Performance Measurement, Compensation, and Multinational Considerations

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Financial and Nonfinancial Measures

Firms are increasingly presenting financial and nonfinancial performance measures for their subunits in a Balanced Scorecard, and its four perspectives:
Financial 2. Customer 3. Internal Business Process 4. Learning and Growth
1.

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Balanced Scorecard Flow

Firms assume that improvements in learning and

growth will lead to improvements in internal business processes Improvements in the internal business processes will lead to improvements in the customer and financial perspectives

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Accounting-Based Performance Measures

Requires a six-step design process:

1. 2.

3.
4.

5.
6.

Choose Performance Measures that align with top managements financial goals Choose the time horizon of each Performance Measure Choose a definition of the components in each Performance Measure Choose a measurement alternative for each Performance Measure Choose a target level of performance Choose the timing of feedback
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Step 1: Choosing Among Different Performance Measures

Four common measures of economic performance:

1. 2.

3.
4.

Return on Investment Residual Income Economic Value Added Return on Sales

Selecting Subunit Operating Income as a metric is inappropriate since it obviously differs simply on the differing size of the subunits
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Return on Investment (ROI)

ROI is an accounting measure of income divided by

an accounting measure of investment

ROI =

Income Investment

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ROI

Most popular metric for two reasons:

Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage 2. May be compared to other ROIs both inside and outside the firm
1.

Also called the Accounting Rate of Return (ARR) or the Accrual Accounting Rate of Return (AARR)

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ROI
ROI may be decomposed into its two components as

follows:
Income Investment

Income Revenues

Revenues Investment

ROI = Return on Sales X Investment Turnover

This is known as the DuPont Method of Profitability

Analysis

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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

Imputed costs are cost recognized in some situations, but not

in the financial accounting records

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Economic Value Added (EVA)

EVA is a specific type of residual income calculation

that has recently gained popularity

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

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Return on Sales (ROS)

Return on Sales is simply income divided by sales
Simple to compute, and widely understood

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Step 2: Choosing the Time Horizon of the Performance Measures

Multiple periods of evaluation are sometimes

appropriate ROI, RI, EVA and ROS all basically evaluate one period of time ROI, RI, EVA and ROS may all be adapted to evaluate multiple periods of time

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Step 3: Choosing Alternative Definitions for Performance Measures

Four possible alternative definitions of investment:

Total Assets Available 2. Total Assets Employed 3. Total Assets Employed minus Current Liabilities 4. Stockholders Equity
1.

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Step 4: Choosing Measurement Alternatives for Performance Measures

Possible alternative definitions of cost:

Current Cost 2. Gross Value of Fixed Assets 3. Net Book Value of Fixed Assets
1.

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Step 5: Choosing Target Levels of Performance

Historically driven targets used to set target goals
Goal may include a Continuous Improvement

component

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Step 6: Choosing the Timing of the Feedback

Timing of feedback depends on: How critical the information is for the success of the organization The specific level of management receiving the feedback The sophistication of the organizations information technology

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Performance Measurement in Multinational Companies

Additional Difficulties faced by Multinational

Companies:
The economic, legal, political, social, and cultural

environments differ significantly across countries Governments in some countries may impose controls and limit selling prices of a companys products Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ across countries Divisions operating in different countries account for their performance in different currencies

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Distinction Between Managers and Organization Units

The performance evaluation of a manager should be

distinguished from the performance evaluation of that managers subunit, such as a division of the company

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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 managers personal goals

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Moral Hazard
Moral Hazard describes situations in which an

employee prefers to exert less effort (0r report distorted information) compared with the effort (or accurate information) desired by the owner because the employees effort (or the validity of the reported information) cannot be accurately monitored and enforced

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Intensity of Incentives
Intensity of Incentives how large the incentive

component of a managers compensation be relative to their salary component

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Preferred Performance Measures

Preferred Performance Measures are those that are

sensitive to or change significantly with the managers performance. They do not change much with changes in factors that are beyond the managers control They motivate the manager as well as limit the mangers exposure to risk, reducing the cost of providing incentives May include Benchmarking

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Performance Measures at the Individual Activity Level

Two issues when evaluating performance at the individual activity level:

Designing performance measures for activities that require multiple tasks 2. Designing performance measures for activities done in teams
1.

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Compensation for Multiple Tasks

If the employer wants an employee to focus on

multiple tasks of a job, then the employer must measure and compensate performance on each of those tasks

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Team-Based Compensation
Companies use teams extensively for problem solving
Teams achieve better results than individual

employees acting alone Companies must reward individuals on a team based on team performance

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Executive 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 firms goals
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Strategy and Levers of Control

Levers of Control:
Diagnostic Control Systems 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

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Diagnostic Control Systems

Diagnostic Control Systems evaluate whether a firm

is performing to expectations by monitoring and evaluating critical performance metrics, including:

ROI, RI, EVA

Customer Satisfaction
Employee Satisfaction

MUST be balanced by the other lever of control

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Boundary Systems
Boundary Systems describe standards of behavior and

codes of conduct expected of all employees

Highlights actions that are off-limits A code of conduct describe appropriate and

inappropriate individual behaviors

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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 employees with respect to each other, shareholders, customers, and communities

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Interactive Control Systems

Interactive Control Systems are formal information

systems that managers use to focus organizational attention and learning on key strategic issues Tracks strategic uncertainties that businesses face

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