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2.3 - KPI's of Financial Performance by Segment

2.3.1 - Accounting Result

The accounting result by segment is calculated by subtracting the direct and indirect expenditure to the income generated by the segment. The indirect costs for each segment are calculated using allocation keys, or using the absorption model (Simões, 2001).
According to Simões (2001), this model has several shortcomings in the assessment of financial performance:
  • The result is based on accounting principles and accounting standards do not always reflect the true economic performance of the segment. How can we present examples of distortion that the accounting value the assets at historical cost, when certain investments made for some considerable time may at present represent a very different investment; using accounting policies that do not reflect the true economic depreciation of investments may also cause distortion.
  • The allocation of indirect costs will lead to a distortion of results by segment, the result being a consequence of allocation criteria used.
  • The allocation of expenses common to large segments put obstacles in the evaluation of performance, since they are not controllable by the heads of the segments. The result
  • book focuses on the findings of expenditures and their allocation, ignoring investments in each segment.
  • Being connected to the information of an accounting nature, focusing on expenditures, the accounting treatment of the segment focuses on product (product cost), being an obstacle to the establishment of results by other segments, such as market / client , distribution channel, responsibility center or business unit.
  • does not take into account that the segments require a certain level of investment, ignoring the cost of domestic financing. In accounting domestic financing has spent zero, however, shareholders have an expectation of return on your investment - the opportunity cost of equity.


2.3.2 - ROI - Return on Investment

ROI - Return on Investment was developed by Du Pont in the 20s of the twentieth century, with the aim of measuring the efficiency of commercial enterprise and its business units (Simões, 2001).
This indicator aims to compare the output generated by a segment with the level of invested capital, resulting from economic assets allocated to the segment. It is calculated using the following formula (Jordan et al., 2007):


This indicator assumes that financial resources are scarce and have an expense. As this principle applies to the company as a whole, as it allows us to identify a minimum return to shareholders and creditors, its extension to multiple threads will not be simple (Jordan et al., 2007).
The diagram below shows how ROI is affected by changes in operating results (via the return on sales) or the elements of balance sheet (via the rotation of sales) (Simões, 2001):


The use of ROI, to assess the results of segments, a single number can reflect all the factors that affect the economic situation of the segment, however, presents the following disadvantages:
  • The emphasis is on optimizing a ratio (result / investment), which can lead to discouragement of investment in the centers of responsibility more profitable. In order to optimize ROI, area managers may limit or even reduce segment assets (Dearden, 1987).
  • can lead to making decisions contrary to the interests of the company. Profitability may be increased by reducing the denominator, ie, reduction of economic assets in order to increase ROI in the short term, regardless of possible negative consequences in the medium term (eg reduction programs of research and development, delays in scheduling investments, extending the average maturity of payments, among others) (Jordan et al., 2007).
  • All assets, whether fixed or circulating, must generate the same return rate, not taking into account the different risk and cost of capital for the company (Dearden, 1987).
  • This indicator represents a relative value, since it evaluates a level of performance for the resources used. Therefore tends to emphasize higher rates of return ignoring their contribution margin value (Jordan et al., 2007).
  • not be universally adopted since it does not apply to investment centers with negative economic asset (the resources in working capital exceed the average net assets) (Jordan et al., 2007).



2.3.3 - EVA® - Economic Value Added

EVA® measures the difference between the return on capital and cost of capital. EVA ® indicates a positive value creation for shareholders of the company and a negative EVA ® means value destruction. The main difference of EVA ®, compared to traditional measures of income, is that consider the total cost of capital and not just the interest. Proponents of the application of EVA ® argue that any measure of performance evaluation that ignores the cost of equity capital does not demonstrate the success of an enterprise to create value for its owners (Young, 1997).
EVA ® can give to investors and managers which areas of the business was created or destroyed value, since it can be used to measure the performance of any enterprise level and not only in its entirety. EVA ® can be used to communicate the performance of the company both externally and internally (Young, 1997).
EVA ® is calculated as follows:


According to Young (1997), EVA ® lets you combine three elements that no other measure of capital could:
  • One way to measure and report the performance that can be used in capital markets;
  • Evaluation of investment;
  • evaluation and compensation management.

The advantage of evaluating the performance of managers and apply bonuses based on EVA ® is that your success is to be connected directly to the shareholders, leading them to think and act like owners. Not being dependent on EVA ® accounting standards, still has an important advantage for the clearance of compensation, since it reduces the incentive to manipulate accounting results (Young, 1997).
EVA ® can overcome some of the limitations outlined in the indicators presented above, not only by considering the cost of capital, but also because it obligatory regardless of investment is positive or negative. Improving the value of EVA ® does not only depend on the increase in turnover (highest income), depending also on cost-cutting and even the management of economic assets, penalizing businesses that use high levels of investment or underspends of them (Jordan et al., 2007).
EVA ® has full applicability in the evaluation of economic performance and financial segment, such as the profitability of customers, markets, distribution channels, projects, or others. This indicator incorporates all factors that contribute to value creation, including the capital employed, even to an analysis by segment (Jordan et al., 2007).

Although not a new concept, EVA ® gained popularity in the 90s of the twentieth century, due to registration of the acronym EVA ® by the company Stern Stewart & Co. and its associated advertising (Simões, 2001).


2.3.4 - Residual Income (MCR - Margem de Contribuição Residual)

This indicator is intended to assess the degree of contribution of each segment to create enterprise value, based on a fee charged by the financing of economic assets used by him (Jordan et al., 2007).

This indicator is obtained as follows:



MCR is very similar to EVA ®, differing in the following points:
  • MCR ignores the income tax. It is best suited to measure their contribution to business value, irrespective of the tax situation in which the company is, in turn, EVA ® is more concerned with the creation of shareholder value (MCR - Tax Segment income = EVA ®) (Jordan et al., 2007).
  • MCR accepts the valuation of assets at market price or replacement value (Simões, 2001).
To determine the MCR will then need to identify (Simões, 2001):
  • Specific Segment Income - All income specific business operated by the segment under consideration (sales of goods, services, trade discounts obtained internal transfer of goods or services, among others).
  • Expenses Direct Segment - all direct expenses by segment of activities (personnel expenses, expenditures of goods sold or of the materials used in production, marketing expenditures, spending customers, among others). It should be also considered the expense of services provided by other segments of the company valued at internal transfer.
  • Rate Cost of Capital (t%) - calculated like the EVA ®.
  • Economic Assets by Segment - the net investment needed to develop the activities of the segment, may be valued at market value or replacement value.

MCR has all the advantages of EVA ®. Ignoring the tax, the MCR is best suited to analysis of segments, since it would not be possible to calculate the tax for the most elementary segments. The tabulation of results by the logic of the contribution simplifies the process of verification of results and provides higher quality information for decision making (Simões, 2001).

2.3.5 - Conclusions

EVA® vs Accounting Result



As shown in the example, the positive result is not sufficient to compensate the investor for the risk assumed, not covering the opportunity cost of capital. A positive accounting income does not warrant the creation of value for the investor.



The new investment has a negative impact on ROI, however, creates value for the investor to the extent that the opportunity cost (10%) is below the payoff (17%). An investment analysis performed only using the ROI would lead to decision not to make the investment. Like the accounting result, ROI can also lead to decisions contrary to the interests of the investor.

Conclusions

According to the above, we conclude that EVA ® and MCR are the indicators that are best suited to assessing financial performance by segment because (Simões, 2001):
  • are decomposable to the most elementary levels of the company;
  • Make a bridge between financial performance of the segments and overall financial performance;
  • With the support of accounting for segments, it is possible to integrate the system of clearance of economic performance segment and the general accounts;
  • Once translate a result, can be calculated by the multiple dimensions of the same reality - a multidimensional perspective of financial reporting.


 
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