Management Control
Systems
Responsibility Centers
Cost
center
Revenue
center
Profit
center
Investment
center
Measuring Managers Performance
Cost/Revenue
Center
Evaluation
Tool
Standard Cost/Flexible
Budget Variances
Profit
Center
Budgeted income
statement
Investment
Center
Return on investment,
residual income and EVA
Accounting-Based Performance
Measure Example
Relax Inns owns three small hotels –
one each in Boston, Denver, and Miami.
At present, Relax Inns does not
allocate the total long-term debt of
the company to the three separate hotels.
Denver Hotel
Current assets
$ 400,000
Long-term assets
600,000
Total assets
$1,000,000
Current liabilities $ 150,000
Revenues
$1,200,000
Variable costs
310,000
Fixed costs
650,000
Operating income $ 240,000
Relax Inns
Balance Sheet
Total current assets
Total long-term assets
Total assets
Total current liabilities
Long-term debt
Stockholders’ equity
Total liabilities and equity
$1,350,000
6,150,000
$7,500,000
$ 500,000
4,800,000
2,200,000
$7,500,000
Approaches to
Measuring Performance
Three approaches include a measure of investment:
Return on investment (ROI)
Residual income (RI)
Economic value added (EVA®)
Return on Investment
Return on investment (ROI) is an
accounting measure of income
divided by an accounting
measure of investment.
Return on investment (ROI)
= Income ÷ Investment
Return on Investment
What is the return on investment
for the Denver Hotel?
Denver Hotel:
$240,000 Operating income
÷ $1,000,000 Total assets = 24%
DuPont Method
The DuPont method of profitability analysis
recognizes that there are two basic
ingredients in profit making:
1. Using assets to generate more revenues
2. Increasing income per dollar of revenues
DuPont Method
Return on sales = Income ÷ Revenues
Investment turnover = Revenues ÷ Investment
ROI = Return on sales × Investment turnover
DuPont Method
How can Relax Inns attain a 30% target
ROI for the Denver Hotel?
Present situation: Revenues ÷ Total assets
= $1,200,000 ÷ $1,000,000 = 1.20
Operating income ÷ Revenues
= $240,000 ÷ $1,200,000 = 0.20
1.20 × 0.20 = 24%
DuPont Method
Alternative A: Decrease assets, keeping
revenues and operating income per
dollar of revenue constant.
Revenues ÷ Total assets
= $1,200,000 ÷ $800,000 = 1.50
1.50 × 0.20 = 30%
DuPont Method
Alternative B: Increase revenues, keeping
assets and operating income per dollar
of revenues constant.
Revenues ÷ Total assets
= $1,500,000 ÷ $1,000,000 = 1.50
Operating income ÷ Revenues
= $300,000 ÷ $1,500,000 = 0.20
1.50 × 0.20 = 30%
DuPont Method
Alternative C: Decrease costs to increase
operating income per dollar of revenues,
keeping revenues and assets constant.
Revenues ÷ Total assets
= $1,200,000 ÷ $1,000,000 = 1.20
Operating income ÷ Revenues
= $300,000 ÷ $1,200,000 = 0.25
1.20 × 0.25 = 30%
Residual Income
Residual income (RI)
= Income
– (Required rate of return × Investment)
Assume that Relax Inns’ required
rate of return is 12%.
What is the residual income from the Denver hotel?
Residual Income
Denver Hotel:
Residual Income = $240,000 - ($1,000,000 X 12%)
= $120,000
Economic Value Added
Economic value added (EVA®)
= After-tax operating income
– [Weighted-average cost of capital
× (Total assets – current liabilities)]
Economic Value Added
Total assets minus current liabilities
can also be computed as:
Long-term assets + Current assets
– Current liabilities, or…
Long-term assets + Working capital
Economic Value Added
Economic value added (EVA®) substitutes the
following specific numbers in the RI calculations:
1. Income equal to after-tax operating income
2. A required rate of return equal to the
weighted-average cost of capital
3. Investment equal to total assets minus
current liabilities
Economic Value Added Example
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%.
Economic Value Added Example
What is the after-tax cost of debt?
0.10 × (1 – Tax rate) = 0.07, or 7%
Assume that Relax Inns’ cost of
equity capital is 14%.
What is the weighted-average cost of capital?
Economic Value Added Example
WACC = [(7% × Market value of debt)
+ (14% × Market value of equity)]
÷ (Market value of debt + Market value of equity)
WACC = [(0.07 × 4,800,000)
+ (0.14 × 4,800,000)] ÷ $9,600,000
WACC = $336,000 + $672,000 ÷ $9,600,000
WACC = 0.105, or 10.5%
Economic Value Added Example
What is the after-tax operating income
for the Denver Hotel?
Denver Hotel:
Operating income $240,000 × 0.7 = $168,000
Economic Value Added Example
What is the investment?
Denver Hotel: Total assets $1,000,000
– Current liabilities $150,000 = $850,000
Economic Value Added Example
What is the weighted-average cost of capital
times the investment for Denver?
Denver Hotel: $850,000 × 10.5% = $89,250
Economic Value Added Example
What is the economic value added?
Denver Hotel: $168,000 – $89,250 = $78,750
The EVA® charges managers for the cost
of their investments in long-term assets
and working capital.