Performance Measurement & Compensation

2009 Foster Business School Cost Accounting L.DuCharme 1

Performance Measurement&

Compensation

Chapter 23


Overview

• Financial & Nonfinancial Measures• Accounting-based Measures

– Return on Investment– Residual Income– Economic Value Added– Return on Sales

• Role of Salaries & Incentives• Best Measure?


Financial and NonfinancialPerformance Measures

Companies are supplementing internal financial measures with measures based on:

External financial informationInternal nonfinancial informationExternal nonfinancial information


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

–


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.


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.


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.



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



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



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



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


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.


Return on Investment

Return on investment (ROI) is anaccounting measure of income

divided by an accountingmeasure of investment.

Return on investment (ROI)= Income ÷ Investment


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%


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


DuPont Method

Investment turnover = Revenues ÷ Investment

Return on sales = Income ÷ Revenues

ROI = Return on sales × Investment turnover


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%


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%


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%



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%



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?


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


Economic Value Added

Economic value added (EVA®)= After-tax operating income

– [Weighted-average cost of capital× (Total assets – current liabilities)]



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.



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


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%.



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?



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%



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



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



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



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.


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%


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%


Comparing Performance

Hotel ROI RI EVA® ROSBoston 3 3 3 3Denver 1 2 2 2Miami 2 1 1 1

Methods Ranking


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.


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.



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.



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.


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.



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.



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.


Multinational Companies

Difficulties exist whencomparing the performance

of divisions operatingin different countries.


Salary & Incentives: The Basic Trade-off

Most often, a manager’s totalcompensation includes somecombination of salary and a

performance-based incentive.


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.


Benchmarks

Owners can use benchmarks toevaluate performance.

Benchmarks representing bestpractice may be available inside

or outside the organization.


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.


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.

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Performance Measurement & Compensation