Cost Accounting: Performance Measurement, Compensation, and Multinational Considerations

COST ACCOUNTING
Sixteenth Edition
Chapter 23
Performance
Measurement,
Compensation, and
Multinational
Considerations
Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
• 23.1 Select financial and nonfinancial performance
measures to use in a balanced scorecard
• 23.2 Examine accounting-based measures for evaluating a
business unit’s performance, including return on
investment (ROI), residual income (RI), and economic
value added (EVA®)
• 23.3 Analyze the key measurement choices in the design
• of each performance measure
• 23.4 Study the choice of performance targets and design
of feedback mechanisms
Learning Objectives (2 of 2)
23.5 Indicate the difficulties that occur when the
performance of divisions operating in different countries is
compared.
23.6 Understand the roles of salaries and incentives when
rewarding managers
23.7 Describe the four levers of control and why they are
necessary
Financial and Nonfinancial Performance
Measures
• Many organizations record financial and nonfinancial
performance measures for their subunits on a balanced
scorecard. The scorecards of different organizations
emphasize different measures but the measures are
always derived from a company’s strategy. In a balanced
scorecard, the four perspectives are:
1. Financial
2. Customer
3. Internal business process
4. Learning and growth
Designing Accounting-Based
Performance Measures Requires
Several Steps
1. Choose performance measures that align with the
firm’s financial goals.
2. Choose the details of each performance measure in
step 1.
3. Choose a target level of performance and a feedback
mechanism for each performance measure in step 1.
Accounting-Based Measures For
Business Units
1. Return on investment
2. Residual income
3. Economic value added
4. Return on sales (this measure does not account for
investment)
Return On Investment (ROI) (1 of 3)
ROI is an accounting measure of income divided by an
accounting measure of investment.
Income
ROI = Investment
• Most popular metric for two reasons:
1. Blends all the ingredients of profitability (revenues,
costs, and investment) into a single percentage
2. Can be compared with the rate of return on
opportunities elsewhere, inside or outside the
company
• Also called the accounting rate of return (ARR) or the
accrual accounting rate of return (AARR)
• ROI may be decomposed into its two components as follows:
Income Income Revenues

Investment = Revenues X Investment
• ROI = Return on Sales X Investment Turnover.

• This approach is known as the DuPont Method of Profitability
Analysis. It recognizes the two basic ingredients in profit
making: increasing income per dollar of revenue and using
assets to generate more revenues. An improvement to either
with no change in the other will increase ROI.
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.
• The imputed cost of the investment is a cost recognized in
particular situations but not recorded in financial
accounting systems because it is an opportunity cost.
Economic Value Added (EVA)
• EVA is a variation of RI used by many companies. It is
calculated as follows:
EVA = After-tax Operating Income – {Weighted-Average
Cost of Capital X (Total Assets – Current Liabilities)}
• Weighted average cost of capital equals the after-tax average cost
of all long-term funds in use.
• EVA substitutes the following numbers in the RI calculation:
– Income: After-tax operating income
– Required rate of return: (After-tax) weighted-average cost of
capital
– Investment: Total assets minus current liabilities
Return on Sales (ROS)
• Return on sales is also known as the income-to-revenues
ratio or the sales ratio
• It is frequently used, simple to compute, and widely
understood.
• It does not take into account investment.
• It measures how effectively costs are managed
It is calculated by taking Operating Income / Revenues and
is expressed as a percentage.
Comparing Performance Measures
Using the example of the hotels from our textbook, we see
the results using each of our methods: (in parentheses are
the ranks)
HOTEL ROI RI EVA ROS
SF 24% (1) $120,000 (2) $68,250 (2) 20% (2)
CHICAGO 15% (3) $ 60,000 (3) $15,750 (3) 21% (1)
NEW 17% (2) $150,000 (1) $73,500 (1) 16% (3)
ORLEANS
Choosing Details of the Performance
Measures
How should each measure be computed? Several questions
should be answered to begin:
• What is the time horizon?
• Which definition of investment will be used?
• How shall we calculate various components of each
performance measure such as the measurement of assets.
• Let’s now discuss each of these measurement details.
Alternative Time Horizons
An important element in designing accounting-based
performance measures is choosing the time horizon of the
performance measures.
• Multiple periods of evaluation are sometimes appropriate.
• ROI, RI, EVA, and ROS all represent the results for a
single period, often a year.
• ROI, RI, EVA, and ROS may all be adapted to evaluate
multiple periods of time to avoid actions that benefit the
short run to the detriment of the long run.
Benefits of Multiyear Analysis
There are several benefits to multiyear analysis:
• Benefits of actions taken in the current period may not
show up in short-run performance measures.
• If managers use NPV for investment decisions, then using
a multiyear RI for performance achieves goal congruence.
• Motivates managers to take a long-run perspective by
compensating them on changes in market price because
stock prices incorporate the expected future effects of a
firm’s current decisions.
Alternative Definitions of Investment
• Four common alternative definitions of investment:
1. Total assets available – all assets.
2. Total assets employed – all assets less idle assets
and assets purchased for future expansion.
3. Total assets employed minus current liabilities – total
assets employed less assets financed by short-term
creditors.
4. Stockholder’s equity – assign liabilities to subunits
and deduct from total assets.
Alternative Asset Measurements (1 of 2)
• Possible alternative asset measurements include:
1. Current cost – cost of purchasing an asset today
identical to the one currently held.
2. Gross value of fixed assets – historical cost.
3. Net book value(NBV) of fixed assets – historical cost.
(Historical cost is used to calculate ROI and there is
always a question whether to use gross or net book
value. NBV is the measure most commonly used by
companies for internal performance evaluation.)
Alternative Asset Measurements (2 of 2)
Proponents of using net book value as an investment base
maintain that it is less confusing because:
1. It is consistent with the amount of total assets shown in
the conventional balance sheet, and
2. It is consistent with income computations that include
deductions for depreciation expense.
Surveys report that the net book value is the measure of
assets most commonly used by companies for internal
performance evaluation.
Target Levels of Performance and
Feedback
• Choosing target levels of performance:
 Establish target ROIs using historical-cost-based
measures.
 Set continuous improvement targets.
 Use balanced scorecards to establish targets.
• Choosing the timing of feedback (depends on):
 How critical the information is for the success of the
organization.
 The management level receiving feedback.
 The sophistication of the organization’s information
technology.
Performance Measurement in
Multinational Companies
• Additional difficulties faced by multinational
companies:
– The economic, legal, political, social, and cultural
environments differ significantly across countries.
– Import quotas and tariffs range widely from country to
country.
– Availability of materials and skilled labor, as well as costs of
materials, labor, and infrastructure also differ significantly
across countries.
– Divisions operating in different countries account for their
performance in different currencies and inflation and
fluctuation in foreign-currency exchange rates affect
performance measurement.
Calculating a Foreign Division’s ROI-
Foreign Currency or US Dollars?
To calculate foreign division’s ROI, should companies use
the foreign currency or US Dollars?
What exchange rate should be used?
In areas with higher inflation, the inflation clouds the real
economic returns on an asset and makes historical-cost-
based ROI higher.
The different in inflation between countries make a direct
comparison of ROI misleading.
Distinguishing the Performance of
Managers from the Performance their
Subunits
• 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.
• The reason for this is to recognize that a company may put
the most skilled division manager in charge of the division
with the poorest return in an effort to improve that division
and that may take years.
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.
 The motivation for having some salary and some
performance-based compensation is to balance the
benefit of incentives against the extra cost of imposing
risk on a manager.
Moral Hazard
Moral hazard describes a situation in which an employee
prefers to exert less effort compared with the effort the
owner desires because the owner cannot accurately monitor
and enforce the employee’s effort.
Intensity of Incentives (1 of 2)
Intensity of incentives—how large the incentive component
of a manager’s compensation should be relative to their
salary component.
Preferred performance measures are those that are
sensitive to or that change significantly with the manager’s
performance. They do not change much with changes in
factors that are beyond the manager’s control.
Sensitive performance measures motivate the manager and
limit the manager’s exposure to risk, reducing the cost of
providing incentives.
Intensity of Incentives (2 of 2)
The tradeoff between considerations of sensitivity and risk,
on the one hand, and the congruence of goals, on the other,
determines the effective intensity of incentives placed on
each measure of performance.
The relative weight placed on the various measures in the
scorecard is ideally aimed at achieving congruence between
the extent to which the manager is motivated to maximize
each performance metric and its importance in generating
the long-run objective the firm wishes to achieve.
Benchmarks and Relative Performance
Evaluation
BENCHMARKS ARE METRICS THAT CORRESPOND TO
THE BEST PRACTICES OF ORGANIZATIONS AND MAY
BE AVAILABLE INSIDE OR OUTSIDE OF THE
ORGANIZATION.
Benchmarking, which is also called relative performance
evaluation, filters out the effects of the common
uncontrollable factors.
Performance Measures at the Individual
Activity Level
• Managers need to do two things when designing the
measures used to evaluate performance of individual
employees:
1. Design performance measures for activities that
require multiple tasks.
2. Design performance measures for activities done in
teams.
Compensation for Multiple Tasks &
Team-Based
• Employers want employees to allocate their time and effort
intelligently among various tasks or aspects of their jobs.
• A team achieves better results than individual employees
acting alone. Many companies reward employees on
teams based on how well their team performs.
• Team-based incentives encourage individuals to help one
another as they strive toward a common goal.
Executive Performance Measures and
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 long-run incentives to achieve the firm’s
goals.
Strategy and Levers of Control (1 of 2)
Performance evaluation measures help managers track their
progress toward achieving a company’s strategic goals.
• Because these measures help diagnose whether a
company is performing to expectations, they are
collectively called Diagnostic Control Systems.
• Companies motivate managers by holding them
accountable and rewarding them for meeting goals.
Strategy and Levers of Control (2 of 2)
To prevent unethical and outright fraudulent behavior,
companies balance the push for performance (resulting from
Diagnostic Control Systems) with three other levers of
control:
 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.
Boundary Systems
• Boundary systems describe standards of behavior and
codes of conduct expected of all employees.
– Highlights actions that are “off-limits.”
– Codes of business conduct signal appropriate and
inappropriate individual behaviors.
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 other employees
when interacting with one another, shareholders,
customers, and communities.
Interactive Control Systems
• Interactive control systems are formal information systems
managers use to focus the company’s attention and
learning on key strategic issues.
• Managers use interactive control systems to create an
ongoing dialogue around these key issues and to
personally involve themselves in the decision-making
activities of subordinates.
• New strategies emerge from the dialogue and debate
surrounding the interactive process.
Terms to Learn
TERMS TO LEARN PAGE NUMBER
REFERENCE
Belief systems 913
Boundary systems 912
Current cost 901
Diagnostic control systems 911
Economic value added (EVA) 897
Imputed cost 895
Interactive control systems 913
Investment 893
Moral hazard 907
Residual income (RI) 895
Return on investment (ROI) 894
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COST ACCOUNTING

Income Income Revenues

• ROI = Return on Sales X Investment Turnover.

• Each lever is important and needs to be monitored.

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