Week 7 Financial Performance Measurement Systems

Question 1

WHAT IS PERFORMANCE MEASUREMENT SYSTEM?

Answer 1

A system that measures performance by comparing actual results with some target.

Question 2

Performance Measure system monitors/reports, evaluates, and provides what?

Answer 2

monitors and reports of accomplishments
Evaluates performance and provides incentives
provides early warning signals to management

Question 3

WHAT ARE THE BENEFITS OF PERFORMANCE MEASUREMENT? (x 7)

Answer 3

1. Supports strategic planning and goal-setting
2. Enhances decision-making
3. Strengthens accountability
4. Surveillance and controllability
5. Make corrective interventions
6. Assists organisations in determining effective
   resource use
7. Improves customer service

Question 4

TYPES OF PERFORMANCE MEASUREMENT?

Answer 4

financial and non-financial

Question 5

Common Financial measures focuses on? (3 formulas)

Answer 5

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)

Question 6

Return on Investment (ROI)?

Answer 6

Represents the benefit an organisation receives for its investment of financial resources in a project or asset

Question 7

Return on Investment (ROI)? 2 common methods? which one focus on for our unit?

Answer 7

MANAGEMENT perspective
Operating profit BEFORE tax

Shareholders’ perspective
Operating profit AFTER tax

Question 8

3 ways to increase ROI?

Answer 8

increase sales
reduce expense
reduce assets

Question 9

Advantages of ROI?

Answer 9

• single measure that offer global evaluation of performance
• easy to understand as expressed as %
• data easily accessible thru accting system
• ROI focuses on relative performance so allow comparison of business different in size

Question 10

Limitations / Problems of ROI?

Answer 10

• Encourages focus on short term performance at the expense of long-term viability and competitiveness.
• Can encourage managers to defer asset replacement
• can lead to underinvestment
• Invested capital is typically based on historical costs

Question 11

MINIMISING THE BEHAVIOURAL PROBLEMS OF ROI

Answer 11

Use ROI as one of several 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

Question 12

RESIDUAL INCOME (RI)?

Answer 12

is the amount of income earned (dollar amount) that remains after subtracting an imputed interest charge

Question 13

Advantages of Residual Income (RI)?

Answer 13

More likely to promote goal congruence, compared to ROI

WHY?
Takes account of the organisation’s required rate of return
Encourages investment in projects which yield a positive residual income

Question 14

Disadvantages of Residual Income (RI)

Answer 14

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 (because it is an absolute dollar measure)
Can encourage short-term orientation/focus, as with ROI

Question 15

Economic value added (EVA) – who uses it?

Answer 15

• performance measure used by companies focusing on value-based management
• measure of value created over single accounting period
• spread between return generated by business activities and cost of capital

Question 16

ECONOMIC VALUE ADDED (EVA) is a method of determining?

Answer 16

extent to which an organisation earns profits in excess of its weighted average cost of capital

Question 17

what are the 3 main differences between EVA and RI?

Answer 17

• operating profit
• cost of capital
• focus

Question 18

difference between EVA and RI - operating profit?

Answer 18

RI - Operating profit is accounting based (commonly before tax)
EVA - Profit is cash based (always after tax)

Question 19

difference between EVA and RI - Cost of capital?

Answer 19

RI - Various options : Required rate of return, interest rate based on cost of capital or WACC
EVA - Weighted Average Cost of Capital (WACC)

Question 20

difference between EVA and RI - Focus?

Answer 20

RI - Management Perspective

EVA - shareholder perspective

Question 21

Advantages of EVA

Answer 21

1. Easy to calculate.
2. Economic Value Added causes the manager to adopt
3. the mentality of a business owner

Question 22

disadvantages of EVA?

Answer 22

Same limitations as ROI and RI:

Single period measure of performance, thus potential for manipulation and short term orientation