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Chapter 23. Performance Measurement & Compensation. 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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Performance measurement compensation

Chapter 23

Performance Measurement&Compensation


Overview
Overview

  • Financial & Nonfinancial Measures

  • Accounting-based Measures

    • Return on Investment

    • Residual Income

    • Economic Value Added

    • Return on Sales

  • Role of Salaries & Incentives

  • Best Measure?


Financial and nonfinancial performance measures
Financial and NonfinancialPerformance Measures

Companies are supplementing internal financial measures with measures based on:

External financial information

Internal nonfinancial information

External nonfinancial information


Financial and nonfinancial performance measures1
Financial and NonfinancialPerformance 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


Accounting based performance measure
Accounting-BasedPerformance 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.


Accounting based performance measure1
Accounting-BasedPerformance 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.


Accounting based performance measure example
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.


Accounting based performance measure example1
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


Accounting based performance measure example2
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


Accounting based performance measure example3
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


Accounting based performance measure example4
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


Approaches to measuring performance
Approaches toMeasuring 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.


Return on investment
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


Return on investment1
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%


Roi dupont method
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


Dupont method
DuPont Method

Return on sales = Income ÷ Revenues

Investment turnover = Revenues ÷ Investment

ROI = Return on sales × Investment turnover


Dupont method1
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%


Dupont method2
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%


Dupont method3
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%


Dupont method4
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%


Residual income
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?


Residual income1
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


Economic value added
Economic Value Added

Economic value added (EVA®)

= After-tax operating income

– [Weighted-average cost of capital

× (Total assets – current liabilities)]


Economic value added1
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.


Economic value added2
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


Economic value added example
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%.


Economic value added example1
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?


Economic value added example2
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%


Economic value added example3
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


Economic value added example4
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


Economic value added example5
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


Economic value added example6
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.


Return on sales
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%


Comparing performance
Comparing Performance

HotelROIRIEVA®ROS

Boston 18% $ 58,000 $ 26,950 15%

Denver 24% $120,000 $ 78,750 20%

Miami 21% $480,000 $249,900 36%


Comparing performance1
Comparing Performance

Methods Ranking

HotelROIRIEVA®ROS

Boston 3 3 3 3

Denver 1 2 2 2

Miami 2 1 1 1


Choosing the time horizon
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.


Choosing alternative definitions
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.


Choosing alternative definitions1
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.


Choosing alternative definitions2
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.


Choosing measurement alternatives
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.


Choosing measurement alternatives1
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.


Choosing measurement alternatives2
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.


Multinational companies
Multinational Companies

Difficulties exist when

comparing the performance

of divisions operating

in different countries.


Salary incentives the basic trade off
Salary & Incentives: The Basic Trade-off

Most often, a manager’s total

compensation includes some

combination of salary and a

performance-based incentive.


Intensity of incentives
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.


Benchmarks
Benchmarks

Owners can use benchmarks to

evaluate performance.

Benchmarks representing best

practice may be available inside

or outside the organization.


Good measures
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.


Best measure
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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