Posts Tagged ‘earnings’

Ralph knew that his managers needed clear targets and performance measures to track their progress. While the stock price performance was the ultimate measure, he needed something more concrete and directly manageable by his managers,particularly his business unit managers. He also knew that traditional accounting measures like net income ignored the opportunity cost of the capital tied up to generate earnings. Return on invested capital (ROIC), on the other hand, ignored value-creating growth. So he turned to a measure that incorporated both growth and return on invested capital, called economic profit (EP). EP is the spread between the return on capital and its opportunity cost times the quantity of invested capital:Ralph chose this measure because he knew that the discounted value of future economic profit (plus the current amount of invested capital) would equal the discounted cash flow (DCF) value (see Chapters 3 and 4 for a more complete  description). In other words, EG could maximize DCF value by maximizing economic profit. Ralph asked that all strategic plans and budgets include economic profit targets for each of the business units.
Knowing that lower level managers also needed targets and performance measures that they could directly influence, he asked his business unit managers to translate economic profit targets into specific operational performance measures for their operating managers. For example, the manufacturing manager might be measured by cost per unit, quality, and meeting delivery schedules. Sales might be measured by sales growth, price discounts of list prices, and selling costs as a percent of revenues.
This integrated system of target setting and performance measurement required a new mindset for Ralph’s accounting group, which was accustomed to dealing with accounting results. The accounting group resisted but Ralph convinced it of the benefits of integrating financial results with operating measures and with moving toward more economically relevant financial measures.