Divisional Performance Evaluation

Management Accounting Systems Cost Accounting Systems Budgeting Systems Variance Analysis Performance Measurement Systems Transfer Pricing

Agenda Describe the mechanics of computing accounting-based measures of financial performance – ROI (Return on Investment) – RI (Residual Income) – EVA (Economic Value Added) Discuss the strengths and shortcomings of these accounting-based performance measures Example: Ross Parts Takeaway

Motivating Accounting Performance Measures The most common accounting measure of performance is income Since external investors are interested in income, it is an obvious choice for evaluating units of the organization It also provides a common metric with which to compare different units in the organization

ROI Return on investment (ROI) or return on assets (ROA) is an accounting measure of income divided by an accounting measure of investment ROI = Income ÷ Investment

ROI Strengths ROI is easy to compute ROI is a ratio – Can be compared across divisions

ROI Weakness: Dilution of ROI A problem with ROI is that it is a ratio rather than a sum The company’s cost of capital is 15 % – Your division’s ROI is currently 25 % You see an opportunity that yields 20 % – What does headquarters (if it knew about this opportunity) think about taking on this opportunity? [Yes % pulls its 15% up] – What do you as a divisional manager compensated on ROI think about taking on this opportunity? [No % pulls your 25% down] This organizational inefficiency is called: ROI Dilution Problem

Residual Income (RI) RI = Income – (Cost of Capital x Investment) RI is a dollar figure RI is positive if a project generates income greater than the project’s cost of capital. Colloquial Interpretation – Suppose cost of capital is 15%. You pay the lender his interest of 15%, and “keep” the rest of the income for yourself.

Strengths of Residual Income Measure No ROI dilution problem – Suppose the corporate target cost of capital is 15% – The divisional manager compensated on RI will take on any opportunity that generates more than 15% Taking on such an opportunity can only increase the divisional manager’s RI dollars. – Colloquially speaking, the manager gets to “keep” any income over and above the “interest charge” of 15%.

Different Treatment of Input Resources Division A hires a scientist (input resource) to improve its operations. That scientist costs $100,000. Division B gets a machine (input resource) instead that also costs $100,000 and has the same economic impact on efficiency. RI = Income – (Cost of Capital x Investment) – Because wages are expensed, the entire $100,000 paid to the scientist hits Division A’s income immediately. – Because machine purchases are capitalized, only the first year depreciation hits Division B’s income immediately.

Economic Value-Added (EVA) EVA reduces reporting distortions in residual income – Adjust reporting of several income items EVA = Adjusted Income – [cost-of-capital x (Total assets – current liabilities)] NOTE: There are many variations to EVA applied in practice

Agenda Describe the mechanics of computing accounting-based measures of financial performance – ROI (Return on Investment) – RI (Residual Income) – EVA (Economic Value Added) Discuss the strengths and shortcomings of these accounting-based performance measures Example: Ross Parts Takeaway

Example: Ross Parts North DivisionSouth Division Profit$200$390 Investment (Assets)$2,000 $3,000 Current liabilities$200 Cost of capital15% R&D expenditure*$500$0 * (Assumed to benefit this period and the following three periods equally – a total benefit period of four years.)

Example: Ross Parts North DivisionSouth Division ROI($200 ÷ $2,000)($390 ÷ $3,000) = 10%= 13% Residual Income $200 – (15% x $2,000) = – $100 $390 – (15% x $3,000) = – $60 Note: Residual Income for North Division is negative in part because all the R&D has been expensed, resulting in a low income figure.

R&D Amortization For North Division Amortization Schedule of $500 R&D expenditures over four periods This period + 1 This period + 2 This period + 3 Traditional R&D Expense Amortized R&D Expense125 Remaining Capitalized R&D Adjustment to Income Adjustment to Assets

Ross Parts Current Period EVA North Division “Adjusted” profit:$200 + $375 =$575 “Adjusted” assets:$2,000 – $200 # + $375 =$2,175 EVA:$575 – (15% x $2,175) =$ > 0 South Division “Adjusted” profit:$390 =$390 “Adjusted” assets:$3,000 – $200 # =$2,800 EVA:$390 – (15% x $2,800) =– $30 # $200 is current liabilities that we subtract in our definition of EVA assets

Another EVA Example: Lincoln, Inc Revenue R&D Expense(60) Assets (Beginning of year) 100 Income(10)10080 Residual Income(10) – 15% 100 = ($5) 100 – 15% 100 = $85 80 – 15% 100 = $65

Another EVA Example: Lincoln, Inc Amortization Schedule of $60 R&D expenditures over three periods Revenue R&D Expense “Left over” R&D Assets (20) 40 (20) 20 (20) 0 Assets (Beginning of year) Adjusted Assets Adjusted Income Residual Income30 – 15% 100 = $15 80 – 15% 140 = $59 60 – 15% 120 = $42

Takeaway Some commonly used financial performance measures are – Income – Return on Investment (ROI) – Residual Income – EVA Organizational Issues: – Each measure has strengths and weaknesses – Effective use requires Management Judgment and Leadership