Slide 10.

Chapter 10:
Financial Performance
Measures and Their Effects

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.2

Summary measures

 Summary, 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 (net income after taxes, operating
profit, residual income, economic value added) or ratio terms
(return on investment, return on equity, or return on net assets).

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.3

Market measures

 Timely — measured in short time periods

 Precise — in well-functioning capital markets
 Objective — not manipulable 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)

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.4

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 in the organization, those who have the
power to make decisions of major importance.

 Realized performance
 Market measures are heavily influenced by future expectations, but
these expectations might not be realized.

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.5

Limitations (Continued)

 Congruence?

 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

 Other “anomalies”

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.6

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.

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.7

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

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.8

Limitations (Continued)

 Accounting income does not reflect economic income

perfectly, because accounting measures:
 Are transactions oriented
 Are dependent on the choice of measurement method
 Are conservatively biased
 Ignore intangibles
 Ignore the cost of equity capital
 Ignore risk
 Focus on the past

The change in the value of the entity

over a given period, where “value” is
obtained by discounting future CFs.

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.9

Myopia

 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

 Making operational decisions to shift income

across periods, even when harmful long-term

Operational myopia

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.10

ROI performance measures

 Return on Investment
» 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 is a dollar amount obtained by subtracting a
capital charge from the reported accounting profits.

» RI = profits - capital charge

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.11

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?

 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.

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.12

An example
- Assume corporate cost of capital = 15%
- Division investment of $25,000 that generates
5,000 annual profit (=20%)
New
Division Asset
WITHOUT WITH Alone
Profit 25,000 30,000 5,000
Assets 100,000 125,000 25,000
ROI 25% 24% 20%

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.13

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%

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.14

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

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.15

Suboptimization (Continued)
Assume Corporate cost of capital = 10%
Worthwhile ! Investment of $10 to earn $1.1 per year

DOES NOT INVEST INVESTS INVESTS

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 New situation New situation New situation

Profit before tax $ 25.1 $ 11.6 $ 4.9

Investment $ 130 $ 115 $ 85
ROI 19.30 % 10.08 % 5,76%

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.16

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

DOES NOT INVEST INVESTS INVESTS

Base situation Unit A Unit C Unit D

Profit Before tax $ 24 $ 10.5 $ 3.8

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

New situation New situation New situation New situation

Profit before tax $ 25.1 $ 11.6 $ 4.9

Investment $ 130 $ 115 $ 85
ROI 19.30 % 10.08 % 5.76%

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.17

Other issues

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

measures when the capital charge is set at or above the
cost of capital.

 ROE measures induce managers to use debt financing

(if they have financing authority).

» This is not the case with RI if the capital charge is

equal to the weighted average cost of debt and
equity.

 ROA measures induce managers to lease assets (again, if

they have authority over such decisions).

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.18

The fixed assets portion

 Net Book Value
» 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
» 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 %

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.19

Misleading performance signals

 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.

 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.

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007
Slide 10.20

Economic Value Added (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)

Adding LIFO-reserves to correct for undervalued inventories

etc.

Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition © Pearson Education Limited 2007