Introduction

Definition of 'Return On Investment - ROI' A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

The return on investment formula:

In the above formula "gains from investment", refers to the proceeds obtained from selling the investment of interest. Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.

Investopedia explains 'Return On Investment - ROI' Keep in mind that the calculation for return on investment and, therefore the definition, can be modified to suit the situation -it all depends on what you include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation.

For example, a marketer may compare two different products by dividing the gross profit that each product has generated by its respective marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment

by the total value of all resources that have been employed to make and sell the product.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit the user's purposes, and the result can be expressed in many different ways. When using this metric, make sure you understand what inputs are being used.

A performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. To calculate ROI, the return on an investment is divided by the cost of the investment, as shown here; the result is expressed as a percentage or a ratio. Return on investment is a popular metric because it is versatile and simple to use. If an investment does not have a positive ROI or if there are alternative investment opportunities with a higher ROI, the investment should not be undertaken.

Return on investment is a method of calculating profits from an investment. The gain is converted to a percentage to facilitate uniform comparison. The usual formula is 100 X gain/cost. The number is useful for comparing the performance of investments and resembles the yield paid on fixed income investments like CDs. The time period used for the calculation can vary, but the most common one is for the calendar year or the fiscal year. When stock investments are compared it is common to calculate the gain as the difference between the closing value for a recent date and the closing value for one year earlier. When dividends have been paid or distributions from a mutual fund, they are added to the gain. In some cases cost is adjusted by subtracting depreciation or other allowances like depletion. A negative value is reported when the result is a loss.

When the time period exceeds one year, the compound interest formula can be used to calculate the compounded rate of return for the investment. When calculations are based on single stock prices, the number can vary wildly depending on the particular times chosen to select stock prices. More reliable estimates can be obtained by averaging prices over a specified period or by using curvefitting techniques such as least squares (regression analysis) to fit a calculated line to a collection of stock prices. Then the slope of the calculated line approximates return on investment.

For example, if you invested $5,000 and the investment was worth $7,500 after two years, your annual return on investment would be 25%. To get that result, you divide the $2,500 gain by your $5,000 investment, and then divide the 50% gain by 2. Return on investment includes all the income you earn on the investment as well as any profit that results from selling the investment. It can be negative as well as positive if the sale price plus any income is lower than the purchase price. Purpose The purpose of the "return on investment" metric is to measure per-period rates of return on dollars invested in an economic entity. ROI and related metrics (ROA, ROC, RONA and ROIC) provide a snapshot of profitability adjusted for the size of the investment assets tied up in the enterprise. Marketing decisions have obvious potential connection to the numerator of ROI (profits), but these same decisions often influence assets usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected. ROI is often compared to expected (or required) rates of return on dollars invested.

Construction For a single-period review just divide the return (net profit) by the resources that were committed (investment): Return on investment (%) = Net profit ($) / Investment ($) * 100 %

Calculation The initial value of an investment, Vi, does not always have a clearly defined monetary value, but for purposes of measuring ROI, the expected value must be clearly stated along with the rationale for this initial value. Similarly, the final value of an investment, Vf, also does not always have a clearly defined monetary value, but for purposes of measuring ROI, the final value must be clearly stated along with the rationale for this final value. The rate of return can be calculated over a single period, or expressed as an average over multiple periods of time. Single-period Arithmetic return The arithmetic return is:

rarith is sometimes referred to as the yield. Logarithmic or continuously compounded return The logarithmic return or continuously compounded return, also known as force of interest, is defined as:

or R = P*e^{-rt} where: R = Return P = Principal amount r = rate t = time period It is the reciprocal of the e-folding time.

Multiperiod average returns Arithmetic average rate of return The arithmetic average rate of return over n periods is defined as:

Geometric average rate of return The geometric average rate of return, also known as the True Time-Weighted Rate of Return, over n periods is defined as:

The geometric average rate of return calculated over n years is also known as the annualized return. Time-weighted rates of return (TWRR) are important because they eliminate the impact of cash flows. This is helpful when assessing the job that a money manager did for his/her clients, where typically the clients control these cash flows.

Internal rate of return The internal rate of return (IRR), also known as the dollar-weighted rate of return or the money-weighted rate of return (MWRR), is defined as the value(s) of following equation: that satisfies the

where:

NPV = net present value of the investment Ct = cashflow at time t , the investment is profitable, i.e., NPV >

When the cost of capital r is smaller than the IRR rate 0. Otherwise, the investment is not profitable.

MWRR are helpful in that they take cash flows into consideration. This is especially helpful when evaluating cases where the money manager controls cash flows (for private equity investments, for example, as well as sub-portfolio rates of return) as well as to provide the investor with their return. Contrast with TWRR. Comparisons between various rates of return Arithmetic and logarithmic return The value of an investment is doubled over a year if the annual ROR rarith = +100%, that is, if rlog = ln($200 / $100) = ln(2) = 69.3%. The value falls to zero when rarith = -100%, that is, if rlog = . Arithmetic and logarithmic returns are not equal, but are approximately equal for small returns. The difference between them is large only when percent changes are high. For example, an arithmetic return of +50% is equivalent to a logarithmic return of 40.55%, while an arithmetic return of -50% is equivalent to a logarithmic return of -69.31%.

Logarithmic returns are often used by academics in their research. The main advantage is that the continuously compounded return is symmetric, while the arithmetic return is not: positive and negative percent arithmetic returns are not equal. This means that an investment of $100 that yields an arithmetic return of 50% followed by an arithmetic return of -50% will result in $75, while an investment of $100 that yields a logarithmic return of 50% followed by a logarithmic return of -50% it will remain $100. Comparison of arithmetic and logarithmic returns for initial investment of $100 Initial investment, Vi Final investment, Vf Profit/loss, Vf Vi Arithmetic return, rarith Logarithmic return, rlog $100 $0 $100 $100 $50 $50 $100 $100 $100 $150 $0 0% 0% $50 50% $100 $200 $100 100%

100% 50% 69.31%

40.55% 69.31%

Arithmetic average and geometric average rates of return Both arithmetic and geometric average rates of returns are averages of periodic percentage returns. Neither will accurately translate to the actual dollar amounts gained or lost if percent gains are averaged with percent losses. A 10% loss on a $100 investment is a $10 loss, and a 10% gain on a $100 investment is a $10 gain. When percentage returns on investments are calculated, they are calculated for a period of time not based on original investment dollars, but based on the dollars in the investment at the beginning and end of the period. So if an investment of $100 loses 10% in the first period, the investment amount is then $90. If the investment then gains 10% in the next period, the investment amount is $99. A 10% gain followed by a 10% loss is a 1% loss. The order in which the loss and gain occurs does not affect the result. A 50% gain and a 50% loss is a 25% loss. An 80% gain plus an 80% loss is a 64% loss. To recover from a 50% loss, a 100% gain is required. The mathematics of this

are beyond the scope of this article, but since investment returns are often published as "average returns", it is important to note that average returns do not always translate into dollar returns. Example #1 Level Rates of Return Year 1 Year 2 Year 3 Year 4 Rate of Return 5% 5% 5% 5% 5% 5% 5%

Geometric Average at End of Year 5% Capital at End of Year Dollar Profit/(Loss) Compound Yield

$105.00 $110.25 $115.76 $121.55 $5.00 5% $10.25 $15.76 $21.55 5.4%

Example #2 Volatile Rates of Return, including losses Year 1 Year 2 Year 3 Year 4 Rate of Return 50% -20% 9.5% 30% 16% -40% -1.6%

Geometric Average at End of Year 50% Capital at End of Year Dollar Profit/(Loss) Compound Yield

$150.00 $120.00 $156.00 $93.60 ($6.40) -1.6%

Example #3 Highly Volatile Rates of Return, including losses

Year 1 Year 2 Year 3 Year 4 Rate of Return -95% 0% 0% 115%

Geometric Average at End of Year -95% -77.6% -63.2% -42.7% Capital at End of Year Dollar Profit/(Loss) Compound Yield $5.00 $5.00 $5.00 $10.75 ($89.25) -22.3%

Annual returns and annualized returns Care must be taken not to confuse annual and annualized returns. An annual rate of return is a single-period return, while an annualized rate of return is a multi-period, arithmetic average return. An annual rate of return is the return on an investment over a one-year period, such as January 1 through December 31, or June 3, 2006 through June 2, 2007. Each ROI in the cash flow example above is an annual rate of return. An annualized rate of return is the return on an investment over a period other than one year (such as a month, or two years) multiplied or divided to give a comparable one-year return. For instance, a one-month ROI of 1% could be stated as an annualized rate of return of 12%. Or a two-year ROI of 10% could be stated as an annualized rate of return of 5%. In the cash flow example below, the dollar returns for the four years add up to $265. The annualized rate of return for the four years is: $265 ($1,000 x 4 years) = 6.625%.

Uses

ROI is a measure of cash generated by or lost due to the investment. It measures the cash flow or income stream from the investment to the investor, relative to the amount invested. Cash flow to the investor can be in the form of profit, interest, dividends, or capital gain/loss. Capital gain/loss occurs when the market value or resale value of the investment increases or decreases. Cash flow here does not include the return of invested capital.

Cash Flow Example on $1,000 Investment Year 1 Year 2 Year 3 Year 4 Dollar Return $100 ROI 10% $55 5.5% $60 6% $50 5%

ROI values typically used for personal financial decisions include Annual Rate of Return and Annualized Rate of Return. For nominal risk investments such as savings accounts or Certificates of Deposit, the personal investor considers the effects of

reinvesting/compounding on increasing savings balances over time. For investments in which capital is at risk, such as stock shares, mutual fund shares and home purchases, the personal investor considers the effects of price volatility and capital gain/loss on returns.

Profitability ratios typically used by financial analysts to compare a companys profitability over time or compare profitability between companies include Gross Profit Margin, Operating Profit Margin, ROI ratio, Dividend yield, Net profit margin, Return on equity, and Return on assets.

During capital budgeting, companies compare the rates of return of different projects to select which projects to pursue in order to generate maximum return or wealth for the company's stockholders. Companies do so by considering the average rate of return,

payback period, net present value, profitability index, and internal rate of return for various projects.

A return may be adjusted for taxes to give the after-tax rate of return. This is done in geographical areas or historical times in which taxes consumed or consume a significant portion of profits or income. The after-tax rate of return is calculated by multiplying the rate of return by the tax rate, then subtracting that percentage from the rate of return.

A return of 5% taxed at 15% gives an after-tax return of 4.25% 0.05 x 0.15 = 0.0075 0.05 - 0.0075 = 0.0425 = 4.25%

A return of 10% taxed at 25% gives an after-tax return of 7.5% 0.10 x 0.25 = 0.025 0.10 - 0.025 = 0.075 = 7.5%

Investors usually seek a higher rate of return on taxable investment returns than on non-taxable investment returns.

A return may be adjusted for inflation to better indicate its true value in purchasing power. Any investment with a nominal rate of return less than the annual inflation rate represents a loss of value, even though the nominal rate of return might well be greater than 0%. When ROI is adjusted for inflation, the resulting return is considered an increase or decrease in purchasing power. If an ROI value is adjusted for inflation, it is stated explicitly, such as The return, adjusted for inflation, was 2%.

Many online poker tools include ROI in a player's tracked statistics, assisting users in evaluating an opponent's profitability.

Cash or potential cash returns Time value of money Investments generate cash flow to the investor to compensate the investor for the time value of money. Except for rare periods of significant deflation where the opposite may be true, a dollar in cash is worth less today than it was yesterday, and worth more today than it will be worth tomorrow. The main factors that are used by investors to determine the rate of return at which they are willing to invest money include:

estimates of future inflation rates estimates regarding the risk of the investment (e.g. how likely it is that investors will receive regular interest/dividend payments and the return of their full capital) whether or not the investors want the money available (liquid) for other uses.

The time value of money is reflected in the interest rates that banks offer for deposits, and also in the interest rates that banks charge for loans such as home mortgages. The risk-free rate is the rate on U.S. Treasury Bills, because this is the highest rate available without risking capital. The rate of return which an investor expects from an investment is called the Discount Rate. Each investment has a different discount rate, based on the cash flow expected in future from the investment. The higher the risk, the higher the discount rate (rate of return) the investor will demand from the investment.

Compounding or reinvesting Compound interest or other reinvestment of cash returns (such as interest and dividends) does not affect the discount rate of an investment, but it does affect the Annual Percentage Yield, because compounding/reinvestment increases the capital invested.

For example, if an investor put $1,000 in a 1-year Certificate of Deposit (CD) that paid an annual interest rate of 4%, compounded quarterly, the CD would earn 1% interest per quarter on the account balance. The account balance includes interest previously credited to the account.

Compound Interest Example 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Capital at the beginning of the period $1,000 Dollar return for the period $10 $1,010 $10.10 $1,020.10 1% $1,020.10 $10.20 $1,030.30 1% $1,030.30 $10.30 $1,040.60 1%

Account Balance at end of the period $1,010.00 Quarterly ROI 1%

The concept of 'income stream' may express this more clearly. At the beginning of the year, the investor took $1,000 out of his pocket (or checking account) to invest in a CD at the bank. The money was still his, but it was no longer available for buying groceries. The investment provided a cash flow of $10.00, $10.10, $10.20 and $10.30. At the end of the year, the investor got $1,040.60 back from the bank. $1,000 was return of capital. Once interest is earned by an investor it becomes capital. Compound interest involves reinvestment of capital; the interest earned during each quarter is reinvested. At the end of the first quarter the investor had capital of $1,010.00, which then earned $10.10 during the second quarter. The extra dime was interest on his additional $10 investment. The Annual Percentage Yield or Future value for compound interest is higher than for simple interest because the interest is reinvested as capital and earns interest. The yield on the above investment was 4.06%. Bank accounts offer contractually guaranteed returns, so investors cannot lose their capital. Investors/Depositors lend money to the bank, and the bank is obligated to give investors back

their capital plus all earned interest. Because investors are not risking losing their capital on a bad investment, they earn a quite low rate of return. But their capital steadily increases. Returns when capital is at risk Capital gains and losses Many investments carry significant risk that the investor will lose some or all of the invested capital. For example, investments in company stock shares put capital at risk. The value of a stock share depends on what someone is willing to pay for it at a certain point in time. Unlike capital invested in a savings account, the capital value (price) of a stock share constantly changes. If the price is relatively stable, the stock is said to have low volatility. If the price often changes a great deal, the stock has high volatility. All stock shares have some volatility, and the change in price directly affects ROI for stock investments. Stock returns are usually calculated for holding periods such as a month, a quarter or a year. Reinvestment when capital is at risk: rate of return and yield

Example: Stock with low volatility and a regular quarterly dividend, reinvested End of: Dividend Stock Price 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter $1 $98 $1.01 $101 0.01 1.020204 $103.04 4.08% $1.02 $102 0.01 1.030204 $105.08 1.98% $1.03 $99 0.010404 1.040608 $103.02 -1.96%

Shares Purchased 0.010204 Total Shares Held 1.010204 Investment Value Quarterly ROI $99 -1%

Yield is the compound rate of return that includes the effect of reinvesting interest or dividends. To the right is an example of a stock investment of one share purchased at the beginning of the year for $100.

The quarterly dividend is reinvested at the quarter-end stock price. The number of shares purchased each quarter = ($ Dividend)/($ Stock Price). The final investment value of $103.02 is a 3.02% Yield on the initial investment of $100. This is the compound yield, and this return can be considered to be the return on the investment of $100.

To calculate the rate of return, the investor includes the reinvested dividends in the total investment. The investor received a total of $4.06 in dividends over the year, all of which were reinvested, so the investment amount increased by $4.06.

Total Investment = Cost Basis = $100 + $4.06 = $104.06. Capital gain/loss = $103.02 - $104.06 = -$1.04 (a capital loss) ($4.06 dividends - $1.04 capital loss ) / $104.06 total investment = 2.9% ROI

The disadvantage of this ROI calculation is that it does not take into account the fact that not all the money was invested during the entire year (the dividend reinvestments occurred throughout the year). The advantages are: (1) it uses the cost basis of the investment, (2) it clearly shows which gains are due to dividends and which gains/losses are due to capital gains/losses, and (3) the actual dollar return of $3.02 is compared to the actual dollar investment of $104.06. For U.S. income tax purposes, if the shares were sold at the end of the year, dividends would be $4.06, cost basis of the investment would be $104.06, sale price would be $103.02, and the capital loss would be $1.04. Since all returns were reinvested, the ROI might also be calculated as a continuously compounded return or logarithmic return. The effective continuously compounded rate of return is the natural log of the final investment value divided by the initial investment value:

Vi is the initial investment ($100) Vf is the final value ($103.02)

. Total returns This section addresses only total returns without the impact of U.S. federal individual income and capital gains taxes. Mutual funds report total returns assuming reinvestment of dividend and capital gain distributions. That is, the dollar amounts distributed are used to purchase additional shares of the funds as of the reinvestment/ex-dividend date. Reinvestment rates or factors are based on total distributions (dividends plus capital gains) during each period.

Average annual total return (geometric) US mutual funds are to compute average annual total return as prescribed by the U.S. Securities and Exchange Commission (SEC) in instructions to form N-1A (the fund prospectus) as the average annual compounded rates of return for 1-year, 5-year and 10-year periods (or inception of the fund if shorter) as the "average annual total return" for each fund. The following formula is used.

Where: P = a hypothetical initial payment of $1,000. T = average annual total return. n = number of years. ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of the 1-, 5-, or 10-year periods at the end of the 1-, 5-, or 10-year periods (or fractional portion). Solving for T gives

Example Example: Balanced mutual fund during boom times with regular annual dividends, reinvested at time of distribution, initial investment $1,000 at end of year 0, share price $14.21

Year 1 Dividend per share Capital share Total Distribution Per Share Share Price At End Of Year Reinvestment factor gain distribution per $0.26

Year 2 $0.29

Year 3 $0.30

Year 4 $0.50

Year 5 $0.53

$0.06

$0.39

$0.47

$1.86

$1.12

$0.32 $17.50 1.01829

$0.68 $19.49 1.03553 71.676 $48.73 $19.90 2.449 74.125

$0.77 $20.06 1.03975 74.125 $57.10 $20.88 2.734 76.859

$2.36 $20.62 1.11900 76.859 $181.73 $22.98 7.893 84.752

$1.65 $19.90 1.09278 84.752 $141.60 $21.31 6.562 91.314

Shares owned before distribution 70.373 Total distribution Share price at distribution Shares purchased Shares owned after distribution $22.52 $17.28 1.303 71.676

Total return = (($19.90 1.09278) / $14.21) - 1 = 53.04% Average annual total return (geometric) = ((($19.90 91.314) / $1,000) ^ (1 / 5)) - 1 = 12.69%

Using a Holding Period Return calculation, after five years, an investor who reinvested owned 91.314 shares valued at $19.90 per share. ((($19.90 91.314) / $1,000) - 1) / 5 = 16.34% return. An investor who did not reinvest received total cash payments of $5.78 per share. ((($19.90 + $5.78) / $14.21) - 1) / 5 = 16.14% return. Mutual funds include capital gains as well as dividends in their return calculations. Since the market price of a mutual fund share is based on net asset value, a capital gain distribution is

offset by an equal decrease in mutual fund share value/price. From the shareholder's perspective, a capital gain distribution is not a net gain in assets, but it is a realized capital gain. Rate of Return and Return on Investment indicate cash flow from an investment to the investor over a specified period of time, usually a year. ROI is a measure of investment profitability, not a measure of investment size. While compound interest and dividend reinvestment can increase the size of the investment (thus potentially yielding a higher dollar return to the investor), Return on Investment is a percentage return based on capital invested. In general, the higher the investment risk, the greater the potential investment return, and the greater the potential investment loss.

USES OF ROI The general formula for computing ROI is income / invested capital. ROI can be computed on a company-wide basis by dividing net income by owners' equity. This measure indicates how well the overall company is utilizing its equity investment. Calculated in this way, ROI provides a good indicator of profitability that can be compared against competitors or an industry average. Experts suggest that companies usually need at least 10-14 percent ROI in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROI can either mean that management is doing a good job, or that the firm is undercapitalized. ROI can also be computed for various divisions, product lines, or profit centers within a small business. In this way, it gives management a basis for comparing the performance of different areas. One large division may generate much higher profits than another, smaller division, for example, which might encourage management to consider investing further in that division. But an ROI analysis might reveal that a great deal more capital investment was required by the large division than by the smaller one. The smaller division may have generated a lower dollar amount

of profit, but a greater percentage of profit on every dollar of investment. As Ronald W. Hilton wrote in his book Managerial Accounting, "The important question is not how much profit each division earned, but rather how effectively each division used its invested capital to earn a profit." ROI can also be used to evaluate a proposed investment in new equipment by dividing the increase in profit attributable to the new equipment by the increase in invested capital needed to acquire it. For example, a small business may be able to save $5,000 in operating expenses (and thus raise profit by the same amount) by spending $25,000 on a piece of new equipment. This yields an ROI of $5,000 / $25,000 or 20 percent. If this figure is higher than the company's cost of capital (the interest paid on debt and the dividends paid to investors) prior to the investment, and no better investment opportunities exist for those funds, it may make sense to purchase the equipment. In addition to the various uses ROI holds for a small business managers, it can also be a useful measure for investors. For example, a stockholder might calculate the return of investing in a company by the following formula: dividends stock price change / stock price paid. This calculation of ROI measures the gain (or loss) achieved by placing an investment over a period of time. ROI and ROE Performance Measure Worksheet model used to calculate Return on Investment (ROI) and Return on Equity (ROE) that also provides easy methods of changing input values and seeking a final ROE. You can develop a model of your business with an Excel workbook. This model calculates ROE, ROI, profit margin and asset turnover. Once the model is developed, you can try various what if scenarios. You can use Goal Seek functions to solve the model for a desired output (ROE). By adjusting different inputs to the ROE calculation, you can better understand the financial structure and opportunities facing the business. Notes like those inserted in cells N13, N15, Q14 and X18 describe methods of increasing ROE.

Enter starting values in column B. Click the reset buttons to show ROE for the input values. Click on the spinner buttons to change assumptions and use the reset buttons to return to the original values. Enter a desired ROE in cell M4 and click on the Seek button -- choose which input variable you want to change to solve for the desired ROE.

Decentralisation and the need for performance measurement Decentralisation is the delegation of decision-making responsibility. All organisations decentralise to some degree, some do it more than others. Decentralisation is a necessary response to the increasing complexity of the environment that organisations face and the increasing size of most organisations. Nowadays it would be impossible for one person to make

all the decisions involved in the operation of even a small company, hence senior managers delegate decision-making responsibility to subordinates. One danger of decentralisation is that managers may use their decision-making freedom to make decisions that are not in the best interests of the overall company (so called dysfunctional decisions). To redress this problem, senior managers generally introduce systems of performance measurement to ensure - among other things - that decisions made by junior managers are in the best interests of the company as a whole. Example 1 details different degrees of decentralisation and typical financial performance measures employed. Example 1 Responsibility structure Cost centre Profit centre* Typical financial performance measure Standard costing variances

Manager's area of responsibility

Decisions over costs

Decisions over costs and revenues Controllable profit Decisions over costs, revenues, and Return on investment and residual assets income

Investment centre*

* These two structures are often referred to as divisions - divisionalisation refers to the delegation of profit-making responsibility. What makes a good performance measure? A good performance measure should:

provide incentive to the divisional manager to make decisions which are in the best interests of the overall company (goal congruence)

only include factors for which the manager (division) can be held accountable recognise the long-term objectives as well as short-term objectives of the organisation.

Traditional performance indicators Cost centres Standard costing variance analysis is commonly used in the measurement of cost centre performance. It gives a detailed explanation of why costs may have departed from standard. Although commonly used, it is not without its problems. It focuses almost entirely on short-term cost minimisation which may be at odds with other objectives, for example, quality or delivery time. Also, it is important to be clear about who is responsible for which variance - is the production manager or the purchasing manager (or both) responsible for raw material price variances? There is also the problem with setting standards in the first place - variances can only be as good as the standards on which they are based. Profit centres Controllable profit statements are commonly used in profit centres. A proforma statement is given in Example 2. Example 2: Controllable profit statement $ Sales (external) (internal) XXX XXX XXX Controllable divisional variable costs Controllable divisional fixed costs Controllable divisional profit Other traceable divisional variable costs (XXX) (XXX) XXX (X) $

Other traceable divisional fixed costs Traceable divisional profit Apportioned head office cost Net profit

(XXX) XXX (XXX) XXX

The major issue with such statements is the difficulty in deciding what is controllable or traceable. When assessing the performance of a manager we should only consider costs and revenues under the control of that manager, and hence judge the manager on controllable profit. In assessing the success of the division, our focus should be on costs and revenues that are traceable to the division and hence judge the division on traceable profit. For example, depreciation on divisional machinery would not be included as a controllable cost in a profit centre. This is because the manager has no control over investment in fixed assets. It would, however, be included as a traceable fixed cost in assessing the performance of the division. Investment centres In an investment centre, managers have the responsibilities of a profit centre plus responsibility for capital investment. Two measures of divisional performance are commonly used: 1 controllable controllable (traceable) investment 2 Residual income = controllable (traceable) profit - an imputed interest charge on controllable (traceable) investment. Example 3 demonstrates their calculation and some of the drawbacks of return on investment. Return on (traceable) investment profit (ROI) = %

Example

Division X is a division of XYZ plc. Its net assets are currently $10m and it earns a profit of

$2.2m per annum. Division X's cost of capital is 10% per annum. The division is considering two proposals. Proposal 1 involves investing a further $1m in fixed assets to earn an annual profit of $0.15m. Proposal 2 involves the disposal of assets at their net book value of $2.3m. This would lead to a reduction in profits of $0.3m. Proceeds from the disposal of assets would be credited to head office not Division X. Required: calculate the current ROI and residual income for Division X and show how they would change under each of the two proposals. Current Return ROI $10.0m Residual Profit $2.2m Imputed $10.0m x 10% $1.0m Residual income $1.2m Comment: ROI exceeds the cost of capital and residual income is positive. The division is performing well. Proposal Return ROI = $2.35m = 21.4% $11.0m Residual Profit $2.35m income on 1 investment interest charge income = on $2.2m = situation investment 22%

Imputed $11.0m x 10% $1.1m Residual income $1.25m

interest

charge

Comment: In simple terms the project is acceptable to the company. It offers a rate of return of 15% ($0.15m/$1m) which is greater than the cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting proposal 1. This would be a dysfunctional decision. Residual income increases if proposal 1 is adopted and this performance measure should lead to goal congruent decisions. Proposal Return ROI = $1.9m = 24.7% $7.7m Residual Profit $1.90m Imputed $7.7m x 10% $0.77m Residual income $1.13m Comment: In simple terms the disposal is not acceptable to the company. The existing assets have a rate of return of 13.0% ($0.3m/$2.3m) which is greater than the cost of capital and hence should not be disposed of. However, divisional ROI rises and this could lead to the divisional manager accepting proposal 2. This would be a dysfunctional decision. Residual income decreases if proposal 2 is adopted and once again this performance measure should lead to goal congruent decisions . interest charge income on 2 investment

Criticism/Disadvantages or Limitations of Return on Investment (ROI) Method of Performance Evaluation: Learning Objectives: 1. What are the limitations of return on investment method of performance evaluation? Although the return on investment is widely used in evaluating performance, it is not a perfect tool. The method is subject to the following criticism: 1. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI; they may increase ROI in a way that is inconsistent with the company's strategy; or they may take actions that increase ROI in the short run but harm company the long run (such as cutting back on the research and development). This is why ROI is best used as part of a balanced scorecard. A balanced scorecard can provide concrete guidance to managers, making it more likely that action taken are consistent with the company's strategy and reducing the likelihood that short-run performance will be enhanced at the expense of long-term performance. 2. A manager who takes over a business segment typically inherent many committed costs over which the manager has no control. These committed costs may be relevant in assessing the performance of the business segment as an investment but make it difficult to fairly assess the performance of the manager relative to other managers. 3. A manager who is evaluated based on return on investment (ROI) may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager's performance evaluation.

Methods of Controlling and Improving the Rate of Return on Investment (ROI): Return on investment is normally used to judge the managerial performance in an investment center. Managers therefore try to control and improve the ROI of their investment center. Here we shall discuss the methods of improving rate of return on investment.

The following formula is usually used for computing return on investment. Return on investment (ROI) = Net operating income / Average operating income This formula is also discussed at rate of return for measuring managerial performance page. We can modify this formula slightly by introducing sales as follows: ROI = (Net operating income / Sales) (Sales / Average operating assets) These two equations are equivalent because the sales terms cancel out in the second equation. The first term on the right hand side of the equation is margin, which is defined as follows: Margin = Net operating income / Sales Margin is a measure of management's ability to control operating expenses in relation to sales. The lower the operating expenses per dollar of sales, the higher the margin earned. The second term on the right hand side of the equation is turnover, which is defined as follows: Turnover = Sales / Average operating assets Turnover is a measure of the sales that are generated for each dollar invested in operating assets. The following alternative form of the ROI formula, which we will use here, combines margin and turnover. ROI = Margin Turnover Both the formulas give same answer. However margin and turnover formulation provides some additional insights. Some managers tend to focus too much on margin and ignore turnover. To some degree the margin can be a valuable indicator of a manager's responsibility. Standing alone, however, it overlooks one very crucial area of manager's responsibility--the investment in operating assets. Excessive funds tied up in operating assets, which depresses turnover, can be just as much of a drag on profitability as excessive operating expenses, which depresses margin. One of the advantages of return on investment (ROI) as a performance measure is that it forces

the manager to control the investment in operating assets as well as to control expenses and the margin. To illustrate how an investment center manager can improve ROI by making the use of three methods mentioned above consider the following example: Example: The following data represents the results of an investment center of the operations of a company for the most recent month.

Net Sales Average operating assets

operating

income$10,000 100,000 50,000

The rate of return generated by the company for this investment center is as follows: ROI = Margin Turnover

(Net operating income / Sales) (Sales / Average operating assets) ($10,000 / $100,000) ($100,000 / $50,000) 10% 2 = 20% As we stated above that manager can increase sales, reduce expenses, or reduce the operating assets to improve the ROI figure.

Approach 1: Increase sales: Assume that the manager is able to increase sales from $100,000 to $110,000. Assume further that either because of good cost control or because some costs in the company are fixed, the net operating income increases even more rapidly, going from $10,000 to $12,000 per period. Assume that operating assets remain constant. The new ROI will be: ROI = ($12,000 / $110,000) ($110,000 / $50,000) 10.91% 2.2 24% Approach 1: Reduce expenses: Assume that manager is able to reduce expenses by $1,000 so that net operating income increases from $10,000 to $11,000. Assume that both sales and operating assets remain constant. The new ROI would be: ROI = ($11,000 / $100,000) ($100,000 / $50,000) 11% 2.2 22% Approach 3: Reduce operating assets: Assume that the manager of the company is able to reduce operating assets from $50,000 to $40,000, but that sales and operating income remain unchanged. Then the new ROI would be: ROI = ($10,000 / $100,000) ($100,000 / $40,000) 11% 2.2 22%

The use of the return on investment formula, if properly used, can be to have a fair estimate and comparisons of different investments decisions. In fact, the simplicity of the ROI formula enables homeowners and small enterprises to use the formula along with the corporate big names. The return on investment formula is especially a very efficient tool of a personal budget worksheet as the general investor can clearly make a decision about what to do and what not to do. The ROI formula can also be used to have a fair comparison of different investment strategies and to calculate the percentage of increment (or decrement) on an investment.

Finally, an important factor to be kept in consideration in the ROI calculations is that the time factor is not included in the formula. The time factor should be kept in mind while you are evaluating the return on investment formula percentages presented to you.

Residual Income When most hear the term residual income, they think of excess cash or disposable income. Although that definition is correct in the scope of personal finance, in terms of equity valuation residual income is the income generated by a firm after accounting for the true cost of its capital. You might be asking, "But don't companies already account for their cost of capital in their interest expense?" Yes and no. Interest expense on the income statement only accounts for a firm's cost of its debt, ignoring its cost of equity, such as dividends payouts and other equity costs. Looking at the cost of equity another way, think of it as the shareholders' opportunity cost, or the required rate of return. The residual income model attempts to adjust a firm's future earnings estimates, to compensate for the equity cost and place a more accurate value to a firm. Although the return to equity holders is not a legal requirement like the return to bondholders, in order to attract investors firms must compensate them for the investment risk exposure. Residual income is a performance measure that consists of some measure of operating income minus some charge for the capital used by the manager (or unit) being evaluated. The concept appeared as early as the 1920s (e.g., in DuPont's bonus plan calculation of its "Executive Trust

Fund"), and has been frequently discussed in management accounting texts since General Electric adopted it in the 1950s. Despite its merits, residual income was not widely used in practice until recently. The business community's greater attention to this type of performance measure in recent years is due largely to the stimulus from Stern Stewart & Co.'s touting of their version of residual income, which they call Economic Value Added or EVA. As a performance measure, residual income is designed to influence management's investment in capital assets, ideally inducing managers to undertake investments for which the net present value is positive and to reject those for which the net present value is negative. The rate used in calculating the capital charge, often called the "cost of capital," is clearly the riskless interest rate in a world of certainty or risk neutrality with no private pre-contract management information. However, we show that determining the appropriate measure of the cost of capital under uncertainty and risk aversion is complex, even if management does not have private pre-contract information. Definition of 'Residual Income' The amount of income that an individual has after all personal debts, including the mortgage, have been paid. This calculation is usually made on a monthly basis, after the monthly bills and debts are paid. Also, when a mortgage has been paid off in its entirety, the income that individual had been putting toward the mortgage becomes residual income. Actually Residual Income is1. Net income that an investment can earn over the minimum rate of return. 2. Royalty income that accrues to the owner of an intellectual property, such as art, books, lyrics, music, patents, etc.

Barron's Accounting Dictionary: Operating income that an investment center is able to earn above some minimum return on its assets. It is a popular alternative performance measure to return on investment (ROI). RI is computed as:

Residual income, unlike ROI, is an absolute amount of income rather than a rate of return. When RI is used to evaluate divisional performance, the objective is to maximize the total amount of residual income, not to maximize the overall ROI percentage figure. For example, assume that operating assets are $100,000, net operating income is $18,000, and the minimum return on assets is 13%.

Residual income is $18,000 - (13% X $100,000) = $18,000 - $13,000 = $5,000. RI is sometimes preferred over ROI as a performance measure because it encourages managers to accept investment opportunities that have rates of return greater than the charge for invested capital. Managers being evaluated using ROI may be reluctant to accept new investments that lower their current ROI, although the investments would be desirable for the entire company. Advantages of using residual income in evaluating divisional performance include: (1) It takes into account the opportunity cost of tying up assets in the division; (2) The minimum rate of return can vary depending on the riskiness of the division; (3) Different assets can be required to earn different returns depending on their risk; (4) The same asset may be required to earn the same return regardless of the division it is in; and (5) The effect of maximizing dollars rather than a percentage leads to goal congruence.

Investopedia Financial Dictionary: Residual Income is the amount of income that an individual has after all personal debts, including the mortgage, have been paid. This calculation is usually made on a monthly basis, after the monthly bills and debts are paid. Also, when a mortgage has been paid off in its entirety, the income that individual had been putting toward the mortgage becomes residual income.

Investopedia explains 'Residual Income' is often an important component of securing a loan. The loaning institution usually assesses the amount of residual income an individual has left after paying off other debts each month. If the individual requesting the loan has sufficient residual income to take on additional debt, the loaning institution will be more likely to grant the loan because having an adequate amount of residual income will ensure that the borrower has sufficient funds to make the loan payment each month.

For Example: In calculating a firm's residual income the key calculation is to determine its equity charge. Equity charge is simply a firm's total equity capital multiplied by the required rate of return of that equity, can be estimated using the capital asset pricing model. The formula below shows the equity charge equation. Equity Charge = Equity Capital x Cost of Equity Once we have calculated the equity charge, we only have to subtract it from the firm's net income to come up its residual income. For example, if Company X reported earnings of $100,000 last year and financed its capital structure with $950,000 worth of equity at a required rate of return of 11%, its residual income would be: Equity Charge $950,000 x 0.11 = $104,500

Net Income Equity Charge Residual Income

$100,000 -$104,500 -$4,500

So as you can see from the above example, using the concept of residual income, although Company X is reporting a profit on its income statement (which it should), once its cost of equity is included in relation to its return to shareholders, it is actually economically unprofitable based on the given level of risk. This finding is the primary driver behind the use of the residual

income method. A scenario where a company is profitable on an accounting basis, it may still not be a profitable venture from a shareholder's perspective if it cannot generate residual income.

Passive Income vs. Residual Income Often we come across terms in regards to doing business online that we are not 100% familiar with. Sometimes even several terms that are mistakenly interchanged to the point that the true meaning of each gets lost altogether. According to a recent survey, two such terms are "passive income" and "residual income". Both are often associated with Network Marketing opportunities... but today we're going to explore their true meaning, as well as other online opportunities to earn one or both types of income. - Residual Income Recurring payments that you receive long after the initial sale is made, usually in specific amounts and at regular intervals.

- Passive Income "Income derived from business investments in which the individual is not actively involved" Passive basically means "inactive" or "submissive", so Passive Income could be viewed as money that you make that doesn't require an effort from you. From those definitions, it's obvious that Residual Income is also considered Passive Income. Once you make the initial sale, your residual income can be considered passive. In most cases, you do not have to "work", or make additional sales, in order to continue to reap the profits.

Examples of residual income options might include:

Network Marketing, where you enroll customers or recruit representatives that you earn a monthly commission from.

Affiliate programs for recurring payment type services or products, such as: hosting, membership sites, dating sites, etc. In these programs, you are paid a commission each time the recurring payment is billed to the customer you referred.

Selling anything that is automatically renewable or consumables where the re-ordering is automated.

There are also OTHER ways to earn Passive Income, outside of these traditional 'Residual Income' options. Again, a great definition of Passive Income is: "Income derived from business investments in which the individual is not actively involved".

Residual income model A residual income model values securities using a combination of book value of the company (i.e. its NAV), and a present value based on accounting profits. The value of a company is the sum of:

the NAV at the time of valuation, and, the present value of the residual income: the amounts by which profits are expected to exceed the required rate of return on equity.

The latter, like most present value calculations, ends with a terminal value which is calculated on a different basis to the other future amounts. The residual return is: (R - r) B

Where; B is the NAV R is the return based on accounting profits and owners equity (net profit B), and r is the required rate of return on equity.

This can also be expressed as net profit - (r B)

The terminal value is somewhat different from that used in an NPV. Rather than being the actual value of the company at that time, it is the actual value minus the NAV at that time. The significance of the extra profit over the required rate of return is that it is a measure of the wealth the company creates for shareholders. This is what the company adds to the value of is assets, and what justifies a company being worth more than the value of its assets. Therefore, the value of a company should be the sum of this and its assets. The NAV will vary from year to year, which affects the calculation of the returns. The change is the net profit, fewer dividends and other returns to shareholders, plus capital rose. Basing valuation on wealth creation is conceptually similar to EVA. Residual income models are better suited to securities valuation (whereas EVA is primarily useful to management). The advantage of the residual income model is that it is entirely based on accounting measures of profit and value of assets. The most obvious objection to the residual income model is that it is based on accounting numbers that often fail to reflect the true economic value of assets and cash flows.

The Residual Income Valuation Model When used to value stocks, the residual income model separates value as the sum of two components:

The current book value of equity (BV) The present value of expected future residual income [sum from time t=1 to infinity(RI/(1+r)^t)]

The model can be used to value the firm (based on total book value and residual income) or a share, using book value and residual income per share. Unlike models that discount dividends or free cash flow, in which a significant portion of the estimated value is the terminal value, a residual income model tends to be front-end loaded by the reliance on book value. This can be an advantage since forecasting errors tend to magnify over time. Using only the residual income is likely to result in smaller errors and even if the error is not reduced, the future income is less significant to the overall value calculation.

Valuing a Company Using the Residual Income Method There are many different methods to valuing a company or its stock. One could opt to use a relative valuation approach, comparing multiples and metrics of a firm in relation to other companies within its industry or sector. Another alternative would be value a firm based upon an absolute estimate, such as implementing discounted cash flow modeling or the dividend discount method, in an attempt to place an intrinsic value to said firm. One absolute valuation method which may not be so familiar to most, but is widely used by analysts is the residual income method. In this article we will introduce you to the underlying basics behind the residual income model and how it can be used to place an absolute value on a firm. (The Dividend Discount Mode (DDM) is one of the most foundational of financial theories, but it's only as good as its assumptions.)

Intrinsic Value with Residual Income

Now that we've found how to compute residual income, we must now use this information to formulate a true value estimate for a firm. Like other absolute valuation approaches, the concept of discounting future earnings is put to use in residual income modeling as well. The intrinsic, or fair value, of a company's stock using a the residual income approach can be broken down into its book value and the present values of its expected future residual incomes, as illustrated in the formula below.

As you may have noticed, the residual income valuation formula is very similar to a multistage dividend discount model, substituting future dividend payments for future residual earnings. Using the same basic principles as a dividend discount model to calculate future residual earnings, we can derive an intrinsic value for a firm's stock. In contrast to the DCF approach which uses the weighted average cost of capital for the discount rate, the appropriate rate for the residual income strategy is the cost of equity.

"Cost of capital" in residual income for performance evaluation. BASIC PRODUCTION MODEL The model has two factors of production: the effort supplied by the manager, denoted by its cost a, and the capital supplied by the principal, denoted by its cost q, with a [member of] A = [0, [infinity]) and q [member of] Q = [0, [infinity]). The outcome (e.g., net revenue) x generated by these two factors also depends on a random productivity factor [delta]. In particular, we assume: x = h(a) + [delta]g(q),

Where h(a) and g(q) are increasing, concave production functions with h(0) = g(0) = 0 and infinite marginal productivities at a = 0 and q = 0. The additive separability between the two factors of production, a and q, simplifies the analysis, whereas the multiplicative relation fig(q) is a simple means of having the investment choice q influence the riskiness of the outcome. (5) We let [delta] = [bar][delta] + [[epsilon].sub.[delta]], where [delta] is the prior mean and [[epsilon].sub.[delta]] ~ N(0, [[tau].sub.[delta].sup.2]) is the random component.

No Pre-decision Information We now consider the setting in which the manager does not receive any pre-decision information about [delta]. In that case, there is a unique optimal investment level q (as well as a unique optimal effort level a). From Remarks 1 and 2 we know that for any effort level a there is a unique incentive rate [nu] that will induce a, and for any investment level q (given the incentive rate [new]) there is unique capital charge [GAMMA] that will induce q. Since q is contractible information, the desired investment level could be induced by specifying the amount that will be provided by the principal (essentially a penalty contract). However, it is instructive to identify the capital charge that will induce the desired investment choice if it is delegated to the manager, since we view this setting as the limiting case in which little of the manager's uncertainty is resolved before he makes his production decision. That is, post-decision risk is a central feature of this setting, and we are interested in identifying the impact of firm-specific post-decision risk on the optimal capital charge in the manager's incentive contract

MARKET RISK As discussed in the introduction, the management accounting literature has generally held that the appropriate "cost of capital" in measuring residual income is the "weighted average cost of capital." This implies that firm-specific (i.e., diversifiable) risk is irrelevant and that the focus is on the relation of the firm's outcome to the market return. In Section IV, we demonstrated that, in the absence of market risk, firm-specific risk affects the optimal capital charge if a principal uses residual income as a performance measure in a setting in which capital investment affects the

amount of firm-specific risk. Interestingly, in that setting, firm-specific risk does not affect the first-best investment level, but it does affect the second-best level. We now introduce market risk into the no-pre-decision-information setting. As we demonstrate, market risk influences both the first- and second-best investment levels, but it does not directly affect the optimal capital charge in the manager's performance measure. This result depends crucially on the assumption that either the manager can invest (go long or short) in the market portfolio or the principal can vary the manager's compensation with the return on the market portfolio. The effects of firm-specific risk are essentially the same as in Section IV, in which there was no market risk.

Net income Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings. As profit and earnings are used synonymously for income (also depending on UK and US usage), net earnings and net profit are commonly found as synonyms for net income. Often, the term income is substituted for net income, yet this is not preferred due to the possible ambiguity. Net income is informally called the bottom line because it is typically found on the last line of a company's income statement (a related term is top line, meaning revenue, which forms the first line of the account statement). The items deducted will typically include tax expense, financing expense (interest expense), and minority interest. Likewise, preferred stock dividends will be subtracted too, though they are not an expense. For a merchandising company, subtracted costs may be the cost of goods sold, sales discounts, and sales returns and allowances. For a product company advertising, manufacturing, and design and development costs are included. An equation for net income

Net sales (revenue)

 Cost of goods sold = Gross profit SG&A expenses (combined costs of operating the company) = EBITDA Depreciation & amortization = EBIT Interest expense (cost of borrowing money) = EBT Tax expense = Net income (EAT)

Economic Value Added In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit being the value created in excess of the required return of the company's investors (being shareholders and debt holders). Quite simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is created when the return on the firm's economic capital employed is greater than the cost of that capital; see Corporate finance: working capital management. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments that could be made but in practice only five or seven key ones are made, depending on the company and the industry it competes in.

Calculating EVA EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of capital and the economic capital. The basic formula is:

Where:

, is the Return on Invested Capital (ROIC); is the weighted average cost of capital (WACC); is the economic capital employed; NOPAT is the net operating profit after tax, with adjustments and translations, generally for the amortization of goodwill, the capitalization of brand advertising and others noncash items.

EVA Calculation: EVA = net operating profit after taxes a capital charge [the residual income method] Therefore EVA = NOPAT (c capital), or alternatively EVA = (r x capital) (c capital) so that EVA = (r-c) capital [the spread method, or excess return method] Where: r = rate of return, and c = cost of capital, or the Weighted Average Cost of Capital (WACC).

NOPAT is profits derived from a companys operations after cash taxes but before financing costs and non-cash bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to the firm. Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs). The capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of economic capital invested.The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for bearing risk, their opportunity cost. Another perspective on EVA can be gained by looking at a firms return on net assets (RONA). RONA is a ratio that is calculated by dividing a firms NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system. EVA = (RONA required minimum return) net investments If RONA is above the threshold rate, EVA is positive. Comparison with other approaches Other approaches along similar lines include residual income (RI) and residual cash flow. Although EVA is similar to residual income, under some definitions there may be minor technical differences between EVA and RI (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual cash flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique to EVA. Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of "profit", the utility of having a separate and more precisely defined term

such as EVA is that it makes a clear separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while actually approaching insolvency. Other measures of shareholder value include:

Added value Market value added Total shareholder return.

Relationship to market value added The firm's market value added, or MVA, is the discounted sum (present value) of all future expected economic value added:

Note that MVA = PV of EVA. More enlightening is that since MVA = NPV of Free cash flow (FCF) it follows therefore that the NPV of FCF = PV of EVA; Since after all, EVA is simply the re-arrangement of the FCF formula.

Residual Income-A Method to Measure Managerial Performance

Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets.

Residual income is another approach to measuring an investment center's performance. Economic Value Added (EVA) is an adoption of residual income that has recently been adopted by many companies. Under EVA, companies often modify their accounting principles in various ways. For example funds used for research and development are often treated as investment rather than as expenses. under EVA. These complications are best dealt with in more advanced courses. Here we will focus on the basics and will not draw any distinction between residual income and EVA. When residual income or EVA is used to measure managerial performance, the objective is to maximize the total amount of residual income or EVA, not to maximize return on investment (ROI).

Example: For the purpose of illustrating consider the following data for an investment center of a company.

Basic Data for Performance Evaluation Average Net operating operating assets $100,000 income $20,000 15%

Minimum required rate of return

The company has long had a policy of of evaluating investment center managers based on ROI, but it is considering a switch to residual income. The controller of the company, who is in favor of the change to residual income, has provided the following table that shows how the the performance of the division would be evaluated under each of the two methods: Alternative Performance Measures ROI Residual income

Average operating assets (a) Net ROI, operating (b) income (b) (a)

$100,000 ======= $20,000 20%

$100,000 ======= $20,000 15,000 ----------

Minimum required return (15% $100,000) Residual income

$5,000 =======

The reasoning underlying the residual income calculation is straight forward. The company is able to earn a rate of return of at 15% on its investments. Since the company has invested $100,000 in the division in the form of operating assets, The company should be able to earn at least $15,000 (15% $100,000) on this investment. Since the division's net operating income is $20,000, the residual income above and beyond the minimum required return is $5,000. If residual income is adopted as the performance measure to replace ROI, the manager of the division would be evaluated based on the growth in residual income from year to year.

Comparison of return on investment (ROI) and residual income: One of the primary reasons why controllers of companies would like to switch from ROI to residual income has to do with how managers view new investment under the two performance measurement schemes. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated by ROI formula. To illustrate consider the data mentioned above and further suppose that the manager of the division is considering purchasing a machine. The machine would cost $25,000 and is expected to generate additional operating income of $4,500 a year. From the stand point of the company, this would be a good investment since it promises a rate of return of 18% [($4,500 / $25,000)

100], which is in excess of the company's minimum required rate of return of 15%. If the manager of the division is evaluated based on residual income, she would be in favor of the investment in the machine as shown below.

Performance evaluated using residual income Present Average operating assets Net operating income $100,000 ======= $20,000 15,000 ----------$5,000 ======== Minimum required return Residual income New Project $25,000 ======= $4,500 3,750 ----------$750 ======== Overall $125,000 ======== $24,500 18750 ----------$5,750 =======

Since the project would increase the residual income of the division, the manager would want to invest in the new machine.

Now suppose that the manager of the division is evaluated based on the return on investment (ROI) method. The effect of the machine on the division's ROI is computed as below: Performance evaluated using residual income Present Average operating assets (a) $100,000 Net operating income (b) $20,000 20% New project $25,000 $4,500 18% Overall $125,000 $24,500 19.6%

ROI, (b) (a)

The new project reduces the ROI from 20% to 19.6%. This happens because the 18% rate of return on the new machine, while above the company's15% minimum rate of return, is below the

division's present ROI of 20%. Therefore the new machine would drag the division's ROI down even though it would be a good investment from the standpoint of the company as a whole. If the manager of the division is evaluated based on ROI, she would be reluctant to even propose such an investment. Basically, a manager who is evaluated based on ROI will reject any project whose rate of return is below the division's current ROI even if the rate of return on the project is above the minimum rate of return for the entire company. In contrast, any project whose rate of return is above the minimum required rate of return of the company will result in an increase in residual income. Since it is in the best interest of the company as a whole to accept any project whose rate of return is above the minimum rate of return, managers who are evaluated on residual income will tend to make better decisions concerning investment projects than manager who are evaluated based on ROI.

Return on Investment and Residual Income

Evaluating Investment Centers The first step in evaluating investments centers is to create a segmented income statement for the segment to be evaluated. It should contain only the costs and revenue that the segment manager is able to control. Recall that companies can be segmented by geographical area such as the southeast region, product lines such as the Mustang for Ford Motor Company, and often by customer channels such as retail, wholesale, government, etc.

'Income' Measurement

As you have already seen, income can be expressed by different measurements. Net income, a common expression, is the net amount after deducting all expenses from revenue including income taxes. Income can also be expressed as NOI (net operating income, operating income, income before taxes, or a more generic name, profit.

Removing Uncontrollable Amounts If all the costs of a corporation are divided up and allocated to individual segments, there will likely be some allocated costs assigned to segments for which managers of those segments have no control. Many of these costs are considered expenses and impact income. Managers who are evaluated on profit believe it is wrong to be evaluated on amounts for which they have no control.....and rightfully so. To remedy this issue, uncontrollable costs should be removed from the amounted of reported income prior to performance evaluation.

NOPAT We will use a concept utilized by a number of companies referred to as NOPAT. This pneumonic stands for 'net operating profit after taxes.' Net operating profit includes all revenues minus the costs that can be associated with the segment. Because segments must pay their share of income taxes, NOPAT holds the manager of the segment responsible for income taxes on the segment's profits as well. The NOPAT computation requires the removal of interest from the 'income' amount. Interest Expense from Income One item of controversy that often appears on the income statement of a segment is interest expense. Managers at the segment level are most often unable to control interest costs. The answer lies in how a company is financed.

Recall the discussion from an earlier chapter that the first activity that must occur when a company goes into business is financing. All assets are financed by the two equities on the right side of the accounting equation. Debt financing occurs when a company obtains long-term loans or issues bonds. Debt creates an Interest cost measured using an annual percentage rate. This costs reduces profit as interest expense. Equity financing has no interest cost, but investors expect some type of return, either dividends or increase in company value (growth). Neither

dividends nor stock values have an income statement cost. Suppose there are two divisions, the South and the West divisions. The assets invested IF the South division were financed by issuing stock and as a result, has no interest expense. The assets invested in the West division were financed by issuing debt, resulting in interest expense on its segment income statement. Neither segment manager was able to decide how his division would be financed. Is it fair to punish one manager with interest expense making his profits look lower than the other manager? Likely not. To even the playing field, you will remove interest expense from the 'income' amount on which we will be evaluating the segment managers so that the means of financing has no impact on how these managers are evaluated.

To calculate NOPAT:

NOPAT = Net income + interest expense - tax savings from interest expense = NI + [Interest expense*(1 - t)

Where t = tax rate and NI = net income

Why is Interest Removed? Interest is removed because it is considered an uncontrollable cost by segment managers. Why is it uncontrollable? Because managers don't make a decision of how their segment assets will be financed. Those financed by debt have interest expense, whereas those financed by equity have no 'expense' as it relates to profit. Upper level management determines the source of funding and a manager should not be charged with interest if it was not his or her decision to finance with debt.

Responsibility accounting tells us that managers should not be held responsible for what they cannot control. Segment managers rarely make the decision of how to finance their segment operations and assets. The benefit of using NOPAT over another interpretation of 'income' is that

managers are not held responsible for costs they cannot control. In this case, you can assume that segment managers are unable to control interest expense.

Why is Interest Removed by Adding? The goal is to remove interest as if it had not been part of the computation. In determining net income, interest was initially subtracted. To remove the subtraction, we add interest.

Why are Income Taxes Considered? The more expenses a company incurs, the less income taxes it pays. When a company recognizes interest expense, the amount on which it pays taxes is reduced. Because the base amount has been reduced, the amount of income taxes will be less. When interest is omitted from income, the amount on which a company calculates it income taxes is higher. The

Other Uncontrollable Costs Segment managers find a number of costs listed on their segment's income statement. All uncontrollable costs should be removed before evaluating managers. For purposes of this course, we will only remove interest to simply the process. From a practical point of view, other removed costs are treated the same way including the consideration of income taxes.

Determining the Cost of Assets The second components of evaluating investment center performance are the assets invested in each segment. Upper level managers make a decision to invest money in the form of assets into a division in hopes that the manager responsible will provide a good return for the company as a whole. The dilemma involves which assets have a cost attached to them.

Upper level management's ultimate goal is to maximize the return on its investment. Upper level managers decide which segments to create. Each segment created requires an investment of

assets. For each dollar of assets invested, management expects to earn its required rate of return. Recall from financial accounting that the actual return on assets can be calculated for a company by dividing net income by the average amount of assets. Determining the amount of total assets was relatively easy. You just examine the balance sheet. For a segment, you look at the assets assigned to the segment for which the manager of the segment has control. We also need to consider which assets have a cost attached to them. Think about the accounting equation:

Assets = Liabilities + Owners' Equity

There are two classifications of assets and two classification of liabilities--some are current and some are long-term. The expanded equation now looks like this:

Current Assets + Long-term Assets = Current Liabilities + Long-term Liabilities + Owners' Equity

All assets on the left side of the equation are financed with the equities on the right side of the equation. Not all of the equities on the right side have a cost attached to them. Recall that we already established that owners' equity has a cost through the dividends and reinvestment of profits to grow the company. We also have established there is a cost of issuing long term loans or bonds, called a debt financing cost. That leaves us with one equity on the right side of the equation--current liabilities. Current liabilities do not always have a financing cost attached to them. The only current liabilities that have a cost are notes and loans payable that are short-term. These liabilities bear an interest cost. Liabilities for which an interest cost is attached are considered interest-bearing. They usually have a stated interest rate which requires the borrower to pay interest, creating interest expense. All other current liabilities are considered non-interest bearing.

Non-Interest Bearing Liabilities Non-interest bearing liabilities bear no interest cost. These include accounts payable, dividends payable, a number of different accrued liabilities such as salaries payable, taxes payable, interest payable, warranty expense payable, utilities, payable, etc. All of these liabilities are essentially

'free;. They have no interest cost attached to them for the roughly 30-day time period during which the company uses the assets acquired with them, but does not have to immediately pay out cash to liquidate.

Invested Assets You will use invested assets' as the amount of assets tied up in a particular segment. To determine the assets tied up, we remove non-interest bearing liabilities because the related assets have no financing cost. To calculate invested assets: . Total assets - non-interest bearing current liabilities . We abbreviate non-interest bearing currently liabilities as NIBCL.

Evaluation on Investment Center Managers Evaluation of managers is based on all three components for which managers are responsible-revenues, expenses, and the assets for which they have control. Evaluation is based on a rate of return (%) relative to a benchmark rate of return. The benchmark rate of return is the rate that upper level management has set as the minimum acceptable. You know this amount as the required rate of return.

Return on investment (ROI) focuses the attention of a manager on both income and investment, making it a better measure of performance than just income. Measures the degree to which one division is a better candidate for expansion compared to the other.

One important gauge of the performance of investment centers is return on investment which is calculated as follows:

ROI = Net Operating Income After Taxes Invested Assets

There are two essential components of ROI:

ROI

= Profit margin X investment turnover

= 'Income' Sales

Sales Invested capital

NOPAT Invested Capital

Where Profit margin is the ratio of 'income' to sales. This is the same as the profit margin ratio you learned in financial accounting, except that we have to modify income to become NOPAT.

Where Investment Turnover is the ratio of sales to invested capital, similar to the asset turnover ratio you learned in financial accounting.

The answer is reported as a percentage which tells us the percent of profit earned for each dollar of invested assets. For example, if ROI is calculated to be 23.14%, it would tell us that for each dollar invested on the average, the segment is generating about 23 cents of profit that increased the value of the whole company.

An increase in ROI can be achieved by increasing margin or increasing turnover. More specifically, ROI can be increased by: Increasing sales Decreasing expenses Decreasing the amount of operating assets in the segment

Return on investment (ROI) measures the ability to generate additional profits for the parent company. The division with a higher ROI is a better candidate for expansion.

Residual income is calculated as:

Residual Income = NOPAT Required Profit = NOPAT - (cost of capital x invested capital)

Note that the required profit is the cost of financing times the amount of assets tied up in the segment that have a cost attached to them. Residual income (RI) measures the amount the division adds to shareholder value.

Overinvesting Measuring a manager's performance based only on income often makes a manager focus on increasing profits. It often causes managers to accept investments which earn less than the required rate of return solely to increase profit. Take for example an investment of $10,000 with an expected ROI of 10%. If the company's required rate of return is 12%, upper level management would not want managers to invest. Because this investment will increase profit by $1,009 which is 1) % of $10,000, the segment manager will likely accept it even though it is less than the RRR.

Relative merits of ROI and residual income Return on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow unlimited amounts of money from the bank at a cost of 10% per annum. Would you rather borrow 100 and invest it at a 25% rate of return or borrow $1m and invest it at a rate of return of 15%? Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net return (residual income) of $15 per annum after borrowing costs. The bigger investment would give a net return of $50,000. Residual income, being an absolute measure, would lead you to select the project that maximises your wealth. Residual income also ties in with net present value, theoretically the best way to make investment decisions. The present value of a project's residual income equals the project's net present value. In the long run, companies that maximise residual income will also maximise net

present value and in turn shareholder wealth. Residual income does, however, experience problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher residual income because of the size of the division rather than superior managerial performance. Problems common to both ROI and residual income The following problems are common to both measures:

Identifying controllable (traceable) profits and investment can be difficult. If used in a short-term way they can both overemphasise short-term performance at the expense of long-term performance. Investment projects with positive net present value can show poor ROI and residual income figures in early years leading to rejection of projects by managers (see Example 4).

If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery (see Example 4).

Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of modern businesses, multi-faceted measures of performance are necessary.

Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.

Example

PQR plc is considering opening a new division to manage a new investment project. Forecast cashflows of the new project are as follows: Year Forecast net cash flow $m 0 (5.0) 1 1.4 2 1.4 3 1.4 4 1.4 5 1.4

PQR's cost of capital is 10% pa. Straight line depreciation is used.

Required: Calculate the project's net present value and its projected ROI and residual income over its five-year life.

NPV Year Forecast net cash flow $m Present value factors at 10% Present value NPV = $0.30m 0 (5.0) 1.00 (5.0) 1 1.4 0.91 1.27 2 1.4 0.83 1.16 3 1.4 0.75 1.05 4 1.4 0.68 0.95 5 1.4 0.62 0.87

ROI Year 1 Opening investment at net book value 2 Forecast net cash flow $m 3 Straight line depreciation 4 Profit 1 5.0 1.4 (1.0) 0.4 2 4.0 1.4 (1.0) 0.4 3 3.0 1.4 (1.0) 0.4 4 2.0 1.4 (1.0) 0.4 5 1.0 1.4 (1.0) 0.4

ROI (4 1 x 100)

8%

10%

13%

20%

40%

Residual income Year 1 2 3 4 5

Profit (as above) Imputed capital charge (opening investment x 10%) Residual income

0.4 0.5

0.4 0.4 0.4 0.4 0.4 0.3 0.2 0.1

(0.1) 0.0 0.1 0.2 0.3

Comment: this example demonstrates two points. Firstly, it illustrates the potential conflict between NPV and the two divisional performance measures. This project has a positive NPV and should increase shareholder wealth. However, the poor ROI and residual income figures in the first year could lead managers to reject the project. Secondly, it shows the tendency for both ROI and residual income to improve over time. Despite constant annual cashflows, both measures improve over time as the net book value of assets falls. This could encourage managers to retain outdated assets. Non-Financial Performance indicators In recent years, the trend in performance measurement has been towards a broader view of performance, covering both financial and non-financial indicators. The most well-known of these approaches is the balanced scorecard proposed by Kaplan and Norton. This approach attempts to overcome the following weaknesses of traditional performance measures:

Single factor measures such as ROI and residual income are unlikely to give a full picture of divisional performance.

Single factor measures are capable of distortion by unscrupulous managers (eg by undertaking proposal 2 in Example 3).

They can often lead to confusion between measures and objectives. If ROI is used as a performance measure to promote the maximisation of shareholder wealth some managers will see ROI (not shareholder wealth) as the objective and dysfunctional consequences may follow.

They are of little use as a guide to action. If ROI or residual income fall they simply tell you that performance has worsened, they do not indicate why.

The balanced scorecard approach involves measuring performance under four different perspectives, as follows: Perspective Financial success Customer satisfaction Process efficiency Growth Question How do we look to shareholders? How do customers see us? What must we excel at? Can we continue to improve and create value?

The term 'balanced' is used because managerial performance is assessed under all four headings. Each organisation has to decide which performance measures to use under each heading. Areas to measure should relate to an organisation's critical success factors. Critical success factors (CSFs) are performance requirements which are fundamental to an organisation's success (for example innovation in a consumer electronics company) and can usually be identified from an organisation's mission statement, objectives and strategy. Key performance indicators (KPIs) are measurements of achievement of the chosen critical success factors. Key performance indicators should be:

specific (ie measure profitability rather than 'financial performance', a term which could mean different things to different people)

measurable (ie be capable of having a measure placed upon it, for example, number of customer complaints rather than the 'level of customer satisfaction')

relevant, in that they measure achievement of a critical success factor.

Example 5 demonstrates a balanced scorecard approach to performance measurement in a fictitious private sector college training ACCA students. Example 5 Perspective Critical Success Key Performance Indicators

Factor Financial success Shareholder wealth Dividend yield % increase in share price Cashflow Actual Debtor days Customer satisfaction Exam success College Premier Tutor grading by students Flexibility Average number of course variants per subject (eg fulltime, day release, evening) Process efficiency Resource utilisation % Average room class occupancy size pass rate v college national average status v budget

Average tutor teaching load (days) Growth Innovation products Information technology % of sales from < 1 year old

Number of online enrolments

The balanced scorecard approach to performance measurement offers several advantages:

it measures performance in a variety of ways, rather than relying on one figure managers are unlikely to be able to distort the performance measure - bad performance is difficult to hide if multiple performance measures are used

it takes a long-term perspective of business performance success in the four key areas should lead to the long-term success of the organisation it is flexible - what is measured can be changed over time to reflect changing priorities

'what gets measured gets done' - if managers know they are being appraised on various aspects of performance they will pay attention to these areas, rather than simply paying 'lip service' to them.

The main difficulty with the balanced scorecard approach is setting standards for each of the KPIs. This can prove difficult where the organisation has no previous experience of performance measurement. Benchmarking with other organisations is a possible solution to this problem. Allowing for tradeoffs between KPIs can also be problematic. How should the organisation judge the manager who has improved in every area apart from, say, financial performance? One solution to this problem is to require managers to improve in all areas, and not allow tradeoffs between the different measures.

Solutions to over and under investing Residual income helps solve both over- and under-investment of long-term asset problems because there is no denominator effect. Economic value added helps solve over-investment and under-investment problems in much the same manner, while encouraging managers to spend money on R&D, customer development, and employee training. All three of these latter items help keep up with the competition in the long-run.

Other ways to measure managers performance:

Feedback as a need for decision making

Good performance is the criterion whereby an organization determines its capability to prevail. Performance measurement estimates the parameters under which programs, investments, and acquisitions are reaching the targeted results.[1] However, a model for performance set faulty may depict a disadvantageous situation which does not support the organization nor the thriving to the set aims.

Performance Reference Model of the Federal Enterprise Architecture, 2005.[2]

All process of measuring performance requires the use of statistical modeling to determine results. A full scope copy of the performance of an organization can never be obtained, as generally some of the parameters cannot be measured directly but must be estimated via indirect observation and as a complete set of records never delivers an assessment without compression to key figures.

[edit] The extended rationale for measuring performance

Fundamental purpose behind measures is to improve performance. Measures that are not directly connected to improving performance (like measures that are directed at communicating better with the public to build trust) are measures that are means to achieving that ultimate purpose (Behn 2003). Behn 2003 gives 8 reasons for adopting performance measurements: 1. To Evaluate how well a public agency is performing. To evaluate performance, managers need to determine what an agency is supposed to accomplish. (Kravchuk & Schack 1996). To formulate a clear, coherent mission, strategy, and objective. Then based on this information choose how you will measure those activities. (You first need to find out what are you looking for). Evaluation processes consist of two variables: organizational performance data and a benchmark that creates a framework for analyzing that data. For organizational information, focus on the outcomes of the agencys performance, but also including input/ environment/ process/ outputto have a comparative framework for analysis. It is helpful to ask 4 essential questions in determining organizational data:

Outcomes should be directly related to the public purpose of the organization. Effectiveness Q: did they produce required results (determined by outcomes). Cost-effective: efficiency Q (outcome divided by input).

Impact Q: what value organisation provides. Best-practice Q: evaluating internal operations (compare core process performance to most effective and efficient process in the industry).

As in order for organization to evaluate performance its requires standards (benchmark) to compare its actual performance against past performance/ from performance of similar agencies/ industry standard/political expectations. 2. To Control How can managers ensure their subordinates are doing the right thing. Today managers do not control their workforce mechanically (measurement of time-and-motion for control as during Taylor) However managers still use measures to control, while allowing some space for freedom in the workforce. (Robert Kaplan & David Norton) Business has control bias. Because traditional measurement system sprung from finance function, the system has a control bias. Organisations create measurement systems that specify particular actions they want execute- for branch employess to take a particular ways to execute what they want- branch to spend money. Then they want to measure to see whether the employees have in fact taken those actions. Need to measure input by individual into organisation and process. Officials need to measure behavior of individuals then compare this performance with requirements to check who has and has not complied. Often such requirements are described only as guidelines. Do not be fooled. These guidelines are really requirements and those requirements are designed to control. The measurement of compliance with these requirements is the mechanism of control. 3. To Budget Budgets are crude tools in improving performance. Poor performance not always may change after applying budgets cuts as a disciplinary action. Sometimes budgets increase could be the answer to improving performance. Like purchasing better technology because the current ones are outdated and harm operational processes. So for decisions highly influenced by circumstance, you need measures to better understand the situation. At the macro level, elected officials deciding which purpose of government actions are primary or secondary. Political priorities drive macro budgetory choices. Once elected officials have established macro political priorities, those responsible for micro decisions may seek to invest their limited allocation of resources in the most cost-effective units and activities. In allocating budgets, managers, in response to macro budget allocations (driven by political objectives), determin alloactions at the micro level by using measures of efficiency of various activities, which programs or organisations are more efficient at achieving the political objectives. Why spend limited funds on programs that do not guarantee exceptional performance?

Efficiency is determined by observing performance- output and outcome achieved considering number of people involved in the process (productivity per person) and cost-data (capturing direct cost as well as indirect) 4. To Motivate Giving people significant goals to achieve and then use performance measuresincluding interim targets- to focus peoples thinking and work, and to provide periodic sense of accomplishment. Performance targets may also encourage creativity in developing better ways to achieve the goal (Behn) Thus measure to motivate improvements may also motivate learning. Almost-real-time output (faster, the better) compared with production targets. Quick response required to provide fast feed-back so workforce could improve and adapt. Also it is able to provide how workforce currently performing. Primary aim behind the measures should be output, managers can not motivate people to affect something over which they have little or no influence. Once an agencys leaders have motivated significant improvements using output targets, they can create some outcomes targets.

output- focuses on improving internal process. outcome- motivate people to look outside the agency (to seek way to collaborate with individuals & organisations may affect the outcome produced by the agency)

5. To Celebrate Organisations need to commemorate their accomplishments- such ritual tie their people together, give them a sense of their individual and collective relevance. More over, by achieving specific goals, people gain sense of personal accomplishment and selfworth (Locke & Latham 1984). Links from measurement to celebration to improvement is indirect, because it has to work through one of the likes- motivation, learning... Celebration helps to improve performance because it brings attention to the agency, and thus promotes its competence- it attracts resources.

Dedicated people who want to work for successful agency. Potential collaborators. Learning-sharing between people about their accomplishments and how they achieved it.

Significant performance targets that provide sense of personal and collective accomplishement. Targets could ones used to motivate. In order for celebration to be a success and benefits to be a reality managers need to ensure that celebration creates motivation and thus improvements.

By leading the celebration.

6. To Promote How can public managers convince political superiors, legislators, stakeholders, journalists, and citizens that their agency is doing a good job. (National Academy of Public Administrations center for improving government performanceNAPA 1999) performance measures can be used to: validate success; justifing additional resources; earn customers, stakeholder, and staff loyalty by showing results; and win recognition inside and outside the organisation. Indirectly promote, competence and value of goverement in general. To convince citizens their agency is doing good, managers need easily understood measures of those aspects of performance about which many citizens personally care. (National Academy of Public Administration-NAPA in its study of early performancemeasurement plans under the government performance and results Act) most plans recognized the need to communicate performance evaluation results to higher level officials, but did not show clear recognition that the form and level of data for these needs would be different than that for operating managers. Different needs: Department head/ Executive Office of President/ Congress. NAPA suggested for those needs to be more explicitly defined- (Kaplan & Nortan 1994) stress that different customers have different concerns(1992). 7. To Learn Learning is involved with some process, of analysis information provided from evaluating corporate performance (identifying what works and what does not). By analysing that information, corporation able to learn resons behind its poor or good performance. However if there is too many performance measures, managers might not be able to learn anything. (Neves of National Academy of Public Administration 1986)

Because of rapid increase of performance measures there is more confusion or noise than useful data. Managers lack time or simply find it too difficult to try to identify good signals from mass of numbers.

Also there is an issue of black box enigma (data can reveal that organisation is performing well or poorly, but they dont necessarily reveal why). Performance measures can describe what is coming out of black box as well as what is going in, but they do not reveal what is happening inside. How are various inputs interacting to produce the output. What more complex is outcome with black box being all value chain. Benchmarking is a traditional form of performance measurement which facilitates learning by providing assessment of organisational performance and identifying possible solutions for improvements. Benchmarking can facilitate transfer of knowhow from benchmarked organisations. (Kouzmin et al. 1999)

Identifying core process in organisation and measuring their performance is basic to benchmarking. Those actions probably provide answer to issue presented in purpose section of the learning. Measurements that are used for learning act as indicators for managers to consider analysis of performance in measurements related areas by revealing irregularities and deviations from expected data results. What to measure aiming at learning (the unexpected- what to aim for?) Learning occurs when organisation meets problems in operations or failures. Then corporations improve by analysing those faults and looking for solutions. In public sector especially, failure usually punished severely- therefore corporations and individuals hide it. 8. To Improve What exactly should who- do differently to improve performance? In order for corporation to measure what it wants to improve it first need to identify what it will improve and develop processes to accomplish that. Also you need to have a feedback loop to assess compliance with plans to achieve improvements and to determine if those processes created forecasted results (improvements). Improvement process also related to learning process in identifying places that are need improvements. Develop understanding of relationships inside the black box that connect changes in operations to changes in output and outcome. Understanding black box processes and their interactions.

How to influence/ control workforce that creates output. How to influence citizens/ customers that turn that output to outcome (and all related suppliers)

They need to observe how actions they can take will influence operations, environment, workforce and which eventually has an impact on outcome. After that they need to identify actions they can take that will give them improvements they looking for and how organisation will react to those actions ex. How might various leadership activities ripple through the black box. Principles of performance measurement All significant work activity must be measured.

Work that is not measured or assessed cannot be managed because there is no objective information to determine its value. Therefore it is assumed that this work is inherently valuable

regardless of its outcomes. The best that can be accomplished with this type of activity is to supervise a level of effort. Unmeasured work should be minimized or eliminated. Desired performance outcomes must be established for all measured work. Outcomes provide the basis for establishing accountability for results rather than just requiring a level of effort. Desired outcomes are necessary for work evaluation and meaningful performance appraisal. Defining performance in terms of desired results is how managers and supervisors make their work assignments operational. Performance reporting and variance analyses must be accomplished frequently. Frequent reporting enables timely corrective action. Timely corrective action is needed for effective management control.

If we dont measure

How do you know where to improve? How do you know where to allocate or re-allocate money and people? How do you know how you compare with others? How do you know whether you are improving or declining? How do you know whether or which programs, methods, or employees are producing results that are cost effective and efficient?

Common problems with measurement systems that limit their usefulness:

Heavy reliance on summary data that emphasizes averages and discounts outliers. Heavy reliance on historical patterns and reluctance to accept new structural changes (or redesign of processes) that are capable of generating different outcomes, like measuring the time it takes them to do a task. Heavy reliance on gross aggregates that tend to understate or ignore distributional contributions and consequences. Heavy reliance on static, e.g., equilibrium, analysis and slight attention to time-based and growth ones, such as value-added measures.

Performance Measurement topics

Most of us have heard some version of the standard performance measurement cliches: what gets measured gets done, if you dont measure results, you cant tell success from failure and thus you cant claim or reward success or avoid unintentionally rewarding failure, if you cant recognize success, you cant learn from it; if you cant recognize failure, you cant correct it, if you cant measure it, you can neither manage it nor improve it," but what eludes many of us is the easy path to identifying truly strategic measurements without falling back on things that are easier to measure such as input, project or operational process measurements. Performance Measurement is addressed in detail in Step Five of the Nine Steps to Success methodology. In this step, Performance Measures are developed for each of the Strategic Objectives. Leading and lagging measures are identified, expected targets and thresholds are established, and baseline and benchmarking data is developed. The focus on Strategic

Objectives, which should articulate exactly what the organization is trying to accomplish, is the key to identifying truly strategic measurements. Strategic performance measures monitor the implementation and effectiveness of an organization's strategies, determine the gap between actual and targeted performance and determine organization effectiveness and operational efficiency. Good Performance Measures

Focus employees' attention on what matters most to success Allow measurement of acTo Budget

Budgets are crude ork that is performed

Provide a common language for communication Are explicitly defined in terms of owner, unit of measure, collection frequency, data quality, expected value(targets), and thresholds Are valid, to ensure measurement of the right things Are verifiable, to ensure data collection accuracy

Practice
Several performance measurement systems are in use today, and each has its own group of supporters. For example, the Balanced Scorecard (Kaplan and Norton, 1993, 1996, 2001), Performance Prism (Neely, 2002), and the Cambridge Performance Measurement Process (Neely, 1996) are designed for business-wide implementation; and the approaches of the TPM Process (Jones and Schilling, 2000), 7-step TPM Process (Zigon, 1999), and Total Measurement Development Method (TMDM) (Tarkenton Productivity Group, 2000) are specific for teambased structures. With continued research efforts and the test of time, the best-of-breed theories that help organizations structure and implement its performance measurement system should emerge. Although the Balanced Scorecard has become very popular, there is no single version of the model that has been universally accepted. The diversity and unique requirements of different enterprises suggest that no one-size-fits-all approach will ever do the job. Gamble, Strickland and Thompson list ten financial objectives and nine strategic objectives involved with a balanced scorecard. Problems in Performance Appraisals:

discourages teamwork evaluators are inconsistent or use different criteria and standards only valuable for very good or poor employees encourages employees to achieve short term goals

managers has complete power over the employees too subjective produces emotional anguish

Solutions

Make collaboration a criterion on which employees will be evaluated Provide training for managers; have the HR department look for patterns performing.

Primary aim beh or over or under evaluation

Rate selectively(introduce different or various criteria and disclose better performance and coach for worst performer without disclosing the weakness of the candidate) or increase in frequency of performance evaluation. Include long term and short term goals in appraisal process Introduce M.B.O.(Management By Objectives) Make criteria specific and test selectively{Evaluate specific behaviors or results} Focus on behaviors; do not criticize employees; conduct appraisal on time.

Management accounting
Definition

IFAC Definition of Managerial Accounting showing Cost Measurement embracing three broad areas: Cost Accounting; Performance Evaluation & Analysis; Planning & Decision Support. Copyright July 2009 Professional Accountants in Business Committee. International Good Practice Guidance: Evaluating and Improving Costing in Organizations

According to the Chartered Institute of Management Accountants (CIMA), Management Accounting is "the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for nonmanagement groups such as shareholders, creditors, regulatory agencies and tax authorities"(CIMA Official Terminology). The Institute of Management Accountants (IMA) recently updated its definition as follows: "management accounting is a profession that involves partnering in management decision making, devising planning and performance management systems,and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organizations strategy". The American Institute of Certified Public Accountants(AICPA) states that management accounting as practice extends to the following three areas:

Strategic ManagementAdvancing the role of the management accountant as a strategic partner in the organization. Performance ManagementDeveloping the practice of business decision-making and managing the performance of the organization. Risk ManagementContributing to frameworks and practices for identifying, measuring, managing and reporting risks to the achievement of the objectives of the organization.

The Institute of Certified Management Accountants(ICMA), states "A management accountant applies his or her professional knowledge and skill in the preparation and presentation of financial and other decision oriented information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking". Management Accountants therefore are seen as the "value-creators" amongst the accountants. They are much more interested in forward looking and taking decisions that will affect the future of the organization, than in the historical recording and compliance (score keeping) aspects of the profession. Management accounting knowledge and experience can therefore be obtained from varied fields and functions within an organization, such as information management, treasury, efficiency auditing, marketing, valuation, pricing, logistics, etc.

Traditional vs. innovative practices

Managerial Costing Timeline presented at IMA's Annual Conference - Managerial Costing Conceptual Framework Session Sep 7, 2011 (Orlando, FL). Used with permission by the author A.van der Merwe Copyright 2011 All Rights Reserved.

Within the area of Management Accounting there are almost an infinite number of tools, methods, techniques and approaches floating around. The distinction between traditional and innovative accounting practices is perhaps best illustrated with the visual timeline (see sidebar) of managerial costing approaches presented at the Institute of Management Accountants 2011 Annual Conference. Traditional Standard Costing (TSC), used in Cost Accounting dates back to the 1920s and is a central method in management accounting practiced today because it is used for financial statement reporting for the valuation of Income Statement and Balance Sheet line items such as Cost of Goods Sold (COGS) and Inventory valuation. Traditional Standard Costing must comply with generally accepted accounting principles (GAAP US) and actually aligns itself more with answering Financial Accounting requirements rather than providing solutions for management accountants. Traditional approaches limit themselves by defining cost behavior only in terms of production or sales volume. In the late 1980s, accounting practitioners and educators were heavily criticized on the grounds that management accounting practices (and, even more so, the curriculum taught to accounting students) had changed little over the preceding 60 years, despite radical changes in the business environment. In 1993, the Accounting Education Change Commission Statement Number 4calls for faculty members to come down from their ivory towers and expand their knowledge about

the actual practice of accounting in the workplace. Professional accounting institutes, perhaps fearing that management accountants would increasingly be seen as superfluous in business organizations, subsequently devoted considerable resources to the development of a more innovative skills set for management accountants. Variance analysis, which is a systematic approach to the comparison of the actual and budgeted costs of the raw materials and labor used during a production period. While some form of variance analysis is still used by most manufacturing firms, it nowadays tends to be used in conjunction with innovative techniques such as life cycle cost analysis and activity-based costing, which are designed with specific aspects of the modern business environment in mind. Life-cycle costing recognizes that managers ability to influence the cost of manufacturing a product is at its greatest when the product is still at the design stage of its product life-cycle (i.e., before the design has been finalized and production commenced), since small changes to the product design may lead to significant savings in the cost of manufacturing the products. Activity-based costing (ABC) recognizes that, in modern factories, most manufacturing costs are determined by the amount of activities (e.g., the number of production runs per month, and the amount of production equipment idle time) and that the key to effective cost control is therefore optimizing the efficiency of these activities. Both lifecycle costing and activity-based costing recognize that, in the typical modern factory, the avoidance of disruptive events (such as machine breakdowns and quality control failures) is of far greater importance than (for example) reducing the costs of raw materials. Activity-based costing also deemphasizes direct labor as a cost driver and concentrates instead on activities that drive costs, As the provision of a service or the production of a product component. Other approaches that can be viewed as innovative to the U.S. is the German approach, Grenzplankostenrechnung (GPK). Although it has been in practiced in Europe for more than 50 years, neither GPK nor the proper treatment of 'unused capacity is widely practiced here in the U.S. Thus GPK and the concept of unused capacity is slowing become more recognized in America, and "could easily be considered 'advanced' by U.S. standards". One of the more innovative accounting practices available today is Resource consumption accounting (RCA). RCA has been recognized by the International Federation of Accountants (IFAC) as a sophisticated approach at the upper levels of the continuum of costing techniques because it provides the ability to derive costs directly from operational resource data or to isolate and measure unused capacity costs. RCA was derived by taking the best costing characteristics of the German management accounting approach Grenzplankostenrechnung (GPK), and combining the use of activity-based drivers when needed, such as those used in Activity-based costing. With the RCA approach, resources and their costs are considered as foundational to robust cost modeling and managerial decision support, because an organizations costs and revenues are all a function of the resources and the individual capacities that produce them.

Role within a corporation

Consistent with other roles in today's corporation, management accountants have a dual reporting relationship. As a strategic partner and provider of decision based financial and operational

information, management accountants are responsible for managing the business team and at the same time having to report relationships and responsibilities to the corporation's finance organization. The activities management accountants provide inclusive of forecasting and planning, performing variance analysis, reviewing and monitoring costs inherent in the business are ones that have dual accountability to both finance and the business team. Examples of tasks where accountability may be more meaningful to the business management team vs. the corporate finance department are the development of new product costing, operations research, business driver metrics, sales management scorecarding, and client profitability analysis. See Financial modeling. Conversely, the preparation of certain financial reports, reconciliations of the financial data to source systems, risk and regulatory reporting will be more useful to the corporate finance team as they are charged with aggregating certain financial information from all segments of the corporation. In corporations that derive much of their profits from the information economy, such as banks, publishing houses, telecommunications companies and defence contractors, IT costs are a significant source of uncontrollable spending, which in size is often the greatest corporate cost after total compensation costs and property related costs. A function of management accounting in such organizations is to work closely with the IT department to provide IT Cost Transparency. Given the above, one widely held view of the progression of the accounting and finance career path is that financial accounting is a stepping stone to management accounting. Consistent with the notion of value creation, management accountants help drive the success of the business while strict financial accounting is more of a compliance and historical endeavor

CONCLUTION The residual income approach offers both positives and negatives when compared to the more often used dividend discount and DCF methods. On the plus side, residual income models make use of data readily available from a firm's financial statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow. Most importantly, as we discussed earlier, residual income models look at the economic profitability of a firm rather than just its accounting profitability. The biggest drawback of the

residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements. All that being said, the residual income valuation approach is a viable and increasingly popular method of valuation and can be implemented rather easily by even novice investors. When used alongside the other popular valuation approaches, residual income valuation can give you a clearer estimate of what the true intrinsic value of a firm may be.

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