International Budgeting and Performance Evaluation

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Chapter 14

• International Budgeting and Performance Evaluation

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The Strategic Control Process

• Four stages of strategic control
• Periodic strategy reviews for each business
• Annual operating plans
• Formal monitoring of strategic results
• Personal rewards and central intervention
• Benefits from a former control process
• Greater clarity and realism in planning
• More stretching of performance standards
• More motivation for business unit managers
• More timely intervention by central management
• Clearer responsibilities

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The Strategic Control Process

• Difficult to implement this process in a global
  environment
• Different operating environments include
• Legal systems
• Political differences
• Economic systems (inflation, market size, growth)

4
Target measures for strategic purposes

• Return on investment
• Sales
• Cost reduction
• Quality targets
• Market share
• Profitability
• Budget to actual
• Targets for a unit should be linked to its
  objective and to the part of operations it
  controls

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Studies of U.S. Multinationals

• Robbins and Stobaugh (1973) conclusions
• Tangible and intangible items that entered into
  the original investments calculations were rarely
  taken into account in evaluating the foreign
  subsidiaries performance
• Foreign subsidiaries were judged on the same
  basis as domestic subsidiaries
• Most utilized measure of performance for
  subsidiaries was ROI
• Nearly all multinationals used some supplementary
  measure to evaluate performance
• Most widely used supplementary measure was
  comparison to budget

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Studies of U.K., Japanese Multinationals

• Appleyard, Strong, and Walton (1990)
• British companies tend to use budget/actual
  comparisons and ROI
• British firms use the same ROI measure for all
  subsidiaries
• Shields, Chow, Kato, Nakagawa (1991)
• Japanese companies tend to rely on sales
• Insert Exhibit 14.2
• Bailes and Assada (1991)
• ROI tends to be relatively unimportant to
  Japanese firms

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Studies of APEC Multinationals

• Merchant, Chow, and Wu (1995)
• Little evidence suggesting a link between
  national culture and firms goals in Taiwan
• Sample only had 4 firms
• Kong, Harrison, Harrell (1994)
• Anglo-American managers prefer short term,
  quantitative objectives
• Asian firms tend to choose objectives that fit a
  long-term market dominance strategy

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Budgeting studies

• Anglo-American practice
• Budget process is improved by the participation
  of those who carry out the budget
• Brownell (1982) for budget participation to
  work, managers must feel like insiders
• Mexican companies
• Frucot and Shearon (1991) found a similar
  approach in Mexican companies
• Insider/outsider dimensions did not matter
• Mexican managers of foreign owned subs showed
  almost no desire to participate in budgeting

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Budgeting studies

• APEC Multinationals
• Harrison (1992) found that both Australia and
  Singapore prefer participative style
• Budgetary participation universally enhances job
  satisfaction regardless of culture
• Finnish MNE
• Hassel and Cunningham (1996) found that higher
  exchange of info between headquarters and
  domestic subs increases performance
• Exchange of info had no effect on foreign subs
• Market and technology info exchange is a major
  advantage for domestic subsidiaries

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Budgeting Studies

• U.S./Japan Comparisons Bailes and Assada
• American companies take 12 days longer to prepare
  annual budgets
• Major objective for U.S. companies is ROI
  Japanese companies focus on sales
• Division managers participate in budget committee
  discussions more in the U.S.
• Japanese companies follow a bottom-up approach
  managers wishes are less important than group
  consensus
• Japanese managers are more likely to use budget
  variances to recognize problems
• American managers are more likely to be evaluated
  by the budgets
• Bonus and salary of American managers are more
  affected by budget performance than those of
  Japanese managers

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Budgeting studies

• U.S./Japan Comparisons
• Ueno and Sekaran (1992)
• U.S. budget managers tend to create more slack
• This behavior is linked to individualism
• Japanese managers tend to have a long-term focus
  for performance

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Budgeting studies

• Interaction of Culture and Geographic Distance
• Hassel and Cunningham (2004) findings
• Subsidiaries with low psychic distance show
  stronger financial performance
• Psychic distance combination of culture and
  geographic distance
• Findings suggest that budget controls work most
  effectively for subs that are closer to the
  parent in psychic distance

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Planning and Budgeting Issues

• Currency determination is a major issue
• After-translation basis is used if the goal is
  to maximize domestic purchasing power
• Before-translation basis is used if the goal is
  global optimization
• Local currency is more indicative of the overall
  operating environment
• Translating budgets into the parent currency
  allows a firm-wide view of the upcoming year

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Planning and Budgeting Issues

• Three approaches in dealing with foreign exchange
  in the budgeting process
• Allow operating managers to enter into hedge
  contracts with corporate treasury
• Adjust the actual performance of the unit for
  variations in the real exchange rate after the
  end of the period
• Adjust performance plans in line with variations
  in the real exchange rate

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Ways to Bring Foreign Exchange into the Budgeting
Process
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Budgeting and Currency Practices

• Study of British subs of Japanese firms
• (Demirag 1994)
• Companies that indicated that financial
  statements presented in sterling (local currency)
  provided them with better understanding of the
  performance of their companies operations and
  their managementNone of the companies translated
  their profit budgets into yen for performance
  evaluation purposesand none of the parent
  companies sent a copy of the translated yen
  statements.
• None of the sub managers were aware of their
  performance in parent currency terms

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Capital Budgeting

• MNEs use sophisticated techniques to forecast
  cash flows, assess risks, and determine the right
  discount rate for NPV
• Hasan et al. (1997) findings
• Subs that are majority owned by the parent
  company were more likely to use NPV and IRR
• Subs that were large, publicly traded, and
  well-established use more complex methods (WACC)
• Can ROI be used to evaluate individual operations
  and individual managers?

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Intracorporate Transfer Pricing

• Prices should be based on production costs, but
  often are not
• Companies face the dilemma between complying with
  tax laws and maximizing profits
• Transfer pricing manipulation can occur
• Arms length standard is used by tax authorities
  to combat this problem
• One set of prices for both performance evaluation
  and arms length standards could be used

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Intracorporate Transfer Pricing

• Managers must be careful in this area
• DHL was fined 60 million for inappropriate
  transfer pricing of intangible assets
• (Przysuski et. al, 2003)
• Eden (2001) 3 trends that will play a major
  role in transfer pricing in the coming years
• Globalization
• Regionalization
• The Internet

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Matching Price to Market Conditions
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Allocation of Overhead

• Firms must decide what to do with it
• Example
• How does IBM, headquartered in New York,
  allocate overhead to its operations in different
  countries? What are the tax implications of this
  issue?

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Cross-Border Allocation of Expenses

• Differing tax rates complicate the situation
• Using tax law to allocate overhead can eliminate
  the possibility for a firm to allocate overhead
  based on manufacturing strategy
• Hiromoto (1988) study of Japan shows that
  Japanese managers are concerned about how
  allocation of costs motivates employees
• Japanese teach us that overhead is lowered
  permanently only through controllable and highly
  integrated manufacturing processes

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Performance Evaluation Issues

• Gupta and Govindarajan (1991) findings
• Global innovators and integrated players need
  evaluation systems that are flexible compared to
  implementers or local innovators
• Global innovators and integrated players rely
  more on behavioral controls and less on output
  controls
• Global innovators need more autonomy than
  implementers
• Global innovators rely more on internal control
  of performance than external control

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Performance Evaluation Issues

• No single basis of performance evaluation is
  appropriate for all units of an MNE
• Multiple bases for performance measurement should
  be used for different operations
• Must be cost-beneficial
• Proper measures should eliminate uncontrollable
  impacts due to interdependencies between units

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Properly Relating Evaluation to Performance

• Performance measures can be manipulated
• Example the ROI income denominator can be
  increased by increasing intracorporate transfer
  prices above the arms length standard
• Solution compare performance to the plan given
  to the subsidiary
• Limitations include
• Illogical and unreasonable plans
• Managers inputs to plan are bleak so the plan
  can be surpassed

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Economic Value Added (EVA)

• EVA After-tax profit Total cost of capital
• Measure of the total value added or depleted from
  shareholder value in one period
• Used primarily for performance evaluation and
  compensation rather than for capital budgets
• Differences in accounting standards and changing
  currency values can influence EVA
• Managers should consider the risks to
  international investing to obtain correct costs
  of equity and debt

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Economic Value Added (EVA)

• EVA ROIC WACC AIC
• ROIC Return on invested capital
• Operating profit minus cash taxes paid
  divided
• by average invested capital
• WACC Weighted average cost of capital
• (Net cost of debt debt used)
• (Net cost of equity equity used)
• AIC Average invested capital
• Average stockholders equity average debt

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Economic Value Added (EVA)

• Total revenues 6,500 (million)
• Total costs 4,000
• Total operating expenses
  1,800
• Cash taxes paid
  230
• Stockholders Equity (Average)
  1,500
• Debt (Average)
  2,370
• After-tax cost of debt
  5.5
• debt used
  40
• Cost of Equity
  15
• equity used
  60
• Operating Profit 6500 4000 1800 230 470
• AIC 1,500 2,370 3,870
• ROIC 470/3,870 12.1
• WACC (5.5 .40) (15 .60) 11.2
• EVA (12.1 - 11.2) 3,870 34.83 gt cost of
  capital, value is added

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The Balanced Scorecard

• Developed by Kaplan and Norton (1992)
• Takes a broader view of performance
• Bain Co. results (Gumbus and Lyons 2002)
• 50 of Fortune 1,000 North American companies use
  the balanced scorecard
• 40 of European companies use a version of the
  BSC
• Perspectives in the scorecard include
• Financial
• Customer
• Internal business processes
• Learning and growth

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The Balanced Scorecard

• IKEA uses the BSC approach, as does Philips
• Adequate use of the BSC
• Helps managers avoid using only one performance
  measure
• Forces managers to link financial measures with
  the non-financial factors that drive them
• Ensures that subs are evaluated based on a
  coherent set of performance bases
• Insert Exhibit 14.10