Applications, Advantages and Disadvantages for Management Reward - Essay Example

Residual Income Measuring Managerial Performance: Applications, Advantages & Disadvantages for Management Reward By YOU Your Academic Organization Here Appropriate Date Here Abstract Due to the nature of todays contemporary businesses, in relation to complicated domestic and global business practices, different methods are required to measure the performance levels of corporate executives. The traditional Return on Investment (ROI) template, which calculates the net operating income of the firm divided by its average operating assets, is being abandoned by some firms when measuring performance and is being replaced with the residual income method. This paper will describe residual income as well as highlight the advantages and disadvantages of its implementation for executive compensation guidelines. Residual Income Measuring Managerial Performance: Applications, Advantages & Disadvantages for Management Reward INTRODUCTION In business, residual income represents a specific financial amount derived from an equation which subtracts invested capital from total, pre-tax profitability (Accaglobal.com, 1999). Where the traditional return on investment (ROI) template, which calculates a percentage by dividing the average operating assets from net operating income, residual income is represented in actual dollars through its calculation. Professionals argue that residual income (RI) may not necessarily reflect the total performance of a managerial professional, hence there is the debate as to whether compensation directly linked to RI totals is a fair measure of reward for performance. This paper examines the contemporary usage of residual income as a performance measure. DEFINING RESIDUAL INCOME There are several viable calculations to determine residual income (RI), with the most common being operating income minus the required return on investment in dollars (Marshall, McManus & Viele, 2006). A second method is subtracting required income from actual income, representing a final financial (not percentage) total, indicating either a negative or positive residual income (Economist, 1996). For instance, if the actual income of the firm is $100,000 and required income (often calculated from ROI) is $50,000, the firm has experienced a residual income increase of $50,000, which may indicate that the company executive leadership has made positive strides in boosting profitability. When ROI is used in the equation to determine residual income, positive RI occurs when actual ROI is greater than the minimum required ROI. These calculations may sound very simplistic and relatively straightforward, however, calculating residual income is not always a fair measure of total executive performance, especially when a particular company has experienced years of negative residual income. For instance, assume that a firm maintained a negative residual income for five years, amounting to $75,000 each year. When a new executive leader is assigned to a position of executive-level decision-making, he or she may boost the residual income by only $45,000, still indicating a $30,000 deficit in RI calculations. Should this manager receive inadequate bonus or reward payments for this or should the executive be rewarded for making a sizeable dent in the negative totals? Defining residual income is increasingly difficult, as a variety of firms tend to use different calculations to determine this financial total. However, it is clear that a basic template exists surrounding RI which represents a tangible financial total (dollar amount) that is used as the primary element behind what constitutes a fair executive compensation or bonus package. RESIDUAL INCOME CALCULATIONS AND SCENARIOS In business, maintaining large-scale assets can often be detrimental to determining the total return on investment in the company, especially when net operating income is unusually low, due to a variety of reasons. Assets represent the cost of capital, which involves accumulating various properties, machinery or inventory. Though an executive leader may determine that, in any particular period, the business must invest heavy financial totals into asset accumulation, this executive may actually be diminishing the likelihood of receiving performance-related compensation due to this activity. Why? If the net operating income of the firm equals to $200,000 and the firm invests $180,000 in assets, this represents only $20,000 of residual income. Of course, under this same calculation, if the asset investment figures exceed the operating income, there will be a negative residual income total for the firm. Though this manager may have created an increased, internal capability for the company in relation to machinery and property acquisition, which might boost productivity or product output, the costs of capital could be similarly compared to an individual who makes purchases equal or above what is actually earned through sales. Despite creating a long-term capability on behalf of the firm to maintain a competitive advantage, short-term this diminished residual income due to heavy asset investment might represent a perceived failure to provide an adequate return on investment. Under this scenario, where asset purchases outweigh operating income, analysts argue that residual income calculations are not a fair assessment of a managers true contribution to enhancing profitability. This hypothetical manager may have actually used long-term strategic goal-setting to improve the asset position of the company, perhaps by recognizing that to maintain competitiveness in their industry, immediate expansion was required to sustain increased product output. When the firms Board of Directors analyze performance levels based strictly on the RI totals during the specific period, the executive may actually be chastised for creating a negative or diminished residual income calculation despite having secured the longevity of the firm in relation to expansionary efforts. This would, of course, depend on the specific calculation used to determine residual income and the actual assessment capabilities of the board responsible for determining total executive performance. ADVANTAGES OF RI ASSESSMENTS Some proponents of RI as a measure of managerial performance suggest that the largest advantage of this method is that it makes executives actively consider the costs associated with accumulating and using capital investments (Inman, 1999). Capital investments represent various asset purchases and usages, which is commonly understood as being a costly element to sustaining business competitiveness and growth. When managers are more responsible in capital purchases or utilization, they are able to provide a lower-cost method of business enhancement without sacrificing residual income based on net operating income. By using residual income, as the dollar amount leftover after subtracting required ROI from tangible income, it promotes a stronger assessment capability in the manager related to asset acquisition. Essentially, using residual income as a measure of performance forces the manager to consider the costs of assets carefully instead of making rapid decisions without weighing both the short- and long-term costs to the business (Gebhardt, Lee & Swaminathan, 2001). It basically provides the incentive for intelligent managerial decision-making related to capital expenditures. Additionally, the residual income calculation is also cited as providing executive management with a tangible financial figure to be concerned with, rather than simply working toward the receipt of a percentage, which ROI typically provides. This would, in theory, allow the manager to assess the costs of capital accumulation and utilization from a physical dollar amount instead of a broad percentage, which would promote higher levels of scrutiny related to economic expenses, perhaps giving this leader enhanced experienced with analyzing accounting documents as they begin analyzing the costs of capital expense by expense. Instead of reviewing quarterly financial documents and then acting on shortcomings, they are promoted to review financial data more consistently, giving them time to make educated decisions in real-time (rather than over an elongated period) to reduce capital expenses. DISADVANTAGES OF RI ASSESSMENTS The aforementioned residual income calculations create disadvantages as well, in relation to determining a fair bonus or reward for managerial business performance. One major disadvantage lies in periodic reporting, which highlights a specific time period by which performance is measured. For instance, an executive may impose above-average costs of capital as part of a broader business project, such as the development of a newly-acquired property as part of a global expansion initiative. In the short-term, the costs associated with taxation, building development, sewer and sanitation aspects, and construction labor payouts will impact the financial position of the firm, reducing ROI and residual income. However, over a period of, perhaps, two years, this original capital investment may provide a superior operating income for the firm due to the physical utilization of this finished property investment, which will likely boost the RI totals in the following yearly period. As such, should the manager be penalized for long-term, forward thinking or should he or she be applauded for making a superior judgment for long-term sustainability? This is the most primary disadvantage: Managers may not receive adequate compensation simply because the costs of capital rise during a short, immediate time period despite their actions to preserve the integrity of the business as a whole. Net present value is important to identify as well, which represents a technique of budgeting related to costs of capital investments (Marshall, McManus & Viele, 2007). Net present value measures the immediate value of, for instance, a piece of property that has yet to be developed or utilized to its fullest potential. This property in the short-term may only have a value of $1 million in the first quarter of the business reporting period, but be worth significantly more by the end of the last quarter (Bausch, Weifenberger & Blome, 2005). Having an immediate negative financial total associated with the current value of the undeveloped property may be a catalyst for failure to receive adequate compensation for performance, even though this investment represented a rather obvious informed decision on behalf of the manager despite the short-term loss on the required return on investment. Taking into consideration, again, the most common calculation for return on investment, this being net operating income divided by average operating assets (MIT, 2006), residual income as a financial dollar amount as opposed to ROI as a percentage creates increased difficulty for the manager. When ROI represents a percentage, and when ROI is used as a performance measurement, there are controllable factors involved which provide the manager with a much broader opportunity to enhance profitability without necessarily having to consider only the costs associated with various assets (Bujold, 1998). For instance, net operating income can be manipulated through other business activities or investment-related practices which will boost the numerator in the original ROI equation, thus enhancing total ROI percentages. Under the residual income calculation, costs of capital are the primary element of the business which the manager must regulate expense for expense, creating additional work volumes in relation to monitoring how the firm spends its resources on long-term investments (Viele, 2004). Thus, if required ROI were assigned at 15%, achieving this goal can be accomplished through other business activities, perhaps from marketing efforts to boost sales volumes primarily, outweighing capital investments. However, add residual income into the equation as a total from operating income minus required income, there is much more opportunity to experience lessened profit as a dollar amount than as a percentage of the business total operating activities. With this in mind, residual income may be a fair performance measurement in one firm, where in another with more uncontrollable or complicated investment activities, this is not a balanced method to determine total managerial performance (Cross, Martin & Wong, 2000). ARE RESIDUAL INCOME MEASUREMENTS FAIR? General Electric, a long-standing company providing innovation in appliances, consumer electronics, and even large-scale air and transportation developments (among many other products and activities) incorporated the residual income measurement of performance in the 1950s. This was largely due to similar acknowledgement that the more traditional methods of using ROI figures as a firm measure of managerial performance maintained its weaknesses and provided managers with less motivation and incentive to maintain lowered capital expenditures ((Dierks & Patel, 1997). By adopting the RI method of evaluation, the firm provided its managers with increased levels of personal accountability related to high asset purchases and land acquisition (Dodd & Chan, 1998). After adopting residual income as the most appropriate measure of performance, the firm began to experience higher returns on investment due largely to managers being forced to routinely monitor their costs of capital as a motivation to receive performance-based compensation. Having offered this, and with the research support of the case of General Electric adopting RI as the standard for executive bonus payments, it appears that calculating residual income can measurably provide firms with a more balanced executive leader who is actively involved in enhancing the firms total financial position and is routinely aware of wasteful capital expenditures. There may be a significant portion of executives in America who would disagree, arguing that certain capital expenditures have uncontrollable elements and simply must occur in order to sustain the business (Anwar, 2002). These elements might include payments for asset accumulation in relation to inventory and machinery. For instance, consider a firm who relies on quarterly customer forecasting as the primary basis of its production and raw materials purchases (supply chain). As part of the forecast agreement, the firm purchases extensive machinery and materials, at a significant price, to meet these demands. However, market conditions rapidly change and the firm finds itself with equipment that is no longer being utilized and a full warehouse of inventory that cannot be returned. If no agreement exists which imposes these costs back to the customer, the manager has essentially done what was required and was not irresponsible in capital expense management. However, this uncontrollable scenario would create the likelihood of a significantly diminished residual income, leading to diminished financial reward for performance. The aforementioned scenario is one that could occur within any business, and serves to identify the risks of using residual income as the primary focus of executive compensation for performance. There are any number of situations which could occur that are outside of the managers ability to regulate, however the impact to the ROI figures and residual income would likely illustrate a managerial failure in relation to regulating capital expenses. Further, assume that an executive determines that this same business would receive a high level of profitability through construction of a global production facility overseas. However, after constructing the property, environmental factors or new foreign legislation suddenly makes this new division experience difficulties in operation, forcing the new facility to be closed or sold (Nickels, McHugh & McHugh, 2005). Once again, the manager experienced external influences which were uncontrollable, however the impact to ROI, residual income calculations, and total profitability have been reduced even though the decision was originally sound. CONCLUSION All of these hypothetical scenarios tend to illustrate that residual income does, indeed, have its advantages and disadvantages. The largest advantage is that the process provides managers with increased knowledge and motivation to conform to Board-identified profit targets, with the largest disadvantage representing management inability to control the uncontrollable business environment. It largely comes down to whether the assessing entities are able to look beyond the short-term gains or losses received through managerial decision-making and view performance as a percentage of total executive competency. If those parties involved in determining whether the manager deserves praise or chastisement for residual income totals can actually consider that assets often do not receive returns until a longer period of time has elapsed, then it would appear residual income is, indeed, a fair method of gauging managerial performance. In the unlikely event that these assessors consider only short-term financial figures, it is likely that the manager will consider residual income as an improper method of determining total business competence and exit the firm in pursuit of new company which measures the broader corporate environment, perhaps the ROI equation, as the best career option (Hubbell, 1996). References Accaglobal.com. (1999). Performance Measurement. 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