Performance Measurement & Compensation Chapter 23 Performance Measurement & Compensation 2009 Foster Business School Cost Accounting L.DuCharme

Overview Financial & Nonfinancial Measures Accounting-based Measures Return on Investment Residual Income Economic Value Added Return on Sales Role of Salaries & Incentives Best Measure? 2009 Foster Business School Cost Accounting L.DuCharme

Financial and Nonfinancial Performance Measures Companies are supplementing internal financial measures with measures based on: External financial information Internal nonfinancial information External nonfinancial information 2009 Foster Business School Cost Accounting L.DuCharme

Financial and Nonfinancial Performance Measures Some organizations present financial and nonfinancial performance measures for their subunits in a single report  the Balanced Scorecard. Most scorecards include: (1) profitability measures (2) customer-satisfaction measures (3) internal measures of efficiency, quality, and time (4) innovation measures – 2009 Foster Business School Cost Accounting L.DuCharme

Accounting-Based Performance Measure Step 1: Choose performance measures that align with top management’s financial goal(s). Step 2: Choose the time horizon of each performance measure in Step 1. Step 3: Choose a definition for each. 2009 Foster Business School Cost Accounting L.DuCharme

Accounting-Based Performance Measure Step 4: Choose a measurement alternative for each performance measure in Step 1. Step 5: Choose a target level of performance. Step 6: Choose the timing of feedback. 2009 Foster Business School Cost Accounting L.DuCharme

Accounting-Based Performance Measure Example Relax Inns owns three small hotels: one each in Boston, Denver, and Miami. At the present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels. 2009 Foster Business School Cost Accounting L.DuCharme

Accounting-Based Performance Measure Example Boston Hotel Current assets $350,000 Long-term assets 550,000 Total assets $900,000 Current liabilities $ 50,000 Revenues $1,100,000 Variable costs 297,000 Fixed costs 637,000 Operating income $ 166,000 2009 Foster Business School Cost Accounting L.DuCharme

Accounting-Based Performance Measure Example Denver Hotel Current assets $ 400,000 Long-term assets 600,000 Total assets $1,000,000 Current liabilities $ 150,000 Revenues $1,200,000 Variable costs 310,000 Fixed costs 650,000 Operating income $ 240,000 2009 Foster Business School Cost Accounting L.DuCharme

Accounting-Based Performance Measure Example Miami Hotel Current assets $ 600,000 Long-term assets 5,000,000 Total assets $5,600,000 Current liabilities $ 300,000 Revenues $3,200,000 Variable costs 882,000 Fixed costs 1,166,000 Operating income $1,152,000 2009 Foster Business School Cost Accounting L.DuCharme

Accounting-Based Performance Measure Example Total current assets $1,350,000 Total long-term assets 6,150,000 Total assets $7,500,000 Total current liabilities $ 500,000 Long-term debt 4,800,000 Stockholders’ equity 2,200,000 Total liabilities and equity $7,500,000 2009 Foster Business School Cost Accounting L.DuCharme

Approaches to Measuring Performance Three approaches include a measure of investment: Return on investment (ROI) Residual income (RI) Economic value added (EVA®) A fourth approach, return on sales (ROS), does not measure investment. 2009 Foster Business School Cost Accounting L.DuCharme

Return on Investment Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment. Return on investment (ROI) = Income ÷ Investment 2009 Foster Business School Cost Accounting L.DuCharme

What is the return on investment for each hotel? Boston Hotel: $166,000 Operating income ÷ $900,000 Total assets = 18% Denver Hotel: $240,000 Operating income ÷ $1,000,000 Total assets = 24% Miami Hotel: $1,152,000 Operating income ÷ $5,600,000 Total assets = 21% 2009 Foster Business School Cost Accounting L.DuCharme

ROI: DuPont Method The DuPont method of profitability analysis recognizes that there are two basic ingredients in profit making: 1. Using assets to generate more revenues 2. Increasing income per dollar of revenues 2009 Foster Business School Cost Accounting L.DuCharme

DuPont Method Return on sales = Income ÷ Revenues Investment turnover = Revenues ÷ Investment ROI = Return on sales × Investment turnover 2009 Foster Business School Cost Accounting L.DuCharme

DuPont Method How can Relax Inns attain a 30% target ROI for the Denver hotel? Present situation: Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = 1.20 Operating income ÷ Revenues = $240,000 ÷ $1,200,000 = 0.20 1.20 × 0.20 = 24% 2009 Foster Business School Cost Accounting L.DuCharme

DuPont Method Alternative A: Decrease assets, keeping revenues and operating income per dollar of revenue constant. Revenues ÷ Total assets = $1,200,000 ÷ $800,000 = 1.50 1.50 × 0.20 = 30% 2009 Foster Business School Cost Accounting L.DuCharme

DuPont Method Alternative B: Increase revenues, keeping assets and operating income per dollar of revenues constant. Revenues ÷ Total assets = $1,500,000 ÷ $1,000,000 = 1.50 Operating income ÷ Revenues = $300,000 ÷ $1,500,000 = 0.20 1.50 × 0.20 = 30% 2009 Foster Business School Cost Accounting L.DuCharme

DuPont Method Alternative C: Decrease costs to increase operating income per dollar of revenues, keeping revenues and assets constant. Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = 1.20 Operating income ÷ Revenues = $300,000 ÷ $1,200,000 = 0.25 1.20 × 0.25 = 30% 2009 Foster Business School Cost Accounting L.DuCharme

Residual Income Residual income (RI) = Income – (Required rate of return × Investment) Assume that Relax Inns’ required rate of return is 12%. What is the residual income from each hotel? 2009 Foster Business School Cost Accounting L.DuCharme

Residual Income Boston Hotel: Total assets $900,000 × 12% = $108,000 Operating income $166,000 – $108,000 = Residual income = $58,000 Denver Hotel = $120,000 Miami Hotel = $480,000 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Economic value added (EVA®) = After-tax operating income – [Weighted-average cost of capital × (Total assets – current liabilities)] 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Total assets minus current liabilities can also be computed as: Long-term assets + Current assets – Current liabilities, or… Long-term assets + Working capital TA – CL = L-T debt + SE = funds invested for the long term. 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Economic value added (EVA®) substitutes the following specific numbers in the RI calculations: 1. Income equal to after-tax operating income 2. A required rate of return equal to the weighted-average cost of capital 3. Investment equal to total assets minus current liabilities 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Example Assume that Relax Inns has two sources of long-term funds: 1. Long-term debt with a market value and book value of $4,800,000 issued at an interest rate of 10% 2. Equity capital that also has a market value of $4,800,000 and a book value of $2,200,000 Tax rate is 30%. 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Example What is the after-tax cost of capital? 0.10 × (1 – Tax rate) = 0.07, or 7% Assume that Relax Inns’ cost of equity capital is 14%. What is the weighted-average cost of capital? 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Example WACC = [(7% × Market value of debt) + (14% × Market value of equity)] ÷ (Market value of debt + Market value of equity) WACC = [(0.07 × 4,800,000) + (0.14 × 4,800,000)] ÷ $9,600,000 WACC = ($336,000 + $672,000) ÷ $9,600,000 WACC = 0.105, or 10.5% 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Example What is the after-tax operating income for each hotel? Boston Hotel: Operating income $166,000 × 0.7 = $116,200 Denver Hotel: Operating income $240,000 × 0.7 = $168,000 Miami Hotel: Operating income $1,152,000 × 0.7 = $806,400 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Example What is the investment? Boston Hotel: Total assets $900,000 – Current liabilities $50,000 = $850,000 Denver Hotel: Total assets $1,000,000 – Current liabilities $150,000 = $850,000 Miami Hotel: Total assets $5,600,000 – Current liabilities $300,000 = $5,300,000 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Example What is the weighted-average cost of capital times the investment for each hotel? Boston Hotel: $850,000 × 10.5% = $89,250 Denver Hotel: $850,000 × 10.5% = $89,250 Miami Hotel: $5,300,000 × 10.5% = $556,50 2009 Foster Business School Cost Accounting L.DuCharme

Economic Value Added Example What is the economic value added? Boston Hotel: $116,200 – $89,250 = $ 26,950 Denver Hotel: $168,000 – $89,250 = $ 78,750 Miami Hotel: $806,400 – $556,500 = $249,900 The EVA® charges managers for the cost of their investments in long-term assets and working capital. 2009 Foster Business School Cost Accounting L.DuCharme

Return on Sales The income-to-revenues (sales) ratio, or return on sales (ROS) ratio, is a frequently used financial performance measure. What is the ROS for each hotel? Boston Hotel: $166,000 ÷ $1,100,000 = 15% Denver Hotel: $240,000 ÷ $1,200,000 = 20% Miami Hotel: $1,152,000 ÷ $3,200,000 = 36% 2009 Foster Business School Cost Accounting L.DuCharme

Comparing Performance Hotel ROI RI EVA® ROS Boston 18% $ 58,000 $ 26,950 15% Denver 24% $120,000 $ 78,750 20% Miami 21% $480,000 $249,900 36% 2009 Foster Business School Cost Accounting L.DuCharme

Comparing Performance Methods Ranking Hotel ROI RI EVA® ROS Boston 3 3 3 3 Denver 1 2 2 2 Miami 2 1 1 1 2009 Foster Business School Cost Accounting L.DuCharme

Choosing the Time Horizon The second step of designing accounting-based performance measures is choosing the time horizon of each performance measure. Many companies evaluate subunits on the basis of ROI, RI, EVA®, and ROS over multiple years. 2009 Foster Business School Cost Accounting L.DuCharme

Choosing Alternative Definitions The third step of designing accounting-based performance measures is choosing a definition for each performance measure. Definitions include the following: 1. Total assets available – includes all assets, regardless of their particular purpose. 2009 Foster Business School Cost Accounting L.DuCharme

Choosing Alternative Definitions 2. Total assets employed: includes total assets available minus the sum of idle assets and assets purchased for future expansion. 3. Total assets employed minus current liabilities excludes that portion of total assets employed that are financed by short-term creditors. 2009 Foster Business School Cost Accounting L.DuCharme

Choosing Alternative Definitions 4. Stockholders’ equity: using in the Resorts Inns example requires allocation of the long-term liabilities to the three hotels, which would then be deducted from the total assets of each hotel. 2009 Foster Business School Cost Accounting L.DuCharme

Choosing Measurement Alternatives The fourth step of designing accounting-based performance measures is choosing a measurement alternative for each performance measure. The current cost of an asset is the cost now of purchasing an identical asset to the one currently held. Historical-cost asset measurement methods generally consider the net book value of the asset. 2009 Foster Business School Cost Accounting L.DuCharme

Choosing Measurement Alternatives The fifth step of designing accounting-based performance measures is choosing a target level of performance. Historical cost measures are often inadequate for measuring economic returns on new investments and sometimes create disincentives for expansion. 2009 Foster Business School Cost Accounting L.DuCharme

Choosing Measurement Alternatives The sixth step of designing accounting-based performance measures is choosing the timing of feedback. Timing of feedback depends largely on how critical the information is for the… …success of the organization. …specific level of management involved. …sophistication of the organization. 2009 Foster Business School Cost Accounting L.DuCharme

Multinational Companies Difficulties exist when comparing the performance of divisions operating in different countries. 2009 Foster Business School Cost Accounting L.DuCharme

Salary & Incentives: The Basic Trade-off Most often, a manager’s total compensation includes some combination of salary and a performance-based incentive. 2009 Foster Business School Cost Accounting L.DuCharme

Intensity of Incentives How large should the incentive component be relative to salary? Preferred performance measures are ones that are sensitive to, or change significantly, with the manager’s performance. 2009 Foster Business School Cost Accounting L.DuCharme

Benchmarks Owners can use benchmarks to evaluate performance. Benchmarks representing best practice may be available inside or outside the organization. 2009 Foster Business School Cost Accounting L.DuCharme

Good Measures Obtaining performance measures that are more sensitive to employee performance is critical for implementing strong incentives. Many management accounting practices, such as the design of responsibility centers and the establishment of financial and nonfinancial Measures, have as their goal better performance evaluation. 2009 Foster Business School Cost Accounting L.DuCharme

Best Measure So then, what is the best measure of performance? NONE (is best)!! They all measure a different aspect (dimension) of performance! Often times several measures are combined to get a “better” measure. 2009 Foster Business School Cost Accounting L.DuCharme