A D V A N C ED A N A LY S IS &

A P P R A IS A L O F
P ER FO R M A N C E

CO VERAG E
1. Introduction
2. Financial & Nonfinancial Performance
3.
4.
5.
6.

Measures
Designing Accounting-Based Performance
Measures
Performance Measurement in
Multinational Companies
Performance of Managers vs.
Performance of Organizational Units
Intensity of Incentives

IN TRO D U CTIO N
Performance evaluation: process by w/c

mgrs. gain info about task performance &

judge it vs. criteria
Goals of top mgt. in strategic performance
measurement:
Motivate mgrs. to exert high level of effort
Guide them to make decisions congruent w/ top
mgt. goals
Have basis for fairly compensating mgrs.

Performance measures: central

component of mgt. control systems

FIN AN CIAL & N O N -FIN AN CIAL PERFO RM AN CE

M EASURES

Financial Performance Measures

include ROI & residual income
can be:
1) Internal (e.g., operating profit)
2) External (e.g., stock prices)

Non-Financial Performance Measures

can be:
1) Internal (e.g., manufacturing lead time)
2) External (e.g., customer satisfaction)

FIN AN CIAL & N O N -FIN AN CIAL PERFO RM AN CE

M EASURES

Some techniques used:

1. Benchmarking: unit/co. compared w/

other subunits within the org., or w/

other companies deemed best
performers
2. Balanced Scorecard see separate
topic

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Includes ff. steps:
1. Choose measures that align w/ top mgt.s
2.
3.
4.
5.
6.

financial goals
Determine time horizon of each performance
measure.
Define components of each performance
measure.
Choose a measurement alternative for each
performance measure.
Decide on a target level of performance
Choose the timing of feedback

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Choosing Among Different Performance Measures
Good performance measures: a) promote goal
congruence w/ org. objectives; b) facilitate
comparisons across different subunits
4 approaches (previously discussed):
1. Return on investment *
2. Residual income*
3. Economic value added*
4. Return on sales
*include investment: resources/assets used to
generate profits

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Comparison of approaches:

1. No 1 method is superior to others; each

evaluates a slightly different aspect of
performance.
2. In markets where revenue growth is limited:
return on sales is most meaningful performance
indicator
3. To evaluate overall aggregate performance:
return on investment or residual-income-based
measures are more appropriate (consider both
income earned & investments made)

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Choosing the Time Horizon
Question: should performance measures be
calculated for 1 year, or multiple years?
Generally desirable to evaluate subunits on basis
of ROI/RI/EVA/ROS over multiple years for ff.
reasons:
1. To avoid short-run changes in performance
measures that could conflict w/ long-run goals
2. Benefits of action in current period may not show
in short-run measures
3. If NPV method is used in investment decisions,
using multi-year RI achieves goal congruence

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Choosing from Among Alternative Definitions
Alternative definitions of investment:
1. Total assets available
- includes all assets
2. Total assets employed
= total assets available idle assets assets
purchased for future expansion
3. Total assets employed minus current liabilities
- excludes portion of total assets employed
that are financed by short-term creditors

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES

4. Working capital plus long-term

assets
- excludes portion of current assets
financed by short-term creditors
5. Shareholders equity
- combines operating decisions
made by mgrs. w/ financing
decisions regarding equity made by
corporate mgt.
Total assets available is generally used

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES

Choosing from among Asset

Measurement Alternatives
1. Asset measurement options:

Historical cost
Present value
Current cost
Current disposal price

2. Options for depreciable assets:

Gross book value

Net book value

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Historical Cost
Assets recorded at amt. of cash or cash
equivalents paid or fair value of consideration
given to acquire them at time of acquisition
Present Value
Measure of assets based on discounted cash
flow (DCF) estimates
Useful since it measures economic value of
investment based on future cash flows
Difficulty: estimating expected net cash flows

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Current Cost
Amount of cash or cash equivalents that
would have to be paid if same or
equivalent asset was acquired currently, or
Undiscounted amt. of cash or cash
equivalents that would be required to
settle an obligation currently, or
Cost of purchasing services provided by
asset if identical asset cant be purchased
currently

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Current-cost ROI: better measure of

current economic returns from

investment than historical-cost ROI
- drawback: difficulty in obtaining
current-cost estimates for some assets
Use of current values:
Help reduce unfairness of historical cost net

book value
Make ROI calculation relevant & comparable

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Long-Term Assets: Gross or Net Book Values
Gross book value: original/acquisition cost
Net book value: acquisition cost
accumulated depreciation
Advantages of Net Book Value
1. Consistent w/ balance sheet; allows for more
meaningful comparisons across companies
2. Consistent w/ definition of income
(depreciation deducted as expense)
numerator in ROI

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES

Advantages of Gross Book Value

Arbitary methods of computing
depreciation
Net book value of long-lived assets
decline over time, resulting to
misleading increase in ROI & RI
Enables more accurate comparisons
across subunits

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES
Choosing Target Performance Levels
Careful selection of benchmarks/targets can

offset shortcomings w/ traditional, historical

cost-based ROI, RI, or EVA
Example: Higher-target ROIs for divisions w/ older
assets

Many problems of asset valuation & income

measurement can be solved if everyone focuses
on whats attainable in a period
Set continuous improvement targets (e.g., yearto-year changes in EVA rather than absolute
amounts)

D ESIG N IN G ACCO UN TIN G -BASED

PERFO RM AN CE M EASURES

Choosing the Timing of Feedback

e.g., should mfg. performance
reports be provided daily, weekly or
monthly?
Factors considered:
1. How critical is info for org. success
2. Specific mgt. level receiving
feedback
3. Sophistication of orgs IT

PERFO RM AN CE M EASUREM EN T IN
M ULTIN ATIO N AL CO M PAN IES
Multinationals
cos. operating in several countries
Have more complicated reporting needs than

domestic cos.
Performance evaluation can be complicated by:
1. Changes in exchange rates (foreign vs. local
currency)
2. Legal, cultural, political, economic & social
differences
3. Availability of materials & skilled labor, as well as
costs of materials, labor & infrastructure
4. Transfer pricing
5. Import & price controls

M AN AG ERIAL VS.
O RG AN IZATIO N AL U N IT
Performance
PERFO
RM AN
CE
evaluation:
done at all org. levels
Performance evaluation of mgr. must be

distinguished from that of org. sub-unit

Ff. considered in evaluating managerial
performance:
Uncertainty in environment thats influenced by

factors in & out of the firm - beyond managers

control
Include only factors that manager controls
A risk-averse mgr. is biased to avoid decisions w/
uncertain outcomes

IN TEN SITY O F IN CEN TIVES

Mgt. compensation may include incentives

tied to performance
- objective: encourage goal congruence
Preferred performance measures: those
sensitive to or change significantly w/
managers performance
- this encourages use of nonfinancial
measures
Salary: dominant part of compensation when
measures sensitive to mgrs actions are not
available

EN VIRO N M EN TAL & ETH ICAL

RESPO N SIBILITIES
Sustainability Reporting
Enron Scandal