STI Performance Measurement PDF

BM2305 PERFORMANCE MEASUREMENT Performance measurement is a continuous process that an organization implements to meet its performance objectives. While such process...

BM2305 PERFORMANCE MEASUREMENT Performance measurement is a continuous process that an organization implements to meet its performance objectives. While such processes may be broad, we can generalize this into the following: 1. Setting up a financial reporting system that will provide segmented accounting reports based on responsibility centers; 2. Defining performance measures and targets; and 3. Reviewing performance and taking actions as necessary. In the previous unit, responsibility accounting is defined as a system that segregates financial information according to responsibility centers whose manager has control over and is accountable for such financial information. The types of responsibility centers are listed below: Cost centers Revenue centers Profit centers Investment centers This unit will discuss the two (2) financial performance measures in evaluating investment centers. (Brewer et al.. 2019) Financial Performance Measures (BPP Learning Media, 2021) Financial performance measures, or key performance indicators (KPIs), can tell the entity’s economic well- being. Some of the widely used financial performance measures include various ratio analyses. There are two (2) financial performance measures in evaluating investment center performance. These are: 1. Return on Investment (ROI) and 2. Residual Income 𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 𝑅𝑂𝐼 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 Where: Net operating income pertains to net Income before interest and taxes (EBIT); and Operating assets pertain to all assets (current and non-current) used in the company’s operations. The ROI can also be expressed in terms of margin and turnover. ROI = Profit Margin x Asset Turnover or 𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑅𝑂𝐼 = 𝑥 𝑆𝑎𝑙𝑒𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 03 Handout 1  [email protected] *Property of STI Page 1 of 8  BM2305 It is also known as the DuPont Analysis. It allows you to determine which financial activities contribute to the most changes to the ROI. Two (2) metrics that determine the ROI are as follows: 1. Profit Margin, which measures operating efficiency; and 2. Asset Turnover, which measures asset use efficiency Analyzing the ROI using these two (2) financial performance metrics may provide more insights into assessing a manager’s performance. For instance, the ROI can measure the financial performance of an investment center which can be used to compare with the returns of another investment center within an organization. Or it can also be used to compare the performance of other companies in the industry. Also, it can be compared to the past returns of the investment center itself to monitor its performance over time. The management can also set a target ROI based on the budgets and projections and evaluate managers’ actual results and performance. It is an example of performance management. Illustration: STI Company is currently assessing its financial performance since it wants to know if the company is utilizing the company’s assets efficiently. The company hired you as its management accountant to serve as a consultant in providing the relevant information to determine if the company is efficiently using its assets. Below are the company’s 20X3 and 20X2 financial statements for your reference. STI Company Income Statement For the years ended December 31 20X3 20X2 Sales P1,800,000 P1,600,000 Less: Cost of Sales 1,200,000 960,000 Gross Profit P600,000 P640,000 Less: Operating Expenses 400,000 300,000 Operating Profit P200,000 P340,000 STI Company Statement of Financial Position As of December 31 20X3 20X2 Current Assets Cash P400,000 500,000 Accounts Receivable 600,000 200,000 Inventory 240,000 140,000 P1,240,000 P840,000 Non-Current Assets Building 600,000 600,000 Equipment 260,000 280,000 P860,000 P880,000 Total Assets P2,100,000 P1,720,000 Current Liabilities Accounts Payable 620,000 100,000 03 Handout 1  [email protected] *Property of STI Page 2 of 8  BM2305 Income Tax Payable 60,000 15,000 Dividends Payable 60,000 90,000 P740,000 P205,000 Shareholders’ Equity Ordinary Share Capital 400,000 400,000 Retained Earnings 960,000 1,115,000 P1,360,000 P1,515,000 Total Liabilities & Equity P2,100,000 P1,720,000 Requirement: 1. Compute the 20X3 ROI using the basic formula. 2. Compute the 20X3 ROI using the Dupont formula. Solutions: 1. Using the basic ROI formula, the net operating Income must be divided by the average operating assets. The average operating assets can be computed by adding the total assets in the current year and the prior year and then dividing the combined totals by two (2). P200,000 Return on Investment = (P2,100,000+P1,720,000)/2 P200,000 Return on Investment = P1,910,000 Return on Investment = 10.47% 2. Using the Dupont formula, the profit margin must be multiplied by the asset turnover. The profit margin can be computed by dividing the net operating Income by the sales. In contrast, the asset turnover can be computed by dividing the sales by the average operating assets. Return on Investment = P200,000 X P1,800,000 P1,800,000 P1,910,000 Return on Investment = 0.11 X 0.9424 Return on Investment = 10.37% In interpreting the return on investment, it is best to compare it to the return on investment of other companies in the same industry to have a more realistic assessment of the company’s financial performance. 03 Handout 1  [email protected] *Property of STI Page 3 of 8  BM2305 A high return on assets indicates that the company utilizes the assets efficiently, while a low return on investment may or may not be bad depending on the surrounding circumstances. Possible reasons for having a low return on investment (Akers, 2019) 1. Low operating Income - A low return on investment may be due to low operating Income, inefficient use of assets, and poor management. A low return on investment could be acceptable in some circumstances. For instance, the return on investment may be low for the first few years of operation if a company recently bought expensive machinery for one of its manufacturing plants. If the return stays poor after the first few years, management may have made an inappropriate investment. It could be that the equipment was not being used efficiently. 2. Inefficiency - Low percentage return on investment could signify inefficient utilization of the business's fleet, machinery, or facilities. It is particularly true if the company's return on investment is lower than the industry standard. For instance, the business can possess many fleet vehicles for parking lots rather than transporting manufactured items. Another option is that the fleet cars were already old and required frequent repairs and maintenance. 3. Poor Management - A company's strategic management may be ineffective if it continuously generates a poor return on investment percentage. The business might be growing too quickly. Its assets and capital expenditures will rise quickly if it buys excessive land, structures, and machinery. It could backfire if real revenue and sales fall short of management's growth expectations. If management improperly distributes its manufacturing facilities and tasks, it may misuse the company's assets. A more effective method might be to combine or integrate various tasks, including order fulfillment and warehousing. Limitations of using ROI in performance measurement (BPP Learning Media, 2021) 1. Managers may undertake decisions to increase ROI in the short term but harm the company in the long term (for instance, delaying the acquisition of assets in favor of repairs and maintenance). 2. Managers may be assigned to a segment with many committed costs due to the previous manager, which the new manager may not control. These committed costs may increase the operating assets and thereby decrease ROI, making it difficult to assess the performance management of a manager. 3. Managers assessed based on ROI may reject an investment opportunity that can be profitable for the company but might negatively affect the manager’s performance measurement. Because of this, Residual Income can be used as another approach to measure an investment center’s performance. Residual Income (CFI Team, 2019) Residual Income is a measure used in accounting to evaluate the performance and profitability of a business or investment. Residual Income is calculated using the formula: Residual Income = Net Operating Income - (Investment * Cost of Capital). Net Operating Income is a business's profit after deducting all operating expenses, including taxes and interest. The Investment is the average operating assets invested in the business or project, and the Cost of Capital is the minimum return that investor anticipates as payment for the risk they are taking. Positive residual Income suggests that the business or investment creates value by producing more profit than its cost of capital. A negative residual income, on the other hand, means that the business or investment is not producing enough profit to pay its cost of capital. The formula for the residual Income can be constructed as follows: 03 Handout 1  [email protected] *Property of STI Page 4 of 8  BM2305 Residual Income = Net operating income – (Average Operating Assets X Minimum required rate of return) Limitation of the Residual Income The residual Income cannot be used to compare the performance of investment centers of different sizes due to the formula. Bigger centers would have higher net operating and residual incomes but are not necessarily managed better. Illustration – Calculating Residual Income STI Company has total average operating assets of P20,000,000. The minimum required rate of return is 12%. The company has earnings before interest and taxes (EBIT) of P2,000,000 and a tax rate of 30%. The net Income of the company is determined as follows: EBIT P2,000,000 Less: Interest Expense 700,000 Pretax Income P1,300,000 Less: Income Tax Expense 390,000 Net Income P910,000 With a net Income of P910,000, we can say that the company is profitable. Residual Income can contradict this. To determine if this net Income is profitable, we need to compute the residual Income, which considers the minimum required rate of return. Minimum Required Return = P20,000,000 X 12% = P2,400,000 Net Income P910,000 Less: Minimum Required Return 2,400,000 Residual Income P(1,490,000) The STI Company's net Income fell short of the minimum required return. It has a negative residual income as a result. Although STI Company is profitable in accounting, it is not economically profitable. Economic Value Added (BPP Learning Media, 2021) Economic Value Added (EVA) is an improved version of residual Income as it considers the information stored in the accounting record and implicit costs such as the opportunity costs. Implicit costs cannot be seen in the accounting records or statements but can be computed using certain business information not recorded in the accounting books. Opportunity costs are those gains forgone when pursuing a business decision, as in the case of make or buy decisions. Suppose a corporation, for example, is considering whether buying new equipment or making one would be better. In that case, the opportunity costs are the savings it would have realized from not incurring the manufacturing costs if it had chosen to purchase new equipment instead. A more detailed 03 Handout 1  [email protected] *Property of STI Page 5 of 8  BM2305 discussion about implicit costs is in Strategic Cost Management's courseware. To simplify the discussion in this handout, any other distinction between residual Income and EVA will not be discussed. Operating Performance Measures (BPP Learning Media, 2021) Companies use a variety of non-financial performance measures to evaluate management performance. While financial measures quantify the results of operations, they do not measure what drives organizational performance. For instance, ROI and Residual Income allow management to determine which segment performed better financially, but it does not measure the specific targets that drive overall organizational performance. For instance, the sales of a particular company may be influenced by the length of the delivery cycle time. Delivery Cycle Time Delivery cycle time is when the customer order is received up to when the order is completed and received by the customer. The longer the delivery cycle time, the less attractive the product is, ultimately affecting overall sales. Delivery Cycle Time = Wait time + Throughput Time Illustration – Calculation of Delivery Cycle Time: STI Company carefully monitors the time spent on orders and their production. The following average times (in days) were noted for each item or order during the most recent quarter: Wait time 18.0 Inspection time 0.4 Process time 2.0 Move time 0.6 Queue time 5.0 Goods are shipped as soon as production is finished. Delivery cycle time is calculated as follows: Delivery cycle time = Wait Time + Throughput Time = 18.0 days + 8.0 days = 26.0 days Throughput time = Process time + Inspection Time + Move Time + Queue Time = 2.0 days + 0.4 day + 0.6 day + 5.0 days = 8 days Throughput Time Throughput time is the time it takes to turn raw materials into finished goods. Throughput Time = Processing time + Inspection Time + Move time + Queue time 03 Handout 1  [email protected] *Property of STI Page 6 of 8  BM2305 Throughput time should be determined before calculating the delivery cycle time since, according to the delivery cycle time's formula, the throughput and processing time are combined to generate the delivery cycle time. In this equation, the processing time is the only value-added time. The other three (3) activities, inspecting, moving, and queuing, add no value and should be reduced if possible. Manufacturing Cycle Efficiency To reduce non-value-added time, companies have adopted Manufacturing Cycle Efficiency (MCE) as an operating performance measure to improve performance. 𝑉𝑎𝑙𝑢𝑒 − 𝑎𝑑𝑑𝑒𝑑 𝑡𝑖𝑚𝑒 (𝑃𝑟𝑜𝑐𝑒𝑠𝑠𝑖𝑛𝑔 𝑡𝑖𝑚𝑒) 𝑀𝐶𝐸 = 𝑇ℎ𝑟𝑜𝑢𝑔ℎ𝑝𝑢𝑡 𝑡𝑖𝑚𝑒 Illustration: Using the same given data in the previous illustration, we can compute the MCE: 2 days MCE = 8 days = 25% It means that only 25% of the production process provides real value to the customers. Monitoring the MCE allows companies to reduce non-value-added activities and thus reduce Delivery Time. While these operating measures focus on a manufacturing company, these can also be adopted by a service organization. These are just a few operational performance measures that an entity may use to monitor its progress. The management must identify its Critical Success Factors (CSF), the ingredients a company needs to achieve its objectives. These are also known as Key Result Area (KRA). Since measuring success is a complex process, breaking it down into various Key Performance Indicators (KPI) will allow every team member to know exactly what matters the most to its survival. As the CSF may differ per organization, operational performance measures may also vary across different industries. Companies use many other operating performance ratios that allow management to focus on efficiency in various aspects of a company’s operations. Traditional businesses rely on the actual time that an employee logs in to the time card to reward their employees. While actual time spent during regular working hours may indicate one’s performance, management may also consider an output-based, rather than a time-based, approach to performance appraisal. As more businesses shift to work-from-home arrangements, operational performance measures become more relevant than ever to evaluate an employee’s performance outside the company premises. In conclusion, when companies rely on financial performance indicators alone, these do not convey the full picture of what drives the organization's success. Critical success factors of a business often involve non- 03 Handout 1  [email protected] *Property of STI Page 7 of 8  BM2305 financial factors. The recommended system for performance management is to use a combination of financial and non-financial performance indicators to ensure survival in a dynamic and ever-changing environment. References Akers, H. (2019, January 22). What Does a Low Percentage Return on Assets Mean? Retrieved from www.bizfluent.com: https://bizfluent.com/13709406/what-is-the-roa-formula BPP Learning Media. (2021). CIMA Operational Paper. CFI Team. (2019, December 10). Residual Income. Retrieved from www.corporatefinanceinstitute.com: https://corporatefinanceinstitute.com/resources/valuation/residual-income/ 03 Handout 1  [email protected] *Property of STI Page 8 of 8