Chapter 14 - PERFORMANCE MEASUREMENT, BALANCED SCORECARDS, AND PERFORMANCE REWARDS

CHAPTER
PERFORMANCE MEASUREMENT,
14 BALANCED SCORECARDS, AND
PERFORMANCE REWARDS
Learning Objectives
After reading and studying Chapter 14, you should be able to answer the following questions:
1. Why is a mission statement important to an organization?
2. What roles do performance measures serve in organizations?
3. What guidelines or criteria apply to the design of performance measures?
4. What are the common short-term financial performance measures, and how are they calculated
and used?
5. Why should company management focus on long-run performance?
6. What factors should managers consider when selecting nonfinancial performance measures?
7. Why is it necessary to use multiple performance measures?
8. How can a balanced scorecard be used to measure performance?
9. What is compensation strategy, and what factors must be considered in designing the
compensation strategy?
10. What difficulties are encountered in trying to measure performance and design compensation
plans for multinational firms?
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Chapter 14: Performance Measurement, Balanced Scorecards, & Performance Rewards IM 2
Terminology
Asset turnover: a ratio that measures asset productivity and shows the number of sales dollars
generated by each dollar of assets
Compensation strategy: a foundation for the compensation plan that addresses the role compensation
should play in the firm
Du Pont model: a model that computes the return on investment as the product of two variables: profit
margin and asset turnover
Economic value added (EVA): conceptually similar to residual income, EVA is a measure of the profit
produced above the cost of capital
Employee Stock Ownership Plan (ESOP): a profit sharing compensation program in which investments
are made in the securities of the employer
Expatriates: parent companies or third-country nationals assigned to a foreign subsidiary or foreign

nationals assigned to the parent company
Lagging indicator: measures or reflections of past decisions
Leading indicator: statistical data about the actionable steps that will create desired results in the future
Process productivity: total units produced during a period divided by value-added processing time
Process quality yield: the proportion of good units that results from the activities expended
Profit margin: the ratio of income to sales, and an indicator of what proportion of each sales dollar is not
used for expenses
Residual income (RI): profit earned that exceeds an amount charged for funds committed to an
investment center
Return on investment (ROI): a ratio that relates income generated by the investment center to the
resources (or asset base) used to produce that income
Tax-deferral: taxation of current compensation that occurs at a future date rather than currently
Tax-exemption: an item of current compensation that is never subjected to income taxation, in other
words, such income is exempt from taxation
Throughput: the number of good units or quantity of services produced and sold by an organization
during a time period
Values Statement: a statement that reflects the organization’s culture by identifying fundamental beliefs
about what is important to the organization
Lecture Outline
LO.1: Why is a mission statement important to an organization?
A. Introduction
1. Historically, managers focused almost exclusively on short-run financial performance measures

and ignored the long-run and critical nonfinancial activities because managers were commonly
judged on a short-term basis and long-run and non-financial performance data were often
unavailable.
2. Because many of the recent accounting scandals resulted from intense pressure on managers to
achieve short-term performance targets, more managers are beginning to recognize the need for
a longer horizon to gauge performance.
3. An organization’s performance evaluation and reward systems are key tools for aligning the
efforts and goals of workers, managers, and owners.
4. This chapter discusses one of the most important ways of motivating employees to maximize
stockholder wealth: the design and implementation of effective employee performance
measurement and reward systems.
B. Organization Mission Statements
1. Management must conduct the affairs of the company in such a way that both the short-term and
long-term needs of the firm are met.
2. The mission statement expresses a company’s purpose with regard to how it will meet its
targeted customers’ needs through its products or services.
3. A Values Statement reflects the organization’s culture by identifying fundamental beliefs about
what is important to the organization.
a. Such values may be either objective or subjective. Examples include safety of employees,
customer orientation, ethical behavior, respect for individuals, and environmental concerns.
4. Mission and values statements are two of the underlying bases for setting organizational goals
and objectives.
a. Goals are abstract targets to be achieved.
b. Objectives are quantified targets with expected completion dates.
c. Goals and objectives can be short term or long term but they are inexorably linked.
i. Long-term success cannot be achieved without short-term success along the way.
ii. Without long-term planning, short-run success will rapidly fade.
LO.2: What roles do performance measures serve in organizations?
C. Organizational Roles of Performance Measures
1. Managers design and implement strategies that apply organizational resources to activities in
fulfilling organizational missions.
a. Management talent and time are dedicated to planning, decision making, controlling, and
evaluating performance with respect to these activities.
b. The intent in these managerial processes is for management to implement actions that
maximize efficiency and effectiveness of resources used.
c. Managers must devise appropriate information systems to track resource applications.
d. Management resources can be gauged effectively and efficiently only if the terms “effective”
and “efficient” can be defined, and measures that are consistent with the definitions can be
formulated.
e. As indicated in text Exhibit 14–1, performance measures should exist for all elements that
are critical to an organization’s success in a competitive market.
2. Internal Performance Measures
a. Internal process measures must reflect concern for streamlined production, high quality, and
minimization of product complexity.
b. Products and services compete with others on the dimensions of price, quality, and product
features so superior performance in any of these three areas can provide the competitive
advantage needed for success.
c. Developing performance measures for each competitive dimension can identify alternative
ways to leverage a firm’s competencies.
d. Employee performance is also a critical element of organizational success. Internal

performance measures are used to communicate organizational mission, goals, and
strategies and to motivate subordinates to strive to accomplish the stated targets.
e. Measures are also used to implement organizational control over activities such as
comparing actual to budgeted results in responsibility accounting reports.
f. Performance measures also compare individuals’ work to make judgments about promotions
and retention. A firm searching for new ways to provide customers with more value at less
cost must develop an organizational culture that promotes employee learning, job
satisfaction, and production efficiency.
3. External Performance Measures
a. Externally, performance measures must reflect an organization’s ability to satisfy its

customers.
b. Meeting or exceeding the performance targets set for customers should result in the
increased likelihood of meeting or exceeding the performance targets set for investors and
creditors.
c. The most common performance measure used for all organizations is profit, which can be
measured as operating income or net income.
d. Generally accepted accounting principles are formulated to provide information that is

comparable across firms which facilitates investor/creditor judgments about which firms
deserve capital investments and which firms can provide acceptable returns.
e. Financial performance measures typically determine whether top management is retained or

dismissed.
i. Meeting or exceeding the market’s expectations of performance should create the capital
inflows that will result in improved processes, more qualified employees, and more
satisfied customers.
ii. Recent accounting scandals in the business community should remind management that
“good” financial performance should not be sought by improper accounting—whether by
“managing” either revenues or expenses.
LO.3: What guidelines or criteria apply to the design of performance measures?
D. Designing a Performance Measurement System
1. Managers will focus on the things by which they are measured.
a. The critical question to address in evaluating a performance evaluation measure is: What
managerial actions will this performance measurement encourage?
b. The performance measurement system should be designed to encourage behaviors that will
result in outcomes that generate organizational success.
2. General Criteria
a. As illustrated in text Exhibit 14-2, five general criteria should be considered in designing a
performance measurement system:
i. the measures should be established to assess progress toward organizational goals and
objectives;
ii. the individuals being evaluated should be aware of the measurements to be used and
have had some input in developing them;
iii. the individuals being evaluated should have the appropriate skills, equipment,
information, and authority to be successful under the measurement system;
iv. feedback of accomplishment should be provided in a timely and useful manner; and
v. the system should be flexible to adapt to new conditions in the organizational

environment.
3. Assess Progress Towards Mission
a. Organizations have a variety of objectives, including the need to be financially viable.
b. In addition to financial success, many companies are now establishing operational targets of
total customer satisfaction, zero defects, minimal lead time to market, and environmental and
social responsibility.
c. Nonfinancial performance measures that indicate progress—or lack thereof—toward the

achievement of a world-class company’s critical success factors must also be developed.
4. Awareness of and Participation in Performance Measures
a. Top management must set high performance standards and communicate them to lower-
level managers and employees, and the measures should promote harmonious operations
among organizational units.
b. Because people will usually act specifically in accordance with the way they are measured,
they must be aware of and understand the performance measures being used.
c. Employees will not be able to perform at their highest level of potential if measurement
information is withheld from them, and such a practice will not foster feelings of mutual
respect and cooperation.
d. Participation in setting performance standards results in a social contract between

participants and evaluators.
i. Participation generates an understanding and acceptance of the reasonableness of the

standards or budget.
ii. People who have participated in setting targets generally work hard to achieve the results
to affirm that the plans were well founded.
5. Appropriate Tools for Performance
a. For performance measures to be fair, people must first possess or obtain the appropriate
skills for their jobs.
i. Competent people must then be given the necessary tools (equipment, information, and
authority) to perform their jobs in a fashion consistent with the measurement process.
ii. People cannot be expected to accomplish their tasks if the appropriate tools are
unavailable.
b. Since upper-level managers in decentralized firms have little opportunity to observe the
actions of subordinates, they must make evaluations based on the outcomes that are
captured by performance measures.
i. This fact makes it imperative that the performance measures selected be those that are
highly correlated with the subunit mission, reflect fair and completely the subunit
manager’s performance, and measure performance dimensions that are under the
subunit manager’s control.
c. To evaluate performance, benchmarks must be established against which accomplishments

can be measured.
i. Benchmarks can be monetary (such as standard costs or budget appropriation amounts)

or nonmonetary (such as zero defects or another organization’s market share).
6. Need for Feedback
a. Performance should be monitored and feedback (both positive and negative) should be
provided on a continuing basis to the appropriate individuals.
b. In addition to annual evaluations, feedback on performance should be provided periodically

during the year so that employees are aware of how they are doing, have ample opportunities
to maximize positive results and correct negative results, and are not negatively “blindsided”
during their performance reviews.
c. The ultimate feedback is that organizational stakeholders exhibit belief in the firm’s viability.
The primary determinant of this belief is typically provided by short-run financial performance
measures.
LO.4: What are the common short-term financial performance measures, and how are they
calculated and used?
E. Short-Term Financial Performance Measures for Management
1. A traditional focus of performance measurement at the managerial level is on financial aspects of

operations, concentrating on monetary measures such as profits, achievement of and variations
from budget objectives, and cash flow.
2. The type of responsibility center being evaluated affects the performance measure(s) used since
managers should only be evaluated using performance measures relating to their authority and
responsibility.
a. In a cost center, the primary financial performance measurements are the variances from
budgeted or standard costs.
b. Performance can be judged in a pure revenue center primarily by comparing budgeted to

actual revenues.
c. Profit and investment center managers are responsible for both revenues and expenses;
therefore, other performance measures can be used in addition to the measures used by cost
and revenue centers.
3. Divisional Profits
a. The segment margin of a profit or investment center is frequently used as a measure of

divisional performance because it does not include allocated costs.
b. The actual segment margin is compared with the center’s budgeted income objective and
variances are calculated to determine whether objectives were exceeded or not achieved.
c. One problem in using the segment margin as a performance measure is that the individual
components used to derive it are subject to manipulation.
i. If a cost flow method other than FIFO is used, inventory purchases can be accelerated or
deferred at the end of the period to manage the period’s Cost of Goods Sold.
ii. Replacement of workers who have resigned or been dismissed can be deferred to
minimize salary expense for the period.
iii. Routine maintenance can be delayed or eliminated to reduce perceived expenses in the
short run.
iv. If fixed overhead is being allocated to inventory, production can be increased so that cost
per unit declines.
v. Sales recognition can be delayed or accelerated.
vi. Advertising expenses or other discretionary costs can be delayed or accelerated.
vii. Depreciation methods can be changed to affect depreciation expense.
4. Cash Flow
a. To succeed, an entity or an investment center must meet two requirements: long-run

profitability and continuous liquidity.
b. The Statement of Cash Flows (SCF) provides information about the cash impacts of the three
major categories of business activities: operating, investing, and financing.
i. The SCF explains the change in cash balance by indicating the sources and uses of
cash; such knowledge can assist managers in judging the entity’s ability to meet current
fixed cash outflow commitments, to adapt to adverse changes in business conditions,
and to undertake new commitments.
ii. The SCF assists managers in judging the quality of the entity’s earnings by identifying the
relationships between segment margin (or net income) and net cash flow from operating
activities.
iii. Analysis of the SCF in conjunction with budgets and other financial reports provides
information on cost reductions, collection policies, dividend payout, impact of capital
projects on total cash flows, and liquidity position.
c. Many cash flow ratios (such as the current ratio, quick ratio, and number of days’ collections
in accounts receivable) are available to assist managers in conducting their responsibilities
effectively.
5. Return on Investment
a. Return on investment (ROI) is a ratio that relates income generated by the investment
center to the resources (or asset base) used to produce that income. The ROI formula is:
ROI = Income ÷ Assets Invested
Both terms in the formula must be specifically defined before the ROI calculation can be used
effectively as a performance measure to evaluate an investment center and to make
intracompany, intercompany, and multinational comparisons.
i. See text Exhibit 14-3 for alternative definitions and preferred definitions.
ii. Text Exhibit 14-4 provides data for an example company, Nationwide Services, that is
used to illustrate return on investment computations.
iii. Text Exhibit 14-5 provides the return on investment rates using a variety of bases for the
example company.
b. The Du Pont model is a model that indicates the return on investment as it is affected by
profit margin and asset turnover.
ROI = Profit Margin x Asset Turnover
= (Income ÷ Sales) x (Sales ÷ Assets Invested)
c. Profit margin is the ratio of income to sales and indicates what proportion of each sales
dollar is not used for expenses and, thus, becomes profit.
d. Asset turnover is a ratio that measures asset productivity and shows the number of sales
dollars generated by each dollar of assets.
e. Text Exhibit 14-6 shows the calculations of the ROI components for each of the example
company’s investment centers using segment margin and total historical cost as the income
and asset base definitions.
i. Segment margin is preferred to operating income in the ROI computation if the

investment center manager does not have control in the short run over unavoidable fixed
expenses and allocated corporate costs.
f. Sales prices, volume and mix of products sold, expenses, and capital asset acquisitions and
dispositions affect ROI.
i. Return on investment can be increased through various management actions including

(1) raising sales prices if demand will not be impaired, (2) decreasing expenses, and (3)
decreasing dollars invested in assets, especially nonproductive ones.
g. Profit margin, asset turnover, and return on investment can be assessed as favorable or
unfavorable only if each component is compared with a valid benchmark such as expected
results, prior results, or results of other similar entities.
6. Residual Income
a. Residual income (RI) is the profit earned that exceeds an amount “charged” for funds
committed to an investment center. The RI calculation is:
Residual Income = Income – (Target Rate x Asset Base)
b. Text Exhibit 14-7 illustrates the calculation of RI for each of the example company’s
investment centers.
i. The “charged” amount is equal to a specified target rate of return multiplied by the asset
base and is comparable to an imputed interest rate of interest on the divisional assets
used; such rate can be changed from period to period consistent with market rate
fluctuations or to compensate for risk.
ii. Residual income yields a dollar figure rather than a percentage.
iii. Expansion (or additional asset investments) should occur in an investment center if
positive residual income is expected on the dollars of additional investment.
c. One difficulty in using RI as a performance measure is that it is hard to make valid

comparisons among divisions of various sizes.
7. Economic Value Added (EVA)
a. One of the most well-known measures that has been developed to directly align the interests
of common shareholders with managers’ is economic value added (EVA®). Conceptually
similar to RI, EVA is a measure of the profit produced above the cost of capital.
b. However, EVA applies the target rate of return to the market value of the capital invested in
the division rather than the book value of assets used for RI.
c. The EVA calculation is as follows:
EVA = After-Tax Profits – (Cost of Capital % x Market Value of Invested Capital)
d. Text Exhibit 14-8 presents the EVA computations for the example company.
e. As the difference between the market value of invested capital (total equity and interest-
bearing debt) and the book value of assets increases, so do the relative benefits of using
EVA rather than RI as a performance measure.
f. Despite its growing popularity, EVA cannot measure all dimensions of performance and is
short-term focused.
i. Accordingly, the EVA measure can discourage investment in long-term projects because
such investments cause an immediate increase in the amount of invested capital but
increase after-tax profits only at some future point.
ii. For greatest benefit, EVA should be supplemented with longer term financial and
nonfinancial performance measures.
8. Limitations of ROI, RI, and EVA
a. Income can be manipulated on a short-run basis and does not consider cash flows or the
time value of money.
b. Asset investment is difficult to properly measure and assign to center managers since assets
are acquired at different times and are subject to price-level changes.
c. Since ROI and RI both focus attention on how well an investment center itself performs in
isolation, rather than how well that center performs in relation to company-wide objectives,
suboptimization of resources can result.
LO.5: Why should company management focus on long-run performance?
F. Differences in Perspectives
1. Financial measures are lagging indicators, or reflections of the results of past decisions.
2. Measurements for improving performance should involve tracking leading indicators or

statistical data about the actionable steps that will create the results desired.
3. As presented in text Exhibit 14–9, leading indicators reflect causes and lagging indicators reflect
effects or outcomes.
4. Managing for the long run has commonly been viewed as managing a series of short runs.
Although appealing, this approach fails when the firm does not keep pace with long-range
technical and competitive improvement trends.
a. Thinking only of short-run performance and ignoring the time required to make long-term
improvements can doom a firm in the global competitive environment.
b. Short-run objectives generally reflect a focus on the effective and efficient management of
current operating, investing, and financing activities.
c. A firm’s long-term objectives generally involve resource investments and proactive efforts to
enhance competitive position, such as customer satisfaction issues of quality, delivery, price,
and service.
d. Because competitive position results from the interaction of a variety of factors, a firm must
identify the most important drivers (not just predictors) of the achievement of a particular long-
run objective.
e. The true drivers of increased market share for a firm are likely to be product and service
quality, speed of delivery, and reputation relative to competitors. Measurements of success
in these areas would be leading indicators of increased market share and profitability.
LO.6: What factors should managers consider when selecting nonfinancial performance
measures?
G. Nonfinancial Performance Measures
1. Managerial performance can be evaluated using both qualitative and quantitative measures;
qualitative measures are often subjective.
2. Managers are usually more comfortable with and respond better to quantitative measures of
performance since such measures provide a defined target at which to aim. Quantifiable
performance measures are of two types: nonfinancial and financial.
3. Selection of Nonfinancial Measures
a. Nonfinancial performance measures (NFPMs) are based on nonmonetary details, such as

time (e.g., manufacturing cycle time or setup time), quantities (e.g., number of patents
generated or pounds of material moved), and ratios (e.g., percentage of good units to total
units produced or percentage of sales generated by repeat customers).
b. Appropriate nonfinancial metrics are those that can be clearly articulated and defined, are
relevant to the performance objective, can trace responsibility, rely on valid data, have target
objectives, and have established internal and/or external benchmarks.
c. As indicated in text Exhibit 14–10, NFPMs have many distinct advantages over financial
performance measures.
d. Using a very large number of NFPMs is counterproductive and wasteful. Additionally, there
may be considerable interdependence among some of the measures.
e. An organization must determine which factors are essential to long-term success and develop
short-run and long-run metrics for these areas to steer the company toward success.
f. A short-run measure of success for quality is the number of customer complaints in the
current period; a long-range success measure for quality is the number of patents obtained
for quality improvements of company products.
i. Choosing appropriate performance measures can also help a company focus on the
activities that cause costs to be incurred and, thus, control costs and improve processes.
g. Three nonfinancial performance measures are throughput, cost of quality, and lead time.
i. Throughput
 Throughput is the number of good units or quantity of services that are produced
and sold or provided by an organization within a specified time.
 Because its primary goal is to earn income, a for-profit organization must sell
inventory (not simply produce) for throughput to be achieved.
 Throughput = Manufacturing Cycle Efficiency x Process Productivity x Process

Quality Yield
 Manufacturing cycle efficiency is the proportion of value-added processing time to

total processing time.
 Process productivity is total units produced during the period divided by the value-
added processing time.
 Process quality yield is the proportion of good units resulting from activities.
 A example of these calculations is given in text Exhibit 14-11.
 Management should strive to increase throughput by decreasing non-value-added

activities, increasing total unit production and sales, decreasing the per-unit
processing time, increasing process quality yield, or a combination of these actions.
ii. Cost of Quality
 Companies operating in the global environment are also generally concerned with
high product and service quality and the need to develop quality measurements such
as those presented in text Exhibit 14–12.
 As quality improves, management’s threshold of acceptable performance becomes

more demanding and performance is evaluated against progressively more rigorous
benchmarks.
iii. Lead Time
 Lead time refers to how quickly customers receive their goods after placing their
orders.
 Measuring lead time should cause products to be available to customers more

rapidly.
 Using fewer parts, interchangeable parts, and parts that require few or no
engineering changes after the start of production shortens lead time.
 Lead time incentives can also drive changes in facility layout to speed work flow, to
increase workforce productivity, and to reduce defects and rework.
 Lead time incentives should cause managers to observe and correct any non-value-
added activities or constraints that are creating production, performance, or
processing delays.
4. Establishment of Comparison Bases
a. Managers should establish acceptable performance levels to provide bases against which to
compare actual statistical data. Such benchmark comparison bases can be developed
internally or determined from external sources.
b. A general model for measuring the relative success of an activity compares a numerator
representing number of successes with a logical and valid denominator representing total
outcome volume.
LO.7: Why is it necessary to use multiple performance measures?
5. Use of Multiple Measures
a. A performance measurement system should encompass a variety of measures, especially

those that track factors considered necessary for mission achievement and long-run success.
b. Good performance is typically defined as providing a product or service that equals or

exceeds a customer’s quality, price, and delivery expectations.
c. Knowing that performance is to be judged using external criteria should cause companies to
implement concepts such as just-in-time inventory management, total quality management,
and continuous improvement.
i. Two common themes of these concepts are to make the organization, its products, and
its processes (production as well as customer responsiveness) more effective and
efficient and to generate higher value through lower costs.
d. Text Exhibit 14–13 provides ideas for judging managerial performance in four different areas.
LO. 8: How can a balanced scorecard be used to measure performance?
H. Using a Balanced Scorecard for Measuring Performance
1. A balanced scorecard provides a set of measurements that complements financial measures of

past performance with measures of the drivers of future performance.
2. The scorecard should reflect an organization’s mission and strategy and typically includes
performance measures from four perspectives:
a. financial;
b. internal business;
c. customer; and
d. learning and growth.
3. Text Exhibit 14-14 shows how Crown Castle International, a telecommunications company, uses
the balanced scorecard to drive its strategy.
4. Companies adapt the balanced scorecard to fit their own structures and environments.
a. Financial measures should reflect stakeholder-relevant issues of profitability, organizational

growth, and market price of stock (lagging indicators).
b. Customer measures lead financial perspective measures and should indicate how the
organization is faring relative to customer issues of speed (lead time), quality, service, and
price.
c. Internal process measures should focus on things the organization needs to do to meet
customer needs and expectations, and might include such measures as process quality
yields, manufacturing or service cycle efficiency, time to market on new products, on-time
delivery, and cost variances.
d. Learning and growth measures lead customer perspective measures and should focus on
using the organization’s intellectual capital to adapt to changing customer needs or influence
new customer needs and expectations through product or service innovations. Such
measures might include number of patents or copyrights applied for, percentage of research
and development projects resulting in patentable products, average time of R&D projects
from conception to commercialization, and percentage of capital investments on high-tech
projects.
5. Balanced Scorecards (BSC) may be used in organizations at multiple levels: top management,
subunit, and even individual employees.
a. When a BSC is implemented at lower levels of the organization, care should be taken to
make certain that the measurements used can “roll up” into higher level measurements that
will ultimately provide the organizational results desired.
b. Taken together, the measures provide a holistic view of what is happening both inside and
outside the organization or level, thus allowing all constituents of the organization to see how
their activities contribute to attainment of the organization’s overall mission.
6. A clear and growing trend in performance measurement is accounting for environmental impact
and sustainability of operations.
7. No single BSC, measurement system, or set of performance measurements is appropriate for all
organizations or, possibly, even all responsibility centers within the same company.
a. Although some performance measurements, such as financial viability, zero defects, and
customer service, are important regardless of the type of organization or its location, foreign
operations may require some additional considerations in performance measurement and

evaluation compared to domestic operations.
I. Performance Evaluation in Multinational Settings
1. Use of only one measurement criterion such as income is less appropriate for multinational
segments than it is for domestic responsibility centers.
2. The investment cost necessary to create the same type of organizational unit in different
countries can differ significantly due to factors such as exchange rates and legal costs.
3. Income comparisons between multinational units could be invalid because of differences in trade
tariffs, income tax rates, currency fluctuations, political risks, and the possibility of restrictions on
the transfer of goods or currencies among countries.
4. Firms with multinational profit or investment centers need to establish flexible systems of
measuring performance to recognize that differences in sales volumes, accounting standards,
economic conditions, and risk might be outside the control of the units’ managers.
5. Regardless of location, performance measures must be linked to the organization’s mission and
reward structure to motivate employees to improve performance.
LO.9: What is compensation strategy, and what factors must be considered in designing the
compensation strategy?
J. Compensation Strategy
1. A compensation strategy addresses the role compensation should play in the organization.
2. The foundation for the actual compensation plan should tie organizational goals, mission, and
strategies to performance measurements and employee rewards. The relations and interactions
among these elements are shown in text Exhibit 14–15.
3. The traditional U.S. compensation strategy usually differentiates three basic employee groups
that are compensated differently: top management, middle management, and workers.
a. Top managers’ compensation generally includes financial incentives which are monetary
rewards provided for performance above targeted objectives.
b. Middle managers are given salaries with the opportunity for future raises based on some,
usually accounting-related, measure of performance such as segment margin or divisional
ROI.
c. Workers are paid wages for the number of hours worked or production level achieved; current
or year-end bonuses may arise when performance is above some specified quantitative
measure.
d. The most basic reward plan consists of hourly, weekly, monthly, or other periodic
compensation, which is related to time spent at work rather than on tasks accomplished.
i. The only motivational aspects of periodic compensation are the prospects for
advancement to a higher periodic pay rate/amount, demotion to a lower pay rate/amount,
or dismissal.
K. Pay-for-Performance Plans
1. Compensation plans should encourage greater levels of employee performance and loyalty, while
concurrently lowering overall costs and raising profits.
2. Such plans must encourage behavior that is essential to achieving organizational goals and
maximizing stockholder value.
3. The defined performance measures must be highly correlated with the organization’s operational
targets, or suboptimization may occur and workers could earn incentive pay even though the
broader organizational objectives are not achieved.
4. A second consideration when designing a performance-based reward system is that the

measures should not focus solely on the short run since the primary function of U.S. business is
long-run wealth maximization.
a. Short-run measures are not always viable proxies for the long-run concept of wealth
maximization; specifically, short-term profits may be achieved at the expense of long-term
growth.
b. Pay-for-performance criteria should encourage workers to adopt a long-run perspective, and

many financial incentives now include shares of corporate common stock.
c. Employees tend to develop the same long-run wealth maximization perspective as other
stockholders when they become stockholders in their employer company.
d. Text Exhibit 14–16 indicates how the form of reward is influenced by the subunit mission.
5. Job commitment of employees can also be an important factor in designing employee incentive
plans since it is possible that younger employees may have a longer-term perspective than older
employees who expect to retire from the firm within a few years.
6. The balancing of incentives provided for both groups and individuals is also an important
consideration in designing employee incentives.
a. Workers in automated production systems function more by indirectly monitoring and

controlling machinery and are therefore less directly involved in hands-on production.
b. Incentives for small groups (teams) and individuals are often virtual substitutes; as the group
grows larger, incentives must be in place for both the group and the individual.
c. Group incentives are necessary to encourage cooperation among workers, and if only group
incentives are offered, the incentive compensation system may be ineffective since the
reward for individual effort goes to the group. The larger the size of the group, the smaller is
the individual’s share of the group reward.
d. Eventually, some workers could decide to take a “free ride” on the group because they
perceive their proportional shares of the group reward to be insufficient to compensate for
their efforts.
L. Links Between Performance Measures and Rewards
1. General
a. Performance measures for individual employees or employee groups can be determined

based on their required contribution to the operational plan once the target objectives and
compensation strategy are known.
b. Performance measures should link, directly or indirectly, the basic business strategies with
individual actions.
c. Rewards in a performance-based compensation plan should be based on monetary and

nonmonetary, short-term and long-term measures.
2. Degree of Control over Performance Output
a. Actual performance is a function of worker effort, worker skill, and random effects that include
performance measurement error, problems or efficiencies created by co-workers or adjacent
work stations, illness, and weather-related production problems.
b. The determination of the contributions of the controllable and noncontrollable factors to the
achieved performance is often impossible after the actual performance has been measured.
c. The worker consequently bears the risk of the outcome effects of both types of factors, and
efforts need to be made to identify performance measures that minimize the risk that is borne
by the workers and are associated with noncontrollable factors.
d. At the worker level, performance measures should be specific and typically have a short-run
focus - usually on cost and/or quality control.
e. As the level of responsibility increases, performance measures should, by necessity, become

less specific, focus on a longer time horizon, and be more concerned with organizational
longevity than with short-run cost control or income.
3. Incentives Relative to Organization Level
a. Individuals at different organizational levels typically view monetary rewards differently

because of the relationship of pay to standard of living.
b. Relative pay scales are essential to recognizing the value of monetary rewards to different
employees.
c. At lower employee levels, most incentives should be monetary and short term (to enhance
current lifestyles), but some nonmonetary and long-term incentives should also be included
so these individuals will take a long-run organizational ownership view.
d. At higher levels, most incentives should be nonmonetary and long term (such as stock and
stock options) so that managers will be more concerned about the organization’s long-term
well being rather than short-term personal gains.
4. Performance Plans and Feedback
a. As employees perform their required tasks, performance related to the measurement

standards is monitored.
b. The two feedback loops in the model shown in text Exhibit 14–15 exist so that problems
identified in one period can be corrected in future periods.
c. The first feedback loop relates to monitoring and measuring performance, which must be
considered in setting targets for the following periods.
d. The second feedback loop relates to the rewards given and the compensation strategy’s
effectiveness. Both loops are essential for managerial planning.
5. Worker Pay and Performance Links
a. The competitive environment in many industries has undergone substantial changes that
have, among other effects, led companies to use more automation and fewer labor-intensive
technologies.
b. There is also more emphasis on the need for workers to perform in teams and groups.
c. Workers are more detached from the production function and more involved with higher
technology tasks. Therefore, the trend is to rely more on performance-based evaluation and
less on direct supervision to control worker behavior.
d. This trend is consistent with the movement to empower workers and decrease levels of
supervision and layers of management.
6. Promoting Overall Success
a. Many performance-based plans have the expressed goal of getting common stock into the
hands of employees. One popular arrangement is profit sharing, which provides incentive
payments to employees in the form of cash or stock.
b. One popular profit sharing compensation program is the employee stock ownership plan
(ESOP), in which investments are made in the employer’s securities.
i. An ESOP offers both tax and incentive advantages since the employer makes tax-
deductible payments of cash or stock to a trust fund and trust beneficiaries are
employees whose wealth grows with both the employer contributions and advances in
the stock price.
7. Nonfinancial Incentives
a. Besides various forms of monetary compensation, workers can also be motivated by

nonfinancial factors.
b. Employees are typically more productive in environments in which they think their efforts are
appreciated.
c. Supervisors can formally recognize contributions of subordinates through simple gestures

such as compliments and small awards
d. Allowing employees to participate in decisions affecting their own and the firm’s welfare also
contributes to making employment socially fulfilling and lets employees know that superiors
are attentive to, and appreciative of, their contributions.
M. Tax Implications of Compensation Elements
1. Tax treatment differences are important since they affect the amount of after-tax income received
by the employee and the after-tax cost of the pay plan to the employer.
2. Three different tax treatments exist for employee compensation: full and immediate taxation,
deferral of taxation, and exemption from taxation.
a. Tax deferral indicates that taxation occurs in the future rather than currently.
b. Tax exemption is the most desirable form of tax treatment because the amount is never
subject to income taxation.
3. When analyzing the compensation plan, employers and employees must consider the entire
package—not simply one element of the package.
4. For the employer, compensation beyond wages and salaries will create additional costs; for
employees, such compensation creates additional benefits.
5. Fringe benefits can include employee health insurance, childcare, physical fitness facilities, and
pension plans.
6. Certain employee fringe benefits are not treated as taxable income to the employee, but are fully
and currently deductible by the employer, such as employer-provided accident and health
insurance plans.
LO.10: What difficulties are encountered in trying to measure performance and design
compensation plans for multinational firms?
N. Global Compensation
1. Expatriates are parent-company or third-country nationals assigned to a foreign subsidiary, or

foreign nationals assigned to the parent company.
2. Compensation systems must be developed that compensate expatriate employees and

managers on a fair and equitable basis.
a. The problem of establishing fair compensation for expatriates is one of the biggest challenges
in developing an international workforce.
b. The compensation package paid to expatriates must reflect labor market factors, cost-of-
living considerations, and currency fluctuations, as well as give consideration to tax
consequences.
c. Typically, an expatriate’s base salary and fringe benefits should reflect what he or she would
have been paid domestically—adjusted for reasonable cost-of-living factors.
d. Expatriates may be paid in the currency of the country in which they reside, in the currency of
their home country, or a combination of both.
e. Price-level adjustment clauses are usually built into the compensation system in order to
counteract any local currency inflation or deflation. The fringe benefit related to retirement
must be aligned with the home country and should be paid in that currency, regardless of the
currency makeup of the pay package.
f. Tying compensation to performance is essential because all workers recognize that what gets
measured and rewarded determines what gets accomplished and so organizations must
structure their reward structures to motivate employees to succeed at all activities that will
create shareholder, and personal value.
O. Ethical Considerations of Compensation
1. A major issue of discussion and contention involves perceptions of disparity between the pay of
ordinary workers and top managers.
2. Today, there are numerous examples of CEOs earning many times the pay of the average
worker.
a. In the recent global economic downturn, there has been considerable discussion about the
gap between the income of the elite and the typical worker.
b. It appears that the long-term trend of a growing gap between executives and workers may be
in the process of reversing because of the recession.
c. In 2007, the top one percent of income earners accounted for 23.5 percent of personal
income in the U.S. but it is believed that in 2010, the top one percent will claim only 15-19
percent of total personal income.
3. The greatest ethical compensation dilemmas involve circumstances that pit the welfare of
employees against that of stockholders or the welfare of managers against the welfare of
workers.
4. Only if there is a perception of equity across the contributions and entitlements of labor,
management, and capital will the organization be capable of achieving the efficiency to compete
in global markets.

Chapter 14 - PERFORMANCE MEASUREMENT, BALANCED SCORECARDS, AND PERFORMANCE REWARDS

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Chapter 14 - PERFORMANCE MEASUREMENT, BALANCED SCORECARDS, AND PERFORMANCE REWARDS

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CHAPTER

1. Why is a mission statement important to an organization?

2. What roles do performance measures serve in organizations?

3. What guidelines or criteria apply to the design of performance measures?

5. Why should company management focus on long-run performance?

7. Why is it necessary to use multiple performance measures?

8. How can a balanced scorecard be used to measure performance?

Expatriates: parent companies or third-country nationals assigned to a foreign subsidiary or foreign

Lagging indicator: measures or reflections of past decisions

LO.1: Why is a mission statement important to an organization?

1. Historically, managers focused almost exclusively on short-run financial performance measures

B. Organization Mission Statements

a. Goals are abstract targets to be achieved.

b. Objectives are quantified targets with expected completion dates.

ii. Without long-term planning, short-run success will rapidly fade.

LO.2: What roles do performance measures serve in organizations?

C. Organizational Roles of Performance Measures

c. Managers must devise appropriate information systems to track resource applications.

2. Internal Performance Measures

d. Employee performance is also a critical element of organizational success. Internal

3. External Performance Measures

a. Externally, performance measures must reflect an organization’s ability to satisfy its

d. Generally accepted accounting principles are formulated to provide information that is

e. Financial performance measures typically determine whether top management is retained or

LO.3: What guidelines or criteria apply to the design of performance measures?

D. Designing a Performance Measurement System

1. Managers will focus on the things by which they are measured.

v. the system should be flexible to adapt to new conditions in the organizational

3. Assess Progress Towards Mission

a. Organizations have a variety of objectives, including the need to be financially viable.

c. Nonfinancial performance measures that indicate progress—or lack thereof—toward the

4. Awareness of and Participation in Performance Measures

d. Participation in setting performance standards results in a social contract between

i. Participation generates an understanding and acceptance of the reasonableness of the

5. Appropriate Tools for Performance

c. To evaluate performance, benchmarks must be established against which accomplishments

i. Benchmarks can be monetary (such as standard costs or budget appropriation amounts)

6. Need for Feedback

b. In addition to annual evaluations, feedback on performance should be provided periodically

E. Short-Term Financial Performance Measures for Management

1. A traditional focus of performance measurement at the managerial level is on financial aspects of

b. Performance can be judged in a pure revenue center primarily by comparing budgeted to

a. The segment margin of a profit or investment center is frequently used as a measure of

v. Sales recognition can be delayed or accelerated.

vi. Advertising expenses or other discretionary costs can be delayed or accelerated.

vii. Depreciation methods can be changed to affect depreciation expense.

a. To succeed, an entity or an investment center must meet two requirements: long-run

ROI = Income ÷ Assets Invested

ROI = Profit Margin x Asset Turnover

= (Income ÷ Sales) x (Sales ÷ Assets Invested)

i. Segment margin is preferred to operating income in the ROI computation if the

i. Return on investment can be increased through various management actions including

Residual Income = Income – (Target Rate x Asset Base)

ii. Residual income yields a dollar figure rather than a percentage.

c. One difficulty in using RI as a performance measure is that it is hard to make valid

7. Economic Value Added (EVA)

c. The EVA calculation is as follows:

EVA = After-Tax Profits – (Cost of Capital % x Market Value of Invested Capital)

8. Limitations of ROI, RI, and EVA

LO.5: Why should company management focus on long-run performance?

2. Measurements for improving performance should involve tracking leading indicators or

G. Nonfinancial Performance Measures

3. Selection of Nonfinancial Measures