1
Q
General principles: Performance Evaluation
A
The major costs to be allocated. Time and effort should be focused on allocating these ‘correctly’ to divisions. The other costs are relatively immaterial.
The basis of allocation should be transparent and fair as this will impact the divisions’ performances and possibly bonuses paid and the more closely aligned with the usage of the underlying resource the more accurate the allocation will be
-The allocation of the majority of overheads is most likely going to be arbitrary
-It is important to note that the benefits of the better allocation system should exceed the cost.
-The majority of costs are directly traceable to the division and will therefore not need to be allocated. Only costs that are not directly traceable will need to be allocated
-Should salary costs be allocated? They could be treated as a fixed cost in the business
2
Q
Performance evaluation formulas
A
- Return on Investment = Net Income / Equity capital
- Residual Income = Net Income- (Cost of equity Capital)
- EVA = Net Operating Profit After Taxes (NOPAT)- (Capital * Cost of Capital)
3
Q
ROI
A
Advantage
• Simple to calculate
• Relative measure and easy to compare
- Indicates relationship between income and amount invested
-It indicates effectiveness of asset management
Disadvantage
• Ignores risk
• Easy to manipulate
• Can lead to incorrect decisions
*Accounting based measure of profits
-Sub optimal decisions
-Short term is emphasized
-It ignores risk
4
Q
RI
A
Advantages:
- Considers risk (through WACC)
• Usually motivates correct decisions
• Considers income earned relative to investment made
- Sub-optimal decisions are discouraged
-Rate of return is arbitrary
-Short term is emphasized
-Ignores cash
Disadvantages:
*Absolute number
• Accounting base
5
Q
EVA
A
Advantages
Operating income limits manipulation
• Accounting adjustments remove IFRS distortions and provide economic profit
Takes tax into account
Proper calculated WACC
• Takes gearing into account
• Allows different risks levels to be taken into account ,through the use of different costs of capital
Absolute measure
Working capital management rewarded
Economic measure – based on NPV principles- Moving towards cash basis rather than accounting
Disadvantages
Not a percentage therefore cannot compare across different size
investments.
• (Should be compared to budgets or targets to reflect size.)
Complexities in calculation.
6
Q
Balanced scorecard
A
- Financial performance (Net income/ ROI)(EVA, ROA)
- Customer satisfaction (Retention, market share, profitability) (Repeat purchases)
- Learning and growth (EE satisfaction, EE retention, EE productivity, Training ) (Training time)
- Internal business process (Supplier relations, process improvement incentives) (Number of times something happens)
- Mention overall sustainability
- If something is not done, mention and that it should be corrected
- The company must devise a strategy and then find KPI’s at each staffing level that drive that strategy.
- It is vital to involve staff in the design of the KPI’s to ensure they buy in, and that they are reasonable measures.
- Each KPI must be linked to a desired final outcome.
- Financial Revenue maximisation, cost minimisation and profit maximisation, to make sure the company performs well for shareholders.
- Measure of asset value created, increases in the capital value of the investment assets to ensure value is created in asset base.
- Debt ratios to monitor and manage the amount of debt the company is exposed to, interest cover etc.
- Could use the covenant ratios for interest cover, and debt to market value, to ensure compliance.
- Customer Renewal success rate, to measure that clients are renewing their contracts, and revenue not being lost.
- Customer satisfaction measures in surveys, adequacy of services and state of repair of buildings, to ensure that clients are content and remain as tenants.
- Number of new clients being attracted to spaces. This will measure the effectiveness of marketing and reputation in bringing in new revenues.
- Customer other 2 Internal business Revenue generated per square meter of gross lettable area, measuring how efficiently the spaces are generating revenue.
- Number of vacancies, to ensure that properties are in good areas where clients are prepared to return to, and how quickly empty spaces get filled, to increase revenue.
- Expenses per GLA at properties, to measure the amount of cost being spent on different properties and track which properties are less profitable to be disposed of.
- Other internal business 2 Learning and growth Number of new building spaces acquired, new investments, to measure the amount of growth in the property portfolio.
- Number of training hours logged for staff, or number of training courses, to monitor how well we are training staff, ultimately to minimise costs and maximise revenues.
- Number of innovative ideas implemented from staff to repurpose the office spaces after the change to work at home, how well are we redesigning and reselling our spaces.
7
Q
Bonus scheme critical analysis
A
- It is easy to understand and calculate the incentive.
- Incorporating ROE into the calculation forces management to focus on capital utilisation and not just profits.
- Encourages team work, as bonuses are dependent on overall xx performance.
- There is no link to individual performance, achievement of KPIs. Certain senior managers could slack off and still receive bonuses
- There is no limit on bonuses
- There is no carry forward of the bonus pool – bonuses should be paid out over e.g. three years, subject to minimum performance targets in subsequent years.
- The scheme encourages short-term decision making.
- Higher salaried managers receive higher bonuses – perhaps bonuses should rather reward value-added contributions? (or alt)
- The bonus calculation is skewed towards EPS achievement (annual increase in EPS versus nominal increase in ROE). This encourages a focus on profits as opposed to cash generation and value creation.
- It ignores the cost of capital – an EVA type scheme rewards value creation as opposed to profit growth.
- There are no negative consequences for poor performance in a particular year, which encourages write-offs / higher provisions / impairments in ‘poor years’ and gaming of the system / PAT manipulation.
- Qualitative factors are ignored in the scheme, such as customer satisfaction, innovation and business improvement. A balanced scorecard approach should be used.
- Senior management can increase bonuses through share buybacks, raising debt funding(improves the ROE).
- Based on accounting numbers, not economic. EVA is focused on achieving a return on assets above the cost of capital and the bonus scheme should be directly aligned with the EVA performance of the firm in order to incentivise and achieve goal congruence.
- The approach is not benchmarked to market practice. Should consider attractiveness of competitors offerings.
- Book value of equity is used, argued that the market value of equity should rather be used.
- Scheme is not clear on whether added back bonus is cumulative, calculation therefore messy.
- As the scheme includes only senior management, could result in resentment from other staff, lower productivity, and union action as other staff are not incentivised to improve performance
- It discriminates against high asset divisions
- It disregards risk
8
Q
Performance Evaluation: Managers
A
- The current performance evaluation used to evaluate the f manager inappropriate for the following reasons:
1) It does not take into account the strategy of the company and whether the manager has acted in line with this.
2) The strategy of both AVI and I&J have sustainability has a core focus, which was not incorporated into the performance review.
3) It measures the manager on costs and revenues that he has no control over.
4) It focuses on short-term profitability as opposed to long-run profitability which is of critical importance in this industry.
5) The huge delay between actual performance and evaluation is inappropriate as it creates a disconnect which is required to motivate staff.
6) The current system ignores innovations incorporated as well as key relationships that have been established.
-Only costs under the control of the respective divisional managers should be included in their performance evaluation.
-Current scheme puts the divisional managers in opposition to compete for annual
bonuses rather than encouraging collaborative value creation.
-The current scheme does not consider utilisation of capital
-The current scheme is cash based only and has little/no alignment to shareholder value.
-Difference in the degree of operating leverage should be considered
- There seems to be a fair weighting between financial and non-financial measures. But the financial measures are skewed to the short term, rather than long-term value added, and percentages rather than absolute value added.
- The fact that the weightings are different for the MDs and CFO makes sense as the MDs would have to do more work on the ground (e.g. relating to client satisfaction) and the CFO would have greater responsibility for budgets and cost control (net profit percentage).
- Qualitative elements are at an in appropriately high level; there is a need to add more detail so that they are objectively measurable
- The company should consider using a balanced scorecard approach to correctly drive performance management, they should also consider using economic measures that are not impacted by accounting shortcomings
- There should be consideration of the controllability of the different aspects. It is not clear that all aspects in each indicator can be controlled
- There is an element which does align the outcomes of the management with the shareholders, thus less agency issues.
- There is no indication of how the client satisfaction or staff utilisation is measured, this should be explained.
Other aspects to consider when evaluating performance:
- Co’s response to changes in market and technology
- Efficiency of resource management
- Capacity utilisation
9
Q
ROCE and EVA
A
ROCE
- Based on accounting information and does not ensure goal congruency
- Sub-optimal decisions can be made
- ROCE will not pose a problem for divisions that are investment centers
EVA
- Focus on wealth creation
- It is based on investment center and will lead to goal congruency
- Discount rate specifically relating to to risk profile of division
- Measures economic returns not accounting returns
- Ensures the required return on capital is taken into account
10
Q
Evaluate the current bonus scheme
A
- Based on accounting numbers, particularly the assets which are at historic cost.
- This would incentivise holding on to assets for long periods to decrease denominator.
- Includes non controllable aspects of costs such as rentals and headoffice costs.
- Is not based on economic principles, cash flows, therefore inherently flawed.
- Compares divisions which are operationally very different. Not appropriate.
- Doesn’t analyse elements of fixed and variable to determine risk and sensitivity.
- Includes depreciation which is non cash and an accounting item.
- Does not include risk element. (Other)
- No long term aspect measured, only short term, one year, should be multi year.
- Measure ignores the companies core values, sustainability
- ROA should only be used for capital intensive businesses, divisions are not.
11
Q
Performance evaluation methodology
A
- Evaluate the performance management formula
- Every division has different functions, therefore is difficult to use one set of criteria.
- Divisions are not profit centers, therefore non-financial measures may be better.
- Standard costing may also be useful based on the structure given.
- Recommend the balanced scorecard.
- Performance should be considered more frequently, and corrective action taken, annual is too long.
- One measure for all employees is innappropriate.
- Individual measures based on what the employee can control should be used.
- Allocation based on number of hours worked is incorrect, as it merely rewards hours charged.
- The formula should include a measure of efficiency, productivity etc.
- Multiplying hours by an arbitrary factor is not justified, and seems unreasonable.
- The quantum of 3 is also unsuported and seems unreasonable that office staff should receive 3 times the bonus.
- All work has its stresses, and is difficult to quantify, this would cause friction with staff.
- NPAT is an accounting measure, not an economic measure, therefore has shorcomings.
- The arbitrary multiplication by 30% is not explained or justified.
- Presumably the company is distributing 30% of profits? production/capacity is outside of the control of many of the staff.
- production/capacity is positive in that it incentivises using full capacity.
- production/capacity is negative as it will encourage overproduction to maximise bonus in formula manipulating the multiplier.
- production/capacity is negative as it will encourage overproduction to move costs into inventory, manipulating the profit.
- There is a disincentive from increasing capacity, therefore employees will avoid growth to avoid dilution of bonus.
- Including rejects is positive as it encourages quality control, and ensuring no wastage.
- Comparing rejects to prior year is however negative, as employees would just plan on one bad year to lower the base, and then outperform on the comparitive later.
- Rejects unfair, as most employees cannot control rejects, yet will be measured on them.
- Using carbon footprint is a good idea, brings in an environmental measure.
- Comparing carbon to prior year is however negative, as employees would just plan on one bad year to lower the base, and then outperform on the comparitive later.
- Carbon unfair, as most employees cannot control carbon, yet will be measured on them.
- Hours / total hours does not differentiate between different levels of employees. This could be positive or negative as long as justified.
- Introducing a rating results in the whole bonus pool not being distributed, what happens to the excess?
- Using a rating is positive, as it does bring in an individual element.
- The rating methodology is however flawed and subjective.
- Also ratings by colleagues may be negative or positive, popular people rewarded, less popular penalised, and not necessarily best workers.
12
Q
Evaluate each geographical segments’ performance in relation to the key performance indicators
A
- Consider the ability of the division to control
- If non controllable, should be excluded from the performance evaluation.
- What makes sense and why (use general things to support argument)
- It is positive that qualitative elements are being considered.
- The arbitrary allocation of management fees distorts the performance of the divisions
- Management fees should be allocated to the division(s) that require the most management attention
- company should consider using a balanced scorecard approach to correctly drive performance management,
- they should also consider using economic measures that are not impacted by accounting shortcomings.
- SA was the only segment whose net profit percentage increased significantly showing an excellent performance
- The above is most likely due to…
- staff costs have decreased significantly, investigate as to why, either less staff, or they are being paid less
- The decline in staff costs means that with less staff at SITS SA, the capacity utilisation is necessarily higher
- There is a significant increase in other fixed costs. This is a concern and needs to be investigated coz results in higher DOL
- SA’s net profit percentage is still lower because of the higher tax rate
- Profitability would have been significantly higher if based on ABC
- A decline in their return on assets (ROA), indicating that assets have been used less effectively to generate profits.
- Would have expected the SITS SA ROA to have improved, given its strong increase in profits. (Consider assets individually and question anything)
- The assets have declined, therefore the profit decline is the biggest driver of this decrease.
- An opportunity cost for not being able to take advantage of
- It is surprising that…
- Brazil appears to have managed its other fixed costs well given the large decrease, increasing profit.
- Conclude on which division is the best
*
