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)
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Return On Investment (ROI)
Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI.
Learning objective number 2 is to compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI.

6. Return on Investment (ROI) Formula
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Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)
ROI =
Net operating income
Average operating assets
An investment center’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as net operating income divided by average operating assets.
Net operating income is income before taxes and is sometimes referred to as earnings before interest and taxes (EBIT). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes.
Net operating income is used in the numerator because the denominator consists only of operating assets.
The operating asset base used in the formula is typically computed as the average operating assets (beginning assets + ending assets) divided by 2.
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets.

7. Net Book Value versus Gross Cost
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Most companies use the net book value of depreciable assets to calculate average operating assets.
Most companies use the net book value (i.e., acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets. With this approach, ROI mechanically increases over time as the accumulated depreciation increases. Replacing a fully-depreciated asset with a new asset will decrease ROI.
An alternative to using net book value is the use of the gross cost of the asset, which ignores accumulated depreciation. With this approach, ROI does not grow automatically over time, rather it stays constant; thus, replacing a fully-depreciated asset does not adversely affect ROI.

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. Average operating assets Average operating assets
Understanding ROI
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ROI =
Net operating income
Average operating assets
Margin =
Net operating income
Sales
Turnover =
Sales
Average operating assets
DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover.
Margin is computed as shown and is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned.
Turnover is computed as shown. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI.
ROI =
Margin  Turnover

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
Minimum return of 10%

11. Margin and Turnover Comparisons
Snack Food Appliance
Year 1 Year 2 Year 1 Year 2
Margin 6.0% 5.0% 3.0% 2.5%
Turnover x x x x 6.0
ROI % 20.0% 18.0% 15.0% === === === ===

12. There are three ways to increase ROI . . .
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Increasing ROI
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There are three ways to increase ROI . . .
Reduce
Expenses
Increase
Sales
Reduce
Assets
Any increase in ROI must involve at least one of the following – increased sales, reduced operating expenses, or reduced operating assets.

13. Increasing ROI – An Example
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Increasing ROI – An Example
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Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000
What is Regal Company’s ROI?
Assume that Regal Company reports net operating income of $30,000; average operating assets of $200,000; sales of $500,000; and operating expenses of $470,000. What is Regal Company’s ROI?
ROI =
Margin  Turnover
Net operating income
Sales
Average operating assets ×
ROI =

14. Increasing ROI – An Example
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Increasing ROI – An Example
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ROI =
Margin  Turnover
Net operating income
Sales
Average operating assets ×
ROI =
$30,000
$500,000 ×
$200,000
ROI =
Given this information, its current ROI is 15%.
6%  2.5 = 15%
ROI =

15. Investing in Operating Assets to Increase Sales
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Investing in Operating Assets to Increase Sales
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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
Suppose that Regal's manager invests $30,000 in a piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000.
Let’s calculate the new ROI.
Let’s calculate the new ROI.

16. Investing in Operating Assets to Increase Sales
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Investing in Operating Assets to Increase Sales
ROI =
Margin  Turnover
Net operating income
Sales
Average operating assets ×
ROI =
$50,000
$535,000 ×
$230,000
ROI =
In this case, the ROI increases from 15% to 21.8%.
9.35%  2.33 = 21.8%
ROI =
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 In the absence of the balanced
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Criticisms of ROI
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.
Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI in a manner that is consistent with the company’s strategy.
This is why ROI is best used as part of a balanced scorecard. A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. This may make it difficult to assess this manager relative to other managers.
A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager’s performance evaluation.
Managers evaluated on ROI
may reject profitable
investment opportunities.

20. Compute residual income and understand its strengths and weaknesses.
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Residual Income
Compute residual income and understand its strengths and weaknesses.
Learning objective number 3 is to compute residual income and understand its strengths and weaknesses.

21. Residual Income - Another Measure of Performance
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Residual Income - Another Measure of Performance
Net operating income
above some minimum
required return on operating assets
Residual income is the net operating income that an investment center earns above the minimum required return on its assets.
Economic Value Added (EVA) is an adaptation of residual income. We will not distinguish between the two terms in this class.

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
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Calculating Residual Income ( )
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.
The equation for computing residual income is as shown. Notice that this computation differs from ROI. 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
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
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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.
Assume the information for a division of Zephyr, Inc. is as follows. 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.
Let’s calculate residual income.
Let’s calculate residual income.

27. Residual Income – An Example
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Residual Income – An Example
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The residual income of $10,000 is computed by subtracting the minimum required return of $20,000 from the actual income of $30,000.

28. Motivation and Residual Income
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Motivation and Residual Income
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.
The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using the ROI formula.
It motivates managers to pursue investments where the ROI associated with those investments exceeds the company’s minimum required return but is less than the ROI being earned by the managers.

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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%
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?

30. 10-30
Quick Check 
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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%
The ROI is 20%.
ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%

31. 10-31
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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
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?

32. This lowers the division’s ROI from 20.0% down to 19.5%.
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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
No, she would not want to invest in this project because its return is 18%, which would reduce her division’s ROI from 20% to 19.5%.
ROI = $78,000/$400,000 = 19.5%
This lowers the division’s ROI from 20.0% down to 19.5%.

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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
The company’s required rate of return is fifteen percent. 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?

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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
ROI = $18,000/$100,000 = 18%
The return on the investment exceeds the minimum required rate of return.
Yes, she would want to invest in this project because the return on the investment exceeds the minimum required rate of return.

35. 10-35
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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
Review this question. What is the division’s residual income?

36. 10-36
Quick Check 
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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
The residual income is $15,000.

37. 10-37
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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
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?

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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
Yes, she would want to invest in this project because it will increase the residual income by $3,000.

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

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Zephyr, Inc. - Continued
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Assume the following information for the Wholesale Division of Zephyr, Inc.
Recall the following information for the Retail Division of Zephyr, Inc.
Recall that the Retail Division of Zephyr had average operating assets of $100,000, a minimum required rate of return of 20%, net operating income of $30,000, and residual income of $10,000.
Assume that the Wholesale Division of Zephyr had average operating assets of $1,000,000, a minimum required rate of return of 20%, net operating income of $220,000, and residual income of $20,000.

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Zephyr, Inc. - Continued
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The residual income numbers suggest that the Wholesale Division outperformed the 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.
The residual income numbers suggest that the Wholesale Division outperformed the 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. The equation for EVA is expressed as follows:
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:
Amount Percent x After-Tax Cost = Weighted Cost
Bonds $2,000, ( ) =
Equity ,000, =
Total $8,000,
======== =====

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:
Amount Percent x After-Tax Cost = Weighted Cost
Common stock $10,000,
Mortgage bonds ,000,
Unsecured bonds 3,000,
Total $15,000,
========= ====

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