Performance Measurement, Compensation, and Multinational Considerations © 2009 Pearson Prentice Hall All rights reserved 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: Financial Customer Internal Business Process Learning and Growth © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved Accounting-Based Performance Measures Requires a six-step design process: Choose Performance Measures that align with top management’s financial goals Choose the time horizon of each Performance Measure Choose a definition of the components in each Performance Measure Choose a measurement alternative for each Performance Measure Choose a target level of performance Choose the timing of feedback © 2009 Pearson Prentice Hall All rights reserved Step 1: Choosing Among Different Performance Measures Four common measures of economic performance: Return on Investment Residual Income Economic Value Added Return on Sales Selecting Subunit Operating Income as a metric is inappropriate since it obviously differs simply on the differing size of the subunits © 2009 Pearson Prentice Hall All rights reserved Return on Investment (ROI) ROI is an accounting measure of income divided by an accounting measure of investment (c) 2009 Pearson Prentice Hall All rights reserved 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 ROI’s both inside and outside the firm Also called the Accounting Rate of Return (ARR) or the Accrual Accounting Rate of Return (AARR) © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 (c) 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved Moral Hazard Moral Hazard describes situations in which an employee prefers to exert less effort (0r 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 © 2009 Pearson Prentice Hall All rights reserved Intensity of Incentives Intensity of Incentives – how large the incentive component of a manager’s compensation be relative to their salary component © 2009 Pearson Prentice Hall All rights reserved Preferred Performance Measures Preferred Performance Measures are those that are sensitive to or change significantly with the manager’s performance They 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 © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 longrun incentives to achieve the firm’s goals © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 describe appropriate and inappropriate individual behaviors © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved 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 © 2009 Pearson Prentice Hall All rights reserved © 2009 Pearson Prentice Hall All rights reserved ... 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 © 2009 Pearson Prentice Hall... (revenues, costs, and investment) into a single percentage 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. .. rights reserved 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)