Vital Importance for Making Effective Planning and Control Decisions - Essay Example

Decision Making for Capital Budgeting and Performance Evaluation Executive Summary Performance measures are to be regarded as the central components of management control systems in any progressive organization. Information on the performance of different functional areas of a firm is of vital importance for making effective planning and control decisions. In order to be effective both financial and non-financial measures must be able to motivate the managers and employees at various levels of the organization so that the organizational goals can be achieved. Performance evaluation and rewards are the major drivers for effectively motivating individuals in a firm. The management has the option of employing different techniques for evaluating the performance of individual project managers, each of which has its own characteristics. This paper makes a critical analysis of the performance evaluation technique adopted by Brand Neue Corporation and suggests that the project creating positive shareholder value based on Economic Value Added (EVA) calculation is to be accepted for providing overall greater bonus to the project manager. Introduction Organizations adopt both financial and non-financial metrics for evaluating the performance of senior managers. Many of the companies use performance measures such as operating income which rely mostly on financial information generated internally within the organization and are therefore are deficient in making the evaluation perfect. In order to overcome this problem firms have started combining both financial and non-financial measures in the form of balanced scorecards specifying different elements such as profitability measures, customer satisfaction measures, internal measures of efficiency, quality and time and innovation measures. The measures incorporate both long-term and short-term horizon in the evaluation. The internal financial measures are normally based on the accounting numbers routinely prepared and reported by the organization. The idea behind evaluating the performance of different projects is not only to judge the profitability of the projects but also to provide a meaningful basis for compensating and motivating the senior managers. The objective of this paper is to analyze the project performance appraisal techniques adopted by Brand Neue Corporation. This company has been working on three projects, the performance of which was under review. The company was using ROI technique for evaluating the performance of the projects based on which the performance of the project managers was assessed for compensating them. However the evaluation technique was changed to EVA, since the management was convinced that some of the project managers have been accepting or rejecting projects based on their current ROI status in relation to the bonus structure of the firm. One of the projects was in jeopardy as the project evaluation has not considered the cost of clean up to be incurred consequent upon the passing of an environmental legislation. The cleaning cost has made the project unviable. Therefore the management wants to have a relook at the different project performance evaluation techniques. This report will analyze the effectiveness of the capital budgeting and performance evaluation techniques adopted by Brand Neue such as Return on Investment (ROI), Residual Income (RI) and Economic Value Added (EVA) and recommend to the board of directors, the best technique for evaluating the performance of the managers. The report will also substantiate the recommendation of a particular technique and the likely issues the management has to consider in the process of evaluation. This paper is organized to present theoretical aspects of the evaluation techniques, comparison of the performance evaluation under different techniques and finally a recommendation on the technique that the management can adopt. Project Performance Evaluation Techniques The objective of performance evaluation systems is to provide the information feedback loop to the management to evaluate the efficiency and effectiveness of the corporate and business level strategies. The management makes use of different techniques of performance measurement as tools for evaluating the performance of subunits and these techniques also enable the board of directors to determine the bonus and compensation payable to senior managers and project executives. Through this the management is able to achieve effective management control systems and these control systems in turn promote effective management behavior. The managers are thus motivated to align their personal goals with those of the organization. The policy of the management of several companies today is to supplement traditional financial measures with non-financial metrics, as financial based measures are susceptible to manipulation by opting for changes in accounting policies like valuation of stocks or change in amortization policies. Another issue with financial measures is that they do not recognize the intellectual human capital associated with the activities. The finance measures also do not represent the qualitative aspects of performance like the customer satisfaction level in the case of service organizations. Yet the financial or accounting based measures are in favor with many of the organizations because of the simplicity and ease to use. Accounting-based Performance Measures In designing and implementing accounting based performance measures the management considers the way in which the measures help in achieving the overall organizational objectives. Usually the management has to adopt a six step process in designing the accounting based performance measures that takes into account the identification of variables congruent to the organization's financial goals, time horizon of performance measure, identification of the measures to be included in the measure, choosing a target against which the performance can be measured and determining the timing of feedback (Horngren, Foster and Datar). There are at least four accounting based performance measures that are used - Return on Investment, Residual Income, Economic Value Added and Return on Sales. This report takes ROI and EVA for review as the possible options for Brand Neue based on the nature of the projects being carried out by the company. Return on Investment Return on investment as a traditional measure of performance is criticized as having a single focus and short-term orientation for companies that would like to invest in newer markets and new technologies. Since return on investment concentrates on the short-term profitability to enhance the return on investment expectations of the shareholders, such a measure cannot be compatible to achieving the long-term objectives of improving the competitive ability of the company. Return on investment as a performance measure lacks in accuracy and neutrality with dominance of result over determinant measures with an emphasis on the short-term. This short-term view of profitability often overweighs the application of strategic planning and futuristic approach as there will be little appreciation of the links and relationships between key areas and aspects of an organization with the focus on enhancing the return on investment at any cost. This would lead to an overall lack of balance on the part of the managers of different projects. It is vitally important for the companies to concentrate on the right things and issues to be focused and this involves the right selection of performance metrics to ensure the achievement of the long-term objectives of the company. Measures such as customer satisfaction, market share and quality are arguably more important indicators of success and are therefore are fit to be the appropriate performance metrics for the project managers than profitability. In reality, customer satisfaction and market share are the main drivers of profitability and hence are lead measures while profit is only the result of such initiatives and is to be considered as a lag indicator (Fitzgerald, Lin and Johnston). Since these features have become more important, requirements to augment the competitive ability of projects they must be incorporated into the performance measurement systems than the traditional measure of return on investment. Apart from these considerations, the ROI cannot take into account other salient aspects of the project. For instance it cannot take cognizance of other issues affecting the project performance like the impact of environmental legislation. Economic Value Added Economic Value added (EVA) is a risk-adjusted quantitative measure of project performance (Goodpasture). EVA facilitates the calculation of the true economic profit of any organization. This method gained its popularity due to its simplicity and it is possible to apply this measure to calculate the business earnings at a divisional or strategic business unit level. Unlike the measures that are used to value the stocks, EVA is a flow and can be used to measure the performance of the firm over a period. EVA being the economic value added to the business is different from accounting profit, represented by 'Earnings before Interest and Tax' (EBIT), 'Net Income' and 'Earnings per Share' (EPS). The objective behind EVA is that the financial performance of the business can be measured by its ability to cover both the operating costs and the capital costs (ValueBasedManagement). EVA is a unique financial performance measure because of its simplicity in the concept and ease in understanding and use of the measure. EVA is the only measure of performance, which directly ties to Net Present Value and it helps in the creation of shareholder wealth by enabling the organization to achieve a continuous improvement in its performance. "EVA emphasizes the residual wealth creation in a company after all costs and expenses have been charged including the firm's cost of capital invested." (Abdeen and Haight) EVA can be calculated as the Net Operating Profit after Taxes (NOPAT) less the opportunity cost of capital invested in the firm calculated at a certain percentage. Thus, EVA is to be regarded as an estimate of true "economic" profit, which is arrived at by the amount by which earnings exceed or fall short of the required minimum rate of return, which shareholders and lenders could get. This minimum rate of return can be taken as the rate of return, which the investors would have got by investing in other securities of comparable risk. However, in the calculations initial investments in new projects require a careful evaluation and adjustment to arrive at the correct EVA. While in the case of GAAP, the initial investment is expensed off immediately, under EVA method those expenditure, which have proved successful are capitalized. Such capitalized expenditure is amortized over the period during which the benefits of the projects are recovered. This treatment of initial investments cost is recommended to arrive at the true financial performance of the firm, since in the case of GAAP, the expenses will be overstated and the profit is reduced when the initial investment cost as a whole is written off. Advantages of EVA The following are some of the areas in which EVA method can be used to the advantage of the firm. The EVA method can be used to set the organizational goals in terms of profitability The evaluation of the performance of the firm is made simpler and accurate It provides a clear way of arriving at the bonuses for surpassing of the budgets Meaningful communication with the shareholders and investors is possible with the help of the EVA method It provides as the best means of motivating the managers and executives Effective ways of making the capital budgets is also possible to achieve An accurate corporate valuation can be arrived at by using the EVA method Based on an exact valuation using the EVA method an efficient analysis of the securities can be attempted. By adopting EVA, economic distortions of GAAP can be eliminated so that focus can be diverted on real economic results. There can be a better assessment of business decisions, which affect balance sheet and income statement as it covers all aspects of business cycle. Concerns on the Introduction of EVA It is critically important that the limitations of EVA be taken into account before introducing EVA as a financial performance measure in Brand Neue. The major limitation of EVA is that the only available sample evidence of the method is the in-house study conducted by Stern Stewart, which does not provide reliable past use of the method by more number of organizations. Brewer, Chandra, & Hook, (1999) have observed the following limitations. (i) EVA does not have the ability to control different sizes of business units across plants or divisions of large organizations (ii) EVA is based on financial accounting methods which could be easily manipulated by the managers to their advantage (iii) Since the focus of EVA is on immediate results, it hampers innovations in approach (iv) Even though, EVA provides obvious information in the same way as the historical financial statements, it does not have the ability to provide any concrete solutions to the issues. Calculation of Financial Performance of Projects The application and suitability of ROI and EVA techniques can be illustrated by calculating these metrics for the three projects of Brand Neue based on the following hypothetical figures. Project C Year 2009 2010 2011 2012 2013 Revenues 14,000 23,000 28,000 27,000 32,000 Costs 15,000 19,000 21,000 18,000 23,000 Initial investment for the project is $ 14,000. The project is expected to incur additional cost of $ 8000 towards environmental costs in year 2013. The costs are assumed to be cash costs for all the projects. Project A Year 2009 2010 2011 2012 2013 Revenues 4,000 7,000 8,000 8,000 8,000 Costs 5,000 4,000 4,000 3,000 3,000 Initial investment for the project is $ 9,000 with no salvage value expected. Project B Year 2009 2010 2011 2012 2013 Revenues 9,000 17,000 15,000 12,000 7,000 Costs 7,000 10,000 13,000 8,000 5,000 Initial investment for the project is $ 11,700 with no salvage value expected. Taxation is 30% and the cost of capital is 10% Calculation of performance Measures Project A Cash Flows Net Cash Flow Discount Rate PV 2009 (1000) 0.909 (909.0) 2010 3000 0.826 2487.0 2011 4000 0.751 3004.0 2012 5000 0.683 3415.0 2013 5000 0.621 3105.0 Initial Investment (9000.0) Net Present Value 2093.0 Total 16000 The Average Annual Rate of Return or ROI can be calculated as below: Increase in expected average annual operating income/Net Initial investment Increase in expected average annual operating income = Average annual cash flows - Amortization of Initial investment Average cash flow per year = cumulative net cash flow $ 16,000 / 5 years = $ 3200 Amortization $ 9000 - 0 /5 years = $ 1800 per year ROI = (3200 - 1800) / 9000 = 15.6% EVA = 3200 x (1 - .3) - (9000 x 10%) = 1340 Project B Cash Flows Net Cash Flow Discount Rate PV 2009 2000 0.909 1818 2010 7000 0.826 5782 2011 2000 0.751 1502 2012 4000 0.683 2732 2013 2000 0.621 1242 Initial Investment (11700) Net Present Value 1376 Total 17000 Average cash flow per year = cumulative net cash flow $ 17,000 / 5 years = $ 3400 Amortization $ 11700 - 0 /5 years = $ 2340 per year ROI = (3400 - 2340) / 11700 = 9.1% EVA = 3400 x (1 - .3) - (11700 x 10%) = 1210 Current Cumulative ROI = (1400 + 1060) / (9000 + 11700) = 11.9% Current Cumulative EVA = [(3200 + 3400) x (1 - .3] - [(9000 + 11700) x 10%)] = 2550 Project C Cash Flows Net Cash Flow Discount Rate PV PV 2009 (1000) 0.909 (909) (909) 2010 4000 0.826 3304 3304 2011 7000 0.751 5257 5257 2012 9000 0.683 6147 6147 2013 9000/1000 0.621 5589 621 Initial Investment (14000) (14000) Net Present Value 5388 420 Total 28000 Average cash flow per year = cumulative net cash flow $ 28,000 / 5 years = $ 5600 Amortization $ 14000 - 0 /5 years = $ 2800 per year Income = 5600 - 2800 = 2800 Calculation of Income with the new environmental costs: Average cash flow per year = cumulative net cash flow $ 20,000 / 5 years = $ 4000 Amortization $ 14000 - 0 /5 years = $ 2800 per year Income = 4000 - 2800 = 1200 Project ROI = (5600 - 2800) / 14000 = 20% (Without environmental costs) Project ROI = (4000 - 2800) / 14000 = 8.6% (With environmental costs) Cumulative ROI = (1400 + 1060 + 2800) / (9000 + 11700 + 14000) = 15.2% Cumulative ROI = (1400 + 1060 + 1200) / (9000 + 11700 + 14000) = 10.5% Cumulative EVA = [(3200 + 3400 + 5600) x (1 - .3] - [(9000 + 11700 + 14000) x 10%)] = 5070 Cumulative EVA = [(3200 + 3400 + 4000) x (1 - .3] - [(9000 + 11700 + 14000) x 10%)] = 3950 Analysis of the Recommended Decision The company proposes to change the method of measuring the performance of projects. If the company would like to follow the EVA method, it may not be possible for the company to fix any performance targets, as no benchmark performance has been established so far for the EVA from similar projects. In the ROI method there can be a definite standard set against which the performance of the projects can be evaluated. However the purpose of EVA is to determine whether the project could create positive shareholder value which is greater than the cost of capital. If the return from the project C is analyzed it may be observed that the project can be accepted based on the old technique of NPV as the project results in a positive NPV. Even though Project C has a lower ROI, the rate is still greater than the cost of capital for the company. The management would have accepted Project C when the environmental costs are not included. The project would have been rejected when the environmental costs are included. The rejection of Project C based on the costs including the environmental costs would have resulted in a lower rate of bonus for the project managers handing the project. Right Decision The right decision as shown by the calculation of EVA is to accept the project C and acceptance of the project would provide additional bonus as reward for the project managers. The EVA calculation in the example shown above proves that the project C has created positive shareholder value which becomes beneficial to the investing company. The company can set up the reward structure for attaining this EVA with greater bonus. The reward structure would enhance the EVA irrespective of the fact that whether an environmental legislation is passed necessitating the additional investment at the beginning of the year 2013. Creation of positive shareholder value enhances the image of the company among the investors and also achieves the objective of increasing the profitability of the company. The performance measure in terms of EVA becomes realistic as the measure considers the present value of future cash inflows. It is simpler to use and provides the best means of motivating the managers and project leaders who are compensated based on the project performance. Other issues to Consider Apart from the profitability of the company and enhancement in the shareholder value there are certain other issues that need to be considered while going ahead with the project based on the evaluation. There are ethical issues concerning the potential environmental costs associated with the project. There is the likelihood that the project might create a negative goodwill to the company on the long term, when the environmental issues are ignored because of the additional cost of cleaning up to be incurred on the completion of the project. The public will consider that the company has followed unethical policies if the project environment is left un-cleaned. This is detrimental to the reputation of the company in the long run. When the company has to incur the additional cost, then the company would not accept this project, as it would not result in the maximization of shareholders' wealth. On the personal level of the project manager, the project manager would lose his/her job since vital financial information in respect of the additional environmental cost has not been considered while accepting the project. The poor performance would have also affected the bonus structure of the concerned management team. Based on the faulty information on the returns from the project (calculated without taking into account the effect of additional environmental cost) the CEO of the company would have reported a higher forecasted income for the company which eventually would not materialize. This would negatively impact the stock prices of the company in the market. The only alternative to get this low NPV project is to ignore the environmental cost which is not in the best interests of the managers as it would have seriously hit their bonus and other rewards. The decision would also seriously affect the performance of the company, along with low compensation to the managers and executives connected with the project Conclusion The foremost consideration for making capital budgeting decision is that such decisions are to be made after taking into account all the factors affecting the decision as the decision once taken cannot be reversed easily. Since the capital budgeting decisions are difficult to evaluate the organization should take those decisions within a strategic framework. Similarly project performance evaluation techniques should be based on the nature and size of projects under review. It is also vitally important that the managers study the relative merits and demerits of each technique and apply one, which is appropriate for the investment to be reviewed. The managers should also take care in arriving at the EVA which is one of the important considerations in evaluating the capital budgeting decisions. If the probable costs are not taken into account it may lead to the decision to accept projects, which should otherwise be rejected. The managers should also ensure that the wealth maximization for the stockholders is given prominence in evaluating the capital decisions. When the company associates the rewards and bonus structure with the performance of the projects, the managers will get motivated in aligning the organizational objectives. Works Cited Abdeen, Adnan M and G Timothy Haight. "A Fresh Look At Economic Value Added:Empirical Study Of The Fortune Five Hundred Companies." Journal of Applied Business Research 18.2 (2002): 27-36. Fitzgerald, et al. Performance Measurement in Service Businesses. Surrey UK: The Gresham Press, 1991. Goodpasture, John C. Quantitative methods in project management. New York: J Ross Publishing House, 2003. Horngren, Charles T, Georege Foster and Srikant M Datar. Cost Accounting: A Managerial Emphasis. New Delhi: Prentice Hall of India Private Limited, 2002. ValueBasedManagement. Economic Value Added. 2009. 19 November 2009 . Read More