Chapter 19 1
Chapter 19
Performance Measurement, Balanced Scorecards, and
Performance Rewards
Questions
Chapter 19 1
1.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.
2.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.
Performance measures should be both qualitative and quantitative. 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, managers need to employ qualitative measures to capture performance in the dimensions of customer service, product and service quality, product innovation, advancement in job skills, and effectiveness in communications.
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.
3.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 who are 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.
4.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.
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. 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.
No, because the measures must be consistent with the span of authority and responsibility of each manager. This requirement means that different responsibility centers must be evaluated using different measures. Further, the chosen measures must be consistent with the time horizon of decisions made by the manager.
5.Conceptually, net cash flow from operations measures the same thing as net income. Thus, cash flow may be a useful measure in a profit 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 affected to some extent by adjusting 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, the most significant weakness of net cash flow from operations is that it is a short-term measure and, thus, provides no long-term incentives.
6.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 person being evaluated?
- Does the measure balance long-term and short-term incentives?
- Is the measure sufficiently related to overall organizational goals?
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 they can achieve a high level of performance by either performing very well or manipulating the measure. External measures are far superior to internal measures in this respect because they are not susceptible to internal manipulation.
7.Residual income (RI) is a type of derivative of return on investment (ROI). In many ways, the relationship between RI and ROI 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, particularly in an environment in which ROI varies substantially across company divisions.
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. Thus, EVA should more nearly correlate with effects on shareholder value than RI. A weakness of RI 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. EVA is conceptually similar to RI in its computations but utilizes a market measure of asset value and applies a target return rate that reflects the cost of capital. EVA computations also include the effects of income taxes, which are normally excluded in computing RI.
8.By linking managerial rewards to performance, the welfare of managers is linked to their success in achieving organizational goals and objectives. Because a firm’s goals and objectives are reflected in the performance measurements, these measures are, in a sense, reflections of managers’ contributions to the achievement of the organization’s goals and objectives. The linkage forces managers to be directly concerned with achieving those goals and objectives.
The performance measurement and reward strategy for each managerial level 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 theirsphere 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.
9.The balanced scorecard (BSC) is a conceptual approach to measuring performance that weighs performance from four perspectives. Managers choosing to apply the BSC 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 BSC are financial, customers, learning/innovation, and internal processes.
10.To remain competitive, there has been a shift in American industry toward performance-based compensation for two reasons. First, workers are becoming more removed from the actual production activities because of automation, making 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 required of them for the organization to be successful.
11.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 while pursuing achievement of individual goals. When performance measures and rewards of individuals are only loosely correlated with the organization’s and segment’s goals, achievement of the individual’s goals may not result in achievement of the organization’s goals.
12.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.
13.If the organizational mission of each subunit is unique, 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.
Financial performance measures are more appropriate for short-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 often 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.
14.Feedback is critical to improving performance. Negative or critical feedback provides information about what the manager needs to change. It provides a focus for improvement. Positive feedback confirms what the manager is doing well and encourages continuation of behavior. Feedback provides information to (1) improve the reward system and (2) take action to improve future performance.
15.When employees hold stock, they 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 a firm’s employees and its stockholders. 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.
If managers are also shareholders, there is a natural consistency between their actions as managers and their actions as shareholders. This situation is not necessarily true when managers hold no stock. 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.
16.Equity in the reward structure must be maintained throughout the organization. Equity requires 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 long run to keep all stakeholders motivated.
Chapter 19 1
Exercises
17.Division 1: $ 750,000 ÷ $ 5,000,000 = 15%
Division 2: $ 250,000 ÷ $ 1,000,000 = 25%
Division 3: $2,000,000 ÷ $20,000,000= 10%
18.a.Asset Turnover= Sales ÷ Average Assets
4 = $3,600,000 ÷ Average Assets
Average Assets = $3,600,000 ÷ 4
Average Assets = $900,000
b.Profit Margin = Segment Margin ÷ Sales
.08 = Segment Margin ÷ $3,600,000
Segment Margin = $288,000
c.ROI = 8% x 4 = 32%
19.a.ROI = Income ÷ Assets Invested
= ($26,400,000 - $24,600,000) ÷ $7,200,000
= $1,800,000 ÷ $7,200,000
= 25%
b.Profit margin = Income ÷ Sales
= $1,800,000 ÷ $26,400,000
= 6.82% (rounded)
c.Asset turnover = Sales ÷ Assets invested
= $26,400,000 ÷ $7,200,000
= 3.67 (rounded)
d.ROI = Asset turnover × Profit margin
= 3.67 x 6.82% = 25.03%
Note: parts (a) and (d) differ slightly due to rounding.
20.Revenue $60,000,000
Expenses (56,000,000)
Income 4,000,000
Target return (.10 × $22,400,000) (2,240,000)
Residual income $ 1,760,000
The residual income is positive; thus, the division met its target return.
21.a. Division 1 Division 2
Sales $2,100,000 $1,200,000
Variable costs (1,260,000) (300,000)
Fixed costs (250,000) (700,000)
Income 590,000 200,000
Target return:
$3,050,000 x .12 (366,000)
$1,100,000 x .12 ______(132,000)
Residual income $ 224,000 $ 68,000
According to the residual income measure, Division 1 outperformed Division 2.
b. Division 1 Division 2
Sales $2,562,000 $1,464,000
Variable costs (1,537,200) (366,000)
Fixed costs (250,000) (700,000)
Income 774,800 398,000
Target return:
$3,050,000 x .12 (366,000)
$1,100,000 x .12 ______(132,000)
Residual income $ 414,800 $ 266,000
Based on the residual income, Division 1 will outperform Division 2 in the absolute amount of residual income generated. However, one should note that Division 2 actually had greater improvement than Division 1 in residual income from the base case in part a). Division 2’s residual income increased by $198,000 compared to Division 1’s increase of only $190,800. Similarly, the percentage increase in residual income for Division 2 was 291%, while the percentage increase in residual income in Division 1 was merely 85%.
c.Division 2 is has more operating leverage (relatively more fixed costs than Division 1) and, therefore, benefits to a more significant extent from an increase in sales volume. If sales decreased rather than increased, Division 2’s residual income would have decreased at a faster rate than Division 1’s.
22.a.Income = Sales - Variable Costs - Fixed Costs
= $39,000,000 - ($39,000,000 x 0.45) - $6,750,000
= $39,000,000 - $17,550,000 - $6,750,000
= $14,700,000
ROI = Income ÷ Assets invested
= $14,700,000 ÷ $25,000,000
= 58.8%
b.Income $14,700,000
Target return (0.14 x $25,000,000) (3,500,000)
Residual income $11,200,000
c.Profit margin= Income ÷ Sales
= $14,700,000 ÷ $39,000,000
= 37.7% (rounded)
d.Asset turnover = Sales ÷ Assets Invested
= $39,000,000 ÷ $25,000,000
= 1.56
23.EVA = After-tax Income - (Cost of Capital x FMV of Capital)
$3,270,000 = After-tax Income - (0.11 x $26,500,000)
$3,270,000 = After-tax Income - $2,915,000
After-tax Income = $6,185,000
24.a.EVA = After-Tax Income - (Cost of Capital x FMV of Capital)
= $13,260,000 - (0.13 x $8,900,000)
= $13,260,000 - $1,157,000
= $12,103,000
b.Determining the amount of capital invested in a particular division is difficult because divisions do not issue debt or stock as companies do. The challenge faced is to divide the firm’s total value among its operating divisions.
One would start by determining the amount of capital invested in the entire company and then apportion this amount among the divisions. The established value would include both debt and equity.
The level of debt investment can be estimated by the face amount of the debt if market values cannot be obtained. If the debt is publicly traded, the market value can be determined readily. The stock value can be found by multiplying the market value per share by the number of shares outstanding. This approach is appropriate for both common and preferred stock.
Next, the firm’s total market value must be divided among the operating divisions. This step will involve some judgment. One approach is to allocate market value to the divisions based on relative book value of assets. A second approach is to establish the value of divisions by determining the value of independent companies operating in the same industries as the divisions. The market value of a division is set by multiplying the ratio of book value of the division to book value of the independent firm by the market value of the independent firm. A third approach would be to hire a consulting firm to establish appraised values for each division.
25.The new division will have a mission of “build.” When the new division is established, it will have only a potential customer base but no existing sales. Accordingly, the division’s major objective will be to obtain market share and establish a high rate of sales growth. This objective must be accomplished by adding value to existing services provided to clients.
The same performance measures are not appropriate across a division’s entire life cycle. Performance measures established at the outset for this new division should emphasize growth. Later in the life cycle, performance measurements will be added or deleted to shift the focus to generation of cash flow and profits. Following are performance measurements that would be useful initially:
- Percentage of existing clients that have video game installations. The emphasis would be on measuring the annual growth in this number.
- Sales growth. Sales targets should be established and compared to actual levels of sales generated.
- Percentage of clients who have received sales calls informing them of the services available from the new division. As an early life-cycle performance measure, this measure captures the extent to which the new division has made contact with the existing client base.
- Number of face-to-face sales calls made to clients. This is similar to the prior measure but emphasizes personal contact.
- Sales and promotions budget. A key device to increasing market share will be the appropriate use of advertising and promotions. Budgets can be prepared for these expenditures, by category, and can then be compared against actual expenditures. This is a useful tool for understanding and executing a comprehensive and internally consistent marketing strategy.
26.Asset Turnover Profit Margin ROI RI
a.N III
b.D I??
c. ID??
d. ID ID*
e.D** I??
f.NNN I
g. ID I I
h. I???
*As long as the target return < 100% of assets.
**Assuming that the automation created an increase in the asset base.
27.No solution provided. Each student will have a different answer.
28. a.MCE = Value-added time ÷ Total time
= 343 ÷ 2,450
= 14%
b.Process productivity= Total units ÷ Value-added time
= 391,020 ÷ 343
= 1,140 units per hour
c.Process quality yield= Good units ÷ Total units