Performance Measurement, Compensation, and Multinational Considerations

Performance Measurement,
Compensation, and
Multinational Considerations
Chapter 23
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 1

Learning Objective 1
Measure performance
from a financial and a
nonfinancial perspective.

Financial and Nonfinancial
Performance Measures
Companies are supplementing internal financial

measures with measures based on:
External financial information
Internal nonfinancial information
External nonfinancial information

Some organizations present financial and

nonfinancial performance measures for
their subunits in a single report
– the balanced scorecard.
Most scorecards include:
– profitability measures
– customer-satisfaction measures
– internal measures of efficiency, quality, and time

– innovation measures
Some performance measures have
a long-run time horizon.
Other measures have a short-run time horizon.

Design an accounting-based
performance measure.

Accounting-Based
Performance Measure
Step 1:
Choose performance measures that align
with top management’s financial goal(s).
Step 2:
Choose the time horizon of each
performance measure in Step 1.
Step 3:
Choose a definition for each.
Accounting-Based
Performance Measure
Step 4:
Choose a measurement alternative for
each performance measure in Step 1.
Step 5:
Choose a target level of performance.
Step 6:
Choose the timing of feedback.

Accounting-Based Performance
Measure Example
Relax Inns owns three small hotels –

one each in Boston, Denver, and Miami.
At the present, Relax Inns does not
allocate the total long-term debt of
the company to the three separate hotels.

Measure Example
Boston Hotel
Current assets $350,000 Revenues $1,100,000

Long-term assets 550,000 Variable costs 297,000
Total assets $900,000 Fixed costs 637,000
Current liabilities $ 50,000 Operating income $ 166,000

Measure Example
Denver Hotel
Current assets $ 400,000 Revenues $1,200,000

Long-term assets 600,000 Variable costs 310,000
Total assets $1,000,000 Fixed costs 650,000
Current liabilities $ 150,000 Operating income $ 240,000

Measure Example
Miami Hotel
Current assets $ 600,000 Revenues $3,200,000

Long-term assets 5,000,000 Variable costs 882,000
Total assets $5,600,000 Fixed costs 1,166,000
Current liabilities $ 300,000 Operating income $1,152,000

Measure Example
Total current assets $1,350,000

Total long-term assets 6,150,000
Total assets $7,500,000
Total current liabilities $ 500,000
Long-term debt 4,800,000
Stockholders’ equity 2,200,000
Total liabilities and equity $7,500,000

Approaches to
Measuring Performance
Three approaches include a measure of investment:

Return on investment (ROI)
Residual income (RI)
Economic value added (EVA®)
A fourth approach, return on sales (ROS),
does not measure investment.
Analyze return on investment

(ROI) using the DuPont method.

Return on Investment
Return on investment (ROI) is an

accounting measure of income
divided by an accounting
measure of investment.
Return on investment (ROI)

= Income ÷ Investment
Return on Investment
What is the return on investment for each hotel?

Boston Hotel: $166,000 Operating income
÷ $900,000 Total assets = 18%
Denver Hotel: $240,000 Operating income
÷ $1,000,000 Total assets = 24%
Miami Hotel: $1,152,000 Operating income
÷ $5,600,000 Total assets = 21%
DuPont Method
The DuPont method of profitability analysis

recognizes that there are two basic
ingredients in profit making:
1. Using assets to generate more revenues
2. Increasing income per dollar of revenues

DuPont Method
Return on sales = Income ÷ Revenues
Investment turnover = Revenues ÷ Investment
ROI = Return on sales × Investment turnover

DuPont Method
How can Relax Inns attain a 30% target

ROI for the Denver hotel?
Present situation: Revenues ÷ Total assets
= $1,200,000 ÷ $1,000,000 = 1.20
Operating income ÷ Revenues
= $240,000 ÷ $1,200,000 = 0.20
1.20 × 0.20 = 24%
DuPont Method
Alternative A: Decrease assets, keeping

revenues and operating income per
dollar of revenue constant.
Revenues ÷ Total assets
= $1,200,000 ÷ $800,000 = 1.50
1.50 × 0.20 = 30%

DuPont Method
Alternative B: Increase revenues, keeping
assets and operating income per dollar
of revenues constant.
= $1,500,000 ÷ $1,000,000 = 1.50
= $300,000 ÷ $1,500,000 = 0.20
1.50 × 0.20 = 30%
DuPont Method
Alternative C: Decrease costs to increase
operating income per dollar of revenues,
keeping revenues and assets constant.
= $1,200,000 ÷ $1,000,000 = 1.20
= $300,000 ÷ $1,200,000 = 0.25
1.20 × 0.25 = 30%
Use the residual-income (RI)

measure and recognize
its advantages.

Residual Income
Residual income (RI)

= Income
– (Required rate of return × Investment)
Assume that Relax Inns’ required
rate of return is 12%.
What is the residual income from each hotel?

Residual Income
Boston Hotel:
Total assets $900,000 × 12% = $108,000
Operating income $166,000 – $108,000
= Residual income $58,000
Denver Hotel = $120,000
Miami Hotel = $480,000

Describe the economic value

added (EVA®) method.

Economic Value Added
Economic value added (EVA®)

= After-tax operating income
– [Weighted-average cost of capital
× (Total assets – current liabilities)]

Total assets minus current liabilities

can also be computed as:
Long-term assets + Current assets
– Current liabilities, or…
Long-term assets + Working capital

Economic value added (EVA®) substitutes the

following specific numbers in the RI calculations:
1. Income equal to after-tax operating income
2. A required rate of return equal to the
weighted-average cost of capital
3. Investment equal to total assets minus
current liabilities
Economic Value Added Example
Assume that Relax Inns has two sources of
long-term funds:
1. Long-term debt with a market value and
book value of $4,800,000 issued at an
interest rate of 10%
2. Equity capital that also has a market value of
$4,800,000 and a book value of $2,200,000
Tax rate is 30%.
What is the after-tax cost of capital?

0.10 × (1 – Tax rate) = 0.07, or 7%
Assume that Relax Inns’ cost of
equity capital is 14%.
What is the weighted-average cost of capital?

WACC = [(7% × Market value of debt)

+ (14% × Market value of equity)]
÷ (Market value of debt + Market value of equity)
WACC = [(0.07 × 4,800,000)
+ (0.14 × 4,800,000)] ÷ $9,600,000
WACC = $336,000 + $672,000 ÷ $9,600,000
WACC = 0.105, or 10.5%
What is the after-tax operating income for each hotel?

Boston Hotel:
Operating income $166,000 × 0.7 = $116,200
Denver Hotel:
Operating income $240,000 × 0.7 = $168,000
Miami Hotel:
Operating income $1,152,000 × 0.7 = $806,400
What is the investment?

Boston Hotel: Total assets $900,000
– Current liabilities $50,000 = $850,000
Denver Hotel: Total assets $1,000,000
– Current liabilities $150,000 = $850,000
Miami Hotel: Total assets $5,600,000
– Current liabilities $300,000 = $5,300,000
What is the weighted-average cost of capital

times the investment for each hotel?
Boston Hotel: $850,000 × 10.5% = $89,250
Denver Hotel: $850,000 × 10.5% = $89,250
Miami Hotel: $5,300,000 × 10.5% = $556,50

What is the economic value added?

Boston Hotel: $116,200 – $89,250 = $26,950
Denver Hotel: $168,000 – $89,250 = $78,750
Miami Hotel: $806,400 – $556,500 = $249,900
The EVA® charges managers for the cost
of their investments in long-term assets
and working capital.
Return on Sales
The income-to-revenues (sales) ratio, or return

on sales (ROS) ratio, is a frequently used
financial performance measure.
What is the ROS for each hotel?
Boston Hotel: $166,000 ÷ $1,100,000 = 15%
Denver Hotel: $240,000 ÷ $1,200,000 = 20%
Miami Hotel: $1,152,000 ÷ $3,200,000 = 36%
Comparing Performance
Hotel ROI RI EVA® ROS

Boston 18% $ 58,000 $ 26,950 15%
Denver 24% $120,000 $ 78,750 20%
Miami 21% $480,000 $249,900 36%

Comparing Performance
Methods Ranking
Hotel ROI RI EVA® ROS
Boston 3 3 3 3
Denver 1 2 2 2
Miami 2 1 1 1

Contrast current-cost and

historical-cost asset
measurement methods.

Choosing the Time Horizon
The second step of designing accounting-based

performance measures is choosing the time
horizon of each performance measure.
Many companies evaluate subunits on the basis
of ROI, RI, EVA®, and ROS over multiple years.

Choosing Alternative Definitions
The third step of designing accounting-based

performance measures is choosing a definition
for each performance measure.
Definitions include the following:
1. Total assets available – includes all assets,
regardless of their particular purpose.

2. Total assets employed – includes total assets

available minus the sum of idle assets and
assets purchased for future expansion.
3. Total assets employed minus current liabilities
– excludes that portion of total assets employed
that are financed by short-term creditors.

4. Stockholders’ equity – using in the Resorts Inns

example requires allocation of the long-term
liabilities to the three hotels, which would then
be deducted from the total assets of each hotel.

Choosing Measurement
Alternatives
The fourth step of designing accounting-based
performance measures is choosing a measurement
alternative for each performance measure.
The current cost of an asset is the cost now of
purchasing an identical asset to the one
currently held.
Historical-cost asset measurement methods
generally consider the net book value of the asset.
Alternatives
The fifth step of designing accounting-based

performance measures is choosing a target
level of performance.
Historical cost measures are often inadequate for
measuring economic returns on new investments
and sometimes create disincentives for expansion.

Alternatives
The sixth step of designing accounting-based
performance measures is choosing the timing
of feedback.
Timing of feedback depends largely on how
critical the information is for the…
…success of the organization.
…specific level of management involved.
…sophistication of the organization.
Indicate the difficulties when

comparing the performance
of divisions operating
in different countries.

Multinational Companies
Example
Assume that Relax Inns

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

a decline in value.
The exchange rate on December 31, 2003,
is 12 pesos = 1 dollar.
What is the average exchange rate during 2003?
(8 + 12) ÷ 2 = 10 pesos = 1 dollar

Example
The investment (total assets) in Acapulco

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

Example
What is the return on investment in dollars?

6,200,000 ÷ 10 = $620,000 operating income
32,000,000 ÷ 8 = $4,000,000 investment
$620,000 ÷ $4,000,000 = 15.5%
This is lower than the Boston ROI of 18%.

Recognize the role of

salaries and incentives
when rewarding managers.

The Basic Trade-off
Most often, a manager’s total

compensation includes some
combination of salary and a
performance-based incentive.

Describe the management

accountant’s role in helping
organizations design better
incentive systems.

Intensity of Incentives
How large should the incentive component

be relative to salary?
Preferred performance measures are ones
that are sensitive to, or change significantly,
with the manager’s performance.

Benchmarks
Owners can use benchmarks to

evaluate performance.
Benchmarks representing best
practice may be available inside
or outside the organization.

Measuring
Obtaining performance measures that are more

sensitive to employee performance is critical
for implementing strong incentives.
Many management accounting practices, such
as the design of responsibility centers and the
establishment of financial and nonfinancial
measures, have as their goal better
performance evaluation.
End of Chapter 23

Performance Measurement, Compensation, and Multinational Considerations

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Performance Measurement,

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 1

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 2

Companies are supplementing internal financial

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 3

Some organizations present financial and

– internal measures of efficiency, quality, and time

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 5

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 6

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 8

Relax Inns owns three small hotels –

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 9

Current assets $350,000 Revenues $1,100,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 10

Current assets $ 400,000 Revenues $1,200,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 11

Current assets $ 600,000 Revenues $3,200,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 12

Total current assets $1,350,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 13

Three approaches include a measure of investment:

Analyze return on investment

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 15

Return on investment (ROI) is an

Return on investment (ROI)

What is the return on investment for each hotel?

The DuPont method of profitability analysis

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 18

Return on sales = Income ÷ Revenues

Investment turnover = Revenues ÷ Investment

ROI = Return on sales × Investment turnover

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 19

How can Relax Inns attain a 30% target

Alternative A: Decrease assets, keeping

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 21

Use the residual-income (RI)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 24

Residual income (RI)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 25

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 26

Describe the economic value

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 27

Economic value added (EVA®)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 28

Total assets minus current liabilities

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 29

Economic value added (EVA®) substitutes the

What is the after-tax cost of capital?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 32

WACC = [(7% × Market value of debt)

What is the after-tax operating income for each hotel?

What is the investment?

What is the weighted-average cost of capital

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 36

What is the economic value added?

The income-to-revenues (sales) ratio, or return

Hotel ROI RI EVA® ROS

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 39

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 40

Contrast current-cost and

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 41

The second step of designing accounting-based

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 23 - 42