Performance Measurement, Compensation, and Multinational Considerations

Performance Measurement,
Compensation,
and Multinational Considerations
By:
Ashwin Chaudhary
Financial and Nonfinancial Measures
 Firms are increasingly presenting financial
and nonfinancial performance measures for
their subunits in a Balanced Scorecard, and
it’s four perspectives:
1. Financial
2. Customer
3. Internal Business Process
4. Learning and Growth
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 23-2
Balanced Scorecard Flow
 Firms assume that improvements in learning
and growth will lead to improvements in
internal business processes
 Improvements in the internal business
processes will lead to improvements in the
customer and financial perspectives
Accounting-Based Performance
Measures
 Requires a six-step design process:
1. Choose Performance Measures that align with top
management’s financial goals
2. Choose the time horizon of each Performance
Measure
3. Choose a definition of the components in each
Performance Measure
4. Choose a measurement alternative for each
Performance Measure
5. Choose a target level of performance
6. Choose the timing of feedback
Step 1: Choosing among Different
Performance Measures
 Four common measures of economic performance:
1. Return on Investment
2. Residual Income
3. Economic Value Added
4. Return on Sales
 Selecting Subunit Operating Income as a metric is
inappropriate since it obviously differs simply on the
differing size of the subunits
Return on Investment (ROI)
 ROI is an accounting measure of income divided by
an accounting measure of investment
Income
ROI = Investment
ROI
 Most popular metric for two reasons:
1. Blends all the ingredients of profitability
(revenues, costs, and investment) into a
single percentage
2. May be compared to other ROIs both inside
and outside the firm
 Also called the Accounting Rate of Return
(ARR) or the Accrual Accounting Rate of
Return (AARR)
ROI
 ROI may be decomposed into its two
components as follows:
Income Income Revenues
Investment = Revenues X Investment
 ROI = Return on Sales X Investment Turnover

 This is known as the DuPont Method of
Profitability Analysis
Residual Income
 Residual Income (RI) is an accounting measure of
income minus a dollar amount for required return on
an accounting measure of investment
 RI = Income – (RRR x Investment)
 RRR = Required Rate of Return
 Required Rate of Return times the Investment is the
imputed cost of the investment
 Imputed costs are costs recognized in some situations,
but not in the financial accounting records
Economic Value Added (EVA®)
 EVA is a specific type of residual income calculation
that has recently gained popularity
EVA = After-tax
Operating Income { Weighted-Average
Cost of Capital X( Total
Assets
Current
Liabilities )}
 Weighted-average cost of capital equals the after-tax

average cost of all long-term funds in use
Return on Sales (ROS)
 Return on Sales is simply income divided by
sales
 Simple to compute, and widely understood
Step 2: Choosing the Time Horizon of
the Performance Measures
 Multiple periods of evaluation are sometimes
appropriate
 ROI, RI, EVA, and ROS all basically evaluate
one period of time
 ROI, RI, EVA, and ROS may all be adapted
to evaluate multiple periods of time
Step 3: Choosing Alternative Definitions
for Performance Measures
 Four possible alternative definitions of
investment:
1. Total Assets Available
2. Total Assets Employed
3. Total Assets Employed minus Current
Liabilities
4. Stockholders’ Equity
Step 4: Choosing Measurement
Alternatives for Performance Measures
 Possible alternative definitions of cost:
1. Current Cost
2. Gross Value of Fixed Assets
3. Net Book Value of Fixed Assets
Step 5: Choosing Target
Levels of Performance
 Historically driven targets used to set target
goals
 Goal may include a Continuous Improvement
component
Step 6: Choosing the
Timing of the Feedback
 Timing of feedback depends on:
 How critical the information is for the success
of the organization
 The specific level of management receiving
the feedback
 The sophistication of the organization’s
information technology
Performance Measurement in
Multinational Companies
 Additional Difficulties faced by Multinational
Companies:
 The economic, legal, political, social, and cultural
environments differ significantly across countries
 Governments in some countries may impose controls
and limit selling prices of a company’s products
 Availability of materials and skilled labor, as well as
costs of materials, labor, and infrastructure may differ
across countries
 Divisions operating in different countries account for
their performance in different currencies
Distinction between Managers and
Organization Units
 The performance evaluation of a manager
should be distinguished from the performance
evaluation of that manager’s subunit, such as
a division of the company
The Trade-Off: Creating Incentives vs.
Imposing Risk
 An inherent trade-off exists between creating
incentives and imposing risk
 An incentive should be some reward for
performance
 An incentive may create an environment in
which suboptimal behavior may occur: the
goals of the firm are sacrificed in order to meet
a manager’s personal goals
Moral Hazard
 Moral Hazard describes situations in which
an employee prefers to exert less effort (or
report distorted information) compared with
the effort (or accurate information) desired by
the owner because the employee’s effort (or
the validity of the reported information)
cannot be accurately monitored and enforced
Intensity of Incentives
 Intensity of Incentives – how large the
incentive component of a manager’s
compensation is relative to their salary
component
Preferred Performance Measures
 Preferred Performance Measures are those that are
sensitive to or change significantly with the
manager’s performance
 They do not change much with changes in factors
that are beyond the manager’s control
 They motivate the manager as well as limit the
manager’s exposure to risk, reducing the cost of
providing incentives
 May include Benchmarking
Performance Measures at the
Individual Activity Level
 Two issues when evaluating performance at
the individual activity level:
1. Designing performance measures for
activities that require multiple tasks
2. Designing performance measures for
activities done in teams
Compensation for Multiple Tasks
 If the employer wants an employee to focus
on multiple tasks of a job, then the employer
must measure and compensate performance
on each of those tasks
Team-Based Compensation
 Companies use teams extensively for
problem solving
 Teams achieve better results than individual
employees acting alone
 Companies must reward individuals on a
team based on team performance
Executive Compensation Plans
 Based on both financial and nonfinancial
performance measures, and include a mix of:
 Base Salary
 Annual Incentives, such as cash bonuses
 Long-Run Incentives, such as stock options
 Well-designed plans use a compensation mix that
balances risk (the effect of uncontrollable factors on
the performance measure, and hence compensation)
with short-run and long-run incentives to achieve the
firm’s goals
Strategy and Levers of Control
 Levers of Control:
 Diagnostic Control Systems
 Boundary Systems
 Belief Systems
 Interactive Control Systems
 Each lever is important and needs to be monitored

 Levers should be interdependent and collectively
represent a living system of business conduct
Diagnostic Control Systems
 Diagnostic Control Systems evaluate whether a firm
is performing to expectations by monitoring and
evaluating critical performance metrics, including:
 ROI, RI, EVA
 Customer Satisfaction
 Employee Satisfaction
 MUST be balanced by the other lever of control
Boundary Systems
 Boundary Systems describe standards of
behavior and codes of conduct expected of
all employees
 Highlights actions that are “off-limits”
 A code of conduct describes appropriate and
inappropriate individual behaviors
Belief Systems
 Belief Systems articulate the mission,
purpose, and core values of a company
 They describe the accepted norms and
patterns of behavior expected of all managers
and employees with respect to each other,
shareholders, customers, and communities
Interactive Control Systems
 Interactive Control Systems are formal
information systems that managers use to
focus organizational attention and learning on
key strategic issues
 Tracks strategic uncertainties that businesses
face

Performance Measurement, Compensation, and Multinational Considerations

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Performance Measurement,

 ROI = Return on Sales X Investment Turnover

 Weighted-average cost of capital equals the after-tax

 Each lever is important and needs to be monitored

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