Financial performance measures for investment centres, and reward systems

Chapter 13 Financial performance measures for investment centres, and reward systems13-1Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOutlineFinancial measures in investment centresReturn on investmentsResidual incomeMeasuring profit and invested capitalMeasures of shareholder valueReward systemsTheories of motivationPerformance-related reward systems13-2Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithFinancial measures in investment centresFocus on summary profit-based measures used to evaluate the performance of profit centres and investment centresReturn on investment (ROI)Residual income (RI)Economic value added (EVA)13-3Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithReturn on investment13-4Return on investment (ROI)Used to measure the performance of an investment centre Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Return on investment (cont.)13-5Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Return on investment (cont.)Invested capitalThe assets that the investment centre has available to generate profitsReturn on salesThe percentage of each sales dollar that remains as profit after all the expenses are coveredInvestment turnoverThe number of sales dollars generated by every dollar of invested capital13-6Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Return on investment (cont.)Improving ROIIncrease return on salesBy increasing the selling price or sales revenue, or decreasing expensesIncrease investment turnover By increasing sales revenue or reducing invested capitalActions that are taken with the sole purpose of making these ratios more favourable in the short term may have adverse effects on performance in future years13-7Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithThe advantages of ROIVery widely used to measure the performance of units and managersEncourages managers to focus on profits, and the assets required to generate those profitsPromotes an understanding of the relationship between revenues, costs and assetsCan be used to evaluate the relative performance of investment centresEven when those business units are of different sizes13-8Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithThe limitations of ROIEncourages managers to focus on short-term financial performance at the expense of long-term viability and competitivenessEncourages managers to defer asset replacementTo maintain high ROI and apparent high performanceDiscourages managers from investing in projects which are acceptable from the organisation’s point of view, but decrease the investment centre’s ROI13-9Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithMinimising the behavioural problems of ROIUse ROI as one of several performance measures that focus on both short-term and long-term performanceConsider alternative ways of measuring invested capital to minimise dysfunctional decisionsUse alternative financial measures, such as residual income or economic value added13-10Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithResidual incomeResidual income (RI)= profit – (invested capital × imputed interest rate) Imputed interest chargeBased on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capitalWeighted average cost of capital (WACC) is the weighted average of the cost of funds from all sources of borrowings and equity13-11Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithThe advantage of residual incomeMore likely to promote goal congruence, compared to ROITakes account of the organisation’s required rate of return in measuring performance Encourages investment in projects which yield a positive residual income to the organisation13-12Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithDisadvantages of residual incomeCannot be used to assess the relative performance of businesses that are of different sizes, unlike ROIFormula is biased in favour of larger businesses, unlike ROICan encourage short-term orientation/focus, as with ROI 13-13Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithMeasuring profit and invested capitalTotal assets Investment centre manager is responsible for decisions about all assetsTotal productive assetsInvestment centre managers retain non-productive assetsTotal assets less current liabilitiesInvestment centre is responsible for decisions about assets and manages short-term liabilitiesChoose average or end-of-year balances13-14Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithAsset measurementAdvantages of carrying amountConsistency with balance sheet that is prepared for external reporting purposesConsistent with the definition of profitAdvantages of acquisition costChoice of depreciation method is arbitrary and resulting carrying amount does not provide a reliable measureDepreciating non-current assets may provide a disincentive to invest in new equipment13-15Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith13-16Measuring profitProfit margin controllable by investment centre managerSuitable when the focus is performance of the managerEncourages managers to focus on profit that they can controlMotivational impactProfit margin attributable to investment centreTo calculate the investment centre ROI13-17Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith13-18Measures of shareholder valueShareholder valueImproving the worth of the business from the shareholders’ perspectiveValue-based management Using shareholder value analysis to manage a businessA framework for making key business decisions that add economic value to the businessConsists of four aspectsValuation, strategy, finance and corporate governance13-19Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Measures of shareholder value (cont.)ValuationDiscounted cash flows (DCF) are usually used to measure valueFuture cash flows of the business are discounted taking into account the risk associated with those cash flowsValue drivers are the activities or actions that create value for a businessInclude spread, growth, sustainability and cost of capital13-20Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Measures of shareholder value (cont.)StrategyHas a substantial and continuing impact on the value of the businessFinanceFinancial policies will influence value creationCorporate governanceInvolves selecting and implementing systems that contribute to value creation13-21Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Measures of shareholder value (cont.)Economic value added (EVA)Measure of the value created over a single accounting periodThe spread between the return generated by the business activities and the cost of capital13-22Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Measures of shareholder value (cont.)Weighted average cost of capitalUsed in the calculation of EVA and RITo improve EVAImprove profitability without employing additional capitalBorrow additional funds when profits earned are more than the cost of borrowingPay off debt by selling assetsLimitations of EVAPotential for manipulation and short-term orientation13-23Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Measures of shareholder value (cont.)Shareholder value added (SVA)= corporate value – the market value of debtCorporate value is the present value of the future cash flowsResidual value is the value of the firm at the end of the forecast period13-24Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithReward systemsProcesses, practices and systems which are used to provide levels of pay and benefits to employeesMotivationThe processes that account for an individual’s intensity, direction and persistence of effort towards attaining goalsIntrinsic motivationDerives from the interest and enjoyment of the workExtrinsic motivationDerives from sources outside the individual13-25Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTheories of motivationHerzberg’s theory of work motivationHygiene factorsProvide the setting for encouraging employee motivation, but do not themselves motivate employees Working conditions, wage levels, rules and regulations, relationships with colleagues, job securityMotivatorsFactors that relate to job content and which provide employee motivationAchievement, recognition, the nature of the work, responsibility, opportunities for personal growth13-26Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Theories of motivation (cont.)Expectancy theoryEmployee motivation is a result of the strength of the relationships between expectancy, instrumentality and valenceExpectancy: perception that effort will lead to a certain performanceInstrumentality: perception that performance will lead to desired outcomeValence: the attractiveness of the rewardMotivational theories need to be considered by managers when they are designing performance evaluation and reward systems13-27Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithPerformance-related reward systemsPerformance-related pay systems (incentive compensation schemes) Link employee rewards for achieving or exceeding some performance targetIndividual incentive plansIndividuals are rewarded for achieving individual performance targets Subjective criteria may also be usedCommon at the senior levels of the organisation13-28Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Performance-related reward systems (cont.)Profit-sharing plansCash bonuses are paid to each employee, based on a specified percentage of the company’s profitDoes not tie individual effort to individual rewardsEmployee share plans (share option plans)Provide employees with the right to purchase shares in their company, at a specified price at some specified future time Commonly used for senior managers, and sometimes more junior managers and employeesConsidered to encourage goal congruence13-29Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Performance-related reward systems (cont.)GainsharingCash bonuses are distributed to employees when the performance of the company, or their segment of the company, exceeds some performance target Team-based incentive schemesIndividuals are rewarded based on their work team exceeding certain performance targetsIntended to encourage teamwork and cooperation between employeesDoes not tie individual effort to individual rewards13-30Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithGroup versus individual performanceConsider the following issuesIdentification with the groupEquity among employees Competitiveness between employeesRelating individual effort to rewardRewarding only good performersThe timing of incentive payments can be crucial to achieving desired outcomesMore frequent rewards may help ensure continual motivation13-31Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithSummaryReturn on investment is often used to evaluate performance of investment centresCan encourage managers to focus on achieving high profits through the efficient use of assets, but can also encourage dysfunctional decisionsThese can be reduced through using a range of performance measures that focus on short and long term, using alternative measures of profit and invested capital, and using other financial measures such as residual income or EVA13-32Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Summary (cont.)Reward systems can be used to encourage goal congruent behaviourWhen designing performance-related schemes it is important to understand what motivates employeesPerformance-related reward systems include individual incentives, profit-sharing, employee share plans, team-based incentivesThe frequency and timing of payments may impact on effectiveness of the reward system13-33Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith