Relying solely on financial measures can result in dysfunctional business operations.

Chapter learning objectives

Upon completion of this chapter you will be able to:

• identify the accounting information requirements and describe the different types of information systems used for strategic planning, management control and operational control and decision making
• discuss, with reference to performance management, ways in which the information requirements of a management structure are affected by the features of the structure
• discuss the impact on performance management of the use of business models involving strategic alliances, joint ventures and complex supply chain structures
• discuss the problems encountered in planning, controlling and measuring performance levels, e.g. productivity, profitability, quality and service levels, in complex business structures
• evaluate whether the management information systems are lean and the value of the information that they provide
• define and discuss the merits of, and potential problems with, open and closed systems with regard to the needs of performance management
• highlight the ways in which contingent (internal and external) factors influence management accounting and its design and use
• evaluate how anticipated human behaviour will influence the design of a management accounting system
• assess the impact of responsibility accounting on information requirements
• identify and discuss the principal internal and external sources of management accounting information
• demonstrate how these principal sources of management information might be used for control purposes
• identify and discuss the direct data capture and process costs of product information
• discuss the limitations of using externally generated information
• discuss those factors that need to be considered when determining the capacity and development potential of a system
• demonstrate how the type of business entity will influence the recording and processing methods
• discuss the difficulties associated with recording and processing data of a qualitative nature
• discuss the principal controls required in generating and distributing internal information
• discuss the procedures that may be necessary to ensure security of highly confidential information that is not for external consumption
• evaluate the output reports of an information system in the light of best practice and avoiding the problem of information overload
• discuss how the effective recruitment, management and motivation of people is necessary for enabling strategic and operational success
• discuss the judgemental and developmental role of assessment and appraisal and their role in improving business performance
• advise on the relationship of performance management to performance measurement (performance rating) and determine the implications of performance measurement to the quality initiatives and process redesign
• explore the meaning and scope of reward systems
• discuss and evaluate different methods of reward practices
• explore the principles and difficulty of aligning reward practices with strategy
• advice on the relationship of reward management to quality initiatives, process re-design and harnessing e-business opportunities
• assess the potential beneficial and adverse consequences of linking reward schemes to performance measurement, for example, how it can affect the risk appetite of employees
• discuss the accountability issues that might arise from performance measurement systems
• evaluate the ways in which performance measurement systems may send the wrong signals and result in undesirable business consequences
• demonstrate how management style needs to be considered when designing and effective performance measurement system.

1 Exam focus

Student Accountant article: visit the ACCA website, www.accaglobal.com, to review the following article on the topics in thischapter:

Management control - a pre-requisite for survival - October 2004

2 Introduction

This chapter focuses on a number of important topics with regards to performance measurement systems. These include:

• the points to consider when designing a system
• the different types of system
• the sources of information
• the control and quality of management report information.

The chapter also reviews the behavioural aspects of performance management.

3 Performance management information systems

3.1 Accounting information requirements at different business levels

As discussed in chapter 1, there are three levels of planning and control within an organisation:

At the operational level, sales ledger staff will be posting thesales ledger accounts, sending out statements and dealing with accountsqueries. Credit approval for new orders will be given at this levelalso.

At the managerial level, credit control managers will be concernedto follow up slow paying customers to ensure that bad debts areminimised and that cash flow is kept healthy.

At the strategic level, the board might decide that more capital isneeded and that factoring debts or invoice discounting might offeruseful ways of raising cash balances.

3.2 Information systems at different business levels

Good decision making is at the heart of good management. A hierarchy of decision-based systems may be used:

Two additional systems that can be used at all levels of management are:

• Management information systems (MIS): provide information to all levels of management to enable them to make timely and effective decisions for planning and controlling the activities for which they are responsible. Middle managers will find these systems particularly useful:
  • A MIS will collate information from individual transactions recorded in the accounting system to allow middle managers to control the business.
  • Customer purchases are summarised into reports to identify the products and customers providing the most revenue.
  • The level of repeat business can be viewed giving an indication of customer satisfaction.
  • Management accounts can be produced by the system showing margins for individual products and customers. This will assist in setting individual/team rewards.
• Expert systems: hold specialist knowledge, e.g. on law or taxation, and allow non-experts to interrogate them for information, advice and recommended decisions. Can be used at all levels of management.

Question focus: Now complete or review questions 9 and 10from chapter 13. These are not past exam questions but should help togive you a broader understanding of some of the areas covered above andin the previous chapter.

3.3 The influence of structure on information requirements

Responsibility accounting is a system of accounting basedupon the identification of individual parts of a business which are theresponsibility of a single manager.

Budgetary control and responsibility accounting are inseparable.

• An organisation chart must be drawn up in order to implement a budgetary control system satisfactorily. It may even be necessary to revise the existing organisation structure before designing the system.
• The aim is to ensure that each manager has a well-defined area of responsibility and the authority to make decisions within that area, and that no parts of the organisation remain as 'grey' areas where it is uncertain who is responsible for them.
• This area of responsibility may be simply a cost centre, or it may be a profit centre (implying that the manager has control over sales revenues as well as costs) or an investment centre (implying that the manager is empowered to take decisions about capital investment for his department). Appropriate performance measures for such structures are discussed in later chapters .
• Once senior management have set up such a structure, with the degree of delegation implied, some form of responsibility accounting system is needed.
• Each centre will have its own budget, and the manager will receive control information relevant to that budget centre.
• Costs (and possibly revenue, assets and liabilities) must be traced to the person primarily responsible for taking the related decisions, and identified with the appropriate department.
• Some accountants would go as far as to advocate charging departments with costs that arise strictly as a result of decisions made by the management of those departments.

Management accounting systems should be designed to reflect theresponsibility structure in place and ensure that costs and revenues canbe traced to those responsible.

Controllability

The principal of controllability is very important inresponsibility accounting. Whilst controllability refers mainly tocosts, it is important to remember that its principles can also apply torevenues and investments.

• Controllability can depend on the time scale being considered.
  • Over a long enough time-span, most costs are controllable by someone in the organisation.
  • In the short-term some costs, such as rent, are uncontrollable even by senior managers, and certainly uncontrollable by managers lower down the organisational hierarchy.
• There may be no clear-cut distinction between controllable and non-controllable costs for a given manager, who may also be exercising control jointly with another manager.
• The aim under a responsibility accounting system will be to assign and report on the cost to the person having primary responsibility. The most effective control is thereby achieved, since immediate action can be taken.
• Some authorities would favour the alternative idea that reports should include all costs caused by a department, whether controllable or uncontrollable by the departmental manager. The idea here is that, even if he has no direct control, he might influence the manager who does have control.

Explain why, as businesses become larger and morediverse, strict financial controls are more likely to be used by topmanagement.

A production manager will have control over the usage of rawmaterials but not over price, as buying is done by a separatedepartment.

Responsibility accounting would suggest that the price and usagevariances are separated and, under the first approach, the productionmanager would be told only about the usage variance, a separate reportbeing made to the purchasing manager about the price variance.

Give an alternative argument as to why the production manager should also be told about the price variance.

Complex business structures

Complex business structures include:

• joint ventures
• strategic alliances
• multinationals
• virtual organisations
• supply chains
• divisionalised structures

The high level of interaction and inter-dependence between partners makes performance management difficult.

3.4 Closed and open systems

A supermarket may operate an inventory system which:

• is updated automatically as customers purchase different items of inventory
• sends an automatic order to the supplier when inventory reaches the re-order level
• is linked to the management accounting information system.

Internal and external (contingent) factors will be taken intoaccount when designing the management accounting system. For example:

• If the external environment is stable it will be possible for the system to produce budgets and targets that provide meaningful measures of performance.
• The internal business strategy may be one of introducing new products or entering new markets. As a result, a comprehensive management information/performance evaluation system will be required.

The contingency approach to management accounting proposes thatthere are no universally appropriate accounting system applicable to allorganisations in all circumstances.

David Otley has identified five sets of contingent variables thatimpact on the character of management accounting in an organisation.

(1)The external environment

The external environment of a business can range from beingcertain, static and calm to being uncertain, dynamic and turbulent. Itis widely considered that those businesses in the certain/static end ofthe range are most amenable to a formula based approach to performanceevaluation. Where market conditions are well known in advance then it ispossible to produce budgets and standards that provide meaningfultargets. Compliance with such targets provides a reliable measure ofperformance.

Conversely, at the uncertain/dynamic end of the range, marketconditions are very difficult to predict and pre-determined budgets andstandards may be meaningless. An attempt to rely on budgetary control inthis sort of environment is likely to produce dysfunctional behaviourof various kinds. In an uncertain environment a more sophisticatedapproach to performance evaluation is needed, relying on a range offinancial and non-financial indicators.

(2)Competitive strategy

This issue has already been touched on in an earlier consideration of Porter'sfive competitive forces (chapter 1). Where a business follows a lowcost strategy, that is producing an undifferentiated product andcompeting mainly on unit cost, then it may be appropriate to adoptmanagement control systems that seek to standardise operating proceduresin order to maximise production efficiency. Reliance on a traditionalstandard costing and variance analysis may work well in such a case.

Conversely, where a business produces a differentiated productand constantly seeks to introduce new products or constantly seeks toenter new markets – then a more comprehensive managementinformation/performance evaluation system may be required. Success insuch an environment depends on initiative and innovation. Sole relianceon a simple standard costing system is entirely inadequate in such acase.

(3)Technology

Business units can range from being independent through to havingpooled, sequential or reciprocal interdependencies with other businessunits. To the extent that a business unit is interdependent with others,it shares pooled resources and is constantly confronted with the needto share pooled costs on an appropriate basis with the other units.

The treatment of pooled resources can involve the design ofsophisticated accounting systems for the treatment of overheads. To theextent that sequential or reciprocal interdependencies exist thenbusiness units inside the same business supply one another with goodsand services. Appropriate transfer pricing systems have to be devised toaccount for such supplies.

(4) Business unit

Discussed above.

(5) Knowledge and observability

In a factory that produces widgets on a continuous basis, it isnot difficult to know what the production process involves and observewhat inputs it uses and what outputs it achieves. The managementaccounting system will be built around this high degree of knowledge andobservability.

However, the situation may be much more opaque in a researchlaboratory or in a sales office. In such cases, there may be limitedknowledge of what actually happens in the production process and it maybe very difficult to observe what the outputs of the process are. Onewriter advocates the use of clan controls in the context of a drugcompany's research laboratory. Performance is monitored and evaluated byreporting number of seminars attended by researchers, number ofarticles published and number of breakthroughs that will lead to newmarketable products.

Closed systems are rare because interaction with the environment isnecessary for business survival. These systems will not provideadequate information for performance management.

• Systems sit in their environments and are separated from their environment by the systems boundary.
• Examples are: accounting systems, manufacturing systems, quality control systems, IT systems.

Management accounting systems should be open for the following reasons.

• Closed systems can have only short lives. Without input, closed systems will usually run out of energy, material, information or some other resource needed to function.
• Closed systems, even if they can be self-sufficient, normally become increasingly irrelevant as environmental changes are not reflected in the system so the system becomes out of date. For example, a company might attempt to make the same products year after year whilst ignoring advances in technology and changes in customer taste.
• Internal information is relatively easy for organisations to capture, but that is not enough to ensure success. It is much more difficult to know what external information is going to be relevant and to capture that reliably. But it has to be done or the organisation will be operating in its own, isolated, short-lived world.

3.5 Lean management information systems

The need for new ideas in management accounting is particularlyevident in lean manufacturing organisations. In order to appreciate leanaccounting systems, it is helpful to understand the concepts of leanmanufacturing.

• just-in-time production and purchasing (JIT)
• total quality management (TQM).

These will be reviewed in detail in chapter 11.

Management accounting systems within a JIT environment must becapable of producing performance and control information consistent witha JIT philosophy. Information must therefore be produced that directsmanagement attention to the following issues:

• elimination of waste
• reduction in set-up time
• continuous improvement.

Lean accounting

Lean accounting is the application of the idea that accountingsystems should be simplified, to remove waste. Management should beprovided with statements that are:

• instantly accessible through an IT system, and
• simple to read.

4 Sources of management information

4.1 Internal and external sources

Internal sources

Internal sources of information may be taken from a variety ofareas such as the sales ledger (e.g. volume of sales), payroll system(e.g. number of employees) or the fixed asset system (e.g. depreciationmethod and rate).

Examples of internal data:

External sources

In addition to internal information sources, there is muchinformation to be obtained from external sources such as suppliers (e.g.product prices), customers (e.g. price sensitivity) and the government(e.g. inflation rate).

What are the limitations of using externally generated information?

The internal and external information may be used in planning and controlling activities. For example:

• Newspapers, the Internet and business enquiry agents (such as Dun and Bradstreet) may be used to obtain external competitor information for benchmarking purposes (benchmarking was covered in chapter 5).
• Internal sales volumes may be obtained for variance analysis purposes.

Briefly explain the use of customer data for control purposes.

4.2 The costs of information

The benefit of management information must exceed the cost (benefit > cost) of obtaining the information.

The design of management information systems should involve acost/benefit analysis. A very refined system offers many benefits, butat a cost. The advent of modern IT systems has reduced that costsignificantly. However, skilled staff have to be involved in theoperation of information systems, and they can be very expensive tohire.

Let us illustrate this with a simple example. Production costs in afactory can be reported with varying levels of frequency ranging fromdaily (365 times per year) to annually (1 time per year). Costs ofbenefits of reporting tend to move as follows in response to increasingfrequency of reporting.

• Information has to be gathered, collated and reported in proportion to frequency and costs will move in line with this. Experience suggests that some element of diseconomy of scale may set in at high levels of frequency.
• Initially, benefits increase sharply, but this increase starts to tail off. A point may come where 'information overload' sets in and benefits actually start to decline and even become negative. If managers are overwhelmed with information, then this actually starts to get in the way of the job.

The position may be represented graphically as follows:

An information system is just like any part of a businessoperation. It incurs costs and it offers benefits. In designing aninformation system, the accountant has to find some means of comparingthe two for different options and determining which option is optimal.In this sense, system design follows the same practices for investmentappraisal and decision making which are explored later in this text.

In the above case it can be seen that net benefits (benefits lesscosts) are maximised at around 120 reports per year – suggesting anoptimal information cycle of about 3 days. The system should be designedto gather, collate and report information at three-day intervals. Thisis an over-simplified example but it serves to illustrate a generallogic which can be applied to all aspects of information system design.

Discuss the factors that need to be considered when determining the capacity and development potential of a system.

The costs of information can be classified as follows:

5 Dealing with qualitative data

In both decision making and control, managers should be aware thatan information system may provide a limited or distorted picture of whatis actually happening. In many situations, sensitivity has to be usedin interpreting the output of an information system.

It is worth noting that as many economies move from beingmanufacturing based to service based there may be fewer opportunities touse quantitative measures and that qualitative measures become moreimportant.

Qualitative information is often in the form of opinions, for example:

• employees – who will be affected by certain decisions which may threaten their continued employment, or cause them to need re-training
• customers – who will be interested to know about new products, but will want to be assured that service arrangements, etc. will continue for existing products
• suppliers – who will want to be aware of the entity's plans, e.g a move to a just-in-time (JIT) environment.

It is difficult to record and process data of a qualitative naturebut qualitative factors still need to be considered when making adecision. These include:

• The effects on the environment: certain decisions may affect emissions and pollution of the environment. The green issue and the entity's responsibility towards the environment may seriously affect its public image.
• Legal effects: there may be legal implications of a course of action, or a change in law may have been the cause of the decision requirement.
• Political effects: government policies, in both taxation and other matters, may impinge on the decision.
• Timing of decision: the timing of a new product launch may be crucial to its success.

Each of these factors must be considered before making a finaldecision. Each of these factors is likely to be measured by opinion.Such opinions must be collected and co-ordinated into meaningfulinformation.

Here are some examples of qualitative effects.

• The impact of a decreased output requirement on staff morale is something that may be critical but it is not something that an information system would automatically report.
• The impact of a reduction in product range may have a subtle impact on the image that a business enjoys in the market – again something that an information system may not report.

Information and Investment

Moffat ltd commenced trading on 01/12/X2, it supplies and fitstyres and exhaust pipes and service motor vehicles at thirty locations.The directors and middle management are based at the Head Office ofMoffat Ltd.

Each location has a manager who is responsible for day-to-dayoperations and is supported by an administrative assistant. All otherstaff at each location are involved in the fitting and servicingoperations.

The directors of Moffat Ltd are currently preparing a financialevaluation of an investment of $2 Million in a new IT system forsubmission to its bank. They are concerned that sub-optimal decisionsare being made because the current system does not provide appropriateinformation throughout the organisation. They are also aware that notall of the benefits from the proposed investment will be qualitative innature.

Required:

(a)Explain the characteristics of THREE typesof information required to assist in decision-making at different levelsof management and on differing timescales within Moffat Ltd, providingtwo examples of information that would be appropriate to each level.

(b)Identify and explain THREE approaches thatthe directors of Moffat Ltd might apply in assessing the QUALITATIVEbenefits of the proposed investment in a new IT system.

(c)Identify TWO QUALITATIVE benefits that mightarise as a consequence of the investment in a new IT system and explainhow you would attempt to assess them.

6 Management reports

6.1 Controlling access to data

Business data will often consist of information that is confidential and/or commercially sensitive.

Controls will be required when generating and distributing this information.

Controls over input

Controls over processing

• Passwords and software audit trails are important to track what processing was carried out.
• Programmes should not be altered without authorisation and testing, otherwise incorrect or fraudulent processing could be carried out.

Controls over output

• Password systems can be very powerful controls – each password being allocated suitable access rights.
• Sensitive printed output could have a distribution list and should be physically safeguarded.

Tel Insure is a major insurance company, specialising in insuringoffice and business premises. Last year they implemented a workflowsoftware package for handling claims. Unfortunately the workflow packagehas not been well received by users in the insurance company who feelthat it is a poor fit to their requirements. As a result, the processingof insurance claims is taking longer than before and is causing a largenumber of complaints from customers.

The senior management team of the insurance company is veryconcerned about this and so commissioned a management consultant toinvestigate the suitability of the workflow software and to investigate apossible upgrade and link to an extranet.

Required:

How could Tel Insure control the access to data (input, processing and output)?

One feature of modern information system design is that databasematerial can be readily accessed from remote locations connected to theoffice network. This ease and immediacy of access offers many advantagesto a business operation. For example, a salesman may be able todetermine product costs, job resource requirements, resourceavailability and delivery times using his laptop computer from thepremises of a potential customer. A salesman in this position can offerimmediate firm quotes and delivery times to his customer. Such asalesman will always have an advantage over a competitor using inferiorinformation systems who takes seven days to offer quotes and deliverytimes.

However, ease and flexibility of information access carry risks.Cost and price information are usually commercially sensitive. If acompetitor is able to access this information then the competitor may beable to use this information to marginally undercut prices quoted onthe most attractive jobs. In some sectors (e.g. banking and financialservices), customer account information may also be very sensitive.

It is therefore normal to incorporate security features in thedesign of systems. Certain parts of a database or a website may haveaccess restricted to certain users with passwords.

However, one should be aware that any information system, howeversophisticated, is just as secure as the people who operate it. In mostorganisations there are mildly corrupt people who will provideinformation to outsiders in exchange for some consideration. Theconsideration offered may not always be monetary. An individual who hasbeen passed over for promotion may derive some satisfaction from harminghis employer. Many people do not perceive the theft of information tobe as immoral as the theft of property – and indeed the law tends tofollow this perception.

It is believed that there are firms of investigation agents who canreadily access almost any information from police records, bank recordsand company records. Such agents maintain a list of contacts inrelevant organisations. These contacts have authorised access toinformation and will pass on that information upon request from theagent. In the era of the cellphone, it is very easy to communicate with acontact in an organisation. It is often surprising how much accesscertain junior employees may have to sensitive information.

The management of a business should not therefore rely solely onelectronic means of restricting access to information. Traditionalmethods of security (including locked doors, monitoring telephone callsand the use of open-plan offices) should not be overlooked. A randomaudit of information requests from staff may also be productive.

Traditional methods of securing information against the possibilityof fire or equipment failure should also not be overlooked. An externalback-up copy of each database might be made at intervals or after eachupdate. This back-up copy should be retained at a different physicallocation from the main computer.

6.2 Output reports

The output reports produced for management should contain good information.

Discuss the weaknesses in an information system that could result in poor output reports.

7 Behavioural aspects of performance management

7.1 Introduction

The design of a management accounting system must take into account human behaviour.

7.2 The relationship between people management and organisational success

An organisation uses human resource management (HRM) to ensure thatit has the correct people in place to fulfil its strategic andoperational objectives.

The following aspects of HRM are of particular importance:

• Recruitment - careful recruitment will be necessary to ensure that the organisation has in place the correct number of staff with the right skills base.
• Performance management - individual objectives should be set which support the organisation's overall targets and goals. These should be communicated to and understood by employees.
• Retention and motivation - motivated staff are more likely to achieve targets and organisational goals. Vroom's motivation theory is examinable:

Vroom believed that people will be motivated to do things to reach a goal if they believe in the worth of that goal and if they can see that what they do will help them in achieving it. Vroom's expectancy model is stated as:

Retention may be achieved using:

• induction
• training
• job design
• rewards.

Some examples of the link between HRM and strategy are as follows:

If competitive advantage is sought through differentiation then HRMneeds to ensure that high quality, skilled staff are recruited, thatthese staff are given the freedom to be creative and innovate, that aculture of service and quality is prevalent, and that rewards are gearedtowards long-term success and beyond short-term financial measures.

On the other hand, if a strategy of cost leadership was pursued,then HRM needs to focus on recruiting low skilled workers, providingrepetitive, simple tasks, minimising staff numbers, providing strictcontrols, and focusing appraisals and rewards on short-term costmeasures.

If an organisation planned to grow through acquisition, how might HRM contribute to the achievement of this strategy?

7.3 Using appraisal to improve business performance

The most usual rationalisation and justification forappraisal is to improve individual performance. However, there are anumber of other reasons. Identify four of these reasons.

The reasons for appraisal were discussed in the TYU above. These can be grouped into two broad categories:

• The judgement purpose - the appraiser exercises their judgement to make decisions regarding factors such as pay, promotion and work responsibilities.
• The development purpose - the appraiser strives to bring about employee performance improvements through the identification of training and development needs. An action plan should be implemented to meet these needs.

This can lead to a conflict in the process between on the one handassessing value (judgement purpose), and on the other hand offeringsupport (development purpose).

A judgmental analysis may lead to an assessment that the employeehas failed to achieve goals or objectives that had been agreed upon inadvance. This judgement might result in the employee not receiving a payrise or promotion or a bonus. The employee will therefore feel thathe/she has been criticised as this part of the assessment and build upresistance to the appraiser and the appraisal process.

But at the same time the appraiser will want to make adevelopmental appraisal. They will want to determine why the employeehas failed and offer support in avoiding these failures in the future bydeveloping the employee's skills (e.g. via training).

It is therefore important that the employee understands that theappraisal is as much for their benefit as for the employers. This is whyfeedback is important.

Lockett suggests that appraisal barriers can be identified as follows:

Critically evaluate the statement that appraisal will lead to improvements in business performance.

The importance of target selection

Appraisal (performance management) will only be beneficial andachieve its aims if appropriate targets (performance measures) are set.Targets should be:

• Relevant to the organisation's overall objective, e.g. if the organisation has an objective of 100% quality then an individual production worker maybe set a target to produce products with zero defects. (It is worth noting that quality initiatives are often undermined by targets that focus on short term profits).
• Achievable - employees may be unmotivated if they consider targets are very difficult or impossible to achieve, e.g. zero defects may be seen as impossible. However, it is worth noting that the same may be true if targets are too easy to achieve.
• Controllable - the individual will be unmotivated if they feel they can't control the target set, e.g. a production worker may not be responsible for defects if poor quality materials are purchased.
• Prioritised - employees will be overwhelmed and hence unmotivated if they are set a large number of targets.

The reward system of an organisation comprises the monetary and non-monetary payments given to employees in return for work performed.

The purpose of reward systems

• To provide a fair and consistent basis for rewarding employees.
• To motivate staff and maximise performance.
• To further company objectives through the achievement of employee's objectives.
• To reward performance through promotion or progression.
• To control salary costs.

Methods of reward

Employee rewards fall into three categories:

• Basic pay - determined in a number of ways such as market rates or job evaluation.
• Performance-related pay - pay is based on the level of performance. Rewards may be based on individual, group or organisational performance, all of which will have a different impact on behaviour.
• Benefits - a wide range of non-monetary rewards such as company cars or health insurance.

Evaluate the three different reward methods.

Benefits and problems of linking reward schemes to performance

The benefits and problems were touched on in the TYU but a more detailed list is included below:

As mentioned above, one of the problems associated with linkingreward schemes to performance is that employees will prioritise theachievement of their reward which may impact their risk appetite.

UK banking executive's pay has received widespread political andmedia coverage since the 2008 financial crisis. It is argued thatperformance related bonuses have incentivised excessive risk taking andshort-termism and there are widespread concerns that remunerationpolicies may have been a contributory factor to the financial crisis.

Reward management in the modern business environment

We have already discussed the need for individual staff targets andhence rewards to be aligned with strategic goals. There have been somecommon changes to strategic goals in the modern business environment:

• Quality - as mentioned previously, strategic quality objectives should be translated into individual quality objectives. Pay or rewards should then be linked to the achievement of these targets.
• Process re-design - a change to a process and hence job roles will result in changes to organisational and individual goals. Rewards should be based on the achievement of these new goals. Managers should be aware that employees may be resistant to changes in their job role and must therefore ensure that the reward scheme provides sufficient incentives for change.
• E-business - an organisation embarking on a strategy of e-business (i.e. using the internet to connect with customers, partners and suppliers) will have to ensure that an individual's objectives and rewards reflect the new process and technological objectives of the organisation.

Question focus: Now attempt question 8 from chapter 13.

7.5 Other behavioural aspects of performance measurement

Wrong signals and inappropriate action

A control system which is badly designed or which is applied in an insensitive manner may end up doing more harm than good.

For example, the manager of a production line may get his costswithin budget by cutting back on inspection costs – with adverseconsequences for the business as a whole when customers reportconsequent higher numbers of defective units.

There are many ways in which poorly designed performancemeasurement can result in wrong signals and dysfunctional behaviour.Berry, Broadbent and Otley identified the following problem areas:

• Misrepresentation – 'creative' reporting to suggest that a result is acceptable.
• Gaming – deliberate distortion of a measure to secure some strategic advantage.
• Misinterpretation – failure to recognise the complexity of the environment in which the organisation operates.
• Short-termism – leading to the neglect of longer-term objectives.
• Measure fixation – measures and behaviour in order to achieve specific performance indicators which may not be effective.
• Tunnel vision – undue focus on stated performance measures to the detriment of other areas.
• Sub-optimisation – focus on some objectives so that others are not achieved.
• Ossification – an unwillingness to change the performance measure scheme once it has been set up.

A number of actions might be taken in order to minimise the impactof imperfections that may exist within the performance measurementsystem. These methods will be explored in later chapters.

Management Styles

Hopwood identified three distinct management styles ofperformance appraisal. The style needs to be considered when designingan effective performance measurement system.

Budget­ constrained style

The manager's performance is primarily evaluated upon the basis ofhis ability to continually meet the budget on a short-term basis. Themanager will receive unfavourable feedback from his superior if, forinstance, his actual costs exceed the budgeted costs, regardless ofother considerations.

Profit-conscious style

The manager's performance is evaluated on the basis of his abilityto increase the general effectiveness of his unit's operations inrelation to the long-term purposes of the organisation.

Non-accounting style

The budgetary information plays a relatively unimportant part in the superior's evaluation of the manager's performance.

Accountability and performance measurement

In companies, the identification of the principal (shareholders)and agent (managers and employees) is relatively straightforward.

In the public sector and not-for-profit organisations therelationship is more complex and there may be several principals. Forexample, in a government funded hospital the principals may include thegovernment (who provide the funds) and the patients (as recipients ofthe treatment). The agent will be the doctors, managers and otherhospital staff.

The achievement of accountability, i.e. holding the agent toaccount is an important aspect of the relationship between the principaland the agent.

In the case of performance measurement:

• the principal is the employer
• the agent is the employee.

The problem is how the agent can be motivated and monitored so thatthey do what the principal wants. In reality this may be achieved byaligning the principal's goals with the agent's goals and the rewardsystem (as previously discussed).

Chapter summary

Test your understanding answers

As businesses become larger and more diverse, it becomes moredifficult for top management to control them in any way other than bystrict financial targets. The diversity of information and complexity issimply too great. Targets on profitability, return on investment,residual income are easy to set and monitor without knowing much aboutthe details of business activities.

If there is high diversity, then sub-units are largely independentof one another so that each can be judged fairly in isolation, i.e. poorperformance in one division should have no effect on another.

With additional information the production manager may attempt topersuade the purchasing manager to try alternative sources of supply.

• External information may not be accurate.
• External information may be out of date.
• The company publishing the data may not be reputable.
• External information may not meet the exact needs of the business.
• It may be difficult to gather external information, e.g. from customers or competitors.

Historical customer data will give information about:

• product purchases and preferences
• price sensitivity
• where customers shop
• who customers are (customer profiling).

For a business that prioritises customer satisfaction this willgive important control information. Actual customer data can be comparedwith plans and control action can be taken as necessary, e.g. pricesmay be changed or the product mix may be changed.

An information system can be developed to varying levels of refinement. Specifically:

• Reporting frequency - information can be collected and reported with varying levels of frequency, e.g. for example, the management accounting system of a manufacturer can report actual production costs on a daily, weekly, monthly or even annual basis
• Reporting quantity and level of detail - information can be collected and reported at varying levels of detail e.g. in absorbing overheads into product costs one can use a single factory overhead absorption rate (OAR) or one can operate a complex ABC system. The information requirements of the latter are far more elaborate than those of the former
• Reporting accuracy and back-up - subtle qualitative factors can be incorporated into information systems at varying levels, e.g. information can be rigorously checked for accuracy or a more relaxed approach can be adopted.

Broadly, the more refined the system is, then the more expensive itis to establish and operate. The organisation has to decide if theincreased benefits outweigh the increased costs.

Information and Investment – Moffat Ltd

(a) The management of an organisation need toexercise control at different levels within an organisation. Theselevels are often categorised as being strategic, tactical andoperational. The information required by management at these levelsvaries in nature and content.

Strategic information

Strategic information is required by the management of anorganisation in order to enable management to take a longer term view ofthe business and assess how the business may perform during the period.The length of this long term view will vary from one organisation toanother, being very much dependent upon the nature of the business andthe ability of those responsible for strategic decision to be able toscan the planning horizon.
Strategic information tends to be holistic and summary in nature andwould be used by management, when for example, undertaking SWOTanalysis.

In Moffat Ltd strategic information might relate to the developmentof new services such as the provision of a home-based vehicle recoveryservice or the provision of 24hr servicing. Other examples would relateto the threats posed by Moffat Ltd's competitors or assessing thepotential acquisition of a tyre manufacturer in order to enhancecustomer value via improved efficiency and lower costs.

Tactical information

Tactical Information is required in order to facilitatemanagement planning and control for shorter time periods than strategicinformation. Such information relates to the tactics that managementadopt in order to achieve a specific course of action. In Moffat Ltdthis might involve the consideration of whether to open an additionaloutlet in another part of the country or whether to employ additionalsupervisors at each outlet in order to improve the quality of serviceprovision to its customers.

Operational information

Operational information relates to a very short time scale and isoften used to determine immediate actions by those responsible forday-to-day management.

In Moffat Ltd, the manager at each location within Moffat Ltdwould require information to relating to the level of customer sales,the number of vehicles serviced and the number of complaints receivedduring a week. Operational information might be used within Moffat Ltdin order to determine whether staff are required to work overtime due toan unanticipated increase in demand, or whether operatives requirefurther training due to excessive time being spent on servicing certaintypes of vehicle.

(b) One approach that the directors of MoffatLtd could adopt would be to ignore the qualitative benefits that mayarise on the basis that there is too much subjectivity involved in theirassessment.

The problem that this causes is that the investment will probablylook unattractive since all the costs will be included in the valuationwhereas significant benefits and savings will have been ignored. Thisapproach lacks substance and would not be recommended.

An alternative approach would involve attempting to attributevalues to each of the identified benefits that are qualitative innature. Such an approach will necessitate the use of managementestimates in order to derive the cash flows to be incorporated in a costbenefit analysis. The problems inherent in this approach includegaining consensus amongst interested parties regarding the footing ofthe assumptions from which estimated cash flows have been derived.Furthermore, if the proposed investment does take place then it may wellprove impossible to prove that the claimed benefits of the new systemhave actually been realised.

Perhaps the preferred approach is to acknowledge the existence ofqualitative benefits and attempt to assess them in a reasonable manneracceptable to all parties including the company's bank. The financialevaluation would then not only incorporate 'hard' facts relating tocosts and benefits that are qualitative in nature, but also wouldinclude details of qualitative benefits which management consider existbut have not attempted to assess in financial terms. Such benefits mightinclude, for example, the average time saved by location managers inanalysing information during each operating period.

Alternatively the management of Moffat Ltd could attempt toexpress qualitative benefits in specific terms linked to a hierarchy oforganisational requirements.

For example, qualitative benefits could be catergorised as being:

(1) Essential to the business

(2) Very useful attributes

(3) Desirable, but not essential

(4) Possible, if funding is available

(5) Doubtful and difficult to justify

(c) One of the main qualitative benefits thatmay arise from an investment in a new IT system by Moffat Ltd is theimproved level of service to its customers in the form of reducedwaiting times which may arise as a consequence of better scheduling ofappointments and inventory management. This could be assessed via theintroduction of a questionnaire requiring customers to rate the servicethat they have received from their recent visit to a location withinMoffat Ltd according to specific criteria such as adherence to appointedtimes, time taken to service a vehicle, cleanliness of the vehicle andattitude of staff.

Alternatively a follow-up telephone call from a centralisedcustomer services department may be made by Moffat Ltd personnel inorder to gather such information.

Another qualitative benefit may arise in the form of competitiveadvantage. Improvement in customer specific information and servicelevels may give Moffat a competitive advantage.

Likewise improved inventory management may enable costs to bereduced thereby enabling a 'win-win' relationship to be enjoyed withcustomers.

Software audit trail

A software audit trail records selected transactions so that theycan be subsequently verified. Typically, financial information isaudited so that possible fraud can be detected. The claims informationwill be audited to ensure that claims are not paid without going throughthe normal procedure. The software audit trail usually records the typeof transaction made (for example, make payment), the value of thetransaction, who made the payment (the user identifier), where they madethe payment from (terminal identifier) and the date and time of thetransaction. The audit trail is usually inspected by internal auditors.Without this information they are unlikely to quickly identifypotentially fraudulent activity and to monitor and eventually apprehendthe culprit.

Archiving facility

An archiving facility is needed so that infrequently accessed dataheld on the system can be transferred to off-line storage, typically adisk, CD or DVD. This frees up space on the operational system. This notonly means that there is more room for storing current data but alsothat infrequently accessed data that potentially slows the system downis also removed. This results in the system being quicker afterarchiving and indeed this is one of the reasons often given forproviding an archiving facility in the first place. Archived data may beaccessed if required, so a facility is required to effectively restorethe archived data. Without the archiving facility the claims system islikely to store a large amount of rarely accessed data, which may mean(at best) that the system is low and (at worst) that there is no roomleft on the disk to store information about current claims. Anotherpossible scenario is that incorrect decisions may be made, from usingold inaccurate data.

Encryption facility

An encryption facility allows data to be encoded when it istransmitted from one location to another. The sending software uses akey to translate the data into an undecipherable set of characters.These characters are then transmitted.

The only receivers who can understand the transmitted charactersare those with access to the key to turn the data back into its originalstate. Without encryption the insurance company is restricted in itsuse of the data. Unscrambled data transmitted across networks is open tounauthorized interception and to users who receive the data by mistake.In the example, this data will include both financial and customerinformation, valuable to both thieves and competitors. Hence encryptionis necessary for multi-site use.

Password maintenance facility

Most software requires a password (or series of passwords) torestrict user access to certain defined areas of the computer system. Apassword maintenance facility is required to establish and maintainpasswords which allow either read only or read and write access tocertain specified parts of the system. Such a facility should alsodetect the currency of passwords, so that passwords which have not beenchanged for a defined period are detected and the user is prompted tochange the password. Without a password facility the system (or morerealistically parts of the system) cannot be protected from unauthorizedaccess. Similarly, without checks on the currency of passwords, apassword may be used for too long and hence make the software prone tounauthorized access by people who essentially 'steal' a user's identity.

• Unreliable information: Information must be sufficiently reliable (e.g. accurate and complete) so that managers trust it to make judgements and decisions.
• Timeliness: Information must be available in time for managers to use it to make decisions.
• Responsibility and controllability: Information systems might fail to identify controllable costs, or indicate management responsibility properly. Information should be directed to the person who has the authority and the ability to act on it.
• Information overload: In some cases, managers might be provided with too much information, and the key information might be lost in the middle of large amounts of relatively unimportant figures.
• Cost and value: The cost of providing the information should not exceed the benefits obtained.

HRM may have to:

• plan potential redundancies when staff are measured
• facilitate and manage the changes in culture and performance that are necessary
• ensure that corporate goals and missions are understood and communicated
• unify reward systems
• redesign jobs
• plan training.

This is just one further example of the link between HRM andstrategy, but it should illustrate how HRM plays a role in contributingto the achievement of an organisation's objectives.

The main purpose of appraisal is to improve individual performance. Other purposes include:

• to review past performance:
  • action should be taken to solve any problems identified
  • rewards should be determined
• to assess future potential/promotion prospects
• to set future performance objectives (these should be aligned to the overall objectives)
• To improve motivation and morale since employees can see a clear link between the achievement of their objectives and their rewards.

Appraisal may lead to business improvements because:

• employees will be more motivated (and hence more productive) since they feel that they are rewarded for achieving their objectives
• employees will be more motivated since they feel that their developmental needs are being addressed
• individual employee objectives should be aligned with business objectives. Therefore, if an employee achieves their objectives the performance of the business should also improve.

However, the judgemental purpose of appraisal has the ability to demotivate (and hence to reduce productivity) because:

• employees may feel that they are being criticised
• employees may not consider the assessment to be fair
• employees may not think that the appraisal has any purpose or worth.

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