Performance Evaluation and Analysis
Variance analysis and its limits
You must be able to compute and interpret variances - material, labour, overhead, sales mix and yield - and, crucially, explain their causes and interrelationships. The trap is calculating a variance correctly and then interpreting it in isolation; a favourable material price variance may explain an adverse material usage variance (cheaper, poorer-quality material).
Financial analysis techniques
Know ratio analysis (profitability, liquidity, gearing, efficiency), common-size statements, and trend and index analysis. Understand the limitations of ratio analysis: differing accounting policies, inflation, seasonality, and the absence of non-financial context.
Divisional performance
Distinguish ROI, RI and EVA as divisional measures. Understand why ROI can cause under-investment (managers reject projects below current ROI but above cost of capital), and how RI and EVA mitigate this. Know the treatment of controllable versus uncontrollable items.
Transfer pricing
Understand market-based, cost-based and negotiated transfer prices, and the tension between divisional autonomy and goal congruence. Know the general transfer pricing rule (minimum price = marginal cost plus opportunity cost).
Worked rule of thumb
For ROI versus RI: if a division earns 15% ROI and considers a project returning 12% when the cost of capital is 10%, ROI rejects it (it dilutes the average) but RI accepts it (it exceeds the charge). Use this to argue for RI/EVA where investment is being suppressed.
Exam traps
- Interpreting variances without linking them.
- Comparing ratios across firms with different accounting policies.
- Ignoring non-financial indicators when explaining performance.