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Chapter Chapter 1313
Business Unit Performance Business Unit Performance MeasurementMeasurement
13-2
Learning ObjectivesLearning Objectives
4.Interpret and use economic value added (EVA®).
2.Interpret and use return on investment (ROI).
3.Interpret and use residual income (RI).
5.Explain how historical cost and net book value-based accounting measures can be misleading in evaluating performance.
1.Evaluate divisional accounting income as a performance measure.
13-3
Accounting IncomeAccounting IncomeL.O. 1 Evaluate divisional accounting income as a performance measure.
Division revenues minus division costs
Divisional Income
Investors use income to assess firm performance.
Firm uses a division’s income to assess divisional performance.
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Divisional IncomeDivisional Income
Western EasternDivision Division Total
Sales 5,200.0$ 2,800.0$ 8,000.0$ Cost of sales 2,802.0 1,515.0 4,317.0
Gross margin 2,398.0$ 1,285.0$ 3,683.0$ Allocated corporate overhead 468.0 252.0 720.0 Local advertising 1,200.0 500.0 1,700.0 Other general and admin 250.0 227.0 477.0
Operating income 480.0$ 306.0$ 786.0$ Tax expense (@30%) 144.0 91.8 235.8
After-tax income 336.0$ 214.2$ 550.2$
Mustang FashionsDivisional Income Statements
For Year 1 (in $000)
13-5
Divisional Income:Divisional Income:Advantages and Advantages and DisadvantagesDisadvantages
Understandable
Reflects decisions controlled by the division manager
Makes comparison of divisions easy
Divisions may be different sizes
Inconsistency between decision authority and performance measurement
13-6
Using Financial RatiosUsing Financial Ratios
Ratio Definition Western Eastern
Gross margin percentage (Gross margin / Sales) 46.12% 45.89%Operating margin (Operating income / Sales) 9.23 10.93Profit margin (After-tax income / Sales) 6.46 7.65
Mustang FashionsSelected Financial Ratios
For Year 1
13-7
Return on InvestmentReturn on InvestmentL.O. 2 Interpret and use return on investment (ROI).
Ratio of profits to investment in the asset that generates those profits.
Can compare divisions of different size
ROI =After-tax income
Divisional assets
Return on Investment (ROI)
13-8
ROI ContinuedROI Continued
ROI = Profit margin ratio
x Asset turnover
Sales
Divisional assets
xAfter-tax income
SalesROI
=
ROI
=After-tax income
Divisional assets
13-9
Limitations of ROILimitations of ROI
Increase sales
Decrease costs
Decrease assets
ROI =After-tax income
Divisional assets
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ROI ContinuedROI Continued
Western Division
Eastern Division Total
AssetsCash 250$ 150$ 400$ Accounts receivable 225 250 475 Inventory 250 150 400
Total current assets 725 550 1,275 Fixed assets (net) 775 350 1,125
Total assets 1,500$ 900$ 2,400$
EquitiesAccounts payable 125 95 220 Other current liabilities 227 280 507
Total current liabilities 352 375 727 Long-term debt - - -
Total liabilities 352 375 727 Total shareholders equity 1,148 525 1,673
Total equities 1,500$ 900$ 2,400$
Mustang FashionsBalance Sheets
January 1, Year 1 (in $000)
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ROI ContinuedROI Continued
Western Division
Eastern Division
After-tax income 336,000$ 214,200$ Divisional investment 1,500,000 900,000
ROI 22%a 24%b
a 336,000/1,500,000b 214,200/900,000
Mustang FashionsReturn on Investment
For Year 1
13-12Limitations of ROI Limitations of ROI ContinuedContinued
Mustang FashionsRequired Returns
Company Western Division
Eastern Division20% 22% 24%
13-13Limitations of ROI Limitations of ROI ContinuedContinued
Dysfunctional behavior
If the return is:
Company Western Division
Eastern Division
20% 22% 24%
13-14Limitations of ROI Limitations of ROI ContinuedContinued
Organization
Western Division Manager Division
managers’ goals differ from the organization’s
goals.
Eastern Division Manager
24%
20%
22%
13-15
Residual IncomeResidual IncomeL.O. 3 Interpret and use residual income (RI).1
Excess of actual profit over the cost of invested capital in the unit.
Cost of debt and equity used to finance a project or an operation (e.g., product or product line).
Residual income
= After-tax income Cost of capital Divisional assets
- x
Residual Income (RI)
Cost of Capital
13-16
Residual IncomeResidual Income
Eliminates the dysfunctional behavior caused by evaluating performance based on ROI
Western Division
Eastern Division
After-tax income 336,000$ 214,200$ Less required return 300,000 a 180,000 b
Residual income 36,000$ 34,200$
a 20% x $1,500,000b 20% x $900,000
Mustang FashionsResidual Income
For Year 1
Both managers will invest if return is ≥ 20%
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Economic Value AddedEconomic Value AddedL.O. 4 Interpret and use economic value added (EVA®).
Annual after-tax (adjusted) divisional income minus the total annual cost of (adjusted) capital.
Makes adjustments to after-tax income and capital to “eliminate accounting distortions”
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EVA: A Simplified ExampleEVA: A Simplified Example
Advertising Expenditures
Western Division
$800,000
Eastern Division
$300,000
Mustang Fashion believes advertising campaign has a two year life.
GAAP requires advertising be expensed when incurred.
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EVA: A Simplified Example EVA: A Simplified Example ContinuedContinued
Western Division
Eastern Division
After-tax income 336.0$ 214.2$ Add back advertising expense 1,200.0 500.0
Income before advertising 1,536.0$ 714.2$ Less amortization of advertising 700.0 a 275.0 a
Adjusted income 836.0$ 439.2$
Divisional investment 1,500.0 900.0 Less current liabilities 352.0 375.0
Net investment 1,148.0 525.0 Unamortized advertising 600.0 b 225.0 b
Adjusted divisional investment 1,748.0$ 750.0$
EVA (@20%) 486.4$ c 289.2$ c
a $700 = $800 x 50% + $1,200 x 25% $275 = $300 x 50% + 500 x 25%b $600 = $800 - $200 amortization ($800 x 25%); $225 = $300 - $75 amortization ($300 x 25%)c $486.4 = $836.0 - 0.2 x $1,748 $289.2 = $439.2 - 0.2 x $750
Mustang FashionsEVA (in $000)
13-20
EVA LimitationsEVA Limitations
Based on accounting income not present value of cash flows
13-21Measuring the Investment Measuring the Investment BaseBaseL.O. 5 Explain how historical cost and net book value-based accounting measures can be misleading in evaluating performance.
Performance measures use divisional assets or investments in the calculation.
Gross book value?
Historical costs?
Measured at the beginning or end of year?
13-22Gross versus Net Book Gross versus Net Book ValueValue
Profits before depreciation (all in cash flows at end of year) $100 each year for 3 years
Depreciation: Ten year life, straight-line, no salvage value
The Facts
Asset cost at beginning of year 1, $500
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Gross versus Net Book Value Gross versus Net Book Value ContinuedContinued
Calculation ROI Calculation ROI
1 $100a - (.1 x $500)b 11.10% $50c/$500 10%
$500d - (.1 x $500)e
2 $100a - (.1 x $500)b 12.50% $50/$500 10%
$450d - (.1 x $500)e
3 $100a - (.1 x $500)b 14.30% $50/$500 10%
$400d - (.1 x $500)e
a Annual cash profitb Depreciation for the yearc Net income (annual cash profit - depreciation [$100 - ($500 x .1)])d Beginning-of-the-year asset valuee Current year's depreciation
Impact of Net Book Value vs Gross Book Value on ROI
13-24Historical versus Current Historical versus Current CostCost
Historical CostOriginal cost to purchase or build an asset
Current CostCost to replace or rebuild an existing asset
13-25
Historical versus Current Cost Historical versus Current Cost ContinuedContinued
Operating profits before depreciation (all in cash flows at end of year):
Annual rate of price changes: 20 percent
Asset cost at beginning of year 1 is $500
The Facts
Year 1, $100; Year 2, $120; Year 3, $144
13-26
Historical versus Current: Net Historical versus Current: Net Book ValueBook Value
YearCalculations ROI Calculations ROI
1 $100a - (.1 x $500)b 11.10% $100a
- (.1 x $600)b 7.40%
$500c - (.1 x $500) $600d - (.1 x $600)e
2 $120 - (.1 x $500) 17.50% $120
- (.1 x $720) 8.30%
$500 - (.2d x $500) $720f - (.2 x $720)e
3 $144 - (.1 x $500) 26.90% $144
- (.1 x $864) 9.50%
$500 - (.3d x $500) $864g - (.3 x $864)e
YearCalculations ROI Calculations ROI
1 ($100a - $50b)/$500c10% ($100a - $60b)/$600d
6.70%
2 ($120 - $50)/$500 14% ($120 - $72)/$720f6.70%
3 ($144 - $50)/$500 18.80% ($144 - $86.4)/$864g6.70%
a Annual operating profit before depreciationb Depreciation for the yearc Beginning-of-the-first-year value of the assets used in the investment based Current cost of asset ($500 x 120%)e Accumulated depreciation at the end of the yearf Current cost of asset ($600 x 120%)g Current cost of asset ($720 x 120%)
Current CostHistorical Cost
Net Book Value
Gross Book Value
Historical Cost Current Cost
13-27
Beginning, Ending, or Average Beginning, Ending, or Average BalanceBalance
Managers can manipulate purchases and disposition based on which balance is being used in evaluations.
13-28
Chapter 13Chapter 13