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Lubaba JabinFinancial Performance Measurement FAQ
1. What are the key financial performance measures used to assess profit and investment
centers?
Three primary measures are used:
Return on Investment (ROI): This metric, calculated as profit divided by invested capital,
provides a percentage indicating the efficiency of utilizing assets to generate profit. It
allows comparisons with returns from other opportunities.
Residual Income (RI): RI focuses on absolute profit generated above a minimum
required return on invested capital. It encourages managers to prioritize projects that add
value beyond the cost of capital. The formula is: Residual income = profit – (invested
capital × imputed interest rate).
Economic Value Added (EVA®): A refined version of RI, EVA® utilizes after-tax
operating profit, the weighted average cost of capital, and total assets minus current
liabilities in its calculation. It offers a comprehensive view of value creation considering
tax implications and the organization's financing structure.
2. What are the advantages and disadvantages of using ROI?
Advantages:
Encourages managers to consider both profitability and asset utilization.
Facilitates performance comparison between investment centers of varying sizes.
Disadvantages:
Can lead to a short-term focus as managers prioritize immediate ROI improvement.
May discourage asset replacement to maintain a high ROI, potentially impacting long-term
performance.
3. How does Residual Income promote better goal congruence compared to ROI?
RI focuses on maximizing an absolute amount of profit above a minimum required return. This
encourages managers to pursue projects that generate positive residual income, aligning their
actions with the organization's goal of maximizing overall value creation. In contrast, ROI might
lead managers to reject profitable projects if they reduce the overall ROI percentage, even if they
generate positive value for the company.
4. What are the limitations of using Residual Income and EVA®?
Comparability: Both measures are difficult to compare across divisions or companies of
different sizes, as larger entities tend to have higher absolute values.
Short-term Focus: While less pronounced than with ROI, RI and EVA® can still
encourage managers to prioritize short-term gains over long-term value creation.
5. What is the DuPont method of profitability analysis?
The DuPont method breaks down ROI into two components:
Return on Sales (Profit Margin): This reflects the percentage of each sales dollar that
contributes to profit after expenses are deducted.
Investment Turnover: This measures how effectively assets are used to generate sales
revenue.
By analyzing these components, managers can identify specific areas for improvement in either
profitability or asset utilization.
6. What are some ways to improve ROI?
Increase Return on Sales: Achieve this by increasing selling prices, raising sales
volume, or reducing expenses.
Increase Investment Turnover: This can be achieved by increasing sales revenue or
decreasing invested capital.
Caution: Focusing solely on short-term ratio improvements may have adverse long-term
consequences.
7. Why shouldn't organizations solely rely on financial performance measures?
Financial measures provide a limited perspective, often neglecting crucial non-financial factors
that drive long-term success. They may not capture aspects like customer satisfaction, employee
morale, innovation, and process efficiency.
8. What is a more comprehensive approach to performance management?
Frameworks like the Balanced Scorecard (BSc) offer a more holistic view. The BSc integrates
financial measures with non-financial ones across various perspectives, such as:
Financial: ROI, RI, EVA, etc.
Customer: Customer satisfaction, retention, acquisition cost, etc.
Internal Processes: Efficiency, quality, lead times, etc.
Learning and Growth: Employee skills, innovation, information systems, etc.
This integrated approach links performance measurement to strategic goals and provides a
balanced view of organizational effectiveness.
