Chapter 24 Chapter 24

HAPTER

PERFORMANCE
MEASUREMENT PART 3
1. Responsibility centres
In a previous chapter, we briefly discussed the concept of responsibility centres –
splitting the organisation up into divisions for budgeting and control purposes. The
idea was that each division would have its own budget and its own manager,
responsible for ensuring the centre performed to an acceptable standard.

There are four main types of responsibility centres:

Cost centres
A cost centre is a responsibility centre to which only costs are attributed (and not
earnings or capital). For example, an organisation may consider its customer service
division to be a cost centre. The organisation will use this centre to “collect” customer
service costs, making it easy to determine the cost per cost unit. For example, if the
overhead to run the customer service centre is £10,000 for the period, and the centre
deals with 1,000 customer queries, then the organisation can conclude the cost per
query is £10.

© Astranti 2024 533

Chapter 24 Performance Measurement Part 3

Revenue centres
A revenue centre is a responsibility centre that is focused solely on generating
revenue. A good example of this may be a fundraising department of a not-for-
profit, or a sales department of a commercial organisation. These centres will allocate
all their resources to achieving the highest revenue possible without any link to the
associated costs.

Profit centres
A profit centre is a responsibility centre where the manager has autonomy over
both costs and revenue. An example might be a particular store or region, operated
by a single manager as a stand-alone unit. Obviously, these centres are more
involved than simple cost and revenue centres, as the manager must control both
facets in order to achieve a good result.

Investment centres
An investment centre is a responsibility centre that is responsible for both costs
and revenues, as well as the investment in assets used to support the division.
The manager will, therefore, be responsible for supporting itself through sound asset
disposals and acquisitions, as well as running a profitable operation. Dividing an
organisation into investment centres is a heavy form of decentralisation – in effect,
each unit of the business operates with its own management as an independent
business unit. For this reason, investment centres are also commonly known as
Strategic Business Units (SBUs).

Performance measurement of responsibility

centres
Due to the difference between the departments and what their managers are
responsible for, each type of responsibility centre should be appraised on a
different basis. For example, cost centre managers on spending against budget,
while profit centre managers can also be appraised on profit.

It is important to appraise managers in the right way to ensure they are motivated
and achieve the goals of the company as a whole. Performance measurement is
most effective when:

© Astranti 2024 534

Chapter 24 Performance Measurement Part 3

• There is goal congruence, i.e. the goals of the company and the goals of the
centre’s manager are aligned.

• Only aspects which can be controlled by the manager are evaluated. Items
that are uncontrollable should be disregarded or clearly segregated in reports.
This falls in line with the concept of responsibility accounting.

• Both long-term and short-term objectives are considered. This generally

requires both financial and non-financial performance measures.

• Managers and divisions are evaluated separately. High-performing managers

may be in control of particularly weak divisions and vice versa. The
performance of the division is not always a direct reflection of the manager in
charge.

Performance measures for cost centres

The simplest form of measuring the performance of a responsibility centre is a
comparison between budget and actual results. This will measure the manager’s
ability to control costs and generate revenue. This is the typical measure used in cost
centres.

In addition, they may also use non-financial measures such as:

 Efficiency and productivity measures, e.g. transactions processed per hour

 Learning and innovation, e.g. amount spent on training, or number of new

ideas implemented

Performance measures for revenue centres

In revenue centres, the key measure is revenue. A sales department, for instance
has achieving sales as its key focus, so that should be its main goal.

Revenue centres also incur some costs - staff salaries, for instance - and as such, can
also be measured against costs incurred versus budget. They may also have non-
financial measures too. For a sales department, that might be:

 Brand awareness

 Percentage of sales calls resulting in a sale

© Astranti 2024 535

Chapter 24 Performance Measurement Part 3

 Average sales per sales call

Performance measures for profit centres

Profit centres have the advantage of being both revenue generating and incurring
costs; thus, the main measure is profit. Profit targets will encourage managers to
balance incurring more costs with generating more revenues.

They can also have pure revenue and cost targets and budgets if appropriate, but
if the ultimate goal of the organisation is profit then this is the better overall
measure. Profit centres can have non-financial measures too, such as:

 Customer-focused, e.g. customer satisfaction, number of complaints

 Internally focused, e.g. efficiency levels and productivity

 Learning and innovation, e.g. revenue from new products

Performance measures for investment centres

Investment centres require a slightly more thorough approach. This is because
managers of these centres are given the responsibility to oversee both profit and
level of capital investment. While the profit, revenue, cost and non-financial
measures discussed in other sections are still relevant, there are even better
measures that will assess profits in relation to the required investment. Detailed
below are some common methods:

Return on Investment (ROI)

Undoubtedly, you have heard of this measure in your studies before as it is widely
used and accepted around the world. The formula is as follows:

Net income
ROI =
Cost of investment

Here’s a basic example:

© Astranti 2024 536

Chapter 24 Performance Measurement Part 3

Centre A Centre B

Sales £20,000 £100,000

Profit before tax £5,000 £50,000

Assets £25,000 £400,000

ROI 20% 12.5%

Advantages of ROI
 Easy to understand – useful for performance measures for non-financial
managers and reporting to directors without a financial background.

 It is a percentage-based measure, which allows comparability between

different centres. Notice in the example above that, although Centre B has a
higher profit, its ROI is much lower as it is not making as good use of its
assets.

 Relates profit to the level of investment in the centre and so is better than
profit alone.

Disadvantages of ROI
• It is based on net assets, which can fluctuate depending on which point the
centre is in their asset life cycle (older assets will have depreciated and so have
lower asset values). It can also deter management to invest for the long term,
as large investments will reduce their ROI in the short term.

• Managers may be reluctant to take on any projects which return lower

than the current ROI. In trying to keep the ROI as high as possible, they
forgo projects that would increase the centre’s overall profit, albeit at a lower
rate of return.

Let's look at an example of that second point.

Say a new project costs £20,000 in investment and returns £3,000 profit a year. Let's
look at how each cost centre would end up if they did this project:

© Astranti 2024 537

Chapter 24 Performance Measurement Part 3

Centre A Centre B

Profit before tax £8,000 £53,000

Assets £45,000 £420,000

ROI 17.8% 12.6%

Change  

Note here then how Centre B's ROI has gone up, so they would do the project, while
Centre A's has gone down so that manager would not.

This is what is known as “dysfunctional behaviour”, which is where the managers

act in a way that is right for them given their “measure” but not right for the
organisation as a whole. In this case, the company wants the project to go ahead
but the managers are taking different views, not because of what is right for the
company but because of they way their division is measured.

Residual Income (RI)

Residual income (RI) is different from ROI in that it produces an absolute figure
rather than a percentage. When using this metric, managers are usually
encouraged to achieve the highest residual income figure possible, and this helps
avoid dysfunctional behaviour. It is calculated as follows:

RI = Profit – Capital charge (where Capital charge = Assets x Cost of Capital)

Let’s go ahead and calculate the RI of Centres A and B to see how they compare.
We’ll assume a cost of capital of 10%.

Centre A Centre B

Profit before tax £5,000 £50,000

Capital charge (Assets x 10%) £2,500 £40,000

Residual income £2,500 £10,000

© Astranti 2024 538

Chapter 24 Performance Measurement Part 3

As can be seen here, the ROI of Centre A is significantly higher than that of Centre B.
However, Centre B has a higher RI, meaning it contributes more to the organisation’s
overall profit.

Let's return to our earlier example to show how RI helps prevent dysfunctional
behaviour.

Remember that the new project costs £20,000 in investment and returns £3,000
profit a year. Let's look at how each cost centre would end up if they did this project:

Centre A Centre B

Profit before tax £8,000 £53,000

Assets £45,000 £420,000

Capital charge (Assets x 10%) £4,500 £42,000

RI 3,500 11,000

Change  

RI will encourage both managers to take on the project as it returns more than the
10% costs of capital. This is “goal-congruent” behaviour where divisional managers
make decisions that are right for the organisation as a whole.

The central management must also be careful with that approach though as Centre A
simply may not have the same opportunities for expansion as Centre B or be much
newer so has not had the time to grow, yet Centre B's RI is much higher than Centre
As. In that case, RI-based performance measurement would simply be unfair on the
manager of A not because of his poor performance but simply because she's
managing a smaller division, and would likely alienate the manager of Centre A.

This demonstrates the issue of goal congruence and aligning the interests of
managers and shareholders as a central issue in good performance measurement.

Have a look at the following diagram to see the advantages and disadvantages of RI:

© Astranti 2024 539

Chapter 24 Performance Measurement Part 3

2. Measuring performance in the

service sector
Many of the techniques and indicators for performance measurement we have
already discussed will also apply to the service sector; however, it may be
necessary to apply them in different ways to assess the performance of a service
sector business.

There are four types of basic financial analysis tools which we've already talked
about. These are the profitability ratio, liquidity ratio, gearing and activity ratios.
Service industry ratios will be compared to past performance or competitor's
ratios. These ratios include:

• Market share

• Market share increase

• Profit increase

• Staff costs as a % of revenues

© Astranti 2024 540

Chapter 24 Performance Measurement Part 3

• Revenue per service unit (e.g. occupied hotel room)

• Revenue per staff member (e.g. in a legal practice)

Of course, these financial ratios often miss out the human aspect to a service, and
this is where quality must be considered. Companies will often administer
questionnaires which ask questions about customer satisfaction and experience.

3. Measuring managerial performance

Evaluating how well managers are doing their jobs is crucial for any organisation. It’s
like giving a report card at the end of the term – but in the business world! Here are
some key measures and the practical problems you might face while using them.

Key measures

Financial metrics

• Return on Investment (ROI): Measures how effectively a manager uses the

resources to generate profits. It’s like asking, “Are we getting our money’s
worth?”

• Profit margin: Looks at how much profit is generated from sales. Think of it
as checking if the effort is turning into actual money.

• Budget variance: Compares budgeted figures with actual results. It’s the
difference between what we planned to spend and what we actually spent.

Operational metrics

• Efficiency ratios: Measure how well resources are being used. For example,
how much output is generated per unit of input.

• Capacity utilisation: Indicates how much of the available production capacity

is being used. Are we making full use of our capabilities?

© Astranti 2024 541

Chapter 24 Performance Measurement Part 3

Quality metrics

• Customer satisfaction: Evaluates how happy customers are with the products
or services. Happy customers often mean the manager is doing something
right.

• Product defect rate: Measures the percentage of defective products. Lower

defect rates typically indicate better management.

Employee metrics

• Employee turnover rate: Measures how often employees leave the company.
High turnover can be a red flag.

• Employee engagement: Assesses how motivated and committed the

employees are. Engaged employees usually mean a positive work
environment.

Practical problems

OK, so measuring performance sounds straightforward, right? Well, actually there are
some issues with measurement that need to be considered.

Data accuracy and availability

Getting accurate and timely data can be a headache. Sometimes, the data you need
just isn’t available or isn’t reliable.

Subjectivity

Metrics like customer satisfaction and employee engagement can be subjective.

People’s opinions can vary wildly, making it tough to get a clear picture.

© Astranti 2024 542

Chapter 24 Performance Measurement Part 3

Short-term vs long-term focus

Managers might focus on short-term gains to look good on their performance

review, ignoring long-term sustainability, so the very act of measuring a manager’s
performance could lead to problems for the company’s long-term objectives.

External factors

Sometimes, factors outside a manager’s control can skew performance results.

Economic downturns, supply chain disruptions, or even a sudden change in market
trends can impact performance.

Balancing multiple metrics

Managers often have to juggle multiple performance metrics, which can

sometimes conflict. For example, focusing too much on cutting costs might harm
product quality.

Resistance to change

Implementing new performance measures can meet resistance from managers who
are used to the old ways. Change is hard, and not everyone embraces it with open
arms.

Measuring managerial performance is essential for driving success, but it comes

with its set of challenges. Different metrics all provide valuable insights, but practical
problems can complicate the actual usefulness of measurement.

It’s important to remember that the goal is to help everyone improve and succeed
– not just to point out what’s going wrong.

© Astranti 2024 543

Chapter 24 Performance Measurement Part 3

4. Sustainability and performance

measurement
We’ve already considered in a previous chapter how sustainability is important when
creating budgets, but how does it affect the performance measurement of a
business?

• Broader performance metrics: Traditional financial performance metrics are

complemented by environmental, social, and governance (ESG) indicators.
This includes measures such as carbon footprint, energy consumption, waste
management, social responsibility initiatives, and corporate governance
practices.

• Long-term focus: Sustainability encourages a shift from short-term financial

performance to long-term value creation. Performance measurement must,
therefore, account for future risks and opportunities related to sustainability,
ensuring that decisions made today do not negatively impact future
performance.

• Risk management: Incorporating sustainability into performance

measurement helps identify and manage risks associated with environmental
and social issues. This includes regulatory compliance, reputation
management, and operational risks tied to resource scarcity or climate change.

• Stakeholder engagement: Performance measurement frameworks must

consider the expectations and values of a broader range of stakeholders,
including customers, employees, investors, and communities. Sustainable
performance metrics help demonstrate an organisation's commitment to
these stakeholders and build trust.

• Integrated reporting: Many organisations are moving towards integrated

reporting, which combines financial and sustainability performance into a
single report. This holistic approach provides a comprehensive view of the
organisation’s overall performance and impact, aligning financial results with
sustainability goals.

© Astranti 2024 544

Chapter 24 Performance Measurement Part 3

• Enhanced competitiveness: Companies that effectively measure and report

on their sustainability performance can gain a competitive advantage.
Transparent and robust sustainability performance metrics can attract socially
conscious investors, customers, and employees.

• Continuous improvement: Sustainability performance measurement

encourages continuous improvement by setting benchmarks and targets for
environmental and social performance. This drives innovation and operational
efficiency as organisations strive to meet their sustainability goals.

Incorporating sustainability into performance measurement ensures a more

comprehensive and balanced evaluation of an organisation’s success, promoting
long-term resilience and positive impact on society and the environment.

5. Government regulation
Government regulation has a big impact on how organisations measure their
performance. Think of it like this: imagine trying to run a race without knowing
where the finish line is or what the rules are. Regulations provide that clarity,
setting the rules of the game so everyone knows what’s expected.

Compliance and reporting

First off, regulations make sure that companies follow certain standards. This
means businesses need to track and measure specific things to prove they’re playing
by the rules. For example, they might have to measure how much pollution they’re
producing or how safe their workplaces are. This keeps companies in line and
ensures they're not cutting corners.

Transparency

Regulations often require businesses to be more transparent. They have to share

information about their operations, which means measuring and reporting on things
like environmental impact or financial health. This transparency is good news for
investors, customers and the public because it helps build trust. After all, when you

© Astranti 2024 545

Chapter 24 Performance Measurement Part 3

can see what’s going on behind the scenes, you’re more likely to believe in the
company.

Standardisation

Standardisation is another key impact of regulation. Regulations help create a level

playing field by standardising performance measurements. It’s much easier to see
who’s doing well and who needs to improve when everyone is measuring their
performance the same way.

Risk management

Regulations also help companies manage risks. By requiring businesses to measure

things like financial stability or environmental impact, they help identify potential
problems early on. This way, companies can take action before things go wrong,
which can save them a lot of trouble (and money) down the line.

Incentives and penalties

Governments often use incentives to encourage good behaviour and penalties to

discourage bad behaviour. Companies need to measure how well they’re doing to
see if they qualify for incentives or to avoid getting hit with fines. This can drive
improvements and innovations, as businesses strive to meet or exceed regulatory
standards.

Keeping up with change

Finally, regulations are always evolving. Companies need to keep up with these
changes and adjust their performance measurements accordingly. It’s like having to
update your game strategy when the rules change mid-season. Staying adaptable
and responsive is key to staying compliant and competitive.

© Astranti 2024 546

Chapter 24 Performance Measurement Part 3

6. Economic and market conditions

So, we’ve considered the impact of government regulation on performance
measurement, but there are other external factors that can have a big impact.
Economic and market conditions play a crucial role in shaping performance
measurement.

Let’s get back to a business we’ve spent far too long away from, the one and only
Bob's Lunchbox…

Economic conditions

Recession

When the economy is strong, people have more disposable income to spend on
lunches, leading to higher sales for Bob's Lunchbox. During a recession, however,
customers might cut back on eating out to save money.

Impact on performance measurement:

• Revenue targets: In good times, Bob might set higher sales targets. In a
recession, he might adjust these targets downwards to reflect decreased
customer spending.

• Cost control: During an economic downturn, Bob would focus more on

controlling costs. Performance metrics might include tighter control of
operating expenses and COGS.

• Customer retention: Bob might track customer retention rates more closely
during a recession to ensure he keeps his loyal customers even when they’re
cutting back on spending.

© Astranti 2024 547

Chapter 24 Performance Measurement Part 3

Inflation and deflation

Inflation means higher costs for ingredients and supplies, while deflation might
lead to lower prices but also potential revenue drops.

Impact on performance measurement:

• Cost metrics: With rising costs due to inflation, Bob needs to monitor his
ingredient costs closely and adjust his pricing strategy to maintain profit
margins.

• Profit margins: Performance metrics would include monitoring profit margins

to ensure they are not eroded by higher costs.

• Price adjustments: During deflation, Bob might measure the impact of price
adjustments on sales volumes and overall revenue.

Market conditions

Competitive landscape

New sandwich shops opening in Anytown or changes in customer preferences can

affect Bob’s business.

Impact on performance measurement:

• Market share: Bob might start tracking his market share to see how he’s
performing relative to new competitors.

• Customer satisfaction: With more competition, Bob would focus on customer

satisfaction scores to ensure his shop stands out.

• Innovation: Performance metrics might include the number of new sandwich

varieties introduced or improvements in service speed.

© Astranti 2024 548

Chapter 24 Performance Measurement Part 3

Regulatory changes

Like with government regulation, changes in health regulations or food safety laws
can impact how Bob operates his shop.

Impact on performance measurement:

• Compliance costs: Bob might track additional costs associated with meeting
new regulatory requirements.

• Operational adjustments: Metrics could include the number of staff training

sessions on new regulations and the compliance rate during health
inspections.

• Risk management: Ensuring compliance with regulations can be tracked

through regular audits and risk assessments.

Technological advances

New technology, like a state-of-the-art POS system or an online ordering platform,

can transform Bob’s operations.

Impact on performance measurement:

• Efficiency metrics: Bob could measure the impact of technology on efficiency,

such as faster transaction times or reduced waiting times.

• Customer engagement: Metrics might include the number of online orders,

app downloads, or digital loyalty programme sign-ups.

• Adaptation: Tracking how quickly and effectively Bob’s team adopts new
technology can be a key performance indicator.

Adapting performance measurement

So, given these economic and market conditions, Bob needs to adapt his
performance measurement systems:

© Astranti 2024 549

Chapter 24 Performance Measurement Part 3

• Flexibility: Bob’s metrics should be flexible, allowing for regular reviews and
adjustments based on current economic and market conditions.

• Balanced Scorecard: Bob could use a balanced scorecard approach to

consider both financial and non-financial metrics, giving a well-rounded view
of performance.

• Scenario planning: Incorporating scenario planning can help Bob prepare for
various economic and market conditions, ensuring he remains resilient and
adaptable.

7. Performance reports
So, armed now with all this knowledge, how can you use this to help management
make the best decisions for the organisation? The answer is: reports!

Producing performance measurement reports involves systematically collecting,

analysing, and presenting data on key performance indicators (KPIs) to provide
insights into the efficiency and effectiveness of business operations. Here’s our
step-by-step guide on how to produce such reports:

1. Define objectives and KPIs

Determine the specific objectives of the performance measurement report. Identify

the KPIs that are most relevant to these objectives. Common KPIs might include:

• Financial metrics (e.g. revenue, profit margins)

• Operational metrics (e.g. production efficiency, machine utilisation)

• Employee performance (e.g. labour productivity, absenteeism rates)

• Customer metrics (e.g. customer satisfaction, order fulfilment rates)

© Astranti 2024 550

Chapter 24 Performance Measurement Part 3

2. Collect data

Gather data from various sources, such as financial records, operational logs, and
employee performance data. Ensure the data is accurate and up-to-date.

3. Analyse performance

Compare actual performance data against predefined targets or benchmarks.

Identify variances and analyse their causes. Key areas to focus on might include:

• Significant deviations from targets

• Trends over time

• Comparison with industry standards or competitors

4. Summarise key findings

Highlight the most critical variances and trends in the report. Use relevant visual
aids such as graphs, charts, and tables to make the data easy to understand.

5. Develop recommendations

Based on the analysis, provide recommendations for improvement. Make sure

that the recommendations are specific, feasible, and aligned with the company’s
strategic goals.

6. Structure the report

Organise your report in a clear and logical format. We suggest you include the
following sections:

© Astranti 2024 551

Chapter 24 Performance Measurement Part 3

• Executive summary - Provide a brief overview of the report’s purpose, key

findings, and main recommendations.

• Introduction - Outline the objectives of the report and the KPIs being
monitored.

• Performance analysis - Present the data analysis, highlighting key areas for
management attention. Use visual aids to enhance clarity.

• Findings and discussion - Discuss the causes of significant variances and

their impact on the business. Include insights from trend analysis and
comparisons with benchmarks.

• Recommendations - Offer specific actions to address the identified issues.

Explain how these actions will improve performance.

• Conclusion - Summarise the main points and emphasise the importance of

taking corrective actions.

Example of a performance measurement report

Executive summary

This report evaluates the financial and operational performance of the toy car factory
for Q1 20X4. Key areas requiring management attention include raw material costs
and machine utilisation rates. Recommendations are provided to improve cost
efficiency and operational productivity.

Introduction

The purpose of this report is to assess the performance of the toy car factory against
key performance indicators (KPIs) and provide recommendations for improvement.
The KPIs include raw material costs, machine utilisation, labour productivity, and
production downtime.

© Astranti 2024 552

Chapter 24 Performance Measurement Part 3

Performance analysis

Benchmark
KPI Target Actual Variance Trend
Comparison
Raw material Above industry
130,000 150,000 (20,000) Increasing
Costs (£) average
Machine Below industry
85% 75% (10%) Decreasing
utilisation standard
Labour 5 4.5 (0.5) At industry
Steady
productivity units/hr units/hr units/hr) average
Production Above industry
5% 10% 5% Increasing
downtime standard

Findings and discussion

1. Raw material costs:

• The actual raw material costs exceeded the budget by £20,000, mainly
due to an increase in plastic prices. This indicates a need for better cost
management and supplier negotiations.

2. Machine utilisation:

• The machine utilisation rate is 10% below the target, suggesting

underutilisation of equipment. This could be due to maintenance issues
or inefficient production scheduling.

3. Labour productivity:

• Labour productivity is slightly below target, which may indicate

inefficiencies in the production process or a need for additional
training.

4. Production downtime:

• Production downtime is twice the target rate, pointing to significant

disruptions. This could be due to equipment failures, inadequate raw
material supply, or other operational issues.

© Astranti 2024 553

Chapter 24 Performance Measurement Part 3

Recommendations

1. Raw material costs:

• Supplier negotiations: Renegotiate contracts with suppliers to secure

better prices and terms.

• Alternative suppliers: Explore alternative suppliers to reduce

dependency on current ones and achieve cost savings.

• Inventory management: Implement just-in-time inventory

management to minimise holding costs and reduce waste.

2. Machine utilisation:

• Preventive maintenance: Establish a preventive maintenance schedule

to minimise breakdowns and ensure smooth operations.

• Optimised scheduling: Improve production scheduling to maximise

machine utilisation and reduce idle time.

3. Labour productivity:

• Skills training: Conduct additional training sessions to enhance worker

skills and improve productivity.

• Process optimisation: Review and optimise production processes to

eliminate bottlenecks and improve workflow efficiency.

4. Production downtime:

• Root cause analysis: Perform a thorough analysis to identify the root

causes of downtime and implement corrective actions.

• Inventory management: Ensure adequate inventory levels to prevent

production stoppages.

© Astranti 2024 554

Chapter 24 Performance Measurement Part 3

Conclusion

Addressing the identified variances in raw material costs, machine utilisation, labour
productivity, and production downtime will significantly enhance the overall
performance of the toy car factory. Implementing the recommended actions will
lead to improved cost efficiency and operational productivity.

© Astranti 2024 555