SHORT ANSWER

1. Answer the following questions regarding economic value added (EVA):

a. What is it intended to do?

ANS:

a. The purpose of EVA is to more directly align the interests of common shareholders
and managers.
b. EVA = A/Tax profit - (market value of invested capital x cost of capital %).
c. EVA uses after-tax profit, cost of capital and market value of assets invested. RI uses
segment income, target rate of return and book value of assets invested.
d. Because it recognizes that there may be a significant difference between book value
and market value of assets. The market value of a company is reflected in stock prices
which are another measure of performance evaluation.
e. EVA includes the increased investment immediately even though significant income
may not occur until sometime in the future. Most investments will show decreased
short-term performance (EVA) and may cause a company to refuse projects that are
profitable in the long-term (similar to shortcomings of the payback method).

DIF: Moderate OBJ: 19-4

2. What items affect comparability of different divisions within the same company on the basis
of EVA, ROI and RI?

ANS:

a. Each measure is based on accounting income which can be manipulated in the short-
term by accounting methods used, which can differ between investment centers.
b. The measurement of the asset base is affected by the choice of what to include, and
may include items that relate to decisions made by prior managers.
c. All measures focus primarily on how well the segments do in isolation with results
compared to prior years for the same segment, rather than relative company-wide
objectives.

DIF: Moderate OBJ: 19-4

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3. Why is it likely that a subordinate manager would be more attentive to certain performance
measures than overall corporate objectives to guide his decision making?

ANS:
Managers are evaluated based on how their actual results compare to specific measures of
performance. These performance measures are intended to be surrogates for the overall
corporate goals as they apply to specific managers. Thus performance measures are selected
by the extent to which they are good proxies for corporate goals (that is the extent to which
they operationally define, and are consistent with, corporate goals) and are intended to be
major focal points for managers.

DIF: Moderate OBJ: 19-5

4. What are some of the major problems associated with accrual-based accounting
performance measures?

ANS:
There are two major problems with accrual-based accounting numbers. The first problem is
that they can be easily manipulated by managers. For example, the timing of end of period
transactions can be accelerated or delayed to affect performance measures. Secondly,
accounting measures cannot capture all corporate goals. Accounting measures are
particularly inappropriate to measure qualitative changes in the workforce, qualitative
changes in products, and achievement of social and non-monetary objectives. Additionally,
accounting measures reflect only a short-term perspective of operations rather than a long-
range goal orientation.

DIF: Moderate OBJ: 19-5

5. What distinct advantage does a return on investment measure have over a residual income
measure? Explain.

ANS:
The advantage of ROI measure over RI is that ROI facilitates a comparison of organizational
sub-units of differing sizes. Because ROI is a performance measure that automatically scales
for size, large and small sub-units can be compared to each other (subject to all the factors
that should be considered when two units in different industries, different geographical
areas, etc. are compared).

DIF: Moderate OBJ: 19-4

6. How can return on investment result in sub-optimization when it is used as a performance

ANS:

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 Because performance measures are used to reward performance, managers use them as
decision criteria when they evaluate alternative courses of action. For example, if ROI is the
performance criterion, a division manager will only invest in new projects that will result in
an increase in his/her division's ROI. This is sub-optimal if the overall organization would be
better off by the division manager's investment in available projects with lower ROIs.

DIF: Moderate OBJ: 19-4

7. Define residual income. Evaluate residual income as a measure of performance.

ANS:
Residual income is the remainder of net profit once a target cost of capital has been taken
into consideration. Residual income is determined by deducting from net income a
prescribed or imputed interest charge on assets. This method allows an organization to use
different rates of interest for various organizational assets. A main advantage of using RI is
that it overcomes some limitations of ROI (sub-optimization).

DIF: Moderate OBJ: 19-4

8. What are some common problems encountered in determining ROI?

ANS:
Net income and investment involved can both be calculated several ways. Multiple
calculations are often presented to show the different factors that affect ROI, changes in
sales, expenses, and capital investments.

DIF: Moderate OBJ: 19-4

9. Discuss the ways in which management uses flexible budgets.

ANS:
Flexible budgets are important to managers in performing a variety of functions. Formulating
budgets commits certain activities agreed to during the planning process to specific
monetary amounts. The flexible budget provides the means to estimate costs at various
levels of activity. The control function is undertaken to assure that actual operations meet
planned operations. Through this function, deviations are determined and variances can be
ascertained. Managers also use flexible budgets in performance evaluation. Evaluation is
more meaningful with valid and accurate data to make the process of evaluation beneficial
to all involved.

DIF: Moderate OBJ: 19-4

10. Identify the steps to follow in establishing the performance reward system for a company.

ANS:
The steps are in the following order:

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 1. set strategic goals
2. identify the critical success factors
3. set the compensation strategy
4. identify performance measures
5. set performance rewards
6. measure/monitor performance
7. determine rewards

DIF: Moderate OBJ: 19-10

11. Discuss pay-for-performance plans.

ANS:
Employees should be encouraged by compensation plans to perform and be loyal to the
organization. Performance measures should be related to a company's operational targets.
These performance measures do not have to be evenly weighted. Management can assign
higher weights to more important performance measures as they are related to the
corporate goals.

DIF: Moderate OBJ: 19-10

12. Discuss the rethinking taking place regarding the time frame used in American business
performance systems.

ANS:
Historically, American time frames for performance has been short term, often only one
year. Presumably management tries to do what is best for the firm and its owners. Thus,
shareholder wealth maximization should be the primary focus of management. Short term
profit maximization doesn't necessarily result in long-run shareholder wealth maximization.

To encourage this different attitude, employees and management are being asked to take a
longer run perspective. This is enhanced with employee stock ownership in their firm.

DIF: Moderate OBJ: 19-10

13. Deferred compensation techniques are currently used in the American work place. What are
they and how do they benefit the employer and the employee?

ANS:

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 Deferred compensation is pay that was earned on current performance but is paid later to
the employee. The compensation may include profit sharing plans, pensions, and stock-
based plans like ESOPs. The payment by the employer can be deducted currently for tax
purposes but the employee doesn't recognize it as income until it is received. In stock option
plans, earnings in the plan are not taxable to the employee until the plan is distributed. Size
of the plans are affected by the firm's stock value and encourage employees to take a more
positive attitude about the company's future.

DIF: Moderate OBJ: 19-10

14. List the five general criteria that should be considered when designing a performance
measurement system.

ANS:
1. The measures should be established to assess progress toward the organizational mission
and its related goals and objectives.
2. The persons being evaluated should be aware of the measurements used and have some
input in developing them.
3. The persons being evaluated should have the appropriate skills, equipment, information,
and
authority to be successful under the measurement system.
4. Feedback of accomplishment should be provided in a timely and useful manner.
5. The system should be flexible to adapt to new conditions in the organizational
environment.

DIF: Moderate OBJ: 19-3

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