Question

Financial performance measures are essential tools used by managers to evaluate the financial health of their organization. They provide an overview of the company's financial performance, help identify areas of improvement, and support decision making. CarniTrin is a manufacturer of Carnival costumes in a highly competitive market. The company's management team is seeking guidance on the use of financial performance measures to identify the key drivers of the company's financial performance and develop a strategy to improve it.

The following data relate to the company for the year 2019:
• In its clothing division, the company has $4,000,000 invested in assets. After-tax operating income from sales of clothing in 2019 is $700,000. Income for the clothing division has grown steadily over the last few years.
• The cosmetics division has $12,000,000 invested in assets and an after-tax operating income in 2019 of $1,700,000.
• The weighted-average cost of capital for CarniTrin is 10% and the 2018’s after-tax return on investment for each division was 15%.
• The general manager of CarniTrin has asserted that in future, managers should have their compensation structure aligned with their performance measures with no fixed salaries. However, the general manager has told the manager of each division that the better division in 2019will get a bonus.
Question: Return on investment (ROI), residual income (RI), and economic-value added (EVA) are performance measures for subunit managers. Discuss the relative merit of these performance measures?

Answer 1

Financial performance measures like ROI, RI, and EVA are tools for evaluating a company's financial health. While ROI is common and easily understood, it may promote short-term views. RI and EVA encourage long-term profitability but need to be aligned with long-term strategic goals to avoid overemphasis on short-term gains.

Step-by-step explanation:

Financial Performance Measures

Return on investment (ROI), residual income (RI), and economic value added (EVA) are financial performance measures used to assess the health of a company's finances. ROI is computed by dividing net income by the average invested capital and is expressed as a percentage. It indicates how effectively the company is using its capital to generate profits. RI is the operating income earned beyond the minimum required return on its operating assets; it is calculated by subtracting the cost of capital from the operating income. This helps in determining whether the division is covering its cost of capital and contributing to overall profitability. EVA is similar to RI but adjusts for taxes and includes adjustments for the company's accounting practices.

The merits of these measures vary. ROI is widely used and understood but can lead to short-term thinking since managers may be hesitant to make long-term investments that could initially lower ROI. RI encourages the pursuit of any project that exceeds the cost of capital, promoting more profitable investments for the long-term growth of the company. EVA takes into account the full cost of capital, which includes the cost of equity, making it a more comprehensive performance measure.

Managers' compensation being tied to these financial measures can lead to alignment of managerial and shareholder interests, as long as these measures are designed to encourage long-term, value-creating activities. However, if not carefully structured, this could motivate managers to focus excessively on short-term financial performance at the expense of long-term strategic objectives.