Denotes and elaborate on the budgeting process and controls in the public sector

1. Topic 6
Budgeting and budgetary control in
the public sector

2. Topic outlines
• Importance of budgeting
• Approaches to budgeting
• Budgetary process in central and local
governments
• Virement
• Performance evaluation

3. Key concepts and issues for discussion
• Budget
• Budgeting versus planning
• Public sector
• Budgeting is important in all sectors but it is even more
important in public sector organizations (WHY?)
• Different types of budgets in public sector
• Problems of budgeting
• Behavioural aspects of budgeting
• Budgetary control-what is it?. Its role/why is it important?

4. Key concepts and issues for discussion ctd…
• Approaches to budgeting: Incremental budgeting (IB);
Programme Planning and Budgeting System (PPBS); Zero Base
Budgeting (ZBB); Medium Term Expenditure Framework
approach to budgeting
• The relevance of MTEF approach to budgeting
• Why is incremental budgeting approach still preferred despite its
well known weaknesses?
• Examine the budgetary process in Tanzania, both central
government and LG (What are the key steps/stages; what are the
key issues under each stage or what is the importance of each
stage? What is the relevance of MTEF in the budgetary process
and how and when is it linked to budget?)

5. Key concepts and issues for discussion ctd…
• What is virement?under what circumstance is virement
permissible?
• Performance evealuation-meaning? Why and how is it carried
out?
– i.e. explain the meaning of performance evaluation; the philosophy
behind performance evaluation; why performance evaluation, who and
when evaluate performance
– Performance measures/measurements (criteria)-understand meaning
of performance measures/measurements; major categories of
performance measures (criteria), i.e. financial measures and non
financial measures and the types involved; rationale for the
introduction of non financial measures; strengths and limitations of
both, financial and non financial measures

6. Budgeting versus planning
• Planning and then budgeting are essential in any business irrespective
of size and nature if it is to accomplish its aims and objective
• Two separate processes, with differing objectives and requirements
• Planning tends to have a perspective of more than one year while
much of budgeting is concerned with the current and subsequent year
• The two processes are linked, however. Financial planning logically
precedes, and provides the general framework and policies for detailed
budgeting
• i.e. The linking between budgeting and planning is:The Budget is
regarded as a tool for strategic resources allocation according to the
existing plans

7. Budgeting versus planning ctd…
Budgeting (public sector perspective)
• Whereas planning is about deciding on what to do,
how to do it, when to do it etc, budgeting is about
deciding on what is to be collected (from which
sources, how, and how much) and allocating the
collected resources (usually scarce recourses) to the
planned activities to achieve the planned objectives
• A need to ‘allocate’ resources in public sector is
important because resources are always not enough
compare to growing demand

8. Budget defined
Budgets
• The outcome of the budgeting process is the budget
document
• A budget is a financial plan. It summarises, in financial
figures, the activities planned for the forthcoming year by
setting out the costs [expenses] of these activities, and where
the income will come from to pay for the expenses.
• Shows planned income to be generated and expenditure to
be incurred , and capital to be generated to attain a given
objective
• It is prepared and approved prior to defined period of time

9. Budget defined….key features ctd…
• A defined period of time which covers the budget is
one year, i.e. Budgets are prepared on annual basis to
meet specified objectives.
• The annual budget, therefore clearly expresses what is
to be undertaken during the next year and authorizes
the financial resources that will be needed,
• i.e. Once a budget is approved by the Parliament,
Minister for Finance is empowered to collect revenues
from various authorized sources and allocate these to
the spending units

10. Rationale for preparing budgets in public
sector
• It details all the steps to be taken, and therefore can act
as a check on the overall viability of the organisation’s
objectives (mapping role).
• The importance of the budgets in public sector
organizations stems originally from its use in
determining taxation levels or the amounts to be
charged for services [this is the basic purpose of the
budget]
– Planned activities are decided on, and then are translated into
tax or charge requirement OR charge level is first fixed and
activities are then planned under this ceiling

11. Rationale for preparing budgets in public
sector ctd…
• Other purposes include:
– Budget provides the authority to incur
expenditure or levy the charges that have been
agreed.
– Budget provides the basis for controlling income
and expenditure.
– Basis for evaluating performance/ A budget may
provide a benchmark against which actual
performance can be measured

12. Rationale for preparing budgets in public
sector ctd…
• Other purposes of budgets ctd...
– A method of communication/communication device, i.e.
the budget serves as a source of information for everyone
concerned.
– They can be used as a source of motivation to managers
as the budgetary process involve a consultation process/is
participatory in nature
– A means to co-ordinate the activities [because
it is supposed to contain all the information on the
policies, objectives and activities of the
organization/government in one document]

13. Rationale for preparing budgets in public
sector ctd…
• Other purposes of budgets ctd...
- Decision-making. A well-designed budget can be a useful
tool in evaluating the consequences of proposed changes
in actions, since it should be possible to track the effect of
any change throughout the organisation.
- Key policy tool
• The budget is a policy statement declaring the goals and specific
objectives an authority wishes to achieve by means of
the expenditure concerned.

14. Budgeting is even more important in public
sector- WHY?
• Examine why is this the case
– Recall the basic objectives of Public Expenditure
Management (PEM) covered in Topic 4. We said that
these are also the objectives of all budget systems
– Think of any other relevant justification …why is
budgeting very important in public sector
organization
– Consider the nature, definition and motives of
public sector while analysing this issue

15. Types of budgets
• Almost all activities of a public sector entity
can be budgeted.
• In the public sector context, a range of
budgets is prepared to include:
a) Revenue budgets;
b) Capital budgets;
c) Cash budgets;
d) Manpower budgets

16. Types of budgets ctd…
Revenue budgets
• Also known as operating budgets and
recurrent budgets
• List the planned operating expenditure (costs)
and income, for the delivery of all services to
the community.

17. Types of budgets ctd…
• The capital budget -
– Long-term plan regarding investments in facilities, equipment or
other lines of governmental ventures
– The capital budget puts money aside, for planned expenditure on
long-term purchases and big investments such as land, buildings,
motor vehicles, equipment and office furniture that will be a
public /private sector entity’s asset for more than a year -
probably for many years to come.
• A cash budget is a budget or plan of expected cash receipts
and disbursements during the period/ is an estimation of
the cash inflows and outflows for a business over a specific
period of time.

18. Budgeting does have its problems,
including:
Practical/technical/organizational and Behavioural
problems
Practical problems related to:
• Inflation;
• Predicting the volume of activity/unforeseen limiting
factors (e.g. agricultural produces may be affected by
weather);
• Organizational problems;
• Problems of motivation;
• Problems of excessive budget expenditure claims

19. Budgeting problems ctd…
Behavioural problems/perception based problems/dysfunctional problems of budgeting:
Also, budgets do have its disadvantages particularly in perception terms. These are related to aspects of human behaviour
on budgeting; and as such, reflect dysfunctional effects of budgeting, and include:
• Budgets can be seen as pressure devices imposed by management, thus resulting in:
– bad labour relations
– inaccurate record-keeping.
• Departmental conflict arises due to:
– disputes over resource allocation
– departments blaming each other if targets are not attained.
• Lack of goal congruence: It is difficult to reconcile personal/individual and corporate goals.
• Waste may arise as managers adopt the view, "we had better spend it or we will lose it". This is often coupled with
"empire building" in order to enhance the prestige of a department.
• Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs.
• Managers may overestimate costs so that they will not be blamed in the future should they overspend.
DISCUSSION QUESTION:
• Explore in detail problems of budgeting, paying particular attention on the behavoural aspects of budgeting
• Identify/examine the nature of dysfunctional problems which might exist in various structures of Local government
authorities local , describing the possible causes for each problem
• Ascertain measures which can be used to reduce or minimize dysfunction effect on budgeting in public sector
organization/local government authorities

20. Approaches to budgeting in
public sector
• The way in which revenue/operating budget is
prepared in the public sector depends on whether
the emphasis is on the nature of the expenditure
or on the purpose of the expenditure.
• If the emphasis is on the nature of expenditure,
then the approach is termed as line-item
budgeting, whereas if the approach is based on
the purpose the approach is described as
programme budgeting.

21. Approaches to budgeting in public sector
• Literature and practice reveal the
following approaches/budgeting
techniques:
a) Incremental budgeting (line item
budgeting)
b) Programme Planning and Budgeting
System (PPBS)
c) Zero Base Budgeting (ZBB)

22. Incremental budgeting (IB)
• Most organizations operate a system of IB-that is, current
year estimates of income/expenditure are used as the
starting point for determining the budget for the next year.
Mechanics and application of the IB system:
• The previous year’s budget for a department or division is
carried forward for the next annual budget.
• It is adjusted for known factors such as new legislative
requirements, additional resources, service developments,
anticipated price and wage inflation and so on.

23. Incremental budgeting (IB) ctd…
• It is known as incremental budgeting because
the process is mainly concerned with the
incremental (or marginal) adjustments to the
current budgeted allowance.
• It is applicable/suitable/fair in stable
conditions where there are few changes and
where objectives remain unchanged

24. Advantages/strengths of Incremental
Budgeting
• Certain reasons are put forward for using
(continued use) of this system:
• What are these?................ i.e. what justifies
the use or continued use of IB?

25. Criticisms of Incremental Budgeting
•There are arguments which
question the validity of the
IB system:
•What are these?...............

26. A concern!!!
• Despite widely declared deficiencies, most
organizations still operate a system of
‘incremental budgeting’.....why?
• Refer to the assumptions put forward to
support its use, and try to evaluate its
relevance. Are they sufficient enough to justify
its existence today?

27. Programme Planning and Budgeting System (PPBS)
An overview of PPBS
• PPBS and ZBB are described as rational approaches (why?)
• Measurement of output in public sector organisations (non-
profit seeking organizations) such as local and central
governments, hospitals, charities etc is difficult and
sometimes impossible (why?)
• Thus, it is difficult to relate inputs to benefits achieved.
• Consequently, budgeting process frequently just compares
current expenditure with little or no attempts to compare
expenditure against performance achieved, i.e. line item
/incremental budgeting.

28. Programme Planning and Budgeting System (PPBS) ctd…
• In an attempt to address this weakness, PPBS was developed
and introduced.
• The objective of PPBS is to enable decision about resources
allocation to be made with as much knowledge as to their
consequences (output) as possible.
• Where PPBS has been adopted as an approach to budgeting, the
budgetary process should seek to answer the following
questions]:
– What the objectives are;
– Alternative inputs;
– How the inputs combine together into activities;
– How well the inputs help achieve the objective

29. Justification of PPBS
PPBS was introduced because traditional
approach in particular IB systems was
generally lacking in several respects:
• E.g Starting from last year’s budget tends to
encourage the view that existing procedures and
spending patterns are correct, normal, and
inevitable.
• Etc (refer to the fundamental
weaknesses/criticisms of IB)

30. Objections to PPBS
• There are several objections to PPBS and its
suitability for the public sector-where
objectives and outputs are difficult to specify
and even more difficult to measure and
quantify. These objections have led to the
rejection of this technique in most public
sector organizations.
• TASK: Examine in detail the nature of the
objections and criticisms of PPBS

31. ZERO BASE BUDGETING (ZBB)
Definition and nature of ZBB (see Box 1 for the summary)
• Method of budgeting whereby all activities are re-evaluated each
time a budget is formulated. Each functional budget starts with
the assumption that the function does not exist and is at zero cost.
• It involves justifying each item of expenditure (before money is
allocated) in relation to the way it helps to meet objectives and
how the expenditure/spending benefits the organization
• The principle of ZBB is simple: the budget for each
centre/department should be made from a zero base. In that
respect, every item of expenditure has to be justified, and
annually re-justified.
• In this way, inefficient and obsolete expenditure will be eliminated

32. Merits of ZBB
• Since it requires each item of expenditure to
be justified before its inclusion in the budget,
it is easier to identify inefficient, obsolete or
less cost effective operations and other non-
value adding activities

33. Criticisms
•More time consuming
than IB, i.e. It may
become overly
bureaucratic.

34. Introduction and importance of Medium
Term Expenditure Framework (MTEF)
approach to budgeting
• Although in almost all countries government
budgets are prepared on an annual cycle, to
be formulated well they must take into
account events outside the annual cycle, in
particular the macroeconomic realities, the
expected revenues, the longer-term costs of
programs, and government policies.

35. MTEF approach to budgeting ctd…
• In purely annual budgeting, the link between sectoral policies and budget
allocations is often weak. Sector politicians announce policies, but the
budget often fails to provide the necessary resources
• A medium-term outlook (between 3-5 years)is necessary because the time
span of an annual budget is too short for the purpose of adjusting
expenditure priorities and uncertainties become too great over the longer
term
• A medium term perspective to budgeting is increasingly recognized as
crucial to the effective linking of policy, planning and resources.
• The appeal of MTEFs lies in their potential to link the often competing short
term imperatives of macroeconomic stabilization with the medium and
longer term demands on the budget which contribute to improved
policymaking, planning, as well as to the efficiency and effectiveness of
service delivery.

36. MTEF approach to budgeting ctd…
• MTEF involves matching costs with available
resources which take place in the context
of annual budget process.
• The MTEF shifts budgeting process from
“needs” to an “availability of resources
• The concept of MTEF in Tanzania was
introduced in 1997, and started to be in
implementation 1999/2000.

37. Budget preparation in the public sector
• The budget process is actually about the annual budget cycle
events and activities
• Process of budget preparation in the public sector include the
following steps:
– The formulation of guidelines;
– The preparation of estimates for each department;
– The combing of estimates into an overall budget;
– Approval of the overall budget.
• To complete the budget cycle, the following steps/stages/actions
are also included in the process:
– Budget execution;
– Budget monitoring and control

38. Budget preparation in the public sector ctd…
1. Formulation of guidelines
• The budget estimates are formulated in line with detailed macroeconomic forecasts on future growth, inflation and
external sector (import) trends.
• Once the macro-policy and sectoral performance review and resource projections are completed, the government then
formulates goals, objectives and budget priorities which should be achieved in the forthcoming financial year
• The budget frame is also formulated for a longer three-year time period in a document called the Budget Guidelines (BG)
or Medium Term Expenditure Framework (MTEF). This is prepared by a Committee which comprises representatives from
the Ministry of Finance, Planning Commission, Prime Ministers Office, Civil Service Department and Regional
Administration and Local Government. The Budget Guidelines contain:
– an overview of macroeconomic performance and projections
– priority sector MTEFs
– vote expenditure ceilings based on resource availability; and
– procedures for preparation and submission of the draft budget to the Ministry of Finance
2. Scrutiny/review of budget proposals and dialogue; and approval /authorization of the budget
After the Estimates have been reviewed by the sector committees of the Parliament, they have to be tabled to parliament
for debate and authorisation. The major events during Parliamentary debate and authorization of the government are as
follows:-
– Presentation of a Public Speech on macroeconomic performance and projections by the Minister for Finance
– Presentation of the government budget proposals to Parliament by the Minister for Finance through a budget speech
– Parliamentary debates/discussions on sector estimates submitted by each minister responsible
– Parliamentary approval of estimates by passing the Appropriation Bill.
– Parliamentary approval and passing the Finance Bill that empowers the Minister for Finance to raise the money and finance the budget.

39. Budget preparation in the public sector ctd…
3. Budget execution
• Budget execution is an important stage of the budget process as it is at this stage that actual
revenue collections and service delivery takes place.
• Execution of the budget therefore is about the collection and accounting for revenue,
provision of services through the recurrent budget and implementation of development
projects.
• The key documents used during implementation of the budget are Revenue and Expenditure
estimates books, action and cash flow plans and budget memorandum.
• Some of the main activities at this stage include:-
– Release of funds by the Ministry of Finance (MoF)
– Collection and accounting for revenue collections by Tanzania Revenue Authority (TRA) and other
MDAs(MDAs = Ministries, Departments, and Agencies)
– Delivery of services and project implementation by institutions. This involves both government institutions
and Development Partners. Donors are required in some cases to release funds and award of contracts.
– Maintenance of proper Accounts for control and Accountability
– Reporting on budget performance (both financial and physical) and evaluation
– Project inspection and expenditure monitoring

40. Budget preparation in the public sector ctd…
Budget monitoring and control
• Budget monitoring, control and evaluation are necessary for closer supervision of work programmes and
projects. This involves a continuous monitoring of the plans and budget in order to identify achievements
and bottlenecks
• Mechanisms for control and monitoring include:
– Periodic reporting and followup.
– Internal Audit
– External Audit
– Parliamentary control
– Budget Review and Adjustments
– Project inspection
• Recent initiative regarding control and monitoring includes control through Integrated Financial
management System (IFMS).
• The overall control and monitoring of public expenditure is now effected/implemented largely through an
Integrated Financial management System (IFMS). This is a computerized system which links up most of
the government paying stations in Dar es Salaam/Central bank. Therefore most payments are centralized
and controlled. Hardly expenditure or commitment can be incurred without financial provision from IFMS

41. The Local government budgeting and
implementation process in Tanzania/The
budget process in LGAs
• TASK:Examine the budgeting and
implementation process in Local Government
in Tanzania

42. Budgetary control
• Budgetary control is defined as “establishment
of budgets relating the responsibilities of
executives to the requirements of a policy, and
the continuous comparison of actual with
budgeted results either to secure by individual
action the objective of that policy or to provide
basis for its revision”

43. Budgetary control ctd…
The role of budgetary control:
• To determine business policies for the attainment of desired
objectives during a particular period of time. It provides definite
targets of performance and gives the guidance for the execution of
activities and efforts.
• To regulate the activities and efforts of people to ensure that the
actual results conform to the planned results.
• To operate various cost centres and departments with efficiency and
economy.
• To correct the deviations from the established standards, and to
provide a basis for revision of budgets and policies

44. What are virements?
• Virements are movements of budgetary resources
between line ministries, programs, policy areas,
expenditure categories or line items.
• Virements
(a) take place after the budget has been authorized by the
legislature,
(b) do not affect the total level of budgeted expenditure,
(c) should not fundamentally alter the composition of
expenditure appropriated by the legislature, and
(d) are carried out under the executive authority of the
government and do not require legislative authorization.

45. Virements vs reallocation
• By contrast, in-year reallocations of
budgetary appropriations fundamentally alter
the allocation of expenditure appropriated by
the legislature and therefore require its
approval through a supplementary budget

46. What are the purpose of virements?
• Virements are among a number of tools to deal
with the uncertainties that arise during the
course of budget execution and result in the
need to vary the allocation of government
expenditure (see other tools under Note 1).
• Budgeting is inherently uncertain, and
therefore there is often a need to make
adjustments to the appropriations, as approved
by the legislature, during its implementation.

47. Purpose of virements ctd…
• The adjustments may be warranted by:
(i) changing priorities or demands on the
government services;
(ii) expenditure required in response to unforeseen
events;
(iii) the need to reward managers for achieving
savings in their budgets; or
(iv) inaccurate assumptions underlying the original
budget estimates.

48. Purpose of virements ctd…
• Virements provide limited standing authority to
the executive to make adjustments to the
budget to respond to these uncertainties.
• Note 1:There are a number of different ways to
deal with budget uncertainties. These include,
for example, the use of supplementary
appropriations, automatic or open-ended
appropriations, carryovers, contingency
reserves, and more aggregated appropriations

49. Why are virement rules important?
[why are virement limits or restrictions
necessary?]
• It is not uncommon for governments to introduce changes
to the appropriations approved by the legislature – both in
terms of the overall level of expenditure and its
composition.
• Such changes, if carried out transparently and within
accepted limits, can reinforce budget discipline and
expenditure efficiency.
• However, large, unregulated changes to approved budgets
can lead to loss of budget credibility and can undermine
the budget’s relevance as a government’s principal policy
and financial planning instrument.

50. Why are virement rules important? Ctd…
• Regimes for managing these virements differ widely across
countries.
• While a few countries require all changes to the composition of
the budget to be authorized by the legislature, most countries’
legislatures give their executives some standing discretion to
change the composition of the budget during execution.
• These virement restrictions can be in the form of strict
prohibitions, nominal ceilings, or percentage limits on the
amount of budgetary resources the government can move
within or between legislative appropriations without recourse
to a supplementary budget.

51. Why are virement rules important? Ctd…
• The limits to that discretion, the “virement
rules,” are typically set out either in the
organic budget law, its supporting regulations,
or the standing orders of the legislature itself.

52. Virement regimes in OECD countries
• Completely banned in some countries
• Typically not allowed between ministries, but
sometimes are permitted in the case of inter-
ministerial appropriations
• Virements between programs are allowed, but
with restrictions
• Virements between certain economic
categories are often restricted

53. Virement regime in Tanzania

54. Performance evaluation
Performance Evaluation –definition and justification
• Periodic review of operations to ensure objectives are being met.
• “The systematic review and evaluation of job performance as well
as the provision of performance feedback for the employee’s
assigned duties and responsibilities”
• Comparison of attained performance with the standards of
performance with a view of performance management
(organization, process, work, and so on)
• Standards of performance usually mean determined measures in
which the set goals of the organization are attained.

55. Performance evaluation (PE)…meaning,
rationale ctd...
Rationale for performance evaluation/role/why PE?
• Report of success or failure/monitoring objectives.
• Performance management-Usually part of
financial/management control system (see note 1)
• Allows judgement of;
 Profitability
 Allocation of Resources
 Identification of non-performance
• Performance management includes the system of processes,
procedures and resources that help the organization to
optimize performance.

56. Performance evaluation as part of managerial
planning and control process [performance
management] (Note 1)
Managerial process involves setting up control
systems which consist of the following (4) steps:
1. Establishing standards and methods for
measuring performance (i.e. benchmark
against which subsequent performance will
be measured. They are simply criteria of
performance);
2. Measuring the actual performance;

57. Performance management steps ctd…
The measurement of performance against standards
should be done on a forward-looking basis so that
deviations may be detected in advance of their
occurrence and avoided by appropriate actions
3. Determining whether performance matches the
standard;
– It is an important step in the control process which involves
comparing the measured results with the standards already
set. If performance matches the standard, managers may
assume that “everything is under control”.

58. Performance management steps ctd…
4. Taking corrective actions
This step becomes essential if performance falls
short of standards and the analysis indicates
that corrective action is required

59. What is the philosophy behind performance evaluation (process or act)?
The Annual Performance Evaluation Procedure is
designed to improve District services (or to
accomplish overall organization objective) by:
• Setting individual objectives and strategies.
• Assessing the progress of the objectives and
strategies.
• Conducting a comprehensive evaluation of
performance

60. Critical factors for successful performance
evaluation
• Establishment and existence of responsibility
centres is a prerequisite for allocating
resources within the organization and
subsequent performance evaluation
• That is, performance evaluation is practically
impossible in absence of clearly defined
responsibility centres.

61. The concept of responsibility centres
• The term responsibility centre is used to denote any
organization unit that is headed by a responsible
manager
• In fact, a company is a collection of responsibility
centres, represented by a box in the organization chart
• At the highest level are departments or business units
(divisions). And from the standpoint of senior
management and the board of directors, the whole
company is a responsibility center, although the term
is usually used to refer to units within the company.

62. The concept of responsibility centres ctd…
• A responsibility centre exists to accomplish one
or more purposes known as objectives, within
the organization goals and set of strategies lay
down to achieve these goals.
• The objectives of the responsibility centres are to
do their part in implementing these strategies.
• A responsibility centre uses inputs, such as:
physical quantities of material, hours of various
types of labour and variety of services.

63. The concept of responsibility centres ctd…
• It requires working capital, equipment and other assets to
do this work.
• As a result of this work, the responsibility centre produces
outputs such as goods or services (in case of staff units
such as: human resources, engineering, accounting,
administration).
• The goods and services produced by a responsibility centre
may be given either to another responsibility center as
inputs or to the outside world, in which case, they
become outputs of the whole organization and revenues
are earned by selling these outputs.

64. Types of Responsibility Centres
Type Description Examples
Expense/cost center Inputs, or expenses are measured in
monetary terms, but in which outputs are
not measured in monetary terms
 A production center or service
department is an example of cost
center.
Revenue center Output is measured in monetary terms.
Outputs (revenues) are measured in
monetary terms, but no formal attempt is
made to relate inputs (i.e., expenses or
costs) to outputs.
Revenue/sales
Profit center A responsibility centre in which financial
performance is measured in terms of profit
(i.e., the difference between the revenues
and expenses) Inputs are measured in terms
of expenses and outputs are measured in
terms of revenues. Both the elements of
accounting information – cost (input) and
revenues (output) are considered.
 Individual departments of retail stores
and branch offices of banks.
Investment center a responsibility centre in which inputs are
measured in terms of cost/expenses and
outputs are measured in terms of revenues
and in which assets employed are also
measured. investment centres consider not
only costs and revenues but also assets used
in
the division. As a responsibility centre, the
performance of a unit would be measured in
relation
to the revenues / profits and the assets
employed in a division. The essence of
investment centre
analysis is the relationship between the
profits and the assets that are used to
generate those
Subsidiary companies

65. Who and when evaluate “individual” performance
Who?
• Immediate Supervisor
• Higher Management
• Self-Appraisals
• Peers (Co-Workers)
• Evaluation Teams
• Customers
When?
• Evaluations will be completed on a calendar year basis.
• Evaluations report (for individuals) must be submitted to
Human Resources for salary/promotion recommendation

66. Why performance evaluation? (repeated)
• Recognize excellence.
• Provide rational for evaluation decisions.
• Identify performance areas needing
improvement.
• Identify areas of general management
development training.
• Providing appropriate learning and
development opportunities

67. Performance criteria (indicators)
Performance criteria how do we evaluate performance of,
say, a manager or responsibility centre?
• Need more than single criteria
• Single criteria unlikely to capture all factors of interest
regarding performance.
• Both Financial and Non-Financial Measures are
important
• Recent studies suggest that comprehensive
performance measurement system should include both
financial and non financial measures (why?)

68. Financial measures
• ‘Monetary’ measures of performance
• Quantitative indicators of performance
• Financial measures can be divided into 2
categories:
– Those measures of performance expressed in
accounting terms; and
– Those measures of performance expressed in
market terms.

69. Financial measures ctd…
• Accounting measures of performance
– These can be defined either in terms of residual term or
ratio term
– Indicators of performance under residual term may include
net income after taxes, operating profit, residual
income/retained profit etc.
– Examples of accounting measures defined by ratio terms
include return on net assets, return on investment, and
return on equity
• Common measures (relative to market and other
measures ) of performance by most organizations

70. Financial measures ctd…
Strengths and limitations of accounting measures of
performance
Strengths:
• accounting profits can be measured on a timely basis, relatively
precisely and objectively; ideally accounting measures are
conceptually congruent with organizational goals of profit
maximization; are controlled by the managers whose
performances are being evaluated; easily understandable i.e. it
is common known how they will affect and what those
measures represent; inexpensive because most of the firms
have to report financial results to outside users

71. Financial measures ctd…
• Limitations
– Accounting information is very transaction oriented i.e. accounting profits are summary
of the transaction’s effect that took place during the period (most of the changes in
value that are not shown in the transaction cannot be seen in accounting profit)
– Accounting profit is highly determined (and depend on) by the choice of measurement
methods (the accounting process through which profit is reported involves
assumptions, estimates, judgments, non cash items etc)
– Accounting rules (Generally Accepted Accounting Principles-GAAP) require slow
recognition of gains and revenues but quick recognitions of expenses and losses
– Calculations of profit ignore economic values and value changes that accountants feel
that they cannot measure accurately and objectively
– Profit ignores the cost of investments in working capital and only takes into account
the cost of borrowed capital
– Accounting profit ignores the changes in the risk
– Accounting measures focus on the past performance and not in the future
performance

72. Financial measures ctd…
• Market measures of performance
– Based on changes in the market value of the firm or
return to shareholders
– Contain measures that reflect changes in shareholder
return or stock price
• Strengths and weaknesses/problem (??)
– TASK: Guided by relevant literature, examine the
strengths(advantages, potentials) and limitations
(problems, weaknesses) of market measures of
performance.

73. Examples of financial measures
• Net income
• Prices of company’s products (services) compared with
competitors
• Cost and revenue measurements for each responsibility
centre
• Return on investment (ROI)
• Return on sales
• Earning per share
• Direct material and direct labour variances
• Cost per activity level

74. Non financial measures of
performance
• Use of non financial measures of performance is one of
the most important developments of management
accounting in recent periods/over the past two or so
decades
• The development has evolved from criticisms directed at
the obsolescence and irrelevance of management
accounting practices in today’s competitive environment
• [Hint: pay particular attention on the limitations of
financial measures and recent growth of interest on
quality of goods and services and the increasing role of
other qualitative factors in measuring performance]

75. Non financial measures of
performance
• Advanced as a solution to overcome the inadequacies
(limitations) of traditional financial measures
• Recall, limitations of FM in a nut shell: Financial measures
such as costs, revenues and budget variances, are in
general relatively narrow (i.e. expressed only in monetary
value); too aggregate (this is encouraged by the use of
common monetary measures) ;and have a short-term
focus because they have to correspond to the monthly or
annual reporting cycle, as such long-term results are
excluded in the evaluation, hence, inaccurate performance
appraisals

76. Non financial measures ctd…
• For performance evaluation to be procedurally fair, mainstream
literature suggests several fairness criteria:
– Accuracy and completeness of information;
– Control over decisions;
– Avenues to rectify unfair decisions; and
– Long term orientation
• According to these criteria, for performance evaluation to be fair,
employees must perceive that the evaluation is based on complete
and accurate information; should also feel that they have some
degree of control over the evaluation process and be able to appeal
against unfair appraisal; and evaluation process should reflect their
long term rather than their short term interests

77. Non financial measures ctd…
• Financial criteria (measures) such as costs, revenues and budget
variances, are unlikely to meet these fairness criteria [WHY?].
• Because of their link to external reporting and the consequential
need to meet objectivity and regulating requirements, financial
measures are in general relatively narrow, too aggregate and have
a short-term focus
• By contrast non financial performance measures which refer to/is
defined as an indicator or measure of performance of firm or an
individual which cannot be captured in monetary way as financial
measures can be, are more likely to meet the fairness criteria
mentioned previously [how/why is this the case?justification…]

78. Non financial meassures ctd…
Justification for non financial measures (strengths)
• Not tied to the monthly or annual cycles, hence, they are able to
measure effort and results that are extended over a long term
period. Consequently, they are capable of capturing a broader
spectrum of employee performance over a long term horizon
leading to more complete and accurate performance appraisals
(monitoring trends, customer satisfaction….)
• They are broad because they are expressed in a wide variety of
non monetary terms such as customer satisfaction rate and
defect rate, hence, it is easier for supervisors to develop
measures which are tailored specifically to the individualized
circumstances of different subordinates

79. Non financial measures ctd…
– Performance measures, designed specifically to suit the individualized
circumstances of employees are not only more accurate, they are also likely
to be more meaningful and easier for employees to comprehend and relate
to.
– Well chosen non financial measures such as product quality, new product
development and customer satisfaction can provide information about what
is likely to happened in the future, i.e. these measures are drivers and
leading indicators in the future performance (e.g. customer satisfaction
develops in a long term)
• Some social costs and benefits associated to an investment are not
only difficult to quantify, but are also (and only) realizable over
several periods subsequent to the year of investment (use of short
term financial measures may be problematic here)
• Less susceptible to external influence than accounting measures

80. Non financial measures ctd…
Limitations
• Time consuming and expensive (how?)
• No common system between companies to
describe nonfinancial measurements such as
customer satisfaction, hence, it is more difficult
to compare nonfinancial measurements between
firms or inside firms
• Lack of statistical reliability (measures should
always represent what is it created for)

81. Examples of non financial measures
• Customer satisfaction
• Employee satisfaction
• Product or service quality
• Market share
• Number of new products/services
• Number of transactions processed per hour
• Capacity utilization
• Inventory level not to exceed certain amounts
• etc

82. Financial vs Non financial measures/criteria
Financial Non financial
Short-term, i.e. linked to financial
accounting cycle (less than 1 year)
long-term, i.e not linked to financial
accounting cycle
Narrow, i.e. limited to monetary
items/ignore intangibles
Broad (non monetary terms)
Objective Subjective
Linked to financial accounting

83. Examples of Financial Measures of
Performance
• Budgeted outcomes – comparison of budget
to performance
• Cost & Sales.
• Actual vs Budget
• Budget Variances (Material Price, Labour
Efficiency, Variable Overhead Spending, Fixed
Overhead Production).