Return on Investment and Residual Income Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 25

Performance Evaluation of Investment Centers  Investment center is  A segment or area of responsibility in which a manager controls revenues, costs, and the assets invested in that segment  Evaluation of investment center managers based on all three components for which these managers are responsible  Three primary quantitative evaluation methods  Return on investment  Residual income  Economic value added 2

Return on Investment  A primary tool for evaluating the performance of investment centers and their managers  Managers are able to control revenues, costs, and assets  A broader measurement than income  Focuses on income and investment  Removes the bias of larger investments over smaller investments  Indicates the percentage of every dollar of assets invested that is returned as profit 3 Segment “Profit” Assets invested in the segment =

Measuring Segment Profit  Various measurements possible  Net income  EBIT – earnings before interest and taxes  Does not hold managers responsible for interest or taxes  EBITDA – earnings before interest, taxes, depreciation, and amortization  Operating income before taxes  Net operating profit after taxes  The best and commonly used measurement  Referred to as NOPAT  Does not hold managers responsible for items beyond their control  Interest = a financing cost 4

Measuring Investment Center Assets  Cost of financing assets  All assets (left side of accounting equation) are financed by either liabilities or equity (right side of the equation)  Not all assets have financing costs  Assets with free financing  Those financed with non-interest bearing current liabilities  Includes accounts payable, income taxes payable, accrued liabilities, etc.  Measurement of ‘assets’  Invested capital  Represents the amount of assets that have a financing cost attached to them  Total assets less NIBCL  Where NIBCL = non-interest bearing current liabilities 5

ROI and its Two Components ROI = × 6 NOPAT Invested Capital Sales Invested Capital NOPAT Sales × = Profit Margin How much of each sales dollar is generated as profit Profit Margin How much of each sales dollar is generated as profit Investment Turnover How much sales is generated out of each dollar of assets invested Investment Turnover How much sales is generated out of each dollar of assets invested Return on investment is Can be drilled down into two components Provides information on what causes changes in ROI from period to period

Controlling ROI Three ways to improve ROI...  Increase Sales  Reduce Expenses  Reduce Assets 7 NOPAT Invested Capital

Problems with Performance Evaluation Based on Profit 8  Managers that are evaluated on profit are more willing to invest in assets  Because every investment that generates even $1 of profit improves performance Example  AB Division has profit of $10,000 based on assets of $100,000: ROI = $10,000/$100,000 = 10%  AB proposes an investment in a project that will cost $14,000 and generate $280 of profit: ROI = 2%  If the manager accepts the investment, profit increases by $280 making the manager look good, even though the ROI is very low

Problems with Performance Evaluation Based on ROI  The denominator, invested capital  Based on historical costs net of depreciation  Annual depreciation decreases book value  Causes ROI to increase  Often causes managers to defer new equipment acquisitions  Managers unwilling to invest if project will decrease current ROI, even if greater than RRR 9

Problems with ROI As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 15% on all new investments. Your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. Invest or not? As division manager, I won’t invest in that project because it will lower my bonus! I thought we were supposed to do what was best for the company! 10

Residual Income  Used to measure performance  Measures the shareholder value added to the parent company by a segment  Shareholder value is the net worth of a company  Defined as the income that exceeds the cost of financing the invested assets  Encourages managers to make profitable investments that would be rejected by managers using ROI  Objective is to maximize the contribution to shareholder wealth RI = NOPAT – [CC% × Invested capital]

Divisional Comparison  Bigger segments are expected to have more residual income than a smaller division  Why? Simply because they are bigger  Not because of better management 12 ROI = 12.00% 16.00% Which Division is the better candidate for expansion? Which Division contributed more to shareholder wealth?

ROI Example Sales $980,000 Non-interest-bearing current liabilities 21,000 Interest expense 17,000 Interest-bearing current liabilities 45,000 Assets 664,000 Net income 36, AB Inc. compiled the following for its East Division for 2018: The income tax rate is 30%, the cost of capital is 5.4%, and the required rate of return is 7%. ROI = NOPAT = $36,500 + [$17,000 x (1 - 30%)] = 7.53% Invested capital $664,000 - $21,000 Residual income = NOPAT - (Cost of capital) x (Invested capital) = $36,500 + [$17,000 x (1 - 30%)] - (5.4% x ($664,000 - $21,000)) = $13,678 East Division generated about 7.53 cents on every dollar of invested assets. East Division contributed $13,678 to AB’s shareholder’ equity.

14 The End