FINANCIAL PERFORMANCE MEASURESWhat is Performance measures/ How is it used/ What is its problem: Use to measure and reflect performance of the division or work unit Used diagnostically to detect performance issues and take routine corrective actions to get back on track in line with expectations, there is no alteration of strategy The type of PMs used and its associated target can lead to Unintended consequences: Negative behavioural effect Put individuals under pressure for PMs used and associated target PMs problems related to goal congruence: When performance is purely measured on divisional level Encourge mgr to act in best int of own div and not the company Not goal congruence Solution: use a bonus split: 75(division perf) 25(corp perf) to encourage decision making at division level that is good for firm When a PM is used in isolation Performance perspective: reflect division performance Behavioural effect perspective: Encourage ST focus on meeting target than LT benefit, discourage goal congruence, encourage dysfunctional decision makingWhat determines the suitability of the PMs:1. Linked to strategy2. Consistent with value creation3. Structure change, responsibility centre change, PM change4. Does PM encourage goal congruence decision the behavioural effect of PM5. Performance is measured at what level? inidi, div/ unit, org If performance measured purely on divisional lvl > goal congruence problem6. Reflect managerial control and accountability7. Be relatively objective, timely and responsiveWhat are the different responsibility centre and their performance measure?Cost centres: manufacturing, supporting, discretionary cost Cost budget and variance compared to benchmark Efficiency measuresRevenue centres: sales Revenue budget and variance compared to sales target Net operating income, net growth in revenue, customer satisfaction indexProfit centres: Retail sales outlet Profit plan and variances Net profit margin, Net operating incomeInvestment centres: ROI, RI, EVA = measure returns on investments (profitability performance of the division/ co)What are the Financial PMs to measure profitability?1. ROI= NOI/Total asseta. Measure returns on investment in percentageb. Problem: i. When used in isolation, linked to reward system and on annual basisii. Encourages short term focus on meeting targets than LT benefit, encourage dysfunctional decision making and discourage goal congruenceiii. Through: 1. Cost cutting R&D, training, staff2. Defer asset replacement3. Not investing in projects due to negative ST impact on ROI when it is overall good for the company in the long termc. Solution:i. Use a comprehensive set of measurements to measure performance, balance scorecard that is well balance with ST/LT measures, F &NF measuresii. Use alternative FM: RI, EVAiii. Longer assessment period: 3 years >annuallyiv. Manager service history v. Redefine components of ROI vi. Create a goal congruence environment2. RI= NOI (cap charge X total asset)a. Measures profit left over after charging for asset utilisationb. Measure return on investment in dollar termsc. Adds value to the firmd. Offers a different behavioural effect as compared to ROI3. EVA = (NPAT+R&D)-(cap charge X asset +R&D-CL)a. Measure return on investment in dollar terms adjusted for economic factorsb. Reflect shareholders value c. Worries about economic profit and assetd. Add values to the company e. Limitations:i. Still has a short term focus on decision makingii. Base on past performanceiii. Reduce to a single FM used in isolationiv. Just an alternative FM that is better at the org lvlv. Offers a different behavioural effect as compared to ROI and RI

The performance perspective & behavioural effect of PMs Performance P: All reflect the profitability performance of the division or work unit BE: different for each PM ROI: manager have a ST focus on meeting target than its long term benefit> dysfunctional decision making: may not pursue project because of ST impact on ROI RI: manager pursue project because positive ST impact on RI, adds value to the firm EVA: manager pursue project because positive ST impact on EVA, adds value to the firm Why the different behavioural effect? ROI: worries about existing ROI, if ROI is lower will make dysfunctional decision RI: worries about profit left over, existing ROI doesnt matter, less likely to make dysfunctional decision although ROI is lower because the project still adds value to the company EVA: worries about economic profits, existing ROI doesnt matter, less likely to make dysfunctional decision although ROI is low but projects still adds value to the firm and brings in economic profits Different PMs have different emphasis thus leading to different behavioural effect How to use performance measures diagnostically? Common use:1. Set a range of target2. Measure actual performance3. Compare the two4. Use variance to diagnose the performance issue5. Take routine corrective actions to get performance back on track in line with expectation/ strategy If variation is within target range, managers will not be alerted If variation exceed target range, managers will be alerted to take actions to improve performance but will not warrant a change strategy PMs are used diagnostically to implement strategy effectively & conserve managers attention

NON-FINANCIAL PMS & BSCWhat is traditional Finance PMs ROI, RI, EVA, Profit Good measure to reflect profitability performance of the division/ manager Limitations of Financial PMs: Lag indicators = result based, doesnt provide info on emerging problems and warning signals Focus on the past = doesnt identify causes of business performance ST oriented annual metrics Unhelpful at operational level Bank teller performance measured using orgs EVA, distance between EVA performance and bank teller activities are too far apart FMs nota suitable measure at operational lvlWe need a more comprehensive set of PMs to measure business performance What is NF PMs Leading indicators = the management and monitoring of NF PM leads to improvement in other measures and outcomes Large co track employee engagement index because it is a leading indicator about organizational performance, if employee feels less engage, over time it would negatively affect performance Monitor and improve customer satisfaction index lead to Increase in profit Monitor and improve market share lead to increase in profit They are enablers = provide information about organizational activities Can be developed in many areas: qualitative, productivity, competitiveness, deliver performance, innovation, supply chain performance Can be qualitative or quantitative Quantitative: customer satisfaction can be 4.2 Qualitative: customer seem to be happy when they leave the store Limitations of NF PMs1. Difficult to choose the right NF PMs to use2. Difficult to choose a NF PM that reflects the performance of the div or mgr (mgr span of control), managerial control and accountability3. Difficult to measure or quantify4. The more measures used, the more conflict we have if there is no integration of measuresWhat is and why we use BSC? It is a comprehensive set of ST/LT PMs and F&NF PMs Measured across 4 perspective: Financial, customers, Internal business processes, Legal and regulatory It creates a set of measures that is linked and explains the cause and effect relationship within an organization between the different measures and performance Improving customer satisfaction, improves sales Improving knowledge of workforce, improve revenue It overcomes limitations of using FPM in isolationFinancial perspective EVA Net profit per barrel Total manufacturing cost per barrel Net growth in revenue, net growth in ROI, NPMCustomer perspective Customer satisfactory index Market share Internal business process Cycle time (time to produce a box of beer) Load schedule Waste per total productionLearning and growth perspective Employee engagement index LT injury free rate Training hours per employee per year Hours of community work involvedLimitations of BSC Difficult to get the right balance of F&NF M Does the measure reflect the performance of the mgr and div/ the managerial control and accountability Does the measure reflect the strategic objective Is the measure suitable at the different levels within the organization Measure suitable for the plant may not be suitable for the co Difficult to link the strategies and measures to an incentive plan Common measure bias tend to be bias towards financial perspective measures so what is the point of the rest?

REWARD SYSTEM and how to DEV REWAD SYSTEM FROM BSCWhat factors affect the reward system Agency issue: Senior exec may not act in the best interest of the shareholders , not goal congruence unless the incentive plan is structured in a way that encourages them to act in best int of SHEvaluation of reward system1. Who is it for? CEO> senior manager? divisional manager2. How is it rewarded?a. Fix pay component fixed annual remunerationb. Pay-for-performance component ST / LT incentive plan 3. What reward mix? ST perspective use cash LT perspective use equity Use equity to overcome agency problem, if mgr hold more equity cause them to think and act in SH interest Downside: tempted to increase personal wealth by altering acc number to maintain or increase share price4. What PMs to use? ST/ LT? F/NF?a. Fixed annual remuneration: Base on scope of the role and individual performanceb. Short-term incentive plan: Offer cash incentive Performance assessed against scorecard measuresc. Long-term incentive plan: Offer equity incentive: shares and rights awarded with vesting share criteria Performance assessed against 3 years financial target d. PM used link to strategy, consistent with value creation, objective, timely& responsive, reflect managerial control and responsibility5. Weightage for managers on different incentive plans changes we go down the organization: CEO has more compensation link to LT performance Manager has more compensation link to ST performance6. Uses relative performance evaluation:a. Performance relative to a peer group or benchmarkb. Total SH return vs S&P/ ASX 100 indexReward system that are structured around bonus pool Annual shared bonus pool shared among a group of managers Consideration: Size of bonus pool How is it distributed In what form?Bonus plan1. KPM: ROI 2. Size :3. Form: cash4. How to distribute:a. Bonus pool divided between different level of managers b. Bonus distributed to managers on basis of number of bonus unit awardedi. ROI=5%, one bonus unitii. For each full percentage point above 5% a further bonus unit awarded until a cap of 6 bonus unitiii. Monetary value of bonus unit is found by dividing bonus pool by total number of bonus unit earned by all managersBonus plan evaluation When bonus plan linked to performance measure Mgr want to increase bonus by max ROI, may cause dysfunctional decision making Even if mgr ROI increase, bonus may still decrease because other mgr also has an increased ROI, hence bonus distribution is limited to bonus pool size Use BSC to develop a bonus plan1. Set targets for performance2. Measure actual performance using a BSC3. Compare the two and calculate the variance between actual performance and its associated target4. Decide the weights to assign to the different perspective and its measurements:a. More weights on Financial perspectiveb. So award 4 points for every positive variance under the financial perspectivec. Award 2 points for every positive variance under the restd. Calculate the total weighted variance points for each division5. Use the weighted variance point on manager performance to evaluate their performance 6. After considering the performance from the BSC and discussing it through with the managers, the remuneration committee will decide the managers deserve how much for performance on a scale of 1 -10 , 5 being average and 10 being outstanding7. The bonus pool size is decided8. The bonus is distributed to the manager on basis of the number of bonus unit awarded:a. Base on the performance evaluation scale,b. A performance rate of 5 is awarded 1 bonus unitc. Every full percentage point above 5 is further awarded 1 bonus unit d. Monetary value of bonus unit is found by dividing total bonus pool with the total number of bonus unit earned by all managers.

Problems with using BSC to develop a bonus plan Difficult to get the right balance of F&NF M Does the measure reflect the performance of the mgr and div/ the managerial control and accountability Does the measure reflect the strategic objective Is the measure suitable at the different levels within the organization Measure suitable for the plant may not be suitable for the co Difficult to link the strategies and measures to an incentive plan Common measure bias tend to be bias towards financial perspective measures so what is the point of the rest? Difficult to assign weights to the different perspective, how to know which is more important > may lead to unintentional behaviour to max one pers @ the expense of another Arbitrary conversion of the weighted variance points on mgr performance on to a number of the performance scale index There may be possible inadvertent errors Intentional bias Collapsing the BSC into an arbitrary scale number may cause disaggregated info on mgrs performance lost Even if process is fair, manager may not be able to see the causal link between the performance and bonusHow the BSC can be used as a diagnostic tool or interactive tool Diagnostically> specify a target range for the variances > as long as variance within range mgr ignore it, if outside, it alerts mgr and routine corrective action taken in line with existing strategy , performance issue may not warrant a change in strategy unless a long-term trend Interactively> analyse market trend to identify opp or threats as early to adj business strategy accordingly , mkt share interactively focus firm perf relative to competitors >result inform regular revision and adjustment of business strategy to enhance competitive advantage

REVENUE ANALYSIS : CAUSE OF PROFIT DEVIATION FINDING OUT MORE INFOUse market-related data to further analyse the profit deviation Overall profit variance due to Cost variance Efficiency/ cost variance Non-variable cost variance Revenue variance Volume Mkt size, share, product mix Price Selling price, Variable cost variance, NV cost variance By comparing the flexible budget and the profit plan we get the variance for the profit deviation WE want to unpack the variance to get more information on what causes this variance? Why are we selling more or less than expected? The revenue is higher or lower than expected because of volume effect (competitive effectiveness) or price effect (operating efficiency). Tell us more about the organizations performance WE want to know the proportion of volume and price effect Using the information we get, we can make better future decisions Can use info in a routine fashion to diagnose performance issue and improve performance Can use info interactively to compare performance with competitors, develop new plans How to unpack the deviation in profit?1. The variance between the planned CM and the flexi budget CM, indicates that profit is higher or lower than expected. 2. This variance can be explained by 2 offsetting components: mkt size , mkt share and product mix variance3. Market size variancea. Given planned market share and standard product CM, company would have gain XX profit dut to overall gowth in mkt, especially.. b. Fav profit cause by actual mkt size being diff from expected c. Why?i. Maybe caused by the external environment like gov subsidy, cause more ppl to buy, or general increase in demand4. Market share variancea. Given act market size, loss of profit due to loss in mkt share ( offsetted by mkt share gain in the other product)b. UNFAV profit because market share is lower than expectedc. Why?i. Given growth in mkt size, our mkt share is lower in proportion. It indicates our organizational performance is not well. Probably because of managerial performance5. Overall, this variance analysis tells us that the favourable profit variance is because market growth is bigger than expected because of ext factors , little to do with org performance 6. Product mix variancea. Chang in avg cm x act unit volb. Is due to actual sales ratio of product is different from expectedWhole story Revenue increase because Actual market size is a lot bigger than expected because of external demand But revenue performance is dragged by share market lower than expected Manager performance evaluation: Cannot hold them responsible for changes in market size outside of their span of control Might look at market shareUse this market info diagnostically, Say the overall strategy is ok, But the reason for lower rev performance is due to managerial actions and decisions It is a routine assessment, wouldnt cause strategy to changeUse this interactively Say the info tell us, the deviation may be due to a poor strategy Trend in poor performance indicate problem with strategy and goals rather than performance, have to rethink strategy We look at info differently

BUDGETING for expenses & PROFIT PLANNINGProfit planning1. Company has some strategies2. Gave some expectations: targets, goals3. Ask us what they should do? a. So we analyse the alternate course of actions b. And the financial impact of itc. Eg. We drop some products because demand not going strong forward, what is the financial effect d. Question do our strategy create value? Enuf value to attract sh and lenders? Do we have enuf cash to fund the strategies4. Make a conclusion on actions that should be taken5. And prepare budget3 wheels of profit planning Cash: sales> ac receivable > opt cash > inventory Profit: sales >opt exp> profit> investment in ass ROE: profit> asset utilization> ROE> Shhs eq It highlights the connections btwn the different financial constructsPlanning and budgeting for different cost centres: difficulties with aspect of planning and budgeting Engineered cost centres: Production We know the OP no can plan for IP no Relationship between OP and IP is engineered Can easily plan for budget Discretionary cost centres RND Harder to plan because There is not a clear and direct relationship btwn OP no and RND exp Harder to plan, need to make discretionary decision on how much should we budget the RND expense for Usually we use the incremental budgeting But we can use the program budgeting to structure budgets around projects than funding a total amount to the department

STRATEGIC CAPITAL INVESTMENTClassification of investment Regulatory investment: due to reg compliance go for lowest cost, most cost effective way Operational investment: Asset replacement, enhance operating efficiency, increase capacity , upgrade Use CAPEX decision model: NPV, IRR, PP, ARR fine provided all relevant data are incuded Strategic investment: Investment in new tech, new mkt, new products that involve change in strategy Eg: acquisition, merger Goggle bought utube for 1.6 bil as a strategic decision to diversify business But just breaking-even so why investment? What was the decision model that they used?Decision models used to analyse investment CAPEX decision model Traditional tools NPV measure time value of money, is a rough estimation of expected future CF in dollars , might not be accurate and objective IRR measure time value of money in % PP time taken to recover investment , used in conjunction with others , easy to use at screening stage ARR- link to our financials Cost-benefit analysis Simulation Sensitivity analysisEvaluating strategic investment CAPEX might not be adequate or suitable because The strategic issue is at the forefront Financial tools show that it doesnt generate positive returns Uncertainty in future cash flow streams Short term benefit hard to quantified and isolate Large outlays, long payback period , benefits that comes in the later part of the CF stream is penalized by the Discounted Cash Flow analysis Doesnt capture other benefits like high quality, shorter lead time, environmental imact because they are hard to quantified Doesnt capture the synergies of the investment that might flow to other parts of the business because it is hard to quantified and show its financial effect Ignores the moving-baseline risk, risk of not investing. DCF presumed that not investing means there is a continuation of cash flow stream. But cannot assume that, because if we dont invest we might fall behind our competitors , so donot invest becomes declining cf So other than financial tools we need to include non-financial tools into our decision making model:1. Alignment of proposal with strategy2. Risk of moving-baseline3. Reputation impact4. Impact on employees (cultural fit), customers and mkt5. Impact on structural cost drivers (scope, scale complexity)a. When virgin add new international line ned to increase scope, scale and complexity6. Capability and ability of managers7. Synergies and integration with other parts of the business8. Quality of the info supporting the proposal9. Feasibility and cost of reversing the decision 10. Sustainability effect(environmental, social, ethical)So types of information to include in our decision making model: 1. Financial information: NPV, IRR, PP, ARRa. Cash flow basedb. Non-cash flow base2. Non-financial informationa. Quantitativei. Non-monetized : quantified on a scale on index not dollar termsii. Monetized: in dollars b. Qualitativei. Judgement, intuition Decision framework1) What are the components of the decision making model ? factors We have 2 components Financial: NPV, IRR, PP, ARR Non-F : Effect on community, effect on environment, synergies & integration with other parts of the business, strategic fit, cultural fit, impact of changes in management, competitive effect (buy skype , google canot buy), employee fit, feasibility and cost of reversing decision, alignment with strategy, reputation impact, impact on structural cost drivers, risk of moving baseline, quality of info 2) Are the components qualitative or quantitative? Financial tools are quantitative Non-F tools can be both quali or quanti: Strategic fit can be quantified by measuring on a scale of 1-5 Or can be qualitative by basing it on judgement 3) How is it accounted for in the evaluation process: At the start: strategic fit which is about judgement Screening process: PP Analysis process: Financial tools that require calculation

Lecture 11: Risk management Type of risk: Strategic, Operational, Financial, Legal and regulatory What each entails and examples >>How to manage these risk: Set conduct barrier and belief system Set internal control Market analysis? >>Potential risk or risk profile: Strategic risk: impediment in achievement of hgh lvl goals aligned with and support mission Mkt-related activitiy: supplier behaviour, customer change preference, availability of substitute products , mkt trends, consumer health concern Competitive dynamics Techno innovation Operational risk: anything that damage the co ability to provide product and services Extent of formalized procedures and protocol employess ability to follow protocol co ability to safeguard asset and info ability to response to crisis cyber security damage due to natural events production process need to comply with strict practices security to prevent contamination impact of changes in key personnel avoid mistake in processes Financial risk: exposure to & potential shortfall in liquidity Financial crisis Increase in input cost due to natural events Potential reduction in CF Risk of acquisition/ foreign investment Foreign exchange risk, hedging Impact of acquisition of leverage and gearing levels Legal and reg: exposure to & ability to comply with applicable and impending law and reg Food and safety law Lending reg Consumer protection Banking and finance reg Foreign invst law Irrigation law Livestock law Export law >>How to manage risk: Set conduct boundaries through code of conducts: what cannot do Set belief system Set internal control, structural safeguard: clear line of hierarchy authority, system safeguard: transaction timely, accurately securely recorded and reported, staff safeguard: enough training, job rotation, special assignment Minimize market-related strategic risk Scan mkt, swot analysis Attend org meeting and networking event wif competitors Minimize operational riskConduck internal system checks