1. Accounting 4310 Chapter 14 Business Unit Performance

2. Performance Measurement Performance Measurement Systems –Formal, information-based routines and procedures managers use to maintain or alter patterns in organizational activities –Should motivate managers and employees at all levels of the organization to achieve company strategies and goals

3. Performance Measurement Financial and nonfinancial measures used –Financial often based on accounting numbers –Often measures are benchmarked against outside organizations or other divisions in their company –Both internal and external information is used Internal – net income, sales, return on investment, new customers, accts. receivable turnover External – stock price, customer satisfaction, market share –Balanced scorecard is very useful (Ch. 18)

4. Divisional Performance Measures Divisions What should be considered in developing performance measures? –Must be consistent with the decision making authority of the manager –Must reflect improvements in the organization –Must be able to determine actions that can be taken to improve the measure

5. Accounting Income

6. Computation Advantages Disadvantages Pertinent Financial Ratios –Gross margin ratio = Gross Margin/Sales –Operating margin ratio = Oper. Income/Sales –Profit margin ratio = Net income/Sales

7. Return on Investment ROI = Accounting Profit/Investment in Business –Results in a percentage which can be compared internally or externally –Varies based on what is included in numerator and denominator Often operating income and assets Sometimes income and assets limited to what is controllable by managers Gross book value, net book value or current cost of tangible assets can be used

8. Return on Investment Dupont method of breakdown: IncomeX Revenues RevenuesInvestment (Profit margin)(Asset turnover)

9. Limitations of ROI Short-term oriented (myopia) Can be manipulated by managers by increasing income or decreasing assets Does not include future value (only past accounting information) No capitalization of future assets (R/D, advertising, leases, etc.) Causes companies to lease instead of purchase or not invest in lower-rated assets

10. Residual Income –Income – cost of invested capital –Income remaining after expected return on operating assets –Required rate of return often cost of capital –Maximizes absolute dollars

11. Residual Income –Similar to economist’s notion of profit –Goal congruence more likely with this method –Encourages companies to invest in lower-rated assets (rate is higher than company’s expected return but lower than division’s ROI) –Limitations

12. Economic Value Added EVA = Annual after-tax adjusted divisional income less the total annual adjusted cost of capital Adjustments: –Add expensed research and development costs back to net income and assets Amortize the R & D over the life of the asset –Same for advertising and other expensed intangibles Subtract current liabilities from total assets

13. Economic Value Added Positive EVA requires that a company earn a return on its assets that exceeds the cost of debt and equity. It is an actual monetary amount of value added. It measures changes in value for a period More long-term oriented Goal congruence more likely than ROI

14. Investment Base Gross book value versus net book value –With net book value, ROI will increase just because the investment denominator decreases (with increasing accumulated depreciation) –Gross book value avoids this decrease Current cost –Use current cost of assets in denominator –Avoids declining asset balance from depr.

15. Investment Base Beginning Balance –Firms will try to buy assets early and sell assets late in the year to avoid being counted in total assets. Ending Balance –Same as above (beginning balance) Average Balance –Take the average of the beginning and ending balances –Reduces manipulation

16. Other Considerations Performance Measures in Multinational Companies –Different cultures –Foreign currency translation –Inflation –Subsidiaries/divisions often set up for a special reason; be sure to evaluate them on that purpose

17. Other Considerations There should be a distinction between evaluating managers and evaluating the organizational units they manage Incentives should reflect what managers can control Rewards to individuals Rewards to team members

18. Executive Compensation Annual incentives Long-run incentives Fringe Benefits Should motivate executives to achieve organizational goals Balance short-run and long-run incentives Intrinsic and extrinsic motivators