This weeks’ discussion focused on why companies measure performance and how it is done. Performance measurement is an integral part of performance improvement in the long run and therefore its importance cannot be downplayed. Ideally, performance measurement enables the organization to identify its weaknesses and strengths wherein the strengths can be leveraged to gain value and the weaknesses can be contained or managed as is necessary. Performance management is vital for competitiveness and provides the organization with performance data relative to the competition and gives a detailed picture of whether the company is succeeding or failing.
Traditional Vs New Methods of Performance Measurement
Historically, company performance has solely be measured using financial statements. However, simply looking at values from the statements does not provide sufficient information to make judicious projections about the foreseeable performance of the organization. Due to this weakness, newer and better methods of measuring performance have been developed to replace these conventional methods. These methods of performance management focus on value-addition with respect to the underlying costs and benefits. For example, the cost of capital which is the cost associated with the use of investor funding is a key consideration in the novel methods compared to the traditional measures. The most widely applied of the new methods are EVA and MVA techniques which will be enumerated in the subsequent section with examples. Before this, it is, however, very important to evaluate the characteristics of performance measures.
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Characteristics of Measures Used To Measure Company Performance
The measure should have low sensitivity to the accounting method employed by the organization
The measure should take into account the current decisions relative to anticipated future results
The measure should take into consideration the risks underlying any major company decisions
The measure should NOT take into account factors outside the control of the organization such as economic downturn and exchange rate fluctuations.
Economic Profit Vs Accounting Profit In Performance Measurement
While traditional measures focused on accounting profits, that is, the deviation in revenue and cost, the novel techniques focus on economic profits which encompass the cost of capital and opportunity cost.
Example
An investor turned down an employment offer of $50,000 and invested $1.5 million in a startup company during a given year. At the end of the year, he earns $2 million.
Accounting profit = returns- initial investment = (2,000,000-1,500,000) = $500,000
Economic profit = (2,000,000-1,500,000-50,000) = $450,000. This is on account of the opportunity cost foregone.
Market Value Added (MVA)
MVA does not tell how the firm is performing rather it explores the changes in the market value of the firm over time. It is expressed in dollars. The higher the MVA the better the operational capability of the firm
MVA = market value – initial capital investment
Example
If the current market value of ABC Company Limited is $4 million from an initial startup investment of $2 million. Then,
MVA= (4,000,000-2,000,000) = $2,000,000
Economic Value Added (EVA)
It measures the economic profit of the firm. It is based on residual wealth obtained after subtracting the cost of capital from the profit.
EVA = Net Operating Profit after Taxes − (Capital x Cost of Capital)
Where the Net Operating Profit after Taxes = Operating Income x (1 − Tax Rate)
Or
EVA = (Return on Capital − Cost of Capital) x Capital
Example
TTT Company limited in the year ending 2020 reported a net profit of $200,000. It invested capital worth $2 million at an estimated cost of 8.5%.
EVA= 200,000 - (2,000,000 x 8.5%) = $30,000.
