Strategic Management Accounting and Performance Measurement
Return on Investment (ROI)
ROI refers to a financial tool that is commonly used by managers and/or investors to analyze the rate at which their businesses investments or projects performed and as well in assisting them to make sound investment decisions. Effectiveness of these projects/investments is measured by computing the times it would take for the original returns to be recovered from the net returns. In such a situation, the net benefits are used to refer to the weighted average return accrued during the project’s lifetime (Kaplan, and Norton, 2004). The appropriate use of ROI can be achieved by ensuring that long-term performance, value of money, and cash flows are considered when computing the ROI.
The ROI is calculated by dividing the net operating income (income before taxes and interests) by the average operating assets (all productive assets). The advantages associated with using ROI include the simplicity associated with its computation, the consistency with various management systems, and uniformity in judging the effectiveness associated with effective utilization of company assets.
Nonetheless, ROI is subject to a number of limitations when using it as a performance measurement tool. First, ROI fails to consider the time value of money during the project period. The value of money earned today is not necessarily equal with the value earned tomorrow. Second, ROI does not account for project risks in addition to other financial uncertainties related to the project. Third, ROI overlooks long-term costs by favoring short-term savings and as such, investment projects can be overvalued. Finally yet importantly, ROI computation can lead to inconsistency given that there is more than one standard formula used during its computation. Residual Income
This managerial performance indicator is used to measure the net operating income that is accrued by an investment center over the minimum return needed from operating assets. It is used to measure the center of investment performance. Residual income measurement model puts much emphasis on the value of an organization’s securities by combining the present value of a company (accounting profits) and book value. The residual income is very advantageous managerial measure of performance because it enables managers to accept any project that earns more than the minimum rate. The formula for computing residual income is Operating income – (minimum rate of return x average operating assets) -
If the residual income is less than the minimum rate of return, then the residual income is less than zero and vice versa. The limitations associated with the use of residual income include the fact that residual income can encourage a short run orientation. Additionally, residual income is also an absolute measure and this makes it difficult to make direct comparisons when investments differ. Economic Value Added (EVA)
EVA refers to a measure of financial performance that is obtained by calculating residual wealth of a company by subtracting capital cost from the operating profit. The operating profit used for such purposes must be adjusted on a cash basis. EVA estimates the amount under which the earnings of a company fall short or exceed the minimum return rate for investment managers with comparable risks. EVA= after tax operating income- (actual percentage cost of capital * total capital employed) If the value of EVA is positive, then the company is creating wealth. The reverse is also true.
Limitations associated with EVA include the failure to take into account the company’s future prospects in addition to requiring many adjustments to information about the company. This calls for the need for more accuracy and simplicity of calculation, which can compromise the credibility associated with the results. Question Two
This refers to a management tool of...
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Kaplan, R. S., and Norton, D. P. 2004. Measuring the strategic readiness of intangible assets. Harvard Business Review, 82(2): 52-63.
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