Accounting Business Reporting for Decision Making

CHAPTER 14 Performance measurement 579

The advantages of using the EVA as a performance indicator are similar to those for residual income.

They include the following.

• The minimisation of suboptimal decision making. That is, subtracting the charge for capital focuses

managers’ attention on the economic value added to the entity. It is argued that this helps managers

make decisions similar to those they would make if they were the owners.

• The charge can vary to take into account various risk levels.


• Adjustments can be made to the components within the equation to suit the specific circumstances of

each division.

The disadvantages of using the EVA as a performance indicator include the following.

• The modifications to the formula are complex.


• The modifications could be seen as being manipulated.


• It is still a short-term economic performance indicator based on financial accounting data.

ROI, RI and EVA compared

The three measures for each of our divisions are compared in table 14.6.

TABLE  14.6 Fun Hats Company — ROI, RI and EVA compared

ROI RI EVA

Corporate 18.2% $70 000 −$41 860

Department stores −93.3% −$81 250 −$54 890

Specialty stores 31.1% $36 250 $16 290

Under the ROI and EVA calculations, the specialty stores division is the higher performer; under the

RI calculation, however, the corporate division is the higher performer. The ROI calculation indicates

that the specialty stores division has the highest yield relative to the investment base. This indicates a

good use of assets. The RI and EVA are calculated in absolute terms, and they attempt to overcome the

goal congruence problem encountered with ROI. Goal congruence problems arise when the goals of

the entity are not in line with the goals of the individual manager. Recall that with ROI a manager may

reject an investment proposal — even though the proposal would give an ROI favourable to the owners

of the entity — because the proposal would reduce the overall ROI obtained by the manager. RI and

EVA are both based on the principle of deducting a charge for capital, but RI is based on pre-tax profits

and the EVA is based on after-tax profits. This illustrates that, although the corporate division seems to

be performing well, it has not increased the economic value of the investment when tax is considered.

An inspection of the corporate division’s assets in table 14.4 reveals a high proportion of current assets.

This could lead to a review of its inventory policy, debtors’ policy and its cash-on-hand requirements.

The investment base

To calculate the ROI and RI, the investment base was needed. This is the value of the investment that

is used in ratio analysis. There is some choice as to what investment base can be used. It could be the:

• gross book value (original cost)


• net book value (written-down value)


• market value (current cost).

The investment base used can alter the ROI and RI outcome. Using written-down values will produce

more favourable ROI and RI calculations over time as the value of the investment in assets is depreci-

ated. That is, if profit remains constant, the decrease in the investment base will increase the ROI and

RI over time. Such an increase may delay investment in new assets, and the subsequent retention of old

assets may adversely affect the efficiency and effectiveness of operations over the long term. However,

the use of the original cost may not represent a true reflection of the actual investment in the entity.