Performance Measurement

Chapter 23

Financial and NonfinancialPerformance Measures

Some organizations present financial andnonfinancial performance measures for

their subunits in a single report– the balanced scorecard.

Most scorecards include:

– profitability measures

– customer-satisfaction measures

– internal measures of efficiency, quality, and time

– learning and growth (innovation) measures

Management Control Systems

A management control system is a means ofgathering and using information to coordinate

the planning and control functions of thecompany.

It guides the behavior of managers towardsattaining the goals shown in the Balanced

Scorecard.

Evaluating ManagementControl Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary

Organization Structure

Total centralization

Total decentralization

Benefits of Decentralization

Allows for greater responsiveness to local needs

Leads to gains from quicker decision making

Increases motivation of subunit managers

Assists management development and learning

Allows top management to focus on strategy

Costs of Decentralization

Suboptimal decision making may occur

Focuses the manager’s attention on the subunitrather than the organization as a whole

Lack of coordination among autonomous managers

Results in duplication of activities

Responsibility Centers

Costcenter

Revenuecenter

Investmentcenter

Profitcenter

Measuring Managers Performance

Cost/RevenueCenter

Standard Cost/FlexibleBudget Variances

ProfitCenter

Budgeted incomestatement

InvestmentCenter

Return on investment,residual income and EVA

Evaluation Tool

Accounting-Based PerformanceMeasure Example

Relax Inns owns three small hotels – one each in Boston, Denver, and Miami.

At present, Relax Inns does notallocate the total long-term debt of

the company to the three separate hotels.

Denver Hotel

Current assets $ 400,000Long-term assets 600,000Total assets $1,000,000Current liabilities $ 150,000

Revenues $1,200,000Variable costs 310,000Fixed costs 650,000Operating income $ 240,000

Relax Inns Balance Sheet

Total current assets $1,350,000Total long-term assets 6,150,000Total assets $7,500,000Total current liabilities $ 500,000Long-term debt 4,800,000Stockholders’ equity 2,200,000Total liabilities and equity $7,500,000

Approaches toMeasuring Performance

Three approaches include a measure of investment:

Return on investment (ROI)

Residual income (RI)

Economic value added (EVA®)

A fourth approach, return on sales (ROS),does not measure investment.

Return on Investment

Return on investment (ROI) is anaccounting measure of income

divided by an accountingmeasure of investment.

Return on investment (ROI)= Income ÷ Investment

What is the return on investment for the Denver Hotel?

Return on Investment

Denver Hotel: $240,000 Operating income÷ $1,000,000 Total assets = 24%

The DuPont method of profitability analysisrecognizes that there are two basic

ingredients in profit making:

DuPont Method

1. Using assets to generate more revenues

2. Increasing income per dollar of revenues

DuPont Method

Investment turnover = Revenues ÷ Investment

Return on sales = Income ÷ Revenues

ROI = Return on sales × Investment turnover

DuPont Method

How can Relax Inns attain a 30% targetROI for the Denver Hotel?

Present situation: Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20

Operating income ÷ Revenues= $240,000 ÷ $1,200,000 = 0.20

1.20 × 0.20 = 24%

DuPont Method

Alternative A: Decrease assets, keepingrevenues and operating income per

dollar of revenue constant.

Revenues ÷ Total assets= $1,200,000 ÷ $800,000 = 1.50

1.50 × 0.20 = 30%

DuPont Method

Alternative B: Increase revenues, keepingassets and operating income per dollar

of revenues constant.

Revenues ÷ Total assets= $1,500,000 ÷ $1,000,000 = 1.50

1.50 × 0.20 = 30%

Operating income ÷ Revenues= $300,000 ÷ $1,500,000 = 0.20

DuPont Method

Alternative C: Decrease costs to increaseoperating income per dollar of revenues,

keeping revenues and assets constant.

Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20

1.20 × 0.25 = 30%

Operating income ÷ Revenues= $300,000 ÷ $1,200,000 = 0.25

Residual Income

Residual income (RI)= Income

– (Required rate of return × Investment)

Assume that Relax Inns’ requiredrate of return is 12%.

What is the residual income from the Denver hotel?

Residual Income

Denver Hotel:Residual Income = $240,000 - ($1,000,000 X 12%)

= $120,000

Economic Value Added

Economic value added (EVA®)

= After-tax operating income

– [Weighted-average cost of capital

× (Total assets – current liabilities)]

Economic Value Added

Total assets minus current liabilitiescan also be computed as:

Long-term assets + Current assets– Current liabilities, or…

Long-term assets + Working capital

Economic Value Added

Economic value added (EVA®) substitutes thefollowing specific numbers in the RI calculations:

1. Income equal to after-tax operating income

2. A required rate of return equal to theweighted-average cost of capital

3. Investment equal to total assets minuscurrent liabilities

Economic Value Added Example

Assume that Relax Inns has two sources oflong-term funds:

1. Long-term debt with a market value andbook value of $4,800,000 issued at aninterest rate of 10%

2. Equity capital that also has a market value of$4,800,000 and a book value of $2,200,000

Tax rate is 30%.

Economic Value Added Example

What is the after-tax cost of debt?

0.10 × (1 – Tax rate) = 0.07, or 7%

Assume that Relax Inns’ cost ofequity capital is 14%.

What is the weighted-average cost of capital?

Economic Value Added Example

WACC = [(7% × Market value of debt)+ (14% × Market value of equity)]

÷ (Market value of debt + Market value of equity)

WACC = [(0.07 × 4,800,000)+ (0.14 × 4,800,000)] ÷ $9,600,000

WACC = $336,000 + $672,000 ÷ $9,600,000

WACC = 0.105, or 10.5%

Economic Value Added Example

What is the after-tax operating income for the Denver Hotel?

Denver Hotel:Operating income $240,000 × 0.7 = $168,000

Economic Value Added Example

What is the investment?

Denver Hotel: Total assets $1,000,000– Current liabilities $150,000 = $850,000

Economic Value Added Example

What is the weighted-average cost of capitaltimes the investment for Denver?

Denver Hotel: $850,000 × 10.5% = $89,250

Economic Value Added Example

What is the economic value added?

Denver Hotel: $168,000 – $89,250 = $78,750

The EVA® charges managers for the costof their investments in long-term assets

and working capital.

Return on Sales

The income-to-revenues (sales) ratio, or returnon sales (ROS) ratio, is a frequently used

financial performance measure.

What is the ROS for the Denver hotel?

Denver Hotel: $240,000 ÷ $1,200,000 = 20%