Financial measures for performance evaluation

This paper addresses three main topic in managerial accounting, namely performance evaluation using financial measures such as return on investment, transfer pricing, and incentives and rewards in human resource management. To show critical thinking in strategic management decision, this paper answers different questions based on different cases, and interprets the results results here in.

To calculate the return on investment (ROI) for each division we first find the net operating profit after tax (NOPAT), which is equal to the operating profit before tax minus the tax at a rate of 28 percent. The invested capital is obtained by subtracting the current liabilities from the total assets. Thus, ROI is calculated as NOPAT divided by invested capital (Hansen & Mowen, 2007), as indicated in the table below.

	South Island division ($000)	North Island division ($000)	Fishing Fleet division ($000) Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
Operating profit before tax	$5,400	$1,200	$900
Tax (28%)	$1,512	$336	$252
Net Operating profit after tax	$3,888	$864	$648
Total assets	$52,500	$6,000	$25,200
Current liabilities	$12,000	$3,000	$2,400
Invested Capital	$40,500	$3,000	$22,800
ROI	9.60%	28.80%	2.84%

The best performing division based on the calculated ROI is North Island Division with 28.80% return on investment, followed by the South Island division with 9.60%, and the worst performance was from the Fishing Fleet division with ROI of 2.84%.

Nonetheless, when interpreting divisional performance using return on investment, the information on assets within each division should be taken into account.

There are clear differences among the division’s assets, which might affect their ROI. That is, the South Island division will have more assets than the other divisions because is owns all its assets. On the other hand, the Fishing Feet division’s profits could be affected by the fact that the division replaced all its fleet two years ago.

The divisional economic value added (EVA) is calculated using the following formula:

Economic value added (EVA) = Net operating profit after tax (NOPAT) – {Invested capital * Weighted average cost of capital(WACC)} (Hansen & Mowen, 2007)

The WACC used in this case is 8 percent. The results of the divisional economic value added (EVA) are shown in the table below.

	South Island division ($000)	North Island division ($000)	Fishing Fleet division ($000)
Operating profit before tax	$5,400	$1,200	$900
Tax (28%)	$1,512	$336	$252
Net Operating profit after tax	$3,888	$864	$648
Total assets	$52,500	$6,000	$25,200
Current liabilities	$12,000	$3,000	$2,400
Invested Capital	$40,500	$3,000	$22,800
EVA	$648.00	$624.00	$(1,176.00)

We use both the ROI and EVA to compare the financial performance of each division. The South Island division has a ROI of 9.6% and EVA of $648. The ROI of the South Island division is below the company’s target of 10%. However, this division has a positive EVA meaning that there is added value to the divisions invested capital. However, the North Island division outperforms the South Island division in terms of ROI, but has a slightly smaller EVA of $624.

The Fishing Fleet has the worst financial performance of the three divisions of the company. Its ROI is 2.84% which is way below the company’s target of 10%, and it has a negative EVA, which indicated lose of value on the capital invested in the division.   

Comparison of three company divisions’ financial performance

In the EVA calculations, the company should use the gross book value of assets rather than the net book value of assets. Using the net book value of assets with give the oldest division, South Island, an advantage over the others divisions because this method makes false assumptions about the earning power of South Island, given its assets have been fully depreciated. Using the gross book value of assets unmasks the real earning power of the oldest division (Hansen & Mowen, 2007). In this case, Fishing Fleet division seems to have the lowest EVA even though the replacement of all its fleets may have positive long-term effects for the company.

The key limitation for evaluating performance of investment centers using ROI is that division managers may be motivated to turn down projects that don’t increase ROI even though investing in these projects may earn a return better that the required rate of return of the company in the long run. The motivation for divisional managers to turn these projects down is because the investment reduces the division’s overall ROI in the short run which makes the division appear to be performing poorly.

Residue Income (RI) eliminates the limitation of ROI of goal incongruence (Langfield-Smith, Thorne & Hilton, 2005). Residual Income motivates divisional managers to make profitable investments because any investments that earns more than the required rate of return increase the RI, therefore increases the divisions’ performance evaluations.

• The minimum transfer price that the Motherboard division wold be prepared to accept is calculated as (Garrison, Noreen & Brewer, 2012): 

The Motherboard Division has a production capacity of 300,000 units but is only able to sell 150,000 units externally due to the recession. Hence, the division has idle capacity of 150,000, therefore there is no opportunity cost, in terms of external sales, when it takes on the Computer Division’s business.

• The maximum transfer price that the Computer Division would be prepared to accept, should not exceed what the division is currently paying to the external supplier for an equivalent motherboard.

Thus,

• The internal transfer should take place because the minimum transfer price acceptable to the Motherboard Division is below the maximum transfer price acceptable to theComputer D Assuming the managers understand the value of the internal transfer within their divisions, they should be able to agree on a transfer price within the range;
• If the Motherboard Division was in Australia and the Computer Division was in India, the objectives of transfer pricing will change because the goods being transferred cross international borders. When international transfers are involved, the company will focus on charging a transfer price that reduces its total tax bill or that strengthens a foreign subsidiary (Garrisonet al., 2012). In this case domestic objectives become secondary to the company’s international focus on minimizing foreign exchange risks, duties and taxes.

(i) Of the three types of transfer price, a negotiated price is most likely to elicit desirable management behaviour in an organization. This approach encourages decentralization within the company by ensuring divisions are autonomous (Garrison et al., 2012). Moreover, the managers of the divisions involved become more conscious of cost control because they are exposed to to much more information about the potential costs and benefits of the transfer than others in the organization. It promotes cooperation between managers of various divisions, hence ensuring the company always takes advantage of inter transfers that result in higher overall profits for the entire company (Langfield-Smith et al., 2005). Finally, the negotiate transfer prices provide the basis of a more realistic performance evaluation for divisions.

Role of negotiated transfer prices and activity-based costing in transfer pricing

(ii) The role of activity-based costing in transfer pricing.

Activity-based costing focus on the allocation of overhead costs, which are substantial in determining the appropriate transfer price when good and services are being transferred between divisions (Langfield-Smith et al., 2005).

• The features of the performance-related pay system that are causing problemsinclude:

The bonus pay is based on the work team performance which should exceed the team performance targets. This will potentially create a free rider effect where the lazier members of the team benefit from the hard work of the more dedicated team members. Also, only three of the four work teams are participating in the new pay scheme, yet the four work teams are interdependent in the production process. There is potential for teams to sabotage to output of the other team so that they can benefit. The exclusion of one team is also a problem because the team might not be motivated because they have cannot share in the performance bonus, yet they are contributing to the achievement of the targets by other work teams. The performance related pay system has created friction among the teams. The manager is also not fully aware of the team dynamics and how the scramble for the reward is affecting the production process.  

• The three performance measures are appropriate for assessing performance and awarding bonuses. The performance measures for the new system are based on targets for cycle time, material usage and production output. These targets should be specific, measurable, attainable, realistic and timely, so that there is a clear determination of the wining team. However, these measures not sufficient since the work of two of the work teams is organized sequentially. Therefore, other performance financial measures such as low production cost and increased profits for the plant should be considered to encourage collaboration between the teams.
• The company should consider a combination of both individual and group incentives in order to motivate individual behaviour and ensure that employees work together, where needed, to promote team targets. Individual performance measure could be performance appraisal and quantity of individual output. In addition to the three performance measure for the work teams, the company can include combined group measures such as cost reduction and operating income increased.

The individual performance-related pay scheme gives each employee control over their rewards (Langfield-Smith et al., 2005), which do not depend on the effort of other members of the work team. This will address Peter’s concern of his team member not working to capacity and having the same reward as the other hardworking team members. Similarly, the group performance-related pay scheme dynamic will encourage teamwork where as each individual works to improve their output, they will also be conscious of their group output, hence the issue of one work team producing faulty products so as to sabotage the success of the other work team, will not arise.

More importantly, the manager should give careful considerations to the dimensions of team performance in the plant. He should be willing to constantly review the performance measurement system, based on the employees concerns, so as to overcome the arising problems.

Conclusion

In the first question, the financial measures used to evaluate the performance of the company’s division were return on investment (ROI), economic value added (EVA) and residue income (RI). We conclude that divisional performance evaluation based on ROI encourages goal incongruence where divisional managers are motivated to turn down investment projects because they lower their division’s ROI even though they may be of benefit to the whole company.

In the second question, we conclude that negotiated transfer price is most likely to elicit desirable management behaviour in an organization, since It promotes cooperation between managers of various divisions, and provide the basis of a more realistic performance evaluation for divisions. More so, transfer pricing highly rely on activity-based costing.

Lastly, there are various incentives and reward that companies incorporate to their chosen performance-related pay scheme. We conclude that there should be extensive consultation between managers and employees, before a company adopts any pay scheme to avoid problems in the future.  

References

Garrison, R., Noreen, E., & Brewer, P. (2012). Managerial Accounting (14th ed.). New York, NY: McGraw-Hill/Irwin.

Hansen, D., & Mowen, M. (2007). Managerial Accounting (8th ed.). Mason, OH: Thomson/South-Western.     

Langfield-Smith, K., Thorne, H., & Hilton, R. (2005). Management accounting. Sydney: McGraw-Hill.