Management Control Systems

Responsibility Centers Cost center Revenue center Profit center Investment center

Measuring Managers Performance Evaluation Tool Cost/Revenue Center Standard Cost/Flexible Budget Variances Profit Center Budgeted income statement Investment Center Return on investment, residual income and EVA

Accounting-Based Performance Measure Example Relax Inns owns three small hotels – one each in Boston, Denver, and Miami. At present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels.

Denver Hotel Current assets $ 400,000 Long-term assets 600,000 Total assets $1,000,000 Current liabilities $ 150,000 Revenues $1,200,000 Variable costs 310,000 Fixed costs 650,000 Operating income $ 240,000

Relax Inns Balance Sheet Total current assets $1,350,000 Total long-term assets 6,150,000 Total assets $7,500,000 Total current liabilities $ 500,000 Long-term debt 4,800,000 Stockholders’ equity 2,200,000 Total liabilities and equity $7,500,000

Approaches to Measuring Performance Three approaches include a measure of investment: Return on investment (ROI) Residual income (RI) Economic value added (EVA®)

Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment. Return on investment (ROI) = Income ÷ Investment

What is the return on investment for the Denver Hotel? Denver Hotel: $240,000 Operating income ÷ $1,000,000 Total assets = 24%

The DuPont method of profitability analysis recognizes that there are two basic ingredients in profit making: 1. Using assets to generate more revenues 2. Increasing income per dollar of revenues

Return on sales = Income ÷ Revenues DuPont Method Return on sales = Income ÷ Revenues Investment turnover = Revenues ÷ Investment ROI = Return on sales × Investment turnover

How can Relax Inns attain a 30% target ROI for the Denver Hotel? DuPont Method How can Relax Inns attain a 30% target ROI for the Denver Hotel? Present situation: Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = 1.20 Operating income ÷ Revenues = $240,000 ÷ $1,200,000 = 0.20 1.20 × 0.20 = 24%

Alternative A: Decrease assets, keeping DuPont Method Alternative A: Decrease assets, keeping revenues and operating income per dollar of revenue constant. Revenues ÷ Total assets = $1,200,000 ÷ $800,000 = 1.50 1.50 × 0.20 = 30%

Alternative B: Increase revenues, keeping DuPont Method Alternative B: Increase revenues, keeping assets and operating income per dollar of revenues constant. Revenues ÷ Total assets = $1,500,000 ÷ $1,000,000 = 1.50 Operating income ÷ Revenues = $300,000 ÷ $1,500,000 = 0.20 1.50 × 0.20 = 30%

Alternative C: Decrease costs to increase DuPont Method Alternative C: Decrease costs to increase operating income per dollar of revenues, keeping revenues and assets constant. Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = 1.20 Operating income ÷ Revenues = $300,000 ÷ $1,200,000 = 0.25 1.20 × 0.25 = 30%

– (Required rate of return × Investment) Residual Income Residual income (RI) = Income – (Required rate of return × Investment) Assume that Relax Inns’ required rate of return is 12%. What is the residual income from the Denver hotel?

Residual Income = $240,000 - ($1,000,000 X 12%) Denver Hotel: Residual Income = $240,000 - ($1,000,000 X 12%) = $120,000

Economic value added (EVA®) = After-tax operating income – [Weighted-average cost of capital × (Total assets – current liabilities)]

Total assets minus current liabilities can also be computed as: Economic Value Added Total assets minus current liabilities can also be computed as: Long-term assets + Current assets – Current liabilities, or… Long-term assets + Working capital

Economic value added (EVA®) substitutes the following specific numbers in the RI calculations: 1. Income equal to after-tax operating income 2. A required rate of return equal to the weighted-average cost of capital 3. Investment equal to total assets minus current liabilities

Economic Value Added Example Assume that Relax Inns has two sources of long-term funds: 1. Long-term debt with a market value and book value of $4,800,000 issued at an interest rate of 10% 2. Equity capital that also has a market value of $4,800,000 and a book value of $2,200,000 Tax rate is 30%.

Economic Value Added Example What is the after-tax cost of debt? 0.10 × (1 – Tax rate) = 0.07, or 7% Assume that Relax Inns’ cost of equity capital is 14%. What is the weighted-average cost of capital?

Economic Value Added Example WACC = [(7% × Market value of debt) + (14% × Market value of equity)] ÷ (Market value of debt + Market value of equity) WACC = [(0.07 × 4,800,000) + (0.14 × 4,800,000)] ÷ $9,600,000 WACC = $336,000 + $672,000 ÷ $9,600,000 WACC = 0.105, or 10.5%

Economic Value Added Example What is the after-tax operating income for the Denver Hotel? Denver Hotel: Operating income $240,000 × 0.7 = $168,000

Economic Value Added Example What is the investment? Denver Hotel: Total assets $1,000,000 – Current liabilities $150,000 = $850,000

Economic Value Added Example What is the weighted-average cost of capital times the investment for Denver? Denver Hotel: $850,000 × 10.5% = $89,250

Economic Value Added Example What is the economic value added? Denver Hotel: $168,000 – $89,250 = $78,750 The EVA® charges managers for the cost of their investments in long-term assets and working capital.