CHAPTER 23

PART I

The Balanced Score Card 

6 Step Process

1)  Choose perform measures align w/ top mgt’s financial goals

2)  Choose the time horizon for each financial measure

3)  Choose the def. for each component in the perform measures

4)  Choose a measure alternative for each performance measure

5)  Choose a target level of performance

6)  Choose the timing of the feedback

Return on Investment (ROI)

ROI =

Income / Investment =

(Income / Revenues) x (Revenues / Investment)

ROI has a few major strengths.

 Easy to compute and understand

It can be used to compare all types of business entities

ROI also has one major weakness

What managers need to do to increase ROI:

1)  Decrease the amount of invested capital (investment). (often measured as total assets or some variation of assets.)  By lowering assets (i.e. receivables), and keeping revenues constant, capital turnover will increase.

2)  Increase revenues while keeping income per dollar of revenue and invested capital constant.  This will increase return on sales (ROS) and ROI.

3)  Increase income while keeping revenues and invested capital constant.  To increase income while holding revenue constant, costs will have to be lowered.

RI = Income – (RRoR * Investment)

The great strength of RI

 RI is additive in nature, so every time a manager takes on a project with positive RI, overall RI goes up.  This better aligns the firm’s goals with managers’ goals. 

One minor disadvantage of RI

 RI is that it lacks comparability.  Larger projects will yield larger RI, and smaller projects yield smaller RI.  This is important when thinking about comparisons between units inside a company or comparisons between firms.  Larger units (larger companies) tend to have larger RI.

EVA is a variation of RI. 

EVA is actually trademarked and owned by the consulting firm Stern Stewart. (So this is a generic formula)

 Weighted-Average Cost of Capital

WACC =

(After Tax Cost of Debt * MV Debt + Cost of Equity * MV Equity)/

MV Debt + MV Equity

 [FYI, to turn something from pre-tax to after-tax, multiply the pre-tax number by (1 – tax  rate).  Works every time!]

EVA’s great strength

EVA gets all managers to view their actions in terms of shareholder wealth.  It does a very good job of promoting goal congruence

ROS = Income / Revenues

ROS is a measure of _____

and measures_____

 ...how well costs are contained

...cost structure.

Chapter 23

PART 2

More Stuff

When using performance metrics to evaluate performance, owners want to encourage managers to make both short-term and long-term decisions that benefit the company.  However, if a manager is solely (or mainly) evaluated using short-term measures, then they will be more likely to make decisions that are beneficial in the short-term, but may destroy firm value long-term.  Examples include inflating inventories to boost reported income, cutting R&D to boost current period earnings, or delaying scheduled maintenance to improve current period earnings.  To encourage managers to keep a long-term focus, many companies use a multiyear analysis where the results of current decisions are able to be fully recognized before any reward is issued.

Firms have a myriad of choices when it comes to defining “Income” and “Investment” for their performance measures.  Income could be net income, operating income, income before income taxes, income before depreciation and taxes, or some other definition.  Likewise, investment could be viewed as total assets, total assets employed (no idles assets included), total assets minus current liabilities, stockholders’ equity, or some other definition.  The exact definition used for these measures can have a significant impact on the outcome.  Controllability is often a key in determining what definition to use.

A long-standing debate in business is how to measure the assets included in our performance measures.  One side of the debate argues that using current costs (fair market values) is a more fair and accurate method.  Current cost is the cost of purchasing an asset today that is identical to the one currently held.  By using current costs, you can eliminate any variations in performance measures that results strictly from the cost at time of purchase.  However, there are serious drawbacks to using current costs.  First, many assets are difficult to value in present terms.  Advances in technology often make comparisons between old equipment and currently available equipment difficult.  Second, current costs estimates are inherently subjective and open the possibility of abusive financial reporting.  Managers would constantly push to have the current cost estimates reduced as low as possible to generate higher ROI.

Rather the use current costs, most businesses use historical costs (what was paid for the asset).  Even here there are options for how to use historical costs.  Firms can use gross book values or net book values (gross book value – accumulated depreciation).  Proponents of net book value argue that it more closely resembles asset values on the balance sheet and better aligns with the revenue producing capacity of the asset as it ages.  However, using net book value can have negative consequences.  As the net book value of assets decrease, ROI increases.  This may encourage managers to delay replacing old assets because the purchase on new (possibly more efficient) assets could cause a decrease in their performance measures.

Often firms rely on historical performance levels to establish current targets.  While historical data is helpful in establishing targets, new developments must also be taken into consideration.  For example, if a factory has a major equipment overhaul, that is likely to make current ROI change dramatically from prior ROI.  Thus, target levels should be negotiated using past-oriented historical data, as well as forward-looking estimates.  Including the managers being evaluated in the negotiating process will likely produce positive behavior results as well as lead to more accurate targets.

Choosing the Timing of Feedback

Three factors influence the timing of feedback

1) how critical is the information for the success of the company,

2) the level of management receiving feedback, and

3) the sophistication of the company’s information technology. 

1) how critical is the information for the success of the company,

2) the level of management receiving feedback, and

3) the sophistication of the company’s information technology. 

[Examples]

1)  For example, a manager responsible for airline sales needs daily data on passenger loads because of the high fixed cost involved in the airline industry.  Airlines’ profits are very sensitive to fluctuations in passenger load.

2)  Top manager don’t need to see information about daily operations, instead they may review operational data weekly or monthly.  However, middle-level mangers are assigned to responsibility of overseeing daily operations and thus need to see performance data each day.

3)  Sophisticated information technology makes providing a data much cheaper and easier.  Thus, firms with better IT are more likely to provide performance data more frequently.

Performance Measurement in Multinationals

When calculating performance measures for multinational companies, currencies should be translated into one common currency and adjustments for inflation should be made.  This makes comparisons across countries possible.  However, choices have to be made about what exchange rate to use (beginning of period, end of period, average) and how to best adjust for inflation.

When interpreting performance measures across countries, you must consider that each nation has its own unique economic, legal, political, social, and cultural environments that affect business performance.  Target performance levels should take into consideration all of these differences.

Incentives versus Risk

Moral hazard describes situations in which an employee prefers to exert less effort compared with the effort desired by the owner because the employee’s effort cannot be accurately monitored and enforced.  Companies design compensation contracts to minimize moral hazard.  The goal of compensation contracting is to create incentives for the managers to behave the way owners want them to behave.  However, in creating incentives for managers, owners must be careful not to place unnecessary risk on the managers.  When performance is influenced by factors beyond the manger’s control, then she is bearing risk.  The more risk a manager takes on, the more compensation she will demand in return.  Therefore, a manager’s performance evaluation should be based on controllable factors as much as possible.

Most executive compensation plans use a variety of financial and non-financial measures to evaluate an executive’s performance and give a mix of base salary, short-term bonuses, long-term bonuses, and other perks.  Short-term incentives are generally bonuses based on accounting measures such as ROI, RI, EVA, ROS, net income, cash flows, or EPS.  Long-term incentives are usually tied to long-term stock trends and generally come in the form of stock options.  The use of stock options and the level of executive compensation have come under tremendous scrutiny in recent years.