CHAPTER 11

Performance Measurement,Compensation,

and Multinational Considerations

Financial and Nonfinancial Measures

• Firms are increasingly presenting financial and nonfinancial performance measures for their subunits in a Balanced Scorecard, and its four perspectives:

– Financial– Customer– Internal Business Process– Learning and Growth

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 goals2. Choose the time horizon of each

Performance Measure3. Choose a definition of the components in

each Performance Measure4. Choose a measurement alternative for

each Performance Measure5. Choose a target level of performance6. Choose the timing of feedback

Step 1: Choosing among Different Performance

Measures• Four common measures of economic

performance:1. Return on Investment2. Residual Income3. Economic Value Added4. 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

IncomeInvestmentROI =

ROI

• Most popular metric for two reasons:

Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage

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:

• ROI = Return on Sales X Investment Turnover

• This is known as the DuPont Method of Profitability Analysis

Income Income RevenuesInvestment Revenues InvestmentX=

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

• Weighted-average cost of capital equals the after-tax average cost of all long-term funds in use

After-tax Weighted-Average Total CurrentOperating Income Cost of Capital Assets Liabilities ) }EVA {= X (

Return on Sales (ROS)

• Return on Sales is simply income divided by sales

• Return on Sales = Income Revenues

• 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– may be adapted to evaluate multiple

periods of time

Step 3: Choosing Alternative Definitions for Performance

Measures• Alternative definitions of

investment:1. Total Assets Available2. Total Assets Employed3. Total Assets Employed minus

Current Liabilities4. Stockholders’ Equity

Step 4: Choosing Measurement Alternatives for

Performance Measures• Possible alternative definitions of

cost: Current Cost Gross Value of Fixed Assets 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 – 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:

Designing performance measures for activities that require multiple tasks

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 levers of control

Boundary Systems

• Boundary Systems– 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 – formal information systems that

managers use to focus organizational attention and learning on key strategic issues

• Track strategic uncertainties that businesses face