A GUIDE TO BUSINESS PERFORMANCE MEASUREMENTS

Also by Edwin Whiting

HOW TO GET YOUR EMPLOYMENT COSTS RIGHT

A GUIDE TO BUSINESSPERFORMANCE

MEASUREMENTS

Edwin WhitingBA (Eean), FeA

MMACMILLAN

© Edwin Whiting 1986 Softcover reprint of the hardcover 1st edition 1986 978-0-333-37416-0

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright Act 1956 (as amended).

Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

First published 1986

Published by THE MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG212XS and London Companies and representatives throughout the world

Filmsetting by Vantage Photosetting Co. Ltd Eastleigh and London

British Library Cataloguing in Publication Data Whiting, Edwin A guide to business performance measurements. I. Organisational effectiveness I. Title 338.7'4 HD58.9 ISBN 978-1-349-07474-7 ISBN 978-1-349-07472-3 (eBook) DOl 10.1007/978-1-349-07472-3

To Patricia

Contents

Preface

PART I OBJECTIVES AND SCOPE

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INTRODUCTION 3Problems of profit. Profitability. Other measures.External and internal. Short-term and long-term.Tailoring to the user.

2 PURPOSES AND PROBLEMS OF MEASUREMENT 7External users. Internal users. Management control.Incentive schemes. Budgetary control. Managementdecision. The business entity. Divisional performance.Divisional and entity performance.

3 PLAN OF THE BOOK 13Basicclassifications. Measures in detail. Accountingconventions. Ratios . Conclusion.

4 INCOME, VALUE AND COST 18A theory of performance measurement. Income.Value. Cost. Inflation. Replacement value (CCA).Realisable value (COCOA). Current purchasing powervalue (CPP). Capital maintenance. Asymmetry ofaccounting values. Performance . Value in decision-making.

Part I References 26

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PART II THE MEASURES IN DETAIL

5 TURNOVER 29Definition. Accountancy. Underly ing philosophy.Businesses best suited. Organisa tions best suited.Power to motivate . Problems and troubles .

Trouble Spot 5.1: Transfer pricing 34Trouble Spot 5.2: Foreign currency translation 40

6 GROSS MARGIN 43Definition. Accountancy. Underlying philosophy .Businesses best suited. Organisations best suited.Power to motivate. Problems and troubles .

Trouble Spot 6.1: Stocks and work-in-progress 48

7 VALUE ADDED 59Definition. Accountancy. Underlying philosophy .Businesses best suited. Organisations best suited.Power to motivate . Problems and troubles .

Trouble Spot 7.1: Depreciation 65Trouble Spot 7.2: Revenue investment 75

8 OPERATING PROFIT 81Definition. Accountancy . Underlying philosophy.Businesses best suited. Organisations best suited.Power to motivate. Problems and troubles.

Trouble Spot 8.1: Pensions costs 87Trouble Spot 8.2: Allocation of central costs 94

9 PROFIT AFTER INTEREST 99Definition. Accountancy. Underlying philosophy .Businesses best suited. Organisations best suited.Power to motivate. Problems and troubles .

Trouble Spot 9.1: Interest and cost of capital l04Trouble Spot 9.2: Capitalisation of interest 108

Contents ix

10 PROFIT AFTER TAXATION 111Definition. Underlying philosophy. Businessesbestsuited. Organisations best suited. Power to motivate.Problems and troubles.

Trouble Spot 10.1: Capital allowances and deferred taxation 117Trouble Spot 10.2: Dividends, surplus ACT and losses 128Trouble Spot 10.3: Group relief 135

II ALL-INCLUSIVE PROFIT 138Definition. Underlying philosophy. Businesses bestsuited. Organisations best suited. Power to motivate.Problems and troubles.

Trouble Spot 11.1: Extraordinary items 142Trouble Spot 11.2: Goodwill 147

Part II References 151

PART III BASES OF ACCOUNTING

12 ACCOUNTING MECHANICS 155Introduction. Comparative bases of company accounts.Divisional accounts .

13 HISTORIC COST 163Origin and definition. Accounting statements.Features of pure historic cost. Valuation. Advantagesof historic cost. Disadvantages of historic cost. Wherehistoric cost is good. Conclusion.Statement 13.1: Group profit and loss account 170Statement 13.2: Value added statement 171

14 CURRENT COST 172Origin and definition. Accounting statements.Features of current cost. Valuation. Advantages ofcurrent cost. Disadvantages of current cost. Wherecurrent cost is good. Conclusion.Statement 14.1: Adjustments to group profit and loss

account 187

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15 CASH FLOW 188Origin and definition. Accounting statements.Features of cash flow. Valuation. Advantages of cashflow. Disadvantages of cash flow. Where cash flow isgood. ConclusionStatement 15.1: Cash flow statement 196Statement 15.2: Cash valueadded statement 197Statement 15.3: Long term total cashflow statement 198

16 FUNDS FLOW 200Origin and definition. Accounting statements.Features offunds flow. Advantages offunds flow.Disadvantages of funds flow. Where funds flow isgood. Conclusion.Statement 16.1:Fundsflow statement 205

Part III References 206

PART IV PERFORMANCE RATIOS

17 RATIOS IN GENERAL 209Need for comparison. Absolute versus comparative.Forms of ratio . Caveats on ratios . Measurement byratio .

18 RETURN ON CAPITAL EMPLOYED 214Introduction. Types and definitions. Net presentvalue and rate of return. Formula for ROCE. Basis ofaccounting. Fixed assets gross or net of depreciation.Inclusion of cash in the asset base. 'Intangibles'.Assets at lower than cost. Leased assets. Publishedand divisionafROCE. Alternative to divisional ROCE .Labour and capital intensive. New and old businesses.Merits of ROCE. Pitfalls in ROCE. Conclusion.

19 OTHER OPERATING RATIOS 232Introduction. Operating profit/operating capital.Gross margin /turnover. Operating profit/turnover.Value added /turnover. Value added /employment cost.Operating capital/turnover. Value added/operatingcapital. Fixed assets/turnover. Working capital /turnover. Stocks/materials consumed (or turnover).Debtors/turnover.

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20 EARNINGS PER SHARE 243Introduction. Definition. Tax and distribution basis.Extraordinary items. Versions ofEps. Relationshipwith ROCE. Drawbacks ofEps. Price/earnings ratio.Conclusion.

21 PRODUCTIVITY RATIOS 252Introduction. Definition: volume-to-volume ratios .Specificproductivity ratios. Drawbacks of volume-to-volume ratios . Money-to-volume ratios . Drawbacksof money-to-volume ratios. Money-to-money ratios.Conclusion.

22 STRATEGIC RATIOS 260Introduction. Market share. Quality . Level ofservice. Delivery and orders outstanding. Trainingand education. Growth. Conclusion.

Part IV References 271

PART V BUSINESS TYPES AND STYLES

23 BUSINESSES, INDUSTRIES AND ORGANISATIONS 275Introduction: which measurements for whom? Businessobjectives. Long-term and short-term. Categories ofbusinesses. Single business public companies. Singlebusiness private companies. Business divisions ofcompanies. Small businesses. New businesses. Oldbusinesses. Sales-oriented businesses. Production-oriented businesses. Capital-intensive businesses.Labour-intensive businesses. Co-operatives and co­partnerships. Nationalised businesses. Charities andnon-profit-making businesses.

24 MOTIV ATION, PHILOSOPHY AND ACCOUNTING 292Multiple measurements. Motivation and acceptability.Incentives. Orientation and philosophy. Accountingliaison.

25 LIMITATIONS TO MEASUREMENT 300Subjectivity. Risk. Tyranny of the yearly account.Unmeasurable facets. Use of performancemeasurement. Value and performance.

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AbbreviationsList of Measurements UsedBibliographyIndex

307308310313

Preface

At Manchester Business School there was a project for the MBAstudents called the Corporate Appraisal Project. The teaching ofaccounting at the school was based mostly on historic cost; case studiesand exercises were generally in that vein.

The Corporate Appraisal Project attempted to teach something ofalternative methods: current cost, value added and cash flow. At the endofthe project I could never say which method of appraisal was best. Theonly true answer I could givewas 'It all depends' . If asked 'It all dependson what?', I could list a few factors, such as type of business, philosophyof the management, entity and equity measure and so on. But I ought tobe able to do better than that, I thought, if I had time to study all theissues.

Professor Gerry Lawson, who participated in the project with me, is anexpert on cash flow accounting, and hence naturally biased in its favour.Was it not possible, I mused, to produce something which wouldimpartially show all the advantages and disadvantages of each methodand in what situations each kind of measurement was most appropriate?

The result of my ruminations is this book. It has been greatly assisted bymy research work for the Financial Control Research Institute (FCRI)at the Business School. It was from this that I gained most of'theknowledge about what happens in practice and what managers,accountants and financial directors actually think . The research itselfwas perhaps less valuable than the contacts and conversations withsenior financial managers of the member companies and othersassociated with the FCRI.

I must acknowledge also the knowledge gained from research on aproject funded by the Social Science Research Council (as it was thencalled) on the effectof inflation on planning and control systems during1979-80. This provided much practical insight, through visits to

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xiv Preface

companies, into their use of current cost accounting, cash flow, fundsflow and productivity measures .

The book is not an academic treatise or a scholarly work . Most of it isunoriginal. But there is some new material based on the more recentresearch and my own opinions. The arrangement, I believe, is complete­ly new. It is intended to make looking-up easy while providing a logicalorder for all the many issues in performance measurement. It is not likelythat many will read the whole book from Chapter I to Chapter 25. In asense it is an encyclopaedia of measurements arranged, not inalphabetical order, but in accounting order, that is, the order in whichaccounts are usually produced.

References are kept to a minimum, used only to identify a source where areader wishes to look up the actual words and their context.

The reasoning behind the explanations and descriptions is brief. Rarelydoes it add up to a fully argued case. But the main points are alwayslisted, and definitions clarified where there could be doubt. History, Ibelieve, is not bunk and the origin of the measurement is an importantpointer as to where and how it may be used.

For revising and commenting on the text I acknowledge the great helpgiven to me by David Gilbert and James Carty, who have made manyconstructive suggestions. On the more routine aspects I must thank myfreelance typist, Ann Poole, who has typed all the text, and my wife forcarefully checking it.

ManchesterJanuary 1985

EDWIN WHITING