Modified Chapter 25

Chapter 25
Rewarding
Business
Performance
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25-1
Rewarding Goal Achievement
 This chapter focuses on motivating employees, customers,
suppliers, and others in and outside of the company to
help the organization achieve its goals and objectives.
 Accounting systems instill motivation in three distinct
ways.
1. Help to set organizational goals and objectives
through planning activities such as budgeting.
2. Measure employee progress and provide
achievement-related feedback.
3. Instrumental in allocating rewards to employees for
achieving organizational goals and objectives.
25-2
Role of the Accounting System in Goal
Achievement
25-3
The DuPont System
 One of the first systems to focus on business
performance measurement was created during the
early 1900s by managers at the DuPont de Nemours
Powder Company.
 Managers at DuPont wanted a method to help them set
goals and measure progress toward achieving
objectives.
 These managers began by experimenting with a
performance evaluation system that still has many
advocates around the world.
25-4
Return on Investment (ROI)
Return
Return on
on investment
investment isis the
the ratio
ratio of
of operating
operating
income
income to
to the
the average
average investment
investment used
used to
to
generate
generate the
the income.
income.
Operating Income
ROI =
Average Total Assets
ROI is usually discussed as a percent that

conveys the average amount of each
invested dollar converted into earnings.
25-5
DuPont System of Performance
Measurement
25-6
Components of Return on Investment
1. Capital turnover tells managers about how well the
capital invested in assets is generating (or “turning
over”) sales dollars. In other words, CT measures the
amount of sales dollars generated from each dollar of
capital investment.
2. Return on sales indicates the operating earnings or
profitability that can be expected from one dollar of
sales. Operating earnings rather than net income is
used to compute return on sales because operating
earnings better reflect the resources that managers can
control.
25-7
Accounting Information for Bastille Company
25-8
Return on Sales
 Results for the fine china division in year 1 show that
the return on sales was 30 percent or, alternatively, each
sales dollar generated $0.30 of earnings.
 For the cookware division, however, each sales dollar
generated $0.525 of earnings.
 To have an impact on return on sales in year 2, a
division manager would need to reduce cost of goods
sold or operating expenses without any impact on
revenue or increase revenue without a proportional
impact on expenses.
25-9
Return on Sales (cont.)
 In year 2, the manager of the fine china division was
able to increase revenue from $1,500,000 to $1,700,000
without a proportional increase in cost of goods sold.
 Although cost of goods sold did increase, the percentage
increase was smaller than the percentage increase in
revenue, shown as follows.
25-10
Return on Sales (concluded)
 The cookware division manager did not fare as well with
return on sales between years 1 and 2 as the manager of the
fine china division.
 By comparing return on sales in year 1 and year 2, you can
see that the cookware division showed a drop of $0.01 of
earnings (52.5% − 51.5% = 1%) for each sales dollar.
 Using our DuPont method to analyze the cookware division
shows that revenue remained constant while cost of goods
sold and operating expenses increased.
25-11
Capital Turnover
 The turnover ratio for fine china in year 1 tells us that this
division is creating $0.25 of sales for each dollar of invested
capital.
 The turnover ratio improved significantly in year 2 to $0.274 per
dollar of invested capital.
 How was the manager of fine china able to achieve this
increase?
◦ By increasing sales without a proportional increase in average
invested capital, shown as follows. Evidently the additional
capital expenditures made by the manager of the fine china
division significantly improved sales revenue.
25-12
Return on Equity: DuPont
3 Factor Approach
25-13
Criticisms of ROI
 The primary reason for using any performance
measurement criteria such as ROI is to motivate
employees to make decisions consistent with the goals
and objectives of the organization.
 Managers who are measured and rewarded only on their
divisions’ ROI may decide to increase profits and
decrease capital in their divisions in ways that are
inconsistent with the best interests of the whole
company.
 There are three primary criticisms (discussed on the
following slides) of using ROI and the DuPont system
as the only business performance measurement.
25-14
Short Horizon Problem
1. The first criticism is the short horizon problem that occurs
because managers frequently move from one job to another.
a. Many people believe ROI encourages a short-term
orientation to the detriment of longer-term planning.
o For example, the cookware division manager in the
example discussed previously might know that he will
soon be transferred to another job assignment. By selling
assets to reduce the average invested capital, he can
improve his ROI now. Even though those assets may be
critical for the long-term success of the division, he is not
concerned about long-run issues because he will not be
managing the division in the long run.
25-15
Failing to Undertake Profitable Investments
2. It presents an incentive for a manager to reject a good
project that would increase the ROI for the firm as a
whole.
a. The project rejection occurs when investing in a
project would reduce the division’s ROI.
b. A division manager who is evaluated on the
division’s ROI would not undertake a project that
would reduce the ROI of that particular division
even if the project contributed to the total ROI of
the business.
25-16
Measurement Problems
3. A third criticism of ROI is the inherent difficulty in
measuring both the average invested capital and the actual
operating earnings associated with that capital.
a. Many units within an organization share invested capital,
and often the allocation of capital between those units is
arbitrary.
o For example, if both the cookware and fine china
divisions share costs associated with a research and
development facility and administrative headquarters,
how will the invested capital of those activities be
allocated between the two divisions?
b. Organizations constantly struggle with how to make
capital allocations in their attempt to evaluate business
performance.
25-17
Residual Income and Economic Value
Added
 In response to the criticisms leveled at ROI, other
financially based business performance measures have
been created.
1. Residual Income (RI)
2. Economic Value Added (EVA)
 These measures also help managers evaluate
profitability and performance.
 But these measures do not suffer from some of the
horizon and underinvestment criticisms attributed to
ROI.
25-18
Residual Income
The amount by which operating earnings exceed a
minimum acceptable return on average invested
capital is referred to as residual income.
25-19
Residual Income
Invested Capital is defined as:
NOTE: It is based on book values, NOT market

values.
25-20
Residual Income: Example
To understand how residual income avoids some of the
criticisms associated with ROI, consider the previous example
where the manager of the cookware division had the opportunity
to undertake a new project. The expected operating earnings for
the project were $55,000 on invested capital of $500,000
(project ROI = 11%). If the minimum acceptable return for the
cookware division is set at 10 percent and residual income is the
performance measure, then the division manager would be
motivated to undertake the investment opportunity. Consider the
following computations.
25-21
Economic Value Added
 Referred to in the popular press as EVA, economic value
added is a refinement of the residual income measure.
 EVA has gained significant popularity as a component of
compensation plans.
 This formula can apply to a division or a total company.
25-22
The Balanced Scorecard
Total
Total quality
quality management
management includes
includes careful
careful
consideration
consideration of of quality
quality across
across the
the entire
entire value
value chain.
chain.
Below
Below isis the
the value
value chain
chain for
for Bastille’s
Bastille’s cookware
cookware
division.
division.
25-23
The Balanced Scorecard (cont.)
 Developed in the early 1990s by two Harvard Business
School professors, the balanced scorecard is a system for
performance measurement that:
1. Links a company’s strategy to specific goals and
objectives.
2. Provides measures for assessing progress toward those
goals.
3. Indicates specific initiatives to achieve those goals.
 It is a systematic attempt to create a business performance
measurement process that integrates objectives across the
span of the value chain.
 The main objective of the balanced scorecard is achieving the
organization’s strategic goals.
25-24
Balanced Scorecard Linkages
25-25
Balanced Scorecard Strategies
25-26
Financial Perspective
 Managers use the financial perspective lens of the
balanced scorecard to view the company through the
eyes of creditors and shareholders.
 This lens helps employees consider the impact of
strategic decisions on the traditional financial measures
by which shareholders and creditors evaluate business
performance.
 The balance sheet, income statement, and statement of
cash flows are the underlying financial measures
associated with the financial perspective.
25-27
Customer Perspective
 The customer perspective lens of the balanced scorecard
provides a means for managers to consider customers
needs and the markets in which their products sell.
 Through the customer perspective lens managers
examine how the organization’s strategies, products, and
services add value for the customer.
 Examples may include: customer retention, customer
satisfaction, customer quality perceptions, market share
growth, and customer profitability.
25-28
Business Process Perspective
 Standard cost variance analyses, just-in-time inventory, and
total quality management ideas are embodied in the business
process perspective lens.
 This balanced scorecard lens focuses on internal business
processes and external business relations with suppliers and
distributors.
 Quality measures such as amounts of scrap, downtime,
number of defects, costs of rework, and the number of
warranty claims enable assessment of the quality of internal
processes.
 Relations with suppliers and distributors are assessed with
both quality measures (on-time delivery, parts defects per
million from suppliers) and profitability measures
(profitability per distributor arrangement).
25-29
Learning and Growth Perspective
 The balanced scorecard also recognizes the importance
of intangibles to the strategic goals of organizations by
using the learning and growth perspective lens.
 This lens focuses on the people, information systems,
and organizational procedures in place for
organizational learning and growth.
 Employee satisfaction, retention, skill, development, and
the hours invested in employee training are measures
focused on people.
 This lens also measures the reliability, accuracy, and
consistency of the information provided by the
organizations’ information systems.
25-30
Balanced Scorecard
25-31
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.
25-32
Components of Management
Compensation
The three primary components of management
compensation are:
1. Fixed salary
• May take the form of a fixed annual salary or a
fixed hourly pay rate.
2. Bonuses
• May include cash or stock options.
3. Other types of incentives
• Examples may include paid life insurance policies,
automobiles, personal use of company assets (i.e.
aircraft), apartments, etc.
25-33
Design Choices for Management
Compensation
Several important design choices must be made when
creating incentive compensation systems for managers.
1. Choice of time horizon.
2. Choice of fixed versus variable bonus.
3. Choice of stock- versus accounting-based
performance evaluation.
4. Choice of rewarding local versus companywide
performance.
5. Choice of cooperative versus competitive incentive
plans.
25-34
Compensation
Constructing a well-balanced compensation package
includes:
Base salary: The easiest approach
Short-term incentive (bonus): Short-term
incentives, typically structured as annual
bonuses, are intended to reward executives for
achieving your short-term business objectives
and are usually set by annual performance goals.
25-35
Compensation
Constructing a well-balanced compensation package
includes:
 Long-term incentive: long-term incentives are what
really sets executive compensation planning apart.
Companies typically seek to provide longer term
compensation incentives to executives (usually ranging
up to three to five years) because turnover at these levels
is more costly, and this team is often driving strategies
that take multiple years to implement.
 Other benefits and perquisites: parking spaces, working
from home
25-36
Compensation
What types of equity compensation are available?
Phantom Stock: type of stock plan that pays a cash award
to an employee that equals a set number or fraction of
company shares times the current share price.
Stock Appreciation Rights: this type of plan gives
participants the right to the appreciation in the price of
their company stock, but not the stock itself.
Company Stock: outright distribution of the stock at a
certain point in time.
25-37
Compensation
Restricted Stock: is a grant of company stock in which
the recipient’s rights in the stock are restricted until the
shares vest (or lapse in restrictions). The restricted period
is called a vesting period. Once the vesting requirements
are met, an employee owns the shares outright and may
treat them as she would any other share of stock in her
account.
25-38
Compensation
Incentive Stock Options: are usually only offered to key
employees and top-tier management. These options are
also commonly known as statutory or qualified options,
and they can receive preferential tax treatment in many
cases. These are intended to retain key employees or
managers. ISOs often have more favorable tax treatment
than other types of employee stock purchase plan. no tax
reporting of any kind is made until the stock is sold. If the
stock sale is a qualifying transaction, then the employee
will only report a short-term or long-term capital gain on
the sale.
25-39
Compensation
Non-qualified Stock Options: are the more commonly
known stock option plans. Unlike the ISOs, these once
you exercise these non-qualified stock options, the
difference between the stock price and the strike price is
taxed as ordinary income. This income is usually reported
on your paystub. There are no tax consequences when you
first receive your non-qualified stock option, only when
you exercise your option. You pay tax again once you sell
the stock.
25-40
End of Chapter 25
25-41

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Chapter 25

ROI is usually discussed as a percent that

NOTE: It is based on book values, NOT market

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