Financial Performance Choices

qustions story  While Sue was working on the question she had been asked about suitable performance reports, Tim Costigan, the General Manager for Flexibles division scheduled a discussion with her.   His concern was that presently there were no suitable financial performance measures for his division and this was causing immense problems with allocating incentives to the managers who report to him. While some of them favoured Return on Investment, other managers were promoting Residual Income or Economic Value Added as better measures of performance.  His major concern was the flexible manufacturing plants in Australia.  He summarised what happens at the flexible manufacturing plants as follows:

“Flexibles is one of the world’s largest suppliers of flexible packaging and folding carton packaging.  It has three operating divisions each manufacturing flexible and film packaging for their respective industries,   Flexibles Europe and Americas, Flexibles Asia Pacific and Global Tobacco Packaging.  The business supplies a wide range of products to the food, beverage, healthcare and tobacco packaging markets.  This includes fresh foods such as meat, fish bread, produce and dairy processed foods such as confectionary, snack foods, coffee and ready meals, as well as high value-added resin and aluminium based packaging for industrial, hospital, pharmaceutical, home and personal care and wine end markets.  The strategy of Amcor is to deliver increases in shareholder value of more than 10% per annum.  A key component in achieving this objective is appropriately allocating the strong cash generated to a combination of dividends, organic growth opportunities, acquisitions and capital management.  Although it is clearly a growth oriented agenda, it will not be growth for growth’s sake.  Returns measured as PBIT over average funds employed is the key financial metric and a minimum 20% return in the third year is required for all investments.”

Given the above circumstances, Sue starts to wonder whether a balanced approach would be possible in setting the financial performance measures for the Flexibles division.  She has learnt the different methodologies of setting financial performance measures in her management accounting course.

example answer

Q1. Return on investment has many advantages including its ability to evaluate the performance of investment centres of different sizes, encouraging managers to focus on both profits and the assets required to generate those profits and its wide use in practice to measure the performance of managers and units. Return on investment also has limitations which include encouraging managers to focus on short-term financial performance, encourage managers to defer asset replacement and discourages managers from investing in projects that are acceptable from the organisation’s point of view.

Compared with return on investment, residual income has the advantage of promoting goal congruence, takes account of the organisation’s required rate of return and encourages investment in projects that yield a positive residual income to the organisation. However, residual income also has disadvantages that include its inability to be used to assess the relative performance of businesses of different sizes, formula being biased towards larger businesses and can encourage short-term orientation.

Q2. Incentive plans can influence performance measures by providing intrinsic and/or extrinsic motivation to complete tasks more efficiently and work toward goal congruence. For example, if part of a director’s remuneration package is linked to the share price of the firm then they will work harder to increase returns and the share price.

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