Performance Measurements in Decentralized Organizations
Return on Investment (ROI)
ROI is a performance metric for investment centers, calculated as . It measures the efficiency of invested capital utilization in percentage terms, allowing comparison between different-sized investment centers.
Deconstructing ROI
ROI can be deconstructed into:
\frac{Profit}{Sales Revenue} \times \frac{Sales Revenue}{Invested Capital}
which equals Return on Sales multiplied by Investment Turnover. Strategies to improve ROI include increasing selling prices, decreasing expenses to boost return on sales, increasing sales revenue relative to investment, or reducing invested capital to enhance investment turnover.
Limitations of ROI
ROI's limitations include encouraging a short-term focus, potentially leading to decisions that adversely affect long-term performance. Managers might defer asset replacement to avoid increasing the asset base and lowering ROI. It may also discourage investments in projects that, while beneficial for the organization, could decrease the investment center's ROI.
To minimize these issues, ROI should be used alongside other performance measures that focus on both short-term and long-term performance.
Residual Income
Residual income is an alternative performance measure calculated as Profit minus (Investment Capital times Imputed Interest Rate). The imputed interest rate represents the firm's required rate of return on investments, based on the organization's cost of capital.
Advantages of Residual Income
Advantages include promoting goal congruence and considering the organization's required rate of return. It encourages investments in projects with a positive residual income, aligning with the organization's objectives.
Disadvantages of Residual Income
Disadvantages include its inability to effectively compare businesses of different sizes and the potential for short-term orientation, similar to ROI.
Measuring Profit and Investment Capital
Total assets are commonly used as invested capital, with a focus on total productive assets. Measurement approaches can involve average or end-of-year balances. Using the carrying amount of assets aligns with external reporting but acquisition cost can avoid issues related to depreciation methods.
Measures of Shareholder Value
Value-based management uses a shareholder value analysis approach to manage a business, incorporating valuation, strategy, finance, and corporate governance.
Economic Value Added (EVA)
EVA is calculated as Net Operating Profit After Tax minus (Capital Employed times Weighted Average Cost of Capital). Improving EVA involves enhancing profitability without additional capital, borrowing when profits exceed borrowing costs, and paying off debt by selling assets.
Summary
Performance measurement systems like ROI and residual income can encourage goal-congruent behavior but may also lead to dysfunctional decisions. ROI is useful for evaluating investment centers of different sizes but can incentivize short-term focus. Using ROI with complementary measures and considering long-term impacts can mitigate these issues.