1

ACCT3104  Managerial Costing and Control

Lecture Topic 11Performance Measurement and CompensationReading: Horngren et al Chapter 23

Lecture OverviewMeasurement and evaluation of performanceCost, Revenue, Profit Centres (considered to date)Financial and non‐financial 

Designing accounting‐based performance measures

Meas rement and e al ation of PerformanceMeasurement and evaluation of PerformanceInvestment Centres (ROI, RI, EVA®, ROS)

Consider each measure and what it shows

Centre vsManager evaluationEfficacy of Financial Control

Principles of Incentives and Compensation PlansUnderstand the role of salaries and incentives when rewarding managers

Introduction…Performance measures are an integral part of any management management control systemcontrol system ‐ subunit and individual performance evaluation. 

Making strategic planning and control decisions requires information about how different subunits of the organization 

f fhave performed.  The measures used can be financial and non‐financial. 

To be effective the performance measures and rewards need to motivate managers and employees at all levels to strive to achieve company strategies and goals.  

Measurement & Evaluation of Measurement & Evaluation of PerformancePerformance

We have considered some accounting‐based (financial) performance measures used in different types of responsibility centres:

‐ Cost and Revenue Centres use flexible budgets and variance analysis (Flexible Budget Variances and Sales Volume Variances)

‐ Profit Centres use contribution margin income statements by segments (Segment Reporting), flexible budgets and variance analysis

‐ Investment Centres (focus of L 11) use ROI, RI and EVA Why not compare operating incomes (segment margins) of these divisions?

Accounting based performance measures can be used as good indicators of progress the Company has made towards its goals and objectives.

Financial Financial andand NonNon‐‐Financial Financial MeasuresMeasuresAccounting based performance measures comprise only a subset of the measures managers use to evaluate subunits and sub‐ordinates…

Non‐financial measures:‐ assist our interpretation of the financial measures‐ provide leading indicators of future financial performance can be used to evaluate aspects of a business that are critical to its long‐ can be used to evaluate aspects of a business that are critical to its long 

term success…

Recall the “Balanced Scorecard” approach  encourages managers to adopt a balanced perspective and take actions in the Company’s long‐run interests.  Measures are derived from the Company’s strategy.  Include measures of  profitability or return; customer satisfaction; innovation and productivity / quality / time measures as well as employee satisfaction and turnover.The Balanced Scorecard can be applied in a number of situations – from subunits to individuals

Designing Accounting Designing Accounting ‐‐ Based Based Performance MeasuresPerformance Measures

1. Choose performance measures that align with top management’s financial goals (best measure of a subunits performance?)

2. Choose the time horizon of each performance measure (Annual? Multi‐year period?)

3. Define components of the performance measure4. Choose a measurement alternative for the components of the C oose a easu e e t a te at e o t e co po e ts o e

performance measure5. Set the target level of performance (do all subunits have identical 

targets such as the same required rate of return on assets?)6. Determine the timing of the feedback (frequency of calculating & 

reporting the measure to top management?)Selection between alternatives at each step? How does each alternative fulfil the:

‐ promoting Goal congruence‐ promoting Management effort‐ promoting Subunit performance evaluation‐ promoting Subunit autonomy

2

Measurement and Evaluation of Measurement and Evaluation of performance: performance: Investment Investment CentresCentres

1. Return on Investment (ROI)a) Profit margin (ROS) x Investment (asset) turnover (Du Pont)b) ‘Accounting Rate of Return’

2 Residual Income (RI)2. Residual Income (RI)3. Economic Value Added (EVA)

The above are ‘investment’ measuresInvestment = resources or assets used to generate income

4. Return on Sales (ROS) – does not include any ‘investment’

1. Return On Investment (ROI)1. Return On Investment (ROI)Evaluates profit relative to the level of investment Definition of the components?

Segment or Operating Income?Before or after tax?

ROI = ROI = IncomeIncome

Investment Investment

Investment = the resources or assets used to generate incomeincomeTotal assets employed, total assets available

or a measure of net assets?Valued at cost, book value, current cost?

Beginning, ending or average?

Total assetsemployed

Total assets (available)

Appropriate if the division managerhas considerable authority in makingdecisions about all of the division’s

assets, including non-productive assets

Appropriate if the division manager has been directed by top level management

to keep non-productive assets,

Varied definitions of Investment

Total assets lesscurrent liabilities

making it appropriate to exclude non-productive assets from

the measure of invested capital

Appropriate if the division manager has authority to secure short-term bank

loans and other short-term credit

Measurement Alternative? Measurement Alternative? Current cost – cost of purchasing an identical (or similar) asset todayHistorical cost – can include Gross Book Value or Net Book Value 

Assessing Return on Investment Performance

Analyse trends over time

Compare to competitors

• Decompose and compare to competitors

Compare to alternative ‘returns’p

Look for signals suggesting where there might be problems

Use cautiously and in conjunction with other measures

Interpretation of ROI

Net Book Gross Book

Lecture Example: Assume that Compu‐soft Pty Ltd is a retailer with 3 product lines;  computers, software and computer help books, that operates out of stores in Brisbane, Sydney and Melbourne. Calculate the ROI using (i) NBV of assets, (ii) GBV of assets and (iii) Current cost of assets as alternative definitions of “Investment”, and interpret your results 

Financial data(2010) Profit Value Value Current Cost Brisbane 26,000$ 195,500$ 250,500$ 388,000$ Sydney 38,500 212,000 445,000 650,000 Melbourne 16,850 133,000 155,450 225,500 Return on Investment Brisbane 13.30% 10.38% 6.70% Sydney 18.16% 8.65% 5.92% Melbourne 12.67% 10.84% 7.47%

$26,000 $26,000 ÷÷ $195,500 = 13.30%$195,500 = 13.30%

Net Book Value vs Gross Book ValueNet Book Value vs Gross Book Value

Using net book value:

maintains consistency with

The usual methods of computing depreciation are arbitrary and should not be

Advantages: gross book valueDisadvantages: net book value

Advantages: net book valueDisadvantages: gross book value

maintains consistency with balance sheet prepared for external reporting purposes

to measure invested capital is also more consistent with the definition of income, which is the numerator in ROI calculations

arbitrary and should not be allowed to affect ROI, residual income, or EVA calculationsWhen non-current assets are depreciated, their net book value declines over time resulting in a misleading increase in ROI, RI, and EVA across time

3

Factors Underlying ROIFactors Underlying ROI-- the Du Pont methodthe Du Pont method

Return on investmentReturn on investment IncomeInvestment

IncomeSales revenue

Sales revenueInvestment

= X

Return on Sales

Measures the percentage of each sales dollar that

remains as profit after allexpenses are covered

- a measure of efficiencyefficiency

=Investment Sales revenue Investment

Investment(Asset)Investment(Asset)Turnover

Focuses on thenumber of sales

dollars generatedby each dollar of invested capital

- a measure of effectivenesseffectiveness

Note: Investment = AssetsHighlights the benefits of reducing investment in inventories, & spending carefully on fixed assets

The Du Pont Method (ROI)The Du Pont Method (ROI)

Lecture Example contd: Calculate, using the figures provided below the ROI, Return on Sales, and Investment (Asset) Turnover for Compu-Soft (Brisbane) for each product line & in total for Years 2009 & 2010 and interpret your results.

Year 2009 Year 2010 Year 2009 Year 2010 Year 2009 Year 2010Computers 8,000$ 5,000$ 50,000$ 62,500$ 200,000$ 250,000$ Software 15,000 16,000 100,000 80,000 150,000 160,000 Books 3,200 5,000 32,000 50,000 80,000 100,000 Total 26,200$ 26,000$ 182,000$ 192,500$ 430,000$ 510,000$

Income Investment Sales

Du Pont Method of Return Du Pont Method of Return on Investmenton Investment

ROI= Return on Sales x Investment Turnover

Return on Sales Invest Turnover ROI

$8,000 $8,000 ÷÷ $200,000$200,000 $200,000 $200,000 ÷÷ $50,000$50,000

Year 1 Year 2 Year 1 Year 2 Year 1 Year 2Computers 4.00% 2.00% 4.00 4.00 16.00% 8.00%Software 10.00% 10.00% 1.50 2.00 15.00% 20.00%Books 4.00% 5.00% 2.50 2.00 10.00% 10.00%Total 6.10% 5.10% 2.36 2.65 14.40% 13.50%

Return on Sales Invest. Turnover ROI

$8,000 $8,000 ÷÷ $50,000$50,000$26,200 $26,200 ÷÷ $430,000$430,000

Controlling ROIControlling ROI

Increase Sales Increase Sales without a

similar increase in

Reduce Expenses

Reduce Assets

Three ways to improve ROI

increase in costs

IncomeSales

Sales InvestmentX

Return onSales

InvestmentTurnover

Technical Problems of ROITechnical Problems of ROI

1. 1. ROI is too aggregated too aggregated to give guidance about the trade‐off that can be made between profit and investment

A simple example:Quarter ROI    = ROS(Profit Margin)* Investment Turnover1 12.6% = 17.1% * .7362 13 4% 20 2% * 6642 13.4% = 20.2% * .664

The ROI has improved but the manager in this case has simply produced more units for inventory. How did this work?How did this work?

As a compound (aggregated) measure it is subject to manipulationmanipulation by managers aiming for a favourable result‐ Can result in dysfunctional decisions‐ Has a short term “profit” focus (effect?)

2. The measure gives rise to inconsistent capital investment inconsistent capital investment decisions decisions across the company which lead to sub‐optimal outcomes.Denominator problem with fixed assets ‐ GBV or NBV?E g Div ROI = 20%; Company ROI = 16%E.g., Div ROI = 20%; Company ROI = 16%An new investment opportunity has arisen for the division which offers an 18% return. Decision?There is a lack of goal congruence in the investment decision.

What about the disposal decision and use of GBV? NBV?NBV provides less incentive to dis‐invest but this incentive may become too strong.

4

3. NPV calculation and evaluation of investment is inconsistent with ROI outcomes after the investment.ROI encourages investment in fast payback assets.

4. What about the effect of transfer prices effect of transfer prices on Divisional ROI?C fit l ti i d b ti i i di i i lCompany profits are rarely optimised by optimising divisional profit. (Solution? Remove the decision rights?)

5. ROI Results may be misleading and decisions dysfunctionalIs comparison of different divisions appropriate?Measuring the performance of the division rather than the performance of the manager?

Be careful comparing the ROI’s of Different Business Segments…

Invalid comparisons between different work units can occur because:age of assets are different (GBV vs NBV)asset‐intensive vs low‐asset business typesdifferent national (and cultural) contextsdifferent legal restrictions etc

…and Multinational Companies…Comparing the performance of divisions of a multinational company creates additional difficulties.

Differences in the economic, legal, political, social, and cultural environmentGovernmental controlsAvailability of materials and skilled labourCurrency differences

…and be careful evaluating Managers’ performance…

The economic performance of a business unit is different from the The economic performance of a business unit is different from the performance of its manager.performance of its manager.

Comparisons between managersbetween managers of different units on the basis of ROI are not necessarily not necessarily validvalid:O a e o ecessa yo ecessa y a da d

different types of businesses deliver different levels of returna a good manager of a poor division may not appear to do as well as a good manager of a poor division may not appear to do as well as a poor manager of a good ROI division. poor manager of a good ROI division. A managers performance is limited by the division’s profit potential.the extent to which a manager can control an item is irrelevant to the division’s performance BUT is relevant to the managers performance.

>> Single comprehensive figure that Single comprehensive figure that focuses managers on profit & focuses managers on profit & assets needed to generate the assets needed to generate the profitsprofits

Return on InvestmentReturn on Investment

>> high ROI units may be unwilling to invest high ROI units may be unwilling to invest in projects with ROI greater than in projects with ROI greater than minimum rate of return but less than minimum rate of return but less than unit’s current unit’s current ROIROI

AdvantagesAdvantages LimitationsLimitations

>> easily understood easily understood --comparable to comparable to interest rates and rates of return interest rates and rates of return on alternative investmentson alternative investments

>> Motivates managers to use Motivates managers to use assets optimally and only acquire assets optimally and only acquire when justifiedwhen justified

>> widely usedwidely used>> improvement over evaluation improvement over evaluation

based on dollar profit alonebased on dollar profit alone

>> using investment based on historical using investment based on historical costs, net of costs, net of depreciation (NBV), depreciation (NBV), managers may put off purchasing new managers may put off purchasing new equipment when assets fully equipment when assets fully depreciateddepreciated

>> Aggregated measure Aggregated measure ––may lead to may lead to manipulationmanipulation

2. Residual Income2. Residual IncomeEvaluates profit relative to a minimum required return on investment

Residual Income = Residual Income = Income Income -- (Required rate of return x Investment) (Required rate of return x Investment)

Typically use Operating IncomeUses an ‘imputed cost of the investment’ based on the minimum acceptable rate of return the company seeks on its investment. (Typically measured by the weighted average cost of capital (WACC))Measure is expressed in dollar terms →motivates managers to maximise $ outcome rather than a %A potential solution to under/over investment →managers have incentive to accept all projects that more than cover the cost of capital → goal congruent

Residual Income

Investment centre profit– Investment charge = Residual income

Investment capitalInvestment capital× Imputed interest rate= Investment charge

Investment centre’sminimum required

rate of return

5

Residual Income

Financial data Profit Average Net Book Value

Brisbane 26,000$ 195,500$ Sydney 38,500 212,000 Melbourne 16,850 133,000 Return on Investment

Lecture example: Calculate the Residual Income for each area. Compu‐soft requires a 12% rate of return

Return on Investment Brisbane 13.30% Sydney 18.16% Melbourne 12.67%Residual Income = minimum return is 12%

Minimum Return

Residual Income

Brisbane 23,460$ 2,540$ Sydney 25,440 13,060 Melbourne 15,960 890

Investment 195,500$ Minimum rate of return 12%Minimum profit 23,460 Actual profit 26,000 Residual income 2,540$

Brisbane

> supports incentive to accept all projects with ROI greater than then minimum rate of return

Residual IncomeResidual Income

> favours large units when minimum rate of return is 

AdvantagesAdvantages LimitationsLimitations

then minimum rate of return> can use the minimum rate of

return to adjust for differences in risk

> can use a different minimum rate of return for different types of assets

low

> not as intuitive as ROI

> may be difficult to obtain a minimum rate of return

Quick Check 

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. q p yWhat is the division’s ROI?a. 25%b.   5%c. 15%d. 20%

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?a. 25%b.   5%c. 15%d. 20%

ROI = NOI/Average operating assets

= $60,000/$300,000 = 20%

Quick Check 

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to 

$make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb.  No

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to 

$make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb.  No

ROI = $78,000/$400,000 = 19.5%

This lowers the division’s ROI from 20.0% down to 19.5%.

6

Quick Check 

The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income 

$of $18,000 per year?a. Yesb.  No

The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?o $ 8,000 pe yea

a. Yes

b.  No ROI = $18,000/$100,000 = 18%

The return on the investment exceeds the minimum required rate

of return.

Quick Check 

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?

$240 000a. $240,000b. $  45,000c. $  15,000d. $  51,000

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?

a. $240,000

b. $  45,000

c. $  15,000

d. $  51,000Net operating income $60,000Required return (15% of $300,000) $45,000Residual income $15,000

Quick Check 

If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb.  No

If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $$18,000 per year?

a. Yes

b.  No

Net operating income $78,000Required return (15% of $400,000) $60,000Residual income $18,000 This is an increase of $3,000 in the residual income.

7

3. Economic Value Added3. Economic Value Added®®

Stern Stuart – consulting firmRI adjusted for “accounting distortions”EVA is the income “pie” available to creditors and shareholders less the required return on funds invested for the L‐T by creditors and shareholdersevaluates income relative to level of investment required to earn that incomemotivates managers to undertake economic value added activities

Economic Value Added = A-T Profit – Cost of Capital

Economic Value AddedEconomic Value Added

After‐tax operating income ‐ total annual cost of capital

Economic Value Added = AfterEconomic Value Added = After tax Operating Income tax Operating Income Economic Value Added = AfterEconomic Value Added = After--tax Operating Income tax Operating Income --

[Weighted average cost of capital x [Weighted average cost of capital x (Total assets (Total assets -- Current Liabilities)]Current Liabilities)]

• Non-current assets + Current assets - Current liabilities• or Non-current assets + Working Capital

Two sources:Debt and Equity & after tax

Economic Value AddedEconomic Value Added

Investment centre’s after-tax operating income– Investment charge= Economic Value Added

W i ht dI t t I t t( ) Weightedaverage

cost of capital

Investmentcentre’s

total assets

Investmentcentre’s

current liabilities–( )

After-taxcost ofdebt

Marketvalue

of debt

Cost ofequity capital

Marketvalue

of equity( () )Marketvalue

of debt

Marketvalue

of equity

EVA for our EVA for our Lecture ExampleLecture Example

Now assume long term funds are:$160,000 long‐term bonds

after‐tax cost of debt, 6.3% i.e., 9% (1 ‐ .30)

$300,000 ordinary shares$ , ycost of equity,12%

Two calculations requireddollar value of investmentWACC (% figure)

After-taxcost of

debtcapital

Weightedaveragecost of capital

Market value

of debt

Cost ofequitycapital

Market value ofequity

Market value

of debt

Market value ofequity

+

=

+

.063

.1002Or 10.02%

$160,000 .12 $300,000

$160,000 $300,000

+

=

+

Economic Value AddedEconomic Value Added

Brisbane Sydney MelbourneIncome 26,000 38,500 16,850Total Assets 195,500 212,000 133,000Current Liabilities 31,500 20,500 4,650

Some additional information for the lecture example

B $26 x (1 - .30) - [($195.5 - $31.5) x .1002] = $1,767.20S $38.5 x (1 - .30) - [($212 - $20.5) x .1002] = $7,761.70M $16.85 x (1 - .30) - [($133 - $4.65) x .1002] =($1,065.67)

Economicvalueadded

Investmentcentre’s after-tax operating

profit

Investmentcentre’s

total assets

Investmentcentre’s current

liabilities

Weighted-averagecost ofcapital

=-- X

In thousands

8

> approximates real underlying increase in the value of shareholder’s wealth

> makes management focus on 

EVAEVA

> complex RI > cost of capital imprecise> capital calculation based on book value, not market value, ∴ no 

AdvantagesAdvantages LimitationsLimitations

goptimising the company’s capital mix

> Studies ? Some show closer correlation with share price than conventional profits

, ,account for opportunity cost of  investment 

> capital base may fluctuate from year to year distorting EVA

> may discourage long term investment 

> Studies? Some show weak correlation with share price

Quick Check 

A negative feature of defining investment by excluding the portion of total assets employed that are financed by short‐term creditors is that:  

a. current liabilities are sometimes difficult to define  

b. short‐term debt is always more expensive to finance than long‐term debt  

c. this method encourages managers to use an excessive amount of short‐term debt  

d. this method encourages managers to use an excessive amount of long‐term debt 

Quick Check 

A negative feature of defining investment by excluding the portion of total assets employed that are financed by short‐term creditors is that:  

a. current liabilities are sometimes difficult to define  

b. short‐term debt is always more expensive to finance than long‐term debt  

c. this method encourages managers to use an excessive amount of short‐term debt  

d. this method encourages managers to use an excessive amount of long‐term debt 

Waldorf Company has two sources of funds - long-term debt with a market and book value of $10 million issued at an interest rate of 12 percent, and equity capital that has a market value of $8 million (book value of $4 million). Waldorf Company has profit centres in the following locations, with the following operating incomes, total assets, and total li biliti Th t f it it l i 12 t hil th

Quick Check

liabilities. The cost of equity capital is 12 percent, while the tax rate is 25 percent.

CurrentOperating Income Assets Liabilities

St.Louis $960,000 $4,000,000 $200,000Cedar Rapids $1,200,000 $8,000,000 $600,000Wichita $2,040,000 $12,000,000 $1,200,000

1. What is EVA for St. Louis?

a. $255,740b. $327,460c. $392,540

Quick Check

c. $392,540d. $720,000

1. What is EVA for St. Louis?a. $255,740b. $327,460c. $392,540d. $720,000

WACC = [(0.09 x $10,000,000) + (0.12x $8,000,000)]$18,000,000

= .1033St. Louis (EVA) = ($960,000 x 0.75) - .1033 x (4,000,000-

$200,000) = $720,000 - 392,540 = $327,460

9

Summary: ROISummary: ROI, RI, EVA Limitations, RI, EVA Limitations

Incomecan be manipulated in short runto compare, must use same accounting methodsbased on accrual accounting

Asset InvestmentMay be understated (e.g. R&D)Current management may be judged on decisions of previous managersAssets not restated for changing (rising) price levels (older assets will report higher ROI) – can be overcome by using ‘current cost’ measures as opposed to historical cost measures

4. Return on Sales (ROS)4. Return on Sales (ROS)

ROS = Operating Income (EBIT)/Sales

f f fSuitable for use in firms where the level of investment in investment in assets is lowassets is low and therefore the corresponding ROI would be extremely high

Shows how effectively costs are managed

Time Horizon?ROI, RI, EVA (and ROS) represents results for a single period (Year)

Managers may be inclined to take actions that improve short‐run performance but that re detrimental to long‐run interests of Companydetrimental to long run interests of CompanyMany companies evaluate subunits on these measures over multiple years

Measuring Investment Centre & Measuring Investment Centre & ManagerManager

Performance evaluation of a manager should be distinguished from the subunit. Managers should be evaluated on the profit margin they control.

Exclude these costs:Costs traceable to the division but not controlled by Costs traceable to the division but not controlled by the division managerthe division manager

Common costs incurred elsewhere and allocated to Common costs incurred elsewhere and allocated to the divisionthe division

The key issue is controllability

Quick Check 

In performance evaluations:  

a. the performance of the division prior to the manager assuming control should be considered  

b. economic conditions for the specific industry should not p ybe considered  

c. to have an effective and fair evaluation, a manager should be evaluated over several time periods  

d. Both a and c are correct.  

In performance evaluations:  

a. the performance of the division prior to the manager assuming control should be considered  

b. economic conditions for the specific industry should notp ybe considered  

c. to have an effective and fair evaluation, a manager should be evaluated over several time periods  

d. Both a and c are correct.  

10

Efficacy of Financial Control?Efficacy of Financial Control?Criticisms

delayed information

highly aggregated information

not actionable; limited guidance for future actions

narrow measures that emphasise only one aspect of performance and that do not evaluate how well the organisation is meetingand that do not evaluate how well the organisation is meeting shareholders’ requirements

too focused on short‐term results

may encourage actions that decrease both shareholder and customer value

Overcome this? Take a balanced scorecard approachUse financial and non‐financial measuresSelect measures that support the strategic orientationUse external benchmarksIncorporate continuous improvement

Fundamental Principles of Fundamental Principles of Incentive Compensation Incentive Compensation PlansPlans

The basic idea behind incentive compensation plans is “pay for performance.”

The two keyelements ofan incentive

compensationplan are the:

Method of compensation

Measure of performance

The Trade‐Off: Creating Incentives vs. Imposing Risk

Compensation may range from:Flat salary with no performance based incentives…toNo salary and full commission…

An inherent trade‐off exists between creating incentives and imposing risk

An incentive should be some reward for performanceAn incentive may create an environment in which suboptimal behaviour may occur (the goals of the firm are sacrificed in order to meet a manager’s personal goals)

Managers do not like being subject to risk BUT lack of risk can create MORAL HAZARD

Moral HazardWhen an employee prefers to exert less effort compared with the effort desired by the owner because the employee’s effort cannot be accurately monitored and enforced

Intensity of Incentives – size of incentive component relative to the salary component

Intensity of Incentives

Preferred Performance Measures

Are sensitive to or change significantly with the manager’s performance.  Do not change much with changes in factors that are beyond the manager’s control

Should motivate the manager as well as limit the manager’s exposure to riskFinancial and non‐financial benchmarksmay be used to evaluate performance.

Merchant’s six criteria of an “ideal” motivational contract

Performance measures that are congruent with overall corporate goals of maximising shareholder value

Controllable results measuresAccurate results measuresPreset and challenging performance standardsRewards that are meaningful, but at a minimum costSimplicity

11

Elements of a typical Incentive Elements of a typical Incentive SchemeScheme

Variable/s used to measure, assess and reward performanceBasis for determining the standard or target level of performanceRules for translating levels of performance into individual g prewardsNature of rewardssize of reward, type of reward

Basis for determining bonus pool sizeBasis for determining participants in scheme

What Behaviour should the Incentive Compensation Plan motivate?

It depends on the situation faced by each company

Current versus FutureCurrent FutureFuture

Performance

Compensation awards are usually cash or shares

that can be cashed soon after the award that are

based on performance in the recent past

Current Future

Compensation awards are based on future

performance providing an incentive for workers to stay and for workers to focus on the long run

Designing Incentive SystemsDesigning Incentive Systems

Division Performance vs Companywide Performance

Division Company-wide

F tt ti Allows managers to consider theFocuses managers attention on their own responsibility centre

may be detrimental to other responsibility centres and

performance of company as a whole

fits more in a decentraliseddiverse organisation

Allows managers to consider the impact of their actions on the

company as a whole

may be difficult to see relationship between their actions

and the company as a whole

fits more in a centralisedorganisation

Designing Incentive Systems

Using Fixed Formulae or Subjectivity in providing rewards

Fixed Formulae Subjective

EXAMPLE:For each percentage point by which revenue growth exceeds 5%, managers

receive a bonus of 10% of their base salary

Managers know precisely what is expected of them

EXAMPLE:A manager’s ROI dipped

because of research, employee training, and advertising

expenses that will not pay off until the future

It is difficult to capture activities in fixed formulae

Designing Incentive Systems

Absolute Performance Evaluation or Relative Performance Evaluation?

Relative

Your evaluation depends on

Absolute

Your evaluation is on an Your evaluation depends onhow you perform in

relation to everyone else

EXAMPLE:Comparing divisional

performanceto other divisions

in the same industry

Your evaluation is on anabsolute scale and does

not depend on what otherpeople do

EXAMPLE:90 - 100 = A80 - 89 = B70 - 79 = C60 - 69 = D

Evaluation based on Share Price rather than accounting based measures?

Performance Evaluation Based on Share Performance?

Aligns managers’ incentives with those of shareholders

Division managers in big companiesmay see little relationship between their performance and the company’s shares.

EVA focuses on creating value for shareholders, while relying on nonshare

performance measures

12

Management Compensation

Cash incentives are highly liquid and

attractive -short term

Share incentives are usually not redeemable into

cash until a future time-longer term, aligns

interests…

Prizes, promotions (titles), location can be more attractive than money, and

more motivational

Question: Management CompensationQuestion: Management Compensation

The top management of Aussie Industries is considering the following compensation arrangements for its division managers:

Fixed salary without bonus.

Base compensation based entirely on their division’s residual income.

Use benchmarking of each division’s RI against the RI of other divisions ofUse benchmarking of each division s RI against the RI of other divisions of similar size in other firms in similar industries. 

Assume that division managers do not like bearing risk.• List the advantages and disadvantages of each alternative.• What compensation arrangement would you recommend?