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ACCT 2302
Fundamentals of Accounting II
Spring 2011
Lecture 15
Professor Jeff Yu
Review: Performance Evaluation
Cost Center(controls costs only) Spending Variance;
Standard Cost Variances
Profit Center(controls costs & revenues)
SegmentedIncome Statement(Segment Margin)
Investment Center(controls costs & revenues
& Investments)
Return on Investment (ROI);Residual Income
Evaluation Tool
Review: Standard Cost Variances
Materials Price Variance
AQ(AP - SP)
Labor/VOH Rate Variance
AH(AR – SR)
Materials Quantity Variance
SP(AQ - SQ)
Labor/VOH Efficiency Variance
SR(AH – SH)
AP (AR)= Actual Price (Actual Rate): the amount actually paid foreach unit of the materials (labor or VOH).
SP (SR)= Standard Price (Standard Rate): the amount that should Have been paid for each unit of the materials (labor or VOH).
AQ (AH)= Actual Quantity (Actual Hour): the amount of materials(labor or VOH activity) actually used in the production.
SQ (SH)= Standard Quantity (Stan. Hour) allowed for the actual output = actual production in units * standard quantity (hours) per unit
Sales - Variable ExpensesContribution Margin
- Traceable Fixed costsSegment Margin
NOI for the company = the sum of segment margins minus Common fixed costs.
Important: CVP analyses using the segmented income statement!
Review: Segmented Income Statement
Return on Investment (ROI)
MarginMargin
TurnoverTurnoverROI = NOI ÷ AOA
AOA
Sales
Sales
NOI
Thought Question: how will changes in sales, operating expenses and average operating assets affect ROI?
AOA=Average Operating Assets =(Beginning + Ending Operating Assets)/2
Holly Company reports the following information in 2009:
Net Operating Income $ 30,000Sales Revenue $ 500,000Average Operating Assets $ 200,000
Q: (1)Holly’s 2009 ROI? Margin? Turnover? Operating Expenses?
(2) How will Holly’s ROI change if sales increases to $600,000 and both AOA and operating expenses do not change in 2010?
(3) How will Holly’s ROI change if there is no change in sales and AOA but operating expenses decrease to $458,000 in 2010?
(4) How will Holly’s ROI change if there is no change in sales and operating expenses, but AOA decreases to $100,000 in 2010?
Example
Summary: Improving ROI
DuPont Analysis: ROI = Margin * Turnover
IncreaseSales
DecreaseOperating
Expensesgenerate the same NOI
with Less Operating Assets
Residual Income (RI)
RI = NOI - Required rate of return × AOA
NOI- Net operating income (profits)AOA- Average operating assets
Required rate of return × AOA = Required return
Decision Rule: Invest if RI>0.
Practice Problem
At Pitts Co. the required rate of return on operating assets is 8%. The 2010 sales revenue for division A is $10 million, NOI is $2 million, AOA is $2.5 million.
Q: Division A’s 2010 ROI? Margin? Turnover? Residual Income?
Given the following information for Division C:
NOI $560,000Margin 35%Turnover 1.6Minimum required rate of return 12%
What is the division’s residual income?
Practice Problem
Example: ROI vs. RI
Flower Co. Division C has an opportunity to invest $100,000 (AOA) in a project that will yield NOI of $25,000 for the year.
Flower Co. has a 20% required rate of return and Division C has a 30% ROI on its existing business.
Q: (1) As a manager at Division C, will you invest in that project if you are evaluated based on division ROI (the higher the ROI, the bigger the bonus)?
(2) Is this investment project good for the company?
(3) Will your decision be different if you are evaluated using residual income?
As division manager,I wouldn’t invest in
that project becauseit would lower my pay!
Gee . . .I thought we were
supposed to do what was best for the
company!
ROI – A Drawback
Residual Income VS. ROI
Under ROI, the basic message is:
Maximize rate of return, a percentage.
Under the residual income approach, the basic message is:
Maximize residual income, an absolute amount.
Residual income may encourage managers to make profitable investments that would be rejected by managers using ROI to evaluate that same investment.
However, residual income cannot be used to compare the performance of divisions with different sizes (i.e. different AOA).
The Balanced Scorecard
Management translates its strategy into performance measures that
employees understand and accept.
Management translates its strategy into performance measures that
employees understand and accept.
Performancemeasures
Customers
Learningand growth
Internalbusinessprocesses
Financial
The Balanced Scorecard: FromStrategy to Performance Measures
FinancialHas our financial
performance improved?
CustomerDo customers recognize that
we are delivering more value?
Internal Business Processes
Have we improved key business processes so that we
can deliver more value to customers?
Learning and GrowthAre we maintaining our ability
to change and improve?
Performance Measures
What are ourfinancial goals?
What customers dowe want to serve andhow are we going towin and retain them?
What internal busi-ness processes arecritical to providingvalue to customers?
Vision and
Strategy
The Balanced Scorecard: Non-financial Measures
The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons:
Financial measures are lagging indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance.
Financial measures are lagging indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance.
Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers.
Top managers are ordinarily responsible for financial performance measures – not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers.
Example: The Balanced Scorecard
Employee skills in installing options
Number ofoptions
available
Time toinstall option
Customer satisfactionwith options
Number of cars sold
CM per car
Profit
Learningand Growth
Internal Business Processes
Customer
Financial
ROI and the Balanced Scorecard
It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A
well constructed balanced scorecard can provide managers with a road map that indicates how the
company intends to increase ROI.
Which internal business process
should be improved?
Which customers should be targeted
and how will they be attracted and
retained at a profit?
For Next Class
Review for Midterm Exam II
Homework Problem 1
At Davis Co. the required rate of return on operating assets is 8%.
The 2010 residual income of division B is $120,000, Margin is 25%, ROI is 20%.
Q: (1) What is Division B’s 2010 Turnover?
(2) What is Division B’s NOI?
(3) What is Division B’s AOA?
(4) What is Division B’s Sales?
Homework Problem 2
DFW Inc.’s required rate of return is 10%. In 2009, its Division A reported the following performance data: Residual Income = $18,000, Margin = 20%, Turnover = 1.5.
Q: (1) What is Division A’s ROI in 2009?
(2) What is Division A’s NOI in 2009?
(3) What is Division A’s AOA in 2009?
(4) What is Division A’s sales revenue in 2009?