Critical evaluation of ROCE as a performance metric on Culharb plc

Critical evaluation of ROCE as a performance metric on Culharb plc

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Return on capital employed (ROCE) is a measure of performance where it shows the return on every penny invested by an organisation. It is the ratio between the wealth generated to the wealth invested. The simplest way of calculating it is taking the ratio percentage of operating profit before tax and interest against the capital employed i.e.

ROCE = Operating profit before tax and interest/ Capital employed*100

Given that short-term profit is not being generated at the expenses of long term, this ratio should be as high as possible. To achieve higher ROCE either the profits have to be kept high through higher volume of sales or the capital invested has to be kept low by efficient usage of capital. A higher return on capital employed value indicates higher performance. It is arguable that performance is about realigning managerial calculations towards those of the investor around higher returns on capital.

ROCE though is a good way of measuring organisational performance, has few drawbacks. It can be observed from the given case that Culharb plc., is a multi-divisional organisation with each division having its own investment responsibility. One particular problem is that ROCE may understate capital employed. Research and development, trademarks, brand, etc. are not considered in spite of the fact that they still represent the capital employed. However the advantages of not considering these intangible assets are that, it helps in keeping ROCE consistent by measuring only operating efficiency and also this does not change operating efficiency of a business being acquired (In case of an acquisition of a smaller brand by a bigger one, it does not impact the performance rating of either of them).

Secondly ROCE does not consider depreciation to which it is very sensitive. If one division is writing off assets at a relatively faster rate than the other, then its ROCE will be affected. Also if a division is using an asset which has been largely written off, both its current depreciation charge and its investment base will be low. As a consequence its ROCE will be high in relation to newer divisions as in case of Visicon division and other divisions together. If there are some costs which are utilised over a period of time like equipment cost, it is not considered to be a year on year investment but as a onetime initial investment. Thus the year on year capital employed decreases if other costs are kept the same. And if we assume that the profits are also constant over years, ROCE decreases though the management has done nothing towards driving the financial value of the firm.

In this case there are proposed projects wherein the divisions will be trading with one another (Pumps and Visicon trading the automation technology). When this happens, the cost at which goods are procured or traded by the respective divisions will certainly affect their divisional performance. Another fact which should be considered here is that ROCE reduces if the cash reserves are high i.e., money generated (through equity or debt) is not invested but kept as reserve.

Finally the condition under which the divisions operate plays a major role in their performance. But unfortunately the conditional factors are not considered while calculating ROCE. If one division operates in a market where the conditions are favourable in terms of high rates of return, while the other suffers excessive competition, the differences may cause one to look bad and the other good. This is a percentage measure and managers may try to manage the ratio by reducing the level of investment rather than increasing profits. For example, a profit of £10 over zero investment gives a performance level which is infinite. It is also more difficult to allow for the relative risks associated with the different divisions within the group when percentage returns are being compared.

Considering all the above discussed factors it is not preferable using ROCE as a measure to assess divisional performance in Culharb plc. In order to use this concept at the divisional level, the division must exercise control not only over sales revenue and relevant associated costs but also over the level of investment made in this area of business. It is therefore much suited for self contained independent units within a large group of business. And in the given case Culharb plc the divisions though enjoy a significant amount of autonomy, they are not totally independent and the control is over access to funding. The group wishes to allocate funds to those divisions which will generate the best risk adjusted return over time.

Residual Income as an indicator of divisional performance

Residual Income (RI) is nothing but the operating profits that an organisation is able to generate above some minimum return value (preset rate) on its capital employed or assets. And it is calculated using the below mentioned formula:

RI = Net Operating Income - (Minimum Rate of Return on Investment x Operating Assets)

where Net Operating Income is operating profit, Minimum Rate of Return on Investment is an organisation preset rate, which is the expected rate of return from the investment (Capital Employed) being made.

Operating assets is the capital employed.

When RI is used to evaluate divisional performance, the objective is to maximize the total amount of residual income, not to maximize the overall return on investment percentage figure. RI is preferred sometimes as a measure of performance because it encourages accepting investment opportunities that have rates of return greater than the charge for invested capital. Using RI, the organisation levies a charge in terms of interest on any funds utilised by the division. The level of interest applied depends on the risk associated with the division and investment; however it reduces the net profit of a division compared to its investment. Hence the remaining profit which is the residual income is the net contribution of the division towards the wealth of the organisation.

The advantages of using residual income in assessing the performance of a division in Culharb plc., would be the fact that it considers the opportunity cost of tying up assets in the division. Secondly the rate of return could be modified according to the risk undertaken by the division. Next advantage is that various assets might be required to earn different returns depending on their risk. Finally the effect of maximizing income rather than a percentage leads to achievement of organisational goal.

Considering the proposal from pumps division, the capital employed is zero as the division is not investing anything, but shelving a product to earn income. Applying ROCE here yields an infinite value which indicates an excellent performance rate for the division. Whereas this might be unfair when compared to the performance of forging division which could be performing equally well had it had to shun a product and generate income by selling the assets associated with the product (ROCE becomes infinite due to zero investment). Instead they are investing in a new project whose future returns looks promising enough. Thus, it is vitally important to use RI as a performance measure, where the parent organisation sets the benchmark to be achieved by both the divisions and then compares the value to evaluate their performance.

Thus it would not be appropriate to set the same target RI for the segments that have different asset value. RI tends to increase over life of an asset. That is as the value of asset depreciates, the finance charge decreases. However, as long as a new investment generates profit at a rate above the company's cost of capital it will increase the total ri of the division. RI may vary from year to year or company to company.

Balanced Scorecard approach at divisional level

The balanced scorecard (BSC) is a strategic planning and performance management tool that is used extensively in the business industries worldwide to align their business activities to the vision and mission of the organization, improve internal and external communications, and monitor organizational performance against strategic goals. It is a concept for measuring the smaller-scale operational activities of a company and comparing it with the larger-scale objectives in terms of vision and strategy of the organization. BSC was designed to help organisations measure performance considering not only the financial and accounting ratios but also other aspects of performance evaluation. BSC has four perspectives, namely

Learning and Growth Perspective - Can we continue to improve and add value

Internal Business Processes Perspective - What must we achieve

The Customer Perspective - How do customers see us

Financial Perspective - What do shareholders feel about our value improvement

Each of these perspectives is linked to one another. Achievement of one leads to the other. For an organisation to grow financially in the eyes of shareholders it has to satisfy its customers and keep them happy. This can be accomplished through defining a target to be achieved or competencies that the organisation needs to excel in. And this motivation comes from answering the question if the organisation is capable of continuing to learn and innovate, thus adding value to the organisation. Taking into consideration these perspectives as a whole ensures that the managerial decisions made are fair enough because it gives a balanced view of the organisation's performance and not just the financial performance. Secondly it helps in differentiating and setting short and long term goals when you know what you want to achieve (customer and shareholder perspective) and how to get there (business and learning perspective). The divisions just need to focus on things to be done in order to stay competitive in the market.

This would be certainly a very good measure of performance as it would consider various aspects of performance measurement, especially in case of Culharb plc., which has different divisions whose operating market conditions as well as requirements are different. Visicon division is relatively new to the market when compared to the other divisions and is yet to establish itself as a major player. And assessing its performance based on financial measurement alone is unfair. The reason being the fact ,that it has made huge investments in R&D and also have requested funds for training & recruitment process, which tends to yield benefits in the future and not the present. So it will be appropriate if we could measure its performance based on other criterions as well i.e. the non-financial aspect. Unlike ROCE or any other financial performance metric BSC helps in measuring the performance of the divisions across various attributes and not just one. Performance of the divisions should be regarded as a whole measure and not only. Based on the outcome of a particular division's BSC, varying targets and strategies to accomplish the task could be set for that division. The way of defining the task and describing the strategy to achieve that could vary across divisions. Thus enabling Culharb plc., to assign different criterions to be met by each division in order to enhance their performance. These factors will largely be dependent on the organisation's vision thus enabling Culharb plc., to realise its vision through improved divisional performance. Implementing BSC would result in increased financial output through greater customer satisfaction and motivated employees. Though it's not a quick fix solution as it needs a considerable amount of time before it bears positive results, implementation of balanced scorecard approach as a measure of performance in Cuharb plc will be beneficial.

Part B

Is Economic Value Added a profit centric performance measurement tool?

Economic Value Added (EVA) is a performance metric which lays emphasis on maximising shareholder's wealth. One important observation to be made is that it is increasing shareholders' wealth and not value. This reflects the notion that, for a business to be profitable in an economic sense, it must generate returns that exceed the required returns by the investors.

EVA is the measure of the extent to which, if at all, the after tax operating profit of the business for a period, exceeds the required minimum profit, which in turn is based on the shareholders' minimum required rate of return on their investment multiplied by the amount of that investment. Hence EVA is calculated using the below mentioned formula:

As per the formula what could be understood is that in order to achieve higher EVA either NOPAT has to be increased or R reduced else efficiency of C needs to be increased. NOPAT can be enhanced by registering more profit through sales, R can be reduced by decreasing shareholders' expected rate of interest maybe by raising funds through debt and efficiency in C can be obtained by smart investments in high yielding assets rather than low yielding ones. Initially a target can be set for EVA for a business as a whole or for individual units. These values can then be compared with the actual values or returns generated after the completion of the planning period.

What EVA says is that to assess it with greater accuracy and detail some adjustments is necessary which otherwise would result in inconsistent measurement data. This is done due to the problems and limitations of conventional accounting measures. The amount of capital used is also subject to various adjustments including capitalising R & D and operating leases. However these adjustments are matter of judgements. It all depends on the perception of the person who is evaluating the factors and variables for adjustments. A variable which might be important from one evaluator's point of view might not be as significant for others.

Right from the beginning what can be observed is that EVA is shareholder centric and gives negligible relevance to stakeholders. To drive the performance of any organisation using EVA would mean creating more wealth. This hardly emphasises on other value drivers such as stakeholder benefits which can be observed from the EVA formula where profit after tax is considered and not before tax signifying that it's shareholder benefits (more wealth) which has more prominence.

EVA signifies momentary swings in the capital market rather than performance. Not any other types of changes except economic changes are reflected in EVA, though the drivers' might be relevant to performance. For example, a sudden downturn (eg. Credit crunch) in the market resulting in a varied product requirement might effect the sales of the company thus reducing the revenue and the overall profits generated. Though the organisation might have performed well till now, it will still result in a lower EVA value because of low operating profits and not being able to achieve the predetermined EVA target. So it's until the organisation is generating more and more wealth it is creating economic value for its shareholders. In order to earn more profits the organisation might increase the capital employed, which is not an efficient way of creating wealth. Sometimes EVA might be blown out of proportion just to reflect a higher economic value whereas in reality it might be even lower than the risk free rate. Hence EVA can be considered to be a measure of monetary performance and not an overall way of assessing performance of an organisation.

Bibliography

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