Business Unit Performance Measurement Chapter 14 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Accounting Income L.O. 1 Evaluate divisional accounting income as a performance measure. Divisional Income: Division revenues minus division costs Investors use accounting income to assess a firm's performance. Firms use a division’s income to assess divisional performance

Divisional Income LO1 Mustang Fashions Divisional Income Statements For Year 1 ($000) Sales Cost of sales Gross margin Allocated corporate overhead Local advertising Other general and administrative Operating income Tax expense 30%) After-tax income $5, ,802.0 $2, , $ $ $2, ,515.0 $1, $ $ $8, ,317.0 $3, , $ $ Western Division Eastern DivisionTotal

Some Simple Financial Ratios LO1 Gross margin percentage Operating margin Profit margin Gross margin ÷ sales Operating income ÷ Sales After-tax income ÷ Sales 46.12% 9.23% 6.46% 45.89% 10.93% 7.65% Western Division Eastern DivisionDefinitionRatio Mustang Fashions Selected Financial Ratios For Year

Return on Investment L.O. 2 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

Return on Investment LO2 Mustang Fashions Balance Sheets January 1, Year 1 Assets Cash Accounts receivable Inventory Total current assets Fixed assets (net) Total assets Liabilities and Equities Accounts payable Other current liabilities Total current liabilities Long-term debt Total liabilities Total shareholders equity Total liabilities and equities $ 250, , ,000 $ 725, ,000 $1,500,000 $ 125, ,000 $ 352, $ 352,000 1,148,000 $1,500,000 $ 150, , ,000 $ 550, ,000 $ 900,000 $ 95, ,000 $ 375, $ 375, ,000 $ 900,000 $ 400, , ,000 $1,275,000 1,125,000 $2,400,000 $ 220, ,000 $ 727, $ 727,000 1,673,000 $2,400,000 Western Division Eastern DivisionTotal

Return on Investment LO2 After-tax income from income statement Divisional investment from balance sheet ROI (After-tax income ÷ Divisional investment) $ 336,000 $1,500,000 22% $ 214,200 $ 900,000 24% Western Division Eastern Division Mustang Fashions ROI for Western and Eastern Divisions For Year

Residual Income Measures L.O. 3 Interpret and use residual income (RI). Residual Income (RI): This is the excess of actual profit over the cost of invested capital in the unit

Economic Value Added (EVA) L.O. 4 Interpret and use economic value added (EVA). EVA is the annual after-tax (adjusted) divisional income minus the total annual cost of (adjusted) capital. It makes adjustments to after-tax income and capital to “eliminate accounting distortions.”

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. How should divisional assets be measured? – Gross book value versus net book value – Historical cost versus current cost – Beginning, ending, or average balance

Gross Book Value versus Net Book Value Example LO5 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 Amounts are in thousand of dollars

Gross Book Value versus Net Book Value Example LO5 ROI= $50 c $500 =10% Year = = = ROI= $50 c $500 =10% ROI= $50 c $500 =10% Net Book ValueGross Book Value $100 a – (0.1 × $500) b $500 d – (0.1 × $500) e 11.1%ROI=1… 2… $100 a – (0.1 × $500) b $450 d – (0.1 × $500) e 12.5%ROI= 3… $100 a – (0.1 × $500) b $400 d – (0.1 × $500) e 14.3%ROI= a The first term in the numerator is the annual cash profit. b The second term in the numerator is depreciation for the year. c Net income = $50 = $100 – ($500 × 0.1) d The first term in the denominator is the beginning-of-the-year asset value. e The second term in the denominator reduces the beginning-of-the-year value of the asset by the amount of current year's depreciation

Historical Cost versus Current Cost LO5 Current cost: Cost to replace or rebuild an existing asset Historical cost: Original cost to purchase or build an asset

Historical Cost versus Current Cost LO5 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 is 20 percent. Asset cost at beginning of year 1 is $500. Amounts are in thousand of dollars. Straight-line depreciation is used; the straight-line rate is 10% per year

Historical Cost versus Current Cost LO5 Year = Historical Cost $100 a – (0.1 × $500) b $500 c – (0.1 × $500) 11.1%ROI=1… =2… $120 a – (0.1 × $500) b $500 c – (0.2 × $500) 17.5%ROI= =3… $144 a – (0.1 × $500) b $500 c – (0.3 × $500) 26.9%ROI= Year = Current Cost $100 a – (0.1 × $600) b $600 d – (0.1 × $600) e 7.4%ROI=1… =2… $120 a – (0.1 × $720) b $720 f – (0.2 × $720) e 8.3%ROI= =3… $144 a – (0.1 × $864) b $864 g – (0.3 × $864) e 9.5%ROI= Year = Historical Cost $100 a – $50 b $500 c 10.0%ROI=1… =2… $120 a – $50 b $500 c 14.0%ROI= =3… $144 a – $50 b $500 c 18.8%ROI= Year = Current Cost $100 a – $60 b $600 d 6.7%ROI=1… =2… $120 a – $72 b $720 f 6.7%ROI= =3… $144 a – $86.4 b $864 g 6.7%ROI= Net Book Value Gross Book Value 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 × 120%) e Accumulated depreciation at the end of the year. f Current cost of asset ($600 × 120%) g Current cost of asset ($720 × 120%)

Beginning, Ending, or Average Balance? LO5 Managers can manipulate purchases and disposition based on which balance is being used in evaluations

End of Chapter 14 LO1 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin