1. law, govt and politics
2. legal issues
3. human rights

Performance Measurement,
Compensation,
and Multinational Considerations
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1.
2.
3.
Select financial and nonfinancial
performance measures to use in a balanced
scorecard
Examine accounting-based measures for
evaluating a business unit’s performance,
including return on investment (ROI),
residual income (RI), and economic value
added (EVA®)
Analyze the key measurement choices in
the design of each performance measure
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4.
5.
6.
7.
Study the choice of performance targets
and design of feedback mechanisms
Indicate the difficulties that occur when
the performance of divisions operating in
different countries is compared
Understand the roles of salaries and
incentives when rewarding managers
Describe the four levers of control and why
they are necessary
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
Many organizations record financial and
nonfinancial performance measures for
their subunits on a balanced scorecard.
The scorecards of different organizations
emphasize different measures but the
measures are always derived from a
company’s strategy. In a balanced
scorecard, the four perspectives are:
1.
2.
3.
4.
Financial
Customer
Internal business process
Learning and growth
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
Requires several steps:
1.
2.
3.
Choose performance measures that align with
the firm’s financial goals.
Choose the details of each performance
measure.
Choose a target level of performance and a
feedback mechanism for each performance
measure.
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Return on investment
2. Residual income
3. Economic value added
4. Return on sales (this measure does
not account for investment)
1.
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 ROI
is an accounting measure of income
divided by an accounting measure of
investment.
ROI =
Income
Investment
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
Most popular metric for two reasons:
1.
2.

Blends all the ingredients of profitability
(revenues, costs, and investment) into a
single percentage
May be compared to other ROI’s both inside
and outside the firm
Also called the accounting rate of return
(ARR) or the accrual accounting rate of
return (AARR)
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
ROI may be decomposed into its two components
as follows:
Income
Investment
=
Income
Revenues
X
Revenues
Investment
ROI = Return on Sales X Investment Turnover.
 This approach is known as the DuPont Method of
Profitability Analysis. It recognizes the two basic
ingredients in profit making: increasing income
per dollar of revenue and using assets to generate
more revenues. An improvement to either with no
change in the other will increase ROI.

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 Residual
income (RI) is an accounting
measure of income minus a dollar amount
for required return on an accounting
measure of investment.
 RI = Income – (RRR X Investment)

RRR = Required Rate of Return
 Required
rate of return times the
investment is the imputed cost of the
investment.

Imputed costs are costs recognized in some
situations, but not in the financial accounting
records.
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 EVA
is a variation of RI used by many companies.
It is calculated as follows:
EVA
=
After-tax
Operating Income
{
Weighted-Average
Cost of Capital
X(
Total
Assets
Current
Liabilities
 Weighted
)}
average cost of capital equals the
after-tax average cost of all long-term funds in
use.
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 Return
on sales is also known as the incometo-revenues ratio or the sales ratio
 It is frequently used, simple to compute, and
widely understood.
 It does not take into account investment.
 It measures how effectively costs are
managed
It is calculated by taking Operating Income /
Revenues and is expressed as a percentage.
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 Using
the example of the hotels from our
textbook, we see the results using each of
our methods: (in parentheses are the ranks)
Hotel
ROI
RI
EVA
ROS
SF
24% (1)
$120,000 (2)
$68,250 (2)
20% (2)
Chicago
15% (3)
$ 60,000 (3)
$15,750 (3)
21% (1)
New Orleans
17% 92)
$150,000 (1)
$73,500 (1)
16% (3)
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How should each measure be computed?
Several questions should be answered to begin:
 What is the time horizon?
 Which definition of investment will be used?
 How shall we calculate various components
of each performance measure such as the
measurement of assets.
 Let’s now discuss each of these measurement
details.
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An important element in designing accountingbased performance measures is choosing the time
horizon of the performance measures.
 Multiple periods of evaluation are sometimes
appropriate.
 ROI, RI, EVA, and ROS all basically evaluate one
period of time.
 ROI, RI, EVA, and ROS may all be adapted to
evaluate multiple periods of time.
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There are several benefits to multiyear analysis:
 Benefits of actions taken in the current period
may not show up in short-run performance
measures.
 If managers use NPV for investment decisions,
then using a multiyear RI for performance
achieves goal congruence.
 Motivates managers to take a long-run
perspective by compensating them on changes
in market price.
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
Four common alternative definitions of
investment:
1.
2.
3.
4.
Total assets available – all assets.
Total assets employed – all assets less idle assets
and assets purchased for future expansion.
Total assets employed minus current liabilities –
total assets employed less assets financed by
short-term creditors.
Stockholder’s equity – assign liabilities to
subunits and deduct from total assets.
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
Possible alternative asset measurements
include:
Current cost – cost of purchasing an asset today
identical to the one currently held.
2. Gross value of fixed assets – historical cost.
3. Net book value(NBV) of fixed assets – historical
cost.
(Historical cost is used to calculate ROI and there is
always a question whether to use gross or net book
value. NBV is the measure most commonly used by
companies for internal performance evaluation.)
1.
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 Choosing



Establish target ROIs using historical-cost-based
measures.
Set continuous improvement targets.
Use balanced scorecards to establish targets.
 Choosing
on):



target levels of performance:
the timing of feedback (depends
How critical the information is for the success of
the organization.
The management level receiving feedback.
The sophistication of the organization’s
information technology.
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 Additional
difficulties faced by multinational
companies:
The economic, legal, political, social, and cultural
environments differ significantly across countries.
 Import quotas and tariffs range widely from country
to country.
 Availability of materials and skilled labor, as well as
costs of materials, labor, and infrastructure also
differ significantly across countries.
 Divisions operating in different countries account for
their performance in different currencies and
inflation and fluctuation in foreign-currency
exchange rates affect performance measurement.

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 The
performance evaluation of a manager
should be distinguished from the
performance evaluation of that manager’s
subunit, such as a division of the company.
 The reason for this is to recognize that a
company may put the most skilled division
manager in charge of the division with the
poorest return in an effort to improve that
division and that may take years.
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 An
inherent trade-off exists between
creating incentives and imposing risk.



An incentive should be some reward for
performance.
An incentive may create an environment in which
suboptimal behavior may occur: the goals of the
firm are sacrificed in order to meet a manager’s
personal goals.
The motivation for having some salary and some
performance-based compensation is to balance
the benefit of incentives against the extra cost of
imposing risk on a manager.
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 Moral
hazard describes a situation in which an
employee prefers to exert less effort
compared with the effort the owner desires
because the owner cannot accurately monitor
and enforce the employee’s effort.
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 Intensity
of incentives—how large the
incentive component of a manager’s
compensation should be relative to their
salary component.
 The tradeoff between considerations of
sensitivity and risk, on the one hand, and the
congruence of goals, on the other,
determines the effective intensity of
incentives placed on each measure of
performance.
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 Benchmarks
are metrics that correspond to
the best practices of organizations and may
be available inside or outside of the
organization.
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
Managers need to do two things when
designing the measures used to evaluate
performance of individual employees:
1.
2.
Design performance measures for activities
that require multiple tasks.
Design performance measures for activities
done in teams.
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 Employers
want employees to allocate their
time and effort intelligently among various
tasks or aspects of their jobs.
 A team achieves better results than
individual employees acting alone.1 Many
companies reward employees on teams based
on how well their team performs.
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 Based
on both financial and nonfinancial
performance measures, and include a mix
of:
Base salary.
 Annual incentives, such as cash bonuses.
 Long-run incentives, such as stock options.

 Well-designed
plans use a compensation
mix that balances risk (the effect of
uncontrollable factors on the performance
measure, and hence compensation) with
short-run and long-run incentives to
achieve the firm’s goals.
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Performance evaluation measures help
managers track their progress toward
achieving a company’s strategic goals.
 Because these measures help diagnose
whether a company is performing to
expectations, they are collectively called
Diagnostic Control Systems.
 Companies motivate managers by holding
them accountable and rewarding them for
meeting goals.
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To prevent unethical and outright fraudulent
behavior, companies balance the push for
performance (resulting from Diagnostic Control
Systems) with three other levers of control:



Boundary systems.
Belief systems.
Interactive control systems.
 Each
lever is important and needs to be
monitored.
 Levers should be interdependent and
collectively represent a living system of
business conduct.
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 Boundary
systems describe standards of
behavior and codes of conduct expected of
all employees.


Highlights actions that are “off-limits.”
A code of conduct describes appropriate and
inappropriate individual behaviors.
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 Belief
systems articulate the mission,
purpose, and core values of a company.
 They describe the accepted norms and
patterns of behavior expected of all
managers and other employees when
interacting with one another, shareholders,
customers, and communities.
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 Interactive
control systems are formal
information systems that managers use to
focus the company’s attention and learning
on key strategic issues.
 Helps managers create open dialog and
eliminate or manage an excessive focus on
diagnostic control systems.
 Tracks strategic uncertainties that businesses
face.
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TERMS TO LEARN
PAGE NUMBER REFERENCE
Belief systems
Page 895
Boundary systems
Page 895
Current cost
Page 884
Diagnostic control systems
Page 894
Economic value added (EVA®)
Page 880
Imputed cost
Page 879
Interactive control systems
Page 896
Investment
Page 876
Moral hazard
Page 890
Residual income (RI)
Page 879
Return on investment (ROI)
Page 877
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