chapter 23

Copyright © 2015 Pearson Education, Inc. All Rights Reserved

Performance Measurement,Compensation,

and Multinational Considerations


1. Select financial and nonfinancial performance measures to use in a balanced scorecard

2. Examine accounting-based measures for evaluating a business unit’s performance, including return on investment (ROI), residual income (RI), and economic value added (EVA®)

3. Analyze the key measurement choices in the design of each performance measure

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4. Study the choice of performance targets and design of feedback mechanisms

5. Indicate the difficulties that occur when the performance of divisions operating in different countries is compared

6. Understand the roles of salaries and incentives when rewarding managers

7. Describe the four levers of control and why they are necessary

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Many organizations record financial and nonfinancial performance measures for their subunits on a balanced scorecard. The scorecards of different organizations emphasize different measures but the measures are always derived from a company’s strategy. In a balanced scorecard, the four perspectives are:

1. Financial2. Customer3. Internal business process4. Learning and growth

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Requires several steps:1. Choose performance measures that align

with the firm’s financial goals.2. Choose the details of each performance

measure.3. Choose a target level of performance

and a feedback mechanism for each performance measure.

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1. Return on investment2. Residual income3. Economic value added4. Return on sales (this measure

does not account for investment)

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IncomeInvestmentROI =

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ROI is an accounting measure of income divided by an accounting measure of investment.


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 ROI’s both inside and outside the firm

Also called the accounting rate of return (ARR) or the accrual accounting rate of return (AARR)

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ROI may be decomposed into its two components as follows:

ROI = Return on Sales X Investment Turnover. This approach is known as the DuPont Method

of Profitability Analysis. It recognizes the two basic ingredients in profit making: increasing income per dollar of revenue and using assets to generate more revenues. An improvement to either with no change in the other will increase ROI.

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Income Income RevenuesInvestment Revenues InvestmentX=


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.

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

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EVA is a variation of RI used by many companies. It is calculated as follows:

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


Return on sales is also known as the income-to-revenues ratio or the sales ratio

It is frequently used, simple to compute, and widely understood.

It does not take into account investment. It measures how effectively costs are

managedIt is calculated by taking Operating Income /

Revenues and is expressed as a percentage.

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Using the example of the hotels from our textbook, we see the results using each of our methods: (in parentheses are the ranks)

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Hotel ROI RI EVA ROS

SF 24% (1)

$120,000 (2)

$68,250 (2)

20% (2)

Chicago 15% (3)

$ 60,000 (3)

$15,750 (3)

21% (1)

New Orleans 17% 92)

$150,000 (1)

$73,500 (1)

16% (3)


How should each measure be computed? Several questions should be answered to begin:What is the time horizon?Which definition of investment will be used?How shall we calculate various components of each performance measure such as the measurement of assets.Let’s now discuss each of these measurement details.

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An important element in designing accounting-based performance measures is 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.

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There are several benefits to multiyear analysis:Benefits of actions taken in the current period may not show up in short-run performance measures.If managers use NPV for investment decisions, then using a multiyear RI for performance achieves goal congruence.Motivates managers to take a long-run perspective by compensating them on changes in market price.

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Four common alternative definitions of investment:

1. Total assets available – all assets.2. Total assets employed – all assets less idle

assets and assets purchased for future expansion.

3. Total assets employed minus current liabilities – total assets employed less assets financed by short-term creditors.

4. Stockholder’s equity – assign liabilities to subunits and deduct from total assets.

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Possible alternative asset measurements include:

1. Current cost – cost of purchasing an asset today identical to the one currently held.

2. Gross value of fixed assets – historical cost. 3. Net book value(NBV) of fixed assets –

historical cost.(Historical cost is used to calculate ROI and

there is always a question whether to use gross or net book value. NBV is the measure most commonly used by companies for internal performance evaluation.)

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Choosing target levels of performance:Establish target ROIs using historical-cost-

based measures.Set continuous improvement targets.Use balanced scorecards to establish

targets. Choosing the timing of feedback

(depends on):How critical the information is for the

success of the organization.The management level receiving feedback.The sophistication of the organization’s

information technology.

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Additional difficulties faced by multinational companies: The economic, legal, political, social, and cultural

environments differ significantly across countries. Import quotas and tariffs range widely from country

to country. Availability of materials and skilled labor, as well as

costs of materials, labor, and infrastructure also differ significantly across countries.

Divisions operating in different countries account for their performance in different currencies and inflation and fluctuation in foreign-currency exchange rates affect performance measurement.

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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 reason for this is to recognize that a company may put the most skilled division manager in charge of the division with the poorest return in an effort to improve that division and that may take years.

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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.

The motivation for having some salary and some performance-based compensation is to balance the benefit of incentives against the extra cost of imposing risk on a manager.

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Moral hazard describes a situation in which an employee prefers to exert less effort compared with the effort the owner desires because the owner cannot accurately monitor and enforce the employee’s effort.

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Intensity of incentives—how large the incentive component of a manager’s compensation should be relative to their salary component.

The tradeoff between considerations of sensitivity and risk, on the one hand, and the congruence of goals, on the other, determines the effective intensity of incentives placed on each measure of performance.

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Benchmarks are metrics that correspond to the best practices of organizations and may be available inside or outside of the organization.

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Managers need to do two things when designing the measures used to evaluate performance of individual employees:

1. Design performance measures for activities that require multiple tasks.

2. Design performance measures for activities done in teams.

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Employers want employees to allocate their time and effort intelligently among various tasks or aspects of their jobs.

A team achieves better results than individual employees acting alone.1 Many companies reward employees on teams based on how well their team performs.

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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.

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Performance evaluation measures help managers track their progress toward achieving a company’s strategic goals. Because these measures help diagnose whether a company is performing to expectations, they are collectively called Diagnostic Control Systems.Companies motivate managers by holding them accountable and rewarding them for meeting goals.

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To prevent unethical and outright fraudulent behavior, companies balance the push for performance (resulting from Diagnostic Control Systems) with three other levers of control:

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.

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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.

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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 other employees when interacting with one another, shareholders, customers, and communities.

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Interactive control systems are formal information systems that managers use to focus the company’s attention and learning on key strategic issues.

Helps managers create open dialog and eliminate or manage an excessive focus on diagnostic control systems.

Tracks strategic uncertainties that businesses face.

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TERMS TO LEARN PAGE NUMBER REFERENCE

Belief systems Page 895

Boundary systems Page 895

Current cost Page 884

Diagnostic control systems Page 894

Economic value added (EVA®)

Page 880

Imputed cost Page 879

Interactive control systems Page 896

Investment Page 876

Moral hazard Page 890

Residual income (RI) Page 879

Return on investment (ROI) Page 87723-34

chapter 23

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