19.
Organisational and operational control

19.1 Corporate strategy

Any organisation that wishes to succeed needs to have a strategic plan. A strategic plan sets out:

• what the organisation is seeking to achieve
• how it will measure success
• who it wishes to serve
• what goods or services it wishes to supply
• which parts of a market it wishes to serve
• how the organisation will differentiate its goods or services so that people become aware of them
• what pricing and other marketing strategies the organisation will use.

A strategic plan also covers other major policies, including:

• employment
• environment
• customer and other relationships
• attitudes to tax and other aspects of socially responsible risk management.

To truly understand the organisation that they work for, and to provide those managing it with relevant information, the management accountant has to comprehensively understand the strategy of the organisation that they work for so that they might help it fulfil its objectives.

19.2 Key performance indicators

Key performance indicators (KPIs) are a tool to assist an organisation achieve its goals. KPIs measure performance in activities that are most likely to influence the achievement of the goals of an organisation over a period of time, whether that be an hour, week, month, year or even a longer period for which a corporate strategy is established.

Worked example

The strategy of a firm of accountants might suggest that it wishes to grow revenues by an agreed percentage per annum. This strategy might also be expressed as requiring:

• an increase in revenue per partner, or employee
• planned growth through recruiting new personnel, or by tactical mergers and acquisitions
• a reduction in the amount of unbilled work undertaken by the firm’s employees on administration or other such tasks
• attracting new clients, particularly in key target markets
• selling more high-value services.

These aims can be translated into key performance indicators. Examples of these KPIs might include:

• revenue per partner
• revenue per employee
• net staff turnover
• total hours work billed to clients by partners or employees during a period
• new client recruitment, both by number and value
• changes in the sales mix.

Using modern practice-management software, as most firms of accountants do, reporting against these KPIs is simple and there is little excuse for not doing so. This includes reporting by each member of staff who might have a goal attributed to them, for example, a target number of billable hours.

19.3 Budgeting

The strategy of an organisation can, when combined with targeted goals for identified key performance indicators that will assist its delivery, be used to assist the creation of budgets for an organisation. The budgets can then be used to monitor its performance against expectations so that performance can be appraised, variances can be analysed and lessons can be learned.

There are two approaches to budget-setting:

• In a top-down approach, targets are set by the highest-level managers for the organisation as a whole. These are then imposed on the managers and staff reporting to them.
• In a bottom-up approach, target-setting is devolved to individual managers and a budget is created on the basis of what they believe to be possible.

The problem with top-down budgeting is that impossible goals may be set, and managers and staff might then be alienated by having demands made of them based on goals they were not consulted about when they were set. This might lead them to feel no sense of ownership for delivering on them.

The problem with the bottom-up approach to budgeting is that individual employees, managers, departments or other parts of an organisation may set goals that are not in line with those in the organisation’s strategy and a lack of cohesion may result as different functional areas pursue divergent goals.

In reality, a wise organisation finds compromises between these two methods. Overall goals will be established by top-level management, hopefully after some consultation with senior managers and staff. The delegation of responsibility for setting precise KPIs to facilitate delivery of these goals will then be delegated as far as possible so that responsibility for delivery can be attributed, meaning that personnel can then be held to account for actual performance.

The budget should be broken down so that:

• the KPIs driving it are specified
• the links between those KPIs and the corporate strategy are explained
• the links between the KPIs and the budget are clear
• the person responsible for delivering the budget, and who can control the KPIs, is specified.

Example

A departmental sales budget for an accounting firm could be based on:

• the number of personnel of each grade to be employed in each period
• how many hours they are expected to work in each period
• what proportion of those hours are expected to be chargeable to clients for services provided
• the hourly rate at which these services might be charged.

The result is a sales figure for which the manager can be responsible because KPIs can be established for:

• staff numbers, often by grade
• hours worked
• hours billed
• effective charge rates.

There are also several alternative approaches to budgeting. Most organisations will take an incremental approach, building on prior budgets. Alternative approaches to the top-down and bottom-up approaches include activity-based budgeting, zero-based budgeting and beyond budgeting.

• Activity-based budgeting starts with detailed production and sales forecasts for products and services, including sales costs.
• Zero-based budgeting (sometimes referred to as priority-based budgeting) seeks to address the limitation of incremental budgeting approaches. It requires that the projected expenditure for organisational activities to start at zero rather than building on the prior year’s budget. This approach is typically used with discretionary costs and support activities rather than production processes.
• Beyond budgeting (Hope & Fraser, 2003) seeks to abolish traditional budgeting processes and empower local managers to develop goals using external benchmarks rather than internally generated fixed targets. This motivates managers who have a sense of ownership and shifts behaviours to focus on external instead of internal competitiveness. This approach is considered helpful for knowledge-based companies. To learn more, read How Equinor and Handelsbanken abolished budgeting.

19.4 Organisational control

Having noted this approach to organisational management and budget-setting, it then becomes apparent that in most types of organisation there are two types of activity centres – profit centres and cost centres. (These can, on occasion, be combined in a profit centre responsible for generating revenues and controlling costs.)

Profit centres, which might be described as income centres in the case of not-for-profit organisations, are for management accounting purposes focused on the monitoring and control of the revenue sources of the organisation. In many organisations this will require the management of sales revenues, but it might also in other types of organisation involve accounting for:

• grants
• donations
• the management of non-revenue-generating supplies of goods or services.

Since managers with responsibility for revenue generation might, simultaneously, be tasked with managing the cost associated with that activity, they might also have budgets for direct expenditure, including that on:

• advertising
• marketing
• entertaining
• exhibitions
• social media

They might also have cost centres for semi-variable costs such as:

• staff salaries
• staff-related overheads, for example, pension costs
• staff ‘benefits in kind’, such as the use of company cars.

As a result, it is commonplace that managers with responsibility for revenues are usually in charge of what are most appropriately called profit centres.

Other managers might, however, only manage costs. Cost centres might include:

• production facilities
• administrative support facilities
• an accounts department
• the manager of a dedicated overhead operation, for example, a team managing insurance for an organisation.

The way in which profit and cost centres are decided upon depends on:

• the preferences of the organisation
• the way in which it organises its management
• its willingness to share performance data with management and staff.

19.5 Management accounting and budget comparison

Types of organisational control vary considerably, but in all cases, when linked to KPIs, budgeting should permit the use of a management accounting technique known as standard costing.

If the methodologies described above have been used to establish the estimated or standard costs and revenues, and these figures have been used in the budget for a period, the variances between outcomes at an anticipated level of activity and outcomes at actual levels of activity can be reported.

One of the major contributions that management accounting can make to the success of an organisation is to explain why the outcomes of business activities are not as expected. The lessons learned from this analysis of variances can inform future business activities so that past mistakes can be avoided and successes built on.

Note that standard costs are the estimated costs of materials, labour and overheads of producing an organisation’s goods or services. These standard costs can, and ideally should, be used for budgeting and then serve as benchmarks for evaluating actual performance.

Example 1

The mobile coffee shop used as an example in Unit 18 forecasts that it will sell 1,000 coffees over a weekend. It forecasts that the average selling price will be £3.25 per cup and the standard variable cost of the cup of coffee will be £0.40. Its budget for the weekend is:

	£
Sales	3,250
Variable costs	(400)
Contribution	2,850

In practice, the weekend did not work out as planned, as is often the case in business. Only 800 coffees were sold at the price of £3.25 and the standard variable cost of a cup of coffee was actually £0.50.

The actual performance was:

	£
Sales	2,600
Variable costs	(400)
Contribution	2,200

We can calculate that the business underperformed by £650 compared to its plan (budgeted contribution of £2,850 minus actual contribution of £2,200). A direct comparison suggests that only a fall in sales revenue is to blame. Is this true?

A flexed budget is required to eliminate any changes which are a result of selling more or fewer cups of coffee, as follows:

	Original budget	Flexed budget	Actual performance	Variance
	1,000 cups	800 cups	800 cups
	£	£	£	£
Sales	3,250	2,600	2,600	Nil
Variable costs	(400)	(320)	(400)	(80) Adverse
Contribution	2,850	2,280	2,200	(80) Adverse

The flexed budget flexes – that is, multiplies – the standard price and standard variable cost by the actual volume.

Now when we compare the flexed budget to the actual performance, we can see that the business spent more on variable costs than it should have for the volume of cups actually sold.

The financial impact of selling fewer cups of coffee can be calculated using the sales volume variance. This is calculated using the contribution or profit per unit (depending on the costing method being used). In this case the standard contribution per unit is the £3.25 selling price minus the £0.40 variable cost, which totals £2.85. The van sold 200 fewer cups of coffee than expected, so the variance is £2.85 × 200 = £570 adverse.

The management of the coffee van now knows that:

• Reduced sales volume cost the business £570 contribution.
• The variable costs rose and cost the business £80 contribution.
• Together these caused the £650 underperformance between the original budget and the actual result.

This example has been simplified. More detailed variances in variable and overhead costs would commonly be calculated (see the example below). If the management accountant is involved throughout the process of budgeting, in setting standard prices and costs, and in the reporting of actual financial performance, then they can create variance analyses that can inform an organisation’s decision-making to improve its performance. Management accountants can significantly contribute to the overall performance of the organisation for which they work.

Example 2

Building on the above example, the business’s manager may want to look more closely at the variable cost of the coffee beans used in each cup of coffee. In the standard-setting process the business calculated that it needed 4 grammes of ground beans per cup of coffee and the cost per gramme of beans was budgeted to be £0.05. Looking more closely at the variable cost variance, the manager finds that the price of beans has risen to £0.07 per gramme and the newly trained barista used on average 5 grammes of ground beans per cup.

In the original budget the cost of beans would be calculated as:

\[4\ \text{grammes}\ ×\ £0.05\ ×\ 1,000\ \text{cups} = £200\]

The actual cost of beans used would be:

\[5\ \text{grammes}\ ×\ £0.07\ ×\ 800\ \text{cups} = £280\]

This shows that they overspent on beans by £80 (£280 − £200). However, this does not take account of the fact that the business also made fewer cups of coffee than forecast. To calculate the impact of this, the budget needs to be flexed to the actual number of cups of coffee made:

\[4\ \text{grammes}\ ×\ £0.05\ ×\ 800\ \text{cups} = £160\]

We can now see that the situation is a little worse than the £80 variance shown by the original calculations above. As the beans are a variable cost, the total cost of beans to make 800 cups of coffee is £40 less than making 1,000 cups of coffee (£200 − £160). Therefore, the actual cost of the beans for 800 cups, at £280, is £120 more than the flexed budget.

To understand this in more detail, we can break it down further to identify whether the £120 cost variance was as a result of using more or fewer beans, paying more or less per gramme for the beans, or both.

A quantity variance reveals that the business spent £40 more because they used more ground beans than they should have:

\[\begin{align} &\text{They should have used } (4 \text{ grammes } × 800 \text{ cups}) = 3,200 \text{ grammes }\ @\ £0.05\text{p} = £160\\ \\ &\text{They actually used } (5 \text{ grammes }\ × 800 \text{ cups}) = 4,000 \text{ grammes } @\ £0.05\text{p} = £200\\ \\ &£200\ \text{ minus } £160 = £40 \text{ overspent (adverse)} \end{align}\]

A price variance reveals that the business overspent by £80 because they paid more for the beans than they expected to pay.

\[\begin{align} &\text{They should have paid } £0.05 \text{ per gramme for the } 4,000 \text{ grammes actually used } = £200\\ \\ &\text{They actually paid } £0.07 \text{ per gramme for the } 4,000 \text{ grammes actually used } = £280\\ \\ &£280 \text{ minus } £200 = £80 \text{ overspent (adverse)} \end{align}\]

Note that our two sub-variances add back to our overall variance of £120 overspent (adverse) between the business’s flexed budget and its actual performance.

There is an issue to note here. Superficially, the management accounts for the organisation would have not have shown a variance in the cost of coffee for this period because according to the budget it should have been £400, and it actually was £400 (1,000 × £0.4 and 800 × £0.5). However, variance analysis makes it clear that this is not a fair representation of what actually happened. There is, in practice, a significant problem with the cost of the coffee that the business uses. This might require a permanent adjustment to standard costs if the price of coffee beans is not to go down, and budgets might also need to be updated to reflect the likely future cost. Future variances calculated would offer better understanding to the management of the business.

This example illustrates that neither a budget nor standard cost are set in stone. They exist to support management decision-making. If the cost of a raw material changes permanently in a way that the management cannot control and they have no choice but to pay the new market price if they are to continue to supply the product, then an update to both standard costs and the budget is appropriate.

Budgeting and standard costing require the exercise of judgement, like all other parts of accounting.

Variance analysis can also be extended to sustainability metrics, for example, budgeting for greenhouse gas emissions (GHGs). It could be that GHGs are favourable or adverse due to overall volume of production or service provision; or they might be favourable or adverse because of a problem in the production of each unit or provision of each service (for example, a different power source is used, or a worker uses electric vehicle instead of diesel).

19.6 Balanced scorecard

So far, we have mainly considered financial plans and control of financial performance. These can help decision-makers appraise past performance that will help them decide on future courses of action. There are, however, also qualitative aspects, or non-financial measures, that can be just as important to the success of an organisation. Management accounting also considers these issues.

The ‘balanced scorecard’ framework developed by Kaplan and Norton (1992) is helpful. It considers the following perspectives:

• Financial. These measures are concerned with financial performance and seeks to answer the question ‘Have we kept our providers of finance happy?’

• Customer. These measures relate to customer satisfaction, market share and quality-related issues to answer the question ‘Have we kept our customers happy?’ This might involve appraisal of:

  • customer satisfaction scores
  • customer retention rates
  • changes in market share.

• Internal business processes. These measures consider operational efficiency and seek to answer the question ‘What are we good at?’ The measures can vary greatly depending on the type of organisation and might include:

  • telephone response times
  • service response times
  • product quality and defect rates
  • complaint rates.

• Learning, growth and innovation. These measures can be wide-ranging but tend to focus on employee development, corporate culture and product innovation. The measures seek to answer the question ‘How can we improve to create more value?’ To do so they focus on:

  • employee training and skill development
  • staff engagement and satisfaction
  • knowledge-sharing and innovation rates.

Organisations using this approach usually have targets and initiatives for each of these perspectives, although partial approaches are possible.

Setting performance targets for these objectives generally means that people will pay more attention to these areas. The downside is that they might, as a result, pay less attention to important areas that have no set targets. This gives rise to the phenomenon known as ‘Goodhart’s Law’. Charles Goodhart, a UK-based economist, is credited with expressing the idea that ‘When a measure becomes a target, it ceases to be a good measure.’ An example might be employees finding loopholes to meet targets without genuinely improving performance. For example, when hospitals target wait times, simpler cases are given priority over more complex, time-consuming ones; this might allow the unit to achieve its target but might not improve patient outcomes.

Measures need to be set with care. The following factors are relevant:

• Financial perspective. This aspect asks how value can be created for interested parties. For-profit organisation may relate this measure to shareholder value, but needs adaptation for not-for-profit organisations where goals set by funders and donors might need to be considered instead.
• Customer perspective. This perspective looks at what existing and potential customers want from the organisation but asking them might not be reliable. Instead, businesses might seek to be more creative, for example, with a loyalty card that offers customers their fifth or tenth coffee for free. By tracking how many coffees are given away, it is possible to work out how many customers return. Assuming that a customer who comes back for a coffee five or ten times is happy customer, we can then create a measure of success. However, if there is no other coffee shop nearby this proves nothing at all. All measures have to be used with care and in context.
• Internal business perspective. This perspective considers those aspects of the business at which it must excel at to achieve best performance. First, these need to be identified, not least by asking customers what matters to them. Then this service quality must be delivered and performance against the plan measured. Note that these measures need to be appropriate to the scale of the business.
• Learning, growth and innovation perspective. This perspective considers how the business can continuously improve, and to take advantage of new technologies and thinking. This might require product innovation, staff training or adoption of new technology. Feedback processes on such innovations are required. Again, they need to be appropriate to the scale of the business.

Question

What objectives, appraised under the four perspectives of the balanced scorecard, might be appropriate for the coffee van noted in examples in this module and in Unit 18?

The balanced scorecard might be set out as follows:

Perspective	Agreed objectives	Chosen measure of success
Financial
Customer
Internal business
Learning, growth and innovation

There are no right answers to this question, but some suggestions may be more appropriate than others. Importantly, while it can be tempting to draw up several objectives, it is usually wise to limit them to no more than three or four per perspective. This ensures that the organisation is focused on what is important to its success. It is worth noting that the balanced scorecard approach can easily be extended to include sustainability measures, and it is increasingly being used in this this way.

Some companies have sought to align management remuneration with metrics derived from a balanced scorecard. See BT plc and DBS as examples of companies that have done so. This is intended to ensure that management are financially incentivised to achieve the goals set by the balanced scorecard, but this also assumes that such goals have been appropriately identified and lead to the expected outcomes.

19.7 Summary

In this module we have shown how an organisation should:

• integrate its goals into its operational budgets
• set standard costs to use in those budgets
• allocate responsibility for managing budget outcomes
• prepare variance analyses that explain the difference between anticipated and actual performance
• set non-financial as well as financial goals.