Papers P2 and E3 - CIMA

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In this issue:

Paper F2 Financial Management

Papers P2 and E3 Performance Management and Enterprise Strategy

Financial measures such as profit, residual income and ecnomic value added serve to focus managers' minds on the most important factors under their control, but they can also encourage dysfunctional behaviour By Adrian Sims

A distinctive feature of management accounting is its combination of financial economics with commercial management. This is clearest in the area of control and performance measurement, which has been examined in every P2 paper since November 2012 and five times in E3 over the same period. Candidates who sat P2 and E3 in November 2013 faced questions involving similar topics, albeit with different slants to reflect the particular papers: the calculation of return on capital employed (ROCE) or return on investment (ROI) and, in E3, the pros and cons of using ROCE/ROI as a divisional performance measure.

Learning the mathematical aspects of performance measurement alone is missing the point. Students need to

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understand how performance measures help an organisation to achieve its objectives and how they serve as a management control mechanism.

Performance measurement is a control system based on numbers. The job of performance measures is to ensure that all of the organisation's employees do the right things to achieve its goals ? ie, they govern how people behave.

In Measuring Business Performance: Why, What, How (Economist Books, 1998), Andy Neely suggests the "four CPs" as a mnemonic by which to remember how performance measures control what people do. These are: ? Confirm priorities. The fact that something is being measured and reported on means that its achievement is a priority for the senior management team. ? Compel progress. Each manager will want to ensure that their performance looks good against each measure because their career prospects may depend on it. ? Check position. They enable managers to monitor whether the activities they are responsible for are going well or not. ? Communicate position. Measures are summaries that can be used by other employees and outsiders to understand how parts of the organisation are performing.

A further CP, not highlighted by Neely, could also apply: cash prizes. Measures can be the basis for bonus payments ? a particularly effective way to "compel progress".

Profit as a performance measure A basic assumption of economics since the 18th century is that businesses seek to maximise their profits. Firms use profit measures to control the management of profit centres. Profit is measured periodically as the difference between the revenues earned by the profit centre in the period and the controllable costs it incurs over that time.

Examples of profit centres include a particular product line, store or territory, or a stage in the manufacturing

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process. Some systems configure a production cell ? engine assembly, for example ? as a profit centre in order to encourage flexible manufacturing.

Profit as a performance measure can become the basis of a standard costing and budgetary control system. This system will monitor more detailed measures that contribute to profit ? eg, labour rate, materials costs, contribution per unit and price per unit. Achievement of the profit objective is also controlled by non-financial measures such as capacity utilisation, cycle time, material usage, labour/machine efficiency and quality. (Students often assume ? wrongly ? that the use of non-financial performance measures should be restricted to not-for-profit organisations.)

The financial benefits of using profit-based performance measures are as follows: ? It is congruent with the profit-seeking goals of businesses. ? It can be used as a basis for further performance measures that monitor the factors affecting profit. ? It enables profitable and non-profitable parts of the organisation to be determined.

The use of profit-based measures permits responsibility to be delegated to profit-centre managers, motivates them to improve short-term efficiency and can form the basis of their financial rewards. But these managers know that they are being evaluated on their ability to generate short-term profits, so this could affect them in the following negative ways: ? It encourages cost-cutting that could jeopardise the future of the business. ? It can encourage risky and/or exploitative behaviour. ? It can lead to conflict among profit-centre managers if individuals feel that they are being unfairly charged costs, being denied sales support and so on. ? It can cause stress among profit centres' managers and their staff if their profits come in below budget.

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? It prioritises profit at the expense of other goals ? eg, those of corporate social responsibility.

Profitability as a performance measure Higher profits are not necessarily a measure of higher performance. Suppose that division A of a firm has made a profit of $20m while division B has made a profit of $10m. Does this mean that the manager of division A has done better than their counterpart in division B?

Financial economics recognised by the start of the 20th century that investors do not merely require maximised profits ? they require a high return on the money they have invested. ROCE is a common measure of profitability. ROCE = profit before interest and tax ? capital employed. This, or a similar measure such as ROI or return on net assets, is used to gauge the performance of divisions and their managers.

Suppose that division A made its profit of $20m using assets worth $400m, while division B made its profit of $10m using $100m of assets. A's return on net assets/investment would be 5 per cent and B's would be 10 per cent. From a management point of view we might conclude from this that B's manager is twice as good as A's manager. We can make this inference because we assume that a bigger percentage is better than a smaller one. This judgement could have the following effects: ? Division B's manager will be more likely to be selected for promotion and greater responsibility because they are more effective. But they'll need to keep hitting that 10 per cent target or even improve on it. ? Division A's manager will feel under pressure to improve on 5 per cent and may even face the threat of demotion or even dismissal.

These measures have different implications from an economic point of view. In the second half of the 20th

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century the concept of a required rate (also known as the cost of capital, target rate, hurdle rate or discount rate) emerged. This represents the minimum rate of return demanded by banks and shareholders to compensate them for the risks of investing in a given enterprise. One of these risks is the possibility that they could have achieved a better return by investing elsewhere. So, if the required rate for the firm in our example is 12 per cent, both divisions' managers have underperformed and let down the shareholders. If the required rate is 4 per cent, both managers have improved the wealth of shareholders.

From a management perspective the benefits of using ROCE and similar measures to gauge performance are as follows: ? It can be understood readily. ? It can be calculated easily from the standard financial data that's already produced. This makes it cheap to monitor ? and reliable, because the data will be complied using established accounting conventions. ? It compares divisions or investment centres of different sizes fairly because it is a percentage.

The drawbacks are as follows: ? It can be demotivating when uncontrollable factors are having a significant effect. Divisional managers often cannot influence all of the variables affecting ROCE/ROI because they are compelled to charge certain prices and use particular assets, for instance. ? It discourages investment. Managers have no incentive to replace assets regularly, because a division with older written-down assets would score a higher ROI for the same level of profit than one with newer assets. Using outdated manufacturing equipment, for example, could jeopardise health and safety, harm product quality and reduce flexibility, among other things. ? It encourages dysfunctional decisions. Managers will want to reject a project if its ROI is lower than the ROI

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that their division presently achieves and they will want to accept it if its ROI is higher. This does not ensure that a project with an ROI that exceeds the rate required by investors will be pursued.

Residual income Residual income (RI) can be calculated using the following formula: net profit ? (capital employed x required rate). This compares the profit with the opportunity costs of the assets used to achieve it. The RI approach requires managers to create a residual ? ie, an amount by which the profits exceed the opportunity cost of the investment tied up in the assets. A positive residual income shows that the manager has maximised shareholder wealth, because the profit they have made is greater than the minimum required level of profit.

In economic terms this measure is valid and useful, while its advantage in management terms is that, unlike ROI and ROCE, it doesn't encourage dysfunctional investments. But RI is still subject to the depreciation effect and problems concerning controllability. Despite being a better performance measure, the RI approach has not been widely accepted. This may be because of its unfamiliarity to managers, its complexity and its inability to compare divisions of different sizes.

Shareholder value analysis The principle behind shareholder value analysis ? an approach that's examinable at strategic level only ? is that businesses should be run to increase the wealth of their shareholders over time. This is measured by market value added (MVA). The formula used to calculate MVA is: the total stock market value of a firm ? the amount of shareholder capital invested in the firm.

A company's stock market value is published along with its share price and it fluctuates with that price.

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Financial economics predicts that this market capitalisation will be equivalent to the present value of the business's future free cash flows. MVA takes a special view of shareholder capital that involves abandoning the conventions of asset valuation. Instead of taking the book value of physical assets, shareholder value analysis values them at the total cash that was used to buy them originally. It also adds in the cash spent on other projects such as acquisitions or research and marketing campaigns. These all represent "shareholder capital invested in the firm" and, if the money were spent wisely, it would have increased the firm's market capitalisation by at least as much.

Since the development of MVA in the 1990s, sophisticated investors have increasingly used it to rate how well companies are run rather than applying ROCE alone. This has created the need for new divisional performance measures to control divisional managers in order to ensure that they maximise shareholder value.

Economic value added (EVA) was developed by the Stern Stewart consultancy as a divisional performance measure. Its formula is as follows: net operating profit after tax ? (required rate x economic capital employed).

EVA looks similar to residual income, but the calculation of profit and capital employed uses concepts of cash accounting rather than those of accruals accounting. This brings the calculation of EVA close to the notion of the present value of future cash flows that is said to determine a company's market capitalisation. If a divisional manager generates a positive EVA using the cash provided by the shareholders, this will improve the firm's MVA.

Another approach to the same problem is provided by the "seven drivers of shareholder value" proposed by Alfred Rappaport in his book Creating Shareholder Value: The New Standard for Business Performance (Free Press, 1986). This model identifies the following performance

Adrian Sims is a freelance lecturer and author specialising in the integrated case studies of the CIMA qualification

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measures that together influence the present value of a business's free cash flows: 1. The increase in sales revenue. 2. The operating profit margin on sales. 3. The cash tax rate. 4. The ratio of incremental expenditure on fixed assets to incremental sales. 5. The ratio of incremental expenditure on working capital to incremental sales. 6. The period over which the sales are forecast to last at the forecast level. 7. The investors' required rate of return.

Multiplying 1 by 2 gives the annual increase in operating profit. Deducting 3, 4 and 5 converts this extra profit into increases in free cash flows. These cash flows are then forecast into the future using 6 and discounted to presentvalue terms using 7.

The managerial benefit of these shareholder value analysis performance measures are that they focus managers' minds on delivering financial benefits to shareholders and away from window-dressing the accounts. One key drawback is that they remain poorly understood by investors and managers.

The financial measures I have covered here communicate the need for a profit-seeking organisation to achieve a return, but they cannot control how it makes its profits ? and they are of limited relevance if that entity's goals extend beyond making a profit. This is where non-financial performance measures are needed in order to control how managers behave. I will discuss these in my next article, which will appear in the August issue.

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