Business Unit PerformanceMeasurement

Chapter 14

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Accounting IncomeL.O. 1 Evaluate divisional accounting income as a performance measure.

• Divisional Income:Division revenues minus division costs

• Investors use accounting income to assessa firm's performance.

• Firms use a division’s income to assessdivisional performance.

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Divisional IncomeLO1

Mustang FashionsDivisional Income Statements

For Year 1 ($000)

SalesCost of salesGross marginAllocated corporate overheadLocal advertisingOther general and administrativeOperating incomeTax expense (@ 30%)After-tax income

$5,200.0 2,802.0$2,398.0 468.0 1,200.0 250.0$ 480.0 144.0$ 336.0

$2,800.0 1,515.0$1,285.0 252.0 500.0 227.0$ 306.0 91.8$ 214.2

$8,000.0 4,317.0$3,683.0 720.0 1,700.0 477.0$ 786.0 235.8$ 550.2

WesternDivision

EasternDivision Total

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Some Simple Financial RatiosLO1

Gross margin percentageOperating marginProfit margin

Gross margin ÷ salesOperating income ÷ SalesAfter-tax income ÷ Sales

46.12% 9.23% 6.46%

45.89%10.93% 7.65%

WesternDivision

EasternDivisionDefinitionRatio

Mustang FashionsSelected Financial Ratios

For Year 1

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Return on InvestmentL.O. 2 Interpret and use return on investment (ROI).

• Return on Investment (ROI):Ratio of profits to investment in the asset thatgenerates those profits

• Provides a comparison of different size divisions.

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Return on InvestmentLO2

Mustang FashionsBalance Sheets

January 1, Year 1

AssetsCashAccounts receivableInventory

Total current assetsFixed assets (net)

Total assetsLiabilities and Equities

Accounts payableOther current liabilities

Total current liabilitiesLong-term debt

Total liabilitiesTotal shareholders equityTotal liabilities and equities

$ 250,000 225,000 250,000$ 725,000 775,000$1,500,000

$ 125,000 227,000$ 352,000 -0- $ 352,000 1,148,000$1,500,000

$ 150,000 250,000 150,000$ 550,000 350,000$ 900,000

$ 95,000 280,000$ 375,000 -0- $ 375,000 525,000$ 900,000

$ 400,000 475,000 400,000$1,275,000 1,125,000$2,400,000

$ 220,000 507,000$ 727,000 -0- $ 727,000 1,673,000$2,400,000

WesternDivision

EasternDivision Total

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Return on InvestmentLO2

After-tax income from income statementDivisional investment from balance sheet

ROI (After-tax income ÷ Divisional investment)

$ 336,000$1,500,000

22%

$ 214,200$ 900,000

24%

WesternDivision

EasternDivision

Mustang FashionsROI for Western and Eastern Divisions

For Year 1

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Residual Income MeasuresL.O. 3 Interpret and use residual income (RI).

• Residual Income (RI):This is the excess of actual profit overthe cost of invested capital in the unit.

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Economic Value Added (EVA)L.O. 4 Interpret and use economic value added (EVA).

• EVA is the annual after-tax (adjusted)divisional income minus the total annualcost of (adjusted) capital.

• It makes adjustments to after-tax income andcapital to “eliminate accounting distortions.”

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Measuring the Investment BaseL.O. 5 Explain how historical cost and net book value-based accounting

measures can be misleading in evaluating performance.

• Performance measures use divisional assetsor investments in the calculation.

• How should divisional assets be measured?– Gross book value versus net book value– Historical cost versus current cost– Beginning, ending, or average balance

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Gross Book Value versusNet Book Value Example

LO5

• Profits before depreciation (all in cash flows at end of year):$100 each year for 3 years

• Asset cost at beginning of year 1, $500

• Depreciation: Ten year life, straight-line, no salvage value

• Amounts are in thousand of dollars.

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Gross Book Value versusNet Book Value Example

LO5

ROI = $50c $500 = 10%

Year

=

=

=

ROI = $50c $500 = 10%

ROI = $50c $500 = 10%

Net Book Value Gross Book Value

$100a – (0.1 × $500)b

$500d – (0.1 × $500)e 11.1%ROI =1…

2… $100a – (0.1 × $500)b

$450d – (0.1 × $500)e 12.5%ROI =

3… $100a – (0.1 × $500)b

$400d – (0.1 × $500)e 14.3%ROI =

a The first term in the numerator is the annual cash profit.b The second term in the numerator is depreciation for the year.c Net income = $50 = $100 – ($500 × 0.1)d The first term in the denominator is the beginning-of-the-year asset value.e The second term in the denominator reduces the beginning-of-the-year value of the asset by the amount of current year's depreciation

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Historical Cost versus Current CostLO5

• Current cost:Cost to replace or rebuildan existing asset

• Historical cost:Original cost to purchaseor build an asset

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Historical Cost versus Current CostLO5

• Operating profits before depreciation(all in cash flows at end of year):Year 1, $100; Year 2, $120; Year 3, $144

• Annual rate of price changes is 20 percent.

• Asset cost at beginning of year 1 is $500.

• Amounts are in thousand of dollars.

• Straight-line depreciation is used;the straight-line rate is 10% per year

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Historical Cost versus Current CostLO5

Year

=

Historical Cost$100a – (0.1 × $500)b

$500c – (0.1 × $500) 11.1%ROI =1…

=2… $120a – (0.1 × $500)b

$500c – (0.2 × $500) 17.5%ROI =

=3… $144a – (0.1 × $500)b

$500c – (0.3 × $500) 26.9%ROI =

Year

=

Current Cost$100a – (0.1 × $600)b

$600d – (0.1 × $600)e 7.4%ROI =1…

=2… $120a – (0.1 × $720)b

$720f – (0.2 × $720)e 8.3%ROI =

=3… $144a – (0.1 × $864)b

$864g – (0.3 × $864)e 9.5%ROI =

Year

=

Historical Cost$100a – $50b

$500c 10.0%ROI =1…

=2… $120a – $50b

$500c 14.0%ROI =

=3… $144a – $50b

$500c 18.8%ROI =

Year

=

Current Cost$100a – $60b

$600d 6.7%ROI =1…

=2… $120a – $72b

$720f 6.7%ROI =

=3… $144a – $86.4b

$864g 6.7%ROI =

Net Book Value

Gross Book Value

a Annual operating profit before depreciation. b Depreciation for the year.c Beginning-of-the-first-year value of the assets used in the investment base. d Current cost of asset ($500 × 120%)e Accumulated depreciation at the end of the year. f Current cost of asset ($600 × 120%)g Current cost of asset ($720 × 120%)

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Beginning, Ending,or Average Balance?

LO5

• Managers can manipulate purchases anddisposition based on which balance isbeing used in evaluations.

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End of Chapter 14

LO1

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin