chapter 13 business unit performance measurement

Chapter Chapter 1313

Business Unit Performance Business Unit Performance MeasurementMeasurement

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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.

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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)

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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

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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

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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)

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ROI ContinuedROI Continued

ROI = Profit margin ratio

x Asset turnover

Sales

Divisional assets

xAfter-tax income

SalesROI

=

ROI

=After-tax income

Divisional assets

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Limitations of ROILimitations of ROI

Increase sales

Decrease costs

Decrease assets

ROI =After-tax income

Divisional assets

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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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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%


Dysfunctional behavior

If the return is:

Company Western Division

Eastern Division

20% 22% 24%


Organization

Western Division Manager Division

managers’ goals differ from the organization’s

goals.

Eastern Division Manager

24%

20%

22%

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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

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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)

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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

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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

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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

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Beginning, Ending, or Average Beginning, Ending, or Average BalanceBalance

Managers can manipulate purchases and disposition based on which balance is being used in evaluations.

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Chapter 13Chapter 13

chapter 13 business unit performance measurement

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