1. Financial performance measures and reward systems
TOPIC 10:
Financial performance measures and reward systems
Reference Chapter: 13 Financial performance measures for investment centres, and reward systems

2. Financial measures in investment centres
Summary financial performance measures are used to assess the performance of profit centres and investment centres
Return on investment (ROI)
Residual income (RI)
Economic value added (EVA)

3. Return on investment Return on investment (ROI)
Used to measure the financial performance of an investment centre
(cont.)

4. Return on investment (cont.)

5. Return on investment (cont.)
Invested capital
The assets that the investment centre has available to generate profits
Return on sales
The percentage of each sales dollar that remains as profit after all the expenses are covered
Investment turnover
The number of sales dollars generated by every dollar of invested capital
(cont.)

6. Return on investment (cont.)
Improving ROI
Increase return on sales
By increasing the selling price or sales revenue, or decreasing expenses
Increase investment turnover
By increasing sales revenue or reducing invested capital
Actions that are taken with the sole purpose of making these ratios more favourable in the short term may have adverse effects on performance in future years

7. The advantages of ROI
Widely used in practice to measure the performance of units and managers
Encourages managers to focus on both profits, and the assets required to generate those profits
Promotes an understanding of the relationship between revenues, costs and assets
Can be used to evaluate the relative performance of investment centres, even when those business units are of different sizes

8. The limitations of ROI
It may encourage managers to focus on improving short-term financial performance, which may sometimes reduce long-term financial performance
May encourage managers to defer asset replacement, to maintain a high ROI
Discourages managers from investing in projects which are acceptable from the organisation’s point of view, but which decrease the investment centre’s ROI

9. Minimising the behavioural problems of ROI
Use ROI as one of several performance measures that focus on both short-term and long-term performance
Consider alternative ways of measuring invested capital to minimise dysfunctional decisions
Use alternative financial measures, such as residual income or economic value added

10. Residual income Residual income (RI) Imputed interest charge
= profit – (invested capital × imputed interest rate)
Imputed interest charge
Based on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capital
Weighted average cost of capital (WACC) is the weighted average of the cost of funds from all sources of borrowings and equity

11. The advantage of residual income
More likely to promote goal congruence, compared to ROI
Takes account of the organisation’s required rate of return in measuring performance
Encourages investment in projects which yield a positive residual income to the organisation

12. Disadvantages of residual income
Cannot be used to assess the relative performance of businesses that are of different sizes, unlike ROI
Formula is biased in favour of larger businesses, unlike ROI
Can encourage short-term orientation/focus, as with ROI

13. Measuring profit and invested capital
Total assets
Investment centre manager is responsible for decisions about all assets
Total productive assets
Investment centre managers retain non-productive assets
Total assets less current liabilities
Investment centre is responsible for decisions about assets and manages short-term liabilities
Choose average or end-of-year balances

14. Measuring profit
Profit margin controllable by investment centre manager
Suitable when the focus is to assess the performance of the manager
Encourages managers to focus on profit that they can control
Motivational impact
Profit margin attributable to investment centre
Suitable when the focus is to assess the performance of the investment centre
(cont.)

15. Reward systems
Processes, practices and systems which are used to provide levels of pay and benefits to employees
Motivation
The processes that account for an individual’s intensity, direction and persistence of effort towards attaining goals
Intrinsic motivation
Derives from the interest and enjoyment of the work
Extrinsic motivation
Derives from sources outside the individual

16. Theories of motivation
Herzberg’s theory of work motivation
Hygiene factors
Provide the setting for encouraging employee motivation, but do not themselves motivate employees
Working conditions, wage levels, rules and regulations, relationships with colleagues, job security
Motivators
Factors that relate to job content and which provide employee motivation
Achievement, recognition, the nature of the work, responsibility, opportunities for personal growth
(cont.)

17. Theories of motivation (cont.)
Expectancy theory
Employee motivation is a result of the strength of the relationships between expectancy, instrumentality and valence
Expectancy: perception that effort will lead to a certain performance
Instrumentality: perception that performance will lead to desired outcome
Valence: the attractiveness of the reward
Motivational theories need to be considered by managers when they are designing performance evaluation and reward systems

18. Performance-related reward systems
Performance-related pay systems (incentive compensation schemes)
Link employee rewards for achieving or exceeding some performance target
Individual incentive plans
Individuals are rewarded for achieving individual performance targets
Subjective criteria may also be used
Commonly used at the higher levels of an organisation
(cont.)

19. Performance-related reward systems (cont.)
Profit-sharing plans
Cash bonuses are paid to each employee, based on a specified percentage of the company’s profit
Does not tie individual effort to individual rewards
Employee share plans (share option plans)
Provide employees with the right to purchase shares in their company at a specified price at some specified future time
Commonly used for senior managers, and sometimes more junior managers and employees
Considered to encourage goal congruence
(cont.)

20. Performance-related reward systems (cont.)
Gainsharing
Cash bonuses are distributed to employees when the performance of the company, or their segment of the company, exceeds some performance target
Team-based incentive schemes
Individuals are rewarded based on their work team exceeding certain performance targets
Intended to encourage teamwork and cooperation between employees
Does not tie individual effort to individual rewards

21. Group versus individual performance
Consider the following issues
Identification with the group
Equity among employees
Competitiveness between employees
Relating individual effort to reward
Rewarding only good performers
The timing of incentive payments can be crucial to achieving desired outcomes
More frequent rewards may help ensure continual motivation
Providing rewards as close as possible after the period they relate to may be more motivational

22. Summary
Return on investment is often used to evaluate performance of investment centres
Can encourage managers to focus on achieving high profits through the efficient use of assets, but can also encourage dysfunctional decisions
These can be reduced through using a range of performance measures that focus on short and long term, using alternative measures of profit and invested capital, and using other financial measures such as residual income or EVA
(cont.)

23. Summary (cont.)
Reward systems can be used to encourage goal congruent behaviour
When designing performance-related schemes it is important to understand what motivates employees
Performance-related reward systems include individual incentives, profit-sharing, employee share plans, gainsharing, team-based incentives
The frequency and timing of payments may impact on the effectiveness of the reward system in increasing motivation