Chapter 13 Financial performance measures for investment centres, and reward systems Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Outline Financial measures in investment centres Return on investments Residual income Measuring profit and invested capital Measures of shareholder value Reward systems Theories of motivation Performance-related reward systems Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Financial measures in investment centres Focus on summary profit-based measures used to evaluate the performance of profit centres and investment centres Return on investment (ROI) Residual income (RI) Economic value added (EVA) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Return on investment Return on investment (ROI) Used to measure the performance of an investment centre (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Return on investment (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Return on investment (cont.) Invested capital The assets that the investment centre has available to generate profits Return on sales The percentage of each sales dollar that remains as profit after all the expenses are covered Investment turnover The number of sales dollars generated by every dollar of invested capital (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Return on investment (cont.) Improving ROI Increase return on sales By increasing the selling price or sales revenue, or decreasing expenses Increase investment turnover By increasing sales revenue or reducing invested capital Actions that are taken with the sole purpose of making these ratios more favourable in the short term may have adverse effects on performance in future years Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

The advantages of ROI Very widely used to measure the performance of units and managers Encourages managers to focus on profits, and the assets required to generate those profits Promotes an understanding of the relationship between revenues, costs and assets Can be used to evaluate the relative performance of investment centres Even when those business units are of different sizes Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

The limitations of ROI Encourages managers to focus on short-term financial performance at the expense of long-term viability and competitiveness Encourages managers to defer asset replacement To maintain high ROI and apparent high performance Discourages managers from investing in projects which are acceptable from the organisation’s point of view, but decrease the investment centre’s ROI Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Minimising the behavioural problems of ROI Use ROI as one of several performance measures that focus on both short-term and long-term performance Consider alternative ways of measuring invested capital to minimise dysfunctional decisions Use alternative financial measures, such as residual income or economic value added Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Residual income Residual income (RI) Imputed interest charge = profit – (invested capital × imputed interest rate) Imputed interest charge Based on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capital Weighted average cost of capital (WACC) is the weighted average of the cost of funds from all sources of borrowings and equity Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

The advantage of residual income More likely to promote goal congruence, compared to ROI Takes account of the organisation’s required rate of return in measuring performance Encourages investment in projects which yield a positive residual income to the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Disadvantages of residual income Cannot be used to assess the relative performance of businesses that are of different sizes, unlike ROI Formula is biased in favour of larger businesses, unlike ROI Can encourage short-term orientation/focus, as with ROI Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measuring profit and invested capital Total assets Investment centre manager is responsible for decisions about all assets Total productive assets Investment centre managers retain non-productive assets Total assets less current liabilities Investment centre is responsible for decisions about assets and manages short-term liabilities Choose average or end-of-year balances Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Asset measurement Advantages of carrying amount Consistency with balance sheet that is prepared for external reporting purposes Consistent with the definition of profit Advantages of acquisition cost Choice of depreciation method is arbitrary and resulting carrying amount does not provide a reliable measure Depreciating non-current assets may provide a disincentive to invest in new equipment Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measuring profit Profit margin controllable by investment centre manager Suitable when the focus is performance of the manager Encourages managers to focus on profit that they can control Motivational impact Profit margin attributable to investment centre To calculate the investment centre ROI Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measures of shareholder value Improving the worth of the business from the shareholders’ perspective Value-based management Using shareholder value analysis to manage a business A framework for making key business decisions that add economic value to the business Consists of four aspects Valuation, strategy, finance and corporate governance (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measures of shareholder value (cont.) Valuation Discounted cash flows (DCF) are usually used to measure value Future cash flows of the business are discounted taking into account the risk associated with those cash flows Value drivers are the activities or actions that create value for a business Include spread, growth, sustainability and cost of capital (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measures of shareholder value (cont.) Strategy Has a substantial and continuing impact on the value of the business Finance Financial policies will influence value creation Corporate governance Involves selecting and implementing systems that contribute to value creation (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measures of shareholder value (cont.) Economic value added (EVA) Measure of the value created over a single accounting period The spread between the return generated by the business activities and the cost of capital (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measures of shareholder value (cont.) Weighted average cost of capital Used in the calculation of EVA and RI To improve EVA Improve profitability without employing additional capital Borrow additional funds when profits earned are more than the cost of borrowing Pay off debt by selling assets Limitations of EVA Potential for manipulation and short-term orientation (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Measures of shareholder value (cont.) Shareholder value added (SVA) = corporate value – the market value of debt Corporate value is the present value of the future cash flows Residual value is the value of the firm at the end of the forecast period Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Reward systems Processes, practices and systems which are used to provide levels of pay and benefits to employees Motivation The processes that account for an individual’s intensity, direction and persistence of effort towards attaining goals Intrinsic motivation Derives from the interest and enjoyment of the work Extrinsic motivation Derives from sources outside the individual Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Theories of motivation Herzberg’s theory of work motivation Hygiene factors Provide the setting for encouraging employee motivation, but do not themselves motivate employees Working conditions, wage levels, rules and regulations, relationships with colleagues, job security Motivators Factors that relate to job content and which provide employee motivation Achievement, recognition, the nature of the work, responsibility, opportunities for personal growth (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Theories of motivation (cont.) Expectancy theory Employee motivation is a result of the strength of the relationships between expectancy, instrumentality and valence Expectancy: perception that effort will lead to a certain performance Instrumentality: perception that performance will lead to desired outcome Valence: the attractiveness of the reward Motivational theories need to be considered by managers when they are designing performance evaluation and reward systems Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Performance-related reward systems Performance-related pay systems (incentive compensation schemes) Link employee rewards for achieving or exceeding some performance target Individual incentive plans Individuals are rewarded for achieving individual performance targets Subjective criteria may also be used Common at the senior levels of the organisation (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Performance-related reward systems (cont.) Profit-sharing plans Cash bonuses are paid to each employee, based on a specified percentage of the company’s profit Does not tie individual effort to individual rewards Employee share plans (share option plans) Provide employees with the right to purchase shares in their company, at a specified price at some specified future time Commonly used for senior managers, and sometimes more junior managers and employees Considered to encourage goal congruence (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Performance-related reward systems (cont.) Gainsharing Cash bonuses are distributed to employees when the performance of the company, or their segment of the company, exceeds some performance target Team-based incentive schemes Individuals are rewarded based on their work team exceeding certain performance targets Intended to encourage teamwork and cooperation between employees Does not tie individual effort to individual rewards Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Group versus individual performance Consider the following issues Identification with the group Equity among employees Competitiveness between employees Relating individual effort to reward Rewarding only good performers The timing of incentive payments can be crucial to achieving desired outcomes More frequent rewards may help ensure continual motivation Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Summary Return on investment is often used to evaluate performance of investment centres Can encourage managers to focus on achieving high profits through the efficient use of assets, but can also encourage dysfunctional decisions These can be reduced through using a range of performance measures that focus on short and long term, using alternative measures of profit and invested capital, and using other financial measures such as residual income or EVA (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Summary (cont.) Reward systems can be used to encourage goal congruent behaviour When designing performance-related schemes it is important to understand what motivates employees Performance-related reward systems include individual incentives, profit-sharing, employee share plans, team-based incentives The frequency and timing of payments may impact on effectiveness of the reward system Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith