Chapter 15 Chapter 15 Performance Evaluation and Compensation Key Topics: –Agency theory –Knowledge and assigning decision-making authority –Performance measures: ROI, RI, EVA © –Incentive problems with measures –Transfer pricing Cost based versus market based –Incentive problems with transfer prices

Chapter 15 Principals and Agents Principals hire agents to make decisions for them and to act in their behalf. Agency Costs Costs that arise when agents are not acting in the interest of principals: Losses from poor decisions Losses from incongruent goals Monitoring costs Goal alignment costs Contracting costs

Chapter 15 Reducing Agency Costs To measure, monitor and motivate performance: –Assign responsibility for decision making –Link decision making authority to performance measurement –Use income-based measures to assess performance –Motivate performance with compensation schemes –Establish prices for the transfer of goods and services within an organization

Chapter 15 Assigning Authority and Responsibility Centralized and Decentralized Organizations General Versus Specific Knowledge Types of Responsibility Centers –Cost Centers –Discretionary Cost Centers –Revenue Centers –Profit Centers –Investment Centers Suboptimal Decision Making

Chapter 15 Return on Investment (ROI) ROI = operating income/average operating assets DuPont Analysis: ROI = investment turnover X return on sales = (revenue/average operating assets) X (operating income/sales)

Chapter 15 How to Increase ROI ROI = (sales/assets) X (income/sales) Increase sales (may increase income) Cut costs (increases income) Decrease assets Can encourage short-term improvements that reduce long-term gains

Chapter 15 Residual Income Residual income = operating income – (required rate of return * average operating assets) Less incentive to reduce assets Same incentives around operating income Increase sales and reduce costs

Chapter 15 Economic Value Added (EVA®) EVA © = Adjusted after-tax operating income – [weighted average cost of capital X (adjusted total assets – current liabilities)] Adjustments potentially remove incentives that encourage suboptimal behavior

Chapter 15 Problem Family Shoe Company produces and sells foot wear nationally and internationally. Following is information about two divisions. U.S. European Invested capital (total assets)$4,000,000$500,000 Net operating income$1,000,000$150,000 Required rate of return10% 10% Weighted average cost of capital 9% 9% Current liabilities$100,0000$10,000 After-tax income $700,000$75,000

Chapter 15 Questions A. Calculate each division’s ROI. B. Calculate each division’s residual income. C. Calculate each division’s EVA ©. D. Suppose the U.S. division had an opportunity to invest $3,500,000 in a project that would generate sales of $5,000,000 and return on sales 10%, or $500,000. Would the division manager be likely to undertake this project if he or she is evaluated using ROI? Explain. E. Recommend a performance evaluation measure that would increase the managers’ incentives to make decisions that would be in the best interests of the owners.

Chapter 15 Transfer Pricing Commonly-used alternatives: *Cost based * Market based Less commonly-used but good alternatives * Activity based *Dual rate *Negotiated

Chapter 15 Transfer Price Problem

Chapter 15 Questions

Chapter 15 Ideal Transfer Price The ideal transfer price is the opportunity cost. If at capacity: TP = VC + CM foregone = Market Price If excess capacity: TP = VC + 0 = Variable Cost

Chapter 15 Incentive Issues Conflicts among managers Suboptimal decision making Managers often have no control over transfer prices yet they affect results International income taxes restrict organizations’ ability to set transfer prices