1. Chapter 13 Financial performance measures for investment centres and reward systems
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

2. 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

3. Return on investment Return on investment (ROI)
Used to measure the performance of an investment centre
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

4. Return on investment
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

5. Return on investment Invested capital Return on sales
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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

6. Return on investment 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

7. The advantages of ROI
Very widely used to measure the performance of divisions 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

8. 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 divisional 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

9. Minimising the behavioural problems of ROI
Use ROI as one of a series of 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

10. 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

11. The advantages 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

12. 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

13. 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

14. Asset measurement Advantages of net book value
Consistency with balance sheet that is prepared for external reporting purposes
Consistent with the definition of profit
Advantages of gross book value
Depreciation is arbitrary and should not be allowed to affect calculations
Depreciating non-current assets may provide a disincentive to invest in new equipment
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

16. 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

18. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

19. Measures of shareholder value
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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

20. Measures of shareholder value
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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

21. Measures of shareholder value
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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

22. Measures of shareholder value
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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

23. Measures of shareholder value
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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

24. 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 rewards
Intangible, arise from the positive experiences of being satisfied with performing well
Extrinsic rewards
Given to employees from an external source
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

25. 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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

26. Theories of motivation
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
Valance: the attractiveness of the reward
Motivational theories need to be considered by managers when they are designing performance evaluation and reward systems
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

27. Performance-related reward systems
Performance-related pay systems (incentive compensation schemes)
Link employee rewards for achieving or exceeding some performance targets
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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

28. Performance-related reward systems
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
Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

29. Performance-related reward systems
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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith

30. 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  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e
By Kim Langfield-Smith