ACT 4131 Management Accounting III

1. ACT 4131 Management Accounting III Financial Measures of Performance

2. Four Different Perspectives in BSC • How do we look to shareholders? (financial perspective) • How do customers see us? (customer perspective) • What must we excel at? (internal business process perspective) • Can we continue to improve and create value? (learning and growthperspective)

3. Financial Perspective • Financial measures summarise economic consequences • Measures are ‘bottom-line’, the results of operations • Examples: operating income, ROCE, EVA, cash flow • Financial measures provide adequate indicators of past performance, not of future performance

4. Financial Perspective • Typical measures include ROI, RI and EVA • Besides targets for the above, other objectives include revenue growth, cost reduction and asset utilization. • Argued by some that by focusing on other perspectives, financialmeasures will take care of themselves.

5. Objectives Measures Revenue Growth: Increase the number of new Percentage of revenue products from new products Create new applications Percentage of repeat customers Develop new customers and Percentage of revenue from markets new sources Adopt a new pricing strategy Product and customer profitability

6. Objectives Measures Cost Reduction: Reduce unit product cost Unit product cost Reduce unit customer cost Unit customer cost Reduce distribution channel cost Cost per distribution channel Asset Utilization: Improve asset utilization Return on investment Economic value added

7. Widespread Use • Profit articulates directly with organisation’s objectives • Financial measures provide aggregate/overall view of performance • Measures can be used to control – investigate drivers of costs and revenues to reveal reasons for the unfavourable profit variance

8. Divisional Profitability • Ideally focus should be on relative measures (profitability)rather than absolute measures of profit and on controllable items • Relative profitability measures: 1. Return on investment (ROI) 2. Residual income (RI) 3. Economic value added (EVA ™)

9. Return on Investment (ROI) Division ADivision B Profit RM1m RM2m Investment RM4mRM20m ROI 25%10% • Division B earns higher profits but A is more profitable • ROI can becompared with other investments/divisions. • It also provides a usefulsummary measure of the ex post return on capitalemployed. • A major disadvantage of ROI is that managers may bemotivated to make decisions that make the company worseoff. How?

10. Residual Income (RI) • Residual Income relates income to cost of capital • Formula: Income – [capital cost rate X Investment] • Assume rate is 11% • RI for Div A = 1M – 11%(4M) = RM0.56M • RI for Div B = 2M – 11%(20M) = -RM0.2M

11. Economic Value Added (EVA™) • During the 1990 ’s RI was refined and renamed EVA ™ • Economic Value Added (EVA) -- a name trademarked by Stern Stewart & Co. • EVA ™ = Conventional profit based on GAAP ± Accounting adjustments– Cost of capital

12. Accounting Adjustments • Adjustments typically include capitalization of discretionary expenses • Examples: adjustments to capital for LIFO reserves, goodwill amortization, and capitalized intangibles and adjustments to NOPAT for deferred taxes, unusual losses, and increases in reserves • Which adjustments should be made depends largely on the accounting policies of the firm.

13. What is EVA? • Defined as net operating profit after tax less a charge for capital employed • Subtracts the capital charge (the capital investment times the cost of capital) from the net financial benefits of the investment. • EVA is a financial performance method to calculate the true economic profit of a corporation.  

14. Economic Profit • Adjustments convert historic accounting profit to anapproximation of economic profit. • In calculating economic profit, opportunity costs of the inputs used are deducted from revenues earned.  • Opportunity costs are the alternative returns foregone by using the chosen inputs. • As a result, accounting profit can be significantly different from economic profit.

15. EVA • EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum return for shareholders or lenders at comparable risk. • Concept is practically the same as economic profit, residual income and economic value management

16. Cost of Capital • Economic profit is wealth created above the capital cost of the investment. • The fundamental proposition of EVA is that capital is not free and its cost must be factored into every benefit analysis or return-on-investment model when an investment in a plant, equipment or a new customer relationship management system is contemplated. • One of the key tasks in calculating EVA is the determination of the divisional cost of capital.

17. Capital Charge • there is a minimum level of profitability expected from investors, called capital charge • capital charge is the average equity return on equity markets; investors can achieve this return easily with diversified, long term equity market investment • investors can divest and invest elsewhere • Thus, creating less return in the long run than the capital charge is economically not acceptable especially from the shareholders perspective

18. Cost of Capital • EVA targets equity capital as opposed to only debt capital. • Managers often treat equity capital as free when it's not -- shareholders could have invested elsewhere. • EVA prevents managers from thinking that the cost of capital is free. • The capital to finance investments are not free

19. Weighted Average Cost of Capital • WACC is the average of the cost of each of these sources of financing weighted by their respective usage • Sources of finance: debt or equity or both • A firm's WACC is the overall required return on the firm as a whole.

20. Calculating EVA • EVA = Net operating profit after tax – required return on assets • Required rate of return on assets = assets employed x cost of capital • NOPAT (Net operating profit after tax) or EBV (economic book value) adjustments must be made,

21. Steps in Calculating EVA • Calculate net profit after tax (NOPAT) • Identify company’s cost of capital • Determine a reasonable capital cost rate • Calculate company’s EVA

22. Calculating NOPAT Sales COGS SG&A Depreciation Other operating exp Operating income Tax (28%) NOPAT 5200 2800 800 300 200 1100 308 792

23. Calculate Company’s Capital • Total liabilities less non-interest bearing liabilities Total liabilities 4000 • Less Accounts Payable 100 • Less Accrued Expenses 300 Capital 3600

24. Determine Weighted Average Cost of Capital • Assume company has 60% debt and 40% equity • Cost of debt is 8% and cost of equity 13% • WACC = (0.4 x0.13) + (0.6 x0.08) = 10%

25. Calculate EVA EVA = NOPAT – cost of capital = 792 – 10% (3600) =792-360 =RM432 Company has created an EVA of RM432

26. Calculating EVA • EVA can be calculated as net operating after taxes profit minus a charge for the opportunity cost of the capital invested • Unlike accounting profit, such as EBIT, net income and EPS, EVA is economic and is based on the idea that a business must cover both the operating costs and the capital costs. • EVA can be calculated at divisional level for performance evaluation

27. Calculating EVA EVA = Net operating profit after taxes - capital charge (capital investment x cost of capital) Net sales Less operating expenses Operating profit (EBIT) Less taxes Net operating profit after tax (NOPAT) Less Capital charges (invested capital x cost of capital) EVA

28. Calculating EVA • EVA is always expressed as a dollar amount. It reflects the company’s performance in dollars. • Positive EVA indicates shareholder’s value creation • Negative EVA indicates shareholder’s value destruction

29. Translate EVA into Shareholder Value • Empirical correlation between EVA and share price • EVA reminds that resources are costly and that firms can generate shareholder returns only when projects and investments generate a return in excess of the cost of capital. • Thus,EVA is a useful tool for allocation of scarce capital resources

30. Translate EVA into Shareholder Value • Managers are obliged to create value for their shareholders – investors invest money because they expect adequate returns • Managers improve decisions because they have deeper knowledge of about capital and its cost

31. Value-based Measure • EVA measures the absolute amount of shareholder value created or destroyed during the year; can be used to protect the destruction of shareholder value • To be effective firms must continually reinforce the shareholder value • Estimates the company’s true economic value • Thus, it is argued that EVA is a value-based financial performance measure

32. Uses of EVA • Setting organisational goals • Performance measurement • Determining bonuses • Communication with shareholders and investors • Motivation of managers • Capital budgeting

33. EVA as a management tool • goal setting and performance measurement: motivate managers to make decisions that create shareholder value • capital budgeting and restructuring • incentive compensation

34. Improving through EVA • Since EVA helps the organization to realize that capital is a costly resource the most immediate effect of EVA is improved capital efficiency (improved capital turnover) • EVA scarce capital resources can be more efficiently allocated using EVA than by using intuition or traditional methods

35. Improving through EVA • The bigger the EVA the better • Improve returns with no or with only minimal capital investments • Invest new capital in projects that able to cover cost of capital while avoiding investments with low returns • Divest in investments in which returns are below the cost of capital

36. Dysfunctional Consequences ofFinancial Measures • Managers become short-term oriented: boost short-term profits at the expense of long-term profits. • Cannot rely excessively on financial measures • Incorporate non-financial measures that measure thosefactors that are critical to the long-term success of the organization.

37. Evolution of Performance Measures • Move towards a more holistic approach • Studies have reported over-measurement • Tendency towards measuring what can readily be measured rather than what is relevant • Measurements should be able to influence the business process and add value • Adopt a Balanced Scorecard Approach

38. Evolution of Performance Measures Time period Measures Pre-20th Century Mostly financial 1964 & onwards Human resource 1970 onwards Scenario planning 1990s BSC 1994 EVA 1997 Intellectual Capital