performance measurement & compensation
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Chapter 23. Performance Measurement & Compensation. Overview. Financial & Nonfinancial Measures Accounting-based Measures Return on Investment Residual Income Economic Value Added Return on Sales Role of Salaries & Incentives Best Measure?. - PowerPoint PPT PresentationTRANSCRIPT
2009 Foster Business School Cost Accounting L.DuCharme 1
Performance Measurement&
Compensation
Chapter 23
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Overview
• Financial & Nonfinancial Measures• Accounting-based Measures
– Return on Investment– Residual Income– Economic Value Added– Return on Sales
• Role of Salaries & Incentives• Best Measure?
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Financial and NonfinancialPerformance Measures
Companies are supplementing internal financial measures with measures based on:
External financial informationInternal nonfinancial informationExternal nonfinancial information
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Financial and NonfinancialPerformance Measures
Some organizations present financial andnonfinancial performance measures for
their subunits in a single report the Balanced Scorecard.
Most scorecards include: (1) profitability measures (2) customer-satisfaction measures (3) internal measures of efficiency, quality, and time (4) innovation measures
–
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Accounting-BasedPerformance Measure
Step 1:Choose performance measures that alignwith top management’s financial goal(s).
Step 2:Choose the time horizon of eachperformance measure in Step 1.
Step 3:Choose a definition for each.
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Accounting-BasedPerformance Measure
Step 4:Choose a measurement alternative foreach performance measure in Step 1.
Step 5:Choose a target level of performance.
Step 6:Choose the timing of feedback.
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Accounting-Based Performance Measure Example
Relax Inns owns three small hotels: one each in Boston, Denver, and Miami.
At the present, Relax Inns does notallocate the total long-term debt of
the company to the three separate hotels.
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Accounting-Based Performance Measure Example
Boston Hotel
Current assets $350,000Long-term assets 550,000Total assets $900,000Current liabilities $ 50,000
Revenues $1,100,000Variable costs 297,000Fixed costs 637,000Operating income $ 166,000
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Accounting-Based Performance Measure Example
Denver Hotel
Current assets $ 400,000Long-term assets 600,000Total assets $1,000,000Current liabilities $ 150,000
Revenues $1,200,000Variable costs 310,000Fixed costs 650,000Operating income $ 240,000
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Accounting-Based Performance Measure Example
Miami Hotel
Current assets $ 600,000Long-term assets 5,000,000Total assets $5,600,000Current liabilities $ 300,000
Revenues $3,200,000Variable costs 882,000Fixed costs 1,166,000Operating income $1,152,000
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Accounting-Based Performance Measure Example
Total current assets $1,350,000Total long-term assets 6,150,000Total assets $7,500,000Total current liabilities $ 500,000Long-term debt 4,800,000Stockholders’ equity 2,200,000Total liabilities and equity $7,500,000
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Approaches toMeasuring 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.
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Return on Investment
Return on investment (ROI) is anaccounting measure of income
divided by an accountingmeasure of investment.
Return on investment (ROI)= Income ÷ Investment
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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%
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The DuPont method of profitability analysisrecognizes that there are two basic
ingredients in profit making:
ROI: DuPont Method
1. Using assets to generate more revenues
2. Increasing income per dollar of revenues
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DuPont Method
Investment turnover = Revenues ÷ Investment
Return on sales = Income ÷ Revenues
ROI = Return on sales × Investment turnover
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DuPont Method
How can Relax Inns attain a 30% targetROI 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
1.20 × 0.20 = 24%
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DuPont Method
Alternative A: Decrease assets, keepingrevenues and operating income per
dollar of revenue constant.Revenues ÷ Total assets
= $1,200,000 ÷ $800,000 = 1.501.50 × 0.20 = 30%
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DuPont Method
Alternative B: Increase revenues, keepingassets and operating income per dollar
of revenues constant.Revenues ÷ Total assets
= $1,500,000 ÷ $1,000,000 = 1.50
1.50 × 0.20 = 30%
Operating income ÷ Revenues= $300,000 ÷ $1,500,000 = 0.20
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DuPont Method
Alternative C: Decrease costs to increaseoperating income per dollar of revenues,
keeping revenues and assets constant.Revenues ÷ Total assets
= $1,200,000 ÷ $1,000,000 = 1.20
1.20 × 0.25 = 30%
Operating income ÷ Revenues= $300,000 ÷ $1,200,000 = 0.25
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Residual Income
Residual income (RI)= Income – (Required rate of return × Investment)
Assume that Relax Inns’ requiredrate of return is 12%.
What is the residual income from each hotel?
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Residual Income
Boston Hotel:Total assets $900,000 × 12% = $108,000Operating income $166,000 – $108,000
= Residual income = $58,000Denver Hotel = $120,000Miami Hotel = $480,000
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Economic Value Added
Economic value added (EVA®)= After-tax operating income
– [Weighted-average cost of capital× (Total assets – current liabilities)]
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Economic Value Added
Total assets minus current liabilitiescan also be computed as:
Long-term assets + Current assets– Current liabilities, or…
Long-term assets + Working capital
TA – CL = L-T debt + SE = funds invested for the long term.
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Economic Value Added
Economic value added (EVA®) substitutes thefollowing specific numbers in the RI calculations:
1. Income equal to after-tax operating income
2. A required rate of return equal to theweighted-average cost of capital
3. Investment equal to total assets minuscurrent liabilities
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Economic Value Added Example
Assume that Relax Inns has two sources oflong-term funds:
1. Long-term debt with a market value andbook value of $4,800,000 issued at aninterest 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%.
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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 ofequity capital is 14%.
What is the weighted-average cost of capital?
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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)] ÷ $9,600,000WACC = ($336,000 + $672,000) ÷ $9,600,000
WACC = 0.105, or 10.5%
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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
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Economic Value Added Example
What is the investment?Boston Hotel: Total assets $900,000
– Current liabilities $50,000 = $850,000Denver Hotel: Total assets $1,000,000
– Current liabilities $150,000 = $850,000Miami Hotel: Total assets $5,600,000
– Current liabilities $300,000 = $5,300,000
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Economic Value Added Example
What is the weighted-average cost of capitaltimes the investment for each hotel?
Boston Hotel: $850,000 × 10.5% = $89,250Denver Hotel: $850,000 × 10.5% = $89,250
Miami Hotel: $5,300,000 × 10.5% = $556,50
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Economic Value Added Example
What is the economic value added?Boston Hotel: $116,200 – $89,250 = $ 26,950Denver Hotel: $168,000 – $89,250 = $ 78,750Miami Hotel: $806,400 – $556,500 = $249,900
The EVA® charges managers for the costof their investments in long-term assets
and working capital.
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Return on Sales
The income-to-revenues (sales) ratio, or returnon 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%
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Comparing Performance
Hotel ROI RI EVA® ROSBoston 18% $ 58,000 $ 26,950 15%Denver 24% $120,000 $ 78,750 20%Miami 21% $480,000 $249,900 36%
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Comparing Performance
Hotel ROI RI EVA® ROSBoston 3 3 3 3Denver 1 2 2 2Miami 2 1 1 1
Methods Ranking
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Choosing the Time Horizon
The second step of designing accounting-basedperformance 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.
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Choosing Alternative Definitions
The third step of designing accounting-basedperformance 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.
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Choosing Alternative Definitions
2. Total assets employed: includes total assetsavailable 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 employedthat are financed by short-term creditors.
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Choosing Alternative Definitions
4. Stockholders’ equity: using in the Resorts Innsexample requires allocation of the long-term
liabilities to the three hotels, which would thenbe deducted from the total assets of each hotel.
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Choosing Measurement Alternatives
The fourth step of designing accounting-basedperformance 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 onecurrently held.
Historical-cost asset measurement methodsgenerally consider the net book value of the asset.
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Choosing Measurement Alternatives
The fifth step of designing accounting-basedperformance measures is choosing a target
level of performance.Historical cost measures are often inadequate formeasuring economic returns on new investments
and sometimes create disincentives for expansion.
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Choosing Measurement Alternatives
The sixth step of designing accounting-basedperformance measures is choosing the timingof feedback.Timing of feedback depends largely on howcritical the information is for the……success of the organization.…specific level of management involved.…sophistication of the organization.
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Multinational Companies
Difficulties exist whencomparing the performance
of divisions operatingin different countries.
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Salary & Incentives: The Basic Trade-off
Most often, a manager’s totalcompensation includes somecombination of salary and a
performance-based incentive.
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Intensity of Incentives
How large should the incentive componentbe relative to salary?
Preferred performance measures are onesthat are sensitive to, or change significantly,
with the manager’s performance.
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Benchmarks
Owners can use benchmarks toevaluate performance.
Benchmarks representing bestpractice may be available inside
or outside the organization.
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Good Measures
Obtaining performance measures that are moresensitive to employee performance is critical
for implementing strong incentives.Many management accounting practices, suchas the design of responsibility centers and theestablishment of financial and nonfinancial
Measures, have as their goal betterperformance evaluation.
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Best Measure
So then, what is the best measure of performance?
NONE (is best)!!
They all measure a different aspect (dimension)of performance!
Often times several measures are combined toget a “better” measure.