ADVANCED MANAGEMENT
ACCOUNTING
PPT 10-1
Performance
Evaluation
PPT 10-2
Learning Objectives
 Compute and explain return on investment
(ROI), residual income (RI), and economic
value added (EVA)
 Discuss methods of evaluating and
rewarding managerial performance
PPT 10-3
Measuring the Performance of
Investment Centers
 Return on Investment (ROI)
 Residual Income (RI)
 Economic Value Added (EVA)
PPT 10-4
10-5
Return On Investment (ROI)
Compute return on investment
(ROI) and show how changes in
sales, expenses, and assets
affect ROI.
PPT 10-5
10-6
Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)
Net operating income
ROI =
Average operating assets
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets.
PPT 10-6
10-7
Net Book Value versus Gross Cost
Most companies use the net book value of
depreciable assets to calculate average
operating assets.
Acquisition cost
Less: Accumulated depreciation
Net book value
PPT 10-7
Components of ROI
Decomposition of the ROI formula:
ROI = Operating income/Average operating
assets
= (Operating income/Sales) x
(Sales/Average operating assets)
= Operating income margin x
Operating asset turnover
PPT 10-8
10-9
Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating assets
ROI = Margin  Turnover
PPT 10-9
An ROI Example
Year 1:
Snack Foods
Division
Sales
$30,000,000
Operating income
1,800,000
Average operating assets
10,000,000
Appliance
Division
$117,000,000
3,510,000
19,500,000
Year 2:
Sales
Operating income
Average operating assets
$117,000,000
2,925,000
19,500,000
$40,000,000
2,000,000
10,000,000
Minimum return of 10%
PPT 10-10
Margin and Turnover Comparisons
Snack Food
Appliance
Year 1
Year 2
Year 1
Year 2
Margin
6.0%
5.0%
3.0%
2.5%
Turnover
x 3.0
x 4.0
x 6.0
x 6.0
18.0%
===
20.0%
===
18.0%
===
15.0%
===
ROI
PPT 10-11
10-12
Increasing ROI
There are three ways to increase ROI . . .
Reduce
Increase Expenses Reduce
Sales
Assets
PPT 10-12
10-13
Increasing ROI – An Example
Regal Company reports the following:
Net operating income
$ 30,000
Average operating assets
$ 200,000
Sales
$ 500,000
Operating expenses
$ 470,000
What is Regal Company’s ROI?
ROI = Margin  Turnover
ROI =
Net operating income
Sales
×
Sales
PPT 10-13
Average operating assets
10-14
Increasing ROI – An Example
ROI = Margin  Turnover
ROI =
Net operating income
Sales
$30,000
ROI =
$500,000
×
Sales
Average operating assets
$500,000
×
$200,000
ROI = 6%  2.5 = 15%
PPT 10-14
10-15
Investing in Operating Assets to
Increase Sales
Suppose that Regal's manager invests in a
$30,000 piece of equipment that increases sales
by $35,000, while increasing operating
expenses by $15,000.
Regal Company reports the following:
Net operating income
Average operating assets
Sales
Operating expenses
$ 50,000
$ 230,000
$ 535,000
$ 485,000
Let’s calculate the new ROI.
PPT 10-15
10-16
Investing in Operating Assets to
Increase Sales
ROI = Margin  Turnover
ROI =
Net operating income
Sales
×
ROI = $50,000
$535,000
×
Sales
Average operating assets
$535,000
$230,000
ROI = 9.35%  2.33 = 21.8%
ROI increased from 15% to 21.8%.
PPT 10-16
Advantages of ROI
 It encourages managers to pay careful attention
to the relationships among sales, expenses, and
investment, as should be the case for a manager
of an investment center.
 It encourages cost efficiency.
 It discourages excessive investment in operating
assets.
PPT 10-17
Disadvantages of the ROI Measure
 It discourages managers from investing in
projects that would decrease the divisional ROI
but would increase the profitability of the
company as a whole. (Generally, projects with an
ROI less than a division’s current ROI would be
rejected.)
 It can encourage myopic behavior, in that
managers may focus on the short run at the
expense of the long run.
PPT 10-18
10-19
Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.
Managers often inherit many
committed costs over which
they have no control.
Managers evaluated on ROI
may reject profitable
investment opportunities.
PPT 10-19
10-20
Residual Income
Compute residual income
and understand its
strengths and weaknesses.
PPT 10-20
10-21
Residual Income - Another
Measure of Performance
Net operating income
above some minimum
required return on
operating assets
PPT 10-21
Residual Income
Residual income is the difference between
operating income and the minimum dollar
return required on a company’s operating
assets:
 Residual income = Operating income -
(Minimum rate of return x Operating assets)
PPT 10-22
10-23
Calculating Residual Income
Residual
=
income
Net
operating income
(
Average
operating
assets

)
Minimum
required rate of
return
ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
PPT 10-23
Residual Income Example
Investment
Operating income
Targeted ROI
Project I
Project II
$10,000,000
$4,000,000
1,300,000
640,000
10%
10%
PPT 10-24
Residual Income Example
Project I
Residual income = Operating income - (Minimum rate
of return x Operating assets)
Residual income = $1,300,000 - (0.10 x $10,000,000)
= $1,300,000 - $1,000,000
= $300,000
Project II
Residual income = $640,000 - (0.10 x $4,000,000)
= $640,000 - $400,000
= $240,000
PPT 10-25
10-26
Residual Income – An Example
The Retail Division of Zephyr, Inc. has
average operating assets of $100,000 and
is required to earn a return of 20% on
these assets.
In the current period, the division earns
$30,000.
Let’s calculate residual income.
PPT 10-26
10-27
Residual Income – An Example
Operating assets
$ 100,000
Required rate of return ×
20%
Minimum required return $ 20,000
Actual income
Minimum required return
Residual income
$ 30,000
(20,000)
$ 10,000
PPT 10-27
10-28
Motivation and Residual Income
Residual income encourages managers to
make investments that are profitable
for the entire company but would be
rejected by managers who are evaluated
using the ROI formula.
PPT 10-28
10-29
Quick Check 
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000.
The required rate of return for the company
is 15%. What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%
PPT 10-29
10-30
Quick Check 
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000.
The required rate of return for the company
is 15%. What is the division’s ROI?
a. 25%
b. 5%
c. 15%
ROI = NOI/Average operating assets
d. 20%
= $60,000/$300,000 = 20%
PPT 10-30
10-31
Quick Check 
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000. If
the manager of the division is evaluated
based on ROI, will she want to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year?
a. Yes
b. No
PPT 10-31
10-32
Quick Check 
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. If the
manager of the division is evaluated based on
ROI, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No
ROI = $78,000/$400,000 = 19.5%
This lowers the division’s ROI from
20.0% down to 19.5%.
PPT 10-32
10-33
Quick Check 
The company’s required rate of return is
15%. Would the company want the manager
of the Redmond Awnings division to make
an investment of $100,000 that would
generate additional net operating income of
$18,000 per year?
a. Yes
b. No
PPT 10-33
10-34
Quick Check 
The company’s required rate of return is 15%.
Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generate
additional net operating income of $18,000 per
year?
ROI = $18,000/$100,000 = 18%
a. Yes
b. No
The return on the investment
exceeds the minimum required rate
of return.
PPT 10-34
10-35
Quick Check 
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000.
The required rate of return for the company
is 15%. What is the division’s residual
income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
PPT 10-35
10-36
Quick Check 
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000.
The required rate of return for the company
is 15%. What is the division’s residual
income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
Net operting income
Required return (15% × $300,000)
Residual income
$ 60,000
(45,000)
$ 15,000
PPT 10-36
10-37
Quick Check 
If the manager of the Redmond Awnings
division is evaluated based on residual income,
will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No
PPT 10-37
10-38
Quick Check 
If the manager of the Redmond Awnings
division is evaluated based on residual income,
will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No
Net operting income
Required return (15% × $400,000)
Residual income
$ 78,000
(60,000)
$ 18,000
Yields an increase of $3,000 in residual income
PPT 10-38
10-39
Divisional Comparisons and
Residual Income
The residual
income approach
has one major
disadvantage.
It cannot be used
to compare the
performance of
divisions of
different sizes.
PPT 10-39
10-40
Zephyr, Inc. - Continued
Recall the following
information for the Retail
Division of Zephyr, Inc.
Assume the following
information for the Wholesale
Division of Zephyr, Inc.
Retail
Wholesale
Operating assets
$ 100,000 $ 1,000,000
Required rate of return ×
20%
20%
Minimum required return $ 20,000 $ 200,000
Retail
Wholesale
Actual income
$ 30,000 $ 220,000
Minimum required return
(20,000)
(200,000)
Residual income
$ 10,000 $
20,000
PPT 10-40
10-41
Zephyr, Inc. - Continued
The residual income numbers suggest that the Wholesale
Division outperformed the Retail Division because its
residual income is $10,000 higher. However, the Retail
Division earned an ROI of 30% compared to an ROI of 22% for
the Wholesale Division. The Wholesale Division’s residual
income is larger than the Retail Division simply because it is
a bigger division.
Retail
Wholesale
Operating assets
$ 100,000 $ 1,000,000
Required rate of return ×
20%
20%
Minimum required return $ 20,000 $
200,000
Retail
Wholesale
Actual income
$ 30,000 $
220,000
Minimum required return
(20,000)
(200,000)
Residual income
$ 10,000 $
20,000
PPT 10-41
Economic Value Added
Economic value added (EVA) is after-tax
operating profit minus the total annual cost
of capital.
The equation for EVA is expressed as
follows:
EVA = After-tax operating income - (Weighted
average cost of capital) x (Total capital
employed)
PPT 10-42
Cost of Capital
There are two steps
involved in computing cost
of capital:
1. determine the weighted
average cost of capital (a
percentage figure)
2. determine the total dollar
amount of capital
employed
PPT 10-43
Weighted Average Cost of Capital
Suppose that a company has two sources of financing: $2 million of longterm bonds paying 9 percent interest and $6 million of common stock,
which is considered to be of average risk. If the company’s tax rate is 40
percent and the rate of interest on long-term government bonds is 6
percent, the company’s weighted average cost of capital is computed as
follows:
Amount
Percent
Bonds
$2,000,000
0.25
0.09(1.0 - 0.4) = 0.054
0.0135
Equity
6,000,000
0.75
0.06 +0 .06
0.0900
Total
$8,000,000
========
x After-Tax Cost
= Weighted Cost
= 0.120
0.1035
=====
PPT 10-44
EVA Example
Suppose that Furman, Inc., had after-tax
operating income last year of $1,583,000. Three
sources of financing were used by the company:
$2 million of mortgage bonds paying 8 percent
interest, $3 million of unsecured bonds paying 10
percent interest, and $10 million in common
stock, which was considered to be no more or less
risky than other stocks. Furman, Inc., pays a
marginal tax rate of 40 percent.
PPT 10-45
Weighted Average Cost of Capital
The weighted average cost of capital for Furman, Inc. is computed as follows:
Amount Percent x After-Tax Cost = Weighted Cost
Common stock
$10,000,000
0.667
0.120
0.080
2,000,000
0.133
0.048
0.006
Unsecured bonds 3,000,000
0.200
0.060
0.012
Mortgage bonds
Total
$15,000,000
=========
0.098
====
PPT 10-46
EVA Example
Furman’s EVA is calculated as follows:
After-tax profit
Less: Weighted average cost of capital
EVA
$1,583,000
1,470,000
$ 113,000
=========
The positive EVA means that Furman, Inc., earned operating
profit over and above the cost of the capital used.
PPT 10-47
Behavioral Aspects of EVA
A number of companies have discovered that EVA helps
to encourage the right kind of behavior from their
divisions in a way that emphasis on operating income
alone cannot. The underlying reason is EVA’s reliance
on the true cost of capital.
In many companies, the responsibility for investment
decisions rests with corporate management. As a result,
the cost of capital is considered a corporate expense. If
a division builds inventories and investment, the cost of
financing that investment is passed along to the overall
income statement and does not show up as a reduction
from the division’s operating income.
PPT 10-48
End of Week
PPT 10-49