REWARDING BUSINESS PERFORMANCE Chapter 25 REWARDING BUSINESS PERFORMANCE Chapter 25: Rewarding Business Performance

Learning Objective To explain the importance of incentive systems for motivating performance. Learning objective number 1 is to explain the importance of incentive systems for motivating performance. LO1

Motivation and Aligning Goals and Objectives Goal Congruence Alignment of employee goals and objectives with organizational goals and objectives. Goal congruence exists when employees, acting in their own self interest, are at the same time acting in the best interest of the business. The goals of employees and the goals of the business are achieved simultaneously.

Motivation and Aligning Goals and Objectives Feedback Steer employees toward goals. Measure progress in achieving goals. Measure performance. Reward performance. To encourage employees to act in the best interests of the business, we measure employee performance, provide positive feedback to employees, and reward employees whose performance is helping the business reach its goals. Improve performance.

To use the DuPont system to evaluate business performance. Learning Objective To use the DuPont system to evaluate business performance. Learning objective number 2 is to use the DuPont system to evaluate business performance. LO2

Return on Investment (ROI) Return on investment is the ratio of profit to the average investment used to generate the profit. ROI = Profit Average investment Let’s look at some common measures used to evaluate the performance of a business segment. One of the most common is return on investment, or ROI. ROI is defined as profit divided by average investment. It is the percentage return on the average capital invested to generate the profit in a period of time. Because DuPont Company first used ROI to evaluate business performance about 100 years ago, this method is is often referred to as the DuPont system. Using ROI to evaluate business performance is often referred to as the DuPont system.

Return on Investment (ROI) Profit Average Investment Sales × Sales Average Investment Sometimes it’s helpful to take a more detailed look at ROI, by considering two additional financial ratios that are components of ROI. A company’s return on sales is defined as profit divided by sales. Capital turnover is sales divided by average investment in assets. You can see that sales is common to both return on sales and capital turnover. It’s in the denominator of the return on sales and in the numerator of the turnover. When we multiply return on sales times capital turnover, we get ROI. Return on Sales Capital Turnover

Return on Investment (ROI) Holly Company reports the following: Profit $ 30,000 Sales $ 500,000 Average Investment $ 200,000 Here we can see some information for Holly Company. Before advancing to the next screen, calculate ROI for Holly Company. Let’s calculate ROI.

Return on Investment (ROI) Sales Average Investment ROI = Profit × ROI = 6% × 2.5 = 15% $500,000 $200,000 ROI = $30,000 × Part I Did you find ROI to be 15 percent? Now let’s calculate ROI by using return on sales and capital turnover. Part II Return on sales is the $30,000 income divided by $500,000 in sales. Capital turnover is $500,000 in sales divided by the $200,000 average investment. Now we can compute ROI by multiplying the 6 percent return on sales times the capital turnover of 2.5.

Three ways to improve ROI Improving ROI Decrease Expenses Increase Sales Prices Lower Invested Capital As business managers, it’s important to know there are three ways to improve your return on investment. The first is to increase sales prices. The second is to reduce your expenses (which increases your operating income), and the third way is to reduce your invested capital. Three ways to improve ROI

Let’s calculate the new ROI. Improving ROI Holly’s manager was able to increase sales revenue to $600,000 which increased income to $42,000. There was no change in invested capital. Let’s return again to the Holly example, but in this particular case, the managers at Holly were able to increase sales to $600,000 and that led to an increase in income to $42,000. Average invested capital is unchanged at $200,000. Let’s calculate ROI, using return return on sales and capital turnover. Let’s calculate the new ROI.

Improving ROI Sales Average Investment ROI = Profit × $600,000 $200,000 ROI = $42,000 × Part I Calculate ROI using return on sales and capital turnover. Part II Return on sales is the $42,000 income divided by $600,000 in sales. Capital turnover is $600,000 in sales divided by the $200,000 average investment. Now we can compute ROI by multiplying the 7 percent return on sales times the capital turnover of 3.0. By increasing return on sales from 6 percent to 7 percent and increasing capital turnover from 2.5 to 3.0, Holly increased ROI from 15 percent to 21 percent. Holly increased ROI from 15% to 21%.

Learning Objective To identify and explain the criticisms of using return on investment (ROI) as the only performance measure. Learning objective number 3 is to identify and explain the criticisms of using return on investment (ROI) as the only performance measure. LO3

As division manager would you Criticisms of ROI As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. ROI is sometimes criticized because it can lead to managers to make decisions contrary to the best interests of the business, a lack of goal congruence. Let’s illustrate this problem with an example. Suppose you’re the manager of a segment of a company, and ROI is used to evaluate your performance and to determine your annual bonus. The company requires an ROI of 15 percent on all invested funds. Your division has been producing an ROI of 30 percent, well above the company minimum. You are presented an opportunity to invest in a new project that will produce an ROI of 25 percent. As the division manager, would you invest in this project? As division manager would you invest in this project?

Criticisms of ROI Gee . . . I thought we were supposed to do what was best for the company! As division manager, I wouldn’t invest in that project because it would lower my pay! As the division manager, you probably wouldn’t invest in this 25 percent project because it would reduce your overall ROI below 30 percent, resulting in a reduction of your bonus. The problem is that the project, overall, would be profitable to the operations of the business. So you’re doing what’s best for your personal interest, but it may not be in the company’s best interest. Your decision illustrates a lack of goal congruence.

Learning Objective To calculate and explain residual income (RI) and economic value added (EVA). Learning objective number 4 to calculate and explain residual income(RI) and economic value added (EVA). LO4

Investment center’s minimum acceptable return Residual Income Operating Earnings – Investment charge = Residual income Investment capital × Minimum return = Investment charge Another measure of performance is known as residual income. Residual income is operating earnings above some minimum return on invested capital specified by the company. The dollar amount of the minimum return on invested capital is called an investment charge. On your screen you see the investment charge subtracted from operating earnings to get residual income. Investment center’s minimum acceptable return

Let’s calculate residual income. Flower Co. has an opportunity to invest $100,000 in a project that will earn $25,000. Flower Co. has a 20 percent minimum acceptable rate of return and a 30 percent ROI on existing business. Suppose you’re a division manager for a company and you have the opportunity to invest $100,000 in a new project that will earn $25,000. The company requires that you earn a minimum return of 20 percent on all invested capital. Let’s calculate residual income for the new project. Let’s calculate residual income.

Investment center’s minimum acceptable return Residual Income Operating Earnings = $25,000 – Investment charge = 20,000 = Residual income = $ 5,000 Investment capital = $100,000 × Minimum return = × 20% = Investment charge = $ 20,000 We calculate the $20,000 investment charge by multiplying the 20 percent minimum return times the $100,000 of invested capital. Next, we subtract the $20,000 investment charge from the operating earnings of $25,000 to get $5,000 of residual income. Investment center’s minimum acceptable return

Residual Income As a manager at Flower Co., would you invest the $100,000 if you were evaluated using residual income? Would your decision be different if you were evaluated using ROI? If you are evaluated on the ability to generate residual income, you would invest in the project. Since your division’s current ROI is 30 percent and the new project returns only 25 percent, you would reject the investment if your performance is evaluated using ROI.

Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. One of the real advantages of residual income is that it encourages managers to make profitable investments that might be rejected by managers whose performance is evaluated on the basis of ROI.

Economic Value Added Economic value added tells us how much shareholder wealth is being created. Now let’s look at another concept to measure performance, economic value added, an indication of increase in shareholder wealth.

Economic Value Added Economic value added is the annual after-tax operating profit minus the total annual cost of capital. Cost of capital is weighted-average after-tax cost of long-term borrowing and the cost of equity. Economic value added is annual after-tax operating profit less the total annual cost of invested capital used to generate the operating income. The dollar amount of the cost of invested capital is a function of the weighted average cost of acquiring investment funds by long-term borrowing and by equity investments of the owners. Equity Debt

After-tax cost of long-term borrowing and the cost of equity Economic Value Added After-tax Operating Income – Investment charge = Economic value added (Total assets – current liabilities) × Weighted-average cost of capital = Investment charge Here we see how to compute economic value added. Economic value added is after-tax operating income above an investment charge. The investment charge is computed by multiplying the weighted average cost of capital times total assets minus current liabilities. Total assets minus current liabilities is the portion of the total asset investment financed by long-term borrowing and owners’ equity. After-tax cost of long-term borrowing and the cost of equity

Economic value added can be improved in three ways . . . Increase profit without using more capital. Use less capital to earn the same amount of profit. Invest capital in high-return projects. Companies can increase economic value added by using the same amount of capital to earn more profits, by using less invested capital to earn the same amount of profits, and by investing its capital in higher return projects.

Learning Objective To use the balanced scorecard to identify, evaluate, and reward business performance. Learning objective number 5 is to use the balanced scorecard to identify, evaluate, and reward business performance. LO5

Balanced Scorecard A set of performance targets and results that show an organization’s performance in meeting its responsibilities to various stakeholders. It would be shortsighted for a business to maximize one performance measure at the expense of other, possibly equally important performance measures. Businesses have the responsibility to serve several interested parties, including employees, owners, and customers. A balanced approach to serving all parties will lead to long-run success. Employee Stakeholder Group Investor Stakeholder Group 13

Balanced Scorecard Financial Perspective How do we look to the firm’s owners? Vision and Strategy Learning and Growth Perspective How can we continually improve and create value? Business Process Perspective In which activities must we excel? In the balanced scorecard approach, we continually develop measurements that help us analyze or answer questions such as how do we appear to our owners; how do we appear to our customers; what kind of continual learning and growth are we involved in; which processes within the organization are excellent and which need improvement? The key sequence of events in the balanced scorecard approach is that learning improves business processes. Improved business processes translate to improved customer satisfaction. When we have a high degree of customer satisfaction, we have improved financial results. Customer Perspective How do our customers see us?

Learning Objective To identify and explain the components of management compensation and the trade-offs that compensation designers make. Learning objective number 6 is to identify and explain the components of management compensation and the trade-offs that compensation designers make. LO6

Components of Management Compensation I prefer a bonus arrangement that gives me the opportunity to earn larger amounts. I don’t mind the varying compensation. I like both profit sharing and stock options. I prefer a fixed salary so that I know what I will be paid each year. As companies design and implement compensation systems, they must be sensitive to different employee preferences in order maximize the motivational effect of compensation. Some employees are willing to take risks with a smaller salary and an opportunity for greater, but varying, compensation based on bonus plans, profit sharing and stock options. Other employees prefer a known fixed amount of compensation.

Design Choices for Management Compensation Should we reward current performance or future performance? Should teams of employees share bonuses equally or should they be in competition? Should bonuses be fixed or should they vary with a performance measure? Compensation and reward systems are complex. Management faces a number of difficult choices. Some of those choices are displayed as questions on your screen. The objective is to reward outstanding performance in a manner that creates and maintains goal congruence throughout the business. Should bonuses be based on local or company-wide performance? Should our rewards be based on accounting numbers or stock price performance?

Ethics, Fraud, and Corporate Governance Companies may compensate management with perquisites such as company planes and luxury sports boxes that are sometimes controversial and subject to abuse. These perquisites must be (1) authorized by the board of directors, (2) properly disclosed, and (3) included in taxable compensation of management. Companies may compensate management with perquisites such as company planes and luxury sports boxes that are sometimes controversial and subject to abuse. These perquisites must be (1) authorized by the board of directors, (2) properly disclosed, and (3) included in taxable compensation of management. If these requirements are not met, both the company and management are exposed to civil and criminal legal actions. If these requirements are not met, both the company and management are exposed to civil and criminal legal actions.

End of Chapter 25 End of Chapter 25.