Financial performance measures and reward systems TOPIC 10: Financial performance measures and reward systems Reference Chapter: 13 Financial performance measures for investment centres, and reward systems

Financial measures in investment centres Summary financial performance measures are used to assess the performance of profit centres and investment centres Return on investment (ROI) Residual income (RI) Economic value added (EVA)

Return on investment Return on investment (ROI) Used to measure the financial performance of an investment centre (cont.)

Return on investment (cont.)

Return on investment (cont.) Invested capital The assets that the investment centre has available to generate profits Return on sales The percentage of each sales dollar that remains as profit after all the expenses are covered Investment turnover The number of sales dollars generated by every dollar of invested capital (cont.)

Return on investment (cont.) Improving ROI Increase return on sales By increasing the selling price or sales revenue, or decreasing expenses Increase investment turnover By increasing sales revenue or reducing invested capital Actions that are taken with the sole purpose of making these ratios more favourable in the short term may have adverse effects on performance in future years

The advantages of ROI Widely used in practice to measure the performance of units and managers Encourages managers to focus on both profits, and the assets required to generate those profits Promotes an understanding of the relationship between revenues, costs and assets Can be used to evaluate the relative performance of investment centres, even when those business units are of different sizes

The limitations of ROI It may encourage managers to focus on improving short-term financial performance, which may sometimes reduce long-term financial performance May encourage managers to defer asset replacement, to maintain a high ROI Discourages managers from investing in projects which are acceptable from the organisation’s point of view, but which decrease the investment centre’s ROI

Minimising the behavioural problems of ROI Use ROI as one of several performance measures that focus on both short-term and long-term performance Consider alternative ways of measuring invested capital to minimise dysfunctional decisions Use alternative financial measures, such as residual income or economic value added

Residual income Residual income (RI) Imputed interest charge = profit – (invested capital × imputed interest rate) Imputed interest charge Based on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capital Weighted average cost of capital (WACC) is the weighted average of the cost of funds from all sources of borrowings and equity

The advantage of residual income More likely to promote goal congruence, compared to ROI Takes account of the organisation’s required rate of return in measuring performance Encourages investment in projects which yield a positive residual income to the organisation

Disadvantages of residual income Cannot be used to assess the relative performance of businesses that are of different sizes, unlike ROI Formula is biased in favour of larger businesses, unlike ROI Can encourage short-term orientation/focus, as with ROI

Measuring profit and invested capital Total assets Investment centre manager is responsible for decisions about all assets Total productive assets Investment centre managers retain non-productive assets Total assets less current liabilities Investment centre is responsible for decisions about assets and manages short-term liabilities Choose average or end-of-year balances

Measuring profit Profit margin controllable by investment centre manager Suitable when the focus is to assess the performance of the manager Encourages managers to focus on profit that they can control Motivational impact Profit margin attributable to investment centre Suitable when the focus is to assess the performance of the investment centre (cont.)

Reward systems Processes, practices and systems which are used to provide levels of pay and benefits to employees Motivation The processes that account for an individual’s intensity, direction and persistence of effort towards attaining goals Intrinsic motivation Derives from the interest and enjoyment of the work Extrinsic motivation Derives from sources outside the individual

Theories of motivation Herzberg’s theory of work motivation Hygiene factors Provide the setting for encouraging employee motivation, but do not themselves motivate employees Working conditions, wage levels, rules and regulations, relationships with colleagues, job security Motivators Factors that relate to job content and which provide employee motivation Achievement, recognition, the nature of the work, responsibility, opportunities for personal growth (cont.)

Theories of motivation (cont.) Expectancy theory Employee motivation is a result of the strength of the relationships between expectancy, instrumentality and valence Expectancy: perception that effort will lead to a certain performance Instrumentality: perception that performance will lead to desired outcome Valence: the attractiveness of the reward Motivational theories need to be considered by managers when they are designing performance evaluation and reward systems

Performance-related reward systems Performance-related pay systems (incentive compensation schemes) Link employee rewards for achieving or exceeding some performance target Individual incentive plans Individuals are rewarded for achieving individual performance targets Subjective criteria may also be used Commonly used at the higher levels of an organisation (cont.)

Performance-related reward systems (cont.) Profit-sharing plans Cash bonuses are paid to each employee, based on a specified percentage of the company’s profit Does not tie individual effort to individual rewards Employee share plans (share option plans) Provide employees with the right to purchase shares in their company at a specified price at some specified future time Commonly used for senior managers, and sometimes more junior managers and employees Considered to encourage goal congruence (cont.)

Performance-related reward systems (cont.) Gainsharing Cash bonuses are distributed to employees when the performance of the company, or their segment of the company, exceeds some performance target Team-based incentive schemes Individuals are rewarded based on their work team exceeding certain performance targets Intended to encourage teamwork and cooperation between employees Does not tie individual effort to individual rewards

Group versus individual performance Consider the following issues Identification with the group Equity among employees Competitiveness between employees Relating individual effort to reward Rewarding only good performers The timing of incentive payments can be crucial to achieving desired outcomes More frequent rewards may help ensure continual motivation Providing rewards as close as possible after the period they relate to may be more motivational

Summary Return on investment is often used to evaluate performance of investment centres Can encourage managers to focus on achieving high profits through the efficient use of assets, but can also encourage dysfunctional decisions These can be reduced through using a range of performance measures that focus on short and long term, using alternative measures of profit and invested capital, and using other financial measures such as residual income or EVA (cont.)

Summary (cont.) Reward systems can be used to encourage goal congruent behaviour When designing performance-related schemes it is important to understand what motivates employees Performance-related reward systems include individual incentives, profit-sharing, employee share plans, gainsharing, team-based incentives The frequency and timing of payments may impact on the effectiveness of the reward system in increasing motivation