ACCT3104   Lecture Overview

y Measurement and evaluation of performance
Managerial Costing and Control y Cost, Revenue, Profit Centres (considered to date)
y Financial and non‐financial 
y Designing accounting‐based performance measures
y Measurement and evaluation of Performance
Meas rement and e al ation of Performance
Lecture Topic 11
y Investment Centres (ROI, RI, EVA®, ROS)
Performance Measurement and Compensation y Consider each measure and what it shows
Reading: Horngren et al Chapter 23 y Centre vs Manager evaluation
y Efficacy of Financial Control
y Principles of Incentives and Compensation Plans
y Understand the role of salaries and incentives when 
rewarding managers

Measurement & Evaluation of 
Introduction… Performance
y Performance measures are an integral part of any management 
management  y We have considered some accounting‐based (financial) 
control system ‐ subunit and individual performance evaluation.  performance measures used in different types of responsibility 
centres:
y Making strategic planning and control decisions requires  ‐ Cost and Revenue Centres use flexible budgets and variance 
information about how different subunits of the organization  analysis (Flexible Budget Variances and Sales Volume Variances)
have performed.  The measures used can be financial and non‐
f f
‐ Profit Centres use contribution margin income statements by 
financial.  segments (Segment Reporting), flexible budgets and variance 
analysis
y To be effective the performance measures and rewards need to  ‐ Investment Centres (focus of L 11) use ROI, RI and EVA 
motivate managers and employees at all levels to strive to  ™ Why not compare operating incomes (segment margins) of these divisions?
achieve company strategies and goals.  
Accounting based performance measures can be used as good 
indicators of progress the Company has made towards its goals 
and objectives.

Designing Accounting ‐ Based 
Designing Accounting ‐
Financial and
Financial and Non
Non‐‐Financial 
Financial Measures
Measures Performance Measures
1. Choose performance measures that align with top management’s 
y Accounting based performance measures comprise only a subset of the  financial goals (best measure of a subunits performance?)
measures managers use to evaluate subunits and sub‐ordinates…
2. Choose the time horizon of each performance measure (Annual? 
y Non‐financial measures:
Multi‐year period?)
‐ assist our interpretation of the financial measures 3. Define components of the performance measure
‐ provide leading indicators of future financial performance  4. Choose a measurement alternative for the components
C oose a easu e e t a te at e o t e co po e ts o of the 
e
‐ can be used to evaluate aspects of a business that are critical to its long 
can be used to evaluate aspects of a business that are critical to its long
term success… performance measure
5. Set the target level of performance (do all subunits have identical 
y Recall the “Balanced Scorecard” approach  encourages managers to adopt  targets such as the same required rate of return on assets?)
a balanced perspective and take actions in the Company’s long‐run  6. Determine the timing of the feedback (frequency of calculating & 
interests.  Measures are derived from the Company’s strategy.  Include 
measures of  profitability or return; customer satisfaction; innovation and  reporting the measure to top management?)
productivity / quality / time measures as well as employee satisfaction and  Selection between alternatives at each step? How does each alternative fulfil the:
turnover. ‐ promoting Goal congruence
y The Balanced Scorecard can be applied in a number of situations – from  ‐ promoting Management effort
subunits to individuals ‐ promoting Subunit performance evaluation
‐ promoting Subunit autonomy

1
 Measurement and Evaluation of  1. Return On Investment (ROI)
Evaluates profit relative to the level of investment 
performance: Investment Centres
performance: Investment  Centres Definition of the components?

1. Return on Investment (ROI)
a) Profit margin (ROS) x Investment (asset) turnover (Du Pont)
Segment or Operating Income?
b) ‘Accounting Rate of Return’
Before or after tax?
2
2. Residual Income
Residual Income (RI)
3. Economic Value Added (EVA)
The above are ‘investment’ measures Income
Investment = resources or assets used to generate income
ROI = Investment
4. Return on Sales (ROS) – does not include any ‘investment’ Investment = the resources or assets used to generate income
Total assets employed, total assets available
or a measure of net assets?
Valued at cost, book value, current cost?
Beginning, ending or average?

Varied definitions of Investment Assessing Return on Investment 

Total assets (available)
Total assets
employed
Total assets less
current liabilities
Appropriate if the division manager
Performance
has considerable authority in making
decisions about all of the division’s † Analyse trends over time
assets, including non-productive assets
† Compare to competitors
Appropriate if the division manager has
been directed by top level management
• Decompose and compare to competitors
to keep non-productive assets, † Compare to alternative ‘returns’
p
making it appropriate to exclude
non-productive assets from
the measure of invested capital ¾ Look for signals suggesting where there might be 
Appropriate if the division manager problems
has authority to secure short-term bank
loans and other short-term credit
¾ Use cautiously and in conjunction with other measures

Measurement Alternative? 
Current cost – cost of purchasing an identical (or similar) asset today
Historical cost – can include Gross Book Value or Net Book Value 

Interpretation of ROI Net Book Value vs Gross Book Value

Lecture Example: Assume that Compu‐soft Pty Ltd is a retailer with 3 product 
lines;  computers, software and computer help books, that operates out of stores  Advantages: net book value Advantages: gross book value
in Brisbane, Sydney and Melbourne.  Disadvantages: gross book value Disadvantages: net book value
Calculate the ROI using (i) NBV of assets, (ii) GBV of assets and (iii) Current cost of 
assets as alternative definitions of “Investment”, and interpret your results 
Using net book value: † The usual methods of
Net Book Gross Book
computing depreciation are
Financial data(2010) Profit Value Value Current Cost
† maintains consistency with arbitrary and should not be
Brisbane $ 26,000 $ 195,500 $ 250,500 $ 388,000 balance sheet prepared for allowed to affect ROI,
Sydney 38,500 212,000 445,000 650,000 external reporting purposes residual income, or EVA
Melbourne 16,850 133,000 155,450 225,500 calculations
Return on Investment † to measure invested capital † When non-current assets are
Brisbane 13.30% 10.38% 6.70% is also more consistent with depreciated, their net book
Sydney 18.16% 8.65% 5.92% the definition of income, value declines over time
Melbourne 12.67% 10.84% 7.47% which is the numerator in resulting in a misleading
ROI calculations increase in ROI, RI, and EVA
across time
$26,000 ÷ $195,500 = 13.30%

2
 Factors Underlying ROI
- the Du Pont method The Du Pont Method (ROI)
Measures the percentage of
each sales dollar that Lecture Example contd:
remains as profit after all Return on Sales
Calculate, using the figures provided below the ROI, Return on Sales,
expenses are covered and Investment (Asset) Turnover for Compu-Soft (Brisbane) for each
- a measure of efficiency product line & in total for Years 2009 & 2010 and interpret your results.
Income Income X Sales revenue
Return on investment = =
Investment Sales revenue Investment
Note: Investment = Assets
Income Investment Sales
Highlights the benefits of reducing
Investment(Asset) Year 2009 Year 2010 Year 2009 Year 2010 Year 2009 Year 2010
investment in inventories, &
Computers $ 8,000 $ 5,000 $ 50,000 $ 62,500 $ 200,000 $ 250,000
spending carefully on fixed assets Turnover
Software 15,000 16,000 100,000 80,000 150,000 160,000
Focuses on the Books 3,200 5,000 32,000 50,000 80,000 100,000
number of sales Total $ 26,200 $ 26,000 $ 182,000 $ 192,500 $ 430,000 $ 510,000
dollars generated
by each dollar of
invested capital
- a measure of effectiveness

Du Pont Method of Return on Investment
Du Pont Method of Return on Investment Controlling ROI
ROI= Return on Sales x Investment Turnover † Three ways to improve ROI

$8,000 ÷ $200,000 $200,000 ÷ $50,000 Increase Sales

without a Reduce Reduce
similar Expenses Assets
Return on Sales Invest. Turnover
Invest ROI increase in
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 costs
Computers 4.00% 2.00% 4.00 4.00 16.00% 8.00%
Software 10.00% 10.00% 1.50 2.00 15.00% 20.00% Income Sales
Sales X Investment
Books 4.00% 5.00% 2.50 2.00 10.00% 10.00%
Total 6.10% 5.10% 2.36 2.65 14.40% 13.50%

Return on Investment
$26,200 ÷ $430,000 $8,000 ÷ $50,000 Sales Turnover

Technical Problems of ROI
1. 
1. ROI is too aggregated to give guidance about the trade‐off that 
too aggregated  2. The measure gives rise to inconsistent capital investment 
inconsistent capital investment 
can be made between profit and investment decisions across the company which lead to sub‐optimal 
decisions 
A simple example: outcomes.
Quarter ROI    = ROS(Profit Margin)* Investment Turnover
¾ Denominator problem with fixed assets ‐ GBV or NBV?
1 12.6% = 17.1% * .736
2 13 4% 20 2%
13.4% = 20.2% * .664
664 E g Div ROI = 20%; Company ROI = 16%
E.g., Div ROI = 20%; Company ROI = 16%
An new investment opportunity has arisen for the division 
The ROI has improved but the manager in this case has simply produced more  which offers an 18% return. Decision?
units for inventory. How did this work?
How did this work? There is a lack of goal congruence in the investment decision.
¾ As a compound (aggregated) measure it is subject to manipulation
manipulation by 
managers aiming for a favourable result ¾ What about the disposal decision and use of GBV? NBV?
‐ Can result in dysfunctional decisions NBV provides less incentive to dis‐invest but this incentive may 
‐ Has a short term “profit” focus (effect?) become too strong.

3
 Be careful comparing the ROI’s of Different 
Business Segments…
3. NPV calculation and evaluation of investment is inconsistent  ‰ Invalid comparisons between different work units can occur because:
with ROI outcomes after the investment. ƒ age of assets are different (GBV vs NBV)

¾ ROI encourages investment in fast payback assets. ƒ asset‐intensive vs low‐asset business types

ƒ different national (and cultural) contexts
ƒ different legal restrictions etc
4. What about the effect of transfer prices 
effect of transfer prices on Divisional ROI?
¾ Company profits are rarely optimised
C fit l ti i d by optimising
b ti i i divisional 
di i i l
profit.  …and Multinational Companies…
(Solution? Remove the decision rights?) ‰ Comparing the performance of divisions of a multinational company 
creates additional difficulties.
ƒ Differences in the economic, legal, political, social, and cultural 
5. ROI Results may be misleading and decisions dysfunctional environment
¾ Is comparison of different divisions appropriate? ƒ Governmental controls
¾ Measuring the performance of the division rather than the  ƒ Availability of materials and skilled labour
performance of the manager? ƒ Currency differences

…and be careful evaluating Managers’  Return on Investment
performance…
Advantages Limitations
‰ The economic performance of a business unit is different from the 
> Single comprehensive figure that > high ROI units may be unwilling to invest 
performance of its manager.
focuses managers on profit & in projects with ROI greater than 
assets needed to generate the minimum rate of return but less than 
‰ Comparisons between managers
between managers of different units on the basis of  profits unit’s current ROI
unit’s current ROI
O a e not necessarily valid
o ecessa y valid:
ROI are not necessarily  a d
ƒ different types of businesses deliver different levels of return
> easily understood -comparable to > using investment based on historical 

ƒ a 
a good manager of a poor division may not appear to do as well as a 
good manager of a poor division may not appear to do as well as a  interest rates and rates of return costs, net of depreciation (NBV), 
costs, net of depreciation (NBV), 
poor manager of a good ROI division. A managers performance is 
poor manager of a good ROI division.  on alternative investments managers may put off purchasing new 
limited by the division’s profit potential. > Motivates managers to use equipment when assets fully 
ƒ the extent to which a manager can control an item is irrelevant to the  assets optimally and only acquire depreciated
division’s performance BUT is relevant to the managers performance. when justified > Aggregated measure 
Aggregated measure ––may lead to 
manipulation
> widely used
> improvement over evaluation
based on dollar profit alone

2. Residual Income Residual Income

Evaluates profit relative to a minimum required return on investment Investment centre profit
– Investment charge
Residual Income = = Residual income
Income - (Required rate of return x Investment)
Investment capital
‰ Typically use Operating Income
‰ Uses an ‘imputed cost of the investment’ based on the minimum  × Imputed interest rate
acceptable rate of return the company seeks on its investment. (Typically 
measured by the weighted average cost of capital (WACC))
= Investment charge
‰ Measure is expressed in dollar terms → motivates managers to maximise 
$ outcome rather than a %
‰ A potential solution to under/over investment → managers have incentive  Investment centre’s
to accept all projects that more than cover the cost of capital → goal 
congruent minimum required
rate of return

4
 Lecture example: Calculate the Residual 
Residual Income Income for each area. Compu‐soft requires a 
12% rate of return Residual Income
Average Net
Financial data
Brisbane
Profit
$ 26,000
Book Value
$ 195,500
Advantages Limitations
Sydney 38,500 212,000 > supports incentive to accept all > favours large units when 
Melbourne 16,850 133,000 projects with ROI greater than
minimum rate of return is 
Return on Investment then minimum rate of return
Brisbane 13.30% low
Brisbane > can use the minimum rate of
Investment $ 195,500 Sydney 18.16% return to adjust for differences > not as intuitive as ROI
Melbourne 12.67%
Minimum rate of return 12% in risk > may be difficult to obtain a 
Minimum profit 23,460 Residual Income = minimum return is 12%
Actual profit 26,000 > can use a different minimum minimum rate of return
Minimum Residual
Residual income $ 2,540 rate of return for different types
Return Income
of assets
Brisbane $ 23,460 $ 2,540
Sydney 25,440 13,060
Melbourne 15,960 890

Quick Check 9
Redmond Awnings, a division of Wrapup Corp., 
Redmond Awnings, a division of Wrapup Corp.,  has a net operating income of $60,000 and 
has a net operating income of $60,000 and  average operating assets of $300,000. The 
average operating assets of $300,000. The  required rate of return for the company is 15%. 
q p y
required rate of return for the company is 15%.  What is the division’s ROI?
What is the division’s ROI? a. 25%
a. 25% b.   5% ROI = NOI/Average operating assets
b.   5% c. 15% = $60,000/$300,000 = 20%
c. 15% d. 20%
d. 20%

Quick Check 9
Redmond Awnings, a division of Wrapup Corp., has a  Redmond Awnings, a division of Wrapup Corp., has a 
net operating income of $60,000 and average  net operating income of $60,000 and average 
operating assets of $300,000. If the manager of the  operating assets of $300,000. If the manager of the 
division is evaluated based on ROI, will she want to  division is evaluated based on ROI, will she want to 
make an investment of $100,000 that would 
$ make an investment of $100,000 that would 
$
generate additional net operating income of $18,000  generate additional net operating income of $18,000 
per year? per year?
a. Yes a. Yes ROI = $78,000/$400,000 = 19.5%
b.  No b.  No
This lowers the division’s ROI from
20.0% down to 19.5%.

5
 Quick Check 9
The company’s required rate of return is 15%. Would 
The company’s required rate of return is 15%. Would  the company want the manager of the Redmond 
the company want the manager of the Redmond  Awnings division to make an investment of $100,000 
Awnings division to make an investment of $100,000  that would generate additional net operating income 
that would generate additional net operating income  o $ 8,000 pe yea
of $18,000 per year?
of $18,000 per year?
$
a. Yes
a. Yes
b.  No ROI = $18,000/$100,000 = 18%
b.  No
The return on the investment
exceeds the minimum required rate
of return.

Quick Check 9
Redmond Awnings, a division of Wrapup Corp., has a 
Redmond Awnings, a division of Wrapup Corp., has a  net operating income of $60,000 and average 
net operating income of $60,000 and average operating  operating assets of $300,000. The required rate of 
assets of $300,000. The required rate of return for the  return for the company is 15%. What is the division’s 
company is 15%. What is the division’s residual income? residual income?
a. $240,000
$240 000 a. $240,000
b. $  45,000
b. $  45,000
c. $  15,000
c. $  15,000
d. $  51,000
d. $  51,000
Net operating income $60,000
Required return (15% of $300,000) $45,000
Residual income $15,000

Quick Check 9
If the manager of the Redmond Awnings division is  If the manager of the Redmond Awnings division is 
evaluated based on residual income, will she want  evaluated based on residual income, will she want 
to make an investment of $100,000 that would  to make an investment of $100,000 that would 
generate additional net operating income of $18,000  generate additional net operating income of 
per year? $18,000 per year?
a. Yes a. Yes Net operating income $78,000
Required return (15% of $400,000) $60,000
b.  No b.  No Residual income $18,000
This is an increase of $3,000 in the residual
income.

6
 3. Economic Value Added® Economic Value Added
y Stern Stuart – consulting firm
‰ After‐tax operating income ‐ total annual cost of capital
y RI adjusted for “accounting distortions”
y EVA is the income “pie” available to creditors and shareholders 
less the required return on funds invested for the L‐T by creditors 
and shareholders
Economic Value Added = After-
After-tax Operating Income -
y evaluates income relative to level of investment required to earn 
that income Two sources: [Weighted average cost of capital x
y motivates managers to undertake economic value added activities Debt and Equity & after tax (Total assets - Current Liabilities)]

• Non-current assets + Current assets - Current liabilities

Economic Value Added = A-T Profit – Cost of Capital • or Non-current assets + Working Capital

Economic Value Added

EVA for our 
EVA for our Lecture Example
Lecture Example
Investment centre’s after-tax operating income
– Investment charge y Now assume long term funds are:
= Economic Value Added y $160,000 long‐term bonds
y after‐tax cost of debt, 6.3% i.e., 9% (1 ‐ .30)
y $
$300,000 ordinary shares
, y

( )
I
Investment
t t I
Investment
t t W i ht d
Weighted y cost of equity,12%
centre’s – centre’s ± average
total assets current liabilities cost of capital
y Two calculations required
y dollar value of investment

( After-tax Market
cost of ± value
debt of debt ) ( Cost of Market
ª equity ± value
capital of equity ) y WACC (% figure)

Market Market
value ª value
of debt of equity

After-tax
cost of
Market Cost of Market Economic Value Added
value + equity value of Some additional information for the lecture example
Weighted debt
of debt capital equity
average capital Brisbane Sydney Melbourne
cost of = Income 26,000 38,500 16,850
capital 195,500 212,000 133,000
Market Market Total Assets
value + value of Current Liabilities 31,500 20,500 4,650
of debt equity

Investment Investment Weighted-

Investment Economic
centre’s after- centre’s average
- centre’s - X = value
tax operating current cost of
.063 $160,000 + .12 $300,000 total assets added
profit liabilities capital

.1002 In thousands
=
Or 10.02%
B $26 x (1 - .30) - [($195.5 - $31.5) x .1002] = $1,767.20
$160,000 + $300,000 S $38.5 x (1 - .30) - [($212 - $20.5) x .1002] = $7,761.70
M $16.85 x (1 - .30) - [($133 - $4.65) x .1002] =($1,065.67)

7
 EVA Quick Check 9
Advantages Limitations
A negative feature of defining investment by excluding the portion 
> approximates real underlying  > complex RI  of total assets employed that are financed by short‐term creditors 
increase in the value of  > cost of capital imprecise is that:  
shareholder’s wealth > capital calculation based on book 
a. current liabilities are sometimes difficult to define  
g
> makes management focus on  value, not market value, ∴
, , no 
optimising the company’s  account for opportunity cost of  
investment  b. short‐term debt is always more expensive to finance than long‐
capital mix term debt  
> Studies ? Some show closer  > capital base may fluctuate from 
correlation with share price  year to year distorting EVA c. this method encourages managers to use an excessive amount 
than conventional profits > may discourage long term  of short‐term debt  
investment 
> Studies? Some show weak  d. this method encourages managers to use an excessive amount 
correlation with share price of long‐term debt 

Quick Check 9
Quick Check 9 Waldorf Company has two sources of funds - long-term debt
with a market and book value of $10 million issued at an
A negative feature of defining investment by excluding the portion  interest rate of 12 percent, and equity capital that has a
of total assets employed that are financed by short‐term creditors 
is that:   market value of $8 million (book value of $4 million). Waldorf
Company has profit centres in the following locations, with
a. current liabilities are sometimes difficult to define   the following operating incomes, total assets, and total
li biliti
liabilities. Th
The costt off equity
it capital
it l iis 12 percent,
t while
hil th
the
b. short‐term debt is always more expensive to finance than long‐ tax rate is 25 percent.
term debt  
Current
c. this method encourages managers to use an excessive amount  Operating Income Assets Liabilities
of short‐term debt  
St.Louis $960,000 $4,000,000 $200,000
d. this method encourages managers to use an excessive amount  Cedar Rapids $1,200,000 $8,000,000 $600,000
of long‐term debt  Wichita $2,040,000 $12,000,000 $1,200,000

Quick Check 9 1. What is EVA for St. Louis?

a. $255,740
1. What is EVA for St. Louis? b. $327,460
c. $392,540
a. $255,740 d. $720,000
b. $327,460
c. $392,540
d. $720,000
WACC = [(0.09 x $10,000,000) + (0.12x $8,000,000)]
$18,000,000
= .1033
St. Louis (EVA) = ($960,000 x 0.75) - .1033 x (4,000,000-
$200,000)
= $720,000 - 392,540
= $327,460

8
Summary: ROI, RI, EVA Limitations
Summary: ROI, RI, EVA Limitations 4. Return on Sales (ROS)

y Income
y can be manipulated in short run ROS = Operating Income (EBIT)/Sales
y to compare, must use same accounting methods
y based on accrual accounting
y Asset Investment ¾ Suitable for use in firms where the level of investment in 
f f f investment in 
y May be understated (e.g. R&D) assets is low and therefore the corresponding ROI would 
y Current management may be judged on decisions of previous managers be extremely high
y Assets not restated for changing (rising) price levels (older assets will  ¾ Shows how effectively costs are managed
report higher ROI) – can be overcome by using ‘current cost’ measures as 
opposed to historical cost measures

Measuring Investment Centre & 
Time Horizon? Manager
y ROI, RI, EVA (and ROS) represents results for a single 
period (Year) Performance evaluation of a manager should be 
distinguished from the subunit. Managers should be 
y Managers may be inclined to take actions that 
evaluated on the profit margin they control.
improve short‐run performance but that re 
detrimental to long‐run
detrimental to long run interests of Company
interests of Company „ Exclude these costs:
Costs traceable to the division but not controlled by 
y Many companies evaluate subunits on these measures 
the division manager
over multiple years
Common costs incurred elsewhere and allocated to 
the division

The key issue is controllability

Quick Check 9
In performance evaluations:   In performance evaluations:  
a. the performance of the division prior to the manager  a. the performance of the division prior to the manager 
assuming control should be considered   assuming control should be considered  
p y
b. economic conditions for the specific industry should not  p y
b. economic conditions for the specific industry should not
be considered   be considered  
c. to have an effective and fair evaluation, a manager should  c. to have an effective and fair evaluation, a manager should 
be evaluated over several time periods   be evaluated over several time periods  
d. Both a and c are correct.   d. Both a and c are correct.  

9
 Efficacy of Financial Control? Fundamental Principles of
‰ Criticisms
Incentive Compensation
„ delayed information Plans
„ highly aggregated information
„ not actionable; limited guidance for future actions The basic idea behind incentive compensation
„ narrow measures that emphasise only one aspect of performance  plans is “pay for performance.”
and that do not evaluate how well the organisation is meeting 
and that do not evaluate how well the organisation is meeting
shareholders’ requirements
The two key
„ too focused on short‐term results elements of
„ may encourage actions that decrease both shareholder and customer  an incentive
value compensation
‰ Overcome this? Take a balanced scorecard approach plan are the:
ƒ Use financial and non‐financial measures
ƒ Select measures that support the strategic orientation Measure of Method of
ƒ Use external benchmarks performance compensation
ƒ Incorporate continuous improvement

The Trade‐Off: Creating Incentives vs. Imposing Risk Moral Hazard
y Compensation may range from: ‰ When an employee prefers to exert less effort compared 
Flat salary with no performance based incentives… with the effort desired by the owner because the employee’s 
effort cannot be accurately monitored and enforced
to
No salary and full commission…

y An inherent trade‐off exists between creating  Intensity of Incentives
incentives and imposing risk
y An incentive should be some reward for performance
‰Intensity of Incentives – size of incentive component relative 
to the salary component
y An incentive may create an environment in which 
suboptimal behaviour may occur (the goals of the firm are 
sacrificed in order to meet a manager’s personal goals)
y Managers do not like being subject to risk BUT lack of 
risk can create MORAL HAZARD

Merchant’s six criteria of an “ideal” 
Preferred Performance Measures motivational contract
‰ Are sensitive to or change significantly with the 
manager’s performance.   ‰ Performance measures that are congruent with 
‰ Do not change much with changes in factors that 
overall corporate goals of maximising shareholder value
are beyond the manager’s control ‰ Controllable results measures
‰ Accurate results measures
‰ Should motivate the manager as well as limit the  ‰ Preset and challenging performance standards
manager’s exposure to risk
‰ Rewards that are meaningful, but at a minimum cost
‰ Financial and non‐financial benchmarks may be 
‰ Simplicity
used to evaluate performance.

10
 What Behaviour should the
Elements of a typical Incentive Scheme
Elements of a typical Incentive Scheme Incentive Compensation Plan
y Variable/s used to measure, assess and reward performance
motivate?
y Basis for determining the standard or target level of  It depends on the situation faced by each company
performance Current versus
y Rules for translating levels of performance into individual 
g p Current Future Future
rewards Performance
y Nature of rewards
y size of reward, type of reward
y Basis for determining bonus pool size Compensation awards are Compensation awards
usually cash or shares are based on future
y Basis for determining participants in scheme
that can be cashed soon performance providing
after the award that are an incentive for workers
based on performance in to stay and for workers
the recent past to focus on the long run

Designing Incentive Systems Designing Incentive Systems

Division Performance vs Companywide Performance Using Fixed Formulae or Subjectivity in providing rewards

Division Company-wide Fixed Formulae Subjective

Focuses managers attention

F tt ti on
their own responsibility centre
Allows managers to consider the
Managers know precisely It is difficult to capture
impact of their actions on the
what is expected of them activities in fixed formulae
company as a whole

may be detrimental to other may be difficult to see EXAMPLE: EXAMPLE:

responsibility centres and
performance of company as a whole
fits more in a decentralised
diverse organisation
relationship between their actions
and the company as a whole
fits more in a centralised
organisation
For each percentage point
by which revenue growth
exceeds 5%, managers
receive a bonus of 10% of
their base salary
A manager’s ROI dipped
because of research, employee
training, and advertising
expenses that will not pay off
until the future

Evaluation based on Share Price

Designing Incentive Systems rather than accounting based
measures?
Absolute Performance Evaluation or Relative Performance
Evaluation? Performance Evaluation Based on Share Performance?

Absolute Relative Aligns managers’ incentives with

those of shareholders
Your evaluation is on an Your evaluation depends on
absolute scale and does how you perform in
not depend on what other relation to everyone else Division managers in big companies
people do may see little relationship between their
performance and the company’s shares.
EXAMPLE: EXAMPLE:
90 - 100 = A Comparing divisional
80 - 89 = B performance
EVA focuses on creating value for
70 - 79 = C to other divisions shareholders, while relying on nonshare
60 - 69 = D in the same industry performance measures

11
Management Compensation 9 Question: Management Compensation
Cash incentives are
The top management of Aussie Industries is considering the following 
highly liquid and
compensation arrangements for its division managers:
attractive
y Fixed salary without bonus.
-short term
y Base compensation based entirely on their division’s residual income.
Share incentives are y Use benchmarking of each division
Use benchmarking of each division’ss RI against the RI of other divisions of 
RI against the RI of other divisions of
usually not redeemable into similar size in other firms in similar industries. 
cash until a future time
-longer term, aligns
interests…

Prizes, promotions (titles), location can
be more attractive than money, and
more motivational
Assume that division managers do not like bearing risk.
• List the advantages and disadvantages of each alternative.
• What compensation arrangement would you recommend?

12