Transcript Performance Evaluation - Middle East Technical

Performance Evaluation
EMBA 5412 Fall 2010
Performance of what?




Companies
Divisions
Products
managers
2
Centralization - Decentralization
 Total decentralization-minimum constraints
and maximum freedom for managers at the
lowest levels of an organization to make
decisions
 Total centralization - maximum constraints
and minimum freedom for managers at the
lowest levels of an organization to make
decisions
 A structure is chosen based on cost vs.
benefit analysis
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Decentralized Organizations
 substantial decision making authority the managers of subunits
 managers at lower levels of the
organization free to make decisions
 Autonomy is the degree of freedom to
make decisions. The greater the
freedom, the greater the autonomy
 Usually some decentralized some
centralized
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Advantages of Decentralization
 Provides better information to make decisions – at the
local and top management levels
 Leads to gains from faster decision making
 quicker responses to changing circumstances
 Creates greater responsiveness to local needs
Increases motivation of subunit managers
 Provides excellent training for future top-level
executives
 Sharpens the focus of subunit managers
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Disadvantages of Decentralization
 Costly duplication of activities
 Lack of goal congruence
 Agency
 Management pursues personal goals
 Personal goals are incompatible with the
company’s goals
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Why Evaluate
 A company evaluates subunits in order to decide if it
should expand or contract them or change their
operations
 A company evaluates subunit managers in order to
motivate them to take actions that maximize the
value of the firm
 Reasons for evaluating subunit managers:
 Identifies successful operations and areas needing
improvement
 Influences the behavior of managers
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Responsibility Accounting and
Performance Evaluation
 Responsibility accounting - managers
responsible only for costs and revenues
that they can control
 To implement responsibility accounting in a
decentralized organization, costs and
revenues are traced to the organizational
level where they can be controlled
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Tracing Costs to Organizational
Levels
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Types of responsibility centers
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
Cost Center
Revenue Center
Profit Center
Investment Center
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Cost Centers
 Subunit responsible for controlling costs but
not responsible for generating revenue
 Most service departments are cost centers (i.e.,
janitorial, maintenance, computer services,
production)
 Must provide service to company at a
reasonable cost
 Evaluation based on comparison of
budgeted or standard costs with actual
costs
11
Profit Centers
 Subunit responsible for generating revenues and
controlling costs
 Goal is to maximize profit for the division
 Performance can be evaluated in terms of profitability
 Motivates managers to focus their attention on ways of
maximizing profit
 A
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variety of methods are used to evaluate profitability
Current income compared to budgeted income
Current income compared to past income
Comparison with other profit centers, called relative
performance evaluation
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Investment Centers
 Subunit responsible for generating revenue,
controlling costs, and investing in assets
 Goal is to maximize return on investment
 Evaluation based on comparison with a
benchmark, previous years, or other
investment centers
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Boyner Example
 A wide range of products varying from cosmetics to
sports, and from home appliances to kidswear are
presented at 24 Boyner Stores all over Turkey in
İstanbul, Ankara, Adana, Antalya, Bursa, İzmir,
Trabzon, Mersin, Diyarbakır, Denizli and Konya.
 Women, Men, Kids and Shoes at each of the Discount
Stores servicing the customers at 8 different locations
all over Turkey
 Outlet centers and stores could be profit or
investment centers
 Each store could be a revenue or profit center –
depending how autonomous they are
 Accounting department and maintenance-cost centers
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Study Break #1
 An investment center is responsible
for:
a.
b.
c.
d.
Investing in long term assets
Controlling costs
Generating revenues
All of the above
Answer:
d. All of the above
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Study Break #2
 Cost centers are often evaluated
using:
a.
b.
c.
d.
Variance analysis
Operating margin
Return on investment
Residual income
Answer:
a. Variance analysis
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Study Break #3
 Profit centers are often evaluated
using:
a.
b.
c.
d.
Investment turnover
Income targets or profit budgets
Return on investment
Residual income
Answer:
b. Income targets or profit budgets
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Accounting-Based Performance
Measures
 Requires a six-step design process:
1. Choose Performance Measures that align with
top management’s financial goals
2. Choose the time horizon of each Performance
Measure
3. Choose a definition of the components in each
Performance Measure
4. Choose a measurement alternative for each
Performance Measure
5. Choose a target level of performance
6. Choose the timing of feedback
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Step 1: Choosing among Different
Performance Measures
 Four common measures of economic
performance:
1.
2.
3.
4.
Return on Investment
Residual Income
Economic Value Added
Return on Sales
 Selecting Subunit Operating Income as a
metric is inappropriate since it obviously
differs simply on the differing size of the
subunits
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Evaluating Investment Centers With
ROI
 ROI is a primary tool for evaluating the performance
of investment centers
= Investment Center Income
Invested Capital
Focuses management’s attention on income and level of
investment
 Most popular metric for two reasons:
 Blends all the ingredients of profitability (revenues,
costs, and investment) into a single percentage
 May be compared to other ROIs 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 Components
 ROI may be broken down into two components:
profit margin and investment turnover.
 ROI = Profit Margin x Investment Turnover
ROI =
Income
Sales
x ____Sales_____
Invested Capital
 ROI = Return on Sales X Investment Turnover
 This is known as the DuPont Method of
Profitability Analysis
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Which investment?
 Four possible alternative definitions of
investment:
1. Total Assets Available- all assets
2. Total Assets Employed-total assets
available less any idle assets or assets
purchased for expansion in the future
3. Total Assets Employed minus Current
Liabilities
4. Stockholders’ Equity
 Gross or net?
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Measuring Income
 In calculating ROI, companies measure
“income” in a variety of ways
 net income after tax
 Operating income
 Income before tax
 Most common method is NOPAT
 Net Operating Profit After Taxes
 To calculate NOPAT, a company must add back
non-operating items to net income and adjust tax
expense accordingly
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NOPAT Example
Tax rate 35%
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Measuring Income and Invested
Capital for ROI
 In calculating ROI, companies
measure “invested capital” in a
variety of ways
 Approach used here:
Total assets less non-interest-bearing
current liabilities
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Invested Capital Example
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ROI – France, Germany, and Japan
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Most common financial measures
Country
Financial Measures
USA
Budgeted-Actual Income (49%)ROI (29%) EVA
(14%) ROSales(3%)
Australia
ROI, Budgeted-Actual Income
Germany
Revenue, Contribution Margin(per unit)
India
ROI, Budgeted-Actual Income
Japan
ROS(82%) ROI (37%)
Netherlands
ROI, cash flows, income
Singapore
ROI
Horngren et al, 2006,p.799
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Return on Sales (ROS)
 Return on Sales is simply income
divided by sales
 Simple to compute, and widely
understood
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Example Exercise #1
 Davenport Mills is a division of Iowa Woolen
Products, Inc. For the most recent year,
Davenport had net income of $16,000,000.
Included in income was interest expense of
$1,300,000. The operation’s tax rate is
40%. Total assets of Davenport Mills are
$225,000,000, current liabilities are
$45,000,000, and $30,000,000 of the
current liabilities are noninterest-bearing.
 Calculate NOPAT, invested capital, and ROI.
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Example Exercise #1 Solution
 NOPAT
= Net income + interest expense (1 - tax rate)
= $16,000,000 + $1,300,000 (1 - .40)
= $16,780,000
 Invested Capital
= Total assets - noninterest-bearing current
liabilities
= $225,000,000 - $30,000,000
= $195,000,000
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Example Exercise #1 Solution
 ROI
= NOPAT ÷ Invested capital
= $16,780,000 ÷ $195,000,000
= 86.05%
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Problems with ROI
 Invested capital is typically based on historical costs
 Fully depreciated assets lead to a low invested capital
number resulting in high ROI
 Makes comparison of investment centers using ROI
difficult
 Managers may put off purchase of new equipment
 May lead to underinvestment
 Possible alternative definitions of cost:
1. Current Cost
2. Gross Value of Fixed Assets
3. Net Book Value of Fixed Assets
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Problems of Overinvestment and
Underinvestment
 Evaluation using Profit can lead to
overinvestment
 Managers may be motivated to make
investments that earn a return that is less than
the cost of capital
 Evaluation using ROI can lead to
underinvestment
 Managers may not take on projects that have a
low ROI just to increase profit if they are
evaluated in terms of the return they earn
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Residual Income (RI)
 Net operating profit after taxes of an
investment center in excess of its required
profit
 Required profit is equal to the investment
center’s required rate of return times the
level of investment in the center
 RI = NOPAT – Required Profit
 Required rate of return is generally the cost
of capital for the investment center
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Residual Income
 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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Example Exercise #2
 Using the same information as in
Example Exercise #1, calculate the
residual income if the company’s cost
of capital is 10%.
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Example Exercise #2 Solution
 Residual Income
= NOPAT – (Cost of Capital x Invested Capital)
= $16,780,000 – (10% x $195,000,000)
= ($2,720,000)
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Decision Making
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Economic Value Added (EVA)
 EVA is residual income adjusted for accounting
distortions that arise from GAAP
 A performance measure approach to solving
overinvestment and underinvestment problems
 Advantage is that managers are less tempted to cut
those costs that distort income under GAAP
 For example, under GAAP research and
development costs are expensed, but the
costs benefits future periods
 Thus, under EVA research and development is
capitalized and amortized over future periods
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Economic Value Added (EVA®)
 EVA is a specific type of residual income
calculation that has recently gained
popularity
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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Residual Income
NIBCL = Net Income Before
Current Liabilities(excluding debt)
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Study Break #4
 Use of profit as a performance measure:
a. May lead to overinvestment in assets
b. Is appropriate for an investment center
c. Is appropriate as long as profit is calculated
using GAAP
d. Encourages managers to finance operations
with debt rather than equity
Answer:
a. May lead to overinvestment in assets
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Study Break #5
 Investment centers are often
evaluated using:
a.
b.
c.
d.
Standard cost variances
Return on investment
Residual income/EVA
Both b and c
Answer:
d. Both b and c
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EVA
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Economic Profit – Economic
Value Added – EVA*
 yardstick to measure if the business is
earning above its cost of capital of
resources it employs
 developed by Stern Stewart and Co.
EVA= NOPAT – C*k
NOPAT = operating profit after tax (adjusted)
C = capital base employed net of depreciation
k = weighted average cost of capital
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EVA Adjustments to NOPATOperating leases
 operating lease expenses: in a sense the assets
under operating lease should be part of the capital
employed – thru off balance sheet financing
 operating lease (net of tax) is added back to
operating profit
 therefore future payments of the operating lease is
discounted and added to assets and a related liability
is also established
 then the present value of the operating lease is
amortized over an appropriate period such as the
contract period, and this derived amortization amount
is deducted from net income
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EVA Adjustments to NOPAT- Research
and Development and Advertising and
Promotional Expenses
 the benefits extend into the future
 therefore R&D and A&P expenses are
removed from the income determination
 R&D and A&P expenses are capitalized
and amortized over a reasonable period
 the amortized amount is then deducted in
the income determination
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EVA Adjustments to NOPAT- Inventory
Value Adjustment (LIFO)and Deferred
tax
 when companies use LIFO as their inventory cost flow,
then the value of the inventories on the balance sheet
will be different from its current value because the
amount that appears on the balance sheet is based on
“old” cost figures
 recent additions to inventory become part of COGS
 thus inventories are restated to current higher (the
method is usually used under inflationary conditions)
values with an offsetting increase to earnings- add
back the change in LIFO reserves to income
 add the changes in deferred taxes to NOPAT
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EVA Adjustments to NOPATGoodwill
 any amortization of goodwill is added back
to operating profit before tax
 assumption : total amount of goodwill
should be reflected in the balance sheet
because this asset is a permanent part of
the capital base
 so adjust NOPAT by the amount of
amortization and balance sheet to reflect
the total amount of goodwill
 IFRS-watch for “goodwill impairment”
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EVA Adjustments to Capital
Base
 Non-operating assets: such assets
should be excluded from the capital
base because they are not used in
generation of earnings
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How to compute EVA*
Step 1 - Calculate the capital base
Current assets (excluding cash)
+
Net Fixed Assets
+
+
+/=
Capitalization of Operating Leases
Other Long-term Assets
Equity Equivalents
Current Liabilities (excluding debt)
Long term liabilities (excluding debt)
Capital Employed ( Capital Base)
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How to compute EVA*
Step 2 - Calculate net operating profit after
tax
EBIT
+/Change in equity equivalents
+
operating lease payments
Cash tax
=
NOPAT
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How to compute EVA*
Step 3 - Calculate Capital Charge =
Cost of Capital * Capital base (opening)
Step 4 - Calculate EVA *= NOPAT - Capital Charge
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EVA* example
Inventory method
Inventory end
Operating leases
R&D
Net PPE (book value)
NOPAT
Cost of capital
Goodwill
Impairment of goodwill
Current Assets
Cash
Interest Expense
Tax rate 30%
Company A
Uses FIFO
50,000 annual for 3 years
Company B
Uses LIFO
100.000 60000 (change in LIFO reserve 9,000)
40,000 annual for 4 years
45.000
40.000
250.000
300.000
70.000
80.000
10%
15%
40.000
50.000
1000
1250
150000
175000
15000
15000
9000
1250
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EVA* example
Capital Base:
Current Assets
Net PPe
Goodwill
Operating lease
R&D (amortize over 3 yrs)
Inventory increase
135,000
250,000
40,000
124,343
45,000
0
594,343
160,000
300,000
50,000
114,199
40,000
9,000
673,199
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EVA* example
NOPAT adjusted:
NOPAT
Impairment of goodwill
LIFO adjustment
Oper.Leases Amort. PV/period
Operating lease Expense net of tax
Research and Development
70.000
1.000
0
-41.448
35.000
15.000
79.552
80.000
1.250
9.000
-38.066
28.000
13.333
93.517
Capital employed x cost of cap
59.434
100.980
EVA:
20.118
-7.463
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Example - comparison
EVA:
Total Assets
NI
ROA:
Residual Income Calculation
Required Return*Tot Assets
NI- Req.Ret*TA
20.118
-7.463
385.000
61.000
15,84%
460.000
78.750
17,12%
38.500
22.500
69.000
9.750
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Discussion of financial measures
 Growth- may lead to over investmentinvesting in projects with lower returns
 ROI – may lead to under investment –
lower capital base produces higher returns
 Residual Income – affected by the
accounting standards
 EVA* - motivates good investment
decisions because EVA increases as good
investment decisions are made – effects of
accounting standards are eliminated
 However, they are all backward looking –
based on historical performance
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Cash flow ROI-CFROI
 represents company’s economic performance
 developed by Holt Value Associates
 based on transforming financial results to current
dollar cash flow return on investment
 many adjustments
 when applied to future cash flows and combined
with projected growth in the company’s assets –
can be used to estimate the company’s market
value
 culminates the concept of Cash Value Added –
CVA- finding the economic value created by
successful business strategies and investments
over and above earning the cost of capital on a
discounted cash flow basis
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Financial and Nonfinancial
Measures
 Firms are increasingly presenting
financial and nonfinancial
performance measures for their
subunits in a Balanced Scorecard,
and it’s four perspectives:
1.
2.
3.
4.
Financial
Customer
Internal Business Process
Learning and Growth
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Balanced Scorecard Flow
 Firms assume that improvements in
learning and growth will lead to
improvements in internal business
processes
 Improvements in the internal
business processes will lead to
improvements in the customer and
financial perspectives
63
The Balanced Scorecard
 The balanced scorecard translates an
organization’s mission and strategy into a
set of performance measures that provides
the framework for implementing its
strategy
 It is called the balanced scorecard because
it balances the use of financial and
nonfinancial performance measures to
evaluate performance
64
Balanced Scorecard Perspectives
1.
2.
3.
4.
Financial
Customer
Internal Business Perspective
Learning and Growth
65
The Financial Perspective
 Evaluates the profitability of the
strategy
 Uses the most objective measures in
the scorecard
 The other three perspectives
eventually feed back into this
dimension
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The Customer Perspective
 Identifies targeted customer and
market segments and measures the
company’s success in these segments
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The Internal Business Prospective
 Focuses on internal operations that
create value for customers that, in
turn, furthers the financial
perspective by increasing
shareholder value
 Includes three subprocesses:
1. Innovation
2. Operations
3. Post-sales service
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The Learning and Growth
Perspective
 Identifies the capabilities the
organization must excel at to achieve
superior internal processes that
create value for customers and
shareholders
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Balanced Scorecard
Set of performance measures constructed for four dimensions
of performance

Financial


Customer


Examines the company’s success in meeting customer
expectations
Internal Processes


Critical measures even if they are backward looking
Examines the company’s success in improving critical business
processes
Learning and Growth

Examines the company’s success in improving its ability to adapt,
innovate, and grow
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Balanced Scorecard
 Company develops three to five
performance measures for each
dimension
 Measures should be tied to company
strategy
 Balance among the dimensions is critical
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Balanced Scorecard
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How Balance is Achieved in a
Balanced Scorecard
 Performance is assessed across a
balanced set of dimensions
 Balance quantitative measures with
qualitative measures
 There is a balance of backwardlooking measures and forwardlooking measures
73
The Balanced Scorecard Flowchart
Financial
Customer
Internal
Business
Process
Learning
&
Growth
74
Balanced Scorecard
Implementation
 Must have commitment and
leadership from top management
 Must be communicated to all
employees
75
Developing a Strategy Map for a
Balanced Scorecard
 A strategy map is a diagram of the
relationships of the strategic objectives
across the four dimensions
 Used to test the soundness of the strategy
 Identifies how strategy is linked to
measures on the scorecard
 Communicates strategic objectives to
employees
76
Strategy Map Example
77
Features of a Good
Balanced Scorecard
 Tells the story of a firm’s strategy,
articulating a sequence of cause-and-effect
relationships: the links among the various
perspectives that describe how strategy will
be implemented
 Helps communicate the strategy to all
members of the organization by translating
the strategy into a coherent and linked set
of understandable and measurable
operational targets
78
Keys to a Successful Balanced
Scorecard





Targets
 For each measure, there should be a target so managers
know what they are expected to achieve
Initiatives
 For each measure, the company must identify actions that
will be taken to achieve the target
Responsibility
 A particular employee must be given responsibility and held
accountable for successfully implementing each initiative
Funding
 Initiatives must be funded appropriately
Top Management Support
 It is crucial to have the full support of top management
79
Features of a Good
Balanced Scorecard
 Must motivate managers to take actions
that eventually result in improvements in
financial performance
 Predominately applies to for-profit entities, but
has some application to not-for-profit entities as
well
 Limits the number of measures, identifying
only the most critical ones
 Highlights less-than-optimal tradeoffs that
managers may make when they fail to
consider operational and financial measures
together
80
Balanced Scorecard
Implementation Pitfalls
 Managers should not assume the
cause-and-effect linkages are precise:
they are merely hypotheses
 Managers should not seek
improvements across all of the
measures all of the time
 Managers should not use only
objective measures: subjective
measures are important as well
81
Balanced Scorecard
Implementation Pitfalls
 Managers must include both costs
and benefits of initiatives placed in
the balanced scorecard: costs are
often overlooked
 Managers should not ignore
nonfinancial measures when
evaluating employees
 Managers should not use too many
measures
82
Distinction between Managers and
Organization Units
 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
83
The Trade-Off: Creating Incentives
vs. Imposing Risk
 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
84
Moral Hazard
 Moral Hazard describes situations in
which an employee prefers to exert
less effort (or report distorted
information) compared with the effort
(or accurate information) desired by
the owner because the employee’s
effort (or the validity of the reported
information) cannot be accurately
monitored and enforced
85
Intensity of Incentives
 Intensity of Incentives – how large
the incentive component of a
manager’s compensation is relative to
their salary component
86
Preferred Performance Measures
 Preferred Performance Measures are those
that are sensitive to or change significantly
with the manager’s performance
 They do not change much with changes in
factors that are beyond the manager’s
control
 They motivate the manager as well as limit
the manager’s exposure to risk, reducing
the cost of providing incentives
 May include Benchmarking
87
Preferred Performance Measures
 Preferred Performance Measures are those
that are sensitive to or change significantly
with the manager’s performance
 They do not change much with changes in
factors that are beyond the manager’s
control
 They motivate the manager as well as limit
the manager’s exposure to risk, reducing
the cost of providing incentives
 May include Benchmarking
88
Performance Measures at the
Individual Activity Level
 Two issues when evaluating
performance at the individual activity
level:
1. Designing performance measures for
activities that require multiple tasks
2. Designing performance measures for
activities done in teams
89
Compensation for Multiple Tasks
 If the employer wants an employee to
focus on multiple tasks of a job, then
the employer must measure and
compensate performance on each of
those tasks
90
Team-Based Compensation
 Companies use teams extensively for
problem solving
 Teams achieve better results than
individual employees acting alone
 Companies must reward individuals
on a team based on team
performance
91
Executive Compensation Plans
 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
92
Step 2: 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
93
Step 3: Choosing Alternative Definitions
for Performance Measures
 Four possible alternative definitions
of investment:
1. Total Assets Available
2. Total Assets Employed
3. Total Assets Employed minus Current
Liabilities
4. Stockholders’ Equity
94
Step 4: Choosing Measurement
Alternatives for Performance Measures
 Possible alternative definitions of
cost:
1. Current Cost
2. Gross Value of Fixed Assets
3. Net Book Value of Fixed Assets
95
Step 5: Choosing Target
Levels of Performance
 Historically driven targets used to set
target goals
 Goal may include a Continuous
Improvement component
96
Step 6: Choosing the
Timing of the Feedback
 Timing of feedback depends on:
 How critical the information is for the
success of the organization
 The specific level of management
receiving the feedback
 The sophistication of the organization’s
information technology
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Performance Measurement in
Multinational Companies
 Additional Difficulties faced by Multinational
Companies:
 The economic, legal, political, social, and
cultural environments differ significantly across
countries
 Governments in some countries may impose
controls and limit selling prices of a company’s
products
 Availability of materials and skilled labor, as well
as costs of materials, labor, and infrastructure
may differ across countries
 Divisions operating in different countries account
for their performance in different currencies
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