Section B Performance Measures Example of ROI under the three inventory cost flow assumptions in a period of rising prices with all other variables held constant: Weighted Average Cost FIFO LIFO Average Inventory $ 1,000,000 $ 1,500,000 $ 500,000 Average Other Assets 5,000,000 5,000,000 5,000,000 Average Total Assets 6,000,000 6,500,000 5,500,000 Net Income 1, 100,000 1,600,000 600,000 ROI .18 .25 .11 Depreciation The divisions need to be using the same method to depreciate fixed assets, and the methods used in measurement need to be fair for all of the divisions. Even though the same depreciation method may be being used for all of the divisions, the results may still not be comparable or fair. • Older fixed assets will have a lower book value than newer fixed assets because more depreciation has been recognized. Therefore, if book value affixed assets is used in Total Assets, the same dollar amount of income in two divisions will produce a higher ROI in the division with the older assets. Be cause the assets are older and their book value is lower, the denominator will be lower and the ROI will be higher. • Furthermore, depreciation expense on the older assets will be lower. If an accelerated method of depreciation is being used, more depreciation expense is recognized in the early years of the assets lives, so income will be higher in the later years of the assets lives. And older assets may be fully depreciated, so no depreciation expense at all will be recognized on those assets. • For a division with older assets, a higher income combined with lower fixed asset values together can create an unrealistically high ROI and the profitability of the division with older assets may appear to be higher than it actually is. When the assets are replaced, as they must be, the current replacement value will be much higher and the ROI much decreased. The divisions net income may not be ade quate to support the replacement of the assets at their current higher value. This problem can be alleviated by using current market value or replacement value of the assets rather than historical or net book value. In this way, a future profitability problem can be revealed, enabling timely corrective action. Use of current asset values will make the ROI more relevant and comparability of divisions will be restored. Capitalization Policy Companies have policies that state when an item is to be expensed and when it is to be capitalized as an asset. When a newly purchased asset is expensed, net income is reduced, resulting in reduced ROI; and the opposite is true when the asset is capitalized. The same policy needs to be in effect for all divisions of the company. Use of Full Costing The use of full costing will cause net income and thus ROI to rise when inventory levels rise and to fall when inventory levels fall. Disposition of Variances Firms also have policies about the way variances are to be handled. The variances may be closed to Cost of Goods Sold, or they may be prorated among Cost of Goods Sold and the Inventory accounts. The choice will affect both net income and inventory balances. If variances are closed to Cost of Goods sold only, net income and also inventory will be distorted, and ROI will in turn be distorted. The distortion could go either way. 165 Performance Measures CMA Part 1 However, if the variances are prorated, net income and inventory will not be distorted because they will be the same as they would have been had there been no variances. To maintain comparability among divisions, all divisions must use the same accounting policies in these five areas. Furthermore, top management should consider whether the accounting policies in use, even if standardized among divisions, may be causing income to be under- or overstated and/or investment to be under- or overstated throughout the organization. Other Income Measurement Issues Other things can affect the measurement of income and thus, the measurement of ROI, reducing comparabili ty among business units. • Nonrecurring Items - Nonrecurring charges or revenues can cause net income of a given business unit to be not comparable to that of prior periods and not comparable to net income of other busi ness units. • Income taxes - Income taxes may affect different units differently, especially if the units are located in different countries with different tax rates and varying tax treaties. Even within the U.S., state income and franchise tax rates vary from state to state. • Foreign exchange - Income and value of investments in foreign countries can fluctuate due to fluctuations in currency exchange rates. • Joint asset sharing - Allocations of costs for common facilities or services need to be allocated on a fair basis, as discussed in the topic of Allocation of Common Costs. Different methods of allocat ing the common costs will result in different costs for each unit and thus will affect the units income. Which Assets to Include in Investment and How to Value Them We have already said that the primary method for defining investment for the purpose of calculating ROI is to use working capital plus net fixed assets. However, what specific assets should be included? • Investment is commonly defined as the net cost of long-lived assets plus net working capital (total current assets minus total current liabilities). However, only assets actually controlled by a unit should be included in its investment for the purposes of calculating its ROI. • If current assets on the books of a division are actually controlled at a higher level in the company, they should not be included in the calculation of that divisions investment. This includes cash, recei vables and inventory. Only the cash, receivables and inventory that are controlled by the division should be included. • Fixed assets should be included in a divisions investment only if they can be traced to that division. Problems arise when assets are leased or idle or if they are shared with another division. o Leased assets should generally be included in investment, because they are assets being used to o If idle assets can be used for something else or can be sold, they should generally be included in generate income. The company should have a policy about how leases are treated in calculating ROI, so that managers will either lease or not lease, according to policy. the divisions investment amount for calculating ROI. However, this policy can be used to en courage managers to either sell idle assets or hold them. Including them in investment will motivate the manager to sell the idle assets in order to reduce investment and increase the ROI, so if top management wants managers to sell idle assets, they should include them in invest ment. On the other hand, if top management believe holding the idle assets would be advantageous for some reason, excluding them from investment for ROI will motivate managers to hold them, since holding them will not reduce their ROI. 166 Section B Performance Measures o If facilities are shared by two or more divisions, management must work out a fair sharing ar rangement. Assets that cannot be traced to one particular division need to be allocated on a basis that reflects actual usage by each division as much as possible. Some shared facilities need to be quite large in order to accommodate periods of high demand. In that circumstance, the as sets should be allocated based on the peak demand by each division rather than on total usage. The value of investment is typically the historical cost of the assets. For current assets, the historical cost is their book value. For fixed assets, the historical cost is the net book value, i.e., their historical cost less accumulated depreciation. However, the use of net book value for long-lived assets can create a problem if the long-lived assets make up a major portion of a units total investment. Price changes since the purchase of the assets can cause their historical costs figures and net book values to be at best irrelevant and at worst misleading. The relatively small historical cost of the assets can cause ROI to be significantly overstated when compared with what ROI would be if it were calculated using the current value of the fixed assets. The inflated ROI can create an illusion of profits that will not be there when the assets are replaced in the future at their current value at that time. The amount of income the business unit is generating may not be adequate to support the assets replacement. 1) Use of current value makes it possible for the company to identify low profitability in a timely man ner, whereas use of historical value can delay this recognition. 2) The use of current value for the assets of all the business units reduces the unfairness of using net book value when the various business units have assets of different ages. When net book value is used, units with older assets will have higher ROIs than units with new assets, because the net book values of the older assets will be significantly lower than the net book values of the newer assets. If the older and the newer assets are providing equivalent service, this will be unfair to the manager of the unit with newer assets. The use of current value for long-lived assets is preferred for the calculation of ROI because the use of current values improves ROI as a measure both of the economic performance of the units and of the managers performance. Measures that may be used for current values include: (1) gross book value not reduced by accumulated depreciation; (2) replacement cost; and (3) liquidation value. All of the measures have their place, depending upon the purpose of the ROI calculation. • Gross book value is the historical cost of the existing assets. The advantage of using gross book value is that it eliminates the problem of different ages of assets among business units. However, it does not reflect price increases that may have taken place since the assets were purchased. Gross book value is preferred by managers who want to use a verifiable, objective number. • Replacement cost is the current cost to replace the assets at their current functionality. Replace ment cost would be preferable if ROI is being used to evaluate managers and units as on-going enterprises, because it represents what it will cost to replace the assets they are currently using. • Liquidation value is what the assets would bring in a liquidation of the business. It does not represent the value of the units as on-going enterprises, because of the assumption that the busi ness would be being liquidated. Liquidation value will almost always be lower than replacement value and historical cost. However, it is useful when management is using a business units ROI to evaluate whether to dispose of the unit. In that situation, the relevant current cost would be the assets liqui dation value. A company may have a significant amount of intangible assets that are not recorded in the financial statements. Under U.S. GAAP, only intangible assets that have been purchased, such as patents, copyrights or goodwill resulting from an acquisition may be recorded as assets. Investments in R & D will not be on the balance sheet, because those must be expensed as they are incurred. Therefore, investment may be substantially undervalued on the financial statements and net income may be distorted by the high expense for R & D. This fact must be considered when evaluating a business units ROI. 167 Performance Measures CMA Part 1 Question 86: The following information pertains to Quest Co.s Gold Division for the current year: Sales Variable costs Traceable fixed costs Average invested capital Imputed interest rate Quests return-on-investment was: a) 10.00% b) 13.33% c) 27.50% d) 30.00% $31 1,000 250,000 50,000 40,000 10% (CPA Adapted) Question 87: Listed below is selected financial information for the Western Division of Hinzel Company for last year: Average working capital General and admin expenses Net sales Average plant and equipment Cost of goods sold If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before tax ROI for last year? a) 34.78% b) 22.54% c) 19.79% d) 16.67% $625,000 75,000 4,000,000 1,775,000 3,525,000 (CMA Adapted) Question 88: The selection of the denominator in the return-on-investment (ROI) formula is critical to the measures effectiveness. Which denominator is criticized because it combines the effects of operating decisions made at one level of the organization with financing decisions made at another organizational level? a) Total assets employed. b) Working capital. c) Total assets available. d) Shareholders equity. (CMA Adapted) 168 Section B Performance Measures Question 89: Return-on-investment (ROI) is a term often used to express income earned on capital invested in a business unit. A companys ROI will increase if: a) Sales increase by the same dollar amount as expenses and total assets increase. b) Sales remain the same and expenses are reduced by the same dollar amount that total assets increase. c) Sales decrease by the same dollar amount that expenses increase. d) Sales and expenses increase by the same percentage that total assets increase. (CMA Adapted) Residual Income (RI) Residual Income (RI) attempts to overcome the weakness in ROI by measuring the amount of return that is provided by a department. RI for a division is calculated as the amount of return (net income before taxes) that is in excess of a targeted amount of return on the Investments employed by that division. Residual income is the income earned after the division has covered the required charge for the funds it has invested in its operations. Two items that you need to know in regard to the calculation of RI are: • The targeted amount of return is usually some percentage of the total employed assets of the division or the invested capital in the division, and • The percentage used in the calculation is the target rate that management has set. If the target rate is not available in the question, you should use the companys weighted average cost of capital (which will be given in the question). Note: Invested capital is usually calculated as fixed assets plus working capital. Capital assets or land that is idle should not be included in the amount of the investment. When using this method to evaluate investment opportunities, any project that has a positive RI will be accepted even if it will reduce the overall company or division ROJ. The formula for RI is: Net income before taxes on project or investment opportunity Taroet return in dollars: a % of employed assets or invested capital = Residual Income Example: Paterno Company has Total Assets of $4,000,000 and Net Operating Income of $600,000. Its target, or required, rate of return is 10%. How much residual income does Paterno have? The Target return = $4,000,000 x .10 = $400,000 Net Operating Income of $600,000 less $400,000 target return = $200,000 of residual income. In the calculation of Residual Income, the target rate of return multiplied by invested capital is considered an imputed cost of the investment. This imputed cost is the opportunity cost of other potential returns that have been forgone in order to make the investment. Note: Residual Income may be a negative amount. This occurs when the profits that the division or project actually achieved are less than the target income that was set for the division or project. 169 Performance Measures CMA Part 1 Alternate Methods of Calculating Residual Income Although gross assets employed are generally used in calculating Residual Income, a variation on the calculation adjusts net income to remove interest expense (i.e., by adding interest expense after tax) and adjusts the calculation of the target return by subtracting from total employed assets the current liabilities that do not incur interest. In other words, the calculation is: Net Income + [Interest expense x (1 - t)] Taroet return in dollars: a % of (Employed assets - Non-interest bearing current liabilities) = Residual Income Another alternate method of calculating Residual Income uses Operating Income instead of Net Income. Residual Income under this approach would be Operating income of division or other segment Taroet return in dollars: a % of employed assets or invested capital = Residual Income Use of operating income is consistent with the purpose of Residual Income, which is to evaluate individual operating units. However, in reality, Residual Income can be calculated in any way that management wants to see it, depending on what is meaningful to them. If you get an exam question on Residual Income, be aware of the various ways in which RI can be calculated. Advantages and Disadvantages of Using Residual Income RI overcomes the weakness inherent in using ROI alone to evaluate managers. Its advantage is that it motivates them to maximize an absolute amount - dollars of Residual Income - instead of a percentage (ROI). The result of this is that as long as a project for a subunit will earn an amount in excess of the charge for the funds needed for the investment, that project will be accepted. Using RI as a performance measure instead of ROI overcomes the tendency of managers to reject projects that would be profitable to the company as a whole but that would lower the business units current ROI. This would happen when a project has an ROI that is lower than the units current ROI, but the project would still be beneficial to the company. Thus, using RI a project that would be good for the company is more likely to be selected, even if its ROI is lower than the units existing ROI. Another advantage of RI is that a firm can adjust the required rates of return for differences in risk. A unit with higher business risk can thus be evaluated using a higher required rate of return than that used for a unit with lower business risk. RI also enables a company to use a different investment charge for different classes of assets. For example, the company could use a higher required rate of return for long-lived assets especially if their resale value is expected to be low and a lower required rate of return for shorter-term assets such as inventory. However, RI has a weakness in that it focuses on the dollar amount of the return that is provided. Although a $1 return is beneficial to the company, the amount of the return may be so small in comparison with the amount invested that the return provided is not worth it. As such, RI is often used together with another evaluation measure. Another disadvantage of using RI to compare performance of different subunits is that because RI is not a percentage, it is not very useful for comparing units of different sizes. A large subunit would have larger residual income than a small unit, whereas the smaller unit might be performing much better than the large unit, relative to its size. In addition, a small change in the required rate of return would have a greater effect in dollars on the RI of a large unit than it would on the RI of a small unit. 170 Section B Performance Measures In addition, RI has the same issues as ROI with respect to distortion caused by the accounting policies selected by the company. Residual Income must be interpreted carefully because of the various effects of different accounting policies on net income and on the amount used for investment. Question 90: Zack Corp. had the following information for 2003: Sales Operating income Operating assets Imputed interest rate What amount of residual Income did Zack have? a) $(20,000) b) $5,000 c) $10,000 d) $30,000 $500,000 50,000 200,000 10% (HOCK) Question 91: The imputed interest rate used in the residual income approach to performance evaluation can best be described as the: a) Average lending rate for the year being evaluated. b) Historical weighted-average cost of capital for the company. c) Target return-an-investment set by the companys management. d) Average return-an-investments for the company over the last several years. (CMA Adapted) Question 92: REB Service Co. is a computer service center. For the month of May, REB had the following operating statistics: Sales Operating income Net profit after taxes Total assets Shareholders equity Cost of capital Based on the above information, which one of the following statements is correct? REB has a : a) Return-an-investment of 4%. b) Residual income of $(5,000). c) Return-an-investment of 1.6%. d) Residual income of $(22,000). $450,000 25,000 8,000 500,000 200,000 6% (CMA Adapted) 171 Performance Measures CMA Part 1 Question 93: Residual income is a better measure for performance evaluation of an investment center manager than return-on-investment because: a) The problems associated with measuring the asset base are eliminated. b) Desirable investment decisions will not be neglected by high-return divisions. c) Only the gross book value of assets needs to be calculated. d) The arguments about the implicit cost of interest are eliminated. (CMA Adapted) Weighted Average Cost of Capital (WACC) Note: In Part 1 it is very unlikely that you will need to calculate the WACC. It will be given in the problem, and the information below is merely offered for those who would like to know what WACC is. WACC is the weighted average cost of capital, and it is calculated as the rate made up of the total cost of long-term funds (debt and equity) divided by the fair value of these long-term funds. In short, the formula for WACC looks like this: (Interest paid on Debt - Effect of Taxes) + Dividends paid on Shares = WACC Average Fair Value of Debt outstanding + Fair Value of Shares outstanding If you examine this closely, you will see that we use the fair value (market value) of outstanding debt and stock to calculate the WACC, in contrast to our use of the book value of balance sheet accounts in other ratios. Note: In the calculation of WACC, the total interest cost must take into account the effect of taxes. Because interest is a deductible expense, the true cost of interest is the amount of interest expense minus (the tax rate x the interest amount). It could also be calculated as the amount of interest x (1 - the tax rate). This means that the interest expense that is used in the calculation if WACC will be less than the actual interest that was expensed by the company. Using These Measures On the Exam, you need to be able to calculate not only the residual income and return-on-investment, but also the individual components of these figures, given a larger set of data. You also will need to determine how a change in certain things such as income, expenses or interest rate will impact these figures and calculations. In this type of question, it is best to create a simple example, then change the number that the question says changes, and recalculate the answer with the new information. The main thing you will need to know is to be able to contrast residual income and return-on-investment. The difference is that ROI is focused on % of the return and RI is focused on the $ of the return. This means that, depending upon the decision criterion, these two methods may lead to different decisions as to which investments to accept or reject. Role of Accounting Methods on Performance Measurements Be familiar with the role that accounting policies play in performance measurements. This was discussed in detail in the topic of ROI, but as noted, it is also applicable to RI. When items such as inventory and fixed assets are used, their values are influenced by the chosen accounting method. For example, in inventory, the value of the inventory can be calculated under the FIFO, LIFO or 172 Section B Performance Measures weighted average methods. Because any of these different methods can be used to value inventory when a comparison is made between two business units, it is important that both subunits use the same inventory method, because use of different methods will reduce their comparability. The idea of using the same standards in both subunits is also applicable in any other area where there are different accounting methods that can be chosen. Different methods of recognizing revenues and expenses among different business units and companies can reduce comparability of performance measurements among them. For instance, the use of absorption costing instead of variable costing will cause net income to be higher when inventory increases, because some fixed costs will be capitalized in inventory. For the Exam, you dont need to be able to calculate the differences that would arise from the use of different accounting methods, but you do need to recognize the issue of comparability that arises from use of the different methods. Use of Average Balances for Assets and Liabilities Balance sheet items are as of a moment in time, whereas an income amount covers a period of time. When we are using an income figure and relating that to a balance sheet item such as total assets or debt outstanding, it is customary to use the average balance of the balance sheet item during the same period as the income figure covers. This makes the income amount and the balance sheet amount applicable to the same period of time. This average balance of a balance sheet item is usually calculated as the average of the balances for the beginning and the ending of the period. For example, average total assets for the year 2010 will be the average of year-end total assets for the years 2009 and 2010 (since total assets at year-end 2009 are the same as total assets at the beginning of 2010). In addition, if the income amount is for less than one year, such as for one quarter, it is customary to annualize it. In other words, if we have an income amount for only a single quarter, we would multiply that quarterly income figure by 4 to determine what the income would be for the entire year if that level of income were to continue for one full year. The average balance of the balance sheet item used in the denominator should be the average for only the period (month, quarter, whatever) that the income item pertains to, though. It is especially important to annualize income when an annual percentage rate of return is being calculated. Performance Measurement in Multinational Companies When a company operates in different countries, it creates additional difficulties in comparing the perfor mance of its operating divisions. • Governments in many countries impose controls and limit selling prices of a companys products. • Taxes vary across countries. • Tariffs and custom duties may be imposed that restrict the import of certain goods. • Availability and costs of labor, materials and infrastructure vary among countries. • EconomiC, legal, political, social and cultural environments vary Significantly from country to country. • Different divisions in different countries account for their operations and performance in different currencies. Exchange rate fluctuations and inflation can significantly affect reported results. • Assets in foreign countries may be subject to expropriation risk, increasing the business risk of the subunit substantially. In order to compare performance measures across countries, adjustments are necessary. 173 Performance Measures CMA Part 1 Foreign Currency Calculation of ROI Should a foreign divisions ROI be calculated in the divisions currency of record, or in the U.S. dollar? If senior management wants to compare that divisions performance with one in another country, how can they do that? If inflation in one country is higher than in another country and prices charged in the high inflation country have been increased because of the inflation, then the ROI of the division in that country calculated in that countrys currency will be inflated, as well. To make the comparison of the two divisions more meaningful, both divisions income should be restated into U.S. dollars at the average exchange rate that was in effect during the year. This will eliminate any increase in operating income in the local currency of the division in the high inflation country that is strictly a result of the countrys high inflation rate. One of the factors that determines the currency exchange rate between any two nations is the difference between their inflation rates. Therefore, conversion of both divisions incomes to U.S. dollars at the average exchange rate between each countrys currency and the U.S. dollar during the period will eliminate the distortion caused by high inflation in one of the countries and make the two divisions incomes comparable. The divisions assets should be restated into U.S. dollars at the exchange rate that was in effect when the assets were acquired. Using later exchange rates for the assets would be inaccurate, because those later exchange rates would incorporate the inflation. Example: Fun In the Sun Resorts of Phoenix, Arizona, a U.S. company, invests in a resort property in Rio de Janeiro. The exchange rate on the date of the investment, December 31, 2008, was R$2.356 BRL (Brazilian Reals) = $1 USD. The amount of the investment was R$1,500,000 BRL. During 2009, operating income of the Rio de Janeiro resort is R$300,000. During the same period, the operating income of the Phoenix resort was $500,000 USD, and the average investment in that resort was $2,000,000. During 2009, the U.S. Dollar declined in value against the Brazilian Real. At year end, the exchange rate was R$1.570 = $1 USD. Over the one-year period, the average exchange rate is R$1.963 BRL = $1 USD. 2009 ROI for the Phoenix resort property is $500,000 .;. $2,000,000, or .25. 2009 ROI for the Rio de Janeiro resort property in Brazilian Reals is R$300,000 .;. R$1,500,000, or .20. It appears that the Phoenix propertys ROI is considerably higher than the Rio de Janeiro propertys ROI. However, when the Rio de Janeiro propertys income and investment amounts are restated into U.S. Dollars, here is what its ROI becomes: The Rio de Janeiro propertys income is restated using the average exchange rate for the year of R$1.963 BRL = $1 USD. Income is therefore 300,000 .;. 1.963, which equals $ 152,827. Investment is restated using the exchange rate in effect when the investment was made, which was R$2.356 = $1 USD. Investment is therefore 1,500,000 .;. 2.356, which equals $636,672. The ROI for the Rio de Janeiro property, stated in U.S. Dollars, is $152,827 .;. $636,672, or .24. Now, the ROIs for the two properties are very comparable (.25 versus .24). Note that we did not use average investment to calculate the ROI for the Rio de Janeiro resort. We assumed that the original investment made on December 31, 2008 did not change during 2009. If we had assumed that investment had changed during the year, we would have had to use the exchange rate for each increase in investment on the date the additional investment was made and used the daily balances to calculate a daily average investment to use as the denominator. That much detail would be outside the scope of the exam. 174 Section B Performance Measures Multiple Measures of Performance and the Balanced Scorecard The trend today is to use a more encompassing method of evaluation and include not only financial measures, but also non-financial measures by looking at the overall contribution to the achievement of company goals. This is called a balanced scorecard. The balanced scorecard is a strategic management tool which developed as a response to problems caused by evaluating managers only on the quarterly or annual financial performance of their business units. If managers are evaluated and rewarded for one thing (short-term financial performance), it results in their focus on that one thing, often to the detriment of other dimensions which are equally, if not more, important for improved long-term financial performance. For example, a focus on cost containment in order to improve quarterly results can result in a loss of quality due to lower quality parts being used. The long-term result of loss of quality is loss of customers and, ultimately, can be loss of the business. The balanced scorecard encourages managers to focus on elements of long-term success instead of on short-term financial performance by rewarding them for improvements in those elements of long-term success. While it does use financial measurements, it also uses non-financial and operational indicators which measure basic performance of the company and improvements that it is making in those indicators. Improvements in these non-financial measures provide the prospect of increased future economic value for shareholders. When managers are evaluated and rewarded based on these non-financial indicators, it leads to long-term financial performance improvements. This again comes back to the idea of goal congruence and making sure that everyone is working toward the same goals. Each company needs to develop its own set of metrics and means to assess continual improvement, and they will probably be different for different divisions and departments within the same company. However, the metrics fall into four broad categories of performance indicators, known as perspectives. The four perspectives are: 1) Financial perspective, focusing on profitability. Financial performance is still a priority, but it is recognized that good long-term financial performance will not be achieved if goals in the other cate gories are not attained. Some of the more common measures of financial performance are: operating income, revenue growth, revenue from new products, gross margin percentage, cost reductions, EVA and ROI. 2) Customer perspective. Developing the companys customer perspective involves identifying the market segment(s) it wants to target and then measuring its success in those segments. A common method of measuring this success is the trend in the companys share of the market over time: is it increasing in line with management goals? Customer satisfaction is another vital part of the customer perspective, because if customers are not satisfied, they will take their business elsewhere. And without customers, a business has no business. Customer satisfaction goals relate to how the com pany wants its customers to view it. This may include pricing goals (becoming the lowest cost supplier); meeting the customers needs better than the competition; and/or being known for high quality and excellent customer service. Being the lowest cost supplier can be measured by the cus tomers total cost of using the companys product relative to the customers total cost to use competitors products. How well customers needs are being met can be measured by the number of repeat customers and the percentage of deliveries that are made as promised and when promised. Quality goals can be measured by means of number of defective products returned and the level of product reliability over time. The level of customer service provided after the sale can be measured with customer surveys. 3) Internal business process perspective, which includes innovation in products and services, innovations and improvements in operations, and customer service/support after the sale. If one of the companys customer goals is to be the lowest cost supplier, that will need to be supported opera tionally by maintaining efficient, low-cost production, which can be measured by metrics such as the cost of raw materials, the number of employee hours needed to manufacture a unit of product, and plant utilization. Efficient cycle times also keep costs low. Here also is the support for quality in the 175 Performance Measures CMA Part 1 product required to meet the customer satisfaction goals. And meeting customers needs better than the competition is supported by innovations in products and services. Number of new product intro ductions is one way to measure this. Technological capability for customer service personnel is necessary to be able to provide excellent customer service, and it is also needed in the manufactur ing area to be able to manufacture product efficiently. Employee surveys of customer service personnel could be used to determine whether those employees have the information they need im mediately available to them, or whether they frequently have to put customers on hold to go search out the information. Percentage of manufacturing processes with advanced controls would be a way of measuring manufacturing technology. 4) Innovation and learning, which emphasizes an organizational culture that supports employee innovation, growth and development. In todays technological environment, employees need to be continuously updating their skills. Employee capabilities can be improved through employee training programs and measured by means of percentages of employees trained and their evaluations of the training. Learning involves more than training, however. It can include assigning mentors and tutors or having supervisors act as coaches to help employees develop their problem-solving and decision making skills, thereby empowering them. Employee empowerment can be measured by the percen tage of frontline workers who are capable of managing processes. It is important for the business to select just a few critical measures that are most relevant to its specific business strategy and then to track them rigorously, rather than using many different measurements. These critical measures are called critical success factors. They are measures of the aspects of the companys performance that are essential to its competitive advantage and therefore its success. Each companys critical success factors depend on the type of competition it faces. Critical success factors and competitive advantage will be discussed in more detail in Section C in the topic on Business Process Performance. Different business strategies call for different scorecards, and quality is more important than quantity when developing balanced scorecard measures. Management attention needs to be focused on the few key measures that are the most important to implementation of the companys chosen strategies and not be distracted by measures that are not critical. For instance, in a business where customer service is critical, telephone wait time would be an important measurement to track, as would the level of knowledge and empowerment of customer service personnel, in addition to the availability of needed information to them. As an example, a company that provides printing services using documents prepared and uploaded by the customer to its website needs service people who can access a customers uploaded files and who are knowledgeable enough to provide technical advice about the proper preparation of those document files to achieve a satisfactory printing job. And it needs enough customer service people and telephone lines to keep customers wait times to a minimum. The balanced scorecard uses a concept of a strategy map which links these four perspectives together, beginning at the bottom, innovation and learning. The goals of the innovation and learning perspective contribute to the internal business process perspective, because the staff members use their competenCies and strategic awareness to make operational improvements. In turn, the operational improvements made in internal business processes support the goals of the customer satisfaction perspective, since they provide the operations support needed to fulfill the goal of customer satisfaction. And customer satisfaction brings about increased business, increased profits, and improved financial performance. When the companys financial and non-financial measures are linked in this way, the non-financial measures serve as leading indicators of the firms future financial performance. The strategy map provides a way for all employees to see how their work is linked to the corporations goals. Implementing a Balanced Scorecard Implementation of a balanced scorecard system of performance measurement is most successful when the entire organization is aware of it and supports it. The way the organization communicates the role, the use, and the benefits of the balanced scorecard to its employees is one of the most important factors in its successful implementation. The balanced scorecard needs to be introduced by illustrating the sequence of cause-and-effect relationships - the way the perspectives are linked, and why meeting the goals at the 176 Section B Performance Measures bottom level makes it possible to meet the goals at the next level up, which in turn make the next level of goals possible, and so forth. It is important to have senior management support for the program, even as high as the board of directors. The board of directors can have balanced scorecard goals, too. That creates support at the very top of the organization, and the support filters down. Each business unit and division should be involved in developing its own customized scorecard, based on the companys overall objectives and what that unit needs to do to contribute to those objectives. Just as is true for budget development, involvement of the users builds their support. However, the scorecards as developed by middle managers need to be reviewed and approved with input from senior management to make sure they are congruent with the companys goals. The actual scorecard report for a business unit should be organized according to the four perspectives, with each selected scorecard measure on a line, classified within its perspective. The target can be in one column, followed by the actual results in the next column, and then the actual results versus the target. Results that are in line and out of line can be identified, perhaps by color. Each manager should be accountable for speCific lines on each report; and a division head is accountable for all the lines on the divisional report. A good, balanced scorecard report can also identify tradeoffs that managers might make by, for instance, reducing R&D spending in order to achieve short-run financial goals, or making other tradeoffs that could hurt future financial performance. The decline of R&D spending or other problems would be signaled. The balanced scorecard needs to be marketed to both management and staff to get their support. Internal promotion of the program should take place through various media, such as print, verbal and electronic means. A brochure can be used to explain how the balanced scorecard will help achieve the companys long-term goals in a way that simply tracking financial performance cannot. Employee newsletters can be utilized to feature the balanced scorecard program and report on results. If improvement in market share is one of the metrics and market share improves, an article can appear about that, explaining what factors created the positive results - including goals met in the perspectives below. On the other hand, if a metric is not met, an article can explain why and outline a plan to correct the situation. Verbal communication can occur in regular employee meetings where management reviews the results and gives employees the opportunity to ask questions. One-on-one conversations between supervisors and employees can give the people who do the jobs an opportunity to point out weaknesses in the program. Suggestion systems, programs inviting employee comments, and employee training programs with reports can also be used to enlist employee support. However, employees need to know that management is taking their ideas seriously, responding to them, and rewarding them appropriately for their ideas. If employee suggestions are ignored, employees will shrug and decide that this is just another program and why should they try to tell management anything, because nothing ever changes. Managers must be willing to listen to criticism and to make changes. General results can be posted on the companys intranet, with links to the overall corporate goals that each balanced scorecard result supports. In addition to general results available to all employees, the company can give password intra net access to detailed results to senior managers for their use in decision making. All employees can be linked to the goals by linking their bonuses to them. Aligning balanced scorecard results with compensation maximizes their use and effectiveness. Balanced Scorecard Reporting Software can be used to provide balanced scorecard performance information to the people who need it. However, installing dedicated balanced scorecard software does not mean that the balanced scorecard has been implemented. A business must develop its own balanced scorecard for each perspective and undertake the implementation project as covered in the previous discussion. But once that has been done, specialized software is available to track the results. 177 Performance Measures CMA Part 1 Problems With Balanced Scorecard Use There are several problems with using the balanced scorecard approach to performance evaluation: • It is difficult to use scorecards to make comparisons across business units, because each business unit has its own scorecard. Scorecard evaluation is more effective when used to judge the progress of an individual business unit relative to the prior year or to the goal rather than when used to com pare a managers performance with other managers. • In order to implement balanced scorecard performance measurement, a firm must have extensive enterprise resource planning systems to capture the detailed information required. • Non-financial data is not subject to control or audit and thus its reliability could be questionable. However, whether used for individual performance evaluation or not, the balanced scorecard is still a very effective method of developing strategy and evaluating progress toward meeting goals. Customer and Product Profitability Analysis The ability to evaluate a specific customer or group of customers profitability to the firm is important, because the 80-20 rule is operative: 80% of profits usually come from the top 20% of a firms customers. Furthermore, the customers in the bottom 20% of a firms customers are usually completely unprofitable. To maintain competitive advantage, a company needs to work hard to attract profitable customers and keep them; and it needs to work equally hard to discourage the unprofitable customers from continuing to drag down profits. Profitable customers can be attracted and kept through outstanding customer service; and unprofitable customers can be discouraged with fewer discounts and promotional offers. Customer profitability analysis can be used to determine the profitability of each customer or group of customers. This analysis enables managers to manage their customers costs-to-serve. A manager might want to reprice activities that cause high costs-to-serve or reduce available services for customers that are high cost-to-serve. To customers that are identified as low cost-to-serve, the manager can offer discounts in order to increase the sales volume from those customers. The most profitable customers can be provided with improved customer service in order to maintain them as customers. If a particular customer is unprofitable because of the particular products or services being purchased, the manager may be able to shift that customers mix toward higher-margin products and services, thereby converting that customer into a profitable customer. Customer profitability information can be used for targeted marketing, as well. It can reveal the types of customers that the company wants to market to and the types it does not want to market to. An example of customer profitability information is data generated in a bank concerning the services being used by each business customer. Many banks use account analysis to determine the total fees to charge their business customers. The bank analyzes the average balance on loans outstanding, the interest rate being charged, and its cost for the funds lent out to that customer. A large commercial customer might use cash management services such as lockbox or concentration banking, and providing those services generates costs for the bank, such as an allocated portion of the cash management operations employees salaries and facility costs. The checking account deposits that the commercial customer keeps in the bank do not pay interest to the customer, but the average balance of the funds is available to the bank to invest in loans to other customers. All of this is put together into an account analysis for each customer each month, and the analysis process generates the monthly fee that should be charged the customer. The account analysis report goes out to the customer along with the monthly fee invoice, and if a customer wants to decrease its future monthly fees, it can increase the amount of non-interest bearing deposits it keeps on deposit with the bank. Product profitability analysis is just as important as customer profitability analysis. Product profitability analysis can identify products and services that are unprofitable so those products and services can be either repriced or discontinued and replaced with new products and services that are more profitable. When customers and products are being evaluated for their profitability, accurate allocations of common costs are critical. Several methods of allocating common costs will be discussed in the next section, Section C, on Cost Management. ABC Costing is particularly useful
Posted on: Tue, 12 Nov 2013 09:22:25 +0000
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