Performance Measurement Using IncomeRelated Measures
Types of Performance Centers
Type of Ctr
Cost
Income
Investment
Manager Controls:
Costs
Revenues Investments
D
D
D
D
D
D
Functional organization
President
VP
Manufacturing
VP
Sales
Controller
Type title here
Etc.
Divisional organization:
President/CEO
Plastic Products Div.
VP
Manufacturing
Electronics Division
VP
Sales
Accounting
Food Services Div.
VP
Etc.
[Each fairly autonomous. The assumed structure for ROI!]
Etc.
ROI=(Net Income)/(Invested Capital)
Problems of definition and
measurement.
NET INCOME
Definition
! Absorption-costing?
with/without allocation of
noncontrollable costs
! Contribution approach?
with/without allocation of
noncontrollable costs
Measurement
! Historical cost basis?
! Some definition of current cost?
Replacement cost
Current market (exit) value?
Inflation index adjustment?
INVESTED CAPITAL
Definition(what to include)
Conceptually, include the assets
used to generate the income in the
numerator.
Total assets available?
Total assets employed (omit,
e.g.,
construction in progress)?
Wkg Capital + other assets, i.e.,
Assets- ST. Liab.?
Shareholders' Equity???
Measurement of invested capital:
Historical book value?
Original Cost?
Net of deprec? (what kind?)
Current value?
Replacement?
Current mkt (exit)?
Inflation index?
COMPONENTS OF ROI
Sales
Invested Capitol
x
NI
Sales
= ROI
ù
ù
Capital turnover Profit margin
(Also called Return on Sales)
This is the "DuPont" method.
Emphasizes that both or either factor can be
changed to improve ROI
E.G.,
T/O
Housewares 2
Groceries
10
Mgn ROI
10% 20%
2%
20%
Different ROI's are appropriate for
evaluating....
Managers vs. Segments
Purpose: Raise, Bonus Retention,
expansion
What to Controllable
Items traceable
Include
items
to the segment
Residual Income
Dysfunctional effect of ROI: can lead to
a lack of “goal congruence.”
E.G., Corporate mgt. wants 15% min.
return on investment.
Div. A currently earns 19%
Div. B currently earns 14%
Div. C currently earns 16%
Investment opportunity: chance to
invest $100,000 that will earn
16%($16,000/yr).
Lack of goal congruence:
Corporate mgt. wants to invest
Div. A or C mgrs reject.
Residual Income overcomes the conflict:
Income for the year
$16,000
Less imputed interest
15,000 at
15%
Residual Income
$ 1,000
(Same regardless of division. Any mgr.
should view investment the same way)
Why has RI not replaced ROI?
Economic Value Added (EVA)
All material below taken from Esa Mäkeläinen's Master's
thesis at the Helsinki School of Economics, 1998
Background of EVA
EVA is not a new discovery.
$
variation of residual income
$
Stern Stewart & Co. trademarked “EVA”
$
often called Economic Profit (EP) to avoid
trademarking problems
$
In the 1970s or earlier RI failed get wide publicity or
become popular
$
However EVA, practically the same concept with a
different name, has done it in the recent years.
Furthermore the spreading of EVA and other residual
income measures does not look to be on a weakening
trend.
Main theory behind EVA
EVA measures whether the operating profit is enough compared to
the total costs of capital employed. It is net operating profit after taxes
(NOPAT) subtracted with a capital charge:
EVA = NOPAT - CAPITAL COST
EVA = NOPAT - COST OF CAPITAL x CAPITAL employed
Or equivalently, if rate or return is defined as NOPAT/CAPITAL, this
turns into a perhaps more revealing formula:
EVA = (RATE OF RETURN - COST OF CAPITAL) x CAPITAL
Where:
1.
2.
3.
Rate of return = NOPAT/Capital
Capital = Total balance sheet minus non-interest bearing debt
(i.e., accounts payable) in the beginning of the year
Cost of capital =
Cost of Equity x (% of capital from equity)
+ Cost of debt x (% of capital from debt) x (1-tax rate).
Cost of equity capital is the opportunity return from an investment
with same risk as the company has.
Cost of debt is naturally more straightforward, and includes the tax
shield due to tax allowance on interest expenses.
If ROI is defined after taxes then EVA can be presented with familiar
terms to be:
EVA = (ROI - WACC) x CAPITAL EMPLOYED