CHAPTER 11

MANAGEMENT ACCOUNTING - Solutions Manual

Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and NonfinancialAdvanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24

CHAPTER 24ADVANCED ANALYSIS AND APPRAISAL OF PERFORMANCE: FINANCIAL AND NONFINANCIAL

I.Questions1.Return on investment (ROI) is the ratio of profit to amount invested for the business unit.2.The measurement issues for ROI are:a.The effect of accounting policies, which affect the determination of net income.

b.Other measurement issues for income, which include the handling of non-recurring items in the income statement, differences in the effect of income taxes across units, differential effect of foreign currency exchange, and the effect of cost allocation when two or more units share a facility or cost.

c.Measuring investment: which assets to include.

d.Measuring investment: allocating the cost of shared assets.

3.The advantages of return on investment are:

a.It is intuitive and easily understood.

b.It provides a useful basis for comparison among SBUs.c.It is widely used.

The limitations of return on investment are:

a.It has an excessive short-term focus.

b.Investment planning uses discounted cash flow analysis while managers are evaluated on ROI.

c.It contains a disincentive for new investment by the most profitable units.

4.The key advantage of residual income is that it deals effectively with the limitation of ROI, that is ROI has a disincentive for the managers of the most profitable units to make new investments. With residual income, no matter how profitable the unit, there is still an incentive for new profitable investment. In contrast, a key limitation is that since residual income is not a percentage, it suffers the same problem of profit SBUs in that it is not useful for comparing units of significantly difference sizes. It favors larger units that would be expected to have larger residual incomes, even with relatively poor performance. Moreover, relatively small changes in the desired minimum rate of return can dramatically affect the residual income for different size units. And, in contrast to ROI, some managers do not find residual income to be as intuitive and as easily understood.

5.Economic value added (EVA) is a business units income after taxes and after deducting the cost of capital. The idea is very similar to what we have explained as residual income. The objectives of the measures are the same to effectively motivate investment SBU managers and to properly measure their performance. In contrast to residual income, EVA uses the firms cost of capital instead of a desired rate of return. For many firms the desired rate of return and the cost of capital will be nearly the same, with small differences due to adjustments for risk and for strategic goals such as the desired growth rate for the firm. Also, while residual income is intended to deal with the undesirable effects of ROI, EVA is used to focus managers attention on creating value for shareholders, by earning profits greater than the firms cost of capital.

6.Examples of financial and nonfinancial measures of performance are:Financial:ROI, residual income, and return on sales.

Nonfinancial:Manufacturing lead time, on-time performance, number of new product launches, and number of new patents filed.

7.The six steps in designing an accounting-based performance measure are:

a.Choose performance measures that align with top managements financial goal(s).

b.Choose the time horizon of each performance measure in Step 1.

c.Choose a definition of the components in each performance measure in Step 1.

d.Choose a measurement alternative for each performance measure in Step 1.

e.Choose a target level of performance.

f.Choose the timing of feedback.

8.Yes. Residual income (RI) is not identical to return on investment (ROI). ROI is a percentage with investment as the denominator of the computation. RI is an absolute amount in which investment is used to calculate an imputed interest charge.

9.Economic value added (EVA) is a specific type of residual income measure that is calculated as follows:

10.Definitions of investment used in practice when computing ROI are:

a.Total assets available.

b.Total assets employed.

c.Working capital (current assets minus current liabilities) plus other assets.

d.Equity.

11.Present value is the asset measure based on DCF estimates. Current cost is the cost of purchasing an asset today identical to the one currently held if identical assets can currently be purchased; it is the cost of purchasing the services provided by that asset if identical assets cannot currently be purchased. Historical-cost-based measures of ROI compute the asset base as the original purchase cost of an asset minus any accumulated depreciation.

Some commentators argue that present value is future-oriented and current cost is oriented to current prices, while historical cost is past-oriented.

12.Special problems arise when evaluating the performance of divisions in multinational companies becausea.The economic, legal, political, social, and cultural environments differ significantly across countries.

b.Governments in some countries may impose controls and limit selling prices of products.

c.Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ significantly across countries.

d.Divisions operating in different countries keep score of their performance in different currencies.

13.a.Consider each activity and the organization itself from the customers perspective,

b.Evaluate each activity using customer-validated measures of performance,

c.Consider all facets of activity performance that affect customers and are comprehensive, and

d.Provide feedback to help organization members identify problems and opportunities for improvement.

II.ExercisesExercise 1 (ROI and Residual Income)

Requirement 1

A quick inspection of the data shows mortgage loans with a higher ROI to be more successful. But see requirement 2 below.

Requirement 2

Division A

(Mortgage Loans)Division B

(Consumer Loans)

Total Assets P2,000P10,000

Operating Income 4001,500

Return on Investment25%15%

Residual Income:

(a) *at 11%P180P400

(b) **at 15%1000

(c) ***at 17%60(200)

*P400 (P2,000 x 0.11) = P180P1,500 (P10,000 x 0.11) = P 400

**P400 (P2,000 x 0.15) = P100P1,500 (P10,000 x 0.15) = P 0

***P400 (P2,000 x 0.17) = P 60P1,500 (P10,000 x 0.17) = P(200)

There is no simple answer to which is more successful in terms of residual income. Division B is more successful at low rates, while A is more successful at high rates. This reflects an important limitation of residual income; larger divisions (Division B in this case) are favored when the desired return used to determine residual income is relatively low.

Exercise 2 (Return on Investment; Comparisons of Three Companies)

Companies in the Same Industry

ABC

Sales P1,500,000P 750,000P3,750,000

Income200,00075,00018,750

Investment (assets)500,0007,500,0002,500,000

Return on sales13%10%0.5%

Asset turnover30.11.5

Return on investment40%1%0.75%

Exercise 3 (ROI, RI, ROS, Management Incentives)

Requirement 1

If Magic Industries uses return on investment to measure the Jump-Start Divisions (JSDs) performance, Tan may be reluctant to invest in the new plant because, as shown below, return on investment for the plant of 19.2% is lower than JSDs current ROI of 24%.

Operating income for new plantP480,000

New investmentP2,500,000

Return on investment for new plant19.2%

Investing in the new plant would lower JSDs ROI and, hence, limit Tans bonus.

Requirement 2

The residual income computation for the new plant is as follows:

Residual income = Income- (Imputed interest x Investment)

InvestmentP2,500,000

Operating income for new plantP 480,000

Charge for funds

(Investment, P2,500,000 x 15%) 375,000

Residual incomeP 105,000Investing in the new plant would add P105,000 to JSDs residual income. Consequently, if Magic Industries could be persuaded to use residual income to measure performance, Tan would be more willing to invest in the new plant.Requirement 3

If Magic Industries uses ROS to determine Tans bonus, Tan will be more willing to invest in the new plant because ROS for the new plant of 20% exceeds the current ROS of 19%.

The advantages of using ROS are (a) that it is simpler to calculate and (b) that it avoids the negative short-run effects of ROI measures that may induce Tan to not make the investment in the new plant. Tan may favor ROS because she believes that eventually increases in ROS will increase ROI and RI.

The main disadvantage of using ROS is that it ignores the amount of investment needed to earn a return. For example, ROS may be high but not high enough to justify the level of investment needed to earn the required return on an investment.

III.Problems

Problem 1 (RI, EVA)

Requirement 1

Truck Rental DivisionTransportation Division

Total assetsP650,000P950,000

Current liabilities120,000200,000

Investment

(Total assets current liabilities)530,000750,000

Required return (12% x Investment)63,60090,000

Operating income before tax75,000160,000

Residual income

(Operating income before tax

required return)11,40070,000

Requirement 2

After-tax cost of debt financing = (1 0.4) x 10% = 6%After-tax cost of equity financing = 15%

Required return for EVA

9.6% x Investment

(9.6% x P530,000; 9.6% x P750,000)P50,880P72,000

Operating income after tax

0.6 x operating income before tax 45,00096,000

EVA (Operating income after tax required return)(5,880)24,000

Requirement 3

Both the residual income and the EVA calculations indicate that the Transportation Division is performing better than the Truck Rental Division. The Transportation Division has a higher residual income (P70,000 versus P11,400) and a higher EVA [P24,000 versus P(5,880)]. The negative EVA for the Truck Rental Division indicates that, on an after-tax basis, the division is destroying value the after-tax economic return from the Truck Rental Divisions assets is less than the required return. If EVA continues to be negative, Lighthouse may have to consider shutting down the Truck Rental Division.

Problem 2 (ROI, RI, Measurement of Assets)

The method for computing profitability preferred by each manager follows:

Manager ofMethod Chosen

SResidual income based on net book value

PResidual income based on gross book value

FROI based on either gross or net book value

Supporting Calculations:

Return on Investment Calculations

Operating IncomeOperating Income

DivisionGross Book ValueNet Book Value*

SP94,700 ( P800,000 = 11.84% (3)P94,700 ( P370,000 = 25.59% (3)

PP91,700 ( P760,000 = 12.07% (2)P91,700 ( P350,000 = 26.20% (2)

FP61,400 ( P500,000 = 12.28% (1)P61,400 ( P220,000 = 27.91% (1)

Residual Income Calculations

DivisionOperating Income 10% Gross BVOperating Income 10% Net BV*

SP94,700 P80,000 = P14,700 (2)P94,700 P37,000 = P57,700 (1)

PP91,700 P76,000 = P15,700 (1)P91,700 P35,000 = P56,700 (2)

FP61,400 P50,000 = P11,400 (3)P61,400 P22,000 = P39,400 (3)

* Net book value is gross book value minus accumulated depreciation.

The biggest weakness of ROI is the tendency to reject projects that will lower historical ROI even though the prospective ROI exceeds the required ROI. RI achieves goal congruence because subunits will make investments as long as they earn a rate in excess of the required return for investments. The biggest weakness of residual income is it favors larger divisions in ranking performance. The greater the amount of the investment (the size of the division), the more likely that larger divisions will be favored assuming that income grows proportionately.

Problem 3 (Multinational Performance Measurement, ROI, RI)

Requirement 1

(a)

Hence, operating income = 15% x P8,000,000 = P1,200,000.(b)

Requirement 2

Convert total assets into pesos at December 31, 2004 exchange rate, the rate prevailing when the assets were acquired (8 kronas = P1)

Convert operating income into pesos at the average exchange rate prevailing when during 2005 when operating income was earned equal to

The Swedish Divisions ROI calculated in kronas is helped by the inflation that occurs in Sweden in 2005. Inflation boosts the divisions operating income. Since the assets are acquired at the start of the year on 1-1-2005, the asset values are not increased by the inflation that occurs during the year. The net effect of inflation on ROI calculated in kronas is to use an inflated value for the numerator relative to the denominator. Adjusting for inflationary and currency differences negates the effects of any differences in inflation rates between the two countries on the calculation of ROI. After these adjustments, the Phil. Division shows a higher ROI than the Swedish Division.

Requirement 3

Phil. Divisions RI in 2005=P1,200,000 12% x P8,000,000

=P1,200,000 P960,000 = P240,000

Swedish Divisions RI in 2005 (in Phil. pesos) is

P1,080,000 12% x P7,500,000 = P1,080,000 P900,000 = P180,000.

The Phil. Divisions RI also exceeds the Swedish Divisions RI in 2005 by P60,000 (P240,000 P180,000).

Problem 4 (ROI Performance Measures Based on Historical Cost and Current Cost)

Requirement 1

ROI using historical cost measures:

Luzon Division=38.24%

Visayas Division=19.13%

Mindanao Division=23.46%

The Luzon Division appears to be considerably more efficient than the Visayas and Mindanao Divisions.

Requirement 2

The gross book values (i.e., the original costs of the plants) under historical cost are calculated as the useful life of each plant (12) x the annual depreciation:

Luzon12 x P 70,000=P 840,000

Visayas12 x P100,000=P1,200,000

Mindanao12 x P120,000=P1,440,000

Step 1: Restate long-term assets from gross book value at historical costs to gross book value at current cost as of the end of 2005.

LuzonP 840,000 x (170 ( 100)=P1,428,000

VisayasP1,200,000 x (170 ( 136)=P1,500,000

MindanaoP1,440,000 x (170 ( 160)=P1,530,000

Step 2: Derive net book value of long-term assets at current cost as of the end of 2005. (Estimated useful life of each plant is 12 years).

LuzonP1,428,000 x (2 ( 12)=P 238,000

VisayasP1,500,000 x (9 ( 12)=P1,125,000

MindanaoP1,530,000 x (11 ( 12)=P1,402,500

Step 3: Compute current cost of total assets at the end of 2005. (Assume current assets of each plant are expressed in 2005 pesos.)

LuzonP200,000 + P238,000=P 438,000

VisayasP250,000 + P1,125,000=P1,375,000

MindanaoP300,000 + P1,402,500=P1,702,500

Step 4: Compute current-cost depreciation expense in 2005 pesos.

Gross book value of long-term assets at current cost at the end of 2005 (from Step 1) x (1 ( 12)

LuzonP1,428,000 x (1 ( 12)=P119,000

VisayasP1,500,000 x (1 ( 12)=P125,000

MindanaoP1,530,000 x (1 ( 12)=P127,500

Step 5: Compute 2005 operating income using 2005 current-cost depreciation.

LuzonP130,000 (P119,000 P70,000)=P 81,000

VisayasP220,000 (P125,000 P100,000)=P195,000

MindanaoP380,000 (P127,500 P120,000)=P372,500

Step 6: Compute ROI using current-cost estimate for long-term assets and depreciation.

LuzonP 81,000 ( P 438,000=18.49%

VisayasP195,000 ( P1,375,000=14.18%

MindanaoP372,500 ( P1,702,500=21.88%

ROI: Historical CostROI: Current Cost

Luzon38.24%18.49%

Visayas19.13%14.18%

Mindanao23.46%21.88%

Use of current cost results in the Mindanao Division appearing to be the most efficient. The Luzon ROI is reduced substantially when the ten-year-old plant is restated for the 70% increase in construction costs over the 1995 to 2005 period.

Requirement 3

Use of current costs increases the comparability of ROI measures across divisions operating plants built at different construction cost price levels. Use of current cost also will increase the willingness of managers, evaluated on the basis of ROI, to move from divisions with assets purchased many years ago to division with assets purchased in recent years.IV.Multiple Choice Questions1. A11. B21. C31. A

2. B12. D22. D32. A

3. C13. C23. C33. B

4. C14. A24. A34. A

5. D15. C25. C35. C

6. B16. C26. D36. B

7. A17. A27. A37. D

8. C18. C28. C

9. B19. B29. D

10. A20. A30. D

=15.3%

9,180,000 kronas

60,000,000 kronas

=15%

Operating income

P8,000,000

=

=

=9.6%

Operating income

Total assets

Phil. Divisions ROI in 2005 =

P900,000 x 6% + 600,000 x 15%

P900,000 + 600,000

Weighted average

cost of capital

=20%

480,000

2,400,000

=

Operating income

Sales

Return on Sales (ROS)=

Economic value added (EVA)

=

Total Assets minus Current Liabilities

x

(

After tax operating income

Weighted Average Cost of Capital

= P1,080,000

9,180,000 kronas

8.5 kronas per peso

Swedish Divisions ROI in 2005 in kronas=

=14.4%

P1,080,000

P7,500,000

Comparable ROI for Swedish Division=

P130,000

P340,000

P220,000

P1,150,000

P380,000

P1,620,000

Gross book value of long-term assets at historical cost

x

Construction cost index in 2005

Construction cost index in year of construction

Estimated useful life remaining

Estimated total useful life

x

Gross book value of long-term assets at current cost at the end of 2005

Current assets at the end of 2005 (given)

Historical-cost operating income

Net book value of long-term assets at current cost at the end of 2005 (Step 2)

+

Current-cost depreciation in 2005 pesos (Step 4)

Historical-cost depreciation

Operating income for 2005 using 2005 current cost depreciation (Step 5)

Current cost of total assets at the end of 2005 (Step 3)

= P7,500,000

60,000,000 kronas

8 kronas per peso

24,000,000 kronas=

24-124-224-3