ACT 4131 Management Accounting III

1. ACT 4131 Management Accounting III Financial Measures of Performance

2. BSC: Four Different Perspectives • 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. The 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.

4. Measuring 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 ™)

5. 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?

6. 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

7. 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

8. 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.

9. 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. 

10. 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.

11. 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

12. 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.

13. 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 • Thus, creating less return in the long run than the capital charge is economically not acceptable especially from the shareholders perspective

14. 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.

15. Weighted Average Cost of Capital (WACC) • 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.

16. 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,

17. 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

18. 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

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

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

21. 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%

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

23. 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

24. How does EVA translate into shareholder value? • Empirical correlation between EVA and share price • Invest only when generate a return in excess of the cost of capital • Thus,EVA is a useful tool for allocation of scarce capital resources

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

26. 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

27. 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

28. Dysfunctional Consequences ofFinancial Performance 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. • Adopt a Balanced Scorecard Approach