Performance Measurement

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Performance MeasurementCompensation
Chapter 23
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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 NonfinancialPerformance 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 NonfinancialPerformance 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-BasedPerformance 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.
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Accounting-BasedPerformance 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

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

Revenues 1,200,000 Variable costs
310,000 Fixed costs 650,000 Operating
income 240,000
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Accounting-Based Performance 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
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Accounting-Based Performance Measure Example
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
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Approaches toMeasuring 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 ROI RI EVA ROS Boston 18
58,000 26,950 15 Denver 24 120,000
78,750 20 Miami 21 480,000 249,900 36
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Comparing Performance
Methods Ranking
Hotel ROI RI EVA
ROS Boston 3 3 3 3 Denver 1 2 2 2
Miami 2 1 1 1
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Choosing the Time Horizon
The second step of designing accounting-based perf
ormance 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 perfo
rmance 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 perf
ormance measures is choosing a measurement alterna
tive 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 perfo
rmance 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 perfo
rmance 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 managers 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
managers 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.