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MBA Lecture 11 Last Lecture

This document discusses various approaches to performance measurement. It introduces return on investment (ROI), residual income, and economic value added (EVA) as three common accounting-based measures. ROI measures net operating income relative to average operating assets. Residual income measures net operating income above a minimum required return on assets. EVA is a variant of residual income that deducts the cost of equity and debt capital from operating profits. The document explains the formulas and calculations for each measure and discusses their advantages and limitations in assessing organizational performance.

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Mai Atef Dabour
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
25 views

MBA Lecture 11 Last Lecture

This document discusses various approaches to performance measurement. It introduces return on investment (ROI), residual income, and economic value added (EVA) as three common accounting-based measures. ROI measures net operating income relative to average operating assets. Residual income measures net operating income above a minimum required return on assets. EVA is a variant of residual income that deducts the cost of equity and debt capital from operating profits. The document explains the formulas and calculations for each measure and discusses their advantages and limitations in assessing organizational performance.

Uploaded by

Mai Atef Dabour
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Performance Measurement :

ROI, Residual Income, and Economic


Value Added
Dr Maha Rabei
12-2

Introduction
 In recent years, because of the dynamic of the
environment where organizations compete,
more and more of them developed a
considerable interest for performance
measurement.
 The main role of performance measurement is
to assess the current position of the
organization and also to help managers create
and implement a better strategy.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.


12-3

 performance measurement, is a process which allows an


organization to evaluate whether it is on track, or whether actions
should be initiated that help achieving its objectives.
 Early performance measurement focused mainly on financial
measures.
 This uni-dimensional approach has been criticized in the 1980’s by
various authors.
 Changes in the world markets and the increasing competition that
enterprises were facing in the 1990’s led to new approaches to
performance measurement.
 Performance measurement provides the information needed to
assess the extent to which an organization delivers value.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.


12-4

Accounting-Based performance Measures

 Companies commonly use four measures to


evaluate the economic performance.
 Three of the approaches to measuring
performance include a measure of investment:
return on investment, residual income, and
economic value added.
 A fourth approach, return on sales, does not
measure investment

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.


12-5

 The choice of performance measures is


one of the most critical challenges facing
organizations.
 Poorly chosen performance measures
routinely create the wrong signals for
managers, leading to poor decisions and
undesirable results.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.


12-6

 Traditional performance measurement systems


were developed at a time when decision-making
was focused at the center of the organization and
responsibilities for decision-making were very
clearly defined.
 ‘these performance measurement systems were
designed to measure accountability to confirm that
people met their budget and followed orders’.
 However, during the last two decades it was
widely argued that most of the performance
measurement systems failed to capture and
encourage a corporation’s strategy, producing
mostly poor information leading to wrong
McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.
12-7

Return on Investment

 Return on investment is the most popular


approach to measure performance. ROI is
popular for two reasons: it blends all the
ingredients of profitability—revenues, costs, and
investment—into a single percentage; and
 it can be compared with the rate of return on
opportunities elsewhere, inside or outside the
company.
 Like any single performance measure ,ROI
should be used cautiously and in conjunction
with other measures.
McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.
Return on Investment (ROI)
Formula
Income before interest
and taxes (EBIT)

Net operating income


ROI =
Average operating assets

Cash, accounts receivable, inventory,


plant and equipment, and other
productive assets.
Increasing ROI
There are three ways to increase ROI . . .
Reduce
Expenses
Increase Reduce
Sales Assets
Residual Income - Another Measure
of Performance

Net operating income


above some minimum
return on operating
assets
Calculating Residual Income

Residual
income
=
Net
operating -
income
(
Average
operating
assets

Minimum
)
required rate of
return

This computation differs from ROI.


ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
12-13

Economic Value Added

 One such model in the field of internal and external


performance measurement is a trade-marked
 variant of residual income known as EVA(Economic Value-
Added).
 EVA is financial performance measure that most
accurately reflects company’s true profit (Stewart, 1991).
 EVA is the calculated after deducting the cost of equity
capital and debt from the operating profits.
 EVA is a revised version of Residual Income (RI) with
 a difference the way the economic profit and the
economic capital are calculated.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.


 EVA recommended as a measure that could be
used instead of earnings or cash from operations in
order to capture both internal and external
performance
 Economic value added (EVA®) is a specific type of
residual income calculation that has recently
attracted considerable attention.
 Economic value added (EVA®)
= After-tax operating income
– (Weighted-average cost of capital) × (Long-term assets +
Working capital)
Economic Value Added
 Why Long-term assets + Working capital?
 Can also be computed as Total assets
minus current liabilities
 That is, the investment base is reduced by
current liabilities—largely Accounts
Payable!
12-16

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

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