F 09420010120134022 PP T 09

Course : F0942 Management Control System
Year
: 2013-2014
Financial Performance Measures and

their Effects
Slide 10.3
Chapter 10:
Financial Performance Measures
and Their Effects
Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition Pearson Education Limited 2007
Slide 10.4
Summary measures
Summary, single-number, aggregate, bottom-line financial

measures of performance.
Reflect the aggregate or bottom-line impacts of multiple

performance areas.
e.g., accounting profits reflect the aggregate effects of both
revenue- and cost-related decisions.
Two types:
Market measures
Reflect changes in stock prices or shareholder returns.
Accounting measures
Defined in either residual terms (net income after taxes, operating profit,
residual income, economic value added) or ratio terms (return on
investment, return on equity, or return on net assets).
Slide 10.5
Market measures
Timely measured in short time periods
Precise in well-functioning capital markets
Objective not manipulable by the managers whose

performances are being evaluated
Congruent the most direct manifestation, or closest proxy,

of the theoretical notion of firm value
Cost effective do not require any company measurement

expense
Understandable in terms of what the measures represent

(changes in market value of the firm)
Slide 10.6
Limitations
Feasibility
Market measures are not available either for privately-held
firms or wholly-owned subsidiaries or divisions, and they are
not applicable to non-profit organizations.
Controllability
Market measures can generally be influenced to a significant
extent only by the top few managers in the organization, those
who have the power to make decisions of major importance.
Realized performance
Market measures are heavily influenced by future expectations,
but these expectations might not be realized.
Slide 10.7
Limitations (Continued)
Congruence?
For competitive reasons, markets are not always fully
informed about a companys plans and prospects,
and hence, its future cash flows and risks
Market valuations can be affected by carefully timed
or managed disclosures which are not always in
the companys long-term interest
Other anomalies
Slide 10.8
These limitations of market measures cause

organizations to look for surrogate measures
of performance.
Accounting measures are the most important
surrogates used, particularly at management
levels below the very top management team.
Slide 10.9
Accounting measures
Timely measured in short time periods
Precise subject to extensive accounting rules
Objective audited by independent auditors
Congruent
In for-profit firms, accounting profits or returns are relatively
congruent with the true firm goal of maximizing shareholder value.
Positive correlations between accounting profits and changes in
stock prices.
Cost effective already required for financial reporting
Understandable
Slide 10.10
Accounting income does not reflect economic

income perfectly, because accounting measures:
Are transactions oriented
Are dependent on the choice of measurement method
Are conservatively biased
Ignore intangibles
Ignore the cost of equity capital
Ignore risk
Focus on the past
The change in the value of the entity

over a given period, where value is
obtained by discounting future CFs.
Slide 10.11
Myopia
The motivational effect of these measurement limitations

can be perverse because managers who are motivated
to produce accounting profits or returns can (in the
short-term) do so by:
Not making investments, even worthwhile ones
Investment myopia
Making operational decisions to shift income
across periods, even when harmful long-term
Operational myopia
Slide 10.12
ROI performance measures
Return on Investment
ROI is a ratio of the accounting profits earned by
the business unit divided by the investment
assigned to it.
ROI = profits investment base
Residual Income
RI is a dollar amount obtained by subtracting a
capital charge from the reported accounting profits.
RI = profits - capital charge
Slide 10.13
Problems caused by ROI-measures
Numerator
Accounting profits, hence,
ROI contains all problems associated with these profit
measures.
Denominator
How to measure the fixed assets portion?
Suboptimization
ROI-measures can lead division managers to make
decisions that improve division ROI even though the
decisions are not in the corporation's best interest.
Slide 10.14
An example
- Assume corporate cost of capital = 15%
- Division investment of $25,000 that generates
5,000 annual profit (=20%)
New
Division
Asset
Alone
WITHOUT
WITH
Profit
Assets
25,000
30,000
5,000
100,000
125,000
25,000
ROI
25%
24%
20%
Slide 10.15
Another example
ROI
Entity
A
B
C
D
E
RI
Entity
A
B
C
D
E
Cash Receivables Inventories Fixed Assets

$ 10
20
15
5
10
Profit
$ 24.0
14.4
10.5
3.8
(1.8)
$ 20
20
40
10
5
$ 30
30
40
20
10
$ 60
50
10
40
10
Cur. Assets Req. Earn. Fixed Assets

$ 60
70
95
35
25
$ 2.4
2.8
3.8
1.4
1.0
4%
Total Invest.
$ 120
120
105
75
35
Required Earn.
$ 60
50
10
40
10
$ 6.0
5.0
1.0
4.0
1.0
Profit
ROI
$ 24.0
14.4
10.5
3.8
(1.8)
20 %
12
10
5
(6)
Res. Income
$ 15.6
6.6
5.7
(1.6)
(3.8)
10%
Slide 10.16
Suboptimization
ROI provides different incentives for investments
across organizational entities.
Entity manager will not invest if
Entity manager will invest if
Corporate
Cost of
Capital
Corporate
Cost of
Capital
<
IRR
of
Project
<
Entity
ROI
>
IRR
of
Project
>
Entity
ROI
Hence, if corporate cost of capital is 10%,

IRR of project is 11%, then A and B are unlikely to invest
IRR of project is 9%, then D and E are still likely to invest
Slide 10.17
Suboptimization (Continued)
Assume
Worthwhile !
Corporate cost of capital = 10%

Investment of $10 to earn $1.1 per year
DOES NOT INVEST
INVESTS
INVESTS
Base situation
Entity A
Entity C
Entity D
Profit Before tax

Investment base
ROI
$ 24
$ 120
20 %
$ 10.5
$ 105
10 %
$ 3.8
$ 75
5%
New situation
New situation
New situation
New situation
Profit before tax

Investment
ROI
$ 25.1
$ 130
19.30 %
$ 11.6
$ 115
10.08 %
$ 4.9
$ 85
5,76%
Slide 10.18
Suboptimization (Continued)
Assume
Not worthwhile !
Corporate cost of capital = 15%

Investment of $10 to earn $1.1 per year
DOES NOT INVEST
INVESTS
INVESTS
Base situation
Unit A
Unit C
Unit D
Profit Before tax

Investment base
ROI
$ 24
$ 120
20 %
$ 10.5
$ 105
10 %
$ 3.8
$ 75
5%
New situation
New situation
New situation
New situation
Profit before tax

Investment
ROI
$ 25.1
$ 130
19.30 %
$ 11.6
$ 115
10.08 %
$ 4.9
$ 85
5.76%
Slide 10.19
Other issues
Suboptimization is not an issue with residual income (RI)

measures when the capital charge is set at or above the
cost of capital.
ROE measures induce managers to use debt financing

(if they have financing authority).
This is not the case with RI if the capital charge is
equal to the weighted average cost of debt and
equity.
ROA measures induce managers to lease assets (again, if

they have authority over such decisions).
Slide 10.20
The fixed assets portion
Net Book Value

Both ROI and RI get better merely to passage of time
Both ROI and RI are usually overstated if the division
includes a relatively large number of older assets
Example
Invest $100; Cash flow $27 per year; Depreciation $20 (5 years)
Yr
NBV
Incremental
Income
1
2
3
4
5
100
80
60
40
20
7
7
7
7
7
(=27-20)
Capital
Charge
RI
ROI
10
8
6
4
2
-3
-1
1
3
5
7%
9%
12%
18%
35%
10 %
Slide 10.21
Misleading performance signals
Division managers are encouraged to retain assets beyond

their optimal life and not to invest in new assets.
Corporate managers may be induced to over-allocate

resources to divisions with older assets.
Combined with the suboptimization issue, managers of

entities with older assets, and hence a higher ROI, are
likely to be more reluctant to invest in desirable projects
with an IRR higher than the corporate cost of capital.
Slide 10.22
Economic Value Added (EVA)
Modified after-tax operating profit

(Modified capital x weighted average cost of capital)
Similar to RI (=profitcapital charge), except for the

modifications (164 in total, as suggested by Stern
Stewart & Co)
e.g., Capitalization and subsequent amortization of intangible
investments (e.g. in R&D, employee training)
Adding LIFO-reserves to correct for undervalued inventories
etc.

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Course : F0942 Management Control System

Financial Performance Measures and

Summary, single-number, aggregate, bottom-line financial

Reflect the aggregate or bottom-line impacts of multiple

Timely measured in short time periods

Precise in well-functioning capital markets

Objective not manipulable by the managers whose

Congruent the most direct manifestation, or closest proxy,

Cost effective do not require any company measurement

Understandable in terms of what the measures represent

These limitations of market measures cause

Timely measured in short time periods

Precise subject to extensive accounting rules

Objective audited by independent auditors

Cost effective already required for financial reporting

Accounting income does not reflect economic

The change in the value of the entity

The motivational effect of these measurement limitations

ROI performance measures

Problems caused by ROI-measures

Cash Receivables Inventories Fixed Assets

Cur. Assets Req. Earn. Fixed Assets

Entity manager will invest if

Hence, if corporate cost of capital is 10%,

Corporate cost of capital = 10%

Profit Before tax

Profit before tax

Corporate cost of capital = 15%

Profit Before tax

Profit before tax

Suboptimization is not an issue with residual income (RI)

ROE measures induce managers to use debt financing

ROA measures induce managers to lease assets (again, if

The fixed assets portion

Net Book Value

Misleading performance signals

Division managers are encouraged to retain assets beyond

Corporate managers may be induced to over-allocate

Combined with the suboptimization issue, managers of

Economic Value Added (EVA)

Modified after-tax operating profit

Similar to RI (=profitcapital charge), except for the

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