financial accounting Chap 025

8/11/2019 financial accounting Chap 025

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The McGraw-Hill Companies, Inc., 2005McGraw-Hill/Irwin

25-1

REWARDING

BUSINESS

PERFORMANCE

Chapter

25


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25-2

Goal Congruence

Alignment of employeegoals and objectiveswith organizational

goals and objectives.

Motivation and AligningGoals and Objectives


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Motivation and AligningGoals and Objectives

Feedback

Steer employeestoward goals.

Measure progressin 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 (ROI)

ROI = ProfitAverage investment


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SalesAverage Investment

ROI =Profit

Average Investment

ROI =ProfitSales


Returnon Sales

CapitalTurnover


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Holly Company reports the following:

Profit $ 30,000

Sales $ 500,000

Average Investment $ 200,000

Lets calculate ROI


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ROI =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

SalesPrices

DecreaseExpenses

Lower

InvestedCapital

Improving ROI



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Improving ROI

Hollys manager was able to increasesales revenue to $600,000 whichincreased income to $42,000.

There was no change in invested capital.

Lets calculate the new ROI



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Improving ROI


ROI =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., yourcompensation package includes a salary plusbonus based on your divisions ROI -- the higheryour ROI, the bigger your bonus.

The company requires an ROI of 15% on all newinvestments -- your division has been producing anROI of 30%.

You have an opportunity to invest in a new projectthat will produce an ROI of 25%.

As division manager would you

invest in this project?

Criticisms of ROI



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As division manager,I wouldnt invest in

that project becauseit would lower my pay!

Criticisms of ROI

Gee . . .I thought we were

supposed to do what

was best for thecompany!



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Operating EarningsInvestment charge= Residual income

Investment capitalMinimum return= Investment charge

Investment centersminimum acceptable

return

Residual Income



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Residual Income

Flower Co. has an opportunity to invest$100,000 in a project that will earn $25,000.

Flower Co. has a 20 percent minimumacceptable rate of return and a 30 percent ROIon existing business.

Lets calculate residual income


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Residual Income

Operating Earnings = $25,000Investment charge = 20,000= Residual income = $ 5,000

Investment capital = $100,000Minimum return = 20%= Investment charge = $ 20,000

Investment centersminimum acceptable

return


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Residual Income

As a manager atFlower Co., would youinvest the $100,000 if

you were evaluatedusing residualincome?

Would your decision

be different if you wereevaluated using ROI?


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Residual income encourages managers tomake profitable investments that would

be rejected by managers using ROI.

Residual Income


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Economic value added tells us how muchshareholder wealth is being created.

Economic Value Added


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Economic value addedis the annual after-taxoperating profit minus the total annual cost of capital.

Cost of capitalis weighted-average after-tax

cost of long-term borrowing and the cost of debt.

DebtEquity


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After-tax Operating IncomeInvestment 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



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Economic value added can be improved in threeways . . .

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 thatshow an organizations performance in

meeting its responsibilities to various

stakeholders.

EmployeeStakeholder

Group

InvestorStakeholder

Group

Balanced Scorecard


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Financial PerspectiveHow do we look

to the firms owners?

Learning and GrowthPerspective

How can we continuallyimprove and create value?

Business ProcessPerspective

In which activitiesmust we excel?

Customer PerspectiveHow do our

customers see us?

Balanced Scorecard

Visionand

Strategy


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Components of ManagementCompensation

I prefer a fixed salaryso that I know what

I will be paid each year.

I prefer a bonusarrangementthat gives me the opportunity

to earn larger amounts. Idont mind the varying

compensation.I like both profit sharingand

stock options.


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Design Choices forManagement Compensation

Should we rewardcurrent performance or

future performance?

Should our rewards bebased on accounting

numbers or stockprice performance?

Should bonuses befixed or should theyvary with a

performance measure?

Should bonuses bebased on local or

company-wideperformance?

Should teams ofemployees share bonusesequally or should they

be in competition?


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The McGraw Hill Companies Inc 2005ill/ i

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End of Chapter 25

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financial accounting Chap 025