Chapter 13 Financial performance measures for investment centres, and reward systems

1. Chapter 13Financial performance measures for investment centres, and reward systems

2. Outline Financial measures in investment centres Return on investment Residual income Measuring profit and invested capital Measures of shareholder value Reward systems Theories of motivation Performance-related reward systems

3. 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)

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

5. Return on investment (cont.) (cont.)

6. Return on investment (cont.) (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

7. 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

8. 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

9. 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

10. 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

11. Residual income • Residual income (RI) = 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

12. 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

13. 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

14. 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

15. Asset measurement (cont.) • Advantages of using the carrying amount • Consistency with balance sheet that is prepared for external reporting purposes • Consistent with the definition of profit • Advantages of using acquisition cost • Choice of depreciation method is arbitrary and resulting carrying amount does not provide a reliable measure • Depreciating non-current assets may provide a disincentive to invest in new equipment

16. Asset measurement (cont.)

17. Measuring profit (cont.) • 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

18. Measuring profit (cont.)

19. Measures of shareholder value (cont.) • Shareholder value • The worth of the business from the shareholders’ perspective • Value-based management (VBM) • Using shareholder value analysis to manage a business • A framework for making key business decisions that add economic value to the business • Consists of four aspects • Valuation, strategy, finance and corporate governance

20. Measures of shareholder value (cont.) (cont.) • Valuation • Discounted cash flows (DCF) are usually used to measure value • Future cash flows of the business are discounted taking into account the risk associated with those cash flows • Value drivers are the activities or actions that create value for a business • Include spread, growth, sustainability and cost of capital

21. Measures of shareholder value (cont.) (cont.) • Strategy • Has a substantial and continuing impact on the value of the business • Finance • Financial policies will influence value creation • Corporate governance • Involves selecting and implementing systems that contribute to value creation

22. Measures of shareholder value (cont.) (cont.) • Economic value added (EVA) • Measure of the value created over a single accounting period • The spread between the return generated by the business activities and the cost of capital

23. Measures of shareholder value (cont.) (cont.) • Weighted average cost of capital • Used in the calculation of EVA and RI • To improve EVA • Improve profitability without employing additional capital • Borrow additional funds when the profits earned are more than the cost of borrowing • Pay off debt by selling assets • Limitations of EVA • There is potential for manipulation and for taking a short-term orientation, as with ROI and RI

24. Measures of shareholder value (cont.) • Shareholder value added (SVA) = corporate value – the market value of debt • Corporate value is the present value of the future cash flows • Residual value is the value of the firm at the end of the forecast period

25. 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

26. Theories of motivation (cont.) • 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

27. 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

28. Performance-related reward systems (cont.) • 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

29. Performance-related reward systems (cont.) (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

30. 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

31. 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

32. Summary (cont.) 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

33. 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