Chapter 13 Business Unit Performance Measurement

13-2 Learning Objectives 4.Interpret and use economic value added (EVA ® ). 2.Interpret and use return on investment (ROI). 3.Interpret and use residual income (RI). 5.Explain how historical cost and net book value-based accounting measures can be misleading in evaluating performance. 1.Evaluate divisional accounting income as a performance measure.

13-3 Accounting Income L.O. 1 Evaluate divisional accounting income as a performance measure. Division revenues minus division costs Divisional Income Investors use income to assess firm performance. Firm uses a division’s income to assess divisional performance.

13-4 Divisional Income Mustang Fashions Divisional Income Statements For Year 1 (in $000)

13-5 Divisional Income: Advantages and Disadvantages Understandable Reflects decisions controlled by the division manager Makes comparison of divisions easy Divisions may be different sizes Inconsistency between decision authority and performance measurement

13-6 Using Financial Ratios Mustang Fashions Selected Financial Ratios For Year 1

13-7 Return on Investment L.O. 2 Interpret and use return on investment (ROI). Ratio of profits to investment in the asset that generates those profits. Can compare divisions of different size ROI= After-tax income Divisional assets Return on Investment (ROI)

13-8 ROI Continued ROI=Profit margin ratioxAsset turnover Sales Divisional assets x After-tax income Sales ROI= = After-tax income Divisional assets

13-9 Limitations of ROI Increase sales Decrease costs Decrease assets ROI= After-tax income Divisional assets

13-10 ROI Continued Mustang Fashions Balance Sheets January 1, Year 1 (in $000)

13-11 ROI Continued Mustang Fashions Return on Investment For Year 1

13-12 Limitations of ROI Continued Mustang Fashions Required Returns CompanyWestern DivisionEastern Division 20%22%24%

13-13 Limitations of ROI Continued Dysfunctional behavior If the return is: CompanyWestern DivisionEastern Division 20%22%24%

13-14 Limitations of ROI Continued Organization Western Division Manager Division managers’ goals differ from the organization’s goals. Eastern Division Manager 24% 20% 22%

13-15 Residual Income L.O. 3 Interpret and use residual income (RI).1 Excess of actual profit over the cost of invested capital in the unit. Cost of debt and equity used to finance a project or an operation (e.g., product or product line). Residual income = After-tax incomeCost of capitalDivisional assets -x Residual Income (RI) Cost of Capital

13-16 Residual Income Eliminates the dysfunctional behavior caused by evaluating performance based on ROI Mustang Fashions Residual Income For Year 1 Both managers will invest if return is ≥ 20%

13-17 Economic Value Added L.O. 4 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”

13-18 EVA: A Simplified Example Advertising Expenditures Western Division$800,000 Eastern Division$300,000 Mustang Fashion believes advertising campaign has a two year life. GAAP requires advertising be expensed when incurred.

13-19 EVA: A Simplified Example Continued Mustang Fashions EVA (in $000)

13-20 EVA Limitations Based on accounting income not present value of cash flows

13-21 Measuring the Investment Base L.O. 5 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?

13-22 Gross versus Net Book Value Profits before depreciation (all in cash flows at end of year) $100 each year for 3 years Depreciation: Ten year life, straight-line, no salvage value The Facts Asset cost at beginning of year 1, $500

13-23 Gross versus Net Book Value Continued Impact of Net Book Value vs Gross Book Value on ROI

13-24 Historical versus Current Cost Historical Cost Original cost to purchase or build an asset Current Cost Cost to replace or rebuild an existing asset

13-25 Historical versus Current Cost Continued Operating profits before depreciation (all in cash flows at end of year): Annual rate of price changes: 20 percent Asset cost at beginning of year 1 is $500 The Facts Year 1, $100; Year 2, $120; Year 3, $144

13-26 Historical versus Current: Net Book Value

13-27 Beginning, Ending, or Average Balance Managers can manipulate purchases and disposition based on which balance is being used in evaluations.

13-28 Chapter 13