Performance measures
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Performance measures. Managerial Accounting David Fender. What is a responsibility center?. A subunit in an organization whose manager is held accountable for specified financial results. What kind of responsibility centers?. Cost Center/ Revenue Center Profit center Investment center.

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Performance measures

Performance measures

Managerial Accounting

David Fender


What is a responsibility center

What is a responsibility center?

A subunit in an organization whose manager is held accountable for specified financial results.


What kind of responsibility centers

What kind of responsibility centers?

  • Cost Center/ Revenue Center

  • Profit center

  • Investment center

Accountability

Authority


Responsibility centers

Revenue Center

Segment

is responsible

for the revenue of a unit.

The Reservations

Department of an airline

Responsibility Centers

Cost Center

Segment has control over the incurrence of costs.

The Paint Department

in an automobile plant.


Responsibility centers1

Responsibility Centers

Profit Center

Segment has control over both costs and revenues.

Investment Center

Segment has control over profits and invested capital.

Adivision of a

large corporation.

Company-owned restaurant in a fast-food chain.


Measuring management performance

Cost

Center

Profit

Center

Investment

Center

Measuring Management Performance

Evaluation Tool

Cost

standards

Contribution

income

statement

Rate of return

on invested

funds or

residual income


Responsibility centers2

Responsibility Centers


Investment center

Investment Center

  • Decision rights:

    • input mix, product mix, selling prices and invested capital

    • Assumes manager has specialized knowledge of investment opportunities

  • Performance measure:

    • ROI, Residual Income/EVA


Why relate profits to assets employed

Why Relate Profits to Assets Employed?

  • To assess if assets are being effectively and efficiently used.

    • Shareholders can compare to alternatives.

    • Firms can identify and reduce/eliminate (relatively) non-productive use of assets

  • To promote discipline in the capital budgeting process.

    • Is management accurately estimating future cash flows?

    • Are capital budgeting criteria appropriate?


  • The big debate roi vs ri

    The Big Debate: ROI vs. RI

    ISSUE:

    What is the best way to evaluate performance of investment centers?

    Residual income concepts?


    Roi the big dog

    ROI the big dog


    Return on investment roi

    Return on Investment (ROI)

    • ROI is an accounting measure of income divided by an accounting measure of investment

    • Is a percentage measure

    • Puts net income in relation to assets


    Return on investment roi1

    Net operating income

    Average operating assets

    ROI =

    Return on Investment (ROI)

    Income before interest

    and taxes (EBIT)

    Cash, accounts receivable, inventory,

    plant and equipment, and other

    productive assets.


    Return on investment roi2

    Return on Investment (ROI)

    • Most popular metric for two reasons:

      • Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage

      • May be compared to other ROI’s both inside and outside the firm

        (ROI intuitive compared to other measures)

    • Managers seem to have an affinity for %


    Return on investment roi3

    Return on Investment (ROI)

    Holly Flower Company reports :

    Income $ 30,000

    Invested Capital$ 200,000

    What is the ROI?


    Return on investment roi4

    Income

    Invested Capital

    ROI =

    $30,000

    $200,000

    ROI =

    Return on Investment (ROI)

    ROI = 15%


    Improving roi

    Improving ROI

    Three ways to improve ROI

    2. Decrease

    Expenses

    1. Increase

    Revenues

    3. Lower

    Invested Capital


    Problem

    Problem:

    • Think about the following:

      • A department has an IRR of 20%

      • The company can borrow money at 10%

      • A manager has an opportunity to implement a project that would yield an IRR of 15%

    • Would the manager implement the project?

    • Should the manager implement the project?


    Underinvestment problem

    Underinvestment Problem

    ROI can be a disincentive to taking on lucrative projects!!!


    Roi advantages disadvantages

    ROI Advantages/Disadvantages

    • Advantage:

      • simple

      • comparable across business units (because it’s a %)

    • Disadvantages:

      • Manipulation potential

        • of Net Income Calculation

          • e.g., Defer R&D expenditures

        • of Investment Base Calculation

          • e.g., Dispose of assets

      • Underinvestment problem


    Other form of roi

    Income

    Invested Capital

    ROI =

    Income

    Sales Revenue

    Sales Revenue

    Invested Capital

    ROI =

    ×

    Sales

    Margin

    CapitalTurnover

    Other form of ROI


    Roi measurement issues

    ROI Measurement Issues

    • Choice of net income:

      • Before tax

      • After tax

    • Choice of investment base:

      • Total Assets

      • Total Productive Assets

      • Net Assets (A-L)

      • Controllable Assets

      • Gross or net book value


    Ri the contender

    RI the contender


    Charge for capital employed

    Charge for capital employed

    Money costs money!


    Residual income

    Residual Income

    • Residual Income (RI) is an accounting measure of income minus a dollar amount for required return on an accounting measure of investment

    • RI = Income – (RRR X Investment)

      • RRR = Required Rate of Return

    • Required Rate of Return times the Investment is the imputed cost of the investment

      • Imputed costs are cost recognized in some situations, but not in the financial accounting records


    Residual income1

    Residual Income

    (

    )

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

    (ROI measures net operating income earned relative to the investment in average operating assets.)


    Residual income2

    Residual Income

    Investment center profit

    – Investment charge

    = Residual income

    Investment capital

    ×Imputed interest rate

    = Investment charge

    Investment center’sminimum requiredrate of return


    Residual income3

    Residual Income

    • Flower Co. has an opportunity to invest $100,000 in a project that will return $25,000.

    • Flower Co. has a 20 percent required rate of return and a 30 percent ROI on existing business.

    What is the residual income?


    Residual income4

    Investment center profit = $25,000

    – Investment charge = 20,000

    = Residual income = $ 5,000

    Residual Income

    Investment capital= $100,000

    × Imputed interest rate = 20%

    = Investment charge = $ 20,000

    Investment center’sminimum requiredrate of return


    Residual income5

    Residual Income

    • Disadvantages:

      • More complicated(calculating cost of capital)

      • Harder to compare (because not a %)

      • Arguably, the manipulation potential is the same

        • of Net Income Calculation

        • of Investment Base Calculation

    • Advantage:

      • Mitigates the underinvestment problem


    Roi background

    ROI Background

    • Background:

      • CAPM

        • Capital asset pricing model

      • Computers


    What is interest for

    What is interest for?

    • What would you base interest demands on?

      • What would you rather have - $1,000 today or $1,000 in 10 years?

      • Would you charge Mr Goodman with a credit score of 740 and MrNogoodman with a credit score 0f 450 the same interest rate?


    Performance measures

    CAPM

    The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).


    Performance measures

    Also referred to as “beta” – beta is an indicator of how much a stock changes in relative to changes in the overall market

    Beta is calculated on historical data

    For example: a stock has a beta of 0.5 – this means the stock is less risky than the market; when the market decreases by 10% the stock decreases by 5% - on the same token, when the market increases by 10% the stock increases by 5%

    CAPM

    • Interest rate for equity in RI and EVA is based on the capital asset pricing model (CAPM)

      • Interest equity = risk free interest rate + risk return


    Performance measures

    EVA

    Economic Value Added

    censored

    censored


    Performance measures

    EVA

    • EVA “improvements” marketed by Stern Stewart

      • Firm-specific market-based risk assessment based on CAPM (to compute WACC)

        • weighted average cost of capital (debt and equity)

      • After-tax net income

      • Adjusts for distortions introduced by GAAP…


    Economic value added eva

    Economic Value Added (EVA)

    • EVA is a specific type of residual income calculation that has recently gained popularity

    • Weighted average cost of capital equals the after-tax average cost of all long-term funds in use


    Eva net income adjustments

    EVA Net Income “Adjustments”

    • Industry specific

    • Hundreds are theoretically possible; 10-15 common

    • Common adjustments to GAAP income:

      • Capitalize and amortize R&D

      • Capitalize and amortize marketing costs

      • Include leased assets in the investment base

      • FIFO inventory accounting

      • Substitute economic depreciation for straight line methods

      • Adjust for inflation


    Economic value added

    Weightedaveragecost of capital

    (

    )

    Investmentcenter’s

    total assets

    Investmentcenter’scurrent liabilities

    Economic Value Added

    Investment center’s after-tax operating income

    – Investment charge

    = Economic Value Added


    So how to calculate cost of capital

    So how to calculate cost of capital?

    When both equity and debt are used (which is usually the case) then calculate a weighted cost of capital:

    % of debt of total capital

    Debt interest rate

    Equity interest rate

    % of equity of total capital

    WACC =

    +

    x

    x


    Economic value added1

    Economic Value Added

    The Atlantic Division of Suncoast Food Centers reportedthe following results for the most recent period:

    Compute Atlantic Division’s economic value added.


    Economic value added2

    (9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

    = 0.0972

    $40,000,000 + $60,000,000

    Economic Value Added

    First, let’s compute theweighted-average cost of capital


    Economic value added3

    Economic Value Added

    $6,750,000 × (1 – 30%)

    $4,725,000 After-tax operating income

    – 4,315,680

    = $ 409,320 Economic value added

    ($45,000,000 – $600,000) × 0.0972 = $4,315,680

    (9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

    = 0.0972

    $40,000,000 + $60,000,000


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