Week 7: Financial Performance

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
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The Performance Management Problem

• All of the strategic and operating decisions managers

make impact on “value” of the firm
• Managers who have been delegated responsibility may
not act in the best interests of the firm
• How do we encourage the right value adding decisions?
– Measure performance
o Performance measurement systems are designed to ‘capture’
value and encourage desired behaviour
o Performance measures signal to managers the types of
decisions/behaviours that top management wants
This week, a focus on financial measures
• The appropriate measure/s depend on
– The type of responsibility centre

– Manager’s/individual’s
o span of accountability and authority
o span of attention

• Financial measures will usually always be used for

performance measurement at corporate/strategic/business
unit level
– Financial measures are generally considered short-term

• Performance measurement in investment and discretionary

cost centres can be challenging

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Recap: Responsibility centres and performance
Performance measure classification

Financial performance measures are also recognised as

traditional or conventional performance measures
– Short-term, financial measures
o Profit
o Revenue
o Costs
o Return on Investment (ROI)
o Residual Income (RI)
o Economic Value Added (EVA)

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Measuring performance with ‘profit’ measures

• How will the ‘profit’ measure motivate the manager to ‘add

value’ to the firm?
– Increase profits through
o Effective pricing
o Increasing volume
o Reducing costs (i.e. improving efficiency)

• In what ways might a manager add to subunit profit and not

add value to the firm?
– Reducing costs with long-term adverse consequences (i.e.
R&D, staffing levels, training etc)
– Short-term price reductions to increase volume in current
period
– Manipulating application of accounting rules to show artificial
profit increase
What is value?...What is congruence?
• The value of any economic asset:
– Can be calculated at any specific time by discounting to
present value the future cash flows that the firm is expected
to generate
– Can be reflected in amounts for which they were sold in
recent market transactions (i.e. barrel of oil)
– Can be reflected in the recent share price
• A performance measure is highly congruent if it is
highly correlated with changes in value
• Incongruent measures can be counterproductive
– i.e. cut R&D to boost short-term profits; increase sales by
extending payment terms or selling to customers with
questionable credit 8
What influences the value of a firm?

• Value drivers:
– Management cannot influence directly the ‘value of the firm’
– Management can influence the ‘drivers of value’

• Actions to influence value drivers

– Improving cash flow from operations
o Making optimal operational and investment decisions
– Minimising cost of capital
o Making optimal capital structure decisions

• There are alternative measures to ‘profit’ that influence the

value drivers of a firm
• These measures take into account both income and balance
sheet items (explained on the next slide)
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Financial performance measures

• Three measures commonly used to evaluate investment

centre performance are:
– return on investment (ROI)
– residual income (RI)
– economic value added (EVA)

• Return on investment (ROI) is the ratio of operating income

to average operating assets.
– Operating income is defined as earnings before interest and
taxes (EBIT).
– Operating assets include cash, accounts receivable, inventory,
and the property and equipment used in producing the revenue.

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Calculating ROI

• ROI can be decomposed (see DuPont analysis next slide):

– Numerator and denominator are multiplied by revenue
– Items are then rearranged

ROI = Operating income  Operating assets

• Operating assets equate to invested capital or the assets an
investment centre has available to generate profit

ROI = Investment turnover × Return on sales

• DuPont analysis is useful to determine ways ROI can be
improved

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The DuPont Model

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Calculating ROI cont.

• Example:

New Zealand Division Australian Division

Operating Assets $2 000 000 $200 000

Operating Income $500 000 $60 000

Sales $5 000 000 $1 000 000

* All New Zealand information has been converted to Australian dollars

ROI (NZ) = $500 000  $2 000 000 = 25%

ROI (Aus) = $60 000  $200 000 = 30%

• How can ROI (NZ) be improved?

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Calculating ROI cont.

Decomposing ROI (NZ):

Return on sales = $500 000  $5 000 000

= 10%
Investment turnover = $5 000 000  $2 000 000
= 2.5 times
ROI = 10% x 2.5
= 25%

• ROI (NZ) can be increased in three ways:

– increasing sales
– decreasing costs
– decreasing investment in operating assets.

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Benefits of using ROI

1. Encourages managers to focus on both profit AND asset

utilisation
– Supports the Investment Centre concept of responsibility
accounting
– Provides a directional and motivational influence on
behaviour

2. ROI is a ratio – allows comparisons of different sized

investment centres

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Limitations of using ROI

1. Individuals might maximise their measured performance, but

not the strategic goals underlying performance measures

Measured performance is enhanced, but actual performance

and strategic goals are not

• This is considered as Short-termism/myopic behaviour

– Behaviours individuals undertake to maximise short-term
performance at the expense of long-term performance
• Examples
– Putting off necessary equipment/machine maintenance, so that budget
targets are met
– Postponing capital investments to achieve a target ROI, even though those
investments would support strategic goals in the long term

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Short-termism and dysfunctional behaviour

Examples of short termism and/or performance measure

manipulation
• Creating budgetary slack to increase chances of meeting budget/
variances targets
• Putting off necessary equipment/machine maintenance, so that
budget targets are met (possible extra repair costs in the future)
• Postponing capital investments to achieve a target ROI, even
though those investments would support strategic goals in the
long term
• Offering discounts at the end of the period to attract sales, in
order to meet revenue targets for the period

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Limitations of using ROI

2. There is not ONE correct method of calculating profit or assets

– Assets
o Total assets?
o Total assets less current liabilities?
o Average or end-of-year balances?
o Controllable assets
o Assets at book value or gross value

– Profit
o net operating profit after taxes (NOPAT)? Before tax?
o earnings before interest and taxes (EBIT)?
o Controllable profit

Debates over what comprises “profit”, “costs”, “revenues” are not

uncommon (i.e. should head office cost allocations be included?)
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Limitations of using ROI

3. When rewards are attached to a target ROI managers may be

encouraged to focus on short-term ROI performance at the
expense of long-term performance
– Managers use their annual (short-term) ROI target as a
benchmark for choosing whether to make asset replacements or
invest in projects

They may not use more appropriate evaluation methods –

e.g. NPV

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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)

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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…..

– but is maximising subunit profit or ROA/ROI really congruent

with maximising the value of the firm for external
stakeholders?........
Residual Income (RI): An alternative to ROI
• Residual income (RI) measures the dollar amount of profits
above the minimum required rate of return.
• RI is operating income less the minimum required operating
income given the segment’s investment in assets.

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
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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

Residual income is calculated as:

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Limitations of Residual Income

1. There is not ONE correct method of calculating profit or

assets (see ROI)

2. When rewards are attached to a target RI managers may be

encouraged to focus on short-term RI performance at the
expense of long-term performance
– Managers use their annual (short-term) ROI target as a
benchmark for choosing whether to replace assets or invest in
projects
o They may not use more appropriate evaluation methods –
e.g. NPV
• What about the use of Economic Value Added (EVA) instead of
RI?
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Issues with using RI to evaluate performance

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.

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EVA a proxy for share market value

• Share-value based measures as measures of

value added by management have limitations:
– Too aggregated?
– Cannot be used for non-listed firms
– Cannot be used within a firm (i.e. at a divisional level)
– Assumes stock market efficiency
– Share prices are influenced by:
o Macro economic conditions
o Uncontrollable factors
o Factors unrelated to management quality during the period

• Can we develop a good proxy?.....EVA?

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Economic Value Added (EVA)

• Economic value added (EVA) incorporates a number of

adjustments to reduce the disadvantages produced by
residual income.
– Income is defined as “adjusted” after-tax operating income.
– Required rate of return is defined as the weighted average
cost of capital (WACC).
– Operating assets is defined as “adjusted” total assets less
current liabilities.
• WACC is the after-tax cost of all long-term financing for the
business segment.
• Business segments in riskier industries will have a higher
WACC.

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Economic Value Added (EVA)

The basic EVA calculation is:

Adjusted after- Adjusted Current
EVA = tax operating – WACC x –
total assets liabilities
income
– EVA’s “adjustments” are specific to the organisation’s
structure and goals.
– WACC is a weighted average of the after-tax cost of debt
and the cost of equity.
• While EVA helps to better define measurement, it is not
unlike RI and has similar advantages/disadvantages

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Why short-term, financial measures encourage
dysfunctional behaviour - Four primary reasons

Short-term, financial measures:

1. Measure performance over a short period of time
– Encourages a short-term focus to performance

2. Are outcome (not process) based

– Don’t measure the process by which performance outcomes
are achieved
– Therefore are unable to distinguish between valued
processes and processes arising from dysfunctional
behaviours

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Four attributes of short-term, financial measures
that encourage dysfunctional behaviour

3. Are usually easily understood

– Therefore individuals know how to influence measured
performance

4. Provide a reward if performance targets are achieved

– Incentives are provided which encourage individuals to act
dysfunctionally

Next week: further examples of the behavioural implications of

performance measures. Later in the course we will focus on non-
financial measures and balanced performance measurement.

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