Essentials of Corporate Performance Measurement

Essentials of Corporate Performance MeasurementVariations of ROIGMROI Gross Margin Return on Investment

CMROI Contribution Margin Return on InvestmentGross Margin Return on InvestmentExamines the relationship between the gross margin on sales and the investment in inventory required to support the sales.

GMROI = Gross Margin / Average Inventory @ cost

Where:Gross Margin = Sales Cost of SalesSales of $1,000 and COS of $600 yield a gross margin of $400 for the year. If the sales require an average inventory equal to two months cost of sales, what is the GMROI?

Gross Margin = $400Average inventory = ($600/12 x 2) = $100GMROI = GM/AI = $400/$100 = 400%Gross Margin Return on InvestmentBalance SheetCashAccounts ReceivableInventoryCurrent AssetsProperty, Plant and EquipmentLong-term InvestmentOther AssetsNon-current AssetsTOTAL ASSETS

Accounts PayableIncome Tax PayableAccrued Liabilities and Deferred IncomeCurrent LiabilitiesLong-term Debt or Notes PayableOther Non-current CreditsNon-current LiabilitiesShare CapitalRetained EarningsShareholders EquityTOTAL LIABILITIES AND EQUITY

Income Statement

Sales-Cost of Goods Sold=Gross Margin-Other Operating Expenses=Operating Income-Non-operating Income=Net IncomeComponents of GMROIGross Margin on sales= gross margin / sales

Inventory turnover= sales / inventoryImproving GMROIImproving Gross MarginIncreasing Selling PriceReducing the Cost of Goods Sold

Increasing TurnoverReducing Average InventoryIncreasing SalesTypes of CostsFixed Costs cost that do not change in total when a companys activity level changes.

Variable Costs - cost that do change in total when a companys activity level changes.Direct MaterialsDirect LaborOverhead CostA variable cost is an incremental (or increased) cost associated with increased activity. The increased cost of producing an additional order is sometimes called the marginal cost.Examines the relationship between the contribution margin on sales and the incremental investment in inventory required to support the sales.

Contribution Margin = Sales variable costsVariable costs sum of variable manufacturing, selling and administrative cost.

CMROI uses a contribution margin subtotal called manufacturing margin or manufacturing contribution margin.MCM = Sales variable manufacturing costsContribution Margin Return on InvestmentGross ProfitIncome StatementSalesLess: Cost of Goods SoldGross ProfitLess:Selling CostsAdministrative CostsNet IncomeSalesLess: Variable cost of goods soldManufacturing contribution marginLess:Variable selling costsVariable administrative costsContribution marginFixed costs:ManufacturingSellingAdministrativeNet incomeContribution MarginIncome StatementComponents of CMROIManufacturing contribution margin percentage= manufacturing CM / sales

Inventory turnover= sales / inventoryWhich is better?CMROICash Return on InvestmentExamines the relationship between the cash flow from operation and the average total assets.

CROI = cash flow from operations / average total assets= cash return on asset x asset turnoverWhere:Cash return on sales= cash flow from operations / salesAsset turnover= sales / average assetsAnalyzing Sales Revenues, Costs and ProfitsMarket Size VarianceManagers are aware that the economy in general can have a great impact on what they are trying to achieve. If the market for the companys products changes, sales revenue will change, independent the managers performance.

Any analysis of revenue generation where a company has a substantial market share should include a determination of the effect of changes in market size.Assume the manager of wholesale refrigerator sales established a target of 50,000 refrigerators at a standard price of $300 each. The revenue center manager actually sold only 40,000 refrigerators during the year. As a result,Forecasted sales 50,000refrigeratorsActual sales(40,000)refrigeratorsVariance 10,000refrigerators UFx $300standard price $3,000,000unfavorable

But to analyze the managers performance in a more meaningful way, we should look at the expected market for refrigerator.Forecasted market 500,000refrigeratorsActual market(450,000)refrigeratorsMarket variance 50,000refrigeratorsMarketSales @ 10% of MarketForecast500,00050,000RefrigeratorsMarket variance(50,000)UF(5,000)RefrigeratorsUFActual market450,000RefrigeratorsAdj. forecast45,000RefrigeratorsAnd therefor,RefrigeratorsAdj. forecast45,000Actual sales(40,000)Variance5,000unfavorableMarket Share VarianceRefers to the percentage share of the company in the market.

Forecasted market share50,000/500,000Refrigerators10.00%Less: actual market share40,000/450,000Refrigerators8.88%Market share variance1.12%UFSales Volume Variance and ProfitsWhen managers increase o decrease sales revenue by changing the number of units sold, there is also a corresponding change in the cost of goods sold and perhaps other expenses, such as commissions or other product delivery costs. Other expenses/ like rent or insurance, do not change.

Thus, revenues change in direct proportion to a change in units, but total expenses and profits do not. Because of this, differences between actual and budgeted sales that result from volume differences are often stated in terms of their effect on profits.Budgeted Income @ Budgeted QuantitySales @ Standard Cost(50,000 X $300)$15,000,000Cost of sales and other budgeted cost(50,000 x $200)10,000,000Budgeted gross margin5,000,000Other expenses not changing with sales1,500,000Budgeted net income$3,500,000Given:

Budgeted Variable Cost : $200Fixed Cost : $1,500,000Budgeted Income @ Actual QuantitySales @ Standard Cost(40,000 X $300)$12,000,000Cost of sales and other budgeted cost(40,000 x $200)8,000,000Budgeted gross margin4,000,000Other expenses not changing with sales1,500,000Budgeted net income$2,500,000UnitsProfit per UnitTotal ProfitForecasted profit$3,500,000Market variance(5,000)UF$100(500,000)UFMarket share variance(5,000)UF$100(500,000)UFProfit after market variances$2,500,000May also be stated as,Sales Price VariancesWhen there is a change in selling price of a companys products, the increase or decrease goes directly to the bottom line because there is no accompanying change in cost.

Example, if the refrigerator was sold @ $315.

40,000 units x ($315 300 SP per unit) = $600,000 favorableEffect in SalesUnitsStandard Price per unitTotal SalesForecast sales50,000$300$15,000,000Sales volume variances:Market variance(5,000)UF$300(1,500,000)UFMarket share variance(5,000)UF$300(1,500,000)UFSales price varianceNA600,000FActual sales40,000$12,600,000Effect in ProfitUnitsStandard Price per unitTotal SalesForecast profitNA$3,500,000Sales volume variances:Market variance(5,000)UF$100(500,000)UFMarket share variance(5,000)UF$100(500,000)UFSales price varianceNA600,000FActual sales$3,100,000Sales Collection VarianceCash flows from sales are often determined by the companys ability to collect credit sales. If the company fails to screen customers properly or to anticipate economic downturns, sales result in uncollectible accounts expense rather than cash inflows.

Thus, it is useful to reconcile budgeted cash collections from sales to actual cash collected from sales. If collection is a problem, determination and isolating a sales collection variance demonstrates that collections are as important as sales volume or selling price.Uncollectible salesBudgeted : 6% of total salesActual : 10% of total salesUnitsSalesForecast sales50,000$15,000,000Sales volume variances:Market variance(5,000)UF(1,500,000)UFMarket share variance(5,000)UF(1,500,000)UFSales price varianceNA600,000FActual Sales40,000$12,600,000Less: Budgeted uncollectible sales(756,000)Budgeted cash collections from sales$11,844,000Collection variance(504,000)UFActual cash collected from sales$11,340,000UnitsProfitForecast profit$3,500,000Sales volume variances:Market variance(5,000)UF(500,000)UFMarket share variance(5,000)UF(500,000)UFSales price variance600,000FActual profit before collection variance$3,100,000Collection variance(504,000)UFActual profit$2,596,000Effect per profitSummary AnalysisIncome Performance

Sales(40,000 x $315)$12,600,000Cost of sales and other @ budgeted cost(40,000 x $200)8,000,000Budgeted gross margin4,600,000Additional uncollectible accounts expense504,000Other expenses not changing with sales1,500,000Net income$2,596,000Variable Cost VarianceStandard/BudgetedxStandard/Budgeted=Standard/BudgetedQuantity of InputsPrice of InputsCost of Output

ActualxActual=ActualQuantity of InputsPrice of InputsCost of Output

Quantity VarianceEfficiency variance (labor) difference in number of labor hour workedUsage variance (materials) difference in the quantity of materials used

Price VarianceRate variance (labor) difference in the hourly wage of an assembly line workerSpending variance (material) difference in the cost of supplies Materials Quantity VarianceActual PriceStandard/Budgeted PriceActual QuantityStandard/Budgeted QuantityMaterials Price VarianceTotal Materials VarianceActual QuantityStandard/Budgeted PricexxxActual RateStandard/Budgeted RateActual HoursStandard/Budgeted HoursLabor Rate VarianceTotal Labor VarianceActual HoursStandard/Budgeted RatexxxLabor Efficiency VarianceROI and Investment CentersInvestment CenterAutonomous operationsFree access to vendors and customersSeparate revenues and costsManagement design

Use ROI to measure the performance of the investment center.

Autonomous operationsThe segment is an independent operating unit.Manager must control most of the operating decisionsInvestment in assetsIts maintenanceProduction volumeProduct mixPricesFree Access to Vendors and CustomersThe segment is free to purchase of sell both inside and outside the company.

Separate Revenues and CostsAn investment center must be able to separate its costs and revenues from the rest of the company. Without this ability the segment cannot determine a profit return. If a segment sells its production to another segment in the same company, there might be a degree of arbitrariness to the selling or transfer price established between the two operations.Management DesignFocus in the objectives of the segment.ROI and Transfers between SegmentsMisdirected capital investments made based on artificial returns.Misdirected operating funds because budgets are based on cost and revenue figures.Bonuses and other performance rewards based on assessments using negotiated or mandated results, rather than real costs and revenues.Erroneous actions resulting from evaluations of problems and opportunities distorted by ignorance of true revenues and costs.Inappropriate responses to changes in markets and competitors due to costs and revenues that do not reflect these processes.Poor morale among segment managers, resulting from perceptions of differential treatment.

Transfer PriceUsed in place of actual market prices established in competition with producers outside the company vary greatly in their usefulness and their potential for harm.

Methods to set transfer pricePublished market pricesMarginal costFull costingMarkups on costPublished Market PricesUsually spot prices, rather than long-term contract prices more suitable to the relationship between a companys segment and may be adjusted for differences, especially when of different type, grade or quality.Published spot price$107Quality upgrade12Quantity discount(9)Shipping cost adjustment5Sales commission saving(20)Required packaging22Transfer price$117Marginal CostAdditional cost required for a segment to produce an additional unit of product or service. Most frequently, this is raw materials and labor plus whatever components of overhead costs are increased when additional units are produced.Materials usedMetal$46Hinges4L-brackets24$74Labor usedAssembly hours (2 x $36)72Marginal overhead82Transfer price$228Full CostingTotal (full) cost required for a segment to produce a product or service, consisting of raw material, labor, and an allocated portion of all overhead costs.Materials used:Metal$46Hinges4L-brackets24$74Labor used:Assembly hours (2 x $36)72Full overhead per unit190Transfer price$336Markups on CostTo make cost-based transfer prices appear more useful, many companies add an arbitrary profit markup.

Cost-plus transfer prices do not bring the discipline of competition to producing segments. They are authoritarian and arbitrary, most commonly set by top management using a markup return based on the companys ultimate gross profit on sales when it sells to customers outside the company, or some measure of the companys or the segments cost of capital. Another approach to setting segment markups is to allow segment managers to earn the profit they think would be necessary when selling to an outside customer. Neither Approach creates a competitive market price.