Managerial Accounting¶

IESE MBA Year 1 -- Professors Gaizka Ormazabal & Edi Soler Technical Notes: CN-223-E through CN-229-E 22 sessions, two parts: Business Decisions (1-11) and Management Control (12-22)

Why This Matters¶

Every manager makes decisions that have economic consequences: Should we drop this product line? Accept a discount order? Make a component in-house or buy it? Managerial accounting gives you the quantitative toolkit to evaluate these alternatives -- and then to design the internal systems (cost allocation, transfer pricing, variance analysis, performance metrics, incentive contracts) that keep everyone in the organization pulling in the same direction.

Unlike financial accounting (which follows GAAP/IFRS for external reporting), managerial accounting has no regulatory standard. It follows economic principles applied case by case. The information stays internal, so there is no risk of manipulation by outsiders -- but there is a real risk of bad internal signals leading to bad decisions.

Three objectives of managerial accounting: 1. Evaluate alternative decisions -- quantify the differential economic impact of choices 2. Evaluate business performance -- measure profitability of products, clients, divisions 3. Achieve goal congruence -- align employees' incentives with the firm's interests

How It All Connects¶

PART 1: BUSINESS DECISIONS                    PART 2: MANAGEMENT CONTROL

Relevant Costs & Revenues                     Cost Systems (allocation)
        |                                              |
   Contribution Margin                         Transfer Pricing
        |                                              |
   Decision Framework:                         Variance Analysis
   - Product line decisions                            |
   - Discounts                                 Performance Measurement
   - Technology changes                        (ROI, RI, EVA)
   - Outsourcing / make vs buy                         |
   - Special orders                            Monetary Incentives
        |                                     (bonus design, equity comp)
        v                                              |
   Breakeven Analysis <-----> Pricing <------> Goal Congruence

Cross-references: - --> Financial Accounting: COGS, inventory valuation (absorption vs variable costing), balance sheet - --> Corporate Finance: WACC used in EVA, cost of capital in residual income, NPV of alternatives - --> Operations Management: make-vs-buy, capacity constraints, bottleneck analysis - --> Marketing Management: pricing decisions, contribution margin for product/customer profitability - --> Competitive Strategy: cost advantage, value chain analysis, ABC for strategic positioning

Part 1: Business Decisions¶

Lesson 1: Foundations -- Relevant Costs and the Decision Framework¶

Session 1 | Case: RCD Espanyol | Notes: CN-223-E, CN-224-E

The Central Idea¶

Not all costs matter for every decision. A relevant cost is a cost that is: 1. Future (not sunk) 2. Different between alternatives (differential)

Everything else is noise. Sunk costs -- money already spent -- are irrelevant no matter how painful they are. The decision framework strips away irrelevant costs and compares only what changes.

Key Concepts¶

Core Formulas¶

Contribution Margin (total):

CM = Revenue - Variable Costs

Contribution Margin per unit:

CMU = Price - Variable Cost per Unit

Break-Even Quantity:

BEQ = Fixed Costs / CMU

Margin of Safety:

Margin of Safety = Actual Sales - BEQ

Profit equation (single product):

Profit = Q x (P - VCU) - FC Profit = Q x CMU - FC

Profit equation (multi-product):

Profit = SalesVolume x [%A x CMU_A + %B x CMU_B + ...] - FC

Variable Definitions¶

Intuition: WHY Does Contribution Margin Matter?¶

Contribution margin answers a deceptively simple question: "If I sell one more unit, how much better off am I?" Fixed costs exist whether you sell zero units or a million. So the only thing that matters at the margin is how much revenue each unit brings in above its variable cost. That surplus -- the contribution margin -- first covers fixed costs, then generates profit.

This is why a product with a low or even negative gross margin under full-cost accounting might still be worth keeping: if it contributes positive CM, dropping it removes revenue without removing the fixed costs allocated to it.

Quick Mental Math¶

• Breakeven in units: Fixed Costs / CMU. If FC = EUR 100,000 and CMU = EUR 25, you need 4,000 units.
• Breakeven in euros: BEQ x P. At P = EUR 50, that is EUR 200,000 in revenue.
• CM ratio: CMU / P. Here, 25/50 = 50%. For every EUR 1 of revenue, EUR 0.50 covers fixed costs.
• Target profit: (FC + Target Profit) / CMU. Need EUR 50,000 profit? (100,000 + 50,000) / 25 = 6,000 units.

Back-of-Napkin: The Decision Framework¶

For ANY decision, follow this sequence: 1. List the alternatives (including "do nothing") 2. Identify all future cash flows that differ between alternatives 3. Ignore sunk costs and unavoidable fixed costs 4. Compare the differential contribution margin 5. Consider qualitative factors (strategy, reputation, relationships)

Lesson 2: Product Line Decisions -- Should We Drop a Product?¶

Session 2 | Case: Le Grand Hotel de Leysin

The Central Idea¶

A product showing an accounting loss under full-cost allocation may still be profitable to keep. The question is never "Is this product profitable after allocating all overhead?" The question is: "Would the company be better off without this product?"

Decision Rule¶

Keep the product if: its Contribution Margin > Avoidable Fixed Costs

Drop the product if: its Contribution Margin < Avoidable Fixed Costs

The Trap: Full-Cost Allocation¶

When corporate overhead is allocated to products, low-volume products often look unprofitable. But dropping them does not eliminate the overhead -- it just redistributes it to the remaining products, making them look worse too. This is the death spiral of cost allocation.

Worked Intuition¶

Suppose Product C has: - Revenue: EUR 200,000 - Variable costs: EUR 150,000 - Allocated fixed costs: EUR 80,000 (only EUR 30,000 avoidable)

Full-cost profit: 200,000 - 150,000 - 80,000 = -EUR 30,000 (looks like a loser)

Relevant analysis: - CM = 200,000 - 150,000 = EUR 50,000 - Avoidable FC = EUR 30,000 - Net benefit of keeping = 50,000 - 30,000 = EUR 20,000

Dropping Product C would make the company EUR 20,000 worse off, not EUR 30,000 better off.

Quick Mental Math¶

Ask: "If I shut this down tonight, what costs actually disappear?" Those are avoidable. Everything else stays. If CM exceeds avoidable costs, keep it.

Lesson 3: Discount Decisions -- Should We Accept a Lower Price?¶

Session 3 | Case: Becker Textilwerk

The Central Idea¶

A customer wants a big discount. Should you say yes? The answer depends on whether the discounted price exceeds the variable cost per unit (so you earn positive CM), whether you have spare capacity, and whether the discount will contaminate your regular pricing.

Decision Rule¶

Accept the discount if: Discounted Price > VCU (positive incremental CM) AND you have excess capacity (no opportunity cost) AND it will not erode regular-price sales

When Capacity Is Constrained¶

If accepting the discount order means turning away full-price customers, the opportunity cost equals the CM lost on displaced sales:

Relevant Cost = VCU + Opportunity Cost (lost CM on displaced units)

The discount order must cover this full relevant cost to be worthwhile.

Intuition: WHY Is Excess Capacity the Key?¶

With excess capacity, the marginal cost of producing one more unit is just the variable cost. Fixed costs are already covered by existing production. Any price above VCU adds to profit. But at full capacity, every unit you produce for the discount customer is a unit you cannot produce for a full-price customer -- and you must count that sacrifice.

Back-of-Napkin¶

• Excess capacity? Compare discount price vs VCU. If discount price > VCU, accept.
• At capacity? Compare discount price vs VCU + CM lost on displaced sale. Usually reject.
• Watch for: cannibalization, precedent-setting, strategic relationship value.

Lesson 4: Technological Changes -- Investing in New Technology¶

Session 4 | Case: EnGuang Solar

The Central Idea¶

Technology investments typically substitute variable costs for fixed costs: automation replaces labor. The managerial accounting question is whether the cost structure change is favorable given your expected volume.

Decision Framework¶

Compare the two cost structures:

Indifference Point¶

The volume at which both alternatives yield the same profit:

Q* = (FC_new - FC_old) / (VCU_old - VCU_new)

Below Q, the old technology is better (lower fixed costs). Above Q, the new technology wins (lower variable costs generate more CM per unit).

Intuition: WHY Does Operating Leverage Matter?¶

Higher fixed costs and lower variable costs mean higher operating leverage. When volume is high, profits grow faster because each unit carries a bigger margin. But when volume drops, losses mount faster too -- fixed costs do not shrink. Technology decisions are bets on volume.

Quick Mental Math¶

• Calculate the incremental fixed cost: Delta_FC = FC_new - FC_old
• Calculate the incremental VCU saving: Delta_VCU = VCU_old - VCU_new
• Indifference volume: Delta_FC / Delta_VCU
• If you are confident volume will exceed this, invest.

Lesson 5: Outsourcing -- Make vs Buy¶

Session 5 | Case: 3P S.A.

The Central Idea¶

Should you make a component in-house or buy it from a supplier? The relevant comparison is the outsource price vs the costs you would actually save by outsourcing.

Decision Rule¶

Outsource if: Outsource Price < Variable Cost + Avoidable Fixed Costs

Keep in-house if: Outsource Price > Variable Cost + Avoidable Fixed Costs

Variable Definitions¶

Full Decision Rule (with opportunity cost)¶

Outsource if: P_buy < VCU_make + AFC_make/Q + OC per unit

If the capacity freed up by outsourcing can be used for something else (alternative product, rental income), include that opportunity cost on the "make" side.

Intuition: WHY Not Just Compare Total Costs?¶

Because total costs include allocated fixed costs that will not disappear if you outsource. If you are paying EUR 100,000 in factory rent and it stays whether you make or buy, it is irrelevant. Only costs that actually go away matter.

Back-of-Napkin: Make vs Buy Threshold¶

"If outsource price < variable cost + avoidable fixed cost per unit, outsource."

Watch for: quality control, supply risk, strategic capabilities, long-term dependency.

Lesson 6: Special Orders¶

Session 6 | Case: Orbea

The Central Idea¶

A one-time order at a price below your normal selling price. Should you accept? This is the discount decision with an additional nuance: the order is typically from a new channel, so cannibalization risk may be lower.

Decision Rule (same as discount)¶

Accept if: Special Order Price > Incremental Cost per Unit

Incremental Cost = VCU (if excess capacity) or VCU + lost CM on displaced sales (if at capacity)

Capacity Constraint with Multiple Products¶

When capacity is scarce, rank products by CM per unit of the constrained resource (e.g., CM per machine hour, CM per labor hour). Accept orders that maximize CM per unit of the bottleneck.

CM per Bottleneck Unit = CMU / Resource Usage per Unit

Intuition¶

Special orders are attractive precisely because they are incremental: if the factory is idle, the marginal cost of filling that capacity is just the variable cost. But "special" must mean truly one-time. If it becomes regular business at a low price, you have a pricing problem, not a capacity-utilization opportunity.

Lesson 7: Cost Systems -- Allocating Indirect Costs¶

Session 7 | Lecture | Note: CN-225-E

The Central Idea¶

When you need to know product or divisional profitability, you must allocate indirect costs (costs shared across products, divisions, or customers). A cost system is the model a company uses to trace and allocate these costs. The choice of allocation base can dramatically change which products look profitable.

Elements of a Cost System¶

The Four Steps¶

1. Identify indirect costs and group them into cost pools
2. Define an allocation base for each pool
3. Compute the allocation rate = Total Cost Pool / Total Allocation Base
4. Allocate to cost objects = Allocation Rate x Object's Usage of the Base

Core Formulas¶

Allocation Rate:

Allocation Rate = Total Indirect Cost in Pool / Total Allocation Base

Allocated Cost to Object j:

Allocated Cost_j = Allocation Rate x Allocation Base consumed by j

Full Cost of Product:

Full Cost = Direct Materials + Direct Labor + Allocated Manufacturing Overhead

Critical Warning: Allocation Rates Are Not Variable Costs¶

An allocation rate of EUR 50/machine-hour does not mean costs increase by EUR 50 for each additional machine hour. Overhead is often fixed. The rate is an accounting artifact for distributing costs, not a measure of marginal cost. Confusing the two leads to bad decisions.

Capacity Utilization and Allocation¶

If the denominator uses actual capacity utilization, the idle capacity cost gets allocated to products -- making them look more expensive (and potentially mispriced). If the denominator uses maximum capacity, idle capacity cost is isolated and not burdened onto products.

Rate (actual) = Total OH / Actual Hours Used --> products absorb idle capacity cost Rate (max capacity) = Total OH / Max Hours Available --> idle capacity cost is separated

Intuition: WHY Does the Allocation Base Matter So Much?¶

Because it determines which products subsidize which. A volume-based allocation (units produced) spreads overhead evenly -- great for high-volume products, terrible for low-volume specialty products that actually consume disproportionate resources. The wrong allocation base can make you think your best product is a dog and your worst product is a star.

Lesson 8: Activity-Based Costing (ABC) and Product Profitability¶

Session 8 | Case: Tidal Cloud | Note: CN-225-E

The Central Idea¶

Traditional cost systems allocate overhead using volume-based measures (units, labor hours). Activity-Based Costing (ABC) allocates overhead by identifying the activities that drive costs and using the specific cost driver for each activity.

ABC vs Traditional Costing¶

ABC Procedure¶

1. Identify major activities (e.g., packing/shipping, machine setup, quality inspection, maintenance)
2. Assign costs to each activity pool
3. Identify the cost driver for each activity (the factor that causes the cost)
4. Compute the activity rate = Activity Cost / Total Cost Driver Volume
5. Allocate to products based on each product's consumption of each driver

ABC Allocation Formula¶

Activity Rate = Total Activity Cost / Total Cost Driver Volume

Cost Allocated to Product j = Activity Rate x Driver Volume consumed by j

Classic ABC Insight: Cross-Subsidization¶

Low-volume, complex products consume disproportionate overhead (more setups, more orders, more quality checks) but traditional systems spread these costs evenly across all units. Result: high-volume products subsidize low-volume products. ABC reveals this cross-subsidization.

Example (from CN-225-E, Limon)¶

Traditional allocation of distillery overhead by # bottles: - Creme de cassis (high volume): EUR 300,000 overhead --> Profit EUR 360,000 - Creme d'or (low volume): EUR 50,000 overhead --> Loss EUR 110,000

ABC allocation by # orders and maintenance hours: - Creme de cassis: EUR 240,000 overhead --> Profit EUR 420,000 - Creme d'or: EUR 160,000 overhead --> Loss EUR 220,000

ABC revealed that Creme d'or was even more unprofitable than traditional costing suggested (it had many small orders driving packing/shipping costs).

Intuition: WHY Does ABC Matter for Strategy?¶

Because strategic decisions about which products to push, which customers to serve, and how to price depend on knowing the true cost to serve. If you are cross-subsidizing without knowing it, your pricing is wrong, your product mix is suboptimal, and competitors who understand their costs better will eat your lunch.

--> Cross-reference: Competitive Strategy -- cost advantage requires knowing your true costs. ABC is a tool for identifying where value is created and destroyed in the value chain.

Lesson 9: Cost Systems and Competitive Strategy¶

Session 9 | Case: Bruxelles Services

The Central Idea¶

Cost system design is not just an accounting exercise -- it is a strategic choice. The level of detail, the allocation bases, and the treatment of capacity costs all send signals within the organization that influence behavior.

Strategic Implications of Cost System Design¶

When to Use ABC vs Traditional¶

• Use ABC when: product diversity is high, overhead is large relative to direct costs, products consume resources in very different proportions
• Traditional is fine when: products are homogeneous, overhead is small, or the cost of implementing ABC exceeds the benefit

Part 2: Management Control¶

Lesson 10: Internal Accounting and Control Systems¶

Session 12 | Lecture

The Central Idea¶

Part 2 shifts from "What should we decide?" to "How do we design systems that make the whole organization decide well?" Management control systems use internal accounting information to: 1. Evaluate business performance (products, divisions) 2. Evaluate individual performance (managers, employees) 3. Achieve goal congruence (align individual incentives with firm goals)

Responsibility Centers¶

The Delegation Problem¶

Decentralization is necessary (CEOs cannot make every decision), but it creates agency problems: divisional managers may act in their own interest rather than the firm's. The sales manager who cuts price to boost revenue volume (because her bonus is on revenue) may destroy profitability. Control systems exist to prevent this.

Lesson 11: Transfer Pricing -- Cost-Based¶

Session 13 | Case: Al Jakani | Note: CN-227-E

The Central Idea¶

When one division sells to another, the transfer price determines each division's profit. If the TP is wrong, divisional managers will make decisions that look good for their division but are bad for the company. Transfer pricing is the single most important mechanism for goal congruence in multi-divisional firms.

The Goal Congruence Condition¶

A transfer price achieves goal congruence when it leads divisional managers, acting in their own self-interest, to make the same decision the company would make if it were centralized.

Transfer Price Range¶

Variable Cost <= TP <= Market Price

For internal transfers to make economic sense: - The selling division will not accept less than its incremental cost (otherwise it loses money) - The buying division will not pay more than the external market price (otherwise it would buy outside)

Cost-Based Transfer Pricing¶

TP at Full Cost (+ markup):

TP = Variable Cost + Allocated Fixed Cost + Markup

Problem: includes allocated fixed costs that are not incremental. Can make a profitable transaction look unprofitable for one division.

TP at Variable Cost (+ markup):

TP = Variable Cost + Markup

Problem: the selling division earns no contribution to its fixed costs on internal sales. Its reported profit is artificially low.

The KBC Example (CN-227-E)¶

Private-label bikes: selling price EUR 300, variable cost of frame EUR 75, variable assembly cost EUR 60, allocated fixed overhead EUR 100/division.

Company CM = 300 - 75 - 60 = EUR 165 per bike (good deal!)

The Root Cause: Bad Cost Systems¶

In the KBC example, goal congruence was initially impossible because the cost system used an outdated production volume to compute allocation rates. After updating the cost system (70,000 units instead of 50,000; 35:65 split instead of 50:50), the goal-congruent range became 125 <= TP <= 150.

Lesson: Transfer pricing problems are often cost system problems in disguise.

Back-of-Napkin: Transfer Pricing Decision Tree¶

Is there excess capacity in the selling division?
  YES --> TP = Variable Cost (+ small markup)
          "At the margin, the selling division's cost is just variable cost"
  NO  --> Is there an external market?
            YES --> TP = Market Price
                    "Both divisions can trade externally; market price is fair"
            NO  --> Negotiate within range [Variable Cost, Buyer's Max Willingness to Pay]

Lesson 12: Transfer Pricing -- Market-Based¶

Session 14 | Case: Salers Dairy

The Central Idea¶

When an external market exists for the intermediate product, using the market price as the transfer price generally achieves goal congruence. Each division faces the same price it would face if it were an independent company.

Market-Based TP¶

TP = Market Price of the intermediate product

Advantages¶

• Provides a fair benchmark: both divisions face the same opportunity cost
• Simulates arm's-length transactions
• Preserves divisional autonomy and accountability

Limitations¶

• Requires a competitive external market with observable prices
• Market prices may be volatile
• May not exist for specialized or proprietary intermediate products
• Transaction costs (search, quality assurance) may differ between internal and external trades

When Market Price Works Best¶

• The intermediate product is a commodity with many external suppliers/buyers
• Both divisions have genuine freedom to trade externally
• Market prices are stable and transparent

When Market Price Fails¶

• No external market exists (proprietary components)
• The internal transaction creates synergies not captured by market price (shared quality knowledge, lower logistics costs)
• Volatile markets make divisional profit measurement noisy

Lesson 13: Variance Analysis and Budgeting¶

Session 15 | Case: Agrismart | Note: CN-226-E

The Central Idea¶

Variance analysis decomposes the difference between budgeted and actual profit into components attributable to specific factors: sales volume, product mix, selling price, efficiency, input prices, and fixed costs. It answers: "We missed the budget -- but WHY?"

Profit Decomposition¶

Profit = Sales Volume x [%A x CMU_A + %B x CMU_B] - Fixed Costs

Where:

CMU = Price - VCU VCU = Efficiency Ratio x Input Price

The Six Variances¶

Variable Definitions¶

The Waterfall (Sequential Substitution Method)¶

The key rule: when analyzing one item, use actual values for all previously analyzed items and budgeted values for all remaining items.

Budgeted Profit
  +/- Sales Volume Variance      (change Q, keep everything else at budget)
  = Sales-Adjusted Profit
  +/- Product Mix Variance        (change mix %, keep rest at budget)  
  = Mix-Adjusted Profit
  +/- Selling Price Variance      (change prices)
  = Price-Adjusted Profit
  +/- Efficiency Variance         (change efficiency ratios)
  = Efficiency-Adjusted Profit
  +/- Input Price Variance        (change input prices)
  = Input-Price-Adjusted Profit
  +/- Fixed Cost Variance         (change fixed costs)
  = Actual Profit

Competitive vs Operational Variances¶

• Competitive variances (sales volume, mix, selling price): measure market performance. Were we selling the right products at the right prices in the right quantities?
• Operational variances (efficiency, input price, fixed cost): measure production performance. Were we producing efficiently and buying inputs at good prices?

Favorable (F) vs Unfavorable (U)¶

• Positive variance = favorable (increases profit)
• Negative variance = unfavorable (decreases profit)

Convention: often expressed as absolute values with (F) or (U) notation.

The Fashion Textiles Example (CN-226-E)¶

Budget profit = EUR 3,025K; Actual profit = EUR 3,025K. Looks like everything went as planned!

But variance analysis reveals:

Insight: Total profit hit the target, but for completely different reasons than planned. The competitive side outperformed while the operational side underperformed. Without variance analysis, management would have missed this.

Intuition: WHY Decompose When the Total Is Fine?¶

Because the total can be on target while fundamental problems are brewing. If input prices are rising 30% and you are only surviving because the mix shifted toward premium products, you have a procurement problem that needs attention before the mix shifts back.

Quick Mental Math for Variance Analysis¶

• Price variance isolates the per-unit price effect: (Actual Price - Budget Price) x Actual Quantity
• Volume variance isolates the quantity effect: (Actual Volume - Budget Volume) x Budgeted CMU
• Mix variance: shift toward products with above-average CM is favorable

Terminology¶

Lesson 14: Variance Analysis with Absorption Costing¶

Session 16 | Case: PriceClub Spain | Note: CN-226-E

The Central Idea¶

When inventories are valued at full cost (absorption costing, required by GAAP), a new variance appears: the production volume variance. This variance can make a manager look good simply by overproducing -- a dangerous incentive.

Variable vs Absorption Costing¶

Key Formulas Under Absorption Costing¶

Standard Full Cost per Unit:

Standard Full Cost = Standard Variable Cost + (Budgeted Fixed Cost / Budgeted Volume)

Profit Under Absorption Costing:

Profit = Sales_Vol x Selling_Price - Sales_Vol x Std_Full_Cost - [Prod_Vol x ER x IP + FC - Prod_Vol x Std_Full_Cost] - SGA

Production Volume Variance:

PVV = (Actual Production - Budgeted Production) x Standard Fixed Cost per Unit

The WALLCO Example (CN-226-E)¶

Budget: produce and sell 1,000 wallets. Actual: produced 1,200, sold only 800.

The key insight: Under absorption costing, overproducing 200 units generates a favorable production volume variance of EUR 18,000 (= 200 x 90 standard fixed cost/unit). This makes actual profit (EUR 6,400) higher than budgeted profit (EUR 5,000) even though the company sold fewer units at a lower price with higher costs! Under variable costing, the picture is clear: the company lost EUR 29,600.

Difference: Absorption Profit - Variable Profit = (Production - Sales) x Std Fixed Cost/Unit = 400 x 90 = EUR 36,000.

Intuition: WHY Can Managers Game Absorption Costing?¶

Because overproduction pushes fixed costs into inventory (an asset on the balance sheet) instead of the income statement. Profit looks higher today, but those costs will hit the income statement when the inventory is eventually sold (or written off). It is borrowing from the future.

--> Cross-reference: Financial Accounting -- this is why GAAP requires absorption costing (matching principle), but why analysts often adjust for inventory changes.

Lesson 15: Financial Performance Measures¶

Session 17 | Case: Schneider Electric | Note: CN-228-E

The Central Idea¶

How do you evaluate the performance of a division that controls its own investments? You need metrics that account for both profit and the capital employed to generate it.

The Three Key Metrics¶

Return on Investment (ROI):

ROI = Operating Income / Invested Capital

Residual Income (RI):

RI = Operating Income - (Cost of Capital x Invested Capital)

Economic Value Added (EVA):

EVA = NOPAT - (WACC x Invested Capital)

Where: - NOPAT = Net Operating Profit After Taxes - WACC = Weighted Average Cost of Capital

EVA is RI with specific accounting adjustments (capitalize R&D, operating leases, etc.) to remove distortions from conservative accounting rules.

Variable Definitions¶

Intuition: WHY ROI Can Lead to Bad Decisions¶

Division A has ROI = 20%. A new project offers 15% return. The company's cost of capital is 10%. The project creates value (15% > 10%), but the division manager rejects it because it would dilute her ROI from 20% toward 15%. Under RI or EVA, the project has positive incremental RI (15% - 10% = 5% spread on invested capital), so the manager would accept it.

ROI vs RI: The Decision Test¶

Quick Mental Math¶

• ROI: Operating Income / Invested Capital. If you earn EUR 2M on EUR 10M of assets, ROI = 20%.
• RI: Operating Income - (Cost of Capital x Invested Capital). If cost of capital = 12%, RI = 2M - 1.2M = EUR 800K.
• EVA spread: ROIC - WACC. Positive spread = value creation.

--> Cross-reference: Corporate Finance -- WACC calculation, cost of equity (CAPM), value creation

Lesson 16: Non-Financial Performance Measures¶

Session 18

The Central Idea¶

Financial metrics are lagging indicators -- they tell you what already happened. Non-financial measures (customer satisfaction, defect rates, employee turnover, lead times) are leading indicators that predict future financial performance.

The Balanced Scorecard Framework¶

Why Use Non-Financial Measures?¶

1. Leading indicators: customer complaints today predict lost revenue tomorrow
2. Controllability: a factory manager can control defect rates more directly than EVA
3. Strategy alignment: if your strategy is differentiation, measure quality and innovation, not just cost
4. Gaming resistance: harder to manipulate non-financial metrics (though not impossible)

The Trade-Off: Too Many Measures¶

More measures = more information but also more confusion, more cost, and weaker incentive power (if bonuses depend on 15 metrics, each metric has only ~7% weight, reducing motivation to focus on any single one).

Lesson 17: Employee Incentives -- Designing Bonus Schemes¶

Session 19 | Case: ATH Technologies A | Note: CN-229-E

The Central Idea¶

Monetary incentives -- bonuses, equity compensation -- are the primary tool for aligning employee behavior with firm objectives. But every compensation design involves trade-offs: motivation vs risk-bearing, short-term vs long-term, individual vs team performance.

Three Problems Compensation Addresses¶

1. Retention: Match or exceed outside wage opportunities
2. Effort: Make pay contingent on performance to motivate effort
3. Risk-taking: Control the amount of risk employees take

Bonus Scheme Design¶

Linear bonus (no floor/cap):

Bonus = Slope x Performance Metric

Simple but problematic: no downside protection, unlimited upside may incentivize excessive risk.

Bonus with floor and cap:

                    Cap
                   /-------- Max bonus
                  /
                 / Slope
                /
    Floor -----/
    Min bonus    Min        Target       Max
              Performance threshold    Performance

Bonus = Fixed Salary + min(Cap, max(Floor, Slope x (Performance - Threshold)))

Key Design Elements¶

Risk Premium¶

Variable pay subjects employees to uncertainty (performance depends partly on factors outside their control). Risk-averse employees demand a risk premium -- total expected compensation must exceed what they could earn in a fixed-salary job to compensate for bearing risk.

The Floor-Cap Trade-Off¶

• Floor prevents rewarding bad luck as bad performance
• Cap prevents rewarding good luck as good performance
• BUT near the floor: "I am already below threshold, no point trying" (gives up)
• AND near the cap: "I have already maxed out, any extra effort goes unrewarded" (coasts or defers revenue to next period)

Intuition: WHY Floors and Caps Reduce Risk-Taking¶

Without a cap, the upside is unlimited. An employee comparing Strategy 1 (safe, RI = 10M) vs Strategy 2 (risky, RI = 42M or -18M) may choose the risky strategy because the upside bonus is huge. With a cap at RI = 15M, both strategies pay the max bonus in the good scenario, but Strategy 2 pays zero in the bad scenario. The employee prefers the safe strategy.

The PrivateBuy Example (CN-229-E)¶

Note: exceeds outside wage opportunity of $400,000 because of the risk premium.

Lesson 18: Equity Compensation and Long-Term Incentives¶

Session 19-20 | Note: CN-229-E

The Central Idea¶

Cash bonuses incentivize short-term performance. Equity compensation (restricted stock, stock options) ties managers' wealth to long-term stock price, aligning their interests with shareholders.

Types of Equity Compensation¶

Valuation¶

Restricted Stock Value:

Value = Number of Shares x Current Stock Price

Stock Options (Black-Scholes):

Value = [p x e^(-dT) x N(Z) - X x e^(-rT) x N(Z - sigma x sqrt(T))]

where Z = [ln(p/X) + T(r - d + sigma^2/2)] / (sigma x sqrt(T))

Advantages of Equity Compensation¶

1. Long-term focus: stock price reflects future cash flows, not just current earnings
2. Retention: vesting requirements keep employees at the firm
3. Ownership alignment: managers become shareholders -- less likely to waste assets
4. Cash conservation: no immediate cash outflow
5. Market discipline: stock price is hard to manipulate long-term

Disadvantages of Equity Compensation¶

1. Market noise: stock price reflects macro factors beyond the manager's control
2. Dilution: existing shareholders share value with employees
3. Valuation complexity: Black-Scholes assumptions may not perfectly fit employee options
4. Gaming: short-term stock manipulation is possible (earnings management, buybacks before option exercise)

Lesson 19: Top Management Incentives and Governance¶

Session 20 | Case: Citigroup

The Central Idea¶

CEO and top management compensation raises all the design issues from Lessons 17-18, amplified by the scale of the stakes and the difficulty of monitoring. Corporate governance mechanisms (Board of Directors, compensation committees, shareholder votes) exist to oversee executive pay.

Key Governance Concepts¶

The Executive Pay Mix¶

Typical CEO compensation: - ~15-20% fixed salary - ~25-30% annual cash bonus - ~50-60% long-term equity (restricted stock + options)

The heavy equity weighting is intentional: it forces skin in the game and a long-term orientation.

Moral Hazard in Executive Compensation¶

• Excessive risk-taking: guaranteed base + unlimited upside from options can incentivize reckless bets (Citigroup pre-2008)
• Short-termism: if vesting is short, managers boost near-term metrics at the expense of long-term health
• Earnings management: managers manipulate accounting to hit bonus thresholds

Design Remedies¶

• Clawback provisions
• Multi-year performance periods
• Deferred compensation
• Relative performance evaluation (vs peers, not absolute)
• Mix of financial and non-financial metrics

Quick Reference¶

Master Formula Sheet¶

Back-of-Napkin Decision Rules¶

Glossary¶