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Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Business Unit PerformanceMeasurement

Chapter 14

14-3

Learning Objectives

LO 14-1 Evaluate divisional accounting income as a performance measure.

LO 14-2 Interpret and use return on investment (ROI).

LO 14-3 Interpret and use residual income (RI).

LO 14-4 Interpret and use economic value added (EVA).LO 14-5 Explain how historical cost and net book value-based accounting

measures can be misleading in evaluating performance.

14-4

Divisional Performance Measurement

As we develop performance measures, our discussion will be guided by three considerations.

1. Is the performance measure consistent with the decision authority of the manager?

2.Does the measure reflect the results of those actions that improve the performance of the organization?

3.What actions might managers be taking that improve reported performance but are actually detrimental to organizational performance?

14-5

Accounting IncomeLO 14-1 Evaluate divisional accounting income as a performance

measure.

Divisional IncomeDivision revenues minus division costs

Investors use accounting income to assess a firm's performance.

Firms use a division’s income to Assess divisional performance.

LO 14-1

14-6

Divisional IncomeLO

14-1

14-7

Advantages and Disadvantagesof Divisional Income

• It is easy to understand.

• Decisions controlled by the managerare reflected.

• Results of decisions affecting revenuesand costs are summarized.

• It makes comparison of divisions easy.

LO 14-1

14-8

Advantages and Disadvantagesof Divisional Income

• Since the size of the division may have an impact,it may not reflect performance of divisional managers

• It does not determine if managers are making gooddecisions regarding the use of assets

LO 14-1

14-9

Some Simple Financial RatiosMustang Fashions

Selected Financial RatiosFor Year 1

LO 14-1

14-10

Return on InvestmentLO 14-2 Interpret and use return on investment (ROI).

Return on Investment (ROI)Ratio of profits to investment in the asset that

generates those profits

Provides a comparison of different size divisions

LO 14-2

14-11

Return on InvestmentLO

14-2

14-12

Return on InvestmentLO

14-2

14-13

Return on InvestmentLO

14-2

14-14

Limitations of ROI• Short-term focus (myopia) from accounting information

• Conflicting incentives for managers (suboptimization)

LO 14-2

14-15

Limitations of ROI

Increase sales

Decrease costs

Decrease assets

LO 14-2

14-16

Limitations of ROI

Mustang Fashions requires areturn on investments of 20%.

Current division performanceWestern: 22%Eastern: 24%

LO 14-2

An Example: Mustang Fashions

14-17

Limitations of ROI

Should an investment be made if the following returns are expected?

Company: ≥ 20%Western Division: ≥ 22%Eastern Division: ≥ 24%

LO 14-2

14-18

Limitations of ROIOrganization

20%

Western DivisionManager

22%

Eastern DivisionManager

24%

Conflicting IncentivesThe division managers’ goals differ

from the organization’s goals.

LO 14-2

14-19

Residual Income MeasuresLO 14-3 Interpret and use residual income (RI).

Residual Income (RI)This is the excess of actual profit overthe cost of invested capital in the unit.

LO 14-3

14-20

Residual Income Measures

Cost of CapitalThis is the opportunity cost of the resources

(equity and debt capital) invested in the business.

LO 14-3

14-21

Residual Income Measures

After-tax incomeDivisional investmentCost of capitalCost of invested capital:

Cost of capital × Divisional investmentResidual income

$1,500.0 20%

$336.0

300.0$ 36.0

$214.2

180.0$ 34.2

Western Division Eastern Division

$900.0 20%

Mustang FashionsRI for Western and Eastern Divisions

For Year 1 ($000)

• RI eliminates the dysfunctional behavior causedby evaluating performance based on ROI.

• Both managers will invest if return is ≥ 20%

LO 14-3

14-22

Economic Value Added (EVA)LO 14-4 Interpret and use economic value added (EVA).

EVA is the annual after-tax (adjusted)divisional income minus the total annual

cost of (adjusted) capital.

It makes adjustments to after-tax income andcapital to “eliminate accounting distortions.”

LO 14-4

14-23

EVA Example• Advertising expenditures in Year 0:

Western Division: $800,000 (50% charged to Year 1)Eastern Division: $300,000 (50% charged to Year 1)

• Mustang Fashion believes an advertising campaignhas a two-year life.

• GAAP requires advertising be expensed when incurred.

• Advertising expenditures charged to Year 1:Western Division: ($800,000 × 50%) + $1,200 × 25%)Eastern Division: ($300,000 × 50%) + $ 500 × 25%)

LO 14-4

14-24

EVA Example

Western Division Eastern DivisionAfter-tax incomeAdd: Back advertising expense

Less: Amortization of advertisingAdvertising expenditure in Year 0Advertising expenditure in Year 1Adjusted incomeDivision investmentLess: Current liabilitiesNet investmentUnamortized advertising (800 – 200), (300 – 75)Adjusted divisional investmentCalculation of EVA:Adjusted income (from above)Cost of adjusted divisional investment (@ 20%)EVA

$400.0 300.0

$ 336.0 1,200.0$1,536.0

700.0$ 836.0$1,500.0 352.0$1,148.0 600.0$1,748.0

$ 836.0 349.6$ 486.4

$214.2 500.0$714.2

275.0$439.2$900.0 375.0$525.0 225.0$750.0

$439.2 150.0$289.2

$150.0 125.0

Mustang FashionsEVA for Western and Eastern Divisions

For Year 1 ($000)

LO 14-4

14-25

Limitations of EVA

Who determines the "accounting distortions"?

EVA is based on accounting income, notpresent value of cash flows

LO 14-4

14-26

Measuring the Investment Base

LO 14-5 Explain how historical cost and net book value-based accounting measures can be misleading in evaluating performance.

Performance measures use divisional assetsor investments in the calculation.

How should divisional assets be measured?– Gross book value versus net book value– Historical cost versus current cost– Beginning, ending, or average balance

LO 14-5

14-27

Gross Book Value versusNet Book Value Example

• Profits before depreciation (all in cash flows at end of year):$100 each year for 3 years

• Asset cost at beginning of year 1, $500

• Depreciation: Ten year life, straight-line, no salvage value

• Amounts are in thousand of dollars.

LO 14-5

14-28

Gross Book Value versusNet Book Value Example

ROI = $50c $500 = 10%

Year

=

=

=

ROI = $50c $500 = 10%

ROI = $50c $500 = 10%

Net Book Value Gross Book Value

$100a – (0.1 × $500)b

$500d – (0.1 × $500)e 11.1%ROI =1…

2… $100a – (0.1 × $500)b

$450d – (0.1 × $500)e 12.5%ROI =

3… $100a – (0.1 × $500)b

$400d – (0.1 × $500)e 14.3%ROI =

a The first term in the numerator is the annual cash profit.b The second term in the numerator is depreciation for the year.c Net income = $50 = $100 – ($500 × 0.1)d The first term in the denominator is the beginning-of-the-year asset value.e The second term in the denominator reduces the beginning-of-the-year value of the asset by the amount of current year's depreciation

LO 14-5

14-29

Historical Cost versus Current Cost

Current CostCost to replace or rebuildan existing asset

Historical CostOriginal cost to purchase

or build an asset

LO 14-5

14-30

Historical Cost versus Current Cost

• Operating profits before depreciation(all in cash flows at end of year):Year 1, $100; Year 2, $120; Year 3, $144

• Annual rate of price changes is 20 percent.

• Asset cost at beginning of year 1 is $500.

• Amounts are in thousand of dollars.

• Straight-line depreciation is used;the straight-line rate is 10% per year

LO 14-5

14-31

Historical Cost versus Current Cost

Year=

Historical Cost$100a – (0.1 × $500)b

$500c – (0.1 × $500) 11.1%ROI =1…

=2… $120a – (0.1 × $500)b

$500c – (0.2 × $500) 17.5%ROI =

=3… $144a – (0.1 × $500)b

$500c – (0.3 × $500) 26.9%ROI =

Year=

Current Cost$100a – (0.1 × $600)b

$600d – (0.1 × $600)e 7.4%ROI =1…

=2… $120a – (0.1 × $720)b

$720f – (0.2 × $720)e 8.3%ROI =

=3… $144a – (0.1 × $864)b

$864g – (0.3 × $864)e 9.5%ROI =

Year=

Historical Cost$100a – $50b

$500c 10.0%ROI =1…

=2… $120a – $50b

$500c 14.0%ROI =

=3… $144a – $50b

$500c 18.8%ROI =

Year=

Current Cost$100a – $60b

$600d 6.7%ROI =1…

=2… $120a – $72b

$720f 6.7%ROI =

=3… $144a – $86.4b

$864g 6.7%ROI =

Net Book Value

Gross Book Value

a Annual operating profit before depreciation. b Depreciation for the year.c Beginning-of-the-first-year value of the assets used in the investment base. d Current cost of asset ($500 × 120%)e Accumulated depreciation at the end of the year. f Current cost of asset ($600 × 120%)g Current cost of asset ($720 × 120%)

LO 14-5

14-32

Beginning, Ending,or Average Balance?

Should beginning, ending, or average balance be used for the investment base?

LO 14-5

Managers can manipulate purchases anddisposition based on which balance is

being used in evaluations.

14-33

Other Issues in Divisional Performance Measurement

LO 14-5

Divisional income, ROI, residual income, and EVA are financial performance measures that consider the activities of the business unit independently of other units in the firm.

Measuring the manager only on the division’s results risks suboptimal decision making because the manager ignores the effect of the decisions on other business units.

14-34

End of Chapter 14