Measuring and Rewarding Performance

1. Measuring and Rewarding Performance Chapter 11 © 2007 by Nelson, a division of Thomson Canada Limited.

2. Measuring and Rewarding Performance Tying the compensation system to performance measurement is essential because everyone in business recognizes that what gets measured and rewarded is what gets accomplished. Businesses must focus their reward structures to motivate employees to succeed at all activities that will create shareholder and personal value. In this highly competitive age, success comes from providing high-quality products and services at reasonable prices while generating reasonable profit margins. © 2007 by Nelson, a division of Thomson Canada Limited.

3. Learning Objectives Why should organizations use multiple performance measures to assess performance? How are return on investment (ROI) and residual income (RI) similar and different? Why has economic value added (EVA) become a popular performance measure? Why are nonfinancial measures important for evaluating performance? © 2007 by Nelson, a division of Thomson Canada Limited.

4. Learning Objectives How are activity-based costing concepts related to performancemeasurement? Why is it more difficult to measure performance in multinational firms than in solely domestic companies? How should employee rewards, including compensation, and performance be linked? How do expatriate reward systems differ from those for domestic operations? © 2007 by Nelson, a division of Thomson Canada Limited.

5. Supplementary Learning Objectives on the Web What is open-book management and why does its adoption require changes in accounting methods and practices? Why are operations of many firms becoming more diverse, and how does the increasing diversity affect the roles of the firms' accounting system? W11-1 W11-2 © 2007 by Nelson, a division of Thomson Canada Limited.

6. Measuring Organizational and Employee Performance Organizational Goals and Objectives General Rule #1: Measures should assess progress © 2007 by Nelson, a division of Thomson Canada Limited.

7. Measuring Organizational and Employee Performance General Rule #2: Persons being evaluated should have had some input in developing performance measurements and should be aware of them. © 2007 by Nelson, a division of Thomson Canada Limited.

8. Measuring Organizational and Employee Performance General Rule #3: Persons being evaluated should have appropriate skills and be provided the necessary equipment, information, and authority to be successful under the measurement system. © 2007 by Nelson, a division of Thomson Canada Limited.

9. Measuring Organizational and Employee Performance General Rule #4: Feedback relative to performance should be provided in a timely and useful manner. © 2007 by Nelson, a division of Thomson Canada Limited.

10. The Need for Multiple Measures Minimal lead time to market Satisfactory earnings Environmental social responsibility Adequate cash flow Customer satisfaction Multiple Company Goals Zero defects © 2007 by Nelson, a division of Thomson Canada Limited.

11. Balanced Scorecard A balanced scorecard ultimately links all aspects of performance to the company’s strategies. It is a performance measurement conceptualization that translates an organization's strategy into clear objectives, measures, targets, and initiatives organized by four perspectives: • financial, • customer, • internal business processes, and • learning and growth. The balanced scorecard provides a set of financial and nonfinancial measures that encompass both internal and external perspectives. © 2007 by Nelson, a division of Thomson Canada Limited.

12. Balanced Scorecard To succeed financially, how should we appear to our shareholders? Objectives Measures Targets Initiatives Financial To achieve our vision, how should we appear to our customers? Customer To satisfy shareholders and customers, what business processes must we excel at? Internal Business Process Objectives Measures Targets Initiatives Objectives Measures Targets Initiatives To achieve our vision, how will we sustain our ability to change and improve? Learning and Growth Objectives Measures Targets Initiatives © 2007 by Nelson, a division of Thomson Canada Limited.

13. Balanced Scorecard Research has shown that the strongest drivers of competitive achievement are the intangibles, especially intellectual property, innovation, and quality. If they are important, they should be measured. Some of the most important intangible assets are relationships with employees and customers. The quality of important relationships must be measured. Performance measures not only reflect strategy, they are also used for process control. Therefore, they must be based on an analysis of the company's processes, as well as an understanding of how these processes are supported by knowledge and relationships. Performance measures must be set at levels that will motivate employees to do their best. Employees must know how they are going to be evaluated. Communication of this information is essential in any performance measurement process. © 2007 by Nelson, a division of Thomson Canada Limited.

14. Need for Feedback Adjustment Performance should be monitored and feedback provided on a continuous basis. Monitor performance Feedback © 2007 by Nelson, a division of Thomson Canada Limited.

15. Financial Performance Measurements for Managers • Cash Flow • Return on Investment • Residual Income • Economic Value Added © 2007 by Nelson, a division of Thomson Canada Limited.

16. Cash Flow Statement • provides information about the cash impacts of operating, investing, and financing activities • helps managers to judge an entity’s ability to meet current fixed cash outflow commitments, undertake new commitments, and adapt to adverse changes in business conditions • assists managers in judging the quality of the entity’s earnings • can be manipulated • short-term © 2007 by Nelson, a division of Thomson Canada Limited.

17. Return on Investment (ROI) ROI = Income  Assets Return on investment – a ratio that relates income generated by the investment centre to the resources (or asset base) used to produce that income © 2007 by Nelson, a division of Thomson Canada Limited.

18. Return on Investment (ROI) or ROI = Profit Margin x Asset Turnover* IncomeSalesROI = x Sales Assets Profit margin – the ratio of income to sales Asset turnover – a ratio that measures asset productivity; it is the number of sales dollars generated by each dollar of assets during a specific period *Du Pont model © 2007 by Nelson, a division of Thomson Canada Limited.

19. Return on Investment (ROI) • Income defined • Is income defined as segment margin or operating income? • Is income defined on a before-tax or after-tax basis? • Is income defined on a before-interest or after-interest basis? • Assets defined • Should assets be defined as total asset utilized; total assets available for use; or net assets? • Should plant assets be included in the asset denominator at original cost; depreciated book value; or current values? • Should beginning, ending, or average assets be used? © 2007 by Nelson, a division of Thomson Canada Limited.

20. Return on Investment (ROI) Du Pont model – profit margin x asset turnover The Du Pont model provides refined information about organizational improvement opportunities. Profit margin indicates management's efficiency (the relation between sales and expenses). Asset turnover can be used to judge the effectiveness of asset use relative to revenue production. © 2007 by Nelson, a division of Thomson Canada Limited.

21. Return on Investment (ROI) Richmond Machine Company (Exhibit 13-3) Materials Machinery Handling Tools Segment Margin $ 2,800,000 $ 460,400 $ 653,500 Assets Invested ** 11,532,000 1,037,000 8,915,000 ROI 24.3% * 44.4% 7.3% * Profit Margin X Asset Turnover = $2,800,000 X $6,000,000 $6,000,000 $11,532,000 = .467 X .520 = .243 ** Used original cost of assets as current value was not easily determinable © 2007 by Nelson, a division of Thomson Canada Limited.

22. Return on Investment (ROI) • Division's performances (profit margin and asset turnover) • can be evaluated relative to benchmark ratios. • Benchmarks • expectations of performance • industry performance levels • similar ratios for specific competitors • ROI can be manipulated • raising selling price (if demand will not be impaired) • decreasing expenses • decreasing dollars invested in assets © 2007 by Nelson, a division of Thomson Canada Limited.

23. Return on Investment (ROI) Many companies establish target rates of return (for the company or by division). Favourable rates should mean rewards for investment centre managers. Unfavourable rates should be viewed as opportunities for improvement. If asset turnover is low, analyze inventory turnover, accounts receivable turnover, and rate of utilization measures. Identify the causes of the problem and take corrective action. When using ROI for performance evaluation consider all the relationships that determine ROI. © 2007 by Nelson, a division of Thomson Canada Limited.

24. Residual Income Residual income – the profit earned that exceeds an amount charged for funds committed to an investment centre. Residual Income = Income - (Target Rate x Asset Base) • The amount charged for funds is equal to a management specified target rate of return multiplied by the assets used by the division. • RI is concerned with dollars rather than percentages. © 2007 by Nelson, a division of Thomson Canada Limited.

25. Residual Income Richmond Machine Company Materials Machinery Handling Tools Segment Margin $ 2,800,000$ 460,400$ 653,500 Assets Invested $11,532,000 $1,037,000 $8,915,000 Targeted ROI x 12% x 12% x 12% $ 1,383,840$ 124,440$1,069,800 RI $1,416,160 $ 335,960 $ (416,300) ========= ======== ======== © 2007 by Nelson, a division of Thomson Canada Limited.

26. Limitations of ROI and RI • Problems related to income • Income can be manipulated on a short-run basis • All investment centers must use the same accounting methods • Does not consider cash flows • Does not consider time value of money © 2007 by Nelson, a division of Thomson Canada Limited.

27. Limitations of ROI and RI • Problems related to asset base • Some asset investment values are difficult to measure; others are not capitalized (R & D) • Some investments may not have been authorized by the current manager • Inflation causes investment book values to be understated unless they are price-level adjusted © 2007 by Nelson, a division of Thomson Canada Limited.

28. Limitations of ROI and RI Measures how well a profit center performs without regard to corporate objectives, which can result in suboptimization Richmond Machine Company Materials MachineryHandlingTools ROI 24.3%44.4%7.3% RI $1,416,160$335,960$(416,300) © 2007 by Nelson, a division of Thomson Canada Limited.

29. Limitations of ROI and RI Richmond Machine Company (continued) Which division(s) would be willing to invest in a new project with an expected ROI of 15% a. if performance evaluation was based on ROI? b. if performance evaluation was based on RI? c. What is the company's desired rate of return? a. Tools. Machinery and Materials Handling would not accept the project as it would reduce their ROI. b. All three divisions as the investment would increase RI. c. 12% is the percent indicated by the calculation of RI © 2007 by Nelson, a division of Thomson Canada Limited.

30. Economic Value Added The trend in performance measurement is the development of measures intended to align the interest of common shareholders and managers more directly. Leading this trend is economic value added (EVA). EVA is a measure of net income produced above the cost of capital*. The difference between RI and EVA is that the target rate of return for EVA is applied to capital invested** in the division rather than market value or book value of assets. Also, EVA uses after-tax income (the amount available to shareholders). *cost of capital – the weighted-average cost of capital (Web chapter 13) **capital invested – the market value of total equity and interest-bearing debt. © 2007 by Nelson, a division of Thomson Canada Limited.

31. Economic Value Added Economic Value Added (EVA) – After-tax Income - (Cost of capital % x Capital invested) From Exhibit 11-7: EVA = $1,942,710 - (0.12 x $45,000,000) = $(3,457,290) © 2007 by Nelson, a division of Thomson Canada Limited.

32. Nonfinancial Performance Measures Nonfinancial performance measures (NFPMs) – statistics on activities such as on-time delivery, manufacturing cycle time, set-up time, defect rate, number of unplanned production interruptions, and customer returns. • include the other three parts of the balanced scorecard • customer measures • internal business process measures • learning and growth measures • directly measure performance in the activities that create customer satisfaction and shareholder wealth © 2007 by Nelson, a division of Thomson Canada Limited.

33. Nonfinancial Performance Measures • Selection of nonfinancial measures • Identify critical success factors • Select attributes relating to measurement of critical success factors for continuous improvement (short- and long-run) • Can be qualitative or quantitative • Focuses on the activities that can improve the future • Establishment of comparison bases © 2007 by Nelson, a division of Thomson Canada Limited.

34. Nonfinancial Performance Measures • Benchmarks can be developed internally or determined from • external sources, such as other companies (regardless of • whether they are within the company's industry). • Employees must agree to • accept responsibility for performance • be evaluated • Monitoring and reporting performance levels should be carried • out at appropriate intervals – lower-level measures more • frequently than upper-level measures. Measures addressed • by middle-level employees are linkages between lower-level • and upper-level measures. © 2007 by Nelson, a division of Thomson Canada Limited.

35. Nonfinancial Performance Measures • Nonfinancial measures are superior, but they are not • always effective • there must be a causal relationship between • measures and strategy • links to strategy must be proven or validated • amount of periodic improvements must be made • explicit • metrics need to be employed that have statistical • validity and reliability © 2007 by Nelson, a division of Thomson Canada Limited.

36. Process Quality Yield Manufacturing Cycle Efficiency Process Productivity Throughput = x x Throughput Synchronous management – all endeavours that help an organization achieve its goals Intent is to increase throughput while reducing inventory and operating expenses Throughput – the rate at which a company generates cash from selling products and services to customers components of throughput © 2007 by Nelson, a division of Thomson Canada Limited.

37. Throughput Example Worked 15,000 hours Value-added – 6,000 hours Units started, completed and sold – 30,000 units Good units – 7,000 units Throughput = Good units / Total time Throughput = 27,000 / 15,000 = 1.80 units OR, using the expanded version © 2007 by Nelson, a division of Thomson Canada Limited.

38. Process Quality Yield Manufacturing Cycle Efficiency Process Productivity Throughput = x x Throughput Example © 2007 by Nelson, a division of Thomson Canada Limited.

39. Manufacturing Cycle Efficiency MCE = Value-added Processing Time Total Time MCE = 6,000  15,000 = 40% The manufacturing cycle efficiency is the proportion of total processing time from beginning of production to completion that is value added time (relates to activities that increase the product's worth to the customer). © 2007 by Nelson, a division of Thomson Canada Limited.

40. Process Productivity Process productivity – the total units produced during a period using value-added processing time Process Productivity = Total Units Value-Added Processing Time Process Productivity = 30,000  6,000 = 5.0 © 2007 by Nelson, a division of Thomson Canada Limited.

41. Process Quality Yield Process Quality Yield = Good Units Total Units Process Quality Yield = 27,000  30,000 =90% Process quality yield – the proportion of good units that resulted from the activities expended (reflects the quality of the production process) © 2007 by Nelson, a division of Thomson Canada Limited.

42. Throughput Throughput = .40 x 5.0 x .9 =1.80 units The division produced and sold only 1.80 good units for every hour of total actual processing time. This is quite different from the 5.0 units indicated as process productivity. Increase throughput by decreasing non-value-added activities. © 2007 by Nelson, a division of Thomson Canada Limited.

43. Quality Indicators Cost of Quality Classifications Measures Prevention Hours of quality training Appraisal Number of inspections Internal failure Number of pieces rejected External failure Number of customer complaints Drive down costs of appraisal and internal and external failure by investing in prevention. Suggestion programs can be effective in pointing out opportunities for continuous improvement. © 2007 by Nelson, a division of Thomson Canada Limited.

44. ABC and Performance Measurement • Traditional performance measurements include non-value-added activities • Non-value-added activities must be removed from performance evaluation measurements • Value-added activities must be substituted • Stresses external performance measurements © 2007 by Nelson, a division of Thomson Canada Limited.

45. Traditional Performance Measures and Results • Purchase price variance • Action • Purchasing increases order quantity to get a lower price. • They ignore quality and speed of delivery. • Purchasing acquires inferior quality materials to generate a favourable price variance. • Result • Excess inventory, increased carrying cost; suppliers with • the best quality and delivery are overlooked • Production quality suffers and customers receive inferior • goods © 2007 by Nelson, a division of Thomson Canada Limited.

46. Traditional Performance Measures and Results • Machine Utilization Percentage • Action • Supervisor requires employees to produce more than daily unit requirements to maximize machine utilization percentage • Result • Excess inventory; wrong inventory © 2007 by Nelson, a division of Thomson Canada Limited.

47. Traditional Performance Measures and Results • Scrap Built into Standard Cost • Action • Supervisor takes no action if there is no variance • (from the lax standard) • Result • Inflated standard; scrap threshold built in © 2007 by Nelson, a division of Thomson Canada Limited.

48. Traditional Performance Measures and Results • Overhead Rate Based on Expected Capacity • Action • Supervisor overproduces WIP or FG to have a • favourable fixed overhead volume variance • Result • Excess inventory © 2007 by Nelson, a division of Thomson Canada Limited.

49. Traditional Performance Measures and Results • Responsibility Centre Reporting • Action • Management focus is on responsibility centres instead • of activities • Result • Missed cost reduction opportunities because common • activities among responsibility centres are overlooked © 2007 by Nelson, a division of Thomson Canada Limited.

50. Performance Evaluation in Multinational Settings • Recognize differences in comparing multinational units • Culture and economies • Accounting standards and reporting practices • Government regulations • Investment base may differ substantially; assign different target rate to compute residual income • Consider trade tariffs, income tax rates, currency fluctuations, restrictions on transfer of goods and currency © 2007 by Nelson, a division of Thomson Canada Limited.