Business Unit Performance Measurement
Chapter 13
Learning Objectives
1. Evaluate divisional accounting income as a
performance measure.
2. Interpret and use return on investment (ROI).
3. Interpret and use residual income (RI).
4. Interpret and use economic value added (EVA®).
5. Explain how historical cost and net book value-based
accounting measures can be misleading in
evaluating performance.
13-2
Accounting Income
L.O. 1 Evaluate divisional accounting income as a performance measure.
Divisional Income
Division revenues minus
division costs
Investors use
income to assess
firm performance.
Firm uses a division’s
income to assess
divisional performance.
13-3
13-4
Divisional Income
Mustang Fashions
Divisional Income Statements
For Year 1 (in $000)
Sales
Cost of sales
Gross margin
Allocated corporate overhead
Local advertising
Other general and admin
Operating income
Tax expense (@30%)
After-tax income
Western
Division
$ 5,200.0
2,802.0
$ 2,398.0
468.0
1,200.0
250.0
$ 480.0
144.0
$ 336.0
Eastern
Division
$ 2,800.0
1,515.0
$ 1,285.0
252.0
500.0
227.0
$ 306.0
91.8
$ 214.2
Total
$ 8,000.0
4,317.0
$ 3,683.0
720.0
1,700.0
477.0
$ 786.0
235.8
$ 550.2
13-5
Divisional Income:
Advantages and Disadvantages
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
13-6
Using Financial Ratios
Mustang Fashions
Selected Financial Ratios
For Year 1
Ratio
Gross margin percentage
Operating margin
Profit margin
Definition
(Gross margin / Sales)
(Operating income / Sales)
(After-tax income / Sales)
Western
46.12%
9.23
6.46
Eastern
45.89%
10.93
7.65
Return on Investment
L.O. 2 Interpret and use return on investment (ROI).
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
13-7
13-8
ROI Continued
ROI
=
ROI =
ROI
=
Profit margin ratio x Asset turnover
After-tax income
Sales
x
After-tax income
Divisional assets
Sales
Divisional assets
Limitations of ROI
ROI
=
After-tax income
Divisional assets
Increase sales
Decrease costs
Decrease assets
13-9
13-10
ROI Continued
Mustang Fashions
Balance Sheets
January 1, Year 1 (in $000)
Assets
Cash
Accounts receivable
Inventory
Total current assets
Fixed assets (net)
Total assets
Equities
Accounts payable
Other current liabilities
Total current liabilities
Long-term debt
Total liabilities
Total shareholders equity
Total equities
Western
Division
Eastern
Division
$
$
250
225
250
725
775
$ 1,500
125
227
352
352
1,148
$ 1,500
Total
$
150
250
150
550
350
900
$ 400
475
400
1,275
1,125
$ 2,400
$
95
280
375
375
525
900
220
507
727
727
1,673
$ 2,400
13-11
ROI Continued
Mustang Fashions
Return on Investment
For Year 1
After-tax income
Divisional investment
ROI
a
336,000/1,500,000
b
214,200/900,000
Western
Division
Eastern
Division
$ 336,000
1,500,000
$ 214,200
900,000
22%a
24%b
Limitations of ROI Continued
13-12
Mustang Fashions
Required Returns
Company
Western Division
Eastern Division
20%
22%
24%
Limitations of ROI Continued
13-13
Dysfunctional behavior
If the return is:
Company
20%
Western Division
22%
Eastern Division
24%
Limitations of ROI Continued
Organization
20%
Western
Division
Manager
22%
Division
managers’ goals
differ from the
organization’s
goals.
Eastern
Division
Manager
24%
13-14
13-15
Residual Income
L.O. 3 Interpret and use residual income (RI).1
Residual Income (RI)
Excess of actual profit over
the cost of invested capital in
the unit.
Cost of Capital
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
x
Divisional assets
13-16
Residual Income
Mustang Fashions
Residual Income
For Year 1
Western
Division
Eastern
Division
After-tax income
Less required return
$ 336,000
300,000
$ 214,200
180,000
Residual income
$ 36,000
a
b
$ 34,200
a
20% x $1,500,000
b
20% x $900,000
Eliminates the dysfunctional behavior caused
by evaluating performance based on ROI
Both managers will invest if return is ≥ 20%
Economic Value Added
L.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”
13-17
EVA: A Simplified Example
13-18
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.
13-19
EVA: A Simplified Example Continued
Mustang Fashions
EVA (in $000)
Western
Division
Eastern
Division
After-tax income
Add back advertising expense
Income before advertising
Less amortization of advertising
$
$ 214.2
500.0
$ 714.2
275.0
Adjusted income
$
836.0
$ 439.2
Divisional investment
Less current liabilities
Net investment
Unamortized advertising
Adjusted divisional investment
1,500.0
352.0
1,148.0
600.0
$ 1,748.0
900.0
375.0
525.0
225.0
$ 750.0
EVA (@20%)
$
a
336.0
1,200.0
$ 1,536.0
700.0
486.4
a
b
c
$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
$ 289.2
a
b
c
EVA Limitations
Based on accounting income
not present value of cash flows
13-20
13-21
Measuring the Investment Base
L.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?
Gross versus Net Book Value
The Facts
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
13-22
13-23
Gross versus Net Book Value Continued
Impact of Net Book Value vs Gross Book Value on ROI
Calculation
1
a
ROI
b
$100 - (.1 x $500)
Calculation
ROI
11.10%
$50c /$500
10%
12.50%
$50/$500
10%
14.30%
$50/$500
10%
$500d - (.1 x $500)e
2
a
b
$100 - (.1 x $500)
$450d - (.1 x $500)e
3
a
b
$100 - (.1 x $500)
$400d - (.1 x $500)e
a
b
c
d
e
Annual cash profit
Depreciation for the year
Net income (annual cash profit - depreciation [$100 - ($500 x .1)])
Beginning-of-the-year asset value
Current year's depreciation
Historical versus Current Cost
Historical Cost
Original cost to
purchase or build
an asset
Current Cost
Cost to replace
or rebuild an
existing asset
13-24
13-25
Historical versus Current Cost Continued
The Facts
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: 20 percent
Asset cost at beginning of
year 1 is $500
13-26
Historical versus Current: Net Book Value
Net Book Value
Year
1
Historical Cost
Calculations
ROI
a
b
$100 - (.1 x $500)
11.10%
c
$500 - (.1 x $500)
2
$120 - (.1 x $500)
17.50%
b
d
e
$120 - (.1 x $720)
f
$500 - (.2 x $500)
$144 - (.1 x $500)
a
$100 - (.1 x $600)
ROI
7.40%
$600 - (.1 x $600)
d
3
Current Cost
Calculations
8.30%
e
$720 - (.2 x $720)
26.90%
d
$144 - (.1 x $864)
g
$500 - (.3 x $500)
9.50%
e
$864 - (.3 x $864)
Gross Book Value
Year
a
Historical Cost
Calculations
ROI
Current Cost
Calculations
ROI
1
($100a - $50b)/$500c
10%
($100a - $60b)/$600d
6.70%
2
($120 - $50)/$500
14%
($120 - $72)/$720f
6.70%
3
($144 - $50)/$500
18.80%
($144 - $86.4)/$864g
6.70%
Annual operating profit before depreciation
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 x 120%)
e
Accumulated depreciation at the end of the year
f
Current cost of asset ($600 x 120%)
g
Current cost of asset ($720 x 120%)
b
13-27
Beginning, Ending, or Average Balance
Managers can
manipulate purchases
and disposition based
on which balance is
being used in
evaluations.
Chapter 13
13-28