Cost15EChapter 23 Solutions PDF

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CHAPTER 23 PERFORMANCE MEASUREMENT, COMPENSATION, AND MULTINATIONAL CONSIDERATIONS 23-1

Examples of financial and nonfinancial measures of performance are Financial: ROI, residual income, economic value added, and return on sales Nonfinancial: Customer perspective: Market share, customer satisfaction Internal-business-processes perspective: Manufacturing lead time, yield, on-time performance, number of new product launches, and number of new patents filed Learning-and-growth perspective: employee satisfaction, informationsystem availability

23-2 1. 2.

The three steps in designing an accounting-based performance measure are as follows: Choose performance measures that align with top management’s financial goals. Choose the details of each performance measure in Step 1, including the time horizon and measurement of various aspects of the measure. Choose a target level of performance and feedback mechanism for each performance measure in Step 1.

3.

23-3 The DuPont method highlights that ROI is increased by any action that increases return on sales or investment turnover. ROI increases with 1. increases in revenues, 2. decreases in costs, or 3. decreases in investments, while holding the other two factors constant. 23-4 Yes. Residual income (RI) is not identical to return on investment (ROI). ROI is a percentage with investment as the denominator of the computation. RI is an absolute monetary amount which includes an imputed interest charge based on investment. 23-5 Economic value added (EVA) is a specific type of residual income measure that is calculated as follows:



Weighted-average Total assets minus Economic value After-tax cost of capital current liabilities added (EVA ) = operating income – 23-6 1. 2. 3. 4.

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Definitions of investment used in practice when computing ROI are as follows: Total assets available Total assets employed Total assets employed minus current liabilities Stockholders’ equity

23-7 Current cost is the cost of purchasing an asset today identical to the one currently held if an identical asset can currently be purchased; it is the cost of purchasing an asset that provides services like the one currently held if an identical asset cannot be purchased. Historical-cost-

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based measures of ROI compute the asset base as the original purchase cost of an asset minus any accumulated depreciation. Some commentators argue that current cost is oriented to current prices, while historical cost is past-oriented. 23-8 Special problems arise when evaluating the performance of divisions in multinational companies because a. the economic, legal, political, social, and cultural environments differ significantly across countries. b. governments in some countries may impose controls and limit selling prices of products. c. availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ significantly across countries. d. divisions operating in different countries keep score of their performance in different currencies. 23-9 In some cases, the subunit’s performance may not be a good indicator of a manager’s performance. For example, companies often put the most skillful division manager in charge of the weakest division in an attempt to improve the performance of the weak division. Such an effort may yield results in years, not months. The division may continue to perform poorly with respect to other divisions of the company. But it would be a mistake to conclude from the poor performance of the division that the manager is performing poorly. A second example of the distinction between the performance of the manager and the performance of the subunit is the use of historical cost-based ROIs to evaluate the manager even though historical cost-based ROIs may be unsatisfactory for evaluating the economic returns earned by the organization subunit. Historical cost-based ROI can be used to evaluate a manager by comparing actual results to budgeted historical cost-based ROIs. 23-10 Moral hazard describes situations in which an employee prefers to exert less effort (or to report distorted information) compared with the effort (or accurate information) desired by the owner because the employee’s effort (or validity of the reported information) cannot be accurately monitored and enforced. 23-11 No, rewarding managers on the basis of their performance measures only, such as ROI, subjects them to uncontrollable risk because managers’ performance measures are also affected by random factors over which they have no control. A manager may put in a great deal of effort but her performance measure may not reflect this effort if it is negatively affected by various random factors. Thus, when managers are compensated on the basis of performance measures, they will need to be compensated for taking on extra risk. Therefore, when performance-based incentives are used, they are generally more costly to the owner. The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager. 23-12 Benchmarking or relative performance evaluation is the process of evaluating a manager’s performance against the performance of other similar operations. The ideal benchmark is another operation that is affected by the same noncontrollable factors that affect

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the manager’s performance. Benchmarking cancels the effects of the common noncontrollable factors and provides better information about the manager’s performance. 23-13 When employees have to perform multiple tasks as part of their jobs, incentive problems can arise when one task is easy to monitor and measure while the other task is more difficult to evaluate. Employers want employees to intelligently allocate time and effort among various tasks. If, however, employees are rewarded on the basis of the task that is more easily measured, they will tend to focus their efforts on that task and ignore the others. 23-14 Disclosures required by the Securities and Exchange Commission are as follows: a. A summary compensation table showing the salary, bonus, stock options, other stock awards, and other compensation earned by the five top officers in the previous three years b. The principles underlying the executive compensation plans, and the performance criteria, such as profitability, sales growth, and market share used in determining compensation c. How well a company’s stock performed relative to the stocks of other companies in the same industry

23-15 The four levers of control in an organization are diagnostic control systems, boundary systems, belief systems, and interactive control systems.  Diagnostic control systems are the set of critical performance variables that help managers track progress toward the strategic goal. These measures are periodically monitored and action is usually only taken if a measure is outside its acceptable limits.  Boundary systems describe standards of behavior and codes of conduct expected of all employees, particularly by defining actions that are off-limits. Boundary systems prevent employees from performing harmful actions.  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 with respect to each other, shareholders, customers, and communities.  Interactive control systems are formal information systems that managers use to focus an organization's attention and learning on key strategic issues. They form the basis of ongoing discussion and debate about strategic uncertainties that the business faces and help position the organization for the opportunities and threats of tomorrow. 23-16 (30 min.) ROI, comparisons of three companies. 1. The separate components highlight several features of return on investment not revealed by a single calculation: a. The importance of investment turnover as a key to income is stressed. b. The importance of revenues is explicitly recognized. c. The important components are expressed as ratios or percentages instead of dollar figures. This form of expression often enhances comparability of different divisions, businesses, and time periods. 23-

d. The breakdown stresses the possibility of trading off investment turnover for income as a percentage of revenues so as to increase the average ROI at a given level of output. 2.

(Filled-in blanks are in bold face.) Revenue Income Investment Income as a % of revenue Investment turnover Return on investment

Companies in Same Industry A B C $2,000,000 $500,000 $ 200,000 $ 150,000 $ 60,000 $ 60,000 $ 250,000 $ 1,000,000 $1,000,000 30% 30% 3.0% 2.0 2.0 0.2 6% 60% 6%

Income and investment alone shed little light on comparative performances because of disparities in size between Company A and the other two companies. Thus, it is impossible to say whether B’s low return on investment in comparison with A’s is attributable to its larger investment or to its lower income. Furthermore, the fact that Companies B and C have identical income and investment may suggest that the same conditions underlie the low ROI, but this conclusion is erroneous. B has higher margins but a lower investment turnover. C has very small margins (1/10th of B) but turns over investment 10 times faster. I.M.A. Report No. 35 (page 35) states: Introducing revenues to measure level of operations helps to disclose specific areas for more intensive investigation. Company B does as well as Company A in terms of income margin, for both companies earn 30% on revenues. But Company B has a much lower turnover of investment than does Company A. Whereas a dollar of investment in Company A supports two dollars in revenues each period, a dollar investment in Company B supports only twenty cents in revenues each period. This suggests that the analyst should look carefully at Company B’s investment. Is the company keeping an inventory larger than necessary for its revenue level? Are receivables being collected promptly? Or did Company A acquire its fixed assets at a price level that was much lower than that at which Company B purchased its plant? On the other hand, C’s investment turnover is as high as A’s, but C’s income as a percentage of revenue is much lower. Why? Are its operations inefficient, are its material costs too high, or does its location entail high transportation costs? Analysis of ROI raises questions such as the foregoing. When answers are obtained, basic reasons for differences between rates of return may be discovered. For example, in Company B’s case, it is apparent that the emphasis will have to be on increasing turnover by reducing investment or increasing revenues. Clearly, B cannot appreciably increase its ROI simply by increasing its income as a percent of revenue. In contrast, Company C’s management should concentrate on increasing the percent of income on revenue.

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2 3 1 7 ( 3 0mi n. ) Anal ys i so fr e t ur noni nv e s t e das s e t s , c ompar i s o noft wodi v i s i o ns ,DuPontme t hod. 1 .

Test Preparation Division 2012 2013 2014 Language Arts Division 2012 2013 2014 Global Data, Inc. 2012 2013 2014

Operating Income

Operating Revenues

Total Assets

Operating Income  Operating Revenues

$720 920 1,140

$9,000 $920 11.5% = $8,000 $1,140 9.5% = $12,000

$1,800 $920  46% = $2,000 $12,000  6 = $2,000

8.0% 11.5% 9.5%

5.0 4.0 6.0

40.0% 46.0% 57.0%

$660

$3,000 3,525 $2,900 1.6 = $4,640

$2,000 2,350 2,900

22.0% 20.0% 12.5%

1.5 1.5 1.6

33.0% 30.0% 20.0%

$1,380 $920 + $705 = $1,625 $1,140 + $580 = $1,720

$12,000 $8,000 + $3,525 = $11,525 $12,000 + $4,640 = $16,640

$3,800 $2,000 + $2,350 = $4,350 $2,000 + $2,900 = $4,900

11.5% 14.1% 10.3%

3.2 2.6 3.4

36.3% 37.4% 35.1%

$3,525 $2,900

20%= $705 20% = $580

Operating Revenues  Total Assets

Operating Income Total Assets

2 . Ba s e donr e v e n ue s ,Te s tPr e p a r a t i o ni smor et ha nt wi c et h es i z eofLa n g ua g eAr t s .I na d d i t i o n,t heTe s tPr e p a r a t i o nDi v i s i o n t u r n so v e ri t sa s s e t sa tmo r et h a nt wi c et h er a t eo ft heLa n g ua g eAr t sDe p a r t me nt( o pe r a t i n gr e v e nu e sa samu l t i p l eo ft o t a la s s e t s ) . Ho we v e r ,La n g ua g eAr t si st wi c ea spr o fit a bl ei nt e r mso fma r gi n s( o p e r a t i n gi nc o mea sap e r c e n tofo pe r a t i n gr e v e nu e s ) . Th en e tr e s u l t i st ha tTe s tPr e p a r a t i onh a sah i g h e rROI , t y pi c a l l yi nt h e40 – 60 %r a n g e , wh i l eLa n g ua g eAr t sh a sROIi nt h e2 0– 3 5 %r a n g e . Mor e o v e r , t heROIoft h eTe s tPr e pa r a t i onDi v i s i onh a sbe e ni n c r e a s i n gf r o m2 0 12t o2 01 4,wh i l et h eROIo ft h eLa n g u a g e Ar t sDe pa r t me nth a sb e e nf a l l i n g . Ov e r a l l ,t h i sh a sr e s u l t e di nGl o ba lDa t as ho wi n gs t a b l eROIo v e rt h ep a s tt h r e ey e a r s .

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

23.18

(10–15 min.) ROI and RI. Operating income = (Contribution margin per unit  150,000 units) – Fixed costs = ($720 – $500)  150,000 – $30,000,000 = $3,000,000

1.

ROI =

Operating income Investment

= $3,000,000 ÷ $48,000,000 =

6.25% 2.

Operating income =

ROI  Investment

[No. of pairs sold  (Selling price – Var. cost per unit)] – Fixed costs = ROI Investment Let $X = minimum selling price per unit to achieve a 25% ROI 150,000 ($X – $500) – $30,000,000 = 25% ($48,000,000) $150,000X = $12,000,000 + $30,000,000 + $75,000,000 X = $780 3.

Let $X = minimum selling price per unit to achieve a 20% rate of return

150,000 ($X – $500) – $30,000,000 = 20% ($48,000,000) $150,000X = $9,600,000 + $30,000,000 + $75,000,000 X = $764 23-19 (20 min.) ROI and RI with manufacturing costs. 1. The operating income is: Sales revenue ($13,000 × 9,000) Less: Direct materials ($1,000 × 9,000) Setup ($1,600 × 7,000) Production ($470 × 176,500) Gross margin Selling and administration Operating income

$117,000,000 $ 9,000,000 11,200,000 82,955,000

103,155,000 $ 13,845,000 8,940,000 $ 4,905,000

Average invested capital is ($24,500,000 + $30,000,000) ÷ 2 = $27,250,000 ROI =$4,905,000 / $27,250,000 =18% 2. Residual income = Operating income − (8% × Invested capital) = $4,905,000 − (8% × $27,250,000) = $4,905,000 − $2,180,000 = $2,725,000

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23-20 (20 min.) ROI, RI, EVA. 1. The after-tax net income is: Operating income Less: Interest expense ($600,000 × 6.25%) Income after interest and before taxes Income taxes ($162,500 × 20%) Net income after taxes

$200,000 37,500 $162,500 32,500 $130,000

2. Investment = Total assets = $1,250,000 Income = Operating income = $200,000 $200,000 $1, 250,000 = 16% ROI =

3. Income = Operating income = $200,000 Imputed cost of investment = Investment ($1,250,000) × Required rate of return (10%) = $125,000 Residual income

4. a.

b.

= Income – Imputed cost of investment = $200,000 – $125,000 = $75,000

Net operating profit after taxes = Operating income × (1 – Tax rate) = $200,000 × (1 – 0.2) = $160,000 Market value of debt = $600,000 After-tax cost of debt = 6.25% × (1 – Tax rate) = 6.25% × 80% = 5% Market value of equity = $400,000 × 2 = $800,000 Cost of equity capital = 12% (5% $600,000)  (12% $800, 000) $600,000  $800,000 = 9% Weighted-average cost of capital =

c.

Investment = Total Assets – Current Liabilities = $1,250,000 – $250,000 = $1,000,000 Therefore, EVA = $160,000 – 9% × $1,000,000 = $70,000. 23-

23-21 (25 min.) Goal incongruence and ROI. 1. McCall would be better off if the machine is replaced. Its cost of capital is 4%, and the IRR of the investment is 10%, indicating that this is a positive net present value project. 2.

The ROIs for the first five years are as follows:

Operating income1 End of year net assets Average net assets ROI 1 2

Year 1 $3,000 45,000 47,5002 6.32%

Year 2 $3,000 40,000 42,500 7.06%

Year 3 $3,000 35,000 37,500 8.00%

Year 4 $3,000 30,000 32,500 9.23%

Year 5 $3,000 25,000 27,500 10.91%

Income is cash savings of $8,000 less $5,000 annual depreciation expense.

($50,000 + $45,000) ÷ 2 = $47,500

The manager would not want to replace the machine before retiring because the division is currently earning a ROI of 10%, and replacement of the machine will lower the ROI every year until the fifth year, when the manager is long gone. 3. McCall could use long-term rather than short-term ROI, or use ROI and some other longterm measures to evaluate the Patio Furniture division to create goal congruence. Evaluating the managers on residual income rather than ROI would also achieve goal congruence. For example, replacing the machine increases residual income in Year 1. Residual income = Operating income − (4% × Average net assets) = $3,000 − (4% × 47,500) = $3,000 − $1,900 = $1,100 23-22 (25 min.) ROI, RI, EVA. 1. The required division ROIs using total assets as a measure of investment is shown in the row labeled (1) in Solution Exhibit 23-22.

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SOLUTION EXHIBIT 23-22 New Car Division

(1)

(2)

(3)

Total assets Current liabilities Operating income Required rate of return

$33,000,000 $6,600,000 $2,475,000 12%

Total assets – current liabilities

$26,400,000

ROI (based on total assets) ($2,475,000  $33,000,000; $2,565,000 $28,500,000)

Performance Parts Division $28,500,00 0 $8,400,000 $2,565,000 12% $20,100,00 0

7.5%

9.0%

RI (based on total assets – current liabilities) ($2,475,000 – (12% $26,400,000); $2,565,000 – (12% $20,100,000))

$(693,000)

$153,000

RI (based on total assets) ($2,475,000 – (12%  $33,000,000); $2,565,000 – (12% $28,500,000))

$(1,485,000)

$(855,000)

2. The required division RIs using total assets minus current liabilities as a measure of investment is shown in the row labeled (2) in the table above. 3. The row labeled (3) in the table above shows division RIs using assets as a measure of investment. Even with this new measure that is insensitive to the level of short-term debt, the New Car Division has a worse RI than the Performance Parts Division. Both RIs are negative, indicating that the divisions are not earning the 12% required rate of return on their assets. 4.

After-tax cost of debt financing = (1– 0.4) 10% = 6% After-tax cost of equity financing = 15% ($18,000,000 6%) + ($12,000,000 15%) Weighted average = cost of capital $18,000,000 + $12,000,000 = 9.6%

Operating income after tax 0.6  operating income before tax (0.6 $2,475,000; 0.6 $2,565,000) Required return for EVA 9.6%  Investment (9.6% $26,400,000; 9.6% $20,100,000) EVA (Optg. inc. after tax – reqd. return)

$ 1,485,000

$1,539,000

2,534,400 1,929,600 $(1,049,400) $ (390,600)

5. Both the residual income and the EVA calculations indicate that the Performance Parts Division is performing better than the New Car Division. The Performance Parts Division has a higher residual income. The negative EVA for both divisions indicates that, on an after-tax basis,

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the divisions are destroying value––the after-tax economic returns from them are less tha...