Chapter

24

McGraw-Hill/Irwin

Rewarding Business
Performance

© The McGraw-Hill Companies, Inc., 2002
Motivation and Aligning
Motivation and Aligning
Goals and Objectives
Goals and Objectives
Goal Congruence
Alignment of emp...
Motivation and Aligning
Motivation and Aligning
Goals and Objectives
Goals and Objectives

Measure
performance.

Feedback
...
Return on Investment (ROI)
Return on Investment (ROI)
Return on investment is the ratio of
profit to the average investmen...
Return on Investment (ROI)
Return on Investment (ROI)
Profit
ROI = Average Investment

ROI =

Profit
Sales

Return
Return
...
Return on Investment (ROI)
Return on Investment (ROI)
Holly Company reports the following:
Profit
Sales
Average Investment...
Return on Investment (ROI)
Return on Investment (ROI)
ROI =

Profit
Sales

×

$30,000
ROI =
×
$500,000

Sales
Average Inve...
Improving ROI
Improving ROI
 Decrease
Expenses
 Increase
Sales
Prices

 Lower
Invested
Capital

Three ways to improve R...
Improving ROI
Improving ROI
Holly’s manager was able to increase

sales revenue to $600,000 which
increased income to $42...
Improving ROI
Improving ROI
ROI =

Profit
Sales

×

$42,000
ROI =
×
$600,000

Sales
Average Investment
$600,000
$200,000

...
Criticisms of ROI
Criticisms of ROI
 As division manager at Winston, Inc., your

compensation package includes a salary p...
Criticisms of ROI
Criticisms of ROI
Gee . . .
I thought we were
supposed to do what
was best for the
company!

McGraw-Hill...
Residual Income
Residual Income
Operating Earnings
– Investment charge
= Residual income
Investment capital
× Minimum retu...
Residual Income
Residual Income
Flower Co. has an opportunity to invest

$100,000 in a project that will earn
$25,000.
F...
Residual Income
Residual Income
Operating Earnings = $25,000
– Investment charge = 20,000
= Residual income
= $ 5,000
Inve...
Residual Income
Residual Income
As a manager at

Flower Co., would you
invest the $100,000 if
you were evaluated
using re...
Residual Income
Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected ...
Economic Value Added
Economic Value Added
Economic value added tells us how much
shareholder wealth is being created.

McG...
Economic Value Added
Economic Value Added
Economic value added is the annual after-tax
operating profit minus the total an...
Residual Income
Residual Income
After-tax Operating Income
– Investment charge
= Economic value added
(Total assets – curr...
Economic Value Added
Economic Value Added
Economic value added can be improved in
three ways . . .
 Increase profit witho...
Balanced Scorecard
Balanced Scorecard
A set of performance targets and results that
show an organization’s performance in
...
Balanced Scorecard
Balanced Scorecard
Financial Perspective
How do we look
to the firm’s owners?

Learning and Growth
Pers...
Components of Management
Components of Management
Compensation
Compensation
I prefer a fixed salary
so that I know what
I ...
Design Choices for
Design Choices for
Management Compensation
Management Compensation
Should we reward
Should we reward
cu...
End of Chapter 24
End of Chapter 24
My performance
was magnificent!

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc.,...
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  1. 1. Chapter 24 McGraw-Hill/Irwin Rewarding Business Performance © The McGraw-Hill Companies, Inc., 2002
  2. 2. Motivation and Aligning Motivation and Aligning Goals and Objectives Goals and Objectives Goal Congruence Alignment of employee goals and objectives with organizational goals and objectives. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  3. 3. Motivation and Aligning Motivation and Aligning Goals and Objectives Goals and Objectives Measure performance. Feedback  Steer employees toward goals.  Measure progress in achieving goals. Improve performance. McGraw-Hill/Irwin Reward performance. © The McGraw-Hill Companies, Inc., 2002
  4. 4. Return on Investment (ROI) Return on Investment (ROI) Return on investment is the ratio of profit to the average investment used to generate the profit. ROI = McGraw-Hill/Irwin Profit Average investment © The McGraw-Hill Companies, Inc., 2002
  5. 5. Return on Investment (ROI) Return on Investment (ROI) Profit ROI = Average Investment ROI = Profit Sales Return Return on Sales on Sales McGraw-Hill/Irwin × Sales Average Investment Capital Capital Turnover Turnover © The McGraw-Hill Companies, Inc., 2002
  6. 6. Return on Investment (ROI) Return on Investment (ROI) Holly Company reports the following: Profit Sales Average Investment $ 30,000 $ 500,000 $ 200,000 Let’s calculate ROI. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  7. 7. Return on Investment (ROI) Return on Investment (ROI) ROI = Profit Sales × $30,000 ROI = × $500,000 Sales Average Investment $500,000 $200,000 ROI = 6% × 2.5 = 15% McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  8. 8. Improving ROI Improving ROI  Decrease Expenses  Increase Sales Prices  Lower Invested Capital Three ways to improve ROI McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  9. 9. Improving ROI Improving ROI Holly’s manager was able to increase sales revenue to $600,000 which increased income to $42,000. There was no change in invested capital. Let’s calculate the new ROI. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  10. 10. Improving ROI Improving ROI ROI = Profit Sales × $42,000 ROI = × $600,000 Sales Average Investment $600,000 $200,000 ROI = 7% × 3.0 = 21% Holly increased ROI from 15% to 21%. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  11. 11. Criticisms of ROI Criticisms of ROI  As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus.  The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%.  You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager would you invest in this project? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  12. 12. Criticisms of ROI Criticisms of ROI Gee . . . I thought we were supposed to do what was best for the company! McGraw-Hill/Irwin As division manager, I wouldn’t invest in that project because it would lower my pay! © The McGraw-Hill Companies, Inc., 2002
  13. 13. Residual Income Residual Income Operating Earnings – Investment charge = Residual income Investment capital × Minimum return = Investment charge Investment center’s minimum acceptable return McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  14. 14. Residual Income Residual Income Flower Co. has an opportunity to invest $100,000 in a project that will earn $25,000. Flower Co. has a 20 percent minimum acceptable rate of return and a 30 percent ROI on existing business. Let’s calculate residual income. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  15. 15. Residual Income Residual Income Operating Earnings = $25,000 – Investment charge = 20,000 = Residual income = $ 5,000 Investment capital × Minimum return = Investment charge = $100,000 = × 20% = $ 20,000 Investment center’s minimum acceptable return McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  16. 16. Residual Income Residual Income As a manager at Flower Co., would you invest the $100,000 if you were evaluated using residual income? Would your decision be different if you were evaluated using ROI? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  17. 17. Residual Income Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  18. 18. Economic Value Added Economic Value Added Economic value added tells us how much shareholder wealth is being created. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  19. 19. Economic Value Added Economic Value Added Economic value added is the annual after-tax operating profit minus the total annual cost of capital. Cost of capital is weighted-average after-tax cost of long-term borrowing and the cost of debt. Equity McGraw-Hill/Irwin Debt © The McGraw-Hill Companies, Inc., 2002
  20. 20. Residual Income Residual Income After-tax Operating Income – Investment charge = Economic value added (Total assets – current liabilities) × Weighted-average cost of capital = Investment charge After-tax cost of long-term borrowing and the cost of equity McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  21. 21. Economic Value Added Economic Value Added Economic value added can be improved in three ways . . .  Increase profit without using more capital.  Use less capital to earn the same amount of profit.  Invest capital in high-return projects. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  22. 22. Balanced Scorecard Balanced Scorecard A set of performance targets and results that show an organization’s performance in meeting its responsibilities to various stakeholders. Employee Investor Stakeholder Stakeholder Group Group McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  23. 23. Balanced Scorecard Balanced Scorecard Financial Perspective How do we look to the firm’s owners? Learning and Growth Perspective How can we continually improve and create value? Vision and Strategy Business Process Perspective In which activities must we excel? Customer Perspective How do our customers see us? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  24. 24. Components of Management Components of Management Compensation Compensation I prefer a fixed salary so that I know what I will be paid each year. I prefer a bonus arrangement that gives me the opportunity to earn larger amounts. I don’t mind the varying compensation. I like both profit sharing and stock options. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
  25. 25. Design Choices for Design Choices for Management Compensation Management Compensation Should we reward Should we reward current performance or current performance or future performance? future performance? Should teams of Should teams of employees share bonuses employees share bonuses equally or should they equally or should they be in competition? be in competition? Should our rewards be Should our rewards be based on accounting based on accounting numbers or stock numbers or stock price performance? price performance? McGraw-Hill/Irwin Should bonuses be Should bonuses be fixed or should they fixed or should they vary with a vary with a performance measure? performance measure? Should bonuses be Should bonuses be based on local or based on local or company-wide company-wide performance? performance? © The McGraw-Hill Companies, Inc., 2002
  26. 26. End of Chapter 24 End of Chapter 24 My performance was magnificent! McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002

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