Performance measurement

Question 1

In a divisionalised structure the organization is?

Answer 1

divided into separate investment or profit centres (PC ’s) and a functional structure applies below this level.

Question 2

A functional structure is

Answer 2

where all activities of a similar type are placed under the control of a departmental head.

Question 3

Divisionalised structures generally lead to

Answer 3

decentralization of the decision-making process whereas managers in a functional structure will tend to have less independence.

Question 4

Advantages of divisionalisation

Answer 4

• Improved quality of decisions
• Speedier decisions
• Increases managerial motivation
• Enables top management to devote more time to strategic issues

Question 5

Disadvantages of divisionalisation

Answer 5

• Sub-optimization and may promote a lack of goal congruence.
• More costly to operate a divisionalised structure.
• Loss of control by top management.

Question 6

Conditions for successful divisionalisation:

Answer 6

• More appropriate for companies with diversified activities.
• Relations between divisions regulated so that no division, by seeking to increase its own profit, can reduce the profitability of the company as a whole.

Question 7

Methods of measuring divisional profitability

Answer 7

1. Return on investment (ROI)
2. Residual income (RI)
3. Economic value added (EVA ™)

Question 8

arguments for producing two measures of divisional profitability

Answer 8

1. to evaluate managerial performance;
   and
2. to evaluate the economic performance of the division.

Question 9

ROI?

Answer 9

ROI = profit/investment.

ROI is a relative measure of performance (profitability) that can be compared with other investments. It also provides a useful summary measure of the ex-post return on capital employed.

Question 10

Disadvantages of ROI

Answer 10

• managers may be motivated to make decisions that make the company worse off.
• ROI may also motivate managers to make incorrect asset disposal decisions.

Question 11

why may ROI not increase value?

Answer 11

ROI doesn’t look at value creation. It will take the ROI percentage and then remove the cost of capital required percentage for a project. If there is a positive percentage left this would increase the value of the firm and should be accepted. However, managers may reject If they think accepting the project will bring down the average ROI as it would show a worse ROI figure on average. This is a problem with ROI as a performance meausure

Question 12

controllable Residual income?

Answer 12

profit less a cost of capital charge on the investment controllable by the manager.

Question 13

what is RI more likely to encourage?

Answer 13

It is claimed that RI is more likely to encourage goal congruence than other performance measures

Question 14

EVA came from?

Answer 14

RI was refined and renamed to be EVA in the 1990’s

Question 15

what is EVA?

Answer 15

EVA = diff between return on capital (investments) and the cost of capital.

EVA = Net sales
Less operating expenses (including tax)
=Operating profit
Less capital charges (debt and equity)
=EVA 

Capital charges = company’s invested capital x weighted average cost of capital

Question 16

why is EVA used?

Answer 16

argued that company only earns genuine profits when revenues cover firms operating costs including the cost of capital.

EVA is a tool that allows us to see where value is created or destroyed.
EVA also helps managers engage in communicating value creation.

Question 17

MVA?

Answer 17

Market Value added (MVA)= Total value of the firm – Total capital of the firm

Question 18

what is the aim of the firm in terms of MVA and why?

Answer 18

Aim of firm is to increase MVA not just value of the firm, as can do this easily by investing in assets.

Question 19

MVA = PV of…?

Answer 19

MVA = PV of firms expected future EVAs

Question 20

How is EVA used?

Answer 20

• EVA can be used at lower levels in organizations (divisions, managers)
• Measures and communicates performance to capital markets
• Evaluation of capital investment appraisal
• Compensation of managerial performance
• Overcomes the agency problem (managers paid using EVA start to think like owners)
• Reduces the incentive for managers to manipulate accounting profits

Question 21

BOUWENS AND SPEKLE CONCLUDE what about EVA?

Answer 21

EVA IS NOT UNIVERSALLY BENEFICIAL AND THAT MUCH MORE WORK IS NEEDED TO SEE IF EVA ADDS VALUE.

Question 22

what do people who use EVA think

Answer 22

Think it’s the best performance measure on the claim that EVA is the best proxy for value creation.

Question 23

why can net income be value destructive for investment decisions?

Answer 23

net income doesnt include cost of capital. EVA does.

Question 24

Sterns most important accounting adjustments that change RI to EVA

Answer 24

• Adjustments to marketing and R&D costs
• Deferred taxes
• Purchased goodwill
• Operating leases
• Bad debts and warranty costs
• LIFO inventory valuation
• Construction in progress
• Discontinued operations

These are the parts that will be accounted for differently for EVA and RI, and resultantly is the difference between the two.

Question 25

Relationship between EVA, cash flow and value?

Answer 25

NPV of a project (or firm) = PV of future cash flows. This can also be modelled as the PV of future EVAs. This proving that EVA is a good measure for capturing value creation.

Question 26

Why EVA better than net income method at divisional method?

Answer 26

no finance charge in net income at divisional level. on operational charges. so EVA make sure the cost of capital is accounted for at divisional level rather than ignoring it

Question 27

why might it be better for profit centre managers to base performance on net income?

Answer 27

Profit centre managers typically can’t make decisions over investments unless they are decentralised.

But as net income excludes cost of capital, this will be ignored in thought of managers and therefor isn’t a very good performance measurement tool. One solution is for management to file for investment proposal when WC is needed but this removes diversification. THE SOLUTION TO THIS WOULD BE TO USE EVA AS IT PROVIDES AN INCENTIVE TO MANAGERS TO PAY ATTENTION TO THE WC EFFECTS ASSOCIATED WITH SERVING LARGE BUT SLOW PAYING CLIENTS. THE EVA WOULD INCORPORATE A CAPITAL CHARGE FOR WC.

Question 28

results of EVA v others?

Answer 28

EVA not superior to alternative performance measures, and depends on the circumstances in which it is used.

Question 29

why eva not preferred over npv model?

Answer 29

but EVA not preferred over NPV as it includes cash flows which are more volatile and distant approximation of value.

Question 30

what do profit centre managers need in order to influence EVA?

Answer 30

Profit centre managers need influence over assets to affect EVA. If they don’t then not effective performance measure.

If dont have influence cant make decisions about investments and therefor account for the cost of capital.

Question 31

interdependencies between groups - effect on EVA?

Answer 31

If there are significant interdependencies, the use of EVA can distort incentives

Question 32

what to consider when looking at EVA for supporting inter-unit cooperation?

Answer 32

Need to consider levels of decentralisation and of interdependencies when deciding on the performance measure.

Question 33

accumulated evidence on success of EVA?

Answer 33

LITTLE EVIDENCE EVA WORKS.

Mixed results on performance of EVA users compared to non-EVA users.

Question 34

what is the difference between RI and EVA/

Answer 34

The accounting adjustments.

see slide on sterns most important accounting components to be changed.