As you can see, setting goals, measuring progress toward goal achievement, and designing reward plans that recognize goal achievement are some of the most difficult tasks faced by man- agers. All of us struggle when determining our goals, both current and future. In deciding on these goals, we keep in mind the rewards we are likely to get as we progress toward goal achieve- ment. Some of these rewards are monetary and are current. Other rewards will occur in the future. Measuring and rewarding goal achievement helps motivate all of us in our daily pursuits.
Concluding Remarks
The focus of this chapter is rewarding business performance using incentive compensation systems to motivate decision makers to align their goals and objectives with those of the orga- nization. We discussed how the DuPont ROI system measures financial performance and why some critics think ROI is flawed. We saw how RI and EVA can correct some of the criticisms of ROI. The balanced scorecard is a broader means for directing, measuring, and reward- ing business performance. Finally, we described the components of and design choices for management compensation. In the remaining chapter we will discuss capital budgeting tools.
These are financial tools that managers use to decide which major investments to undertake.
Concluding Remarks
Th f f thi h t i di b i f i i ti ti
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END-OF-CHAPTER REVIEW
S U M M A R Y O F L E A R N I N G O B J E C T I V E S
Explain the importance of incentive systems for motivating performance. Employees may have goals and objectives that differ from those of the organization.
Incentive systems provide a tool that helps align employee goals with those of the organization by drawing attention to the organization’s goals, by choosing to measure particular com ponents of performance, and by rewarding employees for the actual outcomes associated with those components of performance being measured.
Use the DuPont system to evaluate business performance. The DuPont system measures return on investment (ROI) by dividing the operating earnings of a product line or division by the average invested capital used in that product line or division. ROI can be broken into two components, return on sales and capital turnover. Return on sales is computed by dividing the operating income by the total sales for the particular business segment or product line. It tells managers the amount of earnings generated from one dollar of sales. Capital turnover is a measure created by dividing sales by the average invested capital to generate those sales. The capital turnover ratio tells managers the amount of sales generated by a dollar of invested capital.
Identify and explain the criticisms of using return on investment (ROI) as the only performance measure. Return on investment provides a systematic method for evaluating a product line or business segment. It is a percent that can be used to compare financial performance across products and/or business segments. ROI can be broken into its component parts to further analyze business performance.
Criticisms of ROI include that it motivates short-term decision making, that managers choose to underinvest in projects with acceptable ROIs from the firm’s perspective, that it is difficult to
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match invested capital with related sales and operating earnings, and that ROI focuses only on financial measures and ignores other important components of the value chain.
Calculate and explain residual income (RI) and economic value added (EVA). Residual income is the amount by which operating earnings exceed a minimum acceptable return on the average invested capital. Economic value added is a refinement of the residual income measure that makes many adjustments for items such as taxes, interest, and amortization. Like RI, EVA does not motivate managers to turn down investments expected to earn a return below their current ROI, but above the minimum acceptable return to the firm.
Use the balanced scorecard to identify, evaluate, and reward business performance. The balanced scorecard uses four lenses to consider business per- formance. These lenses provide financial, business process, customer, and learning and growth perspectives. Each of these perspectives helps to identify goals, strategies to achieve the goals, and measures to assess goal achievement.
Identify and explain the components of manage- ment compensation and the trade-offs that com- pensation designers make. In creating management compensation plans, designers consider multiple characteristics such as fixed salary versus bonuses and the types of bonuses (cash, stock, or stock options). In addition, there are numerous design trade-offs that include choosing the time horizon over which compensation is available, choosing to emphasize local versus global performance, or choosing a cooperative or a competitive incentive scheme.
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Key Terms Introduced or Emphasized in Chapter 25
balanced scorecard (p. 1086) A system for performance measurement that links a company’s strategy to specific goals, measures that assess progress toward those goals, and specific initiatives to achieve those goals. This systematic business per- formance measurement process integrates objectives across four business lenses to achieve the organization’s strategic goals.
business process perspective (p. 1088) The balanced score- card lens through which internal business processes, supplier relations, and distributor relations are strategically analyzed and evaluated.
capital turnover (CT) (p. 1081) A measure created by divid- ing sales by the average invested capital to generate those sales.
Capital turnover tells managers the amount of sales generated by a dollar of invested capital.
customer perspective (p. 1088) The balanced scorecard lens through which organizations analyze and measure their
customers’ needs, expectations, and outcomes that will lead to business success.
DuPont system of performance measurement (p. 1081) A method that analyzes business performance by considering both the earnings per sales dollar and the investment used to generate those sales dollars.
economic value added (EVA) (p. 1085) A specific type of resid- ual income that is computed by multiplying the after-tax weighted- average cost of capital by total assets minus current liabilities and subtracting that product from the after-tax operating income.
financial perspective (p. 1087) The balanced scorecard lens that managers and shareholders (or other financial stakeholders) use to view the organization’s business performance.
learning and growth perspective (p. 1088) The balanced scorecard lens that focuses on the people, information systems, and organiza- tional procedures in place for organizational learning and growth.
residual income (RI) (p. 1084) The amount by which operat- ing earnings exceed a minimum acceptable return on the aver- age invested capital. The minimum rate of return represents the opportunity cost of using the invested capital.
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return on investment (ROI) (p. 1079) The operating income divided by the average invested capital associated with the gen- eration of that income.
return on sales (ROS) (p. 1081) Computed by dividing the operating income by the total sales for the particular business segment or product line. It tells managers the amount of earn- ings generated from one dollar of sales.
stock options (p. 1089) An employee receives the right to purchase a prespecified number of shares at a prespecified price within a certain future time period. Options provide incentives for managers to make decisions that help increase stock prices.
value chain (p. 1085) The set of activities necessary to create and distribute a desirable product or service to a customer.
Bergly Automart
Divisions ROI Return on Sales Capital Turnover
New Car . . . $500,000 $5,000,000 10% $500,000 $10,000,000 5% $10,000,000 $5,000,000 200%
Used Car . . . $200,000 $1,000,000 20% $200,000 $5,000,000 4% $5,000,000 $1,000,000 500%
Service . . . $125,000 $500,000 25% $125,000 $600,000 20.8% $600,000 $500,000 120%
Bergly . . . $825,000 $6,500,000 12.7% $825,000 $15,600,000 5.3% $15,600,000 $6,500,000 240%
Demonstration Problem
Bergly Automart is a full-service auto dealer with three divisions: the New Car, Used Car, and Service divisions. Budget information for the coming year for these three divisions is shown below.
Each division manager’s annual evaluation and bonus is based on divisional ROI.
The manager of the New Car Division complains that one reason the sales and resulting earn- ings for the New Car Division are not higher is the reputation of the Service Division. Because the Service Division does not have the most recent equipment (e.g., a new hydraulic lift) customers buy their new cars from a competitor on the other side of town that has a service department with new equipment, including new lifts that make its service quicker and better. The manager of the New Car Division has requested that other evaluation techniques be considered (such as residual income or a balanced scorecard approach) in an attempt to resolve this problem.
Bergly Automart
New Car Used Car Service Average investment . . . $ 5,000,000 $1,000,000 $500,000 Sales revenue . . . $10,000,000 $5,000,000 $600,000 Cost of goods sold . . . 8,750,000 4,000,000 300,000 Operating expenses . . . 750,000 800,000 175,000 Operating earnings . . . $ 500,000 $ 200,000 $125,000 Instructions
a. Compute the ROI for each of the divisions and the entire company. Use the DuPont method to analyze its return on sales and capital turnover. Comment on the results
b. Assume the Service Division is considering installing a new hydraulic lift. Upon investigating, the manager of the division finds that the lift would add $100,000 to the division’s average invested capital and that the Service Division’s operating earnings would increase by $20,000 per year.
1. What is the ROI of the new hydraulic lift?
2. What impact does the investment in the hydraulic lift have on the Service Division’s ROI?
3. What is the impact on Bergly Automart’s overall ROI? (Assume no change in car sales.) 4. Would the manager of the Service Division be motivated to undertake such an investment?
c. Compute the residual income for each division if the minimum required rate of return for Bergly Automart is 15 percent. Would the Service Division purchase the hydraulic lift if the performance evaluation were based on the division’s residual income and a 10 percent bonus of residual income were awarded? Show calculations to support your answer.
d. What measures might be appropriate for Bergly Automart to use for its divisions if it uses a balanced scorecard to evaluate and reward the division managers?
Solution to the Demonstration Problem a.
Demonstration Problem
Confirming Pages
Demonstration Problem 1095
Return on sales is much lower for the New Car and Used Car divisions than for the Service Division, reflecting the small markups typical for new and used car sales. To offset the lower return on sales, the capital turnover for both new and used cars is higher. The Service Division has a high profit margin with a low turnover. Despite its old equipment, the invest- ment base of the Service Division is still relatively larger than showroom assets for new and used cars.
b. 1. ROI of the hydraulic lift $20,000 $100,000 20%
2. Impact of the lift on the Service Division’s ROI: ($125,000 $20,000) ($500,000
$100,000) 24%
3. Impact on the Bergly Automart ROI:
($500,000 $200,000 $125,000 $20,000)
($5,000,000 $1,000,000 $500,000 $100,000) 12.8%
4. Because adding the new lift will lower the Service Division’s ROI and presumably lower the bonus received by the Service Division manager, the division manager will not purchase the new lift even though it improves Bergly Automart’s ROI.
c.
Divisions Residual Income without Lift Bonus New Car . . . $500,000 (0.15 $5,000,000) ($250,000) –0–
Used Car. . . $200,000 (0.15 $1,000,000) $50,000 $5,000 Service . . . $125,000 (0.15 $500,000) $50,000 $5,000
Service Division residual income after purchasing the lift:
$145,000 (0.15 $600,00) $55,000
The Service Division manager’s bonus would increase to $5,500 and thus, the manager would purchase the lift.
d. Many answers are possible, for example:
Division
New Car
Used Car
Service
Financial
Residual income of both division and company.
Residual income of both division and company.
Residual income of both division and company.
Business Process
• Number of customers processed.
• Number of used cars acquired.
• Number of customers processed.
• Efficiency of services performed.
• Number of cars to be serviced in process.
• Number of reworks.
Customer
• Customer satisfaction.
• Number of retained customers.
• Customer satisfaction.
• Number of retained customers.
• Number of complaints.
• Customer satisfaction.
• Lost customers.
Learning and Growth
• Sales seminars attended.
• Accessibility and use of knowledge of new car models.
• Sales seminars attended.
• Information on used car market gathered.
• Service training time.
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Self-Test Questions
Self-T est Questions
The answers to these questions appear on page 1111. There may be more than one response per question.
1. Which of the following are not part of the components of the DuPont system for measuring and evaluating business performance?
a. Return on sales.
b. Residual income.
c. Return on investment.
d. Capital turnover.
e. Number of patents.
2. Premo Pens is a division of InCommunicato, Inc. Premo generates annual revenue of $162,000, operating earnings of
$55,000, and has average assets of $400,000. InCommuni- cato expects its divisions to earn a minimum required return of 12 percent. Which of the following does not represent either return on sales, residual income, or return on investment for Premo Pens?
a. 13.75%.
b. $7,000.
c. 34%.
d. 40.5%.
e. $9,000.
3. Criticisms of return on investment as the only performance measure include:
a. ROI focuses on short-term decisions.
b. ROI is focused on only one component of the value chain.
c. Managers evaluated based only on ROI are sometimes motivated not to make an investment that is in the best interest of the organization as a whole.
d. All of the above.
4. Which of the following is not represented in the balanced scorecard?
a. A learning and growth perspective.
b. The internal business process perspective.
c. The government’s perspective.
d. The customers’ perspective.
e. The financial perspective.
5. Which of the following is not likely to be included in the typical components of management compensation?
a. Company stock options.
b. Cash bonuses.
c. Free meals.
d. Fixed salary.
e. Company stock.
Discussion Questions Discussion Questions
ASSIGNMENT MATERIAL
1. Identify three ways that accounting systems help align the goals of employees and the goals of the organization.
2. Suppose you are interested in opening a new restaurant in your area. What specific activities would you identify as goals for your restaurant?
3. What activities would make up the learning and growth component of the balanced scorecard for a large public accounting firm?
4. Distinguish between the four lenses of the balanced scorecard and provide an example of a business measure for each category for a family-owned grocery store.
5. Assume you are the manager of the finished goods warehouse of a computer manufacturer. Which warehouse-related busi- ness measures might help the company achieve its balanced scorecard goals?
6. What are some problems that companies have encountered in using the balanced scorecard?
7. Why is residual income suggested as an improvement over ROI for business measurement?
8. In designing a compensation plan for the manager of the international operations of Tootsie Roll Industries , what trade-offs should the company’s board of directors consider?
9. How would you expect the components of return on invest- ment to be different for a mostly Internet-based retailer
compared to a more traditional bricks-and-mortar retailer (e.g., Amazon.com versus Barnes & Noble )?
10. Under which circumstances is a fixed salary preferable to a pure bonus compensation system?
11. Exhibit 25–9 identifies balanced scorecard performance measures. Review this exhibit and identify two measures from the customer perspective category that in the short run might be in conflict with some of the measures listed in the financial perspective category. Explain why they might be in conflict.
12. For which perspective of the balanced scorecard would the output from a standard cost system (e.g., variances) provide useful performance measurement information?
Explain.
13. Assume sales remain constant from Year 1 to Year 2 and return on sales (ROS) increases from Year 1 to Year 2.
Identify two reasons why the return on sales ratio might increase from Year 1 to Year 2.
14. Identify the costs and benefits of a cooperative incentive plan in which a team of individuals equally shares a bonus pool if the team achieves a predetermined goal.
15. Identify the costs and benefits of a competitive incentive plan in which only one individual out of a group receives the bonus if he or she outperforms the others in the group.
Confirming Pages
Brief Exercises 1097
Brief Exercises
Marsha’s Pet Store employs six employees. Their duties are to sell pets, replenish the stock, keep the pets’ cages clean, feed the pets, and maintain good records. Marsha pays a fixed hourly rate and a commission on sales of pets. Lately, Marsha has been finding that the records have not been well maintained and the stock has not been replenished. However, pet sales are good and the pets’
cages are clean.
How might Marsha’s current reward structure be motivating the employees to pay more atten- tion to the pets than to their other duties?
Zylex Corporation has multiple factories across the United States. The upper management at Zylex evaluates each factory based on the capital turnover ratio from the DuPont system. Below is infor- mation for the factory in Pennsylvania for the past year.
Brief Exercises accounting
BRIEF
EXERCISE 25.1 Motivating Employee Performance
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EXERCISE 25.2 Evaluate Business Performance Using ROI
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Year 2 Sales . . . $1,000,000 Operating expenses . . . 640,000 Total assets . . . 2,200,000 Accumulated depreciation . . . 220,000
Division 1 Division 2 Earnings . . . $ 750,000 $ 2,000,000 Investment base . . . 5,000,000 20,000,000
Compute the capital turnover ratio using (1) total assets and (2) assets net of depreciation.
Which investment base will the Pennsylvania factory manager prefer and why?
Use the information in Brief Exercise 25.2 to compute the ROI for the Pennsylvania factory using total assets and assets net of depreciation. Now find residual income if the company expects an 18 percent return on total assets. Is the Pennsylvania factory performing up to management’s expectations?
Ricoh Company Ltd., the 74-year-old leading supplier of office automation equipment and elec- tronics, has implemented a balanced scorecard. Match each of the performance indicators from their scorecard below to the four balanced scorecard perspectives (Financial, Customer, Internal Processes, and Learning and Growth).
a. Number of Customer Relationships Managed b. Hours of Employee Training
c. Customer Service Quality Ratings d. Revenue Growth
e. Customer’s Total Cost of Ownership f. Asset Utilization
g. Employee’s Competitor Knowledge Increased h. Pounds of Recycled Waste Products
Saxwell Corporation has many divisions and evaluates them using ROI. The corporation’s expected ROI for each division is 12 percent or above.
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EXERCISE 25.3 Comparing ROI and Residual Income C
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EXERCISE 25.4 Balanced Scorecard B
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Compute the ROI for Divisions 1 and 2. Are the divisions meeting the expected ROI? What other information would you want to know about the investment base before comparing Division 1 and 2 performance?
Consider the information in Brief Exercise 25.5. Assume that the manager of Division 1 has the opportunity to purchase a new piece of equipment for $1,000,000 that would increase earnings by
$130,000 per year. Show the impact of this purchase on Division 1’s ROI. Would the manager of Division 1 undertake the investment? Why or why not?
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EXERCISE 25.6 Criticisms of ROI B
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Wellinghouse Industries has established a 10 percent target ROI for its divisions. The following data have been gathered for the Ionia Division’s operations for the previous year: Revenues
$30,000,000; Expenses $28,000,000; Invested capital $11,200,000. Did the Ionia Division meet the ROI target? What is the Ionia Division’s residual income?
The weighted-average cost of capital for Forstone Corporation is 12 percent. Last year one of the divisions of Forstone generated an EVA of $3,720,000, while the division’s assets less its current liabilities were $25,600,000. How much after-tax operating income did the division generate?
Compensation for top executives (e.g., CEOs and CFOs) has become more variable over time.
For example, recent data show that in large corporations only 20 percent of CFO pay is fixed and 80 percent is variable, based on companywide performance. Explain why you believe this type of reward plan has been chosen for CFOs of large companies.
Boris Jasper is the manager of an auto parts division for a large auto parts supplier. The division makes dampers and oil pumps. Identify three things Boris could do to increase the division’s ROI in the coming year.
Exercises
Listed below are eight terms introduced or emphasized in this chapter:
Residual income Balanced scorecard Management compensation Return on investment
Return on sales Stock options
Business process lens Capital turnover
Each of the following statements may (or may not) describe one of these terms. For each statement, indicate the term described, or answer “none” if the statement does not correctly describe any of these terms.
a. Tells managers the incremental operating earnings for each additional sales dollar.
b. The focus of this business performance measurement is the sales dollars earned from each invested dollar.
c. A tool used by managers and owners of organizations to align managers’ goals with those of the organization.
d. This method considers all costs borne by the consumer from purchase to disposal of a product.
e. A business performance measurement that takes into account the minimum required return on the assets employed.
f. Measures for this category of business performance are associated with eliminating non-value- added costs from the value chain.
g. A method in which a product’s selling price is determined by adding a fixed amount to the product’s current production cost.
h. This performance evaluation method is criticized for motivating managers, in some instances, to ignore investments that are in the best interest of the company as a whole.
i. An important aspect of this method is the consideration of the many perspectives of the mul- tiple stakeholders in an organization.
Assume you have just been hired as the management accountant in charge of providing your firm’s managers with product information. What activities might you undertake if you were participating in the design of a balanced scorecard?
In a Wall Street Journal quiz about the impact of technology at the office, 2 quiz respondents were requested to say whether a specific activity was unethical. Forty-nine percent of respondents said that using office technology for playing games at work is unethical and 54 percent said that shop- ping on the Internet at work is unethical. Which performance evaluation and incentive systems would encourage or discourage these behaviors?
BRIEF
EXERCISE 25.7 Calculate Residual Income
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EXERCISE 25.8 Calculate EVA B
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EXERCISE 25.9 Variable versus Fixed Compensation C
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EXERCISE 25.10 Components of ROI C
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Exercises accounting
EXERCISE 25.1 Accounting Terminology E
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EXERCISE 25.2 Balanced Scorecard Activities
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EXERCISE 25.3 Employee Motivation E
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2 Source: The Wall Street Journal, October 21, 1999, page B1.