Chapter 24: Performance Measurement

What is the purpose of Performance Measures?

• To motivate managers to exert a high level of effort to achieve the goals set by top management

• To provide the incentive for managers, acting autonomously, to make decisions consistent with the goals set by top management

• To fairly reward managers for their effort, skill, and the effectiveness of their decision-making

What is a “good” Performance Measure?

• Those that are sensitive to or change significantly with the manager’s performance

• They do not change much with changes in factors that are beyond the manager’s control

What is the best motivators of effort?

Moderately difficult, but attainable, goals

What are three common measures of economic performance?

1. Return on Investment

2. Residual Income

3. Economic Value Added

What is Return on Investment (ROI)?

An accounting measure of income divided by an accounting measure of investment

What is the formula for ROI?

Accounting Income/Investment

Why is ROI a popular metric?

• Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage

• May be compared to other ROIs both inside and outside the firm

What can the ROI formula be further broken down into?

Income/Sales Revenue * Sales Revenue/Invested Capital

What are the factors underlying Income/Sales Revenue?

Return on Sales (% of each sales dollar that remains as profit after all expenses are covered)

What are the factors underlying Sales Revenue/Invested Capital?

Investment Turnover (# of sales dollars generated by each dollar of invested capital)

What are different options to improving a division’s ROI?

• Option 1: Increase the sales price or cut expenses

• Option 2: Increase the sales price or decrease our total investment required for sales

What is included as the Asset Basis in ROI computation?

Only assets controllable by the units (generally long-lived assets)

What are the different basis options for value of assets?

• Gross Book Value

• Net Book Value

• Current Cost

• Liquidation Value

What is Gross Book Value?

Objective measure but differs by age

What is Net Book Value?

Consistent with assets on the balance sheet but not always objective

What is Current Cost?

Market-based but difficult to determine

What is Liquidation Value?

For disposal considerations

What are the Advantages of ROI?

• Easily understood by managers

• Comparable to interest rates and the rates of return on alternative investments

• Widely used and reported in the business press

What are the Limitations of ROI?

Goal Congruency Issue: Creates an incentive for high ROI units to only invest in projects with ROI higher than the unit’s current ROI

What kind of metric is ROI?

A percentage

What is the Risk with ROI being a percentage metric?

Highly profitable units (e.g., divisions) may be incentivized to reject positive NPV projects that would benefit the firm overall (in $)

What is Residual Income (RI)?

An accounting measure of income minus a dollar amount for required return on an accounting measure of investment

What is the formula for RI?

Income - (RRR * Investment)

What is the Required Rate of Return (RRR)?

Discount Rate (e.g., cost of capital)

What is the RRR * Investment referred to as?

Imputed Cost of the Investment (this reflects the opportunity costs but is not recognized in the financial accounting records)

What is the formula for Net Assets?

Total Assets - Current Liabilities

What are the Advantages of RI?

• Supports incentive to accept all projects with ROI > minimum rate of return

• Can use the minimum rate of return to adjust for differences in risk

• Can use a different minimum rate of return for different types of assets

What are the Limitations of RI?

• Favors large units

• Not as intuitive as ROI

• May be difficult to obtain a minimum rate of return at the subunit level

What is Economic Value Added (EVA)?

• A specific type of RI

• Reflects a business unit’s “economic profit” (e.g., after-tax operating income minus the cost of capital)

What is the formula for EVA?

After-Tax Operating Income - [Weighted Average Cost of Capital * (Assets - Current Liabilities)]

What is the Weighted-Average Cost of Capital?

After-tax average cost of all long-term funds in use

What is included to adjust for assets and operating income when calculating EVA?

R&D and Advertising

What is the formula for WACC?

(D/EV * Rd * (1-Tax)) + (E/EV * Re)

What should we consider when developing the performance measurement and evaluation process?

• Is the proposed performance measure consistent with the manager’s decision authority?

• Does the proposed performance measure reflect the results of actions that improve firm performance?

• What actions can the manager take that improve the performance measure but are detrimental to firm performance?

Can a single performance measure perfectly align the interest of managers with the firm?

No