CTEA 3227

Management Accounting III

TOPIC 6
Performance Management Systems 1
(Financial Measures)
Outline
Responsibility accounting
Compute accounting based performance measures:
Return on Investment (ROI)
Residual Income (RI)
Economic Value Added (EVA)
Describe possible investment bases for ROI
Describe different measures of assets for ROI calculation
Describe some advantages and disadvantages of ROI and
RI as divisional performance measures.

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Responsibility Accounting
Responsibility accounting
The practice of holding managers responsible for the
activities and performance of their area of the business
Example:
Managers of various departments:
Develop their own budget estimates for cost, revenue
or profits of their area of responsibility
They are then held responsible for meeting those
budget targets

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Responsibility Accounting (contd)
Responsibility centres
A unit of the organisation whose manager is held
accountable for the units activities and performance
Cost centre, revenue centre, profit centre and
investment centre
The type of responsibility centre determines the
types of financial results for which a manager is held
accountable

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Measuring Performance in
Investment Centers
Investment Center: managers make decisions that affect
both profit and invested capital.
3 approaches:
ROI
RI
EVA

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Return on Investment
Return on investment (ROI)
Used to measure the performance of an investment centre

profit
Return on investment
invested capital
profit
ROI
invested capital
profit sales revenue

sales revenue invested capital
return on sales investment turnover 6
Return on Investment (contd)
Invested capital
The assets that the investment centre has available to
generate profits
Return on sales
The percentage of each sales dollar that remains as
profit after all the expenses are covered
Investment turnover
The number of sales dollars generated by every dollar of
invested capital

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Return on Investment (contd)
ROI relates operating profits to assets employed:

ROI = Operating Income

Average Operating Assets

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Return on Investment (contd)

What is operating income?

What are operating assets?

Operating income is earnings before

interest & taxes.
Operating assets are assets acquired
to generate operating income.
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Possible Investment Bases for ROI
Total assets available.
Total assets employed.
These are operating assets currently used productive assets.
Net working capital plus other assets
Total assets less current liabilities.
Stockholder's equity or net worth.
Choose average or end-of-year balances

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How to Measure Assets for ROI
Calculation
Gross Book Value, i.e., historical cost.
This may encourage managers to dispose of old assets too soon,
where assets are still useful, but not very efficient
Net Book Value, i.e., historical cost less depreciation.
Using net book value may encourage managers to keep old assets
too long.
Replacement Cost or Current Cost, i.e., cost of
identical assets or similar assets that would provide the
same level of service.
This may be more equitable for comparing different age divisions,
but creates the problem of determining current value for all assets.

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Arguments For Historical Cost
Accounting
More reliable than current cost statements because it is
based on actual transactions.
The recorded amounts are reliable and verifiable and free
from management bias.
Helps the managers to forecast future operational cost
based on past data.
No scope for manipulation, because the data is supported
by sufficient evidences such as: invoices, receipts etc.
Fixed interest debt, produces a smooth and predictable
interest cost or return outcome and valuation.

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Arguments Against Historical
Cost Accounting
Balance sheet represents out of date values
Unadjusted for inflation
Old interest rate and an outdated assessment of the
amounts

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Arguments For Current Cost
Accounting
Provides up-to-date information consistent with market
and as it takes into account the inflationary adjustment to
the acquired cost.
More transparency to users - regulators, depositors &
investors may have achieved greater regulatory and market
discipline.
Better capture an entitys exposure to risk and increase its
visibility in the balance sheet.
Provide investors with valuable information for decision
making.

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Arguments Against Current Cost
Accounting
Market values are basically based on unverifiable subjective
estimates of managers
Developing reliable methods for measuring current cost
are too critical
Valuing tangible and intangible assets at current costs
extremely difficult and time consuming

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Increasing ROI
There are three ways to increase ROI . . .
Reduce Reduce
Expenses Assets
Increase
Sales

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Increasing ROI (contd)
Increase return on sales
By increasing the selling price or sales revenue, or
decreasing expenses
Increase investment turnover
By increasing sales revenue or reducing invested capital
Actions that are taken with the sole purpose of making
these ratios more favourable in the short term may have
adverse effects on performance in future years.

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Advantages of ROI
Very widely used to measure the performance of units and
managers
Encourages managers to focus on profits, and the assets
required to generate those profits
Promotes an understanding of the relationship between
revenues, costs and assets
Can be used to evaluate the relative performance of
investment centres even when those business units are of
different sizes
Cost efficiency
Operating asset efficiency
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Limitations of ROI
Encourages managers to focus on short-term financial
performance at the expense of long-term viability and
competitiveness
Encourages managers to defer asset replacement
To maintain high ROI and apparent high performance
Discourages managers from investing in projects which are
acceptable from the organisations point of view, but
decrease the investment centres ROI

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Exercises

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Question 1:
During the past twelve months, the Zenith Corporation had a
net income of RM39,200. What is the return on investment if
the amount of the investment is RM280,000?
a. 10%
b. 12%
c. 14%
d. 16%
Question 2:
During the past twelve months, the Aaron Corporation had a
net income of RM50,000. What is the amount of the investment
if the return on investment is 20%?
a. RM100,000
b. RM200,000
c. RM250,000
d. RM500,000
Question 3
The Cybertronics Corporation reported the following
information for its Cyclotron Division:
Revenues $1,000,000
Operating costs 600,000
Taxable income 200,000
Operating assets 500,000
Income is defined as operating income.

What is the Cyclotron Division's return on

investment?
a. 0.2
b. 0.4
c. 0.5
d. 0.8
Question 4
Return on investment can be increased by
a. increasing operating assets.
b. decreasing operating assets.
c. decreasing revenues.
d. both (b) and (c).

Question 5
The Bandage Medical Supply Company has two divisions that operate independently
of one another. The financial data for the year 20x3 reported the following results:
North South
Sales $3,000,000 $2,500,000
Operating income 750,000 550,000
Taxable income 650,000 375,000
Investment 6,000,000 5,000,000
The company's desired rate of return is 10%. Income is defined as operating income.

What are the respective return-on-investment ratios for the North and South
Divisions?
a. 0.110 and 0.125 b. 0.108 and 0.075
c. 0.125 and 0.110 d. 0.050 and 0.150
Residual Income
Residual income (RI)

RI = Profit (invested capital imputed interest rate)

Imputed interest charge:

Based on the required rate of return that the firm
expects of its investments, which is based on the
organisations cost of capital
Weighted average cost of capital (WACC) is the
weighted average of the cost of funds from all sources of
borrowings and equity
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Residual Income (contd)
Residual income (RI)
The difference between operating income and the
minimum dollar return required on a companys
operating assets

Income Income
Residual = Operating - Minimum rate of return
Operating assets

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Advantages of Residual Income
More likely to promote goal congruence, compared to ROI
Takes account of the organisations required rate of return
in measuring performance
Encourages investment in projects which yield a positive
residual income to the organisation

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Disadvantages of Residual Income
Cannot be used to assess the relative performance of
businesses that are of different sizes, unlike ROI
Formula is biased in favour of larger businesses, unlike ROI
You would expect larger divisions to have more residual
income than smaller divisions, not necessarily because
they are better managed but simply because they are
bigger.
Can encourage short-term orientation/focus, as with ROI

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Disadvantages of Residual Income
comparing divisions of different sizes

Division A Division B
Average operating assets $15,000,000 $2,500,000
Operating income $ 1,500,000 $ 300,000
Minimum returna 1,200,000 200,000
Residual income $ 300,000 $ 100,000
Residual returnb 2% 4%
a0.08 Operating assets.
bResidual income divided by operating assets.

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ROI versus RI
ROI measures the average return for dollars invested.

RI measures net excess (shortfall) over the cost of capital

required.

ROI is preferred over residual income when evaluating

investment centers of different sizes.

ROI encourages dysfunctional/suboptimal decision making,

while RI does not.
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Exercises

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The Bandage Medical Supply Company has two divisions that operate independently
of one another. The financial data for the year 20x3 reported the following results:
North South
Sales $3,000,000 $2,500,000
Operating income 750,000 550,000
Taxable income 650,000 375,000
Investment 6,000,000 5,000,000
The company's desired rate of return is 10%. Income is defined as operating income.

Question 6
What are the respective residual incomes for the North and South Divisions?
a. $30,000 and $50,000
b. $150,000 and $30,000
c. $150,000 and $50,000
d. $50,000 and a negative $150,000

Question 7
Which division has the best return on investment and which division has the best
residual income figure, respectively?
a. North, North b. South, South c. North, South d. South, North
Economic Value Added (EVA)
A measure of shareholder value
improving the worth of the business from the

shareholders perspective

Measure of the value created over a single accounting

period

The spread between the return generated by the business

activities and the cost of capital

Weighted average cost of capital is used in the calculation

of EVA and RI
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Economic Value Added (EVA)
To improve EVA
Improve profitability without employing additional capital

Borrow additional funds when profits earned are more

than the cost of borrowing

Pay off debt by selling asset

Limitations of EVA
Potential for manipulation and short-term orientation

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Economic Value Added (EVA)
EVA is net income minus total annual cost of capital. Projects with
positive EVA are acceptable.

Economic value added (EVA)

= Net income (% cost of capital x Capital employed)
or

Economic value added (EVA)

= After tax operating income [Weighted-average cost of capital

(Total assets current liabilities)]

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Weighted-Average Cost of Capital
Weighted-average cost of capital equals the after-tax
average cost of all long-term funds in use

( After-tax
cost of
debt
Market
value
of debt) ( Cost of
equity
capital
Market
value
of equity )
Market Market
value value
of debt of equity

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Weighted-Average Cost of Capital
Assume that Relax Inns has two sources of long-term funds:

1. Long-term debt with a market value and book value of $4,800,000 issued
at an interest rate of 10%

2. Equity capital that also has a market value of $4,800,000 and a book value
of $2,200,000

Tax rate is 30%.

What is the after-tax cost of debt?

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Weighted-Average Cost of Capital
Assume that Relax Inns cost of equity capital is 14%.
(opportunity cost to investors of not investing in another investment of
similar risk)

What is the weighted-average cost of capital?

WACC = [(7% Market value of debt) + (14% Market value of equity)]

(Market value of debt + Market value of equity)

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Exercises

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Question 8
Waldorf Company has two sources of funds: long-term debt with a market and
book value of $10 million issued at an interest rate of 12%, and equity capital that
has a market value of $8 million (book value of $4 million). Waldorf Company has
profit centers in the following locations with the following operating incomes, total
assets, and total liabilities. The cost of equity capital is 12%, while the tax rate is
25%.

Current
Operating
Income Assets Liabilities
St. Louis $ 960,000 $ 4,000,000 $ 200,000
Cedar Rapids $1,200,000 $ 8,000,000 $ 600,000
Wichita $2,040,000 $12,000,000 $1,200,000

What is the EVA for St. Louis?

a. $255,740
b. $327,460
c. $392,540
d. $720,000

EVA for Cedar? EVA for Wichita?

Question 9
The Coffee Division of American Products is planning the 20x3 operating
budget. Average operating assets of $1,500,000 will be used during the year
and unit selling prices are expected to average $100 each. Variable costs of
the division are budgeted at $400,000, while fixed costs are set at
$250,000.The company's required rate of return is 18%.

Required:
a. Compute the sales volume necessary to achieve a 20% ROI.
b. The division manager receives a bonus of 50% of residual income.
What is his anticipated bonus for 20x3, assuming he achieves the 20%
ROI from part (a)?
END OF LECTURE

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