Report
To: Board of Iron Chicken (IC)
From: A. Accountant
Date: December 2015
Subject: Performance management issues at IC
Introduction
This report evaluates the accuracy and assumptions used in the calculation of EVA™. It then suggests new KPIs for the current CSFs at IC. Finally it considers the impact of three quality improvement projects on these CSFs and a proposed new information system.
(i) Economic value added (EVA™)
There are a number of errors in the existing calculation of (EVA™). These are described below and then the corrected EVA™ is calculated.
Non-cash expenses are correctly added back to profit as such costs are treated as unacceptable accounting adjustments on a cash-based view. Marketing activities for long-term benefit are correctly added back as they generate future value for the business and so the prior year expenditure is also added in to capital employed. Operating leases should be added back to profit and to capital employed and a suitable additional depreciation charged as these are now treated as assets of the business. Research and development (R&D) expenditure should be treated as for the long-term marketing spending (note that there was no R&D expenditure in the prior year). The tax cost in the calculation should be the amount paid adjusted for lost tax on interest and not the adjusted amount of tax charged in the accounts. The WACC is incorrectly calculated as it should be based on the post-tax cost of debt. The capital employed figure should be based on the year start figure.

WACC = (1/2 x 16%) + (1/2 x 6·8% x (1 – 30%)) = 10·38%
EVA™ = NOPAT – (WACC x Capital employed) = 205
The recalculated economic value added has increased from $181m to $205m which still indicates a positive position for the company as it adds to shareholder wealth.
In addition to the corrections above, the following assumptions in the calculation require comment:
1. There is an implicit assumption that accounting depreciation (included in operating profit) is equivalent to economic depreciation (which should be used for EVA™ calculations). This is questionable generally, although there is no information to allow a more accurate calculation. Also, there is additional marketing spending which will probably have a limited economic life in building the brand. No estimation of this life and the resulting additional economic depreciation has been attempted in the above calculation.
2. It has been assumed that no amortisation needs to be charged on the research and development costs since the product has not yet launched. This is in line with the accounting treatment of such items.
(ii) Key performance indicators for the critical success factors
Greater staff productivity
The current measure of units produced per labour hour does not reflect the skill and effort which goes into producing different units. The products of IC range from complex to simple and so revenue per employee would better reflect the different skill levels involved in production.
Reduction of wastage
The weakness of the existing measure is that it only looks at one cost area of production (power consumption). Stock obsolescence will measure the wastage due to technological change which is present in the complex products produced by IC.
Greater innovation of products
The number of patents filed will reflect greater innovation at IC. Patents will legally protect groups of products. This will represent a stronger measure of innovation than new products launched since the patent gives legal exclusivity.
[Tutor note: There are many possible acceptable answers to this question, e.g.
Greater staff productivity
Actual staff hours as a percentage of standard hours for actual production as this would measure staff efficiency in producing a wide range of products.
Reduction of wastage
Input/output analysis of material which looks at the percentage of material purchased which goes into the final product.
Greater innovation of products
Percentage of income earned from products which did not exist last year. This will measure the ability of IC to develop successful products. (The existing measure would record unsuccessful products as innovation.)]
(iii) Lean manufacturing projects
The three projects link together as improvements to the quality of the manufacturing process at IC. There are common elements to these projects in the elimination of waste and empowerment of employees which will occur in the long term. In the short term, there may be increased costs due to these disruptive changes.
Just-in-time manufacturing (JIT)
JIT seeks to produce on a pull-basis to meet the customers’ demands rather than to produce products for inventory, which then acts as a buffer between production levels and demand. The main impact of JIT is the reduction of inventory which is held. The main enablers for such a system are a need for close links to customers and suppliers in order to predict demand and to quickly supply that demand. In terms of IC’s CSFs, this project will improve productivity as production lines must be made more flexible to meet changes in demand, although it should be noted that there could be a negative impact as constant changes in production lines will require more time to be spent setting up new production runs. It will also help to reduce wastage through losses in inventory as there will be less inventory. It also pushes some of the responsibility for improved quality of components (and reduced wastage) on to suppliers. However, it does not directly impact on product innovation.
The project will not necessarily immediately change any of the existing KPIs as it is about producing the right products at the right time not just more products for any given input and does not impact directly on new product launches.
Use kaizen costing
Kaizen costing aims to reduce current costs of production through continuous improvement. Each period, goals for lower costs are set and then performance monitored against these using variances. At the end of the period, a new lower cost goal is set for the next period. The process also often uses target costing to set the initial planned cost of a product thus incorporating the idea of only producing what the customer values. The purpose is to build into the control of the production process the idea of continuous improvement.
This project has the explicit aim of reducing waste and improving productivity and so is directly linked to the first two CSFs. As a result, it will have an impact on the KPIs which are related to productivity and resource consumption. The project will also require the empowerment of staff to make improvement decisions within their quality circles (teams) and so it may give scope for more innovative thinking. However, this thinking is not aimed at producing new products but at improving the production process, so new product innovation may only be affected indirectly.
Costs of quality and a ‘zero defects’ approach to manufacturing
Costs of quality can be broken down into four parts:
– prevention costs which occur before or during production and aim to prevent the production of defective products;
– appraisal costs which occur after production and aim to check that products meet quality standards;
– internal failure costs which occur when products are identified as defective before delivery to the customer and so are scrapped or reworked; and
– external failure costs which occur when defective products are delivered to the customer.
The ‘zero defects’ approach is also known as ‘total quality management’ (TQM). The TQM philosophy is that it is better to spend money on prevention, which involves challenging all aspects of the production process in order to improve and so avoid failure costs.
This project will affect the CSFs relating to improved productivity and waste by reducing defective products, provided that staff time is not adversely affected by aiming for perfection in production. In terms of the KPIs, it may lead to increased time in production but reduced wastage. It will not have a direct impact on power consumption. Again, this project is unlikely to affect the number of new products launched as it focuses on the production process not product development.
(iv) New information system
The move to a single database for the organisation will integrate the subsystems from different functions (such as production and sales). It will require existing systems to be networked and compatible or else be replaced. It will affect overall decision-making by improving the visibility of each function’s operations to the others and to the strategic decision-makers. This shift is often achieved by using an enterprise resource planning system and a strategic enterprise management system.
The unified database will be critical in achieving the goal of JIT manufacturing as close links between production scheduling and demand forecasts will be required in order to match production runs with demand forecasts/orders. Also, the production schedules will need links to inventory levels in warehousing so that inventory is run down before new production is initiated. As closer communication with suppliers and customers will also be required, some change to existing information systems will be necessary in any case. It may be worthwhile to consider including electronic data interchange (EDI) in the specifications of the new system.
In using kaizen costing, cross-functional communication will be important. The design team will need to communicate with the production team so that the design is more easily streamlined for production. The financial systems will need to be frequently updated for information from the quality circles as improvements are made. This will affect the kaizen cost targets which need to be continually monitored and new targets set regularly. Quality circles often involve groups from across the business and so a common information system will facilitate communications amongst them.
The introduction of TQM will require clearer reporting of quality costs to assist in the on-going motivation of staff, which is often a problem in TQM. Informing the quality teams of the impact that increased prevention costs are having on lowering failure costs will be important in maintaining the push to zero defects. The quality improvements and changes to production processes will need to be communicated across IC’s different sites which the new database can facilitate.
The nature of the data used in the current system is quantitative but with the new projects, there will be a need to communicate qualitative information, for example, relating to the nature of defects or the new production processes put in place. This will require a fundamental change to existing systems which again motivates the change to a new database.