Chapter 13
Financial performance measures for investment centres and reward
systems
Copyright ª 2006 McGrawHill Australia Pty Ltd
13 1
Financial measures in investment centres
• Focus on summary profit-based measures used to evaluate the performance of profit centres and investment centres
– Return on investment (ROI) – Residual income (RI)
– Economic value added (EVA)
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-2
Return on investment
• Return on investment (ROI)
– Used to measure the performance of an investment centre
Returnoninvestment
profit
investedcapital
continued
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-3
Return on investment
ROI
profit investedcapital
profit
salesrevenue
salesrevenue
investedcapital
returnonsales investment turnover
continued
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-4
Return on investment
• Invested capital
– The assets that the investment centre has available to generate profits
• Return on sales
– The percentage of each sales dollar that remains as profit after all the expenses are covered
• Investment turnover
– The number of sales dollars generated by every dollar of invested capital
continued
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-5
Return on investment
• Improving ROI
– Increase return on sales
By increasing the selling price or sales revenue, or decreasing expenses
– Increase investment turnover
By increasing sales revenue or reducing invested capital
– Actions that are taken with the sole purpose of making these ratios more favourable in the short term may have adverse effects on performance in future years
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-6
The advantages of ROI
• Very widely used to measure the performance of divisions and managers
• Encourages managers to focus on profits, and the assets required to generate those profits
– Promotes an understanding of the relationship between revenues, costs and assets
• Can be used to evaluate the relative performance of investment centres
– Even when those business units are of different sizes
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-7
The limitations of ROI
• Encourages managers to focus on short-term financial performance at the expense of long-term viability and competitiveness
• Encourages managers to defer asset replacement
– To maintain high divisional ROI and apparent high performance
• Discourages managers from investing in projects which are acceptable from the organisation’s point of view, but decrease the investment centre’s ROI
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-8
Minimising the behavioural problems of ROI
• Use ROI as one of a series of performance measures that focus on both short-term and long-term performance
• Consider alternative ways of measuring invested capital to minimise dysfunctional decisions
• Use alternative financial measures, such as residual income or economic value added
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-9
Residual income
• Residual income (RI)
= profit – (invested capital × imputed interest rate)
• Imputed interest charge
– Based on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capital
– Weighted average cost of capital (WACC) is the weighted average of the cost of funds from all sources of borrowings and equity
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Management Accounting: Information for managing and creating value 4e By Kim Langfield-Smith
13-10
The advantages of residual income
• More likely to promote goal congruence, compared to ROI
• Takes account of the organisation’s required rate of return in measuring performance
• Encourages investment in projects which yield a positive residual income to the organisation
Copyright 2006 McGraw-Hill Australia Pty Ltd