Rewarding Business

Performance

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 Motivation
Motivation and
and Aligning
Aligning
Goals
Goals and
and Objectives
Objectives
Goal Congruence

Alignment of employee
goals and objectives
with organizational
goals and objectives.

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 Motivation
Motivation and
and Aligning
Aligning
Goals
Goals and
and Objectives
Objectives

Feedback
 Steer employees
Measure
toward goals.
performance.
 Measure progress
in achieving goals.

Improve Reward
performance. performance.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
 Return
Return on
on Investment
Investment (ROI)
(ROI)
Return on investment is the ratio of
profit to the average investment used
to generate the profit.

Profit____
ROI =
Average investment

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Return
Return on
on Investment
Investment (ROI)
(ROI)

Profit
ROI = Average Investment

Profit Sales
ROI = ×
Sales Average Investment

Return
Return Capital
Capital
on
on Sales
Sales Turnover
Turnover
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
 Return
Return on
on Investment
Investment (ROI)
(ROI)

Holly Company reports the following:

Profit P 30,000
Sales P 500,000
Average Investment P 200,000

Let’s calculate ROI.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
 Return
Return on
on Investment
Investment (ROI)
(ROI)
Profit Sales
ROI = ×
Sales Average Investment

P30,000 P500,000
ROI = ×
P500,000 P200,000

ROI = 6% × 2.5 = 15%

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Improving
Improving ROI
ROI
 Decrease
Expenses
 Increase  Lower
Sales Invested
Prices Capital

Three ways to improve ROI

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 Improving
Improving ROI
ROI
 Holly’s manager was able to increase
sales revenue to P600,000 which
increased income to P42,000.
 There was no change in invested capital.

Let’s calculate the new ROI.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Improving
Improving ROI
ROI
Profit Sales
ROI = ×
Sales Average Investment

P42,000 P600,000
ROI = ×
P600,000 P200,000

ROI = 7% × 3.0 = 21%

Holly increased ROI from 15% to 21%.

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 Criticisms
Criticisms of
of ROI
ROI
 As division manager at Winston, Inc., your
compensation package includes a salary plus
bonus based on your division’s ROI -- the higher
your ROI, the bigger your bonus.
 The company requires an ROI of 15% on all new
investments -- your division has been producing an
ROI of 30%.
 You have an opportunity to invest in a new project
that will produce an ROI of 25%.
As division manager would you
invest in this project?
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
 Criticisms
Criticisms of
of ROI
ROI
Gee . . .
I thought we were As division manager,
supposed to do what I wouldn’t invest in
was best for the that project because
company! it would lower my pay!

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 Residual
Residual Income
Income
Operating Earnings
– Investment charge
= Residual income

Investment capital
× Minimum return
= Investment charge

Investment center’s
minimum acceptable
return
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 Residual
Residual Income
Income

 Flower Co. has an opportunity to invest

P100,000 in a project that will earn P25,000.
 Flower Co. has a 20 percent minimum
acceptable rate of return and a 30 percent
ROI on existing business.

Let’s calculate residual income.

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 Residual
Residual Income
Income
Operating Earnings = P25,000
– Investment charge = 20,000
= Residual income = P 5,000

Investment capital = P100,000

× Minimum return = × 20%
= Investment charge = P 20,000

Investment center’s
minimum acceptable
return
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 Residual
Residual Income
Income

 As a manager at
Flower Co., would you
invest the P100,000 if
you were evaluated
using residual income?
 Would your decision
be different if you were
evaluated using ROI?

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 Residual
Residual Income
Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

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 Economic
Economic Value
Value Added
Added
Economic value added tells us how much
shareholder wealth is being created.

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 Economic
Economic Value
Value Added
Added
Economic value added is the annual after-tax operating
profit minus the total annual cost of capital.

Cost of capital is weighted-average after-tax

cost of long-term borrowing and the cost of debt.

Equity Debt

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Residual
Residual Income
Income
After-tax Operating Income
– Investment charge
= Economic value added

(Total assets – current liabilities)

× Weighted-average cost of capital
= Investment charge

After-tax cost of
long-term borrowing
and the cost of equity
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
 Economic
Economic Value
Value Added
Added
Economic value added can be improved in
three ways . . .

 Increase profit without using more capital.

 Use less capital to earn the same amount of
profit.
 Invest capital in high-return projects.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Balanced
Balanced Scorecard
Scorecard
A set of performance targets and results that
show an organization’s performance in
meeting its responsibilities to various
stakeholders.

Employee Investor
Stakeholder Stakeholder
Group Group

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 Balanced
Balanced Scorecard
Scorecard
Financial Perspective
How do we look
to the firm’s owners?

Learning and Growth Vision

Business Process
Perspective Perspective
and
How can we continually In which activities
improve and create value? Strategy must we excel?

Customer Perspective
How do our
customers see us?
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 Components
Components of
of Management
Management
Compensation
Compensation
I prefer a bonus arrangement
I prefer a fixed salary that gives me the opportunity
so that I know what to earn larger amounts. I
I will be paid each year. don’t mind the varying
compensation.
I like both profit sharing and
stock options.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

 Design
Design Choices
Choices for
for
Management
Management Compensation
Compensation
Should
Should we
we reward
reward
current
current performance
performance or
or
future
future performance?
performance?

Should
Should teams
teams of
of Should
Should bonuses
bonuses be be
employees
employees share
share bonuses
bonuses fixed
fixed or
or should
should they
they
equally
equally oror should
should they
they vary
vary with
with aa
be
be in
in competition?
competition? performance
performance measure?
measure?

Should
Should our
our rewards
rewards bebe Should
Should bonuses
bonuses be be
based
based onon accounting
accounting based
based on
on local
local or
or
numbers
numbers or or stock
stock company-wide
company-wide
price
price performance?
performance? performance?
performance?
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 End
End of
of Discussion
Discussion

My performance
was magnificent!

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