Management Accounting and Financial Management (MAF) is all about “unstructured problem solving”. You are often required to get into the shoes of management, identify a problem and solve it. This generally involves 4 steps (I am grateful to Andrew Horsfall from CA Connect, who introduced me to this material):
- Identify the problem – what is not working?
- Find appropriate models to try and understand and solve the problem
- Implement the best models – this can involve calculations
- Decide on a solution based on the evidence collected
When studying MAF, try not to view the discipline as a bunch of models/tools or complex calculations. Rather identify the problems that keep management awake at night and then the usefulness of the tools will become apparent.
SAICA want to develop CA(SA)s that are business leaders – hence the introduction of the Competency Framework and the new discipline of Strategy, Risk Management and Governance (SRMG). Questions in the SAICA exams of course require calculations, but generally only 50% of marks are allocated to these (Point 3 above), with Points 1, 2 and 4 above making up the other 50%. You therefore need to develop your problem solving and communication skills if you want to qualify as a CA(SA).
After lecturing a topic, these PGDA posts, will try and develop these skills, so here we go…
Divisional Performance Evaluation
You start a business and run everything yourself. You keep close to the action, watch how every cent is spent. Customers love you and soon you are hiring others to satisfy demand. Years later, you no longer can be close to every decision. You need to trust those that are managing operations. How will you know if they are doing well or not? How will you measure their performance? How much should you pay them? These are the crisp questions that we explored for the past week in PGDA.
AB Inbev will have divisions based on brands (Budweiser, Corona, Castle) and geography (EMEA = Europe, Middle East and Africa) and so will many of the large Multinationals that are listed on the JSE. It is impossible for one person to take responsibility for every little decision. These are delegated to managers and then their performance is closely monitored. Top management will indeed spend most of their time working within the business, looking at management performance, rather than in the trenches where operating decisions are made.
Profit – this is the simplest measure and it is appropriate the level where the person being evaluated doesn’t make any investment decisions (i.e. manager of an existing store). When evaluating divisional managers, this would normally not be appropriate as they do make investment decisions. If profit was used as their measure, they would be incentivised to take on all profitable projects, even if these earned a return less than WACC. The business would be growing but destroying financial value – hence the need to develop another measure, like ROI.
Return on Investment (ROI) – here you take profit but also include the balance sheet amount that the manager had control over. There are generally 2 ways to calculate profit – (EBIT x 72%) or (Net Profit + (Interest charge x 72%)). You will be comparing this to WACC – hence the need for the amount to be BEFORE interest but after tax. The denominator also needs to be comparable with WACC – hence you include (Equity + Long-term borrowings) or (Total Assets – Accounts payable) – which is the same thing. Brilliant stuff – surely we are sorted now? Not quite. Managers can grow ROI by not taking on projects that would add value – they shrink the business – and get rewarded for it! Hence the need to come up with another measurement, enter…
Residual Income (RI) – counters the shrinkage effect of ROI, by not being a % but rather an absolute number. Take the Profit calculated under ROI and now subtract (WACC x Net Investment (which is the Investment number you also calculated for ROI). Managers that now reject projects with a ROI greater than WACC, would be shooting themselves in the foot. Residual Income encourages managers to grow the business with projects that earn greater than WACC. Are we finished? Not quite. We still are using accounting numbers – which are dictated by IFRS – and they might not be the best for the business in the long-term. Advertising, staff training – these are expensed under IFRS but don’t we want our managers investing in the business? We need a new measure that will adjust for these accounting anomalies, so along comes …
Economic Value Added (EVA) – is the creation of Stern Stewart and involves adjusting the IFRS numbers to encourage better behaviour by managers. Investing in new PPE, Advertising, Training and other desirable actions are not punished as badly as they are under the Residual Income approach. Have we solved all our problems? You have to pay Stern Stewart if you want EVA installed in your organisation – but Singapore and Coca-Cola think it is worth it!
Some keys to remember, no matter what performance measurement tool you use:
- Consistency and Fairness – make sure you measure things the same way when comparing different divisions and that everyone knows how score will be kept.
- Controllability and Autonomy – only measure what the manager can control or influence, otherwise you remove their autonomy and they will feel unfairly treated.
- Goal congruence – the measures you use must align managers to choose what is best for the entire company, not just for them.
- Hiring the right people – by far the most important factor! Hire the right people, and many dysfunctional situations will never arise. Jim Collins speaks about “getting the right people on the bus” – it really is crucial. Zappos, now owned by Amazon, has an incredible hiring process. They offer prospective employees $3000 to walk away from joining the company – they want to make sure you aren’t just after the money! Read about their process here.
- Answer the question “Why?” whenever performance changes – the whole idea of performance evaluation is not just to dish out punishments or rewards – you also want to get a feel for what is happening in the business. What are the key drivers of performance? What has happened? All good managers need more than just good measurement tools; they need a curious mind that digs deeper into the reasons for any movements.
Remember all of these tips for when you start your great SA business one day soon!