advanced management accounting

PPT 10-1

ADVANCED MANAGEMENT ACCOUNTING

PPT 10-2

Performance Evaluation

PPT 10-3

Learning Objectives

Compute and explain return on investment (ROI), residual income (RI), and economic value added (EVA)

Discuss methods of evaluating and rewarding managerial performance

PPT 10-4

Measuring the Performance of Investment Centers

Return on Investment (ROI)

Residual Income (RI)

Economic Value Added (EVA)

PPT 10-5

Return On Investment (ROI)

Compute return on investment (ROI) and show how changes in

sales, expenses, and assets affect ROI.

10-5

PPT 10-6

Return on Investment (ROI) Formula

ROI = Net operating income

Average operating assets

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Income before interestand taxes (EBIT)

Income before interestand taxes (EBIT)

10-6

PPT 10-7

Net Book Value versus Gross Cost

Most companies use the net book value of depreciable assets to calculate average

operating assets.

Acquisition costLess: Accumulated depreciationNet book value

10-7

PPT 10-8

Components of ROI

Decomposition of the ROI formula:

ROI = Operating income/Average operating assets

= (Operating income/Sales) x

(Sales/Average operating assets)

= Operating income margin x

Operating asset turnover

PPT 10-9

Understanding ROI

ROI = Net operating income

Average operating assets

Margin = Net operating income

Sales

Turnover = SalesAverage operating

assets ROI = Margin Turnover

10-9

PPT 10-10

An ROI Example

Year 1: Snack FoodsAppliance

Division Division

Sales $30,000,000$117,000,000

Operating income 1,800,0003,510,000

Average operating assets 10,000,00019,500,000

Year 2:

Sales $40,000,000$117,000,000

Operating income 2,000,0002,925,000

Average operating assets 10,000,00019,500,000

Minimum return of 10%

PPT 10-11

Margin and Turnover Comparisons

Snack Food Appliance

Year 1 Year 2 Year 1 Year 2

Margin 6.0% 5.0% 3.0% 2.5%

Turnover x 3.0 x 4.0 x 6.0 x 6.0

ROI 18.0% 20.0% 18.0% 15.0% === === === ===

PPT 10-12

Increasing ROI

There are three ways to increase ROI . . .

IncreaseSales

ReduceExpenses Reduce

Assets

10-12

PPT 10-13

Increasing ROI – An ExampleRegal Company reports the following:

Net operating income $ 30,000

Average operating assets $ 200,000

Sales $ 500,000

Operating expenses $ 470,000

ROI = = Margin Turnover

Net operating income Sales

Sales Average operating assets×ROI =

What is Regal Company’s ROI?

10-13

PPT 10-14

Increasing ROI – An Example

$30,000 $500,000

× $500,000$200,000

ROI =

6% 2.5 = 15%ROI =

ROI = Margin Turnover



10-14

PPT 10-15

Investing in Operating Assets to Increase Sales

Suppose that Regal's manager invests in a $30,000 piece of equipment that increases sales

by $35,000, while increasing operating expenses by $15,000.

Let’s calculate the new ROI.

Regal Company reports the following:

Net operating income $ 50,000

Average operating assets $ 230,000

Sales $ 535,000

Operating expenses $ 485,000

10-15

PPT 10-16

Investing in Operating Assets to Increase Sales

$50,000 $535,000

× $535,000$230,000

ROI =

9.35% 2.33 = 21.8%ROI =

ROI increased from 15% to 21.8%.ROI increased from 15% to 21.8%.

ROI = Margin Turnover



10-16

PPT 10-17

Advantages of ROI

It encourages managers to pay careful attention to the relationships among sales, expenses, and investment, as should be the case for a manager of an investment center.

It encourages cost efficiency.

It discourages excessive investment in operating assets.

PPT 10-18

Disadvantages of the ROI Measure

It discourages managers from investing in projects that would decrease the divisional ROI but would increase the profitability of the company as a whole. (Generally, projects with an ROI less than a division’s current ROI would be rejected.)

It can encourage myopic behavior, in that managers may focus on the short run at the expense of the long run.

PPT 10-19

Criticisms of ROI

In the absence of the balancedscorecard, management may

not know how to increase ROI.

Managers often inherit manycommitted costs over which

they have no control.

Managers evaluated on ROImay reject profitable

investment opportunities.

10-19

PPT 10-20

Residual Income

Compute residual income and understand its

strengths and weaknesses.

10-20

PPT 10-21

Residual Income - Another Measure of Performance

Net operating incomeabove some minimum

required return on operating assets

10-21

PPT 10-22

Residual Income

Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:

Residual income = Operating income - (Minimum rate of return x Operating assets)

PPT 10-23

Calculating Residual Income

Residual income

=Net

operating income

-Average

operating assets

Minimum

required rate of return

( )ROI measures net operating income earned relative

to the investment in average operating assets.

Residual income measures net operating income earned less the minimum required return on average

operating assets.

10-23

PPT 10-24

Residual Income Example

Project I Project II

Investment $10,000,000 $4,000,000

Operating income 1,300,000 640,000

Targeted ROI 10% 10%

PPT 10-25

Residual Income ExampleProject I

Residual income = Operating income - (Minimum rate of return x Operating assets)

Residual income = $1,300,000 - (0.10 x $10,000,000)

= $1,300,000 - $1,000,000

= $300,000

Project II

Residual income = $640,000 - (0.10 x $4,000,000)

= $640,000 - $400,000

= $240,000

PPT 10-26

Residual Income – An Example

The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets.

In the current period, the division earns $30,000.

The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets.

In the current period, the division earns $30,000.

Let’s calculate residual income.

10-26

PPT 10-27

Residual Income – An Example

Operating assets 100,000$ Required rate of return × 20%Minimum required return 20,000$

Operating assets 100,000$ Required rate of return × 20%Minimum required return 20,000$

Actual income 30,000$ Minimum required return (20,000) Residual income 10,000$

Actual income 30,000$ Minimum required return (20,000) Residual income 10,000$

10-27

PPT 10-28

Motivation and Residual Income

Residual income encourages managers to make investments that are profitablefor the entire company but would be

rejected by managers who are evaluatedusing the ROI formula.

10-28

PPT 10-29

Quick Check Redmond Awnings, a division of Wrap-up

Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?

a. 25%

b. 5%

c. 15%

d. 20%

10-29

PPT 10-30

Quick Check

Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?

a. 25%

b. 5%

c. 15%

d. 20%

ROI = NOI/Average operating assets

= $60,000/$300,000 = 20%

10-30

PPT 10-31

Quick Check

Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?

a. Yes

b. No

10-31

PPT 10-32

Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check

ROI = $78,000/$400,000 = 19.5%

This lowers the division’s ROI from 20.0% down to 19.5%.

10-32

PPT 10-33

Quick Check

The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?

a. Yes

b. No

10-33

PPT 10-34

The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check

ROI = $18,000/$100,000 = 18%

The return on the investment exceeds the minimum required rate

of return.

10-34

PPT 10-35

Quick Check

Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?

a. $240,000

b. $ 45,000

c. $ 15,000

d. $ 51,000

10-35

PPT 10-36

Quick Check Redmond Awnings, a division of Wrap-up

Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?

a. $240,000

b. $ 45,000

c. $ 15,000

d. $ 51,000

Net operting income 60,000$ Required return (15% × $300,000) (45,000) Residual income 15,000$

10-36

PPT 10-37

Quick Check

If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?

a. Yes

b. No

10-37

PPT 10-38

Quick Check

If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?

a. Yes

b. NoNet operting income 78,000$ Required return (15% × $400,000) (60,000) Residual income 18,000$ Yields an increase of $3,000 in residual income

10-38

PPT 10-39

Divisional Comparisons and Residual Income

The residual income approach

has one major disadvantage.

It cannot be used to compare the performance of

divisions of different sizes.

10-39

PPT 10-40

Zephyr, Inc. - Continued

Retail WholesaleOperating assets 100,000$ 1,000,000$ Required rate of return × 20% 20%Minimum required return 20,000$ 200,000$

Retail WholesaleActual income 30,000$ 220,000$ Minimum required return (20,000) (200,000) Residual income 10,000$ 20,000$



Recall the following information for the Retail Division of Zephyr, Inc.

Assume the following information for the Wholesale

Division of Zephyr, Inc.

10-40

PPT 10-41

Zephyr, Inc. - Continued





The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its

residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for

the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is

a bigger division.

10-41

PPT 10-42

Economic Value Added

Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.

The equation for EVA is expressed as follows:

EVA = After-tax operating income - (Weighted average cost of capital) x (Total capital

employed)

PPT 10-43

Cost of Capital

There are two steps involved in computing cost of capital:

1. determine the weighted average cost of capital (a percentage figure)

2. determine the total dollar amount of capital employed

PPT 10-44

Weighted Average Cost of Capital

Suppose that a company has two sources of financing: $2 million of long-term bonds paying 9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average cost of capital is computed as follows:

Amount Percent x After-Tax Cost = Weighted Cost

Bonds $2,000,000 0.25 0.09(1.0 - 0.4) = 0.054 0.0135

Equity 6,000,000 0.75 0.06 +0 .06 = 0.120 0.0900

Total $8,000,000 0.1035

======== =====

PPT 10-45

EVA Example

Suppose that Furman, Inc., had after-tax operating income last year of $1,583,000. Three sources of financing were used by the company: $2 million of mortgage bonds paying 8 percent

interest, $3 million of unsecured bonds paying 10 percent interest, and $10 million in common

stock, which was considered to be no more or less risky than other stocks. Furman, Inc., pays a

marginal tax rate of 40 percent.

PPT 10-46

Weighted Average Cost of Capital

The weighted average cost of capital for Furman, Inc. is computed as follows:

Amount Percent x After-Tax Cost = Weighted Cost

Common stock $10,000,000 0.667 0.120 0.080

Mortgage bonds 2,000,000 0.133 0.048 0.006

Unsecured bonds 3,000,000 0.200 0.060 0.012

Total $15,000,000 0.098

========= ====

PPT 10-47

EVA Example

Furman’s EVA is calculated as follows:

After-tax profit $1,583,000

Less: Weighted average cost of capital 1,470,000

EVA $ 113,000

=========

The positive EVA means that Furman, Inc., earned operating profit over and above the cost of the capital used.

PPT 10-48

Behavioral Aspects of EVAA number of companies have discovered that EVA

helps to encourage the right kind of behavior from their divisions in a way that emphasis on operating income

alone cannot. The underlying reason is EVA’s reliance on the true cost of capital.

In many companies, the responsibility for investment decisions rests with corporate management. As a result, the cost of capital is considered a corporate

expense. If a division builds inventories and investment, the cost of financing that investment is

passed along to the overall income statement and does not show up as a reduction from the division’s

operating income.

PPT 10-49

End of Week

advanced management accounting

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