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ADVANCED MANAGEMENT ACCOUNTING

ADVANCED MANAGEMENT ACCOUNTING. Performance Evaluation. 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.

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ADVANCED MANAGEMENT ACCOUNTING

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  1. ADVANCED MANAGEMENT ACCOUNTING

  2. Performance Evaluation

  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

  4. Measuring the Performance of Investment Centers • Return on Investment (ROI) • Residual Income (RI) • Economic Value Added (EVA)

  5. Return On Investment (ROI) 10-5 Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI.

  6. Return on Investment (ROI) Formula 10-6 Net operating income Average operating assets ROI = Income before interest and taxes (EBIT) Cash, accounts receivable, inventory, plant and equipment, and other productive assets.

  7. Net Book Value versus Gross Cost 10-7 Most companies use the net book value of depreciable assets to calculate average operating assets.

  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

  9. Understanding ROI 10-9 Net operating income Average operating assets ROI= Net operating income Sales Margin = Sales Average operating assets Turnover = Margin  Turnover ROI =

  10. An ROI Example Year 1: Snack Foods Appliance Division Division Sales $30,000,000 $117,000,000 Operating income 1,800,000 3,510,000 Average operating assets 10,000,000 19,500,000 Year 2: Sales $40,000,000 $117,000,000 Operating income 2,000,000 2,925,000 Average operating assets 10,000,000 19,500,000 Minimum return of 10%

  11. Margin and Turnover Comparisons Snack FoodAppliance Year 1 Year 2Year 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% === === === ===

  12. Increasing ROI There are three ways to increase ROI . . . 10-12 • Reduce • Expenses • Increase • Sales • Reduce • Assets

  13. Increasing ROI – An Example Regal Company reports the following: Net operating income $ 30,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 470,000 10-13 Net operating income Sales Sales Average operating assets ROI = × ROI = MarginTurnover What is Regal Company’s ROI?

  14. Increasing ROI – An Example 10-14 Net operating income Sales Sales Average operating assets ROI = × $30,000 $500,000 $500,000 $200,000 ROI = × ROI = 6%  2.5 = 15% ROI = Margin  Turnover

  15. Investing in Operating Assets to Increase Sales 10-15 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. Regal Company reports the following: Net operating income $ 50,000 Average operating assets $ 230,000 Sales $ 535,000 Operating expenses $ 485,000 Let’s calculate the new ROI.

  16. Investing in Operating Assets to Increase Sales 10-16 Net operating income Sales Sales Average operating assets ROI = × $50,000 $535,000 $535,000 $230,000 ROI = × ROI = 9.35%  2.33 = 21.8% ROI = Margin  Turnover ROI increased from 15% to 21.8%.

  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.

  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.

  19. Criticisms of ROI 10-19 In the absence of the balanced scorecard, management may not know how to increase ROI. Managers often inherit many committed costs over which they have no control. Managers evaluated on ROI may reject profitable investment opportunities.

  20. Residual Income 10-20 Compute residual income and understand its strengths and weaknesses.

  21. Residual Income - Another Measure of Performance 10-21 Net operating income above some minimum required return on operating assets

  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)

  23. Calculating Residual Income 10-23 ( ) 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.

  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%

  25. Residual Income Example • Project 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

  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. 10-26 Let’s calculate residual income.

  27. Residual Income – An Example 10-27

  28. Motivation and Residual Income 10-28 Residual income encourages managers to make investments that are profitable for the entire company but would be rejected by managers who are evaluated using the ROI formula.

  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

  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% 10-30 ROI = NOI/Average operating assets = $60,000/$300,000 = 20%

  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

  32. Quick Check  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. Yes b. No ROI = $78,000/$400,000 = 19.5% This lowers the division’s ROI from 20.0% down to 19.5%.

  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

  34. Quick Check  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. Yes b. No ROI = $18,000/$100,000 = 18% The return on the investment exceeds the minimum required rate of return.

  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

  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 10-36

  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

  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. No 10-38

  39. Divisional Comparisons and Residual Income 10-39 The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes.

  40. Zephyr, Inc. - Continued 10-40 Recall the following information for the Retail Division of Zephyr, Inc. Assume the following information for the Wholesale Division of Zephyr, Inc.

  41. Zephyr, Inc. - Continued 10-41 The residual income numbers suggest that the Wholesale Division outperformedthe 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.

  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)

  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

  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: AmountPercent 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 ======== =====

  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.

  46. Weighted Average Cost of Capital The weighted average cost of capital for Furman, Inc. is computed as follows: AmountPercent 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 bonds3,000,0000.200 0.060 0.012 Total$15,000,000 0.098 ========= ====

  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.

  48. Behavioral Aspects of EVA • A 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.

  49. End of Week

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