3. Performance measurement - Userpage

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3. Performance measurement Financial and non-financial performance measures & ROI and residual income & Benchmarks and relative performance evaluation Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008

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Introduction Performance measures are a central component of management control systems. Making good planning and control decisions requires information about how different subunits of the organisation have performed. This chapter discusses the design, implementation and uses of performance measures.

Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008

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Learning Objectives 1

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Provide examples of financial and nonfinancial measures of performance Design an accounting-based performance measure Understand the return on investment (ROI) method of profitability analysis


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Learning Objectives (Continued) 4. 5.

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Describe the residual-income (RI) measure Recognise the role of salaries and incentives in compensation arrangements Describe the management accountant’s role in designing incentive systems


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Learning Objective 1 Provide examples of financial and non-financial measures of performance


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Financial and Non-Financial Performance Measures Many widely-used performance measures, such as operating profit, rely on internal financial information. Companies are supplementing internal financial measures with measures based on: – External financial information – Internal non-financial information – External non-financial information.


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Financial and Non-Financial Performance Measures (Continued) Some organisations present financial and non-financial performance measures for their subunits in a single report – the balanced scorecard. Most scorecards include: – Profitability measures – Customer-satisfaction measures


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Financial and Non-Financial Performance Measures (Continued) Internal measures of efficiency, quality and time – Innovation measures. Some performance measures have a long-run time horizon. Other measures have a short-run time horizon. –


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Learning Objective 2 Design an accounting-based performance measure


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Accounting-Based Performance Measure 1

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Designing an accounting-based performance measure requires six steps: Choose performance measures that align with top management’s financial goal(s). Choose the time horizon of each performance measure in Step 1. Choose a definition for each performance measure in Step 1. Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008

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Accounting-Based Performance Measure (Continued) 4

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Choose a measurement alternative for each performance measure in Step 1. Choose a target level of performance. Choose the timing of feedback.


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Accounting-Based Performance Measure (Continued) Ye Olde Brewery owns three small hotels at airports in London, Manchester and Birmingham. At present, Ye Olde Brewery does not allocate the total long-term debt of the company to the three separate hotels.


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Accounting-Based Performance Measure (Continued) London Hotel: Current assets: Long-term assets: Total assets: Current liabilities:

£350,000 £550,000 £900,000 £50,000


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Accounting-Based Performance Measure (Continued)

London Hotel: Revenues Variable costs Fixed costs Operating profit

£1,100,000 297,000 637,000 £166,000


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Accounting-Based Performance Measure (Continued) Manchester Hotel: Current assets: Long-term assets: Total assets: Current liabilities:

£400,000 £600,000 £1,000,000 £150,000


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Manchester Hotel: Revenues Variable costs Fixed costs Operating profit

£1,200,000 310,000 650,000 £240,000


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Accounting-Based Performance Measure (Continued) Birmingham Hotel: Current assets: Long-term assets: Total assets: Current liabilities:

£600,000 £5,000,000 £5,600,000 £300,000


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Birmingham Hotel: Revenues Variable costs Fixed costs Operating profit

£3,200,000 882,000 1,166,000 £1,152,000


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Accounting-Based Performance Measure (Continued) Ye Olde Brewery: Total current assets Total long-term assets Total assets Total current liabilities Long-term debt Stockholders’ equity Total liabilities and equity

£1,350,000 6,150,000 £7,500,000 £500,000 4,800,000 2,200,000 £7,500,000


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Accounting-Based Performance Measure (Continued) Which hotel is the most successful? London Hotel with an operating profit of £166,000, Manchester Hotel with £240,000, or … Birmingham Hotel with £1,152,000? It appears that the Birmingham Hotel is the most successful.


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Accounting-Based Performance Measure (Continued) A major weakness of comparing operating profits alone is ignoring differences in the size of the investments in each hotel. Investment refers to the resources or assets used to generate profit.


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Accounting-Based Performance Measure (Continued) 1 2

Two approaches include investment in the performance measure: Return on investment (ROI) Residual income (RI)


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Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment. Return on investment (ROI) = Income ÷ Investment


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Accounting-Based Performance Measure (Continued) Some companies use operating profit for the numerator. Other companies use net profit. Some companies use total assets in the denominator. Others use total assets minus current liabilities.


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The ROI can be compared with the rate of return on opportunities elsewhere, inside and outside the company.


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Accounting-Based Performance Measure (Continued) What is the ROI for each hotel? London Hotel: £166,000 Operating profit ÷ £900,000 Total assets = 18% Manchester Hotel: £240,000 ÷ £1,000,000 = 24% Birmingham Hotel: £1,152,000 ÷ £5,600,000 = 21%


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Learning Objective 3 Understand the return on investment (ROI) method of profitability analysis


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ROI Method

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The ROI method of profitability analysis recognises that there are two basic ingredients in profit making: Using assets to generate more revenue Increasing income per unit (e.g. €, £) of revenue.


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ROI Method (Continued) Investment turnover = Revenues ÷ Investment Return on sales = Profit ÷ Revenues ROI = Investment turnover × Return on sales Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008

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ROI Method (Continued)

Assume that top management at Ye Olde Brewery adopts a 30% target ROI for the Manchester Hotel. How can this return be attained? Present situation: Revenues ÷ Total assets = £1,200,000 ÷ £1,000,000 = 1.20 Operating profit ÷ Revenues = £240,000 ÷ £1,200,000 = 0.20 1.20 × 0.20 = 24% Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008

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ROI Method (Continued) Alternative A: Decrease assets, keeping revenues and operating profit per £ of revenue constant. Revenues ÷ Total assets = £1,200,000 ÷ £800,000 = 1.50 1.50 × 0.20 = 30%


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ROI Method (Continued) Alternative B: Increase revenues, keeping assets and operating profit per £ of revenues constant. Revenues ÷ Total assets = £1,500,000 ÷ £1,000,000 = 1.50 Operating profit ÷ Revenues = £300,000 ÷ £1,500,000 = 0.20 1.50 × 0.20 = 30%


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ROI Method (Continued) Alternative C: Decrease costs to increase operating profit per £ of revenues, keeping revenues and assets constant. Revenues ÷ Total assets = £1,200,000 ÷ £1,000,000 = 1.20 Operating profit ÷ Revenues = £300,000 ÷ £1,200,000 = 0.25 1.20 × 0.25 = 30%


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Learning Objective 4 Describe the residual-income (RI) measure


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Residual Income Residual income (RI) is an accounting measure of profit minus a required monetary unit (e.g. €, £) return on an accounting measure of investment. Residual profit (RI) = Income – (Required rate of return × Investment)


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Residual Income (Continued) Assume that Ye Olde Brewery’s required rate of return is 12%. What is the residual income from each hotel? London Hotel: Total assets £900,000 × 12% = £108,000 Operating profit £166,000 – £108,000 = Residual income £58,000


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Residual Income (Continued) Manchester Hotel: Total assets £1,000,000 × 12% = £120,000 Operating profit £240,000 – £120,000 = Residual income £120,000 Birmingham Hotel: Total assets £5,600,000 × 12% = £672,000 Operating profit £1,152,000 – £672,000 = Residual income £480,000


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Residual Income (Continued) The objective of maximising ROI may induce managers of highly profitable divisions to reject projects that, from the viewpoint of the organisation as a whole, should be accepted. Goal congruence is more likely to be promoted by using residual income rather than ROI.


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Learning Objective 5 Recognise the role of salaries and incentives in compensation arrangements


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The Basic Trade-Off Performance evaluation often affects managers’ and employees’ rewards. Compensation arrangements run the range from a flat salary with no direct performancebased incentive to rewards based only on performance.


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The Basic Trade-Off (Continued) Managers may face risks because factors beyond their control may also affect performance. Owners choose a mix of salary and incentive compensation to trade off the incentive benefit against the cost of imposing risk.


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The Basic Trade-Off (Continued)

Most often, a manager’s total compensation includes some combination of salary and a performance-based incentive.


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Learning Objective 6 Describe the management accountant’s role in designing incentive systems


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Intensity of Incentives How large should the incentive component be relative to salary? Preferred performance measures are ones that are sensitive to, or change significantly, with the manager’s performance and do not change much with changes in factors that are beyond the manager’s control.


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Benchmarks Owners can use benchmarks to evaluate performance. Benchmarks representing best practice may be available inside or outside the organisation.


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Measuring Obtaining performance measures that are more sensitive to employee performance is critical for implementing strong incentives. Many practices in management accounting, such as the design of responsibility centres and the establishment of financial and nonfinancial measures, have as their goal better performance evaluation.


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Measuring (Continued) –

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Other issues in evaluating performance are: Designing performance measures for activities that require multiple tasks Team-based compensation arrangements Executive performance measures and compensation Environmental and ethical responsibilities. Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008

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End of Chapter 3
