1.

0 Definition

Definition

Transfer price – the price at which goods or services are transferred from one division to another
company, or from one subsidiary to another within a group.
In divisionalised organisations, the output of one division may form the input for
another division. For the purpose of preparing management accounts for the two
divisions, which reflect the work performed by both divisions, a transfer pricing
system is required.
1.1 When Needed

A transfer pricing policy is needed when:

 an organisation has been decentralised into divisions; and
 inter-divisional trading of goods or services occurs.
Transfers between divisions must be recorded in monetary terms as revenue for
supplying divisions and costs for receiving divisions.
Transfer pricing is more than just a bookkeeping exercise. It can have a large effect
on the behaviour of divisional managers.

Example 1 Inter-divisional Trading

Division A makes components for a cost of $30 and transfers them to Division B for $50. Division B
the components in at $50, incurs own costs of $20, and then sells to outside customers for $90.
At a transfer price of $50, each division makes a profit of $20/unit and the company overall makes
of $40/unit ($90 – ($30 + $20)).
For every $1 increase in the transfer price, Division A will make $1 more profit and Division B will m
less, although the overall profit per unit is unchanged. However, changing transfer price profits can
in each division making different decisions and as a result of those decisions, total profits might be
affected.
 Transfer pricing has implications for:
 Performance evaluation (ROI and RI);
 Performance-related pay;
 Motivation;
 Make vs buy decisions;
 Investment appraisal;
 Taxation and remittance of profits (see s.4).
 1.2 Objectives of Transfer Pricing

 1.2.1 Goal Congruence
 Transfer prices should encourage divisional managers to make decisions that
are in the best interests of the organisation as a whole.
 In any divisionalised organisation there is a risk of dysfunctional decision
making. Where inter-divisional trading occurs, this risk is particularly high.
 A dysfunctional decision occurs when a divisional manager makes a decision
that benefits his division but is detrimental to the group as a whole. Usually
this would involve a transaction that increases divisional contribution, but
reduces group contribution.
 Achievement of goal congruence must be the primary objective of a transfer
pricing system.
 1.2.2 Divisional Autonomy
 Divisional managers should be free to make their own decisions. A transfer
pricing system should eliminate the need for head office to tell divisions what
to do.
 Autonomy should improve motivation of divisional managers.
 1.2.3 Divisional Performance Evaluation
 Transfer prices should be "fair" and allow an objective assessment of
divisional performance.
 1.2.4 Which Objective Takes Priority?
 There is likely to be conflict between these objectives. Goal congruence must
take priority.
 1.2.5 Divisional Profit
 The transfer price used should permit each division to make a profit. Profits
are motivating and allow divisional performance to be measured using ROI or
RI.

Example 2 Goal Congruence

ABC Consulting has offices in several major cities in Central Europe. Sometimes consultants in one office
work on projects for other offices. The transfer price charged is $1,100 per day of consulting.
The managing director of the Budapest office of ABC Consulting discovered that he could hire reliable
consultants on a freelance basis for $500 per day. On a recent project, in July, he used the services of a
local freelance consultant for five days, paying $2,500 in total. "I've saved the Budapest office $3,000!" he
declared triumphantly at the end of the week.
During the week in question, the Prague office of ABC Consulting had a free consultant who could have
done the work that the freelance consultant was hired to do. This consultant earns a fixed salary, so the
additional cost to the company of this consultant working on the project in Budapest would have been a
 Example 2 Goal Congruence

flight ticket of $500 and accommodation of $500 in total.

The decision of the managing director of the Budapest office to hire the freelance consultant cost the ABC
Group an additional $1,500 (the fee paid to the freelance consultant of $2,500 less the savings on travel
and accommodation of $1,000).
This is an example of goal incongruence. The managing director of the Budapest office has made a
decision that is good for the Budapest office, but not good for the overall group. The reason for this was
that the internal transfer price was too high.

11.2.1 From the Point of View of the Selling Division

2.1 From the Point of View of the Selling Division

The minimum transfer price acceptable to the selling division is equal to:
Marginal (variable cost) + Opportunity cost
The opportunity cost is usually the lost contribution from external sales – either of the
same product that is the subject of the transfer price, or other products that the
supplying division makes.

2.1.1 Scenario 1 – Opportunity Cost Is Zero

When to use:

No external market

or and No production constraints

External market but spare capacity

In this situation, opportunity cost is zero because internal transfers do not reduce
contribution from external sales.
Activity 1 Spare Capacity

Division Buy requires some components for its electronic games console. Division
Sell has some spare capacity, and could make the components for a variable cost of
$60 each.
Required:
a. Determine the minimum transfer price acceptable to Division Sell.
b. State what will happen if Division Buy can buy externally for $55.
c. Explain whether the actions of Division Buy and Division Sell in part (b)
lead to goal congruence.
*Please use the notes feature in the toolbar to help formulate your answer.
a. Minimum transfer price = Marginal cost + Opportunity Cost = $60 + $0 =
$60.
 Opportunity cost is $0 because the 500 units needed could be produced within
the spare capacity of Division Sell.
b. External price $55
Division Buy will buy externally. No transfer takes place.
c. Conclusion
Both divisions are acting in the company's overall best interests. By buying
externally for $55, Division Buy is saving the company $5 per component, since
the cost to the company of making the components is $60.

2.1.2 Scenario 2 – Opportunity Cost Arises

Key Point

An opportunity cost arises when an internal sale sacrifices an external sale.

When to use:

External market
and
Supplying division is at full capacity
Activity 2 No Spare Capacity

Division Red makes Product Y and Product Z. The maximum capacity of the factory
is 5,000 units per month in total.
This capacity can be used to make either 5,000 units of Product Y or 5,000 units of
Product Z, or any combination of the two.

Y Z

Selling price $12 $16

Variable cost $9 $11

Extra cost if sold externally $1 $1

Contribution $2 $4
Required:
a. Determine which product Division Red would make, and what would be
the monthly contribution of the division.
b. Division Blue has asked Division Red to supply 1,000 units of Product Y per
month.
Determine the minimum transfer price which would be acceptable to
Division Red.
c. Division Blue now informs Division Red that it can buy product Y from an
external supplier for $11 per unit and is not prepared to accept a price above
this from Division Red.
 Explain what would happen if both divisions were given autonomy to make
their own decisions. Comment on whether this benefits the company as a
whole.
*Please use the notes feature in the toolbar to help formulate your answer.

2.2 From the Point of View of the Buying Division

The maximum transfer price acceptable to the buying division will be the lower of:
 External market price (if an external market exists); and
 The net revenue of the buying division.
The net revenue of the buying division means the ultimate selling price of the goods
or services sold by the buying division, less the costs incurred by the buying division.

Example 3 Maximum Transfer Price

The bottling division of a large soft drinks manufacturer buys special syrup, made according to a secret
recipe, from the syrup division. The bottling division adds carbonated water to the syrup to make the drink,
bottles the drink, and sells it to the distributors.
Each bottle is sold for $0.50. The bottling division has calculated that the costs of making the drink and
bottling it (excluding the cost of the syrup) are $0.20 per bottle. The net revenue of the bottling division is
therefore $0.30 per bottle.
If the syrup division were to propose a transfer price in excess of $0.30 per bottle for the syrup, the
bottling division would make a loss.

2.3 Economic Transfer Price Rule

In summary:
Minimum (per selling division) transfer price ≥ Marginal cost of selling division;
And
Maximum (per buying division) transfer price ≤ The lower of external market price (if
an external market exists) and net marginal revenue of buying division.
Activity 3 Alternative Transfer Prices

Division I is an intermediate division. It supplies a special chemical to division F, the

final division. Division I has spare capacity.
Output of the chemical is limited. Variable cost per kg is $500.
No external market for the chemical exists.
Division F processes the chemical into the final product. Each unit of the final
product requires 1 kg of the chemical. Demand for the final product exceeds
production.
Selling price per unit of the final product is $1,000. Further processing cost per unit in
Division F = $200.
 Required:
a. Calculate the maximum price Division F will be prepared to pay for one
kg of the chemical.
b. Calculate the minimum price Division I will accept for one kilo of the
chemical.
c. Comment on the performance evaluation issues if:
i. a transfer price of $500 is used;
ii. a transfer price of $800 is used.
d. Suggest an alternative transfer price which would lead to a fairer
evaluation of the performance of the two divisions.
*Please use the notes feature in the toolbar to help formulate your answer.
a. Maximum transfer price to Division F = Net revenue

b. $

Selling price 1,000

Further processing costs in Division F (200)

Net revenue 800

c. The net revenue of $800 per kilo represents the maximum that Division F
would be prepared to pay to Division I for the chemical. If the price exceeds
this, then Division F will incur a loss.
d. $

Marginal (variable) cost per kilo 500

Opportunity cost 0

Minimum transfer price 500

e. Minimum price acceptable to Division I
f. Performance evaluation
i. If the minimum transfer price of $500 is used, then Division I will make no profit.
ii. If the maximum transfer price of $800 is used, then Division F makes no profit.
g. Alternative transfer price
Any transfer price between $500 and $800 per kilo should be acceptable to both
parties. Without any further information about the nature of the production
process and how much effort is made by the two divisions, it is difficult to make a
judgement about what would be a "fair" transfer price.
One suggestion might be to set a transfer price that is the mid-point between the
minimum and the maximum. This would be a price of $650 per kilo. If this were
the case, both divisions could share the profits equally.

3.1 Market Price

The market price may be used if buying and selling divisions can buy/sell externally
at market price.
 Advantages Disadvantages

 Optimal for goal congruence if selling division is at full  Only possible if a perfectly competitive
capacity. external market exists.
 Encourages efficiency – supplying division must  Market prices may fluctuate.
compete with external competition.
However, it may need to be adjusted downwards if internal sales incur lower costs
than external sales (e.g. due to lower delivery costs).

3.2 Full Cost Plus

The supplying division charges full absorption cost plus a mark-up.

Advantages Disadvantages

 Easy to calculate if standard  Fixed costs of selling division become variable costs of buying
costing system exists. division – may lead to dysfunctional decisions.
 Covers all costs of selling  If selling division has spare capacity it may lead to dysfunctional
division. decisions.
 May approximate to market price.  Mark-up is arbitrary.
Standard costs should be used rather than actual to avoid selling divisions
transferring inefficiencies to buying divisions.

3.3 Marginal Cost

Marginal cost = Variable cost + Any incremental fixed costs (e.g. stepped costs)

Advantages Disadvantages
 Optimal for goal congruence when:  May be difficult to calculate (variable cost is often used as
o the selling division has spare an approximation)
capacity; or
o no external market exists.
3.4 Variations on Variable Cost

There are two approaches to transfer pricing which aim to preserve the economic
information inherent in variable costs while permitting the transferring division to
make a profit, and allowing better performance evaluation.

3.4.1 Variable Cost Plus Lump Sum (Two-part Tariff)

Transfers are made at variable cost with a periodic “lump sum” charge from the
buying division to the selling division to account for fixed costs and profit. The
purchasing division can make good decisions based on cumulative variable cost and
the lump sum transfer ensures the divisions are treated fairly when measuring
performance. The lump sum amount could be linked to the quantity or the value of
the goods transferred.
 3.4.2 Dual Pricing
The selling division transfers at cost plus a mark-up (possibly market price), thereby
making a motivating profit, while the buying division transfers in at variable cost,
thereby having appropriate information about cumulative variable cost in the group.
Such an approach requires period-end adjustments to reconcile the two prices and
remove fictitious inter-divisional profits.

4.0 Additional Objectives

As well as the issues considered in section 3, multinational companies may have

additional objectives of transfer pricing.

4.1 Minimising Global Taxation

Ideally, multinationals prefer profits to be taxed in low tax jurisdictions. Transfer

pricing can help achieve this.
 When a subsidiary in a low tax country sells to a subsidiary in a high tax country,
a high transfer price will reduce the profits in the high tax country.
 When a subsidiary in a high tax country sells to a subsidiary in a low tax country,
a low transfer price will transfer a smaller share of profits.
Tax authorities may challenge transfer prices. Many now comply with the guidelines
for transfer pricing issued by the OECD. These state the principle that transfer prices
should be based on "arm's length" prices. Tax authorities may challenge the
deduction of expenses in the calculation of taxable profits if transfer prices appear to
be inflated.

Definition

Arm's length principle – transactions should be valued as if they had been carried out between
unrelated parties, each acting in his own best interest.

4.2 Minimising Import Tariffs

Most countries charge tariffs on the import of products based on the value of the
products imported. When a division in one country sells to a division in another
country, a lower price might be used in order to reduce the import tariffs charged.
As for corporate taxes, tax authorities are aware of such practices and many apply
the "arm's length basis" principle.

4.3 Dividend Controls

Governments in some less developed countries may aim to limit the amount of
profits that multinationals remit back to the "home country". Transfer pricing may
 circumvent these controls by charging the divisions in such countries higher prices
for goods imported from other group companies.

Example 4 Multinational Transfer Pricing

Several high-profile investigations into transfer pricing in a number of jurisdictions and the subsequent
underpayment of tax in recent years, include those into Chevron, Facebook, Fiat Chrysler, Microsoft,
Vodafone and Apple.
In the case of Facebook, for example, there is an issue concerning the role of the organisation’s
international headquarters in Dublin, Ireland. Facebook claims it was integral to the organisation’s
success, while the Internal Revenue Service (IRS) of the US claims it was used to move profits overseas
and reduce the organisation’s tax bill. The trial began in February 2020 and as at October 2021 is still in
progress. If the IRS’s claim is successful, Facebook estimate it could face a tax liability of up to $9 billion
plus interest and penalties.
https://news.bloombergtax.com/daily-tax-report/breaking-down-facebooks-9-billion-tax-fightwith- irs-
podcast

1.1 Types of Organisation

1.1.1 Features
Not-for-profit organisations are distinguishable from commercial organisations by the
following features:
 They do not have shareholders.
 They do not pay dividends. Any surplus of income over expenditure is normally
retained within the organisation to support its future activities.
 The objectives of not-for-profit (NFP) organisations are normally to provide some
social, philanthropic, welfare or other type of service that may not be provided by
the free market.
NFP organisations include:
 Public sector organisations that provide public goods. These are services that
would not be available at the right price to those that need to use them and
include schools, medical care and museums.
 Private sector organisations, such as charities, self-help organisations and sports
clubs.

1.1.2 Charities
Additional distinguishing features include:
 Existence is entirely to benefit defined groups in society;
 Favourable tax treatment available for philanthropic purposes requires
registration with a regulator;
 Activities are restricted or limited by a regulator;
 Reliance on the financial support of the public and/or businesses;
 Heavy reliance on voluntary (unpaid) managers and workers in order to be
financially viable.

1.1.3 Profit-making Activities

 Example 1 Commercial and NFP Organisation

BUPA, the health insurance group, states that its purpose is "helping people live longer, healthier, happier
lives". While the organisation operates on a commercial basis with customers paying insurance premiums,
the company has no shareholders, and all profits are reinvested in improving the services of the
organisation.

The activities of NFP organisations may include profit-making activities. Many

charities in the UK, for example, run chains of retail outlets, which sell second-hand
goods. The profits from these activities are then used to support the other activities
of the organisation. It is therefore not always true to say that NFP organisations do
not make profits.

1.2 Stakeholders

As non-profit organisations do not have shareholders, other stakeholder groups

become more important.
The main stakeholders in a public organisation are likely to be:
 The relevant government body that provides finance for the organisation (e.g. the
ministry of health for a hospital).
 The users of the service of the organisation (e.g. patients in a hospital). There
may be organised user groups who try to influence the organisation's activities.
 The trustees or management board of the organisation. For example, many state
schools have a board of governors to oversee the activities (equivalent to a board
of directors with non-executive and executive members).
 The general public, as taxpayers, are interested in where their tax money is
spent.
In a private sector non-profit organisation (e.g. a charity), the most powerful
stakeholders are likely to be:
 The management, which may be made up of volunteers.
 The beneficiaries of the work of the organisation.
 Governments, who may work alongside the organisation or see it as a threat.
 Donors, who provide funds.
 The patron. Many charitable organisations have a patron (usually an eminent
person or celebrity) who acts as its figurehead, which helps to give it publicity
(which attracts more donors and so raises finance). Famous patrons include the
British Royal family, Sir David Attenborough, Stephen Fry, Dame Judi Dench and
Desmund Tutu.

12.2.0 Introduction
2.0 Introduction

This section discusses the challenges involved in setting strategic performance

measures for NFP organisations:
 More diverse stakeholder groups;
 Funding may be outside of the control of the organisation;
 Output may be difficult to measure.
2.1 Diversity of Stakeholders

Before performance can be measured, it is necessary to know the objectives of an

organisation. Performance measurement means measuring how well an organisation
achieves its objectives.
In private sector NFP organisations, such as charities, the organisations' objectives
are often stated in the foundation documents. For the purposes of performance
measurement therefore, it is relatively easy to identify the objectives against which
performance can be measured.
Because public sector organisations have multiple stakeholder groups, and each
group has its own objectives which may conflict, it can be more difficult to identify the
key objectives that should be monitored.
As noted above, NFP organisations are unlikely to have the objective of maximising
shareholder wealth. Instead, they seek to satisfy the particular needs of their
members or the sections of society that they aim to support. Objectives of NFP
organisations will therefore be diverse and might include:
 To treat patients (a hospital);
 To care for the local community (a local council);
 To provide relief to victims of flooding (a charity.
Activity 1 Stakeholder Groups

Identify the major stakeholder groups of a state maintained school for children, and
for each stakeholder group, identify what the focus of performance measurement
would be for that group.
*Please use the notes feature in the toolbar to help formulate your answer.
The following is a list of some of the stakeholder groups of a school and the focus of
performance measurement that is relevant to their needs. It is by no means an
exhaustive list.

Stakeholder group Focus of performance measurement

Quality of education
Government Value for money

Parents Quality of education

Taxpayers Value for money

Quality of teachers
Pupils Range of extra curricular activities

Principals Quality of staff

Employers Skills obtained by future employees

Activity 1 shows that public sector bodies such as schools have many different
stakeholder groups. Each group has its own wants or needs, and many of these
conflict – for example, the school principal wants more funds, while the government,
representing the taxpayer, would like to have a lower cost.
Since there are potentially many different objectives, it can make performance
measurement difficult. Whose objectives should be given priority?
Solutions to the problem of multiple objectives include:
 Trying to rank the objectives and to focus on those that are deemed to be the
most important. This would include subjective judgement, and would likely be
biased towards the objectives of the provider of funds.
 Use a wider range of performance measures to try to capture more of the
objectives.

12.2.2 Funding
2.2 Funding

2.2.1 Commercial Sector

One of the features of organisations in the commercial sector is a relationship
between output and revenue. If output increases so too should revenue. Cash flow
forecasts can be produced which can predict fairly reliably any potential shortfall in
funds.
Capital expenditure can be financed in a range of ways, such as the issue of shares
or bonds, bank loans and venture capital, to name but a few.

2.2.2 Private Sector Charities

Charities typically rely on donations to fund their operations. This poses two potential
problems:
1. There is uncertainty over how much in donations the organisation will receive.
This makes planning difficult.
2. There is no relationship between the level of output, in terms of the amount of
service provided, and the amount of income received. For example, if a charity
providing shelter for the homeless has a policy of not turning people away, the
amount of service provided depends on the number of people who request it.
It is unlikely that charities would be able to borrow to support their investment
programmes, and instead rely on grants.

2.2.3 Public Sector

In the public sector, customers do not pay directly for the services they receive and
there may be little relationship between the costs of providing the service and the
amount it is used. This means it is more difficult to decide how much should be spent
on the service. In addition, the allocation of funds to the various public sector
organisations will depend on political objectives. Therefore, management has little
control over funding. This may cause the following problems:
  Organisations may be rewarded for failure; if they operate efficiently, and
therefore do not spend all their allocated funding, the funding may be cut in the
future. If they are inefficient on the other hand, and operate a deficit,
governments may increase their funding.
 The funds received may not bear relation to the amount of funding required to
perform the organisation's role. If this is the case, organisations may find that
they have insufficient funds. For example, the amount of activity in a hospital
emergency ward depends on the number of emergencies, not on how much
funding is allocated by government.
 Changes in political objectives may lead to changes in funding, which means
programmes may have to be scrapped if funding is cut.
 Many governments budget on an annual basis; this makes longer-term planning
uncertain.
2.3 Measuring Outputs

One difficulty of measuring performance in NFP organisations is the fact that it is not
always easy to measure the output of the organisation. In commercial organisations,
output is normally measured in units of production or in monetary terms, such as
revenue. This is not feasible in NFP organisations for the following reasons:
 The organisation is not involved in selling as its primary activity. Many of the
services it provides are free to the customer.
 It is not always possible to quantify the objectives. A regional health authority
may have as its objective "to improve the health of the citizens of this region".
How can this be measured? Similarly, there may be multiple objectives, such as
the cleanliness of the hospital, the quality of care provided by the nurses and the
technical abilities of the doctors.
 It is often difficult to identify a direct cause and effect between the work of the
NFP organisation and the improvements in a situation. An environmental
protection agency, for example, may exist to reduce pollution in a particular
country. What may not be clear is how much of the reduction is due to the work of
the environmental protection agency and how much due to other factors.
 The time and cost of collecting and collating the information about output are
increased when the measure of output is less standardised. In a hospital, for
example, a measure of output may be the number of patients treated. This would
include patients from many different departments with many different types of
treatment.
 As discussed in the previous section, many different stakeholders imply that there
can be many conflicting objectives for an organisation. This may complicate the
process of selecting a measure of output.
Example 2 Multiple Objectives

A hospital will have a range of stakeholders, each stakeholder group having its own distinct objectives.
For example:
 Patients will not want to wait for treatment and will expect a high level of care;
 Employees will want job satisfaction and an appropriate work-life balance.
The objectives of these two stakeholder groups may conflict. An appropriate work-life balance might mean
less weekend working, say, or fewer shifts during the evening or at night. This could affect the speed at
 Example 2 Multiple Objectives

which patients are seen, however, and the standard of care they receive at certain times of the day.
When stakeholders' objectives conflict, they must be prioritised. In this example, the patients' expectations
around the level of care they receive would be prioritised above the employees' desire for a better work-
life balance. That said, some level of compromise would be needed to maintain staff motivation, which
might include increases in pay.

3.1 Rationale

Private sector bodies face competition from competitors. This provides incentives to
improve performance, as poor performance will most likely lead to loss of customers
and ultimately profits.
Public sector bodies do not normally face such competition. Many public sector
organisations operate as monopolies. Even if customers are not happy with the
service provided, they cannot switch supplier. This is in stark contrast to commercial
organisations, where bad service usually leads to a loss of customers and revenue.
As a result, performance may often fall behind that of private sector bodies in a
range of areas, such as quality of service and efficiency.
Many writers have proposed the use of benchmarking in the public sector as a way
of providing incentive for performance improvement to compensate for this lack of
competition. As benchmarking was described in Chapter 1, this section only deals
with additional discussion relevant to the public sector.

3.1.1 Selecting Metrics

In public sector benchmarking, the performance indicators used tend to focus on
cost and efficiency or differentiation. Cost variables might include items such as
labour efficiency, or total costs for a particular function as a percentage of income.
Regarding differentiation, many of the metrics used would be of a qualitative nature,
such as client satisfaction or quality of service. It is difficult to measure these directly
due to their subjectivity. One approach is to use customer surveys for these.
In attempting to find relevant metrics, benchmarking exercises carried out in the past
by similar organisations can be a useful source. Much information about these is
available in accounting and business journals, and online, or by contacting
organisations that have already performed a benchmarking exercise.
This is easier in the public sector, as the government (as overseer and beneficiary of
the benchmarking) may require other organisations to disclose information. This
would not be the case in the private sector.

3.2 Effect of Benchmarking on Performance

In theory, benchmarking in the public sector leads to improvements in performance

because of the following:
  Benchmarking provides the opportunity to learn from other organisations'
practices, as described previously.
 Where an organisation's actual performance is poor, and benchmarking
highlights this, the organisation will experience pressure from stakeholders to
improve.
Some research was performed by Van Helden and Tillema to identify whether
benchmarking had been a success in the public sector in practice. Focusing on
water boards in the Netherlands, they found that benchmarking had not led to strong
improvements in performance, even when it had identified that there was substantial
room for improvement.
Van Helden and Tillema identified the following problems, which they claimed are
fairly common throughout the public sector:
 In the public sector, benchmarking tends to focus only on comparing performance
indicators against best practice, without learning how the best practice
organisations achieve those superior performance indicators.
 Not all managers in the public sector have the motivation to improve their
performance, even when the benchmarking indicates that their performance falls
well short of the best practice.
 The hope for pressure from stakeholders to improve poor performance was
actually rather weak.
 In some public sector institutions, customers can switch from one provider to
another, so exerting economic pressure on poorer performing organisations to
improve (e.g. in state run universities). However, customers may find it difficult to
interpret benchmarking scores. The costs of switching may also be high.
Many of the potential weaknesses of performance measurement systems discussed
in a previous chapter also apply to public sector benchmarking:
 "Measure fixation" where organisations take action to improve the reported score
without improving the underlying organisation.
 "Tunnel vision" where organisations focus only on the benchmarked scores at the
expense of other important targets.
3.3 League Tables

Benchmarking scores are often presented in the form of a league table whereby the
performance of one organisation can be compared with other similar organisations
and ranked. Typically, a score will be given for each of several benchmarks.
These scores will then be added up. Weightings may be applied across items so that
more important factors have a greater impact on the final score.
League tables are often used for schools, hospitals, and even criminal justice.

Example 3 School League Tables

The UK government publishes league tables for schools. Rather than using one overall performance
score that summarises all performance measures, there are several different league tables, each ranking
schools by different criteria.
For example, in the 2019 league tables, primary school (pupils up to the age of 11) were ranked by the
 Example 3 School League Tables

following criteria:
 Overall performance
 Progress
 % meeting expected standards in reading, writing and maths
 % of pupils achieving at a higher standard in reading, writing and maths
 Average scores in reading and maths
 % of pupils achieving each writing standard
 Results by prior attainment.

3.3.1 Advantages
 League tables encourage competition, which should lead to managers aiming to
improve the performance of their organisation.
 League tables summarise many different characteristics into one number (or
rank) making it easy for stakeholders to identify overall performance.

3.3.2 Disadvantages
 Can lead to greater levels of dysfunctional behaviour, such as measure fixation
and tunnel vision, since performance evaluation is based on one final score,
without providing additional analysis of the range of performance measures.
 Can ignore important differences in the organisations being measured. In
schools, for example, exam results do not only reflect the performance of the
school; they also depend on many other external factors (e.g. the ability of the
children and socioeconomic factors). These are ignored in league tables.
 They do not provide any standards of what is acceptable behaviour.
4.1 Historical Background

The period after the Second World War saw an expansion of public services in many
countries throughout the world, particularly in areas such as healthcare provision,
education and housing. However, in the period since the 1980s, many began to
question the continued expansion of such organisations, and began to demand
reform to the way public sector organisations were managed.
Governments in many OECD countries responded by introducing reforms to the way
public sector organisations were organised. These changes have been termed "New
Public Management".
The following goals have been fairly typical of reforms:
 To improve the overall efficiency and effectiveness of the public expenditure;
 To reduce overall levels of expenditure;
 To improve accountability and transparency of the public sector;
 To enhance the responsiveness of public sector organisations to citizens.
One of the features of many reform programmes has been the increasing use of
performance measures and targets to measure all aspects of the performance of an
organisation.
4.2 Rationale for the Use of Targets

4.2.1 Improved Performance

The use of performance targets in the public sector is based on the assumption that
if managers know what is expected of them, they will perform better. Performance
management systems in the public sector tend to be based on the following steps:
 Objectives are identified based on the mission statement. Key targets would then
be set for each objective;
 Strategies are developed to help achieve those targets;
 Actual performance is measured against the targets;
 Managers must explain any variances between actual performance and the
targets.

4.2.2 Accountability
A second reason for the use of targets is accountability. In the public sector, the
managers of the organisation are the agents, who act on behalf of the general public,
the principal (although the role of principal is often played by the government on
behalf of the general public).
Much discussion of accountability focuses on whether managers have acted ethically
(i.e. have not stolen the funds provided to them) and can account for their use. An
equally important aspect of accountability, however, is how well the agent has
performed.
The disclosure of performance information is an essential part of the principal-agent
relationship that exists in the public sector.

4.2.3 Focus on Outputs Not Inputs

In many countries, the emphasis of performance reporting has changed from the
reporting of inputs to the reporting of results. This encourages management to spend
less time accounting for the funds, and where the money has been spent, and more
time on what has been achieved. For such an approach to be successful, it is
necessary that clear objectives must be stated, and clear and realistic standards of
performance are set.

4.2.4 Linking Reward Schemes to Targets

Performance-related pay schemes are often introduced in conjunction with targets –
a bonus is paid if particular targets are met, so as to improve employee performance
and hence organisational performanc

4.3 Difficulties of Using Targets in the Public Sector

 In public sector bodies, there may be less of a direct link between intentions and
outcomes. In a hospital, for example, mortality rates may depend on many factors
that are outside of the control of the hospital.
  It may be difficult to identify quantifiable goals in the public sector. How does one
measure the effectiveness of the local fire brigade, for example?
 Targets may lead to managers focusing on what is measured, and ignoring
qualitative things that are not measured.
 If systems are implemented in a very rigid way, without giving consideration to
local issues, or special situations relating to the organisations being measured,
then this may lead to problems such as manipulation of data, tunnel vision, sub-
optimisation, etc.
 Often the system can become a meaningless ritual, with management "playing
along" with the system of defining missions and objectives, and setting targets,
but in reality improving nothing
4.4 Politics and Public Sector Performance Measurement

Politics can have negative effects on performance measurement in the public sector:
 Long-term objectives can be sacrificed to meet short-term political aspirations.
This is particularly the case when there are frequent changes in government.
 The greater the public’s interest in an area of the public sector, the greater the
likelihood of political interference. Education and health are particularly prone to
this.
Example 4 Politics and Undesirable Service Outcomes

Politicians often claim they will increase funding to and ensure improved performance in the public sector
as these are often high on the list of voters’ objectives, but such action can have undesirable service
outcomes.
Negative effects of increased funding include:
 Funding that is not used effectively or efficiently;
 Other parts of the public sector might lose funding;
 Only high-profile areas that voters are interested in receiving funding;
 Funding is only a short-term measure, to gain voters’ approval.
Negative effects of improved performance include:
 Improvements due to data manipulation with no actual changes;
 Possible increased pressure on employees;
 Not all users of the service may benefit;
 Performance in other areas may suffer.

5.1 Value for Money (VFM) Framework

One method that is widely used for assessing the performance of NFP organisations
particularly in the public sector is the value for money criteria, or the "3Es". This is
based on the rationale that funding is limited for NFP organisations, and therefore it
is desirable to measure how well those organisations perform, given their limited
resources.
 Three performance measures were designed by the UK's Audit Commission:
1. Economy – minimising inputs (in terms of lowest cost for the quality
required);
 2. Efficiency – maximising the output/input ratio;
3. Effectiveness – achievement of objectives.
 It is clear that high effectiveness may conflict with economy and efficiency.
 Multiple and conflicting objectives may also exist due to the multiple stakeholders
involved.
Activity 2 Economy, Efficiency and Effectiveness

Continuing with the example of a state maintained school, and using a teacher as a
unit of input, suggest measures for economy, efficiency and effectiveness of a
school.
*Please use the notes feature in the toolbar to help formulate your answer.

Economy Cost per teacher (total costs of the school divided by the number of teachers.

Efficiency Number of pupils per teacher

Average results in exams

Percentage of pupils who gain a place at a University
Effectiveness Portion of pupils who can read by the age of 7
Comments: economy allows the government to compare different schools. As far as
efficiency is concerned, a high pupil to teacher ratio is good, although this may
conflict with effectiveness.

5.1.1 Benefits of the VFM Framework

 It should help ensure better allocation of resources. In the future, more resources
would be allocated to those organisations that perform better.
 It helps demonstrate the value of work performed to stakeholders and resources
could be allocated to areas taxpayers value more.
 It helps save money and may contribute to increases in funding.
 It encourages decisions to provide better services as well as reduce costs.

5.1.2 Potential Problems with the VFM Framework

 The 3Es may conflict with each other. Taking a school as an example, economy
would suggest that schools with a higher ratio of students to teachers are better.
However, in terms of the quality of education, or effectiveness, having high
student- teacher ratios is likely to reduce this.
 Measuring the inputs may be difficult. In the health service, for example, it must
be possible to accurately measure the funds used in hospital departments.
 Sometimes there is a delay between the service and the final outcome of the
service. For example, pupils may spend 10 years in a school and it is not clear
until they leave whether they have received an appropriate education (to enable
them to get the job they want, go to university or college, etc).
 When VFM measures are used to compare different bodies such as hospitals,
care must be taken to adjust for different operational constraints. For example,
Type of Gain Definition HEFCE’s Key Themes

Economy The institution has reduced its costs by purchasing  Use of purchasing
goods or services for a lower unit price or by consortia/framework
lowering staff headcount. contracts
 Review of existing contracts
and purchasing
arrangements
 Competitive tendering for
goods and services
 Negotiation with existing
suppliers

Efficiency The institution has achieved cash savings by making  Energy efficiency measures
– cash- more efficient use of its resources, i.e. achieving the  Organisational or
releasing same or a greater level of output for a lower input of departmental restructuring
 Use of IT-based processes
financial resources. to reduce costs

Efficiency The institution has freed up staff time by  Streamlining of operational

– time- implementing more efficient ways of working, and administrative
releasing allowing such staff time to be invested elsewhere. processes
 Use of IT-based processes
to free up staff time

Efficiency The institution has freed up space or  Restructuring activities to

– space- teaching/research capacity through the adoption of make more efficient use of
releasing more efficient design, space configuration or ways of space
 Centralising the
working. management of space
 Remodelling of space to
increase capacity

Effectiveness The institution has implemented better ways of  Initiatives to enhance the
achieving desirable outcomes, such as improved student experience
student satisfaction or staff engagement.  Actions to increase staff
engagement or productivity
 Restructuring activities to
better respond to student
need

Equity The institution has taken action to enhance its ability  Providing support to
to reach all of the people for whom its activities and students with additional
services are intended. needs
 Taking action to identify and
support disengaged students
 Improving personal tutor
support to students

Income The institution has created new income streams that  Introduction of charges for
generation bring in additional financial resources. specific services
 Improved marketing of
facilities to external users
 Introduction of public short
course programmes
  the level of salaries may be very different in the locations where the hospitals are
located. This gives an advantage to hospitals in lower cost areas.
 In practice, the VFM performance systems that have been implemented are not
complete due to the sheer complexity of the situations. This does not mean that
they do not provide any value, but that more work is required to complete them.

12.5.2 Value for Money Audits

5.2 Value for Money Audits

VFM audits may be undertaken to ascertain whether projects have achieved their
objectives in a way that is most economic, efficient and effective. They are often
conducted on behalf of charities. The purposes of the audit are:
 To learn lessons for the future.
 To evaluate sub-contractors who have been engaged to perform parts of a
project.
Exhibit 1 Value For Money

Set out below is an extract from the Value For Money Report for 2016/17 for Queen Mary College of the
University of London, showing definitions for the three measures and how the Higher Education Funding
Council of England’s key themes have been addressed.

5.3 Charity Ratings

The American Institute of Philanthropy uses a rating system to help potential donors
select which charities to donate to. Their rating system includes the following criteria:
 Percentage of total expenses that go to charitable programmes. According to the
institute, 60% or more is reasonable, with the remaining 40% being used for fund-
raising activities, administration and management salaries.
 Amount spent to raise $100 of donations. This looks at marketing costs as a
percentage of revenue raised. The lower the amount spent to raise $100 the
better. It is important that only the revenue raised as a result of the marketing
activity is included.
While the American Institute of Philanthropy method is useful in seeing how efficient
the operations of charities are, and therefore what portion of the charity's revenues
are ultimately spent on the charity, it does not really give any indication of how
effective the charities are at achieving their objectives.
Other measures are likely to focus on the output of the charity in quantitative terms.
For example:
 The number of people who were given food in a famine- affected region.
 The number of homeless people that an organisation managed to help.
 The number of teachers provided to a special needs school.
 5.4 Qualitative Measures

  Quality of service is an area that is important in both commercial and not-for-
profit organisations. Given the difficulty of measuring performance in not-for-
profit organisations, however, it is likely that qualitative measures will be used
more for not- for-profit organisations.

13.1.1 Interaction of Financial and Non-Financial Performance Measures

1.1 Interaction of Financial and Non-Financial
Performance Measures

1.1.1 Weakness of Using Only Financial Measures

Traditional performance measurement was based almost exclusively on financial
measures. However, since the 1980s, many companies recognised that there are
inherent weaknesses in focusing only on financial factors:
 They lead to excessive focus on cost reduction. Short-term cost reductions may
be achieved at the expense of long-term performance – due to the effect on staff
morale, quality and other factors.
 Financial performance measures tend to have an internal focus, but in order to
compete successfully an organisation needs to consider external factors such as
the activities of customers and competitors.
 Financial measures are traditionally backward looking. Organisations must
consider the future given the current dynamic business environment.
 Financial performance indicators ignore the drivers of business success. The
things which drive business success are:
o Quality
o Delivery
o Customer satisfaction
o After-sales service
o Employee satisfaction.
 NFPIs drive businesses forward in the long run. Financial performance indicators
may measure success, but they do not ensure success.
Since the 1980s therefore, many companies have started to develop non-financial
performance indicators. These are used alongside financial performance measures
to give a "rounder" picture of the performance of an organisation.

1.1.2 Links and Trade-offs

Financial and non-financial performance indicators interact with each other even
though they may measure different aspects of performance or different activities.
If, for example, an organisation wishes to increase market share (an NFPI), it may
reduce prices or make special offers available to customers. Such actions might
increase market share in the short term, before competitors react, but is likely to
reduce profit margins (a financial measure).
Or suppose an organisation has a focus on cost reduction and has an objective of
100% on-time deliveries to improve customer satisfaction. If there are production
delays, orders may need to be delivered by courier, say, to ensure on-time delivery,
but this will increase delivery costs. There may therefore need to be a trade-off
between the financial and non-financial aspects of performance.

1.1.3 Advantages of NFPIs

 They are usually easier to calculate than financial measures, so they can be
provided much more quickly (e.g. at the end of each shift).
 Flexibility – organisations can come up with any measures that are appropriate to
their objectives.

13.1.2 Implications of Growing Emphasis on NFPIs

1.2 Implications of Growing Emphasis on NFPIs

The popularity of NFPIs was driven by a more competitive environment in which

organisations found that in order to compete, it was necessary to consider qualitative
factors such as quality and customer satisfaction, not just producing at a lower cost.

1.2.1 Problems of Growing Emphasis on Non-Financial

Performance Measures
 Organisations often ignored financial performance entirely – this is clearly not
appropriate when the objective of an organisation is to maximise the wealth of its
shareholders.
 Organisations developed too many NFPIs, many of which conflicted, and this
resulted in confusion for the managers that were trying to achieve the measures.
 It is often difficult to interpret or make decisions based on qualitative data.

1.2.2 Use of Balanced Scorecard Model

As a result of these problems, Kaplan and Norton came up with the idea of the
Balanced Scorecard. The Balanced Scorecard encourages organisations to take a
more balanced view of performance measures by choosing a small number of
financial and non-financial performance measures that cover the most important
areas of the business. The Balanced Scorecard is covered later in Chapter 15.

1.2.3 Fitzgerald and Moon's Building Block Model

Although Fitzgerald and Moon's building block model is described later (see Chapter
15) it is worth mentioning here, as it includes financial and non-financial performance
indicators. The building block model was conceived for use in services business, and
proposes measuring performance under six categories or dimensions, as follows:
Results
1. Profitability
2. Competitiveness (e.g. market share)
Determinants
1. Quality of service
2. Flexibility (i.e. the ability to customise the service to meet customer needs)
3. Resource utilisation
4. Innovation (e.g. developing new products).
Within each category of the building block model, the organisation must decide on
appropriate measures of performance.
The two dimensions of results will be influenced by the other four "determinants". For
example, a high quality of service may lead to greater customer loyalty, which will
increase both market share (competitiveness) and profits.
 The determinants are likely to be mainly non-financial in nature (i.e. focusing on
the things that drive success).
1.3 Non-Financial Performance Measures in Relation to
Employees

The value of an organisation's employees is not considered in an organisation's

financial statements. For many organisations, particularly in service organisations,
the value of "human capital" may be very important, however.
Facets that organisations may wish to measure relating to employees include:
 Knowledge and skills. This may come from previous education and/or previous
job experience.
 Attitude. In service industries in particular, it is important that employees
demonstrate a positive and helpful attitude when dealing with customers or
clients.
 Morale. Poor employee morale may affect the attitude of the employees. It may
also lead to higher staff turnover. High staff turnover leads to additional costs in
terms of recruitment costs and training costs of new staff to replace those who
leave.
Activity 1 Measuring Employees

Suggest possible performance measures that could be used by an organisation to

measure the following three facets relating to employees:
 Knowledge and skills;
 Attitude;
 Morale.

*Please use the notes feature in the toolbar to help formulate your answer.
The following is not an exhaustive list of all possible measures.
Knowledge and skills
 Number of staff with relevant qualifications (e.g. number of qualified ACCA staff
in the finance function).
 Number of days training per year provided to employees.
 Total number of years' experience of all staff.
Attitude
 Rankings from customer feedback forms.
 Absentee records (number of days off work due to sickness per year).
 Punctuality records.
 Rankings from colleagues and managers.
Morale
 Staff turnover.
 Confidential staff surveys conducted by independent third parties.
1.4 Performance Measures in Relation to Quality

Quality of product or quality of service is far more important in a competitive

environment. Many organisations compete on quality which is an important driver of
long-term success.
Many companies have adopted total quality management programmes, and
therefore monitor quality at all stages in the production process. Total quality
management is covered in greater detail later in this chapter.

1.4.1 Quality of Products

Possible measures of overall quality and customer satisfaction are as follows:
 Percentage of goods produced that are identified as being faulty before sale, and
have to be scrapped or re-worked.
 Percentage of products sold that are returned because they do not meet required
standards.
 Cost of fixing products under warranty claims.
 Customer retention rates. Crude indicators of loyalty of an organisation’s
customer base are sales and market share. More insightful information often
comes from customers who have not been retained.

1.4.2 Quality of Services

Services are different to products, in that there is no tangible product, and what
clients value about the service is not always so clear. Possible measures of the
quality of service and customer satisfaction are as follows:
 Number of complaints. The problem with this measure is that it does not take
into account customers who were unhappy with the service, but who did not
complain.
 Number of repeat clients. This is an objective measure of performance. If the
customer is happy, he will come back for more.
 Rankings from customer surveys. The problem with these is that some
customers may not complete the survey at all; others may do it quickly without
really thinking. Therefore, the results of the survey may not be entirely reliable.
 Rankings of customer attitude performed by management or internal auditors
by going "under cover" and pretending to be clients.

1.4.3 Access and Availability of Products and Services

These are key aspects of performance, as customer may leave if they are not able to
obtain goods and services when they want to.
Activity 2 Quality of Treatment

Suggest measures that might be used to assess the quality of treatment provided by
a hospital.
*Please use the notes feature in the toolbar to help formulate your answer.
The following measures could be used. However, this is not an exhaustive list, and
other sensible suggestions could be equally valid.
  Percentage of cases where initial diagnosis was incorrect.
 The number of successful operations as a percentage of total operations
performed. The number of remedial operations undertaken could measure this.
 Mortality rates.
 Number of instances of drug administrative errors.
 Percentage of patients who return to the hospital within three months due to
original treatment being insufficient.
 Rankings based on patient feedback. This would focus on areas such as
responsiveness of staff to patients' requests.

1.5 Interpreting Data on Qualitative Issues

Understanding the message provided by qualitative data usually requires a certain

amount of judgement before any conclusions can be drawn about the meaning of the
data.
If rankings indicate that customers are dissatisfied, for example, it will be necessary
to identify why they were dissatisfied. This may not always be clear from the data
given.

Example 1

A fast food restaurant recently asked its customers to complete the following questionnaire:

In one particular week, 100 responses were received. For the question "How friendly were the staff?" 40
respondents rated it as poor, 10 rated it as satisfactory and 50 rated it as excellent. Here are some potential
 Example 1

conclusions that could be drawn from this:

 The answers are inconsistent, meaning that the overall data is meaningless.
 Some of the staff are not friendly while others are. It is necessary to identify the less friendly staff.
 Staff members sometimes have a bad day, or a bad moment, particularly during peak times when they
have a lot of customers to deal with.
 Some customers will never be satisfied and will complain about anything.

13.2.1 Significance

2.1 Significance

Although it can be expensive for a organisation to develop and maintain a brand

and/or a company profile, such intangibles can have a significant positive impact on
organisational performance. That impact will depend on the extent to which the
brand and/or profile has the following features:
 A recognisable name;
 High levels of customer loyalty;
 The perception of quality and/or luxury;
 Accompanying trademarks or patents/

13.2.2 Brand Awareness

2.2 Brand Awareness

Definition

Brand awareness – the ability of customers to recognise and recall a brand.

2.2.1 Brand Awareness vs Brand Loyalty

It is important to distinguish between brand awareness and brand loyalty.
 Brand awareness is the extent to which customers can recognise and recall a
brand. It reflects the brand’s ability to attract new customers.
 Brand loyalty is the extent to which customers buy a product because of the
brand, and will continue to buy it. As such it reflects a brand's ability to retain
existing customers.

2.2.2 Significance to Business

If customers do not know about an organisation they will not buy from it, and hence
one of the main objectives of an organisation is to grow brand awareness. For many
organisations, their brands are the most valuable assets that they control.
A brand may:
 be the name of the company, in which case all products made by the company
will benefit from it (e.g. the names of car manufacturers such as Mercedes-Benz);
or
 relate to particular products (e.g. the Persil washing powder brand owned by
Unilever).
Various benefits accrue to the organisation that owns the brand:
 The brand name differentiates the product, enabling the company to focus on its
target market and possibly charge a premium price.
 If the brand relates to one product, that brand can be leveraged to other products
(e.g. the cigarette brand Marlboro was used to launch various lines of men's
clothing).
 The brand may lead to brand loyalty and therefore to repeat customers, ensuring
success in the future.

2.2.3 Performance Management Issues

In order to maintain brand awareness, organisations must invest in advertising and
publicity:
 It is important to select a method of advertising and locations that are appropriate
for the image of the brand. For example, companies that produce up-market
country clothing often sponsor events such as horse-jumping competitions.
 The management accountant will have to prepare budgets for each type of
promotion and judge their effectiveness by monitoring the additional revenue
generated.
If the brand suggests quality, the organisation will need to have quality assurance
and control procedures in place to ensure the quality. The management accountant
may be involved in providing financial information about quality costs, as well as non-
financial information (e.g. the number of defective products).
Brand awareness and recognition can be measured by market research. Typically,
surveys seek to determine the portion of the public that is aware of the brand, and
those who are aware are asked about the image that the brand conveys to them.

13.2.3 Company Profile

2.3 Company Profile

A company profile is how an organisation appears to the outside world. As with

brands, a positive company profile can lead to increased sales, as consumers are
attracted to buying from the company. If the company has a bad profile, this can lead
to a fall in sales.
A bad company profile could be the result of:
 Bad quality of service (rude staff, delays in returning calls);
 Poor ethical or social behaviour;
 Poor quality of products.
3.1 Total Quality Management
 Definition

Total quality management (TQM) – continuous improvement in activities involving everyone (ma
and workers) in the organisation in a totally integrated effort towards improving performance at eve
level.

3.1.1 Key Concepts

TQM is a philosophy of “get it right the first time every time”. It recognises that the
costs of bad quality may exceed the costs of good quality.
 The aim is perfect quality (i.e. zero defects).
 There is dissatisfaction with the status quo. Even if a target of zero defects is not
feasible, management and staff should believe it is possible to get it more right
next time.
 Every process has a process owner and every person contributes to its
improvement.
 Goods and services from a TQM system will be competitive on cost, flexible,
delivered in a minimum time and backed up by guarantees and swift customer
service.
 Successful implementation and running of a TQM system require education and
training of all those involved in the production of goods, from suppliers of parts,
through the workforce to management of the organisation.
 Training produces the benefits of reduced wastage, improved products and
market position, increased sales and profits, elimination of waste, establishment
of common aims, more contented employees and more satisfied customers.

3.1.2 Quality Costs

The cost of quality is the difference between the costs of producing, selling and
supporting products/services and the equivalent costs if there were no failures during
production.

3.1.3 Internal Failure Costs

Definition

Internal failure costs – costs arising from inadequate quality identified before transfer of ownersh
supplier to purchaser (i.e. before delivery to the customer).
Internal failure costs include:
 Re-work costs;
 Disposal of defective products; and
 Downtime due to quality problems.

3.1.4 External Failure Costs

Definition

External failure costs – costs arising from inadequate quality identified after transfer of ownership
 Definition

supplier to purchaser (i.e. after delivery to the customer).

External failure costs include:
 Complaint investigation and processing;
 Warranty claims;
 Cost of lost sales (e.g. due to loss of goodwill);
 Product recalls.
 Internal and external failure costs are collectively referred to as “costs of non-
conformance”.

3.1.5 Appraisal Costs

Definition

Appraisal costs – costs incurred to ensure that output meets required quality standards.
Costs of monitoring and inspecting products in terms of specified standards before
the products are released to the customer. For example:
 Measurement equipment;
 Inspection and tests;
 Product quality audits;
 Process control monitoring;
 Test equipment expense.

3.1.6 Prevention costs

Definition

Prevention costs – costs incurred to prevent defective or substandard products or services from being
produced (therefore incurred prior to or during production).
Investments in machinery, technology and education programmes designed to
reduce the number of defective products during production. For example:
 Customer surveys;
 Research of customer needs;
 Field trials;
 Quality education and training programmes;
 Supplier reviews;
 Investment in improved production equipment;
 Quality engineering;
 Quality circles.
 Appraisal and prevention costs are collectively refer to as "costs
of conformance".

3.1.7 Impact of TQM on Quality Costs

TQM will result in an increase in prevention costs but internal and external costs
should fall by a greater extent.
3.2 Just-in-Time

Definition

Just-in-time (JIT) manufacturing – a manufacturing production method that aims to produce the
required items at the required quality and in the required quantities at the precise time they are req
JIT manufacturing includes the following goals:
 Elimination of non-value added activities
 Zero inventory
 Zero defects
 Batch sizes of one
 Zero breakdowns
 A 100% on-time delivery service.
These goals represent perfection and are unlikely to be achieved in practice.

3.2.1 Elimination of Non-Value-Added Activities

In a typical western factory, the time taken to produce goods is made up of:
 Process time
 Inspection time
 Move time
 Storage time
 Queue time.
Non-value-added activities are any activities that do not add value to the product.
Of the above, only process time adds value to the final product. In many western
companies, however, this typically accounted for less than 20% of the total cycle
time.

3.2.2 Batch Sizes of One

Traditionally manufacturing was performed in large batches in order to reduce the
costs of setups. These costs were incurred because it was necessary to set up the
machines in a different manner to produce different products. The problem with large
batch sizes is that it leads to delays and large inventory.
In the just-in-time approach, the aim is to have batch sizes of one, by having
machines that do not need to be continually set up for different products – this can
be assisted by having cell-based manufacturing. Having batch sizes of only one
saves costs and makes the producer more responsive to changes in customer
demand.

3.2.3 Weaknesses of the Traditional Western Approach

The traditional Western approach to manufacturing was to produce maximum
capacity. Production was driven by internal plans rather than external demand. This
led to:
 Excessive holding of inventory – with the associated costs of storage and
obsolescence;
  Delays between customer ordering products and the delivery of the products;
 Bottlenecks in the production process were not highlighted;
 A lack of flexibility in meeting changes in customer requirements.

3.2.4 JIT Production

A system that is driven by the demand for finished products whereby each
component on a production line is only produced when needed for the next stage.
 A "pull through philosophy" – customer demand drives production.
 Requires careful planning of demand and production requirements.

3.2.5 JIT Purchasing

Matching the receipt of materials closely with usage so that raw material inventory is
reduced to near zero levels.
 Achieved by having a series of small production units to which materials are
delivered.
Exhibit 1 JIT Supply Chain

The Financial Times reported on 13 February 2020 that digger maker JCB, an organisation using JIT
supply chains, was to cut production and working hours at its UK factories owing to a shortage of
components from China. This marked the first significant impact of the coronavirus outbreak on a British
manufacturer.
More than 25% of JCB’s component suppliers in China were closed as a result of the Covid-19 outbreak.
JCB sources hundreds of components from China and its announcement underlined the risk to global
supply chains from the coronavirus outbreak.
Source: Financial Times, February 13 2020

 A few dedicated suppliers deliver defect-free components on time two or three

times per day.
3.3 Target Costing

In traditional cost plus pricing models, the cost of a product is the starting point for
calculating price; a profit margin is added to the unit cost. In a competitive world,
such an approach may not be realistic. The price calculated in this way may be too
high for the market to accept.
Target costing is an approach that starts with the market price of a product. The
required profit margin is deducted from this to calculate a target cost. The target cost
is then compared to the actual (expected) cost, and ways are found to narrow the
"gap" between the two.
Target costing is normally used during the design phase of a new product.

3.3.1 Steps in Target Costing

1. Determine the price that the market will accept for the product, based on market
research. This may take into account the market share required.
2. Deduct a required profit margin from this price – this gives the target cost.
3. Estimate the actual cost of the product. If it is a new product, this will be an
estimate.
4. Identify ways to narrow the gap between the actual cost of the product and the
target cost.
Target costing can be illustrated by the following flow diagram:

Source: Skurai M., Journal of Cost Management for the Manufacturing Industries,
"Target Costing and How to Use It," vol. 3, No 2 (1989).

3.3.2 Implications of Using Target Costing

 Target costing is not a pricing method. However, its use implies that old cost plus
methods of pricing will not be used. Prices will be set based on external factors.
This is likely to make the organisation more outward looking and competitive.
 It is often easier to eliminate costs during the design phase rather than later on
during manufacture.
 When identifying methods to reduce costs, management considers the impact
these will have on the quality of the final product.
 For performance measurement, target costing may provide a more relevant
target than traditional standard costs. The target is based on the required level of
profit rather than on some engineered cost, which may be arbitrary in nature.

3.3.3 Narrowing the Target Cost Gap

Target costing relies on multi-disciplinary teams, which discuss ways to reduce the
gap between the actual (expected) cost and the target cost.
Some methods that have been used successfully in practice are as follows:
 Reconsider the design to eliminate non-value-added elements;
 Reduce the number of components or standardise components;
 Use less expensive materials;
 Employ a lower grade of staff on production;
 Invest in new technology;
 Outsource elements of the production or support activities;
 Reduce manning levels or redesigning the workflow.
Such methods may be assisted by the following techniques:
 Tear down analysis (reverse engineering) – this involves examining a
competitor's product to identify possible improvements or cost reductions.
 Value engineering – involves investigating the factors that affect the cost of a
product or service. The aim is to improve the design of a product so that the
 same functions can be provided for a lower cost, or eliminating functions which
the customer does not value, but which increase costs.
 Functional analysis – involves identifying the attributes/functions of a product
that customers value. The determination of a price that the customer is prepared
to pay for each of these functions is then performed. If the cost of providing the
function exceeds the value, then the function is dropped.
3.4 Kaizen Costing

"Kaizen" means continuous improvement. Kaizen costing is a technique of

continually trying to reduce the cost of a product. The three main characteristics of
kaizen costing are:
1. Setting standards and then continually improving these standards to achieve
long-term sustainable improvements.
2. A focus on eliminating waste, improving processes and systems and improving
productivity.
3. Involvement of all employees and all areas of the business.
Target costing is used during the design phase of a product to try to ascertain the
required cost. However, the target cost is simply the starting point for Kaizen costing.
Once manufacturing starts, actual costs are recorded on a regular basis (monthly,
say) and a new target set for the next period, based on the first period’s actual cost
minus target reductions.
Compared to standard costing, Kaizen costing is more challenging. In standard
costing, the standard is based on current operating conditions. Under Kaizen costing
the standard is based on more efficient conditions than current.
Improvements come from the following sources:
 Elimination of waste;
 Elimination of non-value-added activities;
 Improvements in the production cycle time.
.5 Accounting Systems

Traditional management accounting systems include traditional budgeting, costing,

standard costing and variance analysis. Such systems will be inadequate to support
the techniques mentioned above. The following changes may be required:

3.5.1 TQM
As management will need to be aware of quality costs, an analysis will be needed,
based on the four categories of quality cost mentioned above. (Such costs are
typically "invisible" within general overheads in traditional management accounting
systems.)
It also may be appropriate to introduce activity-based management systems in order
to calculate quality costs accurately. This involves showing costs analysed by activity
rather than under traditional cost headings (see Chapter 15).

3.5.2 Kaizen Costing

For the introduction of kaizen costing, management will require an accounting
system that can provide a functional analysis of the costs of producing a product.
 This will be used initially as a basis for calculating target cost.
 In subsequent years, small reductions in this target cost will need to be made.
This is in contrast to the traditional standard cost, which is set and may not be
revised for many years. Also, the setting of a standard cost may be less detailed
than the setting of a target cost.

3.5.3 JIT
In a traditional manufacturing environment, a lot of time may be spent calculating the
value of work in progress and finished products. In a JIT, such items should be
minimal, so complex valuations will not be needed.
The accounting and logistics system will need to focus on ensuring that the
production systems are able to meet planned demand. This will include:
 accurately predicting customer demand; and
 ensuring that all materials received from suppliers are of the right quality, as
poor-quality materials may lead to bad production that will prevent the system
from meeting planned production.
4.1 Meaning of Quality

The importance of management information systems and the contribution of

information technology in improving the performance of organisations have been
examined in earlier chapters. Because management information systems are
important, it is clearly important that they are of a good quality. In IT systems, quality
can be taken to mean the following:
 Functionality – The system performs the tasks it was designed for, it conforms
to the requirements of the users and provides the information they require in the
format they want.
 Reliability – The systems are reliable. They do not continually break down. They
are free from processing errors.
 Usability – The systems are easy to use. This implies user-friendly interfaces,
well-designed menu structures, the availability of help, and the existence of
warning messages to prevent accidental actions such as shutting down without
saving data.
 Build quality – The system is flexible; changes can be made to it as business
requirements change.
4.2 Need for Quality

Quality is important in management information systems for the following reasons:

 The system may be critical for the operations. If the system is down, business will
be interrupted.
 Poor systems will provide poor-quality information, which will lead to poor
decision-making.
 External stakeholders may have an interest in the system (e.g. customers placing
orders online). A poor system may lead to poor relations with these stakeholders.
4.3 Qualities of Good Information

Ultimately, a system can be judged on the quality of the information that it produces.
Qualities of good information are:
 Accurate – the information should be arithmetically correct or objective.
 Complete – all relevant information should be included.
 Cost beneficial – the cost of obtaining the information should be less than the
benefits.
 User targeted – it should address the needs of the user and avoid information
overload.
 Relevant – to the person to whom the information is given.
 Authoritative – users need to be able to trust the information provided.
 Timely – the earlier the information is available, the more useful it is.
 Easy to use – excessive detail should be avoided and tables and graphics used
to convey summarised information.
⇒ ACCURATE acronym.

13.5.1 Meaning

5.1 Meaning

Six Sigma is a quality improvement programme that was developed by Motorola in

the 1980s. The objective of Six Sigma quality is to reduce the variation in process
output so that on a long-term basis there will be not more than 3.4 defects per million
opportunities (DPMO).
Six Sigma has been used in both manufacturing and service industries.

13.5.2 Aims

5.2 Aims

There are two aims of achieving Six Sigma:

1. To improve customer satisfaction through better quality products and services;
and
2. To reduce costs (e.g. of poor quality).

13.5.3 Six Sigma Methodology

5.3 Six Sigma Methodology

Six Sigma focuses on business processes. The programme examines the existing
processes in an attempt to identify what causes variations in the process – in other
 words, what causes the processes to deviate from the required output. The
methodology attempts to find ways of improving the process, using tools such as
Business Process Re-engineering (Chapter 4) and benchmarking (Chapter 1).
Many versions of the Six Sigma methodology exist. Most of them are based on the
DMAIC methodology:
1. Define the customer requirement/problem. This is usually the factor that
causes customer dissatisfaction. It could be some product quality issue, such as
the number of products that break down within a few weeks, or it could be related
to service, such as the number of delays in receiving a response to a query.
2. Measure existing performance. This normally involves measuring the number
of occurrences of the problem that was identified in stage 1. Measurement often
involves sending out customer questionnaires.
3. Analyse the existing process – identify the key variables that cause the
processes to deviate. At this point of the project, the team is trying to identify the
root causes of the problems identified in steps 1 and 2.
4. Improve – generate solutions based on what was identified during the analyse
stage and put them into action.
5. Control – develop monitoring processes for continued high-quality performance.
This is concerned with monitoring performance after the project has been
complete, in order to check that the expected improvement in performance has
taken place.
Six Sigma also helps to drive innovation. For example, when an organisation
understands what customers want but cannot satisfactorily eliminate mistakes or
improve current products to match customers’ expectations, it tends to innovate to
retain the customer.

Example 2 DMAIC

An online bank in the US had no branches. If customers wished to make deposits to their account, they
sent cheques and cash by post to the bank.
Many customers complained that it was taking too long for the deposits to be credited to their bank
accounts, so the bank instigated a Six Sigma programme for the deposit process.
The process worked as follows: Customers mailed their deposits to an office in the state they lived in.
These were then sent on by courier to the central US office. The following reasons for delays were
discovered:
1. Many of the state offices were not sending the deposits on to the central office the same day due to
lack of formal procedures.
2. Many of the state offices were not receiving post every day from the US post, so there was a delay in
receiving the deposits as the state office.
3. The courier company did not work on weekends – so deposits received by post on Saturday morning
were not sent to the central office until Monday evening.
4. In some states the postal service was very slow – sometimes taking three days for deposits to arrive.
As a result of the project, it was decided that customers should post their deposits directly to the central
office. This cut out most of the delays. It also saved the company stationery costs, as it only had to print
one address for customers all over the US, instead of one address for each state. The bank reported
savings of US 4 million per year as a result of the programme.

5.4 Advantages and Disadvantages

 Advantages Disadvantages
 Improvements to processes are based on detailed  Focus on existing systems and data could
analysis of processes, rather than on management's stifle creativity and new process innovations.
"gut feel" about how processes can be improved.  It is time consuming and expensive.
 Six Sigma projects involve managers from all parts of  The use of models to demonstrate processes
the business as well as external experts. This means often simplifies the reality.
that the projects are given proactive management,  It requires a supportive culture from the
which gives them a greater chance of success. organisation. In some organisations,
 Cost savings – many companies have adopted Six management and staff may be sceptical
Sigma (e.g. General Electric) and have reported huge about the benefits of such a programme.
cost savings as a result.
 It focuses management on customer needs and
meeting them.
 Provides detailed analysis of current processes,
whereby redundant processes would be identified.

16.1.1 Types of Complex Business Structure

1.1 Types of Complex Business Structure

Traditionally, performance management and performance measures are aligned to

the internal activities of an organisation, so as to maximise the value that
the organisation generates.
Increasingly, however, organisations form relationships with other organisations,
creating networks of relationships. These might include:
 Joint ventures;
 Strategic alliances;
 Virtual organisations;
 Supply chains.
In these circumstances a wide range of stakeholders and activities contribute to
performance and hence performance management must incorporate the entire
network and, to be effective, must incorporate building trust and relationships.

1.2 Joint Ventures

Definition

Joint venture – a business arrangement between two (or more) parties to pool resources for a sp
project or activity. The most common structure for a joint venture is a separate business entity (e.g
partnership or company).

1.2.1 Reasons for Forming

Joint ventures enable the parties to share costs, risks and expertise.
 Organisations can share strengths while overcoming weaknesses. For example,
in a joint venture between General Motors and Toyota, Toyota took over the
management of GM's factory in the US. This venture allowed GM to benefit from
the production processes of Toyota and for Toyota to overcome restrictions on
importing its cars into the US.
 It enables organisations to enter new markets with a local venturer. The local
venturer benefits from the experience of the foreign venturer. In some countries
this may be the only legal way for a foreign company to enter the market.

1.2.2 Performance Management Issues

Each party to a joint venture has less control than it would have if it owned 100%. It
is essential that the venturers trust each other.
 The objectives of the venture need to be specified and agreed by all parties from
the outset. This may help to avoid disputes later. Many ventures fail because of
disagreements over objectives.
 The management structure of the venture needs to be set up:
o A specific management team may be put in place to report to the
venturers; or
o Managers from each venturer participate in the management of the
venture.
 Performance measurement metrics need to be agreed in advance and planning
and reporting frameworks established.
 Reporting of information, such as profits or losses, might be problematic if the
parties do not want to share information or if they do not have integrated
systems.
 Risk management can be difficult if the parties have different attitudes to risk.
Likewise parties might have different views on cost control and quality.
 There may be concerns over the confidentiality of commercially sensitive
information.
 The co-evolutionary nature of joint ventures means that it is not possible to
specify all future possibilities in a joint venture contract and new issues may arise
that were not foreseen at the start.
1.3 Strategic Alliances

Definition

Strategic alliance − an arrangement between two (or more) organisations to undertake a mutuall
beneficial project, with each remaining independent.
The organisations in a strategic alliance remain independent organisations, and so
retain their own procedures, culture and objectives. There could therefore be
different approaches to performance management and control if partners have
differing cultures and objectives.
In this type of complex business structure, it is more difficult to put in place common
performance measures and to collect and analyse management information. And, as
for joint ventures, there are likely to be concerns around sharing sensitive
commercial information to assist with performance management.
 Although the following example concerns a joint venture that was formed nearly 20
years ago, it is an excellent illustration of the problems that can arise in a joint
venture and hence is highly relevant.

Example 1 Joint Venture

TNK-BP, a joint venture, was formed in 2003 between the international major oil company BP and the
Russian consortium AAR to benefit from the extensive knowledge of BP and the oil rights of AAR,
estimated at 4.1 billion barrels.
The venture included oil production in Siberia, oil refining and a network of filling stations across Russia. It
was agreed to share profits 50:50. BP had the right to appoint the CEO and AAR had the right to appoint
the chairman.
The first four years of the venture were claimed to be a success by both parties. However, during 2007,
the relationship soured and a long period of disputes began.
 BP claimed that it was being put under pressure by the Russian government, which wanted to
repatriate Russian oil interests.
 The government threatened to close a large oil field that was owned by the venture, citing
environmental protection issues, but eventually sold it instead to Russian state-owned Gazprom.
 The CEO of the venture had his Russian visa revoked in 2008.
 AAR complained about the high costs of the salaries of the expatriate staff sent over by BP.
In 2012, the interests of TNK-BP were sold to the Russian oil company Rosneft, with BP taking a major
stake in Rosneft.

1.4 Virtual Organisations

A virtual organisation creates networks of relationships that allow it to contract out

business functions that others can do better or more economically.
 Outsourcing functions, such as research and development, manufacturing,
distribution and sales, allow the virtual organisation to focus on its core
competencies (e.g. design and marketing).
 A small group of executives ("core") at the centre of the organisation oversee
directly any in-house activities and coordinate relationships with the other
organisations that perform other primary functions.
 Subcontractors are widely used for certain activities, rather than hiring
employees. Although they generally charge more per hour, their services can be
employed as needed, which can save costs during periods when they are not
needed.
 Telecommuting (i.e. teleworkers work from home and connect with the office via
the Internet) saves the costs of office rental (and other associated office costs).
Less time spent in commuting to the office every day motivates employees.
Virtual organisations provide additional challenges for performance management as
management's control over primary business activities is very different from a
traditionally run business.

1.4.1 Planning
  Planning requires coordination with the external partners, unlike traditional
planning, which involves only coordination with internal departments.
 Targets will need to be set during the planning process for partners. Commonly
used terms will need to be clearly defined so there is no misunderstanding.
 There may be less use of detailed budgets as the prices of goods and services
supplied by the partners will be agreed in advance. More emphasis will be placed
on quality.

1.4.2 Controlling and Measuring Performance

Controlling teleworkers is more difficult because they work from home. It may be
possible to monitor working hours by seeing what time they logged onto the systems,
but this will be complicated by issues such as the system being down, or people
being logged on but not actually working. Areas of particular concern will be staff
productivity and quality of work. Management will need to rely more on output
controls or cultural controls.
Where core processes are outsourced, one or more partners may be dealing directly
with customers. The organisation will need to identify ways to control activities in this
area to ensure that satisfactory levels of service and quality of product are provided.
This could be achieved through service-level agreements that include metrics
specifying minimum levels of service.
It may be necessary for systems to be linked. For example, if a partner is holding
inventory, its inventory records must be accessible by the organisation's systems
(e.g. to view inventory availability for customers). There may be issues relating to
compatibility.
Measuring performance may be difficult. Targets may be set for partners but
measuring actual performance will most likely be performed by the organisation and
the partner independently. If the two organisations' measurements are not the same,
reconciliation may be required.
Metrics will need to be defined very specifically. For example, a target for receivables
collection period must specify whether the period starts from the delivery date, the
invoice date or the due payment date.

Example 2 Virtual Organisation

TrendyClothes is a fashion retailer that makes all of its sales though a website. The organisation was
founded by Clare White and is run from a small office close to Clare's house. The company employs a
small team of fashion designers and an IT team that manages the website.
The clothes are made to order by suppliers carefully chosen by Clare. Orders have to be placed three
months before required delivery dates. Once complete, the finished clothes are sent to the warehouse.
The warehouse is owned and operated by another company. It stores the finished clothes until they are
ready for dispatch to customers. As customers order clothes from the TrendyClothes.com website, the
orders are passed automatically to the warehouse company's system. The warehouse company then
packages the clothes and sends them directly to the customer.
TrendyClothes has signed a contract with the warehouse company. The warehouse charges a fixed
monthly fee for storing all the finished goods on behalf of TrendyClothes, plus a fee of $10 per order for
packaging and dispatch to the customer. The service level agreement also specifies penalties that will be
payable to TrendyClothes if there are delays in dispatching goods.
Clare has recently reviewed the way the organisation works and has identified the following problems:
 It is difficult to know how much to order three months before the clothes are required. This has led to a
shortage of some popular lines and a surplus of some less popular lines, which have had to be sold at
clearance prices.
 There have been complaints about customers receiving faulty clothes. The warehouse company
blames the suppliers, but the warehouse company is supposed to check the quality of the clothes
when they arrive from the supplier.
 Customers complain about orders being delivered late, but the warehouse company claims that it
cannot be held responsible if the post is slow.

1.5 Complex Supply Chain Structures

In complex supply chains (e.g. the manufacture of cars or computer equipment) the
manufacturers rely on their suppliers to provide vital components for their products
(e.g. braking or ignition systems). Alliances may also exist with independent
organisations that provide complementary products (e.g. Apple has alliances with the
developers that produce applications that can be used on Apple products).

1.5.1 Effect on Performance Management

The network of alliances has a common goal in the success of the products and, in
theory, there should be no conflicts. However, members of the alliance need to
manage the following issues:
 Quality of all other key parts of the network. The failure of one part can lead to a
loss of reputation and sales for the others. Over the last ten years there have
been a number of product recalls by Toyota due to faulty parts manufactured by
suppliers. In early 2020, for example, approximately 138,000 vehicles from the
late 1990s and early 2000s − including RAV4 SUVs and Celica and Supra
coupes − were recalled for dangerous airbags produced by a supplier.
 Compatibility of parts. Ensuring that parts are compatible will inevitably lead to
sharing confidential technical data. Controls such as patents are needed to
protect the intellectual property from being copied or passed on to others.
 In case of unsatisfactory performance, there may be high switching costs in
moving to alternative suppliers.
 Collaborators in one alliance may be competitors in another. Although Apple and
Samsung were involved in a seven-year court battle relating to infringement of
copyright of each other's tablets (which was finally settled in 2018), Samsung
continues to be a supplier of components to Apple.
6 Other Complex Structures

1.6.1 Franchising and Licensing

Franchising − where a franchisee pays the franchiser a fee for the right to use a
business name and format in a particular market. Examples of franchises include
McDonald's restaurants. A franchisee sets up and runs one or more McDonald's
restaurants for a royalty fee, calculated as a percentage of revenue. In return,
McDonald's provides the right to use the McDonald's name, training, marketing
materials and other support.
 The franchisee operates what is effectively an independent branch of the
franchiser.
 The franchiser usually ensures that these branches do not cannibalise each
other's revenues.
 The franchiser exerts a considerable degree of control over the operations and
processes used by the franchisee.
Licensing − where a licensor sells licences to other (typically smaller) organisations
to use intellectual property, brands, designs or software (e.g. Microsoft Office). The
licensee has the right to use the licensed property (e.g. to manufacture a product in a
particular location) for a royalty (usually a percentage of revenue). Licensing is
common in the brewing industry where local breweries produce well-known
international brands locally under licence.
 Licences are usually non-exclusive (i.e. they can be sold to multiple competing
companies serving the same market).
 The licensor exercises control over how its property is used but does not control
the business operations of the licensee.