performance measures in investment centres

Question 1

how can revenues in investment centres be earned?

Answer 1

revenues here may be earned from external sales or through transfers made to other centres. difference is that in addition the mgr will be responsible for capital investment.

Question 2

what are the decisions rights / performance measurements for cost centres?

Answer 2

decision rights = choose output for given fixed amount of resources

perf measurement = qty and quality of output (maximise under constraints)

OR

decision rights = choose input mix to achieve given target output

perf measurement = cost (minimise given constraints)

Question 3

what are the decisions rights / performance measurements for profit centres?

Answer 3

decision rights = choose input mix and output given fixed resources

perf measurement = profit (maximise)

Question 4

what are the decisions rights / performance measurements for investment centres?

Answer 4

decision rights = choose input mix, outputs and level of investment

perf measurement = return on investment, residual income (maximise)

Question 5

what is a strategic business unit?

Answer 5

another term for investment centres to some extent. SBUs may be treated as profit centres but they are more usually treated as investment centres as they cannot be evaluated on profit alone, and inevitably they differ in size and operating characteristics at very least. each investment centre/SBU will have mgr and mgmnt team in charge of activities and performance.

Question 6

what should the main aim of head office mgment be for SBUs?

Answer 6

motivate mgr and team to achieve group goals

provide right incentive for mgr and their team to make decisions that are consistent with group mgment’s goals.

• traditional way to do this is ROI, and tying bonus payments into them.

Question 7

what is ROI?

Answer 7

seen as a universal measure and used as key perf measure for almost every org, exception being Japan who like ROS - return on sales. ROI does have variety of slightly different definitions/meanings.

RONA - return on net assets and ROCE - return on capital employed very similar. ROCE common at overall corporate level, ROI more for investment appraisal and divisional performance.

Question 8

what ROI formula should be used for investment appraisal vs profit against size of inv centre

Answer 8

for investment appraisal and divisional performance.

ROI = operating profit before tax / net operating assets

for evaluating profit measured against size of investment centre:

ROI = earnings before interest / total assets of investment

(if operating profit is not given, use net profit instead)

Question 9

what costs/assets should be included in ROI when assessing unit performance?

Answer 9

used to appraise investment decisions of a dept. mgr is not usually in control of tax paid so excluded. also, only assets actually used in business unit should be used in calculation as these are only assets for which investment centre’s mgment has responsibility. generally leave depreciation in. use net assets if capital employed not given. Non-current assets might be valued at cost, net replacement cost or net book value (NBV). The value of assets employed could be either an average value for the period as a whole or a value as at the end of the period. An average value for the period is preferable. However, in the exam you should use whatever figure is given to you.

Question 10

how does ROI differ US vs UK?

Answer 10

in UK operating assets = net assets = fixed and current assets minus current liabilities. in US, only assets included. treats liabilities as part of the financing.

Question 11

how can ROI be broken down in terms of formula? how does this help?

Answer 11

ROI = pretax profit / sales * sales / net assets

looking at sales, profit and assets separately means you can gain insight in how to improve. e.g. can show operating costs too high or asset turnover needs improving. take care with asset valuation - if new they will not have been depreciated much but as they age depreciation will reduce value and turnover will look better (but all that has happened is base has decreased)

Question 12

what are the advantages of ROI?

Answer 12

widely used and accepted, in line with ROCE so fits well.

relative measure so enables comparison between divisions

can be broken down into secondary ratios for more detailed analysis (profit margin, asset turnover).

Question 13

what are the limitations of ROI in terms of % measurement, short termism and gaming?

Answer 13

% return vs size of investment

would you rather have 15% on 100 or 12% on 200? shareholders would prefer first because they have more freedom with remaining funds, but mgrs might pick latter because business’ growth safeguards the job and role will expand. ROI tends to limit growth - is this the intention?

short term vs long term returns

generally, a business has to invest now in order to obtain positive cash flows and profits in future. therefore successful business is always reducing profit it can earn this year to create a situation which will generate profit in future. but what are the rules, and what is an acceptable ROI for this? focus on high ROI may not invest for the future, and if its short term increase leads to a promotion someone else will have to pick up the pieces. can overcome this by excluding things that benefit the future like R&D, staff development and advertising from profit calculation

massaging the ROI

when single measure is used there is always the chance that it will be ‘gamed’. especially if bonuses are involved. asset base can be altered by inc/dec the creditors and debtors (speeding up or delaying payments to and from the business units. 5% discount will reduce debtors, but if they would have paid next month it’s a costly exercise.

Question 14

what are the limitations of ROI?

Answer 14

different businesses and industries have different ROIs

intra-group transfers

mgrs must feel transfer price is fair as it affects profit and therefore ROI. if one is required to transfer at a low price and ROI is used, mgment may find it demotivating.

asset value - ROI increases with age of asset if NBVs are used.

doesn’t necessarily measure change in market value, based on historical asset values

doesn’t recognise risk of investment centre - higher returns imply higher risk

may lead to under-investment in assets where only assets with huge returns purchased.

different accounting policies can confuse comparisons.

Question 15

what is the DuPont example of ROI?

Answer 15

early part of 20th century saw growth of multidivisional diversified orgs which required new ways to coordinate operating activities. specific techniques developed by the CFO of DuPont:

• operating budget
• capital budget
• return on investment

Question 16

how does the DuPont method break down ROI?

Answer 16

ROI = sales turnover*return on sales

sales turnover = sales/total investment
ROS = earnings/sales

Question 17

what is residual income?

Answer 17

residual income - difference between investment centre’s profits and opportunity cost of using the assets of the investment centre.

Residual income = profits - notional cost of capital * capital employed

Question 18

why is it an issue that ROI contains no element of scale?

Answer 18

can result in trying to slim down business to small high-yield core. can mean you lose a large volume of perfectly profitable trade.

Question 19

what is the notional cost of capital in residual income?

Answer 19

notional cost of capital can be average cost throughout company, current cost of borrowing, target ROI etc. generally given this one.

Question 20

how is residual income used in practice?

Answer 20

residual income has never been widely used in practice. ROI is more widely used, but even then measures like profit before tax and staying within budget are seen as more important.

Question 21

what are the advantages of residual income?

Answer 21

resolves dysfunctional aspect if ROI - no issue of rejecting projects with ROI in excess of company’s target but lower than divisions current ROI.

cost of financing a division brought home to mgrs

risk can be incorporated in the notional rate.

Question 22

what are the limitations of residual income?

Answer 22

changes in market value are not measured when using it. as historical cost of assets is used, mgrs will always try to increase residual income, while stockholders would like to see market value increase

when residual income is used as a performance measure the comparison across investment centres of different sizes becomes difficult

can also be mislead as increases over time as assets depreciate.

subject to accounting measures of profit and capital employed which may be subject to manipulation.

Question 23

why was ROI developed?

Answer 23

as orgs started engaging in wide range of activities, needed a mechanism to measure performance of diverse business + allocate resources

Question 24

how can RI be misleading when compared to NPV?

Answer 24

RI is concerned with profit flows not cash flows, so a project may have a positive RI through its lifetime but have a negative NPV. This project should be rejected

Question 25

how has performance measurement moved on from ROI/RI?

Answer 25

range of financial metrics judged to be appropriate to new economy have been developed, including EVA and CFROI. recent surveys by US institute of cost and management accountants, nearly 2/3 of companies want better metrics, with a focus on shareholder value.

Question 26

what is EVA?

Answer 26

variant on residual income more attuned to economics of a business than traditional accounting model. adopts economic valuation of capital employed, so figure is based on assets at replacement cost or even the whole business unit at estimated sales value. basic concept is that performance as a whole should be measured in terms of value that has been added during the period. measure of performance directly linked to creation of shareholder wealth.

Question 27

how is goodwill, R&D expenditure and depreciation treated for EVA?

Answer 27

goodwill amortised over effective life — payments made may be viewed as adding value to the company. represent part of intangible asset value of the business. R&D expenditure written off over useful like - increase net operating profit after tax by net increase in capital development costs and increase economic value of capital employed by same amount. depreciation will reflect decline in asset values — depreciation therefore added back to profits after tax and economic depreciation charged. economic depreciation is a measure of economic use of assets during a year. period change in market value of asset.

Question 28

how are assets valued, and interest, provisions and leases treated under EVA?

Answer 28

assets will be valued at current cost not historical provisions for doubtful debts are reversed interest paid at net of tax - if tax is 35% take interest payments and multiply by 0.65. leases — all should be capitalised. finance leases already capitalised but operating leases should be too. econ value of capital employed increase to include current value of operating lease. capitalised cost should then be amortised. value of net operating profit after tax should be increased by operating lease charge and reduced by amortisation charge. net effect increases operating profit after tax by implied interest cost of operating lease.

Question 29

how do the EVA adjustments change the profit reported?

Answer 29

depreciation, provisions, non cash and interest adjustments get you a profit that would’ve been reported if your company was financed with ordinary shares. charge for interest and tax effect of gearing incorporated into WACC so will double count interest if it’s left in the profit. net interest added back because interest already allowed as an expense in tax liability.

Question 30

once adjusted profit is calculated how is EVA produced?

Answer 30

interest rate charge*value of capital employed deducted to produce EVA. interest rate used in EVA usually complex and based on CAPM. all above features require systems to be implemented so data available. separate depreciation calculations and records of assets are needed.

Question 31

what is the formula and objective of EVA?

Answer 31

objective is to better measure true economic performance of a division. formula: EVA = net operating profit after tax - (cost of capital*net assets)

Question 32

what is normally used to approximate RI?

Answer 32

RI normally used as an approximation for EVA. however, adjustments used to derive it are designed to minimise benefit mgrs may obtain by manipulating accounting numbers. e.g. little gain to short run profit from failing to invest in new machinery and at least part of cost of advertising would be deferred until benefits arose.

Question 33

what are the advantages of EVA?

Answer 33

attempts to put a figure to the increase/decrease that should have arisen during a period from operations of a company or individual decisions within a company. can be measured for each reporting period ? - this is a grab surely based on economic profit and values of assets, not accounting ones meaning manipulation opportunities are lower. focuses on activities that drive value

Question 34

how can EVA be used?

Answer 34

can be used to set performance targets at any level, measure actual performance, plan and make decisions on basis of how it’ll affect EVA. when used to measure performance, Stern Stewart recommend that divisional mgrs should be: given training to understand principles, non accountants tend to find the concept easy to understand informed about interest cost that will be applied for capital charge taught how to calculate EVA for decision making purposes given a pay incentive based on a bonus for achieving or exceeding a target EVA

Question 35

how can EVA be used for control purposes?

Answer 35

identify customers who provide greatest EVA and give priority to serving them identify activities that don’t add to EVA and eliminate them identify capital not providing sufficient return to cover its capital cost such as excess equipment and seek to reduce capital investment.

Question 36

what is CFROI?

Answer 36

yield for a business unit taking the EVA of its assets as the capital base and using projected future cash flows as the return. this involves the use of DCF. forward looking linked to what is forecast rather than what happened.

Question 37

how should performance metrics be selected for CFROI?

Answer 37

behavioural and business economics issue: metrics should be linked to drivers of shareholder value. performance should be evaluated, and mgrs rewarded, on basis of achieving objectives that cause share price to rise. be wary of performance improvements that could just be mathematical manipulation. fixed costs can be carried over and production levels can be changed to give impressions of profit. using simple measures can easily lead to dysfunctional behaviour. consider involving non-financial indicators linked to growth (new customers, sales volume, cash conversion periods).

Question 38

what is report visualisation?

Answer 38

report visualisation = process of presenting report formats that represent data and information in a pictorial/graphical format. visualisation helps recipient understand significance of content more easily than if presented traditionally. volume of data is larger than ever so report visualisation increasingly important. also becoming interactive and dynamic.

Question 39

what is important to remember when reporting for different types of responsibility centre?

Answer 39

for effective decisions to be taken info presented must focus on right KPIs that drive true business performance. overriding principle in deciding how to present data is one size doesn’t fit all!!

Question 40

what are the two key areas fundamental for quality in responsibility centre reporting?

Answer 40

data and master data that are subject to robust control - this ensure reporting integrity standards in reporting that drive commonality across the whole org and aid assimilation to the consumer. e.g., red always meaning bad

Question 41

what are the five principles for effective report visualisation?

Answer 41

ensure data is optimised for visualisation relevant visualisation tool applied appropriate report layout must be chosen reader experience must be optimised visualisation to appropriate delivery channel must be optimised

Question 42

how can you ensure data is optimised for report visualisation?

Answer 42

once right reporting measures identified, relevant data sources need locating. Key points to consider per data source are: where is it? can it be refreshed in time to make report relevant? second area is creating structure/hierarchies within the data that facilitates drill down to the reader. this is important if using tools that encourage users to drill to next level (e.g. mobile tech). e.g., if there’s a map of the world showing adverse variances in europe, may want to drill down in different ways - country, region, product, distribution channel. this is facilitated by the correct dimensional structure that stores data against reporting hierarchies.

Question 43

how should a relevant visualisation tool be chosen for effective report visualisation?

Answer 43

principal factor in choosing relevant report visualisation technique will undoubtedly be driven by what the user for the report feels comfortable with. there are a few common guiding principles that can help: variance analysis is often depicted by waterfall charts / bridges. the size of the steps in the bridge are to scale so the eye naturally focuses on significant movements first. in providing a relevant overview of an area, dashboards can be helpful. key to delivering a useful dashboard is identifying what are the four or five relevant drivers that can be reported on one page or screen. dashboards provide a summary and often lead to a drill down to the next level, which is likely to be a different report. trend analysis or time based results tend to go on line charts - modern planning solutions can also use line charts as the interface to plan for future periods by establishing a baseline and then allowing the planner to drag the chart, which models underlying data. orgs with areas or regions can use mapping charts, especially helpful if they’re interactive. when comparing data sets built up from component parts then a bar chart or side by side pie charts help (e.g. subs revenue by sub type)

Question 44

what should be considered in the layout chosen for report visualisation?

Answer 44

layout (simple, clean, impactful. don’t overcrowd, use clear headings) presentation (if delivering digitally, visible page should match screen with no scrolling) positioning (key messages go top left) colours - attractive and engaging but also assist your storytelling. red and green as bad/good, colours in related charts should always be consistent. don’t overdo it, will likely look messy. scaling can also be used - make it appropriate to the data and don’t hide the story. if there are multiple charts don’t mix the scaling.

Question 45

how can reader experienced be optimised in report visualisation?

Answer 45

personalised - key to engaging. can anything from bookmarks/favourites to AI reporting suggestions based on history. intuitive - searching should be similar to web search, home buttons should have familiarity interactive - with touchscreen computers, tablets and smartphones more common in business it’s often desirable to use touch in an interactive report. whether choosing next report or drilling down to next level, much more intuitive to swipe than click. customised - certain group of report users may want to customise and this is facilitated by certain software vendors. can create own experience but care must be taken to ensure the underlying data model is robust and does not allow the misrepresentation of data when customised.

Question 46

what should be considered in delivery channels for report visualisation?

Answer 46

reports can be delivered by many channels - desktop, laptop, tablet, mobile, paper. clear that phone clearly smaller than A4 paper and logical to change design. many software providers support functionality that automatically renders the report and layout based on delivery device (AKA author once/run everywhere). tools are useful but consider user experience, e.g. smaller screen = less data. can provide drill paths and filter options to dig in as required. consider urgency of report requirement. urgent notifications can be sent to mobiles but full analysis may wait until user is in front of a computer. previous visualisation principles become even more important when thinking of various delivery channels. tech is just the enabler to appropriately satisfy these.