Performance Measurement, Compensation, And Multinational Considerations

23 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Performance Measurement,Compensation, and

Multinational Considerations

Performance Measurement,Compensation, and

Multinational Considerations

Chapter 23


Learning Objective 1Learning Objective 1

Measure performance

from a financial and a

nonfinancial perspective.


Financial and NonfinancialPerformance Measures


Companies are supplementing internal financialmeasures with measures based on:

External financial information

Internal nonfinancial information

External nonfinancial information




Some organizations present financial andnonfinancial performance measures for

their subunits in a single report– the balanced scorecard.

Most scorecards include:

– profitability measures

– customer-satisfaction measures




– internal measures of efficiency, quality, and time

– innovation measures

Some performance measures havea long-run time horizon.

Other measures have a short-run time horizon.



Design an accounting-based

performance measure.


Accounting-BasedPerformance Measure


Step 1:Choose performance measures that alignwith top management’s financial goal(s).

Step 2:Choose the time horizon of eachperformance measure in Step 1.

Step 3:Choose a definition for each.




Step 4:Choose a measurement alternative foreach performance measure in Step 1.

Step 5:Choose a target level of performance.

Step 6:Choose the timing of feedback.


Accounting-Based PerformanceMeasure Example

Accounting-Based PerformanceMeasure Example

Relax Inns owns three small hotels – one each in Boston, Denver, and Miami.

At the present, Relax Inns does notallocate the total long-term debt of

the company to the three separate hotels.


Accounting-Based Performance Measure Example


Boston Hotel

Current assets $350,000Long-term assets 550,000Total assets $900,000Current liabilities $ 50,000

Revenues $1,100,000Variable costs 297,000Fixed costs 637,000Operating income $ 166,000




Denver Hotel

Current assets $ 400,000Long-term assets 600,000Total assets $1,000,000Current liabilities $ 150,000

Revenues $1,200,000Variable costs 310,000Fixed costs 650,000Operating income $ 240,000




Miami Hotel

Current assets $ 600,000Long-term assets 5,000,000Total assets $5,600,000Current liabilities $ 300,000

Revenues $3,200,000Variable costs 882,000Fixed costs 1,166,000Operating income $1,152,000




Total current assets $1,350,000Total long-term assets 6,150,000Total assets $7,500,000Total current liabilities $ 500,000Long-term debt 4,800,000Stockholders’ equity 2,200,000Total liabilities and equity $7,500,000


Approaches toMeasuring Performance

Approaches toMeasuring Performance

Three approaches include a measure of investment:

Return on investment (ROI)

Residual income (RI)

Economic value added (EVA®)

A fourth approach, return on sales (ROS),does not measure investment.



Analyze return on investment

(ROI) using the DuPont method.


Return on InvestmentReturn on Investment

Return on investment (ROI) is anaccounting measure of income

divided by an accountingmeasure of investment.

Return on investment (ROI)= Income ÷ Investment


What is the return on investment for each hotel?

Return on InvestmentReturn on Investment

Boston Hotel: $166,000 Operating income÷ $900,000 Total assets = 18%

Denver Hotel: $240,000 Operating income÷ $1,000,000 Total assets = 24%

Miami Hotel: $1,152,000 Operating income÷ $5,600,000 Total assets = 21%


The DuPont method of profitability analysisrecognizes that there are two basic

ingredients in profit making:

DuPont MethodDuPont Method

1. Using assets to generate more revenues

2. Increasing income per dollar of revenues



Investment turnover = Revenues ÷ Investment

Return on sales = Income ÷ Revenues

ROI = Return on sales × Investment turnover



How can Relax Inns attain a 30% targetROI for the Denver hotel?

Present situation: Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20

Operating income ÷ Revenues= $240,000 ÷ $1,200,000 = 0.20

1.20 × 0.20 = 24%



Alternative A: Decrease assets, keepingrevenues and operating income per

dollar of revenue constant.

Revenues ÷ Total assets= $1,200,000 ÷ $800,000 = 1.50

1.50 × 0.20 = 30%



Alternative B: Increase revenues, keepingassets and operating income per dollar

of revenues constant.

Revenues ÷ Total assets= $1,500,000 ÷ $1,000,000 = 1.50

1.50 × 0.20 = 30%




Alternative C: Decrease costs to increaseoperating income per dollar of revenues,

keeping revenues and assets constant.

Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20

1.20 × 0.25 = 30%




Use the residual-income (RI)measure and recognize

its advantages.


Residual IncomeResidual Income

Residual income (RI)= Income

– (Required rate of return × Investment)

Assume that Relax Inns’ requiredrate of return is 12%.

What is the residual income from each hotel?


Residual IncomeResidual Income

Boston Hotel:Total assets $900,000 × 12% = $108,000Operating income $166,000 – $108,000

= Residual income $58,000

Denver Hotel = $120,000

Miami Hotel = $480,000



Describe the economic valueadded (EVA®) method.


Economic Value AddedEconomic Value Added

Economic value added (EVA®)

= After-tax operating income

– [Weighted-average cost of capital

× (Total assets – current liabilities)]



Total assets minus current liabilitiescan also be computed as:

Long-term assets + Current assets– Current liabilities, or…

Long-term assets + Working capital



Economic value added (EVA®) substitutes thefollowing specific numbers in the RI calculations:

1. Income equal to after-tax operating income

2. A required rate of return equal to theweighted-average cost of capital

3. Investment equal to total assets minuscurrent liabilities


Economic Value Added ExampleEconomic Value Added Example

Assume that Relax Inns has two sources oflong-term funds:

1. Long-term debt with a market value andbook value of $4,800,000 issued at aninterest rate of 10%

2. Equity capital that also has a market value of$4,800,000 and a book value of $2,200,000

Tax rate is 30%.



What is the after-tax cost of capital?

0.10 × (1 – Tax rate) = 0.07, or 7%

Assume that Relax Inns’ cost ofequity capital is 14%.

What is the weighted-average cost of capital?



WACC = [(7% × Market value of debt)+ (14% × Market value of equity)]

÷ (Market value of debt + Market value of equity)

WACC = [(0.07 × 4,800,000)+ (0.14 × 4,800,000)] ÷ $9,600,000

WACC = $336,000 + $672,000 ÷ $9,600,000

WACC = 0.105, or 10.5%



What is the after-tax operating income for each hotel?

Boston Hotel:Operating income $166,000 × 0.7 = $116,200

Denver Hotel:Operating income $240,000 × 0.7 = $168,000

Miami Hotel:Operating income $1,152,000 × 0.7 = $806,400



What is the investment?

Boston Hotel: Total assets $900,000– Current liabilities $50,000 = $850,000

Denver Hotel: Total assets $1,000,000– Current liabilities $150,000 = $850,000

Miami Hotel: Total assets $5,600,000– Current liabilities $300,000 = $5,300,000



What is the weighted-average cost of capitaltimes the investment for each hotel?

Boston Hotel: $850,000 × 10.5% = $89,250

Denver Hotel: $850,000 × 10.5% = $89,250

Miami Hotel: $5,300,000 × 10.5% = $556,50



What is the economic value added?

Boston Hotel: $116,200 – $89,250 = $26,950

Denver Hotel: $168,000 – $89,250 = $78,750

Miami Hotel: $806,400 – $556,500 = $249,900

The EVA® charges managers for the costof their investments in long-term assets

and working capital.


Return on SalesReturn on Sales

The income-to-revenues (sales) ratio, or returnon sales (ROS) ratio, is a frequently used

financial performance measure.

What is the ROS for each hotel?

Boston Hotel: $166,000 ÷ $1,100,000 = 15%

Denver Hotel: $240,000 ÷ $1,200,000 = 20%

Miami Hotel: $1,152,000 ÷ $3,200,000 = 36%


Comparing PerformanceComparing Performance

Hotel ROI RI EVA® ROSBoston 18% $ 58,000 $ 26,950 15%Denver 24% $120,000 $ 78,750 20%Miami 21% $480,000 $249,900 36%


Comparing PerformanceComparing Performance

Hotel ROI RI EVA® ROSBoston 3 3 3 3Denver 1 2 2 2Miami 2 1 1 1

Methods Ranking



Contrast current-cost andhistorical-cost asset

measurement methods.


Choosing the Time HorizonChoosing the Time Horizon

The second step of designing accounting-basedperformance measures is choosing the time

horizon of each performance measure.

Many companies evaluate subunits on the basisof ROI, RI, EVA®, and ROS over multiple years.


Choosing Alternative DefinitionsChoosing Alternative Definitions

The third step of designing accounting-basedperformance measures is choosing a definition

for each performance measure.

Definitions include the following:

1. Total assets available – includes all assets,regardless of their particular purpose.



2. Total assets employed – includes total assetsavailable minus the sum of idle assets and

assets purchased for future expansion.

3. Total assets employed minus current liabilities– excludes that portion of total assets employed

that are financed by short-term creditors.



4. Stockholders’ equity – using in the Resorts Innsexample requires allocation of the long-term

liabilities to the three hotels, which would thenbe deducted from the total assets of each hotel.


Choosing Measurement Alternatives


The fourth step of designing accounting-basedperformance measures is choosing a measurement

alternative for each performance measure.

The current cost of an asset is the cost now ofpurchasing an identical asset to the one

currently held.

Historical-cost asset measurement methodsgenerally consider the net book value of the asset.




The fifth step of designing accounting-basedperformance measures is choosing a target

level of performance.

Historical cost measures are often inadequate formeasuring economic returns on new investments

and sometimes create disincentives for expansion.




The sixth step of designing accounting-basedperformance measures is choosing the timingof feedback.

Timing of feedback depends largely on howcritical the information is for the…

…success of the organization.

…specific level of management involved.

…sophistication of the organization.



Indicate the difficulties whencomparing the performance

of divisions operatingin different countries.


Multinational Companies Example


Assume that Relax Innsinvests in a hotel inAcapulco, Mexico.

The exchange rate at thetime of the investment on

December 31, 2002, is8 pesos = 1 dollar.




During 2003, the Mexican peso suffersa decline in value.

The exchange rate on December 31, 2003,is 12 pesos = 1 dollar.

What is the average exchange rate during 2003?

(8 + 12) ÷ 2 = 10 pesos = 1 dollar




The investment (total assets) in Acapulco= 32,000,000 pesos.

The operating income of the AcapulcoHotel in 2003 is 6,200,000 pesos.

What is the return on investment in pesos?

6,200,000 ÷ 32,000,000 = 19.4%




What is the return on investment in dollars?

6,200,000 ÷ 10 = $620,000 operating income

$620,000 ÷ $4,000,000 = 15.5%

This is lower than the Boston ROI of 18%.

32,000,000 ÷ 8 = $4,000,000 investment



Recognize the role ofsalaries and incentives

when rewarding managers.


The Basic Trade-offThe Basic Trade-off

Most often, a manager’s totalcompensation includes somecombination of salary and a

performance-based incentive.



Describe the managementaccountant’s role in helpingorganizations design better

incentive systems.


Intensity of IncentivesIntensity of Incentives

How large should the incentive componentbe relative to salary?

Preferred performance measures are onesthat are sensitive to, or change significantly,

with the manager’s performance.


BenchmarksBenchmarks

Owners can use benchmarks toevaluate performance.

Benchmarks representing bestpractice may be available inside

or outside the organization.


MeasuringMeasuring

Obtaining performance measures that are moresensitive to employee performance is critical

for implementing strong incentives.

Many management accounting practices, suchas the design of responsibility centers and theestablishment of financial and nonfinancial

measures, have as their goal betterperformance evaluation.


End of Chapter 23End of Chapter 23

Performance Measurement, Compensation, And Multinational Considerations

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