Financial Analysis and Control

Mohammad Qayoumi

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Published by APPA:
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From APPA Body of Knowledge

APPA: Leadership in Educational Facilities, Alexandria, Virginia, 2009
This BOK is constantly being updated. For the latest version of this chapter, please visit
www.appa.org/BOK .

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Financial Analysis and Control

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 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

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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:
Goals are set.
Steps to achieve the goals are chosen.
Actual performance occurs, either according to plan or with variation.
Performance is monitored through feedback mechanisms.
Adjustments are made to goals, plans, or actions.
Additional feedback is received.
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, 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
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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
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 interinstitutional 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:
Full-time equivalent (FTE) student enrollment
Total gross square footage of all buildings
Gross square footage maintained in facilities budget
Ground acreage
Administrative cost per gross square foot
FTE administrators
Engineering cost per gross square foot
FTE engineering personnel
Maintenance cost per gross square foot
FTE maintenance employees
Custodial cost per gross square foot
FTE custodial personnel
Landscape and grounds cost per gross square foot
FTE landscape and grounds personnel
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 a maintenance and operations cost survey, with costs analyzed as follows:
Custodial salaries, stated in dollars per student and per square foot
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 Custodial salaries, stated in dollars per student and per square foot
Maintenance salaries, stated in dollars per student and per square foot
Heat, other utilities, and other costs, stated in dollars and per square foot
Average custodial and maintenance salaries
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:
A 20-day backlog of work should be maintained at all times.
Actual job costs should be within 10 percent of the estimates.
Actual labor performance should be from 95 to 105 percent of standard labor.
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:
Current asset/current liability
Long-term asset/long-term liability
Fund balances/debt
Fund balances/types of expenditures and mandatory transfer
Credit worthiness ratios
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.
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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 (P A ) and standard price (P S)
multiplied by the actual quantity (Q A ):

Quantity variance V Q = the difference between actual quantity (Q A ) and standard quantity
(QS) multiplied by the standard price (P S):

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 (1848-1923), 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

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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 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:
1. Operating risk, caused by variations in operating earnings before interest and taxes (such as
fluctuations in ratio of fixed cost to variable cost).
2. Financial risk, caused by variations in earnings per share owing to use of leverage in the
capital structure.
3. Market risk, caused by external elements that affect the economy in general and that impact
earnings.
4. 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
rb = Business risk associated with an individual firm as a result of the business cycle,
technological change, availability of materials, etc.

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 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:
Whether to contract certain services, such as elevator maintenance, or to use in-house crews
Whether to buy certain equipment that will make maintenance more productive
Whether to generate utilities or buy from a utility company
Whether to purchase computers and other equipment or lease from a third party
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 stockout 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. Stockout 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
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.

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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 .1

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 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
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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, 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:

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 where
r = Discount rate
n = Expected useful life of the project
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 will 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
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.

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

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Figure 1. 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
whom 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/non-value-added"
label for every activity, a more appropriate approach is dividing the activities into four categories:
essential, incremental, sustaining, and waste.
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. 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. Sustaining activities are
performed in response to internal and external regulations, institutional policies that add no value
to the internal/external customer. Institutions must evaluate the basis for the requirements and
minimize the level of effort applied here.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

Financial Analysis and Control Page 15 Copyright APPA 2009

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.
1. Internal benchmarking. This entails analyzing internal practices within an institution to
identify best practices within the institution and measuring the baselines.
2. 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).
3. Competitive benchmarking. This involves comparing targeted data with a few selected
peers and competitors.
4. 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

Note
1. Pringle, John. Essentials of Managerial Finance. Glenview, Illinois: Scott, Foresman &
Company, 1984.
Additional Resources
Brimson, James A. Activity-Based Management for Service Organizations, Government Entities
and Nonprofit. New York: Wiley, 1994.
Lewis, Ronald J. Activity-Based Models for Cost Management Systems. Westport, Connecticut:
Quorum Books, 1995.
McFarland, Walter B. Concepts for Management Accounting. New York: National Association of
Accountants, 1996.
Nemmer, Erwin E. Basic Managerial Finance. St. Paul, Minnesota: West Publishing Company, 1975.
Qayoumi, Mohammad H. "Using Activity-Based Management as a Vehicle for Managing Change"
Facilities Manager, Vol. 12, 1996, pp. 28-32.
Wiersema, William H. Activity-Based Management: Today's Powerful New Tool for Controlling
Cost and Creating Profits. New York: AMACOM, 1995.

Financial Analysis and Control Page 16 Copyright APPA 2009