ACT503 Chap.13 Performance Measurement and Strategic Frameworks
Performance Measurement and Strategic Frameworks
Three ways of combining profit with the capital that produced it
An investment centre manager answers for revenues, costs and the capital employed, so the measure has to combine a profit figure with the assets used to earn it.
Return on investment is operating income divided by operating assets and decomposes into an operating margin multiplied by an asset turnover, a decomposition that is not decoration because it says whether a change came from the income statement or from the balance sheet. Residual income is operating income less a charge for the capital employed at the required rate of return.
Economic value added is the same idea with three refinements: after tax operating profit, the weighted average cost of capital rather than a target rate, and a charge applied to assets net of current liabilities.
Every one of them divides or charges against an asset base, so the definition of that base moves all three.
One structural flaw, and the measure that does not have it
A percentage measure makes a manager reject any project earning below the division's own current rate, even when that rate is well above what the group requires.
A division earning eighteen per cent offered a project earning seventeen, against a group requirement of twelve, raises group value by accepting and lowers its own percentage by doing so, so a manager paid on the percentage declines. Residual income and economic value added are amounts, so the same project adds to them and the manager accepts.
What residual income gives up is comparability: because it is an amount, a large division posts a larger figure than a small one on identical management.
Use the percentage and its levers to compare and diagnose, and the amount to evaluate a decision and pay the person taking it.
Predictable distortions, and the frameworks that answer them
All three measures are computed over a period while the investments that determine long run performance pay back over several, so any of them can be raised by deferring maintenance, cutting training and delaying a replacement.
Three further distortions are predictable: an old division with written down assets reports a higher return than a newly equipped one, a manager can shrink the base by leasing rather than buying, and a group cost allocation moves a result the manager never influenced.
Non financial measures with their own targets are the instrument that resists the first, because they cannot be improved by deferring the spending the financial measure rewards deferring, which is why the published content pairs performance measurement with sustainability metrics rather than treating them separately.
What this chapter covers
- 01
Return on investment and its two levers
- 02
Operating margin against asset turnover
- 03
Residual income and the capital charge
- 04
Economic value added and its three refinements
- 05
The suboptimisation problem, and why an amount fixes it
- 06
What residual income gives up in exchange
- 07
Defining the asset base, and why the definition must be stated
- 08
Four predictable distortions and what counters each
- 09
The elements of a strategic management accounting framework
Three measures, one division, one project
- 3Return on investment and its decomposition into margin and turnover.
- 4Residual income and economic value added for the division.
- 4The project under each measure, and the divergence explained.
Key terms
- Return On Investment
- Operating income divided by the operating assets used to earn it. It decomposes into an operating margin multiplied by an asset turnover, which is what tells you whether a change came from the income statement or the balance sheet.
- Asset Turnover
- Revenue divided by operating assets, measuring how hard the asset base works. Two divisions can report an identical return on investment with very different turnovers, which is why the decomposition is computed before the ratio is discussed.
- Residual Income
- Operating income less a charge for the capital employed at the required rate of return. Because it is an amount, a manager measured on it accepts any project earning above the required rate, which a percentage measure would cause the same manager to reject.
- Economic Value Added
- After tax operating profit less the weighted average cost of capital charged on assets net of current liabilities. It refines residual income and is the most contestable of the three to compute, because it requires adjustments and a cost of capital estimate.
- Suboptimisation
- A decision that improves a division's own measure while making the organisation worse off. Rejecting a project that earns above the group's required return because it sits below the division's current percentage is the standard example.
- Investment Centre
- A responsibility centre whose manager answers for revenues, costs and the capital employed. It is the only centre for which these three measures are appropriate, because it is the only one where the manager decides on assets.
- Short Horizon Problem
- The distortion by which a manager raises a period measure by deferring maintenance, training or replacement, improving the reported figure while damaging later capacity. Non financial measures with their own targets are the standard counter.
Performance Measurement and Strategic Frameworks FAQ
Why can two divisions with the same return on investment need opposite advice?
Because the ratio is a product of two levers. A division earning fifteen per cent on a three per cent margin runs a turnover of five and is a high volume, thin margin business whose assets work hard. One earning fifteen per cent on a ten per cent margin runs a turnover of one and a half and is asset heavy. A cost reduction programme aimed at margin belongs at the first and an asset programme at the second.
Which measure should a division manager be paid on?
An amount rather than a percentage, because an amount points the same way as the group objective. A manager paid on return on investment has a standing reason to decline any project below the division's own current rate, however far that rate sits above what the group requires. Use the percentage and its decomposition to compare divisions and to diagnose where a result came from.
Why does the definition of the asset base matter so much?
Because every one of the three measures divides or charges against it, so a change in the definition moves all three. Three choices have to be made and stated: cost or written down value, whether idle and under construction assets are included, and whether assets a manager cannot influence belong at all. A comparison between divisions is meaningless unless the same answer was used for both.
What does the case supplied with this course show about frameworks?
That measurement decays where nothing depends on it. The system captured costs a traditional one had missed and induced standardised practices, but several activity drivers were abandoned after a restructuring because recording them was seen as extra work once nobody was measured on them, and the sales function resisted analysis that threatened its autonomous status. That is goal congruence read from the other end.
Exam move
Compute all three measures on one division, then invent a project that the first accepts and the second rejects. You will find it is hard, and the reason is instructive: the divergence runs one way far more often than the other, which is why the percentage measure is the one the literature criticises. Then list three things a manager could do before an evaluation date that would improve every measure and damage the business.
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