1992-05 menu of financial indicators used in mousan exercise in clarification

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Menu of Financial Indicators Used in MOUsAn Exercise in Clarification

Prajapati Trivedi

M P Vithal

Financial performance has moved to the centre-stage of MOU policy. The main issue before policy+makers is

to devise ways of internalising this policy goai The best way to do so will be to give clear and unambiguous

signals to public enterprises with regard to what is. expected from them in terms of financial performance.

I

I n t r o d u c t i o n

THE purpose of this paper is to highlightscale issues involved in choosing financialindicators to measure managerial performance in Memorandum of Understanding(MOU). A glance at the existing MOUsmakes it clear that there is a wide divergencein perceptions regarding the utility andrationale of various financia l indicators in

cluded in MOUs. This is hardly surprising,because there is no unanimity on an 'ideal'financial indicator even in the literature dealing with the private sector. Be that as it may,there is a convincing case to narrow down,if not eliminate, this diversity in the publicsector for the following reasons.

First, unlike the private sector, there isonly one ultimate owner of the public enterprises. In fact, the more accurate comparisonof public enterprises is with targe businesshouses or multinational corporations, whereone finds that there is a tendency to evaluateunits under their control using same finan

cial indicators and measures across all units.Second, using a diverse set of indicatorscan have the unintended effect of measuringthe same aspect of enterprise performancedifferently by different indicators and thusconfo und the performance evaluation exercise. Thus, inclusion of duplicative perfor-mance criteria can be 'unfair' to both themanagement as well as the owner (government) depending on the particular set offinancial indi cator s chosen. We shallelaborate on this point later.

The rationale for using a single indicatoris simple. If Birtas have invested someamount of money in cement, textiles,

engineering and chemical concerns, theywould want 'favourable return from all investments. A rupee earned from cement division is no different from a rupee earned fromthe chemical divi sion . Thus they would wantthe same indicator for all their divisions.1

This paper is not intended to be exhaustivein its coverage. Rather, it is to be used as abasis for discussion and future refinement.The language used is also cryptic reflectinga preference for producing this paper ontime to have a focused debate on this important topic However, before we examinethe various options available to us forevaluating financial performance of publicenterprises signing MOUs, let us look at theconcern of the High Power Committee(HPC) on MOU in this regard.2

I I

Concern for Financial

Performance

Given the desperate financial positio n ofthe nation, one does not have to spend agreat deal of effort in making a case for improving the financial performance of publicenterprises, in general, and those signingMOUs, in particular. Little wonder, therefore, that the HPC issued a guideline urging the concerned parties in the MOU exercise to give 'profit related criteria aminimum weight of 50 per cent. However,since no details have been given by the HPC',a controversy of sorts relating to the realintentions of the HPC has arisen. In particular, the interpretatio n of the term 'pro fit-related criteria' is at the heart of this controversy. To untangle the myriad of issuesinvolved let us begin by examining the rationale behind this decision.

Table 1 summarises the thinking of theHPC on this subject. In general, the criteriaincluded in any MO U could be divided intotwo broad categoriesProfit" and 'All

Others'. The latter category could include asmany sub-categories as may be relevant forthe specific enterprise in question. Table 1lists the sub-categories recommended in the"Guidelines on M O U " issued by the HPCBefore we go to the confusion regarding theinterpretation of the first category of 'Profit*, let us look at the significance behindthe recommended distribution of weightsamong the two broad categories.

The main objective of attaching a weightof 50 per cent to the profit category is toensure that no public enterprise achieves anoverall excellent rating unless it achieves itstarget for profit in that particular year. To

see how this is sought to be achieved, imagine that a particular public enterprise getsan excellent rating for all criteria includedin the second broad category of "all others'That is, on a scale of 1-5 it gets a raw scoreof '1.00' and a 'weighted raw score' of ;50'.Since to qualify as 'excellent' the enterprisehas to get a composite score of 1.50 or less,it must get a 'weighted raw score' of '1.00'or less for 'profit. Which, in turn, impliesthat the enterprise must achieve a raw scoreof 2.00 or less for 'pr ofi t'. Further, sincethe budgeted target for profit is placed under'2 in the 5-point scale for criteria values, theabove implies that to be rated as excellent,

an enterprise must, at the very least, achievethe target for profit. This is, of course, based on the assumption that the enterprise has

received an excellent rating for 'all other'criteria. If the enterprise does not get a rawscore of 1 in every other indicator besidesprofit, then the only way it could achieve anexcellent rating is by exceeding its target forprofits, that is, by getting a raw score of lessthan 2' for Profi t.

A few points are worth noting before proceeding any further. First, in the mannerdescribed above, the MOU system is able tointernalise the changing priorities of the.government in a systematic way. In the

absence of an objective methodology forperformance evaluation, there is a danger forextreme reactions which are either difficultto enforce or justify . In contrast, the currentmethod of mid-course adjustment appearsto be both just ifiable as well as quite feasible-

Second, the emphasis is on achieving the'target' for profit. That is, public enterprisesare not being asked to do a miracle and produce a whopping increase in their profits.Rather, the signal that is sought to be conveyed is that any slippage on the profit frontis becoming increasingly unacceptable. If anenterprise commits a certain level of profit,it must ensure that it delivers that amount

to the nation.1 However, before we examinewhat is it that the nation expects from ourpublic enterprises in the area of financialperformance, we must be clear about themeaning of the term 'performance in thiscontext.

I l l

Concept of Performance in MOUs

In any discussion on public enterprise performance, one must keep the followingdistinctions in mind:

(a) 'Enterprise' Performance versus

'Managerial' Performance: To highlight thisdistinction, let us illustrate it by taking anexample. Suppose we have a situation inwhich a profit-making enterprise suddenlybegins to make losses because of a reduction in the administered prices, in spite ofincreases in the physical efficiency parameters. In this case, we would say that the'enterprise performance has deterioratedeven though the managerial' performancehas improved. The reverse is an equallyplausible phenomenon. For instance, a sudden windfall gain could camouflage adecline in managerial efficiency, lb estimate'managerial performance; therefore; one hasto adjust 'enterprise performance for the effects of alI factors beyond the con trol of themanagement of the enterprise.

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However, "Table 4 shows that it is possibleto draft a M O U (such as that given in Table3) that enables the enterprise to get a composite score of '1.5 which is considered tobe 'excellent in the MO U parlance. Let usexamine the reasons for this apparently conflicting situation.

First, the mai n reason for this dichotomyis the lack of correlation between the threemajor financial indicators. While theGM/CE decreases, the other two-GP/CE

and PBT/NWdecrease. T his 'happensbecause there is a decline in 'Depreciation'as well as 'Previous tear's Expenses'. The important issue is that, in general, both theseitems do not have any relationship to managerial efficiency in the year in which theM O U is signed. I f one is using the accelerated depreciation method, the figures fordepreciation will decline automatically,ceteris paribus. Similarly, 'Previous Year'sExpenses' is a highly flexible item and oneof the major instruments of cosmeticsurgery for enterprise accounts. We surelydo not want to reward public enterprisesfor 'creative' accounting.

Some have argued that by measuring performance after netting out depreciationcharges, we wi l l force the public enterprisesto take better investment decisions. Thisbetrays a lack of understanding regardingthe purpose of the MOU pol icy. We have to,in fact, make a distinction between invest-ment efficiency' and 'operational' efficiency, MOUs focus is on the latter. It is concerned with the investment efficiency onlyto the extent of insuring that investmentdecisions are efficiently executed. Any majorinvestment decision takes several years toplan and implement. The final verdict on the

wisdom of that decision can only be madeonly after the project has become operational, which takes even longer. The MOUdocument, therefore, concentrates on the efficiency of executing the important milestones of a project. Clearly, depreciationcharges in a particular year have very littleto do with the efficiency or inefficiency inthis area. Most of the depreciation chargesfor a particular year are a result of the investment in the past.

Another reason for the anomalous outcome of Table 4 is the relative weights givento different criter ia. Since the earlier circulardid not mention any particular distributio n

of weights, this example is a valid possibility.Those who are famil iar wi th the science andart of conceptualisation would agree that avalid p ossibili ty is enough to warn us of thepotential dangers.

Unfortunately, the response to this eventuality has been equally misplaced It is beingsuggested by some that we must specify fixedrelative weights for each of these criteria.There are two problems wi th this approach.First, a particular distribution of weight willnot eliminate the possibility we have mentioned earlier. It might make it a bit diffic ultbut certainly not impossible. With anotherset of numbers one can demonstrate the

point.Further, this penchant for highly detailed,

uniform and dictated evaluation system iscontrary to the MOU philosophy as we

understand it. By keeping the evaluationcriteria unambiguous and simple, we will beimpr ovin g the quali ty of signals being sent.By increasing the number of duplicative andcontradictory indicators wit h sonic arbitrarydistribution of relative weights, we will befallin g in the Same trap from w hich we aretry ing to salvage our public enterprises. Thatis, to correct for one error we should makeanother error and make the situation evenworse.

As a final argument against the proposedevaluation system one has to ask the advocates of that system as to how they wishto evaluate the performance of the M O Usystem on the financial front in, say, fiveyears time, We wi ll be leaving a large leewayfor subjective judgments, i f at the end of fiveyears we find ourselves in a situation thatfor the entire set of MOU signing enterprises, some financial indicators have goneup and others have come down. Critics ofpublic enterprise will pick up indicators thathave gone down and the supporters wil l tryto focus on the ones that have increased.That is, at the macro level, there wiH still remain the age-old confusion in th inki ng wi thregard to public enterprises. For us, this isone good definition of the 'failure' for theMOU system.

Thus, we propose that the 50 per cent ofweight should be allocated to 'one particular'defin ition of pro fit. This wou ld be consistentwith the thinking of the HPC and help us

ju dg e the effectiveness pf the M O U systemmore objectively in this very important areaof concern. To see which par ticula r defini tion will be most appropriate, we examinethe following most commonly usedindicators.

OPTION l: RETURN ON INVESTMENT (ROI)

To start with there is no one standarddefinition of Return on Investment (ROI).

As per the most widely used Du Pom Con-trol Chart', ROI can be defined as:5

= Profit before Interest and Tax (PBIT)Total Assets (Net Block + Current

Assets)The problems associated with this in

dicator are as follows:

(1) Assume that from year 1 to year 2 thereis no change in any aspect of the 'real'performance of the enterprises that is,

it uses the same amount of inputs to produce identical output in both years,Therefore, we would like to have an indi cator that also reflects this reality of unchanged financial performance, How-ever, if ROI is included as the sole indicator in the MOU it would show animprovement because the denominatorwi l l decrease automatically by theamount of 'depreciation.

it is possible to argue that, indeed,performance has improved because themanager is producing the same amountwith an older plant and machinery.,However, since depreciation rates do not

reflect true 'deterioration', the percentageincrease in ROI may not be an accuratemeasure of managerial performance,

Further, depreciation rates depend onaccounting policies and can change overtime and across enterprises both as aresult of a change in policy as well as dueto cosmetic, though legal, surgery Onaccounts.

(2) Another problem wi th R OI is that it implicitly discriminates between differentways of 'cost-reduction'. This assumeserious proportions in the current context where cost reduction is a major

thrust area for MOUs.As an illust ratio n, let us take the following example: Suppose in yeai 1

ROI = PBIT/TA = 50/100;In year 2, let us see the implication of

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two alternative ways of reducing cost;Alternative V: Energy saving of Rs 10. Thisw i l l make RO I in year 2 = 60/1QP = .60Alternative 2: Reduction in stock of sparesby this amount will make ROI in year 2 -50/90 = .55

Thus, the first alternative will give a better ROI for same amount of cost savings.Ill other words, the management of an enterprise is being given a signal that cost savingsvia reduction in energy consumption aremore valuable than cost savings by othermeans, Now if this is done consciously, itmay be acceptable. Otherwise; use of ROIhas the risk of sending confusing signals.

The foregoing is not a general indictmentof ROI. Our only point is that it may notbean appropriate indicator for performanceevaluation in MOUs. Indeed, even in theprivate sector ROI is used more for diag-nostic' purpose as in the case of the famousDu Pont analysis rather than for performance evaluation, in the management controlliterature, 'Residual Income is advocated asa measure of perfo rmance evalua tion[Ant hony , 1989].

OPTION 2; GROSS PROFIT

According to DPEs Public EnterpriseSurvey, Gross Profit is defined as:

Excess of income over expenditure after providing for depreciation and charges pertaining to previous years but before providing forinterest on loans, taxes and appropriationsto reserves.

The difficulties associated with the use ofgross profit as an indi cator in the MO U areas follows:(1) It is subject to variation on account of

changes in depreciation policy which hasno correlation with changes in managerial performance. For example, if thereis no changes in inputs used and outputgenerated from year 1 to year 2, onewould want an MOU indicator thatwould also not change. However, GrossProfit wil l change automatically becausecurrent depreciation calculated on wr itten down value of assets (the most common accounting method of depreciation)will be lower in year 2, As discussed inan earlier section, this situation may leadto rewarding a manager when his marginal contribution to the national welfare

is n il . The bask problem is that depreciation is a function of time, accountingand taxation policies, rather than use, Intheory, it is supposed to be a proxy foreconomic rate of deterioration which is afunction of use and is a true economic cost.

(2) Another concern with Gross Profitrelates to the absence of a denominatoror numerator. It is possible that an enterprise may increase its gross profit fromyear 1 to year 2. However, if there hbeen a major increase in investment thena mere increase in gross profit may notbe truly reflective of any managerialachievements. Thus, we need a denomi

nator to normalise the performance inthe two years. This explains the preference for ratios in the performanceevaluation literature, (DPE circular sug

gests GP/CE; the problems pertaining toCE are explained earlier.)

(3) Net profit has the above problems in addition to several more. For example,change in the tax policy or practice canchange net profi t in an arbitrar y fashion.This would make a manager look goodor bad without any correlation with hiscontribution or true efforts made.

OPTION 3: GROSS MARGIN

Gross margin is defined as excess of income over expenditure before providing fordepreciation, deferred revenue expenditure,interest on loans, taxes and appropriationsto reserves.

This is a particularly important conceptand also a popular one Of the 23 enterprisesthat signed M O U for 1990-91' 10 includedgross margin as a criteria for performanceevaluation in one way or another.

As opposed to the previous two indicato rsthis has only one major problemit givesabsolute value rather than a ratio of performance. It is, without question, 'fair' to the

managers and the nation. However, it givesan indication of the absolute amount ofsurplus generated,

Only if the surplus generated increases canan enterprise have greater capacity to paydividend, taxes, interest, etc That is we needto make a distinction between 'surplusgenerated' and 'surplus distributed.

One must remember that if gross marginincreases, other things remaining constant,ROI, gross profit and internal resourcegeneration will necessarily go up. However,if ROI, gross profit and internal resourcegeneration go up, there is no guarantee thatthe gross margin wi l l necessarily go up.

MODIFYING GROSS MARGIN

The remaining problems associated wit hthe gross margin can be modified easily asfollows'

Problem 1: It is affected by changes in administered prices which arc beyond the control of managers.

Solutionflake it at a given year's price, i e, atconstant prices.

Problem 2; It ignores problems associated withcurrent asset management. This is, even ifthere is an increase in the level of inventories, the gross margin wilt not be affected-

However, the nation is clearly worse off asa result of accumulation of excess inventories.

Solution: Include Inventory Turnover and DebtorTurnover ratios in addition to Gross Margin'.

Problem 3: It represents an absolute value.Solution; Divide by gross block. As argued

earlier. Capital Employed can change simplywith the passage of time and, therefore,using CE as a denominator has the potential of giving a wrong signal.

V

Conclus ion

It is clear that financial performance has

moved to the centre-stage of the MOUpolicy. Th e mai n issue before policy-makersis to devise ways of internalising this policygoal. The above discussion reveals that the

best way to do so will be to give clear anaunambiguous signals to public enterpriseswith regard to what is espected from themin terms of financial performance. The current thin king of includin g a menu of profitand profit-related criteria may not be thebest way to achieve this. It is our belief thatwe can achieve the avowed policy objectivemore effectively by choosing Gross Ma rg in /Gross Block as the primary indicator forfinancial performance and attaching a

weight of $0 per cent to it . Gross Mar gin is,indeed, just one variant of the profit concept. In fact, wecan use PBITD instead ofGross Margin since both are nearly synonymous. In addition, we think the Debtors'Turnover and Inventory Turnover shouldalso be included in each M O U The weightsfor the latter ought to be in add itio n to the50 per cent for P BI TD but left to the jud gment of the M O U signing parties.

Notes

(We would like to thank the participants of theWorkshop on Memorandum of Understanding,

Hyderabad, February 11 13, 1992 for their valuableinputs While the conclusions of t his paper reflectthe broad consensus among the 40 participantsin the workshop, all errors of Omission and commission remain our sole responsibility. Part of thework on this paper was supported by the Centrefor Studies in Public Enterprise Management,Indian Institute of Management. Calcutta,!

1 In fact, in ihe Porta Control System, the DailyCash Flow report is the significant unique reportused for performance evaluation. See Sharma(1988) for further details on this system.

2 For details regarding the design and implementation of the MOU system, see Trivedi (1990 and1992).

3 It goes without saying that targeted profit implies targeted 'profit or loss'.

4 The distinction between 'performance evaluation' and 'performance explanation' is alsoworth keeping in mind. The former deals with'what' happened while the latter with 'why' ithappened, MOUs are supposed to deal wkh4whaf happened. Therefore, to includeparameters which will also tell us 'why' it happened can, at best, dilute the evaluation exercise and. at worst, affect performance by sen-ding fuzzy signals to the public enterprisemanagements.

5 Some people define ROI as PBT/NW, For moredetails regarding the Du Pom Control Chart,see: Sharma and Vithal (1989),

ReferencesAnthony, R N et al, Management Control Systems,

Sixth Edition, Richard D Irwin. Illinois, 1989.

Iyer, Rarrtaswamy R. 'Past Experience with PublicEnterprise Evaluation Systems in India' inPrajapati Trivedi (ed). Memorandum ofUnderstanding: An Approach to ImprovingPublic Enterprise Performance 1990, Inter-national Management Publishers, New Delhi.

Sharma. Subhash, Management Control Systems:Text and Cases. 1988. Tata-McGraw Hill, NewDelhi.

Sharma, Subhash and Vithal, M P, FinancialAccounting for Management: Text and Casts,1989, Macmillan, New Delhi.

Trivedi, Prajapati (ed). Memorandum of

Understanding: An Approach to ImprovingPublic Enterprise Performance, 1990, International Management Publishers, New Delhi.

A Critique of Public Enterprise Policy,1992, International Management Publishers, New Delhi.

4-62 Economic and Pol itical Weekly May 30, 1992

1992-05 menu of financial indicators used in mousan exercise in clarification

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