Gaming for a bonus, absorption costing; dcf; scorecard

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See the attached file.

Board of Directors:

I would like to show you that adopt four new practices will enhance our competitiveness and improve our ability to study our own performance. And then I would like to warn against a common "gaming" of cost per unit which I will not tolerate. First, let's review the new practices.

1. Discounted Cash Flow.

While payback method ensures that you don't take on a project with cash flows well beyond a reasonable forecast length, it has some weaknesses. First, it treats all cash flows as if they are received today. This is a problem because cash received today can be invested now and grow while cash received later cannot grow, that is be reinvested, until it is received. Therefore, you may select a lesser investment using the payback method. Take the example below:

See Excel for better formatting

Yellow Green
Investment $ (60,000) $ (60,000)
Year 1 $ 50,000 $ 5,000
Year 2 $ 5,000 $ 5,000
Year 3 $ 5,000 $ 50,000 < -- both projects have identical 3 yr payback
Year 4 $ 5,000 $ 5,000
Year 5 $ 5,000 $ 5,000

PV of future cash flows $ 63,515 $ 58,845
discount rate 6% 6%

Net present value $ 3,515 $ (1,155)

These projects are identical in terms of payback. Both have a three-year payback, returning exactly the initial $60,000 over the first three years. But the timing of the cash flows differs. And so the present value of the future cash flows differs. In the above, I calculated the present value at 6% (discount rate). Here, the Yellow project would be approved with a 6% hurdle rate but the Green Project would not! The discounted cash flow practice includes an assessment for not only the total amount of returns in later years but also the length of delay until the returns available for reinvestment.

2. Balanced Scorecard.

There are some classic performance metrics that businesses use and they can be very information. For instance, many firms use return on assets. While these measures can be useful in reviewing outcomes, they have two limitations. First, they are narrow in focus and give managers an incentive to skimp on activities that would actually improve the long term performance. For instance, if your bonus is dependent on your return on asset percent, are you going to be eager to invest in a new project if it only give average returns? Or might take two years before it starts to perform? At the least, the manager may hesitate if not ignore the new idea. Why? Before performance is concentrated on the final outcome and there are no incentives to invest in the capacity or the leading indicators which would move the organization closer to the outcome.

The second issue is that return on assets does not inform the manager about the critical success factors identified in the strategic plan and therefore provides no guidance on how the return on asset should best be orchestrated to harmonize with others on the team and the vision of the leadership. A balanced scorecard, however, does provide these and puts return on assets into context as an outcome of strategic initiatives, all of which can be tracked and rewarded to ensure that the strategic plan is communicated and monitored.

The balanced scorecard contains four perspectives, or categories, which contains measures to monitor activities that "lead" to better results at the next level. For instance:

Learning and Growth (technology, workforce ability, new product, research)
l
l
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Leads to better: Internal Business Process (quality, on-time delivery, right products, low errors, process ...