Performance Measurement, Compensation, and Multinational Considerations

1
Performance Measurement, Compensation, and
Multinational Considerations

• Chapter 23

2
Introduction

• Performance measures are a central component of
  management control systems.
• Making good planning and control decisions
  requires information about how different subunits
  of the organization have performed.
• This chapter discusses the design,
  implementation, and uses of performance measures.

3
Learning Objective 1

• Measure performance from a financial and
  nonfinancial perspective

4
Financial and Nonfinancial Performance Measures

• Many widely used performance measures, such as
  operating income, rely on internal financial
  information.
• Companies are supplementing internal financial
  measures with measures based on
• External financial information
• Internal nonfinancial information
• External nonfinancial information

5
Learning Objective 2

• Design an accounting-based performance measure

6
Accounting-Based Performance Measure

• Resorts Inns own three small hotels at airports
  in Chicago, Dallas, and Miami.
• At the present, Resorts Inns does not allocate
  the total long-term debt of the company to the
  three separate hotels.

7
Accounting-Based Performance Measure

• Resorts Inns
• Total current assets 1,350,000
  Total long-term assets 6,150,000
  Total assets 7,500,000
• Total current liabilities 500,000
  Long-term debt 4,800,000
  Stockholders equity 2,200,000
  Total liabilities and
  equity 7,500,000

8
Accounting-Based Performance Measure

• Chicago Hotel
• Current assets 350,000
• Long-term assets 550,000
• Total assets 900,000
• Current liabilities 50,000

9
Accounting-Based Performance Measure

• Dallas Hotel
• Current assets 400,000
• Long-term assets 600,000
• Total assets 1,000,000
• Current liabilities 150,000

10
Accounting-Based Performance Measure

• Miami Hotel
• Current assets 600,000
• Long-term assets 5,000,000
• Total assets 5,600,000
• Current liabilities 300,000

11
Accounting-Based Performance Measure

• Chicago Hotel
• Revenues 1,100,000
  Variable costs 297,000
  Fixed
  costs 637,000
  Operating income 166,000

12
Accounting-Based Performance Measure

• Dallas Hotel
• Revenues 1,200,000
  Variable costs
  310,000
  Fixed costs 650,000
  Operating income 240,000

13
Accounting-Based Performance Measure

• Miami Hotel
• Revenues 3,200,000
  Variable costs 882,000
  Fixed
  costs 1,166,000
  Operating income 1,152,000

14
Accounting-Based Performance Measure

• Which hotel is the most successful?
• Chicago with an operating income of 166,000,
• Dallas with 240,000, or
• Miami with 1,152,000?
• It appears that the Miami Hotel is the most
  successful.

15
Accounting-Based Performance Measure

• A major weakness of comparing operating incomes
  alone is ignoring differences in the size of the
  investments in each hotel.
• Investment refers to the resources or assets used
  to generate income.

16
Accounting-Based Performance Measure

• Three approaches include investment in the
  performance measure
• Return on investment (ROI)
• Residual income (RI)
• Economic value added (EVA)
• A fourth approach measures return on sales (ROS).

17
Accounting-Based Performance Measure

• Return on investment (ROI) is an accounting
  measure of income divided by an accounting
  measure of investment.
  

Return on investment (ROI) Income Investment
18
Accounting-Based Performance Measure

• Some companies use operating income for the
  numerator.
• Other companies use net income.
• Some companies use total assets in the
  denominator.
• Others use total assets minus current liabilities.

19
Accounting-Based Performance Measure

• The return on investment (ROI) is also called the
  accounting rate of return.
• The ROI can be compared with the rate of return
  on opportunities elsewhere, inside and outside
  the company.

20
Accounting-Based Performance Measure

• What is the ROI for each hotel?
• Chicago Hotel
  166,000 Operating income
  900,000 Total assets 18
• Dallas Hotel 240,000 1,000,000 24
• Miami Hotel 1,152,000 5,600,000 21

21
Learning Objective 3

• Analyze profitability using the DuPont method

22
DuPont Method

• The DuPont method of profitability analysis
  recognizes that there are two basic ingredients
  in profit making
• Using assets to generate more revenues
• Increasing income per dollar of revenues

23
DuPont Method
Investment turnover Revenues Investment
Return on sales Income Revenues
ROI Investment turnover Return on sales
24
Learning Objective 4

• Use the residual-income (RI) measure and
  recognize its advantages

25
Residual Income

• Residual income (RI) is an accounting measure of
  income minus a required dollar return on
  an accounting measure of investment.
• Residual income (RI) Income (Required rate of
  return Investment)

26
Residual Income

• Assume that Resorts Inns required rate of return
  is 12.
• What is the residual income from each hotel?
• Chicago Hotel
  Total assets 900,000 12 108,000
  Operating income 166,000 108,000
  Residual income 58,000

27
Residual Income

• Dallas Hotel
  Total assets 1,000,000 12
  120,000 Operating income 240,000 120,000
  Residual income 120,000
• Miami Hotel
  Total assets 5,600,000 12 672,000
  Operating income 1,152,000 672,000
  Residual income 480,000

28
Residual Income

• The objective of maximizing ROI may induce
  managers of highly profitable divisions to reject
  projects that, from the viewpoint of the
  organization as a whole, should be accepted.
• Goal congruence is more likely to be promoted by
  using residual income rather than ROI.

29
Learning Objective 5

• Describe the economic value added (EVA) method

30
Economic Value Added

• Economic value added (EVA) is a specific type of
  residual income calculation that has recently
  attracted considerable attention.
• Economic value added (EVA) After-tax
  operating income
  Weighted-average cost of capital
  (Total assets current liabilities)

31
Economic Value Added

• Economic value added (EVA) substitutes the
  following specific numbers in the RI
  calculations
• Income equal to after-tax operating income
• A required rate of return equal to the
  weighted-average cost of capital
• Investment equal to total assets minus current
  liabilities

32
Economic Value Added

• Assume that Resorts Inns has two sources of
  long-term funds
• Long-term debt with a market value and book value
  of 4,800,000 issued at an interest rate of 10
• Equity capital that also has a market value of
  4,800,000 and a book value of 2,200,000
• Tax rate is 30.

33
Economic Value Added

• What is the after-tax cost of capital?
• 0.10 (1 Tax rate) 0.07, or 7
• The cost of equity capital is the opportunity
  cost to investors of not investing their capital
  in another investment that is similar in risk to
  Resorts Inns.
• Assume that Resorts Inns cost of equity capital
  is 14.

34
Economic Value Added

• 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)
  9,600,000
• WACC 336,000 672,000 9,600,000
• WACC 0.105, or 10.5

35
Economic Value Added

• What is the after-tax operating income for each
  hotel?
• Chicago Hotel
  Operating income 166,000 0.7 116,200
• Dallas Hotel
  Operating income 240,000 0.7 168,000
• Miami Hotel
  Operating income 1,152,000 0.7 806,400

36
Economic Value Added

• What is the investment?
• Chicago Hotel Total assets 900,000
  Current liabilities 50,000 850,000
• Dallas Hotel Total assets 1,000,000
  Current liabilities 150,000 850,000
• Miami Hotel Total assets 5,600,000
  Current liabilities 300,000 5,300,000

37
Economic Value Added

• What is the weighted-average cost of capital
  times the investment for each hotel?
• Chicago Hotel 850,000 10.5 89,250
• Dallas Hotel 850,000 10.5 89,250
• Miami Hotel 5,300,000 10.5 556,500

38
Economic Value Added

• What is the economic value added?
• Chicago Hotel 116,200 89,250 26,950
• Dallas Hotel 168,000 89,250 78,750
• Miami Hotel 806,400 556,500 249,900
• The EVA charges managers for the cost
  of their investments in long-term assets
  and working capital.

39
Economic Value Added

• What can managers do to improve their EVA?
• Earn more after-tax operating income with the
  same capital.
• Use less capital to earn the same after-tax
  operating income.
• Invest capital in high-return projects.

40
Return on Sales

• The income-to-revenues (sales) ratio, or return
  on sales (ROS) ratio, is a frequently used
  financial performance measure.
• What is the ROS for each hotel?
• Chicago Hotel 166,000 1,100,000 15
• Dallas Hotel 240,000 1,200,000 20
• Miami Hotel 1,152,000 3,200,000 36

41
Comparing Performance

• Hotel ROI RI EVA
  ROS Chicago 18 58,000 26,950
  15 Dallas 24 120,000 78,750
  20 Miami 21 480,000 249,900 36

42
Comparing Performance
Hotel ROI RI EVA
ROS Chicago 3 3 3 3 Dallas 1 2 2 2
Miami 2 1 1 1
Methods Ranking
43
Comparing Performance

• Why are ROI or RI measures more appropriate than
  ROS to evaluate overall aggregate performance?
• Because they consider both income earned and
  investments made.
• RI measures overcome some of the goal-congruence
  problems that ROI measures might introduce.

44
Learning Objective 7

• Indicate the difficulties that arise when
  comparing the performance of divisions operating
  in different countries

45
Multinational Companies

• Comparing the performance of divisions of a
  multinational company creates additional
  difficulties.
• Differences in the economic, legal, political,
  social, and cultural environment
• Governmental controls
• Availability of materials and skilled labor
• Currency differences

46
Multinational Companies

• Assume that Resorts Inns invests in a hotel in
  Cancun, Mexico.
• The investment consists mainly of the costs of
  the building and furnishings.
• The exchange rate at the
  time of the investment on
  December 31, 2000,
  is 8 pesos 1 dollar.

47
Multinational Companies

• During 2001, the Mexican peso suffers a decline
  in value.
• The exchange rate on December 31, 2002, is
  12 pesos 1 dollar.
• What is the average exchange rate during 2001?
• (8 12) 2 10 pesos 1 dollar.

48
Multinational Companies

• The investment (total assets) in Cancun
  32,000,000 pesos.
• The operating income of the Cancun Hotel in
  2001 is 6,200,000 pesos.
• What is the return on investment in pesos?
• 6,200,000 32,000,000 19.4

49
Multinational Companies

• What is the return on investment in dollars?
  
  6,200,000 10 620,000 operating income
  32,000,000 8 4,000,000 investment
• 620,000 4,000,000 15.5
• This is lower than the Chicago ROI of 18

50
Learning Objective 8

• Recognize the role of salaries and incentives in
  compensation arrangements

51
The Basic Trade-off

• Performance evaluation often affects managers
  and employees rewards.
• Compensation arrangements run the range from a
  flat salary with no direct performance-based
  incentive to rewards based only on performance.

52
The Basic Trade-off

• Managers may face risks because factors beyond
  their control may also affect performance.
• Owners choose a mix of salary and incentive
  compensation to trade off the incentive benefit
  against the cost of imposing risk.

53
The Basic Trade-off

• Most often, a managers total compensation
  includes some combination of salary and a
  performance based incentive.