Performance Evaluation Flashcards
Name and give brief definition of 4 types of “centres”
- A cost centre, is the smallest segment of activity or area of responsibility for which costs are accumulated.
- A revenue centre, like a cost centre is a small segment of activity or area of responsibility for revenue generated.
- A profit centre is a segment responsible for both revenues and expenses.
- An investment centre is a segment responsible for its invested capital and the related net income.
Name 3 main areas of adding value
a. Growth (You want management to accept all investment with positive NPV, reject all investment with negative NPV)
b. You want management to Cost control (GP%, Op Profit%, individual cost items relative to sales, cost per unit, etc)
c. You want Efficient Asset Utilisation (Asset turnover, working capital days or relative to Turnover, etc)
Name 4 generic performance measures used
Net Profit
Return on Investment (ROI)
Residual Income (RI)
Economic Value Added (EVA)
General disadvantages of using accounting-based measures and a companywide WACC include:
Potential performance measures that fit in to this category are Profit, ROI and RI.
• Managers are encouraged to reduce potentially beneficial discretionary expenditure;
• Accounting figures can be manipulated;
• Accounting measures do not represent free cash flow;
• The measure may not consider asset efficiency; and
• The company WACC might not be representative of the risk of the division being evaluated, which could make results look artificially poor or impressive.
Ways of over-coming disadvantages of using accounting-based measures and a companywide WACC include:
- More than one measure should be used;
- Some non-financial measures should also be used to evaluate performance (consider the use of a balanced score card);
- Accounting figures can be adjusted in a similar manner to calculating EVA;
- WACC can be risk adjusted as appropriate for each division; and
- A bonus bank can be used. For example, bonuses could be linked to EVA with a portion of the bonus being retained in a bonus bank. In bad times when the EVA is negative, managers would lose portions of their accrued bonuses.
Balanced Scorecard
- explain
- How do customers view us? (Customer needs)
- What should we excel at? (Internal business process)
- How can we continue to growth and improve? (Learning and growth systems)
- How do our shareholders view us? (Financial metrics)
The overall aim of the Scorecard is to provide a comprehensive framework for translating strategic objectives into performance measures. Performance measures cannot be viewed in isolation but must be linked to goals/strategies.
The Balanced Scorecard should also be a tool to manage strategy in organizations. Strategy should be linked to specific measures, and mechanisms should be identified to achieve goals/objectives.
Advantages and Disadvantages of ROI
The advantages of using ROI are:
• As it is a percentage, comparisons with other divisions, companies and available investments are possible;
• It reveals information about cost control and asset management; and
• It is easily understood by managers.
The disadvantages of ROI are as follows:
• It encourages management to either not replace assets or inappropriately sell assets. This decreases the denominator and increases ROI;
• ROI does not support goal congruence. The acceptable return on a new project for the company is WACC. If WACC< Project A < ROI, such a project will not be accepted as it will reduce the ROI of the division, but it would have created value for the company. If Project A is an existing project, a manager might discontinue it in order to boost ROI resulting in shrinkage of the business;
• ROI can result in acceptance of value destroying projects. If ROI < Project A< WACC, Project A will be accepted, as it will boost the ROI of the division, but since the return is less than WACC, value is being destroyed; and
• ROI encourages management to target percentage returns and not to maximise returns in absolute terms i.e. they will rather accept a R5m investment that returns 30% (R1.5m) rather than a R10m investment that returns 20% (R2m). As long as WACC is less than 20% the second investment should be accepted.
Advantages and Disadvantages of RI
The advantages of RI are:
• This approach is conceptually superior to ROI as it encourages expansion where return rates exceed the charge for invested capital i.e. WACC. Any project that returns more than WACC will cause RI to increase. Thus, goal congruence is encouraged;
• RI is more flexible, since different costs of capital can be used to assess divisions with different risk profiles; and
• RI is a better indication of value creation or destruction.
The disadvantages of RI are:
• It is an absolute measure and therefore comparisons are difficult; and
• It encourages cutting of discretionary expenditure that could have long-term benefit, for example training costs. It is
subject to accounting manipulations.
Advantages and Disadvantages of Net Profit
- It is now generally accepted that Net Profit is not a good performance measure.
- Net Profit does not encourage managers to seek returns in excess of the cost of funding the investment.
Rather, management is encouraged to maximize net profit, which would encourage all investment where positive returns are earned regardless of the firms cost of capital rather than investment with positive NPV’s.
Consequently, it is inappropriate to use net profit as a performance measure where management is able to control the investment decision.
Net profit makes managers focus on the short term, cut discretionary costs and make bad investment decisions.
There are no real advantages to net profit.
EVA common accounting adjustments
1) Capitalise and amortise discretionary expenditure
2) Capitalise leases
3) Inventory valuation should be on LIFO, not FIFO
4) Absorption costing: treat FMOH as a period cost
5) Use annuity rather than straight line depreciation
6) The use of economic asset values, rather than historic, written down values
Residual Income (RI)
EBIAT* – [WACC (%) x Net investment] OR (ROI – WACC) x Net investment
Net Profit
Revenue + other income - expenses (could include or exclude financing costs)
Return on Investment (ROI)
Earnings before interest after tax (EBIAT*) /Net investment (Total assets – current liabilities**)
Economic Value Added (EVA)
EBIAT* +/- acc adj’s – [WACC (%) x (Net Investment +/- acc adj’s)]
