ADVANCED MANAGEMENT

CONTROL
Objective settings
Can be financial vs. non-financial; quantified, explicit vs. implicit; economic, social…

The control problems:

1. LACK OF DIRECTIONS Don’t know what the direction means
Employees don’t know what organization wants from them
COMMUNICATION +

2. LACK OF MOTIVATION I understood what I have to do but I don’t want to do it

The employees choose to no perform as they would have to
There can be a lack of goal congruence: the personal goal can be different from the organization one
There can be a self-interested behaviour: individuals can be lazy, or more extreme examples of
motivational problems (crime…)

3. PERSONAL LIMITATIONS I know what to do and I want to do it, but I can’t

Control problem avoidance:

- Activity elimination (subcontracts, licensing agreements, divestment)
- Automation (computers, robots eliminate human problems)
- Centralization (most critical decision is for superiors)

à I have to implement when it’s not possible management control system:

• action controls: control action of people, what personnel has to do
• result controls: responsible for the overall “score”
• people control coordinate more easily, recruiting people that share the same
vision and organizational cultures

Are people working in the right way?

ACTION CONTROLà aims at ensuring that employees

- perform actions to be beneficial to the organization
- do not perform actions that are harmful to the organization

They are usable and effective only when managers:

- Know what actions are desirable (Difficult in highly complex and uncertain task environments.
e.g., research engineers or top-level managers)
- Have the ability to make sure that the desirable actions occur (For example, effectiveness of
organizational procedures?)

most action controls are aimed at preventing/detecting undesirable behaviours

types:
o behavioural constraintà devices that can be physical (locks, password, limited access) or
administrative (restriction of decision making, separation of duties…)
o pre-action reviewsà consist in scrutiny, review and approval of action plan, investment
proposal and budgets
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 o action accountabilityà when action is standardized; I tell you what you can’t do and then I
check. Define what is unacceptable, communicate this information to employees, observing
or otherwise tracking what happens and then rewarding goods actions or punish actions that
deviate.
o redundancy à repeat; assigning more people to a task than necessary (“backup” people or
backup facilities)

pros:
the most direct form of control, document
the accumulation of knowledge as to what
work best and increase the predictability
of actions and reduce the amount of of
inter-organizational information flows to
achieve a coordinated effort
cons:
only for routine works; May discourage
creativity, innovation and adaptation
Sometimes very costly

PERSONNEL/CULTURAL CONTROLSà
it ensures that employees will control their own behaviours

o personnel controlà selection and placement of people and training them; Personnel
controls build on employees’ natural tendencies to control themselves, because most people
have a conscience that leads them to do what is right and find self-satisfaction when they do
a good job and see their organization succeed (Self-control, Intrinsic motivation, Ethics and
morality, Trust and atmosphere, Loyalty)
Generally, it is about “… finding the right people, giving them a good work environment
and the necessary resources”
Selection and placement (Finding the right people to do a particular job (es background
check) and Training (Give employees a greater sense of professionalism and Create interest
in the job by helping employees to understand their job better)
o self-monitoring à

and will control each other

o cultural control à tap into social pressure and group norms and values; are effective because
members of a group have emotional ties and a sense of responsibility (built on shared
traditions, norms, beliefs, ideologies, attitudes, ways of behaving…)
Ways to shape culture:
§ codes of conduct (Codes of ethics; corporate credos, mission statements, etc.,
Formal written documents with broad statements of corporate values,
commitments to stakeholders, and the ways in which top management would like
the firm to function, Fundamental guiding principles of the company)
§ group-based rewards (For example, profit-sharing, employee ownership of
company stock; These are cultural controls (although of a results control nature)
because the link between group (individual) performance and rewards is stronger
(weaker))
§ intra organization transfers (Improve the socialization of individuals in an
organization and alleviate the formation of incompatible goals and perspectives,
improve identification with the organization as a whole as opposed to subunit
identification)

2
 §
physical and social arrangements (office plans, interior decor, dress codes and
vocabulary…)
§ tone at the top (Top management statements must be consistent with the culture
they are trying to create, and importantly, their behaviors should be consistent with
their statements)
o mutual controlà

RESULT CONTROLà
Involves rewarding individuals for generating good results: result accountability
It influences actions because it causes employees to be concerned about the consequences of the actions
they take (employees are not constrained, but are empowered to take action they believe will best produce
the desired results)

Key results control elementsà

- define the performance dimensions: you select an area; what you measure is what you get, so the
selected dimension has to be significant and congruent. Employees would not do other things or do
them worse. Congruence is necessary!
- measuring performance on these dimensions: you need to operationalize the dimension in
measures.
o Objective measures can be financial (market based or accounting-based) or non-financial
(market share, customer satisfaction…)
o Subjective measures for example managerial characteristics
Finding the right measure is a very hard thing, we need to make shore that is congruent (is capable
to evoke appropriate behaviour) and significant (takes a picture of something important)
- setting performance targets: express the future desired level, they are model based / historical /
negotiated; internally or externally derived; fixed or flexible. Motivational effects
- providing rewards or punishment: feedback means positive incentives (things employees value) or
negative incentives (things they like to avoid); they can be monetary or non-monetary

Conditions for effective results control

1. organizations must know what results are desired in the areas being controlled à
CONGRUENCE
o high quality is desirable if a differentiation strategy is pursued
o low price is desirable if a cost leadership strategy is pursued
o short time span is desirable if an organization is short of cash a want to minimize the amount
of inventory

those 3 things are in conflict with themselves, we need to presume one of them.
CONGRUENCE is the property à result measures should be congruent with the organization’s
intended objectives; what your measures is what you get:
Congruent measures will evoke appropriate behaviours
If measure and weightings are not congruent with the organization’s objective, we encourage
employees to do the wrong things

2. The individuals whose behaviours are being controlled must have significant influence on the
results
The person whose behaviors are controlled must be able to affect the results in a material way in a
given time spanà Controllability principle
If the results are uncontrollable, the controls tell us little about the actions that were taken:
- Good actions will not necessarily produce good results
- Bad actions may be obscured
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 3. organizations must be able to measure the results effectively
we have some measurement properties:

o precision (different from accuracy)à is the degree to which repeated measurements under
similar conditions show the same results (reliability).
§ Imprecise measurements increase the risk of misleading performance;
§ Employees will react negatively to inequalities
§ precision does not mean accuracy;
§ Accuracy refers to the degree of closeness of measurements to its true value

o Objectivityà means that a measure is not influenced by personal feelings, mental states,
tastes and is therefore accurate
§ For example, self-reported evaluation is typically scarcely objective;
§ There are two main ways to increase objectivity:
§ Measuring should be done by people independent of the process that generate the
results;
§ Measurement should be verified by third independent parties

o Timelinessà we don
§ refers to the lag between the performance vs the measurements of results +
the attribution of rewards/punishments
§ Timeliness is important because:
1. measures and rewards that are delayed over time might lose motivational
impact (low pressure)
2. If performance measurement is not timely, it becomes harder to intervene
and fix potential problems

o Understandabilityà Measures needs to be understandable and intelligible by those being

evaluated
§ Understandability means that:
- employees need to be aware of what they are being held accountable
- employees need to be aware of what to do to influence the measure

o Cost efficiencyà Every measurement and control process have its costs
§ Cost efficiency means that costs of control should not exceed the benefits

Pro and cons of result control:

PRO
- Behaviour can be influenced while allowing significant autonomy
- They yield greater employee commitment and motivation
- They are often “inexpensive”
- For example, performance measures are often already collected for reasons not directly related to
management control (e.g., financial reporting)

CONS
- Often less-than-perfect indicators of whether good actions have been taken
- They shift risk to employees (due to uncontrollable factors); hence, they often require a risk premium
for risk averse employees
- Sometimes conflicting functions:
• Motivation to achieve (targets should be “challenging”)
• Communication among entities (targets should be slightly conservative)

4
 L3 - financial responsibility centres (clue topic) à chapter 7

Financial result controlà focuses on financial control

The ubiquity of financial results control; financial result control is very common since:
- Financial objectives are paramount in for profit organizations
- Many financial measures are summary measures (reflect the aggregate effects of multiple
performance areas)
- It allows management by exception: (fundamental in large and decentralized organization)
- Financial measures are in general precise and objective:
- Its establishments are relatively cheap (most elements in place already)

Pillars:
1. Financial responsibility centres
The apportioning of accountability for financial results within the organization
who is responsible for what?
2. Performances measures
Against which FRCs will be evaluated
3. Planning and budgeting systems
To define targets and standards for evaluating performance
4. Incentive system
To define the links between results and various organizational incentives

1. FINANCIAL RESPONSIBILITY CENTRES

Decentralization and specialization:

- The possibility of implementing financial results control is contingent on the assignment of
decision-making authority to managers at different levels
- Especially in large organizations, managers have to delegate some decisions to those who are at
lower levels in the organization.
- In a decentralized organization, decision-making authority is spread throughout the organization
rather than being limited to a few top executives.

Who is responsible for what?

Responsibility centreà An organization unit (entity) headed by a manager with responsibility for a
particular set of inputs and/or outputs (schedule, defects, customer satisfaction)
Financial responsibility centreà A responsibility centre in which the manager’s responsibilities are
defined primarily in financial terms
Financial responsibility centre types: (each type of centre is responsible for different financial
statement line item)
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a. COST CENTRESà

Cost centres are RC whose managers are held accountable for cost levels
Cost is a financial measure of the inputs consumed by the responsibility centre)
» “Standard” or “engineered” cost centres (ECC)
» “Managed” or “discretionary” cost centres (DCC)

“Standard” or “engineered” cost centres (ECC)

- Inputs are easy to quantify and can be measured in monetary terms;
- Outputs are easy to quantify and can be measured in monetary terms;
- There is a direct ‘causal’ relationship between inputs and outputs
For example, manufacturing departments are typically engineered cost centres
- Given the sales target (PxQ), the production department is responsible for
producing the necessary number of items.
- Therefore, it can be determined beforehand:
- The quantity of outputs to produce
- The quantity of inputs needed to produce a given quantity of outputs;
- The unit cost of inputs

Standard cost vs. actual cost (ex variance analysis)

• Analysis of the cost of inputs that should have been consumed in producing
the output vs.
• the cost that was actually incurred

“Managed” or “discretionary” cost centres (DCC)

- Outputs are difficult to quantify and measured in monetary terms
- Relationship between inputs and outputs is hard to establish
For example, most service departments are discretionary cost centres:
- R&D;
- human resources;
- accounting

Control in Discretionary cost centres

- It entails some discretionary elements
- Ensuring that managers adhere to the budgeted expenses while successfully
accomplishing the tasks of their centre
- Subjective, non-financial controls
- For example, quality of service provided
- Organization might transform DCC in (quasi) profit centres, allowing them to
charge internal units for their services
- ex.training programmes
- This works well only when the non-service departments are not captive (free
to contract external providers);
- DCC in this case have an incentive to deliver good quality services in an
efficient (cost efficient) way

6
b. REVENUE CENTRESà RCs
Revenue centres are RCs whose managers are held accountable for generating
revenues
• the amount received from customers in exchange for the goods or services
provided by the company.
• Revenues are a financial measure of outputs
Example 1: sales departments in for profit organizations
Example 2: fundraising managers in not-for-profit organizations
Accountability on revenues generation provides a simple and effective incentive to:
Attract customers and Retain customersà try to have a market orientation

Problem: However, attributing accountability solely on revenues can create

misplaced behaviours:
- revenue responsibility will not necessarily lead to the most profitable sales if no
formal attempt is made to relate expenses to revenues;
- Fast sharp in revenues can lead to liquidity problems;
- conflicts with production departments can arise;
» Most revenue centre managers are also held accountable for some expenses
(e.g., salespeople’s salaries and commissions)
» But still they are not profit centres because:
- Such costs are only a small fraction of the revenues generated
- Revenue centres are not charged for the costs of the goods they sell

Revenue is different from profits: profits are revenues and costs; so people tent not
to focalize only to sales but also on other things

c. PROFIT CENTRESà (PCs)

- Profit Centres are unit whose managers are held accountable for generating profits
Profit is the financial measure of the difference between revenues and costs)
- A profit centre can be treated virtually as a standalone entity
- generates its own revenues
- It runs its operations
- Managers have control over pricing and costs
- Its profits and losses can be calculated separately
- Profit centres directly add (or are expected to) to the bottom-line profitability of the
entire organization
- Profit centres are crucial in determining which units are the most and least profitable
within an organization
Allow cross comparison
Help decisions on resource allocation
- Variations in profit centres
• Gross Margin Centreà Charge standard cost of goods sold to sales-focused
entities (responsibility on gross margin)
Incentive to focus on profitability rather than gross revenues

• Incomplete Profit Centre à Managers without authority on all the functions

relevant for their product or line of business
ex. Research and development, Advertising

• Before-tax Profit Centre à Managers with authority on all the functions

relevant for their product or line of business
responsible for income statement lines item before tax
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 • Complete Profit Centre à Managers with authority on all the functions
relevant for their product or line of business
Therefore, responsible for each income statement line item

• Micro Profit Centres à Organizations can assign revenues to cost-focused

entities on a function of cost (ex. Cost plus mark-up)
Ex. Manufacturing department that supply solely internally
Ex Training unit delivering courses to other departments
Might lead to noise for poor service and create a «quasi competitive pressure;
If they have no interface with the market and no control over revenues) they
are merely pseudo profit centres

d. INVESTMENT CENTRESà (ICs)

Investment centre are RC whose managers are held accountable for the
accounting returns (profits) on the investment made to generate those returns
Objective = return on capital
Sometimes business terminology is not precise, and IC are referred to
as Profit Centres;
Howere, IC are conceptually different from PC

Absolute differences in profits are not meaningful if the various organizational

entities use different amounts of resources
In fact, IC managers have two performance objectives
- Generate maximum profits from the resources at their disposal
- Invest in additional resources only when such an investment will
produce an adequate return
- IC Managers are delegated authority over pricing, costs and
investment decisions

ROI TYPE MEASURES

Return on equity (ROE)

Return on Common Equity (ROCE)
Return on Assets (ROA)
Operating Return on assets (Operating ROA)
Return on Total Capital (ROTC)
Return on capital employed (ROCE)
Return on invested capital (ROIC)
Return on controllable Assets (ROCA)
Return on risk adjusted capital (RORAC)
Risk adjusted return on capital (RAROC)
Risk adjusted return on risk adjusted capital (RARORAC)

8
 L4 - FINANCIAL RESPONSIBILITY (Chapter 7)

ORGANIZATIONAL STRUCTURE
“Organizational structure” refers to:
• horizontal differentiation, i.e. the formal division of the organization into sub-units
• vertical differentiation, i.e. the location of decision-making responsibilities (centralized vs.
decentralized)
• integrating mechanisms, i.e. the mechanisms for coordinating the activities of sub-units,
including cross-functional teams or pan-regional committees

Horizontal differentiation: the design of structure

Horizontal differentiation is concerned with how the firm decides to divide itself into sub-units
The decision is usually based on:
- function
- type of business
- geographical area

Organizational structure and financial responsibility centres

In the following, some basic concepts concerning organizational structure will be refreshed;
(It will be discussed how Financial Responsibility Centres are arranged in different types of structure)

a) Entrepreneurial structureà Most firms begin with no formal structure

They are run by a single entrepreneur or a small team of individuals (entrepreneurial structure)
Roles/offices in charge for single tasks
An example is: Gas station; Small Maintenance firm; Kindergartner à so you have some people that
take care of different tasks
In the entrepreneurial structure, there is no need for designing financial responsibility centers; and
that’s because there is Low level of complexity and Low level of decentralization (because is very
flat)

b) Functional structureà (groups of tasks)

As organizations grow, the demands of management become too great for one individual or a small
team to handle; there is a need for specialization.
The organization is split into functions reflecting the firm’s value creation activities;
They adopt, in other term a functional structure;
The functions are typically coordinated and controlled by top management, and decision-making
tends to be centralized.
FRC within a functional structure:
In a functional structure, financial responsibility centres are normally arranged as follows:
- Manufacturing is a (standard) cost centre;
- Service and administrative functions are (discretionary) Cost centres
- Sales is a Revenue Centre
In a functional structure, no function managers have:
- significant decision-making authority over both revenues and costs;
- Significant authority over Investments;
Therefore revenues, costs and investments are brought together in return measures (Roi Type) only
at the top level.

9
 c) Divisional structureà
If the firm diversifies its product line or the markets, further horizontal differentiation may be
necessary;
If firms may switch to a divisional structure:
- where each division is responsible for a distinct product line
- where each division is responsible for a distinct market
The divisions are internally organised along functional lines
Headquarters retains control for the overall strategic direction of the firm and for the financial
control of each division
FRC within a divisional structure:
In a divisional structure:
- Each division is either a profit centre or an investment centre
- The functions within the divisions are either cost or revenues centres
• Manufacturing is a (standard) cost centre;
• Service and administrative functions are (discretionary) Cost centres
• Sales is a Revenue Centre
- Top management is an investment centre

Example Ferreteria de Mexico: store managers evaluation

Store ROIà Bonus eligible revenues-expenses/ total store
investment
Eligible revenues à shipments from store – sales orders from
regional/headquarters
Expenses: àstore direct costs
Investment: à Annual average of month end balance of cash,
inventory in stock,accounts receivable, equipment, forniture,
fixtures, buildings and land. And Rented property is recognized
as an expense

FRCs and organizational structure

Decisions about the structure do not necessarily precede
decisions about FRC;
For example, the desire to have managers make revenues/costs trade-off might lead to divisionalization;
What matter is consistency between decision authority and financial results accountability.

Kranworth chair
• KCC has to deal with essentially two different markets for their products.
• Some of theirfolding chair models are appealing to the mass market that can be reached through
major retail chains.
• At the same time, KCC also produces customized chairs and chairs with extra features that seem to
generate better margins and require product differentiation that is more difficult to pull off by
foreign competitors.
• Given the growing complexity of their business, the two owner–managers have to consider
delegating more operational autonomy to other managers (especially, because of the time
constraints the owners face).
• Adoption of a divisional structure:
ü Custom Division;
ü Retail Division.
• Divisional controllable returns
ü Divisional Operating income /controllable assets
ü Controllable assets: inventories, accounts receivable, and allocated assets (facilities)

10
Questionà If a Division (profit center) provides a product/service to another Division (profit center)
within the same firm, should they charge a price?
Since they are both profit centers , they might charge the price. This price is called transfer price.
As they are profit centers, they can be consider standalone entities so it makes sense charge a price. But the price should be lower compared
to that of market otherwise they can outsource.
Yes, I think that for intra-firm “trade” both the parent company and the subsidiary one need to charge prices and
these prices do not differ much from the market price. Because if the price does differ, then one of the entities have
a disadvantage and so it would start buying from the market to get a better (lower) price.

This kind of price have two meanings:

- important for tax; uses to shift taxes to other compartment

L5 – intro to transfer price (chapt 7)

A Transfer price is the price at which products or services are transferred between profit (or investment)
centres within the same firm. (Merchant and Van Der Stede, 2017)

Transfer prices refer to the terms and conditions which so-called “associated enterprises” agree for their
“controlled transactions.”
According to this widely used OECD definition, enterprises are associated if:
- an enterprise participates directly or indirectly in the management, control or capital of another enterprise
or
- the same persons participate directly or indirectly in the management, control or capital of two enterprises

Associated enterprisesà when an enterprise participate directly or indirectly in the management control
of one other enterprise

Example: Enterprise X manufactures pianos; Enterprise Y distributes the pianos manufactured by X

; Both X and Y are 100% owned by Enterprise Z; Because Z participates directly in the capital of both
X and Y, they are all associated enterprises.

Example 2: When selling pianos on the market, Z has no control on the price at which one piano is
sold.
prices are set by supply and demand. However, Z does control any transactions between X and Y;
Therefore, the internal sale of a piano by X to Y is called a “controlled transaction.”

Transfer prices are relevant for:

a. The firm’s management control system (Internal reason)
b. Compliance to tax rules (External reason)
i. Firm runs operation in multiple tax jurisdictionà if firms run operations in multiple
countries there are problems in taxes

11
a. The managerial relevance of transfer prices

Acme vacuum exampleà

Acme Vacuum has two SBUs: Motor Unit and Vacuum Unit; Motor Unit produces motors; It can transact with the market and sell motors to the
Vacuum Unit; Vacuum Unit sells Vacuums that incorporate a motor; It can both transact with providers or buy motors from Motor Unit; Both are Profit
centers

Scenario 1: Motor sells to Vacuum at market price Motor Unit

Motor Unit manifactures a motor at the cost of 75
Motor Unit sells to Vacuum Unit at 125 (market price) Revenues 125
Vacuum Unit combines the motor with 50 other product and labor costs and sells
the Vacuum at 250 Product cost 75
Vacuum Unit
What behaviour does each price level encourage? Other costs 0
Motor Unit could be encouraged to sell internally Revenues 250
Vacuum Unit could be encouraged to source externally or at least look for Gross margin 50
external providers Product cost 125
How would you evaluate PCs managers’ performance?
Motor Unit perfomance might be overstated Other costs 50
Vacuum unit performance might be understated
Gross margin 75
Scenario 2: Motor sells to Vacuum at an internal price < market price
Motor Unit manifactures a motor at the cost of 75 Motor Unit
Motor Unit sells to Vacuum Unit at 100 (<market price)
Vacuum Unit combines the motor with 50 other product and labor costs and Vacuum Unit Revenues 100
sells the Vacuum at 250
Revenues 250 Product cost 75
What behaviour does each price level encourage?
Motor Unit could be encouraged to transact externally Product cost 100 Other costs 0
Vacuum Unit could be encouraged to source internally
How would you evaluate PCs managers’ performance? Other costs 50 Gross margin 25
Vacuum Unit performance might be overstated
Motor Unit performance might be understated Gross margin 100

Scenario 3: Motor provides Vacuum with motors for free

Motor Unit manifactures a motor at the cost of 75 Motor Unit
Motor Unit provides Vacuum Unit with motors for free
Vacuum Unit combines the motor with 50 other product and labor costs and Revenues 0
sells the Vacuum at 250
Vacuum Unit
Product cost 75

What behaviour does each price level encourage? Revenues 250 Other costs 0
Motor Unit could be encouraged to transact externally
Vacuum Unit could be encouraged to source internally Product cost 0 Gross margin (75)
How would you evaluate PCs managers’ performance in each case?
Other costs 50
Motor Unit performance is understated
Vacuum Unit performance is overstated Gross margin 200

Failing at setting the right transfer price leads to wrong decisions about:
- Production quantities and sourcing
- Evaluation of the Profit Center managers’ performance
Both Buying and selling PCs

In multibusiness firms divisions’ managers can make decisions about production quantities and
sourcing that are:
- Functional from the single division/profit center standpoint;
- dysfunctional from the corporate standpoint;
Ex. Buying Profit Center sources externally while there is excess capacity elsewhere in
the corporation

Transfer Prices should provide proper economic signals to Profit Centers:

- Selling profit center: how much produt/service supply internally
- Buying profit center: how much produt/service buy internally
12
 so that managers make good economic decisions from a corporate standpoint
For example, in the case of Acme Vacumm, the transfer price should be: high enough to allow Motor
Unit to earn some ‘‘book profit’’ when it produces efficiently; Low enough to motivate Vacuum Unit
to order more motors and sell more vacuums.

Transfer prices influence also the financial performance of Profit Centers’ managers

Transfer prices affect:

- the revenues of the selling profit center (PC),
- the costs of the buying PC
- the profits of both entities
- Zero-sum games

Ideal transfer prices should not cause the performance of either buying or selling units to be over or
under-estimated

Misleading profitability signals:

- Adversely infuence allocation of resources within the firm
- Undercut profit centers managers’ motivation
- Problems with accuracy and controllability

b. Relevance of transfer prices: compliance with tax rules

The problem of profit shifting

- Many multibusiness firms run operations in multiple countries
There are large differences in tax rates between countries.
- Firms might be motivated to use transfer prices to shift profit in low taxation jurisdictions;
- The effect is to maximize after tax worldwide profit

Example :
Enterprise X manufactures pianos; Enterprise Y distributes the pianos manufactured by X ; Both X and Y are 100%
owned by Enterprise Z; Because Z participates directly in the capital of both X and Y, they are all associated
enterprises.
Example of controlling transactions:
When selling pianos on the market, Z has no control on the price at which one piano is sold.
prices are set by supply and demand. However, Z does control any transactions between X and Y; Therefore, the
internal sale of a piano by X to Y is called a “controlled transaction.”
The price at which one piano is sold by X to Y affects their individual financial results;
If X charges a high price, X makes more profit. If X charges a low price, Y makes more profit.
For shareholder Z, it doesn’t matter which of the two companies makes the profit.
However, from a tax perspective it does matter.
X is taxed in Malaysia and Y is taxed in Hong Kong.
The corporate tax rate in Hong Kong is 16.5%. In Malaysia, it is 25%.
Z wants to see as much worldwide profit after tax as possible.
Z can use its influence as a shareholder to set the prices in such a way that the profits are highest where taxes are
lowest (Hong Kong).
Piano Unit Cost: USD 1.000.
Average third party piano manufacturer realizes a profit before tax of USD 3.000 when selling one piano to a
distributor.
Market price for one piano: USD 5.000.
Scenario 1 shows the profit if the price X charges to Y is the market price (USD 4.000 as this ensures a profit of USD
3.000)
Transfer price=market price
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 The 2nd scenario shows the potential profit when X charges a price of USD 2.000.
Transfer price<market price

Scenario 1: controlled transaction if TP=market price

Scenario 2: controlled transaction if TP < market price

Consequences on different TP levels

In scenario 1, most of the profit is made by X in Malaysia at 25%
tax.
In scenario 2, most of the profit shifts to Y in Hong Kong at 16.5% tax.
In scenario 2, The result is an extra profit after tax of USD 170 per piano sold.

Relevance of transfer prices: tax base erosion

• If left unchecked, the practice could lead to the shifting of profits from high-tax countries to
low(er)-tax countries;
• Profits shifting using Transfer Prices erodes countries’ tax base;
• The main goal of transfer pricing regulation is to prevent this situations and ensure that profits
are taxed at the place where value is actually created.

Arm’s length principle

In response to this problem, tax authorities impose the “arm’s length principle”:
- Intercompany process must be treated if they were open market transactions;
- TP must be in line with what have been charged to an independent non related counter-party.
- In a nutshell, these rule provides that the terms and conditions of controlled transactions may not differ
from those which would be made for uncontrolled transactions.

Further distortions in Transfer Prices

- TP might be set to shift profits to jurisdictions where limits to profit repatriation are less strict
- Sometimes, TP could be set so to shift profits to entities positioned for disinvestment
increasing valuation hence selling price
- Firms might set TPs to shift profits between wholly owned operations and entity where profit is shared
(joint ventures)

Purpose of transfer prices: trade-offs between managerial and tax rules compliance goals
- In MCS terms, TPs are meant to align managers’ incentive and achieve coordination;
- The regulation by tax authorities prescribe the arm’s lenght principle;
- There are potential trade offs between tax compliance purposes and managerial purposes of TPs

14
 L6- Transfer pricing alternatives

Transfer pricing alternatives

Transfer prices are relevant for:
- The firm’s management control system (Internal)
- Compliance to Tax rules (External)

Therefore, there are different sets of TP alternatives:

- A set of alternatives relevant solely for control purposes
- A set of alternatives requested by tax authorities to comply with tax rules
o Firm runs operations in multiple tax jurisdictions

Transfer prices can be set according to different logics:

a. Market based
It is used where a (“perfectly” competitive) external market exists;
- No dominant position
- Homogeneous product

Managers of both the selling and buying PC will make decisions that are optimal from a corporate
perspective:
If the selling (upstream) PC cannot perform should be shut down and firm should source from
the market;
If the buying (downstream) PC cannot perform, firm should not sell that product
Reports of their performances will provide good information for evaluation purposes

Methodology: Actual price, which is charged to external customers; listed price of a similar product;
price a competitor is offering (bid price)

Deviations can be allowed that reflect differences between internal and external sales:
» Savings in marketing, selling, and collecting costs
» Differences in quality standards; special features; special services provided
External price might be not sustainable (lawball bid to get orders)

b. Marginal cost

Marginal cost: cost of producing an extra unit of product ( i.e the change in total cost arising from
producing an extra unit); Used often in short-term pricing decisions

It allows to avoid double marginalization:

- Since both PCs have some product pricing power, then each of the two units has the incentive to
mark up their product’s price above its marginal cost.
- Acting on their own incentives, the vacuum price will include two successive markups (double
marginalization)
- fewer vacuums being sold to the market and fewer motors ordered from Motor Unit.

PROBLEMS:
-Marginal cost transfer prices provides poor information for evaluation purposes
- The selling PC incurs a loss since bears the full cost of production and receives in revenues
only the marginal cost.
- The profits of the buying PC are overstated
15
 - Marginal cost TPs are difficult to implement since MC is not easy to measure:
- Direct costs not problematic (material, labor)
- Indirect costs are problematic
- In general: MC meant as standard variable cost with no clear breakdown between
variable and fixed indirect costs
- Rarely used in practice

VARIATION:
§ One variation on marginal cost TPs is Marginal cost + lump-sum fee;
The lump sum fee is designed to compensate the selling PC for tying up some capacity
for products that are transferred internally;
§ It preserves information for evaluation since:
» The marginal cost of the transfer remains visible
» The selling PC can recover its fixed cost and a profit margin through the lump-sum
fee
• It favors interorganizational dialogue (basis for lump sum fee)
• Problem:
Managers involved must estimate the capacity to “reserve” for internal «customers» in the
forthcoming period;
If this estimates are incorrect:
• charges will be inaccurate;
• Capacity will not be assigned to the most profitable users.

c. Full cost
They are widely used and relatively easy to implement
- Firms have cost systems in place to calculate the full cost of production
They are a good measure of long run viability
- In order to generate profit, full cost must be recuperated
Full cost TPs are not as distorsive for evaluation purposes
- The selling PC does not incurs a loss

Problems:
However, full costs rarely reflect actual costs of producing the products
- arbitrary overhead cost allocations
There is still no incentive for the selling PC to transfer internally
- there is no profit margin
- The profit of the selling PC is understated

d. Full cost + mark up

An alternative could be Full cost + markup TPs
It allows the selling PC to earn a profit on internally sold products/services
Crude approximation of the market price
§ in cases where no competitive external market price exists
Such transfer prices, however, are not (quite) responsive to market conditions

16
e. Negotiated

Transfer prices are negotiated between:

» the selling PC Managers
» the buying PC managers themselves
Negotiated TPs are viable if:
» Profit centers are not captive (i.e., some possibilities to sell or source outside)
» Both PC managers have some bargaining power

Negotiated Transfer Prices presents some problems:

- The outcome is often not economically optimal, but rather depends on the negotiating skills
of the managers involved
- Their implementation is costly (time-consuming)
- They can accentuates conflicts and politics between PC managers (competitions for bonuses,
promotions and prestige)
- Often requires corporate management intervention

f. Dual rate

Method
- The selling PC is credited with the outside sales price
- The buying PC is charged the (marginal) cost of production only
- Or any price <market price
- The difference is charged to a corporate account and eliminated
at the time of financial statement consolidation

Dual transfer prices serve an internal management control function of :

- Providing incentives and information to decentralized managers to optimize profits of the firm….
- …..When the managerial objectives for the upstream and downstream units are in conflict;

managerial purposes:
Advantages
- It provides proper economic signals for decision-making
- It maintains proper information for evaluation purposes
- It ensures that internal transactions will take place
Disadvantages
- It destroys incentives to negotiate favorable outside prices for supplies
- (buying PC now only pays the marginal cost)
- It destroys incentives to improve productivity
- (selling PC finds “easy” sales inside)

control and tax compliance objectives:

The same dual rate transfer pricing can also naturally arise in the international tax accounting, where
- the market (arm’s length) price is required for compliance with tax rules
- internal price < market price is preferred for control purposes.
It might attract the scrutiny of tax authorities

17
 L7- Transfer pricing alternatives (part 2)
Transfer pricing alternatives

Transfer prices are relevant for: The firm’s management control system (Internal) and Compliance to Tax
rules (External)

Therefore, there are different sets of TP alternatives:

• A set of alternatives relevant solely for control purposes
• A set of alternatives suggested by tax authorities to comply with tax rules
• Firm runs operations in multiple tax jurisdictions

Alternatives prices: compliance with tax rules:

• A set of alternatives suggested by tax authorities to comply with tax rules
The OECD Transfer Pricing Guidelines provide 5 common transfer pricing methods that are accepted by
nearly all tax authorities.
Arm’s length principle
The five transfer pricing methods are divided in:
1. traditional transaction methods: measure terms and conditions of actual transactions between
independent enterprises; compares these terms with those of a controlled transaction.
and they are:
- CUP (Comparable Uncontrolled Price)
- Resale price method
- Cost plus method

2. transactional profit methods: measure the net operating profits realized from controlled
transactions; compare that profit level to the profit level realized by independent enterprises in
comparable transactions.
And they are:
- Transactional net margin method (TNMM)
- Transactional profit split method

If a traditional transaction method and a transactional profit method are equally reliable, the traditional
transaction method is preferred.
If the CUP method and any other transfer pricing method can be applied in an equally reliable manner, the
CUP method is to be preferred.

CUP method

The CUP Method compares the terms and conditions (including the price) of a controlled transaction to
those of a third party transaction.
There are two kinds of third party
transactions.
- Firstly, a transaction between
the firm and an independent
enterprise (Internal Cup).
- Secondly, a transaction
between two independent
enterprises (External Cup).

18
 Example:
A manufacturing company (X) manufactures the “Buster 3.0., a high-quality vacuum cleaner.
The only similar competing manufacturer is (Z), with its renowned “Dragon Buster.”
X and Z sell their vacuum cleaners via both associated and third party distributors.
X has received an order from distribution company Y for the supply of 1 Buster 3.0. X and Y have the same
shareholder.
àWhat should the transfer price be?
This means that X should find the terms and conditions (here: the price) of a comparable transaction.
Under the CUP method, there are 2 options:
v X looks at the price for which it sells 1 “Buster 3.0” to a third party distributor (Internal CUP).
v X looks at the price for which Z sells 1 “Dragon Buster” to a third party distributor (External CUP).

The resale price method

The Resale Price Method is also known as the “Resale Minus Method.”
As a starting position, it takes the price at which an associated enterprise sells a product to a third
party (resale price);
Then, the resale price is reduced with a gross margin (the “resale price margin”),
It is determined by comparing
gross margins in comparable
uncontrolled transactions.
After this, the costs associated with the
purchase of the product, like custom
duties, are deducted.
What is left, can be regarded as an arm’s
length price for the controlled transaction

Example:
Alpha, based in Hong Kong, brews a very
exclusive non-alcoholic beverage called “the
Mountain.”
It sells this beverage to high-end nightclubs via
associated distributors.
The market price for one can of “the Mountain” is USD 100.
Alpha does not sell the beverage to independent distributors and there is no company in Asia that brews a
comparable beverage.
Source: Transferpricingasia
However, there are comparable distributors that sell “the Vulcano”, a competing alcoholic beverage brewed by
Beta, a company also based in Hong Kong.
The market price for one bottle of “the Vulcano” is USD 100.
In addition, distributors report USD 5 gross margin per bottle sold with 2 USD on custom duties.
Alpha wants to set the transfer price for the supply of “the Mountain” to the associated distributors.
the CUP method can’t be applied here:
There is no Internal Cup (no third party transactions by Alpha)
There is no External Cup (no comparable transactions).
In our example, the distributors of “the Vulcano” are comparable to the
distributors of “the Mountain.”
The result is that the gross margin and custom duties reported can be used
as input for the Resale Price Method.

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Cost-plus method

The Cost Plus Method compares gross profits to the cost of sales.
Steps:
1. determine the costs incurred by the supplier in a controlled transaction for products
transferred to an associated purchaser.
2. an appropriate mark-up has to be added to this cost, to make an appropriate profit in light of
the functions performed.
3. After adding this (market-based) mark-up to these costs, a price can be considered at arm’s
length.
An arm’s length mark-up can be determined based on the mark-up applied on comparable transactions
among independent enterprises.

Example:
(X) manufactures smartphone cases for associated
enterprises.
There are many companies around that manufacture
Iphone cases, including independent enterprise (B).
B and X manufacture similar smartphone cases.
X is asked by associated enterprise Y to manufacture
100,000 cases.
What is the arm’s length price?
This means that X should find the price of a comparable
transaction.
Under the Cost Plus Method, X should then first
compare its cost base with the cost base of B when
manufacturing 100,000 cases for a third party client.
Provided that the cost base is comparable, the next
step is to identify the mark-up on costs applied by B.
That mark-up should be added to the cost by X.
The result is the arm’s length price.

Transactional Net Margin Method

The Transactional Net Margin Method (TNMM)

v determines the net profit of a controlled transaction of an associated enterprise (tested party).
v net profit is then compared to the net profit realized by comparable uncontrolled transactions
of independent enterprises.
As opposed to other transfer pricing methods, the TNMM requires transactions to be “broadly similar”
to qualify as comparable.
A comparable uncontrolled
transaction can be between an
associated enterprise and an
independent enterprise (internal
comparable) and between two
independent enterprises (external
comparables)

20
The most important aspect of the TNMM is the “net profit indicator.”
This is a ratio of net profit relative to a base, such as “costs,” “sales” or “assets.”
The net profit indicator that a taxpayer firm realizes from a controlled transaction, is compared with the
net profit earned in comparable uncontrolled transactions.
Two examples of commonly used net profit indicators are:
v the Net Cost Plus Margin;
v the “Net Resale Minus Margin”.

a. TNMM I: Net Cost Plus Margin

Company X provides administrative support services such as invoicing and bookkeeping.
Associated enterprise Y asks X to provide invoicing services (1.000 hours of such services);
X knows that the total cost of 1.000 hour of services is 125.000 USD.
X wonders what transfer price it has to charge.
This means that X should find the the price of a comparable transaction.
There are many companies around that provide comparable services, including independent
Enterprise B.
X and B have exactly the same business model.
Company X can look at Enterprise B to determine a good arm’s length price.

The second step is to use the Net Cost Plus Margin to

calculate the arm’s length transfer price.
To calculate the transfer price one simply has to add
the Net Cost Plus Margin to the existing total cost.
The total cost of the services is 125,000 USD.
Net Cost Plus Margin of 0.25 x 125.000= 31,250 USD
Transfer price = 156,250 USD (125.000+ 31,250).

b. TNMM II: Net Resale Minus Margin

The Net Resale Minus Margin is the ratio of EBIT to turnover (return on sales).
By using this net ratio, the comparison eliminates differences resulting from categorizing sales
under sales revenues or other revenues.
This is not allowed under the traditional transactions method Resale Minus as that method uses
information on gross sales level (and thus requires a detailed specification).
This method is often used for sales and distribution activities.
Company X provides distribution services. Associated enterprise Y asks X to provide distribution
services.
This means that X should find the terms and conditions (here: the price) of a comparable
transaction.
There are many companies around that provide comparable
services, including independent Enterprise B. X and B have
exactly the same business model.
Company X can look at Enterprise B to determine a good
arm’s length price.
first we need to find the ratio of EBIT to turnover
The second step is to calculate the arm’s length transfer
price.
Any price at which the Net Cost Plus Margin is 0.15

21
The Profit Split Method

Associated enterprises sometimes engage in transactions that are very interrelated.

Therefore, they cannot be examined on a separate basis.
For these types of transactions, associated enterprises normally agree to split the profits.
The Profit Split Method examines
the terms and conditions of these
types of controlled transactions
by determining the division of
profits that independent
enterprises would have realized
from engaging in those
transactions

Example:
In the above example, we see two comparable joint ventures.
v Joint Venture I is owned by associated enterprises Y and X.
v Joint Venture II is owned by independent enterprises A and B.
we need to determine the transfer prices to be charged for the transactions related to Joint Venture I.
For that, we can compare the terms and conditions of the controlled transactions by determining the division of
profits of comparable uncontrolled transactions.
In this example, this means that we can compare Profit Split I with Profit Split II.

There are two kinds of Profit Split Methods:

ü Contribution profit split method;
ü Residual profit split method.

Transactional profit methods:The Profit Split Method

The contribution profit split method splits profit among associated enterprises according to the
functions performed and risks assumed.
In addition, the assets are analyzed which are contributed by each entity (in particular, intangible
assets).
The application of the contribution profit split method requires careful measurement and analysis
of:
v the functions performed, risks borne and assets used by each associated enterprise.
v the allocation of cost, expense, earnings, and capital of the associated enterprises involved
in the transaction
The residual profit split method requires the identification of the routine profit for an entity as a
first step.
Any remaining profit is then split based on each party’s contribution to the earning of the non-
routine profit
for example the ownership of intangibles

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 L8- summary measures
Financial results control: main elements

Financial responsibility centers

- The apportioning of accountability for financial results within the organization
Performance measures
- Against which FRCs will be evaluated
Planning and budgeting systems
- To define targets and standards for evaluating performance
Incentive systems
- To define the links between results and various organizational incentives

Firm valueà For profit organizations should maximize the firm’s value;
Although most agree that corporations’ responsability are broader (CSR, Corporate Citizenship)
• The value of a firm in any moment can be calculated discounting the future expected cash flows;
• The discount rate incorporates the value of money and time;
Other things being equal, the value can increase:
- Increasing the size of cash flows;
- Anticipating their timing;
- Reducing the risk
Change in firm value over any given period is called economic income/profit;
Economic profit differs from accounting profit;

Economic profit vs accounting profit

Accounting profit considers solely actual revenues and costs;
Economic profit represents the excess profit that is gained from an investment over and above the profit
that could be obtained from the best alternative foregone (Rao, 1992, p. 87).
Economic profit is the difference between profit from that investment and profit from the best alternative
foregone.
In other terms, the alternative foregone's profit acts as an opportunity cost (see Buchanan, 1969).

Performance measures
Proxy measures for employees’ contribution to value creation are needed;
Proxy measures are needed expecially to assess the performance of managers and executives (profit and
investment centers)
Ideally, performance measures should go up when value is created and go down when it is destroyed

Summary measures reflect in a single number the aggregate or bottom-line impacts of multiple
performance areas
- accounting profits (R-C) reflect the effects of:
• Pricing-related decisions
• cost-related decisions
- Return on investment reflects:
• Pricing-related decisions
• cost-related decisions
• Investment decisions

23
Main typologies of summary measures
– Market measures
– Accounting measures
» Accounting profit measures
» Roi-type measures
– Residual income measures
– Combined measures
» Summary measure + disaggragated and /or non-financial
– One way of assessing value changes is by using market measures of performance
» Reflect changes in a firm’s market value:
» Share price
» Total shareholder return (TSR)
» Relative Total Shareholder return (RTSR)

Accounting profit measures

– Accounting profit measures:
» Gross profit
» Operating Income / Ebit (earning befor interest and taxes)
» Pretax income / EBT (Earning before taxes)
» Net income
» Net Income Before Preferred Dividends
» Net Income Available to Common Shareholders
» Ebitda (Earning before interest, taxes, depreciation and amortization)
– Accounting profit as margin ratios:
» Gross profit margin
» Operating profit margin
» Pretax margin
» Net profit margin
» Ebitda margin

Accounting profits per share

» EPS (Earnings per Share):
• Basic EPS
• Diluted EPS

Roi Type measures

accounting profits on the investment made to generate them
- Return on equity (ROE)
- Return on Common Equity (ROCE)
- Return on Assets (ROA)
- Operating Return on assets (Operating ROA)
- Return on Total Capital (ROTC)
- Return on capital employed (ROCE)
- Return on invested capital (ROIC)
- Return on controllable Assets (ROCA)
- Return on risk adjusted capital (RORAC)
- Risk adjusted return on capital (RAROC)
- Risk adjusted return on risk adjusted capital(RARORAC)

24
Residual income measures
- Traditional residual income measures
- EVA (Economic Value Added)

Summing up
Measures will be analyzed in terms of their:
• Congruence
• Controllability
• Precision
• Objectivity
• Timeliness
• Understandability
• Cost efficiency

Combined measures
Summary measures (and financial measures in general) can lead to distorted incentives
In order to correct them, organizations recur to combanied measures:
- Summary measures +
- Non financial measures

25
 L9- Market measures

Market measure is one of the typology of Summary measures

One way of assessing value changes is by using market measures of performance
Reflect changes in a firm’s market value:
1. Share price
2. Total shareholder return (TSR)
3. RelativeTotal shareholder return (RTSR)

Share is: A stock or "share“ is a type of security that signifies ownership in a corporation;
• It represents a claim on part of the corporation's assets
• It represents a claim on part of the corporation’s earnings
• A stockholder may also receive earnings in the form of dividends.
• The company can decide the amount of dividends to be paid in one period, or can decide to
retain all of the earnings to expand the business further.
• It attributes the power to vote
• shareholders are entitled to vote for management changes if the company is mismanaged.
There are two main types of stock:
- Common stock usually entitles the owner to vote at shareholders' meetings and to receive dividends.
- Preferred stocks generally do not have voting rights, though they have a higher claim on assets and
earnings than the common stockholders.
example, owners of preferred stock receive dividends before common shareholders and have
priority in the event that a company goes bankrupt and is liquidated.

1. SHARE PRICE

- When a stock is sold, a buyer and a seller exchange money for share ownership.
- The stock's price fluctuates based on supply and demand;
- The more demand for a stock, the higher it drives the price and vice versa.
- The more supply of a stock, the lower it drives the price and vice versa
- There are many factors that affect share prices (global economy’s trends, sector performance,
government policies, natural disasters, and other factors).
- Investor sentiment – how investors feel about the company’s future prospects – often plays a
large part in dictating price.
- The price movement of a stock indicates then what investors feel a company is worth;
- If investors are confident about a company’s ability to rapidly grow and eventually produce
large returns on investment, then the company’s stock price may be well above its current
intrinsic, or actual, value

Volatility à
• Stock exchange markets always experience (big) swings in the security’s price value in
either direction at some point.
• In finance, the degree at which the security’s price in the market moves up or down for a
certain period of time is called volatility;
• Generally, volatility is a metric used by investors in the stock exchange market to gauge
how risky securities maybe;
• Volatile assets are often considered riskier than less volatile assets because the price is
expected to be less predictable.
• Volatility represents how large prices swing around the mean price;
• In other terms, volatility is a measure of the dispersion of returns for a given security or
market index.

26
 • Volatility is often measured as the standard deviation between returns from that same
security or market index (over a period of time).

Standard deviation: recall

• The standard deviation measures the dispersion of a dataset relative to its mean;
• It is calculated as the square root of the variance, determining the variation between each
data point relative to the mean.
• If the data points are further from the mean, there is a higher deviation within the data set;
• thus, the more spread out the data, the higher the standard deviation.

Standard deviation: recap

• When referred to a security’s price, standard deviation measures the amount of dispersion
in a security’s prices.
• The greater the standard deviation of securities, the greater the variance between each
price and the mean, which shows a larger price range.
• For example, a volatile stock has a high standard deviation, while the deviation of a
stable stock is usually rather low

Example:
Gather the security’s past prices.
Calculate the average price (mean) of the security’s past prices. Determine the difference between each price in
the set and the average price. Square the differences from the previous step. Sum the squared differences. Divide
the squared differences by the total number of prices in the set (find the variance).
Calculate the square root of the number obtained in the previous step.
You want to find out the volatility of the stock of ABC Corp. for the past four days.
The stock prices are given below: - Square the difference from the previous
§ Day 1 – $10 step:
§ Day 2 – $12 Day 1: (-1.25)2 = 1.56
§ Day 3 – $9 Day 2: (0.75)2 = 0.56
§ Day 4 – $14 Day 3: (-2.25)2 = 5.06
- Find the average price: Day 4: (2.75)2 = 7.56
$10 + $12 + $9 + $14 / 4 = $11.25 - Sum the squared differences:
- Calculate the difference between each 1.56 + 0.56 + 5.06 + 7.56 = 14.75
price and the average price: - Find the variance:
Day 1: 10 – 11.25 = -1.25 Variance = 14.75 / 4 = 3.69
Day 2: 12 – 11.25 = 0.75 - Find the standard deviation:
Day 3: 9 – 11.25 = -2.25 Standard deviation = 1.92 (square root of
Day 4: 14 – 11.25 = 2.75 3.69)

Historical vs Implied volatility

Historical Volatilityà This measures the fluctuations in the security’s prices in the past.
Implied Volatilityà It provides a forward-looking aspect on possible future price fluctuations
and captures the market's view of the likelihood of changes in a given security's price.

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2. SHAREHOLDERS RETURN

The return from any stock investment consists of two main components:
- Capital gains
- difference of the current stock price and its purchase price.
- rise in the value of a capital asset that gives it a higher worth than the purchase price.
(The gain is not realized until the asset is sold).
- Dividends
- A dividend is the distribution of reward from a portion of company's earnings and is paid
to a class of its shareholders

Total shareholder returnà The value created for shareholders can be measured for any period
(monthly, yearly, quarterly) as:

The change in the market value of the stock (capital gain) +The sum of dividends paid to shareholders
in the period

Whichever way it is calculated, TSR means the same thing: the total amount returned to investors

TSR formula
(Current share price – share purchase price) + dividends
------------------------------------------------------------------------------------ X 100
Share purchase price
Example:
TSR = (Current price – purchase price)+dividends / Purchase price x 100
For example, an investor buys 100 shares of a stock at the rate of $10 per share.
His total investment would be $10 x 100 = $1000.
Assume that the investor has chosen to hold onto this stock for the long term.
For a measured interval l1 the company has paid out a total dividend of $2 per share, while the share
price appreciated to $12.
{($12 – $10) +$2} / $10 = 2+2/10 = 4/10 = 0.4
0.4 x100 = 40%
TSR for I1= 40%

3. RELATIVE PERFORMANCE EVALUATION

TSR is mostly use in terms of relative performance evaluations

RPE (relative performance evaluations) means that performance is evaluated:
NOT in term of the absolute level of performance
In comparison of units or groups of units: Performing the same tasks; Facing the same constraints
and opportunities
Relative Total Shareholder Returnà RTSR
• Long-term change in a share price is due to broad macroeconomic factors and to industry-
specific factors rather than to company-specific performance; (share price is somehow out of
management’s control.)
• To rule out the effects of general and specific market conditions and to isolate relative
performance, firms recur to relative total shareholder return (RTSR);
• RTSR positions the performance of a company against that of chosen peers and/or relevant
indices (measured in the same way over the same time period.)

28
Using RTSR: When RTSR is used as a performance measure, there are several choices to be made:
- Selection of the peer group
- Averaging period for the share price assumed at end of period and beginning of period
(Since RTSR is a naturally volatile incentive metric, companies commonly employ stock
price averaging to smooth out the impact of daily stock price movements)
- Assumption (or otherwise) of dividend equivalents during performance period
- Performance period chosen

RTSR: selection of the peer group

The selection of an RTSR peer group is a critical factor in the establishment of an RTSR program.
There are three categories of peer groups used by companies to benchmark RTSR:
- Multi-sector index—a broad-based index comprising multiple sectors such as the S&P
500 or two or more sectors within a broad-based index
- Single-sector index—an index comprising a single sector, such as an S&P sector index or
non-S&P index such as the MSCI US REIT Index; other examples include the S&P 500
Utility Index or S&P 1500 Utility Index.
- Custom peer groups—the custom compensation benchmarking peers or custom
performance peers.

Broadly selected peers can introduce a substantial amount of market volatility into the plan (and
make employees feel discontented with potential payout outcomes);
To build custom peer groups, companies typically start by looking at factors such
- industry
- sector
- revenue size
- business size (headcount or operational scale)

Averaging period
• Another important aspect of RTSR calculations to consider during the design process is the
length of the averaging period.
TSR is a naturally volatile metric
• Companies use averaging periods to:
ü smooth out the stock price around the start and end points of the performance period
ü Minimize the risk of a single day extreme impacting the measurement of long-term
shareholder return.
• Plans could use, for example:
ü averaging periods that are one calendar month or twenty trading days.
ü averaging periods tend to be slightly longer ( ex. three months in length).

Relative TSR prevalence and design of S&P 500 companies, 2018

• Among those companies disclosing averaging periods:
ü approximately 60% use a period of one to four weeks
ü (e.g., five trading days to 30 calendar days), with 20 trading or 30 calendar days being
the most prevalent periods.
• Among the remaining companies:
ü 25% use a period of five to ten weeks (e.g., 45 calendar or 25–30 trading days),
ü and 15% a period of 90-calendar days or longer.

29
 Treatments of dividends
There are four dates to conceptually be aware of with respect to dividends:
• Declaration Date: The date on which a company announces an upcoming dividend payment;
• Ex-Dividend Date: After the record date has been determined, then the ex-dividend date is
assigned. If an investor buys a stock before the ex-dividend date, then he or she will receive the
dividend payment. If an investor purchases the stock on or after the ex-dividend date, then he or
she is not entitled to receive the dividend
• Record Date: A dividend record date is the date on which the company finalizes the list of investors
who qualify as "shareholders of record." Investors listed as shareholders of record will receive the
firm's dividend payment;
• Payable Date: A dividend payable date is the date on which a company pays a dividend to its
shareholders of record.

Use of RTSR in performance plans

Companies typically employ RTSR in one of two ways:
• discrete metric within a performance plan à Used as a discrete metric, RTSR is assigned a
weighting within the performance plan
- (e.g.,a RTSR 50% and return on capital 50)
• modifier to a financial metricà As a modifier, RTSR generally adjusts performance plan
payouts, which typically measure a non-market metric (e.g., return on capital).
- RTSR modifiers provide for upward or downward adjustment to plan payouts (e.g., a
modifier of +/- 25%)

Use of RTSR as a performance metric

When RTSR is used as a performance metric a company initially implements a relative TSR plan,
one of the first decisions plan designers must make is to determine how the company will be
measured vs. its peers.
There are two general approaches :
• Outrank plans determine the payout ultimately earned by ranking a company's TSR against
the shareholder return of a defined peer group (e.g. 100% of target is earned if the company's
TSR is at the 75th percentile against the peer group).
• Outperform plans determine the payout based on the magnitude of outperformance or
underperformance against a benchmark TSR level (e.g. 100% of target is earned if the
company's TSR exceeds the index TSR by 25 percentage points)

Using RTSR: Outranking plan

Outrank plans determine the payout
ultimately earned by ranking a
company's TSR against the
shareholder return of a defined peer
group
ü (e.g. 100% of target is earned
if the company's TSR is at the
75th percentile against the
peer group).
Steps:
1. A ranking of TSR results for each comparator company is established (from top to
bottom)
2. Once this step is complete, a simple percentile rank calculation is performed to
determine exactly where the subject company ends up in the peer group.
Each position in the peer group corresponds to a predetermined payout level
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 RTSR Outperformance plans
Outperform plans determine the payout based on the magnitude of outperformance or
underperformance against a benchmark TSR level
(e.g. 100% of target is earned if the company's TSR exceeds the benchmark index TSR
by 25 percentage points)
In this case, the comparator group is used to create a single benchmark performance level
around which all potential payouts are determined.

• Maximum at 50% above Benchmark: payout 200%

• +1 Percent Above Benchmark: payout 102%
• Benchmark: Median of NASDAQ 100: payout 100%
• -1 Percent Below Benchmark: payout 98%
• Threshold at 50% below Benchmark: payout 50%

Ability to measure results effectively

Measurement properties:
a. Congruenceà
Market measures are the most direct manifestation, or closest proxy, of the firm value and its
change (especially for exchange listed firms)
Measurement congruence allays political pressures that outsiders might bring in the firm
But the cons/limitations are that:
§ Market measures incorporate future expectations
§ These expectations however might not be realized
§ It is then risky to build incentives systems on expectations
Example: What TSR primarily measures is a shift in shareholder expectations about future
cash flows
there is no necessary alignment between TSR performance and longer term shareholder
interests.
§ Market measures are oversensitive to news (ex political events, appointments, new project,
etc
This is a trigger for opportunistic behaviours
Executives can try to affect market valuations trhough carefully-timed or “managed
disclosures” that are not in the firm’s long-term interest
Example: provoking downward or upward effect on stock prices for granting or exercising
stock option
§ Due to competitive sensitivities, firms might keep information confidential;
§ markets are not always fully informed about a company’s plans and prospects
and hence, its future cash flows and risks
§ If rewards are linked to market evaluations, executive might be tempted to disclose
information even if it harms the firm;
§ Other “anomalies”:
Monday effect is a theory that states that returns on the stock market on Mondays
will follow the prevailing trend from the previous Friday.
Cross. F. (1973), “The Behavior of Stock Prices on Fridays and Mondays
The January effect is a seasonal increase in stock prices during the month of
January.
Analysts generally attribute this rally to an increase in buying, which follows the
drop in price that typically happens in December when investors, engaging in tax-
loss harvesting to offset realized capital gains, prompt a sell-off.

31
 Another possible explanation is that investors use year-end cash bonuses to
purchase investments the following month.

b. Precision and accuracyà precision is There is no or little random error (in well-functioning capital
markets); accuracy is There is no or little systematic bias (in well-functioning capital markets)
Precision and accuracy: the problems with intra-period volatility:
• As we can see, TSR performance is volatile and intra-period volatility poses some problems;
• The returns achieved by investors are entirely dependent on when they invested within the TSR
calculation period used by a company;
• The hold period for shares by shareholders will need to coincide exactly with the TSR
calculation period for the interpretation to be drawn that shareholder wealth increased of
decreased.
• A strict point-to-point interpretation of TSR is not a reliable indicator of wealth creation;
• As a point-to-point measure, then, TSR per se does not necessarily reflect a fair and reasonable
view of shareholder returns over a measurement period;
• The investor’s actual return experience is the reality that lies between the two data points that
make up TSR.

c. Objectivityà
not (easily) manipulable by the managers whose performances are being evaluated

d. Timelinessà
- Market measures are timely available for publicly traded firms;
- Market measures are not available for: privately-held firms and wholly-owned subsidiaries or
divisions
- Market measures are not applicable to not-for-profit organizations

e. Understandabilityà
Market measures are understandable in terms of what the measure represent
Changes in market value

f. Cost efficiencyà
Collection of market measures do not require any company measurement expense

g. Controllabilityà
Market measures can generally be affected to a significant extent only by the top few managers in
the organization
those who have the power to make decisions of major importance
Even for top managers there are many uncontrollable factors
– Economic growth
– Political climate (es election results)
– Monetary policy (Interest rate)
– Industry events (es oil spill)
– Market mood (Bearish vs bullish)
– See previous discussion on RTSR

32
 L10- Accounting profit measures. (part 1)

Accounting profit measures Accounting profit measures (as ratios):

• Gross profit • Gross profit margin
• Operating Income / Ebit (earning before • Operating profit margin
interest and taxes) • Pretax margin
• Pretax income / EBT (Earning before • Net profit margin
taxes) • Ebitda margin
• net income • EPS (Earnings per Share):
o Net Income Before Preferred o Basic EPS
Dividend o Diluted EPS
o Net Income Available to Common
Shareholders
• Ebitda (Earning before interest, taxes,
depreciation and amortization

Income statement

Revenues
- Cost of goods sold (COGS)
= Gross Profit (a)
- Operating Expenses
• Selling expense
• Administrative expense
• Depreciation expense
=Operating Income (Earning Before Interest and Taxes) (c)
- Interest Expenses
=Pretax Income (Earning Before Taxes)
- Income Tax
=net income

Revenues
- of goods sold (COGS)
= Gross Profit
- Operating Expenses
• Selling expense
• Administrative expense
• Depreciation expense
= Operating Income (Earning Before Interest and Taxes) (c)
- Interest Expenses
= Pretax Income (Earning Before Taxes)
- Income Tax
= Net Income Before Preferred Dividends
- Preferred share dividends
= Net Income Available to Common Shareholders

33
a. Gross Profit
Revenues : the amount received from customers in exchange for the goods or services provided by
the company.
Cost of good sold: Cost of goods sold (COGS) refers to the direct costs of producing the goods sold
by a company.
v for a retailer or wholesaler, the cost of goods sold is simply the amount paid for the
inventory that is then sold to the company’s customers.
v For a manufacturer, COGS is the sum of the raw materials and direct labor incurred to
manufacture the company’s products.

Revenues-COGS= Gross Profit

Gross profit represents the amount available to pay for the company’s operating expenses and
other expenses and to generate profit.

b. Gross Profit Margin (also Gross Profit ratio)

Gross profit/Revenues (sales) x100

indicates the percentage of revenue available to cover operating and other expenses and to
generate profit.

• Higher gross profit margin indicates some combination of higher product pricing and lower
product costs.
• The ability to charge a higher price is constrained by competition, so gross profits are
affected by (and usually inversely related to) competition.
• If a product has a competitive advantage (e.g., superior branding, better quality, or
exclusive technology), the company is better able to charge more for it.
• On the cost side, higher gross profit margin can also indicate that a company has a
competitive advantage in product costs.
• Comparing gross margins to those of peers can reveal differences in strategy among firms;
• A company focused on product differentiation would generally expect to report gross
margins in excess of their peers;
• one focused on cost advantages may be willing to accept a lower gross margin in the
expectation that operating expenses will be lower.

Example: Manufacturer ‘Alpha’ has recorded net sales revenue worth 100.000 Its cost of goods sold
(COGS) for the same period is 40.000. Gross Profit = 100.000 – 40.000 = 60.000. Gross Profit Margin =
60.000 / 100.000 = 0.6 x100=60%

c. Operating Income (operating profit or EBIT)

Operating expenses : Operating expenses include selling, general, and administrative

expense (SG&A), depreciation, and amortization, and other operating expenses.
These overhead activities are incurred to both service existing customers and to acquiring new
customers and developing new products.

Gross Profit- Operating Expenses = Operating Income (EBIT, or earnings before interest and taxes)

Operating income is an important point of comparison to other firms;

It is the lowest level of earnings that is unaffected by sources of financing;
In other words, a company’s operating income/margin reflects the efficiency with which it converts
revenue to profits before taking interest expense into account.
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d. Operating Profit Margin

Operating profit (EBIT)/ Revenues (sales) x100

A company’s operating margin reflects the efficiency with which it converts revenue to profits
before taking interest expense into account.
Therefore, an operating profit margin increasing faster than the gross profit margin can indicate
improvements in controlling operating costs, such as administrative overheads.
In contrast, a declining operating profit margin could be an indicator of deteriorating control over
operating costs.
Example:
• Company “Beta” earned total sales revenues of $25M;
• The cost of raw materials and supplies used for the sold products was $9M
• labor costs directly applied were $2M
• administrative and staff salaries totaled $4M
• depreciation and amortizations totaled $1M.
• Operating Income (Ebit) = 9 M
• Operating profit margin = Operating profit (EBIT)/ Revenues= 9/25= 0,36 x100= 36%

e. Pretax income (Profit Before Tax or EBT)

Lenders receive current returns in the form of interest payments.

Interest payments are recorded as expense on the income statement
the amount of interest expense is not correlated with the amount of revenue or operating income
generated by the company during the period.

Operating Income - minus interest= Pretax income ( “earnings before tax” or “EBT”)

Pretax income (or Profit before tax or EBT) is a measure that looks at a company's profits before
the company has to pay corporate income tax.
It deducts all expenses from revenue including interest expenses and operating expenses except
for income tax

f. Pre-Tax Margin
Pretax income (EBT) /Revenues x100

The pretax margin reflects the effects on profitability of leverage and other (non-operating)
income and expenses.
If a company’s pretax margin is increasing primarily as a result of increasing amounts of non-
operating income, the analyst should evaluate whether this increase reflects a deliberate change in
a company’s business focus and, therefore, the likelihood that the increase will continue.

35
g. Net Income (Net Profit)

The final deduction in calculating net income is income tax expense.

For taxable entities, income tax expense will ordinarily be proportionate to the reported pre-tax
income.

revenues - all expenses = net income or net profit

Net income is found by taking sales revenue and subtracting COGS, SG&A, depreciation, and
amortization, interest expense, taxes and any other expenses
Net income is the change in shareholders’ equity during the period resulting from the operations of
the business.

h. Net Profit Margin (Net Profit Margin Ratio, After Tax margin)

Net Profit Margin is a financial ratio used to calculate the percentage of profit a company produces
from its total revenue.
It measures the amount of net profit a company obtains per dollar of revenue gained.

Net Income/Revenues x100

Generally, the net income used in calculating the net profit margin is adjusted for non-recurring
items to offer a better view of a company’s potential future profitability.

Example:
• Net Profit Margin = Net Profit/Revenue x100
Company XYZ:
• Net Profit Margin = Net Profit/Revenue =
$30/$100 = 30%
Company ABC:
• Net Profit Margin = Net Profit/Revenue =
$80/$225 = 35.56%
• Company ABC has a higher net profit margin

Year 5 Year 4 Year 3 Year 2 Year 1

Revenues 78.924 98.469 101.569 99.222 95.209

(millions euros)

Gross Profit margin 16,92% 21,89% 23,62% 20,60% 19,48%

Operating profit (EBIT) -1,92% 2,77% 8,58% 5,03% 3,02%

margin

Pre tax Margin -2,91% 2,84% 9,04% 4,94% 2,55%

Net profit margin -3,35% 1,73% 4,78% 3,19% 2,37%

36
 L10- Accounting profit measures (part 2)

i. EBITDA

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization

Ebitda is a metric used to evaluate a company’s

operating performance.
It is not a standardized measure under IFRS or US
GAAP.
EBITDA focuses on the operating decisions of a
firm because it looks at the
business’ profitability from its core operations
before the impact of capital structure, leverage,
and non-cash items such as depreciation are
taken into account.

example:

Company XYZ accounts for their $20 depreciation and amortization expense as a part of their operating
expenses.
EBITDA = Net Income + Tax Expense + Interest Expense + Depreciation & Amortization Expense
$25 + $20 + $10 + $20
= $75

Alternative formulas:
• EBITDA = Revenue – Cost of Goods Sold – Operating Expenses + Depreciation &
Amortization Expense
• EBITDA = Operating income (EBIT) + Depreciation & Amortization Expense

Backgroundà
• The notion of EBITDA came into widespread use during the late 1980s amid the leveraged
buy-out (LBO) boom.
• A leveraged buyout is the acquisition of another company using a significant amount of
borrowed money (debt) to meet the cost of acquisition.
• Because of the high debt/equity ratio, the bonds issued in the buyout are usually are not
investment grade and are referred to as high yield bonds.
• The proliferation of EBITDA as a financial metric was encouraged by LBO promoters, and
other parties with interests in the issuance of highyield securities;

37
 • The primary usage of EBITDA was highlighting to prospective investors in high–yield
securities that the debt servicing capacity of highly leveraged companies was more
accurately reflected in an EBITDA cover ratio than other traditional interest cover ratios
such as EBIT/Interest.
v to calculate quickly whether these companies could pay back the interest on these
financed deals.
• They argued that non-cash charges could be added back to EBIT, given the assumption
that adequate investment had been made in fixed assets prior to a an LBO;
v negligible Capex would be required over the intermediate period post – LBO;
• As a result, high-yield investors gravitated towards EBITDA-based liquidity ratios as a key
measure of debt servicing capacity
• Beside its original purpose to assess LBOs, EBITDA and EBITDA-based ratios became
widely accepted;
• During the 1990s, the rationale supporting EBITDA was that it supplied a superior measure
of operating earnings versus the traditional measure of EBIT;
• Therefore, it was argued that EBITDA provided equity investors with a more accurate
reflection of not only a company’s debt servicing capacity but also its underlying operating
earnings, operating margins and return on invested capital.
• Today EBITDA and its derivative ratios are a standard feature in a wide variety of financial
market information sources.

Logic behind Ebitda:

Interest
• Interest is excluded from EBITDA, as it depends on the financing structure of a company.
• It is determined by the money the firm has borrowed to fund its business activities.
• Different companies have different capital structures, resulting in different interest
expenses.
• Hence, it is easier to compare the relative performance of companies by adding back
interest and ignoring the impact of capital structure.
Taxes
• Taxes vary and depend on the tax jurisdiction where the firm is operating.
• They are a function of tax rules in use;
v They are not part of assessing a management team’s performance;
• Therefore, many financial analysts prefer to add them back when comparing different
firms.

Depreciation and amortization

• Depreciation and amortization (D&A) depend on the investments the company has made in
the past and not on the current operating performance of the business.
v The depreciation expense is based on a the company’s tangible fixed assets losing value
over time;
v Amortization expense is incurred if the asset is intangible. Intangible assets such as
patents are amortized because they have a limited useful life (competitive protection)
before expiration.
• D&A is heavily influenced by assumptions regarding useful economic life, salvage
value, and the depreciation method used.
• Therefore, analysts may find that operating income is different than what they think the
number should be, and therefore D&A is backed out of the EBITDA

38
Arguments pro EBITDA
Promoters of EBITDA stress that:
ü EBITDA is a widely used metric of profitability;
ü EBITDA is a good measure of core profit trends because it not distorted by differences in
accounting treatments of depreciation and amortisation, the effects of financial leverage
and varying tax rates and treatments
ü Hence it facilitates comparable company analysis against each other, against industry
averages on both a country–specific and global basis;
ü It can can be seen as a proxy for cash flow from the entire company’s operations or at least
provide a starting point in the calculation of cash flow;
ü EBITDA provides an indication of the potential debt burden that a business can endure, via
liquidity measures such as EBITDA/Interest and Debt/EBITDA;
ü EBITDA provides a key input in valuation analysis, in particular EV/EBITDA valuation.

Warren Buffet on Ebitda

“It amazes me how widespread the use of EBITDA has become. People try to dress up financial
statements with it.”
“We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies,
and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a
lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never
use EBITDA in their annual report.”
Warren Buffett is credited with having said, “Does management think the tooth fairy pays for capital
expenditures?”

Arguments against EBITDA

• Some investors and analysts criticize EBITDA;
• Some are skeptical of using it because it presents the company as if it has never paid any
interest or taxes, and it shows assets as having never lost their natural value over time;
• For example, if a company has a large amount of depreciable equipment (and thus a high
amount of depreciation expense), then the cost of maintaining and sustaining these capital
assets is not captured.
• It assumes that profitability is a function of sales and operations alone – almost as if the
assets and financing the company needs to survive were a gift
• For example, a fast-growing manufacturing company may present increasing sales and
EBITDA year over year.
• To expand rapidly, it might have acquired many fixed assets over time and all were funded
with debt.
• Although it may seem that the company has strong top-line growth, investors should look
at other metrics as well, such as capital expenditures, cash flow, and net income.
• As an example, imagine a company that has no other assets other than multiple factories
under its Property, Plant, and Equipment asset account.
• Naturally, over time, these factories would lose value as they age and are used up.
• Using EBITDA as a means of valuing this company would be entirely fallacious, as it would
not account for the loss in value that the factories are experiencing.
• Using EBITDA, in this case, would overstate the company’s earnings, and thus, overstate
their value.
• A company that spends zero money on capital expenditures could be well suited to
use EBITDA but this applies to almost no businesses.
• A recurrent criticism is that companies could tend to spotlight their EBITDA performance
when they do not have very impressive net income.
• It's not always a telltale sign of malicious market trickery, but it can sometimes be used to
distract investors from the lack of real profitability.
39
à Putting EBITDA In Perspective, Moody’s Investors Service (2000): summary points

• The use of EBITDA and related EBITDA ratios as a single measure of cash flow without
consideration of other factors can be misleading.
• EBITDA is probably best assessed by breaking down its components into
EBIT,Depreciation, and Amortization. Generally speaking, the greater the percentage
of EBIT in EBITDA, the stronger the underlying cash flow.
• EBITDA is relevant to determining cash flow in its extremis. EBITDA remains a
legitimate tool for analyzing low-rated credits at the bottom of the cycle. Its use is less
appropriate, however, for higher-rated and investment grade credits particularly mid-
way through or at the top of the cycle.
• EBITDA is a better measurement for companies whose assets have longer lives – it is
not a good tool for companies whose assets have shorter lives or for companies in
industries undergoing a lot of technological change.
• EBITDA can easily be manipulated through aggressive accounting policies relating to
revenue and expense recognition, asset writedowns and concomitant adjustments to
depreciation schedules, excessive adjustments in deriving “adjusted pro-forma
EBITDA,” and by the timing of certain “ordinary course” asset sales.

Ten critical failings of using EBITDA as the principal determinant of cash flow:

1. EBITDA ignores changes in working capital and overstates cash flow in periods of
working capital growth
2. EBITDA can be a misleading measure of liquidity
3. EBITDA does not consider the amount of required reinvestment – especially for
companies with short lived assets
4. EBITDA says nothing about the quality of earnings
5. EBITDA is an inadequate standalone measure for comparing acquisition multiples
6. EBITDA ignores distinctions in the quality of cash flow resulting from differing
accounting policies – NOT all revenues are cash
7. EBITDA is not a common denominator for cross- border accounting conventions
8. EBITDA offers limited protection when used in indenture covenants
9. EBITDA can drift from the realm of reality
10. EBITDA is not well suited for the analysis of many industries because it ignores their
unique attributes

à EVA, Not EBITDA: A Better Measure of Investment Value; Bennett Stewart (2019)

1. EBITDA does not encourage discipline around soliciting or investing capital. Managers
need never worry about generating a decent return on capital or even a return of the
original capital investment because capital, in the EBITDA world, is a free resource.
2. EBITDA ignores the value of managing assets and accelerating asset turnover, which
results in releasing superfluous capital.
3. EBITDA systematically understates the value of outsourcing. Consider a company that
sells its technology assets and converts to third-party cloud operations. Cost increase to
pay for the outsourced services reduce EBITDA. But EBITDA ignores the benefit of selling
the associated assets and releasing capital.
4. EBITDA overstates the value of vertical integration. Why ever farm out production or
distribution, and give up some margin? The correct answer is that shedding capital may be
worth more than losing the margin. But again, EBITDA is blind to that.

40
 5. EBITDA favors higher margin products and services, regardless of the additional capital
those lines may need compared to lower margin lines.
6. EBITDA sees no benefit in lowering a company’s tax bill or using loss carryforwards.
7. With EBITDA, there’s never a value to selling or exiting a business if it is profit positive.
And yet, selling or exiting poor performing and time-sapping units and lavishing attention
on the remaining ones can add a lot value.
8. EBITDA is distorted by bookkeeping rules that do not always reflect economic reality
(for instance, expensing R&D outlays, or deducting reported pension costs.
9. EBITDA is not mathematically connected to value.

à EBITDA Margin
EBITDA margin is a profitability ratio that measures how much in earnings a company is
generating before interest, taxes, depreciation, and amortization, as a percentage of revenue.

EBITDA Margin = EBITDA / Revenues x 100

The margin does not include the impact of the company’s capital structure, non-cash expenses,
and income taxes.
If a company has a low net income, it might be tempted to use the EBITDA margin as a way to
inflate its financial performance.

j. Earnings per share (EPS)

• Earnings per share (EPS) is an indicator of a company's profitability.
• Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares
of its common stock.
• There are two main types of stock:
• Common stock usually entitles the owner to vote at shareholders' meetings and to receive
dividends.
• Preferred stocks generally do not have voting rights, though they have a higher claim on assets
and earnings than the common stockholders.

Earnings per share (EPS):

ü Basic EPS
ü Diluted EPS

Basic Earning per share

The most common formula to calculate Basic EPS is:

Basic EPS = (Net Income – Preferred Dividends) / Weighted Average Shares Outstanding

The number of shares of a company outstanding is not constant and may change at various times
throughout the year, due to a share buyback, new issues, etc
Therefore using the number of shares outstanding at the end of a period would be inaccurate and
provide a distorted view of EPS.

Weighted Average Shares Outstanding

The weighted average of outstanding shares is a calculation that takes into consideration any
changes in the number of outstanding shares occurred over a specific reporting period.
In general, the weighted average is a mean value calculated by averaging each quantity against an
assigned weighting to determine the relative importance of each quantity.
41
The weighted average number of shares is determined by taking the number of outstanding shares
and multiplying it by the percentage of the reporting period for which that number applies for each
period.
In other words, the formula takes the number of shares outstanding during each month weighted
by the number of months that those shares were outstanding.

A company has 100,000 shares outstanding at the start of the year.

Halfway through the year, it issues an additional 100,000 shares, so the total amount of shares outstanding
increases to 200,000.
If at the end of the year the company reports earnings of $200,000, which amount of shares should be used to
calculate EPS: 100,000 or 200,000?
If the 200,000 shares were used, the EPS would be $1, and if 100,000 shares were used, the EPS would be $2

Basic eps example:

à Diluted Earnings per share

Diluted EPS is a calculation used to gauge earnings per share (EPS) if all convertible securities were
exercised
ü stock options, warrants, convertible preferred shares, convertible debentures;
The conversione would increase the total number of shares outstanding in the market

Diluted EPS = (net income – preferred dividends) / (weighted average number of shares
outstanding + the conversion of dilutive securities)

Earnings per share (EPS):

• The earnings per share metric are one of the most important variables in determining a
share's price.
• It is also a major component used to calculate the price-to-earnings (P/E) valuation ratio,
where the E in P/E refers to EPS.
• By dividing a company's share price by its earnings per share, an investor can see the value
of a stock in terms of how much the market is willing to pay for each dollar of earnings.

42
Using EPS within performance plans
• There has been a decline in the use of earnings-based metrics as Total Shareholder Return
(TSR) has overtaken as the top long-term performance metric used.
• The decline in use of EPS as a performance metric mirrors that overall trend.
• While EPS is popular in part due to its use as a measure of investability and as a common
benchmark for performance, there are concerns about using EPS as a metric in
performance awards
Reliability problems
• some institutional investors and regulators view EPS as easy to manage, through either
“numerator” or “denominator” changes:
ü Earnings (numerator) can be impacted through various earnings management techniques
ü Number of shares outstanding (denominator) can be impacted through share buybacks.
ü The effect is to prop up EPS results to achieve performance targets when financial results
are just short of expectations.
Short-termism
ü management focus on EPS, or more broadly on EPS as a proxy for stock price, can lead to
decisions that will prop up EPS in the short-term, but are not in the long-term interest of
the company.
ü Stock buybacks are one notable example, with cash used to buy back stock instead of other
potential uses such as R&D, capital expenditures, acquisitions, or dividends.
Unpredictability
ü EPS is one of the most volatile metrics (too many moving parts in the numerator and
denominator calculations) and may not be suitable as a performance metric for many
companies, particularly for long-term awards.

43
 L10- Accounting profit measures (part 3)

Ability to measure results effectively

Measurement properties

a. Congruence:
Pros:
» In for-profit firms, accounting profits or returns are relatively congruent with the
true firm goal of maximizing shareholder value
» Positive correlations between accounting profits and changes in stock prices
» (the longer the measurement period, the higher the correlation)
Limitation:
à Accounting profits provide lagged indicators of economic income perfectly
àChanges in economic income are reflected only later in accounting profit measures
àTrade off between timeliness and congruence

Economic income àThe change in the value of the entity over a given period, where “value” is
obtained by discounting future CFs

Accounting income does not reflect economic income perfectly because accounting measures
are:
§ transaction oriented: sum of the transaction that happen
o Accounting profits are the sum of the effects of the transactions occured during a given period;
o Those changes in value that do not result in transactions are not acknowledge in accounting
profits; (Ex a firm is issued regulatory approval or receives a patents)
§ dependent on the choice of measurement method
o Multiple measurement methods can be available to account for the same economic event;
§ (Ex. Depreciation account choices (straight line vs accelerated))
§ Longer live of an asset spreads the costs over the years, thus affecting accounting
profits
§ derived from rules that are conservatively biased
o Accounting rules requires: Slow recognition of gains and revenues and Quick recognition of losses
and costs
o Measurement periods are shorter than firms’ investment payoff horizons
§ overlook relevant values
o Investments in most major categories of intangible assets are expensed immediately (research in
progress, human resources); Do not appear on balance sheet
o These type of assests are often as important as some old industrial era assets (plants and
equipments)
§ ignore the cost of equity capital
o Profits reflect instead the cost of borrowed capital through interest deductability
§ If a business has issued bonds, which is essentially a loan to the business, the
organization will have to pay interest on those loans;
§ The interest paid to bondholders reduces the business' revenue and therefore decreases
the amount of taxable income the business will claim.
o Since a firm earn real income only when return on capital >cost of capital, ignoring the cost of
equity capital:
§ overstates difference between return and costs (profit)
§ hinders comparison between firms with different debt/equity proportion
o Cost of equity capital is higher for companies with riskier stocks.
§ ignore risk and Changes in risk
o Entities or firms that keep the pattern of timing of expected future cash flows, but make them
more certain:
o Have increased their economic value
44
 o Will not see that value change reflected in accounting profits
§ focus on the past
o Value increases due to expections, while accounting profits are created by realised transactions;
o Past performance, however is not an indicator of future performance

Firm valueàFor profit organizations should maximize the firm’s value although most agree that
corporations’ responsibility are broader (CSR, Corporate Citizenship)
• The value of a firm in any moment can be calculated discounting the future expected cash flows;
• The discount rate incorporates the value of money and time;
Other things being equal, the value can increase:
§ Increasing the size of cash flows;
§ Anticipating their timing;
§ Reducing the risk
Change in firm value over any given period is called economic income/profit;
Economic profit differs from accounting profit;

Economic profit à represents the excess profit that is gained from an investment over and above
the profit that could be obtained from the best alternative foregone (Rao, 1992, p. 87). Economic
profit is the difference between profit from that investment and profit from the best alternative
foregone. In other terms, the alternative foregone's profit acts as an opportunity cost (see
Buchanan, 1969).

Accounting profità considers solely actual revenues and costs

Myopia:
Accounting profit measures can lead to two main types of behavioural misplacement:
» Investment myopia: Investment myopia is mainly related to the “intangibles”
problem and to the “conservative bias”;
In order to boost profits or returns in the short term, managers might not make
investments that are expensed now but promise payoffs only in future
measurement periods:
even worthwhile ones ( positive NPV); R&D projects; Employee development
initiatives; Customer acquisition initiatives
Thus managers produce accounting profits in the short term, harming value in the
long term
Investment myopia might occur also in the form of manipulative earning
management practices;
This occurs when operating expenses: are not booked immediately/ Are pushed in
the future as capital investments

» Operational myopia: Operational myopia occurs when managers make operational

decisions to boost short term profits even when harmful long-term;
I. Forcing staff to overtime at the end of the measurement period to finish
production and generating revenues immediately;
II. Cutting corners and ship lower quality products at the end of the
measurement period to generate revenues immediately;
III. Channel stuffing, i.e. boosting near term sales by extending lower prices to
distributors
In the long term, these practices might harm goodwill built with customers, staff,
suppliers

45
b. Precision and accuracyà
Accounting rules are generally set in details by domestic rule-makers;
Domestic rules are coordinated by international principles;
Therefore, different people assigned to measure the profit of a unit will likely arrive to the same
results

c. Objectivityà
Independents auditors provide, mandatorily or voluntarily, objectivity checks of accounting
calculations
Publicly traded firms
Privately held firms that require bonds or equity capital

d. Timelinessà
Accounting profits and returns can be measured in short time periods

e. Understandabilityà

f. Cost efficiencyà
Using accounting summary measures is pretty inexpensive;
Firms have to measure, report and disclose financial results to ouside users;
In order to obtain funding (debt or equity) firms need to report results to fund providers

g. Controllabilityà

46
 L11- ROI type measures (Part 1)

ROI performance measures

Return on Investment (ROI) is a performance measure used to evaluate the profitability of an investment
ROI is a ratio of the accounting profits earned divided by the investment base
ROI = profits ÷ investment base
express as a percentage ie. (x100)

(Beginner’s) Example
For example, suppose Joe invested $10,000 in a business and realized a total of profit $2000 ;
To calculate his return on his investment, he would divide his profits ($2000) by the investment ($10,000);
ROI = 2.000/10.000= 0,2 (x100)= 20%
With this information, he could compare his investment with his other projects.
Suppose Joe also invested $2,000 in another small business and made 800;
The ROI would be $800/$2,000=0,4 (x100) 40 %

Advantage of ROI-measures What return? return on what?

ROI type measures are widely used because: There are several variations on Roi type
v They reflect in one number the main measures;
trade off of managing : Include different income statement and balance
– revenue- related decisions sheet line items
– cost-related decisions ◆ Numerator (example)
– Investment decisions - Net income
v They provide a basis to compare returns - Operating income (EBIT)
on dissimilar businesses: - Nopat
• Different divisions within a firm ◆ Denominator (example)
• Firms’ or divisions’ Competitors - All assets
• Types of investment - Shareholder’s equity
- Only controllable assets
◆ In order to benchmark, consistency is
required

◆ Return on equity (ROE) Income statementà

◆ Return on Common Equity Return on Assets Revenues
(ROA) -Cost of goods sold (COGS)
◆ Operating Return on assets (Operating ROA) =Gross Profit
◆ Return on Total Capital -Operating Expenses
◆ Return on capital employed • Selling expense
◆ Return on invested capital (ROIC) • Administrative expense
◆ Return on controllable Assets • Depreciation expense
◆ Return on risk adjusted capital (RORAC) =Operating Income (Earning Before Interest and
◆ Risk adjusted return on capital (RAROC) Taxes)
◆ Risk adjusted return on risk adjusted -Interest Expenses
capital(RARORAC) =Pretax Income (Earning Before Taxes)
-Income Tax
=Net Income Before Preferred Dividends
-Preferred share dividends
=Net Income Available to Common Shareholders

Balance sheet Assets Liabilities and Equity

Current Assets Current Liabilities
Net Fixed Assets Interest-Bearing Debt
Goodwill & Intangibles Equity
47
ROE – Return on Equity

Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of
its total shareholders’ equity
ROE = Net Income / Shareholders’ Equity

The number represents the return on equity capital and shows the firm’s ability to turn equity investments
into profits.
To put it another way, it measures the profits made for each dollar from shareholders’ equity.

Beginning Balance Sum of historical net contributions from equity holders and retained earnings
+ Net Income Actual earnings, including unusual and non-recurring items
- Dividends Paid Dividends are a return of capital that reduce equity
+ Share Issuance The issuance of new shares provides capital for investment and debt retirement
- Stock Buybacks Stock buybacks reduce equity
= Ending Balance

Net income/Average shareholder equity

Average shareholder equity: (Beginning shareholders' equity + Ending shareholders' equity)/2

ROE can be compared to the historical ROE of the company

An increasing ROE over time can mean a company is good at generating shareholder value;
In contrast, a declining ROE can mean that management is making poor decisions on reinvesting capital in
unproductive assets.
ROE can be compared to the industry’s ROE average;
Higher ROE can indicate a competitive advantage.

A high ROE could mean a company is more successful in generating profit;

However, it doesn’t fully show the risk associated with that return.
A company may rely heavily on debt to generate a higher net profit, thereby boosting the ROE higher.
Furthermore, it is useful to compare a firm’s ROE to its cost of equity.
A firm that has earned a return on equity higher than its cost of equity has added value.
The stock of a firm with a 20% ROE will generally cost twice as much as one with a 10% ROE (all else being
equal).

Drivers of ROEà
While the simple return on equity formula is net income divided by (average) shareholder’s equity, we can
break it down further into additional drivers.
Return on equity formula is also a function of a firm’s :
ü return on assets (ROA)
i.e. how efficiently the assets are being used for generating profit
ü the amount of financial leverage
i.e. the use of borrowed money (debt) to finance the purchase of assets with the expectation that the
income from the new asset will exceed the cost of borrowing.

48
Attention to give managers the possibility to have too much debt à too much risky

DuPont Analysis
Once ROE as been decomposed, ROA can be futher decomposed as

ROA = net profit/revenues x Revenues/ Total assets

Therefore ROE can be analyzed as the product of:

ü net profit margin
ü asset turnover
ü leverage.
ROE = Net Profit Margin x Total Asset Turnover x Leverage

This decomposition is sometimes referred to as DuPont analysis.

The basic DuPont Analysis model is a method of breaking down the original equation for ROE into three
components:
ü operating efficiency à is measured by Net Profit Margin and indicates the amount of net income
generated per dollar of sales.
ü asset efficiency à is measured by the Total Asset Turnover and represents the sales amount
generated per dollar of assets.
ü Leverageà is determined by the Equity Multiplier.

Example:
• A high ROE could mean a company is more
successful in generating profit internally.
• However, it doesn’t fully show the risk
associated with that return.
• A company may rely heavily on debt to generate
a higher net profit, thereby boosting the ROE
higher.
• A riskier firm will have a higher cost of capital
and a higher cost of equity.

49
Return on common equity

The Return on Common Equity ratio refers to the return that common equity investors receive on their
investment.
Net Income available to common shareholder /Average Common Equity
Average common equity= (Common Equity at t-1 + Common Equity at t) / 2

Return on common equity is different from Return on Equity (ROE) in that it isolates the return that the
company sees on its common equity, rather than measuring the total returns that the company generated
on all of its equity.
Capital received from investors as preferred equity is excluded from this calculation

Return on Common Equity is used by some investors to assess the likelihood and size of dividends that the
company may pay out in the future.
A high Return on Common Equity indicates the company is generating high profits from its equity
investments, thus making dividend payouts more likely.
v Dividends are discretionary, meaning that a company is not under a legal obligation to pay
dividends to common equity shareholders
The Return on Common Equity can also be used to evaluate how well the company’s management has
utilized equity capital to generate values.
A high ratio suggests that the company’s management is making good use of equity capital by investing in
NPV-positive projects. à This should create more value for the company’s shareholders.

50
ROA – Return on assets

Return on Assets or ROA measures the profitability of a business in relation to its overall assets.

ROA= Net Income/Average Total Assets

Average Total Assets= (Total assets at t-1 + Total Assets at t) / 2

It allows a company to estimate how efficiently the assets of the company are being used for generating
profit
The higher the ratio, the more income is generated by a given level of assets.

Problemsà
An issue with this computation is that net income is the return to equity holders;
Assets are financed by both equity holders and creditors. (debt)
Interest expense (the return to creditors) has already been subtracted in the numerator.
Some analysts, therefore, prefer to add back interest expense in the numerator in order to ignore the cost
of debt.
In such cases, the formula for ROA is: ROA= Net Income + Interest Expense / Average Total Assets

However in order to performed a better analysis, In such cases, interest must be adjusted for income taxes
because net income is determined after taxes!
With this adjustment, the ratio would be computed as:

ROA= Net Income + Interest Expense (1-tax rate) / Average Total Assets

Operating ROA:

Alternatively, some analysts elect to compute ROA on a pre-interest and pre-tax basis as:

ROA=Operating income or EBIT/Average total assets

In this ROA calculation, returns are measured prior to deducting interest on debt capital (i.e., as operating
income or EBIT).
This measure reflects the return on all assets invested in the company, whether financed with liabilities,
debt, or equity.

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Return on Total Capital

Return on Total Capital (ROTC) is a return on investment ratio that quantifies how much return a company
has generated through the use of its capital structure
Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and
finance its assets.
The structure is typically expressed as a:
v debt-to-equity ratio
v debt-to-capital ratio

This ratio is different from return on (common) equity , as the former quantifies the return a company has
made on its (common) equity investment.
The ROE figure can be misleading, as it does not take into account a company’s use of debt.
(A company that employs a large amount of debt in its capital structure will have a high ROE).
Return on Total Capital can be used to evaluate how well a company’s management has utilized its capital
structure to generate value for both equity and debt holders.

ROTC= Earnings Before Interest & Taxes (EBIT)/ Total Capital

Total capital= Short Term Debt + Long Term Debt + Shareholder’s Equity

In the case of a business that has no liabilities outside of short-term debt, long-term debt, and total
equity, return on total capital is virtually identical to the return on assets (ROA) ratio.
This is because the business’ capital structure would make up the entirety of the business’ liability section
on its balance sheet. That figure would be equal to the business’ total assets. (Assets = Liabilities + Equity).
While ROA is also a useful profitability metric, it takes a more reactive approach to computing a business’
use of capital. ROA measures the value a business is able to generate based on the assets it employs,
rather than on capital allocation decisions

Return on capital employed

Return on Capital Employed (ROCE), a profitability ratio, measures how efficiently a company is using
its capital.

ROCE=EBIT /capital employed

Capital employed= total assets - current liabilities

Instead of using capital employed at an arbitrary point in time, analysts and investors often calculate
ROCE based on the average capital employed

average capital employed: opening capital employed + closing capital employed / 2

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Return on Invested Capital

ROIC stands for Return on Invested Capital and is a profitability or performance ratio

ROIC: Nopat / invested capital

NOPAT stands for Net Operating Profit After Tax and represents a company’s theoretical income from
operations if it had no debt (no interest expense).

NOPAT = EBIT x (1 – tax rate)

Invested capital is the book value of debt and equity capital less cash and cash equivalents;
ROIC addresses the issues with ROA and ROE in calculating profitability.
ROA can be substantially skewed based on a firm’s cash balance.
ROE can:
ü be positively impacted by actions that reduce shareholder equity (i.e. share buybacks) but do not
increase net income
ü be due to excess leverage
When using ROIC:
ü Cash is netted out when solving for invested capital in the denominator, solving the issue of
differences in cash balances across firms.
ü ROIC can be compared across firms with different capital structures, since NOPAT in the
numerator is a measure of earnings available to all of the providers of capital

Roic is typically compared to the weighted average cost of capital (WACC)

v Roic-WACC spread

The primary reason for comparing a firm’s return on invested capital to its weighted average cost of
capital is to see whether the company destroys or creates value.
If the ROIC is greater than the WACC, then value is being created as the firm invests in profitable projects.
Conversely, if the ROIC is lower than the WACC, then value is being destroyed as the firm earns a return
on its projects that is lower than the cost of funding the projects.

53
Return on controllable assets

Roi type measures can refer to a single divisions’ performance;

Divisional ROI is a ratio of the accounting profits earned by the division divided by the investment
assigned to it
ROI = Division’s profits ÷ Division’s investment base

Return on controllable assets measure come in several different forms

Example Ferreteria de Mexico: store ROI

Store ROIà Bonus eligible revenues-expenses/ total store investment
Numerator:à Eligible revenues: shipments from store – sales orders from regional/headquarters; Expenses: store direct
costs
Denominator:à Investment: Annual average of month end balance of cash, inventory in stock,accounts receivable,
equipment, forniture, fixtures, buildings and land.

Kranworth chairs
Divisional controllable returnsà Divisional Operating income /controllable assets
Numeratorà Divisional Ebit
Denominator à Controllable assets: inventories, accounts receivable, and allocated assets (facilities)

RAROC - Risk-adjusted return on capital

Risk-adjusted return on capital (RAROC) is a modified return on investment (ROI) figure that takes
elements of risk into account.
It does this by accounting for any expected losses and income generated by capital

Raroc= Revenues- Expenses – expected loss+ capital income/ capital

Income from capital = (capital charges) x (the risk-free rate)

Expected loss = average loss expected over a specified period of time

The return on risk-adjusted capital (RORAC) is a rate of return measure where various projects, endeavors,
and investments are evaluated based on capital at risk.
v Capital at risk (CaR) refers to the amount of capital set aside to cover risks
Projects with different risk profiles are easier to compare with each other once their individual RORAC
values have been calculated.
The calculation for this metric is similar to RAROC, with the major difference being capital is adjusted for
risk instead of the rate of return.

Return on Risk Adjusted Capital=Net income/ Risk-Weighted Assets

Allocate risk capital, economic capital, value at risk

RARORAC – Risk adjusted return on risk-adjusted capital

Another similar ratio the risk-adjusted return on risk-adjusted capital (RARORAC).

RARORAC =risk-adjusted return/ economic capital

In this ratio both numerator and denominator are risk adjusted.

54
 L11- ROI type measures. (part 2)

Problems caused by ROI-measures

a. ROI contains all problems associated with accounting profit measures (Myopia): Numerator refers
to accounting profits
b. Furthermore, ROI type measures presents:
- the problem of Suboptimizationà
- The problem of misleading performance signalsà

Suboptimization:
- ROI measures can lead division managers to make decisions that:
v M improve division ROI
v are not optimal for the corporation as a whole
- The problem arise because:
v division managers are unlikely to propose investment that yield returns below their
target ROI, even if they are good for the company;
v division managers are willing to propose investment that yield return below the
corporate cost of capital is they improve the division ROI

cost of capitalà
Cost of capital is the cost of funds used to finance a business.
Typically, firms obtain financing through a combination of issuing equity in the form of shares, and by
taking on debt through borrowing from banks or issuing bonds.
The people who provide a company with its capital also want to earn a return on their investment.
Combined, those factors comprise a company’s overall cost of capital:
- The cost of debt is the interest a company pays.
- The cost of equity is the compensation investors demand in exchange for owning a company’s
shares.
The overall cost of capital is the weighted average of a company’s capital sources, also known as the
weighted average cost of capital, or WACC

Cost of capital and rate of return

Businesses use cost of capital to analyze whether or not to proceed with a project.
As long as the cost of capital is below the rate of return that the company earns by using its capital, it’s a
good investment.
If the capital needed to make money exceeds the amount of money the capital will generate, it’s a bad
investment.

Example:
Both divisions of the firm Alpha face the opportunity Worthwhile ! Invest! Does not invest
of a new investment; Base situation Unit A Unit B
Divisions are investment centers; Profit Before tax 100.000 400.000
Divisional managers’ performance is evaluated in terms Investment base 1.000.000 1.000.000
of divisional ROI ROI 10 % 40%
Assume corporate cost of capital = 15% New situation New situation New situation
Investment opportunity $100.000 to earn $20.000 Profit before tax 120.000 420.000
per year investment 1.100.000 1.100.000
Problems caused by ROI-measures: ROI ?
suboptimization
Assuming corporate cost of capital 15% , a new investment opportunity promising 20% return is
worthwhile;
However, a manager whose current divisional ROI is 10% would invest;
Instead, a manager whose current divisional ROI is 40% would not invest;
55
Assume corporate cost of capital = 25% NOT Worthwhile ! Invest! Does not invest
Investment opportunity $100.000 to earn $20.000 Base situation Unit A Unit B
per year Profit Before tax 100.000 400.000
Problems caused by ROI-measures: suboptimization Investment base 1.000.000 1.000.000
Assuming corporate cost of capital 25% , a new ROI 10 % 40%
investment opportunity promising 20% return is NOT New situation New situation New situation
worthwhile; Profit before tax 120.000 420.000
However, a manager whose current divisional ROI is investment 1.100.000 1.100.000
10% would invest regardless; ROI 10,9% 38,2%
Instead, a manager whose current divisional ROI
is 40% would not invest;
Where division managers have the authority to make financing decisions, there is a further problem;
For example ROE measures can induce managers to use debt financing;
Reducing the denominator, improving the ratio
• While debt financing can be used to boost ROE, it is important to keep in mind that overleveraging
has a negative impact in the form of high interest payments and increased risk of default.
• The market may demand a higher cost of equity, putting pressure on the firm’s valuation.
• While debt typically carries a lower cost than equity and offers the benefit of tax shields, the most
value is created when a firm finds its optimal capital structure that balances the risks and rewards
of financial leverage.
• Furthermore, it is important to keep in mind that ROE is a ratio, and the firm can take actions such
as asset write-downs and share repurchases to artificially boost ROE by decreasing total
shareholders’ equity (the denominator).

Misleading performance signals from Roi type measures

Another problem associated with Roi type measures are the «misleading performance signals»;
This is associated to the fact that Net book value is normally used to compute divisional ROI
» ROI gets better merely through passage of time
» ROI is usually overstated if the division
includes a relatively large number of older assets
Example 1 :
The firm Alpha is organized along divisional lines;
Divisions are investment centers;
Divisional managers’ performance is evaluated in terms of divisional ROI
What is the problem? Division C Division D
àROI overstatement if older assets
Profit before depreciation 110.000 110.000
(denominator in NBV)
Depreciation 10.000 20.000à10.000
(ovvero come deve essere)
Profit after depreciation 100.000 90.000à100.000
Assets (NBV) 500.000 3.000.000
ROI 20% 3%

Example 2:
The firm Alpha is organized along divisional lines;
Divisions are investment centers;
Divisional managers’ performance is Year 1 Year 2 Year 3
evaluated in terms of divisional ROI Profit before depreciation 110.000 110.000 110.000
Division E performance is shown for y1 to y3 Depreciation 50.000 50.000 50.000
What is the problem? Profit afterà before depreciation 60.000 60.000 60.000
à ROI increasing merely to passage of Assets (NBV) 500.000 450.000 400.000
time (After à before ) ROI 12% 13,3% 15%

56
Misleading performance signals
Misleading performance signals can incourage misplaced behaviours:
- Division managers are encouraged to retain assets beyond their optimal life and not to invest in
new assets
- Corporate managers may be induced to over-allocate resources to divisions with older assets
- Division manager might opt for leasing rather than buying relevant assets (not recognized in
balance sheet).
Example:
Assume corporate cost of capital = 15%
Division investment of $25,000 that generates 5,000 annual profit (=20%)

57
 L12- Residual income measures

Residual Income
RI is the amount obtained by subtracting a capital charge from the accounting profits

RI = profits − capital charge

Capital charge = capital × cost of capital

Example :
Division A made a profit of $10,00; The capital used by the division was $70,000;
The weighted average cost of capital of the company is 13%
The residual income of Division A was therefore: Profit 10,000
- capital charge 9,100 (70,000 x 13%)
Residual income 10.000-9.100= 900

Residual income :
The capital charge of $9,100 represents the minimum return required by the providers of funds on the
$70,000 capital they provided.
Since the actual profit of the division exceeds this, the division has recorded residual income of $900.
It means that the organisation is providing a return that is greater than that required by providers of
finance (beyond cost of capital

Economic Value Added (EVA)

A known measure built on this footprint is EVA (Economic value added)

EVA was developed by the US consulting firm Stern Stewart & Co, and it has gained widespread use
among many well-known companies

Modified NOPAT− (Modified capital × WACC)

NOPAT = Net Operating Profit after Tax

NOPAT stands for Net Operating Profit After Tax and represents a company’s theoretical income from
operations if it had no debt (no interest expense).

Capital= capital invested (equity+long term debt)

WACC =Weighted Avarage Cost of Capital

EVA is Similar to RI (= profit − capital charge)

However several modifications has been made to both numerator and denominator in order to address
flaws to accounting measures; 164 in total, as suggested by Stern Stewart & Co

EVA modifications:
a. Research & Development (R&D) is treated as an investment, added back to the income statement,
capitalized on the balance sheet, and expensed/depreciated over 5 years (or longer for industries
with lengthier product cycles).
b. Advertising and Promotional spending is treated in a similar way, but instead is expensed over 3
years.
c. Leased assets are treated as owned and capitalized on the balance sheet. The decision to rent
versus to own is non-operational and should not drive value creation.
d. Depreciation charge is added back to profit and instead, a charge for economic depreciation is
made.

58
 e. Restructuring charges are added back to the income statement, and are then capitalized on the
balance sheet, holding management accountable over future years with the associated capital
charge. Such charges are viewed as an investment in future productivity and should be treated as
such, not written off at once.
f. Other adjustments, such as utilizing a smoother tax rate, account for the inevitable variability
between estimated and actual taxes.

NOPAT
NOPAT shows profits before taking out the cost of interest.
The cost of interest is included in the finance charge that is deducted from NOPAT when calculating EVA.
Two approaches to adjusting for interest are taken:
ü start with operating profit
ü start with profit after tax

method 1à
First Approach:
§ start with operating profit.
§ Then deduct the adjusted tax charge.
§ The tax charge should be adjusted because it includes the tax benefit of interest.
§ Since interest is a tax-deductible item, having interest in the income statement means that the tax
charge is lower.
§ Since we are taking the cost of interest out of the income statement, it is also necessary to remove
the tax benefit of it from the tax charge.
§ To do this, multiply the interest by the tax rate, and add this to the tax charge

example
Income statement NOPAT
• Operating profit 1,000 • Operating profit 1,000
• Interest charge (100) • Less tax charge adjusted to exclude tax relief on
• Profit before tax 900 interest
• Tax at 25% (225) • (225 + (100 x 25%)) 250
• Profit after tax 675 • NOPAT 750

Method 2à
Second approach:
ü start with profit after tax
ü add back the net cost of interest
ü This is the interest charge multiplied by (1 – rate of corporate tax).

Example
Income statement
• Operating profit 1,000 NOPAT
• Interest charge (100) • Profit after tax 675
• Profit before tax 900 • Add after tax interest (100 x 75%) 75
• Tax at 25% (225) • NOPAT 750
• Profit after tax 675

59
Problems caused by ROI-measures
1. ROI contains all problems associated with these profit measures (operational/investment myopia)
a. Numerator refers to accounting profits
2. Furthermore, ROI type measures presents:
a. the problem of Suboptimization
b. The problem of misleading performance signals
Residual income measures can fix some problems related to ROI type measures.

Residual income and suboptimization

The use of residual income can fix the suboptimization problems with ROI measures
If the capital charge is set at the weighted average corporate cost of capital……
……the residual income measure will provide all division managers an equal incentive to invest;
Regardless the ROI level in each division, they will invest in all projects that promise return >corporate
cost of capital

Suboptimization (example) Residual income and suboptimization

Assume Corporate cost of capital = 15% Assume Corporate cost of capital = 15%
Investment opportunity $100.000 to earn Investment opportunity $100.000 to earn
$20.000 per year $20.000 per year

Residual income and suboptimization

Residual income measure can fix suboptimization related to financing suboptimization when using ROE
measures (net income/equity)
ROE induces managers to use debt financing over equity in case they have financing authority (leverage)

This is not the case with RI if the capital charge is equal to the weighted average cost of both debt and
equity

Problems caused by ROI-measures: suboptimization

• While debt financing can be used to boost ROE, it is important to keep in mind that overleveraging
has a negative impact in the form of high interest payments and increased risk of default.
• The market may demand a higher cost of equity, putting pressure on the firm’s valuation.
• While debt typically carries a lower cost than equity and offers the benefit of tax shields, the most
value is created when a firm finds its optimal capital structure that balances the risks and rewards
of financial leverage.

RI and misleading performance signals

However, the use of residual income measures cannnot fix misleading performance signals;
Net book value:
- Both ROI and RI get better merely through passage of time
- Both ROI and RI are usually overstated if the division includes a relatively large number of older
assets

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RI and ROI: passage of time
Invest $100; Profit $27 per year; Depreciation $20 (5
years); cost of capital 10%

RI and ROI: older assets

Invest $100; Profit $27 per year; Depreciation $20 (5
years); cost of capital 10%

Economic Value Added (EVA): congruence

EVA addresses some myopia problems of accounting profit measures;
v Involves capitalization of costs that manager could cut off if pressured for short term profits (R&D,
customer acquisition, etc)
v Mitigate the difference between accounting and economic profit
v But still is focused on the past and based on transactions
Being a residual income type measure addresses the suboptimization problems of ROI type measures

Advantage of using EVA and RI

• Invest in divisions where the returns on those divisions exceed the costs of capital.
• Increase the operating performance of its existing divisions – thus increasing the net operating
profits after tax (NOPAT) without increasing the finance charge (valid for EVA);
• The firm can ‘harvest assets’ by closing down divisions where the return is less than the costs of
capital, and either re-invest the proceeds in other divisions, or return the cash to shareholders as a
dividend.
• The firm can increase its debt to equity ratio, and thus reduce the weighted average cost of capital
(as the cost of debt is less than the cost of equity).

Advantage of using EVA and RI to assess Divisions

• EVA can also be used as a performance evaluation tool for divisional managers.
• EVA encourages divisional managers to create return beyond the cost of capital and maximise the
wealth of the division.
• Some sivisional managers may not have sufficient autonomy to make decisions about financing
(Not able to change the weighted average cost of capital (WACC).
• However, using EVA should ensure that divisional managers only invest in projects where the
return on the projects exceed the costs of the company’s capital.

Disadvantages of EVA
• The adjustments to profits and capital can become cumbersome, especially if performed every
year; (problem with cost efficiency)
• EVA involves a complex formula including its application as a metric for executive incentive
programs and it might create problems of understandability;
• Valid comparisons of EVA performance among different companies may be difficult. Different
companies may give different interpretations to the numerous adjustments (problem with
precision and accuracy)
• EVA (and RI) is an absolute measure, so it cannot be used to compare companies of different sizes,
unlike return on investment.

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ISS’s EVA-Based Metrics

• In order to allow comparability, four EVA-based financial metrics have been proposed by ISS:
• In order to measure a firm’s ability to earn EVA (profitability)
- EVA Margin
- EVA Spread
• In order to measure a firm’s ability to increase EVA (progress)
- EVA Momentum vs Sales
- EVA Momentum vs Capital

ISS’s EVA-Based Metrics: ability to earn EVA

EVA Margin:
• Computed as EVA/Sales
• is the percent of sales remaining after covering all operating and capital costs, a combined
measure of profitability and balance sheet management.
• Analysts recommend the 3-year average figure.

EVA Spread:
• Computed as EVA/Capital
• is the EVA yield on capital, which also equals the spread between the firm’s return on capital (ROC)
and its cost of capital (COC).
• Analysts recommend the 3-year average figure.

Example: EVA Margin (EVA/Sales): 4%

EVA: $50 Capital: $1,000
Sales: $1,250 EVA Spread: (EVA/Capital): 5%

ISS’s EVA-Based Metrics: ability to increase EVA

EVA Momentum vs Sales:

- EVA Momentum vs Sales = the Change in EVA/Prior Year Sales
- It is an EVA growth rate, scaled to the sales size of the business.

EVA Momentum vs Capital:

- EVA Momentum vs Capital = the Change in EVA/Prior Year Capital
- It is an EVA growth rate scaled to the firm’s capital base.
- Rather than looking at EVA Momentum over the most recent year, analysts suggest to
compute the average EVA growth rate over a span of three years.

Example: EVA Momentum vs sales (Change/Prior Year Sales):

Y2 EVA: $50 ; Y1 EVA (prior year): $30 2.00%
Change in EVA: + $20 Capital (prior year): $800
Sales (prior year): $1,000 EVA Momentum vs capital (Change/Prior Year Capital):
2.5%

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The link between EVA and TSR
• Some analyst argue that EVA and TSR are fundamentally linked and, over the very long term, are
equivalent
• The basic idea is that by deducting the capital charge, EVA sets aside the profit that must be
earned in each period to recover the value of the capital that has been or will be invested in a
business;
• thus, EVA always discounts to the net present value of future cash flows.
• EVA, and the change in EVA, are thus strong proxies for wealth creation and a firm’s TSR.

Example of EVA Used as a Metric in a LTIP:

• Performance period: 3y .
• Target: cumulative EVA for the performance period equal to a specified dollar amount;
• Cumulative EVA for the performance period would be determined by aggregating the EVA figures for y 1,2,3
and measured against the target;
• If target is achieved, full payout of the incentive award would be made;
• If performance is over or under target, adjustments would be made in the payout of the incentive award,
with no payout if the cumulative EVA for the performance period was less than a threshold amount.

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 L13-Remedies to the Myopia Problem

The myopia problem:

• Financial summary measures of performance often are not, by themselves, sufficient to motivate
optimal management decisions
• They often create pressures for short-term performance at the expense of long-term value
creation
àThe myopia problem

Accounting measures can lead to two main types of behavioural misplacement:

» Investment myopia
» Operational myopia

Investment myopia :
Investment myopia is mainly related to the “intangibles” problem and to the “conservative bias”;
In order to boost profits or returns in the short term, managers might not make investments that are
expensed now but promise payoffs only in future measurement periods
even worthwhile ones ( positive NPV)
• R&D projects
• Employee development initiatives
• Customer acquisition initiatives
Thus managers produce accounting profits in the short term, harming value in the long term

Investment myopia might occur also in the form of manipulative earning management practices;
This occurs when operating expenses:
- are not booked immediately
- Are pushed in the future as capital investments

Operational myopia:
Operational myopia occurs when managers make operational decisions to boost short term profits even
when harmful long-term
- Forcing staff to overtime at the end of the measurement period to finish production and
generating revenues immediately
- Cutting corners and ship lower quality products at the end of the measurement period to
generate revenues immediately
- Channel stuffing, i.e. boosting near term sales by extending lower prices to distributors
In the long term, these practices might harm goodwill built with customers, staff, suppliers

Actions to reduce myopia

Myopia problems can be addressed in several ways:
§ Reduce pressure for short-term profit
§ Control investments with preaction reviews
§ Extend the measurement horizon
§ Measure changes in value directly
§ Improve accounting profit measures
§ Measure a set of drivers of future financial performance

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Overcoming myopia:

Reduce pressure for short-term profit

◆ Reduce the weighting placed on the annual profit target (ex 60% profit, 40% other target)
◆ emphasize other, longer-term performance indicators
– market share
– technical break-throughs
– Customer satisfaction
◆ Trade off: subjective performance evaluations?

Reduce pressure for short-term profit

◆ Make the short-term profit targets easier to achieve
– Some slack is created to fund longer-term projects
◆ However there are major trade-off
– motivational effects of “easy” targets can ne weak
– Ratchet effect

Ratchet effects
Ratchet effects refers to the tendency for controllers to base next year ’ s targets on last year ’ s
performance
Actors have a perverse incentive not to exceed targets even if they could easily do so
Ratchet effect is common in target system

Control investments with preaction reviews

◆ Separating “today” business from “tomorrow business”;
◆ Operating costs are separated from developmental expenses;
v Operating cost are borne to generate revenues now;
v Developmental expenses are borne to generate revenue in the future;

Control investments with preaction reviews

◆ Financial results control is used only to reward improvements in short term operating
performance;
◆ Costs of longer term investments are not considered in the income statement line manager are
held accountable;
◆ Quality of long-term ideas (and expenses) is controlled through non-financial measures and pre-
action control

Control investments with preaction reviews

◆ Operating expenses – Developmental expenses
◆ “Today” businesses – “Tomorrow” businesses

Combination of non-financial
Financial results controls performance indicators
and action controls

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 Action controls: recall
Action control ensures that employees:
v perform
v (or do not perform)
certain actions known to be beneficial (or harmful) to the organization
Most action controls are aimed at preventing undesirable behaviors

Scrutiny of action plans, investment proposals, budgets

• Review and approval
• Part and parcel in (capital) budgeting processes, which are otherwise mainly a
results control mechanism

Extend the measurement horizon

Accounting profit measures presents a well known congruence problem
Accounting profits provide lagged indicators of economic income, expecially in the short term;
measurement periods are shorter than firms’ investment payoff horizons
The longer the period of measurement, the higher the correlation between accounting income and
economic income
Therefore one solution to myopia is to extend the measurement horizon:
Ex. Profit, EPS, ROI, ROE measured over a three to five years period
Alligning measurement periods to investment payoff horizons
Lenghten managers’ horizons
However expected payoff must discount deferred compensation
Cost- effectiveness problem

Measure changes in “shareholder value” directly

A radical solution to mypia problem is to try to measure economic income
» Valuation difficulties
Measurement precision and objectivity of future cash flows for non-publicly
traded entities?
» Cost?
Expensive to do on a recurring, ongoing basis

Improve accounting profit measures

Viable improvements are:
To Adjust depreciable lives of fixed assets
v Normally conservatively short
v Not reflect useful economic life
v charge depreciation also for fully depreciated assets
v adopt fair value / current value (address misleading performance signals)

historical cost vs. fair value

Historical cost accounting and mark-to-market, or fair value, accounting are two methods used to
record the price or value of an asset.
Historical cost measures the value of the original cost of an asset and carries it at historical cost-
depreciation

mark-to-market measures the current market value of the asset

v can then be increased or decreased depending on the fair market value of the fixed asset

Historical cost is conservative and safe;

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 It is a particular problem when a business has older fixed assets whose current values may differ
sharply from their recorded values
Current value is that it provides information to the readers of a company's financial statements
that most closely relates to current business conditions.
When sharp, unpredictable volatility in prices occurs, mark-to-market accounting proves to be
inaccurate.

Improve accounting profit measures

Viable improvements are:
§ Capitalize expenditures related to long-term investments:
- Made with the express purpose of generating revenues or savings tomorrow
- Capitalization provides a better time matching of revenue and costs
- Capitalization, in accounting, is when the costs to acquire an asset are expensed over the life of
that asset rather than in the period it was incurred.
- To capitalize is to record a cost/expense on the balance sheet for the purposes of delaying full
recognition of the expense
- Capitalizing assets has many benefits. Because long-term assets are costly, expensing the cost
over future periods reduces significant fluctuations in income, especially for small firms.
§ Recognize profits more quickly
§ Impute a cost of equity on income statement
§ Put leases on the balance sheet

Developing performance reports for control purposes might become more costly

Measure a set of drivers of future financial performance

– Use non-financial performance measures
– Balanced scorecard
§ The BSC includes financial measures that tell the results of actions already
taken
§ It complements the financial measures with operational measures on customer
satisfaction, internal processes, and the firm’s innovation and improvement
activities

“Template” Balanced Scorecard

A balanced scorecard “tells the story of your strategy”

Every measure is part of a chain of cause and effect linkages
All measures eventually link to organizational outcomes
A balance exists between outcome measures (financial,
customer) and performance drivers (customer value, internal
processes, learning, and growth)

Why do Companies Need a BSC?

The source of value has shifted from tangible
to intangible assets

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Creating value from intangible assets is
different
Intangible assets do not have a direct impact
on financial results — They have second- or
third-order impacts

Evaluating the BSC-approach

à Establishing the chain of cause-and-effect linkages?

à Are BSCs “balanced”?

What is the proper weighting to achieve “balance” …
» Among the four perspectives?
» Among the two dozen measures?

“ We never figured out how to use the scorecard to measure performance. We used it to transfer
information, a lot of information, from the divisions to the senior management team. At the end of the
day, however, your performance depended on your ability to meet your targets for contribution to
bottom-line profits.”
– Senior manager in a large financial institution.
Quoted in M.C. Jensen, “Value maximization, Stakeholder Theory, and the Corporate Objective Function,” Journal of Applied Corporate Finance (Fall 2001), p. 19.

àDo employees make the “right” tradeoffs?

For example, throughput and labor productivity are possible measures in the internal business
process perspective, and costs and profits are common measures in the financial perspective
§ Throughput can be increased by forcing employees to work more overtime, but as fatigue
sets in, labor productivity will decrease
§ The overtime is also costly, so there is a cross-dimension tradeoff between throughput and
many financial measures, such as costs and profits

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à How to tie BSC-performance to incentives?
“In the short term, tying incentive compensation of managers to a balanced set of scorecard measures will
foster commitment to overall organizational goals, rather than suboptimization within functional
departments …
Whether such linkages should be explicit … or applied judgmentally … will likely vary from company to
company.
More knowledge will undoubtedly continue to be accumulated in the years ahead …”
– Kaplan and Norton, 1996

Bottom-line measures
- Are like a “compass” leading managers in the desired direction
- Allow managers greater autonomy:
» The managers can decide what intermediate measures to focus on achieving the
desired financial result
» The managers can achieve the desired financial result by putting different
combinations of inputs and outputs together
- Are like a “roadmap” that provides guidance to managers as to how to achieve the desired end
- If done well, can provide a linked cascading of measures from the top of the organization to
the bottom. They show everybody how their efforts contribute to the overall goal.
- Can be restrictive (managers have less autonomy in making the tradeoffs)
- Propensity to become obsolete as conditions change

But:
Complexity provides challenges:
- Identifying right measures, measurement rules, and importance weightings
- Developing the measurement systems
- Setting properly challenging performance targets for many measures
- Linking to incentive compensation
- Keeping up-to-date (avoiding obsolescence)

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 L14- Intro to Planning and Budgeting

Financial results control: main elements

o Financial responsibility centers
§ The apportioning of accountability for financial results within the organization
o Performance measures
§ Against which FRCs will be evaluated
o Planning and budgeting systems
§ To define targets and standards for evaluating performance
o Incentive systems
§ To define the links between results and various organizational incentives

Planning cycles
In big organizations all three cycles are likely to be present and
clearly defined;
In smaller organizations:
v one or more cycles are combined
v Some cycles are not formalized

Strategic planning
§ It is the broad process of thinking about the:
- Overarching mission and objectives for the organization as a whole;
- The organization’s present position, strengths and weaknesses, opportunities and risks;
- what type of activities/business the organization should (or should not) pursue (ex
diversification)
§ The formal output of strategic planning is a written plan
- Strategic plan
§ The time horizon is the long term
- (3-5 years; 10 years);
§ Strategic planning provides framework for detailed yearly planning.
§ Strategic planning normally involves top corporate managers.

Strategyà
There are several conceptions of what strategy is One of the most popular school of though depict
strategy as a “plan” (in Mintzberg’s terms);
Two main approaches can be grouped under this definition (some differences):
ü the so called “Design school” (Harvard);
ü The so-called “Planning school” (I.Ansoff).
Strategy, in this light, is the link between the organization and its operating environment; (market and
society for the Design School);
An organization should pursue the “strategic fit”;
Through a rational decision-making process an organisation should:
ü Analyze its operating environment
ü Analyze its current conditions
ü formulates the “plan” to reach a desired future state
This process is “strategic planning

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 Rational model of
strategy formulation

Capital budgeting
Capital budgets are situated between stragegic plans and annual budgets;
The term capital budgeting (also known as programming)is used to describe how managers plan:
- significant investments in projects that have long-term implications
- action programs to be implemented over the next few years (1-3; 5)and specification of the
resources each will consume

Programs should:
- translate strategies into a set of activites meant to implement them;
- be somehow constrained by the strategies devised in the strategic plan.

Capital budgeting involves managers at different levels

(top-down/bottom-up)

Budgeting
(Operational) Budgeting involves the preparation of a short term plan;
The budget is stated in monetary terms (Ex. expected revenues and costs;
Budgets ordinarily cover a one-year period corresponding to a company’s fiscal year.
Many companies divide their annual budget into four quarters.

Budget Period
Operating budgets ordinarily cover a one-year period corresponding to a company’s fiscal year. Many
companies divide their annual budget into four quarters.
A continuous budget is a 12-month budget that rolls forward one month (or quarter) as the current month
(or quarter) is completed.

Budget and responsability centers

Budgets normally match the financial responsability centers’ structure:
§ IC
§ PC
§ CC
§ RC

It contains an element of management commitment

managers agree to accept the responsibility for attaining the budgeted objectives

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the process:
The budget is the outcome of a process that
involves multiple actors within an
organizations;
The budgeting process takes about 4 months in
most firms;The budget is approved by an
authority higher than the budgetee; The
process can be either bottom-up or top-down.

Self-Imposed Budget

A self-imposed budget or participative budget is a

budget that is prepared with the full cooperation and
participation of managers at all levels.

Advantage of self-imposed (bottom up) budgets:

ü Individuals at all levels of the organization are viewed as members of the team whose judgments
are valued by top management.
ü Budget estimates prepared by front-line managers are often more accurate than estimates
prepared by top managers.
ü Motivation is generally higher when individuals participate in setting their own goals than when
the goals are imposed from above.
ü It is an effective way of information sharing bringing together corporate priorities and constraints
with lower-level insights about business potentials and risks;

Advantage of top-down budgets :

ü the corporate management has sufficient information to plan properly (programmable/routinary
activities);
ü relative performance evaluation is in use;
ü Units’managers thinking is bound by historical achievements;
ü Units’ managers are biased;

Planning and budgeting

Purposes of planning and budgeting processes:

§ To engage in long(er)-term thinking
§ To allow control:
– Pre-action review (checking plans and proposals)
– Management by exception (ex variance analysis)
§ To achieve coordination
– Force units to work together
– Force units to share information
§ To increase motivation
– “challenging-but-achievable” performance targets
– Goal setting theory (Latham)
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The Master Budget: An Overview

73
 L15- Targets and target setting

Basic control issues; recall

Three issues:
1. Do they understand what we expect of them?
« Lack of direction

2. Will they work consistently hard and try to do what is expected of them?
« Lack of motivation

3. Are they capable of doing what is expected of them?

« Personal limitations

Targets:
Budgeting involves setting targets that express the future desired “level” of performance (Based on the
measures in use);
Targets are commonly used as standards against which to evaluate performance;
Targets contains an element of management commitment;
managers agree to accept the responsibility for attaining the budgeted objectives

Motivational effect of targets:

Targets provides:
• Direction (let employees know what is expected form them)
• Motivation (motivate them to work consistently to achieve it)

The relevance of targets has been stressed by a very famous psycological theory applied to management
(The Goal – setting theory);
The goal- setting theory has several practical implications for management studies and practice.

Goal setting theory: main findings

• Goals serve a directive function à they direct attention and effort toward goal-relevant activities
and away from goal irrelevant activities.
• Goals have an energizing functionà Challenging goals lead to greater effort than easy goals.
• Goals affect persistence à High goals prolong effort; tight deadlines lead to a more rapid work
pace than loose deadlines.
• Fourth, goals lead to the use of task-relevant knowledge and strategies à Goals motivate people
to use the knowledge they have that will help them to attain the goal or to discover the knowledge
needed to do so

Types of financial performance targets

« Base: Model-based / historical /zero-based

« Process: imposed (top-down)/ negotiated (bottom-up, self-imposed)
« Source: Internally derived / externally-derived
« Flexibility: Fixed / Flexible

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Model based targets

Model-based are derived from predictions of possible performance in subsequent measurement periods;
When they are used for very programmable activities they are called enginereed targets;
Stable and deterministic input/ouput relationship;
Ex: in production departments (CC):
Inputs and outputs can be derived from production specifics;
Standard quantities X standard unit costs;
Model base targets can be used also in less programmable areas;
Example: Average score in teaching among uni professors
Sum of professors’ score/n. of professors
In less programmable areas is normally used as a base for negotiation

Types of financial performance targets

Historical targets are derived from performance in prior periods:

v Marginally incremented (ex. +10% sales or profit)
v Marginally decremented (ex. - 5% costs)
Historical target setting is a form of «incremental» decision-making approach;

As an incremental approach, historical target setting is:

v time-efficient
v cost-efficient;
However, the process might incorporate past inefficiencies;
Furthermore, it is prone to ratchet effects.

Zero-based targets
If prior periods are not considered, budgets are called zero-based
v Budget is built from scratch
v Each item needs to be reassesed and justified
Zero-based budgets are seldom used in practice
Complex, lenghty, potentially lead to conflicts
Zero base budget is used by private equity or hedge fund when they buy a company
Seek for any potential inefficiency due to past decisions

Imposed (topdown) vs negotiated (bottom-up, self-imposed) targets

Targets can be imposed by upper tiers (top-down);
Often targets are negotiated between supervisors and subordinates
Ex. division managers negotiated divisions’ targets with corporate
In decentralized organizations, targets are negotiated due to the information asimmetry between tiers;
Negotiation should induce superiors and subordinates to share information

The budget preparation process

The budgeting process takes about 4 months in most firms

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Internally derived targetsà Most organizations’ targets are internally focused and generated; (Ex.
Internal negotiation; Target costing based on past performance)

Externally derived targetsà Externally-derived targets use external units’ performance as a benchmark:
- Targets based on the market’s performance
- Targets based on selected firms’ performance
- Targets based on best in industry’s performance
- Targets based on best in class performance

RPEà (relative performance evaluations) means that employees’ performance is evaluated (and target
are set):
§ NOT in term of the absolute level of performance
§ In comparison of units or gropus of units:
- Performing the same tasks
- Facing the same constraints and opportunities

Should managers be held accountable for achieving their targets regardless of the business conditions
they face?

Fixed vs flexible targets

Fixed targets do not vary over a given time period;
Flexible targets are adjusted according to the conditions face during the period:

Recall: Controllability principle

• Employees should be held accountable only for that which they can
control;
• Uncontrollable factors distort performance measures and evaluations
• Uncontrollable risks are best borne by shareholders (who are better
able to diversify them)
• If managers bear the risk, they may engage in undesirable actions to
protect themselves from the risks
• For example, by engaging in “gameplaying” behaviors

Most firms do not recast targets but periodically re-forecast

Targets are normally fixed at PC level and above
Achieving targets irrespectively of business conditions
When targets are flexible it is normally at the lower level
- Soap budget adjusted upward or downward if occupancy rate higher or lower (CC)
- Hotel manager’s target is not adjusted (PC)

Types of uncontrollable factors

- Acts of nature (force majeure) Ex. Natural disasters
- Economic and competitive factors
§ Price of inputs
§ Interest rates
§ Currency exchange rates
- Interdependencies: Uncontrollable due to decisions made by personnel in other parts of the
organization, such as at higher levels or in other entities
-
Should the adjustments be for negative uncontrollable factors only, or in either direction, both positive
and negative?

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Benefits of making adjustments. Adjustments allow:
• More accurate performance evaluations;
• Less manager frustration and better motivation;
• Lower compensation costs (in the long run – less risk, less turnover)

For some types of adjustments, the benefits clearly outweigh the costs
• Factor is “totally” uncontrollable
• The effect of the uncontrollable factor can be calculated objectively
• Costly in terms of management time involved to investigate the claims and determine
appropriate adjustments

Costs of making adjustments.

• In all other cases, adjustments should be used sparingly
• Managers are prone to make excuses instead of addressing the problems
• Consideration of adjustments leads to the creation of an “excuse culture”
• The motivational effects of results control system might be undermined

Methods for adjustments. There are different ways of granting flexibility:

• Flexible performance targets (e.g., “flexed budgets”)
• Variance analysis
• Relative performance evaluations (RPE)
• Subjective judgments

Flexibility via RPEà RPE (relative performance evaluations) means that employees’ performance is
evaluated (and target are set):
NOT in term of the absolute level of performance
In comparison of units or gropus of units:
§ Performing the same tasks
§ Facing the same constraints and opportunities

Example: Pizza parlors chain

§ The price of a fundumental input (mozzarella) sharply rose;
§ Prices cannot rise proportionally since demand is elastic
§ All parlors (PC) experienced decline in profits and could not achieve targeted profit;
§ If a manager’s performance is evaluated in absoluted terms, he/she should be considered an
underperformer
§ In relation to his/her peer group, he might have bein line with the peers’ performance

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Variance analysisà Variance analysis is a systematic approach to explain why actual results differ from:
v Predetermined standards
v Budgets

Variance analysis allows to:

v Understand the reasons of the variance;
v Clarify who should be accountable;
v Segregate controllable from uncontrollable variances

In manifacturing operations
Variance analysis is usually applied to manifacturing operations;
It allows to explain why actual manifacturing costs are different from standard costs:
v Materials;
v Labor;
v Overhead.

In other settings
Variance analysis can be used in many settings other than production
It involves:
v varying one performance factor at a time;
v From expected to actual levels;
v Within a computational model
v To see what caused variance

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Challenging but achievable ...

◆ To minimize dysfunctional management actions

» Myopic behavior, data manipulation
◆ To increase manager’s commitment to budget targets
◆ To reduce the cost of organizational interventions
» Management-by-exception
◆ To protect against the cost of optimistic revenue projections
» Over-commitment of resources
◆ To create a “winning” atmosphere and positive attitude

Game-playing
Game-playing is an unintended effect of result control systems;
Game-playing is a reactive subversion to the result control system;
Rational actors try to benefits from incentives and avoid sanctions, irrespectively to improving thier
performance and generating value;
If the result control features are ill-designed, they will encourage gameplaying

There are three well-documented gaming problems (Hood, 2006):

ü ratchet effects
ü threshold effects
ü output distortions

Ratchet effectsà
• Ratchet effects refers to the tendency for controllers to base next year ’ s targets on last year ’ s
performance
• Managers have a perverse incentive not to exceed targets even if they could easily do so;
• Ratchet effect is common in target system that use past performance level as the point of
reference.

Threshold effectsà
• Threshold effects refer to the effects of targets on the distribution of performance among a range
of units
• It might be associated to target and ranking systems
• There is pressure on those performing below the target level to do better
• Also provides a perverse incentive for those doing better to deteriorate their perfomance
• Or more generally to crowd performance towards the target

Output distortion
Output distortion occurs when:
ü activities that are not measured are ignored or disregarded;
ü managers find ways to hit the targets or to move their organizations up the ranking in ways that do
not reflect the intentions of those who framed the system;
ü data reported to controllers are manipulated;

Output distortion is refers to behaviours aimed at :

ü getting the target
ü winning the league
ü missing the point;

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Output distortion might be associated to targets and rankings system

“Beyond Budgeting”?
Some “principles”
• Goals
– Set relative goals for continuous improvement; not fixed performance contracts
• Rewards
– Reward success based on relative performance; not on meeting fixed targets
• Planning
– Make planning a continuous and inclusive process; not a top-down annual event
• Coordination
– Coordinate interactions dynamically; not through annual planning cycles
• Resources
– Make resources available as needed; not through annual budget allocations
• Controls
– Base controls on relative indicators and trends; not on variances against plan

• Applicability in practice?

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 L16- Variance analysis

Variance analysis is a systematic approach to explain why actual results differ from:
• Predetermined standards
• Budgets

Variance analysis allows to:

• Understand the reasons of the variance;
• Clarify who should be accountable;
• Segregate controllable from uncontrollable variances.

Variance analysis in manufacturing operationsà Variance analysis is usually applied to manufacturing

operations
It allows to explain why actual manufacturing costs are different from standard costs:
• Materials;
• Labour;
• Overhead.

Variance analysis in other settingsà Variance analysis can be used in many settings other than
production
It involves:
• varying one performance factor at a time;
• From expected to actual levels;
• Within a computational model
• To see what caused variance

Sales: budgets vs actual

• Industry volume;
• Market share;
• Price in local currency
• Exchang rate

Standard Costs: Standards are benchmarks or “norms” for measuring performance. In managerial
accounting, two types of standards are commonly used.

Price standardsà specify how much should be paid for each unit of the input
Quantity standardsà specify how much of an input should be used to make a product or provide
a service.
Examples: Firestone, Sears, McDonald’s, hospitals, construction, and manufacturing companies.

Setting Direct Materials Standards Setting Direct Labor Standards

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Setting Variable Manufacturing
Overhead Standards The Standard Cost Cardà A standard cost
card for one unit of product might look like this:

Using Standards in Flexible Budgets

Standard costs per unit for direct materials, direct labor, and variable manufacturing overhead can be
used to compute activity and spending variances.
à Spending variances become more useful by breaking them down into price and quantity variances.

A General Model for Variance Analysis

Price and Quantity Standards

Price and quantity standards are determined separately for two reasons:
1. The purchasing manager is responsible for raw material purchase prices and the production
manager is responsible for the quantity of raw material used.
2. The buying and using activities occur at different times. Raw material purchases may be held in
inventory for a period of time before being used in production.

A General Model for Variance Analysis

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A General Model for Variance Analysis

(2) Actual quantity is the amount of direct materials, direct labor, and variable manufacturing overhead
actually used
(3) Standard quantity is the standard quantity allowed for the actual output of the period.
(1) Actual price is the amount actually paid for the input used.
(2 and 3) Standard price is the amount that should have been paid for the input used.

Learning objective 1: Compute the direct materials price and quantity variances and explain their
significance

Materials Variances – An Example : Glacier Peak Outfitters has the following direct materials standard for the
fiberfill in its mountain parka.
0.1 kg. of fiberfill per parka at $5.00 per kg.
Last month 210 kgs. of fiberfill were purchased and used to make 2,000 parkas. The materials cost a total of
$1,029.

Materials Variances Summary

0.1 kg per parka ´ 2,000 parkas
= 200 kgs

$1,029 ÷ 210 kgs = $4.90 per kg

Materials Variances: Using the Factored Equations

Materials price variance Materials quantity variance

MPV = (AQ × AP) – (AQ × SP) MQV = (AQ × SP) – (SQ × SP)
= AQ(AP – SP) = SP(AQ – SQ)
= 210 kgs ($4.90/kg – $5.00/kg = $5.00/kg (210 kgs – (0.1 kg/parka ´
= 210 kgs (– $0.10/kg) = $21 F 2,000 parkas))
= $5.00/kg (210 kgs – 200 kgs)
= $5.00/kg (10 kgs) = $50 U

Responsibility for Materials Variances

The standard price is used to compute the quantity variance so that the production manager is not held responsible for
the purchasing manager’s performance.

Materials Price Varianceà Purchasing Manager --< Your poor scheduling sometimes requires me to rush order
materials at a higher price, causing unfavorable price variances.

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 Materials Quantity Varianceà Production Manager--< I am not responsible for this unfavorable materials
quantity variance. You purchased cheap material, so my people had to use more of it.

Learning Objective 2 à Compute the direct labor rate and efficiency variances and explain
their significance.

Labor Variances – An Example: Glacier Peak Outfitters has the following direct labor standard for its
mountain parka. 1.2 standard hours per parka at $10.00 per hour
Last month, employees actually worked 2,500 hours at a total labor cost of $26,250 to make 2,000 park

1.2 hours per parka ´

2,000 parkas = 2,400 hours

$26,250 ÷ 2,500 hours =

$10.50 per hour

Labor rate variance Labor efficiency variance

LRV = (AH × AR) – (AH × SR) LEV = (AH × SR) – (SH × SR)
= AH (AR – SR) = SR (AH – SH)
= 2,500 hours ($10.50 per hour – $10.00 per = $10.00 per hour (2,500 hours – 2,400 hours)
hour) = $10.00 per hour (100 hours)
= 2,500 hours ($0.50 per hour) = $1,000 unfavorable
= $1,250 unfavorable

Responsibility for Labor Variances

Production managers are usually held accountable for labor variances because they can influence the:
- Mix of skill levels assigned to work tasks.
- Level of employee motivation
- Quality of production supervision.
- Quality of training provided to employees.

Learning Objective 3à Compute the variable manufacturing overhead rate and efficiency variances and
explain their significance.

Variable Manufacturing Overhead Variances – An Example: Glacier Peak Outfitters has the following direct
variable manufacturing overhead labor standard for its mountain parka.
1.2 standard hours per parka at $4.00 per hour
Last month, employees actually worked 2,500 hours to make 2,000 parkas. Actual variable manufacturing
overhead for the month was $10,500.

1.2 hours per parka ´ 2,000

parkas = 2,400 hours
$10,500 ÷ 2,500 hours
= $4.20 per hour

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Variable manufacturing overhead rate variance Variable manufacturing overhead efficiency variance
VMRV = (AH × AR) – (AH – SR) VMEV = (AH × SR) – (SH – SR)
= AH (AR – SR) = SR (AH – SH)
= 2,500 hours ($4.20 per hour – $4.00 per hour) = $4.00 per hour (2,500 hours – 2,400 hours)
= 2,500 hours ($0.20 per hour) = $4.00 per hour (100 hours)
= $500 unfavorable = $400 unfavorable

Materials Variances―An Important Subtlety

The quantity variance is computed only on the quantity used.
The price variance is computed on the entire quantity purchased.

Advantages of Standard Costs

- Standard costs are a key element of the management by exception approach
- Standards can provide benchmarks that promote economy and efficiency
- Standards can greatly simplify bookkeeping
- Standards can support responsibility accounting systems

Potential Problems with Standard Costs

- Standard cost variance reports are usually prepared on a monthly basis and may contain
information that is outdated.
- If variances are misused as a club to negatively reinforce employees, morale may suffer and
employees may make dysfunctional decisions
- Labor variances assume that the production process is labor-paced and that labor is a variable
cost. These assumptions are often invalid in today’s automated manufacturing environment
where employees are essentially a fixed cost.
- Just meeting standards may not be sufficient; continuous improvement may be necessary to
survive in a competitive environment.
- In some cases, a “favorable” variance can be as bad or worse than an unfavorable variance.
- Excessive emphasis on meeting the standards may overshadow other important objectives
such as maintaining and improving quality, on-time delivery, and customer satisfaction.

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 L17- Incentive Systems

Positive and negative incentives

Positive incentives à “rewards” Things employees value

Negative incentives à “punishments” Things employees like to avoid

Individuals are believed to be more strongly motivated by the potential of earning rewards than by the
fear of punishment
Rewards and punishments can both be : monetary or non-monetary

Forms of rewards Forms of punishments

Monetary Monetary
• Salary increases • No raise
• Bonuses • No bonus
• Benefits • No perquisites
• Perquisites:
- Club memberships
- Vacation trips
Non-monetary Non-monetary
• Promotion • Interference in jobfrom superiors
• Autonomy • Loss of job
• Recognition • Assignment to unimportant tasks
• Participation in decisions • No promotion
• Office assignments • naming and shaming
• Preferred parking places
• Titles

Purpose of incentives
• Control purposes
- Informational
Directing effort: helping employees understand
what is expected of them
v Rewards attract the employees’ attention and inform them of the relative
importance of often-competing results areas

- Motivational
Motivation has two elements
§ Inducing effort: getting employees to work hard
v Employees typically put forth more (less) effort on activities that are (not)
rewarded

- Attraction/retention (people control)

v Paying employees only guaranteed salaries tends to attract risk-averse employees
v Paying performance-dependent compensation tends to attract employees who are more
risk tolerant, more confident in their abilities
v (also more aggressive/competitive)
v Restricted stock, for example, often are geared towards employee retention
§ “golden handcuffs”

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 • Non-control purposes
§ Provide a competitive compensation package
§ Make compensation variable with firm performance
§ Tax efficiency
§ Compliance

The compensation packages

◆ Salary
◆ Benefits
– Pension and health benefits
– Perquisites of various types
◆ Incentive compensation
– Short-term incentive plans
Based on the performance in the current year or less
– Long-term incentive plans
Based on the performance measured over periods greater than 1 year
Incentive compensation is called «performance pay» or «at risk pay»; Different from «base
salary»
It is based on actual performanceà Mostly measured against «targets» (attributed through
budgets)

Short-term incentive plans

Based on performance in the current year or less
The most common type is the bonus (annual incentive)à Cash payment
Other types: piece-rate payments or commissions

Long-term incentive plans

Based on the performance measured over periods greater than 1 year
- Usually restricted to higher management levels
- based on perfomance over a period of 3–5 years
- Accounting performance (e.g., EPS, ROE, ROA)
- Market-based performance (RTSR)

The incentive has the form of:

• Delayed cash payment
• Stocks:
- Stock options plans
- Restricted stocks
- Performance stock options plans
- Performance stocks

Overcoming myopiaà (recall)

Therefore, one solution to myopia is to extend the measurement horizon:
v Ex. EPS, ROI, ROE measured over a three to five years period
v Aligning measurement periods to investment payoff horizons
v Lengthen managers’ horizons
However expected payoff must discount deferred compensation
Cost- effectiveness problem

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 L18- Incentive System part 2

Stock options plans

Stock options plans give employees the right to:

- purchase a set number of shares of company stock;
- At a set price (exercise price or strike price);
- During a specified period of time
- (After the option vest but before they expire)

Most options are granted at the money: Exercise price=stock price on the day of grant
Vesting rate is normally three to five years
- 1/3; 1/4,1/5 vest at the end of each year
10 years maturity
- Options expire 10 years after they are granted
When stock price is > exercise price, (in the money) the employee can:
- Hold the shares
- Sell them with a gain
When stock price is < exercise price (underwater):
- Morale problem
- Retention problem

Underwater stock option during Covid

There are four main strategies to consider:
(i) taking a “wait and see” approach,
(ii) providing additional cash compensation
(iii) providing additional equity compensation
(iv) restructuring the underwater options.

Stock options plansà Beside motivational effects for employees, stock options have advantages for
granting firms:
- Granting incentive alignment
- Avoiding cash outlay

Agency relationship à The «principal» delegates the «agent» to act on his behalf;
- Owners – Management
- Boss - staff

Agency problemsà Agents might act in their own interests rather than pursuing principals’ interests:
- Diverging objectives
- Different risk adversion /tolerance
- Informational asymmetry

Stock options plans: aligning incentives

Employees benefit only when the stock price goes up;
» Motivation to work hard to increase company’s stock price
» Employees benefit only when shareholder benefit
» Tying employees’ future wealth to company future
» Vesting schedules, coupled with service based restrictions enhance long term focus
and retention

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Stock options plans
Potential problems:
- Strategic behaviours (congruence problems)
- Dilution

Stock options and congruence problems

Share price is oversensitive to news (ex political events, appointments, new project, etc
– This is a trigger for opportunistic behaviours
– Executives can try to affect market valuations through carefully-timed or “managed
disclosures” that are not in the firm’s long-term interest
Example: provoking downward or upward effect on stock prices for granting or exercising stock option

Stock options and dilution

• Dilution occurs when a company issues new stock which results in a decrease of an existing
stockholder's ownership percentage of that company.
• Dilution can also occur when holders of stock options, such as company employees, or holders of
other optionable securities exercise their options.
• When the number of shares outstanding increases, each existing stockholder owns a smaller, or
diluted, percentage of the company, making each share less valuable.
• While it affects company ownership, dilution also reduces EPS which often depresses stock prices

Diluted Earnings per share

• Diluted EPS is a calculation used to gauge earnings per share (EPS) if all convertible securities were
exercised
ü stock options, warrants, convertible preferred shares, convertible debentures;
• The conversion would increase the total number of shares outstanding in the market

Diluted EPS = (net income – preferred dividends) / (weighted average number of shares outstanding
+ the conversion of dilutive securities)

Restricted stock plans

◆ Under restricted stocks plan, eligible employees are simply given the share;
◆ Selling the shares is restricted for a specified period of time and contingent upon employment;
◆ Employees have full:
» Voting rights
» Dividend rights
◆ Restricted stocks provides a reward in case stock price goes up;
◆ However, the stock itself has a value also in case price is flat or declines (unlike stock options);
◆ Since restricted stocks are less risky than stock options, the firm provide fewer shares;
» Prevents dilution
◆ Restricted stocks have been criticized as a «giveaway» or «pay for pulse»;
◆ The stock has a value in itself and restrictions disappear merely due to passage of time;
◆ Restricted serves better retantion purposes than motivation purposes.

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Performance option plans
Performance options are alternative stock options plans:
- Vesting or exercise of the options contingent on improvements in stock performance or other
targets
Performance options can be:
- Premium options (exercise price > stock price on grant date)
- Indexed options (exercise price contingent on RPE)
- Performance vested options (options vesting linked to performance goal achievement)

Performance stocks plans

Some firms resort to performance stocks:
- Restricted stock that vest on the achievement of specific performance targets
- Until the goal is achieved shares are subjected to restrictions

Variations
- Performance share units (Coca cola):
Employees receive stocks if CAGR in economic profit target is met over 3 year period
- Stock appreciation rights:
Employees receive an amount = increase in stock price over a given period
They do not have to spend cash to buy the stocks

Designing incentive plans:

- Eligible employees:
Incentive plans are different for different categories of employees
ü CEOs
ü Corporate managers
ü Divisional managers
ü Functional managers

- Size of awards :
(fixed vs. variable «performance» pay)
(ex. target bonus = 30% of salary)
– Performance-dependent rewards impose risk on the employees as performance is
never fully controllable
– Across firms, differences in the proportion of “at-risk” pay are greater than
differences in base pay
– Levels of “at-risk” pay generally decrease at lower organization levels

- Bonus pool:
• Function of firm performance
Example: ferreteria de mexico (4 m+8%income in excess of 120m)
• It is a function of firm performance since it aligns incentives
ü management/owner
ü across units

- Level and type of measurement:

o Performance at the individual, entity or company level
o Financial vs. non-financial performance;
o single or multiple measures performance criteria
o weights
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 - Bonus calculation:
◆ Formulaically
» The performance-reward link is explicit
» Alleviates bias or favoritism in assessing and rewarding performance
but
» Possibly less focus on performance dimensions that are more difficult to
quantify (e.g., R&D)
◆ Subjectively
» Allows performance to be evaluated more “completely” considering any of a
number of hard-to-quantify, but important, performance areas
» Lack of explicitness increases the employee's risk (due to possible bias)

- Shape of reward function:

Commonly, the link between rewards and results is linear, but over a restricted performance range
only

Cutoffs
◆ Lower cutoff
– To avoid paying bonuses for performance which is considered mediocre or worse
◆ Upper cutoff
– To maintain vertical compensation equity
– To keep total compensation somewhat smooth over time
– To avoid the fact that managers will be “unduly” motivated to take actions to maximize
bonus payouts
– To avoid undeserved bonuses due to “windfall” gains
– To alleviate the possibility of a faulty compensation plan design

Group rewards
◆ Team-based rewards are often used to implement personnel / cultural controls
– Group members monitor and sanction each other’s behaviors
◆ They rarely provide a direct incentive effect
– Stock-based plans, for instance, provide direct incentives only for a small number of
managers at the very top of the firm
– Hence, for lower-level employees, compensation is made more volatile, although
motivation may not be (greatly) affected

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Criteria for evaluating reward systems
◆ Rewards should be valued
» Rewards that have no value do not provide motivation
» Reward tastes vary across individuals and are situational
◆ Rewards should be large enough to have impact
» Reward “visibility” can affect impact
◆ Rewards should be understandable
» What is the reason for earning the reward?
◆ Rewards should be timely
» The discount rate employees apply to delayed rewards
is said to be greater than the time value of money
◆ Rewards should be durable
» Rewards have greater value if positive feelings generated
through the reward are long-lasting, that is, if employees remember them
◆ Rewards should be reversible
» To make rewards “variable” with performance and to create a lasting incentive
effect (pay-for-performance vs. pay-for-pulse)
» Promotions, for instance, are difficult to reverse
◆ Rewards should be cost efficient
» To stimulate the desired motivation at minimal cost

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