Presented by Ruvendra Nandan

Lecture 6 Reading: Chapter 13 Financial performance measures for investment centres and reward systems

Learning outcomes
Understand the nature of investment centres Identify various performance measures to evaluate investment centres Calculate and evaluate return on investment measure Calculate and evaluate residual income measure Calculate and evaluate economic value added measure Link performance with reward to enhance goal congruence

Recognise sources of motivation and understand theories of motivation

Financial measures in investment centres

Focus on summary profit-based measures used to evaluate the performance of profit centres and investment centres
Return on investment (ROI) Residual income (RI) Economic value added (EVA)

Return on investment
Return on investment (ROI)
Used to measure the performance of an investment centre

ROI =

Profit Invested Capital

Return on investment
ROI: ROI = ROI = the Du Pont Perspective Margin x Turnover Net income x Sales Sales Invested capital

Du Pont provides more in-depth insights for managers to increase ROI (hence self-interest)

Return on investment
Invested capital
The assets that the investment centre has available to generate profits

Return on sales
The percentage of each sales dollar that remains as profit after all the expenses are covered

Investment turnover
The number of sales dollars generated by every dollar of invested capital

Return on investment
Improving ROI
Increase return on sales
> By increasing the selling price or sales revenue, or decreasing expenses

Increase investment turnover

> By increasing sales revenue or reducing invested capital

Actions 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 years

The advantages of ROI

Very widely used to measure the performance of divisions and managers Encourages managers to focus on profits, and the assets required to generate those profits Promotes an understanding of the relationship between revenues, costs and assets Can be used to evaluate the relative performance of investment centres Even when those business units are of different sizes

The limitations of ROI

Encourages managers to focus on short-term financial performance at the expense of longterm viability and competitiveness Encourages managers to defer asset replacement To maintain high divisional ROI and apparent high performance Discourages managers from investing in projects which are acceptable from the organisations point of view, but decrease the investment centres ROI

Minimising the behavioural problems of ROI

Use ROI as one of a series of performance measures that focus on both short-term and long-term performance Consider alternative ways of measuring invested capital to minimise dysfunctional decisions Use alternative financial measures, such as residual income or economic value added

Residual income
Residual income (RI)

= profit (invested capital imputed interest rate)

Imputed interest charge Based on the required rate of return that the firm expects of its investments, which is based on the organisations cost of capital Weighted average cost of capital (WACC) is the weighted average of the cost of funds from all sources of borrowings and equity

The advantages of residual income

More likely to promote goal congruence, compared to ROI Takes account of the organisations required rate of return in measuring performance Encourages investment in projects which yield a positive residual income to the organisation

Disadvantages of residual income

Cannot be used to assess the relative performance of businesses that are of different sizes, unlike ROI Formula is biased, in favour of larger businesses, unlike ROI Can encourage short-term orientation/focus, as with ROI

Measuring profit and invested capital

Total assets Investment centre manager is responsible for decisions about all assets Total productive assets Investment centre managers retain nonproductive assets Total assets less current liabilities Investment centre is responsible for decisions about assets and manages short-term liabilities Choose average or end-of-year balances

Asset measurement
Advantages of net book value
Consistency with balance sheet that is prepared for external reporting purposes Consistent with the definition of profit

Advantages of gross book value

Depreciation is arbitrary and should not be allowed to affect calculations Depreciating non-current assets may provide a disincentive to invest in new equipment

Measuring profit
Profit margin controllable by investment centre manager Suitable when the focus is performance of the manager Encourages managers to focus on profit that they can control Motivational impact Profit margin attributable to investment centre To calculate the investment centre ROI See exhibit 13.3, p. 622

Measures of shareholder value

Economic value added (EVA)
Measure of the value created over a single accounting period The spread between the return generated by the business activities and the cost of capital

Measures of shareholder value

Weighted average cost of capital Used in the calculation of EVA and RI To improve EVA Improve profitability without employing additional capital Borrow additional funds when profits earned are more than the cost of borrowing Pay off debt by selling assets Limitations of EVA Potential for manipulation and short-term orientation

Reward systems
Processes, practices and systems which are used to provide levels of pay and benefits to employees Motivation The processes that account for an individuals intensity, direction and persistence of effort towards attaining goals Intrinsic rewards Intangible, arise from the positive experiences of being satisfied with performing well Extrinsic rewards Given to employees from an external source

Theories of motivation
Herzbergs theory of work motivation
Hygiene factors
> Provide the setting for encouraging employee motivation, but do not themselves motivate employees > Working conditions, wage levels, rules and regulations, relationships with colleagues, job security

Motivators
> Factors that relate to job content and which provide employee motivation > Achievement, recognition, the nature of the work, responsibility, opportunities for personal growth

Theories of motivation
Expectancy theory Employee motivation is a result of the strength of the relationships between expectancy, instrumentality and valence Expectancy: perception that effort will lead to a certain performance Instrumentality: perception that performance will lead to desired outcome Valance: the attractiveness of the reward Motivational theories need to be considered by managers when they are designing performance evaluation and reward systems

Performance-related reward systems

Performance-related pay systems (incentive compensation schemes)
Link employee rewards for achieving or exceeding some performance targets

Individual incentive plans

Individuals are rewarded for achieving individual performance targets Subjective criteria may also be used Common at the senior levels of the organisation

Performance-related reward systems

Profit-sharing plans Cash bonuses are paid to each employee, based on a specified percentage of the companys profit Does not tie individual effort to individual rewards Employee 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 employees Considered to encourage goal congruence

Performance-related reward systems

Gainsharing Cash bonuses are distributed to employees when the performance of the company, or their segment of the company, exceeds some performance target Team-based incentive schemes Individuals are rewarded based on their work team exceeding certain performance targets Intended to encourage teamwork and cooperation between employees Does not tie individual effort to individual rewards

Summary and Conclusion

Understand the nature of investment centres Focus on financial measures of investment centres Note the strengths and weaknesses of ROI, RI and EVA Agency theory and goal congruence Ingredients of a good reward pack Note the roles of motivational theories in designing and implementing performance related reward systems Lecture 7 will focus on a more balanced approach to managing and evaluating performance Techniques involve the use of a balanced-scorecard, benchmarking and the use of non-financial measures