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REWARDING BUSINESS PERFORMANCE

Chapter

25

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Goal Congruence

Alignment of employeegoals and objectiveswith organizational

goals and objectives.

Motivation and AligningGoals and Objectives

Motivation and AligningGoals and Objectives

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Motivation and AligningGoals and Objectives

Motivation and AligningGoals and Objectives

Feedback Steer employees toward goals. Measure progress in achieving goals.

Measureperformance.

Improveperformance.

Rewardperformance.

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Return on investment is the ratio ofprofit to the average investment used

to generate the profit.

Return on investment is the ratio ofprofit to the average investment used

to generate the profit.

Return on Investment (ROI)Return on Investment (ROI)

ROI = Profit Average investment

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SalesAverage Investment

ROI = Profit

Average Investment

ROI = ProfitSales ×

Return on Investment (ROI)Return on Investment (ROI)

Returnon Sales

Returnon Sales

CapitalTurnover

CapitalTurnover

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Return on Investment (ROI)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.Let’s calculate ROI.

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Return on Investment (ROI)Return on Investment (ROI)

SalesAverage InvestmentROI =

ProfitSales ×

ROI = 6% × 2.5 = 15%

$500,000$200,000

ROI = $30,000

$500,000 ×

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Three ways to improve ROI

Increase Sales Prices

Decrease Expenses

Lower Invested Capital

Improving ROIImproving ROI

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Improving ROIImproving ROI

Holly’s manager was able to increasesales revenue to $600,000 whichincreased income to $42,000.

There was no change in invested capital.

Holly’s manager was able to increasesales revenue to $600,000 whichincreased income to $42,000.

There was no change in invested capital.

Let’s calculate the new ROI.Let’s calculate the new ROI.

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Improving ROIImproving ROI

SalesAverage InvestmentROI =

ProfitSales ×

Holly increased ROI from 15% to 21%.

ROI = 7% × 3.0 = 21%

$600,000$200,000

ROI = $42,000

$600,000 ×

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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 As division manager would you invest in this project?invest in this project?

Criticisms of ROICriticisms of ROI

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As division manager,I wouldn’t invest in

that project becauseit would lower my pay!

Criticisms of ROICriticisms of ROI

Gee . . .I thought we were

supposed to do what was best for the

company!

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Operating Earnings– Investment charge = Residual income

Investment capital× Minimum return = Investment charge

Investment center’sminimum acceptable

return

Residual IncomeResidual Income

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Residual IncomeResidual 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.Let’s calculate residual income.

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Residual IncomeResidual 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’sminimum acceptable

return

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Residual IncomeResidual 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?

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Residual income encourages managers to make profitable investments that would

be rejected by managers using ROI.

Residual IncomeResidual Income

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Economic value added tells us how much shareholder wealth is being created.

Economic Value AddedEconomic Value Added

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Economic Value AddedEconomic Value Added

Economic value addedEconomic value added is the annual after-tax operating profit minus the total annual cost of capital.

Cost of capitalCost of capital is weighted-average after-taxcost of long-term borrowing and the cost of debt.

DebtEquity

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After-tax Operating Income– Investment charge = Economic value added

(Total assets – current liabilities)× Weighted-average cost of capital= Investment charge

After-tax cost oflong-term borrowing

and the cost of equity

Economic Value AddedEconomic Value Added

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Economic Value AddedEconomic 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.

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A set of performance targets and results that show an organization’s performance in meeting its responsibilities to various

stakeholders.

A set of performance targets and results that show an organization’s performance in meeting its responsibilities to various

stakeholders.

EmployeeEmployeeStakeholderStakeholder

GroupGroup

InvestorInvestorStakeholderStakeholder

GroupGroup

Balanced ScorecardBalanced Scorecard

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Financial PerspectiveHow do we look

to the firm’s owners?

Learning and Growth Perspective

How can we continuallyimprove and create value?

Business ProcessPerspective

In which activities must we excel?

Customer PerspectiveHow do our

customers see us?

Balanced ScorecardBalanced Scorecard

Visionand

Strategy

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Components of Management Compensation

Components of Management Compensation

I prefer a fixed salaryso 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.

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Design Choices for Management Compensation

Design Choices for Management Compensation

Should we rewardcurrent performance or

future performance?

Should we rewardcurrent performance or

future performance?

Should our rewards be based on accounting

numbers or stock price performance?

Should our rewards be based on accounting

numbers or stock price performance?

Should bonuses befixed or should they

vary with aperformance measure?

Should bonuses befixed or should they

vary with aperformance measure?

Should bonuses bebased on local or

company-wideperformance?

Should bonuses bebased on local or

company-wideperformance?

Should teams ofemployees share bonuses

equally or should theybe in competition?

Should teams ofemployees share bonuses

equally or should theybe in competition?

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End of Chapter 25End of Chapter 25