Performance Measurement, Compensation, and Multinational Considerations

Performance Measurement, Compensation, and Multinational Considerations
Chapter 23
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Learning Objective 1
Measure performance from a financial and a nonfinancial perspective.
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Financial and Nonfinancial Performance Measures

Companies are supplementing internal financial measures with measures based on: External financial information Internal nonfinancial information External nonfinancial information
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Some organizations present financial and nonfinancial performance measures for their subunits in a single report the balanced scorecard.
Most scorecards include: profitability measures customer-satisfaction measures
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internal measures of efficiency, quality, and time innovation measures
Some performance measures have a long-run time horizon. Other measures have a short-run time horizon.
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Design an accounting-based performance measure.
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Accounting-Based Performance Measure

Step 1: Choose performance measures that align with top managements financial goal(s). Step 2: Choose the time horizon of each performance measure in Step 1. Step 3: Choose a definition for each.
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Accounting-Based Performance Measure

Step 4: Choose a measurement alternative for each performance measure in Step 1. Step 5: Choose a target level of performance. Step 6: Choose the timing of feedback.
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Accounting-Based Performance Measure Example

Relax Inns owns three small hotels one each in Boston, Denver, and Miami. At the present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels.
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Boston Hotel
Current assets $350,000 Long-term assets 550,000 Total assets $900,000 Current liabilities $ 50,000
Revenues $1,100,000 Variable costs 297,000 Fixed costs 637,000 Operating income $ 166,000
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Denver Hotel
Current assets $ 400,000 Revenues $1,200,000 Long-term assets 600,000 Variable costs 310,000 Total assets $1,000,000 Fixed costs 650,000 Current liabilities $ 150,000 Operating income $ 240,000
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Miami Hotel
Current assets $ 600,000 Revenues $3,200,000 Long-term assets 5,000,000 Variable costs 882,000 Total assets $5,600,000 Fixed costs 1,166,000 Current liabilities $ 300,000 Operating income $1,152,000
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Total current assets Total long-term assets Total assets Total current liabilities Long-term debt Stockholders equity Total liabilities and equity $1,350,000 6,150,000 $7,500,000 $ 500,000 4,800,000 2,200,000 $7,500,000
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Approaches to Measuring 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.
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Analyze return on investment (ROI) using the DuPont method.
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Return on Investment
Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment. Return on investment (ROI) = Income Investment
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Return on Investment
What is the return on investment for each hotel?
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%
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DuPont Method
The DuPont method of profitability analysis recognizes that there are two basic ingredients in profit making: 1. Using assets to generate more revenues 2. Increasing income per dollar of revenues
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DuPont Method
Return on sales = Income Revenues
Investment turnover = Revenues Investment ROI = Return on sales Investment turnover

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DuPont Method
How can Relax Inns attain a 30% target ROI 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%
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DuPont Method
Alternative A: Decrease assets, keeping revenues and operating income per dollar of revenue constant. Revenues Total assets = $1,200,000 $800,000 = 1.50 1.50 0.20 = 30%
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DuPont Method
Alternative B: Increase revenues, keeping assets and operating income per dollar of revenues constant. Revenues Total assets = $1,500,000 $1,000,000 = 1.50 Operating income Revenues = $300,000 $1,500,000 = 0.20 1.50 0.20 = 30%
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DuPont Method
Alternative C: Decrease costs to increase operating income per dollar of revenues, keeping revenues and assets constant. Revenues Total assets = $1,200,000 $1,000,000 = 1.20 Operating income Revenues = $300,000 $1,200,000 = 0.25 1.20 0.25 = 30%
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Use the residual-income (RI) measure and recognize its advantages.
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Residual Income
Residual income (RI) = Income (Required rate of return Investment) Assume that Relax Inns required rate of return is 12%. What is the residual income from each hotel?
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Residual Income
Boston Hotel: Total assets $900,000 12% = $108,000 Operating income $166,000 $108,000 = Residual income $58,000 Denver Hotel = $120,000
Miami Hotel = $480,000

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Describe the economic value added (EVA) method.
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Economic Value Added

Economic value added (EVA) = After-tax operating income
[Weighted-average cost of capital

(Total assets current liabilities)]
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Total assets minus current liabilities can also be computed as: Long-term assets + Current assets Current liabilities, or Long-term assets + Working capital
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Economic value added (EVA) substitutes the following specific numbers in the RI calculations: 1. Income equal to after-tax operating income 2. A required rate of return equal to the weighted-average cost of capital 3. Investment equal to total assets minus current liabilities
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Economic Value Added Example

Assume that Relax Inns has two sources of long-term funds: 1. Long-term debt with a market value and book value of $4,800,000 issued at an interest 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%.
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What is the after-tax cost of capital? 0.10 (1 Tax rate) = 0.07, or 7%
Assume that Relax Inns cost of equity capital is 14%. What is the weighted-average cost of capital?
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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%
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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
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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
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What is the weighted-average cost of capital times 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
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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 cost of their investments in long-term assets and working capital.
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Return on Sales
The income-to-revenues (sales) ratio, or return on 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%
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Comparing Performance
Hotel Boston Denver Miami ROI 18% 24% 21% RI $ 58,000 $120,000 $480,000 EVA $ 26,950 $ 78,750 $249,900 ROS 15% 20% 36%
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Comparing Performance
Methods Ranking
Hotel Boston Denver Miami ROI 3 1 2 RI 3 2 1 EVA ROS 3 3 2 2 1 1
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Contrast current-cost and historical-cost asset measurement methods.
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Choosing the Time Horizon

The second step of designing accounting-based performance measures is choosing the time horizon of each performance measure. Many companies evaluate subunits on the basis of ROI, RI, EVA, and ROS over multiple years.
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Choosing Alternative Definitions

The third step of designing accounting-based performance 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.
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2. Total assets employed includes total assets available 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.
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4. Stockholders equity using in the Resorts Inns example requires allocation of the long-term liabilities to the three hotels, which would then be deducted from the total assets of each hotel.
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Choosing Measurement Alternatives

The fourth step of designing accounting-based performance measures is choosing a measurement alternative for each performance measure. The current cost of an asset is the cost now of purchasing an identical asset to the one currently held. Historical-cost asset measurement methods generally consider the net book value of the asset.
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The fifth step of designing accounting-based performance measures is choosing a target level of performance. Historical cost measures are often inadequate for measuring economic returns on new investments and sometimes create disincentives for expansion.
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The sixth step of designing accounting-based performance measures is choosing the timing of feedback. Timing of feedback depends largely on how critical the information is for the success of the organization. specific level of management involved. sophistication of the organization.
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Indicate the difficulties when comparing the performance of divisions operating in different countries.
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Multinational Companies Example

Assume that Relax Inns invests in a hotel in Acapulco, Mexico. The exchange rate at the time of the investment on December 31, 2002, is 8 pesos = 1 dollar.
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During 2003, the Mexican peso suffers a 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

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The investment (total assets) in Acapulco = 32,000,000 pesos. The operating income of the Acapulco Hotel in 2003 is 6,200,000 pesos. What is the return on investment in pesos?
6,200,000 32,000,000 = 19.4%

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What is the return on investment in dollars? 6,200,000 10 = $620,000 operating income
32,000,000 8 = $4,000,000 investment

$620,000 $4,000,000 = 15.5% This is lower than the Boston ROI of 18%.
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Recognize the role of salaries and incentives when rewarding managers.
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The Basic Trade-off
Most often, a managers total compensation includes some combination of salary and a performance-based incentive.
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Describe the management accountants role in helping organizations design better incentive systems.
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Intensity of Incentives
How large should the incentive component be relative to salary? Preferred performance measures are ones that are sensitive to, or change significantly, with the managers performance.
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Benchmarks
Owners can use benchmarks to evaluate performance. Benchmarks representing best practice may be available inside or outside the organization.
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Measuring
Obtaining performance measures that are more sensitive to employee performance is critical for implementing strong incentives. Many management accounting practices, such as the design of responsibility centers and the establishment of financial and nonfinancial measures, have as their goal better performance evaluation.
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End of Chapter 23
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Performance Measurement, Compensation, and Multinational Considerations

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Performance Measurement, Compensation, and Multinational Considerations

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Performance Measurement, Compensation, and Multinational Considerations

Measure performance from a financial and a nonfinancial perspective.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Financial and Nonfinancial Performance Measures

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Financial and Nonfinancial Performance Measures

Financial and Nonfinancial Performance Measures

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Design an accounting-based performance measure.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Accounting-Based Performance Measure

Accounting-Based Performance Measure

Accounting-Based Performance Measure Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Accounting-Based Performance Measure Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Accounting-Based Performance Measure Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Accounting-Based Performance Measure Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Accounting-Based Performance Measure Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Approaches to Measuring Performance

Residual income (RI)

Analyze return on investment (ROI) using the DuPont method.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Investment turnover = Revenues Investment ROI = Return on sales Investment turnover

Use the residual-income (RI) measure and recognize its advantages.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Miami Hotel = $480,000

Describe the economic value added (EVA) method.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Economic Value Added

[Weighted-average cost of capital

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Economic Value Added

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Economic Value Added

Economic Value Added Example

Economic Value Added Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Economic Value Added Example

Economic Value Added Example

Economic Value Added Example

Economic Value Added Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Economic Value Added Example

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

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

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Contrast current-cost and historical-cost asset measurement methods.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Choosing the Time Horizon

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Choosing Alternative Definitions

Choosing Alternative Definitions

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Choosing Alternative Definitions

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Choosing Measurement Alternatives