressed, might identify opportunities
for achieving sustainable reductions in costs.
No
No
No
Ideally, an organisation’s product portfolio should include products at each stage. Mature products
generate the cash flows required to fund investment in new products and support the service
commitments associated with declining products. If an organisation has a large proportion of its
products entering the decline phase, it may face difficulty in getting new products to market in
sufficient time to ensure continued viability.
Source: Andrew, J. P. & Sirkin, H. L. 2004, ‘Making innovation pay’, Strategic Finance, vol. 86, no. 1, p. 7.
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(Figure 1. ‘The cash curve’ republished with the permission of the Institute of Management Accountants;
permission conveyed through the Copyright Clearance Center Inc.).
We can see in Figure 4.4, that in the early stages of the product life cycle, the cumulative
cash curve is negative. However, as the market for the new product develops and matures,
the accumulated cash surplus becomes positive and continues to grow. At some future point,
the cumulative cash flow from the product will start falling and, in the absence of any compelling
strategic reason (e.g. to augment other product lines), it would be withdrawn from the market.
Thus, life cycle management views any new product as an investment which, over its entire
economic lifetime, should recover the initial and subsequent cash costs of investment and
generate sufficient returns to justify the risk taken in developing that product.
The shape of the cash curve can be modified by decisions taken by the organisation.
For example, a manufacturing company may decide to speed up the product design and
development stage of a new product’s life cycle by employing more production designers
and engineers. The initial investment cost will be increased by the salaries of the additional
designers and engineers and this will add depth to the negative section of the cumulative
cash flow. However, the company hopes that, in getting the product to market more quickly,
the time taken before cumulative positive cash flows appear will be reduced. Other initiatives,
such as collaborating with suppliers and/or customers, may be helpful in bringing about a
favourable change in the shape of a new product’s cash curve.
392 | TECHNIQUES FOR CREATING AND MANAGING VALUE
At each stage in the life cycle of a product or service, opportunities for achieving improved
cost performance are available. As illustrated in Figure 4.5, 85 to 90 per cent of the total cost of a
product is committed at the time of product design, prototype manufacture and the construction
of production facilities (Raffish 1991). Thus, a focus on cost reduction during production is unlikely
to yield significant economies, as the main scope for improvement exists in respect to the yet to
be committed costs.
Target costing deals with the pre-production stages of the product life cycle and promises the
greatest opportunity for improving product cost performance. Kaizen costing (discussed below)
is primarily associated with the manufacturing and distribution stages (maturity) of the product
life cycle and provides a more restricted opportunity for improving the cost performance of
a product.
Figure 4.5: Product life cycle: Cost committed versus cost incurred
%
100
95%
Cost commitment 85%
75
66%
Strategic cost Traditional cost-
management focus accounting focus
50
25
Cost incurrence
0
Product Design and Production Production Marketing
planning and manufacture preparation and logistics
concept design of prototype support
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Source: Adapted from Raffish, N. 1991, ‘How much does that product really cost?’,
Management Accounting, vol. 72, no. 9, p. 37.
Figure 4.5 shows that in the manufacturing process, a high level of cost is committed and
cannot be avoided before production begins (e.g. capital expenditure, long-term contracts).
This is shown by the dotted cost commitment line. This shows that by the time the product is
ready for production, close to 95 per cent of all costs have already been committed.
The rate of cost incurrence is shown by the dashed cost incurrence line. This refers to the
actual payments of costs, which may have been committed (but not paid) at a much earlier
stage. We see here that by the time production starts, only 25 per cent of total costs may
have been paid out, even if 95 per cent of them have been committed.
Up to the time before production begins, a strategic cost management focus is required
to ensure that the outcomes of the manufacturing project are in line with the strategic
plan. The activities of the project are then carried out according to the proposed project
schedule to ensure that manufacturing activities begin on time. Once manufacturing begins,
a traditional cost accounting focus approach can be adopted to measure the efficiency of
inputs and outputs of the manufacturing process.
Study guide | 393
It is important to gain control of costs at an early stage—when they are committed. This highlights
the importance of early planning. A useful tool to support this work is target costing, which is
discussed in the next section.
Once manufacturing begins, the focus will be more on making the production line run efficiently,
rather than large-scale decisions about which vehicles to produce or equipment to install.
Target costing
Organisations must be able to determine realistically what price a new product is likely to
command, given the:
• specified market conditions;
• total costs of developing, manufacturing and supplying that particular product; and
• profit margin that will be obtained.
Target costing is a strategic management accounting technique that helps this type of
analysis. Target costing initially focuses on what the market is prepared to pay for the product
(i.e. identifies the likely target price). Knowing the accepted market price enables the
organisation to determine the cost that can be incurred in manufacturing the product after
allowing for the desired (or target) profit. The target selling price is the price the market is
prepared to pay for a product and is determined by the:
• functionality of a product relative to alternative products; or
• volume of sales (i.e. market penetration) that an organisation wishes to achieve. For example,
if an organisation wanted to sell two million units of a product to build an adequate market
position in a competitive market, the selling price would need to be set lower than if it only
wanted to sell one million units.
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Target costing is supported by the concept of value engineering. According to Langfield Smith &
Thorne et al. (2012), value engineering involves:
Analysing the design of the product and the production process to eliminate any non value
adding elements, in order to achieve the target cost while maintaining or increasing customer
value (Langfield Smith & Thorne et al. 2012, p. 750).
Thus, target costing embraces the total cost of the product throughout the product life
cycle, including:
• research and development;
• product design;
• manufacturing processes, including supply chain management;
• marketing;
• distribution systems; and
• customer service.
394 | TECHNIQUES FOR CREATING AND MANAGING VALUE
In summary: if, after the organisation completes the target costing analysis of a proposed
product, it decides to proceed to production, then the product can be manufactured at
a cost that enables the organisation to make an acceptable profit when it is sold at the
estimated market-determined price.
If an organisation is using target costing, the following steps should be completed before a
product launch:
Step 1 Identify the target selling price for the product. The target selling price is established
after market research that also takes into account the business strategy that will be
employed to market the product (e.g. cost leadership or differentiation).
Step 2 Determine the profit margin the organisation requires to achieve its objectives
(e.g. maximise shareholder wealth).
Step 3 Determine the target cost for the planned product by subtracting Step 2 from Step 1.
Step 4 Determine whether the product can be produced at or below the target cost. As the
target cost must incorporate life cycle costs, the organisation will include design,
engineering, manufacturing and distribution costs within the total target cost.
Step 5 Compare the estimated cost determined in Step 4 with the target cost in Step 3.
If the estimated life cycle cost is less than the target cost, the organisation should
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proceed with production. If the estimated life cycle cost is greater than the target cost,
the organisation could:
–– produce the product and derive a profit margin lower than considered acceptable
in Step 2;
–– produce the product and attempt to reduce costs now, or over an acceptable time
period, by redesigning the product, revising production process technologies,
or changing the quality and/or mix of inputs. The intention is to achieve either
an immediate or planned reduction in actual costs to a level at or below the
target cost;
–– attempt to increase the functionality of the product (e.g. more features) while
keeping costs constant, to enable the organisation to increase the price to a
level that customers are willing to pay; or
–– decide not to manufacture the product.
Target costing is usually applied to products that have clearly defined inputs (raw materials and
labour) and outputs that can be more carefully analysed, managed and changed. However,
it is also possible to apply these principles to service industries. Although it can be more
difficult because services are less tangible and unique compared to mass-produced products,
significant improvements are still available.
Study guide | 395
The combination of advanced, custom-built facilities and well-trained specialised employees working
in lower cost countries has created a whole new industry where patients travel to another country and
receive treatment (and often have a holiday as well—hence the ‘tourism’ descriptor).
The target-costing-based approaches that have enabled this enormous cost reduction started with
a focus on providing a service at well below the current market price to draw customers from other,
more developed and higher cost countries. The largest costs are the facilities and the specialists
needed to perform the procedures and operations.
Careful design of hospitals that allow for effective flow of patients and which ensure high levels of
utilisation lead to lower costs per procedure being achievable. Training specialists from countries
with lower wage levels also helps keep prices down. Training specialists who become experts in a
single procedure which is then repeated many times per day creates high levels of patient throughput
or efficiency.
Careful work has been done to make sure each procedure or operation is performed in a similar or
routine way every time. This leads to better quality, more consistent results. By increasing the volume
of patients for a particular procedure, the provider is able to specialise their treatment. Operations
and treatment lose their unique features and work is scheduled in a similar way to a production
line. This reduces excess capacity and ensures specialist staff are used solely on productive effort
(i.e. performing procedures on patients). This leads to faster, higher-quality and lower-cost treatment.
Specific examples linked to the insurance, banking and telecommunications industries include being
available for help or customer service 24/7 and being able to perform tasks immediately, rather than
taking days or weeks. Customers want to open accounts, withdraw or transfer funds, lodge insurance
claims, receive prompt claim payments, and access a variety of telecommunication services with ease.
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Target-costing methods help service organisations to provide these services cost effectively by
completely transforming how they are provided. Action that may have previously taken weeks or even
months may now be completed within minutes or hours.
The highest cost in many situations will be the cost of employee time required to perform particular
activities. Therefore, attention is devoted to redesigning activities and work processes (rather than
physical products or components). By identifying areas that can be automated or streamlined,
an organisation can reduce labour costs and also significantly improve the speed of service.
Automated processing of repetitive activity combined with systematic checklists for approvals and
processing events can both lead to reduced costs. When this is coupled with greater authority given
to front-line staff, faster decisions and quicker responses are made and costs are reduced.
396 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Kaizen costing
Kaizen costing is based on the concept of achieving incremental reductions in product costs
through a continuous program of small improvements. This is a different perspective to
target costing, which is usually seeking significant reductions in product costs, prior to the
commencement of production.
In practice, organisations will set a target specifying by how much they expect costs to be
reduced in a subsequent control period (e.g. a 2% reduction in production costs per year).
This improvement may be achieved through:
• better utilisation of existing technologies and resources (e.g. a telephony service provider
increasing the customer load that can be carried on its mobile telephone system);
• elimination of waste (e.g. idle employee time, material scrap, material handling and
excessive inventory levels);
• increased productivity from operational personnel (e.g. from staff development and
technical training) or having multi-skilled employees who can perform different roles
(e.g. where employee headcount is kept to a minimum); or
• reducing business activities and costs by outsourcing services that can be provided at the
desired standard at a lower cost by an outside supplier.
Figure 4.6 links the strategic cost management tools of target and kaizen costing to the
activity-analysis approaches of business-process management and continuous-improvement
programs. Activity-based management and business process management will be discussed
later in this module.
Low High
Continuous Business process
Extent of changes made in
improvement management
business processes
Life-cycle costing
Figure 4.7 provides a product life cycle flow chart for a manufacturing company, illustrating
how target and kaizen costing help to answer questions such as ‘Should this product be
manufactured?’ and ‘At what point should this product be withdrawn from the market?’
Study guide | 397
Product and
Target selling price • Product specifications formulated
process design
established • Manufacturing process designed
changes
Target profit
determined
No
Are product life cycle costs acceptable? Do not manufacture
Yes
Production phase (Kaizen costing)
Commence production
Yes
Product and process improvements Continue production
Yes
Is the product still ‘profitable’?
No
Abandon production phase
Cease manufacturing
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Source: CPA Australia 2015.
For some products, the combined market share of HPD’s largest rivals is now over 85 per cent. HPD is
therefore investigating alternative manufacturing opportunities, hoping they will provide the division’s
growth over the next decade.
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Solar products
Recognising the growing worldwide consumer interest in renewable energy products, such as
solar hot-water and solar-power systems, HPD has decided to focus on expanding into this area.
The worldwide market for such renewable energy products is expected to become one of the fastest
growing product markets over the next 30 to 40 years.
Fuelling the demand for renewable energy products are rising electricity costs and a desire to pursue
more sustainable methods, combined with the introduction in many countries of greenhouse gas
reduction initiatives such as emission trading schemes (ETSs) and establishing a price for carbon
emissions (commonly referred to as a carbon tax).
Government support (e.g. solar credits or rebates) for renewable energy make the purchase and
installation of renewable energy products more affordable to both industrial and consumer users. This is
coupled with increased community interest in achieving reductions in greenhouse gas emissions. As a
result, HPD believes that entry into this market will provide it with a growing domestic and international
market for these types of products.
The following sales and manufacturing data for the expected five-year product life of the Solarheat
1 have been developed.
1. Total sales revenue $24 000 000 is forecast to be earned on total sales of 30 000 units.
2. Total life cycle costs of $22 500 000 are expected to be incurred for a total production volume
of 30 000 units. Total forecast life cycle costs have been analysed into:
(i) Research and development $ 1 300 000
(ii) Product and process design $ 2 500 000
(iii) Production $16 200 000
(iv) Marketing and distribution $ 1 750 000
(v) After-sales service $ 750 000
Study guide | 399
➤➤Tasks
In your role as the management accountant for the HPD, and in preparation for your first
management meeting on the development of Solarheat 1, you need to perform some calculations
for discussion.
(a) Calculate the average selling price per unit of the Solarheat 1 over its expected five-year
product life.
Table 4.30: E
xpected average selling price per unit for the Solarheat 1 for sales
achieved over its five-year life
Total sales revenue Total units to be sold Average selling price per unit
$ units $
(b) Calculate the expected average total cost per unit of the Solarheat 1.
Table 4.31: E
xpected average total cost per unit for the Solarheat 1 for total units
manufactured over its five-year life
$ units $
(c) Calculate the target average total cost per unit of the Solarheat 1 if HPD is to achieve a
30 per cent net profit on the average selling price per unit sold. Use this information to
determine the difference between the target and the expected average cost per unit.
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Table 4.32: Target average total cost per unit of the Solarheat 1
Details Amounts
Expected average cost below (above) the target average cost per unit ($)
(d) At the meeting, Martin Emmitt, HPD’s divisional manager, states that he is interested in
identifying performance measures that he could use to evaluate how well the division has
managed the pre-production activities of research and development, and product and
process design. Prepare a one-page explanation that identifies and briefly discusses three
financial and three non-financial measures that Martin might use to evaluate the research
and development, and product and process design activities.
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(e) Martin is contemplating whether target costing would be required for the planned
Solarpower 2 product. Given the significant increase in global interest in the use of renewable
energy sources, he knows that there are in excess of 100 solar power system manufacturers
worldwide. Martin’s research suggests that the prices set by the leading solar power system
manufacturers in individual markets (e.g. Australia and New Zealand) are influenced by such
local environmental factors as:
(i) the amount of energy that would be generated by the manufacturer’s solar power product;
(ii) cost savings that customers will obtain from using self-generated power as opposed to
mains-supply power; and
(iii) the availability and amount of government subsidies and rebates made available for the
purchase and installation of solar- power systems.
Advise Martin on whether HPD will need to undertake a target costing exercise for the proposed
Solarpower 2.
After further investigation of the conventional and time-driven ABC models, analysis of the initial
activity and cost data for HPD reveals that six cost pools will be sufficient. The following cost pools and
pool rates have been estimated and the number of transactions to be carried out in manufacturing
the Solarheat 1 has been forecast.
Table 4.33: ABC cost pools and activity data for the Solarheat 1
Solarheat 1 indirect
Cost pool Cost pool rate manufacturing activities
➤➤Tasks
Martin Emmitt has asked you to review the activity and cost data provided, and has also requested
that you:
(a) (i) calculate for each cost pool, the total indirect manufacturing costs that would be allocated
to the Solarheat 1 using the ABC model;
(ii) determine the difference between the total indirect manufacturing costs that
would be allocated to the Solarheat 1 using the ABC model in comparison to the
traditional labour-based allocation model (both in total and per unit); and
(iii) comment on how Solarheat 1’s total average cost per unit now compares to the target
average cost per unit.
Study guide | 401
Table 4.34: Indirect manufacturing costs allocated to Solarheat 1: ABC versus HPD’s
traditional labour-based allocation model
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Despite these small costs, wherever possible it is important to make improvements here also.
To do this, we need to make sure that more effort is being placed earlier in the industry value
chain (upstream). This involves focusing on the selection and choice of raw materials and the
design of products. The purpose of making changes here is so that, at later stages when the
product is being recycled or disposed of, it can be accomplished at less cost or possibly even
generate some revenue. An example would be redesigning a product to use material that can
be recycled rather than material that must be disposed of to landfill. Another example would
be to redesign a product to use considerably less material than was previously used, so that it
takes up less space in landfill.
Figure 4.8 illustrates reverse value chain flows that begin with the recovery of a product from
customers at the end of its economic life and the ultimate fate of the reclaimed product.
402 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Figure 4.8: Value chain flows: Recovery, re-use, repurposing and recycling
Social impacts
Raw material
harvesting or
extraction and Procurement
Product Product Product Product
processing, (e.g. of raw
manufacturer distribution use reclamation
including materials)
reprocessed
materials
Product re-use
(e.g. printer cartridges)
Environmental impacts
Including energy usage as detailed below and the type and potency of effects caused by compounds and
other contaminants released during the manufacture and consumption of products.
Harvesting or Consumption
Transportation
extraction and Transportation Manufacturing Transportation and/or
and recycling
processing energy costs energy costs energy costs operation
energy costs
energy costs energy costs
In some cases, the recovered product can be re-used repeatedly (e.g. printer toner cartridges
that are refilled for re-use). A reclaimed product may also be put to an alternative purpose
(e.g. the conversion of used polyethylene terephthalate (PET) bottles into hard plastic cases
for notebook computers). Alternatively, a reclaimed product might be broken down and
the recovered materials or components either used to manufacture the same product again
or be used in the making of a different product (e.g. repurposing computer crystalline silicon
semi-conductor wafers in the manufacture of silicon-based solar panels).
Finally, where no other economically viable use can be found for a reclaimed product, or any of
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its parts, it may need to be disposed of in a landfill or a high temperature treatment incineration
system. Many organisations are responsible for the cost of properly disposing of the products
(e.g. car tyres and batteries, and increasingly, mobile telephones and personal computers) that
have been recovered from their customers. A growing awareness of the economic cost and
opportunities for realising an economic benefit from reversals in an organisation’s value chain
is now generating managerial interest in making upstream changes to the design of products.
Such changes are directed at lowering total life cycle costs when the costs and benefits of
recovery, re-use, recycling and/or disposal are taken into account.
Figure 4.8 also illustrates the social and environmental context of an organisation’s value chain.
In particular, the environmental impact of an organisation’s value chain activities can be very
extensive and include:
• Energy usage which can occur during:
–– harvesting or extracting raw materials;
–– processing raw materials;
–– manufacturing products;
–– consuming and/or operating a product;
–– transporting procured raw materials;
–– distributing finished product; and
–– reclaiming used products.
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• Potency of effects caused by compounds and other contaminants released during the
manufacture and consumption of products. For example:
–– global warming;
–– air quality (e.g. smog formation);
–– depletion of the ozone layer;
–– acidification of oceans;
–– aquatic and terrestrial toxicity; and
–– human carcinogens.
Example 4.7 reports how Apple Inc. seeks to reduce the environmental effects that result from
its products.
Apple has included energy saving features into its products, including:
• a high-efficiency power supply connection from the energy source (e.g. a mains supply power
point to the computer); and
• advanced power management (e.g. ‘sleep mode’ when the computer is not in use) and energy
efficient hardware components (e.g. LED-backlit displays).
In terms of materials, Apple has targeted the elimination of harmful toxic substances such as mercury,
arsenic, brominated flame-retardants (BFRs) and polyvinyl chloride (PVC) (Apple Inc. 2015b). Apple uses
BFR-, PVC-, lead- and mercury-free display glass in its iMac computer range. Furthermore, Apple
uses a single, solid piece of recyclable aluminium to enclose the iMac computer and recyclable glass
is used for the display. The iMac’s aluminium and glass materials are economically valuable to recyclers,
so these materials can then be re-used in other products.
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A significant responsibility now assumed by managers is to own and improve business processes
continuously. Business Process Management focuses on the definition, direction and improvement
of processes for the delivery of superior customer value. Simply stated, processes are the activities
that transform inputs (e.g. materials, labour and capital) into business outputs (e.g. goods and
services) that are desired by customers. Two additional approaches to improving organisational
value are:
1. activity-based management (ABM); and
2. continuous improvement (CI).
At this point, it is useful to clarify the relationship between ABM and ABC (see Figure 4.9). ABM is
shown in the horizontal part of the figure, while ABC is illustrated in the vertical part. The centre
of both is the activities and activity analysis. ABM and ABC differ mainly in their objectives.
ABM—focuses on managing activities along the organisation’s value chain to reduce costs.
ABM is focused on strategic decision-making and aims to improve customer value through
business process improvements. It is focused on strategic planning and performance.
404 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Activity
management Resources
view (i.e. costs)
Activity Performance
Activities
(cost) drivers measures
Cost objects
(e.g. products Benchmarking of
or services) performance
Source: Adapted from Raffish, N. 1991, ‘How much does that product really cost?’,
Management Accounting, vol. 72, no. 9, p. 38.
Activity-based management
The ABM process begins in a way similar to ABC. The first step is an activity analysis and drawing
an activity map. Next, the management accountant must identify inputs, drivers and outputs for
each activity. As in ABC, the inputs comprise the cost of all the resources used in the activity and
the driver (the item that creates or ‘drives’ the cost of the activity).
ABM then differs from ABC with its focus on outputs. All activities should produce valuable
outputs. Activities that do not produce valued outputs are called non-value adding activities
and need to be eliminated or reduced as much as possible. The management accountant must
determine the nature of the outputs for each activity and appropriate ways of measuring them.
For some activities, outputs are clearly defined. For the activity ‘running machinery’, units of
product are the likely output; for other activities like ‘purchasing supplies’, the output might be
the number of purchase orders generated, or the dollar value of purchases.
Having determined the inputs, outputs and drivers for each activity, the management accountant
is in a position to analyse and improve both individual activities and the broader activity map to
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increase the overall productivity and efficiency of the organisation or specific business process.
The analysis should start at the strategic level with the activity map.
The most complex aspect of ABM is analysing groups of interrelated activities in the activity
map to see if they can be reorganised in a more efficient or strategically relevant manner.
This often occurs in manufacturing companies when traditional, functionally oriented (output)
manufacturing systems are replaced by customer- and product-focused manufacturing cells
(e.g. flexible manufacturing system cells). Similarly, major changes to business processes need to
be considered for every part of the organisation’s value chain. It is critically important to ensure
that any significant new investment in process change is consistent with the strategic direction of
the organisation (see Module 5 for more detail on managing major investment projects).
Study guide | 405
To determine the cost savings that may be realised from ABM, it is necessary to understand
the factors that determine the economics of the organisation’s value chain. Factors to be
analysed include:
• Scale—the extent to which the organisation has sufficient production capacity and volume
of output to achieve economies of scale and with it, a significant market share.
• Scope—the extent of vertical integration influences control over the industry value chain.
Highly integrated organisations have more control over the prices paid for inputs and
revenues received for outputs.
• Experience—the benefit of that experience should be reflected in higher levels of
productivity and lower wastage and rework rates.
• Technology—employing advanced manufacturing technology should produce higher-quality
products or services at lower cost.
• Complexity—a highly complex product or service portfolio has costs which are likely to be
significantly higher than an organisation with a relatively simple range of products or services.
This additional cost must be balanced against the desirability of offering a full product range.
• Channels—the channels used to distribute products can have a significant effect on value
chain costs and benefits. For example, the use of the internet for providing banking services
not only extends the reach of a bank in time (i.e. 24/7) and space (e.g. banking from office or
home), but can also lead to a significant reduction in the cost of service provision.
• Quality of operational management—competent operational management results in
the best capacity utilisation, improved product and process design, a continuing stream of
learning opportunities flowing from total quality management and continuous-improvement
programs and well-exploited external linkages with suppliers and customers.
Management efforts to make major changes to the way business processes are carried
out are often called business process management (BPM). This is akin to the business
process re-engineering approach to process improvement adopted by engineers, and both
approaches are very similar to the strategic analysis of ABM.
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the most advanced technology.
The BPM approach assumes a value chain perspective and examines business processes from the
viewpoint of the organisation’s customers. BPM can result in the organisation being restructured
around business processes rather than functions.
Suncorp, an Australian insurer, conducted a study which focused on process improvements to reduce
the length of time it took for processing insurance claims. Through this analysis and by redesigning
processes, the company was able to reduce the time it took to process claims—from one to two
months to between one and five days. This extraordinary improvement shows that process analysis is
just as important in service industries (Suriadi & Wynn et al. 2013).
406 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Mary Johnson, the assistant production manager for HPD, has suggested that part of the Solarheat
1 manufacturing line be reorganised into five production cells. Instead of one long production line,
all of the production activities from start to finish would be contained within these cells—groups of
people and equipment that have multiple roles. Mary believes this would minimise handovers, and
create a greater level of responsibility and accountability for time, quality and efficiency.
Furthermore, as a result of BPM achieving a leaner manufacturing process through the permanent
reduction in direct labour requirements for the production of the Solarheat 1, the forecast direct labour
cost is expected to decrease by $30 per unit.
➤➤Tasks
Mary Johnson has asked for your help to look into the possible BPM exercise.
(a) If the cost of reorganising the Solarheat 1 manufacturing facility into a cellular format is
$300 000, should Mary proceed with her suggestion?
Table 4.35: Functional versus cellular manufacturing layout for the Solarheat 1:
Indirect manufacturing cost allocations and savings in direct labour costs
(Table SA4.15)
Net benefit realised from BPM implementation per unit $ per unit
(Net benefit realised from BPM implementation / Number of units)
(b) With the ABC model now being used for allocating indirect manufacturing costs, the expected
product cost for Solarheat 1 had been revised down to $725 per unit (i.e. $750 – $25)—see
Case Study 4.6.
(i) If HPD undertakes the BPM exercise for the Solarheat 1 manufacturing facility, what will
be the expected product cost per unit?
(ii) How much will the expected cost per unit be above the target cost for the Solarheat 1
as a result of the BPM exercise being undertaken?
(c) Write a response for Mary Johnson that identifies and briefly explains two financial and two
non-financial performance measures that she could recommend to Martin Emmitt to evaluate
the success of the BPM exercise.
Organisations engage in many activities when producing the goods or services they sell
to customers. Some activities directly or indirectly contribute to increasing the value of
the organisation’s products to customers and increase the level of customer satisfaction
(e.g. through improved product design and manufacturing processes). As discussed in
Module 2, these activities are termed ‘value adding’, because they increase the attractiveness
or saleability of the organisation’s products or services. The organisation should strive to
carry out these activities as efficiently as possible.
However, there are other non-value adding activities (e.g. process set-up time, storage,
inspection and movement of items) that do not increase the attractiveness or saleability of
the products and, if eliminated, allow the organisation to reduce its costs without affecting its
revenue. Where activities that are not inherently required in supplying a product are eliminated,
a reduction in the cost of the product should be achieved.
Figure 4.10 provides a series of questions that will assist with the task of identifying if a particular
activity is value adding or not. By undertaking a rigorous approach to activity value analysis,
an organisation is more likely to achieve a sustainable reduction in operating and support costs
through the elimination of non-value adding activities.
MODULE 4
408 | TECHNIQUES FOR CREATING AND MANAGING VALUE
You now need to prepare for the next HPD senior management meeting and you decide to undertake
an activity value analysis of HPD’s value chain.
Study guide | 409
➤➤Tasks
(a) Activities involved in the production of the Solarheat 1 have been determined and are shown
in Table 4.36. In your checklist, classify each activity as more likely to be value adding or
non-value adding.
Table 4.36: Analysis of HPD’s activities: Value adding versus non-value adding
1. Designing a product
9. Processing product
MODULE 4
Source: CPA Australia 2015.
(b) HPD’s functional activities and life cycle costs are presented in Table 4.37. The total costs for
each function incorporate the ABC and BPM projections made earlier. For each functional
activity, classify the related costs as more likely to be value adding or non-value adding.
410 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table 4.37: A
nalysis of HPD’s functional activities and costs: Value adding versus
non-value adding
Production costs (made up of direct materials and labour and indirect manufacturing costs)
Direct materials
Direct labour
After-sales service
(c) Ignoring the cost of making the changes, determine the potential cost reductions that could
be realised if all activities that are more likely to be non-value adding were economically
eliminated.
(d) Martin Emmitt is interested in understanding how the division will determine which of the
non-valuing adding activities should be eliminated. Write an explanation for Martin, covering
the factors that would need to be taken into account before deciding if a particular non-value
adding activity is to be eliminated.
(e) Explain why some of the costs associated with the non-value adding activities cannot be totally
eliminated by stopping them immediately. Illustrate your answer by using the ‘$600 000 of
rework’ indirect manufacturing cost as an example.
(f) You establish a business case to eliminate many non-value adding activities. While it is desirable
to eliminate them all, it may be too difficult and costly. Further, you have been advised that
the following activities and costs are to be excluded from the analysis as they are currently
considered unavoidable in the short to medium term:
Quality control
3000 inspection hours of $125 per hour $375 000
MODULE 4
You initially identify two levels of elimination: partial and total. Table 4.38 shows the benefit
(in cost savings) and cost for the partial or total elimination of the relevant non-value adding
activities.
412 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table 4.38: A
nalysis of HPD’s non-value adding activities and costs:
Costs versus benefits
Rework of prototypes $115 000 ($30 000) $150 000 ($40 000)
Rework patterns $220 000 ($25 000) $300 000 ($50 000)
On-the-job inspection activity $205 000 ($30 000) $250 000 ($65 000)
Repair and maintenance $70 000 ($10 000) $120 000 ($40 000)
Hazardous waste disposal $50 000 ($20 000) $75 000 ($35 000)
Warranty claims $550 000 ($80 000) $600 000 ($150 000)
Customer complaints $110 000 ($45 000) $150 000 ($100 000)
Total costs $1 320 000 ($240 000) $1 645 000 ($480 000)
To determine whether to pursue partial or total elimination you need to complete Table 4.39
as follows:
(i) Identify the:
– net saving of partial elimination; and
– net saving of total elimination.
(ii) Identify the preferred BPM initiative for each activity—total or partial elimination—and
the resulting net saving that is expected.
(iii) Calculate the total amount of savings expected for the Solarheat 1 product by performing
the preferred elimination option for each activity. What is the revised expected cost per
unit and the gap to the target average cost per unit?
MODULE 4
Function and activities Partial elimination of non-value Total elimination of non-value
adding activities adding activities
initiative† preferred
If C > F = BPM initiative†
Partial If G = Partial
If F > C = then C
Benefit Cost Net saving Benefit Cost Net saving Total If G = Total
A B C D E F G then F
Rework of prototypes $115 000 ($30 000) $85 000 $150 000 ($40 000) $110 000 Total $110 000
Rework patterns $220 000 ($25 000) $ $300 000 ($50 000) $ $
On-the-job inspection activity $205 000 ($30 000) $ $250 000 ($65 000) $ $
Repair and maintenance $70 000 ($10 000) $ $120 000 ($40 000) $ $
of non-value adding activities
Hazardous waste disposal $50 000 ($20 000) $ $75 000 ($35 000) $ $
Warranty claims $550 000 ($80 000) $470 000 $600 000 ($150 000) $450 000 Partial $470 000
Customer complaints $110 000 ($45 000) $ $150 000 ($100 000) $ $
Total costs $1 320 000 ($240 000) $ $1 645 000 ($480 000) $ Total savings: $
†
We compare columns C and F to see which has the higher net saving. This will determine the preferred BPM initiative and net saving.
MODULE 4
414 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Continuous improvement
Once activities have been rearranged, non-value adding activities eliminated, value adding
activities replaced with other more efficient activities, and management is generally satisfied
with their revised activity map, individual activities can be analysed to identify ways of improving
them. This aspect of ABM is often called continuous improvement (CI) and was originally
developed by Japanese motor vehicle manufacturers. It has a strong focus on teamwork and
worker empowerment. CI is focused on existing activities and aims to engage all personnel
involved in that activity in an ongoing improvement process. An important incentive often
associated with CI implementations is ‘gainsharing’. Workers involved in the CI process share
a portion (say 10%) of any cost improvements they are able to achieve.
While both BPM and CI seek to improve process performance, they approach the task differently
(see Figure 4.11).
Having established the inputs and outputs for each main activity at the beginning of the ABM
process, the management accountant can support CI by providing management information in
relation to efficiency or productivity ratios. That is, output/input or alternatively, input/output.
The first approach, output/input, should be adopted for consistency’s sake, and when the ratio
has output in the numerator, any increase in the ratio can be interpreted as a positive outcome.
This approach to measuring improvements in productivity obtained from a CI initiative is
generally more easily understood.
The activity ratios as defined above are also known as efficiency or productivity ratios.
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Performance is enhanced for an efficiency ratio when inputs (the denominator) are reduced.
Performance can be enhanced for a productivity ratio by increasing the output level
(the numerator). Return on investment (ROI), is an output/input ratio. ROI can be improved
by decreasing the denominator (net assets) and/or increasing the numerator (profit).
Both actions have a positive impact on the ratio.
Study guide | 415
Units of product
Activity cost
If the activity results in 10 000 units of product in a time period where activity costs are $5000, then the
ratio is 10 000 units / $5000 = 2 units per dollar of input. To improve the performance of this activity,
the ratio must increase. To achieve this increase, managers must focus on the activity’s inputs,
outputs and cost driver.
• An input focus might lead managers to reduce the wages of machine operators or have one
operator supervise multiple machines.
• An output focus might lead managers to add a second shift to produce more product. This would
also increase cost, but the net change in the ratio is what is important.
• A driver focus might lead managers to reduce machine hours by running the machines at
faster speeds.
The success or failure of management initiatives is measured by the effect of management’s actions
on the activity ratio.
Example 4.10: E
stablishing the social and environmental
impact of the Solarheat 1
MODULE 4
To illustrate how social and environmental factors might be recognised, we will consider HPD’s
Solarheat 1.
Establishing the social impact of Solarheat 1 should include reviewing where materials or components
might be sourced from low-labour-cost developing countries. A question to ask may be: How can
HPD be assured that its suppliers are behaving in socially responsible ways towards its employees,
their families and the broader community?
When reviewing the environmental factors, we can consider the inputs and processes, as well as the
outcomes from using the product. From an inputs perspective, we need to consider the:
• types of materials used to make the Solarheat 1;
• impact of the manufacturing processes employed, including the creation of any toxic by-products; and
• potential for recycling materials at the end of its economic life.
From an outcomes perspective, based on usage of the product, we can look to the benefits of using
this renewable energy product.
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The financial cost associated with procuring raw materials and components is not simply the
visible supplier invoice cost. The relationship with a supplier imposes other costs. For example,
an organisation may incur costs of:
• purchasing—the expenses incurred in placing orders; having orders delivered and receiving;
and inspecting incoming orders;
• delivery failure—the expenses incurred in expediting orders that are delivered late or
incomplete; in processing the balance of orders that were initially delivered incomplete; the
production time lost due to late deliveries; and the opportunity cost of the lost contribution
margin on sales not made because of late delivery of raw materials;
• poor quality—the expenses incurred in returning materials to a supplier because they are
defective or not in accord with order specifications; rework; scrap; lost production time due
to poor-quality materials being used; and the opportunity cost of the lost contribution margin
on sales that were not made because of the inferior quality of the materials delivered; and
• holding inventory—the expenses incurred in carrying raw materials inventory such
as storage, insurance and obsolescence costs; and the opportunity cost of holding an
investment in inventory.
These supplier-related expenses are not usually explicitly recorded in inbound logistics-related
overheads and, depending on the performance of a particular supplier, can be significant.
Of the total cost structure for companies involved in manufacturing, purchased goods and
services might account for between 20 and 60 per cent of total costs.
For organisations involved in wholesaling or retailing, purchased goods and services can account
for between 80 and 90 per cent of their total cost structure. Besides the invoice cost of purchased
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goods and services, a thorough review of other supplier-related costs can potentially lead to
significant cost reductions. However, a single focus on supplier-related cost reduction needs to
be balanced against the risks involved. Risks (which are explained further in Module 5) can be
classified in different ways, but often include the identification of:
• strategic risks linked to an organisation’s external environment and hindrances in executing
strategy;
• operational risks which relate to internal failures and threats to operations;
• legal and regulatory risks which emerge from changes to the regulatory environment of
the organisation and might include changes to government policy; and
• financial risks which relate to the potential threat to an organisation’s financial viability
(Simons 2000).
These risks are not mutually exclusive and may on their own or in combination not only cause
damage within the particular risk category, but also impact significantly on the brand value or
reputation of the organisation. The risk associated with supply chain management needs to be
handled carefully, with appropriate steps being undertaken to try to reduce the risk exposure
of the organisation. For example, poor supplier selection processes may result in inferior raw
materials, lower quality products or problems within the local facility of the supplier. Any of these
may ultimately affect the performance of the organisation, but more importantly they pose a
threat to the reputation of the organisation, resulting in a longer-term effect (see Example 4.11).
Study guide | 417
Supplier management
Organisations frequently spend considerable time interacting with customers to find out
how to serve them better and meet their needs. Generally speaking, this is not the case with
the organisation’s suppliers—because suppliers rely on the organisation to place orders—
so organisations are generally less interested in meeting the suppliers’ needs. However,
devoting attention to building long-term supplier relationships will help minimise risks
and build stronger partnerships within the value chain. Suppliers are often able to point
out opportunities for improvements within the organisation that they supply. An effective
relationship with a supplier can lead to improvements that are to both organisations’ benefit,
by providing higher-quality goods and services to customers and possibly also reducing costs
in the value chain.
Meetings with suppliers to discuss and explain the organisation’s strategic direction, types of
products, future product strategies and other relevant information may be risky. The more
information a supplier has about an organisation the more power it has when it comes to
negotiations, and this may be used against the organisation. But sharing information may also
lead to useful contributions from suppliers at the design and development stage of new strategies
that avoid major mistakes, or lead to better options being considered and implemented.
Suppliers may be more willing to make changes in their organisation to provide better service.
This may include the appropriate selection of particular raw materials, or determining the most
suitable location to set up operations for a particular item to be supplied.
Attention also needs to be focused carefully on suppliers of services, because it is often more
difficult to evaluate the quality and ensure the timeliness of the work. Services are often provided
in an ongoing manner, which means that clear terms, expected outputs and timeframes need to
be agreed. Dealing with issues or differing expectations requires careful negotiation and clear
communication to ensure requirements are met, while at the same time maintaining harmonious
and constructive working relationships.
Building these relationships also provides further opportunity to work on reducing the
hidden costs highlighted earlier within the supplier’s business that are flowing through to
the organisation. Helping suppliers improve the quality of their products or services will lead
to greater efficiency and less double-checking, saving additional time and money.
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Global suppliers
As shown in Example 4.11, many organisations source their required materials and components
from global suppliers. By choosing an overseas supplier, an organisation may hope to obtain
a price reduction because of the supplier’s lower production costs. Cost advantages that an
overseas supplier may have over a domestic supplier could include cheaper labour costs,
the benefit of lower taxes, greater access to required commodities at lower prices and/or
better operational competencies. A range of factors will therefore influence the decision to
contract with specific global suppliers. The evaluation and audit of potential global suppliers
is an important part of the selection process. One key characteristic sought by organisations
is whether the potential global supplier has achieved accreditation status for one or more
of the international standards that exist. These voluntary standards are developed by the
International Organisation for Standards (ISO). The more popular standards include:
• ISO 9000 Quality Management;
• ISO 14000 Environmental Management;
• ISO 26000 Social Responsibility;
• ISO 3100 Risk Management; and
• ISO 22000 Food and Safety Management.
Organisations wanting to secure global supply contracts will commonly seek accreditation
(which is conducted by external certification agencies) for one or more of the standards,
even if not explicitly required to do so by the customer.
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Example 4.11: W
alMart consolidates its global sourcing
structure and upgrades its risk management
US retailer WalMart is consolidating its global sourcing structure in a bid to reduce costs and accelerate
its speed to market. The global sourcing strategy involves the creation of global merchandising centres,
a change in leadership and structure, and an alliance with global sourcing organisation Li & Fung.
The moves are considered to be ‘important elements in the organisation’s strategy to deliver even
greater value to its customers and shareholders’. The new structure leverages the organisation’s global
scale across both general merchandise categories and global food sourcing.
The core of the organisation’s strategy will be to continue increasing direct sourcing for the
organisation’s private brands. Furthermore, Li & Fung, which will form a new organisation to manage
the WalMart account, is expected to build capacity that would enable it within the first year to act as
a buying agent for goods valued around $2 billion.
… we are redefining how we source products that are imported into WalMart retail markets
around the globe … By realigning our resources, leveraging our scale, and restructuring our
relationship with suppliers, we will enable our businesses around the world to offer even more
competitive pricing …
WalMart has been forced to review its risk management practices within its global sourcing portfolio.
The building collapse in 2013 at a Bangladesh factory, which killed more than 1100 workers, triggered a
review of risk-management practices by many organisations that use garment factories from Bangladesh
as part of their supply network. WalMart planned to use outside auditors to inspect nearly 280 factories
and where safety concerns are not met, remove those factories from its list of approved suppliers.
Sources: WalMart 2010,‘WalMart leverages global scale to lower costs of goods, accelerate speed to
market, improve quality of products’, accessed August 2012, http://news.walmart.com/news-archive/
investors/walmart-leverages-global-scale-to-lower-costs-of-goods-accelerate-speed-to-market-improve-
quality-of-products-1380021; Banjo S. & Zimmerman A. 2013, ‘WalMart goes it alone on Bangladesh
garment factory safety pact’, The Australian Wall Street Journal, Supplement, 16 May.
However, offsetting the cost savings that might be obtained from sourcing globally rather than
domestically, is the possible increase in the length of an organisation’s supply chain and there
might also be costs and risks associated with international trade. As well as additional inbound
freight costs (including insurance), the lead time from order placement to order fulfilment will
also increase. The organisation may also need to consider exchange rate movements and
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relevant international freight regulations, including any customs and duties. Another risk of
a global sourcing strategy is the negative impact of business and/or political practices in the
international supplier’s country.
Beyond these business practice risks, other more qualitative issues may emerge from a global
sourcing strategy, such as:
• cultural and language differences;
• legal and political system differences; and
• a lack of immediate interpersonal engagement (i.e. with long distances and different time
zones, it may be difficult to maintain regular interpersonal contact).
Many global manufacturers choose to have their components produced and assembled in low
labour-cost developing countries. Such labour-cost savings emerge because the employment
environment and conditions for many workers (e.g. health and safety, human rights, hours of
work and rates of pay) are significantly lower than those in place in more developed economies.
However, the use of these suppliers may expose an organisation to a level of criticism that could
damage the organisation’s reputation and the value of its brand and products. In the past,
both Nike and Apple (as mentioned in Module 2) have been severely criticised for the poor
working conditions of employees in companies located in less developed economies where they
have subcontracted manufacturing.
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Just as important as having a code of conduct is the monitoring of the suppliers’ actual compliance
with the terms of the code. Thus, an organisation may use its own personnel, supplemented
where required with local third-party experts, to audit the supplier’s manufacturing and related
facilities (e.g. residential accommodation, sporting and recreational facilities, and transport,
health and educational services). It is also important that any detected violations of a supplier
code of conduct are dealt with appropriately. This may include corrective action plans to
remedy the situation (and prevent it from occurring in the future) or, for more serious breaches,
termination of the supplier agreement.
In terms of Apple’s view of its own supplier code of conduct, the organisation notes that:
To do business with Apple, every supplier must agree to meet the standards we’ve established
in our Supplier Code of Conduct and our Supplier Responsibility Standards. They contain more
than 100 pages of comprehensive requirements in 20 key areas, including labor and human rights,
health and safety, environment, management systems, and ethics. Often, these standards exceed
what local laws require.
To keep the bar high, we constantly re-evaluate these documents to ensure that they represent
the strongest values of human rights, safety, and environmental responsibility expected by Apple,
our stakeholders, and the industry. Anytime our suppliers fall short of our objectives, we work
closely with them so they can get back on track. And stay on track.
Apple Inc. 2015c, Supplier Responsibility: 2015 Progress Report, accessed September 2015,
https://www.apple.com/supplier-responsibility/pdf/Apple_Progress_Report_2015.pdf.
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many benefits. These include reduced space required for storage, fewer people required
to manage physical inventory, reduced waste by avoiding obsolete or out-of-date stock and
a lower requirement for working capital.
JIT is not just focused on lower inventory levels but also on having the right inventory levels,
the right quality of inventory and an effective inventory management system. Together,
these are likely to contribute to better product quality, faster set-up times and less waste.
Within the organisation’s own value chain activities, excess inventories can be eliminated by:
• better control over material flows from an inbound logistics perspective (e.g. materials
being delivered by suppliers in small batches, on time, in full and to specification); and
• better management of material flows throughout the manufacturing process by:
–– ensuring preventative maintenance reduces unscheduled downtime; and
–– reducing the build-up of work-in-process inventories by removing production
bottlenecks.
While much of the success of a JIT initiative relies on the changes a manufacturing company
makes within its own value chain, the suppliers’ ability to deliver raw materials and components
on time, in full and as specified is also very important. In some cases, manufacturing companies
have entered vendor managed inventory (VMI) arrangements where the supplier takes full
responsibility for ensuring that raw materials and components are delivered exactly where
and when they are required by the production process.
420 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Despite the benefits of a JIT approach to minimising inventories, it is also important to remember
that a major potential issue that arises with having minimal inventory is supply chain disruption.
prices. For example, it would be a reasonable assumption that a supplier who has a good
environmental and social performance record would charge a greater price than a supplier with
lesser credentials in this area. However, there are practical difficulties when evaluating potential
suppliers to identify those who are environmentally and socially responsible. Organisations may
therefore need to invest in upstream (supplier) monitoring activities to ensure that suppliers not
only commit to, but also continually comply with environmental and social expectations.
Another supply chain consideration is deciding whether to have single or multiple suppliers.
Having more than one supplier addresses several supply chain risks. As the organisation is not
dependent on just one vendor, a more competitive supply-side market is created and alternative
sources of supply are available, should one vendor be unable to fulfil its contractual obligations.
In addition, having only one supplier may pose an unacceptable risk to supply.
Ultimately, the selection of a supplier not only depends on their pricing, but also on their
past and expected future supply performance (e.g. a supplier’s reliability in delivering on time,
in full and to specification). These non-financial measures relating to a supplier’s delivery
performance are important. While the economic cost of a supplier’s performance failure in any
of these areas cannot always be readily determined, non-financial delivery performance metrics
provide a leading measure of the economic cost that would ultimately be incurred if a supplier’s
performance deteriorated.
Areas that would be thoroughly examined when initially selecting a supplier include their ability,
expertise and experience. Although suitable, accurate and timely supplier performance measures
can be limited in their coverage of these criteria, they cannot be neglected. Careful consideration
of all supply chain factors ensures that the suitability of fit is maximised between the organisation
and the suppliers it selects.
After a supply contract with a vendor is entered into, other factors will emerge that influence how
the supplier’s performance will be monitored. When a vendor always fulfils their obligations under
the supply contract and establishes a reputation for always dealing promptly and equitably with
any problems that arise, the organisation may find that, after more informal and interpersonal
exchanges in this procurement relationship, a level of trust develops that leads to less emphasis
on written contractual requirements.
Such a progression from behavioural compliance (i.e. where the terms of the procurement
contract dictate the interactions between the supplier and the organisation when resolving
a supply problem) to attitudinal compliance (i.e. where both parties willingly collaborate
to resolve a supply problem jointly) is an important ingredient for long-term and mutually
sustainable supply arrangements.
Three potential suppliers (Componentz, ElectricalPartz and Parts100), who have been used before by
HPD, are being evaluated for the supply of raw materials for the Solarheat 1. Jane Smith is contemplating
departing from her previous purchasing policy by sourcing the raw materials for the Solarheat 1 from
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just one supplier.
Jane extracts some representative data that she has been compiling on the three suppliers. Table 4.40
reveals the invoiced cost of recent materials purchased. Jane notes that Parts100 is typically the
cheapest supplier with whom she has been ordering the greatest volume of materials, leading to a
greater dollar value of invoiced costs. ElectricalPartz is the most expensive supplier, costing about
3 per cent more than Parts100, and is given the least business in both volume and dollar value terms.
Componentz is about 2 per cent more expensive than Parts100, with both volume of ordered materials
and dollar value of orders sitting in between the other two suppliers.
While both Componentz and Parts100 make deliveries every week to HPD, ElectricalPartz
prefers to make deliveries every fortnight. Total costs relating to each supplier are a function
of the invoice cost of the raw materials and additional supplier-related costs. Management finds
that the supplier cost performance ratio is a useful measure (this ratio is a function of supplier-
related costs as a proportion of the invoice cost).
➤➤Tasks
Martin Emmitt has asked you to review the current purchasing practices.
(a) Review Table 4.40 then complete Table 4.41 below by calculating the:
(i) total supplier-related costs for each supplier (based on activities performed);
(ii) total procurement costs; and
(iii) supplier cost performance ratio.
Note that Jane estimates that the ratio of supplier-related costs to invoice costs over all
HPD purchases is 1:5 (i.e. an additional 20 per cent of the cost of the average purchase order
is spent on supplier-related activities). Accordingly, she estimates that if the raw materials for
the Solarheat 1 product line were sourced from Parts100 at an invoice cost of $7.5 million,
an additional $1.5 million would be spent on supplier-related activities.
Order materials
Receive orders
Inspect deliveries
Costs $120 $18 000 $10 800 $21 600 $50 400
Return materials
Activities 15 6 30 51
Account queries
Activities 15 6 30 51
Process payments
Activities 36 75 36 147
(b) Using Table 4.42 below, calculate the expected Solarheat 1 total procurement costs that
would be incurred for each of the three potential preferred suppliers if they were chosen as
the preferred supplier.
Table 4.42: T
otal expected raw material costs for the new Solarheat 1 for each
of the three preferred suppliers
Suppliers
Estimated
Details Componentz ElectricalPartz Parts100 costs
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index†
Expected invoice cost of direct ($7 500 000 × ($7 500 000) × ($7 500 000) ×
materials (calculation) (1.02) (1.03) (1.00)
†
From the introduction in Case Study 4.9, Parts100 is the cheapest supplier and so has been selected
as the base against which all other suppliers are analysed. Thus, Parts100 has been assigned a supplier
invoice cost index of 1.00. Since the cost of materials supplied by Componentz is 2 per cent more
expensive than Parts100’s, it has a supplier invoice cost index of 1.02 (1.00 + 0.02). Similarly, as the
cost of materials supplied by ElectricalPartz is 3 per cent more expensive than Parts100’s, the supplier
invoice cost index for ElectricalPartz is 1.03 (1.00 + 0.03).
A draft report has been prepared which, with respect to the lean manufacturing model, has made
several recommendations that the cross-functional team believes will deliver improvements in both
manufacturing efficiency and product quality. The team recommends that the product be redesigned,
the manufacturing process refined and employees given increased training. As a result of these
investigations and the greater customer value provided through improved quality, the average selling
price of the Solarheat 1 can be increased by $10 per unit (from $800 to $810).
Table 4.43 details some of the changes that will occur for the broad-level manufacturing activities
undertaken and costs incurred as a result of this recommendation. For example, you will see that by
increasing expenditure in research and development and design work, HPD believes it can save a
greater amount in activities such as prototype design, pattern issue and quality control.
Production costs
Direct materials
Direct labour
Indirect manufacturing
overhead
➤➤Tasks
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As leader of the cross-functional team, you will need to provide information to Martin Emmitt
regarding the product redesign:
(a) Calculate the target and expected costs per unit of the Solarheat 1 and the difference between
the two costs if HPD is able to lift the selling price from $800 to an average of $810 per unit.
Assume that HPD still wants a profit margin of 30 per cent on the Solarheat 1.
426 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table 4.44: A
verage selling price, target and expected costs per unit after
implementing the lean manufacturing initiative
Details Amounts
Price increase per unit from improved product quality: Lean manufacturing initiative $
Expected average cost above (below) the target average cost per unit ($)
(b) Write an explanation for Martin that identifies and briefly explains two financial measures
and two non-financial measures that could be used to assess the success of the product and
production design changes that your team has proposed.
Quality can be defined as conformance to standards. This concept sits well with accounting
notions of standard costs and variance analysis. Any variance from a standard is a quality problem.
Quality services or products are those that are suitable for their function or purpose and which
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conform to the needs of customers. TQM means that an organisation will attempt to produce
quality products at a reasonable cost in all its operations. Thus, for a production department,
the quality of inputs as well as outputs must be monitored. Other support departments,
such as accounts or planning, will all be expected to provide quality inputs in terms of service
and back-up support to production activities.
Juran (1962), a quality cost pioneer, separated the costs of controlling quality (e.g. prevention
and appraisal) from the costs of failing to control quality (e.g. internal and external failure).
• Prevention costs are incurred in avoiding the manufacture of products or provision
of services that do not conform to quality requirements (e.g. quality planning costs,
product design modification costs, quality training costs, equipment maintenance costs,
and information systems costs).
• Appraisal costs are those costs spent on making sure that materials and products meet
predetermined quality standards (e.g. testing and inspection costs, equipment and
instrument testing costs, supplier monitoring costs, quality audit costs).
• Internal failure costs are incurred before products are sent to customers, and relate to
products that fail to meet quality standards (e.g. costs of corrective action, rework and
scrap costs, process costs, expediting costs, re--inspection and retest costs).
• External failure costs are incurred when inferior quality products are delivered to customers
(e.g. warranty costs, costs to handle customer complaints and returns, product recall and
product liability costs, lost sales from unsatisfactory products and customer ill-will).
Study guide | 427
Toyota prides itself on developing a supply chain that does not supply defective material. A rigorous
process of certification of suppliers, as well as training from Toyota engineers, ensures that quality
is built in to all components (prevention costs). Toyota processes also exist to check that supplied
components are within specification (appraisal costs). Despite these efforts, it appears that Toyota
experienced problems with supplied components and/or manufacturing processes that led to automatic
acceleration in several car models.
Sample testing of final products would likely have taken place to identify such faults, with corrective
action then being taken (internal failure costs). However, it appears that the sample testing did not
detect the intermittent issue, which led to customers experiencing dangerous driving situations.
This has, in turn, led to significant direct costs relating to the product recall, as well as claims for
damages and compensation (expected to be several billions), and reputational damage (external
failure costs) (Gagliardi 2010).
The categorisation of quality costs into prevention, appraisal, internal failure and external failure
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is not without some difficulty. For example, assume that HPD has three types of appraisal activity:
1. initial appraisal of potential suppliers in terms of their ability to deliver raw materials and
components at or above quality specifications;
2. appraisal of raw materials and components delivered by a supplier who has not been
certified as being quality assured; and
3. appraisal of work-in-progress and finished products as a result of plant and equipment and
machine operators not always being able to manufacture to exact product specifications.
Clearly, the initial supplier quality accreditation (1) falls into the prevention classification of quality
costs, as the desired outcome is to ensure that only those suppliers who will deliver raw materials
and components meeting HPD’s requirements will be selected. The inspection of inbound raw
materials and components (2) is an appraisal cost, since it is intended to detect and remove
defective materials and components before they are issued to production.
The inspection of work-in-progress and finished products (3) is less clear-cut. This activity and
cost occurs during production, but it could be considered to fall into either the appraisal cost
or internal failure cost category. The typical classification of this quality cost is by its nature,
rather than by its place within the product life cycle (i.e. it is an appraisal rather than an internal
failure cost). However, it could be argued that the need to inspect work-in-progress and finished
products is attributable to HPD’s inability to have manufacturing equipment and operators always
achieve desired product specifications, meaning that this type of appraisal activity could be an
internal failure quality cost.
428 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Typically, reworking defective products would be classified as an internal failure cost. Furthermore,
since rework costs are additional costs incurred to bring a defective product up to a predetermined
commercially acceptable level (e.g. to factory ‘seconds’ standard), and customers are not prepared
to pay for rectifying production errors, the rework costs would be viewed as being non-value
adding. This is from the viewpoint that they should not have been incurred in the first place.
Keep in mind that while we say rework is not considered to be value-adding, it may still be
worth doing in some cases. This is because the organisation may recover more money than
the cost of rework from the proceeds realised from the sale of the reworked product.
1. Totally scrap the defective unit at a cost of $10. If HPD decided to scrap all defective FC101 food
processors, then, in addition to the costs incurred to date in manufacturing the defective units,
a further $10 per unit would need to be added to calculate the total wastage cost.
2. Scrap the defective unit and recover re-usable materials and components at a cost of $25 per unit.
The recovered materials and components have an economic value of $18 per unit. If the re-usable
materials and components are recovered and the defective unit scrapped, the total wastage
cost would be $3 lower than if the unit was totally scrapped. This is because there is a net cost of
$7 per unit realised from the decision to recover the re-usable materials and components from
the scrapped defective unit (i.e. $18 of economic value recovered – $25 cost of recovery and
eventual scrapping).
3. Rework and repackage the defective unit at a cost of $40 per unit so that it can be sold as a factory
‘second’ to a discount electrical retailer for $70 per unit.
While the option to rework and repackage a defective FC101 model food processor results in the
highest rework cost of $40 per unit, it also provides HPD with a product that it can sell for $70 per
unit. In this situation, the rework is still not regarded as a value-adding activity, because it should
never have occurred. However, it is still a best option as it generates a net economic benefit of
$30 (i.e. $70 for factory seconds – $40 rework and repackaging costs).
According to Shank and Govindarajan (1994), a useful ‘rule of thumb’ for assessing the interaction
between the four categories of quality costs is that a $1 expenditure spent on prevention activities
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saves $10 in appraisal and internal and external failure costs. Similarly, it may be expected that
increased expenditure on appraisal activities will result in a shift in costs to internal failure from
external failure costs (i.e. increase the cost of scrap and reworked units and decrease customer
returns and warranty claims). The fundamental message from these studies is that managers
should invest their quality dollars in prevention and appraisal activities so that failure costs are
decreased and customer satisfaction is enhanced.
Table 4.45 shows the changes that will occur in the manufacturing activities undertaken and costs
incurred as a result of the total quality management recommendations.
Study guide | 429
Rework of prototypes $0 $0
Rework patterns $0 $0
Production costs
Direct materials
Direct materials invoice costs $7 725 000 $8 265 900
Direct labour
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On-the-job inspection activity $0 $0
After-sales service
†
As a result of better quality materials being acquired and used in the manufacture of the Solarheat 1,
a higher direct materials cost is forecast to be incurred. While it might be expected that the absolute
dollar value of supplier-related costs should not increase, particularly given the total quality focus
of the initiatives being implemented, it is assumed that the supplier cost ratio for ElectricalPartz
of 14.93 per cent is still relevant. Thus, forecast supplier-related costs are $1 234 100, rounded up
(i.e. $8 265 900 × 14.93%).
➤➤Tasks
As leader of the cross-functional team, you need to provide information to Martin Emmitt
regarding the TQM initiative:
(a) Calculate the target and expected costs per unit of the Solarheat 1, if HPD is able to lift the
selling price to an average of $870 per unit. Also, write a paragraph to include in your report
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to Martin Emmitt that outlines whether HPD managed to achieve the target cost per unit for
the Solarheat 1.
Table 4.46: A
verage selling price, target and expected costs per unit after
implementing the TQM initiative for the Solarheat 1
Details Amounts
Price increase per unit due to improved product quality: TQM initiative $
Expected average cost below (above) the target average cost per unit ($)
Study guide | 431
(b) Quality is often perceived as an important characteristic desired by the purchasers of electronic
products such as cordless telephones. Ken Lee, the quality engineer for HPD, was so persuaded
by the perceived importance of product quality that he made the following comment: ‘Quality
goals are always superior to the profit maximisation objective’. Critically evaluate Ken’s
comment. Do you believe that Ken has identified the correct relationship between quality
goals and the profit-maximisation objective? Write a short explanation outlining your views.
(c) Write an explanation for Martin that identifies and briefly explains two financial measures
and two non-financial measures that could be used to assess the success of the total quality
improvements your team has proposed.
It is important to note that an investment in upstream quality initiatives, such as the redesign to a
defect-free production system or employee training and development, may not yield immediate
improvements in downstream quality costs. In the short term, total quality costs may increase
before the improvements from the TQM initiative are realised and the quality costs of appraisal
and internal and external failures decline.
Outsourcing and offshoring are also covered in the ‘Contemporary Business Issues’ subject of
the CPA Program.
In offshoring, the company moves some of its activities to subsidiaries in overseas locations where
labour costs are lower than those prevailing in the company’s domestic market. By locating such
facilities offshore, the company seeks to obtain the economic benefit of reduced operating costs
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that may be derived from such things as economies of scale or differences in resource costs
that would not be available if the good or service were to be procured from a domestic source.
Furthermore, some companies not only choose to procure from overseas but also to outsource
this activity to specialist external suppliers.
In deciding to outsource, a main consideration is cost. Many organisations fail in their outsourcing
programs because they are unable to follow up with effective internal cost reduction strategies
that deliver the expected cost savings. Care must also be exercised in assessing the long-run
supply cost of external service provision, as life cycle costs for the outsourced function might
end up being greater than if the function had been retained in-house. For example, costs typically
increase as an organisation becomes more dependent on outside suppliers.
Decisions about the source of goods or services will not only be influenced by the relative costs
of internal versus external supply, but also by differences in the level of quality, on-time delivery
and after-sales service provided. The organisation also needs to consider its capacity to manage
outsourcing contracts, as well as the loss of business critical knowledge that may take place once
a decision to outsource is implemented.
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Inevitably, there are also labour-related issues that arise with outsourcing. Apart from the
displacement of employees and the potential for industrial action, there can also be an adverse
impact on the morale of remaining employees. Unless the labour-related consequences of a
decision to outsource are thoroughly examined and dealt with to the satisfaction of all parties,
the forecast cost savings may fail to materialise.
Offshoring presents its own unique costs and benefits. Many of the potential risks with
international suppliers have already been discussed, including longer supply chains and
other international trade risks. These factors introduce additional costs and make it difficult
for organisations to respond quickly to changes in their product markets or the competitive
environment.
Another factor that influences the outsourcing decision is the strategic importance of the
function that is to be outsourced. Figure 4.12 illustrates the types of activities or functions that
may be the subject of an outsourcing decision where factors, other than cost, may influence
the decision.
Strategic
Never outsource
direction
Rarely is the information required to make the outsourcing decision available from existing
strategic management accounting reports. While the total cost of providing goods or services
internally may be estimated with some accuracy, the costs that will be avoided with the decision
to outsource are less clear. The presence of unavoidable fixed costs (e.g. administrative overheads)
or other costs that must be met following a decision to outsource (e.g. employee redundancies
or redeployment) can often be underestimated and lead to an incorrect decision being made.
Study guide | 433
Similarly, the decision to outsource may provide benefits to the organisation in the form of
freeing up scarce resources formerly used for internal supply. The opportunity cost of these
alternative uses of the resources is also rarely known, nor can they be reliably quantified.
Further, if information about the supplier’s environmental and social performance is important,
this can be difficult to obtain and the organisation may have to rely on data that is incomplete
or not independently verified.
Once the decision has been made to outsource, the organisation must identify the criteria it will:
• initially use in selecting the external provider; and
• subsequently use in monitoring the external supplier’s delivery performance.
Apart from a typical financial performance measure such as cost, performance indicators may
include the percentage of services not supplied to specification, services supplied late or the
time taken to respond to a dispute. Wherever possible, these performance measures might be
supplemented with data about the broader environmental and social impact of the supplier.
Both financial and non-financial performance measures will provide managers with an indication
of how successful the outsourcing decision has been. These measures are typically in the form of
a service-level agreement (SLA). Through SLAs, both parties document what is expected of each
other and identify the measures that will be used to monitor the performance of both parties in
meeting those expectations.
The decision to use outside vendors for the supply of goods and services is said to provide many
benefits. In summary, the main benefits derived from outsourcing can be:
• cost reduction;
• reduction in the use of assets;
• increased expertise;
• access to resources;
• greater flexibility; and
• opportunity to focus on managing core activities.
While outsourcing may provide a wide range of strategically significant benefits, outsourcing also
has disadvantages, including:
• increase in long-run operating costs;
• loss of specialised skills and knowledge;
• dependence on third parties;
MODULE 4
• risk of security breaches; and
• quality problems.
In many respects, the problems that outsourcing can create may have more to do with the way
outsourcing decisions are initially evaluated and then negotiated, rather than be intrinsic to the
use of external suppliers. Contract management, project management and supplier management
skills are critical.
➤➤Tasks
(a) Martin Emmitt has asked you to determine the financial effect of moving the distribution of
the Solarheat 1 to Supersonic on the life cycle cost per unit of the product.
Table 4.47: A
verage expected costs per unit resulting from outsourcing the
Solarheat 1 distribution to Supersonic
Details Amounts
Expected average cost per unit after implementation of cross-functional team’s lean $615.00
manufacturing and TQM initiative
Expected average cost below (above) the target average cost per unit $
(b) From a purely financial perspective, should HPD recommend that the Solarheat 1 product
line be manufactured? What qualitative issues should be considered before accepting the
outsourcing proposal? Does this influence or change your recommendation as to whether
HPD should manufacture the Solarheat 1?
(c) HZ senior management are contemplating forcing HPD to use the services of the organisation’s
freight division for distributing the Solarheat 1 at any cost. Prepare some notes for
Martin Emmitt, outlining how HPD should respond to a potential ultimatum from senior
management not to outsource the distribution of the Solarheat 1 to Supersonic.
(d) Assume that your recommendation to outsource the distribution of all HPD’s product lines
to Supersonic was accepted. Write a response for Martin Emmitt that identifies and briefly
explains two financial and two non-financial measures that he could incorporate into the
contract for monitoring the performance of Supersonic.
Downstream activities:
MODULE 4
Customer profitability analysis
ABC was initially used as a tool to help organisations better understand cost behaviour and
provide more reliable product-related cost data through the better treatment of indirect costs.
Now ABC, through its focus on activities, is fundamental across a range of organisational
information needs. This includes customer-profitability analysis, which shifts the focus from the
usual cost object of products or services to customers or groups of customers. Managers often
need cost data on specific customers or classes of customers, suppliers, distribution channels or
product families. An ABC system can be designed to meet any of these costing needs.
While customer service has become a key tool for enhancing an organisation’s competitive
position as it battles for sales volume and profit margins, it comes at a cost. In seeking to satisfy
customers, an organisation may overlook whether it is actually profiting from the business it does
with a particular customer or group of customers. It may be that only a small group of customers
contributes the greatest proportion of profits, effectively subsidising a large number of marginal
or unprofitable customers.
Traditionally, we have limited revenue analysis to customer gross margins (sales less cost of
goods sold). The profitability of an individual customer is not only influenced by the gross
margin realised on the sales made, but also on the magnitude of the other costs associated
with the provision of customer service. We need to focus on the net margin earned. This is
the net price (gross selling price less all sales discounts and other allowances) minus the cost
of the goods supplied and all other customer-related costs.
MODULE 4
field-based sales force to market the organisation’s products and services.
• After-sales service—Some customers may require more ongoing service support.
• Product mix—For the supplier of multiple products, there is likely to be a significant variation
in the cost of purchasing, manufacturing, storing and shipping the organisation’s products.
Thus, the mix of products purchased by each customer influences the total cost of supply
and overall customer profit margins.
• Marketing approach—Some customers may require an intensive marketing effort,
whereas others buy the product simply on the basis of quality and price.
• Order processing—Customer characteristics such as inventory holding and reorder policies
affect customer order-taking and processing costs.
• Quality—The costs of quality control can vary between customers, as some customers
may demand higher quality than others.
• Delivery—Variations in order type and size, and in delivery locations can affect the costs
of delivery.
• Promotions and discounts—Some customers may need more intensive customer-
relationship activities than others.
• Financing—Some customers may demand more liberal credit policies than others.
436 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Adopting an ABC approach and systematically allocating customer-related costs will enable
a more accurate analysis to be obtained of the costs the organisation incurs in servicing
each customer. Figure 4.13 illustrates how ABC supports customer-profitability analysis.
As in ABC for products, customer-related costs can relate to a number of different categories.
These could be volume based (i.e. related to the volume of sales) or non-volume related cost
drivers. For example, a cost driver could be the number of orders placed (regardless of the size
of each order).
An organisation may not be able to assign some customer-related costs to individual customers
meaningfully because there is no clear cause–effect relationship between the cost being incurred
and the particular customer (e.g. sales administration salaries and overheads). Apart from having
no plausible cause–effect relationship, most of these costs are likely to be fixed in the short term
and are unlikely to change with the addition of new customers or the loss of old customers.
Is customer profitable?
Improve customer
profit margins by
MODULE 4
Increasing revenues
Classify, analyse and Cost reduction strategies
allocate customer costs. (e.g. fewer orders and
ABC approach? larger order sizes)
Table 4.48 provides a summary of where differences can arise in the cost of servicing individual
customers. The objective of customer-profitability analysis is to relate these cost differences to
individual customers. Managers can use this information to check whether certain customers are
too costly to sell to and should be abandoned, and to assess whether strategies for reducing
costs or improving revenues can improve the profitability of a customer.
MODULE 4
Source: CPA Australia 2015.
Analysing the relationship between the net margin earned from sales and customer-service costs
enables the organisation to obtain an understanding of the profitability of customers and identify
strategies for increasing the level of profits made. Figure 4.14 examines the four-way relationship
between the net margin earned from sales and customer-service costs.
438 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Figure 4.14: Interaction between customer net margin and cost to serve
Customer type
Profits
High Passive Costly to service
• Product crucial to customer • Pay top prices
• Good match to supplier
A B
Net margin
realised Inexpensive to service Aggressive
• Price sensitive • Customer leverages buying power
• Few special • Low price and highly customised
demands specifications
C D
Low
Low High
Cost to serve Losses
The dashed diagonal line indicates the demarcation between the more profitable customers
and the less profitable (or loss-making) customers. Ideally, an organisation would like all
customers to fall in quadrant A where each sale results in a high net margin but requires low
customer-service costs. Unfortunately, these types of customers are rare and susceptible
to being poached by competitors. If an organisation has customers exhibiting this type of
net-margin and customer-service cost profile, it should ensure they receive priority service
and appropriate incentives (e.g. modest discounts) or other inducements (e.g. hospitality at
major sporting and cultural events) to retain their loyalty and continued patronage. Of course,
these efforts will increase customer-related costs, so it needs careful management.
Many organisations have customers who fall in quadrant D, where the customer generates
low net margins, yet demands a high level of customer service.
MODULE 4
The low margins may arise from the customer requiring products that have to be:
• manufactured to the customer’s specifications;
• in small production batch sizes; and
• in shorter production cycle times.
Some customers are relentless in pushing for lower prices. They may also require suppliers
to make substantial investments in new technology to service their needs. In this latter case,
customer profitability analysis needs to focus on the long-term costs and benefits of the
relationship. Some large retail organisations are famous for this type of behaviour.
Study guide | 439
In each case, it is important to ensure that the net margin achieved aligns with the characteristics
of the product supplied (e.g. a standard versus a customised product) and the service-level
requirements of the customer (e.g. pre- and post-sale support). In this situation, an organisation
may adopt a menu-based pricing policy where the price of the product supplied is influenced by
both product characteristics and customers’ service-level requirements.
If an organisation knows how much it costs to serve each customer, it can become more
discriminating in the customers it chooses and then focus on its most profitable customers.
But should an organisation view its unprofitable customers in a totally negative light?
Kaplan (1992) notes that an organisation may retain currently unprofitable customers for
one of three reasons:
1. new and growing customers who are currently loss-making may be retained as they could
provide profitable business in the future, or they currently help enter new but eventually
lucrative markets;
2. customers who provide qualitative rather than financial benefits may be worthy of being
retained. An unprofitable customer may possess strengths (e.g. being at the leading edge
of technology or marketing). By maintaining the relationship with the unprofitable customer,
an organisation may draw on these strengths to the benefit of its relationships with other
customers who are profitable; and
3. association with highly reputable but unprofitable customers provides the credibility to do
business with other profitable customers.
MODULE 4
With an appropriate strategy, existing unprofitable customers may become an organisation’s
greatest source of future profitability. It can be easier and cheaper to convert an existing
unprofitable customer into a profitable one than it is to secure new profitable customers.
Unlike the planned Solarheat 1 product range, Martin knows that HPD has an extensive set of financial
and non-financial data for the division’s existing food processors product range. Although these data
are available for the last five years, Martin decides that he will confine his analysis to the data for the
latest year ending 31 December. In doing so, he hopes to ensure that he accounts for any seasonal
influences that may affect the analysis of customer-segment profitability.
For many years, HPD has used the gross margin percentage as the measure of the profitability of the
different customer segments. The gross margin percentage is calculated as:
(Sales revenue – Cost of sales) / Sales revenue.
Sally Greene, HPD’s assistant management accountant, reports the following data for the latest year
ending 31 December:
Table 4.49: R
evenues and costs of sales by customer segment for HPD’s small
household product range
Total sales revenue $15 000 000 $3 000 000 $1 200 000
Total cost of sales $12 000 000 $2 100 000 $720 000
After extensive discussions, Sally and the other HPD managers agree that there are five key activity
areas performed by HPD in serving the three different customer segments. The following table
details each cost pool and the relevant driver anticipated to provide the best measure of the total
cost behaviour for that item.
MODULE 4
Each order placed consists of one or more food processor product line items. A line item represents a
single product (e.g. FC101 or FC202). Each delivery requires one or more cartons or pallets of product
to be sent to each customer. Each delivery of cartons or pallets may involve separate packaging
(i.e. smaller cartons) for individual product lines ordered by the customer. Each customer receives a
certain level of customer-relations activity. However, over 60 per cent of the customer-support activity
is directed to the nationwide retailers.
The total indirect service costs (i.e. excluding the cost of sales) for the latest year ending 31 December
amount to $1 380 000. The division of this cost into the five cost pools and the transactions carried
out in each pool are shown in Table 4.51.
Table 4.51: A
BC customer service indirect cost pools, costs and cost
driver transactions
The number of transactions in each cost pool by the three types of customers during the latest year
ending 31 December is shown in Table 4.52.
Table 4.52: T
ransaction data for each customer service indirect cost pool and
customer market segment
MODULE 4
2. Average number of line items per order 20 15 6
3. Total line items ordered (1) × (2) 12 000 13 500 27 000 52 500
➤➤Tasks
Martin Emmitt has asked you to provide information to management to help make decisions
regarding customer profitability.
(a) Calculate the gross margin for each customer market segment and confirm each segment’s
gross margin percentage.
Table 4.53: A
verage gross margin percentage in the year ending 31 December for
each customer segment
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
% % % 22.81%
(b) Determine the pool rate for each of the five cost pools.
Table 4.54: ABC costs per transaction for customer service indirect cost pools
2. Line item ordering $210 000 line items $ per line item
(c) Determine the total customer-service costs for each of the three market segments.
Nationwide retailers Statewide retailers Small local retailers
Cost
driver Number Customer Number Customer Number Customer
tran- of cost service of cost service of cost service
Table 4.55: C
2. Line item ordering $4.00 12 000 $ 10.6% 13 500 $ 25.7% 27 000 $ 15.0%
MODULE 4
444 | TECHNIQUES FOR CREATING AND MANAGING VALUE
(d) Determine the most profitable market segment in dollars and by net margin. Compare the
results to those in task (a) above and comment on any findings.
Table 4.56: R
evised net margin calculations for HPD’s food processors
customer segments
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Customer service indirect costs ($450 000) ($210 000) ($720 000) ($1 380 000)
Net margin $2 550 000 $690 000 ($240 000) $3 000 000
% % % 15.63%
(e) Identify and describe at least two major problems that would confront Sally in allocating the
customer-service costs to the activity areas and customer segments.
electrical retailer market segment may reveal quite adequate returns being generated from sales
made to some individual electrical retailers.
Sally, the assistant management accountant for HPD, decides to use the ABC data to further examine the
profitability of individual customers in the small local electrical retailer market segment. Sally randomly
selects two small electrical retailers (Mini-Electrical and Home Appliances). The following data for these
two customers for the year ending 31 December is extracted from HPD’s sales database.
Study guide | 445
Table 4.57: A
BC customer service indirect cost pools and cost driver transactions,
sales revenue and cost of goods sold for Mini-Electrical and
Home Appliances
Sally then decides to complete the customer-profitability analysis for all individual customers within
the small local electrical retailer market segment and ranks those customers on the basis of their dollar
contribution to the division’s profit. The cumulative net margin for the top 20 per cent of the local
electrical retailer market segment for the year ending 31 December is a profit of $180 000.
➤➤Tasks
After seeing the customer profitability information, Martin Emmitt has asked for further
information.
(a) Calculate the total line items, total cartons/pallets and gross margin.
Table 4.58: C
ustomer service transaction data for each customer service indirect
cost pool for Mini-Electrical and Home Appliances
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1. Total orders processed 45 30
4. Total deliveries 30 30
Table 4.59: Customer service indirect costs for Mini-Electrical and Home Appliances
3. Distribution $100.00 30 $ 30 $
Total costs $ $
(c) Calculate the profitability of the two local retailers. Comment on your findings.
Table 4.60: Net margin calculations for Mini-Electrical and Home Appliances
Gross margin $ $
% (%)
(d) Identify and describe two strategies that could be recommended to HPD for managing its
relationship with individual customers.
MODULE 4
Customer-profitability analysis has disadvantages that are primarily attributable to the problems
of allocating certain types of customer support costs, including:
• the allocation of common costs (e.g. advertising) is arbitrary. While an advertising campaign
might be intended to attract new customers, it may also have a positive impact on the
amount of business that existing customers do with the organisation. To allocate all
advertising campaign costs to new customers would appear unreasonable. Similarly,
advertising specific products may have flow-on effects for other products; and
• the treatment of unavoidable or committed costs (e.g. a sales manager’s salary) as not
being attributable to any particular customer ignores the need for these costs to be
recovered from all sales made.
Study guide | 447
In many industries, the main driver of business value can be the retention of the existing
customer base. Studies of banks and other financial institutions by A. T. Kearney—see Green
and Hutchins-Ball (2005) and Kearney (2005)—have shown that keeping and increasing the
value of the existing customer base can represent up to 75 per cent of the financial institution’s
shareholder value. Shifting the delivery of financial services to the internet and developing
customer-loyalty programs are some of the strategies that financial institutions have used to
bolster their customer relationships.
MODULE 4
448 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Review
In Module 4 we focused on how an organisation can manage its value chain more effectively.
For superior performance to be created in an organisation’s value chain, managers must have
access to information about internal value chain activities and also their suppliers and customers.
With this greater understanding, opportunities for reconfiguring and improving value chain
activities can be identified, analysed and then implemented.
The management accountant provides information to support the strategic decisions that
managers must make about their organisation’s value chain. The issues discussed in this
module are summarised below.
• For managers to effectively develop and manage the competitive position that their
organisation’s value chain provides, they must have a sound understanding of the business
model that underlies their value chain. In particular, managers must identify and effectively
manage those core competencies or capabilities that provide their organisation with its
unique sustainable competitive advantage.
• The case study covered the practical application of the following strategic management
accounting concepts and tools.
–– Two forms of activity analysis—activity-based management (ABM) and activity-based
costing (ABC)—help to develop organisational understanding about the sequencing
and cost of value chain activities, and to develop targeted strategies for improving the
performance of the value chain.
–– Strategies for improving the performance of an organisation’s value chain can involve
either the major re-design of value chain activities (business process management)
or fine-tuning of existing activities (continuous improvement).
–– Understanding the behaviour of product life cycle costs is important for determining
when and where the most significant cost-reducing strategies occur. Greater opportunities
for achieving better cost performance typically exist within pre-production activities.
–– Target costing assumes selling prices for new products are set by the market and to
achieve desired profit margins, product costs must be incurred at or below a target cost.
–– Kaizen costing provides the focus for achieving in-production cost improvements and
can be very beneficial in ensuring that standard cost targets are continually challenged.
–– Where it is operationally and economically feasible for non-value-adding activities to be
eliminated, an organisation may be able to reduce its total value chain costs.
–– In knowing the nature and magnitude of supplier-related costs, managers can identify
MODULE 4
and evaluate different strategies for obtaining required inputs at a lower overall cost.
–– Outsourcing examines the relative costs and benefits of using an external supplier to
provide goods or services instead of creating them internally. It also assists in identifying
those few critical competencies that must be retained and effectively managed.
–– Knowing where the organisation spends its resources on quality can be important
to delivering not only better-quality products but also improved cost-performance
outcomes. By having information about where the costs of quality are incurred
(i.e. in the categories of prevention, appraisal, internal failure and external failure),
an organisation is able to identify and implement those total quality management
initiatives that are likely to achieve improved strategic outcomes (e.g. greater
customer satisfaction and/or lower product cost).
–– Customer-profitability analysis measures the profit or loss from each customer or
customer segment and identifies the various customer-related activities that have
a significant impact on the net margin of each sale. It also guides the selection of
strategies that ensure profitable customers are retained and unprofitable customers
are managed in a manner consistent with the long-term goals of the organisation.
Figure 4.15 shows how these strategic cost management tools can be related to one another.
Study guide | 449
Figure 4.15: L
ife cycle, activity-based, target and kaizen costing and customer-
profitability analysis
Stages in product
life-cycle costs
Kaizen costing
Standard costing and Improving cost
to achieve
variance analysis performance?
cost improvements
In this module, we have seen the contribution that each of these strategic management accounting
concepts and tools can make to improving the performance of an organisation’s value chain.
The overall objective of this module has been to demonstrate how strategic management
accounting helps an organisation to manage its competitive position and ensure that value
is continually created from its activities.
MODULE 4
MODULE 4
Suggested answers | 451
Suggested answers
Suggested answers
MODULE 4
Total DLHs for the food processor product line 27 000
Table SA4.3: Total manufactured cost per unit for each product line
Table SA4.4: Indirect manufacturing cost rates for HPD’s food processor product
line using ABC
Cost pool 3—production scheduling and other set-up costs $120 000
FC101 50
FC202 150
FC303 200
Total production scheduling and other set-up related costs / $120 000
Total budgeted production runs 400 production runs
Production scheduling and other set-up cost pool rate $300.00 per production run
FC101 90
FC202 260
FC303 350
(b)
Table SA4.5: Indirect manufacturing cost per unit for each product line using ABC
FC101
Number of Indirect
MODULE 4
Cost pools Cost pool rates cost drivers manufacturing cost %
FC202
Number of Indirect
Cost pools Cost pool rates cost drivers manufacturing cost %
FC303
Number of Indirect
Cost pools Cost pool rates cost drivers manufacturing cost %
Table SA4.6: Cost pool consumption percentages across the HPD FC product series
The FC101 food processor consumes 74 per cent of the number of DLHs and 40 per cent
of machinery- related activities, but it only uses 12.50 per cent of production scheduling
and set-up activities, and 12.86 per cent of materials handling activities.
The labour-related cost pool is only 33.33 per cent of the total budgeted overhead costs
(i.e. $270 000 / $810 000) (see Table 4.10). The FC101 food processor would therefore be
allocated a significantly disproportionate share of the total indirect manufacturing costs
where DLHs are used as the sole basis for allocating overhead to the three product lines.
On the other hand, the FC303 is less intensive in its consumption of labour-related activities
(9.26%), yet is a more intensive consumer of machinery-related activities (24%), production
scheduling and set-up activities (50%) and materials handling activities (50%). Thus,
where indirect manufacturing costs are allocated on the basis of DLHs, the FC303 model
will be significantly under-costed.
The indirect manufacturing costs for the FC303 have increased from $37.50 to $102.00
MODULE 4
(see Table SA4.5) by using ABC. This increase in costs allocated to the FC303 reflects:
–– capital intensive production requirements relative to the other two products. The FC303
is absorbing a greater amount of machine costs than it was previously allocated;
–– that it is a low-volume product with short production runs. Thus, it is receiving a greater
allocation of production scheduling costs; and
–– that being a low-volume product with a large number of materials movements, it is
receiving a greater allocation of materials handling costs.
In light of the greater allocation of indirect manufacturing costs to the FC303 model and the
small production volume relative to the other two food processor product lines, these costs
are being spread over a smaller number of units and result in a significant increase in indirect
manufacturing costs per unit.
456 | TECHNIQUES FOR CREATING AND MANAGING VALUE
This has been clearly demonstrated in relation to the FC range of products. If the same issues
were shown to exist for other HPD product lines, then an ABC system may be much more
appropriate for obtaining product costings.
(d)
Table SA4.7: C
omparison of budgeted profit margins for the FC101 using the
traditional and ABC product costing systems
Based on the information given, BigShop appears to be able to buy an equivalent product
to the FC101 from overseas suppliers at 15 per cent less than $180.00, which is a cost of
$153.00 per unit (i.e. $180.00 × (1 – 15%)). This is 85 per cent of HPD’s standard wholesale
price of $180.00 per unit. This appears to be lower than the $155.00 cost that HPD can
make the product, based on the traditional product costing approach. Based on this
data, William’s suspicion that overseas suppliers are dumping their spare capacity on the
Australasian market at less than full cost appears to have some merit.
However, the more accurate ABC product-costing approach indicates that the budgeted
manufactured cost of the FC101 model is only $131.40 per unit and the anticipated profit
margin with a standard wholesale price of $180.00 per unit is really $48.60 and not the
previously assumed $25.00 per unit.
Suggested answers | 457
If HPD’s management team was prepared to drop the wholesale price of the FC101 to,
say, $150.00 per unit—a profit margin of $18.60 based on the ABC system (i.e. $150.00
– $131.40)—not only might it win back the business it has lost with BigShop, but it
might also retain other retailers who perhaps have contemplated a switch to equivalent
imported food processors. HPD’s profits would be expected to increase as a result
of the greater number of units manufactured and sold.
Typically, where a product is of high complexity and low-production volume, such as the
FC303, it can be an intensive consumer of indirect manufacturing activities. The opposite
low-complexity, high-volume products, such as the FC101, tend to use fewer indirect
manufacturing activities. A volume-based, indirect-manufacturing, cost allocation model
(e.g. direct labour hours) would tend to under-allocate indirect manufacturing costs
to the highly complex but low production-volume FC303 and over-allocate indirect
manufacturing costs to the low-complexity but high-production-volume FC101. The result
of such misallocations is typically a severe under-costing of high-complexity, low-volume
products and a small over-costing of low-complexity, high-volume products.
Where a product is under- or over-costed (actual cost is different from the amount shown
in the accounts), managers may make decisions that adversely affect the organisation’s
competitive position. For example, where products are under-costed, managers may set
MODULE 4
selling prices that are too low to recover the ‘true’ cost of manufacturing and supporting
each product. In this case, the organisation will lose money on every unit sold, even though
the accounting system shows that the product is being sold at a profit. On the other hand,
where a product, such as the FC101, is over-costed, managers may set selling prices that
are too high for current market conditions and, so, lose market share because competitors
may easily underbid the price. As volumes start to fall, an over-costed product may appear
to become even more expensive to produce and managers might cease production of
that product.
Activity-based costing (ABC) is a potential solution to the under- and over-costing problem
faced by HPD. The introduction of ABC on the allocation of indirect manufacturing costs
for all HPD product lines will help ensure that low-volume, high-complex products are not
under-costed, and that high-volume low-complexity products are not over-costed.
458 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Less: Time spent by materials handling personnel in professional development, (104 000)
training activities, staff meetings and similar events
Budgeted total practical capacity (or productive time) in minutes 1 000 000 minutes
Total budgeted costs of the materials handling function to be allocated $1 504 000
Total budgeted costs to be allocated / Budgeted total practical capacity $1 504 000 / 1 000 000
TDABC cost rate per minute (rounded to three decimal places) $1.504
(b)
Table SA4.9: Budgeted costs and unused capacity for the materials handling function
Total practical capacity and costs 1 000 000 $1.504 $1 504 000
(Table SA4.8)
The planned usage time for the four materials handling tasks is 950 000 minutes out of a total
practical capacity level of 1 000 000 minutes, indicating 50 000 minutes of unused or idle
capacity. This unused capacity has a cost of $75 200.
By highlighting both the time and dollar value of the difference between available capacity
and the capacity that is planned to be used, Kaplan and Anderson (2007, p. 12) suggest that
the TDABC approach will encourage managers to explore options for reducing the cost of
supplying unused resources or allocating these to more productive uses.
Suggested answers | 459
(c)
Table SA4.10: Budgeted time for the materials handling activity for the FC303
The total time required for the materials-handling activity for the FC303 is 17 700 minutes.
Notice that all 200 transactions for sourcing for production are regarded as a complex
activity for FC303. This means that all 200 transactions will require 15 minutes of standard
time (3000 minutes) with an additional 10 minutes of variation (complex) time (2000 minutes)
to complete the activity, for a total of 25 minutes each (5000 minutes in total).
The same situation has also occurred in the fourth materials-handling activity, production
movements. All 350 transactions require 15 minutes of standard time plus five minutes of
additional variation time.
(d)
Table SA4.11: B
udgeted materials handling costs allocated to the FC303 food
processor model
MODULE 4
Budgeted activity Cost rate
time (minutes) per minute Materials handling
Materials-handling activity (Table SA4.10) (Table SA4.8) costs allocated
(e) (i) The conventional ABC approach would allocate $35 000 in budgeted materials-handling
costs to the FC303. This amount was calculated in Table SA4.5 as 350 materials-handling
transactions multiplied by $100 per materials movement. This is equivalent to $17.50
per unit for the planned production of 2000 units (i.e. $35 000 / 2000).
460 | TECHNIQUES FOR CREATING AND MANAGING VALUE
(ii) The budgeted materials-handling costs that would be allocated by the TDABC
approach to the FC303 is $26 621. This amount was calculated in Table SA4.11 and
effectively represents 17 700 minutes (total across four activities) multiplied by $1.504
per minute. This is equivalent to $13.31 per unit for the planned production of 2000
units (i.e. $26 621 / 2000).
The difference of $8379 in the total allocated costs is explained by the fact that the ABC and
TDABC calculations use different assumptions. In the ABC calculation, the assumption is that
the cost is $100 per move and in the TDABC calculation the assumption is $1.504 per minute.
A key message is that TDABC only allocates used time, and separates out unused capacity
such that management can take appropriate action.
Table SA4.12: Expected average selling price per unit for the Solarheat 1 for sales
achieved over its five-year life
Total sales revenue Total units to be sold Average selling price per unit
(b)
Table SA4.13: Expected average total cost per unit for the Solarheat 1 for total
units manufactured over its five-year life
(c)
Table SA4.14: Target average total cost per unit of the Solarheat 1
Details Amounts
Less: The net profit margin expected per unit (30% × $800) ($240)
Expected average total cost per unit (from task (b)) $750
Expected average cost below (above) the target average cost per unit ($190)
(d) Martin is targeting activities that comprise the pre-production stage of HPD’s value chain
and would want to be provided with performance measures that reflect how well the
division has managed the activities related to R&D, concept development and product
launch. Financial measures include:
–– Comparisons of various revenue, expense and asset categories with historical
performance and with budget, including:
|| R&D spending (in total and by individual R&D project);
|| product concept development expenditures, including the cost of product
prototypes;
|| the cost of designing and testing alternative manufacturing processes and
technologies;
|| the potential capital cost of the production facilities for manufacturing the new
product; and
|| the proportion of sales revenue derived from new products.
–– Non-financial measures can also be compared to expectations. Examples include:
|| the time taken from R&D to concept development and to product launch;
|| the number of R&D projects currently, or projected to be, undertaken;
|| concept-development projects as a proportion of R&D projects;
|| product launches as a proportion of concept-development projects;
|| the number of new product launches compared to prior years or rival
organisations; and
|| the market share generated from new products.
Measures focusing on R&D activities show how committed HPD is to undertaking R&D.
For example, if HPD is spending more on R&D in absolute dollar terms and/or as a
percentage of sales revenue, this indicates a greater divisional commitment to innovation.
The number of product concept development projects or product launches indicates how
successful HPD has been in converting its innovation activities into commercially exploitable
products. Similarly, the time taken from R&D project initiation to product launch provides a
time-to-market measure of the success of innovation activities. Finally, the ultimate success of
HPD’s innovation activities might be reflected in the proportion of sales revenue generated
by new products or in the market share commanded by new product sales.
(e) Given that HPD is a late entrant to the renewable energy product market, it is highly likely
that it will need to undertake a target-costing exercise for the proposed Solarpower 2
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product line. As there are well-established and leading solar power systems already trading
in the markets likely to be served by HPD (e.g. Australasia), the division is likely to be a price
taker rather than a price maker. While HPD’s design of the Solarpower 2 will have some effect
on how efficient the solar power system will be and the dollar value of energy savings realised
by customers, the price it will be able to achieve will be strongly influenced by the prices
set by its competitors.
462 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Solarheat 1
indirect ABC indirect
manufacturing manufacturing
Costs pool Cost pool rate activities costs
Quality control $125 per inspection hour 3 000 hours $375 000
Repair and maintenance $200 per maintenance hour 2 400 hours $480 000
Hazardous waste disposal $50 per kilogram disposed 3 900 kilograms $195 000
Excess indirect manufacturing costs allocated to the Solarheat 1 product line $750 000
(ii) In comparison to ABC, the use of the traditional volume-based indirect manufacturing
cost allocation method using DLHs has over-allocated $750 000 to the Solarheat 1.
Based on 30 000 units, this over-allocation equates to $25 per unit.
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(iii) The original estimated cost per unit was $750 (see Table SA4.13). Each unit has been
over-costed by $25 ($750 000 / 30 000 units). Thus, the switch to ABC indicates that the
expected average total cost per unit should be decreased to $725 ($750 – $25).
If we refer to Table SA4.14, we see there was an original gap of $190 between the expected
average cost of $750 and the target average cost per unit of $560. Under ABC, this gap
will also fall by $25, from $190 to $165 (representing the difference between average total
cost of $725 per unit and target average cost per unit of $560).
Suggested answers | 463
Material moves will decrease from six to four per batch. This is 4/6 or 66.67 per cent of the
3600 original movements, which is 2400 moves. The reduction in material moves is therefore
1200, saving $300 000 (i.e. 1200 × $250 per move).
The indirect manufacturing cost reduction is therefore expected to be $900 000 (i.e. $600 000
+ $300 000). This $900 000 cost reduction can also be calculated as the total ABC costs
allocated under the functional layout ($2 400 000) less the cellular layout ($1 500 000) as per
Table SA4.16.
In addition to this, there will be a direct labour saving of $900 000 (i.e. 30 000 units × $30 per
unit). Note that the budget of 30 000 units is provided in Case Study 4.5.
The total cost reduction is therefore expected to be $1 800 000 (i.e. $900 000 + $900 000).
However, this will be offset by the cost of implementing the BPM initiative ($300 000), so the
net benefit is expected to be $1 500 000.
Because total costs will fall by a net amount of $1 500 000 or $50 per unit (i.e. $1 500 000 /
30 000 units) as a result of moving the Solarheat 1 manufacturing facility to a cellular layout,
you should proceed with the recommendation that HPD undertake the BPM exercise.
Table SA4.16: F
unctional versus cellular manufacturing layout for the Solarheat 1:
Indirect manufacturing cost allocations and savings in direct
labour costs
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Machine set-ups $500 per set-up 3 000 set-ups $1 500 000 1 800 set-ups $900 000
Materials moves $250 per move 3 600 moves $900 000 2 400 moves $600 000
Reduction in indirect manufacturing cost allocations ($2 400 000 – $1 500 000) $900 000
Add: Direct labour cost savings (30 000 units × $30 per unit) $900 000
Lower costs as a result of BPM initiative ($900 000 + $900 000) $1 800 000
Net benefit realised from BPM implementation ($1 800 000 – $300 000) $1 500 000
Net benefit realised from BPM implementation per unit ($1 500 000 / 30 000 units) $50 per unit
(b) (i) The original expected average cost of Solarheat 1 was $750 (see Table SA4.13). However,
in Case Study 4.6 we saw that the expected average cost of the Solarheat 1 had been
reduced to $725. This cost will now fall again by $50 per unit to $675 ($725 – $50).
(ii) In Case Study 4.6 we saw that the gap between the expected average cost and the
target average cost per unit for the Solarheat 1 had been reduced from $190 to $165.
This should now fall again by the $50 saving per unit to $115 ($165 – $50)—representing
the difference between average total cost of $675 per unit and target average cost per
unit of $560.
(c) The BPM initiative changes the layout of HPD’s manufacturing facility from a functional to a
cellular layout. Through achieving reductions in the number of machine set-ups and material
movements, the BPM initiative is intended to reduce the costs incurred for (or allocated to)
the Solarheat 1. Two financial measures that may be recommended are the:
–– delivery of the project within the cost budget of $300 000; and
–– set-up and movement-related costs for the Solarheat 1 to fall from $2 400 000 to
$1 500 000.
Martin would want to know that the BPM initiative was delivered on time and within budget.
Failure to achieve either of these BPM targets may weaken the financial benefits that the
initiative actually delivers. Similarly, Martin will want to know that what was promised in the
business case for the BPM initiative has actually been achieved. If planned improvements have
not eventuated, Martin may be able to take action that improves the post-implementation
performance of this particular initiative. He can also draw on the experience provided by this
project to improve the planning for and execution of subsequent BPM exercises.
While the BPM exercise is about how HPD hopes to improve the performance of its own
value chain, the value chain activities of HPD’s suppliers and customers may also be worthy
of examination.
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Value-adding activities—philosophy
When looking at whether an activity is value adding, we need to ask: ‘In an ideal world,
when planning or designing a value chain, would this activity need to happen?’ In practice,
it is hard to set a clear rule to categorise activities as either value adding or non-value adding.
There is likely to be a continuum where part of the activity is required and part can/should be
eliminated. Further, we may find that a non-value adding activity (e.g. warranties) costs less
in the short term than making changes and fixing activities in the value chain to ensure that
there are zero defects in the products produced. In such cases, with access to all available
information, we may decide not to eliminate the non-value adding activity because to do
so would be too costly (i.e. the cost outweighs the benefit).
Table SA4.17: Analysis of HPD’s activities: Value adding versus non-value adding
Value Non-value
Nature of activity or event adding adding Explanation
1. Designing a product This is necessary to create an item that has value to the customer.
2. Designing a manufacturing An efficient and effective manufacturing facility layout is a key to saving substantial costs during the production
facility layout time or manufacture of the product.
3. Commissioning of If there were no manufacturing facility, there would be nowhere to manufacture the product and no customer value
manufacturing facility would be generated.
4. Setting up production runs The setting up of production runs (e.g. machine set-ups) is usually required because the company manufactures
multiple products and has to switch machinery or components/inputs. Manufacturing facilities can be designed
for a particular product such that production-run set‑ups are not required (or are minimised), and so set-ups are
typically classified as non‑value adding.
5. Receiving raw materials and These activities need to take place in order to receive supplies. Without receipt of supplies, products could not be
components manufactured, and so inbound logistics are deemed to be value adding.
6. Inspecting incoming raw This is needed because of potential quality failures by suppliers, but it does not generate customer value.
materials and components
7. Returning materials and Customers will not pay a premium for the errors made by suppliers.
components to suppliers
8. Storing raw materials and This does not transform or change the materials, so does not increase value for customers.
components
9. Processing product This activity transforms raw materials into a product for which the customer is willing to pay.
10. Incomplete products waiting This does not transform or change the materials, so it does not increase value for customers.
for further processing
11. Moving product through the This does not transform or change the materials, so it does not increase value for customers.
production facility
12. Inspecting incomplete This is needed because of potential quality failures in an activity performed earlier in the value chain and therefore
products during processing does not add value.
Suggested answers |
465
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466
Value Non-value
Nature of activity or event adding adding Explanation
13. Reworking product This is done because of a quality failure in an activity performed earlier in the value chain. Customers will not pay a
premium for the errors made in the production process.
14. Inspecting completed This is needed because of potential quality failures in an activity performed earlier in the value chain.
product
15. Storing inspected product This does not transform or change the materials, so it does not increase value for customers.
16. Delivering product to The customer will often pay an additional amount for this, indicating its value. Alternatively, this value is included in
customers the price of the product.
17. Receiving and handling While it might appear that helping a customer with a warranty claim is adding value (because not doing it would
warranty claims annoy them and therefore not add value), this is not what the concept is about. The philosophy of value-added
analysis suggests that if you have a warranty claim, then you have had an external failure whereby the product or
service was faulty or defective and this fault or defect was experienced by the customer.
| TECHNIQUES FOR CREATING AND MANAGING VALUE
Making a faulty or defective product does not add value and so should be avoided. By eliminating all faulty or
defective products you could eliminate warranty claims and customer complaints. From this perspective, trying
to fix or address warranty claims or customer complaints is non-value adding. Even though this service will be
necessary to keep customers satisfied, we still do not call this value-added. This is because the customer would
prefer to have a working product or satisfactory service delivery, and never have a warranty claim or complaint in
the first place.
There are limited circumstances where the provision of warranties may challenge the above explanation:
• At the point that a product is found to be faulty, a warranty service makes the customer experience more
pleasant. However, this can be regarded as ‘making the best of a bad situation’ rather than being value adding
itself.
• The incremental cost of achieving 100 per cent product performance may be such that it exceeds the
incremental benefit the supplier might obtain. In such a situation, notwithstanding any statutory requirements
for safety or warranties, it may make financial sense to offer warranties and accept some level of claims.
• The provision of product warranties beyond a statutory minimum can provide a competitive advantage that is
of net financial benefit to the firm (e.g. the incremental revenue derived from increased customer patronage
exceeds the cost of extended warranties).
However, for the purposes of this subject, we consider warranty claims as more likely to be a non-value adding activity.
18. Dealing with customer These are likely to occur because of a quality failure in an activity performed earlier in the value chain and do not
complaints add customer value (as customers would perceive making complaints as annoying).
Suggested answers | 467
(b, c)
Table SA4.18: A
nalysis of HPD’s functional activities and costs: Value adding versus
non-value adding
Total research and development $1 300 000 $1 150 000 $150 000
Total product and process design $2 800 000 $2 500 000 $300 000
Production costs (made up of direct materials and labour and indirect manufacturing costs)
Direct materials
Direct labour
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Indirect manufacturing overhead
After-sales service
Total cost of Solarheat 1 $20 250 000 $15 650 000 $4 600 000
value adding.
As can be seen from Table SA4.18 above, there are $4 600 000 worth of activities that are
more likely to be non-value adding.
(d) Once you have worked through the flow chart in Figure 4.10 to classify items as value adding
or non-value adding, the next step is to rank or prioritise which non-value adding activities
you will focus on eliminating.
Using this information, Martin would hope to improve the design of the Solarheat 1
(e.g. through using fewer components) and reduce the complexity of the manufacturing
process. This will enable HPD to deliver the product that customers want, and at a lower
total cost to the organisation.
It is important to note that not all non-value adding activities will be eliminated by
an organisation, as it may be too ‘costly’ to do so (i.e. the cost of eliminating or modifying
a non-value adding activity may exceed the benefit derived from its elimination or
modification). The discussion on warranties in task a is relevant here.
A further factor to consider is the extent to which an activity is actually non-value adding.
For example, for the purposes of this subject, inventory storage is considered more likely
to be a non-value adding activity due to the holding cost involved (and potential for
obsolescence, spoilage and theft). However, if inventories were eliminated, this would likely
lead to stock-outs (an inability to provide stock to customers), which could also be regarded
as non-value adding. It may therefore be valuable to hold some inventory to protect against
unpredictable variations in manufacturing processes or customers’ ordering patterns.
This highlights the ‘continuum’ nature of the value adding/non-value adding assessment.
The real non-value adding activity in this example is therefore ‘excessive inventory storage’.
While this task appears to focus on the value chain activities of HPD itself, Martin may also
be interested in the effect of the non-value adding activities of the division’s suppliers and
customers of HPD. Communication with both suppliers and customers may therefore be a
useful strategy prior to making radical changes here.
(e) Non-value added activities often exist to fix mistakes. So, efforts to eliminate the causes
of the mistakes must be made (i.e. perform earlier activities better) in order for this cost to
be eliminated over time. If you eliminate the non-value added cost by ceasing the activity,
the mistake itself (or underlying cause) will not be fixed. This will likely lead to greater costs as
shown in the following discussion of the $600 000 of rework.
By stopping the rework you will save $600 000 in costs. However, we must weigh that against
the benefit that will be obtained by the rework. While the amount of rework will reduce by
$600 000, it is likely that scrap/wastage costs will increase as more items are scrapped rather
than fixed and sold. So we have a range of alternatives. The first and best is to make the
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product without mistakes, rework or scrap. However, if we do make a mistake, we will do
rework as long as it costs us less than the additional benefit to be received. If the rework
cost is greater than the additional benefit to be received, then we should scrap the item.
So we can assume that the cost of reworking defective Solarheat 1 products generates an
economic benefit greater than $600 000 and the net benefit of reworking these defective
units is greater than any other alternative (e.g. scrapping and recycling).
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470
Partial elimination of non-value adding activities Total elimination of non-value adding activities Preferred Net saving
BPM from preferred
(f) (i, ii)
Rework of prototypes $115 000 ($30 000) $85 000 $150 000 ($40 000) $110 000 Total $110 000
Rework patterns $220 000 ($25 000) $195 000 $300 000 ($50 000) $250 000 Total $250 000
On-the-job inspection $205 000 ($30 000) $175 000 $250 000 ($65 000) $185 000 Total $185 000
activity
Repair and maintenance $70 000 ($10 000) $60 000 $120 000 ($40 000) $80 000 Total $80 000
Hazardous waste disposal $50 000 ($20 000) $30 000 $75 000 ($35 000) $40 000 Total $40 000
Warranty claims $550 000 ($80 000) $470 000 $600 000 ($150 000) $450 000 Partial $470 000
| TECHNIQUES FOR CREATING AND MANAGING VALUE
Customer complaints $110 000 ($45 000) $65 000 $150 000 ($100 000) $50 000 Partial $65 000
of non-value adding activities
Total costs $1 320 000 ($240 000) $1 080 000 $1 645 000 ($480 000) $1 165 000 Total savings $1 200 000
†
We compare columns C and F to see which has the higher net saving. This will determine the preferred BPM initiative and net saving.
(iii) Successfully implemented, this initiative will reduce the estimated total costs of the
Solarheat 1 by $1 200 000. This is a saving of $40 per unit (i.e. $1 200 000 / 30 000 units).
The revised expected cost per unit was already down to $675 (explained in Case Study 4.7).
This expected cost per unit will decrease by $40 to $635.
The gap between the expected average cost and the target average cost per unit for the
Solarheat 1 was already down to $115 (explained in Case Study 4.7). This should now fall
again by the $40 cost saving per unit to $75 ($115 – $40)—representing the difference
between average total cost of $635 per unit and target average cost per unit of $560.
Cost Total
per activities and
Activity type activity Componentz ElectricalPartz Parts100 total costs
Order materials
Receive orders
Inspect deliveries
Costs $120 $18 000 $10 800 $21 600 $50 400
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Return materials
Activities 15 6 30 51
Account queries
Activities 15 6 30 51
Process payments
Activities 36 75 36 147
Total supplier-related costs $47 490 $31 350 $56 940 $135 780
Invoice cost of raw materials $222 900 $210 000 $246 000 $678 900
(Table 4.40)
Total procurement costs $270 390 $241 350 $302 940 $814 680
(Total supplier-related costs +
Invoice cost of raw materials)
Supplier cost performance ratio $47 490 / $31 350 / $56 940 / $135 780 /
(Total supplier-related costs / $222 900 = $210 000 = $246 000 $678 900 =
Invoice cost of raw materials) 21.31% 14.93% = 23.15% 20.00%
472 | TECHNIQUES FOR CREATING AND MANAGING VALUE
(b)
Table SA4.21: T
otal expected raw material costs for the new Solarheat 1 for each
of the three preferred suppliers
Suppliers
Estimated
Details Componentz ElectricalPartz Parts100 costs
Expected invoice cost of direct ($7 500 000 × ($7 500 000) × ($7 500 000) ×
materials (calculation) (1.02) (1.03) (1.00)
Expected invoice cost $7 650 000 $7 725 000 $7 500 000 $7 500 000
Expected supplier-related costs $1 630 215 $1 153 343 $1 736 250 $1 500 000
(Expected invoice cost × ($7 500 000 ×
Supplier cost performance ratio) 20.00%)
Total procurement cost $9 280 215 $8 878 343 $9 236 250 $9 000 000
(Expected invoice cost + ($7 500 000 +
Expected supplier-related costs) $1 500 000)
The expected invoice cost of direct materials to be sourced from ElectricalPartz is $225 000
more expensive than Parts100 (i.e. 3% × $7 500 000). However, the hidden supplier-related
costs for ElectricalPartz are $582 907 lower than the costs that would be incurred if Parts100
was the selected vendor (i.e. $1 736 250 – $1 153 343). So, the net benefit from selecting
ElectricalPartz over Parts100 as the supplier of direct materials for the Solarheat 1 product
is $357 907 (i.e. $9 236 250 – $8 878 343).
In determining the expected cost for the Solarheat 1, the impact of the hidden supplier
costs on the total cost of direct materials procured was not fully understood. As the direct
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materials total costs were estimated to be only $9 000 000, the anticipated cost reduction from
choosing ElectricalPartz as the vendor is only $121 657 (i.e. $9 000 000 – $8 878 343). A further
reduction in the expected cost of $4.06 per Solarheat 1 unit (i.e. $121 657 / 30 000 units)
is now achieved.
In Case Study 4.8, we saw that the revised expected cost had been reduced to $635. This is
reduced again to $630.94 (i.e. $635.00 – $4.06). The gap between the expected average cost
and the target average cost per unit for the Solarheat 1 will also fall by the $4.06 cost saving
per unit to $70.94 (i.e. $75.00 – $4.06)—representing the difference between average total
cost of $630.94 per unit and target average cost per unit of $560.
Suggested answers | 473
Table SA4.22: A
verage selling price, target and expected costs per unit after
implementing the lean manufacturing initiative
Details Amounts
Price increase per unit due to improved product quality: lean manufacturing initiative $10.00
Less: Net profit margin expected per unit (30% × $810.00) ($243.00)
Expected average total cost per unit ($18 093 343 / 30 000 units) (see Table 4.43) $603.11
Expected average cost below (above) the target average cost per unit ($567.00 – $603.11) ($36.11)
(b) The financial and non-financial measures that could be reported can be categorised in
two ways:
(i) the success of the product and production design changes as a project itself
(i.e. was the project delivered on time, within budget and to the required scope
and specifications); and
(ii) the benefits delivered ultimately from the redesigned product.
In the short term, Martin might want to know how the cost of making the necessary design
changes is tracking (e.g. has the change in actual spending on R&D been kept within the
planned increase of $100 000?) or the time taken to redesign the Solarheat 1 (e.g. has the
time taken to redesign the Solarheat 1 been in line with the revised time plan?). Martin would
want to know that the redesign initiative was delivered on time and within budget. Failure to
achieve either of these targets may weaken the financial benefits that the redesign initiative
actually delivers to HPD.
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Martin will want to know in the longer term that what was promised in the business case for
the redesign initiative has been achieved. Therefore, he will be more interested in quantifying
the benefits that have actually been realised. If the planned improvements in pre-production,
production and post-production activities have not eventuated, Martin may be able to take
action to improve the post-implementation performance of the redesign initiative. He can also
draw on the experience provided by this project to improve the planning for and execution of
similar projects in the future.
As the benefits have been split into three separate areas (i.e. pre-production, production
and post-production activities), the non-financial and financial measures could be reported
to Martin as follows:
474 | TECHNIQUES FOR CREATING AND MANAGING VALUE
1. Pre-production activities
Non-financial measures include reductions in the time and savings in the physical
resources used in designing the prototypes and patterns (e.g. the reductions in the
quantities of materials and other physical inputs consumed in pre-production).
Financial measures include R&D and production design activities (net increase in costs
of $100 000).
2. Production activities
Non-financial measures include reductions in manufacturing labour time and the
savings in physical resources used in quality control, rework, repair and maintenance
and hazardous waste disposal (e.g. quantities of materials that no longer have to be
reworked, scrapped and/or disposed of as being hazardous waste).
Financial measures include the actual cost savings realised in production costs
and indirect manufacturing overhead. These would be compared against the total
budgeted cost savings of $810 000 (i.e. DLHs ($220 000), on-the-job training (–$200 000),
quality control ($250 000), rework ($400 000), repair and maintenance ($80 000), and
hazardous waste disposal ($60 000)).
3. Post-production activities
Non-financial measures include ‘customer’ response to the improved product
(e.g. improved ratings as to product performance given by independent consumer
advocate bodies or internet-based, product-sourcing websites), change in market
share generated from the redesigned product and the number and type of warranty
claims and customer complaints (e.g. expectations would be that the number of
customer complaints will decrease and the nature of the customer complaints
submitted would shift away from product performance concerns).
Financial measures include the actual cost savings realised in marketing campaigns,
warranty claims, and handling of customer complaints (e.g. were the reductions in
the actual costs of post-production activity greater than $125 000?).
improvement initiative
(a)
Table SA4.23: A
verage selling price, target and expected costs per unit after
implementing the TQM initiative for the Solarheat 1
Details Amounts
Price increase per unit due to improved product quality: TQM initiative $60.00
Less: Net profit margin expected per unit (30% × $870.00) ($261.00)
Expected average total cost per unit ($18 450 000 / 30 000 units) (see Table 4.45) $615.00
Expected average cost below (above) the target average cost per unit ($6.00)
Suggested answers | 475
HPD is now very close ($6) to achieving the target average total cost per unit. Based on the
calculations above, the new target average total cost per unit is $609, while the expected
average total cost per unit is $615.
(b) Organisations such as HPD will not pursue quality goals in isolation from considerations
of profit. Rather, quality is the means by which they seek to maximise long-term profits.
Organisations that produce high-quality products and have a significant reputation for
quality may be able to command higher prices and/or sell greater volumes of their products.
Certainly, HPD hopes to increase its selling price by an additional $60 per unit as a
result of the TQM initiative. This increase in sales revenue may lead to higher profits.
However, at times, the pursuit of quality goals and long-term profitability may conflict
with short-term profitability. For example, the redesign of a production facility or
increased training of manufacturing personnel to ensure improved product quality
may incur costs that initially are greater than the immediate benefits they generated.
However, as noted in the section dealing with value chain analysis, the pursuit of quality
is only optimal to the extent that the long-term benefits of reduced internal and external
failures exceed the costs of prevention and appraisal. Thus, an organisation may not
want to eliminate all internal and external failures, as it will reduce the organisation’s
overall profitability. However, note, that there will be some regulatory circumstances
(e.g. product safety) where quality considerations will outweigh the profit outcome.
(c) As shown in Table 4.45, while the TQM program results in higher raw material and labour
costs, these are expected to translate into reduced costs for such things as:
–– quality control;
–– rework;
–– repair and maintenance;
–– hazardous waste disposal;
–– marketing campaigns;
–– warranty claims; and
–– customer complaints.
The financial measures will focus on whether spending in support of the TQM initiatives is
incurred as planned and whether lower costs do actually eventuate. Furthermore, given the
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higher product quality resulting from the TQM initiative, Martin will want to see if the
expected price increase of $60 per unit has been achieved.
As for the non-financial measures, Martin will want to examine such things as the:
–– number of suppliers meeting quality-assurance standards;
–– number and value of defective parts and components returned to suppliers;
–– hours devoted to TQM training courses;
–– hours devoted to preventative maintenance activities;
–– number of defective products detected during and at the end of production;
–– number of customer complaints or defective-product returns;
–– number of warranty claims; and
–– number of on-site service calls made by HPD’s customer-service personnel.
These financial and non-financial measures help HPD to determine whether the investment
in the TQM initiative achieves improvements in the cost performance of the Solarheat 1 and
ultimately delivers better overall financial returns.
476 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table SA4.24: A
verage expected costs per unit resulting from outsourcing
Solarheat 1 distribution to Supersonic
Details Amounts
Expected average cost per unit after implementation of cross-functional team’s lean $615.00
manufacturing and TQM initiative
Revised expected average cost per unit after outsourcing distribution $605.00
Target average total cost per unit (see Table SA4.23) $609.00
Expected average cost below (above) the target average cost per unit $4.00
(b) We can see that the expected average cost per unit ($605) is now below the target
average cost per unit ($609). From a purely financial perspective, the product line should
be manufactured as it has achieved the desired profit margin. However, this analysis has
ignored the freight costs that may still be incurred outside HPD, but within the HZ group,
as a result of excess capacity that would arise because of HPD’s outsourcing.
Some potential risks to consider include the possibility that an unsustainable low price has
been quoted, which could mean that poor quality service is provided or that, once HPD
has become reliant on Supersonic, they may increase their fees and charges to more realistic
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An analysis of these qualitative issues (i.e. service, ongoing low price, unused capacity) will
determine whether the recommendation to outsource should be accepted, which in turn
will lead to the appropriate cost structure to commence manufacture.
(c) The following points are relevant to the insourcing/outsourcing decision faced by HPD:
–– It seems that a specialised freight company can distribute the products at a significantly
lower cost than HZ’s own distribution division. Whether the same level of distribution
service can be delivered by Supersonic is questionable. However, it could be expected
that there would not be a dramatic difference in the quality of service between internal
and external supply.
–– The difference in costs should be examined. Investigating the cost difference might pose
the following questions:
|| Does the lower price quoted by Supersonic reflect an initial ‘low-ball’ below cost
tender price that is intended to capture the distribution business from HPD?
If so, as HPD becomes more dependent on Supersonic for distribution support,
the distributor might then opportunistically increase costs to levels above the
long‑run cost of internal supply.
Suggested answers | 477
|| Does the lower price quoted by Supersonic reflect the specialised freight company’s
use of new or advanced freight moving technology, the more effective management
of existing distribution infrastructure or simply greater economies of scale?
|| Is the higher price quoted by HZ’s freight division based on the incremental variable
cost (marginal cost) or full cost? If the $950 000 was the full cost, then this would
include fixed costs that are going to be incurred regardless of whether this work was
performed. Since it appears that the freight division expects to have idle capacity as a
result of HPD’s intention to outsource the distribution of the Solarheat 1, perhaps the
price quoted should not include these fixed costs and only be based on the division’s
out-of-pocket (or variable) costs. If this were the case, a quote based on the freight
division’s marginal cost of supply (only those costs directly related to providing this
additional piece of work) would be significantly less than the initially quoted $950 000,
and HPD may be more inclined to use the internal distribution function.
–– Finally, as the use of a multi-divisional structure by HZ is intended to achieve the many
benefits that come from decentralised decision-making (e.g. greater use of local
knowledge, quicker and more appropriate responses to changing operational conditions
and improved motivation and commitment), a direction from HZ’s head office to HPD
that it use the internal freight division ‘at any cost’ may be counterproductive. Provided
appropriate performance measures are in place, HZ should afford HPD the freedom to
make operational decisions as to how the division chooses to distribute its products.
(d) The decision to allow HPD to outsource the distribution of all its product lines addresses
issues about which set of competencies HZ should retain. Where an external supplier is
contracted to provide a previously internally supplied function, it may be assumed that HZ
has carefully examined the costs and benefits of outsourcing and decided that the external
supplier provides net benefits greater than can be achieved by using the internal supplier.
Thus, the external supplier has a core competency that HZ currently does not possess or wish
to acquire.
In terms of financial performance measures, Martin would want to ensure that the life cycle
distribution costs charged by Supersonic for the Solarheat 1 are as quoted (i.e. $650 000) and
that there is also a reduction in the distribution costs for all other HPD product lines that are
now to be distributed by the specialist freight company. Martin might also wish to monitor
the cost of damages that occur during distribution, as these might reveal the superior
(or inferior) freight handling practices of Supersonic.
MODULE 4
In relation to non-financial measures, the performance of Supersonic would be monitored
through metrics such as on-time deliveries, freight-breakage rates and customer ratings
(e.g. the disruption Supersonic might cause at the customer’s receiving docks).
The financial and non-financial measures used to monitor the performance of Supersonic are
intended to give Martin some assurance that HPD’s distribution needs are being well serviced
by the specialist freight company in a cost-effective manner.
478 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Table SA4.25: A
verage gross margin percentage in the year ending 31 December
for each customer segment
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Gross margin % on sales $3 000 000 $900 000 $480 000 $4 380 000
$15 000 000 $3 000 000 $1 200 000 $19 200 000
(b)
Table SA4.26: ABC costs per transaction for customer service indirect cost pools
2. Line item ordering $210 000 52 500 line items $4 per line item
Cost
driver Number Customer Number Customer Number Customer
tran- of cost service of cost service of cost service
Cost pools sactions drivers costs % drivers costs % drivers costs %
Table SA4.27: C
1. Order processing $50.00 600 $30 000 6.7% 900 $45 000 21.4% 4 500 $225 000 31.2%
2. Line item ordering $4.00 12 000 $48 000 10.6% 13 500 $54 000 25.7% 27 000 $108 000 15.0%
3. Distribution $100.00 300 $30 000 6.7% 300 $30 000 14.3% 3 000 $300 000 41.7%
4. Cartons/pallets shipped $5.00 45 000 $225 000 50.0% 6 000 $30 000 14.3% 15 000 $75 000 10.4%
food processors
5. Customer relations $200.00 585 $117 000 26.0% 255 $51 000 24.3% 60 $12 000 1.7%
Total costs $450 000 100% $210 000 100% $720 000 100%
ustomer service indirect costs by customer segments for HPD’s
Suggested answers |
479
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480 | TECHNIQUES FOR CREATING AND MANAGING VALUE
(d) As shown in Table SA4.28, the most profitable market segment in absolute dollar terms
is the nationwide market segment ($2 550 000). However, the statewide retailers are the
most profitable market segment when measured on a net margin basis (23%). Interestingly,
the small local-retailer market segment incurs an overall loss of $240 000 and has a negative
net margin of 20 per cent. This is a significant turnaround from the gross margin figures
identified in Table SA4.25. Net margin therefore provides a more accurate assessment of
the profitability of customers.
Table SA4.28: R
evised net margin calculations for HPD’s food processors
customer segments
Total sales revenue $15 000 000 $3 000 000 $1 200 000 $19 200 000
Total cost of sales ($12 000 000) ($2 100 000) ($720 000) ($14 820 000)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Customer service indirect costs ($450 000) ($210 000) ($720 000) ($1 380 000)
Net margin $2 550 000 $690 000 ($240 000) $3 000 000
Net margin % on sales $2 550 000 $690 000 ($240 000) $3 000 000
$15 000 000 $3 000 000 $1 200 000 $19 200 000
(e) The main problems in allocating the customer-service costs to the activity areas and customer
groups in the year ending 31 December include:
–– Choosing the appropriate cost driver for each area of activity. While the cost driver
for each activity seems to be an economically plausible base on which to allocate the
total indirect costs in that cost pool, identifying the appropriate cost driver is likely to
be difficult and require refinement over time.
–– Developing a reliable database for the chosen cost drivers. For some cost drivers,
MODULE 4
Table SA4.29: Customer service transaction data for each customer service indirect
cost pool for Mini-Electrical and Home Appliances
4. Total deliveries 30 30
(b)
MODULE 4
1. Order processing $50.00 45 $2 250 30 $1 500
(c)
Table SA4.31: Net margin calculations for Mini-Electrical and Home Appliances
(d) The following strategies could be recommended to HPD for managing its relationship with
individual customers:
–– Refocus sales force—Pay increased attention to the top 20 per cent of customers.
HPD may wish to educate its workforce as to the importance of their customers so that
the employees always strive to meet, if not surpass, their expectations of product quality,
on-time delivery and after-sales service.
–– Cost management—Endeavour to identify those strategies that will improve efficiency
levels and reduce the cost per driver transaction.
–– Inform—Seek to educate HPD’s customers about the ‘costs’ they will bear as a result of
unprofitable orders. The approach to customers could seek to reduce both the number
of orders placed (i.e. increase the order size per delivery) and decrease the complexity
of the order (i.e. the number of line items ordered).
MODULE 4
While it might be suggested that it would be profitable for HPD to cease trading with
the bottom 40 per cent of its small local electrical-retailer market segment, this decision
should only be taken after all other avenues for improving customer profitability have been
exhausted. In particular, it may be that a currently unprofitable small local electrical retailer
such as Home Appliances will become profitable to HPD once the customer’s market has
grown. Surrendering a relationship with this type of customer to a rival supplier may appear
to make economic sense in the short term, but it may result in the permanent loss of a
very profitable customer in the long term. Thus, customer-profitability analysis needs to be
undertaken in the context of the long-term strategic plans that HPD has about the markets
it wishes to compete in.
References | 483
References
References
Andrew, J. P. & Sirkin, H. L. 2004, ‘Making innovation pay’, Strategic Finance, vol. 86, no. 1,
pp. 7–10.
Apple Inc. 2011, Apple Supplier Responsibility: 2011 Progress Report, accessed July 2014,
http://images.apple.com/supplierresponsibility/pdf/Apple_SR_2011_Progress_Report.pdf.
Apple Inc. 2015a, Environmental Responsibility: FAQ, accessed October 2015, http://www.apple.
com/au/environment/answers/.
Apple Inc. 2015b, Environmental Responsibility Report, accessed October 2015, http://images.
apple.com/au/environment/pdf/Apple_Environmental_Responsibility_Report_2015.pdf.
Apple Inc. 2015c, Supplier Responsibility: 2015 Progress Report, accessed September 2015,
https://www.apple.com/supplier-responsibility/pdf/Apple_Progress_Report_2015.pdf.
MODULE 4
Banjo, S. & Zimmerman. A. 2013, ‘WalMart goes it alone on Bangladesh garment factory safety
pact’, The Australian Wall Street Journal, Supplement, 16 May.
Deloitte 2013, ‘Save to grow: Deloitte’s third biennial cost survey: Cost-improvement practices
and trends in the Fortune 1000’, March, Deloitte Consulting LLP, accessed July 2015,
http://www2.deloitte.com/us/en/pages/operations/articles/save-to-grow-deloitte-third-
biennial-cost-survey.html.
Dolan, K., Murray, M. & Duffin, K. 2010, ‘What worked in cost cutting—and what’s next’,
McKinsey Quarterly, February, pp. 1–9.
Green, A. & Hutchins-Ball, H. 2005, Rising to the Growth Challenge, A. T. Kearney, Chicago.
484 | TECHNIQUES FOR CREATING AND MANAGING VALUE
Hannam, P. 2013, ‘Walls keep water out and flood bills down’, Sydney Morning Herald, 2 February,
accessed July 2015, http://www.smh.com.au/business/walls-keep-water-out-and-flood-bills-down-
20130201-2dq1d.html.
Kaplan, R. S. 1992, ‘In defense of activity-based cost management’, Management Accounting,
November, pp. 68–73.
Kaplan, R. S. & Anderson, S. R. 2007, ‘The innovation of time-driven activity-based costing’,
Cost Management, vol. 21, no. 2, March/April, pp. 5–15.
Kearney, A. T. 2005, Banks Shift Gears in Drive for Top-line Growth, A. T. Kearney, Chicago.
Langfield Smith, K., Thorne, H. & Hilton, R. 2012, Management Accounting—Information for
creating and managing value. 6e McGraw Hill. Sydney.
Raffish, N. 1991, ‘How much does that product really cost?’, Management Accounting, vol. 72,
no. 9, pp. 36–9.
Roberts, P. 1997, ‘There’s more to reform than trimming costs’, Australian Financial Review,
15 August, p. 64.
Shank, J. K. & Govindarajan, V. 1994, ‘Measuring the “cost of quality”: A strategic cost
management perspective’, Journal of Cost Management, vol. 8, no. 2, pp. 5–17.
Simons, R. 2000, Performance Measurement and Control Systems for Implementing Strategy:
Text and Cases, Prentice-Hall, Upper Saddle River, New Jersey.
Suriadi, S., Wynn, M. T., Ouyang, C., Ter Hofstede, A. H. M. & Dijk, N. J. 2013, ‘Understanding
process behaviours in a large insurance company in Australia: a case study’, Advanced Information
Systems Engineering—Lecture Notes in Computer Science, Springer, Valencia, Spain, pp. 449–64,
accessed July 2015, http://eprints.qut.edu.au/55502/4/55502.pdf.
Victorian Auditor-General’s Office 2010, Fees and Charges—Cost Recovery by Local Government,
MODULE 4
WalMart 2010, ‘WalMart leverages global scale to lower costs of goods, accelerate speed to
market, improve quality of products’, accessed July 2015, http://news.walmart.com/news-archive/
investors/walmart-leverages-global-scale-to-lower-costs-of-goods-accelerate-speed-to-market-
improve-quality-of-products-1380021.
World Health Organization (WHO) 2013, Medical Tourism, October, accessed July 2015,
http://www.who.int/global_health_histories/seminars/kelley_presentation_medical_tourism.pdf.
Optional reading
Agrawal, S. P., Rezaee, Z. & Pak, H. S. 2006, ‘Continuous improvement: An activity-based model’,
Management Accounting Quarterly, Spring, vol. 7, no. 3, pp. 14–22.
Liker, J. K. & Morgan, J. M. 2006, ‘The Toyota way in services: The case of lean product
development’, Academy of Management Perspectives, May, pp. 5–20.
STRATEGIC MANAGEMENT ACCOUNTING
Module 5
PROJECT MANAGEMENT
TEEMU MALMI AND DAVID BROWN*
Contents
Preview 489
Introduction
Objectives
Residual income
Deficiencies in accounting-based measures
Sensitivity and scenario analysis
Financial analysis—multiple projects 530
Equivalent annual cash flow (Equivalent annual annuity)
Balancing stakeholder interests with project specification
and financial returns 532
CONTENTS | 487
Review 565
Appendices 567
Appendix 5.1 567
Appendix 5.2 573
References
MODULE 5
595
Optional reading
MODULE 5
Study guide | 489
Module 5:
Project management
Study guide
Preview
Introduction
The organisations we work in have many projects. It is easy to see projects in a company whose
operations focus on delivering projects, such as the Lend Lease construction company building
the new Royal Children’s Hospital (Lend Lease 2015), or a software development company
such as Microsoft, which delivers new software for your computer. Projects may be focused
on improving a current product, such as Toyota upgrading the new Corolla, or a new edition
of a mobile phone, such as the latest Apple iPhone. Projects may also be oriented toward the
development of a new product line, such as the Apple iPad. Projects can also focus on improving
core processes in an organisation (e.g. process mapping and improvement), or be oriented
towards support activities (e.g. IT upgrade of enterprise resource planning software such as SAP),
or decision support software (e.g. COGNOS).
These examples show that projects are strategically important to organisations. For example,
Apple’s development of the iPad was central to its strategy to gain competitive advantage in
the marketplace. Project management must be aligned with an organisation’s strategic planning.
In fact, in many organisations these two functions are interdependent or even indistinguishable.
Projects are very important and management accountants are likely to be constantly involved in
MODULE 5
them in the workplace. Projects are also very challenging. Each project typically has a different
customer and location, a smaller or larger scope, and so on. These characteristics highlight one
of the inherent features of any project—it involves doing something that has not been done
before; it is unique.
Part A considers the definition of project management, including the stages of a project and
organisational structures for projects. Part B discusses the roles within project management
teams. Part C explores the role of the management accountant in project selection and the range
of analytical techniques that are used in this task. Part D examines planning tools that are central
to the successful implementation of a project. Part E considers the management accountant’s
role in project implementation, risk management, control and monitoring. Finally, in Part F,
the post-completion and review processes are addressed.
E E
n n
v v
i i
r r
o Value o
n n
m m
e Vision/Mission e
n n
t Goals and objectives t
a a
l Strategy—Creation l
RESOURCES SYSTEMS
a a
n Strategy—Implementation n
a PROJECTS a
l l
y Strategy—Implementation y
s VALUE CHAIN s
i i
s Control and feedback systems s
Strategy—Implementation
Projects: Projects are a major part of implementing strategy. They need people,
planning and performance measures, as well as systems and control. They also
need to be evaluated based on qualitative and quantitative factors.
Objectives
After completing this module, you should be able to:
• examine the steps and roles in project management and the different types of
organisational structures for projects;
• explain and apply risk assessment and financial analysis, and discuss the factors affecting
project identification and selection;
• apply project management scheduling and budgeting techniques;
• explain and apply approaches to monitoring project progress;
• discuss the role of risk management in the ongoing monitoring and management
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of projects; and
• explain the importance of project post-completion and review.
Study guide | 491
• Projects typically have a defined start and finish time. Management focus on the finishing
time is often very high, as most projects require considerable investment before the benefit
of the project is realised. The longer the project runs, the longer it is before it generates a
return on the investment.
• Projects consist of related activities that often have operationally specific relationships.
Additionally, project activities use multiple resources that need coordination. It is important
to understand which activities must occur sequentially and which can proceed concurrently.
• All projects are time limited—by the LNG reserves available. When the reserves are depleted,
or their recovery becomes uneconomic, the project will be abandoned.
• LNG projects are very complex. Finding suitable gas fields, building offshore gas rigs, and drilling to
access the LNG is only the beginning. When the field is in production, the gas must be transported
in ships, or by pipelines to ports for shipment.
492 | PROJECT MANAGEMENT
➤➤Question 5.1
List six key characteristics of a project and explain how these make it different from day-to-day
operations.
The Project Management Institute (PMI 2013, p. 6) defines project management as ‘the application
of knowledge, skills, tools and techniques to project activities to meet project requirements’.
Project management is an extremely challenging activity when we consider the level of success
and failure in projects. For example, research on 5400 large IT projects found:
• half of all projects had large budget blowouts. These projects, in total, had a cost overrun
of $66 billion;
• on average, the projects ran 45 per cent over budget and delivered 56 per cent less value
than predicted; and
• the longer a project was scheduled to last, the more likely it was that it would run over time
and budget (Bloch & Blumberg et al. 2014).
Not only is project management about trying to deliver what is expected, but good project
management requires an understanding of how to maintain control over costs. This is
often difficult.
What is interesting is that many of the techniques or tools used in project management were
developed during World War II and in the two decades afterwards (Gorog & Smith 1999) as a result
of experiences in weapons development and space exploration. The skilful application of these tools
has an enormous influence on whether a project is delivered on time and on budget, while satisfying
its objectives. Before considering the range of tools used, we will discuss the basic steps in the project
management process.
Study guide | 493
Stage 3 Stage 4
Stage 1 Stage 2
Project implementation, Project completion
Project selection Project planning
control and monitoring and review
Management accountant
involvement
Stage 1
Project selection
The project selection stage is where project objectives are identified, acceptable levels of
performance are made clear and the key deliverables are established. In addition, this is the
point at which the initial project team is formed, and the feasibility and justification for the
project are established.
The primary objectives of the project need to be identified during project selection. These are
typically grouped under:
• Specification—the technical needs of the project sponsor (discussed in the next section).
• Budget—how to meet the project specifications with the available resources.
• Completion time—the period during which the project is expected to start and finish.
The key criteria in project selection are strategic fit and risk analysis. The project must
support organisational strategy. Where the project does not fit with organisational strategy,
the investment will likely be wasted. For example, manufacturers often pursue a low-cost strategy.
Projects or investments to support this strategy should increase efficiency and reduce labour
costs. Therefore, while projects or investments in flexible machinery (i.e. robots) might increase
the organisation’s technical capacity (useful if the company was pursuing a differentiation
strategy), they do not necessarily support a low cost strategy.
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In this stage, the management accountant provides support in identifying and quantifying risk(s),
and in applying an analysis of strategic strengths, weaknesses, opportunities and threats (SWOT)
(as discussed in Module 2). Assessment of the financial viability of the project is also central to
the role of the management accountant.
494 | PROJECT MANAGEMENT
Stage 2
Project planning
The project planning stage is where the specific strategy for delivery of the project specifications
is developed in detail and where tentative dates for deliverables are established. It is also when
schedules and budgets for time and cost are formulated. Planning is usually broken down into
five key areas:
1. Scheduling includes the activities that need to be performed in the project, and the
sequence in which they are to be performed is considered.
2. Optimising cost and time is where the sequence of activities is analysed and optimal trade-offs
are established.
3. Budgeting is where the project budget is prepared in detail to communicate the resource
requirements in terms of people and supplies; and to establish a control framework so that
variance analysis can be undertaken during and after project implementation.
4. Performance measurement converts the project specifications into a set of performance
measures or key performance indicators (KPIs). KPIs are usually set against the key
project deliverables and incorporate clearly defined time-frames. Critical points in project
implementation called ‘milestones’ are established.
5. Incentives address how the project team (discussed in Part B) will be rewarded for achieving
the project’s KPIs.
The management accountant will often have input into the budget and other financial planning
aspects of project planning as well as the design of KPIs. Once the five areas of project
planning outlined above are complete, the project sponsor (discussed in Part B) reconsiders
the feasibility of the project and either formally approves commencement of the project or
decides to discontinue it.
Stage 3
Project implementation, control and monitoring
The project implementation stage occurs when project activities begin.
Progress against the set deliverables’ dates and the budget is monitored, variances are examined
and necessary adjustments are made. An important part of monitoring is the consideration of
how the project’s progress compares to the milestones.
(the spending variance), and the difference between the budgeted costs of work done and the
work planned (the schedule variance). Accordingly, project variance reports can be complex.
The management accountant is typically involved in ongoing budget variance analysis as well as
tracking performance against KPIs.
Study guide | 495
Stage 4
Project completion and review
The final stage of a project is when all the deliverables have been completed and the original
objectives achieved. The members of the project team are gradually taken off the project and
the project itself shuts down. As each project will have a set of lessons learned, it is important
that these are documented and fed into new projects where applicable. The management
accountant will often be one of the last people taken off the project (along with the project
manager), as they are involved in determining final project costs and closing down the
related accounts.
➤➤Question 5.2
List the four main stages of a project and briefly explain the role of the management accountant
in each stage.
Project organisations
Project organisations are those that have projects as their core operating activity. Examples of
this would be construction companies, software companies or professional service organisations.
Internal projects
This is where a project exists within an organisation whose main business is some other form of
product or service provision. In these situations, the project is typically not related to delivering
the core operating activities of the organisation. For instance, the project might be new product
development, implementing new IT systems, asset replacement, cost-reduction programs,
or implementing new performance indicator systems. For many management accountants,
much of the project management that they will be involved in, is likely to be for internal
(within the organisation) projects.
496 | PROJECT MANAGEMENT
Joint ventures
This structure is used when two or more organisations contribute equity in the form of capital
or technology and undertake a project where the revenue and expenses are also shared.
Joint ventures (JVs) are common in international projects where significant risks occur or
where undertaking the project is not possible without a local partner. One of the challenges
in JVs is maintaining control of the project, as two or more parties have input and may have
different motivations for undertaking the project.
Collaborations
Collaborations are like JVs in that two or more parties contribute towards the achievement of a
project outcome. These parties can be different organisations, as well as business units within
the same organisation. However, they tend to be less formal or more fluid and flexible than JVs,
and do not always have a commercial motive.
Source: Sundin, H. J., Brown, D. A., Wakefield, J. A. & Ranganathan, J. 2009,
‘Management control systems in a non-enterprise network:
The greenhouse gas protocol initiative’,
Australian Accounting Review, vol. 19, no. 2.
A good example of this type of PPP is the International AIDS Vaccine Initiative, with information
available online at: http://www.iavi.org/press-releases/archives/352-public-private-partnerships-play-
a‑critical-role-in-creating-solutions-for-neglected-diseases.
Virtual projects
Virtual projects are when project team members are located in different places and the
MODULE 5
➤➤Question 5.3
Is ‘collaboration’ a type of ‘project organisation’ or a ‘within organisation’ project activity?
Geographical spread Projects can be in multiple locations across different cities and countries
Larger project scope Typically they have a wider scope and are more complex
Higher risk International projects often have much higher uncertainties and unknowns
which increase the level of risk
Project cost As international projects are often large and are geographically dispersed,
the costs involved in coordinating activities, transport, and communication
are higher
More than anything else, complexity typifies international projects. Lientz and Rea (2003) outline
the following seven issues with regard to complexity.
• Lack of control—The project sponsor or manager may not have very much control. This can
be due to the distance or from the lack of congruence between the goals of the local staff
and the sponsoring organisation.
• Different culture—Local culture will impact on how projects are initiated and then
how they are undertaken. This can be manifested in different work practices and
employee expectations.
• Different time zones—Communication across different time zones can be a problem,
essentially due to differences in scheduling.
• Different currencies—This can affect how expenses are paid and how revenue is received,
how profit is transferred out of the country, and how inflation and foreign exchange
movements affect purchasing power.
• Different legal structures—Each country has its own legal structure and a local
interpretation of this.
• Political uncertainty—This can range from countries that have relatively stable and secure
governments to countries where governments change regularly.
• Project visibility—Due to their size, often international projects may be highly visible to the
MODULE 5
outside world and the sponsoring organisations may be exposed to international scrutiny.
So how can a project manager, or you as the management accountant, deal with this kind of
complexity? Ensure that:
• you have selected appropriate project team members (see Part B);
• all the stakeholders collaborate and that each stakeholder is satisfied (see Part C);
• resources are appropriately allocated to the project (see Part D);
• systems are set up that enable constant monitoring of the project (see Parts C, D,
and E); and
• the lessons learnt and knowledge is captured as the project is progressing, rather than
waiting until the end when it is all over (see Part F).
498 | PROJECT MANAGEMENT
A final consideration is to be culturally sensitive or have ‘cultural fluency’ (Turner 2003, p. 153).
This is an understanding of how people do business in other parts of the world. To gain cultural
fluency, project team members involved in international projects need cultural training and
development. This includes three things:
• Strategic cultural fluency—This is an understanding of the strategic relationships across
cultures, how business is structured, cultural behaviour at a senior level and how this forms a
context for projects.
• Workgroup cultural fluency—Work teams that are either formed within a different culture
or contain multi-cultures have their own issues and processes that project managers need to
understand.
• Personal cultural fluency—Individuals have their own social etiquette, language, skills and
knowledge. Good project managers understand this and operate within these parameters.
A lack of cultural fluency can mean that while a project may be technically excellent, it may fail
due to a lack of understanding of the cultural context that it operates and how this translates
into practice.
Project sponsor
The project sponsor is a senior executive who should ensure the project’s business case is
realised and its goals are met. This means that the sponsor (also referred to as project owner)
represents the project funder during the project. Working closely with the project manager,
the sponsor provides guidance to the project team in the following three ways:
1. During the project selection stage the project sponsor establishes the objectives for the
project, the priority the project will have, the political environment of the organisation,
and the make-up of the project team.
2. The project sponsor will also have the responsibility of managing the high-level stakeholder
relationships. These stakeholders may be external or internal to the organisation. Over the
life of the project, a project sponsor may be a key advocate for these stakeholders. If a
project has an outside customer as one of the stakeholders, the project sponsor may be
the key intermediary for negotiating the contract and ensuring continuing communication
over the life of the project.
3. If the project encounters serious problems, the project sponsor may need to become involved
in discussions and actions to resolve the problems. The sorts of problems where this might be
necessary are those that relate to the non-completion of the project deliverables according
to specifications, budget or schedule.
Due to the level of responsibility, the project sponsor will usually be a senior executive in the
organisation. Sometimes, senior executives will sponsor several projects in addition to their
regular responsibilities.
One of the most difficult issues in project sponsorship is the extent to which the project sponsor
should be involved in the project. It is important to ensure that the project manager and project
team are empowered to make relevant decisions and that there is no loss of authority through
the involvement of the project sponsor. A balance has to be struck between open and visible
support, and micro-managing the project. For example, a project sponsor may provide access
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to resources and maintain a focus on the project meeting its cost, quality and time targets;
but they will not interfere in the operational activities of how the targets are being met or the
way resources are deployed—they leave that to the project manager and project team.
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Project manager
A project manager has functional responsibility for the project and has to perform a range of
roles. Project managers need to be sufficiently senior so that they can coordinate the activities
and resources required to complete the project. The project manager must:
• define the project, including specifications, scope, budget and cost;
• organise and then manage the team for the project; this includes deciding on the activities
that need to be performed and coordinating the personnel and other resources required to
meet project deliverables;
• take responsibility for meeting the targets and deliverables for the project on an ongoing
basis, as well as the final deliverables; and
• manage problems as they arise.
The nature of projects presents a range of significant challenges for project managers:
• Uncertainty—Organisations usually prefer certainty, but the unique nature of projects makes
this difficult.
• Schedules and budgets—Project activities are often uncertain, and planning and target
setting often require frequent readjustment of targets.
• Authority—While project managers may be given full responsibility for delivering the project
within specification, on time and on budget, often they are not given enough authority or
political support to command the necessary resources.
Example 5.5: A
n IT project in a service-based organisation—
Part A
A service-based organisation undertook an IT project with the aim of making the performance of 4000
front-line employees transparent through an automated performance measurement system. The project
was not allocated enough resources to undertake consultation on performance measures with the
users of the system, or to train employees adequately in the use of the new system. Furthermore,
technical design faults meant that the data in the system were not always accurate. This resulted in
compensation inaccuracies for the affected staff. The redesign processes undertaken to try to fix the
inherent design problems meant that the project deliverable date was constantly moved back and the
project went considerably over budget. Still, the project manager and his team were evaluated on the
original project time and cost, and the satisfaction of the users of the system. An impossible situation!
As shown in Table 5.2, project managers need to possess a range of technical and interpersonal skills.
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Study guide | 501
Technical
Process skills—while project managers are often from an engineering or management background,
they need to be trained in a range of project management skills such as critical-path analysis, risk analysis
and management, and capital budgeting.
Project-specific skills—technical skills that relate to the objectives of the project (e.g. IT skills in an IT project).
General knowledge of all aspects of the project so that they can discuss the technical work and understand
the technical data used.
Interpersonal
Communication skills—to provide the required knowledge and information to people involved in the
project in an unambiguous way. This includes the ability to listen to what is being communicated by others.
Problem-solving skills—completing projects completed usually involves dealing with the unexpected,
including opportunities and problems. Part of this skill requires project managers to foresee and detect
problems before they arise or escalate. For example, if a component of the project requires specific
technical skills or input materials that are hard to find, this issue needs to be addressed before it becomes
critical to the completion of the project.
Insight—to manage significant amounts of data and to establish what is relevant. Often, some project data
is incomplete, inaccurate and misleading.
Negotiation—to be able to negotiate for extra resources and other support in order to deliver the project.
Conflict resolution—conflicts can occur in areas such as expectations, level of resources, costs, time,
responsibilities and personality clashes.
Leadership—both the tasks and challenges that project managers need to deal with require considerable
capacity for leadership.
A range of new challenges faces the management accountant in the context of modern
project management:
• The preparation of accurate and timely information is a particularly significant issue in a
project environment, as uncertainty is high. In non-project operations, historical data is
available to construct meaningful budgets. In a project situation, however, historical data
is usually not available and many assumptions and estimates need to be made.
• Managers will be making decisions based on the information prepared, so management
accountants need to display a high level of ethical behaviour and political sensitivity when
communicating this information. Capital budgeting models need to be based on realistic
assumptions and care has to be taken that management’s desires to proceed with a project
do not unduly influence the assumptions used to evaluate projects.
• Obtaining accurate data can lead to politically difficult situations—such as where a project
manager needs data for reporting but also wants to report in a manner that is more (or less)
favourable than the data indicate.
Leadership is one way the role of the management accountant in projects can be defined.
While we might think that leadership is something the project sponsor or the project manager
should display—and this is true—leadership is not their sole domain. All members of a project
team, including the management accountant, will have some form of leadership responsibility.
The management accountant may be the project manager or a member of the team; in either
case, the need for leadership is there, but the way it is demonstrated may be different. A project
manager is the person with the title and the responsibility to deliver the project. However, a leader
is someone who is able to inspire and motivate team members to get the job done. There is a
significant difference between the two and it is important to recognise this. Manager is a formal
title and, while they may have authority, they may not be able to succeed if they cannot get the
project team to deliver. A leader is someone who can inspire people to deliver, although they
may not have the formal authority.
Pinto (2010) outlines four key ways that a project manager exercises leadership.
• Acquiring project resources—These are the staff, materials and other support
required to meet the project requirements. Often, the main reason for project failure
is inadequate resources.
• Motivating and building teams—A project manager has to take a diverse group and form
them into a working team in a short period of time. They then have to ensure that the team
delivers in the face of considerable challenges and competing organisational pressures.
• Having a vision and solving problems—A project manager needs to be able to articulate
the vision of the project clearly, maintain focus on this and, at the same time, deal with the
inevitable crises that occur.
• Communicating—This can be formal or informal and needs to be from the project manager
to the team, as well as within the team itself.
We can see that each of the above leadership roles can also apply to the management
accountant. Of all the roles on a project team, the management accountant’s is most like the
project manager’s in that both roles are more general. Other roles in the team tend to focus
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A task-force approach is when a team is set up specifically for the project and is dedicated
to it. The project manager has total authority and responsibility for the members of the team.
A matrix approach, on the other hand, occurs when project team members continue to work in
their functional areas (in their day-to-day jobs) while also working on the project. This may mean
time spent on operational tasks as well as on the project, or all the team members’ time may be
spent on the project, while their position remains situated in a functional department and under
the authority of the department manager.
Executive
management
Procurement
Engineers
Operations
Finance and
accounting
Executive
management
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Advantages Disadvantages
Task-force project team Team members focus solely on Unless the project is of sufficient size,
completing the project. team members potentially may not
be consistently busy.
Team members operate
autonomously. Unlike in a matrix team, if team
members are unavailable, it may be
Team members have their own more difficult to cover absences.
resources.
Some functional staff might resist
Team members get to work in working in a cross functional team
cross-functional teams, potentially as compared to working in their own
making their job more interesting departments.
and gaining additional experience
outside their primary discipline or As functions (like that of the
area of expertise. management accountant) change,
a lack of day-to-day involvement may
reduce staff members’ exposure to
the latest thinking.
A range of specialist skills can be The project manager may not have
tapped into, providing the project sufficient authority to ensure that staff
manager with flexibility. do what is required for the project
when competing priorities surface for
During project downtimes staff team members.
can be used on other tasks in
their department.
One of the key difficulties encountered in putting together project teams is that functional
managers in organisations may not be keen to supply staff for a project. Project teams may
not get staff who have the requisite skills, but may be supplied with whoever is available or
maybe an individual who is less in demand due to skill deficiencies or behavioural problems.
The simple fact is that everybody wants to work with the best people and, so, getting the best
people onto the project team is going to be difficult.
The make up of the team depends on the functional areas available and what the project
demands. A more carefully constructed project specification and definition will make it easier
to identify the personnel needed on the project team.
➤➤Question 5.4
Reflect on a project that you might be familiar with in your organisation. What is your understanding
of the three main roles? Explain what each of these roles entails.
Lientz and Rea (2003) outline a number of ways that international project teams are different from
the standard project team:
• Collaboration—The need for collaboration between individuals and tasks is greater due to
the dispersed nature of these projects.
• Parallelism—Tasks in the project may be undertaken in parallel in multiple locations.
• Changing requirements—The turnover of staff is greater, as the variation in skills tends
to be greater over the life of the project. This is often compounded by greater variation in
project direction.
• Semi-autonomous work—Many parts of the project may be beyond the direct supervision
of managers, making the supervision of staff and tasks difficult.
When you consider the above characteristics of international project teams and international
projects, discussed earlier (managing international projects), it should be clear that a number
of issues are likely to be faced by each member of the team as well as the project manager.
The question is: What are the desirable individual characteristics that will help ensure
international project teams successfully deliver on projects?
Lientz and Rea (2003) discuss this question. See Table 5.4 for more detail.
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506 | PROJECT MANAGEMENT
Table 5.4: T
he unique context of international projects and international
project teams
Characteristic Explanation
Similar project experience The more experience an individual has with similar projects
(in terms of the specific technical nature of the project),
the better.
Ability to work with other people As collaboration is even more important on international
projects, team members need to know how to work with other
team members.
Ability to solve problems Problem solving is a critical skill for international project work,
especially where different legal and social frameworks need to
be navigated.
Awareness of potential problems Team members need to have the ability to anticipate
problems so as to reduce their impact.
Ability to work with competing demands International projects often require staff to be able to juggle
multiple and conflicting tasks.
Ambition and energy International projects are demanding, so team members need
to have lots of energy and ambition; otherwise, they will not
have the drive to achieve the project goals.
Knowledge of the organisation’s business When projects are within an organisation, team members
processes need to have an understanding of the organisation’s
business processes.
Knowledge of the methods and tools The more the team members know about project software
used on the project and other tools and techniques (such as PERT), the more they
will be able to devote their energy and intellect to the more
substantive issues.
Ability to understand different cultures This refers to both the organisation/team culture and
the region/country culture in which the project exists.
Team members need to be tolerant and sensitive to cultural
differences.
Willingness to travel for extended Team members may have to live overseas for extended
time periods periods of time or travel on a regular basis. They need to have
the practical circumstances and an almost uncompromising
willingness to do it.
Source: Lientz, B. P. & Rea, P. R. 2003, International Project Management, Academic Press, Amsterdam.
Study guide | 507
What makes building trust harder in virtual teams is the lack of face-to-face communication
where you would normally have the chance to pick up more cues (other than just verbal cues)
to establish whether someone has the goodwill or competence to fulfil their obligations.
One way to overcome this is to make sure that project team members have enough demonstrated
experience so that the risk of competence failure is reduced. In addition, ensuring that delivery
dates are clearly understood and adhered to helps establish goodwill and trust.
Another issue for virtual teams is defining roles and responsibilities. Morris and Pinto (2007)
explain that one way to overcome this is to get team members to commit to the tasks that they
feel most skilled to do, rather than assigning tasks and obligating team members to perform
those tasks. However, a danger with this approach is that it is unlikely that anyone will volunteer
for the difficult tasks. Clearly, careful management of the process is required.
Pinto (2010) has some other suggestions for helping virtual project teams to work.
• Try to include some face-to-face communication whenever possible to complement the
electronic communication.
• Maintain constant communication and don’t let team members ‘disappear’ for an
extended period.
• Create communication protocols or codes of conduct about what kind of information
needs to be shared and what kind of contact is expected, for how long, and how often.
• Keep all team members informed about what is happening with the project.
• Decide on a protocol for how interpersonal conflict is to be resolved.
One way that virtual project teams are better enabled is through document- management
websites (e.g. Google Docs or Launchpad), voice or video telecommunications (e.g. Skype)
and coordination software (e.g. Webex or Gotomeeting).
1. Project selection;
2. Project planning;
3. Project implementation, control and monitoring; and
4. Project completion and review.
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These tasks are complex and there are a number of useful analytical techniques that the
management accountant can use to complete these tasks. Typically, the outcomes of these key
tasks are combined to form the project proposal or business case.
When preparing a business case for a project, it is important to ensure that the key assumptions
used in the preparation of the quantitative data are provided so that decision-makers gain a
better understanding of the project. It is also important to provide a discussion of the advantages
and disadvantages of a particular option, as well as supplementary information (such as qualitative,
non-financial information) so that a complete business case can be presented. Let us review in
more detail the purpose and content of a project’s business case.
In many organisations, it is the project manager who is responsible for compiling the business
case. In large organisations, the management accountant is usually part of a team that will
develop a project’s business case. Consequently, unless the management accountant has
been delegated responsibility for the overall preparation of the case, they will typically only
have input into part of the process (often the financial analysis). In this setting, some of the
other skills we have discussed, such as being able to work in teams, become particularly
important. In smaller organisations, the management accountant will often be responsible
for putting together the whole business case. In this instance, not only will the management
accountant need the technical competence and written communication skills to prepare each
section of the business case, but they will also need additional soft skills, such as relationship
management, negotiation and persuasion, to work with the executive decision-making team.
The following example highlights the content that is usually included in a business case. The role
of the team involved in the preparation of the business case is to translate this analysis into an
understandable format to enable decision-makers to act.
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Background and problem This section contains the reason or problem that has triggered the
need for a project. In most cases, there is some kind of opportunity or
a problem to fix. It is important that there is a clear understanding of
the issue to be addressed. Failure to have this understanding may lead
to a decision to undertake a project that addresses the wrong problem.
Strategic fit This section outlines the extent to which the project fits into the
organisation’s strategy. It is important to understand that the business
case is not the organisation’s strategy but is there to support or deliver
a component of the strategy.
Objective This section states clearly what the objectives of the project are and
what ‘success’ looks like in a tangible or measurable way. The objectives
of the project will reflect the strategy, as discussed above.
Identification of alternatives This section outlines the options or alternatives to be considered along
with supporting analysis. As most problems or opportunities can be
addressed in a number of ways, an analysis and a strong argument for
how the recommended solution fits the criteria for success are required.
Selected project This section provides detailed analysis of the selected option and
will contain:
• risk assessment;
• financial analysis;
• benefits analysis;
• cost benefit analysis;
• project planning;
• project budget;
• project monitoring and performance measurement; and
• project completion and review process.
You will notice that the contents of this module follow a similar order to the sections in a typical
business case, outlined in Example 5.7 above. Let’s discuss in more detail what needs to be
considered in each of the key areas of analysis.
Strategic analysis/fit
The first project selection criterion is the strategic fit between the proposed project and the
organisation’s objectives and strategy. Projects need to support organisational strategy and
help an organisation achieve its overall objectives. When an organisation has an operating
model based around projects (e.g. a company that builds infrastructure projects, such as
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Leighton Holdings, discussed in Part A), then the strategy of the company is implemented
through projects. Clearly, a fit between the project and the company strategy is a central issue.
However, when a project is intended to support an organisation’s operating model, such as a
research and development project to improve or introduce a new product (e.g. the Apple iPad
example in Part A), then this project has to fit within the strategy of the organisation. When a
project does not have its origins directly from an organisation’s strategic planning, a strategic-fit
assessment can be conducted by reviewing strategy documents or assessing how the project
supports the initiatives presented in a strategy map.
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One way to align projects to the strategy is to link the project explicitly to the strategy. Loch and
Kavadias (2011) developed a method for doing this. The first task is to clarify the business
strategy by addressing five questions:
1. What product (or service) does the organisation offer?
2. Who are the organisation’s customers?
3. How does the organisation deliver its product or service?
4. Why do customers buy from this organisation rather than from somewhere else?
5. What will happen if the environment changes?
The answers to these questions are then used to inform the project strategy, where a clear
understanding of what the project delivers against the business strategy is developed.
This includes what target products or technology the projects will deliver and what it will
contribute to the organisation. The business strategy will provide the financial boundary for
the project and a direction for what is to be delivered, and the project strategy will provide
the kind of constraints and opportunities to be delivered back to the organisation strategy
(Loch & Kavadias 2011).
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512 | PROJECT MANAGEMENT
E-business site
The underlying problem for the company was that it was one of only a few companies that sold a
particular resource for which there were numerous customers. It had a sense that it was selling the
resource too cheaply. Due to the market structure, the resource was not traded regularly on commodity
markets, so there was very little external information on the market price to allow them to make
comparisons. To remedy this, the company set up an e-business site that enabled it to release certain
amounts of the resource at a chosen price to establish how quickly it sold.
This information then enabled the company to understand what the actual market price was and
thereby increase its revenue and profit.
1. What is the likely long-term impact of this project on key measures used to evaluate business
success (and presented in the strategy map, if one exists)?
Like most profit-oriented companies, it had a specific level of profitability as a key project objective.
This project had a clear impact on profitability through more effective revenue management
from better market pricing. This had longer-term effects as the company previously had very
little capacity to gain market intelligence on price, and the project enabled it to create a more
transparent market in the long term.
2. Is this project in line with the objectives and actions listed in the organisation’s strategy
document?
Yes. The company had objectives centred on ensuring it was in the lowest quartile in terms of cost
structures and maximising revenue streams in highly competitive commodity markets.
3. Does this project address an emerging or existing risk, and/or a new opportunity?
Yes. While the key risk was that the company was not able to obtain appropriate revenue streams
due to underpricing, it was also able to create a more transparent market, which opened up better
opportunities for supplying new customers and servicing its current market more effectively.
(over the long term) the proposed ERP system. Notwithstanding these concerns, the CIO made the
decision to invest in a new ERP system.
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1. What is the likely long-term impact of this project on key measures used to evaluate business
success (and presented in the strategy map, if one exists)?
The ERP system investment had a negative effect on profitability because: depreciation on the
assets base increased; the debt capital required to fund the asset incurred interest expense; and
the operating costs over the life cycle of the systems were increased.
2. Is this project in line with the objectives and actions listed in the organisation’s strategy
document?
No, the company had no strategy in relation to improvements in information provision and
more seamless information integration. One of the objectives of an ERP system investment is to
improve information flow and reduce human input into data entry and other data processing and
conversion processes. However, as explained above, senior IT executives in the company were of
the opinion that this could be achieved at a fraction of the cost with alternative IT systems.
3. Does this project address an emerging or existing risk, and/or a new opportunity?
One of the risks the company faced at the time was the increasing use of particular types of
ERP systems, which could have made it harder for buyer/supplier relationships to be managed.
However, this was considered to have a low probability for the company at the time. There were
no new market opportunities to be created and very few cost-saving opportunities.
The discussion in Module 2 about strategic analysis (e.g. SWOT) is clearly relevant to the three
questions above.
So, while a project may present a financially viable opportunity with minimal risk, it may not be
in line with the current organisational strategy. In the absence of a strategic fit, the decision to
proceed with the project should acknowledge this. Such opportunistic project selection should at
least be a conscious choice.
➤➤Question 5.5
Please now read part A and B of the case study in Appendix 5.1 on the Sydney Seafood Bar.
Do you think the project has strategic fit? Why or why not?
Note: The concepts covered in this appendix (not the specific details of the case) are examinable.
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514 | PROJECT MANAGEMENT
Stakeholders are key individuals, groups or functions that have a stake or interest in the project.
They can be categorised as internal and external. Within these two categories, Pinto (2010)
identifies a number of different types of stakeholders.
Internal stakeholders
• Top management—Top management have control over projects and typically make the
final decision on whether a project is approved, the level of resources that are devoted to it,
and whether, if required, it is terminated early.
• Finance and accounting—During project implementation, the finance and accounting
functions in organisations are typically focused on whether a project is within its budget and
is using resources efficiently.
• Functional management—Members of project teams are often supplied by functional
managers and they may either be on loan to the project (i.e. in the case of task-force
project teams) or still working within the functional manager’s area (i.e. in the case of matrix
structures). Project managers should understand that project staff may have divided loyalties
and that functional management may be more interested in their own function’s success,
rather than the success of other organisational projects.
• Project team members—The project team has an interest in the success of the project,
but at the same time, may still have loyalty to their functional area. Moreover, project
team members may be motivated by their own career paths and their own incentive and
compensation packages, which—although they should be—may not always be aligned with
the project objectives.
External stakeholders
• Clients—Clients are typically interested in the project being completed on time, within budget
and to specifications. In the simplest sense, a client may be external to the project organisation
(e.g. a software company developing software for a manufacturing organisation). However,
a client may also be external to the project team, but still be within the same organisation.
For example, the IT project team may develop software for the manufacturing department
and both are within the same larger organisation. In this way the manufacturing department is
the client of the IT department. One of the issues with project stakeholders is that they often
realise after the drawing up of the project specifications, that there are complexities or issues
they had not considered requiring an alteration of the project scope. Another issue is that there
may be a number of different stakeholders within the organisation who may have different
interests. One of the challenges for project managers is to communicate with these multiple
stakeholder groups and attempt to satisfy their needs.
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• End users–the client entity requires the output from the project (e.g. the software) to
be used by its employees or customers. Those who utilise the project output are often
called end-users, or customers. Although end-users do not have a strong voice during
the project, it is recommended that the project team involves them during the project in
the development of the solution. It is important that end users are comfortable with the
solution, because if they do not utilise the deliverables from the project, the project will
fail to realise its target benefits (Zwikael & Smyrk 2011).
• Regulators—Regulators may be bodies such as local, state or federal government,
as well as government agencies and statutory bodies that have legal backing
(e.g. standards authorities).
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Stakeholders often have quite different interests and these may be incompatible. For example,
if you worked for a property development company you may have banks or shareholders who
have provided financial resources and who want an adequate return. Part of this return would be
to fast track the construction by working weekends and later in the day so that the construction
can be completed earlier and start generating positive cash flows. At the same time, you may
have the community that surrounds the construction site which does not want the excessive noise
at night and on weekends. Clearly, these interests are incompatible and will need to be balanced.
This balancing issue will be addressed in more detail later in this section.
When management accountants undertake stakeholder identification and assessment, they need
to think critically about what the interests of the stakeholders are and what kinds of data and
KPIs could be accurately captured and tracked over time to ensure that stakeholder satisfaction
is maintained. You will recall in Module 3 we discussed the use of the balanced scorecard (BSC).
An interesting research study on using a BSC for signalling information to stakeholders was
conducted by Sundin et al. (2010) where they looked at how multiple and competing stakeholder
objectives can be reflected in a BSC. One key finding is that managers have to understand
who their stakeholders are, what their interests are, and how these can be reflected in the
design of performance indicators. This is to enable tracking of the extent to which they deliver
stakeholders’ requirements.
A further insight on this issue that is very useful for management accountants is provided by
Malmi and Brown (2008). They make a distinction between information for decision-making versus
information for control. Some management systems can be used for control of behaviour—such as
a project manager’s need for performance indicators on cost, quality or time to ensure the project
is delivered as specified. There are also management systems used by decision-makers, which are
not directly related to the behaviour of organisational staff—such as a client who may have
technical specification requirements, which are reflected in performance indicators so they can
make the decision as to whether the project fits their requirements.
and assessment if they are to design appropriate management systems for projects.
➤➤Question 5.6
Assume that the organisation that you work for, or one that you are familiar with, has won a tender
for a project to construct a new shopping centre in a suburban area. Who are your key external
stakeholders and at what stages of the project are their interests going to be important to you?
516 | PROJECT MANAGEMENT
Projects can significantly affect both internal stakeholders (e.g. through the changes in
assets, technology or organisational processes that the project was designed for) and
external stakeholders (e.g. through changes to the competitive environment). Consequently,
the effect of the project (both during implementation and at completion) needs to be assessed
as to whether it is morally good or bad (i.e. ethical or not). Two important issues that may
make ethical choices in projects more difficult than in the day-to-day operations of typical
organisations include the following.
1. Projects are unique, meaning that often previous practices and experiences do not exist
that can be used or learned from. It also means that there may not have been sufficient time
elapsed for ethical differences between employees to have emerged, or been resolved and
for common ethical practices to have been established. Where appropriate, there should be
an alignment between organisational values and project team values.
2. As projects are often finite in terms of time, the results of poor ethical choices may be less
apparent in the immediate future. Also, the project team, organisation, or team members
may complete the project without having to bear the consequences of unethical decisions.
Project sponsors and managers have a critical role to play in the development of ethical practices
in projects. Part of their role is to overcome the two key issues outlined above. First, they have to
ensure that an ethical framework or set of practices is developed that is aligned with the overall
organisation. Second, they have to ensure that the long-term effects of decisions are taken into
account in addition to the short-term focus. Some responsibilities are important and will help
to ensure better outcomes for project stakeholders.
To evaluate whether a project decision is ethical or not, as well as how it will affect project
stakeholders, we can use a modified version of the American Accounting Association (AAA)
ethical decision-making model that is described in the Ethics and Governance subject of
the CPA Program. Some additional questions that can be asked are provided by Drellinger
(citied in Turner 2003, p. 170).
1. Which goals or priorities does this solution support or work against?
2. Does the solution reflect the values of the organisation and the decision-makers?
3. What are the consequences (in terms of benefit or harm) and ramifications (effect of time and
outside influences) for each of the stakeholders?
4. What qualms would the decision-maker have about the disclosure of a favourable decision to
this solution to the CEO, board of directors, family, the public?
5. What is the positive or negative symbolic potential of this solution if understood—
or misunderstood—by others? Will it contribute to building and maintaining an ethical
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environment?
While some of these questions relate to a normative (what ought to be) approach to ethics,
there are also real utilitarian (the value is related to the benefits gained or reduction in loss)
aspects as well.
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So, you will notice that point 4 focuses on the disclosure of decisions to others. This has an
effect on the reputation of a project or company, based on the decisions made. For example,
if a decision is made that is not seen as ethical by the public, the reputation of the organisation
or project can be damaged regardless of whether the decision is normatively right or not.
A good example of this is the discussion around the company James Hardie and some
of its decisions relating to asbestos compensation, corporate restructuring and location.
Regardless of whether these decisions were legal or normatively acceptable from a maximising
shareholder wealth perspective, or not, their public reputation was damaged by the disclosure
of these choices.
Ethics is discussed in more detail in the ‘Ethics and Governance’ subject of the CPA Program.
Risk assessment
Project risk assessment is an integral part of project selection and involves risk identification,
classification, prevention and monitoring. At the project selection stage, major sources of risk
are identified, evaluated and classified. Typical sources of risk include:
• the time to complete the project;
• the availability of key resources and personnel, and the cost of these resources;
• the existence of, and solution to, technological problems;
• macro-economic variables such as finance costs, inflation and foreign currency risk;
• for project organisations, project variations required by the client and client solvency; and
• that the project will not achieve its deliverables.
Based on identified risks, a decision regarding the acceptable level of risk is made. The cost
of removing excess risk needs to be calculated and incorporated into project cost estimates.
Typical risk mitigation strategies involve contractually assigning the risk of currency movements,
financing costs or resource costs to the client. This is common (and politically controversial)
in government infrastructure projects where, because of the large size of projects,
governments assume many of the risks more commonly borne by private organisations.
Management accountants can help in identifying and quantifying risks, and in finding the
most economical way of transferring risks.
The management accountant should understand techniques such as the calculation of expected
values, and the estimation of the probability of the occurrence of risk events. Calculation of
probabilities is particularly important where risk events are interdependent.
Eden and Ackermann (2005) analysed several large projects that experienced massive cost
overruns. The authors attribute these large overruns to interdependencies and conclude that
‘Costs combine together in non-linear ways, and accelerating projects can set up vicious
cycles that increase costs many more times than expected’.
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518 | PROJECT MANAGEMENT
Risk identification
There are a number of ways to identify project risk. Organisations undertaking projects
regularly develop checklists to help with risk identification. One approach centres on the
following questions.
What? What is the outcome of the project, and will it work (e.g. technical functionality)?
What skills will be required?
Who? Who are the stakeholders? Who will be involved, and are suitable personnel
available? Who will be responsible for what? To whom is the project a threat?
Why? Why are they involved? The purpose here is to identify the aims of different
stakeholders involved in the project (e.g. subcontractors, partners, local
government).
How? How do we ensure that the required actions are undertaken and required
resources are available?
Where? Where is the project located, or where will the project have an impact?
The purpose here is to identify the risk associated with project location
(e.g. environmental, political).
When? When will the project take place, and what is the schedule? What are the
main threats to timelines? What is the impact of missing the deadlines?
How much? How much is the project likely to cost? What is the level of uncertainty in
project costs? Can reliable maximum and minimum cost estimates be made?
Risk classification
Risk identification is followed by classification. The purpose of classification is to assist in
deciding whether a project should be abandoned because it is too risky, or in identifying
specific risks that need to be reduced or transferred before starting a viable project.
As illustrated in Figure 5.5, probability and financial impact are assessed as high or low
for each risk, and risks are assessed on this basis.
Risks that are highly probable and that have a high financial impact if realised are critical and
should be considered first. Next in importance are those risks with a low probability of occurrence,
but high financial impact. The viability of reducing these risks, including any associated costs,
will assist in deciding whether the proposed project is worth pursuing, and what the expected
outcomes should be to compensate the organisation for the risks taken.
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Study guide | 519
Probability
Assume you undertake risk assessment for this company and you have four projects to undertake.
These are:
1. a new gas line to an area that has to pass through a relatively geologically unstable parcel of land;
2. cabling for telecommunications through the same parcel of land mentioned above;
3. cabling for telecommunications in a newly developed area; and
4. installing high-voltage underground electricity cables through a local area in an already
existing path.
The next thing is to assess each of the projects and identify both the probability and impact and then
multiply the probability by the impact. This approach is outlined for the above four projects in the
following text.
Project 1 has a high level of probability of failure, as the land is unstable and has been assessed at
seven. The financial impact is also high which may be judged at eight. This will result in a rating of 56.
Project 2 has a high probability of failure, as the cabling is through the same parcel of unstable land
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and so has been assessed at seven. But it has a low financial impact so it may be assessed at two.
The result is a rating of 14.
Project 3 has a low probability of failure, as the cabling is in a newly developed area (a risk rating of
two). It also has a low financial impact, being cabling for telecommunications (a risk rating of two).
This will result in a rating of four.
Project 4 has a low probability of failure, as the underground electricity cabling is through a local area
in an already existing path (a risk rating of three). However, it has a high financial impact because it
relates to high voltage electricity cables (a risk rating of seven). This will result in a rating of 21.
From this analysis, you can start to rank the projects and focus on more intensive risk management
for the higher risk projects.
520 | PROJECT MANAGEMENT
The identification and classification of risks facilitate project selection decisions. Project managers
need to make sure that the same risks are not accounted for more than once—for example,
when engineers revise their cost estimates to adjust for risk and, at the same time, accountants
compensate for the same risk by raising the project’s required rate of return (RRR). A management
accountant can assist project managers by designing systematic approaches to managing project
risk that ensure that the risk is accounted for just once.
At this point, an important issue to keep in mind is that what we have discussed is risk
assessment, which is different from risk management. As we have outlined, risk assessment is
undertaken before the project starts. Risk management, on the other hand, is undertaken while
the project is being undertaken. It is the ongoing process of monitoring and managing the risks
of the project. In Part E we address, in more detail, the processes involved in risk management.
Analysing profitability does not complete the management accountant’s financial analysis.
There also needs to be sufficient funds available to finance a project. Management accountants
may assist in project finance analysis, although in large organisations there is usually a separate
project finance function. Project finance is beyond the scope of this module, but for the majority
of projects, project financing is no different from the financing of other organisational activities.
The NPV method compares the present value (PV) of all project cash inflows and outflows
with the initial investment required. Note that for large projects the investment may span
several years.
All project cash flows are discounted using a required rate of return (RRR) or discount rate.
Often, the discount rate used is the organisation’s cost of capital. The NPV is the sum of the
PVs of all project cash flows. An NPV above zero tells us the extent to which the project will
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n
1
=
PVt = 0 ∑ × CFt
(1 + i )
t
t =1
Where:
i = discount rate
n = project life
CF = cash flow
t = year
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Project costs
Project cost is also called the initial investment. Preliminary cost estimates are usually made when
alternative project proposals are prepared for consideration. Cost estimates may be revised as
project planning proceeds. Final cost estimates are completed only after schedules are agreed
to, and major contracts regarding the project are completed. Financial analysis of project costs
and budgets should be updated as more detailed and accurate information becomes available.
Large projects are usually broken down into sub-projects; then cost estimates are devised for
each sub-project. It is common practice to include a reserve amount to account for risks. This is
necessary if risk analysis has not been completed and/or the amount of reduction or transferral
of risk is uncertain. Reserves can be based on experience from similar projects. In construction
projects, a 10 per cent reserve is common. The percentage used depends on the reliability of
the cost estimates. Reserves do not account for changes in project content or scope, as those
are normally negotiated and priced separately.
Management accountants need to consider whether a project will require an increase in the
organisation’s working capital in addition to the funding of direct project costs. Where a project
is expected to increase productive capacity and increase sales volume, increases in inventories
and accounts receivable will require additional finance.
Sunk costs should not be included in the project’s profitability analysis. They are cash flows that
have already taken place and, so, have no impact on future cash flows.
When using DCF methods, finance costs are accounted for in the discount rate used. Therefore,
cash flows associated with financing the project (i.e. interest payments) are not separately
included in project cash flows.
One main problem in using DCF methods is the prediction of future cash flows.
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Where revenues need to be estimated, management accountants can analyse market growth,
developments in market share, the actions of competitors and trends in price levels. Forecasting
is likely to be easier if the project aims to replace an organisation’s resources instead of
expanding them.
When a project involves delivery to a customer, cash inflows are contractually determined, and so
are more easily forecast. Sometimes, however, contracts make allowance for inflation or currency
fluctuations, and so future cash flows, even if contractually determined, can vary depending on
economic circumstances.
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Future cash flows most often have tax implications and it is important to include these tax
effects in any DCF analysis. Most revenues increase taxable income, while expenses decrease it.
Of particular note, depreciation, like other accruals, is a non-cash expense so it does not appear
in a DCF analysis. However, depreciation does reduce taxable income and in that way it affects
cash flows. So, this component needs to be included in any NPV calculation.
For example, consider a project involving the purchase of new machinery for $8 000 000.
Assume the taxation regulations permit this asset to be written off on a straight-line basis over
four years and that the tax rate is 30 per cent. The annual depreciation charge will be $2 000 000
and the resulting tax saving will be 30 per cent of this, or $600 000 per year. The cash flows to be
included in the project’s DCF analysis include an immediate outflow of $8 000 000, and for years
one to four, an inflow (a tax saving) of $600 000. Note that depreciation has no cash flow effect
except for the tax saving.
One of the challenges faced when a project is being implemented is the reconciliation of
forecast cash flows with the actual cash flows. While we will talk in more detail about this later
in the module, the key issue to keep in mind is that the forecast cash flows are going to be
based on assumptions that may or may not translate into practice. For example, the expected
timing of the cash flow may be different, possibly caused by the rate of completion of the
project being slower than expected. A further consideration to keep in mind for projects is that,
like any financial reporting, the profit and loss for a project budget will be different to the cash
flow statement prepared for reporting and monitoring purposes.
Residual value
This is the value of the asset at the end of its useful life. It may be either negative or positive.
For example, a nuclear power plant project may have a long initial project development phase,
decades of power generation and positive cash flows, but a negative residual value at the end
due to decommissioning costs and long-term nuclear waste-management costs. However,
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for projects with long lives (greater than 15 years), residual value usually has little relevance due
to the time value of money. For example, the PV of a cash outflow of $1 000 000 in 15 years at
a discount rate of 10 per cent is approximately –$239 400; in 30 years it is –$57 300. In contrast,
for short-term projects, the residual value can have a significant impact on the project’s NPV.
Tax impacts relating to residual values are often important. When a capital asset is disposed of,
a capital gain or loss can result. Tax effects should be incorporated into any DCF analysis.
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Discount rate
The selected discount rate has a profound effect on the NPV analysis. For example, as illustrated
below, the PV of $100.00 to be paid in one year’s time is $86.96 if the return on investment (ROI)
is 15 per cent ($100 / (1 + 0.15)). In other words, if you invested $86.96 at a 15 per cent ROI,
you would have $100 in one year’s time. If 5 per cent is used as the discount rate for the same
future cash flow, the PV is $95.24 ($100 / (1 + 0.05)). The higher the discount rate, the lower the
PV of project cash flows. As the discount rate has such a large impact on the PV of future cash
flows, selecting an appropriate discount rate is one of the most important steps for increasing
NPV accuracy.
PV FV
So how are discount rates set? The first factor to consider in estimating a discount rate is the
organisation’s cost of capital. When organisations raise project funding from highly competitive
markets, estimating the cost of capital is relatively straightforward as prices are readily observable.
For example, if an organisation is going to finance a project using a bank loan, the cost of capital
is the interest rate and fees associated with the loan. If the project is funded by an equity raising,
then the shareholders’ expected returns from dividends and share price growth, can be taken as
the project’s cost of capital.
Another factor to consider in setting the discount rate is the opportunity cost of capital or the
return the organisation could get from some other project or investment of equal risk. If the next
best opportunity is forecast to generate a 15 per cent ROI over the same time frame at the same
level of risk, the opportunity cost of capital is 15 per cent. If the next best project is riskier than
the project being evaluated, then a risk premium needs to be deducted from the opportunity
cost of capital. The opposite is also true. This adjustment improves the validity of the discount
rate that is applied to the project being evaluated.
Many organisations use their weighted average cost of capital (WACC) to discount project cash
flows. The WACC is the cost of the organisation’s present capital structure—the capital for all of
the organisation’s existing assets. It is appropriate to use this discount rate as long as the project
under consideration does not differ in its risk profile, or in any other economically significant way,
from the organisation’s existing projects. The calculation of the WACC is detailed below.
WACC = Rd × Wd + Re × We
For example, if a project is financed by 40 per cent debt with an (after-tax) interest rate of
7.5 per cent and the rest is financed using equity with an opportunity cost of 14 per cent,
the WACC would be 11.4 per cent (7.5% × 40% + 14% × 60 %). Estimation of opportunity cost
and the risks associated with future cash flows is usually completed in consultation with each
relevant department, including marketing, operations and finance. Estimation of the WACC is
usually overseen by the finance department, with most organisations setting clear policies and
specifying the WACC (usually termed a ‘hurdle rate’).
524 | PROJECT MANAGEMENT
As mentioned earlier, some organisations use a discount rate that adds an allowance for project
risk to their WACC. High discount rates can severely reduce the PV of distant cash flows, because
generally the distant project cash flows are the revenues that the project creates. This approach
can therefore create a bias against long-term projects. It is preferable to identify and manage
each element of project risk than to use an arbitrarily high discount rate for this purpose.
In hierarchical organisations, business units are sometimes required to use high discount rates
to ensure large enough returns to cover corporate overheads. In other words, projects returning
15 per cent at the business unit level will return less than 15 per cent at the corporate level
(due to the inclusion of corporate overheads).
Weighted average cost of capital is also discussed in the ‘Financial Risk Management’ subject of the
CPA Program.
Time period 0 1 2 3 4 5
Net cash flow –1 000 000 300 000 300 000 300 000 300 000 300 000
PV calculation –1 000 000 300 000 300 000 300 000 300 000 300 000
/ 1.0000 / 1.1500 / 1.3225 / 1.5209 / 1.7490 / 2.0114
PV –1 000 000 260 870 226 843 197 252 171 527 149 150
The project has an NPV of $5642, being the PV of all future cash flows less the initial investment
($1 005 642 – $1 000 000). The positive NPV means that, based on forecast cash flows and the cost of
the investment, the organisation will recover its cost of capital plus the equivalent of $5642 invested
at the cost of capital. Would you accept such a project? It would depend on how confident you are in
the forecast net cash flows and whether you had a better project to invest in (your opportunity cost).
Given that the NPV is small in relation to the investment, strategic fit and risk factors are critical in
project selection or rejection. If this project is a good strategic fit and low risk, it should be selected;
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➤➤Question 5.7
Big Firm Pty Ltd is considering an IT project that will increase the efficiency of service staff.
The old system that it will be replacing has a book value of $100 000 and a present resale value
of $70 000. Data on the new system and the projected impact on service operations costs are:
Development cost $700 000
Implementation cost $400 000
Residual value $100 000
Reduction in labour cost per year $180 000
Increase in utility costs per year $10 000
Big Firm Pty Ltd has an RRR of 14 per cent and the economic life of the project is expected to
be 10 years.
(a) In a table format, show the cash flows and calculate the NPV for the project. Disregard taxes.
(b) On financial grounds, would you recommend the project?
(c) The project manager who prepared the above data called to say that there are several errors
in the cost calculations. The development cost is actually $760 000, and the reduction in
labour cost is $230 000. Does this affect your recommendation to undertake the project?
Show your workings.
If the project’s IRR is higher than the organisation’s RRR, this indicates a profitable project
(i.e. the NPV is positive). Alternatively, if the NPV is negative, the IRR will be lower than the
organisation’s RRR. IRR is similar to NPV in that they are both DCF methods that account for
the time value of money. They differ rather obviously, however, because NPV is measured
in dollars, while the IRR is a percentage measure. The NPV gives a sense of what a project
will add to an organisation’s net assets; the IRR makes it easy to compare different projects
and indicates the effect of a project on the organisation’s current ROI. A project with an IRR
higher than the organisation’s ROI will increase that ROI if adopted.
Note that without a financial calculator or spreadsheet, the calculation of IRR is typically
undertaken by trial and error. It is important to understand the concept of IRR and be aware
of how to estimate the IRR using trial and error. For example, if a project has a 10 per cent
discount rate and an NPV of $100 000, we know that the IRR will be higher than 10 per cent.
We would continue testing new discount rates (e.g. 12%, 14%, 16%) until we were able to
obtain an NPV of zero (and hence determine the IRR for the project).
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526 | PROJECT MANAGEMENT
➤➤Question 5.8
Assume that you are comparing two projects, only one of which can be undertaken. Your analysis
indicates that one project yields a higher NPV than the other. However, the one with the lower
NPV has the higher IRR.
Given a discount rate of 10 per cent, the project NPVs and IRRs have been calculated as follows:
Project 1 Project 2
$ $
PV of Year 1 cash flow (discount rate = 10%) 200 000 1 200 000
NPV calculation (100 000) + 200 000 (1 000 000) + 1 200 000
IRR †
120% 32%
†
Calculated using spreadsheet software. You are not expected to re-calculate this figure.
Profitability index
The profitability index (PI) is the PV of all future expected cash flows divided by the initial cash
investment. When the PI is 1, this indicates that the project NPV is zero. Values greater than one
indicate an acceptable project.
Payback
Payback is a break-even concept. It is the time it takes a project or an investment to generate
a cash amount equal to the initial outlay. Alternatively, payback is the time taken for a project’s
cumulative cash flows to equal zero. For projects with regular cash flows, payback can be
calculated using the formula:
If project cash flows are irregular, it is necessary to add annual cash flows for years 1, 2, etc.,
until they equal the original investment.
Payback does not account for the time value of money. To account for this, management
accountants can calculate the PV of yearly cash flows using an appropriate discount rate,
and so calculate a discounted payback period (DPP). Discounting cash flows leads to longer
payback times. The discounted payback period is calculated as follows:
• identify the annual cash flows;
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The payback method will not indicate whether a project is profitable, because it only measures how
long the project takes to break even. It is a measure of project risk, not profitability. Potential cash
flows after the break-even point are not considered.
The payback method is normally recommended for analysis of small investments. Forecasting
cash flows in the near future is likely to be reasonably accurate, and therefore a short payback
can be considered a reliable measure of risk. This can be a trap for some organisations,
however. To avoid risk, organisations select short-term projects and avoid long-term projects.
Such an approach may allow competitors to implement major projects and achieve significant
competitive advantage.
Return on investment
Return on investment (ROI) is an accounting-based measure, as the ‘return’ referred to is profit.
In the context of capital budgeting, ROI is sometimes called the average accounting rate of
return (AARR) or accounting rate of return (ARR).
There are many variants of ROI, but the basic idea is simple.
Average yearly return on the project (profit) is divided by the capital invested. Some variants
use yearly operating profit, while others rely on yearly cash flows. Some variants use initial
investment, and others use average investment. Average investment may be calculated as
the sum of initial investment and residual value divided by two. To illustrate using the data
in Question 5.7: the initial investment is $1 030 000 and the residual is $100 000. The average
investment is therefore:
Note that if there was no residual value, the average investment is $1 030 000 / 2 = $515 000.
Because ROI does not account for the time value of money, it should only be used in conjunction
with DCF methods, especially for longer-term projects.
Residual income
Residual income (RI) is calculated by deducting a notional capital charge from an accounting
return. The accounting return used is most often net operating profit after tax (NOPAT).
The capital charge is calculated by multiplying either the project initial investment or the
project average investment (as described above) by the WACC. The best-known application
of RI is Economic Value Added (EVA).
When applied to project evaluation, RI is determined for each year, the PV of each RI is calculated,
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and the sum of RIs over the project’s life reveal how much value a project is expected to create.
So, in this sense, RI combines accounting measures with DCF techniques.
528 | PROJECT MANAGEMENT
Example 5.12: C
alculating the profitability index, payback
period, ROI and RI
Using the data from Question 5.7†, we will calculate the profitability index, payback period, ROI and
RI. Tax effects are ignored and a WACC of 14 per cent is assumed.
Profitability index
Profitability index = PV of cash flows / Initial cash investment
PI = PV / I
PI = $913 715 / $1 030 000
= 0.89
A PI < 1 is unacceptable, as it indicates an NPV < 0.
†
From the suggested answer to Question 5.7, the NPV is –$116 285 and the original investment (Year 0) is
$1 030 000. Therefore, the PV of the Years 1 to 10 cash flows is: $1 030 000 – $116 285 = $913 715.
Payback period
Payback = Initial investment / Annual cash flow
= $1 030 000 / $170 000 per annum‡
= 6.06 years
‡
Exclude residual value
This is a measure of one aspect of project risk. It takes over six years to recover the initial investment.
However, payback tells us nothing about the profitability of the project, whether in real economic
terms, or in accounting terms.
Note that because the project NPV is < 0, if a discounted payback was calculated, the payback period
would be longer than the 10-year project life (i.e. payback would not be achieved).
Return on investment
ROI = Profit (or annual cash flow)§ / Original investment
= $170 000 / $1 030 000
= 16.5%
§
Exclude residual value
ROI (like other percentage measures and ratios) is mainly useful for comparing projects of different
sizes. Also, ROI does not account for the time value of money. For long-term projects, ROI should
only be used in conjunction with DCF measures such as NPV.
Note: Other versions of ROI may also be used. For example, the average investment (($1 030 000 +
$100 000) / 2 = $565 000) could be used in the denominator.
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Residual income
RI = Profit – Capital charge
= $170 000 – 14% ($1 030 000)
= $25 800
Note: Other versions of RI can be used. For example, the average investment of $565 000 could be
used in place of the initial investment amount of $1 030 000.
Study guide | 529
The RI is an estimate of the annual impact on the organisation’s profit if the project proceeds.
However, NPV is a more economically valid assessment of the increase in the organisation’s
value than RI.
Measure
PI 0.89
ROI 16.5%
RI $25 800
As can be seen in Table 5.5, payback only measures risk, and so it provides no financial
measure of the project. The DCF measures (NPV and PI) indicate that the project is
unacceptable—it destroys value. In contrast, the accounting-based measures (ROI and RI)
show the project to be acceptable. The difference in the outcomes is attributable to the
deficiencies of accounting-based measures.
1. Accounting profits include accruals such as depreciation which are not economic measures,
but are based on assumptions about limited asset lives, conservatism in accounting
estimates, and an inevitable decline in value.
2. The second issue is linked to the first. If accruals are unreliable or economically invalid,
then the asset values with which they are associated are equally so.
3. Asset values do not take inflation, or the decline in value of the currency, into account.
A property, plant and equipment account will typically include assets purchased over a
number of years when the currency had different purchasing power. Yet the value of the
account fails to take this into consideration, and the values of assets acquired at different
times are simply added together. The resulting balance is, to some extent, meaningless.
Asset accounts can be adjusted for inflationary effects, but this adjustment is seldom
considered by accountants.
The key message for accountants is that when carrying out financial analysis of projects,
DCF methods like NPV, IRR and PI are preferred to accounting-based measures such as ROI
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and RI. This is because they focus on cash flows rather than accruals, and they distinguish
between the PV and the future value of these cash flows. The main use of accounting-based
measures is to estimate the effect of a project on the organisation’s financial reports.
530 | PROJECT MANAGEMENT
Sensitivity analysis is where changes in key project assumptions are evaluated against financial
returns, such as the effect of a 1 per cent increase in sales growth or cost increases.
Scenario analysis is where the effect of changing a group of assumptions is evaluated, and it
usually involves best versus worst case scenarios. For example, in uncertain economic times, it is
prudent to evaluate a recession scenario, which may include lower consumer demand and lower
input prices from discounting, as well as lower interest rates. An advantage of scenario analysis
is that key risks and contingencies can be planned for, which has the overall effect of reducing
the risk of the project through improved project planning. Worst case scenario planning also
allows projects that have the potential to destabilise the whole organisation to be identified
and avoided.
➤➤Question 5.9
Ideally, the cost of capital used in financial evaluation should reflect the level of project risk, with
investors demanding higher returns for projects with greater risk. Hence, it is common to conduct
sensitivity analysis on differences in cost of capital. Now read Parts C and D of the case study in
Appendix 5.1 on the Sydney Seafood Bar.
(a) Do you think the project is financially viable if the managers have 10 years left on the lease
of the premises and if the shareholders want an 8 per cent return on their invested capital?
(b) What if the shareholders want 10 per cent return on capital? Would that change the decision?
(c) What if the shareholders want 15 per cent return on capital? Would that change the decision?
and risk profiles, based on the annual value that they add (or based on being able to repeat
the project in perpetuity). From a financial perspective, the project with the highest EAC will
be selected.
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NPVt = 0
EACt = 0 =
Annuity factor
Where:
NPV = the net present value of a project
Annuity factor = present value of $1 received annually for n years,
where n is the project life.
1 − (1 + i ) − n
Annuity factort = 0 =
i
Where:
i = discount rate†
n = project life
t = year
†
Sometimes referred to as ‘r’
Example 5.13: A
n organisation with two mutually
exclusive projects
An organisation has two mutually exclusive projects of different lives to choose between: Project A
and Project B. The discount rate for both projects is 10 per cent. The NPV has already been calculated.
Project A Project B
Initial investment –$620 000 –$1 100 000
Net cash flows
Year 1 $540 000 $610 000
Year 2 $540 000 $610 000
Year 3 $610 000
NPV $317 190 $416 980
When comparing projects with the same lives, Project B would be selected. However, as these two
projects are mutually exclusive and have different lives, we need to calculate the EAC to determine
which project adds the most value.
1 − (1 + i ) − n
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Annuity factort = 0 =
i
1 − (1 + 10% )−2
=
Annuity factor : Project At = 0 = 1.7355
10%
1 − (1 + 10% )−3
=
Annuity factor : Project Bt = 0 = 2.48685
10%
532 | PROJECT MANAGEMENT
NPVt = 0
EACt = 0 =
Annuity factor
317 190
=
EAC : Project At = 0 = 182 766
1.7355
416 980
=
EAC : Project Bt = 0 = 167 674
2.48685
Project A has the higher EAC, which means that it delivers more value per year than Project B. As the
capital from Project A will be returned by the end of Year 2, a new project can be started which also
has a high EAC. By using EAC, the management accountant can maximise shareholder returns by
continually recommending that the organisation invest in projects with a higher EAC.
Capital budgeting techniques—mutually exclusive projects with different lives—is covered in the
CPA Program subject ‘Financial Risk Management’.
This trade-off between financial returns and project specification and timeliness has long been
understood in project management. Program evaluation and review technique (PERT) diagrams
and the critical path method (CPM), discussed in the next part of this module, help us to assess
the cost of meeting project specifications and deadlines.
Project
Financial returns specification and
timeliness
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What is less well understood, however, is how to acknowledge the interests of other stakeholders
such as the community or the environment.
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Community
Financial returns and
environment
One useful way to think about this issue is through procedural versus distributive justice
(Sundin & Granland et al. 2010). Distributive justice is the perception of fairness associated
with how much is distributed to individuals (i.e. how big a piece of the pie you get). Procedural
justice is how much say you have in distribution decisions and whether you perceive distribution
processes as fair (i.e. you have a say in how the pie is cut).
If stakeholders perceive that their interests have been taken into account and that procedural
justice has been exercised—even if they are unhappy with how much has been distributed—
then they are satisfied overall. Often, such stakeholders are as satisfied as they would have been
if they had received the distribution they originally wanted. This is important in the context of
balancing stakeholders’ interests with financial returns. If stakeholders perceive that procedural
justice has been exercised, they are likely to believe that their interests have been balanced with
financial returns. The management of stakeholders’ interests is discussed in more detail in Part E.
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534 | PROJECT MANAGEMENT
At the planning stage, the management accountant should assume a leading role in project
budgeting and scheduling, and in consideration of a range of cost-optimisation options.
Many scheduling techniques combine time and cost information, and hence project cost
optimisation must be tightly linked to schedules. Management accountants therefore need to
be able to use scheduling tools.
Example 5.14: A
n IT project in a service-based organisation—
Part B
You will recall that Example 5.5 was about a service-based organisation that undertook an IT project
aimed to make transparent the performance of 4000 front-line employees by using an automated
performance measurement system. If you now consider the problems faced by the company and then
think about how appropriate planning may have either overcome these problems or made them easier
to manage, you will see the benefits of the tools and techniques in this section.
• The project was not allocated enough resources to undertake consultation on performance
measures with the users of the system, or to train employees adequately in the use of the system
when it was implemented. Both these problems reflect poor planning and budgeting.
• Technical design faults meant that the data in the system were not always accurate. This resulted in
compensation for inaccuracies to the affected staff. This is partly the result of not having a proper
description of the various activities or tasks that needed to be undertaken to achieve the project’s
objectives. Furthermore, techniques such as PERT and CPM (discussed below) would have helped
to get the project back on track when unforeseen problems emerged.
• The project manager and his team were evaluated on the original project time and cost, and
the satisfaction of the users of the system. Had proper monitoring and an appropriate plan for
the project’s completion been used, the situation may not have been impossible.
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Project scheduling
Project scheduling is a difficult issue, especially in large, complex projects. A range of methods
has been developed to aid this process. The key methods discussed are:
• Gantt charts;
• program evaluation and review technique (PERT); and
• critical path method (CPM).
Gantt charts
One of the oldest and most widely used methods for presenting schedule information is
the Gantt chart. A Gantt chart shows planned and actual progress for project tasks against a
horizontal time scale (see Figure 5.8). The chart is constructed by listing tasks/activities on a
vertical axis, normally in the approximate order of execution. For each scheduled task, the start
and end dates are illustrated on the horizontal timeline. Project progress can be monitored by
inserting actual start and end times for each task.
Additional information can be added to increase the usefulness of Gantt charts. Project
milestones, both scheduled and achieved, can be marked on the horizontal axis. Various
colour codes can be used to highlight tasks that are behind schedule or those tasks that form
the project’s critical path. The project budget can be related to the Gantt chart by inserting
budgeted dollar amounts on the vertical axis (right-hand side), thereby illustrating how much
money is budgeted for each time period.
The Gantt chart in Figure 5.8 shows each activity, and the time taken to complete the activity,
as a horizontal bar. The bar runs from the start date of the activity to the finish date. In this
example, most activities need to be completed before the next one is started, except for B and
C, and E and F which overlap. In complex projects, there may be a number of activities that can
be undertaken concurrently by different team members. Overlapping horizontal bars show which
activities can be performed at the same time.
Gantt charts for complex projects with many activities may be constructed using software packages.
These packages help decision-makers to perform sensitivity analyses for scheduling (e.g. what is
the impact on Stage B if Stage A is delayed by one week?). In Example 5.15, missing the date for
obtaining planning permission (A) by one day would delay the project for a month, as planning
permission is only granted by the local authority at its monthly meeting. However, being two days
late in installing the electric cables (F) might have no effect on the project completion time, as it
may be possible for Stage G to begin while waiting for Stage F to be completed.
Gantt charts are simple, and are easy to understand, construct and use. Although they require
regular updating, this is easily done, as long as there are no changes to task requirements or
major alterations to the schedule. They are particularly helpful when expediting, sequencing and
reallocating resources among different tasks. All major project management software packages
include Gantt charts.
Gantt charts can also describe task interdependencies, identify critical paths, highlight changes in
the project schedule and identify slack time available for project completion. In order to be able
to understand the meaning of this additional information included in Gantt charts, we first have
to familiarise ourselves with another scheduling tool—PERT.
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Note 1: There is a detailed step-by step example of drawing a PERT diagram available in
Appendix 5.2 of this module.
Note 2: The concepts covered in Appendix 5.2 (not the specific details of the case) are examinable.
Study guide | 537
There are two formats used to prepare a network diagram. The format used in this module
displays activities as arrows and events as nodes (circles). This is called an activity-on-arrow
(AOA) network (see Figure 5.9). An alternative format is an activity on-node (AON) network
(see Figure 5.10). In this second format, nodes represent activities and events are not illustrated.
The choice of AOA or AON representation is a matter of personal preference, although some
software packages support only one of the two formats. We will use the AOA format (Figure 5.9).
2a
1a 3a
1b 3b
2b
1a 2a 3a
Start End
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1b 2b 3b
Network diagrams are normally drawn from left to right reflecting the sequence of activities.
Networks can include a time dimension, with the length of the arrows representing the duration
of each activity. This can make drawing the diagram difficult. Hence, normally the time of activities
is simply noted on the diagram. To draw the diagram, the place to start is with activities that have
no predecessors.
Where an activity has no precedent activity, it can start from the start node. For example,
if Activity (b) has no precedent activity (i.e. does not need to wait until Activity (a) is complete
before it can start), Activity (b) can start from the start node (see Figure 5.11, panel B).
All activities in the project should be joined or linked so that they eventually connect to an
end point, which represents project completion. Where an activity is not a precedent activity
for another activity, it can end at the end node. For example, assume there are eight activities
(a – h). If Activity (e) is not a precedent activity for another activity (i.e. Activities (f), (g) or (h)),
then Activity (e) can end at the end node.
If the project has complex precedence relationships, there might be a need for dummy (false)
activities to be added to the network diagram. This is because, when drawing a network diagram,
we are not permitted to draw two activities between the same two events (e.g. two activities
cannot start at node ‘a’ and both finish at node ‘b’)—see Panel A below. We distinguish the
two activities by inserting two end events (nodes), with a dummy activity connecting the two—
see Panel B. Panels A and B are identical, but Panel B is the correct PERT representation.
Note that a dummy activity has no duration and uses no resources. Its purpose is to indicate a
precedence relationship and it is illustrated by a dashed arrow.
Panel B
a
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Dummy
Activity A 5
Activity B 10
Activity C A and B 3
Activity A has no precedent relationships and is expected to take five days. We can draw a line
representing Activity A from the start node to Node 1.
Activity B has no precedent relationships and is expected to take 10 days. We can draw a line
representing Activity B from the start node to Node 2.
Node 1
Activity A
Start node
Activity B
Node 2
Activity C can only start once both Activities A and B are complete. As Activity B takes longer than
Activity A, we can draw a line representing Activity C from Node 2. However, we still need to join
Node 1 to the ongoing path. As there is no ‘real’ activity joining Activity A with any other activity in
the project, we simply draw a ‘dummy’ activity (dashed line) from Node 1 to Node 2.
Node 1
Activity A
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Activity B
Activity C
Node 2
In this example, we can’t have Activities A and B starting from the same node and ending at the
same node (i.e. the same two events). They need to end at different nodes and then we use a dummy
activity to connect those two nodes. Activity C can then start from the node at the end of Activity B
(i.e. Node 2) and the project continues from there.
ET = (O + 4ML + P)/6
Note for statisticians: The weighting of 1:4:1 assumes that the distribution of possible times
covers six standard deviations and is based on a beta distribution; other weightings might
be considered. For a more-detailed discussion on the use and assumptions of this formula,
see Littlefield and Randolph (1987) or Gallagher (1987).
To highlight scheduling risk, it is useful to estimate the time-related uncertainty (variance) of each
activity. The variance will help in understanding the likelihood of completing the project on time.
A high variance indicates a high risk of out-of-schedule completion. The variance calculation is:
If you are interested in learning more about this, refer to Meredith and Mantell (2012) listed in the
References section at the end of this module.
The EOT for the last event in the project (86 days) is the expected completion time or the ‘project
critical time’. The critical path for a project is the path(s) that result(s) in the project critical time,
that is, the longest time to completion. In Figure 5.12, the path a – d – h is termed the critical
path because this path of events takes the longest. If there are any delays on this path, the whole
project is delayed. Conversely, if events on this path are shortened, the whole project length can
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be reduced (a – d – h).
The critical path is the shortest length of time in which you can complete a project. It is also
the longest path through the PERT diagram. This is because the project will only be completed
when all tasks are finished. This means that the sequence of tasks which takes the longest amount
of time will determine the total time it takes to complete the project.
Note that all events, even those not on the critical path, still form part of the overall project
and must still be carried out in order to complete the project. What we are looking for is the
total length of the project, given that some activities can start immediately, while others have
precedent relationships and can only start once another activity has finished. The critical path
is usually depicted as a heavy line.
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d
2 4
(30,50)
h
a
(40,8) (16,10)
e
EOT = 40 (20,8) EOT = 86
b f
1 3 6
(40,0) (28,8)
g
c i
EOT = 48 (36,56)
(8,0)
(44,12)
The LST can be worked out by starting from the project critical time and deducting activity times
from it (i.e. working from right to left). For example, in Figure 5.12:
• the latest day Activity (f) can be started is 58 (86 – 28). As the earliest start time of Activity (f)
is day 40 (i.e. EOT for event 3), it has slack of 18 days (58 – 40). Where the PERT network is
pictured on a time axis (i.e. arrow length is proportional to time), slack can be indicated by
dotted lines;
• the path c – i takes 80 days and the critical path is 86 days. So, there are six days of slack in
path c – i. This means that Activity (c) could potentially start after six days and the project
would still be completed in 86 days; and
• we see that Activity (h) can only start after both Activities (d) and (e) are complete. The EOT
at Node 4 is 70 days, so unless other preceding activities are reduced in time, this is the EST
for Activity (h). As Activity (h) is on the critical path, the LST and EST are the same (i.e. 70 days)
and there is no slack available.
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A clear understanding of the slack involved in various activities is essential for project managers
who want to ensure that resources are used efficiently. Resources allocated to tasks with some
slack can be reallocated to tasks without slack. Smooth distribution of resource usage leads to
better economic performance for a project, as there is, for instance, less need for overtime.
Note: There are learning tasks available in My Online Learning that provide a further opportunity for
you to enhance your understanding of PERT.
542 | PROJECT MANAGEMENT
For example, if the normal time is 30 days and by adding resources the duration would become
25 days, the crash time would be 25 days. The difference between the normal time and the crash
time reflects the number of days that have been crashed (i.e. 30 – 25 = 5).
Similarly, two costs are specified for each activity: normal cost (budget) and crash cost. Crash cost
is the normal cost together with all the extra costs that are related to expediting the activity.
Careful planning is essential when trying to expedite a project. The likelihood that a project will
need to be expedited is fairly high in situations where time estimates are uncertain and there is a
firm project deadline.
Crashing project activities is typically undertaken where the time-cost trade-off is feasible.
Here we are trying to determine whether it is worthwhile spending more money on additional
resources (e.g. labour or machines) to speed up the project. For example, if it costs $50 000
to crash the project by 10 weeks, but we end up earning a $100 000 bonus, then the time-cost
trade off is feasible.
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You should note, however, that crashing critical path activities may make some other path
critical, or create more than one critical path. Therefore, reducing project time may require the
simultaneous crashing of multiple activities.
Refer again to Figure 5.12. The critical path a – d – h has an EOT of 86 days. The second longest
path is b – g – i, which is 84 days. If the critical path a – d – h is crashed by two days, the critical
path becomes 84 days, and so the duration is equivalent to the path b – g – i. Now we have
two critical paths and further crashing must take into account both critical paths. If you continue
to crash path a – d – h you will receive no benefit: if path a – d – h is reduced to 83 days, path
b – g – i still remains 84 days. In other words, the duration of the whole project has not changed
(84 days). As such, once you have two (or more) critical paths you will need to reduce the duration
of all critical paths simultaneously to have any effect on the project completion time.
Cost optimising
In the case where we are seeking a cost optimum for a project, we continue crashing critical-path
activities one by one until the point where the additional cost of crashing an activity equals the
incremental savings. Figure 5.13 illustrates cost behaviour in cost–time optimisation decisions.
Figure 5.13: Cost behaviour in cost––time optimisation decisions.
Benefit
Crash
Normal Optimum time
time time/cost
Finding a cost optimum is difficult in practice, especially in large projects that are very complex.
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A possible way to overcome this problem is to determine a few alternative time–cost points and
select the one with the lowest total cost.
A graph illustrating a project cost function such as Figure 5.13 above can be drawn based on
information about crashing costs and benefits. Such graphs may be useful in communicating with
senior managers or customers who may argue for early completion without a clear understanding
of the cost implications.
Note: There is a learning task available in My Online Learning which provides a further opportunity
for you to enhance your understanding of crashing a project.
544 | PROJECT MANAGEMENT
➤➤Question 5.10
The managers of the Sydney Seafood Bar (SSB) have decided to use a critical path model to
plan the renovation project, as outlined in Appendix 5.1. The table below indicates the activities
required to complete the project, plus their durations and precedence relationships.
4. Remove mezzanine 2 4 6 14
5. Repair mezzanine 4 6 10 20
7. Build toilets 6 5 10 21
9. Build kitchen 6 20 30 46
(a) Construct the PERT network for the SSB project using the AOA approach (as shown in
Figure 5.9).
(b) Determine the expected completion times for all SSB project activities.
Project budgeting
A project budget has several important functions.
• It is a plan to allocate resources to project activities. As senior managers approve a project
budget, they also approve the use of resources determined in the plan.
• It facilitates the control of project costs and revenues through variance analysis.
• It is the main benchmark used to evaluate a project’s financial success.
• When project team members know that costs will be closely monitored, they are less likely
to engage in actions that cause budget overruns.
Project budgeting was discussed briefly in the project selection section. Project-cost estimation
is the main input for a project budget. The main difference between a project-cost estimate and
a project budget is the time dimension. A project budget provides cost estimates on a weekly,
monthly or quarterly basis, and should reflect project milestones.
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It is often more sensible to budget for activities and milestones rather than time periods that bear
no relation to a project’s critical dates. It is common practice, however, to create project budgets
on a monthly and yearly basis. Typically, project budgets contain only project costs. Revenues and
cash flows are presented in separate finance and cash flow budgets.
Expenses can be allocated to a project as a whole (i.e. where the project is one cost centre),
different deliverables or to business units within the company. The account coding used
varies among companies based on project size, type, complexity and organisational structure.
However, it is preferable if the accounting system can capture the project as a separate unit
to other organisational activities to allow effective project cost control.
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There are different ways to treat overheads in project budgets. If overhead is out of the control
of the project team, allocation will merely obscure evaluation of project success.
As with other budgets in today’s dynamic business environment, it is unlikely that a budget
for a long-term project will remain valid for the entire duration of the project. Therefore,
project budgets need updating, at least after major changes in project circumstances or
major deviations from plan. A revised budget provides a fairer benchmark to evaluate project
management if changes are due to uncontrollable factors. On the other hand, if changes were
controllable, the original budget provides a valid benchmark for performance evaluation. In these
cases, however, a revised project budget may still be necessary to plan for cash flows and to
control costs.
Finally, budget preparation provides a good opportunity for management accountants to inform
project managers about revenue recognition and cost-allocation conventions. This improves the
project manager’s understanding of accounting reports and increases the likelihood of correct
decisions being made regarding the project.
Most organisations will have their preferred project management software which project staff
will be trained to use. These packages generally reflect the underlying project management
scheduling and budgeting techniques discussed above.
Contracts
The project contract with the client and the activity contracts with individual suppliers can be
designed in many ways. Management accountants should consider the effect that contract terms
have on cost control and the actual costs incurred. For example, fixed-price contracts provide
certainty and pass profit risk back to the supplier. In fixed-price contracts, the management
accountant will work with the project manager mainly to control the quality of work and its timing.
Cost control is less important because the supplier has an incentive to keep costs under control
and cannot pass on cost overruns.
Another type of contract that is open to negotiation is payment for work done (i.e. hours or days).
In this case, the supplier (e.g. a building contractor) has an incentive to work more in order to
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increase their revenues. The project manager and management accountant must monitor hours
and costs in addition to quality and time. Some contracts are prepared on a cost-plus basis.
The supplier is reimbursed for their costs plus a margin for profit. In this case, the management
accountant must carefully monitor a supplier’s cost records to ensure that they are prepared in
accordance with the contract and that non-reimbursable costs are excluded.
Additionally, various types of bonuses and profit-sharing schemes can be used to achieve
desired project targets. One of the ways that management accountants can provide added
value for management is in the design of contracts that create the right incentives for suppliers
to reduce cost and time, and to minimise administrative costs for the organisation.
546 | PROJECT MANAGEMENT
Monitoring progress
There are three major areas that are considered in the context of monitoring progress:
• cost;
• time; and
• quality/specification.
Project
cost
Project
Project
specification and
time
quality
An important role for management accountants during project implementation is the collection,
recording and reporting of cost, time and quality related information to control the progress
of the project. Project control is focused on the project budget, project schedule, and other
measures used to establish the achievement of quality and specification.
The main control tools used by management accountants are budget and schedule variances.
In reporting variances, the management accountant must keep in mind that because of the
unique and uncertain nature of projects, and the difficulty of predicting future costs and
activities, significant variances will inevitably arise. These variances will not necessarily reflect
the performance of project managers. Variance analysis is, however, useful in both providing
feedback to project managers about their performance, and in helping to revise budgets and
schedules to reflect new knowledge about the project and the project environment. We will
MODULE 5
extend the discussion on monitoring cost, time and quality/specification to consider two
other related issues that have a significant effect on project progress; risk management and
stakeholder management.
Study guide | 547
Monitoring costs
Project-cost reporting needs to be regular, timely, accurate and relevant. This creates a challenge,
as project reporting is usually tied to the invoicing, record-keeping and reporting routines
of an organisation. Keeping a separate record of committed costs for project purposes will
ensure timely and useful information in project reports. A cost is committed when a contract is
concluded or a purchase order is issued.
The company commits to the cost when the order is placed (1 March), but unless a separate record is
kept of these committed costs, accounting reports will not recognise these commitments in a timely
way. The expenditure might show up in the project report for May, or even as late as June. One may
ask how timely and useful this type of reporting is for controlling project costs.
Regular project-cost reports should contain incurred costs, committed costs and an estimate
of costs still required to complete an activity. These costs are compared against the budget.
Deviations from the budget suggest the need for corrective actions. Management accountants
should not automatically estimate required costs by subtracting incurred costs from budgeted
costs. The key to efficient cost management is accurate budgeting—to produce good estimates
of required costs.
Part of the process of managing costs is evaluating the project cash flows against forecast cash
flows. Some projects will work with a more traditional budget and use accrual accounting to
manage expenses being incurred; however, others will run a cash budget. For projects using a
cash budget, the schedule of cash flows prepared in the initial project analysis will often form the
basis of the cash budget for the project and variance analysis undertaken against these forecasts.
It should also be kept in mind that many projects are dynamic and constantly changing, requiring
the allocation or reallocation of resources to meet a possibly turbulent environment.
A method called earned value (EV) has been developed to assess cost and time performance
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simultaneously. The idea behind the method is to break down the usual budget variance
(actual – budget) into two parts. The key factor in this breakdown is the EV or the expected
cost of project work completed to date.
548 | PROJECT MANAGEMENT
EV can be estimated for a whole project if it is small. For large projects, EV analysis is applied at
the activity level. The EV of work performed is found by multiplying the estimated percentage
completion of each activity by the budgeted cost for that activity. That is:
This gives the amount that should have been spent on the activity so far. For example, if an
activity with a budget of $1000 is 25 per cent complete, its EV is $250. This method of calculation
is appropriate where activity costs are incurred evenly throughout the activity. Estimating EV can
be more difficult if costs are incurred on an irregular basis.
Comparing EV with budgeted costs and with actual costs produces two variances. Project
(or activity) spending variance (sometimes called the cost variance) is the difference between
EV and actual cost at that point in time. The schedule variance is the difference between the
EV and the budgeted cost at that point in time. That is:
Although not universal practice, these variances should be defined in such a way that they will be
negative when the project is over budget (spending variance) and/or behind schedule (schedule
variance). This is the approach taken above.
Continuing the above example where EV is $250: if we had actually spent $350 at that point in
time (i.e. actual cost = $350), the spending variance would be –$100 (i.e. $250 – $350), and the
project would be over budget. If we had expected $300 to have been spent at that point in time
(i.e. budget cost = $300), the schedule variance would be –$50 (i.e. $250 – $300), and the project
would be behind schedule.
A spending variance would likely lead to a reassessment of the budgeted costs of the project,
whereas a schedule variance would likely lead to a reassessment of the estimated completion
time of the project.
As the magnitude of these variances depends on project dollar values, they are commonly stated
as ratios to make them easier to understand, or when the organisation wishes to compare the
performance of multiple projects. The ratios are called the cost performance index (CPI) and the
schedule performance index (SPI).
In addition to these variances, two other variances can be calculated. The time variance is simply
the difference between scheduled time and actual time. The overall difference between actual
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The following EV chart (Figure 5.15) illustrates the tools to be used in reporting project progress
and highlights that the project is currently behind schedule (EV is lower than budgeted cost) and
over budget (actual cost is higher than EV). Example 5.18 further explains how Figure 5.15 can
be interpreted.
Study guide | 549
Cost
Cost variance = CV
Schedule
variance = SV
Time
Actual time Scheduled Estimated
completion completion
Budgeted cost time time
Earned value
Actual cost
WaterSupplyCo is responsible for the main water pipes in a large city. They determine that they need
to initiate a project to replace the water pipes which run under the footpath. The total length of the
water pipe replacement is 480 metres.
WaterSupplyCo engages a contractor (DJ Water) to do the job. DJ Water estimates that it can complete
an average of eight metres of piping a day, so the whole project will take 60 days or 12 weeks. Based on
this, DJ Water puts together the following project budget for the three activities.
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Within the first week of the project, DJ Water find a major problem. When excavating the ground
where the current water pipes are, they find that it is a type of rock called sandstone. This means
that DJ Water needs to widen the channel the pipes sit in, which requires more expense (e.g. hiring
additional equipment) and time in excavation.
After the first four weeks (20 days) of the project, DJ Water has provided the following data:
• incurred $134 064 in costs:
– $94 584 for excavation;
– $39 480 for laying the pipes, filling in the hole and re-concreting; and
• completed 94 metres of water piping.
DJ Water undertakes a variance approach to understand how it is tracking against budget. The first
step is to refer to the original budget for the project. DJ Water originally calculated that at this point,
it would have completed 160 metres of the job (i.e. 20 days at a forecast of eight metres per day).
An initial inspection of the figures suggests that the project is over budget by $42 864 (actual cost
$134 064 – budgeted cost $91 200). This is highlighted by the actual cost being above the budgeted
cost in Figure 5.15.
The second step to undertake is an EV analysis. This shows that the earned value to date is $53 580 (94
metres completed × $570 per metre). From this information, DJ Water calculates that the scheduled
variance is unfavourable by $37 620 (EV $53 580 – budget $91 200). This is highlighted by the budgeted
cost being above the EV curve in Figure 5.15.
DJ Water also calculates that the spending or cost variance is unfavourable by $80 434 (EV $53 580 –
actual cost $134 064). This is highlighted by the actual cost being above the EV curve in Figure 5.15.
The final step is to re-forecast both the time to completion (estimated delay) and the revised budget
(cost overrun), both of which are reflected in Figure 5.15.
The standard budget variance would show that the project has real budgetary problems. When the
spending and schedule variances are calculated (i.e. based on EV), we can see just how serious the
situation is.
EV cannot replace scheduling techniques such as PERT, as it does not account for critical
activities, the critical path or slack. A combination of network analysis techniques and
EV analysis provides a useful system for project planning and control. The management
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➤➤Question 5.11
Explain how project managers can benefit from the use of EV analysis. What are the difficulties
in implementing EV analysis?
Study guide | 551
There are three stages to project quality management as outlined in Figure 5.16.
Quality
monitoring
Quality
planning
Quality
assurance
• Quality planning—At the beginning of the project, the project scope and specifications will
be established. This planning needs to happen at the same time as the project budget and
timelines are established.
• Quality monitoring—A critical task for the management accountant will be to establish
performance measures to reflect the planned specifications. The discussion in Module 3
relating to the characteristics of good performance measurement design applies here.
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This stage is about ensuring that the activities and processes for delivering the project
specifications are controlled.
• Quality assurance—This is about ensuring that all the outcomes of the project are in accord
with the planned specifications and, if they are not, that this is dealt with appropriately.
A significant issue for managing quality is that, unless good performance measurement design
is achieved and constant monitoring and assurance are undertaken, specification or quality may
be traded off against cost or timeliness. This is because the progress of cost and time is typically
easier to recognise and monitor. However, not only is quality or specification more difficult to
measure, but it may also not be apparent until later in the life of the project. Moreover, it may
be difficult to establish who has responsibility for the particular project’s failure to deliver the
project specifications.
552 | PROJECT MANAGEMENT
MIT argued that poor design led to the problems. However, Gehry argued that the problems in the
project were due to the workmanship of the subcontractor in the building process.
Gehry is also reported to have argued elsewhere that his client tried to save construction costs by
reducing components of the design, which resulted in some of the problems.
The case was finalised on 5 February 2010. Most of the issues of design and construction cited in the
lawsuit were resolved and the case was ‘reported settled’.
Quality failure in project organisations not only impedes their ability to deliver quality
projects, but can seriously damage their reputation. This contrasts somewhat with quality
failure in projects within organisations, which can be harder to quantify, as the projects can
sometimes be hidden among the many other organisational activities. There may also be
fewer or no external stakeholders to hold the organisation accountable for quality.
Quality costs
One way to think about quality management is to consider the four different types of
quality costs.
1. Prevention costs are incurred in the design of an organisation’s processes and activities so as
to prevent quality failure. This is through a focus on quality inputs and systems, staff training
and equipment maintenance.
2. Appraisal costs are incurred when incoming supplies and materials are received, and when
products are inspected during, and at the completion of, the production process.
3. Internal failure costs are incurred when quality failure is identified in either the quality control
or assurance process, and rework is able to be completed before the customer takes control
of the project.
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4. External failure costs are incurred when the customer finds that the project does not meet
specifications and the project organisation has to cover the expense of reworking the project.
This is the most expensive type of quality cost. Not only are there costs involved in reworking
already completed work, but there are reputational costs for project organisations.
These costs were discussed in Module 4 when we considered total quality management (TQM),
and they are just as important in the management of projects.
The international standards ISO 10006:2003, ‘Quality management systems—Guidelines for quality
management in projects’, outlines a number of relevant quality management concepts and assists the
management accountant with the application of quality management in projects. It is available online
at: http://www.iso.org/iso/catalogue_detail.htm?csnumber=36643.
Study guide | 553
There are two major challenges for management accountants in project performance
measurement. The first challenge is that in many organisations, projects are cross-functional
and are organised with a matrix-like structure. However, planning, resource allocation and lines
of accountability normally follow functional lines. This means that line managers are responsible
for the performance of their own function and their rewards are linked to the success of their
function. As staff tend to focus on the performance for which they are rewarded, project work
may be given a lower priority when trade-offs are required. This can jeopardise the satisfactory
completion of projects. An important contribution that management accountants can make is to
design appropriate reward schemes so that line managers are given incentives for successfully
completing projects.
One area in which probity is especially important, and management accountants need to
be particularly vigilant, is the procurement of goods and services of high value or goods
that are contentious or dangerous. While probity is something that needs to be considered
and managed right through the project process, there may be instances where a specific
probity advisor or probity auditor needs to be engaged. This is particularly so in the case
of government projects and contracts (ICAC 2005).
Risk management
In this section, we discuss risk management, which is different to the section on risk assessment
discussed in Part C. Risk management happens when the project commences. It is about
the ongoing process of monitoring and managing the risks of the project while it is being
implemented (see Stage 3 in Figure 5.17).
Risk assessment typically happens prior to project commencement, in Stages 1 and 2, and is
about identifying and assessing the probability and financial impact of these risks. However,
as part of the risk management process, an ongoing risk-assessment exercise may still
be undertaken.
Example 5.21: T
he difference between risk assessment and
risk management
Assume that your organisation is undertaking an offshore construction project and you identify that
material inputs are likely to be unstable, and foreign currency fluctuations are likely to be volatile.
Identifying both of these issues is the result of your risk-assessment exercise.
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Your risk management approach may include establishing a range of suppliers (including some in your
own country as a contingency plan) and also hedging against currency fluctuations.
Risk assessment is about clarifying what the risks are, whereas risk management is about trying to
manage those risks.
Study guide | 555
Figure 5.17: Risk assessment and risk management in the different project stages
Stage 3
Stage 1 Stage 2
Project implementation,
Project selection Project planning
control and monitoring
Risk management,
Initial risk assessment including ongoing
risk assessment
Effective risk management requires a good risk management strategy, which consists of four key
areas, as outlined in Figure 5.18.
Risk
management
strategy
you can establish a strategy of ensuring that your essential staff stay on the project. You also
need to create a back-up plan for what to do in case those strategies fail.
Robert Simons (1995), a Harvard professor, provides some thoughts on this in what he calls
‘interactive control’ (see Table 5.6), which can be applied to monitoring unknown risks. A key
idea in this form of monitoring is that the project team stays alert and involved in the ongoing
process of risk assessment and risk management. When unforeseen risks appear, project staff
are then able to recognise and manage them.
There are three characteristics of diagnostic There are four characteristics of interactive
control approaches: control approaches:
1. There are measures—in this case KRIs. 1. The agenda or issues are important and
2. There is a predetermined standard to which recurring, and managers at the highest level
results can be compared. pay attention to any information provided.
3. There is an opportunity to correct deviations There is an awareness to ensure that, as new
from the standard. risks arise, managers recognise them.
2. The agenda and issues require regular
attention from managers and staff at all levels
of the organisation. The search for new risks
is undertaken by both managers and team
members.
3. Information is interpreted and discussed in
face-to-face meetings between management
and staff. The risk information is shared.
4. There are constant challenges and arguments
which may arise from the underlying data,
assumptions and plans, or the arrival of other
uncertainties that may appear or exist. How the
risks are recognised, monitored and managed
undergoes constant challenge and discussion.
With diagnostic control, we are using performance With interactive control, we are trying to stay on
measures to monitor progress. For risk top of what is highly uncertain and unpredictable,
management, it is measuring the level of risk to and this requires active management on all levels.
ensure it stays at an acceptable level.
Source: Adapted from Simons, R. 1995, Levers of Control, Harvard University Press, Boston, p. 97.
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Study guide | 557
The ‘known unknowns’ are the ‘known risks’—things that can go wrong that we know about.
The ‘unknown unknowns’ is the idea of ‘unknown risk’ and represents the things that can go wrong
that we cannot foresee.
Source: US Department of Defense 2002, ‘DoD news briefing—Secretary Rumsfeld and Gen. Myers’,
accessed July 2015, http://www.defense.gov/transcripts/transcript.aspx?transcriptid=2636.
➤➤Question 5.12
What is the critical difference between project risk assessment and project risk management,
and what are the key components of project risk management?
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558 | PROJECT MANAGEMENT
Stakeholder management
Stakeholder management is the ongoing process of managing the expectations and influence of
stakeholders on a project. While there are a number of different approaches to this, there are a
number of common stages that are consistent across the approaches.
• Identify the stakeholders—A good starting point is to establish a stakeholder register.
This should be established at the project selection stage, and be constantly updated while
the project is being undertaken.
• Identify their interests—Establish what the interests of the stakeholders are. Are they
supportive of the project or are they against it? Why? If they are against it, is there anything
that you can do to accommodate their interests?
• Assess your capability to satisfy their interests—The interests of different stakeholders
may conflict and your role may be to balance the interests of competing stakeholders. If you
are not able to satisfy their interests, or if it is prohibitive for you to do so, what kind of
ethical responsibilities do you have to these stakeholders?
If you think back to our earlier discussion on balancing stakeholder interests (Part C),
stakeholders will often be satisfied if you can demonstrate procedural justice. Moreover,
regular communication with stakeholders of what you are doing and why, is a critically
required component of managing them. One aspect of this communication that is particularly
applicable to the client is signalling specification, quality and timeliness. A very useful approach
is to design a stakeholder scorecard that contains appropriate performance indicators that can
be used by stakeholders to track progress on the project. Clearly, this provides a monitoring
mechanism for stakeholders. While it may seem that this enables stakeholders to manage the
project, rather than project managers managing the stakeholder, creating transparency and
signalling problems before they escalate provides a more proactive approach to ensuring that
stakeholders are on side. Within this, is appropriate specification of measures to ensure that the
stakeholders are satisfied as the project develops. However, a word of caution: these kinds of
information-signalling approaches need to be carefully managed as they can create opportunities
for stakeholders to try to increase functionality or renegotiate the parameters of the project.
This is sometime labelled as ‘scope creep’.
Scope creep is when there are changes in a project’s scope. It usually happens when the original
specification of the project is not defined and explained clearly enough and then the processes
are not managed adequately.
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Study guide | 559
Checklist
At the completion of a project, there will be numerous small tasks that need to be completed
prior to official closure. Heerkens (2002) calls this the ‘punch list’ of activities. Developing
the punch list, or what we would probably describe as a checklist, involves several stages,
much like a mini-project. First, a list of final deliverables has to be drawn up by comparing
the original project plan with the objectives completed to date. The next stage is to list the
activities required to complete the project, then to produce a schedule for those activities
and assign responsibilities for their completion.
customer should have taken place to ensure expectations were being met. Consequently,
at the end of the project, there should not be any surprises about project success. A project
completion meeting should be held with relevant stakeholders to ensure that consensus is
reached on the extent to which the project has met its original or adjusted objectives. This part
of the process is usually managed by the project sponsor.
560 | PROJECT MANAGEMENT
What was the underlying problem or opportunity that the project was dealing with and
did it deliver against this?
In the earlier section on project business cases, we discussed the need to document the
underlying reason or problem that triggered the need for a project. This may have been,
for example, an opportunity for the company, or a problem to fix. In the final review of
the project, an analysis needs to be undertaken about whether the project addressed the
particular problem or opportunity. Sometimes, for projects that operate over long time
periods, it becomes more difficult to reconcile what the project was intended to fix or deliver
in the first place. This is why making the reason clear at the outset and keeping it on record is
so important.
Did the project deliver against the strategy that it was intended to support?
Earlier in this module we discussed that the key criteria for project selection was the strategic
fit for the project. Unless the project supports the organisation’s strategy, it does not contribute
to the central operation of the company and so the effort involved in undertaking the project is
likely to be wasted. Consequently, consideration of the extent to which the project was able to
support the organisation’s strategy and objectives is central to this analysis. Typically, the strategy
of the organisation will give rise to specific objectives for the project which, if met, would signal
project success.
Did the project deliver against its objectives and associated performance measures and targets?
At the project selection stage, the project objectives are identified. These should be demonstrated
in performance measures and targets reflecting the desired level of performance. These objectives
and measures are usually grouped as budget-related, time-related, and specification-related.
The key questions to ask when undertaking an analysis at the completion of the project are:
• What were the objectives and targets in each of these three areas?
• What was the actual performance in each of the three areas (budget, time and specification)?
• How much was the variance?
• What was the reason for the variance?
There are a number of challenges with analysing the extent to which a project has delivered
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When a project is complete, an assessment against the original strategic fit analysis can be
undertaken to see how the project delivered against its original objectives. However, there are
a number of challenges with this analysis.
The first challenge is that strategies in organisations change and so, while a project may
have fitted the original strategy, strategic change itself may put the project into strategic
misalignment. This refers to the earlier point of ensuring that constant review of alignment
between strategy and project delivery is undertaken.
Study guide | 561
The second challenge is that project outcomes are not always clear and quantifiable. Sometimes,
benefits feed into operational activities and processes, which may hide obvious outcomes and
benefits from projects. The management accountant needs to stay aware of these second-order
impacts. Moreover, benefits from projects could be qualitative rather than quantitative, and it
is important to identify and explain these benefits. For example, an energy-efficiency project
may save energy costs for the organisation (a clear measureable outcome) and at the same
time create a culture of awareness of environmental issues that may influence employees to
reduce their environmental impact in other activities.
The qualitative benefits from a project may not be obvious. A good example of this comes
from projects in relation to the implementation of activity-based costing (ABC) systems.
While many companies that implemented ABC did meet their objective of having a more
accurate costing system and supported their strategy through better customer profitability
analysis, a significant though unintentional benefit of ABC was the increased level of
communication and understanding they gained of how their companies operated. While this
is often unintentional for ABC project designers, it is also one of the hard-to-measure qualitative
benefits. In fact, research shows that many companies see this as the outcome that provided
them with the greatest benefit.
Information about how stakeholders’ needs were met, as well as any problems and successes
that arose, should feed into how stakeholders are managed in future projects. This is part of
knowledge management which we will discuss later in this section.
Financial closure
Financial closure has several aspects to it:
• determining the final budget and schedule variances;
• closing the cost records; and
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Final budget
The calculation of the project’s final cost and the final budget-variance analysis are undertaken
at the end of the project. Analysis of variance size and cause is important, especially if knowledge
gained through this analysis can be used to enhance future projects. One way that this can
be applied is through improving the estimation processes in project budgets in the future.
Organisational learning is a key aspect of project completion and review.
562 | PROJECT MANAGEMENT
Post-project expenditure
After the project is officially complete, there may still be some final costs to be incurred and
the management accountant can hold a project account open past the official closing date
to deal with such costs. Examples of the type of expenditure are invoices from contractors
or subcontractors that may not have been issued to the project by the closure date. This is
a significant issue in larger projects.
Resource dispersion
Management accountants can be involved in the disposal of excess supplies and capital
equipment at the end of the project. Some of the ways of dealing with these include:
• the project’s customer may be interested in purchasing the stock;
• materials may be returned to suppliers for a refund; or
• the stock can be absorbed into the inventory of the organisation to be used in other
projects or in operations.
The latter option has to be handled with care as, unless the stock is directly useful, it may be
left in storage until it reaches obsolescence. It may be better to disperse such stock promptly
to avoid storage costs.
Final report
Typically, a final report is prepared at the end of the project. This usually contains an
overview, the major outcomes, how these related to the original specifications, budget and
variance-analysis data, and an analysis of the administrative and functional performance of
those involved in the project. Clearly, this can be a sensitive political exercise, particularly if
poor outcomes are identified with the senior management of the organisation. It is important
to clarify the key issue of controllability in relation to budget variances. The final report can also
contain the lessons learned from the project and the way these can be applied in future projects.
Knowledge management
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Although each project is unique, there is much useful knowledge that can be gained from
the process of project management. The management accountant can provide value here by
ensuring that organisational learning occurs, particularly about cost and budget data, but also
about non-financial performance data that might have been collected. Final cost information
can provide a useful knowledge resource for estimating the cost of future projects. This
applies particularly to the activities or events that caused significant deviations from budget.
Questions that the management accountant might ask to enhance organisational learning in
this area include:
• What problems appeared during the project?
• What was the impact of these problems?
• What caused them, and why were they not anticipated or detected earlier?
Study guide | 563
When this knowledge is identified, there are several strategies to ensure that it is not lost.
The organisation can set up a database or archive of the lessons learned from the project.
Some of these lessons can be standardised across the organisation or across projects, and may
be reflected in policies or procedures for how activities are to be performed. For example,
processes to ensure that probity is maintained for the purchase of input materials are applicable
to all projects.
At times, the lessons may be specific to particular types of projects, such as the development of
new software or other IT development projects. For example, updating the software of all staff in
a large organisation is a project from which lessons can be learned that will benefit similar future
projects. There are occasions where a project is completely new and is unlikely to be repeated.
Nevertheless, it is still useful to record these lessons as they may prove to be useful in the future.
Much of the knowledge gained in projects is based on the experiences of the staff who have
worked on them. It is therefore contained in the minds of individuals and, at times, in group
practices or culture. One important part of knowledge management, then, is ensuring that
these individuals can use the knowledge they gained in future projects. Clearly, a redeployment
strategy needs to be in place while the current project is in process or as it draws to a close.
This tends to be easier in project-based organisations, where staff can be moved onto another
project when the current one is finished.
It is more difficult for projects that occur within organisations. Sometimes, staff are moved back
to operational roles and the lessons from the project may be lost. One solution is to set up a
central database of staff and their relevant project-based skills and knowledge, so that when a
new project is initiated, staff who fit the new project can be found. This type of information tends
to be in the minds of organisational managers, which is only useful for as long as that manager
is at the organisation. As we know, managers move and take the knowledge of employees’ skills
with them.
A further point is that the lessons learned from projects can be fed back into the strategy of the
organisation, which may provide a basis for the emergent strategy that Henry Mintzberg (1987)
wrote about. ‘Intended strategy’ is when an organisation starts with objectives and a strategy
which they intend to implement. This is typical of most strategy in organisations. However,
strategy can also emerge in the process of undertaking tasks, and this feeds back into the
intended strategy of the organisation. New strategy and ideas will only emerge if managers
have mechanisms that enable this to happen. One way that new strategy and ideas can
emerge from projects is by having training sessions where the lessons learned from the project
are communicated back to employees in the organisation. The feedback from project-gained
knowledge can also be enabled by involving project staff in the strategy process. This is
particularly important when many of the lessons learned from the project reside in the minds
of organisational employees.
An extremely useful technique is to keep a project diary or archive so that lessons learned can be
recorded as the project unfolds, rather than waiting until the end of the project. An example of
a useful tool to enable this is a ‘cloud’ file storage system such as ‘Dropbox’, or a similar system
MODULE 5
One important thing to keep in mind is that there are inhibitors for project knowledge
management. Having enough time for staff to record their knowledge is always a challenge,
particularly as time constraints on project delivery are often considerable and time spent
recording lessons learned is not time spent actually getting the project done. A second
issue is that there may not be incentives for staff to turn their individual knowledge into
organisational knowledge. How the organisation manages their culture and incentive
structures tends to have a large impact on this.
Project-related knowledge is increasingly useful because many organisations are taking a more
project-centric approach to their business. Capturing and codifying knowledge enables similar
tasks to be performed more effectively if they are repeated. Knowledge management will help
the management accountant, the project sponsor and the project manager to create value in
future projects.
➤➤Question 5.13
How can a management accountant add value to their organisation in the project completion
and review process?
MODULE 5
Study guide | 565
Review
In Module 5, we saw that projects are an increasingly important part of organisational activities.
There are six characteristics that are common to projects and distinguish them from day-to-day
operations. Projects:
1. are unique;
2. often have high levels of uncertainty;
3. relate to solving a problem within a specified scope;
4. have a specific start and finish time;
5. have operationally specific relationships; and
6. have multiple resources that need coordination.
Projects are usually run by teams. The roles within the teams are not usually defined in the same
way in all projects. However, there are several roles that tend to be consistent—the project
sponsor, project manager and project team. The project team includes functional staff and
this is where the management accountant is located. Management accountants provide a key
role in supporting the project manager. They provide traditional cost and budget information,
undertake capital budgeting analysis, carry out network analysis techniques such as PERT,
and support and guide management decision-making.
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Appendix 5.1 | 567
Appendices
Appendices
Appendix 5.1
Sydney Seafood Bar (SSB)
In this case study we examine a hypothetical company, the Sydney Seafood Bar (SSB).
John Kelly and some other business partners won the tender for a site at Circular Quay in Sydney,
Australia. They had an idea to turn a small rundown building into an alfresco dining restaurant/
bar. Initially, it was a business that focused on the self service of fresh seafood, alcohol and other
beverages. They opened the business one year later.
As time passed, the original business evolved and the SSB emerged as a more up-market
harbour-front dining experience. The SSB still focuses on seafood—but now also serves other
cuisines. The main factor influencing this change was that public demand and expectations had
altered since the original SSB design. Sydney is now a world-class destination and the SSB is part
of the Sydney Harbour Foreshore Authority (SHFA) Rocks/Circular Quay precinct and so is part of
Sydney’s image to the world.
The contemporary dining experience needs everything from expensive glassware, stylish plates,
MODULE 5
unusual imported wines and a menu that has unique ingredients. Moreover, customers want all
of this with great service, at an affordable price.
Over the last 20 years the SSB has become something of a Sydney landmark with its fresh
seafood and fantastic waterfront location.
568 | PROJECT MANAGEMENT
Current operations
Current strategy
There does not seem to have been a deliberate choice made in relation to strategy by the SSB
management beyond attempting to provide great seafood and great service in a great location.
However, the following would best reflect the strategy that has emerged.
Operational strategy
• The SSB invests in expert menu and wine advice, obtains the best ingredients and constantly
focuses on improving kitchen processes (which are particularly important in peak periods).
• In order to maintain high standards of service, staff are proactively trained and every attempt
is made to retain good staff.
The premises
The SHFA leases the building and outdoor area to the SSB. SHFA manages public assets on
the harbour foreshore on behalf of the New South Wales state government. As a consequence,
the SSB needs to take into account SHFA’s vision and strategy (available online at http://www.
shfa.nsw.gov.au) including functioning in a caretaker role in relation to the main building which is
a ‘State significant site’.
Renovation project
Due to the wear and tear on the building and kitchen, the SSB is about to undergo a major
renovation. Project costs will be more than a million dollars (AUD). The project will include:
• an upgrade of the kitchen;
• changes and upgrades to the toilet facilities (one key issue is providing disabled access); and
• an upgrade of the mezzanine level above the kitchen.
The project is estimated to take three to four months during which the business will be closed.
B: Project proposal
The original fit-out for the SSB was completed 30 years ago and, while the SSB has continued
to upgrade the facilities, it has now reached the point where major works are required in
three areas.
1. A complete removal of the old kitchen, reconfiguration of the floor plan and construction
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All the requirements by the relevant local authorities have been addressed in the
submitted plans.
Figure A1 5.1 shows the interrelationship of the project requirements, which will be expanded.
Amenity maintenance
and enabling
disabled access
Kitchen changes
Structure, fixture
1. Regulatory changes
and fitting changes
2. Changed public expectations
and improvements
3. Kitchen equipment replacement
Kitchen changes
Regulatory changes
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The initial design of the kitchen layout suited the original operation of the SSB which centred
on the self-service concept of a cold seafood menu. However, changes in the liquor licence laws
over the last 20 years have specified additional requirements for kitchens. This has ultimately led
to two problems:
1. The increased kitchen functionality requirements have led to operational problems with the
original design.
2. The additional requirements now mean that the SSB needs to address narrow ‘traffic areas’
and improve working conditions to maintain a ‘duty of care’ for staff.
C: Project budget
Table A1 5.1
Table notes:
†
This is from a formal quantity survey report. Three tenderers have put in proposals; two are almost
the same as this figure and one is 50 per cent more.
‡
Each of these costs is incremental and is a direct result of the project; they have been calculated by
the company accountant in consultation with management.
§
As the business will be closed for an estimated four months, marketing advice will be sought and a
vigorous marketing campaign will be undertaken to promote the new opening. Consultation with the
SHFA about cross promotion and other sponsorship will be undertaken.
The remainder of the project costs ($809 501) are to be capitalised and depreciated over 10 years.
While depreciation expense has no direct effect on cash flows, the expense is tax-deductible,
and so reduces taxes payable. Assume that these cash inflows occur in each of the Years 1 to 10.
The tax rate is 30 per cent.
SSB’s accountants believe a baseline NPAT of $433 913 is sustainable without the investment.
A tax rate of 30 per cent has been used to generate this after-tax figure.
The baseline net profit for the first year is reduced by the lost sales for the four months SSB
will be closed, and the associated variable costs, totalling $118 995. The first-year net profit
is therefore $118 995 lower than the baseline, reflecting an incremental cash outflow associated
with the project.
The future increase in NPAT as a result of the investment is estimated at 7 per cent per annum
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(compounding). This increase is based on the baseline NPAT (not the reduced first-year NPAT)
and reflects an incremental cash inflow from Year 2 onwards. This 7 per cent estimate is based
on SSB’s historic average increase in NPAT over the last 10 years.
572 | PROJECT MANAGEMENT
Discount rate
Three discount rates were used for the analysis:
1. A conservative discount rate of 8 per cent. This represents a relatively risk-free investment.
2. A 10 per cent discount rate—which is close to long-term portfolio stock-market returns.
3. A 15 per cent discount rate. This figure is more realistic, taking into account shareholders’
expected returns from a small unlisted private company.
Residual value
There is an assumption of no residual value in the project. Building fabric changes such as
disabled access, amenities reconstruction and mezzanine repairs have no residual value for the
business (though these do have long-lasting value for the lessor—the SHFA). The equipment
and other fittings only have material value in their current setting and have no disposal value.
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Appendix 5.2 | 573
Appendix 5.2
Constructing a network diagram using PERT
Our project has nine activities (as shown in Table A2 5.1). The activity that needs to be
completed before the next one can begin, is known as the preceding activity. These are
shown in the right-hand column. For example, we can see that Activities 2, 3 and 4 all
need Activity 1 to have been completed before they can start.
Activity 1 —
Activity 2 1
Activity 3 1
Activity 4 1
Activity 5 2
Activity 6 3
Activity 7 4
Activity 8 5
Activity 9 6
Note: As we did in the study guide, for this exercise we will use the activity-on-arrow (AOA)
method to draw the diagram (remember that AOA shows activities as arrows and events
as nodes).
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We can now start to transfer the items from the project activity list (Table A2 5.1) into the diagram.
Activity 1
a
Activity 1
a b
2
v ity
Acti
Activity 1 Activity 3
a b
Ac
tiv
ity
4
y2
tivit
Ac
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Activity 1 Activity 3
a b d
Ac
tiv
ity
4
e
Appendix 5.2 | 575
So now we draw Activity 5 and its completion node (‘f’) into the diagram, directly after the
completion of Activity 2 (node ‘c’).
y5
Activit f
c
y2
tivit
Ac
Activity 1 Activity 3
a b d
Ac
tiv
ity
4
y5
Activit f
c
y2
tivit
Ac
e
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576 | PROJECT MANAGEMENT
y5
Activit f
c
Ac
tiv
2 ity
vity 8
Acti
y5
Activit f
c
Ac
tiv
ity
it y2 8
v
Acti
Ac
tiv
ity
4 7
ivity
Act
We use the following formula to calculate the ‘expected time’ (ET) for each activity.
ET = (O + 4ML + P) / 6
The ET calculated using this formula, is a weighted average of the three time estimates—
where the weighting for O is 1 / 6, ML is 4 / 6, and P is 1 / 6.
ET for Activity 1: (20 + 100 + 30) / 6 = 25 days (where 100 is calculated as 4 × 25)
ET for Activity 6: (20 + 112 + 60) / 6 = 32 days (where 112 is calculated as 4 × 28)
The ET estimates for the activities of this project are shown in Table A2 5.2.
Activity 1 20 25 30 25
Activity 2 1 10 20 30 20
Activity 3 1 15 20 25 20
Activity 4 1 6 20 40 21
Activity 5 2 6 35 70 36
Activity 6 3 20 28 60 32
Activity 7 4 8 19 24 18
Activity 8 5 10 45 50 40
Activity 9 6 6 9 18 10
Once the ETs have been calculated for each activity, they are added to the network diagram on
the arrows (underneath the activity labels) as shown.
y5
Activit f
c 36
Ac
tiv
2 ity
vit
y 40 8
Acti
20
Activity 1 Activity 3 Activity 6 Activity 9
a b d g h
25 20 32 10
Ac
tiv
ity
21 4 7
ivity
Act
18
e
To determine the critical path, we add together the ETs for the activities on each path through
the network diagram.
In this case, the critical path is Path 1 (as shown below, the critical path is usually drawn on a
network diagram as a bold line).
y5
Activit f
c 36
Ac
tiv
2 ity
vit
y 40 8
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Acti
20
Activity 1 Activity 3 Activity 6 Activity 9
a b d g h
25 20 32 10
Ac
tiv
ity
21 4 7
ivity
Act
18
e
Activities on the critical path are the main focus of management attention, because if these
activities are not finished on time, the planned project time will be exceeded. Critical path
activities must be carefully managed. The critical path is also important for managers, because if
they need to finish the project early, this can only be achieved by speeding up the activities on
the critical path. Activities on other paths may run ahead or behind schedule—to a degree—
and not affect the overall project completion time.
To summarise, the critical path is the longest path through the diagram and it shows the shortest
time in which the project can be completed.
Therefore, the project manager has considerable flexibility in deciding when to start Activity 4.
MODULE 5
MODULE 5
Suggested answers | 581
Suggested answers
Suggested answers
Question 5.1
Six characteristics that distinguish projects from day-to-day operations are:
1. Projects are novel or unique—they will not usually be repeated in the same way again.
2. They often have high levels of uncertainty, which may be a result of their unique nature.
3. They are usually focused on providing a solution for some underlying problem.
4. They have a defined start and finish time.
5. Projects typically consist of activities that are related and often have operationally
specific relationships (i.e. a particular activity has to be performed before the next one
can be started).
6. Finally, they usually have multiple resources which need coordination, and this can be
particularly challenging.
While these characteristics set projects apart from day-to-day operations, they are not necessarily
all present in each project. They do, however, provide a guide for helping to distinguish projects
from the operational activities present in most organisations.
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582 | PROJECT MANAGEMENT
Question 5.2
There are four stages in a project.
Project selection
This stage focuses on the objectives and scope of the project. Included in this is the project
feasibility and justification which often centres on strategic fit, risk assessment, preliminary
budgets and completion time. The management accountant is often integrally involved in the
application of techniques to deal with these issues, including strategic analysis, risk analysis,
budgets and schedules.
Project planning
Project planning adds more depth to the project selection analysis. This addresses five key areas:
1. scheduling;
2. optimising cost and time;
3. budgeting;
4. performance measurement; and
5. incentives.
Once again, the management accountant is central to the use of techniques in each of
these areas.
Question 5.3
A collaboration could be either. It depends on whether the project is related to the core activities
of the organisation (such as a building project for a construction organisation) or not (such as the
development of a new IT solution).
MODULE 5
Suggested answers | 583
Question 5.4
The three main roles in project management are the:
1. project sponsor, who is usually involved in contract negotiation, customer liaison and
ensuring that resources are made available for the project. The project sponsor may also
become involved if there is a major crisis;
2. project manager, who has functional responsibility for the project, including managing the
day-to-day operations; and
3. project team, who undertake the functional tasks required. The management accountant is
part of the project team and works closely with the project manager in preparing necessary
information for decision-making and project control.
Question 5.5
Yes, the project does fit within the strategy of the Sydney Seafood Bar (SSB). Clearly, the managers
want to maintain a differentiated approach to the competitive strategy of the business, and the
project contributes to this by keeping the building and equipment at an international standard
which complements the location.
The kitchen renovation will enable operational efficiencies to be gained that will improve kitchen
processes. This has a leveraged effect in that it will enable the employment of better staff
(due to the better standard of facilities) and also improve menu offerings due to the improved
functionality of the kitchen. It will also enable better management of throughput times for
orders during busy periods. However, the project goes beyond the basic strategy of the SSB
and also addresses legal and regulatory requirements.
Question 5.6
Clients—The clients are keenly interested in your ability to complete the project on time,
within budget and according to specifications. You will probably have intense involvement
with them at the project planning stage, then ongoing involvement reporting on progress, and
finally at the end of the project ensuring that the project meets expectations and final payment
is received.
Regulators—Regulators have significant involvement at the project approval and planning stages,
while they may be less involved during the construction (as long as compliance is maintained as
the project progresses).
Community and society—As the project takes place in a suburban community, the needs of the
community that will use the centre clearly have to be taken into account in the planning stage
of the project. Moreover, the way that the completed development affects the community will
need to be considered. Furthermore, community inconvenience and dislocation need to be
managed while the project is undertaken.
Year 0 1 2 3 4 5 6 7 8 9 10 (a)
Sale of old system ($) 70 000
Reduction in labour cost 180 000 180 000 180 000 180 000 180 000 180 000 180 000 180 000 180 000 180 000
per year ($)
Increase in utility cost (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000)
per year ($)
Net cash flow ($) (1 030 000) 170 000 170 000 170 000 170 000 170 000 170 000 170 000 170 000 170 000 270 000
Discount factor = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 +
calculation (cost of 14%)1 14%)2 14%)3 14%)4 14%)5 14%)6 14%)7 14%)8 14%)9 14%)10
capital = 14%)
Discount factor 1.0000 1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV working 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 170 000 / 270 000 /
1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV cash flows ($) (1 030 000) 149 123 130 809 114 749 100 651 88 293 77 449 67 938 59 595 52 277 72 831
You may get a slightly different answer based on whether you use a table, spreadsheet or financial calculator to discount the cash flows.
Table SA5.1: Cash flow and NPV analysis of Big Firm Pty Ltd’s IT project
Reduction in labour 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000
cost per year ($)
the project is not viable.
Increase in utility cost (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000)
per year ($)
Net cash flow ($) (1 090 000) 220 000 220 000 220 000 220 000 220 000 220 000 220 000 220 000 220 000 320 000
(updated cost inputs)
Discount factor = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 +
calculation (cost of 14%)1 14%)2 14%)3 14%)4 14%)5 14%)6 14%)7 14%)8 14%)9 14%)10
capital = 14%)
Discount factor 1.0000 1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV working 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 220 000 / 320 000 /
1.1400 1.2996 1.4815 1.6890 1.9254 2.1950 2.5023 2.8526 3.2519 3.7072
PV cash flows ($) (1 090 000) 192 982 169 283 148 498 130 255 114 262 100 228 87 919 77 123 67 653 86 319
Source: CPA Australia 2015.
It seems that the extra development cost and the further reduction of labour costs make the project viable. It now has a positive NPV of $84 522.
Table SA5.2: Cash flow and NPV analysis of Big Firm Pty Ltd’s IT project
(b) No, as the NPV is (116 285). Given the cash flow projections and the discount rate used,
Suggested answers |
585
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586 | PROJECT MANAGEMENT
Question 5.8
Projects with the highest NPV should be selected because the NPV informs us of the amount
by which the net assets of the organisation will increase by undertaking the project. Therefore,
you should select Project 2.
Conflicting results between IRR and NPV are due to differences in project size. A large project
like Project 2, with a relatively smaller percentage return (but still above the discount rate),
will generally return a large NPV in absolute dollar terms. A small project like Project 1, even one
with a return that is multiples of the discount rate, will generally only create a relatively small NPV
in absolute dollar terms. This is an example of a more general problem of comparing relative
measures such as percentages and ratios (e.g. ROI), with absolute measures such as net profit.
In evaluating projects, a range of tools should be used. The management accountant cannot rely
on single measures. A range of measures will provide more useful information.
Question 5.9
Sydney Seafood Bar
Project capital budgeting and net present value (NPV)
To establish the financial viability of the project, capital budgeting has been undertaken,
involving the calculation of the project’s NPV using different discount rates.
(a) Over 10 years, with a discount rate of 8 per cent, the project has a positive NPV of $41 612,
close to break-even on the project.
(b) Over 10 years, with a discount rate of 10 per cent, the project has a negative NPV of $85 992.
While this NPV is negative, because the project sits clearly within the SSB’s strategy and there
are good reasons for undertaking the project, it is probably still viable.
(c) Over 10 years, with a discount rate of 15 per cent, the project has a negative NPV of $330 092.
This indicates that it is not financially viable and the SSB management should think about
other options to gain regulatory conformance.
The following tables and commentary further explain the NPV calculations and results.
MODULE 5
Suggested answers | 587
Total project cost = Total cash outflow (i.e. $200 000 + $809 501) (1 009 501)
Table SA5.3 reveals that the total cash outflow in Year 0 is –$1 009 501. This is split between:
• operating costs of –$200 000 that are paid in Year 0, resulting in a tax reduction in Year 1
(because the tax return is lodged after the end of Year 0); and
• other project costs of –$809 501 that are paid in Year 0, capitalised and depreciated
(tax‑deductible expense) over the life of the project (Years 1–10) using straight-line
depreciation.
Depreciation is a non-cash expense and so does not appear directly in the NPV cash flows.
However, depreciation leads to a tax-deductible expense (30% of the depreciation amount).
This tax deduction leads to a reduction in the amount of tax payable, and this is treated as
a cash inflow in NPV calculations. Project construction costs and associated fees (totalling
$809 501) are depreciated on a straight-line basis over 10 years. The annual depreciation
expense is therefore $80 950 (i.e. $809 501 / 10).
Table SA 5.4 shows the tax effect of expenses in Years 1–10. In Year 1, the cash inflow of $84 285,
is made up of the:
• benefit from tax-deductible operating costs in Year 0 of $60 000 (i.e. $200 000 × 30%); and
• benefit from tax-deductible depreciation expense in Year 1 of $24 285 (i.e. $809 501 /
10 years × 30%).
The Years 2–10 cash inflows are $24 285, reflecting the benefit from tax-deductible depreciation
expense (i.e. $809 501 / 10 years × 30%).
Note that while the initial decrease in operating net profit after tax (NPAT) due to the project is
shown in the tax-effect calculations above (Table SA5.4), the ongoing increase in NPAT due to
the project is not shown. This is because the baseline NPAT provided in this question is after tax,
so no adjustment for tax-related cash flows is necessary (see Table SA5.5).
MODULE 5
Year 0 1 2 3 4 5 6 7 8 9 10
Calculation of baseline NPAT 433 913 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 ×
growth (7% annual growth in × (1.071 (1.072 – 1) (1.073 – 1) (1.074 – 1) (1.075 – 1) (1.076 – 1) (1.077 – 1) (1.078 – 1) (1.079 – 1)
baseline NPAT from Year 2) – 1)(c)
Incremental cash inflow ($) 30 374 62 874(d) 97 649 134 858 174 672 217 273 262 856 311 630 363 818
(7% annual growth in baseline
NPAT from Year 2)
Note: Table SA5.5 reveals the incremental cash flows from the net increase/(decrease) in NPAT. Note that we are after the net increase/(decrease) in NPAT from the base year,
not from each subsequent year. This helps us to determine the actual cash inflow/(outflow) that is directly related to the project (and, hence, whether we should proceed
with the investment).
(a) The baseline net operating profit after tax (NPAT) is $433 913.
(b) In Year 1, we are told that the baseline net profit is reduced by $118 995. So, the net decrease in operating profit is –$118 995.
(c) In Year 2, the baseline NPAT increases by 7 per cent to $464 287 (i.e. $433 913 × 1.07). The net increase in NPAT is therefore $30 374 (i.e. $464 287 – $433 913).
(d) In Year 3, the baseline NPAT again increases by 7 per cent to $496 787 (i.e. $464 287 × 1.07). The net increase in NPAT is therefore $62 874
Table SA5.5: Net increase/(decrease) in NPAT for Sydney Seafood Bar
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590
Year 0 1 2 3 4 5 6 7 8 9 10 Total
Total tax 84 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 302 850
| PROJECT MANAGEMENT
effect of
expenses (see
Table SA5.4)
Net increase/ (118 995) 30 374 62 874 97 649 134 858 174 672 217 273 262 856 311 630 363 818 1 537 009
(decrease)
in NPAT (see
Table SA5.5)
Total net (1 009 501) (34 710) 54 659 87 159 121 934 159 143 198 957 241 558 287 141 335 915 388 103 830 358
cash flows
8% discount
rate
Table SA5.6: NPV analysis of Sydney Seafood Bar
Discount 1.0000 1.0800 1.1664 1.2597 1.3605 1.4693 1.5869 1.7138 1.8509 1.9990 2.1589
factor (8%)
PV (Total net (1 009 501) (32 139) 46 861 69 190 89 625 108 310 125 377 140 947 155 134 168 041 179 767 41 612
cash flow
/ Discount
factor)
10% discount
rate
Discount factor 1.0000 1.1000 1.2100 1.3310 1.4641 1.6105 1.7716 1.9487 2.1436 2.3579 2.5937
(10%)
PV (Total net (1 009 501) (31 555) 45 173 65 484 83 283 98 816 112 306 123 958 133 954 142 461 149 631 (85 992)
cash flow /
Discount factor)
15% discount
rate
Discount factor 1.0000 1.1500 1.3225 1.5209 1.7490 2.0114 2.3131 2.6600 3.0590 3.5179 4.0456
(15%)
PV (Total net (1 009 501) (30 183) 41 330 57 308 69 716 79 122 86 015 90 811 93 867 95 488 95 933 (330 092)
cash flow /
Discount factor)
Note: Please note that the figures in the three rows of PV (Total net cash flow / Discount factor) are calculated using an MS Excel spreadsheet. There will be rounding differences if
the Total net cash flows are divided by the Discount factor (rounded to four decimal places).
MODULE 5
592 | PROJECT MANAGEMENT
Question 5.10
(a)
Figure SA5.1
Activity
Activity
7 g
6
d f 11
3 Activity
Activity Activity 8
17
3 14 31 9
Activity
4 Activity
7 5
11
e
†
ET = (O + 4ML + P ) / 6
Where:
O = Optimistic
ML = Most likely
P = Pessimistic
Question 5.11
The most applicable context for the use of EV is in projects where output or percentage completion
can be measured. This is because the key factor in the EV method is the comparison of actual
cost incurred to the cost that should have been incurred for the work done.
One of the problems with variance analysis is ensuring that comparisons are made between
actual costs and a meaningful cost estimate or budget. The EV method provides this
meaningful base for comparison. This is important, because a project may have what seems
to be a favourable cost variance due to the fact that the costs incurred are below budget.
However, when compared to the work completed, there may be a significant cost overrun
because the work is behind schedule.
Question 5.12
Risk assessment typically happens prior to project commencement and is about identifying and
assessing the probability and the financial impact of risk.
Risk management is the ongoing process of managing the risks of the project while the project
is being implemented.
Question 5.13
While the management accountant may be involved in the decision to complete a project,
creating the task list, obtaining specification satisfaction consensus and undertaking a
stakeholder satisfaction assessment, the key area where the management accountant
adds value is in the financial closure of the project.
This includes preparing the final budget and closing the cost records so that expenses can
no longer be charged against the project. In addition, the management accountant may be
involved in resource dispersion which can involve negotiating with suppliers for stock returns
and selling assets that cannot be absorbed into the organisation.
MODULE 5
Finally, the management accountant can add value by documenting the knowledge gained from
the project. This includes budget-related information—such as the events that caused deviation
from cost estimations, the systematic identification of the problems with a project, and what
could be done to reduce their reoccurrence—which can be useful for planning future projects
MODULE 5
References | 595
References
References
Australian Petroleum Products and Exploration Association 2014, ‘Australian LNG projects’,
accessed July 2015, http://www.appea.com.au/oil-gas-explained/operation/australian-lng-
projects.
Bloch, M., Blumberg, S. & Laartz, J. 2012, ‘Delivering large-scale IT projects on time, on budget,
and on value’, Insights & Publications, McKinsey & Company, October, accessed July 2015,
http://www.mckinsey.com/insights/business_technology/delivering_large-scale_it_projects_on_
time_on_budget_and_on_value.
Brimson, J. A. 1993, ‘Activity product cost’, IEEE Engineering Management Review, Spring.
Eden, C., Ackermann, F. & Williams, T. 2005, ‘The amoebic growth of project costs’,
Project Management Journal, vol. 36, no. 2, pp. 15–26.
Gorog, M. & Smith, N. J. 1999, Project Management for Managers, Project Management Institute,
Newtown Square, Pennsylvania.
Independent Commission Against Corruption (ICAC) 2005, Probity and probity advising, Sydney,
New South Wales.
MODULE 5
Lend Lease 2015, ‘The New Royal Children’s Hospital’, accessed July 2015, http://www.lendlease.
com/australia/projects/the-new-royal-childrens-hospital?take=1&q=P2V2PTEsMCZyZWdpb249Q
XNpYS9TaW5nYXBvcmUvLEF1c3RyYWxpYS8mY29tcGxldGlvbj0x.
Lientz, B. P. & Rea, P. R. 2003, International Project Management, Academic Press, Amsterdam.
Littlefield, T. K. & Randolph, P. H. 1987, ‘An answer to Sasieni’s questions on PERT times’,
Management Science Quarterly, October.
Loch, C. & Kavadias, S. 2011, ‘Implementing strategy through projects’, The Oxford Handbook
of Project Management, Oxford University Press, Oxford.
Malmi, T. & Brown, D. A. 2008, ‘Management control systems as a package: Opportunities,
challenges and research directions’, Management Accounting Research, vol. 11 issue 4,
December, pp. 287–300.
Meredith, J. R. & Mantel, J. M. 2012, Project Management: A Managerial Approach, 8th edn,
Wiley, New York.
Mintzberg, H. 1987, ‘The strategy concept 1: Five P’s for strategy’, California Management
Review, vol. 30, no. 1, pp. 11–16.
Morris, P. & Pinto, J. K. 2007, The Wiley Guide to Project, Program and Portfolio Management,
Wiley and Sons, New Jersey.
Phillips, R., Freeman, R. E. & Wicks, A. C. 2003, ‘What stakeholder theory is not’, Business Ethics
Quarterly, vol. 13, no. 4.
Pinto, J. K. 2010, Project Management: Achieving Competitive Advantage, Prentice Hall,
New Jersey.
Pogrebin, R. & Zezima, K. 2007, ‘M.I.T. sues Frank Gehry, citing flaws in center he designed’,
New York Times, 7 November, p. A20.
Project Management Institute (PMI) 2013, A Guide to the Project Management Body of
Knowledge, 5th Edition, Project Management Institute, Newtown Square, Pennsylvania.
Sundin, H., Granland, M. & Brown, D. 2010, ‘Balancing multiple competing objectives with
a balanced scorecard’, European Accounting Review, vol. 19, no. 2, pp. 203–46.
US Department of Defense 2002, ‘DoD news briefing—Secretary Rumsfeld and Gen. Myers’,
accessed July 2015, http://www.defense.gov/transcripts/transcript.aspx?transcriptid=2636.
Zwikael, O. & Smyrk, J. R. 2011, Project Management for the Creation of Organisational Value.
Springer-Verlag, London, UK. ISBN 978-1-84996-515-6 (print book); ISBN 978-1-84996-516-3
(ebook).
References | 597
Optional reading
Dalal, A. 2011, The 12 Pillars of Project Excellence, CRC Press, Boca Raton, Florida.
Institute of Civil Engineers and The Actuarial Profession 2005, RAMP Risk Analysis and
Management for Projects: A Strategic Framework for Managing Project Risks and Its Financial
Implications.
Mompo, F. 2014, ‘Big Data too big? No problem: co-innovate with best data scientist in the
world’, accessed October 2015, www.co-society.com/big-data-big-problem-co-innovate-best-
data-scientist-world.
MODULE 5
MODULE 5
STRATEGIC MANAGEMENT ACCOUNTING
Case study
600 | STRATEGIC MANAGEMENT ACCOUNTING
Contents
Preview 601
Introduction
Concepts, tools and techniques 602
Introduction to WattleJet 603
Company background
Mission, vision and strategy
Business operations
Performance
Australian domestic airline industry 609
Brief history
Industry statistics
Industry segments
Drivers of demand
Industry cost structure and profitability
Factors influencing change
Industry competitors 616
Qantas Airways Ltd
Virgin Australia Holdings Ltd
Regional Express Holdings Ltd (REX)
Competitors—performance
WattleJet strategic initiatives 621
Strategic cost and profit management
Project analysis, selection and implementation
Summary 623
Case study tasks 624
Appendix 625
Case study: Appendix 1 625
References 647
CASE STUDY
Case study | 601
Case study
Case study
Preview
Introduction
In this case study, we help you to revise and consolidate your understanding of strategic
management accounting. This is done through completion of various tasks and practice
questions that require you to apply the concepts, tools and techniques covered in Modules 1
to 5. The case study is ‘WattleJet’ and focuses on a service environment—the Australian domestic
airline industry. This hypothetical company is a new competitor in the marketplace, and is trying
to establish a niche alongside established competitors including Qantas, Jetstar, Tigerair and
Virgin Australia.
E Module 2 E
n n
v v
i Module 1 i
r r
o Module 3 Value o
n n
m Module 2 m
e Vision/Mission e
n n
t Goals and objectives t
a a
l Strategy—Creation l
Module 5
RESOURCES SYSTEMS
a a
n Strategy—Implementation n
a Module 4 a
PROJECTS
l l
y Strategy—Implementation y
s VALUE CHAIN s
i i
s Control and feedback systems s
At the end of the case study is a set of tasks that you are expected to complete by referring back
to the earlier modules and applying the necessary knowledge. These tasks are your focus:
• analysing the industry;
• analysing the strategic approaches of the main competitors;
• assessing the performance of WattleJet and its competitors;
• analysing the value chain for problems and opportunities;
• evaluating capital-expenditure decisions; and
• project analysis, evaluation and planning.
Please note that while the case study is not examinable, the concepts, tools and techniques covered
in Modules 1 to 5 and used in the case study are examinable.
Traditional management accounting techniques include budgeting, variance analysis and product
costing. As the management accountant’s role has developed to include being a business advisor,
additional techniques have emerged.
The first main tool described was the industry and organisational value chain. This is used to gain
an overall perspective of the organisation itself and its place within its industry value chain. This is
done by listing and sequencing the tasks and activities of both the organisation and the industry
in which it operates.
Once a clear picture of the organisation is obtained, the organisation and its environment can be
analysed using tools such as SWOT analysis, product life cycle analysis and five forces industry
analysis. A broader PEST exploration is used to ensure that major external risks and opportunities
are not ignored or forgotten.
The Business Model Canvas is a useful method for creating and capturing an organisation’s
strategy, once both internal and external analysis have been performed. In addition, classifying
the competitive strategy—linked to cost leadership or differentiation in either the whole industry
or focused on a particular niche—helps to ensure that an organisation does not get ‘stuck in the
middle’ trying to be everything to everyone.
Providing feedback and control mechanisms is another crucial role. The use of both financial and
non-financial measures helps to achieve this. Integrating measures into scorecards and strategy
maps is a powerful way of making sure that all critical aspects of an organisation are properly
monitored to enable corrective action to be taken if necessary.
In contrast to the concepts, tools and techniques that focus on a broader organisational view,
it can also be necessary to focus very specifically on individual parts, tasks and activities within
the value chain. Activity-based costing, life cycle costing and target costing are all examples of
this. Controlling costs, understanding customer profitability and eliminating non-value adding
activities are all valuable approaches for improving performance.
Management accountants often perform a role in the selection and implementation of projects
to achieve organisational objectives. Financial and qualitative analyses, combined with project
scheduling, are essential for successful strategic implementation.
CASE STUDY
Case study | 603
This case study focuses on most of the approaches described above, including:
• value chain analysis;
• industry analysis, including SWOT and five forces analysis;
• balanced scorecard (BSC) reporting; and
• project evaluation, selection and implementation, including net present value (NPV)
and the project evaluation and review technique (PERT).
To help you to understand this case study, please review Reading 2.1 ‘Strategic cost management
and the value chain’, with a specific focus on ‘Comparative analysis’, ‘A strategy for competitive
advantage’, ‘Exhibit 6’ and ‘Exhibit 7’.
Introduction to WattleJet
This case study examines a hypothetical Australian company called WattleJet Ltd (referred to
as WattleJet) that is competing in the Australian domestic airline industry.
An important theme in this case study is the role of the management accountant in a service
environment. The service provided involves flying people (or freight) from one destination to
another. Despite the perception that strategic management accounting is often focused on
manufacturing or product-based businesses, this case study demonstrates the importance
of supporting value creation in a service industry. Similar issues still arise in different types of
industries. For example, although there is no ‘physical inventory’ to be produced or managed,
there is an inventory of ‘available seats’ that must be filled. If these seats are not filled, then the
opportunity to sell that service disappears.
Two critical areas must be addressed for profitable and sustainable performance:
1. Efficiency: Ensuring proper use or utilisation of capacity (often called seat factor or
passenger load factor). The main aim of this is to avoid having empty seats on flights.
2. Effectiveness: Maintaining revenues or yields on seats sold. The main aim of this is to make
sure that the airfares covers costs and also generate profits.
It is much easier to achieve efficiency. For example, flights may be filled by offering incredibly
low fares. However, this may not be effective, as prices may be below cost. Achieving both
simultaneously is very difficult in a highly competitive environment.
Company background
WattleJet was formed in 2006 and is based in Perth, the capital city of Western Australia (WA).
It chartered small aircraft that were used to fly employees from Perth, the capital city of WA,
to mines and other worksites in remote areas of Australia.
A mining boom started in 2005 following a significant rise in the demand for energy and minerals
by fast-growing developing countries. This led to very high commodity prices and also encouraged
mining companies to make significant investments to expand capacity and output.
Many Australian mining sites are located in remote areas, many thousands of kilometres from
the capital cities. As a consequence, many employees are engaged on fly-in/fly-out contracts.
Under this type of arrangement, employees commute to their workplace by air, and stay on-site
temporarily (often for several weeks at a time), rather than moving permanently to the area of
work. The decision to commute by air is often made because there is only a small amount of local
accommodation or infrastructure close to the mine site.
CASE STUDY
604 | STRATEGIC MANAGEMENT ACCOUNTING
In the last two years, WattleJet has started to compete on major routes across Australia,
including between Perth and the major Australian capital cities of Adelaide, Melbourne, Sydney
and Brisbane.
A decade after the mining boom began, most analysts believe that the boom is now over,
even though demand and prices are still reasonably strong.
Its mission focused on providing safe, reliable and cost-effective commuting for workers
employed on remote mining sites. With low overheads and a specific focus on the fly-in/fly-out
market, WattleJet offered a viable alternative to the larger, established airlines.
However, the company does not presently have a formal approach to strategic management
and has no strategic plan, specific goals, objectives, timelines or data collection and analysis.
There is also no established formal approach to deal with environmental or corporate social
responsibility (CSR) issues. Overarching goals have been simplified to:
• remain profitable;
• grow successfully; and
• maintain a perfect safety record.
At monthly management meetings, strategic issues are raised and discussed in an ad hoc
manner. The company currently reacts and responds to changes in the marketplace intuitively
and spontaneously, rather than following a formal or structured long-range action plan.
The decision to expand beyond the original market evolved over time and was not formally
researched or planned. As such, the company does not have a current vision or mission
statement that is consistent with its operations.
Business operations
WattleJet has a single office based near Perth airport. It has a fleet of 12 aircraft, made up
of Bombardier Dash 8, ATR 72 Turboprop and Embraer 170 aircraft.
WattleJet mainly flies to the Kimberley, Pilbara and Goldfields–Esperance regions in WA,
as shown in Figure CS2 below. It has also recently started flying to the major capital cities
within Australia.
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KIMBERLEY
PILBARA
GASCOYNE
MID WEST
GOLDFIELDS–ESPERANCE
WHEATBELT
PERTH
PEEL
SOUTH WEST
GREAT SOUTHERN
WattleJet has many fixed-rate, medium-term contracts in place with companies based
throughout regional WA. Many bookings for flights to regional centres are made by employers
(rather than individual employees), directly with the head office call centre. Individuals may
also book directly with the airline via the call centre or online by using the WattleJet website.
The company has no relationships with any travel agencies. For interstate travel to capital cities;
most bookings are made by individuals online or via the call centre.
Staff in the head office are involved in planning routes, capacity analysis, marketing, purchasing
and human resources, as well as regulatory compliance.
Sales staff spend a considerable amount of time working with companies involved in the mining
industry. They focus on developing suitable pricing strategies and winning longer-term contracts
to ensure that flights carry enough passengers to be profitable.
Most operational staff are based at Perth airport and aircraft maintenance is outsourced to
providers who are also located there.
The ground crew prepare the aircraft so that they are ready to fly. This includes passenger check-
in, baggage handling and aircraft preparation (e.g. fuel, safety checks and catering). The flight
schedules are planned to minimise costs (including crew accommodation, employee allowances
and leasing space). To help to achieve this, the schedules ensure that all staff and aircraft finish
each day back at Perth airport.
Performance
WattleJet has a very simple performance measurement system that captures the financial results
at a broad level, as well as some important operational statistics. The most important financial
measures are:
• total revenues;
• employee costs;
• fuel costs; and
• flight expenses.
Flight expenses are sometimes called ‘aircraft operating variable’, and are a combination of costs
that are incurred as a result of each flight including:
• route navigation fees;
• landing fees;
• maintenance expenses;
• crew expenses; and
• passengers’ expenses.
Relevant non-financial measures are focused on how much capacity is available, how effectively
that capacity is used (i.e. passenger load), on-time performance and safety (see Table CS2).
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For example, the RPK for a flight from Perth to Newman Airport (1021 km)
with 54 paying passengers would be:
Based on our example above, we have RPK of 55 134 and ASK of 71 470.
Passenger load factor would be:
Incidents and near misses Measures the effectiveness of safety and control systems
Incidents and near misses is a count of the number of safety and
risk incidents that actually occurred, as well as any near misses.
It provides a picture of activities that may be dangerous or processes
that need attention. These must also be immediately reported to
the Australian Transport Safety Bureau (ATSB).
Monthly reporting is currently based on a statement of profit or loss and other comprehensive
income, a statement of financial position, and non-financial indicators. The financial and
operating results for the last four years are shown in Table CS3.
Expenses
Wages and salaries expense $28.562 $33.073 $37.954 $37.690
Fuel expenses $20.683 $24.805 $27.908 $28.725
Flight expenses $8.864 $9.302 $8.875 $8.637
Aircraft rentals and leases $7.879 $8.268 $8.985 $9.121
Sales and marketing expenses $1.477 $1.860 $1.763 $1.898
Other expenses $12.804 $12.402 $13.531 $12.494
Total expenses $80.269 $89.710 $99.016 $98.565
†
Earnings Before Interest, Tax, Depreciation and Amortisation
Brief history
Two airlines dominated the domestic airline industry for nearly 40 years because of the
‘Two Airlines Policy’ that was established by the Australian federal government in 1952 and
only removed in 1990. Ansett Airlines (a privately held company) and Trans Australia Airlines
(or TAA, a government-owned company) held a duopoly over major routes within Australia and
were protected from competition. In 1986, Trans Australia Airlines became Australian Airlines
and, in 1992, was absorbed into Qantas, which had been operating international routes.
A reduction in government regulation (deregulation) of the industry saw the removal of the
Two Airlines Policy and allowed new entrants to the marketplace. The first attempt at a low-cost
start-up was Compass Airlines, which was established in 1990. However, due to a combination
of factors, including a price war, Compass collapsed in late 1991. An attempt to revive the airline
was made in 1992, but it once again failed in 1993.
In 2000, a new low-cost airline started business—Virgin Blue Airlines. The entry of this new
competitor led to significant fare reductions and opened up air travel to leisure travellers who
previously could not afford to fly. When Ansett Airlines collapsed a year later, Virgin Blue Airlines
was able to capture significant market share, and fares across Australia continued to remain low.
In response to the entry of Virgin Blue Airlines, Qantas launched a new low-cost airline called
Jetstar in 2003. This initiative was designed to assist Qantas to compete against Virgin Blue
Airlines without sacrificing the traditional full-service model offered by the main Qantas brand.
In 2007, Tiger Airways (now called Tigerair Australia), another low-cost competitor, started
operations with extremely low prices that attracted many more leisure travellers. Tigerair’s low
fares have meant that the company has struggled to be profitable throughout its existence, and it
has since been taken over by Virgin Australia Holdings (now renamed Virgin Australia Airlines).
Over the last few decades, the industry has changed from a highly regulated, uncompetitive
duopoly with high prices, to an intensely competitive environment with a range of options and
prices to suit both low- and high-fare-paying travellers.
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Industry statistics
Nearly 58 million people and 385 000 tonnes of cargo were carried on (slightly fewer than)
700 000 domestic airline trips in 2014. Passenger numbers were virtually unchanged from 2013,
but freight volumes declined by just under 7 per cent from the previous year.
Sydney’s domestic airport had the greatest number of passenger movements with 25.5 million
arrivals or departures. This was followed by Melbourne with 23.5 million passenger movements
(BITRE 2015a).
55
50
45
40
35
4
4
-0
-0
-0
-0
-0
-0
-1
-1
-1
-1
-1
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
D
D
Year ending
Source: BITRE 2015a, ‘Domestic aviation activity, Annual 2014’, Statistical Report, April,
Australian Government, Canberra, ACT, p. 2, accessed July 2015,
https://bitre.gov.au/publications/ongoing/files/domestic_aviation_activity_2014.pdf.
© Commonwealth of Australia 2015. Reproduced under a Creative Commons
by Attribution 3.0 Australia licence.
Passenger growth was rapid from 2004 to 2008 (from just under 40 million to 50 million). Demand
between 2008 and 2009 faltered when the global economy experienced difficult conditions.
After this period, growth continued but at a slower pace from 2009 to 2014, rising to 57.5 million.
This increase in passengers came at a cost, as airlines were forced to reduce prices to entice
customers to fly. Operating profit margins were thus dramatically reduced, from around
8 per cent before the global financial crisis (GFC) to around 1 per cent, slowly recovering to
about 2 per cent by 2014. The whole industry generates revenues of approximately $15 billion,
with overall profits of nearly $360 million. Annual revenue growth has been low at just over
2 per cent in the last five years and is expected to climb to around 2.3 per cent over the next
five years to about $17.0 billion (IBISWorld 2015).
The most important non-financial metrics in the airline industry are ASK, RPK and on-time
performance. From this, we can derive the capacity utilisation (load factor), which also reveals
how many empty-seat kilometres are flown. Table CS4 shows a summary of results from 2011
through to 2014, and Figure CS4 provides a 10-year snapshot of these results.
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Total passengers 54.32 million 56.54 million 57.55 million 57.52 million
Source: https://bitre.gov.au/statistics/aviation/otp_annual.aspx.
BITRE 2013a, p. 2; 2013b, p. 1; 2014a, p. 2; 2014b, p. 1; 2015a, p. 2; 2015b, p. 1.
© Commonwealth of Australia 2015. Reproduced under a Creative Commons
by Attribution 3.0 Australia licence.
90
80
ASKs / RPKs (billions)
Load factors ( % )
40 65
4
4
-0
-0
-0
-0
-0
-0
-1
-1
-1
-1
-1
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
ec
D
Year ending
Source: BITRE 2015a, ‘Domestic aviation activity, Annual 2014’, Statistical Report, April,
Australian Government, Canberra, ACT, p. 2, accessed July 2015,
https://bitre.gov.au/publications/ongoing/files/domestic_aviation_activity_2014.pdf.
© Commonwealth of Australia 2015. Reproduced under a Creative Commons
by Attribution 3.0 Australia licence.
The ASK and RPK are measured on the left-hand-side axis and both metrics show consistent
increases over the 10 years. After peaking close to 80 per cent at the end of both 2007 and 2009,
the load factor, which is measured on the right-hand-side axis, has been gradually trending
downward, ending 2014 at just over 75 per cent.
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Industry segments
The three main segments of the domestic airline industry are:
1. business travel;
2. leisure travel; and
3. freight.
Other minor parts of the industry are the additional revenues earned through special fees,
charges, excess baggage and luggage storage. In addition to these segments there are deep
interlinkages with other industries or markets, including international airline travel and reward
programs, as well as road and train freight. Figure CS5 reveals the revenue breakdown for
each segment.
AUSTRALIAN
DOMESTIC AIRLINE INDUSTRY
Revenues: $15 billion
Passengers: 57.52 million
Freight: 385 000 tonnes
Sources: Adapted from IBISWorld 2015, ‘Domestic airlines in Australia: Market Research Report’,
ANZIC I4902, IBISWorld, February, Melbourne, p. 14, accessed July 2015,
http://www.ibisworld.com.au/industry/default.aspx?indid=472;
BITRE 2015a, ‘Aviation: Domestic aviation activity, Annual 2014’, Statistical Report, April, Australian
Government, Canberra, ACT, p. 2, accessed July 2015,
https://bitre.gov.au/publications/ongoing/files/domestic_aviation_activity_2014.pdf.
Business travel
The business or ‘full-fare’ segment refers to full-fare paying passenger transport which is usually
used by business travellers and employees working in the public sector. In addition to business-
class tickets, this segment includes fully flexible fares in economy class that allow booking and
flight changes at short notice.
Although the tickets are more expensive, business travellers prefer the business class full-
fare service because of the flexible nature of the tickets, enabling them to change flights at
minimal cost. Additional benefits or services that are provided as part of these fares include
the availability of business lounges in airports and a range of on-board services, including
entertainment, generous baggage allowances, meals, beverages, newspapers and magazines.
Full-fare tickets also lead to faster accumulation of reward points.
While the business travel segment offers a higher quality experience, it has been under pressure
since the GFC, as business and government have had cost-control policies that have focused
on lower cost.
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Leisure travel
The leisure or ‘low-fare’ segment is mainly provided to travellers who travel for holidays, to visit
family or friends, or for other personal reasons. While some business travellers will use low-cost
travel arrangements, most of this segment is related to personal and leisure travel. Only limited
peripheral services and benefits are provided with most low-cost travel.
The lowest priced tickets do not include peripheral items such as baggage allowance, meals,
onboard entertainment, lounge access or reward points. Self-service is often required for
booking, checking in, printing boarding passes and baggage drop-off. Additional benefits may
be purchased separately in a menu-type arrangement. This includes food, drinks, entertainment,
special seating arrangements with additional legroom or being close to exits, and checked
baggage. As such, the revenues for this segment are a combination of ticket prices and the
ancillary or extra benefits that have been purchased separately.
Freight
Items that are time sensitive or that have a high value-to-weight ratio are generally transported
by air rather than by road or rail. Freight services are for both personal and business clients.
The boom in online (internet) shopping has led to a significant growth in this industry segment.
Other revenues
Other revenues are generated that are not clearly linked to the three main segments of business,
leisure and freight. These revenues include fees for booking changes, charges for excess baggage,
late fees and luggage-storage charges. While the low-cost airlines usually charge for food,
drink and other benefits separately from ticket prices, the revenues from these items are still
usually included in the leisure travel segment.
Drivers of demand
Demand for domestic air travel is closely linked to several factors. These include:
• international airline travel (which feeds passengers into the domestic network);
• business growth; and
• consumer wealth and confidence.
As many travellers are sensitive to prices, changes in fuel costs (which are passed on to
customers) also have an effect on demand.
In the business segment, demand is based on business conditions such as corporate profitability
and the need to travel. The price of airfares in the business segment is not as important when
compared to the leisure segment, as the fares are a business cost and are typically tax deductible.
However, the growth of videoconferencing and an emphasis on cost control has slightly affected
growth in this segment in recent years.
In the leisure segment, price is an extremely important factor and is normally the first issue
considered when planning a trip. This is supported by the significant increase in passengers
since low-cost airlines started operating. Leisure travellers are prepared to trade off less flexible
tickets, flight times and other services for low fares. Other influences or drivers of demand
include general consumer confidence, as well as the general strength of the economy. In difficult
economic conditions, many people are still able to afford air travel, but they may be too fearful
of losing their jobs to take holidays.
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A significant cause of the low margins is the increasing level of capacity, which has meant
that prices are kept low to maintain market share and to ensure that aircraft do not fly empty.
Increased capacity and strong competition for market share have led to lower fares in both
the business segment and the leisure segment (see Figure CS6). Despite lower fares, the unit
value of a sale per passenger for the business segment is approximately double that of the
leisure segment.
120
110
Index (July 2003 = 100)
100
90
80
70
60
Jun 2010
Sep 2010
Dec 2010
Mar 2011
Jun 2011
Sep 2011
Dec 2011
Mar 2012
Jun 2012
Sep 2012
Dec 2012
Mar 2013
Jun 2013
Sep 2013
Dec 2013
Mar 2014
Jun 2014
Sep 2014
Dec 2014
Mar 2015
Jun 2015
Source: Adapted from BITRE 2015c, ‘Air fares time series from October 1992 to July 2015’,
Australian Government, Canberra, ACT, accessed July 2015,
https://bitre.gov.au/statistics/aviation/air_fares.aspx. © Commonwealth of Australia 2015.
Reproduced under a Creative Commons by Attribution 3.0 Australia licence.
In addition to lower fares, margins have been squeezed due to rising costs. The most significant
cost increase is for fuel, which tripled in cost from USD 30 per barrel in 2003 to USD 90 per
barrel in 2012. While it was initially expected to remain above USD 95 per barrel for some years,
the price has since eased to around USD 60 per barrel, mainly due to an increase in supply from
CASE STUDY
the Middle East and subdued demand. From the perspective of a domestic airline, Qantas saw
fuel costs grow from 18 per cent of total expenses in FY 2005 up to a forecast 28 per cent in
the financial year 2014 (see Figure CS7).
Case study | 615
18% 23% 25% 26% 27% 25% 26% 28% 27% 28%
FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14
Source: Qantas 2014b, Qantas Data Book 2014, p. 21, accessed July 2015,
http://www.qantas.com.au/infodetail/about/investors/qantas-data-book-2014.pdf.
Another environmental issue is noise. Curfews on flying at night (between 11 pm and 6 am)
exist at Sydney Airport, which makes additional growth difficult. Noise issues also have a major
impact on the development and location of new airports, which will hamper opportunities for
growth in the future. For example, attempts to develop a new airport in Sydney or to add another
runway to the existing airport are meeting with fierce opposition from local communities. In 2014,
approval for a new airport in Badgerys Creek, in the west of Sydney, was granted by the federal
government. However, it is not expected to be operational for at least another decade.
The rise in alternatives to airline travel due to technological advances will also affect growth and
profitability. The quality and price of videoconferencing for both business and personal activity,
combined with a greater reliance on virtual offices, may limit growth in air travel (previously,
it was seen to be essential). The concept of high-speed trains linking major capital cities is also
being discussed. Such technological and infrastructure advances will make it difficult to raise
ticket prices.
A combination of regulatory change and new technology is also likely to affect the domestic
airline industry. Automatic Dependent Surveillance–Broadcast (ADS-B) is a system for broadcasting
information about aircraft during flight. Linked to GPS networks, the data that is transmitted
include the position, speed and identity of the aircraft.
This will make tracking aircraft more accurate and will provide several benefits, including more
direct flight routes and aircraft operating in closer proximity to each other (facilitating more
takeoffs and landings and reducing time spent in holding patterns and at airports). A significant
expected benefit will be the ability to perform a continuous descent—rather than a stepped
CASE STUDY
descent—which reduces fuel costs and emissions. The ADS-B system is being phased into
Australian airspace between December 2013 and 2018.
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Technology is also helping airlines with operational management and pricing. Software tools
and algorithms for the efficient scheduling of aircraft and flight crews are becoming more
powerful. Pricing of tickets can also be adjusted in real time to reflect small changes in demand,
helping to ensure that aircraft are not only filled, but also that they have the highest possible
yield (or revenue per seat). The use of technology to enable flight bookings, web check-in
and self-service baggage drop-off has also led to improvements. Operational costs have
been reduced and combined with increased efficiency by processing passengers more quickly
through terminals, while using fewer staff.
Individual events may also affect the industry and lead to changes. These include health issues
such as preventing the transmission of infectious diseases (e.g. bird flu), environmental events
such as volcanic ash clouds, which have led to periodic flight cancellations (including major
disruptions to air traffic between Bali and Australia in July 2015) and safety issues such as crashes
and near misses.
Industry competitors
Competition within the domestic airline industry is slightly unusual because there are only two
significant companies (Qantas Airways Ltd and Virgin Australia Airlines) currently competing
in the industry. However, between them, they have four significant brands (Qantas, Jetstar,
Virgin Australia and Tigerair) that compete vigorously against each other, and they also control
several minor brands focused on regional areas. So, instead of acting in a protected duopoly
with high prices and low efficiency, prices have remained comparatively low as the airlines fight
for market share, especially in the business segment. In addition to Qantas and Virgin Australia,
Regional Express Holdings Ltd (REX) is a regional airline providing similar services to WattleJet.
Qantas
Qantas primarily targets the business segment, which it dominates, and also the discerning
private traveller. For nearly 10 years, it was the only participant in this market because of the
collapse of Ansett Airlines in 2001. Its domination is also linked to having the largest network
across Australia and internationally, including code-sharing arrangements with other airlines.
Code-sharing is a type of commercial agreement between two or more carriers for which an
airline on a specific route prices its code and sells seats on flights operated by a partner carrier.
Qantas was a founding member of the Oneworld alliance, a network of airlines that share
services such as access to airport lounges, and allow passengers to fly as Qantas passengers on
their flights. This extends the effective ‘reach’ of Qantas by giving access to virtually all global
destinations and thus providing a seamless travel experience.
Historically, the business segment was much less competitive; however, since Virgin Australia
started providing business class arrangements, there has been greater competition. Qantas
has reacted strongly to maintain its market share by adding extra capacity and also by
reducing prices.
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Jetstar
Jetstar provides low-cost fares with a focus on the leisure market. The company’s mission is
to ‘offer all day, every day low fares to enable more people to fly to more places, more often’
(Jetstar 2015).
Jetstar was created in 2003, with flights starting in 2004. Creating Jetstar made it easier for
Qantas to compete effectively against Virgin with a low-cost offering, without harming the Qantas
brand, which was known for premium services. Having two brands (Qantas and Jetstar) allows
Jetstar to focus specifically on the leisure industry segment.
Initial attempts at maintaining a low-cost structure included only having one type of aircraft.
This minimised complexity (e.g. with maintenance and pilot certification), as well as removing
additional services such as checked luggage and preferred seating, and only providing them to
customers on a user-pays model.
QantasLink
QantasLink is the result of the merger of three airlines (Airlink, Eastern Australia Airlines and
Sunstate Airlines). It is the largest regional airline and flies to over 50 destinations. It uses
smaller aircraft to provide both metropolitan and regional services within Australia and also
in Papua New Guinea. It also performs well because of the links to other Qantas benefits,
including frequent-flyer rewards and baggage connections for onward Qantas travel.
Virgin Australia
From its creation in 2000 until 2010, Virgin Blue Airlines had focused almost entirely on the leisure
travel segment and had successfully grown through capturing market share and expanding the
number of low-fare passengers. This strategy enabled Virgin Blue Airlines to hold the number
one position in the leisure segment, while maintaining its low-cost focus.
However, the introduction of competition in the leisure segment in 2004 (with Qantas Airways’
launch of Jetstar) curtailed Virgin’s strong growth. The entry of Tigerair, the ultra-low-cost airline
created even more pressure on maintaining profitability in the leisure market.
In response, Virgin decided that it needed to broaden its offering by adding more services to
enter the business segment to attract higher-yield customers (see the ‘Game Change’ program
discussed below).
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Over time, the move from a pure low-cost provider towards more of a full-fare offering has been
demonstrated by added services, including developing its passenger lounges, introducing
a loyalty reward scheme—Velocity Rewards—and providing the first web check-in service in
Australia. By 2010, Virgin had secured about 10 per cent of business travellers and approximately
30 per cent of all domestic air travellers.
Virgin managed to finish the 2010 financial year making a small profit, despite the uncertainties
caused by the GFC, rising fuel costs and interest rates, and fierce competition from low-cost
carriers in the domestic market. However, it still faced some significant challenges, including only
having the third-largest market share of industry revenue.
In response to the challenges the company was facing, its newly appointed CEO John Borghetti
(a previous long-serving Qantas executive) announced a ‘Game Change’ program and a new
vision for the company: ‘to be the airline of choice for Australian business and leisure travellers’.
Through the Game Change program, Virgin sought to reinvent itself as a full-service brand by
altering its low-cost, no-frills model to take market share from Qantas in the higher-margin,
business market. As part of this approach, the name Virgin Blue Airlines was changed to
Virgin Australia.
In July 2013, Virgin Australia took control of Tigerair. As part of Virgin’s change in strategic
direction to becoming a full-fare provider, it needed some mechanism for competing against
Jetstar and maintaining its market share in the leisure segment. Having a separate brand—in a
similar manner to the use of Jetstar by Qantas—allows the company to provide two very different
experiences for customers. It also helped to avoid having Tigerair as a competitor that was
undercutting Virgin’s prices and reducing margins.
REX does not have a specific vision or mission statement, but it does have a broad statement
of values, which states that it is ‘committed to providing … customers with safe and reliable air
transportation with heartfelt hospitality’. Staff members are seen to be ‘part of the REX family,’
not just employees, and suppliers are regarded more as partners rather than just as contractors in
goods and services (REX 2013a).
Competitors—performance
It is useful to consider financial performance in combination with operational results. Integrating
these items helps us to evaluate whether a competitor is achieving short-term profits at the
expense of long-term success.
Financial performance
There is a lot of published financial performance data about competitors, but a significant
proportion is aggregated at a level beyond just the domestic aviation industry. This is because
the major competitors also operate in the international airline industry and provide a variety of
ancillary products and services. For example, Qantas also has a catering arm, a ground services
division and Qantas holidays.
The appendix to this case study contains details of aggregated financial results for WattleJet’s
major competitors, including results from their international flights.
While it is possible to directly analyse the results of REX in the domestic market, a further
breakdown is required of Qantas and Virgin results that separates out revenues from international
flights and other parts of the business. The estimated domestic results for Qantas and Virgin
are shown in Table CS5.
Qantas
Virgin Australia
Source: IBISWorld 2014, ‘Domestic airlines in Australia’, IBISWorld Industry Report I4902,
February, pp. 24–25, IBISWorld, Melbourne, accessed June 2014,
http://www.ibisworld.com.au/industry/default.aspx?indid=472.
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Operational performance
In addition to financial performance, we must assess the operational performance of competitors.
Competitor performance in the key areas of ASK, RPK and on-time performance is summarised
in Tables CS6 and CS7.
Passengers 17.073 16.796 16.813 16.280 16.049 16.938 16.674 15.576 1.173 1.101 1.091 1.049
carried
ASK 30.928 31.203 32.119 32.097 22.312 24.323 25.883 24.246 743.8 741.4 739.5 722.3
RPK 24.719 24.770 24.938 24.158 17.855 19.233 19.431 18.744 443.7 413.4 411.1 393.3
Sources: Qantas 2014b, p. 48; REX 2012b, 2013b, 2014b; and Virgin Australia 2012, 2013b, 2014.
Departures Arrivals
Sectors on time on time Cancellations
Qantas 116 386 114 952 101 219 88.1 100 045 87.0 1 434 1.2
QantasLink 124 452 121 804 104 212 85.6 100 716 82.7 2 648 2.1
Regional Express 64 141 63 936 56 802 88.8 54 915 85.9 205 0.3
Virgin Australia 130 872 128 523 110 764 86.2 109 088 84.9 2 349 1.8
Virgin Australia 30 241 29 884 25 863 86.5 25 332 84.8 357 1.2
Regional Airlines
All Airlines 573 232 564 712 484 792 85.8 476 046 84.3 8 520 1.5
Source: BITRE 2015b, ‘Aviation: Domestic airline on-time performance 2015’, Statistical Report,
Australian Government, Canberra, ACT, p. 2, accessed July 2015, http://bitre.gov.au/publications/
ongoing/files/BITRE_OTP_Report_2014.pdf. © Commonwealth of Australia 2015. Reproduced under a
Creative Commons by Attribution 3.0 Australia licence.
CASE STUDY
Case study | 621
Total costs in the sales and marketing area for 2014 were $1.898 million. The marketing and
advertising costs were nearly $1.1 million. The remaining overhead costs of $0.779 million were
split between four main categories:
1. maintenance of the sales website;
2. staffing of the bookings call centre;
3. resolution of complaints and disputes; and
4. distribution of physical tickets.
Of the approximately 300 000 passengers per annum, 190 000 passengers purchased tickets online,
while 110 000 used the call centre. WattleJet has decided that the best way of differentiating its
customer groups is by how they purchase their tickets (i.e. online versus call centre), and that
the remaining $0.779 million in overhead costs should be properly allocated between these two
customer groups to determine the profitability (or otherwise) of each group.
An initial analysis, presented in Table CS8, has discovered the main types of activities and costs
within the ticket sales component of the sales and marketing function.
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622 | STRATEGIC MANAGEMENT ACCOUNTING
The estimated upfront costs for implementing ADS-B are $235 000. Additional ongoing training,
testing and implementation costs of $75 000 will be incurred during the first year of the project.
Table CS9 contains a probability analysis of the estimated fuel and other efficiency savings
from an early upgrade to ADS-B, compared to waiting until 2018.
Table CS9: Estimated fuel and other efficiency savings from an early upgrade
to ADS-B
Probability $ $ $
Table CS10 details the activities required and the time estimates for implementing the ADS-B
system. The first activity involves WattleJet requesting information from potential suppliers about
the new technology and infrastructure. At the same time, the second activity requires quotes to
be obtained for various types of technology systems.
Once a supplier is chosen, the equipment will need to be obtained, installed and tested.
At the same time as the technology is being implemented, the planning department will be
reconfiguring routes and takeoff and landing methods to reduce fuel usage. An additional
benefit will be an improvement in on-time arrivals and departures. This could potentially
generate more ASKs per day per available aircraft, thus increasing the level of capacity without
additional leasing or purchases of aircraft.
Preceding
Activity Activity description Time estimates (working days) activity
Summary
This case study is designed to provide you with some appreciation of the complex challenges
and issues that managers face in a service company. WattleJet typifies a company that has
experienced turbulent conditions in a mature, competitive market with high entry costs and
significant operational, economic and environmental risks.
The tasks below require you to apply strategic management accounting concepts and tools as
you analyse the key issues facing WattleJet and the implications of these for management.
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Appendix
Appendix
IMPORTANT NOTE
To maintain consistency and simplicity the presentation of some data in the following tables has
been slightly edited/modified from the original company reports.
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Expenditure
Staff related 3 695 3 774 3 846 3 717
Fuel 3 627 4 220 4 154 4 461
Aircraft operating variable 2 768 2 980 3 061 3 142
Other 4 368 4 923 4 643 7 804
Total expenditure 14 458 15 897 15 704 19 124
Net finance costs 113 176 187 204
Statutory (loss)/profit before
income tax expense 323 (349 ) 11 (3 976 )
Income tax benefit/(expense) (74 ) 105 (9 ) 1 133
Statutory (loss)/profit for the year 249 (244 ) 2 (2 843 )
Sources: Qantas 2012, Qantas Annual Report 2012, p. 65, accessed October 2015,
http://www.qantas.com.au/infodetail/about/investors/2012AnnualReport.pdf;
Qantas 2013, Qantas Annual Report 2013, p. 98, accessed October 2015,
https://www.qantas.com.au/infodetail/about/investors/2013AnnualReport.pdf;
Qantas 2014a, Qantas Annual Report 2014, p. 68, accessed October 2015,
http://qantas2014.reportonline.com.au/.
Sources: Qantas 2012, Qantas Annual Report 2012, p. 67, accessed October 2015,
http://www.qantas.com.au/infodetail/about/investors/2012AnnualReport.pdf;
Qantas 2013, Qantas Annual Report 2013, p. 100, accessed October 2015,
https://www.qantas.com.au/infodetail/about/investors/2013AnnualReport.pdf;
Qantas 2014a, Qantas Annual Report 2014, p. 70, accessed October 2015,
http://qantas2014.reportonline.com.au/annual-report/financial-report/financial-statements.
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Case study: Appendix 1 | 627
Sources: Virgin Australia 2013a, Virgin Australia Annual Report 2013, p. 76, accessed June 2014,
http://www.virginaustralia.com/cs/groups/internetcontent/@wc/documents/
webcontent/~edisp/annual-rpt-2013.pdf;
Virgin Australia 2014c, Virgin Australia Annual Financial Report 2014, p. 44, accessed October 2015,
http://www.virginaustralia.com/cs/groups/internetcontent/@wc/documents/
webcontent/~edisp/annual-financial-report-2014.pdf.
Sources: Virgin Australia 2013a, Virgin Australia Annual Report 2013, p. 78,
accessed June 2014, http://www.virginaustralia.com/cs/groups/internetcontent/
@wc/documents/webcontent/~edisp/annual-rpt-2013.pdf;
Virgin Australia 2014b, Virgin Australia Annual Financial Report 2014, p. 20, accessed July 2015,
http://www.virginaustralia.com/cs/groups/internetcontent/@wc/documents/
webcontent/~edisp/annual-financial-report-2014.pdf.
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Sources: Regional Express Holdings Ltd 2013a, Regional Express Holdings Ltd Annual Report 2013,
p. 28, accessed June 2014, http://www.rex.com.au/AboutRex/InvestorRelations/img/AR_FY1213.pdf;
Regional Express Holdings Ltd 2014b, Regional Express Holdings Ltd Annual Report 2014, p. 28,
accessed July 2015, http://www.rex.com.au/AboutRex/InvestorRelations/img/AR_FY1314.pdf.
Non-current assets
Property, plant and equipment
(including aircraft) 185 732 176 676 93 409 134 079
Other property, plant and equipment 75 261 80 461
Other 6 938 7 049 7 023 7 947
Goodwill and intangible assets 7 475 7 399 8 311 8 113
Total non-current assets 200 145 191 124 184 004 230 600
Total assets 239 569 259 571 260 029 289 225
Current liabilities
Trade and other payables 19 400 19 595 22 691 26 029
Unearned revenue 19 761 19 189 19 446 18 753
Other 11 342 16 060 10 719 16 020
Total current liabilities 50 503 54 844 52 856 60 802
Non-current liabilities 28 299 28 028 26 232 39 322
Total liabilities 78 802 82 872 79 088 100 124
Net assets 160 767 176 699 180 941 189 101
Sources: Regional Express Holdings Ltd 2013a, Regional Express Holdings Ltd Annual Report 2013, p. 30,
CASE STUDY
Suggested answers
Suggested answers
Case study
Task 1
(a) Management accounting has traditionally supported the different levels of internal decision-
making of organisations. In its early history, the emphasis of the management accounting
role was on planning and control with a particular focus on budgeting and cost management.
Organisations and their environments were typically stable and decisions were made under
conditions of relative certainty. However, strategic management accounting goes beyond this
and helps to create and manage value.
In Table 1.2 of Module 1, we outlined a variety of decisions that managers make. In relation
to WattleJet, these include:
–– Strategy: competitive approach, organisational structure and target setting.
–– Products: product mix (flight destinations and additional benefits provided) and pricing.
–– Supply chain: choosing suppliers for fuel, aircraft and maintenance.
–– Infrastructure: information systems and website capability.
–– Financing: obtaining finance, ensuring dividend payments are appropriate and
structuring leases and loans for aircraft.
–– Resource allocation: staffing of flights and other functions, route planning and ensuring
that assets (e.g. fuel) are carefully managed and controlled.
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Strategic management accounting provides a wide range of tools and techniques that
support these decisions, including:
–– BSCs for supporting the analysis of organisational performance and guiding strategy
choice;
–– activity-based costing and activity analysis to identify and cost non-value adding activities
that may be eliminated or reduced;
–– capital budgeting tools, such as discounted cash flows, that enable project evaluation;
–– project management tools to consider both the time and cost of implementation; and
–– customer profitability analysis to identify which segments the organisation should be
focusing on.
To compete effectively in the domestic airline industry, WattleJet will need to make decisions
based on a sound analysis of both financial and qualitative characteristics. Capturing enough
customers, including the right types of customers, controlling costs and implementing
efficiency improvements will all be essential for developing a successful and sustainable
business.
(b) The types of information that will be useful for WattleJet may be split into internal and
external parts.
Internal data will be needed across a range of categories, including financial performance,
customer satisfaction, employee efficiency, operational effectiveness and environmental
impact. This information will also need to be able to be segregated easily by customer,
route and aircraft type to support detailed analysis.
One of the important aspects of strategic management accounting is its focus on areas that
are external to the organisation—especially competitors and customers. Data on competitor
performance, market share, customer demographics and preferences, cost structures and
approaches to things such as fuel-cost management and selection of aircraft will be very
useful when developing strategic plans. Broader economic data will also be essential in
terms of Australian economic growth rates, consumer sentiment, and the performance of
the mining industry, which drives a lot of the fly-in/fly-out customer segment.
(c) WattleJet will need a management accounting system that considers performance across the
value chain, rather than just the financial results. It will need to capture operational statistics
quickly and easily including ASK, RPK and load factor for each route. It will also need to be
extended to capture physical flows and environmental data which will aid both efficiency and
environmental improvements by providing a baseline for current performance.
The ability to identify and assess costs that are often hidden in overheads (e.g. by using
activity-based costing approaches) will also help to ensure that efficiencies are obtained and
that waste is reduced or eliminated. The management accounting system will therefore need
to capture data on the various types of activities performed, how often they are performed
and the costs of those activities.
As well as effective data capture and analysis, the system must provide quick and timely
reports that are easily understood by managers and staff throughout the organisation.
CASE STUDY
Suggested answers | 631
Task 2
(a) Taking a very broad view, WattleJet offers a service that is of value to customers by providing
air transportation between destinations. When customers purchase a ticket they indicate
that they are receiving value. To ensure that the customers have an appropriate experience,
effort is made to ensure that the flight is safe, on time, has appropriate inflight benefits
(such as meals and drinks) and pre-flight support (such as easy check-in and boarding).
WattleJet creates shareholder value when the prices obtained from customers are higher
than the costs of providing the service. These profits will be sustainable if value is also
created for other stakeholders, such as employees, in terms of appropriate wages and
working conditions, and suppliers, in terms of pricing and payment terms.
From a more specific point of view, we can also give examples of how WattleJet creates
value, including through:
–– providing flights to regional and remote areas;
–– offering fixed rates and medium-term contracts to companies flying staff to mine
sites; and
–– minimising costs by returning crew to Perth after each flight.
(b) There may be a number of ways to represent the organisational value chain for WattleJet.
The following is a high-level representation of WattleJet’s key activities. Please note that
it does not capture all of the activities as are represented in Porter’s (1985) organisation
value chain:
Primary activities
Support activities
(c) There may be a number of ways in which to represent the industry value chain for the
domestic airline industry. The airline industry is a service-based industry, so its value chain
is different from product-based industries. Instead of having raw materials flow through to
manufacturing, which is then shipped to retailers and sold to the final consumer, the airlines
provide a service of taking passengers or freight from one location to another. Figure SA1
captures the key inputs and activities in the industry value chain. Note that each role could be
analysed in a much greater level of detail.
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Figure SA1
Airports
Aircraft Tourism
Pre- In-flight Arrival
Departure
departure services and exit
Fuel Freight
Catering
The airlines only have a few major inputs—they require airports from which to operate,
and aircraft to fly. They also require fuel, and food and drinks for catering purposes.
These are shown at the left of the diagram.
Then, the actual service provided by the airline is broken down into its component parts,
from pre-departure to post-arrival. This industry will feed into other industries including road/
rail freight and tourism, but once the flight has landed and passengers have collected their
checked luggage, this is the end of the service provision in most circumstances. The ‘service’
has been provided, so there is no product to be passed further down a value chain.
Most passengers will then take care of their own transportation to their final destination,
while freight will usually be transferred to trains and trucks to move items to warehouses and
retail destinations.
Additional considerations that may affect the design of an industry value chain include:
–– flight routes (regional or major city);
–– flight types (passenger, freight, charter); and
–– industry segment (business, leisure, freight).
(d) The business segment currently has the least competition, the highest revenues, and is more
profitable than the leisure segment on a per-seat basis, despite the higher costs associated
with the additional benefits and services. However, with aggressive attempts to capture
market share being made by Virgin Australia, and just as strong defensive measures taken
by Qantas to protect its market share, this may be a difficult segment in which to establish a
strong foothold. Previous attempts by start-up airlines to provide solely business class flights
between major capital cities have often ended disastrously, and so this may not be a suitable
segment on which to focus.
The leisure segment is experiencing strong competition with low prices and high costs.
The constant increases in capacity have kept prices down because of the need to increase
capacity utilisation on flights. It is also possible that total growth in this market, in terms of
passenger numbers, is starting to mature. When low-cost airlines arrived just over a decade
ago, there were many people who had not previously flown. With lower prices, these people
started flying and created significant growth in the industry. However, after more than
10 years of low-cost flying, it is likely that there are very few potential passengers remaining
who have not yet flown. As such, the competitors will be fighting for market share among
current passengers, and the most effective way of doing this is often through pricing.
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Suggested answers | 633
Regional flights experience lower levels of competition and even a monopoly on particular
routes. Many customers are flying for business purposes and this leads to additional stability
in the market, as long as those industries remain strong. Business-related travel to regional
areas may also attract higher prices for benefits such as ticket flexibility. A major issue to
factor into any analysis is the significant decline in the mining industry that would lead
to tougher conditions.
From this analysis, we may conclude that WattleJet should continue to focus on the regional
market, and work hard to establish itself in the broader business segment as well. Due to
competitive pressure, WattleJet should pay the least attention to the leisure segment.
Task 3
(a) In Module 2, we described the five forces model that considered the following industry issues:
(i) the threat of new entrants to the industry;
(ii) the threat of substitute products;
(iii) the power of customers;
(iv) the power of suppliers; and
(v) the intensity of competition.
The threat of new competitors is reasonably low because of the high start-up capital costs
and the regulatory approvals required to start a new domestic airline in Australia.
The threat of direct substitutes, such as road and train travel, is low (with bullet trains
being a distant threat). The low ticket prices, especially for leisure travel, make flying
a valuable alternative because travel times using other means of transportation are so
lengthy. The threat of indirect substitutes, especially in the business segment, are low
but are starting to increase. Video communication technology is becoming increasingly
powerful, while its costs are decreasing rapidly, making it an increasingly affordable way
to communicate with staff, customers and suppliers across the country. In many situations,
companies may decide to replace air travel with electronic communications.
Customers are powerful because they have a range of choices between very similar products
in both the business and leisure segments. Therefore, pricing becomes a key differentiator
between competitors, and leads to very low fares and reduced margins. This power is
reduced on some regional routes that are serviced by only one airline.
Suppliers of fuel are powerful, as these prices are set globally and are very difficult to
influence. Aircraft suppliers are less powerful and are willing to negotiate lower prices to
ensure that they have full order books to maintain production.
The intensity of competition is high, and this is shown by the decline in ticket prices in both
the leisure and business segments. Despite constantly increasing passenger numbers, total
revenues across the whole industry have been flat, indicating that volume growth has not led
to revenue growth.
(b) In the following analysis, growth rates are calculated between two periods using the standard
growth formula:
WattleJet
Table SA1: Review of WattleJet’s performance
Revenue growth After two successful years of revenue growth of 5 and 8 per cent, WattleJet has
experienced a decline in revenue of nearly 4 per cent. It has not been able to
maintain its previously strong performance, and this may be linked to the mining
boom coming to an end.
Cost control After growing by a cumulative 23 per cent between 2012 and 2014, in 2015 total
expenses were slightly lower than in the previous year. This reflected the need for
greater control as a result of the 3.6 per cent decline in revenue experienced in
2015. Even though costs have reduced, it is concerning that fuel costs continue
to rise, confirming they are much less controllable than other expenses.
Fuel expenses Between 2012 and 2015, these have crept up from 21 per cent of revenues
to nearly 27 per cent (and 29% of total expenses in 2015), which equates to a
39 per cent increase in fuel costs. It is extremely difficult to influence this cost
and, as such, it is a major influence on profitability.
Wages expense Wages should be expected to rise with increased revenues, as a significant
proportion of wages will relate to variable staffing linked to the number of flights.
After growing by 33 per cent between 2012 and 2014, wages expense stabilised
and actually fell a little in 2015, which is likely linked to the reduction in revenue.
Profitability Despite the strong revenue growth, net profit declined considerably between
2012 and 2014, from $5.7 million (5.8% net margin) to $1.1 million (1.0% net
margin) as a result of the higher growth in costs. The main factors that influenced
this include the significant jump in their fuel and wages expenses. In 2015, their
inability to reduce costs, combined with lower revenues, saw the company report
a loss.
Operational New capacity (measured by ASK) of around 18 per cent has been added
efficiency over four years, but this has not been matched by revenue passenger growth
(measured by RPK), which grew by less than 10 per cent in that period. This has
had a detrimental effect on seat factor (capacity utilisation), calculated as RPK/
ASK, which has declined from 75 per cent to 70 per cent.
On-time performance has been maintained. However, this efficiency may have
occurred at a high price because of high levels of wages and the low levels
of profitability. The company may need to find ways of maintaining efficiency,
but with a lower level of resources.
Revenue growth The strong revenue growth between 2011 and 2012 of nearly 15 per cent
indicated that REX was capturing new customers, as well as expanding into
new routes. However, REX has seen a slump in revenues, with this dropping by
5 per cent in 2013 and a further 1.9 per cent in 2014.
Cost control In 2012, REX was able to control growth in total expenses to 10.5 per cent,
even as revenues grew by nearly 15 per cent. However, in 2013, with 5 per cent
lower revenues, total expenses rose slightly. Compared to competitors, REX has
benefited from smaller increases in fuel and wages expenses, indicating greater
efficiency. In 2014, total expenses accounted for 96.4 per cent of total revenue,
compared to 94.08 per cent in 2013, highlighting the low operating margins in
the airline industry.
Fuel expenses REX has managed to keep fuel expenses to between 14 and 16 per cent
of revenues and below 17 per cent of total expenses, which is a favourable
performance compared to other airlines.
Wages expense Comparing 2011 and 2014, wages have increased in line with revenues. However,
throughout that period, wages represented around 39 per cent of revenues,
which was higher than for its larger competitors.
Profitability The profit margin has declined from nearly 10 per cent in 2012 to only 5 per cent
of revenues in 2013 and 3 per cent in 2014. This is, arguably, still a reasonable
result compared to their competitors, who incurred significant losses throughout
2013 and 2014. This suggests that REX may have found a niche in the market that
is less volatile and more profitable than for some of the other competitors.
Operational efficiency In 2014 REX saw a 3.8 per cent decline in the total number of passengers carried
compared to the previous year. RPK fell by 11.36 per cent from 443.7 million
to 393.3 million between 2011 and 2014. On-time performance is strong at
85.9 per cent, second only to Qantas, the industry on this metric.
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Qantas
Table SA3: Review of Qantas’s performance
Revenue growth There has been virtually no revenue growth for the domestic segment over the last
three years, with very low growth overall for the company. In 2014, total revenue fell
by AUD 550 million—a decrease of 3.5 per cent compared to 2013.
Cost control Total expenses have grown since 2011, although they were well-controlled in
2013. In 2014, a well-reported AUD 2.5 billion impairment charge resulted
in expenses increasing significantly, from 98.75 per cent of revenue in 2013 to
124.5 per cent in 2014, resulting in an overall loss for 2014 of nearly AUD 3 billion.
Fuel expenses Fuel expense increased by 16 per cent from 2011 to 2012, remained steady in
2013, but increased significantly (to 29% of revenue) in 2014. These expenses are
quite considerable, representing more than a quarter of revenues (and 23% of
total expenses).
Wages expense Wages growth has been constrained throughout 2013 and 2014, indicating
strong efficiency.
Profitability Profit after tax was reasonably strong in 2011 but a loss was incurred in 2012, and
profit was quite low in 2013. Profit was again negative in 2014 (by AUD 2.84 billion)
primarily because of the AUD 2.56 billion impairment charge.
Operational efficiency Despite adding nearly 4 per cent more seat capacity (ASK) between 2011
and 2014, RPK has reduced, so that seat factor (capacity utilisation) fell
from approximately 79.9 per cent to 75.27 per cent. There was also a strong
on‑time performance of approximately 87 per cent for Qantas, but Jetstar’s
and QantasLink’s performance was considerably lower at 83.1 per cent
and 82.7 per cent respectively.
Virgin Australia
Table SA4: Review of Virgin Australia’s performance
Revenue growth In the domestic segment, revenue growth has been exceptional at nearly
40 per cent from 2011 to 2014, and close to 15 per cent from 2013 to 2014.
The move into the business class segment appears to be yielding higher
revenues, and the acquisitions (Skywest and Tigerair) have also led to higher
revenues. Overall, revenue growth is strong, rising by 23 per cent from 2011 to
2013 and 7.1 per cent between 2013 and 2014.
Cost control Total expenses are rising faster than revenues, which has led to losses in each
of the 2013 and 2014 financial years.
Fuel expenses Fuel costs have increased by over 33 per cent, and for the 2014 financial year
represent around 28 per cent of revenues and 26 per cent of total expenses.
Wages expense Wages have increased by more than 31 per cent over the 2011 to 2013 period,
but from a reasonably low base. In 2014, wages amounted to 24.2 per cent
of total revenues, indicating that high levels of efficiency and well-negotiated
remuneration packages are in place.
Profitability After a net loss in 2011, Virgin Australia achieved a significant turnaround
to achieve a $23 million profit in 2012. The profit margin was less than
1 per cent, but this was still a positive achievement, as it was realised despite
significant increases in several cost areas, including fuel and wages. However,
the company was unable to continue with its profits in 2013, with a reported
loss of AUD 98 million. The situation deteriorated further in 2014, with a loss of
AUD 356 million being reported.
Operational efficiency Virgin’s seat factor declined from 80 per cent to 77 per cent between 2011 and
2014. Virgin has relatively good on-time statistics that are above the average for
all airlines. This is important for customer satisfaction and effective utilisation
of aircraft. Tiger is very low at 75 per cent.
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(c) Table SA5 presents a high-level SWOT analysis for WattleJet. It is presented to demonstrate
the type of analysis that needs to be undertaken and is not an exhaustive list of strengths,
weaknesses, opportunities and threats. There may be additional factors to include in
the analysis.
Strengths Weaknesses
Opportunities Threats
Economic growth and leisure travel in regional areas Decline in mining activity and profits will hurt
indicates growth opportunities for both current and regional air travel, especially in the business
new flight routes. segment.
There has been an increase in passenger traffic A slowdown in the general economy will also
between major capital cities in recent years. reduce the number of leisure travellers going to
regional destinations.
Task 4
(a) As outlined in Module 3, effective performance measures help to achieve a variety of
outcomes including:
–– helping to implement and monitor strategy;
–– supporting decision-making;
–– motivating managers and other employees; and
–– communicating with, or signalling to, stakeholders.
Effective environmental measures should therefore help the organisation to focus attention
on this area, ensuring that improvements are made and appropriate outcomes are achieved.
The following environmental measures are sourced from competitors’ annual reports.
Note that additional measures may be relevant, such as those provided by the GRI Guidelines
as well as sustainability indices (e.g. FTSE4Good or the Dow Jones Sustainability Index).
The first two measures are a numerical count, so they are a useful starting point in
measuring performance, but are not very useful in establishing efficiency or improvement
over time. Thus, the measures are reliable (may be measured objectively and accurately),
have clarity and timeliness, but they are not as valid as other measures in actually capturing
‘environmental performance’.
To address this issue, we can convert total fuel use and total emissions into a ratio linked to
RTK. RTK is the total number of passengers and the amount of freight carried, multiplied
by the number of kilometres flown, measured in tonnes. This enables us to obtain data that
are comparable over time and with competitors. As such, it has greater validity than the first
two measures, and may still be measured in a reliable manner.
(b) Table SA6 is presented to demonstrate the type of analysis that needs to be undertaken.
There may be a variety of other measures (financial or non-financial, leading or lagging) to
include in the BSC. In addition, it would be ideal to include targets for each measure that
meet the SMART criteria—namely, Specific, Measurable, Achievable and Agreed, Relevant,
Time-based and Timely.
Traditional BSCs have financial, customer, business process, and learning and growth as
their four categories, but it is possible to add an extra perspective such as an environmental
perspective. The BSC also emphasises cause–effect relationships and so it is important to
ensure that the BSC that you have designed has cause–effect relationships present and also
has both leading and lagging indicators.
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Task 5
(a) A value analysis of the main activities that were described in the sales ticketing process is
presented in Table SA7.
Staffing of the Value adding and Staffing the call centre is likely to be a combination
bookings call centre non-value adding of value adding and non-value adding activity. As the
website is a lower-cost alternative, it can be argued to
be mainly a non-value adding cost. However, if certain
customers desire this service and are willing to pay
a premium for it, this would demonstrate that it is a
valuable activity. The important thing here would be
to minimise the number of customers using the call
centre and transfer them to the website. This might be
achieved through additional communication and lower
prices for web-based bookings.
Complaint and Non-value adding Complaint and dispute resolution may be regarded
dispute resolution as a non-value adding activity. While it is important for
the company to have this activity in place to deal with
frustrated customers, it indicates failures in other areas
of the business. In quality terms, complaints are an
external failure, and it is better to try to eliminate them
completely by spending more money in other areas to
prevent issues from arising in the first place.
1. Website design and $167 200 2 200 hours $167 200 / 2 200 = $76 per hour
maintenance
2. Call centre queries, $464 000 32 000 calls $464 000 / 32 000 = $14.50 per call
bookings and changes
3. Complaint and dispute $42 400 800 $42 400 / 800 = $53 per complaint
resolution complaints
4. Physical ticket distribution $105 000 42 000 tickets $105 000 / 42 000 = $2.50 per ticket
Step 2: Allocate the cost of each activity (cost pool) to the customer groups based on the
number of driver transactions used by each customer group.
1. Website design $76 per hour $167 200 2 150 hours $163 400 50 hours $3 800
and maintenance
2. Call centre $14.50 per $464 000 5 800 calls $84 100 26 200 calls $379 900
queries, bookings call
and changes
3. Complaint $53 per $42 400 635 $33 655 165 $8 745
and dispute complaint complaints complaints
resolution
4. Physical ticket $2.50 per $105 000 4 000 tickets $10 000 38 000 tickets $95 000
distribution ticket
Step 3: Calculate the total cost for each customer group, as well as the cost per ticket for
each customer group.
Customer group Total cost Number of customers Average cost per ticket
Difference $2.8989
From the table in Step 3, we can see that the cost of servicing online ticket purchasers
($1.5324 per ticket) is considerably less than that for call centre ticket purchasers ($4.4313
per ticket). The difference is $2.8989 per ticket. WattleJet should ensure that prices are
set accordingly (i.e. menu-based pricing), so that call centre purchasers pay a premium for
the additional service. This ticketing cost information can then also be used in assessing
the profitability of particular customer segments and the types of flights and routes
that they book.
Task 6
(a) Step 1: Establish the weighted average value of the efficiency savings that were identified
in Table CS9 (reproduced below in Table SA8). This is done by multiplying the probability
weightings by each amount and then summing up the value for each year.
Table SA8: E
stimated fuel and other efficiency savings from an early upgrade
to ADS-B
Probability $ $ $
The table below shows the calculations for the weighted averages.
30% × $45 300 $13 590 30% × $111 800 $33 540 30% × $145 300 $43 590
50% × $86 800 $43 400 50% × $152 000 $76 000 50% × 178 000 $89 000
20% × $114 000 $22 800 20% × $165 000 $33 000 20% × $190 000 $38 000
Weighted average: $79 790 Weighted average: $142 540 Weighted average: $170 590
Step 2: Prepare a cash flow and NPV-analysis table. The estimated upfront costs (investment
outlay) for implementing this system are $235 000, to be spent at the start of the project
(Year 0), with additional ongoing training, testing and implementation costs of $75 000 spent
in Year 1 of the project.
The weighted average of the fuel efficiency savings are inserted as cash savings over the
three years of the project. We can then establish the net cash flow for each year and the
total for the project. We can see in Table SA9 that the total net cash flow is a positive result
of $82 920. However, we need to discount these cash flows to their present value to evaluate
the project properly.
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644 | STRATEGIC MANAGEMENT ACCOUNTING
To do this, we apply a discount factor of 14 per cent. Remember that we do not discount
the initial investment, as this occurs at the start of the project (Year 0) and is regarded as the
present value already.
$ $ $ $ $
Fuel efficiency savings $79 790 $142 540 $170 590 $392 920
Net cash flow ($235 000) $4 790 $142 540 $170 590 $82 920
calculation (14%)
Present value ($235 000) $4 202 $109 680 $115 147 ($5 971)
The net present value for this project is negative (–$5 971). From a financial perspective,
this suggests that the project will not add value to the organisation (although the result is
immaterial because of the size of the business). We must also consider qualitative and risk
factors before deciding whether or not to proceed. It would also be worthwhile to check all of
the assumptions and cash flow estimates, as a small change may lead to a different result.
Step 3: Here, we need to identify qualitative and risk factors. There are a variety of benefits in
addition to fuel savings to be achieved by implementing the system. As it will become a legal
requirement, early action may lead to a more efficient and effective implementation, with a
longer transition, fewer mistakes and lower prices in the short term (as costs will likely rise as
the compulsory implementation date approaches).
More accurate positioning of aircraft in the air is likely to reduce the chance of a mid-air
collision or other incidents, which provides an enormous safety benefit. It will also enable
faster routing of aircraft around airports, leading to better on-time departure and arrival
performance. This will provide additional customer and operational efficiency benefits.
In terms of risks, there is the potential for faulty implementation and the small chance that
the government may change the regulations again. Faulty implementation may be addressed
by running the current system simultaneously for a considerable period to test accuracy.
The technology that is being implemented should be carefully selected to ensure that,
if regulations change, the capabilities of the system will match the new requirements, or are
at least able to be adapted to do so.
CASE STUDY
Suggested answers | 645
A
Activity 1 Activity 3 D Activity 5
Activity 4
Both Activity 1 and Activity 2 can start at the same time. This is shown by having two arrows
flow from the start node. However, both of these activities must be completed before you can
start Activity 3, as they are listed as preceding activities.
You will notice that we have used a dummy activity to link node B to node A. This is because
we cannot have two arrows starting from one node and finishing together at the same node.
Activity 3 starts and reaches node C once it is completed. From here we can start both
Activity 4 and Activity 6 at the same time, as these both list Activity 3 as a preceding
activity. Activity 5 is able to start once Activity 4 is finished. Once Activity 5 and Activity 6
are completed, there are no more tasks to be done. So, these are linked by an arrow to the
end node.
ET = (O + 4ML + P) / 6
In Table SA10, the time estimates have been rounded to the nearest day.
CASE STUDY
646 | STRATEGIC MANAGEMENT ACCOUNTING
Time estimate
(working days)
So, the critical path is 1 – 3 – 4 – 5. This is the longest time in days, but it is also the shortest
amount of time actually required to complete the whole project. The project is forecast to take
257 days.
A
Activity 1 Activity 3 D Activity 5
53 Activity 4
15 102 87
Start Activity 6 End
C
Activity 2 108
21
B
References
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CASE STUDY
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CASE STUDY
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