Management Accounting and Performance Evaluation: PFA Limited - Essay Example

?Management Accounting and Performance Evaluation- PFA Limited Table of Contents Table of Contents 2 Introduction 3 Facts of the Case 3 Nature of theProblem 4 Management Accounting Control Systems 4 Responsibility Accounting 5 Identification of Controllability 5 Determination of difficulty of financial targets 5 Participation of managers in setting the financial targets 7 Contingency Theory 8 Characteristics of an Effective Performance Measurement 8 Use of Accounting Information in Performance Evaluation 9 Recommendations 10 Conclusion 12 References 13 Introduction This project is an analysis of the management control problems faced by Plastics For All Ltd. In order to fully understand the problems and suggest recommendations to the company, a critical analysis has been provided regarding the management accounting control systems along with its two components- formal planning process and responsibility accounting. Facts of the Case Following are the facts of the case: Shirley Banks has recently joined PFA Ltd as factory manager with a motive to increase the turnover and market share. The factory runs for 24 hours with three eight-hour shifts. The shifts are rotated in such a manner that no one team has to consistently work at night. Currently the factory has a high number of temporary staff and the production is behind the targets. The shipment of orders is always done late. The workers are highly discontent due to the frequent impractical actions by the management regarding the factory management. Recent examples are the decisions to change every shift to twelve hours, cancellation of overtime payments and introduction of weekly performance reports. The high unachievable monthly targets have put undue strain on the workers. Moreover, the general office costs are allocated to each shift manager. The overall effect is that the workers are not motivated enough. The logistics manager is running the local election campaign and in doing so he is using the company’s resources. No one has raised the issue so far. Nature of the Problem The basic nature of the problem lies with the incompetent management control process in the company. This has caused several other problems such as late order delivery, highly de-motivated workers, unachieved targets, unexplained allocation of general office costs to each shift manager and high level of temporary workforce. Management Accounting Control Systems Although the management accounting control systems and management control systems are mostly used interchangeably, the management accounting control is only one aspect of the control mechanism exercised by the management. The primary aim of management control systems is to achieve the organization’s objectives by influencing employee behaviours. There are three different types of control approaches i.e. action controls, results control, personnel and cultural controls (Merchant, 1998 cited in Drury, 2007, p.388). The management accounting control system is related to the results control. It is based on two elements, the one is formal planning process and the second is responsibility accounting. The formal planning process encompasses budgeting process and long-term planning process whereas the responsibility accounting involves the establishment of responsibility centres (Drury, 2007, p.395). Responsibility Accounting The responsibility accounting involves creating responsibility centres to make accountable the individuals for financial results and outcomes. The individuals responsible for responsibility centres are made accountable any deviations from budget targets. Overall, the responsibility accounting involves: Identification of Controllability The items, which can be controlled by managers and those which they cannot control and therefore, should not be held accountable for, should be identified. This is based on controllability principle. The principle states that only those costs can be or should be charged to responsibility area that can be influenced by the manager responsible. This principle is applied by removing the uncontrollable items from the accountability area or estimating the effects of these items in the performance reports. In case of PFA Ltd, the controllable and uncontrollable items do not seem to be segregated and the shift supervisors are being held accountable for all the factors. There is another approach to measure performance i.e. informativeness principle (Balakrishnan, Sivaramakrishnan and Sprinkle, 2008, p.494). A measurement of performance is informative if it gives an idea about the manager’s efforts irrespective of whether the manager has control over it or not. Determination of difficulty of financial targets It is often said that tight budgets motivate maximum performance and adverse variances should be taken positively because if the target budget is achieved with no adverse variance then it may be possible that the targets were too loose to drive best possible performance. However, tight budgets with low probability of achievement hamper the planning. Therefore, setting the target budget tight enough to motivate the performance and likely to be achieved meet both the motivational and planning requirements, and so, is an important part of responsibility accounting. In PFA Ltd, the targets given by the management to the production supervisors were too high to be achievable, which in turn affected the workers’ performance and reduced motivation to perform better. If the company had set targets with high probability of achievement, then it would have provided the supervisors and workers the sense of achievement and self-worth that is likely to benefit the company with their increased levels of commitment. It is also believed that low success probability motivates the managers to resort to distortion in their performance and therefore, is harmful for the company. A study of relationship between the task difficulty and probability of its success showed that the relationship was curvilinear where the highest effort in the task was put at the moderate level of difficulty (Atkinson, 1958 cited in Locke and Latham, 2002, p.705). This reveals that, at a particular level of probability of successful achievement of targets, the manager is going to put maximum effort. Overall, the past empirical research on theory of goal-setting, it was revealed that there was a linear relationship between difficulty of goals or targets, and effort and performance (Locke and Latham, 2002, p.706). This means that difficult targets produced highest levels of performance and efforts. However, it was also found that without the commitment to goal and required ability and knowledge, the performance dropped at higher level of difficulty of goals (Locke, 1996, p.118). The relationships can be seen in figure 1 where up to a certain level of difficulty the performance is increasing while it drops after the difficulty level reaches where the probability of achievement becomes low. Figure 1: Budget Difficulty and Performance Source: (Otley, 1987 cited in Drury, 2007, p.403) Participation of managers in setting the financial targets There are two major approaches to budget setting process i.e. top-down approach and bottom-up approach. In a top-down budget-setting approach, the managers and subordinates do not participate in the budget-setting process and therefore, have no influence on the targets. In bottom-up budget-setting approach, the subordinates participate and influence the targets. The bottom-up approach has many advantages. The subordinates are likely to accept the targets and be committed to them. Moreover, their participation reduces the information asymmetry that results when the standards are imposed by the top management. This information asymmetry occurs because the subordinates are more informed on the relationship between inputs and outputs along with the operating level constraints whereas the top management happens to have a broader view of the business and the knowledge of resource constraints. The information sharing is more likely to result in more effective targets, which can deal with both organizational and operational constraints. The imposed standards by the top management without considering the opinions of the managers can result in dissatisfaction and de-motivation amongst the managers and workforce. The shift supervisors in PFA Ltd were highly de-motivated and dissatisfied by the targets and standards imposed on them by the top management without even considering the operational constraints. The control problem is mainly caused by the top-down approach being following in budget-setting process which increases the information asymmetry between the workforce and top management. Erez, Earley and Hulin (1985) found that participative goal-setting as compared to goal assignment resulted in higher acceptance of goal and performance. Subordinate participation is very important for setting the strategies to accomplish goals (Locke, 1996, p.119). However, it has also been noted that participative management style may not be more effective than other styles if the participative methods are not used carefully (Drury, 2006, p.470). Contingency Theory Contingency theory asserts that the applicability of management control systems is contingent on the particular situational factors in an organization. The situational factors are contingent variables such as the external environment, organizational structure, competitive strategy and production process. This theory has focussed on certain aspects of management accounting control systems like budgeting, performance evaluation from accounting information and aspects of information. The basic assumption underlying this theory is that there is no general strategy that can be applied to every organization. Characteristics of an Effective Performance Measurement An appropriate performance measure has the following characteristics: 1. Provides maximum information regarding the actions or decisions of the responsible manager or individual unit. 2. Aligns the employees’ goals with that of the organization’s. 3. Easy to measure, understand and communicate. Use of Accounting Information in Performance Evaluation The performance evaluation based on accounting information has been identified in three styles: Budget Constrained Style: The performance of the manager is evaluated on his/her ability to achieve short-term targets. If the budgeted costs are lower than the actual costs then the evaluation attracts unfavourable criticism from the superiors. Profit-Conscious Style: Here the performance is evaluated on the basis of overall effectiveness of his/her unit as per the long-term objectives of the organization. For example, reduction in long-term costs or increase in revenues over long-term. The budget information is used in a flexible way. Non-Accounting Style: The budgetary information is less important in evaluating the performance as per this approach. Although, it is still used to infer if the manager has achieved success in the budgeted targets but the most important consideration is the intention of manager to work towards overall long-term interests of the organization (Atrill and McLaney, 1994, p.411). Recommendations Recent practices of budgeting have changed with the incremental improvements and importance placed on forecasting due to fast changing environment. There is also a shift from top-down approach to participative bottom-up approach (CIMA and ICAEW, 2004, p.6). As the contingency theory states that assuming no general theory for all organizations, the management control system of an organization is contingent upon the specific situational factors. Therefore, PFA Ltd needs to adopt the changing approach towards budgeting and management control keeping in view its external environment, organizational structure, competitive strategy and production process. The specific problems as mentioned before can be analyzed in the light of these factors except the external and competitive environment because of unavailability of sufficient data. Therefore, in the light of management control theory and essentials of performance evaluation, following are the probable solutions for PFA Ltd: Late Order Delivery: PFA Ltd needs to adopt a consistent work schedule instead of changing it frequently and disturbing the production process. In order to do this, it can include the shift managers or supervisors and invite suggestions as to how to improve the performance and avoid the delayed order delivery. Instead of working with traditional budgeting process, the company can adopt the balanced scorecard approach, in which the company can set its short-term objectives as well as long-term strategic goals. This can be accompanied by creating small teams of managers and making them responsible for setting their own short-term goals and accountable for their results. As historically, participation in goal setting process has yield positive relationship with the performance, the improvement in performance can be expected. Low Motivation: The problem can be solved by openly communicating with the workforce and managers regarding the financial and operating performance of the company. The information dissemination and two-way communication are important tools in rectifying the problems which the company is facing. The setting of optimal targets can only be achieved if the shift managers and workforce would set the targets themselves and perceive the targets to be achievable rather than blindly assigned by the management. The role of top management remains to watch out for the optimal levels of targets, which should not be too easy to achieve or too high to be difficult. This way they can be motivated from the sense of achievement and self-efficacy. Furthermore, the performance evaluation of each shift manager should not just be based on the short-term accounting information such as weekly in case of PFA Ltd. The short-term evaluation can be left with the managers themselves in the form of self-evaluation and the long-term performance in a profit-conscious style and non-accounting style. Unachieved Targets: PFA Ltd can leave its current practice of top-down approach of target setting and adopt the more participative bottom-up approach. The setting of targets by the managers themselves is likely to help improve their performance. Unexplained Allocation of General Office Costs: The Company can adopt more meaning costing method such as activity-based costing instead of using traditional standard costing. This will help the company to assess which activity is contributing towards high costs in the company and therefore, take measures in controlling them. The benefits of activity-based costing over standard costing includes more control over overhead costs, better management decisions and more relevant cost drivers (Weygandt, Kimmel and Kieso, 2009, p.161). High Level of Temporary Workforce: PFA Ltd can make their temporary workers to be permanent based on their performance within a stipulated time period. It can offer attractive compensation in order to drive them to perform better to get permanent employment with the company. Also, the cancellation of overtime payments can be declared as a temporary resort to cut costs, which should be explained by the company. The issue of logistics manager running the local election campaign should be brought up by Shirley Banks along with the supervisors in front of the managing director of the company. They should explain as to how such expenditure does not add to the betterment of current situation of the company. Conclusion From the recommendations provided on the basis of the management accounting control process and the critical evaluation of its various aspects, it can be said that the management control process is an important part of any decentralized organization because it ensures the accomplishment of the organization’s mission and short-term as well as long-term objectives effectively and efficiently. The sole purpose of management control system is to drive the individuals to work towards the best interests of the organization. Considering this, the factory manager of PFA Ltd should take the recommended steps in order to drive the company towards profitability and value-creation for its investors. References Atrill, P. and McLaney, E., 1994. Management accounting: an active learning approach. United Kingdom: Wiley-Blackwell. Balakrishnan, R., Sivaramakrishnan, K. and Sprinkle, G.B., 2008. Managerial Accounting. USA: John Wiley and Sons. CIMA and ICAEW, 2004. Better Budgeting. [Pdf] Available at: http://www.cimaglobal.com/Documents/ImportedDocuments/betterbudgeting_techrpt_2004.pdf [Accessed 29 February 2012]. Drury, C., 2006. Cost and management accounting: an introduction. 6th ed. United Kingdom: Cengage Learning EMEA. Drury, C., 2007. Management and Cost Accounting. 7th ed. United Kingdom: Cengage Learning EMEA. Erez, M., Early, P.C. and Hulin, C.L., 1985. The Impact of Participation on goal acceptance and performance: A two-step model. Academy of Management Journal, 28 (1), 50-65. [Pdf] Available at: http://ie.technion.ac.il/~merez/papers/erezearley.pdf [Accessed 29 February 2012]. Locke, E.A. and Latham, G.P., 2002. Building a practically useful theory of goal setting and task motivation. American Psychologist, 57, 705-717. [Pdf] Available at: http://www.owlnet.rice.edu/~antonvillado/courses/08c_psyc101002/Research%20Report%204.pdf [Accessed 29 February 2012]. Locke, E.A., 1996. Motivation through conscious goal setting. Applied & Preventive Psychology, 5, 117-124. [Pdf] Available at: http://expand.nu/wp-content/uploads/M%C3%A5ls%C3%A6tning-review.pdf [Accessed 29 February 2012]. Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2009. Managerial Accounting: Tools for Business Decision Making. 5th ed. New Jersey: John Wiley and Sons. Read More