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Strategic Cost Management
NANDU J. NAGARAJAN
Performance measurement and incentives
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PERFORMANCE MEASUREMENT AND
INCENTIVES
CHAPTER 14
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Decentralization
Managerial responsibility should be tied tothe allocation of decision rights. Thus, ourchoice of performance measures should belinked to the level of decentralization
Cost Centers cost
Revenue Centers sales, market share, CRM
Profit Centers All of the above
Investment Centers All of the above & investment Corporate versus divisional versus individual measures
Line of sight measures
Financial versus non-financial measures
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PERFORMANCE MEASUREMENT
Tailor performance measurement to the businessunit
Link performance measurement to a units
short and long-term targets Combine financial and operating performance in
the measurement (Income Statement valuedrivers and Balance Sheet value drivers)
Avoid too many measures (LBO model versusBalanced Score Card)
Identify performance measures that serve asearly warning indicators
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CHOOSING PERFORMANCE
MEASURES
Performance measures should be linked to value Managers should be able to influence the
performance measures through their actions Effect of other factors such as external shocks
and other individuals should not be excessive In the absence of these conditions holding, the
performance measure will impose risk on themanagers to overcome moral hazard but may notinduce value creation
Financial or non-financial performance measures?Financial e.g., EBIT, ROI, RI, EVANon-financial e.g., customer satisfaction,
quality, cycle time
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FINANCIAL MEASURES OF
PERFORMANCE
There are four main categories of financialmeasures:
1) Income
2) Cash
3) Return
4) Value
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CASH FLOW MEASURES
Gross cash flow
Earnings before interest, tax anddepreciation/amortization (EBITDA)
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INCOME MEASURES
Earnings before interest and tax (EBIT)
EBITDA Depreciation/Amortization
Net operating profit after tax (NOPAT)
EBIT ( 1- tax rate) Net Income (NI)
EBIT + Interest Income InterestExpense
Earnings per share (EPS):
NI/ # of shares outstanding
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RETURN MEASURES
Return on Equity (ROE):
Net income/Total common equity
ROI: After Tax Income/Assets (Divisional)
Dupont ratio:
(After tax Income/Sales) x (Sales/TA) = ROI ROI also defined as Operating Income/TA
Identify value drivers based on different components ofROE
Return on Capital Employed (ROCE) or Return on NetAssets (RONA):
NOPAT/ Net Assets (TA-Current Liabilities)
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SINGLE PERIOD VALUEADDED
MEASURES
Residual Income (RI): After Tax Incomeminus a charge for assets
Economic Value Added (EVA):
Stern Stewart measure of economic profitminus a charge for capital employed
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WHICH FINANCIAL MEASURES?
COMMON FINANCIAL MEASURES
ROI
Residual Income (RI)
Earnings before interest, tax and depreciation(EBITDA)
Economic Value Added (EVA)
Net Operating Profit After Taxes (Stern Stewart)
- (Weighted Average x (CapitalCost of Capital) Employed)
EVA = NOPAT (SS) WACC X CE
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MORE ON EVA
NOPAT (SS) modifies profit calculation comparedto NOPAT
Change in EVA associated with change inshareholder value
Ways to increase EVA* Increase net profit without increasing
capital* Reduce capital employed in projects
earning returns lower than the cost ofcapital
* Invest capital in projects with returnshigher than the cost of capital
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CRITICAL THINKING EXAMPLE
Consider the following data for the twogeographical divisions of the PittsburghHome Products (PHP) Company that operateas profit centers:
Allegheny Ohio
Total assets $1,000,000 $5,000,000
Current liabilities 250,000 3,000,000Operating income 200,000 750,000
Tax Rate: 40%
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CRITICAL THINKING EXAMPLE
(CONTINUED)
REQUIRED
Calculate the ROI for each division using after taxincome as the measure of income and using totalassets as the measure of investment.
Allegheny: $ 200,000(1-.40)/1,000,000 = 12%
Ohio: $ 750,000(1-.40)/5,000,000 = 9%
Allegheny is doing better
Some analysts compute ROCE as after taxincome divided by capital employed ( 16% and22.5%, respectivelyaccording to this criterion,Ohio is doing better)
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PROBLEMS WITH THE ROI
MEASURE
Definition of numerator (after tax income) and denominator(total assets)
Operating income is subject to several accountingadjustments such as expensing advertising and R&D,
inventory valuations, and amortizing goodwill
ROI is a myopic measure not consistent with NPV criterion
Decentralization with use of the ROI measure can lead toagency problemswrong decisions by managers
Case 1: Managers ROI is 20%, cost of capital is 15%,project return is 18%
Case 2: Managers ROI is 15%, cost of capital is 20% andproject return is 18%
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CRITICAL THINKING EXAMPLE
(CONTINUED)
Pittsburgh Home Products Company hasused RI as a measure of managementperformance, the variable it wants a
manager to maximize. Using thiscriterion, what is the RI for each divisionusing operating income and total assets, ifthe required rate of return on investment
is 10 percent?
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RESIDUAL INCOME
CALCULATIONS
Residual income is defined as :
After Tax Income (required rate of return) x (total assets)
Allegheny:
$120,000 - (0.10 x $1,000,000) = $ 20,000 Ohio:
$ 450,000 (0.10 x $5,000,000) = ($50,000)
Allegheny is doing better Required rate of return should be set at cost of capital If set at accounting rate of return, ordering of divisional
performance could be different
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EVALUATING RESIDUAL
INCOME
Does not have the problem that ROI has in being anefficiency measure, so managers get overly focused on onenumber
It is a myopic one period measure
However, present value of Residual Income equals NPV
It also has several measurement problems
Where does rate of return come from? Is it set at cost ofcapital?
Bias towards larger divisions?
Not as popular as ROI
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CRITICAL THINKING EXAMPLE
(CONTINUED)
Pittsburgh Home Products has two sources offunds: long-term debt with a market value of$3,500,000 and an interest rate of 10%, andequity capital with a market value of $3,500,000at a cost of equity of 14 percent.
PHPs income tax rate is 40 percent. PHP applies the same weighted-average cost of
capital to both divisions, since each division facessimilar risks.
Calculate the EVA for each division. Which of the measures calculated in
requirements 1, 2, and 3 would you recommendPHP use?
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EVA CALCULATIONS
Recall that EVA = NOPAT WACC X CE
Usually the first step is to calculate theNOPAT. To do this the effect of accounting
adjustments have to be undone, forexample (Vyaderm case)
1)Capitalize R&D
2) Capitalize advertising3) Switch to FIFO instead of LIFO
inventory valuation
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EVA (CONTINUED)
These adjustments have implications both for theIncome Statement and the Balance Sheet. SternStewart lists more than a hundred adjustments,but in practice 7-10 are most common
For simplicity, we have ignored theseadjustments in our numerical example. However,in the Vyaderm case we will consider someadjustments. Please study these carefully.
Next, the net after tax operating income is
calculated:Allegheny: $200,000 (1-0.40) = $120,000
Ohio : $750,000 (1-0.40) = $450,000
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EVA (CONTINUED)
The Weighted average cost of capital(WACC) is calculated by weighting thecost of equity and the after tax cost of
debt by their proportions in the unitscapital structure. PHP has 50% equity and50% debt
WACC = 0.14 X 0.5 + 0.10 (1-0.4) x 0.5
= 0.10
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EVA (CONTINUED)
Capital Employed is:
Total Assets Current Liabilities
Allegheny:
$1,000,000 $250,000 = $750,000
Ohio:
$5,000,000 $3,000,000 = $2,000,000
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EVA (CONTINUED)
EVA calculation:
NOPAT WACC X CE
Allegheny:
$120,000 - 0.10 x 750,000 = $45,000
Ohio:
$ 450,000 0.10 x 2,000,000 = $250,000
Therefore, the Ohio division is performingbetter
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LIMITATIONS OF EVA
Operationally, determining the cost of capital atthe divisional level is not easy
You need to have complete financial statementsfor the EVA center. Allocations of costs andassets, transfer pricing and other inter-divisionalproblems can impact the effect of EVA as aperformance measure
Macroeconomic factors outside the managerscontrol, such as interest rates, can affect cost ofcapital
Operationally, subjective factors can creep intothe EVA calculation in determining the managersbonus payout
EVA can operate as a myopic measure also. It isbased on accounting profit not cash flows
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SYMPTOMS OF PERFORMANCE
MEASUREMENT FAILURE Performance is acceptable on all dimensions
except profit. Customers dont buy even when prices are
competitive. No one notices when performance measurement
reports are not produced. Managers spend a lot of time debating the meaning
of the measures. Share price performance is lethargic despite solid
financial performance. You havent changed your performance measures in
a long time. Youve recently changed your corporate strategy.
(Vitale/Mavrinac)
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Problems 14-40 and 14-41
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VYADERM PHARMACEUTICALS
Case documents the companys implementationof EVA
Class discussion issues in addition to numericalissues listed in course outline
What are the industry factors affecting theDermatology division?
What are the various stages in the evolution ofthe EVA system?
What is the importance of EVA value drivers?
What are the EVA numbers for dermatology for2000 and 2001 What should be done about managers 2000
bonus?
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Balanced Score Card perspectives and
Strategy Maps
Financial
Customer
Business Process
Learning and Growth
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GOVERNANCE
AND INTERNAL CONTROL
Management control mechanisms in companies are veryimportant
Recall the example of Barings Bank
The Barings Bank example shows that weaknesses inmanagement control can lead to value destruction.
Management control mechanisms involve the system ofchecks and balances, performance measurement andreward systems and coordination mechanisms
One important coordination mechanism with strongimplications for value is transfer pricing
Transfer pricing is the pricing of goods and services inintra-company transfers
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TRANSFER PRICING
CHAPTER 15
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TRANSFER PRICING Vertically integrated companies or companies with common
services use transfer pricing as an internal control andcoordination mechanism.
We will see that transfer pricing arises when companiesvertically integrate through acquisitions for strategicreasons including avoiding hold-up problems
Because managers are evaluated based on theperformance of their divisions in decentralizedenvironments, transfer pricing creates externalities that cancloud incentive control and evaluation
The objectives of transfer pricing are:- tax minimization- managing internal sourcing- evaluating divisional performance- implementing corporate strategy
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TRANSFER PRICING
(CONTINUED)
Transfer pricing formula:TP = Incremental cost +Opportunity
cost for supplying division
Operationally for the supplier,
TP = (marginal cost/unit) variable cost/unit + change in fixed cost/unit + lost
contribution margin for not makingoutside sales
Assumes constant marginal cost
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EXAMPLE
The Hong Kong Home Products companyhas two divisions, Appliances and KitchenDesigns . The Appliance division suppliesrefrigerators to the Kitchen Designs
division. The capacity of the appliancedivision is 2000 refrigerators per year. Thevariable cost of production is $60 perrefrigerator. The fixed cost per unit is
$100 ( based on a volume of 2000 units).The market price for this category ofrefrigerator is $225 per unit.
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EXAMPLE ( CONTINUED)
Required:
1. If the Appliance division is at capacity, what isthe optimal transfer price?
2. If the Appliance division has excess capacity,
what is the best decision for the company, as awhole, buy inside or outsource?
3. What transfer price with divisionaldecentralization will provide the optimal solutionfor the company?
4. What other factors would become important ifthe Kitchen Designs division is located in Manila,Phillipines?
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TRANSFER PRICING METHODS
Transfer pricing methods
- Market - based pricing
- Variable cost pricing
- Full cost pricing
- Negotiated transfer pricing
- Dual transfer pricing
Value Chain considerations andmanagerial incentives become veryimportant in transfer pricing
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Problems 15-26, 15-27 and 15-29
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