Performance Measurement,

Compensation,
and Multinational Considerations

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Financial and Nonfinancial Measures
 Firms are increasingly presenting financial and
nonfinancial performance measures for their
subunits in a balanced scorecard, and it’s four
perspectives:
1. Financial
2. Customer
3. Internal business process
4. Learning and growth

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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.

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Accounting-Based Performance Measures
 Requires several steps:
1. Choose performance measures that align with top
management’s financial goals.
2. Choose the details of performance measures.
3. Choose a target level of performance and a feedback
mechanism for each performance measure.

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Choosing Among Different Performance
Measures
 Four common measures of economic
performance:
1. Return on investment
2. Residual income
3. Economic value added
4. Return on sales
 Selecting subunit operating income as a metric is
inappropriate because it obviously differs simply
on the differing size of the subunits.

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Return on Investment (ROI)
ROI is an accounting measure of income divided by
an accounting measure of investment.

Income
ROI = Investment

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ROI
 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
ROI may be decomposed into its two components as
follows:
Income Income Revenues
Investment = Revenues X Investment

ROI = Return on Sales X Investment Turnover

This is known as the DuPont Method of Profitability
Analysis

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Noemi Corporation had the following
information for 2018:

Revenue 450,000
Operating expenses 335,000
Total assets 575,000

What is the return on investment?

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(450,000 - 335,000)/575,000

= 20%

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Devz Company has two regional offices. The data for each are as
follows:
Maryland New Jersey
Revenues 290,000 298,000
Operating assets 2,400,000 4,500,000
Net operating income 1,008,000 1,200,000

What is the Maryland Division's return on investment?

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1,008,000/2,400,000

= 0.42 or 42%

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Devz Company has two regional offices. The data for each are as
follows:
Maryland New Jersey
Revenues 290,000 298,000
Operating assets 2,400,000 4,500,000
Net operating income 1,008,000 1,200,000

What is the New Jersey Division's return on investment?

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1,200,000/4,500,000

= 0.27 or 27%

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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 cost recognized in some situations, but
not in the financial accounting records.

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The Bandage Medical Supply Company has two divisions that operate
independently of one another. The financial data for the year 2018 reported
the following results:

North South
Sales 6,000,000 5,000,000
Operating income 1,500,000 1,100,000
Taxable income 1,300,000 750,000
Investment 12,000,000 10,000,000

The company's desired rate of return is 10%. Income is defined as

operating income.

What are the respective residual incomes for the North and South Divisions?

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C) North = 1,500,000 - (0.1 × 12,000,000)
= 300,000

South = 1,100,000 - (0.1 × 10,000,000)

= 100,000

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Economic Value Added (EVA)
EVA is a specific type of residual income calculation
that has recently gained popularity.

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

Weighted average cost of capital equals the after-tax

average cost of all long-term funds in use.

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Springfield Corporation, whose tax rate is 40%, has two sources of funds:
long-term debt with a market value of 8,000,000 and an interest rate of 8%,
and equity capital with a market value of 12,000,000 and a cost of equity of
12%. Springfield has two operating divisions, the Blue division and the Gold
division, with the following financial measures for the current year:

Total Assets Current Liabilities Operating Income

Blue Div. 9,500,000 2,800,000 1,055,000

Gold Div. 11,000,000 2,200,000 1,200,000

What is Economic Value Added (EVA) for the Blue Division?

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WACC = [(8,000,000 × (1 - .4) × (.08)) +
(12,000,000 × .12)] / (8,000,000 +
12,000,000) = .0912

EVA = (1,055,000 × (1 - .4)) - ((9,500,000

- 2,800,000) × .0912) = 21,960

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Return on Sales (ROS)
Return on sales is simply income divided by sales.
Simple to compute, and widely understood.

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The Cybertronics Corporation reported the
following information for its Cyclotron
Division:

Revenues 2,000,000
Operating costs 1,200,000
Taxable income 400,000
Operating assets 1,000,000
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2,000,000 - 1,200,000 = 800,000;
800,000/2,000,000 = 0.40

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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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Choosing Alternative Definitions for
Performance Measures
 Four possible alternative definitions of investment:
1. Total assets available
2. Total assets employed
3. Total assets employed minus current liabilities
4. Stockholder’s equity

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Choosing Measurement Alternatives for
Performance Measures
 Possible alternative definitions of cost:
1. Current cost
2. Gross value of fixed assets
3. Net book value of fixed assets

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Choosing Target Levels of Performance
Historically driven targets used to set target goals
Goal may include a continuous improvement
component

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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

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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.

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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.

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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.

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Moral Hazard
Moral hazard describes 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.

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

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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
manger’s exposure to risk, reducing the cost of
providing incentives.
May include benchmarking.

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Performance Measures at the
Individual Activity Level
 Two issues when evaluating performance at the
individual activity level:
1. Designing performance measures for activities that
require multiple tasks
2. Designing performance measures for activities done
in teams

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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.

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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.

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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.

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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.

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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 lever of control

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Boundary Systems
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
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 one another, shareholders, customers,
and communities.

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Interactive Control Systems
Interactive control systems are formal information
systems that managers use to focus organizational
attention and learning on key strategic issues.
Tracks strategic uncertainties that businesses face.

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© 2012 Pearson Education. All rights reserved.