Performance Measurement, Compensation, and Multinatinal Considerations by TBd92btU

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									                                                             Chapter 23


       Performance Measurement
                  &
             Compensation



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                                       Overview

• Financial & Nonfinancial Measures
• Accounting-based Measures
      –    Return on Investment
      –    Residual Income
      –    Economic Value Added
      –    Return on Sales
• Role of Salaries & Incentives
• Best Measure?
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           Financial and Nonfinancial
             Performance Measures

          Companies are supplementing internal
       financial measures with measures based on:
                       External financial information
                    Internal nonfinancial information
                   External nonfinancial information

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           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
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                     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.
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                     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.
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             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.


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            Accounting-Based Performance
                 Measure Example

                                            Boston Hotel


Current assets      $350,000                            Revenues         $1,100,000
Long-term assets 550,000                                Variable costs   297,000
Total assets        $900,000                            Fixed costs         637,000
Current liabilities $ 50,000                            Operating income $ 166,000

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                 Accounting-Based Performance
                      Measure Example


                                           Denver Hotel


Current assets      $ 400,000 Revenues         $1,200,000
Long-term assets       600,000 Variable costs  310,000
Total assets        $1,000,000 Fixed costs        650,000
Current liabilities $ 150,000 Operating income $ 240,000

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                 Accounting-Based Performance
                      Measure Example


                                            Miami Hotel


Current assets      $ 600,000                           Revenues         $3,200,000
Long-term assets 5,000,000                              Variable costs   882,000
Total assets        $5,600,000                          Fixed costs       1,166,000
Current liabilities $ 300,000                           Operating income $1,152,000

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             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
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                    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.
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                    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
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                     Return on Investment

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%
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                   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


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                              DuPont Method


          Return on sales = Income ÷ Revenues


Investment turnover = Revenues ÷ Investment


ROI = Return on sales × Investment turnover

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                              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%
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                              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%

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                              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%
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                              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%
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                              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?

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                              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

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                Economic Value Added

                  Economic value added (EVA®)
                     = After-tax operating income
             – [Weighted-average cost of capital
             × (Total assets – current liabilities)]



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                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.

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                 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
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 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%.
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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?

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 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%
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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
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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
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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


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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.
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                              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%
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               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%




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               Comparing Performance

                                     Methods Ranking
        Hotel                        ROI              RI     EVA® ROS
       Boston                         3                3      3    3
       Denver                         1                2      2    2
       Miami                          2                1      1    1


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          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.


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 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.

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  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.

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  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.




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                 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.
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                 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.

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                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.
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              Multinational Companies


            Difficulties exist when
          comparing the performance
            of divisions operating
            in different countries.

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         Salary & Incentives: The Basic
                   Trade-off


                              Most often, a manager’s total
                              compensation includes some
                               combination of salary and a
                              performance-based incentive.



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                   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.


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                                   Benchmarks

                 Owners can use benchmarks to
                      evaluate performance.
                  Benchmarks representing best
                 practice may be available inside
                   or outside the organization.


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                              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.
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                                 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.
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