Session 4A: Incentives and Performance

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Session 4A Incentives and Performance

• Dr Frank Selto
• CURISES
• Cost and Managerial Accounting

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Overview

• Roots of Motivation and Behavior
• Elements of Incentive Systems
• Comprehensive View of Incentive Systems

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Roots of Motivation

• Expectancy Theory
• Goal-setting Theory
• Agency Theory
• Cognitive Theory
• Communication Theory

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Expectancy Theory

• Effort is high when employees believe that
• Performance causes rewards
• Effort causes performance

Performance-based rewards motivate effort
Effort Causes Performance
Performance Causes Reward
High Effort
Performance based on Effort
Reward Based on Performance
Controllable performance motivates effort
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Goal Setting Theory

• Difficult, attainable, specific goals motivate
  best

Specific Goals
Low Performance High
Vague Goals
Low Goal Difficulty High
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Agency Theory

• Best incentive system minimizes agency and
  incentive costs

Total Costs
Cost of Incentives and Monitoring
Cost of Misbehavior
Low Total Cost High
Best System
Low Incentives and Monitoring High
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Cognitive Theory

• Arranging performance measures in natural
  groupings promotes understanding
• Arranging performance measures in causal
  patterns promotes understanding and better
  decision making
• Trigger causal knowledge
• Provide line of sight to ultimate performance

People Measures
Process Measures
Customer Measures
Financial Measures
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Communication Theory

• Boy Scout measures promote better decision
  making
• Credible, reliable, unbiased, fair, and clearly
  communicated
• Boy Scout rewards motivate better, too
• Talk the talk vs. Walk the walk

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Summary of Incentive Theories

• Link rewards to controllable performance
• Set difficult, attainable, specific goals
• Use grouped measures with causal links
• Communicate performance expectations and rewards
  credibly and reliably
• What if causality does not exist?
• Use financial logic and believable finality

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Elements of Incentive Systems
Absolute or Relative Performance
Financial or Non-financial Performance
Current or Deferred Rewards
Performance Based Incentive System
Formula-based or Subjective Performance
Narrow or Broad Responsibility For Performance
Salary or Bonus Rewards
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Do Rewards Have to be Financial?

• Examples of non-financial rewards
• Intrinsic rewards
• Ranking
• Recognition
• Pictures, trophies, banners

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An Actual Performance/Incentive System
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Summary of Basic Design Issues

• How do you structure an organization?
• Organizational design and nature of
  decentralization determine measurement of
  performance
• Financial and non-financial performance of
  business units
• Internal transfers affect profits of both selling
  and buying business units
• Transfer pricing
• Serious issue that affects decision making,
  performance measurement, and overall profitability

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Definitions of Business Unit

• Typical structure determined by type of financial
  responsibility
• Decentralized unit may be
• Cost Center (Operating or Discretionary)
• Revenue Center
• Profit Center
• Investment Center
• Business Unit Subunit with Significant
  financial responsibility
• Organized by Product, Project, Service, Region

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When to Organize Into Profit Centers?

• Fad was to organize every unit into profit center
• Peter Drucker regrets promoting Pseudo-Profit
  Centers
• Profit center can introduce too much internal
  competition
• Current (fading?) fad is Micro Profit Centers
• Factors justifying profit center status
• Large external sales
• Low internal transfers
• High market uncertainty

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Profit Centers

• Evaluated on Profits and/or Return on Investment
• Also Residual Income and EVA
• What if use ROI for evaluation and NPV for
  project selection?
• Sets up IRR vs NPV conflict
• Evaluate manager differently than business unit?
• Keep business unit if profitable
• Reward manager if successful on other dimensions

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Performance Measures for Managers

• Financial measures most common
• Controllability or Informativeness?
• Controllability Evaluate only on components of
  ROI (for example) controllable by manager
• Informativeness Does measure reveal managers
  efforts?

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Controllability or Informativeness?

• Part of measure may not be Controllable but might
  be Informative
• Example Sales activity variance
• Market Size
• Market Share
• Compare with other managers in same circumstances
• Also called Relative Performance Evaluation
• Grading on the curve

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Absolute Performance
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Relative and Informative Performance
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Measures of Financial Performance

• ROI, MV/BV, RI, and EVA
• ROI measures return on physical capital
• Income/Value of physical capital
• MV/BV indicates companys excess value
  over/under physical capital
• Due to Intangible Assets such as Intellectual
  Capital (?)
• RI EVA purport to measure return on intangible
  assets (intellectual and social capital?)
• EVA EBIT - Required return on physical capital
  employed

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Return on Investment (ROI)

• ROI Net Income / Invested Capital
• Extremely popular business unit measure
• Purports to measure opportunity cost of
  investment
• Every component of ROI potentially a funny
  number
• Consistency within measure?
• Consistency across business units?

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ROI Example Deere Co vs. Microsoft
Is this a meaningful comparison? Why or why not?
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Economic Value Added (EVA)

• EVA Net Income - Cost of Capital
• Similar to Residual Income (RI)
• RI never popular, but EVA now is
• Difficulties of ROI plus cost of capital
• Net Incomewhich measure?
• Assets or Capital Employedhistorical or
  replacement or market value?
• Cost of Capitalmarginal or weighted average?
• Benefits might outweigh costs of implementation
  (and errors)
• EVA consulting very expensive
• Maintenance costs high, too

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Comparisons of Deere With Microsoft MV/BV
Q Why doesnt Microsoft have debt?
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Comparisons of Deere with Microsoft EVA ROI
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Summary of Financial Measures of Performance

• Calculations of both EVA and ROI full of
  assumptions
• Components of earnings
• Measures of capital employed
• Which is better?
• Consultants say EVA of course
• Adoptions reportedly common

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Are EVA firms more profitable?

• Academics say No Evidence
• Earnings and ROI at least as good as predictors
  of stock returns
• Managers of EVA firms appear to make different
  decisions
• Many firms are returning to ROI

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Future Discussions of Financial Performance

• Financial Performance Ultimate Business Result
• Acting on Financial Performance Usually Too Late
  
• Need Pro-Active Measures - Leading Indicators of
  Financial Performance
• Continued Financial Performance Requires
  Investment in People, Processes, Customer
  Relations, and Social Responsibility(??)
• Topic for future session

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Summary

• Organizational structure AND performance
  evaluation critical to business success
• Profit centers good if
• Large external sales
• Low internal sales
• Uncertain economy and
• Reliable measures of profit performance
• Measuring financial performance is subjective
• What about non-financial performance?