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Financial Management summary
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This summary includes class notes of trainings given in IBO semester (Year 3, Quarter 2), and the 4 chapters from the book 9449.
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Financial Management Y3Q2 SummaryContents
Chapter 23 Horngren – Performance Measurement, Compensation, and Multinational
Considerations ........................................................................................................................................ 1
Chapter 5 Horngren – Activity-based costing and activity-based management .................................. 11
Chapter 13 – Strategy, Balanced Scorecard, and Strategic Profitability Analysis ................................. 18
Chapter 22 – Management control systems, transfer pricing, and multinational considerations ....... 23
Chapter 23 Horngren – Performance Measurement, Compensation,
and Multinational Considerations
Financial and nonfinancial performance measures
There are several measures for performance, e.g.:
- Financial perspective: stock price, net income, return on sales, return on
investment, and economic value added.
- Customer perspective: market share in different geographic locations, customer
satisfaction, and average number of repeat visits.
- Internal-business-process perspective: for a hotel this could be quality of
restaurant experience, number of new services provided to customers, time taken
to plan and build new hotels.
- Learning-and-growth perspective: employee education and skill levels, employee
satisfaction, employee turnover, etc.
This chapter will focus on organization subunits’ most widely used performance measures
that cover an intermediate-to-long time horizon. These are internal financial measures
based on accounting number routinely reported by organizations. Designing accounting-
based performance measures requires several steps:
1. Choose performance measures that align with top management’s financial goals.
2. Choose the details of each performance measure in step 1.
3. Choose a target level of performance and feedback mechanism for each
performance measure in step 1.
Accounting-based measures for business units
The main weakness of comparing operating incomes alone is that differences in the size
of the investment in each subsidiary are ignored. Investment = the resources or assets
used to generate income.
➔ The real question is whether a division generates sufficient operating income
relative to the investment made to earn it.
There are three approaches to measuring performance including a measure of investment:
1. Return on investment (ROI)
2. Residual income (RI)
3. Economic value added (EVA)
➔ Note: Return on sales is not an approach because it does not measure investment.
Return on investment (ROI)
𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐼 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Can also be read as income / total assets if there is no investment given
1 Y3 IBO – Suzanne Glas
,ROI is popular for 2 reasons:
1. It blends all the ingredients of profitability (revenue, costs, investment) into a
single %
2. It can be compared with the rate of return on opportunities elsewhere (inside or
outside the company)
Managers usually use the term ‘ROI’ when evaluating the performance of an organization’s
subunit and the term ‘accrual accounting rate of return’ when using an ROI measure to
evaluate a project.
The highest % of ROI is better, then the use of assets is most efficient.
ROI can be increased by
- increasing revenues
- decreasing costs
- decreasing investment (decrease assets)
Also written as…
Reducing the investment base involves decreasing idle cash, managing credit judiciously,
determining proper inventory levels, and spending carefully on long-term assets.
2 Y3 IBO – Suzanne Glas
, Advantages ROI: easy to calculate and easy to understand. It combines revenue, cost and
investment into a single number, so that managers can clearly see what can be changed
to increase returns.
Limitations ROI: Managers who are evaluated based on ROI have incentives to reject
investments with ROIs below their division's current average ROI, even when the
investments have positive NPVs.
Residual income
= an accounting measure of income minus a dollar amount for required return on an
accounting measure of investment (required rate of return = RRR).
𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 ∗ 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)
RRR * investment is the imputed cost of the investment.
Imputed cost of investment = a cost recognized in particular situations but not recorded
in financial accounting systems because it is an opportunity cost.
➔ The higher the RI, the better. It means that with a high RI you earn a higher income
after covering the required rate of return on investment
Some companies favour the RI measure, because managers will concentrate on
maximizing an absolute amount (such as dollars or RI) rather than a percentage (such as
ROI).
The objective of maximizing RI means that as long as a subunit earns a return in excess
of the required return for investments, that subunit should continue to invest.
The objective of maximizing ROI may induce managers of highly profitable subunits to
reject projects that, from the viewpoint of the company as a whole, should be accepted.
3 Y3 IBO – Suzanne Glas
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