Chapter 13

Financial performance
measures and incentive
schemes

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 Outline
• Financial measures in investment centres
• Return on investment
• Residual income
• Measuring profit and invested capital
• Measures of shareholder value
• Incentive systems
• Theories of motivation
• Performance-related pay systems
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 Financial measures in
investment centres
• Summary financial performance
measures are used to assess the
performance of profit centres and
investment centres
– Return on investment (ROI)
– Residual income (RI)
– Economic value added (EVA)

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 Return on investment
• Return on investment (ROI)
– Used to evaluate the financial performance
of investment centres

profit
Return on investment 
invested capital

(cont.)
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 Return on investment (cont.)

profit
ROI 
invested capital
profit sales revenue
 
sales revenue invested capital
 return on sales  investment turnover

(cont.)
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Return on investment (cont.)
• Invested capital
– The assets that the investment centre
has available to generate profits
• Return on sales
– The percentage of each sales dollar that
remains as profit after all the expenses
are covered
• Investment turnover
– The number of sales dollars generated
by every dollar of invested capital
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Improving return on investment
• Increase return on sales
―Increase the selling price or sales revenue,
or decrease expenses
• Increase investment turnover
―Increase sales revenue or reduce invested
capital
• Actions that are taken only to make
these ratios more favourable in the short
term may have adverse effects on
performance in future years
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 The advantages of ROI
• Widely used in practice to measure the
performance of units and managers
• Encourages managers to focus on both
profits and the assets required to
generate those profits
• Can be used to evaluate the relative
performance of investment centres, even
when those business units are of
different sizes
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 The limitations of ROI
• May encourage managers to focus on
improving short-term financial
performance
• May encourage managers to defer asset
replacement, to maintain a high ROI
• Discourages managers from investing in
projects that are acceptable from the
organisation’s point of view

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 Minimising the behavioural
problems of ROI
• Use ROI as one of several performance
measures that focus on both short-term
and long-term performance
• Consider alternative ways of measuring
invested capital to minimise dysfunctional
decisions
• Use alternative financial measures, such
as residual income or economic value
added
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 Residual income
• Residual income (RI)

= profit – (invested capital × imputed interest

rate)

• Imputed interest charge

– Based on the required rate of return that the
firm expects of its investments, which is
based on the organisation’s cost of capital

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 The advantage of
residual income
• More likely to promote goal congruence,
compared to ROI
• Takes account of the organisation’s
required rate of return in measuring
performance
• Encourages investment in projects which
yield a positive residual income to the
organisation
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 Disadvantages of
residual income
• Cannot be used to assess the relative
performance of businesses that are of
different sizes, unlike ROI
• Formula is biased in favour of larger
businesses, unlike ROI
• Can encourage short-term
orientation/focus, as with ROI

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 Measuring profit and
invested capital
• Total assets
– Investment centre manager is responsible for
decisions about all assets
• Total productive assets
– Investment centre managers retain non-productive
assets
• Total assets less current liabilities
– Investment centre is responsible for decisions about
assets and manages short-term liabilities
• Average or end-of-year balances
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 Asset measurement
• Advantages of using the carrying amount
– Consistency with balance sheet that is
prepared for external reporting purposes
– Consistent with the definition of profit
• Advantages of using acquisition cost
– Choice of depreciation method is arbitrary
and resulting carrying amount does not
provide a reliable measure
– Depreciating non-current assets may provide
a disincentive to invest in new equipment

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 Increase in ROI over time

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 Measuring profit
• Profit margin controllable by investment
centre manager
– Suitable when the focus is to assess the
performance of the manager
– Encourages managers to focus on profit that they
can control
– Motivational impact
• Profit margin attributable to investment
centre
– Suitable when the focus is to assess the
performance of the investment centre
(cont.)
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 Various definitions of profit

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 Measures of shareholder value
• Shareholder value
– The worth of the business from the
shareholders’ perspective
• Value-based management (VBM)
– Using shareholder value analysis to
manage a business
– A framework for making key business
decisions that add economic value to the
business
– Consists of four aspects
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 Value-based management
• Valuation
– Discounted cash flows (DCF) are usually
used to measure value
– Future cash flows of the business are
discounted taking into account the risk
associated with those cash flows
– Value drivers are the activities or actions
that create value for a business
§ Includes spread, growth, sustainability and cost
of capital
(cont.)
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Value-based management (cont.)
• Strategy
– Has a substantial and continuing impact on
the value of the business
• Finance
– Financial policies will influence value
creation
• Corporate governance
– Involves selecting and implementing
systems that contribute to value creation

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 Economic value added
• Economic value added (EVA)
– Measures the value created over a single
accounting period
– The spread between the return generated
by the business activities and the cost of
capital

(cont.)
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 Economic value added (cont.)
• Weighted average cost of capital
• To improve EVA
– Improve profitability without employing
additional capital
– Borrow additional funds when the profits
earned are more than the cost of borrowing
– Pay off debt by selling assets
• Limitations of EVA

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 Shareholder value added
• Shareholder value added (SVA)
= corporate value – the market value of debt
• Corporate value is the present value of
the future cash flows
• Residual value is the value of the firm
at the end of the forecast period

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 Incentive schemes
• Processes, practices and systems that
are used to provide levels of pay and
benefits to employees
• Motivation
• Intrinsic motivation
– Derives from the interest and enjoyment of
the work
• Extrinsic motivation
– Derives from sources outside the individual
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 Theories of motivation
• Herzberg’s theory of work motivation
– Hygiene factors
§ Provide the setting for encouraging employee
motivation, but do not themselves motivate employees
§ Working conditions, wage levels, rules and regulations,
relationships with colleagues, job security
– Motivators
§ Factors that relate to job content and which provide
employee motivation
§ Achievement, recognition, the nature of the work,
responsibility, opportunities for personal growth

(cont.)
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 Theories of motivation (cont.)
• Expectancy theory
– Employee motivation is a result of the strength of the
relationships between expectancy, instrumentality and
valence
– Expectancy: perception that effort will lead to a certain
performance
– Instrumentality: perception that performance will lead to
desired outcome
– Valence: the attractiveness of the reward
• Motivational theories
– need to be considered by managers when they are
designing performance evaluation and incentive
schemes
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 Performance-related
pay systems
• Performance-related pay systems
(incentive compensation schemes)
– Link employee rewards for achieving or
exceeding some performance target
• Individual incentive plans
– Individuals are rewarded for achieving
individual performance targets
– Subjective criteria may also be used
– Commonly used at the higher levels of an
organisation (cont.)
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 Performance-related
pay systems (cont.)
• Profit-sharing plans
– Cash bonuses are paid to each employee,
based on a specified percentage of the
company’s profit
– Does not tie individual effort to individual
rewards
• Employee share plans (share option
plans)
(cont.)
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 Performance-related
pay systems (cont.)
• Gainsharing
– Cash bonuses are distributed to employees
based on some performance target exceeded
• Team-based incentive schemes
– Individuals are rewarded based on their work
team exceeding targets
– Intended to encourage teamwork and
cooperation between employees
– Does not tie individual effort to individual
rewards
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 Group versus individual
performance
• Consider the following issues
– Identification with the group
– Equity among employees
– Competitiveness between employees
– Relating individual effort to reward
– Rewarding only good performers
• The timing of incentive payments can be
crucial to achieving desired outcomes

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 Summary
• Return on investment is often used to evaluate
performance of investment centres
• Can encourage managers to focus on achieving
high profits through the efficient use of assets,
but can also encourage dysfunctional decisions
• These can be reduced through using a range of
incentive schemes that focus on short and long
term, using alternative measures of profit and
invested capital, and using other financial
measures such as residual income or EVA
(cont.)
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 Summary (cont.)
• Incentive schemes can be used to encourage
goal congruent behaviour
• When designing performance-related schemes
it is important to understand what motivates
employees
• Performance-related incentive schemes include
individual incentives, profit-sharing, employee
share plans, gainsharing, team-based
incentives
• The frequency and timing of payments may
impact on the effectiveness of the rewards in
enhancing motivation
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