1. Financial Accounting
Page 1

2. Definition
Accounting is the process of
•identifying,
•measuring
•and communicating
•financial information about an entity
•to permit informed judgments and decisions
•by users of the information.
Page 2

3. The Accounting Equation
Assets minus Liabilities equals Equity
A - L = E
Assets equals Liabilities plus Equity
A = L + E
Equity Capital Ownership claim
Shareholders’ funds
Page 3

4. Power of Accounting
“Accounting provides a very selective but powerful
representation of the corporate identity..”
“The detailed language of assets, liabilities, costs, profits
provide a range of corporate imagery and vocabulary
…….”
“Accounting provides the categories through which
organisational participants perceive both themselves and
the organisation.”
Mike Powers
Page 4

5. Creative Accounting?
“Things may exist independently of our accounts, but they
have no human existence until they become accountable.
They may not exist, but they take on human significance by
becoming accountable..”
“Accounts define reality and at the same time they are that
reality….”
“Accounts do not more or less accurately describe things.
Instead they establish what is accountable in the setting in
which they occur”
“Whether they are ACCURATE OR INACCURATE by some other
standards, accounts define reality for a situation in the sense
that people act on the basis of what is accountable in the
situation of their action.”
Ruth Hines
Page 5

6. You will discover
That accounting is subjective, partial and potentially
misleading
Accountants use language / numbers in a highly technical
way
Accounts are a highly stylised story, representation,
description of organisational events
Differences between the ‘Accounting World’ and the
‘Organisational World’
Problematic nature of accounting numbers
Page 6

7. And there’s more….
The tribe of accountants takes many forms and lives
within all organisations
No such thing as a correct ‘cost’, ‘value’, ‘profit’..it
all depends on context
The value of accounting in managing
organisations
Page 7

8. Roles of Accounting
Improve problem solving / decision making
Manage risks
Trust, Assurance
Educational - learn about organisations
Language of business
Construct, define, measure success/failure
Page 8

9. Roles of Accountants
Assisting the internal management of organisations
Complying with external financial reporting,
controls and with taxation regulations
Expert consultants on financial and organisational
performance
Page 9

10. Financial Accounting
Accounting concepts
Profit and Cash distinction
Financial statements
Organisational impact
Page 10

11. Hierarchy of Accounting Qualities
Decision Makers and their characteristics
Benefits > Costs
Understandability
Decision-Usefulness
Relevance Reliability
Predictive Timeliness Verifiability Representational
value
Faithfulness
Comparability &
Feedback consistency Neutrality
Value
Materiality
Page 11

12. Transactions
Buy materials on credit
from suppliers
Sell goods or services on
credit to customers
Pay suppliers
Receive cash
Page 12

13. When is profit reported?
When goods or services are sold
NOT
when cash is paid or received
Page 13

14. Example: Antiques dealer
Buy 10 chairs for cash Rs 200 each
Sell 6 chairs on credit Rs 300 each
Profit 6 x 100 each = Rs.600
Cash flow = minus 2,000
Page 14

15. Profit, not cash
Matching Concept – match revenues received with
the costs incurred to generate them
Goods received but not paid for –Creditors
(Payables)
Goods or services supplied but no cash yet - Debtors
(Receivables)
Prudence concept – providing for known / probable
losses – e.g. Doubtful debts, Depreciation of fixed assets
Page 15

16. Profit, not cash contd
Customers pay in advance for services extending
beyond the accounting period
Company agrees with supplier to buy
materials at fixed price for 5 years
Home currency euros, borrow in dollars
Increase in valuation of fixed assets
Page 16

17. Change over a period
start Assets - Liabilities = Equity
During the period Profit/loss
end Assets - Liabilities = Equity
Page 17

18. Contents of annual report
Financial highlights
Company overview
Chairman’s statement
Chief Executive’s review
Audit report
Financial statements
Notes to the accounts
Page 18

19. The main financial statements
Balance Balance Balance
Sheet 1 Sheet 2 Sheet 3
AS AT AS AT AS AT
31 Dec Year 1 31 Dec Year 2 31 Dec Year 3
Profit and Loss Profit and Loss
Account Account
For period For period
Cash Flow Report Cash Flow Report
Page 19

20. Balance sheet horizontal
• Fixed assets • Liabilities
• Current assets • Shareholders’ funds
Page 20

21. Balance sheet vertical
Fixed assets
Current assets
Less
Current liabilities
Less long term liabilities
Equals
Shareholders’ funds
Page 21

22. Profit and loss account
Revenue (sales)
Less Expenses (costs)
Equals Profit
Page 22

23. Cash flow statement
Operating cash flows
plus
Investing cash flows
plus
Financing cash flows
Equals change in cash and bank loans
Page 23

24. Creative accounting
What do we want to create?
More profit? Less profit?
More assets? Fewer assets?
More liabilities? Fewer liabilities?
Page 24

25. Creative Accounting Practices
Income smoothing – move profit from one year to
another
Changing accounting policies, particularly
depreciation, asset valuations
Overstating costs, particularly in regulated industries
Making expenses into Assets - ‘capitalisation’
Page 25

26. Off-balance sheet financing , e.g leasing, Sale
and buyback, special purpose vehicles
Recognising profits that aren’t really there –
foreign exchange rates affecting values of
assets and loans
Corporate takeovers – ACCOUNTING
MINEFIELD adjusting policies, fair values,
goodwill, brands, reorganisation costs……...
Page 26

27. Corporate crime / fraud
Directors are responsible for preventing crime and
fraud
They are required to have a system of internal
controls
Who controls executive directors for honesty/?
Audit committees, Non-executive Directors,
Supervisory Board
Page 27

28. Corporate crime/ fraud contd.
Creating fictitious contracts
Fictitious Assets, inaccurate valuations
Omitting Liabilities, misleading valuations
Raid the employees’ pension fund
Page 28

29. Analysis and
Interpretation of
Financial Statements
Page 29

30. First Steps BC
(before calculation)
• Why are you analysing accounts?
• Who are you interpreting for?
• When are you interpreting?
• What are you intending to interpret?
• Limitations of Financial Accounts
Page 30

31. Always bear in mind
• Preparers of accounts know how people will interpret
their accounts
• Be cynical – assume the accounts are the best possible
picture
• Analysis only as good as original data –
• Never just use accounts – check from many different
sources
• Accounting terms are different from general
understandings
Page 31

32. However….
• Accounts are main source of systematically produced
regulated information
• Good as it gets
• Usually reliable – 3rd party verified
• Follow the same basic rules
• Most of the information is there (in the small print)
• You can never eliminate the risk of fraud / criminal
misrepresentation
Page 32

33. Analyse Accounts to determine
Is the company:
•Growing? •Profitable?
•Managing its assets effectively?
•Sufficiently liquid?
•Financed properly?
•Able to meet its financial obligations?
•Viewed favourably by financial markets?
Page 33

34. Financial ratios
• Quick and simple check on financial health
• Small number of ratios gives a picture of the
business. Easy to calculate, harder to interpret.
• Provide a starting point for further investigation.
Page 34

35. Key areas for analysis
• Profitability
• Liquidity
• Asset management
• Debt management (financial structure)
• Market value
Page 35

36. Success in making profit
Return on capital employed
profit sales Profit
_____ x _______ = __________
sales total assets total assets
profitability x efficiency = ROCE
Page 36

37. Managing liquidity
• Can we pay the bills as they fall due?
• Can we pay the wages of employees?
• Buy stock (inventory) on credit
• Sell on credit = accounts receivable
• Pay suppliers = accounts payable
• Ideally, match cash flows in and out
Page 37

38. Asset management
• Use fixed assets to earn sales revenue
• Manage working capital
• stocks (inventory)
• debtors (accounts receivable)
• creditors (accounts payable)
• working capital cycle
Page 38

39. Financial structure
• Is it a good idea to borrow?
• Creates greater risk - interest payments and
capital repayments
• Benefits to shareholders when profits are rising
• Risks to shareholders when profits are falling
Page 39

40. Advantages of ratios
• Comparisons are relative to other figures
• Compare businesses of different size
• Gives picture of company strategy
• Financial and trading performance
• Compare with industry averages
• Simple summary of complex information
Page 40

41. Reasons for using ratios
• Gives summary statistics
• Helps identify industry benchmarks
• Input to formal decision model
• Standardise for size
Page 41

42. Applications of analysis
• Predictions of corporate earnings
• Construct projected financial statements
• Predict corporate failure
• Indicators of financial distress
e.g. Altman’s models, combination of ratios
Page 42

43. Problems with ratio analysis
• No agreement on definitions or specific set of
ratios
• Accounting estimation
• Data not available
• Timing of data does not match
• Differing accounting policies
• Negative numbers and small divisors
Page 43

44. Limitations of ratio analysis
• Diverts attention from the underlying information
• May not give sufficient attention to the notes to
the accounts
• Accounting policies may affect comparison
• Industry differences
Page 44

45. Creative accounting
Could involve:
• Inflating reported profits and EPS
• Accounting for losses via balance sheet reserves
and all profits through P & L
• Reporting profits without generating equivalent
cash
• Reporting lower borrowings
Page 45

46. Survival Tips for Accounting Jungle
• Read the accounts backwards
• Read the accounting policies and compare
• Screen accounts using filters – e.g. high profit
low tax, changing depreciation policies
• Cash is King (or Queen)
• Assess risk: If in doubt, keep out (or get out)
Page 46

47. Return on Capital Employed
Profit before interest and taxation x 100
Shareholders’ funds plus long term debt
• Often called ‘Operating profit’
Assets minus Liabilities = Equity
• Total assets minus current liabilities equals
Shareholders’ funds plus long term loans
Page 47

48. Return on Capital Employed
Top line questions
• What increases/ decreases profit?
• Sales? Operating Costs?
Bottom line questions
• Recent increases in assets may not yet have
created profit
• Is there any debt ‘off balance sheet’?
Page 48

49. Return on Shareholders Funds
(also called Return on Equity)
Net profit after taxes x 100
Shareholders’ funds
Page 49

50. Return on Shareholders Funds
Top line questions
• What increases/ decreases profit?
• Sales? Operating Costs?
• Interest charges? Taxes?
Bottom line questions
• Is the company high/ low geared?
Page 50

51. Net Profit Percentage
Net profit after taxes x 100
Sales
• Often shown as ‘Profit attributable to
ordinary shareholders’
• Sales also called ‘turnover’
Page 51

52. Net Profit Percentage
Top line questions
• Is gross profit high or low?
• What are the admin and selling costs?
• What are the effects of interest and taxation?
Bottom line questions
• Is the measurement of sales explained?
Page 52

53. Gross Profit Percentage
Gross profit x 100
Sales
Gross profit = Sales minus cost of sales
Cost of sales = making ready for sale
Page 53

54. Gross Profit Percentage
Top line questions
• Have sales volumes or prices changed?
• Have costs of sales changed?
• Are costs of sales mainly variable or fixed?
Bottom line questions
• Is the measurement of sales explained?
Page 54

55. Current Ratio
Current Assets
Current Liabilities
Solvency = Ability to meet obligations as
they fall due
Working capital = CA minus CL
Page 55

56. Current Ratio
Top line questions
• What affects levels of stocks, debtors, cash
Bottom line questions
• What affects levels of bank borrowing, trade
creditors, other short term creditors
Overall - How does the company manage its
working capital?
Page 56

57. Quick Ratio (Acid Test)
Current Assets less Stock
Current Liabilities
Solvency = Ability to meet obligations as
they fall due
Cash flow: How does the company manage
inflows and outflows of cash?
Page 57

58. Quick Ratio (Acid Test)
Top line questions
• How is the company managing debtors and cash?
Bottom line questions
• How is the company managing trade creditors and
bank overdraft?
Page 58

59. Stock Holding Period (days)
Stock x 365
Cost of Sales
• Change 365 to 12 for a calculation in months.
• Sales minus cost of sales equals gross profit
Page 59

60. Stock Holding Period (days)
Top line questions
• Year-end stock or average stock? Use year-end
for ease of calculation but check there are no
significant changes from start.
Bottom line questions
• May have to make some approximations to get
cost of sales
Page 60

61. Debtor Payment Period (days)
Trade Debtors x 365
Sales
• Debtors = Accounts receivable (customers
who buy on credit terms)
•Use notes to the accounts to find trade
debtors.
Page 61

62. Debtor Payment Period (days)
Top line questions
• Average or year-end? Year-end is less
trouble but check there are no major
changes.
Bottom line questions
• Are all sales made for credit? Think about the
nature of the business.
Page 62

63. Creditor Payment Period (days)
Trade Creditors x 365
Purchases or cost of sales
•Trade creditors = Accounts payable
(suppliers who provide goods on credit terms)
• Use notes to the accounts for detail.
•
Page 63

64. Creditor Payment Period (days)
Top line questions
• Average or year-end?
Bottom line questions
• Opening stock + purchases - closing stock = Cost
of goods sold.
• Should be Purchases but Cost of goods sold is Ok
if stocks are constant.
Page 64

65. Gearing
Long Term Debt
Long Term Debt plus Equity
• Look carefully at balance sheet and use
notes to accounts.
•Add Preference shares to Debt
•Omit Provisions
Page 65

66. Gearing
Top line question
• What are the sources of finance that create fixed
commitments to pay interest and repay capital?
Bottom line question
• What is the total long-term financing of the
business, based on borrowings and equity?
Page 66

67. Interest Cover
Profit before interest and tax
Interest expense
• EBIT = Earnings Before Interest and Taxation
• Interest expense: either in profit and loss account
or in detailed notes.
Page 67

68. Interest Cover
Top line questions
• What is the amount of profit available to ‘cover’
interest payments?
• Is the company generating sufficient wealth to
meet interest payments?
Bottom line questions
• What is the cost of servicing borrowings?
Page 68

69. Concepts, Cost and Costing
Page 69

70. Management accounting
• Integral part of management
• identify, present and interpret information
• for strategy, planning and control,
• for decision taking and use of resources
• for disclosure to employees
• to safeguard assets
Page 70

71. Management accounting (contd)
• Internal use within organisation
• No regulation by law
• Projections for future
• Analysis of past
• Directing attention, planning and control
• Solving problems
Page 71

72. Measuring and
analysing
performance
Implementing Examining future
plans environment
Action plans and budgets
Developing
objectives
Operating plans
Formulating strategy
Page 72

73. Importance of costing
• Many organisational decisions rely on costings
• Costing is complex but essential
• “An accountant knows the cost of everything but
the value of nothing” Oscar Wilde
Page 73

74. Describing costs
• Direct (identified with a saleable unit)
• Indirect (spread across saleable units)
• Indirect costs = Overheads
• How to find a fair way of spreading the
overheads?
Page 74

75. Confusing terminology
• Allocate = give all cost to one unit or centre
• Apportion = share across units or centres
• Absorb (Absorption) Soak up into the units of
output
See page 142 of text book
Page 75

76. Terminology (contd)
• What are the direct costs? Allocate these to units
of output
• What are the indirect costs? Allocate to cost
centres if we know where they belong.
• Otherwise Apportion (share) across cost centres.
• Absorb costs from production centres into
products.
Page 76

77. Absorption bases
Absorb as
• cost per unit
• cost per labour hour
• cost per £ of labour
• cost per kilo of material
• cost per machine hour
Different bases give different answers
Page 77

78. Cost behaviour
Pairs of classifications
• Direct or indirect?
• Fixed or variable?
• Period or product?
Case: Bus company sends buses to 10 schools for
taking children home each day. How does the
company describe the costs?
Page 78

79. Direct or indirect?
Direct for each school:
Driver’s working time, fuel for bus, bridge tolls
Indirect to spread across all journeys:
Insurance, repairs, maintenance, licences,
depreciation, driver’s idle time, holiday pay
Page 79

80. Fixed or variable?
Variable change with activity level
Fuel, repairs, bridge tolls
Fixed regardless of activity level
Drivers’ wages, Insurance, Licences,
Maintenance checks, Depreciation
Page 80

81. Period or product?
What is the product?
A person-mile.
Product costs
Driver’s time, fuel, bridge tolls
Period costs
Insurance, Licences, routine maintenance,
depreciation
Page 81

82. Examples of decisions
• Price setting, tendering for contracts
• Product profitability analysis
• Product design modifications
• R & D management
• Value Engineering
• General Cost Management
• Contracting out / Buying in
• Plant / Department Closure
Page 82

83. Short-term decisions
In the short term business can continue if the selling
price covers variable costs and makes a
contribution to fixed costs.
Contribution = Selling price - variable cost
Page 83

84. Contribution analysis
Break even point =
Fixed costs
Contribution per unit
Pay £1,000 rent for market stall. Buy toys for £6
each, sell for £8 each. What is breakeven
volume?
£1,000/£2 = 500 toys
Page 84

85. Contribution analysis (contd)
Sell 500 at £8 = £4,000.
Variable cost 500 x £6 = £3,000
Add fixed costs £1,000
Neither profit nor loss
How many toys to sell for profit of £4,000?
£(1,000 + 4,000)/£2 = 2,500 toys
Page 85

86. Scarce resources
Sell gardening services and house cleaning.
Contribution per job £10 and £8.
Gardening needs 2 hours per job, House cleaning
needs 1 hour per job.
Shortage of labour. Which has priority?
House cleaning £8 per hour, Gardening £4 per hour.
Contribution per unit of limiting factor
Page 86

87. Short term decisions
• Make internally or buy externally
• Hire own staff or pay agency for outsourcing
• Keep a business activity going
• Take on a special order at lower price
Page 87

88. Other factors in decisions
Not just an accounting matter. Consider
• organisation’s objectives
• relationship with employees
• marketing
• corporate goodwill/ image
• customer reactions
• government policies
Page 88

89. Get the costs wrong and...
•Set prices too high - lose sales;
too low - sell products at loss
•Lose potentially profitable contracts, win loss
making contracts
•Don’t know where we are making / losing money
•Continue with loss making products, cut profit
making products, sub-optimal product mix
Page 89

90. Get the costs wrong and...
•R & D to create ‘better’ product when none
needed
•Product Design Modifications not done when
needed
•Contracting out production that costs more than
internal production
•Making products that could be cheaper to buy in
•Close profit-making Plant / Keep open loss
making plant
Page 90

91. Different Costs for Different
Purposes
Not a single, universal ‘true’ cost.
Appropriate cost is governed by:
Needs of management
Specific organisational situations
Specific problem to be solved
Available information - pragmatics
Page 91

92. Different Costs for Different Purposes
Activity Based Failure Cost Planned Cost
Cost
Average Cost Full Cost Product Cost
Avoidable Cost Historic Cost Quality Cost
Budgeted Cost Incremental Relevant Cost
Cost
Controllable Indirect Cost Step Cost
Cost
Current Cost Joint Cost Sunk Cost
Direct Cost Marginal Cost Standard Cost
Environmental Opportunity Total Cost
Cost Cost
Engineered Overhead Transfer Cost
Cost Cost
Fixed Cost Period Cost Variable Cost
Page 92

93. Costing Problem
•In contemporary organisations the fixed/variable
classification is not relevant
•Logical impossibility of attributing all costs to
products
•Wrong approach to the problem
•‘Solution’ based in the ‘accounting world’ not the
‘organisational world’
Page 93

94. Activity ‘Solution’
Costs don’t drive activities, activities cause costs
Organisations do things that consume resources
and (should) create value
Costing should start with what the firm does -
activities in organisational world
Page 94

95. Activity Based Costing
• What are the activities of the organisation?
• What resources are used by each activity?
• How much does each resource cost?
• Collect cost in ‘cost pools’
• How does each product or service make use of
each activity?
• Share cost from the cost pools.
Page 95

96. Money
cost
Resources
consume
Non-financial
Collect
Data
Activities Performance
Analysis
produce
Outputs
creates Value
Page 96

97. Benefits of ABC
• Makes visible the activities that drive the costs
• Prevents misallocation of costs
• Links costs more closely to responsibility for
causing costs
BUT does not save money or generate profit. It
only gives more accurate information
Page 97

98. Activity costing is...
•Not based on accounting coding structures
•Not based on accounting time frames
•Not based on techniques designed to make
the accountants life easier
•Not based on producing Financial
Statements
Page 98

99. Short term planning
Budgets and
Budgetary Control
Page 99

100. What is a budget?
• Quantified format
• management plans and strategies
• for decision making
• communication medium
Page 100

101. Mission/ goals
Financial plans
Corporate objectives
Assumptions
Assessed market Long term on critical
opportunities/ strategy factors
organisational
capability
Long term plans
Page 101

102. Long term strategy
Long term planning
Market
opportunities Forecasting
assumptions
Short term strategy
Organisational
capability Budget/ short term
Modify
planning
assumptions
Page 102

103. Budget process
• Formalises planning and control
• Defines goals
• Goal congruence - brings goals together
• Authority and responsibility are clear
• Framework to judge performance
Page 103

104. operating financial
Master budget
Sales budget Capital budget
+
Cost of goods sold budget
+ Cash budget
Development /design budget
+
Marketing budget
+ Budgeted
Distribution budget
+ balance sheet
Administration budget
Budgeted profit and loss Budgeted statement
account of cash flow
Page 104

105. Budget preparation
•Start with sales budget (demand driven)
•Then match with cost of sales
•Is this a production organisation?
Plan:
inventories of raw materials, finished goods
purchases to cover sales and inventories
Page 105

106. Budget preparation (contd)
• Is this a service organisation?
Plan service programme, labour needs, materials
needed
• Plan all other operating expenses
• Plan capital expenditure
• Bring together in cash budget, budgeted profit
and loss account, balance sheet.
Page 106

107. Cash budget
• Most important part of budget cycle
• Monthly, quarterly?
• Cash receipts from operations
• Cash payments for operations
• Other cash receipts (new finance, sale of fixed
assets)
• Other cash payments (tax, dividends, interest)
Page 107

108. Fixed and flexible budgets
• Fixed means that budget is not adjusted later if
volumes start to vary
• Flexible budgets means that budget is adjusted to
take account of change in volumes of activity
over the period
Page 108

109. Fixed and flexible (contd)
Budget variable costs of £200,000 for 5,000 units of
output
Actual variable costs are £195,000 for 4,500 units
of output
How has manager performed against budget?
Page 109

110. Fixed and flexible (contd)
Appears to have saved £5,000
But budgeted cost = £4 per unit
So flexible budget for 4,500 is £180,000
Performance is £15,000 worse than flexible budget.
Page 110

111. Alternative approaches
Easy approach = Last year plus inflation
Zero-based budgeting
• Start with a clean sheet
• Justify every item
• Focus on goals and objectives
Page 111

112. Alternative approaches (contd)
Activity based budgeting
• Extension of activity based costing
• Focus on cost of each activity
Kaizen budgeting
• continuous improvement
• budget is achieved if improvements are met
Page 112

113. Not-for-profit organisations
• Goals and objectives measured differently
• Need to be cost effective
Planning programming budget system
• Focus on outputs rather than inputs
• ‘joined-up’ government
Page 113

114. Behavioural aspects
Budgets can motivate employees to achieve goals of
the organisation. What helps?
• degree of difficulty
• top management participation
• perceived fairness
• feeling of ownership
• avoid discontent about preparation
Page 114

115. Not foolproof
Why might budgets fail?
• Fail to understand changing environment
• using unsuitable existing structures
• fail to understand business systems
• lack of senior management support
• fail to understand central role of budgeting
Page 115

116. Are budgets necessary?
What matters is PLANNING
This does not have to use budgets. Essential:
• Set targets: to maximise long term value
• Strategy: Make development continous
• Growth and improvement: challenge staff
• Resource management: wealth creation
Page 116

117. Are budgets necessary?
• Co-ordination: manage cause and effect
• Cost management: challenge all costs
• Forecasting: use rolling forecasts
• Measurement and control: key indicators
• Rewards: unit rewards not individuals
• Delegation: give managers freedom to act
Page 117

118. Performance Measurement
Page 118

119. Strategic planning
Five year plan, rolling forward.
• Profitability
• Growth of sales, profit
• Market share
• Customer satisfaction
• Rate of innovation
How to measure achievement of strategy?
Page 119

120. Accounting-based performance
measures
Profit?
• Could compare actual profit against budget, but
companies don’t give information
• An absolute measure, needs ratios for
comparison.
• Affected by choice of accounting policies
• Measured differently in different countries
Page 120

121. Accounting-based performance
measures (contd)
Profitability
• A relative measure, better for comparison.
• Calculate for subdivisions of an organisation.
Methods
• Return on capital employed
• Residual income
• Economic value added
Page 121

122. Return on capital employed
Profit before interest and taxes
Fixed assets plus current assets less current
liabilities
Can be used for divisions of a company if assets and
liabilities can be allocated.
Page 122

123. Return on shareholders’ funds
Net profit after interest and taxation
Shareholders’ funds
Can only be calculated for the company as a whole,
not subdivided for divisions of organisation.
Page 123

124. Residual income
Ask: What is the income (profit) remaining after
deducting a notional interest charge for the use of
capital?
X Z £000’s
Operating profit (EBIT) 18 1,500
Capital employed 100 10,000
ROCE 18% 15%
Page 124

125. Residual income (contd)
Suppose cost of capital is 10% for both.
X Z £000’s
Operating profit (EBIT) 18 1,500
Less interest charge (10) (1,000)
Residual income 8 500
Company Z gives higher income to shareholders
Page 125

126. Economic Value Added (EVA)
Companies should deliver value that exceeds the
cost of capital.
X Z
Profit after tax (before interest) 13 1,050
Interest charge (net of tax) (7) (700)
EVA 6 350
Z gives higher EVA than does X
Page 126

127. Performance of a division
Divisions are created by decentralisation
• Gives greater responsiveness
• Allows faster decisions
• Motivates managers
• Uses specialist experience of managers
But needs a measure of performance
Page 127

128. Performance of a division (contd)
Problems of decentralisation
• Focus on division, not on total organisation
(Called ‘dysfunctional decision making)
• More information is needed, cost involved
• Duplication of activities
Page 128

129. Performance of a division (contd)
Cost centre
• Manager is responsible for costs
Discretionary cost centre
• Manager has some choices in cost budget
Revenue centre
• Manager is responsible for generating planned
sales
Page 129

130. Performance of a division (contd)
Profit centre
• Manager is responsible for revenues and costs
• Target profit is set
Investment centre
• Manager is responsible for resources and profit,
target return to be achieved
Page 130

131. Transfer pricing
What price is charged for transfers between
divisions within an organisation?
• Variable cost?
• Variable cost plus a profit margin?
• Variable cost plus portion of fixed cost?
• Variable + fixed + profit margin?
• Negotiated price? Reflect market?
Page 131

132. Financial Performance
Measurement
• Success / Failure often determined by accounting
numbers
• Growth in profit, ROCE, Sales
• Reduction in costs, headcount, errors, stock
• Financial Ratio Analysis
Page 132

133. Financial Performance Measurement
(contd)
• Achieving outcome at or under budget
• Adverse / Favourable variance analysis
• Project NPV – cost overruns
• OBJECTIVE APPROACH TO Performance
measurement
Page 133

134. Problem with financial measures
A Simple Scenario.
Division in large company enjoyed major growth in
profitability over two years ..manager promoted.
New manager ….drop in profits.
WHY ?
Page 134

135. Financial measures (contd)
Top line answer
• Division’s market share dropped
• Costs were reduced by reducing maintenance of cutting
machine, reducing staff training
•build up of stocks (inventory) of unsold goods
Bottom line answer
• Reduced investment in new technology
Financial System did not pick up the BAD Events
Page 135

136. Problems with financial information
• Complexity /mystery and the method of
calculation
• Arbitrary treatment of some cost items
• Time lag between event and the financial ledger
• No direct observable relationship between
activities and reported costs
• Irrelevant to managers
Page 136

137. Problems with financial information
(contd)
• Managers need to convert data into meaningful
information.
• Implied assumption that control costs will control
activities.
• Focus on cost minimisation, not on effectiveness or value-
adding. Could be valid reasons for costs increasing.
• Simplification of organisational activities, by reducing
everything into a single £ value.
Page 137

138. Value of Financial Performance
Measurement
• Managers accept importance of financial outcome
of their function (especially if linked to pay /
prospects).
• Managers will try to increase their profitability.
• Managers often devise their own budget
'systems’.
Page 138

139. Value of Financial Performance
Measurement (contd)
• Need information on relationships between
activities they control and financial outcome
• Ignore formal budget reports / spend time and
effort proving official budget is wrong
• Do not assume that managers can "translate" £s
into actual activities
Page 139

140. Information Managers Use
US study concluded information used for daily
operating control did not come from the budgeting
system.
Managers' information needs are affected by:
•the resources most significant to their process, in
terms of cost, quality, availability
•the time frame in which this information is needed
Page 140

141. Indicators for managers
 level of finished goods
 level of orders (demand)
 key production limiting factors
 simple counts of output per hour / shift / day,
 physical quantities of materials / labour used,
 down-time
Page 141

142. Indicators for managers (contd)
 scrap quantities,
 rework rates.
 capacity utilisation
 physical production requirements (long - medium
and short-term)
Page 142

143. Non-Financial Measures
Non-financial is any information not valued in £s.
It has the following advantages:
• Expressed in terms/language understandable to
managers (non-accountants)
• Requires very little "translation" by managers
Page 143

144. Non-Financial Measures (contd)
• Potentially quicker, relevant
• Relates to events, activities, actual observable
performance
• Can be used to make sense of financial budgets
• Better reflects the "reality" of the situation, not
confused by strange accounting
rules/conventions
Page 144

145. Integrating Non-£ and £ measures
• Activity Based Accounting
• Benchmarking
• Performance Scoring
• Balanced Scorecard
• Strategic Management Accounting
• Many other – multiple criterion decision making,
data envelopment analysis, etc…
Page 145

146. Financial
Perspectiv
e
er Perspe
ctiv e
Vision and Internal B
usiness
Strategy Perspectiv
e
Learning
& Growth
Perspectiv
e
Balanced Scorecard
Page 146

147. Balanced Scorecard
• systematic attempt to design performance
measurement system that integrates
– organisational objectives,
– co-ordination of individual decision making
– need for organisational learning.
• create an environment that facilitates continual
improvement
Page 147

148. Balanced Scorecard (contd)
• reflect the organisation’s understanding of the
causes of successful performance.
• monitoring performance and what managers
believe are drivers of good performance
• performance measure system should measure the
most critical aspects of organisational
performance.
Page 148

149. Balanced Scorecard (contd)
BS performance measures should
• be clearly understood by all employees
• link manufacturing performance and financial
performance
• be linked to ensure constancy of purpose.
Page 149

150. Balanced Scorecard (contd)
BS performance measures should
• be able to identify cause-effect relations to enable
employees to deal with poor performance and
continue good practices.
• be based on critical success factors
• identify trends and rate of change
Page 150

151. Not-for-profit organisations
• Economy
Cost at which resources are acquired
• Efficiency
Compare inputs and outputs
• Effectiveness
How resources are used
Value for Money
Page 151