financial accounting chap 025
TRANSCRIPT
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REWARDING
BUSINESS
PERFORMANCE
Chapter
25
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Goal Congruence
Alignment of employeegoals and objectiveswith organizational
goals and objectives.
Motivation and AligningGoals and Objectives
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Motivation and AligningGoals and Objectives
Feedback
Steer employeestoward goals.
Measure progressin achieving goals.
Measureperformance.
Improveperformance.
Rewardperformance.
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Return on investment is the ratio ofprofit to the average investment used
to generate the profit.
Return on Investment (ROI)
ROI = ProfitAverage investment
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SalesAverage Investment
ROI =Profit
Average Investment
ROI =ProfitSales
Return on Investment (ROI)
Returnon Sales
CapitalTurnover
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Return on Investment (ROI)
Holly Company reports the following:
Profit $ 30,000
Sales $ 500,000
Average Investment $ 200,000
Lets calculate ROI
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Return on Investment (ROI)
SalesAverage Investment
ROI =ProfitSales
ROI = 6% 2.5 = 15%
$500,000$200,000
ROI =$30,000
$500,000
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Three ways to improve ROI
Increase
SalesPrices
DecreaseExpenses
Lower
InvestedCapital
Improving ROI
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Improving ROI
Hollys manager was able to increasesales revenue to $600,000 whichincreased income to $42,000.
There was no change in invested capital.
Lets calculate the new ROI
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Improving ROI
SalesAverage Investment
ROI =ProfitSales
Holly increased ROI from 15% to 21%.
ROI = 7% 3.0 = 21%
$600,000$200,000
ROI =$42,000
$600,000
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As division manager at Winston, Inc., yourcompensation package includes a salary plusbonus based on your divisions ROI -- the higheryour ROI, the bigger your bonus.
The company requires an ROI of 15% on all newinvestments -- your division has been producing anROI of 30%.
You have an opportunity to invest in a new projectthat will produce an ROI of 25%.
As division manager would you
invest in this project?
Criticisms of ROI
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As division manager,I wouldnt invest in
that project becauseit would lower my pay!
Criticisms of ROI
Gee . . .I thought we were
supposed to do what
was best for thecompany!
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Operating EarningsInvestment charge= Residual income
Investment capitalMinimum return= Investment charge
Investment centersminimum acceptable
return
Residual Income
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Residual Income
Flower Co. has an opportunity to invest$100,000 in a project that will earn $25,000.
Flower Co. has a 20 percent minimumacceptable rate of return and a 30 percent ROIon existing business.
Lets calculate residual income
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Residual Income
Operating Earnings = $25,000Investment charge = 20,000= Residual income = $ 5,000
Investment capital = $100,000Minimum return = 20%= Investment charge = $ 20,000
Investment centersminimum acceptable
return
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Residual Income
As a manager atFlower Co., would youinvest the $100,000 if
you were evaluatedusing residualincome?
Would your decision
be different if you wereevaluated using ROI?
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Residual income encourages managers tomake profitable investments that would
be rejected by managers using ROI.
Residual Income
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Economic value added tells us how muchshareholder wealth is being created.
Economic Value Added
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Economic Value Added
Economic value addedis the annual after-taxoperating profit minus the total annual cost of capital.
Cost of capitalis weighted-average after-tax
cost of long-term borrowing and the cost of debt.
DebtEquity
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After-tax Operating IncomeInvestment charge=Economic value added
(Total assets current liabilities)Weighted-average cost of capital= Investment charge
After-tax cost oflong-term borrowing
and the cost of equity
Economic Value Added
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Economic Value Added
Economic value added can be improved in threeways . . .
Increase profit without using more capital.
Use less capital to earn the same amount of profit.
Invest capital in high-return projects.
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A set of performance targets and results thatshow an organizations performance in
meeting its responsibilities to various
stakeholders.
EmployeeStakeholder
Group
InvestorStakeholder
Group
Balanced Scorecard
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Financial PerspectiveHow do we look
to the firms owners?
Learning and GrowthPerspective
How can we continuallyimprove and create value?
Business ProcessPerspective
In which activitiesmust we excel?
Customer PerspectiveHow do our
customers see us?
Balanced Scorecard
Visionand
Strategy
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Components of ManagementCompensation
I prefer a fixed salaryso that I know what
I will be paid each year.
I prefer a bonusarrangementthat gives me the opportunity
to earn larger amounts. Idont mind the varying
compensation.I like both profit sharingand
stock options.
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Design Choices forManagement Compensation
Should we rewardcurrent performance or
future performance?
Should our rewards bebased on accounting
numbers or stockprice performance?
Should bonuses befixed or should theyvary with a
performance measure?
Should bonuses bebased on local or
company-wideperformance?
Should teams ofemployees share bonusesequally or should they
be in competition?
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End of Chapter 25