Lesson 6: Financial and Nonfinancial Measures Financial and Nonfinancial Performance

Measures
MAC 406: PERFORMANCE MANAGEMENT
SYSTEM - Information used in a management
control system can be financial and
BS Management Accounting
nonfinancial.
- Financial measures such as return on
investment and residual income can
Learning Objectives: capture important aspects of both
1. Measure performance from a financial and manager performance and organization
nonfinancial perspective; subunit performance.
- Increasingly, companies are using
2. Design an accounting-based performance internal financial measures alongside
measure; with measures based on external
3. Compute return on investment (ROI), residual financial information (e.g., stock prices),
income (RI), economic value added (EVA) and internal nonfinancial information (such as
return on sales (ROS). manufacturing lead time, velocity, defect
rates or even new patents) and external
nonfinancial information (such as market
share, degree of customer satisfaction,
Performance Evaluation
etc.)
- Furthermore, benchmarking against
other subunits with the organization and
❑The principal focus of management control
other organizations is done.
systems is strategic performance measurement
or evaluation, ❑ In designing accounting-based
performance measures, the following steps
- Performance evaluation is the process by
may be followed:
which managers at all levels gain
information about the performance of 1. Choose performance measures that
tasks within the firm and judge that align with top management’s financial
performance against preestablished goal.
criteria as set out in budgets, plans and 2. Determine the time horizon of each
goals. performance measure.
- The goal of top management in using 3. Define the component of each financial
strategic performance measurement is to measure.
motivate the managers to provide high 4. Choose a measurement alternative for
level of effort, to guide them to make each performance measure.
decisions that are congruent with the 5. Decide on a target level of performance.
goals of top management and to provide
STEP 1: Choosing among different performance
a basis for determining fair compensation
measures
for the managers.
- Performance measures are a central There are four commonly used measures to
component of management control evaluate the economic performance of
system and to be effective, such organization subunits. These are:
measures (financial and nonfinancial)
must also motivate managers and (a) Return on investment (ROI) =
employees at all levels of the Income/Investment or Investment
organization to strive to achieve Turnover x Return on Sales
organization goals. (b) Residual Income (RI)
= Income – (Required rate of return x
Investment)
(c) Economic value added (EVA) = After tax
operating income – [Weighted average
cost of capital x (Total assets – Current
liabilities)]

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 (d) Return on sales (ROS) = Operating STEP 4: Choosing Measurement Alternatives for
income/Sales Performance Measures

STEP 2: Choosing the Time Horizon of the These are different ways to measure or value
Performance Means assets included in the investment calculations.
These are
• The ROI, RI, EVA and ROS calculations
represent the results of a single time period. (1) Current cost – which could mean
To draw conclusions based on short-run (a) The amount of cash or cash equivalent
changes in these measures could conflict that would have to be paid if the same or
with the long-run interest of the an equivalent asset was acquired
organization. currently
(b) The undiscounted amount of cash or cash
• It is generally desirable to evaluate
equivalent that would be required to
subunits on the basis of ROI, RI, EVA, and
settle an obligation currently
ROS over multiple years for the following
(2) Historical cost
reasons:
(a) Assets are recorded at the amount of
1. To avoid using a single year or short-run cash or cash equivalents paid or the fair
changes in performance measures that value of the consideration given to
could run counter with the long-run acquire them at the time of their
goals of the firm. acquisition.
2. The benefits of action taken in the (b) Liabilities are recorded at the amount of
current period may not show up in short- proceeds received or in exchange for the
run performance measures. For obligation, or in some circumstances at
example, the investment in a new hotel the amounts of cash or cash equivalents
may adversely affect ROI and RI in the expected to be paid to satisfy the liability
short run but benefit ROIs and Ris in the in the normal course of business.
long run. - Measuring assets at current costs will
3. If managers use the net present value result in different ROIs and RIs compared
method to make investment decisions, to ROI and RI calculations using historical
using multiyear RI to evaluate manager’s costs.
performances achieve goal congruence. - Current-cost ROI is considered a better
measure of the current economic returns
STEP 3: Choosing Alternative Definitions for from the investment compared to
Performance Measures historical –cost ROI.
The following are the alternative definitions of - A drawback, however using current cost
investment that companies use: is that it can be difficult to obtain current
cost estimates for some assets.
(a) Total assets available = includes all - This is because the estimate requires a
assets company to consider technological
(b) Total assets employed = includes total advances, when determining the current
assets minus the sum of idle assets and cost of assets needed to earn today’s
assets purchased for future expansion operating income.
(c) Total assets employed minus current - The use of current values helps to reduce
liabilities = this definition excludes that the unfairness of historical cost net book
portion of total assets employed that are value.
financed by short-term creditors - When comparing among business units
(d) Shareholders’ equity = use of this basis with different aged assets, units with
combines operating decisions made by older assets under the historical cost net
managers with financing decisions book value have significantly higher ROIs
regarding equity made by corporate that units with newer assets because the
management effect of price changes and of
accumulating depreciation over the life of
the assets.

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- The use of current values improves the STEP 5: Choosing Target Levels of Performance
use of ROI both as a measure of the
(a) The careful selection of benchmarks
performance of the manager and of the
or targets can help offset
economic performance of the unit;
shortcomings with traditional,
current values make the ROI calculation
historical cost-based ROI, RI and EVA
both relevant and comparable.
measure.
- Long-term Assets: Gross or Net Book
- For example, since older assets valued at
Values
historical cost inflate ROI (particularly if
- Another decision to make in choosing a
investment is defined as net rather than
measure of invested capital is whether to
gross assets), management may set
use the gross book value (acquisition
higher ROIs for divisions with older
cost) or the net book value of long-lived
assets.
assets (net book value is the acquisition
(b) Many problems of asset valuation
cost less accumulated depreciation).
and income measurement (whether
- Advantages of Net Book Value:
based on historical cost or current
Disadvantage of Gross Book Value
cost) can be satisfactorily solved if
1. Using net book value maintains
top management gets everybody to
consistency with the statement of
focus on what is attainable in the
financial position prepared for
forthcoming budget period
external reporting purposes.
regardless of whether ROI, RI or EVA
- This allows for more meaningful
is used and regardless of whether
comparisons of return-on-investment
the financial measures are based on
measures across different companies.
historical costs or some other
2. Using net book value to measure
measure, such as current costs.
invested capital is also more
(c) Another popular way to establish
consistent with the definition of
target is to set continuous
income, which is the numerator in
improvement targets.
ROI calculations. In computing
- For example, if a company is using EVA as
income, the current period’s
a performance measure, top
depreciation on long-lived assets is
management can evaluate operations on
deducted as an expense.
year-to-year changes in EVA, rather than
- Advantages of Gross Book Value:
on absolute measurements of EVA.
Disadvantage of Net Book Value
- Evaluating performance on the basis of
1. The usual methods of computing
improvements in EVA makes the initial
depreciation, such as straight-line
method of calculating EVA less important.
and the declining-balance methods,
are arbitrary. Hence, they should not STEP 6: Choosing the Timing of Feedback
be allowed to affect ROI or residual
income calculations. The final step in designing accounting-based
- Advantages of Gross Book Value: performance measure is the timing of feedback.
Disadvantage of Net Book Value The following factors should be considered in
1. When long-lived assets are timing the report of analysis:
depreciated, their net book value (a) How critical is the information for the
declines over time. This results in a success of the organization
misleading increase in ROI and (b) The specific level of management that is
residual income across time. receiving the feedback
- However, using gross book value (c) The sophistication of the organization’s
eliminates this problem. If an accelerated information technology
depreciation were used instead of the
straight-line method, the increasing
trend in ROI would be even more
pronounced.

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The other consideration that should not be
overlooked is that lower-level managers who are
responsible for day-to-day operations usually
require more frequent feedback than senior
executives, who primarily exercise oversight
over the lower-level managers.

- Strategic feedback should enable managers to

1. Implementation problems, or

2. An invalid strategy

- The timely reporting of actual results and