PERFORMANCE

MANAGEMENT

F.M.KAPEPISO
LEARNING OBJECTIVES
At the end of the lecture, you should be able to:
 Explain the conceptual aspects of performance
measurement
 Distinguish between centralised and decentralised
management responsibility
 Explain what responsibility centres are and the
difference between cost, revenue, profit and
investment centres
 Discuss the concepts of controllability and traceability
 Determine and discuss measures such as ROI, RI and
EVA for use in performance evaluation
 Discuss the value-based management concepts of
shareholder value analysis and market value added
 INTRODUCTION
 Every organization is established for a purpose.
Therefore, there is a need to determine how well
organisations are performing and units of an
organization.
 ‘Unit’ can be a branch, division, department,
subsidiary, and so on
 For this reason, senior managers evaluate the
performance parts of an organization.
 PERFORMANCE MANAGEMENT
 Distinguish between: Performance management, Performance
evaluation and Performance measurement
 Performance evaluation can be described as ‘Backward’-
looking it assesses something that has already happened.
 Evaluation of past performance can provide valuable information for
the management of future performance
 Performance management aims to encourage desirable actions and
discourage undesirable actions
 Nature and purpose of organisation determines which aspects of
performance are important  reflected in objectives
 Vision/mission formulated as part of strategic planning process
 When performance evaluation criteria are designed to measure
achievement of objectives
 Performance management focuses on what is important
 Achievement of all prioritised objectives can be measured
 Performance measurement
 Performance is measured to enable its evaluation
 Use yardstick to evaluate performance
 Specific target set, prior period, similar unit /organisation

 Adjust for known differences to enhance comparability

 Management accounting information is required for

performance management
 CENTRALISED AND DECENTRALISED ORGANISATION
 As organisational structures vary, management responsibility
and control may be assigned differently within organisations.
 In the context of performance management, centralisation
versus decentralisation refers to the extent of delegation of
decision-making responsibility to lower organisational level
 Where an organisation’s senior managers retain extensive
control over strategic and operational decisions at all levels of
the organisation, the structure is said to be centralised
 Where authority and responsibility are given to subordinates
for certain aspects of the operations, and they are held
accountable for the results of those operations, this is referred
to as decentralisation.
 Decentralisation inevitably leads to owners and senior
managers relinquishing control to some extent and the
possibility that lower-level managers will make decisions that
are not in the organisation’s best interest.
 To ensure that congruence is achieved between organisational
goals and the interests of divisional managers, a system of
performance measurement and evaluation is required.
 POTENTIAL BENEFITS OF DECENTRALISATION

1. Greater responsiveness to needs at lower levels

2. Faster decision-making
3. Increased motivation
4. Improved senior management focus
5. Division into manageable size
6. Management development
7. Elimination of internal inefficiencies
 POTENTIAL NEGATIVE CONSEQUENCES
1. Increased risk of acting against the best interest of the
organisation as a whole
• ‘Sub-optimal’ decisions occur when best interest of units
conflicts with best interest of organisation
2. Undesirable duplication of assets and activities
3. Risk of competition between units rather than co-
operation
4. Higher information management costs
5. Loss of control and knowledge by senior management
 PREREQUISITES FOR SUCCESSFUL
DECENTRALISATION

 ‘Goal congruence’ is required

 Act in own best interest while simultaneously acting
in best interest of organisation as a whole
 Performance management system designed to
encourage goal congruence
 Absolute goal congruence not practically
attainable
 Eliminates potential negative consequences
 More difficult for ‘interdependent’ units
 Units perform similar operations
 RESPONSIBILITY ACCOUNTING
 Responsibility accounting is used to manage
performance of responsibility centres
 The area of responsibility for which each manager is
accountable is called a responsibility centre.
 A Responsibility centre is a division of an organization
for which a manager has responsibility to a limited
extent.
 The extent of the operations for which each manager is
responsible varies, and this results in different types of
responsibility centres:
 Cost centres
 Revenue centres
 Profit centres and
 Investment centres
 RESPONSIBILITY ACCOUNTING …
Types of responsibility centres
 Cost Centre – is a business segment whose manager has control
over costs but not over revenue or investment funds. Performance
management focuses primarily on minimizing costs while providing
the level of services or the amount of products demanded by other
parts of the organization. Performance can be measured by
comparing actual costs to standards or budget variances.
 Revenue Centre- managers are held responsible for its revenue
only. Sales departments that directly generate sales income are
sometimes classified as revenue centres. Performance management
focuses primarily on maximizing revenues. Performance can be
measured by return on sales.
 Profit centre – is any business segment whose manager has
control over both costs and revenue but not over investment funds.
Performance management in an investment centre focuses
primarily on maximizing profit. Performance can be measured by
comparing actual profit to targeted or budgeted profit.
 Investment centre – is any segment of an organization whose
manager has control over costs, revenue and investment in
operating assets. Performance management in an investment centre
focuses primarily on maximizing profit per dollar invested.
Performance can be measured using return on investment or
residual income.
 FINANCIAL PERFORMANCE MEASURES
 Different performance measures exist in an investment
centres:
 Return on investment
 Residual income
 Economic value added
 Return on sales

 Choice of performance measure is likely to influence

behaviour
 FINANCIAL PERFORMANCE MEASURES…
Return on investment (ROI) also known as Return on
capital employed (ROCE) – is an accounting measure of
income divided by an accounting measure of investment.
The formula is:
 ROI = Income / Investment
 Operating profit rather than profit is used in the
numerator of ROI formula. Operating profit is profit
before interest and taxes (EBIT)
 Investment in the denominator of ROI formula refers to
total assets minus current liabilities
 A higher ROI is preferred to a lower ROI, the higher the
ROI the more income generated per $ invested
 Du Pont analysis investigates ROI further:
 ROI = (revenue/investment) x (income /revenue)
= asset turnover x return on sales
 FINANCIAL PERFORMANCE MEASURES…
Return on investment (ROI)
 Example 1:

The revenue, income (profit), total assets and current

liabilities of a branch are $1 200 000, $350 000, $3 500
000 and $300 000 respectively. Compute the ROI and
analyse it further using Du Pont analysis.
 Solution:
 ROI = 350 000 / 3 200 000 = 10,94% p.a.
 ROI = asset turnover x return on sales
= (1 200 000 / 3 200 000) x (350 000 /
1 200 000)
= 37,5% x 29,2 % = 10,95% p.a.
 FINANCIAL PERFORMANCE MEASURES…
Return on investment (ROI)
Advantages:
1. Easy to calculate, interpret and obtain input
information
2. Income related to size of investment, therefore focusing
on asset productivity
3. Answer is a percentage, which enables comparisons

Disadvantages:
1. Can cause goal incongruence
• e.g. branch that earns 15% ROI may not invest in project
that earns 13%, even if 13% is desirable from company
perspective
2. Uses accounting information
3. Short-term measure based on historical results
4. May be difficult to know what ‘investment’ and ‘income’
to use
 FINANCIAL PERFORMANCE MEASURES…
Residual income (RI) – is income earned by an investment
centre, less imputed interest on the investment. The formula is
as follow:
 RI = income – (required rate of return x investment)
 The required rate of return multiplied by investment is called
imputed cost of the investment
 The income and investment is determined in the same way as
for ROI
 Higher RI is preferred, while negative RI is undesirable
 Unit is likely to invest in all projects that earn more than
required rate of return
Example 2:
Consider the information provided for the previous example.
The required rate of return is 11% p.a. Compute the residual
income.

Solution:
RI = 350 000 – (11% x 3 500 000)
= (2 000)
 FINANCIAL PERFORMANCE MEASURES…
Residual income (RI)
Advantages:
1. Different required rates can be used for different units
(adjusted for risk)
2. Addresses goal-congruence problem of ROI, because RI
renders absolute value as answer
•Company ROI is weighted average of project ROIs, while
company RI is sum of project RIs
Disadvantages:
1. More difficult to interpret – does not allow for easy
comparison
2. Uses accounting information
3. Short-term measure based on historical results
4. May be difficult to know what ‘investment’, ‘required
rate of return’ and ‘income’ to use
 FINANCIAL PERFORMANCE MEASURES…
Controllability and traceability costs: ROI and RI
 a distinction needs to be made between the performance of a
unit in an organisation and the performance of the manager in
charge of that unit.
 Ideally, the performance evaluation of a manager should be
based on those aspect over which the manager has had control
this is referred to controllability concept
 Only controllable costs should be included, which are usually
taken to be all variable costs and directly attributable fixed
costs. Assets that are managed by head office or apportioned
expenditure are not controllable and should not affect their
performance evaluation
 When unit performance is evaluated, allocated amounts are
usually subtracted from income to the extent that they are
traceable to the unit.
 Traceable items are those that can be traced directly to
division e.g. all items in profit and loss statement apart from
apportioned expenditure and all assets employed
 FINANCIAL PERFORMANCE MEASURES…
Controllability and traceability costs: ROI and RI
 The formula for ROI and RI can be modified as:
 Controllable ROI= controllable income/ controllable investment
 Controllable RI= controllable income – (required rate of return
x controllable investment)
 Traceable ROI= traceable income/ traceable investment
 Traceable RI= traceable income – (required rate of return x
traceable investment)
 FINANCIAL PERFORMANCE MEASURES…
Controllability and traceability costs: ROI and RI
Example 3
North Division and South Division are two divisions of a large company
that operates in similar markets. The divisions are treated as investment
centres. Operating statement for the two division for 2012 are given bellow:
North Division South Division
$'000 $'000
Sales revenue 6 300 4 440
Less: variable costs -2 415 -2 496
Contribution 3 885 1 944
Less: Fixed costs -2 366 -1 440
Less: Apportioned costs -665 -336
Profit before tax 854 168
Total divisional net assets 3 120 1 080
Apportioned costs include depreciation on land & building of $166 000 and
$40 000 respectively, which is controlled by head office. The amount of
divisional net assets is inclusive of land & building of $1 660 000 and $400
000 respectively. The company has a target return on capital of 12% per
annum. REQUIRED: Calculate controllable and traceable ROI and
RI
 5.3 ECONOMIC VALUE ADDED
 EVA® = Adjusted before interest after tax
operating income – [WACC x (adjusted total
assets - current liabilities)]
 Specific form of RI, the key calculation is the WACC
it uses market value of debt and equity
 Concentrates manager’s efforts on delivering
shareholder value
 Adjustments to eliminate undesirable accounting
conventions
 Examples: revaluation of assets, treating R & D as
depreciable asset etc.
 5.3 ECONOMIC VALUE ADDED…

 Example 4:
Consider the information provided for the previous
example. Adjustments amount to additional income of
R70 000 and additional total assets of R88 200;
taxation is computed at 29%; the required rate of
return is 10%; and current liabilities are R300 000.
No long-term liabilities exist. Calculate the EVA.
 5.3 ECONOMIC VALUE ADDED…

Solution
 After-tax income = (350 000 + 70 000) x 71% = R298 200
 Investment = 3 500 000 + 88 200 – 300 000 = R3 288 200
 Required income = 10% x 3 288 200
= R328 820
 EVA = 298 200 – 328 820 = (30 620)
 5.3 ECONOMIC VALUE ADDED…
Example 5-annual financial data for Hotel Desfleurs
2011 Valson Perpignan La Rochelle Total
Revenue 1200000 1400000 3185000 5785000
Variable costs 310000 375000 995000 1680000
Fixed cost 650000 725000 1680000 3055000
Operating profit 240000 300000 510000 1050000

Interest cost on long term debt at 10% 450000

Profit before income taxes 600000
Income taxes at 30% 180000
Net profit 420000

Average book value for 2011

Current assets 400000 500000 600000 1500000
Long term assets 600000 1500000 2400000 4500000
Total assets 1000000 2000000 3000000 6000000

Current liabilities 50000 150000 300000 500000

Long-term debt 4500000
Shareholders equity @15% with a market value of
3000000 1000000
Total liabilities and shareholders equity 6000000
Calculate EVA
 5.3 ECONOMIC VALUE ADDED
(CONTINUED)
 Advantages:
 Same as for RI
 Specifies ‘investment’, ‘required rate
of return’ and ‘income’
 Disadvantages:
 Same as for RI, except that definitions
are clear
 Difficult to make adjustments, as
quantifications may be arbitrary
 5.4 RETURN ON SALES
 Return on sales (ROS) = Income / Revenue
 Income per rand of sales

 Part of Du Pont analysis (refer to example)

 5.4 RETURN ON SALES (CONTINUED)
 Advantages:
1. Easy to calculate, interpret and obtain input
information
2. Answer is a percentage, which enables
comparisons
 Disadvantages:
1. Does not indicate whether assets have been used
productively
2. Uses accounting information
3. Short-term measure based on historical results
4. May be difficult to know what ‘income’ to use
 5.5 DEFINITION AND MEASUREMENT

 Investment definition:
 Depends whether manager (controllable) or unit
(used in operation) is evaluated
 Possibilities for unit performance evaluation
 Total assets held (intangibles often not recorded)
 Total assets employed

 Only assets in use, therefore exclude idle assets or assets held

for future use
 Useful if senior management dictates retention of
unproductive assets
 Total assets less current liabilities
 Acknowledges branch performance in use of current liabilities
as source of funding
 More correct to use average investment
 5.5 DEFINITION AND MEASUREMENT
(CONTINUED)

 Investment measurement:
 Historical cost versus current cost
 Historical cost (at time of acquisition) results in timing
inconsistency between income and investment
 Current cost (acquisition of similar asset at present time)
might be difficult to obtain and might require extensive
calculations
 Net book values versus gross book values
 Net book value favours units with older assets, as ROI
increases without extra income being generated
 Gross book value ignores the decrease over time in income-
earning capability of assets
 5.5 DEFINITION AND MEASUREMENT
(CONTINUED)

 Required rate of return:

 Using same rate used to determine desirability of
projects promotes goal congruence
 Adjust to reflect risk profile of unit
 Ensure consistency between rate and income:
 Both over same period
 Both after tax

 Income:
 Before interest after tax
 Preferred, as includes operating cost (tax) and excludes
cost of finance (interest)
 Before interest and tax
 Useful if effect of tax needs to be excluded (e.g. different
tax laws apply)
 5.5 DEFINITION AND MEASUREMENT
(CONTINUED)

 Consistency between treatment of income,

rate of return and investment
 Taxation
 Long-term and current liabilities and related interest

 Non-operating assets and related income

 If use gross book value might prefer to add back

depreciation to income
 No correct method, best guidelines are
controllability and traceability concepts, but
also depends on specific circumstances
5.6 MULTINATIONAL CONSIDERATIONS

 Comparing performance of units across borders is

complex
 Different political, economic, social and technological conditions
 Different currencies
 Differences in economic factors (e.g. inflation) are
addressed by currency conversion
 Exchange rates to be used in conversion
 Income: average rate for period
 Investment: rate at purchase date (if historical cost is used)
 Need to understand remaining potential differences
before drawing conclusion on relative performance
 6 VALUE-BASED MANAGEMENT
 Value-based management (VBM) is the
management of all aspects of a company with the
aim of maximising shareholder wealth
 Types of performance measures linked to concept
of VBM:
 Shareholder value analysis (SVA)
 Market value added (MVA)
 Disadvantage of VBM techniques:
 Focus exclusively on wealth of shareholder (while
interest of all stakeholders should be considered)
 6.1 SHAREHOLDER VALUE ANALYSIS

 Value of company = PV of free CFs + value of

marketable securities
 Shareholder value = value of company – market
value of debt
 Compute for company as whole or for individual units
 Rappaport’s 7 value drivers used to calculate free CFs:
1. Sales growth rate↑ value↑
2. Operating profit margin↑ value↑
3. Planning period↑ value↑
4. Cash income taxes↓ value↑
5. Investment in fixed assets↓ value↑
6. Investment in working capital↓ value↑
7. Cost of capital↓ value↑

See example about Kango Cc in study guide, page 247

 6.1 SHAREHOLDER VALUE ANALYSIS
(CONTINUED)
 Compute for company as a whole or for individual
units
 Can calculate ‘threshold margin’
 Minimum operating profit required to maintain
shareholder value
 No single period performance measure, because CFs
differ from period to period
 Use for valuation and planning
 6.2 MARKET VALUE ADDED
 MVA = increase in market capitalisation during
the period – increase in capital invested during
the period (including retained income)
 External measure indicating how shareholders are
affected by management’s actions
 Choose period relevant to purpose of evaluation

 MVA versus EVA

 MVA is the present value of all future EVA®s

EVA MVA
Historical measure Forward-looking
One historical period Discounts all future EVAs
Internal performance measure External investor’s measure
Individual units/company Only for company as whole
 6.2 MARKET VALUE ADDED (CONTINUED)

 Example 6:
Market has value increased by R55m since
the new CEO took over. In the same period
R15m new capital was invested and retained
income increased by R10m. Compute the
MVA.

 Solution:

MVA is therefore R55m – R15m – R10m =

R30m
 6.2 MARKET VALUE ADDED (CONTINUED)

 Disadvantages of MVA:
1. Adjustments to accounting figures need to be made
2. Adjustments may be arbitrary
3. Absolute value, therefore does not consider size of the
company
4. Market sentiment also impacts share price
5. Self-fulfilling prophecy?
6. Dividends not taken into account
 PRACTICE QUESTION
Ravi Industries produces tool and die machinery for car manufactures. The company
expanded in 20X2 by acquiring one of its suppliers of alloy steel plates, Joe steel company
reported separately as an investment centre. Ravi monitors its division on the basis of both
divisional contribution margin and return on investment (ROI). Investment is defined as
average total assets. Management bonuses are based on ROI, but the company is considering
using EVA* in the future. All investments in operating assets are expected to earn a minimum
return of 11 per cent after income taxes.

Joe cost of goods sold is considered to be entirely variable, while the division’s administrative
costs are fixed. Selling costs are semi variable cost with 40 per cent attributed to sales volume.
Joe ROI after tax has ranged from 11.8 to 14.7 per cent since 20X2. The division total assets
were N$15 750 000 on 31 December 20X6, a 5 per cent increase over the 20X5 year-end
balance. Joe funds are obtained from both debt and equity and the weighted average cost of
capital is 10 per cent. The income tax rate is 28 per cent. An extract from the 20X6 profit
statement for Joe follows:

Joe Steel Division

Profit statement for year ended 31 (N$, 000)
December 20X6
Sales 50000
Less: Costs 46400
Costs of goods sold 33000
Administrative costs 8000
Selling costs 5400

Required: (4 + 16 + 5 marks)

a) Calculate the divisional contribution margin for Joe steel division for 20X6.
b) Calculate the following performance measures for 20X6 for Joe steel division:
i. After tax Return On Investment
ii. Economic Value Added
iii. Residual income, and
iv. Return on sales
c) Comment on the 20x6 performance of Joe Steel DIvision