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Managerial FinanceEmerald Article: Measuring the Performance of Production Systems UsingManagement Ratios

Hisham Fadel

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To cite this document: Hisham Fadel, 1976"Measuring the Performance of Production Systems Using Management Ratios", Managerial

Finance, Vol. 2 Iss: 1 pp. 31 - 49

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| 31

Measur ing th e Per fo rm ance o fPro d u c t io n Sys tems Us ingManagement Rat iosby Hisham FadelManagement Centre, University of BradfordProduction systems can be:(1) functional layout-based manufacture(sometimes referred to a s batch production),(2) assem bly lines and manufacturing lines,(3) plant dominated systems,(4) small groups in manufacturing (group technology),(5) small groups in assembly (group assembly),or various combinations of the above.Accountants measure the performance of these systems, broadly speaking, in only oneway. This paper suggests that the performance of different kinds of productionsystems requires the use of different measuring rods. It further suggests that productiondepartments should share in designing their operational systems if they wish to bejudged fairly. The age-old conflict between works managers and accountants isdiscussed here by a management accountant. An additional objective of this paper isto repo rt a study of m ulti-product engineering manufacturing firms in order to developan improved and more detailed framework within which to conduct performancemeasurement. The measurement of performance is a primary objective for all management teams when they consider the way in which control should be effected.The multi-product engineering firm in Britain manufactures a wide and diverserange of products in a market which is difficult to predict and has a continua l degreeof change in prod uct m ix. In such systems the basis of the organisation of productioncentres is functionalism (millers, drillers, borers, g rinders , etc.) and the system ofproduction is best described as a "functional layout-based system" (Figure 1).The second production system listed, alone is mainly applicable to engineeringproducts (automobiles, television sets, refrigerators, etc.) of a multi-product type inwhich the product range is not nearly as wide and diverse as the functional layout-based system, and this is called an assembly-line or flow-line system. The flow-linesystem is usually illustrated as an assembly system (flow-line assemblyFigure 2)but there are also manufacturing lines (Figure 3). Whereas the functional layout-basedsystem is usually based in manufacturing, it is also possible to observe it in assembly.


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1. Similar metal-cutting machines are collected together.2. Skills are brought together and trade training is given within sections.3. The top operator becomes foreman. His qualities of leadership are not in question, since hecarries the authority of superior skill.4. Cost accounting begins with the need to define cost centres. It was quite natural for the sectionsabove to form the basis of cost centre definition.Source: G. A. B . Edwards[1].


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Production Systems Performance \ 3 3

One foreman and one team of workers complete each productive stage and themachines arc used in the same sequence. These two systems of production, functionallayout-based andflow-line(assembly and manufacturing) are those in most commonuse and are generally considered to be labour intensive.A third system of produ ction, again based on flow, is the plant-dominated systemidentified by Edwards[2] and Champion[3] who observed that although there aremany varying degrees of plant domination, there appears to be the common featureof "degree of plant domination" ranging from a fully automated plant to one whichmay employ several teams of people (Figure 4). Such systems are no t relatively labourintensive when compared to functionalism orflow-lines,but are often referred to as

capital intensive by economists.The observations of Edw ards' research team[4], in the late sixties and early seventies,led to the notion that a system should be orderly and systematic but they observedalso that, although some production systemsfor example, those based on the flow-line conceptwere deliberately designed systems and as such were orderly andsystematic, there were others which were much less so. The many different kinds ofproducts made under functionalism (functional layout-based) seemed to be undisciplined, unsystematic and disorderly (a non-system in fact). There were rules andlaws governing some systems which often were clearly evident, but there were eitherno laws or they were continually being contravened in "systems" of the functionaltype. Figure 5 shows some aspects of unsystematic behaviourroutine or spaghettipatterns through which raw materials are processed intofinishedcomponents.Production systems numbered 4 and 5 at the beginning of this paper are applicableto small groups in manufacturing and assembly. During the sixties and seventies workin the field of group technology and cell systems led to the adoption of these newsystems, based on small groups, which replaced the functional (non-systems) atFerranti Ltd., Edinburgh; Platt International, Bolton; Whittaker-Hall and EnglishElectric, Bradford. Furthermore, there were findings by others at Serck Audco andHopkinsons, Huddersfield, where there appeared to be general acceptance by thosefirms of the absence of order and discipline in their earlier functional layout-basedsystems. W ork of comparison by A. T . Fatheldin[5], J. C. Furlonger[6] (roofing felt),

J. Champion[3] (beer, biscuits, etc.) and J. P. Schmitt[7] (glass bottle making), indicated that "system" and "production system" needed to be defined in such a wayas to enable comparison between one kind of production system and another. Problemsof a similar nature have been observed at British Steel and De Beer in Holland.The work of Edwards' team indicated th at the functional layout-based system had"just happen ed" as a result of the way industrial society itself had developed[8]. Theresearch has no t only been directed at finding out how to design a p roduction systemof the small group and cell system kind, but also at developing a fundamental theory,basis, or framework which permitted comparison between one system and another.In this latter regard the work of R.N . Anthony was found by Edwards and Schmitt[7]


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to be most useful, since it provided a means for the work of production system designto be fitted into accountants' work in the field of finance and control. The diagramappertaining to this (Figure 6) is taken from Anthony but has been developed byEdwards and Schmitt to embrace marketing and production.The importance of the small group or cell system of production arises from the factthat it suggests a more detailed and more objective approach to production and theanalysis of the whole problem of management in multi-product engineering firms.


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Production Systems Performance | 3 7

MethodAny framework designed to measure the performance of different kinds of productionsystems has to be based upon an adequate description of each different system andhas to embrace at least its important characteristics, system by system. A basicproblem for research workers wishing to contribute to the development of such aframework is the absence of production system definition and the consequent absenceof statements indicating the primary and secondary characteristics of each kind ofsystem. The writer has attempted to measure system performance, not engage insystem design.It is expected that, through distinguishing between different production systems,the observation of common ratios associated with each different production systemcould be a useful determinant for other researchers seeking to improve productionsystem design.The criterion of ra te of return on investment is well-known. How ever, vital factorswhen attempting to measure return on investment are the definitions of both thereturn and the investment. The concept of the production system implies that thereare inputs, transformation and outputs. The rate of flow from inputs to outputs isclearly the rate of flow of material only through the system. The result of the m anufacturing process of every production system is to add cost or value to the materialflow ing through the system. This added cost results from the operations (worktasks) carried out on the m aterial as itflows.At th e point of completion, the productsare sold or stored for future sale. The revenue of sales is needed to acquire newresources as inputs for the production system. In order to realise its objective everyproduction system has to invest fixed capital in machines, equipment, jigs, fixturesand tools to provide the resources for transformation. A well-trained and loyalpersonnel is another asset within the system. However, changes in the productionsystem's human assets should be taken into account as well as the wages andbonuses[15]. The working capital of the production system is concentrated in theconstituent p arts of produ cts being manufactured. Overheads are incurred to completethe production process. The manufacturing process adds costs. It is hoped it will alsoadd value. Whether it does or not depends on consumers. Figure 7 shows the elementsand characteristics of a production system within the framework of systems theory.

One of the common ratios that has been often re-examined in the past and is stillcommonly in use is, as already mentioned) return on investment. This ratio reflectsnot only the effectiveness of the production system but also the effect of many otherfactors on the firm (Figure 8). These other factors, which also share in achieving areturn on investment for all resources and efforts of the firm, include marketing andfinancial systems. This paper aims at developing the return on investment ratio sothat the ratio deals, as far as possible, with the production system only. It is hopedalso to demonstrate the way in which this ratio may be modified to reflect humanresources. When developing the modified ratio thefluctuationsof market price will belimited by using one of the usual pricing policies such as standard cost-plus. The


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IN P UT S :Raw materialsBought-out itemsRESOURCES:Machines and equipment (fixed capital)Workforce (depreciation of human assets and expenses)Constituent parts of products (working capital)Other overheads (cost of power, maintenance, heating, etc.)BASIC REQUIREMENTS:Market demand (change in quantities and variety) and informationO UT P UT S :Finished products or complete components or set of componentsapplication of this ratio with respect to individual production systems will enableinter-system comparisons to be made. The results of these comparisons may providea useful and reliable yardstick of production system efficiency. Since this ratio willignore the effect of fluctuation in market price, any improvement in the manufacturingprofit will indicate either tha t manufacturing cost has been reduced or tha t fixed,working, and human capital has been worked harder.For the purposes of this research it was of paramount importance that practicaldata be accumulated by an extensive field research within firms having differentproduction systems. The companies visited had to reflect the basic production systemsfound in the multi-product engineering industry, i.e.(a) examples of functional layout-based systems,(b) examples of plant dominated systems,(c) examples of group manufacturing such as Ferranti L td., Platt International,Whittaker-Hall Ltd. and Trantor Ltd.,(d) examples of group assembly such as Friedland Ltd., Philips of Holland,Volvo of Sweden, and again Trantor Ltd.Reference was also made to published information concerning the automobile andhome domestic industries as examples of assembly line systems.The writer acquired the data from several firms, generally from the productionand cost accounting information systems existing in those firms.Some estimated dataare necessary for the calculation of the ratios as it is clear that, for the purpose of thisresearch, the traditional accounting information systems will not be sufficient.


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Using Management Ratiosas a yardstickfor measuring and comparing the performanceof various production systemsA production system is a group of resources allocated in such a way as to produce acomplete component or set of components (Figure 7) or afinishedproduct to meet aspecific demand. The amount of resources allocated will change to suit changes indemand. The resources are:(1) machines,(2) hum an resources (workforce), and(3) constituent parts of products (materials, components, assemblies) and theexpenses of management (control and policy) which can broadly be called theoverheads of the production system.

Figure 9 shows the elements and characteristics of the production system in the firm.Figure 9. The Elements and Characteristics of the Production System in the Firm


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The success of the production system to manufacture the required product orcomponent in the correct order depends on the efficient contro l of the various resources.It is clear that some of the factors affecting the end results of the production systemare controlled by top management (Figure 9the policy and the strategy of the firm).In the preliminary stages of this study, the resources involved in the production systemwill be determined partly by the speed of flow, and partly by the costs incurred inutilising the resources of the production system. "Flow", for the purpose of thisstudy, is the flow of funds relating to the actual physical operation of the productionsystem which, in turn, can be considered to be the flow of raw materials and components from inputs, through transformation, to outputs. Although existing well-usedmanagement ratios are quite adequate for the measurement of material flow and themeasurement of efficiency of the use of resources in a firm in general term s, the w riterbelieves that further refinements are necessary in order to clarify the effects of policyand all other external factors influencing the measurement of the performance of theproduction system. By using a series of refined ratios, developed during this research,it is possible to obtain m ore accurate comparisons of one production system comparedto another. Management ratios, refined or otherwise, can however only provide acertain amount of detail and for further information regarding, for example, thecauses of favourable or unfavourable variances, budgetary control techniques havealso to be utilised. An article to appear in a future issue of this journal will considerthe use of budgetary control in the measurement of the performance of productionsystems.Primary and Secondary RatiosPrimary and secondary ratios that ignore policy effects have been developed by theauthor so that the efficiency of the production system alone can be measured. Hence,the framework shown in Figure 8 is an improved version of the regular return-on-investment rat io themes[16]. This framework has been developed so as to be applicableto any kind of production system and has three primary ratiosoperating profit as apercentage of output, investment turnover, and return on investment.

(1) The ra tio: reflects the efficiency of the production system increating profit during a period of time.

(2) The ra tio : indicates turnover of the production resources in a periodof time relative to output produced. It is clear that the combination of thesetwo ratios produces the third ratio:

The calculations of these ratios over a time series allows the monitoring of theefficiency of the production system. The higher the ratios the more efficient is theproduction system. In order to avoid the problems and biases usually associated with


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the conventional return-on-investment ratio and its constituents, usually called apyramid of ratios, improvements have been made as described below.(1) In the "refined" rat ios , the profit factor refers to operating profit instead of netearnings. Output replaces the customary sales figure found in conventionalratio analysis. The traditional measure of profit is the result of subtractingactual cost of sales from sales revenue to yield net earnings. However, thesales revenue does not reflect the efficiency of the production system and isinfluenced by market factors. Since revenues are not normally influenced bymanufacturing processes, control in manufacturing is essentially cost control.By using the standard cost-plus method in pricing the ou tput of the production

system, any improvement in operating profit indicates that the cost in p roportion to investment or output is being reduced. Standard cost-plus is a pricingmethod which takes into account the variable costmaterials, bought-outcomponents, direct labour costs and other direct overheads which are easilyallocated in the production system. Management policy dictates some percentage as a proportion of this standard cost to cover other indirect overheadsand a mark-up for profit. Therefore, the standard cost-plus method providesthe value of the production system's output. For the purpose of this paper,operating profit means the profit expected from operating the productionsystem. As mentioned before, it is the proportion that has been added to thevariable manufacturing standard cost of the production system for the predicted period of production. But the actual activity levels carried out duringthe manufacturing process will cause some change to value of this proportion.Thereby, the operating profit is derived from the difference between thestandard cost-plus, as projected by managem ent policy, and th e actual cost ofproduction. The operating profit can also be expressed by the followingformulae:

operating profit = standard cost-plus actual costwherestandard cost-plus = (direct material + direct labour + direct overhead)+ indirect overhead + mark-up for profitindirect overhead = Y % x (direct material + direct labour + directoverhead)mark-up for profit = Z % x (direct material + direct labour + directoverhead).If the production system is responsible only for the used quantities resources,the actual cost of these resources should be stated entirely in terms of standardunit prices multiplied by the actual quantities. Operating profit will thereforebe used as a means of measuring performance.Although much work has been done with mathematical programming todevelop a transfer pricing system for commodities which are produced


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internally within a production system, this approach may not prove to be thebest single criterion for measuring operating profit[17]. The use of transferprices is normally reserved for transactions between centres with the samedegree of autonomy, such as different divisions in a divisionalised firm. It iswell known that operation of an optimal transfer price system to govern suchtransactions is subject to certain limitations.(a) It may only be possible to operate it by taking away some of the autonomyof divisions. Therefore an optimal transfer pricing system may result inless decentralisation.(b) Such a system is, of course, only worth considering if the expected benefitsfrom using it outweigh the cost of operating it.(2) The use of the standard cost-plus method ignores all fixed costs. It does, however, account for all direct costs as well as some of the indirect variable overheads. The reason for ignoring the fixed costs and the remainder of the indirectvariable overheads is that these costs are usually only allocated arbitrarily.Furthermore, there is no specific relationship between these costs and theefficiency of the production system operating within a firm.

(3) In spite of the vital importance of human resources to a business, their value iscontinually ignored by the accountant. The value of these resources as adominant asset of the production system is rarely given consideration in therecords. In research currently being undertaken, human resources are considered as an asset. Their value is based on estimated cost of replacement.This includes the costs of recruiting, training and the familiarising of workerswith the production system. The cost of depreciation in terms of expected lifewithin the production system is also calculated. The costs of maintaining anddeveloping the workforce a re not seen only as a current expense.Although Likert[18] and his associates believe that the behavioural conditions surrounding the production systemmotivation, loyalty and groupcohesiondetermine the productive capacity an d should be taken into accountwhen evaluating human resources, there is empirical evidenced[9] that suggeststhat this does not provide a reliable basis upon which accountants can basetheir measurements. The author has indeed found this to be the case.(4) Inflation problem s have been dealt with in this framework by changing thedepreciated book value of fixed assets within the production system toestimated replacement value. All fixed assets are valued at their currentestimated economic value. This is normally the replacement value minus theaccumulated depreciation. The accumulated depreciation is calculated as aproportion of the replacement value based on the life of the assets. Anyobsolete or idle assets are valued at their worth to the o rganisation, a valuationwhich may not appeal equally to accountants and production managers.However, this appro ach is an acceptable way of avoiding the non-existence of


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the replacement value. The cost of revenue expenditures, such as material andbought-out components, labour cost and electricity, are already influenced bythe existing rate of inflation.The principal advantage of the above primary ra tios is the comprehensive treatm entof all the interacting factors within production systems. Secondary ratios deal witheach element of production systems and are listed below along with the elementsthemselves. Each group of ratios reflects elements of the prod uction system, and canbe combined with the primary ratios to give a more comprehensive picture of thewhole system.

(1) InputsEvery production system deals with materialflowfrom one end of a system, as input,to the other end of the system, as output, during which time all operations will beperformed. The inputs to various systems may include one or more of the following:raw m aterial, bought-out com ponents, or semi-finished comp onents, which could bethe output from another production system. To measure the efficiency of the production system it is important to guarantee a regular flow of materials into the system.The following ratio measures the reliability of suppliers. These can be either externalor internal suppliers, i.e. raw material stores or o ther prod uction systems.The value of orders overdue from suppliersThe value of the average daily purchases or the average of the daily output of otherinternal production systems.This ratio helps to determine the responsibility for any delays which occur in theproduction system due to an absence of materials.The quality of the inputs to the production system is measured by the ratio:The value of the orders returned by the production systemThe value of all the orders issued by the production systemTo emphasise the importance of materials in the great majority of industries, thefollowing ratio indicates the material cost as a proportion of the output of theproduction system:The direct material costThe outputAn improving yield of the productivity of materials increases the efficiency of theproduction system by ensuring that more output is achieved from the same quantityof materials. This relationship can be measured by the ratio:The value or the quantity of the output of the production systemThe material cost or the quantities of material

Fo r m ore precisefigures t is necessary to relate the qu antity of ou tput t o the particularmaterials used in the production system.


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(2) Machines, equipment, tools and other production facilitiesAll production facilities should be used effectively. There are two ratios worthexamining h ere. The first is :

This ratio declares the value of production facilities per 100 of output per period oftime. It is possible to apply this same ratio to eachfixedasset on an individual basis.The second ratio deals with capacity utilisation. H owever, since capacity has manyvaried definitions, there are similar variations in the expression of this ratio. Thesevariations also differ according to each different production system. For the morecommonly used p roduc tion system this ratio can be expressed as below.(a) Fun ctional layout systemcapacity utilisation =(b) Flow-line system

capacity utilisation =(c)i. Plant dom inated system (labour intensive)

capacity utilisation =(c)ii. Plant dominated system (machine or capital intensive)

capacity utilisation =(d) Group manufacturing system

capacity utilisation =family of components for which the cell wasdesigned, per period of time

(e) Group assembly systemcapacity utilisation =

(3) Workforce or internal human resourcesThe ratios which could be used to monitor the performance of employees within theproduction system are as follows:


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Employee performance =(per employee)Employee performance =(per cost)These two ra tios indicate the yield per employee or the yield per cost of labour in theproduction system. The higher these ratios the m ore efficient is the use of the internalhuman resources.For a comparative study of various production systems the following ratios are

suggested:This ratio avoids the effect of material cost and expresses all other factors of valueadded in terms of m oney. The impact of the surrounding prod uction system, includingfor instance inflation and economic crises, is similarly avoided because they have beentaken into account in both the num erator and denom inator of the ratio. It is importantto measure the influences of industrial relations and organisational behaviour on theworkforce. In this case, the turnover of employees should be a helpful indicator andcan be expressed thus:

The real significance of this ratio is found in terms of the money saved or expendedfor each per cent reduction or increase in the rate of turnover[20]. Fo r a w ide sensitivemeasure of the state of industrial relations surrounding the production system thefollowing ratio may be useful:

(4) Constituent parts of the productsWork-in-progress consists of most constituent p arts of the products. The importanceof considering all these constituents stems from the amount of funds invested inwork-in-progress and the time needed to achieve throughput. This latter factor ofthroughput time requires careful control since the output of one production systemcan form the input to others. Thus, any deviation in the throughput time in onesystem can have adverse effects on other dependent systems. The work-in-progressviewed as the production system's working cap ital, raises the cash cost for the production system in terms of the rate of interest charged on this working capital. Clearlyin order to minimise this interest charge and to cut cash flow requirements, thethroughput time should be kept as short as possible.


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There arc two ratios which express the relationship between work-in-progress andoutput. The first is:

This ratio expresses the value of work-in-progress as a proportion of the output fora period of time. The lower this ra tio the more efficient is the production system. Thesecond ratio is:

This ratio indicates the throughput time for the production system under consideration . One of the elements of a comparative study of various production systems wouldbe the cost of the cash invested in work-in-progress for the period of throughput time.(5) Market DemandAny production system should respond to changes in market demand. Such changescould be in terms of quantity of existing products or in terms of the product range andvariety. Therefore, it is worthwhile to measure the effects of changes in marketdemand on the production system and to investigate the reaction of the productionsystem to these changes. An approximate ratio which shows the reaction of theproduction system is as follows:Changes in this ratio will express the ability of the production system to respond tochanges in market demand if all other external resourcessuch as electricity, fuel andraw material suppliesand all other external influences, such as labour disputes,remain constant. Furthermore, since the production system can also change in responseto internal factors such as changes in materials, workforce, machine technology andcomponent flow, these factors must also be compensated for. Increased efficiency ofthe production system to meet changes in market demand will be indicated by adecrease in the ra tio . The converse applies to increased inefficiency.(6) OutputsThe value of finished goods or finished components reflects the culmination of theefforts of various production resources within the system. The success of the production system in terms of performance during a period of time can be expressed by thefollowing ratio:

where the maximum will be taken as the historical maximum in the previous periods.


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This ratio could be helpful in indicating the capacity utilisation of all resources in theproduction system.To measure the quality of output, the following ratio may help:The value of finished product or component rejected by inspection per period of

A tendency for this ra tio to rise is a w arning of decrease in efficiency, the reasons forwhich should be investigated in more detail.As a final comment, the writer believes that the number of primary and secondaryratios should be kept to a minimum in order to eliminate confusion when using theratios to measure the efficiency of the production system or when conducting acomparative performance study of various production systems.AcknowledgmentThe author expresses his thanks for helpful comments from L. R. Amey, Professor of Accounting,McGill University; K. G. Lockyer, Professor of Operations Management, University of Bradford;and G. A. B. Edwards, Senior Lecturer in Production Management, University of Bradford.References1. E dwards, G . A. B., "Gro up Technology: A Bridge Between Accountant and Engineer", Manage-ment Accounting, February 1971.

2. Edwards, G. A. B., Variety Compendium, Uni\ersity of Bradford Management Centre, 1975.3. Champion, J., Planning and Control of the Production System in the Process Industries, M.Sc.Thesis, Department of Management Sciences, UMIST, 1973.4. Edwards, G. A. B., "Group TechnologyA Technical Answer to a Social Problem", PersonnelManagement, March 1974.5. Fatheldin, A. T., Family FormationA New Technique as a Basis for Variety Control an d GroupTechnology, M.Sc. Thesis, Department of Management Sciences, UM IST, 1966.6. Furlonger, J. C., Th e Implications of Product Policy upon the Total Management Functions of anOrganisation Manufacturing a Variety of Products in a Process Industry, M.Sc. Thesis, Department of Management Sciences, UMIST, 1969.7. Edwards, G. A. B., and Schm itt, J. P., "ManufacturingNot So Much Technology, Mo re aWay of Life", Personnel Review, Spring 1973.8. Edwards, G. A. B., "Production Management in Transition", Management Education andDevelopment, February 1971.9. The Centre for Interfirm Comp arison, Interfirm Comparison in Depth, 1974.10. Hofstede, G. H., Th e Game of Budget Control, Tavistock, Lond on: 1968.11. Caplan, E. H., Management Accounting and Behavioural Science, Addison-Wesley, Massachusetts, 1971.12. Solomons, D., Divisional Performance: Measurement and Control, Irwin, Homewood, Illinois:1965.13. McNally, G. M., "Profit Centres and Transfer PricesAre They Necessary?", Accounting andBusiness Research, Winter, 1973.14. Samuels, J. M., "Opportunity Costing: An Application of Mathematical Programming", inD . Solomons (ed.) Studies in Cost Analysis, Sweet and Maxwell, London: 1968.15. Brummet, R. L ., Pyle, W. C., and Flam holtz, E. G., "H um an Resource Accounting in Industry ",Personnel Administration, July/August 1969.16. Kline, C. A., Jr., and Hessler, H. L., "The DuPont Chart System for Appraising OperatingPerformance", in W. E. Thomas (ed.) Readings in Cost A ccounting, Budgeting and Control,

Southwestern Publishing Co., 1960.


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17. Abdel-Kalik, A. R., and Lusk, E. J., "Transfer PricingA Synthesis", The Accounting Review,January 1974.18. Likert, R., and Pyle, W . C., "Hum an Resource AccountingA Hum an O rganisational Measure-ment Ap proach", Financial Analysts Journal, January/February 1971.19. Dermer, J., and Siegel, J. P., "The Role of Behavioural Measures in Accounting for HumanResources", The Accounting Review, January 1974.20 . Norstedt, J-P., and A uguren, S., The Saab-ScaniaReport, The Swedish Employe rs' Con federation,Technical Department, Stockholm, 1973.

measuring the

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