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REWARDING BUSINESS PERFORMANCE

Chapter 25. REWARDING BUSINESS PERFORMANCE. Motivation and Aligning Goals and Objectives. Goal Congruence Alignment of employee goals and objectives with organizational goals and objectives. Feedback Steer employees toward goals. Measure progress in achieving goals.

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REWARDING BUSINESS PERFORMANCE

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  1. Chapter25 REWARDING BUSINESS PERFORMANCE

  2. Motivation and AligningGoals and Objectives Goal Congruence Alignment of employeegoals and objectiveswith organizationalgoals and objectives.

  3. Feedback • Steer employees toward goals. • Measure progress in achieving goals. Improveperformance. Rewardperformance. Motivation and AligningGoals and Objectives Measureperformance.

  4. Return on investment is the ratio ofprofit to the average investment usedto generate the profit. Profit Average investment ROI = Return on Investment (ROI)

  5. Profit Average Investment ROI = Profit Sales ROI = × Returnon Sales CapitalTurnover Return on Investment (ROI) Sales Average Investment

  6. Holly Company reports the following: Profit $ 30,000 Sales $ 500,000 Average Investment $ 200,000 Return on Investment (ROI) Let’s calculate ROI.

  7. Profit Sales Sales Average Investment ROI = × $30,000 $500,000 $500,000 $200,000 ROI = × ROI = 6% × 2.5 = 15% Return on Investment (ROI)

  8. Improving ROI Three ways to improve ROI • Decrease Expenses • Increase Sales Prices • Lower • Invested Capital

  9. Holly’s manager was able to increasesales revenue to $600,000 whichincreased income to $42,000. There was no change in invested capital. Improving ROI Let’s calculate the new ROI.

  10. Profit Sales Sales Average Investment ROI = × $42,000 $600,000 $600,000 $200,000 ROI = × ROI = 7% × 3.0 = 21% Improving ROI Holly increased ROI from 15% to 21%.

  11. 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?

  12. Gee . . . I thought we were supposed to do what was best for the company! As division manager, I wouldn’t invest in that project because it would lower my pay! Criticisms of ROI

  13. Residual Income Operating Earnings – Investment charge = Residual income Investment capital ×Minimum return = Investment charge Investment center’sminimum acceptablereturn

  14. 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.

  15. Residual Income Operating Earnings = $25,000 – Investment charge = 20,000 = Residual income = $ 5,000 Investment capital = $100,000 ×Minimum return = × 20% = Investment charge = $ 20,000 Investment center’sminimum acceptablereturn

  16. 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?

  17. Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

  18. Economic Value Added Economic value added tells us how much shareholder wealth is being created.

  19. Economic value addedis the annual after-tax operating profit minus the total annual cost of capital. Cost of capitalis weighted-average after-taxcost of long-term borrowing and the cost of equity. Economic Value Added Equity Debt

  20. Economic Value Added After-tax Operating Income – Investment charge =Economic value added (Total assets – current liabilities) ×Weighted-average cost of capital = Investment charge After-tax cost oflong-term borrowingand the cost of equity

  21. 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. Economic Value Added

  22. Balanced Scorecard A set of performance targets and results that show an organization’s performance in meeting its responsibilities to various stakeholders. Employee Stakeholder Group Investor Stakeholder Group

  23. Balanced Scorecard Financial Perspective How do we lookto the firm’s owners? Vision and Strategy Learning and Growth PerspectiveHow can we continuallyimprove and create value? Business ProcessPerspective In which activities must we excel? Customer Perspective How do our customers see us?

  24. 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. I prefer a fixed salaryso that I know whatI will be paid each year. Components of Management Compensation

  25. Design Choices for Management Compensation Should we rewardcurrent performance orfuture performance? Should teams ofemployees share bonusesequally or should theybe in competition? Should bonuses befixed or should theyvary with aperformance measure? Should bonuses bebased on local orcompany-wideperformance? Should our rewards be based on accountingnumbers or stock price performance?

  26. End of Chapter 25

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