© 2009 Pearson Prentice Hall. All rights reserved. Performance Measurement, Compensation, and...

© 2009 Pearson Prentice Hall. All rights reserved.

Performance Measurement,Compensation,

and Multinational Considerations


Financial and Nonfinancial Measures Firms are increasingly presenting financial

and nonfinancial performance measures for their subunits in a Balanced Scorecard, and it’s four perspectives:

1. Financial2. Customer3. Internal Business Process4. Learning and Growth


Balanced Scorecard FlowFirms 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


Accounting-Based Performance Measures Requires a six-step design process:

1. Choose Performance Measures that align with top management’s financial goals

2. Choose the time horizon of each Performance Measure

3. Choose a definition of the components in each Performance Measure

4. Choose a measurement alternative for each Performance Measure

5. Choose a target level of performance6. Choose the timing of feedback


Step 1: Choosing Among Different Performance Measures Four common measures of economic

performance:1. Return on Investment2. Residual Income3. Economic Value Added4. Return on Sales

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

(c) 2009 Pearson Prentice Hall. All rights reserved.

Return on Investment (ROI)ROI is an accounting measure of income

divided by an accounting measure of investment

IncomeInvestmentROI =


ROI Most popular metric for two reasons:

1. Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage

2. May be compared to other ROI’s both inside and outside the firm

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


ROIROI may be decomposed into its two

components as follows:

ROI = Return on Sales X Investment TurnoverThis is known as the DuPont Method of

Profitability Analysis

Income Income RevenuesInvestment Revenues InvestmentX=


Residual IncomeResidual 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 investmentImputed 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

Weighted average cost of capital equals the after-tax average cost of all long-term funds in use

After-tax Weighted-Average Total CurrentOperating Income Cost of Capital Assets Liabilities ) }EVA {= X (


Return on Sales (ROS)Return on Sales is simply income divided by

salesSimple to compute, and widely understood


Step 2: Choosing the Time Horizon of the Performance MeasuresMultiple periods of evaluation are sometimes

appropriateROI, RI, EVA and ROS all basically evaluate

one period of timeROI, RI, EVA and ROS may all be adapted to

evaluate multiple periods of time


Step 3: Choosing Alternative Definitions for Performance Measures Four possible alternative definitions of

investment:1. Total Assets Available2. Total Assets Employed3. Total Assets Employed minus Current

Liabilities4. Stockholder’s Equity


Step 4: Choosing Measurement Alternatives for Performance Measures Possible alternative definitions of cost:

1. Current Cost2. Gross Value of Fixed Assets3. Net Book Value of Fixed Assets


Step 5: Choosing Target Levels of PerformanceHistorically driven targets used to set target

goalsGoal may include a Continuous Improvement

component


Step 6: Choosing the Timing of the FeedbackTiming 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 organization’s information technology


Performance Measurement in Multinational CompaniesAdditional Difficulties faced by

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

environments differ significantly across countriesGovernments in some countries may impose

controls and limit selling prices of a company’s 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


Distinction Between Managers and Organization UnitsThe 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 Trade-Off: Creating Incentives vs. Imposing RiskAn inherent trade-off exists between creating

incentives and imposing riskAn incentive should be some reward for

performanceAn 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


Moral HazardMoral 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 employee’s effort (or the validity of the reported information) cannot be accurately monitored and enforced


Intensity of IncentivesIntensity of Incentives – how large the

incentive component of a manager’s compensation be relative to their salary component


Preferred Performance MeasuresPreferred Performance Measures are those

that are sensitive to or change significantly with the manager’s performance.

They do not change much with changes in factors that are beyond the manager’s control

They motivate the manager as well as limit the manger’s exposure to risk, reducing the cost of providing incentives

May include Benchmarking


Performance Measures at the Individual Activity Level Two issues when evaluating performance at

the individual activity level:1. Designing performance measures for

activities that require multiple tasks2. Designing performance measures for

activities done in teams


Compensation for Multiple TasksIf 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


Team-Based CompensationCompanies use teams extensively for problem

solvingTeams achieve better results than individual

employees acting aloneCompanies must reward individuals on a

team based on team performance


Executive Compensation PlansBased on both financial and nonfinancial

performance measures, and include a mix of:Base SalaryAnnual Incentives, such as cash bonusesLong-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 ControlLevers of Control:

Diagnostic Control SystemsBoundary SystemsBelief SystemsInteractive Control Systems

Each lever is important and needs to be monitored

Levers should be interdependent and collectively represent a living system of business conduct


Diagnostic Control SystemsDiagnostic Control Systems evaluate

whether a firm is performing to expectations by monitoring and evaluating critical performance metrics, including:ROI, RI, EVACustomer SatisfactionEmployee Satisfaction

MUST be balanced by the other lever of control


Boundary SystemsBoundary Systems describe standards of

behavior and codes of conduct expected of all employeesHighlights actions that are “off-limits”A code of conduct describe appropriate and

inappropriate individual behaviors


Belief SystemsBelief 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


Interactive Control SystemsInteractive 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

© 2009 Pearson Prentice Hall. All rights reserved. Performance Measurement, Compensation, and...

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