Handout Performance Evaluation and Compensation -...

Performance Evaluation and
Compensation
Steve Wu
11.29.2012

Objectives for today

Performance Evaluation for Business Units

Commonly used financial performance measures

Details about accounting-based performance measures

Target setting and feedback mechanisms

Performance Evaluation and Compensation for
Individuals

How to tie compensation to performance

Preferred performance measures

Executive compensation

Levers of Control Framework

Financial and Nonfinancial Measures

Firms are increasingly presenting financial
and nonfinancial performance measures for
their subunits in a balanced scorecard, and
it’s four perspectives:
1.
Financial
2.
Customer
3.
Internal business process
4.
Learning and growth

Accounting-Based Performance Measures

Requires several steps:
1.
Choose performance measures that align with
top management’s financial goals.
2.
Choose the details of performance measures.
3.
Choose a target level of performance and a
feedback mechanism for each performance
measure.

Choosing Among Different Performance
Measures

Selecting subunit operating income as a metric
may be inappropriate because it obviously differs
simply on the differing size of the subunits.

Four common measures of economic
performance:
1.
Return on investment
2.
Residual income
3.
Economic value added (EVA)
4.
Return on sales

Return on Investment (ROI)

ROI is an accounting measure of income divided
by an accounting measure of investment.

ROI may be decomposed into its two components
as follows ( DuPont method of profitability
analysis ):

ROI = Return on Sales x Investment Turnover
Income Income Revenues
Investment Revenues Investment
X =
ROI =
Investment
Income

Return on Investment (ROI)

Most popular metric for two reasons:
1.
Blends all the ingredients of profitability
(revenues, costs, and investment) into a single
percentage
2.
May be compared to other ROI’s both inside
and outside the firm

Has many different variations.

A Hotel Chain Example
San Fran Hotel Chicago Hotel New Orleans Hotel
Revenue 1,200,000 1,400,000 3,185,000
Variable Costs 310,000 375,000 995,000
Fixed Costs 650,000 725,000 1,680,000
Operating Income 240,000 300,000 510,000
Current Asset 400,000 500,000 660,000
Long-term Asset 600,000 1,500,000 2,340,000
Total Asset 1,000,000 2,000,000 3,000,000
Current Liabilities 50,000 150,000 300,000

A Hotel Chain Example on ROI
Operating Income
(1)
Total Asset
(2)
ROI
(3)= (1)/(2)
San Fran 240,000 1,000,000 24%
Chicago 300,000 2,000,000 15%
New Orleans 510,000 3,000,000 17%
Operating
Income
(1)
Revenue
(2)
Total
Assets
(3)
ROS
(4)= (1)/(2)
Investment
Turnover
(5)= (2)/(3)
ROI
(6)= (4)x(5)
San Fran 240,000 1,200,000 1,000,000 20% 1.2 24%
Chicago 300,000 1,400,000 2,000,000 21.43% 0.7 15%
New
Orleans
510,000 3,185,000 3,000,000 16.01% 1.06 17%

A Hotel Chain Example on ROI
Operating
Income
(1)
Revenue
(2)
Total
Assets
(3)
ROS
(4)= (1)/(2)
Investment
Turnover
(5)= (2)/(3)
ROI
(6)= (4)x(5)
Original 240,000 1,200,000 1,000,000 20% 1.2 24%
Plan 1 240,000 1,200,000 800,000 20% 1.5 30%
Plan 2 300,000 1,500,000 1,000,000 20% 1.5 30%
Plan 3 300,000 1,200,000 1,000,000 25% 1.2 30%
How to increase San Francisco Hotel’s ROI from 24% to 30%?
Plan 1: reduce total assets by $200,000
Plan 2: increase revenue by $300,000 (while keeping ROS constant)
Plan 3: cut costs by $60,000