Performance Measurement and Rewards

1. Chapter 15 Measuring and Rewarding Performance

2. Learning Objectives 1. Why should organizations use multiple performance measures to assess performance? 2. How are return on investment (ROI) and residual income (RI) similar and different? C15

3. Continuing . . . Learning Objectives 3. Why has economic value added (EVA) become a popular performance measure? 4. Why are nonfinancial measures important to evaluating performance? C15

4. Continuing . . . Learning Objectives 5. How are activity-based costing concepts related to performance measurement? 6. Why is it more difficult to measure performance in multinational firms than in solely domestic companies? C15

5. Continuing . . . Learning Objectives 7. How should employee rewards, including compensation, and performance be linked? 8. How do expatriate reward systems differ from those of domestic operations? C15

6. Performance Measurement Organizational Goals and Objectives General Rule #1: Measures should assess progress

7. Continuing . . . Performance Measurement General Rule #2: Persons being evaluated should have had some input in developing performance measurements and should be aware of them.

8. Continuing . . .Performance Measurement General Rule #3: Persons being evaluated should have appropriate skills and be provided the necessary equipment, information, and authority to be successful under the measurement system.

9. Continuing . . .Performance Measurement General Rule #4: Feedback relative to performance should be provided in a timely and useful manner.

10. Need for Multiple Measures Minimal lead time to market Satisfactory earnings Customer satisfaction MULTIPLE COMPANY GOALS Adequate cash flow Zero defects Environmental social responsibility

11. Balanced Scorecard A balanced scorecard ultimately links all aspects of performance to the company’s strategies. The balanced scorecard provides a set of financial and nonfinancial measures that encompass both internal and external perspectives.

12. Balanced Scorecard A balance scorecard examines the following questions: • How will we look to our stockholders if we succeed? • How must we look to our customers to achieve our strategies? • What business processes must we excel at to satisfy customers? • How must our organization function to achieve our strategies?

13. Appropriate Tools for Performance Training Support Information Authority Equipment

14. Need for Feedback Performance monitored and feedback provided on a continuous basis Feedback Adjustment Monitor performance

15. Financial Performance Measurements for Managers • Divisional Profits • Cash Flow • Return on Investment • Residual Income • Economic Value Added

16. Divisional Profits • Segment margin of a profit center or income of an investment center • Compare with budget • Also compare individual revenues and expenses with budget • Short-term measure

17. Potential Manipulation of Segment Margin • Sales transactions can be shifted between periods. • If a cost flow method other than FIFO is being used, inventory purchases can be accelerated or deferred to change the Cost of Goods Sold. • If actual OH is allocated to inventory, an increase in production will cause cost per unit to decline because of the nature of fixed costs.

18. Continuing . . . PotentialManipulation of Segment Margin • Replacement of workers who have resigned or been terminated can be deferred to minimize salary expense for the period. • Discretionary costs can be delayed or eliminated to reduce expenses. • Depreciation methods may be changed.

19. Statement of Cash Flows • Provides information about the cash impacts of operating, investing, and financing activities • Helps managers to judge an entity’s ability to meet current fixed cash outflow commitments, undertake new commitments, and adapt to adverse changes in business conditions • Assists managers in judging the quality of the entity’s earnings • Can be manipulated

20. Return on Investment (ROI) ROI = Income  Assets or ROI = Profit Margin x Asset Turnover or Income Sales ROI = ---------- x ---------- Sales Assets

21. Return on Investment Questions • Income defined • Is income defined as segment or operating income? • Is income defined on a before-tax or after-tax basis? • Is income defined on a before-interest or after-interest basis? • Assets defined • Should assets be defined as total asset utilized; total assetsavailable for use; or net assets? • Should plant assets be included in the asset denominator at original cost; depreciated book value; or current values? • Should beginning, ending, or average assets be used?

22. Exhibit 15-3:Bellingham Machine Company Materials Machinery Handling Tools Segment Margin $ 2,800,000 $ 460,400 $ 653,500 Assets Invested 11,532,000 1,037,000 8,915,000 ROI 24.3% 44.4% 7.3%

23. Residual Income • The profit earned that exceeds an amount “charged” for funds committed to an investment center • Concerned with dollars rather than percentages Residual Income = Income - (Target Rate x Asset Base)

24. Exhibit 15-5:Bellingham Machine Company Materials Machinery Handling Tools Segment Margin $ 2,800,000$ 460,000$ 653,500 Assets Invested $11,532,000 $1,037,000 $8,915,000 Targeted ROI x 12% x 12% x 12% $ 1,383,840$ 124,440$1,069,800 RI $ 1,416,160 $ 335,960 $ (416,300) ========= ======== ========

25. Limitations ofROI and Residual Income • Problems related to income • Income can be manipulated on a short-run basis • All investment centers must use same accounting methods • Does not consider cash flows • Does not consider time value of money

26. Continuing . . . Limitations ofROI and Residual Income • Problems related to asset base • Some asset investment values are difficult to measure • Some investments may not have been authorized by current manager • Inflation causes investment book values to be understated unless they are price-level adjusted • Measures how well center performs without regard to company-wide objectives

27. Economic Value Added EVA = After-tax Profits - (Capital Invested x Cost of capital %) From Exhibit 15-7: EVA = $1,942,710 - ($45,000,000 x 0.12) = $(3,457,290)

28. NonfinancialPerformance Measures • Directly measure an entity’s performance in the activities that create shareholder wealth • May better predict the direction of future cash flows

29. Continuing . . . NonfinancialPerformance Measures • Selection of nonfinancial measures • Identify critical success factors • Select attributes relating to measurement of critical success factors • Can be qualitative or quantitative • Focuses on the activities that can improve the future • Establishment of comparison bases

30. Performance Evaluation System ISSUES FREQUENCY Top management Broad Less Middle management Lower-level management More Immediate

31. Process Quality Yield Manufacturing Cycle Efficiency Process Productivity Throughput = x x Throughput The number of good units or quantity of services produced and sold within a time period

32. Throughput Example Worked 15,000 hours Value-added was 6,000 hours Units started, completed and sold was 30,000 units Good units were 27,000 units

33. Manufacturing Cycle Efficiency MCE = Value-added Processing Time Total Time MCE = 6,000  15,000 = 40%

34. Process Productivity Process Productivity = Total Units Value-Added Processing Time Process Productivity = 30,000  6,000 = 5.0

35. Process Quality Yield Process Quality Yield = Good Units Total Units Process Quality Yield = 27,000  30,000 = 90% ===

36. Throughput Example Throughput = .40 x 5.0 x .9 = 1.80 units The division produced and sold only 1.80 good units for every hour of total actual processing time. This is quite different from the 5.0 units indicated as process productivity.

37. Quality Indicators Prevention Prevention cost Total cost of quality Appraisal Number of inspections Internal failure Number of pieces rejected External failure Number of customer complaints Cost of Quality Classifications Measure

38. Activity-Based Costing and Performance Measurement • Traditional performance measurements include non-value-added activities • Non-value-added activities must be removed from performance evaluation measurements • Value-added activities must be substituted • Stresses external performance measurements

39. Performance Evaluation inMultinational Settings • Recognize differences in comparing multinational units • Culture and economies • Accounting standards and reporting practices • Government regulations • Investment base may differ substantially; assign different target rate to compute residual income • Consider trade tariffs, income tax rates, currency fluctuations, restrictions on transfer of goods and currency

40. RelatingCompensation and Performance

41. Plan-Performance-Reward Model Set strategic goals Identify critical success factors; set operational targets and compensation strategy Employee/employee groups perform tasks Measure/monitor performance Identify performance measures Set performance rewards Determine reward

42. Pay-for-Performance Plans • Must be highly correlated with operational targets • Should encourage employees to adopt a long-run perspective • Appropriate time horizon • At basic worker level, performance should be specific and focus on cost and/or quality control • At higher levels, focus on longer time horizon

43. Compensation Packages • Lower-level workers • Hourly wage • Bonus above some specified quantitative measure • Middle managers • Salaries • Opportunity for raise based on performance

44. Continuing . . .Compensation Packages • Top management • Significant incentive pay • All levels some monetary and some nonmonetary rewards • Balance incentives for both groups and individuals

45. Nonfinancial Factors • Recognition of efforts • Compliments and small awards • Allow subordinates to participate in decisions • Job security

46. Global Compensation • Labor market factors • Cost-of-living considerations • Currency fluctuations • Tax consequences Begin with base salary and fringe benefits that employee would get domestically and adjust for: