Performance Measurement,
Compensation,
and Multinational Considerations
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Financial and Nonfinancial Measures

Firms are increasingly presenting financial and
nonfinancial performance measures for their
subunits in a Balanced Scorecard, and it’s four
perspectives:
Financial
2. Customer
3. Internal Business Process
4. Learning and Growth
1.
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Balanced Scorecard Flow
 Firms assume that improvements in learning and
growth will lead to improvements in internal business
processes
 Improvements in the internal business processes will
lead to improvements in the customer and financial
perspectives
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Accounting-Based Performance Measures

Requires a six-step design process:
1.
2.
3.
4.
5.
6.
Choose Performance Measures that align with top
management’s financial goals
Choose the time horizon of each Performance Measure
Choose a definition of the components in each
Performance Measure
Choose a measurement alternative for each Performance
Measure
Choose a target level of performance
Choose the timing of feedback
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Step 1: Choosing Among Different
Performance Measures

Four common measures of economic
performance:
1.
2.
3.
4.

Return on Investment
Residual Income
Economic Value Added
Return on Sales
Selecting Subunit Operating Income as a metric is
inappropriate since it obviously differs simply on
the differing size of the subunits
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Return on Investment (ROI)
 ROI is an accounting measure of income divided by
an accounting measure of investment
ROI =
Income
Investment
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ROI

Most popular metric for two reasons:
Blends all the ingredients of profitability (revenues,
costs, and investment) into a single percentage
2. May be compared to other ROI’s both inside and
outside the firm
1.

Also called the Accounting Rate of Return (ARR) or
the Accrual Accounting Rate of Return (AARR)
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ROI
 ROI may be decomposed into its two components as
follows:
Income
Investment
=
Income
Revenues
X
Revenues
Investment
 ROI = Return on Sales X Investment Turnover
 This is known as the DuPont Method of Profitability
Analysis
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Residual Income
 Residual Income (RI) is an accounting measure of
income minus a dollar amount for required return
on an accounting measure of investment
 RI = Income – (RRR X Investment)
 RRR = Required Rate of Return
 Required Rate of Return times the Investment is the
imputed cost of the investment
 Imputed costs are cost recognized in some situations, but not
in the financial accounting records
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Economic Value Added (EVA)
 EVA is a specific type of residual income calculation
that has recently gained popularity
EVA
=
After-tax
Operating Income
{
Weighted-Average
Cost of Capital
X(
Total
Assets
Current
Liabilities
)}
 Weighted average cost of capital equals the after-tax
average cost of all long-term funds in use
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Return on Sales (ROS)
 Return on Sales is simply income divided by sales
 Simple to compute, and widely understood
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Step 2: Choosing the Time Horizon of the
Performance Measures
 Multiple periods of evaluation are sometimes
appropriate
 ROI, RI, EVA and ROS all basically evaluate one period
of time
 ROI, RI, EVA and ROS may all be adapted to evaluate
multiple periods of time
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Step 3: Choosing Alternative Definitions for
Performance Measures

Four possible alternative definitions of investment:
Total Assets Available
2. Total Assets Employed
3. Total Assets Employed minus Current Liabilities
4. Stockholder’s Equity
1.
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Step 4: Choosing Measurement Alternatives
for Performance Measures

Possible alternative definitions of cost:
Current Cost
2. Gross Value of Fixed Assets
3. Net Book Value of Fixed Assets
1.
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Step 5: Choosing Target
Levels of Performance
 Historically driven targets used to set target goals
 Goal may include a Continuous Improvement
component
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Step 6: Choosing the
Timing of the Feedback
 Timing of feedback depends on:
 How critical the information is for the success of the
organization
 The specific level of management receiving the feedback
 The sophistication of the organization’s information
technology
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Performance Measurement in Multinational
Companies
 Additional Difficulties faced by Multinational
Companies:
 The economic, legal, political, social, and cultural
environments differ significantly across countries
 Governments in some countries may impose controls and
limit selling prices of a company’s products
 Availability of materials and skilled labor, as well as costs of
materials, labor, and infrastructure may differ across
countries
 Divisions operating in different countries account for their
performance in different currencies
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Distinction Between Managers and
Organization Units
 The performance evaluation of a manager should be
distinguished from the performance evaluation of that
manager’s subunit, such as a division of the company
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The Trade-Off: Creating Incentives vs.
Imposing Risk
 An inherent trade-off exists between creating
incentives and imposing risk
 An incentive should be some reward for performance
 An incentive may create an environment in which
suboptimal behavior may occur: the goals of the firm are
sacrificed in order to meet a manager’s personal goals
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Moral Hazard
 Moral Hazard describes situations in which an
employee prefers to exert less effort (0r report
distorted information) compared with the effort (or
accurate information) desired by the owner because
the employee’s effort (or the validity of the reported
information) cannot be accurately monitored and
enforced
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Intensity of Incentives
 Intensity of Incentives – how large the incentive
component of a manager’s compensation be relative to
their salary component
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Preferred Performance Measures
 Preferred Performance Measures are those that are
sensitive to or change significantly with the
manager’s performance.
 They do not change much with changes in factors
that are beyond the manager’s control
 They motivate the manager as well as limit the
manger’s exposure to risk, reducing the cost of
providing incentives
 May include Benchmarking
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Performance Measures at the
Individual Activity Level

Two issues when evaluating performance at the
individual activity level:
Designing performance measures for activities that
require multiple tasks
2. Designing performance measures for activities done
in teams
1.
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Compensation for Multiple Tasks
 If the employer wants an employee to focus on
multiple tasks of a job, then the employer must
measure and compensate performance on each of
those tasks
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Team-Based Compensation
 Companies use teams extensively for problem solving
 Teams achieve better results than individual
employees acting alone
 Companies must reward individuals on a team based
on team performance
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Executive Compensation Plans
 Based on both financial and nonfinancial
performance measures, and include a mix of:
 Base Salary
 Annual Incentives, such as cash bonuses
 Long-Run Incentives, such as stock options
 Well-designed plans use a compensation mix that
balances risk (the effect of uncontrollable factors on
the performance measure, and hence compensation)
with short-run and long-run incentives to achieve
the firm’s goals
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Strategy and Levers of Control
 Levers of Control:
 Diagnostic Control Systems
 Boundary Systems
 Belief Systems
 Interactive Control Systems
 Each lever is important and needs to be monitored
 Levers should be interdependent and collectively
represent a living system of business conduct
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Diagnostic Control Systems
 Diagnostic Control Systems evaluate whether a firm
is performing to expectations by monitoring and
evaluating critical performance metrics, including:
 ROI, RI, EVA
 Customer Satisfaction
 Employee Satisfaction
 MUST be balanced by the other lever of control
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Boundary Systems
 Boundary Systems describe standards of behavior and
codes of conduct expected of all employees
 Highlights actions that are “off-limits”
 A code of conduct describe appropriate and
inappropriate individual behaviors
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Belief Systems
 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 employees with
respect to each other, shareholders, customers, and
communities
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Interactive Control Systems
 Interactive Control Systems are formal information
systems that managers use to focus organizational
attention and learning on key strategic issues
 Tracks strategic uncertainties that businesses face
© 2009 Pearson Prentice Hall. All rights reserved.
© 2009 Pearson Prentice Hall. All rights reserved.