Measuring and Rewarding Performance

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Chapter 15

• Measuring and Rewarding Performance

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Learning Objectives

• 1. Why should organizations use multiple
  performance measures to assess performance?
• 2. How are return on investment (ROI) and
  residual income (RI) similar and different?

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Continuing . . . Learning Objectives

• 3. Why has economic value added (EVA) become a
  popular performance measure?
• 4. Why are nonfinancial measures important to
  evaluating performance?

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Continuing . . . Learning Objectives

• 5. How are activity-based costing concepts
  related to performance measurement?
• 6. Why is it more difficult to measure
  performance in multinational firms than in solely
  domestic companies?

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Continuing . . . Learning Objectives

• 7. How should employee rewards, including
  compensation, and performance be linked?
• 8. How do expatriate reward systems differ from
  those of domestic operations?

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Performance Measurement
Organizational Goals and Objectives
General Rule 1
Measures should assess progress
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Continuing . . . Performance Measurement
General Rule 2
Persons being evaluated should have had some
input in developing performance measurements and
should be aware of them.
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Continuing . . . Performance Measurement
General Rule 3
Persons being evaluated should have appropriate
skills and be provided the necessary
equipment, information, and authority to be
successful under the measurement system.
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Continuing . . . Performance Measurement
General Rule 4
Feedback relative to performance should
be provided in a timely and useful manner.
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Need for Multiple Measures
Minimal lead time to market
Satisfactory earnings
Customer satisfaction
MULTIPLE COMPANY GOALS
Adequate cash flow
Zero defects
Environmental social responsibility
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Balanced Scorecard

• A balanced scorecard ultimately links all
  aspects of performance to the companys
  strategies.
• The balanced scorecard provides a set of
  financial and nonfinancial measures that
  encompass both internal and external perspectives.

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Balanced Scorecard

• A balance scorecard examines the following
  questions
• How will we look to our stockholders if we
  succeed?
• How must we look to our customers to achieve our
  strategies?
• What business processes must we excel at to
  satisfy customers?
• How must our organization function to achieve our
  strategies?

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Appropriate Tools for Performance
Training
Support
Information
Authority
Equipment
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Need for Feedback
Performance monitored and feedback provided on a
continuous basis
Feedback
Adjustment
Monitor performance
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Financial Performance Measurements for Managers

• Divisional Profits
• Cash Flow
• Return on Investment
• Residual Income
• Economic Value Added

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Divisional Profits

• Segment margin of a profit center or income of an
  investment center
• Compare with budget
• Also compare individual revenues and expenses
  with budget
• Short-term measure

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Potential Manipulation of Segment Margin

• Sales transactions can be shifted between
  periods.
• If a cost flow method other than FIFO is being
  used, inventory purchases can be accelerated or
  deferred to change the Cost of Goods Sold.
• If actual OH is allocated to inventory, an
  increase in production will cause cost per unit
  to decline because of the nature of fixed costs.

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Continuing . . . PotentialManipulation of
Segment Margin

• Replacement of workers who have resigned or been
  terminated can be deferred to minimize salary
  expense for the period.
• Discretionary costs can be delayed or eliminated
  to reduce expenses.
• Depreciation methods may be changed.

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Statement of Cash Flows

• Provides information about the cash impacts of
  operating, investing, and financing activities
• Helps managers to judge an entitys ability to
  meet current fixed cash outflow commitments,
  undertake new commitments, and adapt to adverse
  changes in business conditions
• Assists managers in judging the quality of the
  entitys earnings
• Can be manipulated

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Return on Investment (ROI)

• ROI Income ? Assets
• or
• ROI Profit Margin x Asset Turnover
• or
• Income
  Sales ROI ---------- x
  ----------
  Sales Assets

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Return on Investment Questions

• Income defined
• Is income defined as segment or operating income?
• Is income defined on a before-tax or after-tax
  basis?
• Is income defined on a before-interest or
  after-interest basis?
• Assets defined
• Should assets be defined as total asset utilized
  total assets available for use or net assets?
• Should plant assets be included in the asset
  denominator at original cost depreciated book
  value or current values?
• Should beginning, ending, or average assets be
  used?

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Exhibit 15-3Bellingham Machine Company

• 
  Materials Machinery Handling
  Tools
• Segment Margin 2,800,000 460,400
  653,500
• Assets Invested 11,532,000
  1,037,000 8,915,000
• ROI 24.3
  44.4 7.3

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Residual Income
Residual Income Income - (Target Rate x Asset
Base)

• The profit earned that exceeds an amount
  charged for funds committed to an investment
  center
• Concerned with dollars rather than percentages

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Exhibit 15-5Bellingham Machine Company

• 
  Materials Machinery Handling
  Tools
• Segment Margin 2,800,000 460,000
  653,500
• Assets Invested 11,532,000 1,037,000
  8,915,000
• Targeted ROI x 12 x
  12 x 12
• 1,383,840
  124,440 1,069,800
• RI 1,416,160
  335,960 (416,300)
• 
  

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Limitations of ROI and Residual Income

• Problems related to income
• Income can be manipulated on a short-run basis
• All investment centers must use same accounting
  methods
• Does not consider cash flows
• Does not consider time value of money

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Continuing . . . Limitations of ROI and
Residual Income

• Problems related to asset base
• Some asset investment values are difficult to
  measure
• Some investments may not have been authorized by
  current manager
• Inflation causes investment book values to be
  understated unless they are price-level adjusted
• Measures how well center performs without regard
  to company-wide objectives

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Economic Value Added

• EVA After-tax Profits - (Capital Invested x
  Cost of capital )
• From Exhibit 15-7
• EVA 1,942,710 - (45,000,000 x 0.12)
  (3,457,290)

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Nonfinancial Performance Measures

• Directly measure an entitys performance in the
  activities that create shareholder wealth
• May better predict the direction of future cash
  flows

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Continuing . . . Nonfinancial Performance
Measures

• Selection of nonfinancial measures
• Identify critical success factors
• Select attributes relating to measurement of
  critical success factors
• Can be qualitative or quantitative
• Focuses on the activities that can improve the
  future
• Establishment of comparison bases

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Performance Evaluation System
FREQUENCY
ISSUES
Top management
Broad
Less
Middle management
Lower-level management
More
Immediate
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Throughput
The number of good units or quantity of
services produced and sold within a time period
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Throughput Example

• Worked 15,000 hours
• Value-added was 6,000 hours
• Units started, completed and sold was 30,000
  units
• Good units were 27,000 units

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Manufacturing Cycle Efficiency

• MCE Value-added Processing Time Total
  Time
• MCE 6,000 ? 15,000 40

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Process Productivity

• Process Productivity Total
  Units Value-Added Processing Time
• Process Productivity 30,000 ? 6,000 5.0

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Process Quality Yield

• Process Quality Yield Good Units Total
  Units
• Process Quality Yield 27,000 ? 30,000
• 90

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Throughput Example

• Throughput .40 x 5.0 x .9 1.80 units
• The division produced and sold only 1.80 good
  units for every hour of total actual processing
  time.
• This is quite different from the 5.0 units
  indicated as process productivity.

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Quality Indicators
Cost of Quality Classifications
Measure

• Prevention Prevention cost Total cost of
  quality
• Appraisal Number of inspections
• Internal failure Number of pieces rejected
• External failure Number of customer complaints

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Activity-Based Costing and Performance Measurement

• Traditional performance measurements include
  non-value-added activities
• Non-value-added activities must be removed from
  performance evaluation measurements
• Value-added activities must be substituted
• Stresses external performance measurements

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Performance Evaluation in Multinational Settings

• Recognize differences in comparing multinational
  units
• Culture and economies
• Accounting standards and reporting practices
• Government regulations
• Investment base may differ substantially assign
  different target rate to compute residual income
• Consider trade tariffs, income tax rates,
  currency fluctuations, restrictions on transfer
  of goods and currency

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Relating Compensation and Performance
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Plan-Performance-Reward Model
Set strategic goals
Identify critical success factors set
operational targets and compensation strategy
Employee/employee groups perform tasks
Measure/monitor performance
Identify performance measures
Set performance rewards
Determine reward
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Pay-for-Performance Plans

• Must be highly correlated with operational
  targets
• Should encourage employees to adopt a long-run
  perspective
• Appropriate time horizon
• At basic worker level, performance should be
  specific and focus on cost and/or quality control
• At higher levels, focus on longer time horizon

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Compensation Packages

• Lower-level workers
• Hourly wage
• Bonus above some specified quantitative measure
• Middle managers
• Salaries
• Opportunity for raise based on performance

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Continuing . . . Compensation Packages

• Top management
• Significant incentive pay
• All levels some monetary and some nonmonetary
  rewards
• Balance incentives for both groups and individuals

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Nonfinancial Factors

• Recognition of efforts
• Compliments and small awards
• Allow subordinates to participate in decisions
• Job security

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Global Compensation
Begin with base salary and fringe benefits that
employee would get domestically and adjust for

• Labor market factors
• Cost-of-living considerations
• Currency fluctuations
• Tax consequences