Performance measurement

Performance measurement - Measures how well something or somebody is doing in relation to a plan.

Financial performance indicators - relating to revenues, costs, profits, return on capital, asset values or
cash flows.
Performance measures
Non-financial performance indicators - Product or service quality, Reliability, Speed of performance,
Risk, Flexibility, Customer attitudes, Innovation, Capability, Pollution

Measurement needs resources – people, equipment and time to collect etc.

Performance must be measured in relation to plans and objectives.

Factors that influence the
Measures must be relevant and fair.
design of a performance
management system
Short- and long-term achievement should be measured.

Realistic estimates may be required for measures to be employed.

Measurement needs responses, and managers to make decisions

Financial performance indicators

Note 1-
Financial indicators include
(presented as ratios)
Budgeted sales, costs and profits
Standards
Profit (both gross profit and net profit) The trend over time
Revenue
Costs compared against Results of other parts of the business
Cash flows
Debt and gearing Results of other businesses
Share price
Future potential

Note 2 - MEASURING PROFITABILITY

By how much percentage this

Sales in current year - Sales in previous year year's sale is bigger or smaller
Sales Growth = than last year's profit or loss
Sales in previous year

Return on Capital Employed = Net Profit before interest and tax x 100

Capital Employed

( Capital employed is defined as total assets less current liabilities or share capital and reserves plus long term capital )
Capital invested in a corporate entity is only available at a cost – corporate bonds or loan stock finance generate interest payments
and finance from shareholders requires either immediate payment of dividends or the expectation of higher dividends in the future.

Assets of a non-operational nature should be excluded from capital employed.

Profits should be related to average capital employed. In practice, many companies calculate the ratio using year-end assets.

The change in ROI from one year to the next

Two principal comparisons related to ROI or ROCE

The ROI being earned by other entities

Capital employed = non-current assets + investments + current assets – current liabilities

Profit = operating profit before tax
ROCE can also be calculated as: Operating profit/(Ordinary shareholders' funds + non-current liabilities)

ROI using controllable profit Controllable (traceable) profit ×100%

Controllable (traceable) investment

Residual income (RI)

(RI is calculated as follows
RI = Controllable (traceable) profit – imputed interest charge on controllable (traceable) investment

Note - ROI is a relative measure, whereas RI is an absolute measure.

Return on Equity (ROE) = Net income

Shareholder's equity

ROE-measures the ability of a firm to generate profits from its shareholders' investment in the company. It shows how much
profit each unit of shareholders' equity generates.
Net income is for the full year (before dividends paid to ordinary shareholders but after preference dividends.) Shareholder's
equity does not include preference shares.

ROE is often said to be the ultimate ratio or 'mother of all ratios' that can be obtained from a company's financial statements.
 Asset Turnover = Turnover
Capital Employed

The asset turnover is a measure of utilisation and management efficiency. It indicates how well the assets of a business are being
used to generate sales or how effectively management have utilised the total investment in generating income.

Profit on ordinary activities before taxation is

Net Profit Margin = Net Profit x 100 generally thought to be a better figure to use
than profit after taxation,
Turnover

The profit margin indicates how much of the total revenue remains to provide for taxation and to pay the providers of capital, both interest
and dividends. This return to sales can be directly affected by the management’s ability to control costs and determine the most profitable
sales mix.

Gross Profit Margin = Gross Profit x 100

Turnover PBIT = profit on ordinary activities before taxation +
interest charges on long-term loan capital.

PBIT is also often Gross profit – Other operating costs.

The ratio of sales and distribution costs to sales

Cost/sales ratios The ratio of administrative costs to sales

The ratio of another cost to sales, such as R&D costs

Note 3 - MEASURING LIQUIDITY

Liquidity is the ability of an organization to pay its current liability when they fall due.

The current ratio = Current assets

Current Liabilities

If current assets exceed current liabilities, then the ratio will be greater than 1 and indicates that a business has sufficient current
assets to cover demands from creditors. However, the speed at which stock can be converted into cash flow is such that it is not
prudent to regard stock as available to cover creditors

Quick (Acid Test) Ratio = Current assets – Stocks

Current Liabilities

If this ratio is 1:1 or more, then clearly the company is unlikely to have liquidity problems. If the ratio is less than 1:1 we would need
to analyse the structure of current liabilities, to those falling due immediately and those due at a later date.
This ratio should ideally be at least 1 for companies with a slow inventory turnover.

Note 4 - MEASURES OF UTILISATION (MEASURES OF EFFICIENCY) INCLUDES

Debtors (receivables) collection period = Debtors x 365 days

Sales

This is an indicator of the effectiveness of the company’s credit control systems and policy. The control of debtor days is an important
element of working capital management.

Creditors (payables) period = Creditors (trade) x 365 days

Purchases

This ratio is an aid to assessing company liquidity, as an increase in creditor days is often a sign of inadequate working capital control.
 Inventory holding period = Inventory x 365 days
Cost of sales

The holding period may increase because of: -

Build-up of inventory levels as a result of increased capacity following expansion of non-current assets. Increasing inventory levels in
response to increased demand for product
This is a measure of working capital management and relates to stock turnover. Controls need to be maintained so that liquidity is
not sacrificed.

Note 5 - MEASURING RISK

Financial Gearing= Debt x 100% Debt X 100%

OR
Equity Debt + Equity

If the firm has excessive debt, then the need to pay interest before dividends will increase the risks faced by shareholders if profits fall.

Interest Cover = Profit before interest and tax (Number of times)

Interest paid

This ratio represents the number of times that interest could be paid out of profit before interest and tax.

Dividend Cover = Earnings after tax and preference dividends ( Number of times )

Ordinary dividend

:
This is an indication of dividend policy – whether profits tend to be distributed or reinvested.

Operating Gearing = Fixed Costs

Total Costs

The higher the proportion of fixed costs, the higher the operating gearing. Companies with high operating gearing tend to have volatile
operating profits. This is because fixed costs remain the same, no matter the volume of sales.

Thus, if sales increase, operating profit increases by a larger percentage. But if sales volume falls, operating profit falls by a larger
percentage.

Generally, it is a high-risk policy to combine high financial gearing with high operating gearing. High operating gearing is common in
many service industries where many operating costs are fixed.

Earnings per share (EPS) = Profit available to equity shareholders

Number of shares

EPS is widely used as a measure of a company's performance, especially in comparing results over a period of several years
Earnings per share (EPS) is defined as the profit attributable to each equity (ordinary) share.
It is used for comparing the results of a company over time and thus must be calculated consistently.
Earnings are used to compare one company's shares with another, this is done using the P/E ratio or perhaps the earnings yield.
 The company as a whole faces threat of liquidation
Debt creates financial risk.
Payables/ creditors worry about not being paid in full in case of default Or liquidation.

Ordinary shareholders might not get any share of profit distribution in case the company is
unable to pay Interest in full.

The effect of gearing on earnings

A highly geared company must earn enough profit to cover its interest charges before anything is available for equity.
It increases the probability of financial failure.However the shareholders can earn high amount of profit if earnings are higher than interest
rate paid to debt.

Liquid funds include:

(a) Cash
(b) Short-term investments
(c) Fixed-term deposits with a bank or building society
(d) Trade receivables
(e) Bills of exchange receivable

Working capital period = working capital

X 365 days
operating costs

The ratio has two principal limitations.

(a) It is based on the working capital level on one particular day, which may not be representative of working capital levels throughout
the entire period.
(b) Working capital includes a figure for inventory which may be a very subjective valuation.

Yardsticks are needed for comparison purposes.

Limitations of statement The measures used must be carefully defined.

of profit or loss and
statement of financial
position measures Measures are not properly comparable where inflation in prices has occurred during the period,

Various companies may be following different methods thus cannot be compared with other
companies

Measures use using historical costs may not be a guide to the future.

The ratios are merely averages

Affected by any new investment towards the end of the financial year
Limitations of the ratios and
inter-company comparisons
Member companies may be using different accounting policies

Different formula for calculating one or more of the ratios

Companies may have diversified range of activities, which will distort the ratios and make
direct comparison difficult.
 Subjective measures

Judgement of outsiders ( example share price reflects many aspects of performance )

Management
performance
measures Upward appraisal ( staff giving their opinions on the performance of their managers )

Accounting measures ( must be tailored )

Cost Control Cost Reduction

1 Cost control aims at maintaining the costs in accordance 1 Cost reduction is concerned with reducing costs. It challenges
with the established standards. all standards and endeavours to better them continuously

2. Cost control seeks to attain lowest possible cost under 2. Cost reduction recognises no condition as permanent, since a
existing conditions. change will result in lower cost.

3. In case of cost control, emphasis is on past and present 3. In case of cost reduction, it is on present and future.

4. Cost control is a preventive function 4. Cost reduction is a corrective function. It operates even when an
efficient cost control system exists.
5. Cost control ends when targets are achieved. 5. Cost reduction has no visible end.

Crash programmes to The management might decide on an immediate programme

cut spending levels to reduce spending.

Planning for cost reduction

Planned programmes Continuing and planned campaigns to cut expenditure.

to reduce costs

Resistance from employees

Costs are reduced in one cost centre, only to reappear as an extra cost in another cost centre.

Difficulties introducing cost

reduction programmes Costs reduction plans are usually desperate measure instead of a carefully organised

Cost reduction is possible only with efforts and support of management

It should cover the the activities of the entire company.

Scope of cost It should have both short term objectives and Long term goals
reduction
campaigns Cost reduction efforts for variable costs are taken
Short-term objectives
Most of the fixed costs factors are non changeable

Some fixed costs are avoidable in the short term,called

discretionary fixed costs.

Long term objectives All costs are reducible

 obtain lower prices for purchases

Materials usage improve stores control and cut stores costs

use alternative materials.

improve the
=of
efficiency Changing the methods of work
Productivity of labour
Replacing people with machinery

Machinery or other equipment. Purchase of better machines

Methods of
cost reduction Reassessing policies for offering early payment discounts to credit

② Considering taking advantage of discounts for early payment

Savings of
finance cost Borrowing at the lowest obtainable rates

Improved foreign exchange dealings to ensure least conversion costs

⑦
Rationalisation Elimination of unnecessary duplication and the concentration of resources

⑨ Control of other expenses

Capital expenditure proposals should be carefully evaluated.

Need of incurring a cost should be evaluated

⑤
Consultant may be hired to reduce expenses

Control over spending decisions

Notes
1. Value analysis is a planned, scientific approach to cost reduction, which reviews the material composition of a product and the
product's design so that modifications and improvements can be made which do not reduce the value of the product to the customer
or the user. VA attempts to provide the same (or a better) use value at the lowest cost, providing better esteem to product.

It encourages innovation and a more radical outlook for ways of reducing costs.
It recognises the various types of value which a product or service provides.

2. Value engineering is the application of VA techniques to new products, so that new products are designed and developed to a
given value at minimum cost.

3. Value Cost value is the cost of producing and selling an item.

Exchange value is the market value of the product or service.

Use value is what the article does; the purposes it fulfils.

Esteem value is the prestige the customer attaches to the product.

Product design- Simple product design can avoid production and quality control problems, thereby
resulting in lower costs, called value engineering.
4. Scope of VA

Components and material costs - desired quality materials at the lowest possible price.

Production methods - reviewed continually

5. Steps in value analysis
steps in a VA study are as follows.
– Select a product or service for investigation
– Obtain and record information about it
– Evaluate the product
– Consider alternatives
– Select the least-cost alternative
– Make a recommendation
– If accepted, implement the recommendation
– After a period, evaluate the outcome and measure the cost savings

Give the VA programme their visible support

Establish goals for the programme to achieve.

Select the personnel

6. Support from management required for VA
Allocate sufficient budget

Insist on a continuing audit

Give rewards