Week 6: Performance

Measurement
Measuring the Performance of Investment
Centres
• Return on Investment (ROI)

• Residual Income (RI)

• Economic Value Added (EVA)

• Balanced Scorecard (BSC)

 Return on Investment (ROI)

• ROI is an accounting measure of income divided by an

accounting measure of investment

Income
ROI = Investment
• ROI may be decomposed into its two components as
follows:
Income Income Revenues
= X
Investment Revenues Investment
ROI = Return on Sales X Investment Turnover

• This is known as the DuPont Method of Profitability Analysis

An ROI Example
Electronics Div. Medical Supplies Div.
Sales $30,000,000 $117,000,000
Operating income 1,800,000 3,510,000
Average operating assets 10,000,000
19,500,000

Minimum return of 10%

Margin and Turnover Comparisons
Electronics Medical
Products

Margin 1.8/30 = 6.0% 2.51/117 =

3.0%
X
Turnover 30/10 = 3.0 117/19.5= 6.0

ROI 18.0%
18.0%
Residual Income (RI)
• Income minus a required dollar return on the investment

RI = Income – (Required rate of return x Investment)

• Required rate of return (ROR) x Investment is also called

the imputed cost of the investment
– Recognized in some situations that are not recognized in the financial
accounting records
– Represents the return forgone as a result of choosing an alternative of
similar risk
• ROR used is the company’s weighted-average cost of
capital (WACC): the after-tax average cost of all long-term
funding
An RI Example
Project 1 Project 2
Operating Income $1,300,000 $640,000

Average Operating Assets 10,000,000 4,000,000

Minimum Return 10% 10%
Expected Return 1,000,000 400,000

Residual Income (OI – EI) $300,000 $240,000

Both projects have a positive residual income, take them both if funds
are available.
 ROI vs. RI
Sales………………………………....$25M
Net Operating Income…………….…$3M
Average Operating Assets…………..$10M
ROI = NOI x Sales = $3M x $25M = 30%
Sales AOA $25M $10M
 ROI vs. RI
Sales………………………………....$25M
Net Operating Income…………….…$3M
Average Operating Assets…………..$10M
ROI = NOI x Sales = $3M x $25M = 30%
Sales AOA $25M $10M

Opportunity to invest $2M in project: $1M Sales and NOI of $0.5M

ROI (new) = $3.5M x $26M = 29.16%

$26M $12M
 ROI vs. RI
Sales………………………………....$25M
Net Operating Income…………….…$3M
Average Operating Assets…………..$10M
ROI = NOI x Sales = $3M x $25M = 30%
Sales AOA $25M $10M
Opportunity to invest $2M in project: $1M Sales and NOI of $0.5M
ROI (new) = $3.5M x $26M = 29.16%
$26M $12M
Present New Project
Overall
Avg.Op.Assets $10M $2M
$12M NOI $3M
$0.5M $3.5M Minimum (20%)
$2M $0.4M $2.4M RI
$1M $0.1M
$1.1M
Economic Value Added (EVA)
• Similar to Residual Income
• Uses NOPAT (Net Operating Profit After Taxes)
• Often requires adjustments to adjust from accrual to a cash
basis.
– Use cash tax rates instead of statutory rates
– Add back amortization, goodwill, bad debts exp.
– Add back research and development costs (capitalized costs)
 Economic Value Added (EVA®)

• A specific type of residual income calculation that has recently

gained popularity

EVA = After-tax
Operating Income {
Weighted-Average
Cost of Capital
Total
X ( Assets
Current
Liabilities )}

– Key calculation is the WACC (Weighted Average Cost of Capital)

EVA Example
Suppose that Mahalo, Inc., had after-tax operating income
last year of $1,700,000. Mahalo, Inc. pays a marginal tax rate
of 40 percent. Three sources of financing were used by the
company:

– $2 million of mortgage bonds paying 8 percent interest,

– $3 million of unsecured bonds paying 10 percent interest,
and
– $10 million in common stock, which was considered to be no
more or less risky than other stocks. (assume gov’t long-
term bonds 6%, and additional risk of investing in market is
an additional 6%)
 Weighted Average Cost of Capital
The weighted average cost of capital for Mahalo, Inc. is computed
as follows: (Percentage of Financing by method x After tax cost)

Amount Percent x After-Tax Cost =

Weighted Cost

Mortgage bonds $ 2,000,000 (.08 x (1-0.4)=

0.048

Unsecured bonds 3,000,000 (.10 x (1-0.4)= 0.060

Common stock 10,000,000 (0.6 + 0.6)=

0.120

Total $15,000,000 1.000

========= ====
EVA Example
Mahalo’s EVA is calculated as follows:

After tax operating income $1,700,000

Less: Cost of capital ($15M x 0.098)
1,470,000
EVA $230,000
========

The positive EVA means that Mahalo, Inc. earned operating profit
over and above the cost of capital used.
 ROI vs. RI Example
• Three divisions have been given a choice of ROI vs. RI @
12% to determine bonuses (only 1 division will receive the
bonus). They can use book value or net value (50% of book)
as the asset base.
Division Gross Book Value Operating
Income
Ontario $1,100,000 $150,000
Quebec $800,000 $120,000
Alberta $350,000 $55,000

Which would each manager chose?

 ROI vs. RI
ROI Gross Book Value Net Book Value

Division

Ontario

Quebec

Alberta

RI

Ontario

Quebec

Alberta
• Strategy and the Balanced
Scorecard
Financial Performance Indicators
• Return on Investment (Problems)
– Lag Indicators
– Used as evaluation measure forces managers to have a
short-term focus
– Cannot measure different components of product life-
cycle
– Poor evaluation for international comparison
– Measures financial transactions but not intangibles (ex.
human capital and knowledge based companies)
– Easily manipulated through choice of accounting policies
Non-Financial Performance Indicators
• Company must focus on financial as well as non-financial
indicators to evaluate performance.
– Ex. Hockey or Baseball Player Value.
– Ex. On-time delivery, defect rates, manufacturing cycle time and
efficiency.
• Advantages:
– Directly measure performance that creates shareholder wealth (Ex.
Delivering customer satisfaction)
– Measure productive activity directly, could be good measures of
direction of future cash flows.
 Balanced Scorecard

Balanced Scorecard: has 4 perspectives:

1) Financial Perspective – how do we look to
shareholders?
2) Customer Perspective – how do we look to
customers?
3) Internal Business Perspective – what business
processes are the value drivers?
4) Organizational Learning and Growth – how can we
sustain innovation, change and improvement?
4 Key Balanced Scorecard
Perspectives
• Financial perspective:
– Highlights achievement of financially strategic goals
– Include operating and net profit margins; return on capital
employed, on equity, on assets
• Customer perspective:
– Identifies targeted customer and measures the company’s success in these
segments
– Include measures of market share, number of new customers and customer
satisfaction
Balanced Scorecard Key
Perspectives
• Internal business process perspective:
– Requires analysis of how to improve internal operations of the entire value
chain
– Measures across the entire organization, including variance
analysis and capacity management
• Learning and growth perspective:
– The identification, development, retention and valuation of intellectual
capital – human, structural and relational capital
– Difficult to identify and value
 The Four Perspectives of the
Balanced Scorecard

Financial
Financial Perspective
Perspective
Creating
Creating organizational
organizational value
value
for owners/shareholders.
for owners/shareholders.

Customer Internal
Internal Business
Business
Customer Perspective
Perspective Strategy Ensuring
Ensuring efficiency
efficiency and
and
Adding
Adding value
value for
for customers.
customers. quality in the value chain.
quality in the value chain.

Learning
Learning and
and Growth
Growth
Investing
Investing in
in organizational
organizational
infrastructure.
infrastructure.
Managing on One Measure
Strategic Continuum
Mission
Why we exist

Values
What’s important to us
Vision
What we want to be
Strategy
Our game plan

Strategy Map
Translate the strategy
Balanced Scorecard
Setting up the management process

Target and Initiatives

What we need to do
Personal Objectives
What I need to do

Strategic Outcomes
Satisfied Happy Efficient/Effective Motivated/Prepared
Shareholders Customers Processes Workforce

*Robert S. Kaplan and David P. Norton

BSC: The Strategic Framework
FINANCIAL PERSPECTIVE

“How do we obj. meas targ. init.

look to
stakeholders?
”

CUSTOMER PERSPECTIVE MISSION, INTERNAL BUSINESS PROCESS

obj. meas targ. init.

VISION, obj. meas targ. init.
“How do our
customers see STRATEGIC “What must
we excel at?”
us?” GOALS

LEARNING & INNOVATION

“How can we obj. meas targ. Init.
continue to
improve &
create
value?”

*Robert S. Kaplan and David P. Norton

Balanced Scorecard
Financial

Objective Measures Targets Initiatives

Asset ROA 14% Update

utilization technology
Adequate Cash Flow $400,000 Cash Budget
cash available collection of
A/R policy
Investor ROE 18% Financial
return leverage
Balanced Scorecard
Customer

Objectives Measures Targets Initiative

Retention Renewal 90% Discount on

rate Renewal

Customer Increase 15% Sales

satisfaction revenue growth in Distribution
from sales Force
customer
Balanced Scorecard
Internal
Process
Objectives Measures Targets Initiative

Manufacture Cycle Time 1.5 days Automated

Excellence manufacturing
New product Actual vs. 3 new Increase R&D
introduction Plan product/yr Spending
Responsive On-time < 2% late Co-ordinate
Supply delivery delivery computer
systems
Balanced Scorecard
Learning &
Growth
Objectives Measures Targets Initiative
Technology Time to 1.2 years R&D Spending,
Leadership develop new Training of
generation employee

Time to Actual vs. 9 months Increase R&D

Market Plan Spending
Employee Employee <5% MBO process
Satisfaction Turnover training, stock
option
Examples of objectives
• Financial
– Increase in shareholder value through:
 Revenue growth: build the franchise with revenue from new markets,
customers or increase sales in existing customers and markets through
cross selling.
 Productivity: improve cost structure by lowering direct and indirect
expenses, utilizing assets more efficiently and reducing working and
fixed capital needs
• Customer
– Customer value proposition (how the company differentiates itself
from competitors and delivers value to customers)
 Operational excellence (McDonalds, Dell Computers), competitive
pricing, product quality, selection, lead time
 Customer Intimacy (Home Depot, IBM), quality of relation with customer,
service, suitability of solutions
 Product Leadership (Intel, Sony), functionality, features and performance
of services
Examples
• Internal processes
– Critical organizational processes and activities
 Build the franchise by innovation to develop new products and services,
penetrate markets
 Increase customer value by expanding and deepening relationships with
existing customers
 Achieve operational excellence by improving supply chain management,
internal processes, asset utilization, resource capacity
 Become a good corporate citizen by establishing effective relationships
with external stakeholders
– Cost savings from operational efficiency (short term)
– Revenue growth from enhancing customer relationships
(intermediate term)
– Innovation produces long term revenue and margin improvements.
Examples
• Learning and growth
– Foundation of any strategy
 Define employee capabilities, skills, technology, and
corporate climate needed to support a strategy.
 Enable the company to align HR and information
technology with strategic requirements from critical
internal processes, differentiated value proposition
and customer relationships.
 Engage the right infrastructure, equipment, training,
research and development to effectively implement
the corporate strategy (managing resources to
develop core competencies).
BSC Example Measurements
Financial
Objectives Measures
Revenue Growth:
Increase in number of new products % of revenue from new products
Create new applications % of revenue from new applications
Develop new customers/markets % of revenue from new sources
Adopt new pricing strategy Product and customer profitability
Cost Reduction:
Reduce unit product cost Unit product cost
Reduce unit customer cost Unit customer cost
Reduce distribution channel cost Cost per distribution channel

Asset Utilization:
Improve asset utilization Return on investment
Economic Value Added
BSC Measurements Customer
Objectives Measures
Core: Market share (% of market)
Increase market share % growth of business from existing
Increase customer retention customers
Increase customer acquisition % of repeating customers
Increase customer satisfaction Number of new customers
Increase customer profitability Ratings from customer surveys
Customer profitability

Customer Value Price

Decrease price Postpurchase costs
Decrease postpurchase costs Ratings from customer surveys
Improve product functionality % of returns
Improve product quality On-time delivery % aging schedule
Improve delivery reliability Ratings from customer surveys
Improve product image and reputation
BSC Measurements
Internal Business Perspective
Objectives Measures
Innovation:
Increase number of new products # of new products vs. planned
Increase proprietary products % revenue from proprietary products
Decrease new product development Time to market (start to finish)
time
Operations: Quality costs/Output yields/% defects
Increase process quality Unit cost/ Output to inputs
Increase process efficiency Cycle time and velocity
Decrease process time Manufacturing Cycle Time
(Process/Throughput time)
Post Sales Service: First-pass yields
Increase service quality Cost trends/ Output to input
Increase service efficiency Cycle time
Decrease service time
BSC Measurements: Learning and Growth
Objectives Measures
Employee capabilities: Employee satisfaction ratings,
Increase employee capabilities turnover %, employee productivity
(revenue/employee), hours of training,
% of positions filled internally, % of
employees in training programs

Employee motivation, Suggestions per employee,

empowerment and goal alignment: suggestions implemented, Avg. length
Increase employee motivation, of employment, % of employees who
empowerment, and goal alignment intend to stay with company

Information system capabilities: % of processes with real-time

Increase info. System capabilities feedback, % of customer-facing
employees with on-line access to
customer and product info.
Steps in the Development of Balanced
Scorecard
• Evaluate current strategy (environmental scanning)
• Evaluate Current Performance Measurement system
• Develop a Customer Value Proposition (CVP)
• Re-visit mission statement (if necessary)
• Develop measurement’s for All 4 measures in relation to
CVP and Strategy – Strategic & functional
• Defense of Performance Indicators
• Monitor measurement’s (Employee involvement)
• Analysis and comparison of new measurements versus
initial measurement
• Cyclical process
 Balanced Scorecard
Perspectives Objectives Measurements 2022 2023
Financial Maximum returns Return on Equity 12% 13%
Utilization of Assets Utilization Rates 7% 8%
Revenue Growth % Change in Revenues +11% +11%
Customer Customer Retention Retention % 75% 75%
Customer Service Service Rating 85% 85%
Customer Relations % Self Initiated Calls 35% 40%
Internal Fast Delivery Turnaround Time 15m 14m
Perspective Effective Service 1st Time Resolvement 68% 70%
Optimal Cost % Cost of Sales 66% 64%
Resource Utilization Productivity Indicator 77% 80%
Learning & High Skill Set Skill set Ratio 65% 68%
Growth Employee Survey Index 75% 78%
Satisfaction
Link objectives and initiatives
 Add Programs/initiatives
Objectives Measurements Targets Programs
2020 2021
 Balanced Scorecard - Hotel
BSC Value Driver Measures
• Room RevPAR and occupancy rates
Financial Revenue • RevPAR Index (versus competition – LRA)
Maximization • Cashflow

• Guest comment cards (Overall satisfaction

Customer Value rating, likelihood of return, willing to
Value Proposition recommend to others – customer loyalty
measures)
• Sample of guest via telephone survey

• EBITDA and EBITDA margin

Internal Operational • Guest Comment Cards (individual ratings of
Processes Effectiveness different departments – pool, cleanliness,
value, front-desk, restaurant)
• Supplier survey (satisfaction rating – value,
on-time, responsiveness)
• Employee survey (Overall satisfaction rating)
Learning Employee • Individual evaluation by supervisor
and Growth Satisfaction • Employee Turnover
Ambassador Hotel and Convention Center
Balanced Scorecard Ambassador Hotel
Strategic Level January February
Measurement Value Driver Responsibility Planned Actual Planned Actual

Financial Incicators
Room RevPar 1 Accounting

Room RevPar Indice 1 Accounting

Occupation Level 1 y2 Front Desk

Cash Flow 1 Accounting

 Stoplight System
Indicator December January February March April

Occupancy 0.85 0.72 0.78 0.81 0.85

Room $88 $82 $81 $83 $85

RevPAR
 Strategy

Financial Revenue Growth Productivity

Strategy

Customer Product Leadership Operational

Valuation Customer Intimacy Excellence
Proposition

Internal Innovation Operations and

Business Customer Logistics
Processes Mgmt.
Learning Employee Satisfaction
Perspective
Develop Skills Access Info. Personal goals
Strategy Map
• A logical and comprehensive architecture for describing
strategy.
• Creates a common and understandable point of reference
for all organizational units and employees.
• The strategy map is built from top down, starting with
destination and then charting the different routes to get
there.
 To be rated #1 by
customers in total value
Strategies & Values
delivered

Balanced Scorecard
Financial Measures - Market leadership
Profitability, Growth & - High revenue growth
Shareholder Value - Profitability

Customer Measures - Superior lead times

Time, Quality, Service & - Low defect rates
Price/Cost - Ontime delivery
- Responsiveness

Internal Business - Time to market

Perspective - Manuf. Cycle time
Time, Quality, Productivity - Low process defects
& Cost - High yield

Human Resources, - High sales from new

Innovation, Training products
and Intellectual assets - Low % of employee
turnover
An Example Strategy Map

2-
49
 Strategy Map: An Example
Strategy Map Objectives
Financial Incr. revenue • Increase revenue
• Increase production
Increase
production
Increase
sales levels
• Increase sales levels

Customer • Increase client loyalty

Increase Develop • Build client relationships
client loyalty cust. relation.
• And identify client needs

Internal • Develop innovative products

Facilitate
Develop client interaction • Reduce client handling
new products
• Facilitate client interaction
Learning
Develop • Develop and hire sales staff
cust. service
Align staff
Sales team • Develop / hire customer service staff
 BSC and Map: An Example

Strategy Map Objectives Measures Targets Initiatives

Financial • Revenue incr. • Revenue stmt. • 35% in 2 years • Ident. markets
Incr. revenue • Production plan • Production level • 22% / year • Stabilize prod
• Increase sales • Sales forecasts • 40% / year cost
• Acquire sales
Increase Increase tools
production sales levels
Customer • Increase client • Cust. satisf • < 90% satisf. • Cust. service
loyalty survey/levels rate from 2005 • Innovation
Develop • Identify client • Survey current • Survey 75% management
Increase cust. relation. needs customers clients • Customer
client loyalty • % change loyalty program

Internal • Develop innov. • Invst. in R&D • <$2M/quarter • Incr. Resource

Facilitate products • Development to • >75 days from to R&D
Develop client interaction • Reduce client mkt turnaround current • Benchmarking
new products handling • Cust. resp time • >10 min/client

Learning • Develop/hire • Sales/month • 50% incr leads • Sales training

Develop sales staff • Client satisf. • 10% incr. satisf program

Align cust. service • Develop/hire • Client retention • Maintain/incr • Custom. service

Sales team staff cust. Service • Weekly perform level by training

staff reviews 15%/mth • HR hiring plan
Example of BSC Software: Overview of company
and strategic map
Drill down to track over time
Cause and Effect of Strategy Map
Features of a Good
Balanced Scorecard
• Tells the story of a firm’s strategy
– Articulates a sequence of cause-and-effect relationships
• Helps communicate the strategy to all members of the
organization
– Translates the strategy into a coherent and linked set of
understandable and measurable operational targets
• Places strong emphasis on financial objectives and
measures
– Applies to for-profit entities
• Limits the number of measures, identifying only the most
critical ones
• Highlights suboptimal tradeoffs that managers may make
when they fail to consider operational and financial
measures together