Why measure performance?

When you can measure what you are speaking about and express it in numbers, you know something about it. -Kelvin

You cannot manage what you cannot measure. -Anon

3. Time Horizon of the Performance Measures 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. Companies review the time horizon being considered in ROI, RI, and EVA to determine how the timeline will affect managers decision making. Managers can make short-term decisions that have a positive impact on measures such as ROI but are harmful to the long-term viability of the organization. Since ROI can be positively affected by decreasing either costs or investments, a decrease in investments such as not updating to new technology will give a short-term rise in ROI but the decision can hurt the companys competitiveness in the long-run. Because results of investment in research and development will not show up in net income for many periods, management evaluation requires multi-period analyses. Many companies (especially in high-tech or biotechnology industries) therefore use multiple measures, including both net income and share price. Since potential shareholders consider investment in research and development positively, this type of investment is reflected in the share price, even though the effect does not show up in the current periods net income. A number of alternatives can be used when considering investment in the calculations of ROI, RI, and EVA: Total assets available all business assets, regardless of intended purpose

Total assets employed total assets less idle assets and assets purchased for further expansion (for example, land held for future expansion) Working capital (current assets less current liabilities) plus long-term assets excludes current assets financed by short-term creditors Shareholders equity total assets less total liabilities Capital assets employed shareholders equity plus long-term liabilities

Example: 2

Relax Inns owns three small hotels one each in Boston, Denver, and Miami. At the present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels.

Boston Hotel Current assets Long-term assets Total assets Current liabilities

$350,000 550,000 $900,000 $ 50,000

Revenues Variable costs Fixed costs Operating income

$1,100,000 297,000 637,000 $ 166,000

Denver Hotel

Current assets Long-term assets Total assets Current liabilities

$ 400,000 600,000 $1,000,000 $ 150,000

Revenues Variable costs Fixed costs Operating income

$1,200,000 310,000 650,000 $ 240,000

Miami Hotel

Current assets Long-term assets Total assets Current liabilities

$ 600,000 5,000,000 $5,600,000 $ 300,000

Revenues Variable costs Fixed costs Operating income

$3,200,000 882,000 1,166,000 $1,152,000

Total current assets Total long-term assets Total assets Total current liabilities Long-term debt Stockholders equity Total liabilities and equity

$1,350,000 6,150,000 $7,500,000 $ 500,000 4,800,000 2,200,000 $7,500,000

Three approaches include a measure of investment 3

Return on investment (ROI) Residual income (RI) Economic value added (EVA) A fourth approach, return on sales (ROS),does not measure investment.

ROI Boston Hotel: $166,000 Operating income / $900,000 Total assets $240,000 Operating income $1,000,000 Total assets = $1,152,000 Operating income $5,600,000 Total assets =

18%

Denver Hotel: Miami Hotel:

24%

21%

The DuPont method of profitability analysis recognizes that there are two basicingredients in profit making: 1. Using assets to generate more revenues 2. Increasing income per dollar of revenues Return on sales = Income Revenues Investment turnover = Revenues Investment ROI = Return on sales Investment turnover

How can Relax Inns attain a 30% target ROI for the Denver hotel? Present situation: Revenues Total assets = $1,200,000 $1,000,000 = 1.20 Operating income Revenues = $240,000 $1,200,000 = 0.20 1.20 0.20 = 24%

Alternative A: Decrease assets, keeping revenues and operating income per dollar of revenue constant. Revenues Total assets = $1,200,000 $800,000 = 1.50 1.50 0.20 = 30% Alternative B: Increase revenues, keeping assets and operating income per dollar of revenues constant. 4

 Revenues Total assets = $1,500,000 $1,000,000 = 1.50 Operating income Revenues = $300,000 $1,500,000 = 0.20 1.50 0.20 = 30% Alternative C: Decrease costs to increase operating income per dollar of revenues, keeping revenues and assets constant. Revenues Total assets = $1,200,000 $1,000,000 = 1.20 Operating income Revenues = $300,000 $1,200,000 = 0.25 1.20 0.25 = 30% Residual income (RI) = Income (Required rate of return Investment) Assume that Relax Inns required rate of return is 12%. What is the residual income from each hotel?

Boston Hotel: Total assets $900,000 12% = $108,000 Operating income $166,000 $108,000= Residual income $58,000 Denver Hotel = $120,000 Miami Hotel = $480,000 Economic value added (EVA) = After-tax operating income [Weighted-average cost of capital (Total assets current liabilities)] Total assets minus current liabilities can also be computed as: Long-term assets + Current assets Current liabilities, or Long-term assets + Working capital

Problem on EVA Assume that Relax Inns has two sources of long-term funds: Long-term debt with a market value and book value of $4,800,000 issued at an interest rate of 10% Equity capital that also has a market value of$4,800,000 and a book value of $2,200,000 Tax rate is 30%.

What is the after-tax cost of capital? 0.10 (1 Tax rate) = 0.07, or 7% Assume that Relax Inns cost of equity capital is 14%. What is the weighted-average cost of capital?

WACC = [(7% Market value of debt)+ (14% Market value of equity)] (Market value of debt + Market value of equity) WACC = [(0.07 4,800,000)+ (0.14 4,800,000)] $9,600,000 WACC = $336,000 + $672,000 $9,600,000 5

WACC = 0.105, or 10.5% What is the after-tax operating income for each hotel? Boston Hotel: Operating income $166,000 0.7 = $116,200 Denver Hotel: Operating income $240,000 0.7 = $168,000 Miami Hotel: Operating income $1,152,000 0.7 = $806,400 What is the investment? Boston Hotel: Total assets $900,000 Current liabilities $50,000 = $850,000 Denver Hotel: Total assets $1,000,000 Current liabilities $150,000 = $850,000 Miami Hotel: Total assets $5,600,000 Current liabilities $300,000 = $5,300,000

What is the weighted-average cost of capital times the investment for each hotel? Boston Hotel: $850,000 10.5% = $89,250 Denver Hotel: $850,000 10.5% = $89,250 Miami Hotel: $5,300,000 10.5% = $556,50

What is the economic value added? Boston Hotel: $116,200 $89,250 = $26,950 Denver Hotel: $168,000 $89,250 = $78,750 Miami Hotel: $806,400 $556,500 = $249,900

4. Choosing Alternative Definitions for Performance Measures 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.

5. Choosing Measurement Alternatives for Performance Measures 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. 6

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. 6. Choosing Target Levels of Performance 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.

What is a target value? Target values are used to evaluate performance measurement data, usually to assess performance achieved compared to performance expected. Discussions concerning Target Setting normally focus on the methods used to choose a Target Value for a measure, but it is also critically important to consider explicitly the choice of processing rules that will describe how the performance measurement data will be compared to the Target Value. Typically, processing rules are designed to generate an assessment of achieved performance in the form of a single value (e.g. a Traffic Light colour). The simplest form of rule is a numerical comparison between performance measure data and pre-defined target value, qualified directionally (e.g. green light if value is equal to or higher than target, red light otherwise). However in practice the rules adopted by organisations are more complex (e.g. with three or more traffic lights, or the combination of several data values into a single composite value). Why do targets get set? Target setting as an activity is common within organisations, and used for a variety of purposes. For example, the broadcast communication of target values for key performance measures is sometimes used as a substitute for a richer communication concerning strategic choices made (e.g. communicating a target cost per transaction, rather than a description of a cost-effectiveness strategic choice). Similarly, operational targets can be used as a shorthand way to describe best practice activity levels for defined activities (e.g. proportion of transactions completed without error), targets for intangibles (although often impossible to measure) can be used to describe desired attitudinal or cultural characteristics or goals (e.g. proportion of workforce who advocate organisations products within non-work communities). When do targets get set? Because of this wide variety of potential uses, target setting is often carried out concurrently with

other management activities, in particular the implicit consideration of tactical or strategic choices. The selection and communication of a performance target implies choices being made about tactical or strategic priorities. However, despite this, in our experience it is not unusual for performance targets to be adopted without explicit consideration of the underlying strategic or tactical implications and this can result in the adoption of targets that depend upon performance measures that cannot be collected, or require levels of performance that cannot be achieved. Such outcomes are clearly unhelpful. Target setting is of most value when the performance measures chosen have been selected in a way that encourages explicit and informed consideration of the underlying strategic choices, and the selection of practicable performance measures. How should targets be set? The setting of target values is an important test of the design of a performance measure; the comparison of achieved performance with targeted performance is the main method by which performance measurement data alerts managers to the need to make interventions to improve performance. Without a target value, performance measurement data is more difficult to appraise. By implication, targets should be set in a way that reflects the subsequent need to appraise performance data: the target value should be chosen to trigger an alert to managers if expected performance is not being achieved, but with sufficient tolerance that the alert fires only when there is likely to be an unambiguous case for intervention. In a multi-measure system of performance measures, if all the targets are firing alerts all the time the utility of targets to alert managers to significant issues will be diminished. Types of Targets Although there are thousands of potential performance measures that can be defined, the targets that can be set can be grouped into four categories, as illustrated below.

A final target type is based on a mixture of scalar and level based measures. A factor to note is that for targets based on Multiple values, the basis for the combination of measure values into a composite measure that can then be targeted is as important as the definition of the measures being combined. With the exception of weighted average type combination rules, rule based methods are necessary for multiple-value targets. Choosing a Target Value

This depends upon the type of measure, but three general types apply: Threshold Based (i.e. need to reach a fixed value on linear scale one side of threshold is OK, other side not OK) Limit Based (i.e. 100% or 0%) usually operational or aspirational. Operational as it may describe required operating pattern. Aspirational, as it may be impractical to achieve, but may define worthy goals Rule based (i.e. multiple values need x out of y to hit a limit or threshold type target for target to have been achieved). Practical issues of target setting Knowing enough to know what target to set is particularly an issue when there is no baseline, and this is often the case when an organisation adopts a new measure. In 2GCs experience, about half of all measures selected for corporate performance management systems are ones that were previously unrecorded. In such cases it may be necessary to first measure current performance for some months, before it will be possible to establish what a realistic target might be. Knowing how much activity is needed in the short-term in order to achieve long-term goals is very hard. 2GC recommends that the management team first decide on the long-term target, then decide upon the required rate of motion toward target linear, hockey-stick curve etc The destination statement component of a modern 3rd Generation Balanced Scorecard initially evolved as a tool to help managers agree on a common set of long-term targets to aid target setting. Setting targets for frequently and infrequently reported measures in the same system Often there is a need to reconcile measures that have long reporting cycles (e.g. annual) but are nonetheless the best measure for a particular objective selected by a management team, with other more frequently reported measures that can be used as surrogates for these best values. The need for this substitution is clear for without the frequent data from the surrogate measures, insufficient information may available for the management team to identify the need for interventions on a timely basis. Under these circumstances, the long reporting cycle data can be used to calibrate the target values set for the more frequent surrogate data. However, the additional management effort associated with this should not be underestimated: the calibration may encourage management to think more deeply about the relationship between long term and surrogate measure, but it is quite probable that insufficient long-term data will be available to determine anything more than an intuitive relationship between the two values. 7. Choosing the Timing of Feedback Three factors influence the timing of feedback 1) how critical is the information for the success of the company, 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) the level of management receiving feedback, 9

2) Top manager dont 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) the sophistication of the companys information technology. 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. 8. Performance Measurement in Multinationals We next discuss the additional difficulties created when the performance of divisions of a company operating in different countries is compared. Several issues arise.9 _ The economic, legal, political, social, and cultural environments differ significantly across countries. _ Governments in some countries may limit selling prices of, and impose controls on, a companys products. For example, some countries in Asia, Latin America, and Eastern Europe impose tariffs and custom duties to restrict imports of certain goods. _ Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure (power, transportation, and communication), may also differ significantly across countries. _ Divisions operating in different countries account for their performance in different currencies. Issues of inflation and fluctuations in foreign-currency exchange rates affect performance measures. As a result of these differences, adjustments need to be made to compare performance measures across countries. 9. Distinction between manager and organizational unit Up to this point, you have been looking at performance measurement from the perspective of evaluating organizational units. You studied challenges of using historical cost-based assets for calculating performance measures, and analyzed subunits operating in different countries with corresponding unique political and economic realities. Management compensation is also tied to subunit performance, and a subunits performance evaluation can be tied to the evaluation of its managers. Compensation based on salary plus performance-based measures creates a tradeoff between creating incentives and imposing risks. The more a managers compensation is based on subunit performance, the more risk the manager is exposed to because many factors that the manager does not control are nevertheless evaluated in subunit performance. Owners therefore offer differing amounts of performance-based compensation ranging up to 100% of a managers compensation package. Information asymmetry then becomes a problem for owners. Because researchers report that many employees tend to be both risk and effort averse, owners may not know whether a manager is exerting the appropriate amount of effort. Paying an employee with a flat wage that is guaranteed regardless of effort reduces incentive for the employee to provide superior performance, so performancebased incentives are often included in compensation packages. This introduces a level of risk for employees and the greater the risk, the greater the reward that must be offered. Risk-averse managers may alter their behavior to reduce risk, thereby not taking on projects that could be in the best interest of owners. In such situations, owners can use multiple performance measures to mitigate some of the risks. A Balanced Scorecard, for example, includes nonfinancial measures that are specific to the situation, and can more accurately assess factors that managers can control. It is important 10

to note that evaluating managers on factors that are outside their control is not only unfair, but also likely to be counter-productive. In some cases, especially when economic conditions or outside events have an impact on performance, owners may also use relative performance measures to benchmark operations and managers. For example, if the economy is in recession and performance has suffered generally, using a relative benchmark against competitors can determine how well a unit performed given current economic conditions, which would give a better assessment of the managers contribution. Not all managers are motivated by financial gain, however, and not all managers are effort averse. Some managers are competitive or driven by other motivations and goals. In developing performance evaluation methods, remember to look at the full range of actual motivations and develop an appropriate response to them. When dealing with specific evaluation situations, it is important to take nonfinancial motivators into consideration and not take advantage of them. Because a person is willing to work for peanuts does not mean that is what they should be paid unless that is what the job is worth. Fairness must go both ways.

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 employees 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 mangers control, then she is bearing risk. The more risk a manager takes on, the more compensation she will demand in return. Therefore, a managers performance evaluation should be based on controllable factors as much as possible. 10. 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 Designing performance measures for activities done in teams

Executive Compensation Most executive compensation plans use a variety of financial and non-financial measures to evaluate an executives 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. 11

11. Executive Performance Measures and Compensation The principles of performance evaluation described in the previous sections also apply to executive compensation plans. These plans are based on both financial and nonfinancial performance measures and consist of a mix of (1) base salary; (2) annual incentives, such as a cash bonus based on achieving a target annual RI; (3) long-run incentives, such as stock options (described later in this section) based on stock performance over, say, a five-year period; and (4) other benefits, such as medical benefits, pensions plans, and life insurance. 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 organizations goals. For example, evaluating performance on the basis of annual EVA sharpens an executives short-run focus. And using bEVA and stock option plans over, say, five years motivates the executive to take a long-run view as well. Stock options give executives the right to buy company stock at a specified price (called the exercise price) within a specified period. Suppose that on September 16, 2011, Hospitality Inns gave its CEO the option to buy 200,000 shares of the companys stock at any time before June 30, 2019, at the September 16, 2011, market price of $49 per share. Lets say Hospitality Inns stock price rises to $69 per share on March 24, 2017, and the CEO exercises his options on all 200,000 shares. The CEO would earn $20 ($69 $49) per share on 200,000 shares, or $4 million. If Hospitality Inns stock price stays below $49 during the entire period, the CEO will simply forgo his right to buy the shares. By inking CEO compensation to increases in the companys stock price, the stock option plan motivates the CEO to improve the companys long-run performance and stock price. The Securities and Exchange Commission (SEC) requires detailed disclosures of the compensation arrangements of top-level executives. In complying with these rules in 2010, Starwood Hotels and Resorts, for example, disclosed a compensation table showing the salaries, bonuses, stock options, other stock awards, and other compensation earned by its top five executives during the 2007, 2008, and 2009 fiscal years. Starwood, whose brands include Sheraton, Westin, and the W Hotels, also disclosed the peer companies that it uses to set executive pay and conduct performance comparisons. These include competitors in the hotel and hospitality industry (such as Host, Marriott, and Wyndham), as well as companies with similar revenues in other industries relevant to key talent recruitment needs (including Colgate-Palmolive, Nike, and Starbucks). Investors use this information to evaluate the relationship between compensation and performance across companies generally, and across companies operating in similar industries.

12

REFERENCES: http://www.cga-pdnet.org/Non_VerifiableProducts/CourseNotes/2010/ma2/module08.pdf www.csus.edu/indiv/m/mackeyjt/accy121/powerpoint/11ch23.ppt http://www.flashcardmachine.com/advanced-cost-accounting1.html http://www.2gc.co.uk/ http://www.businessballs.com/dtiresources/performance_measurement_management.pdf

13