The ‘forgotten’ part of performance management
I recently read an article in The Economist online http://bit.ly/aiSE5K about assessing the performance of fund managers. I found the article quite interesting, as we all know how people in the financial sector have been (and still are) rewarded based on their performance. And, what bank or fund has really performed in recent times?
The article mentions an idea called the ‘inertia benchmark’ – this the performance which would have been achieved if a fund manager did absolutely nothing. This measure could then be compared with the actual performance of the fund to assess if the actions of a fund manager actually yielded better results. This idea made me think do business owners and managers ‘forget’ the meaning of improved performance? As accountants we can create plans, monitor actions and report on performance against plans. And we know too how important it is to use the right performance indicators. In larger companies and many SMEs, reward systems are often linked performance ( banks and funds are a good example), and performance is often measured in terms of profit – again something accountants are good at measuring. So understanding, or more precisely, defining, the meaning of performance can have a big effect on rewards and the information needed to assess it. I wonder how many managers ask themselves what would have happened if the course of action taken was actually to do nothing. Yes, this would be tricky and identifying an inertia benchmark would be considerably more difficult than with a fund. But it might be good to consider such ideas when performance and reward systems are closely linked.
Relevant costs and revenues – opening a barber shop earlier?
One Saturday morning recently I went along to one of the two local barber shops to get a haircut. I usually like to get out early so I was in my local town about 9:30. For my last haircut I tried a the newer of the barbers, who to build up business had a loyalty scheme where you get your fifth haircut free. But it did not open until 10:00, so I went to the other barber ( who opens at 9:00 ) and I made up my mind I’ll stick with this one.
Now let’s talk accounting. The newest barber is in a high rent shopping mall. They also want to build up a customer base. The older one probably pays less rent or maybe none. Now let’s assume the new barber is thinking if opening at 9:00 to attract early birds like me. What costs and revenues are relevant to this decision in – in other words, what are the marginal costs and revenues. The revenue is easy – simply all extra revenue generated e.g. 5 extra cuts at £/€10 per cut = £/€50 And costs? The main cost would be labour of any employees, say £/€20. Other minimal costs would be utilities (power, water) and any hair products like gels or creams, say £/€5. So in this simple example a profit of £/€25 is made. Hang on, what about other costs like rent? These are not relevant as these will be incurred even if the shop is closed. This kind of decision is made by businesses quite regularly and while my barber example is simplifying things, such decisions can make a huge difference to profits. Why? Simply because all additional revenue contributes to profits and once fixed costs like rent are covered, each extra sale (haircut in my example) means more profit. So make these types of decision as best you can in your business. Obviously, if your figures are showing a loss, the course of action might be the wrong one – maybe the new barber in my example thinks no customers will come before 10:00, so he’d loss all labour costs!
What is management accounting?
This is a question which as an academic I could spend a long time on, but let’s keep it simple. If you open a text book on accounting you’ll get something like ‘management accounting is the branch of accounting which provides information to managers to help them make business decisions’. It earlier times, the term cost accounting was used, as the provision of cost information was most prevalent in the work of what today we’d call management accountants.
In a larger business, it’s easy to imagine one or more internal accountants working to provide information on costs, revenues etc. to managers. In a smaller business it’s more difficult to picture this, and I believe the lack of management accounting is a major issue for lots of small businesses. Take a typical sole trader as an example. They typically trade away during the year and make the annual visit to an accountant to find out how much profit they made. But this routine trip is not about management accounting; it’s more about making sure accounts are prepared and taxes on profits calculated. Any business needs much more regular information than this to make key decisions. As mentioned, a typical management accounting task might be to have regular and detailed information on costs – without this a business might not even know if it is making a profit or not. While I admire the dedication and zeal of many budding business owners and entrepreneurs, sometimes a dose of reality is needed on business decisions. Management accounting information does this. For example, many businesses fail because they expand too quick. A typical scenario for a small business might be increasing the work force by adding another employee. Let’s assume the wages amount to £/€/$ 35,000. What management accounting would do is look at the effect of this extra cost of profits, revenues and existing costs e.g. are extra sales needed to cover the cost and how likely are they to occur. Let’s forget about the term ‘management accounting’ for a moment. The point I am making is that accounting (i.e. financial/monetary) information is an essential part of any business decision. What we call it does not matter. But, smaller and/or new businesses don’t seem to do enough of this. How can thus be improved? Well there’s a whole host of things, but in my view the simplest thing any small business can do is make full use of the data it already has. Rather than just going to an accountant annually, prepare accounts on a quarterly or monthly basis. While this may be a daunting task at first thought, there are plenty of accounting software packages out there to help e.g. Quickbooks, Sage and TAS. More regular accounts will at minimum identify losses or poor profits at an earlier stage.
Thinking about costs and revenues when setting a price
Here’s a great example of how you need to think about costs when setting a price for a product or service. During the recent volcanic ash cloud over Europe (April/May 2010), many travellers were left with no option but to hire a car to drive home. One result of this was that 100’s of hire cars from Spain and Portugal ended up in places like Kiel and Rostock in Northern Germany as people from the Baltic states and Scandinavia tried to get home. To get these cars back to their places of origin was a problem. So what at least one major hire car company did was to offer cars for hire for €1 per rental period (incl. the fuel in the tank) once they were going south. Over a few weeks 70-80% of the fleet were back to where the needed to be or a lot closer. But surely no profit could be made at a price of €1. No, none was, but think about the costs saved by not having to hire additional car transporter trucks to carry the cars 1000’s of miles! So the “profit” was made by saving costs.Risk in business
Any business faces risks at some time or another. Some may be easy to avoid or foresee, and thus measures can be taken to avoid or reduce them. Student Accountant (the ACCA’s student magazine) of June 16th last includes a feature on the recent volcanic ash cloud take caused chaos over European airspace on April this year. It might be something the airlines had not really thought about before now, but you can bet they now include disruption from volcanic ash in their assessment of business risk. The estimated losses from the disruption are in excess of $1bn – not exactly what the already recession hit airline sector needed. Can all business risks be eliminated ? Of course not, but businesses can try to minimise or reduce risks. As mentioned in the article, a four point TARA model can be used to assess risk:
No Accounting for startups?
While having a regular look on inc.com, I found this interesting blog post from Steve Blank’s blog. He writes that financial statements are not the best thing to use to monitor a start-up business. Sometimes banks or venture capitalists insist on things like regular income statements and balance sheets. While I don’t think it’s right to say “no accounting”, there is a point in the pieces in that a start-up might be much better served concentrating on more important performance indicators. Have a read and see for yourself.
How to price your products or services
Setting a price is a very important task for any business. Set the price too high and sales may not come; set it too low and you might not make money or customers might perceive your product/service as poor quality. As an accountant, I would of course first think of costs – without a clear knowledge of what your cost base is, how can you sell something at a profit. But other things determine price too, like the customer and the competition. Given that I’m sort of on holidays, and writing accordingly, here’s a great piece from inc.com that will help you set a price.
Performance indicators – a bad example
I watched a Channel 4 documentary (Dispatches) last month (June 7th) about the somewhat lacking work done by some child social workers in the UK. While they may be over-stretched and burdened with bureaucracy, the have a job to do which can seriously effect peoples lives – so was quite annoyed when I watched what an undercover social worker found (have a quick look here http://www.channel4.com/programmes/dispatches/articles/undercover-social-worker-exclusive-video-clips). But that’s not what this blog is about, so sorry for the little rant. One thing struck me though as a management accountant while watching this. One senior social workers mentioned how their performance is rated. Using performance metrics is common in business and all kinds of organisation, but the right metric must be used. For example, profit is one metric, but this does not tell us much about how the company treats its workers or the environment for example. And on a day-to-day basis, business might used metrics like units sold e.g. bums on seats for airlines. In the documentary, the senior social worker mentioned that performance was measured by the number of cases closed by each social worker. The more closed, the better they were deemed to perform. Then, she mentioned how silly this was, as there was no measure of quality – how well the case was dealt with, or how the outcomes matched what children needed. If I remember her quote correctly, she said “you could write ‘cream buns, cream buns, cream buns’ in the middle of a care report and nobody would even look at it. They (local councils or health officials I presume) are only interested in the number of cases dealt with”. Yes, this might be a bit of an extreme example, but it really does show the importance of linking a performance metric to the desired outcomes of any organisation. So, spend a little time getting it right!
The future role of management accountants
CIMA’s CEO, Charles Tilley, outlines his views on the what the future holds for management accountants in a recent interview with Insight, CIMA’s e-magazine. Accountants might not have a great reputation in recent years with many corporate scandals and various banking “meltdowns”.
Tilley suggests a number of ways management accountants can develop and enhance their roles over the next decade or so. First, Tilley notes that successful companies focus on longer-term sustainability. To do this, the right kind of management structures and incentives need to be in place. Here, management accountants can help by ensuring boards get the right kind of information to ask the right questions. Second, companies need to focus beyond increasing shareholder value. While capital growth is important, running business with an ethical and longer-term focus might be better. Again, management accountants can help here, by providing a robust and ethical analysis of business information. Third, globalisation will continue to effect management accounting. More and more companies are increasingly bigger and face greater challenges on dealing with local knowledge, cultures etc. Again management accountants have a key role to play in providing information and assessing risks.
You can read the full piece here http://bit.ly/c0t4CA and lots more on CIMA’s Insight.
The profit volume relationship – an important lesson for any business
Tracey Taylor writes in the NY Times (Apr 7, 2010) about a US design and build company, mkdesigns. The company designs and builds prefabricated, environmentally friendly homes. The founder, Michelle Kaufmann, decided in 2006 to buy or build a factory as she could not find producers willing to form a strong business alliance to deliver quality product on time. The reason for this? Simply, it was 2006 – the top of the construction boom in the US (and Europe). Kaufmann acquired one factory, then another, which increased the businesses cost base. Higher sales volumes were needed to cover the increased costs and maintain profits. Then, the bust came in 2008, sales volume declined and the business had to close its two factories. The basic lesson here is that a certain level of sales are needed to cover costs; increase costs without a corresponding increase in sales an your business is in trouble . Read the full article here –My Green Prefab Business, and How It Once Grew – NYTimes.com.
Tacit knowledge in management accounting
Burns, J. & Scapens, R. 2000, “Conceptualising management accounting change: an institutional framework”, Management Accounting Research, vol. 11, pp. 3-25.
Preparing a small business budget – 7 easy steps to help you plan
You’ve just started out in business, a first time entrepreneur. Maybe you’ve lost your job or given one up. Whatever the reason, you’re now in business on your own. Your business goals should include making some money. Waiting until the end of a year when dealing with an accountant is too late to see if you’re losing money. You need to plan, or budget from the start to avoid that daunting situation. A budget is simply a plan of revenues and costs for the coming year. It will not be the same as what actually happens, but you can adjust it as actual event happen. So where do you start? Below I outline 7 easy steps to help you. You might find these work quite well in a spreadsheet (MS Office, OpenOffice or even GoogleDocs). To keep it simple, let’s assume all costs are paid as incurred.
Step 1. Decide when the period of the budget. It’s normally a year, and this is broken down by month or quarter.
Step 2. Make a list of all the recurrent costs you know. Things like rent, purchase of goods for resale, wages and so on.Try to work out the costs according to month or quarter, as decided in step 1. Some costs may be higher or lower depending on the time of year e.g. heating or air-conditioning.
Step 3. Think about any one off costs you will have. For example, you might buy some new equipment. Add these costs to those in step 2.
Step 4. Now, think about the income of the business. Try to work out by month or quarter what you hope to sell and at what price.
Step 5. Now you have costs and income, so you have a basic budget by month or quarter. Adding all the number up will give you an annual budget. if you’re just starting out in business, you might find that costs exceed income, which is okay in the short term. At this point, you should be able to see how much profit or loss your business might make.
Step 6. As the months past by, compare your budget to the actual income and costs of the business. You might find that you have to revise the budget, which is always a good idea as it gives a better reflection of actual circumstances.
Step 7. Get on with your business, using the revised budgets as a tool to measure your business performance.
Most businesses of course do not pay for items immediately, but often get a credit period from suppliers or spread payments over a number of months or years. This means that a cash budget might need to be prepared also to complement an income and costs budget. I’ll post something soon on cash budgets.
Locals allocate money – an example of Zero-base budgeting?
Michael Portillo (a British MP) currently hosts a BBC documentary called “Power to the People”, which looks at ways more democracy can empower people . In a recent episode (March 20th, BBC2, 21:00), Portillo describes what is in effect an example of Zero-base budgeting (ZBB). What is ZBB? ZBB is often associated the the public sector. It is a technique used to create budgets which starts off with a figure of zero,and is often cited as being useful for discretionary type expenditure. From this, each item of expenditure must be analysed, discussed and ranked. Then, out of a limited pool of money, the highest ranking items get priority until all funds are used up. Sounds simple, but a lot of work is needed to discuss and rank expenditure items.
In the BBC documentary, Portillo visits a “You Decide” session organised by the local council in Tower Hamlets, London. At this session, local people decide what is to be done with £250,000 of council money. They are given fully costed options under headings like health-care, the elderly and local policing. The options in each category can be debated for a time, then all present “vote” for their preferred option using an electronic voting system. This continues until all funds are used up. What in effect is happened here is that the local residents are undertaking the ranking and deciding part of ZBB. This, it could be argued, saves the council a bit of time and allocates resources to where residents want them most. Of course £250,000 is a long way off a council’s full budget, but this is ZBB in action.
By the way, if you’re in the UK you can get this programme on BBC IPlayer.
Recent CIMA research report on the use of standard costing
The Chartered Institute of Management Accounting (CIMA) have just released some interesting research findings on the use of standard costing. The research warns that accountants need to “wake-up and smell the coffee” and be careful how standard costing is used in an organisation. Poor use of standard costing can create a “percolator” effect with bad practice filtering up and down the organisation. Click the link for more detail and access to the full report http://bit.ly/b6v4f0
McDonalds and management accounting – what’s the link?
In management accounting (the branch of accounting that provides decision making information to business managers), a technique called “standard costing” is often used to cost products or services. This technique tries to establish a “standard” for things like the amount of time taken to perform a task or the amount of material used to make a product. For example, the National Car Testing Service (NCTS) in Ireland performs a standard set of checks on each car which lasts about 30 minutes. This standardised list of checks can be used to schedule work and estimate costs. You might be thinking that a technique like standard costing would be less relevant to accountants in business as so many businesses nowadays try to be “non-standard”, delivering differentiated products and trying to offer varying levels of service. But as the NCTS example shows, may businesses still operate in accordance with standards. One of the best known examples of such a business is the ubiquitous McDonald’s. No matter you go a Big Mac is a Big Mac – it’s a really standard product which has a recipe something like this:
Two 1.6 oz (45 g) patties,special “Mac” sauce, lettuce, cheese, pickles, onions and a three part bun.
This ingredients can be easily costed to get a standard ingredients cost. You can probably imagine too how the actual preparation of a Big Mac in a restaurant could be timed, so you could easily have a standard preparation time. In fact the way McDonalds do things has been coined “McDonaldsization” by sociologist George Ritzer (see here). With such standard products, it’s quite easy to see how a business like McDonalds can use standard costing techniques to not only cost its products, but also to measure performance. This is simply because of such little variation in products like a Big Mac. But care should be taken in using standard costing ideas, even where it might appear as a useful idea. Take healthcare for example – I’m not suggesting McDonalds start doing healthcare! There are many “standard” diseases with “standard” treatments. All treatments cost money and as healthcare providers struggle with falling budgets, would it be an idea to provide “standard” treatments? I’d like to think no. For example, what would happen if the treatment time for goes beyond standard. Do you tell the patient “sorry you allotted time is up, next please”. The difference here is that although something may appear like a pretty standard task (i.e. the treatment), the standard will be broken regularly. To hold people accountable for breaking the standard would potentially be a life-threat – unlike your Big Mac taking a little longer to cook. For a little more information, take a look at this link http://bit.ly/9yuhZ6
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