CIMA P2 Advanced Management Accounting First Intro slide – change details to your own For exams in 2016 江西财经大学会计学院 吉伟莉 499159596@qq.com

Chapter 6 Performance measurement Financial Performance Indicators ROI & RI EVA ® Non-financial Performance Indicators (NFPIs) Balanced scorecard Benchmarking First Intro slide – change details to your own

Financial performance indicators 1 Financial performance indicators (FPIs) Liquidity Current ratio Quick ratio Accounts receivable days Accounts payable days Inventory days

Financial performance indicators 2 Financial performance indicators (FPIs) continued Profitability Sales margin ROCE Profit margin Asset turnover FPIs allow comparison between similar companies in the same industry and Between results for different years for the same company

ROI & RI 1 Return on investment (ROI) Also known as the return on capital employed (ROCE) Shows how much profit has been made in relation to the amount of capital invested Typically measured as (profit/capital employed) × 100% ROI is generally regarded as the key performance measure Ties in directly with the accounting process Measures the performance of a division/company as a single entire unit

ROI & RI 2 Residual income (RI) This is calculated by deducting and imputed interest based on investment in the investment centre, from profit It is typically measured as follows. £ Profit (after depreciation) X Imputed interest (capital employed × cost of capital) (X) Residual income X

ROI & RI 3 Both ROI and RI use the same basic figure for profit and investment But RI produces an absolute measure whereas ROI is expressed as a percentage

ROI & RI 4 Disadvantages of ROI / RI Both methods suffer from disadvantages in measuring profit and investment Investment can be based on net assets (most usually), gross assets or replacement cost However none of these bases is ideal Investment centres might use different bases to value inventory and to calculate depreciation Charges made for the head office expenses/assets for investment centres are likely to be arbitrary

ROI & RI 5 There may be problems when bonuses are linked to ROI or RI The measures can be massaged if the asset base of the ratio is altered by increasing/decreasing payables and receivables If it is the performance of the manager (rather than the investment centre) being assessed, then the profit should be based on the revenues/costs controllable by the manager Service and head office costs should be excluded (except those specifically attributable to the investment centre)

ROI & RI 6 The biggest problem in divisional performance measurement occurs if: A division maintains the same annual profit, keeps the same assets without a policy of regular non-current asset replacement and values assets at net book value ROI or RI will increase year by year as the assets get older, even though profits may be static This can give a false impression of improving performance over time It acts to discourage managers from undertaking new investments

ROI & RI 7 Problems with RI in particular It does not facilitate comparisons between investment centres It does not relate the size of a centre's income to the size of the investment In these respects ROI is a better measure

ROI & RI 8 Problems with ROI in particular Avoiding new investments whose initial returns are lower than required ROI Encourages focus on short-term performance RI can help to overcome this problem of sub-optimality and lack of goal congruence by highlighting projects which return more than the cost of capital

ROI & RI 9 Problems with ROI in particular continued It can be difficult to compare percentage ROI results of investment centres if their activities are very different RI can overcome this problem through the use of different interest rates for different investment centres

ROI & RI 10 Behavioural implications Managers like to ensure that their performance/results of their decisions appear in the most favourable light They may have no regard for the later life of their centre's projects or overall performance of the group This could have the following results: They will favour proposals that produce excellent results in the short term but may be unacceptable in the longer term They will disregard proposals that are in the best interests of the group as a whole

ROI & RI 11 Example 1 A manager might decide to reduce investment and depreciation (and hence increase ROI) by scrapping some machinery not currently in use When the machinery is eventually required, the manager would be obliged to buy new equipment

ROI & RI 12 Example 2 A manager might reject a project with an ROI of 30% if it causes the investment centre’s ROI to fall from 38% to 35% Even if the return is above the organisation’s target of 25% and hence the project is beneficial for the group as a whole

ROI & RI 13 This type of performance measurement may therefore produce dysfunctional decision-making Managers will consider their own performance Not the longer-term interests of the investment centre or the interests of the group

EVA® 1 Economic value added EVA® is an absolute performance measure like RI EVA® differs from RI because it is based on economic profit and not on accounting profit It also takes into account a capital charge based on the entity’s weighted average cost of capital and the replacement cost of net assets EVA® = net operating economic profit after tax (NOPAT) less capital charge Where capital charge = weighted cost of capital x net assets at replacement cost

EVA® 2 EVA® and RI compared EVA® and RI are similar as they are both absolute performance measures In both measures a deduction is made for the capital charge EVA® and RI differ in that EVA® uses economic profit and not accounting profit For the calculation of the capital charge, EVA® values the net assets at their replacement cost EVA® is a registered trademark owned by Stern Stewart & Co.

EVA® 3 (EVA®) continued Economic profit Costs which are normally treated as expenses may be added back to NOPAT If these costs are considered as investments, building for the future Examples Research and development, advertising, and goodwill These are added back to accounting profit to reflect the economic reality of the expenditure They are also included in net assets employed

EVA® 4 Economic profit continued Adjustments are sometimes made to economic depreciation to reflect the economic fall in asset value due to wear and tear or obsolescence Interest is excluded from NOPAT as it is taken into account in the capital charge Capital charge = replacement cost of net assets employed × weighted average cost of capital (WACC)

Non-financial performance indicators 1 Non-financial performance indicators (NFPIs) Value of NFPIs Can be provided quickly Easy to understand Tailored to circumstances NFPIs for employees Labour turnover Absenteeism Skills levels

Non-financial performance indicators 2 NFPIs for quality Quality of incoming supplies Quality of work done as it proceeds Measure of customer satisfaction

Balanced scorecard 1 Balanced scorecard A way of measuring performance which integrates traditional financial measures with operational, customer and staff issues It is ‘balanced’ in the sense that managers are required to think in terms of all four perspectives This is to prevent improvements being made in one area at the expense of another

Balanced scorecard 2 Customer perspective Measures relating to what actually matters to customers For example time, quality, performance of product Examples Customer complaints On-time deliveries

Balanced scorecard 3 Internal business perspective Measures relating to the business processes that have the greatest impact on customer satisfaction For example quality, employee skills Examples Average set-up time Quality control rejects

Balanced scorecard 4 Innovation and learning perspective Measures to assess the organisation’s capacity to maintain its competitive position through the acquisition of new skills/development of new products Examples Labour turnover rate % of revenue generated by new products

Balanced scorecard 5 Financial perspective Measures that consider the organisation from the shareholder’s point of view Examples ROCE EPS

Benchmarking 1 Benchmarking A comparison exercise through which an organisation attempts to improve performance The idea is to seek the best available performance against which the organisation can monitor its own performance

Benchmarking 2 Types of benchmarking Metric benchmarking Comparing appropriate metrics to identify possible areas for improvement Process benchmarking Comparing processes with a partner company as part of an improvement process Diagnostic benchmarking Reviewing the processes of a business to identify those which indicate a problem and offer a potential for improvement