Choosing the Details of the Performance Measures

Learning Objective 3 Analyze the key measurement choices in the design of each performance measure

It is not sufficient for a company to identify the set of performance measures it wishes to use. The company has to decide how to compute the measures. This includes deciding on the time frame over which the measures are computed, defining key terms such as investment, and agreeing on how to calculate the components of each performance measure.

Alternative Time Horizons

An important element in designing accounting-based performance measures is choosing the time horizon of the performance measures. The ROI, RI, EVA, and ROS calculations represent the results for a single period, 1 year in our example. Managers could take actions that cause short-run increases in these measures but that conflict with the long-run interest of the company. For example, managers might curtail research and development (R&D) and plant maintenance spending in the last 3 months of a fiscal year to achieve a target level of annual operating income. For this reason, many companies evaluate subunits on the basis of ROI, RI, EVA, and ROS over multiple years.

Another reason to evaluate subunits over multiple years is that the benefits of actions taken in the current period may not show up in short-run performance measures, such as the current year’s ROI or RI. For example, an investment in a new hotel may adversely affect ROI and RI in the short run but positively affect them in the long run.

A multiyear analysis highlights another advantage of the RI measure: The net present value of all cash flows over the life of an investment equals the net present value of the RIs.* This means that if managers use the net present value method to make investment decisions (as Chapter 22 advocates), then using a multiyear RI to evaluate managers’ performances achieves goal congruence.

A table shows net present values of cash flows and residual incomes

The table depicts cash flow, present value of 1 dollar discounted at 12 percent, present value, operating income, assets at start of year, capital charge, residual income, and present value of residual income for years 0 through 5. The details of the table are as follows:

1. Cash flow

2. Present value of 1 dollar discounted at 12 percent

3. Present value, cash flow times present value of 1 dollar discounted at 12 percent

4. Operating income

5. Assets at start of year

6. Capital charge, assets at start of year times 12 percent

7. Residual income, operating income minus capital charge

8. Present value of residual income, residual income times present value of 1 dollar discounted at 12 percent

9. Net present value: 140,716 dollars

Another way to motivate managers to take a long-run perspective is by compensating them on the basis of changes in the market price of the company’s stock because stock prices incorporate the expected future effects of a firm’s current decisions.