Strategic Management Accounting Methods: Return on Investment versus Economic Value Added

You are required to critically evaluate the following statement: “Both Return on Investment (ROI) and Economic Value Added (EVA), when used as performance measures in an organisation, encourage managers to be short-term in their focus and decision making”.

Return on Investment

Return on Investment (ROI) and Economic Value Added (EVA) are two of the performance measures that organisations can use to measure the performance of projects and make investment decisions. They are both applicable concepts in strategic management accounting. ROI and EVA can also be used to measure divisional profitability in organisations. In this case, performance of each division is measured to determine which division has made more profits than the other. ROI is given as: (Revenue – Investment)/Investment × 100. ROI is a relative measure that can be used to compare the performance of one investment from the performance of another investment. The manager makes the decision based on the investment with higher ROI. This may lead managers to choose investment options with short term profits without considering long-term benefits of the investment against other alternatives (Bromwich, and Bhimani, 1994).

Economic Value Added Method

On the other hand, Economic Value Added method of measuring performance involves measuring divisional profits based on the GAAP principles (Bromwich and Bhimani, 1994). In this case, accounting adjustments to the profits are added or subtracted while the cost of capital charge on assets of a given division is subtracted. The accounting profit is converted to economic profit. Since the accounting profit measures the organisation’s profit for a single accounting period, EVA is appropriate for only short term decision making. Therefore, it is true to say that both Return on Investment (ROI) and Economic Value Added (EVA), when used as performance measures in an organisation, encourage managers to be short-term in their focus and decision making.

Analysis

In order to support this statement, it is important to understand the concept of strategic management accounting and how it uses different performance measures to provide the information needed by managers to make investment decisions. Strategic management accounting refers to an approach of accounting which involves the provision and analysis of data of management accounting in order to develop and monitor strategy within a business division or the entire organisation. This involves the analysis of costs and cost structures while considering the strategies of the organisation. In this case, strategic management accounting approaches consider different strategic options and provide measures that can enable managers to choose between such options.

Strategic Management Accounting involves the use of information about internal and external factors, including costs, to make strategic decisions. Strategic management accounting approaches such as ROI and EVA can be used to obtain information about the profitability of strategic activities or products and find out why one product earns more profit than another. This leads managers to choose the most viable product or investment based on the strategic management accounting information obtained. This information can be analysed using approaches such as ROI or EVA. The information obtained can be related to prices, costs and profits. This enables managers to identify the impact of pricing strategies and other decisions made regarding the product or investment being measured. Strategic Management Accounting can provide information that can be used to obtain competitive advantage through cost leadership, differentiation and focus strategies. For example, when ROI is used to compare two investments information about the costs of such investments can be used to decide whether it is viable to pursue cost leadership or differentiation strategies.

Strategic Management Accounting plays a crucial role in the strategic choice of organisations. The strategic choices of different companies have implications on the management accounting and control of the organisation. The management may choose to concentrate on cost control, quality, differentiation or new product development. ROI is an important tool to make those strategic choices. ROI therefore helps in strategic management accounting which helps to determine which industry the organisation may choose to operate in, technology to be used, and the organisational structure to be considered (Farris et al, 2010). Strategic management accounting uses the Returns on Investment approach to make decisions by using given information about the strategic alternatives.

Implementation of strategy can also be enhanced through Strategic Management Accounting. ROI determines whether the low cost strategy or the differentiation strategy can be used. If the low-cost strategy is to be used, the traditional budgetary control may be used to implement the project. In this case, Strategic Management Accounting uses information about the company’s external environment to determine the approach used to implement strategy (Farris et al, 2010). The marketing mix can be used to determine the competitive position of the organisation. For instance, ROI may use the element of price to determine the returns of the product on its investment. If the short-term profits (return on investment) are less than initial investment, then the prices may have to be adjusted to cover the initial cost outlay of the investment and earn profits.

Return on Investment is used in strategic management accounting to measure ex post return on capital employed. ROI focuses on short term profits and readily available data. The manager selects the project with higher ROI because high ROI reflects more favourable investment gains that investment cost. In other words, the manager uses Return on Investment to compare profits with capital invested and make appropriate investment or strategic decision. The disadvantage of this measure of performance is that it uses historical measure which may not be a true prediction of the returns of a project. It also ignores risks and leads to the rejection of projects with slow and long term payoff. In other words, Return on Investment encourages managers to focus on the short-run rather than the long-term. This is because ROI only includes current costs and returns in its measurements instead of focusing on future costs and benefits of the project.

Other explanations of Return on Investment suggest that Return on Investment measures profitability adjusted for the investment assets invested in the business. This approach can be used to carry out strategic cost analysis which is necessary in strategic management accounting in comparing and choosing from alternative investments. Porter (1985) suggested that competitive advantage can be enhanced through innovation, quality and cost reduction. When ROI is used to determine the returns of a project, it takes into consideration costs of the project. As a result, the company chooses the project with lowest cost and higher returns in order to gain competitive advantage. ROI does not take into consideration the quality of the project and the efficiencies of the organisation, but just focuses on the ability of the project to recover its costs in the short-term (Fitz-enz, 2009). Therefore, projects that may take a long time to recover its costs are neglected by the Return on Investment approach irrespective of their quality, efficiency or the amount of future cash inflows.

ROI encourages managers to make short term focus and decisions because the ROI is used to measure their performances. Managers focus on short term decisions in order to raise ROI for their own interests and neglecting the interests of the company in general (Kim, 2008). In some organisations, managers are compensated based on the ROI. In this case, they will be motivated to pursue short term projects in order to get favourable ROI and earn more compensation in terms of salary. Projects with low ROI in the short term would impact negatively on the performance of the manager when measured in terms of ROI. Division managers therefore develop short term focus and make short-term decisions if ROI is used as a measure of performance in Strategic Management Accounting.

Economic Value Added (EVA) involves the subtraction of the product of investment in assets and WACC from the operating income after tax (Savarese, 2000). Positive EVA reflects wealth creation in the organisation while negative EVA indicates consumption of capital. Therefore,   three items used to calculate EVA are: cost of capital, asset investment, and operating income after tax.

One of the main disadvantages of this approach, like ROI, is that it has a short-term orientation. EVA is used as a performance measurement tool that helps to match the efforts, accomplishments and performance of employees and managers with their compensation. If a manager comes up with an innovative idea, proposes it to the company management team, and implements it in the current financial year, he/she is given some compensation for that effort (Savarese, 2000). However, if EVA is used to measure performance of employees, it overemphasizes the need to achieve immediate results. This discourages managers from implementing innovative ideas in the current period whose returns will be felt in the future (Lord, 1996). Strategic Management Accounting recognizes costs and expenses incurred for a particular project immediately, and the benefits and revenues derived from the project are not recognized until later in the future. EVA for long term projects is low at the current period; hence acting as a disincentive for managers to make such an investment. Managers investing in an innovation whose benefits are to be realized in future get unsatisfactory pay rise while managers investing in projects with immediate returns get higher pay rise. Therefore, managers prefer using EVA to produce good results immediately and get good compensation for their efforts.

Strategic managers also understand that the concepts of risk and time value of money can override the future pay rise that is accompanied with long term investments (Acar, 2001). They prefer money in the pocket now than the money earned in future which is less valuable and uncertain. EVA acts as a sort of managerial remote control which relies heavily on short-term measures of financial performance where the results and returns exceed risks and costs in the short term.

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