Performance analysis and behavioural aspects

Performance analysis and behavioural aspects

1. Using variance analysis

1.1 Analysing past performance with variance analysis: Variance analysis compares actual performance with a budget or standard cost. Differences between actual results and the budget or standard are reported in monetary terms as variances, and variances can be used to reconcile budgeted profit and actual profit in an operating statement. For the exam, you also need to show an awareness of what variances tell us, and what control measures management should take when a variance is reported. Basic principles of variance reporting are that:

(a) The monetary value that is given to variances should be a reasonable indication of how much profit has been made or lost as a result of actual performance differing from the budget or standard.

(b) The managers responsible for variances (adverse or favourable) should be identified, and they should be expected to account for the variance and, where appropriate, indicate what corrective or control measures they are taking.

1.1.1 Responsibility for planning variances: It was explained in the previous chapter that planning variances arise when a budget or standard cost is revised. 'Errors' in the budget or standard cost are attributable to the managers (planners) who prepared the budget or standard cost. Variances arising because the budget or standard cost was inappropriate should not be attributed to operational management.

In many cases, revisions to a budget or standard cost are due to causes outside the control of the planners. An unexpected increase in the market price for materials, for example, is beyond the control of planners. Similarly, an unexpected collapse in market demand for an industry's products, resulting in an adverse sales volume planning variance, cannot usually be 'blamed' on planners.

Even so, planning variances, where they occur, should be identified separately. Operational managers should be held responsible only for variances that may be realistically attributable to differences between actual performance and a realistic budget or standard. In other words, operational managers should be held responsible for operational variances. Unless they were also involved in the budgeting or standard- setting process, operational managers are not responsible for planning variances.

1.1.2 Responsibility for operational variances: Responsibility for operational variances should be traced to the managers who are in a position of authority and control over operations where the variances occur. Operational management responsibility for variances depends on the organisation structure and the division of authority and responsibility between management.

For example, a material price variance is the difference between actual and standard purchase costs of materials. The operational manager responsible for this variance should be the manager who makes the decisions about buying materials. This may be the head of buying in one organisation, and the production manager in a different organisation.

You should be able to identify the managers responsible for operational variances. A general guide is given in the table below.

Variance	Responsibility
Sales price variance	Sales or marketing management
Sales volume variance	Normally sales or marketing management However, if sales are less than budget due to problems with production, the production manager is responsible
Material price variance	The manager responsible for purchasing materials
Material usage variance	Normally the production manager
Labour rate variance	The manager responsible for pay rates. This may be senior management or Human Resources management. However, the production manager will be responsible for any adverse rate variances caused by working overtime and paying employees a premium rate per hour
Labour efficiency variance	Normally the production manager
Idle time variance	This depends on the cause of the idle time. It may be caused by lack of sales orders (sales management responsibility), inefficient production management (production management responsibility) or delays in deliveries of key raw material (buying manager responsibility)

1.2 Using variance analysis to improve future performance: Variance analysis is not simply a method of analysing past performance. It should provide guidance for operational management about aspects of performance that need improving. Variances should be a guide to control action and improving future performance.

It is important to understand that a reported variance is a measurement that relates to historical performance. Control action affects the future, not the past. So, for example, if an adverse labour efficiency variance of $10,000 is reported one month, and the production manager takes measures to improve efficiency:

(a) The effect of the control measures should be to improve efficiency, but the value of the efficiency improvement in future months is unlikely to be $10,000. Control measures may result in savings of more or less than $10,000 per month, depending on how effective the measures are.

(b) The effect of control measures should have a reasonably long-term impact, so control measures may result in savings not just in the following control period but also for a reasonably long time into the future.

1.2.1 The significance of variances: Control action to improve future performance should only be taken when a variance seems significant. Some variances are inevitable, because it is most unlikely that actual results will be exactly the same as the budget or standard.

(a) Favourable as well as adverse variances should be investigated, with a view to taking control action if they seem significant. Control action to improve poor performance may seem an obvious requirement. However, control action to reinforce favourable performance should also be expected from management.

(b) Variances need not be investigated if they do not seem significant. For example, variances that are less than, say, 5% of the budget or standard cost amount may be disregarded, because they fall within an acceptable tolerance limit.

(c) Management may not use variances in a single reporting period as a guide to control action, since a variance in one month may be due to a once-only event. Instead of relying on variances reported in a single month, management may monitor cumulative variances over a period of time, and identify those that should be investigated on the basis of performance or trend over a number of months.

1.2.2 The cost of control action: Taking control measures to deal with the cause of a variance takes effort and costs money. Control measures should only be taken if it seems probable that the benefits arising from improved performance are sufficient to justify the cost of investigating the causes of the variance and taking control action. This is a reason why insignificant variances are not investigated.

1.2.3 Improving performance: An exam question may ask about the nature of control action that an operational manager may take to deal with the cause of an adverse variance and so improve performance. The appropriate control measures will obviously depend on the circumstances and the reasons why a variance occurred, so you may need to use common sense and judgement in dealing with any question on this topic. A few ideas are set out in the following table to give you an idea of the issues that may be considered.

Variance	Possible control action
Adverse sales volume variance	Consider reducing the sales price in order to increase sales demand, although this will result in an adverse sale price variance
Adverse material price variance	Search for a supplier who is prepared to offer a lower price Consider purchasing in bulk quantities in order to obtain large-order discounts
Adverse material usage variance Adverse labour efficiency variance	Consider providing training for the workforce, with the objective of improving labour efficiency and reducing wastage of materials

2. Behavioural implications: Used correctly, a budgetary control and variance reporting system can motivate managers and employees to improve performance, but it may also produce undesirable negative reactions.

The purpose of a budgetary control and variance reporting system is to assist management in planning and controlling the resources of their organisation, by providing appropriate control information. The information will only be valuable, however, if it is interpreted correctly and used purposefully by managers and employees.

The appropriate use of control information therefore depends not only on the content of the information itself but also on the behaviour of its recipients. This is because control in business is exercised by people. Their attitude to control information will colour their views on what they should do with it and a number of behavioural problems can arise.

(a) The managers who set the budget or standards are often not the managers who are then made responsible for achieving budget targets.

(b) The goals of the organisation as a whole, as expressed in a budget, may not coincide with the personal aspirations of individual managers.

(c) Control is applied at different stages by different people. A supervisor may receive weekly control reports, and act on them; their superior may receive monthly control reports, and decide to take different control action. Different managers can get in each other's way, and resent the interference from others.

2.1 Motivation: Motivation is what makes people behave in the way that they do. It comes from individual attitudes, or group attitudes. Individuals will be motivated by personal desires and interests. These may be in line with the objectives of the organisation, and some people 'live for their jobs'. Other individuals see their job as a chore, and their motivations will be unrelated to the objectives of the organisation they work for.

It is therefore vital that the goals of management and the employees harmonise with the goals of the organisation as a whole. This is known as goal congruence. Although obtaining goal congruence is essentially a behavioural problem, it is possible to design and run a budgetary control system which will go some way towards ensuring that goal congruence is achieved. Managers and employees must therefore be favourably disposed towards the budgetary control system so that it can operate efficiently.

The management accountant should therefore try to ensure that employees have positive attitudes towards setting budgets, implementing budgets (that is, putting the organisation's plans into practice) and feedback of results (control information).

2.2 Poor attitudes when setting budgets: Poor attitudes or hostile behaviour towards the budgetary control system can begin at the planning stage. If managers are involved in preparing a budget the following may happen.

(a) Managers may complain that they are too busy to spend much time on budgeting.

(b) They may build 'slack' into their expenditure estimates.

(c) They may argue that formalising a budget plan on paper is too restricting and that managers should be allowed flexibility in the decisions they take.

(d) They may set budgets for their budget centre and not co-ordinate their own plans with those of other budget centres.

(e) They may base future plans on past results, instead of using the opportunity for formalised planning to look at alternative options and new ideas.

On the other hand, managers may not be involved in the budgeting process. Organisational goals may not be communicated to them and they might have their budget decided for them by senior management or administrative decision. It is hard for people to be motivated to achieve targets set by someone else.

2.2.1 Poor attitudes when putting plans into action: Poor attitudes also arise when a budget is implemented.

(a) Managers may put in only just enough effort to achieve budget targets, without trying to beat targets.

(b) A formal budget may encourage rigidity and discourage flexibility.

(c) Short-term planning in a budget can draw attention away from the longer-term consequences of decisions.

(d) There may be minimal co-operation and communication between managers.

(e) Managers will often try to make sure that they spend up to their full budget allowance, and do not overspend, so that they will not be accused of having asked for too much spending allowance in the first place.

2.2.2 Poor attitudes and the use of control information: The attitude of managers towards the accounting control information they receive might reduce the information's effectiveness.

(a) Management accounting control reports could well be seen as having a relatively low priority in the list of management tasks. Managers may take the view that they have more pressing jobs on hand than looking at routine control reports.

(b) Managers may resent control information; they may see it as part of a system of trying to find fault with their work. This resentment is likely to be particularly strong when budgets or standards are imposed on managers without allowing them to participate in the budget-setting process.

(c) If budgets are seen as pressure devices to push managers into doing better, control reports will be resented.

(d) Managers may not understand the information in the control reports because they are unfamiliar with accounting terminology or principles.

(e) Managers may have a false sense of what their objectives should be. A production manager may consider it more important to maintain quality standards regardless of cost. They would then dismiss adverse expenditure variances as inevitable and unavoidable.

(f) If there are flaws in the system of recording actual costs, managers will dismiss control information as unreliable.

(g) Control information may be received weeks after the end of the period to which it relates, in which case managers may regard it as out of date and no longer useful.

(h) Managers may be held responsible for variances outside their control.

It is therefore obvious that management accountants and senior management should try to implement systems that are acceptable to budget holders and which produce positive effects.

2.2.3 Pay as a motivator: Many researchers agree that pay can be an important motivator, when there is a formal link between higher pay (or other rewards, such as promotion) and achieving budget targets. Individuals are likely to work harder to achieve budget if they know that they will be rewarded for their successful efforts. There are, however, problems with using pay as an incentive.

(a) A serious problem that can arise is that formal reward and performance evaluation systems can encourage dysfunctional behaviour. Many investigations have noted the tendency of managers to pad their budgets either in anticipation of cuts by superiors or to make the subsequent variances more favourable. Moreover, there are numerous examples of managers making decisions in response to performance indices, even though the decisions are contrary to the wider purposes of the organisation.

(b) The targets must be challenging but fair, otherwise individuals will become dissatisfied. Pay can be a demotivator as well as a motivator!

3. Setting the difficulty level for a budget: 'Aspirations' budgets can be used as targets to motivate higher levels of performance but a budget for planning and decision-making should be based on reasonable expectations.

The level of difficulty in a standard cost may range from very challenging to fairly undemanding: standard costs may be ideal, or many establish either a target or a currently attainable level of performance.

Budgets can motivate managers to achieve a high level of performance. But how difficult should budget targets or standard levels of efficiency be? And how might people react to targets of differing degrees of difficulty in achievement?

(a) There is likely to be a demotivating effect where an ideal standard of performance is set, because adverse efficiency variances will always be reported.

(b) A low standard of efficiency is also demotivating, because there is no sense of achievement in attaining the required standards. If the budgeted level of attainment is too 'loose', targets will be achieved easily, and there will be no impetus for employees to try harder to do better than this.

(c) A budgeted level of attainment could be the same as the level that has been achieved in the past. Arguably, this level will be too low. It might encourage budgetary slack.

Academics have argued that each individual has a personal 'aspiration level'. This is a level of performance, in a task with which individuals are familiar, which individuals undertake for themselves to reach.

Individual aspirations might be much higher or much lower than the organisation's aspirations, however. The solution might therefore be to have two budgets.

(a) A budget for planning and decision-making based on reasonable expectations

(b) A budget for motivational purposes, with more difficult targets of performance

These two budgets might be called an 'expectations budget' and an 'aspirations budget' respectively. Similarly, the level of difficulty in a standard cost may vary.

Type of standard
Ideal	A standard of performance that assumes the highest possible level of achievement. A desirable target, but not at all achievable at the moment. Reported variances will always be adverse. This can be demotivating for the managers responsible for performance.
Target	This is a standard cost that sets performance targets at a higher level than is currently being achieved. However, the targets are not unrealistic. Improvements in performance will be needed to turn adverse variances into favourable variances. The value of target standards depends on the strength of motivation of management to improve performance. An incentive scheme may be needed to persuade managers to 'buy in' to the target standard.
Currently attainable	This standard is based on levels of performance that are currently being achieved. They do not provide an incentive to improve performance, although they may encourage management to avoid a deterioration in performance.
Basic standard	This is an original standard that is unchanged over a long period of time. It is used to measure trends and changes in performance standards over time. It is not a useful type of standard for control purposes.

3.1 The effect of reported variances on staff action: Reported variances, if significant and adverse, should prompt managers into taking control action to improve performance. The success of a variance reporting system in achieving this objective will depend on several factors.

(a) The manager who is considered responsible for the variance should agree and accept that the cause of the variance is their responsibility. Variances should be reported to the appropriate manager.

(b) The manager should consider the reported variance to be 'fair'. Variances should be a realistic measure. This is a reason why it is advisable to separate planning variances from operational variances when a budget or standard needs revision. It is also a reason why variances reported using ideal standards may be demotivating.

(c) The manager should want to do something to deal with the causes of the variance. Incentives and motivation are important factors.

(d) Variance should be reported in a timely manner, as soon as reasonably practical. If a reported variance relates to events that occurred a long time ago, managers will be reluctant to investigate them 'now' because the variance will seem out of date.

(e) The manager must believe that the cause of the variance is something that they are in a position to control. If a manager considers the cause of a variance to be outside their sphere of authority, or to be due to a factor that they cannot do anything to change, they will not be motivated to look for control measures.

The control culture within the organisation may also affect the response of managers to variances. If there is a 'blame culture', managers will be blamed for adverse variances and accused of poor performance.

This is likely to provoke a defensive reaction, with the manager trying to justify what has gone wrong.

In contrast, if there is an 'improvement culture', variances are considered as useful indicators for control action and improving performance. Managers are not blamed for adverse variances, but encouraged to look for suitable control measures whenever significant adverse variances occur.

4. Participation in budgeting: A budget can be set from the top down (imposed budget) or from the bottom up (participatory budget). Many writers refer to a third style, the negotiated budget.

4.1 Participation: It has been argued that participation in the budgeting process will improve motivation and so will improve the quality of budget decisions and the efforts of individuals to achieve their budget targets (although obviously this will depend on the personality of the individual, the nature of the task (narrowly defined or flexible) and the organisational culture).

There are basically two ways in which a budget can be set: from the top down (imposed budget) or from the bottom up (participatory budget).

4.2 Imposed style of budgeting (top-down budgeting): In this approach to budgeting, top management prepare a budget with little or no input from operating personnel which is then imposed on the employees who have to work to the budgeted figures.

The times when imposed budgets are effective are as follows.

• In newly formed organisations

• In very small businesses

• During periods of economic hardship

• When operational managers lack budgeting skills

• When the organisation's different units require precise co-ordination

There are, of course, advantages and disadvantages to this style of setting budgets.

Advantages

• Strategic plans are likely to be incorporated into planned activities.

• They enhance the co-ordination between the plans and objectives of divisions.

• They use senior management's awareness of total resource availability.

• They decrease the input from inexperienced or uninformed lower-level employees.

• They decrease the period of time taken to draw up the budgets.

Disadvantages

• There may be dissatisfaction, defensiveness and low morale among employees.

• The feeling of team spirit may disappear.

• The acceptance of organisational goals and objectives could be limited.

• The feeling of the budget as a punitive device could arise.

• Unachievable budgets for overseas divisions could result if consideration is not given to local operating and political environments.

• Lower-level management initiative may be stifled.

4.3 Participative style of budgeting (bottom-up budgeting): In this approach to budgeting, budgets are developed by lower-level managers who then submit the budgets to their superiors. The budgets are based on the lower-level managers' perceptions of what is achievable and the associated necessary resources.

Participative budgets may be effective in the following circumstances.

• In well-established organisations

• In very large businesses

• During periods of economic affluence

• When operational managers have strong budgeting skills

• When the organisation's different units act autonomously

The advantages of participative budgets are as follows.

• They are based on information from employees most familiar with the department.

• Knowledge spread among several levels of management is pulled together.

• Morale and motivation is improved: employees feel more involved and that their opinions matter to senior management.

• They increase operational managers' commitment to organisational objectives.

• In general they are more realistic.

• Co-ordination between units is improved.

• Specific resource requirements are included.

• Senior managers' overview is mixed with operational level details.

There are, on the other hand, a number of disadvantages of participative budgets.

• They consume more time.

• When individuals are involved in negotiating their budget targets, they may want to set targets that are easily attainable rather than targets that are challenging. In other words, an ability to negotiate targets may tempt managers to introduce budgetary slack into their targets.

• Individuals may not properly understand the strategic and budget objectives of the organisation, and they may argue for targets that are not in the best interests of the organisation as a whole.

• Changes implemented by senior management may cause dissatisfaction if they seem to ignore the opinions of employees who have been involved in negotiating targets.

• Budgets may be unachievable if managers are not sufficiently experienced or knowledgeable to contribute usefully.

• They can support 'empire building' by subordinates.

• An earlier start to the budgeting process will be required, compared with top-down budgeting and target setting.

4.4 Negotiated style of budgeting: At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice, different levels of management often agree budgets by a process of negotiation. In the imposed budget approach, operational managers will try to negotiate the budget targets which they consider to be unreasonable or unrealistic with senior managers.

Likewise, senior management usually review and revise budgets presented to them under a participative approach through a process of negotiation with lower-level managers. Final budgets are therefore most likely to lie between what top management would really like and what junior managers believe is feasible. The budgeting process is hence a bargaining process and it is this bargaining which is of vital importance, determining whether the budget is an effective management tool or simply a clerical device.

5. Variances in a JIT or TQM environment: Standard costing and variance analysis may sometimes be inappropriate in a production environment based on Just in Time (JIT) methods or a Total Quality Management (TQM) approach.

The use of standard costs and variance analysis is based on certain assumptions about the way in which operations should be managed. In particular, variance analysis is based on the view that:

(a) All resources should be used as efficiently as possible.

(b) A standard cost is a performance target that operational managers should seek to achieve.

However, this approach to analysing performance is not always appropriate. Variances indicating adverse performance are sometimes inappropriate in a Just in Time (JIT) or Total Quality Management (TQM) environment.

5.1 Variances and a JIT environment: In a JIT manufacturing environment, production is managed on the principle that items should not be produced until they are required to meet sales orders. There should be no accumulation of inventories of work in progress and finished goods.

A JIT approach implies that if there are no sales orders, production resources should be kept idle. In addition, as explained in the earlier chapter on the theory of constraints, the volume of production should be restricted to the output capacity of the bottleneck resource, meaning that there will inevitably be idle capacity for all resources that are not the bottleneck resource.

(a) In JIT manufacturing, idle time should therefore be expected.

(b) In a system of standard costing, idle time is an adverse labour efficiency variance, and is undesirable.

If idle time variances are reported for a manufacturing operation that is based on JIT methods, the variances will encourage managers to use idle capacity in a productive way, by producing more and building up inventories. With increases in inventory, there will be a higher reported profit.

This is unacceptable in a JIT environment.

5.2 Variances and a TQM environment: Total Quality Management (TQM) is an approach to management that originated from different sources, and has a number of different aspects.

(a) One aspect of TQM is the view that work should be 'right first time'. Mistakes that result in wastage and reworking of faulty output should be avoided.

(b) Another aspect of TQM is similar to the JIT principle that items should be produced only when they are needed for the next stage in the production process, and finished goods should not be produced until they are needed for sales orders.

(c) A third aspect of TQM is the principle of continuous improvement or 'kaizen'. This is the view that the organisation should always look for small ways of improving performance standards and that improvements should be made continually. The ideal level of performance will never be reached, because further improvements will always be possible.

Each of these principles of TQM may be inconsistent with standard costing and variance analysis. The inconsistency between standard costing and the view that production resources should be kept idle until required has already been discussed in the context of JIT.

(a) The philosophy in TQM of 'right first time' may be inconsistent with a standard cost that includes an allowance for wastage. TQM is more consistent with environmental cost accounting (material flow cost accounting) than a costing system that allows for normal loss in the standard cost.

(b) The principle of 'kaizen' or continuous improvement is that a steady state of production will never be achieved, because further improvements will always be possible. A standard cost is based on an assumption of a desirable steady state; this view is inconsistent with the principle of continuous improvement.

5.2.1 Quality and quantity: Standard costing concentrates on quantity and ignores other factors contributing to effectiveness. In a total quality environment, however, quantity is not the main issue; quality is. Effectiveness in such an environment therefore centres on quality of output, and the cost of failing to achieve the required level of effectiveness is measured not in variances, but in terms of internal and external failure costs, neither of which would be identified by a traditional standard costing analysis.

Standard costing systems might measure, say, labour efficiency in terms of individual tasks and level of output. In a total quality environment, labour is more likely to be viewed as a number of multi-task teams who are responsible for the completion of a part of the production process. The effectiveness of such a team is more appropriately measured in terms of reworking required, returns from customers, defects identified in subsequent stages of production, and so on.

Traditional feedback control would seek to eliminate an adverse material price variance by requiring managers to source cheaper, possibly lower-quality supplies. This may run counter to the aim of maximising quality of output.

5.2.2 Can standard costing and TQM coexist?

Arguably, there is little point in running both a Total Quality Management programme and a standard costing system simultaneously.

(a) Predetermined standards are at odds with the philosophy of continual improvement inherent in a total quality management programme.

(b) Continual improvements are likely to alter methods of working, prices, quantities of inputs, and so on, whereas standard costing is most appropriate in a stable, standardised and repetitive environment.

(c) Material standard costs often incorporate a planned level of scrap. This is at odds with the TQM aim of zero defects and there is no motivation to 'get it right first time'.

(d) Attainable standards which make some allowance for wastage and inefficiencies are commonly set. The use of such standards conflicts with the elimination of waste which is such a vital ingredient in a TQM programme.

(e) Standard costing control systems make individual managers responsible for the variances relating to their part of the organisation's activities. A TQM programme, on the other hand, aims to make all personnel aware of, and responsible for, the importance of supplying the customer with a quality product.

6. Standard costs in a rapidly changing environment: The role of standards and variances in the rapidly changing modern business environment is open to question.

It can be argued that standard costs have limited relevance and value in the modern business world, where the environment is continually changing, and the life cycle of products can be very short.

Standard costs are appropriate for a 'steady state' production environment where the manufacturing system produces standard products, often in large quantities, using standard and repetitive production methods and processes.

In many industries today:

(a) Products are customised to the individual specifications of the customer. Although there may be a basic product, customers do not buy a standard product. Standard costing is more suitable for a mass production environment.

(b) In such countries as the UK, there are more service industries than manufacturing industries, and services are often non-standard in nature and the way they are delivered.

(c) Standard cost variances focus mainly on material cost and labour cost variances (and overhead variances may be a simple fixed cost expenditure variance). In many manufacturing companies, overhead costs are much more significant than labour costs. Variance reporting therefore fails to focus on the most important costs.

(d) Many of the variances in a standard costing system focus on the control of short-term variable costs. In most modern manufacturing environments, the majority of costs, including direct labour costs, tend to be fixed in the short run.

(e) In some industries, products have a very short life cycle. In these circumstances, it may not be worthwhile developing a standard cost for new products. Instead, costing techniques, such as life cycle costing and target costing, may be more appropriate for planning and control purposes.

(f) Variance reporting involves regular formal performance reports, typically every four weeks or month. Modern IT systems make it possible for operational managers to monitor performance much more frequently and 'on demand'. Variance reporting is not easily adapted to 'on demand' performance monitoring.

6.1 The role in modern business of standards and variances: However, a survey by Drury et al (1993) indicated the continued widespread use of standard costing systems. Although this survey is now somewhat out of date, the following points should be noted.

• Planning: Even in a TQM environment, budgets will still need to be quantified. For example, the planned level of prevention and appraisal costs needs to be determined. Standards, such as returns of a particular product should not exceed 1% of deliveries during a budget period, can be set.

• Control: Cost and mix changes from the plan will still be relevant in many processing situations.

• Decision-making: Existing standards can be used as the starting point in the construction of a cost for a new product.

• Performance measurement: If the product mix is relatively stable, performance measurement may be enhanced by the use of a system of planning and operational variances.

• Product pricing: Target costs may be compared with current standards, and the resulting 'cost gap' investigated with a view to reducing it or eliminating it using techniques such as value engineering.

• Improvement and change: Variance trends can be monitored over time.

• Accounting valuations: Although the operation of a JIT system in conjunction with backflush accounting will reduce the need for standard costs and variance analysis, standards may be used to value residual inventory and the transfers to cost of sales account.

Performance Management Information Systems

Performance Management Information Systems

1. Introduction to planning, control and decision – making

Strategic planning is the process of deciding on objectives for the organisation, changes in these objectives, the resource to attain these objectives, and the policies that are to govern the acquisition, use and disposition of these resources.

Management control is the process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organisation’s objectives. It is sometimes called tactics or tactical planning.

Operational control (or operational planning) is the process of assuring that specific tasks are carried out effectively and efficiently.

Within and at all levels of the organisation, information is continually flowing back and forth, being used by people to formulate plans and take decisions, and to draw attention to the need for control action, when the plans and decisions don’t work as intended.

Key terms: Planning means formulating ways of proceeding. Decision – making means choosing between various alternatives. These two terms are virtually inseparable: you decide to plan in the first place and the plan you make is a collection of decisions.

Strategic decisions are long – terms decisions and are characterised by their wide scope, wide impact, relative uncertainty and complexity.

Control is used in the sense of monitoring something so as to keep it on course, like the ‘controls’ of a car, not (or not merely) in the sense of imposing restraints to exercising tyrannical power over something. We have more to say about control later in this Study Text.

1.1 Information for planning, control and decision - making

Robert Anthony, a leading writer on organisational control, suggested what has become a widely used hierarchy, classifying the information used at different management levels, for planning, control and decision – making into three tiers: strategic planning, management control and operational control.

We consider each tier in turn in Section 2 – 4.

Key terms: Strategic planning. The process of deciding on objectives of the organisation, changes in these objectives, the resources used to attain these objectives, and the policies that are to govern the acquisition, use and disposition of these resources.

Management (or tactical) control. The process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organisation’s objectives. It is sometimes called tactics or tactical planning.

Operational control (or operational planning). The process of assuring that specific tasks are carried out effectively and efficiently.

2. Management accounting information for strategic planning, control and decision – making

Management accounting information can be used to support strategic planning, control and decision – making. Strategic management accounting differs from traditional management accounting because it has an external orientation and a future orientation.

This section identifies the accounting information requirements for strategic planning, control and decision – making.

2.1 Future uncertainty: Much strategic planning is uncertain.

(a) Strategic plans may cover a long period into the future, perhaps five to ten years ahead or even longer.

(b) Many strategic plans involve big changes and new ventures, such as capacity expansion decisions, decisions to develop into new product areas and new markets, and so on.

Inevitably, management accounting information for strategic planning will be based on incomplete data and will use forecasts and estimates.

(a) It follows that management accounting information is unlikely to give clear guidelines for management decisions and should incorporate some risk and uncertainty analysis (e.g. sensitivity analysis).

(b) For longer – term plans, discounted cash flow techniques ought to be used in financial evaluation.

(c) The management accountant will be involved in the following.

        I.            Project evaluation

      II.            Managing cash and operational matters

    III.            Reviewing the outcome of the project (post implementation review)

2.2 External and competitor orientation: Much management accounting information has been devised for internal consumption. However, it is important to balance this with a consideration of external factors.

(a) Strategic planning and control decisions involve environmental considerations.

(b) A strategy is pursued in relation to competitors.

2.3 The challenge for management accountants

Traditional accounting systems have had a number of perceived failings.

(a) Direction towards financial reporting. It is necessary to report historical costs to shareholders, but the classifications of transactions for reporting purposes are not necessarily relevant to decision making.

(b) Misleading information. This is particularly with regard to overhead absorption.

(c) Neatness rather than usefulness. Importance is placed on financial reporting templates, rather than providing solutions for management accountants.

(d) Internal focus. Management accounting information has been too inward looking (for example, focusing on achieving internal performance targets, like budgets). However, organisations also need to focus on customers and competition.

(e) Inflexibility. Traditional accounting systems have displayed an inability to cope with change, and the modern business environment.

The challenge lies in providing more relevant information for strategic planning, control and decision – making. Traditional management accounting systems may not always provide this.

(a) Historical costs are not necessarily the best guide to decision-making. One of the criticisms of management accounting outlined by Kaplan, Bromwich and Bhimani is that management accounting information is biased towards the past rather than the future.

(b) Strategic issues are not easily detected by management accounting systems.

(c) Financial models of some sophistication are needed to enable management accountants to provide useful information.

2.4 What is strategic management accounting?

The aim of strategic management accounting is to provide information that is relevant to the process of strategic planning and control.

Key Term: Strategic management accounting is a form of management accounting in which emphasis is placed on information about factors which are external to the organisation, as well as non-financial and internally generated information.

2.4.1 External orientation: The important fact which distinguishes strategic management accounting from other management accounting activities is its external orientation, towards customers and competitors, suppliers and perhaps other stakeholders. For example, while a traditional management accountant would report on an organisation's own revenues, the strategic management would report on market share or trends in market size and growth.

(a) Competitive advantage is relative. Understanding competitors is therefore of prime importance. For example, knowledge of competitors' costs, as well as a firm's own costs, could help inform strategic choices: a firm would be unwise to pursue a cost leadership strategy without first analysing its costs in relation to the cost structures of other firms in the industry.

(b) Customers determine if a firm has competitive advantage.

2.4.2 Future orientation: A criticism of traditional management accounts is that they are backward looking.

(a) Decision-making is a forward- and outward-looking process.

(b) Accounts are based on costs, whereas decision-making is concerned with values.

Strategic management accountants will use relevant costs (i.e. incremental costs and opportunity costs) for decision-making.

2.4.3 Goal congruence: Business strategy involves the activities of many different functions, including marketing, production and human resource management. The strategic management accounting system will require inputs from many areas of the business.

(a) Strategic management accounting translates the consequences of different strategies into a common accounting language for comparison.

(b) It relates business operations to financial performance, and therefore helps ensure that business activities are focused on shareholders' needs for profit. In not for profit organisations this will not apply, as they do not focus on shareholder profitability. (We look at not for profit organisations in more detail later in this Study Text.)

It helps to ensure goal congruence, again by translating business activities into the common language of finance. Goal congruence is achieved when individuals or groups in an organisation take actions which are in their self-interest and also in the best interest of the organisation as a whole.

2.5 What information could strategic management accounting provide?

Bearing in mind the need for goal congruence, external orientation and future orientation, some examples of strategic management accounting are provided below.

Item	Comment
Competitors' costs	What are they? How do they compare with ours? Can we beat them? Are competitors vulnerable because of their cost structure?
Financial effect of competitor response	How might competitors respond to our strategy? How could their responses affect our sales or margins?
Product profitability	A firm should want to know not just the profits or losses that are being made by each of its products but also why one product should be making good profits whereas another equally good product might be making a loss.
Customer profitability	Some customers or groups of customers are worth more than others.
Pricing decisions	Accounting information can help to analyse how profits and cash flows will vary according to price and prospective demand.
The value of market share	A firm ought to be aware of what it is worth to increase the market share of one of its products.
Capacity  expansion	Should the firm expand its capacity and, if so, by how much? Should the firm diversify into a new area of operations, or a new market?
Brand values	How much is it worth investing in a brand which customers will choose over competitors' brands?
Shareholder wealth	Future profitability determines the value of a business.
Cash flow	A loss-making company can survive if it has adequate cash resources, but a profitable company cannot survive unless it has sufficient liquidity.
Effect of acquisitions and mergers	How will the merger affect levels of competition in the industry?
Decisions to enter or leave a business area	What are the barriers to entry or exit? How much investment is required to enter the market?

3. Management accounting information for management control

Management control is at the level below strategic planning in Anthony's decision-making hierarchy and is concerned with decisions about the efficient and effective use of resources to achieve objectives.

Management control, which we briefly touched on in Section 1, is at the level below strategic planning in Anthony's decision-making hierarchy. While strategic planning is concerned with setting objectives and strategic targets, management control is concerned with decisions about the efficient and effective use of an organisation's resources to achieve these objectives or targets.

(a) Resources (which can be categorised as a series of 'M's): money, manpower, machinery, methods, markets, management, and management information.

(b) Efficiency in the use of resources means that optimum output is achieved from the input resources used. It relates to the combinations of men, land and capital (e.g. how much production work should be automated) and to the productivity of labour, or material usage.

(c) Effectiveness in the use of resources means that the outputs obtained are in line with the intended objectives or targets.

The time horizon involved in management control will be shorter than at the strategic decisions level, there will be much greater precision and the focus of information will be narrower.

Management control activities are short-term non-strategic activities.

3.1 Examples of management control (or tactical) planning activities

(a) Preparing budgets for the next year for sales, production, inventory levels, and so on

(b) Establishing measures of performance by which profit centres can be gauged

(c) Developing a product for launching in the market

(d) Planning advertising and marketing campaigns

(e) Establishing a line of authority structure for the organisation

3.2 Examples of management control activities

(a) Ensuring that budget targets are reached, or improved on

(b) Ensuring that other measures of performance are satisfactory, or even better than planned

(c) Where appropriate, changing the budget because circumstances have altered

Management control is an essentially routine affair in that it tends to be carried out in a series of regular planning and comparison procedures; that is, annually, monthly or weekly, so that all aspects of an organisation's activity are systematically reviewed. For example, a budget is usually prepared annually, and control reports issued every month or four weeks. Strategic planning, in contrast, might be irregular and occur when opportunities arise or are identified.

3.3 Information requirements

Features of management control information

(a) Primarily generated internally (but may have a limited external component)

(b) Embraces the entire organisation

(c) Summarised at a relatively low level

(d) Routinely collected and disseminated

(e) Relevant to the short and medium terms

(f) Often quantitative (labour hours, volumes of sales and production)

(g) Collected in a standard manner

(h) Commonly expressed in money terms

Types of information

(a) Productivity measurements

(b) Budgetary control or variance analysis reports

(c) Cash flow forecasts

(d) Manning levels

(e) Profit results within a particular department of the organisation

(f) Labour revenue statistics within a department

(g) Short-term purchasing requirements

3.4 Source of information: A large proportion of this information will be generated from within the organisation (it has an endogenous source) and it will often have an accounting emphasis. Tactical information is usually prepared regularly; perhaps weekly or monthly.

3.5 Management control and strategic planning compared: The dividing line between strategic planning and management control is not a clear one. Many decisions include issues ranging from strategic to tactical. Nevertheless, there is a basic distinction between the two levels of decision.

(a) The decision to launch a new brand of calorie-controlled frozen foods is a strategic plan (business strategy), but the choice of ingredients for the frozen meals involves a management control decision.

(b) A decision that the market share for a product should be 25% is a strategic plan (competitive strategy), but the selection of a sales price of $2 per unit, supported by other marketing decisions about sales promotion and direct sales effort to achieve the required market share, would be a series of management control decisions.

Management control tends to be carried out in a series of regular planning and comparison procedures (annually, monthly, weekly). For example, a budget is usually prepared annually and control reports issued every month or four weeks. Strategic planning, in contrast, might be irregular and occur when opportunities arise or are identified.

4. Management accounting information for operational control

Operational control, the lowest tier in Anthony's hierarchy, is concerned with assuring that specific tasks are carried out effectively and efficiently.

The third and lowest tier in Anthony's hierarchy of decision-making consists of operational control decisions. Just as 'management control' plans are set within the guidelines of strategic plans, so too are 'operational control' plans set within the guidelines of both strategic planning and management control.

4.1   Example: Link between strategic plans and operational/management control decisions

(a) Senior management may decide that the company should increase sales by 5% per annum for at least five years – a strategic plan.

(b) The sales director and senior sales managers will make plans to increase sales by 5% in the next year, with some provisional planning for future years. This involves planning direct sales resources, advertising, sales promotion, and so on. Sales quotas are assigned to each sales territory – a tactical management control decision.

(c) The manager of a sales territory specifies the weekly sales targets for each sales representative. This is an operational control decision: individuals are given tasks which they are expected to achieve.

Operational control decisions are therefore much more narrowly focused and have a shorter time frame than tactical or strategic decisions.

4.2 Operational control activities: Although we have used an example of selling tasks to describe operational control, it is important to remember that this level of decision-making occurs in all aspects of an organisation's activities, even when the activities cannot be scheduled nor properly estimated because they are non-standard activities (such as repair work and answering customer complaints).

The scheduling of unexpected or 'ad hoc' work must be done at short notice, which is a feature of much operational decision-making. In the repairs department, for example, routine preventive maintenance can be scheduled, but breakdowns occur unexpectedly and repair work must be scheduled and controlled 'on the spot' by a repairs department supervisor.

Operational control activities can also be described as short-term non-strategic activities.

4.2   Information requirements

(a) Operational information is information which is needed for the conduct of day-to-day implementation of plans.

(b) It will include much 'transaction data', such as data about customer orders, purchase orders, cash receipts and payments and is likely to have an endogenous source.

(c) Operating information must usually be consolidated into totals in management reports before it can be used to prepare management control information.

(d) The amount of detail provided in information is likely to vary with the purpose for which it is needed, and operational information is likely to go into much more detail than tactical information, which in turn will be more detailed than strategic information.

Whereas tactical information for management control is often expressed in money terms, operational information, although quantitative, is more often expressed in terms of units, hours, quantities of material, and so on.

5. Types of information systems: You should be aware of the main characteristics of transaction processing systems, management information systems, executive information systems and enterprise resource planning systems.

5.1 Transaction processing systems: Transaction processing systems (TPS) collect, store, modify and retrieve the transactions of an organisation.

A transaction is an event that generates or modifies data which is eventually stored on an information system.

Transaction processing systems (TPS) collect, store, modify and retrieve the transactions of an organisation. The four important characteristics of a TPS are as follows.

(a) Controlled processing: The processing must support an organisation's operations.

(b) Inflexibility: A TPS wants every transaction to be processed in the same way regardless of user or time. If it were flexible there would be too many opportunities for non-standard operations.

(c) Rapid response: Fast performance is critical. Input must become output in seconds so customers don't wait.

(d) Reliability: Organisations rely heavily on transaction processing systems, with failure potentially stopping business. Back-up and recovery procedures must be quick and accurate.

5.1.1 Properties of a TPS: The components of a TPS include hardware, software and people. People in a TPS can be divided into three categories – users, participants and people from the environment.

The users are employees of the company who own the TPS. The users will not alter data themselves, but will use the TPS to provide inputs for other information systems such as inventory control.

Participants are direct users of the system. They are the people who enter the data. Participants include data entry operators, customer service staff and people working at checkouts.

People from the environment are people who sometimes require the services of a TPS as they enter transactions and validate data, such as customers withdrawing money from an ATM.

5.1.2 Types of TPS: Batch transaction processing (BTP) collects transaction data as a group and processes it later, after a time delay, as batches of identical data.

An example of BTP is cheque clearance. A cheque is a written order asking the bank to pay an amount of money to the payee. The payee cannot withdraw the money until the cheque is cleared. This involves checking that the payer has enough money in their account to cover the cheque. It usually takes three working days – cheques are cleared in a group during a quiet period of the day.

Real time transaction processing (RTTP) is the immediate processing of data. It involves using a terminal or workstation to enter data and display results and provides instant confirmation. A large number of users can perform transactions simultaneously but access to a central online database is required.

An example of an RTTP system is a reservation system involved in setting aside a service or product for the customer to use at a future time. Such systems are commonly used for flight or train bookings and hotel reservations and require an acceptable response time, as transactions are made in the presence of customers.

5.2 Management information systems: Management information systems (MIS) convert data from mainly internal sources into information (e.g. summary reports, exception reports). This information enables managers to make timely and effective decisions for planning, directing and controlling the activities for which they are responsible.

Management information systems (MIS) generate information for monitoring performance (eg productivity information) and maintaining co-ordination (e.g. between purchasing and accounts payable).

MIS extract, process and summarise data from the TPS and provide periodic (weekly, monthly, quarterly) reports to managers.

Today MIS are becoming more flexible by providing access to information whenever needed, rather than pre-specified reports on a periodic basis. Users can often generate more customised reports by selecting subsets of data (such as listing the products with a 2% increase in sales over the past month), using different sorting options (by sales region, salesperson, highest volume of sales) and different display choices (graphical, tabular). MIS have the following characteristics.

• Support structured decisions at operational and management control levels

• Designed to report on existing operations

• Little analytical capability

• Relatively inflexible

• An internal focus

5.3 Executive information systems: Executive information systems (EIS) draw data from the MIS and allow communication with external sources of information.

Executive information systems (EIS) provide a generalised computing and communication environment for senior managers to support strategic decisions.

Executive information systems draw data from the MIS and allow communication with external sources of information. EIS are designed to facilitate senior managers' access to information quickly and effectively. They have:

• Menu-driven user friendly interfaces

• Interactive graphics to help visualisation of the situation

• Communication capabilities linking the executive to external databases

An EIS summarises and tracks strategically critical information from the MIS and includes data from external sources, eg competitors, legislation and databases such as Reuters.

A good way to think about an EIS is to imagine the senior management team in an aircraft cockpit, with the instrument panel showing them the status of all the key business activities. EIS typically involve lots of data analysis and modelling tools, such as what-if analysis to help strategic decision-making.

A model of a typical EIS is shown below.

5.4 Enterprise resource planning systems: Executive resource planning systems (ERP systems) are modular software packages designed to integrate the key processes in an organisation so that a single system can serve the information needs of all functional areas.

Most organisations around the world have realised that, in a rapidly changing environment, it is impossible to create and maintain a custom-designed software package that will cater to all their requirements and also be completely up to date. Realising the requirement of user organisations, some of the leading software companies have designed enterprise resource planning software which will offer an integrated software solution to all the functions of an organisation.

ERP systems are large-scale information systems that impact an organisation's accounting information systems. These systems permeate all aspects of the organisation. A key element necessary for the ERP to provide business analysis is the data warehouse. This is a database designed for quick search, retrieval, query, and so on.

Executive resource planning systems (ERP systems) are modular software packages designed to integrate the key processes in an organisation so that a single system can serve the information needs of all functional areas.

ERP systems primarily support business operations – those activities in an organisation that support the selling process, including order processing, manufacturing, distribution, planning, customer service, human resources, finance and purchasing. ERP systems are function-rich, and typically cover all these activities – the principal benefit being that the same data can easily be shared between different departments.

This integration is accomplished through a database shared by all the application programs. For example, when a customer service representative takes a sales order, it is entered in the common database and it automatically updates the manufacturing backlog, the price, the credit system and the shipping schedule.

ERP systems work in real time, meaning that the exact status of everything is always available. Further, many of these systems are global. Since they can be deployed at sites around the world, they can work in multiple languages and currencies. When they are, you can immediately see, for example, exactly how much of a particular part is on hand at the warehouse in Japan and what its value is in yen or dollars.

5.4.1 Example: ERP: Say you are running a bicycle shop. Once you make a sale, you enter the order on the ERP system. The system then updates the inventory of bicycles in the shop, incorporates the sale into the financial ledgers, prints out an invoice, and can prompt you to purchase more bikes to replace the ones that you have sold. The ERP system can also handle repair orders and manage the spare parts inventory. It can also provide automated tools to help you forecast future sales and to plan activities over the next few weeks. There may also be data query tools present to enable sophisticated management reports and graphs to be generated. In addition, the system may handle the return of defective items from unhappy customers, the sending out of regular account statements to customers and the management of payments to suppliers.

ERP systems can assist with the scheduling and deployment of all sorts of resources, physical, monetary and human. A water company might use their ERP system to schedule a customer repair job, deploy staff to the job, verify that it got done, and subsequently bill the customer. An oil company might use it to ensure that their tankers are loaded, that a shipping itinerary is prepared and completed on schedule, and that all the equipment and people required for loading and unloading the cargo in each port are present at the right times. A bus company might use its system to manage customer bookings, record receipts and plan preventive maintenance activities for their fleet.

5.4.2 Benefits of ERP: The benefits that may be realised from a successfully implemented ERP project include:

(a) Allowing access to the system to any individual with a terminal linked to the system's central server

(b) Decision support features, to assist management with decision-making

(c) In many cases, extranet links to the major suppliers and customers, with electronic data interchange facilities for the automated transmission of documentation, such as purchase orders and invoices

(d) A lot of inefficiencies in the way things are done can be removed; the company can adopt so-called 'best practices' – a cookbook of how similar activities are performed in world-class companies

(e) A company can restructure its processes, so that different functions (such as accounting, shipping and manufacturing) work more closely together to get products produced

(f) An organisation can align itself to a single plan, so that all activities, all around the world, are smoothly co-ordinated

(g) Standardising Information and work practices so that the terminology used is similar, no matter where you work in the company

(h) A company could do a lot more work for a lot more customers without needing to employ so many people

6. Open and closed systems: Systems can be open or closed. The word system is impossible to define satisfactorily (the tax 'system', the respiratory 'system', the class 'system'). Basically it means something that connects things up.

6.1 Closed systems: A closed system is isolated and shut off from the environment. Information is not received from or provided to the environment.

Closed systems are seldom, if ever, found in naturally occurring situations. A typical example of a closed system would be a chemical reaction that takes place under controlled conditions in a laboratory. Closed systems can be created to eliminate external factors and then used to investigate the relationship between known variables in an experiment.

All social systems have some interaction with the environment and so cannot be closed systems. A commercial organisation, for example, could not operate as a closed system, as it would be unable to react to the external environment and so would not be commercially or economically viable.

6.2 Open systems: An open system is connected to and interacts with the environment and is influenced by it.

An open system accepts inputs from its surroundings, processes the inputs in some manner and then produces an output. The input parameters can be foreseen or unpredictable. Similarly, outputs can either be predicted or unforeseen. For example, consider a metal smelting works. Predictable inputs would include items like the raw materials and coal while the predictable outputs would be ash, smoke and the smelted metal. If the raw material to be smelted became contaminated in some way, it is likely that an undesirable product would be produced. These are examples of unforeseen inputs and outputs.

All social systems, including business organisations, are open systems. For example, a business is a system where management decisions are influenced by or have an influence on suppliers, customers, competitors, the Government and society as a whole. Employees are obviously influenced by what they do in their job, but as members of society at large they are also part of the external environment, just as their views and opinions expressed within the business are often a reflection of their opinions as members of society at large.

6.3 Open and closed systems and performance management: Systems are rarely either open or closed, but open to some influences and closed to others. Organisations must carefully choose the form of management accounting system based on the respective scenario.

The chemical laboratory could use a closed system. Here, performance is largely influenced by an internally created environment and external factors would not affect the output or result of the activity.

However, if an organisation's performance is influenced by environmental factors, it should operate an open system that accepts input from the external factors and examines their impact on performance output.

The advantages of an open system are:

(a) It encourages strong communication, which helps an organisation to operate efficiently and become effective.

(b) It adapts to the changing environment and there is scope for absorbing new pieces of information into the system.

(c) It highlights the interdependencies of different operations and processes within a business and the environment in which it operates.

(d) It helps business leaders and managers to focus on the external factors that shape behaviour and patterns within the organisation.

Management should consider the potential limitations of open systems.

(a) Non-linear relationships could exist among variables. A small change in one variable could cause a large change in another and affect the business result in a positive or negative way.

(b) It could prove difficult to measure the success of the system, specifically metrics relating to input, processing and output as well as the interrelationship among them.