Chapter 13 Solution_Langsfield_5e

Chapter 13: Financial Performance Measures for Strategic Business Units and Reward Systems

CHAPTER 13

FINANCIAL PERFORMANCE MEASURES FOR STRATEGIC BUSINESS UNITS AND REWARD SYSTEMS ANSWERS TO QUESTIONS 13.1

Return on investment is a financial measure calculated as profit divided by invested capital, as shown below: Return on investment (ROI)

=

profit Invested capital

Invested capital is the assets that an investment centre has available to generate profit. Assume that in the previous year, ABC Ltd. generated profits of $25 million on investments of $200 million. The return on investment is calculated as $25 million x 100 $200 million = 12.5% This indicates that ROI takes into account both investment centre profit and the capital invested in that business centre. 13.2

A responsibility accounting system makes managers of business units responsible for achieving the objectives which have been agreed upon prior to the performance measurement period. Cost centre managers are responsible for attaining a particular physical target (such as a certain number of units produced) at an agreed cost. Profit centre managers are responsible for achieving a certain profit target, but without taking into consideration the capital invested in the profit centre. Both ROI and residual income are further refinements of the measurement process, in that they measure the profit made by the investment centre in relation to the capital invested in the investment centre. The calculation of ROI is explained in 13.1 above. Residual income is the amount of profit that remains (as a residual) after subtracting an imputed interest charge. The calculation of residual income is shown below: Residual income = profit – (invested capital x imputed interest rate) Suppose that in the example of ABC Ltd. in 13.1 above, the firm had a required rate of return (or imputed interest rate) of 10%, residual income would be: Residual income = = =

$25 million – ($100 million x 10%) $25 million - $10 million $15 million

In both cases, the investment centre’s manager is being evaluated according to the profit earned from a parcel of assets under his or her control or influence. Depending on whether ROI or residual income is used, the method of calculating the performance measure may be slightly different, however, the general principle of accountability is the same. 13.3

There are risks associated with focusing on improving the two components of the return on investment. These include the following actions by managers.  Engaging in excessive cost cutting activities to improve short-term profit (and, hence, ROI) but this may weaken future competitiveness.  Disposing of productive assets to decrease the investment base and increase ROI. However, this may

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reduce the capacity of the business.  13.4

Deferring expenditure on new assets when these assets are needed. New assets will usually increase ROI due to the way we measure the investment base.

There are many activities that managers in the Business Studies Textbook Division could engage in to improve ROI. Some are desirable, some are not. Desirable  Managing costs more effectively  Increasing sales volume  Increasing selling prices  Decreasing staff numbers  Disposing of unnecessary assets  Deferring the purchase of much needed machinery  Delaying research into new markets and publications  Deleting unprofitable book titles from the sales list  Disposing of obsolete inventory

13.5

yes yes ? ? yes no no yes yes

There are several ways to minimise the negative behavioural effects of ROI:   

Using a broader set of performance measures which encompass both long-term and short-term measures, and financial and non-financial measures. This de-emphasises ROI as a performance measure. Consider alternative ways of measuring invested capital so that the replacement of an asset does not have such an adverse effect on ROI. The use of market values or gross book value can help here. Use alternate profit measures, such as residual income, to minimise some of the investment disincentives.

13.6

Many businesses continue to use ROI to evaluate the performance of investment centres, despite the difficulties associated with the measure. This is because ROI can be used to evaluate the relative performance of investment centres, and it requires managers to consider both profits generated and the assets used to obtain those profits. A simple measure of profit does not provide these advantages.

13.7

Example of the calculation of residual income: Suppose income is $100,000, invested capital is $800,000, and the imputed interest rate is 12 per cent: Residual income = $100,000 – (12%)($800,000) = $4,000 The imputed interest rate is used in calculating residual income, but it is not used in calculating ROI. The imputed interest rate reflects the firm's minimum required rate of return on invested capital.

13.8

The chief disadvantage of using ROI as a performance measure is as follows. When there is an investment centre that earns a rate of return greater than the company's cost of raising capital, the manager of that investment centre may have an incentive to reject any new asset or project if it results in reducing the investment centre’s ROI. This may occur even when the new asset or project meets the company’s hurdle rate for new investments. The residual income measure eliminates this disadvantage by including in the residual income calculation the imputed interest rate, which reflects the firm's cost of capital. Any project that earns a return greater than the imputed interest rate will show a positive residual income.

13.9

The rise in ROI or residual income across time results from the fact that periodic depreciation charges reduce the book value of the asset, which is generally used in determining the investment base within ROI or residual income calculations. This can have a serious effect on the incentives of investment centre managers. Investment centres with old assets will show higher ROIs than investment centres with relatively new assets. This can discourage investment centre managers from investing in new equipment. If these dysfunctional decisions persist over a long period of time, a division's assets can become obsolete—making the division uncompetitive.

13.10 (a)

Total assets: Includes all divisional assets. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets, including nonproductive assets.

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(b)

Total productive assets: Excludes assets that are not in service, such as construction in progress. This measure is appropriate when a division manager is directed by top management to keep non-productive assets, such as vacant land or construction in progress.

(c)

Total assets less current liabilities: All divisional assets minus current liabilities. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. This approach encourages investment-centre managers to minimise resources tied up in assets and maximise the use of short-term credit to finance operations.

13.11 The use of gross book value instead of net book value to measure a division's invested capital eliminates the problem of an artificially increasing ROI or residual income across time. Also, the usual methods of calculating depreciation, such as straight-line or diminishing value methods, are arbitrary. As a result, some managers prefer not to allow these depreciation charges to affect ROI or residual income calculations. 13.12 Within a divisionalised organisation invested capital and profit must be consistently defined, when used in ROI calculations. However, the advantages and disadvantages of particular definitions must also be considered. For example, using net book values rather than market values may have certain behavioural consequences. The investment base used in the ROI calculation should normally include only those assets and liabilities that are attributable to the division, or controllable by the divisional manager. Similarly, the profit measure should be either attributable or controllable profit for that division. The ROI used must be capable of measuring the relative performance of divisions (or managers), or performance of a division (or manager) over time (hence the need for consistency), and be as ‘valid’ a measure of performance as possible. 13.13 While perfect controllability of all activities of a business is not possible, the idea behind performance measurement is that we would like to assign responsibility for particular aspects of a business (eg. revenue, costs, profits, ROI) to those managers who are in the best position to influence those aspects and explain performance in those areas. In this way we have a chance of achieving a certain level of control and, hence, effectiveness. 13.14 Shareholders – and other types of business owners – are interested in profits and a return on their investment. Various measures of ‘owner value’ have been developed, for example, ‘shareholder value’ is defined as improving the worth of the business from the perspective of the shareholders. When organisations use shareholder value analysis to manage their business, they are said to be practicing valuebased management, that is, a framework for making key business decisions that add economic value to the business. A strategy adopted or decision made adds value to the business when the return on capital is greater than the cost of capital. 13.15 The four aspects of value based management are valuation, strategy, finance and corporate governance. These will be examined in more detail below. When considering valuation, value can be measured in a number of ways. One popular method is to discount future cash flows associated with a project to attain their present value, using a discount rate that incorporates both the cost of capital and the level of risk in the project. The drivers of value are the activities or actions that create value for the business. Strategy relates to broad tactical decisions designed to achieve corporate or business unit objectives. These have substantial on-going affects on the business and its value, and management can attempt to evaluate the effect of alternative strategies on the value of the business. The creation of value will also be affected by the financial strategies adopted by the business, including the proportions of borrowed versus internal funds, and the costs associated with each. Corporate governance involves selecting and utilising systems (such as performance measurement systems and rewards systems), which contribute to value creation. Under most circumstances, managers will – either consciously, or subconsciously – seek to maximise their own personal position by using performance measurement and rewards systems to their own advantage. Unless these have been thoughtfully considered and constructed, they will not reinforce and support business value creation systems. This may result in dysfunctional behaviour and decision-making which is not goal-congruent, that is, there may be a lack of harmony between corporate goals and manager’s personal goals.

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13.16 There are many definitions of ‘value’. The Oxford Dictionary (1967) refers to it as ‘worth, desirability or utility’. Michael Porter (1985, p3) says, ‘Value is what buyers are willing to pay.’ In management accounting terms, ‘value’ is frequently related to how somebody outside the firm calculates the worth of the business. Shareholder value, defined as improving the worth of the business from the shareholders’ perspective, is often used to illustrate what is meant by the value of the firm. The rationale behind measuring (shareholder) value is to determine whether a business is generating value for its owners. 13.17

Compare the definitions of both terms as contained in this chapter. Residual income = Economic value added =

profit – (invested capital x imputed interest rate) net profit after tax – (investment capital x weighted average cost of capital)

In essence, these measures are similar. Both suggest that the profit contribution by an investment centre should be related to the cost of supplying the capital with which it generates its profit. This is done by subtracting the capital charge (in dollar terms) from the profit (also in dollar terms) The first noticeable difference is that residual income uses net profit before tax, whereas EVATM uses net profit after tax as its starting point. Proponents of residual income would probably argue that this measures profit earned, and the tax paid is a distribution of that profit – albeit to the taxation authorities. Neither the firm nor its manager can influence this amount, whereas profit before tax is a measure which is within the bounds of what the firm and its manager can control. Since EVATM is largely a shareholder measure of value added, shareholders recognise that they can only ever get access to after tax profits. If it can be assumed that ‘invested capital’ equates with ‘investment capital), the other difference is the charge for the use of the capital. Residual income refers to an imputed rate of return, which is the required rate of return that the firm expects of its investments. While this is generally based on its weighted average cost of capital, it may also have been adjusted to incorporate the firm’s perception of the risk inherent in the project. EVATM on the other hand specifically defines the charge as the weighted average cost of capital. Shareholders are able to calculate this figure, but are unlikely to have sufficient details of various investments entered into by the firm to be able to assess the inherent risk. In EVATM a number of adjustments are usually made to convert accrual accounting data to cash-based figures and to eliminate the effects of gearing. The most common adjustments made appear to be the capitalisation of expenditure made which will benefit several periods (research and development and major, long-term advertising are examples) and adding back the amortisation of goodwill. These adjustments are not made to residual income, thus it could be argued that residual income is a less sophisticated measure than EVATM. 13.18

Determining the strategies which, when employed, will improve EVATM , are apparent from the formula used to calculate EVATM. These include: (a) any measures which improve profitability without requiring additional capital (increased prices, higher volume of sales, reduced costs, etc.); (b) reduction of the asset base where assets are under-utilised and which will not affect the level of sales, or result in increased costs; (c) using the funds derived from the sale of assets to reduce debt, as long as the savings in interest are greater than any loss of profits caused by reducing the asset base; (d) borrowing additional funds and employing these funds in projects where the profits earned from the project exceed the increased interest cost.

13.19

The advantages, which EVATM has over both ROI and residual income, are mainly related to the greater sophistication that stems from the adjustments made to profit. These are thought to result in more accurate indicators of economic value than either the other two methods of measuring profit-related performance. Experience from Australian companies that have adopted EVATM appear to substantiate its advantages in areas such as focusing managers’ minds on value creation, and, when linked with reward systems, has led to

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improved productivity, improved management systems, and greater levels of co-ordination and co-operation within and between business units. 13.20

Economic value added is net profit after tax less a capital charge calculated by multiplying the investment capital by the weighted average cost of capital. EVATM has been fully described and discussed in questions 13.17 and 13.19 above. Market value added (MVA) relates to the value of a firm at a point in time. It is defined as ‘the economic value at a point in time, calculated as the fair market value of the company (as reflected primarily in its share price) and the book value of the company’.

13.21

Shareholder value added (SVA) is the corporate value of the company less the market value of debt. Corporate value is comprised of the present value of cash flows from operations during the forecast period, plus the residual value of the business (including marketable securities) at the end of the forecast period. The market value of debt is not the face value of the debt, but the amount which would have to be paid today on the day on which it was to be retired. Shareholder value added (SVA) is the corporate value of the company less the market value of debt. EVA is the net profit after tax less a capital charge calculated as the investment capital multiplied by the weighted average cost of capital, hence, it is similar to the concept of residual income. MVA relates to the value of a firm at a point in time. It is defined as ‘the economic value at a point in time, calculated as the fair market value of the company (as reflected primarily in its share price) and the book value of the company’. The main difference between SVA, EVA and MVA relates to the time period or horizon of measurement. SVA requires an estimate to be made of future cash flows from operations. EVA is a measure of what has already occurred and MVA relates to the value of the firm at a point in time.

13.22 Hertzberg’s theory of motivation is based on the idea that two types of factors affect employee motivation. First, hygiene factors provide the necessary setting for motivation but do not themselves motivate employees. Second, motivators are factors that relate to the job content and will provide motivation. Expectancy theory states that an employee’s motivation is a function of three factors: expectancy, instrumentality and valence. Expectancy is the individual’s perception that effort will lead to a particular outcome. Instrumentality is the likelihood that achieving the outcome will lead to a reward. Valence is the preference that an employee has for the particular reward. These theories are quite different. Expectancy allows for individual preferences in the types of performance measurement and reward systems that may motivate employees, while Hertzberg’s theory is prescriptive and assumes that there is a class of rewards that employees find motivational. 13.23 The advantages of basing individual rewards on group performance is that it can help individuals identify with the group and can promote equity among employees. However, it can encourage excessive competition between employees, can cause individuals difficulty in relating their individual effort to group outcomes and can reward group members who are not good performers. 13.24 Intrinsic rewards are intangible and can arise from positive experiences of being satisfied with performing well. Thus, as employee can feel rewarded from doing a good job and from knowing that there is opportunity to advance within the company. Extrinsic rewards are rewards that are given to employees, such as cash bonuses and plaques. 13.25 A gainsharing system is when cash bonuses are distributed to employees when the performance of the company exceeds some performance target. Under a profit-sharing plan bonuses are paid to employees based on a specified percentage of the company’s profit. 13.26 When individual bonuses are based on group performance, according to expectancy theory this may not be motivational. This is because it is difficult for an individual to see a close linkage between their effort and achieving the performance target (expectancy). When individual bonuses are based on individual performance, under expectancy theory, as long as the employees have confidence that the reward will be provided when a performance target is met (instrumentality) and the reward is valued (valence), the system should be motivational.

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EXERCISES EXERCISE 13.27. (20 minutes) Return on investment; residual income 1. True. If the statement is referring to a post-hoc evaluation of a new project, the statement is definitely true, as it will measure the incremental profit attained from the incremental investment. If the statement relates to deciding whether a proposed new project should be adopted, then the answer is less clear cut. ROI is almost identical with ‘accounting rate of return’ which is one method used to evaluate new projects. It is calculated as the average annual profit from the project divided by the initial investment – as such, it is almost identical to ROI. ARR however is not the best method to evaluate new projects since it ignores both cash flows and the time value of money. Discounted cash flow methods such as net present value (NPV) and the internal rate of return (IRR) include both of these elements and are therefore preferable to ARR. 2. False. ROI is a financial measurement, whereas customer value is a subjective measure expressed in nonfinancial terms. Over a period of time, if customers believe that the firm provides them with goods or services which they value, the increased sales may well result in an increase in ROI – but it is by no means certain. 3. False. If anything, one could say that as the balance of assets decreases, the residual income may increase. There is nothing in the calculation of residual income which results in a decrease in the balance of assets. 4. False. Residual income will encourage managers to replace assets where the projected rate of return in the replacement of an asset is above the business unit’s required minimum rate of return. ROI is likely to encourage managers to defer asset replacement if this will result in a reduction in the business unit’s ROI, even though the return inherent in the new project may be above the firm’s minimum required rate of return. 5. True. ROI encourages mangers to focus on short-term profit improvement and by deferring expenditure such as research and development, even though this will presumably improve the firm’s long-term position. With regard to the increasing marketing expenditure, it is false if the same criteria as deferring research and development expenditure is adopted. On the other hand, an increase in marketing expenditure may increase profit if the contribution margin from the increased sales is greater than the increased marketing expenditure. In these circumstances, the statement will be true.

EXERCISE 13.28 (20 minutes) Value-based management. 1.

False. Value based management is a framework for making key business decisions that add economic value to the business. Increasing return on sales (that is, the profit margin) is likely to add value to the firm if it is the outcome of a strategy where the return on capital is greater than the cost of capital.

2.

False Economic value added is a measure of the value created over a single accounting period, measured by the spread between return generated by business activities and the cost of capital.

3. True. MVA is defined as ‘the economic value at a point in time, calculated as the fair market value of the company (as reflected primarily in its share price) and the book value of the company’. Note that the basis of value relates to the market value of the firm, derived from the share price on the share market or Stock Exchange. This qualifies it as ‘market value accounting’. 4.

True. EVATM, ROI and RI are all single period measures of performance and there is potential for manipulation and short-term focus. The value of a business is really the outcome of several years of managerial decision making, at both strategic and operational levels.

5.

True Shareholder value analysis (SVA) measures attempt to calculate the present value of future cash flows resulting from strategic decisions relating to products, markets, mergers and acquisitions.

EXERCISE 13.29 (20 minutes) Components of ROI; improving ROI; residual income: wholesaler 1.

Return on sales

=

$4,000,000 profit = = 8% $50,000,000 sales revenue

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2.

Investment turnover

=

Return on investment

=

sales revenue $50,000,000 invested capital = $20,000,000 = 2.5 profit $4,000,000 = = 20% invested capital $20,000,000

There are many ways to improve the division's ROI to 25 per cent. Here are two of them: (a)

Improve the return on sales to 10 per cent by increasing profit to $5,000,000: ROI

= = =

return on sales  investment turnover $5,000,000 $50,000,000    $50,000,000 $20,000,000 10%  2.5 = 25%

Since sales revenue remains unchanged, this implies a cost reduction of $1,000,000 at the same volume. (b)

Improve the turnover to 3.125 by decreasing average invested capital to $16,000,000: ROI

= = =

return on sales  investment turnover $4,000,000 $50,000,000  $50,000,000 $16,000,000 8%  3.125 = 25%

Since sales revenue remains unchanged, this implies that the firm can divest itself of some productive assets without affecting sales volume. 3.

Residual income

= = =

$4,000,000 – ($20,000,000 x 10%) $4,000,000 – 2,000,000 $2,000,000

EXERCISE 13.30(15 minutes) Improving ROI: manufacturer 1.

Return on sales

=

$100,000 * Profit = = 5% $2,000,000 sales revenue

*Profit = $100,000 = $2,000,000 - $1,100,000 - $800,000

2.

sales revenue $2,000,000 = =2 invested capital $1,000,000 Profit $100,000 = = 10% invested capital $1,000,000

Investment turnover

=

ROI

=

ROI

=

15% =

Profit Profit Profit Expenses

= = = =

15%  $1,000,000 = $150,000 sales revenue - expenses = $150,000 $2,000,000 - expenses = $150,000 $1,850,000

Profit Profit = invested capital $1,000,000

Therefore, expenses must be reduced to $1,850,000 in order to raise the firm's ROI to 15 per cent. 3.

Return on sales 7.5% ROI

= = = =

Profit sales revenue

=

$150,000 $2,000,000

=

return on sales  investment turnover 7.5%  2 15%

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EXERCISE 13.31(25 minutes) Comparing the performance of two divisions: retail company 1.

A comparison of the profits of the two divisions does not give an accurate picture of the relative performance of the two divisions as each division derives that profit from different amounts of assets. If ROI is used, then the furnishing division performs better than the dressmaking division. However, ROI may also not provide a good basis for comparison as the two divisions operate in two different industries. We do not know what constitutes good performance in the furnishing or the dressmaking industries. Nor do we know the firm’s required rate of return, or any ROI or profit targets that management may have set for each division.

2.

If the firm's required rate of return is 12 per cent, then dressmakimg has a higher residual income than furnishing. Using 15 per cent or 18 per cent, furnishing has a higher residual income.

(a)

Imputed interest rate of 12%

Furnishing Dressmaking __________________________________________________________________________________ Divisional profit $200,000 $900,000 Less: Imputed interest charge: Furnishing: $1,000,000 ? 12% 120,000 Dressmaking: $6,000,000 ? 12% 720,000 Residual income $ 80,000 $180,000 (b)

Imputed interest rate of 15%

Division I Division II __________________________________________________________________________________ Divisional profit $200,000 $900,000 Less: Imputed interest charge: Furnishing: $1,000,000 ? 15% 150,000 Dressmaking: $6,000,000 ? 15% 900,000 Residual income $ 50,000 $ 0 (c) Imputed interest rate of 18% __________________________________________________________________________________ Divisional profit $200,000 $ 900,000 Less: Imputed interest charge: Furnishing: $1,000,000 ? 18% 180,000 Dressmaking: $6,000,000 ? 18% 1,080,000 Residual income $ 20,000 $(180,000)

EXERCISE 13.32 (25 minutes) ROI and EVA: service firm 1. ROI Invested capital ROI 2. EVA

3.

Equipment Rental Division ($750 000 – 80 000) = $670 000

Truck Rental Division ($3 000 000 – 250 000) = $3 750 000

$45 000/ $670 000 x 100 = 6.72%

$110 000/ $2 750 000 x 100 = 4.0%

$45 000 – ($670 000 x 0.08)

$110 000 – ($2 750 000 x 0.08)

$45 000 – 53 600

$110 000 – 220 000

($8 600)

($110 000)

The Equipment Rental Division (ERD) has done better then the Truck Rental Division (TRD) under both measures. While TRD makes a much higher profit figure, when the invested capital is brought into consideration, the high investment base of TRD has a major impact. TRD’s profit $110 000 is 2.44 times that of ERD ($45 000),

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whereas TRD’s invested capital of $2 750 000 is 4.1 times that of the $670 000 invested in ERD. When EVA is calculated, both figures are negative, indicating that the weighted average cost of capital of 8% is greater than the rate of the return calculated under ROI. This is true for both divisions, however the excess is greater for TRD than for ERD. The impact of the absolute amount of invested in each division is emphasised under measures such as EVA or RI, because it indicates that the amount of profit generated is insufficient to service the capital invested. The negative figure of TRD ($110 000) is 12.8 times greater than that of ERD ($8 600). While at this stage, ERD is the better-performing division, the firm would gain better insight into the performance of each division if comparisons were made with other firms in the same business. At the same time, TRD may have invested large amounts of capital in the short term with a view to improving long term performance and this highlights the dangers of making single period measurements.

EXERCISE 13-33 (25 minutes) Performance measurement and reward systems 1. True. In a sense, the statement is correct. Herzberg argued that hygiene factors provide the necessary setting for motivation, but do not themselves motivate employees. However, employees need a certain level of hygiene factors to prevent dissatisfaction. Motivators are said to provide motivation. 2. False. Not necessarily. Providing rewards for group performance has both advantages and disadvantages over providing individual rewards for individual performance. For example, basing rewards on group performance can encourage identification with the group and equity among employees who are given the same level of rewards. However, these schemes can make it difficult for employees to see how their own effort directly relates to the group performance, and it can encourage ‘free riders’. 3. True. It seems that many performance-related pay systems are not closely linked to an effective performance measurement system, and so may not encourage improved performance. See the ‘Real Life’ information on pages 13.30-13.31 for more discussion on this issue. 4. Perhaps. It is difficult to know whether this statement is true or false. Some people do believe that individual reward systems may work better at senior levels as these managers may be in a better position to take actions that can be directly measured, so it may be easier to design measures that reflect an individual’s performance.

EXERCISE 13-34 (25 minutes) Reward systems: manufacturer To:

The Managing Director Safety Chemicals Ltd

From:

Grant Lawson Financial Controller

The introduction of a profit-sharing plan is a good idea. However, there are a few issues that need to be considered before our plans are finalised. Let’s consider the advantages first. Basing individual rewards on group performance can provide a way of encouraging employees to identify with the company and may lead to increased motivation. Also, as employee bonuses will all be based on a percentage of base pay, employees may see this as fair. Against these advantages, we must consider whether the scheme will encourage ‘free riders’. That is, some employees may not perform well, but will be given the same rewards as those employees who have outstanding performance. This may cause high performers to feel dissatisfied. Closely related to this issue is the difficulty of individual employees not being able to clearly relate their own effort to improved company performance, this can dampen employee enthusiasm to perform well. Another issue relates to the timing of bonus payments. It is often desirable to reward employees more frequently than once a year. The company could consider paying bonuses six monthly, or each quarter.

PROBLEM 13.35 (30 minutes) ROI; residual income: manufacturer Solutions Manual t/a Management Accounting:An Australian Perspective 3/e, by Langfield-Smith, Thorne and Hilton. 58

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1.

Average investment in productive assets: Balance on 31/12/2002 Balance on 31/12/2001 ($12,600,000  1.05) Beginning balance plus ending balance Average balance (24,600,000  2) (a)

ROI

=

2.

Profit from operations before income taxes average productive assets

= =

(b)

$12,600,000 12,000,000 $24,600,000 $12,300,000

$2,460,000 $12,300,000 20%

Profit from operations before income taxes Less: Imputed interest charge: Average productive assets Imputed interest rate Imputed interest charge Residual income

$ 2,460,000 $12,300,000 x .15 $

1,845,000 615,000

Yes, Presser's management probably would have accepted the investment if residual income were used. The investment opportunity would have lowered Presser's 2002 ROI because the project's expected return (18 percent) was lower than the division's historical returns (19.3 per cent to 22.1 per cent) as well as its actual 2002 ROI (20 percent). Management may have rejected the investment because bonuses are based in part on the ROI performance measure. If residual income were used as a performance measure (and as a basis for bonuses), management would accept any and all investments that would increase residual income (i.e., a dollar amount rather than a percentage) including the investment opportunity it had in 2002.

PROBLEM 13.36 (45 minutes) ROI and residual income; missing data: manufacturer 1. Plumbing Industrial Retail ______________________________________________________________________________________ Sales revenue $1,000,000 $21,333,333e $ 800,000l Profit $ 100,000 $6,400,000 200,000k f Average investment $ 500,000 $12,190,476 $1,000,000j Return on sales 10%a 30% 11% Investment turnover 2b 1.75 1.82i c g ROI 20% 52.5% 20% Residual income $ 60,000d $ 4,693,333h $ 120,000 Explanatory Notes: (a)

Return on sales

=

$1000,000 profit = = 10% 1,000,000 sales revenue

(b)

Investment turnover

=

sales revenue 1,000,000 = =2 invested capital 500,000

(c)

ROI

=

return on sales  investment turnover = 10%  2 = 20%

(d)

Residual income

= =

profit – (imputed interest rate)(invested capital) $100,000 – (8%)($500,000) = $60,000

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(e)

Profit sales revenue $6,400,000 sales revenue $21,333,333

Return on sales

=

30%

=

Therefore, sales revenue

=

Investment turnover

=

sales revenue invested capital

1.75

=

$2,133,333 invested capital

Therefore, invested capital

=

$12,190,476

(g)

ROI ROI

= =

return on sales  investment turnover 30%  1.75 = 52.5%

(h)

Residual income

= = =

profit – (imputed interest rate)(invested capital) $6,400,000 – (8%)($21,333,333) $4,693,333

(i)

ROI 20% Therefore, investment turnover

= = =

return on sales  investment turnover 11%  investment turnover 1.82

(j)

ROI

=

Therefore, profit Residual income

= = =

(f)

Profit = 20% invested capital

(20%)(invested capital) profit – (imputed interest rate)(invested capital) $120,000

Substituting from above for profit: (20%)(invested capital) – (8%)(invested capital) = Therefore, (12%)(invested capital) = So, invested capital = (k)

(l)

ROI

=

20%

=

Therefore, profit

=

Return on sales

=

11%

=

Therefore, sales revenue

=

$120,000 $120,000 1,000,000

Profit invested capital

Profit $1,000,000 $200,000

Profit sales revenue $200,000 sales revenue $1,818,182

2.

Three ways to increase the Plumbing Division's ROI:

(a)

Increase profit, while keeping invested capital the same. Suppose profit increases to $250,000. The new ROI is: Profit $250,000 ROI = = = 50% invested capital 500,000

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(b)

Decrease invested capital, while keeping profit the same. Suppose invested capital decreases to The new ROI is: Profit $100,000 ROI = = = 25% invested capital 400,000

(c)

Increase profit and decrease invested capital. Suppose profit increases to $150,000 and invested capital decreases to $450,000. The new ROI is: Profit $150,000 ROI = = = 33.3% invested capital 450,000

3.

ROI

= =

$400,000.

return on sales  investment turnover = 20%  1.82 36.4 %

4. ROI does not provide a suitable basis for comparing the performance of the three divisions. Each division operates in a different industry, has different degrees of dependence on assets, and manage assets of differing ages. For example, the Plumbing Division is using old machinery which may be fully depreciated, so its asset base is low. This would boost the ROI, making it appear more profitable. In contrast the Industrial Division is machine intensive and has recently acquired expensive computerised machinery. This would tend to reduce the ROI in the earlier years of acquisition. Despite this, the Industrial Division has the highest ROI of the group, as it has the highest return on sales. What is not known is whether an ROI of 52.5% is considered good performance within its own industry. The Retail Division has the lowest reliance on assets, and it is difficult to evaluate this division’s performance unless the performance of similar retail venture within the industry is known.

PROBLEM 13.37 (30 minutes) ROI, residual income: manufacturer 1.

The calculation of the divisional contribution margin for Reigis Steel Division, assuming 1,484,000 units were produced and sold during the year, is as follows: Reigis Steel Division Divisional Contribution Margin For the Year Ended December 31, 2002 (in thousands) Sales Less: Variable costs: Cost of goods sold Selling costs ($2,700  40%) Contribution margin

2.

$25,000 $16,500 1,080

17,580 $ 7,420

Calculations of selected performance measures for 2002 for Reigis Steel Division are as follows: (a)

After-tax return on investment is 8.4%: ROI

= = =

profit from operations after taxes  average total assets $1,291,500 ÷ $15,375,000* 8.4%

*Average total assets: ($15,750,000 + $15,000,000†)  2 = $15,375,000 †December 31, 2001 total assets: $15,750,000  1.05 = $15,000,000

(b)

Economic value added, calculated as follows: Divisional profit after tax Less: Imputed interest charge: Invested capital  Imputed interest rate Imputed interest charge

$1,291,500 $15,375,000  .10 1,537,500

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Economic value added

($246,000)

3.

Assuming that the 11.5% ROI referred to in the question relates to after-tax ROI, the management of the Reigis Steel Division would have been likely to accept the project whichever method of performance measure had been used. The investment would have increased both the division's EVA and ROI, and hence, management's bonuses. Using EVA, management would accept all investments with a return higher than 10 per cent, since these investments would increase the dollar value of EVA. When using ROI as a performance measure, Reigis' management is likely to reject any investment that would lower the overall ROI (8.4 per cent for 2002), even though the return may be higher than the required minimum, since this would lower bonus awards. In this case, a project with an after-tax ROI of 11% would increase the overall ROI and increase bonus rewards.

4.

Reigis management must be able to control all items related to profit and investment if it is to be evaluated fairly as an investment centre using either ROI or EVA as a performance measure. Reigis management must control all elements of the business except the cost of acquiring capital, which would be controlled by Raddington Industries.

5.

Unit contribution margin

= =

total divisional contribution margin  unit sales $7,420,000  1,484,000 units = $5 per unit.

The advantage of using the divisional contribution margin is that it measures the total contribution of the Reigis Steel Division toward covering the fixed costs and profit of Raddington Industries. The disadvantage is that this measure is not related in any way to the assets invested in the division. The advantage of using the unit contribution margin is that it provides a gauge of the cost control, efficiency, and marketing effectiveness of Reigis Steel Division in generating a positive contribution per unit sold. The per unit measure does not, however, show the overall magnitude of the Reigis Steel Division's contribution toward covering Raddington's fixed costs and profit.

PROBLEM 13.38 (20 minutes) Behavioural implications of ROI: computer-integrated manufacturer 1.

The new equipment has not resulted in the expected improvement in financial performance in the first year of operation due to the inconsistencies between the way that the capital investment was evaluated and accrual accounting principles. When the decision was made to invest in the new equipment, the decision was probably made on the basis of the project's anticipated cash flows. This capital budgeting approach (which is covered in Chapters 20 and 21) is not consistent with accrual accounting using straight-line or diminishing value methods. The new equipment was expected to save $36,500 per year in operating expenses. This has occurred. However, to calculate the ROI, depreciation of 20% is charged against profit, and the asset value used in the denominator is reduced by depreciation. Over the life of the equipment, the ROI will rise as the NBV of the asset reduces. However, in the early years the ROI will be low. The ROI calculation does not emphasis savings in cash flows due to the new equipment.

2.

The behavioural problem that can result is that the manager of the Springvale Division may have a disincentive to invest in the new equipment, even though it is a sound economic investment. In the early years of an investment the use of ROI can mask improved financial performance. Also, in this case, as the Springvale Division is a high performing division, the ROI of 18.2 per cent on the new equipment decreased the division's previous ROI of 20 per cent. The next time such an investment decision arises, the Springvale Division manager might reject the proposed investment.

PROBLEM 13.39 Review of Chapters 12 and 13: divisional performance reporting and evaluation; ethics 1. Value of the annual performance report. (a)

The major concern is that the Bell Division is treated as an investment centre when it appears to sell only to Cornish Division. The ‘sales’ figure is derived from transfer prices based on market prices, and is completely beyond the control of the Bell Division manger. If Bell does not sell to the outside market, it should be treated as a cost centre only and all notions of both profit and ROI discarded. Treating Bell as an investment centre increases the complexity of accounting and appears to serve no useful purpose.

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If the same accounting techniques are used for the Cornish Division, they appear to be suitable for an investment centre, with certain improvements desirable. (b)

If the company continues to treat Bell Division was an investment centre, using a financial accounting approach to reporting, a number of improvements could be made: (i) Gross profit should be shown, as it is an important element in any profit-based measurement system. (ii) Divisional administration should be shown as a separate cost below gross profit – not included in manufacturing overhead. This distorts the cost of production and hides a cost which appears to represent the only administrative cost traceable to the division. The remaining administrative and financial activities are conducted at corporate level. (iii) If the performance of both the division and the manager are being measured, the report should identify controllable and non-controllable items.

(c)

2.

If only two years are being shown in the report, a horizontal analysis such as that is shown appears adequate. Changes are shown in both dollars and percentages, thus dealing with the magnitude and relativity of both measures. A $300 change in, say, prepaid expenses may represent a 100% change, whereas a change of 10% in sales, which amounts to $1 000 000 is far more significant. If the number of years being considered warranted it, a time-series based on Year 1 being 100 may be more meaningful. A better approach may be to include the 2002 budgeted figure as well as the 2001 actual figure and identify the ‘off-budget’ items.

Specific recommendations (a)

Continue to treat Cornish Division as an investment centre and use both ROI and EVA as financial performance measures.

(b)

Introduce non-financial measures where they are more useful (customer satisfaction, supplier suitability, quality, etc.)

(c)

Identify clearly those items which can be traced accurately to the division and which are controllable by the division manager. For those activities conducted by Corporate, costs should be based on predetermined rates, otherwise there is no incentive for Corporate to attempt to control these costs. The present basis of allocating the costs of personnel, administration and financing appears equitable, but the rates should be carefully monitored.

(d)

Treat Bell Division as a cost centre within the investment centre of Cornish Division, since it appears to supply only Cornish Division. This would eliminate transfer pricing and any notions of profit and ROI, thereby simplifying the accounting procedures and obviating the need for asset valuations etc. It may also mean that many of the corporate function costs need not be allocated, since they will be carried out for one division only.

(e)

The reporting of Bell Division’s performance as a cost centre will be improved by the following changes: (i)

Introduce budgeting and standard costing and report actual costs against budgets and standards. As the firm appears to be facing a market where cheaper houses are becoming more in demand, cost control is vital. Since the kits appear to be a standardised product, separate standards should be developed for each model. Calculating the normal variances would be an improvement on using actual costing, with standard and actual gross profits being prepared and the variances introduced at gross profit level rather than cost of goods sold.

(ii)

The production data in units is too complicated, especially if Bell becomes a part of Cornish. Production is triggered by a Cornish order, so output can be monitored using non-financial measures such as the number of completed orders, the time taken, and so on.

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(iii) Any non-production costs incurred by Bell Division can be shown as actual-versus-budgeted. Comparisons with the previous year could be shown, if this is meaningful to the manager. 3.

Ethical issues Clearly, Thompson should reject the approach of the general manager, since it contravenes the ethics laid down by the accounting profession. In particular, it contravenes the standards relating to the determination of profit, and could therefore mislead outsiders reading the financial statements. He should explain to the manager that it is against the ethics of his profession and that he must refuse the request. If he is subjected to further pressure from his divisional manager, he should approach somebody at a more senior level, presumably in the Corporate Division in order to absolve himself from guilt. If he is still under pressure to comply, he faces the difficult decision about whether to approach the firm’s auditors or resign and seek employment elsewhere.

CASES Case 13.40 (75 minutes) Review of Chapters 12 and 13; ROI and EVA; centralised versus decentralised service units; service company Note that Port Fairy Fisheries is defining invested capital as ‘total assets less current liabilities’ and this method will be used for all calculations. This definition assumes that investment centre managers have control (or at least strong influence) over short-term liabilities such as short-term bank loans and employee entitlements. This approach encourages managers to minimise resources tied up in assets and manage the use of short-term credit to finance operations. 1. ROI Southern Australian Division

Northern Australian Division

Fishing Fleet

Pre-tax profit

$3 600 000

$800 000

$300 000

After-tax profit (70%)

$2 520 000

$560 000

$210 000

$35 000 000 – 8 000 000

$4 000 000 – 2 000 000

$8 400 000 – 800 000

= $27 000 000

= $2 000 000

= $7 600 000

$2 520 000/ $2 700 000

$560 000/ $2 000 000

$210 000/ $7 600 000

= 9.3%

= 26.0%

= 2.8%

Invested capital ROI

2.

Based on ROI, Northern with 26.0% clearly exceeds the performance of the other two divisions, but when interpreting the ROI figures, the following should be considered: (a) Northern leases all is assets, whereas both the other divisions own their assets (b) Southern Australia has old assets which have probably been heavily depreciated, but the assets of the Fishing Fleet have recently been updated. (c) Southern’s assets may well be less efficient than Northern’s newer assets (which presumably will be modern if they are being leased) Any comparisons between the divisions are meaningless because of the differences in the way profit is calculated (Northern’s lease payments are deductible) and the valuation of the asset base.

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One of the advantages of ROI is said to be that it allows comparisons to be made between internal divisions, but this case suggests that this is not always feasible. Operating a fishing fleet cannot realistically be compared with operating a restaurant. Whereas all divisions are expected to meet an ROI target of 9%, the Fishing Fleet clearly does not. Is this requirement to be waived because the fleet has recently been updated? Which method of capital project evaluation was used to evaluate the updating of the fishing fleet, knowing that meeting the ROI target was unlikely in the short term? 3.

EVA (using 8% as the weighted average cost of capital) Southern Australian Division

Northern Australian Division

Fishing Fleet

After-tax profit (70%)

$2 520 000

$560 000

$210 000

Less capital charge

$27 000 000 x 0.08

$2 000 000 x 0.08

$7 600 000 x 0.08

= 2 160 000

= 160 000

= 608 000

$360 000

$400 000

($398 000)

EVA 4.

When EVA is introduced into the performance measurement process, Northern still appears to be the best performer, although the gap between it and the Southern has diminished. This could be due to the compilation of Northern’s non-leased assets and how they are valued, and also the extent of lease payments which are treated as expenses in the determination of profit. The performance of the Fishing Fleet continues to be poor – going from a token ROI of 2.8% to a negative EVA figure – because both figures highlight the very high asset base used to generate only a small profit. Although the divisions are said operate as ‘stand-alone’ businesses, logic suggests that the fishing fleet may provide at least some fresh fish for the restaurants. If this is the case, the transfer price charged will affect the profit of both supplying and buying divisions.

5.

In order to make more meaningful comparisons between divisions using ROI and EVA, the following data should be supplied: (a) Sales value – this helps to identify whether investment turnover is increasing or decreasing, and is a part of the Du Pont ratio used to disaggregate the ROI formula. It is also useful in comparing growth in sales with growth in profit. (b) Transfer prices between the Fishing Fleet and the restaurants, if this applies. (c) The value of the assets leased by Northern and the value of leasehold payments allowed as expenses. These could be used to adjust the figures of Northern to be comparable with Southern. (d) The asset values at the beginning of the period, so that average asset values could be used. In particular, this may be applicable to the Fishing Fleet, since the amount of the fleet replacement is having a serious affect on the performance of this division.

6.

(a) (i) Centralisation of service areas enables economies of scale to be achieved with avoidance of duplicated aspects of the service. This is particularly applicable to the IT service, given the cost of programmers, software and hardware. Centralisation of the services also means that corporate policies with regard to these areas will be uniform across all users. The disadvantages are the need to allocate the services to competing demands of users allocating the cost to the users and denying the users the opportunity to ‘customise’ the service to their own needs. If the costs of using the services are charged to user departments, they will feel frustrated if they have no opportunity to go outside the firm – they are being evaluated as stand-alone units, but fettered by internal costs over which they have no control. (ii) Decentralisation of services has the advantages of the user departments being able to meet their own particular

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requirements, being able to go outside the firm if they believe that outsourcing is cheaper, and not being saddled with costs over which they have no control. The disadvantages are the cost of duplication of activities and the lack of uniformity in the treatment of important aspects of the business. (iii) Creating shared services units shares the advantages and disadvantages of both centralisation and decentralisation but may be the answer in this situation. Provided that the responsibilities, costs and usage of the services between the two divisions are agreed at the outset, a shared service may overcome the present problems. One problem which might arise is that, in time, one of the divisions may wish to withdraw, leaving the other division with a service which it can not fully utilise and which it may no longer desire. 6.

(b) (i) The nature, volume, timing and particular requirements of each of the divisions should be established and documented before the shared service is established. (ii) To the extent that it is possible, variations to these aspects should be carefully considered and evaluated before they occur, so that there are no disputes when changes arise. (iii)The manner of charging divisions for the establishment and usage of the service should be determined beforehand. (iv) Measures of evaluating the service should be established and many of these may be expressed in nonfinancial terms.

Case 13.41 (50 minutes) Performance measures and reward systems; behavioural issues: manufacturer 1.

2.

3.

There are several features of the performance-related pay system that are causing problems. 

The performance of teams A and B are not independent. This means that several aspects of Team B’s performance are dependent on the actions of Team A. Also, the activities of the purchasing department are also impacting unfavourably on Team B.



The performance measures may not be appropriate to encourage the correct actions by teams. Team A can maximise its performance in terms of cycle time, material usage and production output, by supplying a defective product to Team B. Team B’s performance is then compromised as it takes longer to process faulty product.



The use of group performance assessment is allowing at least one team member to free ride, and receive the same rewards as other members of the team.



Team D is not participating in sharing the bonus pool and this is creating some dissatisfaction among the members of Team D.



There appears to be some tampering with the calibrating machine, which is impacting on the performance of Team C.



The bonus pool is fixed, and shared among the three teams. Thus, it is in the interests of a team to perform well at the expense of the other teams.

The three performance measures are cycle time, material usage and production output. These measures encourage the efficient use of material and speedy manufacturing practices. The focus on these three measures is having at least one dysfunctional outcome: Team A is providing faulty output to Team B, who takes much longer to process this product. These measures do not seem suitable for assessing performance and awarding bonuses as they are allowing Team A to achieve high-performance outcomes at the expense of Team B. The following changes could be made to improve the system:

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

Changes could be made to the selection of performance measures. Either a quality measure could be introduced, such as ‘percentage of units passing quality inspection’, or the production output measures could be modified to only record the output of 100% defect-free production units.



Performance measures could be introduced for the Purchasing Department to encourage them to provide material to the teams on time and when required.



Teams should be encouraged to manage their non-performing team members themselves. In many companies self-managed work teams are encouraged to manage their own team members and apply sanctions when necessary.



Management needs to bring Team D into the scheme, despite the introduction of the new production technology. Carefully designed performance measures and targets should be able to be formulated to accommodate their particular production situation. There are two choices that could be made to deal with the problem of shared equipment. Either separate equipment can be purchased for each team (this may be far too costly!) or, controls or procedures need to be introduced to minimise teams tampering with equipment/leaving equipment in an unfit state. The calibrating machine could be made the responsibility of a particular employee or team. The use of a shared bonus pool may need to be reassessed, as a team’s share of the pool is partially dependent on the performance of the other teams. Management could consider an open-ended bonus pool, so team rewards are not constrained by the good performance of other teams. However, this could end up being costly for the company. Alternatively, separate bonus pools could be established for each team, say $2,500 per team, and obtaining the maximum bonus may be dependent on achieving certain performance targets.

CASE 13-42 (50 minutes) Financial performance measures and reward systems; behavioural issues: manufacturer 1. Profit Assets ROI

Outboard

Automotive

Blue Grass

$ 600,000 2,000,000 30%

$2,200,000 4,000,000 55%

$100,000 800,000 12.5%

Based on both profit and ROI, the Automotive Division had the best performance, followed by the Outboard Division and the Blue Grass Division. 2.

3.

Bonus pool

= =

($600,000 + $2,200,000 + $100,000) x 1/10 $290,000

% bonus

= $290,000 ($1,00,000 + $1,400,000 + $700,000) =

$290,000 $3,100,000

=

9.355%

The senior managers of the Outboard and Automotive Divisions have been participating in the performance-related pay system for some time. However, with the acquisition of Blue Grass by Marlin, and the entry of their senior managers into the scheme, this could cause some dissatisfaction among the managers in the other two divisions. This is because the profitability of the Blue Grass Division is lower that the other two divisions, so that the inclusion of Blue Grass will effectively lower the % bonus paid to the Outboard and Automotive Division managers. The bonus % that those managers would have been paid if Blue Grass was not included is 11.67%, close to the 11% and 12% bonuses of the previous two years.

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Bonus % without Blue Grass Division

=

($600,000 + 2,200,00) x 10% $1,000,000 + $1,400,000

=

$280,000 $2,400,000 11.67%

= 4.

Blue Grass Division was a small family-owned company that was noted for its lack of ‘them and us’ attitude between employees and management. Under the previous management all employees participated in a gainsharing program which yielded equal bonuses for every employee. The introduction of a performance bonus for the senior managers of Blue Grass and discontinuance of the gainsharing program is contrary to the culture of Blue Grass, and may cause some dissatisfaction among those Blue Grass employees who are not senior managers.

5.

There are several possible changes that could be made to the performance-related pay system, to alleviate some of the potential problems. 

The gainsharing system could be retained within Blue Grass and senior managers of that Division might not participate in the company-wide bonus pool. This will satisfy employees in Blue Grass, and the senior managers in the other two divisions. However non-management employees in the other two divisions may lobby for a similar gainsharing program, so head office management may need to consider this possibility. Another potential problem is that the senior managers of Blue Grass may see themselves as not being treated on an equitable basis with the senior managers in the other two divisions. This may be the case, particularly when managers are transferred to the Blue Grass Division from the existing two divisions.



Marlin may decide that it is preferable to include all the senior managers in a performance-related bonus scheme, but to have separate percentage bonuses for each division. This may have the positive effect of having each manager’s bonus dependent only on his or her own division’s performance. The one disadvantage for Marlin is that no part of the performance bonus is based on company-wide performance. Some managers believe that it is good practice to have at least some proportion of a divisional manager’s bonus based on company-wide performance, as this encourages managers to consider the impact of decisions on both the division and the company. This is a goal-congruence issue.

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