CHAPTER 23

PERFORMANCE MEASUREMENT, COMPENSATION, AND

MULTINATIONAL CONSIDERATIONS
23-1 Examples of financial and nonfinancial measures of performance are:
Financial: ROI, residual income, economic value added, and return on sales.
Nonfinancial: Manufacturing lead time, yield, on-time performance, numer of ne!
product launc"es, and numer of ne! patents filed.
23-2 #"e six steps in designing an accounting-ased performance measure are:
$. %"oose performance measures t"at align !it" top management&s financial goals
'. %"oose t"e time "ori(on of eac" performance measure in )tep $
*. %"oose a definition of t"e components in eac" performance measure in )tep $
+. %"oose a measurement alternative for eac" performance measure in )tep $
,. %"oose a target level of performance
-. %"oose t"e timing of feedac.
23-3 #"e /u0ont met"od "ig"lig"ts t"at ROI is increased y any action t"at increases
investment turnover or income margin. ROI increases !it":
$. increases in revenues,
'. decreases in costs, or
*. decreases in investments,
!"ile "olding t"e ot"er t!o factors constant.
23-4 1es. Residual income 2RI3 is not identical to return on investment 2ROI3. ROI is a
percentage !it" investment as t"e denominator of t"e computation. RI is an asolute amount in
!"ic" investment is used to calculate an imputed interest c"arge.
23-5 Economic value added 2E453 is a specific type of residual income measure t"at is
calculated as follo!s:
6 7

s liailitie current
minus assets #otal
capital of cost
average - 8eig"ted

23-6 /efinitions of investment used in practice !"en computing ROI are:
$. #otal assets availale
'. #otal assets employed
*. #otal assets employed minus current liailities
+. )toc."olders& e9uity
23-7 %urrent cost is t"e cost of purc"asing an asset today identical to t"e one currently "eld
if identical assets can currently e purc"ased: it is t"e cost of purc"asing t"e services provided y
t"at asset if identical assets cannot currently e purc"ased. ;istorical-cost-ased measures of
ROI compute t"e asset ase as t"e original purc"ase cost of an asset minus any accumulated
depreciation.
)ome commentators argue t"at current cost is oriented to current prices, !"ile "istorical
cost is past-oriented.
'*-$
23-8 )pecial prolems arise !"en evaluating t"e performance of divisions in multinational
companies ecause
a. #"e economic, legal, political, social, and cultural environments differ significantly
across countries.
. <overnments in some countries may impose controls and limit selling prices of
products.
c. 5vailaility of materials and s.illed laor, as !ell as costs of materials, laor, and
infrastructure may differ significantly across countries.
d. /ivisions operating in different countries .eep score of t"eir performance in different
currencies.
23-9 %ompanies often put t"e most s.illful division manager in c"arge of t"e !ea.est
division in an attempt to improve t"e performance of t"e !ea. division. )uc" an effort may
yield results in years, not mont"s. #"e division may continue to perform poorly !it" respect to
ot"er divisions of t"e company. =ut it !ould e a mista.e to conclude from t"e poor
performance of t"e division t"at t"e manager is performing poorly.
5 second example of t"e distinction et!een t"e performance of t"e manager and t"e
performance of t"e suunit is t"e use of "istorical cost-ased ROIs to evaluate t"e manager even
t"oug" "istorical cost-ased ROIs may e unsatisfactory for evaluating t"e economic returns
earned y t"e organi(ation suunit.
23-10 Moral "a(ard descries contexts in !"ic" an employee prefers to exert less effort 2or
report distorted information3 compared !it" t"e effort 2or accurate information3 desired y t"e
o!ner ecause t"e employee&s effort 2or validity of t"e reported information3 cannot e
accurately monitored and enforced.
23-11 No, re!arding managers on t"e asis of t"eir performance measures only, suc" as ROI,
su>ects managers to uncontrollale ris. ecause managers& performance measures are also
affected y random factors over !"ic" t"e manager "as no control. 5 manager may put in a
great deal of effort ut "er performance measure may not reflect t"is effort if it is negatively
affected y various random factors. #"us, !"en managers are compensated on t"e asis of
performance measures, t"ey !ill need to e compensated for ta.ing on extra ris.. ;ence, !"en
performance-ased incentives are used, t"ey are generally more costly to t"e o!ner. #"e
motivation for "aving some salary and some performance-ased onus in compensation
arrangements is to alance t"e enefits of incentives against t"e extra costs of imposing
uncontrollale ris. on t"e manager.
23-12 Measures of performance t"at are sensitive to a manager?s performance 2measures t"at
c"ange significantly !it" t"e manager&s performance and not very muc" !it" c"anges in factors
t"at are eyond t"e manager&s control3 are t"e .ey to designing strong incentive systems in
organi(ations. 8"en selecting performance measures, t"e management accountant must c"oose
t"ose performance measures t"at c"ange !it" c"anges in t"e actions ta.en y managers. For
example, if a manager "as no aut"ority for ma.ing investments, t"en using an investment-ased
measure to evaluate t"e manager imposes ris. on t"e manager and provides little information
aout t"e manager&s performance. #"e management accountant mig"t suggest evaluating t"e
manager on t"e asis of costs, or costs and revenues, rat"er t"an ROI.
'*-'
23-13 =enc"mar.ing or relative performance evaluation is t"e process of evaluating a
manager&s performance against t"e performance of ot"er similar operations. #"e ideal
enc"mar. is anot"er operation t"at is affected y t"e same noncontrollale factors t"at affect
t"e manager&s performance. =enc"mar.ing cancels t"e effects of t"e common noncontrollale
factors and provides etter information aout t"e manager&s performance.
23-14 8"en employees "ave to perform multiple tas.s as part of t"eir >os, incentive
prolems can arise !"en one tas. is easy to monitor and measure !"ile t"e ot"er tas. is more
difficult to evaluate. Employers !ant employees to intelligently allocate time and effort among
various tas.s. If, "o!ever, employees are re!arded on t"e asis of t"e tas. t"at is more easily
measured, t"ey !ill tend to focus t"eir efforts on t"at tas. and ignore t"e ot"ers.
23-15 /isclosures re9uired y t"e )ecurities and Exc"ange %ommission are:
a. 5 summary compensation tale s"o!ing t"e salary, onus, stoc. options, ot"er stoc.
a!ards, and ot"er compensation earned y t"e five top officers in t"e previous t"ree
years
. #"e principles underlying t"e executive compensation plans, and t"e performance
criteria, suc" as profitaility, sales gro!t", and mar.et s"are used in determining
compensation
c. ;o! !ell a company&s stoc. performed relative to t"e stoc.s of ot"er companies in
t"e same industry
23-16 2*@ min.3 ROI, comparisons of three companies.
$. #"e separate components "ig"lig"t several features of return on investment not revealed y
a single calculation:
a. #"e importance of investment turnover as a .ey to income is stressed.
. #"e importance of revenues is explicitly recogni(ed.
c. #"e important components are expressed as ratios or percentages instead of dollar
figures. #"is form of expression often en"ances comparaility of different divisions,
usinesses, and time periods.
d. #"e rea.do!n stresses t"e possiility of trading off investment turnover for income
as a percentage of revenues so as to increase t"e average ROI at a given level of
output.
'. 2Filled-in lan.s are in old face.3
Companies in Same Industry
A B C
Revenue
Income
Investment
Income as a A of revenue
Investment turnover
Return on investment
B$,@@@,@@@
B $@@,@@@
B ,@@,@@@
10
2.0
20
B ,@@,@@@
B ,@,@@@
$5,000,000
10
0.1
$A
$10,000,000
$ 50,000
B ,,@@@,@@@
@.,A
'.@
1
'*-*
23-16 2%ont?d.3
Income and investment alone s"ed little lig"t on comparative performances ecause of
disparities in si(e et!een %ompany 5 and t"e ot"er t!o companies. #"us, it is impossile to
say !"et"er =&s lo! return on investment in comparison !it" 5&s is attriutale to its larger
investment or to its lo!er income. Furt"ermore, t"e fact t"at %ompanies = and % "ave identical
income and investment may suggest t"at t"e same conditions underlie t"e lo! ROI, ut t"is
conclusion is erroneous. = "as "ig"er margins ut a lo!er investment turnover. % "as very
small margins 2$C'@t" of =3 ut turns over investment '@ times faster.
I.M.A. Report No. 35 2page *,3 states:
DIntroducing revenues to measure level of operations "elps to disclose specific areas for
more intensive investigation. %ompany = does as !ell as %ompany 5 in terms of income
margin, for ot" companies earn $@A on revenues. =ut %ompany = "as a muc" lo!er turnover
of investment t"an does %ompany 5. 8"ereas a dollar of investment in %ompany 5 supports
t!o dollars in revenues eac" period, a dollar investment in %ompany = supports only ten cents in
revenues eac" period. #"is suggests t"at t"e analyst s"ould loo. carefully at %ompany =&s
investment. Is t"e company .eeping an inventory larger t"an necessary for its revenue levelE
5re receivales eing collected promptlyE Or did %ompany 5 ac9uire its fixed assets at a price
level t"at !as muc" lo!er t"an t"at at !"ic" %ompany = purc"ased its plantED
DOn t"e ot"er "and, %&s investment turnover is as "ig" as 5&s, ut %&s income as a
percentage of revenue is muc" lo!er. 8"yE 5re its operations inefficient, are its material costs
too "ig", or does its location entail "ig" transportation costsED
D5nalysis of ROI raises 9uestions suc" as t"e foregoing. 8"en ans!ers are otained, asic
reasons for differences et!een rates of return may e discovered. For example, in %ompany =&s
case, it is apparent t"at t"e emp"asis !ill "ave to e on increasing turnover y reducing
investment or increasing revenues. %learly, = cannot apprecialy increase its ROI simply y
increasing its income as a percent of revenue. In contrast, %ompany %&s management s"ould
concentrate on increasing t"e percent of income on revenue.D
23-16 Excel Application
Performance Measurement, Compensation, and
Multinational Considerations
Companies in Same Industry
A B C
Revenues $1,000,000 $500,000 $10,000,000
Income $100,000 $50,000 $50,000
Investment $500,000 $5,000,000 $5,000,000
Income as a % of revenues 10% 10% 0.5%
Investment turnover 2 0.1 2
RI 20% 1% 1%
'*-+
23-17 2', min.3 Analysis of return on invested assets, comparison of two
divisions.
Operating Revenues Operating Income Operating Income
Total Assets Operating Revenues Total Assets
Soft Drinks
'@@* '.**** @.@+'F @.$@@
'@@+ '.+@@@ @.@,** @.$'G
'@@, '.,H$+ @.@--H @.$H$
Restaurants
'@@* $.*$', @.$@@@ @.$*$
'@@+ $.',@@ @.@F$' @.$$+
'@@, $.$H-F @.@-,+ @.@HH
Quality Products
'@@* $.F',@ @.@,G+ @.$$'
'@@+ $.GGGF @.@-+, @.$''
'@@, $.F@@@ @.@--* @.$'-
Soft Drink Division. =ot" t"e investment turnover ratio and t"e income as a percent of revenues
"ave increased: t"ere is an increase in t"e ROI over t"e '@@* to '@@, period.
Restaurant Division. =ot" t"e investment turnover ratio and t"e income as a percent of revenues
"ave decreased: t"ere is a decrease in t"e ROI over t"e '@@* to '@@, period.
Quality Products, Inc. #"ere "as een a small increase in investment turnover and t"e income as
a percent of revenues over t"e '@@+ to '@@, period: t"ere is a small increase in t"e ROI over t"e
'@@* to '@@, period.
Note "o! t"e small increase in ROI for Iuality 0roducts mas.s some ma>or c"anges in t"e
fortunes of t"e t!o divisions: t"at is, t"e increased ROI of t"e soft drin. division and t"e
decreased ROI of t"e restaurant division.
'*-,
23-18 2$@7$, min.3 ROI and RI 2/. Jleespie3.
ROI 6
Investment
income Operating
Operating income 6 ROI Investment
KNo. of men"irs sold 2)elling price 7 4ar. cost per unit3L 7 Fixed costs 6 ROI Investment
Met N 6 minimum selling price per unit to ac"ieve a '@A ROI
$. $@,@@@ 2N 7 B*@@3 7 B$,@@@,@@@ 6 '@A 2B$,-@@,@@@3
$@,@@@N 6 B*'@,@@@ O B*,@@@,@@@ O B$,@@@,@@@ 6 B+,*'@,@@@
N 6 B+*'
'. $@,@@@ 2N 7 B*@@3 7 B$,@@@,@@@ 6 $,A 2B$,-@@,@@@3
$@,@@@N 6 B'+@,@@@ O B*,@@@,@@@ O B$,@@@,@@@ 6 B+,'+@,@@@
N 6 B+'+
23.19 2*@ min.3 Pricing and ROI.
$. ROI 6 Operating income
Investment
'@A 6 Operating income
BF@,@@@,@@@
Operating income 6 B$G,@@@,@@@
#arget revenues:
Fixed costs B *@,@@@,@@@
4ariale costs, $@@,@@@ P B$,*'@ $*',@@@,@@@
/esired operating income $G,@@@,@@@
Revenues B$G@,@@@,@@@
Operating income as a percentage of revenues is
@@ B$G@,@@@,@
@ B$G,@@@,@@
or $@A
'. #"e selling price per unit to ac"ieve ROI of '@A is B$G@,@@@,@@@ Q $@@,@@@ units 6 B$,G@@.
*. ROI at Various Sales Volumes over 3 Years
Rnits sold $@@,@@@S $,@,@@@S ,@,@@@S
Revenues, B$,G@@ per unit B $.G@SS B '.H@SS B @.F@SS
4ariale costs, B$,*'@ per unit $.*' $.FG @.--
Fixed costs @.*@ @.*@ @.*@
#otal costs $.-' '.'G @.F-
Operating income B @.$G B @.+' B 2@.@-3
Return on investment '@A +-.-HA 7 -.-HA
SRo! not directly used in calculations.
SS5ll revenues, costs, and operating income are in "undreds of millions of dollars.
'*--
23-19 2%ont?d.3
5 summary analysis of t"ese t"ree cases follo!s:
Operating Income Revenues
Volume Revenues Total Assets Return on Investment
$@@,@@@ $@.@@A ' '@.@@A
$,@,@@@ $,.,,A * +-.-,A
,@,@@@ 7-.-HA $ 7-.-HA
4. One year may often e too s"ort a time span in t"e use of an operating income measure for
gauging performance or for paying onuses. For instance, motorcycle sales may e "eavily
influenced y general economic conditions t"at are uncontrollale y t"e division managers !"ose
onuses are significantly affected t"erey. 5lso, some s"ort-run savings in manufacturing costs may
"ave long-run damaging effects. Examples include repairs, maintenance, 9uality control, and
exerting severe pressures on employees for productivity.
23-20 2', min.3 Financial and nonfinancial performance measures, goal
congruence.
$. Operating income is a good summary measure of s"ort-term financial performance. =y
itself, "o!ever, it does not indicate !"et"er operating income in t"e s"ort run !as earned y
ta.ing actions t"at !ould lead to long-run competitive advantage. For example, )ummit&s
divisions mig"t e ale to increase s"ort-run operating income y producing more product !"ile
ignoring 9uality or re!or.. ;arrington, "o!ever, !ould li.e to see division managers increase
operating income !it"out sacrificing 9uality. #"e ne! performance measures ta.e a alanced
scorecard approac" y evaluating and re!arding managers on t"e asis of direct measures 2suc"
as re!or. costs, on-time delivery performance, and sales returns3. #"is motivates managers to
ta.e actions t"at ;arrington elieves !ill increase operating income no! and in t"e future. #"e
nonoperating income measures serve as surrogate measures of future profitaility.
'*-H
23-20 2%ont?d.3
'. #"e semiannual installments and total onus for t"e %"arter /ivision are calculated as
follo!s:
Charter Division Bonus Calculation
For Year Ended December 31, 2003
1anuary 1, 2003 to 1une 30, 2003
0rofitaility
Re!or.
On-time delivery
)ales returns
2@.@' B+-',@@@3
2@.@' B+-',@@@3 7 B$$,,@@
No onusTunder F-A
K2@.@$, B+,'@@,@@@3 7 BG+,@@@L ,@A
B F,'+@
2','-@3
@
2$@,,@@3
)emiannual installment
)emiannual onus a!arded
B 2*,,'@3
B @
1uly 1, 2003 to December 31, 2003
0rofitaility
Re!or.
On-time delivery
)ales returns
2@.@' B++@,@@@3
2@.@' B++@,@@@3 7 B$$,@@@
F-A to FGA
K2@.@$, B+,+@@,@@@3 7 BH@,@@@L ,@A
B G,G@@
2','@@3
',@@@
2',@@@3
)emiannual installment
)emiannual onus a!arded
B -,-@@
B -,-@@
#otal onus a!arded for t"e year B -,-@@
'*-G
23-20 2%ont?d.3
#"e semiannual installments and total onus for t"e Mesa /ivision are calculated as
follo!s:
Mesa Division Bonus Calculation
For Year Ended December 31, 2003
1anuary 1, 2003 to 1une 30, 2003
0rofitaility
Re!or.
On-time delivery
)ales returns
2@.@' B*+',@@@3
2@.@' B*+',@@@3 7 B-,@@@
Over FGA
K2@.@$, B',G,@,@@@3 7 B++,H,@L ,@A
B -,G+@
@
,,@@@
2$,@@@3
)emiannual onus installment
)emiannual onus a!arded
B$@,G+@
B$@,G+@
1uly 1, 2003 to December 31, 2003
0rofitaility
Re!or.
On-time delivery
)ales returns
2@.@' B+@-,@@@3
2@.@' B+@-,@@@3 7 BG,@@@
No onusTunder F-A
K2@.@$, B',F@@,@@@3 7 B+',,@@L !"ic"
is greater t"an (ero, yielding a onus of
B G,$'@
@
@
*,@@@
)emiannual onus installment
)emiannual onus a!arded
B$$,$'@
B$$,$'@
#otal onus a!arded for t"e year B'$,F-@
*. #"e manager of t"e %"arter /ivision is li.ely to e frustrated y t"e ne! plan, as t"e
division onus is more t"an B'@,@@@ less t"an t"e previous year. ;o!ever, t"e ne! performance
measures "ave egun to "ave t"e desired effect77ot" on-time deliveries and sales returns
improved in t"e second "alf of t"e year, !"ile re!or. costs !ere relatively even. If t"e division
continues to improve at t"e same rate, t"e %"arter onus could approximate or exceed !"at it
!as under t"e old plan.
#"e manager of t"e Mesa /ivision s"ould e as satisfied !it" t"e ne! plan as !it" t"e
old plan, as t"e onus is almost e9uivalent. On-time deliveries declined consideraly in t"e
second "alf of t"e year and re!or. costs increased. ;o!ever, sales returns decreased slig"tly.
Rnless t"e manager institutes etter controls, t"e onus situation may not e as favorale in t"e
future. #"is could motivate t"e manager to improve in t"e future ut currently, at least, t"e
manager "as een ale to maintain "is onus !it" s"o!ing improvement in only one area
targeted y ;arrington.
=en ;arrington&s revised onus plan for t"e %"arter /ivision fostered t"e follo!ing
improvements in t"e second "alf of t"e year despite an increase in sales:
U increase of $.FA in on-time deliveries.
U B,@@ reduction in re!or. costs.
U B$+,@@@ reduction in sales returns.
'*-F
23-20 2%ont?d.3
;o!ever, operating income as a percent of sales "as decreased 2$$ to $@A3.
#"e Mesa /ivision&s onus "as remained at t"e status 9uo as a result of t"e follo!ing
effects
U increase of '.@ A in operating income as a percent of sales 2$'A to $+A3.
U decrease of *.-A in on-time deliveries.
U B',@@@ increase in re!or. costs.
U B',',@ decrease in sales returns.
#"is !ould suggest t"at t"ere needs to e some revisions to t"e onus plan. 0ossile
c"anges include:
U increasing t"e !eig"ts put on on-time deliveries, re!or. costs, and sales returns in t"e
performance measures !"ile decreasing t"e !eig"t put on operating income.
U a re!ard structure for re!or. costs t"at are elo! 'A of operating income t"at !ould
encourage managers to drive costs lo!er.
U revie!ing t"e !"ole year in total. #"e onus plan s"ould carry for!ard t"e negative
amounts for one six-mont" period into t"e next six-mont" period incorporating t"e
entire year !"en calculating a onus.
U developing enc"mar.s, and t"en giving re!ards for improvements over prior periods
and encouraging continuous improvement.
23-21 2$, min.3 ROI, RI, EVA

2/. )olomons, adapted3.
Re9uirements $ and ' are ans!ered toget"er:
Atlantic Division Pacific Division
#otal assets
Operating income
Return on investment
B$,@@@,@@@
B '@@,@@@
B'@@,@@@ Q $,@@@,@@@ 6 '@A
B,,@@@,@@@
B H,@,@@@
BH,@,@@@ Q B,,@@@,@@@ 6 $,A
Residual income at $'A
re9uired rate of returnS BG@,@@@ B$,@,@@@
SB'@@,@@@ 7 2@.$' B$,@@@,@@@3 6 BG@,@@@: BH,@,@@@ 7 2@.$' B,,@@@,@@@3 6 B$,@,@@@
'*-$@
23-21 2%ont&d.3
#"e taulation s"o!s t"at, !"ile t"e 5tlantic /ivision earns t"e "ig"er return on investment, t"e
0acific /ivision earns t"e "ig"er residual income at t"e $'A re9uired rate of return.
*. 5fter-tax cost of det financing 6 2$ 7 @.+3 $@A 6 -A
5fter-tax cost of e9uity financing 6 $+A
#"e !eig"ted-average cost of capital 285%%3 is given y
85%% 6
BH,@@@,@@@
B+F@,@@@ B'$@,@@@
B*,,@@,@@@ B*,,@@,@@@
B*,,@@,@@3 2@.$+ 3 B*,,@@,@@@ 2@.@- +
=
+
+
6 6 @.$@ or $@A
Economic value added 2E453 calculations are as follo!s:
Division
After-Tax
Operating
Income
-
Weighted-
Average Cost of
Capital

Total Assets Minus

Current Liabilities

Economic
Value Added
(EVA)
5tlantic
0acific
B'@@,@@@ @.-
BH,@,@@@ @.-
7
7
K$@A
K$@A

2B$,@@@,@@@ 7 B',@,@@@3L
2B,,@@@,@@@ 7 B$,,@@,@@@3L
6
6
B$'@,@@@ 7 BH,,@@@
B+,@,@@@ 7 B*,@,@@@
6
6
B +,,@@@
B$@@,@@@
0otomac s"ould use t"e E45 measure for evaluating t"e economic performance of its
divisions for t!o reasons: 2a3 It is a residual income measure and, so, does not "ave t"e
dysfunctional effects of ROI-ased measures. #"at is, if E45 is used as a performance
evaluation measure, divisions !ould "ave incentives to ma.e investments !"enever after-tax
operating income exceeds t"e !eig"ted-average cost of capital employed. #"ese are t"e correct
incentives to maximi(e firm value. ROI-ased performance evaluation measures encourage
managers to invest only !"en t"e ROI on ne! investments exceeds t"e existing ROI. #"at is,
managers !ould re>ect pro>ects !"ose ROI exceeds t"e !eig"ted average cost of capital ut is
less t"an t"e current ROI of t"e division: using ROI as a performance evaluation measure creates
incentives for managers to re>ect pro>ects t"at increase t"e value of t"e firm simply ecause t"ey
may reduce t"e overall ROI of t"e division: 23 E45 calculations incorporate tax effects t"at are
costs to t"e firm. It, t"erefore, provides an after-tax compre"ensive summary of t"e effects of
various decisions on t"e company and its s"are"olders.
'*-$$
23-22 2', min.3 RI, EVA

.
$.
Truck Rental
Division
Transportation
Division
#otal assets
%urrent liailities
Investment
2#otal assets 7 current liailities3
Re9uired return
2$'A Investment3
Operating income efore tax
Residual income
2Optg. inc. efore tax 7 re9d. return3
B-,@,@@@
$'@,@@@
,*@,@@@
-*,-@@
H,,@@@
$$,+@@
BF,@,@@@
'@@,@@@
H,@,@@@
F@,@@@
$-@,@@@
H@,@@@
'. 5fter-tax cost of det financing 6 2$7 @.+3 $@A 6 -A
5fter-tax cost of e9uity financing 6 $,A
6
-@@,@@@ BF@@,@@@
$,A -@@,@@@ -A BF@@,@@@
+
+
6 F.-A
Re9uired return for E45
F.-A Investment
2F.-A B,*@,@@@: F.-A BH,@,@@@3 B,@,GG@ BH',@@@
Operating income after tax
@.- operating income efore tax +,,@@@ F-,@@@
E45 2Optg. inc. after tax 7 re9d. return3 2,,GG@3 '+,@@@
*. =ot" t"e residual income and t"e E45 calculations indicate t"at t"e #ransportation /ivision
is performing etter t"an t"e #ruc. Rental /ivision. #"e #ransportation /ivision "as a "ig"er
residual income 2BH@,@@@ versus B$$,+@@3 and a "ig"er E45 KB'+,@@@ versus B2,,GG@3L. #"e
negative E45 for t"e #ruc. Rental /ivision indicates t"at, on an after-tax asis, t"e division is
destroying value77t"e after-tax economic return from t"e #ruc. Rental /ivision&s assets is less
t"an t"e re9uired return. If E45 continues to e negative, =urlingame may "ave to consider
s"utting do!n t"e #ruc. Rental /ivision.
'*-$'
23-23 2'@7*@ min.3 ROI, RI, measurement of assets 2%M5, adapted3.
#"e met"od for computing profitaility preferred y eac" manager follo!s:
Manager of Method Chosen
=ristol
/arden
<regory
Residual income ased on net oo. value
Residual income ased on gross oo. value
ROI ased on eit"er gross or net oo. value
Supportin !alculations"
Return on Investment Calculations
Division Value Book Gross
Income Operating
` Value Book Net
Income Operating
=ristol
/arden
<regory
BF+,H@@ Q BG@@,@@@ 6 $$.G+A 2*3
BF$,H@@ Q BH-@,@@@ 6 $'.@HA 2'3
B-$,+@@ Q B,@@,@@@ 6 $'.'GA 2$3
BF+,H@@ Q B*H@,@@@ 6 ',.,FA 2*3
BF$,H@@ Q B*,@,@@@ 6 '-.'@A 2'3
B-$,+@@ Q B''@,@@@ 6 'H.F$A 2$3
Residual Income Calculations
Division Operating Income - 10 Gross BV Operating Income - 10 Net BV
`
=ristol
/arden
<regory
BF+,H@@ 7 BG@,@@@ 6 B$+,H@@ 2'3
BF$,H@@ 7 BH-,@@@ 6 B$,,H@@ 2$3
B-$,+@@ 7 B,@,@@@ 6 B$$,+@@ 2*3
BF+,H@@ 7 B*H,@@@ 6 B,H,H@@ 2$3
BF$,H@@ 7 B*,,@@@ 6 B,-,H@@ 2'3
B-$,+@@ 7 B'',@@@ 6 B*F,+@@ 2*3
S
Net oo. value is gross oo. value minus accumulated depreciation.
#"e iggest !ea.ness of ROI is t"e tendency to re>ect pro>ects t"at !ill lo!er "istorical ROI
even t"oug" t"e prospective ROI exceeds t"e re9uired ROI. RI ac"ieves goal congruence
ecause suunits !ill ma.e investments as long as t"ey earn a rate in excess of t"e re9uired
return for investments. #"e iggest !ea.ness of residual income is it favors larger divisions in
ran.ing performance. #"e greater t"e amount of t"e investment 2t"e si(e of t"e division3, t"e
more li.ely t"at larger divisions !ill e favored assuming t"at income gro!s proportionately.
'*-$*
23-24 2'@ min.3 Multinational performance measurement, ROI, RI.
$a. R.). /ivision&s ROI in '@@* 6
assets #otal
income Operating
6
BG,@@@,@@@
income Operating
6 $,A
;ence, operating income 6 $,A BG,@@@,@@@ 6 B$,'@@,@@@.
$. )!edis" /ivision&s ROI in '@@* in .ronas 6
.ronas -@,@@@,@@@
.ronas F,$G@,@@@
6 $,.*A
'. %onvert total assets into dollars at /ecemer *$, '@@', exc"ange rate, t"e rate prevailing
!"en assets !ere ac9uired 2G .ronas 6 B$3 e9ual to
dollar per .ronas G
.ronas -@,@@@,@@@
6 BH,,@@,@@@
%onvert operating income into dollars at t"e average exc"ange rate prevailing during '@@*
!"en operating income !as earned 2G., .ronas 6 B$3 e9ual to
dollar per .ronas G.,
.ronas F,$G@,@@@
6 B$,@G@,@@@
%omparale ROI for )!edis" /ivision6
@@@ , ,@@ , H B
@@@ , @G@ , $ B
6 $+.+A
#"e )!edis" /ivision&s ROI calculated in .ronas is "elped y t"e inflation t"at occurs in )!eden
in '@@*. Inflation oosts t"e division&s operating income. )ince t"e assets are ac9uired at t"e
start of t"e year on $-$-'@@*, t"e asset values are not increased y t"e inflation t"at occurs during
t"e year. #"e net effect of inflation on ROI calculated in .ronas is to use an inflated value for t"e
numerator relative to t"e denominator. 5d>usting for inflationary and currency differences
negates t"e effects of any differences in inflation rates et!een t"e t!o countries on t"e
calculation of ROI. 5fter t"ese ad>ustments, t"e R.). /ivision s"o!s a "ig"er ROI t"an t"e
)!edis" /ivision.
*. R.). /ivision?s RI in '@@* 6 B$,'@@,@@@ $'A BG,@@@,@@@
6 B$,'@@,@@@ BF-@,@@@ 6 B'+@,@@@
)!edis" /ivision?s RI in '@@* 2in R.). dollars3 is
B$,@G@,@@@ $'A BH,,@@,@@@ 6 B$,@G@,@@@ BF@@,@@@ 6 B$G@,@@@.
#"e R.). /ivision?s RI also exceeds t"e )!edis" /ivision?s RI in '@@* y B-@,@@@ 2B'+@,@@@
B$G@,@@@3.

'*-$+
23-25 2'@ min.3 Multinational performance measurement, ROI, RI.
$a. /ur"am&s ROI for '@@+ 6 6 $HA
. Myon /ivision&s '@@+ ROI in Frenc" francs 6
francs @@@ , @@@ , '@
francs @@@ , -@@ , *

6 $GA
c. 8e can&t tell !"ic" division earned a etter ROI ecause Myon&s return may "ave een
"elped y greater inflation in France and a !ea.ening franc.
'. #o ma.e RI comparale, !e need to ma.e t"e follo!ing conversions for t"e Myon /ivision
#otal assets at /ecemer *$, '@@*, rate 6
dollar per francs +
francs '@,@@@,@@@
6 B,,@@@,@@@
%onvert operating income into dollars at t"e average exc"ange rate prevailing during '@@+
!"en operating income !as earned e9ual to
dollar per francs +.,
francs *,-@@,@@@
6 BG@@,@@@
'@@+ RI for Myon in dollars 6 BG@@,@@@ 7 $,A B,,@@@,@@@ 6 B,@,@@@
'@@+ RI for /ur"am 6 BH-,,@@@ 7 $,A B+,,@@,@@@ 6 BF@,@@@
On a comparale asis, after ad>usting for inflationary and currency differences, /ur"am "as t"e
"ig"er residual income.
*. Myon&s '@@+ ROI calculated in dollar terms 6 6 $-A
=ot" t"e ROI and t"e residual income calculations indicate t"at, after removing t"e effects
of any differences in inflation rates et!een t"e t!o countries, t"e /ur"am /ivision "as
performed etter t"an t"e Myon /ivision in '@@+ 2ROI of $HA versus $-A and residual return of
BF@,@@@ versus B,@,@@@3.
Even after ad>usting for inflation differences, t"e relative performance of t"e t!o divisions
in '@@+ is inade9uate for ma.ing t"e decision aout !"ic" manager to promote to t"e vice-
president&s position. #"e economic performance of t"e divisions must e distinguis"ed from t"e
performance of t"e managers of t"ose divisions. For example, t"e poorer performance of t"e
Myon division in '@@+ relative to t"e /ur"am /ivision may e attriutale to t"e more difficult
usiness environment in Myon. Recall t"at t"e economic, legal, political, social, and cultural
environments differ significantly across countries as does t"e availaility and costs of inputs suc"
as materials and laor. Furt"ermore, promotion to t"e vice president&s position s"ould not e
ased on t"e performance of t"e divisions in '@@+ alone. #"e decision s"ould consider t"e
performance "istory of t"e t!o managers over t"e most recent fe! years.
'*-$,
23-26 2'@7*@ min.3 Risk sharing, incentives, benchmarking, multiple tasks.
$. 5n evaluation of t"e t"ree proposals to compensate Mar.s, t"e general manager of t"e
/exter /ivision follo!s:
2i3 0aying Mar.s a flat salary !ill not su>ect Mar.s to any ris., ut !ill provide no incentives
for Mar.s to underta.e extra p"ysical and mental effort.
2ii3 Re!arding Mar.s only on t"e asis of /exter /ivision&s ROI !ould motivate Mar.s to put
in extra effort to increase ROI ecause Mar.s&s re!ards !ould increase !it" increases in
ROI. =ut compensating Mar.s solely on t"e asis of ROI su>ects Mar.s to excessive ris.
ecause t"e division&s ROI depends not only on Mar.s&s effort ut also on ot"er random
factors over !"ic" Mar.s "as no control. For example, Mar.s may put in a great deal of
effort, ut, despite t"is effort, t"e division&s ROI may e lo! ecause of adverse factors
2suc" as "ig" interest rates or a recession3 !"ic" Mar.s cannot control.
#o compensate Mar.s for ta.ing on uncontrollale ris., 5M%O must pay "im
additional amounts !it"in t"e structure of t"e ROI-ased arrangement. #"us,
compensating Mar.s only on t"e asis of performance-ased incentives !ill cost 5M%O
more money, on average, t"an paying Mar.s a flat salary. #"e .ey 9uestion is !"et"er t"e
enefits of motivating additional effort >ustify t"e "ig"er costs of performance-ased
re!ards.
Furt"ermore, t"e o>ective of maximi(ing ROI may induce Mar.s to re>ect pro>ects
t"at, from t"e vie!point of t"e organi(ation as a !"ole, s"ould e accepted. #"is !ould
occur for pro>ects t"at !ould reduce Mar.s?s overall ROI ut !"ic" !ould earn a return
greater t"an t"e re9uired rate of return for t"at pro>ect.
2iii3 #"e motivation for "aving some salary and some performance-ased onus in
compensation arrangements is to alance t"e enefits of incentives against t"e extra costs
of imposing uncontrollale ris. on t"e manager.
'. Mar.s?s complaint does not appear to e valid. #"e senior management of 5M%O is
proposing to enc"mar. Mar.s?s performance using a relative performance evaluation 2R0E3
system. R0E controls for common uncontrollale factors t"at similarly affect t"e performance of
managers operating in t"e same environments 2for example, t"e same industry3. If usiness
conditions for car attery manufacturers are good, all usinesses manufacturing car atteries !ill
proaly perform !ell. 5 superior indicator of Mar.s?s performance is "o! !ell Mar.s
performed relative to "is peers. #"e goal is to filter out t"e common noise to get a etter
understanding of Mar.s?s performance. Mar.s?s complaint !ill e valid only if t"ere are
significant differences in investments, assets, and t"e usiness environment in !"ic" 5M%O and
#iara operate. <iven t"e information in t"e prolem, t"is does not appear to e t"e case.
Of course, using R0E does not eliminate t"e prolem !it" t"e ROI measure itself. #o .eep
ROI "ig", Mar.s !ill still prefer to re>ect pro>ects !"ose ROI is greater t"an t"e re9uired rate of
return ut lo!er t"an t"e current ROI.
'*-$-
23-26 2%ont&d.3
*. )uperior performance measures c"ange significantly !it" t"e manager&s performance and
not very muc" !it" c"anges in factors t"at are eyond t"e manager&s control. If Mar.s "as no
aut"ority for ma.ing capital investment decisions, t"en ROI is not a good measure of Mar.s?s
performance77it varies !it" t"e actions ta.en y ot"ers rat"er t"an t"e actions ta.en y Mar.s.
5M%O may !is" to evaluate Mar.s on t"e asis of operating income rat"er t"an ROI.
ROI, "o!ever, may e a good measure to evaluate /exter&s economic viaility. )enior
management at 5M%O could use ROI to evaluate if t"e /exter /ivision&s income provides a
reasonale return on investment, regardless of !"o "as aut"ority for ma.ing capital investment
decisions. #"at is, ROI may e an inappropriate measure of Mar.s&s performance ut a
reasonale measure of t"e economic viaility of t"e /exter /ivision. If, for !"atever reasonsT
ad capital investments, !ea. economic conditions, etc.Tt"e /ivision s"o!s poor economic
performance, as computed y ROI, 5M%O management may decide to s"ut do!n t"e division
even t"oug" t"ey may simultaneously conclude t"at Mar.s performed !ell.
+. #"ere are t!o main concerns !it" Mar.s?s plans. First, creating very strong sales
incentives imposes excessive ris. on t"e sales force, ecause a salesperson&s performance is
affected not only y "is or "er o!n effort, ut also y random factors 2suc" as a recession in t"e
industry3 t"at are eyond t"e salesperson&s control. If salespersons are ris. averse, t"e firm !ill
"ave to compensate t"em for earing t"is extra uncontrollale ris.. )econd, compensating
salespersons only on t"e asis of sales creates strong incentives to sell, ut may result in lo!er
levels of customer service and sales support 2t"is !as t"e story at )ears auto repair s"ops !"ere a
c"ange in t"e contractual terms of mec"anics to DproduceD more repairs caused unoservale
9uality to e negatively affected3. 8"ere employees perform multiple tas.s, it may e important
to DluntD incentives on t"ose aspects of t"e >o t"at can e measured !ell 2for example, sales3 to
try and ac"ieve a etter alance of t"e t!o tas.s 2for example, sales and customer service and
support3. In addition, t"e division s"ould try to etter monitor customer service and customer
satisfaction t"roug" surveys, or t"roug" 9uantifying t"e amount of repeat usiness.
'*-$H
23-27 2*@ min.3 Relevant costs, performance evaluation, goal congruence
2N. Melumad, adapted3.
#"is prolem illustrates t"e dysfunctional e"avior t"at could e motivated y aritrary
allocations of corporate over"ead to profit-conscious divisional managers.
$. 8it"out t"e BG@@,@@@ in sales from t"e lo!-margin product line in t"e 5ndorian /ivision,
t"e second 9uarter operating statements 2in t"ousands3 !ill e:
Andorian Orion Tribble Total
Net sales B$,'@@ B$,'@@ B$,-@@ B+,@@@
%ost of sales +,@ ,+@ -+@ $,-*@
/ivisional over"ead $,@ $', $-@ +*,
/ivisional contriution -@@ ,*, G@@ $,F*,
%orporate over"ead 'GG 'GG *G+ F-@
Operating income B *$' B '+H B +$- B FH,
'. #"e company is !orse off as a result of dropping t"e lo! profitaility line of products
ecause it "as lost B$@@,@@@ in contriution margin from t"e dropped product line !it" no
reduction in corporate over"ead. #otal operating income decreases from B$,@H,,@@@ in t"e first
9uarter to BFH,,@@@ in t"e second 9uarter.
*. #"e 5ndorian /ivision manager&s performance evaluation measure 2divisional operating
income3 is "ig"er 2B*$',@@@ in t"e second 9uarter versus B*@@,@@@ in t"e first 9uarter3 as a result
of dropping t"e lo!-profitaility product line. #"e 5ndorian /ivision manager is ale to s"o! a
B$',@@@ "ig"er operating income ecause t"e B$@@,@@@ in lost contriution margin from t"e
dropped product line is more t"an offset y t"e B$$',@@@ reduction in corporate over"ead t"at is
c"arged to t"e 5ndorian /ivision. 5ndorian /ivision sales are no! only *@A of corporate sales
rat"er t"an t"e previous +$.HA of sales 2so *@A of total corporate over"ead costs of BF-@,@@@
e9ual to B'GG,@@@ are allocated to t"e 5ndorian /ivision in t"e second 9uarter, !"ereas +$.HA of
BF-@,@@@ e9ual to B+@@,@@@ are allocated to t"e 5ndorian /ivision in t"e first 9uarter3.
+. #"e easiest solution is to not allocate fixed corporate over"ead to divisions. #"en, t"e
prolem of dysfunctional e"avior !ill not arise. =ut central management may !ant t"e division
managers to DseeD t"e cost of corporate operations so t"at t"ey !ill understand t"at t"e
corporation as a !"ole is not profitale unless t"e comined divisions& contriution margins
exceed corporate over"ead. In t"is case, an allocation asis s"ould e c"osen t"at is not
manipulale or under t"e control of division managers. It must also "ave t"e property t"at t"e
action ta.en y one division does not affect t"e corporate over"ead allocations t"at get made to
t"e ot"er divisions 2as occurred in t"e second 9uarter for t"e company3.
In general, a lump sum allocation ased on, say, udgeted net income, or udgeted assets,
rat"er t"an an allocation t"at varies proportionately !it" an actual measure of activity 2suc" as
sales or actual net income3 !ill minimi(e dysfunctional e"avior. #"e allocation s"ould e suc"
t"at managers treat it as a fixed, unavoidale c"arge, rat"er t"an a c"arge t"at !ill vary !it" t"e
decisions t"ey ma.e. Of course, a potential disadvantage of t"is proposal is t"at managers may
try to underudget t"e amounts t"at serve as t"e cost allocation ases, so t"at t"eir divisions get
less of t"e corporate over"ead c"arges.
'*-$G
23-28 2', min.3 Historical-cost and current-cost ROI measures.
$. City
Plaza
South
Station
Central
Park
cost "istorical at Investment
income Operating
@@@ , *@@ B
@@@ , F@ B
6
*@.@A
@@@ , ,@@ B
@@@ , $'@ B
6
'+.@A
@@@ , '+@ B
@@@ , -@ B
6 ',.@A
cost current at Investment
income Operating
@@@ , -@@ B
@@@ , F@ B
6
$,.@A
@@@ , H@@ B
@@@ , $'@ B
6
$H.$A
@@@ , +,@ B
@@@ , -@ B
6 $*.*A
'. Rsing investments at "istorical cost as t"e denominator, %ity 0la(a "as t"e "ig"est ROI and
)out" )tation t"e lo!est. Rsing investment at current cost as t"e denominator, )out" )tation "as
t"e "ig"est ROI and %entral 0ar. t"e lo!est.
#"e c"oice of an appropriate measure depends on "o! Noillo %orporation >udges t"e
performance of its convenience stores.
If Noillo uses a single enc"mar. 2say, $-A3 in >udging t"e performance of eac" store, t"e
current cost measure !ill promote comparaility among stores t"at !ere oug"t at different
times or in areas !it" different real estate mar.ets. ;istorical cost !ill give rise to differences in
ROI among convenience stores t"at are unrelated to differences in operating efficiency. For
example, in times of rising prices, t"e oldest store 2%ity 0la(a3 !ill "ave a lo!er "istorical cost
investment level t"an t"e ne!est store 2)out" )tation3 for comparale amounts of s9uare feet of
store space in comparale locations. #"e current cost differences of t"e investment in t"e %ity
0la(a and )out" )tation stores, for example, are muc" smaller t"an t"e differences in "istorical
costs, due largely to t"e different time periods in !"ic" t"e t!o stores !ere uilt. 5 dra!ac. of
current cost is t"at current cost estimates are difficult to otain.
If Noillo tailors t"e performance enc"mar. for eac" convenience store in its udgeting
process, t"en t"e c"oice of a specific investment measure is less contentious. For example, if
"istorical cost is used, t"e udgeted ROI enc"mar. for t"e )out" )tation store could e, say,
',A !"ereas t"e udgeted ROI enc"mar. for t"e %ity 0la(a store could e, say, *@A. 5not"er
enefit of tailoring t"e udget to eac" manager is t"at more incentives are provided to managers
!"o are put in c"arge of poorly performing stations or stations in "ig"ly competitive mar.ets.
'*-$F
23-29 2+@7,@ min.3 ROI performance measures based on historical cost and
current cost.
$. ROI using "istorical cost measures:
%alistoga 6 *G.'+A
5lpine )prings 6 $F.$*A
Roc.y Mountains 6 '*.+-A
#"e %alistoga /ivision appears to e consideraly more efficient t"an t"e 5lpine )prings and
Roc.y Mountain /ivisions.
'. #"e gross oo. values 2i.e., t"e original costs of t"e plants3 under "istorical cost are
calculated as t"e useful life of eac" plant 2$'3 t"e annual depreciation:
%alistoga $' BH@,@@@ 6 B G+@,@@@
5lpine )prings $' B$@@,@@@ 6 B$,'@@,@@@
Roc.y Mountains $' B$'@,@@@ 6 B$,++@,@@@
Step 1: Restate long-term assets from gross oo. value at "istorical cost to gross oo. value at
current cost as of t"e end of '@@+.

on constructi of year in index cost on %onstructi
'@@+ in index cost on %onstructi
%alistoga B G+@,@@@ 2$H@ Q $@@3 6 B$,+'G,@@@
5lpine )prings B$,'@@,@@@ 2$H@ Q $*-3 6 B$,,@@,@@@
Roc.y Mountain B$,++@,@@@ 2$H@ Q $-@3 6 B$,,*@,@@@
Step 2: /erive net oo. value of long-term assets at current cost as of t"e end of '@@+.
2Estimated useful life of eac" plant is $' years.3
'@@+ of end at t"e
cost current at
assets term - long of
oo. value <ross

life useful total Estimated
remaining life useful Estimated
%alistoga B$,+'G,@@@ 2' Q $'3 6 B '*G,@@@
5lpine )prings B$,,@@,@@@ 2F Q $'3 6 B$,$',,@@@
Roc.y Mountains B$,,*@,@@@ 2$$ Q $'3 6 B$,+@',,@@
23-29 2%ont?d.3
Step 3: %ompute current cost of total assets at t"e end of '@@+. 25ssume current assets of eac"
plant are expressed in '@@+ dollars.3
'*-'@
2given3 '@@+ of
end at t"e assets %urrent
O
'3 2)tep '@@+ of end at t"e cost current
at assets term - long of oo. value Net
%alistoga B'@@,@@@ O B'*G,@@@ 6 B +*G,@@@
5lpine )prings B',@,@@@ O B$,$',,@@@ 6 B$,*H,,@@@
Roc.y Mountains B*@@,@@@ O B$,+@',,@@ 6 B$,H@',,@@
Step 4: %ompute current-cost depreciation expense in '@@+ dollars.
<ross oo. value of long-term assets at current cost at t"e end of '@@+
2from )tep $3 2$ Q $'3
%alistoga B$,+'G,@@@ 2$ Q $'3 6 B$$F,@@@
5lpine )prings B$,,@@,@@@ 2$ Q $'3 6 B$',,@@@
Roc.y Mountains B$,,*@,@@@ 2$ Q $'3 6 B$'H,,@@
Step 5: %ompute '@@+ operating income using '@@+ current-cost depreciation.
7

on depreciati
cost - ;istorical

+3 2)tep dollars '@@+
in on depreciati
cost - %urrent
%alistoga B$*@,@@@ 7 2B$$F,@@@ 7 BH@,@@@3 6 B G$,@@@
5lpine )prings B''@,@@@ 7 2B$',,@@@ 7 B$@@,@@@3 6 B$F,,@@@
Roc.y Mountains B*G@,@@@ 7 2B$'H,,@@ 7 B$'@,@@@3 6 B*H',,@@
'*-'$
23-29 2%ont?d.3
Step 6: %ompute ROI using current-cost estimates for long-term assets and depreciation.
*3 2)tep '@@+ of end at t"e assets total of cost %urrent
,3 2)tep on depreciati cost current '@@+ using '@@+ for income Operating
%alistoga B G$,@@@ Q B +*G,@@@ 6 $G.+FA
5lpine )prings B$F,,@@@ Q B$,*H,,@@@ 6 $+.$GA
Roc.y Mountains B*H',,@@ Q B$,H@',,@@ 6 '$.GGA
ROI:
Historical Cost
ROI:
Current Cost
%alistoga *G.'+A $G.+FA
5lpine )prings $F.$* $+.$G
Roc.y Mountains '*.+- '$.GG
Rse of current cost results in t"e Roc.y Mountains /ivision appearing to e t"e most efficient.
#"e %alistoga ROI is reduced sustantially !"en t"e ten-year-old plant is restated for t"e H@A
increase in construction costs over t"e $FF+ to '@@+ period.
*. Rse of current costs increases t"e comparaility of ROI measures across divisions?
operating plants uilt at different construction cost price levels. Rse of current cost also !ill
increase t"e !illingness of managers, evaluated on t"e asis of ROI, to move from divisions !it"
assets purc"ased many years ago to divisions !it" assets purc"ased in recent years.
'*-''
23-30 2+@7,@ min.3 Evaluating managers, ROI, value-chain analysis of cost
structure.
$.
Assets Total
Revenues

Revenues
Income Operating

Assets Total
Income Operating
%omputer 0o!er
'@@'
'@@*
$.$$$
@.F+$
@.',@
@.$',
@.'HG
@.$$G
0eac" %omputer
'@@'
'@@*
$.',@
$.+,G
@.$@@
@.$H$
@.$',
@.',@
%omputer 0o!er&s ROI "as declined si(aly from '@@' to '@@*, largely ecause of a decline in
operating income to revenues. 0eac" %omputer?s ROI "as douled from '@@' to '@@*, in large
part due to an increase in operating income to revenues.
'. Computer Power Peach Computer
Business Function 2002 2003 2002 2003
Researc" and development
/esign
0roduction
Mar.eting
/istriution
%ustomer )ervice
#otal costs
$'.@A
,.@
*+.@
',.@
F.@
$, .@
$@@ .@A
-.@A
*.@
+@.@
**.@
G.@
$@ .@
$@@ .@A

$@.@A
'.@
+-.@
'@.@
$@.@
$' .@
$@@ .@A
$,.@A
+.@
*+.@
'*.@
G.@
$- .@
$@@ .@A
'*-'*
23-30 2%ont&d.3
=usiness functions !it" increasesCdecreases in t"e percentage of total costs from '@@' to '@@*
are:
Computer Power Peach Computer
Increases 0roduction Researc" and development
Mar.eting /esign
Mar.eting
%ustomer service
/ecreases Researc" and development 0roduction
/esign /istriution
/istriution
%ustomer service
%omputer 0o!er "as decreased expenditures in several .ey usiness functions t"at are critical to
its long-term survival77notaly researc" and development and design. #"ese costs are 2using t"e
c"apter?s terminology3 discretionary and can e reduced in t"e s"ort run !it"out any s"ort-run
effect on customers, ut suc" action is li.ely to create serious prolems in t"e long run.
*. =ased on t"e information provided, 0rovan is t"e etter candidate for president of Rser
Friendly %omputer. =ot" %omputer 0o!er and 0eac" %omputer are in t"e same industry.
0rovan "as "eaded 0eac" %omputer at a time !"en it "as consideraly outperformed %omputer
0o!er:
a. #"e ROI of 0eac" %omputer "as increased from '@@' to '@@*, !"ile t"at of %omputer
0o!er "as decreased.
. #"e computer maga(ine "as increased t"e ran.ing of 0eac" %omputer&s main product,
!"ile it "as decreased t"e ran.ing of %omputer 0o!er&s main product.
c. 0eac" %omputer "as received "ig" mar.s for ne! products 2t"e lifelood of a computer
company3, !"ile %omputer 0o!er ne!-product introductions "ave een descried as
Dmediocre.D
'*-'+
23-31 2', min.3 ROI, RI, ROS, management incentives 2%M5, adapted3.
$. If Mason Industries uses return on investment to measure t"e Vump-)tart /ivision?s 2V)/?s3
performance, <rieco may e reluctant to invest in t"e ne! plant ecause, as s"o!n elo!, return
on investment for t"e plant of $F.'A is lo!er t"an V)/?s current ROI of '+A.
Operating income for ne! plant B+G@,@@@
Ne! investment B',,@@,@@@
Return on investment for ne! plant $F.'A
Investing in t"e ne! plant !ould lo!er V)/?s ROI and, "ence, limit <rieco?s onus.
'. #"e residual income computation for t"e ne! plant is as follo!s:
Residual income 6 Income 7 2Imputed interest Investment3
Investment B',,@@,@@@
Operating income B +G@,@@@
%"arge for funds
2Investment, B',,@@,@@@ $,A3 *H,,@@@
Residual income B $@,,@@@
Investing in t"e ne! plant !ould add B$@,,@@@ to V)/?s residual income. %onse9uently, if
Mason Industries could e persuaded to use residual income to measure performance, <rieco
!ould e more !illing to invest in t"e ne! plant.
*. Return on )ales 2RO)3 6
@@@ , +@@ , '
@@@ , +G@
)ales
income Operating
=
6 '@A
If Mason Industries uses RO) to determine <rieco?s onus, <rieco !ill e more !illing to invest
in t"e ne! plant ecause RO) for t"e ne! plant of '@A exceeds t"e current RO) of $FA.
#"e advantages of using RO) are 2a3 t"at it is simpler to calculate and 23 t"at it avoids t"e
negative s"ort-run effects of ROI measures t"at may induce <rieco to not ma.e t"e investment in
t"e ne! plant. <rieco may favor RO) ecause s"e elieves t"at eventually increases in RO)
!ill increase ROI and RI.
#"e main disadvantage of using RO) is t"at it ignores t"e amount of investment needed to
earn a return. For example, RO) may e "ig" ut not "ig" enoug" to >ustify t"e level of
investment needed to earn t"e re9uired return on an investment.
'*-',
23-32 2'@7*@ min.3 Division manager's compensation, risk sharing, incentives
(continuation of 23-31).
$. %onsider eac" of t"e t"ree proposals t"at t"e management of Mason Industries is
considering:
a. %ompensate <rieco on t"e asis of a fixed salary !it"out any onus.
0aying <rieco a flat salary !ill not su>ect <rieco to any ris., ut !ill provide no
incentives for <rieco to underta.e extra p"ysical and mental effort.
. %ompensate <rieco on t"e asis of division residual income 2RI3.
#"e enefit of t"is arrangement is t"at <rieco !ould e motivated to put in extra effort to
increase RI ecause <rieco&s re!ards !ould increase !it" increases in RI. =ut compensating
<rieco largely on t"e asis of RI su>ects <rieco to excessive ris., ecause t"e division&s RI
depends not only on <rieco&s effort ut also on random factors over !"ic" <rieco "as no control.
<rieco may put in a great deal of effort, ut t"e division&s RI may e lo! ecause of adverse
factors 2"ig" interest rates, recession3 t"at t"e manager cannot control. For example, general
mar.et conditions !ill influence <rieco&s revenues and costs.
#o compensate <rieco for ta.ing on uncontrollale ris., Mason Industries must pay "er
additional amounts !it"in t"e structure of t"e RI-ased arrangement. #"us, only using
performance-ased incentives costs Mason more money, on average, t"an paying a flat salary.
#"e .ey 9uestion is !"et"er t"e enefits of motivating additional effort >ustify t"e "ig"er costs of
performance-ased re!ards.
c. %ompensate <rieco using ot"er companies t"at also manufacture go-carts and recreational
ve"icles as a enc"mar..
#"e enefit of enc"mar.ing or relative performance evaluation is to cancel out t"e effects
of common noncontrollale factors t"at affect a performance measure. #a.ing out t"e effects of
t"ese factors provides etter information aout management performance. ;o!ever,
enc"mar.ing and relative performance evaluation are effective only !"en similar
noncontrollale factors affect eac" of t"e companies in t"e enc"mar. group. If t"is is t"e case,
as it appears to e "ere, enc"mar.ing is a good idea. If, "o!ever, t"e companies in t"e
enc"mar. group are not exactly comparale ecause, for example, t"ey "ave ot"er areas of
usiness t"at cannot e separated from t"eir go-cart and recreational ve"icle usiness, or t"ey
operate under different mar.et conditions, enc"mar.ing may not e a good idea. If t"e
noncontrollale factors are not t"e same, t"en comparing t"e RI of <rieco?s division to t"e RI of
t"e ot"er companies !ill not provide useful relative performance evaluation information.
'. Mason s"ould use a compensation arrangement t"at includes ot" a salary component and a
onus component ased on residual income. #"e motivation for "aving some salary and some
performance-ased onus in <rieco?s compensation is to alance t"e enefits of incentives
against t"e extra costs of imposing uncontrollale ris. on t"e manager. If similar noncontrollale
factors affect t"e performance of t"e enc"mar. companies t"at also manufacture and sell go-
carts and recreational ve"icles, a onus ased on t"e V)/?s residual income relative to t"e
residual income earned y t"e enc"mar. companies !ould e preferred.
'*-'-
23-33 2*@7+@ min.3 ROI, RI, investment decisions.
$.

Assets Total
Revenue

Revenues
Income Operating

Assets Total
Income Operating
#$$3
Ne!spapers
#elevision
Film )tudios
@.F*F
'.$**
@.-*,
@.'*F
@.@',
@.$'$
@.''+
@.@,*
@.@HH
#$$#%
Ne!spapers
#elevision
Film )tudios
$.@'*
'.'''
@.-+@
@.'@@
@.@''
@.$*G
@.'@,
@.@+G
@.@GG
SNot Re9uired
#"e Ne!spaper /ivision "as a "ig" ROI ecause of its "ig" income margin. #"e #elevision
/ivision "as a lo! ROI despite a "ig" investment turnover ecause of its very lo! income
margin. #"e Film )tudios /ivision "as a lo! ROI despite a reasonaly "ig" income margin
ecause of its lo! investment turnover.
'. 5lt"oug" t"e proposed investment is small, relative to t"e total assets invested, it earns less
t"an t"e '@@* return on investment 2@.''+3 Kor t"e '@@' return on investment 2@.'@,3L 25ll dollar
numers in millions3:
'@@* ROI 2efore proposal3 6
F@@ , + B
$@@ , $ B
6 @.''+
Investment proposal ROI 6
'@@ B
*@ B
6 @.$,@
'@@* ROI 2!it" proposal3 6
$@@ , , B
$*@ , $ B
6 @.'''
<iven t"e existing onus plan, any proposal t"at reduces t"e ROI is unattractive.
*. Residual income for '@@* 2efore proposal, in millions3:
Operating Imputed Division
Income Interest Charge Residual Income
Ne!spapers B$,$@@ 7 B,GG 2@.$' B+,F@@3 6 B ,$'
#elevision $-@ 7 *-@ 2@.$' B*,@@@3 6 2'@@3
Film )tudios '@@ 7 *$' 2@.$' B',-@@3 6 2$$'3
+. Residual income for proposal 2in millions3:
Operating Imputed Residual
Income Interest Charge
Income
B*@ 7 B'+2@.$' B'@@3 6 B-
Investing in t"e fast-speed printing press !ill increase t"e Ne!spaper /ivision&s residual income.
;ence, if Jearney is evaluated using a residual income measure, Jearney !ould e muc" more
!illing to adopt t"e printing press proposal.
'*-'H
23-34 2'@7*@ min.3 Division manager's compensation (continuation of 23-33).
%onsider eac" of t"e t"ree proposals t"at Rupert 0rince is considering:
a. !o&pensate &anaers on t'e (asis of division R)I.
#"e enefit of t"is arrangement is t"at managers !ould e motivated to put in extra effort
to increase ROI ecause managers& re!ards !ould increase !it" increases in ROI. =ut
compensating managers largely on t"e asis of ROI su>ects t"e managers to excessive ris.,
ecause eac" division&s ROI depends not only on t"e manager&s effort ut also on random factors
over !"ic" t"e manager "as no control. 5 manager may put in a great deal of effort, ut t"e
division&s ROI may e lo! ecause of adverse factors 2"ig" interest, recession3 t"at t"e manager
cannot control.
#o compensate managers for ta.ing on uncontrollale ris., 0rince must pay t"em additional
amounts !it"in t"e structure of t"e ROI-ased arrangement. #"us, using mainly performance-
ased incentives !ill cost 0rince more money, on average, t"an paying a flat salary. #"e .ey
9uestion is !"et"er t"e enefits of motivating additional effort >ustify t"e "ig"er costs of
performance-ased re!ards. #"e motivation for "aving some salary and some performance-
ased onus in compensation arrangements is to alance t"e enefits of incentives against t"e
extra costs of imposing uncontrollale ris. on t"e manager.
Finally, re!arding a manager only on t"e asis of division ROI !ill induce managers to
maximi(e t"e division&s ROI even if ta.ing suc" actions are not in t"e est interests of t"e
company as a !"ole.
. !o&pensate &anaers on t'e (asis of co&pany*ide R)I.
Re!arding managers on t"e asis of company!ide ROI !ill motivate managers to ta.e
actions t"at are in t"e est interests of t"e company rat"er t"an actions t"at maximi(e a division&s
ROI.
5 negative feature of t"is arrangement is t"at eac" division manager&s compensation !ill
no! depend not only on t"e performance of t"at division manager ut also on t"e performance of
t"e ot"er division managers. For example, t"e compensation of Jen Jearney, t"e manager of t"e
Ne!spaper /ivision, !ill depend on "o! !ell t"e managers of #elevision and Film studios
perform, even t"oug" Jearney "imself may "ave little influence over t"e performance of t"ese
divisions. ;ence, compensating managers on t"e asis of company!ide ROI !ill impose extra
ris. on eac" division manager.
c. !o&pensate &anaers usin t'e ot'er divisions+ averae R)I as a (enc'&ark.
#"e enefit of enc"mar.ing or relative performance evaluation is to cancel out t"e effects
of common noncontrollale factors t"at affect a performance measure. #a.ing out t"e effects of
t"ese factors provides etter information aout a manager&s performance. 8"at is critical,
"o!ever, for enc"mar.ing and relative performance evaluation to e effective is t"at similar
noncontrollale factors affect eac" division. It is not clear t"at t"e same noncontrollale factors
t"at affect t"e performance of t"e Ne!spaper /ivision 2cost of ne!sprint paper, for example3
also affect t"e performance of t"e #elevision and Film studios divisions. If t"e noncontrollale
factors are not t"e same, t"en comparing t"e ROI of one division to t"e average ROI of t"e ot"er
t!o divisions !ill not provide useful information for relative performance evaluation.
'*-'G
23-34 2%ont&d.3
5 second factor for 0rince to consider is t"e impact t"at enc"mar.ing and relative
performance evaluation !ill "ave on t"e incentives for t"e division managers of t"e Ne!spaper,
#elevision, and Film studios /ivisions to cooperate !it" one anot"er. =enc"mar.ing one
division against anot"er means t"at a division manager !ill loo. good y improving "is or "er
o!n performance, or y ma.ing t"e performance of t"e ot"er division managers loo. ad.
23-35 2', min.3 Ethics, manager's performance evaluation 25. )pero, adapted3.
$a. 4ariale manufacturing cost per unit 6 B'
Fixed manufacturing cost per unit 6 BF,@@@,@@@ ,@@,@@@ 6 B$G
Revenues, B'@ ,@@,@@@ B$@,@@@,@@@
4ariale manufacturing costs, B' ,@@,@@@ $,@@@,@@@
Fixed manufacturing costs, B$G ,@@,@@@ F,@@@,@@@
Fixed mar.eting costs +@@,@@@
#otal costs $@,+@@,@@@
Operating loss B 2+@@,@@@3
$. 4ariale manufacturing cost per unit 6 B'
Fixed manufacturing cost per unit 6 BF,@@@,@@@ -@@,@@@ 6 B$,
Revenues, B'@ ,@@,@@@ B$@,@@@,@@@
4ariale manufacturing costs, B' ,@@,@@@ $,@@@,@@@
Fixed manufacturing costs, B$, ,@@,@@@ H,,@@,@@@
Fixed mar.eting costs +@@,@@@
#otal costs G,F@@,@@@
Operating income B $,$@@,@@@
'. Vones?s e"avior is not et"ical. 0rofessional managers are expected to ta.e actions t"at are
in t"e est interests of t"eir s"are"olders. Vones?s action enefited "imself at t"e cost of
s"are"olders. Vones?s actions are e9uivalent to Dcoo.ing t"e oo.s,D even t"oug" "e ac"ieved t"is
y producing more inventory t"an !as needed, rat"er t"an t"roug" fictitious accounting. )ome
students mig"t argue t"at Vones&s e"avior is not unet"ical77"e simply too. advantage of t"e
faulty contract t"e oard of directors "ad given "im !"en "e !as "ired.
*. 5s.ing distriutors to ta.e more products t"an t"ey need is also e9uivalent to Dcoo.ing t"e
oo.s.D In effect, distriutors are eing coerced into ta.ing more product. #"is is a particular
prolem if distriutors !ill ta.e less product in t"e follo!ing year or alternatively return t"e
excess inventory next year. )ome students mig"t argue t"at Vones?s e"avior is not unet"icalTit
is up to t"e distriutors to decide !"et"er to ta.e more inventory or not. )o long as Vones is not
forcing t"e product on t"e distriutors, it is not unet"ical for Vones to pus" sales t"is year even if
t"e excess product !ill sit in t"e distriutors? inventory.
'*-'F
'*-*@
23-36 2*@ min.3 ROI, RI, division manager`s compensation, nonfinancial
measures.
$. RO) 6
)ales
Income Operating
6
@@@ , @@@ , $,
@@@ , G@@ , $
6 $'A
ROI 6
5ssets #otal
Income Operating
6
@@@ , @@@ , $@
@@@ , G@@ , $
6 $GA
'a. ROI 6 '@A 6
5ssets #otal
income Operating
6
@@@ , @@@ , $@
N
;ence operating income 6 '@A $@,@@@,@@@ 6 B',@@@,@@@
Operating income 6 Revenue %osts
#"erefore, %osts 6 B$,,@@@,@@@ B',@@@,@@@ 6 B$*,@@@,@@@
%urrently,
%osts 6 Revenues Operating income 6 B$,,@@@,@@@ B$,G@@,@@@ 6 B$*,'@@,@@@
%osts need to e reduced y B'@@,@@@ 2B$*,'@@,@@@ B$*,@@@,@@@3.

'. ROI 6 '@A 6
assets #otal
income Operating
6
N
B$,G@@,@@@
;ence N 6 $,G@@,@@@ '@A 6 BF,@@@,@@@
0/ !ould need to decrease total assets in '@@+ y B$,@@@,@@@ 2B$@,@@@,@@@ BF,@@@,@@@3.
*. RI 6 Income 2Re9uired rate of return Investment3
6 B$,G@@,@@@ 2@.$, $@,@@@,@@@3
6 B*@@,@@@
+. 0/ !ants RI to increase y ,@A B*@@,@@@ 6 B$,@,@@@
#"at is 0/ !ants RI in '@@+ to e B*@@,@@@ O B$,@,@@@ 6 B+,@,@@@
If 0/ cuts costs y B+,,@@@ its operating income !ill increase to
B$,G@@,@@@ O B+,,@@@ 6 B$,G+,,@@@
RI'@@+ 6 B+,@,@@@ 6 B$,G+,,@@@ 2@.$, 5ssets3
B$,*F,,@@@ 6 @.$, 5ssets
5ssets 6 B$,*F,,@@@ @.$, 6 BF,*@@,@@@
0/ !ould need to decrease total assets y BH@@,@@@ 2B$@,@@@,@@@ BF,*@@,@@@3.
,. =arrington could use RO) to some degree. #"at !ay t"ere is less focus on cutting costs
and reduction in assets and more emp"asis on actual revenues and "o! t"ey translate into
operating income.
=arrington may also !ant to consider nonfinancial measures suc" as customer satisfaction
and mar.et s"are, 9uality, yield and on-time performance as !ell as monitor employee
satisfaction and t"e development of employee s.ills.
'*-*$
Chapter 23 Internet Exercise
,'e Internet e-ercise is availa(le to students only on t'e Prentice .all !o&panion /e(site
***.pren'all.co&0'ornren. Students can click on !ost Accountin, 11
t'
ed., and access t'e
Internet 2-ercise for t'e c'apter, *'ic' links to t'e /e( site of a co&pany or orani3ation. ,'e
Internet 2-ercise on t'e /e( *ill (e updated periodically so t'at it is current *it' t'e latest
infor&ation availa(le on t'e su(4ect orani3ation+s /e( site. A printout copy of t'e Internet
e-ercise for t'is c'apter as of early #$$# appears (elo*.
,'e solution to t'e Internet e-ercise, *'ic' *ill also (e updated periodically, is availa(le
to instructors fro& t'e !o&panion /e(site+s faculty vie*. ,o access t'e solution, click on !ost
Accountin, 11
t'
ed., 5aculty link, and t'en reister once to o(tain your pass*ord t'rou' t'e
online for&. After t'e initial reistration, you *ill 'ave a personal loin ID and pass*ord to use
to lo in. A printout of t'e solution to t'e Internet e-ercise for t'is c'apter as of early #$$#
follo*s. ,'e e-ercise and solution provide instructors *it' an idea of t'e content of t'e Internet
e-ercise for t'is c'apter.
Internet Exercise
Investors today "ave unparalleled access to financial information on t"e 8e. In addition to
corporate 8e sites, t"ere are countless ot"er 8e sites providing financial advice, investment
recommendations, and a !ide array of financial information. #"is exercise re9uires you to
researc" a company of your c"oice and evaluate its financial performance. <o to
"ttp:CC!!!.9uic.en.com and enter a tic.er symol in t"e W<et Iuotes and Ne!sX ox. Rse t"e
Iuic.en?s stoc. evaluator to ans!er t"e follo!ing 9uestions.
$. %lic. on t"e W<ro!t"-#rendsX lin.. In !"at industry does your company operateE
'. 8"at are your company?s one-year gro!t" rates for revenues and net incomeE ;o! does
t"is compare to industry averagesE
*. %lic. on WManagement 0erformanceX lin., and t"en on t"e lin.s for WReturn on E9uity,X
WReturn on 5ssets,X and WReturn on Invested %apital.X
a. 8"at does eac" of t"ese measures mean, and "o! are t"ey used to evaluate
performanceE
. 8"at are your company?s one-year ROE, RO5, and ROI%E ;o! do t"ey
compare to t"e industry averagesE
c. %lic. on t"e W* 1earsX lin.. Evaluate your company?s t"ree-year performance.
;as your company?s performance improved over t"e past t"ree yearsE
+. 8"at are t"e t!o components of return on investmentE
,. %lic. on WFinancial )tatementX lin.. Rse t"e financial data to calculate t"e profit margin
2net incomeCsales3 and asset turnover 2salesCassets3 for eac" of t"e last t"ree years. Rse
your results to explain t"e c"ange you oserved in your company?s performance in
9uestion *c.
'*-*'
Internet Exercise 2%ont?d.3
Solution to Internet Exercise
$. 5ns!ers !ill vary.
'. 5ns!ers !ill vary.
*a. ROE is a percentage t"at indicates "o! !ell a company uses its investor?s money. It e9uals
net income divided y common stoc."olders? e9uity. It is used for measuring gro!t" and
profitaility.
RO5 is t"e amount of profits earned 2efore interest and income taxes3, expressed as a
percentage of total assets. RO5 is a !idely follo!ed profit measure, and as long as a
company&s RO5 exceeds its interest rate on orro!ing, it is said to "ave positive financial
leverage.
ROI% is calculated y dividing earnings y total assets. ROI% is a roader measure of
profitaility t"an return on e9uity, ecause it includes ot" det and e9uity. Note t"at
companies !it" t"e same earnings and assets !ould "ave t"e same ROI%: ut t"at if one of
t"e companies finances more of its assets !it" det, it !ould "ave a "ig"er return on
e9uity.
*. 5ns!ers !ill vary.
*c. 5ns!ers !ill vary.
+. #"e t!o components of ROI% are return on sales 2NI Q Revenues3 and asset turnover
2RevenuesC5ssets3.
,. 5ns!ers !ill vary.
'*-**
Video Case
,'e video case can (e discussed usin only t'e case *riteup in t'e c'apter. Alternatively,
instructors can 'ave students vie* t'e videotape of t'e co&pany t'at is t'e su(4ect of t'e case.
,'e videotape can (e o(tained (y contactin your Prentice .all representative. ,'e case
6uestions c'allene students to apply t'e concepts learned in t'e c'apter to a specific (usiness
situation.
McDONALD`S CORPORATION: PERFORMANCE MEASUREMENT AND
COMPENSATION ISSUES
$. 8"ile it may seem t"at Mc/onald?s aims for consistency and uniformity across all stores
2restaurants3, t"e operations do differ from location to location, and region to region. 5
store in one location may "ave fe! competitors, resulting in "ig" sales figures and aove-
average profits. In t"is case, t"e store manager may neglect items suc" as cleanliness or
employee satisfaction. If a store is given incentives to offer speedy service, 9uality may
suffer. For example, employees may not e friendly and mista.es at t"e drive-t"roug"
!indo! 2orders filled incorrectly due to "aste3 can occur. Mc/onald?s "as c"osen to
provide a standard scorecard to its company-o!ned stores, ut it !eig"ts t"e components
of t"e scorecard differently to "elp focus t"e attention of store managers on t"e areas t"ey
need to !or. on t"e most, given differences in location, customers, and competitors.
'. 5ccording to t"e text, ROI is t"e most popular approac" for incorporating t"e investment
ase into a performance measure. It lends revenues, costs, and investment into a single
percentage measuring profitaility. ROI can e increased y increasing revenues or
decreasing costs. )tore managers "ave direct control over costs and are actually
evaluated along a numer of dimensions in t"is area 2food cost, laor cost are t"e t!o
largest3. Managers also "ave sales revenue targets to ac"ieve. For t"e company-o!ned
stores, managers may not "ave direct control over investment, "o!ever. For example, t"e
company?s investment in p"ysical facilities and e9uipment rests outside t"e scope of t"e
manager. )o using ROI means t"at managers are re!arded on t"e asis of investments
made t"at t"ey do not influence or control. On t"e ot"er "and, management could
evaluate store managers against ROI targets t"at factor in t"e investments already made.
=ecause managers do not "ave direct control over investments, t"e dysfunctional
incentives of managers not investing in pro>ects t"at "ave a return less t"an t"e current
ROI ut greater t"an t"e cost of capital, do not arise.
*. 8it" $,G@@ company-o!ned stores, it !ould e relatively easy to enc"mar. against
stores !it"in t"e company. )tores !it" similar locations, demograp"ic trends, and
economic conditions could e compared. 5ny differences noted !ould e attriuted to
differences in t"e managers? performances since t"e common uncontrollale factors
!ould e filtered out. #"ere is a do!nside, "o!ever. #"is approac" may reduce t"e
incentive for store managers to "elp one anot"er. For example, a s"ortage of a critical
food item or paper product at one store mig"t e met y anot"er, ut if s"aring adversely
affects t"e store t"at provides t"e needed goods, t"e manager may e loat" to do so. <oal
incongruence may result since t"e managers !ould not e !or.ing toget"er for t"e
overall good of t"e company.
'*-*+