CPA review BEC Module 45Performance Measures and Management Techniques

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Organization of Module 45

A. Financial and Nonfinancial Performance

B. Balanced Scorecard and Performance Measures

C. Value Based Management

D. Choosing Among Different Performance Measures

E. Traditional Financial Statement Analysis

F. Benchmarking and Best Practices

G. Quality Control Principles

H. Cost of Quality

I. Business Process Management

J. Project Management

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Concept of Performance Measures and Management Techniques

• Financial and nonfinancial measures are used for a variety of purposes including: resource allocation, incentive compensation, divisional and business unit evaluation, budgeting and planning.

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Internalbusiness

processes

Customers

Learningand growth

The Balanced ScorecardManagement translates its strategy into performance measures that employees

understand and influence.

Management translates its strategy into performance measures that employees

understand and influence.

Performancemeasures

Financial

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The Balanced Scorecard: FromStrategy to Performance Measures

FinancialHas our financial

performance improved?

CustomerDo customers recognize that

we are delivering more value?

Internal Business ProcessesHave we improved key business processes so that we can deliver

more value to customers?

Learning and GrowthAre we maintaining our ability

to change and improve?

What are ourfinancial goals?

What customers dowe want to serve andhow are we going towin and retain them?

What internal busi-ness processes arecritical to providing

value to customers?

Vision and

Strategy

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The Balanced Scorecard: Non-Financial Measures

The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons:

Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance.

Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance.

Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers.

Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers.

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Understanding Return On Investment

ROI = Net operating income

Average operating assets

Margin = Net operating income

Sales

Turnover = SalesAverage operating assets

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Increasing ROI – An ExampleRegal Company reports the following:

Net operating income $ 30,000

Average operating assets $ 200,000

Sales $ 500,000

Operating expenses $ 470,000

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$30,000 $500,000

× $500,000$200,000

ROI =

6% 2.5 = 15%ROI =

ROI = Margin Turnover Net operating income Sales

Sales Average operating assets×ROI =

Increasing ROI – An Example

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Investing in Operating Assets to Increase SalesAssume that Regal's manager invests in a $30,000

piece of equipment that increases sales by $35,000, while increasing operating expenses by

$15,000.

Regal Company reports the following:

Net operating income $ 50,000

Average operating assets $ 230,000

Sales $ 535,000

Operating expenses $ 485,000

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Investing in Operating Assets to Increase Sales

$50,000 $535,000

× $535,000$230,000

ROI =

9.35% 2.33 = 21.8%ROI =

ROI increased from 15% to 21.8%.ROI increased from 15% to 21.8%.

ROI = Margin Turnover Net operating income Sales

Sales Average operating assets×ROI =

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Criticisms of ROI

Telling managers to increase ROI may not be enough..

A manager who takes over a business segment typically inherits many committed costs over which the manager has no control.

A manager who is evaluated based on ROI may

reject investment opportunities…

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Calculating Residual Income

Residual income

=Net

operating income

-Average

operating assets

Minimum

required rate of return

( )This computation differs from ROI.

ROI measures net operating income earned relative to the investment in average operating assets.

Residual income measures net operating income earned less the minimum required return on average operating

assets.

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Residual Income – An Example

Division A Division B

Average operating assets $1,000,000 $3,000,000

Net operating income $  200,000 $  450,000

Minimum required return: 12% × average operating assets    120,000    360,000

Residual income $   80,000 $   90,000

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Residual Income – An Example

Average operating assets (a)$1,000,000 $250,000 $1,250,000

Net operating income (b)$  200,000 $ 40,000 $  240,000

Minimum required return: 12% × (a)    120,000   30,000    150,000

Residual income $   80,000 $ 10,000 $   90,000

PresentNew

Project Overall

Average operating assets (a)$1,000,000 $250,000 $1,250,000

Net operating income (b)$200,000 $40,000 $240,000

ROI (b) ÷ (a) 20.0% 16.0% 19.2%

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GPM = Gross Profit/Net Sales

GPM = $986,000/$3,074,000 = 32.1%

Gross (Profit) Margin

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OPM = EBIT/Net Sales

Your book hasOPM = operating income/Net Sales

OPM = $418,000/$3,074,000 = 13.6%

Operating Profit Margin

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ROA = Earnings Available to Common Stockholders Total Assets

You book has

ROA = Net income after interest and taxes average total sales

ROA = $221,000/$3,597,000 = 6.1%

Return on Total Assets (ROA)

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ROE = $221,000/$1,754,000 = 12.6%

ROE = Earnings Available to Common Stockholders

Total Equity

You book hasROE = Net income after interest and taxes

average common stockholders equity

Return on Equity (ROE)

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Current Ratio

Current ratio = total current assets

total current liabilities

Current ratio = $2,447,830 = 1.24

$1,968,662

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Quick ratio = Total Current Assets - Inventory

total current liabilities

Quick ratio = $2,447,830 - $300,459 = 1.09

$620,000

Quick Ratio

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Cash Ratio

Cash ratio = Cash

total current liabilities

Cash ratio = $680,623 = 0.346

$1,968,662

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Debt to Total Assets Ratio =

Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

Debt to Total Assets Ratio

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Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5

Times Interest Earned Ratio

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A constraint (also called a bottleneck) is anything that prevents you from getting more of what you want.

The Theory of Constraints is based on the observation that effectively managing the constraint is the key to success.

The constraint in a system is determinedThe constraint in a system is determinedby the step that has theby the step that has the smallest capacitysmallest capacity.

Theory of Constraints

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4. Recognize that the weakest linkis no longer so.

4. Recognize that the weakest linkis no longer so.

1. Identify the weakest link.1. Identify the weakest link.

2. Allow the weakest link to set the tempo.

2. Allow the weakest link to set the tempo.

3. Focus on improving

the weakest link.

3. Focus on improving

the weakest link.

Only actions that strengthen the weakest link in the “chain” improve the process.

Theory of Constraints

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Six SigmaA process improvement method relying on customer feedback and fact-based data gathering and analysis

techniques to drive process improvement.

A process improvement method relying on customer feedback and fact-based data gathering and analysis

techniques to drive process improvement.

Refers to a process that generates no more

than 3.4 defects per million opportunities.

Refers to a process that generates no more

than 3.4 defects per million opportunities.

Sometimes associated

with the term zero defects.

Sometimes associated

with the term zero defects.

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Six Sigma

Stage GoalsDefine ● Establish the scope and purpose of the project.

● Diagram the flow of the current process.● Establish the customer's requirements for the process.

Measure ● Gather baseline performance data related to the existing process.● Narrow the scope of the project to the most important problems.

Analyze ● Identify the root cause(s) of the problems identified in the Measure stage.

Improve ● Develop, evaluate, and implement solutions to the problems.

Control ● Ensure that problems remain fixed.● Seek to improve the new methods over time.

The Six Sigma DMAIC Framework