Chapter 10:

Financial Performance Measures

and Their Effects
Performance measurement

 Performance measurement is one of the most

important issues in advanced management
accounting

 Performance measures are an integral part of

control, in particular, results controls
– Measure employees’ contributions to value creation
» Direct measure?
» Proxies?
 Summary measures
 Single-number, aggregate, bottom-line financial measures of
performance.
 Reflect the aggregate or bottom-line impacts of multiple performance
areas.
– e.g., accounting profits reflect the aggregate effects of both revenue- and
cost-related decisions.
 Two types:
– Market measures
» Reflect changes in stock prices or shareholder returns.
– Accounting measures
» Defined in either residual terms, such as net income after taxes, operating
profit, residual income, economic value added
» or ratio terms, such as return on investment, return on equity, return on net
assets = net income/(fixed assets + working capital)

 A third type (combinations) will be discussed in Chapter 11.

Market measures

 Timely — measured in short time periods

 Precise — in well-functioning capital markets
 Objective — not manipulatable by the managers whose
performances are being evaluated
 Congruent — the most direct manifestation, or closest proxy,
of the theoretical notion of firm value
 Cost effective — do not require any company measurement
expense
 Understandable — in terms of what the measures represent
(changes in market value of the firm)
Limitations
 Feasibility
– Market measures are not available either for privately-held firms or
wholly-owned subsidiaries or divisions, and they are not applicable to
non-profit organizations.

 Controllability
– Market measures can generally be influenced to a significant extent
only by the top few managers, those who have the power to make
decisions of major importance. Market valuation can also be affected
by things beyond top manager’s control (macroeconomic activity and
policy, etc.) –RPE?

 Realized performance
– Market measures are heavily influenced by future expectations, but
these expectations might not be realized. e.g. market reacts to hiring a
new CEO with good track record with other firms, expecting s/he leads
this firm to success.
Limitations (Continued)
 Congruence (with firm value)?
– For competitive reasons, markets are not always fully
informed about a company’s plans and prospects,
and hence, its future cash flows and risks

– Market valuations can be affected by “carefully timed”

or “managed” disclosures which are not always in
the company’s long-term interest (e.g. R&D or pricing
strategies that should be confidential but could move
markets)

– Market valuations may be affected by things such as

manipulations of large investors which has nothing to
do with firm’s performance
Limitations (Continued)

 These limitations of market measures cause

organizations to look for surrogate measures
of performance.

– Accounting measures are the most important

surrogates used, particularly at management
levels below the very top management team.
Accounting measures

 Timely — measured in short time periods

 Precise — subject to extensive accounting rules
 Objective — audited by independent auditors
 Congruent
» In for-profit firms, accounting profits or returns are relatively
congruent with the true firm goal of maximizing shareholder value.
» Positive correlations between accounting profits and changes in
stock prices.

 Cost effective — already required for financial reporting

 Understandable (everyone should take accounting
courses )
Limitations (Continued)
 Accounting income does not reflect economic
income perfectly, because accounting measures:
– Are transactions oriented (changes in value that do not
result in a transaction are not recognized)
– Are dependent on the choice of measurement method
(e.g. depreciation method)
– Are conservatively biased
– Ignore intangibles (R&D, human resources not on B/S)
– Ignore the cost of equity capital
– Ignore (change in) risk (less risky cash flows increase firm
value)
– Focus on the past. Economic value is derived from future
cash flows The change in the value of the entity
over a given period, where “value” is
obtained by discounting future CFs.
Myopia (a behavioral displacement problem)

 The motivational effect of these measurement limitations can

be perverse because managers who are motivated to produce
accounting profits or returns can (in the short-term) do so by:

– Not making investments, even worthwhile ones

» Investment myopia. Why? Accounting’s conservative

bias, ignoring intangibles

– Making operational decisions to shift income across

periods, even when harmful long-term

» Operational myopia: channel stuffing; force employee

over time to boost sales (low quality and customer
satisfaction, unhappy employees, destroying goodwill)
ROI performance measures
 Return on Investment (or variations: ROE, ROCE, RONA)
» ROI is a ratio of the accounting profits earned by the business
unit divided by the investment assigned to it.

» ROI = profits ÷ investment base

 Residual Income (RI)

» RI is a dollar amount obtained by subtracting a capital charge
from the reported accounting profits.

» RI = (operating) profits - capital charge

» Capital charge = (invested capital) x (required rate of return).

» The required rate of return can be set by top management, it can be

viewed as imputed interest rate.
Problems caused by ROI-measures
 Numerator
» Accounting profits, hence,
» ROI contains all problems associated with these profit
measures.

 Denominator
» How to measure the fixed assets portion?
-misleading signals

 Suboptimization
» ROI-measures can lead division managers to make
decisions that improve division ROI even though the
decisions are not in the corporation's best interest.
An example
- Assume corporate cost of capital = 15%
- Division investment of $25,000 that generates
5,000 annual profit (=20%)
Division New
Asset
WITHOUT WITH
Alone
Profit 25,000

Assets 100,000
ROI
25%
 Another example

Entity Cash Receivables Inventories Fixed Assets Total Invest. Profit ROI
A $ 10 $ 20 $ 30 $ 60 $ 120 $ 24.0 20 %
ROI

B 20 20 30 50 120 14.4 12
C 15 40 40 10 105 10.5 10
D 5 10 20 40 75 3.8 5
E 10 5 10 10 35 (1.8) (6)

Entity Profit Cur. Assets Req. Earn. Fixed Assets Required Earn. Res. Income
A $ 24.0 $ 60 $ 2.4 $ 60 $ 6.0 $ 15.6
B 14.4 70 2.8 50 5.0 6.6
RI

C 10.5 95 3.8 10 1.0 5.7

D 3.8 35 1.4 40 4.0 (1.6)
E (1.8) 25 1.0 10 1.0 (3.8)

4% 10%
Suboptimization

– ROI provides different incentives for investments

across organizational entities.
Corporate IRR
Cost of < of < Entity
» Entity manager will not invest if
Capital Project ROI

Corporate IRR
» Entity manager will invest if Cost of > of > Entity
Capital Project ROI

» Hence, if corporate cost of capital is 10%,

– IRR of project is 11%, then A and B are unlikely to invest
– IRR of project is 9%, then D and E are still likely to invest
 Suboptimization (Continued)
Assume Corporate cost of capital = 10%
Worthwhile! Investment of $10 to earn $1.1 per year

Base situation Entity A Entity C Entity D

Profit Before tax $24 $10.5 $3.8

Investment base $120 $105 $75
ROI 20% 10% 5%

New situation

Profit before tax

Investment
ROI
 Suboptimization (Continued)
Assume Corporate cost of capital = 15%
Not Worthwhile! Investment of $10 to earn $1.1 per year

Base situation Entity A Entity C Entity D

Profit Before tax $24 $10.5 $3.8

Investment base $120 $105 $75
ROI 20% 10% 5%

New situation

Profit before tax

Investment
ROI
 Advantage and disadvantage of RI relative to
ROI

 Suboptimization is not an issue with residual income (RI) measures

 When residual income is used, managers are encouraged to move the
focus from percentage return and to the absolute dollar value of the
additional profit

 However, using an absolute dollar to measure performance can also be a

disadvantage of RI: when comparing the performance of different-sized
divisions (or investment centers), RI has a bias in favor of larger divisions

Division A Division B
Average operating assets $15,000,000 $2,500,000
Operating income $1,500,000 $300,000
Minimum return 8% $1,200,000 $200,000
Residual income $300,000 $100,000
Residual return (RI/Assets) 2% 4%
Advantage and disadvantage of RI relative to
ROI

 Division A outperforms Division B based on residual income

 Division A’s RI is three times that of Division B
 However, Division A uses six times as many assets to produce
this difference
 Division B is more efficient

 How to correct this advantage?

 Using residual return will show that Division B outperforms
Division A
 Compute both ROI and residual income and use both for
performance evaluation. ROI could be used for interdivisional
comparison while RI could be used for measuring absolute
performance of a division
The fixed assets portion
 Net Book Value (NBV)
» Both ROI and RI get better merely to passage of time
» Both ROI and RI are usually overstated if the division
includes a relatively large number of older assets
» GBV? Reduces the problem, but old assets’ GBV is still smaller than
new assets due to inflation
» Example
 Invest $100; Cash flow $27 per year; Depreciation $20 (5 years)

Incremental Capital
Yr NBV Income Charge RI ROI
1 100 7 10 -3 7%
2 80 7 8 -1 9%
3 60 7 6 1 12%
4 40 7 4 3 18%
5 20 7 2 5 35%

(=27-20)
10 %
Misleading performance signals
 Asset values on B/S do not represent real value (economic value)
of the assets available to managers for earning current returns.

 Division managers are encouraged to retain assets beyond their

optimal life and not to invest in new assets.

 Corporate managers may be induced to over-allocate resources

to divisions with older assets. —those divisions are “better
performers” with higher ROI or RI.

 Combined with the suboptimization issue, managers of entities

with older assets, and hence a higher ROI, are likely to be more
reluctant to invest in “desirable” projects with an IRR higher than
the corporate cost of capital.
ROI and RI encourage myopia
 A common disadvantage of ROI and RI is that they encourage a
short-run orientation (i.e., myopic behavior)

 Some cost reductions can result in more efficiency (i.e. higher

ROI) and residual income in the short run
 Cutting advertising budget, laying off highly-paid employees,
delaying employee training, reducing maintenance, using
cheaper materials
 These actions can reduce short run expenses, thus increase
ROI or RI, but at the expense of the long run
Economic Value Added (EVA)

 Residual Income is calculated largely based on

accounting standards. It thus cannot reflect economic
income
– Important assets are not recognized; managers engage in
myopic behavior to current period profits
– Earnings manipulation: reducing asset base, shifting income
across different periods

 Can we adjust accounting numbers so that Residual

Income measures economic income?
– This is what EVA intends to do
– EVA may be an improved measure, but not a panacea
EVA
 Modified after-tax operating profit
– (Modified capital x weighted average cost of capital)

 Similar to RI (=profit–capital charge), except for the

modifications (164 in total, as suggested by Stern Stewart
& Co)

» e.g., Capitalization and subsequent amortization of intangible

investments (e.g. in R&D, employee training)

 EVA is used to evaluate operating performance

– A positive EVA means that operations have increased

shareholder value
EVA

 Stern & Stewart Co. thinks that for most companies, no

more than 10 adjustments need to be made to obtain
“adjusted” profit
– Adjust those that affect managerial behavior, that are easy to
understand, and that significantly influence market value of the
firm
 R&D expenditures; advertising and promotion
expenditures; employee training and development
expenditures
– These can be viewed as investments that will bring significant
future benefits. Should be capitalized and amortized over time
instead of being expensed in the period incurred
EVA

 Provisions and impairments: inventory, PPE,

investments, intangibles
– Too much provisions will understate income; too little provisions
will overstate income
– Use the actual expenditures (or cash losses) of the year to
measure real economic effects

 Depreciation adjustments
– Accelerated depreciation is used for tax purpose
– Adjust depreciation so that it better approximates “economic
depreciation”, which is the deterioration of the expected capacity
or utility of an asset (driven by wear and tear, new technology,
changing market conditions, etc.), like “impairment”
EVA
 Capital charge: amount that shareholders and lenders
charge a company for the use of their money
– Capital used = [total assets – current liability] (i.e., equity plus
long-term liability)
» Could use beginning balances
» Some define capital used as the sum of notes payable, current
maturities of long-term debt, long-term debt, and equity

– Weighted average cost of capital = costs of long-term loans,

bonds, and equity, each multiplied by its proportion in “capital
used”, then sum up

» E.g. 0.5 x 10% + 0.3 x 6% + 0.2 x 8% = 8.4%

» Cost of equity needs to be estimated
EVA

 EVA could be calculated for the whole company, a

division, a plant, a branch, a production line, even a
customer

– JD Group (based in Johannesburg) has over 1,000 stores in

South Africa, Namibia, and Botswana, selling furniture, home
appliances, electronic products, etc. JD Group calculates the
EVA for every store manager each month and ties it to the
manager’s compensation
EVA

 EVA takes into account cost of equity capital.

 Measured by accounting profits, many companies are

profitable. But the profit may be smaller than TOTAL
costs of capital. Thus, these companies are destroying
shareholder value

– Managers/firms must pay for capital when using it, just like they
must pay for labor or raw materials when using them

– Accounting system only measures cost of debt, but ignores cost

of equity (i.e., does not subtract it from operating profits)
EVA

 Equity capital has a cost

– Equity holders invest in company A by giving up the opportunity to

invest in other companies

– If they could invest in a company with comparable risk as

company A, then the return that they would have received from
investing in that company is the opportunity cost of investing in
company A

– Cost of equity is an opportunity cost, not an accounting cost

– In practice, need to estimate cost of equity

EVA
 Incorporating the costs of all capital, EVA approximates
the value created for each period
– EVA can be viewed as profit defined by shareholders (because
shareholder’s opportunity cost is part of capital cost in EVA)

 As such, EVA motivates managers to make decisions

that are consistent with maximizing shareholder value

 EVA may mitigate investment myopia because it

capitalizes the most important types of discretionary
expenditures managers might try to cut if they were
pressured for profit
EVA
 But EVA is not economic income. It still focuses on the past
while economic income reflects changes in future cash flow
potentials.
– Thus EVA is still likely to be a poor indicator of value changes for firms
that derive a significant portion of their value from future growth
– EVA reflects only financial numbers, not the non-financial aspects of firm
performance/value

 EVA adjustments require considerable judgments. Managers

can bias EVA just as they can bias accounting numbers

 Other problems: understandability, expensive (often need

assistance from consultants)