Accounting-Based Performance Measures

Managers of responsibility centersOpens in new window are evaluated based on performance measures. Those performance measures should be based on the controllability principleOpens in new window.

Performance measures in many organizations include both accounting-based and non-financial metrics. Return on investment and residual income/economic value added are accounting-based performance measures that are commonly used to evaluate managers of investment centers.

These performance measures have their own strengths and weaknesses, and tend to be more effective when used in conjunction with other performance measures. A diverse set of performance measures attempt to capture the many dimensions of a manager’s performance that contribute to the creation of organizational value.

Return on Investment (ROI)

The profit (excluding the opportunity cost of capital) generated by an investment center depends on the size of the investment center; therefore, performance measures should reflect the size of the investment center. The more assets in the investment center, the greater the opportunity cost of capital wrapped up in the assets of the investment center.

Return on investment (ROI) adjusts for size by dividing the profit, excluding interest expense generated by the investment center, by the total assets of the investment center.

ROI is the most popular investment center performance measure. It has intuitive appeal since the comparison of ROI to the opportunity cost of capital (the interest rate of borrowing or the dividend rate of share capital) provides a benchmark for a division’s performance.

The ROI measure can be traced to the E.I. Du Pont de Nemours Powder Company, where it was developed to deal with the allocation of capital resources across its business operations.

If the ROI is greater than the opportunity cost of capital, then the assets of the investment are increasing organizational value. An organization that can borrow $1,000 in cash for 10 percent per year, then turn around and invest the money in assets that generate a 14 percent annual return on the investment will increase the value of organization.

At the end of the year, the organization must repay the loan ($1,000) and the interest ($1,000 x 0.10), or a total of $1,100. But the organization has the investment ($1,000) and a return of ($1,000 x 0.14), or $1,140. The net gain is $1,140 - $1,100, or $40.

Numerical Example I

An investment center of an organization has the following investment opportunities:

The opportunity cost of capital of the organization is 8 percent. What is the ROI of these investment opportunities and which investment would add value to the organization?

Solution

The ROI is the earnings divided by the investment.

Projects A and C would add value to the organization. The return on those investments is greater than the opportunity cost of capital of 8 percent. Project B would not add value because its return on investment is less than the opportunity cost of capital.

Limitations of ROI

Although ROI has the advantage of controlling for the size of the investment center, limitations exist with ROI as a performance measure. These limitations include measurement problems, not recognizing the risk of the projects, and incentives to under- or over-invest.

ROI is not necessarily a measure of the division’s percentage change in market value for at least two reasons.

1. First, accounting (the numerator of the ROI) is not a measure in market value of the organization.
2. Second, ‘investment’ (the denominator of the ROI) is not the market value of the division’s investment.

Traditionally, the profit and investment are measure using historical costs, which usually differ from the market value. Accounting depreciation, which is deducted from accounting profits, does not necessarily reflect the change in market value of fixed assets.

Investment center managers, who are evaluated based on ROI, can make inappropriate decisions due to the way in which the ROI is measure. For example, new assets cause higher depreciation expenses, lower profits (the numerator of ROI), and the higher net assets (the denominator of ROI). The combined effect will reduce the short-term ROI, even though long-term benefits to purchasing the new assets may exist.

The ROI of an investment center does not explicitly recognize the center’s risk. From finance theory, we know that risky investments should have a higher expected return to compensate for the higher risk. Therefore, a manager who generates a large ROI could be investing in riskier assets, which may not be consistent with organizational goals.

The use of ROI as a performance measure of an investment center can also lead to an under- or over-investment in assets. Managers might attempt to increase the average ROI by investing only in assets that have ROIs above the current ROI, and forgoing projects with ROIs below the current average ROI.

If a project with an ROI above the current average but less than the opportunity cost of capital is chosen, the organization decreases in value. Likewise, rejecting a project with an ROI above its costs of capital, but below the average ROI of the investment center, reduces organizational value.

To increase organizational value, a manager should invest in all assets that have returns greater than the opportunity cost of capital rather than projects that raise the investment center’s average ROI.

For example, suppose an investment center has an average ROI of 20 percent and a cost of capital of 15 percent. A proposed project has an ROI of 18 percent. Although accepting this project lowers the investment center’s average ROI, it is still profitable because its return of 18 percent exceeds its cost of capital of 15 percent.

Numerical Example II

An investment center manager is considering four possible investments. The required investment, annual profits (which are approximately equal to cash flows), and ROIs of each investment are:

The investment center is currently generating an ROI of 18 percent, based on €1 million in assets and a profit of €180,000. The company can borrow cash at a 10 percent annual rate. Which projects will increase the ROI of the investment center? Which projects will increase organizational value?

Solution

Only project A will increase the ROI of the investment center:

Projects C and D also will increase the value of the entire organization. The additional profit generated by these projects is greater than the interest expense from borrowing to invest in C (€300,000 x 10% = €30,000) and D (€100,000 x 10% = €10,000).

ROI can lead to over-investment problems as well. Suppose an investment center has an ROI of 12 percent but its cost of capital is 14 percent. Clearly, this investment center is not earning its cost of capital.

The investment center manager might be tempted to invest in a new project with an ROI of 13 percent. This new investment raises the average investment center ROI above 12 percent, but this investment shouldnot be accepted. Its ROI of 13 percent is below the investment center’s opportunity cost of capital of 14 percent.

Residual Income/Economic Value Added

To overcome the incentive problems of ROI, such as under- or over-investment and lack of risk adjustment, some firms use residual income to evaluate performance.

The opportunity cost of using the assets is the opportunity cost of capital times the market value of the assets. The following equations define the relation between residual income and ROI.

Residual income

Therefore, the residual income is positive if the ROI is greater than the opportunity cost of capital.

A positive residual income number means that the investment center manager has added value to the organization by achieving a higher return on the assets than the cost of using the assets. If residual income is used as a performance measure, the investment manager will be motivated to invest in all assets that have a positive residual income. No under- or over-investment incentive exists.

In measuring residual income, the profit figure does not include any interest expense. Interest expense is excluded to avoid double counting the cost of debt. The opportunity cost of capital includes a charge for the cost of both debt and equity.

Measuring residual income requires a measure of the opportunity cost of capital; the opportunity cost of capital should reflect the risk of the assets in the investment center.

Financial institutions are more reluctant to lend money to organizations that invest in high-risk projects, and to compensate for the additional risk, they charge a higher interest rate. By choosing the opportunity costs of capital to reflect the risk of the assets, no incentives exist to choose high-risk projects just to increase the ROI figure.

Numerical Example III

A tractor division has profits (not including interest expenses) of $20 million and investment (total assets) of $100 million. The division has an opportunity cost of capital of 15 percent. What is the residual income of the division?

Solution

The residual income is: $20 million – (15% x $100 million) = $5 million.

As with ROI, residual income is not a perfect performance measure. The profits and total assets are commonly measured using the historical costs from the financial reporting system. If the accounting profits vary due to changes in the market value of the assets, and the book value of assets is not representative of their market value, then residual income will not function well as a performance measure. Managers will be trying to maximize accounting residual income, but the owners of the organization would prefer that managers increase the market value of the organization.

Another perceived problem in using residual income is the comparison and evaluation of performance across investment centers of different sizes. Residual income is an absolute dollar figure and is likely to be larger for larger investment centers. For example, consider the example in Table XI of two investment centers, division A and B:

Division A has a larger ROI, but Division B has a larger residual income because Division B is bigger. Which division’s manager is performing better?

If both managers have control over the size of their divisions (that is, they are investment centers), then the manager of Division B is performing better.

Although the manager of Division A is operating efficiently with a smaller amount of net assets, she is not able to find as many profitable opportunities as can the manager of Division B. Division B’s manager adds more value to the organization and should be rewarded accordingly.

Residual income is appropriate for evaluating managers of investment centers of different sizes, since the manager has control of the size of the investment center. If the manager does not have control over size and the division is more like a profit center, then ROI is more appropriate as a relative performance measure of managers of differently sized divisions.

A variant of residual income is the economic value added (EVA). EVA is calculated in the same manner as is residual income, but difference in the general formula are noted in practice.

Economic Value Added (EVA)

Economic value added (EVA) is a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.

EVA is a trademark by Stern Stewart & Co. EVA is different from other performance metrics such as EPS (Earnings Per Share), EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and ROIC (Return On Invested Capital) because it measures all of the costs of running a business, including those incurred in operating and financing the company. This makes EVA a sound performance metric (or measure) and one very closely aligned with the creation of shareholder value.

EVA shows the economic profit that a company creates within a financial year. If EVA is positive, economic profit is created; and economic profit declines if EVA is negative.

EVA has some advantages: firstly, EVA is an operational tool that can be applied to calculate the economic profit that different divisions within a company create.

Secondly, the company has the possibility of budget future EVAs or changes in EVAs by setting targets for EVA for single divisions; and, in addition, EVA can be used as the foundation for bonus payments.