Financial analysis and control final

FINANCIAL ANALYSIS AND CONTROL

TABLE OF CONTENTS

TOPIC

PAGE

NAME

NUMBER

INTRODUCTION
CONTROL AND ANALYSIS CONCEPTS
CONTROL
PRESENT-VERSUS-PAST COMPARISON
ACTUAL-VERSUS-BUDGET COMPARISON
TYPES OF ANALYSIS
COMPARATIVE ANALYSIS
CONSTANT-DOLLAR ANALYSIS
PERFORMANCE ANALYSIS
RATIO ANALYSIS
VARIANCE ANALYSIS
EXCEPTION ANALYSIS
CONCEPTS IN FINANCE
TIME VALUE OF MONEY
RISK AND RETURN
FINANCIAL PLANNING AND CONTROL
BREAK-EVEN ANALYSIS
FINANCIAL FORECASTING
DEBT FINANCING
BOND EVALUATION
CAPITAL BUDGETING TECHNIQUES
PAYBACK METHOD
NET PRESENT VALUE
INTERNAL RATE OF RETURN
THIRD-PARTY FINANCING
PRODUCTIVITY MEASUREMENTS
ACTIVITY-BASED MANAGEMENT
BENCHMARKING
REFERENCES

* Rejaul Islam * FINANCIAL ANALYSIS AND CONTROL*

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INTRODUCTION
Since the 17th century, organizations have used financial and nonfinancial information to
direct managerial decisions. Until the 1950s, financial accounting information was primarily
used to control the work of individuals and production units. However, in the 1950s,
businesses started using this information not only to control work but also to plan the extent
of financing of the enterprises as a whole. Therefore, when financial accounting information
is used for controlling people and financial planning, it is referred to as management
accounting.
Management accounting reports are built around the information needs of managers, who
must define specific objectives of the enterprise. Different institutions have different
objectives, and management accounting focuses on the financial dimensions of how and why
institutional objectives are achieved. Unlike audited financial reports, managerial financial
reports are more subjective and less rigid in form. The form or content may vary and can
include graphs or charts to supplement the statements. Moreover, these reports can
encompass nonfinancial elements such as the size and quality of enrollment, faculty size, the
condition of physical facilities, and the scope of administrative staff.
Nearly all facilities management problems involve alternatives, and resolution of these
problems requires consideration and comparison of the costs of alternatives. What levels of
electric power should be purchased and produced? Should a heating or power plant be
converted to a different type of fuel? Should building cooling systems be converted to a
central chiller plant with a chilled water distribution system? There are alternatives when
replacing building components and equipment such as absorption chillers, compressors,
components of a steam distribution system, roofs, and roof drainage systems. The choice
among alternatives often is not simple; machines and structures generally are part of a
complex plant, and this complexity creates difficulties when determining the effects of
alternatives. Many alternatives embody subsidiary alternatives.
Satisfaction of the engineer's sense of technical perfection is not normally the most
economical alternative; imperfect alternatives are sometimes the most economical.
In most cases, the costs to be compared are not immediate costs but long-term costs. Initial
cost, operating and maintenance costs, life expectancy, and replacement cost all must be
considered.
The time value of money is a factor and should always be considered. A business manager
who is not technically trained must rely on the facilities manager for advice as to the
differences among technical alternatives. Facilities management must translate the

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differences among alternatives into money terms, both for internal decision making and to
justify requests to higher authorities for funds.
This chapter addresses the basic financial principles and methods with which facilities
professionals must be familiar in order to participate competently and effectively in college
and university financial management. As mentioned earlier, managerial accounting involves
planning analysis and control for financial decision making. These topics will be discussed
briefly.

CONTROL AND ANALYSIS CONCEPTS
Control is so closely interlinked with planning that the two are virtually inseparable. Planning
is the process of deciding what needs to be done and anticipating the steps needed to produce
the desired outcome. Control involves implementing the planning decision, comparing actual
results with what was planned, and taking corrective action if there is an unacceptable
deviation. This close relationship is illustrated by the planning and control cycle, which
continues until goals are achieved:
a. Goals are set.
b. Steps to achieve the goals are chosen.
c. Actual performance occurs, either according to plan or with variation.
d. Performance is monitored through feedback mechanisms.
e. Adjustments are made to goals, plans, or actions.
f. Additional feedback is received.
g. Additional adjustment takes place.

CONTROL
To control, it is necessary to have a way of measuring performance and a standard to which
that performance will be compared. The cost accounting system, when properly structured,
provides a means of measuring cost performance. The standards for comparison can take
many forms. The two most common comparisons are present versus past and actual versus
budget.

PRESENT-VERSUS-PAST COMPARISON
Even the most rudimentary accounting systems permit a comparison of present to past costs
for the same time period. If conditions are generally the same and the account breakdown is
sufficiently detailed, this can be an effective control method. Even in the presence of other,

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more sophisticated techniques, a present-versus-past comparison is usually useful. Its
usefulness is enhanced if trend lines are established that depict performance over a series of
time periods.
The chief difficulty with using past performance as a standard is that there is no indication of
what performance should have been. Historical data could represent excellent or poor
performance. Unless past conditions are known, a standard may be adopted that contains
inefficiency and extraordinary costs. Although present-versus-past comparisons should not be
dismissed entirely, they must be used with extreme caution and skepticism. They are most
valuable when used in conjunction with other indicators.

ACTUAL-VERSUS-BUDGET COMPARISON
Comparison of actual costs to budget is perhaps the most important technique available to the
facilities manager. It is generally superior to comparisons against past performance because
of the characteristics of budgets in general and the unique role they play in nonprofit
organizations.
When properly prepared, budgets represent the plan, stated in monetary terms, that has been
formulated to meet the objectives of the organization. As such, they force the manager to
anticipate changes.
In nonprofit organizations, budgets play an even more important role in management control.
In such organizations, control is generally viewed to be more difficult because of the absence
of profit as an objective, as a criterion for appraising alternative courses of action, and as a
measure of performance. This shifts the focus from profits to plans and budgets and makes
the budget the principal means of overall control.
When budgets are used, cost control will be much more effective if the cost accounting
system is designed to be consistent with the budget, and vice versa. Unless the two are stated
in the same terms and structured similarly, there is no way of determining whether spending
occurred according to the budget plan. This does not mean that a budget should be set for
each detail account, but it does mean that there should be accounts in the cost accounting
system that match each line item in the budget so that a direct comparison can be made.

TYPES OF ANALYSIS
There are many different types of analysis that can be performed to get better insight into the
effect of management on the institution's financial performance. The most common ones are


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comparative analysis, constant dollar analysis, performance analysis, ratio analysis, variance
analysis, and exception analysis.

COMPARATIVE ANALYSIS
Comparative analysis involves comparing specific internally stipulated objectives against
those of other similar institutions. However, because of the inconsistency of inter institutional
data the validity of this technique is questionable. Most managers are interested in how their
operations compare with those at other universities, or with the average of those at other
universities, and seek performance measures common to all facilities. For example, the time
required to run 100 ft. of electrical conduit can be measured on an absolute basis. The task
should take the same amount of time anywhere, assuming that workers of equal ability do the
job and similar conditions exist.
However, few absolute measures exist against which actual performance can be compared.
Most measurements are relative to past performance, are in index or ratio form, and are most
meaningfully analyzed using trend lines and charts.
Every two years, APPA: The Association of Higher Education Facilities Officers surveys its
members and publishes the results in its Comparative Costs and Staffing Report for College
and University Facilities. The information reported by each participating institution includes
the following:
a. Full-time equivalent (FTE) student enrollment
b. Total gross square footage of all buildings
c. Gross square footage maintained in facilities budget
d. Ground acreage
e. Administrative cost per gross square foot
f. FTE administrators
g. Engineering cost per gross square foot
h. FTE engineering personnel
i. Maintenance cost per gross square foot
j. FTE maintenance employees
k. Custodial cost per gross square foot
l. FTE custodial personnel
m. Landscape and grounds cost per gross square foot
n. FTE landscape and grounds personnel


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The report presents this information in a format that permits comparisons. Managers can
compare their institution's performance to that of institutions of similar size, type, and
educational purpose.
Other information, although not nearly as comprehensive as APPA's report, is published
periodically in various trade journals. For example, American School & University magazine
annually publishes maintenance and operations cost survey, with costs analyzed as follows:
a. Custodial salaries, stated in dollars per student and per square foot
b. Maintenance salaries, stated in dollars per student and per square foot
c. Heat, other utilities, and other costs, stated in dollars and per square foot
d. Average custodial and maintenance salaries
e. Square feet per custodian
The above data are presented for each of ten regions of the United States, including Alaska
and Hawaii. At best, published indicators can serve only as a guide. Large differences are
often noticeable, even among similar organizations. These wide variations reflect the
differences not only in costs but also in methods of accounting for costs. For this reason,
caution is required in using such comparative data.
A better approach to comparative analysis is benchmarking, which is discussed later in this
chapter.

CONSTANT-DOLLAR ANALYSIS
This analysis is a primary concern for institutions and indicates the impact of inflation on the
institution's budget. These are several sources that can be used for comparison; an example is
the Higher Education Price Index, from which an institution-specific cost index can be
developed.

PERFORMANCE ANALYSIS
This analysis seeks to establish standards other than budgets against which to measure and
compare actual performance. These standards are frequently nonmonetary and are intended to
complement, not replace, budgets. In many cases these standards provide the detail on which
budgets are built.
Performance standards may be generated internally, or they may come from outside sources.
Both are useful. Internal standards usually relate to the budget in some way or to an
individual department's unique goals and objectives. Examples of internal standards are the
following:

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a. A 20-day backlog of work should be maintained at all times.
b. Actual job costs should be within 10 percent of the estimates.
c. Actual labor performance should be from 95 to 105 percent of standard labor.
d. Energy use should not exceed 100,000 Btus per square foot per year.

RATIO ANALYSIS
This constitutes trending ratios of key financial indicators over time to determine their
stability or instability over time. Following are some examples of these ratios:
a. Current asset/current liability
b. Long-term asset/long-term liability
c. Fund balances/debt
d. Fund balances/types of expenditures and mandatory transfer
e. Credit worthiness ratios
f. Return-on-investment ratios

VARIANCE ANALYSIS
Deviation from a standard is known as variance. The standard can be historical data,
comparable data from another university, or any other predetermined yardstick.
For cost control, it is of little use to know only the dollar amount of the variance, especially if
many factors are at work to influence cost. To take effective action, it is necessary to break
down the total difference into its individual elements using variance analysis.
There are basically two types of variance: price and quantity. Several other variances can be
developed for specialized purposes, but each one is ultimately traceable to variations in price,
variations in quantity used, or a combination of the two.
Any cost can be stated in terms of price and quantity, as follows:
Cost = Price x Quantity
If two costs are involved, one can be considered the standard and the other, the actual. The
difference between them represents the variance. From this come the basic definitions of
price and quantity variances:
Price variance VP = the difference between actual price (PA) and standard price (P S)
multiplied by the actual quantity (QA):


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Quantity variance VQ = the difference between actual quantity (Q A) and standard quantity
(QS) multiplied by the standard price (PS):

EXCEPTION ANALYSIS
A cost control system operated on the exception principle is one in which management's
attention is focused on the relatively small number of items for which actual performance is
significantly different from the standard. This principle acknowledges that management time
is a scarce resource that should be applied to problems that have the greatest impact on the
organization. The relatively large number of minor variances from standard are either ignored
or left to become the priority concern of a lower level manager in the responsibility
accounting hierarchy.
Management by exception is implicitly based on "Pareto's Law". Vilfredo Pareto (18481923), an Italian economist and sociologist, first proposed the theory that in any type of
activity, a small percentage of forces will influence a large percentage of results. This is also
known as the 80-20 rule: 80 percent of any result is controlled by 20 percent of that which is
producing the result.
Management by exception focuses on the 20 percent of the deviations from standard that
account for 80 percent of the problems.

CONCEPTS IN FINANCE
Analysis and interpretation of accounting information necessitates basic knowledge of
finance. The key concepts needed for decision making are briefly discussed in this section.

TIME VALUE OF MONEY
Where a choice is made between alternatives that involve different receipts and
disbursements, it is essential that interest be considered. Economy studies in facilities
management generally involve decisions between such alternatives. When a facilities
manager is evaluating alternative solutions to a problem, the dollar values must be made
comparable. This requires computations of interest.
Interest may be defined as money paid for the use of borrowed money. The rate of interest is
the ratio between the interest payable at the end of a period of time, usually a year or less, and
the money owed at the beginning of the period. If $8 interest is paid annually on a debt of
$100, the interest rate is $8/$100, or 8 percent per annum. Simple interest refers to interest
that is paid each year of the loan period. Interest that each year is based on the total amount
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owed at the end of the previous year, an amount that includes the original principal and
accumulated interest, is called compound interest. Compound interest is the general practice
of the business world; simple interest usually applies to loans for periods of a year or less.

RISK AND RETURN
It is impossible to project future economic developments with certainty. Risk is defined as the
probability of the occurrence of an unfavorable outcome. There are two types of risk:
systematic and unsystematic. Systematic risk is variability of outcome owing to causes that
simultaneously affect the general market, such as economic, political, or social changes,
international conflicts, and securities markets. Unsystematic risk is variability of outcome
unique to a firm or an industry, such as labor strikes, management errors, new inventions,
advertising campaigns, shifts in consumer tastes, and new government regulations.
The four major sources of systematic risk are as follows:
a. Operating risk, caused by variations in operating earnings before interest and taxes
(such as fluctuations in ratio of fixed cost to variable cost).
b. Financial risk, caused by variations in earnings per share owing to use of leverage in
the capital structure.
c. Market risk, caused by external elements that affect the economy in general and that
impact earnings.
d. Purchasing power risk, mainly caused by inflation that reduces the purchasing power
of savings or invested wealth.
Return is defined as benefit received from incurring a certain cost. It is intuitively obvious
that a financial venture is attractive only when the benefit is greater than the cost. Rate of
return is defined as follows:

When capital is invested in any financial venture, the rate of return must be high enough to
compensate for systematic and unsystematic risks in addition to the pure interest rate.
Therefore,

Where
rp= Pure interest rate due solely to the use of money, about 2 to 2.25 percent
ri = Interest rate risk, resulting from variations in the present rate

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rb = Business risk associated with an individual firm as a result of the business cycle,
technological change, availability of materials, etc.
rf = Financial risk
rpp = Purchasing power, which accounts for inflation
rt = Tax-related issues
Risk and return are closely tied together; one cannot be calculated without the other. If the
rate of return increases, so will the risk, and vice versa.

FINANCIAL PLANNING AND CONTROL
BREAK-EVEN ANALYSIS
A major task for every manager is to choose financial alternatives. The motivation behind
analyzing various alternatives is to utilize the funds available for getting a particular job done
in the most cost-effective manner. Some typical problems are as follows:
a. Whether to contract certain services, such as elevator maintenance, or to use in-house
crews
b. Whether to buy certain equipment that will make maintenance more productive
c. Whether to generate utilities or buy from a utility company
d. Whether to purchase computers and other equipment or lease from a third party
e. How frequently and in what quantities stock items should be ordered
A technique that can be used in making such decisions is called break-even analysis. One
methodology, which can be illustrated with the last item in the preceding list, is commonly
referred to as the economic order quantity (EOQ).
There are many costs associated with maintaining an inventory, such as carrying costs,
ordering costs, and stock out costs. Carrying costs refer to the cost of capital tie-up in
inventory, storage costs, insurance, depreciation, and obsolescence costs. Ordering costs refer
to the cost of placing an order (including production setup costs, if appropriate), shipping and
handling costs, and loss of quantity discount savings. Stocks out costs include added
expenses that might be incurred because of loss of good will. The idea is to minimize the total
cost as shown below:

Where
TC = Total cost
Q = Quantity to be ordered

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C1 = Annual holding cost per unit
D = Annual demand for the part
Co = Cost of placing an order
To minimize total cost, take the first derivative of TC with respect to Q and put it equal to
zero.

Where Q* is equal to the economic order quantity.

FINANCIAL FORECASTING
One of the important uses of financial ratios is in financial forecasting. The objective is to
determine how changing external factors will affect the financial health of the institution. For
example, most institutional funding is enrollment driven. When enrollment decreases,
campuses that have a higher ratio of fixed operation cost to total cost will be hurt; similarly,
when federal funds for research drop, campuses that have a higher ratio of research revenue
to total revenue will suffer.
The key to financial forecasting is the ability to project factors for a period of five years or
more with a reasonable degree of accuracy. This will determine whether the changes in these
factors are linear, curvilinear, cyclic, or simply a result of temporary fluctuations of
conditions beyond management's control. Statistical methods can provide better insight in
this case. Some of the most common tools are scatter diagrams and regression techniques. For
more information, please refer to John Pringle's Essentials of Managerial Finance.

DEBT FINANCING
Debt financing is becoming a viable method of financing a capital project. There are two
types of debt financing: short-term and long-term. The essential factors in selecting a source
for short-term debt financing are the effective cost of credit, the availability of credit, and the
influence of a particular credit on the availability and cost of other sources. The decision to
finance an asset using short-term or long-term debt is made by hedging principal, which

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means that permanent assets should be financed with long-term debt, and temporary
investments should be financed with short-term debt. Therefore, the most common form of
debt financing encountered by a facilities manager is long-term debt, and the most common
form of long-term debt is bond financing.

BOND EVALUATION
A bond is a long-term promissory note issued by the federal government, a state or local
government, or an individual firm. It usually is issued for a period of more than ten years in
denominations of $1,000. The par value of a bond is the face value appearing on the note to
be redeemed by the bondholder at maturity. The market value of the bond varies with the
market interest rate. When the interest rate increases, the market value of bonds drops below
par, and vice versa. The bond's selling price is quoted as a percentage of par value. For
instance, if a bond is selling at $650, this means the market price is $650, but at maturity the
bondholder will receive $1,000.
The coupon interest rate indicates the percentage of the par value to be paid to the bondholder
on an annual basis. For example, if the coupon interest rate of a bond is 11 percent, it means
the bondholder receives $110 annually, regardless of market interest rates. Bond interest
usually is paid semiannually. Therefore, it can be deduced that when the coupon interest rate
is more than the market interest rate, the market value of the bond will be more than par
value, and vice versa.
Bond rating is a debt quality measurement of a firm based on both subjective and objective
assessments of the relative degree of risk associated with the timely payments required by the
obligation. The role of debt-rating agencies is to assist those responsible for primary debt
issues in setting the price and fixed rate of return. The quality assessment often is expressed
as a number or a letter and is based on a scale that expresses the highest quality to the lowest
quality relative to prior quality assessments of the rater. The analysis is based on a review of
financial ratios and a comprehensive analysis of the issue, including the issuer's industry.
The first formal bond rating was begun by John Moody in 1909. Presently, two other
agencies rate bonds in addition to Moody's: Standard & Poor's and Fitch Investor Services.
Standard & Poor's rating system starts with a AAA rating as the highest assigned, followed
by AA, A, BBB, BB, B, CCC, CC, C, and D. The AAA rating is given to bonds with the least
amount of risk, and the D rating to ones in default. Therefore, AAA bonds normally have the
lowest yield because of the relatively low level of risk associated with them and, of course,

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the opposite is true for D-rated bonds. The other two types of ratings are basically similar to
Standard & Poor's.

CAPITAL BUDGETING TECHNIQUES
Capital budgeting deals with the planning and investment of a fixed asset when the
expenditure and expected return extend beyond one year. Capital budgeting is an important
function of plant management, because today's decisions will have an impact for many years
to come, and reversing or modifying decisions will be costly. Moreover, in most of these
situations the size of the investment requires careful analysis. There are a number of different
techniques to use in comparing various project alternatives. Descriptions of the most common
ones, such as payback method, net present value, internal rate of return, and third-party
financing, follow.

PAYBACK METHOD
This method determines the number of years over which the initial capital outlay will be
recovered. A project is accepted if the payback period is less than or equal to a predetermined
desired period. The advantage of the payback method is its simplicity. It also emphasizes the
early years' cash flow, which is more certain than that of later years. The drawback of the
payback method is that it does not take into account the time value of money. In addition,
revenues beyond payback years are not considered. Despite these serious shortcomings,
however, this method usually is used as a prescreening technique.

NET PRESENT VALUE
Net present value (NPV) is the accumulation of the future contribution of the project profit to
the firm, minus the initial capital outlay. It is important to note that every year's profit is
discounted using the present value technique. The rate of return usually is set by the
institution as the opportunity cost of capital. In formula expression, the NPV is given by:

Where
r = Discount rate
n = Expected useful life of the project

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Rt= Net revenue (income minus expenses) for year t
Io = Initial capital outlay
For a project to be investigated further the NPV must be larger than zero; if it is below zero, it
will be rejected. When various project options are compared, the one with the highest NPV is
the most attractive. This is a much better technique for analyzing capital budgeting options
than the payback method for the reasons mentioned earlier, but there also are some potential
problems associated with NPV.
First, the discount rate has a significant role, not only in providing a go/no-go solution but
also in comparing various investment options, especially if different options have diverse
income streams.
In other words, the method discriminates heavily against options that provide larger revenues
in later years versus first years. This intuitively makes sense, because the returns in the first
years are more certain than returns in later years. To illustrate this, assume two investment
options, A and B, have the same NPV at a discount rate of 10 percent. Option A has a
uniform revenue stream during the project life, whereas Option B has small revenues in the
first year but gradually increases toward the end of the project. If the discount rate is changed
to 12 percent, Option A will be more attractive than B. Conversely, if the discount rate is
dropped to 8 percent, Option B wills be more attractive.
Second, the NPV technique assumes that any cash flow created by the project can be invested
almost instantaneously at the discounted rate. In reality, this is hardly the case. Therefore, the
resulting NPV might be a bit skewed; but even with these shortcomings NPV is preferred to
the payback method in capital budgeting.

INTERNAL RATE OF RETURN
This is a variation of the NPV method in which a discount rate on the project is calculated
using an NPV of zero. If the calculated discount rate is equal to or greater than the
institution's discount rate, the project is accepted; otherwise, it is rejected. If different options
are compared, the project with the highest internal rate of return (IRR) is favored. The IRR is
given by the following formula:

Where

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n = Expected useful life of the project
Rt = Net revenues for year t
Io= Initial capital outlay
IRR = IRR for the project
Although IRR is a better technique than NPV, it is more difficult to calculate the result. That
is why many use the NPV technique.

THIRD-PARTY FINANCING
There are many occasions when lack of funding prevents many desired capital projects from
being accomplished. Since the mid-1980s, third-party financing has become a viable option
for funding certain types of capital outlay projects, mostly in the areas of central utilities and
energy projects.
Third-party financing also has been applied in central plant projects other than or combined
with cogeneration. There have been cases in which a campus has leased its existing chillers
and boilers to a third party and entered into a contract to provide a certain quantity of steam
and chilled water at predetermined costs. The third party in turn has expanded the plant,
adding new chillers and boilers to meet the projected load, recovering its investment through
guaranteed buy-back contracts for unit cost and quantity. In this scenario, the campus has
transferred its responsibility to produce steam, chilled water, and/or electricity to the third
party. The campus does not have to be concerned about financing any equipment upgrades or
labor problems associated with running the central plant; but in losing control of the central
plant, its operational flexibility also is limited.
In such situations, it is paramount that the facilities manager have major input in writing the
contract between the third party and the university.
Third-party financing for energy projects has occurred mostly in the area of installing more
energy-efficient hardware, such as new lamps, variable-frequency drives, or energy
management systems. Independent financing companies as well as equipment vendors have
provided this service. In such a project, the third-party financier performs a preliminary audit.
If the project appears to be financially attractive, the financier will fund the purchase and
installation of the hardware; the savings or cost avoidance resulting from the project will then
be shared between the third party and the host institution.
One of the biggest problems experienced in such projects is determining the savings
attributed to the modification. For instance, if installing an energy management system will

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reduce the heating cost for a building by so many million British thermal units (MMBTU)
from the baseline year, what happens if there is an extremely severe or a mild winter, or if
changes occur in building occupancy?
Sharing the savings between the third party and the host institution, although simple in
theory, can become involved in actual practice.
In summary, third-party financing has offered another potential savings mechanism. It must
be understood that because the third party is assuming the risk and funding the project, it will
want to be compensated for that risk. Generally speaking, third-party financing is less
attractive for nonprofit institutions, as the tax implications usually are moot. However, for
institutions that have limited capital funding for the needed levels, it can be a viable funding
mechanism.

PRODUCTIVITY MEASUREMENTS
Since the 1970s, with the popularity of continuous improvement and quality improvement
practices, management accounting has come under a lot of scrutiny. Many believe that after
World War II, accounting information displayed a distorted picture about many businesses,
and this distorted picture is viewed as one of the causes of declining competitiveness and
profitability in many American enterprises. Traditional cost management systems focus on
controlling cost by means of cost-based budgets, standards, variances, and measurements
established at the departmental level. They do not provide the analytical tools needed to
identify areas where administrative and support processes can be more cost-effective. In
short, traditional management accounting is often not connected to the company's goals and
objectives. It usually proves to be inflexible, emphasizes short-term considerations, and has
an affinity for suboptimal solutions.
Moreover, it fails to eliminate the root cause of inefficiencies and non-value-added activities
in the organizations.
Currently, it is widely recognized that the world for which traditional management
accounting was designed is rapidly disappearing. Today, management accounting is focused
on processes and activities cost and performance measurements for quality attributes such as
customer satisfaction, reliability, cycle time, flexibility, and productivity. Therefore, the key
elements of this approach are continual involvement in management-level activities and an
understanding of the critical success factors in the business-namely, customer markets,
technology, and the nature of services provided. These needs triggered the developments of

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activity-based costing (ABC) in the late 1970s, followed by activity-based management
(ABM). ABC was originally used to determine the cost of products and services. However,
ABM expanded the ABC concept and began to serve as the accounting system for the
continuous improvement of institutions.

ACTIVITY-BASED MANAGEMENT
ABM is based on the assertion that in most organizations, productivity and cost are too
complex to know or control by referring to management accounting reports. Instead,
institutions must track costs in relation to the activities performed. Conventional costing
assumes that products/services cause cost. In contrast, ABM assumes that activities cause
cost, and cost items create the demand for activities. In other words, activities consume
resources, and products/services consume activities. This means the tracing and assigning of
costs to products/services must be decoupled and computed in two stages. In other words,
ABM indicates the not-so-salient difference between usage of resources and spending on
resources. Spending on resources refers to the funds expended on total available capacity,
whereas usage refers to only the portion of that resource utilized. So, if usage of resources is
cut without reducing spending on labor and overhead, there will not be any change in the
bottom line. This concept is particularly important in the current environment, where the
overhead cost for most services consists of an ever-increasing percentage of the total cost.
Thus, the traditional overhead allocation system does not provide the insights needed to
reduce overall cost for productivity improvements.
The ABM approach cuts across different functional areas depending on specific processes.
As shown in figure 1, the approach is two-dimensional, with a process view and a cost
assignment view. The cost assignment view determines the resources consumed by activities
by means of resource drivers. The process view provides information on how the series of
activities is linked to perform a specific goal. The cost drivers consist of factors that
determine the workload and effort that determines the activity. The performance measures
should be derived from the institutional vision and the organization's enduring objectives. An
excellent model, proposed by Robert S. Kaplan and David P. Norton, calls for developing a
"balanced score card" approach. Kaplan assigns the following four dimensions to the
institutional objectives with specific measure:
1. Financial perspective: "If we succeed, how will we look to our stakeholders?"

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2. Customer perspective: "To achieve our vision, how must we look to our customers?"
Internal perspective: "To satisfy our customers, what management processes must we excel
at?"
3. Organizational learning: "To achieve our vision, how must our organization learn and
improve?"

Figure1. Cost Assignment and Process Views
Every activity in the process is a customer of another activity and in turn has its own
customers. In other words, all activities are part of a customer chain and work together to
provide value to the outside customer.
After activities have been defined, the next phase of ABM is to do a value analysis for every
activity. The purpose of this step is to determine whether value is being added in every step,
for which the value is being added, and whether this value is something for which the
customer is willing to pay. In higher education, rather than using a binary "value-added/nonvalue-added" label for every activity, a more appropriate approach is dividing the activities
into four categories: essential, incremental, sustaining, and waste.
a. Essential activities are those that add value for both internal and external customers.
Thus, institutions would like to maximize their efforts and resources for these
activities.
b. Incremental activities provide value only to the supplier, with no stated requirement
from the customer. Institutions need to assess whether such activities are truly
necessary.
c. Sustaining activities are performed in response to internal and external regulations,
institutional policies that add no value to the internal/external customer. Institutions

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must evaluate the basis for the requirements and minimize the level of effort applied
here.
d. Waste activities are performed because of an insufficient or outdated process. These
activities should be eliminated entirely.
It is important to recognize that when using ABM, we are not interested in attaining the same
level of precision used in financial reports. The accuracy level should be reasonable for
decision-making purposes. The core processes in organizations normally fall into three areas:
human processes, information processes, and material processes.
Another valuable tool that can assist in continuous process improvement is benchmarking.
This determines what kind of gap exists between an institution's performance level and that
of other organizations.

BENCHMARKING
There is an old maxim that states, everything is relative, in reality, everything is relative to an
absolute frame of reference. The technique of comparing activities, practices, and procedures
against a frame of reference is benchmarking. Simply put, benchmarking means seeking out
the best procedures and practices in use at other firms‚ even if these firms are an institution's
competitors‚ and developing a strategy for matching them in the future. It provides an
external point of reference to evaluate the quality and cost of activities, and it assists an
organization in identifying opportunities for improvement. Benchmarking attempts to assess
how an organization is doing compared with others. Who is best in the industry, and how can
an institution adopt what they do?
There are four types of benchmarking for an institution.
a. Internal benchmarking. This entails analyzing internal practices within an institution
to identify best practices within the institution and measuring the baselines.
b. Industry benchmarking. In this form of benchmarking, general trends across an
industry are used for comparison purposes (e.g., APPA's Strategic Assessment Model,
National Association of College and University Business Officers' [NACUBO]
Benchmarking Survey for Higher Education).
c. Competitive benchmarking. This involves comparing targeted data with a few selected
peers and competitors.


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d. Best in class. In this, the most comprehensive benchmarking process, multiple
industries are observed to search for new and innovative approaches. The most critical
step in benchmarking is identifying the processes that must be benchmarked.
Managers should not try to benchmark everything but instead should benchmark only core
processes and functions of the highest strategic importance. It should be recognized that
benchmarking is only a means and not an end in itself. As improvement opportunities are
identified, managers must seek the root cause of the issues and reengineer the process to
improve productivity. Because the journey in continuous improvement is a never-ending
process, the task of benchmarking is never complete. The target strived for is always moving
forward.

REFERENCES
a. Pringle, John. Essentials of Managerial Finance. Glenview, Illinois: Scott, Foresman
&
b. Company, 1984.
c. Brimson, James A. Activity-Based Management for Service Organizations,
Government Entities and Nonprofit. New York: Wiley, 1994.
d. Lewis, Ronald J. Activity-Based Models for Cost Management Systems. Westport,
Connecticut: Quorum Books.
e. McFarland, Walter B. Concepts for Management Accounting. New York: National
Association of Accountants.
f. Wiersema, William H. Activity-Based Management: Today's Powerful New Tool for
Controlling Cost and Creating Profits.


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