Financial And Operational Measures example essay topic

The last two decades has seen a revolution in management accounting theory and practice due to the challenges of the competitive environment in the 1980's. Kaplan and Johnson (1987) identified the failings and obsolescence of existing cost and performance measurement systems which led to re-examination of traditional cost accounting and management control systems. Conventional financial and management accounting methods have developed primarily as a result of corporate legislation in the 1930's forcing companies to provide externally published financial accounts. Management accounting is primarily focused as a decision making tool for running a business, hence they require more flexibility. According to Kaplan management accounts have become a subset of financial accounts and that they reflect more on the external rather than internal requirements of the company.

Most of the managerial decision-making and control systems in use in the late 1980's were described by Johnson and Kaplan as stagnant. As a result, they went onto research in new accounting systems raising the profile of internal accounting systems by use of financial and non-financial measures although their work was seen as controversial by Drury but is now considered of key importance to manufacturing industries aiming to become world class. This essay aims to discuss the ways in which new management accounting techniques can bring life into mature businesses, in particular those using non-financial measures. Most companies still use the same cost accounting and management control systems that were developed decades ago in a competitive environment drastically different from today. These systems have major drawbacks described below: They distort product costs i.e. absorption of production overheads into product costs for the purpose of stock valuation.

The external financial reporting process was purely driving this allocation of overheads for stock valuation. They do not produce the key non-financial data required for effective and efficient operations, hence they are of little help to operating managers's e eking to reduce costs and improve productivity. The data produced reflected on external reporting requirements far more than the reality of the new manufacturing environment. Failure to provide accurate product costs as they were distributed by simplistic and arbitrary measures usually direct labour based. The short term profit pressures led to a decline in long term investment. These poorly designed or outdated systems can distort the realities of manufacturing performance.

As companies become more efficient by using new technologies, labour costs are accounting for a smaller proportion of a company's overall cost, hence the allocation of overheads to labour hours will become irrelevant and counter-productive to the company's operations. The most enduring management accounting innovation was the return on investment (ROI) measure which provided an overall measure of the financial performance of each operating units or the entire company. The ROI, initially developed by Du Pont and General Electric in the early 20th century, came about due to the excessive focus on achieving short-term financial performance. As ROI control was introduced, managers aimed to achieve good performance by making operating and investment decisions on developing new and better products / processes, increasing sales and reducing operating costs. But it later became evident that during hard times, when sales were decreasing and operating costs were increasing, ROI targets could still be achieved through financial entrepreneurship by reducing discretionary expenses and exploiting accounting conventions.

The creation of wealth through these activities will not help companies survive as world-class competitors. Problems of ROI are only surfacing now because of: the difference in size of organisations, changes in the competitive environment and the rapid movement of technology less pressure for short-term financial performance in the last two decades current managers have little knowledge of their organisation's technology hence they rely on creating value through accounting activities Cooper and Kaplan introduce the Activity Based Costing (ABC) systems for manufacturing expenses as a replacement for traditional cost allocation systems. ABC is an internal accounting system designed to track overheads to cost units. ABC attempts to track overhead costs to units as accurately as possible hence the concept of the cost driver is essential to this system. A cost driver is a unit measure of a particular overhead that can be assigned to a user of that overhead. For example, in attempting to allocate administration overheads to products, the cost driver may be the number of invoices generated for that product.

Hence the product generating most invoices will acquire the largest share of the administration overhead. There does not have to be one driver per overhead. There can be more drivers per overhead if they are relevant to the organisation. The ABC model is shown below: A more accurate means of allocating overheads means that product costs can now be more accurately assessed. ABC analysis allows companies to discover profitable products that have not been properly exploited because the correct costs had not been appreciated. If unit costs are based on budgeted capacity rather than actual, ABC highlights excess capacity because only consumed capacity is allocated via cost drivers.

Hence there is a now a measure of excess capacity. This takes away the focus of meeting budgets at all costs and instead focuses on continuous improvement. Product costing is not the only use of ABC. By finding appropriate drivers and cost units, overheads can be assigned to anything that uses them. This allows sales and marketing costs to be assigned both to the products and customers. Traditional systems do not take into account costs generated by customers.

For organisations concerned with customer focus, ABC will give valuable insights into customer behaviour. The other benefits of using ABC are its focus on continuous improvement, its measurement of activities at the process level, its provision of accurate cost data including those generated by the customers, and it is geared for the medium term (3-5 years). An extension of ABC is Activity Based Management (ABM), where using the cost drivers, a deeper understanding of the process is enabled. By measuring activity and costs, ABM has a system to monitor continuous improvement and manages a business from a process perspective rather than a departmental one. Therefore it can make decisions based on accurate process level information.

A greater understanding of factors critical to the success of manufacturing organisations is needed. Accounting researchers can play a critical role in this effort by attempting to develop non-financial measures of manufacturing performance like quality, productivity, inventory innovation and workforce. A particular challenge is to de-emphasise focus on short-term financial measures and develop indicators that are more consistent with long-term competitiveness and profitability. The challenge of improving a firm's manufacturing performance is particularly relevant to managerial accountants as they are supposed to provide information for planning and decision making.

Therefore, measurement systems for today's manufacturing operations must consider the following non-financial indicators of manufacturing performance: Quality Quality is emerging as perhaps the most important factor if companies are trying to excel as world-class competitors. U.S. firms typically inspect quality into products whereas Japanese manufacturing is dedicated to eliminating all product defects. Quality is planned and thought into the product at all stages of manufacture including design and supplier specifications. Further commitment is required in training employees, maintenance of equipment and integrating with suppliers. With this embedded into the processes the goal of achieving zero defects can be achieved.

Executives claim that manufacturing costs decrease as quality increases thus a continuous drive to reduce product defects will enhance the long run productivity of the production process. Inventory Managers tend to use the economic order quantity (EQ) model which helps in determining the cost balance between an additional set-up (for a new production run or change of product) to the cost of holding inventory. If set-up costs could be driven to zero and by just-in-time inventory control systems implementation firms would hold less inventory and raw materials. These would result to lesser costs in holding material that has no value being added to it. In addition, reducing uncertainties in deliveries from suppliers through close co-ordination can enable factories to run without any raw materials in stock. Reducing machine breakdowns also contributes significantly toward reducing work-in-process (WIP).

Thus by investing in information systems and integrating with suppliers, inventory costs can be reduced significantly and accurate information on the company's manufacturing performance can be obtained. Productivity Productivity measures for manufacturing performance have not yet been considered as part of the information that will help managers in decision making and control activities. These measures should be a supplement to financial measures that highlight improvements. Developing new productivity measures would thus be a fruitful field for accountants. Innovation There are companies present whose competitive strategy is based on the introduction of new products with unique characteristics, rather than producing mature products with lower costs. These companies will only succeed if their products are introduced at the right time and have features that are desired by their customers.

Companies that are forced to produce these products on existing line, due to lack of space, will have to directly monitor the performance, quality and delivery and disregard traditional measurements which put an emphasis on efficiency. Work force The attitudes, skills and morale of employees are important if companies are to succeed in achieving their goals. Investing in skills training, conducting surveys of employee attitudes etc by human resources are all critical if employees are to share company goals. It is clear from the above indicators of manufacturing performance that non-financial measures are essential in rejuvenating mature businesses to become world-class. Executives are also aware that traditional accounting measures like ROI can give misleading information on continuous improvement and innovation which current competitive environments demand. Managers want a balanced presentation of both financial and operational measures which led Kaplan and Norton to devise a balanced scorecard that incorporated both such measurements.

The scorecard aids the building of a comprehensive picture of the company's health and effectiveness in achieving its goals. The balanced scorecard includes financial measures that produces results on actions already taken and is complemented by operational measures on customer satisfaction, internal business processes, innovation and learning activities. It is these operational measures that will fuel the performance of future financial measures. The balanced scorecard yields several benefits, including the ability to bridge the gap between objectives of high level executives and those of front-line workers whose performance is ultimately responsible for reaching the company's goals.

Rather than focusing on short-term financial results, which can blind management to internal efficiency and lead to continued revenue losses, chief executives can benefit by using the balanced scorecard as a strategic management system for translating strategy into action at all levels of the enterprise. The four measures will be discussed further below: 1. Customer Perspective: How do customers see us Many companies want to achieve 100% customer satisfaction. To do so, they must translate the strategy (that achieves this) into specific measures that will reflect on factors that are really important to customers. Kaplan and Norton recognise time, quality, performance and service as the four key categories. Lead-time measures are to do with the time taken for the company to deliver a product or service upon request by the customer.

Quality measures the number of defects produced and the quality complaints received by customers. Performance and service measures how much value the product or service is giving to the customer. In addition, carrying out regular surveys in the company ranking as seen by customers, customer satisfaction indexes and market share statistics will also aid in identifying new measures that need to be taken. 2. Internal Business Perspective: What must we excel at internally If all the customer requirements have been identified, the company must look at its internal processes for achieving these needs. Companies must identify their core competencies and define measures that will help them to excel at them.

Measures for factors such as quality, delivery, cycle time and productivity, which have the greatest impact on customer satisfaction, should be translated to the shop floor levels, as this is where goals can be achieved. 3. Innovation and Learning Perspective: How do we learn and innovate In today's global environment, companies must make their processes more efficient, innovate new products (either through radical or incremental innovation strategies) that create more value to customers and make continuous improvements on mature products and services. By reducing the time to market new innovative products, companies are able to gain market share and penetrate new markets. Employee suggestions are a good method of obtaining ideas in how to make processes efficient. 4.

Financial Perspective: How do we look to shareholders Financial measures indicate how healthy a company is. Typical measures are return on capital employed (ROCK), cash flow and shareholder value. This is a critical measure, as managers need to translate the improved operational performance into financial performance e.g. if cycle times were reduced significantly this would result in an increase in capacity (excess capacity) which need to be utilised or discarded, otherwise the true financial benefits will not be realised. Utilisation of excess capacity can be through expanding sales into new and existing markets, which will add to revenues without significant rise to operational expenses.

By combining financial, customer, internal and innovation perspectives, the balanced scorecard helps managers in problem solving and decision making. Managers should, if possible, integrate the scorecard into their planning and budgeting processes. In this way, the scorecard helps managers align their business units as well as their financial and physical resources, to the strategy of the whole organisation. The integrated planning and budgeting process directs capital investments, capital initiatives and discretionary expenses to achieving ambitious targets for the objectives and measures on the business unit's scorecard. The balanced scorecard has helped companies like Rockwater's achieve its mission of being the industry's leader. Present cost accounting and management control systems were developed almost a century ago when the nature of competition and demands for internal information were very different from what they are today.

Accounting and financial executives must redirect their thinking from external reporting to the more effective management of their companies' tangible and intangible assets. Internal management accounting systems also need renovation. This essay has highlighted the ways in which these can be done.