Chapter 14 – Business Unit Performance Measurement
14-1
Chapter 14
Business Unit Performance Measurement
Learning Objectives
1. Evaluate divisional accounting income as a performance measure.
2. Interpret and use return on investment (ROI).
3. Interpret and use residual income (RI).
4. Interpret and use economic value added (EVA).
5. Explain how historical cost and net book value-based accounting measures can be
misleading in evaluating performance.
Chapter Outline
I. DIVISIONAL PERFORMANCE MEASUREMENT
II. ACCOUNTING INCOME
A. Computing divisional income
B. Advantages and disadvantages of divisional income
C. Some simple financial ratios
III. RETURN ON INVESTMENT
A. Performance measures for control: A short detour
B. Limitations of ROI
1. Short-term focus (myopia) from accounting information
2. Conflicting incentives for managers (Suboptimization)
IV. RESIDUAL INCOME MEASURES
♦ Limitations of residual income
V. ECONOMIC VALUE ADDED (EVA)
♦ Limitations of EVA
VI. DIVISIONAL PERFORMANCE MEASUREMENT: A SUMMARY
VII. MEASURING THE INVESTMENT BASE
A. Gross book value versus net book value
B. Historical cost versus current cost
C. Beginning, ending, or average balance
VIII. OTHER ISSUES IN DIVISIONAL PERFORMANCE MEASUREMENT
IX. SUMMARY
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Key Concepts
LO 14-1 Evaluate divisional accounting income as a performance measure.
♦ “Division” is a common term for an investment center (or a business unit) whose manager is
responsible for asset deployment, at least to some extent, in addition to revenue and cost
responsibility.
• What to consider when performance measures are developed?
(1) Is the performance measure consistent with the decision authority of the manager?
(2) Does the measure reflect the results of the actions that improve the performance of the
organization?
(3) What actions can the manger take that improve reported performance, but are
detrimental to organizational performance?
• No performance measurement system perfectly aligns the manager’s and organization’s
interests.
• Possible dysfunctional decisions made by managers must be considered when designing
the system.
• Divisional measures are more important (relative to firm measures) when the division’s
accounting measure correlates highly with the relevant industry’s price-earnings ratio.
• The role of divisional measures decreased with the extent to which the manager’s
decisions affected the performance of other divisions.
♦ Because divisions have both revenue and cost responsibility, an obvious performance measure
is accounting income (divisional income).
• Divisional income = Divisional revenues – Divisional costs.
• Divisional income serves as a useful summary measure of performance by equally
weighting the division’s performance on revenue and cost activities.
• Divisional income statements are not subject to compliance with generally accepted
accounting principles (GAAP).
• Exhibit 14.1 shows an example of divisional income statements.
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• Many firms are organized into geographical responsibility units. Another common basis
for organization is product line.
• Advantages of using after-tax income as a performance measure are:
(1) It is easy to understand, prepared in the same way as the firm’s income.
(2) It reflects the results of decisions under the division manager’s control.
(3) It summarizes the results of decisions affecting revenues and costs.
(4) It makes comparison of divisions easy because they use the same measure, dollars of
income.
• Disadvantages of using divisional income as a performance measure are:
(1) While the results of the divisions can be compared, it is not clear that the comparison
reflects only the performance of the managers. The divisions may be of different sizes.
(2) The measure does not fully reflect the manager’s decision authority, especially the
effect of asset decisions. When such an inconsistency exists, it is likely that the
management control system might not be effective.
♦ When the divisions are different in sizes, the use of financial (profitability) ratios may improve
comparison. Three profitability ratios are suggested.
(1) Gross margin ratio =
Sales
margin Gross
.
• Gross margin = Revenues – Cost of goods sold.
• The gross margin ratio reflects the performance of the manager regarding sales and the
cost of goods sold.
• Gross margin ratio ignores costs other than the cost of goods sold.
(2) Operating margin ratio =
Sales
income Operating
.
• The operating margin ratio is a more comprehensive performance measure because it
includes the effect of not only the cost of goods but also operating costs.
(3) Profit margin ratio =
After-tax income
Sales
.
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• The profit margin ratio includes the effect of divisional activities on taxes.
• None of these adjustments to the divisional income (for size differences) addresses the
omission of asset usage in the performance measure.
======================
Demonstration Problem 1
Health Quest operates fitness centers and organizes its operations into three geographical areas:
Western, Midwestern, and Eastern Divisions. The following shows Health Quest’s divisional
income statements from last year.
Western
Division
Midwestern
Division
Eastern
Division
Sales
$2,800,000
$2,226,000
$3,391,060
Cost of sales
1,497,000
1,201,000
1,648,059
Gross margin
$1,303,000
$1,025,000
$1,743,001
Operating expenses
503,000
385,000
663,000
Allocated corporate overhead
228,571
182,857
308,572
Operating income
$571,429
$457,143
$771,429
Income tax (30%)
171,429
137,143
231,429
After-tax income
$400,000
$320,000
$540,000
Required:
Calculate the gross margin ratio, the operating margin ratio, and the profit margin ratio for
the three divisions of Health Quest.
Solution:
Western
Division
Midwestern
Division
Eastern
Division
Gross margin ratioa
46.54%
46.05%
51.40%
Operating margin ratiob
20.41%
20.54%
22.75%
Profit margin ratioc
14.29%
14.38%
15.92%
a Gross margin ratio = Gross margin / Sales.
b Operating margin ratio = Operating income / Sales.
c Profit margin ratio = After-tax income / Sales.
Eastern Division consistently outperformed the other two divisions across all three measures.
Operating margin ratio and profit margin ratio provided the same ranking while gross margin
ratio ranked Western Division higher than Midwestern Division.
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======================
LO 14-2 Interpret and use return on investment (ROI).
♦ Return on investment (ROI) =
After-tax income
Divisional Assets
.
• Return on investment is the ratio of profits to investment in the asset that generates
those profits.
• The manager can use the beginning-of-the-year, end-of-year, or average investment as
the base for the ROI calculation.
• Return on investment is an effective performance measure for managers with
responsibility for asset acquisition, usage, and disposal.
• Exhibit 14.4 shows the calculation of ROI based on information from Exhibit 14.1
(Divisional income statements) and Exhibit 14.3 (Divisional balance sheets).
♦ Return on investment can be used to highlight areas of the business that require attention. That
is, ROI can also play a role in the function of control.
• ROI can be decomposed into two components (profit margin ratio and asset turnover)
by introducing sales in the following formula:
ROI
=
After-tax income
Sales
×
Sales
Divisional Assets
=
Profit margin ratio
×
Asset turnover.
• The profit margin ratio is a measure of the investment center’s ability to control its costs
for a given level of revenues.
• The asset turnover ratio is a measure of the investment center’s ability to generate sales
for each dollar of assets invested in the center.
• By decomposing ROI, managers can anticipate where problems will occur in achieving
acceptable ROIs and can take actions early.
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• Declining profit margins suggest the need to implement cost controls; lower asset
turnover suggests the need to review asset utilization.
• Capital is a scarce resource. If one unit of a company shows a low return, the capital
could be better employed in another unit where the return is higher, invested elsewhere,
or paid to stockholders.
• Relating profits to capital investment provides an intuitive scale for measuring
performance.
======================
Demonstration Problem 2
(Continued from Demonstration Problem 1)
The divisional balance sheets of Health Quest showed the investment bases (divisional assets) as
follows.
Division
Divisional Assets
Western Division
$2,000,000
Midwestern Division
1,720,000
Eastern Division
2,550,000
Required:
Calculate ROI and its associated profit margin ratio and asset turnover ratio for the three
divisions of Health Quest.
Solution:
Western
Division
Midwestern
Division
Eastern
Division
ROIa
20.00%
18.60%
21.18%
Profit margin ratiob
14.29%
14.38%
15.92%
Asset turnoverc
1.4
1.29
1.33
a ROI = After-tax income ÷ Divisional assets.
b Profit margin ratio = After-tax income ÷ Sales.
c Asset turnover = Sales ÷ Divisional assets.
======================
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♦ Two major limitations of ROI are:
(1) Short-term focus: Because accounting results are based on historical information, measures
of profit and investment base tend to focus on current activities, which are myopic.
(2) Suboptimization: The use of ROI can give incentives to managers that lead to lower
organizational performance. Using ROI can lead the manager to make suboptimal decisions.
• One advantage of using ROI is that the information needed to compute it already exists
in the accounting records.
• Accounting information, however, does not reflect the change in value as a result of the
division manager’s actions because of three general problems.
(1) Accounting income, the numerator in ROI, is “backward–looking.” That is, it
reflects what has happened, but does not include all changes in value that will
happen as a result of the decisions that managers make.
(2) Accounting treatment of certain expenditures, especially expenditures on
intangible assets such as research and development, advertising, and leases, often
results in recording the entire expenditure as an expense in the period it is made.
The potential long-term returns from these expenditures are not registered.
(3) Accounting convention treats many sunk costs as providing benefits in the future
even after the assets are no longer used.
• A more serious problem with ratio-based measures is that managers can make decisions
that lower organizational performance, but increase the manager’s reported performance.
• As a performance measure, ROI (a ratio) is not consistent with the investment analysis
based on the net present value calculation (which generates absolute numbers). Therefore,
ROI does not provide a signal that is consistent with the decision criteria used for the
investment decision.
• Using ROI as the performance measure may lead to a situation where the division
performing more poorly, according to ROI, has the incentive to make the most
investment.
• A manager who considers adopting a new project will calculate the ROI as the weighted
average of the ROI of the project and the ROI of the division without the project. The
weights are the relative investments in the new project and the division prior to the
project.
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Example 1: The Western Division of Health Quest currently enjoys a 20 percent ROI
based on after-tax income of $400,000 and invested assets of $2,000,000. That is,
ROIWestern Division =
$400,000
$2,000,000
= 20%.
The manager of the Western Division looks to expand into the northwestern part of the
country. One proposal under consideration will generate an estimated after-tax income
of $80,000 with an infusion of $500,000 from the head office. The proposal alone will
generate ROI of 16%, or
ROIProposal =
$80,000
$500,000
= 16%.
The manager, whose bonus depends on maintaining or improving her division’s ROI,
is reluctant to proceed. Her concern is justified by the combined ROI, calculated below.
ROICombined =
$400,000 $80,000
$2,000,000 $500,000
= 19.2%.
The combined ROI, a weighted average of the ROI of the proposal and the ROI of the
division without the proposal, is lower than what the Western Division has achieved so
far.
Because ROI measure is a ratio, the manager of the Western Division is expected to
reject the proposal even though it may bring in positive contributions to her division
and the company.
• Any project with an ROI below that of the division without the project will lower the
division’s reported performance. A manager compensated on annual ROI performance
could choose not to adopt a project that increases firm value.
• Many companies continue to use ROI despite its limitations. The potential for managers
having incentives to take actions that are not in the organization’s interest must be
recognized in designing the performance measurement system.
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LO 14-3 Interpret and use residual income (RI).
♦ Residual income is defined as the excess of actual profit over the cost of invested capital in the
unit. That is,
Residual income = After-tax income – Cost of invested capital.
• Cost of invested capital measures the investment in the division. It is the cost of the
investment required to operate the division.
Cost of invested capital = Cost of capital × Divisional assets.
• Cost of capital represents the opportunity cost of the resources invested (debt and
equity capital) in the business. It is the payment required to finance projects.
Example 2: Operationally, the cost of capital is a weighted average of interest rates
from the sources of capital – debt and equity. The cost of debt is the interest paid,
which is tax deductible. The cost of equity represents stockholders’ opportunity cost of
not being able to invest their money elsewhere, which does not have tax implications.
The weights are determined by the relative proportion of debt and equity in the capital
structure.
Consider a company with three sources of capital: $1,000,000 in mortgage bonds with
8% interest rate, $2,000,000 in unsecured bonds with 10% interest rate, and $3,000,000
in common stock with opportunity cost of 12% for the stockholders. The tax rate is
assumed to be 30%. Then the cost of capital can be calculated as follows.
Capital
Weight
(1)
After-tax rate
(2)
Cost of capital
(1) × (2)
Mortgage bond
$1,000,000
16.7%
8% × (1 – 30%)
1.0%
Unsecured bond
2,000,000
33.3%
10% × (1 – 30%)
2.3%
Common stock
3,000,000
50.0%
12%
6.0%
$6,000,000
9.3%
• Residual income is similar to economist’s notion of profit as being the amount left over
after all costs, including the cost of the capital employed in the business unit, are
subtracted.
• Exhibit 14.7 shows a calculation of the residual income.
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Chapter 14 – Business Unit Performance Measurement
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Demonstration Problem 3
(Continued from Demonstration Problems 1 and 2)
Required:
Calculate the residual income for the three divisions of Health Quest, assuming a 12% cost of
capital.
Solution:
Western
Division
Midwestern
Division
Eastern
Division
After-tax income
$400,000
$320,000
$540,000
Divisional assets
2,000,000
1,720,000
2,550,000
Residual Income
$160,000a
$113,600
$234,000
a Residual income = $400,000 – 12% × $2,000,000 = $160,000.
======================
• One advantage of residual income over ROI is that it is not a ratio. Managers evaluated
using the residual income will invest only in projects that increase residual income.
• Residual income reduces the suboptimization problem, as seen in Exhibit 14.8. The
residual income for the division is the sum of the residual income for the project and the
residual income for the division prior to the investment in the project.