Performance Measurement & Compensation

PERFORMANCE MEASUREMENT & COMPENSATION **Financial Metrics of Performance Measurements** * Designing accounting-based performance measures. 1. Choose performance measures that align with the firm's financial goals. 2. Choose the details of each performance measure 1   1. present5.com present5.com (the numerator and denominator). 3. Choose a target level of performance for each performance measure and a feedback mechanism. 4. How to review current performance. **Common Measures of Economic Performance** **Ex. Hospitality Industry Segment Financial Reports (in dollars)** **Income Statement** | | San Francisco (SF) | Chicago (C) | New Orleans (NO) | Total Company | |---------------|---------------------|--------------|---------------------|----------------| | Revenue | 1,200,000 | 1,400,000 | 3,185,000 | 5,785,000 | | Variable Costs | (310,000) | (375,000) | (995,000) | (1,680,000) | | Fixed Costs | (650,000) | (125,000) | (1,690,000) | (3,055,000) | | Operating Income | 240,000 | 900,000 | 510,000 | 1,650,000 | | Interest Exp (10%) | (450,000) | (450,000) | | Income before taxes | | 1,180,000 | | Income Tax (30%) | | (354,000) | | Net Income | | 826,000 | **Balance Sheet** | | San Francisco (SF) | Chicago (C) | New Orleans (NO) | Total Company | |---------------|---------------------|--------------|---------------------|----------------| | Current Assets | 400,000 | 500,000 | 1,560,000 | 2,460,000 | | L.T. Assets | 600,000 | 1,500,000 | 2,340,000 | 4,440,000 | | Total Assets | 1,000,000 | 2,000,000 | 3,900,000 | 6,900,000 | | Current Liabilities | 50,000 | 150,000 | 300,000 | 500,000 | | L.T. Debt | | 4,500,000 | | Shareholder's Eq | | 1,500,000 | | Total Liab. & Eq. | 1,000,000 | 2,000,000 | 3,900,000 | 6,900,000 | 1. Return on Investment (ROI) - Most popular performance measure - Accounting Rate of Return ROI = Income / Investment | | SF | C | NO | Total Company | |--------|---------|---------|----------|---------------| | Operating Income | 240,000 | 300,000 | 510,000 | 1,050,000 | | Total Assets | 1,000,000 | 2,000,000 | 3,000,000 | 6,000,000 | | ROI | 24% | 15% | 17% | 18% | 2. Residual Income (RI) - Remaining income in excess of the "Imputed Cost of Investment" - RI = Income - (Required rate of Return x Investment) | | SF | C | NO | Total Company | |--------|---------|---------|----------|---------------| | Total Assets | 1,000,000 | 2,000,000 | 3,000,000 | 6,000,000 | | Req. rate of return | 12% | 12% | 12% | 12% | | Imputed Cost of Inv | 120,000 | 240,000 | 360,000 | 720,000 | | Operating Income | 240,000 | 300,000 | 510,000 | 1,050,000 | | RI | 120,000 | 60,000 | 150,000 | 330,000 | *Note: 12% is given 3. Return on Sales (ROS) - Also called "Income to Revenue Ratio" ROS = Operating Income / Revenue | | SF | C | NO | Total Company | |--------|---------|---------|----------|---------------| | Operating Income | 240,000 | 300,000 | 510,000 | 1,050,000 | | Revenue | 1,200,000| 1,400,000| 3,185,000 | 5,785,000 | | ROS | 20% | 21.4% | 16% | 18.1% | 4. Economic Value Added (EVA) - A specific type of Residual Income (RI) calculation - Substitutes the ff in RI calculation: * Operating Income --> After-tax operating income * Required rate of return --> After-tax WACC * Investment --> Assets funded by LT debt & Equity - EVA = After-tax operating income - [WACC x (Total Assets - Current Liabilities)] **Additional Info** | Balance Sheet | Rate | MV | |---|---|---| | Long-term Debt | 10% | 4.5M | | SHE | 14% | 4.5M | **Effective Interest Rate** | | Before Tax | After Tax | Market Value | Weight | Weighted Average | |--------|------------|-----------|--------------|---------|------------------| | LT Debt | 10% | 7% | 4.5M | 50% | 3.5% | | SHE | 14% | 14% | 4.5M | 50% | 7.0% | | WACC | 9.0M | 100% | 10.5% | **EVA** | | SF | C | NO | Total Company | |--------|---------|---------|----------|---------------| | Total Assets | 1,000,000 | 2,000,000 | 3,000,000 | 6,000,000 | | Current Liabilities | (50,000) | (150,000) | (300,000) | (500,000) | | Assets funded by LT Debt & SHE | 950,000 | 1,850,000 | 2,700,000 | 5,500,000 | | WACC (After Tax) | 10.5% | 10.5% | 10.5% | 10.5% | | Cost of Investment | 99,750 | 194,250 | 283,500 | 577,500 | | Operating Income after tax | 168,000 | 210,000 | 351,000 | 735,000 | | EVA | 68,250 | 15,750 | 73,500 | 157,500