Copyright © 2003 Pearson Education Canada Inc. Slide Chapter 24 Performance Measurement, Compensation, and Multinational Considerations

Copyright © 2003 Pearson Education Canada Inc. Slide Accounting-Based Performance Measurement Steps to Take in Designing a System 1.Choose variable(s) that represent top management’s financial goal(s) 2.Choose the time horizon for performance measures 3.Choose definitions of the items included in the variables in Step 1 4.Choose measures for the items included in the variables in Step 1 5.Choose a target against which to gauge performance 6.Choose the timing of feedback Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Return on Investment (ROI) Return on Investment = Popular approach to incorporate the investment base into the performance measure Includes all the major ingredients of profitability (revenues, costs and investment) Pages Income Investment Return on Investment = Revenues Investment x Income Revenues ProfitabilityTurnover Can break out the basic formula as follows (sometimes called the DuPont formula) to measure investment turnover and profitability

Copyright © 2003 Pearson Education Canada Inc. Slide Residual Income (RI) Residual Income Pages Required rate of return is also called the imputed cost of capital Residual income yields an absolute number Residual income = $240,000 – (12% x $1,000,000) = $120,000 Required rate of return x Investment = Income -

Copyright © 2003 Pearson Education Canada Inc. Slide Problems with Residual Income (RI) RI is favoured by some firms as managers will focus on maximizing an absolute dollar amount (dollars of residual income) rather than a percentage (ROI) Maximizing a % may result in suboptimal performance managers earning high ROI%s may reject projects that earn more than the company’s required rate of return managers earning low ROI% may accept projects that earn less than the company’s required rate of return Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Economic Value Added (EVA ® ) EVA uses the weighted-average cost of capital (WACC) as the minimum required rate of return WACC represents the after-tax cost of capital from all debt and equity sources Many companies also make adjustments to the accounting definition of operating income such as capitalizing (and amortizing) R&D, restructuring costs, and leases Pages Economic Value Added = After- tax Operating Income - Weighted average cost of capital x Total assets - Current liabilities

Copyright © 2003 Pearson Education Canada Inc. Slide Alternative Measures of Performance When calculating ROI and RI, can consider investment as being: Total assets available Total assets employed Working capital plus long-term assets Stockholders’ equity When considering long-term assets, value based on Current cost Gross book value (historical cost) Net book value (historical cost - accumulated amortization) Replacement cost (replace productive capacity) Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Distinction Between Managers and Units Must distinguish between the performance of the manager and the performance of the organizational sub-unit or division Company may put the strongest manager in the weakest division to change its fortunes Recognize the role of salaries and incentives in compensation arrangements Recognize situations where an employee might less effort than desired because the employee’s efforts cannot be accurately measured and monitored Benchmarking or “relative performance evaluation” may be used to filter out the effect of common uncontrollable factors Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Performance Measures Providing incentives at the individual activity level may be difficult if employees are performing multiple tasks as part of their job Must measure and compensate performance on all aspects of the job and ensure that all aspects are properly emphasized In many cases, employees are grouped together in teams to perform certain tasks May reward individuals on the basis of team performance The success of team-based compensation arrangements depends on the culture and management style of the organization Pages

Copyright © 2003 Pearson Education Canada Inc. Slide Executive Compensation Most executive compensation plans are based on a blend of financial and non-financial performance measures including: base salary annual incentives (often based on net income) long-term incentives (including stock options) fringe benefits Successful combinations emphasize achievement of goals administrative ease acceptance of the overall package as being fair Page 895