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LEARNING NOTE 14.1. Responsibility accounting in profit and investment centres. LN14.1 (1). Measuring divisional profitability • Ideally focus should be on relative measures (profitability) rather than absolute measures of profit. • Alternative profitability measures:

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LEARNING NOTE 14.1

Responsibility accounting in profit and investment centres

slide2

LN14.1 (1)

Measuring divisional profitability

• Ideally focus should be on relative measures (profitability)rather than absolute measures of profit.

• Alternative profitability measures:

1. Return on investment (ROI)

2. Residual income (RI)

3. Economic value added (EVA ™)

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LN14.1 (2a)

Return on investment

Division ADivision B

Profit £1m £2m

Investment £4m£20m

ROI 25%10%

• Division B earns higher profits but A is more profitable.

• ROI is a relative measure of performance that can becompared with other investments. It also provides a usefulsummary measure of the ex post return on capitalemployed.

• A major disadvantage of ROI is that managers may bemotivated to make decisions that make the company worseoff.

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LN14.1 (2b)

Division X Division Y

Investment project available £10 million £10 million

Controllable contribution £2 million £1.3 million

Return on the proposed project 20% 13%

ROI of divisions at present 25% 9%

The overall cost of capital for the company is 15%

The manager of X would be motivated not to invest and the manager of Y

would be motivated to invest.

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LN14.1 (3a)

Residual income

• Controllable residual income = Controllable profit less acost of capital charge on the investment controllable by themanager.

• It is claimed that RI is more likely to encourage goalcongruence

Division X (£m) Division Y (£m)

Proposed investment 10 10

Controllable profit 2 1.3

Cost of capital charge (15%) 1.5 1.5

Residual income +0.5 – 0.2

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LN14.1 (3b)

• The manager of division X is motivated to invest and themanager of division Y is motivated not to invest.

• If RI is used it should be compared with budgeted/target levels which reflect the size of the divisional investment.

• Empirical evidence indicates that RI is not widely used.

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LN14.1 (4)

Economic value added (EVA™)

• During the 1990s RI was refined and renamed EVA ™.

• EVA ™ = Conventional divisional profit based on GAAP

± Accounting adjustments

– Cost of capital charge on divisional assets

• Conventional divisional profit based on principles outlined formeasuring divisional managerial and/or economic profits.

• Adjustments intended to convert historic accounting profit to anapproximation of economic profit.

• Adjustments typically include capitalization of discretionary expenses.