Performance Measurement & Compensation: 2009 Foster Business School Cost Accounting L.Ducharme 1

Chapter 23
Performance Measurement
&
Compensation
2009 Foster Business School
Cost
Overview
Financial & Nonfinancial Measures
Accounting-based Measures
Return on Investment
Residual Income
Economic Value Added
Return on Sales
Role of Salaries & Incentives

Best Measure?
Cost
Financial and Nonfinancial

Performance Measures
Companies are supplementing internal
financial measures with measures based on:
External financial information
Internal nonfinancial information
External nonfinancial information
Cost
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
Cost
Accounting-Based
Performance Measure
Step 1:
Choose performance measures that align
with top managements financial goal(s).
Step 2:
Choose the time horizon of each
performance measure in Step 1.
Step 3:
Choose a definition for each.
Cost
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.
Cost
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.
Cost
Measure Example
Boston Hotel
Current assets
$350,000
Long-term assets 550,000
Total assets
$900,000
Current liabilities $ 50,000
Revenues
$1,100,000
Variable costs
297,000
Fixed costs
637,000
Operating income $ 166,000
Cost
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
Cost
Measure Example
Miami Hotel
Current assets
$ 600,000
Long-term assets 5,000,000
Total assets
$5,600,000
Current liabilities $ 300,000
Revenues
$3,200,000
Variable costs
882,000
Fixed costs
1,166,000
Operating income $1,152,000
Cost
10
Measure Example
Total current assets
Total long-term assets
Total assets
Total current liabilities
Long-term debt
Stockholders equity
Total liabilities and equity
$1,350,000
6,150,000
$7,500,000
$ 500,000
4,800,000
2,200,000
$7,500,000
Cost
11
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.
Cost
12
Return on investment (ROI) is an
accounting measure of income
divided by an accounting
measure of investment.
Return on investment (ROI)
= Income Investment
Cost
13
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%
Cost
14
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
Cost
15
DuPont Method
Return on sales = Income Revenues
Investment turnover = Revenues Investment
ROI = Return on sales Investment turnover
Cost
16
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%
Cost
17
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%
Cost
18
DuPont Method
Alternative B: Increase revenues, keeping
assets and operating income per dollar
of revenues constant.
= $1,500,000 $1,000,000 = 1.50
= $300,000 $1,500,000 = 0.20
1.50 0.20 = 30%
Cost
19
DuPont Method
Alternative C: Decrease costs to increase
operating income per dollar of revenues,
keeping revenues and assets constant.
= $1,200,000 $1,000,000 = 1.20
= $300,000 $1,200,000 = 0.25
1.20 0.25 = 30%
Cost
20
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?
Cost
21
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
Cost
22

Economic value added (EVA)
= After-tax operating income
[Weighted-average cost of capital
(Total assets current liabilities)]
Cost
23

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.
Cost
24

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
Cost
25
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%.
Cost
26

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?
Cost
27

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%
Cost
28

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
Cost
29

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
Cost
30

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
Cost
31

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.
Cost
32
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%
Cost
33
Comparing Performance
Hotel
Boston
Denver
Miami
ROI
18%
24%
21%
RI
$ 58,000
$120,000
$480,000
EVA
$ 26,950
$ 78,750
$249,900
Cost
ROS
15%
20%
36%
34
Comparing Performance
Methods Ranking
Hotel
Boston
Denver
Miami
ROI
3
1
2
RI
3
2
1
EVA ROS
3
3
2
2
1
1
Cost
35
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.
Cost
36
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.
Cost
37

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.
Cost
38

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.
Cost
39
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.
Cost
40
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.
Cost
41
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.
Cost
42
Multinational Companies
Difficulties exist when
comparing the performance
of divisions operating
in different countries.
Cost
43
Salary & Incentives: The Basic

Trade-off
Most often, a managers total
compensation includes some
combination of salary and a
performance-based incentive.
Cost
44
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 managers performance.
Cost
45
Benchmarks
Owners can use benchmarks to
evaluate performance.
Benchmarks representing best
practice may be available inside
or outside the organization.
Cost
46
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.
Cost
47
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.
Cost
48

Performance Measurement & Compensation: 2009 Foster Business School Cost Accounting L.Ducharme 1

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Chapter 23

2009 Foster Business School

Role of Salaries & Incentives

Financial and Nonfinancial

Financial and Nonfinancial

(2) customer-satisfaction measures

2009 Foster Business School

2009 Foster Business School

2009 Foster Business School

$166,000 Operating income

ROI: DuPont Method

2009 Foster Business School

Economic Value Added

2009 Foster Business School

Economic Value Added

Economic Value Added

Economic Value Added Example

Economic Value Added Example

Economic Value Added Example

Economic Value Added Example

Economic Value Added Example

Economic Value Added Example

2009 Foster Business School

Economic Value Added Example

2009 Foster Business School

2009 Foster Business School

Choosing the Time Horizon

2009 Foster Business School

Choosing Alternative Definitions

Choosing Alternative Definitions

Choosing Alternative Definitions

2009 Foster Business School

Salary & Incentives: The Basic

2009 Foster Business School

2009 Foster Business School

2009 Foster Business School

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