Unit 13. Monitoring business performance

Key words: management accounting, quantitative targets, qualitative targets, solvency, budget, sales budget, production budget, current expenditure, capital expenditure, master budget, variance, variance analysis, ratio analysis, liquidity ratios, profitability ratios, net profit margin, return on capital employed (ROCE), activity ratios, asset turnover, stock turnover, debt collection period, aged debtors list

13.1. Accounting for Business Control

Setting business targets

Financial accounts, such as balance sheets and profit and loss accounts, are used by business managers in order to plan and to control the activities of their organisation.

The planning of business activities requires businesses to identify the long-term targets it wants to achieve in the future. These could be to:

• Maximise or increase profit

• Maximise or increase sales revenues

• Increase market share

• Expand into new or overseas markets

• Step up internal growth by increased investment in plant and equipment

• Promote external growth through the acquisition or take-over of other companies

Targets like these, which can be expressed in financial or money terms, are known as quantitative targets.

An organisation may have other targets which are less easy to measure in money terms – for example, to improve reputation of the business, or to increase loyalty among the workforce. Non-profit-making organisations, such as charities, may set targets such as increasing donations, saving more animals from exploitation, housing more homeless people, etc. Targets such as these are known as qualitative, or non-­financial targets. How well an organisation succeeds in meeting these targets is a matter of subjective judgement.

Business plans and targets can usually be found in the chairman’s statement in the annual report and accounts of individual limited companies. The accounts themselves, including the profit and loss statement and balance sheet, represent an organisation’s progress to date in achieving its quantitative targets. The financial accounts of an organisation can, therefore, be used to measure or monitor progress towards business objectives, as well as to set out targets for the future.

Reasons for monitoring business performance

In order to plan and control the running of a business, it is necessary to be able to identify the kinds of information that accounts can give, and how these can be interpreted to show how well a firm is doing.

Accounts can provide a way of monitoring:

Solvency: whether or not a firm has enough assets (both fixed and current) to be able to trade into the future. For example, if a firm is short of cash, it may not be able to meet its debts and be forced to sell off fixed assets, such as machinery and vehicles. Cash flows can be monitored and forecast in order to make provision for periods when cash may be short.

Profitability: profit is one of the most significant measures of business performance. A firm will judge how well it has performed compared to past profit levels and to those of other firms in the industry.

Achievement of targets: for example, has the firm achieved its target of a 10% increase in profits, a 5% growth in its market share, a 20% cut in operating costs, cut bad debts in half, etc.? Financial information can be used to identify areas where an organisation can improve its performance. Actual results can be monitored and action taken if the firm appears to be off-target.

Tax: a business can monitor and prepare for the amount of tax due to be paid to the Inland Revenue and Customs and Excise department.

Financial requirements: a business must monitor loan and credit repayments and make sure they do not fall behind, as this may jeopardise any future requests it makes for loans or credit.

Performance: a business can compare its performance over time and with rival firms in the same industry and other industries.

Accounting information can also be used to identify trends and forecast future performance: in order to make an informed guess at the future performance of a business, it is useful to look at its past performance and see if there are any trends which might be expected to continue into the future. For example, if sales have on average risen by 10% each year, one might reasonably forecast sales to rise at this rate in the future. However, the past is not always the best guide to what might happen in the future. Market conditions are constantly changing. New suppliers entering the market, shortages of raw materials, changing consumer demand, new government policy – all these factors and more can affect the performance of a business. Judgement is, therefore, required.

During the course of each trading period, a business will continually monitor whether or not it is ‘on target’ to achieve its objectives. If the firm is ‘off target’, or under-performing, managers can make changes to the operation of the business in order to move the firm back towards its goals. For example, a firm selling chocolate bars may aim to capture 25% of the market by the end of the year. To do this, it forecasts it must increase sales at 5% each month. If, midway through the year, sales of its chocolate bars are low and are being outstripped by sales of a competitor’s product, the firm may plan a new advertising campaign to raise sales, or may even lower price to boost demand. Plotting actual sales against forecast sales on a graph is a useful way to monitor the achievement of this target.

Similarly, a firm may set a target to increase annual profits by 10% over the previous year. If, at the end of the first quarter, profits are down, it can take action either to boost revenues or cut costs, for example buying materials from a cheaper source of supply.

Using accounting information to assist managers in planning, decision-making, and guiding a business is known as management accounting.

Key components of accounting information

In an efficient organisation, monitoring is continual. To do this financial information must be recorded accurately and be ready available, so that business managers can make decisions and take steps to ensure that their organisation is working towards its targets. Such information will be available to business managers from the following sources:

Forecasts: expectations of future costs, production levels, sales, stocks, input requirements, cash inflows and outflows, and profits

Operating budgets: used to plan the day-to-day use of resources in an organisation. The operating budget will show expenditures and receipts agreed by business managers as required to meet set targets. Budgets will be prepared for all key areas of business activity: output, sales, inputs of labour and materials, overhead expenses, cash inflows and outflows

The master budget: a summary of total expenditure and expected receipts across the entire organisation

Aged creditors reports: lists of suppliers to whom the organisation owes money for goods and services delivered, with details of when each debt is due to be repaid

Aged debtors reports: lists of customers who owe the organisation money, and how long each debt has been outstanding

Balance sheet: showing the assets and liabilities of a business at the end of each trading period

Profit and loss statement: a summary of all the financial transactions undertaken by a business within a trading period. It records total revenue and expenditure, and shows profit or loss.

Cash flow statement: a summary of total cash inflows and outflows at the end of each trading period

Accounting information from the previous years trading against which changes in performance can be judged

Who uses information on business performance?

A variety of people and organisations will wish to use data to monitor business performance:

Business owners will want to see the accounts in order to know how well the firm is doing, how much profit is being made, and how much their investment in the firm is worth.

Employees and Trade Unions may use published account to determine target pay settlements. If the accounts reveal that the company has gained a significant increase in profits, then employees may feel justified in asking for a large increase in their pay.

Potential future investors, including individuals and other organisations, will wish to see accounts in order to judge whether to invest in the company. Accounts allow investors to compare the performance of different companies over time.

Providers of finance, such as banks and building societies, will wish to know the financial health of a business organisation before lending it money.

Competing firms will want to assess the financial strength and efficiency of a rival company by looking at its published accounts.

The Inland Revenue will wish to see accounts to calculate how much tax the firm should pay on any profit. All businesses are required by law to reveal any profit or loss they have made at the end of each financial year for this purpose.

Suppliers of materials to the firm will wish to see accounts before granting it credit, in order to judge if it will be able to pay invoices.

Business managers will use accounting records to control the business. This can be done by setting performance targets and then monitoring financial performance to see if the outcomes match expectations. For example, managers might set a target for profit before tax to rise by 10% over a 12-month period. The actual percentage change in profit each week or month can then be compared to the 10% target. Accounts will provide a picture of the performance of a firm over time.

Business managers can make use of two important techniques to moni­tor the performance of their organisation using financial information. These are:

Variance analysis: this involves examining reasons for differences between business budget plans or forecasts and actual results.

Ratio analysis: this involves comparing key financial figures from the final accounts.

These techniques are considered in detail in the following sections.