Managerial Accounting - Performance Evaluation Measures

Compare EVA to RI

EVA aligns decisions with shareholders wealth, because if EVA is positive companies value is likely to be maximized Simple and easy to understand once you comprehend adjustment overcomes the disadvantages of multiple & inconsistent goals, so when using EVA the focus lies on one measure of performance Accurate measure of corporate performance

ROI Advantages

Easy to compute and to understand using the financial statement helps to identify key drivers Aids comparsion across firm Captures effects of many profit and losses and balance sheet items

Investment Base

Is the sum of assets employed in an investment center. There are two primary methods of relating profit to the investment base (ROI & RI)

Management Control System (MCS)

Is to align employee and organizational interests. A system which gathers and uses information to evaluate the performance of different organizational resources like human, physical, financial and also the organization as a whole in light of the organizational strategies pursued.

Profit and Investment Center & delegating responsibility to lower managers

The two most far-reaching forms of formal deentralization. The manager should have access to the relevant information needed for making such a decision There should be some way to measure the effectiveness of the trade-offs the manager has made Establishing control" performance measurement systems

Performance Measurment System

Used to implement strategy It is important to distinguish whether a measure is used to evaluate a manager of a profit or investment centre. Non-financial, such as customer satisfaction, lead time Performance measurement is the process of collecting, analyzing and/or reporting information regarding the performance of an individual, group, organization, system or component.

Responsibility Accounting

is used to measure the performance of people and departments to foster goal congruence

Performance measurment system

main objective of implementing strategy helps us see if the company has actually received the target

Profit Centre

segment has control over both cost and revenue

Revenue Center

segment is responsible for the revenue of a unit

Advantages of Profit Centers

- The quality of decisions may improve - Provide training ground for general management - Profit consciousness is enhanced

Profit Center

- segment has control over both cost and revenue - responsibility center´s financial performance is measured in terms of profit

Investment Center

- segment has control over profits and invested capital - profits is compared with assets employed in earning it

EVA Advantages

-first, it aligns decisions with shareholders wealth -it is simple and therefore easy to understand by line managers -overcomes the disadvantages of multiple and inconsistent goals -most accurate measure of corporate performance -overall EVA is much more than a performance measurement system

How does ROI lead to misleading performance signals?

-makes firms with old assets to exhibit superior performance, which they dont actually have -To aviod the above companies use RI

EVA desciption

Advanced version of RI it considers the problem that ROI and RI normally uses book values instead of taking profit reported in the annual account, when using EVA managers have to proceed in a number of additional adjustments in order to make sure that the profit measure they use is an appropriate reflection of the companines performance Common adjustments often related to intangible non-current assets capitalization of research and deelopment expense capitalization of market-building expenses capitalization of trade mark the adding back of goodwill amortization

RI Advantages

- Aligns decisions with shareholder wealth, making them take decisions ehich wil maximize companies performance - It comprises a financial measure that managers will understand

Disadvantages of Profit Centers

- Loss of Control - Lack of competent managers - too much emphasis on short term profitability

Profit Centre Advantages & Disadvantages

AD: quality decisions might improve provide training ground for general management profit consciouness is enhanced D: loss of control lack of comptent managers too much emphasis on short term profitability

Decentralization

Communicating strategy of company to all middle managers. Allocating responsibilities to middle managers.

Responsibility Centres

Cost Center, Revenue Center, Profit Center, Investment Center

ROI Disadvantages

If ROI < mean ROI then managers will reject these projects Even if the new ROI > Cost of Capital (always accept) - Net income does not include value increases such as increases in the value of land until this is actually sold - Accounting net income is conservative: recognises losses as soon as they occur but defers the recognition of gains - Total assets exclude intangible assets - ROI leads to underinvestment How? - By providing incentives to managers to reject profitable projects - If ROI < mean ROI then managers will reject these projects - long term profitability is ignored - managers have an incentive only to choose projects with a high rate of return, even though if the project would increase the value of whole business but decrease the managers unit value they would reject - Managers think in terms of their sub unit not in the sense of the whole firm -Managers have an incentive to keep old assets in the books, the lower the value of the asset the higher the ROI will be, thus keeping old assets will mean lower dominator resulting in higher ROI

RI

Residual Income = operating profit - capital charge When using RI all business units will accept the new project if RI > 0

RI

Residual Income= Earnings before interest expenses and taxes - cost of capital*assets employed

ROI

Return on Investment = Earnings before interest expenses and taxes/assets employed

Investment Centre

Segment has control over profits and invested capital

Cost Centre

Segment has control over the incurrence of cost

Cost Center

Segment has control over the incurrence of costs: often for highly mechanical operations

Revenue Centre

Segment is responsible for the revenue of a unit

EVA

adjusted net operating profits after tax - cost of capital * adjusted assets employed