Performance measurement is the attempt in business to be able to quantify what management has been doing during a certain period. The principle behind it is that of giving management authority to make certain decisions in their areas of responsibility and later on make then making them accountable for their decisions. In the end, what a superior wants is a performance report from a manager concerning his division. The report would contain what he has been doing and whether targets set have been attained or not. There are three main financial performance measurement techniques; return on investment, residual income and economic value added.
This report analyzes Everspring Corporation Ltd which made a capital investment of $100,000 in new equipment for one of its divisions, Springvale division, which resulted in an increased contribution of Springvale division by $16,400.However; it resulted in a lower return on investment for the division. Specifically, this report seeks to identify the possible reasons why the new equipment did not result in the anticipated improvement in division financial performance. Secondly, it discusses behavioral problems of return on investment as a divisional appraisal measure. Lastly, it looks at what Gary Speed, the division manager, might do the next time a new equipment purchase is proposed to overcome the limitations of ROI as an appraisal measure.
Reasons why the new equipment did not result in the anticipated improvement in the division financial performance
Return on investment is an appraisal measure that is used to compute and compare the efficiency of different divisions or investments. It is normally expressed as a percentage. It is the most commonly used appraisal measure. It differs from other methods of financial performance appraisal in that profits rather than cash flows are used in the calculation. . It is calculated using the formula;
ROI = Sales * Profit * 100%
Investment Sales
Alternatively, return on investment can be calculated using the formula;
ROI = Profit * 100%
Investment
A division can increase the return on investment of its assets in three ways; reducing cost, increasing the selling price or decreasing investment. Everspring Corporation Ltd which made a capital investment of $100,000 in new equipment for its Springvale division that resulted in an increased contribution of Springvale division by $16,400.However, it resulted in a lower return on investment for the division. The decrease in return on investment can be explained by the increase in investment. Whereas the division’s contribution to profit increased, the investments of the division equally increased by a larger extend. Therefore, the increase in the division’s contribution to profit was offset by the increase in investment.
The return on investment on the additional investment can be calculated as follows;
ROI = Profit * 100%
Investment
ROI = (16,400/90,000) = 18.22%
This return on investment on the additional investment is lower than the return on investment of the division before the purchase of the equipment of 20 percent. That is, 18.22 percent is lower than 20 percent. Therefore, it is expected that the purchase of the equipment will lower the resultant return on investment.
Behavioral problems of return on investment as a divisional appraisal measure
Return on investment is preferred as an appraisal measure partly because it simply requires a single percentage value that is calculated from readily available accounting information. Return on investment also highlights the contribution that managers can gain by decreasing investment in both current and fixed assets. Therefore, using ROI ensures idle cash is invested, proper inventory levels are kept, credit is managed judiciously, and fixed assets are invested in carefully. However, there are several behavioral problems of return on investment as a divisional appraisal measure.
Firstly, use of return on investment as an appraisal measure encourages managers to concentrate on short-term financial goals at the expense of long term sustainability. This is because managers’ performance is measured by their capability to generate short term profits since return on investment is a short term measure. Therefore, making decisions based on ROI will not improve the shareholder wealth. It also contradicts the going concern concept of business.
The second behavioral problem of using return on investment as an appraisal measure is that it encourages managers to defer asset replacement. When net values are used as a base of computing return on investment, it will show that the return on investment is improving as assets get older. Net book value is computed as the original cost of equipment minus any accumulated depreciation on the asset.
Therefore, the investment will be reducing over the years. If the profits remain relatively constant over the years, return on investment will show that the division’s performance has been improving over the years which is not true. This may result in dysfunctional behavior by management of holding on to old assets and not investing in new assets in an effort to get positive appraisals.
Lastly, using return on investment as an appraisal measure does not promote goal congruence. Suboptimal decisions by the management will be taken. A good performance measurement criterion should assist managers in divisions to be able to direct their performance towards the realization of the objectives of the entire firm. Proper coordination should prevent sub optimality and goal congruence would be achieved to a degree. However, when using return on investment as a performance measure, sub optimal decisions are likely to arise. For example, if central management sees that getting new assets will improve the overall return, a divisional manager might opt not to if it reduces his division’s ROI. Further, the division manager might decide to sell off assets to reduce the base even if these assets were generating reasonable profit. Therefore, return on investment may induce managers of a highly profitable division to reject projects, which from the view point of the organization as a whole should be accepted.
What Gary Speed might do the next time a new equipment purchase is proposed
Gary Speed should use multiple evaluation techniques to evaluate the efficiency of the investment to overcome the behavioral shortcoming of return on investment as a performance appraisal technique. Gary Speed should also consider the contribution to the overall performance of the company. The other performance appraisal techniques that Gary Speed should consider are; residual income and economic value added.
Residual income is a measure of a center’s profits after deducting a notional or imputed interest. The imputed cost of capital might be the organizations cost of borrowing or the weighted cost of capital. The use of residual income highlights the finance charge associated with funding. The next new equipment is purchased; Gary Speed should consider evaluating performance using residual income lowers the incentive of deferring replacement of assets because it encourages management to make cash outlays on assets that will give larger returns than the imputed interest. Any project that generates a positive residual income contributes to measured performance of the company and should be accepted. Unlike return on investment, it neither considers the investment or the net book values. Using residual income as an appraisal measure also prevents suboptimal decision making of failing to invest in worthwhile assets or selling off the same just to improve their divisional return on investment. Therefore, residual income is more consistent with the objective of maximizing total profitability of the entire group.
Economic value added tells us how much shareholders wealth has been created. Economic value added is computed using the following formula:
EVA = operating profit after tax - WACC x book value of capital employed
Gary Speed should also consider evaluating the new investment using economic value added because there are some limitations of return on investment that cannot be overcome by residual income. For instance, both return on investment and residual income are a short term measure that breeds a short-term boom–bust culture ignoring long term shareholder’s wealth maximization. Economic value added raises managerial awareness of the need for proper management of both the income statement and the statement of financial position, and helps them to properly assess the trade-offs between the two. This broader, complete view of the economics of a business has a profound influence on overall business performance.
Conclusion
Return on investment is the most preferred financial appraisal method in finance because it is simple to calculate and to understand. However, because of its limitations, ROI should be used together with residual income and economic value added.
References
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