Professional Documents
Culture Documents
7 Financial Performance Measurement
7 Financial Performance Measurement
Measurement
Topic objectives
• Recognise that there are different categories of performance
measures
– financial measures (the focus of this week)
– non-financial measures (in following weeks)
• Explain why ‘profit’ measures on their own are not suitable
performance measures
– Calculate and outline the uses and limitations of return on investment (ROI)
for monitoring performance
– Calculate and outline the uses and limitations of residual income (RI) for
monitoring performance
– Calculate and outline the uses and limitations of economic value added
(EVA) for monitoring performance
• Explain the issues associated with short-term financial measures
when used to evaluate management performance
2
2
The Performance Management Problem
– Manager’s/individual’s
o span of accountability and authority
o span of attention
4
Recap: Responsibility centres and performance
Performance measure classification
6
Measuring performance with ‘profit’ measures
• Value drivers:
– Management cannot influence directly the ‘value of the firm’
– Management can influence the ‘drivers of value’
10
Calculating ROI
11
The DuPont Model
12
Calculating ROI cont.
• Example:
13
Calculating ROI cont.
14
Benefits of using ROI
15
Limitations of using ROI
16
Short-termism and dysfunctional behaviour
17
Limitations of using ROI
– Profit
o net operating profit after taxes (NOPAT)? Before tax?
o earnings before interest and taxes (EBIT)?
o Controllable profit
19
Issues with using ROI
Advantages Disadvantages
• Holding managers • Discourages managers from
responsible reduces their investing in projects that
tendency to over invest in reduce division’s ROI even if
projects they improve overall company
ROI
• Components of ROI
motivate managers to • Does not incorporate
increase sales, decrease measures of risk
costs and minimise asset • Managers may only consider
investments short term impacts (particularly
when bonuses are involved)
20
Behavioural effect of ROI
In theory…..
• If investment/profit centres maximise subunit ROA/ROI or
profit then the firm as a whole maximises ROA/ROI or
profit, and consequently maximises returns to
shareholders…..
Required
Operating
RI = Operating income – rate of X
assets
return
• Operating assets
– Represents the level of invested capital
• Required rate of return (RRR)
– Represents the minimum annual return on investment
required by a business
22
Calculating RI
Example:
New Zealand Australia
Operating Assets $2 000 000 $200 000
Required rate of return 10% 10%
Required Return $200 000 $20 000
23
Limitations of Residual Income
Advantage Disadvantages
• RI removes the • Larger subunits are more
incentive for business likely to have larger residual
segment managers to incomes.
make project investment • Managers may cut costs on
decisions based on a
items of long-term benefit in
comparison of segment
order to obtain short term
ROI and project ROI.
gains.
• Encourages managers • Managers have an incentive
to focus on both profit to set their required rate of
AND asset utilisation return to too low.
25
EVA a proxy for share market value
26
Economic Value Added (EVA)
27
Economic Value Added (EVA)
28
Why short-term, financial measures encourage
dysfunctional behaviour - Four primary reasons
29
Four attributes of short-term, financial measures
that encourage dysfunctional behaviour
30