Rewarding Business Performance

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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright © 2012 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin

Rewarding Business Rewarding Business PerformancePerformanceChapter 25

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Goal CongruenceAlignment of employee goals

and objectives with organizational goals and

objectives.

Motivation and AligningMotivation and AligningGoals and ObjectivesGoals and Objectives

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Motivation and AligningMotivation and AligningGoals and ObjectivesGoals and Objectives

Feedback Steer employees toward goals Measure progress in achieving goals

Measureperformance

Improveperformance

Rewardperformance.

Rewardperformance

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Return on Investment (ROI)Return on Investment (ROI) Return on investment is the ratio of

operating income to the average investment used to generate the

income.

ROI = Operating Income Average Total Assets

Using ROI to evaluate business performanceis often referred to as the DuPont system.

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Components of ROI

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Return on Investment (ROI)Return on Investment (ROI)

SalesAverage InvestmentROI = Profit

Sales ×

ROI = 6% × 2.5 = 15%

$500,000$200,000ROI = $30,000

$500,000 ×

ROI = Operating IncomeAverage Total Assets

ROI = $30,000$200,000

= 15%

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Improving ROIImproving ROI

Increase Sales Prices

Decrease Expenses

Lower Invested Capital

Three ways to improve ROI

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Criticisms of ROICriticisms of ROIAs division manager at Winston, Inc., your

compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus.

The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%.

You have an opportunity to invest in a new project that will produce an ROI of 25%.

As division manager would you invest in this project?

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Operating Earnings– Investment charge = Residual income

Investment capital× Minimum return = Investment charge

Residual IncomeResidual Income

Investment center’sminimum acceptable

return

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Residual IncomeResidual Income Operating Earnings = $25,000– Investment charge = 20,000 = Residual income = $ 5,000

Investment capital = $100,000× Minimum return = × 20%= Investment charge = $ 20,000

Investment center’sminimum acceptable

return

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Residual income encourages managers to make profitable investments that would

be rejected by managers using ROI.

Residual IncomeResidual Income

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Economic value added tells us how much shareholder wealth is

being created.

Economic Value AddedEconomic Value Added

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Economic Value AddedEconomic Value AddedEconomic value added is the annual after-tax operating profit minus the

total annual cost of capital.

Cost of capital is weighted-average after-tax

cost of long-term borrowing and the cost of equity.

DebtEquity

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After-tax Operating Income– Investment charge = Economic value added

(Total assets – current liabilities)× Weighted-average cost of capital= Investment charge

After-tax cost oflong-term borrowing

and the cost of equity

Economic Value AddedEconomic Value Added

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Economic Value AddedEconomic Value AddedEconomic value added can be

improved in three ways . . .Increase profit without using more

capital.Use less capital to earn the same

amount of profit.Invest capital in high-return projects.

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Balanced ScorecardBalanced ScorecardA set of performance targets and results

that show an organization’s performance in meeting its

responsibilities to various stakeholders.

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Financial PerspectiveHow do we look

to the firm’s owners?

Learning and Growth Perspective

How can we continuallyimprove and create value?

Business ProcessPerspective

In which activities must we excel?

Customer PerspectiveHow do our

customers see us?

Balanced ScorecardBalanced Scorecard

Visionand

Strategy

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Components of Management Components of Management CompensationCompensationI prefer a fixed salaryso that I know what

I will be paid each year.

I prefer a bonus arrangement that gives me

the opportunity to earn larger amounts. I don’t mind the varying compensation.

I like both profit sharing and stock options.

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Design Choices for Design Choices for Management CompensationManagement Compensation

Should we rewardcurrent performance or

future performance?

Should our rewards be based on accounting

numbers or stock price performance?

Should bonuses befixed or should they

vary with aperformance

measure?

Should bonuses bebased on local or

company-wideperformance?

Should teams ofemployees share

bonuses equally orshould they

be in competition?

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End of Chapter 25End of Chapter 25