Business Unit Performance

Measurement

McGraw-Hill/Irwin Chapter 14
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.

McGraw-Hill/Irwin
Accounting Income
LO1 Evaluate divisional accounting income as a
performance measure.

Divisional Income
Division revenues minus
division costs

Investors use income to Firm uses a division’s

assess firm income to assess divisional
performance. performance.
McGraw-Hill/Irwin
 Example: Divisional Income
Mustang Fashions
Divisional Income Statements
For Year 1 (in $000)

Western Eastern
Division Division Total
Sales $ 5,200.0 $ 2,800.0 $8,000.0
Cost of sales 2,802.0 1,515.0 4,317.0
Gross margin $ 2,398.0 $ 1,285.0 $3,683.0
Allocated corporate overhead 468.0 252.0 720.0
Local advertising 1,200.0 500.0 1,700.0
Other general and admin 250.0 227.0 477.0
Operating income $ 480.0 $ 306.0 $ 786.0
Tax expense (@30%) 144.0 91.8 235.8
After-tax income $ 336.0 $ 214.2 $ 550.2
McGraw-Hill/Irwin
Divisional Income: Advantages & Disadvantages

1. Easy to understand
2. Reflects decisions controlled by
the division manager
3. Makes comparison of divisions
easy

1. May not reflect performance of divisional

managers since the size of the division may
have an impact

2. Does not determine if managers are making good

decisions regarding the use of assets
McGraw-Hill/Irwin
 Using Financial Ratios
Mustang Fashions
Selected Financial Ratios
For Year 1
Ratio Definition Western Eastern
Gross margin percentage (Gross margin / Sales) 46.12% 45.89%
Operating margin (Operating income / Sales) 9.23 10.93
Profit margin (After-tax income / Sales) 6.46 7.65

McGraw-Hill/Irwin
Return on Investment
LO2 Interpret and use return on investment (ROI).

Return on Investment (ROI)

Ratio of profits to investment in the asset that
generates those profits.
Provides a comparison of different size divisions.

After-tax income
ROI =
Divisional assets

McGraw-Hill/Irwin
ROI, Continued. . .

ROI = Profit margin ratio x Asset turnover

After-tax income Sales

ROI = x
Sales Divisional assets

After-tax income
ROI =
Divisional assets

McGraw-Hill/Irwin
Limitations of ROI

After-tax income
ROI =
Divisional assets

Increase sales

Decrease costs

Decrease assets

McGraw-Hill/Irwin
Example: ROI Limitations
Mustang Fashions
Balance Sheets
January 1, Year 1 (in $000)
Western Eastern
Division Division Total
Assets
Cash $ 250 $ 150 $ 400
Accounts receivable 225 250 475
Inventory 250 150 400
Total current assets 725 550 1,275
Fixed assets (net) 775 350 1,125
Total assets $ 1,500 $ 900 $ 2,400
Liabilities and Equities
Accounts payable 125 95 220
Other current liabilities 227 280 507
Total current liabilities 352 375 727
Long-term debt -0- -0- -0-
Total liabilities 352 375 727
Total shareholders equity 1,148 525 1,673
Total equities $ 1,500 $ 900 $ 2,400
McGraw-Hill/Irwin
Example: ROI Limitations, Continued. . .
Mustang Fashions
Return on Investment
For Year 1
Western Eastern
Division Division
After-tax income $ 336,000 $ 214,200
Divisional investment 1,500,000 900,000
a b
ROI 22% 24%

a
336,000/1,500,000
b
214,200/900,000

McGraw-Hill/Irwin
Example: ROI Limitations, Continued. . .
Mustang Fashions
Required Returns
Current Condition:
Company Western Division Eastern Division
20% 22% 24%

McGraw-Hill/Irwin
Example: ROI Limitations, Continued. . .
Dysfunctional behavior

If the return is:

Company Western Division Eastern Division

20% 22% 24%

McGraw-Hill/Irwin
Limitations of ROI, Continued. . .

Organization
20%

Western Eastern
Division Division
Manager Manager
24%
22%

Conflicting incentives: the division managers’ goals

differ from the organization’s goals.

McGraw-Hill/Irwin
Residual Income
LO2 Interpret and use residual income (RI).

Residual Income (RI)

Excess of actual profit over the cost
of invested capital in the unit.

Cost of Capital
The opportunity cost of the resources (equity and
debt capital) invested in the business.

Residual income = After-tax income - Cost of capital x Divisional assets

McGraw-Hill/Irwin
Example: Residual Income (RI)
Mustang Fashions
Residual Income
For Year 1
Western Eastern
Division Division
After-tax income $ 336,000 $ 214,200
a b
Less required return 300,000 180,000

Residual income $ 36,000 $ 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%
McGraw-Hill/Irwin
 Economic Value Added (EVA ®)
LO4 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”

McGraw-Hill/Irwin
Example: EVA®

Advertising Expenditures

Western Division $800,000

Eastern Division $300,000

Mustang Fashion believes an advertising campaign

has a two year life.

GAAP requires advertising be expensed when

incurred.
McGraw-Hill/Irwin
Example: EVA®, Continued. . .
Mustang Fashions Western Eastern
EVA (in $000) Division Division
After-tax income $ 336.0 $ 214.2
Add back advertising expense 1,200.0 500.0
Income before advertising $ 1,536.0 $ 714.2
a a
Less amortization of advertising 700.0 275.0
Adjusted income $ 836.0 $ 439.2
Divisional investment 1,500.0 900.0
Less current liabilities 352.0 375.0
Net investment 1,148.0 525.0
b b
Unamortized advertising 600.0 225.0
Adjusted divisional investment $ 1,748.0 $ 750.0
c c
EVA (@ 20%) $ 486.4 $ 289.2

a
$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)

McGraw-Hill/Irwin
EVA Limitations

Based on accounting income, not

present value of cash flows

McGraw-Hill/Irwin
Measuring the Investment Base
LO5 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?

McGraw-Hill/Irwin
Example: 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
McGraw-Hill/Irwin
Example: Gross versus Net Book Value, Continued. . .
Impact of Net Book Value vs Gross Book Value on ROI
Year Net Book Value Gross Book Value
Calculation ROI Calculation ROI

1
a
$100 - (.1 x $500)
b
11.10% $50c/$500 10%
$500d - (.1 x $500)e

a b $50/$500
2 $100 - (.1 x $500) 12.50% 10%
$450d - (.1 x $500)e

a b $50/$500
3 $100 - (.1 x $500) 14.30% 10%
$400d - (.1 x $500)e

a
Annual cash profit
b
Depreciation for the year
c
Net income (annual cash profit - depreciation [$100 - ($500 x .1)])
d
Beginning-of-the-year asset value
McGraw-Hill/Irwin
Historical versus Current Cost

Current Cost Historical Cost

Cost to replace or Original cost to
rebuild an existing purchase or build an
asset asset

McGraw-Hill/Irwin
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

McGraw-Hill/Irwin
Historical versus Current Cost, Net Book Value
Net Book Value
Year Historical Cost Current Cost
Calculations ROI Calculations ROI
a b a b
1 $100 - (.1 x $500) 11.10% $100 - (.1 x $600) 7.40%
c d e
$500 - (.1 x $500) $600 - (.1 x $600)

2 $120 - (.1 x $500) 17.50% $120 - (.1 x $720) 8.30%

d f e
$500 - (.2 x $500) $720 - (.2 x $720)

3 $144 - (.1 x $500) 26.90% $144 - (.1 x $864) 9.50%

d g e
$500 - (.3 x $500) $864 - (.3 x $864)

Gross Book Value

Year Historical Cost Current Cost
Calculations ROI 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%

a
Annual operating profit before depreciation
b
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%)
McGraw-Hill/Irwin
Beginning, Ending, or Average Balance?

Managers can manipulate

purchases and disposition
based on which balance is
being used in evaluations.

McGraw-Hill/Irwin
Chapter 14: END!!

McGraw-Hill/Irwin
Calculating the Foreign Division’s
ROI in the Foreign Curency

Hospitality Inns invests in a hotel in Mexico City. The investment consists mainly of the
costs of buildings and furnishings. Also assue the following:
-The exchange rate at the time of Hospitality’s investment on Dec 31, 2011, is 10 peso = $1.
-During 2012, the Mexican peso suffers a steady decline in its value. The exchange rate on
December 31, 2012, is 15 pesos = $1
-The average exchange rate during 2012 is ( 10 + 15 ) / 2 = ….
-The investment ( total assets) in the Mexico City hotel is 30,000,000 pesos.
-The operating income of the Mexico City hotel in 2012 is 6,000,000 pesos
What is the ROI for the Mexico Ctiy hotel in 2012 ?

McGraw-Hill/Irwin
Calculating the Foreign Division’s ROI in US. Dollars

KoneKopf Corporation has a division in the United States, and

another in France. The investment in the French assets was made
when the exchange rate was $1.30 per euro. The average exchange
rate for the year was $1.4 per euro. The exchange rate at the end of
the fiscal year was $1.45 per euro. Income and investment for the
two divisions are as follows:

McGraw-Hill/Irwin