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