Stand alone investment centres- Alumnia example
- Each of its investment centres are regarded as a stand-alone business (business units)
- The managing director of each of the business units is given wide decision-making authority by head office management
- Allowing them to manage their businesses with little day-to-day intervention from head office but in accordance with policies specified by and delegated from head office.
Financial measures in profit/ investment centres
- Used to assess the performance of profit centres and investment centres.
- Focus on summary profit-based measures
- –Return on investment (ROI)
- –Residual income (RI)
- –Economic value added (EVA)
Return on investment (ROI)
- Used to measure the performance of an investment centre
- ROI= profit/invested capital
- Invested capital: the assets that the investment centre has available to generate profits. This may include plant, equipment and buildings.
- How can I increase profit? Increase revenue/decrease cost
Let’s assume that in the previous year, the bauxite and alumina refining unit (Refining) and the smelting business unit (Smelting) generated profits of $32 million and $48 million on investments of $400 million and $800 million, respectively. Sales revenue for the two divisions was $600 million and $900 million, respectively.
- The return on investment for the two business units can be calculated as follows.
- Smelting reported a higher profit than Refining; however, this does not necessarily mean that Smelting had the better financial performance, as it used a much larger amount of invested capital (or assets) to earn that profit. The Smelting business used twice as many assets as the Refining business.
- Using duponte's analysis:
- The return on sales of the Refining business is 5.3 per cent ($32 million profit ÷ $600 million sales revenue). Thus, each dollar of sales resulted in about 5 cents profit.
- The business unit’s investment turnover was 1.5 times ($600 million sales revenue ÷ $400 million invested capital).
- Thus, for Refining, $1.50 of sales revenue was generated by each dollar of capital invested.
- Interestingly, the return on sales for the two businesses is identical.
- However, the Smelting business has an investment turnover of 1.125, which indicates that it is less efficient in its use of assets, compared to the Refining business (investment turnover of 1.5).
- Thus, it is not the profitability of the two businesses that drives the differences in ROI; it is the utilisation of assets.
ROI from a different angle
- Duponte's analysis
- Return on sales: profit/sales revenue. Percentage of each sales dollar that remains as profit after all the expenses are deducted
- Investment turnover: sales revenue/invested capital. The number of sales dollars generated by every dollar of invested capital (assets)
- Since ROI is the product of return on sales and the investment turnover, ROI can be improved by increasing either, or both, of these two components.
- How to increase return on sales: increasing profit by increasing selling prices, increasing sales volume and decreasing expenses. (May not be possible to increase prices)
- When decreasing costs, must be careful to ensure no adverse effects on product quality or customer service. Otherwise, sales may be lost in the future.
- How to increase investment turnover: increase sales revenue or reduce the business unit's invested capital.
- How to reduce level of invested capital: The business unit manager can reduce inventories, or sell plant or other non-current assets.
- However, reducing inventories may have adverse effects on achieving prompt deliveries to customers. Disposal of assets may have longer-term consequences of reduced capacity, which may lead to reduced customer satisfaction and loss of future sales.
Advantages and limitations of ROI
- Widely used
- Encourages managers to focus on profits: and the assets required to generate those profits. It discourages excessive investment in assets, which may occur if performance is measured only on absolute profit. It also encourages managers to focus on increasing revenue and reducing costs.
- Can be used to evaluate the relative performance of different sized investment centres even when those business units have different scales of operations.
- Limitations: a significant emphasis on achieving ROI can lead to dysfunctional decisions
- Management myopia: can encourage managers to focus on short-term financial performance, at the expense of the long term. Many ways of increasing ROI can result in reduced performance in the future.
- Excessive cost cutting activities can improve profit, and hence short-term ROI, but weaken future profits and the business’ future competitiveness.
- For example, research and development, or training expenditure, can be deferred. Reducing employee numbers can increase profit but may affect product quality or the level of customer service.
- Encourages managers to defer asset replacement: Asset replacement may be deferred (particularly when those old assets are fully depreciated), as the purchase of new assets would boost the size of the invested capital.
- Deferring the replacement of assets may improve ROI in the short term, but erode the competitiveness and profits of the business in later years.
- Disposing of productive assets can decrease the investment base and increase ROI, but also reduce the capacity of the business and future profits/ROI.
- These problems are partially caused by the way in which assets are measured in the ROI calculation
may discourage managers from investing in projects that are acceptable from the total organisation’s point of view. This will occur where the project decreases the investment centre’s ROI
. (lack of goal congruence
All of the above are behavioural implications of ROI
How to minimise the behavioural problems of ROI?
- Short-term focus: use multiple measures (eg. non financial such as customer satisfaction) that focus on both short-term and long-term performance.
- Encourages managers to defer asset replacement: Consider alternative ways of measuring invested capital so that the replacement of an asset is less likely to result in a reduction of ROI.
- If alternative measures of invested capital, such as market value or replacement cost, are used, the replacement decision will not cause a major change in the investment base. Eg. acquisition cost so denominator is same is year.
- Goal congruence: use alternative financial measures, such as RI or EVA
- RI = profit – (invested capital × imputed interest rate)
- where the imputed interest rate = the firm’s required rate of return (RRR) or an org's weighted average cost of capital (WACC).
- The imputed interest rate is the rate of return that the organisation expects from its investments and is usually based on the minimum required rate of return on invested capital.
- In other companies it may be based on the organisation’s weighted average cost of capital (WACC) . The weighted average cost of capital is the weighted average of the cost of financing from all sources of borrowings and equity.
- In some firms, investment centres that have different levels of risk may be assigned different imputed interest rates.
RI is a dollar value
not a ratio. It is the amount of an investment centre’s profit that remains (as a residual) after subtracting an imputed interest charge
Advantages and disadvantages of RI
- Advantage of residual income:
- More likely to promote goal congruence, compared to ROI
- Takes account of the organisation’s required rate of return in measuring performance
- Encourages investment in projects which yield a positive residual income to the organisation
- Stops tunnel vision
- Cannot be used to assess the relative performance of businesses that are of different sizes, unlike ROI.
- This is because as an absolute dollar measure it is biased in favour of larger businesses.
- Thus, when evaluating the comparative performance of investment centres of different sizes, ROI is preferred over residual income.
- Can encourage short-term orientation/focus, as with ROI because profit is short term by nature
- Gets rid of tunnel vision that ROI has (because have to think of company's RRR) but does not get rid of myopia problem.
Measuring invested capital
- Total assets: This measure of invested capital is appropriate if the investment centre manager is responsible for decisions about all of the assets of the investment centre, including non-productive assets.
- Total productive assets: In some companies, investment centre managers may be
- directed by corporate management to retain non-productive assets such as vacant
- land or construction in progress. In such cases it is appropriate to exclude these nonproductive
- assets from the measure of invested capital.
- Total assets less current liabilities: In some companies, managers in investment centres manage certain short-term liabilities, including short-term bank loans and employee entitlements such as the provision for long service leave. In these cases,
- invested capital can be measured as total assets less current liabilities. This approach encourages the managers to minimise resources tied up in assets and to manage the use of short-term credit to finance operations. (may encourage short term current liabilities and thus allow managers to work around delaying payments etc)
- Choose average or end-of-year balances: Return on investment and residual income are usually calculated for a period such as a year or a quarter and, during that period, asset balances will change. Therefore, it may be more representative to use average balances of assets to calculate ROI and residual income rather than to use end-of-year balances.
- Asset measurement can vary: Another decision to make when choosing a measure of invested capital is whether to use original acquisition cost, the carrying amount or market value when measuring non-current assets.
- Advantages of the carrying amount (disadvantages of the acquisition cost): Using the carrying amount maintains consistency with the balance sheet.
- Using the carrying amount to measure invested capital is also consistent with the
- definition of profit, which is used in the ROI and residual income calculations. In calculating profit, the current period’s depreciation on non-current assets is an expense.
- Advantages of the acquisition cost (disadvantages of the carrying amount): Some critics claim that the selection of a depreciation method, such as the straightline or diminishing value method, is arbitrary. Hence, the resulting carrying amount does not provide a reliable basis for calculating ROI or residual income.
- When non-current assets are depreciated, their carrying amount declines over time. Using the carrying amount as a measure of invested capital may result in a misleading increase in ROI and residual income across time. It may provide a disincentive to invest in new equipment.
One way of preventing these problems is to use some measure of the market value
- Profit margin controllable by the investment centre manager: may be considered a suitable profit measure if the focus is to measure the performance of the manager of the investment centre. Motivational impact
- Profit margin attributable to the investment centre: Evaluating an investment centre as a viable economic investment. To calculate the investment centre ROI
- In evaluating the performance of a business unit manager, it is important to consider revenues and costs that flow from activities that the manager can influence and control.
- When evaluating the performance of a business unit, the emphasis is on revenues and costs that are attributable to that business unit.
Economic Value Added (EVA)
- EVA is a specific type of residual income calculation that has recently gained popularity.
- Measures the value created over a single accounting period, measured by the spread between the return generated by business activities and the cost of capital.
- Weighted average cost of capital equals the after-tax average cost of all long-term funds in use (such as cost of liabilities and equities) p.1468
- Requires adjustments to eliminate potential distortions of accrual accounting
- Supposedly closer to economic reality than other measures
–Claimed high correlation with market values (Hubbell, 1996)
- How do we compute EVA?
- After tax cost of debt and cost of equity
- –Cost of debt = (1-tax rate) x interest rate
- –Cost of equity
- Dividend capitalisation model
- Capital asset pricing model (CAPM)
- (don't need to calculate those two)
Let’s assume that last year, the NOPAT for the Cloncurry Manufacturing Company was $81 600, and the capital employed was $300 000. The company finances its activities using long-term debt and equity, and the weighted average cost of capital is estimated to be 6 per cent.
- Thus, EVA can be calculated as the company’s net operating profit after tax (NOPAT), less capital employed multiplied by the firm’s weighted average cost of capital
- Thus, the Cloncurry Manufacturing Company generated $63 600 of value for shareholders during the year.
The weighted average cost of capital
Let’s assume that Cloncurry’s Manufacturing Company has debt of $120 000 and the interest rate on that debt is 6.3 per cent before tax. (We will also assume that the market value of debt equals the nominal amount of the debt.) The market value of the company’s equity capital is $180 000, and let’s assume that the return that Cloncurry’s investors could earn from an investment similar to their investment in Cloncurry is 7.5 per cent.
- The WACC is usually calculated for an entire company, not for each business unit. How is this calculated?
- The taxation rate is 40 per cent. As interest on debt is tax deductible, the company’s after-tax cost of debt capital is 3.78 per cent [6.3 per cent × (1 – 0.40)].
How to improve
- How to improve EVA?
- Improve profitability without employing additional capital
- Borrow additional funds when profits earned are more than the cost of borrowing
- Pay off debt by selling assets as long as the savings in reduced interest are greater
- than profits lost though reducing the asset base
- Is EVA the same as RI?
- EVA resembles that of residual income. However, it differs in several ways.
- First, the definition of net operating profit after tax is not necessarily the same as the measure of profit used in the residual income formula.
- Second, the weighted average cost of capital is used in the calculation of EVA, whereas in RI this is not always the case. In the calculation of RI, an imputed interest rate is used, which is the company’s required rate of return. Sometimes this is the WACC, but not in all cases.
- Finally, in the EVA formula, capital employed is often calculated as the company’s total assets, less non-interest-bearing current liabilities. In the RI formula, as in ROI, invested capital can be defined in a variety of ways
- RI = = profit – (invested capital × imputed interest rate)
- Biddle et al. (1997) 95% same information content
- So why pay for EVAjQuery112408739561067063113_1592018041497
- Limitations of EVA: Same as residual income !!
- It is a single-period measure of performance. Thus, the potential for manipulation and a short-term orientation can still arise.
- As with ROI, the use of the acquisition cost of assets may result in decisions not to invest in assets, due to the unfavourable impact of depreciation in the early years of the use of the asset.
- To encourage goal congruence, part of an employee’s remuneration may be tied to achieving certain levels of performance.
- Incentive scheme: consists of processes, practices and systems that are used to provide levels of pay and benefits to employees.
- At any level of the organisation, employee remuneration may consist of a base salary, performance-related pay, and non-financial rewards (such as a better computer or office, overseas travel or even dinner at a restaurant for the family).
- Tying some part of employee remuneration to achieving financial or non-financial performance targets can provide strong positive incentives for managers and employees to strive for higher performance.
- However, if the performance measurement system is not designed carefully, it may encourage behaviours that do not improve organisational performance. (For example, an excessive emphasis on achieving a high ROI can lead to dysfunctional decisions, as we saw earlier in this chapter.)
- Designing an incentive scheme that encourages goal-congruent behaviour is complex.
- It is difficult to reward managers and employees for past actions and decisions while at the same time encouraging them to improve their future performance.
- Issues to consider include the composition of the incentive payments (cash, shares or other means), whether rewards are to be tied to individual or group performance achievements, and the timing of payment of rewards (immediate or deferred).
- Managers also need to understand what types of rewards motivate their employees.
- Processes, practices and systems which are used to provide levels of pay and benefits to employees
- Rewards can be intrinsic or extrinsic
- The processes that account for an individual’s intensity, direction and persistence of effort towards attaining goals
- The level of employee motivation is situation specific. That is, it can vary between individuals in the one organisation, and within the same individual over time.
- Intrinsic motivation: involves employees engaging in activities without any external inducement. Intrinsic motivation has been found to increase job satisfaction and employee performance.
- Extrinsic motivation: derives from sources outside the individual, so it can be induced by financial rewards, such as a pay increase, or non-financial rewards, such as words of congratulations from a senior manager.
- Some researchers argue that designing incentive schemes to encourage extrinsic motivation may only lead to short-term performance improvements. Extrinsic motivation needs to be accompanied by intrinsic motivation, for employees to achieve high performance over the long term.
- Therefore, an organisation that places a high emphasis on rewarding high-performing employees with cash bonuses, shares and salary increases may need to also consider how it can create an organisational culture which encourages intrinsic motivation.
- How can an organisation encourage intrinsic motivation? Clearly, the design of the job that is assigned to employees is relevant. Employee participation and empowerment are also important. Intrinsic motivation cannot be given to employees. Managers can design jobs and systems to encourage intrinsic motivation.
- However, this may not be successful unless they can also encourage the development of an organisational culture where feelings of personal achievement and the intangible aspects of work are valued
Intrinsic motivation may arise when employees experience the following:
- Choice: the employee has the opportunity to select activities that make sense and to perform these in ways that seem appropriate.
- Competence: the accomplishment that follows when activities that have been chosenby the employee are skilfully performed.
- Meaningfulness: the opportunity to pursue a worthy task, which matters in the larger scheme of things.
- Progress: employees feel that they have made significant advancement in achieving the task’s purpose
Managers can design jobs and systems to encourage intrinsic motivation. However, this may not be successful unless they can also encourage the development of an organisational culture where feelings of personal achievement and the intangible aspects of work are valued.
Theories of motivation
Theory of work motivation(Herzberg)
- Herzberg suggested that there are two factors that affect employee behaviour
- Hygiene factors: are those factors that provide the necessary setting for motivation but do not themselves motivate employees
- Examples include working conditions, wage levels, rules and regulations, relationships with colleagues and job security.
- When these factors are adequate, employees will not be dissatisfied, but also, they will not be satisfied.
- Motivators: factors that relate to job content or to outcomes of the job that will encourage motivation. Examples include achievement, recognition, the nature of the work, responsibility and opportunities for personal growth. These factors are said to be intrinsically rewarding.
- Satisfaction and psychological growth are a result of motivation factors
- Dissatisfaction is a result of a lack of hygiene factors
While this theory has been criticised, it does highlight
the fact that many people are not motivated just by increased pay and conditions—attention needs to be paid to their higher-order needs
- Two-factor theory in a diagram
Theories of motivation (cont.)
Expectancy theory (Vroom, 1964)
- This theory it focuses on the effect of incentives.
- Expectancy theory: states that employee motivation is a function
- of the strength of expectancy, instrumentality and valence.
- 1. expectancy (effort → performance): an individual’s perceptions that the effort he or she puts into a task will lead to a certain performance (as measured by the performance measure). If I put in the effort, can I achieve the performance goal?
- 2. instrumentality (performance → outcome): the perception that achieving the performance will lead to the attainment of a desired outcome (a reward). Will I be rewarded if I achieve the outcome and will promises will be kept?
- 3. valence (outcome → personal goals): the degree to which the outcome satisfies the individual’s goals, and the attractiveness of the reward for that individual. People’s emotional orientation with respect to outcomes (rewards). Do I care about the reward?
How can these theories of motivation help managers to design and implement incentive schemes?
- Expectancy theory suggests that individuals will be motivated to
- perform when they perceive a close linkage between their effort and achieving the performance measure (high level of expectancy); when they have confidence that the reward will be provided (high instrumentality); and when they value the particular reward that is offered (high valence).
- Thus, the effectiveness of an incentive scheme in motivating employees may depend on whether employees perceive that the performance target is achievable and will lead to a reward that is valued. Some employees may value monetary rewards, while others may value the sense of achievement that comes with meeting a challenging goal.
- Herzberg’s theory suggests that it is not hygiene factors but factors such as achievement, recognition and responsibility that are strong motivators.
- However, expectancy theory suggests that employees will be motivated only if they value certain rewards.
- As noted above, the culture of the organisation must encourage the appreciation of intrinsic rewards for them to be valued and considered motivational by employees.
- Herzberg also suggests that extrinsic rewards are not motivators but provide only the setting for these intrinsic rewards. However, the proliferation of performance-related pay systems in Australia and in other countries suggests that many managers believe extrinsic rewards are motivational!
Why reward your employees? What are the objectives of a reward system?
- Required by law
- Retention of talent
- Internal equity
- Linkages to performance
- Influence on culture
Performance-related reward systems
Performance-related pay systems
: base rewards on achieving or exceeding some performance target
. Under these systems, employees are paid a base pay, and then additional pay will be awarded based on individual or group performance.
- Can be based on
- –individual performance
- –group performance
- Individual incentive plans: Individuals are rewarded for achieving individual performance targets
- The major advantage of these schemes is that individual effort is clearly tied to outcomes and rewards (the essential elements of expectancy theory).
- Subjective criteria may also be used
- Common at the senior levels of the organisation (can become narrow minded, tunnel vision, selfish)
- However, at the operational level it may be difficult to design measures that separate the performance outcomes of an individual from the performance of their team or department.
- Profit-sharing plans: employees are paid cash bonuses based on a specified percentage of the company’s profit.
- These schemes reward individuals but are based on the overall performance of the organisation
- Bonuses may be distributed to employees in many ways, such as in equal shares or in proportion to their base pay.
- These bonuses do not become part of an employee’s base salary
- Profit-sharing schemes are designed to encourage employees to identify with the performance of the entire company—to think like the owners.
- –Does not tie individual effort to individual rewards (low expectancy?)
- Employee share plans (share option plans)
- –Provide employees with the right to purchase shares in their company, at a specified price at some specified future time
- –Commonly used for senior managers, and sometimes more junior managers and employees
- If the managers intend to purchase the shares, they then have the opportunity to make decisions that improve the firm’s performance over the next two years in order to lift the market price of the shares above $10.
- Some companies do not allow managers to exercise their option until some performance hurdle has been reached. For example, a company may set a hurdle of a 20 per cent increase in share price before senior managers can purchase the shares.
- –Considered to encourage goal congruence
- While senior managers may have some influence on
- improving the company’s share price, for those at more junior levels the impact of their efforts on share prices may not be as direct. Despite this, some companies believe that offering these benefits to lower-level managers and employees is
- motivational, as it helps employees to identify with the fortunes of the company, encouraging goal congruence and motivating them to achieve high performance.
- Gainsharing: Cash bonuses are distributed to the employees when the performance of their segment of the company exceeds some performance target
- Performance targets are often based on achieving some productivity gains that can be directly influenced by employees.
- The employees’ share may go into a pool each quarter and then be distributed to all employees at the end of the year, usually in equal amounts.
- Gainsharing schemes are based on the belief that employees should share in the gains from any contribution that they make to a firm’s performance.
- Compared to profit-sharing plans, gainsharing programs are often considered to be more motivational than company-wide schemes,
- as the performance of a department or production plant may be more controllable by employees.
- Team-based incentive schemes
- –Individuals are rewarded based on their work team exceeding certain performance targets
- –Intended to encourage teamwork and cooperation between employees
- –Does not tie individual effort to individual rewards
- Unfortunately, these schemes may encourage free riding—employees may be rewarded through the efforts of their fellow team members.
Linking rewards to group vs. individual performance
Consider the following issues
- –Identification with the group: Incentive schemes based on group performance are designed to encourage employees to identify with the company, business unit or team. They can enhance goal congruence and encourage teamwork.
- Equity among employees: Group schemes provide the same rewards to each employee. In some organisations, employees consider this to be important, as differential rewards are seen as divisive.
- –Competitiveness between employees: Individual rewards can encourage excessive competitiveness between employees and may encourage employees to make dysfunctional decisions to maximise their own performance, to the detriment of other employees’ performance.
- –Relating individual effort to reward: It is often difficult for employees, particularly at operational levels, to understand how their own efforts can directly influence overall company performance. When incentive payments are awarded for achieving individual targets, the relationship is clearer.
- –Rewarding only good performers: Group schemes do not discriminate between employees who are good performers and those who are bad performers. Bad performers may still be rewarded in a high performing team or business unit. This is not the case when incentive schemes emphasise individual performance achievement.
Frequency and timing of incentive payments
- Some people argue that it is preferable to reward employees frequently to ensure continued motivation. Thus, in some organisations, bonuses may be paid quarterly.
- It is also important to make these payments in a timely fashion, as close as possible to the period in which the performance occurred—that is, very soon after the end of a quarter or year.
- Frequent and timely rewards also help employees to see more clearly the relationship between their effort, performance outcomes and rewards (as described in expectancy theory).
- However, senior managers are often rewarded less frequently,
- often annually.
- Tying rewards to achieving annual performance targets can encourage a short-term focus, particularly when managers are rewarded on achieving a single performance measure, such as ROI or profit.
- Sometimes, to encourage a long-term focus, senior managers’ incentive payments may be deferred for some years.
Summary of key ideas today
- ROI although widely used may lead to myopic behaviour
- It is important how you define profit and investments
- Using multiple measures are always better than using one measure
- All these financial measures are single period, so they are inherently short-term in focus
- Reward systems can be used to encourage goal congruent behaviour
- When designing performance-related schemes it is important to understand what motivates employees
- Performance-related reward systems include individual incentives, profit-sharing, employee share plans, team-based incentives
- The frequency and timing of payments may impact on effectiveness of the reward system