Smhorngren cost accounting 14e CHAPTER 23 PERFORMANCE MEASUREMENT, COMPENSATION, AND MULTINATIONAL CONSIDERATIONS

23–1

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: Customer perspective: Market share, customer satisfaction.

Internal–business–processes perspective: Manufacturing lead time, yield,

on–time performance, number of new product launches, and number of

new patents filed.

Learning–and–growth perspective: employee satisfaction, information–

system availability.

23–2 The three steps in designing an accounting–based performance measure are:

1. Choose performance measures that align with top management’s financial goals

2. Choose the details of each performance measure in Step 1, including the time horizon and

measurement of various aspects of the measure

3. Choose a target level of performance and feedback mechanism for each performance

measure in Step 1

23–3 The DuPont method highlights that ROI is increased by any action that increases return

on sales or investment turnover. ROI increases with:

1. increases in revenues,

2. decreases in costs, or

3. decreases in investments,

while holding the other two factors constant.

23–4 Yes. Residual income (RI) is not identical to return on investment (ROI). ROI is a

percentage with investment as the denominator of the computation. RI is an absolute monetary

amount which includes an imputed interest charge based on investment.

23–5 Economic value added (EVA) is a specific type of residual income measure that is

calculated as follows:

Economic value

added (EVA)

=

After–tax

operating income

–

Total assets minus

Weighted–average

cost of capitalcurrent liabilities

23–6 Definitions of investment used in practice when computing ROI are:

1. Total assets available

2. Total assets employed

3. Total assets employed minus current liabilities

4. Stockholders’ equity

23–2

23–7 Current cost is the cost of purchasing an asset today identical to the one currently held if

an identical asset can currently be purchased; it is the cost of purchasing an asset that provides

services like the one currently held if an identical asset cannot be purchased. Historical–cost–

based measures of ROI compute the asset base as the original purchase cost of an asset minus

any accumulated depreciation.

Some commentators argue that current cost is oriented to current prices, while historical

cost is past–oriented.

23–8 Special problems arise when evaluating the performance of divisions in multinational

companies because

a. The economic, legal, political, social, and cultural environments differ significantly

across countries.

b. Governments in some countries may impose controls and limit selling prices of

products.

c. Availability of materials and skilled labor, as well as costs of materials, labor, and

infrastructure may differ significantly across countries.

d. Divisions operating in different countries keep score of their performance in different

currencies.

23–9 In some cases, the subunit’s performance may not be a good indicator of a manager’s

performance. For example, companies often put the most skillful division manager in charge of

the weakest division in an attempt to improve the performance of the weak division. Such an

effort may yield results in years, not months. The division may continue to perform poorly with

respect to other divisions of the company. But it would be a mistake to conclude from the poor

performance of the division that the manager is performing poorly.

A second example of the distinction between the performance of the manager and the

performance of the subunit is the use of historical cost–based ROIs to evaluate the manager even

though historical cost–based ROIs may be unsatisfactory for evaluating the economic returns

earned by the organization subunit. Historical cost–based ROI can be used to evaluate a manager

by comparing actual results to budgeted historical cost–based ROIs.

23–10 Moral hazard describes situations in which an employee prefers to exert less effort (or to

report distorted information) compared with the effort (or accurate information) desired by the

owner because the employee’s effort (or validity of the reported information) cannot be

accurately monitored and enforced.

23–11 No, rewarding managers on the basis of their performance measures only, such as ROI,

subjects them to uncontrollable risk because managers’ performance measures are also affected

by random factors over which they have no control. A manager may put in a great deal of effort

but her performance measure may not reflect this effort if it is negatively affected by various

random factors. Thus, when managers are compensated on the basis of performance measures,

they will need to be compensated for taking on extra risk. Therefore, when performance–based

incentives are used, they are generally more costly to the owner. The motivation for having some

salary and some performance–based bonus in compensation arrangements is to balance the

benefits of incentives against the extra costs of imposing uncontrollable risk on the manager.

23–3

23–12 Benchmarking or relative performance evaluation is the process of evaluating a

manager’s performance against the performance of other similar operations. The ideal

benchmark is another operation that is affected by the same noncontrollable factors that affect

the manager’s performance. Benchmarking cancels the effects of the common noncontrollable

factors and provides better information about the manager‘s performance.

23–13 When employees have to perform multiple tasks as part of their jobs, incentive problems

can arise when one task is easy to monitor and measure while the other task is more difficult to

evaluate. Employers want employees to intelligently allocate time and effort among various

tasks. If, however, employees are rewarded on the basis of the task that is more easily measured,

they will tend to focus their efforts on that task and ignore the others.

23–14 Disclosures required by the Securities and Exchange Commission are:

a. A summary compensation table showing the salary, bonus, stock options, other stock

awards, and other compensation earned by the five top officers in the previous three

years

b. The principles underlying the executive compensation plans, and the performance

criteria, such as profitability, sales growth, and market share used in determining

compensation

c. How well a company’s stock performed relative to the stocks of other companies in

the same industry

23–15 The four levers of control in an organization are diagnostic control systems, boundary

systems, belief systems and interactive control systems.

Diagnostic control systems are the set of critical performance variables that help

managers track progress toward the strategic goal. These measures are periodically

monitored and action is usually only taken if a measure is outside its acceptable

limits.

Boundary systems describe standards of behavior and codes of conduct expected of

all employees, particularly by defining actions that are off–limits. Boundary systems

prevent employees from performing harmful actions.

Belief systems articulate the mission, purpose and core values of a company. They

describe the accepted norms and patterns of behavior expected of all managers and

other employees with respect to each other, shareholders, customers and

communities.

Interactive control systems are formal information systems that managers use to focus

an organization‘s attention and learning on key strategic issues. They form the basis

of ongoing discussion and debate about strategic uncertainties that the business faces

and help position the organization for the opportunities and threats of tomorrow.

23–4

23–16 (30 min.) ROI, comparisons of three companies.

1. The separate components highlight several features of return on investment not revealed

by a single calculation:

a. The importance of investment turnover as a key to income is stressed.

b. The importance of revenues is explicitly recognized.

c. The important components are expressed as ratios or percentages instead of dollar

figures. This form of expression often enhances comparability of different divisions,

businesses, and time periods.

d. The breakdown stresses the possibility of trading off investment turnover for income

as a percentage of revenues so as to increase the average ROI at a given level of

output.

2. (Filled–in blanks are in bold face.)

Companies in Same Industry

A

B

C

Revenue

Income

Investment

Income as a % of revenue

Investment turnover

Return on investment

$1,000,000

$ 100,000

$ 500,000

10%

2.0

20%

$ 500,000

$ 50,000

$5,000,000

10%

0.1

1%

$10,000,000

$ 50,000

$ 5,000,000

0.5%

2.0 1%

Income and investment alone shed little light on comparative performances because of

disparities in size between Company A and the other two companies. Thus, it is impossible to

say whether B‘s low return on investment in comparison with A’s is attributable to its larger

investment or to its lower income. Furthermore, the fact that Companies B and C have identical

income and investment may suggest that the same conditions underlie the low ROI, but this

conclusion is erroneous. B has higher margins but a lower investment turnover. C has very small

margins (1/20th of B) but turns over investment 20 times faster.

I.M.A. Report No. 35 (page 35) states:

―Introducing revenues to measure level of operations helps to disclose specific areas for

more intensive investigation. Company B does as well as Company A in terms of income

margin, for both companies earn 10% on revenues. But Company B has a much lower turnover

of investment than does Company A. Whereas a dollar of investment in Company A supports

two dollars in revenues each period, a dollar investment in Company B supports only ten cents in

revenues each period. This suggests that the analyst should look carefully at Company B’s

investment. Is the company keeping an inventory larger than necessary for its revenue level?

Are receivables being collected promptly? Or did Company A acquire its fixed assets at a price

level that was much lower than that at which Company B purchased its plant?‖

―On the other hand, C’s investment turnover is as high as A’s, but C’s income as a

percentage of revenue is much lower. Why? Are its operations inefficient, are its material costs

too high, or does its location entail high transportation costs?‖

―Analysis of ROI raises questions such as the foregoing. When answers are obtained, basic

reasons for differences between rates of return may be discovered. For example, in Company B’s

case, it is apparent that the emphasis will have to be on increasing turnover by reducing

investment or increasing revenues. Clearly, B cannot appreciably increase its ROI simply by

increasing its income as a percent of revenue. In contrast, Company C’s management should

concentrate on increasing the percent of income on revenue.‖

23–5

23–17 (30 min.) Analysis of return on invested assets, comparison of two divisions, DuPont method.

1.

Operating Income

Operating Revenues

Total Assets

Operating

Income

Operating

Revenues

Operating

Revenues

Total Assets

Operating

Income

Total Assets

Test Preparation Division

2011

$720

$9,000

$1,800

8.0%

5.0

40.0%

2012

920

$920 11.5% = $8,000

$920 46% = $2,000

11.5%

4.0

46.0%

2013

1,140

$1,140 9.5% = $12,000

$12,000 6 = $2,000

9.5%

6.0

57.0%

Language Arts Division

2011

$660

$3,000

$2,000

22.0%

1.5

33.0%

2012

$3,525 20%= $705

3,525

2,350

20.0%

1.5

30.0%

2013

$2,900 20% = $580

$2,900 1.6 = $4,640

2,900

12.5%

1.6

20.0%

Global Data, Inc.

2011

$1,380

$12,000

$3,800

11.5%

3.2

36.3%

2012

$920 + $705 = $1,625

$8,000 + $3,525 = $11,525

$2,000 + $2,350 = $4,350

14.1%

2.7

37.4%

2013

$1,140 + $580 = $1,720

$12,000 + $4,640 = $16,640

$2,000 + $2,900 = $4,900

10.3%

3.4

35.1%

2. Based on revenues, Test Preparation is more than twice the size of Language Arts. In

addition, the Test Preparation Division turns over its assets at more than twice the rate of the

Language Arts Department (operating revenues as a multiple of total assets). However,

Language Arts is twice as profitable in terms of margins (operating income as a percent of

operating revenues).

The net result is that Test Preparation has a higher ROI, typically in the 40–60% range,

while Language Arts has ROI in the 20–35% range. Moreover, the ROI of the Test Preparation

Division has been increasing from 2011 to 2013, while the ROI of the Language Arts

Department has been falling. Overall, this has resulted in Global Datad showing stable ROI over

the past three years.

23–6

23–18 (10–15 min.) ROI and RI.

1. Operating income = (Contribution margin per unit 150,000 units) – Fixed costs

= ($720 – $500) 150,000 – $30,000,000 = $3,000,000

ROI =

Investment

income Operating

= $3,000,000 ÷ $48,000,000 = 6.25%

2. Operating income = ROI Investment

[No. of pairs sold (Selling price – Var. cost per unit)] – Fixed costs = ROI Investment

Let $X = minimum selling price per unit to achieve a 25% ROI

150,000 ($X – $500) – $30,000,000 = 25% ($48,000,000)

$150,000X = $12,000,000 + $30,000,000 + $75,000,000

X = $780

3. Let $X = minimum selling price per unit to achieve a 20% rate of return

150,000 ($X – $500) – $30,000,000 = 20% ($48,000,000)

$150,000X = $9,600,000 + $30,000,000 + $75,000,000

X = $764

23–19 (20 min.) ROI and RI with manufacturing costs.

1. The operating income is:

Sales revenue ($12,000 × 10,000)

$120,000,000

Less:

Direct materials ($3,000 × 10,000)

$30,000,000

Setup ($1,300 × 6,000)

7,800,000

Production ($415 × 175,200)

72,708,000

110,508,000

Gross margin

9,492,000

Selling and administration

7,340,000

Operating income

$ 2,152,000