©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Performance Measurement, Compensation, and Multinational Considerations

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 1 Measure performance from a financial and a nonfinancial perspective.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Financial and Nonfinancial Performance Measures Companies are supplementing internal financial measures with measures based on: External financial information Internal nonfinancial information External nonfinancial information

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Financial and Nonfinancial Performance Measures Some organizations present financial and nonfinancial performance measures for their subunits in a single report – the balanced scorecard. Most scorecards include: – profitability measures – customer-satisfaction measures

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Financial and Nonfinancial Performance Measures – internal measures of efficiency, quality, and time – innovation measures Some performance measures have a long-run time horizon. Other measures have a short-run time horizon.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Design an accounting-based performance measure.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accounting-Based Performance Measure Step 1: Choose performance measures that align with top management’s financial goal(s). Step 2: Choose the time horizon of each performance measure in Step 1. Step 3: Choose a definition for each.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accounting-Based Performance Measure Step 4: Choose a measurement alternative for each performance measure in Step 1. Step 5: Choose a target level of performance. Step 6: Choose the timing of feedback.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accounting-Based Performance Measure Example Relax Inns owns three small hotels – one each in Boston, Denver, and Miami. At the present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accounting-Based Performance Measure Example Boston Hotel Current assets$350,000 Long-term assets 550,000 Total assets$900,000 Current liabilities$ 50,000 Revenues$1,100,000 Variable costs 297,000 Fixed costs 637,000 Operating income$ 166,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accounting-Based Performance Measure Example Denver Hotel Current assets$ 400,000 Long-term assets 600,000 Total assets$1,000,000 Current liabilities$ 150,000 Revenues$1,200,000 Variable costs 310,000 Fixed costs 650,000 Operating income$ 240,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accounting-Based Performance Measure Example Miami Hotel Current assets$ 600,000 Long-term assets 5,000,000 Total assets$5,600,000 Current liabilities$ 300,000 Revenues$3,200,000 Variable costs 882,000 Fixed costs 1,166,000 Operating income$1,152,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Accounting-Based Performance Measure Example Total current assets$1,350,000 Total long-term assets 6,150,000 Total assets$7,500,000 Total current liabilities$ 500,000 Long-term debt 4,800,000 Stockholders’ equity 2,200,000 Total liabilities and equity$7,500,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Approaches to Measuring Performance Three approaches include a measure of investment: Return on investment (ROI) Residual income (RI) Economic value added (EVA ® ) A fourth approach, return on sales (ROS), does not measure investment.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 3 Analyze return on investment (ROI) using the DuPont method.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Return on Investment Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment. Return on investment (ROI) = Income ÷ Investment

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster What is the return on investment for each hotel? Return on Investment Boston Hotel:$166,000 Operating income ÷$900,000 Total assets=18% Denver Hotel:$240,000 Operating income ÷$1,000,000 Total assets=24% Miami Hotel:$1,152,000 Operating income ÷$5,600,000 Total assets=21%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster The DuPont method of profitability analysis recognizes that there are two basic ingredients in profit making: DuPont Method 1. Using assets to generate more revenues 2. Increasing income per dollar of revenues

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster DuPont Method Investment turnover = Revenues ÷ Investment Return on sales = Income ÷ Revenues ROI = Return on sales × Investment turnover

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster DuPont Method How can Relax Inns attain a 30% target ROI for the Denver hotel? Present situation: Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = 1.20 Operating income ÷ Revenues = $240,000 ÷ $1,200,000 = × 0.20 = 24%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster DuPont Method Alternative A: Decrease assets, keeping revenues and operating income per dollar of revenue constant. Revenues ÷ Total assets = $1,200,000 ÷ $800,000 = × 0.20 = 30%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster DuPont Method Alternative B: Increase revenues, keeping assets and operating income per dollar of revenues constant. Revenues ÷ Total assets = $1,500,000 ÷ $1,000,000 = × 0.20 = 30% Operating income ÷ Revenues = $300,000 ÷ $1,500,000 = 0.20

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster DuPont Method Alternative C: Decrease costs to increase operating income per dollar of revenues, keeping revenues and assets constant. Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = × 0.25 = 30% Operating income ÷ Revenues = $300,000 ÷ $1,200,000 = 0.25

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 4 Use the residual-income (RI) measure and recognize its advantages.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Residual Income Residual income (RI) = Income – (Required rate of return × Investment) Assume that Relax Inns’ required rate of return is 12%. What is the residual income from each hotel?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Residual Income Boston Hotel: Total assets $900,000 × 12% = $108,000 Operating income $166,000 – $108,000 = Residual income $58,000 Denver Hotel = $120,000 Miami Hotel = $480,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 5 Describe the economic value added (EVA ® ) method.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Economic value added (EVA ® ) = After-tax operating income – [Weighted-average cost of capital × (Total assets – current liabilities)]

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Total assets minus current liabilities can also be computed as: Long-term assets + Current assets – Current liabilities, or… Long-term assets + Working capital

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Economic value added (EVA ® ) substitutes the following specific numbers in the RI calculations: 1.Income equal to after-tax operating income 2. A required rate of return equal to the weighted-average cost of capital 3. Investment equal to total assets minus current liabilities

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Example Assume that Relax Inns has two sources of long-term funds: 1. Long-term debt with a market value and book value of $4,800,000 issued at an interest rate of 10% 2. Equity capital that also has a market value of $4,800,000 and a book value of $2,200,000 Tax rate is 30%.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Example What is the after-tax cost of capital? 0.10 × (1 – Tax rate) = 0.07, or 7% Assume that Relax Inns’ cost of equity capital is 14%. What is the weighted-average cost of capital?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Example WACC = [(7% × Market value of debt) + (14% × Market value of equity)] ÷ (Market value of debt + Market value of equity) WACC = [(0.07 × 4,800,000) + (0.14 × 4,800,000)] ÷ $9,600,000 WACC = $336,000 + $672,000 ÷ $9,600,000 WACC = 0.105, or 10.5%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Example What is the after-tax operating income for each hotel? Boston Hotel: Operating income $166,000 × 0.7 = $116,200 Denver Hotel: Operating income $240,000 × 0.7 = $168,000 Miami Hotel: Operating income $1,152,000 × 0.7 = $806,400

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Example What is the investment? Boston Hotel: Total assets $900,000 – Current liabilities $50,000 = $850,000 Denver Hotel: Total assets $1,000,000 – Current liabilities $150,000 = $850,000 Miami Hotel: Total assets $5,600,000 – Current liabilities $300,000 = $5,300,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Example What is the weighted-average cost of capital times the investment for each hotel? Boston Hotel: $850,000 × 10.5% = $89,250 Denver Hotel: $850,000 × 10.5% = $89,250 Miami Hotel: $5,300,000 × 10.5% = $556,50

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Economic Value Added Example What is the economic value added? Boston Hotel: $116,200 – $89,250 = $26,950 Denver Hotel: $168,000 – $89,250 = $78,750 Miami Hotel: $806,400 – $556,500 = $249,900 The EVA ® charges managers for the cost of their investments in long-term assets and working capital.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Return on Sales The income-to-revenues (sales) ratio, or return on sales (ROS) ratio, is a frequently used financial performance measure. What is the ROS for each hotel? Boston Hotel: $166,000 ÷ $1,100,000 = 15% Denver Hotel: $240,000 ÷ $1,200,000 = 20% Miami Hotel: $1,152,000 ÷ $3,200,000 = 36%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparing Performance HotelROI RIEVA ® ROS Boston18%$ 58,000$ 26,95015% Denver24%$120,000$ 78,75020% Miami21%$480,000$249,90036%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparing Performance Hotel ROI RI EVA ® ROS Boston3333 Denver1222 Miami2111 Methods Ranking

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 6 Contrast current-cost and historical-cost asset measurement methods.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Choosing the Time Horizon The second step of designing accounting-based performance measures is choosing the time horizon of each performance measure. Many companies evaluate subunits on the basis of ROI, RI, EVA ®, and ROS over multiple years.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Choosing Alternative Definitions The third step of designing accounting-based performance measures is choosing a definition for each performance measure. Definitions include the following: 1. Total assets available – includes all assets, regardless of their particular purpose.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Choosing Alternative Definitions 2. Total assets employed – includes total assets available minus the sum of idle assets and assets purchased for future expansion. 3. Total assets employed minus current liabilities – excludes that portion of total assets employed that are financed by short-term creditors.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Choosing Alternative Definitions 4. Stockholders’ equity – using in the Resorts Inns example requires allocation of the long-term liabilities to the three hotels, which would then be deducted from the total assets of each hotel.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Choosing Measurement Alternatives The fourth step of designing accounting-based performance measures is choosing a measurement alternative for each performance measure. The current cost of an asset is the cost now of purchasing an identical asset to the one currently held. Historical-cost asset measurement methods generally consider the net book value of the asset.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Choosing Measurement Alternatives The fifth step of designing accounting-based performance measures is choosing a target level of performance. Historical cost measures are often inadequate for measuring economic returns on new investments and sometimes create disincentives for expansion.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Choosing Measurement Alternatives The sixth step of designing accounting-based performance measures is choosing the timing of feedback. Timing of feedback depends largely on how critical the information is for the… …success of the organization. …specific level of management involved. …sophistication of the organization.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 7 Indicate the difficulties when comparing the performance of divisions operating in different countries.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Multinational Companies Example Assume that Relax Inns invests in a hotel in Acapulco, Mexico. The exchange rate at the time of the investment on December 31, 2002, is 8 pesos = 1 dollar.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Multinational Companies Example During 2003, the Mexican peso suffers a decline in value. The exchange rate on December 31, 2003, is 12 pesos = 1 dollar. What is the average exchange rate during 2003? (8 + 12) ÷ 2 = 10 pesos = 1 dollar

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Multinational Companies Example The investment (total assets) in Acapulco = 32,000,000 pesos. The operating income of the Acapulco Hotel in 2003 is 6,200,000 pesos. What is the return on investment in pesos? 6,200,000 ÷ 32,000,000 = 19.4%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Multinational Companies Example What is the return on investment in dollars? 6,200,000 ÷ 10 = $620,000 operating income $620,000 ÷ $4,000,000 = 15.5% This is lower than the Boston ROI of 18%. 32,000,000 ÷ 8 = $4,000,000 investment

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 8 Recognize the role of salaries and incentives when rewarding managers.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster The Basic Trade-off Most often, a manager’s total compensation includes some combination of salary and a performance-based incentive.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 9 Describe the management accountant’s role in helping organizations design better incentive systems.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Intensity of Incentives How large should the incentive component be relative to salary? Preferred performance measures are ones that are sensitive to, or change significantly, with the manager’s performance.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Benchmarks Owners can use benchmarks to evaluate performance. Benchmarks representing best practice may be available inside or outside the organization.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Measuring Obtaining performance measures that are more sensitive to employee performance is critical for implementing strong incentives. Many management accounting practices, such as the design of responsibility centers and the establishment of financial and nonfinancial measures, have as their goal better performance evaluation.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster The End