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Chapter 11 - Lecture Notes
11-8
1. Economic Value Added (EVA®) is an
adaptation of residual income. We will not
distinguish between these two terms.
B. Calculating residual income
i. The equation for computing residual income is
as shown. Notice:
1. 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.
ii. Zepher, Inc. - an example
1. Assume the information as given for a
division of Zepher, Inc.
2. The residual income ($10,000) is computed
by subtracting the minimum required return
($20,000) from the actual income ($30,000).
C. Motivation and residual income
i. 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. More
specifically:
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Chapter 11 - Lecture Notes
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1. 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.
Quick Check – ROI versus residual income
D. Divisional comparison and residual income
i. The residual income approach has one major
disadvantage. It cannot be used to compare the
performance of divisions of different sizes.
ii. Zepher, Inc. – continued
1. Recall that the Retail Division of Zepher 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.
2. Assume that the Wholesale Division of
Zepher 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.
3. The residual income numbers suggest that
the Wholesale Division outperformed the
Retail Division because its residual income
is $10,000 higher. However:
a. 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
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Chapter 11 - Lecture Notes
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simply because it is a bigger
division.
V. Operating performance measures
Learning Objective 3: Compute delivery cycle time,
throughput time, and manufacturing cycle efficiency
(MCE).
A. Key definitions/concepts
i. Delivery cycle time is the elapsed time from when
a customer order is received to when the completed
order is shipped.
ii. Throughput (manufacturing cycle) time is the
amount of time required to turn raw materials into
completed products.
1. This includes process time, inspection
time, move time, and queue time. Process
time is the only value-added activity of the
four mentioned.
iii. Manufacturing cycle efficiency (MCE) is
computed by dividing value-added time by
throughput time.
An MCE less than 1.0 indicates that non-
value-added time is present in the
production process.
Quick Check – internal business process measures
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Chapter 11 - Lecture Notes
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VI. Balanced scorecard
Learning Objective 4: Understand how to construct and
use a balanced scorecard.
A. Key concepts
i. A balanced scorecard consists of an integrated set
of performance measures that are derived from and
support a company’s strategy. Importantly, the
measures included in a company’s balanced
scorecard are unique to its specific strategy.
ii. The balanced scorecard enables top management to
translate its strategy into four groups of
performance measures – financial, customer,
internal business process, and learning and
growth − that employees can understand and
influence.
1. The premise of these four groups of
measures is that learning is necessary to
improve internal business processes, which
in turn improves the level of customer
satisfaction, which in turn improves
financial results.
a. Note the emphasis on improvement,
not just attaining some specific
objective.
iii. The balance scorecard relies on non-financial
measures in addition to financial measures for two
reasons:
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Chapter 11 - Lecture Notes
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1. Financial measures are lag indicators that
summarize the results of past actions. Non-
financial measures are leading indicators of
future financial performance.
2. Top managers are ordinarily responsible for
financial performance measures – not lower
level managers. Non-financial measures are
more likely to be understood and
controlled by lower level managers.
iv. While the entire organization has an overall
balanced scorecard, each responsible individual
should have his or her own personal scorecard as
well.
1. A personal scorecard should contain
measures that can be influenced by the
individual being evaluated and that support
the measures in the overall balanced
scorecard.
v. A balanced scorecard, whether for an individual or
the company as a whole, should have measures that
are linked together on a cause-and-effect basis.
1. Each link can be read as a hypothesis in the
form “If we improve this performance
measure, then this other performance
measure should also improve.”
2. In essence, the balanced scorecard lays out a
theory of how a company can take concrete
actions to attain desired outcomes. If the
theory proves false or the company alters its
strategy, the measures within the scorecard
are subject to change.
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vi. Incentive compensation for employees probably
should be linked to balanced scorecard
performance measures.
1. However, this should only be done after the
organization has been successfully managed
with the scorecard for some time – perhaps
a year or more. Managers must be
confident that the measures are reliable, not
easily manipulated, and understandable by
those being evaluated with them.
B. The balanced scorecard – an example
i. Assume that Jaguar pursues a strategy as shown
on this slide. Examples of measures that Jaguar
might select with their corresponding cause-and-
effect linkages include:
1. If “employee skills in installing options”
increases, then the “number of options
available” should increase and the “time to
install an option” should decrease.
2. If the “number of options available”
increases and the “time to install an
option” decreases, then “customer
surveys: satisfaction with options
available” should increase.
3. If the “customer surveys: satisfaction with
options available” increases, then the
“number of cars sold” should increase.
4. If the “time to install an option” decreases
and the “customer surveys: satisfaction
with options available” increases, then the
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Chapter 11 - Lecture Notes
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“contribution margin per car” should
increase.
5. If the “number of cars sold” and the
“contribution margin per car” increase,
then the “profit” should increase.
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