Copyright © 2015 Pearson Education, Inc. All Rights Reserved Performance Measurement, Compensation, and Multinational Considerations

Copyright © 2015 Pearson Education, Inc. All Rights Reserved 1. Select financial and nonfinancial performance measures to use in a balanced scorecard 2. Examine accounting-based measures for evaluating a business unit’s performance, including return on investment (ROI), residual income (RI), and economic value added (EVA®) 3. Analyze the key measurement choices in the design of each performance measure 23-2

Copyright © 2015 Pearson Education, Inc. All Rights Reserved 4. Study the choice of performance targets and design of feedback mechanisms 5. Indicate the difficulties that occur when the performance of divisions operating in different countries is compared 6. Understand the roles of salaries and incentives when rewarding managers 7. Describe the four levers of control and why they are necessary 23-3

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Many organizations record financial and nonfinancial performance measures for their subunits on a balanced scorecard. The scorecards of different organizations emphasize different measures but the measures are always derived from a company’s strategy. In a balanced scorecard, the four perspectives are: 1. Financial 2. Customer 3. Internal business process 4. Learning and growth 23-4

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Requires several steps: 1. Choose performance measures that align with the firm’s financial goals. 2. Choose the details of each performance measure. 3. Choose a target level of performance and a feedback mechanism for each performance measure. 23-5

Copyright © 2015 Pearson Education, Inc. All Rights Reserved 1. Return on investment 2. Residual income 3. Economic value added 4. Return on sales (this measure does not account for investment) 23-6

Copyright © 2015 Pearson Education, Inc. All Rights Reserved 23-7  ROI is an accounting measure of income divided by an accounting measure of investment.

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Most popular metric for two reasons: 1. Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage 2. May be compared to other ROI’s both inside and outside the firm  Also called the accounting rate of return (ARR) or the accrual accounting rate of return (AARR) 23-8

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  ROI may be decomposed into its two components as follows:  ROI = Return on Sales X Investment Turnover.  This approach is known as the DuPont Method of Profitability Analysis. It recognizes the two basic ingredients in profit making: increasing income per dollar of revenue and using assets to generate more revenues. An improvement to either with no change in the other will increase ROI. 23-9

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Residual income (RI) is an accounting measure of income minus a dollar amount for required return on an accounting measure of investment.  RI = Income – (RRR X Investment)  RRR = Required Rate of Return  Required rate of return times the investment is the imputed cost of the investment.  Imputed costs are costs recognized in some situations, but not in the financial accounting records

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  EVA is a variation of RI used by many companies. It is calculated as follows:  Weighted average cost of capital equals the after-tax average cost of all long-term funds in use.

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Return on sales is also known as the income- to-revenues ratio or the sales ratio  It is frequently used, simple to compute, and widely understood.  It does not take into account investment.  It measures how effectively costs are managed It is calculated by taking Operating Income / Revenues and is expressed as a percentage

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Using the example of the hotels from our textbook, we see the results using each of our methods: (in parentheses are the ranks) HotelROIRIEVAROS SF24% (1)$120,000 (2)$68,250 (2)20% (2) Chicago15% (3)$ 60,000 (3)$15,750 (3)21% (1) New Orleans17% 92)$150,000 (1)$73,500 (1)16% (3)

Copyright © 2015 Pearson Education, Inc. All Rights Reserved How should each measure be computed? Several questions should be answered to begin:  What is the time horizon?  Which definition of investment will be used?  How shall we calculate various components of each performance measure such as the measurement of assets.  Let’s now discuss each of these measurement details

Copyright © 2015 Pearson Education, Inc. All Rights Reserved An important element in designing accounting- based performance measures is choosing the time horizon of the performance measures.  Multiple periods of evaluation are sometimes appropriate.  ROI, RI, EVA, and ROS all basically evaluate one period of time.  ROI, RI, EVA, and ROS may all be adapted to evaluate multiple periods of time

Copyright © 2015 Pearson Education, Inc. All Rights Reserved There are several benefits to multiyear analysis:  Benefits of actions taken in the current period may not show up in short-run performance measures.  If managers use NPV for investment decisions, then using a multiyear RI for performance achieves goal congruence.  Motivates managers to take a long-run perspective by compensating them on changes in market price

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Four common alternative definitions of investment: 1. Total assets available – all assets. 2. Total assets employed – all assets less idle assets and assets purchased for future expansion. 3. Total assets employed minus current liabilities – total assets employed less assets financed by short-term creditors. 4. Stockholder’s equity – assign liabilities to subunits and deduct from total assets

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Possible alternative asset measurements include: 1. Current cost – cost of purchasing an asset today identical to the one currently held. 2. Gross value of fixed assets – historical cost. 3. Net book value(NBV) of fixed assets – historical cost. (Historical cost is used to calculate ROI and there is always a question whether to use gross or net book value. NBV is the measure most commonly used by companies for internal performance evaluation.) 23-18

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Choosing target levels of performance:  Establish target ROIs using historical-cost-based measures.  Set continuous improvement targets.  Use balanced scorecards to establish targets.  Choosing the timing of feedback (depends on):  How critical the information is for the success of the organization.  The management level receiving feedback.  The sophistication of the organization’s information technology

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Additional difficulties faced by multinational companies:  The economic, legal, political, social, and cultural environments differ significantly across countries.  Import quotas and tariffs range widely from country to country.  Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure also differ significantly across countries.  Divisions operating in different countries account for their performance in different currencies and inflation and fluctuation in foreign-currency exchange rates affect performance measurement

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  The performance evaluation of a manager should be distinguished from the performance evaluation of that manager’s subunit, such as a division of the company.  The reason for this is to recognize that a company may put the most skilled division manager in charge of the division with the poorest return in an effort to improve that division and that may take years

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  An inherent trade-off exists between creating incentives and imposing risk.  An incentive should be some reward for performance.  An incentive may create an environment in which suboptimal behavior may occur: the goals of the firm are sacrificed in order to meet a manager’s personal goals.  The motivation for having some salary and some performance-based compensation is to balance the benefit of incentives against the extra cost of imposing risk on a manager

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Moral hazard describes a situation in which an employee prefers to exert less effort compared with the effort the owner desires because the owner cannot accurately monitor and enforce the employee’s effort

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Intensity of incentives—how large the incentive component of a manager’s compensation should be relative to their salary component.  The tradeoff between considerations of sensitivity and risk, on the one hand, and the congruence of goals, on the other, determines the effective intensity of incentives placed on each measure of performance

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Benchmarks are metrics that correspond to the best practices of organizations and may be available inside or outside of the organization

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Managers need to do two things when designing the measures used to evaluate performance of individual employees: 1. Design performance measures for activities that require multiple tasks. 2. Design performance measures for activities done in teams

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Employers want employees to allocate their time and effort intelligently among various tasks or aspects of their jobs.  A team achieves better results than individual employees acting alone. 1 Many companies reward employees on teams based on how well their team performs

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Based on both financial and nonfinancial performance measures, and include a mix of:  Base salary.  Annual incentives, such as cash bonuses.  Long-run incentives, such as stock options.  Well-designed plans use a compensation mix that balances risk (the effect of uncontrollable factors on the performance measure, and hence compensation) with short-run and long-run incentives to achieve the firm’s goals

Copyright © 2015 Pearson Education, Inc. All Rights Reserved Performance evaluation measures help managers track their progress toward achieving a company’s strategic goals.  Because these measures help diagnose whether a company is performing to expectations, they are collectively called Diagnostic Control Systems.  Companies motivate managers by holding them accountable and rewarding them for meeting goals

Copyright © 2015 Pearson Education, Inc. All Rights Reserved To prevent unethical and outright fraudulent behavior, companies balance the push for performance (resulting from Diagnostic Control Systems) with three other levers of control:  Boundary systems.  Belief systems.  Interactive control systems.  Each lever is important and needs to be monitored.  Levers should be interdependent and collectively represent a living system of business conduct

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Boundary systems describe standards of behavior and codes of conduct expected of all employees.  Highlights actions that are “off-limits.”  A code of conduct describes appropriate and inappropriate individual behaviors

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Belief systems articulate the mission, purpose, and core values of a company.  They describe the accepted norms and patterns of behavior expected of all managers and other employees when interacting with one another, shareholders, customers, and communities

Copyright © 2015 Pearson Education, Inc. All Rights Reserved  Interactive control systems are formal information systems that managers use to focus the company’s attention and learning on key strategic issues.  Helps managers create open dialog and eliminate or manage an excessive focus on diagnostic control systems.  Tracks strategic uncertainties that businesses face

Copyright © 2015 Pearson Education, Inc. All Rights Reserved TERMS TO LEARNPAGE NUMBER REFERENCE Belief systemsPage 895 Boundary systemsPage 895 Current costPage 884 Diagnostic control systemsPage 894 Economic value added (EVA®)Page 880 Imputed costPage 879 Interactive control systemsPage 896 InvestmentPage 876 Moral hazardPage 890 Residual income (RI)Page 879 Return on investment (ROI)Page

Copyright © 2015 Pearson Education, Inc. All Rights Reserved 23-35