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Measuring and Rewarding Performance. Chapter 11. Measuring and Rewarding Performance. Tying the compensation system to performance measurement is essential because everyone in business recognizes that what gets measured and rewarded is what gets accomplished. Businesses

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slide1

Measuring and Rewarding Performance

Chapter 11

© 2007 by Nelson, a division of Thomson Canada Limited.

slide2

Measuring and Rewarding Performance

Tying the compensation system to performance measurement is

essential because everyone in business recognizes that what gets

measured and rewarded is what gets accomplished. Businesses

must focus their reward structures to motivate employees to

succeed at all activities that will create shareholder and personal

value. In this highly competitive age, success comes from providing high-quality products and services at reasonable prices while generating reasonable profit margins.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide3

Learning Objectives

Why should organizations use multiple performance

measures to assess performance?

How are return on investment (ROI) and residual income (RI) similar and different?

Why has economic value added (EVA) become a

popular performance measure?

Why are nonfinancial measures important

for evaluating performance?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide4

Learning Objectives

How are activity-based costing concepts related to

performancemeasurement?

Why is it more difficult to measure performance in

multinational firms than in solely domestic companies?

How should employee rewards, including compensation,

and performance be linked?

How do expatriate reward systems differ from those

for domestic operations?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide5

Supplementary Learning Objectives on the Web

What is open-book management and why does its

adoption require changes in accounting methods

and practices?

Why are operations of many firms becoming more

diverse, and how does the increasing diversity

affect the roles of the firms' accounting system?

W11-1

W11-2

© 2007 by Nelson, a division of Thomson Canada Limited.

slide6

Measuring Organizational

and Employee Performance

Organizational

Goals and

Objectives

General Rule #1:

Measures should

assess progress

© 2007 by Nelson, a division of Thomson Canada Limited.

slide7

Measuring Organizational

and Employee Performance

General Rule #2:

Persons being evaluated

should have had some input

in developing performance

measurements and should

be aware of them.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide8

Measuring Organizational

and Employee Performance

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.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide9

Measuring Organizational

and Employee Performance

General Rule #4:

Feedback relative to

performance should be

provided in a timely

and useful manner.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide10

The Need for Multiple Measures

Minimal lead time to market

Satisfactory earnings

Environmental social responsibility

Adequate cash flow

Customer satisfaction

Multiple

Company

Goals

Zero defects

© 2007 by Nelson, a division of Thomson Canada Limited.

slide11

Balanced Scorecard

A balanced scorecard ultimately links all aspects of performance to the company’s strategies. It is a performance measurement conceptualization that translates an organization's strategy into clear objectives, measures, targets, and initiatives organized by four perspectives:

  • financial,
  • customer,
  • internal business processes, and
  • learning and growth.

The balanced scorecard provides a set of financial and nonfinancial measures that encompass both internal and external perspectives.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide12

Balanced Scorecard

To succeed financially,

how should we appear

to our shareholders?

Objectives

Measures

Targets

Initiatives

Financial

To achieve our

vision, how

should we appear to

our customers?

Customer

To satisfy

shareholders and

customers, what

business processes

must we excel at?

Internal Business Process

Objectives

Measures

Targets

Initiatives

Objectives

Measures

Targets

Initiatives

To achieve our

vision, how

will we sustain our

ability to change

and improve?

Learning and Growth

Objectives

Measures

Targets

Initiatives

© 2007 by Nelson, a division of Thomson Canada Limited.

slide13

Balanced Scorecard

Research has shown that the strongest drivers of competitive achievement

are the intangibles, especially intellectual property, innovation, and quality.

If they are important, they should be measured.

Some of the most important intangible assets are relationships with

employees and customers. The quality of important relationships must be

measured.

Performance measures not only reflect strategy, they are also used for

process control. Therefore, they must be based on an analysis of the

company's processes, as well as an understanding of how these processes

are supported by knowledge and relationships.

Performance measures must be set at levels that will motivate employees

to do their best. Employees must know how they are going to be evaluated.

Communication of this information is essential in any performance

measurement process.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide14

Need for Feedback

Adjustment

Performance should be

monitored and feedback

provided on a continuous

basis.

Monitor

performance

Feedback

© 2007 by Nelson, a division of Thomson Canada Limited.

slide15

Financial Performance

Measurements for Managers

  • Cash Flow
  • Return on Investment
  • Residual Income
  • Economic Value Added

© 2007 by Nelson, a division of Thomson Canada Limited.

slide16

Cash Flow Statement

  • 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
  • short-term

© 2007 by Nelson, a division of Thomson Canada Limited.

slide17

Return on Investment (ROI)

ROI = Income  Assets

Return on investment – a ratio that relates income generated by the investment centre to the resources (or asset base) used to produce that income

© 2007 by Nelson, a division of Thomson Canada Limited.

slide18

Return on Investment (ROI)

or

ROI = Profit Margin x Asset Turnover*

IncomeSalesROI = x Sales Assets

Profit margin – the ratio of income to sales

Asset turnover – a ratio that measures asset productivity; it is the

number of sales dollars generated by each dollar of assets during a

specific period

*Du Pont model

© 2007 by Nelson, a division of Thomson Canada Limited.

slide19

Return on Investment (ROI)

  • Income defined
    • Is income defined as segment margin 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 assets available 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?

© 2007 by Nelson, a division of Thomson Canada Limited.

slide20

Return on Investment (ROI)

Du Pont model – profit margin x asset turnover

The Du Pont model provides refined information

about organizational improvement opportunities.

Profit margin indicates management's efficiency

(the relation between sales and expenses).

Asset turnover can be used to judge the

effectiveness of asset use relative to revenue

production.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide21

Return on Investment (ROI)

Richmond Machine Company (Exhibit 13-3)

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%

* Profit Margin X Asset Turnover

= $2,800,000 X $6,000,000

$6,000,000 $11,532,000

= .467 X .520

= .243

** Used original cost

of assets as current

value was not easily

determinable

© 2007 by Nelson, a division of Thomson Canada Limited.

slide22

Return on Investment (ROI)

  • Division's performances (profit margin and asset turnover)
  • can be evaluated relative to benchmark ratios.
  • Benchmarks
  • expectations of performance
  • industry performance levels
  • similar ratios for specific competitors
  • ROI can be manipulated
  • raising selling price (if demand will not be impaired)
  • decreasing expenses
  • decreasing dollars invested in assets

© 2007 by Nelson, a division of Thomson Canada Limited.

slide23

Return on Investment (ROI)

Many companies establish target rates of return (for the company or by division). Favourable rates should mean rewards for investment centre managers. Unfavourable rates should be viewed as opportunities for improvement. If asset turnover is low, analyze inventory turnover, accounts receivable turnover, and rate of utilization measures. Identify the causes of the problem and take corrective action.

When using ROI for performance evaluation consider all the relationships that determine ROI.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide24

Residual Income

Residual income – the profit earned that exceeds an

amount charged for funds committed to an investment

centre.

Residual Income = Income - (Target Rate x Asset Base)

  • The amount charged for funds is equal to a management specified target rate of return multiplied by the assets used by the division.
  • RI is concerned with dollars rather than percentages.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide25

Residual Income

Richmond 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

Targeted ROI x 12% x 12% x 12%

$ 1,383,840$ 124,440$1,069,800

RI $1,416,160 $ 335,960 $ (416,300)

========= ======== ========

© 2007 by Nelson, a division of Thomson Canada Limited.

slide26

Limitations of ROI and RI

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

© 2007 by Nelson, a division of Thomson Canada Limited.

slide27

Limitations of ROI and RI

  • Problems related to asset base
    • Some asset investment values are difficult to measure; others are not capitalized (R & D)
    • Some investments may not have been authorized by the current manager
    • Inflation causes investment book values to be understated unless they are price-level adjusted

© 2007 by Nelson, a division of Thomson Canada Limited.

slide28

Limitations of ROI and RI

Measures how well a profit center performs without

regard to corporate objectives, which can result

in suboptimization

Richmond Machine Company

Materials

MachineryHandlingTools

ROI 24.3%44.4%7.3%

RI $1,416,160$335,960$(416,300)

© 2007 by Nelson, a division of Thomson Canada Limited.

slide29

Limitations of ROI and RI

Richmond Machine Company (continued)

Which division(s) would be willing to invest in a

new project with an expected ROI of 15%

a. if performance evaluation was based on ROI?

b. if performance evaluation was based on RI?

c. What is the company's desired rate of return?

a. Tools. Machinery and Materials Handling would not accept the project as it would reduce their ROI.

b. All three divisions as the investment would increase RI.

c. 12% is the percent indicated by the calculation of RI

© 2007 by Nelson, a division of Thomson Canada Limited.

slide30

Economic Value Added

The trend in performance measurement is the development of

measures intended to align the interest of common shareholders

and managers more directly. Leading this trend is economic

value added (EVA).

EVA is a measure of net income produced above the cost of

capital*. The difference between RI and EVA is that the target

rate of return for EVA is applied to capital invested** in the

division rather than market value or book value of assets. Also,

EVA uses after-tax income (the amount available to shareholders).

*cost of capital – the weighted-average cost of capital (Web chapter 13)

**capital invested – the market value of total equity and interest-bearing

debt.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide31

Economic Value Added

Economic Value Added (EVA) –

After-tax Income

- (Cost of capital % x Capital invested)

From Exhibit 11-7:

EVA = $1,942,710 - (0.12 x $45,000,000) = $(3,457,290)

© 2007 by Nelson, a division of Thomson Canada Limited.

slide32

Nonfinancial Performance Measures

Nonfinancial performance measures (NFPMs) – statistics

on activities such as on-time delivery, manufacturing cycle

time, set-up time, defect rate, number of unplanned

production interruptions, and customer returns.

  • include the other three parts of the balanced scorecard
    • customer measures
    • internal business process measures
    • learning and growth measures
  • directly measure performance

in the activities that create

customer satisfaction and

shareholder wealth

© 2007 by Nelson, a division of Thomson Canada Limited.

slide33

Nonfinancial Performance Measures

  • Selection of nonfinancial measures
    • Identify critical success factors
    • Select attributes relating to measurement

of critical success factors for continuous

improvement (short- and long-run)

    • Can be qualitative or quantitative
    • Focuses on the activities that can

improve the future

  • Establishment of comparison bases

© 2007 by Nelson, a division of Thomson Canada Limited.

slide34

Nonfinancial Performance Measures

  • Benchmarks can be developed internally or determined from
  • external sources, such as other companies (regardless of
  • whether they are within the company's industry).
  • Employees must agree to
  • accept responsibility for performance
  • be evaluated
  • Monitoring and reporting performance levels should be carried
  • out at appropriate intervals – lower-level measures more
  • frequently than upper-level measures. Measures addressed
  • by middle-level employees are linkages between lower-level
  • and upper-level measures.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide35

Nonfinancial Performance Measures

  • Nonfinancial measures are superior, but they are not
  • always effective
  • there must be a causal relationship between
  • measures and strategy
  • links to strategy must be proven or validated
  • amount of periodic improvements must be made
  • explicit
  • metrics need to be employed that have statistical
  • validity and reliability

© 2007 by Nelson, a division of Thomson Canada Limited.

slide36

Process

Quality

Yield

Manufacturing

Cycle

Efficiency

Process

Productivity

Throughput =

x

x

Throughput

Synchronous management – all endeavours that help

an organization achieve its goals

Intent is to increase throughput while reducing inventory

and operating expenses

Throughput – the rate at which a company generates cash

from selling products and services to customers

components of throughput

© 2007 by Nelson, a division of Thomson Canada Limited.

slide37

Throughput Example

Worked 15,000 hours

Value-added – 6,000 hours

Units started, completed and sold – 30,000 units

Good units – 7,000 units

Throughput = Good units / Total time

Throughput = 27,000 / 15,000 = 1.80 units

OR, using the expanded version

© 2007 by Nelson, a division of Thomson Canada Limited.

slide38

Process

Quality

Yield

Manufacturing

Cycle

Efficiency

Process

Productivity

Throughput =

x

x

Throughput Example

© 2007 by Nelson, a division of Thomson Canada Limited.

slide39

Manufacturing Cycle Efficiency

MCE = Value-added Processing Time Total Time

MCE = 6,000  15,000 = 40%

The manufacturing cycle efficiency is

the proportion of total processing time

from beginning of production to

completion that is value added time

(relates to activities that increase the

product's worth to the customer).

© 2007 by Nelson, a division of Thomson Canada Limited.

slide40

Process Productivity

Process productivity – the total units produced during a period using

value-added processing time

Process Productivity = Total Units Value-Added Processing Time

Process Productivity = 30,000  6,000 = 5.0

© 2007 by Nelson, a division of Thomson Canada Limited.

slide41

Process Quality Yield

Process Quality Yield = Good Units Total Units

Process Quality Yield = 27,000  30,000 =90%

Process quality yield – the proportion of good units that resulted

from the activities expended

(reflects the quality of the production process)

© 2007 by Nelson, a division of Thomson Canada Limited.

slide42

Throughput

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.

Increase throughput by decreasing non-value-added

activities.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide43

Quality Indicators

Cost of Quality

Classifications

Measures

Prevention Hours of quality training

Appraisal Number of inspections

Internal failure Number of pieces rejected

External failure Number of customer

complaints

Drive down costs of appraisal and internal and external failure by

investing in prevention. Suggestion programs can be effective in

pointing out opportunities for continuous improvement.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide44

ABC 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

© 2007 by Nelson, a division of Thomson Canada Limited.

slide45

Traditional Performance Measures and Results

  • Purchase price variance
  • Action
  • Purchasing increases order quantity to get a lower price.
  • They ignore quality and speed of delivery.
  • Purchasing acquires inferior quality materials to generate a favourable price variance.
  • Result
  • Excess inventory, increased carrying cost; suppliers with
  • the best quality and delivery are overlooked
  • Production quality suffers and customers receive inferior
  • goods

© 2007 by Nelson, a division of Thomson Canada Limited.

slide46

Traditional Performance Measures and Results

  • Machine Utilization Percentage
  • Action
  • Supervisor requires employees to produce more than daily unit requirements to maximize machine utilization percentage
  • Result
  • Excess inventory; wrong inventory

© 2007 by Nelson, a division of Thomson Canada Limited.

slide47

Traditional Performance Measures and Results

  • Scrap Built into Standard Cost
  • Action
  • Supervisor takes no action if there is no variance
  • (from the lax standard)
  • Result
  • Inflated standard; scrap threshold built in

© 2007 by Nelson, a division of Thomson Canada Limited.

slide48

Traditional Performance Measures and Results

  • Overhead Rate Based on Expected Capacity
  • Action
  • Supervisor overproduces WIP or FG to have a
  • favourable fixed overhead volume variance
  • Result
  • Excess inventory

© 2007 by Nelson, a division of Thomson Canada Limited.

slide49

Traditional Performance Measures and Results

  • Responsibility Centre Reporting
  • Action
  • Management focus is on responsibility centres instead
  • of activities
  • Result
  • Missed cost reduction opportunities because common
  • activities among responsibility centres are overlooked

© 2007 by Nelson, a division of Thomson Canada Limited.

slide50

Performance Evaluation in Multinational 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

© 2007 by Nelson, a division of Thomson Canada Limited.

slide51

Performance Evaluation in Multinational Settings

  • (Continued)
  • Consider the short-run and the long-run.
  • Establish flexible systems of measuring profit.
  • Nonfinancial, qualitative factors may be more useful.
    • market share increases
    • quality improvements (reduction of defects)
    • establishment of JIT systems
    • new product development
  • Use measures that limit suboptimization of resources.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide52

Relating Compensation and Performance

Compensate employees in a manner that motivates them

to act in ways that result in the company's effectively and

efficiently achieving its goals.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide53

Plan-Performance-Reward Model

Set strategic goals

Identify critical success factors;

set operational targets and

compensation strategy

Determine reward

Identify performance measures

Employee/employee

groups perform tasks

Set performance rewards

Measure/monitor performance

© 2007 by Nelson, a division of Thomson Canada Limited.

slide54

Pay-for-Performance Plans

  • Must be highly correlated with operational targets
  • Should encourage employees to adopt a long-run perspective
  • When employees meet improvement objectives,

rewards follow, and organizational results can be

expected

  • Automatic raises are being reduced or eliminated
  • Pay for performance encourages goal congruence

Compensation strategy – a foundation for the compensation plan

that addresses the role compensation should play in the organization

© 2007 by Nelson, a division of Thomson Canada Limited.

slide55

Pay-for-Performance Plans

  • Top management
    • Significant portion of compensation in stock or stock options
    • If executives are short-term oriented, they can manipulate earnings, and exercise their options or sell their shares before share price falls. Nortel, Enron, WorldCom and others.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide56

Pay-for-Performance Plans

  • Basic worker-level
    • Specific measures
    • Focus on cost or quality control
  • Middle managers
    • Less specific, longer time horizon
    • Critical success factors under

manager's control

    • Compensation may include common stock

© 2007 by Nelson, a division of Thomson Canada Limited.

slide57

Pay-for-Performance Plans

  • Shift to evaluation based on output
    • captures results that are controllable and
    • noncontrollable
    • seek to identify measures that minimize
    • this risk
  • Consider basing compensation of subjective
  • measures
    • leadership skills
    • flexibility
    • attitude
    • ability to work well with colleagues
    • professional pride
    • enthusiasm

© 2007 by Nelson, a division of Thomson Canada Limited.

slide58

Compensation Packages

  • Middle Managers
  • Salaried
  • Opportunity for raises based on performance
  • Measurement usually accounting related, such as
  • segment income, ROI, or RI
  • Lower Level Workers
  • Wages (minimum wage, union contract)
  • May be opportunity for bonuses for exceeding some
  • specific quantitative measure – usually small percent
  • of wages
  • Top Management, and possibly, Sales Force
  • Significant incentive pay

© 2007 by Nelson, a division of Thomson Canada Limited.

slide59

Compensation Packages

  • Level and current compensation should affect types of rewards
  • given
  • Lower levels
    • incentive should be monetary and short-term
    • include some nonmonetary and long-term
  • Tangible rewards enhance their lifestyle; other (stock options)
  • cause them to take a long-term ownership view.
  • Higher level
    • incentives should be nonmonetary and long-term
    • include some monetary and short-term
  • More rewards in stock options should motivate them to be
  • concerned about the long-term.

© 2007 by Nelson, a division of Thomson Canada Limited.

slide60

Incentives

  • Group Compensation
  • Small groups
    • Usually the same as for individuals
    • Should include individual and group incentives
  • Nonfinancial Factors
  • Include rewards that show appreciation
  • Reduce Fear of Failure
  • Employee empowerment
  • Some failure is accepted (continuous improvement)

© 2007 by Nelson, a division of Thomson Canada Limited.

slide61

Global Compensation

  • Expatriates
  • Parent-company, and third-country
  • nationals assigned to foreign
  • subsidiaries
  • Foreign nationals assigned to the
  • parent company

© 2007 by Nelson, a division of Thomson Canada Limited.

slide62

Global Compensation

Begin with base salary and fringe benefits that employee would get domestically and adjust for:

  • Labor market factors
  • Cost-of-living considerations
  • Currency fluctuations
  • Tax consequences

© 2007 by Nelson, a division of Thomson Canada Limited.

slide63

Global Compensation

  • Base salary and fringe benefits should reflect what
  • he or she would have been paid domestically
  • cost of living factors
    • transportation, shelter, clothing, food
    • spouse's loss of employment
    • hire caregiver in home country
    • hire portfolio manager in home country
  • price-level adjustments
  • retirement benefits must be tied to home country
  • and paid in that currency
  • increase in amount of total income taxes

© 2007 by Nelson, a division of Thomson Canada Limited.

slide64

The End

© 2007 by Nelson, a division of Thomson Canada Limited.