Tutorial Questions Week 5

1. What are the six steps in designing accounting-based performance measures?

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

1.Choose performance measures that align with top management’s financial goals.

2.Choose the time period of each performance measure in Step 1.

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

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

5.Choose a target level of performance.

6.Choose the timing of feedback.

2. Why is it important to distinguish between the performance of a manager

and the performance of the organisation subunit for which the manager is
responsible? Give an example.

Solution:
In some cases, the subunit’s performance may not be a good indicator of a manager’s
performance. For example, companies often put the most skilful division manager in charge
of the weakest division in an attempt to improve the performance of the weak division. Such
an effort may yield results in years, not months. The division may continue to perform poorly
with respect to other divisions of the company. But it would be a mistake to conclude from
the poor performance of the division that the manager is performing poorly.
A second example of the distinction between the performance of the manager and the
performance of the subunit is the use of historical cost-based ROIs to evaluate the manager
even though historical cost-based ROIs may be unsatisfactory for evaluating the economic
returns earned by the organisation subunit. Historical cost-based ROI can be used to
evaluate a manager by comparing actual results to budgeted historical cost-based ROIs.

3.ROI and RI.

The Sports Equipment Company produces a wide variety of sports equipment. Its newest
division, Golf Technology, manufactures and sells a single product—AccuDriver, a golf club
that uses global positioning satellite technology to improve the accuracy of golfers’ shots.
The demand for AccuDriver is relatively insensitive to price changes. The following data are
available for Golf Technology, which is an investment centre for Sports Equipment:

Total annual fixed costs $26 000 000

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Variable cost per AccuDriver $600
Number of AccuDrivers sold each year 170 000
Average operating assets invested in the division $46 000 000

Required

1. Calculate Sports Equipments’s ROI if the selling price of AccuDrivers is $830 per club.
2. If management requires an ROI of at least 28% from the division, what is the
minimum selling price that the Golf Technology Division should charge per
AccuDriver club?
3. Assume that Sports Equipment judges the performance of its investment centres on
the basis of RI rather than ROI. What is the minimum selling price that Sports
Equipment should charge per AccuDriver unit to achieve a $4 820 000 residual
income if the company’s required rate of return is 18%?

Solution
ROI and RI.

1.Operating profit = (Contribution margin per unit  170 000 units) – Fixed costs
= ($830 – $600)  170 000 – $26 000 000 = $13 100 000

Operating income
ROI = Investment = $13 100 000 ÷ $46 000 000 = 28.48%

2.Operating profit=ROI x Investment

[No. of clubs sold (Selling price – Var. cost per unit)] – Fixed costs = ROI x
Investment

Let $X = minimum selling price per unit to achieve a 28% ROI

170 000 ($X – $600) – $26 000 000 = 28% ($46 000 000)
170 000X = $12 880 000 + $26 000 000 + $102 000 000
X = $828.71

3. Let $X = minimum selling price per unit to achieve a $4 820 000 residual
income with required rate of return = 18%

4 820 000 = 170 000 ($X – $600) – $26 000 000 - 18% ($46 000 000)
$170 000X = $4 820 000 + $102 000 000 + $26 000 000 + 8 280 000

X = $830

4.ROI,RI, EVA®

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 The Performance Auto Company operates a new car division (that sells high-performance
sports cars) and a performance parts division (that sells performance-improvement parts for
family cars). Some division financial measures for 2018 are as follows:

A B C

New car Performance

1
division parts division

2 Total assets $33 000 000 $28 500 000

3 Current liabilities 6 600 000 8 400 000
4 Operating profit 2 475 000 2 565 000
5 Required rate of return 12% 12%

Required

1. Calculate return on investment (ROI) for each division using operating profit as a
measure of income and total assets as a measure of investment.
2. Calculate residual income (RI) for each division using operating profit as a measure
of income and total assets minus current liabilities as a measure of investment.
3. William Abraham, the new car division manager, argues that the performance parts
division has ‘loaded up on a lot of short-term debt’ to boost its RI. Calculate an
alternative RI for each division that is not sensitive to the amount of short-term debt
taken on by the performance parts division. Comment on the result.
4. Performance Auto Company, whose tax rate is 40%, has two sources of funds: long-
term debt with a market value of $18 000 000 at an interest rate of 10% and equity
capital with a market value of $12 000 000 and a cost of equity of 15%. Applying the
same weighted-average cost of capital (WACC) to each division, calculate EVA® for
each division.
5. Use your preceding calculations to comment on the relative performance of each
division.

Solution

ROI,RI, EVA®

1. The required division ROIs using total assets as a measure of investment

is shown in the row labelled (1) in Solution Exhibit 20.21.

SOLUTION

    New Car Performance

Division Parts

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 Division
  Total assets $33 000 000 $28 500 000
  Current liabilities $6 600 000 $8 400 000
  Operating profit $2 475 000 $2 565 000
  Required rate of return 12% 12%
  Total assets – current liabilities $26 400 000 $20 100 000
(1) ROI (based on total assets) ($2 475
000  $33 000 000; $2 565 000  $28
500 000) 7.5% 9.0%

(2) RI (based on total assets- current

liabilities) ($2 475 000 – (12%  $26
400 000); $2 565 000 – (12% 
$20 100 000) ($693 000) $153 000

(3) RI (based on total assets) ($2 475 000

– (12% 
$33 000 000); $2 565 000 – (12% 
$28 500 000) ($ 1 485 000) ($855 000)

2. The row labelled (2) in the table above shows division RIs using total
assets minus current liabilities as a measure of investment. Even with this
new measure that removes the effect of short-term debt, the New Car
Division has a relatively worse RI than the Performance Parts Division.

3. The New Car division RIs using total assets as a measure of investment
is shown in the row labelled (3) in the table above. The New Car division RI is
still worse.

4. After-tax cost of debt financing = (1 – 0.4) x 10% = 6%

After-tax cost of equity financing = 15%
Weighted average =
cost of capital ((18 000 000 x 0.06) + (12 000 000 x 0.15))/
(18 000 000 + 12 000 000) = 9.6%

New Car Performance

Division Parts Division
Operating profit after tax $1 485 000 1 539 000
0.6 x operating profit before tax
(0.6 x $2 475 000; 0.6 x $2 565 000)
Required return for EVA 2 534 400 1 929 600
9.6% x Investment
9.6% x ($33 000 000 – 6 600 000);
9.6% x ($28 500 000 – 8 400 000)
EVA (Operating profit after tax – required $(1 049 400) ($ 390 600)
return)

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5. Both the residual income and the EVA calculations indicate that the
Performance Parts Division is performing better than the New Car Division.
The Performance Parts Division has a higher residual income and EVA.

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