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PERFORMANCE MEASUREMENT
LECTURE 12

ROI
Accountng based RI
performance EVA
measures ROS

Outline Choice of performance

measures

Levers of controls

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Financial and Nonfinancial Measures

Firms are increasingly presenting financial and nonfinancial performance

measures for their subunits in a balanced scorecard, and it’s four
perspectives:
1. Financial
2. Customer
3. Internal business process
4. Learning and growth

Four common measures of economic

performance:
Economic
Return on Residual Return on
value
investment income sales
Choosing Among added

Different
Performance
Measures
Selecting subunit operating income
as a metric is inappropriate because
it obviously differs simply on the
differing size of the subunits

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Accounting-Based Performance Measures

Choose performance measures that align with top

management’s financial goals.

Choose the details of performance measures.

Choose a target level of performance and a feedback

mechanism for each performance measure.

Return on Investment (ROI)

ROI is an accounting measure of income divided by an accounting

measure of investment

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Most popular metric for two

reasons:

Return on • Blends all the ingredients of profitability

(revenues, costs, and investment) into a
Investment single percentage
• May be compared to other ROI’s both
(ROI) inside and outside the firm

Also called the accounting rate

of return (ARR) or the accrual
accounting rate of return (AARR)

Return on Investment (ROI)

• ROI may be decomposed into its two components as follows:

• ROI = Return on Sales X Investment Turnover

• This is known as the DuPont Method of Profitability Analysis

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Return on Investment (ROI)

Leads to
suboptimal
decision making,
Focuses
when a
manger’s
decision’s
benefit to one attention on the Results in Results in
subunit rather duplication of duplication of
subunit is more
than the output activities
than offset by
company as a
the costs or loss
of benefits to whole
the organization
as a whole.

Residual Income

Residual income (RI) is an accounting measure of income minus a dollar

amount for required return on an accounting measure of investment.

RI = Income – (RRR X Investment)

• RRR = Required Rate of Return

Required rate of return times the investment is the imputed cost of the
investment.
• Imputed costs are cost recognized in some situations, but not in the financial
accounting records.

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Economic Value Added (EVA)

• EVA is a specific type of residual income calculation that has

recently gained popularity.

• Weighted average cost of capital equals the after-tax average cost

of all long-term funds in use.

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Return on Sales (ROS)

Return on sales is simply income divided by

sales.

Simple to compute, and widely

understood.

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Lecture example

• Performance Auto Company

operates a new car division
(that sells high-
performance sports cars)
and a performance parts
division (that sells
performance-improvement
parts for family cars). Some
division financial measures
for 2017 are as follows:

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Lecture example

• Calculate return on investment (ROI) for each division using operating income as a measure of
income and total assets as a measure of investment.
• Calculate residual income (RI) for each division using operating income as a measure of income
and total assets minus current liabilities as a measure of investment.
• William Abraham, the new car division manager, argues that the performance parts division has
“load- ed up on a lot of short-term debt” to boost its RI. Calculate an alternative RI for each
division that is not sensitive to the amount of short-term debt taken on by the performance parts
division. Comment on the result.
• Performance Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with
a market value of $18,000,000 at an interest rate of 10% and equity capital with a market value
of $12,000,000 and a cost of equity of 15%. Applying the same weighted-average cost of capital
(WACC) to each division, calculate EVA for each division.
• Use your preceding calculations to comment on the relative performance of each division.

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Choosing the Time Horizon of the

Performance Measures

ROI, RI, EVA, and

Multiple periods of ROI, RI, EVA, and ROS may all be
evaluation are ROS all basically
adapted to
sometimes evaluate one period evaluate multiple
appropriate. of time.
periods of time.

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Choosing Alternative Definitions for

Performance Measures

Four possible alternative definitions

of investment:

• Total assets available

• Total assets employed
• Total assets employed minus current liabilities
• Stockholder’s equity

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Choosing Measurement Alternatives for

Performance Measures

Possible alternative definitions of cost:

• Current cost
• Gross value of fixed assets
• Net book value of fixed assets

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Choosing Target Levels of Performance

Goal may include

Historically driven
a continuous
targets used to
improvement
set target goals component

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Choosing the Timing of the Feedback

Timing of feedback
depends on:

How critical the The specific level of The sophistication

information is for management of the organization’s
the success of the receiving the information
organization feedback technology

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Distinction Between Managers and Organization

Units

• The performance evaluation of a manager should be distinguished

from the performance evaluation of that manager’s subunit, such
as a division of the company.

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The Trade-Off: Creating Incentives vs.

Imposing Risk

An inherent trade-off exists between creating incentives

and imposing risk.
• An incentive should be some reward for performance.
• An incentive may create an environment in which
suboptimal behavior may occur: the goals of the firm
are sacrificed in order to meet a manager’s personal
goals.

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Moral Hazard

• Moral hazard describes situations in which an employee prefers to

exert less effort (or report distorted information) compared with
the effort (or accurate information) desired by the owner because
the employee’s effort (or the validity of the reported information)
cannot be accurately monitored and enforced.

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Intensity of Incentives

• Intensity of incentives—how large the incentive component of a

manager’s compensation should be relative to their salary
component

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Preferred Performance Measures

Preferred performance They motivate the

measures are those that They do not change manager as well as
are sensitive to or much with changes in limit the manager’s May include
change significantly factors that are beyond exposure to risk, benchmarking.
with the manager’s the manager’s control. reducing the cost of
performance. providing incentives.

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Performance Measures at the Individual

Activity Level

• Designing performance measures for

activities that require multiple tasks
Two issues when
evaluating • Designing performance measures for
performance at activities done in teams
the individual
activity level:

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Compensation for Multiple Tasks

• If the employer wants an employee to focus on multiple tasks of a

job, then the employer must measure and compensate
performance on each of those tasks.

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Team-Based Compensation

Teams achieve
Companies use better results than Companies must
teams extensively reward individuals
individual
for problem employees acting on a team based on
solving. team performance.
alone.

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Executive Compensation Plans

Based on both financial and nonfinancial performance measures, and include a mix of:

Annual incentives, such as Long-run incentives, such

Base salary
cash bonuses as stock options

Well-designed plans use a compensation mix that balances risk (the effect of
uncontrollable factors on the performance measure, and hence compensation) with
short-run and long-run incentives to achieve the firm’s goals.

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Diagnostic control
systems
Boundary systems
Levers of control: Belief systems
Interactive
control systems

Strategy and
Levers of Each lever is important and
needs to be monitored.
Control
Levers should be
interdependent and
collectively represent a living
system of business conduct.

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Diagnostic Control Systems

ROI, RI, EVA

Diagnostic control systems evaluate
whether a firm is performing to Customer
expectations by monitoring and
satisfaction
evaluating critical performance
metrics, including:
Employee
satisfaction
MUST be balanced by the other lever
of control

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Boundary Systems

Boundary systems • Highlights actions that are “off-

describe standards limits.”
of behavior and
codes of conduct • A code of conduct describes
expected of all appropriate and inappropriate
employees. individual behaviors

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Belief Systems

Belief systems articulate the mission, purpose, and core values of a

company.

They describe the accepted norms and patterns of behavior expected of

all managers and employees with respect to one another, shareholders,
customers, and communities.

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Interactive control systems are

formal information systems that
managers use to focus
Interactive organizational attention and
learning on key strategic issues.

Control
Systems Tracks strategic uncertainties that
businesses face.

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