CHAPTER 15 Cost Analysis for Control

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Decision Making Strategic, Operational, and Financial Planning Planning and control cycle Executing operational activities (Managing) Data collection and performance feedback Implement plans Revisit plans Performance analysis: Plans vs. actual results (Controlling)

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Cost Classification According to a Time-Frame Perspective Time Degree of Control Costs that may not controllable in the short run are controllable in the long run.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Performance Report Characteristics Activity Budget Amount Actual Amount Explanation – = Favorable Actual revenues > Budget revenues Actual costs < Budget costs Unfavorable Actual revenues < Budget revenues Actual costs > Budget costs Favorable Actual revenues > Budget revenues Actual costs < Budget costs Unfavorable Actual revenues < Budget revenues Actual costs > Budget costs Variance

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Product Cost Budget Amount This variance is unfavorable because the actual cost exceeds the budget cost. A cost variance is the amount by which actual amount differs from the budget amount. Performance Report Characteristics

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Responsibility Reporting Amount of detail varies according to level in organization. A department manager receives detailed reports. A store manager receives summarized information from each department. Performance Report Characteristics

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved The vice president of operations receives summarized information from each store. Management by exception: Upper-level management does not receive operating detail unless activities are not performing according to plan. Responsibility Reporting Amount of detail varies according to level in organization. Performance Report Characteristics

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved The Flexible Budget Improve performance evaluation. May be prepared for any activity level in the relevant range. Show revenues and expenses that should have occurred at the actual activity. Reveal variances due to good cost control or lack of cost control.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved To a budget for different activity levels, we must know how costs behave with changes in activity levels. Total variable costs change in direct proportion to changes in activity. Total fixed costs remain unchanged within the relevant range. Fixed Variable The Flexible Budget

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved First, let’s compare actual results with the original budget. The Flexible Budget

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Cost variances have little meaning since actual costs are at a different activity than the budgeted activity. The Flexible Budget

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Now, let’s compare actual results with a flexed budget prepared at the actual level of activity. The Flexible Budget

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved The Flexible Budget

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved The Flexible Budget A flexible budget is prepared for the same activity level as actually achieved. Note: There is no flex in the fixed costs.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Variable costs have unfavorable variances because actual costs are more than the flexible budget costs. The Flexible Budget

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Standard Cost Variance Analysis Standard Costs are Based on carefully predetermined amounts. Used for planning labor, material, and overhead requirements. The expected level of performance. Benchmarks for measuring performance.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Price Variance Standard Cost Variances The difference between the actual price and the standard price Usage Variance The difference between the actual quantity and the standard quantity Standard Cost Variance Analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price VarianceUsage Variance Standard price is the amount that should have been paid for the resources acquired. Standard Cost Variance Analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Price VarianceUsage Variance Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Standard quantity is the quantity that should have been used for the output achieved. Standard Cost Variance Analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity AQ(AP - SP) SP(AQ - SQ) AQ = Actual Quantity SP = Standard Price AP = Actual Price SQ = Standard Quantity Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price Price VarianceUsage Variance Standard Cost Variance Analysis

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Material Price and Usage Variances Let’s apply what we have learned to calculate standard cost variances, starting with material.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Cruisers, Inc. has the following material standards for fiberglass cloth used to make one SeaCruiser boat hull: 218 yards per hull at $2.10 per yard Last month 22,500 yards of material were purchased and used to make 100 hulls. The material cost a total of $46,125. Calculating Material Price and Usage Variances

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved What is the actual price per yard paid for the material? a.$2.00 per yard. b.$2.10 per yard. c.$2.05 per yard. d.$2.25 per yard. What is the actual price per yard paid for the material? a.$2.00 per yard. b.$2.10 per yard. c.$2.05 per yard. d.$2.25 per yard. Calculating Material Price and Usage Variances

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved What is the actual price per yard paid for the material? a.$2.00 per yard. b.$2.10 per yard. c.$2.05 per yard. d.$2.25 per yard. What is the actual price per yard paid for the material? a.$2.00 per yard. b.$2.10 per yard. c.$2.05 per yard. d.$2.25 per yard. AP = $46,125 ÷ 22,500 yds. AP = $2.05 per yd. Calculating Material Price and Usage Variances

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Material Price and Usage Variances The material price variance (MPV) for the month was: a.$1,125 unfavorable. b.$1,125 favorable. c.$1,255 unfavorable. d.$1,255 favorable. The material price variance (MPV) for the month was: a.$1,125 unfavorable. b.$1,125 favorable. c.$1,255 unfavorable. d.$1,255 favorable.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved The material price variance (MPV) for the month was: a.$1,125 unfavorable. b.$1,125 favorable. c.$1,255 unfavorable. d.$1,255 favorable. The material price variance (MPV) for the month was: a.$1,125 unfavorable. b.$1,125 favorable. c.$1,255 unfavorable. d.$1,255 favorable. MPV = AQ(AP - SP) MPV = 22,500 yds. × ($2.05 – $2.10) MPV = $1,125 Favorable Calculating Material Price and Usage Variances

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved The standard quantity of material that should have been used to produce 100 hulls is: a.22,500 yards. b.21,600 yards. c.21,800 yards. d.22,000 yards. The standard quantity of material that should have been used to produce 100 hulls is: a.22,500 yards. b.21,600 yards. c.21,800 yards. d.22,000 yards. Calculating Material Price and Usage Variances

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved The standard quantity of material that should have been used to produce 100 hulls is: a.22,500 yards. b.21,600 yards. c.21,800 yards. d.22,000 yards. The standard quantity of material that should have been used to produce 100 hulls is: a.22,500 yards. b.21,600 yards. c.21,800 yards. d.22,000 yards. SQ = 100 hulls × 218 yds. per hull SQ = 21,800 yds. Calculating Material Price and Usage Variances

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Material Price and Usage Variances The material usage variance (MUV) for the month was: a.$1,250 unfavorable. b.$1,250 favorable. c.$1,470 unfavorable. d.$1,470 favorable. The material usage variance (MUV) for the month was: a.$1,250 unfavorable. b.$1,250 favorable. c.$1,470 unfavorable. d.$1,470 favorable.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Material Price and Usage Variances The material usage variance (MUV) for the month was: a.$1,250 unfavorable. b.$1,250 favorable. c.$1,470 unfavorable. d.$1,470 favorable. The material usage variance (MUV) for the month was: a.$1,250 unfavorable. b.$1,250 favorable. c.$1,470 unfavorable. d.$1,470 favorable. MUV = SP(AQ - SQ) MUV = $2.10(22,500 yds. – 21,800 yds.) MUV = $1,470 unfavorable

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Material Variances Summary Price variance $1,125 favorable Usage variance $1,470 unfavorable 22,500 yds. 22,500 yds. 21,800 yds. × × × $2.05 per yd. $2.10 per yd. $2.10 per yd. = $46,125 = $ 47,250 = $45,780 Actual Quantity Actual Quantity Standard Quantity × × × Actual Price Standard Price Standard Price

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances Now let’s calculate standard cost variances for labor.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances Cruisers, Inc. has the following direct labor standard to manufacture one boat hull: 26 standard hours per hull at $12.80 per direct labor hour Last month 2,540 direct labor hours were worked at a total labor cost of $32,893 to make 100 hulls.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances What was the actual rate (AR) for labor for the month? a.$12.95 per hour. b.$12.80 per hour. c.$12.50 per hour. d.$12.25 per hour. What was the actual rate (AR) for labor for the month? a.$12.95 per hour. b.$12.80 per hour. c.$12.50 per hour. d.$12.25 per hour.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved What was the actual rate (AR) for labor for the month? a.$12.95 per hour. b.$12.80 per hour. c.$12.50 per hour. d.$12.25 per hour. What was the actual rate (AR) for labor for the month? a.$12.95 per hour. b.$12.80 per hour. c.$12.50 per hour. d.$12.25 per hour. Calculating Labor Rate and Efficiency Variances AP = $32,893 ÷ 2,540 hours AP = $12.95 per hour

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances The labor rate variance (LRV) for the month was: a.$381 unfavorable. b.$381 favorable. c.$462 unfavorable. d.$462 favorable. The labor rate variance (LRV) for the month was: a.$381 unfavorable. b.$381 favorable. c.$462 unfavorable. d.$462 favorable.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances The labor rate variance (LRV) for the month was: a.$381 unfavorable. b.$381 favorable. c.$462 unfavorable. d.$462 favorable. The labor rate variance (LRV) for the month was: a.$381 unfavorable. b.$381 favorable. c.$462 unfavorable. d.$462 favorable. LRV = AH(AP - SP) LRV = 2,540 hrs($ $12.80) LRV = $381 unfavorable

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances The standard hours (SH) of labor that should have been worked to produce 100 hulls is: a.2,500 hours. b.2,600 hours. c.2,700 hours. d.2,800 hours. The standard hours (SH) of labor that should have been worked to produce 100 hulls is: a.2,500 hours. b.2,600 hours. c.2,700 hours. d.2,800 hours.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances The standard hours (SH) of labor that should have been worked to produce 100 hulls is: a.2,500 hours. b.2,600 hours. c.2,700 hours. d.2,800 hours. The standard hours (SH) of labor that should have been worked to produce 100 hulls is: a.2,500 hours. b.2,600 hours. c.2,700 hours. d.2,800 hours. SH = 100 hulls × 26 hours per hulls SH = 2,600 hours

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances The labor efficiency variance (LEV) for the month was: a.$694 unfavorable. b.$694 favorable. c.$768 unfavorable. d.$768 favorable. The labor efficiency variance (LEV) for the month was: a.$694 unfavorable. b.$694 favorable. c.$768 unfavorable. d.$768 favorable.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Labor Rate and Efficiency Variances The labor efficiency variance (LEV) for the month was: a.$694 unfavorable. b.$694 favorable. c.$768 unfavorable. d.$768 favorable. The labor efficiency variance (LEV) for the month was: a.$694 unfavorable. b.$694 favorable. c.$768 unfavorable. d.$768 favorable. LEV = SR(AH - SH) LEV = $12.80(2,540 hrs. - 2,600 hrs.) LEV = $768 favorable

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Rate variance $381 unfavorable Efficiency variance $768 favorable Actual Hours Actual Hours Standard Hours × × × Actual Price Standard Price Standard Price 2,540 hours 2,540 hours 2,600 hours × × × $12.95 per hr. $12.80 per hr. $12.80 per hr. = $32,893 = $32,512 = $33,280 Labor Variances Summary

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances Now let’s calculate standard cost variances for the last of the variable production costs – variable overhead.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances Cruiser, Inc. has the following variable overhead standard to manufacture one boat hull: 26 standard hours per hull at $3.20 per direct labor hour Last month 2,540 hours were worked to make 100 hulls, and actual variable overhead was $8,128.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances What was the actual rate (AR) for variable overhead rate for the month? a.$3.00 per hour. b.$3.11 per hour. c.$3.20 per hour. d.$4.30 per hour. What was the actual rate (AR) for variable overhead rate for the month? a.$3.00 per hour. b.$3.11 per hour. c.$3.20 per hour. d.$4.30 per hour.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances What was the actual rate (AR) for variable overhead rate for the month? a.$3.00 per hour. b.$3.11 per hour. c.$3.20 per hour. d.$4.30 per hour. What was the actual rate (AR) for variable overhead rate for the month? a.$3.00 per hour. b.$3.11 per hour. c.$3.20 per hour. d.$4.30 per hour. AR = $8,128 ÷ 2,540 hours AR = $3.20 per hour

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances The spending variance (SV) for variable overhead for the month was: a.$0. b.$400 favorable. c.$335 unfavorable. d.$300 favorable. The spending variance (SV) for variable overhead for the month was: a.$0. b.$400 favorable. c.$335 unfavorable. d.$300 favorable.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances The spending variance (SV) for variable overhead for the month was: a.$0. b.$400 favorable. c.$335 unfavorable. d.$300 favorable. The spending variance (SV) for variable overhead for the month was: a.$0. b.$400 favorable. c.$335 unfavorable. d.$300 favorable. SV = AH(AR - SR) SV = 2,540 hrs($ $3.20) SV = $0

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances The efficiency variance (EV) for variable overhead for the month was: a.$438 unfavorable. b.$438 favorable. c.$192 unfavorable. d.$192 favorable. The efficiency variance (EV) for variable overhead for the month was: a.$438 unfavorable. b.$438 favorable. c.$192 unfavorable. d.$192 favorable.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Calculating Variable Overhead Spending and Efficiency Variances The efficiency variance (EV) for variable overhead for the month was: a.$438 unfavorable. b.$438 favorable. c.$192 unfavorable. d.$192 favorable. The efficiency variance (EV) for variable overhead for the month was: a.$438 unfavorable. b.$438 favorable. c.$192 unfavorable. d.$192 favorable. EV = SR(AH - SH) EV = $3.20(2,540 hrs. - 2,600 hrs.) EV = $192 favorable 100 hulls × 26 hrs. per hull

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Spending variance $0 Efficiency variance $192 favorable 2,540 hours 2,540 hours 2,600 hours × × × $3.20 per hour $3.20 per hour $3.20 per hour = $8,128 = $8,128 = $8,320 Actual Hours Actual Hours Standard Hours × × × Actual Rate Standard Rate Standard Rate Variable Overhead Variances Summary

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Fixed Overhead Variances Now let’s turn our attention to fixed overhead.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Fixed Overhead Variances Estimated Fixed Overhead POHAR = Overhead costs are applied to products and services using a predetermined overhead application rate (POHAR): Applied Overhead = POHAR × Standard Activity Estimated Total Direct Labor Hours

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Fixed Overhead Variances Budget Variance Volume Variance POHAR = Fixed Overhead Application Rate SH = Standard Hours Allowed SH × POHAR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Fixed Overhead Variances Cruiser, Inc. has the following budgeted and actual fixed overhead information for the year: Calculate the fixed overhead budget and volume variances.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Fixed Overhead Variances Budget variance $87,500 unfavorable Volume variance $98,496 favorable 309,120 hours × $10.80 per hour $3,327,500$3,240,000$3,338,496 SH × POHAR Actual Fixed Fixed Fixed Overhead Overhead Overhead Incurred Budget Applied

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Fixed Overhead Variances Budget Variance Results from paying more or less than expected for overhead items. Volume Variance Results from operating at an activity level different from the planned activity.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Volume Variance Unfavorable when standard hours < planned hours Favorable when standard hours > planned hours Results when standard hours allowed for actual output differs from the planned activity. Volume Variance – A Closer Look

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Volume Variance Unfavorable when standard hours < planned hours Favorable when standard hours > planned hours Results when standard hours allowed for actual output differs from the budgeted activity. Does not measure over- or under spending Explainable by and controllable only through activity Volume Variance – A Closer Look

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Volume Variance – A Closer Look Let’s look at a graph showing the volume variance. We will use Cruisers’ annual numbers from the previous example.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Volume Variance Volume Cost $3,338,496 applied fixed OH $3,240,000 budgeted fixed OH 309,120 Standard Hours 300,000 Budgeted Hours Fixed overhead applied to products 309,120 hours × $10.80 fixed overhead rate { Volume Variance – A Closer Look

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Reporting for Segments of an Organization Cruisers, Inc. reports the following for a recent quarter: Should the Repair Parts Division be discontinued? Let’s take a closer look at fixed expenses before we decide.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Reporting for Segments of an Organization Analysis of fixed expenses shows: Direct fixed expenses are incurred within a division. Common fixed expenses are incurred elsewhere and would continue even if a division is discontinued.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Reporting for Segments of an Organization Cruisers, Inc. would be worse off by $10,000 if the Repair Parts Division is discontinued. Segment margin is the Repair Parts Division’s contribution to overall operations.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Reporting for Segments of an Organization Cost Cost Center A business section that has control over the incurrence of costs, but no control over revenues or investment funds.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Reporting for Segments of an Organization Profit Center A part of the business that has control over both costs and revenues, but no control over investment funds. Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Other

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Reporting for Segments of an Organization Corporate Headquarters Investment Center A profit center where management also makes capital investment decisions.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Cost Center Actual costs compared to budgeted costs Profit Center Investment Center Actual return on investment compared to budgeted return on investment Evaluation Measures Actual segment margin compared to budgeted segment margin Methods of Evaluating Segments Segment

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Investment Centers Return on investment (ROI) is the ratio of segment margin to the investment used to generate the segment margin. ROI = Segment margin Divisional operating assets

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Investment Centers Sales Operating assets ROI = Segment margin Operating assets ROI = Segment margin Sales × Margin Turnover

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Investment Centers Cruisers, Inc. reports the following for a recent quarter: Let’s compute the margin, turnover, and ROI for Cruisers.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Investment Centers Cruisers, Inc. reports the following for a recent quarter:

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Analysis of Investment Centers  Increase Sales Prices  Decrease Expenses  Lower Invested Capital Three ways to improve ROI

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved  As Sailboat Division Manager at Cruisers, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus.  The company ROI is 12.5%, but your division is producing an ROI of 15.3%.  You have an opportunity to invest in a new project that will produce an ROI of 13.5%. As division manager, would you invest in this project? ROI and Dysfunctional Behavior

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved As division manager, I wouldn’t invest in that project because it would lower my pay! Gee... I thought we were supposed to do what was best for the company! ROI and Dysfunctional Behavior

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Segment margin less required return on operating assets Residual Income – Another Measure

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Segment margin – Required return = Residual income Operating assets × Required ROI = Required return Residual Income Let’s calculate the residual income for Cruisers, Inc. using total company information and a 10 percent required return.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Residual Income Segment margin= $150,000 – Required return= 120,000 = Residual income = $ 30,000 Operating assets= $1,200,000 × Required ROI= × 10% = Investment charge= $ 120,000 Let’s calculate the residual income for Cruisers, Inc. using total company information and a 10 percent required return.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Residual Income Now, let’s find residual income for each of the divisions.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Residual Income

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. Residual Income

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved An integrated set of performance measures that show an organization’s performance in meeting its responsibilities to various stakeholders. EmployeeStakeholderGroupInvestorStakeholderGroup The Balanced Scorecard

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Perspective How do we look to the firm’s owners? Learning and Growth Perspective How can we continually improve and create value? Internal Business Process Perspective In which activities must we excel? Customer Perspective How do our customers see us? Integrated measures The Balanced Scorecard

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved End of Chapter 15