Chapter 12 Performance Appraisal Performance measurement and appraisal

Chapter 12 Performance Appraisal

Performance measurement and appraisal is a central component of a management control system. The focus of performance measurement and appraisal is to ensure the business is following its strategies and that each element or unit is contributing to the overall objectives of the business. Performance appraisal of managers is instrumental in decisions regarding salaries, bonuses, future assignments and career advancement. Good performance measurement promotes goal congruence with organisational objectives and facilitates comparison across different subunits.

Performance appraisal techniques Budgetary control and variance analysis Key internal financial performance indicators Return on investment, Profitability and asset utilisation ratios, Residual income. Inter-firm comparisons or benchmarking performance against other companies regarded as best performers in the sector. Various non-financial performance indicators such as levels of innovation, customer satisfaction and staff morale, all of which affect profitability.

Performance measurement – factors for sucess It must be integrated with the overall strategy of the business. There must be a system of feedback and review. The performance measurement system must be comprehensive. The system must be owned and supported throughout the organisation. Performance measures must be fair and achievable. The system needs to be simple, clear and understandable. CIMA Technical briefing ‘Latest Trends into Corporate Performance Measurement’

The objectives of measuring performance To assess and ensure that managements actions and decisions are in line with strategic objectives. To act as a motivational tool in providing a framework to guide and measure managers decisions. To help in improving decision-making across an organisation by ensuring that decisions are informed and based on key performance indicators. To provide timely, relevant information on areas needing management attention, thus acting as a control mechanism. To enable managers to understand the needs and expectations of the various stakeholders in an organisation.

Performance evaluation requires Clearly defined and articulated strategic objectives which are used in assessing whether a strategy or business performance has achieved its primary goals. Clear frameworks and performance indicators to measure performance, assess strategy, explore threats and weaknesses and ultimately provide information for management to take corrective action. Regular feedback, which ensures that management appreciate the impact of their decisions on the overall strategy of an organisation. It also provides early warning to management where the objectives are not going to be achieved.

Benchmarking ‘Establishment, through data gathering, of targets and comparators, that permit relative levels of performance (and particularly areas of underperformance) to be identified’. Benchmarking as defined by CIMA Official Terminology

Approaches to benchmarking Competitor benchmarking is a process of comparing ones financial performance with that of direct competitors. Process benchmarking where data is exchanged between companies with similar operating and administrative systems, with the objective of learning from one another and improving efficiencies. Strategic benchmarking, which compares businesses that possess similar organisational structures and implement similar business strategies.

Inter-firm comparison is the process of comparing the performance of different companies, subsidiaries and investment centres. Performance is compared by preparing key accounting ratios to assess the businesses that are performing above average and those that are not.

Realistic inter-firm comparison require comparison with Businesses within the same sector, Businesses of similar size, Businesses that employ similar accounting policies.

Ratio analysis Financial performance measures are generally expressed as ratios. Ratios measure the relationship between figures and express that relationship as a percentage or ratio. Ratios are useful in that they provide a means of comparison of actual results with: A budget or desired target. Ratios of previous years in order to detect trends. Ratios of other companies or divisions in a benchmarking and inter-firm comparative appraisal process. Industry norms or indices.

Ratio analysis Profitability Efficiency Liquidity Capital Structure Investment

The Du Pont pyramid

Profitability Efficiency Liquidity t ns i a s ag ale s Gross profit margin Net profit margin Expenses to sales l ta i ap d c st oye n ai pl g a em Return on capital employed Return on owners equity Capital Structure

Gross profit margin Gross Profit x 100 Sales This indicates the margin of profit between sales and cost of sales.

A fluctuating gross profit percentage can be caused by Reduction Increase Reduction in selling price. Increase in the cost price of Reduction in cost price of stock purchases. Changes in the product sales mix with the business selling a higher proportion of goods with a lower gross profit with a higher gross profit margin. Theft of cash or stock. Waste.

Operating profit margin Operating Profit x 100 Sales This shows the amount of profit after all expenses are deducted.

A fluctuating operating profit margin can be caused by: Reduction Increase Decrease in gross profit Increase in gross profit margin. Increase in the expenses Decrease in the expenses to sales percentage.

Expenses to sales Expenses x 100 Sales This shows the percentage of sales needing to cover expenses. This ratio assesses the ability of management in controlling expenses of the business.

Breakdown of expenses to sales

Breakdown of expenses to total costs

Return on capital employed (ROCE) Usually net profit before interest and tax Net Profit x 100 Capital employed share capital + reserves + Loans This shows the ratio of net profit to the investment in the business.

Return on owners equity (ROOE) Can be before or after interest and tax Net Profit x 100 Shareholders funds Should only relate to ordinary shareholders This ratio assesses the return (profit) for the ordinary (equity) shareholders alone.

Performance guide Percentage return < 5 per cent Between 5 and 10 per cent Between 10 and 15 per cent Comment Poor Fair Good Greater than 15 per cent Excellent

Profitability Efficiency Liquidity Fixed asset turnover Total asset turnover Stock Turnover Stock days Debtors days Creditors days Capital Structure

Fixed asset turnover Sales _ Fixed Assets This shows the number of times that the fixed assets are turned over in the period. A high rate of return indicates that a business is operating efficiently and is making the best possible use of assets. A low rate suggests inefficient use of assets.

Total asset turnover Sales _ Total assets This shows the number of times that the total net assets are turned over in the period. A high rate of return indicates that a business is operating efficiently and is making the best possible use of assets. A low rate suggests inefficient use of assets.

Stock turnover Cost of sales Average stock Stock turnover is the average number of times per year that the whole value of stock is purchased and resold. The quicker stock is sold the quicker profit will be made on that item. A low rate of turnover shows that old stock is being left on the shelves.

Stock days Stock can also be measured by examining the number of days on average that stock is held. Average stock Cost of sales x 365

Debtors days Trade Debtors x 365 Credit Sales Indicates how quickly debtors pay. This ratio can be expressed as the number of days credit taken by debtors.

Creditors days Trade Creditors x 365 Credit Purchases Indicates how long before creditors are paid. This ratio can be expressed as the number of days credit taken before payment.

Return on capital employed (ROCE) Note: the combination of net profit margin and the asset turnover gives the return on capital employed. Profit Margin Sales Capital Employed x x Asset Turnover Net Profit Sales x 100 = Net Profit x 100 Capital Employed

Profitability Efficiency Liquidity Capital Structure Current ratio Quick Ratio

Current ratio Current Assets Current Liabilities This is a measure of the short term solvency of a business.

Current ratios – sector norms Industry Type Manufacturing Wholesalers Retail/Supermarkets Hotels, restaurants, fast foods Current Ratio 2. 5 – 4. 5 : 1 2: 1 0. 8 : 1 0. 4 : 1

Acid-test ratio Current Assets - Stock Current Liabilities Also know ability of a liabilities liquidation assets. as quick business without of stock ratio. Indicates the to pay off short term resorting to the or the sale of fixed

Profitability Efficiency Liquidity Capital Structure Gearing Interest cover

Capital structure measures the funding mix of a business.

Financing Through debt Through equity Interest must be paid on the debt Dividends will be paid to shareholders Interest is tax deductible Dividends are not tax deductible Debt generally cheaper Equity requires higher returns to compensate for risk Debt is risky because interest must be paid Dividends are at discretion of management and may be deferred Loan must be repaid Equity does not require repayment

Gearing Preference shares and long term loans All shareholders funds and long term loans This is the ratio of fixed interest debt and capital to ordinary share capital.

Gearing The higher the ratio of debt to equity, the more dependent the organisation is upon borrowed funds, and the greater the risk that it will be unable to meet interest payments on these funds as they fall due. Low gearing = where debt is less than capital & reserves. Neutral gearing = debt = capital & reserves. High gearing = debt is greater than capital & reserves. < 100% = 100% > 100%

Interest cover Profit before interest Interest payable The ability of a company to meets interest commitments, measured by expressing the profit before interest as a multiple of the interest paid and payable.

Key operating ratios Hospitality Sector

Key operating ratios Hospitality Sector

Key operating ratios Hospitality Sector

Key operating ratios Hospitality Sector

Key operating ratios Hospitality Sector

Key operating ratios Retail Sector

Key operating ratios Retail Sector

Setting the context The age of the business The size of the business The economic and political environment Industry Trends

Company performance – number of years Have sales increased or decreased and by what percentage? Has operating profit increased or decreased and by what percentage? Has loan interest increased or decreased and by what percentage? Check the long-term loans in the balance sheet to see if they have increased/decreased. Compare profit after tax to see if it has increased or decreased. Calculate percentage increase/decrease in fixed assets. If assets have been increased, has this been financed through increased loans or issued share capital? Check to see if the business has cash or an overdraft, and is this increasing or decreasing? Check current assets and liabilities for any major increases. Check the percentage increase/ decrease in long-term loans.

Company comparison Check both businesses are in the same industry/sector Compare the size of each business. This is normally done, by comparing the total asset levels in the balance sheet (fixed assets + current assets- current liabilities). Compare sales and profit levels. Compare financing. For example is one company highly geared and the other low geared? Compare cash balances/overdraft levels.