Chapter 23
Performance Measurement
&
Compensation
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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 Nonfinancial
Performance Measures
Companies are supplementing internal
financial measures with measures based on:
External financial information
Internal nonfinancial information
External nonfinancial information
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Financial and Nonfinancial
Performance Measures
Some organizations present financial and
nonfinancial 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-Based
Performance Measure
Step 1:
Choose performance measures that align
with top management’s financial goal(s).
Step 2:
Choose the time horizon of each
performance measure in Step 1.
Step 3:
Choose a definition for each.
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Accounting-Based
Performance Measure
Step 4:
Choose a measurement alternative for
each 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 not
allocate 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
$350,000
Long-term assets 550,000
Total assets
$900,000
Current liabilities $ 50,000
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Revenues
$1,100,000
Variable costs
297,000
Fixed costs
637,000
Operating income $ 166,000
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Accounting-Based Performance
Measure Example
Denver Hotel
Current assets
$ 400,000 Revenues
$1,200,000
Long-term assets
600,000 Variable costs
310,000
Total assets
$1,000,000 Fixed costs
650,000
Current liabilities $ 150,000 Operating income $ 240,000
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Accounting-Based Performance
Measure Example
Miami Hotel
Current assets
$ 600,000 Revenues
$3,200,000
Long-term assets 5,000,000 Variable costs
882,000
Total assets
$5,600,000 Fixed costs
1,166,000
Current liabilities $ 300,000 Operating income $1,152,000
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Accounting-Based Performance
Measure Example
Total current assets
Total long-term assets
Total assets
Total current liabilities
Long-term debt
Stockholders’ equity
Total liabilities and equity
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$1,350,000
6,150,000
$7,500,000
$ 500,000
4,800,000
2,200,000
$7,500,000
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Approaches to
Measuring 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 an
accounting measure of income
divided by an accounting
measure of investment.
Return on investment (ROI)
= Income ÷ Investment
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Return on Investment
What is the return on investment for each hotel?
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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ROI: DuPont Method
The DuPont method of profitability analysis
recognizes that there are two basic
ingredients in profit making:
1. Using assets to generate more revenues
2. Increasing income per dollar of revenues
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DuPont Method
Return on sales = Income ÷ Revenues
Investment turnover = Revenues ÷ Investment
ROI = Return on sales × Investment turnover
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DuPont Method
How can Relax Inns attain a 30% target
ROI 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, keeping
revenues and operating income per
dollar of revenue constant.
Revenues ÷ Total assets
= $1,200,000 ÷ $800,000 = 1.50
1.50 × 0.20 = 30%
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DuPont Method
Alternative B: Increase revenues, keeping
assets and operating income per dollar
of revenues constant.
Revenues ÷ Total assets
= $1,500,000 ÷ $1,000,000 = 1.50
Operating income ÷ Revenues
= $300,000 ÷ $1,500,000 = 0.20
1.50 × 0.20 = 30%
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DuPont Method
Alternative C: Decrease costs to increase
operating income per dollar of revenues,
keeping revenues and assets constant.
Revenues ÷ Total assets
= $1,200,000 ÷ $1,000,000 = 1.20
Operating income ÷ Revenues
= $300,000 ÷ $1,200,000 = 0.25
1.20 × 0.25 = 30%
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Residual Income
Residual income (RI)
= Income – (Required rate of return × Investment)
Assume that Relax Inns’ required
rate 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% = $108,000
Operating income $166,000 – $108,000
= Residual income = $58,000
Denver Hotel = $120,000
Miami 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 liabilities
can 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 the
following specific numbers in the RI calculations:
1. Income equal to after-tax operating income
2. A required rate of return equal to the
weighted-average cost of capital
3. Investment equal to total assets minus
current liabilities
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Economic Value Added Example
Assume that Relax Inns has two sources of
long-term funds:
1. Long-term debt with a market value and
book value of $4,800,000 issued at an
interest 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 of
equity 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)] ÷ $9,600,000
WACC = ($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 = $850,000
Denver 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
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Economic Value Added Example
What is the weighted-average cost of capital
times the investment for each hotel?
Boston Hotel: $850,000 × 10.5% = $89,250
Denver 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 = $ 26,950
Denver 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.
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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?
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
Boston
Denver
Miami
ROI
18%
24%
21%
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RI
$ 58,000
$120,000
$480,000
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EVA®
$ 26,950
$ 78,750
$249,900
ROS
15%
20%
36%
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Comparing Performance
Methods Ranking
Hotel
Boston
Denver
Miami
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ROI
3
1
2
Cost Accounting
RI
3
2
1
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EVA® ROS
3
3
2
2
1
1
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Choosing the Time Horizon
The second step of designing accounting-based
performance 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-based
performance 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 assets
available 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 employed
that are financed by short-term creditors.
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Choosing Alternative Definitions
4. Stockholders’ equity: using in the Resorts Inns
example requires allocation of the long-term
liabilities to the three hotels, which would then
be deducted from the total assets of each hotel.
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Choosing Measurement
Alternatives
The fourth step of designing accounting-based
performance 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 one
currently held.
Historical-cost asset measurement methods
generally consider the net book value of the asset.
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Choosing Measurement
Alternatives
The fifth step of designing accounting-based
performance measures is choosing a target
level of performance.
Historical cost measures are often inadequate for
measuring economic returns on new investments
and sometimes create disincentives for expansion.
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Choosing Measurement
Alternatives
The sixth step of designing accounting-based
performance measures is choosing the timing
of feedback.
Timing of feedback depends largely on how
critical 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 when
comparing the performance
of divisions operating
in different countries.
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Salary & Incentives: The Basic
Trade-off
Most often, a manager’s total
compensation includes some
combination of salary and a
performance-based incentive.
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Intensity of Incentives
How large should the incentive component
be relative to salary?
Preferred performance measures are ones
that are sensitive to, or change significantly,
with the manager’s performance.
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Benchmarks
Owners can use benchmarks to
evaluate performance.
Benchmarks representing best
practice may be available inside
or outside the organization.
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Good Measures
Obtaining performance measures that are more
sensitive to employee performance is critical
for implementing strong incentives.
Many management accounting practices, such
as the design of responsibility centers and the
establishment of financial and nonfinancial
Measures, have as their goal better
performance 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 to
get a “better” measure.
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