SMA 2022 (3rd Ed Enhanced)

CPA PROGRAM
Strategic Management
Accounting
THIRD EDITION (ENHANCED)
Published by Deakin University, Geelong, Victoria 3217, on behalf of CPA Australia Ltd, ABN 64 008 392 452
First edition 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
Second edition published January 2019
Third edition published June 2019
Third edition (enhanced) published November 2020
© 2010–2019 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.
Edited by DeakinCo.
Designed by John Wiley & Sons Australia
Printed by IVE Group
ISBN 978 0 6487512 2 9
Authors
Brian Clarke Consultant
Paul Collier Consultant
Rahat Munir Head of Department and Professor, Department of Accounting and
Corporate Governance, Macquarie University
Gary Oliver Senior Lecturer, University of Sydney Business School, University of Sydney
Peter Robinson Senior Lecturer, UWA Business School, University of Western Australia
Natasja Steenkamp Senior Lecturer in Accounting, School of Business and Law, CQUniversity
Ofer Zwikael Associate Professor, College of Business and Economics,
Australian National University
2019 updates
Brian Clarke Consultant
Paul Collier Consultant
Rahat Munir Head of Department and Professor, Department of Accounting and
Corporate Governance, Macquarie University
Gary Oliver Senior Lecturer, University of Sydney Business School, University of Sydney
Paul Shantapriyan Consultant
Natasja Steenkamp Senior Lecturer in Accounting, School of Business and Law, CQUniversity
Ofer Zwikael Associate Professor, College of Business and Economics,
Australian National University
Acknowledgments
Karen Drutman Consultant
Vladimir Malcik Praxtra Pty Ltd
Ann Sardesai Senior Lecturer in Accounting, School of Business and Law, CQUniversity
CPA Australia acknowledges the contributions of David Brown, Courtney Clowes and Teemu Malmi to previous versions of
this Study guide.
Advisory panel
Assoc. Prof. Albie Brooks University of Melbourne
Nicolas Diss CPA Australia
Assoc. Prof. Ralph Kober Monash University
Vladimir Malcik Praxtra Pty Ltd
Alastair Mckenzie Devondale Murray Goulburn
Sarah Scoble Solution Underwriting
Prof. Naomi Soderstrom University of Melbourne
Dr Gillian Vesty RMIT
CPA Program team

Yvette Absalom Yani Gouw Alex Lawrence Alana Penny Helen Willoughby
David Baird Kristy Grady Elise Literski Shari Serjeant Joyce Wong
Shubala Barclay Mandy Herbet Neal Logan Alisa Stephens Emily Wu
James Cole Alex Huang Julie McArthur Tiffany Tan Luke Xu
Jeannette Dyet Jordan Irving Christel O’Connor Seng Thiam Teh Belinda Zohrab-McConnell
Learning designer
Jan Williams DeakinCo.
ACKNOWLEDGEMENTS
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IFAC extracts are from the 2017 Handbook of International Education Pronouncements of the IAESB,
published by the International Federation of Accountants (IFAC) in February 2017; the 2018 Handbook
of the International Code of Ethics for Professional Accountants (including International Independence
Standards) of the IESBA, published by the International Federation of Accountants (IFAC) in April
2018; and the International Guidance Document: Environmental Management Accounting (“Excerpts”),
published by the International Federation of Accountants (IFAC) in July 2005. All extracts are used with
permission of IFAC. Contact permissions@ifac.org for permission to reproduce, store or transmit, or to
make other similar uses of this document.
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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 materials may be updated and amended from time to time. Care has been taken in compiling
these materials, but they 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
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ACKNOWLEDGEMENTS iii
BRIEF CONTENTS
Subject Outline x
1. Introduction to Strategic Management Accounting 1

2. Information for Decision-Making 45
3. Planning, Budgeting and Forecasting 99
4. Project Management 145
5. Performance Management 219
6. Tools for Creating and Managing Value 299
Case Study 385

Suggested Answers 403
Index 475
CONTENTS
Subject Outline x Identifying users with different information
needs 47
MODULE 1 Corporate social responsibility/integrated
reporting 49
Introduction to Strategic Stakeholder management 50
Management Stakeholder risk management 52
Accounting 1 Part B: Information, information systems
and their effect on organisational
Preview 1
decision-making and performance 55
Introduction 1
Impact of information systems on strategy
Objectives 2
formulation and implementation 56
Subject map 2
Different types of information
Part A: Value 3
systems 57
Shareholder value 3
Transaction processing systems 57
Customer value 4
Management accounting systems 57
Stakeholder value 4
Production planning and control
Which viewpoint should be taken when systems 58
determining ‘value’? 4
Customer relationship management
Part B: The strategic management process 6 systems 58
Part C: The role of management accountants Enterprise resource planning
in strategic management 11 systems 59
The role of management Decision support systems 59
accountants 11 Knowledge management systems 59
Analyst, business adviser, partner 12 Sourcing, aggregating and integrating
Contemporary skills and techniques 13 information 60
Part D: The key challenges facing Source or domain of information—external
management accountants 15 versus internal 60
Challenges 15 Methods of aggregation and integration of
Causes of change in the business information 61
environment 17 Characteristics and limitations of different
The global economy 17 kinds of information 63
Technology 23 Dimensions of information 63
Sustainability 25 Limitations of different kinds of
Part E: Analytical techniques available information 64
to management accountants 31 Security of information and ethics of
Value analysis 32 information 64
Strengths, weaknesses, opportunities and Characteristics of information 65
threats 34 Quality of information 66
Internal analysis 35 Effects and challenges of new information
External analysis 38 systems and platforms 69
Porter’s five forces model 39 Data warehousing and data mining 69
Review 42 Big data 69
References 43 Business intelligence 70
Part C: The role of management accountants
MODULE 2 in influencing stakeholder
decision-making 71
Information for Balancing stakeholder requirements and
Decision-Making 45 information delivery 71
Preview 45 Differing levels of information in the
Introduction 45 organisation 72
Objectives 47 Strategic information 72
Part A: Types of information needed for Tactical information 73
stakeholder decision‐making 47 Operational information 74
The information needs of Importance of linking information to
stakeholders 47 strategy 76
CONTENTS v
Using information strategically 77 Step 3: Direct materials cost
Roles of the management budget 112
accountant 78 Step 4: Direct manufacturing labour costs
Trusted business partner 78 budget 113
Custodian of information 79 Step 5: Manufacturing overhead costs
Part D: Upgrading or replacing information budget 113
systems 83 Step 6: Finished goods inventory
Stimulus for a new or updated budget 113
system 83 Step 7: Cost of goods sold
Making a preliminary assessment 83 budget 113
Initially establishing the systems information Step 8: Period costs budgets 114
needs of stakeholders 84 Preparing budgets in non-manufacturing
Other methods of obtaining information organisations 114
needs 89 Preparing financial budgets 114
The life cycle of systems 89 Budgeted income statement 114
Pitfalls in evaluating major information Cash budget 115
needs 90 Budgeted balance sheet 115
Analysing new and existing information Capital expenditure budget 115
systems 91 Preparing budgets for various
Feasibility and criteria for a new information departments 115
system 91 Preparing flexible budgets 116
Making changes to an existing Part C: Variance analyses and control 117
system 92 Static versus flexible budgets 118
Evaluating a suggested information Profit- and revenue-related
solution 93 variances 120
Comparing costs, benefits and key Direct material analysis 122
risks 94 Direct labour analysis 124
Review 95 Variable manufacturing overhead
References 96 analysis 125
Fixed manufacturing overhead
MODULE 3 analysis 127
Part D: Behavioural aspects of budgets 132
Planning, Budgeting and
Participative budgeting 132
Forecasting 99 The top-down approach 133
Preview 99 The bottom-up approach 133
Introduction 99 Setting realistic and achievable
Objectives 100 targets 135
Part A: Introduction to plans, budgets and Monetary and non-monetary incentive
forecasts 100 schemes 136
Relationship between budgets and Part E: Alternative approaches to budgeting
strategic planning 101 137
Roles of operational plans, budgets Shortcomings of traditional
and forecasts 101 budgets 137
Purposes of a budget 103 Incremental budgeting 138
Relationship with responsibility Zero-based budgeting 138
accounting 105 Activity-based budgeting 139
Revenue centres 106 Beyond budgeting: Managing without
Cost centres 106 budgets 141
Profit centres 106 Review 142
Investment centres 106 References 142
Responsibility accounting 106
Planning and control 107 MODULE 4
Part B: Developing master budgets 108
Impact of external and internal factors
Project Management 145
on budgets 108 Preview 145
Preparing operational budgets in Introduction 145
manufacturing organisations 110 Objectives 146
Step 1: Sales budget 111 Part A: Project management defined 146
Step 2: Production budget 111 What is a project? 146
vi CONTENTS
What is project management? 148 Gantt charts 185
The project management process 149 PERT: Program evaluation and review
Stage 1: Project selection 149 technique 186
Stage 2: Project planning 150 Critical path method—crashing
Stage 3: Project implementation and projects 190
control 150 Project budgeting 192
Stage 4: Project completion and Project management software 193
review 150 Supplier contracts 193
Organisational structures for Part E: The management accountant’s role in
projects 151 project implementation and control 193
Project organisations 151 Monitoring progress 194
Internal projects 152 Monitoring costs 194
Joint ventures 152 The earned value method: Time versus
Collaborations 152 cost 195
Public private partnerships 153 Monitoring specification and quality 197
Virtual projects 153 Quality costs 199
International projects 153 Measuring performance 199
Part B: Roles in project management 154 The importance of probity in
Project sponsor 154 projects 200
Project manager 155 Risk management 200
Project leadership and the management Stakeholder management 202
accountant 157 Part F: The management accountant’s role
The project team 158 in project completion and review 203
International project teams 160 The completion decision 203
Project management roles in international Checklist 203
project teams 161 Specification satisfaction
Virtual project teams 161 consensus 204
Challenges for virtual project teams 162 Strategic fit assessment 204
Part C: The management accountant’s role in Stakeholder satisfaction
project selection 162 assessment 205
Developing a business case for Financial closure 205
projects 163 Final costs 205
Strategic fit 164 Closing the cost records 205
Stakeholder identification and Post-project expenditure 205
assessment 166 Resource dispersion 206
Ethically informed decision-making and its Final report 206
impact on stakeholders 168 Knowledge management 206
Risk assessment 169 Review 207
Risk identification 169 Appendices 208
Risk classification 170 Appendix 4.1 208
Risk mitigation 171 Appendix 4.2 212
Financial analysis—single project 172 References 216
Net present value 172 Optional reading 217
Internal rate of return 178
Profitability index 179 MODULE 5
Payback 179
Return on investment 179
Performance
Residual income 180 Management 219
Deficiencies in accounting-based Preview 219
measures 181 Introduction 219
Sensitivity and scenario analysis 181 Objectives 220
Financial analysis—multiple Teaching materials 220
projects 182 Part A: The role of performance management
Equivalent annual cash flow (equivalent 220
annual annuity) 182 What is ‘performance’ and ‘performance
Part D: The management accountant’s role in management’? 221
project planning 184 Performance management and its links to
Project scheduling 185 strategy 222
CONTENTS vii
Financial performance Performance management for performance
management 223 improvement 279
Non-financial performance The importance of performance
management 225 improvement 279
The measurability and reporting of Targets 280
performance 225 Trends 281
The multiple roles of performance Benchmarking 281
management 227 Organisational learning and performance
Performance—a process of value improvement 283
creation 227 Behavioural consequences of performance
Performance and sustainability 230 management 285
Integrated reporting 232 Performance measures and performance
Signalling 233 targets 285
Governance, risk and performance The role of incentives and rewards in
management 236 performance management 286
Ethics and performance Review 288
management 238 Appendix 290
Theories related to performance Appendix 5.1 290
management 240 References 295
Part B: Strategy, management control
and performance management 242 MODULE 6
Performance management and
control—their role in strategy 243 Tools for Creating and
Limitations of traditional controls 247 Managing Value 299
Models of performance Preview 299
management 249 Introduction 299
Operational and strategic Objectives 300
performance 249 Part A: The value chain 301
Leading and lagging measures of Part B: Strategic product costing 303
performance 251
Introduction 303
Frameworks for performance
Product costing 303
management 252
Activity-based costing 305
The Business Model Canvas 253
Value engineering 306
The balanced scorecard 254
Cost drivers 306
Designing a balanced scorecard 256
Steps in activity-based costing 308
Public sector and not-for-profit performance
Benefits of the activity-based costing
management 259
system 314
Designing a strategy map for performance
Time-driven activity-based costing 316
management 260
Adjusting time-driven activity-based costing
Cascading performance measures 263
for more complex activities 317
The role of information systems in
Part C: Strategic revenue management 323
performance management 265
Major influences on pricing
The role of performance management in
decisions 323
implementing and monitoring
strategy 266 Hard and soft functions 323
Part C: Determining performance measures Surplus value 324
and setting performance targets 269 Pricing strategies 325
Designing performance measures 269 Rapid skimming strategy 326
Measuring efficiency, effectiveness and Rapid penetration strategy 326
equity 272 Slow skimming strategy 327
Designing SMART performance Slow penetration strategy 327
targets 272 Legal implications of price setting 328
Characteristics of performance measures Part D: Strategic cost management 328
and targets 274 Increasing efficiency without reducing costs:
Costs and benefits of performance The spare capacity dilemma 329
management 276 Life cycle, target and kaizen
Performance management, power and costing 330
culture 278 End of economic life: Reverse flows in the
value chain 341
viii CONTENTS
Activity-based management and continuous Total quality management 362
improvement 343 Outsourcing and offshoring 367
Social and environmental value chain Part F: Strategic profit management—
analysis 352 downstream activities 370
Part E: Strategic profit management— Customer profitability analysis 370
upstream activities 352 Review 381
Supplier management 354 References 382
Global suppliers 354
Supplier codes of conduct 355
Minimising inventory levels 356 Case Study 385
Supply chain disruptions 356 Suggested Answers 403
Index 475
Vendor or supplier selection 357
CONTENTS ix
SUBJECT 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
• provide information about the exam and its structure.
The CPA Program is designed around five overarching learning objectives to produce future CPAs
who will:
• be technically skilled and solution driven
• be strategic leaders and business partners in a global environment
• be aware of the social impacts of accounting
• be adaptable to change
• be able to communicate and collaborate effectively.
BEFORE YOU BEGIN

Important Information
Please refer to the CPA Australia website for dates, fees, rules and regulations, and additional learning
support at cpaaustralia.com.au/cpaprogram
SUBJECT DESCRIPTION
Strategic Management Accounting
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 high-
lights 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
that are expanded on in Global Strategy and Leadership.
SUBJECT OVERVIEW
General Objectives
On completion of this subject, you should be able to:
• 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 the management accountant as a trusted adviser and a business partner in supporting
strategy development and the day-to-day operations of an organisation
• understand stakeholders’ various decision-making needs and provide adaptive information solutions
• design an effective budgeting system that incorporates uncertainty to assist in strategy implementation
• discuss the role of project selection, planning, monitoring and completion in strategy implementation
• explain the role of performance measurement and control systems in value creation, strategy implemen-
tation and monitoring performance to improve strategies
• apply strategic management accounting tools and techniques to improve the contribution and sustain-
ability of value-creating activities.
x SUBJECT OUTLINE
Module Weightings and Study Time Requirements
Total hours of study for this subject will vary depending on your prior knowledge and experience of the
course content, your individual learning pace and style, and the degree to which your work commitments
will allow you to work intensively or intermittently on the materials. You will need to work systematically
through the study guide, attempt all the questions, and revise the learning materials for the exam. The
workload for this subject is the equivalent of that for a one-semester postgraduate unit.
An estimated 15 hours of study per week through the semester will be required for an average candidate.
Additional time may be required for revision. The ‘Weighting’ column in the following table provides an
indication of the emphasis placed on each module in the exam, while the ‘Recommended proportion of
study time’ column is a guide for you to allocate your study time for each module. Do not underestimate
the amount of time it will take to complete the subject.
TABLE 1 Module weightings and study time

Recommended
proportion of study time Weighting
Module (%) (%)
1. Introduction to strategic management accounting 10 10
2. Information for decision-making 14 15
3. Planning, budgeting and forecasting 20 22
4. Project management 13 13
5. Performance management 21 23
6. Tools for creating and managing value 17 17
Case study 5 0
LEARNING MATERIALS
Module Structure
The study guide is your primary examinable resource and contains all the knowledge you need to learn and
apply to pass the exam. The Strategic Management Accounting study guide includes a number of features
to help support your learning. These include the following.
Learning Objectives
A set of learning objectives is included for each module in the study guide. 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.
Examples
Examples are included throughout the study materials to demonstrate how concepts are applied to real-
world scenarios.
Questions (and suggested answers)
Questions provide you with an opportunity to assess your understanding of the key learning points. These
questions are an integral part of your study and should be fully utilised to support your learning of the
module content.
Case Studies (and suggested answers)
Case studies help you apply theoretical knowledge to real-life scenarios, requiring a deep understanding
of the module content.
Teaching Materials
This section of your Study guide will inform you of any additional resources and readings to be referred
to in conjunction with the module. Any material that is listed under ‘Readings’ in this section will be
examinable. Any readings that are listed as ‘optional’ will not be examined; they are provided if you wish
to explore a particular topic in more detail.
SUBJECT OUTLINE xi
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 6. 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.
My Online Learning and your eBook

My Online Learning is CPA Australia’s online learning platform, which provides you with access to a
variety of resources to help you with your study. You can access My Online Learning from the CPA
Australia website: www.cpaaustralia.com.au/myonlinelearning.
Help Desk
For help when accessing My Online Learning either:
• email myonlinelearning@cpaaustralia.com.au, or
• telephone 1300 73 73 73 (Australia) or +613 9606 9677 (International) between 8.30 am and 5.00 pm
AEST Monday to Friday during the semester.
eBook
An interactive eBook version of the study guide will be available through My Online Learning. The eBook
contains the full study guide and features instructional media and interactive questions embedded at the
point of learning. The media content includes animations of key diagrams from the study guide.
GENERAL EXAM INFORMATION

All information regarding the Strategic Management Accounting exam can be found on My Online
Learning. The study guide is your central examinable resource. Where advised, relevant sections of the
CPA Australia Members’ Handbook and legislation are also examinable.
xii SUBJECT OUTLINE

MODULE 1
INTRODUCTION TO
STRATEGIC
MANAGEMENT
ACCOUNTING
PREVIEW
INTRODUCTION
Contemporary organisations face significant internal and external challenges that must be addressed in
order to operate and function effectively. It is essential for them to create value for multiple stakeholders,
including customers, employees, management, regulators and their shareholders or owners. This must
be achieved in a global environment that is continuously changing and becoming more competitive.
This subject focuses on the role strategic management accounting plays in creating, managing and
protecting value.
For the purposes of this subject, strategic management accounting is defined as follows:
Creating sustainable value by:
• supporting the formation, selection, implementation and evaluation of organisational strategy
• synthesising information that captures financial and non-financial perspectives for both the internal and
external environments, to enable effective resource allocation.
Strategic management accounting requires that management accountants embrace new skills that
extend beyond their traditional practices. They must collaborate with general management (operational
departments), corporate strategists (senior management team) and product development, in creating,
managing and protecting value. Fostering organisational capabilities leads to value creation.
Value creation is essential in contemporary organisations. One way of thinking about commercial
organisations, government bodies and not-for-profit entities is as ‘linked chains’ of resources and
activities. These chains produce products and services of value to consumers and end users. The essential
requirements for successful performance are:
• to generate products and services with value that consumers are willing to pay for
• to constantly develop and improve the resources, activities and processes used to generate that value
(Anderson and Narus 1998).
This module first considers management accounting and its role in supporting management. It then
describes the key changes that have led to the development of strategic management accounting. The
module also identifies the challenges that management accountants face and describes the skills required
to perform their role, at present and in the future.
The ability to support managers at a strategic level has become critically important for organisational
survival, and management accountants must broaden their role from traditional scorekeeping tasks to
business advisory positions. Advances in technology and information systems now help with capturing and
processing 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.
This module concludes with an examination of the various analytical techniques available to manage-
ment accountants that will assist them to support management in their decisions about strategic direction.
OBJECTIVES
After completing this module, you should be able to:
• Explain what is involved in a strategic management process and its various stages.
• Identify the role of management accounting in strategic management and the mindset and values
required to transit from a management accountant to a competent business partner.
• Assess the key challenges facing management accountants in today’s business environment.
• Identify various analysis techniques used in strategic management and their functions.
SUBJECT MAP
Figure 1.1 provides an overview of the important concepts in this subject and how they link together. The
highlighted sections show the concepts that are the focus of Module 1.
FIGURE 1.1 Subject map highlighting Module 1
rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
MANAGEMENT ACCOUNTANT
VALUE INFORMATION
OPERATIONS
E xte
r nal environment
Source: CPA Australia 2019.
An organisation decides on a strategic 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. Creating value for organisations helps sell products and services, increases the share price, and
ensures the future availability of capital to fund operations.
For value creation to occur there must be a clear strategy, based on a vision and mission that combine
resources (including people, technology and time) and their effective use to achieve goals and objectives.
The day-to-day activities and projects that are performed must be linked to the organisation’s overall
strategy to drive towards its desired outcomes. It is important to perform the work required, but it is also
necessary to continuously review, monitor and improve activities and processes. As shown in Figure 1.1,
while there must be an information flow from the strategic level to the operational level, there must also
be clear feedback and reporting from the operational level. This can be used as a control mechanism to
ensure the organisation’s day‐to‐day activities stay in agreement with its vision and mission.
The organisation must also be aware of the external environment in which it operates. Competi-
tor activity, the broader economic and regulatory environment, technological advancements, alliances,
management capabilities, employee and customer relations, and social changes may all affect the organi-
sation. So, monitoring these influences and adapting to change are critical activities.
2 Strategic Management Accounting

The management accountant is at the centre of all these activities. Understanding what creates value
helps management accountants focus capital and talent on the most profitable opportunities for survival
and growth of an organisation.
PART A: VALUE
The main theme of this part of the module is value. The analysis and activities, the tools and techniques,
the reporting and evaluation—all of these take place in the pursuit of value.
Value is a broad concept and has a major influence on an organisation’s behaviour and drive to achieve
its vision, mission and goals. It can be described as combining resources in a manner that creates desirable
outcomes. Examples of value creation include growing food, generating energy, providing health care and
building new machines, software programs and infrastructure.
The role of management accountants is to support management in creating, managing and
protecting value. Value is usually described as increasing shareholder wealth. However, this is both
narrow and simplistic because it ignores other important and interested parties or stakeholders, as shown
in Figure 1.2.
FIGURE 1.2 A broad range of stakeholders
Shareholders
Community
Lenders
groups
Stakeholders
Regulators Customers
Employees Suppliers
Each group has its own interests and desires and therefore its own definition of the ‘value’ 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.
Value creation in contemporary organisations is based on creativity and innovation. This includes the
innovative ways that management adapt to take advantage of new materials, technologies and processes,
as compared to value creation in the past, which was based on economies of scale and mass production.
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
MODULE 1 Introduction to Strategic Management Accounting 3

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 1.3 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.
FIGURE 1.3 Organisational value chain
Business cycle
Operations (obtaining/producing goods or services) Sales Distribution After-sales service
These activities are supported by a variety of business functions.
Support activities
Research and development, accounting, human resources, information technology and infrastructure
For a further explanation of and practice in the concept of value chains, please access the ‘Value
chain’ learning task on My Online Learning.
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. So, consideration of stakeholders
is critical to organisational success.
WHICH VIEWPOINT SHOULD BE TAKEN WHEN

DETERMINING ‘VALUE’?
A significant philosophical issue that must be considered with regard to value is: ‘From which perspective
should value be determined’? The most obvious perspective is from the organisation itself. Value is linked
to the concept of ‘anything that is good for the business or organisation’. However, other perspectives also
exist, including that of society. Some actions may bring value to the organisation as well as to other groups
at the same time—for example, more efficient farming practices may lead to higher yields, lower prices
and more nutritional food. However, other actions may benefit the organisation while causing significant
harm to others, as shown by the examples in Figure 1.4.
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 effect 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.
Value is either created or destroyed by management through the business model they use. The business
model is highly dependent on a broad range of relationships and activities that take place in the market,
in a societal and environmental context within which the organisation operates. Therefore, to be truly
valuable, something must offer economic value to the organisation and provide sustainable value to other
stakeholders within society.

FIGURE 1.4 Organisational value and potential impact
Organisational viewpoint Society’s viewpoint
Unemployment,
Cost cutting—reducing
financial pressure on
the number of staff
communities and additional
by 10% to increase
stress for employees who
profitability
remain employed
Switching production
Local unemployment,
to cheaper offshore
environmental degradation,
locations with lower
and an increase in injuries
standards of employee
and incidents among employees
and environmental
who receive little protection
protections
Massive price A small price reduction

discounting of key items for individual consumers
by supermarkets to gain but at the expense of
market share, forcing producers who are
suppliers to reduce prices unable to remain viable
Selling addictive Social issues in

products or services communities and an
including gambling, increase in health-
alcohol and cigarettes related costs
Strategic management and strategic management accounting

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 describes the process by which an organisation decides:
• the direction it will take
• the industry it will operate within
• the types of products or services it will provide
• its structure, systems and processes
• its goals and objectives.
It also includes the development of specific approaches or strategies as well as implementation plans
and performance measurement that support this process.
Strategic management accounting aims to provide forward-looking information to assist management
in decision-making. Unlike typical cost or/and management accounting, which focuses on internal
accounting information, strategic management accounting evaluates external information—for example,
trends in costs, prices, market share, competitors, suppliers and technologies—and their impacts on
resources. Strategic management accounting uses 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.

PART B: THE STRATEGIC MANAGEMENT
PROCESS
The main theme of this part of the module is to explain the strategic management process—the role of
strategic management accounting in supporting managers. The strategic management accounting process
involves defining the organisation’s strategy and the process by which managers make a choice of a set of
strategies for the organisation that will assist managers in value creation.
Throughout Part B, the strategic management process is presented as a continuous process that evaluates
the business and the environment within which the organisation operates, evaluates/re‐evaluates its
competitors, and defines its objectives and strategy.
Strategic management accounting—supporting managers
Management activities can be classified into the broad categories of:
• strategic management, which focuses on determining the direction and structure of the organisation and
developing plans and objectives for achieving this
• operational management, which can be considered as the implementation phase of strategic
management—turning the strategy into reality.
Strategic management accounting provides a supporting role to managers in both categories. This section
examines the activities that managers are involved in and the types of support management accountants
can provide to help managers perform these activities better.
Strategic management
The strategic management process involves:
• addressing key issues, including determining the vision, mission and purpose of an organisation
• setting specific objectives
• creating and implementing the strategies to achieve these objectives.
Important phases in the strategic management process are shown in Figure 1.5.
FIGURE 1.5 The strategic management process
Strategic analysis—
both internal and
external
Strategy evaluation—
performance Strategy planning
measurement, and choice
feedback and review
Strategy
implementation

This strategic management process shown in Figure 1.5 is continuous, and the phases are closely
interwoven rather than being clearly separate events. The stages are critically useful in evaluating an
organisation’s planning systems and processes and for indicating ways of improving their effectiveness.
Significant amounts of information are required to successfully complete each of the stages.
The stages in the process are briefly discussed below.
Strategic analysis
The strategic management process begins with strategic analysis, which is undertaken through scanning
the internal and external organisational environment. It is important for the organisation to know itself and
its competitors.
Organisations must continuously analyse the external environment to understand trends and changes
that affect the industry and the economy. For instance, Apple redefined the smartphone technology, and its
decision to create the iPhone shows its ability to analyse the traditional industry and create a product that
distinguished Apple in the mobile phone industry.
Organisations must also analyse their own resources and capabilities to understand how they might react
to changes in the environment. For instance, changes in the global economic environment have influenced
the development of business models where intellectual property (IP) has become an important resource
for many contemporary organisations, such as Google, Apple, Louis Vuitton and Mercedes-Benz, for
establishing value and potential growth.
Organisations use various management tools and techniques to scan the organisational environment.
A well-established tool that captures the idea of scanning the environment both external and internal to the
organisation is strengths, weaknesses, opportunities and threats (SWOT) analysis (discussed later in this
module) (Saylor 2012).
Strategy planning and choice
Strategy formulation is the next step in the strategic management process. This includes developing specific
strategies, actions and measures. For instance, part of Apple’s success is due to the unique features of
products it offers, and how these features and products complement each other—for example, an iPod that
plays music from iTunes, which can be stored on Apple’s Mac computer.
Strategy implementation
The next step of the strategic management process is strategy implementation, which entails crafting an
effective organisational structure, organisational processes and culture. For example, the rate of Amazon’s
innovations in supply chain management (SCM) has been significant, with investment in supply chain
automation lessening the overall product delivery time, and increasing the number of warehouses. Its
unique supply chain strategies and continuous technological innovations have changed the way SCM
works. This helped Amazon to successfully implement its Amazon Prime service in 2005 providing
guaranteed two-day shipping of products.
Strategy evaluation
The final stage of the process is strategy evaluation. This involves measuring performance, providing
feedback and undertaking continuous review for improvement. The focus of every organisation is to lead
strategically in order to attain long-term goals. Consequently, how managers understand and interpret the
performance of their organisations is critical to evaluating strategy.
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 of the strategic and operational levels.
Formal strategies are often ignored or postponed as day-to-day issues receive all the attention.
Managers need to produce short-term operational objectives and implementation plans to achieve long-
term strategies. Strategic management accounting supports operational planning with tools including
budgeting, costing systems and variance analysis. Constant feedback is required for an organisation to
achieve short-term plans. If there is a deviation from the plan, the objective may need to be adjusted or
controls put in place to correct the situation. Management accountants provide support for this controlling
function by giving feedback with financial and non-financial information.
There is a direct and impactful relationship between strategic and operations management. The success
of an organisation depends on both the strategic and operational elements. As described earlier, strategic
management is the process of understanding the business environment and developing and implementing
strategies, while operational management involves executing those strategies on a day-to-day basis to
achieve the outcomes in the long run.
Table 1.1 summarises the broad difference between strategic management and operational management.

TABLE 1.1 Broad differences between strategic and operational management
Strategic management Operational management
Directly linked to survival of an organisation Not directly related, but indirectly influences
organisational survival
Organisation-wide phenomenon Relates to specific operations of the organisation
Long-term process Focused on short and medium terms
Involves non-routine activities Involves routine day-to-day activities
Sometimes very ambiguous Does not involve any ambiguity
Requires high-level strategic management orientation Requires tactical management orientation and focus
on doing, implementing and achieving operational
excellence
Manages critical success factors (CSFs) Performs activities on a day-to-day basis

of the organisation
QUESTION 1.1
Will the role of strategic management accounting change if the roles and functions of management
identified so far in part B of this module change in any way?
Example 1.1 highlights how strategic management accounting information can support operational
management.
EXAMPLE 1.1
Supporting operational management with management accounting

information
Planning
Alpha Pty Ltd (Alpha) sells educational toys for children aged one to four years. 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.
Plan Sales target
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 and
expected levels of performance are then communicated to staff.
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 caused
by unfavourable foreign exchange fluctuations. It appears that there will be no bonuses for the sales staff
for quite some time.
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.

Actual result Sales target
Analysing
An analysis of the sales revenue variance uncovers two major issues:
1. 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.
2. An internal problem was 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 additional
sales. 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.
1 January 31 January 31 March
Sales target decreased

Planned result
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 increased target sales volumes
• attempting to improve coordination within the company.
In Example 1.1, 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 (CVP) analysis.
A range of operational support techniques are regarded as assumed knowledge for this subject,
including:
• cost classifications
• CVP analysis
• product costing
• marginal costing
• working capital management.
If you are unsure about your knowledge in these areas, you can find resources through our Guided
Learning offer on My Online Learning.
Strategic management accounting and line managers
Organisations have become leaner with fewer employees and have had their hierarchies flattened with
reduced levels of management. As a result, greater levels of authority and decision-making power have
been delegated to lower-level employees. This has been essential to improve flexibility and responsiveness
within organisations. Management accountants were once the providers of all management accounting
information, but the tasks of collecting and communicating key performance information are now often
delegated to line managers and employees.

Instead of merely recording and providing the information, management accountants are required to
provide support and training to assist line managers and employees to undertake these tasks. An advantage
of this approach is that it transfers routine tasks to other employees to allow time to be devoted to more
complex, non-routine and strategic-level tasks.
Strategic management accounting and service industries

Many management accounting examples involve the manufacture of products. These products are tangible,
easy to visualise, and often produced systematically, so costs can be easily identified and allocated to each
element of the product. However, service industries also require the support of management accounting
tools and techniques.
The detailed Case study at the end of this subject demonstrates this by considering the Australian
domestic airline industry.
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—that is,
inventory cannot be created.
An important issue in a service environment is the proper management of excess capacity. For example,
an airline provides a service by flying passengers from one city to another. But, if half of the seats on
the flight are empty, that ‘excess capacity’ can never be recovered once the service is provided. Similarly,
managing customer call centres is an area in which employees must be available to answer queries even
if there are no customers using the service at a particular time. In these situations, the idle resources can
cause significant costs.
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.
Strategic management accounting and the public sector
The main difference between the public and private sectors is that many (but not all) public sector
organisations do not use profit as their primary measure. An example of this different focus is shown in
Question 1.2, in which important themes for local government are well planned urban growth and fostering
liveability—an enjoyable place to live. From a strategic management accounting viewpoint, there is still
the need to support both the strategic and operational processes.
The key questions to consider are: 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
• effectiveness—the extent to which an organisation achieved its objectives.
QUESTION 1.2
Read this extract from a local government planning document.
STRATEGIC OBJECTIVES
STRONG LEADERSHIP
Council will lead our changing city using strategic foresight, innovation, transparent decision making
and well-planned, effective collaboration
HEALTHY AND INCLUSIVE COMMUNITIES
Council will provide and advocate for services and facilities that support people’s wellbeing, healthy
and safe living, connection to community, cultural engagement and whole of life learning

QUALITY PLACES AND SPACES
Council will lead the development of integrated built and natural environments that are well main-
tained, accessible and respectful of the community and neighbourhoods
GROWTH AND PROSPERITY
Council will support diverse, well-planned neighbourhoods and a strong local economy
MOBILE AND CONNECTED CITY
Council will plan and advocate for a safe, sustainable and effective transport network and a smart
and innovative city
CLEAN AND GREEN
Council will strive for a clean, healthy city for people to access open spaces, cleaner air and water
and respond to climate change challenges
Source: Maribyrnong City Council 2018, Council Plan 2017–21, Maribyrnong, Victoria, Australia, p. 1,
accessed June 2018, https://www.maribyrnong.vic.gov.au/About-us/Our-plans-and-performance/Council-plan.
What strategic management accounting information may be used to support these objectives?
Goal Strategic management accounting information
Strong leadership
Healthy and inclusive communities
Quality places and spaces
Growth and prosperity
Mobile and connected city
Clean and green
PART C: THE ROLE OF MANAGEMENT

ACCOUNTANTS IN STRATEGIC
MANAGEMENT
The objective of this part of the module is to highlight the role of management accountants in the strategic
management process. Management accountants are seen as information providers for business processes,
organisational planning and control, resource management and utilisation, and creation of value through
effective use of financial and non-financial resources. As a trusted business partner, new challenges
facing management accountants mean they must constantly advance their knowledge in diverse areas,
and improve their soft skills to effectively communicate with internal and external stakeholders.
THE ROLE OF MANAGEMENT ACCOUNTANTS

The accounting profession has witnessed significant changes due to globalisation, digital transformation,
regulations and competition. Accountants have to adapt to changing circumstances. The role of man-
agement accounting has expanded to include a focus on helping managers solve problems and improve
their competitive position. For example, management accountants now conduct product life cycle costing
and customer profitability analysis, and prepare balanced scorecards (BSCs); with these contemporary
management accounting tools, dissemination of information has become easier and hence led to faster
customer response times. This is coupled with technological advances that enable electronic data capture,

computer-aided design and computer-aided manufacturing and automatic system updates. These provide
management accountants with the opportunity to focus on non-routine and strategic decisions.
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 is separate from
the strategic process. A key part of the strategic management accounting concept is its focus on the
organisation’s internal and external environments. By collecting information on internal operations, as
well as competitors, customers and suppliers, and gaining an appreciation for the broader economic
environment—including political, social and environmental factors— an organisation is assisted to respond
more quickly to change.
The emphasis on the external environment can be seen in many ways. For example, internal information
(e.g. product costing) is more useful when it is compared with 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 with both the
marketing function—with its focus on customers—and the strategic planning function of the organisation.
This places greater pressure on people working in these roles to increase their levels of skill.
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). These techniques
are discussed in detail in Modules 5 and 6.
Table 1.2 provides a summary of the expanded level of work and responsibility that is expected
from management accountants for strategic management accounting compared to traditional manage-
ment accounting.
TABLE 1.2 Traditional management accounting compared to strategic management accounting
Traditional management accounting Strategic management accounting
Job costing and process costing Product costing and activity-based costing and management
Budgets Life cycle analysis (including social and environmental costs and
benefits)
Variance analysis Value chain analysis
Financial data Financial, operational and qualitative data

Competitor cost structures analysis
Industry and broader economy analysis
ANALYST, BUSINESS ADVISER, PARTNER

Advertised job descriptions for management accountants use a wide range of job titles including business
analyst, commercial analyst, decision support, commercial manager, finance business partner, business
adviser and business support. Regardless of the description, these positions generally include some or all
of the traditional roles of costing, variance analysis and budgeting. Reconciliations, maintaining fixed asset
registers, inventory management, accounts receivable (AR) and accounts payable (AP) management, and
reporting on key performance indicators are also common tasks. The ability to use enterprise resource
planning (ERP) systems, databases and spreadsheets is often essential.
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.

Risk management and mitigation is another important part of enhancing overall performance. In addition
to financial risk management, operational risk throughout the organisation needs to be assessed and
managed effectively. The effective use of controls to manage risk is a valuable role that is often performed
by management accountants (Cooper 2002).
Design and management of information systems and development of effective reporting methods are
often incorporated into the management accounting role. This will typically involve showing others how
to access information themselves rather than being an information gatekeeper. This is highlighted in
Example 1.2. Providing information for stakeholders is discussed in detail in Module 2.
EXAMPLE 1.2
Business partner or objective overseer?

The business partner
This approach suggests that accountants should act as engaged business partners. Rather than being
seen as number-crunchers or as impartial spectators in the game of business, they are involved
throughout the organisation to help improve results and pursue value. No longer just scorekeepers of past
performance, accountants are information facilitators who help and guide management actions, instead
of just evaluating and controlling them.
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 an 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 man-
agement, 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.
An opposing viewpoint—the overseer
There are several risks that arise when accountants start acting in a performance-focused advisory role.
The first risk is the loss of independence when an accountant becomes closely engaged in guiding and
setting strategy and making decisions.
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, hence, could adversely impact
the quality of the task performed and/or the product. 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 (Chartered Institute
of Management Accountants (CIMA) 2010).
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
• the ability to negotiate and communicate with other executives and external stakeholders.
CONTEMPORARY SKILLS AND TECHNIQUES

Accountants are often in high demand, but many senior accounting roles are left unfilled for a considerable
amount of time. This is sometimes because potential employees are missing ‘soft skills’—including
negotiation, presentation, teamwork and communication skills. The ability to analyse information, present
arguments and influence people, and 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
• interpersonal and communication skills
• personal skills
• organisational skills (IAESB 2017).
A report by the International Federation of Accountants (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—supporting management decision-making and implementation
3. preservers of value—protecting value through effective risk management, controls and compliance
4. reporters of value—providing clear and detailed reporting.
A summary of some of the specific types of skill required within each category is presented in Table 1.3.
TABLE 1.3 Professional skills to be achieved by professional accountants
Competence Area
(Level of proficiency) Learning Outcomes
(a) Intellectual (i) Evaluate information from a variety of sources and perspectives through
(Intermediate) research, analysis, and integration.
(ii) Apply professional judgment, including identification and evaluation of
alternatives, to reach well-reasoned conclusions based on all relevant facts and
circumstances.
(iii) Identify when it is appropriate to consult with specialists to solve problems
and reach conclusions.
(iv) Apply reasoning, critical analysis, and innovative thinking to solve problems.
(v) Recommend solutions to unstructured, multifaceted problems.
(b) Interpersonal and (i) Display cooperation and teamwork when working towards organizational goals.
communication (ii) Communicate clearly and concisely when presenting, discussing and reporting
(Intermediate) informal and informal situations, both in writing and orally.
(iii) Demonstrate awareness of cultural and language differences in all
communication.
(iv) Apply active listening and effective interviewing techniques.
(v) Apply negotiation skills to reach solutions and agreements.
(vi) Apply consultative skills to minimize or resolve conflict, solve problems, and
maximize opportunities.
(c) Personal (i) Demonstrate a commitment to lifelong learning.

(Intermediate) (ii) Apply professional skepticism through questioning and critically assessing
all information.
(iii) Set high personal standards of delivery and monitor personal performance,
through feedback from others and through reflection.
(iv) Manage time and resources to achieve professional commitments.
(v) Anticipate challenges and plan potential solutions.
(vi) Apply an open mind to new opportunities.
(d) Organizational (i) Undertake assignments in accordance with established practices to meet
(Intermediate) prescribed deadlines.
(ii) Review own work and that of others to determine whether it complies with the
organization’s quality standards.
(iii) Apply people management skills to motivate and develop others.
(iv) Apply delegation skills to deliver assignments.
(v) Apply leadership skills to influence others to work towards organizational goals.
(vi) Apply appropriate tools and technology to increase efficiency and effectiveness.
Source: IAESB 2017, 2017 Handbook of International Education Pronouncements, ‘Table A: Learning outcomes for professional
skills’, accessed June 2018, https://www.ifac.org/publications-resources/2017- handbook-international-education-pronouncements.
Strategic management accounting requires an extension of the traditional skills to incorporate many of
the following tools and techniques, which will be examined in later modules of this subject:
• competitor analysis, customer cost and profitability analysis, supplier analysis and external
benchmarking—including sustainability perspectives

• industry- and organisation-level value analysis
• strategic costing, life cycle costing and target costing for strategy formulation
• activity-based costing and management for implementing strategic plans
• cost driver analysis, value analysis, benchmarking of operational processes and various forms of budget
variance analysis for managing and controlling the implementation process
• applying strategic management accounting techniques to the management, selection, planning and
implementation of projects
• strategic performance measurement systems (e.g. the BSC) for managing and controlling the implemen-
tation process—and for supporting strategy formulation.
PART D: THE KEY CHALLENGES FACING

MANAGEMENT ACCOUNTANTS
This part of the module aims to provide an overview of the key challenges facing management accountants.
As discussed earlier in this module, in the rapidly changing business environment, management accoun-
tants are experiencing significant changes in their role and responsibilities. Therefore, to be competent,
management accountants should adapt to the changes, to remain relevant in the future. Generally,
factors such as globalisation, advancements in technology, and competition have impacted organisational
structures, inventory costs and the value chain. This part of the module also highlights how these changes
have prompted the introduction of various management accounting tools.
CHALLENGES
Some of the key challenges facing management accountants include:
• using technology effectively while guiding others to effectively use management accounting
systems (MASs)
• managing resources
• promoting innovation.
All this is occurring at a time when globalisation and technological advances are changing the structure
and culture of organisations, with many roles now being outsourced. With an increasing focus on
environmental and social outcomes, management 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 and the strategic level.
These include keeping information secure and maintaining customer privacy (Gelinas and Sutton 2002;
Munir et al. 2013). 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 provided 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—this is highlighted in Example 1.3.
EXAMPLE 1.3
Disruption in the music industry

… the evolution of the music industry is heavily shaped by media technologies. This was equally true
in 1999, when the global recorded music industry had experienced two decades of continuous growth
largely driven by the rapid transition from vinyl records to Compact Discs. The transition encouraged avid
music listeners to purchase much of their music collections all over again in order to listen to their favourite
music with ‘digital sound’. As a consequence of this successful product innovation, recorded music sales
(unit measure) more than doubled between the early 1980s and the end of the 1990s. It was with this

backdrop that the first peer-to-peer file sharing service was developed and released to the mainstream
music market in 1999 by the college student Shawn Fanning. The service was named Napster and it marks
the beginning of an era that is now a classic example of how an innovation is able to disrupt an entire
industry and make large swathes of existing industry competences obsolete. File sharing services such
as Napster, followed by a range of similar services in its path, reduced physical unit sales in the music
industry to levels that had not been seen since the 1970s.
The severe impact of the internet on physical sales shocked many music industry executives who spent
much of the 2000s vigorously trying to reverse the decline and make the disruptive technologies go away.
At the end, they learned that their efforts were to no avail and the impact on the music industry proved
to be transformative, irreversible and, too many music industry professionals, also devastating. But as
always during periods of disruption, the past 15 years have also been very innovative, spurring a plethora
of new music business models. These new business models have mainly emerged outside the music
industry and the innovators have been often been required to be both persuasive and persistent in order
to get acceptance from the risk-averse and cash-poor music industry establishment. Apple was one such
change agent that in 2003 was the first company to open up a functioning and legal market for online
music. iTunes Music Store was the first online retail outlet that was able to offer the music catalogues
from all the major music companies; it used an entirely novel pricing model, and it allowed consumers to
debundle the music album and only buy the songs that they actually liked. Songs had previously been
bundled by physical necessity as discs or cassettes, but with iTunes Music Store, the institutionalized
album bundle slowly started to fall apart. The consequences had an immediate impact on music retailing
and within just a few years, many brick and mortar record stores were forced out of business in markets
across the world.
The transformation also had disruptive consequences beyond music retailing and redefined music
companies’ organizational structures, work processes and routines, as well as professional roles. iTunes
Music Store in one sense was a disruptive innovation, but it was at the same time relatively incremental,
since the major labels’ positions and power structures remained largely unscathed. The rights holders still
controlled their intellectual properties and the structures that guided the royalties paid per song that was
sold were predictable, transparent and in line with established music industry practices.
Source: Wikström, P. & DeFillippi, R. 2016, ‘Introduction’, Business Innovation and Disruption in the Music Industry,
Edward Elgar, Cheltenham, pp. 1–2. Reproduced with permission of the Licensor through PLSclear.
Managing resources
Effective use and control of assets are required for superior results. Mastering areas such as cash flow
management and SCM 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 (Massingham 2014). It is more difficult to deal
with organisational knowledge, customer and employee loyalty, 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, their management is an essential task for protecting and improving business
value (EY 2018).
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—that is, 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) is essential
to creating customer value. Investment in research and development (R&D) requires significant cash
outlays, but is necessary to maintain superior performance as shown in Example 1.4.
EXAMPLE 1.4
Innovation helps improve both financial and environmental

performance
Ferguson Plarre Bakehouses (FPB), located in Australia, demonstrates the benefits of innovation that cover
the key themes of process redesign, performance measurement, environmental waste reduction and cost
improvement.

In 2009, FPB had over 200 employees and a turnover of up to $40 million per annum. It successfully
reduced its carbon output by re-using the heat generated from the baking process for cake and pastry
production. The estimated saving was approximately 5000 tonnes of emission per annum and a more
than 75 per cent reduction in gas per square metre as a result of turning a waste by-product into a
useful input.
It also implemented a real-time monitoring system for energy consumption, and rainwater was used for
flushing toilets. Over 95 per cent of waste was recycled—including plastic, tin, wood and food.
With an estimated $300 000 investment in green initiatives at the time, the financial cost was paid back
just from annual electricity savings of $290 000.
Since then FPB has embraced ‘ethical & sustainable ingredient sourcing’ including ‘premium Victorian
chicken & eggs, hormone free beef’ and committed to ‘continue to reduce our carbon & water footprint
and where necessary offset emissions via tree planting’ (Ferguson Plarre 2018b).
Source: Based on McKeith, S. 2009, ‘Emission magician’, Business Review Weekly, 5–11 November, p. 50, accessed June
2018, https://www.fergusonplarre.com.au/blog/wp-content/uploads/2017/06/BRW-Emission-Magician.pdf; Ferguson Plarre
2018a, ‘FAQ’, accessed June 2018, https://www.fergusonplarre.com.au/about/faq; Ferguson Plarre 2018b, ‘Our history’,
accessed June 2018, https://www.fergusonplarre.com.au/about/history.
Successful innovation requires a clear understanding of customers. Innovation must lead to customer
value for it to be of any use. This may occur by creating similar goods and services more efficiently
than before, which leads to lower prices for customers, or by offering enhanced services or products that
provide a better customer experience. Those who can guide or anticipate the needs of their customers
will be able to cater for those needs more effectively. Management accountants need to integrate market
research information into their systems and analysis. They are also expected to support the development
of strong relationships with customers and suppliers to develop ideas and solve problems (Walker 2004b;
Oboh and Ajibolade 2017).
For management accountants to remain effective in their role, they must understand the causes of change
in the business environment that affect organisations. This is discussed in the next section.
CAUSES OF CHANGE IN THE BUSINESS

ENVIRONMENT
To help understand how and why there have been changes in the business environment and in the role of
management accounting, consider how companies and other organisations have changed over time. Over
the last few decades, many large multinational organisations have grown—and declined. There have also
been many smaller organisations that were ‘born global’ as a consequence of the existence of the internet.
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.
These major factors are briefly examined in Figure 1.6.
THE GLOBAL ECONOMY

Economic turmoil
Economies throughout the world are more deeply integrated and accessible than they have been at any
time. This means that changes or problems in one part of the world quickly spread across the globe. Both
economic and political instability have caused serious issues for many organisations. In a similar way to
illness or disease, we talk about global ‘contagions’ such as potential bank defaults and collapses combined
with fear and panic, sending share markets tumbling.
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.
FIGURE 1.6 Causes of change in the contemporary business environment
Economic
turmoil Capital
equipment
Structural Global
Technology
change economy Information
communication
technology
Globalisation
Changing
business Flatter
environment hierarchies
Environmental
management Outsourcing/
accounting offshoring
Internal Joint
Stakeholders Sustainability ventures
structures
Virtual
Ethics
Management
reporting
At the time of writing, the global economy is more deeply indebted than before the GFC and countries
need to take immediate action to improve their finances before the next downturn. The International
Monetary Fund (IMF) indicated that a prolonged period of low interest rates had stimulated a build-up
of debt worth 225 per cent of world gross domestic product (GDP) in 2016, which is 12 points above the
previous record level, reached in 2009. So it is important to build a buffer now that will help protect the
economy by reducing the risk of financing difficulties if global financial conditions tighten (Elliot 2018).
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
• new regulations.
Table 1.4 reveals actual and forecast 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.
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.
Another example of structural change involves new regulations aimed at minimising or preventing the
same types of problems that caused the GFC. The Basel III Accord provides a useful example of this—as
shown in Example 1.5.

TABLE 1.4 Actual and forecast gross domestic product growth rates
Pre-GFC GFC Post-GFC
Real GDP 2005a 2009a 2016a 2018f
Global growth 3.5% (2.2%) 2.4% 3.1%
High-income countries 2.7% (3.4%) 1.7% 2.2%
Developing countries 6.6% 1.9% 3.7% 4.5%
Euro area 1.4% (4.1%) 1.8% 2.1%
East Asia and Pacific 9.0% 7.4% 6.3% 6.3%
Europe and Central Asia 6.0% (6.4%) 1.7% 3.2%
NB: a = actual, f = forecast

Source: Based on World Bank 2007, Global Economic Prospects, accessed August 2015, http://www.worldbank.org/
content/dam/Worldbank/GEP/GEParchives/GEP2007/381400GEP2007.pdf; World Bank 2011, Global Economic Prospects, vol. 3,
June, accessed August 2015, http://www.worldbank.org/content/dam/Worldbank/GEP/GEParchives/GEP2011b/GEP2011bFull
Report.pdf; World Bank 2014, Global Economic Prospects, vol. 9, June, accessed August 2015, http://www.world
bank.org/content/dam/Worldbank/GEP/GEP2014b/GEP2014b.pdf; World Bank 2018, Global Economic Prospects: The Turning of
the Tide?, accessed June 2018, http://www.worldbank.org/en/publication/global-economic-prospects.
EXAMPLE 1.5
The Basel Accords

Banks lend out the majority of funds they receive from depositors and capital providers, and so they only
hold a small amount of capital reserves. A major problem for banks occurs if many customers decide
to withdraw their deposits at the same time, because this can cause a ‘run on the bank’. When this
happens, there is not enough physical cash to return to depositors, which may cause panic, prompting
more depositors to attempt to withdraw their funds, and lead to the collapse of the bank.
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 default on their obligations—that is, 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.
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.
Basel III accord
A key aim of the revised version of Basel III (Basel Committee on Banking Supervision 2011) is to enable
the banking sector to absorb shocks. Other aims include improving risk management and transparency.
The following requirements for banking institutions are to be implemented by 2019, 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)
Increasing the quality of capital held
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
Supervision Focusing on managing risk and off-balance sheet exposures

Ensuring appropriate compensation and valuation practices
Disclosures More detailed and transparent disclosures
Effect on business
The most likely impact of Basel III 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.
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 effect 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.
TABLE 1.5 Shifting to services from agriculture/manufacturing
Percentage share of GDP of different industries (in 2013–14 price terms)†
Australian industries 1860 1960 2016
Health 0.3% 3.0% 6.5%
Agriculture 23.0% 11.0% 2.2%
Mining 14.6% 1.8% 8.8%
Manufacturing 4.2% 28.9% 5.9%
Education 0.3% 2.9% 4.6%
Professional and technical services 0.0% 1.5% 5.8%
Communication services 1.5% 1.5% 3.0%
Finance and insurance 3.7% 3.7% 8.8%
Property and business services 22.1% 26.2% 30.9%
Hospitality 2.5% 2.0% 2.4%
† The figures in the table are not meant to total 100 per cent.
Source: Based on IBISWorld 2016, ‘Australia’s growth industries’, accessed June 2018, https://www.ibisworld.com.au/media/
2016/08/10/australias-growth-industries/.
The data in Table 1.5 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.

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 2016 there
were only three car makers remaining in Australia (Ford, Holden and Toyota Australia). Ford stopped
manufacturing cars in Australia in 2016, Holden closed its Australian operations on 20 October 2017 and
Toyota ceased plant production on 3 October 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.
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, unre-
stricted capital flows and faster information transfers have all had a significant effect on organisations.
As organisations have been exposed to an increasingly tough business environment, they have struggled
to survive or even failed. However, as a result of globalisation, many opportunities have also arisen.
Organisations that are flexible have been able to take advantage of these opportunities and take sales and
profits away from those who have been too slow or unable to adapt.
The consequences of globalisation have forced managers to have a greater understanding of the com-
petitive environment and to achieve higher levels of customer and employee satisfaction. This requires an
increased focus on flexibility and responsiveness, coupled with innovation of both products and internal
business processes.
Globalisation creates difficult issues that must also be addressed. These include:
• taxation
• protection of IP
• cross-border money laundering
• financing of illegal activities.
Such issues often arise because of different cultures, rules and levels of enforcement in different
countries and regions.
According to Lasserre (2003), there are four main drivers of globalisation:
1. global competition
2. physical and capability factors
3. social factors and national cultures
4. legal and political systems.

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.
• They may be focusing on obtaining lower-cost raw materials and labour.
• It may be a defensive strategy because low-cost competitors have entered their domestic market.
• It may 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.
Example 1.6 provides some historical context for how globalisation developed.
EXAMPLE 1.6
Background to globalisation
The beginning of the current phase of globalisation was marked by the arrival in the 1960s of Japanese
manufacturers competing in markets that were previously dominated by US or European organisations.
As trade barriers opened, and because they had not at that stage invested in national subsidiaries,
Japanese (and later Korean) manufacturers engaged in rapid international expansion, exporting products
designed for global markets. They created global brands such as Sony and Panasonic. This raised quality
standards—with quality production systems—and lowered prices simultaneously. As US and European
manufacturers quickly lost market share in their home markets and internationally, 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 organisa-
tions 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.
Physical and capability factors

A series of breakthroughs, particularly rapid advances in transport and communication, have provided a
technological platform for global activity. These advances, in turn, have encouraged:
• economies of scale—because goods produced in a central location can be cheaply distributed around
the world
• outsourcing of component supplies to low-cost countries—because the transport costs across long
distances are now more affordable.
At the same time as the cost of shipping goods by air or sea has fallen substantially, advances in
telecommunications have dramatically reduced the cost of international business communication.
Technological 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.
Social factors and national cultures
There appears to be a convergence in global consumer tastes, as mass markets are created for new global
products. Youthful demographics are at the forefront of this change in consumption. The diffusion of
lifestyle by movies, television, advertising and music, especially over the internet, has increased the
awareness of consumer brands worldwide. This convergence of tastes is compounded by increasing
urbanisation and industrialisation across the world, with populations adapting quickly to new products.
Many nations are multicultural in that they have significant migrant populations who have blended their
cultures with those of their adopted nation. This has increased similarities and convergence between
countries.
Legal and political systems
Trade barriers such as tariffs are one of the main obstacles to successful globalisation. These are usually
enacted by countries wishing to protect their domestic economy from foreign competition. Example 1.7
provides further explanation of tariffs.

EXAMPLE 1.7
The US tariffs
In 2018 the US administration announced steel and aluminium tariffs that:
are necessary to protect national security and the intellectual property of US businesses.
In response China announced tariffs of their own on USD 34 billion of US goods.

What is a tariff?
• A tariff is essentially a tax imposed on goods entering a country.
• The US imposes tariffs on many different types of goods entering the country via either a customs
broker or an agent. This is in addition to duties and fees that may apply.
• The reasoning behind imposing tariffs is to make locally-made options more attractive as the imported
options will be more expensive.
• In the case of the steel and aluminum tariffs, the US is aiming to induce US-based companies to be
more likely to use US-made items or, if they require items to be imported, to use items from other trade
allies.
Source: Adapted from Bryan, B. 2018, ‘Trump’s tariffs are starting a trade war with Europe, Mexico, and Canada: Here’s what
tariffs are, and how they could affect you’, Business Insider, accessed July 2018, https://www.businessinsider.com.au/trump-
tariffs-what-is-a-tariff-meaning-for-prices-consumer-2018-3.
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, the
North American Free Trade Agreement (NAFTA) and 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. However, the US administration has been taking a more protectionist stance on global trade
since President Trump came into office, withdrawing from the Trans-Pacific Partnership, demanding a
renegotiation of NAFTA and generally taking a tougher stance on global trade deals.
For management accountants, 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, IP risk and foreign currency management all arise in the global context
and add complexity to management accounting roles.
QUESTION 1.3
Identify three competitor-related issues that an organisation might face as a result of the local
currency becoming stronger.
QUESTION 1.4
Consider your organisation or one that you are familiar with and describe 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
communications 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 technolo-
gies 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.
A recent example is additive manufacturing. Powder-based laser sintering technology, is an industrial
3D printing process:
The system starts by applying a thin layer of the powder material to the building platform. A powerful laser
beam then fuses the powder at exactly the points defined by the computer-generated component design
data. The platform is then lowered and another layer of powder is applied. Once again the material is fused
so as to bond with the layer below at the predefined points (EOS 2018).
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.
• 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 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.
Information and communication technologies

Information systems and technology have also increased the ability of organisations to capture data,
information and knowledge. The need for effective knowledge management that both controls and uses this
resource is essential. As with other technological investments, significant cash outlays are often required,
and effective implementation of information systems is a challenging task that often ends in failure.
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 in the
following section.
Cloud computing
Faster internet access has enabled the development of internet-based storage, software applications and
programs, including whole IT platforms—including operating systems—provided from the ‘cloud’. Key
services include:
• SaaS—software as a service
• IaaS—infrastructure as a service
• 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.
Employee-owned devices and open systems
As more employees want to bring their own devices to work, organisations have to decide how open or
closed their systems will be. Employee-owned smartphones, tablets and laptops all provide significant
opportunities for a more flexible work environment, but they also bring compatibility and security issues.
There is a much greater risk of loss of confidential information or IP in more open systems. This must be
carefully managed. Policies that encourage efficiency and protect assets as well as technical integration
with company-owned software are key areas that management accountants may be involved in.
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. Big data is discussed further in Module 2.
QUESTION 1.5
Identify four technological developments and the effect they 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, 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.
Sustainability can relate to economic, social or environmental activity. From a business perspective,
the focus is often on economic sustainability for the business itself—that is, profitable growth. However,
from the perspective of society, a much broader focus is required that includes both economic growth
alongside social development and maintaining the environment. The importance of this is highlighted in
Example 1.8.
EXAMPLE 1.8
The island of Nauru

The island of Nauru (which is located to the north-east of Australia) provides a good example of the
lack of focus on longer-term environmental sustainability that has led to severe economic and social
consequences. Phosphate was discovered in 1900 on Nauru. Within seven years the first shipments of
phosphate began, and over the next 100 years extensive mining of the reserves occurred. For a short
period in the late 1960s, Nauru had the highest per-capita net income in the world. However, by 2006 the
reserves were almost exhausted.

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—for example, nearly three-quarters of Nauruans are obese with 10 per cent
having type 2 diabetes due to dietary changes that came with increasing wealth. The 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.
Industries that have seen, or may see, significant decline due to unsustainable environmental practices
include fishing, 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.
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.
1. There is a broader consideration of qualitative and non-financial factors when making decisions about
long-term projects.
2. 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.
Management accountants will be involved in preparing various types of reporting:
• Environmental reporting—involves capturing and preparing information to inform stakeholders about
an organisation’s impact on the environment. This information may then be used for either management
reporting or external reporting purposes.
• Social reporting—is the process of acknowledging an organisation’s social impact, and incorporates
both the positive and negative aspects of its performance. Social reporting also encompasses the effect
on employees (i.e. conditions of work), the external impact on the community and disclosing social
performance information for both internal and external decision-making.
• Sustainability reporting—combines environmental and social information with economic perfor-
mance. ‘Sustainability reporting is an organization’s practice of reporting publicly on its economic,
environmental, and social impacts’ (Global Reporting Initiative (GRI) 2018).
This broadening focus on stakeholders is not 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.

Environmental management accounting
There is an increasing level of scrutiny being placed on organisations in terms of the resources they are
consuming and disposing of. There is also a broader group of organisational stakeholders that organisations
must communicate with. Therefore, it is critical that strategic management accounting expands and
adapts to properly capture, analyse and report on environmental information. ‘Environmental management
accounting’ (EMA) is a term used to describe this approach—it involves the development of environmental
management accounting systems (EMASs) to capture, report and help improve performance in these areas.
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 implementa-
tion 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 2005, p. 19).
The Expert Working Group of the United Nations Division for Sustainable Development (UNDSD)
emphasised both the physical and monetary aspects of EMA in its definition:
… 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 (AISs) 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 GRI Standards, this
functionality will become expected and normal.
Ethics
Ethics and its relationship with strategic management accounting should be considered in several ways. It is
important to incorporate ethical implications in organisational decision-making. Management accountants
provide significant input into these decisions, so 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 work
health and safety (WHS) (as highlighted in Example 1.9) 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 1.9
Outsourcing 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
Example 1.9, 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 WHS issues.

The term ‘organisational structure’ describes how an organisation is organised. This may involve having
different departments that work on:
• specific functions—for example, sales, marketing, accounting, customer service
• particular product lines—for example, 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, 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. Figure 1.7 outlines what
managers of the various responsibility centres are held accountable for.
FIGURE 1.7 Responsibility centres
Cost Ability to control and reduce costs

centres are the primary responsibilities.
Revenue Performance measurement is focused

centres on increasing revenues.
Responsibility
centres
Successful performance requires the

Profit ability to control costs and increase
centres revenues simultaneously.
Controlling costs, increasing revenues and

Investment
• are the most autonomous of the responsibility
centres
centres
• have more authority to make 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 has been an attempt to eliminate costs by reducing the
number of middle managers and replacing them with IT. 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 the traditional
organisational structure, including:
• offshoring and outsourcing
• virtual offices and global teams
• joint ventures (JVs) and alliances.
Offshoring and outsourcing

Offshoring is where an organisation moves some of its activities to subsidiaries in overseas locations. The
organisation is still performing the work internally, but in a new (and likely cheaper) location.
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.
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 of 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;
Child 2015).
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.
Virtual offices and global teams

Teams of people who work in the same business or department or on the same projects can be located
around the globe. Many team members may never meet in person—only via phone or videoconferencing
technology. The benefits of this include using the best qualified people for the job regardless of location,
work being carried out 24 hours a day (due to time zone differences) and using lower-cost labour locations.
Some negative outcomes include language barriers, cultural differences and difficulties in supervision.
Virtual offices provide similar benefits, where the employees of an organisation from the same region or
location may not be fixed to a specific office location.
Management accountants have a variety of tasks to perform in these environments, including project
planning, budgeting, performance measurement and reporting across time zones and cultures. Virtual
projects and global project teams are discussed further in Module 4.
Joint ventures and alliances

Strategic alliances and JVs have become popular means for organisations to become actively involved in
new markets, products or technologies by collaborating with partners. They can help implement faster, less-
costly and less-risky market penetration strategies, with alliance partners and parties to the JV providing
access to, and knowledge of, the new market.
Acquiring an organisation that is already in a market is another alternative. An acquisition strategy
can bring more immediate results, possibly with less expense and risk than starting a new subsidiary
from scratch in a new market. Of course, blending the culture and operational practices of the purchased
organisation with the parent organisation may take considerable time and effort.

Striving to succeed in unknown or fast-moving markets usually requires frequent collaboration—
hence, the importance of building strategic alliances (as shown in Example 1.10). Through collaboration,
organisations seek to achieve ‘leverage’ of their core resources. This means they try to add value to their
basic resources by coupling or combining them with other companies’ resources to make them more
valuable than they would otherwise be. Management accountants should constantly be on the lookout
for these opportunities and be involved in costings, investment decisions and performance reporting.
EXAMPLE 1.10
Qantas and oneworld—strategic alliance

Alliances in passenger airlines have grown over the years and have become an integral part of the aviation
industry. Oneworld, Star Alliance and SkyTeam are the three main players and make up almost 75 per cent
of the total world airline capacity.
There are a number of reasons why airlines may want to join a global airline alliance scheme, as listed
below.
• An increasing number of passengers want to travel internationally; however, airlines are governed by
restrictions and various business economics that prevent an individual airline from serving all markets.
Having a global alliance scheme allows passengers to connect to many destinations across the world.
• Reduction in cost with various partnerships working together collaboratively.
• Increase in revenue with increased routes and frequencies between destinations.
• Increase in value and benefits for individual and corporate passengers.
There is a high level of competition in the global airline alliance industry.
Source: Qantas 2018, ‘Introduction to oneworld: An alliance of the world’s leading airlines working as one’, accessed July
2018, https://www.oneworld.com/news-information/oneworld-fact-sheets/introduction-to-oneworld.
QUESTION 1.6
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 shown in Figure 1.8. These items are discussed in Modules 4 to 6.
Designing and implementing effective MASs that capture and report this data in a quick and efficient
manner is an important role for management accountants.
QUESTION 1.7
Apart from the factors described in this section, can you identify other factors that have affected
organisations and driven change?

FIGURE 1.8 Information for management reports
• External economic factors

• Core criteria including cost, (e.g. interest rates, GDP and
quality and time foreign exchange rates)
• Business cases, approvals • Internal factors such as
and post-implementation customer satisfaction
reviews • Commodity price changes
Leading
Projects indicators
Management
reports
Non-
performance
Competitor
activity
Industry
• analysis
including throughput, • Estimates of competitor
emissions and waste cost structures and pricing
• Employee performance, • Analysis of competitor
satisfaction and engagement strategies and potential
responses
•
including life cycle and
business cycle analysis
• Impact of current or potential
regulations or political
changes
PART E: ANALYTICAL TECHNIQUES

AVAILABLE TO MANAGEMENT
ACCOUNTANTS
There are many tools and techniques that can be used for strategy analysis. Examples of these tools
and techniques include the organisational and industry value chain analysis, SWOT analysis, the Boston
Consulting Group (BCG) growth/share matrix, Porter’s five forces model and PEST analysis. The
challenge is not in selecting the best tool, but in using the most relevant tool and technique given the
business issue or opportunity.

Table 1.6 and Table 1.7 outline a variety of ways management accountants can support managers both
at the strategic and operation levels.
TABLE 1.6 Strategic management accounting and the strategic management process
Strategic tasks Tools, techniques and accounting information that may be useful
Internal analysis Examine BSC 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 Evaluate and rank the feasibility and profitability of strategies, considering both
choice 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.
TABLE 1.7 Generic operational management tasks and strategic management accounting support
Operational tasks Activities and strategic management accounting information that may
(strategic implementation) be useful
Planning Budgets and forecasts, costing systems and historical data.
Evaluating Benchmarking—collect, analyse, classify, record and report on financial and

non-financial information.
Controlling Identifying causes of variance, establishing performance incentives and criteria,

performing reconciliations and reviewing internal controls.
Communicating Budgets communicate organisational priorities by showing where resources are

allocated. They provide information to employees about what they are expected
to achieve.
Coordinating Collating budgets allows coordination between departments/functions such as

sales, productions and logistics.
Rewarding Individual, departmental, team or organisational performance is measured and

reported as a basis for incentives and rewards.
Decision-making Providing costings, alternative pricing strategies and potential competitor

responses with other information, as required, to support routine and non-routine
decisions.
Many of these approaches are discussed in later modules, and some are discussed in greater detail in the
Global Strategy and Leadership subject of the CPA Program.
The following section provides an overview of some of the tools and techniques most relevant for
this subject.
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.
In analysing the contribution of activities to value creation, it is important to understand the value
propositions of all stakeholders. For example, preparing the organisation’s tax return is an activity that
contributes nothing directly to customers or shareholders, but is important to the government—another
key stakeholder. In an indirect way, therefore, the activity provides both customer and shareholder value
because taxation provides the transport and legal infrastructure that makes business activity possible.
Organisation value chains

Porter (1985) argued that competitive advantage arises from the way an organisation organises and
performs the activities that comprise its value chain. Value analysis focuses on the ‘chain’ because
activities are interrelated and, while individual activities can be improved to provide greater value, it is the
linkages between activities that are critical in creating value. An organisation may improve its competitive
advantage by:
• identifying primary or support activities that either do not add value or actually destroy value—non-
value-adding activities should be minimised or, if possible, eliminated
• using substitute—less costly—inputs for activities
• conceiving new ways to conduct activities, like designing new processes or implementing new
technologies
• linking the activities within its value chain in a more effective way than competitors do.
A ‘non-value-adding activity’ means that customers do not compensate the organisation for the costs
incurred in carrying it out—for example, 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, and reduce the time it takes to bring new
products to market or fill customer orders; this, in turn, may lead to improved competitive advantage.
Industry value chains

Activities that add value are not constrained by an organisation’s boundaries. Each role in the industry value
chain contributes value to the industry’s end product. For example, a restaurant chef plays an important
role in choosing quality ingredients, but the quality is also determined by the farmer. The activities of the
farmer add value for the restaurant’s customers.
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 itself of 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, JVs or alliances. An alternative to
increasing upstream and downstream linkages in the value chain is vertical integration—that is, 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.
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 and Salancik
1978). This is highlighted in Example 1.11.
EXAMPLE 1.11
Sustainable competitive advantage at microsoft

Microsoft developed a popular operating system for computers (Windows), and now most manufacturers
of PC-based (as opposed to Apple) computers supply their machines with Windows installed. This has
led to further opportunities for the organisation, so Microsoft has long enjoyed a sustainable competitive

advantage. This is evidenced by the fact that the company has been the subject of anti-monopoly lawsuits
brought by the US government (in which Microsoft has been successful).
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.
EXAMPLE 1.12
Value analysis
The introduction of a just in time (JIT) system provides an example of how competitive advantage can be
gained from the development of close linkages between an organisation and its suppliers and customers.
A JIT system is an inventory strategy that aims to reduce the stockpiling of goods by 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 a JIT system 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.
Inbound logistics activities must be improved to accommodate the JIT system:
• Reliability of the scheduling activity must be improved.
• Set-up activities that determine the time between production runs must be shortened.
• Suppliers will have to deliver more frequently in smaller lot sizes.
• Improved coordination and communication in the supply chain will be essential.
Example 1.12 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 practice in value analysis, please access Stage 1 of the ‘Save or close the hotel?’ Business
Simulation on My Online Learning.
STRENGTHS, WEAKNESSES, OPPORTUNITIES AND THREATS

SWOT analysis is a well-established approach to strategic analysis. It involves analysis of the organisa-
tion’s internal environment (strengths and weaknesses—SW) and its external environment (opportunities
and threats—OT). The organisation’s strategy should be developed by using the results of the SWOT
analysis—that is, by using its strengths to exploit opportunities, while simultaneously managing the risks
arising from internal weaknesses and external threats.
Classifying strategic issues as internal or external is sometimes difficult—for example, products are
normally part of the internal analysis, but clearly have market or external implications. Nonetheless, the
SWOT approach has proved to be a useful tool as part of the strategic management process.
Figure 1.9 illustrates how an organisation’s strategy should be framed by factors present in the organi-
sation’s external and internal environments.
In the following two sections, four tools that support SWOT analysis are presented:
1. product life cycle analysis
2. the BCG matrix
3. Porter’s five forces model
4. PEST analysis.

FIGURE 1.9 SWOT analysis
National and global
• Political External
• Economic environment
• Social
• Technological
Internal environment Industry
• Assets and resources • Customers

• People and management Strategy • Competitors
• Systems and processes • Suppliers
• Capabilities
Internal
Strategic framework
environment
• Vision
• Mission
• Values
• Goals and objectives
The first two are tools for analysing an organisation’s product portfolio, Porter’s five forces model is a
tool for industry analysis, and PEST analysis addresses the external environment.
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 practice in completing a SWOT analysis please access Stage 1 of the ‘Save or close the hotel?’
Business Simulation on My Online Learning.
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—for example, patents, strong brands, supplier
relationships and government licences. Reproducible capabilities can be copied by other organisations—
most technical capabilities are reproducible.
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 1.9 identified some general categories that should be considered in an internal strategic analysis:
• assets—including 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 MASs.
Much of the focus of business-level strategy is on products and markets, so understanding existing
and potential products is an important part of a strategic analysis. Product analysis is discussed in the
following section. Two complementary approaches to understanding products are discussed—product life
cycle analysis and the BCG matrix.
The product life cycle is also discussed in Module 6.

Portfolio theory and product life cycles
In the stock market, investors frequently purchase a portfolio of shares in order to reduce risk. A well-
constructed portfolio includes shares that perform well in periods of economic growth (e.g. mining
companies), and other shares that perform well in periods of little growth (e.g. supermarkets). In the same
way, organisations invest in a portfolio of products to reduce the risk associated with relying on a single
product. Product life cycle analysis and the BCG matrix are tools used to understand and manage product
portfolios.
Product-related risks arise from uncertainties about:
• demand
• sales volumes
• prices
• investment requirements
• competitor offerings—direct competition or substitute products
• obsolescence.
Product life cycle analysis
Product life cycle analysis helps managers to improve their understanding of and ability to manage these
product-specific risks. Product life cycle analysis 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.
A product’s life cycle can be divided into four distinct stages as shown in Figure 1.10.
FIGURE 1.10 A product’s life cycle
1. Introduction
• Organisation introduces a
new product into the market.
• Risky stage—prices tend to
be high and demand low.
• No guarantee marketplace
will accept the new product.
4. Decline 2. Growth
• Market is saturated. • Market has accepted the
• Sales volumes decline. Product new product.
• Intense competition. life cycle • Rapid increase in market size.
• Competitors enter the market.
negative. • Prices drop.
3. Maturity
• Sales volumes increase
at a lower rate.
• New investment is low.
• Competition increases.

Product life cycle analysis 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.
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
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 R&D 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 dominance is established, the organisation can then increase its prices.
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.
The stages of the product life cycle are further explained in Example 1.13.
EXAMPLE 1.13
Product life cycle

The product life cycle can be seen in the television industry. When plasma, LCD and LED televisions were
introduced, they were very expensive and the market was small, comprising mainly ‘early adopters’. Over
time, product acceptance led to rapid market growth, resulting in many manufacturers entering the market
with volumes increasing and prices falling. Prices will, no doubt, continue to decline and in the future we
can expect consolidation in the industry and replacement of this product with some new technology.
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.
Boston Consulting Group growth/share matrix

BCG developed a 22 matrix for the analysis of product portfolios. The matrix has an external (market
growth) dimension and an internal (market share) dimension, and so contributes to both the internal and
external aspects of strategic analysis. Figure 1.11 shows the four quadrants of the BCG matrix.

FIGURE 1.11 Boston Consulting Group growth/share matrix
Relative market share
High Low
High
Rate of market growth Star Question mark
Low
Cash cow Dog
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.
The BCG matrix identifies four types of products:
1. Stars—products that are sold into high-growth markets and hold a high market share. Although these
products generate large cash inflows, due to the pace of growth in the market, the organisation needs to
continue to invest heavily in the product to maintain its position.
2. Cash cows—as stars enter the maturity phase of their product life cycle, the need for finance slows and
they become cash cows, generating large cash inflows. Cash cows are products that hold a high market
share in a low-growth market. Due to the low market growth, the organisation does not need to continue
investing in the product, and the cash flows it produces support the development of other products.
3. Question marks—products that hold a low market share in a high-growth market. Due to the low market
share, the organisation may need to continue a high level of investment in the product to maintain or
increase its market share and cash inflows. The organisation needs to decide whether ‘question mark’
products are worth continuing (in the hope that they will make the transition to stars) or should be
withdrawn from the market.
4. Dogs—products that hold a low market share in a low-growth market, producing low cash inflows.
The organisation should probably eliminate these products from its portfolio, 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.
For practice in completing a BCG matrix, please access Stage 1 of the ‘Save or close the hotel?’
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—for example, new distribution channels made possible by the digitisation of products
like music, film, TV and education
• the convergence of technologies—for example, cameras, phones, computers and navigation systems.
Traditional management accounting is focused on providing internal information to support strategic
analysis as well as day-to-day operational activities. In contrast, strategic management accounting has a
strongly external focus that identifies and captures information from outside the organisation.
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.
The aim of industry analysis is to understand how competitive forces create the profitability (prices,
costs, investments) of the industry. 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 indus-
try, 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? 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, it is necessary to look at the
industry’s suppliers, buyers, competitors, barriers to entry and so on. In the petroleum industry 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) explained 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 time frame. Strategic analysis should not
be overly concerned with temporary fluctuations in prices or demand, but should focus on the industry’s
business cycle, whether in the short term/run (e.g. mobile phones) or in the long term/run (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.
PORTER’S FIVE FORCES MODEL

According to Porter (1985, 2006), the strategic environment of an industry is shaped by five forces.
Force 1: New entrants

The emergence of a new entrant in an industry may result in significant realignment of the competitive
positions of existing organisations. For example:
• More production capacity and product volume will be added. Economics tells us that when supply
increases, prices will fall.
• New entrants often seek to build market share by setting their price below the prevailing market price.
• The cost-of-production inputs will rise as the new entrant seeks to secure access to scarce resources—for
example, skilled manufacturing labour may become more expensive.
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—for example, 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—for example, 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
• brand reputation barriers give established industry members a strong reputation in the market and high
customer loyalty.
With the ongoing deregulation of many industries—for example, 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.
Force 2: Alternative or substitute products

An alternative product is one that performs a similar function to that produced by the organisation. The
presence of alternatives reduces the demand for an organisation’s products and drives down prices.
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
• can switch to alternative products or suppliers at little incremental cost.
Force 4: Suppliers
Supplier power is the opposite side of customer power. Powerful suppliers have a strong effect on an
organisation’s sustainable competitive advantage because they can drive up the price of business inputs. 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.
• The product provided by the supplier is important to the organisation in terms of the value of its
own products.
Force 5: Existing competitors

The type of business strategy an organisation adopts must be developed in relation to the competitive
strategies adopted by rivals. Understanding a competitor’s strategies has critical implications for the design
of the organisation’s value chain activities, such as product design, quality, pricing and advertising.
Knowledge of competitors’ product/market portfolios assists managers to predict the reaction of a
competitor to their own strategic moves. For example:
• If the competitor has a very narrow market portfolio, the competitor’s response to a threat to its market
will be both prompt and aggressive.
• If the competitor has a broad market portfolio, the competitor’s response to the threat may be less
aggressive.
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.
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.
PEST analysis
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
• social
• 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).
While a multitude of issues arise in a PEST analysis, three that are commonly included are:
1. regulation—an important aspect of the political and legal dimensions
2. CSR—an important aspect of the socio-cultural dimension
3. the business cycle—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.
In a similar vein, the loosening of regulatory constraints in the insurance, telecommunication and civil
aviation industries has changed the competitive positions of many organisations in these industries. Prior to
airline market deregulation, a profitable duopoly existed in Australia—Ansett Airlines and Qantas. After
deregulation, Ansett ultimately failed and several new entrants 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–United
States) trade agreements have had a strong influence on the globalisation of business opportunities and
competitive threats.
Corporate social responsibility
Porter and Kramer (2006) pointed out the importance of CSR to an organisation’s competitive position.
They introduced a framework that organisations can use to:
• identify the social and environmental consequences of their actions
• discover opportunities to benefit both society and themselves (e.g. strategic linkages with stakeholders)
• determine the CSR initiatives they should address.
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 and Kramer 2006, p. 78).
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 to the strategic management process.
Upadhaya et al. (2018) and Carroll and Shabana (2010) summarised 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.
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.
Business cycle
Business cycles are fluctuations in local, national or international economic activity evidenced by changes
in GDP, inflation, interest rates, unemployment rates and other macroeconomic variables.
A business cycle generally comprises four phases:
1. boom—a rise in economic activity that lasts until a peak is reached
2. recession—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. depression—the slide from the mean down to a prolonged and low level of economic activity
4. recovery—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 for sure
is that business cycles recur. A brief overview of the effects of the business cycle since 2002 is shown in
Example 1.14.
EXAMPLE 1.14
Business cycle
The Western world was in a boom period from 2002 to 2007. Low interest rates and a large money supply
led many American consumers to take out loans to purchase real estate. In addition, merchant banks
and hedge funds borrowed money for speculation in mortgage, equity and bond markets. An asset ‘price
bubble’ arose in these markets.
In 2007, the 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:
1. The Shanghai Stock Exchange (which had risen by more than 30 per cent in the previous 12 months)
suffered a correction.
2. Greece defaulted on a loan repayment to its European creditors, mainly German and French banks.
Since then (at the time of writing), global markets have remained volatile.
Many business decisions have long-term implications. Management accountants should use their
understanding of the business cycle to ensure that unreasonable assumptions are challenged—for example,
constant growth in the world economy is frequently, and inaccurately, assumed. Those organisations that
ignore the business cycle, and that 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—for example, 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.
QUESTION 1.8
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?
REVIEW
This module has 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. This part of the module also introduced the
concept of value.
Part B described the strategic management process and the role of strategic management accounting in
supporting managers. The strategic management process is taken as a continuous process that evaluates

the business and the environment within which the organisation operates, evaluates/re-evaluates its
competitors and defines its objectives and strategy.
Part C detailed the role of management accountants in the strategic management process. Management
accountants are seen as information providers for the business process, organisational planning and control,
resource management and utilisation, and creation of value through effective use of financial and non-
financial resources. As a trusted business partner, new challenges facing management accountants mean
they must constantly advance their knowledge in diverse areas and improve their soft skills to effectively
communicate with the internal and external stakeholders.
Part D explained key challenges faced by management accountants. The focus was on three questions:
how these challenges affect them, what the consequences are, and what skills are needed by management
accountants to deal with such challenges.
Part E described the most common analytical techniques available to management accountants, and how
these techniques are applied in a practical setting.
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MODULE 2
INFORMATION FOR
DECISION-MAKING
PREVIEW
INTRODUCTION
This module looks at the information that management accountants work with and provide to satisfy a wide
variety of stakeholders including investors, financiers, the organisation’s managers and other interested
parties who need to make judgments and decisions. There are many methods, techniques and tools that a
management accountant can use to satisfy the information needs of stakeholders. The aim of this module is
to provide an understanding of alternative approaches that are available so that the management accountant
can apply the most appropriate method, technique or tool in any particular situation.
At the outset there are a few terms that need to be clarified. The module uses the expression ‘information’
as an umbrella term—it can mean data, which are numbers, words or symbols, or it can mean coherent
sets of numbers and commentary in combination.
The terms ‘data’, ‘information’ and ‘knowledge’ are often confused. Hislop (2005) makes a useful
distinction. He defines data as raw numbers, images, words or sounds derived from observation or
measurement. Information is data arranged in a meaningful pattern and where some intellectual input
has been added. Knowledge emerges from the application, analysis and productive use of data and/or
information with a further layer of intellectual analysis whereby it is structured and linked with existing
systems of beliefs and bodies of knowledge. Knowledge provides beliefs about causality and the basis for
meaningful action and thought (Hislop 2005, pp. 15–16)
Knowledge may be explicit or tacit. You should be aware if you read academic literature on knowledge
management that these competing definitions exist. Furthermore, they are sometimes not defined, and
sometimes they are used interchangeably, but not always correctly.
The American Institute of Certified Public Accountants (AICPA) and the Chartered Institute of Man-
agement Accountants (CIMA) produced the Global Management Accounting Principles. The principles
are based on the premise that management accounting is at the heart of quality decision-making, because
it brings to the fore the most relevant information and analysis to generate and preserve value. There are
four Global Management Accounting Principles:
1. Communication provides insight that is influential.
2. Information is relevant.
3. Impact on value is analysed.
4. Stewardship builds trust (AICPA and CIMA 2014, p. 3).
In its broadest sense, management accounting encompasses both financial and non-financial information
that comes from sources that may begin with but move far beyond the financial accounting system. The
information produced by management accountants is far more granular than that contained in financial
statements. The management accountant, in assembling various sources of information, must be careful to
faithfully represent that information to management. This involves recognising and reconciling sources of
information that may be inconsistent or ambiguous.
The final introductory point about this module is that it shows many of the reasons why the management
accountant has to work closely with the financial accountant. The current reporting obligations for a
listed entity mean that internal events which may affect market price or company valuation require timely
market disclosure. The management accountant is likely to possess or generate some of this information.
Pdf_Folio:45
Understanding who the external stakeholders are can help to understand how the stakeholders are affected
by the entity. Of course, financial accounting systems are a critical source for the management accountant’s
work, even though they are supplemented by other sources—for example, non-financial performance
measures and operational information sourced from enterprise resource planning (ERP) systems.
The management accountant may have multiple internal stakeholders who rely on the information they
provide. This may be to use financial accounting reports to help non-financial managers interpret monthly
budget versus actual variance reports. However, where these internal stakeholders are making future-
oriented decisions, the management accountant will need to provide additional information to support
capital expenditure proposals, process improvements, cost savings, etc.
Management accountants use financial accounting information but because it is historical information it
may be less relevant to internal stakeholders, particularly management, who need not only more granular
data, but data that is more current, or even prospective. For example, in making decisions about future
pricing, purchasing new equipment, introducing new products, etc., the management accountant will need
to provide current or future estimates of costs rather than historic costs. The management accountant will
also use various tools and techniques to assist in forecasting future revenues and cash flows, using data
that is not contained in the financial accounting system.
This module is concerned with information, management accounting and the systems that unite them.
The management accountant prepares information for different stakeholders, both internal and external to
the organisation. This is explored in Part A, which suggests that stakeholders have different information
needs—management accountants should not attempt to treat all stakeholders as the same.
The idea of dimensions of information is introduced in Part B. The management accountant works
with a large volume of information, from various sources and of varying quality. The stakeholders who
need information to make judgments and decisions can include investors, financiers, the organisation’s
managers and other interested parties. This means that the management accountant must be mindful that
this information needs to be assessed and differentiated in terms of its validity and reliability to ensure that
the information provided is fit for the stakeholders’ purposes (the characteristics of validity and reliability
are defined in Module 5).
An important point about this module is that information provided to stakeholders by management
accountants can also be used to build trust and confidence in their analyses and advice.
Part C considers the strategic influencing of stakeholders. It is important to appreciate that providing
reliable, timely and useful information can be used to build relationships with managers, and the
management accountant can become a ‘trusted adviser’. Trust is required when making an assessment
of an information system and this is particularly the case when identifying its shortcomings.
Part D consolidates concepts from the previous parts of this module and considers situations where
the management accountant has found deficiencies in an information system. These deficiencies can arise
from limitations of the information system itself, using inappropriate information to make decisions, or a
lack of suitable information.
The management accountant needs to carefully consider the approach to be taken (and the tools and
techniques to be used) to provide information that best meets the needs of the stakeholder for whom the
information is provided. This involves:
1. Judgment—the management accountant needs to consider the time and resources that are available in
terms of the scope and depth of the analysis. Any limitations of the management accountant’s analysis
need to be made clear when the information is provided.
2. Analysis and interpretation—the management accountant needs to decide what tools and techniques to
apply, which will depend on the circumstances. Any limitations of specific tools and techniques need
to be made clear with the interpretation that the management accountant provides.
3. Flexibility and a focus on risk—the management accountant needs to be flexible in searching out sources
of information that are useful, but especially where information is externally sourced; where there are
ambiguities between the information generated from different sources, the user must be aware of the
risks of relying on any source of data that cannot be verified or triangulated.
The highlighted sections in Figure 2.1 show that the external environment influences the information that
the management accountant provides to managers to focus their attention on strategic decision-making. It
also shows the central role of management accountants in translating strategy into operational activities
and recognising the impact that actual operations have on achieving goals and objectives.
Pdf_Folio:46

rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
VALUE INFORMATION
OPERATIONS
E xte
r n a l en v ir o n m e n t
OBJECTIVES
• Identify the types of information required to support various stakeholders’ decision-making.
• Examine the characteristics of different types of information and the functions they play in the process
of decision-making.
• Evaluate the roles of management accountants in collecting, analysing and presenting information to
influence stakeholders’ decision-making.
• Provide recommendations to an existing information system to meet the decision-making needs.
PART A: TYPES OF INFORMATION NEEDED

FOR STAKEHOLDER DECISION‐MAKING
This part shows that it is not efficient to consider the information needs of every individual. A more effective
approach is to group them together as stakeholders and identify their common information needs.
THE INFORMATION NEEDS OF STAKEHOLDERS

This section focuses on stakeholder information requirements with an emphasis on the role of management
accountants in supporting internal organisational stakeholders. The first step in providing relevant
information to stakeholders is to determine who the stakeholders are and what information they need.
IDENTIFYING USERS WITH DIFFERENT INFORMATION NEEDS

Stakeholders are often categorised as external or internal stakeholders, as discussed in the following
section.
Pdf_Folio:47
MODULE 2 Information for Decision-Making 47

External stakeholders
Table 2.1 identifies various stakeholders and their key information needs.
TABLE 2.1 External stakeholders and their information needs
Stakeholder Key information requirements or needs
Community • Employment levels and expected duration

• Economics of the (local) economy
• Environmental protection
Creditors, including financiers who • Creditworthiness

provide loans and advances of funds • Credit approval and credit limits
• Important conditions for loan agreements (e.g. covenants)
Customers • Fair trading standards of compliance

• Guarantees, warranties
• After-sales service arrangements including spare parts availability
Government • Assessment of tax and payment

• Financial reporting compliance
• Compliance with industry-specific legislation
Investors • Return on investment calculations

• Income stream (dividends, interest payment, etc.)
Suppliers (vendors) of products and • Long-term supply arrangements

supporting services • Conditions for receipt of payment
• Standards of quality
Trade unions for particular trades or • Future employment prospects

industry types • Working conditions
• Worker income protection
Source: Based on Donaldson & Preston 1995, ‘The stakeholder theory of the corporation: Concepts, evidence, and implications’,
Academy of Management Review, vol. 20, no. 1, pp. 65–91.
Internal stakeholders
Internal stakeholders can be categorised by considering their roles and the information they routinely
need—as shown in Table 2.2.
TABLE 2.2 Internal stakeholders and their information needs
Stakeholder Information needs
Board of directors/senior • High-level analysis of financial and non-financial performance of business units,
management team identifying gaps between actual and budgeted performance
Sales and marketing • Revenue and margin by product group/territory/customer/distribution channel

• Expense analyses
• Customer satisfaction measures such as Net Promoter Score (NPS)
• Analyses such as:
– customer retention
– customer acquisition cost
– customer profitability analysis
– customer lifetime value
Production/logistics • Expense analyses

• Non-financial performance measures such as:
– cycle time (order to delivery)
– quality (rework, warranty claims, waste)
– productivity (cost per unit of output)
– inventory turnover
– on-time delivery
Pdf_Folio:48

Finance and administration • Expense analyses
• Non-financial performance measures such as:
– invoicing error rate
– days sales outstanding
– days purchases outstanding
Since internal stakeholders have familiarity with the operations of the business, the management
accountant can seek to understand the impact of:
• priorities—for example, current concerns, strategies, initiatives
• plans—for example, budgets
• performance objectives.
This will enable them to communicate in the most relevant and useful way for the given situation of the
particular internal stakeholder.
How are the different information needs and requirements of stakeholders reconciled? The manage-
ment accountant is the ideal person to identify potentially useful information and make it available to
stakeholders—both internal and external.
The management accountant’s role encompasses a broad range of activities:
• providing information to financial accountants for the preparation of monthly and annual financial
reports
• assisting non-financial managers to interpret the monthly reports (which may combine financial and non-
financial data) for their areas of responsibility, and advising those managers in relation to continuous
improvement (CI) activities
• interpreting and explaining connections between different sources of information such as strategic
goals, non-financial performance measures, budget allocations, and external sources of data including
benchmarks
• analysing business profitability from various perspectives—for example, by customer group, prod-
uct group, distribution channel, geographic territory and over the product life cycle
• linking profitability to measures of capacity utilisation—for example, production machinery, air-
line seats, hotel rooms or professional services labour
• advising in relation to ad hoc projects—for example, capital expenditure, new product launches.
Information may also be required for organisations engaged in reporting under the Global Reporting
Initiative (GRI), which is a reporting structure that provides a great deal of economic, environmental
and social information not commonly found in annual reports (the GRI is discussed in Module 5). This
also relates to corporate social responsibility (CSR) and integrated reporting, which are discussed in the
next section.
CORPORATE SOCIAL RESPONSIBILITY/INTEGRATED

REPORTING
CSR and integrated reporting (covered in more detail in Module 5) aim to provide stakeholders with
composite, organised and cohesive information that goes beyond financial reporting. Even where it is not
mandatory, some organisations are voluntarily providing this information—for example, Australia Post,
BHP, the Coca-Cola Company, Macquarie Bank and National Australia Bank Ltd.
Integrated reporting aims to:
• Improve the quality of information available to providers of financial capital to enable a more efficient
and productive allocation of capital
• Promote a more cohesive and efficient approach to corporate reporting that draws on different reporting
strands and communicates the full range of factors that materially affect the ability of an organization
to create value over time
• Enhance accountability and stewardship for the broad base of capitals (financial, manufactured, intellec-
tual, human, social and relationship, and natural) and promote understanding of their interdependencies
• Support integrated thinking, decision-making and actions that focus on the creation of value over the
short, medium and long term (IIRC 2013, p. 2).
Pdf_Folio:49

The management accountant is best placed to provide the information that is assembled into a
CSR/integrated report because it is not just financial information that is being provided. Much of this
financial and non-financial information is prepared or encountered by management accountants in their
day-to-day work. An important skill for management accountants is the ability to summarise a large amount
of detail into a succinct yet accurate description of business achievements and prospects from more than
one perspective (i.e. financial, environmental and social).
You can view a report commissioned by CPA Australia on the views of stakeholders regarding inte-
grated reporting. It is available via the CPA Australia website at: cpaaustralia.com.au/~/media/corporate
/allfiles/document/professional-resources/sustainability/report-exploration-stakeholder-needs-integrat
ed-reporting.pdf?la=en.
The next section discusses how the different information needs of stakeholders can be identified
and managed.
STAKEHOLDER MANAGEMENT
As discussed earlier, management accountants should always be able to identify who the stakeholders are
and strive to satisfy the information needs of these stakeholders. The objectives of stakeholder management
are to:
• anticipate the information needs of stakeholders
• determine the likely value the management accountant can contribute
• assess stakeholders’ importance to the functions and performance of the organisation and its organisa-
tional sub-units
• assess the power wielded by a particular stakeholder.
The stakeholder grid or matrix shown in Figure 2.2 is a useful tool for this analysis. It combines two
dimensions:
1. interest in the matter under consideration
2. power.
FIGURE 2.2 Stakeholder grid
High
High power, low interest High power, high interest

Keep satisfied Manage closely
(Protect) (Key players)
Power
Low power, low interest Low power, high interest

Monitor Keep informed
(Minimise effort) (Show consideration)
Low
Low Interest High
Source: Based on Mendelow, A. L. 1981, ‘Environmental scanning: The impact of the stakeholder concept Stakeholder Mapping’,
Proceedings of the International Conference on Information Systems, Paper 20, pp. 407–18, accessed July 2018,
https://aisel.aisnet.org/icis1981/20/.
Essentially, the stakeholder grid analysis is used to:

1. review and evaluate particular stakeholders and assign them to a quadrant in the matrix as a result of their
interest in the matter being considered and their power or influence on the matter under consideration,
in order to,
2. determine the appropriate effort to be allocated to managing like-classified stakeholders.
These classifications are shown in Example 2.1.
Pdf_Folio:50

EXAMPLE 2.1
Stakeholder grid
Boots-4-All Pty Ltd (Boots-4-All) is a stock exchange-listed business. It is considering closing its local
manufacturing plant and relocating to a country with cheaper labour costs and less government regulation.
Boots-4-All intends to ship its products to the home country and continue to supply its existing customers.
It is important first to identify the affected stakeholders:
• the board of directors and the senior management team responsible for planning and executing the
change
• the stock exchange, to ensure share buyers and sellers are informed, as well as current shareholders
• banks and financiers, especially if the change affects any borrowing restrictions or bank covenants
• employees and their unions—some will be affected by the change because they may become
redundant, while others may not be impacted
• customers—these are high risk to Boots-4-All because they still need to be satisfied as to delivery and
quality if production is moved offshore
• existing suppliers who may lose their ability to supply Boots-4-All.
A stakeholder grid drawn by the management accountant to show relevant internal and external
stakeholders may look like the following:
High
Keep satisfied Key players
• Sales and marketing employees who are • Board of directors
largely unaffected other than needing • Senior management
to keep customers satisfied • Stock exchange
• Shareholders
• Financiers
• Customers who need to be reassured
about continuity of supply
Power
Minimal effort Keep informed

• Government regulators who will no • Local suppliers who will be replaced
longer be able to affect the organisation • Employees who will become redundant,
• Employees unaffected by the change and their trade unions
in production
Low
Low Interest High
Inspection of this grid suggests that maximum effort will be directed to stakeholders in the upper
right quadrant because they are the key players for whom management accountants provide information
and analysis. On the other hand, minimal effort will be directed towards stakeholders in the bottom left
quadrant. The top left quadrant contains stakeholders who will need to be kept satisfied in terms of their
particular interests, while the bottom right contains the stakeholders to be kept informed and supported
because they often have highly valuable insights into organisational functioning but little power to enact
improvements.
In some cases it is necessary to drill down further to identify the particular concern of the stakeholder.
Stakeholder power shows the extent of influence the stakeholder has over the work and projects of
management accountants. Organisational studies of power emphasise that stakeholder power should not
be underestimated. A typology of stakeholders based on their power was developed by Mitchell et al.
(1997). According to this typology, stakeholder power is based on three factors:
1. the extent to which a stakeholder can influence an organisation
2. how legitimate the stakeholder is seen to be by the organisation
3. how time critical the stakeholder’s support is to the organisation.
For example, a stakeholder who does not have immediate, high power may have indirect power through
their contacts or expertise in the management accountant’s work or projects.
The stakeholder interest level shows the expected attention the stakeholder will give to the work or
projects. However, the interest of stakeholders can change quite quickly in a dynamic business where day-
to-day attention is focused on meeting targets, satisfying customers and improving quality. Depending on
Pdf_Folio:51

the stakeholder’s perception of whether a management accountant’s analysis is useful, the stakeholder may
become attentive and motivated to share in its success, or become less interested in order to avoid being
associated with the analysis.
An example at the time of writing is the Australian Royal Commission into Misconduct in the Banking,
Superannuation and Financial Services Industry. While banks and other financial services organisations
have routinely been regulated, there has been a significant shift in the power of stakeholders—particularly
indirect stakeholders—throughout 2018 as a result of increased scrutiny by the media and politicians. This
has brought into sharp focus the practice of banks. As a result of this exposure, the focus of banks on their
shareholders, often seen as the primary stakeholder, has been called into question.
A potential role for management accountants is to draw the attention of senior management away from
the profitability of banking products and towards the long-term effects of a higher degree of regulation
by government agencies and the potential loss of business due to the severe reputational impact on the
major banks.
Therefore, conclusions drawn from the stakeholder grid should always be provisional and subject to
continuous review.
STAKEHOLDER RISK MANAGEMENT

Internal stakeholders will often make multiple demands on management accountants for information and
analysis to support their own projects. Managing stakeholder expectations effectively will involve assessing
business risks and opportunities—that is, they can be allocated probabilities and impact. There are three
basic steps in the risk management process:
1. identify threats—that is, harm or conflict
2. assess their likelihood—that is, probability
3. determine their impact or consequence.
The outcome of this analysis should be a clear list of actions that can optimise the management
accountant’s work. The information collection and analysis work of management accountants should be
prioritised in terms of immediate, high pay-off/return activities.
Risk management requires the consumption of resources and this should always be evaluated in terms
of opportunity cost—that is, whether the resources may be better spent on alternative, more profitable
activities.
Example 2.2 shows how the stakeholder management process could be used by an online retail company.
EXAMPLE 2.2
Evaluating the information needs of stakeholders

Distribution Resources Co. (DRC) is a large, nation-wide company that sells products sourced from
hundreds of suppliers around the country. DRC has a large central warehouse where it holds its inventory
of many thousands of individual products. Customers use an online portal to select and pay for goods
that are then picked by warehouse staff and dispatched around the country using subcontracted transport
companies.
DRC has a board of directors comprising three independent members and three senior executives. The
board has only ever been interested in monitoring financial results for reporting to shareholders. DRC
has always been a sales and marketing-driven company with territory managers located in six different
regions. While the business is profitable, sales growth has been lower than target. The central purchasing,
warehousing and logistics function is expected to satisfy customer orders within 24 hours of receiving the
order. The human resources (HR) department recruits and trains a large number of casual employees who
are mainly unskilled. These staff take customer orders, pick the goods and assemble them for dispatch,
awaiting transport to customers. However, absenteeism and staff turnover are problems.
DRC’s business is suffering because of the emergence of Amazon, whose business model is more
sophisticated than that of DRC. The sales and marketing director, who sits on the board with the CEO and
chief financial officer (CFO) is constantly critical of the company’s ability to compete due to out-of-stock
products, picking errors (incorrect goods dispatched) and delivery delays, all of which contribute to an
NPS that has reduced over the last two years.
Dingxiang, the management accountant at DRC, wants to provide the most relevant information for
management to assist them in dealing with these issues. To do this, Dingxiang will:
• perform the stakeholder grid analysis
• use the grid as a tool to provide relevant information to different functional managers
• use the grid to make recommendations to management.
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The following stakeholder grid classifies DRC’s stakeholders into four groups. For each group, different
information needs to be provided.
High
Sales and marketing Board of directors

Geographic business unit managers Senior management
(Keep satisfied: Protect) (Key players)
Power
Purchasing, warehousing
Employees
and logistics HR
(Minimise effort)
(Keep informed: Show consideration)
Low
Low Interest High
The stakeholder grid categorises the four groups by their power and interest in the organisational
problem. Further detail of this categorisation is shown in the following list.
High power/high interest
• Board of directors—although some members are executive directors and will naturally have access to
more detailed information, the focus of decision-making at the board of directors level is aggregated
data that identifies risks to achieving the organisation’s overall strategy and the performance expecta-
tions of its investors and financiers.
• The senior management team needs information at the level of each functional area, geographic territory
and product group to hold business unit managers accountable for their performance.
High power/low interest
• The sales and marketing function is focused on customer satisfaction and generating the level of sales
necessary to achieve sales targets. As the driver of the business strategy, it exercises a high power over
pricing, advertising and promotion and geographic sales activity but has less interest in the problems
of purchasing, warehousing and logistics.
Low power/high interest
• The purchasing, warehousing and logistics functions have always had low power in the organisation.
They are expected to fulfil the sales orders given to them, even when suppliers let them down and they
are out of stock. This function has great interest in the orders received but little information on sales
forecasts and virtually no control over lead times from suppliers or delivery days promised to customers.
• The HR function has little power in the organisation but is required to maintain adequate staffing levels
to maintain service levels in the warehouse.
Low power/low interest
• Employees are largely unskilled labour on casual employment contracts. They have no power and have
little interest in the business other than being paid weekly.
The next step is to consider the information they should be provided.
Stakeholder Key information requirements
Board of directors • Financial results compared to budget

• Competitive position versus Amazon
• NPS
Senior management team • Financial results by territory compared to budget

• Budget versus actual costs (AC) by function
Sales and marketing team • Sales by product group compared to budget

• Sales by territory compared to budget
• Credit notes by reason
• Customer complaints
• NPS by territory
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Stakeholder Key information requirements
Purchasing, warehouse and • Out-of-stock data/Stock below minimum level

logistics team • Picking errors
• Lead time from order to delivery
HR team • Headcount compared to budget

• Staff turnover
• Staff absenteeism
• Recruitment cost per employee
Employees • Position description/List of tasks

• Training events
• Payslips
The stakeholder grid enables Dingxiang to direct his own resources to provide information to the
responsible departments to enable those departments to carry out their functions.
In completing the analysis, it is likely Dingxiang will be able to make some recommendations.
For example:
1. Can the sales and marketing function provide more accurate sales forecasts to enable better purchas-
ing and stock-holding practices? Dingxiang may be able to assist by producing data on sales trends
by product group and by territory, and evaluating minimum stock levels.
2. Would regional warehouses be a more effective means by which customer orders could be satisfied?
Dingxiang may be able to undertake a cost–benefit analysis of this.
3. Would improved staff retention and staff training lead to better results for the business? Dingxiang
could work with the HR function to calculate the cost of staff turnover, recruitment and absenteeism
and undertake an analysis of whether permanent employment of more skilled staff would generate
benefits exceeding the cost.
4. Should the board receive more operationally focused performance information to enable it to identify
problems that give rise to a lower NPS and impact on financial performance? This could help to redress
the power imbalance between the business functions.
Example 2.3 highlights the management accountant’s role in providing useful information for manage-
ment decision-making.
EXAMPLE 2.3
Information for the board

Background
ElectricThingz Pty Ltd (ElectricThingz) is a medium-sized manufacturing plant that has over 80 wholesale
branches throughout Australia. ElectricThingz specialises in items used by electricians, including electrical
and data cables, lights and circuit boards. The defence industry is a major customer group.
A review of information for management was conducted for the company by its management accoun-
tant. This revealed that the board of directors was receiving reports containing information about sales
and receivables with a one to two year time horizon. This showed information by branch, produced by
the accounting system. The accounting system calculated aggregate gross margin and the ageing of
accounts receivable (AR) as an exception report for debtors over 90 days.
However, the board does not receive any information about the external environment such as socioe-
conomic factors.
Question
What recommendations should the management accountant make to improve the information provided
to the board of ElectricThingz?
Possible recommendations
The management accountant should recommend that the board be provided with information that has
a strategic horizon of two to five years to help the board to set a clearer strategic direction. Although
there may be very good reasons for the short-term information the board currently receives—for example,
it may have discovered that debtors were not being carefully managed and bad debts were unacceptably
high—once it ensures that receivables management is under control, it should readdress its priorities and
move towards focusing on the future.
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Specifically, the information should separately identify the primary customer groups—electricians and
defence contractors—each group likely having a different strategic focus and information requirements.
If the management accountant believes the board has a good understanding of the business,
they should ask the board what information it thinks it needs to support strategy and control—
for example, information about socioeconomic trends and government plans, the level of immigration,
housing construction, level of spending on defence, etc.
This board is currently taking a reactive role in relation to a current problem of large outstanding
receivables. Alternatively, a more proactive approach is for the management accountant to consider
the wide variety of information that the business has and provide reports to the board that the
management accountant considers may inform and assist the board. The management accountant may
also recommend obtaining a specific report from a consultant with expertise in other areas, to give the
board information on which to base its strategic plan, if there is no expert available in house.
QUESTION 2.1
Kim Koelski has just been hired as the management accountant at Pinewood Timbers Ltd
(Pinewood Timbers), a manufacturer of timber veneers and laminated beam building products that
has been recently listed on the stock exchange.
On Kim’s first day she meets with her manager, the CFO and the CEO. They are concerned about
whether the six new board members have adequate information to provide adequate governance
for the business (this has been the reason why some major competitors have failed).
What advice should Kim provide the CEO and CFO about the kind of information the new board
members should routinely receive?
QUESTION 2.2
Following on from Question 2.1, it is now Kim’s second day. Kim has found that there are two
new managers (logistics and sales) who are still learning their operational job roles. Since Kim is
investigating the information needs of the new board members, she realises that the information
needs of the new managers may overlap with some of the information she needs to provide to the
board members. So she plans to approach the two new managers.
(a) What advice should Kim provide the CEO and CFO about the kind of information that the new
managers should routinely receive?
(b) What are the soft skills that Kim will need to display in approaching the new managers?
This part of the module has identified the ways in which information is oriented to different groups
known as stakeholders, both external and internal to the organisation. The next part of the module examines
the types of information the management accountant can prepare and use.
PART B: INFORMATION, INFORMATION

SYSTEMS AND THEIR EFFECT ON
ORGANISATIONAL DECISION-MAKING
AND PERFORMANCE
The management accountant is responsible for collating, analysing and interpreting information from
different sources and providing meaningful information to managers in a form they can readily use for
decision-making, and particularly to support the formulation and implementation of strategy.
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This future orientation means that the management accountant needs to draw information from multiple
sources, such as:
• the financial accounting system
• operational information on purchasing, production, distribution, sales, etc., which will comprise detailed
and current financial costs and non-financial performance information
• external data that can be used for benchmarking purposes (benchmarking is described in detail in
Module 5)
• other external data—for example, economic and industry trends, competition.
IMPACT OF INFORMATION SYSTEMS ON STRATEGY

FORMULATION AND IMPLEMENTATION
The current design and scope of the information system in use can affect the support that the management
accountant can provide to management for strategy formulation and implementation. A simple financial
accounting system will provide information on costs and revenues for annual and monthly financial
reporting, but may be very limited in its ability to assist in comprehensive analysis of wider ranging data.
By contrast, an ERP (discussed later) will comprise modules that encompass more detailed information
on, for example, sales, purchasing, production and distribution.
Similarly, if a business uses limited non-financial performance information, the management accountant
will not be able to undertake an analysis to supplement financial data, while a business that uses a balanced
scorecard (BSC) (discussed in detail in Module 5) with data from different perspectives will be able to
provide a greater level of support for strategy formulation and implementation.
Costs and benefits of information

The specific impacts of information on the organisation are its costs and benefits. There are four main
information costs:
1. gathering
2. storing and protecting from unauthorised access
3. analysing and interpreting the information—often the most difficult and time consuming aspect
4. presenting the information to users in a clear and concise way.
Due to these costs, information gathered and analysed should always be directly related to the decisions
for which it is used (discussed in more detail in Part D of this module).
Much of the information used in organisations is the product of information systems that organise
and analyse information. The system may be manual, semi-automated (e.g. spreadsheets) or automated.
Table 2.3 summarises the common functions of an information system. It shows how information is
produced and used.
TABLE 2.3 Functions of an information system
Function Description of function Examples of information production or use
Input Provides data to the system Source documents evidence transactions

or business events
Processing Converts the input data into output— Analysing sales to inform inventory decisions based
usually in the form of a report on whether seasonal factors apply
Output The particular purpose, format and Sales reports on daily transactions provide
frequency of the report information on product groups to determine sales
trends by territory or customer group
Feedback When outputs of a system become Where sales of inventory reach a certain level,
inputs a reorder is triggered that may need managerial
approval
Control Influences behaviour and standards Comparison of actual to budget sales; calculation of
of comparison inventory turnover ratio and debtor days compared
These may be built into the system or to target
separately arranged
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DIFFERENT TYPES OF INFORMATION SYSTEMS
The functions performed and the reports produced depend upon the type of information system. There are
different levels of information system, and these are represented in Figure 2.3. Each is then described in
more detail in the following section.
FIGURE 2.3 Different levels of information system
Decision
support system
Customer relationship Enterprise resource Production planning

management system planning system takes a and control systems
whole-of-business approach,
integrating data flow and
access to information across
the whole range of business activities
Management accounting system includes non-financial

performance, trend analysis and drill-down capability with
comparison against targets and benchmarks
Transaction processing system produces invoices, payments,

audit trails and financial reporting
TRANSACTION PROCESSING SYSTEMS

A transaction processing system (TPS) creates and records the routine primary activities or business
functions (e.g. sales or service) and may perform support functions (e.g. procurement, payroll). So a
TPS will handle giving a quote, recording a sale, return of goods from a sale, payments by cash giving
a receipt, and payment on credit giving a credit invoice. It may also handle making purchases, receiving
materials or goods, placing those goods into inventory and restocking. TPSs are the main source of financial
accounting reports.
The major limitation of a TPS is that it is focused on historical transactions and so is incapable
of providing little more than trend analysis to managers.
MANAGEMENT ACCOUNTING SYSTEMS

There are two roles for management accounting systems (MASs). The first is to identify, analyse, classify
and record accounting transactions. The second is to provide a source of information for stakeholders to
support decision-making. Irrespective of whether an MAS is manual or automated, there will be source
documents that initiate the transaction and act as a reference when there are any questions about the
integrity or particulars of the transaction.
The MAS goes further than the general ledger-based system used for external financial reporting. It is
an organised process or system that identifies, collects, processes and communicates financial and non-
financial information to relevant stakeholders, based on their entitlement to receive the information. Ideally,
the MAS will use information from all relevant business functions.
Managers are users of the MAS because it should help them:
• recognise where value is being created
• manage that value
• protect it and allow it to be captured.
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This is difficult if the MAS is simply an extension of the accounting system centring on the general
ledger. A test to check whether the MAS is sufficiently broad is to ask the following questions:
• Does it capture revenues and allow them to be detailed through drill-down?
• Does it capture costs and allow them to be detailed through drill-down?
• Does it enable the analysis of revenue and cost by important business segments? Examples of business
segments include product/service group, geographic area, business unit, customer group or distribution
channel.
• Does it capture process efficiency and effectiveness measures that are non-financial and allow them to
be detailed through drill-down?
• Does it capture quality measures that are non-financial and allow them to be detailed through drill-down?
• Does it include benchmarks and apply them against the listed measures?
• Does it capture customer satisfaction measures that are non-financial and allow them to be detailed
through drill-down?
Answers to these questions can reveal whether the MAS is receiving input information from other
systems including:
• sales and marketing
• production
• logistics
• warehousing
• HR
• project management.
MASs will vary in their usefulness for strategy formulation and implementation depending on how
well they integrate information from financial and non-financial sources, and from different functional
areas. These systems tend to capture and report different information, but in the absence of a more
sophisticated database may be unable to integrate or reconcile data from different sources. They also
tend to be hierarchical, following the organisational structure, rather than process-driven, reflecting the
through-organisation way in which businesses are typically carried on.
The usefulness of MASs for strategy formulation and implementation will depend on how well those
systems are designed and integrated.
Separate systems have been developed by software suppliers to attempt to solve the problems of
production and marketing. These are:
• production planning and control systems
• customer relationship management (CRM) systems.
PRODUCTION PLANNING AND CONTROL SYSTEMS

In a manufacturing business, there will be a production planning and control system that determines
production arrangements—availability of raw materials, production scheduling and job sequencing, and
labour allocation. Where information is fed to the production system in real time and machinery is
automated, it can operate without manual intervention. These systems have various names such as process
control systems and computer automated systems and are developments of materials requirement planning
(MRP) and manufacturing resource planning (MRP2) systems.
Production planning and control systems can provide powerful data to support decision-making and
strategy formulation and implementation by providing accurate information about, for example, standard
cost revisions, waste and rework of products, and employee unproductive time.
CUSTOMER RELATIONSHIP MANAGEMENT SYSTEMS

‘Customer relationship management (CRM) refers to the practices, strategies and technologies used to
manage and analyse customer interactions and data throughout the customer lifecycle’ (Tech Target 2018).
This helps the organisation to improve and deepen customer relationships, promote customer retention
and maximise the value of the customer to the entity.
CRM systems synthesise customer related information from many different sources to inform the
organisation about, for example:
• customers’ product and service needs
• customer communication preferences
• customer socioeconomic and demographic profile
• buying history—for example, what, where, how much, how frequently
• buying preferences—for example, in-store, online.
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Modern CRM systems extend ‘customer’ data to include sales leads and prospects. CRM systems like
Salesforce facilitate sales forecasting, centralise contact management information, track sales history and
help a business focus on targeting new customers and increasing sales to existing customers.
ENTERPRISE RESOURCE PLANNING SYSTEMS

To overcome the limitations of MASs, and to incorporate developments in standalone systems, software
package vendors have attempted to integrate TPSs, production planning and control systems and CRM
systems into a single system—or ERP system.
ERP systems take a whole-of-business approach. They help to integrate data flow and access to
information across the whole range of business activities. They typically capture transaction data for
accounting purposes together with other data ‘modules’ such as customer, supplier, production and
distribution data. This data is made available through data warehouses from which custom designed reports
can be produced (Collier 2015, p. 191).
High-end ERP systems should operate in real time, provide all the previously identified functions,
provide a consistent look and feel across functions, and use a central database. The management accountant
should therefore be able to rely on the ERP system to provide up-to-date information—as at the time it
was retrieved; however, this is not always the case.
The benefit of ERP systems is that they overcome the limitations of MASs by integrating data from
different modules (different business functions) into a single database—so, there is no duplication of data
(leading to inconsistency) and a single master file that can be updated. For example, customer contact
details will be accessed by AR, by the sales department, and for CRM purposes.
The ERP system provides wide-ranging information to support decision-making and strategy formu-
lation and implementation—including the ability to track and manage actual performance compared
to plan.
DECISION SUPPORT SYSTEMS

Decision support systems (DSSs) are information systems that possess an interactive capability and are
able to answer ad hoc questions. They can incorporate statistical modelling and spreadsheet capabilities.
Importantly, DSSs can access not only data from within the ERP (or equivalent) system, but also external
databases containing economic or industry data (e.g. stock exchange data, data from the Australian
Bureau of Statistics (ABS)). DSSs can perform simulations, sensitivity or ‘what if?’ analyses. The
most sophisticated of these systems may be called ‘expert systems’ and may use elements of artificial
intelligence (adapted from Gelinas et al. 2012, p. 168).
DSSs are the most powerful system for supporting strategy formulation and implementation because
they provide not only a wide variety of the organisation’s data and externally available data, but also remove
human biases by finding patterns and projections that support senior management decision-making.
KNOWLEDGE MANAGEMENT SYSTEMS

Although not really an information system in the sense of a technology, knowledge management is
important because it encompasses technology-based systems, formal systems and procedures, and the
informal ‘way we do things here’ that is often embedded in an organisation’s history and culture. Other
than the information systems described in this module, the organisation’s corporate memory is contained
in manuals (such as standard operating procedures), standard costing systems and training programs
(reflecting the ‘lessons learned’).
Knowledge management systems (KMSs) enable the acquisition, capture, distribution and application of
knowledge and expertise gained by an organisation. KMSs are at times referred to as ‘corporate memory’;
they assist with the retention of vital knowledge from key employees and often contain information about
lessons learned.
KMSs are vital sources of information during periods of rapid change and high staff turnover; assist
with learnings in complex project management; and, if used well, can be a key strategic tool for developing
and protecting an organisation’s sustainable competitive advantage.
Knowledge management is discussed in more detail from the perspective of projects in Module 4.
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QUESTION 2.3
ERP systems have now been around for such a long time that they are fully featured and extremely
reliable. Should most large and medium organisations (except family corner store businesses)
install them?
QUESTION 2.4
Thaddeus & Smart (T&S) is a medium-sized chain of retail clothing stores with a sales growth over
the last 10 years that has averaged 5 per cent per annum. The company has recently experienced
significant competition from online sellers whose prices are lower than those of T&S. Despite their
considerable investment in technology, the competitors do not face the same store rental and
staffing costs incurred by T&S.
The board of directors of T&S is considering investing in an online ordering system for its
customers, and replacing half of the retail stores with a central warehouse from which to dispatch
customer orders. T&S has had an ERP system incorporating a CRM system for several years and
has asked Tim Smith, the management accountant, what information might be available to support
the board’s strategic plan.
(a) What type of good quality information could be available for Tim to inform the board of from
T&S’s ERP and CRM systems?
(b) What other useful information might Tim research that might not be in the ERP or CRM systems?
SOURCING, AGGREGATING AND INTEGRATING

INFORMATION
So far, the information discussed in this part has been in a ‘ready-to-use’ form, however this is rarely the
case. Typically, it has to be obtained from different sources, assembled and integrated. There are many
sources and different approaches to aggregating and integrating. These are discussed in the following
section.
SOURCE OR DOMAIN OF INFORMATION—EXTERNAL

VERSUS INTERNAL
The management accountant would be expected to find information from many sources, including
information that is external to and internal to the organisation, as summarised in Table 2.4.
TABLE 2.4 Important external and internal sources of information
External Internal
Government agencies—e.g. Reserve Bank of Australia Discussions with functional managers

(RBA) for monetary policy and inflation rates, the
consumer price index (CPI)
Australian parliament—economic policies including the Board and senior management reports—summaries of
annual federal budget, which sets taxes and rates performance, prior decisions, plans and proposals
Credit ratings—e.g. Standard & Poor’s, Dun & Reports from operations—e.g. sales, costs,
Bradstreet profitability—financial information and commentary
from managers on performance
Industry information provided by major employer Non-financial information on, for example, cycle time
associations—e.g. chambers of commerce— (order to delivery), on-time delivery, quality, productivity
and specific industry associations such as the Minerals and customer satisfaction measures such as NPS
Council of Australia
Stock exchanges and commodity exchanges The strategy of the organisation as reported in
the approved strategy document
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Publications of international bodies and countries— Specific analyses—e.g. to identify and assess the
e.g. United Nations, World Bank, US Treasury, Australia resources of the organisation; or the capital budget,
China Business Council with its analyses and supporting documentation
Secondary sources: Documentation from projects—e.g. proposals,

• business newspapers—e.g. Australian Financial specifications, plans
Review, The Australian Business Review
• business magazines—e.g. Forbes, Australian
Financial Review Boss, The Australian Deal
• journals—e.g. INTHEBLACK
These contain reports of business activities, interviews
with business identities and commentators, comments
on business activities, opinions on business activities
and business trends
Historical information—sourced from academic libraries

and specialised libraries associated with industry
associations
Having the information available from different systems creates richer, more complex and therefore
potentially more useful information, as suggested by the examples in the Table 2.5.
TABLE 2.5 Integrating information from different systems for decision-making
Integrated information
Source system #1 Source system #2 to support
Revenue by customer + Costs by customer individual → Determining customer profitability

individual or group or group as an individual or group measure
Sales demand by season + Production costs to allow → Setting product prices, monitoring
and any effects of advertising target pricing actual versus standard costs of
or promotion production over time, determining
product profitability
Sales system to provide + Production system to provide → Comparing alternative supplier

volume estimates over quantities used and usage rate costs, setting the standard
a period by month or other period purchasing costs of raw materials
Sales of existing products with + Fixed costs and other → Deciding whether to close a
margins commitments factory
It should be noted that there are also many occasions where information needs to be integrated and the
sources are not systems. For example, discussions with managers or employees may elicit information
they possess from experience or reflection on operations. The experience of non-financial managers
should always be considered by the management accountant when analysing and interpreting non-financial
information.
METHODS OF AGGREGATION AND INTEGRATION OF

INFORMATION
The purpose of aggregating or integrating information is to compile and present it in a way that delivers
greater value than its components possess individually. Management accountants may also aggregate
information to increase confidence in it and detect apparent anomalies. Five common forms of aggregation
are outlined in Table 2.6.
Aggregation that results in summary figures should be capable of being investigated—known as ‘drill-
down’ capability. It ensures the integrity of the information is preserved because the same underlying data
used in the calculation is then made available for inspection and verification. The idea of granular data is
important because in most cases, the more granular (or detailed) the information is (such as drilling down
through a total sales figure by period of time, customer, territory or product), the more accurate it will be
for decision-making.
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TABLE 2.6 Common forms of aggregation
Type of aggregation Description/explanation Example
Aggregating to get the This may occur where totals are lacking Imported volumes may be added
‘bigger picture’ or are unreliable. Estimates may be to internal production volume and
formed from proxy data. estimated competitor volume to
estimate market size.
Triangulating This uses multiple sources of Unexpectedly low Christmas sales may
information to ‘fill in the gaps’ or make be explained by external factors such as
sense of phenomena. low consumer confidence and interest
rate increases—so customers have less
disposable income.
Combining existing This may use existing data or be A company that decides to use the
information to create new the prelude for advanced statistical DuPont return on equity measure will
measures analysis. assemble information for its three
different dimensions—operating
efficiency, asset use efficiency and
financial leverage.
Aggregating to produce Typically these are averages, indexes or The average customer order value in
new, high-level summary ratios. dollars or the gross sales per employee.
measures
Aggregating where Many summary reports contain line For example, Kaplan and Norton
different information is items that do not have an arithmetic (2001) suggest that the BSC should be
presented together relationship but are simply presented connected with strategic objectives in
together for convenience and ease of a cause and effect relationship. This
review. leads to a hierarchical BSC that is
cascaded down through the levels of
the organisation so that managers are
all being measured in relation to the
highest level strategic objectives.
Example 2.4 illustrates how sales data can be ‘drilled down’ to a granular level to enable managers to
make decisions about strategic choices.
EXAMPLE 2.4
How sales data can be ‘drilled down’

A company has annual sales of $4 million that are reported on annual financial statements.
For management purposes to support strategy formulation and to manage performance, this total figure
can be drilled down, depending on the information that is required:
• by month
• by product group
• by territory.
Sales by month—this would reflect seasonality
April … December
(these would be separate columns,
January February March each with a monthly figure) Total for year
$300 000 $350 000 $400 000 $4 000 000
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Sales for the year by product group
Total all
Product group A Product group B Product group C Product group D products
$1 200 000 $800 000 $500 000 $1 500 000 $4 000 000
Sales for the year by territory
North region East region South region West region Total all regions
$300 000 $1 600 000 $600 000 $1 500 000 $4 000 000
More detailed analysis could drill down even further, for example to the sales of Product group B in
the South region in the month of March. This would provide far more granular performance management
information for decision-making to support strategy formulation, implementation and control.
The kind of information in Example 2.4 might also be supplemented by non-financial information. For
example, information on customer satisfaction (e.g. NPS), on-time delivery and product quality could be
used to enhance interpretation of the financial information. A BSC approach could also be used.
The BSC (discussed in more detail in Module 5) integrates information in three ways:
1. It combines financial with non-financial information and stratifies that information in four perspectives:
– financial
– customer
– business process
– learning and growth.
2. It cascades information down to the appropriate organisational layer (strategic, tactical, operations) so
that appropriate information is available for performance management.
3. Actual performance can be compared with target to support decision-making. This is an important
element of integrating information.
The management accountant can add value to information by aggregating and integrating information
if they also consider its attributes. This is discussed in the next section.
CHARACTERISTICS AND LIMITATIONS OF

DIFFERENT KINDS OF INFORMATION
When information is examined in detail it is seen to have characteristics and limitations. The next section
summarises common characteristics before considering limitations.
DIMENSIONS OF INFORMATION
It is always useful to consider a broader view of information when initially gathering or being given new
data. This helps to identify any limitations or lack of balance. One approach is to examine information
across three dimensions:
1. domain—external versus internal (discussed earlier)
2. type—financial versus non-financial
3. source—primary versus secondary.
Financial versus non-financial information

Financial information is information that is expressed in dollars. A variation of financial information is the
calculation of financial ratios such as return on investment (ROI) or gearing ratio, which express financial
information through percentages.
Non-financial information is expressed in non-dollar terms. Often, there are vast quantities of informa-
tion held by organisations, such as the number of products sold, hours worked (in a factory or a professional
service firm), cartons delivered to customers, etc. Wherever possible and cost effective to do so, this
information should be captured (see the earlier discussion about ERP systems) to provide a more holistic
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picture of the organisation than is provided by financial information alone. This kind of information is
invaluable in strategy formulation and implementation.
There are many measures of non-financial information—these can include measures of customer
satisfaction such as NPS and customer retention. Other measures include on-time delivery, cycle time
(from order to delivery) and product or service quality.
Some information is expressed in a combination of financial and non-financial measures. In retail
stores, common measures are sales per square metre of floor space, or sales per employee. Quality can
be expressed as a percentage of production cost or sales revenue (such as rework or waste as a percentage
of cost or sales).
Module 5 describes the importance of non-financial performance measures in detail.
Primary versus secondary sources of information

Whether something is a primary or secondary source of information refers to the closeness of the
information to its source and how much the information may be relied on.
Primary sources generally come directly from the original transactions. They are controlled by
the organisation and are therefore readily verifiable.
The accounting transactions of a business are primary sources, as are non-financial records under the
organisation’s control, such as quality and on-time delivery.
Secondary sources of information are from sources external to the organisation. The organisation has
no control over this information and is unable to verify its accuracy. Information from some sources, such
as the ABS, can be relied on because they have a reputation for accuracy and high-quality information.
Reports from management consulting firms will also come with a high reputational element. By contrast,
information from newspapers, magazines and books is less reliable although these sources may still provide
some useful information.
LIMITATIONS OF DIFFERENT KINDS OF INFORMATION

With all information, it is important to be selective in choosing a source, and to qualify the information
to ensure that the consolidation and aggregation of different sources of information does not raise more
questions than it answers. Management accountants will always seek to qualify the information they obtain
by determining the circumstances under which it was collected, the time period, the quality assurance
used by the collecting agency, and the limitations perceived by the responsible collecting authority. Data
collected externally (and in some cases, internally) often has three limitations:
1. It may use non-uniform measures and bases for collecting data resulting in information that is not
comparable. For example, in the absence of accounting standards that define gross profit, different
companies and industries calculate this figure in different ways in their annual reports.
2. The data may be incomplete or only available for limited periods of time. For example, some ABS
information lags the period it covers by some time, which has limitations for current decision-making.
3. The data may have been originally collected for other purposes, which may affect its quality. For
example, a consultancy firm may have produced an industry report for a particular purpose and hence
omitted valuable information. A business using that report for a different purpose may therefore not be
provided with an accurate or more complete picture.
Considering these various limitations, it is important to remember that there may be risks when
comparing or aggregating information.
SECURITY OF INFORMATION AND ETHICS OF INFORMATION

The management accountant will also want to respect any confidentiality and security issues that arise
from either the volume of data or the sensitivity of so much information from across the organisation
being available in one place. There may also be privacy issues, so the information should be stripped
of all identifying elements—for example, name, address, age. There is increasing evidence of industrial
intelligence (spying) that shows that information has value to competitors.
A related concern is the ethics of information regarding the creation, organisation, dissemination and
utilisation of information. The ethical management accountant will therefore be concerned with preserving
privacy and confidentiality of information—for example, by keeping it secure, using only authorised media
to transmit it, and not discussing it with third parties.
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CHARACTERISTICS OF INFORMATION
Management accountants use the characteristics of information to judge the suitability of the information
they gather and use. They must take into consideration the limitations of information, whether it is
financial or non-financial, whether it is internally or externally derived, and whether it is primary or
secondary source.
The two most important characteristics of information in this respect are:
• validity
• reliability.
These characteristics, together with those of clarity, timeliness, accessibility and controllability, are
discussed in detail in Module 5. However, it is important to recognise here that validity and reliability are
key characteristics that must be considered when information is used to support strategy formulation and
implementation and subsequently used for control purposes.
Validity, sometimes called accuracy, is how well information describes what it is meant to describe.
Information about a particular customer’s level of sales in a period is valid. However, information about
the cost of products sold to that customer may not be valid, because different overhead allocation methods
can lead to different costs. Validity may be called into question because different management accountants
may calculate the cost in different ways.
Reliability is about consistency, or whether information from different sources tells the same story; in
other words, whether we can rely on or trust that information.
Information about rework to faulty products in a factory is a valid measure of product quality, although
it would need to be supplemented by additional information about quality issues that were not found in
the factory but were raised by customers. This highlights the importance of triangulation—comparing,
integrating and reconciling information from different sources to provide a full picture so that reliable
judgments can be made.
Some information is valid but not reliable. So information from the ABS about retail sales trends has
high validity. However, it is not reliable for any one business to assume it will apply to them. For this, a
business would need to look at its own sales trend over time and determine what factors influenced it.
Some information is reliable but may not be valid for a particular purpose. NPS is a reliable measure of
customer satisfaction but would not be valid if we are considering a price increase and using the NPS to
predict customer retention.
Where information comprises performance measures, an important characteristic is that these are
SMART performance measures (Doran 1981). SMART refers to specific, measurable, achievable, relevant
and time-based.
Examples of SMART performance measures are provided in Module 5.
The usefulness of information for strategy formulation and implementation is enhanced if it satisfies the
qualitative information characteristics shown in Table 2.7.
TABLE 2.7 Qualitative information characteristics
Characteristics Description
Comparability Examines how two or more pieces of information resemble each other. For example, the
information may be from different years (to identify trends) or from another company (to
juxtapose performance).
Any use of similar information should be checked to ensure that the accounting methods
are similar—e.g. they use the same depreciation method.
Verifiability Refers to independent observers reaching consensus (but not necessarily 100%) without
simplifying the information.
Two methods of verification are used:
1. direct observation—e.g. stocktake
2. indirect checking of models, formulas or techniques—e.g. checking the input quantities
and costs for inventory.
Timeliness The degree to which older information ceases to be relevant. This encourages efficient
capture/collection and preparation. Decisions should be based on up-to-date information
but what is meant by the latest information is dependent upon the specific task.
Some information is timely long after the period in which it is reported. For example,
information about seasonal trends can be useful despite the current weather pattern being
an anomaly because the trend information allows this judgment to be made.
(continued)
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TABLE 2.7 (continued)
Characteristics Description
Understandability Refers to the interpretation of the information by a proficient user: that is, someone who
has reasonable knowledge of business and economic activities. Understandability begins
with classifying, characterising and presenting information clearly and concisely. Excluding
information to make it less complex may potentially mislead.
QUALITY OF INFORMATION
Wang and Strong (1996) propose four elements for analysing information quality, as outlined in
Figure 2.4.
FIGURE 2.4 Four-way classification of information
• Accuracy
• Objectivity
Intrinsic • Believability
• Reputation
• Relevance
• Value-added
Contextual • Timeliness
• Completeness
• Amount of information
Classifications
• Interpretability
Represen- • Format
tational • Coherence
• Compatibility
• Access
Accessibility • Security
This classification requires accuracy to be weighed up against the other dimensions. It allows a user to
describe information relevant to a particular task as good or poor by making judgments about each of the
dimensions.
Information quality is a measure of the value the information provides to the user of that information.
However, quality can be subjective in how it is perceived by users such that different users ascribe a
different quality to the information.
Each stakeholder is a customer and their needs must be satisfied by the information they receive. These
issues are explored further in Example 2.5.
EXAMPLE 2.5
Information assessment
EventArama Pty Ltd (EventArama) is an event management company. It approaches large corporations
offering to run their company events, such as new product launches, annual general meetings, sales
conferences and public sponsorships of football teams.
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EventArama has eight full-time employees (including six event managers) and numerous casual and
part-time employees who work on particular events. The event managers have high integrity and can
handle about 25 events simultaneously—because so much of the work is outsourced.
Since the company was founded three years ago, the business model has been that each event is
managed using a custom application in a database. The first-year turnover was $5 million. Four years
later, the turnover is forecast to be $45 million. The profit margin is around 9 per cent after deducting all
expenses except tax.
The expansion of the business has resulted in two new appointments:
1. Amandev, an IT manager, to develop and modify the database. He will replace the outsourced service
provided by a small group in the United States
2. Suyin, a management accountant, whose brief is to improve the profit margin and ensure that the
six event managers no longer operate as information silos. Competition has developed among the
event managers because they are responsible for arranging all their own resources for the events they
manage.
Consider how Suyin should approach the event managers and the kind of information she would be
seeking to discover.
Since Suyin knows the event managers operate as information silos, she can begin by asking them
about the information they need and why it is important from a customer (meaning their client) perspective.
Suyin’s findings are summarised in the following table.
Information feature
Dimension, attribute Finding Information needs assessment
Source
External versus internal Information about the client Many informal external sources
is sourced from them and of information are used and there
third parties. are difficulties when they are
Prior event information is contradictory—e.g. creditworthiness.
available internally if done by
the same event manager.
Primary versus Most external information is Some major disputes over payment from
secondary secondary. the client could be resolved by better
Most internal information is controls.
primary because it originates The classification of some information
from source documents. should be more detailed to allow easier
identification.
Dimension
Financial versus non- Financial information is profit, Financial information uses a quite short
financial cost of sales, etc. chart of accounts
Non-financial information is the Non-financial information includes
event size and level of luxury various event parameters: time of day,
(high, medium, low). length of event, number of guests, quality
of venue, quality of keynote celebrity and
location as distance from office.
Aggregation There is no aggregation Aggregation is used for the client’s

across events, but for the number of attendees, use of suppliers
accounts used for each event and costs.
the individual transactions
are aggregated.
Integration Source data for event planning Some sources are outside the accounting
is matched to actual event information system (AIS)—e.g. long-
instances. range weather forecast, industry
performance incentives and rewards,
proven sustainable supplies and
resources, more efficient ways to use
fixed assets.
(continued)
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(continued)
Information feature
Dimension, attribute Finding Information needs assessment
Qualitative
characteristics
Relevance The majority of decisions for The budget system works well but there
the event are based on the is a problem that it is more detailed than
budget set by the client and the the resulting invoice as the budget uses a
specification for the event agreed greater number of items.
with the client.
Faithful representation Some opinions are involved in Because there have been previous
deciding whether to accept a disputes with clients, Suyin will need
new client, as this is a decision to be involved at several stages to
of the individual event manager. create a process that properly and
legitimately ensures arrangements follow
Otherwise, most expenditure falls
best practice.
within the budget.
Variances to budget have to
be approved by the client and
therefore approval is obtained
before expenditure occurs so
that alternatives can be found
if the increase in budget is
not approved.
Comparability Event managers use information There are some variances between
from prior events and similar budget and AC that lead to new controls
events for different clients as the over expenditure being recommended
basis for their proposals for new and greater involvement with suppliers to
events. assure quality.
Verifiability An authorised client representa- This can be time consuming for both
tive is asked to confirm during parties and may require follow-up at the
the event and at the end of office in the following week.
the event whether there are
any issues that would prevent
billing the charges budgeted and
payment of those charges.
Timeliness There are some delays in Late billing from suppliers delays
payment of invoices because invoicing, so Suyin will need to evaluate
third parties are involved in the suppliers and their cost structures
event, and their invoices have to to determine whether to recommend
be received before the event is changing suppliers.
billed.
Understandability Some issues arise from clients Suyin will need to create a contingency
misunderstanding quotes and for events, and evaluate the capabilities
raising complaints that they and pricing of other suppliers.
know the same products and
services can be obtained from
other suppliers at lower prices.
Suyin draws the following conclusions:

• The budget document, which uses more detailed line items, should be reconciled with the new chart
of accounts so that they match and the additional detail is available to avoid discrepancies between
budget and actual.
• Some external information on which decisions are made is too informal and should be substituted with
formal information—for example, credit ratings. This should be accompanied by a credit application
that requires the client (applicant) to request credit and the amount and then reinforces the budgeted
and agreed amount to be charged to the client.
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• Lower prices for products and services may be obtained by having a pool of suppliers who quote on
the event, to create a competitive tender.
• Delays in billing arise from having separate systems, so greater integration is required. This will require
the AIS to recognise multiple supplier codes and product IDs.
• Discrepancies between budget and actual should not be investigated just using variances, but new
relationships with suppliers should be fostered.
EFFECTS AND CHALLENGES OF NEW INFORMATION

SYSTEMS AND PLATFORMS
Technology is constantly evolving so there are always emerging platforms for creating and disseminating
information. For example, recently there has been the adoption of data warehousing (with data mining)
and business intelligence (BI). The wide adoption of online sales and services has allowed very large data
sets to be aggregated. It is therefore important to be aware of the influence of the evolution of data analysis
resulting in ‘big data’. At the same time, ERP systems have emphasised transactions processing.
DATA WAREHOUSING AND DATA MINING

Data warehousing refers to both the system to analyse historical data derived from transactional sources
and the data model that stores data. A data warehouse is distinguished from a traditional database in
two ways:
1. The data warehouse may have redundant information—for example, former addresses of customers that
were current at the time the data was collected.
2. Once accepted into the data warehouse, the information is not updated. The data warehouse is therefore
programmed to aggregate data over a period of time—usually in predefined structures.
The data warehouse then becomes the repository for all enterprise data and is used for data mining. For
example, in a retail chain using loyalty cards, data mining may be used to learn more about a customer’s
purchasing preferences and habits to improve the effectiveness of marketing strategies, as well as increase
sales and decrease costs.
Data mining techniques include common statistical analyses (e.g. correlation) as well as advanced
computational techniques (e.g. cluster analysis). In addition, data integrity checks are conducted for
anomalies and dependencies.
BIG DATA
Big data is a large dataset that can comprise both structured (e.g. spreadsheet information) and unstructured
data (e.g. a collection of web pages). Traditionally, ‘big data’ was thought to be solely defined by its
volume. Large volumes of data were originally created as a by-product of e‐commerce. Laney (2001)
proposed the 3V model. He began with ‘volume’ to refer to the amount of data that arrives via a TPS, but
then added ‘variety’, because there are different types of data (e.g. text, html, images, audio, video), and
‘velocity’, which refers to the rate at which data arrives and which therefore implies a processing speed.
Big data presents two challenges to the management accountant:
1. building predictive models—for example, market success or performance failure, which can be tested
2. managing the data (to ensure that what has to be kept complies with regulations, is held for the
required period) and undertaking analysis of data to improve current business processes for competitive
advantage.
Analysis of data may use either the large volumes or selected extracts. Both are facilitated by
the classification system to ensure data is properly protected (e.g. for privacy reasons) and to ensure
appropriate legal compliance (e.g. legal discovery). Software vendors have developed databases and
analytical methods that can computationally reveal patterns, trends and associations. Initially these were
aimed at products and services, but recent developments allow human behaviour and interaction to be
analysed and predicted.
Big data may be stored by the organisation as part of its data warehouse or managed by third parties who
collect data on the organisation’s behalf. A common example is the expansion of loyalty cards from the
parent organisations’ products and services to multiple vendors. The Australian supermarket chain Coles
created the FlyBuys card to promote customer loyalty towards its supermarket sales. It has expanded its use
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by partnering with organisations who offer other products—for example, eBay, Garmin, National Australia
Bank Ltd—and services—for example, AGL, Medibank.
Issues with ‘big data’ and personal data used for profiling
Recently, technology companies such as Facebook and Google have been found to capture and use personal
data from their customers in ways that were unrelated to the personal transactions for which the data was
collected.
In at least one case (Cambridge Analytica) where permission was given, the information on each user’s
friends was included. There is also the issue of using this data to target advertising to individuals for
products and services they had not expressed interest in receiving marketing information about. This
raises both legal and ethical issues. There is no doubt that permission was sought and given by users
to obtain access to selected tools and services, although the wording did not detail the potential uses and
consequences—for example, extraction of keywords from email (Popkin 2018).
The issue appears to be that while users would never have given the government or a corporation
permission to monitor their activities and locations, this has occurred with Google and Facebook. Of
course, data can be deleted but this affects the efficacy of searches, and based on Facebook testimony,
absolute deletion may not be possible (Curran 2018).
Management accountants should be mindful of the legal and ethical issues associated with the use of
big data. Misuse of data, or even the perception of misuse, can lead to a loss of reputation and may have
a significant financial impact on an organisation, as evidenced by the shareholder value loss of $US119
billion experienced by Facebook in July 2018 (Chau 2018).
BUSINESS INTELLIGENCE
BI is a combination of the strategies and technologies used by organisations to analyse their information
to improve their operational and strategic decision-making. Although BI is related to big data, which uses
analysis to determine interrelationships among data, big data primarily supports implementing existing
decisions. BI may use the same statistical methods (correlation, cause and effect analysis, prediction) but
with the aim of developing computer-aided models for decision-making.
A number of terms have been used in conjunction with BI, including data discovery, executive
information systems (EISs) and online analytical processing (OLAP).
Data discovery features visual tools—e.g. pivot tables, geographical maps, heat maps. It aims to make
patterns or specific items immediately visible.
An EIS facilitates and supports senior executive information and decision-making needs by its orienta-
tion to defined organisational goals. A major EIS function is to combine internal and external information
and present it in an easy-to-use, convenient format.
OLAP performs three analytical operations:
1. consolidation—roll-up
2. drill-down
3. ‘slicing and dicing’ of data—arranged in multiple dimensions or ‘points of view’.
QUESTION 2.5
Tina Macto is the newly appointed management accountant for OutbackRail Pty Ltd (ORPL).
ORPL provides rail services to regional centres. Tina is responsible for producing a weekly financial
report for the regional managers, which is currently sent to them as an email attachment about four
days after the weekend (to allow for weekend services to be included). The report covers sales of
past travel bookings actually completed, and projected journeys based on sales for the next week.
When she was initially introduced to the regional managers, Tina was told by them that they did
not use the report for their decision-making. They explained that the two main kinds of decision
they need to make are:
1. whether to add carriages to the trains to cater for higher demand
2. when buses replace trains due to trackwork—what number and sizes of buses should
be ordered.
However, the regional managers told Tina that they tended to keep the train length standard.
Also, instead of being able to just use buses to cover the distance between major towns where
trackwork was occurring, they tended to replace the entire trip because this avoids the combined
train/bus logistics.
Suggest what Tina should do to discover the information needs of managers that would allow
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her to improve the report. State how she should evaluate the information attributes.

QUESTION 2.6
Bono Musk is the management accountant at StreemMov Pty Ltd (StreemMov), a start-up organi-
sation that offers an online music and movie download and streaming service. To use the service, it
is necessary to either buy a membership or pay for individual downloads. Memberships are divided
into three categories:
1. music
2. movies
3. volume of use.
StreemMov have decided that they will host the service themselves so that they can better know
their customers and their customers’ preferences. So far, they have concentrated on giving the
customer a smooth and reliable service. For example, when there is a disruption to the service it
automatically reconnects and resumes at the point where transmission was broken.
StreemMov have selected an ERP system and have purchased the transaction product distri-
bution module and billing system that connects seamlessly to the data warehouse that stores all
the transactions.
Consider big data and BI.
What should Bono recommend with regard to how big data could be used by StreemMov to make
a difference to its business strategy and decisions?
PART C: THE ROLE OF MANAGEMENT

ACCOUNTANTS IN INFLUENCING
STAKEHOLDER DECISION-MAKING
Earlier parts of this module discussed how the management accountant could identify stakeholders and
evaluate information. This part discusses how these concepts, when combined, can contribute to decision-
making.
BALANCING STAKEHOLDER REQUIREMENTS AND

INFORMATION DELIVERY
Time, for management accountants, is a scarce resource, so they need to balance stakeholder expec-
tations for information with their ability to search for or produce the expected information to an
acceptable quality. Stakeholders have different needs (as discussed earlier) and the management accoun-
tant will, as a result, provide them with different kinds of information in terms of delivery, format
and impact. Table 2.8 summarises the key issues for stakeholder expectations and the management
accountant’s actions.
TABLE 2.8 Key issues for information delivery—stakeholders and management accountants
Issue Stakeholder expectations Management accountant actions
Delivery of • Available early to allow sufficient • Recognise that requirements change over time—
information review e.g. as the stakeholder becomes more familiar
• Consolidated from different sources with the organisation
• Easily usable if accessed online • Acknowledge that stakeholders have individual
• Accessible remotely business areas that may have different needs—
avoid rolling out rigid, standardised solutions
across the organisation
• Communicate clearly the purpose and benefits of
the information—identify the ‘what’s in it for me’
factors
(continued)
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Issue Stakeholder expectations Management accountant actions
Format of • Easy to comprehend—e.g. numerical • Conduct extensive ‘education’ activities with

information tables or lists as well as visual with stakeholders to ensure they can interpret the
graphs and charts information they are receiving—including any
• Provide routine comparisons vocabulary unique to the organisation
Impact of • Immediate or near term • Deliver tangible and visible beneficial information
information • Clear message regarding the action • Follow up with stakeholders to determine whether
to be taken they find the information useful and track that
back to the systems to ensure they are useful and
usable for stakeholders
Before working ‘behind the scenes’ on information system improvements (e.g. improved taxonomy for
information in the data warehouse) or making changes to deliver more visible benefits for stakeholders,
the management accountant should validate the feasibility of suggested systems improvements with
stakeholders.
As well as understanding the information needs of various stakeholders, the management accountant
should be aware of some information behaviours of stakeholders. For example, some stakeholders may:
• prefer to rely on a single piece of paper that encompasses all the issues rather than have to compile and
reconcile information from different sources
• ask others for their opinion—for example, the person next to them—instead of using the systems
provided
• resist when their complex set of needs and problems is converted into simple solutions
• be sceptical when vendors offer ‘silver bullet’ technology solutions—a ‘silver bullet’ is a simple yet
complete solution
• spend differing amounts of time preparing for meetings and evaluating recommendations
• refer to target the urgent issues or business needs that they derive from the organisational strategy.
Given the differing needs and behaviours of stakeholders, when intending to change the information
provided to them it may be necessary to conduct a pilot project to resolve any issues. The reasons for
this lie in the possibility that the management accountant is actually seeking organisational and cultural
change, and this requires the support of strong leaders at all levels in the organisation.
DIFFERING LEVELS OF INFORMATION IN THE

ORGANISATION
One issue that arises from considering information for stakeholders is the ‘level’ at which the information
is needed—some will be operational and some strategic.
Figure 2.5 summarises the different information levels in an organisation. It includes an intermediate
level, known as ‘tactical’, which is sometimes inserted to emphasise the presence of middle management.
However, since the 1980s, organisations have been progressively removing middle managers, so this level
may not appear in some pyramids. Most of the discussion in this module centres on operational and strategic
information.
STRATEGIC INFORMATION
Strategic information is forward looking and assists the organisation with planning. Typically, the planning
horizon is three to five or more years, depending on the industry and technology. This information is
gathered to identify and improve the organisation’s competitive advantage—it is an amalgamation of
different sources, much of which may be sourced externally from the organisation.
Strategy is mainly about opportunities and it is necessary to have information about opportunities
that are:
1. additive—for example, more fully exploiting existing resources
2. complementary—for example, something new that can be combined with the existing business
3. breakthrough—for example, something that changes the fundamental economic characteristics
of the business (Drucker 1964).
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FIGURE 2.5 Organisational layers showing level of manager
Senior
managers
(e.g. CEO, CFO)
(strategic information
needs)
Strategy flows down Information flows up
Business unit or functional managers

(e.g. sales managers, production managers)
(tactical information needs)
Lower-level managers
(e.g. sales team leaders, production planners)
(operational information needs)
Source: Based on Lumen 2018, ‘Management levels: Hierarchical view of management in organizations’, accessed July 2018,
https://courses.lumenlearning.com/boundless-business/chapter/types-of-management/.
According to Drucker (1964), strategic information is necessary to answer key questions such as:
1. Who will be the future customers?
2. How will those customers be reached? (What channels will be used?)
3. What needs to be done now to be ready for a new business direction?
4. What is likely to go wrong with current plans?
Management accountants closely link the time horizon of information with the timing of decisions. One
reason for this is their concern with cause and effect. Many outputs or outcomes—for example, growth,
increased shareholder value and greater market share—result from improved products and services for
customers. Therefore, management accountants need to gather as wide a range of information available as
possible to get early signals about looming problems and opportunities—so that they can inform decision-
making at the right time.
In any organisation, strategy must cascade downward to lower organisational levels such as business unit
managers responsible for profit centres, or functional managers responsible for their cost centres. Equally,
as shown in Figure 2.5, information flows upward from operational information that may be aggregated
and interpreted by these managers, often with the advice and assistance of management accountants.
TACTICAL INFORMATION
Tactical information has a shorter time horizon than strategic information. Tactical information is more
focused on day-to-day operations and aims to assist management with effective execution of strategy. Its
role is informed by the guidelines set by the strategic plan.
Tactical information has the following characteristics:
• It is mainly used by middle management.
• It is focused at the business unit level, rather than at the whole of organisation.
• Typically, it is functionally oriented, with specific goals and objectives and performance targets.
• It contains more detail than strategic information, in terms of project plans, timetables, resource plans,
human resource requirements and budgets.
• It plays a vital role in the coordination of organisational activities, often ranking activities in terms of
their relative importance and urgency.
The importance of the interplay of tactical and strategic information cannot be overestimated. The best
laid strategy will be rendered useless by poor tactical implementation and, conversely, tactical excellence
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will not suffice in light of poor strategy. The management accountant has an important role in the provision
of both types of information.
Middle managers need to interpret strategy, and for effective execution they need to translate this into
detailed tasks and instructions for operational staff such as supervisors of sales representatives, production
operatives, etc. It is at the ‘grass roots’ of organisations (e.g. where there is day-to-day contact with
customers, or where goods and services are produced) that strategic plans succeed or fail.
OPERATIONAL INFORMATION
Operational information is produced from, or used by, the day-to-day transactions of an organisation. For
example, the information may relate to the following functions:
• production—manufacturing or service delivery
• logistics—including purchasing and warehousing of finished goods and distribution of finished goods
to wholesalers and retailers
• marketing
• sales
• after-sales service
• information and communications technology (ICT)
• finance
• accounting.
Operational information has a shorter time horizon and deals with ‘today’ or ‘this period’. It is used to
answer key questions such as:
• How can we satisfy customer orders?
• How can we obtain raw materials for manufacturing, mining or construction; inventory for merchandis-
ing; and labour for production and services?
• How can we improve efficiency?
• How can we reduce costs?
• How can we maximise profitability?
• How can we outperform our immediate and emerging competitors?
Table 2.9 summarises the key features of information needed for decision-making at all three levels of
the organisation.
Table 2.9 shows that managers at different levels require different kinds of information and will use
different sources of information for their decisions, which have different time horizons.
Functional requirements
To understand the different functional requirements for information, it is useful to consider some
examples. Table 2.10 identifies four major functional areas of an organisation and their different needs
for information.
Balancing strategic, tactical and operational decisions is difficult. The management accountant will be
guided by the circumstances of the organisation and the urgency and importance of its immediate problems.
In beginning with strategic decisions, which are future oriented and affect the external positioning of
the organisation, the management accountant will take into account tactical decisions associated with
initiatives to achieve its strategy. For example, a strategy of becoming number one in a market will
require tactics concerning pricing, marketing, deployment of resources, and responses to anticipated and
unanticipated reactions by competitors. The operational decisions to conduct activities will be guided by
the tactical initiatives that are being resourced. As noted earlier, one means of ensuring synergies between
these levels is with the BSC (see Module 5).
Figure 2.6 provides a summary of the types of questions that can be asked at the three levels to ensure
that the right information is gathered and provided to assist decision-making.
In summary, different organisations allocate activities and processes to different levels in the organisa-
tion because they believe that is where they can gain competitive advantage. Each of the levels of planning
has different information requirements, and the management accountant must identify the best source and
best method of aggregating and presenting information to each level.
Senior management plays an important role in setting the vision and mission of the organisation. Vision
is an aspirational description of where an organisation wants to be in the future. Mission is a declaration of
an organisation’s core purpose and focus. Senior management must therefore make many decisions over
current and future courses of action, and the management accountant can assist them do so by providing
useful information that directly links to strategy.
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TABLE 2.9 Levels of planning and decision-making in an organisation with key features
Type of information Level in the

Level of information system organisation Perspective Type of decision Impact Activities
Strategic EIS—integrated Top or senior Organisation-wide Unstructured Policy Scanning external

and very highly management Long-term (two sources
aggregated years and longer) Mergers and alliances
information Complex and downsizing
Non-routine New products
and services
New markets and
channels
Budgeting
Tactical DSS using Middle management Departmental Semi-structured Procedures Concerns the
aggregated Medium-term interrelationships
information (6–24 months) between production,
finance, account-
ing, personnel
and IT
Operational Transaction First-level Sub-department— Structured Immediate Day-to-day timing,

processing with very supervision and e.g. team, individual implementation scheduling, technical
detailed information management of simple and issues, resourcing and
routine matters contingency handling
Short-term
(12 months or
less)

TABLE 2.10 Different information needs of functional areas
Business function Strategic Tactical Operational
Sales • Order entry system— • Forward order planning • Order processing

selection and analysis • Warranty arrangements • Back orders
• Pricing • Refunds
Inventory and Warehousing • Method of inventory—e.g. • Inventory restock levels • Order picking
just in time (JIT) • Contract negotiation • Packing
• Accounting treatment • Despatching
• Restocking
Distribution to customers • Location and size of • Seasonal arrangements— • Space allocation

distribution centre e.g. Christmas • Expediting
• In-house versus
outsourced
Procurement • Preferred suppliers • Contracts • Receiving

• Price ‘package’ • Forward purchasing • Quality
negotiation commitments assurance
• Order size
FIGURE 2.6 Questions for the three levels of planning
• What broad business are we in?

• What is our vision for the business?
Strategic • What identity do customers give our products and services?
• Where is our business heading if left unchanged?
• What basis do we compete on?
• Who are our customers?

• What do customers think of our quality?
Planning
Tactical • How should we perform our processes?
questions
• What kinds of people should we employ?
• How can we remain profitable?
• What resources should we allocate to a particular customer?

• What are our procedures for receiving and filling an order or
providing a service?
Operational • What are our standards of service for completing activities and
the cycle?
• Who will ensure quality is acceptable to the customer?
IMPORTANCE OF LINKING INFORMATION TO

STRATEGY
As Figure 2.5 showed, strategy and information are closely entwined. Effective strategy formulation
requires good quality information that meets as many of the characteristics described earlier as possible.
Strategy implementation requires cascading plans down to the tactical and operational levels. However,
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there must also be flows of information that demonstrate whether or not strategy is being implemented
and whether or not it is effective. This requires an upwards flow of information from transaction level to
top management. A performance management system (described in Module 5) is a critical aspect of this
upwards flow of information.
Linking information to strategy requires a clear understanding of the strategic goals and objectives to
be achieved at the tactical and operational levels, and the projects or tasks that are necessary to deliver
these goals and objectives. The strategy needs to be elaborated in terms of strategic priorities that are
funded and with clear milestones and end-deliverables. Only when this has been established can the
strategy be cascaded down through the organisation for its accomplishment. Traditionally, the following
two approaches have been taken:
1. the financial approach
2. the performance management approach.
The financial approach involves framing budgets that extend down through the organisation and include
lower-level organisational units and their sub-units. Budgets are frequently used to align resources to
strategy because they require each organisational unit to prioritise and allocate its available resources
between key initiatives allocated to it and its existing programs. Usually any projects are separately
resourced as part of the project plan.
Budgets are discussed in detail in Module 3 and project management is discussed in Module 4.
The performance management approach considers the allocated resources and achievements of organ-
isational units against non-financial standards and outcomes. Performance management encompasses CI
of current processes and the accomplishment of transformational breakthroughs.
CI is the ongoing effort to improve service effectiveness or process efficiencies to achieve either best
practice or benchmarks—for example, process improvements measured as faster delivery of services or
less resource utilisation.
Transformational breakthroughs may occur by re-engineering current processes or devising innovative
alternatives that have a high impact and substantially lift operational performance to achieve or exceed best
practice—for example, better management of information across the organisation in terms of its quality
and availability as well as recognition of its knowledge assets.
Performance management and the BSC are discussed in detail in Module 5.
Management accountants can link information to strategy by obtaining stakeholder and market knowl-
edge and building relationships with stakeholders (as discussed later in this module). This will enable them
to determine stakeholder satisfaction and suggest the financial and performance information to be collected
and analysed. This information will then be used to review organisational performance in overall terms as
well as by organisational unit. In many cases, the analysis will reveal shortcomings in performance that
require investigation. This is where the relationships with organisation unit managers will make both the
investigation and recommendations for continuous and transformational improvements easier.
USING INFORMATION STRATEGICALLY

The information systems discussed earlier may be classified as strategic planning systems if they focus on
information to support future decision-making.
The management accountant can take a strategic view of the information by considering the contribution
that it makes to understanding customers, markets and end users of products and services (Drucker 1964,
p. 104). Drucker offers a simple approach to simplifying these quite large issues. He suggests asking four
key questions:
1. Do we have the right information?
2. How effectively are we using that information?
3. Is our information sufficiently built into our products and services?
4. How can we improve? Or what are we missing? Or how do we go about finding and using it? (Drucker
1964, p. 112)
Taking Drucker’s approach means that decision-making should always be converting information
(knowledge) into results for stakeholders. This places an obligation on management accountants to ensure
they do not just gather and analyse the information—they must also provide the information to managers
and employees to help them improve the efficiency and effectiveness of their recommendations and
decisions—as shown in Example 2.6.
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EXAMPLE 2.6
Using information strategically

Acme Enterprises Ltd (Acme) is a bricks and mortar retailer with an online retail presence that has been
quite successful (profitable) for almost 10 years. It specialises in luxury fashion and has its own shopper
card to track purchases. Acme conducts an annual strategy retreat where senior managers and the board
discuss strategy. The management accountant is usually asked to provide supporting documentation on
the business and often attends to make a presentation.
Initially, Danh Nguyen, the management accountant for Acme, provided aggregate information about
revenue, cost of sales, expenses and the capital budget for investment, for both budget and actual for
the last five years as well as the estimates for the current year. The board found this information useful
because there were supporting documents for each, which gave breakdowns and a commentary on major
issues encountered during the year. For example, for expenses that year, the report noted that winter sales
of men’s and women’s coats were very low, because the winter was quite warm and the spring sale of the
surplus stock reduced margin by 11 per cent.
The next year, Danh applied the questions provided by Drucker. He worked with the sales department
to produce sales by customer ranked from top to bottom. Cash sales and sales to individual customers
were simply put into two groups. The list allowed board members and senior managers to see that the
majority of sales had been in Western Australia to fly-in fly-out staff who were either ordering things online
because their work sites were too remote to allow shopping in person, or sending gifts home to family
members as a way of staying in touch.
The list also showed that while some stores were easily covering costs, only a very small proportion of
the number of inventory lines they carried were being purchased. This led to a small project to investigate
whether to continue carrying the lines. The lines were originally stocked to ensure Acme’s slogan—‘we
stock what you need’—was credible.
The additional information obtained during the investigation allowed Danh to support the advertis-
ing expense incurred by the branch managers and sales manager to run product promotion nights.
These events were to inform selected customers about other products that they did not buy but that
may be suitable alternatives or additions to their shopping purchases.
This example illustrates the importance of information when allocating organisational resources.
Consider the damage that could be done to shareholder value by incorrect information and analysis being
provided to management, or, as often is the case, what could have happened in the absence of information
and management having to rely on uninformed guesses.
ROLES OF THE MANAGEMENT ACCOUNTANT

Management accountants must consider the way they interact with organisations and stakeholders not
only in terms of technical skill, but also in terms of ‘soft skills’—such as interpreting information,
communication and influencing decision-making. The best way to ensure that the management accountant
can provide the most appropriate advice and assistance to senior management is to become a trusted
business partner.
TRUSTED BUSINESS PARTNER

The management accountant can succeed as a business partner by gaining the trust of all stakeholders
with whom they deal. This is a necessary prerequisite to proposing advice and providing assistance—and
to such advice being sought or accepted. Maister et al. (2001) suggest that becoming a trusted business
partner can be expressed in the following equation:
Trustworthiness = (Credibility + Reliability + Empathy) / (Self-orientation).
1. Credibility—the management accountant listens empathetically and separates rational from emotional
issues. The aim is to help managers frame the problem in a way that can be solved in the short term, and
then partner with them to craft a detailed solution, recognising that the management accountant may
need to carefully manage expectations.
2. Reliability—the management accountant will always be known for delivering consistently and excel-
lently. The aim is to show that they are mindful of senior management needs and expectations by
providing advice and assistance that anticipates needs and expectations.
3. Empathy—the management accountant fosters sound interpersonal relations and communicates pro-
fessionally. The aim is to share concerns and work through all issues in a way that leaves the senior
manager grateful for the advice and assistance.
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4. Self-orientation—the management accountant shows they are oriented to others and not themselves.
The aim is to show that what you do and say benefits senior management and the organisation even,
if necessary, at your own expense. One way of doing this is to always be transparent in your motives,
flexible, open to change, dedicated, passionate, yet humble.
The management accountant may have difficulty with some of these guidelines when evaluating
strategy, providing information associated with strategy, or being the recipient of sensitive information.
For example, management accountants may need to:
• make highly technical or complex information available to senior management in a short time frame
• respond in a highly competitive work environment where other managers are hostile
• overcome a culture where expertise and mastery are dominant
• reduce boundaries between the job and their personal life to be transparent
• put at risk their own bonus and job.
Maister et al. (2001) suggest working through the following five-step process:
1. Engage
2. Listen
3. Frame
4. Envision
5. Commit to improve communication.
This way, management accountants can build a foundation for assisting senior management.
Management accountants can offer their insights by connecting information they have gathered or
produced with the broader organisational strategy. In discussions with management, the management
accountant may become aware of new information or potential directions for the organisation. The test for
the management accountant is whether they can use this information to propose new options and identify
the related strength and weakness, opportunities and threats of each option. For example, a senior manager
may reveal the board is thinking about splitting off part of the organisation into a publicly listed company,
to improve shareholder value. The management accountant can offer suggestions on the proposal’s effect
on the remaining organisation in terms of costs, losses of synergy from dealing with the unit at arm’s length
and likely implementation issues.
CUSTODIAN OF INFORMATION
Another important role for the management accountant is as a custodian of information. This role should
not be confused with the governance roles of either data steward or data custodian.
A data steward is responsible for the information content, context and application of business rules. They
achieve this through good systems design that validates input data and provides output for verification.
Data custodians are responsible for the authorised access and acceptable integrity of the stored data,
including its transport or communication.
The management accountant, therefore, is concerned with ensuring that any technology deployed to
automate business processes and maximise productivity creates the required accounting information and
non-financial performance management information. They will also check that the technology chosen
is aligned with the business decision-making needs of managers, senior management and stakeholders.
This includes contemplating how disruptions to business continuity might diminish the relevance or faithful
representation of accounting information. Their custodian role also extends to recruiting, developing
and retaining high-performing accounting staff who maintain high engagement with the business of
the organisation by ensuring they are provided with quality information and clearly understand the
organisation’s strategy.
Example 2.7 uses all the points from this part of the module to show how information has wide effect
in the organisation.
EXAMPLE 2.7
Role of the management accountant in presenting information to

influence internal stakeholders
Automobile Signatures Pty Ltd (AS) is now an online outlet for expensive rare cars from around the world. It
commenced in 1977 as a mail-order business with a printed catalogue, but went entirely online as soon as
it was feasible to do so. AS either buys selectively, or acts as agent between buyers, taking a commission
when the sale is finalised.
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AS selectively buys unique cars, after verifying they are in reasonable condition. It then sells them either
at fixed prices or at auctions. The lowest value for a car was $100 000 for a mint condition 1972 Fiat
X1/9 serial number 001. The most expensive was a 1960s Ferrari 250 GTO (in showroom condition) for
$50 million.
AS has a very close relationship with courier companies and airlines so the item is packed and sent with
no chance of damage. Buyers are located around the world and include individuals and also clubs and
organisations. Turnover is currently $100 million, which is down from previous years when it was around
$125 million.
The former owner has sold the business to a syndicate who want to hold sales around the world.
Their strategy is to replace well-known national sales (e.g. Goodwood in the United Kingdom, Peb-
ble Beach in the United States) with their brand. Their vision is to offer a better car sales environment
by selecting major cities that the famous and wealthy are already likely to visit (e.g. New York, London,
St Tropez). They have tasked the management accountant with benchmarking their operations against the
best practices found at the existing national car sales events. They have also advised the management
accountant to form close relationships with each of the managers to ensure the planning for the new
arrangements is comprehensive. The new managers are responsible for marketing, sales, logistics and
maintenance/repairs. AS offers a car restoration and repair service that has a second-to-none reputation
among car collectors. Most of the managers and employees have worked there since the 1990s. None of
the employees belong to a union.
The management accountant is aware that AS is quite an old-fashioned organisation. It uses hard-
copy documentation for most of its operations, although there is some use of email. Managers justify this
approach by claiming that it is what the clients want.
In this scenario, the management accountant could either begin with the internal stakeholders (as out-
lined in Part A) or focus on the information. This example uses the information approach discussed
earlier, showing some of the stakeholder expectations to highlight the information and the management
accounting actions that are needed.
Information Stakeholder expectations Management accountant actions
Delivery Owners—are used to obtaining information Investigate the ethos of confidential

by seeing the relevant manager information and the precautions to keep it
secure—e.g. insurance implications.
Compare current arrangements with
competitors in the UK and US.
International trade barriers are constantly
changing. (At the time of writing in 2018
there are concerns about the effects of any
changes to US trade barriers that may be
imposed by President Trump, and the effect
of the UK’s withdrawal from the
European Union.)
Employees—to have convenient access to Consider the cost and benefit of making
historical and current information electronic copies of past hard‐copy records.
Marketing manager—is concerned
that an incomplete online database will
detrimentally affect their good reputation
for meticulous records
Suppliers—have always maintained their Consider whether cost savings would

own detailed records and given AS copies translate into higher margins.
Customers (buyers and sellers)—rely on Investigate the legal position in the different
original, signed documents countries to see if any common forms and
processes can be devised. (Competitors
operate only in one country.)
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Format Owners—favour the simple format but Investigate whether AS can produce elec-
have recently begun complaining they tronic versions of its own documentation—
do not have any backup of their hard- quotes, repair descriptions, etc.
copy portfolios (photos, receipts, letters, Discuss with owners whether there are any
etc.) providing chain of ownership and weaknesses or shortcomings in using hard
authenticity of repairs and maintenance copy from the point of view of the clients,
and compare AS’s documentation against
methods used by prominent competitors.
Investigate whether AS should create a
database of the cars it appraises and sells
and whether managers would be able to
persuade sellers and buyers of its value
Employees—are used to the current Consider what advantages are enjoyed by

system, which has been used for over 20 competitors who use either semi-automated
years systems or fully online integrated systems.
Suppliers—have expressed interest in Arrange a forum with all managers to

becoming part of a supply chain as their determine what process improvements that
work is often interdependent—e.g. carpet just involve suppliers can be considered.
installer has to cooperate with the leather
upholsterer
Customers—are both buyers and sellers The management accountant should

strive to clearly identify both the customer
acquisition cost and the customer lifetime
value to the organisation (both as the
supplier and customer), and align the
assessment of the relationship with the
strategy of the organisation.
Impact Owners—realise that the edge AS has Discuss what decisions they expect to make
over its competitors is their ‘old‐fashioned and whether they have sufficient information
service’ ethic to make informed decisions.
Employees—job security may be an issue Advise the managers to reassure employees

when checks reveal competitors have but also consider retirement planning and
fewer employees the need for new apprentices in the repair
and maintenance division.
Suppliers—most have long personal Determine whether suppliers have

associations with AS and expect that with suggestions for improvements to protocols
the change of ownership there will be some or processes.
change
Customers—expect that any changes Some analysis of costs and benefits needs
should create opportunities for to be performed before any discussion
higher prices occurs with customers.
QUESTION 2.7
Ally Green, the management accountant for LQ Iron Ore Ltd (LQ), receives numerous requests for
information from shareholders, creditors and suppliers as well as members of the public. Ally has
kept a diary of how she spent the last fortnight and it shows that:
• Forty-five per cent of her time involved responding to LQ’s external stakeholders.
• Twenty-five per cent was spent with senior management in strategy related meetings and
planning workshops.
• Fifteen per cent was spent in discussion with line managers.
• Fifteen per cent was spent with staff, giving guidance and supervision.
Ally realises that although she spends about 55 per cent of her time with internal stakeholders,
answering their management accounting questions, she feels that this is not building rapport. She
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also knows that in the past when she has tried to spend time with line managers, they have been
reluctant to schedule time to see her.
(a) How could Ally deal with the ad hoc requests from stakeholders?
(b) How could Ally approach the line managers and improve her professional relationship
withthem?
QUESTION 2.8
GoodsFast Pty Ltd (GoodsFast) is a small company that quickly grew into a large company by
challenging the dominance of larger parcel companies. GoodsFast specialises in transporting large
and heavy parcels, but will carry any size or weight. It is very customer oriented and known for its
reliable tracking and delivery. Its organisational chart is as follows:
The CEO has overall responsibility for the business while senior managers are responsible for
considering the future sales expectations of customers, the delivery technologies that GoodsFast
should be adopting, and the partners they should use.
The middle managers are responsible for logistics, that is pickup of parcels received for delivery
and making arrangements for redelivery (e.g. customer not home), contract negotiation to ensure
there are couriers covering the delivery locations, advertising the parcel service, recruiting and
timetabling the truck fleet and truck driver work allocation, ensuring there is sufficient warehouse
storage available, approving expedited deliveries and providing customer after-sales service where
there have been delivery delays. In addition, they ensure that stores have sufficient packing
materials (e.g. boxes, bubble wrap) for sale to customers who simply bring in the item they want
to send.
The supervisors are responsible for accepting customer orders to consign their parcels, arrang-
ing day-to-day deliveries and receipting payments made by customers. Their workload is allocated
by family name and delivery location.
Tom Patton has recently been promoted to senior management accountant at GoodsFast and
from his knowledge of the company realises that its information flows are quite poor and no‐one
has taken responsibility for the quality of information that is being produced and used for decision-
making.
Identify the information needs for each of the three levels of manager at GoodsFast.
Strategic level Tactical level Operational level
Senior manager—
marketing
Senior manager—
transport
Senior manager—
warehousing and Middle managers Supervisors
administration (12) (30)
CEO
Senior management
Senior manager—
accountant
accounting and finance
(Tom Patton)
Senior manager—
HR
Senior manager—
information technology
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PART D: UPGRADING OR REPLACING
INFORMATION SYSTEMS
This part considers the role of the management accountant when an existing information system is
considered unsatisfactory. This module does not treat the actions as a project because that requires user
needs and feasibility to be established. It does use some of the analysis of project failure because one of
the important contributors to failure is poor preliminary planning. So this module examines what could
and should be done, but often is not done, in a timely manner or by a thorough analysis. The project
management aspects are discussed separately in Module 4.
Part D distinguishes between preliminary assessment and formal evaluation.
STIMULUS FOR A NEW OR UPDATED SYSTEM

The stimulus to initiate a review or propose a new or replacement system often originates with general
observations about the system, such as:
• The functions performed by the current system are no longer suited to the goals the organisation has
for it.
• The technology used with the current system appears out of date.
• The current system appears too inflexible compared to current or future needs.
• The current system is expensive to maintain compared with alternatives.
Once stakeholders become convinced something needs to be done, it becomes necessary to conduct a
formal investigation into the adequacy of the current system.
The design of a new information system, or major changes to an existing system, require a robust project
management methodology, which is described in detail in Module 4. The following sections relate to
specific aspects of planning for information systems.
MAKING A PRELIMINARY ASSESSMENT

The preliminary assessment is a discovery (or rediscovery) of the current information needs of the business,
the systems and processes that underlie the business model, and the relevant policies of the business and
how those policies operate. It is necessary to understand the features of the current system to make a
judgment about whether the existing systems offer a sound foundation for improvement or are unsuitable
for purpose and should be replaced. If the system is judged to produce some useful outputs then those
outputs can be kept as a benchmark for improvements to the system or be used in a replacement system.
This avoids introducing a new system that lacks some essential functionality.
The preliminary assessment uses interviews with staff members and observation of business processes
and asks three simple questions:
1. What is satisfactory about the current system?
2. What is unsatisfactory that external and internal stakeholders see as weaknesses?
3. What improvements have been requested and what is their status—for example, in progress, approved
and awaiting development, rejected, ignored?
The results of these interviews and observations are compiled and cross-checked for consistency. Incon-
sistencies are investigated and resolved. The output from this assessment is an independent assessment
of current arrangements that can be referred to after obtaining information from managers about their
information needs.
Although this approach might appear to be unnecessary when a completely new system is being installed,
this is not the case. A comparable new system should be examined in the same way. This can be done
by asking what existing business processes would receive outputs or send inputs to the new information
system.
Some managers may complain that this activity causes a delay or is unproductive, however the
management accountant should defend the time and effort for the preliminary assessment as worthwhile
planning. This is shown in Example 2.8.
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EXAMPLE 2.8
The benefits of a preliminary assessment

Gary was hired as the CFO of a $100 million business with the brief of ‘helping the frustrated managers
get the customer system they have always wanted’.
On the first day, six managers made unannounced drop-in visits to his office asking whether their
preferred software package could now be purchased and the project to install and commission it be
completed before the next financial year. Gary replied, ‘As it has to be signed off by the board, I can
do the preliminary assessment myself but I expect it will take about a fortnight’. The managers went to
the CEO to complain. The CEO asked for an explanation. Gary reminded the CEO that the board had to
approve the expenditure of about $2 million and funds were a scarce resource. The CEO agreed the time
was reasonable.
Gary could understand the managers’ frustration. They had found a software package they believed
was better than the one they had and that was offered by a small but reputable supplier. They had also
experienced difficulties with their large IT department, which preferred a mainstream software package
supplier and wanted to have that supplier do all the work including interfacing with the existing systems
(production, accounting, and marketing).
The preliminary assessment found:
1. The existing system used a relational database that the in-house database architect had custom
designed for them—it did things their competitors could not offer. Owing to the limited IT staff, there
was always a programming backlog, so major requests could not be handled. These primarily related
to online access.
2. The software package that the managers had decided was ideal was not in use anywhere.
3. No-one had sought advice from a major law firm that specialised in software contracts on the pitfalls
of making a contract for a software package with promised features.
At the conclusion of the preliminary analysis, a round table meeting was held with all managers.
They were asked: If you could get what you want from the existing system, would you want to keep
it? They were unanimous they would keep it.
The happy ending (about a year later) was that the improved system did everything the managers wanted
at a cost of about 40 per cent of the budget for the replacement.
The preliminary assessment does not preclude assessing the information needs of stakeholders, and this
is discussed in the next section.
INITIALLY ESTABLISHING THE SYSTEMS INFORMATION

NEEDS OF STAKEHOLDERS
Part A of this module identified stakeholders and suggested two analytical frameworks with examples of
each. The nature of information was considered in Part B. This allows the information needs of stakeholders
to be initially established—this process is one of assembly. Critical evaluation comes later. This section
considers the ‘how’ and the ‘what’.
The ‘how’ uses three methods:
1. questionnaires to establish basic facts
2. observation and document inspection to become familiar with the format of information flows and how
that information is used
3. interviews to establish contextual factors and decision-making criteria.
The ‘what’ can become a project in its own right if it is allowed to examine everything. The management
accountant has the choice of establishing information needs by starting with the senior managers (top
down) or first-line supervisors (bottom up). The advantage of a top-down approach is that senior managers
should know what they expect lower managers to be doing and can identify their own needs as well as
those of subordinate managers. The requirements of senior managers can be checked with subordinate
managers and any discrepancies can be resolved with the senior managers.
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This issue that inevitably arises with the top-down method is its lack of detail. Senior managers will use
key performance indicators (KPIs) or critical success factors (CSFs), and the subordinate managers will
say they make many more decisions—and hence need more detailed information—than those envisaged
by the CSFs. This occurs even when hierarchical methods such as the BSC are used.
The recommended approach is to distinguish between whether the problem is a lack of information, or
if the problem is inadequate reports or unavailable suitable reports.
Lack of information
A lack of information suggests the need for data analysis. A proven method that management accountants
can use is a data flow diagram (DFD) (DeMarco 1979). A DFD highlights processes and visually illustrates
what data is the input to and output from a particular system or process.
A DFD starts with an overview that contains a single process (the entire system) that is then broken
down into components. So for example, a system might have five individual component processes that
are identified, of which number 5 is ‘accounting’. Accounting would then be broken down into its ‘child
processes’.
The advantage of a DFD is that the technique is simple to learn, widely applicable and, most importantly,
independent of any hardware or software. After a short period of analysis, the data needs of managers
become visible and the scope of the system is easily determined.
Inadequate reports or unavailable suitable reports

Where reports are inadequate or the system does not produce suitable reports, it is necessary to meet with
managers to identify their needs. Two approaches are common and each has its merits.
The critical success factor approach

The CSF approach (Bullen and Rockart 1981) uses interviews to explore the role and responsibilities of
the managers with questions such as:
1. What are your goals and objectives by period?
2. What major achievements do you expect to complete in the next 12 months?
3. What major achievements do you expect to complete in the next two years?
4. What are the major problems within the organisation?
5. What are the major problems outside the organisation (excluding government)?
6. What issues does the business face from government and regulation?
7. What CSFs do you use now?
8. Do the current performance measures used for your job accurately determine if you are meeting your
goals and objectives?
9. Are there any activities that have never failed? Why is this? What could change in the future?
10. What activities require continual attention because if something goes wrong it will be serious?
11. What questions would the board, CEO or a senior manager expect you to be able to answer?
12. If you had been isolated on a desert island for three months, what would be the three questions you
would ask about your role and responsibilities?
13. Do your subordinates complain about receiving performance information that is unsatisfactory?
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The major weaknesses of this approach are that executives may incorrectly identify the CSFs, or the
CSFs may change without the executive realising it.
Identify and analyse decisions
The other approach is to identify and analyse decisions. This depends on separating three types of decisions
(at the three levels of the organisation, discussed earlier), as shown in Figure 2.7.
FIGURE 2.7 Three types of decisions
• Made by senior managers

• Concerned with the vision, mission, structure and resources of
the organisation
• Mainly unstructured
Strategic • Require searching the external environment
• Occur infrequently
• Longer and broader consequences than management or
operational decisions
• Made by mid-level managers

• Concerned with achieving sales or production goals,
assuring quality, obtaining HR, motivating employees,
Decisions Tactical
coordinating workgroups
• Semi-structured
• Made relatively frequently
• Made by employees and their first-level supervisors

• Concerned with assigning daily tasks (e.g. production,
merchandising, service)
Operational
• Predictable
• Well structured even if exceptions
• Made frequently
Studying decisions requires attention. Some decisions are made consciously, deliberately and at slow
pace. These are often linked to organisational activities such as strategic planning. Or they may be initiated
when external forces (e.g. government regulators) force the organisation to act in certain ways or respond
to an issue. Other decisions have to be made in the moment without careful deliberation. Kahneman (2012)
points out that these decisions use heuristics and may be subject to biases. So particular attention needs to
be paid when making a quick decision.
A second reason for giving attention to the decision process is that it is difficult to know what issues
will be strategically important for the organisation in the future. One heuristic that is often used is to look
at previous planning efforts—but the past is not necessarily a guide to the future.
A systematic approach is to ask each manager when making a decision to answer the following
introductory questions:
1. What information do I need?
2. Why do I need this information?
3. Where do I obtain this information?
4. Do I need to obtain the information from one or more other systems?
5. Are those other systems manual, semi-automated or computer-based information systems?
6. Who else uses the same information?
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7. How do I rate the information I am provided with in terms of content, volume and quality?
8. Who do I send the information I produce to (one or many recipients)?
9. How does the information I produce support any individual, team/group and company goals?
10. Is the flow of information disrupted by inadequate tools, processes and procedures?
11. What changes in workflow, tools, processes, policies or procedures are desirable to improve the quality
of information I receive or provide?
After these questions are answered, the results are summarised in a matrix (table) similar to
Table 2.11.
TABLE 2.11 Matrix of analysis for information needed and information produced
Information needed
What info Why Source Content Volume Quality
Desirable changes
Decision
to workflow,
Information produced processes, policies
Destination/recipient Goals supported Disruptions to flow
The disadvantage of this approach is the effort required—which is intensive since every decision has to
be examined and checked with the decision-maker. It is cumbersome because once the matrix is completed
it can result in a large document. In some cases, the recipient of information may be a committee where
different understandings may exist. However, the advantage is that this can be used to build rapport with
managers and then provides an opportunity for review checks in the future—which should be less time
consuming, allowing more time for discussion.
The assumption with this initial establishing of information is that the decision is significant, stable and
made repeatedly. A practical example of this approach is shown in Example 2.9.
EXAMPLE 2.9
The ‘identify and analyse decisions’ approach

Chenglei Zhang has just commenced work as the management accountant at a large, single-site retail
merchandising department store. It was formerly a family business and the owner and his family were
always at work and knew what was going on in all departments. The investors who have bought the store
have asked Chenglei to look at the systems because they believe inventory asset value is too high. There
are six major departments—each with its own manager:
1. Clothing
2. Electrical
3. Travel
4. Perfume and cosmetics
5. Bedding
6. Manchester.
Chenglei decides to meet with the managers and use the ‘identify and analyse decisions’ approach
because she hopes that there should be considerable overlap among them in their information needs.
The following table is an extract of the matrix.
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Information needed Information produced Desirable changes
Decision What info Why Source Content Volume Quality Destination Goal Disruptions
Range of Number of To Inventory Covered Monthly High CEO Increase but Requires some New product
items existing lines compete system accuracy also reduce hand analysis grouping in more
by product with online some than one dimension
group retailers (e.g. size and
colour)
Inventory Current stock Working Inventory Within Monthly Low Purchasing Better stock — Real-time and ad
level level capital KPI system budget accuracy turnover hoc availability
Reorder Minimum To avoid Inventory Does not Monthly Low Purchasing Flexible reorder Advertising Flexibility in setting
stock level stock-outs system show large accuracy point causes stock- and changing levels
orders outs
The table crystallises the information analysis and indicates that there are common information needs.
It can be used as part of the cost justification for change because it shows that making this information
has high leverage, that is it can satisfy six managers.
OTHER METHODS OF OBTAINING INFORMATION NEEDS

Because of the limitations of the CSF approach and the fact that the decision analysis method is intensive
and can be cumbersome, other methods of assessing information needs may be used. For completeness,
Table 2.12 summarises the common alternatives.
TABLE 2.12 Alternative methods for obtaining information needs
Method Purpose Weaknesses Reference
Analyse organisational tasks See how information is used Focuses on past and Mintzberg 1975
in these tasks present but not future
information needs. Assumes
a stable environment, not a
dynamic one
Ask the decision-maker Detailed interviews Focuses on a single issue, Huysmans 1970
about their needs task or decision assuming Ross and
it is major and repetitive Schoman 1977
Analyse the existing Derive requirements from May specify information Valusek 1985
information system the existing information that does not relate to any
system specific decisions
Strategic goals and Investigate goals top down The decision-makers’ Checkland 1981
concerns personal goals may be
inconsistent with the
organisational goals
Process analysis of inputs Detailed systems analysis Observes users’ behaviour Lundeberg 1979
and outputs without seeking their insight
or helping them examine
their expertise to assess
needs more creatively
Use an expert panel Panel identifies strategic The experts also classify the Gustafson et al.
issues that the organisation information into essential, 1992
will face within the next periodic and low value, and
2–5 years. The related then discard the low value
information is then sought so it is still possible to miss
for high priority issues a future information need
These options are not explored in detail in this module because they do not involve employees in the
detail, and we know from psychological studies (including the Hawthorne effect) that when employees
participate in their workplace design, it is more likely they will be motivated to support the system (or
project) and then use it.
THE LIFE CYCLE OF SYSTEMS

The systems development life cycle (SDLC) identifies a sequence of phases beginning with the need for a
new system and ending with the commissioning and operation of that new system. Table 2.13 presents a
summary of those phases.
One important benefit of the SDLC approach is that it allows the management accountant to estimate
how long it will take to introduce a new or updated information system and to estimate the costs of each
phase of software development or software package implementation.
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TABLE 2.13 Systems development life cycle
Software development Phase Software package
Initiation and proposal Analysis Initiation and proposal

Feasibility ↓ Feasibility
Analysis Analysis
Design Design Installation of hardware

↓ and software package
Programming Implementation Testing

Testing ↓ Migration
Conversion Installation
Installation
Maintenance Post implementation Upgrades of software package

↓
Review of suitability leading Replacement Review of suitability leading

to requirements and feasibility to requirements and feasibility
Source: Based on Oliver, G. R. 2012, Foundations of the Assumed Business Operations and Strategy Body of Knowledge (BOSBOK),
Darlington Press, Darlington, Australia, pp. 261–4.
Prior to investing significant resources in a new or updated information system, the organisation needs
to make an assessment of its life expectancy and whether an investment should be made in a system
approaching obsolescence.
The management accountant will always make enquiries about the original implementation date of a
system or software package and the extent to which it has been updated previously. This gives an indication
of where the system or software is in terms of its whole-of-life expectancy. Systems become obsolete
technically, but also because new software developments and new packages may be a preferred option,
compared with continually updating an underperforming system. This is only a guide to assessing the
expected life of the system, and attention will be needed to determine what new requirements there are and
whether those requirements can be handled by changes to the existing system or software, or acquisition
of a replacement system or software. This is further explored later in this module.
PITFALLS IN EVALUATING MAJOR INFORMATION

NEEDS
There are frequently disagreements among stakeholders about their information needs. To establish the
information needs, the management accountant will consider:
• who to approach (stakeholders)
• how to approach the stakeholders
• what questions to explore with each stakeholder.
The discussion of stakeholders in Part A is a guide to who should be approached.
Stakeholder needs can be ascertained by survey questionnaire, by interview or by focus groups.
Reviewing existing documentation and reports can help triangulate this data. In any case, as a trusted
adviser, the management accountant should meet with key stakeholders for relationship building purposes.
Stakeholders should be able to provide answers to questions including:
• What information do they receive and use?
• What information is needed that is missing?
• Why is that information needed and how is it used? (This separates the ‘need to have’ from the ‘nice to
have’.)
Answers to these questions allow the management accountant to more fully explore the stakeholder’s
information needs.
Once stakeholder responses have been obtained, their information needs can be collated and tabulated.
This may lead to additional small group meetings for confirmation and to explore the kind of information
that needs to be provided.
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Some of the problems that management accountants should be aware of in considering stakeholder
requests for information are:
• over-abundance of irrelevant and unused information
• information collected by managers ‘just in case’ they need it
• the cost–benefit of information not being considered
• excess of transaction reporting (audit trails) rather than exception reporting.
The management accountant needs to be diplomatic when responding to stakeholder expectations. A
manager who believes they need additional information may do so because of a past incident, or because
they believe they will be asked this question by senior management and need to have the information at
their fingertips. The management accountant can use both the CSFs of the business to establish exactly
how the manager will use the information and how the organisation will benefit from that use.
ANALYSING NEW AND EXISTING INFORMATION

SYSTEMS
FEASIBILITY AND CRITERIA FOR A NEW INFORMATION
SYSTEM
A business may decide that to support its future strategy it needs an information system that will provide
the information to support its strategy implementation. Consider the example of a business that has decided
to implement an ERP system (see earlier in this module).
Assessing a new information system can be considered in two steps:
1. its feasibility
2. the criteria required for a new system.
The first step is known as the tests of feasibility (see Table 2.14). Feasibility assessment occurs after the
requirements have been established, and is the decision whether to pursue design or selection of a software
package. The tests are simple yet decisive and encompass any technology change.
TABLE 2.14 Three tests of feasibility
Test name Key question
Technical Is this application possible within the limits of available technology and our
resources?
Economic Will this application return more in monetary benefits than it will cost to develop?
Operational If the system is successfully developed, will it be successfully used?
Source: Based on McKinsey Consulting Organization 1968, ‘The 1968 McKinsey Report on computer utilization’, in T. W. McRae,
Management Information Systems, p. 104, Penguin, Harmondsworth, UK.
If the tests of feasibility are completed and judged as passed then the second step can be commenced
by applying some more detailed criteria. Any organisation looking to evaluate a new information system
needs to assess the criteria it will use, which will depend on its own circumstances. Table 2.15 describes
criteria that could apply to an ERP system.
TABLE 2.15 Identifying the criteria for a new system
Criteria Key question
Comprehensiveness Will all or only selected modules be acquired?
Adaptability As new business needs arise or changes to business processes occur, will it be
adaptable to change?
Fit Is the system specific to the business situation or problem? Or will the business need
to change its processes to fit the new system?
Alternatives What other options exist?
(continued)
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Criteria Key question
Operational skills How many people are required to support the operations and what level of skill and
experience do they need?
Big data capability Is there a capability to extract and analyse internal and externally sourced data for
strategy formulation, implementation and control?
Customisation Is customisation necessary to satisfy business needs? How stable is the customisa-
tion when there are updates or new releases?
The criteria selected by an organisation would need to be ranked in order of importance. Inexperienced
organisations tend to place price and ease of implementation highest, whereas experienced organisations
tend to consider vendor support and track record the highest (Deloitte & Touche, cited in Byard 2018).
Separate to the criteria are the organisation’s goals and objectives. Table 2.16 highlights possible
tangible and intangible goals for an ERP system. The achievement of these goals by implementing a new
ERP system should then be compared with the costs, to justify the acquisition of the system.
TABLE 2.16 Key objectives for ERP system—tangible and intangible goals
Goals
Key objective Tangible Intangible
Increase or capture • Revenue • Visibility

• Profit • Throughput
• Growth
• Market share
• Retention
• ROI or similar
• Efficiency or productivity
• Cash flow
• Suggestions from employees
Eliminate or reduce • Cost or expense • Process cycle

• Time, including time-to-market • Conflict
• Product deficiencies or failures • Paperwork
• Risk • Complaints by customers
• Turnover
Improve • Productivity • Reputation

• Efficiency • Image
• Economy • Morale
• Service • Process
• Information
• Skills
• Loyalty
• Quality
MAKING CHANGES TO AN EXISTING SYSTEM

Continuing the previous example of a business that wants an ERP system to support its strategy formulation
and implementation, the alternative of retaining but modifying the existing system should be considered.
Since the 1980s, total quality management (TQM) has advocated making improvements to accounting
systems by promoting improved performance measures (Kanatsu 1990). It offers a holistic approach by
beginning with information capture and considering the adequacy of information in reports. In this way it
is possible to discover whether reports are inadequate because of:
• the existing content—which may be capable of improvement, or
• the lack of desirable content.
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Management accountants can consider stakeholder views on monthly budget reports; these can often
overwhelm managers by providing intricate detail that makes detecting trends and patterns difficult. As
a result, managers spend their time looking for unfavourable variances and decomposing them. This is
desirable if the organisation is pursuing a major cost reduction program, but not a wise use of time if the
priority is attention to products.
There are various ways the information flow to stakeholders can be improved. Data can be exported
to spreadsheets for analysis. Exception reports rather than detailed reports can be produced. The ability
to drill down from summary data to transaction level data can be implemented. All these changes can be
made to existing information systems.
These simple changes can be justified by the increased attention paid to reports, and can stand alone—
that is, they do not necessarily need to be situated in a project. Once it is known that the management
accountant can improve report formats to provide better information for stakeholders, management
accountants will quickly find they are appreciated and sought out for advice.
Is investment in a new system prudent?

In many cases, the management accountant is confronted with a request for a new system on the grounds
of demonstrated failings of the current system. However, the management accountant may find they can
tailor a solution around the current system and justify this to stakeholders in one of two ways:
1. They can show that the investment to retain and modify the existing system is modest at a time
where there are budget constraints. This approach identifies the tangible benefits from retaining the
existing system (e.g. no new system installation costs) and some intangible benefits (e.g. no business
disruption).
2. They can show that making limited changes to the existing system is preferred over making a major
change now. For example, user requirements may not be stable or cannot be satisfactorily established.
Establishing requirements could be time consuming or unreliable, and thus retaining the existing system
for a further period is a rational choice.
EVALUATING A SUGGESTED INFORMATION

SOLUTION
The benefits of an information solution to address management information and reporting needs fall into
two categories:
1. tangible—measurable financial advantage
2. intangible—where financial benefits are difficult to quantify.
The issue with tangible benefits is the method of measurement. There is no agreement on the best method
and there are a considerable number of reasonable alternatives:
• One view is the derived value method. It considers how a system is intended to be used. Soh and Markus
(1995) recommend that information system success be judged on its actual achievement of the objectives
or goals for which it was implemented. They distinguish this from judgment about how well the system
operates. For example, if the goal is better customer service then evidence should be sought on whether
better customer service occurred, not whether revenue increased.
• There are alternative views of the value of the system to the organisation. A wholly economic criterion
is the decision pay-off (Schell and Cocoma 1986). It requires careful analysis of the proposal and
agreement between stakeholders on the tangible costs and benefits. It frequently shows deficiencies
in the calculation of these, and focuses attention only on proposals with high potential.
• Peters (1990) recommended using the value chain to determine which activities produced value.
• Another view combines weights with ratings to produce a numeric index that indicates the total business
value of the proposed system (Parker et al. 1988). Parker et al. describe this as an information economics
method that provides a broader view of value, allowing prioritisation of individual IT projects or
a portfolio.
So, the management accountant not only has to choose the method they will use to evaluate benefits,
but also whether they will include intangible benefits.
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COMPARING COSTS, BENEFITS AND KEY RISKS
The management accountant has an important role in helping to justify a decision about whether to invest
in a new information system, or modify or retain an existing information system. This is because the
management accountant has the ability to:
• evaluate the tangible and intangible benefits of a new or modified information system
• estimate all the costs associated with a new or modified system
• understand the information needs of stakeholders
• judge the value of the information solution in terms of achieving the organisational goals and objectives.
If we continue with the same example of a business seeking to implement an ERP system, we can
consider the major costs and benefits.
Costs include:
• hardware, which may be purchased outright, leased or hired
• end-user devices—for example, desktops, laptops, tablets
• end-user peripherals—for example, printers, scanners
• distributed communications capabilities—for example, wi-fi, broadband connection
• software (usually subdivided into operating system software and applications software, known as a
‘package’)
• in-house, contractor or implementor development staff
• testing costs for development/installation staff and end users for their acceptance of the system
• migration costs—to bring across existing data and records to allow continuity between the old and
new systems
• training of end users—which may result in their certification to access and operate the system
• contingency costs for late accomplishment of activities or failures
• opportunity costs for the investment and staff engaged on the project.
Traditionally, these costs are also grouped as one-off or recurrent costs. A thorough approach is
necessary to discover, capture and quantify all possible costs to avoid them occurring during the project
where they are unbudgeted.
When considering benefits, there is a possibility that managers may seek to quantify benefits identified
as intangible and thus convert them to tangible benefits. Table 2.17 provides examples of tangible and
intangible benefits that can be compared with costs.
As far as possible, tangible benefits will need to be quantified for comparison with costs. Quantifying
the benefits is far more problematic than estimating costs, and so the assumptions behind the dollar values
allocated to benefits will need to be clearly explained by the management accountant.
TABLE 2.17 Tangible and intangible benefits
Tangible Intangible
Ability to deliver the business strategy, which may be Easier communication—e.g. managers, department
expansion of sales revenue and/or cost reduction, heads and employees are all sharing common
entering a new market or introducing a new product or information
service
Ability to take advantage of market opportunities as Better customer information—e.g. customer service
they arise as a result of more and better integrated can be improved and more effective marketing and
information promotional campaigns designed based on customer
information
Improved output at reduced cost—e.g. faster customer Higher productivity—e.g. employees avoid wasting
service and order fulfilment, improved quality time gathering information for management
Elimination of activities and resources in processes— Improved efficiency—e.g. managers have new
e.g. inventory reduction, waste reduction information to identify strengths and weaknesses
Combination and therefore reduction of activities and Better organisational transparency and responsibility—
resources in processes—e.g. lead time reduction e.g. managers have workflow approvals embedded in
the system
Clearer identification of shortcomings—e.g. it is

easier to reduce and eliminate weaknesses and non-
performing activities
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‘What if’ planning capability—e.g. it is easier to
explore different scenarios for various alternatives
and economic environments and consider the
possible results before giving approval and committing
resources
Quicker decisions—e.g. better or more information

can reduce uncertainty and so there is less decision
guesswork
Analysing costs and benefits also requires an analysis of the risks involved in any change to information
systems. These risks may include, for example:
• poor design of the new system (or changes to an existing system) due to inadequate consultation
with users
• availability and cost of resources to complete the project
• failure of project management to ensure delivery of the new/changed system within time and budget
constraints
• failure to recognise emerging technological or legal changes such as cloud computing developments
and privacy legislation
• poor changeover planning leading to loss of data
• poor implementation training.
As with any other aspect of risk management (covered in detail in Module 4), risks need to be identified,
assessed (in terms of impact and probability), and risk mitigation put in place to reduce the risk to an
acceptable level.
QUESTION 2.9
Anna Field is the management accountant at Homemade Biscuits Pty Ltd (HB). She has been asked
by the CEO to examine their AIS. The CEO was recently hired from a large manufacturing business
that used a database and software including a complex financial module.
The CEO wants to know why the accounting reports that he receives are so poor and why he
cannot drill down to find details about revenues and expenses. He complains that the reports he
receives are hard to read and leave him to do basic calculations such as trend comparison and
some ratios.
How should Anna go about this investigation? Make clear what she should be looking for and
whether a new AIS is the best option.
REVIEW
This module comprises four parts that are linked together by their common theme of information for
decision-making.
Part A reminded the management accountant that they should not initially try to identify the individual
information needs of managers and employees. Instead, they should consider all stakeholders—both
external and internal. External stakeholders are featured in the conceptual framework and play an important
role where financial accountants provide them with general purpose and special purpose reports. Internal
stakeholders may be the primary customers of the management accountant because they require far more
detailed information about business performance, including both more detailed and disaggregated financial
statements as well as a wide range of non-financial performance information.
Part B examined in detail the types of information and their role in decision-making. It outlined how
information is used in the most common systems found in organisations (TPSs, DSSs and ERP systems).
It also discussed that an important role for the management accountant is to integrate the wide variety
of information that is available and present this to managers in a meaningful way, accompanied by a
comprehensive analysis and interpretation to support management decision-making.
Part B also discussed different sources of information used by management accountants. The man-
agement accountant should be cautious in relying on secondary sources as it may contain errors or have
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been fraudulently altered. The management accountant needs to be aware of the possible limitations of all
information.
Part B also focused on security. While privacy and confidentiality are among the most important reasons
for security, the increasing prevalence of industrial intelligence means that information has value to
competitors.
Next, Part B discussed the attributes of information—that is, its qualitative and quantitative character-
istics. This included the conceptual framework approach and the four-way classification approach.
Part B then discussed big data. With big data, it has become common to work with very large sets
of information and these present new challenges for the management accountant. Data warehousing and
data mining are the two most common techniques that allow the analysis of information, usually to
make predictions or uncover hitherto hidden trends or relationships. For these reasons, the management
accountant will be interested in big data, but this will necessitate building predictive models and ensuring
storage is compliant with emerging government concerns.
Part C was concerned with the role of management accountants in influencing stakeholder decision-
making. Having looked at stakeholders in Part A and taken a detailed look at information in Part B, this
part showed how the management accountant can address the requirements stated by stakeholders and yet
deliver the information they need.
The management accountant has to deal with three key issues:
1. delivery of information
2. format of the information
3. impact of the information on the recipient.
Part C also discussed how there have traditionally been three levels of information needed in the
organisation:
1. At the top is strategic information, which is used by the board and senior executives.
2. In the middle is tactical information, which is used by middle managers for decisions about sales and
production and the support activities.
3. Finally, there is operational information, used by employees and first-line supervisors who are
responsible for the routine activities of the organisation.
Part D required the management accountant to analyse existing information systems. This may occur
through them receiving a demand for a new or revised system. Criteria for analysis are suggested, together
with the steps involved in making a preliminary assessment.
One of the responsibilities of the management accountant is to initially establish the system information
needs of stakeholders.
There are three tests of feasibility (technical, economic and operational) that can be applied to any
system. A system that passes these tests can then be assessed against criteria that are likely to reveal
whether costs are understated because functions are omitted.
A second check is provided by the key objectives. Often, the result is the realisation that the existing
system should be retained and changed, so this possibility is also discussed.
There may be instances where stakeholders are proposing to invest in a new system but this can be
shown to be premature. Sometimes this can be achieved by a ‘hard line’ economic analysis that examines
payback from better decisions, or by ensuring the costs and benefits have been fully calculated.
In summary, this module shows the management accountant has an important role in:
• identifying useful information for decision-making
• ensuring that the information they provide is of suitable quality
• managing the information needs of stakeholders, both external and internal
• obtaining useful information by improving the systems and processes or assisting in the selection of
new accounting systems
• assisting in decision-making by not only interpreting accounting information but by becoming a trusted
adviser to managers.
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MODULE 3
PLANNING, BUDGETING
AND FORECASTING
PREVIEW
INTRODUCTION
The business environment is constantly changing, resulting in many challenges. One such challenge is how
an organisation can sustain itself in an uncertain future. The governing board of organisations typically
considers the organisation’s sustainability in their strategic plan and managers implement the strategic
plan through operational plans. Budgets form a part of the operational plan.
Budgets are an accounting tool that helps managers plan to meet the organisation’s goals. During this
planning, they anticipate and consider the challenges posed by an uncertain future and predict the possible
effects of these challenges and uncertainties on their organisation’s limited resources. This culminates
in setting targets that make best use of the organisation’s limited resources and that would achieve the
organisation’s goals. Once targets are set in the budgets, they are used to gauge the performance of the
organisation and the managers.
This module focuses on budgeting as a planning and control mechanism. The role of budgets and their
relationship to the organisation’s strategy is discussed. The module also describes the various components
of budgets and demonstrates how financial forecasts addressing uncertainties are developed.
Variance analyses are then considered as a means to monitor and evaluate the organisation’s and
managers’ performance compared with targets set in the budgets.
The module then discusses the human behavioural issues that typically result when using budgets as a
control mechanism. Finally, the module concludes with a discussion of proposed alternative approaches
to alleviate the limitations of traditional annual budgets.
The highlighted sections in Figure 3.1 provide an overview of the important concepts in this subject and
how they link with this module. This module discusses how the management accountant works to provide
management with information for budgets and operational decision-making that, in turn, informs and is
informed by strategy.
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rnal environment
Exte
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
VALUE INFORMATION
OPERATIONS
Ex te
r nal environment
OBJECTIVES
• Identify the roles of operational plans, budgets and forecasts and the relationship between these elements
and strategy.
• Develop a master budget based on operational plans, previous financial results, and forecasts.
• Perform variance analysis to monitor and evaluate performance.
• Prepare a financial forecast that addresses uncertainty.
• Analyse the behavioural impacts that may result from budgeting
• Discuss the usage of alternative approaches to budgeting.
PART A: INTRODUCTION TO PLANS,

BUDGETS AND FORECASTS
Organisations are continually confronted with making decisions about how to be sustainable in the long
and short term. In making these decisions, they have to decide which market to compete in, which products
or services to offer, and how to allocate resources. When evaluating alternative courses of action, they also
have to consider the likely financial and non-financial effects of each alternative.
Note: This links with the financial analysis and performance measures discussed later in Modules 4 and 5.
The choice the organisation makes about which course of action to pursue, and the direction for their
future activities over the long term, are set out in broad terms in their strategic plan. Strategic plans normally
cover three or more years, with most being for at least five years. A budget is a means to operationalise
strategic plans, create value and shape the future of an organisation (Eldenburg et al. 2017).
Once the strategic plan is in place, organisations focus on short-term decisions that shape their day-to-
day activities for the chosen course of action. These are set out in the operational plan, which is normally
for a one-year period—corresponding to the financial year of the organisation. Although budgets are plans
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of how the organisation is going to achieve its goals for the next year only, they are set within the context
of the organisation’s strategic plan, and are therefore linked with how the organisation is going to achieve
its long-term goals.
Since the future is unknown and uncertain, organisations make predictions about the financial outcomes
of their planned activities. Forecasts in the strategic plan are set out in broad terms, while estimates in the
operational plan are done in much greater detail. A budget is therefore an outcome of the planning process.
RELATIONSHIP BETWEEN BUDGETS AND

STRATEGIC PLANNING
Strategic planning focuses on long-term planning and involves senior managers planning and setting the
direction for future activities to meet the organisation’s goals as set out in its strategy. A strategic plan
is typically divided into long-term and short-term objectives. Although numerous definitions of strategy
exist, in this module, strategy means future direction (Eldenburg et al. 2011). A strategy helps organisations
to think about where they are now, where they want to go, and how they are going to get there. Operational
planning on the other hand focuses on short-term planning. Operational plans are the mechanism that an
organisation uses to address the short-term objectives of the strategic plan. Table 3.1 provides a summary
of the differences between strategic and operational planning.
TABLE 3.1 Differences between strategic and operational planning
Strategic planning Operational planning
Time period involved Long-term, at least five years Short-term, usually one year
Emphasis Identifies long-term goals, selects Focuses on achieving short-term

strategies to achieve those goals, and goals
develops policies and plans to implement
the strategies
Amount of detail Broad plan, much less detail Very detailed

presented
‘Budgeting is used to assist in strategic planning’ (Kleiner & Wilhelmi 1995, p. 78). Budgets are
most useful when they are integrated with an organisation’s strategy (Horngren et al. 2011). Ideally, the
development of a budget should begin with the organisation’s strategy. Budgets set benchmarks for how
an organisation is going to achieve its goals over the short term, so they are useful tools to gauge if an
organisation is on target in meeting its operational plan and hence its strategic plan. If used properly,
budgets can signal if managers need to revise their plans and possibly even the organisation’s strategy.
Consequently, budgets are used as a control mechanism to evaluate managers’ and the organisation’s
performance.
In summary, budgets represent short-term expressions of the long-term horizon of an organisation’s
strategic plan, as illustrated in Figure 3.2.
ROLES OF OPERATIONAL PLANS, BUDGETS

AND FORECASTS
Budgeting is a cross-functional activity. There are many types of budgets and different time periods for
which a budget can be prepared. For example, a budget may be prepared for a specific event (e.g. the
budget for the 2018 Commonwealth Games). A budget may also be prepared for a specific project or
task (e.g. planning an overseas family holiday). This module focuses on budgets where managers and
management accountants work together to plan the performance of an organisation as a whole as well as the
performance of sub-units (i.e. divisions or departments). The most common period for this type of budget
is one year broken down into months. They are often supplemented by quarterly budgets. These budgets
are an organisation’s financial roadmap—demonstrating the financial consequences of an organisation’s
detailed plan of their operating activities.
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MODULE 3 Planning, Budgeting and Forecasting 101

FIGURE 3.2 Relationship between budgets and strategy
Strategic plan
(long-term plan)
Operational plan
Long-term objectives
(short-term plan)
Master budget
Operational budget
Financial budget
Budgets are financial plans, setting out managers’ and owners’ expectations about financial aspects
such as sales prices and operational costs for the next year. However, budgets also include non-financial
aspects of the organisation’s proposed plan. These include, for example, the quantities of units that need
to be manufactured and sold, and the number of labour hours and number of employees. The management
accountant is uniquely placed to add value to an organisation’s budgeting process by analysing and
including non-financial information in the budgets. Budgets are a useful means to monitor and control
the organisation’s performance when they are used to compare what actually happened with initial
expectations.
A master budget is a comprehensive initial plan of what the whole organisation intends to accomplish
in the budget period. In preparing a master budget, managers make decisions about:
• how best to use the limited financial and non-financial resources in the operating activities
• how to obtain funds to acquire those resources.
These decisions are formalised in the operating budget and the financial budget.
The operating budget is associated with the operating activities or income-producing activities of an
organisation and always precedes the financial budget. In the operating budget, an organisation’s sales, cost
of goods sold (COGS), and selling and administration expenses are forecast. Thus, the end result (outcome)
of the operating budget is a budgeted income statement, although the latter is part of the financial budget.
To derive the budgeted income statement, the operating budget consists of numerous budgets prepared in
a specific sequence (discussed later in the module). Developing budgets for the coming year usually starts
a few months before the end of the current financial year.
The financial budget is a set of budgeted financial statements, providing forecasts about the organisa-
tion’s income statement, balance sheet and cash budget for the next financial year. In addition, the financial
budget also contains a plan for acquiring assets beyond the next 12 months, namely the capital expenditure
budget. This budget shows the purchase of assets in the next operating period and beyond.
Operating budgets are developed within the constraints of limiting factors such as demand or capacity,
and therefore based on a limited level of activity. If market demand is the limiting factor, then the defined
level of activity will be expected sales revenue. In a manufacturing organisation, if production capacity is
the limiting factor, then the defined level of activity will be production capacity, as shown in Example 3.1.
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EXAMPLE 3.1
Limiting factors for budgets

Alco Ltd (Alco) has a production capacity level of 10 000 units for a given period. Even though there might
be a demand for 30 000 units of Alco’s products, the budget will be based on the limited production
capacity of 10 000 units.
SprocketCo Ltd (SprocketCo), on the other hand, has a production capacity of 30 000 units but their
forecast sales is only 10 000 units, so their budget will based on the 10 000 units demand level. There is
no point in developing a budget for what SprocketCo can supply if there is no demand for the products.
It is often useful to have either a moving 12-month or quarterly budget, or use a combination of both.
This is made possible by continually adding a month or a quarter to the period that just ended so that
the business always has a 12-month period budget. This budget is referred to as a rolling or continuous
budget. For example, the global appliance company, Electrolux, has a three- to five-year strategic plan and
a four-quarter rolling budget (Horngren et al. 2011). The purpose of a rolling budget is to allow managers
to plan a full year ahead constantly, and not only once a year when budgets are prepared. Constant future
planning is important to all organisations, but more so when organisations operate in rapidly changing
environments.
PURPOSES OF A BUDGET
According to Roosli and Kaduthanam (2018, p. 21), ‘a budget represents a financial plan and a financial
target at the same time’. Budgets are used to:
• implement strategy by allocating limited resources among competing uses
• coordinate activities
• assist in communication between sub-units of the organisation
• motivate managers and employees with bonuses based on meeting or exceeding planned objectives
• provide definite objectives for judging and evaluating managers’ performance at each level of
responsibility
• facilitate learning
• raise management awareness on the organisation’s overall operations
• guide decentralised decision-making
• anticipate potential problems
• show early warning signs to enable management to prepare solutions
• assess performance, goal achievement and hence a basis for rewards (Collier 2015; Covaleski et al.
2003; Weygandt et al. 2012a; Eldenburg et al. 2017).
Traditionally, budgets are used to help managers and owners plan for the future and to formalise goals.
To do this they need to think about what courses of action to take to create value, to achieve their goals,
satisfy their customers and succeed in the marketplace. Further, they need to make decisions about what
courses of action to take in allocating scarce resources. When managers make decisions about allocating
scarce resources, they will typically rank competing projects or programs or products. The ranking of
these is done in Module 4. The emphasis in Module 3 is to illustrate how budgets help managers in making
decisions about scarce resources.
In essence, a budget is a planning instrument for resource allocation and a yardstick for performance
evaluation (Roosli & Kaduthanam 2018). Example 3.2 illustrates how budgets can assist with allocating
scarce resources.
EXAMPLE 3.2
Using budgets to allocate scarce resources

A university has a scarce resource of capital expenditure in its 2019 budget of $2 million to invest in one
of its regional campuses. Three competing projects have been submitted and a decision has to be made
as to which projects will be funded. The following three business cases were submitted:
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Business case A
Currently the academic staff in the nursing department have an open plan office structure. Due to overall
noise, it is very difficult for these academics to do their jobs to the best of their ability. Further, they
experience ongoing challenges due to privacy issues and the nature of discussing learning and teaching
issues with students. The Dean of the nursing department submitted a plan to renovate this space so that
staff can have their own offices. The estimated cost for this project is $1.2 million.
Business case B
Due to the success of the nursing department, there was a huge increase in the student numbers. However,
the university’s carpark is too small to provide off-road parking for these students. They protested and
threatened to study at other universities in a nearby metropolitan area. The Deputy Vice-Chancellor of the
campus submitted a business plan to extend the carpark. The estimated cost for this project is $1 million.
Business case C
The Student Social Network Association has seen that there are not a lot of activities and social events
that attract students on campus. They argue better student life will result in satisfied students and attract
more students in the future. They propose to build a theatre in which art and music performances and
exhibitions can be held. The projected cost for this theatre is $750 000.
To fund all three business cases, $2.95 million is required, but the budget is limited to $2 million.
The Campus Growth Committee has to make decisions about what causes of action to take to create
value, satisfy staff and students, and succeed in the marketplace. After deliberating the three cases, the
Committee decided to allocate the limited resource of funds as follows.
Note: As the decision-making process that the Committee followed is outside the scope of Module 3,
you may assume that the Campus Growth Committee has validated these three business cases against
the University’s key performance indicators (KPIs), perceived risk tolerance and stakeholder importance.
The latter is discussed in Module 2: Information for decision-making).
Business case Funds applied for Funds awarded
A $1 200 000 $1 200 000
B $1 000 000 $800 000
C $750 000 zero
Total $2 950 000 $2 000 000
Justification:
Business case A
The growth in the nursing students will result in an increase in the university’s revenue and perhaps also
enhance the university’s reputation, which may ensure ongoing growth. Such growth depends on satisfied
staff and students. Although there are many factors contributing to their satisfaction, having their own
offices will certainly impact staff job satisfaction. Students may also feel more comfortable to consult their
lecturers when they have the own offices in which private and sensitive issues related to the teaching can
be discussed. The Committee therefore decided to fully fund this project.
Business case B
Providing off-road parking to students is important as this will enable students to attend lectures and
study on the premises of the university without worrying about their cars. It may also encourage students
to attend lectures. Further, students already threatened to leave the university due to not having off‐road
parking. Not only is it important to retain these students, but providing off-road parking may also result
in satisfied students in the future which should enhance the credibility of the university and may result
in growth of student numbers and ultimately increased revenue. Although these benefits were pointed
out in the business plan, the Committee proposed that the Campus Coordinator meet with Council and
to negotiate better public transport facilities. Consequently, the Committee decided to partly fund this
business case with the remaining $800 000.
Business case C
The Committee decided not to fund this project because, compared to the other two projects that will
affect the revenue of the university directly, this project is the least critical at this moment—although it is
an important issue for the future.
The procedures and activities that are undertaken to develop the budget are referred to as the budgeting
process. The budgeting process provides a formal mechanism to ensure organisational objectives and
activities are planned effectively. During the execution period, budgets can serve as a benchmark and
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provide guidelines for operations. As mentioned earlier, it also allows comparison against actual financial
results at all levels of a business, enabling managers to measure and evaluate the performance of
individuals, departments, divisions or the entire organisation. Care should be taken to not make the budget
the target that needs to be met, because ‘when a measure becomes a target, it ceases to be a good measure’
(Strathern 1997). Setting and using budgets as targets will defeat the purpose of budgets and may result
in dysfunctional behaviour (which is discussed in Part D of this module). To discourage dysfunctional
behaviour and encourage individuals to set realistic budgets and strive to achieve them, organisations
often link budgets to incentives for achieving and exceeding both short- and long-term goals. During the
budgeting process, communication and coordination between the budget holders is important, because
they have the responsibility and authority to implement the budget. Consequently, an essential part of an
effective system of budgetary control is responsibility accounting, where budgets are usually developed
using a framework of responsibility centres.
RELATIONSHIP WITH RESPONSIBILITY

ACCOUNTING
Any unit with an ‘individual who controls a specified set of activities can be a responsibility center’
(Weygandt et al. 2012b, pp. 1109–10). Responsibility accounting and centres are particularly valuable, for
example, in decentralised organisations, where decision-making power is transferred and accountability
and responsibility of results are assigned to individuals or units at all levels of an organisation, and not only
top management. Delegating control throughout the organisation reduces the burden on top management,
promotes motivation and enables better supervision and quick decision-making. Responsibility centres
extend the responsibility from the ‘lowest level of control to the top’ level of management (Weygandt
et al. 2012b, pp. 1109–10). A responsibility centre is a unit in an organisation (e.g. a department or
a division) where the manager ‘has the authority to make the day-to-day decisions’ (Weygandt et al.
2012b, pp. 1109–10) about their unit’s activities and performance. The manager is accountable for matters
in their unit only—that is, ones that are directly under their control within their respective units. The four
common types of responsibility centre are shown in Figure 3.3.
FIGURE 3.3 Four common types of responsibility centre
Revenue
Responsibility
Investment Cost
centres
Profit
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‘These classifications indicate the degree of responsibility the manager has for the performance of the
centre’ (Weygandt et al. 2012b, pp. 1109–10).
REVENUE CENTRES
For a revenue centre, the manager is only responsible for activities generating revenue (e.g. sales). The
sales department is therefore a revenue centre and the sales manager is responsible for preparing the
sales budget.
COST CENTRES
In a cost centre, costs and expenses are incurred but the centre does not directly generate revenues.
Since managers in cost centres have the ‘authority to incur costs’, they are responsible and accountable
for meeting the budget targets. Consequently, they are ‘evaluated on their ability to control’ these costs
(Weygandt et al. 2012b, pp. 1109–10). Typical examples of cost centres are support departments such as
accounting, research and development, human resources (HR) and maintenance departments. For example,
the maintenance department of a hotel is a cost centre as the maintenance manager is accountable for the
costs of maintenance. Production departments are also cost centres. For example, in an automobile plant,
the production departments such as welding, painting, and assembling are separate cost centres.
PROFIT CENTRES
In addition to incurring costs and expenses, a profit centre generates revenues. Here managers are judged
on the profitability of their centres. For example, the hotel manager is in charge of the profit for the specific
hotel and is therefore accountable for both revenues and costs. In a retail store, for example a hardware
store, each department (e.g. building materials, gardening, and tools) might be cost centres. Although
the sales, operating expenses and costs budgets may be developed by other managers within the unit,
ultimately, the manager of the profit centre is responsible for the profit centre’s budget.
INVESTMENT CENTRES
In addition to being responsible for generating revenues and incurring costs and expenses, the manager
of an investment centre has the responsibility and control over the centre’s available assets. Managers
in investment centres significantly influence decisions related to investments (e.g. expansion of a
manufacturing plant or entry into new markets). They are therefore ‘evaluated on both the profitability
of the centre and on the rate of return’ (Weygandt et al. 2012b, p. 1112) (using return on investment
(ROI)) earned on invested funds. The ROI shows the manager’s effectiveness in utilising the assets at their
disposal. To use a hotel example, investment centres in this case would be subsidiary companies and the
regional manager of hotels within a region.
RESPONSIBILITY ACCOUNTING
‘Responsibility accounting can be used at every level of management’ (Weygandt et al. 2012b, p. 1109).
However, it is important that when responsibility accounting is used in performance evaluation, that only
revenue and costs that meet the following conditions are included:
• those that can be directly associated with the specific level of management responsibility
• those that can be controlled by management at the level of responsibility with which they are associated.
To ensure this, costs are split between controllable and non-controllable, separating direct cost from
indirect cost in budgets. This is important due to the potential impact on the behaviour of managers during
both the preparation of and assessment against budgets. For example, being held accountable for costs
they cannot control could be perceived as unfair and may demotivate managers. Behavioural aspects are
discussed further in Part D of this module.
An example of a controllable cost of a profit centre is the supervisor’s salary. This direct fixed cost
‘relates specifically to one centre and is incurred for the sole benefit of that centre’ (Weygandt et al. 2012b,
p. 1115). Further, this cost is directly associated as the manager of that responsibility centre can control
this cost because they can influence the costs and these costs can be traced directly to a centre. On the
other hand, indirect fixed costs are common corporate-level costs pertaining to the organisation’s ‘overall
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operating activities and are incurred for the benefit of more than one’ (Weygandt et al. 2012b, p. 1115)
centre. Such costs are non-controllable by divisional managers and are allocated to responsibility centres
on some sort of equitable basis. Examples of indirect fixed cost is property taxes on a building, research
and development costs, and salaries of top management. These costs can be allocated to various centres, for
example based on the square metres of floor space each centre uses. These costs are neither associated nor
can be controlled by revenue and by cost responsibility centre managers and therefore need to be separated
from controllable cost in budgets.
Applying responsibility accounting, first the effectiveness of the individual’s performance for the spec-
ified activity is measured, followed upward throughout the organisation to top management. Since top
management has a broad range of authority, all costs are controllable by them. However, as one moves
down to each lower level of responsibility, fewer costs are directly associated with the specified level, and
due to the individual’s decreasing authority, fewer costs are controllable at each lower level (Weygandt
et al. 2012b).
‘Budgets, coupled with responsibility accounting, provide feedback to top management about the
performance relative to the budget of different responsibility centre managers’ (Horngren 2011, p. 435).
PLANNING AND CONTROL

Budgets are a useful tool helping managers and owners to plan for the organisation’s future. Although
managers make predictions about the future and try to anticipate future problems, it is impossible to make
these accurately. The only certainties about the future is that it is uncertain, change is inevitable, and it is
risky. To plan for the future as best as possible, managers may test alternative courses of action before they
formalise the budget. Consequently, multiple budgets are sometimes prepared that identify best, worst and
most likely scenarios. Once the optimal course of action is selected, the final budget is adopted which will
guide the organisation’s activities.
‘Budgeting is the cornerstone of the management control process’ (Hansen et al. 2003, p. 95). Since
budgets set standards and benchmarks, it is common practice to use budgets as a means to monitor
and to control the use of an organisation’s use of resources and to evaluate its performance (Mowen
et al. 2016). This is done by frequent and timely (usually monthly) comparison of actual results with
budgeted forecasts—referred to as variance analyses. The purpose of variance analyses is to understand
the magnitude of the differences between planned (budgeted) and realised (actual) performance, for both
the monetary values and the quantities of related costs and revenues. Once these are known, the causes
of the differences can be investigated.
Variance analyses show how successful managers have been in their execution of the operational plan,
and as a consequence the implementation of the organisation’s strategies. It may also provide warning
signs of potential problems or events that may otherwise not be easily or immediately evident and may also
signal that strategies are ineffective. Variance analyses enable managers to learn, evaluate the organisation’s
strategies, take corrective actions and change operational plans accordingly.
The financial budgets help management to ensure the organisation remains solvent and sustainable.
For example, it helps to ensure enough cash is available to pay creditors, normal operating expenses and
taxes. It also helps ensure ‘sufficient raw materials are available to meet production requirements’, and
that ‘adequate finished goods will be available to meet expected sales’ (Weygandt et al. 2012b, p. 1054)
and ultimately satisfy customers.
Using budgets as a means to control the performance of managers and employees can be challenging.
Ideally, budgets should neither be too rigid nor too slack. For example, if top management sets budgets
that are too difficult to achieve, employees will be discouraged. Budgets should also not be too rigidly
administered—not meeting the set budget does not necessarily mean the employees did not perform
optimally. Budgets are prepared based on predicted information about an uncertain future—in the inter-
vening period, conditions and markets may have changed. Consequently, to best assess the performance
of individuals and the organisation, budgets are ‘updated’ during the year. This is referred to as a flexed
budget (discussed later in this module).
Now that the relationship between strategic and operational planning, the role and purposes of budgets,
and their relationship with responsibility accounting have been discussed, the next section elaborates on
developing master budgets.
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PART B: DEVELOPING MASTER BUDGETS
A master budget is a comprehensive set of interrelated budgets for an upcoming financial period. Master
budgets reflect an organisation’s plan for its future operating activities (in the operating budgets) and
financing actions (in the financial budgets) resulting from management’s predictions and decisions about
the future. Ideally, these plans should be the result of careful consideration of the following:
• operational plan derived from the strategic plan
• actual results from the past (the past is often a good indication of what may happen in the future)
• predictions about the future.
Many organisations use financial planning models to reduce the computational burden and time required
in preparing budgets. These models ‘are mathematical representations of the relationships among operating
activities, financing activities and other factors that affect the master budget’ (Horngren 2011, p. 432).
Computer-based systems, such as enterprise resource planning (ERP) systems, store a huge amount of data
required for preparing budgets. An ERP system therefore allows quick calculation of budgeted costs, for
example to manufacture products. This includes, for example, information about manufacturing different
products such as:
• the direct manufacturing costs—for example, materials and labour
• the indirect manufacturing overhead costs—for example, power and machine maintenance
• the machinery and equipment required
• information about different activities in the manufacturing process—for example, the number of
set‐ups required.
Further, most financial planning model software packages have a module on sensitivity analysis to test
alternative ‘what-if’ scenarios. For example, what will be the impact on the budget if the assumptions
change, or what will be the outcome for the organisation’s worst-case, best-case and most likely-case
scenario?
In developing plans about the organisation’s future activities, managers use estimates to determine the
resources the organisation is going to need, including the number of employees and specific skill sets
required, the quantities of raw materials and supplies, cash and anything else necessary to the future
operations. To make these decisions, managers consider many internal and external factors that may impact
the organisation’s future. This is discussed in the next section. Later in this part, the development of
operational budgets is discussed, separating those of manufacturing organisations from non-manufacturing
organisations. This is followed by a discussion of the development of financial budgets, budgeting for
various departments and flexible budgets.
IMPACT OF EXTERNAL AND INTERNAL FACTORS

ON BUDGETS
The first budget developed in the operational budget is the sales budget, because all the other budgets in the
operating budget depend on the sales budget. It is important to get the sales budget as accurate as possible,
because an inaccurate sales budget may affect the entire business adversely. ‘An overly optimistic sales
budget may result in excessive inventories that which may have to be sold at reduced prices (Weygandt
et al. 2012b, p. 1060) and even at a loss, while an unduly pessimistic sales budget may result in inventory
shortages, which may result in loss of sales revenue and perhaps loss of customers.
Just as important is getting the forecasts of the raw materials and finished goods inventories as accurate
as possible:
• Inadequate raw material inventories ‘could result in temporary shutdowns of production’ while inade-
quate inventories of finished goods inventories may result either in ‘added costs for overtime work’ to
produce more goods or ‘in lost sales’ (Weygandt et al. 2012b, p. 1061).
• Stockpiling of both raw material and finished goods may result in additional costs such as storage,
insurance, and handling costs, increase the risk that the inventory may become obsolete, and if the
prices of the raw materials drop, the organisation may be stuck with overpriced raw material. If the
economy slows down, excessive finished goods in one period ‘may lead to cutbacks in production and
even employee layoffs’ (Weygandt et al. 2012b, p. 1061) in subsequent periods.
To mitigate this, careful consideration of internal and external factors is extremely important when
planning and developing budgets.
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Table 3.2 provides a summary of the internal and external factors that affect business environments that
should be considered in both strategic and operational plans and budgets.
TABLE 3.2 Internal and external factors that affect business environments
External factors Internal factors
Demand for the goods or services Supply and capacity constraints
Market research studies Political issues in setting budgets, such as game

playing and empire building of budget holders
Suppliers of resources such as raw materials, labour, Anticipated advertising and sales promotions
supplies, and everything that impacts them and their
existence—e.g. a short supply of raw materials may
result in increased prices
General economic climate and past trends of a Policies of organisation (e.g. sales prices,
country—e.g. is it growing, is there an economic inventory levels)
slowdown, or a recession?
General economic climate worldwide New products and services planned by the organi-
sation, which may be the outcome of research and
development
Industry trends Improvements and changes in products and services
Rivalry among existing competitors Change in operations and improvements in operations
Competition in the market Change in management and leaders
Change in political situation in a country Changes in sales and product mixes
New or changing legislation and regulations such as

taxes on certain industries or products (e.g. sugar and
wine)
Environmental issues such as water supply infrastruc-

ture
Trends and fads—e.g. healthy lifestyles may affect the

sugar industry
Changes in prices both in sales and purchases
Technological developments
Reaction of customers to improved products, changes

in products and services
Risk of potential entrants to the market
Risk of substitute products and services
Risk of changing needs and choices of customers
Natural disasters—e.g. cyclones, bushfires and

drought in Australia
Source: Based on Eldenburg, L. G., Brooks, A., Oliver, J., Vesty, G., Dormer, R. & Murthy, V. 2017, Management Accounting, 3rd
edn, Wiley, Milton; Mowen, M., Hansen, D., Heitger, D., Sands, J., Winata, L. & Su, S. 2016, Managerial Accounting, Asia-Pacific
edn, Cengage Learning, Australia, p. 328; Horngren, C. T., Wynder, M., Maguire, W., Tan, R., Datar, S. M., Foster, G., Rajan, M. V.
& Ittner, C. 2011, Cost Accounting: A Managerial Emphasis, rev. edn, Pearson, French Forest, p. 422; Langfield- Smith, K., Smith,
D., Andon, P., Hilton, R. & Thorne, H. 2018, Management Accounting: Information for Creating and Managing Value, 8th edn,
McGrawHill Education, Sydney; Weygandt, J. J., Kimmel, P. D. & Kieso, D. E. 2012a, Managerial Accounting: Tools for Business
Decision Making, 6th edn, Wiley, USA, p. 385.
Although the information in Table 3.2 is not exhaustive, it clearly indicates that setting budgets
requires elaborate information gathering, and a considerable amount of discussion among managers. It
also demonstrates that developing budgets can be time consuming. Managers setting budgets must have
detailed knowledge, understanding and appreciation of the organisation, its products and services, the
markets it operates in and its competitors.
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In addition, the size of an organisation and whether it is a national or international organisation affects
the budgeting process. The larger the organisation, the more complex it is to set budgets. Setting budgets
for international organisations is often even more complex due to cultural and legal differences in different
countries, escalated by communication barriers. Further, since the economies of different countries
rarely move in tandem, forecasting sales for international organisations is more difficult than those of
national organisations (Eldenburg 2017). Other issues that make the budgeting process of international
organisations more challenging are currency translations and differences in inflation and deflation rates.
PREPARING OPERATIONAL BUDGETS IN

MANUFACTURING ORGANISATIONS
Operating budgets for manufacturing organisations are prepared in a specific order, because some figures
in budgets are based on figures calculated in previous budgets. As discussed earlier, the usual starting point
for the operating budget is the sales budget, because production levels depend on the level of units sold.
Further, the costs of production such as direct material, direct labour and manufacturing overhead costs,
depend on production levels. Therefore, the forecast level of sales units generally drives the operating
budget. The steps in this process are summarised in Figure 3.4.
FIGURE 3.4 Preparing an operational budget in a manufacturing organisation
Step 1
Sales budget
Step 2
Production budget
Step 3
Direct materials cost budget
Step 4
Direct manufacturing labour costs budget
Step 5
Manufacturing overhead costs budget
Step 6
Finished goods inventory budget
Step 7
COGS budget
Step 8
Period costs budgets
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In the following discussion, the links between the various operating budgets are highlighted to explain
the sequence in which operating budgets are prepared.
STEP 1: SALES BUDGET

Since the sales forecast is the foundation of operational budgets, a great deal of effort generally goes into
developing the sales budget. Generally, sales representatives and managers have detailed understanding
and knowledge of the markets the organisation operates in and their customers’ demands and needs. They
are therefore best placed to develop the sales forecasts. Organisations may also:
• gather information about the market, competitors and customers through a customer relationship
management (CRM) or sales management system
• use statistical methods, such as regression and trend analysis, and probability distributions, to forecast
future sales
• engage market research firms to forecast sales levels.
In some organisations, production managers may participate in the forecasting of sales. This is because
both supply and demand influence the sales budget. A sales budget set at demand levels that an organisation
cannot supply will be unrealistic and useless, as explained in Example 3.3.
EXAMPLE 3.3
Supply and demand influence on the sales budget

Assume that the expected demand for the organisation’s products is 30 000 units. Usually, forecast sales
will be based on the 30 000 units. However, assume that the organisation has constraints such as
production capacity or short supply of inputs—for example, materials and labour. These constraints in
supply limit the demand level. Consequently, the sales budget will be set on 10 000 units.
Regardless of how organisations forecast sales, ultimately it should represent managers’ collective
experience and judgment.
QUESTION 3.1
Kabuki Ltd imports electrical equipment used in the mining industry from Japan and converts the
equipment so that it is suitable for the Australian environment. Kabuki has been very successful
and operated at full capacity and sold all the products in the past. The organisation has a capacity
to convert 15 000 pieces of the imported electrical equipment per year.
The success of Kabuki Ltd attracted competitors to the market. One competitor also imports the
product from Japan, does the conversion in India, and then imports the final product to Australia.
Consequently, they are able to sell the final product at a significantly reduced price. Another
competitor manufactures the entire product in Australia. It is expected that this organisation may
dominate the market in future as they meet the recent changes in the Australian regulation of
imported electrical equipment. Further, there has been an outcry to buy locally manufactured
goods, which may boost their sales.
The sales representatives of Kabuki Ltd are sceptical about the demand for Kabuki’s product for
the next financial period and believe they will only be able to sell 5000 pieces.
Discuss the factors that should be considered in making the decision about the forecast sales
for the next financial period.
STEP 2: PRODUCTION BUDGET

Preparing the production budget is normally the responsibility of the manufacturing or production manager.
In this budget, the number of finished good units that need to be manufactured is determined. This number
is driven by the level of forecast sales unit and the organisation’s policy regarding finished goods inventory.
If the organisation does not require any finished goods inventory (e.g. if they use a just in time (JIT) system)
then the units it needs to manufacture will be the same as the number of units it forecasts to sell. However,
most organisations require ending inventory of finished goods as a buffer against uncertainties in demand
or production. Therefore, the number of units to produce will be the estimated sales (linked to the sales
budget) plus ending finished goods inventory, minus opening finished goods inventory.
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The next three budgets are prepared to estimate the cost of goods manufactured: direct materials, direct
labour, and manufacturing overhead costs budgets.
STEP 3: DIRECT MATERIALS COST BUDGET

In this budget, two sets of quantities and costs of raw materials used directly in the manufacturing of the
finished goods are determined:
1. for units used
2. for units purchased.
The purchasing manager has the responsibility to determine the costs of the direct materials purchased.
The production manager is responsible for the effective use of raw materials, so also participates in
developing this budget.
If an organisation uses different components of raw material to manufacture the finished product,
separate budgets are prepared for each component for both cost of materials used and materials purchased.
For example, an organisation that manufactures running shoes will prepare separate budgets for the
materials used to manufacture the soles of the shoes and for materials used to manufacture the upper
part of the shoes. These separate budgets are then integrated into one aggregated direct materials
costs budget.
To determine the quantity of direct material that will be used in manufacturing the finished goods, this
budget is linked to the number of finished goods that need to be purchased, forecast for each period in the
production budget. These numbers are multiplied by the quantities of each raw material component used
in the finished product to determine the direct materials that will be used. This is shown in Example 3.4.
EXAMPLE 3.4
Determining the quantity of direct material

GadgetCo uses 1.5 kg of raw material to manufacture a finished product (the MegaGadget). Assume that
5000 MegaGadgets will be produced. The quantity of raw material is then 1.5 kg × 5000 = 7500 kg.
To determine how much (quantity) raw materials to purchase, GadgetCo uses the number of finished
MegaGadgets to be produced (5000 units) plus the closing inventory of raw material minus the opening
raw material inventory.
To calculate the cost of raw materials to purchase, the quantity of each direct materials component
to be purchased is multiplied by the cost per unit of that specific component of direct material used to
manufacture the finished MegaGadget.
Depending on the inventory levels, the figures of raw material purchased will not necessarily be the
same as the figures of raw material used for any period. Both figures are essential though. The purchasing
manager requires information about the quantity and costs of raw material to be purchased. The cost of
direct materials used for the period is required to calculate the COGS. The reason why there is a difference
between the cost of direct materials purchased and the cost of direct materials used is because of direct
material inventory. For example, if an organisation uses the first in, first out (FIFO) method to value its raw
material inventory, the goods that were manufactured first will be sold first. If the costs of direct materials
change (which is very likely), then there will be a difference between the costs of direct materials used
in different periods. It is therefore important to pay attention to the period when the finished goods were
manufactured when valuing finished goods inventory.
It is important to distinguish between costs of direct materials purchased and used when using budgets
in performance evaluations. The purchasing manager must explain any difference between budgeted and
actual costs (AC) to purchase raw materials. The production manager is responsible for the efficient use
of raw material in manufacturing the finished product. However, this can sometimes be tricky, as shown
in Example 3.5.
EXAMPLE 3.5
Explaining variances in budgeted and actual costs of raw materials

ManufacturingCo purchased a batch of raw material that was inferior in quality. This resulted in increased
waste. This resulted in the inefficient use of raw material, for which the production manager was held
responsible. But the decision to purchase the inferior raw materials was actually made by the purchasing
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department, so although the production manager should explain the inefficient use of raw materials, they
are not responsible for the purchase. This shows the importance of coordination and communication
during the budgeting process as well as the actual day-to-day operating activities.
STEP 4: DIRECT MANUFACTURING LABOUR COSTS BUDGET

The production manager normally prepares and is responsible for this budget. In this budget, the total direct
labour hours for all stages of the production phase and the direct labour costs are calculated. Similar to the
direct materials costs budget, the direct labour budget is linked to the production budget. This is because
the cost of labour to produce finished goods is directly related to the number of units produced.
STEP 5: MANUFACTURING OVERHEAD COSTS BUDGET

The production manager is also responsible for preparing this budget. The manufacturing overhead costs
are separated based on their behaviour—namely if the costs are variable or fixed. Separating these
costs is important in analysing and explaining any differences between actual and budgeted costs. To
calculate the budgeted variable costs, predetermined departmental overhead rates are used. For example,
if the driver of the variable overhead costs is labour hours, then this budget will be linked to the direct
labour budget.
STEP 6: FINISHED GOODS INVENTORY BUDGET

The management accountant prepares the finished goods inventory budget. To calculate the cost of
finished goods, the number of units in inventory at the end of a period is multiplied by the cost of goods
manufactured. Consequently, this budget is linked to a few budgets prepared earlier in the sequence. The
first link is to the production budget, where the quantities of finished goods inventory figures are shown.
Second, cost of goods manufactured per unit (direct material, direct labour and manufacturing overhead
costs) are obtained from the following three budgets: direct materials, direct labour and manufacturing
overhead costs.
Since the opening finished goods inventory of one period is the closing finished goods inventory of the
previous period, both opening and closing finished goods inventory figures are available automatically in
this budget. However, the opening balance of finished goods inventory for the start of the budgeted financial
year needs to be estimated. This is because many organisations prepare budgets a few months before the
end of the financial year and therefore have to estimate the cost of closing finished goods inventory for the
current period.
QUESTION 3.2
To which operating budgets are the finished goods inventory budget linked, directly and indirectly?
STEP 7: COST OF GOODS SOLD BUDGET

The COGS budget is also linked to several budgets prepared earlier. To calculate the budgeted COGS,
the budgeted costs of manufacturing need to be determined. This is the sum of the total cost of
direct materials used, plus the direct labour costs plus the total manufacturing overhead costs. The
budgeted opening finished goods inventory is added to the budgeted cost of manufacturing to get the
cost of goods available for sale. Then, the ending finished goods inventory is subtracted to determine
the budgeted COGS. This figure will appear in the budgeted income statement, which is part of the
financial budget.
The budgets prepared in Steps 2 to 7 cover budgeting for an organisation’s production function of
the value chain. Budgets for other parts of the value chain, for example product design, research and
development, marketing and distribution, and administration, are prepared in the next step.
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STEP 8: PERIOD COSTS BUDGETS
Period costs budgets can either be prepared as separate budgets for each cost component such as research
and development, marketing, distribution, and administration costs. Alternatively, this can be combined
into one budget. The costs and expenses included in this budget are all the non-manufacturing overhead
costs or the costs of the non-manufacturing activities of the organisation. Similar to the manufacturing
overhead cost budget in Step 5, costs in this budget can be separated between fixed and variable
components, depending on their behaviour. Consequently, the period costs budget will be linked with
other operational budgets, depending if the period costs are driven by any of the components or activities
in these budgets. For example, sales commission and freight costs normally vary with sales activity and
are therefore variable costs. To determine these costs, this budget will be linked to the sales budget. In
preparing the period costs budget, all non-cash expenditure, for example depreciation on office furniture,
are shown as separate line items. This is because non-cash items are excluded from the cash flow budget
that is prepared in the financial budgets.
PREPARING BUDGETS IN NON-MANUFACTURING

ORGANISATIONS
Retail and wholesale organisations do not manufacture goods, so do not prepare a production budget or
any budget that relates to cost of goods manufactured. Instead of preparing a production budget, retail
and wholesale organisations develop a purchases budget. In this budget, they determine the quantity and
the cost of goods they need to purchase for resale. It is likely that retail and wholesale organisations will
need to carry inventory, so planned levels of inventory will be taken into account in the purchases budget.
The budgets for period costs and expenses for retail and wholesale businesses are similar to those of a
manufacturing organisation.
Many service organisations, ‘such as a public accounting firm, a law office, or a medical practice’
(Weygandt et al. 2012b, p. 1073), provide only services. These organisations will only prepare budgets
to forecast the revenue, and the costs and expenses relevant to their activities in rendering the services. An
accounting firm would for example prepare the following budgets:
• a revenue budget of planned hours and rates that will be charged to clients
• labour costs budgets for staff—including hours of professional staff that will be charged and the cost of
administrative staff
• an overhead budget—including other costs and expenses related to the operations of the organisation.
Service organisations normally have large labour cost budgets and extensive selling and administrative
costs budgets. However, some service organisations also sell goods (e.g. a dentist or a veterinary practice).
Therefore, these organisations will also prepare a purchases budget similar to those prepared by retail and
wholesale organisations.
PREPARING FINANCIAL BUDGETS

Preparing financial budgets for non-manufacturing organisations is similar to that of manufacturing
organisations. Annual financial budgets consist of a set of financial statements plus the capital
expenditure budget.
BUDGETED INCOME STATEMENT

The budgeted income statement is the outcome of the operational budgets. This budget sets out the expected
financial performance for the budgeted period. Expenses not budgeted for in the operating budgets, such
as income taxes, are forecast here, and the budgeted income statement is presented in a format that shows
the gross margin, operating income, and the net income as separate line items.
In preparing the budgeted income statement though, no regard is given to when the money will flow
in and out of the organisation. For example, making a credit sale (and a profit for that matter) in say
February does not necessarily mean that the cash will flow into the business in February. It is important
to know when the cash for credit sales in February will be collected as an ethical organisation always
aims to pay its debts and expenses on time. The inflow and outflow of money is considered in the
cash budget.
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CASH BUDGET
Cash management is essential for the success of any business, which makes the cash budget the most
important financial budget (Weygandt et al. 2012a) and one of the most important budgets in the master
budget. The cash budget also shows when there will be cash shortages (deficiencies) and excess cash
(surpluses). This will enable management to make plans about when to borrow money and when to spend
money (e.g. buying assets, repaying loans or even making short-term investments).
Further, the principal source of revenue and cash inflow should be from the core business of an
organisation, namely its sales. However, for many organisations, a large proportion of sales is on account.
It is therefore important to prepare a schedule for cash sales and collections from credit sales. This schedule
is based on past experience of what percentage of credit sales are paid in the month of and months
following sales. Similarly, a schedule for cash purchases and payments of credit purchases is prepared
in developing the cash budget. In addition to preparing schedules to indicate the periods in which cash will
be collected from credit sales and when cash will be paid for credit purchases, schedules are also prepared
for other inflows and outflows of cash (e.g. when cash will be received from sources such as interest and
dividends (where these are receivable), and proceeds from selling investments and assets). Examples of
other payments are income taxes, acquisition of assets and interest and dividends (where these are payable).
The latter will be identified from the capital expenditure budget.
At its simplest, a cash budget shows the cash balances at the beginning and at the end of the period,
cash inflows, and cash outflows for the period. The cash budget shows how much money will be available
for each period (opening balance plus cash receipts) to finance the cash disbursements for the period. In
developing a cash budget, cash flows from all activities, thus operating, investing and financing activities
are considered.
QUESTION 3.3
How and in which budget is the figure ‘cash in bank’ in the budgeted balance sheet determined?
BUDGETED BALANCE SHEET

The budgeted balance sheet sets out the expected financial position at the end of the budget period. This
budget is linked to a few other budgets:
• the projected profit (or loss) for the budgeted financial year as projected in the budgeted income
statement
• the ending inventory figures for raw material, work in progress and finished goods in the operating
budget
• the cash balance projected in the cash budget.
CAPITAL EXPENDITURE BUDGET

The capital expenditure budget is the organisation’s plan for the acquisition of long-term assets such
as property, plant and equipment. Acquisitions for the next financial year are considered as well as
acquisitions beyond 12 months.
PREPARING BUDGETS FOR VARIOUS

DEPARTMENTS
The process of preparing master budgets for decentralised organisations is the same as preparing a master
budget for an organisation that is centralised. Preparing budgets for decentralised organisations is simply
a bigger and more time-consuming process.
Normally, in preparing budgets for decentralised organisations, the sales managers and representatives
of a specific unit or region or town (in short referred to as a department) prepare the sales budget. Thus the
bottom-up approach is applied. The department for which a budget is prepared may be for example within
a large retail hardware store chain (e.g. gardening supplies) or one of the stores in the chain in a town
or region. Senior management will then aggregate these departmental budgets, which will form the sales
budget for the organisation as a whole. In responsibility accounting, the individual sales representatives
and sales managers are accountable for their centre’s revenue budget only. This is shown in Example 3.6.
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EXAMPLE 3.6
Preparing budgets for decentralised organisations

RunGear manufactures running gear (e.g. shoes, clothes and accessories) and has developed a sales
budget. RunGear has sales representatives in each state in Australia, and each state is divided into a
north, south, east and west region.
The sales representatives responsible for the sales in the north Queensland region will prepare a
sales budget for north Queensland. The sales representatives responsible for the south, east and west
Queensland regions will do the same.
The sales manager for Queensland will then aggregate these budgets for the four regions and be held
responsible for the sales budget for Queensland. A similar process will be followed in the other states.
Ultimately, in developing the sales budget for RunGear as a whole, the sales budgets for all the states
will be aggregated and sales forecasts through other means, such as the internet, will be added.
PREPARING FLEXIBLE BUDGETS

The term ‘flexible budgets’ is often used with two meanings.
1. In the planning phase, the term is used to reflect a range of activity levels (discussed in the next section).
2. In the controlling phase, the term is used to describe the flexing of the static budget as a means to evaluate
the variance between actual results and budgeted forecasts (discussed in Part C of this module).
For planning purposes, flexible budgets are used to study the sensitivity of budgeted revenues and costs
for various activity levels. Large organisations typically use software packages to develop flexible budgets,
while spreadsheets are sufficient for small organisations. ‘Flexible budgets can be prepared for each … of
the budgets … in the master budget’ (Weygandt et al. 2012b, p. 1101).
Example 3.7 provides an illustration of a flexible sales budget, using sales volume ranging from 24 000
units to 32 000 units and a selling price of $50 per unit.
EXAMPLE 3.7
Flexible sales budget

ExampleCo has the following sales volume and budgeted sales revenue figures.
Sales volume 24 000 26 000 28 000 30 000 32 000
Budgeted sales revenue $1 200 000 $1 300 000 $1 400 000 $1 600 000 $1 800 000
The relevant range for fixed costs is 8000 to 12 000 units. ExampleCo uses labour hours as the cost
driver for variable costs. ExampleCo’s production budget indicated that 8000, 9000, 10 000, 11 000, and
12 000 labour hours will be required to manufacture the finished goods required to meet the sales volume
(including the required inventory levels).
Using the information in the following table to prepare a flexible manufacturing overhead cost budget
in the planning phase illustrates the sensitivity of the budgeted costs.
Variable cost rates per direct labour hour Annual fixed costs
$ $
Indirect material 1.50 Depreciation 180 000
Indirect labour 2.00 Supervisor salary 120 000
Utilities 0.50 Property taxes 60 000
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Monthly manufacturing overhead cost budget for various levels of activity
$ $ $ $ $
Activity level: Direct labour hours 8 000 9 000 10 000 11 000 12 000
Variable costs
Indirect material 12 000† 13 500 15 000 16 500 18 000

‡
Indirect labour 16 000 18 000 20 000 22 000 24 000
Utilities 4 000§ 4 500 5 000 5 500 6 000
Total variable costs 32 000 36 000 40 000 44 000 48 000
Fixed costs
Depreciation 15 000 15 000 15 000 15 000 15 000
Supervision salary 10 000 10 000 10 000 10 000 10 000
Property taxes 5 000 5 000 5 000 5 000 5 000
Total fixed costs 30 000 30 000 30 000 30 000 30 000
Total manufacturing 62 000 66 000 70 000 74 000 78 000

overhead costs
Calculations:
†
8000 × $1.50
‡
8000 × $2.00
§
8000 × $0.50
The complete master budget will be prepared for various activity levels as shown in the two tables.
Source: Adapted from Weygandt, J. J., Kimmel, P. D. & Kieso, D. E. 2012a, Managerial Accounting: Tools for Business
Decision Making, 6th edn, Wiley, USA, p. 443.
Using flexible budgets in the planning phase is a useful means to determine a worst case, a best case, a
most likely case and a few alternatives in between, of expected results for the next financial year. Having
budgets for different scenarios provides valuable information for making decisions about the allocation of
resources and also about the most realistic budget.
Although one budget will be approved and adapted, flexible budgets may be useful in the coming year,
because they indicate the outcome of various activity levels that may be a useful reference of probable
outcomes if the planned activity levels are not achieved. When the master budget is formalised, approved
and accepted, it is then used to monitor and evaluate the organisation’s and individuals’ performances. One
way of doing this is comparing the budget forecasts with the actual results, referred to as variance analysis.
This is discussed in the next part of this module.
PART C: VARIANCE ANALYSES

AND CONTROL
As discussed earlier, to evaluate if expectations set out in strategic and operational plans are met, actual
results are compared with budget forecasts or planned objectives. Differences between budget forecasts
and actual results are called budget variances. Because budgets are based on forecasts about the future,
variances are inevitable. Analysing variances is an important mechanism to monitor operations and to
evaluate managers’ performance.
A variance is categorised as unfavourable when AC are greater than budgeted or actual revenues are
less than budgeted. A variance is favourable if actual revenues are larger than the budget or AC are lower
than the budget. The question arises: which variances should be investigated? Normally, organisations set
a materiality level as a percentage difference from the budget, regardless of whether this is over or under
the budget. For example, AC over budget exceeding the materiality threshold need to be investigated to
determine whether they were not properly controlled
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It is sometimes complicated to determine the underlying causes of a variance. This may be due to
the flow-on effects of decisions made and actions taken in other departments or functional units of the
value chain. For example, sales staff may promise a rush delivery to a customer, forcing employees to
work overtime and increasing the labour costs—which will probably result in an unfavourable variance.
Consequently, in analysing variances, the management accountant must have a thorough understanding of
and insight into the connections, interdependencies and interrelatedness of activities in the organisation,
and the effect of one decision and action on other aspects. Management accountants have to ensure that
the managers of responsibility centres provide sensible explanations for actual results deviating from
forecast budgets.
The static budget is only used as a starting point in doing variance analysis. Due to the limitations of the
static budget, flexible budgets are developed to perform variance analyses (discussed in the next section).
Later in this part, the usefulness of variance analyses of revenue and several cost components is discussed.
STATIC VERSUS FLEXIBLE BUDGETS

The approved and adopted master budget is based on forecasts of planned sales and production volumes
determined on one level of activity. ‘When used in budgetary control, each budget in the master budget is
static’ (Weygandt et al. 2012b, p. 1099), hence being referred to as a static budget. In a complex business
environment, it is almost unheard of that the planned levels of activity will be the same as the actual levels.
Many manufacturing costs are variable and therefore the total cost changes proportionately with changes
in production levels. Consequently, comparing actual results with the static budget forecast will not give a
clear picture of the underlying causes of the variance, and the variance may be incorrectly interpreted.
When using variance analysis to monitor and control the organisation’s and managers’ performance,
two aspects are analysed to investigate the underlying causes:
1. quantities—both sales and production
2. prices—both selling prices and costs.
The difference between actual and budgeted prices is known as the price variance, and the difference
between actual and budgeted quantities (volumes) as the efficiency variance. However, comparing actual
results with the static budget will not show either of these variances. Consequently, to interpret variances
appropriately, a flexible budget is developed, as illustrated in Examples 3.8 to 3.13.
EXAMPLE 3.8
Comparing actual results with the static budget forecast—budgeted

quantities exceed actual quantities
StarCo has a budget production level of 5000 units (finished goods) and an actual production level of 4500
units for flagship product ‘Starz’. The raw material required (budget and actual) to manufacture one unit
of Starz is 1.5 kg. Both budgeted and actual cost of the raw material is $2 per kg.
Using a static budget to determine the variance of direct material will result in a favourable variance,
calculated as follows:
Actual results – Budgeted forecasts
(Actual quantity × actual price) – (Budget quantity × budget price)
= (4500 × 1.5 × $2) – (5000 × 1.5 × $2)
= $13 500 – $15 000
= $1500 favourable
Should the production manager receive a bonus for this favourable variance? The answer is no,
because the reason for the favourable variance is simply because they produced less units. The operations
were not more efficient, because the production manager budgeted to use 1.5 kg of raw material per unit
and the actual usage was 1.5 kg per unit. Further, the purchasing manager did not deviate from the
budgeted cost of $2 per kg of raw material. So there are no favourable performances that warrant any
awards. Although simplistic, this example illustrates that the difference between the static budget and
actual results is purely because of the difference in volume.
Care should be taken in analysing and interpreting variances between a static budget and actual results. It
only indicates if more or less units have been sold or more or less units have been produced. To understand
the underlying causes of variances between actual results and budgeted forecasts, the static budgets are
therefore flexed and described as flexible budgets. In developing a flexible budget, the actual quantities
are used instead of the budgeted quantities.
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EXAMPLE 3.9
Developing a flexible budget—actual and budgeted prices are equal

Using the figures in Example 3.8, the flexible budget is determined as follows:
(Actual quantity × actual price) – (Actual quantity × budget price)
= (4500 × 1.5 × $2) – (4500 × 1.5 × $2)
= $13 500 – $13 500
= zero variance
Flexing the static budget clearly shows that the only reason why the difference between the actual result
and the static budget showed a favourable variance is because fewer units were produced. The production
manager certainly should not be rewarded with a bonus. On the other hand, an unfavourable variance will
result if more units have been produced than budgeted. This would not mean that the production manager
underperformed and should be reprimanded, as illustrated in Example 3.10.
EXAMPLE 3.10
Comparing actual results with the static budget—actual quantities

exceed budgeted quantities
Assume now that 5500 units of Starz were produced (everything else remain the same). Logically,
comparing the actual results with the static budget will result in an unfavourable variance, calculated
as follows:
(Actual quantity × actual price) – (Budget quantity × budget price)
Abbreviated from here onwards as: [(AQ × AP) – (BQ × BP)]
= (5500 × 1.5 × $2) – (5000 × 1.5 × $2)
= $16 500 – $15 000
= $1500 unfavourable
EXAMPLE 3.11
Developing a flexible budget—actual and budgeted prices are different

Using the information in Example 3.8, assume that the actual cost per kg of raw material is $2.10. Using a
static budget, the variance is calculated as follows:
(AQ × AP) – (BQ × BP)
= (4500 × 1.5 × $2.10) – (5000 × 1.5 × $2)
= $14 175 – $15 000
= $825 favourable
Again, this does not make sense as the actual cost (price) is higher than the budget so one would have
expected that the variance would be unfavourable. In fact, the purchasing manager should be asked to
explain why the price increased.
EXAMPLE 3.12
Developing a flexible budget—actual and budgeted quantities used per

unit are different
Assume that the actual cost is the same as the budgeted cost but that the actual quantity of raw material
used per unit is 1.6 kg. Using the static budget, the variance is calculated as follows:
(AQ × AP) – (BQ × BP)
= (4500 × 1.6 × $2) – (5000 × 1.5 × $2)
= $14 400 – $15 000
= $600 favourable
Again, this does not look correct because Steve, the production manager, was less efficient in using
1.6 kg as opposed to the budgeted 1.5 kg per unit. Steve should explain why more materials were used
than planned.
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Examples 3.8 to 3.12 illustrate that the causes of variances between actual results and flexible budgets
relate to differences in price as well as differences in quantities used (both number of units produced and
input per unit). Therefore, flexible budgets are developed so that two variances can be determined: price
variance and efficiency variance. Example 3.13 illustrates how an efficiency variance is determined.
EXAMPLE 3.13
Developing a flexible budget—budgeted and actual quantity per unit are

different
To determine the efficiency of Steve, the quantities that should have been consumed (based on the
budgeted consumption) for the actual activity level is determined in the flexible budget. In this example, the
budgeted quantity per output unit was 1.5 kg of the raw material. To determine the figure for raw material
that should have been used to produce the 4500 units in the flexible budget, the following formula is
applied:
Budgeted quantity allowed for Actual quantity × Budget price
This formula is abbreviated in the remainder of this module as:
(BQ allowed for AQ × BP)
Applying this formula, an efficiency variance is calculated as follows:
(AQ × BP) – (BQ allowed for AQ × BP)
= (4500 × 1.6 × $2) – (4500 × 1.5 × $2)
= $14 400 – $13 500
= $900 unfavourable
This formula will be further expanded later in the discussion, as in this example, the actual and budgeted
prices are the same ($2). Examples 3.8 to 3.13 illustrate why using a static budget in performance evaluation
to analyse and interpret variances is not useful. Static budgets hide variances due to efficiencies and
inefficiencies, and also due to changes in prices and costs. To expose these hidden variances, the static
budget is flexed. In a flexible budget, the data is based on the actual activity levels such as sales and
production attained.
The usefulness of flexible budgets as a control mechanism in performance evaluation is illustrated in
the remainder of this module.
PROFIT- AND REVENUE-RELATED VARIANCES

When analysing profit and revenue variances, both the static and the flexible budgets are used. Here the
differences between the static and the flexible budget are due to variances in sales and production volumes.
In preparing the master budget, the budgeted sales volumes drive the production volumes. Hence, the
difference in the bottom lines (operating profit) of the static and the flexible budgets is because of the
difference between the budgeted sales volume (used in the static budget) and the actual sales volume (used
in the flexible budget), referred to as the sales-volume variance. But remember: the operating profit is sales
minus all the costs, both variable and fixed, and that fixed costs is not driven by activity levels (sales and
production). Consequently, in performing variance analyses, the static budget is the same as the flexible
budget for fixed costs. Therefore, to determine the profit-related variance (known as the sales volume
variance), the contribution margin is used (and not the bottom-line, i.e. profit), as shown in the following
formula and Example 3.14.
Sales-volume variance for operating profit = (Actual quantity sold – budgeted quantity sold) × budgeted
contribution margin per unit sold
This formula is abbreviated as follows:

Sales volume variance = (AQ – BQ) × Bcm†
†
cm = contribution margin
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EXAMPLE 3.14
Calculating the sales volume variance

StarCo made and sold 4500 units of Starz, while the budgeted figure was 5000 units. The budgeted selling
price and variable cost per unit was $120 and $70 per unit respectively and the actual selling price and
variable cost per unit was $110 and $75 respectively. The sales volume variance is calculated as follows:
(AQ – BQ) × Bcm
= (4500 – 5000) × ($120 – $70)
= 500 × $50
= $25 000 unfavourable
The sales volume variance indicates that the variance in the profit (or contribution margin) of the
organisation is solely because of the decrease in the number of units sold.
Applying responsibility accounting, the sales volume variance is useful to evaluate the performance
of the manager of a profit or investment centre. Although the variance is referred to as the sales
volume variance, the sales manager is not entirely responsible to explain this variance as it is based
on the contribution margin. The sales manager is only responsible for the performance of the revenue
responsibility centre.
To understand the causes of the sales volume variance and to evaluate the performance of the appropriate
responsible managers in the revenue and costs responsibility centres, the sales volume variance is separated
between sales and various costs components. This is normally done by analysing each line item in the
income statement and calculating a variance. It is important to remember though that the sales volume
variance is calculated using only budgeted prices and costs and budgeted quantities. The reality is that
actual prices and costs, and actual quantities used are seldom the same as budgeted. Consequently, flexible
budgets are developed as explained in the previous section.
To evaluate the performance of the sales manager, the variation in revenue (sales) is determined, referred
to as the selling-price variance. This variance is the difference between actual and budgeted selling prices,
calculated in the following formula and applied in Example 3.15:
Selling-price variance = (Actual selling price – Budgeted selling price) × Actual units sold
This formula is abbreviated as follows:

Selling-price variance = (AP – BP) × AQ
EXAMPLE 3.15
Calculating the selling-price variance

Using the information from Example 3.14, StarCo has an unfavourable selling-price variance, calculated
as follows:
(AP – BP) × AQ
= ($110 – $120) × 4500
= $45 000 unfavourable
Selling prices are likely to affect the sales demand. Consequently, in evaluating the performance of
the revenue centre, the selling-price variance should be considered in conjunction with the sales volume
variance. The sales manager is responsible for both the price and volume of sales and hence the revenue
centre’s performance and will therefore be responsible for providing explanations for these two variances.
Figure 3.5 outlines possible explanations for increases and decreases in selling prices.
However, the sales managers’ decisions to increase or decrease the selling prices will have flow-on
effects on other functional units in the value chain, particularly the production department. For example,
a decrease in the selling price may force the purchasing manager to buy cheaper raw material and
probably of an inferior quality. Further, using raw material of an inferior quality may affect the efficiency
of the production operations and may also result in an inferior quality product being produced, which
may ultimately result in a decrease in the demand for the product. This illustrates the connectivity and
interdependence of various managers’ decisions and the consequential impact these decisions may have
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on other managers’ performance evaluation. Therefore, understanding the connectivity between variances
and their causes is essential when using variance analysis to evaluate the performance of departments
and managers. This also emphasises the importance of open communication and coordination between
managers of various departments.
FIGURE 3.5 Possible explanations for increases and decreases in selling prices
Possible explanations
• Shortage of supply in the market
• Increase in market demand
Increased • Increase in competitors’ prices
selling • Organisation may use a superior quality of
raw material
prices
• Improved quality of the product
• Added features to the product
Possible explanations
Decreased • Decreased selling prices in the
industry/market/competitors
selling
• Decrease in the demand for the product
prices • New competitors may have entered
the market
Variable direct manufacturing costs, such as direct material, direct labour and manufacturing overhead
costs, are generally incurred directly by production departments. Consequently, in responsibility account-
ing, analysing variances of these costs is useful to evaluate the performance of managers of cost centres.
The production and purchasing managers will be held accountable for variances between the actual results
and the budgeted allowance for variable costs. The next three sections illustrate how variances of direct
material, direct labour and variable manufacturing overhead costs are calculated and used as mechanisms
to evaluate the performance of relevant managers.
DIRECT MATERIAL ANALYSIS

EXAMPLE 3.16
Calculating the direct material flexible budget variance

Using the information in Example 3.8, the flexible budget for direct (raw) material is determined as follows:
BQ allowed for AQ × BP
= 4500 × 1.5 × $2
= $13 500
Using the actual quantity direct material used per unit of Example 3.12, and actual cost of Example 3.11,
the actual results of direct material is calculated as follows:
AQ × AP
= 4500 × 1.6 × $2.10
= $15 120
The flexible budget variance is:
Actual results – flexible budget
= $15 120 – $13 500
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The deviation is caused by two factors:
1. the inefficient consumption (1.6 kg as opposed to 1.5 kg)
2. the higher purchase price ($2.10 compared to a budget of $2) of the raw material.
However, it is not always obvious in the flexible variance how much of the variance relates to inefficient
consumption of the raw material and how much is related to the increased price.
To address the situation outlined in Example 3.16, flexible budgets are further subdivided to show the
price variance separate to the efficiency variance. Figure 3.6 illustrates how the price and the efficiency
variances are determined—for all variable cost components: direct material, direct labour, and variable
manufacturing overhead costs.
FIGURE 3.6 Calculations of price and efficiency variance
Actual results Flexed budget Flexible budget
AQ × AP AQ × BP BQ allowed for AQ × BP
Price variance Efficiency variance
As shown in Figure 3.6, the term ‘flexed’ budget is used to determine the price variance—the difference
between actual results and flexed budget. Further, to determine the efficiency variance—the difference
between flexed budget and flexible budget. The formulas for calculating the price and efficiency variances
are illustrated in Examples 3.17 and 3.18 respectively.
EXAMPLE 3.17
Calculating the direct material price variance

The formula for determining price variances of direct material, direct labour and variable manufacturing
overhead (although this is referred to as a spending variance) is as follows:
Price variance = (Actual Quantity of input × Actual price) – (Actual Quantity of input × Budgeted price)
This is abbreviated to:
(AQ × AP) – (AQ × BP)
Applying this formula, and using the information provided in Examples 3.8, 11 and 12, the price variance
of direct material can be determined as follows:
Difference between actual results and flexed budget
= (AQ × AP) – (AQ × BP)
= (4500 × 1.6 × $2.10) – (4500 × 1.6 × $2)
= $15 120 – $14 400
= $720 unfavourable
EXAMPLE 3.18
Calculating the direct material efficiency variance

The formula for determining efficiency variances of direct material, direct labour and variable manufactur-
ing overhead is as follows:
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Efficiency variance = (Actual quantity of input × Budgeted price) – (Budgeted quantity allowed for actual
quantity of input × Budgeted price)
(AQ × BP) – (BQ allowed for AQ × BP)
Using this formula and the information provided in Examples 3.8 and 12, the efficiency variance for
direct material can be determined as follows:
Difference between flexed budget and flexible budget
= (AQ × BP) – (BQ allowed for AQ × BP)
= (4500 × 1.6 × $2) – (4500 × 1.5 × $2)
= $14 400 – $13 500
= $900 unfavourable
Adding the price and efficiency variances shows the flexible budget variance as determined in
Example 3.16: $720 + $900 = $1620 unfavourable.
Separating the flexible budget into a price and an efficiency variance enables effective analyses and
interpretation of variance analysis, to evaluate the performance of appropriate managers. The purchasing
manager is responsible for the price variance of direct material and the production manager is responsible
for the efficiency variance of direct material.
DIRECT LABOUR ANALYSIS

Similar to analysing the price and efficiency variances of direct material, the price and efficiency variances
of direct labour are useful in evaluating the performance of the production manager. Examples 3.19 to 3.21
illustrate how to calculate the price and the efficiency variances of direct labour respectively.
EXAMPLE 3.19
Calculating the direct labour flexible budget variance

Use the information provided in Example 3.8 and assume the following direct labour information:
Budgeted labour hours to manufacture one unit: 15 minutes
Actual labour hours to manufacture one unit: 10 minutes
Budgeted cost per labour hour: $25
Actual cost per direct labour hour: $30
The flexible budget variance for direct labour costs will be determined as follows:
Actual results – Flexible budget
= (AQ × AP) – (BQ allowed for AQ × BP)
= (4500 × 10 / 60 × $30) – (4500 × 15 / 60 × $25)
= $22 500 – $28 125
= $5625 favourable (F)
To understand the causes of the variance in Example 3.19, it is subdivided into the price and the efficiency
variances, calculated as shown in Examples 3.20 and 3.21.
EXAMPLE 3.20
Calculating the direct labour price variance

Price variance = Difference between actual results and flexed budget
= (AQ × AP) – (AQ × BP)
= (4500 × 10 / 60 × $30) – (4500 × 10 / 60 × $25)
= $22 500 – $18 750
= $3750 unfavourable (U)
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EXAMPLE 3.21
Calculating the direct labour efficiency variance

Efficiency variance = Difference between flexed budget and flexible budget
= (4500 × 10 / 60 × $25) – (4500 × 15 / 60 × $25)
= $18 750 – $28 125
= $9375 favourable (F)
The total of the direct labour price and efficiency variances equals the flexible budget variance as
determined in Example 3.19: $3750 (U) + $9375 (F) = $5625 favourable.
Since the production manager is responsible for monitoring and controlling the labour rate and efficiency
of workers, the direct labour price and efficiency variances are used to evaluate the performance of the
production manager.
VARIABLE MANUFACTURING OVERHEAD ANALYSIS

Although variable manufacturing costs is part of the costs to manufacture goods, variable manufacturing
costs are often not within the direct control of the line manager. Variable manufacturing overhead cost
is an indirect cost that cannot be traced directly but is allocated to the products and departments instead.
Consequently, care should be taken when analysing the variances of variable manufacturing overhead costs
as a means to evaluate the performance of the line managers.
Examples of variable overhead costs are:
• indirect material
• indirect labour
• utilities—for example, energy and water consumption
• engineering support
• machine maintenance.
Further, to simplify record keeping, many organisations use standard costing to allocate overhead costs
to the various manufacturing departments. These standards may be derived from either actual or budgeted
costs. To calculate these standards, variable manufacturing overhead costs may be grouped into one cost
pool or a few appropriate cost pools, depending on the complexity of the organisation. For example, the AC
of all variable overhead costs may be accumulated in one cost pool. In determining how to allocate these
costs, managers make decisions about which factor drives these costs. Cost drivers can be for example:
• labour hours
• machine hours
• floor space
• kilometres driven
• number of employees.
The standard overhead-cost allocation rate is determined as follows: total costs for the cost pool / the
driver (also known as the cost-allocation base) of the cost.
These standards are typically calculated at the start of the budget period and used when setting
the budgets. Although line managers often do not have direct control over actual variable overhead
costs incurred (as it is allocated), they help the control of these costs by budgeting for each variable
overhead cost separately, deciding about the cost driver and hence determining the standard allocation rate.
Therefore, line managers have shared responsibility for variable manufacturing overhead costs variances.
To investigate possible causes for variable manufacturing overhead costs variances, variance analyses
can be done for each cost item or in total, depending on the complexity of the organisation, and how
standard costs are determined and allocated. So, in responsibility accounting, variance analyses of variable
manufacturing overhead costs are useful to evaluate the performance of the profit and investment centres.
Although these variances are not directly related to the performance of line managers, they are responsible
for monitoring and controlling these costs and hence have a shared responsibility to explain the causes of
these variances.
Similar to direct material and direct labour costs, a price and an efficiency variance is calculated for
variable overhead costs. Here, the price variance is referred to as the spending variance. Example 3.22
demonstrates how the flexible budget variance is calculated for variable overhead costs.
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EXAMPLE 3.22
Calculating the flexible budget variance forvariable overhead costs

Assume that the variable overhead cost driver is labour hours and the following standard rates are applied:
Budgeted labour hours to manufacture one unit: 15 minutes
Actual labour hours to manufacture one unit: 10 minutes
Standard variable overhead rate: $8
Actual variable overhead rate: $7
Using the actual quantity of 4500 from the Example 3.8, the flexible budget variance for variable
overhead costs will be determined as follows:
Actual results – Flexible budget
= (AQ × AP) – (BQ allowed for AQ × BP)
= (4500 × 10 / 60 × $7) – (4500 × 15 / 60 × $8)
= $5250 – $9000
= $3750 favourable
Subdividing the flexible variance into the spending and efficiency variance for the variable overhead
costs are calculated in Examples 3.23 and 3.24 respectively:
EXAMPLE 3.23
Calculating the variable overhead costs spending variance

Spending variance = Difference between actual results and flexed budget
= (AQ × AP) – (AQ × BP)
= (4500 × 10 / 60 × $7) – (4500 × 10 / 60 × $8)
= $5250 – $6000
= $750 favourable
EXAMPLE 3.24
Calculating the variable overhead costs efficiency variance

Efficiency variance = Difference between flexed budget and flexible budget
= (4500 × 10 / 60 × $8) – (4500 × 15 / 60 × $8)
= $6000 – $9000
= $3000 favourable
The total of the spending and efficiency variances equals the flexible budget calculated in Example 3.22:
$750 (F) + $3000 (F) = $3750 favourable.
The aim of organisations should not necessarily be to achieve favourable variances. A favourable
variance in one cost component is not always desirable, as it may result in unfavourable variances in
other cost components. These are illustrated in Example 3.25.
EXAMPLE 3.25
Favourable and unfavourable variances

Sunil, the purchasing manager for Acropolis Pty Ltd (Acropolis) purchased a batch of lower priced direct
and indirect materials. Consequently, the price and spending variances of direct materials and indirect
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materials was favourable. However, often, the quality and the price of materials are linked. Normally, the
lower the price, the lower the quality.
The decision of Sunil, however, affected the performance of Diego, the production manager of Acropolis,
adversely. Using lower quality material resulted in more materials being used and wasted, which resulted
in unfavourable efficiency variances of direct material and of variable overhead costs.
The lower priced materials also impacted the labour price and efficiency variances of Acropolis
unfavourably because more time was needed to work with the poor-quality material and to rework jobs.
As more time was required, the actual direct labour costs increased and compared to the budgets, the
labourers were less efficient. These unfavourable direct labour price and efficiency variances will impact
the performance evaluation of Diego negatively, although he is not entirely responsible for these, as they
are a direct consequence of the lower quality of materials purchased.
Further, assume that later in the year, Acropolis hired several less skilled workers at a lower pay rate
than usual. Although this resulted in a favourable labour price variance, these workers were slower
to complete tasks. This increased the total labour hours and resulted in an unfavourable direct labour
efficiency variance.
If Acropolis had hired more skilled workers later in the year, they might have been more efficient and
completed the tasks more quickly, using less total direct labour hours, and consequently would have had
a favourable efficiency variance. However, as they are more skilled, hiring them would have resulted in an
unfavourable direct labour price variance. In making decisions about which workers to employ, managers
have to offset the price and efficiency variances.
Correct interpretation of variance analysis provides management with essential information to make the
best decisions so as to find a ‘happy balance’.
Knowledge of how to calculate these variable cost variances is important for management accountants
in analysing and interpreting how variances are derived. However, more important is that the management
accountant can apply this knowledge in analysing and interpreting the possible causes of the variances. It is
essential that management accountants understand the correlations between possible causes of variances,
the interrelatedness and interdependencies within and across business functions in the value chain, and
between activities, decisions and actions, and their flow-on effects.
Figure 3.7 provides some possible causes of variances in variable cost. In addition, remember that
one possible reason why actual results will deviate from budgeted forecasts is because of an ‘incorrect’
budget, either being too high or too low. Although this is a plausible reason as to why AC will deviate
from the budgeted forecasts, be cautious in accepting an ‘incorrect’ budget as a cause for variances year
after year.
FIXED MANUFACTURING OVERHEAD ANALYSIS

The fixed manufacturing overhead costs variances are determined in ways slightly different as to how
the variable cost analyses are determined. This is because sales and production volumes do not affect
fixed manufacturing overhead costs within a relevant range, so no efficiency variance is calculated.
Instead, a production volume variance is calculated. Similar to variable manufacturing overhead costs,
many organisations use standard costing to allocate fixed overhead costs to responsibility centres or
departments.
Actual fixed overhead costs are also accumulated to cost pools with the same cost driver to determine
a predetermined allocation rate—Total fixed costs / cost driver. This rate is then used in developing the
master budget. Examples of fixed manufacturing overhead costs that will be allocated are:
• depreciation on plant and equipment
• leasing cost on plant and equipment
• plant manager’s salary.
Similar to the variable overhead costs, a spending variance is calculated, but not in the same way.
First, no flexible budget is calculated and second, the spending variance is the difference between the
AC and the static budget for fixed costs. In essence, the static budget becomes the flexible budget for fixed
costs. Examples 3.26 and 3.27 illustrate how the spending and production volume variances for fixed
manufacturing overhead costs are determined,
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FIGURE 3.7 Possible reasons for variances
Favourable price and spending Favourable efficiency variance

variance • Workers are more skilled than
• Talented junior staff who can expected, thus use less labour
perform the tasks just as well as hours
higher paid staff • Efficient scheduling if jobs
• Skilful negotiations of the resulting in less machine-hours
purchasing manager used than budgeted
• Oversupply of raw materials in • New and improved production
the market resulting in a drop in scheduling software has been
the price installed
• Buying raw material in bulk at • Using higher quality raw material
reduced prices and indirect materials
• Change to supplier with better
prices
• Using cheaper substitute
materials
• Better financing decisions in
purchasing (e.g. asking for a
discount) Reasons
for
variances
Unfavourable spending variance Unfavourable efficiency variance

• More experienced workers were • Workers are less skilled than
employed with higher wages expected
• Sales staff promised a rushed • Unskilled workers had to be
delivery, so overtime had to be used because of an unexpected
worked, paid at higher rates event that prevented skilled
• Staff underwent training, workers doing the job
obtained qualifications or got • Inefficient scheduling of jobs
promoted, so had an increase in resulting in more machine-hours
their wages used than budgeted
• Short supply of raw materials in • Machines not maintained, so not
the market resulting in an in good operating condition
increase in the price • Machine breakdown
• Using lower quality raw material
and indirect materials
EXAMPLE 3.26
Calculating the spending variance for fixed manufacturing

overhead costs
Continuing on from the previous example, assume the following additional information:
Actual fixed overhead costs $32 000
Budgeted fixed overhead costs $30 000
Fixed manufacturing overhead costs are allocated to finished products based on the labour hours used.
Budgeted labour hours per finished product: 15 minutes per unit
Standard fixed overhead cost rate for allocating fixed overhead costs to finished products:
Total costs / cost driver
= $30 000 / (15 / 60 × 5000)
= $30 000 / 1250
= $24 per hour
Four units are made per hour, therefore the rate per unit is $6.
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The formula for determining the spending variance of fixed manufacturing overhead is as follows:
Actual fixed cost – static budget for fixed overhead cost
= $32 000 – $30 000
It is important to remember that the $30 000 budgeted fixed cost will only be fully allocated if all 5000
budgeted goods are produced. Therefore, this predetermined rate of $6 per unit will only be accurate if
5000 units are produced. However, in this example, only 4500 units are produced. Therefore, not all fixed
costs will be allocated, which is the production volume variance.
The production volume variance is the difference between budgeted fixed overhead and fixed overhead
allocated on the basis of the actual number of finished goods produced. To determine the fixed costs
allocated, the following formula is used:
Budgeted quantity allowed for Actual quantity of input × Budgeted price
BQ allowed for AQ × BP
Example 3.27 shows how the production volume variance is determined.
EXAMPLE 3.27
Calculating the production volume variance for fixed overhead costs

Static budget – (BQ allowed for AQ × BP)
= $30 000 – (15 / 60 × 4500 × $24) or (4500 × $6)
= $30 000 – $27 000
= $3000 unfavourable or under-allocated
This production-volume variance is the fixed costs of units that were not produced (i.e. 500 units ×
$6 = $3000) and could not be allocated (i.e. under-allocated). If more goods are produced than forecast
then the production volume variance will be favourable, which means too much fixed costs were allocated
(i.e. over-allocated). Over-allocated fixed costs is also referred to as over-applied and under-allocated as
under-applied.
It is important to understand the production volume variance so that it can be accounted for in the
accounting records. In accordance with AASB 102 Inventories, manufacturing fixed overhead costs is
considered an inventoriable cost. Using standard costing, fixed costs are viewed as if they had a variable
cost behaviour and are consequently allocated to finished goods accordingly.
In this case, only the fixed overhead costs that are allocated to the actual number of finished goods
produced ($27 000) are recorded in the accounting records. The master budget forecast fixed costs as
$30 000 but only $27 000 will be allocated. This will result in $3000 not being allocated to finished goods.
But remember, the actual fixed costs will eventually have to be recorded in the accounting records and
presented in the income statement, so the unfavourable production volume variance calculation of $3000
will also have to be recorded in the accounting records.
However, be cautious and remember that there is a vast difference between the actual behaviour of fixed
overhead costs (not affected by level of activities) and how fixed overhead costs are allocated to finished
goods (applying a predetermined rate to level of activity). When forecasting fixed overhead costs to develop
a master budget, always use the total lump sum costs (which are based on their behaviour) and never use
the fixed costs per unit.
Although fixed overhead costs are part of the manufacturing costs, they are not under direct control of
the managers of cost centres. In responsibility accounting, managers of the profit and investment centres
are responsible for these costs, and analysing these variances is useful in their performance evaluation.
Analysing the production volume variance is important in making decisions about resource allocation.
Fixed costs are only fixed within a relevant range. The relevant range typically depends on the available
resource capacity. For example, the size of the plant and the number of machines it contains, dictates
how many units will be produced and hence the number of labourers required. Returning to the Acropolis
example (see Example 3.25), assume the relevant range is between 4000 and 6000 units. The budgeted
fixed cost of $30 000 is only appropriate if Acropolis manufactures between 4000 and 6000 units. Now,
assume there is an indication of a sustained increase in the demand of 2000 of Acropolis’s products over
the long term. The relevant range will then change to between 6000 and 8000 units. To enable Acropolis to
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increase its production, they will have to review their strategic plan and make decisions about expanding
resources, such as:
• buying or leasing additional plant and machinery
• employing more workers, including an additional supervisor for the plant.
The production volume variance may also indicate that not all fixed costs are allocated—meaning that
there is idle capacity. This may be an early warning sign of a decrease in the demand of the organisation’s
products, and may signal that the resources need to be downsized and capacity curtailed.
Analysing the spending and the production volume variances of the fixed overhead costs is therefore
important for the profit and investment centres’ managers to monitor the resource allocations. Further, the
production volume variance may provide signals and warning signs that may trigger a chain reaction of
issues that require further investigation. Important questions to ask when analysing fixed overhead costs
variances are:
• Why did the organisation not produce at the capacity forecast in the budget?
• Was there a decrease in demand?
• Did the quality of the product deteriorate, which resulted in customers buying less or from competitors?
• Are there gaps or weaknesses in the product and marketing strategies?
• Do competitors have aggressive product and marketing strategies?
• Were there new entrants to the market?
• Are the selling prices too high?
• Are competitors selling their goods at a lower price?
Answering these questions will help with understanding the organisation’s environment and may help
managers to make decisions about possible future courses of action.
Although variance analyses are useful in evaluating performance of appropriate managers, due to the
connectivity and interrelatedness of issues within an organisation, variance analyses should not be used
as evidence of good or bad performance. A favourable variance does not necessarily indicate that the
manager should be rewarded with a bonus for good performance. Similarly, an unfavourable variance
does not necessarily indicate that a manager should be reprimanded or punished for poor performance.
Variance analyses should only be regarded as a starting point to understand what really happened in
the organisation, and to dig deeper and behind the measured results in order to reveal the underlying
performance. The purpose of setting budgets and doing variance analyses is to improve performance,
monitor the implementation of the operational plan and provide information for management to change
the strategy if needed. So, variance analyses are best used to provide suggestions for further investigation
and future improvements.
Variance analyses are therefore a means that enable management to take appropriate actions and make
more precise predictions in order to achieve improved budgets as well as actual results in future, as
illustrated in Example 3.28.
EXAMPLE 3.28
Implementing improvements informed by variances

Based on the results of the variance analysis provided by their management accountant, Acropolis made
the following decisions:
1. put in place new and improved quality management systems
2. implement improved employee-hiring practices and training procedures
3. install software and systems to allow this task to be done automatically
4. ensure preventive maintenance is done regularly on all machinery and equipment
5. start a project to improve communication and coordination between staff in various functions in the
value chain and to improve processes and systems.
QUESTION 3.4
Leap Ltd (Leap) uses standard costing in planning and flexible budgets in controlling its manufac-
turing. It has two direct-cost categories (direct material and direct labour) and two overhead-cost
categories (variable and fixed manufacturing overhead).
The cost driver for both overhead-cost categories is direct manufacturing labour hours. For the
previous period:
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$
Total variable overhead costs 720 000
Total fixed costs 2 568 000
The fixed costs are incurred equally per month and are for a factory large enough to meet Leap’s
capacity to supply the current demand.
The total direct labour hours forecast for the current year were 80 000 hours.
During May, 16 000 saleable units were produced. Of these, 14 000 units were sold. There was no
beginning inventory of direct materials and no beginning or ending work in process for May.
Due to a natural disaster, there was a short supply of raw material from the current supplier
during April. Consequently, Leap was not able to meet the demands of customers in April, causing
a backlog of 5000 units in sales. To satisfy these customers, the sales manager promised that the
goods would be produced in May and offered a discount of $20 per unit on the budgeted selling
price of $150 per unit.
For the May budget:
Sales volume 10 000 units
Number of units to be manufactured 12 000 units
Standard usage of raw material 1.2 kg per unit
Standard labour hours per unit 30 minutes
To meet the demand for both the backlog of April sales and the planned sales of May,
Leap appointed casual labourers at a pay rate of $20 per hour. The budgeted and actual pay rate for
its permanent labourers is $25 per hour. However, due to the inexperience of the casual labourers,
they had to redo 1000 jobs. It took them 30 minutes to make each of the 2000 units the first time,
and 1000 units took another 30 minutes to redo each one. Fortunately, Leap ended their contracts
within two weeks to avoid any further waste.
However, to meet the sales demand, permanent labourers had to work overtime to manufacture
2000 units. It took them 30 minutes per unit to manufacture the units, for which they were paid time-
and-a-half. The permanent labourers also manufactured 12 000 units that took them 20 minutes
each to make.
Leap’s purchasing manager found and purchased a substitute raw material that was superior
compared to the raw material purchased before, but it cost $44 per kilogram (compared to the
budgeted raw material of $40 per kilogram). Leap started to purchase the substitute material on
1 May. Due to the superior quality, less raw materials were used in the manufacturing process.
In addition, the finished product was of a better quality, so the sales manager increased
the selling price to $160 per unit on 1 May. Unfortunately, some customers were not satisfied with
the increased price and bought from Leap’s competitors instead. Due to this, Leap lost 1000 of the
forecast sales volume for May, although these units were produced.
Due to the improved quality of the raw material purchased in May, the permanent labourers only
used 1.1 kg per unit manufactured. The actual variable manufacturing overhead cost was $60 000
and fixed manufacturing overhead cost was $220 000 for May.
During the planning of the budget, management wanted to increase the finished goods inventory
levels.
The budgeted inventory of finished goods as at 31 May was 2000 units.
(a) Prepare a static income statement budget for Leap
Sales volume
Sales
Direct material costs
Direct labour costs
Variable manufacturing overhead costs
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Fixed manufacturing overhead costs
Operating profit
(b) Calculate each of the following variances so that you can communicate effectively with
the appropriate managers and ask appropriate questions to investigate possible causes for
each variance.
• Sales price variance
• Sales volume variance
• Direct material price variance
• Direct material efficiency variance
• Direct labour price variance
• Direct labour efficiency variance
• Variable manufacturing overhead spending variance
• Variable manufacturing overhead efficiency variance
• Fixed manufacturing overhead spending variance
• Fixed manufacturing overhead production volume variance
(c) Analyse each of the variances you calculated in (b) and discuss sensible and plausible causes
to explain these variances.
• Causes for variances in sales
• Causes for variances in direct material
• Causes for variances in direct labour
• Causes for variances in variable manufacturing overhead
• Causes for variances in fixed manufacturing overhead
(d) Consider each of these variances as a control mechanism to evaluate the responsible man-
agers’ performance. Discuss which variance relates to which manager and whether any of these
managers will be eligible for a bonus or whether anyone needs to be reprimanded.
• Sales manager
• Production manager
• Purchasing manager
PART D: BEHAVIOURAL ASPECTS OF

BUDGETS
When designing and implementing budgets, human behaviour should always be considered, because this
can influence an organisation’s overall effectiveness.
A budget affects virtually everyone in an organisation: those who prepare the budget, those who use the
budget to facilitate decision making, and those whose performance is evaluated using the budget (Langfield-
Smith et al. 2018).
Budgets are often used to judge managers’ performance, so they can have a significant behavioural
effect. When setting budgets, it is best if there is ‘goal congruence’—when an individual’s goals coincide
with the organisation’s goals. Goal congruence motivates individuals and drives each manager to achieve
the set goals. However, this is one of the greatest challenges in managing large organisations. Negative (or
dysfunctional) behaviour may occur if budgets are poorly administrated—resulting in a conflict between
individual goals and those of the organisation.
The next section discusses participative budgeting, including resulting behavioural aspects, and how
negative behaviour can be avoided when setting budgets.
PARTICIPATIVE BUDGETING
Depending on the culture and structure of the organisation, a top-down or a bottom-up approach may be
used to prepare budgets. The approach and degree of lower-level management participation in setting
budgets varies between organisations. Participative budgeting is an iterative process, involving many
lengthy and time-consuming repetitive steps in negotiating and revising figures so as to eventually gain
approval for the budgets. Consequently, participative budgeting is expensive.
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THE TOP-DOWN APPROACH
In the top-down approach, senior managers impose budgets on junior or lower level managers (who have
very little say and participation in the budget-setting process). For example, ‘budgets may be set at the
corporate level and then cascaded down to the various responsibility centres’ (Langfield-Smith et al. 2018).
Although this approach is less time consuming than the bottom-up approach and may therefore be more
cost effective, it has major disadvantages:
• ‘[S]enior managers may have less knowledge of the local business environment than do those managers
working directly in the particular responsibility centres’ (Langfield-Smith et al. 2018, p. 437).
• Due to a lack of involvement in setting the budgets, middle and junior managers may not be committed
to achieve the budgets.
• Although top management may set the target high as a means to encourage improved performance, it
may discourage employees.
Research has shown that the top-down approach to planning and control is not the best way to create
order in complex adaptive systems (Roosli & Kaduthanam 2018). When top management sets the budgets
too tightly, using the top-down approach, it often frustrates and demotivates the individuals who have
to execute the budget. Not only may this result in poorer performance, but managers may be inclined to
manipulate data. Targets and budgets are more likely to be accepted and achieved if they are considered to
be achievable. Therefore, managers of responsibility centres should have direct input into the process
of establishing budget goals of their area of responsibility. If this is not the case, they may adopt an
‘it’s not my budget’ view and consider the goals set by top management as unrealistic or arbitrary.
For these reasons, it is argued that budgets should be developed with the participation of lower-level
management, referred to as the bottom-up approach. The idea is that the bottom-up plan should inform the
top-down plan.
THE BOTTOM-UP APPROACH

In the bottom-up approach, lower-level managers and operational staff participate in the budgeting process.
The decision-making is delegated down to the front line much as is practical. The theory is that people
will be more committed to a budget and try harder to achieve it when they have been consulted during
the target-setting process. It is more likely that targets will be achieved if employees are held responsible
for activities that they believe are within their control and this results in greater motivation to improve
performance. In the bottom-up approach, budgets are developed at the lowest responsibility centres and
fed up to senior managers to make the final decisions.
Advantages
The bottom-up approach encourages coordination and communication between managers by allowing
subordinate managers considerable say in setting budgets. Giving people individual freedom to make
decisions and team autonomy creates a sense of responsibility and fosters creativity. Further, budgets
developed using the bottom-up approach may lead to increased goal congruence because the budgets may
then become the manager’s personal goal.
This approach may also provide greater understanding and appreciation of the organisation’s objectives
and wider strategy when top management communicates strategic goals and targets to division and
department managers, who then incorporate these into the budgeted operating plans. Although top
managers approve the final budget, they rely on the knowledge, insight and expertise of lower-level
management and operational staff to help establish realistic departmental budgets.
Disadvantages
However, using the bottom-up approach can also result in dysfunctional behaviour, including internal
corporate political issues (e.g. power struggles and refusing to cooperate), protracted negotiation games,
‘horse-trading’ tactics, empire building, and eventually blame shifting. Managers associate resources under
their control as power and status, which may lead to a ‘game’ between leaders and would-be leaders.
To avoid these political struggles, top management should foster a culture of cooperation rather than
competition among employees and ensure there is transparency and involvement in budget setting.
The bottom-up approach may also result in potential problems with setting targets and budgets, such as
‘pseudo participation’ and ‘budgetary slack’ (referred to as padding the budget).
Pseudo participation occurs when top management only appears to seek input from lower-level
managers, but they really assume total control of the budgeting process and only seek superficial
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participation from lower-level managers. In essence, top management only seeks lower-level managers’
formal acceptance of the budget and not real input.
Budgetary slack (or padding the budget) exists when a manager deliberately underestimates revenues or
overestimates costs in an effort to make the future period budgets appear less attractive in the budget than
they think it will be in reality (Mowen et al. 2016, p. 352).
Some managers may pad budgets because they know it will be easy to achieve and so they will be entitled
on incentives. In essence, they drain the budget in an attempt to ensure sufficient funds are available in
future budgets. In padding the budget, managers believe they build in a buffer and therefore reduce the risk
of receiving an unfavourable performance evaluation for not meeting their goals. Budgetary slack is also
used as a means to cope with uncertainties and unforeseen or unanticipated events. It is also common for
top management or the budget committee to cut budgets, so managers pad budgets, and because budgets
are likely to be padded, they are cut.
Budgetary slack may be the result of poor budgeting administration, where budgets are used as a
control mechanism of performance. For example, if a regional sales manager received a poor performance
evaluation in the previous period, they may be inclined to set a conservative budget. On the other hand,
managers of cost centres may inflate the budget. When this budget is used in their performance evaluation,
comparing AC with the overestimated costs in the budget will appear as if the manager managed the cost
centre in a cost-effective way.
It is understandable and sensible to build in a buffer in a budget and to estimate some costs slightly
higher than what is really expected so as to factor in uncertainty. However, deliberate excessive padding of
costs and revenue is misrepresentation and is a questionable ethical professional practice. Not only is this
is a violation of credibility standards but it is doubtful if managers applying such behaviour demonstrate
integrity. The challenge is for top management to carefully review participative budgets in an attempt to
reduce the effects of budgetary slack, and to set budgets that are realistic and achievable (this is discussed
in the next section).
QUESTION 3.5
Ariel Ltd (Ariel) uses the bottom-up approach in developing budgets and uses standard costing.
It manufactures a variety of outdoor furniture and equipment in numerous departments. Ariel uses
variance analysis to evaluate the performance of each department and the responsible manager.
In the past, the production department of the Akimo dining chairs and tables has achieved mostly
favourable variances. Consequently, the manager of the Akimo production department has received
excellent performance evaluations and considerable bonuses. Managers receive a bonus if they
either meet the budget or do not deviate from the budget by 10 per cent. The bonus is based on a
fixed percentage of actual profits of the organisation. No bonus is awarded if Ariel’s actual profit is
less than the budgeted profit.
On average, 144 tables of the Akimo dining table and chairs set are produced per day. The
production manager, Martin Steen, provided the following monthly data to be used to prepare the
budget for the next financial year:
Input Budget quantity per table Total quantity
Direct material 20 kilograms 2880 kg
Direct manufacturing labour 25 minutes 60 hours
Machine time 45 minutes 108 hours
Actual results to manufacture 144 tables for April of the following year are:
Input Total quantity
Direct material 2736 kg
Direct manufacturing labour 52.5 hours
Machine time 110 hours
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There are seven labourers each working 7.5 hours per day.
Due to an economic slowdown, Ariel’s top management wants to tighten the budget for the
following year as a means to challenge and encourage employees to improve their performance,
and to reduce costs.
As Ariel’s management accountant, you ask Martin Steen to provide you with challenging yet
achievable data to be used to develop next years’ budget. In response, Martin provided you with
the following input quantities per table:
Input Quantity per table
Direct material 19.5 kilograms
Direct manufacturing labour 24 minutes
Machine time 44 minutes
Martin also informed you that the reductions in the input quantities will only be possible if the
labourers are more efficient. To become more efficient, they will have to receive training in how
to use less time and materials. This will make them more skilled, which will entitle them to a
pay increase.
(a) Why has Martin Steen chosen these figures for the new budget? Are they challenging
and realistic?
(b) What aspects would you consider when communicating with Martin in challenging him about
the proposed figures?
(c) What steps can top management take to encourage Martin to provide budgeted data that will
ensure goal congruence?
SETTING REALISTIC AND ACHIEVABLE TARGETS

To mitigate the negative behaviour and practices of setting unrealistic budgets and to enhance goal
congruence, the challenge is to set realistic budgets. This can be achieved in a few ways.
• One way is to avoid using the budget as a means to rigidly evaluate performance, but instead to allow
some discretion when comparing actual performance with the expectations set out in the budget. For
example, consider the situation when the actual maintenance costs of machinery exceed the budget,
but this is due to a breakdown that was not foreseen—these mitigating circumstances should be taken
into account.
• Since incentives for achieving the budget have the potential to lead to negative behaviour and practice,
another way is to give rewards for consistently providing accurate budget estimates.
• To ensure that everyone makes decisions in the interest of meeting organisation-wide targets, align goals
and incentives giving everyone who achieves their goals an incentive.
To achieve goal congruence, budgets should be based on realistic conditions and expectations. Setting
realistic budgets requires coordination, transparency, communication, cooperation and commitment on all
levels of management. It requires an attitude of ‘us’ and not one of ‘us and them’ or ‘what’s in it for me’.
This is closely related to human behaviour and psychological issues—controlling issues such as greed, ego
and fear is clearly outside the scope of the accounting discipline. No budget will ever be able to completely
prevent this negative behaviour.
According to Horngren et al., most employees will ‘work more intensely to avoid failure than to achieve
success’ (2011, p. 421). From this perspective, top management may set challenging targets but targets
that, in their view, are achievable. However, as discussed earlier, overly ambitious targets and budgets may
be viewed as unachievable and therefore discourage staff because they see very little chance of avoiding
failure. On the other hand, lowering standards and setting targets and budgets that are too easy to achieve
may result in employees not being challenged enough. This may result in them becoming complacent. It is
argued that having a challenging budget, but one that employees believe they can achieve, will encourage
and motivate them—so the trick is to find the balance between a ‘too easy’ and a ‘too hard’ budget. This
is referred to as a realistic budget.
Setting realistic budgets is important when budgets are linked to incentive schemes to reward managers’
performance. This is discussed in the next section.
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MONETARY AND NON-MONETARY INCENTIVE
SCHEMES
The core of nearly every organisation’s management control system is budgetary control (Kleiner &
Wilhelmi 1995). Providing regular feedback to managers on their performance is essential to exercise
budgetary control. It is more likely that targets and budgets will be achieved if managers receive frequent
feedback and if the achievement of targets is accompanied by rewards that are valued. Consequently,
both monetary and non-monetary incentive schemes are used as a means to encourage goal-congruent
behaviour.
Monetary incentives are used to motivate managers to be productive, work efficiently and reduce
waste. Good performance is rewarded with, for example, salary increases, bonuses and promotions. Poor
performance on the other hand may lead to dismissal. While monetary incentive schemes are important,
linking individual bonuses to targets will only increase dysfunctional behaviour (Bogsnes 2018), and
overemphasising monetary incentives can lead to a form of dysfunctional behaviour referred to as ‘myopia’
or ‘milking the firm’. In this case, managers take action to improve short-term performance but at the
expense of the long-term performance of the organisation. They simply disregard or overlook the fact
that concentrating only on short-term goals may have a harmful effect on the organisation’s long-term
sustainability. Further, ‘money loses its motivating power to purpose, mastery, autonomy and belonging’
especially ‘when we move to more complex and team-based “knowledge” work’ (Bogsnes 2018, p. 12)
In addition to monetary incentives, most people are also motivated by intrinsic psychological and
social factors, including non-monetary incentives such as responsibility, challenges, the freedom of not
being micro-managed or the simple acknowledgement and recognition of a job well done. As Bogsnes
states, many people ‘are much more fired up by the right words, igniting our hearts and minds in a very
different way than those clinical and decimal-loaded numbers ever could’ (Bogsnes 2018, p. 9). Intrinsic
factors may boost people’s self-esteem and give them a feeling of job satisfaction. Consequently, some
organisations use non-monetary incentives such as job enrichment, increased responsibility and autonomy,
and recognition programs in budgetary control.
Therefore, to avoid dysfunctional behaviour in the budgeting process, a holistic performance evaluation
should be done, analysing how results were achieved, how ambitious the targets were, which risks were
taken, and how sustainable the achieved results are. Also, a combination of financial and non-financial
incentive schemes that gauge both short-term and long-term effects on the organisation’s performance can
be used to reward managers’ performance. Further, employees should not be rewarded for meeting targets,
but rather, for achieving the best possible outcome given the circumstances. Setting targets is only one way
of trying to achieve the best possible outcome ‘but not the only way and all too often, not the best way’
(Bogsnes 2018, p. 5).
QUESTION 3.6
Following on from the information provided in Question 3.5, the following standards were used in
developing the budget for the Akimo production department of the dining chairs and tables for the
following year:
Input Standard quantity per table
Direct material 15 kilograms
Direct manufacturing labour 20 minutes
Machine time 40 minutes
These standards were made possible due to careful negotiation and coordination. Top manage-
ment agreed to provide training so that the employees could improve their efficiency, but due to
the downturn in the economy, they did not agree on an increased pay rate. The employees were
happy with this decision because they retained their jobs and had an opportunity to upskill.
Due to a redesign in the table, a different type of material is now being used, which requires less
material and fewer machine hours. Further, a new supplier for the material has been found.
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Due to the tighter budget, the Akimo production department received a few unfavourable
variances in the first month of the new year. Martin Steen is concerned about the effect this may
have on his performance evaluation and bonus this year. A few months later, Martin also begins to
doubt that Ariel will achieve its budgeted profit. Due to these concerns, he deliberately works on a
plan to prove that the standards were set too high.
• He convinces the employees that the quality of the tables is not as good as previously and this
encourages them to work more slowly.
• He also convinces the purchasing manager that the quality of the tables is not as good as
previously and to purchase the material from the previous supplier—which is of inferior quality
compared to the material currently used.
Martin knows that these proposed changes will increase the quantities input per table and he
plans to use these more generous standards in setting the budget for the following year. He is
convinced that if this budget gets approved, he will be able to convince the purchasing manager to
purchase the better quality material again and also the labourers to be more efficient.
(a) Comment on Martin Steen’s behaviour and what the potential drivers behind this might be.
(b) What actions can be taken to ensure goal congruence?
(c) Assume that Martin is successful in convincing the labourers and the purchasing manager and
that he develops a budget which is quite obviously padded.
Discuss how you will be able to point out budgetary slack to Martin by discussing which variances
you will analyse and what the expected outcomes of these variances will be.
PART E: ALTERNATIVE APPROACHES

TO BUDGETING
Due to the negative behavioural issues and the limitations of budgets discussed so far, traditional budgeting
practices have been criticised. The shortcomings of annual traditional budgeting practices are discussed
in the next section. Later in this part, three alternative approaches and techniques that are proposed to aid
improved budgeting and planning processes are discussed:
1. incremental budgeting
2. zero-based budgeting
3. activity-based budgeting.
Finally, the Beyond Budgeting (BB) approach is discussed.
SHORTCOMINGS OF TRADITIONAL BUDGETS

Practitioners argue that budgets impede the allocation of an organisation’s resources to their best uses
(Hansen et al. 2003). Further, that it encourages myopic decision-making. ‘By the time budgets are used,
their assumptions are outdated’ (Hansen et al. 2003, p. 97). Criticism of traditional budgets are that
they impose centralised planning and decision-making that is a costly method, stifle initiative, impede
empowered employees from making the best decisions for the organisation, and restrict organisations’
ability to act and react. Due to digitalisation, globalisation or mobility, the business environment is
becoming more and more demanding, causing a VUCA world: volatile, uncertain, complex and ambiguous
(Roosli & Kaduthanam 2018). The unexpected is becoming the norm and organisations need to cope with
unforeseen events. Traditional budgeting methods are too unresponsive in this VUCA environment (Neely
et al. 2003).
Further, traditional budgets are not focused on value creation but merely on reducing costs. Research has
found that responsibility-centre-focused budgets are not compatible with value-chain-based organisations.
‘Traditional budgeting is fundamentally mismatched to today’s rapidly changing and uncertain environ-
ments’ (Hansen et al. 2003, p. 98). Another criticism is that traditional budgeting creates budgets for silo
functional units such as sales, production, and administration departments, and then allocates (or pushes)
these functional budgets to products.
Hansen et al. list the following most cited weaknesses of budgetary control:
1. Budgets are time-consuming to put together;
2. Budgets constrain responsiveness and are often a barrier to change;
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3. Budgets are rarely strategically focused and often contradictory;
4. Budgets add little value, especially given the time required to prepare them;
5. Budgets concentrate on cost reduction and not value creation;
6. Budgets strengthen vertical command-and-control;
7. Budgets do not reflect the merging network structures that organisations are adopting;
8. Budgets encourage gaming and perverse behaviour;
9. Budgets are developed and updated too infrequently, usually annually;
10. Budgets are based on unsupported assumptions and guesswork;
11. Budgets reinforce departmental barriers rather than encourage knowledge sharing; and
12. Budgets make people feel undervalued (Hansen et al. 2003, p. 96).
Neely et al. (2003) also identify 12 significant weaknesses of traditional planning and budgeting
practices, which they categorise into three principal categories:
1. competitive strategy
2. business process
3. organisational capability.
Overall, they state, traditional planning and budgeting processes are failing to deliver results, as ‘they
tend to promote an inward-looking, short-termist culture that focuses on achieving a budget figure rather
than on implementing business strategy and creating shareholder value over the medium to long term’
(Neely et al. 2003, p. 25).
Despite the shortcomings of traditional budgets, the vast majority of organisations around the world
are still using them in planning and control. Three principal approaches and techniques that have been
proposed to improve budgeting and planning processes are discussed next.
INCREMENTAL BUDGETING
Incremental budgeting involves the common practice of projecting next year’s budget by adding an
adjustment (e.g. a percentage increase due to inflation) to either the actual results or the previous budget.
This is a quick and easy way to develop a budget and may be useful in small businesses—especially service
organisations—with simple business models. However, using this approach to develop a budget for large
organisations with complex business models may not be appropriate.
This approach has a few disadvantages, whereby managers will not:
• plan appropriately for the future
• consider the strategic or operational plans of the organisation
• carefully consider the effects of internal and external factors (discussed earlier in this module).
This approach does not force managers to manage resources more efficiently and effectively. Further,
using the previous year’s budget only to plan the next year’s budget may result in complacency and
dysfunctional behaviour and waste of resources. For example, some managers have the belief and attitude
that they should spend the money in a budget even though there is no real need to do so. This dysfunctional
behaviour can be characterised as the ‘if you don’t use it, you will lose it’ mentality—resulting in some
managers spending money unnecessarily simply to avoid cutbacks.
To make these budgets more useful, it is recommended that the organisation use an incremental budget
simply as the starting point and, in addition, consider the internal and external factors that may affect the
organisation in future.
ZERO-BASED BUDGETING
Zero-based budgeting was developed and used widely in the 1970s and 1980s (Langfield-Smith 2018, p.
441). Zero-based budgeting is designed to reduce problems associated with incremental budgeting. As
the name indicates, using this approach, virtually every activity is set to zero. It is argued that this forces
managers to rethink each phase of the operations and to justify each activity and budgeted figure in order
for them to receive an allocation of resources. Under zero-based budgeting, managers prepare a budget
as if no information about revenue and costs from previous budget cycles is available—the budgets are
developed from scratch. It forces managers to carefully consider the effects of internal and external factors
(discussed earlier in this module).
Although rethinking each phase of an organisation’s operations and developing a budget from scratch
has advantages, it is very time consuming and expensive—because it requires extensive in-depth analysis
of expenditures.
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Zero-based budgeting is also criticised as being too introspective. It is argued that managers can overlook
the interactions with other departments and the relevance of their own part of the operations to the overall
business objectives and strategies. Consequently, this approach may not be useful for managing costs
or improving an organisation’s performance. Zero-based budgeting has also been criticised as not being
useful to identify ‘areas of waste, redundant activities, communication barriers or opportunities for more
effectively deploying resources to support business needs’ (Langfield-Smith 2018 p. 441).
For a further explanation of zero-based budgeting, please access the ‘Zero-based budgeting’
Case study on My Online Learning.
ACTIVITY-BASED BUDGETING
Activity-based budgeting (ABB) was developed by consultants Coopers and Lybrand Deloitte (Kleiner
& Wilhelm 1995). This approach primarily focuses on the problems with using traditional budgets as
a planning tool. ABB is a participative management process for control and continuous improvement
(CI) of performance and costs, operating at the activity level. It focuses on developing a budget
explicitly from activities and resources. In essence, ABB aims to make budgeting more meaningful to
operational managers.
In this approach, organisations apply the analytical operational model of activity-based costing (dis-
cussed in Module 6) with a detailed financial model. Opposed to traditional budgeting that is primarily
based on outputs and only use a few cost drivers, ABB uses a considerable amount of cost drivers. In
essence, activity-based and capacity management concepts are expanded into budgeting. In ABB, the
traditional budgeting process is modified to better reflect the operational processes in the organisation.
Various activity cost pools and their related cost drivers are used to forecast the costs for individual
activities. This approach allows managers to identify the resources consumption of each activity separately
and to prepare a budget for that activity accordingly.
Similar to traditional budgeting, the ABB process starts with forecasting future market demand for the
organisation’s products and services. The sales forecast drives the quantities of products to be manufactured
(and the product mix), which then drives the expected production activities. Using a range of activity
drivers (as opposed to the limited drivers of sales and production used in traditional budgeting), ABB
helps managers to estimate the resources that will be needed for each activity. Managers then analyse the
resource capacity of the organisation to conduct the required activities and compare this with the resources
necessary to produce the products. If the activity plan is not feasible, they adjust the budget loop until they
achieve a balance between the required resources and available resource capacity.
In using this approach, a feasible operating budget is developed before generating the financial budget.
Doing this avoids unnecessary calculations of financial effects until the operational plan is feasible. The
financial plan is typically broken down into information by resources, activities, products or other cost
objects (Hansen et al. 2003). In ABB, the product decisions, activity costs and resource costs are reviewed
until the targeted financial results are met (for further details, see Hansen et al. 2003).
It is argued that ABB has several potential benefits. It:
• makes budgeting more relevant for managers as it combines a more complete operational plan with a
detailed financial plan
• crosses departmental borders, leading to a horizontal process-based view of the organisation
• incorporates cost drivers such as batches or a facility, so it identifies the sources of imbalances,
inefficiencies and bottlenecks. In turn, this allows better product, process or activity costing
• allows better decision-making, resource allocation and capacity balancing
• communicates budgeting information to lower-level management in operational terms they can under-
stand more easily and not in financial terms
• strengthens the interface between planning and budgeting
• allows organisations to have feasible operational plans from the start
• provides a complete set of tools for balancing the financial budget—since ABB looks simultaneously
at sales forecasts, production efficiency, procurement prices, capacity decisions and product price
• makes the financial plan more relevant to operational managers—with the increased transparency
reducing dysfunctional behaviour and resulting in better coordination.
Prominent organisations such as Boeing, Emerson Electric, IBM Business Consulting Services, SAS
Institute and the US Marine Corps support the ABB approach. However, at the time of writing, it is still
an open question whether the higher complexity costs of the ABB approach can earn back the credibility
of the budgeting process.
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The components of the master budget in ABB is illustrated in the Figure 3.8.
FIGURE 3.8 Components of a master budget in activity-based budgeting
Strategic plan
Activities Resource capacity
Operational Capital investment

budgets budget
Sales forecast
Production activities
Activity budget
Financial plan
Resources Activities Products
Income statement Cash budget Balance sheet
Source: Based on Groot, T. & Selto, F. 2013, ‘Figure 5.3 Master budget components’, Advanced Management Accounting,
Pearson, Harlow, UK, p. 151.
In ABB, the operating budget implements the organisation’s strategy by forecasting the expected levels
of activities, for example sales, production, purchasing, maintenance, marketing and distribution (and other
overhead activities).
However, according to Neely et al., none of these three alternative approaches and techniques to planning
and budgeting processes provides a complete solution. A criticism that ABB and zero-based budgeting
share ‘is that they tend to involve even more work than traditional budgets so they are best used on a
‘one-off’ basis rather than a regular one’ (Neely et al. 2003, p. 25).
A radical re-engineering proposal to banish budgeting altogether, called Beyond Budgeting (BB), is
discussed next.
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BEYOND BUDGETING: MANAGING WITHOUT
BUDGETS
The BB approach primarily focuses on the problems with using traditional budgets as a performance
evaluation tool. It was developed in the late 1990s (Heupel & Schmitz 2015). This is a new approach
towards holistic organisational goals and their implementation, extending beyond financial planning
concepts (Roosli & Kaduthanam 2018). This approach connects the organisation’s strategy with managers’
decisions, and represents a management philosophy consisting of 12 principles.
See https://bbrt.org/the-beyond-budgeting-principles/ for the 12 principles and Roosli and
Kaduthanam (2018) for some dos and don’ts of these 12 principles.
The purpose of these principles is to guide and inspire organisations in implementing a BB approach.
It is argued that in planning and preparing an annual budget, there are too many uncertainties that cannot
be foreseen. Consequently, this makes annual budgets risky and even dangerous. Advocates of the BB
model argue that traditional ‘fixed’ contract budgets should be eliminated.
BB is a contemporary management model where organisations are managed without budgets. This
model introduces a system that has two interlinked key dimensions: decentralised leadership and adaptive
management processes (Roosli & Kaduthanam 2018). In the BB approach, decision-making is in the hands
of empowered local managers, having responsibility for their units. It is based on principles of employee
empowerment, assuming that employees enjoy contributing to the organisation they work for and they take
pride in their work. This model therefore ‘relies heavily on high levels of trust among employees with a
strong commitment to customer focus’ (Eldenburg et al. 2017, p. 178). The core of this movement rests with
extreme decentralisation of decision-making, with minimal influence from centralised functions. Other
important issues of this model is its transparent accounting and reward systems with relative performance
evaluation. Further, this model uses rolling forecasts as a form of benchmarking, in which plans are adapted
and evolved over time, enabling managers to adapt quickly to changing conditions. It is important to keep
in mind that rolling forecasts are not equivalent to rolling budgets. ‘Rolling forecasts as the prediction of
key values that may or may not be budget related for a period of time into the future, while rolling budgets
specifically link these updates to the budget’ (Bhimani et al. 2018, p. 308). It is argued that this approach to
forecasting can be used as a means to evaluate ‘relative performance assessment with hindsight’(Hansen
et al. 2003) and motivates employees towards CI.
To avoid the dysfunctional behaviour of traditional budgeting when used as a tool to evaluate perfor-
mance, BB uses ‘relative performance contracts with hindsight’ (Hansen et al. 2003, p. 101). The relative
component is because financial compensation is attached to the organisation’s overall financial results and
not relative to the unit’s performance. The hindsight component means that the performance is evaluated
against targets with hindsight. Thus, the performance ‘level is not set inflexibly in advance, but will be
established when the evaluation takes place and is equal to the benchmarked performance’(Groot & Selto
2013, p. 147). BB therefore aims to achieve goal congruence and ‘a philosophy of doing what is best for
the firm in light of current circumstances and to improve teamwork (Hansen et al. 2003, p. 102).
Although budgets are still developed in the BB approach, these budgets will not be used as targets that
must be achieved in performance evaluation. Thus, the planning and the performance evaluation functions
of budgets are separated. It is argued that, in future, less attention should be given to managing performance
through targets, budgets and bonuses, and more on creating conditions to enable great performance
(Bogsnes 2018). So the BB approach will encourage cooperation, make local managers feel responsible
for the performance of the entire organisation and discourage internal rivalry among units.
BB applies a more decentralised model of management control, which is consistent with strong clan
control (Groot & Selto 2013). BB relies on managers to make more strategy-focused planning and control
decisions, but without budgets. This ‘requires authority to be developed through the hierarchical layers to
lower level branches, teams and individual employees’ (Eldenburg et al. 2017, p. 178), giving individuals
autonomy and allowing them to quickly respond to, for example, customers. BB focuses on radically
decentralising organisations. It is argued that radical decentralisation gives employees responsibilities
and power to make decisions that affect their activities and operations they are responsible for. For
example, when decentralising an organisation, the sales managers may have the authority to make decisions
about the best product or service for a local region, and local teams will have the authority to set
prices, offer discounts and make decisions about local marketing and advertising. This decentralisation
allows employees to be innovative and creative. Support units, such as accounting, HR and information
technology departments, will still be maintained as centralised functions.
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While the BB approach sounds like a sensible approach for performance evaluation, not all organisations
will necessarily benefit from decentralisation. Further, the principles of the BB approach have not been
taken up widely across the globe. Only a cluster of Scandinavian companies have taken up the principles of
the BB approach and operate without targets and budgets (Neely et al. 2003). The Swedish bank Svenska
Handelsbanken prepared their last budget in 1970. Skandia, a Swedish financial services organisation, uses
a highly slimmed-down budgeting process that only includes high-level budget figures. To manage their
business, they apply a ‘navigator’ scorecard framework. Another company, Borealis, prepared their last
budget in 1995. They use rolling forecasts to manage the future and a balanced scorecard to keep track
of the organisation’s performance, and motivate staff through target setting. Volvo abandoned budgets in
1994. They use quarterly forecast planning and monthly reporting to manage their business.
Another organisation with a radical reengineering approach to improve the process of planning and
budgeting is Hilcorp Energy (Lalicker & Lambert 2018). McKinsey & Company undertook an interview
with the CEO of Hilcorp Energy, Greg Lalicker, about Hilcorp’s practices in planning and control. Hilcorp
has four practices:
1. Commitment to a flat organisation with no more than five layers above any employee.
2. Delegate decision-making, pushing decision-making as close to the front line as is practical.
3. Align goals and incentives. To ensure everyone makes decisions in the interests of meeting company-
wide targets, everyone gets the same amount, and all employees who achieve their goals receive an
incentive.
4. Have just enough process and control. Start the planning with a bottom-up plan that informs the top-
down plan.
A possible reason why the BB approach has not been widely implemented across the world is because
it lends itself towards a coaching management style, so requires a radical change in mindset or a new
management philosophy. Managing organisations without targets and budgets requires trust, autonomy,
transparency, helping each other, and accountability for creating value. Managers and employees have to
leave the safety of their comfort zones and move into a stretch zone (Heupel & Schmitz 2015). In these
stretch zones, ‘managers have to be ambitious, accept risks and deal with uncertainty’ (Heupel & Schmitz
2015, p. 734). BB is an approach positioning organisations to continuous development so that they can
stay viable for the future (Roosli & Kaduthanam 2018). Giving people the freedom to make their own
decisions develops greater coherence and strength.
REVIEW
This module provided an overview of budgets and how they are developed and used to evaluate
performance. It also discussed negative behavioural issues related to using budgets as a control mechanism
and alternative approaches that have been proposed consequently.
Part A discussed the roles and purposes of budgets and their relationship with an organisation’s strategy
and responsibility centres.
Part B detailed the various components of a master budget and developed operational budgets for an
example manufacturing organisation. It also described how financial and flexible budgets are developed.
Internal and external factors that should be considered in developing budgets were provided.
Part C described why and how static budgets are flexed into flexible budgets. It then illuminated how
flexible budgets are used to analyse variances with actual results for manufacturing organisations. Possible
causes for variances are proposed.
Part D discussed participative budgeting and behavioural issues that result from budgetary control. A
discussion of monetary and non-monetary incentive schemes used to motivate performance was provided.
Part E detailed criticisms against traditional annual budgets and alternative approaches proposed to
alleviate these shortcomings.
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Beyond Budgeting’, Procedia Economics and Finance, vol. 26, pp. 729–39.
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MODULE 4
PROJECT MANAGEMENT
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
Western Sydney Stadium (Lend Lease 2018), or a software development company such as Microsoft,
which develops and 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 towards the development of a new product
line, such as the Apple Watch. 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), or decision support software.
These examples show that projects are strategically important to organisations. For example, the
development of the Apple Watch was central to the company’s strategy to gain competitive advantage
in the marketplace by enhancing iPhone use through wearable technologies. To achieve these objectives,
project management must be aligned with an organisation’s strategic planning.
Projects are very important and management accountants are likely to be constantly involved in them in
the workplace. Projects are also challenging. Typically, each project 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. Even when a project has
similarities with other projects, each project still has its own unique characteristics.
Organisations today operate in an international and fast-paced business environment, which brings
constant change. This presents many challenges, but there are also significant rewards for successful
project management. Due to the uncertain nature of projects, a combination of technical tools, coordination
and individual judgment is required to make them successful. This module considers these issues from a
practical viewpoint.
Part A of this module 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 and control. Finally, in Part F, the post-completion and review processes are addressed.
management with information for projects and operational decision‐making that informs and is informed
by strategy.
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rnal environment
Ext e
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
VALUE INFORMATION
OPERATIONS
Ext e
rnal environment
OBJECTIVES
• Explain the steps and roles in project management and the different types of organisational structures
for projects.
• Undertake financial analysis to assess risk and return of a given project.
• Evaluate the strategic fit of competing projects or projects as a portfolio.
• Apply project management scheduling and budgeting techniques.
• Recommend approaches to monitoring and managing a project.
• Explain the importance of project post-completion review.
PART A: PROJECT MANAGEMENT DEFINED

WHAT IS A PROJECT?
Projects are everywhere—in the workplace, at home and globally. They can be as large and well known
as the construction of the Great Wall of China or the US space shuttle program; or they can be as small
as putting together a new entertainment unit at home; or they can be specific to a workplace such as
the upgrade of an IT system. Regardless of how large or small the project, or how specific, as shown in
Figure 4.2, a number of characteristics are common to all projects.
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FIGURE 4.2 Characteristics common to all projects
1. Unique 2. Provides a solution to

• Principal characteristic of any a problem
project (Zwikael & Smyrk 2011) • Satisfies an objective within
• Key distinction between
day-to-day operations and
#1 ? a defined scope
• Could be about generating
a project profit, reducing costs, or
• Leads to another defining improving a specific system
characteristic—high level or business process
of uncertainty • Objective is commonly
Projects set/agreed upon by the
4. Related activities
• Project activities use multiple business partner
resources that need • Any investment in a project
coordination should provide recognised
• Important to understand added value to the company
which activities must occur funding the project
sequentially and which can 3. Defined start and finish time
proceed concurrently • Management focus on the
finishing time is often very
high—most projects require
considerable investment
before the benefits are realised
• The longer the project
runs, the longer it is before
it generates a return
on investment
Examples of these characteristics can be seen in Example 4.1.
EXAMPLE 4.1
Australian liquefied natural gas (LNG) projects

Australia is the fourth largest LNG exporter in the world, with eight operating LNG developments, and two
other projects under construction. The existing LNG developments are located in Western Australia (the
North West Shelf, Pluto, Gorgon and Wheatstone), Queensland (Queensland Curtis LNG, Gladstone LNG
and Australia Pacific LNG) and the Northern Territory (Darwin LNG). Two large Australian LNG development
projects are located off the north coast of Western Australia (Prelude and Ichthys). ‘In total, Australia
has more than $80 billion of LNG projects under construction’ (Australian Petroleum Production and
Exploration Association 2018).
These projects demonstrate the characteristics of projects discussed earlier:
• While all are LNG projects, and so share some characteristics, their locations and distinctive geology
make each uniquely challenging in terms of accessing the LNG and transporting the gas to market.
• All projects are problem-oriented, being focused on increasing LNG production and associated
revenues.
• 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.
QUESTION 4.1
Complete the following table by listing six key characteristics of a project and explaining how these
make it different from day-to-day operations.
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MODULE 4 Project Management 147

1.
2.
3.
4.
5.
6.
WHAT IS PROJECT MANAGEMENT?

Project management is about planning, controlling and integrating resources and activities so that the
objectives of the project can be achieved on time and within budget. This includes trying to foresee all the
uncertainties or risks associated with the project.
The Project Management Institute (PMI 2017, s. 1.2.2) 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 the level of success and failure in projects
is considered. 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.
• The longer a project was scheduled to last, the more likely it was that it would run over time and budget
(Bloch, Blumberg & Laartz 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, as highlighted in
Example 4.2.
EXAMPLE 4.2
Rio 2016 Summer Olympics

An example of how it is difficult to maintain control over project costs is the Rio 2016 Summer
Olympic Games (Matheson et al. 2018). The actual cost of this project is estimated to have been up to
USD 20 billion. The budget was used for building the competition venues, the Olympic village, international
broadcast centre, media and press centre, road, rail and airport infrastructure, as well as for activities such
as transportation, workforce, security, catering, ceremonies and medical services. Although there is no
agreement on the exact numbers yet, it is clear that the actual cost was much higher than the expected
one; similarly, every Olympic Games since 1968 has finished up with actual costs (AC) exceeding original
estimates. How did this happen?
A number of issues affected the project:
• All Olympic Games events are complex mega-projects that require the involvement and collaboration
of governments, private contractors, international sports bodies and other influencing stakeholders.
• All Olympic Games projects are led by teams who do not have previous experience in managing an
Olympic Games project.
• The Rio 2016 Summer Olympic Games project was more complex for the organisers than originally
anticipated.
• There was a tight schedule because Brazil hosted the 2014 FIFA World Cup and the 2016 Summer
Olympic Games in Rio—two complex projects that needed high-level attention at the same time.
• Financial irregularities and allegations of bribery in Brazil contributed to the poor project results.
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 (Zwikael & Smyrk 2011) 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, the next section discusses the basic steps in the project
management process.
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THE PROJECT MANAGEMENT PROCESS
There are four basic stages in the project management process that sometimes overlap. This section
provides a brief description of each. These stages are shown in Figure 4.3 and will be discussed in more
detail later in the module.
FIGURE 4.3 The four stages of a project
Project
1 selection
Project
2
planning
Management
accountant
involvement
Project implementation
3 and control
Project completion
4 and review
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. This is also when 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 description of the project’s deliverables (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, or the investment will likely be wasted. For example, consider a manufacturer
pursuing a low-cost strategy. Projects or investments to support this strategy should increase efficiency and
reduce labour costs. A project to implement a new quality assurance automated process might increase the
products’ quality and reliability, but it would not necessarily support a low-cost strategy—so may not be
selected. Such a project would be more useful if the company was pursuing a differentiation strategy, such
as a high-quality strategy.
In this stage, the management accountant provides support in:
• identifying and quantifying risk(s)
• applying an analysis of strategic strengths, weaknesses, opportunities and threats (SWOT) (see
Module 1)
• assessing the financial viability of the project.
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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—where the activities that need to be performed in the project and the sequence in which
they are to be performed are considered
2. optimising cost and time—where the sequence of activities is analysed and optimal trade-offs are
established
3. budgeting—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
performed during and after project implementation
4. performance measurement—where the project specifications are converted into a set of performance
measures or key performance indicators (KPIs). KPIs are usually set against the key project deliv-
erables and incorporate clearly defined time frames. Critical points in project implementation called
‘milestones’ are also established
5. incentives—which 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 these five areas of project planning are complete,
the project sponsor reconsiders the feasibility of the project and either formally approves commencement
of the project or decides to discontinue it.
Part D discusses the tools used in project planning.
STAGE 3: PROJECT IMPLEMENTATION AND CONTROL

The project implementation stage happens 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 tracking how the project’s progress
compares to the milestones.
Operational or manufacturing variance analysis is well understood by accountants, but new complexities
arise in project variance analysis. Many projects extend over a long period of time— sometimes several
years. Price variances can arise due to:
• inflation—the decline in the purchasing power of the local currency
• currency movements when project resources are acquired offshore—changes to the local currency
against foreign currencies.
Project managers (discussed in Part B) need to understand how the cost of work completed differs from
the expected cost of this work (the cost 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.
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 learnt, knowledge management is an important skill to
have for this stage. It is important that lessons learnt from the project 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.
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QUESTION 4.2
Complete the following table by briefly explaining the role of the management accountant in each
project stage.
Project stage Management accountant’s role
Stage 1: Project selection
Stage 2: Project planning
Stage 3: Project implementation and control
Stage 4: Project completion and review
Note: This will be covered in greater depth in Parts C, D, E and F.
ORGANISATIONAL STRUCTURES
FOR PROJECTS
The organisational structuring of projects can be done in a number of different ways depending on the
requirements and purpose of the project. The six approaches summarised in Figure 4.4 are the main types
of project structure. These are discussed further in the following section.
FIGURE 4.4 Organisational structures for projects
Project Virtual
organisations projects
Organisational
structures
for projects
Internal Public private

projects partnerships
Joint
Collaborations
ventures (JVs)
PROJECT ORGANISATIONS
Project organisations are those that have projects as their core operating activity. Examples of this would
be construction companies (see Example 4.3), software companies or professional service organisations.
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EXAMPLE 4.3
Leighton Holdings
An example of a project-based organisation is Leighton Holdings, an Australian-based international
construction company whose core operating activity is building and infrastructure projects. A sample
of current projects chosen to demonstrate the scope of the company’s activities includes:
• the redevelopment of the Royal North Shore Hospital in New South Wales
• the development of the Melak coal mine in Indonesia
• the engineering and construction of the Springleaf Station and rail tunnel complex in Singapore
• the operation of the North West Rail Link in New South Wales.
Leighton’s involvement in these projects is as principal or, more commonly, as part of a consortium.
More information is available online at: http://www.cimic.com.au/our-business/projects.
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 supports 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, projects they will be involved in are likely to be internal (within the
organisation) ones.
JOINT VENTURES
This structure is used when two or more organisations co-contribute in a form such as capital and
technology to undertake a project where the revenue and expenses are also shared. JVs are common in
international projects where there are significant risks 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 organi-
sation. However, they tend to be less formal or more fluid and flexible than JVs, and do not always have
a commercial motive. Instead, collaborative projects build a sense of joint belonging and a culture of
cooperation that integrates the diverse skills, knowledge and expertise of people with no experience of
working together—an example of this can be seen in Example 4.4.
EXAMPLE 4.4
Project collaboration
An example of project collaboration involved the Finnish Transport Agency (client organization) and VR
Track Ltd. (the main contractor for both design and construction work) partnering in a complex railway
project. The railway renovation project aimed to improve the safety, reduce maintenance costs by renewing
and repairing structures, and reinforce surface and bench structures. The main goals of the project were
rail track usability, undisturbed railway traffic, scheduling, traffic and occupational safety, cost efficiency,
and planning and construction quality. The total budget of the project was 106.4 million Euro.
This project identified six key activities supporting the formation of collaborative project identity:
(1) articulating a joint vision for collaborative project identity;
(2) converging on mutual conceptions of collaborative project alliance philosophy;
(3) attaining a shared collaborative mentality;
(4) designing ways of working with multiple identities;
(5) attaining distinctiveness and
(6) legitimizing activities.
Source: Hietajärvi, A. & Aaltonen, K. 2018, ‘The formation of a collaborative project identity in an infrastructure alliance
project’, Construction Management and Economics, vol. 36, no. 1, 121.
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PUBLIC PRIVATE PARTNERSHIPS
Public private partnerships (PPPs) are formed when the government and private sector organisations agree
to undertake projects together, often in the public interest. The PPP structure may be used to reduce the
risk for the private sector organisations and provide the technical expertise required by the government.
While these partnerships are often focused on projects such as infrastructure development (e.g. the Sydney
Light Rail), they can also be focused on other areas such as health and welfare development, where the
project may be beyond the ability of any one government or private organisation to deliver.
A good example of this type of PPP is the Peter MacCallum Victorian Comprehensive Cancer Centre
(VCCC) in Melbourne, Australia, with information available at: https://www.petermac.org/about/
partnerships/vccc-partners.
VIRTUAL PROJECTS
Virtual projects are when project team members are located in different places and the dominant method
of communication and operations is via communications technology. A good example of this is software
development, where programmers may be based in Bangalore, India, and work on projects for US,
European or Asian-based organisations (Lewis 2008). The great advantage of this kind of project approach
is that expertise can be employed from the best source and project team members can work independently.
One other advantage of virtual teams is that, if it suits the project, there may be significant cost savings in
not having to relocate project team members.
QUESTION 4.3
Is ‘collaboration’ a type of ‘project organisation’ or a ‘within organisation’ project activity? Explain

your answer.
INTERNATIONAL PROJECTS
An international project is one that is based in a different country (or at times, multiple countries) to the
‘home’ country of the organisation. As such, the environment of the project is more complex. Figure 4.5
highlights a number of factors that make an international project different from a locally based project.
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).
• 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).
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 in and how this translates into practice.
The discussion on international project teams is expanded in Part B.
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FIGURE 4.5 What makes international projects different?
5. Project cost 1. Geographical spread

• Costs involved in • Projects can be in
coordinating activities, multiple locations across
transport and different cities and
communication are higher countries
International
projects
4. Project risk 2. Purpose

• Much higher uncertainties • Often have a more
and unknowns, which complex purpose
increase the level of risk
3. Larger project scope
• Typically, have a wider
scope and are more
complex
PART B: ROLES IN PROJECT

MANAGEMENT
A range of roles exist in project management teams. This part of the module discusses the key roles of
the project sponsor, project manager and management accountant and how these project roles fit together.
Two basic approaches to project team structures are discussed.
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 the project owner) represents the project
funder (or business partner) during the project (Zwikael & Meredith 2018). 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 and
its priority, assesses the political environment of the organisation and establishes the make-up of the
project team.
2. The project sponsor will also have the responsibility of managing the high-level internal or external
stakeholder relationships. A project sponsor may be a key advocate for these stakeholders. If a project
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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. Such problems might include non-completion of the
project deliverables according to specifications, budget or schedule.
Sometimes, senior executives will sponsor several projects in addition to their regular responsibilities.
A number of other choices exist in relation to project sponsorship:
• If a project is not large or complex, there may be no need for a project sponsor, as the project manager
can fulfil all the necessary functions.
• At times, the project sponsorship role may be filled by a committee, especially on large complex projects
requiring high levels of commitment and resources. The committee should be composed of different
functional representatives.
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 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.
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. Figure 4.6 outlines the duties and challenges for project managers.
Example 4.5 highlights some of the challenges that can arise for project managers. Part 2 of this example
is explored in Example 4.13.
EXAMPLE 4.5
An IT project in a service-based organisation—Part 1

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 for 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 was not always accurate. This resulted in compensation
inaccuracies for the affected staff. The redesign processes implemented 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 4.1, project managers need to possess a range of technical and interpersonal skills.
TABLE 4.1 Skills required by project managers
Project manager
Technical skills Interpersonal skills
Process Communication
• Possess project management skills (e.g. critical • Provide the necessary knowledge and information to
path analysis, risk analysis and management, people involved in the project in a clear manner.
and capital budgeting). • Listen to others.
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Project-specific Problem-solving skills
• Possess technical skills that relate to the • Deal with unexpected opportunities and problems.
objectives of the project (e.g. IT skills in an • Foresee and detect problems before they arise or escalate
IT project). (e.g. if a project needs hard to find technical skills or input
materials, this needs to be addressed before it becomes
critical to the completion of the project).
General knowledge Insight
• Understand all aspects of the project to • Manage significant amounts of data and establish what is
discuss the technical work and understand relevant (some project data is incomplete, inaccurate or
the technical data used. misleading).
Negotiation
• Negotiate for extra resources and other support in order to
deliver the project.
Conflict resolution
• Resolve conflicts in areas such as expectations, level of
resources, costs, time, responsibilities and personality
clashes.
Leadership
• Possess a capacity for leadership for the tasks and
challenges that project managers need to deal with.
FIGURE 4.6 Duties and challenges for project managers
Project manager
Duties Challenges
Uncertainty
Monitor
Organisations usually prefer certainty, but the
Specifications, scope, budget and cost
unique nature of projects makes this difficult
Organise and manage

Schedules and budgets
Decide on the activities that need to be
Project activities are often uncertain, and
performed and coordinate personnel and
planning and target setting often require
other resources needed to meet project
frequent readjustment of targets
deliverables
Authority
Take responsibility
Project managers have full responsibility
Meeting targets and deliverables for the
for delivering the project but they are
project on an ongoing basis and
often not given enough authority or political
the final deliverables
support to command the necessary resources
Manage
Deal with problems as they arise

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PROJECT LEADERSHIP AND THE MANAGEMENT
ACCOUNTANT
The management accountant’s role in project management is not as well defined as other roles in project
management. As the distinction between many of the techniques used in project management and those
used in strategic management accounting starts to disappear, the line between the management accountant’s
and the project manager’s responsibilities has become increasingly ambiguous.
The traditional definition of management accounting is the provision of information for management
decisions and control. The management accountant’s key role in the project team is to prepare financial
and non-financial information for decision-making and control activities.
In traditional project management, management accountants tended to focus on preparing detailed cost
information in the form of budgets and budget variance analysis. This role can extend to capital budgeting
and the financing of the project. Much of this financial information influences key aspects of the project,
including contract preparation and fulfilment, accountabilities and risk analysis.
The management accountant faces a range of challenges:
• Preparing 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, but in a project situation, 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.
• Realistic project assumptions must be made as the resulting capital budgeting models will be based on
realistic assumptions. Care must also 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 indicates.
Under some circumstances, it could be the management accountant who takes on a leadership role
within a project. While leadership is something the project sponsor and the project manager should display,
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.
Each of these leadership roles can also apply to the management accountant. Consequently, many of the
characteristics of a good project manager are also the characteristics of a good management accountant.
This includes the previously discussed mix of technical and interpersonal skills. The discussion of the
stages of project management (selection, planning, implementation, and review) later in this module
highlights the many ways management accountants will display leadership in each of these stages.
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THE PROJECT TEAM
There are two basic approaches to organising a project team:
1. the task-force approach
2. the matrix approach.
A task-force approach is when a team is set up specifically for the project and is dedicated to it (as
shown in Figure 4.7). The project manager has total authority and responsibility for the members of the
team. A matrix approach (as shown in Figure 4.8), 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 is 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. Table 4.2 then outlines the advantages and disadvantages of
each approach.
FIGURE 4.7 Task-force project team
Executive
management
Project A Procurement Engineering Operations Finance and

accounting
Project
manager General staff General staff General staff General staff
Procurement
Engineers
Operations
Finance and
accounting
FIGURE 4.8 Matrix project team
Executive
management
Project A Procurement Engineering Operations Finance and

accounting
Project
manager General staff General staff General staff General staff
Project A Project A Project A Project A

Procurement Engineers Operations Finance and
accounting

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TABLE 4.2 Advantages and disadvantages of task-force and matrix approaches
Advantages Disadvantages
Task-force project Team members focus solely on Unless the project is of sufficient size, team
team completing the project. members may not be consistently busy.
Team members operate autonomously. Unlike in a matrix team, if team members are
Team members have their own unavailable, it may be more difficult to cover
resources. absences.
Team members get to work in Some team members might resist working
cross-functional teams, potentially in a cross-functional team as compared to
making their job more interesting working in their own departments.
and enabling them to gain additional As functions (like that of the management
experience outside their primary accountant) change, a lack of day-to-day
discipline or area of expertise. involvement may reduce team members’
exposure to the latest thinking.
If correction is required with some aspect
of the project after completion, obtaining
prompt action to rectify the problem can
be difficult, as the team will have been
dispersed.
A role in the workplace might not be
available once the project has ended,
because project roles are not always on
secondment. These roles can involve a job
move, especially for long-term projects.
Matrix project team Individuals have a constant employment Individuals have multiple responsibilities that
path, as they work in a stable functional can create role uncertainty.
department. The project manager may not have sufficient
A range of specialist skills can be authority to ensure that staff do what is
tapped into, providing the project required for the project when competing
manager with expertise and flexibility. priorities surface for team members.
During project downtimes, staff can be Team members may have multiple
used on other tasks in their department. supervisors (e.g. functional and direct),
exposing them to political pressures and
lack of accountability.
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 may be provided with 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, so getting the best people on to 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 4.4
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.
Explanation
Project sponsor
Project manager
Project team
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INTERNATIONAL PROJECT TEAMS
While in standard projects individuals are included mainly for their technical skills, in international project
teams individual team members can be included for other reasons (e.g. to ease political pressures). Political
issues include the make-up and dynamics of the team, the way a project sits within an organisation, and
the broader political context of the country the project is in.
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 on tasks is greater due to the
dispersed nature of these projects.
• Parallelism—tasks in the project may be done 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 these characteristics of international project teams and international projects
(discussed earlier), 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 as shown in Table 4.3.
TABLE 4.3 The 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.
Previous international project Experience in working on international projects is important, as the individual
experience would be more likely to understand the unique problems and issues faced by
international projects.
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 International projects often require staff to be able to juggle multiple and
demands conflicting tasks.
Communication skills The ability to communicate with internal and external stakeholders is vital for
international projects.
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 When projects are within an organisation, team members need to have an
business processes understanding of the organisation’s business processes.
Knowledge of the methods and The more the team members know about project software and other tools
tools used on the project and techniques (such as PERT [program evaluation and review technique]),
the more they will be able to devote their energy and intellect to the more
substantive issues.
Ability to understand different This refers to both the organisation/team culture and the region/country
cultures culture in which the project exists. Team members need to be tolerant and
sensitive to cultural differences.
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Willingness to travel for extended Team members may have to live overseas for extended periods of time or
time periods travel on a regular basis. They need to have the practical circumstances and
an almost uncompromising willingness to do it.
Multilingual capability The ability to communicate in the local dialect or language is extremely
important, either directly (i.e. by speaking the local language) or through a
third party (i.e. a translator).
Source: Lientz, B. P. & Rea, P. R. 2003, International Project Management, Academic Press, Amsterdam.
PROJECT MANAGEMENT ROLES IN INTERNATIONAL

PROJECT TEAMS
In the earlier discussion on project management roles, the roles and characteristics of project sponsors,
managers and management accountants were outlined. Table 4.4 outlines how these relate to the more
challenging context of international projects.
TABLE 4.4 Project roles in an international context
Project role Specific challenges for international projects
Project sponsor Clarifying project objectives is even more important—due to the more complex political
environment and the increased complexity of coordinating resources.
The make-up of the project team is critical—due to the increased difficulties and specific
skill sets required from team members.
Managing the stakeholders is more challenging—as they may be geographically
dispersed and have diverse languages and political agendas.
Project manager The task of defining the project budget and managing teams that collaborate over
multiple locations and often operate in a semi-autonomous work environment is
more difficult.
The need to communicate well, often with people from other cultures, makes this role
particularly challenging.
The need to be more proactive and see potential problems before they arise is much
greater—because the effects of project problems are so much greater.
Management The collection and presentation of timely information is more difficult. Information may
accountants need to be collected in multiple locations and the management accountant may need to
rely on other project team members to collect data—so their powers of persuasion may
need to be well honed.
There may also be a need to communicate information effectively to managers with
different cultural understandings.
The use of budgeting and project planning and performance evaluation techniques
becomes even more important in the uncertain environment of international projects.
VIRTUAL PROJECT TEAMS

A virtual project team works from different geographical locations and often in different time zones.
Therefore, it is common for such teams to use collaboration tools to facilitate a project (e.g. file sharing
and web conferencing). This is particularly important in international projects because face-to-face
meetings are often difficult due to location dispersion and other physical obstacles, as well as time and cost.
The idea of working on a project outside its physical location is sometimes described as telecommuting.
For example, in a project where team members are located in multiple countries and time zones, they
may use electronic communication supplemented with face-to-face meetings (e.g. through the use of
videoconferencing) to bring the project together.
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CHALLENGES FOR VIRTUAL PROJECT TEAMS
A main challenge for project teams (Pinto 2010) is building trust between members. Trust can be described
as having two components:
1. goodwill trust—which is established when an individual or organisation delivers what they say they
will deliver (they ‘keep their word’)
2. competence trust—which is based on the perception of whether someone has the ability to deliver
what they say they will deliver.
What makes building trust harder in virtual teams is the lack of being in the same room and working
alongside other team members 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. Ensuring that delivery dates are clearly understood and
adhered to also 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 without consultation. 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:
• face-to-face communication whenever possible
• maintain constant communication and do not 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), voice or video telecommunications (e.g. Join Me) and coordination software (e.g.
Webex or Gotomeeting).
To summarise, this section has considered the characteristics of a project, the stages in project man-
agement, project management roles and the nature of project management teams, including international
projects and virtual projects. The next section considers the specific role of the management accountant in
project management, taking into account the four stages of project management:
1. project selection
2. project planning
3. project implementation and control
4. project completion and review.
PART C: THE MANAGEMENT

ACCOUNTANT’S ROLE IN PROJECT
SELECTION
Project selection consists of four main tasks:
1. strategic analysis/fit
2. stakeholder analysis (stakeholder identification and assessment)
3. risk assessment
4. financial analysis.
These tasks are complex and there are a number of useful analytical techniques that the management
accountant can use. 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 to
prepare 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 (e.g. qualitative, non-financial information) so that a complete business
case can be presented. The next section reviews in more detail the purpose and content of a project’s
business case.
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DEVELOPING A BUSINESS CASE FOR PROJECTS
A business case is a document that contains an analysis of the costs, benefits and risks associated with
a proposed project. It provides information about the project to enable decision-makers in the funding
organisation to choose between proceeding with that project, proceeding with an alternative project,
or not proceeding with a project at all. It will often also identify the processes needed to implement
the project.
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 develops 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 discussed earlier, 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.
A good business case:
• provides the basis for a clear decision about the project
• contains the comparisons of the costs and benefits of the project
• identifies a preferred option with a rationale where there are alternative solutions to the problem that the
project needs to address
• makes clear the costs of the project beyond its completion.
Example 4.6 highlights the content that is usually included in a business case. The role of the team
involved in preparing the business case is to translate this analysis into an understandable format to enable
decision-makers to act.
EXAMPLE 4.6
Contents of a business case
Section Content
Background and This section contains the reason or problem that has triggered the need for a
problem 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 commence 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.
Identifying This section outlines the options or alternatives to be considered along with
alternatives 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.
(continued)
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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
• project completion and review process.
The next section discusses in more detail what needs to be considered in each of the key areas of analysis.
STRATEGIC 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 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. 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 Watch example in Part A),
then this project must 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.
Zwikael et al. (2018) claim that project goals should be aligned with the organisation’s current strategy
as well as its long-term vision. Strategic fit means that projects should be explicitly linked to the strategy.
The role of the sponsor/project owner is therefore crucial to support this important link with strategy. Loch
& Kavadias (2011) further suggest 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).
This is a cascading approach to projects and assumes a project is subordinated to the strategy of an
organisation overall and that the project should fit the organisation’s objectives, but as outlined earlier,
a project will also have its own strategy and objectives. This may be because the project has a set
of stakeholders who are not necessarily stakeholders in the organisation. Managing these competing
stakeholder interests is one of the real challenges in project management.
Example 4.7 provides a practical example of assessing the strategic fit for projects.
EXAMPLE 4.7
A mining company’s IT projects

A mining company implemented two IT projects. One was an e-business site and the other was an
enterprise resource planning (ERP) system. The e-business site fitted directly into the organisational
strategy of increasing profitability from the resource sector through creating a transparent market. The ERP
investment, on the other hand, did not result in cost savings and did not provide an advantage over the
previous IT system.
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In evaluating the strategic fit of these projects, the key questions to ask are:
• 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)?
• Is this project in line with the objectives and actions listed in the organisation’s strategy document?
• Does this project address an emerging or existing risk, and/or a new opportunity?
Further analysis
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 enable 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.
If the resource sold quickly—they had likely underpriced it.
If it took a while to sell—they had likely overpriced it.
This information then enabled the company to understand what the actual market price was and thereby
increase its revenue and profit.
Addressing each of the three key questions in evaluating strategic fit:
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.
Enterprise resource planning system
The chief information officer (CIO) decided that the company needed an ERP system. At the time, many
large companies were considering such systems. Industry observers thought it was becoming a status
symbol for companies to have a large ERP system. Senior IT executives in the company were of the
opinion that all of the advantages of an ERP system could be gained by integrating the existing software
and that this could be done at a fraction of the cost of buying, implementing and operating (over the long
term) the proposed ERP system. Notwithstanding these concerns, the CIO made the decision to invest in
a new ERP system.
Addressing each of the three key questions in evaluating strategic fit:
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 increased the company’s 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. As explained earlier, 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, but 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.
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The discussion in Module 1 about strategic analysis (e.g. SWOT) is clearly linked to these three
questions.
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 4.5
Please now read Parts A and B of Appendix 4.1 on the Sydney Seafood Bar.
Do you think the project is a strategic fit? Yes

No
Explain why or why not?
Note: The concepts covered in this appendix (not the specific details of the case) are examinable.
STAKEHOLDER IDENTIFICATION AND ASSESSMENT

Regardless of how well a project fits with organisational strategy or how well time, cost and quality are
managed, a project’s success is largely determined by how well stakeholders have been satisfied.
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) and Zwikael and
Meredith (2018) identify a number of different types of stakeholders. These are outlined in Table 4.5.
TABLE 4.5 Internal and external stakeholders
Internal Top management Senior executives who approve the project (e.g. the CEO or a company’s
board) are also called the ‘project funder’. Because of their seniority in the
organisation, they have control over the project and typically make the
final decision on:
• whether a project is approved
• the level of resources that are devoted to it
• whether more funding can be injected during the project
• whether, if required, it is terminated early.
Finance and Typically focused on whether a project is within its budget and is using
accounting resources efficiently.
Functional Members of project teams are often supplied by functional managers and
management 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:
• Project staff may have divided loyalties.
• Functional management may be more interested in their own function’s
success than the project’s success.
Project management A functional unit that supports all project managers within this business
office unit in conducting their projects. This support is usually administrative
and methodological (e.g. the use of project management methodologies,
templates and software packages).
Project team Have an interest in the success of the project, but may still have loyalty to
members their functional area.
May be motivated by their own careers/incentives/compensation
packages, which—although acceptable—may not always be aligned with
project objectives.
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External Clients Typically interested in the project being completed on time, within budget
and to specifications.
A client may be external to:
• the project organisation (e.g. a company developing software for a
manufacturing organisation)
• the project team, but within the same organisation (e.g. the IT project
team developing software for the manufacturing department in the
same larger organisation).
Project managers should be aware that clients often realise after the
project specifications are drawn up that there are complexities or issues
they had not considered, requiring an alteration of the project scope.
End users The client entity requires the deliverables (output) from the project to be
used by its employees or customers—who are often called ‘end users’.
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. This is important because if they do
not use the deliverables from the project, the project will fail to realise its
target benefits (Zwikael & Meredith 2018).
Competitors May be a significant stakeholder through their effect on the project’s
successful implementation.
This could be by:
• introducing a new product in direct competition
• through other competitive and market activities (e.g. objecting to
projects through legal processes or a social media campaign).
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).
Suppliers Provide the raw materials and other material inputs.

When a project relies on suppliers, the project manager must ensure the
reliable and timely delivery of inputs.
Community and Projects can have a large effect (both positive and negative) on
society communities. For example, the regular customers of the company, as
well as non-customers, may be impacted by the project (e.g. because of
the cannibalisation of an existing product).
In such situations, there needs to be extensive consultation with
the community to ensure that all those affected have their interests
understood and dealt with appropriately.
The environment Although the environment cannot be considered an entity, it is widely
recognised as being a stakeholder that needs to be managed carefully in
any project (Phillips et al. 2003).
Shareholders As projects can affect share price and the dividends distributed to
shareholders, they may also have interest in the project, especially if the
project is strategic and can make a major impact on the company (e.g.
the building of the Boeing 787 Dreamliner).
Stakeholders will have different interests and these may be incompatible. One of the challenges
for project managers is to communicate with these multiple stakeholder groups and attempt to satisfy
their needs.
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, the community surrounding
the construction site may not want the excessive noise at night and on weekends. This balancing issue will
be addressed in more detail later in this section.
When management accountants complete 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. An
interesting research study on using a balanced scorecard (BSC) for signalling information to stakeholders
Pdf_Folio:167

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.
The BSC is discussed in detail in Module 5.
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.
Clearly, the management accountant needs to complete appropriate stakeholder identification and
assessment if they are to design appropriate management systems for projects.
Stakeholder assessment and analysis was discussed in Module 2.
QUESTION 4.6
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. List five key external
stakeholders and identify the stages of the project when their interests are going to be important
to the project.
Stakeholder Stages of the project
1.
2.
3.
4.
5.
ETHICALLY INFORMED DECISION-MAKING AND ITS IMPACT

ON STAKEHOLDERS
Ethical dilemmas often arise in the context of project management, especially when it comes to rela-
tionships with stakeholders. When decisions are made and actions taken (whether ethically right or
wrong), there will be effects on stakeholders. 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. shareholder value and through changes to the competitive environment).
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 there are no previous practices and experiences that can be used
or learnt 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 these two key issues. 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
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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,
the 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 can be used. Some additional
questions that can be asked are provided by Drellinger (cited 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 environment?
While some of these questions relate to a normative (what ought to be) approach to ethics, there are also
real utilitarian aspects (the value is related to the benefits gained or reduction in loss) as well.
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, the company’s 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,
classified and risk mitigation actions proposed. 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
• 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 mitigating or transferring risks.
The management accountant should understand techniques such as calculating expected values and
estimating the probability of the occurrence of risk events. Calculating probabilities is particularly
important where risk events are interdependent.
Eden, Ackermann and Williams (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’.
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 questions outlined in Table 4.6.
Risk identification will produce a list of potential risks.
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TABLE 4.6 Risk identification questions
What? • What is the desired 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 completed 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 • How much is the project likely to cost?
much? • 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 4.9, 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.
FIGURE 4.9 Risk classification
Financial impact
Low High
Consider Consider
Low
last second
Probability
High Consider Consider

third first
Applying the 2×2 matrix approach is illustrated in Example 4.8.
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EXAMPLE 4.8
The 2×2 matrix approach

A large utilities organisation uses the 2×2 matrix approach when considering the environmental sustain-
ability of projects. After risks are identified, they are assessed first for their likelihood, then for the financial
impact should something go wrong. Projects are ranked for selection based on this risk analysis.
Assume you undertake risk assessment for this company and you have four projects to complete.
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
3. cabling for telecommunications in a newly developed area
4. installing high-voltage underground electricity cables through a local area in an already existing path.
Undertaking a risk assessment exercise
The first thing you will need to do is decide on an appropriate composite index for the analysis. A common
approach is to assess the probability and impact on a scale of zero to 10. A rating of zero is a non-existent
probability of failure and no financial impact. A rating of 10 is a 100 per cent probability of failure and the
maximum financial impact.
The next thing is to assess each of the projects and identify both the probability and financial impact,
and then multiply the probability by the impact. This approach is outlined for the four projects as follows:
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 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 rating of two). It
also has a low financial impact, being cabling for telecommunications (a 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 rating of three). It has a high financial impact because it relates to high-voltage
electricity cables (a 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.
The identification and classification of risks facilitates 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, such as identifying cost reserves for risks in the project budget.
RISK MITIGATION
Whereas most organisations identify and classify project risks on a regular basis, not all provide effective
solutions to mitigate those risks that have been found to be critical. Using the risk classification matrix
(Figure 4.9) for these risks needs to be considered first, then effective solutions can be identified to reduce
the probability of those risks emerging and their financial impact if they occur.
The project manager can prepare the risk mitigation plan in consultation with the management
accountant. Furthermore, the execution and monitoring of the plan will need to involve various staff,
including the management accountant.
For example, a risk that ‘a key project team member resigns from the company during the project’ has
high probability of happening and, if it occurs, will impact the project’s completion and potentially delay
it by a significant time, causing major dissatisfaction to a strategic client of the company. A mitigation
plan might include a few potential solutions to choose from:
1. sign a long-term contract with the key team member
2. offer the key team member a project completion bonus
3. have a deputy trained and ready to step in if required.
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A risk mitigation program results in changes to the probability and/or impact of the risk—but it also
usually requires additional cost.
A key tool for risk mitigation is the risk register, which is used to document the results of analysis and
outline the mitigation program being proposed for each risk. The risk register first appears in the business
case and again later in the project plan. It is then updated regularly throughout project implementation.
The risk register usually takes the form of a table. Table 4.7 shows a register entry for one risk.
TABLE 4.7 Example of a risk register entry
Risk attribute Risk entry
Risk number R1
Risk title A key project team member resigns the company during the project
Description David Smiths leaves the company over the next three months to move with his family
interstate
Probability High
Financial impact High
Risk mitigation (1) Sign a long-term contract with David Smiths

(2) Offer David Smiths a project completion bonus
(3) Have a deputy trained and ready to step in if required
Cost of risk mitigation $5000
Risk assigned to Project manager
It is important to note that risk assessment is different from risk management. As discussed, risk
assessment is done before the project starts. Risk management, on the other hand, is done during the
project. It is the ongoing process of monitoring and managing the risks of the project—this is discussed in
more detail in Part E.
FINANCIAL ANALYSIS—SINGLE PROJECT

One of the main responsibilities of a management accountant in project selection is to provide an analysis
of project financial viability. The following techniques are discussed in this section:
• net present value (NPV)
• internal rate of return (IRR)
• profitability index
• payback
• return on investment (ROI)
• residual income (RI), or economic value added (EVA).
The advantages and disadvantages of these techniques will also be discussed.
Analysing profitability does not complete the management accountant’s financial analysis. There also
need 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.
NET PRESENT VALUE

NPV and IRR are both discounted cash flow (DCF) methods used to evaluate projects and investments. In
long-term projects (greater than 12 months), DCF methods are superior to methods that do not account for
the time value of money and project risk. DCF techniques recognise that the money invested in a project
has an opportunity cost—the return forgone from alternative investments.
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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 an 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 yield returns above the organisation’s RRR.
The formula for calculating the PV of future cash flows is:
n
∑ 1
PVt=0 = × CFt
t=1 (1 + i)t
Where:
i = discount rate
n = project life
CF = cash flow
t = year
In determining the project’s NPV, a management accountant considers the following key variables:
• project costs
• forecast cash inflows and outflows
• estimated life of the project
• residual value
• discount rate.
Each of these is discussed in the following sections.
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. The percentage used depends on the reliability of the
cost estimates. Reserves do not account for changes in project content or scope, because 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 (AR) 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 effect 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 (e.g. interest payments) are not separately included in project
cash flows.
Forecasting cash flows

One main problem in using DCF methods is the prediction of future cash flows.
Where revenues need to be estimated, management accountants can analyse market growth, develop-
ments 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 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 and amortisation, like other accruals, are non-cash expenses, so they do not appear in a DCF
analysis. Depreciation and amortisation reduce taxable income and in that way, they affect cash flows, so
these components need to be included in any NPV calculation.
One of the challenges faced when a project is being implemented is the reconciliation of forecast cash
flows with the actual cash flows (see Example 4.9). While this is discussed in more detail 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 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.
EXAMPLE 4.9
Forecasting cash flows

WidgetCo undertook a project to purchase new machinery for $8 000 000. Assume the taxation regulations
permitted this asset to be written off on a straight-line basis over four years and that the tax rate was
30 per cent.
The annual depreciation charge would have been $2 000 000 with a tax saving of 30 per cent of this,
or $600 000 per year (0.3 × 8 000 000 / 4). The cash flows included in the project’s DCF analysis included
an immediate outflow of $8 000 000, and for Years 1–4, an inflow (a tax saving) of $600 000. Note that
depreciation had no cash flow effect except for the tax saving.
However, the actual cash flow for this project was different from the forecast because by the time the
project was implemented, the purchase cost of the machinery was $10 000 000 and the company tax rate
had been reduced to 25 per cent. This means that the tax saving was $625 000 (0.25 × 10 000 000 / 4)
per year as is illustrated in the following table.
Time period 0 1 2 3 4
Forecast Outflow (8 000 000)
Inflow 600 000 600 000 600 000 600 000
Actual Outflow (10 000 000)
Inflow 625 000 625 000 625 000 625 000
Estimated life of the project

Management accountants need to estimate for how long a project (in particular the deliverable or output
developed during the project) is expected to generate a cash flow. For example, consider a project to start
manufacturing a new car model. The car design may take a year, but sales of new vehicles are expected
for five years after the first car has been designed and built, until the next model is introduced. Therefore,
costs required to design, build, test and manufacture the new car are expected to last for six years. Estimates
involving the very long term (e.g. 10 years or more) are highly uncertain. Despite this, it is important that
such estimates are made, as incorporating a highly uncertain estimate in an analysis is preferable to ignoring
the issue. Similarly, the tax regulations permit the write-off of assets over set periods. These periods are
not indicative of the life of those assets and, while these periods should be used for tax calculations, they
have no relevance to project life estimates.
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.
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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 effect 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.
Discount rate
The selected discount rate has a profound effect on the NPV analysis. For example, consider where a PV
of $100.00 to be paid in one year’s time is $86.96 if the 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
$86.96 15% $100
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 because 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. For example, if an organisation chooses to invest in a low-risk project and
the next best project is riskier than the one they have chosen, this means that 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
WACC = Rd × (D / (D + E )) + Re × (E / (D + E ))
Where:
Rd = after-tax cost of debt capital
D = market value of debt
E = market value of equity
Re = cost of equity capital
Wd = weighting of debt capital
We = weighting of equity capital
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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 (also termed a ‘hurdle rate’).
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).
Example 4.10 shows how these concepts can be applied and how calculating the NPV for a project can
assist with project selection.
EXAMPLE 4.10
A project with an expected life of five years

An organisation is thinking of investing in a project with an expected life of five years and a cost of capital
of 15 per cent. The initial investment is $1 000 000 with expected net cash inflows of $300 000 per year.
The cash flows and PVs are presented in the following table.
Time period 0 1 2 3 4 5
Initial investment –1 000 000
Net cash flow –1 000 000 300 000 300 000 300 000 300 000 300 000
Discount factor calculation = (1 + = (1 + = (1 + = (1 + = (1 +

(cost of capital = 15%) 15%)1 15%)2 15%)3 15%)4 15%)5
Discount factor 1.0000 1.1500 1.3225 1.5209 1.7490 2.0114
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
NPV (sum of row above) 5 642
Note: Taxes have been ignored.
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; otherwise, it
should not.
QUESTION 4.7
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:
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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 $10 000
Big Firm Pty Ltd has an RRR of 14 per cent and the economic life of the project is expected to be
10 years.
(a) Complete the following table by showing the cash flows and calculating the NPV for the project.
Disregard taxes.
Year 0 1 2 3 4 5 6 7 8 9 10
Sale of old system ($)
Development cost ($)
Implementation cost ($)
Residual value ($)
Reduction in labour cost per year ($)
Increase in utility cost per year ($)
Net cash flow ($)
Discount factor calculation (cost of

capital = 14%)
Discount factor
PV working
PV cash flows ($)
NPV ($)
(b)
On financial grounds, would you recommend the project? Yes
No
Why?
(c) The project manager who prepared this 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? Yes

No
Show your workings in the following table.
Year 0 1 2 3 4 5 6 7 8 9 10
Sale of old system ($)
Development cost ($)
Implementation cost ($)
Residual value ($)
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Reduction in labour cost per
year ($)
Increase in utility cost per year ($)
Net cash flow ($)
Discount factor calculation (cost

of capital = 14%)
Discount factor
PV working
PV cash flows ($)
NPV ($)
INTERNAL RATE OF RETURN

The internal rate of return (IRR) is the expected return from a project or an investment. It is defined as the
discount rate at which the NPV of project cash flows is equal to zero. In other words, it is the discount rate
at which the project breaks even with respect to the PV of its cash flows.
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, 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 done 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, the IRR
will be higher than 10 per cent. The management accountant would continue testing new discount rates
(e.g. 12%, 14%, 16%) until they were able to obtain an NPV of zero (and hence determine the IRR for
the project).
QUESTION 4.8
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, but 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
$ $
Initial investment (100 000) (1 000 000)
Net cash flow (Year 1) 220 000 1 320 000
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
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NPV 100 000 200 000
IRR† 120% 32%
†
Calculated using spreadsheet software. You are not expected to recalculate this figure.
Which project should you select? Project 1

Project 2
Why?
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 one, 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:
Payback = Initial investment (project cost) / Annual net cash inflow
If project cash flows are irregular, it is necessary to add annual cash flows for Years 1, 2 and so on,
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 DPP is calculated as
follows:
• identify the annual cash flows
• calculate the discount factor for each period
• apply each discount factor to the respective annual cash flow to calculate the PV of the cash flow
• cumulatively sum all the DCFs, starting with Year 0, until the initial investment is fully repaid.
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. 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
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.
ROI = Return / Invested capital
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 4.7: the initial investment is $1 030 000 and
the residual is $100 000. The average investment is therefore:
($1 030 000 + $100 000) / 2 = $565 000
Note that if there was no residual value, the average investment is $1 030 000 / 2 = $515 000.
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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
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 earlier) by the WACC.
The best-known application of RI is EVA.
When applied to project evaluation, RI is determined for each year, the PV of each RI is calculated, 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.
Example 4.11 outlines how these different financial analysis figures are calculated.
EXAMPLE 4.11
Calculating the profitability index, payback period, return on investment

and residual income
Using the data from Question 4.7†, the PI, ‘ Tax effects are ignored and a WACC of 14 per cent is assumed.
Profitability index
PI = 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 4.7, 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
This result (16.5%) must be considered in relation to:
• alternative investment proposals
• the organisation’s WACC
• the organisation’s overall ROI.
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.
The RI is an estimate of the annual impact on the organisation’s profit if the project proceeds, but NPV
is a more economically valid assessment of the increase in the organisation’s value than RI.
Table 4.8 summarises these measures.
TABLE 4.8 Summary of Example 4.11
Measure
NPV ($116 285)
PI 0.89
Payback 6.06 years
ROI 16.5%
RI $25 800
As can be seen in Table 4.8, 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.
DEFICIENCIES IN ACCOUNTING-BASED MEASURES

ROI and RI are accounting-based measures and are therefore poor reflections of economic reality. Three
core issues exist with accounting-based measures:
1. Accounting profits include accruals such as depreciation that 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 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.
SENSITIVITY AND SCENARIO ANALYSIS

Two key methods of evaluating the risk of a project are:
1. sensitivity analysis
2. scenario analysis.
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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. Such an analysis will change relevant parameters in the analysis (e.g. consumer demand is
20% lower than in the original analysis) and analyse the impact of such a change on the outcome. If there is
no change in the decision being made following the introduction of the change, we can say that the decision
is ‘robust’ to the change in this specific scenario, otherwise the decision is ‘sensitive’ to this particular
scenario. 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 4.9
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 Appendix 4.1
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?
FINANCIAL ANALYSIS—MULTIPLE PROJECTS

Most medium-to-large organisations can choose from a range of different projects, which can be a problem
if the organisation has more financially viable projects to choose from than it has the capacity to invest
into. Also, many projects are mutually exclusive. The management accountant can help decision-makers
by preparing reports that compare financial and non-financial rewards and differences in risk and assess
the strategic alignment of projects.
EQUIVALENT ANNUAL CASH FLOW (EQUIVALENT ANNUAL

ANNUITY)
Equivalent annual cash flow (EAC) is a technique that has been devised to compare the financial returns
of projects with different lives and different risk profiles. EAC builds on the NPV technique discussed
earlier, and therefore it accounts for the time value of money and differences in project risk, and it includes
payback of capital invested. EAC converts a project’s NPV into a uniform series of cash flows, enabling
the comparison of projects with different lives 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.
The formula for calculating the EAC for a project is:
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.
The formula for calculating an annuity factor is:
1 − (1 + i)−n
( )
Annuity factort=0 =
i
Where:
i = discount rate†
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n = project life

t = year
†
Sometimes referred to as ‘r’
Example 4.12 shows how EAC can be used to choose between projects.
EXAMPLE 4.12
An organisation with two mutually exclusive projects

An organisation has two mutually exclusive projects of different life spans 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, these two projects
are mutually exclusive and have different life spans, so the EAC needs to be calculated to determine which
project adds the most value.
Step 1: Calculate annuity factors
1 − (1 + i)−n
( )
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%
Step 2: Calculate EAC

NPVt=0
EACt=0 =
Annuity factor
317 190
EAC Projectt=0 = = 182 766
1.7355
416 980
EAC Projectt=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 that 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.
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PART D: THE MANAGEMENT
PLANNING
The steps that are central to project planning are outlined in Figure 4.10.
FIGURE 4.10 Project planning steps
Describe Develop Decide Complete
Describe the activities/

tasks that need to be Decide on how to
done to achieve project Develop a project monitor the project—
objectives—this should budget and schedule that is, when and how Prepare for the
be as detailed as from the detailed often, what form of project’s completion.
possible and include work plans. reports and to whom the
all required resources reports are distributed.
and responsibilities.
At the planning stage, the management accountant should assume a leading role in project budgeting
and scheduling, and in considering 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.
Monitoring and performance measures need to be designed at the project planning stage to ensure
proper monitoring is carried out and to make project team members aware of how their performance
will be evaluated. Often, the project contract will provide a framework for monitoring and performance
measurement systems.
Example 4.13 highlights the importance of project planning tools.
EXAMPLE 4.13
An IT project in a service-based organisation—Part 2

This example continues on from Example 4.5 where the 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. Consider the problems faced by the company and then
how appropriate planning may have either overcome these problems or made them easier to manage.
This highlights the benefits of the tools and techniques in this section:
• The project was not allocated enough resources for 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 was 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 done to achieve the project’s objectives.
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Furthermore, techniques such as PERT and critical path method (CPM) (discussed later) 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.
PROJECT SCHEDULING
Project scheduling is a difficult issue, especially in large, complex projects. A range of methods have been
developed to aid this process. The key methods discussed are:
• Gantt charts
• PERT
• 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
Example 4.14). 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.
EXAMPLE 4.14
Gantt charts
The manager of Smith’s Embroidery Company has decided to construct a new warehouse on land the
company owns on the city’s outskirts. The warehouse has been designed by an architect, and cost
estimates have confirmed that it is the best solution to the problem of insufficient finished goods storage
space. The following activities have been identified:
Activity Start date Finish date
Obtain planning permission (A) 3 February 3 March
Level land (B) 3 March 10 March
Dig foundations (C) 8 March 15 March
Pour concrete for foundations and floor (D) 16 March 20 March
Construct steel sides and roof (E) 5 April 17 April
Install electric cables (F) 10 April 17 April
Plaster internal walls and ceiling (G) 17 April 30 April
Connect electricity (H) 1 May 1 May
The Gantt chart for the warehouse project is illustrated as follows.
Pdf_Folio:185

Activity
H
Time
3 10 17 24 3 10 17 24 31 7 14 21 28 5
February March April May
The Gantt chart in Example 4.14 shows each activity, and the duration 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 done 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 4.14, 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 calculate slack time available for project completion. To be able to understand the
meaning of this additional information included in Gantt charts, another scheduling tool—PERT—needs
to be discussed.
PERT: PROGRAM EVALUATION AND REVIEW TECHNIQUE

PERT was developed in the late 1950s. It is an approach that represents the tasks required to complete a
project. It also enables analysis of what the shortest completion time is and then provides opportunity for
analysis of how completion times can be shortened. This is done through the analysis of the CPM. The
key elements of PERT and then CPM are described next using the following four steps:
Step 1: Draw the network diagram.
Step 2: Calculate the expected time (ET).
Step 3: Define the critical path.
Step 4: Calculate slack.
Note 1: There is a detailed step-by-step example of drawing a PERT diagram available in Appendix
4.2 of this module.
Note 2: The concepts covered in Appendix 4.2 (not the specific details of the case) are examinable.
Step 1: Draw a network diagram

PERT is a network diagram that includes all project activities (e.g. replacing the kitchen in the Sydney
Seafood Bar case in Appendix 4.1), activity precedence relations (where one activity must be completed
before another can start—e.g. removing the old kitchen in Appendix 4.1) and, in some formats, events.
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An event is the point at which an activity is started or completed (e.g. the start of or the finish of removing
the kitchen in the Sydney Seafood Bar).
There are two formats used to prepare a network diagram. One format displays activities as arrows and
events as nodes (circles), hence it is entitled ‘activity-on-arrow’ (AOA) network (see Figure 4.11).
FIGURE 4.11 Activity-on-arrow network diagram
2A
1A 3A
1B 3B
2B
An alternative format, which is used in this module, is an ‘activity on-node’ (AON) network (see
Figure 4.12). In the AON 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. This module uses the AON format, because it is easier to use (e.g. includes real
project activities only and does not require events or dummy activities) and is supported by most project
management software packages.
FIGURE 4.12 Activity-on-node network diagram
1A 2A 3A
Start End
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 immediately after the ‘start’ node.
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 be directly linked to the end node. For example, assume there are eight activities (A–H). If Activity
(E) is not a precedent activity for another activity, then it can be connected to the end node.
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The process of drawing a PERT diagram is explained further in Example 4.15.
EXAMPLE 4.15
Drawing a PERT diagram

Consider a project that starts with the following three activities:
Activity Preceding activity Duration (days)
Activity A N/A 5
Activity B N/A 10
Activity C A and B 3
Activity A has no precedent relationships and is expected to take five days. First draw a node
representing Activity A, which is then connected with an arrow from the start node.
Activity B has no precedent relationships and is expected to take 10 days. Similarly, draw a node
representing Activity B, and connect it with an arrow from the start node.
Activity C can only start once both Activities A and B are complete. Therefore, the node representing
Activity C is connected to both nodes representing Activities A and B.
Finally, all the activities that are not a precedent activity for another activity (in this case, Activity C only)
are connected to the ‘end’ node.
Start C End
Step 2: Calculate expected time

Once all activities and their precedence relationships have been drawn, activity duration can be calculated.
Where schedule uncertainty exists, it is suggested that three duration estimates be made for each activity—
O (optimistic), P (pessimistic) and ML (most likely). The ML time is the estimate of the duration that the
activity will take—if it is completed as planned. The ET can then be calculated as a weighted average of
the three duration estimates according to the following formula:
O + (4ML) + P
ET =
6
Note for statisticians: The weighting of 1:4:1 assumes that the distribution of possible durations 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:
P−O 2
( )
VAR =
6
Some project management software packages provide these calculations.
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If you are interested in learning more about this, refer to Meredith and Mantel (2015) listed in the
References section at the end of this module.
Step 3: Define the critical path

Figure 4.13 is a network chart for a project. For each activity, the ET and its variance are given (e.g. for
Activity (A), there is an ET of 40 days and a variance (VAR) of eight days (40,8)). Beside each node,
the earliest occurrence time (EOT) is displayed. EOT represents the time an activity is expected to be
completed. To find the EOT for an activity, all incoming paths need to be evaluated to find out which one
takes the longest time to complete. For example, to find the EOT for Activity H in Figure 4.13, note that
path A → D takes 70 days (40 + 30), while path B → E takes 60 days (40 + 20). The EOT for Activity
H is, therefore, the maximum between these two numbers (70 days) plus the duration of Activity H itself
(16 days), hence 70 + 16 = 86.
The EOT for the ‘end’ node (86 days) is the expected project completion time or the ‘project
critical time’, calculated as the maximum of all EOT of activities that are not a precedent activity for
another activity. In this case, project duration is the maximum of 86 (Activity H), 68 (Activity F) and
84 (Activity I).
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 4.13, the path A → D → H is termed the critical path because this path has the
longest duration (86 days). If there are any delays on this path, the whole project is delayed. Conversely,
if the duration of activities on this path are shortened, the whole project duration can be reduced.
The critical path is the shortest duration 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 activities that takes the longest amount of time will determine
the total time it takes to complete the project.
Note that all activities, 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 must be determined is the total duration 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.
FIGURE 4.13 Completed PERT diagram
ET = 30
Var = 50
EOT = 70
D
ET = 40 ET = 16
Var = 8 Var = 10
EOT = 40 EOT = 86
ET = 20
A
Var = 8 H
EOT = 60
E
ET = 40
Var = 0 ET = 28
EOT = 40 Var = 8 EOT = 86
EOT = 68
Start B F End
ET = 8
Var = 0
G EOT = 48
ET = 44 ET = 36
Var = 12 Var = 56
EOT = 44 EOT = 84
C I

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Step 4: Calculate slack
From the network diagram, we can calculate the earliest starting time (ES) and the latest starting time
(LST) for each activity. Project managers often want to know the latest time an activity can start without
making the entire project late. The answer depends on how much ‘slack’ or ‘float’ there is in any activity
or path. The slack time is equal to the LST minus the ES.
The LST can be worked out backwards by starting from the project critical time and deducting activity
durations from it (i.e. working from right to left). For example, in Figure 4.13:
• 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 Activity B), 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 duration), 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.
• Activity (H) can only start after both Activities (D) and (E) are complete. The EOT for Activity D is
70 days, so unless other preceding activities are reduced in time, this is the ES for Activity (H).
As Activity (H) is on the critical path, the LST and ES are the same (i.e. 70 days) and there is no
slack available.
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.
CRITICAL PATH METHOD—CRASHING PROJECTS

CPM is a network-scheduling technique based on PERT that provides an additional dimension: the analysis
of cost–time trade-offs in meeting or expediting project schedules. This is one of the most difficult tasks
faced by the project manager. CPM considers how resources such as labour and machinery can be added
to activities to shorten their duration. This is called ‘crashing’ the project.
Define crash duration and costs

CPM analysis usually suggests two possible durations for the project. The ‘normal’ duration is the most
likely to complete the project. The second one is the ‘crash duration’. Crash duration is the total time the
project is expected to take after the project has been crashed. Crash duration is a result of a reduction in
the duration of an activity that can be achieved by adding resources such as:
• overtime hours
• additional staff or machinery
• special equipment
• expediting subcontractors
• paying extra for faster delivery.
For example, if the normal duration is 30 days and by adding resources it would become 25 days, the
crash duration would be 25 days. The difference between the normal and the crash duration reflects the
number of days that have been crashed (i.e. 30 – 25 = 5).
Similarly, two costs are specified for the project: normal cost (budget) and crash cost. Crash cost is the
normal cost together with all the extra costs that are related to expediting one or more activities. Careful
planning is essential when trying to shorten a project. The likelihood that a project will need to be expedited
is fairly high in situations where duration estimates are uncertain and there is a firm project deadline.
Define financial benefits from crashing a project

There may be economic incentives for reducing project duration. Faster completion may expedite cash
inflows, thus reducing the time that a project employs capital. This may lead to lower interest expenses
and increased project ROI. Sometimes, expediting a project may help to avoid late completion penalties,
or alternatively, a project might be crashed to free up resources in a multi-project environment.
Crashing project activities is typically done where the cost–time trade-off is feasible—that is, 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 the project ends up earning
a $100 000 bonus, then the cost-time trade-off is feasible.
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Define the order of activities to crash
After determining which activities can be crashed, the cost of crashing each activity and the potential
benefits due to crashing, the project manager, with the support of the management accountant, determines
which of the critical path activities would be optimal to crash. (Note that project duration can only be
reduced by crashing activities on the critical path.) This is done by calculating the cost–time slope of an
activity. This is the crash cost less normal cost, divided by normal duration less crash duration. The critical
activity with the lowest cost–time slope will be the first one to crash. An alternative to the cost–time slope
is where the crash costs are identified on a common time basis (e.g. $10 000 per week). When all the crash
costs for a project have the same time units (e.g. per day or per week), this information can be used to
determine the order of activities to crash (i.e. the lowest cost on the critical path first).
Note that crashing critical path activities may make some other path critical, or create more than one
critical path. Therefore, reducing project duration may require the simultaneous crashing of multiple
activities.
Refer again to Figure 4.13. 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 there are two critical
paths and further crashing must take into account both critical paths. If path A → D → H continues to be
crashed, there will be 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 there
are two (or more) critical paths, the duration of all critical paths will need to be reduced simultaneously to
have any effect on the project completion time.
Cost optimising
Where minimising the project cost is being sought, critical path activities continue to be crashed one
by one until the point where the additional cost of crashing an activity equals the incremental savings.
Figure 4.14 illustrates cost behaviour in cost–time optimisation decisions.
FIGURE 4.14 Cost behaviour in cost–time optimisation decisions
Cost Crash cost
Benefit
Crash
Normal Optimum time
time time/cost
Finding a cost optimum is difficult in practice, especially in large projects that are very complex. A
possible way to overcome this problem is to determine a few alternative cost–time points and select the
one with the lowest total cost.
A graph illustrating a project cost function such as Figure 4.14 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.
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For further practice in the concept of crashing a project, please access the ‘Crashing Exercise’
learning task on My Online Learning.
QUESTION 4.10
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 4.1. The table below indicates the activities required
to complete the project, plus their durations and precedence relationships.
Duration estimate (days)
Preceding
Activity activity Optimistic Most likely Pessimistic
1. Remove kitchen 4 7 10
2. Remove toilet block 1 5 10 15
3. Excavate floor for new slab 2 5 15 19
4. Remove mezzanine 2 4 6 14
5. Repair mezzanine 4 6 10 20
6. Lay new slab 3 1 2 9
7. Build toilets 6 5 10 21
8. Fit out toilets 7 9 18 21
9. Build kitchen 6 20 30 46
10. Fit out kitchen 9 5 7 15
(a) Construct the PERT network for the SSB project using the AON approach (as shown in
Figure 4.12).
Note: You will either need to do this separately on a piece of paper, or you may prefer to create
the network diagram in a drawing program before adding your response to the answer field.
If you choose to use a drawing program, save your diagram as an image file. Then in the
interactive PDF of this Study guide, you can insert your response by selecting the answer field
and browsing for the image file that you saved on your device.
(b) Determine the expected completion times for all SSB project activities.
(c) Determine the SSB project’s critical path.
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 cost estimates are 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.
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, but it is common practice 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.
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Expenses can be allocated to a project as a whole (i.e. where the project is one cost centre), to 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, but 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.
There are different ways to treat overheads in project budgets. If overheads are 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, a revised project budget may still be necessary to plan for cash
flows and to control costs.
Budget preparation provides a good opportunity for management accountants to inform project man-
agers about revenue recognition and cost-allocation conventions. This improves the project manager’s
understanding of management accounting reports and increases the likelihood of correct decisions being
made regarding the project.
PROJECT MANAGEMENT SOFTWARE

Project management software enables the use of effective planning tools such as Gantt charts, PERT and
CPM, along with project budgeting and cost control. There are many off-the-shelf packages available,
although a number of organisations have also developed in-house applications.
Overviews of different project management software packages are available here:
http://www.businessnewsdaily.com/8237-choosing-project-management-software.html.
SUPPLIER CONTRACTS
The project 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 AC incurred. For
example, fixed-price contracts provide certainty and pass profit risk back to the supplier. In fixed-price
contracts, the management accountant works 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 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.
PART E: THE MANAGEMENT

IMPLEMENTATION AND CONTROL
After the project plan has been developed and approved, project execution starts, when all project activities
are undertaken according to the plan. During this time, the role of the management accountant is to monitor
the progress of the project, compared with its approved plan.
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MONITORING PROGRESS
There are three major areas that are considered in the context of monitoring progress, as shown in
Figure 4.15.
FIGURE 4.15 The three critical factors for monitoring progress
Project
cost
Project
Project
specification
time
and quality
An important role for management accountants during project implementation is collecting, recording
and reporting cost, time and specification/quality-related information (together entitled ‘project iron
triangle’) 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 useful in both providing feedback to project managers about the project’s progress
and in helping to revise budgets and schedules to reflect new knowledge about the project and the project
environment. In the next section, the discussion on monitoring cost, time and quality/specification is
extended to consider two other related issues that have a significant effect on project progress:
1. risk management
2. stakeholder management.
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 (see
Example 4.16). 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.
EXAMPLE 4.16
Controlling project costs

A project manager orders a major component required for a project on 1 March. The component is
delivered on 30 April. An invoice for $400 000 is received on 15 May. The invoice is processed and payment
is made on 14 June.
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.
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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, while 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 performed against these forecasts.
Many projects are dynamic and constantly changing, so they require the allocation or reallocation of
resources to meet a possibly turbulent environment.
THE EARNED VALUE METHOD: TIME VERSUS COST

A common and simple method for project cost reporting involves comparing actual expenditures against
the budget. One major shortcoming of this approach is that it does not account for the amount of work
accomplished relative to costs incurred. So a cost report may show that a project is well below budget
(favourable variance) without revealing that this is because the project is running late.
A method called earned value (EV) has been developed to assess cost and time performance simultane-
ously. 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.
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 total budgeted cost for that activity. That is:
EV = Estimated percentage completion × Budgeted cost
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 planned costs and with AC produces two variances. Project (or activity) cost
variance is the difference between EV and AC at that point in time. The schedule variance is the difference
between the EV and the planned value (PV) at that point in time. That is:
Cost variance = EV – AC
Schedule variance = EV – PV
Although not universal practice, these variances should be defined in such a way that they will be
negative when the project is over budget (cost variance) and/or behind schedule (schedule variance). This
is the approach taken in this section.
Continuing with the example where EV is $250: if the $350 was actually spent at that point in time
(i.e. AC = $350), the cost variance would be ($100) (i.e. $250 – $350), and the project would be over
budget. If it was expected that $300 would have been spent at that point in time (i.e. PV = $300), the
schedule variance would be ($50) (i.e. $250 – $300), and the project would be behind schedule.
A cost 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.
The magnitude of these variances depends on project dollar values, so 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 and the schedule performance
index (SPI).
Cost performance index = EV / AC
SPI = EV / PV
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The following EV chart (Figure 4.16) shows the tools to be used in reporting project progress and
highlights that for the current point in time (‘control point’), the project is behind schedule (EV is lower
than PV) and over budget (AC is higher than EV).
FIGURE 4.16 Reporting project progress
Cost
Estimated final cost overrun
Revised budget Estimated delay
Cost variance = CV
Schedule
variance = SV
Duration
Control point Scheduled Estimated
completion completion
time time
Planned value
Earned value
Actual cost
Example 4.17 further explains how the EV chart shown in Figure 4.16 can be interpreted.
EXAMPLE 4.17
WaterSupplyCo
WaterSupplyCo is responsible for the main water pipes in a large city and has initiated a project to replace
the water pipes that run under the footpath. The total length of the water pipe replacement is 480 metres.
There are three core activities in replacing the water pipes:
1. excavate down to the existing pipes
2. replace the existing pipes
3. fill in the excavated area and re-concrete the footpath.
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.
Activity rate Calculation Total activity cost
Excavation—$150 per metre $150 × 480 $72 000
Replace pipe—$200 per metre $200 × 480 $96 000
Fill and concrete—$220 per metre $220 × 480 $105 600
Total—$570 per metre $570 × 480 $273 600
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Within the first week of the project, DJ Water finds 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
• completed 94 metres of water piping.
DJ Water uses 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).
Activity rate Calculation Budget
Total—$570 per metre 570 × 160 $91 200
An initial inspection of the figures suggests that the project is over budget by $42 864 (AC $134 064 –
PV $91 200). This is highlighted by the AC being above the PV in Figure 4.16.
The second step to complete is an EV analysis. This shows that the EV 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 PV being above the
EV curve in Figure 4.16.
DJ Water also calculates that the cost variance is unfavourable by $80 484 (EV $53 580 – AC $134 064).
This is highlighted by the AC being above the EV curve in Figure 4.16.
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 4.16.
A standard budget variance analysis would show that the project has real budgetary problems. When the
spending and schedule variances are calculated (i.e. based on EV), it highlights just how serious the
situation is.
Estimating the percentage completion of activities is sometimes difficult. The EV method suits projects
where completion can be measured with reasonable accuracy, such as building a highway (km completed)
or dredging a shipping channel (tonnes dredged). Input indicators such as labour hours are not suitable
measures of project completion, as they provide no evidence of what has actually been accomplished.
EV cannot replace scheduling techniques such as PERT, because 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 accountant can play an important role
in implementing such a control system.
QUESTION 4.11
(a) Explain how project managers can benefit from the use of EV analysis.
(b) What are the difficulties in implementing EV analysis?
MONITORING SPECIFICATION AND QUALITY

Quality in projects is meeting the customer’s specification. There are three stages to project quality
management as outlined in Figure 4.17.
A significant issue for managing quality is that, unless good performance measurement design is
achieved and there is constant monitoring and assurance, 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.
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 (see Example 4.18).
Another important aspect of managing quality is contract management. In cases where there is a
contract and an external provider is responsible for some of the project’s deliverables, it is important
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FIGURE 4.17 The three stages to project quality management
1. At the beginning of the

project, the project scope
and specifications are
established. This needs to
Quality happen at the same time
planning as the project budget and
time lines are set.
Quality Quality
monitoring assurance
2. A critical task for the management 3. This stage is about ensuring

accountant is to establish performance that all the outcomes of the
measures to reflect the planned project are in accord with
specifications (see Module 5). This is the planned specifications
about ensuring that the activities and and, if they are not, that this
processes for delivering the project is dealt with appropriately.
specifications are controlled.
to ensure compliance with contractual terms and conditions (e.g. time, quality and deliverables). This
requires a thorough contract variation regime (e.g. time and cost adjustments due to changes in scope).
The management accountant needs to ensure the project critical path is recalculated after every contractual
change and the new activity slacks and their effect on the project are well understood.
EXAMPLE 4.18
Project disputes
The Massachusetts Institute of Technology (MIT) sued Frank Gehry, whom many consider to be the
world’s greatest living architect, over his design of a USD 300 million building project, due to what they
claimed were faults in the design. Alleged problems included cracking masonry, poor drainage in the
outdoor amphitheatre, leaks, sliding ice and snow, and mould growth.
MIT argued that poor design led to the problems, while 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 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’.
Source: Based on Pogrebin, R. & Zezima, K. 2007, ‘M.I.T. sues Frank Gehry, citing flaws in center he designed’, New York
Times, 7 November, p. A20; Hawkinson, J. A. 2010, ‘MIT settles with Gehry over Stata Ctr. Defects’, accessed June 2018,
http://tech.mit.edu/V130/N14/statasuit.html.
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, because the projects can be hidden among the many other
organisational activities. There may also be fewer or no external stakeholders to hold the organisation
accountable.
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QUALITY COSTS
One way to think about quality management is to consider the four different types of quality costs outlined
in Figure 4.18.
FIGURE 4.18 Quality costs
Incurred in the design of an organisation’s processes and activities to

1.
prevent quality failure, by focusing on quality inputs and systems, staff
Prevention
training and equipment maintenance.
Incurred when incoming supplies and materials are

2.
received, and when products are inspected during,
Appraisal
and at the completion of, the production process.
Quality
costs
Incurred when quality failure is identified in either the

3.
quality control or assurance process, and rework is able
Internal
to be completed before the customer takes control of
failure
the project.
4. Incurred when the customer finds that the project does not meet
External specifications and the project organisation has to cover the expense of
failure re-working the project. This is the most expensive type of quality cost—
it includes the costs of reworking already completed work and
reputational costs for the project organisation.
These costs are discussed further in Module 6 when total quality management (TQM) is considered.
The international standard ISO 10006:2017, ‘Quality management—Guidelines for quality man-
agement 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: https://www.iso.org/standard/70376.html.
MEASURING PERFORMANCE
Analysing performance against the project budget and schedule provides basic control over a project for
the project manager—as well as visibility over the project manager for the project sponsor—to ensure that
the project is delivered. Other performance measures are required to ensure that the project achieves its
deliverables and to ensure project quality.
As projects are inherently uncertain, to evaluate the performance of a project, non-controllable events
must be allowed for. Budgets can be adjusted or ‘flexed’ to account for these non-controllable changes.
There are two major challenges for management accountants in project performance measurement:
1. In many organisations, projects are cross-functional and are organised with a matrix-like structure, but
planning, resource allocation and lines of accountability normally follow functional lines. This means
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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 project milestones under their responsibility.
2. In project organisations (such as construction companies), employees must continue to learn and keep
their skills up to date. As a project manager is responsible for completing the project on time and within
budget, they may be reluctant to allow their best people to be absent from project activities for extended
periods of time (e.g. to attend training). Here, management accountants can design performance
measures that encourage project managers to support employees’ learning and development. For
example, a simple measure that may be used is the days spent on educational courses. While this
measure is limited because it does not convey information about the effectiveness of the training, it
highlights the importance of learning and development to project managers. Targets for such measures
should allow for learning and skills development.
THE IMPORTANCE OF PROBITY IN PROJECTS

Probity means honesty or integrity. The potential for dishonest conduct needs to be monitored in projects.
Management accountants have an important role (where they are involved) in probity management through
the design of procedures, processes and systems. Independent Commission Against Corruption (ICAC) in
New South Wales in Australia has a very useful set of guidelines that provide direction on how to deal
with probity issues (ICAC 2005).
A management accountant can draw on five probity fundamentals in the management of project probity:
1. Best value for money—the purchase of inputs is in an open and competitive environment, where the
price of the input is balanced against the other characteristics, such as quality and risk. Part of this means
ensuring that suppliers do not charge unreasonable prices at the expense of a project or organisation.
2. Impartiality—individuals and organisations should expect impartial treatment in their involvement
with a project. If an organisation submits a tender for a public sector contract, it is entitled to impartial
treatment at each stage of the process. Suppliers should be able to expect impartial treatment when they
submit proposals for supply, especially when the effort and time in the preparation of the proposal are
considerable.
3. Conflict of interest—management accountants need to ensure that there is no conflict of interest, such
as when individuals may have other private interests that conflict with the interest of the project (e.g. a
project team member may have a family member who is a supplier to the project). There is an obligation
to ensure that any potential conflict of interest is disclosed and managed.
4. Accountability and transparency—accountability means ensuring that resources are used effectively
and that responsibility is taken for performance. Clearly, the accounting systems that management
accountants design are central to this process. Transparency means ensuring that the project is open
to scrutiny, which involves providing a reason for all decisions made. Again, management accountants
are central through preparing reporting mechanisms and constructing decision-making tools.
5. Confidentiality—while activities in the project need to be accountable and transparent, some infor-
mation needs to be kept confidential, at least for a particular period of time. Examples of this include
proposals, intellectual property and maybe pricing structures (ICAC 2005).
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 adviser or probity auditor needs to be engaged. This is
particularly so in the case of government projects and contracts (ICAC 2005).
RISK MANAGEMENT
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, as shown in Example 4.19.
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EXAMPLE 4.19
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.
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.
Effective risk management requires a good risk management strategy, which consists of four key areas,
as outlined in Figure 4.19.
FIGURE 4.19 Risk management strategy
Risk
management
strategy
Having the Monitoring Monitoring Establishing

right project known risks— unknown risks— contingency
team diagnostically interactively responses
Having the right project team

An effective risk management strategy during project execution is to hire the right project team in the first
place—including people who have the necessary technical skills and experience. When you have achieved
this, the next challenge is keeping them! Project failures are littered with examples of a good project plan,
good people at the start of the project, then poor management of these people during the project, resulting in
them leaving and the project failing. A useful exercise is to determine which staff on the project are critical
to the project’s success, which staff are difficult to replace and which staff can be replaced relatively easily.
From this list, you can establish a strategy of ensuring that your essential staff stay on the project. You also
need to create a backup plan for what to do in case those strategies fail.
Monitor known risks

In the risk assessment process prior to project commencement, a list of risks would have been created,
including the probability and the impact of those risks. A diagnostic approach to monitoring these risks can
be established and, when variances appear, remedial action can be taken. The use of key risk indicators is a
useful approach for diagnostic control, as they help to measure risk levels (sometimes against appropriate
benchmarks).
Monitor for unknown risks

Risk is, by definition, about uncertainty or ambiguity. Consequently, while the probability of some events
can be predicted (trying to manage uncertainty), many projects face events that are simply not predictable or
may be ambiguous. These are what can be defined as the unknown risks—the events that project managers
and teams have no way of knowing in advance. So how can project managers deal with unknown risks?
Robert Simons (1995) provides some thoughts on this in what he calls ‘interactive control’, which can be
applied to monitoring unknown risks. In this form of monitoring, the project team stays alert and involved
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in the ongoing process of risk assessment and risk management. When unforeseen risks appear, project
staff are then able to recognise and manage them.
Establish contingency responses

To manage the known and unknown risks, projects need a contingency response. This should contain a
buffer of both time and resources. It should also contain action plans, so that if things go wrong, the project
can be still delivered on time, on budget and according to specifications. It is important to be mindful that
managers and project staff may use this as a buffer to conceal poor project management or even apathy
by project teams towards project deadlines. A solution to this is only to have the contingency response
triggered by the project sponsor where particular outcomes or events arise from certain types of known or
unknown risks.
The risk–return trade-off

One final issue to keep in mind is that the cost of monitoring and managing risk needs to be balanced
against the outcome of the risk eventuating. This is where risk assessment becomes an important and
integrated part of risk management, because this enables the costs of failure to be balanced against the
costs of monitoring.
QUESTION 4.12
What is the critical difference between project risk assessment and project risk management, and
what are the key components of project risk management?
STAKEHOLDER MANAGEMENT
Stakeholder management is the ongoing process of managing the expectations and influence of stakehold-
ers on a project. While there are a number of different approaches to this, there are a number of common
stages that are consistent as shown in Figure 4.20.
FIGURE 4.20 The stages of stakeholder management
Assess your
Identify the Identify their capability to
stakeholders interests satisfy their
interests
You may need to balance

Establish a stakeholder Are they supportive of the the interests of different
register at the project project or are they against it? competing stakeholders.
selection stage. It should Why? If they are against it, If you can’t satisfy their
be constantly updated is there anything that you interests, or if it is prohibitive
while the project is can do to accommodate for you to do so, what ethical
being undertaken. their interests? responsibilities do you have
to these stakeholders?
Recall the 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 an essential component of managing them. One aspect of this that
is particularly applicable to the client is signalling specification, quality and timeliness. A very useful
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approach is to design a stakeholder scorecard that contains appropriate performance indicators that can be
used by stakeholders to track progress on the project.
This provides a monitoring mechanism for stakeholders. While it may seem that this enables stakehold-
ers 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.
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 called ‘scope creep’.
Scope creep is when there are changes in a project’s scope that are unplanned. It usually happens when
the original project specification is not defined and explained clearly enough and then the processes are
not managed adequately.
QUESTION 4.13
Refer to Appendix 4.1 on the Sydney Seafood Bar’s renovation project.

(a) What are the most suitable project monitoring and control techniques for this project?
(b) What are the advantages and disadvantages of each technique?
PART F: THE MANAGEMENT

COMPLETION AND REVIEW
Many activities require the assistance and expertise of the management accountant at the project comple-
tion stage. These activities include:
• monitoring the project to ensure that completion is the preferred option to abandonment
• managing the activities required to complete the project
• ensuring stakeholder consensus on project deliverables
• financial closure of the project
• dispersal of project assets
• post-implementation review
• preparation of the final project report
• knowledge management.
THE COMPLETION DECISION

As the end of the project approaches, and the management accountant has been monitoring its likely
success or failure, it is important to consider the potential benefits of walking away from an incomplete
project. If the project cannot be completed on time and on budget, it is possible that project completion will
result in a loss. Rather than committing further to a bad project, resources would be better used elsewhere
and the project should be abandoned or sold in its incomplete state.
CHECKLIST
At the completion of a project, there will be numerous small tasks that need to be completed prior to official
closure. 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 responsibility for their completion.
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SPECIFICATION SATISFACTION CONSENSUS
As outlined in Part C, project deliverables are specified at the beginning of the project. Additionally, at
various points during the project life cycle, communication with the project’s customer should have taken
place to ensure expectations were being met. Consequently, at the end of the project, there should not
be any surprises. 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.
STRATEGIC FIT ASSESSMENT

Part C discussed the need for projects to be aligned with the strategy of the organisation. A review of
how a project fits against the strategy of the organisation should not be left until the end of the project.
Management accountants need to ensure that there is constant interaction between organisational strategy
and project delivery so that alignment is maintained. This tends to help in the process of avoiding scope
creep. At the end of the project, there needs to be an analysis of how the project delivered against the
original intentions. There are typically three questions that need to be addressed in this analysis.
What was the underlying problem or opportunity that the project was dealing with and did it
deliver against this?
In the final review of the project, an analysis needs to be done to determine whether the project addressed
the particular problem or opportunity that triggered the project. 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?
As discussed earlier in this module, the key criteria for project selection is 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 that, 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 against its
objectives and the organisation’s strategy.
When a project is complete, an assessment against the original strategic fit analysis should be done to
see how the project delivered against its original objectives. There are a number of challenges with this
analysis:
• Strategies in organisations change—while a project may have fitted the original strategy, strategic
change itself may put the project into strategic misalignment. This is why it is important to ensure
there is a constant review of alignment between strategy and project delivery.
• 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 measurable
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.
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• The qualitative benefits from a project may not be obvious—for example, consider 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.
STAKEHOLDER SATISFACTION ASSESSMENT

A useful exercise is to establish whether each stakeholder’s requirements have been met, as well as to
document any issues that have arisen, or successes that have been achieved, during the project. This is
called a stakeholder satisfaction assessment.
To ensure that a stakeholder satisfaction assessment is meaningful, it needs to be an ongoing process
throughout the project, rather than something that is left until the end. There are two key reasons for this:
1. Stakeholders can have an interest in the project at different stages and may not be interested in it before,
or after, a certain point.
2. By the time the project is finished, the ability to fix any stakeholder concerns may be reduced
significantly, as these may have progressed beyond resolution.
A stakeholder satisfaction assessment is usually led by the project manager, though it can also be
conducted by a specialised unit within the organisation, such as the project management office or the
marketing department. The frequency of such assessments throughout the project depends, for example,
on the importance of the project, its duration and the number of stakeholders. The assessment can be done
using various tools, such as a survey, interviews, focus groups and during regular stakeholder meetings.
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,
discussed later in this section.
FINANCIAL CLOSURE
Financial closure has several aspects to it:
• determining the final actuals versus budget and schedule variances
• closing the cost records
• dealing with post-budget expenditures.
FINAL COSTS
The calculation of the project’s final cost and the final budget variance analysis are completed 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 inform future projects. One way that this can be applied is through improving
the estimation processes in project budgets. Organisational learning is a key aspect of project completion
and review.
CLOSING THE COST RECORDS

The completion of a project requires closing off the project accounts. If the accounts are not closed, project
workers may still bill hours and other non-genuine expenditures. This is a frequent and significant problem
with projects.
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. An example of this type of expenditure is 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.
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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.
• The stock can be absorbed into the inventory of the organisation to be used in other projects or
in operations.
The last 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 project manager or
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 learnt from the project and the way these
can be applied in future projects.
KNOWLEDGE MANAGEMENT
Although each project is unique, there is useful knowledge that can be gained from the process of project
management. The management accountant can provide value 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 in this area include:
• What problems appeared during the project?
• What was the effect of these problems?
• What caused them, and why were they not anticipated or detected earlier?
When this knowledge is identified, there are several strategies to ensure that it is not lost.
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.
Much of the knowledge gained in projects is based on the experiences of the staff who have worked on
them. 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.
The lessons learnt from projects can be fed back into the strategy of the organisation. Some organisations
have training or information sessions where the lessons learnt 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.
One important thing to keep in mind is that there are inhibitors for project knowledge management
including:
• 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 learnt is not time
spent actually getting the project done.
• No 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 effect on this.
In summary, 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.
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QUESTION 4.14
How can a management accountant add value to their organisation in the project completion and
review process?
REVIEW
Module 4 discussed that projects are an increasingly important part of any organisation. Whereas some
organisations spend most of their effort on projects (e.g. IT and construction companies), in all other
organisations different departments conduct projects to enhance their performance (e.g. a marketing
department implementing a new customer relationship management information system).
Part A defined projects and how they are different from operations. 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
6. have multiple resources that need coordination.
Part B discussed the roles in projects. Projects are usually run by teams. The roles within the teams are
not usually defined in the same way in all projects, but there are several roles that tend to be consistent—
the project sponsor, project manager and project team. Within an organisation, 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, perform
capital budgeting analysis, carry out network analysis techniques such as PERT, and support and guide
management decision-making.
There are four stages in project management:
1. Project selection—the objectives of the project are decided on and the project team is formed. As
part of this stage, the management accountant can assist with strategic fit, risk assessment and initial
financial analysis (discussed in Part C).
2. Project planning—the project specifications are documented and deliverable dates established. A range
of techniques are used to accomplish this, including Gantt charts, PERT, CPM and detailed project
budgeting. In each case the management accountant can contribute to these techniques (discussed in
Part D).
3. Project implementation and control—the project activities take place and progress against the set
deliverable dates and the budget is monitored. A useful tool in this stage is the EV method where cost
and time performance are monitored together. The management accountant is central to the process of
control (discussed in Part E).
4. Project completion and review—several steps must happen to complete a project. The management
accountant can add value through writing the final project report and supporting other knowledge
management activities so that lessons learnt in the project can be used in the future (discussed in Part F).
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APPENDICES
APPENDIX 4.1
SYDNEY SEAFOOD BAR
A: HISTORY AND BACKGROUND
This appendix examines 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 run-down 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 tourist destination and the SSB is part of the Property NSW ‘The Rocks’
precinct and so is part of Sydney’s image to the world.
FIGURE A1 4.1 Seafood dish at Sydney harbour
Source: mr_focus / Getty Images Australia.
The contemporary dining experience needs everything from expensive glassware, stylish plates, high-
quality 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
Harbour Bridge and Opera House views.
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. The following would best
reflect the strategy that has emerged.
Competitive or business strategy
• The SSB has a ‘differentiation strategy’ (Porter 1985).
• This differentiation is focused on high-quality organic seafood dishes in a prime Sydney
Harbour location.
• By doing this, the SSB is attempting to do something that is unique.
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Operational strategy
• The SSB invests in expert menu and wine advice, obtains the best organic 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
Property NSW leases the building and outdoor area to the SSB. Property NSW 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 Property NSW’s vision and strategy, 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 is estimated to take three to four months during which the business will be closed.
B: PROJECT PROPOSAL
FIGURE A1 4.2 The kitchen
Source: Lebazele / Getty Images Australia.
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 of a new
kitchen
2. a complete removal of the toilet and bathroom facilities, a reconfiguration of the floor plan and then
construction of new toilets, including an accessible toilet
3. structural improvements to the inside of the building (including the mezzanine level).
Why the project is needed
Amenity, kitchen and structural factors have influenced the requirement for major capital works on the
premises. These are so significant that a short-term fix until the end of the current lease does not meet due
diligence, stewardship, or fiduciary duty standards (although the option to continue to upgrade the current
facilities received thorough consideration). It is unrealistic to expect a ‘world-class’ site with a ‘world-
class’ restaurant to undertake a ‘patch-up’. Moreover, the investment will provide permanent improvement
and enduring benefit to the site to sustain the operating viability of the SSB. Undertaking the project is in
the best interests of Property NSW, customers, staff and stakeholders.
All the requirements issued by the relevant local authorities have been addressed in the submitted plans.
Figure A1 4.3 shows the interrelationship of the project requirements.
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FIGURE A1 4.3 Interrelationship of requirements for the project
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
Amenity maintenance and enabling disabled access

The toilet facilities need a major upgrade. They are at the end of their useful life, with increasing
maintenance costs. Regulations require alteration to install a disabled toilet with wheelchair access.
While the SSB could have drawn upon a heritage provision (due to the age and historical significance
of the building) to avoid the requirement for disabled toilets, they have, in good faith, worked hard
with the architect and the regulators to meet the access requirements while preserving the building. The
management of the SSB believes that this is in the spirit of community responsibility and within the
principles of Property NSW.
Kitchen changes
Regulatory changes
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. Since then, 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.
This fundamental design change is of enduring value to the building.
Changed public expectations
A further and very important related issue is that public demand and expectations have changed since the
original design. This manifests itself in two relevant ways:
1. The current design cannot meet changed and contemporary expectations for service times in busy
periods (this is where it really counts for the city’s reputation). Service throughput improvements are
needed so that the SSB experience is more consistent with customers’ needs and expectations.
2. The level and class of presentation of the kitchen (which is visible to customers) needs to be
benchmarked against ‘world’s best practice’, as it is in a ‘world’s best location’.
Kitchen equipment replacement
The kitchen equipment has reached the end of its useful life and needs replacing (it cannot be used after
this year). This is resulting in increased maintenance and breakdown issues. The reconfiguration of the
kitchen will complement the acquisition and replacement of cooking equipment.
Structure, fixture and ftting changes and improvements
In the engineer’s report required for landholders’ consent, recommendations were made for structural
modification of the mezzanine level. The engineers and architects have recommended that the mezzanine
level’s structure, fixture and fittings be upgraded and reconfigured. A particular issue to address was
ventilation and extraction problems. These changes are of enduring benefit.
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C: PROJECT BUDGET
TABLE A1 4.1
Project construction costs $

†
Quantity surveyor’s estimate of project construction cost 625 001
Packing and storing of equipment 10 000
Associated project fees
Consulting costs 77 420
Architect’s design and project management fees 87 932
Legal fees 9 148
Operating costs associated with the project‡
Staff redundancy costs 60 000
New staff costs 40 000

§
Promotional budget (advertising) 100 000
Total project cost 1 009 501

†
Estimated cost is from a recent 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 there will be a vigorous marketing
campaign to promote the new opening. There will also be consultation with Property NSW about cross promotion and other
sponsorship.
D: FINANCIAL MODELLING OF THE PROJECT

Capital budgeting model
Project costs
The details of the project costs and fees are contained in the project budget (Table A1 4.1).
Tax effects of operating costs and depreciation expense
The operating costs associated with the project ($200 000) are paid in Year 0, and are deductible for tax
purposes. The tax return for Year 0 is filed after the end of the year and so the cash inflow from the tax
reduction is to be recorded in Year 1.
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.
Operating cash flows
SSB management assumes that the investment will result in operating efficiencies, which will translate
into a steady increase in operating profit and cash flows. To estimate these cash flows, a baseline NOPAT
is used and then a growth rate is factored into this over time.
SSB’s accountants believe a baseline NOPAT 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 NOPAT as a result of the investment is estimated at 7 per cent per annum
(compounding). This increase is based on the baseline NOPAT (not the reduced first-year NOPAT) and
reflects an incremental cash inflow from Year 2 onwards. This 7 per cent estimate is based on SSB’s
historic average increase in NOPAT over the last 10 years.
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Discount rate
Three discount rates were used for the analysis:
1. a conservative discount rate of 8 per cent—this represents a low-risk 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—Property NSW). The equipment and other fittings only have
material value in their current setting and have no disposal value.
APPENDIX 4.2
CONSTRUCTING A NETWORK DIAGRAM USING PERT
USING PERT
This appendix provides a step-by-step example of the process of creating a network (or PERT) diagram
and using the CPM to assist with project planning and implementation. It follows the four steps outlined
in the Study guide:
Step 1: Draw the network diagram.
Step 2: Calculate the expected time (ET).
Step 3: Define the critical path.
Step 4: Calculate slack.
The project has nine activities (as shown in Table A2 4.1). 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, notice that Activities 2, 3 and 4 all need Activity 1 to have been completed before they can start.
TABLE A2 4.1 Project activity list
Activity Preceding activity
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 was the case in the Study guide, for this exercise the activity-on-node (AON) method is used
to draw the diagram (remember that AON shows activities as nodes).
Step 1: Draw a network diagram

The project plan can now be transformed into a network diagram. The network diagram includes:
• project activities (left-hand column of Table A2 4.1)
• activity precedence relationships (right-hand column of Table A2 4.1).
The items from the project activity list (Table A2 4.1) can now be transferred into the diagram.
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(i) Draw the start node
Start
(ii) Draw node ‘1’

Activity 1 can start immediately at the start of the project, after the start node.
Start 1
(iii) Draw Activities 2, 3 and 4

Activities 2, 3 and 4 can begin once Activity 1 has been completed.
Start 1 3
(iv) Draw Activity 5

Note that in the project activity list, Activity 2 precedes Activity 5. That is, Activity 2 must be completed
before Activity 5 begins.
So now Activity 5 is added into the diagram, directly after Activity 2.
2 5
Start 1 3
(v) Draw Activity 6

Activity 3 must be completed before Activity 6 begins, so Activity 6 is added to the diagram directly after
Activity 3.
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(vi) Draw Activities 7, 8 and 9
The remaining activities are added to the diagram in the same way:
• Activity 7 after Activity 4
• Activity 8 after Activity 5
• Activity 9 after Activity 6.
2 5
Start 1 3 6
2 5 8
Start 1 3 6 9
4 7
(vii) Draw the end node

When all the remaining activities are complete, they meet at the final end node. Activities that are not a
precedent activity for another activity (in this case, Activities 7, 8 and 9) are connected to the end node.
2 5 8
Start 1 3 6 9 End
4 7
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Step 2: Calculate expected time
Once all activities and their precedence relationships have been drawn, it is necessary to calculate the
expected activity durations. Recall from the Study guide, three duration estimates are usually made for
each activity: optimistic (O—shortest), pessimistic (P—longest) and most likely (ML).
The following formula is used to calculate the ET for each activity.
O + (4ML) + P
ET =
6
The ET calculated using this formula is a weighted average of the three duration estimates—where the
weighting for O is 1 / 6, ML is 4 / 6, and P is 1 / 6.
For example, as per Table A2 4.2, the ET for Activity 1 is:
ET for Activity 1: (20 + 4 × 25 + 30) / 6 = 25 days
The ET for Activity 6 is:
ET for Activity 6: (20 + 4 × 28 + 60) / 6 = 32 days
The ET estimates for the activities of this project are shown in Table A2 4.2.
TABLE A2 4.2 Expected time estimates
Preceding Optimistic Most likely Pessimistic

Activity activity duration (days) duration (days) duration (days) ET (days)
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
(above the activity labels) as shown.
ET = 20 ET = 36 ET = 40
2 5 8
ET = 25 ET = 20 ET = 32 ET = 10
Start 1 3 6 9 End
ET = 21 ET = 18
4 7
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Step 3: Define the critical path
The next step is to determine how long the overall project will take to complete. As can be seen from the
diagram so far, there are three paths. The longest path—the one that has the longest duration—is called
the critical path. This path indicates how long it takes to finish the project.
To determine the critical path, add together the ETs for the activities on each path through the network
diagram.
Path 1: 1 → 2 → 5 → 8 (25 + 20 + 36 + 40 = 121 days)

Path 2: 1 → 3 → 6 → 9 (25 + 20 + 32 + 10 = 87 days)
Path 3: 1 → 4 → 7 (25 + 21 + 18 = 64 days)
In this case, the critical path is Path 1 and the project duration is 121 days.
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.
Step 4: Calculate slack

It is now time to calculate the slack for this project. Two paths through the network diagram have slack or
float. These are 1 → 4 → 7 and 1 → 3 → 6 → 9. The path 1 → 2 → 5 → 8 is critical so, of course, it has
no slack.
Calculating the slack of Activity 4 is provided as an example:
Its earliest start time is day 25, when Activity 1 is complete.
The latest possible start time is the project completion time (121 days) less the time of Activities 4 and 7:
121 – (18 + 21) = 82 days.
The slack in Activity 4 is the difference between its earliest start time and its latest start time: 82 – 25 = 57
days.
Therefore, the project manager has considerable flexibility in deciding when to start Activity 4.
REFERENCES
Australian Petroleum Production and Exploration Association 2018, ‘Australian LNG projects’, accessed September2018,
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 September 2018, http://www.mckinsey.com/insights/business_
technology/delivering_large-scale_it_projects_on_time_on_budget_and_on_value.
Eden, C., Ackermann, F. & Williams, T. 2005, ‘The amoebic growth of project costs’, Project Management Journal, vol. 36, no. 2,
pp. 15–26.
Gallagher, C. 1987, ‘A note on PERT assumptions’, Management Science Quarterly, October.
Independent Commission Against Corruption (ICAC) 2005, Probity and Probity Advising, Sydney, New South Wales.
Lend Lease 2018, ‘Western Sydney Stadium’, accessed September 2018, https://www.lendlease.com/au/projects/western-sydney-
stadium/?id=4dd6e4ac-148b-4724-839c-f73922454b95.
Lewis, J. 2008, Mastering Project Management, McGraw-Hill, New York.
Lientz, B. & Rea, P. 2003, International Project Management, Academic Press, Amsterdam.
Littlefield, T. & Randolph, P. 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 Management, Oxford
University Press, Oxford.
Malmi, T. & Brown, D. 2008, ‘Management control systems as a package: Opportunities, challenges and research directions’,
Management Accounting Research, vol. 11, no. 4, December, pp. 287–300.
Matheson, V. Schwab, D. & Koval, P. 2018, ‘Corruption in the bidding, construction and organisation of mega-events: An analysis
of the Olympics and World Cup’, in The Palgrave Handbook on the Economics of Manipulation in Sport, Palgrave Macmillan,
Cham, pp. 257–78.
Meredith, J. & Mantel, J. 2015, Project Management: A Managerial Approach, 10th edn, Wiley, New York.
Morris, P. & Pinto, J. 2007, The Wiley Guide to Project, Program and Portfolio Management, Wiley and Sons, New Jersey.
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Phillips, R., Freeman, R. & Wicks, A. 2003, ‘What stakeholder theory is not’, Business Ethics Quarterly, vol. 13, no. 4,
pp. 479–502.
Pinto, J. 2010, Project Management: Achieving Competitive Advantage, Prentice Hall, New
Project Management Institute (PMI) 2017, A Guide to the Project Management Body of Knowledge, 6th edn, Project Management
Institute, Newtown Square, Pennsylvania.
Simons, R. 1995, Levers of Control, Harvard University Press, Boston.
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.
Turner, R. 2003, People in Project Management, Gower, Burlington.
Zwikael, O. & Smyrk, J. 2011, Project Management for the Creation of Organisational Value, Springer-Verlag, London, UK.
Zwikael, O. & Meredith, J. 2018, ‘Who’s who in the project zoo? The ten core project roles’, International Journal of Operations
& Production Management, vol. 38, no. 2, pp. 474–92.
Zwikael, O., Chih, Y. & Meredith, J. 2018, ‘Project benefit management: Setting effective target benefits’, International Journal of
Project Management, vol. 36, pp. 650–58.
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, Thomas Telford, London.
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MODULE 5
PERFORMANCE
MANAGEMENT
PREVIEW
INTRODUCTION
The Strategic Management Accounting subject 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 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
management plays in strategy and value creation.
The need for sound design and an understanding of the use and implications of strategic performance
management and control systems is gaining increasing importance in all organisations. This module sets
the context for performance management and control, including the:
• characteristics of effective performance measures and control systems
• use of performance measures
• application of performance management to motivate and reward.
Module 5 is concerned with how performance management helps to achieve goals and objectives through
setting targets and measuring performance against those targets through control and feedback systems.
Module 5 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 management in
the context of value creation and the sustainability of performance over time, as well as sustainability in
the sense of corporate social responsibility (CSR).
This module also builds on Module 1 by discussing the role of the management accountant in generating
and interpreting information about value chain performance. The focus of Module 2 on information is also
relevant as it is the basis of performance management. Similarly, Module 3 looks at variance analysis
as one way in which performance can be managed through comparisons between actual and expected
performance.
The links between strategy, management control systems and performance management, and the limi-
tations of some traditional accounting-based controls, are considered. The various models of performance
management, emphasising the balanced scorecard and the strategy mapping process, as well as cascading
performance measures and the important role of information systems in performance management, will
be highlighted.
Module 6 will be previewed by discussing the role of performance management in the creation and
management of value. 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 management, will be discussed. This module focuses on improving performance
through targets, trends and benchmarking, and the importance of continuous improvement (CI) 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.
management with information for monitoring and decision-making that, in turn, informs and is informed
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by strategy.
rnal environment
Ext e
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
VALUE INFORMATION
OPERATIONS
Ext e
rnal environment
OBJECTIVES
After completing this module you should be able to:
• Explain the importance of performance management and the role of a performance measurement system
in value creation, sustainability performance, and strategic implementation.
• Analyse how a properly designed balanced scorecard can implement and monitor strategy.
• Identify effective performance measures in a given scenario.
• Assess the root causes of performance issues in a given situation.
• Evaluate potential behavioural effects resulting from performance evaluation and reward systems.
TEACHING MATERIALS
• APES 110 Code of Ethics for Professional Accountants
• IESBA International Code of Ethics for Professional Accountants (Including International Indepen-
dence Standards) April 2018
PART A: THE ROLE OF PERFORMANCE

MANAGEMENT
In Part A the concepts of performance and performance management are introduced. Financial and
non-financial performance and the measurability of performance are considered. The multiple roles of
performance management, including its role in value creation and sustainability, are explained. Corporate
governance in terms of the links between risk management and performance management, and the role
of ethics in performance management, are reviewed. Part A concludes with two theories that help explain
differences in how accountants affect and are affected by performance management.
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WHAT IS ‘PERFORMANCE’ AND ‘PERFORMANCE
MANAGEMENT’?
‘Performance’ and ‘performance management’ can mean different things to different people.
Performance
Performance may be a discrete event, as in achieving a certain level of profit or customer satisfaction.
Performance may be considered quantitatively (i.e. a numeric value)—for example, that profit is
$10 million, or that 85 per cent of customers are satisfied. It may also be considered qualitatively (and
typically more subjectively)—for example, the quality of a service or an organisation’s reputation. There
may be a trade-off between quantitative and qualitative aspects of performance—for example, between
achieving a certain level of profitability and the organisation’s reputation. Similarly, there can be a trade-
off between short-term performance and longer-term sustainable performance, whether that be financial,
societal, environmental or reputational.
Performance may be understood either at the level of the whole organisation, or different business units,
products or services, geographic areas, distribution channels or customer segments within the organisation.
At each level of analysis, performance may be interpreted differently. For example, the Australian airline
Qantas achieves quite different results between its international, domestic and low-cost subsidiary (Jetstar)
business segments. Different strategies and measures of performance may apply across each of these
different segments.
Further, different stakeholders—for example, investors, lenders, customers, suppliers, employees,
local communities—may interpret performance in very different (and sometimes competing) ways. For
example, a Qantas customer may see Qantas’s performance in terms of on-time departures or the comfort
of the cabin seating. An investor may be more interested in its financial performance. A member of the
public living near an airport may be more interested in the airline’s environmental performance.
Performance measurement
Performance measurement implies a scientific technique involving comparison to a specific scale (e.g. a
metre in length, a tonne of weight, one thousand dollars). A performance measure is therefore quite specific.
Financial performance, such as profit or return on investment, can be readily measured because it is:
• specified in a single unit—for example, dollars
• clearly defined
• based on a clear application of rules—for example, accounting standards or generally accepted
accounting principles.
A performance indicator is less specific—it is a signal indicating a general direction or trend rather than
an exact comparison against a scale. For example, customer satisfaction can be classified as an indicator
because it can mean different things to different people and can be judged in different ways, such as sales
to returning customers or a survey of a sample of customers. Performance indicators are often presented as
a trend or in comparison to targets as ‘traffic lights’: green for acceptable, red for unacceptable and amber
for borderline performance.
Other aspects of performance
There are many other functions relevant to the concept of performance:
• Performance monitoring involves surveillance of performance.
• Performance reporting involves the dissemination and interpretation of information about performance
to those inside and/or outside the organisation (see Module 2).
Performance management
The management of performance is an active rather than a passive process whereby actions are taken to
effect change in behaviour or results. Performance management is far more than collecting or reporting
information. It extends to analysing performance with a view to understanding its causes. Only when there
is an understanding of causality can change, or recommendations for change, be implemented.
Performance management calls for a wider range of skills for the management accountant. While
performance measurement is the starting point, the management accountant needs to synthesise complex
data sets from different sources and analyse that data. The management accountant then needs skills of
persuasion and communication, backed by evidence, to put in place actions or recommendations for change
with the purpose of improving future performance.
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MODULE 5 Performance Management 221

Performance improvement implies changing behaviour to improve performance to achieve an absolute
or relative target—for example, a return on investment of 12 per cent or a market share that is greater than
a particular competitor.
PERFORMANCE MANAGEMENT AND ITS LINKS

TO STRATEGY
The focus of this module is performance management and its links to strategy. As highlighted in Module 1,
an organisation’s strategy is concerned with value creation (not only for investors, but also for customers
and other stakeholders) that is sustainable over time. The idea of management control to ensure that
strategy is achieved is therefore crucial to an understanding of performance management. The performance
management process incorporates all of the aspects of performance discussed previously. These are:
• defining what the performance is that an organisation needs to achieve
• how to measure performance
• reporting and monitoring performance
• taking deliberate action to improve performance.
Performance can be seen as a method of value creation (‘If we are not creating value, what are we
doing?’) in terms of process or the results of a process. Performance is usually interpreted relative to a
target, a trend over time or by comparison to a benchmark. Targets, trends and benchmarks are discussed
later in this module.
An organisation’s performance should not be viewed from one dimension only (i.e. only from a financial
point of view). As shown in Figure 5.2, performance should be seen more holistically.
FIGURE 5.2 Performance dimensions
Combination of financial Combination of financial and

measures (e.g. profit non-financial quantitative terms
before tax, return on (e.g. dollar sales per square
investment) metre of floor space, earnings
per share (EPS))
Non-financial but Performance Subjective judgments and

quantitative (e.g. market opinions (e.g. employee
share (%), Net Promoter satisfaction, reputation or
Score (NPS), quality environmental awareness)
pass rate)
Organisations use different terms for their performance measures such as key performance indicators
(KPIs) or critical success factors (CSFs). Organisations may call their performance management system
a ‘dashboard’ (picture the dials in an aircraft cockpit), a ‘traffic light’ system (discussed previously
under ‘Performance measurement’) or a ‘scorecard’. These differences in terminology matter less than
understanding what an organisation is trying to measure and how that measurement takes place.
Performance needs to be understood relative to an organisation’s strategy and the particular industry in
which it operates, as shown in Example 5.1. All listed companies report their performance to investors and
other interested stakeholders.
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EXAMPLE 5.1
Performance reporting by Event Hospitality and Entertainment Ltd

Event Hospitality and Entertainment Ltd (EVT) (formerly Amalgamated Holdings Limited) is an Australian
provider of entertainment, hospitality and tourism and leisure services. EVT conducts its operations in
Australia, New Zealand and Germany. The company was established in 1910. It had annual revenue of
$1.2 billion in the year ended June 2017. EVT is listed on ASX. Its market capitalisation in July 2018 was
$2.13 billion.
EVT’s entertainment division operates Event Cinemas in Australia and New Zealand, the State Theatre in
Sydney, Moonlight Cinemas across Australia, Cinestar Cinemas in Germany and Edge Digital Technology.
EVT’s hospitality division operates QT Hotels & Resorts, Rydges Hotels & Resorts, Atura Hotels brands
as well as the premier Australian ski resort township of Thredbo Alpine Resort. Both the entertainment
and hospitality divisions have loyalty programs. Across its owned and managed hotels at June 2017, EVT
had 9132 rooms across 58 different locations (EVT 2017a, p. 10).
EVT’s strategic plan includes future expansion, depending on a number of internal and external factors,
including available capital and customer trends.
For the hospitality division, EVT wants to increase the number of hotel rooms through new hotel man-
agement agreements and freehold acquisitions. It also aims to grow market share, increase occupancy
rates and increase customer spend in all its hotels (EVT 2017a, p. 13).
The most important financial performance aspects for EVT are explained in the annual report as:
• revenue
• earnings before interest
• taxation
• earnings before depreciation and amortisation (EBITDA)
• normalised profit before interest and taxes (PBIT).
Normalised profit, in many companies called underlying profit, supplements the financial statements,
and such figures are unaudited and not comparable to other companies. The underlying profits are
based on judgments by the directors as to what is the profit that best reflects the result of operations,
unencumbered by transactions that are required by Australian Accounting Standards and that do not
reflect ongoing performance.
For each of the divisions, performance is measured based on profit before income tax, which EVT uses
to compare to the performance of competitors.
The audited remuneration reports within annual reports provide a good guide as to what aspects of (most
commonly, financial) performance are important, as these are the basis for rewarding directors and senior
management. These are typically split into short-term incentives (STIs) and long-term incentives (LTIs).
EVT’s remuneration policy aims to reward the CEO and other executives with a level and mix of
remuneration commensurate with their position and responsibilities within EVT. The rewards are linked
to specific targets, goals and KPIs. Parts of the executive remuneration packages depend on the financial
and operational performance of EVT. This element of remuneration is deemed to be ‘at‐risk’ because if
the performance goals are not achieved, executives do not receive that component of the remuneration
package.
QUESTION 5.1
EVT’s Annual Report 2017 and the results presentation for the half year ended 31 December 2017
are available to download at https://www.evt.com/investors/.
Search both documents and identify as many performance measures as you can for the hotel
division.
FINANCIAL PERFORMANCE MANAGEMENT

Accountants are familiar with measuring, monitoring, managing, improving and reporting financial
performance through the income statement (or statement of profit or loss and other comprehensive
income), statement of financial position (balance sheet) and statement of cash flows. Accountants can
interpret financial performance through the use of ratio analysis to discover trends and opportunities from
the five perspectives provided by ratios, as outlined in Figure 5.3.
Various approaches to measuring shareholder value from an investor’s perspective are also available.
Study of the effect of reported financial performance on capital markets is important to understand stock
market expectations and how reported performance influences share price movements over time. Stock
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markets tend to value shares more on expectations of future cash flows, discounted to present values, than
on historical performance. While the analysis of historical, externally reported performance is valuable,
it is through a focus on strategy and value‐adding activities that management accountants can contribute
more to organisations.
FIGURE 5.3 Ratios for financial performance
Profitability
Shareholder
Liquidity
returns
Ratios
Activity or
Gearing
efficiency
While financial statements produced for external parties are governed (in Australia) by the Corporations
Act 2001 (Cwlth), 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 5.1.
Comparison of approaches to performance between financial accounting and strategic
TABLE 5.1 management accounting
Financial accounting 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
Comparison to prior year Comparison to prior year, budget and external

benchmarks
Strategic management accounting also provides comparisons to budgets and standard costs, and enables
variance analysis, product/service profitability analysis, customer and distribution channel profitability
analysis, activity-based cost analysis and a variety of other tools and techniques.
Strategic management accounting information increasingly links the information in the general ledger
with other sources of data such as inventory records, labour routings, bills of materials and standard costs.
Strategic management accounting techniques may move beyond the:
• financial year to encompass a multi-period, life cycle approach to understand performance
• hierarchical organisational structure of reporting to the analysis of its organisational value chain and
business processes, and
• organisation to assess the whole supply chain (industry value chain) of which the organisation is a part,
and to provide comparisons with competitor organisations and competitor supply chains.
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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.
NON-FINANCIAL PERFORMANCE MANAGEMENT

Strategic management accounting increasingly links financial data with non-financial data and reports
them together to managers. Applying the EVT example (from Example 5.1), it is clear that revenue, the
normalised (or underlying) PBIT and EBITDA are the key financial performance measures that are used
to manage the performance of the CEO and senior executives. Non-financial data, particularly the average
room rate, occupancy rate and revenue per average available room (RevPAR), are key determinants of
performance and are metrics used to compare relative profitability in the accommodation industry.
Most organisations maintain comprehensive statistical data to support planning, decision-making and
control. This information may come from:
• data captured as a by-product of the accounting process—for example, quantities of product purchased
and sold, labour hours worked
• data captured by the organisation from non-accounting systems—for example, on-time delivery, product
quality
• external surveys—for example, customer satisfaction
• published data—for example, Australian Bureau of Statistics or industry associations
• stock exchange data—for example, market capitalisation.
Performance, whether it is financial or non-financial, needs to be interpreted in the contexts of the
industry and the organisation’s competitive strategy and business model. For example, measures like
occupancy and average room rates are essential in accommodation but not in manufacturing; ‘sales per
square metre’ is useful for retail stores, but is meaningless for airlines; while ‘available seat kilometres’
has no relevance to retail stores.
All businesses have a finite capacity, whether it is a production line, a hotel, airline or retail store. To
better manage performance, managers need to be able to identify and improve their capacity utilisation,
which will reduce the fixed cost per unit of product sold or service supplied.
Performance measures will also reflect differences between the business segments. For example,
the entertainment division of EVT will have quite different performance measures compared with the
hospitality division. While seasonality may be less important for cinemas (some increase is possible
during school holidays), it will be very important for hotels, and weather conditions in particular will
have a significant impact on EVT’s Thredbo Alpine Resort. While holiday locations will influence some
hotel performance, CBD hotels may be influenced more by Monday to Friday business travel and whether
business confidence is rising or falling, as well as by capital city sports and entertainment events.
Of course, hotels do not simply generate revenue from hotel bookings, but from ancillary services,
including restaurants and bars, laundry services and room service. One of EVT’s strategies is to increase
customer spend in its hotels. Performance measures will need to cascade down (see later in this module)
to lower levels of the organisation to be able to manage performance—for example, restaurant utilisation.
At the corporate level, EVT must also focus on growth through its pipeline of new hotel management
agreements and freehold acquisitions, given its strategy to deliver growth via increased room inventory in
key destinations (discussed previously).
THE MEASURABILITY AND REPORTING OF PERFORMANCE

A favourite saying in performance management is ‘what gets measured, gets done’. This is because
measuring something focuses people’s minds on what is measured, especially if the performance is
reported, compared to some target, and where rewards are linked to achieving the desired performance
level—for example, sales representatives may receive a commission on the value of sales or managers may
receive a bonus on the reported profit. Those things that are not measured or not reported are often deemed
to be unimportant. Unfortunately, organisations tend to measure what is easy to measure, rather than what
is important to measure (Denton 2005). This raises the issue of whether all performance is measurable.
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, safety
incidents do occur. For example, in April 2017, 15 people were injured when a Qantas 747 flying from
Melbourne to Hong Kong had a ‘stick shaker incident in which the pilots experienced ‘airframe buffeting’
at an altitude of 22 000 feet. The ‘stick shaker’ is a warning system that causes the aircraft’s control stick
to vibrate, alerting pilots they may be about to stall. Stalling occurs when the wings stop creating enough
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lift to hold the aircraft in the sky. The Australian Transport Safety Bureau, the airline safety watchdog,
was treating it as a ‘serious incident’, meaning there were indications that an accident causing loss of life
or aircraft damage nearly occurred (Hatch 2017).
Example 5.2 illustrates how airline safety ratings are independently assessed as a means of informing
travellers about the possible risks involved in travel, a critical area of importance for passengers and
airlines alike.
EXAMPLE 5.2
Safety index
The Top 20 Safest Airlines for 2018 rankings by AirlineRatings.com includes Qantas for the fifth year in a
row, making the Australian airline a leader in safety standards (Schultz 2018).
Various safety rankings of airlines around the world exist. The Jet Airliner Crash Data Evaluation Center,
or JACDEC (JACDEC 2017), calculates its safety index and annual rankings based on accidents and
serious incidents (including near-miss accidents) affecting aircraft over the last 30 years. The safety index
relates the number of accidents to revenue passenger kilometres.
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’s 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’s 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.
One development to improve the measurability of customer satisfaction is the Net Promoter Score
(NPS). NPS was developed by Bain & Company to measure 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?’ 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, where it features as a
performance measure in its 2017 annual report. The NPS measures the percentage of promoters minus the
percentage of detractors. Promoters are the loyal, enthusiastic customers who love doing business with
the organisation.
For an example, see the Australia Post 2017 Annual Report where the company emphasised its overall
+1.4 point improvement in the NPS score, available at https://auspost.com.au/content/dam/auspost_
corp/media/documents/Annual-Report-2017.pdf?fm=search-organic.
The importance of NPS is that it provides a measure of sustainable customer satisfaction necessary for
future financial performance, not only in terms of repeat business for existing customers but also extending
to referrals to new customers. This helps the business to focus on keeping profitable customers happy and
CI in customer satisfaction. For example, it is quite likely that the NPS results of the four major Australian
banks and AMP will suffer from the significant criticism it faced during 2018 at the Royal Commission
into Misconduct in the Banking, Superannuation and Financial Services Industry.
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,
as shown in Example 5.3.
EXAMPLE 5.3
Performance reporting by Victoria Police

In its 2016–17 annual report, Victoria Police describes the role and function of police under five headings:
Preserving the peace.
Protecting life and property.
Preventing offences.
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Detecting and apprehending offenders.
Helping those in need of assistance (Victoria Police 2017, p. 4).
Performance is reported against the objectives, objective indicators and outputs agreed by the Chief
Commissioner with the Government for 2016–17 in Victorian Budget Paper Number 3: Service Delivery
(Budget Paper Number 3).
The annual report lists three broad categories of performance measurement:
1. community feelings of safety
2. crime statistics based on reports from the public and crimes detected by police. Each offence
is recorded (e.g. fraud, robbery, drug possession, public nuisance, etc.)
3. road fatalities and injuries
The annual report identifies many performance measures, targets and actual results. Some of these are:
• based on quantity—for example, number of calls for assistance, number of offences recorded
• quality—for example, proportion of the public that has confidence in police, proportion of drivers tested
for alcohol who comply with limits
• time-based—for example, proportion of crimes resolved within 30 days.
Financial performance compared with budget is also reported, as are statistics on work health and
safety (WHS).
An interesting aspect of police performance is that the management of that performance can be difficult
to influence by the police agency alone. The use of the term ‘indicators’ rather than ‘measures’ in the
annual report is important, as no police agency has the ability to control behaviours of the public and
outcomes, although each has an important role to play in conjunction with other agencies in the criminal
justice system—for example, prosecution authorities, courts, prisons and probation services. In addition,
many factors affecting police performance are heavily influenced by social factors such as mental health,
unemployment and education.
Like other public services, care must be exercised in the extent to which agencies are held accountable
for aspects of performance over which they may have little or no control.
Note: Example 5.3 is CPA Australia’s analysis of the performance indicators in the Victoria Police Annual
Report 2016–2017 and is illustrative for educational purposes only. It does not represent the official
position of Victoria Police.
Source: Based on Victoria Police 2017, Annual Report 2016–2017, accessed May 2018, http://www.police.vic.
gov.au/content.asp?a=internetBridgingPage&Media_ID=132934.
Appendix 5.1 explores the case of of Achmea Holdings N.V., the largest insurance provider in the
Netherlands, which has been operating since 1811. This is an interesting case because Achmea is
a ‘mutual’—that is, an entity not listed on a stock exchange but whose customers are, indirectly,
its owners. Appendix 5.1 is included because it provides an example of many of the concepts included
in this Study guide, including performance measures, strategy maps and sustainability.
Note: The concepts covered in this appendix (not the specific details of the case) are examinable.
THE MULTIPLE ROLES OF PERFORMANCE

MANAGEMENT
Performance management has multiple roles that include providing information:
• for managers to aid in planning, decision-making and control in pursuit of value creation
• on environmental and social sustainability for integrated reporting purposes
• for signalling to investors and other stakeholders.
Each of these roles is described in the next section.
PERFORMANCE—A PROCESS OF VALUE CREATION

Value creation is a process of turning one thing into something else, with the ‘something else’ having more
value than the original. Value-adding may be seen as increasing shareholder value to an investor. Value
creation was discussed in Module 1 and will be considered further in Module 6.
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—for example, reducing the distance travelled in making a delivery or the time taken
to carry out a service.
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Performance management can therefore be seen in terms of the value creation process. Porter’s (1985)
‘value chain’ (as discussed in Module 1) 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. So 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;
otherwise, the activities should be eliminated. Performance management should focus on the margin in
value chain activities.
This idea of value creation is particularly important when considering 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 Example 5.4 demonstrates.
EXAMPLE 5.4
Value creation at Apple Inc.

The Global Top 100 Companies by Market Capitalisation 31 March 2017 Update by Pricewaterhouse-
Coopers (PwC) lists Apple as the world’s largest company by market capitalisation (USD 754 billion).
Apple’s nearest rival is Alphabet (previously known as Google). Both Apple and Alphabet have experienced
the largest increases in market capitalisation since the financial crisis of 2009. Apple increased its market
capitalisation between 2009 and 2017 by 705 per cent and its ranking from 33 in the Top 100 companies
in 2009 to number 1 in 2017 (PricewaterhouseCoopers 2017, p. 32).
Warren Buffett’s Berkshire Hathaway Inc.—long known as an exceptionally successful investor—
became Apple Inc.’s second-largest shareholder in May 2018 (Bloomberg 2018).
Apple’s 10-K annual report for 2017 describes its business strategy as designing and developing
operating systems, hardware and software to solve customer needs. It achieves this through a continual
high-level investment in research and development. In addition to advertising and promotion, Apple’s
in-store salesforce provides a high level of advice to customers to attract and retain customers. Apple
operates its own retail stores but also has space and sales staff within retail stores (e.g. within JB
Hi-Fi in Australia).
Given its strategy for value-adding, Apple would be expected to measure and manage the following
aspects of its performance:
• customer satisfaction
• customer retention
• salesperson knowledge
• growth in retail locations
• growth in third-party distributors
• research and development investment.
However, value creation does not need to come only from innovation. It can also come from more
conventional businesses, as Example 5.5 demonstrates.
EXAMPLE 5.5
Value creation at Woolworths

Although there are many ways that market share can be measured (and different methods are supported
or disputed by different interest groups), it is reasonably clear that Woolworths and Coles dominate
the grocery market in Australia, although more recent entrants such as Aldi have begun to erode the
dominance of the ‘Big 2’. While Coles is owned by the Wesfarmers group, Woolworths is listed on ASX in
its own right.
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 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
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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 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 it through the ‘Everyday Rewards’ card. It uses this example of ‘big data’ (see
Module 2) 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 2017 Annual Report, Woolworths identified various performance measures linked to its short-term
incentive plan (STIP) and long-term incentive plan (LTIP), which are part of the audited remuneration report
within the annual report.
Woolworths changed its STIP during the 2016–17 year by setting targets at each level of the business
to ensure that all team members ‘from top executives to store managers, were aligned to a common effort
but were rewarded for their achievement of business results largely within their own control’ (Woolworths
Group 2017, p. 34). Five STIP measures are each equally weighted (i.e. 20% each): sales, EBIT, working
capital, customer satisfaction and safety. LTIP measures are relative total shareholder return (TSR), sales
per trading square metre and return on funds employed—each weighted at 33 per cent (Woolworths Group
2017, p. 38).
STIP and LTIP are regular features of listed company annual reports and are used by companies to link
the performance of the business to the remuneration of directors and senior executives. By focusing on
measuring, managing and rewarding performance in areas like working capital management, customer
satisfaction and employee safety, managerial behaviour is changed in ways consistent with the company’s
strategy. In the longer term, this changed short-term behaviour is more likely to lead to the key financial
performance areas of increased shareholder value (i.e. TSR), return on funds employed, and probably the
most common measure of retail efficiency, sales per square metre (which measures the effective utilisation
of the most expensive retail resource: i.e. rent).
QUESTION 5.2
Please access the Annual Report 2017 of JB Hi-Fi (an Australian consumer electronics and
entertainment retailer), available online at: https://investors.jbhifi.com.au/annual-reports/.
Select ‘Annual Report – 2017 – with Chairman’s & CEO’s Report’ from the list.
(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 management is to understand the organisation’s strategy for value creation
and to measure the success of its value creation activities. As Example 5.5 illustrates, value creation can
be viewed from the shareholder financial perspective, or from a more internal, operational perspective,
although the two are clearly interrelated.
The idea of value creation over time is important, because measuring 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 5.3
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.
However, over the past 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 that is not always available in every store. Market research has revealed that cus-
tomers 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.
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Mega Markets has complained in the press that this competition is unfair because the overseas
suppliers do not have the high rental costs charged by the large shopping centre owners, nor the
high wages 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) What can the company do in the face of online competition?
PERFORMANCE AND SUSTAINABILITY

When we use the term ‘sustainability’ in relation to performance, we mean two things, as shown in
Figure 5.4.
FIGURE 5.4 Sustainability in relation to performance
Performance Meeting the

(e.g. financial, needs of today without
customer satisfaction, compromising the
quality) must ability of future
be sustained generations to meet
over time their own needs
Longer-term
Performance perspective (e.g.
achieved in one avoiding over-fishing,
year, which cannot deforestation, global
be achieved in the oil supplies pollution,
following year, is not carbon emissions
sustainable and waste
disposal)
Most companies listed on ASX now produce a 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. Integrated reporting, which was introduced in Module 2 and is discussed later
in this module, is aimed at providing a wider range of stakeholders with reports that integrate the various
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dimensions of performance, including financial and sustainability performance. 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, 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.
Increasingly, some investors and some customers expect businesses to be more socially and environ-
mentally responsible. Brand image can be tarnished by companies that use, for example, child labour
in developing countries, or source products from factories that have a poor health and safety record for
workers. Some customers are even willing to pay a premium price for more ethically sourced products
such as clothing and coffee.
Returning to Appendix 5.1, we see that Achmea reports its performance against both financial and
environmental criteria. Achmea recognises that its success comes from satisfying customers, yet it must
operate in a sustainable way in order to balance financial, social and environmental responsibilities.
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, as shown in
Example 5.6.
EXAMPLE 5.6
Sustainability at Newcrest Mining

Newcrest Mining is Australia’s leading gold mining company, with operations in Australia,
Papua New Guinea and Indonesia.
In addition to its strategy to deliver long-term growth in shareholder value, Newcrest’s annual report
discloses that Newcrest recognises the importance of sustainability in its broadest meaning. The opening
paragraph of its Chairman’s report begins with the importance of the health and safety of its employees.
Its key performance measures for 2017 are safety, earnings, costs per ounce and free cash flow, each
with a 25 per cent weighting (Newcrest Mining Limited 2017a, p. 81).
Like many businesses that recognise that a focus on sustainability is not only morally and eth-
ically appropriate but is also necessary for sustained financial performance, Newcrest produces a
separate sustainability report in accordance with the Global Reporting Initiative (GRI) (discussed
later in this module).
The Sustainability Report identifies Newcrest’s newly developed sustainability objectives to:
have a safe, healthy and diverse workforce; reduce, reuse and recycle resources responsibly to
minimise environmental impact; and, work with local communities and other stakeholders, to achieve
our vision as Miner of Choice (Newcrest Mining Limited 2017b, p. 8).
The report contains substantial information about People (safety), Economic, Social and Environmental
performance and includes 14 pages of data covering these aspects of performance (Newcrest Mining
Limited 2017b, pp. 87–100).
The GRI G4 content index is also available at the same website and identifies where data can be found
to match the GRI G4 reporting requirements.
The Newcrest example suggests that companies do consider environmental issues in their strategy. GRI
G4 Guidelines address the need to adopt a more holistic approach to reporting performance.
The GRI (see http://www.globalreporting.org) is a multi-stakeholder process aimed at developing and
disseminating globally applicable sustainability reporting. The GRI Sustainability Reporting Standards
(GRI Standards) offer reporting principles, standard disclosures and an implementation manual for the
preparation of sustainability reports by organisations, regardless of their size, sector or location. The GRI
Standards are required for all reports or other materials published on or after 1 July 2018.
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The consolidated PDF of GRI Standards includes the three universal standards—GRI 101, 102 and
103—and the three series of topic-specific standards:
1. 200 (Economic topics)
2. 300 (Environmental topics)
3. 400 (Social topics).
It is available at: https://www.globalreporting.org/standards/gri-standards-download-center/consoli
dated-set-of-gri-standards/.
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 2014, p. 3). GRI sustainability reports under the GRI Standards 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.
Not all of these have to be disclosed, only those where the organisation deems them to be material. Note
that in Example 5.6, Newcrest produced a separate GRI G4 content index that links to where the data in
the G4 can be found in the annual report or sustainability report.
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 isolated financial and sustainability reports, 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 GRI 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’ (GRI 2012).
The move towards integrated reporting has important implications for accountants in terms of perfor-
mance information.
INTEGRATED REPORTING
The International Integrated Reporting (IR) Framework document (‘the Framework’) was issued by the
IIRC in 2013. In relation to performance management:
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 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)
• 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.
More information is available online at: http://integratedreporting.org.
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.
There are important links between integrated reporting and the GRI.
GRI is supportive of integrated reporting as it develops as an important and necessary innovation of
corporate reporting.
GRI advocates for the inclusion of robust sustainability metrics (based on a multi-stakeholder approach) to
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integrated reporting, in support of its overall vision of a sustainable global economy (GRI 2018).

Integrated reporting provides companies with a broad perspective on risk, and GRI encourages those that
want to do integrated reporting to use the GRI Standards. United by the shared vision that businesses
should focus on value creation over the short, medium and longer term, GRI and the International Integrated
Reporting Council (IIRC) continue to work together, aligning the GRI Standards and the International <IR>
Framework to improve corporate reporting.
As the global standard setter for sustainability reporting, GRI is committed to supporting integrated
reporting – including through the Corporate Leadership Group on integrated reporting 2017 (CLGir) … The
CLGir 2017 is exploring how best to leverage the GRI Standards and the International <IR> Framework for
integrated thinking and reporting, with the aim of learning together and identifying best practice guidance
in reporting (GRI 2017).
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.
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’ (XBRL 2018) (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.
Further information about XBRL is available online at: http://www.xbrl.org.
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 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.
As seen in Example 5.5, Woolworths disclosed limited non-financial information in its annual report,
at least in part because of the commercially sensitive information this would give to its 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. As has
been shown in the preceding examples of EVT, Woolworths, JB Hi-Fi and Newcrest, remuneration reports
included in annual reports now contain information about how performance is measured for remuneration
of directors and senior executives. These reports send an important signal to shareholders that the
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short-term and long-term remuneration of directors and senior managers is inextricably linked to improving
shareholder value, as shown in Example 5.7.
EXAMPLE 5.7
Risk management and signalling at Westpac

Like all Australian banks, Westpac is subject to a large number of regulatory agencies, including the
Australian Prudential Regulation Authority (APRA), Reserve Bank of Australia (RBA), Australian Securities
and Investments Commission (ASIC), Australian Securities Exchange (ASX), Australian Competition and
Consumer Commission (ACCC), Australian Transaction Reports and Analysis Centre (AUSTRAC) as well
as the regulatory agencies of the other countries in which it operates.
The Basel Committee on Banking Supervision (BCBS) provides a global regulatory framework known
as Basel III. Basel III, among other things, has increased the required quality and quantity of capital held
by banks and introduced new standards for the management of liquidity risk.
Westpac’s annual report highlights risk management as a key area that needs to be addressed in order
for Westpac to achieve its vision, because risk management affects all aspects of Westpac’s business and
its stakeholders.
Westpac has an ‘Operational Risk Management Framework’ and ‘Compliance Management Framework’
it uses to manage risks, and also a ‘Sustainability Risk Management Framework’ it uses to assess and
manage CSR-related risks.
Westpac’s annual report notes that the culture in the bank is that all staff are responsible for identifying
risk, managing risk and working according to Westpac’s nominated risk profile.
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.
The need to manage and improve performance can lead to 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 access to resources in the future.
Organisations 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.
At the time of writing, Australian financial institutions, including Westpac and other banks, were
facing considerable reputational and potentially financial risks arising from the Royal Commission into
Misconduct in the Banking, Superannuation and Financial Services Industry. Criticism of all financial
institutions has focused on their STI-driven profit focus possibly directing the behaviour of some
employees towards unethical practices. Time will tell what the consequences are of the Royal Commission
for banks and other financial institutions. From a signalling perspective, the Royal Commission draws to
our attention to the idea that we cannot rely on the statements of any business without considering other
relevant factors in the public domain.
A historical example, the HIH case (Example 5.8), illustrates the impact on a financial institution of an
earlier Royal Commission.
EXAMPLE 5.8
HIH Insurance
The collapse of HIH Insurance Group, placed into provisional liquidation in March 2001, was—and
remains—the largest corporate failure in Australian history. The subsequent suspicions about a serious
level of corporate mismanagement within HIH saw the appointment of a Royal Commission later that year.
The Royal Commission’s report was publicly released in April 2003 and had a significant influence on the
ASX’s Principles of Good Corporate Governance and Best Practice Recommendations, from which the
ASX’s current (2014) definition of corporate governance was derived.
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’ (Parliament of Australia 2003). There was a misconception in the
company that ample funds were available to fund these activities.
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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’.
The Royal Commission further found that ‘the acquisition of FAI Insurance Ltd in Australia, com-
bined with re-entry into the US market and the expansion of the UK operations’ (Parliament of Aus-
tralia 2003), 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 (Parliament of Australia 2003).
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 (see Example 5.9 for a more recent case), but there have been no corporate failures
since HIH that approach its magnitude.
The role of regulatory bodies and auditors always comes under scrutiny following large-scale and high-
profile corporate collapses. This is likely to happen as a result of the Royal Commission into Misconduct
in the Banking, Superannuation and Financial Services Industry in which questions about corporate
governance and organisational culture have (at the time of writing in 2018) already been raised.
EXAMPLE 5.9
Dick Smith Group

The Dick Smith Group (DSG) operated consumer electronics retail stores and an online consumer
electronics retail business throughout Australia and New Zealand from in excess of 390 locations with
in excess of 3000 employees. It was listed on ASX in 2013. In January 2016, DSG and its Australian
subsidiaries were placed into voluntary administration by its directors. Banks subsequently appointed
receivers and managers to recover the assets over which they held security.
The report to creditors by administrators McGrath Nicol identified the reasons for the failure:
Although DSG reported profits, its growth required considerable financial commitment, during a
period where DSG was losing market share. The competitive electronics environment resulted in
tightening credit terms, the need for major inventory impairment, and significant cash pressure in late
FY16. Increased borrowings and new finance facilities were required and ultimately DSG could not
operate within the terms of those facilities (McGrath Nicol 2016, p. 10).
The administrators believed that DSG failed because of its high cost base due to its large network of
stores, a loss of market share in a highly competitive market, an expansion plan requiring considerable
financial resources and purchase of inventory that was not justified by consumer demand. Ultimately, its
cash flows were unable to satisfy the covenants it had made with bank lenders.
Banks were paid a proportion of their secured debt but unsecured creditors and shareholders received
nothing. The total shortfall to creditors was about $260 million (McGrath Nicol 2016).
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The example of Dick Smith, like HIH, shows the importance of sound risk management as part of
governance processes. It also reveals that signalling risk factors to investors is not always as clear as it
should be. The suppliers, lenders and customers of Dick Smith are not likely to have understood the risk
of rapid expansion, competition and increases in inventory holdings.
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
• a lack of understanding of risks of investment by investors.
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 management.
GOVERNANCE, RISK AND PERFORMANCE MANAGEMENT

In Australia, the Corporations Act provides the broad legal framework under which companies operate.
Two organisations provide regulation for companies and securities in Australia: the Australian Securities
and Investments Commission (ASIC) and the Financial Reporting Council. ASIC is Australia’s corporate,
markets and financial services regulator. It ensures that Australia’s financial markets are fair and trans-
parent, supported by confident and informed investors and consumers. ASIC administers and enforces the
Corporations Act and is required to:
• maintain, facilitate and improve the performance of the financial system
• promote confident and informed participation by investors and consumers in the financial system
• administer and enforce the law
• make information about companies and other bodies available to the public as soon as practicable.
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 the Royal Commission into HIH Insurance, volume 1: ‘The failure of HIH
Insurance: A corporate collapse and its lessons’ (HIH Royal Commission 2003, p. 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,
which 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.
You can access the Corporate Governance Principles and Recommendations at: http://www.asx.com
.au/documents/asx-compliance/cgc-principles-and-recommendations-3rd-edn.pdf.
Accountants, as significant advisers to the board, play a significant role in contributing to good corporate
governance, not only in terms of safeguarding the integrity of financial reports (the fourth principle), but
also in contributing to a system of management control that monitors and evaluates performance (the first
principle); and establishing and evaluating a risk management framework (the seventh principle).
Corporate governance can be described as constituting the entire accountability framework of the
organisation, with two dimensions:
1. conformance, and
2. performance.
Conformance takes place through assurance (including audit), ensuring that the organisation understands
and is managing its risks effectively. While conformance is an essential aspect of corporate governance, it
needs to be balanced with performance.
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Performance is the need to take risks to achieve objectives, and to do this, risk management needs to be
integrated with decision-making at each organisational level. Performance focuses on strategy, resource
utilisation and value creation, helping the board to make strategic decisions, understand its appetite for risk
and the key performance drivers [in order to achieve shareholder value] (Collier 2009, p. 21).
The board’s role is to set objectives, monitor performance in terms of achieving those objectives and
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, the 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. 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).
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) Enterprise Risk
Management—Integrated Framework (COSO 2004) defines enterprise risk management as a process,
effected by an entity’s board of directors, management and other personnel. It is applied across the
enterprise and is designed to identify potential events that may affect the entity, to manage risk within
its risk appetite and to provide reasonable assurance regarding the achievement of entity objectives.
COSO updated the framework in 2017 as Enterprise Risk Management—Integrating with Strategy and
Performance, which highlights the importance of considering risk in both the strategy-setting process and
in driving performance. The updated framework gives explicit focus to performance. The framework
‘Enhances alignment between performance and enterprise risk management to improve the setting of
performance targets and understanding the impact of risk on performance’ (COSO 2017, p. iii). It further
states that:
Enterprise risk management allows organizations to anticipate the risks that would affect performance and
enable them to put in place the actions needed to minimize disruption and maximize opportunity (COSO
2017, p. 4).
The International Standards Organization also produced an updated risk management standard in 2018:
ISO 31000:2018 Risk management—Guidelines, which provides principles, a framework and a common
process for managing risk of any type. It can be used by any organisation regardless of its size, activity
or sector. The new standard is an update of AS/NZS ISO 31000:2009 Risk Management—Principles and
Guidelines, the Australian-developed international standard for risk management. Risk is now defined as
the ‘effect of uncertainty on objectives’, which focuses on the effect of incomplete knowledge of events
or circumstances on an organisation’s decision-making (Tranchard 2018).
A brief summary of the new standard (which is only available to purchase from ISO) is at: https://
www.iso.org/obp/ui#iso:std:iso:31000:ed-2:v1:en.
Performance management is fundamental to helping the board or its committees exercise the function of
governance and risk management by monitoring performance information in terms of goal achievement,
assessing risks and the effectiveness of management controls. Accounting information is one of the main
sources used by boards to support the governance function. Accountants are involved in performance
reporting to the board and in establishing and monitoring internal controls.
Management accountants in particular are commonly involved in risk management processes (Collier,
Berry & Burke 2007).
Risk management is an important element of performance management because it establishes the
boundaries of what is acceptable and unacceptable in terms of the risk appetite set by the board.
This function results in the board defining the corporate strategy, the management controls and the
performance measures necessary to manage risks and achieve organisational objectives. In particular, the
board of directors must balance short-term and long-term expectations about performance—the notion
of sustainability (discussed previously)—and also to some extent balance the needs of shareholders and
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other stakeholders. Finally, actual performance needs to be monitored against performance expectations,
thereby satisfying the need for good governance. These relationships are shown in Figure 5.5.
FIGURE 5.5 Relationship between elements of the management control system
Corporate governance sets

objectives in line with
stakeholder expectations
and competitive situation
Management controls
Performance measures
(financial, non-financial; Enterprise risk management
and targets
quantitative, qualitative)
Strategies and plans are

implemented and result in
organisational actions
Feedback
Organisational outcomes
QUESTION 5.4
Consider the role of risk management and performance management in your organisation. If your
organisation produces a publicly available annual report, do a word search on ‘risk management’,
‘performance’ or ‘KPIs’. If you work for a smaller organisation, you may be able to ask the CEO
or chief financial officer (CFO) how they view the relationship between risk management and
performance management.
How does risk management relate to performance management?
ETHICS AND PERFORMANCE MANAGEMENT

CPA Australia members must comply with APES 110 Code of Ethics for Professional Accountants (the
Code). The standard is based on the previous version of the Code of Ethics for Professional Accountants
issued by the International Federation of Accountants (IFAC) (at the time of writing, the APESB had issued
an Exposure Draft 02/18 outlining the proposed changes to APES 110, with a proposed effective date of
1 January 2020). The Code applies to members in business as well as members in public practice.
A CPA member’s responsibility is not exclusively to satisfy the needs of an individual client or employer,
as the accountancy profession also 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 fundamental principles in the Code are:
(a) Integrity—to be straightforward and honest in all professional and business relationships
(b) Objectivity—not to compromise professional or business judgments because of bias, conflict of
interest or undue influence of others.
(c) Professional competence and due care – to:
i. Attain and maintain professional knowledge and skill at the level required to ensure that a client
or employing organization receives competent professional service, based on current technical and
professional standards and relevant legislation; and
ii. Act diligently in accordance with applicable technical and professional standards.
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(d) Confidentiality—to respect the confidentiality of information acquired as a result of professional and
business relationships.
(e) Professional behaviour—to comply with relevant laws and regulations and avoid any conduct that the
professional accountant knows or should know might discredit the profession (s. 110.1 A1).
The circumstances in which members operate may create specific threats to compliance with the fun-
damental principles.
Threats to compliance with the fundamental principles might be created by a broad range of facts and
circumstances. It is not possible to define every situation that creates threats. In addition, the nature of
engagements and work assignments might differ and, consequently, different types of threats might be
created (s. 120.6 A2).
Threats to compliance with the fundamental principles fall into one or more of the following categories:
(a) Self-interest threat—the threat that a financial or other interest will inappropriately influence a
professional accountant’s judgment or behavior;
(b) Self-review threat—the threat that a professional accountant will not appropriately evaluate the results
of a previous judgment made; or an activity performed by the accountant, or by another individual
within the accountant’s firm or employing organization, on which the accountant will rely when
forming a judgment as part of performing a current activity;
(c) Advocacy threat—the threat that a professional accountant will promote a client’s or employing
organization’s position to the point that the accountant’s objectivity is compromised;
(d) Familiarity threat—the threat that due to a long or close relationship with a client or employing
organization, a professional accountant will be too sympathetic to their interests or too accepting of
their work; and
(e) Intimidation threat—the threat that a professional accountant will be deterred from acting objectively
because of actual or perceived pressures, including attempts to exercise undue influence over the
professional accountant (s. 120.6 A3).
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 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 feasible options, the professional accountant determines that appropriate action has
not been taken and there is reason to believe that the information is still misleading, the accountant shall
refuse to be or to remain associated with the information (IESBA Code, s. R220.9).
In such circumstances, it might be appropriate for a professional accountant to resign from the employing
organization (IESBA Code, s. 220.9 A1).
Ethics has a great deal of relevance to those responsible for performance management, 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 in Example 5.10).
EXAMPLE 5.10
WorldCom, Enron and Arthur Andersen

WorldCom filed for bankruptcy protection in June 2002. At the time, it was the biggest corporate fraud
in history. The US Securities and Exchange Commission said WorldCom had committed ‘accounting
improprieties of unprecedented magnitude’ (SEC 2002). The company used accounting tricks, largely
by treating operating expenses as capital expenditure to conceal a deteriorating financial condition
and inflate profits. WorldCom admitted in 2004 that the total amount by which it had misled investors
over the previous 10 years was almost USD 75 billion and reduced its stated pre-tax profits for 2001
and 2002 by that amount. Former WorldCom chief executive Bernie Ebbers resigned in April 2002
and is currently serving a 25-year prison term. Scott Sullivan, former chief financial officer, entered a
guilty plea and was sentenced to five years in prison as part of a plea agreement in which he testified
against Ebbers.
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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] (Collier 2015, p. 86).
It also highlighted the employment of staff by Enron who had previously worked for their auditors,
the process of audit appointments and reappointments, the rotation of audit partners, and how auditors
are monitored and regulated.
Before the Big 4 accounting firms, there was a ‘Big 5’, 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
practise as accountants in the United States. 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 taking
over its client business.
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 United States 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). 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—for example, consulting—services.
Further detail on ethics is presented in the Ethics and Governance subject of the CPA Program.
Two theories—agency theory and contingency theory—are relevant to gaining a better understanding
of how accountants affect and are affected by performance management.
THEORIES RELATED TO PERFORMANCE MANAGEMENT

Agency theory
Agency theory is about the relationship between principals (owners of a business) and directors and
managers, who act as the agents of the owners. This is particularly relevant where there is a separation
between owners and managers, as is most common in listed companies.
Control systems and performance management 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.
A simple example of the agency problem is when selling a property. The real estate agent is the agent
of the seller and is expected to obtain the highest price for the property in an open market in return for
a commission—typically a percentage of the selling price. But the reward for the agent in obtaining an
additional amount—say $5000—on the sale price may not warrant the extra effort, so they may recommend
to their principal a lower, but easier to obtain, sale price.
Similarly, 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. For example, as discussed previously, director and
senior executive remuneration is linked to performance management through STIP and LTIP as disclosed
in the remuneration reports within annual reports.
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 Global Financial Crisis (GFC) of 2007–08 (see Example 5.21) was
the level of remuneration paid to executives, even when market conditions in many industries collapsed.
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The same concern has been raised at hearings of the Royal Commission into Misconduct in the Banking,
Superannuation and Financial Services Industry in relation to the payment of senior executives of banks
that may have led to unethical practices with customers.
Agents may also be tempted to disguise true performance levels to inflate their remuneration packages
and their reputations as managers. Financial reporting to shareholders is one way 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. This means managers always have access
to detailed management accounting information, including non-financial performance reports, that are
unseen by shareholders.
Being aware of potential problems in the agency relationship is important in understanding the role of
accountants in performance management.
Contingency theory
Another theory that is relevant to performance management and the role of the accountant is contingency
theory, which states that there is no universal best way to measure performance. Each organisation needs to
develop an appropriate performance management system that is relevant to its needs. This theory suggests
that the performance management system used by an organisation will depend to a large extent on such
factors as the size of the organisation, its environment and its technology.
Table 5.2 provides a hypothetical example of the performance measures that may be used by two
businesses in the retail food industry. The technology and systems in place for a large multi-store retail
chain and a small local shop reflect the contingency theory approach.
Comparison of control systems and performance measures for large and small food
TABLE 5.2 retailers
Large multi-store food retailer Owner-managed suburban food retailer
Management control system:
Comprehensive performance information by store and Simple performance reporting system, probably cash-
product group, which is necessary both for manage- based with sufficient record keeping to satisfy taxation
ment planning and decision-making and to provide the requirements
information needed to report to shareholders
In-store barcode scanner and integrated cash register Simple cash register and separate EFTPOS facility
and electronic funds transfer at point of sale (EFTPOS)
Likely performance measures:
Daily sales by hour of day—to help with rostering— Daily sales

and by product group
Average revenue per customer—provided by Average revenue per customer—may be provided

cash register by their bank, which provides information on all
EFTPOS/credit card transactions
Customer retention—based on loyalty card Customer satisfaction with staff service—

approximation based on observation
Sales per square metre and sales per employee
Time to scan customer’s shopping basket—per Waiting time for customer—approximation based on
item scanned observation
Gross margin per day—point of sale (POS) scans Periodic physical stocktake verifies margin
barcode and calculates margin
Stock reordering—POS scans barcode and updates Owner/manager orders stock by physical observation
inventory, identifying when to order and may and manual reordering
automatically place order on suppliers
Number of stores and locations based on demograph- Single site—location based on rental cost
ics and competition
(continued)
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Large multi-store food retailer Owner-managed suburban food retailer
Technology investment—percentage of sales Technology cost—dollars
Profit by store location Cash at bank
Number of products—maximise variety and choice Number of products—minimise inventory and wastage
Stock losses—difference between physical stock count

and computer inventory record
Stock turnover—financial statement ratio Investment in inventory—dollars
Employee turnover—from human resources Time spent by owner/manager recruiting and training
(HR) records new staff—informal judgment
QUESTION 5.5
Barbara Smith (CPA) works as the CFO of a privately owned company with annual sales of
$10 million. Kevin Jones, the CEO, is the main shareholder, who also acts as chair of the board.
The only other directors are you and Kevin’s wife.
After producing the draft end-of-year financial statements, Barbara discusses the results with
Kevin. 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
(COGSs) and periodic stocktakes, Kevin suggests to Barbara that the year-end stocktake figure be
reduced in order to reduce the taxable profit to around $150 000.
Barbara responds that such a practice is illegal. Kevin’s reply is that the inventory level at year
end was close to $1 million, so any adjustment could be readily disguised. Over Barbara’s further
objections, Kevin demands that Barbara adjusts the inventory downwards by $100 000 and that if
she is not prepared to make the adjustment, then she might as well resign from the company today.
(a) Discuss the implications of Kevin’s demand in relation to the following:
(i) Governance
(ii) Signalling
(iii) Ethics
(b) Recommend any actions that Barbara may be able to take.
PART B: STRATEGY, MANAGEMENT

CONTROL AND PERFORMANCE
MANAGEMENT
Part A considered the role of performance management (both financial and non-financial) in value creation
and sustainability. Performance management was outlined in the broader context of corporate governance
and risk management, as well as the importance of ethics. Part B looks in detail at the role of strategy
in performance management and how performance management can be seen as an important element in
management control. The limitations of some traditional accounting performance measures are considered.
The different models of performance management, including the Business Model Canvas, balanced
scorecard, the role of strategy mapping and the role of information systems in performance management,
are introduced.
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PERFORMANCE MANAGEMENT AND CONTROL—THEIR
ROLE IN STRATEGY
Mintzberg and Waters (1985) defined strategy as a pattern in a stream of decisions. They separated the
intended from the realised strategy, arguing that deliberate strategies provided only a partial explanation,
because some intended strategies were unable to be realised while other strategies emerged over time. As
discussed in Module 1, a common description of intended or deliberate strategy formulation is to begin with
establishing objectives and goals. This is followed by an internal appraisal of strengths and weaknesses
and an external appraisal of opportunities and threats (the SWOT analysis). This leads to a choice from
various strategic options of decisions such as diversification or the formulation of a competitive strategy
(Ansoff 1988).
Strategy must be implemented after it is formulated, and it is here that performance management 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 management.
As discussed in Module 1, various approaches to strategy have been developed by Michael Porter. Porter
(1980) developed his five forces model for analysing an industry’s strategic environment:
1. the threat of new entrants to the market
2. the threat of substitutes
3. the bargaining power of customers
4. the bargaining power of suppliers
5. rivalry (competition) within the industry.
Porter (1980) also identified three ‘generic strategies’ for competitive advantage:
1. cost leadership
2. differentiation
3. focus.
All strategies should contain goals and organisations need to introduce a system of performance
management comprising processes for measuring, monitoring, reporting and improving performance
to ensure that goals and strategies are achieved. Different strategies require different approaches to
performance management. For example, an organisation facing substantial industry competition may
measure market share (e.g. the motor vehicle sales and retail supermarkets industries). An organisation
facing substantial bargaining power by customers may measure customer profitability (e.g. clothing
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 (e.g. the
manufacture of mobile phones). 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. For example, the
performance measures used by Ford and BMW 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 objec-
tives. 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 1 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 perfor-
mance measures. Example 5.11 shows performance measures for a retail store, based on the primary and
support activities in the value chain.
EXAMPLE 5.11
Performance measures and the value chain—a retail store example
Value chain activity Examples of performance measures
Primary activities
Inbound logistics On-time deliveries from suppliers
Operations Out-of-stock products on store shelves
Outbound logistics Queuing time for customers at checkouts
Marketing and sales Store recognition (survey)
Service Customer complaints
Support activities
Procurement Days’ payables outstanding
Technology development Computer downtime
HR management Staff turnover
Firm infrastructure Sales per square metre of floor space
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 5.11 lists examples of performance measures. Each organisation would
develop the performance measures it deems appropriate to achieve its strategic objectives.
QUESTION 5.6
Revisit the information in Question 5.3 about Mega Markets—both the question and suggested
answer. Using Porter’s generic strategies, complete the following table.
(a) How would you describe Mega Markets’ strategy?
(b) Compare the value chain for Mega Markets with one of its international online competitors.
Mega Markets Online competitor
Primary activities
Inbound logistics
Operations
Outbound logistics
Marketing and sales
Service
Support activities
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Procurement
Technology development
HR management
Firm infrastructure
Review Appendix 5.1 for a good example of how strategy influences performance management.
Strategy and decision-making

Strategy is concerned with achieving organisational objectives. Objectives are achieved by allocating
organisational resources (e.g. property, equipment, people and finances) to activities that are effective
(i.e. that generate revenue) and cost-efficient (i.e. the cost of the activity is lower than the revenue
generated).
Decision-making is concerned with making choices from 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.
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 (the assumed cause-and-effect relationships) that are also imperfect.
Management control is most commonly seen as a critical element of strategy implementation, which
is a process of establishing targets, measuring actual performance and taking corrective action where
actual performance differs from the targets. The most common definitions of management control relate
to achieving an organisation’s strategic goals and influencing behaviour during environmental change
(e.g. Anthony 1965). A management control system implies an integrated set of individual controls that
is intended to help accomplish strategy by controlling resource inputs, influencing the production process
and monitoring outputs (Daft & Macintosh 1984).
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. So 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.
Strategy and management control

The most easily recognisable forms of control are ‘cybernetic’ forms of control, based on a feedback
cycle. Cybernetics is the science of communication and control processes in both natural and human-made
systems. Feedback is the process by which variations between actual and desired performance are fed back
into the process to achieve corrective action and bring actual performance in line with expectation. The
simplest example of a cybernetic control is a room thermostat. A thermostat has a set standard (the desired
room temperature), a method of measuring the temperature (a thermometer), a comparison (between
desired and actual temperature) and a means of correction (heating where the room temperature is too
low; cooling where the room temperature is too high).
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 the 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. This is the
heart of performance management—using performance information to manage actual performance so that
goals and objectives are attained.
QUESTION 5.7
SalesVol Ltd (SalesVol) uses a ‘budget versus actual’ comparison. 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. The first two use a traditional budget approach, while the third uses
a flexible (or flexed) budget approach (as discussed in Module 3).
(i) Traditional budget
Budget Actual Variance
Sales revenue $35 000 $33 750 –$1 250 (Unfavourable)
(ii) Expanded information
Budget Actual Variance
Sales volume 10 000 9 000 –1 000
Average selling price $3.50 $3.75 $0.25
Sales revenue $35 000 $33 750 –$1 250 (Unfavourable)
(iii) Flexible budget
Flexed Quantity
Budget budget Actual variance Price variance
Sales volume 10 000 9 000 9 000 $3 500 $2 250

(Unfavourable) (Favourable)
Average selling price $3.50 $3.50 $3.75
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 led to corrective action.
(i) Traditional
(ii) Expanded
(iii) Flexed
(b) Explain how each report could be useful to management decision-making.
(i) Traditional
(ii) Expanded
(iii) Flexed
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Question 5.7 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.
Internal control is:
the process designed, implemented and maintained by those charged with governance, management and
other personnel to provide reasonable assurance about the achievement of an entity’s objectives with
regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with
applicable laws and regulations (AUASB 2018).
Management control is a much broader concept, covering all the processes used by managers to
ensure that organisational goals are achieved and organisations respond to changes in their environment.
Performance management is an integral part of management control, and while relevant to internal control,
it is more concerned with performance improvement than compliance, which is the greater concern of
internal control.
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
3. organisation structure
4. strategies and plans
5. key performance measures
6. target setting
7. performance evaluation
8. reward systems.
These are influenced by four other factors:
1. PMS change
2. PMS use
3. strength and coherence of the core elements
4. information flows, systems and networks.
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
• a broad array of decision support mechanisms and informal personal and social controls.
So management control and performance management, which has financial, non-financial, quantitative
and qualitative dimensions (as already discussed), have become almost synonymous.
QUESTION 5.8
Reconsider the information in Question 5.7. 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
kinds of controls listed in the previous discussion.)
LIMITATIONS OF TRADITIONAL CONTROLS

Traditional management controls, especially those that are accounting-based, have been criticised for their
limitations.
Return on investment (ROI), for example, is often used to measure financial performance, but it has long
been argued that ROI has significant limitations. There are substantial questions around:
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• 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).
Johnson and Kaplan (1987) pointed out two other limitations:

• whether a high rate of return on a small capital investment was better or worse than a lower return on a
larger capital, and
• that managers could increase their reported ROI by rejecting investments that yielded returns in excess
of their organisation’s (or division’s) cost of capital, but that were below their current average ROI.
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, because the 20 per cent return from that investment is still higher than the
organisation’s cost of capital (15%).
As traditional accounting measures 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. Example 5.12 illustrates how one company (TNA) created a different approach where
traditional accounting tools failed to help the organisation’s strategy.
EXAMPLE 5.12
TNA—a strategic management accounting approach to performance

management
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 (R&D),
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 R&D 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. The company also expended many millions of dollars in legal fees in patent litigation against
much larger companies that 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 R&D and the availability of cash to fund business growth. The model used sales volume
to drive purchasing of components and assembly planning, included 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 onslaught from the competition (Collier 2005, p. 327).
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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).
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.
Example 5.12 illustrates the importance of performance management and a very informal kind of
management control used to achieve the goals set by the organisation. It 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
later in this module.
QUESTION 5.9
Assume you are the CFO for an organisation with responsibility for financial reporting, accounts
payable (AP) and accounts receivable (AR). Make a list of the management controls that could be
implemented to help ensure that the organisation’s operations are efficient and effective.
MODELS OF PERFORMANCE MANAGEMENT

Performance management should not be seen as a list of measures without any underlying framework.
Example 5.11 provided a framework, the value chain, which developed performance measures for each
of the organisation’s primary and support activities. In the section that follows, alternative models of
performance management are discussed.
OPERATIONAL AND STRATEGIC PERFORMANCE

One of the key elements of performance management is to distinguish operational from strategic perfor-
mance. All business organisations, particularly listed organisations, need to achieve short-term financial
performance that satisfies shareholder expectations. This is a function of agency theory. Each business
unit, product, service or geographic segment of the business must contribute to whole-of-organisation
performance, which needs to be achieved throughout the financial year in order to meet annual corporate
targets. This relies on operational performance management, but there also must be a balance between
the needs of short-term shareholders and the sustainability of performance over the longer term—for
example, as discussed in Part A where companies report performance-related remuneration through STIPs
and LTIPs.
Strategic performance is concerned with sustainable performance over time at the whole organisa-
tional level, over multiple time periods, taking into account strategic goals, economic conditions and
the competitive environment. Strategic performance is also concerned with product life cycles (see
Module 6) and supply chains, and maintaining or increasing market share through competitive strategy (e.g.
cost leadership, differentiation or focus strategies). Strategic performance is linked to risk management
through the risk–return trade-off and the organisation’s risk appetite as determined by the board of
directors.
Measuring strategic or operational performance requires a different set of key performance measures for
each. Operational measures help to measure the short-term performance of an organisation, while strategic
measures focus on the implementation of the organisation’s long‐term strategy.
What these strategic performance measures are will be determined by the organisation’s strategy.
Chenhall (2003) has argued that financial and non-financial measures cover different perspectives which,
in combination, provide a way of translating strategy into a coherent set of performance measures. Chenhall
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(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.
3. Supplier orientation: linkages to suppliers and includes business process and innovation measures
(Chenhall 2005).
Example 5.13 highlights the importance of balancing short-term operational performance with longer-
term strategic performance, and extending the corporate view of performance beyond the organisation’s
own boundary to its supply chain.
EXAMPLE 5.13
Closure of the Australian automotive manufacturing industry

General Motors Co. closed its Holden factory in South Australia in October 2017, ending more than a
century of car manufacturing in Australia. Shortly before, Toyota Motor Corp. had shut its plant in Victoria,
where Ford Motor Co. had closed two sites in the previous year. The loss of jobs in the automotive sector
was not limited to the big three but extended to the suppliers of automotive parts that fed into the Holden,
Ford and Toyota assembly lines.
Over many years, Ford, General Motors (GM) and Toyota have all said they intended to cease their
Australian production in the absence of continued government subsidies. In 2014, the Productivity
Commission estimated that up to 40 000 people would lose their jobs as a result of the closure of
these assembly plants and the resulting effect on other firms in the supply chain (Australian Government
2014, p. 2).
Companies like GM, Ford and Toyota, being listed on global stock exchanges, needed to satisfy
short-term stock market expectations. Therefore, there was always 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.
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 United States, sales demand that has fallen well
short of GM and Ford’s production capacity and the high fixed costs that result from excess capacity. By
contrast, Toyota steadily won global market share at the expense of the 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 increased quality problems in the United States, 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 (see Module 6), 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 6) 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.
The closure of assembly plants by Ford, GM and Toyota in Australia was a consequence of these
companies having 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 then
cessation, of government financial support for the industry. 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.
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As stated in Example 5.13, there is a substantial effect of these closures not just on direct employment
but on the automotive component sector that 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 more strategic performance measures into their
strategic plans—measures that would likely have addressed the life cycle of automotive products and the
profitability of the whole supply chain.
LEADING AND LAGGING MEASURES OF PERFORMANCE

While the pursuit of shareholder value is crucial for listed organisations and for most businesses,
performance management based on financial performance has two distinct limitations:
1. Financial measures (as mentioned previously) tend to focus on short-term performance, sometimes at
the expense of longer-term performance.
2. 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, 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. For example,
if an organisation restricts its expenditure on advertising, employee training, repairs and maintenance or
R&D, there is not likely to be any significant negative impact on financial performance in the current
year, but 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. So 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.
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)
• 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
5. cost (Neely 2007).
Other measures apply to HR management, procurement and supply chains, as we saw in Example 5.11.
QUESTION 5.10
Chocabloc Ltd (Chocabloc) produces a wide range of chocolate bars. The company’s raw materials
are mainly cocoa, imported from Brazil, and milk, sourced locally from dairy farms. The chocolate
bars are distributed by a national logistics company to retail stores around the country.
Chocabloc has patented the formulas for its range of chocolate bars, many of which have been
sold for a decade, while others have been sold for only a few months. The company spends
considerable funds on R&D for new chocolate bars, and before each new product launch it engages
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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
(including leading and lagging measures). Include financial and non-financial performance mea-
sures in your list.
Strategic performance measures
Operational performance measures
Leading measures
Lagging measures
FRAMEWORKS FOR PERFORMANCE MANAGEMENT

The use of measures of performance other than financial is not new. One of the earliest was the French
tableaux de bord, a kind of instrument panel as would be used by a pilot. It was developed as a set of
performance measures used in French factories and relied on the definition of a causal model at each
organisational unit level by its manager.
Another interesting framework is the performance pyramid of Lynch and Cross (1991). The pyramid
has descending objectives and ascending measures, beginning with corporate vision and 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 with 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 finan-
cial 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 business
processes. It recognises the cost and impact of failure in any single process on the overall yield using a
methodology known as DMAIC: define, 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
7. service and growth.
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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. strategies
4. processes
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 stake-
holder satisfaction.
Notably, the performance prism takes a multi-stakeholder approach to performance management,
reflecting the importance of CSR, whereas most other models (with the exception of the EFQM) take
a predominantly shareholder value focus. Two frameworks are perhaps best known:
1. the Business Model Canvas, a marketing-oriented strategic framework
2. the balanced scorecard, a more financially oriented approach.
THE BUSINESS MODEL CANVAS

The Business Model Canvas was developed by Alexander Osterwalder as a strategic management template
for analysing a business strategy or for designing a new strategy. It comprises a visual representation of
nine building blocks centred on a value proposition, as shown in Figure 5.6.
FIGURE 5.6 The Business Model Canvas
Designed for: Designed by: Date: Version:

The Business Model Canvas
Key Partners Key Activities Value Customer Customer

Propositions Relationships Segments
Key Resources Channels
Cost Structure Revenue Streams
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The makers of Business Model Generation and Strategyzer strategyzer.com
Source: Strategyzer 2018, ‘The business model canvas’, accessed June 2018, https://strategyzer.com/canvas/business-
model-canvas.
You can access the Business Model Canvas website and its various resources free by registering at
https://strategyzer.com/canvas/business-model-canvas.
The Business Model Canvas template links the value proposition with the business’s customer segments,
customer relationships and distribution channels (the right-hand side of the canvas) to key activities, key
resources and key partnerships that satisfy customers (the left-hand side). These are all in turn linked to
revenue streams and cost structures (occupying the bottom of the canvas). A separate Value Proposition
Canvas helps identify what products or services are offered to customers and what motivates them
to buy.
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The Business Model Canvas approach is that strategies can be developed by focusing on the:
• value proposition and its related customer segments, relationships and channels as drivers of revenue
• infrastructure of activities, resources and partnerships that drive costs.
You can try out a Business Model Canvas template either at the Strategyzer website or using a free
online template available at https://canvanizer.com/new/business-model-canvas.
This marketing-oriented view of the world focuses on value as perceived by customers, certainly an
essential element in creating value for the business. Its weakness lies in the absence of performance
measures that determine whether strategy is being achieved. This is the benefit of the second framework,
the balanced scorecard.
THE BALANCED SCORECARD

The balanced scorecard (BSC) was developed by Harvard academic Robert Kaplan and consultant David
Norton based on their work with US organisations. Their work on the BSC has been published in the
Harvard Business Review and is still widely used (Kaplan & Norton 1992; 1993; 1996a).
The BSC takes four perspectives on performance:
1. financial
2. customer
3. business process
4. innovation and learning.
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 previously 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, NPS 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, R&D expenditure and new patent registrations.
There is no rule that says a particular measure should go in a particular perspective. Sometimes market
share will be 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 either 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. 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 BSC. Too few measures will mean the
organisation does not have a clear picture of what is going on in the organisation and it may miss detecting
issues because it does not have enough leading measures. Too many measures means it may be distracted
or unable to focus on the most critical items.
Kaplan and Norton (1992; 1993; 1996a) recommend three or four measures for each of the four
perspectives in the BSC (12 to 16 in total). However, this is only at the top level. For lower levels of
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the organisation there may be many more measures that all link together and are summarised by these
final 12 to 16 measures. The cascading of performance measures to business units is discussed further
under ‘Cascading performance measures’.
The relative importance of performance measures is addressed to some extent in the BSC by the assump-
tion 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 ultimately to improved financial
performance. Between each hierarchical level, some value creation is assumed.
Figure 5.7 illustrates the relationships between the elements in the BSC.
FIGURE 5.7 Illustration of the balanced scorecard
Performance on all dimensions satisfies stakeholders
Financial perspective
Goals, performance measures and targets
Satisfied customers leads to financial performance
Customer perspective
STRATEGY
Efficiency of process reduces costs and satisfies customer
Internal process perspective

Leads to continuous improvement
Learning and growth perspective

Source: Based on Kaplan, R. S. & Norton, D. P. 1992, ‘The balanced scorecard: Measures that drive performance’, Harvard
Business Review, Jan–Feb 1992; Kaplan, R. S. & Norton, D. P. 1993, ‘Putting the balanced scorecard to work’, Harvard Business
Review, Sept–Oct 1993, pp. 134–47; Kaplan, R. S. & Norton, D. P. 1996, ‘Using the balanced scorecard as a strategic
management system’, Harvard Business Review, Jan–Feb 1996, pp. 75–85.
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.
The following benefits have been identified for the BSC:
• It summarises complex information.
• It focuses management attention on the most important variables.
• It enables management by exception and manages areas of underperformance.
• It balances the need for short-term performance with sustainable performance.
• It limits the number of performance measures used.
Criticisms of the balanced scorecard
Despite the undoubted value of the BSC, one criticism of it is the ability to find a true balance between
different performance measures, especially when these are measured in very different terms (e.g. a measure
of on-time delivery performance is difficult to compare with an employee retention figure). How does an
organisation balance, for example, employee satisfaction with customer satisfaction, let alone find the right
balance between these and financial measures such as ROI and ROCE?
Another criticism of the BSC approach is its assumption of cause-and-effect relationships. Norreklit
(2000) questioned whether such causal relationships exist.
What is meant 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.
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The measures in each of the BSC’s four perspectives are meant to successfully link together. Figure 5.7
shows this cause-and-effect situation or relationship, but 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,
because there isn’t one). In a different situation, satisfied customers may not lead to higher profits because
the organisation may be charging prices that are too low.
Therefore, it cannot be assumed that a change to the leading measure will have a cause-and-effect change
on the lagging measure. One of the difficulties in setting objectives and performance 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. It may be useful in developing strategy to start by using the
Business Model Canvas and then translate this into a BSC set of performance measures.
Concerns have also been raised by Norreklit (2000) about how effective the goal-setting and performance
management 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-and-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 at 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).
Finally, Otley and Berry (1980) drew attention to the limited capacity of organisational participants to
effect 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 CI. 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.
Many organisations have additional perspectives to the four in the Kaplan and Norton version. These
perspectives may recognise additional stakeholders—for example:
• donors to a not-for-profit organisation
• social outcomes in the public sector
• quality in health services
• environmental performance.
Appendix 5.1 shows how Achmea uses a BSC with six perspectives in its strategy implementation.
DESIGNING A BALANCED SCORECARD

Understanding the strategy of the organisation or business unit is essential for the construction of a BSC.
The notion of ‘balance’ relies on an understanding of the organisation’s goals and objectives that needs to
encompass its approach to its customers/customer segments, distribution channels, activities and resources,
etc. (as shown for the Business Model Canvas).
The first question to answer when designing a BSC is: ‘What are the organisation’s goals and objectives
that are inherent in its strategy?’
EVT (Example 5.1) showed that its BSC should include aspects of strategy such as market share, room
inventory and customer spend. The case of Apple (Example 5.4) shows that continual R&D is an essential
strategy and needs to be reflected in a BSC, as do retail store numbers and employee knowledge.
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The second question is: ‘Which stakeholders do we need to consider?’ Goals and objectives may well—
perhaps should—consider stakeholders other than shareholders. Victoria Police (Example 5.3), because its
performance is of so much concern to the public, press and politicians, needs to balance a large number
of performance measures to deliver on multiple strategies. The case of Newcrest Mining (Example 5.6)
showed the importance of employee safety, environmental protection and relations with local communities
in ensuring sustainable financial performance.
These examples highlight that an organisation-specific BSC does not have to be limited to four
perspectives. As seen previously in the module under ‘Frameworks for performance management’, the
performance prism has facets that include stakeholders. There is no reason why the scorecard cannot
include social and environmental aspects of performance.
Where organisational strategy is reflected in director or executive remuneration, as cases including
Woolworths (Example 5.5) show, the BSC needs to include short-term measures of sales, EBIT, working
capital, customer satisfaction and safety; and long-term measures of TSR, sales per trading square metre
and return on funds employed.
Consequently, each organisation’s BSC will be unique to its business, its key stakeholders, the environ-
mental and competitive context in which it operates, its size (see Table 5.2), its goals and objectives and
competitive strategy. This is a further example of contingency theory.
Table 5.3 shows how the design of a BSC should proceed. Steps 3, 4 and 5 are covered in more detail
later in Part B.
TABLE 5.3 Designing a balanced scorecard—a step-by-step approach
Steps Question Tasks
1. Assess the organisation’s What are the organisation’s • Source a copy of the organisation’s
strategy overall strategic goal, vision, strategy, usually contained in its
mission and objectives? annual statements.
• If no accounts are available, consult
directly with senior management.
• Identify the most important strategic
goals (financial and non-financial;
short-term and long-term)
2. Assess the organisation’s Who are the organisation’s key • List the key customer groups of
stakeholders stakeholders and how should the the organisation.
organisation meet their needs? • How is the organisation currently
meeting the needs of each group?
• How can the organisation best meet
the needs of its customers?
3. Compile a strategy map How are the various strategic • Construct a strategy map, clearly
goals interlinked? identifying any links that exist.
• Identify any overlap in objectives.
4. Define the key performance How will the strategic goals • Construct a list of key performance
measures and SMART targets be aided by each of the four measures for each of the four
for each of the four BSC perspectives? perspectives.
perspectives
5. Cascade the BSC How will the organisation • Duplicate the previous steps for each
measure its performance at business unit and department that
various hierarchical levels? contributes to organisational goals
and objectives.
An example of how strategy is developed into performance measures for Achmea is given in
Appendix 5.1
Example 5.14 shows how a BSC could be developed for the company TNA.
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EXAMPLE 5.14
Designing a balanced scorecard for TNA

Revisiting the TNA case in Example 5.12, a BSC for the company might be developed in the following
way. TNA’s strategy was not focused on financial performance but on growing the business to a critical
mass. TNA’s strategies were R&D, export market development and growth in market share. A further focus
was cash flow to enable the company’s investment in R&D, export development and growth. The following
performance measures might be recommended to TNA’s management.
Perspective Example performance measures
Financial • Cash flow

• Gross margin
• Sales growth
Customer • New export markets opened

• Number of new customers
• Number of machines installed
• Number of outstanding orders
• On-time delivery
• NPS
Business process • On-time delivery of components from suppliers

• Quality of supplied components
• Time to assemble finished machines
• Quality pass rate from testing of assembled machines
Innovation and learning • Employee retention

• Employee satisfaction
• Investment in R&D
• New patents
• Patent litigation actions won
Strategic • Market share growth

• Competition
TNA’s financial goals required sales growth to achieve its business strategy of reaching critical mass
(shown in Example 5.12), which was defined as having sufficient capital to enable TNA to withstand general
business fluctuations and competition while maintaining its investments in R&D. Cash flow was not only to
maintain organisational viability during its high-growth strategy but also to underwrite its obligations to the
banks that had lent the company money. As TNA subcontracted the manufacture of all components and
assembled the final machines, gross margin was an important measure, but accounting profits were not
important to TNA. 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 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. NPS 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, using its skill base to assemble the components it had designed and retaining its intellectual
capital in-house. So performance management was focused 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 (explained in Example 5.12).
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Linking performance management with strategy is critical to long-term sustainable performance
(compared with a focus on short-term financial results).
For practice in creating a BSC, please access Stage 2 of the ‘Save or close the hotel?’ Business
Questions for strategic planners to ask: 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 BSC are highlighted by Balanced Scorecard Australia
at: http://www.balancedscorecardaustralia.com/bsa/main/frequently-asked-questions/.
PUBLIC SECTOR AND NOT-FOR-PROFIT

PERFORMANCE MANAGEMENT
The public sector and the not-for-profit (NFP) sector have particular challenges in terms of performance
management, as shown in the Victoria Police example. First, they have multiple stakeholders and, second,
they have multiple objectives, and while financial performance is often a constraint on activities (rather
than a goal), non-financial measures of performance (e.g. the quality of health outcomes) are often more
important than financial ones.
Charitable organisations may receive funding from government or other bodies tied to achieving specific
outcomes, so performance measures need to be developed contingent on the outcomes for specific projects.
Within a single organisation with funding for multiple projects, performance measures may be different
for each project in line with the outcomes expected for each project. These are further examples of the
contingent approach to designing BSCs.
In the Australian public sector, public hospitals are a state government responsibility and performance
measures are tied to funding, but funding for specific initiatives comes from both state and federal
governments. As a result, hospitals must have performance measures for reporting on actual results and
the achievement of targets to the funding agencies to be able to show they are managing the outcomes tied
to each different parcel of funding.
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.
Appendix 5.1 provides a good example of how the BSC is applied in a mutual, non-profit
distributing organisation.
QUESTION 5.11
Refer again to Questions 5.3 and 5.6, including the suggested answers. Given the different strate-
gies of Mega Markets and its online competitor, identify some possible performance measures
(covering each of the four BSC 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.
Business process perspective
Innovation and learning perspective
Explanation of differences
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.
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Table 5.3 showed a step-by-step approach to designing a BSC. Step 3 is compiling a strategy map. This
involves deciding how the various strategic goals are interlinked.
DESIGNING A STRATEGY MAP FOR

Strategy mapping (Kaplan & Norton 2001) is a development of the BSC. It is driven by strategy and goals.
The strategy map for an organisation reflects the assumptions of its predictive model.
Strategy maps are a visual approach that helps to identify assumed cause-and-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 rework, 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.
In EVT (see Example 5.1 and solutions to Question 5.1) the design of a strategy map could look
something like the example in Figure 5.7, but candidates should note that there is no ‘one best way’ of
creating a strategy map. For any organisation, it will be based on the predictive model—that is, the set of
cause-and-effect relationships that the manager assumes to be the basis of business success. The logic and
relationships in Figure 5.8 are drawn from the EVT annual report.
An important element of strategy mapping and performance management is setting performance
measures and targets (see step 4 in Table 5.3). A performance measure is the characteristic that is important
to the organisation and its strategy—for example, return on investment or market share. A performance
target is the desired level of performance against that measure—for example, a return on investment of
12 per cent or a market share of 10 per cent. Actual performance is measured and compared against the
target to identify what corrective action may be needed. The criteria for setting performance measures and
targets are discussed in more detail later in this module.
FIGURE 5.8 Event Hospitality and Entertainment Ltd group strategy map (hypothetical)
Grow shareholder value

EPS and TSR growth
Growth in
Sales Profitability
market share
revenue EBITDA and normalised profit before tax
Market share %
Occupancy Average room Cost control

Average no. of rooms utilised revenue Expenses as
compared to total available rooms RevPAR and a % of
average room rate
Brand Total rooms

promotion available
Increase hotel Increase room

management inventory by
agreements acquisition

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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
efficiencies.
In Figure 5.8, performance measures have been included in the strategy map where appropriate,
reflecting those performance measures in the EVT annual report and drawn from the solution to
Question 5.1.
Strategy maps are developed through workshops at several levels. They could also be based on what
the organisation learns through the Business Model Canvas approach described previously in this module.
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 organisation identify those business processes it
should emphasise and measure.
For example, Figure 5.9 shows a strategy map for a manufacturer.
FIGURE 5.9 Example of a strategy map for a manufacturer
Return on investment,
earnings per share etc.
Market share Net profit after tax
Improve customer Increase sales revenue Cost efficiency

satisfaction per customer in production
Quality Efficient production

scheduling
On-time Material purchasing
delivery (price, quality, delivery)
Market research, Supply

Labour skills
advertising and promotion arrangements
In Figure 5.9, 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 to increase
sales revenue from existing customers, quality rather than price is the main motivating factor for
customer spending.
This customer-generated information on cause-and-effect relationships is then used in internal manage-
ment and employee workshops to determine how the best quality and on-time delivery can be achieved.
These internal workshops take place across the sales, marketing and production functions. They identify
two particular issues:
1. Labour skills are essential to improving quality and delivery.
2. Market research, advertising and promotion are key elements in raising customer awareness and
perceptions of quality relative to competitors.
So 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
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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.
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.
Figure 5.9 is an example of how a strategy map is developed to identify the most significant cause-and-
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. 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 NPS 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
• supplier product quality.
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. In practice, budgets are commonly incremental (or
decremental) based on the prior year plus or minus a percentage change factor. Budgets are rarely 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-and-effect relationships, and to
the resulting performance measures and targets. This approach should, wherever necessary, continually
re-evaluate and modify the assumptions in the relationship between strategy, performance management
and budget.
An example of strategy mapping linked to strategy and the BSC can be seen in Appendix 5.1.
QUESTION 5.12
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
3. to increase the value of the organisation as measured by billings (i.e. annual professional fees
charged to clients).
(a) Using Figure 5.9 as an example, construct a strategy map that shows what might be the key
success factors—that is, the cause-and-effect relationships in the business model that the
organisation needs to get right in order to achieve its three objectives.
Note: You will either need to do this separately on a piece of paper, or you may prefer
to create the strategy map in a drawing program before adding your response to the
answer field.
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If you choose to use a drawing program, save your strategy map as an image file. Then in
the interactive PDF of this Study guide, you can insert your response by selecting the answer
field and browsing for the image file that you saved on your device.
(b) Explain the main features of your strategy map, and why you included each element.
(c) 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.
Key success factors Performance Financial or

BSC perspective in strategy map measure non-financial (N/F)
Financial
Client (customer)
Business process
Innovation and learning
(d) Explain your thinking behind the performance measures you have selected.
A further feature of the BSC and strategy mapping approach is the cascading of performance measures
within the hierarchical organisation structure (step 5 in Table 5.3).
CASCADING PERFORMANCE MEASURES

Performance measures at the whole-of-organisation level can only be achieved if individual business units,
customers/customer segments, and products and services contribute to that performance. For example, an
ROI target can only be achieved for the whole organisation if each business unit, product or service and,
ultimately, each asset makes a contribution that achieves the target. While business units, products and
services and assets will achieve higher and lower levels of ROI, a key management task is to ensure that
resources are allocated where the highest (in this example) ROI will be achieved, and to improve the
performance of (or dispose of) underperforming business units, products, services or assets.
The Balanced Scorecard Institute (2013) explains the function of cascading:
the enterprise-level scorecard is ‘cascaded’ down into business and support unit scorecards, meaning the
organizational level scorecard (the first Tier) is translated into business unit or support unit scorecards
(the second Tier) and then later to team and individual scorecards (the third Tier). Cascading translates
high-level strategy into lower-level objectives, measures, and operational details. Cascading is the key
to organization alignment around strategy. Team and individual scorecards link day-to-day work with
department goals and corporate vision. Performance measures are developed for all objectives at all
organization levels. As the scorecard management system is cascaded down through the organization,
objectives become more operational and tactical, as do the performance measures. Accountability follows
the objectives and measures, as ownership is defined at each level. An emphasis on results and the
strategies needed to produce results is communicated throughout the organization (Balanced Scorecard
Institute 2013).
Performance measures should cascade so that, at each successive organisational level, the measures are
different, but lower-level performance on one measure contributes to higher-level performance at the next
level. For example, the board may consider ROI as a critical performance measure. At the business unit
level, this may be translated into a measure of PBIT. Below this level, sales managers may have measures
for the volume (quantity) and value (dollars) of sales as well as the margin achieved on cost. Operations
managers may have the same volume (quantity) measure as sales managers, but the measure relevant to
them may be cost.
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. 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 of the salesperson’s customers or products and
services. Where targets are set, performance must be measured with performance management involving
comparison of actual to expected sales levels and the taking of action aimed at improving performance.
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As stated previously, 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, multidivisional 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 and more non-financial
ones (i.e. the leading measures) because 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.
Sometimes, 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.
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 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 targets, perhaps even measuring
their performance in different ways (see Example 5.15).
In the EVT example, performance measures for all of EVT—for example, average room rate, occupancy,
RevPAR, total rooms available, etc.—will cascade down to the separate divisions (QT Hotels, Rydges,
Atura & Thredbo) and from there to each individual hotel, where performance management will involve
comparing actual performance with targets and taking appropriate corrective action at the individual
hotel level.
Appendix 5.1 provides an example of how Achmea cascades its performance measures through
the organisation.
EXAMPLE 5.15
Performance management in a public hospital

Hospitals have many performance measures and targets, including waiting lists for elective (non‐urgent)
surgery and waiting times in the emergency department before admission to a hospital bed. Targets may
also exist for minimising hospital-acquired infections and patient complaints. Many of these measures
and targets are set by government in response to public expectations and election promises. 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 (e.g. 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. These decisions may need to be made on a daily basis in response to patient demand,
but 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.
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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 conflicts between the
management demand to stay within budget while achieving performance targets and the clinicians’ focus
on proper medical treatment, irrespective of the impact on reported performance.
Performance management in hospitals is largely about balancing available funds with performance
targets that may not relate to resources or to actual demand for services. This kind of problem is unique to
public services and the not-for-profit sector. In this sense, for-profit organisations should find managing
performance easier because, generally, higher levels of customer demand will lead to higher revenues. In
the absence of politically motivated targets, for-profit organisations have far more scope to change what
is measured and how it is measured, and to set specific targets.
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
management system.
THE ROLE OF INFORMATION SYSTEMS IN PERFORMANCE

MANAGEMENT
Information systems more generally were covered in detail in Module 2. This module discusses information
systems from the perspective of performance management.
Balanced scorecard (or similar) performance management systems collate and report information about
customers, suppliers, employees and business processes to supplement financial performance measures.
Therefore, organisations need to capture information from their marketing, purchasing, production,
distribution and HR activities. Information about key factors such as customer satisfaction, cycle times,
quality, waste and on-time delivery need to be part of an information 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 barcode 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—for example, number of customers, number of
items sold—sales analysis, product profitability and inventory reorder requirements. Sales and prof-
itability 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
• time taken to scan a customer’s basket of goods.
Even small businesses like restaurants can take advantage of modern POS 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.
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
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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
• 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 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 previously) 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 POS.
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. As mentioned, traffic
lights (red/amber/green) draw attention to those aspects of performance that:
• are meeting their target (green)
• are in need of urgent attention (red)
• need to be considered because 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—for example, customer, product or service, or business unit.
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 organisation’s own relational database provides what Oracle refers to as a ‘360-degree view’ of
the organisation.
THE ROLE OF PERFORMANCE MANAGEMENT IN

IMPLEMENTING AND MONITORING STRATEGY
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’.
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.
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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
• increased regulation and competition.
Strategy&, the strategy consulting group of PwC, argues that execution of strategy is critical to success.
It recommends ‘strategic performance management’, an approach that ‘makes an organization’s strategic
goals more transparent to line executives and provides an ongoing mechanism to monitor progress toward
these goals through simple and intuitive performance measures’. The authors argue that there is often:
a lack of clear linkage between strategic objectives and operational performance measures, limited account-
ability for outcomes at the operational level, an unmanageable number of sometimes random metrics,
fragmented and redundant systems and efforts, and a greater focus on metric analysis than on management
decision making (Chandrashekhar et al. 2017).
A key recommendation of the Strategy& report is for senior managers to focus on ’metrics that matter’.
This involves becoming more agile in responding to change, changing performance benchmarks and
cascading those changes down through the organisation to deliver on strategic goals (Chandrashekhar
et al. 2017).
Researchers at UK’s Cranfield University are critical of traditional approaches to performance manage-
ment, which rely on stability and predictability. They developed a Performance Management for Turbulent
Environments (PM4TE) model (Barrows & Neely 2012). They argued that:
many traditional performance management practices do not work well in turbulent environments. In
turbulent environments the need for timely information grows significantly. Managers must detect and
interpret information much more rapidly. They have to make faster decisions. They have to execute more
quickly with a narrower margin for error. And they must embrace new ways of operating versus exclusively
focusing on exploiting core businesses (Barrows & Neely 2012, p. 17).
The PM4TE model comprises:

• a performance management cycle
• an execution management cycle that explicitly links projects to performance (as it is through projects
that most organisations drive change and improvement)
• enablers such as leadership and strategic intelligence.
A key enabler is the recognition that performance management 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 a business’s website
and social media such as Facebook and Twitter. While this kind of big data can be a powerful tool for
business, it does raise issues of access to private information.
Further information about the Facebook and Twitter example is available in a 2018 New York Times
article available at: https://www.nytimes.com/interactive/2018/06/03/technology/facebook-device-partn
ers-users-friends-data.html.
A report by McKinsey Analytics argues that most companies are capturing only a fraction of the potential
value from data and analytics. Data and analytics can underpin disruptive business models while granular
data can be used to personalise offerings of products and services to customers. However, many companies
struggle to incorporate data-driven insights into their day‐to-day business operations. Large technology
investments have been made but organisational changes have not always been in place to take advantage
of the technology. The report argues that ‘organizations need to build the capabilities of executives and
mid-level managers to understand how to use data-driven insights—and to begin to rely on them as the
basis for making decisions’ (McKinsey Global Institute 2016, p. 9). The report concludes that:
Data and analytics have even greater potential to create value today than they did when companies first
began using them. Organizations that are able to harness these capabilities effectively will be able to
create significant value and differentiate themselves, while others will find themselves increasingly at a
disadvantage (McKinsey Global Institute 2016, p. 24).
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There is now widespread support for the belief that performance measures should be developed from
strategy. Kaplan and Norton’s (1996b) recommendation for a strategy mapping process identified four
barriers to implementation of performance management systems in relation to strategy:
1. Failure by the senior management team to achieve consensus, leading to different groups pursuing
different agendas not linked to strategy in an integrated way.
2. Strategy that is not linked to department, team and individual goals—that is, an absence of
cascading.
3. Strategy that is not linked to resource allocation decisions—that is, where budgetary allocations are
incremental/decremental and not linked to strategy.
4. Feedback to managers that focuses on short-term financial performance rather than on a review of
measures of strategy implementation and success.
The keys to successful integration of strategy with performance management can be summarised as:
• top management commitment to a unified strategic vision, including synthesising the performance
expectations of multiple stakeholders
• developing performance measures that are consistent with the vision and that enable attention to be
drawn to whether the strategy is being implemented and is successful. This involves balancing the
attention on short-term/operational and long-term/strategic aspects of performance
• ensuring that resource allocations are consistent with strategic priorities
• ensuring that individual and team performance measures are linked to organisational performance
measures
• integrating all available sources of information into a single suite of cascaded performance measures
that all accountable managers in the organisation have access to and use
• using performance measures as a learning tool, not just as a means of control. Learning facilitates
modifications to strategy, resource allocations and what (and how) performance is measured.
Appendix 5.1 provides an example of how Achmea focuses on using strategy mapping and a
BSC of performance measures, not just in strategy formulation, but more importantly, in strategy
implementation.
QUESTION 5.13
Giant Products Ltd (Giant) manufactures ‘triffids’, a product that 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.
Managing
director
Marketing Finance and

Publishing Production
and sales administration
(a) Recommend performance measures that Giant could implement to achieve its goal of a 10 per
cent reduction in the cost of components.
(b) Explain how these performance measures could cascade to lower organisation levels in
each department.
(c) What would be the role of Finance and Administration in achieving this goal?
(d) How might information technology—for example, using an ERP system—assist in this
process?
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PART C: DETERMINING PERFORMANCE
MEASURES AND SETTING PERFORMACE
TARGETS
Part B looked at the role of strategy in performance management and how performance management can
be seen as an important element in management control. Part C of this module is concerned with how to
design a set of appropriate and meaningful performance measures and, having determined those measures,
how to establish SMART (see later in this module) performance targets. This part of the module:
• discusses the characteristics that ensure that performance measures are valid and reliable
• looks at the costs and benefits of performance measures
• reviews how power and culture affect performance management.
Designing performance measures and setting targets has no real value in improving efficiency, effective-
ness and equity unless those performance measures are used to improve performance. This part discusses
how performance improvement relies on three levels of analysis:
1. targets
2. trends
3. benchmarks.
It also considers the role of knowledge management and organisational learning in improving per-
formance. This part concludes with a discussion of the behavioural consequences of performance
management.
DESIGNING PERFORMANCE MEASURES

In considering the BSC framework, while there are many possible performance measures for each of the
four perspectives, 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, because too many measures may result in none of them
being seen as important. As mentioned in Part B, Kaplan and Norton (1992; 1993; 1996a) recommend three
or four from each of the four perspectives. Once cascaded down, these broader measures may be replaced
by more detailed measures, so in total an organisation may have many more than 12 to 16 measures. The
measures may be different at each organisational level, but at any one organisational level the number of
measures needs to be manageable.
As was discussed in Part B, the design of a performance management system will be linked to the
organisational strategy through the strategy mapping process and will most likely be contingent on
the organisation’s competitive environment—for example, size, technology, strategy. 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
later in this section). However, it is even worse to measure performance just because it is easy to measure,
if it is not 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.
In the EVT example, the entertainment and hospitality divisions have different predictive models, and
even for hotels different predictive models will apply because they are influenced by different factors—
business travel to CBD locations compared with holiday destinations in resort locations, with seasonality
affecting occupancy differently, especially for the skiing season at Thredbo. They are therefore likely to
have some performance measures that are different, although there would also be much commonality.
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; as shown in the EVT example, cascading is down to
the individual hotel level.
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It is important to remember the difference between a performance measure (what is being measured) 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—for example, a competitor
or industry average.
Many types of performance measures exist. Table 5.4 provides an overview of some of the more
common types.
TABLE 5.4 Types of performance measures
Type of measure Example
Input Resources: human, physical, financial
Activity Processes: number of hours worked, number of material issues, number of deliveries
Output Quantity of goods and services produced, sales revenue
Efficiency Ratios of outputs to inputs, such as process efficiency, wastage
Effectiveness Measures of output conforming to specified characteristics such as absolute quantities, on-
time delivery and meeting an agreed quality standard
Impact How outcomes contribute to strategic organisational objectives, such as customer

satisfaction, and environmental and CSR goals
Investment Capital expenditure, distribution channel expansion, research and development expenditure
Remember also 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.
Example 5.16 reveals the problem of inappropriate performance measures in a changing market.
Part 2 of this example is explored in Example 5.17.
EXAMPLE 5.16
Mammoth Printing—Part 1
Mammoth Printing was a large stock exchange–listed printing business in a very competitive market in
which most competitors had modern—and expensive—production equipment. As a consequence of high
levels of capital investment and price competitiveness to win business, profits across the sector were low.
Mammoth Printing measured its performance through some common measures:
• Sales performance was measured by the level of invoiced sales.
• Production performance was measured in terms of:
– printing machine running time as a percentage of total time
– wastage
– on-time delivery.
Due to pressure from the board to increase profits, Mammoth sought to increase volume, but 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 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)
• 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 effect 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.
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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 implementation
Three years prior of changes Percentage change
Sales volume (tonnes of 160 000 220 000 +37.5%

paper)
Sales revenue $80 million $100 million +25%
Total costs $72 million $99 million +37%
PBIT $8 million $1 million –87%
Average printing machine 10% 25% +150%

set-up time as a percentage
of total time
Average printing machine 90% 75% –17%

running time as a percentage
of total time
Wastage 5% 7.5% +50%
On-time delivery 90% 80% –10%

performance
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
management 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 that 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 discour-
aged from accepting orders where the value added per machine hour was too low. Attempts by the CFO 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.
Example 5.16 reveals the need for continual reassessment of the business model and performance
measures. It shows the need for management accountants to be able to interpret performance information
and recommend appropriate strategies to respond to changes in performance. 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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MEASURING EFFICIENCY, EFFECTIVENESS AND EQUITY
One consideration in designing performance measures is to balance the measures between those concerned
with efficiency, effectiveness and equity, as summarised in Figure 5.10.
FIGURE 5.10 Efficiency, effectiveness and equity
Efficiency Effectiveness
Conversion of inputs or Focus on the end
resources (physical, human result of production,
and financial) into outputs on quality and customer
(products and services) satisfaction—whether the outputs
achieve what was intended, or
Focus on improving productivity ‘doing the right thing’
and reducing cost—‘doing
more with less’ Particularly important
and ‘doing things right’ in the public and not-for-
profit sectors
Equity
Fairness and equal
treatment—managing differences
such that the costs and benefits of
economic activity are spread equally
among different customer or other
stakeholder groups
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 needs a service
call for some equipment that is not working and wants the service call on Monday, but 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.
This raises the issue of equity. Should all customers be treated equally? In Example 5.15, 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 HR function, where performance measures may exist in relation to
gender equality, the treatment of people with disabilities, or those from Indigenous or ethnic backgrounds.
DESIGNING SMART PERFORMANCE TARGETS

Once performance measures are determined, the target to be achieved also needs to be determined. The
targets may be different for different business units or products and services, based on a study of past
performance, available resources and capabilities. Targets will, like performance measures, cascade down
through the organisational hierarchy to the individual level.
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One way of looking at performance measures and targets is through the acronym SMART, as outlined
in Figure 5.11.
FIGURE 5.11 SMART performance targets
S M A R T
Specific Measurable Achievable Relevant Time-based
• Measures and • Should be and agreed • Measures and and timely
targets should capable of • Targets may targets should • Targets should
be clear and being be ‘stretch’ be relevant to cover a
unambiguous accurately targets rather the strategies defined time
measured than easy to in the business period
• Should be achieve but model • Measures
clear whether must be must be
a target has achievable produced on
been and agreed a timely basis,
achieved, or between so that
how close the managers and corrective
performance subordinates action can
is to target 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 not agreed between the target setter and the accountable manager, they are unlikely to be helpful in
identifying performance gaps or improving performance.
Table 5.5 shows two examples of performance targets that are SMART, as well as two examples
of performance targets that do not satisfy the SMART criteria.
TABLE 5.5 Examples of performance targets
Performance target Analysis
Satisfies SMART criteria
Return on capital employed (ROCE) of The ROCE target is specific, measurable and achievable in
14% in FY 20X4 compared with 13.5% in comparison to prior year, relevant and time-based (FY 20X4).
FY 20X3
Customer satisfaction of 95%, based on The target is specific, measurable and time-based. It may be
survey of products delivered during the achievable provided past customer satisfaction is within a realistic
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.
Fails to satisfy SMART criteria
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
25%—historical staff turnover is 45% be 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,
but the target is not time-based.
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CHARACTERISTICS OF PERFORMANCE MEASURES
AND TARGETS
Effective performance measures are those that achieve what is intended. To be effective, performance
measures need to be able to:
• help management implement and monitor strategy
• support decision-making
• motivate managers and other employees
• communicate with, or signal to, stakeholders.
To be effective, performance measures need to satisfy several criteria, although it is normally impossible
for any single performance measure to satisfy all criteria. Most performance measures have shortcomings
or limitations and this is one reason why using multiple performance measures is recommended—each
measure captures some important aspect of the performance to be measured and satisfies at least some of
the characteristics shown in Figure 5.12 and discussed in the next sections.
FIGURE 5.12 Characteristics of performance measures
Validity
How well a measure
helps evaluate the issue
or item of performance
being considered
Reliability
Controllability
Whatever is being
Must be controllable
monitored can be
by those whose
measured consistently
performance
and in an objective and
is being measured
specific manner
Characteristics
of performance
measures
Accessibility
Can be accessed
Clarity
by all authorised
Easy to understand with
organisational
little or no ambiguity
participants who need
the information
Timeliness
Provides information
early enough to allow
corrective action
Validity
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. In reality, 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.
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Some concepts are quite difficult to measure directly, so indirect measures are used. The problem is
whether or not they accurately capture what is meant to be measured. 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—for example, 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.
Reliability 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’. However, 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—that is, 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 about
measuring customer satisfaction. Reliability of the performance measure will be improved by repeating
the method of 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 because
it could be affected by the particular customer or waiting staff on duty or by 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 technology. The performance measure may
be reliable because 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 because 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, but 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.
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
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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.
COSTS AND BENEFITS OF PERFORMANCE MANAGEMENT

In many organisations, much data is collected that is never used. The cost–benefit issue may be difficult to
assess, because 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 previously. Performance
measures do, however, need to be cost-efficient—that is, 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 management system recognises the cost
of measuring performance and compares this cost with the benefits that are likely to accrue from it.
Performance measures that are very costly but yield little benefit should be avoided or eliminated. Costs
here are not just cash costs, but opportunity costs—that is, the alternative use and the benefits from that
use to which the resources consumed could be put.
In the TNA example discussed previously (Example 5.12), the owner–manager abandoned most tradi-
tional 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 R&D, 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.
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 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. If there are serious discrepancies 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, as shown in
Example 5.17.
EXAMPLE 5.17
Mammoth Printing—Part 2
Returning to the example of Mammoth Printing (see Example 5.16), one of the performance measures
used historically was a measure of the length of paper that was produced by the printing machines. Paper
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is the most significant raw material in printing and this measure was thought to be an important measure
of the volume of paper printed. The data was collected at the end of each print job and recorded on the
job paperwork, then entered into a computer system and reported along with other data on management
reports. However, there was no evidence that the data was used, or had ever been used. Someone 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’, then it should be asked why that performance is being
measured. 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’.
QUESTION 5.14
Review the following 10 performance measures and their associated targets for XYZCo’s latest
financial period. Evaluate the performance measures and targets with reference to SMART (spe-
cific, measurable, achievable, relevant, time-based) design principles, and the characteristics of
effective performance measures and targets (validity, reliability, clarity, timeliness, accessibility
and controllability).
Performance measure Performance target SMART Characteristics
1. Head office recharge of corporate $1 million

costs to business units based on a
percentage of sales revenue in each
business unit
2. Survey of brand recognition among 75%

members of the public
3. Receivable days 45 days
4. Percentage of incoming telephone 90%

calls answered in one minute
5. Percentage of sales revenue from 80%

return customers
6. Dollar value of donations to $100 000 p.a.

charities
7. Reduce employee turnover Reduce turnover by

10% p.a.
8. Sales revenue growth 15% p.a.
9. Headcount 120
10. Compliance with legal Full

requirements
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For further practice in the concept of effective performance measures, please access the ‘Character-
istics associated with performance measures’ learning task on My Online Learning.
PERFORMANCE MANAGEMENT, POWER AND CULTURE

The preceding examples of unquestioned performance management practices reflect the importance of
power and culture within organisations. In describing various approaches to performance management
and management control, the role of culture has been highlighted, whether this is a clan culture (Ouchi
1980) or more general belief systems (Simons 1994; 1995). Cultural elements can be seen as part of the
control package (Malmi & Brown 2008) but cultural factors also influence the design of performance
management systems (Ferreira & Otley 2009). Euske, Lebas and McNair (1993) contrasted the individual
performance measures, used to direct short-term attention, with cultural norms as the basis for guiding
long-term behaviour.
An organisation’s culture will influence the kind of performance measures used. In a culture where
accounting controls are seen as very important, it is more likely there will be 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 management.
Power is also important in determining what performance measures dominate in an organisation. Markus
and Pfeffer (1983, pp. 206–7) argued that accounting and control systems are related to intra-organisational
power ‘because they are used to change the performance of individuals and the outcomes of organizational
processes’. The most powerful group in an organisation is the ‘dominant coalition’ (i.e. those who are
making the choices) (Child 1972). This may not necessarily be the same as shown on the organisational
chart of reporting relationships. Dominant coalitions are more subtle centres of power. Some organisations
are dominated by the accounting and finance function, others by engineers, others by marketing and sales-
focused roles.
Understanding how power influences the design of performance management systems is important
because it enables a view of why certain performance measures exist and remain. The power of dominant
coalitions also influences the relative importance of performance measures and targets. In a sales-
driven organisation, it would be expected that more prominence would be given to measures of sales
performance. In an R&D-focused organisation, relative importance might be given to new products or
patent registrations. For example, the culture and power at Mammoth Printing was quite different to that
at TNA.
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 management, will be
implemented when they are consistent with:
• other sources of power
• the dominant organizational culture in their implications for values and beliefs
• shared judgements about certainty, goals and technology (Markus & Pfeffer 1983, p. 205).
Example 5.18 highlights these issues as they apply to the advertising industry.
EXAMPLE 5.18
International advertising agency

Advertising agencies are dominated by large international conglomerates that are listed on interna-
tional stock exchanges. As for all listed companies, short-term financial performance—primarily EBIT
measures—and sales growth are key success factors.
In the advertising agency business though, creativity is also 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 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).
While financial performance is important, advertising agencies measure their performance in terms of
employee satisfaction and client satisfaction, and also by winning 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 than the ability of the advertising campaign
to generate sales revenue.
In one international advertising agency, these different aspects of performance are managed simu-
ltaneously. 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
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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 its 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. In the history of this agency,
this has proven to be a successful strategy, because newly recruited talent has generated additional client
income.
Creative organisations like advertising agencies need to manage competing priorities in a flexible way 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 Deepwater Horizons oil rig disaster (see Example 5.19), which demonstrated what
can happen when a single aspect of performance is pursued at the expense of all others.
EXAMPLE 5.19
BP 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 were 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).
An independent 15-member committee headed by University of Michigan engineering Professor Donald
Winter released a report in November 2010, which found that BP’s focus on speed over safety contributed
to the accident.
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 (AC) 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.
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 may be familiar with this example from their study of the Ethics and Gover-
nance subject of the CPA Program.
QUESTION 5.15
This module has drawn on the difference between performance measurement and performance
management. Several examples have suggested that performance measurement needs to be
customised to each specific organisation.
Explain why performance measurement needs to be customised and the role of the management
accountant in performance management.
PERFORMANCE MANAGEMENT FOR

PERFORMANCE IMPROVEMENT
THE IMPORTANCE OF PERFORMANCE IMPROVEMENT
While performance management has been considered in relation to strategy and control, one of the most
important aspects of performance management is using the results as part of the feedback cycle (see Part B)
to make decisions aimed at improving performance. This is an area where management accountants can add
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value to their organisations. Such a contribution requires a more ‘soft skills’ approach because management
accountants need to move beyond performance reporting.
There is a significant opportunity for management accountants to collaborate with managers in other
functional areas to identify where improved performance is possible. The management accountant has
access to information that is not always readily available to non-financial managers. Management
accountants can exercise their professional judgment to identify:
• problems with performance targets
• operational issues that may be leading to sub-optimal performance
• data inadequacies.
Management accountants then need the personal skills to be able to use their knowledge to influence
senior managers in relation to performance management by:
• setting SMART measures and targets consistent with strategy
• providing relevant information to support other managers’ decision-making
• identifying and recommending potential approaches to performance improvement.
The opportunity for performance improvement through using targets, trends and benchmarking
is reviewed in the following section.
TARGETS
As outlined previously, at the first level targets need to be set for each performance measure and
performance measures should cascade down the organisational hierarchy through each business unit to the
individual level. Performance targets need to be SMART and meet the six characteristics of effectiveness.
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 because
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, but there are three problems with this approach:
1. the cost–benefit trade-off in continually achieving more stretching targets
2. the impact of achieving some targets on other targets
3. the accuracy of assumptions in the predictive model.
Cost–benefit
As discussed previously, 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 exam 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 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, but 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.
Keeping targets in balance

In Part B of this module the balanced scorecard was introduced. One of the key aspects of the BSC is
the idea of ‘balance’—that is, it may not be possible to always maximise performance on every measure,
but an optimum result should be sought. In the student example, one of the costs of increasing a target
for examination performance on one subject and working towards achieving that performance is that
performance on other subjects may suffer. Equally, the relentless pursuit of profit may damage customer
satisfaction, or the relentless pursuit of customer satisfaction may impact on business process efficiency.
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 underperforming areas (which may result in a
detrimental effect 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. The predictive model is the set of assumptions
that drive the business:
• why customers buy products and services
• 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. It is not 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, but they need to continually challenge their assumptions and ask whether the
performance targets they have set are still appropriate. Continual poor performance compared to targets
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, but organisations will typically monitor non-financial ratios more frequently (monthly, weekly
or even daily for some measures) than for many of the ratios calculated from annual financial statements.
Trends show 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.
BENCHMARKING
The third level of analysis for performance improvement is benchmarking—that is, comparing perfor-
mance 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 5.13 shows the benchmarking process for performance.
FIGURE 5.13 Benchmarking performance
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
Benchmarking requires other organisations’ data to benchmark against, and sometimes access to this
data can be very difficult. In some industries, performance data is held quite closely—for example, the
Big 4 accounting firms or large law firms, where it is difficult to obtain competitively sensitive data. In
other industries, data is publicly available, such as the automotive and retail industries, usually because of
the economic impact of these industries, which results in a lot of statistical data being published. Much
data is collected and reported by industry associations. Industry associations, such as the Master Grocers
Association in Australia, provide data (see http://www.mga.asn.au), although detailed information is
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usually only available to members. Data is collected by government authorities, such as the Australian
Bureau of Statistics (http://www.abs.gov.au). Private sector research organisations such as IBIS World
(http://www.ibisworld.com.au) produce detailed reports, although the cost of obtaining research
reports can be quite high.
Some common areas benchmarked by businesses are:
• sales revenue and profitability
• products and services
• pricing structures, fees and overheads
• quality control processes
• customer service standards or the number of customers
• staff management and turnover.
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 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.
Whereas EPS data is regulated, data on non-financial performance measures is not required under
financial reporting standards. So 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—for example, using
reported sales figures, estimates of supermarket size or employee numbers.
Two kinds of benchmarking are most common:
1. internal
2. external (industry), although sometimes benchmarking with organisations in other industries is
also possible.
Internal benchmarks
Where an organisation has multiple business units, especially when those units have similar operations,
comparisons between units may be useful. For example, retail stores make extensive use of benchmark-
ing, comparing sales per square metre and sales per employee between store locations and between
departments—for example, homewares, clothing, electrical. Internal benchmarks would be particularly
valuable to compare hotel performance within EVT’s hospitality division.
Banks have used internal benchmarking of performance measures as a method of introducing internal
competition and learning. Each branch receives a report indicating how they score on various measures
compared with other branches. Some banks do not allow any branch to stay constantly in the lowest
category and low-ranking branches may be closed, or there may be managerial changes or an investigation
of the causes of a branch scoring in the lowest category with an aim towards improvement.
External (industry) benchmarks

Industry benchmarking provides a comparison of an organisation’s performance against either 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, but if this is a competitor, direct access to data is not normally possible. Indirect data may
be obtained through business intelligence (BI)—for example, from websites, trade exhibitions or speaking
informally with competitors. A common practice in some industries is to hire employees from competitors
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.
One way to have reliable industry benchmarks is to set up a benchmarking consortium that includes a
number of organisations operating in the same industry. Universities do this to compare their performance
on research, teaching quality and graduate outcomes. Independent organisations are commonly selected
to collect the information and provide each organisation with its own results as well as those of other
organisations, in a format that does not allow individual organisations to be identified. In many public
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sector organisations, such as schools and hospitals, government departments benchmark data and make
some publicly available, with other data being restricted to the participating organisations.
Increasingly, governments produce data to enable benchmarking of government-funded services. In
Australia, some websites include:
• ‘My School’ (http://www.myschool.edu.au)
• ‘My Hospitals’ (http://www.myhospitals.gov.au).
Benchmarks for small businesses can be downloaded from the Australian Taxation Office website at:
http://www.ato.gov.au/Business/Small-business-benchmarks.
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.
Problems with benchmarking

Benchmarking is not without its problems. Many issues need to be considered when benchmarking is
undertaken, including:
• obtaining the participation of benchmarking partners, all of whom must see some value in the process
• determining why performance is different compared to a benchmark
• the sometimes widely different contexts of organisations—for example, regulatory, technological and
historical legacies
• non-standardised data—that is, data is measured differently or has a different meaning between
organisations—for example, gross profit may be measured differently
• the historical nature of the data itself, which may not reflect more recent changes.
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—for example, in technology or 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, but all available information should be used when seeking to
improve performance. In comparing actual performance against targets, remember that the variance may
lead to a decision to change behaviour to improve performance relative to targets, or to change a 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 5.16
(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.
ORGANISATIONAL LEARNING AND

PERFORMANCE IMPROVEMENT
The process of learning from performance comparisons using targets, trends and benchmarks involves a
continual process of improvement through organisational learning or knowledge management. Failure to
learn and improve, as reflected in the innovation and learning perspective of the BSC, will likely lead to a
loss of competitive advantage and ultimately to organisational decline.
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Organisational learning
Performance management through improving performance is a learning process. Data is collected,
analysed and interpreted by individual organisational members. When behaviours or performance targets
(or even what elements of performance are measured) need to change, organisational systems, processes
and procedures may prevent these changes from being enacted. Organisations commonly have members
who know what needs to be changed, but the organisation can sometimes seem incapable of change
because the ‘organisational memory’ is institutionalised (or embedded) in IT systems, procedure manuals,
taken-for-granted working practices, budgets and performance targets. Consequently, existing systems,
procedures or working practices may need to be ‘unlearned’. This is a process of organisational learning,
meaning how organisations as institutions (rather than the individuals within them) are able to learn
and improve. This is a distinction between learning in organisations by individuals, and learning by
organisations made by Popper and Lipshitz (1998).
Organisational learning is concerned with the acquisition, sharing and utilisation of individual knowl-
edge within organisations (see Nonaka 1991). It is also concerned with how assumptions about cause-and-
effect relationships are shared within organisations, as well as how redundant information is unlearned
(e.g. Hedberg 1981). Organisational learning is about managing knowledge at the level of the organisation.
Performance improvement
Performance improvement requires a learning process that makes performance comparisons using targets,
trends and benchmarks; identifies changes needed to the assumptions about cause-and-effect relationships
in the predictive models held by individuals about business models; and changes any or all of:
• behaviour
• performance measures
• targets, where necessary.
These are within the domain of the management accountant to influence, as discussed previously.
Learning and knowledge management are particularly important in fast-changing markets or technological
environments, as Example 5.20 demonstrates.
EXAMPLE 5.20
Technological change in music and video

The case of value creation at Apple Inc. highlighted rapid technological change and product innovation.
However, many downstream organisations are affected by the pace of change, which is often outside their
direct control.
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 or
mobile device. 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. Foxtel, which was a major supplier of downloadable content, is facing considerable
competition from Netflix. In music streaming, we have seen the failure of Pandora and its replacement by
Spotify, which provides features valued more by customers.
These technological changes have had significant impacts on the business models of 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 and
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.
Similarly, retailers would have had to adapt quickly to new technologies, and the likely impact of
downloading music and videos on the types of recording and playing equipment required. 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
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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; while Amazon’s launch in Australia has generated much discussion about the threat to
‘bricks and mortar’ retailers from its online platform.
BEHAVIOURAL CONSEQUENCES OF
This section is concerned with how performance management influences the behaviour of managers and
individuals within the organisation. Some of the consequences are unintended and some can be quite
dysfunctional. Again, it is generally accepted that ‘what is measured by organisations is what gets done’,
because management attention to certain aspects of performance focuses the behaviour of individuals on
that performance. If particular performance is rewarded, then this is even more likely to result in individual
behaviour being directed at meeting targets and achieving the rewards offered.
PERFORMANCE MEASURES AND PERFORMANCE TARGETS

Performance measures focus on what is important for the organisation, based on what it has learned about
its business model. When performance is measured, it directs attention towards what is measured. Simons
(1994, 1995) differentiated diagnostic from interactive forms of control:
• Diagnostic controls use feedback to monitor performance and correct deviations from plans.
• 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, because 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—resulted in behaviour that was 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, but the commissions paid to sales representatives rewarded these unprofitable sales.
Professor David Otley (1999) provided two illustrations of the unintended and dysfunctional conse-
quences of performance measures.
1. Otley, an international expert in performance management, undertook research at 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.
2. Otley was buying 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 management 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.
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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
• 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, such as those outlined in Table 5.6.
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. These are the:
• reward system
• influence of recent practice and norms
• 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 to directors and senior managers.
TABLE 5.6 Types of unintended and dysfunctional behaviours
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 Rather than the underlying performance, by ignoring the cause-and-effect or
performance measure action-and-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 reported performance
Smoothing reported Removing fluctuations between reporting periods

performance
THE ROLE OF INCENTIVES AND REWARDS IN

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.
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, a better
performance appraisal). Sanctions include the loss of financial reward; being identified as a poor performer;
a negative personal reputation; or 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- 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. Company LTIPs will often reveal the need for
sustainable performance over time before rewards are awarded.
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This module has used the example that reducing expenditure on advertising, employee training, repairs
and maintenance, or R&D 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. The lack of prior investment makes an incoming manager’s performance appear
worse, because they have to remedy the deficiencies of the previous manager who improved short-term
performance through failing to invest in the longer term.
The process of tying reward to performance requires two issues to be considered:
1. timing
2. group versus individual rewards.
Timing
To reinforce the relationship between performance and reward, rewards need to be timely. If too much
time 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. 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.
Group versus individual performance

There is an inherent conflict between the teamwork required for effective organisational performance and
the use of individual reward systems. For effective motivation, managers must feel that their effort has a
direct impact on their performance and the related performance measure and reward. This is the principle
of ‘controllability’ (discussed previously). The choice between individual and group rewards depends to
an extent on the interdependencies that exist within the organisation. High levels of interdependency will
mean that identifying individual performance, and then paying appropriate compensation, is difficult.
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, so the
motivational effect of a profit-based bonus on the individual is likely to be equally small. This approach is
popular, 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 affecting longer-term
performance has been the GFC. This is explored in Example 5.21.
EXAMPLE 5.21
Global Financial Crisis

The GFC, which commenced in 2007 and reached its peak in 2008, had wide-ranging impacts on individual
countries, global financial markets and institutions and national economies. A recession affecting most
global markets lasted until 2012. Australia has been insulated from any sovereign debt crisis, although
there have been corporate failures and severe personal losses as a consequence of the failure of some
smaller financial institutions.
Two particular causes of the GFC have been given by commentators.
1. 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.
2. A related cause of the GFC was said to be the rewards offered to directors and senior managers,
especially in the financial services industry, for continuously improving performance that was unsus-
tainable 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 United States 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 United Kingdom
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it was 7 per cent. Further, in Europe, many countries were affected by a sovereign debt crisis—that is, 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).
More information on this topic can be found at: http://www.rba.gov.au/speeches/2014/sp-ag-160314.

html.
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.
Example 5.22 provides an example of an alternative approach to performance management and sustain-
ability of performance.
EXAMPLE 5.22
Svenska Handelsbanken
Svenska Handelsbanken’s goal was to be the most profitable bank in Sweden, but size was unimportant
to its CEO Jan Wallander. The bank’s strategy was to be radically decentralised, with nearly all lending
authority independent of head office.
Wallander abandoned budgeting at Handelsbanken but this had no effect on the bank’s performance.
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).
Without a budget, no budget/actual comparisons could be made at Handelsbanken. Instead, the real
target was not in absolute monetary terms but a relative one, a return on capital better than other
businesses were achieving, not just in the banking industry but in other industries as well. Handelsbanken
thus adopted a true shareholder value model.
In the absence of targets, the emphasis in performance management 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, 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 other Swedish banks.
Interestingly, the employees’ share in the profits of the bank was only paid to them when they retired, which
encouraged attention to the sustainability of performance.
QUESTION 5.17
After reading Example 5.22, compare what has been learned about performance management
throughout this module with the approach that Jan Wallander took in Svenska Handelsbanken.
Critically evaluate the Handelsbanken approach in relation to non-bank organisations,
considering:
(a) the type of performance measures used
(b) the reward system.
REVIEW
Performance management focuses on shareholder value through 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 management plays in strategy and value creation.
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Part A looked at the definition of what was meant by performance and performance management
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
CSR. The implications of performance management 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 management.
Part B looked at the links between strategy, management control systems and performance management,
and the limitations of some traditional accounting-based controls. The various models of performance
management, including the Business Model Canvas, were introduced. The BSC and the strategy mapping
process was emphasised, as well as cascading performance measures and the important role of information
systems in performance management.
Part C looked at how performance measures and their associated SMART targets are designed and
the characteristics that make performance measures useful, including the need to compare the costs
and benefits of performance management. This part also briefly introduced the role of power and
culture in performance management. It focused on improving performance through targets, trends and
benchmarking, and the importance of CI through organisational learning and knowledge management
processes. This is a role in which management accountants can use their ‘soft skills’ to add value through
interpreting performance and recommending ways to improve performance. Finally, Part C looked at the
often unintended and dysfunctional consequences of performance management and how reward systems
are implicated in performance management.
Appendix 5.1 explores the case of Achmea including examples of how Achmea develops its performance
measures using a BSC linked to strategy through the strategy mapping process. This process is cascaded
down through the organisation to enable strategy to be implemented. Achmea reports its performance in
financial and non-financial terms and emphasises its commitment to broader sustainability through its GRI
index.
The key themes emerging throughout the module were:
• the importance of performance being both socially responsible and sustainable
• the leadership role of the professional accountant in performance management
• the importance of value-adding activities.
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APPENDIX
APPENDIX 5.1
ACHMEA HOLDING N.V.
Achmea Holding N.V. (hereafter Achmea) is a Netherlands based:
insurance company established in 1811 and is the largest insurance provider in the Netherlands. The group
was formed by mergers and acquisitions of numerous mutual and cooperative insurance providers over a
period of more than two centuries. It operates internationally in selected markets, including Turkey, Greece,
Slovakia, Ireland and with partner Rabobank in Australia where it is an insurer of farms.
As a result of its cooperative background and identity, Achmea (a ‘mutual’) is not listed on the
stock exchange.
The majority of Achmea’s shares (65%) are held by Vereniging (Association) Achmea, which represents
all of Achmea’s customers—so Achmea’s customers are its owners. Partner Rabobank holds 29 per cent
of the shares and the remainder is held by like-minded European insurers (Achmea 2015).
Achmea’s Annual Report 2017 can be downloaded at https://www.achmea.nl/en/investors/reports/

Paginas/default.aspx.
The annual report comprises three parts:
Part 1 is the ‘Annual Review’. This is aimed at a broader target audience and contains a description of
the progress made by Achmea in 2017 and our vision of the future. Part 2 is the ‘Year Report’. This
describes the main financial developments. Among other things it contains the financial statements, the
report of the Executive Board and a report on our Governance. Part 3 comprising the ‘Supplements’ contains
sustainability-reporting information and appendices to the other parts (Achmea 2017, p. 47).
Achmea makes clear it is a stakeholder-oriented company:

As an insurer, by our very nature we are alert to the long-term interests of all stakeholders. Sustainability
is therefore logically of great importance to us. Corporate Social Responsibility forms the foundation for
our business operations and strategy (Achmea 2017, p. 9).
The company identifies four main stakeholder groups:

Customers are our most important stakeholders. … Employees are the human capital and beating heart of
our company … We have several business partners. Rabobank and the brokers are important distribution
partners … Our capital providers (shareholders, bondholders and other equity providers) supply our
financial assets (Achmea 2017, p. 11).
Candidates should note that this structure of stakeholders could be aligned with the Business Model
Canvas described in Part B of this module.
Achmea identifies five main product groups, or ‘value chains’ as Achmea calls them: Non-Life, Health,
Retirement Services, Pension & Life, and International (Achmea 2017, p. 20). Its strategy ‘Delivering
Together’ covers the period 2017–19. The business strategy focuses on:
strengthening our current business models and on developing new products, services and business models
… evolving from its traditional role as an insurance company … to one that focuses more on services
(Achmea 2017, p. 19).
The strategy is described in detail on pp. 19–20. Importantly, the strategic themes Achmea has adopted
incorporate sustainability as a leading motive (see below).
The strategy has been developed in the context of a SWOT analysis, shown in Figure A1 5.1.
Achmea makes explicit use of a BSC and strategy map:
Achmea’s activities are managed on the basis of six perspectives. The essential elements of the strategy
have been translated into a strategy map. Achmea has key performance indicators for each perspective to
guide us in achieving our objectives for the planning period 2017-2019 (Achmea 2017, p. 23).
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FIGURE A1 5.1 Achmea SWOT analysis
STRENGTHS WEAKNESSES
• Customer base, brands; customer ratings • Financial results not yet at target level
• Broad portfolio and advantage of diversification • Growth of Free Capital Generation required to be
• Leading in health and property & casualty insurance able to continue investing in innovation
• Variety in distribution; strong in banking and • Restricted scale of international activities
direct channels • Large market share in mature home market
• Broad access to Dutch businesses
OPPORTUNITIES THREATS
• Increase the number of Rabobank customers with • Introduction of new revenue models in existing
an Interpolis insurance policy Achmea markets
• Use technology for new services, prevention and • Declining risk of use and need for insurance
cost savings • Vertical integration (reinsurers, car manufacturers)
• Expand business model to include services • New ecosystems relating to supply and
• Convert data into value for customers demand platforms
• Revenue models for new risks (cyber, climate) • Changing concept of solidarity
• Partnering in new ecosystems • Impact of climate change
Source: Achmea 2017, Annual Report 2017, Part 1, p. 16.
Performance measures are described for each of the perspectives on pp. 22–3 of the annual report, Part 1.
Further details of the performance against each of these perspectives is shown on pp. 56–9 of the appendix
to the annual report, Part 1. In the 2016 annual report, the performance measures or ‘key performance
indicators’ as they were called were shown diagrammatically and are reproduced in Figure A1 5.2.
Achmea’s six perspectives add two to the four standard perspectives in the BSC: society (both in
terms of its mutual customers/shareholders and to the wider society); and partners (Rabobank and the
businesses that distribute Achmea’s products). It also reflects an employee perspective (rather than learning
and growth). Performance on each perspective is described in detail on pp. 24–39 of Part 1 of the 2017
annual report.
In particular, candidates should note that Achmea highlights its use of the NPS to measure customer
commitment to brands in the customer perspective; and profit before tax as the main measure in the
financial perspective.
Achmea’s strategy map, which links the six BSC perspectives, is shown in Figure A1 5.3.
The links between performance management and remuneration are disclosed in the remuneration
committee report within the annual report, Part 1:
The process of performance management and variable remuneration was conducted in a balanced manner
within Achmea in 2017, while it was also extended to the various organisational levels. In modifying the
process, it was decided to opt for greater simplicity and stricter management by restricting the number of
Key Performance Indicators (KPIs), while also defining them more precisely, in a manner that matches the
company’s risk profile and risk appetite, in a way that aligns the strategy and long term value creation …
there is a sound balance in the type of performance indicator, short and long-term performance management
and in the criteria used as a basis for variable remuneration (Achmea 2017, p. 43).
Mentioned previously is Achmea’s commitment to sustainability issues. The annual report is:
compiled in line with the G4 Guidelines (Core option) of the Global Reporting Initiative (GRI). The Annual
Report’s structure complies in part with the principles of the International Integrated Reporting Framework
laid down by the IIRC. Both the IIRC and GRI stress the importance of reporting on material topics …
Achmea intends to conduct a completely new materiality analysis next year and use the revised material
topics as the starting point for its external reporting (Achmea 2017, p. 47).
Achmea also identifies with the United Nations Social Development Goals (SDGs) under which the
United Nations set out, in July 2016, arrangements for monitoring progress and measurement using
indicators. Figure A1 5.4 shows the four themes and eight related SDGs (described on p. 45).
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FIGURE A1 5.2 Achmea key performance indicators—2016 annual report
KEY PERFORMANCE INDICATORS

KPI TARGET FOR 2019
We have set one or more Key Performance CUSTOMER PERSPECTIVE
Indicators (KPIs) for each of the six perspectives
of our strategy. By measuring these periodically Relational NPS Score1 Top 5 in the market
and, where necessary making adjustments based
on the measured values, we try to achieve our Achmea’s score on KBC dashboard 4.2
strategic objectives and hence respond to societal Number of customer council Each customer council
developments. meetings convenes twice a year
SOCIETAL PERSPECTIVE

Implementation of innovative
ideas which promote safety and
health as part of the revenue At least 2 per brand1
model
EMPLOYEE PERSPECTIVE
Indicator of availability Minimum of 72
PARTNER PERSPECTIVE
Level of market penetration of
Interpolis Insurance
Private More than 25%
Commercial More than 29%
PROCESS PERSPECTIVE
Reduction in number of letters sent More than 25%; down from 2016
FINANCIAL PERSPECTIVE
S&P Rating Rating for insurance entities
Reduction in operating expenses, €200 million
2016-2019
1) Centraal Beheer, Interpolis, Zilveren Kruis

2) Score based on yearly employee engagement survey.
Source: Achmea 2016, Annual Report 2016, p. 32.

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FIGURE A1 5.3 Achmea strategy map
Strategy map 2017-2019
Customers are closely involved

Customers feel strongly Customers are served well by in improving our
Customer perspective our insurances and services
connected to our brands insurances and services
Together with Vereniging Achmea we strengthen the Based on our expertise we contribute to a healthier,
Society perspective
cooperative foundation of Achmea safer and a more future-proof society
Management leads the way and

We excel in customer focus, Working on employability
Employee perspective works together on the realisation
being professional and adaptability is at everybody’s heart
of our strategy
With our (distribution) partners we improve and innovate

Partner perspective Insurance is successful for Rabobank
our insurances and services
Our processes lead to the We work digitally and We use information as

Process perspective
highest NPS based on standards the differentiating factor
We ensure a robust balance and

We optimise our portfolio and We realise a competitive
Financial perspective effective capital and
realise profitable growth below market cost level
liquidity management
Additional information strategy map 2017-2019 can be found in the appendix (p.56).

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FIGURE A1 5.4 Achmea social development goals
Sustainable Development Goals

The Sustainable Development Goals can be found in the societal themes of Achmea.

Healthy Safe Future-proof
Good health Clean, safe and Safe home and (Financial) solutions for
closer to everyone smart mobility working environments today, tomorrow and later

Part 2 of Achmea’s annual report focuses on its commitment to socially responsible investment as:
always being able to fulfil our financial obligations to our customers and invest in a socially-responsible
manner, with respect for the world around us and for future generations … contributing to a healthier, safer
and more future-proof society (Achmea 2017, p. 27).
For example, ‘Achmea does not invest in tobacco producers, as this would be inappropriate for a major
health insurer. We also exclude manufacturers of controversial weapons’ (Achmea 2017, p. 27). Achmea’s
social themes include energy, paper, waste and corruption (Achmea 2017, p. 31); and employee and gender
diversity (Achmea 2017, pp. 33–5).
Part 3 of the 2017 Achmea annual report includes a GRI index (pp. 3–5) that shows where information
complying with the GRI G4 reporting guidelines can be found. Part 3 also includes information about
Achmea’s corporate social themes linked to the insurance industry’s Principles for Sustainable Insurance
(pp. 8–10). There is also a large amount of information about environmental issues (emissions, energy,
paper, waste, etc. pp. 17–21).
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MODULE 6
TOOLS FOR CREATING

AND MANAGING VALUE
PREVIEW
INTRODUCTION
This module draws together the material in Modules 1, 2 and 5 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 effect of climate change. Management accountants play a pivotal role in developing systems that
provide information that business managers must access and use to carry out these tasks. This module
illustrates 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.
It covers the following strategic management accounting concepts and tools:
• activity-based costing (ABC)
• life cycle, target and kaizen costing
• activity-based management (ABM)
• business process management (BPM)
• continuous improvement (CI)
• value chain analysis
• supply chain management
• total quality management (TQM)
• downsizing, outsourcing and offshoring
• customer profitability analysis.
The module also identifies performance measures for assessing the effect of these concepts and tools on
an organisation’s value chain.
It is assumed that you have some prior knowledge of the tools and techniques in this module.
For this reason, the limited background material provided before the practical application of the concept
or tool should be sufficient. If you wish to read beyond this background material, most recently published
management accounting textbooks provide comprehensive coverage of these topics.
Your Tasks
In this module, you will work through the Case study for the company HZ Electrical Pty Ltd (HZ). 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 (HPD) so that they can:
• use ABC 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
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• decide whether to outsource distribution
• assess the profitability of different customer segments
• 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. To
complete the task, work through each table by using the data provided in the Case study and enter your
answers in the editable table cells.
Notes:
1. You will often require answers from earlier parts of the Case study to complete tasks that come later.
2. You may find differences in the rounding for some of your calculations, depending on whether you
manually calculate the answers or use a spreadsheet program. However, these should be only minor, so
if you see a large discrepancy, please check your calculations.
management with information for operational decision-making that, in turn, informs and is informed
by strategy.
r n al e nv iro n m e n t
Ex t e
VISION
VALUE INFORMATION
STRATEGY
STRATEGY
VALUE INFORMATION
OPERATIONS
Ex t e
r n al e n v i ro n m e n t
OBJECTIVES
After completing this module you should be able to:
• Explain the benefits of using value chain analysis and activity-based management to create and manage
value
• Apply appropriate cost management techniques for strategic costing decisions.
• Determine the appropriate pricing strategy to enhance organisational value.
• Apply supplier management methods to evaluate supplier’s performance.
• Apply customer profitability analysis to evaluate different market segments.
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PART A: THE VALUE CHAIN
As introduced in Module 1, the main focus of strategic management accounting is value. Organisations
create value by combining resources to create desirable outcomes for stakeholders—for example, share-
holders, customers, suppliers, creditors, employees and the community. Each stakeholder group has its
own interests and desires and therefore its own definition of the value that it wishes to receive from the
organisation. Most stakeholders measure value in monetary terms (e.g. dividends, wages, taxes) while other
stakeholders value quality of life issues like security of employment or clean air and water, as outlined
in Table 6.1.
TABLE 6.1 Stakeholder value
Stakeholder Value measure
Employees Wages, salaries and bonuses
Trade unions Workers rights, fair and equitable employment practices
Local community Impact on quality of life (Impact of production plants on air quality (e.g. increased
higher living standards as a result of more local jobs)
Advocacy groups Focus on safeguarding the industry value chain from sourcing products that might
use child labour. (Refer to the industry value chain (Figure 6.2).)
Michael Porter (1985; 1996) introduced the concept of the organisational value chain (see Example 6.1).
EXAMPLE 6.1
Organisational value chain for an iPad
Support Infrastructure
activities
Legal, accounting, financial management
Human resources (HR) management
Personnel, training, staff planning
Technology
Product and process design, production engineering, market testing and R&D
Value added – costs = MARGIN
Procurement
Supplier management, funding, subcontracting
Primary Inbound Outbound Marketing

activities logistics Operations logistics and sales Service
• Quality • Assembly • Dispatch • Market • Warranty
control of of iPad costs to research costs
product • Packaging Apple stores costs (replacing
components and boxing and other • Sales defective
received— costs retailers analysis units)
e.g. product • Inspection • Sorting • Maintenance
casing, costs during products for costs (Apple
motherboard production delivery iCare
• Managing process packages)
supply
schedules for
materials and
components
received
from global
suppliers
Source: Based on Porter, M. E. 1985, Competitive Advantage: Creating and Sustaining Superior Performance, The Free
Press, New York, p. 37.
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MODULE 6 Tools for Creating and Managing Value 301

Porter’s work focused on the customer as the key stakeholder because the revenue provided by customers
is the source of value for most other stakeholders. Value created by an organisation is measured by the
margin—that is, the excess of revenues over costs—generated by a product or service.
Example 6.1 is an example of a value chain. It can be seen that value is created through both primary and
support activities. Primary activities are those required to create the organisation’s product. Support activities
facilitate the primary activities. Example 6.1 shows the main activities required to produce an Apple iPad.
Porter’s generic value chain diagram presented in Module 1 (Figure 1.2) is reconfigured in Figure 6.2 to
include the important supplier, channel and customer value chains. These upstream and downstream parts
of the industry value chain are those of most concern to an organisation.
FIGURE 6.2 Supplier, organisational and customer value chains
Support activities
Firm infrastructure
HR management
Value chains:
Technology development
Supplier Procurement Channel Customer

value value value
chain chain chain
s
sale
tics
tics
gis
and
gis
d lo
s
d lo
ting
tion
oun
vice
oun
rke
era
tb
Ser
Inb
Ma
Op
Ou
Primary activities
Value added
Value system
In the downstream part of the value chain, first is the organisation’s distribution channels and then
its customers. An organisation must have an in-depth understanding of the activities carried out in its
distribution channels, so that its own activities can be integrated with those of distributors in the most
efficient and effective way. Similarly, a clear understanding of the customers’ value creation process—in
the case of industry participants—or of the end user’s value proposition, will enable an organisation to
efficiently provide a product offering that will maximise customer value and so the organisation’s profit.
The downstream channel and customer value chains inform all of the organisation’s strategic revenue
management initiatives. This is discussed in more detail in Part C of this module.
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An understanding of upstream suppliers’ value chains is similarly important. By understanding its
supplier’s activities, an organisation can organise its own activities in the most efficient way and so reduce
supply chain costs. An understanding of supply chains is critical to the development of an organisation’s
cost initiatives. Strategic cost management issues are discussed in Parts D, E and F of this module.
Before moving to the discussion of an organisation’s strategic revenue and cost management initiatives,
Part B of this module introduces some key management accounting tools used in the planning and
implementation of strategy: activity analysis, activity-based costing (ABC) and time‐driven activity-based
costing (TDABC).
Activities are defined as the actions that organisations take in order to create value. In ABC and TDABC,
activities are the cost pools used in the allocation of costs to products or other cost objects. ABC should be
clearly distinguished from activity-based management (ABM), which is discussed in Part D of this module.
Like ABC, ABM is based on activity analysis, but it is concerned with enhancing organisational value through
improving the efficiency of activities and improving the structure of the organisation’s value chain.
PART B: STRATEGIC PRODUCT COSTING

INTRODUCTION
This module uses the HZ Case study to demonstrate the practical application of strategic management
accounting to the value chain activities of its HPD. At appropriate points in the analysis, issues that affect
the division’s corporate social responsibility (CSR) will also be highlighted. The first area of focus is
product costing.
PRODUCT COSTING
Organisations need to have accurate costs for the goods or services they supply so they can ensure that
prices are high enough to generate 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—but this method has been
criticised for causing inaccurate costing. This will be discussed further under ‘Activity‐based costing’.
In the first part of the Case study, we see that HPD currently uses this approach.
CASE STUDY 6.1
Traditional approach to allocating indirect costs

HZ makes and sells three different food processor models, as shown in the following diagram.
FC101 FC202 FC303
Source: YAY Media AS / Alamy Australia Pty Ltd; Dio5050 / Getty Images Australia; DonNichols / Getty Images Australia.
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After this Case study, this traditional approach is compared to ABC, 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, the 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.
Sales and production figures

The total forecast sales and production volume for the three food processors next year is 15 000 units.
Expected sales volumes for each model are shown in the following table.
FC101 FC202 FC303 Total
Sales and production volume 10 000 3 000 2 000 15 000
Direct costs of production

Prime costs are the direct materials and direct labour for each product. The estimated prime costs for the
three products are shown in the following table.
Prime cost element FC101 FC202 FC303
Direct materials per unit $55.00 $ 85.00 $105.00
Direct labour per unit $40.00 $ 30.00 $ 25.00
Total prime costs per unit $95.00 $115.00 $130.00
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 the following table.
Cost driver transactions FC101 FC202 FC303
DLHs per unit 2.00 1.50 1.25
TASK
Use the current indirect manufacturing cost allocation method based on direct labour hours (DLHs)
to calculate the budgeted:
(a) indirect manufacturing cost rate
(b) indirect manufacturing cost for each product
(c) 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 following tables. To assist you in understanding how to begin,
some data for FC303 has already been inserted in the tables.
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(a) Calculate the indirect manufacturing cost rate per DLH
Total budgeted indirect manufacturing costs $
Budgeted direct labour hours (DLHs)$
Budgeted
Model volume × DLHs per unit = Total DLHs
FC101
FC202
FC303 2 000 1.25 2 500
Total DLHs for the food processor product line
Total budgeted indirect manufacturing costs / Total DLHs $

DLHs
Indirect manufacturing cost rate DLHs
(b) Calculate the indirect manufacturing cost for each product
Indirect manufacturing cost FC101 FC202 FC303
Indirect manufacturing rate per DLH $ $ $
DLHs per unit
Indirect manufacturing cost per unit $ $ $
Budgeted sales volume
Total indirect manufacturing cost $ $ $
(c) Calculate the total manufactured cost per unit for each product
Total manufactured cost per unit FC101 FC202 FC303
Direct materials per unit $ $ $105.00
Direct labour per unit $ $ $25.00
Total prime costs per unit $ $ $130.00
Indirect manufacturing cost per unit $ $ $
Total manufactured cost per unit $ $ $

(Total prime costs per unit + Indirect manufacturing
cost per unit)
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. 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.
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ABC emerged from the work of Cooper and Kaplan (1991). ABC draws on a hierarchy of costs: facility
sustaining (or organisation sustaining), product sustaining, batch level and unit level. Activities in the unit
level are easily traced to an individual product, such as ice cream and, therefore, costs are accurate, traced
on labour hours (or costs), material used (or material cost) and machine hours (or machine costs).
In the next level, batch, activities are not as directly traced to individual products. When a batch of a
product is made, the set-up of the machine (pre-start up diagnostics, start-up configurations, flushing of
pipes and tubes to make vanilla ice cream after chocolate ice cream is made) is costly. What drives these
costs needs to be understood.
For product sustaining costs, the hierarchy indicates that these costs are further removed from an
individual product type. Some of the drivers of product sustaining costs are shown for ice-cream
manufacturing in Example 6.2.
EXAMPLE 6.2
Hierarchy of costs—ice-cream manufacturing
Unit level costs Milk and sugar
Batch level costs Machine clean and set-up, flavouring (chocolate)
Product sustaining costs New flavour design and introduction (avocado ice cream)
Facility level costs Industrial-scale freezers
Now the contentious area—how are facility or organisation sustaining costs traced? Consider the costs
of a corporate headquarters—for example, CEO salaries and expensive office rental in metropolitan cities.
How are these costs traced to a product manufactured in a plant in an outer suburb? Is there a cause-and-
effect relationship? This is the danger of allocation. The total corporate office costs can be divided by the
number of litres of ice cream made, to the nearest two decimal places—an arbitrary precision that does not
accurately capture the cost of making ice cream. All this will do is allocate a semi-related overhead that
increases the cost of making ice cream to the point that competitors appear cheaper, and the organisation
will not be in a sustainable or value-adding position.
This is one reason why ABC is an expenditure model—to inform strategic decision-making. The choice
to drop a product or product line needs to be made on the basis of the strategy of the business. For example,
if the business has a differentiation strategy, reducing price is not a viable strategic decision. A company
with a differentiation strategy will focus on charging a premium price for a unique product. Cost is always
a significant factor, but for a differentiator, cost is a secondary issue. A variety of organisational approaches
to product pricing are discussed in Part C of this module (‘Strategic revenue management’).
To illustrate a differentiator’s pricing strategy, in 2015 two models of iPhone—iPhone 6S (16Gb) and
iPhone 6S Plus (16Gb)—had a $100 price difference (Jayakumar 2018), yet the cost difference was only $20;
nonetheless, customers were willing to pay the $100 premium. This clearly indicated that there was value
engineering for the customer who was willing to pay $100 more for an incremental cost of $20 to Apple.
VALUE ENGINEERING
Value engineering (VE) is a customer-focused cost management technique. VE improves the value of
products by examining a product’s functions to ensure only functions of value to the customer—its basic
functions—are included in the product offering, and that the cost of these basic functions is minimised.
For example, many consumer products, like the iPhone, have a short life cycle, after which they become
practically or stylistically obsolete. These products could be built to last many years, but through using
VE they are not, because this would create unnecessary cost. A manufacturer will use the least expensive
components that satisfy the product’s lifetime projections.
COST DRIVERS
Activities consume resources and incur costs, so it is necessary to identify what drives these costs.
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
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by cause and effect to these measures—that is, they do not actually ‘drive’ all 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. Table 6.2 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.
TABLE 6.2 Activities and their drivers
Activity cost pool Potential cost driver
Customer service call centre • Number of phone calls

• Average duration of phone call
Vehicle breakdown service provider • Number of call outs attended

• Average duration of call out
Accounting services • Total time taken with the client
Set-up costs • Number of production runs

• Number of engineering changes
• Duration of set-up time
Production scheduling • Number of products

• Number of production runs
Material handling • Number of production runs

• Number of materials movements
Inspection costs • Number of inspections

• Number of inspection hours
Quality assurance costs • Number of items failing inspection

• Number of complaints logged
Maintenance costs • Number of machine hours

• Total facility maintenance hours
Raw materials inventory handling • Quantity of raw materials received

• Number of stocking locations
• Number of parts handled
Finished goods inventory and dispatch • Number of customer orders delivered

• Distance travelled
• Time taken for delivery
Marketing • Number of customers

• Number of sales/marketing staff
While the cost drivers in Table 6.2 are straightforward, as business processes become more complex, it
becomes more important to trace costs from the cost pool to the products, as explained in Example 6.3.
EXAMPLE 6.3
When activity-based costing is useful—capturing complexity

Products
Vanilla Pty Ltd (Vanilla) produces 500 000 litres of vanilla ice cream packaged in 1 L tubs. In contrast,
Flavour Pty Ltd (Flavour) produces 500 000 litres of 30 different flavours of ice cream packaged in 250 mL
cups, 1 L tubs and 5 L catering packs. Flavour obviously has a more complex manufacturing process and
will have significantly more machine set-ups, product-testing, packaging, storage and order-filling costs
than Vanilla. To cope with these indirect costs, Flavour should consider the use of ABC. On the other hand,
Vanilla may be better served by a simple process costing system.
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Services
Pensioner Insurance Ltd (Pensioner) provides car insurance for drivers over 50. Pensioner only insures
customers over 50 years of age who have had no accidents or claims over the last five years. EV Insurance
Ltd (EV) offers insurance for cars, boats, homes and businesses. This insurance is available to everyone.
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. The
time to evaluate customers with completely different risk profiles and for multiple products will be less
predictable and less systematic. Therefore, EV should consider ABC.
Some potential cost pools and drivers that may be useful for cost allocation in such service businesses
are shown in the following table.
Activity cost pool Potential cost driver
Insurance application and processing costs • Number of applications received

• Number of policies approved
Call centre • Number of calls received

• Average duration of call
• Total customer service hours
Claims processing • Number of straightforward claims finalised

• Number of complex claims finalised
• Total claims finalized
Studies indicate that a majority of businesses still are yet to implement ABC, due in part to the
complexity of understanding activities, tracing costs as well as the time line of around 18 months to
implement a well thought-out ABC. The benefits of ABC remain persuasive, especially when cost drivers
are mapped out and linked to performance scorecards. This is revisited later in this module when the health
care industry is highlighted in the discussion on structural and executional cost drivers.
In this module, 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 pricing decisions. It also guides 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 ACTIVITY-BASED COSTING

The steps for implementing ABC are summarised in Figure 6.3 and discussed further in this section.
1. Activity analysis
For many organisations, this stage is 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. This stage is called process mapping or activ-
ity 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 products throughout the factory, running machinery, inspecting products and reporting on
performance.
2. Create cost pools
Next, the management accountant must identify the indirect costs of each activity—that is, form cost
pools. For example, there may be a ‘running machinery’ activity cost pool. Almost all activities involve
labour costs or wages. Other costs, such as rent, maintenance of machinery, depreciation, electricity,
computer equipment and maintenance, can be estimated and assigned to activities as appropriate.
3. Establish the cost drivers
The management accountant must then identify the cost driver for each activity or cost pool. The driver
is the factor that creates or ‘drives’ the cost of the activity. For the ‘running machinery’ cost pool, the
driver is likely to be machine operating hours. That is, the more hours the machine operates, the higher
Pdf_Folio:308

is the level of cost that will be incurred for labour, maintenance, depreciation and electricity during the
‘running machinery’ activity—so machine hours ‘drive’ these costs. There is a cause–effect relationship
between these items.
4. Identify the number of cost driver transactions
Next it is necessary to find out how many times the cost driver event occurs for each product line and in
total. This is called the number of ‘cost driver transactions’—for example, it may be the total number
of hours a machine operates.
5. Determine the ABC allocation rate for each cost pool
Once the cost pools—that is, indirect costs for each activity—and cost drivers have been established,
the ABC transaction cost rate for each cost pool can be established by using the following formula:
Cost pool / Total number of cost driver transactions
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.
6. Allocate cost pools to each product line
Next, the indirect costs from each cost pool are allocated to each product line. This is calculated by
using the following formula:
Number of cost driver transactions per product line × ABC transaction cost rate
7. Calculate the indirect cost per unit
Finally, the indirect cost per unit is calculated. Once each cost pool has been allocated, the total amount
of indirect cost allocated to a product line is divided by the number of units produced.
Indirect cost allocated to a product line / Number of units produced
FIGURE 6.3 Steps for implementing activity-based costing
1. Activity analysis
Identify each activity in a process
2. Create cost pools
Classify indirect costs into activity groups that have similar characteristics
3. Establish the cost drivers
Determine what is causing the costs to be incurred
4. Identify the number of cost driver transactions
For each product line and in total
5. Determine the ABC allocation 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

Pdf_Folio:309

These steps may also be used to apply ABC in a service-based organisation. Example 6.4 provides an
example of the allocation of indirect costs to day care service of a local council. The council runs five-
day care centres with a total enrolment of 600 children. Steps 1 to 7 (as discussed) show how the ABC
information is created and how costs are allocated.
EXAMPLE 6.4
Activity-based costing indirect cost allocation to council

day care services
Step 1 Step 2 Step 4 Step 5

Council Cost Step 3 Total cost Allocation Cost driver Step 6
activities pools Cost drivers drivers rate transactions Allocation
Number of
Finance $220 080 centres 427 $515.41 5 $2 577
Payroll, HR and Number of

risk management $450 000 active staff 422 $1066.35 90 $95 971
Number of
Records registered
management $188 169 documents 22 888 $8.22 27 $222
Number of
Creditors $146 191 live accounts 21 730 $6.73 1 544 $10 387
Number of
Debtors $74 095 invoices 108 582 $0.68 17 207 $11 742
Information Number of
technology $1 187 040 computers 240 $4 946.00 10 $49 460
Accommodation
and organisation Number of
costs $750 000 staff EFTs 330 $2 272.72 65 $147 727
Total indirect costs allocated to day care services $318 086
Step 7 Calculate indirect cost per unit (per child) $318 086 / 600 = $530.14
Source: Based on Victorian Auditor-General’s Office 2010, Fees and Charges—Cost Recovery by Local Government,
Victorian Government Printer, Melbourne, p. 15. Please note that this table has been printed with minor omissions. For
the original table that includes the full set of data, please refer to: https://www.audit.vic.gov.au/report/fees-and-charges-cost-
recovery-local-government.
These same seven 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.
CASE STUDY 6.2
Allocating indirect costs with activity-based costing

In your role as management accountant, you have been concerned about the division’s manufacturing
overhead cost allocation model. You believe that part of the problem HPD has with its existing range of
household electrical products is inaccurate costing.
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 the following table.
Pdf_Folio:310

Indirect manufacturing cost pool Cost driver Annual budgeted costs
1. Labour-related costs Direct labour hours (DLHs) $270 000
2. Machine-related operating costs Machine hours $350 000
3. Production scheduling and other Production runs $120 000

set-up costs
4. Materials handling costs Materials movements $70 000
Total budgeted costs for all cost pools $810 000
Budgeted production details for the food processor product line for next year are summarised in the
next table.
Cost driver transactions FC101 FC202 FC303
DLHs per unit 2.00 1.50 1.25
Machine hours per unit 1.00 3.00 3.00
Number of production runs 50 150 200
Number of materials movements 90 260 350
TASK
(a) Calculate the budgeted indirect manufacturing cost rate for the four ABC cost pools.
Cost pool 1—labour-related costs
Budgeted direct labour hours (DLHs)
Model Budgeted volume MHs per unit
FC101 10 000 2.00 20 000
FC202 3 000 1.50 4 500
FC303 2 000 1.25 2 500
Total budgeted DLHs 27 000
Total labour-related costs / Total budgeted DLHs $
DLHs
Labour-related cost pool rate $ per DLH
Cost pool 2—machine-related operating costs
Budgeted machine hours (MHs)
Model Budgeted volume MHs per unit $
FC101 10 000 1.00
FC202 3 000 3.00
FC303 2 000 3.00 6 000
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Cost pool 2—machine-related operating costs
Model Budgeted volume MHs per unit $
Total budgeted MHs
Total machine-related operating costs / Total budgeted MHs $
MHs
Machine-related operating cost pool rate $ per MH
Cost pool 3—production scheduling and other set-up costs
Budgeted number of production runs
FC101
FC202
FC303 200
Total budgeted production runs
Total production scheduling and other set-up costs / Total

budgeted production runs $
production runs
Production scheduling and other set-up cost pool rates $ per production run
Cost pool 4—materials handling costs
Budgeted number of materials movements
FC101
FC202
FC303 350
Total budgeted material movements
Total materials handling indirect costs / Total $

budgeted materials movements
materials movements
Materials handling cost pool rate $ per materials movement
(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 6.1.
FC101
Number of Indirect
Cost pools Cost pool rates cost drivers manufacturing cost %
1. Labour-related $10.00 $20 000 $200 000 54.9%
2. Machine-related $ $ %
Pdf_Folio:312

3. Scheduling set-up $ $ %
4. Materials handling $ $ %
Total indirect manufacturing costs allocated to FC101 100.0%
Units produced (see Case study 6.1)
ABC indirect manufacturing cost per unit

(Total indirect manufacturing costs allocated to FC101 / Units
produced)
Traditional indirect manufacturing cost per unit (from the $60.00

answers to Case study 6.1)
Difference in indirect manufacturing costs per unit between the

two systems
FC102
Number of Indirect
1. Labour-related $ $ %
Total indirect manufacturing costs allocated to FC202 $ 100.0%
Units produced (see Case study 6.1) $
ABC indirect manufacturing cost per unit $

produced)
Traditional indirect manufacturing cost per unit $45.00

(from the answers to Case study 6.1)
Difference in indirect manufacturing costs per unit between the $

two systems
FC303
Number of Indirect
1. Labour-related $ $ %
Total indirect manufacturing costs allocated to FC303 $ 100.0%
Units produced (see Case study 6.1)
ABC indirect manufacturing cost per unit $

produced)
Pdf_Folio:313

FC303
Number of Indirect
Traditional indirect manufacturing cost per unit $37.50

(from the answers to Case study 6.1)
Difference in costs per unit between the two systems $
BENEFITS OF THE ACTIVITY-BASED COSTING SYSTEM

ABC provides a more meaningful and accurate classification and analysis of most indirect costs incurred
by an organisation. ABC identifies the underlying causes of indirect costs, so that they are more accurately
linked to the products being costed. Replacing traditional overhead allocation with ABC should therefore
provide a more accurate and fairer allocation of overhead costs for products. 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.
CASE STUDY 6.3
Comparing the two costing systems

John Foster, the marketing manager for HPD, has advised William (the production manager) that BigShop,
a longstanding and major retail customer, had stopped sourcing the FC101 food processor model from the
division. According to John, BigShop claimed it was 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, because 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 following table comprises data calculated in Case study 6.1.
Total indirect costs allocated to each food processor product line using traditional method
Product Traditional volume-based cost allocation—direct labour hours (DLHs)
Indirect
DLHs % of total DLHs Cost per DLH manufacturing cost
FC101 20 000 74.07% $30 $600 000
FC202 4 500 16.67% $30 $135 000
FC303 2 500 9.26% $30 $75 000
Total 27 000 100% $30 $810 000
In the next table, 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 6.1 and 6.2.
Total manufactured cost per unit: Traditional versus ABC allocation methods
Total manufactured cost per unit FC101 FC202 FC303
Total prime costs per unit (see the answers for Case study 6.1) $95.00 $115.00 $130.00
Traditional volume-based allocation based on DLHs

Indirect manufacturing cost per unit (see the answers for Case study 6.1) $ 60.00 $ 45.00 $37.50
Total manufactured cost per unit using traditional approach $155.00 $160.00 $167.50
Pdf_Folio:314

ABC-based allocation using four cost pools and drivers
ABC indirect manufacturing cost per unit (see the answers for $36.40 $80.67 $102.00
Case study 6.1)
Total manufactured cost per unit using ABC
(Total prime costs + ABC indirect manufacturing cost per unit) $131.40 $195.67 $232.00
Difference in total manufactured cost per unit between the two systems ($23.60) $35.67 $64.50
TASK
(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 the total indirect costs table in the case facts).
(i) Complete the following comparison table and use it to help explain why the indirect manu-
facturing charge per unit has changed for FC303 when applying the ABC model. The data in
the following tables is from your calculations in Case study 6.2.
(ii) Explanation of figures.
Cost pool 1 Cost pool 2 Cost pool 3 Cost pool 4
Labour-related Machine-related Production/set-up Materials handling
Product Drivers % Drivers % Drivers % Drivers %
FC101 20 000 74.07% 10 000 % 50 % 90 %
FC202 4 500 16.67% 9 000 % 150 % 260 %
FC303 2 500 9.26% 6 000 % 200 % 350 %
Total 27 000 100% 25 000 100% 400 100% 700 100%
(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) Explain how ABC will help the management of HPD with:
(i) External strategy
(ii) Internal strategy
(d) HPD has a standard wholesale price for the FC101 food processor of $180.00 per unit.
Complete the following table 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.
(i) Comparison of budgeted profit margins for FC101 using the traditional and ABC product
costing systems
Traditional
Details costing ABC costing Difference
Total manufactured cost per unit $ $ $
Standard selling price per unit $180.00 $180.00 $0
Budgeted profit margin per unit $ $ $
(ii) What information obtained from the ABC product-costing model helps HPD understand its
lost sales to BigShop?
(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.
For a further explanation of ABC, please access the ‘Activity-based costing’ video on
My Online Learning.
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TIME-DRIVEN ACTIVITY-BASED COSTING
Despite the perceived benefit that ABC provides more accurate product cost data, by 2007 worldwide
adoption of the approach was relatively low. Kaplan and Anderson (2007) suggested that the technical
complexity and the cost of implementing and maintaining an ABC product costing system were among
the primary reasons for the low adoption rate. As such, they developed TDABC. It aims to overcome some
of the difficulties that were affecting the adoption of ABC.
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. As shown in Example 6.5, the two key input calculations are the:
1. cost per time unit of capacity
2. unit time of the activity.
EXAMPLE 6.5
Using time-driven activity-based costing to allocate costs

The membership department of a large professional sporting team performs three main activities:
1. processing membership applications
2. handling membership inquiries
3. performing membership seating checks.
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.
The theoretical capacity of the department would, therefore, be calculated as:
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 per cent of time—would therefore
be calculated as:
96 000 minutes × 80% = 76 800 minutes
The monthly salary cost of the membership department is $65 280.
The cost per minute of supplying capacity can now be calculated as:
$65 280 / 76 800 minutes = $0.85 per minute
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
• five minutes to perform membership seating checks.
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 the following table.
Cost driver
Activity Average unit time (a) Cost per minute (b) rate (c = a × b)
Process membership $12.75

applications 15 minutes $0.85
Handle membership inquiries 12 minutes $0.85 $10.20
Perform membership seating

checks 5 minutes $0.85 $4.25
Pdf_Folio:316

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 the following table.
Total cost allocated

Activity Quantity (a) Cost driver rate (b) (c = a × b)
Process membership applications 2 300 $12.75 $29 325
Handle membership inquiries 1 960 $10.20 $19 992
Perform membership seating checks 2 060 $4.25 $8 755
Total cost allocated $58 072
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—that is,
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 the following table.
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 because 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, management may consider reducing the
resources supplied—to reduce costs. Of course, this should be balanced against the need for quality
service provision.
Total time in Cost Total cost

Unit minutes driver allocated
Activity Quantity (a) time (b) (c = a × b) rate (d) (e = a × d)
Process membership
applications 2 300 15 34 500 $12.75 $29 325
Handle membership inquiries 1 960 12 23 520 $10.20 $19 992
Perform membership
seating checks 2 060 5 10 300 $4.25 $8 755
Total used 68 320 $0.85 $58 072
Practical capacity 76 800 0.85 $65 280
Unused capacity 8 480 $$0.85 $7 208
ADJUSTING TIME-DRIVEN ACTIVITY-BASED COSTING FOR

MORE COMPLEX ACTIVITIES
TDABC can be extended to account for more complex settings or changes in operating conditions.
Many activities may be performed in a variety of ways, depending on the circumstances. For example,
an organisation might estimate that it takes 20 minutes to receive a shipment of standard, low-value
components delivered by a supplier and to place them into storage. Other shipments may have fragile, high-
value materials that need to be handled with greater care and stored more securely. An extra 10 minutes
may be needed to receive and store these materials.
Pdf_Folio:317

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.
In allocating these indirect manufacturing material handling costs, a standard, low-value shipment
received would be allocated a cost based on an activity duration of 20 minutes, whereas a fragile, high-value
shipment would attract a cost based on 30 minutes.
There can be similar variations in other standard activities such as:
• order placement—for example, manual: via sales representative, mail or telephone; or automated: via a
website or electronic data interchange
• order acceptance—for example, existing customer with a sound credit history or a new customer
requiring a credit check
• delivery packaging—for example, standard, fragile or hazardous products to be shipped
• order shipment—for example, standard or express delivery
• after-sales service—for example, standard warranty, extended warranty, on-site service or access to 24/7
technical help.
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, Example 6.6
details some hypothetical time drivers for HPD. It shows the estimated time the division will take for
processing orders from two different customers.
EXAMPLE 6.6
Using time equations to adjust for complexity

Two different customers place orders with HPD.
1. Customer A is an existing customer of good credit standing who lodges their orders through electronic
data interchange (EDI), requires expedited (faster) order fulfilment and shipment but only requires
standard packaging and after-sales service.
2. Customer B is a new customer who requires a credit check, places their first order over the telephone,
requires standard order fulfilment and shipping, fragile packaging and, given their first-time purchase
from HPD, automatically receives an extended post-sale follow-up service.
The following table 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 (standard) = 2 minutes (EDI) [Customer A]
Order receipt (complex) = 2 minutes (EDI) + 5 minutes (manual variation) = 7 minutes [Customer B]
Variation to generic Additional Customer Customer

Generic activity activity minutes A B
1. Order receipt Electronic 1. Manual (by mail or

data interchange (EDI) phone) 5 2 mins 7 mins
2. Customer history Existing 2. New customer credit

customer of good credit history check 15 3 mins 18 mins
standing
3. Order fulfilment Standard 3. Expedited 8 13 mins 5 mins
Pdf_Folio:318

4. Packaging Standard 4. Fragile 7 4 mins 11 mins
5. Order shipment Standard 5. Express 12 15 mins 3 mins
6. Post-sales service follow- 6. Extended

up Standard 7 6 mins 13 mins
Total minutes per order time 43 mins 57 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
• Customer B would be 57 minutes × $2.00 per minute = $114.
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 the business to identify inefficient areas of the business
and make better decisions about what special services (i.e. variations) to offer and what prices might need
to be charged for these extra services.
CASE STUDY 6.4
Using time-driven activity-based costing to allocate indirect

manufacturing costs
You decide to apply the TDABC method to HPD’s materials handling function to assess whether TDABC
will provide a quicker and cheaper way to obtain more accurate product cost data.
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 transac-
tion 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
• 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 the following table and the total number of activities for
the materials handling function is shown in the next table.
Budgeted standard and complex task performance times for the materials handling function
Add-on for more complex

activity performance
Standard activity
Materials handling resource performance time Time unit Nature of complexity leading
categories unit (minutes) (minutes) to increased time demand
Materials sourced from overseas

Materials requisitions 10 +5 suppliers
High-value and/or fragile

Materials received into storage 20 +10 stock item
Sourcing materials for High-value and/or fragile

production 15 +10 stock item
Materials movements Batch size and work-in-process

on production floor 15 +5 value
Pdf_Folio:319

Budgeted activity levels for the materials handling function
Materials handling activity Standard activities Complex activities Total activities
Requisition 3 440 760 4 200
Receipt into storage 3 760 1 340 5 100
Sourcing for production 11 955 3 945 15 900
Production movements 16 630 13 070 29 700
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 preceding two tables have been combined to calculate the total
budgeted time for the materials handling function.
Budgeted time for the materials handling function
Standard activity performance Complex activity performance
Materials Standard Additional Additional Total

handling Unit time Trans- time unit time Trans- time time
activity (mins) actions (mins) (mins) actions (mins) (mins)
Requisition 10 4 200 42 000 5 760 3 800 45 800

Receipt into
storage 20 5 100 102 000 10 1 340 13 400 115 400
Sourcing for
production 15 15 900 238 500 10 3 945 39 450 277 950
Production
movements 15 29 700 445 500 5 13 070 65 350 510 850
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
the preceding table). This matches the formula for ‘Standard time’, 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 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:
3440 standard requistions × 10 minutes = 34 400 minutes
Add: 760 complex requistions × (10 minutes + 5 minutes extra) = 11 400 minutes
45 800 minutes
Employees and Capacity
The materials handling function has 10 full-time equivalent employees who each work 230 eight-hour
days per annum. The theoretical capacity is reduced by the estimated 104 000 minutes per annum that the
employees spend on professional development and training activities, staff meetings and similar events—
that is, time not available for productive work.
The steps to be followed to apply TDABC are:
1. determine the total costs to be allocated—this has been given as $1 504 000
2. establish the practical capacity of the materials handling function
3. determine the cost per minute based on practical capacity
4. apply the cost per minute to each activity to allocate costs to activities
5. calculate the unused or idle capacity time and cost.
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TASK
(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.
Theoretical capacity (total time available) in minutes
Number of eight-hour Number of minutes

days worked per annum per eight-hour day
Number of personnel per person per person
Less: Time spent by materials handling personnel in professional development,

training activities, staff meetings and similar events
Budgeted total practical capacity (or productive time) in 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
$
$
TDABC cost rate per minute (rounded to three decimal places) $
(b) (i) 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.
Budgeted total Budgeted

Materials handling activity time (minutes) Cost rate per minute costs
Requisition 45 800 $ $
Receipt into storage $ $
Sourcing for production $ $
Production movements $ $
Total time and cost 950 000 $ $
Total practical capacity $ $1 504 000

and costs
Unused capacity $ $
(Total practical capacity and
costs – Total time and cost)
(ii) 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?
(c) The following transaction data has been extracted from the budget for the coming year for the
FC303 food processor model.
Materials handling activity Standard activities Complex activities Total activities
Requisition 65 60 125
Receipt into storage 50 105 155
Sourcing for production 0 200 200
Production movements 0 350 350
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Note: The number of standard activities performed is equal to the total number of activities—
for example, 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—for
example, 60 for requisitions. This follows the time equation format mentioned previously, so the
total time for requisitions can be reconciled as follows:
65 standard requistions × 10 minutes = 650 minutes
Add: 60 complex requistions × (10 minutes + 5 minutes extra) = 900 minutes
1550 minutes
(i) Using the time data from the case facts and the activities data budget extract, calculate the
total time required for the materials handling activity for the FC303.
Materials Standard Additional Additional Total

handling Unit time Tran- time unit time Tran- time time
activity (mins) sactions (mins) (mins) sactions (mins) (mins)
Requisition 10 125 1 250 5 60 300 1 550
Receipt into
storage
Sourcing for
production
Production
movements
Budgeted
time Standard time Additional time
(ii) Explain your calculations.

(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.
Materials handling Budgeted activity Cost rate Materials handling

activity time (minutes) per minute costs allocated
Requisition $ $
Receipt into storage $ $
Sourcing for production $ $
Production movements $ $
Total times 17 700 $
(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 Case study 6.1)
(ii) the TDABC approach (calculated in part (d)).
Comment on any differences in the materials handling costs that would be allocated to the
FC303 food processor as a result ofusing either ABC method.
For further practice in TDABC, please access Stage 3 of the ‘Save or close the hotel?’ Business
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PART C: STRATEGIC REVENUE
MANAGEMENT
In Module 2, the organisation’s stakeholders were identified and discussed. While organisations must
ensure they give the necessary attention to each stakeholder group, the primary focus of Module 6 is
examining the options that organisations have to achieve a sustainable increase in profitability and value.
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 that do not. Furthermore, as our measure of value 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 (discussed in Part D of this module).
Strategic revenue management is an approach to managing the revenue, expense and investment areas
of a business with a focus on revenue initiatives. The same can be said about strategic cost management,
except in this case the focus is on cost initiatives. While each strategic lever can be discussed independently,
they are often 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 (a cost initiative) that are so
valued by customers that they are prepared to pay more for the product than it costs to incorporate these
features (a revenue initiative).
MAJOR INFLUENCES ON PRICING DECISIONS

HARD AND SOFT FUNCTIONS
There are two forms of product functionality of interest to customers as shown in Table 6.3. While both
hard and soft functions affect the selling price of a product, hard functions are more objectively determined
than the more subjective soft functions, so a company will usually find it easier to quantify the effect of
the hard functions on the price charged for a product.
TABLE 6.3 Hard functions and soft functions
Definition Example Explanation
Hard The technical and economic By using better-quality Since functionality improve-
functions use of the product and include components or improved ments are not cost-free,
attributes such as: product design, greater low cost should not be
• operational performance— value may be provided the pricing strategy of an
e.g. economic life, for customers. organisation if it is providing
production capacity and This may be due to a product that offers greater
cost of operation the product: value or functionality to the
• ease of use—e.g. minimal • having a longer economic customer than its competitors’
training required in life products.
product use. • better environmental
performance—e.g. zero
greenhouse gas emissions
• lower costs of operation and
maintenance
• improved after-sales
customer support—e.g.
extended warranty period.
(continued)
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Soft The image of the product By making minor modifica- By creating an image in the
functions and include attributes— tions to: mind of customers that the
i.e. appearance, aesthetics, • the product formulation— product is a brand worth
prestige and effect. e.g. better-quality paying more for, the company
ingredients is able to charge a higher
• Packaging—e.g. a more price.
exclusive and expensive
appearance,
In this case a company
may be able to charge a
higher price for a product by
positioning it at the premium
end of the market.
Figure 6.4 shows how product features affect product price.
FIGURE 6.4 Effect of product features on selling prices
Specified Augmented
Generic
Product Value received in Above average hard
features Basic hard functions, conformity to contract functions and a range
no soft functions specifications of soft functions
Price at
Price Price at cost plus competitive parity Price at value to client
Pricing role of
management Estimate
Reduce cost competitor’s price Estimate customer value
accountant
SURPLUS VALUE
As already stated, customer value exists if the customer is willing to pay for a product or service, but this
does not mean that customer value is a single amount or point value. Rather than being a single point value,
a customer will usually have a range of values that they are willing to pay for an item. The upper limit of
those values is the maximum price they are prepared to pay for an item. A simple example can be made with
a quality cup of coffee. A customer may be willing to pay within an expected range of values—for example,
from $3 per cup, up to a maximum of $5 per cup. This concept is highlighted further in Example 6.7.
EXAMPLE 6.7
Surplus value
A product with a high surplus value is drinking water. People would pay very high prices for drinking water
because they need it to survive. The difference in the price that they would pay if they had to, and the
amount that they pay now, is the surplus value.
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From a supplier’s perspective, knowing the upper limit of customer value is important, because 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. The lower limit or price of $3
indicates the minimum profit, given the supplier cost, that a business can make in a competitive market.
The range of between $3 and $5 for setting a price sets the parameters for revenue management for a
business.
However, this does not mean that a customer will be just as willing to pay the maximum price 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 limit, the lower the likelihood of the customer making the purchase.
The greater the gap (or saving) between the customer’s upper limit 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 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 for each customer or customer segment, as shown in Example 6.8.
EXAMPLE 6.8
Product functionality and selling prices

To demonstrate how differences in product functionality affect selling prices, consider two phones sold
by Company A and Company B, as described in the following table.
Cost Price Value to customer Surplus value
Company A $120 $140 $200 $60
Company B $110 $130 $170 $40
Difference $10 $10 $30 $20
Company A’s phone provides a higher level of functionality than Company B’s. The differences in
functionality between the two products may relate to hard and/or soft functions. Where the difference
is attributable to hard functions—that is, added features—these are easy to identify. If the difference is
due to soft functions (e.g. the product’s image), the differences may be more subjective.
The surplus value for the customer is $20 greater for Company A’s product. So, in this situation, even
though Company B’s product is $10 cheaper than Company A’s, 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—that is, 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—that is, 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.
In summary, customers purchase value, which they assess by comparing an organisation’s products
and services with similar offerings from competitors. The organisation creates value by carrying out its
activities either more efficiently than its rivals, or by combining activities in such a way as to provide
a unique product or service. So, a competitive advantage can be obtained by the manner in which an
organisation organises and performs the activities that comprise its value chain.
PRICING STRATEGIES
Price is the amount a customer is willing to pay for a product or service. There are products for which a
customer will pay a premium—a high price—while for other products, the customer will be price sensitive
and pay a low price.
The map of pricing strategies in Figure 6.5 shows how promotion or marketing expenditure (high or
low) is aligned to price.
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FIGURE 6.5 Pricing strategies
Promotion or marketing expenditure
High Low
High Rapid skimming strategy Slow skimming strategy

Price
Low Rapid penetration strategy Slow penetration strategy
Figure 6.5 illustrates two product attributes, price and quality, that influence pricing strategy.
The ability of a business to be a price leader, when compared to rivals, shapes the understanding of price
and promotion.
RAPID SKIMMING STRATEGY

When the price is high (such as the latest release of an iPhone), the strategy used is called ‘rapid skimming’.
Loyal Apple customers in India are willing to pay a premium—for example, USD 700 in India compared
to USD 120 for a rival phone—and potential competition is minimised by brand loyalty. In Australia, the
queues of people waiting for the latest release of an expensive product are testimony to a successful pricing
strategy in the large smart phone market. When a new product is released, the price of older models falls
and the pressure on manufacturing cost control increases. This is illustrated in Table 6.4, showing current
iPhone (August 2018) prices from an online Australian iPhone price comparator. Clearly, the price of older
models is reduced as new models are introduced.
TABLE 6.4 iPhone pricing
iPhone Pricing (RRP)
iPhone X A$1579
iPhone 8 A$1079
iPhone 8 Plus A$1229
iPhone 7 A$849
iPhone 7 Plus A$1049
iPhone 6s A$699
iPhone 6s Plus A$849
iPhone SE A$549
Source: Mac Prices Australia, 2018, ‘Apple iPhone prices’, accessed August 2018,
https://www.macpricesaustralia.com.au/iphone/cheapest/.
RAPID PENETRATION STRATEGY

When the competitor for smart phones in China, Oppo, released its new phone, the price was low
compared to Apple, but the promotion was connected to users being part of the design process. This
close connection—or co-creation of value—by customers saw a rapid penetration strategy. The promotion
resources had to be high to build connections with customers (Yan 2018) and their orientation to
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value. Rapid penetration works when customers are price sensitive, there is strong potential competition
(i.e. rival cheaper phones) and the business enjoys economies of scale. By 2017, Oppo had limited its
number of models and therefore could compete in the $200 to $450 price bracket. Three of the Oppo
models were in the top 10 phones for 2017. Oppo had the capacity as well as the connected customers to
deliver a rapid penetration strategy.
SLOW SKIMMING STRATEGY

For a slow skimming strategy, the launch of a product is done at a high price with low promotion. Low
promotion expenditure makes sense if the market size is limited and most of the market is aware of the
product. Harley-Davidson typically has a slow skimming strategy because customers are willing to pay
a high price. However, caution needs to be exercised because Harley-Davidson is facing pressure from
competitors such as Indian motorcycles and Japanese cruisers. Harley-Davidson may be forced to abandon
its slow skimming strategy and adopt market pricing or, alternatively, invest heavily in promotion and
marketing, and so shift to a rapid skimming strategy.
SLOW PENETRATION STRATEGY

For a slow penetration strategy, the product is launched at a low price with low levels of promotion. This
makes sense if the market is price sensitive and not promotion sensitive. This is a segment in which it
is hard to be successful. Promotion and marketing activities are usually value generating for customers.
Slow penetration can only work if the product life cycle is long. Komatsu tractors is one example of a slow
penetration strategy. This concept is explained in relation to the HPD in Example 6.9.
EXAMPLE 6.9
Pricing strategies for the household products division

Recall the following information about HPD’s new food processors from Part B:
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.
As the company has adopted a high-price strategy for its high-quality products, use Figure 6.5 to analyse
the level (high or low) of promotion or marketing expenditure.
If the senior management had chosen a high level of promotion, the indicated pricing strategy would be
rapid skimming. As noted earlier, however, a rapid skimming strategy depends on customer brand loyalty
(e.g. the iPhone). No such customer loyalty is likely to exist for HPD food processors. A lesson that iPhone
is learning is that when customer loyalty is challenged, this results in 35 per cent less iPhone customers
worldwide upgrading to newer models (Kim 2017). In China, a large mobile phone market, the Chinese
courts banned older iPhone models in a dispute with a chipmaker (ABC 2018). The reputation damage of
the brand, along with a rapid skimming strategy, saw the iPhone struggling for sales.
An alternative strategy is slow skimming to match the high-pricing strategy, where there is a low level of
expenditure on promotion or marketing. Slow skimming can work, but customer satisfaction with product
quality and functionality must align with the price. In the food processer market, companies should monitor
forums, blogs and product reviews. Competitor product offerings must also be monitored, a lesson learned
from Harley Davidson. Winning awards for a food processor is one way of aligning price with product
quality and functionality. An example is Magimix, a food processor over $2000. The high-price, award-
winning product and loyal customers allows a slow skimming strategy to work. Now compare Magimix with
a competitor, Thermomix, which has a different distribution channel and therefore a different expenditure
on promotions and marketing. The market for high-price food processors is extremely competitive. HPD
needs to test its pricing strategy and align the expenditure on promotion and marketing with this pricing
strategy.
An alternative strategy for a high-quality product is rapid penetration. The key to rapid penetration is
high investment in promotion to create customer awareness of product value. As noted, however, success
depends on economies of scale. It is unlikely that HPD can achieve such economies, and the pricing
strategy is inappropriate.
The final strategy, slow penetration, is unsuitable as the premium product price does not fit neatly into
the quadrant in Figure 6.5.
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Candidates are encouraged to view Figure 6.5 as a conceptual map for managers to test the price they
wish the market to pay against the level of expenditure on promotion and marketing. The lessons learned
from iPhone and Harley Davidson are that the alignment of price and expenditure may work one year, but
customer satisfaction and loyalty may change, competitor pricing and promotion may be aggressive, and
the management team need to rethink their product price and expenditure on promotions and marketing.
LEGAL IMPLICATIONS OF PRICE SETTING

Management accountants must be aware of the ethical and legal implications of price setting. In
establishing a price, a business may be motivated to collude with competitors to establish a common price,
thereby reducing price competition with the aim of increasing profits. Such price fixing agreements do not
need to be formal—they can be verbal and informal, even a wink or a nod. The Australian Competition and
Consumer Commission (ACCC) has detailed information on price fixing (ACCC 2018a), market sharing
and cartels (ACCC 2018b). Prosecutions in the Federal Court of Australia have seen fines of $35 million
being awarded. As mentioned in Module 5, there are current ACCC investigations into banks as a result of
the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.
The legal cases are a reminder that not only are there corporate fines—there may also be criminal charges
for directors and executives.
In Australia, the ACCC has pursued 15 local, European and Asian based airlines for price fixing in the
Australian air cargo market. The Federal Court has imposed $58 million in penalties to date including
a $20 million penalty against Qantas, $5 million against British Airways and $5.5 million against each
of Japan Airlines and Korean Airlines. Each penalty was reduced depending on the level of co-operation
provided to the ACCC with Qantas receiving the largest discount of 50%. Qantas has also paid several
overseas penalties and a senior executive was jailed for 6 months in the United States of America (ACCC
2018b)
Part C of this module has introduced strategic revenue management, an approach to value creation with
a focus on revenue initiatives. The following Parts D, E and F discuss strategic cost management, an
approach to value creation based on cost initiatives.
PART D: STRATEGIC COST MANAGEMENT

Many organisations find it necessary to achieve significant reductions in operating costs, boost operational
efficiency, and rationalise investment budgets. A study in 2016 found that 59 per cent of chief financial
officers (CFOs) view strategic cost management as an important defence against disruption (Thomson
2016). Without such cost management, there was concern that many businesses would not remain viable.
Dolan, Murray and Duffin (2010) reported that:
• over 50 per cent of respondents had achieved reductions in overall costs of up to 10 per cent
• nearly one-third had reduced costs by 11 to 20 per cent
• 9 per cent had achieved cost cuts in excess of 20 per cent.
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% 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
• 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 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 have not continued. This fear has been realised, with respondents to a Deloitte (2013) survey
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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.
Blind cost cutting does not last. A 2010 study by McKinsey argued that cost reduction programs do not
identify the true drivers of costs or are simply too difficult to maintain over time (Agrawal, Nottebohm &
West 2010). This stickiness of costs needs a focus on how to cut and not by how much. By understanding
or digging for new drivers, the focus on how to cut is pivotal for an organisation.
Many organisations also find that they must continually achieve a reduction in the cost of their products
or services for competitive purposes—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. 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, significant and sustainable improvements in cost performance come 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.
INCREASING EFFICIENCY WITHOUT REDUCING COSTS: THE

SPARE CAPACITY DILEMMA
Value chain analysis and ABC increase the visibility of an organisation’s costs and activities and create
incentives to achieve improvements by reducing the amount of resources used in undertaking its operations.
However, when changes are introduced to make things more efficient, this can often result in no actual
change in costs. This can lead to frustration and lack of support for more changes or improvements.
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
typically 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; but if current staff have permanent full time positions this will lead to unused labour capacity,
unless they are reassigned to new work or the workforce can be reduced.
This unused capacity may be used in new ways—for example, leasing out the spare space to other
companies requiring storage facilities—but where it is not possible to achieve an improvement in resource
usage or to reduce the unused capacity, planned cost reductions may not occur. Having a conceptual
understanding of cost drivers in a business model is important. The following section maps out a conceptual
framework and applies that to the health care industry.
Shank and Govindarajan (1992) suggest that two different types of drivers are the basis for strategic cost
management, as outlined in Table 6.5.
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 cost reductions by
examining its executional cost drivers. Despite these efforts, success is not easy. One reason for difficulty
in cost cutting is the intransigence of costs, particularly sales, general and administrative (Agrawal et al.
2010). The focus should be on how to cut and not how much.
The complexity of understanding cost drivers is illustrated by the challenges in the health care industry.
The structural cost drivers include the high costs of hospitals, medical technology and e-records while the
executional cost drivers include the salaries of highly qualified HR, training and delivery of health care
services across primary health care centres and hospitals.
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TABLE 6.5 Structural and executional cost drivers
Structural Reflect the organisation’s An organisation may decide to invest in Such an investment
cost drivers decisions about its: up‐to-date automated manufacturing re-engineers the
• structure—e.g. equipment that will enable it to achieve organisation’s cost
centralised versus significant improvements in material structure into a
decentralised usage—e.g. lower wastage and rework form that enables
• its investments— rates and a reduction in labour cost. more successful
e.g. acquisition of For example, as part of a planned competitive strategies
advanced manufacturing expansion in output, Rio Tinto has to be formulated and
technologies invested in driverless train technology implemented—e.g.
• mode of operations—e.g. to transport minerals from mine sites cost leadership.
fixed versus variable cost to ports (de Poloni 2014).
structure.
Executional Relate to how economically An organisation may decide that while Supplier management
cost drivers and efficiently the its existing manufacturing facilities or workforce man-
organisation executes still provide a competitive base for agement initiatives
its strategy. its activities, it can improve its cost drive the costs in
performance by: the organisation’s
• entering into a long-term procurement value chain by
contract with a supplier of raw increasing efficiency
materials, thereby securing a and productivity, in
significant reduction in the price paid the supplier case by
for those materials reducing input costs
• providing additional on-the-job (efficiency), and in
training for operational personnel the training case by
where improvements in manufacturing increasing outputs
yields (e.g. labour efficiency) will be (productivity)
obtained and a lower average cost
per unit produced achieved.
For example, to implement its driverless
trains initiative, Rio Tinto has opened a
control room in Perth. New operators
will be trained to control trains across
Australia from this facility (Diss 2015).
The National Health System in the United Kingdom has a target of increasing general practitioner
numbers by 5000 by 2020. In 2016, ‘Health Education England (HEE), the employment and training
arm of the NHS, has signed a “memorandum of understanding” with Apollo Hospitals in India which
could see hundreds more doctors coming to Britain if they pass rigorous tests’ (Knapton 2016). Apollo
Hospital has emerged since 1991 as a business case demonstrating successful management of executional
and structural cost drivers. Investments in structural cost drivers such as hospitals and medical technology
arose from investments by the International Finance Corporation (an arm of the World Bank). A high
standard of care and training of HR coupled with driving down infection rates saw the executional cost
drivers reduce. Apollo Hospitals is part of an ecosystem with an aim of keeping individuals out of hospitals,
thus reducing costs and increasing efficiency. An integrated value chain perspective is needed to manage
the structural and executional cost drivers.
Figure 6.6 provides a series of five questions that, once addressed, might identify opportunities for
achieving sustainable reductions in costs.
LIFE CYCLE, TARGET AND KAIZEN COSTING

Product life cycle, target and kaizen costing are three related strategic cost management tools that can
be used to manage an organisation’s costs strategically, obtain desired cost reductions and achieve best
practice levels of performance. These methods are examined in detail in the following sections.
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FIGURE 6.6 Identifying opportunities for achieving a reduction in product costs
Question 1 Eliminate or reduce the

Yes
Does the cost relate to activities non-value-adding activities and
that are not value-adding? seek to reduce costs incurred.
No
Question 2 Change source of supply to

Yes
Can the resource employed to carry out value- a lower cost supplier and
adding activities be acquired at a lower cost? realise cost savings.
No
Question 3 Reduce the time and effort

Can the time and effort devoted to carrying Yes expended in carrying out
out value-adding activities be reduced, the activities and achieve
thereby resulting in a reduction in costs? cost savings.
No
Question 4 Identify and pursue alternative

Yes value-adding initiatives that make
Does the cost relate to a resource use of the unused (or idle)
that is under-utilised? resource capacity.
No
Question 5 Coordinate the use of the shared

Yes
Can the services provided by a resource be resource such that lower total
shared with other products or functions? costs are obtained.
Continually monitor organisational activities in an effort to identify and

obtain future opportunities to permanently reduce costs.
Product life cycle

As discussed in Module 1, products or services pass through a series of stages that comprise the ‘product’
life cycle, with each stage having major strategic and functional implications. The stages broadly include:
• introduction
• growth
• maturity
• decline.
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. This relationship is explained further in Figure 6.7.
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FIGURE 6.7 Product life cycle and the cash curve
Product life cycle
Product development Product in market
Cumulative cash
Source: BCG analysis

Time
Source: Andrew, J. P. & Sirkin, H. L. 2004, ‘Making innovation pay’, Strategic Finance, vol. 86, no. 1, p. 7. (Figure 1. ‘The cash
curve’ republished with the permission of the Institute of Management Accountants; permission conveyed through the Copyright
Clearance Center Inc.)
Figure 6.7 shows that in the early stages of the product life cycle, the cumulative cash curve is negative.
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—for example, to augment other product lines—it
would be withdrawn from the market. So, 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.
At each stage in the life cycle of a product or service, opportunities for achieving improved cost
performance are available. As illustrated in Figure 6.8, 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). So, a focus on cost reduction during production is unlikely to yield significant
economies, because 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 later in this module) 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 6.8 shows that in the manufacturing process, a high level of cost is committed and cannot be
avoided before production begins—for example, 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. 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-focused approach can be adopted to
measure the efficiency of inputs and outputs of the manufacturing process, as shown in Example 6.10.
Pdf_Folio:332

FIGURE 6.8 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 Marketing
planning
manufacture Production and logistics
and concept preparation
of prototype support
design
Source: Adapted from Raffish, N. 1991, ‘How much does that product really cost?’, Management Accounting, vol. 72, no. 9, p. 37.
EXAMPLE 6.10
Committed and incurred costs

Consider the construction of a car-manufacturing plant and running the production line once it is
operational. A large proportion of the total cost will be committed prior to any money actually being spent.
This includes a commitment to purchase the land, machines, building the plant and all the other equipment
required. It is at this point that an intensive strategic focus is required. Decisions made here will have long-
term effects that will be difficult to change later—for example, decisions about choosing the right location,
the machines to be used, the layout of the plant and the capacity of the plant.
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.
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.
Target costing
Organisations must be able to determine realistically what price a new product is likely to command, given the:
• specific market conditions
• total costs of developing, manufacturing and supplying that particular product
• profit margin that is desired.
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—that is, it 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—that is, 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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FIGURE 6.9 Target costing steps before a product launch
• 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, focus or differentiation).
Step 1
• Determine the profit margin the organisation requires to achieve its objectives
(e.g. maximise shareholder wealth).
Step 2
• Determine the target cost for the planned product by subtracting Step 2 from Step 1.
Step 3
• Determine whether the product can be produced at or below the target cost—the
target cost must incorporate life cycle costs, so the organisation will include design,
engineering, manufacturing and distribution costs within the total target cost.
Step 4
• 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 proceed
With production. If the estimated life cycle cost is greater that the target cost, the
organisation could:
Step 5 – 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
– decide not to manufacture the product.
Target costing supports value engineering and 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
• customer service.
The advantages of target costing are that it:
• focuses on customer value as represented by market prices
• is consistent with the drive towards CI
• appreciates that the most important points at which to achieve low cost production status are the product
design and process engineering stages—that is, managers are aware of the need to design the product
carefully and establish efficient production methods to achieve cost reductions without a decline in
product quality that would be unacceptable to customers
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• leads to a closer and more productive relationship with suppliers—for example, the suppliers’
livelihood depends on the organisations they supply being able to deliver a correctly priced product
with an adequate mark-up on total cost
• creates cooperation throughout the organisation, as strategies to produce the product at the target cost
are identified and evaluated
• supports setting realistic and attainable target costs that can be used to reinvigorate an organisation’s
standard costing system. Standard costing emphasises historical cost data, while target costing focuses
on future cost data. The coupling of target and standard costing is likely to achieve a fuller and more
proactive approach to cost management.
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 steps outlined in Figure 6.9 should be completed before a
product launch.
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. It is also possible to apply these
principles to service industries, but it is more challenging because services are less tangible and unique
compared to mass-produced products. Nonetheless significant improvements are still available, as shown
in Example 6.11.
EXAMPLE 6.11
Target costing in a service environment

Medical tourism
Medical services, including dentistry, heart surgery and cosmetic surgery, have become increasingly
expensive in many developed countries. This has led to the development of a much lower-priced
alternative called medical tourism. For example, in Australia, knee replacement costs would range between
$19 439 and $42 007 with a median of $26 350 (RACS 2017, p. 11). The wide range for orthopaedic
surgeons reflects the charges that highly qualified surgeons and private hospitals would charge for five
days post-operative recovery. In Singapore the cost would be around USD 13 000, and in India the cost
would be below USD 10 000 (Pacific Prime 2018).
Burgeoning medical tourism in Singapore, Malaysia, Thailand and India are examples of target costing.
The case of Apollo Hospitals used earlier is evidence of the growing business model of strategic
cost management.
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 high-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 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—that is, performing procedures
on patients. This leads to faster, higher-quality and lower-cost treatment.
Insurance, banking and telecommunications
Customers are demanding greater levels of service from service providers. At the same time, they are not
willing to pay a premium—they are actually expecting lower prices as well.
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.
Pdf_Folio:335

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.
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—for example, a 2 per cent reduction in production costs per year. This
improvement may be achieved through:
• better utilisation of existing technologies and resources—for example, a telephony service provider
increasing the customer load that can be carried on its mobile telephone system
• elimination of waste—for example, idle employee time, material scrap, material handling and excessive
inventory levels
• increased productivity from operational personnel—for example, from staff development and technical
training or having multi-skilled employees who can perform different roles, such as 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 6.10 links the strategic cost management tools of target and kaizen costing to the activity-analysis
approaches of business-process management and CI programs. ABM and BPM will be discussed later in
this module.
FIGURE 6.10 Kaizen compared to target costing
Low High
Continuous Business process
Extent of changes made in
improvement management
business processes
Kaizen costing Standard costs Target costing
Activity-based management and costing
Life-cycle costing
Figure 6.11 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?’.
The following section of the Case study shows how a range of tools is used to analyse and evaluate
various options for the planned introduction of two new products and, in particular, improving the expected
profitability of a new solar hot water product.
Pdf_Folio:336

FIGURE 6.11 Product life cycle, target and kaizen costing
Product life cycle
Pre-product planning phase (Target costing)
Product and
Target selling price • Product specifications formulated
process design
established • Manufacturing process designed
changes
Target profit
determined
Do proposed product specifications No

Target cost set and manufacturing processes
achieve target cost?
Yes
Estimate life-cycle costs
No
Are product life-cycle costs acceptable? Do not manufacture
Yes
Production phase (Kaizen costing)
Commence production
Continue
Yes production
Product and process improvements
Yes
Is the product still ‘profitable’?
No
Abandon production phase
Cease manufacturing
CASE STUDY 6.5
Renewable energy products—target costing

Currently, HPD manufactures an extensive range of consumer products and its major customers are Aus-
tralasian electrical-appliance retailers. Following recent consolidation among small electrical-appliance
manufacturers, HPD has slipped to third place, with the two leading overseas-based manufacturers
accounting for the majority of sales in many product categories.
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.
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).
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Government support—for example, 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.
Solarheat 1—Hot water system

John Foster, the marketing manager for HPD, has recommended the introduction of a new technologically
advanced solar hot water system to be known as Solarheat 1. The market for solar hot water systems is
very competitive, but the technical specifications and operational performance of the Solarheat 1 will be
superior to those of its nearest rivals. John believes it will therefore sell at a 10 per cent price premium
over its global competitors.
Solarpower 2—Home electricity system

Given the potential synergy of having a solar power system in its renewable energy product range,
John has proposed that HPD investigate the development of a product for this particular market segment.
HPD’s senior management group has given tentative support for John’s solar power system proposal,
called Solarpower 2, provided that it does not impede the division’s development of the Solarheat 1.
The need for target costing

Initial forecasts indicate that the introduction of either or both of the new products will significantly increase
annual sales revenue. Even so, initial calculations suggest that introducing both products will not achieve
the division’s desired profit target.
Analysing solarheat 1—Identifying the target cost per unit

Given the accelerating rate of technological change expected in the solar-heating industry, HPD believes
that Solarheat 1 will have an economic life of five years. To ensure stable production volumes, the selling
prices will be reduced each year to stimulate demand. Generally, HPD seeks a 30 per cent net profit margin
on the selling price of products in highly competitive markets.
The following sales and manufacturing data for the expected five-year product life of the Solarheat 1
have been developed.
Total sales revenue $24 000 000 is forecast to be earned on total sales of 30 000 units.
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:
Research and development $1 300 000
Product and process design $2 500 000
Production $16 200 000
Marketing and distribution $1 750 000
After-sales service $750 000
The production cost per unit of the Solarheat 1 is estimated to be:
Direct materials cost $300 per unit
Direct labour cost $80 per unit
Indirect manufacturing costs $160 per unit
TASK
In your role as the management accountant for 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.
Pdf_Folio:338

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.
Total costs Total units to be manufactured Average cost per unit
$ 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.
Details Amounts
Average selling price (from task (a)) $
Less: Net profit margin expected per unit ($) ($)

(Desired margin × Average selling price)
Target average total cost per unit $
Expected average total cost per unit (from task (b)) $
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.
(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:
• the amount of energy that would be generated by the manufacturer’s solar power product
• cost savings that customers will obtain from using self-generated power as opposed to
mains-supply power
• 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.
For further practice in Target costing, please access Stage 3 of the ‘Save or close the hotel?’
CASE STUDY 6.6
Reassessing the allocation of indirect manufacturing costs for the

Solarheat 1
Indirect manufacturing costs are currently allocated to each HPD product line on the basis of direct labour
hours. Given the distortions in product costs that have occurred with HPD’s use of a traditional volume-
based indirect manufacturing cost allocation method, you decide to use ABC to re-examine the costing
of the Solarheat 1.
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After further investigation of the conventional and TDABC models, analysis of the initial activity and cost
data for HPD reveals that six cost pools will be sufficient. The following cost pools and cost pool rates
have been estimated and the number of transactions to be carried out in manufacturing the Solarheat 1
has been forecast.
Solarheat 1 indirect manufacturing

Cost pool Cost pool rate activities
Machine set-ups $500 per set-up 3 000 set-ups
Quality control $125 per inspection hour 3 000 hours
Rework $20 per unit produced 30 000 units
Materials movement $250 per movement 3 600 moves
Repair and maintenance $200 per maintenance hour 2 400 hours
Hazardous waste disposal $50 per kilogram disposed 3 900 kilograms
TASK
Martin Emmitt has asked you to review the activity and cost data provided and has also requested
that you complete the following tasks.
(a) (i) Calculate for each cost pool the total indirect manufacturing costs that would be allocated
to the Solarheat 1 using the ABC model.
Solarheat 1 indirect ABC indirect

Cost pool Cost pool rate manufacturing activities manufacturing costs
Machine set-ups $500 per set-up 3 000 set-ups $
Quality control $125 per inspection 3 000 hours $

hour
Rework $20 per unit produced 30 000 units $

Materials $250 per movement 3 600 moves $
movement
Repair and $200 per mainte- 2 400 hours $
maintenance nance hour
Hazardous $50 per kilogram 3 900 kilograms $

waste disposal disposed
Indirect manufacturing costs allocated using ABC $
Indirect manufacturing cost allocation using traditional model $ 4 800 000

(see Case study 6.5, items 2 and 3)
(30 000 units × $160 indirect manufacturing cost per unit)
Excess indirect manufacturing costs allocated to the Solarheat 1 $

product line
(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).
(iii) Comment on how Solarheat 1’s total average cost per unit now compares to the target
average cost per unit.
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END OF ECONOMIC LIFE: REVERSE FLOWS IN THE
VALUE CHAIN
So far, our discussion of industry and individual organisation value chains has assumed that value chain
movements only flow downstream from suppliers to the organisation (through its own value-adding
activities) and then, ultimately, to customers. A reverse value chain flow describes activity that moves
the opposite way through the value chain. Examples of reverse value chain movements include the return
of defective raw materials and components to suppliers, or warranty claims made by customers. Costs can
be substantial, as shown in Example 6.12.
EXAMPLE 6.12
Reverse value chain movements

Toyota has announced it will start fixing ‘sticky’ accelerator pedals, a problem that has led to the recall
of an estimated 8 million vehicles. With … the United States Congress investigating the issue, Toyota is
scrambling to contain the fallout and repair its battered reputation. US production of eight models has
stopped altogether and the company’s share price has fallen 18 per cent in just a couple of weeks.
Source: Millar, L. 2012, ‘Toyota rocked by faulty accelerator recalls’, ABC News, accessed July 2018,
http://www.abc.net.au/news/2010-02-02/toyota-rocked-by-faulty-accelerator-recalls/317798.
Wherever possible, it is important to make improvements here. To do this, it is necessary to ensure that
more effort is placed earlier in the industry value chain—that is, 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. For example, a product may be redesigned to use material
that can be recycled rather than material that must be disposed of in 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.
Whether by organisational choice as a result of increased social responsibility or as a consequence
of legislation, manufacturing organisations are now taking greater responsibility for the recovery of their
products from customers at the end of the products’ economic lives—for example, printer toner cartridges,
car tyres, mobile telephones and paper products. Consequently, the costs associated with reverse flows in
a value chain are likely to become more significant and command greater managerial attention.
Figure 6.12 illustrates reverse value chain flows that begin with the recovery of a product from the
customer at the end of its economic life and the ultimate fate of the reclaimed product.
In some cases, the recovered product can be re-used repeatedly—for example, printer toner cartridges
that are refilled for re-use. A reclaimed product may also be put to an alternative purpose—for example,
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 in the making of a different product—for
example, 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 its
parts, it may need to be disposed of in a landfill or a high temperature treatment incineration system. Many
organisations, both manufacturers and retailers, are taking responsibility for the cost of properly disposing
of products (e.g. car tyres, batteries, and, increasingly, smart phones 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 considered.
Pdf_Folio:341

FIGURE 6.12 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)
Product re-manufacture (e.g. paper products)
Materials recycling (e.g. computer circuit boards)
Environmental impacts
Including energy usage 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
Figure 6.12 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 products
– reclaiming used products.
• 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
– human carcinogens.
Example 6.13 reports how Apple Inc. seeks to reduce the environmental effects that result from
its products.
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EXAMPLE 6.13
Life cycle costing at Apple Inc.

The life cycle analysis undertaken by Apple Inc. accounts for all stages of a product’s life cycle,
commencing from raw material extraction, to manufacturing, packaging, transportation, a three- or four-
year period of use by Apple users and the recycling of the product at the end of its economic life (Apple
Inc. 2018). Apple’s life cycle analysis indicates that the organisation’s effect on the environment can be
measured in terms of:
1. energy usage (and the associated greenhouse gas emissions)
2. the materials and components used in the product and their potential re-use.
Apple has included energy saving in all facets of its business:
• a high-efficiency power supply connection from the energy source (e.g. a mains supply power point to
the computer) for products
• advanced product design to include power management (e.g. ‘sleep mode’ when the computer is not
in use) and energy efficient hardware components (e.g. LED-backlit displays).
In 2018, Apple reached a major milestone: 100 per cent of the electricity used at all facilities is from
renewable sources (Apple Inc. 2018). The new corporate headquarters was opened in 2016 and expected
to save over 6 692 000 kilowatt hours.
In terms of materials, 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.
ACTIVITY-BASED MANAGEMENT AND CONTINUOUS

IMPROVEMENT
A significant responsibility now assumed by managers is to own and improve business processes
continuously. BPM (discussed later in this module) 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. ABM
2. CI.
At this point, it is useful to clarify the relationship between ABM and ABC.
ABC establishes relationships between both manufacturing and non-manufacturing overhead costs and
activities so that overhead costs can be better allocated. The aim of ABC is to provide an accurate cost of
products or other cost objects of interest to management, mainly for operational decision-making.
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.
Activity-based management
The ABM process begins in a way similar to ABC.
1. 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.
2. 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.
3. 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 increase the
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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—for example, 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 4 for more detail on
managing major investment projects).
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 are outlined in
Table 6.6
TABLE 6.6 Activity-based management—factors to be analysed for activity-based management
Factor Definition
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 inte-
grated 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 that 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, Google maps uses location ‘pins’ for drivers who plan their journey.
The pins for McDonald’s not only allow the customer to schedule their trip but have become
a channel for McDonald’s to connect to their customers, who can drill down into the food
menu. These non-traditional channels, in the Internet of Things (IOT), show how businesses
can leverage disruptive technologies.
Quality of Competent operational management results in the best capacity utilisation, improved product
operational and process design, a continuing stream of learning opportunities flowing from total quality
management management and CI 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
referred to as 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.
Business process management

BPM is an approach to reducing value chain costs. The scope of a BPM exercise is necessarily extensive—
it is focused on providing the best customer value and exploring radical alternatives. BPM starts from
an organisation’s strategic position and identifies how business processes can be designed under ideal
conditions using 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, as shown in Example 6.14.
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EXAMPLE 6.14
Is there value in business process management?

HSBC
In 2002 HSBC transferred its back-office processing to India and China, saving around USD 30 million
(HSBC 2003, p. 49). This cost saving is an example of value added in BPM. The use of IT can see costs
rising as well, as long as the value added as perceived by the customer is worthwhile.
Suncorp
Suncorp, an Australian financial conglomerate, conducted a study that 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 et al. 2013).
CASE STUDY 6.7
Business process management and the solarheat 1 manufacturing

facility
The manufacturing facility that will be used for producing the Solarheat 1 is currently set up on a functional
basis—that is, work is lined up in a sequential order throughout the facility and workers specialise in
carrying out only one task or function across multiple products.
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.
With 600 batches of the Solarheat 1 to be produced, Mary expects that:
• machine set-ups per batch will fall from five to three per batch
• materials movements will fall from six to four per batch.
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.
TASK
Mary Johnson has asked for your help to look into the possible BPM exercise.
(a) (i) If the cost of reorganising the Solarheat 1 manufacturing facility into a cellular format is
$300 000, calculate the indirect manufacturing cost allocations and savings in direct labour
costs for the functional versus cellular manufacturing layout.
ABC cost allocations Functional layout Cellular layout
Costs pool Cost pool rate Activities Costs Activities Costs
Machine set-ups (see $ $ $

the answers to Case
study 6.6) set-ups set-ups
Materials moves (see $ $ $

the answers to Case
study 6.6) moves moves
Total ABC costs allocated $ $
Reduction in indirect manufacturing cost allocations $

(Functional layout costs – Cellular layout costs)
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ABC cost allocations Functional layout Cellular layout
Add: Direct labour cost savings $

(Number of units × Direct labour cost saving per unit)
Lower costs as a result of BPM initiative $

(Reduction in indirect manufacturing cost allocations + Direct labour cost savings)
Less: Cost of BPM implementation ($300 000)
Net benefit realised from BPM implementation $

(Lower costs as a result of BPM initiative – Cost of BPM implementation)
Net benefit realised from BPM implementation per unit $ per unit
(Net benefit realised from BPM implementation / Number of units)
(ii) Should Mary proceed with her suggestion? Yes No

(iii) Explain why.
(b) With the ABC model now being used for allocating indirect manufacturing costs, the expected
product cost for Solarheat 1 has been revised down to $725 per unit (i.e. $750 – $25)—see Case
study 6.6.
(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.
Activity value analysis

While significant revisions to the organisation’s activity map, like those contemplated by BPM, are an
important aspect of ABM, it can also involve less radical process improvements. Elimination or reduction
of non-value-adding activities is a secondary focus of ABM.
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—for example, through improved product
design and manufacturing processes. As discussed in Module 1, 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.
There are also other non-value-adding activities—for example, 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 reduced, a corresponding reduction in the cost of the
product should be achieved.
Figure 6.13 provides a series of questions that will assist in 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 by eliminating or reducing non-value-
adding activities.
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FIGURE 6.13 Identifying value-adding and non-value-adding activities
Since activity does not create

Question 1
No value for external customers, it is
Does the activity create value non-value-adding and should be
for external customers? targeted for elimination.
Since activity is not necessary

Question 2
No for good governance, it is
Is the activity required to comply with corporate of no value and should be
rules (e.g. good corporate governance)? targeted for elimination.
Question 3 Since activity does not influence

Is the activity required for sound business No good business practices, it is
practices (e.g. principles and values guiding of no value and should be
interactions with all business stakeholders)? targeted for elimination.
Since activity does not create

Question 4 No value for internal customers,
Does the activity create value it is non-value-adding and
for internal customers? should be targeted
for elimination.
Question 5 Since activity results in waste that

Yes has little or no value, it should be
Does the activity result in waste that has
targeted for process improvement
no or minimal economic value?
to reduce the amount of waste.
CASE STUDY 6.8
Activity value analysis of household products division’s value chain

As a result of implementing the ABC model, and the BPM exercise that changed the design of the
manufacturing process of the Solarheat 1 to a cellular layout at a total cost of $300 000, the current
expected average cost is now $675 per unit. This is $115 above the target cost of $560 per unit. With an
expected total sales and production volume of 30 000 units, a further total cost saving of $3 450 000 must
be achieved ($115 × 30 000 units).
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.
TASK
(a) Activities involved in the production of the Solarheat 1 have been determined and are shown in
the following table. In your checklist, classify each activity as more likely to be value-adding or
non-value-adding.
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Nature of activity or event Value-adding Non-value-adding
1. Designing a product
2. Designing a manufacturing facility layout
3. Commissioning of manufacturing facility
4. Setting up production runs
5. Receiving raw materials and components
6. Inspecting incoming raw materials and

components
7. Returning materials and components to suppliers
8. Storing raw materials and components
9. Processing products
10. Incomplete products waiting for further

processing
11. Moving product through the production facility
12. Inspecting incomplete products during

processing
13. Reworking products
14. Inspecting completed products
15. Storing inspected products
16. Delivering products to customers
17. Receiving and handling warranty claims
18. Dealing with customer complaints
(b) HPD’s functional activities and life cycle costs are presented in the following table. 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.
Value-
Function and activities Total costs adding Non-value-adding
Research and development
Research and development work $900 000 $ $
Prototype design $250 000 $ $
Rework of prototypes $150 000 $ $
Total research and development $1 300 000 $ $
Product and process design
BPM—cellular facility layout costs $300 000 $ $
Design work $1 500 000 $ $
Issue patterns $700 000 $ $
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Rework patterns $300 000 $ $
Total product and process design $2 800 000 $ $
Production costs (made up of direct materials and labour and indirect manufacturing costs)
Direct materials
Inbound logistics costs $1 500 000 $ $
Direct materials invoice costs $7 500 000 $ $
Total direct materials $9 000 000 $ $
Direct labour
Direct labour manufacturing activity $1 100 000 $ $
On-the-job inspection activity $250 000 $ $
On-the-job training activity $150 000 $ $
Total direct labour $1 500 000 $ $
Indirect manufacturing overhead
Machine set-ups $900 000 $ $
Quality control $375 000 $ $
Rework $600 000 $ $
Materials movement $600 000 $ $
Repair and maintenance (excluding $480 000 $ $

preventative maintenance)
Hazardous waste disposal $195 000 $ $
Total indirect manufacturing $3 150 000 $ $
Marketing and distribution
Marketing campaigns $800 000 $ $
Distribution $950 000 $ $
Total marketing and distribution $1 750 000 $ $
After-sales service
Warranty claims $600 000 $ $
Customer complaints $150 000 $ $
Total after-sales service $750 000 $ $
Total cost of Solarheat 1 $20 250 000 $ $
(c) Martin Emmitt is interested in understanding how the division will determine which of the
non-value-adding activities should be eliminated. Write an explanation for Martin, covering the
factors that would need to be considered before deciding if a particular non-value-adding
activity is to be eliminated.
(d) 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.
(e) 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:
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Quality control $375 000
3000 inspection hours of $125 per hour
Repair and maintenance $360 000

1800 maintenance hours at $200 per hour
Hazardous waste disposal $120 000

2400 kilograms at $50 per kilogram
You initially identify two levels of elimination: partial and total. The table in the case facts
shows the benefit (in cost savings) and cost for the partial or total elimination of the relevant
non-value-adding activities.
To determine whether to pursue partial or total elimination you need to complete the following
table, by:
(i) Identifying the:
– net saving of partial elimination
– net saving of total elimination.
(ii) Identifying the preferred BPM initiative for each activity—total or partial elimination—and the
resulting net saving that is expected.
Partial elimination of non-value-adding Total of elimination of non-value-adding

activities activities
Net
saving
from
Function Prefered preferred
and BPM BPM
activities Benefit Cost Net saving Benefit Cost Net saving initiative initiative
Rework of $115.000 ($30 000) $ $150 000 ($40 000) $ Total $

proto types partial
Rework $220.000 ($25 000) $ $300 000 ($50 000) $ Total $

patterns partial
On the job $205.000 ($30 000) $ $250 000 ($65 000) $ Total $
inspection partial
activity
Repair and $70.0000 ($$10 000) $ $120 000 ($40 000) $ Total $
maintenance partial
Hazardous $50.000 ($20 000) $ $75 000 ($35 000) $ Total $

waste partial
disposal
Warranty $550.000 ($80 000) $ $600 000 ($150 000) $ Total $
claims partial
Customer $110.000 ($45000) $ $150 000 ($100 000) $ Total $
complaints partial
Total costs $1320.000 ($240 000) $ $1645 000 ($480 000) $ Total $
savings
(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?
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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 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 implementation 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, as
shown in Figure 6.14 and explained further in Example 6.15.
FIGURE 6.14 Continuous improvement and business process management
Low High
Continuous Business process
Extent of changes made in
improvement management
business processes
Activity-based management and costing
EXAMPLE 6.15
Productivity measures for continuous improvement initiatives

The output–input ratio for the activity ‘running machinery’ is:
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.
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 (i.e. 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.
These activity ratios are also known as efficiency or productivity ratios. 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.
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SOCIAL AND ENVIRONMENTAL VALUE CHAIN ANALYSIS
In the past, much of the focus has been on the economic dimension of an organisation’s value chain.
However, recognition of the social and environmental responsibilities of an organisation allows for a
far broader notion of the value created (and perhaps destroyed) by the organisation’s activities. While
the consequences of an organisation’s activities on society and the environment may eventually be
evident in economic terms (e.g. fines imposed for violating safe work practices or illegally polluting the
environment), these are typically lagging indicators of the level of commitment that the organisation has
to be a socially and environmentally responsible entity. Globally, the focus is on organisations being good
corporate citizens and this entails considering not only the economic dimension of the organisation’s value
chain activities, but also social and environmental factors, as shown in Example 6.16.
EXAMPLE 6.16
Establishing the social and environmental impact of the solarheat 1

To illustrate how social and environmental factors might be recognised, 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 their employees, their families
and the broader community?
When reviewing the environmental factors, the inputs and processes, as well as the outcomes from
using the product, should be considered. From an inputs perspective, consider the:
• types of materials used to make the Solarheat 1
• effect of the manufacturing processes employed, including the creation of any toxic by-products
• potential for recycling materials at the end of its economic life.
From an outcomes perspective, based on usage of the product, the benefits of using this renewable
energy product should be considered.
BMW plans to invest more than €300 million in body and paint facilities (Boeriu 2018). While increasing
capacity, the new plant would be filler free, reduce energy by 30 per cent and waste water by 45 per
cent. From an environmentally conscious customer’s perspective, these environmental improvements make
BMW more attractive.
Part E, following, continues the theme of strategic cost management begun in Part D. Part E focuses
on supplier management—management of the upstream portion of the industry value chain. Key issues
discussed include:
• the complexity of the global supply chain
• supplier codes of conduct relating to ethical treatment of employees and the environment
• supplier selection
• TQM
• outsourcing.
PART E: STRATEGIC PROFIT

MANAGEMENT—UPSTREAM ACTIVITIES
By being able to rely on the quality of a supplier’s production processes and its ability to deliver in
full and on time, a manufacturing organisation can progress more confidently to a just-in-time (JIT)
inventory management system and thereby reduce its investment in receiving and storing raw materials
and components.
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 like those outlined in Figure 6.15.
These supplier-related expenses are not usually explicitly recorded in inbound logistics-related over-
heads 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.
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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 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 were explained in Module 4) can be classified in different ways.
FIGURE 6.15 Example supplier costs
Expenses incurred in:

• placing orders
Purchasing • having orders delivered and receiving
• inspecting incoming orders.
Expenses incurred in:

• expediting orders that are delivered late or incomplete
• processing the balance of orders that were initially
Delivery
delivered incomplete
failure
• the production time lost due to late deliveries
• opportunity cost of the lost contribution margin on sales not
Supplier made because of late delivery of raw materials.
costs Expenses incurred in:
• returning materials to a supplier because they are defective
or not in accord with order specifications
Poor • rework
quality • scrap
• lost production time due to poor-quality materials being used
• opportunity cost of the lost contribution margin on sales that
were not made because of the inferior quality of the materials
delivered.
Holding
inventory Expenses incurred in:
• carrying raw materials inventory (e.g. storage,
insurance and obsolescence costs)
• opportunity cost of holding an investment
in inventory.
There are two broad risks (Ho et al. 2015) in the supply chain:
1. macro risk—for example, natural disasters, war, economic downturns, social and cultural grievances
and legal and regulatory risks
2. micro risks or operational risks (Sodhi et al. 2012), which include:
(i) demand risk—for example, inaccurate forecasts, customer expectations change, short life cycles,
competition changes
(ii) manufacturing risks—for example, labour disputes, product obsolescence, insufficient mainte-
nance as well as production capacity shortages or excess
(iii) supply risk—for example, inability to meet demand changes, failure to deliver on time or to
requirements, supplier bankruptcy or suppliers have unethical or poor management
(iv) infrastructure risk—for example, information infrastructure breakdown, transportation risk factors
due to excessive handling at border crossings, fragmentation of logistics and supply chain
complexity
(v) financial risks—for example, exchange rate risk, interest rate risk, low profit margins, credit risks.
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 significantly affect 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 6.17 in the next section).
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SUPPLIER MANAGEMENT
Organisations typically 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 their 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 time frames 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.
GLOBAL SUPPLIERS
As shown in Example 6.17, 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 is whether the potential global supplier has achieved accreditation status for one or more of
the international standards. These voluntary standards are developed by the International Organisation for
Standards (ISO). The more popular standards include:
• ISO 9001 Quality Management
• ISO 14001 Environmental Management
• ISO 26000 Social Responsibility
• ISO 31000 Risk Management
• 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.
EXAMPLE 6.17
Walmart consolidates its global sourcing structure and upgrades its risk
management
United States 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
Pdf_Folio:354

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.
WalMart vice chairman Eduardo Castro-Wright said:
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 in 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.
Source: Based on 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. & Zim-
merman, A. 2013, ‘WalMart goes it alone on Bangladesh garment factory safety pact’, The Australian Wall Street Journal,
Supplement, 16 May.
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. 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 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
• a lack of immediate interpersonal engagement—for example, 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—for example, health and safety, human rights, hours of work and rates of
pay—are significantly lower than those in place in more developed economies. Using 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 (Nisen 2013) and Apple (Cooper 2013) have been severely
criticised for the poor working conditions of employees in companies located in less developed economies
where they have subcontracted manufacturing.
SUPPLIER CODES OF CONDUCT

Many organisations, such as Apple, now use codes of conduct to regulate the work practices of their
suppliers to manage the risks of using low-cost overseas labour. Such supplier codes of conduct specify,
among other things, the hiring practices of the supplier (e.g. non-discriminatory recruitment and a
prohibition on hiring under-age employees), limits on work hours, minimum rates of pay, and work health
and safety (WHS) policies and practices. They may also specify minimum standards of environmental
management practices.
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Just as important as having a code of conduct is monitoring the suppliers’ actual compliance with the
terms of the code. An organisation may use its own personnel, supplemented where required with local
third-party experts, to audit the supplier’s manufacturing and related facilities—for example, 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.
You can see Apple’s view of its own supplier code of conduct on p. 41 of its Supplier Responsibility:
2018 Progress Report, available at: https://www.apple.com/au/supplier-responsibility/pdf/Apple_SR_
2018_Progress_Report.pdf.
Another example is Levi Strauss & Co. (Levi Strauss), which works with the Better Cotton Initiative
(BCI). In 2013, BCI set out to conserve water and reduce the impacts of fertilisers, and this led to a 23 per
cent reduction of water used by cotton farmers in China (Levi Strauss 2014).
Suppliers are not the only focus for shared value creation at Levi Strauss. Levi Strauss Foundation set
up a Worker Wellbeing initiative and found that for every dollar of investment in worker wellbeing, there
was $4 generated in productivity (Levi Strauss 2016). The company plans that by 2020, 80 per cent of its
production facilities will have Worker Wellbeing programs in place.
MINIMISING INVENTORY LEVELS

A key issue related to supply chain management is the extent to which an organisation can successfully
embrace JIT concepts. Minimising inventory levels has many benefits, including:
• reduced space required for storage
• fewer people required to manage physical inventory
• reduced waste by avoiding obsolete or out-of-date stock
• 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—for example, materials being
delivered by suppliers in small batches, on time, in full and to specification
• better management of material flows throughout the manufacturing process by:
– ensuring preventative maintenance reduces unscheduled downtime
– 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.
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.
SUPPLY CHAIN DISRUPTIONS

Whether sourcing globally, domestically or both, every supply chain strategy is exposed to supply chain
disruption. Disruption to supply can occur for many reasons, as shown in Figure 6.16.
The risk of supply chain disruption has a number of implications, including:
• the amount of inventory that an organisation will hold as buffer (or safety) stocks. The greater the risk of
supply chain disruption and the longer the lead time between order placement and fulfilment, the greater
the level of safety stock the organisation will hold. If insufficient safety stocks are held, a major supply
chain disruption may result in the organisation having to source required materials and components from
other vendors at a significantly greater cost. If there is no alternative supply source, the organisation may
have to cease operations until the disruption has been fixed
• a threat to the organisation’s strategic risk and reputation. The threat of reputational risk is increased
in circumstances where the supplier engages in poor work practices, has insufficient supervision, or
operates in poorly constructed premises. While these events may also affect inventory supply and hinder
the organisation’s capacity to execute its strategy by affecting competitiveness, they are likely to be more
damaging to the reputation of the organisation.
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VENDOR OR SUPPLIER SELECTION
Usually the most important reason or factor for choosing a supplier or vendor is the cost of the item being
purchased. Other factors, such as quality, reliability and environmental credentials, are also important,
but are often much harder to measure. They may also lead to higher prices. For example, it would be a
reasonable assumption that a supplier who has a good environmental and social performance record would
charge a higher 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 (as discussed in the previous section).
FIGURE 6.16 Supply chain disruptions
Supplier failure
(e.g. the supplier cannot deliver because
their manufacturing facilities have been
damaged or they have been liquidated)
Logistics failure
(e.g. workers at the inbound port take
industrial action over a safety issue and
the freight cannot be unloaded)
Disruptions
Natural disasters
(e.g. earthquakes, tsunamis and
cyclones may affect the functioning
of the supply chain)
Geopolitical events
(e.g. trade sanctions)
Another supply chain consideration is deciding whether to have single or multiple suppliers. Having
more than one supplier addresses several supply chain risks. The organisation is not dependent on just one
vendor, so a more competitive supply-side market is created. This means that there are alternative sources
of supply available, should one vendor be unable to fulfil its contractual obligations.
From another perspective, by having a single supplier an organisation may be able to establish a deeper
and more sustainable relationship with the vendor that is to the mutual benefit of both. Through a long-
established trading relationship, greater levels of trust may develop. The willingness of the supplier to offer
exemplary service and support may increase, along with the vendor’s capability to readily innovate and
adjust to the changing procurement needs of the organisation.
Ultimately, the selection of a supplier not only depends on its pricing, but also on its past and expected
future supply performance—for example, 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.
Pdf_Folio:357

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 is monitored. When a vendor always fulfils its 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.
CASE STUDY 6.9
Evaluating supplier-related costs

HPD sources its raw materials and other components from several component suppliers. Jane Smith, the
purchasing manager for the division, believes that this is less risky than relying on a single supplier.
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 extracts some representative data that she has been compiling on the three suppliers. The follow-
ing table 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.
Componentz ElectricalPartz Parts100 Total
$222 900 $210 000 $246 000 $678 900
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).
TASK
Martin Emmitt has asked you to review the current purchasing practices.
(a) Complete the following tables by calculating the:
(i) total supplier-related costs for each supplier (based on activities performed)
(ii) total procurement costs
(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—that is, 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.
Pdf_Folio:358

Number and cost of activities performed
Cost per Electrical Total activities

Activity type activity Componentz Partz Parts100 and total costs
Order materials
Activities 150 75 150 375
Costs $80 $12 000 $6 000 $12 000 $30 000
Receive orders
Costs $70 $10 500 $6 300 $12 600 $29 400
Inspect deliveries
Costs $120 $18 000 $10 800 $21 600 $50 400
Return materials
Costs $100 $1 500 $600 $3 000 $5 100
Account queries
Costs $150 $2 250 $900 $4 500 $7 650
Process payments
Costs $90 $3 240 $6 750 $3 240 $13 230
Total supplier-related $ $ $ $ 135 780

costs
Invoice cost of raw $ $ $ $ 678 900

materials (see table in
case facts)
Total procurement costs $ $ $ $ 814 680

(Total supplier-related
costs + Invoice cost of
raw materials)
Supplier cost per- % % % $ 135 780 /

formance ratio (Total 678 900 =
supplier-related costs / 20.00%
Invoice cost of raw
materials)
(b) (i) Using the following table, 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.
Suppliers
Details Componentz ElectricalPartz Parts100 Estimated costs
Relative supplier 1.02 1.03 1.00 $135 780

invoice cost index†
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Expected invoice cost ($7 500 000 ($7 500 000)
of direct materials × (1.02) × (1.03) ($7 500 000)
(calculation) × (1.00)
Expected invoice cost $ $ $ $7 500 000
Supplier cost % % % 20.00%

performance ratio
(see the answers to
part (a))
Expected supplier- $ $ $ $1 500 000

related costs ($7 500 000
(Expected invoice × 20.00%)
cost × Supplier cost
performance ratio)
Total procurement $ $ $ $9 000 000

cost (Expected ($7 500 000 +
invoice cost + $1 500 000)
Expected supplier-
related costs)
† From the introduction in Case study 6.9, Parts100 is the cheapest supplier and so has been selected as the
base against which all other suppliers are analysed. So 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).
(ii) Explain your calculations.
CASE STUDY 6.10
Life cycle costs of redesigning the product

Martin Emmitt has authorised the formation of a cross-functional team of HPD employees. This team
will re-examine the design of the product and its manufacturing processes to reduce the gap between
the current expected cost and the target cost for the Solarheat 1. The primary task for the team is to
examine HPD’s potential adoption of a lean manufacturing model with a particular focus on JIT inventory
management, quality control and team-based production.
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).
The following table 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, 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.
Lean manufacturing recommendations and Solarheat 1 expected costs
Original design ABC, Activities and costs

BPM, added value reflecting cross-functional
Function and activities analysis and supply chain team recommendations
ABC activity Costs ABC activity Costs
Other $40 000 $40 000
Research and development $900 000 $1 000 000

work
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Prototype design $250 000 $200 000
Total R&D $1 190 000 $1 240 000
BPM—cellular layout costs $300 000 $300 000
Other $50 000 $50 000
Design work $1 500 000 $1 750 000
Issue patterns $700 000 $500 000
Total product/process design $2 550 000 $2 600 000
Production costs
Direct materials
Inbound logistics costs $1 153 343 $1 153 343
Direct materials invoice costs $7 725 000 $7 725 000
Total direct materials $8 878 343 $8 878 343
Direct labour
Direct labour activity $1 100 000 $880 000
On-the-job training activity $150 000 $350 000
Other $65 000 $65 000
Total direct labour $1 315 000 $1 295 000
Quality control 3 000 $375 000 1 000 $125 000
Rework 30 000 $600 000 10 000 $200 000
Repair and maintenance 1 800 $360 000 1 400 $280 000
Hazardous waste disposal 2 400 $120 000 1 200 $60 000
Machine set-ups 1 800 $900 000 1 800 $900 000
Materials movement 2 400 $600 000 2 400 $600 000
Other $75 000 $75 000
Total indirect manufacturing $3 030 000 $2 240 000
Marketing, distribution and after-sales service
Marketing campaigns $800 000 $700 000
Warranty claims $50 000 $35 000
Customer complaints $40 000 $30 000
Other $1 075 000 $1 075 000
Total marketing, distribution

and after-sales service $1 965 000 $1 840 000
Total expected cost $18 928 343 $18 093 343
Planned number of units 30 000 30 000
Expected cost per unit $630.95 $603.11
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TASK
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.
Details Amounts
Initial market price per unit $800.00
Price increase per unit from improved product quality: Lean manufacturing initiative $
New forecast market price per unit $
Less: Net profit margin expected per unit ($)

(Desired margin × New forecast market price per unit)
Expected average total cost per unit $

(Total expected cost / Planned number of units) (see table in the case facts)
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.
TOTAL QUALITY MANAGEMENT

Since the 1980s, TQM has become an important goal for many organisations. ‘Doing it right the first time’
and ‘zero defects’ are two phrases often used to convey the spirit of TQM. As the costs of poor quality
can be significant, many organisations find that a focus on improving quality leads to improved economic
performance. Organisations are likely to realise improved operating efficiency and effectiveness from a
successfully implemented TQM program.
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 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. So, 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). These are
summarised in Table 6.7, and highlighted in Example 6.18 and Example 6.19.
TABLE 6.7 Quality costs
Type of cost Definition Examples of costs
Costs of Prevention Incurred in avoiding the • Quality planning

controlling quality costs manufacture of products or • Product design modification
provision of services that do not • Quality training
conform to quality requirements • Equipment maintenance
• Information systems
Appraisal Spent on making sure that • Testing and inspection
costs materials and products meet • Equipment and instrument testing
predetermined quality standards • Supplier monitoring
• Quality audit
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Costs of failing to Internal Incurred before products are • Corrective action
control quality failure sent to customers, and relate to • Rework and scrap
products that fail to meet quality • Process
standards • Expediting
• Re-inspection and retest
External Incurred when inferior quality • Warranty
failure products are delivered • Handling customer complaints
to customers and returns
• Product recall and product liability
• Lost sales from unsatisfactory
products
• Customer ill-will
EXAMPLE 6.18
Prevention is better than flood

A flood levee protecting the town of Launceston in Australia was completed in the 1960s but deemed
unsatisfactory due to the effects of ground settlement and insufficient maintenance. A project to upgrade
the levee was completed in 2015 at a cost of $58 million. In the extreme 2016 floods, the levees held, thus
preventing an estimated $260 million in flood damage (Monery 2017).
EXAMPLE 6.19
Appraising using statistics

‘Statistical process control’ uses data from sampling and statistical analysis to check that a process is
working within defined limits. For example, consider a production line filling containers with 1 kg of honey.
Samples of the product will be weighed, and the data plotted on a chart. Any data point outside the control
limit indicates that the process is out of control—for example, data points occurring below the limit mean
that some containers of honey are being under-filled. Statistical process control is more efficient than
performing an inspection of 100 per cent of the items produced.
Example 6.20 demonstrates the costs of controlling and of failing to control quality costs.
EXAMPLE 6.20
External failure costs

Takata Corporation was ‘one of the world’s leading automotive safety systems companies, supplying
nearly all the world’s major automakers with a product range that includes seat belts, airbag systems,
steering wheels, child seats, and electronic devices such as satellite sensors and electronic control units’
(Takata 2015, p. 2). Since 2013, a number of deaths and injuries associated with defective Takata airbag
inflators has led to recalls from 14 automakers (Tabuchi & Ivory 2016) involving many millions of cars. In
June 2017, Takata filed for bankruptcy.
The Takata airbag recall that caused car recalls across the world shows that costs of quality, particularly
the cost of external failures, can be huge.
The concept of appraising quality costs is further explained n Example 6.21.
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EXAMPLE 6.21
Categorising quality costs in the household products division

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
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—that is, 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.
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—for example, 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 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, as shown in Example 6.22.
EXAMPLE 6.22
Reworking defective products

If HPD manufactures a defective FC101 model food processor, it can choose from three options.
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—but it is still a best option because it generates a net economic benefit of $30 (i.e. $70 for
factory seconds – $40 rework and repackaging costs).
In general, it can be expected that a $1 expenditure on prevention saves $10 in appraisal and internal and
external failure costs. Similarly, increased expenditure on appraisal activities will reduce external failure
costs, through shifting external failures to internal failures—for example, by increasing the cost of scrap
and rework and decreasing customer returns and warranty claims. So, managers should invest their quality
dollars in prevention and appraisal activities so that failure costs are decreased and overall value increased.
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CASE STUDY 6.11
Impact of a total quality improvement initiative

HPD’s cross-functional team investigated whether it would be worth implementing a total quality program
for the Solarheat 1. With further work in research and development and product and process design, as
well as the use of better-quality raw materials and increased employee training, significant improvements
are forecast. Market research indicates that the improved Solarheat 1 will be very competitive relative
to the leading solar hot water system currently available in the market. To achieve the same volume of
product sales (i.e. 30 000 units), a $60 increase in the selling price per unit (from $810 to $870) will now
be possible.
The following table shows the changes that will occur in the manufacturing activities undertaken and
costs incurred as a result of the TQM recommendations.
TQM recommendations and Solarheat 1 expected costs
Activities and costs Activities and costs

reflecting cross-functional reflecting cross-functional
Function and activities team recommendations team TQM recommendations
Added value analysis costs $40 000 $40 000
Research and development work $1 000 000 $1 100 000
Rework of prototypes $0 $0
Total R&D $1 240 000 $1 390 000
BPM—cellular layout costs $300 000 $300 000
Design work $1 750 000 $1 800 000
Rework patterns $0 $0
Total product/process design $2 600 000 $2 700 000
Production costs
Direct materials
Inbound logistics costs† $1 153 343 $1 234 100
Direct labour
Direct labour activity $880 000 $960 000
On-the-job inspection activity $0 $0
Total direct labour $295 000 $1 425 000
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Activities and costs Activities and costs
reflecting cross-functional reflecting cross-functional
Function and activities team recommendations team TQM recommendations
Machine set-ups 1 800 $900 000 1 800 $900 000
Quality control 1 000 $125 000 600 $75 000
Rework 10 000 $200 000 2 000 $40 000
Materials movement 2 400 $600 000 2 400 $600 000
Repair and maintenance 1 400 $280 000 900 $180 000
Hazardous waste disposal 1 200 $60 000 200 $10 000
Total production costs $12 413 343 $12 805 000
Distribution $950 000 $950 000
Total marketing and distribution $1 650 000 $1 410 000
After-sales service
Total after-sales service $190 000 $145 000
Total expected cost $18 093 343 $18 450 000
Expected cost per unit $603.11 $615.00
† 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. So, forecast supplier-related costs
are $1 234 100, rounded up (i.e. $8 265 900 14.93%).
TASK
As leader of the cross-functional team, you need to provide information to Martin Emmitt regarding
the TQM initiative:
(a) (i) 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. Assume that HPD still wants a profit margin of
30 per cent on the Solarheat 1.
Pdf_Folio:366

Details Amounts
Revised market price per unit $810.00
Price increase per unit due to improved product quality: TQM initiative $
New forecast market price per unit $
Less: Net profit margin expected per unit ($)

(Desired margin × New forecast market price per unit)
Expected average total cost per unit ($)

(Expected total cost / Expected number of units) (see the table in the case
facts)
Expected average cost below (above) the target average cost per unit ($)
(ii) Write a paragraph to include in your report to Martin Emmitt that outlines whether HPD
managed to achieve the target cost per unit for the Solarheat 1.
(b) Quality is often perceived as an important characteristic desired by the purchasers of elec-
tronic 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

Outsourcing and offshoring were discussed in Module 1 and are further expanded on here.
Offshoring
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 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.
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.
Outsourcing
The extent to which it is necessary for an organisation to retain activities in-house as opposed to outsourcing
them is an essential strategic choice. Outsourcing is the process of switching the supply of goods and
services from an internal supplier to an outside vendor.
Areas commonly outsourced are:
• IT
• legal advice
• market research
Pdf_Folio:367

• logistics (e.g. delivery)
• call centres
• accounts payable (AP)
• HR (e.g. payroll).
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, data quality
and data security risk 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.
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.
Another factor that influences the outsourcing decision is the strategic importance of the function that
is to be outsourced. Figure 6.17 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.
FIGURE 6.17 Outsourcing decision pyramid
Strategic
Never outsource
direction
Internal audit, HR and

legal advisory services
Outsource under tight control
IT sharing
Outsource under Logistics, call centres, helpdesks,

service-level performance data centres, manufacturing of parts
agreements or products
Facility management, network management,

Low outsourcing temporary staffing
risk
Payroll, security services and catering
Research and development often represents a manufacturing organisation’s competitive advantage, so it

may be too critical for long-term viability to have that function outsourced. However, other functions
such as preparing and distributing payroll, security, cleaning and catering services pose less risk and
may be readily outsourced to specialist external providers at relatively low cost. For some organisations,
business processes are being entirely outsourced. For example, within the Australian public sector, IT and
accounting services are being outsourced by agencies to centralised or shared service providers.
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.
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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 costs of these alternative uses of
the resources are 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
• subsequently use in monitoring the external supplier’s delivery performance
• include in periodic audits of the supplier.
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
advantages and some disadvantages, as outlined in Figure 6.18.
FIGURE 6.18 Advantages and disadvantages of outside vendors
Disadvantages
• Increase in long-run operating costs
• Loss of specialised skills and knowledge
• Dependence on third parties
• Risk of security breaches
• Quality problems
Advantages
• Cost reduction
• Reduction in the use of assets
• Increased expertise
• Access to resources
• Greater flexibility
• Opportunity to focus on managing core activities
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 being intrinsic to the use of
external suppliers. Contract management, project management and supplier management skills are critical.
CASE STUDY 6.12
Deciding whether to outsource distribution

HPD has been approached by Supersonic Transport (Supersonic), a national transportation organisation,
with a proposal to take over the distribution of all of HPD’s products. Currently, HPD uses HZ’s distribution
division and is to be charged $950 000 for distributing the Solarheat 1. Supersonic has submitted a quote
to distribute the Solarheat 1 product line for a total cost of $650 000. However, HZ is concerned that if
HPD decides to outsource the distribution of the Solarheat 1 to Supersonic, it will have unused capacity
within its own distribution fleet.
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TASK
(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.
Details Amounts
Expected average cost per unit after implementation of cross-functional team’s $615.00
lean manufacturing and TQM initiative
Less: Saving per unit from switching distribution to Supersonic

(Current distribution cost – Supersonic quote) / Estimated number of units ($)
Revised expected average cost per unit after outsourcing distribution $
Target average total cost per unit (see the answers to Case study 6.11) $
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 Mar-
tin 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.
Part E of this module has discussed two key strategic cost management issues—supplier management
and TQM. For many organisations, suppliers are a key stakeholder group. Supplier management requires
the management accountant to understand the upstream activities in the industry value chain, particularly
those activities in what is called the ‘supply chain’. Collaboration with suppliers can lead to increased
value for both the organisation and its suppliers. TQM is a cost analysis technique focusing on value chain
improvements through investment in prevention and appraisal activities, in order to reduce failure costs.
Part F, which follows, deals with another key strategic cost management issue—customer profitability.
The focus in Part F is on understanding the full cost of servicing an organisation’s customers—that is, all
of the costs that contribute to the customer net margin. A limited focus on the cost of goods sold (COGS)
and the customer gross margin is shown to be inadequate in managing customer profitability. An ABC
approach to analysing customer costs is demonstrated.
PART F: STRATEGIC PROFIT

MANAGEMENT—DOWNSTREAM
ACTIVITIES
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,
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suppliers, distribution channels or product families. An ABC system can be designed to meet any of these
costing needs.
Customer profitability analysis moves the focus of strategic management accounting to the customer.
Understanding who an organisation’s customers are and what contribution they make to profits is important
in determining the strategic approach to adopt in dealing with customers. Customer profitability analysis
focuses on the profits generated by each customer or class of customer—for example, differentiated
by location, demographics or purchasing behaviour. It does not automatically assume that the biggest
customer, in terms of sales volume or growth in sales orders, is the organisation’s best or most profitable
customer.
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, revenue analysis has been limited to customer gross margins—sales less COGS. 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. It is
necessary 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.
The profitability of customers can be influenced by differences in revenues and costs. These are
summarised in Figure 6.19.
FIGURE 6.19 Possible causes of revenue differences between customers
• Larger customers, on whom the organisation

Price has some economic dependence, might be
able to negotiate lower prices than smaller
customers.
Volume • Customers who buy more frequently and/or in greater

and order volumes should generate greater sales revenue.
frequency • Greater sales volume might also result in volume discounts
being granted, leading to a reduction in the profit margin
Possible causes per unit sold.
of revenue
differences
• Not all of an organisation’s products will have the same
revenue per unit.
Product
• As the mix of products purchased by customers varies, so
mix
too will the amount of total revenue generated from each
customer.
• Some customers may be able to negotiate

Sales
terms that are not available to other customers
terms
(e.g. free delivery, generous credit terms).
Just as products make differential use of an organisation’s manufacturing and service-related facilities,
so too can customers. For example, if a manufacturing organisation can deal with a customer who places
highly predictable orders (e.g. standardised product specifications, fixed order quantities and a routine
delivery schedule), it can minimise the level of forecast error in its production schedule and reduce its
investment in finished-goods inventories.
Other examples of cost differences are shown in Figure 6.20.
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FIGURE 6.20 Other examples of cost differences between customers
Online sales may be cheaper and more time efficient than using a field-based
Distribution channel
sales force to market the organisation’s products and services.
After-sales service Some customers may require more ongoing service support.
For multiple products, there is likely to be a significant variation in the cost of

purchasing, manufacturing, storing and shipping the organisation’s products—
Product mix
so the mix of products purchased by each customer influences the total cost of
supply and overall customer profit margins.
Some customers may require an intensive marketing effort, whereas others buy
Marketing approach
the product simply on the basis of quality and price.
Customer characteristics such as inventory holding and reorder policies affect

Order processing
customer order-taking and processing costs.
The costs of quality control can vary between customers, as some customers
Quality
may demand higher quality than others.
Variations in order type and size and in delivery locations can affect the costs
Delivery
of delivery.
Some customers may need more intensive customer-relationship activities

Promotions and discounts
than others.
Financing Some customers may demand more liberal credit policies than others.
To manage its customer-service activities successfully, an organisation must have a good understanding
of the processes that drive customer-service costs and profitability. The costs of purchasing, manufacturing,
storage, order taking, delivery and after-sales service can vary widely across customers. Allocating these
customer-related costs using a volume-based measure, such as revenue, sales margin or orders processed,
may not correctly allocate or assign these costs to each individual customer or customer group.
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 6.21
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—for example, 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.
Table 6.8 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.
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 to identify strategies for
increasing the level of profits made. Figure 6.22 examines the four-way relationship between the net margin
earned from sales and customer-service costs.
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FIGURE 6.21 Performing customer-profitability analysis
Determine customers—at individual or group level?
Measure customer costs Determine Measure customer

or expenses (E) customer profit = R – E revenues (R)
Is customer profitable?
Improve customer
profit margins by
Increasing revenues
Classify, analyse and allocate Cost reduction strategies
customer costs. (e.g. fewer orders and
ABC approach? larger order sizes)
Types of cost Customer A Customer B Customer C

Direct materials, direct labour $ $ $
Order processing, distribution, rebates, promotion $ $ $
After-sales service,special inventory carrying
and credit $ $ $
Costs of the organisation’s salesforce and
sales management $ $ $
Total costs $ $ $
TABLE 6.8 High and low cost to serve customers
Cost category High-cost customers Low-cost customers
Pre-sales interaction High-level, pre-sales support via Low-level, pre-sales support with stan-
marketing effort, technical support dard pricing and simple specifications
and sales resources for each order
Product Customised products ordered Standard products ordered
Stock-holding requirements Requires supplier to hold inventory Customer holds inventory
Order placement Unpredictable order lodgment Predictable order lodgment

Small order quantities Large order quantities
Mode-of-order lodgment Manual Internet or other e-commerce systems

(e.g. B2B)
Delivery specifications Urgent delivery Delivery within mutually agreed time

Customised delivery frame
Variations in delivery requirements Standard delivery
from initial schedule Delivery schedule never departed from
Post-sales support Significant post-sales support Minimal or no post-sales support

required in terms of installation, required
training, trouble-shooting,
hotline support, field service
and warranty claims
Credit terms Slow in paying accounts Pay cash or on time if sales on credit
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FIGURE 6.22 Interaction between customer net margin and cost to serve
Customer type
Profits
High
Passive A Costly to service B
• Product crucial to customer • Pay top prices
• Good match to supplier
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 extent of customer profitability is dependent on the amount by which the

net margin realised from sale exceeds the customer-specific costs.
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 they need 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.
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
• in shorter production cycle times.
High customer-service costs could arise through:
• the customer’s unpredictable ordering pattern
• frequent changes to orders
• non-standardised logistics and delivery requirements
• significant after-sales technical support requirements.
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.
Customer profitability analysis, supported by ABC, highlights the specific costs of servicing a particular
customer and can motivate an organisation to:
• share this information with the low net margin and high service-cost customer in an attempt to modify
the buying behaviour of the customer to a less costly style
• give more explicit recognition to the net margin realised. This should prompt a change in the pricing
policy towards low net-margin customers, by removing discounts and other allowances or incorporating
a charge for the ‘special’ services in the price.
Quadrant B and C customers contribute to profitability in different ways. A customer in quadrant C,
while being relatively simple to serve, demands low prices and is prepared to change supplier solely on
the basis of pricing. On the other hand, a customer in quadrant B, while being relatively costly to serve, is
also prepared to pay top prices.
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
Pdf_Folio:374

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.
3. Association with highly reputable but unprofitable customers provides the credibility to do business
with other profitable customers.
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.
The steps to be followed in performing customer profitability analysis are shown in Figure 6.23.
FIGURE 6.23 The steps for customer-profitability analysis
2. 3.
1.
Measure the revenue Measure the full service
Identify the customers
from each customer costs of each customer
6.
4. 5.
Take action—increase
Determine customer Evaluate customer
revenues, reduce costs—
profitability profitability
and continue to monitor
CASE STUDY 6.13
Assessing the profitability of different customer segments

Martin Emmitt decides that HPD should undertake an analysis of the profitability of its customers. Martin
initially decides to examine three different markets for the division’s existing small household product
range (food processors). The three market segments are:
1. major nationwide electrical retailers
2. state-wide electrical retailers
3. small local electrical retailers.
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 this data is
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
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Sally Greene, HPD’s assistant management accountant, reports the following data for the latest year
ending 31 December:
Details of small household Nationwide State-wide Small local

product range retailers retailers retailers
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.
Activity area Cost driver
1. Order processing Number of orders
2. Line item ordering Number of line items ordered
3. Distribution Number of deliveries made
4. Cartons/pallets shipped Number of cartons/pallets shipped
5. Customer relations Number of hours of customer relations
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, but 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 the following table.
Costs in year ending Total cost driver transactions in year

Activity area 31 December ending 31 December
1. Order processing $300 000 6 000 orders
2. Line item ordering $210 000 52 500 line items ordered
3. Distribution $360 000 3 600 deliveries
4. Cartons/pallets shipping $330 000 66 000 cartons/pallets shipped
5. Customer relations $180 000 900 hours
Total costs $1 380 000
The number of transactions in each cost pool by the three types of customers during the latest year
ending 31 December is shown in the following table.
Nationwide State-wide Small local

Transactions retailers retailers retailers Total
1. Orders processed 600 900 4 500 6 000
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
4. Deliveries made 300 300 3 000 3 600
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5. Average cartons/pallets shipped
per delivery 150 20 5
6. Total cartons/pallets shipped

(4) × (5) 45 000 6 000 15 000 66 000
7. Customer relations hours 585 255 60 900
TASK
Martin Emmitt has asked you to provide information to management to help it make decisions
regarding customer profitability.
(a) Calculate the gross margin for each customer market segment and confirm each segment’s
gross margin percentage.

Details retailers retailers retailers Total
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 $__________ $__________ $__________ $4 380 000
$ $ $ $19 200 000
% % % 22.81%
(b) Determine the pool rate for each of the five cost pools.
Total Total cost driver Cost per driver transaction in

Customer service activity costs transactions year ending 31 December
1. Order processing $300 000 orders $ per order
2. Line item ordering $210 000 line items $ per line item
3. Distribution $360 000 deliveries $ per delivery
4. Cartons/pallets shipped $330 000 cartons/pallets $ per carton/pallet

shipped
5. Customer relations $180 000 hours $ per hour
(c) Determine the total customer service costs for each of the three market segments.
Nation wide retailers State wide retailers Small local retailers
Cost
driver Number Customer Number Customer Number Customer
trans- of cost service of cost service of cost service
Cost pools actions drivers costs % drivers costs % drivers costs %
1. order
processing $50.0 600 $ 6.7% 900 $ 21.4% 4500 $ 31.2%
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Nation wide retailers State wide retailers Small local retailers
Cost
driver Number Customer Number Customer Number Customer
trans- of cost service of cost service of cost service
Cost pools actions drivers costs % drivers costs % drivers costs %
2. line idem
ordering $4.00 12 000 $ 10.6% 13 500 $ 25.7% 27 000 $ 15.0%
3. distribution $100.00 300 $ 6.7% 300 $ 14.3% 3000 $ 41.7%
4. carton/pallet
shipping $5.00 45000 $ 50.0% 6000 $ 14.3% 15000 $ 10.4%
5. customer
relations $200.0 585 $ 26.0% 255 $ 24.3% 60 $ 1.7%
Total cost $ 100.0% $ 100% $
(d) Determine the most profitable market segment in dollars and by net margin. Compare the results
to those in task (a) and comment on any findings.

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 $_________ $_________ $_________ $3 000 000
$ $ $ $19 200 000
% % % 15.63%
Comments:
(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.
CASE STUDY 6.14
Customer profitability at the individual customer level

Martin Emmitt was surprised to find that the profitability of the small local electrical retailer market segment
to HPD was much less than expected after the customer service costs had been allocated. He was
unsure whether the customer profitability analysis meant that HPD should consider exiting the small
local electrical retailer market segment and direct its efforts to the remaining two segments. However,
John Chan, the marketing manager for the division, believes that the small local electrical retailer market
segment should still be serviced by HPD. Apart from strategic reasons (e.g. maintaining a strong product
profile in all markets), he believes that a more-detailed analysis of the small local electrical retailer
market segment may reveal quite adequate returns being generated from sales made to some individual
electrical retailers.
Sally Greene, 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.
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Details Mini-Electrical Home Appliances
Total orders processed 45 30
Average number of line items per order 10 15
Total number of deliveries 30 30
Average number of cartons/pallets shipped per delivery 8 4
Customer relations hours 0 6
Total sales revenue $30 000 $12 000
Total cost of sales ($16 500) ($7 500)
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.
TASK
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.
Transactions Mini-Electrical Home Appliances
1. Total orders processed 45 30
2. Average number of line items per order 10 15
3. Total line items (1) × (2)
4. Total deliveries 30 30
5. Average cartons/pallets shipped per delivery 8 4
6. Total cartons/pallets (4) × (5)
7. Customer relations hours 0 6
8. Sales revenue $30 000 $12 000
9. COGS ($16 500) ($7 500)
10. Gross margin $ $
(b) Allocate the customer service costs to each local retailer.
Mini-Electrical Home Appliances
Cost driver
transaction (see Number Customer Number Customer
the answers to of cost service of cost service
Cost pools Case study 6.13) drivers costs drivers costs
1. Order
processing $50.00 45 $ 30 $
2. Line item
ordering $4.00 450 $ 450 $
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Cost driver
transaction (see Number Customer Number Customer
the answers to of cost service of cost service
Cost pools Case study 6.13) drivers costs drivers costs
3. Distribution $100.00 30 $ 30 $
4. Cartons/pallets
shipped $5.00 240 $ 120 $
5. Customer
relations $200.00 0 $ 6 $
Total costs $ $
(c) Calculate the profitability of the two local retailers. Comment on your findings.
Details Mini-Electrical Home Appliances
Gross margin $ $
Customer service indirect costs ($) ($)
Net margin $ ($)
Net margin % on sales $ _____________ $ _____________

$ $
Comments:
(d) Identify and describe two strategies that could be recommended to HPD for managing its
relationship with individual customers.
Customer profitability analysis can provide valuable strategic management accounting information
as it:
• helps to identify unprofitable customers as well as unprofitable products
• helps to identify whether poorly performed customer service activities cause some customers to become
unprofitable
• directs managerial attention to different options for improving profitability, both for individual cus-
tomers and for products.
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
• 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.
Customer profitability analysis can also strengthen the impact of an organisation’s customer relationship
management (CRM) initiatives. CRM seeks to develop and foster long-term customer commitment by
ensuring that the customer’s needs are identified and satisfied. For example, CRM initiatives by financial
institutions have resulted in the development of tailored financial products that meet the needs of individual
customers, thereby helping to gain a greater share of each customer’s total spending on financial products
and services.
In many industries, a key driver of business value is the retention of the existing customer base. A study
of banks and other financial institutions suggested that acquiring a new customer is anywhere from five to
25 times more expensive than retaining an existing one and that increasing customer retention rates by 5
per cent increases profits by 25 per cent to 95 per cent. Yet, businesses that seek to grow often target new
customers and fail to address the retention of existing customers (Gallo 2014).
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For further practice in customer profitability analysis, please access Stage 3 of the ‘Save or close the
hotel?’ Business Simulation on My Online Learning.
REVIEW
Module 6 focused on how an organisation can manage its value chain more effectively. For superior
performance, managers must have access to information about their own internal activities, and about
the suppliers and customers who comprise their industry value chain. With this greater understanding,
opportunities for reconfiguring and improving value chain activities can be identified, analysed and
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 in the
following list.
• 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 (discussed
in Part A).
• Value is a function of revenue and cost. Strategic revenue initiatives focus on price and pricing strategies
like skimming and penetration (discussed in Part C). Strategic cost initiatives focus on cost reduction and
the efficient use of resources (discussed in Part D). While each of these strategic levers can be understood
independently, they are interdependent as both impact on profit. Any cost-saving or revenue-enhancing
initiative must be assessed for its impact on both cost and revenue, and therefore on profit.
• The Case study covered the practical application of the following strategic cost management concepts
and tools.
– Two techniques based on activity analysis—ABM and ABC—help to develop organisational under-
standing about the sequencing and cost of value chain activities, and to develop targeted strategies for
improving the performance of the value chain. Where it is operationally and economically feasible
for non-value-adding activities to be eliminated, or for the efficiency of value-adding activities to be
improved, an organisation should be able to reduce its total value chain costs (discussed in Part B).
– Strategies for improving the performance of an organisation’s value chain can involve either the major
re-design of activities (BPM) or fine-tuning of existing activities (CI) (discussed in Part D).
– Understanding the behaviour of product life cycle costs is important for determining when and where
the most significant cost-reducing opportunities occur. Greater opportunities for achieving better cost
performance typically exist within pre-production activities (discussed in Part D).
– Target costing assumes selling prices for new products are set by the market and that to achieve
desired profit margins, product costs must be at or below a target cost (discussed in Part D).
– Kaizen costing provides the focus for achieving in-production cost improvements and can be
beneficial in ensuring that standard cost targets are continually challenged.
– In knowing the nature and magnitude of supplier-related costs, managers can identify and evaluate
different strategies for obtaining required inputs at a lower overall cost (discussed in Part D).
– 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 (discussed in Part E).
– 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) (discussed in Part E).
– 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 (discussed in Part F).
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This module has demonstrated 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.
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SUGGESTED ANSWERS
MODULE 1
QUESTION 1.1
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—for example, 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 provision of a broader range of non-financial measures, business support and
involvement, the role continues to change and develop to stay relevant.
QUESTION 1.2
Goal Strategic management accounting information
Strong leadership • Corporate plan

• Value chain analysis
• Porter’s five forces analysis
• SWOT analysis
• Cost of capital analysis
Healthy and • Council events per annum—mainstream
inclusive • Council events—ethnic focus
communities • Council events for children, young adults and seniors
• Early learning and preschool facilities
Quality places and Establish maintenance budgets to keep facilities in good working condition, including
spaces playgrounds, community centres, parks and gardens.
Growth and Provide budgets and forecasts in relation to the availability of resources to fund community
prosperity activities and developments. Measure the actual outcomes, compare them to the desired
outcomes and identify reasons for any discrepancies. Help develop action plans to fix
any problems that have occurred. Measure the number of people receiving training and
graduating, as well as the cost of providing this training.
Mobile and Cost various traffic management systems, including new roads, traffic lights and road
connected city 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.
Clean and green Establish benchmarks of acceptable levels of environmental resource usage, pollution and
contamination, and other relevant data. Develop performance measurement systems that
collect, collate and communicate performance in these areas.
Note: These answers are not exhaustive.
QUESTION 1.3
1. An organisation will be able to purchase imported raw materials, or manufacturing parts at a lower cost,
because its currency is able to purchase more foreign currency than before. Having lower costs may enable
the organisation to pass on price cuts that solely domestic competitors might not be able to match. If the
price cuts are not passed on to customers, then profits will increase.
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.
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SUGGESTED ANSWERS 403

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.
Note: Other issues may also exist and the opposite is typically true if the local currency becomes weaker.
QUESTION 1.4
The answer to this question will depend on the organisation chosen.
To provide a simple example of the effect of globalisation, imagine a manufacturer of packaged soup
noodles, with a good standing in its national market. Perhaps growth has now slowed because the local
market is becoming full of low-priced competitors. Meanwhile, its customers are becoming attracted to
new imported brands of soup noodles from another country. Restrictions on trade and transport costs are
no longer an impediment, as both road and air freight have improved considerably.
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.
QUESTION 1.5
Technological development Effect on management accounting
1. Capital intensive investment. Investment in technology Accurate cash flow planning and management
often requires significant amounts of cash. is essential to ensure stability.
2. Shorter product life cycles. Products exist for a much Appropriate pricing, product characteristics
shorter period than in the past, as they are superseded and life cycle costing are essential to ensure
by technological developments. At the same time, greater an appropriate return.
investments in technology are required to keep up with
the competition and ensure that returns on investment
are recouped in the shortest time possible.
3. Automated sales, production and farming methods. Project estimations and evaluations must be
Technologies are reducing the amount of manual labour more accurate, and effective allocation of
required, which changes the nature of costs from variable overhead is essential.
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.
4. Information. Vast amounts of information may now be Management accountants have had to give
stored, tracked, analysed and communicated across up their role as information gatekeepers and
multiple locations in a short time. transfer the power to access this information to
other employees throughout the organisation.
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404 STRATEGIC MANAGEMENT ACCOUNTING

QUESTION 1.6
Advantages Disadvantages
1. Risks may be shared with, or transferred to, 1. Anticipated cost savings are often not realised—
another organisation. this can occur because of the extra time and cost
required to manage the outsourcing relationship
and because of inaccurate estimates.
2. Using outside specialists may be more efficient 2. Outsourced organisations may not be able
and more cost-effective. to provide an acceptable level of service or
performance.
3. Managers no longer have to spend time directly 3. Organisations may lose core business
managing the parts of the organisation that have knowledge, intellectual capital or property
been outsourced—this will give them more time or control of their value-generating activities.
to focus on generating value in the areas where
they are most competent and comfortable.
QUESTION 1.7
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 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 1.8
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 Porter’s five forces analysis would need to focus on these strategic business units separately.
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—for example, 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.
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• 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.
• Alternative or substitute products—Substitute products are not generally provided by direct competi-
tors 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 made 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 and 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.
Note: A hypothetical organisation in the telecommunications industry was chosen, because it provides
a ready basis for illustrating the competitive forces at work and information is easily sourced in the
public arena.
MODULE 2
QUESTION 2.1
Kim has two issues to resolve:
1. identify whether all the new board members are in the same stakeholder group
2. consider how to determine their information needs.
To identify whether all the board members should be treated as equivalent stakeholders, Kim will want
to discover whether any of the board members are executive directors (i.e. attend the office from 9.00 am
to 5.00 pm each day), and whether any of the board members have special committee responsibilities that
require them to have additional information—for example, for audit committee, remuneration committee.
It is likely that as internal stakeholders, the members on committees will require additional information, but
as members of the board, they can be treated as a stakeholder group. This is consistent with the stakeholder
grid in Figure 2.2, which places them in the high power/high interest quadrant.
To determine the main kinds of information they will need, Kim should first consider the information
needs in Table 2.2. This suggests that all board directors will require information about financial
performance, strategy, competitive position and issues of concern. The stakeholder approach is incomplete
and there may be adequate information already available and routinely provided to previous directors,
so this can be separately considered. There will be some specific additional information based on board
committee roles, and these can be investigated separately (using methods discussed in Part C and D of
this module).
QUESTION 2.2
(a) In respect of the two new managers, Kim should find out what their roles responsibilities are and
what information would be of value to them. Unlike the directors, whose information needs will cover
tactical and strategic information, the two managers (assuming they are mid‐level management) are
likely to require tactical information dealing with goals and objectives, detailed performance targets,
budgets and organisational priorities.
In terms of fostering efficiency and effectiveness of information management, Kim should expect
to find that there will be information common to both sets of users and differentiated information to
satisfy the specific needs of the respective users’ job responsibilities.
Finally, Kim will want to use the stakeholder grid and risk analysis to determine whether there are
any communication or risk factors that should receive attention.
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(b) The soft skills that the management accountant should develop are around working with the new
managers. To do this, the management accountant will have the ability to collaborate by developing
and managing relationships with the new managers to understand their needs and ensure information
is available to help the new managers settle into their new roles.
However, to be able to do this the management accountant will need to show the ability to apply
professional judgment to help the new managers to anchor their business decisions taking into account
the information available to them.
The management accountant will assist the new managers to have the ability to influence decision-
making by being a trusted partner.
So developing a trusted adviser position with managers is the soft skill goal.
QUESTION 2.3
It is true that ERP systems have now been around for such a long time, and over the past 10 years
they have become fully featured and extremely reliable. However, the decision to install an ERP system
requires careful analysis. Just because they are reliable and proven does not mean they are suitable for
most organisations.
There are many ERP systems. Large-scale ERP systems such as Oracle and SAP are designed for large
organisations—that is, organisations that have many sites, usually in many countries, and a business with a
large number of products or services. These systems have high purchase costs, high installation costs and
high maintenance costs. So, to ensure benefits exceed costs, it is necessary that they are used for most if
not all the business processes in the organisation.
There are also ERP systems for smaller organisations. It is more likely that a smaller organisation will
not select all the modules, and it is also likely that the smaller ERP system will not have the same amount
of functionality as the large-organisation ERP packages. In part, this is due to the fact that the smaller ERP
packages are often specific to different industries. For example, there are small-to-medium ERP packages
for universities, which focus on their student admission, enrolment and progression. There is no reason for
a small-to-medium business to have an ERP system. The managers are more likely to know the intricacies
and details of the business outside their own department and so will receive little value from having to
standardise their business processes.
QUESTION 2.4
(a) The most important information that the ERP system should be able to provide is the sales and profits
by store location. This will help to identify the least profitable stores that might be closed and the
potential savings in rental costs and staffing.
Sales by product information would also be available from the ERP system. This would enable
judgments to be made about which were the highest volume and/or most profitable products that could
be sold online.
In addition, the CRM system should have information on customers including their lifetime value,
satisfaction, buying trends and location. This information could provide information to support
decision-making about the location of the central warehouse, ideally in proximity to the largest number
of (or largest number of most profitable) customers. Customer buying behaviour could also inform
decision-making about the product range to be carried online.
(b) Broad-ranging research from available statistical and industry sources might provide a ‘big picture’
of the growth of online sales relative to in-store sales to inform a long-term view for the board of the
continued viability of the retail stores.
Tim would need to undertake a price comparison between the prices charged by the existing online
competitors and estimate by how much T&S prices would need to be reduced in order to compete.
Tim would then need to undertake a study to determine an estimated cost to develop an appropriate IT
system to enable online purchasing by customers. An estimate of costs to acquire or build a warehouse
would also have to be carried out, together with an estimate of the necessary staffing, marketing and
promotion costs and means of distribution of ordered products to customers. This would require a
detailed capital expenditure evaluation to be carried out.
Note: Much of the information sourced externally by the management accountant could be available
if T&S had a DSS.
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QUESTION 2.5
Tina needs to conduct further discussion with the managers to discover:
1. whether the policy on train length allows the length of the train to be increased or reduced by changing
the number of carriages
2. the relationship between the number of carriages, passenger numbers and revenues
3. how important revenue measures are to the managers in providing strategic management accounting
4. what is the extent of forward planning in the TPS.
Tina could apply Drucker’s four questions (Drucker 1964) to strategic management accounting to
discover what information managers believe they are missing that would allow them to improve the
efficiency of operations—both for trains and bus substitution.
One approach Tina could suggest is attending the next meeting with the regional managers to understand
their concerns and the ways they use the existing information. This may result in the need to source
information from different sources and/or integrate it. For example, costs change when buses are running
but there is no change to the revenue (fares). Tina needs to consider the possibility that the managers are
concerned about the qualitative attributes of information, so she may explore the four-way classification
of information (see Figure 2.4) with managers.
QUESTION 2.6
Big data uses large data sets for analysis. StreemMov offers a subscriber service where membership entitles
the member to access programs by logging on through their account that acts as the identification and
billing method, which will generate considerable information about customer buying preferences.
Bono therefore makes three recommendations:
1. Collect data that identifies customers and ensures appropriate security and privacy protection.
2. Use the billing and service details to provide predictive suggestions about other services that may be of
interest to the particular customer. This will require predictive models.
3. Use aggregation of customer data to perform trend and pattern analyses. This can be used to ensure that
StreemMov have appropriate products and capacity to provide services.
Bono may also make suggestions that BI could be used to improve StreemMov’s own decision-making,
if it is felt that improvement is warranted.
QUESTION 2.7
(a) How could Ally deal with Ally has been quite diligent in understanding how she spends her time,
the ad hoc requests from and it shows that about 55 per cent of her time is spent helping managers.
stakeholders? Ally has also recognised that much of this time spent with managers is
responding to their specific ad hoc requests and has not been developing
relationships with them. They are reluctant to speak with her when she
attempts to book time with them.
(b) How could Ally approach the There are two possible approaches Ally could take, based on the infor-
line managers and improve mation in this part of the module. The first is to embark on an information
her professional relationship needs analysis, which would take up the time of managers who are already
with them? reluctant to assist. One possibility is that Ally uses the time spent with
managers on answering their ad hoc queries to identify ways in which she
can gain a better understanding of their information needs, which may
then enable her to provide more useful information in the first place. If the
majority of the managers’ queries relate to making decisions, then Ally
could ask whether the managers are interested in completing the log on
decisions they make and information needed.
The alternative approach is to keep track of their information requests
and then compile their requests into the types of information they need
and compare that with what information they receive. Ally would need to
treat it as a small project and develop a project plan to estimate the time
that she would need to spend and the total duration of the project. This is
because it would be important to be able to tell the manager up-front what
her demands on their time will be and when they can expect to see some
results/suggestions.
Pdf_Folio:408

In either of these circumstances, it is always possible that there will be
some managers who are interested in the approach Ally proposes and
some who are not. Ally can work with the interested managers. She
will then be able to demonstrate the achievements to the disinterested
managers.
QUESTION 2.8
Identify the information needs for each of the three levels of manager at GoodsFast.
Strategic This level is concerned with long-term issues of the business direction, which will assure its
revenues and allow it to manage costs. Strategic revenue questions involve what will ensure the
competitive advantage of GoodsFast in the future in terms of its customers, delivery arrangements
and changes in technology that may create challenges or opportunities. Tom will recognise that
external information will be required in addition to the information he can provide to ensure that
strategic management of costs is concerned with improving performance and containing costs so
that the strategic position of the firm is improved overall.
Tactical These are primarily logistics decisions covering arrangements for pickup and delivery of the
parcels. There are some that ensure there are contracts with couriers to pick up and ship parcels
to the destination state and suburb. These arrangements depend on having sufficient drivers and
trucks available for the number and volume of materials. Other middle manager decisions include
staffing each location (branch, shopfront, warehouse) and ensuring adequate supplies. GoodsFast,
like most shopfront packing services, makes additional revenue out of selling packing boxes and
packing material (e.g. bubble wrap) because their clients bring in the package for wrapping as
otherwise any breakage becomes their responsibility. So, having sufficient supplies in stock is
essential, otherwise they incur costs when they have to upgrade the packing to a higher level as a
result of a stock-out.
Operational These are primarily the decisions about accepting orders from customers to consign their parcels,
and determining the method of transport, pickup and delivery.
QUESTION 2.9
This will be a difficult assignment for Anna because the CEO is biased towards the AIS that he previously
used, and it is likely that Anna will begin by suggesting amendments to the reports.
To meet the CEO’s needs, it should not be overly difficult to provide a drill-down facility so that the
CEO can trace from report totals down to individual transactions; every accounting system is comprised
of transactions, so drilling down should not be a problem. Minor modifications to reporting should also be
fairly easy to accommodate the CEO’s need for ratio calculations and trends, without making significant
changes to the information system as these needs are no more than manipulations of data that already exists
in the accounting system.
Generally speaking, before recommending a new system it is wise to try and improve the existing system.
Anna should sit with the CEO to understand the deficiencies in the reports that he receives. She can then
check with the other recipients of the same reports and see whether they too have found deficiencies. Anna
can synthesise the information needs of all the managers and go back to the CEO with a mock-up of a better
designed report. She may have to repeat this several times to get a suite of reports that are acceptable to
the CEO.
In doing so, Anna may determine that the required data is either not input or not calculated—so some
programming changes may also be necessary. It will be necessary to establish the budget for making the
changes, and ensure that the CEO agrees to it otherwise the CEO may perceive her as not following systems
development protocols.
There may be several iterations of these improvements. Eventually, Anna will be able to make a
judgment whether the existing system is still capable of being improved, or whether she has reached its
limits and it is time to consider a replacement. The important thing is that the costs of these refinements
and enhancements are small but the payback in terms of better reporting is high. If Anna is able to improve
these reports in the short term so they are satisfactory, then they can become the baseline for any new
system (should one be proposed). This will encourage Anna and the managers to consider what new level
of functionality for the business should be delivered by any new system.
Pdf_Folio:409

Depending on what additional reports are called for by the CEO, it may be possible for her to visit the
CEO’s former firm (depending on the circumstances) and see examples of the reports to get a comparison.
This is known as benchmarking. If it is not possible then the CEO may be able to use his contacts to find
another organisation that uses the software and that Anna can visit. The reason this is suggested is that if
Anna believes the CEO is unlikely to give up pushing for the larger system, it would be wise for her to
start to understand it now, even though any decision may be two or more years in the future.
MODULE 3
QUESTION 3.1
Although Kabuki Ltd has the capacity to convert 15 000 units per year, the forecast demand is only 5000
units. Therefore, the forecast sales should be set at 5 000 units. In making this decision, the following
factors were considered:
It is not sensible to supply 15 000 units if there is only a demand for 5000. The market has changed
significantly and there is no guarantee that Kabuki will achieve its past success. If the organisation produces
15 000 units and is not be able to sell them, this will result in significant losses. They will incur unnecessary
costs in producing the final product that they will not be able to recoup from selling the products. If such
products are produced, they will end up in inventory, which will cost Kabuki Ltd more money as they will
have to store the inventory and incur many other costs related to inventory. Further, there is the risk that
the inventory may be damaged or become obsolete and has to be written off. Also, they may try to sell the
products at a reduced price, but that is also very risky.
Therefore, Kabuki should not budget to manufacture to full capacity but only to the sales demand. Should
it become apparent in the next year that they are able to sell more units than budgeted for, they will be able
to manufacture and sell it as they have the capacity.
QUESTION 3.2
In most modern businesses, the finished goods inventory budget will be directly linked to the following
operating budgets:
• direct materials
• direct labour
• manufacturing overheads
• sales.
In order to minimise finished good inventory, the sales budget ‘pulls’ from the finished goods inventory,
which requires the direct materials budget to be directly linked to the production budget.
QUESTION 3.3
The closing balance of cash at bank in the budgeted balance sheet is the closing cash figure in the cash
flow budget as at the end of the forecast period. This balance is determined by adding the cash inflows for
the period to the opening cash figure in the beginning of the period, and subtracting the cash outflows for
the period.
QUESTION 3.4
(a)
Sales volume 10 000 units
Sales—10 000 × $150
[!h] $1 500 000
Opening inventory 0
Direct material costs—12 000 × 1.2 × $40 $576 000
Direct labour costs—12 000 × 30 / 60 × $25 $150 000
Variable manufacturing overhead costs—12 000 × 30 / 60 × $9 $54 000
($9 = $720 000 / 80 000 hours)
Total cost of goods available $780 000
Less closing inventory 2000 × (48 + 4.50 + 12.50)† $130 000
COGS $650 000
Less fixed manufacturing overhead costs—$2 568 000 / 12‡ $214 000
Operating profit $636 000
† Valuing the closing inventory:
Pdf_Folio:410

• Material cost per unit = 1.2 × $40 = $48.
• Labour cost per unit = (30 / 60) × $25 = $12.50.
• Variable overhead per unit = (30 / 60) × $9 = $4.50.
• No fixed overhead is added here. Fixed overhead is a period cost in the static budget.
‡
Fixed overhead in a static budget is a simple device to start the analysis. For this part of
Question 3.4:
• Fixed costs do not change with volume. Regard the fixed overhead as a period cost (see ‘Step 8:
Period costs budgets’).
• Fixed overhead reduces the operating profit for the month. The layout shows how the fixed
manufacturing overhead reduces the operating profit.
• Monthly charge for fixed overhead: divide the year’s fixed overhead by 12 to calculate the monthly
fixed overhead. This number of $214 000 is then used in part (b) of this question for the fixed
manufacturing overhead production volume variance.
(b)
Sales price (AP – BP) × AQ
variance April sales: ($130† – $150) × 5000 = $100 000 U
May sales: ($160 – $150) × 9000‡ = $90 000 F
Total sales price variance = $10 000 U
Sales volume Budgeted quantity is 5000 for April and 10 000 for May Budgeted contribution margin
variance per unit calculation:
Selling price $150
Direct material cost 1.2 kg × $40 = $48
Direct labour cost 30 / 60 × $25 = $12.50
Variable overhead cost 30 / 60 × $9§ = $4.50
Contribution margin $85
(AQ – BQ) × Bcm
(14 000 – 15 000) × $85
= $85 000 U
Direct material Actual quantities of raw material used
price variance Casual labourers: (2000 units × 1.2 kg) = 2400 kg
Permanent labourers: (14 000 × 1.1 kg) = 15 400 kg
Total actual quantities used = 17 800 kg
(AQ × AP) – (AQ × BP)
= (17 800 × $44) – (17 800 × $40)
= $71 200 U
Direct material (AQ × BP) – [(BQ of raw materials × AQ produced) × BP]
efficiency = (17 800 × $40) – [(1.2 × 16 000) × $40]
variance = $712 000 – $768 000
= $56 000 F
Direct labour Calculate actual quantities of labour hours used:
price variance 1. Casual labourers: (2000 units × 30 / 60) = 1000 hours
1000 units rework here
1000 × (30 / 60) = 500 hours
Total = 1500 hours
2. Permanent labourers: (12 000 units × 20 / 60) + (2000 units × 30 / 60) = 4000 + 1000
hours = 5000 hours
Total actual labour hours used = 1500 + 5000 = 6500 hours
(AQ × AP) – (AQ × BP)
= [(Casual: 1500 × $20) + Permanent: (4000 × $25 normal hourly rate) + (1000 × $37.50
overtime rate)] – [6500 × $25]
= ($30 000 + $100 000 + $37 500) – $162 500
= 167 500 – 162 500
= $5000 U
Direct labour (AQ × BP) – [(BQ labour × AQ units produced) × BP]
efficiency = (6500 × $25) – [(30 / 60 × 16 000 units manufactured) × $25]
variance = $162 500 – 8000 hours × $25
= $162 500 – $200 000
= $37 500 F
Pdf_Folio:411

Variable Calculation of variable overhead allocation rate:
manufacturing Cost driver is direct labour hours
overhead Total cost / cost driver
spending = $720 000 / 80 000 hours
variance = $9 per hour
Actual results – (AQ × BP)
Actual quantity of labour hours used was determined above (6500 hours)
$60 000 – (6500 × $9)
= $60 000 – $58 500
= $1500 U
Variable (AQ × BP) – [(BQ rate allowed × AQ units produced) × BP]
manufacturing = (6500 hours × $9) – [(30 / 60 × 16 000 units manufactured) × $9]
overhead = $58 500 – 8000 hours × $9
efficiency = $58 500 – $72 000
variance = $13 500 F
Fixed Actual result – Static budget
manufacturing = $220 000 – $214 000
overhead = $6000 U
spending
variance
Fixed Calculation of fixed overhead allocation rate:
manufacturing Cost driver is direct labour hours
overhead Total cost / cost driver
production = $25 680 000 / 80 000 hours
volume variance = $32.10 per hour
Static budget – Allocated: (Budgeted hours per unit × AQ units × Budgeted

rate per hour)
= $214 000 – (30 / 60 × 16 000 units × $32.10)||
= $214 000 – $256 800
= $42 800 F
† Selling price = $150 less discount $20 equals April backlog selling price for 5000 units = $130.
‡ Actual sales (May) = 10 000 (budgeted sales for May) – 1000 (lost sales due to price increase) = 9000 units
§ Variable overhead allocation rate = total cost $720 000 / 80 000 hours = $9 of variable overhead to be allocated per labour
hour.
|| For this calculation, the company needs to decide whether the COGS was charged more or less than the monthly fixed overhead
of $214 000 (part a). To do this, an application rate of $32.10 for the 16 000 units means that $256 000 is charged. This is more
than the monthly fixed overhead of $214 000. The company has over-applied the fixed costs to the COGS. Over-applied fixed
costs are favourable.
(c) Causes for variances The sales price variance will be negatively affected by the $20 discount per
in sales unit for the 5000 backlogged April units, so there is an unfavourable variance
of $100 000. On the other hand, selling 9000 units at $10 per unit more than
budgeted will result in a favourable price variance of $90 000. However, it is
questionable whether the sales manager should have increased the selling price
due to the increased price of the raw materials. The organisation has a large
enough contribution margin that it could be argued that they should not pass the
increased cost on to the customers. Due to this, 1000 units have not been sold
and are now part of the inventory, which may cost the organisation additional
costs to carry. Further, customers were lost, and it is uncertain whether the
organisation will be able to win them back.
The sales volume variance can be explained as 15 000 units that should have
been sold according to the budgets (5000 backlog for April and 10 000 units for
May). However, only 14 000 units were sold, resulting in a decrease in revenue of
$150 000 ($150 for 1000 units).
Causes for variances The purchasing and use of a superior quality of raw material will result in a
in direct material favourable direct material efficiency variance. However, because the purchase
price of this material is $4 per kilogram more expensive than the budget, the direct
material price variance will be unfavourable.
Pdf_Folio:412

The permanent labourers were more efficient than forecast and used 1.1 kg per
unit instead of 1.2 kg per unit. This contributed to a favourable direct material
efficiency variance. As the permanent staff made 14 000 units at 1.1 kg per unit,
compared to casual staff who made 2000 units at 1.2 kg, the material efficiency
variance was overall favourable.
Causes for variances The direct labour price variance has a few explanations. First, casual labourers
in direct labour were paid $5 per unit less than the permanent labourers, resulting in a favourable
price variance. However, they had to redo 1000 units they made, and therefore
$20 for 1000 cost was a waste, contributing to an unfavourable price variance.
Second, the fact that permanent labourers had to work overtime at
time-and-a-half ($37.50) contributed to an unfavourable price variance. However,
since a better quality of raw material was purchased, the permanent labourers
spent less time manufacturing units (12 000 units at 20 minutes), resulting in a
favourable efficiency variance. Having had to redo 1000 units, the casual labourers
contributed to waste. Despite this waste, the efficiency of the permanent staff
was larger than the waste of casual labour and overtime. A favourable efficiency
variance remains.
Causes for The actual variable manufacturing overhead cost was $60 000. The actual hours
variances in variable worked were 6500 hours. Using the actual hours and a rate of $9 per hour means
manufacturing that the applied variable overhead was lower than the actual overhead. The
overhead spending variance is unfavourable.
The efficiency variance measures how many hours were actually worked
(6500) compared to the 8000 hours to make 16 000 units. The efficiency of the
permanent staff more than offset the inefficiency of casual staff and overtime,
resulting in a favourable efficiency variance.
Variable overhead costs consist of all the indirect overhead costs incurred, such
as indirect material and labour, and any other common variable manufacturing
costs that are not directly under the control of any particular production
manager. Consequently, these costs are allocated. To understand the variable
manufacturing overhead spending variance, the management accountant could
break these costs up and investigate each line item. It is possible that some items
will exceed the budgeted costs while other will beat the budgeted costs.
Causes for variances The fixed manufacturing overhead spending variance could be due to renting or
in fixed manufacturing leasing storage for the increased inventory.
overhead
(d) Sales manager Sales price and sales volume variance

As both are unfavourable, it would appear as if the sales manager should not receive
a bonus. The unfavourable sales volume variance can be explained in part due to the
reduced number of units sold. Including the 5000 backlogged April units, 15 000 units
should have been sold, but only 14 000 units were sold. This is because customers
bought their products from the competitors, due to the increased sales price. Thus,
the organisation lost revenue of $150 000 (1000 units × $150). However, the sales
volume variance is determined using the contribution margin. When analysing this
variance, the deviations in the variable costs (both direct and indirect) should be
considered as well. The latter is not under the control of the sales manager.
The unfavourable sale price variance is due to the reduced price applied to the 5000
units not able to be manufactured and sold in April. It is understandable that the sales
manager would have offered a reduced price in order to retain the customers. However,
the decrease is 13.33% (20 / 150), and it could be argued that this is too high. Perhaps
5% would have been sufficient. The sales manager should understand these customers
and in theory should be the best person to judge if this would have convinced them to
stay with the organisation.
In summary, the unfavourable variances are both due to the sales manager’s decision to
change the selling price per unit. Unless they can provide plausible and sensible reasons
to justify their decision, the sales manager should not receive any bonus.
Pdf_Folio:413

Production Direct material, direct labour[!h]
efficiency and the direct labour price variance
manager It appears the product plant operated efficiently as both direct material and labour
efficiency variances are favourable. The reasons they are relate to the superior quality
of the raw material, resulting in the permanent labourers using less material and labour
time to manufacture the finished product.
In evaluating the performance of the production manager, these three variances should
be looked at simultaneously. In this example, when offsetting the unfavourable direct
labour price variance against the two favourable efficiency variances, overall, the
variances are favourable. However, only looking at the final figures in these variances
does not expose the underlying causes of the variance, so the decision whether to
pay a bonus should not be made on the basis of these figures. In this example, the
unfavourable labour price variance is due to the fact that the permanent labourers had
to work overtime to ensure the finished products were made on time, so that they could
be sold on time and so that having a backlog as happened in April could be avoided.
However, the question should be asked as to why they had to work overtime. Was it to
finish the goods on time, or was it because of the inefficiencies of the casual labourers?
The casual labourers caused the organisation to lose profit, as they had to redo 1000
jobs, wasting material and labour costs. The process of their appointment needs to
be investigated. Who was responsible for their appointment—the production manager
or the HR department? Were they appointed due to poor or hasty decisions? The
organisation can learn from this to ensure better communication and coordination in the
future. Perhaps it would have been better to negotiate with the customers—for example,
by informing them that the products would not be manufactured on time and offering
them a reduced price.
In summary, it would appear that the production manager managed the department well
and therefore should be awarded a bonus.
Purchasing The direct material price variance
manager This is unfavourable, and it would appear that the purchasing manager should not
receive a bonus. However, the product purchases are of greater quality than budgeted
for, which resulted in both the direct material and direct labour variances being
favourable, as less material and fewer hours per unit were used. This also resulted in
a better quality of product, which justifies the increase in the purchase price of the raw
material. In theory, an increase in the quality of the product should justify an increase
in the selling price. However, 10% of the customers included in the budgeted sales for
May (1000 / 10 000 units) did not respond positively to the increase in the selling price.
Further analysis of the changes in manufacturing costs per unit and thus the contribution
margin should be done to determine how much of the increased cost of direct material
should be passed on to the customers and what a reasonable increase in the selling
price should be. In this example, it would appear that although the variance is in costs
that the purchasing manager is responsible for, they still might be eligible for a bonus
because their decision had favourable consequences.
QUESTION 3.5
(a) The figures Martin provided are not challenging and realistic. The Akimo production department has
already achieved these levels, as demonstrated in the April actual results.
Total kilograms direct materials used: 2736 / 144 units = 19 kg per table
Total direct labour hours spent: 52.5 hours / 144 units = 21.875 minutes per table
Total machine hours used: 110 hours / 144 units = 45.83 minutes.
Martin probably chose these figures so that the Akimo department will be able to achieve the budget
easily, resulting in favourable variances, which will give him a positive performance evaluation and
ultimately a bonus.
(b) The following ways may be considered to illustrate to Martin that the budgeted figures he provided
are easy to achieve.
• Since Akimo is only one department of Ariel’s operations, there might be other departments that
may be used as benchmarks.
• If available, industry averages may be used.
Further, Martin needs to be made aware that his actions are not ethical.
If Martin does not respond well to these suggestions, the situation may be escalated up the hierarchy.
Pdf_Folio:414

(c) Top management may appoint an independent person, such as a consultant, to conduct studies on
the efficiency of the Akimo department, so as to better understand the operations. If it is found that
the figures Martin provided are indeed too lenient, they could use these studies to encourage him to
improve his management of the Akimo department.
They could also reward the performance of the Akimo department (and consequently Martin’s
bonus) only if it increases productivity and not when it beats the budget.
Further, they could also find out what intrinsic factors motivate Martin so as to make decisions
whether to award Martin with monetary or non-monetary incentive schemes or both. They could award
Martin’s performance only if he sets accurate budgets.
QUESTION 3.6
(a) The standards set for the following year’s budget are considerably higher than those used in the previous
year (in Question 3.5). Further, due to the changes in the design of the table, use of different material
and reduction of material quantities and machine hours, Martin may feel unsure as to whether those
standards will be met, even though employees will receive training. This is further escalated by Martin’s
belief that the company will not achieve the budgeted profit. It is therefore likely that Martin may think
it will be challenging to meet the standards and he may be concerned that he will lose his bonus.
From this perspective, it appears that Martin’s behaviour could be viewed as deceptive—he lowered
the standard to meet the budget, have a favourable performance evaluation and receive a bonus. He has
misrepresented the Akimo department’s capabilities.
Potential drivers of Martin’s behaviour and decisions could include self-interest and fear of losing
his bonus. Martin’s goal (to lower the standards so that he can get a bonus) is not aligned with that
of the organisation (to have realistic standards to ensure the company remains sustainable)—so there
appears to be an absence of goal congruence.
(b) This is not an easy issue to deal with, because as it has potential to create a challenging internal political
situationofpowerandgameplaying.Ifthepurchasingmanagersuspectsdysfunctionalbehaviour,hecould
refuse to change suppliers. If, however, the purchasing manager coheres with Martin, the management
accountant may detect budgetary slack when analysing the direct material price and efficiency variances.
The labourers may report Martin’s leadership. First, he instructed them to improve their efficiency, work
harder and ensured they received adequate training. They would have learned new skills that could have
given them intrinsic rewards such as job satisfaction and knowing that they are capable of performing at
a higher level. However, then Martin instructed them again to work slower. They may feel undervalued
and criticised, which may encourage them to report Martin’s expectations to a higher hierarchy.
(c) Due to the redesign of the Akimo table, less raw material is required. This will be represented in the
standards set in the budget. However, the budget will be based on buying material with a superior
quality from the new supplier at an increased price. Therefore, if the cheaper and inferior material
is purchased, the direct material price variance will be favourable but the direct material efficiency
variance will be unfavourable. Further, the inferior quality of raw material will result in an unfavourable
efficiency variance. If the labourers used the inferior material, there could be waste or rework required,
which would then lead to an unfavourable direct labour efficiency variance.
MODULE 4
QUESTION 4.1
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 that need coordination, and this can be particularly challenging.
Pdf_Folio:415

While these characteristics set projects apart from day-to-day operations, they are not necessarily all
present in each project, but they do provide a guide for helping to distinguish projects from the operational
activities present in most organisations.
QUESTION 4.2
Project stage Management accountant’s role
Stage 1: Project This stage focuses on the objectives and scope of the project. Included in this
selection 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.
Stage 2: Project Project planning adds more depth to the project selection analysis. This addresses
planning five key areas:
1. scheduling
2. optimising cost and time
3. budgeting
4. performance measurement
5. incentives.
Stage 3: Project At the implementation stage, progress against the set deliverables and dates are
implementation and monitored and variances are examined. This provides information for management
control to take actions to reduce the variance between actual and budgeted outcomes
where necessary. The management accountant is often responsible for this
scorekeeping role. Additionally, the project plan deliverable dates and budgets may
need adjustment due to the emergence of new information or risks. Finally, analysis of
the cost involved in crashing project activities can be done to determine whether the
cost–time trade‐offs are feasible.
Stage 4: Project This is when all the objectives of the project have been delivered. The management
completion and review accountant is responsible for the final reporting and closing project accounts during
this stage. A key aspect of this stage is knowledge management, and the final project
report must incorporate this.
QUESTION 4.3
Explanation
Project organ- A collaboration could be either. It depends on whether the project is related to the core
isation or within activities of the organisation (such as a building project for a construction organisation) or
organisation not (such as the development of a new IT solution).
QUESTION 4.4
Explanation
Project sponsor 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.
Project manager Has functional responsibility for the project, including planning, execution and delivery of
the project, as well as managing the day-to-day project operations.
Project team Undertakes 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.
Pdf_Folio:416

QUESTION 4.5
Do you think the project

has strategic fit? Yes
Explain why or why not? 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 that 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 experienced staff of higher quality and ability (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, but it goes beyond the basic strategy of the
SSB and also addresses legal and regulatory requirements.
QUESTION 4.6
Stakeholder Stages of the project
1. Client 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.
2. 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).
3. Suppliers Suppliers of your construction materials and internal fittings are vital throughout the
implementation of the project, so detailed planning for these needs to be done prior
to commencement.
4. Community and As the project takes place in a suburban community, the needs of the community
society 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 during the project—for example, provision of
parking bays.
5. The environment The environment needs to be considered in the design of the project to gain an
acceptable level of environmental sustainability (e.g. energy efficiency ratings). In
addition, suitable environmental sustainability practices need to be implemented in
the construction process.
QUESTION 4.7
(a) See the table at page 418.
(b) No, as the NPV is (116 285). Given the cash flow projections and the discount rate used, the project
is not viable.
(c) See the table at page 419.
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.
Pdf_Folio:417

Pdf_Folio:418
TABLE SA4.1 Cash flow and net present value analysis of Big Firm Pty Ltd’s IT project
Year 0 1 2 3 4 5 6 7 8 9 10
Sale of old system ($) 70 000
Development cost ($) (700 000)
Implementation cost ($) (400 000)
Residual value ($) 100 000
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 calculation = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 +

(cost of capital = 14%) 14%)1 14%)2 14%)3 14%)4 14%)5 14%)6 14%)7 14%)8 14%)9 14%)10
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 ($) (1 030 000) 149 123 130 809 114 749 100 651 88 293 77 449 67 938 59 595 52 277 72 831
NPV ($) (116 285)
Note: Discount rate is 14 per cent.You may get a slightly different answer based on whether you use a table, spreadsheet or financial calculator to discount the cash flows.
Pdf_Folio:419
TABLE SA4.2 Cash flow and NPV analysis of Big Firm Pty Ltd’s IT project (updated cost inputs)
Year 0 1 2 3 4 5 6 7 8 9 10
Sale of old system ($) 70 000
Development cost ($) (760 000)
Implementation cost ($) (400 000)
Residual value ($) 100 000
Reduction in labour cost 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000 230 000
per year ($)
Increase in utility cost per (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000) (10 000)
year ($)
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
Discount factor calculation = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 + = (1 +

(cost of capital = 14%) 14%)1 14%)2 14%)3 14%)4 14%)5 14%)6 14%)7 14%)8 14%)9 14%)10
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 ($) (1 090 000) 192 982 169 283 148 498 130 255 114 262 100 228 87 919 77 123 67 653 86 319
NPV ($) 84 522

QUESTION 4.8
Which project
should you select? Project 2
Why? 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 4.9
SYDNEY SEAFOOD BAR
Project Capital Budgeting and Net Present Value
To establish the financial viability of the project, capital budgeting has been done, involving calculating
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. Therefore, the viability of the project in this case is still positive, although
the final decision may depend on alternative project options the company may have.
(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 may, under some circumstances, still be viable.
(c) Over 10 years, with a discount rate of 15 per cent, the project has a negative NPV of ($330 092). This
indicates that it is not financially viable and the SSB management should think about other options to
gain regulatory conformance.
The following tables and commentary further explain the NPV calculations and results.
TABLE SA4.3 Cash flow analysis of Sydney Seafood Bar
Cash outflows in Year 0 Year 0($)
Operating costs (tax reduction in Year 1)
Staff redundancy costs (60 000)
New staff costs (40 000)
Promotional budget (advertising) (100 000)
Total operating costs (tax reduction in Year 1) (200 000)
Other project costs (capitalised and depreciated annually)
Quantity surveyor’s estimate of project construction cost (625 001)
Packing and storing of equipment (10 000)
Consulting costs (77 420)
Architect’s design and project management fees (87 932)
Legal fees (9 148)
Pdf_Folio:420

Total of capitalised expenses for future depreciation (809 501)
Total project cost = Total cash outflow (i.e. $200 000 + $809 501) (1 009 501)
Table SA4.3 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)
• other project costs of ($809 501) that are paid in Year 0, capitalised and depreciated (tax deductible
expense) over the life of the project (Years 1–10) using straight-line depreciation.
TABLE SA4.4 Tax effect of expenses for Sydney Seafood Bar
Cash inflows in Years 1–10 Year 1($) Years 2–10($)
Total of immediately tax-deductible expenses (200 000)
Tax effect of deductible expense (i.e. $200 000 × 30%) 60 000
Total of capitalised costs for future depreciation (809 501)
Annual depreciation over 10 years (i.e. $809 501 / 10) (80 950)
Annual tax effect of depreciation (i.e. $80 950 × 30%) 24 285 24 285
Total tax effect of expenses 84 285 24 285
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 SA4.4 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%)
• 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 the tax-deductible depreciation
expense (i.e. $809 501 / 10 years × 30%).
Note that while the initial decrease in NOPAT due to the project is shown in the tax-effect calculations in
Table SA4.4, the ongoing increase in NOPAT due to the project is not shown. This is because the baseline
NOPAT provided in this question is after tax, so no adjustment for tax-related cash flows is necessary (see
Table SA4.5).
QUESTION 4.10
(a)
ET = 14 ET = 3 ET = 11 ET = 17
EOT = 31 EOT = 34 EOT = 45 EOT = 62
3 6 7 8
ET = 7 ET = 10
EOT = 7 EOT = 17
ET = 31 ET = 8
EOT = 65 EOT = 73
Start 1 2 End
9 10
ET = 7 ET = 11
EOT = 24 EOT = 35
4 5
Pdf_Folio:421

Pdf_Folio:422
TABLE SA4.5 Net increase/(decrease) in net operating profit after tax for Sydney Seafood Bar
Year 0 1 2 3 4 5 6 7 8 9 10
(a)
Baseline NOPAT ($) 433 913
Incremental cash (118 995)(b)

outflow ($)
(lower NOPAT from lost
sales/variable costs)
Calculation of baseline 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 × 433 913 ×
NOPAT growth (7% (1.071 – 1)(c) (1.072 – 1) (1.073 – 1) (1.074 – 1) (1.075 – 1) (1.076 – 1) (1.077 – 1) (1.078 – 1) (1.079 – 1)
annual growth in

baseline NOPAT from
Year 2)
Incremental cash 30 374 62 874(d) 97 649 134 858 174 672 217 273 262 856 311 630 363 818
inflow ($)
(7% annual growth in
baseline NOPAT from
Year 2)
Note: Table SA4.5 reveals the incremental cash flows from the net increase/(decrease) in NOPAT. Note that we are after the net increase/(decrease) in NOPAT 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 NOPAT 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 NOPAT increases by 7 per cent to $464 287 (i.e. $433 913 × 1.07). The net increase in NOPAT is therefore $30 374 (i.e. $464 287 – $433 913).
(d) In Year 3, the baseline NOPAT again increases by 7 per cent to $496 787 (i.e. $464 287 × 1.07). The net increase in NOPAT is therefore $62 874 (i.e. $496 787 – $433 913).
(This calculation continues for Years 4–10.)
Pdf_Folio:423
TABLE SA4.6 Net present value analysis of Sydney Seafood Bar
Year 0 1 2 3 4 5 6 7 8 9 10 Total
Total cash outflow (1 009 501) (1 009 501)

(see Table SA4.3)
Total tax effect of expenses 84 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 24 285 302 850
(see Table SA4.4)
Net increase/(decrease) in (118 995) 30 374 62 874 97 649 134 858 174 672 217 273 262 856 311 630 363 818 1 537 009
NOPAT (see Table SA4.5)
Total net cash flows (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
8% discount rate
Discount factor (8%) 1.0000 1.0800 1.1664 1.2597 1.3605 1.4693 1.5869 1.7138 1.8509 1.9990 2.1589
PV (Total net cash flow / (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
Discount factor)
NPV (8%) 41 612
10% discount rate
Discount factor (10%) 1.0000 1.1000 1.2100 1.3310 1.4641 1.6105 1.7716 1.9487 2.1436 2.3579 2.5937
PV (Total net cash flow / (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)
Discount factor)
NPV (10%) (85 992)
15% discount rate
Discount factor (15%) 1.0000 1.1500 1.3225 1.5209 1.7490 2.0114 2.3131 2.6600 3.0590 3.5179 4.0456
PV (Total net cash flow / (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)
Discount factor)
NPV (15%) (330 092)
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).

(b) Calculations of ET†
Activity 1: (4 + 4 × 7 + 10) / 6 = 7
2: (5 + 4 × 10 + 15) / 6 = 10
3: (5 + 4 × 15 + 19) / 6 = 14
4: (4 + 4 × 6 + 14) / 6 = 7
5: (6 + 4 × 10 + 20) / 6 = 11
6: (1 + 4 × 2 + 9) / 6 = 3
7: (5 + 4 × 10 + 21) / 6 = 11
8: (9 + 4 × 18 + 21) / 6 = 17
9: (20 + 4 × 30 + 46) / 6 = 31
10: (5 + 4 × 7 + 15) / 6 = 8
†
ET = (O + 4ML + P ) / 6
Where:
O = optimistic
ML = most likely
P = pessimistic
(c) Critical path is 1 → 2 → 3 → 6 → 9 → 10, which is 73 days (7 + 10 + 14 + 3 + 31 + 8).
QUESTION 4.11
(a) Explain how project managers can benefit from the use of EV analysis.
Project managers can use EV in projects where a project deliverable (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.
(b) What are the difficulties in implementing EV analysis?
One of the problems with variance analysis is ensuring that comparisons are made between AC 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, but when compared to the work completed, there may be
a significant cost overrun because the work is behind schedule.
QUESTION 4.12
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.
The key components of project risk management are:
• having the right project team
• monitoring known risks
• monitoring the emergence of unknown risks
• establishing contingency responses so that when things go wrong, the project can still be delivered on
time, on budget and according to specifications.
QUESTION 4.13
(a) Of the various techniques discussed in Part E, it is necessary to choose those that are most relevant to
the unique characteristics of the renovation project at SSB:
1. Quality assurance—the high strategic importance of having a high-quality restaurant in a prime
Sydney Harbour location means that there is an emphasis on ensuring the quality of the renovations
is high and the restaurant has the look of an expensive place with high‐quality facilities.
2. Stakeholder management—the multiple stakeholders of this project and the changed public expec-
tations suggest stakeholders should be managed carefully in this particular project.
3. Earned value—the project has strict deadlines (no more than four months), as well as an expectation
that all scope is delivered with high quality and on budget. This suggests that an integrative technique
such as the earned value method should be employed.
Pdf_Folio:424

(b) Advantages Disadvantages
Quality assurance—important for project performance Quality assurance—qualitative in nature and difficult
and organisational fit, easy to understand and to measure during the execution stages of the
implement construction
Stakeholder management—crucial for effective Stakeholder management—some decisions to
communication and engagement with various internal engage with certain stakeholders may be difficult
and external parties to implement
Earned value—an efficient integrative approach that Earned value—requires ongoing data collection
monitors time, cost and scope, all at the same time about project progress
QUESTION 4.14
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,
one key area where the management accountant adds value is in the financial closure of the project.
This includes calculating the final cost of the project 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.
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 recurrence—which can be useful for planning future projects.
MODULE 5
QUESTION 5.1
This question asked you to search both the annual report and results presentation of the 2017 results for
EVT and find as many performance measures as you can for the hotel division.
As explained prior to the question, EVT’s most important financial performances measures are revenue,
EBITDA and normalised PBIT.
The annual report discloses the managing director’s STI, which is linked to performance targets on p. 19.
Non-disclosure of specific performance measures and targets is often the case for listed companies to
avoid the information being available to competitors. For EVT, the annual report also discloses that EPS and
TSR (growth over the performance period of the three years to 30 June 2019, with performance measured
against the year ended 30 June 2016 (being the base year) (EVT 2017b, p. 20).
You should already be familiar with the most common financial performance measures.
There is very little information in the annual report on non-financial measures. However, there is
reference to some important ones. These are:
• the number of locations and number of rooms (p. 10)
• three key performance measures that are relevant to hotels:
– occupancy
– average room rate
– RevPAR growth (revenue per room), which are shown for all brands combined (p. 10), and separately
for the two brands: Rydges and QT Hotels (pp. 10–11).
In the Half Year Results Presentation for the first half of the 2018 financial year, information is presented
on revenue, EBITDA and normalised PBIT for all hotels (p. 10). Also shown are occupancy percentage,
average room rate and RevPAR for all owned hotels (p. 10) and by hotel brand (p. 11).
The key non-financial performance measures for all hotels are those used by EVT:
• occupancy—average number of rooms utilised compared to total average available rooms
• average room rate—total average room revenue per occupied room per day
• RevPAR—total average room revenue per available room per day.
QUESTION 5.2
(a) The 2017 annual report (p. 5) discloses that the primary role of the board is to protect and enhance long-
term shareholder value and recognises that the board is accountable to shareholders for the company’s
performance. The table on p. 36 of the annual report shows how shareholder value has been created
Pdf_Folio:425

annually for each of the last five years. JB Hi-Fi defines shareholder value as the increase in the
enterprise value, plus cash dividends and share buy-backs paid during the financial year.
(b) JB Hi-Fi’s strategy to create shareholder value is to:
encourage innovation and diversification with new products, technology, merchandising formats,
advertising and property locations in a controlled and responsible manner. This approach provides
opportunities to increase revenue, margin and productivity (JB Hi‐Fi 2017, p. 3).
This strategy clearly shows the goals that are desired (revenue, margin and productivity) but also
how those financial goals are achieved. It is only through expanding the product range, improving
technology, improving store layouts, effective advertising campaigns and investing in the best retail
locations that the desired financial performance can be achieved.
(c) JB Hi-Fi’s performance context during the 2017 year is important because its performance was
influenced by the timing of The Good Guys’ acquisition in November 2016 (JB Hi-Fi 2017, p. 2).
A key measure is the number of stores. The Group CEO’s performance involves an assessment against
both financial and non-financial performance measures (JB Hi-Fi 2017, p. 15).
The remuneration report discloses that the STIP rewards both financial and non-financial measures (JB
Hi-Fi 2017, p. 30) where the main element is statutory EBIT—this annual growth in EBIT is considered
the most relevant measure of the Group’s financial performance as it is ‘a key input in driving and growing
long term shareholder value’ (JB Hi-Fi 2017, p. 33).
Targets for senior executives, in addition to EBIT, include various store operating metrics, inventory,
supply chain and online performance measures. Specific targets are commercially sensitive and are
therefore not disclosed but performance management—and the rewards attached to that—is focused on
succession planning, investor relations, strategic initiatives, internal process improvements, inventory
management, property portfolio, shrinkage control, online initiatives, expenditure control processes,
workplace health and safety, risk management, and engagement with key initiatives (JB Hi-Fi 2017,
p. 34). The LTIP is based on EPS growth (JB Hi-Fi 2017, p. 35).
QUESTION 5.3
(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 in online
shopping, 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—that is,
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.
Of course, Mega Markets could adopt a strategy of selling its products online as well as in stores, as
many Australian retailers have done—for example, JB Hi-Fi, Myer and David Jones. This would enable
customers 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, but 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.
Pdf_Folio:426

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 5.4
There are many possible responses to this question, and it is impossible to cover them all, but you may
have identified:
• the roles and responsibilities of the board of directors, a chief risk officer (if your organisation has one),
and the CFO 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
• whether the accountability for performance and risk management is integrated at the same organisational
level or diverges to different people in the organisation
• what performance measures and measurement processes the company has in place.
Some Additional Information On This Topic

IFAC (2011) carried out a global survey of risk management. Some of its findings were:
• guidelines for risk management tend to be compliance-based and are poorly linked to performance
issues without sufficiently acknowledging the need to make risk-based decisions in pursuit of improved
performance
• creating better linkage between risk management, internal control and performance management
• making line managers accountable for overall performance, including risk management and internal
controls
• making risk management and internal control part of individual goals and objectives and holding people
accountable
• aligning compensation with performance in the area of risk management and internal control, and
• carrying out regular reassessments of risks and controls due to changes in the organisation and its
environment, leading to better organisational performance.
QUESTION 5.5
(a) Discuss the implications of Kevin’s demand in relation to the following.
(i) Governance As a director, Barbara is responsible for the company’s financial statements, a responsibility
that is even more pronounced as the CFO. What has been asked of Barbara 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, Barbara is also
responsible for a system of internal controls, which includes control over the inventory asset
of the company.
In Australia, making a deliberate adjustment to the financial statements is a clear breach of the
Corporations Act 2001 (Cwlth), relating to correct financial records (s. 286), compliance with
accounting standards (s. 304), and presenting a true and fair view (s. 305). Similar legislation
is applicable in many countries. It would be a fraud to mislead the auditors by disguising the
true value of inventory by removing stocktake sheets, and the accounts prepared for taxation
purposes would be similarly misleading. Barbara should be reminded of the illegalities at
WorldCom that resulted in the conviction and imprisonment of the CFO.
(ii) Signalling Financial statements are not produced just for the owner-manager of a privately owned com-
pany. The financial statements provide signals to all shareholders, taxation authorities, banks
and financiers, payables, customers and employees. Even from a shareholder perspective,
Barbara does not know the position of Kevin’s wife with respect to what Kevin wants her 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.
Pdf_Folio:427

(iii) Ethics Kevin’s request presents a clear ethical dilemma for Barbara, irrespective of the illegality of
what she has been asked to do. The HIH case 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 Kevin and
the resulting conflict of interest (Barbara is expected to resign if the demand is not met)
• the demand is also a breach of professional behaviour as the action would breach legislation
and accounting standards, and would be a behaviour that would discredit the profession.
Inappropriate signalling through the financial statements would be a clear failure of corporate
governance, a breach of legislation (in Australia) under the Corporations Act and income tax
legislation, and a clear breach of professional ethics.
(b) There are few options available to Barbara. Barbara could wait a couple of days before discussing the
matter again with Kevin, in the hope that after further consideration, she could change his mind. 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, Barbara could request a board meeting to discuss
the matter with Kevin’s wife.
Beyond these actions, Barbara 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 5.6
(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.
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)
Primary activities
Inbound logistics Sourced from South-East Asia and Sourced locally

imported into Australian warehouses
Operations Distributed from warehouses to shop- Distributed from a large central

ping centres in various style/colour/size warehouse in South-East Asia direct to
combinations customers, avoiding stock holdings in
multiple locations
Outbound logistics Customers shop with young children Customers shop online, make their
in their nearest store, involving travel, product choice and then await delivery
parking, queuing, etc. to their home
Marketing and Significant cost of maintaining and Relatively inexpensive online presence
sales staffing multiple retail stores and with no retail store overhead or retail
marketing the Mega Markets name staffing cost
Service Customers can return or exchange Customers can return or exchange goods
goods in store by post
Support activities
Procurement Identify and contract with suppliers Manufacturer in South-East Asia holds
in South-East Asia, place orders for inventory in large central warehouse
sufficient inventory holdings and awaiting online orders
monitor quality control
Pdf_Folio:428

Technology Not applicable Extensive investment in online ordering
development system
HR management Large investment in retail staff and Relatively low investment in staff for
training of staff technology support and warehouse staff
for picking and delivery of ordered goods
Firm infrastructure Heavy investment in warehousing, Relatively low investment in a single

distribution and shopping centre rental central warehouse
properties, leasehold improvements,
fittings, etc.
QUESTION 5.7
(a) (i) Traditional 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.
(ii) Expanded 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.
(iii) Flexed While the original budget standard is retained, the standard to be applied is the flexed
budget—that is, 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 target price, sales volume has
fallen and this has led to a revenue shortfall.
(b) (i) Traditional Management decision-making is almost impossible because there is no indication of the
causes of the variance.
(ii) Expanded 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.
(iii) Flexed 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
• 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.
Pdf_Folio:429

QUESTION 5.8
There are many possible controls that could affect sales behaviour at SalesVol, and which could have
resulted in the level of sales being below target (remember, volume was lower than targets, but average
selling price was higher than targets):
• 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, particu-
larly 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.
QUESTION 5.9
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)
• 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 CEO
• developing a service level agreement with internal customers.
Process controls:
• standard operating procedures or procedures manual
• regular monitoring of staff by managers and supervisors
• regular meetings to identify problems and solutions.
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
• days’ purchases outstanding performance compared to target (and improvements over time).
Pdf_Folio:430

QUESTION 5.10
Strategic • Sales volume and value for each product bar over the whole product life cycle
performance • Profitability of each product over the whole product life cycle (after deducting R&D,
measures market research and advertising costs)
• 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
• Number of new product launches (and number withdrawn as a result of market research)
over time
Operational performance measures
Leading measures • Advertising spend

• R&D spend
• Market research spend
• Number of sales visits to retail stores
• Orders taken by sales team in each region
• Number of new product launches
• Wastage in production
• Quality problems and production faults
• Productivity
• Time from order to delivery
Lagging • Sales volume for each product

measures • Sales value for each product
• Profitability of each sales region
• Profitability of each product
• Customer satisfaction (retail stores)
• Customer satisfaction (end user)
Note: This list 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 chains. 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.
QUESTION 5.11
• ROI/ROCE/PBIT • ROI/ROCE/PBIT
• Cost • Cost
• Total revenue • Total revenue
• Gearing/interest cover • Gearing/interest cover
• Working capital and asset efficiency • Working capital and asset efficiency
• Shareholder returns • Shareholder returns
• Number of customers • Number of customers

• Sales per customer • Sales per customer
• Returning customers (e.g. based on • Returning customers (this will be more accurate as more accurate
loyalty cards) customer details will be available for online sales where customer
• Number/percentage/value of returns address and payment details are obtained)
• Number/percentage of complaints • Number/percentage/value of returns
• NPS • Number/percentage of complaints
• Number of website hits, time on website
• NPS
Pdf_Folio:431

• Sales per square metre • Cycle time (time from receipt of order to despatch)
• Sales per employee • Out-of-stocks (less likely as there is one central warehouse holding
• Out-of-stocks (lost sales due to all style/colour/size combinations)
style/colour/size combination being • Delivery accuracy percentage (returns due to inaccurate
out of stock) picking/delivery)
Innovation and learning perspective
• Employee turnover • Employee turnover

• Employee training investment • Employee satisfaction/morale
• Employee satisfaction/morale • Investment dollars in online technology
• Number of innovative techniques adopted in online ordering
Explanation of differences
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.
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 that 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.
Note: there are some differences between the performance measures of each company based on their different strategies. Youmay
be able to think of others.
QUESTION 5.12
(a)
Profit Cash flow Value of company
Debtors’ collections
Cost Revenue
Client retention
New client growth
Hours worked Hourly charge-out rates

Billing per client
Quality of work
Maintaining Recruitment
up-to-date and retention
knowledge of staff
Partner contact Marketing and

Prospecting
with clients promotion

Note: this is an illustration of the kind of things that could be part of a strategy map for a small professional services company.
Pdf_Folio:432
The strategy map may be simple or complex—this is just one example.

(b) 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 HR: 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 CSFs and
cause-and-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. The actual strategy map adopted by any
one company will be a reflection of its strategy, competitive position and business model.
(c)
BSC Key success factors [!h] Financial or non-
perspective in strategy map Performance measure financial (N/F)
Financial Profit, cost and Net profitNet All F

revenue profit as percentage of revenue
Revenue growth year-on-year
Direct salaries as percentage of revenue
Indirect salaries as percentage of revenue
Non-salary costs as percentage of revenue
Cash flow Free cash flow

Cash flow as percentage of revenue
Value of company Growth in value as a multiple of average

annual billings
Client Client retention Number of clients lost NF

(customer)
New client growth Number of new clients NF

Number of active prospects NF
Billing per client Growth in billing (calculated for each client) F
Partner contact Number of visits by partners to existing NF

with clients clients per annum
Business Quality of work Number of errors identified by supervisors, NF

process managers, partners
Hours worked Chargeable hours as a percentage of paid NF

hours
Write-offs/ons (i.e. hours charged to clients NF
that cannot be recovered in billing, or due
to efficiencies resulting in a higher than
expected margin)
Hourly charge-out Cost recovery F

rates
Receivables Days billing outstanding (equivalent to days NF
collections sales outstanding)
Pdf_Folio:433

BSC Key success factors Financial or non-
perspective in strategy map Performance measure financial (N/F)
Innovation Marketing and Expenditure on marketing and promotion F

and learning promotion
Prospecting Number of activities aimed at winning new NF

clients
Percentage of partner hours spent NF
on marketing and prospecting
Maintaining up-to- Compliance with CPD requirementsInvest- NFF

date knowledge ment in staff training
Recruitment and Staff turnover as percentage of total staff NF

retention of staff employed
(d) The indicative performance measures are shown for each of the key success 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 included. 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.
Many possible performance measures have not been included. Other measures that could be adopted
include:
• revenue or profit per partner (or per employee)
• the ratio of partners to staff
• the office space (in square metres) per employee.
These have not been considered as critical, but they are important measures, and may be particularly
useful in benchmarking exercises.
QUESTION 5.13
(a) A reduction in the total cost of components can be achieved either through:
• purchasing improvements—reducing the price per component, or
• productivity improvement—reducing the quantity of components used, such as 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:
• number of alternative suppliers identified
• number of quotations sought from suppliers
• successful price negotiations with suppliers
• number of tender comparisons of suppliers.
(b) 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—that is, 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
• number of quality defects.
(c) 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 must 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
Pdf_Folio:434

components ordered due to out of-stock situations, so the number of special purchases due to
components being out of stock needs to be reported, together with the price variation.
Care should be taken that the Purchasing department does not 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.
(d) An enterprise resource planning (ERP) system should:
• record inventory levels of purchased components
• forecast sales demand and production plans
• automatically order purchased components based on the organisational plans (e.g. minimum stock
levels, economic order quantities, seasonal demand fluctuations, order to delivery times)
• record approved suppliers and agreed prices
• place purchase orders on suppliers at the agreed price
• match supplier invoices against purchase orders, highlighting variations in quantity or price
• report actual usage of components (e.g. separating wastage, damage and rework)
• report variations between purchased cost and standard cost of components.
QUESTION 5.14
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-making calculated reliably but it is
business units based or control, because if sales not a valid measure of the
on a percentage of revenue exceeds the target, business units’ demand for
sales revenue in each the head office recharge will be corporate services. It is not
business unit higher than the target. controllable by business unit
managers.
2. Survey of brand 75% This measure is specific and This may be a valid measure
recognition among measurable but achievability of the effectiveness of
members of the may depend on the level of advertising in terms of
public advertising. It also may not be awareness, but it is not a valid
relevant in terms of conversion measure of sales. It may be
of brand recognition into sales. reliable if a standard form of
For example, many consumers statistical survey is properly
are aware of the ‘Coca Cola’ carried out.
brand but do not buy the
product.
3. Receivable days 45 days This measure and target This measure is a valid and
satisfies all the SMART reliable method of calculating
criteria, but the achievability the level of outstanding
of the target depends on the receivables, which is clear, can
organisation’s trading terms be produced in a timely fashion,
(which in this case might be is accessible and controllable.
assumed to be 30 days). It leads to improved activity
in collections and approval of
credit limits, etc.
4. Percentage of 90% This measure and target This performance measure
incoming telephone satisfies all the SMART is usually reliable because it
calls answered in one criteria, but the achievability is a by-product of telecoms
minute of the target depends on technology. However, it is not
the organisation’s staffing valid by itself because it is
of positions that involve usually a proxy for customer
answering telephone calls. service and needs to be
supplemented by a measure
of customer satisfaction with
the quality of the service
provided.
Pdf_Folio:435

5. Percentage of sales 80% While this measure meets most The measure is valid and
revenue from return of the SMART criteria, it is not reliable as it does accurately
customers necessarily time-based (i.e. it capture information about
does not reveal the elapsed customer retention. However,
time between customers it is not controllable as
placing repeat orders, nor the there are many factors
value of their orders compared outside managers’ control
with their prior orders). that influence returning
customers.
6. Dollar value of $100 000 p.a. While this measure and target This measure can be reliably
donations to charities meets most of the SMART calculated and is valid in
criteria, it is not likely to be terms of measuring financial
relevant in terms of something contributions to charities,
that is important for the but by itself it does not
organisation, unless it is an necessarily reflect how well
organisation whose purpose is the organisation’s social,
to donate to charities. environmental or ethical
obligations are satisfied.
7. Reduce employee Reduce turnover This measure meets the This measure is valid and
turnover by 10% p.a. SMART criteria. It may reliable. It is controllable
be achievable provided through a variety of retention
managers have authority over strategies including
remuneration and motivation remuneration and motivation.
strategies. 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 whether available quickly but many
it is achievable based on past factors affecting revenue
performance and economic growth are outside managers’
and competitive conditions in control.
the particular industry.
9. Headcount 120 The measure may not While this measure is reliable
be relevant as, in many it may not be valid, as
organisations with headcount headcount does not reflect
targets, this is circumvented by a number of factors (e.g. the
appointing casual staff through level of business activity, the
agencies or consultants where quality of the workforce, long-
(sometimes higher) costs term illness, maternity or long
are incurred even though the service leave being taken).
payroll headcount target is
satisfied.
10. Compliance with Full This measure and target is It is a valid measure of
legal requirements not specific and it is difficult compliance, but not a reliable
to measure, being based one as different people may
on subjective judgments make different judgments
and probably without full based on different knowledge
knowledge of all requirements and experience.
and the organisation’s
experiences.
Additional explanation of the answers

The following table outlines the method used to determine whether the performance measures and
targets were SMART and effective.
Pdf_Folio:436

Pdf_Folio:437
SMART criteria Characteristics of effective performance measures
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
3. Receivable days Y Y Y Y Y Y Y Y Y Y Y
4. Incoming Y Y ? Y Y N Y Y Y Y Y
telephone calls
5. Sales from return Y Y Y Y N Y Y Y N Y N

customers
6. Donations to Y Y Y N Y Y Y N Y Y Y
charities
7. Employee Y Y Y Y Y Y Y Y Y Y Y
turnover
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 N
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 previously. 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 5.15
Different companies have very different approaches to performance measurement. The measures used in
retail stores such as Woolworths and JB Hi-Fi are quite different to the measures used in a hotel chain
such as EVT, by Apple in its high-tech environment or by Newcrest in the mining industry. Public sector
organisations such as policing and hospitals have very different approaches to performance measurement.
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 organisa-
tions have quite different needs. 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.
Despite the differences in what is measured, the focus of performance management should be the same
in all organisations, business, not-for-profit or public sector. Management accountants need to be able
to add value to their employers or clients by moving beyond the mere reporting of performance against
targets, trends and benchmarks and add value by interpreting that information and making appropriate
recommendations to senior management.
Despite pressure for short-term financial performance, management accountants need to be able to
demonstrate where an excess focus on the short term may detrimentally impact on sustainable financial
performance. Management accountants also need to be able to look at financial and non-financial
performance holistically, recognising the relationship between lagging and leading performance and
identifying the trade-offs between different aspects of performance—for example, high quality and short
lead times may not be consistent with low costs.
Management accountants need to focus on performance improvement. They can suggest ways in which
performance can be interpreted, and recommend methods of improving performance based on their
holistic views of all the available performance information. This means moving away from the desk and
computer screen and talking with non-financial managers who will be able to explain the context in which
performance reports.
QUESTION 5.16
(a) 1. Decide on the performance measures to be benchmarked
Performance measures are selected for benchmarking where differences in performance can be
understood and acted on. Only strategically important measures and processes should be selected
for benchmarking.
2. Decide who you are benchmarking against
Organisations can select internal measures from different organisational units, industry-wide
benchmarks or benchmarks from outside the industry.
3. Find out how to obtain benchmarking measures
Data can be obtained directly from the organisation identified as having the best practices, perhaps
through a benchmarking consortium. Another option is to rely on secondary sources, such as
consulting organisations, newspapers and trade journals, or internet materials. Many organisations
rely on BI gained from common suppliers or from discussions at exhibitions and conferences, etc.
4. Compare and interpret the data
A comparison of the data is what benchmarking really focuses on, but just comparing the data
does not tell us why there are differences. As for all data, it needs to be interpreted sensibly, by
not ignoring different contexts. Further investigation is almost always required.
Pdf_Folio:438

5. Use information for decisions, control and performance evaluation
After comparison and interpretation, benchmark data can be used to improve business practices,
motivate behaviour or signal the organisation’s performance relative to others.
(b) • The commitment by other organisations—especially in a consortium—to provide bench-
marking 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.
(c) Every organisation will be different, will have different opportunities for benchmarking and different
performance measures will be important. One example is university teaching, where a benchmarking
consortium does exist. Some examples of benchmark data for teaching include:
• staff–student ratio
• student retention—that is, the proportion of students who discontinue studies prior to completion
• student progression—the proportion of students who fail and have to repeat
• student satisfaction
• graduate outcomes—employment, salary levels.
The last two examples come from standardised surveys of university students.
QUESTION 5.17
(a) The need to have a limited number of performance measures is consistent with the proponents of
the BSC, 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 management. Despite the absence of targets, the example shows the importance
of relative performance, trend—improvement relative to the past—and benchmarking.
(b) 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 GFC 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 that 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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MODULE 6
CASE STUDY 6.1: TRADITIONAL APPROACH TO ALLOCATING
INDIRECT COSTS
(a) Total budgeted indirect manufacturing costs $810 000
Model Budgeted volume × DLHs per unit = Total DLHs
FC101 10 000 2.00 20 000
FC202 3 000 1.50 4 500
FC303 2 000 1.25 2 500
Total DLHs for the food processor product line 27 000
Total budgeted indirect manufacturing costs / Total DLHs $810 000

27 000 DLHs
Indirect manufacturing cost rate $30.00 per DLH
(b) Indirect manufacturing cost FC101 FC102 FC103
Indirect manufacturing rate per DLH $30.00 $30.00 $30.00
DLHs per unit 2.00 1.50 1.25
Indirect manufacturing cost per unit $60.00 $45.00 $37.50
Budgeted sales volume 10 000 3 000 2 000
Indirect manufacturing cost $600 000 $135 000 $75 000
(c) Total manufactured cost per unit FC101 FC102 FC103
Direct materials per unit $55.00 $85.00 $105.00
Direct labour per unit $40.00 $30.00 $25.00
Total prime costs per unit $95.00 $115.00 $130.00
Indirect manufacturing cost per unit $60.00 $45.00 $37.50
Total manufactured cost per unit $155.00 $160.00 $167.50

(Total prime costs per unit + Indirect
manufacturing cost per unit)
CASE STUDY 6.2: ALLOCATING INDIRECT COSTS

WITH ACTIVITY-BASED COSTING
(a) Cost pool 1—labour-related costs $270 000
Model Budgeted volume DLHs per unit
FC101 10 000 2.00 20 000
FC202 3 000 1.50 4 500
FC303 2 000 1.25 500

Pdf_Folio:440

Total budgeted DLHs 27 000
Total-labour related costs / Total budgeted DLHs $270 000

27 000 DLHs
Labour-related cost pool rate $10.00 per DLH
Cost pool 2—machine-related operating costs $350 000
Model Budgeted volume MHs per unit
FC101 10 000 1.00 10 000
FC202 3 000 3.00 9 000
FC303 2 000 3.00 6 000
Total budgeted MHs 25 000
Total machine-related operating costs / Total budgeted MHs $350 000

25 000 MHs
Machine-related operating cost pool rate $14.00 per MH
Cost pool 3—production scheduling and other set-up costs $120 000
Budgeted number of production runs
FC101 50
FC202 150
FC303 200
Total budgeted production runs 400
Total production scheduling and other set-up related costs / Total budgeted $120 000
production runs 400 production runs
Production scheduling and other set-up cost pool rates $300.00 per
production run
Cost pool 4—materials handling costs $70 000
Budgeted number of materials movements
FC101 90
FC202 260
FC303 350
Total budgeted materials movements 700
Total materials handling indirect costs / 70 000

Total budgeted materials movements 700 materials movements
Materials handling cost pool rate $100.00 per materials movement
Pdf_Folio:441

(b) FC101
Number of Indirect
1. Labour-related $10.00 20 000 $200 000 54.9%
2. Machine-related $14.00 10 000 $140 000 38.5%
3. Scheduling set-up $300.00 50 $15 000 4.1%
4. Materials handling $100.00 90 $9 000 2.5%
Total indirect manufacturing costs allocated to FC101 $364 000 100.0%
Units produced (see Case study 6.1) 10 000
ABC indirect manufacturing cost per unit $36.40

(Total indirect manufacturing costs allocated to FC101 / Units pro-
duced)
Traditional indirect manufacturing cost per unit (from the answers to $60.00
Case study 6.1)
Difference in indirect manufacturing costs per unit between the two $(23.60)
systems
FC202
Number of Indirect
1. Labour-related $10.00 4 500 $45 000 18.6%
2. Machine-related $14.00 9 000 $126 000 52.1%

produced)
Case study 6.1)
Difference in indirect manufacturing costs per unit between the two $35.67
systems
FC303
Number of Indirect
1. Labour-related $10.00 2 500 $25 000 12.3%
2. Machine-related $14.00 6 000 $84 000 41.2%
Pdf_Folio:442


produced)
Case study 6.1)
Difference in costs per unit between the two systems $64.50
CASE STUDY 6.3: COMPARING THE TWO COSTING SYSTEMS

(a) (i) Cost pool 1 Cost pool 2 Cost pool 3 Cost pool 4
Labour-related Machine-related Production/set-up Materials handling
Product Drivers % Drivers % Drivers % Drivers %
FC101 20 000 74.07% 10 000 40.00% 50 12.50% 90 12.86%
FC202 4 500 16.67% 9 000 36.00% 150 37.50% 260 37.14%
FC303 2 500 9.26% 6 000 24.00% 200 50.00% 350 50.00%
Total 27 000 100% 25 000 100% 400 100% 700 100%
(ii) 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 Case study 6.2). 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%). So 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 (see
Case study 6.2) 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, so is receiving a greater allocation
of production scheduling costs
• 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.
(b) An ABC system should be adopted:
• where there are multiple products that consume different resources at different rates, and/or
• where different indirect manufacturing costs are related to different underlying factors (drivers),
many of which are not related to volume measures.
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.
Pdf_Folio:443

(c) (i) External strategy ABC will help the management of HPD to:
• undertake customer profitability analysis where retailers purchase different
product mixes—i.e. where retailers may be ordering more of the FC101 than
of the other two models. Information about customer requirements could be
used to revise the product/service offering.
(ii) Internal strategy ABC will help the management of HPD to:
• understand the real economic cost of its products and the real cost of
servicing its customers. An understanding of the actual costs (AC) should
enable management to create product and customer strategies that deliver
value for customers and other stakeholders.
(d) (i) Details Traditional costing ABC costing Difference
Total manufactured cost per unit $155.00 $131.40 $23.60
Standard selling price per unit $180.00 $180.00 $0.00
Budgeted profit margin per unit $25.00 $48.60 $23.60
(ii) 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.
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.
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.
(e) Where volume-based indirect manufacturing cost-allocation models are employed, overhead rates
assign indirect manufacturing costs to products in proportion to the product’s consumption of volume-
based drivers such as DLHs, machine hours or materials cost. If all products in a multi-product
organisation consume indirect manufacturing activities in proportion to this unit-based driver, no
distortion will occur in the allocation of overhead costs to individual product lines.
However, if different product lines vary significantly in their consumption of indirect-manufacturing
activities (i.e. product diversity is high) and the indirect costs attached to those activities are themselves
significant, distortion may occur in the allocation of indirect manufacturing costs to the individual
product lines. The two key factors likely to distort overhead cost allocations are:
(i) product diversity
(ii) significant indirect manufacturing costs that are not linked to production volumes.
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.
Pdf_Folio:444

CASE STUDY 6.4: USING TIME-DRIVEN ACTIVITY-BASED
COSTING TO ALLOCATE INDIRECT MANUFACTURING COSTS
(a) The following table shows the theoretical capacity (total time available) in minutes:
Number of minutes
Number of eight-hour days per eight-hour
Number of personnel worked per annum per person day per person
10 230 480 1 104 000 mins
Less: Time spent by materials handling personnel in professional development, training (104 000)
activities, staff meetings and similar events
Budgeted total practical capacity (or productive time) in minutes 1 000 000 mins
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) (i) Budgeted total Cost rate

Materials handling activity time (minutes) per minute Budgeted costs
Requisition 45 800 $1.504 $68 883
Receipt into storage 115 400 $1.504 $173 562
Sourcing for production 277 950 $1.504 $418 037
Production movements 510 850 $1.504 $768 318
Total time and cost 950 000 $1.504 $1 428 800
Total practical capacity 1 000 000 $1.504 $1 504 000

and costs
Unused capacity 50 000 $1.504 $75 200

(Total practical capacity and
costs – Total time and cost)
(ii) 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.
(c) (i)
[!h]
Materials Unit Additional Additional Total
handling time Trans- Standard unit time Trans- time time
activity (mins) actions time(mins) (mins) actions (mins) (mins)
Requisition 10 125 1250 5 60 300 1550
Receipt into 20 155 3100 10 105 1050 4150

storage
Sourcing for 15 200 3000 10 200 2000 5000

production
Pdf_Folio:445

Production 15 350 5250 5 350 1750 7000

movements
Budgeted time Standard time 12 600 Additional time 5100 17 700
(ii) 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 move-
ments. All 350 transactions require 15 minutes of standard time plus five minutes of additional
variation time.
(d)
Materials
Budgeted activity Cost rate handling costs
Materials handling activity time (minutes) per minute allocated
Requisition 1550 $1.504 $2331
Receipt into storage 4150 $1.504 $6242
Sourcing for production 5000 $1.504 $7520
Production movements 7000 $1.504 $10 528
Total times 17 700 $26 621
(e) (i) the conventional ABC The conventional ABC approach would allocate $35 000 in
approach ($35 000—see Case budgeted materials-handling costs to the FC303. This amount
study 6.1) was calculated in the answers to Case study 6.2 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).
(ii) the TDABC approach The budgeted materials-handling costs that would be allocated
(calculated in part (d)). by the TDABC approach to the FC303 is $26 621. This amount
was calculated in part (d) of this answer 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).
Comment on any differences in The difference of $8379 in the total allocated costs is explained
the materials-handling costs that by the fact that the ABC and TDABC calculations use different
would be allocated to the FC303 assumptions. In the ABC calculation, the assumption is that
food processor as a result of using the cost is $100 per move and in the TDABC calculation the
either ABC method. 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.
CASE STUDY 6.5: RENEWABLE ENERGY

PRODUCTS—TARGET COSTING
(a)
Total sales revenue Total units to be sold Average selling price per unit
$24 000 000 30 000 units $800
Pdf_Folio:446

(b)
Total costs Total units to be manufactured Average cost per unit
$22 500 000 30 000 units $750
(c)
Details Amounts
Average selling price (from task (a)) $800
Less: The net profit margin expected per unit (30% × $800) ($240)
Target average total cost per unit $560
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, product design and process design. 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 design expenditures, including the cost of product prototypes
– the cost of designing and testing alternative manufacturing processes and technologies
– 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 and product development to product launch
– number of R&D projects currently being undertaken
– number of product launches as a proportion of product development projects
– number of new product launches compared to prior years or to rival organisations
– market share generated from new products.
– number of workplace incidents, accidents and improvements to health and wellbeing.
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 design projects or product launches indicates how successful HPD has been in converting
its R&D 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 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.
Pdf_Folio:447

CASE STUDY 6.6: REASSESSING THE ALLOCATION OF
INDIRECT MANUFACTURING COSTS FOR THE SOLARHEAT 1
(a) (i) Solarheat 1 indirect ABC indirect
manufacturing manufacturing
Cost pool Cost pool rate activities costs
Machine set-ups $500 per set-up 3 000 set-ups $1 500 000
Quality control $125 per inspection hour 3 000 hours $375 000
Rework $20 per unit produced 30 000 units $600 000
Materials movement $250 per movement 3 600 moves $900 000
Repair and maintenance $200 per maintenance 2 400 hours $480 000
hour
Hazardous waste disposal $50 per kilogram 3 900 kilograms $195 000
disposed
Indirect manufacturing costs allocated using ABC $4 050 000
Indirect manufacturing cost allocation using traditional model $4 800 000

(see Case study 6.5, items 2 and 3)
(30 000 units × $160 indirect manufacturing cost per unit)
Excess indirect manufacturing costs allocated to the $750 000

Solarheat 1 product line
(ii) In comparison to ABC, 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.
(iii) The original estimated cost per unit was $750 (see the answers to Case study 6.5). Each unit
has been over-costed by $25 ($750 000 / 30 000 units). So, the switch to ABC indicates that the
expected average total cost per unit should be decreased to $725 ($750 – $25).
Refer to the answers to Case study 6.5, where 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).
CASE STUDY 6.7: BUSINESS PROCESS MANAGEMENT AND

THE SOLARHEAT 1 MANUFACTURING FACILITY
(a) (i) ABC cost allocations Functional layout Cellular layout
Machine set-ups $500 per set-up 3 000 $1 500 000 1 800 $900 000
(see the answers set-ups set-ups
to Case study 6.6)
Materials moves $250 per move 3 600 moves $900 000 2 400 $600 000
(see the answers moves
to Case study 6.6)
Total ABC costs allocated $2 400 000 $1 500 000
Reduction in indirect manufacturing cost allocations $900 000

(Functional layout costs – Cellular layout costs)
Add: Direct labour cost savings $900 000

(Number of units × Direct labour cost saving per unit)
Pdf_Folio:448

Lower costs as a result of BPM initiative $1 800 000
(Reduction in indirect manufacturing cost allocations + Direct labour cost savings)
Less: Cost of BPM implementation ($300 000)
Net benefit realised from BPM implementation $1 500 000

(Lower costs as a result of BPM initiative – Cost of BPM implementation)
Net benefit realised from BPM implementation per unit $50 per unit
(Net benefit realised from BPM implementation / Number of units)
(ii) Yes
(iii) Machine set-ups will fall from five to three per batch. This is 3/5 or 60 per cent of the 3000 original
machine set-ups (i.e. 60% × 3000 = 1800 set-ups). The reduction in machine set‐ups is therefore
1200, saving $600 000 (i.e. 1200 × $500 per set-up).
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 the table in
part (a)(i).
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 6.5.
The total cost reduction is therefore expected to be $1 800 000 (i.e. $900 000 + $900 000). 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,
Mary should proceed with the recommendation that HPD undertake the BPM exercise.
(iv)
(i) If HPD undertakes the BPM exercise for the The original expected average cost of Solarheat 1
Solarheat 1 manufacturing facility, what will was $750 (see Case study 6.5) and in Case study
be the expected product cost per unit? 6.6 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) How much will the expected cost per unit In Case study 6.6 the gap between the expected
be above the target cost for the Solarheat average cost and the target average cost per unit
1 as a result of the BPM exercise being for the Solarheat 1 had been reduced from $190
undertaken? 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.
(b) 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.
Financial measures that may be recommended are the:
• delivery cost of the project compared to the $300 000 budget
• reduction in the set-up and movement-related costs for the Solarheat 1—budgeted to fall from
$2 400 000 to $1 500 000
• set-up costs per batch versus budget
• movement cost per batch versus budget.
The non-financial measures that may be recommended include the:
• time taken to implement the BPM initiative versus the schedule
• number of material movements
• reduction in the number of set-ups and material movements for the Solarheat 1 product line.
Pdf_Folio:449

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.
CASE STUDY 6.8: ACTIVITY VALUE ANALYSIS OF

HOUSEHOLD PRODUCTS DIVISION’S VALUE CHAIN
(a)
Nature of activity or Value- Non-value-
event adding adding Explanation
1. Designing a product ✓ This is necessary to create an item that has

value to the customer.
2. Designing a ✓ An efficient and effective manufacturing facility
manufacturing layout is a key to saving substantial costs
facility layout during the production time or manufacture
of the product.
3. Commissioning ✓ If there were no manufacturing facility, there

of manufacturing would be nowhere to manufacture the product
facility and no customer value would be generated.
4. Setting up production ✓ The setting up of production runs (e.g. machine

runs set-ups) is usually required because the com-
pany 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 ✓ These activities need to take place in order to

materials and receive supplies. Without receipt of supplies,
components products could not be manufactured, and so
inbound logistics are deemed to be value-
adding.
6. Inspecting incoming ✓ This is needed because of potential quality

raw materials and failures by suppliers, but it does not generate
components customer value.
7. Returning materials ✓ Customers will not pay a premium for the

and components errors made by suppliers.
to suppliers
8. Storing raw materials ✓ This does not transform or change the

and components materials, so does not increase value for
customers.
9. Processing products ✓ This activity transforms raw mate-
rials into a product for which
the customer is willing to pay.
10. Incomplete products ✓ This does not transform or change the

waiting for further materials, so it does not increase value for
processing customers.
Pdf_Folio:450

11. Moving product ✓ This does not transform or change the
through the materials, so it does not increase value for
production facility customers.
12. Inspecting incomplete ✓ This is needed because of potential quality

products during failures in an activity performed earlier in the
processing value chain and therefore does not add value.
13. Reworking ✓ This is done because of a quality failure in an

products 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

products failures in an activity performed earlier in the
value chain.
15. Storing inspected ✓ This does not transform or change the
products materials, so it does not increase value for
customers.
16. Delivering products to ✓ The customer will often pay an additional
customers amount for this, indicating its value.
Alternatively, this value is included in the price
of the product.
17. Receiving and ✓ While it might appear that helping a customer

handling warranty with a warranty claim is adding value (because
claims not doing it would 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.
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, it is still not
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 this
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.
Pdf_Folio:451

[!h]
Nature of activity or Value- Non-value-
event adding adding Explanation
• 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).
For the purposes of this subject, warranty
claims are considered to be more likely to be a
non-value-adding activity.
18. Dealing with customer ✓ These are likely to occur because of a quality
complaints failure in an activity performed earlier in the
value chain and do not add customer value (as
customers would perceive making complaints
as annoying).
Please note that this subject follows a particular philosophy towards value-adding activities. You may
be able to present alternative arguments for particular items or have reached a different conclusion. For
the purpose of this subject, the following discussion is the correct application of value analysis based
on this philosophy.
Value-adding Activities—Philosophy
When looking at whether an activity is value-adding, it is necessary 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, it may be
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, it may be decided not to eliminate the non-value-adding
activity because to do so would be too costly (i.e. the cost outweighs the benefit).
(b) Function and activities Total costs Value-adding Non-value-adding
Research and development work $900 000 $900 000
Rework of prototypes $150 000 $150 000
Total research and development $1 300 000 $1 150 000 $150 000
BPM—cellular facility layout costs $300 000 $300 000
Design work $1 500 000 $1 500 000
Rework patterns $300 000 $300 000
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
Inbound logistics costs $1 500 000 $1 500 000
Pdf_Folio:452

Direct labour
Direct labour manufacturing activity $1 100 000 $1 100 000
On-the-job inspection activity $250 000 $250 000
Total direct labour $1 500 000 $1 250 000 $250 000
Machine set-ups $900 000 $900 000
Quality control $375 000 $375 000
Rework $600 000 $600 000
Materials movement $600 000 $600 000
Repair and maintenance (excluding preventative $480 000 $480 000

maintenance)
Hazardous waste disposal $195 000 $195 000
Distribution $950 000 $950 000
Total marketing and distribution $1 750 000 $1 750 000
After-sales service
Total after-sales service $750 000 $750 000
Total cost of Solarheat 1 $20 250 000 $15 650 000 $4 600 000
(c) Once you have worked through the flow chart in Figure 6.13 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.
Important factors to consider include:
• the cost to the organisation of the non-value-added activity
• whether an item can actually be changed or eliminated
• the expenditure required to minimise or eliminate the activity
• the cost saving or benefit that will be realised if the activity is modified or eliminated
• the resources required to make changes to the activity, including:
– time
– skilled people
– capital or funding
– equipment and information technology
• the potential negative response of either employees or customers to significant changes.
Using this information, Martin would hope to improve the design of the Solarheat 1—for example,
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.
Pdf_Folio:453

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—that is, 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.
(d) 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, but this must be weighed 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, there
is a range of alternatives. The first and best is to make the product without mistakes, rework or scrap.
If there is a mistake, the rework should be done as long as it costs less than the additional benefit to
be received. If the rework cost is greater than the additional benefit to be received, then the item should
be scrapped.
So, it can be assumed 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—for example, scrapping or recycling.
(e) (i) and (ii)
(ii) see the table on next page
(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 6.7). 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 (as explained in Case study 6.7). 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.
Pdf_Folio:454

Pdf_Folio:455
Partial elimination of non- Total elimination of non-
value-adding activities value-adding activities
Preferred Net saving from

Function and activities Benefit Cost Net saving Benefit Cost Net saving BPM initiative preferred BPM initiative
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 activity $205 000 ($30 000) $175 000 $250 000 ($65 000) $185 000 Total $185 000
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
Customer complaints $110 000 ($45 000) $65 000 $150 000 ($100 00) $50 000 Partial $65 000
Total costs $1 320 000 ($240 000) $1 080 000 $1 645 000 ($480 000) $1 165 000 Total savings $1 200 000

CASE STUDY 6.9: EVALUATING SUPPLIER-RELATED COSTS
(a)
Number and cost of activities performed
Total
activities
Cost per and total
Activity type activity Componentz ElectricalPartz Parts100 costs
Order materials
Costs $80 $12 000 $6 000 $12 000 $30 000
Receive orders
Costs $70 $10 500 $6 300 $12 600 $29 400
Inspect deliveries
Costs $120 $18 000 $10 800 $21 600 $50 400
Return materials
Costs $100 $1 500 $600 $3 000 $5 100
Account queries
Costs $150 $2 250 $900 $4 500 $7 650
Process payments
Costs $90 $3 240 $6 750 $3 240 $13 230
Total supplier-related costs $47 490 $31 350 $56 940 $135 780
Invoice cost of raw $222 900 $210 000 $246 000 $678 900
materials (see table in
case facts)
Total procurement costs $270 390 $241 350 $302 940 $814 680
(Total supplier-related
costs + Invoice cost of
raw materials)
Supplier cost performance $47 490/ $31 350/ $56 940/ $135 780/
ratio (Total supplier-related $222 900 $210 000 $246 000 $678 900
costs / Invoice cost of = 21.31% = 14.93% = 23.15% = 20.00%
raw materials)
(b) (i)
Suppliers
Estimated
Details Componentz Electrical Partz Parts 100 costs
Relative supplier invoice cost 1.02 1.03 1.00 $135 780

index†
Expected invoice cost of direct ($7 500 000 ($7 500 000) ($7 500 000)
materials (calculation) × (1.02) × (1.03) × (1.00)
Pdf_Folio:456

Expected invoice cost $7 650 000 $7 725 000 $7 500 000 $7 500 000
Supplier cost performance ratio 21.31% 14.93% 23.15% 20.00%

(from part (a) of this question)
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)
† From the introduction in Case study 6.9, Parts100 is the cheapest supplier and so has been selected as the base against
which all other suppliers are analysed. So 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).
(ii) 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 effect of the hidden supplier costs on the total
cost of direct materials procured was not fully understood. The direct materials total costs were estimated
to be only $9 000 000, so 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 6.8, 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.
CASE STUDY 6.10: LIFE CYCLE COSTS OF REDESIGNING THE

PRODUCT
(a) Details Amounts
Initial market price per unit $800.00
Price increase per unit due to improved product quality: Lean manufacturing initiative $10.00
New forecast market price per unit $810.00
Less: Net profit margin expected per unit (30% × $810.00) ($243.00)
Target average total cost per unit ($810.00 – $243.00) $567.00
Expected average total cost per unit ($18 093 343 / 30 000 units) (see the table in the $603.11
case facts)
Expected average cost below (above) the target average cost per unit ($36.11)
($567.00 – $603.11)
(b) The financial and non-financial measures that could be reported can be categorised in two ways:
1. 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)
2. 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
Pdf_Folio:457

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.
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 act 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:
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 against budget (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 overheads. 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, war-
ranty claims and handling of customer complaints (e.g. were the reductions in the AC of post-
production activity greater than $125 000?).
CASE STUDY 6.11: IMPACT OF A TOTAL QUALITY

IMPROVEMENT INITIATIVE
(a) (i) Details Amounts
Revised market price per unit (see the answers to Case study 6.10) $810.00
Price increase per unit due to improved product quality: TQM initiative $60.00
New forecast market price per unit $870.00
Less: Net profit margin expected per unit (30% × $870.00) ($261.00)
Target average total cost per unit $609.00
Expected average total cost per unit ($18 450 000 / 30 000 units) (see the table in the $615.00
case facts)
Expected average cost below (above) the target average cost per unit ($6.00)
(ii) HPD is now very close ($6) to achieving the target average total cost per unit. Based on the
calculations in part (i), the new target average total cost per unit is $609, while the expected average
Pdf_Folio:458
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, but 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. So, an organisation may not want to eliminate all internal and external
failures, because it would reduce its overall profitability.
Note: There will be some regulatory circumstances (e.g. product safety) where quality considerations
will outweigh the profit outcome.
(c) As shown in the case facts, 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
• 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 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
• 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.
CASE STUDY 6.12: DECIDING WHETHER TO

OUTSOURCE DISTRIBUTION
(a) Details Amounts
Expected average cost per unit after implementation of cross-functional team’s lean $615.00
manufacturing and TQM initiative
Less: Saving per unit from switching distribution to Supersonic ($10.00)

(Current distribution cost – Supersonic quote) / Estimated number of units
Revised expected average cost per unit after outsourcing distribution $605.00
Target average total cost per unit (see the answers to Case study 6.11) $609.00
Expected average cost below (above) the target average cost per unit $4.00
Pdf_Folio:459

(b) 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 because 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.
Several qualitative issues need to be considered prior to the outsourcing proposal. While the cost is
lower,theorganisationmustalsoensurethatanidenticalorbetterlevelofserviceisachieved.Thisincludes
delivery reliability, ensuring all deliveries are in good condition and limited on-costs of managing the
outsourcing arrangement—for example, contract negotiations, reviews and regular interactions.
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, it may increase its fees and charges to more realistic levels—when HPD is in a weaker
negotiating position.
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, but 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.
– 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. So, 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
costschargedbySupersonicfortheSolarheat1areasquoted(i.e.$650 000)andthatthereisalsoareduction
inthedistributioncostsforallotherHPDproductlinesthatarenowtobedistributedbythespecialistfreight
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.
Pdf_Folio:460

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—for example, 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.
CASE STUDY 6.13: ASSESSING THE PROFITABILITY OF

DIFFERENT CUSTOMER SEGMENTS
(a)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Gross margin % on sales $15 000 000 $3 000 000 $1 200 000 $19 200 000
20.00% 30.00% 40.00% 22.81%
(b)
Cost per driver
Customer service Total transaction in year
activity costs Total cost driver transactions ending 31 December
1. Order processing $300 000 6 000 orders $50 per order
2. Line item ordering $210 000 52 500 line items $4 per line item
3. Distribution $360 000 3 600 deliveries $100 per delivery
4. Cartons/pallets $330 000 66 000 cartons/pallets $5 per carton/-

shipped pallet shipped
5. Customer relations $180 000 900 hours $200 per hour
(c) See the table at page 462
Pdf_Folio:461

Pdf_Folio:462
Nationwide retailers State-wide retailers Small local retailers
Cost driver Number Customer Number Customer Customer

trans- of cost services of cost services Number of services
Cost pools actions drivers costs % drivers costs % cost drivers costs %
1. Order processing $50.00 600 $30 000 6.7% 900 $45 000 21.4% 4 500 $225 000 31.2%

2. Line idem oredring $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 shipping $5.00 45 000 $225 000 50.0% 6000 $30 000 14.3% 15 000 $75 000 10.4%
5. Customer relations $200.00 585 $117 000 26.0% 255 $51 000 24.3% 60 $12 000 1.7%
Total cost $450 000 100% $210 000 100% $720 000 100%
(d)
Gross margin $3 000 000 $900 000 $480 000 $4 380 000
Customer service indirect ($450 000) ($210 000) ($720 000) ($1 380 000)
costs
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
17.00% 23.00% (20.00%) 15.63%
Comments:
As shown in the case facts, the most profitable market segment in absolute dollar terms is the
nationwide market segment ($2 550 000). However, the state-wide 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 the case facts. Net margin therefore
provides a more accurate assessment of the profitability of customers.
(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, it may need refinement over time.
• Developing a reliable database for the chosen cost drivers. For some cost drivers, the information
required to compile the cost driver database is likely to be readily available—for example, the
number of individual product lines ordered. However, the data on the hours spent in customer-
support activities will rely on the manual diary entries made by each HPD sales representative.
• Deciding how costs that may be common across a number of functions or activities are to
be handled. A similar cost allocation problem occurs in the costs of filling each order where the
order and items ordered activities share some common costs. Accuracy will be uncertain and data
collection expensive.
• Assessing likely adverse reaction of the division’s sales representatives to the new cost-
allocation model. This adverse reaction may be even more pronounced if HPD changes the method
of determining sales commissions from a gross to a net customer profit margin.
CASE STUDY 6.14: CUSTOMER PROFITABILITY AT THE

INDIVIDUAL CUSTOMER LEVEL
(a)
Transactions Mini-electrical Home appliances
1. Total orders processed 45 30
2. Average number of line items per order 10 15
3. Total line items (1) × (2) 450 450
4. Total deliveries 30 30
5. Average cartons/pallets shipped per delivery 8 4
6. Total cartons/pallets (4) × (5) 240 120
7. Customer relations hours 0 6
Pdf_Folio:463

8. Sales revenue $30 000 $12 000
9. COGS ($16 500) ($7 500)
10. Gross margin $13 500 $4 500
(b)
Cost driver
transaction (see Number Customer
the answers to Number of Customer of cost service
Cost pools Case study 6.13) cost drivers service costs drivers costs
1. Order $50.00 45 $2 250 30 $1 500

processing
2. Line item $4.00 450 $1 800 450 $1 800

ordering
3. Distribution $100.00 30 $3 000 30 $3 000
4. Cartons/ $5.00 240 $1 200 120 $600

pallets
shipped
5. Customer $200.00 0 $0 6 $1 200

relations
Total costs $8 250 $8 100
(c)
Details
Gross margin $13 500 $4 500
Customer service indirect costs ($8 250) ($8 100)
Net margin $5 250 ($3 600)
Net margin % on sales ($5 250) ($3 600)
($30 000) ($12 000)
17.50% (30.00%)
Comments:
As indicated by the customer profitability analysis, Mini-Electrical, returning a net margin of $5250 in the
year ending 31 December, generates a net margin on sales of 17.50 per cent. This net margin on sales places
Mini-Electrical marginally above the average return made by HPD from the nationwide customer market
segment (of 17%). Home Appliances made a loss of $3600 for the year ending 31 December, generating
a negative net margin on sales of 30 per cent.
(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 its customers so that the employees always strive to
meet, if not surpass, their expectations of product quality, on‐time delivery and after-sales service.
• 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).
• Remuneration and commissions—offer bonuses to the division’s sales representatives based on
each customer’s net margin rather than the gross margin. The previous remuneration system would
Pdf_Folio:464

need to be phased out over time in a manner that does not adversely affect the level of compensation
paid to the division’s sales representatives.
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. So, 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.
CASE STUDY
TASK 1: STRATEGIC MANAGEMENT ACCOUNTING
AT WATTLEJET
(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, and has appropriate in-flight 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, examples of how WattleJet creates value include:
• providing flights to regional and remote areas
• offering fixed rates and medium-term contracts to companies flying staff to mine sites
• minimising costs by returning crew to Perth after each flight.
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 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.
(b) In Module 1, strategic management accounting was defined as:
Creating sustainable value by:
• supporting the formation, selection, implementation and evaluation of organisational strategy
• synthesising information that captures financial and non-financial perspectives for both the internal
and external environments to enable effective resource allocation.
Module 1 identified a variety of decisions that managers make. In relation to WattleJet, these would
include:
• strategy—competitive approach, organisational structure and target setting
• products—product mix (flight destinations and flight services 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.
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
• ABC and activity analysis to identify and cost non-value-adding activities that may be eliminated
or reduced
• capital budgeting tools, such as NPV, that enable project evaluation
• project scheduling and budgeting tools to manage both the time and cost of implementation
• customer profitability analysis to identify which segments the organisation should focus on.
Pdf_Folio:465

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.
(c) The types of information that will be useful for WattleJet may be split into internal and external data.
Internal data
This will be needed across a range of categories, including financial performance, customer satisfac-
tion, 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.
External data
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.
(d) WattleJet will need a MAS 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,
on-time performance and load factor for each route. It will also need to be extended to capture physical
flows (e.g. fuel usage) and environmental data (e.g. carbon emissions) 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 overhead (e.g. by using ABC approaches)
will also help to ensure that efficiencies are obtained, and that waste is reduced or eliminated. The MAS will
therefore need to capture data on the various types of activities performed, how often they are performed
(the cost drivers) 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.
TASK 2: DECISION-MAKING
(a) Primary users Other users
• Equity investors—shareholders buy, sell, • Air industry regulatory agencies

retain/hold shares—holders of ownership • Government—the Australian Taxation Office (ATO),
interests ASIC, the Australian Competition and Consumer
• Lenders—major lender Commission (ACCC)
• Other creditors—suppliers, management and • Suppliers of fuel, aircraft, airport facilities
employees—ground crew, flight crew and pilots • Customers—passengers and freight
• Trade unions
• Members of the public
• Management
(b)
High ATO Debt holders
ASIC • 2018 interest payment $1.6 million
• Suppliers of fuel, aircraft and airport
facilities
• Airline regulator
• Safety and systems
• Management
Power
Shareholders
Public Customers
Environmental issues • Regional customers have few options
regarding carrier or price Employees
Employees
Low
Low Interest High

Pdf_Folio:466

(c) Stakeholder Key information requirements or needs
Community • WattleJet should ensure that its environmental credentials remain high with a number
of in-house programs to prevent waste and contamination
• The local community should be kept informed about company changes and initiatives
like schedule changes or service interruptions
Creditors • Interest payments

• Evidence that WattleJet has not broken any of the debt covenants
• Financial reports
Customers • An easy-to-access website and an efficient call centre

• Ability to access information and purchase tickets and other services efficiently
• Information on schedule/service changes
Employees/ • Pay slips/notifications

unions • Evidence of proper treatment of superannuation and tax contributions and compliance
with union agreements on pay and entitlements
• Information about company initiatives that may affect staffing—schedule changes,
new route introductions
Government • Tax, superannuation and goods and services tax (GST) returns as required
• Pay amounts due
• Provide reports as required to airline regulators
Shareholders • Annual report

• Financial report
• Dividend notifications
• Timely notification of matters affecting profitability
Suppliers • Evidence of creditworthiness

• Financial reports
• On-time payment
Management • Revenue
• Costs
• Efficiency
• Profitability
• Assets
• Cash flows
• Economy
• Industry
TASK 3: BUDGETING
(a) and (b)
Profit and loss budget

2019 2018 actual 2019 budget 2019 actual Budget variance
A B C C–B
($m) ($m) ($m) ($m)
Revenues
Ticket sales 99.371 100.364 100 (0.364)
Freight 8.213 8.213 10 1.787
Total 107.584 108.577 110 1.423
Expenses
Wages 37.690 37.501 38 (0.499)
Pdf_Folio:467

Profit and loss budget
2019 2018 actual 2019 budget 2019 actual Budget variance
Fuel 28.725 28.581 34 (5.419)
Flight 8.637 8.594 9 (0.406)
Aircraft 9.121 9.075 10 (0.925)
Sales and marketing 1.898 1.617 2 (0.383)
Property and IT 12.494 12.894 13 (0.106)
Total 98.565 98.262 106 (7.738)
EBITDA 9.019 10.315 4 (6.315)
Notes:
1 Ticket sales 99 371 × 1.01 = 100 364
2 Sales and marketing 1898 × 1.01 – 300 = 1617
3 Property and IT 12 494 + 400 = 12 894
4 Other expenses × 0.995
(b) Revenue
Budget RPK growth was 1 per cent, but the actual achieved was 0.6 per cent.
The ticket sales variance was –$364 000.
On a more positive note, freight revenue was well above budget, and delivered a favourable revenue
variance of $1.787 million.
Costs
Total cost variance was $7.738 million. Cost variances were dominated by a fuel cost blow-out of
$5.419 million. Other cost categories were over budget, ranging from 1.33 per cent for wages to 23.7
per cent for sales and marketing.
Sales and marketing expense was $383 000 higher than expected and because cost savings from
the new ticketing system were not realised. The related IT ticketing project was $0.106 million over
budget.
TASK 4: PROJECT MANAGEMENT

(a) Your risk analysis should include:
(i) estimated savings from an early upgrade to ADS-B
(ii) estimated cash flows
(iii) ADS-B early upgrade—DCF analysis
(iv) explanation of the DCF
(v) quantitative risk analysis
(vi) explanation of results
(vii) risk assessment summary.
(i) Year 1 Year 2 Year 3

Probability $ $ $
30% 45 300 111 800 145 300
50% 86 800 152 000 178 000
20% 114 000 165 000 190 000
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(ii)
Year 1 Year 2 Year 3
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 $ 79 790 Weighted $ 142 540 Weighted $ 170 590

average: average: average:
(iii)
Year 0 Year 1 Year 2 Year 3 Total
$ $ $ $ $
Investment outlay ($235 000) ($75 000)
Estimated fuel $79 790 $142 540 $170 590

efficiency savings
Net cash flow ($235 000) $4 790 $142 540 $170 590
1 2
Discount factor 1 (1 + 0.14) (1 + 0.14) (1 + 0.14)3
calculation (14%)
Discount factor 1 1.1400 1.2996 1.4815
Discount $235 000/1 $4 790/ $142 540/ $170 590/

calculation 1.1400 1.2996 1.4815
Estimated present ($235 000) $4 202 $109 680 $115 147 ($5 971)
value
(iv) The estimated up-front 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 is inserted as cash savings over the three
years of the project. The net cash flow for each year and the total for the project can then be
established. As can be seen in part (iii), the total net cash flow is a positive result of $82 920.
However, these cash flows need to be discounted to their present value to evaluate the project
properly.
To do this, a discount factor of 14 per cent is applied. Remember that the initial investment
is not discounted, because this occurs at the start of the project (Year 0) and is regarded as the
present value already.
(v) Worst-case cash flow ($235 000) 45 300 – 111 800 145 300
75 000
Worst-case NPV ($235 000) –26 052 86 026 98 076 (76 950)
Best-case cash flow ($235 000) 114 000 165 000 190 000
–75 000
Best-case NPV ($235 000) 34 210 126 962 128 248 54 420
(vi) The NPV for this project is negative $5971. From a financial perspective, this suggests that
the project will not add value to the organisation—although the amount is immaterial because of
the size of the business.
The quantitative risk analysis presented in part (v) shows that the worst-case scenario for the
project is a negative NPV of $76 950. The best-case scenario is a positive NPV of 54 420. Given
the negative NPV of the weighted average of the three scenarios, the project shows a high risk of
a negative return.
The qualitative risk factors must be considered before deciding whether to proceed. It would
also be worthwhile to check all the assumptions and cash flow estimates, as a small change may
lead to a different result.
Pdf_Folio:469

(vii) This is where the qualitative risk factors need to be identified. There are a variety of benefits in
addition to fuel savings to be achieved by implementing the system. As it will eventually 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—because 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 will be at least able to
be adapted to do so.
(b) (i)
1 4 5
Start 3 End
2 6
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 activities must be completed before you can start Activity
3, as they are listed as preceding activities.
From Activity 3, both Activity 4 and Activity 6 can be started at the same time, because
these both list Activity 3 as a preceding activity. Activity 5 can 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.
(ii) Most Expected

Activity Description Optimistic likely Pessimistic Calculation time
30 + (4 × 50) + 90
1 Review 30 50 90 53
6
and select
technology and
infrastructure
15 + (4 × 20) + 30
2 Obtain quotes 15 20 30 21
6
from various
suppliers
10 + (4 × 14) + 25
3 Choose supplier 10 14 25 15
6
and prepare
formal contracts
65 + (4 × 90) + 185
4 Installation of 65 90 185 102
6
equipment
65 + (4 × 85) + 120
5 Testing and final 60 85 120 87
6
acceptance
6 Re-plan current 85 110 120 108

flight routes 85 + (110 × 4) + 120
6
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(iii) The paths through the project are:
1→3→4→5 This will take 53 + 15 + 102 + 87 = 257 days
1→3→6 This will take 53 + 15 + 108 = 176 days
2→3→4→5 This will take 21 + 15 + 102 + 87 = 225 days
2→3→6 This will take 21 + 15 + 108 = 144 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 required to complete the whole project. The project is forecast to take 257 days.
ET = 53 ET = 102 ET = 87
EOT = 53 EOT = 170 EOT = 257
1 4 5
ET = 15
EOT = 68
Start 3 End
EOT = 257
2 6
ET = 21 ET = 108
EOT = 21 EOT = 176
EOT = Earliest occurrence time
TASK 5: PERFORMANCE MANAGEMENT

(a) Effective environmental measures should help WattleJet 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 Global Reporting Initiative (GRI)
Standards as well as sustainability indices (e.g. FTSE4Good or the Dow Jones Sustainability Index).
Some measures reported by Qantas include:
• aviation fuel consumption (litres) (GRI Indicator EN3)
• carbon dioxide and equivalent emissions (tonnes) (GRI Indicator EN16)
• fuel per 100 revenue tonne kilometre (RTK) (litres) (GRI Indicator EN5)
• carbon dioxide and equivalent emissions per 100 RTKs (tonnes) (GRI Indicator EN16).
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) and have clarity and timeliness,
but they are not as valid as other measures in capturing ‘environmental performance’.
To address this issue, total fuel use and total emissions can be converted 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 is 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.
Other performance measures used include:
• total electricity usage (MWh)
• total water usage (litres)
• direct waste to landfill (tonnes).
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(b) Area Performance measures
Learning and growth • Efficiency gains from new technology

perspective • Employee engagement level
Business process • On-time departures

perspective • Turnaround time at airport (minutes)
• Lost time due to injuries (total and % of hours worked)
• Number of incidents or near misses
• Absenteeism
Customer perspective • On-time arrivals (%)

• Cancellations (%)
• Customer satisfaction level (%)
Financial perspective • Revenue growth

• Expenses (% of sales)
• Net profit
• Operating cash flow
Environmental • CO2-e emissions (total and % of RTK)

perspective • Aviation fuel (total and % of RTK)
• Electricity usage (GW)
• Water usage (litres)
• Waste (landfill) tonnes
Note: The example BSC in part (b) 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-and-effect relationships, and so it is important to ensure that the BSC that you
have designed has cause-and-effect relationships present and has both leading and lagging indicators.
TASK 6: STRATEGIC COST AND PROFIT MANAGEMENT

(a) Activities Classification Reasons
1. Website design and Value-adding Maintaining the website is a value-adding activity because
maintenance it enables customers to access information directly and
to make bookings without additional resources being
consumed. Websites have scalability, in that they can deal
with greater numbers with limited increases in costs when
compared to having a staffed call centre.
2. Call centre queries, Value-adding Staffing the call centre is likely to be a combination of value-
bookings and and non-value- adding and non-value-adding activity. The website is a lower-
changes adding cost alternative, so it can be argued the call centre is 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.
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3. Complaint and Non-value- Complaint and dispute resolution may be regarded as a non-
dispute resolution adding 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.
4. Physical ticket Non-value- Distribution of physical tickets is likely to be a non-value-

distribution adding adding activity. Electronic ticketing is significantly faster
and has virtually no cost, whereas physical tickets take staff
time, have distribution costs and create difficulties if they do
not arrive or are lost. As with the staffing of the call centre,
there may be some customers unable to use electronic
distribution and so such an activity may be value-adding for
this customer segment.
(b) (i) Total costs Cost driver

Activity area transactions Transaction cost rate
1. Website design and $167 200 2 200 hours $167 200 / 2 200 = $76 per
maintenance hour
2. Call centre queries, $464 000 32 000 calls $464 000 / 32 000 = $14.50
bookings and changes per call
3. Complaint and dispute $42 400 800 complaints $42 400 / 800 = $53 per
resolution complaint
4. Physical ticket $105 000 42 000 tickets $105 000 / 42 000 = $2.50
distribution per ticket
(ii) Online ticket Call centre ticket

purchasers purchasers
Driver Driver
Transaction Total trans- Cost trans- Cost
Activity area cost rate costs actions allocation actions allocation
1. Website $76 per hour $167 200 2 150 $163 400 50 hours $3 800
design and hours
maintenance
2. Call centre $14.50 $464 000 5 800 calls $84 100 26 200 $379 900
queries, per call calls
bookings
and changes
3. Complaint $53 per $42 400 635 $33 655 165 $8 745
and dispute complaint complaints complaints
resolution
4. Physical $2.50 per $105 000 4 000 $10 000 38 000 $95 000
ticket ticket tickets tickets
distribution
Total costs $778 600 $291 155 $487 445
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(iii) Number of Average cost
Customer group Total cost customers per ticket
Online ticket purchase customers $291 155 190 000 $1.53
Call centre ticket purchase customers $487 445 110 000 $4.43
Difference $2.90
Overall average $778 600 300 000 $2.59
(iv) From the table in part (iii), it can be seen that the cost of servicing online ticket purchasers ($1.53
per ticket) is considerably less than that for call centre ticket purchasers ($4.43 per ticket). The
difference is $2.90 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 also be used in assessing the profitability of customer segments
and the types of flights and routes that they book.
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CASE STUDY
PREVIEW
INTRODUCTION
Completing this Case study helps 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 6. The Case study
is ‘WattleJet’ and focuses on a service environment—the Australian domestic airline industry. This
hypothetical company is trying to establish a niche alongside established competitors including Qantas,
Jetstar, Tigerair and Virgin Australia.
At the end of the Case study is a set of tasks that you are expected to complete by referring to Modules
1 to 6 and applying the necessary knowledge. These tasks are your focus:
• analysing the airline industry
• analysing the strategic approaches of WattleJet
• measuring and assessing the performance of WattleJet
• analysing the WattleJet value chain
• 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 6 and used in the Case study are examinable.
CONCEPTS, TOOLS AND TECHNIQUES

Modules 1 to 6 introduced a range of concepts, tools and techniques. Value is the main theme of the
Strategic Management Accounting subject, and these concepts, tools and techniques help us to create,
manage and protect value.
Traditional management accounting techniques include budgeting, variance analysis and product
costing. As the management accountant’s role has developed to include being a business adviser, additional
techniques have emerged.
The first main tool described is industry and organisational value chain analysis. This is used to gain an
overall perspective of the organisation and its place within its industry value chain.
Once a clear picture of the organisation and industry is obtained, the organisation and its environment
can be analysed using SWOT analysis, product life cycle analysis and Porter’s five forces analysis.
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 products and activities within the value chain.
Activity-based costing (ABC), life cycle costing and target costing are all examples of this. Understanding
customer profitability and managing value chains are valuable approaches for improving performance.
Management accountants often perform a role in the selection and implementation of projects to achieve
organisational objectives. Financial and risk analyses, combined with project scheduling techniques, are
essential for successful strategy implementation.
This Case study focuses on most of these approaches, including:
• value chain analysis
• industry analysis—Porter’s five forces analysis
• balanced scorecard (BSC) reporting
• project evaluation, selection and implementation, including net present value (NPV) and the program
evaluation and review technique (PERT).
Pdf_Folio:385
CASE STUDY 385

INTRODUCTION TO WAT TLEJET
This Case study examines a hypothetical Australian company called WattleJet Ltd (WattleJet), which 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 and freight from one destination to another.
Strategic management accounting case studies are often focused on manufacturing or product-based
businesses, but this Case study demonstrates the importance of supporting value creation in a service
industry. In this industry, for example, there is no physical inventory produced or managed, but there
is an inventory of available seats that must be filled by travellers. If these seats are not filled, then the
opportunity to sell that service disappears.
Two critical areas must be addressed for sustainable performance:
1. efficiency—utilisation of capacity (passenger load), the main aim of which is to avoid having empty
seats on flights
2. effectiveness—maintaining revenues on seats sold to cover cost and generate profits.
It is much easier to achieve efficiency. For example, flights may be filled by offering low fares. However,
this may not be effective, because prices may be below cost. Achieving both objectives 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 to mines and other worksites around 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 minerals prices and so encouraged mining
companies to make significant investments to expand capacity and output.
Many Australian mining sites are in remote areas, and due to this, 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. 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.
In the last two years, WattleJet has started to compete on major routes across Australia, flying between
Perth and the cities of Adelaide, Melbourne, Sydney and Brisbane.
More than 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.
MISSION, VISION AND STRATEGY

WattleJet’s original vision was to be a safe provider of airline travel throughout regional WA.
Its mission focused on providing safe, reliable and cost-effective commuting for workers employed on
remote mining sites. With low overhead 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, objectives, timelines or data collection and analysis process. There is also no established
approach for dealing with environmental or corporate social responsibility (CSR) issues. WattleJet’s
overarching goals have been simplified to:
• remain profitable
• grow successfully
• 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 company’s decision to expand beyond the original fly-in fly-out market evolved over time and was
not formally planned. Accordingly, the company’s operations do not reflect its vision or mission statements.
BUSINESS OPERATIONS
WattleJet has a single office based near Perth Airport. It has a fleet of 12 aircraft.
WattleJet mainly flies to the Kimberley, Pilbara and Goldfields–Esperance regions in WA, as shown in
Figure CS1. As mentioned earlier, it also flies to the major capital cities within Australia.
Pdf_Folio:386

FIGURE CS1 Main regional destinations for WattleJet
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 route planning, capacity analysis, marketing, purchasing and
human resources (HR), 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.
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CASE STUDY 387

Table CS1 provides a summary of WattleJet’s value chain.
TABLE CS1 WattleJet’s value chain
Primary activities
Marketing and sales Customer service Flights

• Corporate visits • Ticket purchases—online or call • Check-in services
• Promotions and advertising centre • Boarding and departure services
• Ticket printing and distribution • Inflight services
• Complaint handling • Arrival and baggage collection
• Booking changes services
Support activities
Procurement: HR management Firm infrastructure:

Aircraft asset management • Recruitment and training of Information systems
• Purchasing and leasing flight/ground crews and head • Route scheduling
• Maintenance—contract office staff • Load scheduling
management • Management of relationships— • Accounting and finance—
airports, aviation authorities including fuel price hedging
PERFORMANCE
WattleJet has a very simple performance measurement system that captures the following financial results
and some operational measures:
• total revenue
• employee costs
• fuel costs
• 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
• passenger expenses.
Operational measures include capacity availability, usage and efficiency; on-time performance; and
safety—as shown in Table CS2.
TABLE CS2 Non-financial performance measures
ASK Measures capacity

Available seat kilometres ASK is the total distance flown multiplied by the total number of seats
available. It provides a comparable measure of capacity.
Distance × Seats = ASK
For example, a flight from Perth to Newman Airport in the Pilbara region
is 1021 km. In an Embraer E-170 aircraft with a 70-seat configuration,
the ASK would be:
1021 × 70 = 71 470 ASK
RPK Measures consumption or how much capacity was used

Revenue passenger kilometres RPK is the total distance flown multiplied by the number of passengers
who are paying for flights. It provides a comparable measure of
consumption.
Distance × Passengers = RPK

For example, the RPK for a flight from Perth to Newman Airport (1021 km)
with 54 paying passengers would be:
1021 × 54 = 55 134 RPK
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Passenger load factor Measures efficient use of capacity
(Seat factor) Passenger load factor is calculated as RPK / ASK. This measures how
much of the capacity is used by paying passengers. The higher the result,
the more that capacity is being utilised. This indicates a higher level
of efficiency.
Based on our example above, we have RPK of 55 134 and ASK of 71 470.
Passenger load factor would be:
55 134 / 71 470 = 77.14%
On-time performance Measures customer satisfaction and operational efficiency

On-time performance measures the ability to combine all aspects of
operations to ensure that aircraft depart and arrive on time. On-time
performance is a departure or arrival within 15 minutes of the stated time.
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 occur, and 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 management reports include a statement of profit or loss, and of operational indicators. The
financial and operating results for the last four years are shown in Table CS3.
TABLE CS3 Financial and operating results 2015–18
Profit and loss 2015 2016 2017 2018
Revenues ($m) ($m) ($m) ($m)
Ticket sales 92.365 95.871 102.346 99.371
Freight 6.125 7.483 9.284 8.213
Total 98.490 103.354 111.630 107.584
Expenses
Wage and salary expenses 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
EBITDA† 18.221 13.644 12.614 9.019
Depreciation 8.864 8.785 8.930 8.741
EBIT 9.357 4.859 3.684 0.278
Interest and financial expenses .231 1.499 2.065 1.631
Earnings before tax 8.126 3.360 1.619 (1.353)
Tax expense/(benefit) 2.438 1.008 0.486 (0.406)
NPAT‡ 5.688 2.352 1.133 (0.947)
(continued)
Pdf_Folio:389
CASE STUDY 389

TABLE CS3 (continued)
Operational indicators 2015 2016 2017 2018
ASK 126.21 132.36 154.84 148.36
RPK 95.13 97.54 110.96 103.44
On-time performance 82% 83% 81% 82%
Incidents and near misses 0 0 0 1

†
Earnings before interest, tax, depreciation and amortisation
‡
Net profit after tax
AUSTRALIAN DOMESTIC AIRLINE INDUSTRY

Air transport in Australia is a necessity because of the size of the country and the low density of the
population. Australia is the sixth-largest country in the world but has a population of less than 30 million
people. The two primary infrastructure requirements to service the Australian domestic airline industry are
aircraft and airport facilities. 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 until 2024.
INDUSTRY HISTORY
Trans Australia Airlines (TAA) and Ansett dominated the domestic airline industry for 40 years because
of the Two Airlines Policy that was established by the Australian federal government in 1952. Regulations
promoted a duopoly over major routes within Australia. In 1992, TAA was absorbed into Qantas, which
had been operating solely international routes. Several small airlines operated in regional areas.
Deregulation of the industry in 1990 allowed new entrants to the industry. The first attempt at a low-cost
start-up was Compass Airlines, which was established in 1990 and failed in 1991.
In 2000, Virgin Blue Airlines (now Virgin Australia) entered the market. This competition led to
significant fare reductions and opened air travel to tourists. When Ansett collapsed a year later, Virgin
Australia captured significant market share, and low fares continued.
To compete with Virgin Australia, Qantas launched a low-cost airline called Jetstar in 2003. This initia-
tive was designed to assist Qantas to compete against Virgin Australia without sacrificing the traditional
full-service, high-price model offered by the main Qantas brand.
In 2007, Tigerair, another low-cost competitor, started operations. Tigerair’s low fares meant that the
company struggled to be profitable throughout its existence. It was taken over by Virgin Australia in 2017.
Over the last few decades, the industry has changed from a highly regulated, uncompetitive duopoly
with high prices, to an intensely competitive duopoly offering a range of options and prices to suit both
low- and high-fare-paying travellers.
INDUSTRY ECONOMICS
Volume growth
Passenger growth was rapid from 2004 to 2008 (from below 40 million to over 50 million). As shown in
Figure CS2, demand between 2008 and 2009 faltered during the Global Financial Crisis (GFC). After this
period, growth continued, but at a slower pace. In 2017 (latest information available at time of writing),
passenger growth was 1.7 per cent and 60 million domestic flights took place, a decrease of 0.5 per cent.
Other relevant statistics (see Figure CS3) from 2017 include:
• RPK was up 1 per cent.
• ASK was down 1 per cent.
Profit
The increase in passenger numbers and competition for market share came at a cost as airlines reduced
fares. Operating profit margins were dramatically reduced, from around 8 per cent before the GFC to
around 1 per cent, slowly recovering to about 2 per cent. The whole industry currently generates revenues
of approximately $12 billion, with overall profits of nearly $1700 million (2017). Table CS4 shows how
the profit is distributed across the different services in the industry.
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FIGURE CS2 Domestic regular public transport passenger traffic—moving annual totals
65
Total passengers carried (millions)

60
55
50
45
07
09
10
11
13
14
7
15
16
0
-1
-1
c-
c-
c-
c-
c-
c-
c-
c-
c-
c
c
De
De
De
De
De
De
De
De
De
De
De
Year ending
Source: Commonwealth of Australia 2018, Australian Domestic Aviation Activity, p. 2, accessed June 2018,
https://www.bitre.gov.au/sites/default/files/domestic_airline_activity_2017.pdf.
FIGURE CS3 Regular public transport network utilisation—moving annual totals
90 95
90
ASKs/RPKs (billions)
80
Load factors (%)

85
70 80
75
60
Available seat kilometres (ASKs) 70
Revenue passenger kilometres (RPKs)
Load factors (%)
50 65
07
08
11
12
15
16
17
0
-1
1
c-
c-
c-
c-
c-
c-
c-
c-
c-
c-
c
De
De
De
De
De
De
De
De
De
De
De
Year ending
Source: Commonwealth of Australia 2018, Australian Domestic Aviation Activity, p. 2, accessed June 2018,
https://www.bitre.gov.au/sites/default/files/domestic_airline_activity_2017.pdf.
TABLE CS4 Profit share of services
Service Profit (EBIT) share %
Business travel/full-fare travel 43
Leisure travel/low-cost travel 23
Freight 3
Reward programs 31
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CASE STUDY 391

Business travel
The business or ‘full-fare’ segment is mainly used by business travellers and employees working in the
public sector. While this segment offers a higher-quality experience, it has been under pressure due to
business and government cost-control policies. The unit value of a sale per passenger for the business
segment is approximately double that of the leisure segment.
In addition to business-class tickets, this segment includes ‘fully flexible’ fares in economy class that
allow booking and flight changes at short notice, and provide similar services to business class like lounge
access, entertainment, baggage allowances and meals. Flexible economy seats achieve premium prices.
Leisure travel
The leisure or ‘low-fare’ segment is mainly provided to travellers on holidays or for other personal reasons.
Only limited services are provided with low-cost fares. Self-service is often required for booking, checking
in and baggage drop-off. Additional services may be purchased separately, and the revenues for this
segment are a combination of ticket price and the price of services that have been purchased with the
ticket or on-board the aircraft.
Freight
Items that are time sensitive or that have a high value-to-weight ratio are often transported by air rather
than by road or rail. The boom in online shopping has led to a significant growth in this industry segment.
VALUE DRIVERS
RPK and ASK are driven by the key industry value drivers, which include:
• links with travel agents, international airlines (RPK) and road and rail freight handlers
• optimum aircraft capacity utilisation (Passenger load = RPK / ASK)
• ability to expand and reduce aircraft capacity in line with demand (ASK)
• fuel price fluctuations (international oil price)
• domestic tourist visitor nights (RPK)
• real household discretionary income (RPK)
• on-time performance—predictably, Qantas is the best on-time performer, and Tigerair is the least
punctual.
Figure CS4 provides a summary of the airline industry value chain.
FIGURE CS4 Airline industry value chain
Airports
Aircraft Tourism
Pre- In-flight Arrival
Departure
departure services and exit
Fuel Freight
Catering
INDUSTRY COST STRUCTURE

Airline operating margins are relatively low due to price competition and fluctuating/increasing fuel costs.
Over the decade to 2012, fuel prices tripled. Revenue growth has been poor.
Key costs include:
• fuel
• wages
• aircraft operations
• aircraft leasing/depreciation
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• marketing
• property
• IT.
INDUSTRY FACTORS
Environment
Factors like carbon emissions and carbon pricing pressure airlines to become more efficient and environ-
mentally focused and lead to significant capital investment in efficient and lighter aircraft.
Noise is another factor. Curfews on flying at night (between 11.00 pm and 6.00 am) exist at Sydney
Airport, which makes additional growth difficult. Attempts to develop a new airport in Sydney or to add
another runway to the existing airport meet with fierce opposition from local communities.
Technology
Videoconferencing may reduce demand for air travel. The possibility of high-speed trains linking major
capital cities is also a threat.
Technology is helping airlines with cost management and pricing. Software tools for the efficient
scheduling of aircraft and flight crews are becoming more powerful. Ticket pricing can be adjusted in
real time to reflect small changes in demand, helping to ensure that aircraft are not only filled but also
have the highest possible revenue per seat. The use of technology to enable flight bookings, web check-in
and self-service baggage drop-off has also led to cost improvements.
Regulation
A combination of regulatory change and new technology is also likely to affect the 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 includes the position, speed and identity
of the aircraft. The ADS–B system is currently being introduced into Australia.
Benefits include more direct flight routes and aircraft operating in closer proximity to each other,
facilitating more take-offs and landings and reduced time spent in holding patterns and at airports. Another
benefit will be the ability to perform a continuous descent—rather than a stepped descent—which reduces
fuel costs and emissions.
INDUSTRY COMPETITORS
Competition within the domestic airline industry is unique because of the Qantas/Virgin duopoly. Between
them, they have four major brands (Qantas, Jetstar, Virgin and Tigerair), and they control several minor
brands focused on regional areas. So, instead of a protected duopoly with high prices as was the case
before 1990, prices have remained comparatively low as the airlines fight for market share, especially in
the high-price business segment.
Qantas
Qantas primarily targets and is the market leader in the business/full-fare segment. 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.
Historically, the business segment was uncompetitive—however, since Virgin Australia started provid-
ing business class, there has been greater competition. Qantas has reacted strongly to maintain its market
share by adding extra capacity and reducing prices.
QantasLink is the largest regional airline and flies to over 50 destinations. It uses smaller aircraft to
provide both metropolitan and regional services. It provides links to Qantas rewards and provides for
baggage connections for onward Qantas travel.
The company initially started as a low-cost provider in the leisure segment. However, faced with
competition in the low-cost leisure segment, it later focused on market share in the business segment.
Jetstar provides low-cost fares with a focus on the leisure market. Creating Jetstar made it easier for
Qantas to compete effectively against Virgin Australia without harming the Qantas brand. Jetstar’s low-
cost structure was facilitated by having a single type of aircraft. This minimised complexity (e.g. with
maintenance and pilot certification). Services such as checked luggage and preferred seating are provided
on a user-pays model.
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CASE STUDY 393

Virgin Australia
Virgin Australia originally focused on the leisure travel segment and grew its market share through
low prices, branding and cost control. It became the market leader. The introduction of Jetstar curtailed
Virgin Australia’s strong growth. The later entry of Tigerair, an ultra-low-cost airline, created even more
pressure. In response, Virgin entered the business segment to attract higher-yield customers. By 2010,
Virgin Australia had secured about 10 per cent of business travellers and approximately 30 per cent of all
domestic air travellers.
In May 2013, Skywest became part of Virgin Australia. Skywest Airlines was a regional airline that
provided services mainly in regional WA as well as to Darwin in the Northern Territory of Australia.
Tigerair launched in 2007. Tigerair introduced extremely low fares matched with a simple service
offering. Flying out of peripheral airports and terminals, only basic services were provided.
In July 2013, Virgin Australia took control of Tigerair. As part of Virgin’s change in strategic direction
towards 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 eliminate Tigerair as a competitor as it was undercutting Virgin’s prices.
Other players
A number of small regional airlines serve diverse regional areas—like WattleJet, which serves mainly
regional WA. Only 2 million of the current 60 million domestic flights depart from or arrive in
regional towns.
PORTER’S FIVE FORCES MODEL AND THE AUSTRALIAN

DOMESTIC AIRLINE INDUSTRY
Module 1 described Porter’s five forces model, which considers the following industry opportuni-
ties/threats:
1. new entrants
2. substitute products
3. the power of customers
4. the power of suppliers
5. the intensity of competition.
Applying these five forces to the Australian domestic airline industry, it is noted that:
1. 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.
2. The threat of direct substitutes, such as road and train travel, is low—with the possible introduction of
high-speed ‘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, is low but is 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.
3. 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.
4. Suppliers of fuel are powerful because 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.
5. 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.
Pdf_Folio:394

WATTLEJET STRATEGIC INITIATIVES
STRATEGIC COST AND PROFIT MANAGEMENT
WattleJet is attempting to reduce its overall costs and improve its margins. One area that it has started
to review is sales and customer service. Major competitors have made significant savings on ticketing
by replacing call centres with online booking systems. WattleJet decided to review costs incurred in the
ticketing area.
Total costs in the sales and marketing area for 2018 were $1.879 million. Marketing and advertising
costs were $1.1 million. The costs of ticketing ($0.779 million) are split between four main activities:
1. maintenance of the sales website
2. staffing of the bookings call centre
3. resolution of complaints and disputes
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.
Further analysis of its sales and marketing area revealed that:
• Approximately 2200 hours are spent on website design and maintenance during the year.
• The call centre receives approximately 32 000 calls per annum in relation to queries, bookings, changes
and cancellations.
• Approximately 800 complaints are raised during the year.
• The number of tickets physically printed and distributed is 42 000 per annum.
Table CS5 shows the activities and costs within the ticketing component of the sales and
marketing function.
TABLE CS5 Ticketing—activities, drivers, costs and transactions
Cost driver transactions

per customer group
Total cost Online Call centre

Total driver ticket ticket
Activity Cost driver costs transactions purchasers purchasers
1. Website design and Number of $ 167 200 2 200 hours 2 150 50

maintenance employee hours
2. Call centre queries, Number of $ 464 000 32 000 calls 5 800 26 200
bookings and changes phone calls
3. Complaint and dispute Number of $ 42 400 800 635 165

resolution complaints complaints
4. Physical ticket distribution Number of $ 105 000 42 000 4 000 38 000

physical tickets tickets
distributed
PROJECT ANALYSIS, SELECTION AND IMPLEMENTATION

Regulations require WattleJet to adopt the new ADS–B air traffic control technology by the end of 2021.
However, there is also an opportunity to implement the new technology earlier than originally planned.
WattleJet has decided to investigate whether the benefits of ADS-B would justify its early adoption.
The estimated up-front 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 CS6
contains a probability analysis of the estimated fuel and other efficiency savings from an early upgrade to
ADS-B, compared to waiting until 2021.
Pdf_Folio:395
CASE STUDY 395

TABLE CS6 Estimated savings from an early upgrade to ADS-B

Probability $ $ $
30% 45 300 111 800 145 300
50% 86 800 152 000 178 000
20% 114 000 165 000 190 000
Table CS7 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 take-off
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 aircraft leasing or purchase costs.
TABLE CS7 Time estimates for the ADS-B upgrade activities
Time estimates (working days)
Preceding
Activity Activity description Optimistic Most likely Pessimistic activity
1. Review and select technology 30 50 90 —

and infrastructure
2. Obtain quotes from various 15 20 30 —

suppliers
3. Choose supplier and prepare 10 14 25 1 and 2

formal contracts
4. Installation of equipment 65 90 185 3
5. Testing and final acceptance 60 85 120 4
6. Re-plan current flight routes 85 110 120 3
CONCLUSION
This Case study is designed to provide you with some appreciation of the complex challenges and issues
that managers face. 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.
CASE STUDY TASKS

Assume that you have been hired as the management accountant for WattleJet. Your role involves preparing
the following information for management.
TASK 1
Strategic management accounting at WattleJet

(a) How does WattleJet create value?
(b) How may strategic management accounting support management decision-making and help
to create and manage value for WattleJet?
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(c) What are the types of information that will be useful for the management of WattleJet?
(d) What are the requirements for an effective management accounting system (MAS) for
WattleJet?
TASK 2
Decision-making
(a) Use the conceptual framework approach introduced in Module 2 to identify WattleJet’s
stakeholders.
(b) Based on the results of (a), prepare a stakeholder grid (see Module 2) to assess stakeholder-
related risk (Interest × Power).
High
Power
Low
Low Interest High
(c) Based on the results of (b), identify the stakeholders’ information needs.
TASK 3
Budgeting
(a) Using the following template (column B), prepare a budget for 2019. The budget should be based
on the following assumptions.
(i) Ignore inflation.
(ii) Ticket sales and sales and marketing expenses are based on an estimated RPK increase of
1 per cent over 2018 figures.
(iii) Freight will not change.
(iv) Cost saving measures in the ticketing system will reduce sales and marketing expenses by
$0.3 million and increase IT costs by $0.4 million.
(v) All expenses other than property and IT and sales and marketing are estimated to be –0.5
per cent below 2018 figures.
(vi) Property and IT are fixed costs except as noted in (iv).
(b) Using the same template below (column C – B), calculate budget variances.
Profit and loss budget 2019 2018 actual 2019 budget 2019 actual Budget variance
A B C C–B
($m) ($m) ($m) ($m)
Revenues
Ticket sales 99.371 100
Pdf_Folio:397
CASE STUDY 397

Freight 8.213 10
Total 107.584 110
Expenses
Wages 37.690 38
Fuel 28.725 34
Flight 8.637 9
Aircraft 9.121 10
Sales and marketing 1.898 2
Property and IT 12.494 13
Total 98.565 106
EBITDA 9.019 4
(c) Prepare a report to management explaining the significance of the 2019 budget variances.
TASK 4
Project management
(a) Evaluate the ADS-B project using qualitative and quantitative criteria including a risk assess-
ment/NPV analysis. Assume a discount rate of 14 per cent.
Your risk analysis should include:
(i) estimated savings from an early upgrade to ADS-B
(ii) estimated cash flows
(iii) ADS-B early upgrade—discounted cash flow (DCF) analysis
(iv) explanation of the DCF
(v) quantitative risk analysis
(vi) explanation of results
(vii) risk assessment summary.
(i) Estimated savings from an early upgrade to ADS-B

Probability $ $ $
30%
50%
20%
(ii) Estimated cash flows
Weighted Weighted Weighted

average: average: average:
Pdf_Folio:398

(iii) ADS-B early upgrade—DCF analysis
0 Year 1 Year 2 Year 3 Total

Year $ $ $ $ $
Investment outlay
Estimated fuel efficiency

savings
Net cash flow
Discount factor calculation

(14%)
Discount factor
Discount calculation
Estimated present value
(iv) Explanation of the DCF

(v) Quantitative risk analysis
Worst-case cash flow
Worst-case NPV
Best-case cash flow
Best-case NPV
(vi) Explanation of results

(vii) Risk assessment
(b) (i) Construct a PERT network diagram for the ADS-B project based on the data in Table CS7.
(ii) Calculate the expected time (ET) for each activity.
(iii) Define the critical path and calculate the estimated duration of the project.
Draw a network diagram.
Note: You will either need to do this separately on a piece of paper, or you may prefer to create
the network diagram in a drawing program before adding your response to the answer field.
Calculate the expected time for each activity.
Most Expected
Activity Description Optimistic likely Pessimistic Calculation time
1 Review and select technology 30 50 90

and infrastructure
2 Obtain quotes from various 15 20 30

suppliers
3 Choose supplier and prepare 10 14 25

formal contracts
4 Installation of equipment 65 90 185
5 Testing and final acceptance 60 85 120
6 Re-plan current flight routes 85 110 120
Pdf_Folio:399
CASE STUDY 399

Define the critical path and duration of the project.
Draw the completed network diagram, including the expected times and critical path.
Note: You will either need to do this separately on a piece of paper, or you may prefer to create the
network diagram in a drawing program before adding your response to the answer field.
TASK 5
Performance management
(a) Develop suitable performance measures to evaluate WattleJet’s environmental performance.
Note: You should refer for guidance to airline company annual reports or sustainability indices
such as FTSE4Good or the Dow Jones Sustainability Index.
(b) Create a full BSC for WattleJet that includes a fifth perspective—environmental.
Area Performance measures
Learning and growth perspective
Environmental perspective
TASK 6
Strategic cost and profit management

(a) Classify the main activities in WattleJet’s ticketing process as either value-adding or non-value-
adding and provide reasons for your classification.
Activities Classification Reasons
1. Website design and maintenance Value-adding

Non-value-adding
2. Call centre queries, bookings and changes Value-adding

Non-value-adding
3. Complaint and dispute resolution Value-adding

Non-value-adding
4. Physical ticket distribution Value-adding

Non-value-adding
(b) Prepare an ABC estimate using the data in Table CS5 for ticket-purchasing costs of the two main
customer groups—those who purchase tickets online and those who purchase tickets using the
call centre. To do this:
(i) Calculate the ABC transaction cost rate.
(ii) Allocate the cost of each activity (cost pool) to the customer groups based on the number
of driver transactions used by each customer group.
(iii) Calculate the total cost for each customer group, as well as the cost per ticket for each
customer group.
(iv) Analyse the results.
Pdf_Folio:400

(i) Calculate the ABC transaction cost rate.
Cost driver Transaction

Activity area Total costs transactions cost rate
1. Website design and mainte- $ 167 200 2 200 hours

nance
2. Call centre queries, bookings $ 464 000 32 000 calls

and changes
3. Complaint and dispute $ 42 400 800 complaints

resolution
4. Physical ticket distribution $ 105 000 42 000 tickets
(ii) Allocate the cost of each activity (cost pool) to the customer groups based on the number of
driver transactions used by each customer group.
Online ticket Call centre ticket

purchasers purchasers
Driver Cost
Transaction Total trans- allo- Driver Cost
Activity area cost rate costs actions cation transactions allocation
1. Website $ 167 200

design and
maintenance
2. Call centre $ 464 000

queries,
bookings and
changes
3. Complaint $ 42 400
and dispute
resolution
4. Physical ticket $ 105 000

distribution
Total costs $ 778 600
(iii) Calculate the total cost for each customer group, as well as the cost per ticket for each
customer group.
Number of Average cost

Customer group Total cost customers per ticket
Online ticket purchase

customers
Call centre ticket purchase

customers
Difference
Overall average
(iv) Analyse the results.
Pdf_Folio:401
CASE STUDY 401

REFERENCES
Australian Government 2018, Australian Domestic Aviation Activity, accessed June 2018, https://bitre.gov.au/publications/on
going/files/domestic_airline_activity_2017.pdf.
Pdf_Folio:402

INDEX
‘identify and analyse decisions’ Australian domestic airline industry 10 traditional 137–8
approach 86–90 Australian Securities and Investments variances 117
2x2 matrix approach 171 Commission (ASIC) 236 zero-based 138–9
Australian Taxation Office 266 business case 163–4
accessibility 276 Australian Transport Safety contents of 163–4
accountability 200 Bureau 226 business cycle 41–2
accountants 13 automotive manufacturing business environment 38, 267
accounting information 237 industry 250 changes in 17–31
Accounting Professional and Ethical average accounting rate of return business environments 99, 109
Standards Board (APESB) 27 (AARR) 179 business intelligence 70–1
accounting responsibility 106–7 business model 4, 29
accounting system 28, 246 balanced scorecard (BSC) 11, 56, 63, development of 7
accounting-based measures, deficiencies 167, 254–9, 280 business model canvas 253–4
in 181 criticisms of 255–6 business partner 13
accuracy 65 Basel Accords 19–20 business process management (BPM)
accurate costing 308 benchmarking 281–3 344–6
Achmea Holding N.V. 290–5 external (industry) 282–3 continuous improvement and 351–2
acquisition strategy 29 internal 282 supplier management 354–70
activity mapping 308 method of 282
activity value analysis 346–50 problems with 283 capability factors 22
activity-based budgeting (ABB) 139–40 beyond budgeting (BB) 141–2 capital charge 180
master budget in 140 big data 25, 69–70, 266 capital equipment 24
activity-based costing (ABC) 303, Bono Musk 71 capital expenditure budget 115
305–15, 343 Boston Consulting Group Growth 37–8 cascading performance measures
benefits 308 bottom-up approach 133–5 263–5
benefits of 314–5 advantages 133 cash budget 115
cost drivers 306–8 disadvantages 133–5 cash flows, forecasting 173–4
customer profitability BPM See business process management cash management 115
analysis 370–81 BSC See balanced scorecard cause-and-effect relationships 256
implementing 309 budgetary control 137 charitable organisations 259
indirect cost allocation 310–1 budgetary slack 134 Chartered Institute of Management
steps in 307–8 budgeted balance sheet 115 Accountants (CIMA) 45
activity analysis 308 budgeting process 104, 150 CIMA See Chartered Institute of
time-driven 316–23 budgets 100–1, 149 Management Accountants
value engineering 306 activity-based 139–40 clarity 275
activity-based costing (ABC) systems alternative approaches to 137 cloud computing 25, 266
205 and forecasts 101–3 Code of Ethics for Professional
activity-based management (ABM) and strategic planning 101–2 Accountants (CPA) 238
303, 343–4, 351, 352 behavioural aspects of 132 fundamental principles in 238
activity-on-arrow network diagram 187 beyond budgeting 141–2 COGS See cost of goods sold
activity-on-node network diagram 187 external and internal factors on COGS budget See cost of goods sold
actual costs of raw materials 112–3 108–10 budget
agency theory 240–1 for decentralised organisations 116 collaborations 152, 160
aggregation method 61–3 for international organisations 110 Committee of Sponsoring Organizations
agriculture/manufacturing, in Australia incremental 138 of the Treadway Commission
20, 21 limiting factors for 103 (COSO) 237
AICPA See American Institute of managing without 141–2 competence trust 162
Certified Public Accountants monetary and non-monetary incentive competitive advantage 72
alliances 29–30 schemes 136–7 competitive forces 39
American Institute of Certified Public participative 132–5 completion time 149
Accountants (AICPA) 45 bottom-up approach 133–5 computer-based systems 108
amortisation 174 top-down approach 133 confidentiality 200, 239
analysing variances 117 planning and control 107–8 conflict of interest 200
appraising quality costs 363 preparing conformance 236
Asia Pacific Economic Cooperation financial See financial budgets consequences 169
(APEC) 23 flexible budgets 116–7 constant feedback 7
assessment 166–9 for various departments 115–6 constant monitoring 153
assets 16, 181 in non-manufacturing contemporary management model 141
values 181 organisations 114 contingency approach 254
ASX Corporate Governance project 192–3, 211 contingency response 202
Council 236 purposes of 103–5 contingency theory 240–3
auditing 5 setting realistic and achievable continuous budget 103
Australian Competition and Consumer targets 135 continuous improvement 343–52
Commission (ACCC) 328 to allocate scarce resources 103–4 productivity measures for 351
INDEX 475
control systems 58, 240, 241 data mining 69 electronic point of sale (EPOS)
controllability 276 data steward 79 technology 265
core competency 35 data warehousing 69 EMA See environmental management
corporate accountability 17 day-to-day activities 2 accounting
corporate failures 235 day-to-day transactions 74 empathy 78
corporate governance 236 decentralised organisations 115 employee-owned devices and open
corporate memory 59 budgets for 116 systems 25
corporate social responsibility (CSR) decision support systems (DSSs) 59 enablers of value 14
4, 26, 41, 49–50 decision-making process 27, 133 enterprise resource planning (ERP)
corporate strategists 1 by managers 245 system 59, 108, 265
cost centres 106 different systems for 61 benefit of 59
cost committed vs. cost incurred 333 ethically informed 168–9 objectives for 92
cost control 18, 193 influencing stakeholder 71 environmental management accounting
cost drivers 306–9 information needed for (EMA) 27
transactions 309 stakeholder 47 environmental reporting 26
cost leadership strategy 243 levels of planning and 75 equity 272
cost of goods sold (COGS) budget organisation 27 equivalent annual cash flow (EAC)
113–4 organisational 55–6 182–4
cost performance index 195 strategy and 245 errors 39
cost variance 195 decisions, types of 86 ethical decision-making model 168–9
cost-allocation base 125 define, measure, analyse, improve, ethics 27–8
cost-benefit analysis 276–8, 280 control (DMAIC) 252 and performance management
cost-volume-profit (CVP) analysis 9 delegating control 105 238–40
costing systems 314–5 depreciation 174 of information 64
costs 94–5, 106 diagnostic controls 285 European Foundation for Quality
advantages 354 Management (EFQM) Excellence
Dick Smith Group 235
and crash duration 190 Model 252
direct fixed cost 106
efficiency without reducing 329–31 Event Hospitality and Entertainment Ltd
direct labour analysis 124–5
of direct materials 112 223, 260
efficiency variance 125
quality 199 executional cost drivers 330
flexible budget variance 124
records 205 executive information systems (EISs)
price variance 124
time vs. 195–7 70
direct labour costs 125, 306
crash cost 190 expenditure model 306
direct manufacturing labour costs
crash duration 190 eXtensible Business Reporting Language
budget 113
crashing projects 190–2 (XBRL) 233
direct material analysis 122–4
duration and costs 190 external (industry) benchmarks 282–3
direct materials cost budget
financial benefits from 190 external analysis 38–9
112–3
order of activities 191 external environment 2, 12, 46
quantity of 112
creators of value 14 external factors 17
disclosure 169
credibility 78 on budgets 108–10
discount rate 175–8
critical path 189, 216 external sources of information
critical path method (CPM) 190–2 discounted cash flow (DCF)
60–1
crash duration and costs 190 methods 172, 173
external stakeholders 46, 48,
critical success factor (CSF) approach discounted payback period (DPP) 179
95, 166
85–6 disruption, in music industry 15–6
CSR See corporate social responsibility DMAIC See define, measure, analyse,
favourable variance 130
cultural fluency 153 improve, control
feedback 245, 246
culture 278–9 dogs 38
final costs 205
custodian of information 79–83 dominant coalition 278
final report 206
customer focus groups 261 DPP See discounted payback period
financial accounting systems 46, 56,
customer profitability analysis drilled down 61–3
224
370–9, 381 dumping 304
financial analysis
customer relationship management dysfunctional behaviours 105, 286
multiple projects 182–4
(CRM) systems 58–9 equivalent annual cash flow
customer value 4, 324, 334 earliest occurrence time (EOT) 189 182–4
customer value chains 302 earned value method 195–7 single projects
customers economic turmoil 17–8 deficiencies in accounting-based
cost differences 372 economic value added (EVA) 275 measures 181
revenue differences 371 effectiveness 272 internal rate of return 178–9
satisfaction 64, 226 efficiency 351 net present value 172–8
segments 375–7 efficiency variance 123 payback 179
CVP analysis See cost-volume-profit direct material 123–4 profitability index 179
analysis EFQM Excellence Model See European residual income 180–1
cybernetics 245 Foundation for Quality return on investment 179–80
Management Excellence Model sensitivity and scenario analysis
data 45 EISs See executive information systems 181–2
data custodians 79 Electrolux 103 financial and environmental performance
data flow diagram (DFD) 85 electronic commerce 20 16–7
476 INDEX
financial approach 77 global suppliers 354–5 strategic information 72–3
financial benefits 190 globalisation 21–3 tactical information 73–4
financial budgets 102, 107 background to 22 life cycle of systems 89–90
preparing 114–5 global competition 22 limitations of 63–4
budgeted balance sheet 115 legal and political systems 23 different kinds of 64
budgeted income physical and capability factors 22 linking information to strategy 76–8
statement 114 social factors and national matrix of analysis for 87
capital expenditure budget 115 cultures 22 needs of stakeholders 47–50
cash budget 115 goal congruence 132 corporate social responsibility
financial closure 205–6 goodwill trust 162 49–50
cost records 205 granular data 61 external stakeholders 48
final costs 205 GRI See Global Reporting Initiative initially establishing 84–9
post-project expenditure 205–6 gross domestic product (GDP) growth integrated reporting 49–50
financial cost 352 rates 18 internal stakeholders 48–9
financial information 63–4 actual and forecast 18, 19 other methods of 89
financial measures 251 group vs. individual performance 287 pitfalls in evaluating 90–1
financial performance management quality of 66–9
223–5 hard and soft functions 323–4 security of 64
financial planning models 108 hard functions 323–4 solution 93–5
financial reporting 5 High-end ERP systems 59 stakeholder for 46
financial risks 353 HIH insurance 234–5 information and communications
financial services organisations 52 hurdle rate 176 technology (ICT) 24–5
finished goods inventory budget 113 big data 25
fixed manufacturing overhead costs IAESB See International Accounting capital equipment 24
127–32 Education Standards Board cloud computing 25
production volume variance for 129 ICT See information and constant developments in 24
spending variance for 128–9 communications technology employee-owned devices and open
flatter hierarchies 28–9 impartiality 200 systems 25
flexible budgets 116–7, 119 inadequate reports 85–9 information asymmetry 241
direct labour analysis 124–5 incentives 150 information systems 13
direct material analysis 122–4 incremental budgeting 138 analysing new and existing 91–3
fixed manufacturing overhead costs Independent Commission Against control system 58
127–32 Corruption (ICAC) 200 customer relationship management
profit- and revenue-related variances indirect fixed cost 106 systems 58–9
120–2 indirect manufacturing costs 303–5 decision support systems 59
static budget vs. 118–20 allocation 339–40 different types of 57–60
variable manufacturing overhead time-driven activity-based costing effects and challenges of 69–71
analysis 125–7 319–20 big data 69–70
variance forvariable overhead costs with activity-based costing business intelligence 70–1
126 310–1 data mining 69
forecasting cash flows 173–4 industrial 3D printing process 24 data warehousing 69
forecasts 100–1 industry analysis 39 enterprise resource planning systems
budgets and 101–3 industry benchmarking 282–3 59
static budget 118 industry value chains 33–4 feasibility and criteria for 91–2
formal strategies 7 information 45 functions of 56
franchising 29 aggregation method 61–3 in performance management 265–6
functional requirements 74–6 assessment 66–9 knowledge management systems
future cash flows 173 characteristics of 63–9 59–60
future orientation 56 costs and benefits of 56, 94–5 levels of 57
custodian of 79–83 management accounting systems
gainsharing 351 delivery 57–8
Gantt chart 185–6 balancing stakeholder requirements on strategy formulation and
garment-making industry 27 and 71–2 implementation 56
GDP growth rates See gross domestic key issues for 71 production planning 58
product growth rates dimensions of 46, 63–4 transaction processing system 57
GFC See global financial crisis financial vs. non-financial upgrading or replacing 83
global economy 17–23 information 63–4 using information strategically 77–8
economic turmoil 17–8 ethics of 64 infrastructure risk 353
globalisation 21–3 external and internal sources of 60–1 initial investment 173
structural change 18–21 for board 54–5 innovation 16–7
global financial crisis (GFC) 287–8 four-way classification of 66 intangible benefits 93–4
Global Management Accounting functional areas needs 76 intangible goals 92
Principles 45 integration of 61 integrated reporting 49–50, 230, 232–3
global production systems 21 key risks 94–5 integrating information 61–3
Global Reporting Initiative (GRI) 49 levels in organisation 72–6 internal analysis 35–8
Sustainability Reporting functional requirements 74–6 portfolio theory 36–8
Standards 231, 232 operational information product life cycles 36–8
global sourcing strategy 354, 355 74–6 internal benchmarks 282
INDEX 477
internal control 247 Mammoth Printing 270–1, 276–7 national cultures 22
internal factors on budgets 108–10 manage risk 13 National Health System 330
internal projects 152 management accountants 1, 3, 9, net operating profit after tax
internal rate of return (IRR) 178–9 45, 73 (NOPAT) 180
internal sources of information 60–1 advertised job descriptions for 12 net present value (NPV) 172–8
internal stakeholders 47–9, 52, discount rate 175–8
analytical techniques available to
95, 166 estimated life of project 174
31–42
internal workshop 262 forecasting cash flows 173–4
and project leadership 157
International Accounting Education project cost 173
Standards Board (IAESB) 14 changes in business environment
residual value 174–5
international advertising agency 278–9 17–31
Net Promoter Score (NPS) 226
International Federation of Accountants decision-making process 27
network diagram 186–8
(IFAC) 238 in influencing stakeholder
non-essential expenditure 328
International Integrated Reporting (IR) decision-making 71
non-financial information 45, 63–4
Framework 232 in project selection 172
non-financial objectives 245
International Monetary Fund (IMF) 18 in translating strategy 46 non-financial performance management
International Organisation for Standards key challenges facing 15 225
(ISO) 354
innovation 16–7 non-manufacturing organisations 114
international political forces 23
managing resources 16 non-monetary incentive schemes
international project teams 160–1
technology 15–6 136–7
project management roles in 161
international projects 153, 160 potential role for 52 non-value-adding activities 33,
International Standards project planning 184–5 346, 347
Organization 237 roles of 3, 11–5, 78–81, 83 normal cost 190
internet-based storage 25 North American Free Trade Agreement
project selection 162–3
intrinsic factors 136 (NAFTA) 23
trusted business partner 78–9
investment not-for-profit (NFP) organisation 26,
stakeholders and 46, 71 259–60
centres 106
support an organisation 14 not-for-profit entities 1
in new system prudent 93
iPhone pricing 326 traditional definition of 157 NPS See Net Promoter Score
island of Nauru 25–6 use financial accounting
information 46
objective overseer 13
joint ventures 29–30, 152 management accounting information
offshoring 29, 367
8–9
online analytical processing
Kaizen costing 330–40 management accounting systems (OLAP) 70
key performance indicators 292 (MASs) 57–8
operating model 164
key performance indicators (KPIs) 150 management control system 238, 245 operational budgets 102, 108
KMSs See knowledge management strategy and 245–7 in manufacturing organisations
systems management reporting 30–1 110–4
knowledge 45 manufacturing facility 345 cost of goods sold budget 113–4
knowledge management 24, 206–7 direct manufacturing labour costs
manufacturing overhead costs
knowledge management systems budget 113 budget 113
(KMSs) 59–60
manufacturing risks 353 direct materials cost budget 112–3
manufacturing variance analysis 150 finished goods inventory
lack of information 85 budget 113
lagging 251 market growth 38
master budgets 102, 108 manufacturing overhead costs
laser-sintering technology 24
budget 113
latest starting time (LST) 190 developing 108
period costs budgets 114
lean accounting approach 276 in activity-based budgeting 140
production budget 111–2
ledger-based system 57 matrix approach 158 sales budget 111
legal systems 23 matrix project team 158 operational information 74–6
Leighton Holdings 152
maturity 37 operational management 6–9
levels of planning 75, 76
Mega Markets Ltd (Mega Markets) 229 with management accounting
limiting factors 102
for budgets 103 micro risks 353 information 8–9
line managers 9–10 Microsoft 33–4 operational managers 7
linked chains 1 minimising inventory levels 356 operational performance 249–51
linking information to strategy 76–8 mining company 164–5 operational planning 101
Liquefied Natural Gas (LNG) mission 74 roles of 101–3
Projects 147 operational risks 13, 353
monetary incentive schemes 136–7
local government planning opportunity costs 176, 369
monitoring, project
document 10 organisational decision-making 55–6
costs 194–7
long-term planning 101 organisational layers 73
progress 194 organisational learning 205, 256,
long-term sustainability
shareholder value 3 specification and quality 197–9 283–5
music industry 15–6, 284–5 organisational strategy 257
macro risk 353 mutually exclusive projects 183 organisational structures 28
maintenance department 106 myopia 136 for projects 151–3
478 INDEX
organisational value 343 measurability and reporting of slow penetration strategy 327–8
and potential impact 5 225–7 slow skimming strategy 327
chain 4 measures, cascading 263–5 primary activities 302
organisational value chain 33, 301, 302 models of 249–68 prime costs 304
outsource distribution 369 operational and strategic priorities 169
outsourcing 29, 367–70, 381 performance 249–51 privacy 25
in textiles 27 multiple roles of 227–42 private sectors 10
non-financial 225 research organisations 281
parallelism 160 performance and 221–2 probity, in projects 200
participative budgeting 132–5 power and culture 278–9 process mapping 308
bottom-up approach 133–5 risk and 236–8 product costing
top-down approach 133 role in strategy 243–7 activity-based management 343–52
payback 179–81 role of 220–7 continuous improvement 343–52
performance 221–2, 351 signalling 233–6 Kaizen costing 330–40
and sustainability 230–2 strategic management accounting life cycle costs 360–1
aspects of 221 approach to 248–9 reduction in 329
strategy map for 260–3 product functionality 325
dimensions 222
theories related to 240–2 product life cycles 36–8, 337
group vs. individual 287–8
agency theory 240–1 analysis 36–7
indicators 221
contingency theory 241–2 and cash curve 332
integrated reporting 232–3
traditional management controls Boston Consulting Group
leading and lagging measures of
247–9 growth/share matrix 37–8
251–2
value chain 244 cost committed vs. cost incurred 333
measurement 221, 269–72, 279
XBRL 233 costing 331–3
and performance targets 285–6
Performance Management for Turbulent decline 37
characteristics of 274–6
Environments (PM4TE) model growth 37
efficiency, effectiveness and equity
267 introduction 37
272
performance management systems maturity 37
measures and setting performance
(PMSs) 247 product quality 261
targets 269–79
performance measurement 150, production budget 111–2
perspectives on 254
199–200 production capacity 102
reporting 223, 226–7
performance prism 253 production departments 106
smart performance targets 272–4
period costs budgets 114 production planning 58
targets 272–4, 285–6
personal cultural fluency 153 productivity ratios 351
value creation process 227–30
personal data, used for profiling 70 professional accountants 14
performance improvement 279–85,
PEST analysis 40–2 professional behaviour 239
288
physical factors 22 profit 179
balanced scorecard 280–1
profit centres 106
benchmarking 281–3 physical systems 24
profit- and revenue-related variances
importance of 279–80 platforms 69–71
120–2
organisational learning and 283–5 PM4TE model See Performance
profitability index (PI) 179–81
targets 280–1 Management for Turbulent
program evaluation and review technique
trends 281 Environments model
(PERT) 186–90
performance management 221–2 political systems 23
calculate slack 190
and links to strategy 222–3 Porter’s five forces model 39–42
critical path 189
approach 77 alternative product 40
expected time 188–9
balanced scorecard 254–6 customers 40
network diagram 186–8, 212
behavioural consequences of 285 new entrants 39–40
project 146–8, 207–8
business model canvas 253–4 supplier 40
budget 192–3, 211
control systems and 240 portfolio theory 36–8
business case for 163–4
costs and benefits of 276–8 post-project expenditure 205–6
characteristics 147
ethics and 238–40 power 278–9
checklist 203
financial 223–5 predictive model 256, 281
collaborations 152
for performance improvement preliminary assessment 83–90 completion and review 150–1, 203,
279–88 benefits of 84 207
frameworks for 252–3 preservers of value 14 completion decision 203
governance 236–8 price setting, legal implications of 328 cost 173
in implementing and monitoring price variances 118, 123, 150 disputes 198
strategy 266–8 direct material 123 estimated life of 174
in public hospital 264–5 pricing decisions 323–5 financial modelling of 211–2
incentives and rewards 286–8 hard and soft functions 323–4 four stages of 149
group vs. individual performance surplus value 324–5 implementation and control 150, 193
287–8 pricing strategies 325–8 earned value method 195–7
timing 287 for household products division 327 measuring performance 199–200
information systems in 265–6 legal implications of price setting monitoring costs 194–7
International Integrated Reporting 328 monitoring progress 194
(IR) Framework 232 rapid penetration strategy 326–7 monitoring specification and quality
key issue for 229 rapid skimming strategy 326 197–9
INDEX 479
project (continued) project teams 158–9 project 200–2
importance of probity in 200 international 160–1 establish contingency responses
internal 152 matrix 158, 159 202
joint ventures 152 task-force 158, 159 known risks 201
organisational structures for 151–3 virtual 161–2 right project team 201
organisations 151–2 prominent organisations 139 risk-return trade-off 202
quality management 197 pseudo participation 133 unknown risks 201–2
risk assessment 169–72 public private partnerships (PPPs) 153 stakeholder 52–5
risk management 200–2 public sector 259–60 risk-return trade-off 202
selection 149, 207 public sectors 3, 10–1, 26 ROI See return on investment
specification satisfaction consensus purchasing capital items 25 rolling budget 103
204
stakeholder management 202–3 qualitative information characteristics
65 safety index 226
strategic fit assessment 204–5
quality 362 sales budget 111
supplier contracts 193
costs 199, 362, 363 supply and demand influence on 111
virtual 153
monitoring specification and 197–9 sales manager 106
with expected life of five years 176
of information 66–9 sales revenue 251
project budget 192–3
quantity of direct material 112 sales volume variance 120–1
project finance function 172
question marks 38 scenario analysis 181–2
project leadership 157
schedule performance index (SPI) 195
project management 148
and knowledge management 206–7 rapid penetration strategy 326–7 schedule variance 195
and management accountant 157 rapid skimming strategy 326 scope creep 203
assessment 166–9 RAS See responsibility accounting SDLC See systems development life
system cycle
defined 146
raw materials 108 secondary sources of information 64
final report 206
regional economic 23 security of information 64
financial closure 205–6
international project teams 160–1 regulation 41 self-orientation 79
process 149–51 regulatory bodies 235 selling prices 325
project see also project reliability 65, 78, 275 variance 121
characteristics 147 renewable energy products 337–8 semi-autonomous work 160
completion and review 150–1 reporters of value 14 senior management 7, 74
four stages of 149 residual income 180–1 sensitivity 181–2
implementation and control 150 residual value 174–5 separate budgets 112
international 153 resource-based theory 35 service industries 10
resources 35 service organisations 114
joint ventures 152
responsibility accounting 106–7, 121 service-based organisation 155, 184–5
organisational structures for
relationship with 105–7 setting realistic budgets 135
151–3
cost centres 106 share matrix 37–8
organisations 151–2
investment centres 106 shareholder value 3–4, 228
planning stage 150
profit centres 106 short-term planning 101
selection stage 149
revenue centres 106 signalling 233–6
public private partnerships 153
responsibility accounting system (RAS) risk management and 234
resource dispersion 206
28 simple feedback model 245
roles in 154
responsibility centre 105 Six Sigma Business Scorecard 252
international project teams 161
types of 105
project manager 155–7 slow penetration strategy 327–8
responsibility centres 28
project sponsor 154–5 slow skimming strategy 327
retail stores 266
project team See project teams SMART performance measures 65
return on investment (ROI) 63, 106,
software 193 SMART performance targets 272–4
179–81, 247, 351
stakeholder identification 166–9 social development goals 294
revenue centres 106
strategic fit 164–6 social factors 22
reverse value chain 341–3
virtual project teams 161–2 revised project budget 193 social reporting 26
Project Management Institute 148 reworking defective products 364 soft functions 323–4
project managers 155–7 Rio 2016 Summer Olympics 148 soft skills 78
duties and challenges for 156 risk solar power industry 24
exercises leadership 157 classification 170–1 spare capacity 329–31
skills required by 155 identification 169–70 specification 149
project planning 150, 184–5, 207 mitigation 171–2 SPI See schedule performance index
project scheduling 185–92 register entry 172 stakeholders 46
steps 184 risk assessment broad range of 3
project scheduling 185–92 project 169–72 decision-making, information needed
Gantt chart 185–6 risk classification 170–1 for 47
program evaluation and review risk identification 169–70 focus 26
technique 186–90 risk management grid 50–1
project selection, role in 162–3 and mitigation 13 identification 166–9
project sponsor 154–5 and signalling 234 impact on 168–9
480 INDEX
information for 13, 47–50 stakeholder value 4 symbolic potential 169
corporate social responsibility strategic management and 5 systems development life cycle (SDLC) 89
49–50 sustainability See sustainability
evaluating 52–4 SWOT analysis 34–5 tactical information 73–4
initially establishing 84–9 technology 23–5 tangible benefits 93–4
integrated reporting 49–50 traditional management accounting tangible goals 92
internal stakeholders 48–9 compared to 12 target costing 332–8
other methods of 89 value 3–5 Kaizen compared to 335
pitfalls in evaluating 90–1 value analysis 32–4 need for 338
management 50–5, 202–3 strategic performance 249–51 targets 280–1
power 51 management 267 performance 285–6
risk management 52–5 strategic planning 100–1 task-force approach 158, 159
satisfaction assessment 205 and operational planning 101 task-force project team 158
typology of 51 budgets and 101–2 TDABC See time-driven activity-based
value 4, 301 strategic revenue management costing
wealth 4 pricing decisions 323–5 technological changes 22
standard accounting information systems hard and soft functions 323–4 technology 15–6, 23–5
(AISs) 27 surplus value 324–5 capital equipment 24
standard overhead-cost allocation rate pricing strategies 325–8 information and communication
125 rapid skimming strategy 326 technologies 24–5
static budget 118 strategy technology-based systems 59
vs. flexible budgets 118–20 and decision-making 245 tests of feasibility 91
statistical process control 363 and management control 245–7 thermostat 245
step-by-step approach 257 implementation 264 thorough approach 94
stock markets 223 performance management and control time vs. cost 195–7
strategic alliances 29–30 243–7 time-driven activity-based costing
strategic cost management strategy mapping 280, 290, 293 (TDABC) 303, 316–23
offshoring 367 for performance management 260–3 to allocate indirect manufacturing
outsourcing 367–70 strengths, weaknesses, opportunities and costs 319–20
threats (SWOT) analysis 7, 34–5, timeliness 275–6
product life cycle 331–3
290, 291 top-down approach 84, 133
target 333–6
structural cost drivers 329, 330 total quality improvement initiative
total quality management 362–7
supplier 365–6
strategic cultural fluency 153
contracts 193 total quality management (TQM) 92,
strategic fit 164–6
costs 353 362–7
assessment 204–5
trade organisations 23
strategic information 72–3 management 354–70
traditional budgets, shortcomings of
strategic management 5–7 codes of conduct 355–6
137–8
analysis 6–7 global suppliers 354–5
traditional management accounting 12,
and operational management 7–9 minimising inventory levels 356
39
evaluation 7 supply chain disruptions 356
traditional management controls 247–9
implementation 7 vendor/supplier selection 357–62
traditional project management 157
planning and choice 7 value chain 302
traditional skills 14
process 6–11 supply chain disruptions 356–7
traditional volume-based allocation
role of management accountants in 11 supply chain management (SCM) 7
methods 306
strategic management accounting 1 supply risk 353
Trans-Pacific Partnership 23
analyst, business adviser, partner support activities 302
transaction processing system (TPS) 57
12–3 surplus value 324–5
transparency 200
and line managers 9–10 sustainability 25–6, 31
trends 281
and public sector 10–1 alliances 29–30
triple bottom line 230
and service industries 10 corporate social responsibility 26
trusted adviser 46
and strategic management environmental management
trusted business partner 78–9
process 32 accounting 27
approach 248–9 ethics 27–8 unavailable suitable reports 85–9
contemporary skills and techniques flatter hierarchies 28–9 unfavourable variance 130
13–5 joint ventures 29–30 unintended behaviours 286
customer value 4 management reporting 30–1 unsustainable social activities 26
development of 1 Newcrest Mining 231 updated information systems 83
external analysis 38–9 offshoring 29 preliminary assessment 83–90
financial accounting and 224 outsourcing 29 stimulus for 83
global economy 17–23 performance and 230–2 US tariffs 23
economic turmoil 17–8 reporting 26
globalisation 21–3 virtual offices 29 validity 65, 274–5
structural change 18–21 sustainable value 4 value 3–5, 169
in supporting managers 6 Svenska Handelsbanken 288 customer 4
internal analysis 35–8 SWOT analysis See strengths, definition of 3
operational tasks and 32 weaknesses, opportunities and determining 4–5
Porter’s five forces model 39–42 threats analysis shareholder 3–4
shareholder value 3–4 Sydney Seafood Bar 208 stakeholder 4
INDEX 481
value analysis 32–4 flexible budget 126 virtual project teams 161–2
industry value chains spending variance 126 challenges for 162
33–4 variances virtual projects 153
organisation value chains 33 analyses 107, 117–8, 130 vision 74
value chain 32, 243–4 calculation 188 voluntary standards 354
analysis 329 control 117–8
reverse flows in 341–3 direct material flexible budget 122–3 WACC See weighted average cost of
value creation 1–3 capital
favourable and unfavourable 126–7
weighted average cost of capital
Apple Inc. 228 implementing improvements informed
(WACC) 175
in contemporary organisations 3 by 130
whole-of-business approach 59
process of 227–30 in budget 112–3
workgroup cultural fluency 153
Woolworths 228–9 possible reasons for 128 World Trade Organization (WTO) 23
value engineering (VE) 306 price and efficiency 123 WorldCom 239–40
Value Proposition Canvas 253 profit- and revenue-related 120–2 written communication skills 13
value-adding activities 346, 347 sales volume 121 WTO See World Trade Organization
variable direct manufacturing selling-price 121
costs 122 variation time 318 XBRL See eXtensible Business
variable manufacturing overhead vendor/supplier selection 357–62 Reporting Language
analysis 125–7 video 284–5
efficiency variance 126 virtual offices 29 zero-based budgeting 138–9
482 INDEX

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CPA PROGRAM

ISBN 978 0 6487512 2 9

CPA Program team

1. Introduction to Strategic Management Accounting 1

Case Study 385

BEFORE YOU BEGIN

TABLE 1 Module weightings and study time

1. Introduction to strategic management accounting 10 10

2. Information for decision-making 14 15

3. Planning, budgeting and forecasting 20 22

6. Tools for creating and managing value 17 17

My Online Learning and your eBook

GENERAL EXAM INFORMATION

xii SUBJECT OUTLINE

FIGURE 1.1 Subject map highlighting Module 1

Source: CPA Australia 2019.

2 Strategic Management Accounting

FIGURE 1.2 A broad range of stakeholders

Source: CPA Australia 2019.

MODULE 1 Introduction to Strategic Management Accounting 3

FIGURE 1.3 Organisational value chain

These activities are supported by a variety of business functions.

Source: CPA Australia 2019.

WHICH VIEWPOINT SHOULD BE TAKEN WHEN

4 Strategic Management Accounting

Organisational viewpoint Society’s viewpoint

Massive price A small price reduction

Selling addictive Social issues in

Source: CPA Australia 2019.

Strategic management and strategic management accounting

MODULE 1 Introduction to Strategic Management Accounting 5

FIGURE 1.5 The strategic management process

Source: CPA Australia 2019.

MODULE 1 Introduction to Strategic Management Accounting 7

Strategic management Operational management

Organisation-wide phenomenon Relates to specific operations of the organisation

Long-term process Focused on short and medium terms

Involves non-routine activities Involves routine day-to-day activities

Sometimes very ambiguous Does not involve any ambiguity

Manages critical success factors (CSFs) Performs activities on a day-to-day basis

Source: CPA Australia 2019.

Supporting operational management with management accounting

Plan Sales target

8 Strategic Management Accounting

1 January 31 January 31 March

Sales target decreased

MODULE 1 Introduction to Strategic Management Accounting 9

Strategic management accounting and service industries

Read this extract from a local government planning document.

HEALTHY AND INCLUSIVE COMMUNITIES

10 Strategic Management Accounting

GROWTH AND PROSPERITY

MOBILE AND CONNECTED CITY

CLEAN AND GREEN

Goal Strategic management accounting information

Healthy and inclusive communities

Quality places and spaces

Growth and prosperity

Mobile and connected city

Clean and green

PART C: THE ROLE OF MANAGEMENT

THE ROLE OF MANAGEMENT ACCOUNTANTS

MODULE 1 Introduction to Strategic Management Accounting 11

TABLE 1.2 Traditional management accounting compared to strategic management accounting