ACC 516 Chapter 23: Performance Measurement, Compensation, and Multinational Consideration

Describe the 3 disclosures required by the SEC with respect to executive compensation.

a. A summary compensation table showing the salary, bonus, stock options, other stock awards, and other compensation earned by the five top officers in the previous three years b. The principles underlying the executive compensation plans, and the performance criteria, such as profitability, sales growth, and market share used in determining compensation c. How well a company's stock performed relative to the stocks of other companies in the same industry

How to calculate weighted-average cost of capital (WACC)

(Total debt x interest rate) - Taxes = After-Tax Cost of Debt Total equity x Cost of equity (%) = Cost of Equity (After-Tax Cost of Debt + Cost of Equity) / (Total Debt + Total Equity) = WACC

Examples of external non-financial information (2)

- Customer satisfaction ratings - Market share

What are the 4 levers of control in an organization?

- Diagnostic control systems - Boundary systems - Belief systems - Interactive control systems

Why do ROI calculations for subunits operating in different countries need to be adjusted? (2)

- For differences in inflation between the countries - For changes in exchange rates

What does the timing of feedback to managers depend on? (3)

- How critical the information is for the success of the organization - The specific level of management receiving the feedback - The sophistication of the organization's information technology

How to increase ROI (3)

- Increasing revenues using assets to generate additional amount - Decreasing costs (increase income per dollar of revenue) - Decreasing investment (decreasing idle cash, managing credit judiciously, determining proper inventory levels, and spending carefully on fixed assets)

Why would management prefer to use a multiple-year analysis over a single-year analysis?

- Managers could take actions for short-run performance at expense of long-run interests - Benefits of actions taken may not show up in short-run performance measures - Highlights advantage of RI measure—goal congruence achieved by comparing investment decision made by net present value to net present value of RIs - Compensation motivates managers if tied to market prices of company stock—stock prices more rapidly incorporate expected future effects of current decisions

Why would upper management want to use net book value over gross book value? (4)

- Net book value masks the decline in earning power of older assets because investment base is constantly decreasing - Net book value is consistent with the amount of total assets shown in the conventional balance sheet - Net book value is consistent with income computations that include deductions for depreciation - Net book value is the dominant asset measure used by companies in internal performance evaluations

Examples of internal non-financial information (4)

- Rates - Manufacturing lead time - Productivity - Number of new patents

Why should the performance evaluation of a manager be distinguished from performance evaluation of that manager's subunit? (2)

- Skillful manager often put in charge of poorly performing subunit—much time could be required to change subunit's performance - Events over which a manager has no control could adversely affect subunit's performance

Examples of external financial information (1)

- Stock prices

How to calculate return on sales

Operating Income / Revenues

Characteristics of performance measures at the individual activity level for activities that require multiple tasks (3)

1. Desire by employers to have employees allocate their time and effort intelligently among various tasks or aspects of their jobs 2. Nonfinancial measures help motivate employees to emphasize both quantity and quality 3. Goal is to measure quantity and quality aspects of employee's job and to balance incentives for proper emphasis

Performance measures at the individual activity level for activities done in teams characteristics (3)

1. Team incentives encourage individuals to help one another strive toward a common goal 2. Individual incentives to excel are possibly diminished by use of teams, harming overall performance 3. Problem to manage team members who are not productive contributors to team's success but who share in team's rewards

What are the 4 definitions of investment used in practice when computing ROI?

1. Total assets available 2. Total assets employed 3. Total assets employed minus current liabilities 4. Stockholders' equity

What is Economic Value Added (EVA)?

A variation of RI used by many companies

What is internal financial information based on?

Accounting numbers that are routinely reported

How to calculate Economic Value Added (EVA)

After-tax OI - [WACC x (TA - CL)]

What is return on investment (ROI)?

An accounting measure of income divided by an accounting measure of investment

What is residual income?

An accounting measure of income minus a dollar amount for required return on an accounting measure of investment

What performance measure will sharpen the short-run focus of a manager?

Annual EVA

Alternative definitions of investment: What is stockholders' equity?

Assigns liabilities among each subunit and deducts amount assigned from total assets of each subunit (drawback of combining operating decisions made by subunit managers with financing decisions made by top management)

Which two measures overcome some of the goal-congruence problems of ROI?

RI and EVA

Why are ROI, RI, or EVA measures more appropriate than ROS to evaluate overall aggregate performance?

Because they consider both income earned and investments made

Explain the role of benchmarking in evaluating managers.

Benchmarking or relative performance evaluation is the process of evaluating a manager's performance against the performance of other similar operations. The ideal benchmark is another operation that is affected by the same noncontrollable factors that affect the manager's performance. Benchmarking cancels the effects of the common noncontrollable factors and provides better information about the manager's performance.

What is current cost?

Cost of purchasing an asset today identical to the one currently held, or cost of purchasing an asset that provides services like the one currently held if an identical one cannot be purchased

What is the basic tradeoff in management rewards?

Creating incentives vs. imposing risk

Distinguish between measuring assets based on current cost and historical cost.

Current cost is the cost of purchasing an asset today identical to the one currently held if an identical asset can currently be purchased; it is the cost of purchasing an asset that provides services like the one currently held if an identical asset cannot be purchased. Historical-cost-based measures of ROI compute the asset base as the original purchase cost of an asset minus any accumulated depreciation. Some commentators argue that current cost is oriented to current prices, while historical cost is past-oriented.

Why would upper management want to use current cost ROI over historical-cost ROI?

Current-cost ROI is a better measure of current economic returns from investment than historical-cost ROI

What is moral hazard?

Describes situations in which an employee prefers to exert less effort (or report distorted information) compared with the effort (or accurate information) desired by the owner because the employee's effort (or validity of reported information) cannot be accurately monitored and enforced

Alternative definitions of investment: What are total assets employed minus current liabilities?

Excludes those employed assets financed by short-term creditors (may encourage excessive amounts of short-term debt)

What do preferred performance measures not change much with respect to?

Factors that are beyond the manager's control

Is goal congruence more likely to be achieved if a manager is evaluated using ROI or RI?

Goal congruence more likely to be achieved by using RI rather than ROI as measure of subunit manager's performance ROI may induce managers of highly profitable divisions to reject projects that reduce their ROI but should be accepted for the company as a whole

Why would upper management want to use gross book value over net book value?

Gross book value may enable more accurate comparisons across subunits

Why is it important to distinguish between the performance of a manager and the performance of the organization subunit for which the manager is responsible? Give an example.

In some cases, the subunit's performance may not be a good indicator of a manager's performance. For example, companies often put the most skillful division manager in charge of the weakest division in an attempt to improve the performance of the weak division. Such an effort may yield results in years, not months. The division may continue to perform poorly with respect to other divisions of the company. But it would be a mistake to conclude from the poor performance of the division that the manager is performing poorly. A second example of the distinction between the performance of the manager and the performance of the subunit is the use of historical cost-based ROIs to evaluate the manager even though historical cost-based ROIs may be unsatisfactory for evaluating the economic returns earned by the organization subunit. Historical cost-based ROI can be used to evaluate a manager by comparing actual results to budgeted historical cost-based ROIs.

Alternative definitions of investment: What are total assets available?

Includes all assets, regardless of intended purpose

How to calculate residual income

Income - (Required rate of return x Investment)

How to calculate ROI

Income / Investment

What is the DuPont method of profitability analysis (for ROI)

Income/Investment (ROI) = Revenues/Investment (Investment Turnover) x Income/Revenues (Return on Sales)

How does benchmarking factor into this chapter?

Internal financial measures are often benchmarked against external financial information as well as both internal and external non-financial information

What separates EVA from the other measures?

It explicitly considers tax effects

Describe moral hazard.

Moral hazard describes situations in which an employee prefers to exert less effort (or to report distorted information) compared with the effort (or accurate information) desired by the owner because the employee's effort (or validity of the reported information) cannot be accurately monitored and enforced.

"Managers should be rewarded only on the basis of their performance measures. They should be paid no salary." Do you agree? Explain.

No, rewarding managers on the basis of their performance measures only, such as ROI, subjects them to uncontrollable risk because managers' performance measures are also affected by random factors over which they have no control. A manager may put in a great deal of effort but her performance measure may not reflect this effort if it is negatively affected by various random factors. Thus, when managers are compensated on the basis of performance measures, they will need to be compensated for taking on extra risk. Therefore, when performance-based incentives are used, they are generally more costly to the owner. The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager.

Using performance measures directly affected by a manager's efforts encourages the use of financial or non-financial measures?

Non-financial measures

With Economic Value Added (EVA), how is value created?

Only if after-tax operating income exceeds the cost of investing the capital

What is an investment?

Resources or assets used to generate income

What is the imputed cost of equity?

Return forgone by not investing in other equity securities of similar risk

What is the most popular approach to measuring management performance?

Return on investment (ROI)

In markets in which revenue growth is limited and investment levels fixed, what is most meaningful indicator of subunit performance?

Return on sales

Well-designed plans use compensation mix that balances both ______-run and ____-run incentives

Short-run and long-run

ROI, RI, EVA, and ROS calculations represent results for a single time period or multiple time periods?

Single time period

What special problems arise when evaluating performance in multinational companies?

Special problems arise when evaluating the performance of divisions in multinational companies because: a. The economic, legal, political, social, and cultural environments differ significantly across countries. b. Governments in some countries may impose controls and limit selling prices of products. c. Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ significantly across countries. d. Divisions operating in different countries keep score of their performance in different currencies.

What factors affecting ROI does the DuPont method of profitability analysis highlight?

The DuPont method highlights that ROI is increased by any action that increases return on sales or investment turnover. ROI increases with: 1. increases in revenues, 2. decreases in costs, or 3. decreases in investments

What is intrinsic motivation?

The desire to achieve self-satisfaction from good performance regardless of external rewards such as bonuses or promotion

What are preferred performance measures sensitive to?

The manager's performance

What will motivate the CEO to improve company's long-run performance to increase stock price?

The use of stock option plans

Alternative definitions of investment: What are total assets employed?

Total assets available minus sum of idle assets plus assets purchased for future expansion

What does the balanced scorecard do?

Uses a single report for financial and non-financial performance measures

Explain the incentive problems that can arise when employees must perform multiple tasks as part of their jobs.

When employees have to perform multiple tasks as part of their jobs, incentive problems can arise when one task is easy to monitor and measure while the other task is more difficult to evaluate. Employers want employees to intelligently allocate time and effort among various tasks. If, however, employees are rewarded on the basis of the task that is more easily measured, they will tend to focus their efforts on that task and ignore the others.

What is the imputed cost of the investment?

With regard to residual income, Required Rate of Return x Investment Recognized in particular situations that are not usually recognized by accrual accounting procedures

"RI is not identical to ROI, although both measures incorporate income and investment into their computations." Do you agree? Explain.

Yes. Residual income (RI) is not identical to return on investment (ROI). ROI is a percentage with investment as the denominator of the computation. RI is an absolute monetary amount which includes an imputed interest charge based on investment.