Chapter 19 Measuring and Rewarding Organizational Performance Questions Performance measurement is necessary to gauge whether a firm is pursuing its goals and objectives successfully Without performance measurement systems, managers, shareholders, and others would have no basis to assess the success of operations or whether operations were being conducted efficiently A mission statement expresses the organization’s purposes and identifies how the organization will meet its customers’ needs through its products or services Alternatively, a vision statement expresses where the organization wants to be in the future The former is more short run oriented than the latter and should change periodically as customer preferences change A values statement helps provide information on the firm’s organizational culture It indicates the areas of organizational importance so that employees can internalize these beliefs and values Organizational strategies and missions are devised to achieve the goals and objectives of a firm Control systems, including systems of performance measurement, are created to implement the missions and strategies of firms In the absence of benchmarks, the performance measurements will not be meaningful The performance measurements can be interpreted only when they are compared to benchmark measurements such as industry performance or a firm’s historical performance measurements Performance measures have a role in • assessing organizational performance, • relating organizational goals and missions to managerial performance, • fostering the growth of subordinate managers, • motivating managers, • enhancing organizational communication, • evaluating comparative managerial performance, and • implementing organizational control 247 248 Chapter 19 Measuring and Rewarding Organizational Performance Capital is one of the important resources that firms must manage effectively and efficiently If they fail to so, firms will be unable to attract the capital, at a reasonable cost, that is necessary to fund growth opportunities Demonstrating to capital markets that the firm has been successful in managing money is necessary to attract capital Specific products and subunits are uniquely designed to compete in their markets Further, every market has unique competitive dimensions, e.g., quality, price, functionality Managers must have the information that allows them to compete effectively on all competitive dimensions Thus, this information is necessary to deploy organizational resources to yield the maximum benefit Only by linking managerial rewards to performance is the welfare of managers linked to their success in achieving organizational goals and objectives Because the goals and objectives of the firm are reflected in the performance measurements, the performance measurements are, in a sense, reflections of managers’ contributions to the achievement of the organization’s goals and objectives By linking rewards to the performance measurements, managers are made to be vitally concerned with achieving those goals and objectives In selecting bases for performance measurement, managers should consider: * whether the measures capture progress toward organizational goals, * the input of those being evaluated, * whether proposed measures are appropriate for the skills and authority of those being evaluated, and * methods to provide appropriate feedback on performance 10 Performance measures should be both The measures chosen must be reasonable proxies for the organization's critical success factors, many of which are not easily captured by financial or other quantitative measures For example, to capture performance in the dimensions of customer service, product and service quality, product innovation, advancement in job skills, and effectiveness in communications, managers need to employ qualitative measures 11 No The measure must be consistent with the span of authority and responsibility of the given manager This mandates that different responsibility centers be evaluated using different measures Further, the chosen measures must be consistent with the time horizon of decisions made by the manager Chapter 19 Measuring and Rewarding Organizational Performance 249 12 The balanced scorecard is a conceptual approach to measuring performance that weighs performance from four perspectives Managers choosing to apply the balanced scorecard are demonstrating a belief that traditional financial performance measures alone are insufficient to assess how the firm is doing and what specific actions must be taken to improve performance The four perspectives in the balanced scorecard are financial, customers, learning/innovation, and internal process improvements 13 It is expected that people will act specifically in accordance with how they are measured Thus, individuals must know of and understand the performance measures used, so that managers can make decisions in light of the effects of alternative choices on the performance measures Managers allowed to participate in the development of the measures by which their performance is assessed are more likely to accept the performance measures as valid and fair and to understand how their actions influence the measures 14 Feedback critical needs to Positive 15 The traditional performance evaluation measures for cost centers are standard cost variances Traditional measures for revenue centers are deviations from budgeted revenues Historically, these measures have been used because they are consistent with a financial evaluation of performance 16 Manipulation is an important concern because performance measures should be designed to capture only real performance and not manipulation of the performance measure If a performance measure can be manipulated by managers, then managers can achieve a high level of measured performance by either performing very well or by manipulating the measure External measures are far superior to interior measures in this respect because they are not susceptible to internal manipulation is critical to improving performance Negative or feedback provides information about what the manager change It provides a focus for improvement feedback confirms what the manager is doing well 250 17 Chapter 19 Measuring and Rewarding Organizational Performance Net cash flow from operations, conceptually, measures the same thing as net income It may therefore be a useful measure in a profit center or an investment center The only difference between net cash flow from operations and accounting income are accounting accruals Because many accounting accruals are susceptible to manipulation by managers, net cash flow is less prone to manipulation than alternative accounting measures However, it is not beyond manipulation because cash flow can be manipulated to some extent by manipulating the timing of cash receipts and cash disbursements It is best if both an accounting income and a net cash flow measure are used to evaluate performance Each measure provides a quality standard for the other measure Like accounting income, net cash flow from operations is a short-term measure and provides no long-term incentives This is its most significant weakness 18 No Although both measures provide information that explains the change in the cash balance for the period, they are otherwise very different The Statement of Cash Flows provides information about the sources and uses of cash according to three major categories of business activities: operating, investing, and financing The Statement of Cash Flows complements information on the income statement (operating cash flows) Alternatively, the cash budget is an internal tool only; it is not a published external financial statement The purpose of the cash budget is to provide information for the management of cash In particular, the cash budget helps the firm maintain liquidity by highlighting periods of cash shortages, and the need to invest during periods of cash surpluses 19 In defining "income," managers have several major concerns that need to be addressed: * Is the measure wholly controllable by the person being evaluated? * Is the measure susceptible to manipulation by the manager? * Does the measure balance long-term and short-term incentives? * Is the measure sufficiently related to overall organizational goals? 20 The major difference between a profit and an investment center is that the investment center has control over costs, revenues, and the level of assets that is employed Accordingly, investment centers need to be evaluated based on their profitability relative to the value of assets used Profit centers have no responsibility for assets and can be evaluated based on profit alone Chapter 19 Measuring and Rewarding Organizational Performance 251 21 The Du Pont model is a formulation of the ROI ratio In the Du Pont model, ROI is the product of profit margin multiplied by asset turnover Each component ratio provides information on a distinct dimension of performance The profit margin measures how much of each sales dollar is turned into profit; the asset turnover ratio is a measure of asset utilization and captures how many dollars of asset investment are required to generate each dollar of sales 22 Residual income, RI, is a derivative of ROI In many respects the relationship between ROI and RI is parallel to the relationship between net present value, NPV, and internal rate of return, IRR RI provides a dollar measure of divisional achievement whereas ROI provides a percentage measure of achievement The principal strength of RI is that it creates fewer problems with suboptimization than ROI In particular RI minimizes the suboptimization problems associated with ROI in an environment where ROI varies substantially across the divisions in a company Economic value added, EVA, is similar to RI The major distinction is that EVA uses invested capital as the asset base and the company’s cost of capital as the target rate of return This measure should more nearly correlate with effects on shareholder value than RI 23 They have three primary limitations: * Each is subject to manipulation in terms of both the income measurement and the asset measurement * It is frequently difficult to obtain viable proxies for both income and asset measures * Both provide incentives at the division level only There is no integration of division and organizational goals in using these measures alone 24 A weakness of the residual income measure is that it is typically computed using book values of assets rather than market values and the target rate of return is not necessarily the cost of capital Economic value added is conceptually similar to residual income in its computations but utilizes a market measure of asset value and applies a target return rate that reflects the cost of capital Economic value added computations also include the effects of income taxes, which are normally excluded in computing residual income 252 25 Chapter 19 Measuring and Rewarding Organizational Performance Suboptimization may be created in using ROI because the divisional ROIs differ from the overall organization's ROI In such a circumstance, a division may invest (fail to invest) in new assets when, from the perspective of the overall organization's ROI, it would have been better not to invest (to invest) ROI is most likely to create a suboptimization problem in firms that have target and achieved levels of ROI that vary substantially from one division to another This problem is likely to be minimized when there is little variance among all the divisions' ROIs 26 Qualitative measures are sometimes difficult to use in performance evaluation because the individuals being measured see those factors as subjective and “fuzzy.” Additionally, these measures may need to be varied from person to person or group to group because of individual or team differences that create noncomparability 27 These advantages are listed in Exhibit 19-7 28 Bases of comparison are necessary because a performance measurement is meaningless unless it can be interpreted as good, average, or poor performance The comparison base is used as the benchmark against which actual performance is compared 29 Throughput is defined relative to units sold rather than produced because producing units that are not currently in demand generates no revenue or profit from customers Thus, goods only create value for the firm when they are sold 30 Multinational companies have to deal with substantially more issues than companies operating only in a single country Among the important factors that may vary from country to country are culture, religion, labor laws, tax laws, work ethic, individual freedoms, market stability, political stability, inflation and exchange rates, financing costs, and consumer wealth In designing performance evaluation measures, organizational goals as well as local conditions and constraints must be considered Thus, performance measures (regardless of whether they are financial or nonfinancial) should be tailored to fit local circumstances 31 Strategies are successfully implemented only if employees and managers are provided with correct incentives The reward structure is the source of motivation for managers and other employees to implement corporate strategies Chapter 19 Measuring and Rewarding Organizational Performance 253 32 The performance measurement and reward strategy for each level of management must be consistent with the level of responsibility and authority given to each level and the contribution required of each individual manager Although the reward must be consistent with achievement of overall goals, it must also consider the individual contributions of the managers and how effective they were in their sphere of control Also, managers at higher levels are required to be more long-term oriented and managers at lower levels are required to be more short-term oriented The performance and reward system must recognize these differences 33 To remain competitive, there has been a shift in American industry toward performance-based compensation This shift can be attributed to two factors First, workers are becoming more and more removed from the actual production activities because of automation This change makes it more difficult to base compensation on direct observation Second, there is an effort to develop a tighter linkage between pay and reward to make workers more goal oriented and make them more aware of the contribution that is required of them for the organization to be successful 34 The outcome is suboptimization When performance measures and rewards of the individual, the organization, and its segments are compatible, workers maximize achievement of the organization’s goals in pursuing achievement of their individual goals When the performance measures and reward system of individuals are only loosely correlated with the organization’s goals, achievement of the individual’s goals may not result in achievement of the organization’s goals 35 There must be consistency between the time perspective of the reward system and the performance measurement system If the time perspective of a performance-based pay plan is long-term, then the organization must select performance measures that capture long-term performance Otherwise, suboptimization will result because achievement of performance targets will not necessarily result in achievement of the desired performance for the desired time frame 36 The organizational mission of each subunit can be unique If so, the performance measures of each subunit should also be unique For example, if one subunit has a build mission and another subunit has a harvest mission, the former’s performance measures should concentrate on market share and sales growth The latter’s performance measures should concentrate on profit and cash flow performance 254 37 Chapter 19 Measuring and Rewarding Organizational Performance As workers get older, their needs and goals change Young workers are likely to have a very long-term orientation; older workers have a shorter term orientation-up to retirement age Further, as workers age, their monetary needs may diminish as other needs (job security, for example) become more important 38 Workers may shirk Shirking occurs when employees perceive their share of the group's reward as being inadequate to compensate them for their effort This occurs because the entire group splits the benefits of a single worker's effort, whereas the individual worker bears all of the costs of the effort 39 In a performance-based pay plan, workers are evaluated based on their achieved output The performance-based evaluations are riskier because the output of any production process is partly determined by factors beyond the control of the worker Thus, workers’ compensation is partly determined by these factors which are beyond the workers’ control This makes performance-based pay riskier than pay based on workers’ inputs 40 If managers were also major shareholders, there would be a natural consistency between their actions as managers and their actions as shareholders However, when managers and shareholders are different individuals, there is no natural compatibility in their goals and actions Consequently, performance measures must be devised that cause managers to act in the best interest of shareholders To be effective, the performance measures must be highly correlated with shareholders’ objective of wealth maximization 41 Performance-based rewards create risks for managers and employees because part of the measured performance will be attributable to factors beyond the control of the managers and workers The uncontrollable factors affect the measured performance but their effects on performance cannot be managed by the employees and workers 42 Feedback provides information to (1) improve the reward system and (2) take action to improve future performance See Exhibit 19-12 for a graphical display of both feedback loops 43 When employees hold stock, they will have personal incentives to act in the best interest of the stockholders By providing employees with stock, managers are creating a natural incentive-compatible alliance between the employees and the stockholders of the firm As stockholders, workers are likely to develop a broad view of the organization, rather than viewing the organization relative to their narrow roles as employees 44 Financial performance measures are more appropriate for short- Chapter 19 Measuring and Rewarding Organizational Performance 255 term performance measurement To measure long-term performance, the better measures are often nonfinancial For example, profit generated is a good short-term performance measure, but a poor long-term measure Growth in market share is a better indicator of long-term performance The time horizon of the performance measures is linked to the subunit mission For example, performance measures should be long term for growth missions and short term for harvest missions 45 Income taxes must be taken into account because employees can only spend after-tax income By minimizing taxes, employees and employers can maximize the after-tax amount of compensation The alternative tax treatments, ordered from least to most preferred, are fully and currently taxable, tax deferred, and tax exempt 46 Equity in the reward structure must be maintained from the top of the organization to the bottom Equity requires a consideration of the relative pay of top managers versus lower-level managers and workers Ultimately, an equitable pay structure must balance the entitlement of labor, management, and capital A consideration of equity also requires that the reward system be sensitive to local differences (including living costs and tax effects) in global organizations Currently, it could easily be argued that U.S firms have relatively inequitable reward systems The inequity results from the large disparity between average worker pay and top executive pay Equity is necessary in the longer run to keep all stakeholders motivated 47 In addition to the usual concerns, global enterprises must address local tax differences, fluctuations in currency rates, and local cost of living differences Exercises 48 a b c d e f g h i 12 10 11 j k l m n o p q 13 14 15 16 17 49 Chapter 19 Measuring and Rewarding Organizational Performance Division 1: $ 50,000 ÷ $ 200,000 = 25% Division 2: $150,000 ÷ $1,000,000 = 15% Division 3: $400,000 ÷ $4,000,000 = 10% 50 a ROI = = = = b Profit margin = Income ÷ Sales = $900,000 ÷ $13,200,000 = 6.82% rounded c Asset turnover = Sales ÷ Assets invested = $13,200,000 ÷ $3,600,000 = 3.67 rounded d ROI = Asset turnover × Profit margin = 3.67 ì 6.82% = 25.03% 256 Income ữ Assets Invested ($13,200,000 - $12,300,000) ÷ $3,600,000 $900,000 ÷ $3,600,000 25% Note that (a) and (d) differ due to rounding error 51 52 a Asset Turnover = Sales ÷ Average Assets = $1,200,000 ÷ Average Assets Average Assets = $1,200,000 ÷ Average Assets = $300,000 b Profit Margin = Segment Margin ÷ Sales 08 = Segment Margin ÷ $1,200,000 Segment Margin = $96,000 c ROI = 8% × = 32% Revenue Expenses Income Target return (.12 × $11,200,000) Residual income $30,000,000 (28,000,000) $ 2,000,000 (1,344,000) $ 656,000 Yes, because the residual income is positive, the division met its target return Chapter 19 Measuring and Rewarding Organizational Performance 262 Problems 65 a Sales Variable costs CM Fixed costs Pretax income Actual Amounts $6,500,000 (4,875,000) $1,625,000 (1,205,000) $ 420,000 Flexible Budget $6,500,000 (4,550,000) $1,950,000 (1,200,000) $ 750,000 Master Budget $6,000,000 (4,200,000) $1,800,000 (1,200,000) $ 600,000 100% 70% 30% The data show that the actual pretax income fell short of the expected amount by $180,000 ($600,000 $420,000) This occurred despite the fact that the actual level of sales exceeded the expected level by $500,000 The higher level of sales would have generated an additional $150,000 of income ($750,000 - $600,000) if costs and prices would have been maintained at the budgeted level However, this effect was overwhelmed by either a lower per unit sales price or a higher per unit variable cost The budgeted contribution margin was to be 30% of sales The actual contribution margin was only 25% of sales ($1,625,000 ÷ $6,500,000) Without knowing the number of units that were sold, the price and variable cost effects cannot be disentangled By having the actual CM drop by 5%, pretax profits were lowered by $325,000 ($1,950,000 - $1,625,000) This is the principal cause of the drop in profits A more minor effect was the increase in fixed costs These exceeded the budgeted level by $5,000 These differences can be summarized as follows: Effect of increase in volume $ 150,000 Effect of decrease in CM% (325,000) Effect of increase in fixed costs (5,000) Net effect on pretax income $(180,000) Chapter 19 Measuring and Rewarding Organizational Performance 66 67 263 b Complete income statements provide more information for isolating the cause of differences between the budgeted and expected levels of income By comparing only the actual and budgeted levels of pretax income, nothing is learned about the cause of the difference a Accrual accounting measures are subject to manipulation Some of the more common manipulations involve increasing or decreasing the level of discretionary expenses such as maintenance and advertising; increasing or decreasing production relative to sales; manipulating sales and purchases around a period's cutoff date; and manipulating estimates involving the life of assets, pension and retirement obligations, and costs of settling legal obligations b No The cash measure is just as subject to manipulation For example, cash can be manipulated by adjusting policies for credit sales, adjusting policies for retiring accounts payable, and advancing or delaying the payment of expenses around cutoff dates c If any two measures are less than 100% correlated (in other words, the two items measure different things), then a combination of the two measures will be less subject to manipulation than either is separately Such is the case with cash flow and accrual income; some of the sources of manipulation can be identified, and a more complete picture of segment performance will be presented d Yes In theory, the accrual income probably provides a better gauge of long-term profitability and is perhaps a better predictor of future cash flows The annual cash flow measure provides more information on liquidity, cash management, and the policies for credit sales and purchases e Yes One possibility would be to utilize a more detailed budgeted income statement Such a statement would facilitate a line-by-line comparison with actual performance This comparison would yield more information on both performance and manipulation a Analysis of the statement reveals a strong positive cash flow from operations that has permitted acquisitions, dividend payouts and debt reductions for the three years b Revised Original 2003 Budget 2003 Budget Net cash flows from Operating Chapter 19 Measuring and Rewarding Organizational Performance Activities: Net income $ 45,100 $ 45,100 Add reconciling items 4,000 4,000 Total $ 49,100 $ 49,100 Net cash flows from Investing Activities: Sale (purchase) of PP&E $(54,600) $ (4,600) Sale (purchase) of investments 18,400 (15,800) Other inflows (outflows) 2,400 2,400 Total $(33,800) $(18,000) Net cash flows from Financing Activities: Issuing notes for cash $ (7,000) $ (7,000) Paying dividends (8,000) (20,000) Total $(15,000) $(27,000) Net increase (decrease) in cash $ 300 $ 4,100 264 68 c No, the net increase in cash will be only $300 The company would have to settle for that or change plans d The above comparison can quickly give the president an overview of the impact of the $50,000 LAN project From the comparison, she can decide whether she is satisfied with the proposed changes in cash flows By observing the cash flow effects of a particular project within the context of all of the other cash flows of the entity, the decision maker gains an appreciation of the significance of the project and of the entity's ability to implement the project a Actual income: $28,250,000 - $25,885,000 = $2,365,000 Average assets: ($10,200,000 + $12,300,000) ÷ = $11,250,000 Profit margin = $2,365,000 ÷ $28,250,000 = 8.37% Asset turnover = $28,250,000 ữ $11,250,000 = 2.51 ROI = 2.51 ì 8.37% = 21% For 2003, the stores slightly outperformed the industry The better performance was attributable to a higher profit margin that dominated a slightly lower asset turnover b Because the stores are already operating above industry norms on profit margin, corporate management should concentrate on improving the asset turnover ratio Asset turnover can be improved by either increasing sales or decreasing assets However, overall, the stores are already exceeding the industry ROI so management must be careful not to decrease profit margin while they strive to increase sales or decrease assets c The advantage of setting performance measures at the beginning of the year is that management knows what the Chapter 19 Measuring and Rewarding Organizational Performance 265 benchmark figures are as the year unfolds The main disadvantage is that targets set at the beginning of the year not control for industry level factors’ influence on results Consequently, managers will be evaluated partly on factors that they cannot control 266 69 a Chapter 19 Measuring and Rewarding Organizational Performance Sales (100,000 × $30) $3,000,000 CGS [(5,200 × $9 = $46,800) + (94,800 × $10 = $948,000)] (994,800) Gross margin $2,005,200 Expenses Shipping (100,000 × $0.50) $ 50,000 Advertising ($5,000 × 12) 60,000 Salaries 700,000 Other costs 590,000 Repairs 10,000 (1,410,000) Net income before taxes $ 595,200 Target income (0.16 × $4,500,000)$ 720,000 Projected income 595,200 Residual income $(124,800) b Sales (105,000 × $30) CGS [(15,000 × $9 = $135,000) + (90,000 × $10 = $900,000)] Gross Margin Expenses Shipping (105,000 × $.50) Advertising ($5,000 × 11) Salaries Other costs Net income $3,150,000 (1,035,000) $2,115,000 $ 52,500 55,000 694,500 590,000 (1,392,000) $ 723,000 $723,000 ÷ $4,500,000 = 16.07% return 70 c If Ms Rojas actually ships the delivery to the customer, it may anger the customer and perhaps reduce future sales to that customer Should Ms Rojas simply accrue the revenue and expense of shipping but not actually ship the goods, there is a possibility of misstating ending inventory and/or the cancellation of the sale before shipment The failure to advertise, hire a personnel manager, and make needed repairs could adversely affect future operations Finally, if Ms Rojas's manager determines that she has made such decisions for the sole purpose of obtaining her bonus, she may find herself without a job a Actual income: $12,000,000 - $11,280,000 = $720,000 Average assets: ($4,700,000 + $7,300,000) ÷ =$6,000,000 Actual turnover = $12,000,000 ÷ $6,000,000 = Actual profit margin: $720,000 ÷ $12,000,000 = 6% Actual ROI = × 6% = 12.00% The division exceeded its objective for asset turnover However, the division failed to meet the target profit margin and ROI (1.8 × 8% = 14.4%) levels Chapter 19 Measuring and Rewarding Organizational Performance 71 267 b The division needs to improve its profit margin; i.e., the amount of profit generated for each dollar of sales Part of the poor performance may be due to the large increase in assets ($7,300,000 - $4,700,000 = $2,600,000) during the year The return from the newly acquired assets is likely to be reaped in future periods rather than in the present period Consequently, although most of the expense of operating the new assets is fully reflected in income, the revenues will be realized in future periods c Income (from part a) Target return ($6,000,000 × 0.14) Residual income a Power ROI = ($12,000,000 - $10,800,000) ÷ $10,000,000 = 12% Sail ROI = ($48,000,000 - $42,000,000) ÷ $30,000,000 = 20% b The manager of Power Boats is the most likely to invest in a new project Such an investment would increase the overall ROI of the division The manager of Sailboats would not invest because the projected ROI on the new project is lower than the projected divisional ROI c Such an outcome is inconsistent with overall corporate goals Companywide, the projected ROI is ($60,000,000 $52,800,000) ÷ $40,000,000 = 18% Thus the company would probably want the manager of Sailboats to make the investment and would prefer that the manager of Power Boats reject the investment d If the division managers were evaluated on the basis of residual income, they would analyze how a new investment would affect the projected overall RI level in their divisions The projected overall changes can be found as follows: Power Boats Sailboats Projected ROI on new project 14 % 18 % Required target return 17 % 17 % Residual return (3)% % $ 720,000 ( 840,000) $(120,000) The project under evaluation by the manager of Power Boats would cause his/her overall residual income to decline by an amount equal to 3% of the cost of the investment On the other hand, the project under consideration by the manager of Sailboats would generate an overall increase in RI by 1% of the cost of the new investment 72 a Projected EVA = $1,750,000 - ($12,500,000 × 0.12) Chapter 19 Measuring and Rewarding Organizational Performance = $250,000 268 b You would not invest in the project if it would result in a decline in your overall projected EVA Therefore, the maximum amount that you would invest would be the amount that would leave your projected EVA unchanged: Pretax additional earnings $200,000 Taxes ($200,000 × 0.30) (60,000) After-tax change in earnings $140,000 Maximum investment × 12 = $140,000 Maximum investment = $140,000 ÷ 12 Maximum investment = $1,166,667 c After-tax income = $1,750,000 + $140,000 = $1,890,000 Invested capital = $12,500,000 + $1,100,000 = $13,600,000 EVA = $1,890,000 - ($13,600,000 × 12) = $258,000 73 To survive, firms need to manage effectively for both longterm survival and short-term profitability, which are separate managerial concerns Long-term survival is related to acquiring the necessary mix of inputs to remain competitive Long-term management involves the hiring and training of talented employees, acquisition of capital improvements and technology, and the execution of strategies relative to products and markets Short-term management is concerned with the effective and efficient management of resources (such as current assets) over the near term Because long-term management has different objectives than short-term management, a different set of performance measures must be used to gauge success in each area If no performance measures are geared to evaluation of long-term success, there is no incentive created for managers to be long-term oriented in their decision making By balancing performance measurement relative to time horizons, managers will be forced to consider both short-term and long-term consequences of decisions made 74 a MCE = Value-added time ÷ Total time = 16,000 ÷ 56,000 = 28.6% (rounded) b Process productivity = Total units ÷ Value-added time = 64,000 ÷ 16,000 = units per hour Chapter 19 Measuring and Rewarding Organizational Performance c Process quality yield = Good units ÷ Total units = 47,500 ÷ 64,000 = 74% (rounded) d Throughput = Good units ÷ Total time = 47,500 ÷ 56,000 = 0.85 units per hour 269 (rounded) e Yes, throughput only counts units sold, not units produced Therefore, throughput would have been considerably lower because the process yield would have been lower Throughput = Good units ÷ Total time = 22,500 ÷ 56,000 = 0.40 units per hour (rounded) f Total time – Value-added time = Non-value-added time 56,000 – 16,000 = 40,000; 40,000 × 0.80 = 32,000 new time 32,000 + 16,000 = 48,000 total time Throughput = Good units ÷ Total time = 47,500 ÷ 48,000 = 0.99 units per hour (rounded) g 64,000 × 94 = 60,160 good units (from part f) total time = 48,000 hours Throughput = Good units ÷ Total time = 60,160 ÷ 48,000 = 1.25 units per hour (rounded) h 75 Porto could determine how the NVA time was being spent by preparing a process map that would delineate all activities associated with the production of the product One recommendation would be to implement an activitybased management system that would draw attention to the NVA activities and to the costs associated with those activities No solution provided Chapter 19 Measuring and Rewarding Organizational Performance 270 Cases 76 a b The calculation of the unit contribution for Reigis Steel Division, assuming 1,484,000 units were produced and sold during the year ended November 30, 2003, is presented below Reigis Steel Division Contribution Margin For the Year Ended November 30, 2003 ($000 Omitted) Sales $25,000 Less variable costs: Costs of goods sold $16,500 Selling expenses ($2,700 × 40%) 1,080 (17,580) Contribution margin $ 7,420 $7,420 ÷ 1,484 units = $5.00 unit contribution margin Calculations of selected performance measures for 2003 for Reigis Steel Division are presented below The pretax return on average investment in operating assets employed is 12%, calculated as follows: ROI = Income from operations before taxes ÷ average operating assets = $1,845,000 ÷ $15,375,000* = 0.12 or (12%) *Average operating assets employed: ($15,750,000 + $15,000,000**) ÷ = $15,375,000 **November 30, 2002 operating assets: $15,750,000 ÷ 1.05 = $15,000,000 The calculation of residual income on the basis of average operating assets employed is as follows Residual Income = Income from operations before taxes - minimum required return on average assets = $1,845,000 - ($15,375,000 × 0.11) = $1,845,000 - $1,691,250 = $153,750 Chapter 19 Measuring and Rewarding Organizational Performance 77 271 c The management of Reigis Steel would have been more likely to accept the contemplated capital acquisition if residual income were used as the performance measure because the investment would have increased both the division's residual income and the management bonus Using residual income, management would accept all investments with a return higher than 11 percent because these investments would all increase the dollar value of residual income When using ROI as a performance measure, Reigis's management is likely to reject any investment that would lower the overall ROI (12 percent for 2003), even though the return is higher than the required minimum, because this would lower bonus awards d Reigis must be able to control all items related to profits and investment if it is to be evaluated fairly as an investment center using either ROI or residual income as performance measures Reigis must control all elements of the business except the cost of invested capital, which is controlled by Paddington Industries (CMA adapted) a Based on the conversation between Terry Travers and Bob Christensen, it seems likely that their motivation would be stifled by the variance reporting system at Aurora Manufacturing Company Their behavior may include any of the following: * suboptimization, a condition in which individual managers disregard major company goals and focus their attention solely on their own division's activities, and * frustration from untimely reports and formats that are not useful in their daily activities b * * * The benefits that can be derived by both the company and its employees from a properly implemented variance reporting system include the following: Variance analysis can provide standards and measures for incentive and performance evaluation programs Variance reporting can emphasize teamwork and interdepartmental dependence Timely reporting provides useful feedback, helps to identify problems, and aids in solving these problems Responsibility can be assigned for the resolution of problems 272 78 Chapter 19 Measuring and Rewarding Organizational Performance Aurora Manufacturing Company could improve its variance reporting system so as to increase employee motivation, by implementing the following: * Introduce a flexible budgeting system that relates actual expenditures to actual levels of production on a monthly basis In addition, the budgeting process should be participative rather than imposed * Only those costs that are controllable by managers should be included in the variance analysis * Distribute reports on a more timely basis to allow quick resolution of problems * Reports should be stated in terms that are most understandable to the users (i.e., units of output, hours, etc.) (CMA adapted) a EVA could discourage a high-growth strategy because this strategy almost always requires that current profitability be reduced to achieve acceleration in sales The reduction in profitability can be associated with increased costs of marketing and promotion and research and development b Yes The balanced scorecard could be used to provide incentives other than high current profitability Specifically, some performance measures (and rewards) could be devised for the customer perspective: · market share or growth in market share, · customer satisfaction, · sales growth, · customer complaint frequency, and · perceived product quality Still other measures could be devised for the innovation/learning perspective: · number of new products developed, · research and development accomplishments, · number of new product ideas generated, and · increase in employee training The key to encouraging a division to grow, even if growth is to be achieved at the expense of reducing current profits, is to link rewards of managers to the correct performance measures By linking rewards to EVA, managers may be discouraged from investing in new assets that don’t provide an immediate return Alternatively, by focusing measures on innovation and sales growth, incentives can be created for achieving a high growth rate Chapter 19 Measuring and Rewarding Organizational Performance 273 79 The most important point to be made in the arguments is that increases in pay should be related to increases in performance The minimum wage bestows larger pay without requiring a greater contribution of effort or talent The likely consequence is a reduction in employment because the benefits of employing certain workers will no longer exceed the costs It is unreasonable to believe that when higher costs are imposed on businesses with no compensating benefits, they will maintain the status quo in operations Some firms will attempt to substitute automated systems for manual systems to reduce labor bills, and other firms will find it is now more desirable to employ higher skilled, more productive workers rather than lower skilled workers In either case, some of the employees who were intended to be beneficiaries of the higher minimum wage will be unemployed A more productive way to achieve higher income for workers at the bottom of the wage scale would be to find ways to improve their productivity and then reward them for it For example, subsidized training could be given to minimum wage workers to allow them to improve their skills and abilities Alternatively, simply creating an incentive structure that rewards employees for higher productivity encourages the workers to work harder, improve their abilities, and acquire higher-level skills These incentives could be offered in the form of bonuses, profit sharing, or other types of variable pay 80 a Year 1: Year 2: Year 3: b We can only assume that the goals of the university go substantially beyond winning football games, conference championships, and bowl games If this assumption is valid, the coach's contract certainly failed to promote goal congruence c In designing contracts, we assume that wealth-maximizing managers will attempt to maximize the performance measures that are the basis of the contract (subject to legal and ethical constraints) If the performance measures had been different in the coach's contract, it is reasonable to assume that his behavior would have been different $200,000 salary $200,000 salary + $25,000 bonus = $225,000 $200,000 salary + $150,000 bonus = $350,000 274 d Chapter 19 Measuring and Rewarding Organizational Performance Many different performance features could be considered For example, wage penalties could be included for any NCAA rules infraction or violation of school policy In addition, performance measures could be added that would reward the coach for improvement in graduation rates and grade point averages of football players, and involvement of the football coaches and players in university and other civic activities In any case, if the coach's compensation and job security are less directly tied to winning, violations of school policy and NCAA rules are much less likely to occur Reality Check 81 a Asset turnover is defined as Sales ÷ Average Total Assets If the numerator is held constant and the denominator is reduced, the resulting quotient (asset turnover) must be, mathematically, larger Dumping causes one of the assets (raw materials) to be smaller b Top management would expect the plant manager to try to recover something from the inventory he discarded, if it were indeed obsolete It is highly unlikely that they intended that asset turnover be improved by discarding assets without benefit It appears that the plant manager breached an implied understanding that his efforts be directed toward efficient operations Other ethical considerations include unauthorized dumping on public lands and the possibility that the materials are toxic Chapter 19 Measuring and Rewarding Organizational Performance c 275 Thomas's options include the following: * Remain silent * Discuss the matter with the plant manager * Hold a confidential meeting with someone high enough in the organization to assess the problem and take any required action If Thomas does remain silent, he can be considered an accomplice to the dumping and, thus, would be as unethical as the plant manager If he tries to talk to the plant manager, Thomas may be able to convince the manager of the impropriety of the dumping Of course, it is also possible that the manager would ignore Thomas's concerns and possibly fire Thomas If Thomas talks to someone with the expertise and power to ascertain if there is a problem, Thomas may be convinced that the dumping is acceptable to both the company and (if legitimate) may even be considered good for the public in that it is clean landfill If instead, the dumping is a problem, Thomas has done his ethical duty (Thomas should, of course, attempt to talk to the plant manager first to determine all the facts and to avoid the implication of "going over the boss's head.) 276 82 a Chapter 19 Measuring and Rewarding Organizational Performance They are probably having a large effect on his decision By revealing the information about the obsolete inventory to the market, the stock price is likely to fall Also, both the income statement and the balance sheet will suffer from the write-down Both the income statement effect and the stock market effect will reduce the compensation paid to the company president, at least in the short run b It is not an ethical treatment of either the existing shareholders or potential shareholders In the long run, both groups would be better off financially if the information about the obsolete inventory were revealed to the capital markets Only in the short run are the existing shareholders better off from not revealing the information However, one can easily anticipate the law suits that would be filed upon the market discovering the obsolete inventory after the new stock is issued After the fallout, all parties would be worse off than they would have been with an honest and timely disclosure of the inventory information Furthermore, the company would find it very difficult to make credible assertions about its financial position when it needed to return to the stock market in the future c The decision to defer disclosure until after the issuance of the stock is clearly an inappropriate course of action for the company If the president persists in this view, the controller should go to the audit committee and reveal the problem to them This committee could take action to disclose the information Another alternative would be to take the information to the firm's public auditors, or as a last resort the controller could go to the SEC with the information 83 No solution provided 84 No solution provided 85 No solution provided ... decisions made by the manager Chapter 19 Measuring and Rewarding Organizational Performance 249 12 The balanced scorecard is a conceptual approach to measuring performance that weighs performance. .. motivation for managers and other employees to implement corporate strategies Chapter 19 Measuring and Rewarding Organizational Performance 253 32 The performance measurement and reward strategy... measures should concentrate on profit and cash flow performance 254 37 Chapter 19 Measuring and Rewarding Organizational Performance As workers get older, their needs and goals change Young workers