ABSTRACT
Over recent decades, academics and practitioners have discussed the weaknesses of traditional and advanced financial performance measures which incorporate cost considerations. In particular, return on investment (ROI) – as a ratio based on historical accounting information – has major shortcomings in measuring the financial results of organizational units and in motivating management. First, it ignores the financial value of intangible assets such as research in progress, human resources and the competitive position. Due to asset valuation, depreciation policy and lack of instruction about the cost of capital, ROI furthermore has serious dysfunctional implications for investment decisions (Copeland, Koller, and Murrin, 2000; Dearden, 1969: 292; Nobel, 1990). To address some of the weaknesses of ROI, EVA has been advocated as an advanced alternative (Stewart, 1991). One of the strengths of EVA is the inclusion of opportunity costs in the performance assessment and hence in managerial decision-making. Additionally, EVA requires detailed adjustments of earnings and invested capital to move away from historical accounting principles towards more economic-based principles. Yet, empirical evidence shows that EVA has only marginally higher explanatory power in explaining stock returns than unaltered accounting figures (Biddle, Bowen, and Wallace, 1997). However, since the figure relies on past accounting information and disregards many other expectations of market participants, we suggest that the singular focus on such a narrow definition of shareholder value could distort financial performance measurement, and motivate management to undertake dysfunctional, short-term actions or gaming at the expense of long-term profitability. Finally, it should be noted that the conventional wisdom of accounting advocates NPV to be used for managerial decision-making. However, the success of the NPV technique depends on the ability to estimate cash flows and the project-specific weighted average cost of capital. When evaluating possible investments, many companies tend to focus on cost savings only and hence neglect the measurement of (in-)tangible benefits, the opportunity costs of the decision and the project-specific risk (Kaplan and Atkinson, 1989; Nobel, 1990).
