Lecture 5

Question 1

What is the goal of performance measurement systems?

Answer 1

Helps managers and employees understand, implement, and refine the organization’s mission, goals and strategies.

Question 2

Pitfalls when using financial measures

Answer 2

• Pitfall 1: What profit should we use?
• Pitfall 2: Return on Investment or Residual Income

Question 3

What is the ROI?

Answer 3

ROI = Earnings before interest and taxes / Assets employed

Question 4

What is the RI?

Answer 4

• RI = Earnings before interest and taxes − Capital charge
  o Where: Capital charge= Cost of capital × Assets employed

Question 5

Reasons to use RI over ROI to achieve goal-congruent behaviour?

Answer 5

1. All investment centres have the same profit for comparable investments.
2. Decisions that increase a centre’s ROI may decrease its overall profits (disposal of an asset)
3. Different interest rates may be used of different types of asset.

Question 6

Economic value added (EVA)

Answer 6

• An advanced version of RI focuses on the measurement problems of intangible non-current assets.
• Suggest that a number of accounting adjustments need to be performed to arrive at ‘better’ measurement of profit and assets employed than if book values of intangible non-current assets are used.
• EVA® = adjusted net operating profits after taxes − (cost of capital × adjusted assets employed).

Question 7

Non-financial measurements

Answer 7

• Financial measures are defined as lagging or historical measures.
• Non-financial measures are defined as leading in that they also relate to the means to reach future profitability.
• For non-profit organizations non- financial measures are important on a stand-alone basis.
• Relying solely on financial measures can be dysfunctional.

Question 8

What are examples of non-financial measures?

Answer 8

• Customer-oriented measures e.g. market share; customer satisfaction & retention.
• Business process-oriented measures e.g. on- time delivery; capacity utilization.
• Employee-oriented measures e.g. number of training hours completed per employee: employee retention.
• Innovation and environment-oriented measures e.g. number of new products/ services launched and/or percentage of sales from new products or services.

Question 9

Pitfalls when using non- financial measures

Answer 9

• Pitfall 1: Not validating the causal links
• Pitfall 2: Forgetting to consider the system support when choosing non-financial measures
• Pitfall 3: Not setting the right performance targets

Question 10

The Balanced Scorecard

Answer 10

• Financial perspective – how do we look to shareholders? (lagging measures)
• Customer perspective – how do customers see us? (leading measures)
• Internal business perspective – what must we excel at? (leading measures)
• Innovation and learning perspective – can we continue to improve and create value? (leading measures)

Question 11

What are issues related to implementing a BSC?

Answer 11

• Top management commitment and employee involvement.
• Review measures and results frequently.
• Avoid measurement overload and reflect on the link to incentive systems.

Question 12

Agency theory: Related to Theory X, based in economics

Answer 12

• Agency theory describes how an organization in principle is no more than a (collection of) principals and agents that engage in contracting, in which an agent commits themselves to work for a principal.
• What contract should be specified to make the agent work in the best interest of themselves and of the principal.
• The focus in the analysis lies with designing the so-called, payment function in the contract. This payment function specifies the relationship between how the agents perform and what they receive in terms of monetary rewards. Agency theory sees such performance contracts as optimal, although the exact form of the payment function depends on various contextual factors, such as risk.

Question 13

What are different roles of compensation (contract)?

Answer 13

• Pay
• Attract managers and employees
• Keep managers and employees
• Credit for a job well done
• Encourages effort
• Incentives can make people more inspired Goal congruence
• Flexible remuneration
  o Compensation that is on a larger extent variable

Question 14

What are types of incentive and motivators?

Answer 14

• The basic salary
  o A reasonably good level of basic salary may make employees feel appreciated and valued, which may very well contribute to their motivation.
• Short-term variable financial incentives
  o Make bonus equal to a set percentage of the bonus.
• Stock options
  o Right to buy a number of shares at, or after a given date in the future, at a price agreed upon at the time the option is granted.
• Intrinsic incentives
  o Employee satisfaction
  o Interesting work tasks
  o Challenging work
  o Meaningful work
  o Kinship
   Working together with people you like.

Question 15

What are divergent objectives of principals and agents?

Answer 15

• Individuals act in their own self-interest
• Agent’s preference for leisure over effort: work aversion
• Deliberately withholding effort: shirking
• Principals only interested in financial returns

Question 16

Non-observability of agents’ actions

Answer 16

• The principal cannot easily monitor the agent’s actions
• Principal cannot be certain how the agent’s effort contributed to actual company results: information asymmetry
• The agent may know more than the principal about the task: private information
• Diverging preferences may lead the agent to misrepresent information: moral hazard

Question 17

What is monitoring?

Answer 17

o Limiting actions that benefit the agent at the expense of the principal e.g. financial control system and auditing
o Very difficult to monitor complex tasks

Question 18

What is incentive contracting?

Answer 18

Should make the agent work in the principal’s best interest - goal congruence.

Question 19

What is Self-determination theory (SDT)?

Answer 19

• Related to Theory Y, rooted in psychology
• Self-determination theory (SDT) is a macro theory of human motivation and personality that concerns people’s inherent growth tendencies and innate psychological needs. It is concerned with the motivation behind choices people make without external influence and interference. SDT focuses on the degree to which human behaviour is self-motivated and self-determined

Question 20

What is Motivation Crowding theory?

Answer 20

Motivation crowding theory is the theory from psychology and microeconomics suggesting that providing extrinsic incentives for certain kinds of behaviour—such as promising monetary rewards for accomplishing some task—can sometimes undermine intrinsic motivation for performing that behaviour. The result of lowered motivation, in contrast with the predictions of neoclassical economics, can be an overall decrease in the total performance.

Question 21

What is the crowding-out effect?

Answer 21

• Total motivation is the sum of intrinsic and extrinsic motivation
• But increasing one type might reduce (or increase) the other
• Extrinsic motivation tends to crowd-out (but may crowd-in) intrinsic motivation
  o Adding external rewards might even reduce the total motivation
  o Total motivation might increase if an external reward is removed.

Question 22

When does the crowding-out effect appear?

Answer 22

• When there already is a strong internal motivation in place;
• When the external intervention is perceived as controlling;
• If, on the other hand, the external intervention is perceived as supportive, internal motivation is crowded in;
• External rewards do not crowd out motivation if they are unexpected or unrelated to behaviour;
• A collective reward is less likely to crowd out intrinsic motivation.