C.3. Performance Metrics

Question 1

What is goal congruence in performance measurement?

Answer 1

It means aligning the goals of individual managers with the goals of the whole organization.

Goal congruence ensures that managers’ actions benefit the overall company as well as their own departments.

Question 2

Why is the balance between short-term and long-term focus important in performance measurement?

Answer 2

Too much emphasis on short-term results can lead to neglect of activities vital for long-term success.

An example is a pharmaceutical company cutting R&D to improve short-term profits, risking future revenue sources.

Question 3

What are cost drivers, and why are they important in performance measurement?

Answer 3

They are anything that cause costs to be incurred each time they occur. If a performance measure involves costs, a company needs to evaluate the processes that drive those costs, not just compare the actual costs with the budgeted costs. Just looking at a variance in a particular cost without considering the causes, or drivers, of the cost will not help to identify the cause of an unfavorable variance.

Focusing on cost drivers helps identify causes of unfavorable variances in costs.

Question 4

What are revenue drivers, and why are they important in performance measurement?

Answer 4

They are anything that create revenues, such as sales volume and marketing activities. If a performance measure involves revenues, a company needs to evaluate the activities that drive those revenues, not just compare actual revenues with budgeted revenues.

Focusing on revenue drivers helps identify causes of unfavorable variances in revenues.

Question 5

Other than the contribution income statement, what are the two primary methods of measuring the financial success of a segment and the performance of its manager?

Answer 5

• Return on Investment (ROI)
• Residual Income (RI)

Candidates should understand what each is, how each is calculated, interpreted, and how they differ.

Question 6

Return on Investment (ROI) can be used to evaluate a proposed capital investment project (using projected figures) as well as to evaluate the performance of a business unit (using historical figures).

How is ROI calculated and interpreted for a project under consideration?

Answer 6

ROI = Annual Projected Project Income ÷ Planned Project Assets

If the projected ROI of the project is higher than the required rate of return, the project is acceptable. If the projected ROI of the project is lower than the required rate of return, the project is not acceptable.

For performance measurement, “Income” means operating income unless otherwise stated.

Question 7

What is another name for the required rate of return as used in performance evaluation of a business unit and consideration of a capital investment project?

Answer 7

The hurdle rate

Both terms describe the minimum rate of return a business unit or project must earn to justify the investment of resources.

Question 8

What is the weighted average cost of capital?

(WACC)

Answer 8

The total cost of long-term funds (long-term debt and equity) divided by the fair value of the long-term funds.

WACC is expressed as a percentage rate and often serves as the company’s minimum required rate of return.

Question 9

What is a disadvantage of using ROI for performance measurement?

Answer 9

It measures return as a percentage rather than as a monetary amount.

This can lead to rejection of a profitable project if it would lower the division’s overall ROI, even if its ROI is higher than the required rate of return and thus, it should be acceptable.

Question 10

What is residual income?

(RI)

Answer 10

The amount of annual monetary return in excess of a targeted monetary amount of return on a project’s or unit’s assets.

RI measures the operating income before taxes earned after covering the required charge for invested funds.

Question 11

What is the formula for Residual Income (RI) of a business unit?

Answer 11

Residual Income = Annual Operating Income of the Business Unit − (Assets of the business unit × Required Rate of Return)

Assets of the business unit × Required Rate of Return is the targeted monetary amount of return on the unit’s assets.

The targeted monetary amount of return is an imputed cost representing the opportunity cost of other potential returns forgone by investing in the business unit’s assets.

Question 12

How is the required rate of return that is used in the calculation of Residual Income determined?

Answer 12

It is set by management and may be the company’s weighted average cost of capital or another rate.

If the required rate of return is not provided in an exam question, use the company’s weighted average cost of capital if available.

Question 13

True or False:

Residual Income can be negative.

Answer 13

True

Negative residual income occurs when the actual profits are less than the targeted monetary return set for the business unit.

Question 14

What are the benefits of using Residual Income as a performance measure?

Answer 14

• When used in preference to ROI, a project that is beneficial to the company is more likely to be selected, even if its ROI is lower than the unit’s current ROI.
• Allows adjustment of required rates of return for differences in risk.
• Enables different investment charges for different classes of assets.

Question 15

What are the limitations of Residual Income as a performance measure?

Answer 15

• RI focuses on the amount of return, which may be small in comparison to the amount invested and not worth the effort.
• Difficult to compare performance of units of different sizes.
• Small changes in the required rate of return have a greater effect on larger units than on smaller ones.
• Subject to distortion by accounting policies.

Question 16

How do accounting policies affect ROI and RI?

Answer 16

Through revenue and expense recognition and asset measurement policies used, impacting comparability among divisions if different policies are used.

Key areas include inventory cost flow assumptions, depreciation methods used, asset capitalization policies, use of full costing, and disposition of manufacturing variances.

Question 17

What is the impact of using FIFO on ROI?

Answer 17

In a period of rising prices, using FIFO usually results in higher ROI than with any of the other cost flow assumptions because cost of goods sold is lower, increasing operating income.

Question 18

What is the impact of using LIFO on ROI?

Answer 18

During a period of rising prices, using LIFO usually results in lower ROI than with any of the other cost flow assumptions because cost of goods sold is higher, decreasing operating income.

Question 19

Why is it important for divisions to use the same depreciation method?

Answer 19

To ensure comparability of ROI and RI among divisions, as different methods can lead to different asset values and operating incomes.

Question 20

What is the effect of asset capitalization policy on ROI and RI?

Answer 20

The policy affects whether a purchased item is expensed or capitalized, impacting operating income and comparability among divisions.

A consistent policy across divisions is necessary for fair comparison.

Question 21

How does the use of full costing affect ROI and RI?

Answer 21

Full costing causes operating income, and thus ROI and RI, to rise when inventory levels rise and fall when inventory levels fall.

Management’s review of individual divisions’ operating results should include a review of each division’s inventory levels and the amount of change in them, so that each division’s reported operating income can be properly interpreted.

Question 22

What is the effect of the disposition of manufacturing variances on financial statements?

Answer 22

It can affect operating income and inventories, depending on whether the variances are closed to cost of goods sold or prorated among inventories and COGS.

Since it affects operating income, it also affects ROI and RI.

Question 23

What are some other factors that can affect the measurement of operating income and ROI/RI?

Answer 23

• Nonrecurring items
• Income taxes
• Foreign exchange
• Joint asset sharing

Question 24

What factors can cause distortions in the performance of subsidiaries operating in different countries?

Answer 24

• Economic conditions such as inflation and recession
• Political, social, and cultural environments
• Currency exchange rates and laws
• Legal and regulatory requirements
• International trade regulations
• Availability and costs of resources
• Infrastructure differences

These factors can affect performance measures like ROI and RI, necessitating adjustments when comparing subsidiaries.

Question 25

What is the **key difference** between Return on Investment (ROI) and Residual Income (RI)?

Answer 25

* **ROI** focuses on the rate of return * **RI** focuses on the absolute amount of return ## Footnote This difference can influence managerial decisions on investment acceptance or rejection.

Question 26

What is a **balanced scorecard**?

Answer 26

A **performance** management tool that focuses on both financial and non-financial measures. ## Footnote A balanced scorecard helps organizations align business activities to the vision and strategy of the organization by monitoring performance against strategic goals.

Question 27

How is the Balanced Scorecard used?

Answer 27

To manage strategic performance by transforming an organization's strategic plan into **actionable objectives**. ## Footnote It includes both financial and non-financial measures to evaluate contributions to company goals.

Question 28

What are the **four perspectives** of the Balanced Scorecard?

Answer 28

* Financial * Customer * Internal Process * Organizational Capacity/Learning and Growth ## Footnote Each perspective supports the achievement of the objective in the next level above it.

Question 29

What does the Financial perspective of the Balanced Scorecard focus on?

Answer 29

The organization’s financial objectives and tracking financial success and shareholder value. ## Footnote Common measures include operating income, revenue growth, and ROI.

Question 30

What is a **critical success factor** (CSF) in the context of a Balanced Scorecard?

Answer 30

A specific action necessary for achieving organizational goals and maintaining competitive advantage. ## Footnote CSFs have a direct impact on efficiency, effectiveness, and viability.

Question 31

What is a **strategy map** in the context of a Balanced Scorecard?

Answer 31

A tool that links the four perspectives of the Balanced Scorecard, showing how non-financial measures lead to financial performance. ## Footnote It helps employees see how their work is connected to corporate goals.

Question 32

What is the role of senior management in implementing a Balanced Scorecard?

Answer 32

To support the program and ensure alignment with the company's goals. ## Footnote Support from senior management and the board of directors is crucial for successful implementation.

Question 33

What is the **primary purpose** of using a balanced scorecard?

Answer 33

To encourage managers to focus on elements that lead to **long-term success** instead of short-term financial performance.

Question 34

# True or False: Installing balanced scorecard software means the balanced scorecard has been implemented.

Answer 34

False ## Footnote * Senior management and the board of directors must support the program. * The board of directors should also have balanced scorecard goals, to create support at the very top of the organization. * The way management communicates the role, use, and benefits of the program to employees is one of the most important factors in successful implementation. * Each business unit and division should be involved in developing its own scorecard based on the company’s objectives and the action the unit needs to take to contribute to those objectives.

Question 35

What is a **key limitation** of using a balanced scorecard for performance measurement?

Answer 35

It is difficult to use scorecards for comparisons across business units because each business unit has its individualized scorecard.

Question 36

What is **customer profitability analysis**?

Answer 36

The evaluation of the profitability of an individual customer or a group of customers to use their customers' costs-to-serve in making decisions.

Question 37

What is the **80-20 rule** in customer profitability analysis?

Answer 37

80% of profits usually come from 20% of a company’s customers.

Question 38

What should be considered when deciding to drop a customer or product?

Answer 38

Avoidable and unavoidable costs need to be identified in making a decision to drop a customer or discontinue a product. Only the operating profit at the customer level or product level, including relevant revenues and costs should be considered. ## Footnote * Avoidable costs are costs that can be avoided if a particular option is selected. * Unavoidable costs are costs that will not be avoided regardless of which course of action is taken. * Relevant revenues and relevant costs are those expected future revenues and costs that differ among alternatives.

Question 39

What is the benefit of linking employee bonuses to balanced scorecard results?

Answer 39

It aligns employee interests with the goals of the corporation and maximizes the balanced scorecard’s use and effectiveness.

Question 40

What is the significance of non-financial indicators in a balanced scorecard?

Answer 40

They should lead to long-term financial performance improvements if properly selected.

Question 41

What is a potential issue with non-financial data in balanced scorecards?

Answer 41

Non-financial data are not subject to control or audit, making their reliability questionable.

Question 42

After managers ask employees for suggestions with respect to a balanced scorecard program, why should they then be willing to listen to criticism from employees and to make changes?

Answer 42

It is essential for employees to feel that management takes their ideas seriously, responds to them, and rewards useful ideas. If employees feel that their input is ignored, they may conclude that the program is a wasted initiative and disregard it.