Chapter 14

Performance
measurement

©2020 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation you should be able to:

14.1 explain the importance of measuring
organisational performance and outline common
frameworks and reports used to assess and report
organisational performance
14.2 outline common organisational structures,
responsibility centres and reasons for divisional
performance evaluation and generate divisional
performance reports
 Learning objectives

14.3 apply investment-centre performance evaluation

measures such as return on investment (ROI), residual
income (RI) and economic value added
14.4 examine the use of environmental and social
performance measurement
14.5 discuss the issues surrounding individual
performance measurement
14.6 assess the use of non-financial performance
measures.
Organisational performance measurement

• Performance must be measured to verify the

achievement of goals in the overall management
process.
• The measure is normally compared with a benchmark to
decide whether the performance is good or bad.
• An entity’s goals are usually expressed in a mission
statement.
• Entities need to formulate strategies, structure the
entity, and design processes to ensure the efficient and
effective use of resources in achieving their mission.
Organisational performance measurement

• The performance of an entity is normally monitored

both inside and outside the organisation.
• When conducting an external evaluation, key data are
compared with benchmark data to assess good or bad
performance framework.
• Internal performance evaluation can use information
from a variety of sources — internal or external to the
entity, accounting or non-accounting, or financial
(quantitative) or non-financial (qualitative).
Organisational performance measurement

• The balanced scorecard provides a set of performance

measures that reflect entity’s goals and strategies from
four perspectives.
1. Financial (How do we create value for our
shareholders?)
2. Customer (What do new and existing customers
value from us?)
3. Internal operations (What processes must we
excel at to achieve our financial and customer
objectives?
Organisational performance measurement

• The balanced scorecard provides a set of performance

measures that reflect entity’s goals and strategies from
four perspectives.
4. Innovation and improvement activities (How can
we continue to improve and create value?)
 Organisational performance measurement

• Balanced scorecard:
– Measures and drivers are used to monitor progress
towards the goals, and they should be communicated
throughout the entity.
– Key performance indicators (KPIs) are performance
measures that are critical for the success of the entity.
Organisational performance measurement

• Example — balanced scorecard:

Organisational performance measurement

• Criticisms of the balanced scorecard:

– focuses on shareholders
– does not give proper attention to employees and
suppliers
– does not address adequately the selection of specific
measures or the role of performance targets
– causal relationship between some of the measures
and their economic impact has never been
empirically tested.
 Divisional performance measurement

• Organisational structure of an entity helps to:

– direct and control resources to attain mission
– delineate level, responsibility and authority of a
division.
• Organisational structure depends on the nature of its
business (e.g. functional, geographical or enterprise
structures, or combinations of these).
 Divisional performance management

• A manager is normally charged with coordinating the

resources of a business unit and the manager is therefore
responsible for the unit’s performance.
• Different types of responsibilities centres:
– cost centre:
• a division of an entity that is solely responsible for
providing a product or service at minimal cost
– revenue centre:
• a division of an entity that is solely responsible for
generating a target level of revenue
 Divisional performance management

• Different types of responsibilities centres:

– profit centre:
• a division of an entity that is solely responsible for
both cost inputs and revenue, and therefore the
profit of a division
– investment centre:
• a division of an entity that is solely responsible for
costs, revenues (and therefore profit) and
investment in assets.
 Divisional performance management

• Organisational structures:
 Divisional performance management

• Organisational structures:
 Divisional performance management

• Divisional performance evaluation:

– A contribution margin format is normally used when
reporting on divisional performance.
– The main requirement is to distinguish between
controllable and non-controllable costs.
– Each divisional manager’s performance evaluation
should be based on the divisional margin, as they
have control only over the revenues and costs above
the divisional margin line.
 Divisional performance management

• Divisional performance evaluation:

– Example — Fun Hats Company — divisional
performance report:
 Divisional performance management

• Pricing guide:
– Pros and cons of the allocation of corporate and other
common costs to divisions.
 Divisional performance management

• Evaluation of investment level:

– Evaluation may result in an increase or decrease of
investment funds into a division.
– Could include:
• expanding a division
• closing a division
• redistributing investment funds.
– Must evaluate both short-term and long-term
consequences of divisional closure.
 Investment centre performance
evaluation
• Three common investment centre measures are:
– return on investment (ROI)
– residual income (RI)
– economic value added (EVA).
 Investment centre performance
evaluation
• Return on investment:
– ROIs for performance areas are calculated as profit
divided by investment:
Return on investment (ROI) = Profit
Divisional investment

– Example:
 Investment centre performance
evaluation
• Return on investment:
– Further analysis can be conducted using Du Pont ROI.

Du Pont ROI = Profit margin x Investment turnover

Profit = Profit x Sales
Investment Sales Investment
 Investment centre performance
evaluation

• Return on investment:
 Investment centre performance
evaluation
• Return on investment:
– Advantages:
• Easy to use and understand.
• Links profit with investment base, thus increasing
awareness of asset management and
discouraging overinvestment.
• Relationship between assets held in the
statement of financial position and profit in the
statement of profit or loss can be easily linked.
 Investment centre performance
evaluation
• Return on investment:
– Disadvantages:
• Percentage measure, not measure of absolute
values.
• Does not consider divisions that differ in size or
type.
• Divisional managers can manipulate ROI by
decreasing investment base relative to segment
profit.
• ROI could result in suboptimal decision making.
 Investment centre performance
evaluation
• Residual income:
– The formula for residual income is:

Residual income (RI) = Profit before tax

– (Required rate of return x Investment)
– Example:
• Assume required rate of return in 15%.
 Investment centre performance
evaluation
Residual income:
– Advantages:
• Minimises suboptimal decision making that could
result from use of ROI.
• Charge for capital can vary across divisions based on
risk of venture being pursued in each division.
– Disadvantages:
• Can still encourage short-term decision making.
• Required rate of return or a suitable charge for
capital may not be easy to determine.
 Investment centre performance
evaluation
• Economic value added:
– Based on economic increase in value after a suitable
charge for capital is subtracted.
EVA = Profit after tax (PAT) – (Cost of capital x Capital)
– Example:
 Investment centre performance
evaluation
• Economic value added:
– Calculated from financial accounting figures with
adjustments which could also allow manipulation.
• Examples of adjustments:
– adding back R&S costs: capitalised and written
off in financial years in which they bring benefits,
not when incurred — R&D seen as investment
rather than expense
– adding back marketing costs: capitalised and
written off over years in which benefit accrues.
 Investment centre performance
evaluation
• Economic value added:
– Advantages:
• Minimisation of suboptimal decision making.
• Charge can vary to take into account various risk
levels.
• Adjustments can be made to components within
the equation to suit specific circumstances of each
division.
 Investment centre performance
evaluation
• Economic value added:
– Disadvantages:
• Modifications to formula are complex.
• Modifications could be seen as being manipulated.
• Still a short-term economic performance indicator
based on financial accounting data.
 Investment centre performance
evaluation

• ROI, RI and EVA compared:

– Example — Fun Hats Company — ROI, RI and EVA
compared:
 Investment centre performance
evaluation
• The investment base:
– An investment base is needed to calculate ROI and RI,
this could be:
• gross book value (original cost):
– may not be a true reflection of actual
investment
• net book value (written-down value):
– will produce more favourable ROI and RI
calculations over time
 Investment centre performance
evaluation
• The investment base:
– An investment base is needed to calculate ROI and RI,
this could be:
• market value (current cost):
– investment base is being valued on current
costs rather than historical costs.
 Environmental and social performance

• In order to assess environmental and social

dimensions there is a need to develop, track and
monitor key performance indicators.
1. Operational performance indictor (OPI) that
provides information about the environmental
performance of an organisation’s operations.
 Environmental and social performance

• In order to assess environmental and social

dimensions there is a need to develop, track and
monitor key performance indicators (KPIs).
2. Management performance indicator (MPI) that
provides information about the management’s
efforts to influence an organisation’s environmental
performance.
3. Environmental condition indicator (ECI) that
provides information about the local, regional,
national or global condition of the environment.
 Environmental and social performance

• Just like financial information the UNDSD has put

forward some basic principles to be applied. They are
– relevance
– understandability
– target orientation
– consistency
– comparability
– balanced view
– continuity.
 Environmental and social performance

• Eco-efficiency:
– The organisation of economic and co-operative
development (OECD) states that eco-efficiency:
‘expresses the efficiency with which ecological
resources are used to meet human needs’.
– The purpose is to integrate ecological impact with
economic information.
– The result will show the environmental impact added
per chosen unit of economic performance.
 Environmental and social performance

• Sustainability report card:

 Individual performance measurement

• Companies are artificial entities and do not perform any

physical function.
– Apart from bringing owners, workers and resources
together under a legal structure.
• People working within companies perform multiple
tasks, individually and in teams, to help accomplish the
organisation’s goals.
• Therefore, performance measurement at the individual
level should highlight to the employees what tasks are
important.
 Individual performance measurement

• The reward system is also part of performance

measurement system.
– Some companies encourage teamwork
by including rewards based on team, department or
company-wide performance.
– Advantage is encouraging employees to work
together and hopefully achieve synergies that
individuals could not achieve working alone.
– Disadvantage is the difficulty of managing individuals
who shrink their responsibilities.
 Non-financial performance
evaluation
• Use of financial performance measures alone is
insufficient to gauge organisational success.
• Non-financial measures should be:
– linked to organisation’s goals
– well defined
– easily understood
– based on reliable data.
 Non-financial performance
evaluation
• Advantages:
– More user friendly and relevant to non-management
employees.
– More likely to lead to long term performance gains.
– Diminish likelihood of short term management
decision making.
– Identify problems in a more timely fashion.
– Can be easily structured to suit an organisation’s
goals.
– Can be benchmarked easily.
 Non-financial performance
evaluation
• Disadvantages:
– Subjective in nature.
– Number of measures must be limited to increase
understanding and reduce cost.
– Inappropriate measures can be chosen.
– No proven cause and effect link between non-
financial measures and economic success.
– Various measures give conflicting results.
 Non-financial performance
evaluation
• Examples of non-financial performance measures:
 Non-financial performance
evaluation
• Examples of non-financial performance measures:
 Non-financial performance
evaluation
• Examples of non-financial performance measures:
 Summary

• Performance measurement helps determine

achievement of entity’s objectives.
• Balanced scorecard provides a four-perspective
framework that aids performance evaluation.
• Organisational structures include functional,
geographical and enterprise-based groups.
• Preparation of divisional performance reports based on
responsibility centres provides guide for pricing as well
as basis for evaluating performance.
 Summary

• Popular investment-centre performance evaluation

measures are ROI, RI and EVA.
• Companies now have to report on their environmental
performance.
• Award schemes should capture performance on multiple
tasks, individual and team-based tasks, short- and long-
term tasks.
• Incorporating non-financial performance measures in an
evaluation system provides more information about
performance than only relying on accounting numbers.
Prepared by Nicola Beatson