Welcome to Strategic Performance Measurement!
Hello there! Welcome to one of the most important parts of your APM journey. In this chapter, we are looking at Strategic performance measures in the private sector. In the private sector, the main goal is usually simple: maximize shareholder wealth (making the owners rich!). But how do we actually measure if a company is doing that? Is profit enough? (Spoiler alert: Usually, it isn't!)
Don't worry if some of these terms sound like "accounting speak" right now. We are going to break them down into everyday ideas so you can walk into your exam with confidence.
1. The Goal: Shareholder Wealth Maximization
In a private company, the "bosses" are the shareholders. They give the company money (capital) and expect a good return back. If the company performs well, the share price goes up and dividends are paid. This is Shareholder Wealth Maximization.
Why Profit Isn't Everything
You might think, "If the company makes a big profit, isn't that enough?" Not necessarily!
1. Profit can be manipulated: Accounting rules (like how we calculate depreciation) can change the profit figure without changing the actual health of the business.
2. Profit ignores risk: A company could make a high profit by taking huge, dangerous risks.
3. Profit ignores the cost of capital: If you make \( \$10,000 \) profit but it cost you \( \$15,000 \) in interest and bank fees to get there, you've actually lost value!
Quick Review: Strategy is the long-term plan. Performance measures are the "yardsticks" we use to see if the plan is working. In the private sector, our yardsticks must focus on Value.
2. Traditional Measures: ROI and RI
To see if a manager is using the company’s money wisely, we often use two classic measures: Return on Investment (ROI) and Residual Income (RI).
Return on Investment (ROI)
Think of ROI as a percentage. If you put \( \$100 \) in a savings account and get \( \$5 \) back, your "ROI" is \( 5\% \).
Formula: \( \text{ROI} = \frac{\text{Controllable Profit}}{\text{Controllable Capital Employed}} \times 100 \)
The Problem with ROI: It can lead to "dysfunctional behavior." A manager might reject a project that is good for the company just because it slightly lowers their personal ROI percentage. We call this sub-optimization.
Residual Income (RI)
Instead of a percentage, RI gives us a dollar amount. It asks: "How much profit is left after we pay for the cost of the capital we used?"
Formula: \( \text{RI} = \text{Controllable Profit} - (\text{Capital Employed} \times \text{Cost of Capital %}) \)
Analogy: Imagine you borrow \( \$100 \) from your friend at \( 10\% \) interest to start a small business. At the end of the month, you made \( \$15 \) profit.
Your interest cost is \( \$10 \).\n
Your Residual Income is \( \$15 - \$10 = \$5 \).
Because the result is positive, you created value!
Key Takeaway: RI is generally better than ROI because it encourages managers to take any project that earns more than the cost of capital.
3. The "Pro" Measure: Economic Value Added (EVA™)
EVA is a specific type of Residual Income. It was developed by a firm called Stern Stewart & Co. It is very popular in APM because it tries to fix the "lies" that traditional accounting tells us.
The Core Idea: A company is only really profitable if it earns enough to cover both operating costs AND the cost of capital. EVA adjusts the accounting profit to turn it into Economic Profit.
The EVA Formula
\( \text{EVA} = \text{NOPAT} - (\text{Capital Employed} \times \text{WACC}) \)
Where:
• NOPAT: Net Operating Profit After Tax (but with adjustments!).
• WACC: Weighted Average Cost of Capital (the average "interest rate" the company pays for its funding).
• Capital Employed: The total money invested in the business (at the start of the year).
Common EVA Adjustments
Accounting rules often treat long-term investments as "expenses." EVA says "No, that's an investment in the future!" Here are the common tweaks:
1. Research & Development (R&D): In accounting, we usually expense this. In EVA, we add it back to profit and add it to capital employed.
2. Non-cash expenses (e.g., Provisions): Add these back to profit.
3. Operating Leases: These are treated like debt in EVA calculations.
4. Goodwill written off: Add this back to capital employed.
Did you know? Using EVA encourages managers to think like owners. Because R&D is added back to profit, managers won't be tempted to cut R&D just to make this year's bonus look better!
Quick Review: If EVA is positive, the company is creating wealth. If it is negative, they are destroying shareholder value, even if the "accounting profit" looks okay.
4. Short-termism: The Silent Strategy Killer
Short-termism is when managers focus on making the next three months look great, even if it hurts the company in three years.
Example: A manager stops training staff or stops maintaining machinery to save money today. Profit goes up now, but the business fails later.
How to fight Short-termism:
• Use EVA: As we saw, EVA doesn't punish managers for investing in the future.
• Non-financial measures: Track things like customer satisfaction or staff morale. If these are dropping, you know the "good" profit figures are a lie.
• Reward systems: Give managers share options that they can only sell in 5 years. This forces them to care about the long-term share price.
5. Non-Financial Performance Indicators (NFPIs)
While money is the goal, financial measures are "lagging indicators." They tell you what happened in the past. To see the future, you need NFPIs (Leading indicators).
Key Areas for NFPIs:
1. Quality: Number of defects or returns.
2. Customer Satisfaction: Repeat buy rates or "Net Promoter Scores."
3. Efficiency/Productivity: How much output are we getting from our inputs?
4. Innovation: How many new products have we launched this year?
Analogy: Think of a car. The speedometer (Financial Measure) tells you how fast you are going right now. The fuel gauge (Non-Financial Measure) tells you if you are going to make it to your destination in the future.
6. Summary and Common Pitfalls
Common Mistakes to Avoid in the Exam:
• Don't just calculate: APM is about evaluation. If you calculate an ROI, explain what it means for the company's strategy.
• WACC vs. Interest: When calculating RI or EVA, always use the Weighted Average Cost of Capital, not just the bank's interest rate.
• Controllability: Only judge managers on things they can control. Don't blame a branch manager for high head-office costs!
Key Takeaways:
• Private sector focus = Shareholder Wealth.
• ROI is easy but can cause bad decisions (sub-optimization).
• RI is better for decision-making but uses "accounting" numbers.
• EVA is the best "economic" measure but can be complex to calculate due to adjustments.
• Non-financial measures are essential to prevent managers from "gaming" the system for short-term gains.
Don't worry if the EVA adjustments seem tricky at first. Practice the basic formula first, and the adjustments will start to feel like second nature!