Rewarding Business Performance

Chapter 25

McGraw-Hill/Irwin

Copyright © 2010 by The McGraw-Hill Companies, Inc. All

Motivation and Aligning Goals and Objectives
Goal Congruence Alignment of employee goals and objectives with organizational goals and objectives.

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Motivation and Aligning Goals and Objectives
Feedback  Steer employees toward goals  Measure progress in achieving goals

Measure performance

Improve performance

Reward performance. performance

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Return on Investment (ROI)
Return on investment is the ratio of Return on investment is the ratio of operating income to the average operating income to the average investment used to generate the income. investment used to generate the income.

ROI =

Operating Income Average Total Assets

Using ROI to evaluate business performance is often referred to as the DuPont system.

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Return on Investment (ROI)
ROI = Operating Income Average Total Assets

Sales Operating Income ROI = × Average Total Assets Sales

Return on Sales

Capital Turnover
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Improving ROI
 Decrease Expenses

 Increase Sales Prices

 Lower Invested Capital

Three ways to improve ROI
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Criticisms of 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. company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%. have an opportunity to invest in a new project that will produce an ROI of 25%.

 The

 You

As division manager would you invest in this project?
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Failure to Undertake Profitable Investments
Gee . . . I thought we were supposed to do what was best for the company!
As division manager, I wouldn’t invest in that project because it would lower my pay!

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Residual Income and Economic Value Added
Operating Earnings – Investment charge = Residual income Investment capital × Minimum return = Investment charge Investment center’s minimum acceptable return
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Residual Income
Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

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Economic Value Added
Economic value added is the annual aftertax 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 equity.
Equity Debt

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Economic Value Added
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
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Economic Value Added
Economic value added can be Economic value added can be improved in three ways .. .. .. improved in three ways
Increase profit without using more Increase profit without using more capital. capital. Use less capital to earn the same amount Use less capital to earn the same amount of profit. of profit. Invest capital in high-return projects. Invest capital in high-return projects.

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

Learning and Growth Perspective How can we continually improve and create value?

Vision and Strategy

Business Process Perspective In which activities must we excel?

Customer Perspective How do our customers see us?
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Difficulties with the Balanced Scorecard
Some of the difficulties noted by companies using the balance scorecard include: 1.Organizations have difficulty assessing the importance or weights attached to the various perspectives that are part of the scorecard. 2.Measuring, quantifying, and evaluating some of the qualitative components that are part of the balanced scorecard present significant technical hurdles. 3.Difficulty arises from a lack of clarity and sense of direction because of the large number of performance measures. 4.The time and expense required to maintain and operate a fully designed system can be significant.
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End of Chapter 25

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