Management Accounting-Performance Evaluation

PERFORMANCE EVALUATION

INTRODUCTION

Performance evaluation deals with the area of Management Accounting that is concerned with:

• Holding individual managers responsible for certain aspects of the organizational performance.

•   Making them accountable by producing regular performance reports relating to matters for which they are responsible.

•  Motivating managers to achieve better results by setting targets for performance, judging actual results against targets and rewarding good performers.

•  Giving managers control information to enable them to make decisions about improving their performance.

There are two interrelated aspects involved and these are:

•   Giving managers authority to make decisions and holding them responsible for the exercise of that authority.  This is referred to as decentralization.

•   Defining a system of accountability by which to judge how the authority has been used and the responsibility carried out.  This is referred to as responsibility accounting.

RESPONSIBILITY ACCOUNTING

This is a term used to define the measuring of performance of decentralized units, using account results. Responsibility accounting recognizes various decision centres throughout an organization and trace costs (revenues, assets and liabilities) to the individual managers who are primarily responsible for making the decisions about the costs in question.  A responsibility centre is a unit in an organization headed by a manager having direct responsibility for its performance. Examples of responsibility centres include cost centre, profit centre, and investment centre. These centres are defined below:

Cost Centre

Cost centre is a production service location activity or item of equipment whose costs maybe attributed to cost units.  It is therefore any unit of the organization to which cost can be attributed.

Managers in the cost centre have control over various controllable costs (That is costs incurred in the centre) but may have no control for any alterations apportioned from other cost centres.

Performance measurement in a cost centre can be accomplished through variance analysis or through efficiency measures such as output/input ratio.

Profit Centre

A profit centre is a sub unit of an organization such as a division of a company to which both revenue and costs are assigned so that the profitability of that sub unit can be measured. It is also referred to as a strategic business unit.

Managers in a profit centre have control over costs, and revenue decisions.  Performance measurement in a profit centre can be accomplished through the use of profit margin or contribution/sales ratio.

Investment Centre

An investment centre is a sub unit of the organization where managers have control over cost, revenue and some investment decisions.  Managers can buy some assets so as to increase profitability.

Performance in an investment centre is measured by ratios such as return on investment which relates the profit earned to the amount of capital invested.  Performance can also be measured from absolute measures such as residual income.


 

STEPS OF CHOOSING AN ACCOUNTING BASED PERFORMANCE MEASURE

        i.            Consider the overall goal of the organization as a whole. It is important to choose a measure of accomplishment that represents top management goals. Such measures include operating income, net income, Return on investment (ROI), sales, etc. 

      ii.            Determine whether the measure should be maximized or minimized.

    iii.            Select definitions for such items as income and investments (i.e. should income be based on variable or absorption costing? should central overheads be allocated? should investments consist of total assets, net assets or net worth?)

    iv.            How should items such as income and investments be measured (i.e. should we use historical costs, replacement costs, realizable or current values?)

      v.            Determine the standards that should be applied (i.e.  Should all divisions be required to earn the same rate of return on all investments?)

    vi.            What timing of feedback is needed?  Should it be monthly or quarterly?

Financial performance measurement

Financial performance indicators analyze profitability, liquidity and risk.

Financial indicators (or monetary measures) include: Profit, Revenue, Costs, Share price and Cash flow

Financial results should be compared against a yard-stick such as:

·         Budgeted sales, costs and profits

·         Standards in a standard costing system

·         The trend over time (last year/this year,)

·         The  results of other parts of the business

·         The  results of other businesses

·         The economy in general

·         Future potential (for example the performance of a new business may be judged in terms of nearness to breaking even.

Profitability measures of performance

A company ought to be profitable, and there are obvious checks of profitability.

a)      whether the company has made a profit or a loss on its ordinary activities

b)      By how much this years profit or loss is bigger or smaller than last years profit or loss.

•   The main ratio to measure profitability in an organization is return on capital employed (ROCE), which can then be subdivided into:

a)      Net margin-if ROCE indicates poor performance then the net margin would indicate if it is due to low margin or poor overhead control and further ratios can be calculated to investigate.

b)      Asset turnover-if it indicates poor performance then fixed asset utilization and working capital management may be further examined.

ROCE = net profit x 100

                                          Capital employed

Capital employed = shareholders’ funds plus payables: amounts falling due after more than one year plus any long-term. Provisions for liabilities and charges.

= Total assets less current liabilities.

What does a company’s ROCE tell us? What should we be looking for? There are three comparisons that can be made.

a)      The change in ROCE from one year to the next

b)      The ROCE being earned by other companies, if this information is available

c)      A comparison of the ROCE with current market borrowing rates.

i) What would be the cost of extra borrowing to the company if it needed more               loans, and is it earning a ROCE that suggests it could make high enough profits to make such borrowing worthwhile?

ii) Is the company making a ROCE which suggests that it is making profitable use of its current borrowing?

Gross profit margin   = gross profit    x 100

                                 Turnover

Net profit margin = net profit    x 100

                             Turnover

  Asset turnover = turnover    x 100

      Capital employed

Asset turnover is a measure of how well the assets of a business are being used to generate sales

Operating ratios   = expenses   x 100

                                  Turnover

Question

Below are the financial statements for T for the year ended 30 June 2005 and 2006:

Income statements

                                                                  2005                2006

                                                                  $000                $000

Revenue                                                    150,000                       180,000

Cost of sales                                              (60,000)          (65,000)

Gross profit                                                             90,000                       115,000

Operating expenses                                                (28,500)          (39,900)

Profit from operations                                 61,500                       75,100

Finance costs                                             (10,000)           (12,000)

Profit before tax                                          51,500                       63,100

Tax                                                                        (13,600)          (17,300)

Net profit                                                     37,900                       45,800

Dividends of $25m were paid to shareholders in each year.

Balance sheets

                                                                  2005                2006

                                                                  $000                $000

 Property, plant and equipment                  190,000                       266,200

Current assets     

Inventory                                                   12,000             15,000

Receivables                                                           37,500             49,300

Bank                                                               500             __-_____

                                                                  240,000                       330,500

Share capital                                              10,000             12,000

Share premium                                            4,000               5,000

Revelation reserve                                     -                       30,000

Retained earnings                                      78,900             99,700

                                                                  92,900           146,700

Non current liabilities

Loan                                                          125,000                       150,000

Current liabilities

Trade payables                                          10,600             11,700

Overdraft                                                   -                         9,100

Taxation                                                    11500              13000

                                                                  240,000                       330,500

PROFITABILITY

Required:

a) For each of the two years, calculate the following ratios for T                                     

             I.      Gross profit margin                                                                          

          II.      Operating profit margin                                                                   

       III.      Net profit margin                                                         

        IV.      ROCE                                    

b)  Suggest reasons why T’s ratios have changed.

Controllable profit

The profit made by a division after deducting only those expenses that can be controlled by the
divisional manager and ignoring those expenses that are outside the divisional manager’s control.

•   Return on investment (ROI

ROI =  controllable (traceable) profit  x100 %
            controllable (traceable) investment(capital employed)

• Controllable profit is usually taken after depreciation but before tax.

• Capital employed includes both non-current assets and working capital.

• Non-current assets might be valued at cost, net replacement cost or bet book value (NBV).  The value of assets employed could be either an average value for a period as a whole or a value for the period is preferable.

Example

An investment center has reported a profit of £28,000.  It has the following assets and liabilities:

                                                                              £                      £

Non-current assets (at NBV)                                                                      100,000

Inventory                                                               20,000

Trade receivable                                                    30,000

Total         current assets                                                 50,000

Trade payables                                                         8,000              42,000

                                                                                                      142,000                      

• ROI might be measured as: £28,000/£142,000 = 19.7%.

• However, suppose that the center manager has no responsibility for debt collection.  In this situation, it could be argued that the center manager is not responsible for trade receivables and the center’s CE should be£112,000.  If this assumption is used, ROI would be£28,000/£112,000 =25.0%.

Evaluation of ROI as a performance measure

ROI is a popular measure for divisional performance but has some serious failings which must be considered when interpreting results.

Advantages

1. It is widely used and accepted
2. As a relative measure it enables comparisons to be made with divisions or companies of different sizes.
3. It can be broken down into secondary ratios for more detailed analysis.

Disadvantages

• It may lead to dysfunctional decision making, e.g. a division with a current ROI of 30% would not wish to accept a project offering a ROI of 25%, as this would dilute its current figure.

• Different accounting policies can confuse comparisons (e.g. Depreciation policy).

• ROI increases with age of assets if NBVs are used, thus giving managers an incentive to hang on to possibly inefficient, obsolescent machines.

• It may encourage the manipulation of profit and CE figures to improve results.

Example

For the past few years, an investment center has been making annual profits of £60,000 on average capital employed of £400,000 (NBV as at the end of each year).  This performance is expected to continue unless a decision is taken to invest in project X.  Project X would cost £100,000 and have a life of four years.  It would make the following additions to the annual cash profits of the division:

      Year                             £

1                                                                    10,000

2                                                                    30,000

3                                                                    60,000

4                                                                    60,000

Based on the firm’s current hurdle rate of 12%, the project gives a NPV of £13,682 and so should be accepted.  The investment center manager, however, might evaluate the investment on the basis of how it might affect the center’s reported performance in the short-term, say over the next two years.

Depreciation of project X assets will be£25,000 each year.

Year           Profit/loss        Year-end          Divisional        Divisional        ROCE             

                From         CE                    profit                CE

      Project X          Project X

            £                     £                     £                      £

Current     -                             -                  60,000                          400,000         15.0%

1      (15,000)         75,000             45,000                        475,000                      9.5%

2         5,000          50,000             65,000                        450,000                       14.4%

3       35,000          25,000             95,000                        425,000                       22.4%

4      35,000                         0                    95,000                        400,000                       23.8%

The investment center manager is unlikely to undertake project X because ROI over the next two years would be reduced.  The project would make a loss in year 1 (negative ROI) and in year 2 the project’s ROI is only 10% (5,000/50,000), which is lower that the ROI for the rest of the investment center.

Residual income (RI)

•   RI is a measure of the profitability of an investment center after deducting a notional or imputed interest cost.  This interest cost is a notional charge for the cost of the capital invested in the division.

•   Residual income also ties in with net present value, theoretically the best way to make investment decisions.

•   The present value of a project's residual income equals the project's net present value. In the long run, companies that maximize residual income will also maximize net present value and in turn shareholder wealth.

•   Residual income does, however, experience problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher residual income because of the size of the division rather than superior managerial performance.

 Residual income = controllable /accounting (traceable) profit - an imputed /notional interest charge on controllable (traceable) investment.

•  Accounting profit is calculated in the same way as for ROI.

•  Notional interest on capital = the Capital Employed in the division multiplied by a notional cost of capital or interest rate.

•  The selected cost of capital could be the company’s average cost of funds (cost of capital).  However, other interest rates might be selected, such as the current cost of borrowing, or a target ROI.

Question1
Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a profit of $2.2m per annum. Division X's cost of capital is 10% per annum. The division is considering two proposals.

Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of $0.15m.

Proposal 2 involves the disposal of assets at their net book value of $2.3m. This would lead to a reduction in profits of $0.3m.

Proceeds from the disposal of assets would be credited to head office not Division X.

Required: calculate the current ROI and residual income for Division X and show how they would change under each of the two proposals.

Current situation
Return on investment
ROI = $2.2m      x 100 = 22%
            $10.0m

Residual income = Profit $2.2m
Imputed interest charge
$10.0m x 10% = $1.0m

Residual income = 2.2m – 1.0m = $1.2m

Comment: ROI exceeds the cost of capital and residual income is positive. The division is performing well.

Proposal 1
Return on investment
ROI = $2.2 + 0.15m/ 10m + 1m x 100 = 21.4%         

Residual income
Profit $2.35m

Imputed interest charge
$11.0m x 10% = $1.1m

Residual income = $2.35 - $1.1 = $1.25m

Comment: the project is acceptable to the company. It offers a rate of return of 15% ($0.15m/$1m x 100) which is greater than the cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting proposal 1. This would be a dysfunctional decision. Residual income increases if proposal 1 is adopted and this performance measure should lead to goal congruent decisions.

Proposal 2
Return on investment
ROI = 2.2m – 0.3m = $1.9m/7.7m x 100 = 24.7%

Residual income
Profit $1.90m

Imputed interest charge
$7.7m x 10% = $0.77m

Residual income = $1.9 m-$ 0.77m = $1.13m

Comment: the disposal is not acceptable to the company. The existing assets have a rate of return of 13.0% ($0.3m/$2.3m) which is greater than the cost of capital and hence should not be disposed of. However, divisional ROI rises and this could lead to the divisional manager accepting proposal 2. This would be a dysfunctional decision. Residual income decreases if proposal 2 is adopted and once again this performance measure should lead to goal congruent decisions.

Question    2

An investment center has net assets of £800,000 and made profits before interest of £160,000. The notional cost of capital is 12%.

An opportunity has arisen to invest in a new project costing £1900, 000.  The project would have a four-year life, and would make cash profits of£40,000 each year.

Required:

a)      What would be the average ROI with and without the investment? Would the investment center manager wish to undertake the investment if performance is judged on ROI in year 1?

b)      What would be the average annual RI with and without the investment? Would the investment center manager wish to undertake the investment if performance is judged on RI in year 1?

Question 3

Two divisions of a company are considering new investments.

                                                                  Division X                   Division Y

Net assets                                                   £1,000,000                  £1,000,000

Current divisional profit                               £250,000                     £120,000

Investment in project                                               £100,000                      £100,000

Projected project profit                                   £20,000                        £15,000

Company’s required ROI                                                                        18%

Assess the projects using both ROI and RI.

Advantages and disadvantages of residual income

Advantages

1. It makes divisional managers aware of the cost of financing their divisions.
2. It is an absolute measure of performance and not subject to the problems of relative measures such as return on investment.
3. In the long run it supports the net present value approach to investment appraisal (the present value of a project’s residual income equals net present value of that project).

Disadvantages

• In common with most other divisional performance measures, problems exist in defining controllable and traceable income and investment.

• Residual income gives the symptoms not the causes of problems. If residual income falls the figures give little clue as to why.

• Problems exist in comparing the performance of different sized divisions (large divisions will earn larger residual incomes simply due to their size).

• Residual income when applied on a short term basis is a short term measure of performance and may lead managers to overlook projects whose payoffs are long term.

Comparing divisional performance

Divisional performance can be compared in many ways.  ROI and RI are common methods but other methods could be used.

•  Variance analysis – is a standard means of monitoring and controlling performance.  Care must be taken in identifying the control-ability of, and responsibility for, each variance.

•  Ratio analysis- there are several profitability and liquidity measures that can be applied to divisional performance reports.

•  Other management ratios – under this heading would come contribution per key factor and sales per employee or square foot as well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour, etc.  The role of NFPIs is often key here.

•  Other information- such as staff turnover, market share, and new customers gained innovative products or service developed.