On what is the focus with performance measures (Result controls)
On the outcome of employees actions.
When do you want to use PM?
When employee actions cannot be observed
What is the ideal PM?
Individual contribution to firm, but this doesn’t exist, so we chose suboptimal second best.
What formula is used for evaluation of PM?
Firm value = Z
Measure (Y) = a*effort + e
Z = Firm value
Y = PM
effort: amount of effort by employee
a = sensitivity, the higher the better
e = external factors, negative factor
What does a good PM do?
Closely reflect the employee’s effort while minimizing the impact of noise or factors outside their control
What are the 4 criteria to evaluate PMs?
- Sensitivity: to what extent can employee inlfuence measure (a)
- Noise: to what extent is measure influenced by other external factors
- Congruence: to what extent does increase in measure lead to increase in firm value
- Manipulation: to what extent is the measure susceptible to manipulation.
What describes financial PM?
- Summarizes broad set of actions of manager in one comprehensive PM
- Reflects the aggregate, bottom-line impact of multiple performance areas
- Aggregate PM facilitates autonomy at lower-levels.
What are the 2 types of FPM?
Market measures and Accounting measures
What describes market measures?
Forward looking (based on future CF)
- Market incorporates current actions of manager
- May reward anticipated behavior
- manager can influence stock price with strategic information disclosure.
What is the evaluation of market measures?
Sensitivity: good for executives, not for lower-level
Noise: high, strong impact external factors –> Much risk imposed on managers
Congruence: best
What describes accounting measures?
- Available at many levels (eg firm/divisional profit)
- Accounting typically focused on realized gains and losses (backward looking)
- Translation of economic events in accounting reporting system regulated.
What does accounting allow you to do that market doesnt?
Accounting allows measurement at lower-level functions.
What is the evaluation of APM?
- Sensitivity: Good, reward at appropriate level
- Noise: better,
- Manipulation, better: accounting principles & auditor
- Congruence: weak
- Ignore externalities: non included, but might be important (sustainability)
What describes the weak congruence of APM?
- Backward looking
- Poor match current investments and future benefits (conservative accounting)
- Price leads earnings
- Ignores IA
What can control systems result in relating to APM?
Control system can make you make decisions that are not in the best interest of the firm.
What are the 4 APM?
- Gaap earnings
- ROI (ROA, ROE)
- Residual income (RI)
- Economic value added (EVA)
What can be said about GAAP Earnings
- Absolute measure, does not take use of resources into account –> cannot compare NI between segments of different sizes
- No CoE taken into account
–> overinvestment if NI of project < CoE
What can be said about ROI?
- Managers accept if ROI P > ROI current, but should when R > CoC
Can result in underinvestment - Using net value of assets implies ROI increases over time
Can result in postponing investments or retaining current assets beyond useful life.
What is the formula for RI?
RI = OI * (CoC * Capital invested)
What does RI solve?
THe underinvestment problem of ROI, gives incentive to invest in all projects that generate returns > CoC.
Incentives are congruent again.
What are the downsides of RI?
- Susceptible to accounting shortcomings –> investments lower RI, underinvestment
- What is appropriate CoC (risk profile, shareholder return)
- Cannot compare RI of segments of different sizes.
What is the formula for EVA?
EVA = modified profit - (WACC * Modified total capital)
What are the advantages of EVA?
- Can increase decision making with more long-term focus
- Can incentive managers to pursue long term value creation and limit short-termism
- Useful for firms with high IA
What are the main problems with using profit per share as a PM?
- Focus on short term performance (quarter focus)
- Constantly trailing expectations of the market
- Does Not include CoE, only CoD
