To: The CEO of Arkaig Manufacturing (Arkaig)
From: An Accountant
Date: September 20X5
Subject: Performance reporting and management issues at Arkaig
This report evaluates the current performance report used by the board for strategic review. Next, the use of economic value added (EVA™) at Arkaig is illustrated and its use compared to return on capital employed (ROCE). Then, the differences between performance measurement and management at the different levels of the management hierarchy are discussed with reference to Arkaig. Finally, the implications of a value chain analysis for performance management are assessed.
(i) Strategic performance reporting
The current report has a number of strengths and weaknesses. These will be discussed according to whether the report:
– addresses the overall aims of the business;
– contains appropriate information for decision-making; and
– is well-presented.
The primary aim of Arkaig is to maximise shareholder wealth by providing suitable products for its customers. These products should have a number of qualities: be world-class; tailored; use technology innovatively; show improved machine downtime; and reduce energy consumption for customers.
This should be supported by an entrepreneurial culture among the employees.
Overall, the report contains a number of common financial measures but they are only loosely connected to the stated mission. The following problems are noted about how the report measures the achievement of the mission:
1. There is no direct measure of shareholder wealth in the report. The overall measure of performance for shareholders is provided through the absolute profit after tax and ROCE. It usefully benchmarks the net profit margin and ROCE with industry averages. However, these measures are only indirectly linked to value. The suggestion to use EVA™ is, therefore, appropriate for Arkaig.
2. The supporting pillars of the mission are all qualities of the products produced by Arkaig. The report does not measure any of these individually. There is an indirect measure of customer attitude through the revenue growth figure but without competitor comparison or a market share, it is not possible to draw a conclusion about any of the qualities of the products. These elements relating to the products are difficult to measure overall as they are likely to be dependent on each product line individually. For each in turn:
(a) The ‘world class’ nature of the offering could be measured by market share or customer survey responses.
(b) The tailored nature of the products could be measured by the cost of individual design for each installation or customer survey responses.
(c) Technological innovation could be measured through comparison of features with the competition or alternatively, by number of industry awards won.
(d) Machine downtime and energy consumption requires specific testing of each product line.
3. There is no measure of the employee culture although there is a comment that it is being achieved but this lacks evidence.
The report shows the financial performance by sector as well as in total for the business and the provision of some industry averages is useful in benchmarking performance.
For planning purposes, the lack of external information about customers and competitors makes some of the numbers difficult to interpret. For example, there is no indication whether the fall in revenue is due to general economic conditions or specific faults with Arkaig.
For control purposes, there is previous year information given but not sufficient to establish a trend (which requires at least three years of information). There is no indication of whether the business is meeting its budgets through the provision of variances.
In terms of presentation, the report is clear and it avoids overloading the reader with data. It uses terms which would be easily recognisable to those used to reading accounts. It is helpful that a narrative commentary is provided. However, often the commentary does not go beyond restating the figures in the table. It should provide the significant explanations for each of the major changes commented upon. For example, by stating why the ROCE has exceeded the industry average.
The commentary is an appropriate place to handle the less quantitative aspects of performance such as innovation and employee culture but it does not offer anything substantive. For example, it would be helpful to state what mechanisms are in place to emphasise the entrepreneurial culture (such as percentage of employees who own shares and the total proportion of equity owned by staff).
(ii) Economic value added (EVA™)
Workings:

WACC = (55% x 12%) + (45% x 3·8% x (1 – 25%))
           = 7·88%
EVA™ = NOPAT – (WACC x capital employed)
          = 1,321
The business has created $1·32bn of value in the last year. The net operating profit after tax more than covers the cost of the capital used by the business.
The main benefit to EVA™ is its link to the overall corporate objective of maximising shareholder wealth. ROCE gives a much less direct link to shareholder wealth as it is less cash-like and more tied to the accounting assumptions around producing a profit figure.
The basic test of performance is simple since for EVA™ if it is positive, then the business is generating a return above that required by the providers of finance. ROCE requires a target level to be set usually based on benchmarking to the industry sector and the setting of this target return can be somewhat subjective.
EVA™ encourages investment for the future (for example, in advertising and development) by removing such costs from the performance period and treating them like capital expenditure. This will reduce the dysfunctional temptation for management to engage in some short-term decision-making, which can be a problem with the unadjusted capital employed figure from the financial statements which is used in ROCE. This is particularly relevant to Arkaig, where research and development is a significant activity.
EVA™ is consistent with net present value (NPV) as businesses with an increasing present value will increase EVA™. This will aid communication as NPV is a widely used appraisal measure for businesses.
Overall, however, the better link to shareholder wealth creation and the use of EVA™ in a value-based management framework may make this extra complexity worthwhile for a large entity such as Arkaig.
(iii) Performance hierarchy
According to Anthony, there are three tiers to decision-making in an organisation and each one has different needs which impact on the performance information which is required.
The strategic level is the one associated with the higher levels of management (such as the board). Strategic performance is measured over longer periods (3–10 years) since this depends on the achievement of the strategies which will enable the achievement of the overall mission of the business. The information will be externally focused requiring information on competitors and markets against which the company’s performance can be benchmarked. This information will be used mainly for planning rather than controlling. At this level of the hierarchy, forecasts will be prepared and broad targets will be set for the lower levels of management and their performance measured against these targets. Therefore, information will often be heavily aggregated and qualitative in nature (such as customer attitudes). The board report evaluated above is an illustration of this type of information.
At the tactical level, the middle layer of management will be concerned with shorter term and more detailed objectives (possibly over a quarter or year) than the strategic level. The information will be collected on the deployment of the company’s resources and activities on a functional department or business unit level. This information will be used to see that the strategic objectives are being supported by the company’s activities. It will contain information to aid some short-term planning but will focus more on assisting this layer of management to control the operations of the business. Much of the information at this level will be internally generated and will be combined with the targets supplied by the strategic level in order to make decisions. For example, generally, the achievement of budget targets or more specifically, the sales and marketing department might be required to report quarterly on changes in the order book in order that the strategic level can forecast future revenue levels.
The operational level focuses on the day-to-day activities of the business ensuring that specific tasks set by the tactical level are achieved. Therefore, information at this level is detailed and task-specific. It will be prepared on a regular basis (often daily or weekly). It will be aimed to assist management at this level in controlling the business in order to achieve its short-term plans (weekly sales or monthly profit targets). There will be little external information needed at this level as there is very little planning activity being carried out.
(iv) Value chain
The value chain is a model of business integration showing the way that business activities are organised and linked. This model uses activities rather than traditional functional departments (such as finance) to describe the business, emphasising that it is activities which create value and incur costs. The activities are split into two groups: primary ones which the customer interacts with directly and can ‘see’ the value being created and secondary ones which support the primary activities. The business can then identify how value is created and so focus on improving this through its performance measurement system (for example, the board report).
Another important feature of the value chain is the idea of value creation through a chain linking activities to each other. Therefore, there must be a flow of information between the different activities and across departmental boundaries. In performance management terms, this will affect the information systems which will have to ensure good communication across functional boundaries and also, the job descriptions and reporting hierarchies, as these will have to reflect activities rather than being purely contained within functional areas.
This chain will not stop at the organisation’s boundaries as can be seen at Arkaig, where the relationship with suppliers (inbound logistics and procurement) is identified as an area of concern.
A specific area of concern at Arkaig is inbound and outbound logistics where there is an old warehousing and distribution information system. For a business such as Arkaig which aims to use technology innovatively, this could lead to inefficiencies. A state-of-the-art system would be integrated with the production and sales systems and would allow better stock control with fewer errors in picking inventory and reduced obsolescence while improved distribution could lead to faster delivery to customers with reduced costs of transportation.
The concern regarding after-sales service may be due to an inconsistency in having an area which generates a significant amount of revenue but which relates in reality to the failure of reliability of the business’ products. It would be important to identify that customers’ attitude to product reliability is not affected and that they see this service as necessary (maybe by benchmarking failure rates/machine downtime against competitors).
Although the chain shows human resources as a secondary activity, it is recognised as important to achieving the entrepreneurial culture at Arkaig. This culture can be realised through the reward system where employees are rewarded by share ownership or a share option scheme. Its effect can be measured through improved profitability and increased innovation.