© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-1 REWARDING BUSINESS PERFORMANCE Chapter 25

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-2 Goal Congruence Alignment of employee goals and objectives with organizational goals and objectives. Motivation and Aligning Goals and Objectives

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-3 Motivation and Aligning Goals and Objectives Feedback  Steer employees toward goals.  Measure progress in achieving goals. Measure performance. Improve performance. Reward performance.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-4 Return on investment is the ratio of profit to the average investment used to generate the profit. Return on Investment (ROI) ROI = Profit Average investment

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-5 Sales Average Investment ROI = Profit Average Investment ROI = Profit Sales × Return on Investment (ROI) Return on Sales Capital Turnover

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-6 Return on Investment (ROI) Holly Company reports the following: Profit $ 30,000 Sales$ 500,000 Average Investment$ 200,000 Holly Company reports the following: Profit $ 30,000 Sales$ 500,000 Average Investment$ 200,000 Let’s calculate ROI.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-7 Return on Investment (ROI) Sales Average Investment ROI = Profit Sales × ROI = 6% × 2.5 = 15% $500,000 $200,000 ROI = $30,000 $500,000 ×

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-8 Three ways to improve ROI  Increase Sales Prices  Decrease Expenses  Lower Invested Capital Improving ROI

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-9 Improving ROI Holly’s manager was able to increase sales revenue to $600,000 which increased income to $42,000. There was no change in invested capital. Holly’s manager was able to increase sales revenue to $600,000 which increased income to $42,000. There was no change in invested capital. Let’s calculate the new ROI.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Improving ROI Sales Average Investment ROI = Profit Sales × Holly increased ROI from 15% to 21%. ROI = 7% × 3.0 = 21% $600,000 $200,000 ROI = $42,000 $600,000 ×

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager would you invest in this project? Criticisms of ROI

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin As division manager, I wouldn’t invest in that project because it would lower my pay! Criticisms of ROI Gee... I thought we were supposed to do what was best for the company!

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Operating Earnings – Investment charge = Residual income Investment capital × Minimum return = Investment charge Investment center’s minimum acceptable return Residual Income

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Residual Income Flower Co. has an opportunity to invest $100,000 in a project that will earn $25,000. Flower Co. has a 20 percent minimum acceptable rate of return and a 30 percent ROI on existing business. Flower Co. has an opportunity to invest $100,000 in a project that will earn $25,000. Flower Co. has a 20 percent minimum acceptable rate of return and a 30 percent ROI on existing business. Let’s calculate residual income.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Residual Income Operating Earnings= $25,000 – Investment charge= 20,000 = Residual income = $ 5,000 Investment capital= $100,000 × Minimum return= × 20% = Investment charge= $ 20,000 Investment center’s minimum acceptable return

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Residual Income As a manager at Flower Co., would you invest the $100,000 if you were evaluated using residual income? Would your decision be different if you were evaluated using ROI? As a manager at Flower Co., would you invest the $100,000 if you were evaluated using residual income? Would your decision be different if you were evaluated using ROI?

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. Residual Income

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Economic value added tells us how much shareholder wealth is being created. Economic Value Added

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Economic Value Added Economic value added Economic value added is the annual after-tax operating profit minus the total annual cost of capital. Cost of capital Cost of capital is weighted-average after-tax cost of long-term borrowing and the cost of debt. DebtEquity

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin After-tax Operating Income – Investment charge = Economic value added (Total assets – current liabilities) × Weighted-average cost of capital = Investment charge After-tax cost of long-term borrowing and the cost of equity Economic Value Added

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Economic Value Added Economic value added can be improved in three ways...  Increase profit without using more capital.  Use less capital to earn the same amount of profit.  Invest capital in high-return projects. Economic value added can be improved in three ways...  Increase profit without using more capital.  Use less capital to earn the same amount of profit.  Invest capital in high-return projects.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin A set of performance targets and results that show an organization’s performance in meeting its responsibilities to various stakeholders. EmployeeStakeholderGroupInvestorStakeholderGroup Balanced Scorecard

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Financial Perspective How do we look to the firm’s owners? Learning and Growth Perspective How can we continually improve and create value? Business Process Perspective In which activities must we excel? Customer Perspective How do our customers see us? Balanced Scorecard Vision and Strategy

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Components of Management Compensation I prefer a fixed salary so that I know what I will be paid each year. I prefer a bonus arrangement that gives me the opportunity to earn larger amounts. I don’t mind the varying compensation. I like both profit sharing and stock options.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Design Choices for Management Compensation Should we reward current performance or future performance? Should our rewards be based on accounting numbers or stock price performance? Should bonuses be fixed or should they vary with a performance measure? Should bonuses be based on local or company-wide performance? Should teams of employees share bonuses equally or should they be in competition?

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin End of Chapter 25