978-0077733773 Chapter 19 Cases Part 3

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Chapter 19 – Strategic Performance Measurement: Investment Centers
ROI for the entire firm (absent any efficiency gains) was left unchanged by the transfers, 11.76% (see
Table 6).
The practice continued in year two (see Table 4): two segments were transferred from Jill’s division to
3. Can you think of any other shortcomings of using a relative, compared to an absolute, measure
of financial performance? (For those instructors who have covered the topic of capital
budgeting, you might make reference here to the difference between two discounted cash flow
[DCF] decision models: NPV and IRR.)
We know from the discussion in Chapter 19 that relative performance measures, such as ROI, are
subject to manipulation by managers on two fronts: the numerator and the denominator. That is, we
know that when a manager’s performance is assessed using ROI he/she has strong incentives to
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Chapter 19 – Strategic Performance Measurement: Investment Centers
Reading 19-4: “A Better Way to Gauge Profitability” by David C. Burns, J.
Timothy Sale, and Jens A. Stephan, Journal of Accountancy (August 2008), pp. 38-
42. (Available on-line at:
http://www.journalofaccountancy.com/Issues/2008/Aug/ABetterWaytoGaugeProfit
ability.htm).
This article offers and extension to the original “Du Pont” formula for calculating return on equity (ROE).
While the discussion in chapter 19 focuses on organizational subunits classified as investment centers, the
analysis of ROE would be relevant when the investment center is defined as a subsidiary or as an entire
company. The goal of the expanded approach suggested by the authors of this article is to better isolate
operating performance. The measure they propose in this regard is referred to as “return on net operating
assets” (RNOA).
Discussion Questions
1. Why is the issue of financial ratio analysis of interest to accountants and auditors?
(a) Ratios represent an efficient way to summarize a mass of performance-related data.
(b) Financial managers can use ratios to benchmark the performance of their company against that of
(BSC).
2. Describe the original Du Pont formula (ratio) for assessing financial performance. What are the
major components of the ratio, and what information is conveyed by each of these components?
The original Du Pont formula focuses on a decomposition of an entity’s return on equity (ROE).
Thus, ROE is depicted as a function of: return on assets (ROA) and financial leverage. ROA can be
defined as net income (NI) divided by total assets (or, average total assets over a given period), while
financial leverage is measured as the ratio of assets to equity.
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3. What do the authors allege is the primary deficiency of the original Du Pont formula?
The authors maintain that the original Du Pont formula (see #2 above) failed to adequate distinguish
4. Describe what the authors call their “advanced” version of the Du Pont formula. In what sense
does this revised ratio address the issue specified above in (3)?
The core concept introduced in the advanced version of the Du Pont formula is “return on net
operating assets” (RNOA); RNOA, according to the authors, provides a better indication of operating
performance in the sense that this measure is independent of leverage effects. From a controllability
(i.e., behavioral) perspective, this adjustment is clearly desirable: operating managers typically do not
have control over decisions related to capital structure (i.e., the issuance of debt versus equity
Thus, ROE = (income before interest/assets) + [(RNOA Interest rate on debt) × (interest bearing
debt ÷ equity)]
Note that with the above specification pure operating performance is represented as RNOA, a metric
that is unaffected by the mix between debt and equity (FLEV) and independent of the spread between
the rate of return on net operating assets and the effective interest rate paid by the company on
borrowed funds. Naturally, however, both FLEV and Spread affect an entity’s return on equity (ROE),
which is obvious from the above formula.
5. What is the relationship between ROI (discussed in Chapter 19) and ROE? What is the
relationship between ROI and RNOA (as defined in this article)?
ROI (return on investment) can be calculated either for a company as a whole or for major subunits
classified for performance-assessment purposes as “investment centers.” In both cases, the ratio is
defined as some measure of earnings (i.e., “return”) to some measure of invested capital (such as total
assets, or average total assets). Thus, ROI = income ÷ assets.
In chapter 19 we did not discuss ROE as a summary financial performance metric for investment
centers. Rather, ROE is a metric that would be of interest to the company as a whole, not its subunits.
In particular, ROE is of interest to common shareholders.
Pont model, and the latter in the “advanced” Du Pont model.
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Chapter 19 – Strategic Performance Measurement: Investment Centers
Reading 19-5: “Probing Financial Statements in a Post-Sarbanes-Oxley World” by
Carlos A. De Mello-e-Souza and Vidya N. Awasthi, Strategic Finance (April
2009), pp. 37-45.
This article recommends a broadened view of the process of financial analysis, to include (in addition to
conventional ratio analysis) issues of accounting quality and security valuation. This expanded
framework for analysis is applied to three publicly held companies: Wal-Mart, Costco, and Target.
(Notes: Because of the linkage to valuation, this paper could be assigned in conjunction with text Chapter
20. Also, note that two of the three companies examined in this paper are the ones whose performance
was analyzed in Reading 19-4. As such, the instructor might want to assign these two readings as a pair.)
Discussion Questions
1. According to the author of this article, what are the four steps (or stages) that are used
conventionally in the analysis of a company’s financial statements?
a) Stage One—Preliminary Data Adjustments (to achieve uniformity of data across different
companies)
b) Stage Two—Ratio Analysis (using the adjusted data produced in Stage One as well as market-
2. The author of this article examines the financial performance of Wal-Mart over the period
1998-2007. How do the four performance indicators for Wal-Mart over this period compare to
those of its two primary competitors, Costco and Target?
Accounting Rates of Return
Profitability Measures
From 1998 through 2007, the average profit margins of the three companies was as follows: Wal-
Mart, 4%; Target, 5%; and Costco, 2%. Part of the reason for the lower performance of Wal-Mart is
given in Figure 4 and the related discussion taken from the MD&A (management discussion and
analysis) section of various Wal-Mart financial reports.
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Chapter 19 – Strategic Performance Measurement: Investment Centers
Asset Productivity (Turnover)
Turnover is a measure of how productively each organization used its assets to generate sales volume.
Segment Footnotes
Segment footnotes, and related data regarding domestic versus international segment performance,
provides a clue as to the decline in some of Wal-Mart’s performance measures, most notably its asset
productivity and its return on assets (ROA). While the profitability of Wal-Mart’s international
segment improved over the period 2000 through 2007, the performance of this segment still lagged
behind the performance of its domestic segment. More detailed data regarding this issue is presented
in Table 2 and in Figure 6.
Accounting Quality
As noted in Figure 7, for all three entities reported earnings (from continuing operations) did not
grow out of proportion with operating cash flows, providing some evidence regarding the “quality” of
the accounting numbers reported over time by each company. The general point to make to students is
the objective of determining whether and to what extent a company under analysis engaged in
accounting manipulations. (The recent allegations against GE for engaging in such behavior can be
used as a good example.)
3. What does the author of this article suggest as disclosure-related issues associated with the
valuation scenarios reflected in Table 3?
Table three presents a sensitivity analysis regarding “fair values” of Wal-Mart stock (as of January 31,
2008) as a function of assumptions regarding two value-related factors: (1) growth rate in sales, and
(2) profitability, measured as return on assets (ROA). On the basis of this sensitivity analysis, the
author raises the following two disclosure-related issues:
(1) In any scenario at or above steady-state growth, the market seemed to be undervaluing Wal-Mart
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Chapter 19 – Strategic Performance Measurement: Investment Centers
Reading 19-6: Transfer Prices: Functions, Types, and Behavioral Implications,”
by Peter Schuster and Peter Clarke, Management Accounting Quarterly (Winter
2010), pp. 22-32.
Transfer prices affect the profit reported in each responsibility center of a company and can be used to
influence decision making. Showing a variety of examples, the authors describe the functions and types of
transfer prices and discuss the possible behavioral consequences of using them.
Discussion Questions
1. What is the connection between the theory of decentralization and the use of transfer pricing?
Organizations decentralize, that is, diffuse decision-making authority to lower levels of the
organization, because they believe that this organizational design choice results in improved long-term
performance. This can be attributed to increased motivation and other behavioral effects. However, all
design choices have associated costs: one of the most significant cost associated with a decentralized
organizational structure is the need to develop and implement an effective monitoring system—how
2. Evaluate the advantages and disadvantages of each of the following three transfer pricing
choices: marked-based transfer prices, cost-based transfer prices, and negotiated transfer prices.
Market-Based Transfer Prices
Advantages
1. Market-based transfer prices are consistent with the theory of decentralization.
2. Market-based transfer prices yield useful information regarding the profitability of individual
subunits.
Figure 1 in the article shows that using an external market price for the intermediate-product
transfer between subunits is consistent with the theory of decentralization and, further,
Figure 2 of the article presents a situation where the incremental production cost per unit in
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