AND RESEARCH APPROACH
4 E XISTING PERFORMANCE MEASURES
4.3 Profitability ratios
As earlier mentioned, the success of a manufacturing system or company has traditionally been evaluated by the use of financial measures such as monetary value of sales and profit. Nevertheless, one should keep in mind that these
types of performance measures have significant limitations and that several problems have been connected to the use of them. There is, for instance, no completely unambiguous way of knowing when a company is profitable, since many business opportunities involve sacrificing current profits (Ross et al, 1993). But as described earlier, productivity and profitability often come hand in hand, and profitability ratios can therefore be used as indicators of produc- tivity changes, as long as impact from the price recovery factor is kept in mind. Although financial measures can appear in several different forms, the follow- ing sections will in short explain the most commonly used profitability ratios.
4.3.1 Profit margin
Profit margins (also known as return on sales) measure how much a company
earns relative to its sales. These measures determine the company’s ability to withstand competition and adverse rising costs, falling prices or declining sales in the future (Ross et al, 1993). There are two types of profit margin ratios:
gross profit margin and net profit margin. Gross profit margin measures the
income before interest and taxes, and is calculated as:
S I
PMG= (4.7)
where
PMG= Gross profit margin [%]
I= Income before interest and taxes [money]
S= Sales [money]
Net profit margin measures income after taxes and is calculated as:
S I
PM T
N = (4.8)
where
PMN= Net profit margin [%] IT= Income after taxes [money]
S= Sales [money]
While it seems as if they measure the same attribute, their results can be dra- matically different due to the impact of interest and tax expenses.
However, it should be noted that ROA does not tell how well a company is performing for the stockholders. A very similar measure to ROA is the return on investment (ROI), which is calculated in almost the same way but is used on
a minor level. ROA is calculated as:
tot T A I ROA = (4.9) where
ROA= Return on assets [%] IT= Income after taxes [money] Atot= Average total assets [money]
ROA can also be expressed in terms of the profit margin and assets turnover (i.e. Sales / Average total assets)
tr
A PM
ROA = ⋅ (4.10)
where
ROA= Return on assets [%]
PM= Profit margin [%] Atr= Assets turnover [%] Return On Assets Net profit margin Total asset turnover Net income Sales Total assets Sales Total costs Current assets Fixed assets multiplied by divided by divided by minus plus Land Buildings Machinery and equipment Inventories Marketable sequrities Others Cash Accts recievables COGS Selling expenses Admin expenses
4.3.3 Return on equity
Return on equity (ROE) measures how well the company is doing for the inves-
tor (i.e. stockholders), since it tells how much income the investors are getting for their investments. It is calculated as:
E I
ROE= T (4.11)
where
ROE= Return on equity [%] IT= Income after taxes [money]
E= Equity [money]
4.3.4 Limitations of financial measures
There is a simple explanation for that the value the financial performance measures offers the company must be questioned. Financial performance meas- ures are based on simple cost accounting systems that were developed in the early 1900s. Such systems are focused on controlling and reducing direct labour costs and designed for an environment of mass production of a few standardised items, which make them more or less inadequate in a manufactur- ing environment that includes newer philosophies, such as Just-In-Time. Nowadays companies are experiencing a business environment that is charac- terised by complexity, competition, change and uncertainty. The mass produc-
tion era has been replaced by a lean production era, which is now slowly trans-
forming into a new era of agile manufacturing and mass customisation. Agile manufacturing can be described as one key to future competition by the ability
to thrive in rapidly changing, fragmented markets (The Iacocca Institute Re- port, 1991). Mass customisation relates to the ability to provide customised products or services through flexible processes in high volumes and reasonable low costs.
However, while the climate for companies has changed enormously, the tech- niques of management accounting have changed very little. Numerous of re- searchers have in turn exposed several limitations with the traditional approach to performance measurement using solely financial performance measures (Maskell, 1991), (Ghalayini et al, 1997), (Jagdev et al, 1997):
• Financial measures are concerned with cost elements and try to quan- tify performance solely in financial terms, but many enhancements are
• Financial reports are usually produced monthly and are results of deci- sions that were made one or two months prior.
• Financial measures have predetermined inflexible format that is used across all departments ignoring the fact that most department has its own unique characteristics and priorities.
To use PMS that solely consists of financial performance measures can also cause several problems in the company, such as (Maskell, 1991), (Hill, 1995), (Crawford and Cox, 1990), (Ghalayini et al, 1997), (Jagdev et al, 1997), (Kap- lan and Cooper, 1998), (Bitichi, 1994):
• Financial measures show lack of relevance for the control of produc- tion and are not directly related to manufacturing strategy. Excessive use of ROI also distorts strategy building and may conflict with strate- gic objectives.
• Traditional criteria such as cost efficiency and utilisation may pressure managers and supervisors for short-term result and, for that reason,
discourage improvements.
• Financial measures do not report accurately on the cost of processes, products, and customers. They are also focused on controlling proc- esses in isolation rather than as a whole system.
• Financial measures are not always applicable to the new management techniques that give shop-floor-operators responsibility and autonomy. • Financial measures do usually not penalize overproduction and do not
adequately identify the cost of quality.
4.3.5 Activity-based costing
To cope with the demands from today’s business environment, a new approach to cost accounting, known as activity-based costing (ABC), was developed by Kaplan and Johnson in the late 1980’s as an attempt to resolve some of the fundamental inadequacies of traditional cost accounting (Kaplan and Cooper, 1998).
ABC is concerned with the cost of activities within a company and their rela- tionships to the manufacture of specific products rather than on functional base (Hill, 1995). The basic technique of ABC is to analyse the indirect costs within a company and to discover the activities that cause those costs. Such activities are called cost-drivers and can be used to apply overheads to specific products. In this way, it is believed that ABC results in a more accurate identification of costs than traditional cost allocation.
According to Maskell (1991), several practical cases indicate that ABC can be of practical value for product pricing, production decision making, overhead
cost reduction, and continuous improvement. But on the other hand, there are also researchers who concur that the claim that ABC provides more accurate product costs has never been proven (Neely et al, 1997).
However, as it is argued that even an improved cost accounting system will not entirely solve the problem with financial measures, other measures than cost are needed to gauge adequately manufacturing performance relative to a com- petitive strategy (White, 1996). This is why many researchers have focused on developing more complex conceptual performance measurement frameworks during the last decade. Most of these frameworks propose that a PMS should include both cost and non-cost performance objectives, it is also argued that such an approach are more suitable for the business environment of today than the use of traditional performance measures.
In the light of this, the next section will deal with some of the more well- known conceptual performance measurement frameworks.