Chapter 14 – Business Unit Performance Measurement
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Example 3 (Continued from Example 1): Health Quest faces 12% of cost of capital.
The Western Division of Health Quest currently earns an after-tax income of $400,000
based on assets of $2,000,000. Its residual income can be calculated as follows.
RIWestern Division = $400,000 – 12% × $2,000,000 = $160,000.
A proposal under consideration will generate an estimated after-tax income of $80,000
for the division with an infusion of $500,000 from the head office. Its residual income
will be $20,000, or
RIProposal = $80,000 – 12% × $500,000 = $20,000.
The combined RI will be $180,000, or
RICombined = ($400,000 + $80,000) – 12% × ($2,000,000 + $500,000)
= $160,000 + $20,000
= $180,000.
The manager of the Western Division should consider accepting any project that
produces positive RI. The proposal under consideration meets the criterion. Both the
division and the head office of Health Quest will benefit from the decision.
• Residual income does not eliminate the suboptimization problem. The analysis in
Exhibit 14.8 shows that there is still a conflict between the decision criterion, net present
value, and the performance measure, residual income.
• Residual income, like ROI, is based on divisional income and suffers from the same
problem of myopia as ROI.
• One approach to reducing the problem of managerial myopia is to modify divisional
income so that it better reflects economic performance, such as EVA.
LO 14-4 Interpret and use economic value added (EVA).
♦ Economic value added (EVA®) is defined as the annual after-tax (adjusted) divisional income
minus the total annual cost of (adjusted) capital. That is,
EVA = (After-tax income ± adjustments) – (Divisional investments ± adjustments).
Chapter 14 – Business Unit Performance Measurement
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• EVA is a concept closely related to residual income. However, it makes adjustments to
after-tax income and capital to eliminate accounting distortions, including the treatment
of inventory costs, the expensing of many intangibles, and so on.
Example 4: Generally accepted accounting principles require the expensing of research
and development (R&D) expenditures in the U.S. Managers who are evaluated using
accounting income-based measures are less motivated to invest in R&D. One
adjustment is to capitalize the expenditure and amortize it over the economic life of the
project.
A related adjustment applies to the capital employed. For capitalized R&D, the portion
of its expenditures not included in income is recorded on the balance sheet and
represents additional investment in the business unit. A second adjustment is to deduct
current liabilities that do not represent debt from the calculation of capital.
Many implementations of EVA differ in the details of the computations, however.
• The computations of EVA are exactly what would be made if the accountant mistakenly
recorded the entire cost of a machine as an expense instead of properly recording it as an
asset and then depreciating it over its useful life.
======================
Demonstration Problem 4
Pharma Inc. has two product lines organized as divisions (Pain Reliever and Weight Loser) and
spends heavily on research and development (R&D) activities. The following information is
related to Pharma Inc.’s second year of operations.
Pain Reliever
Weight Loser
R&D expenditures (second year)
$450,000
$300,000
After-tax income
275,000
$210,000
Current liabilities
584,000
397,000
Divisional investment
1,365,000
982,000
Cost of capital
23%
23%
Chapter 14 – Business Unit Performance Measurement
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In the first year, Pain Reliever spent $300,000 on R&D, while Weight Loser spent $150,000.
Pharma Inc. estimates that R&D expenditures have a three-year life to be amortized according to
the following schedule:
1/6 in the year incurred, 1/3 in the next two years, and 1/6 in the fourth year after the initial
spending.
Required:
Calculate EVA for the two divisions of Pharma Inc. for its second year of operations.
Solution:
The after-tax income is adjusted for R&D expenditure to reflect its (potential) future benefits.
The capital is adjusted for current liabilities that do not represent debt from the calculation of
capital, as well as for the unamortized portion of R&D that represents additional investment
in the business unit.
Pain Reliever
Weight Loser
After-tax income
$275,000
$210,000
Add: R&D expenditure
450,000
300,000
Income before amortization
$725,000
$510,000
Less: Amortization of R&D
175,000a
100,000a
Adjusted divisional income
$900,000
$410,000
Divisional investment
$1,365,000
$982,000
Less: Current liabilities
584,000
397,000
Net investment
$781,000
$585,000
Add: Unamortized R&D
250,000b
125,000b
Adjusted divisional investment
$1,031,000
$710,000
EVA®
$662,870c
$246,700c
a $300,000 × 1/3 + $450,000 × 1/6 = $175,000;
$150,000 × 1/3 + $300,000 × 1/6 = $100,000.
b $300,000 – $50,000 amortization ($300,000 × 1/6) = $250,000;
$150,000 – $25,000 amortization ($150,000 × 1/6) = $125,000.
c $900,000 – 0.23 × $1,031,000 = $662,870;
$410,000 – 0.23 × $710,000 = $246,700.
======================
• Conceptually, EVA addresses problems associated with ROI and residual income.
Chapter 14 – Business Unit Performance Measurement
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• EVA is not a ratio, so managers are willing to invest in projects as long as EVA is
positive.
• EVA corrects for many of the accounting distortions that make the other measures
myopic.
• The difficulty with EVA is that it replaces one accounting system for another. The
implementation could be problematic.
• EVA also does not resolve the suboptimization problem. The fundamental issue is that
EVA is based on accounting income while the decision to invest is based on present
value of cash flows.
• There is very little systematic evidence on whether using EVA for evaluating business
unit managers affects decision making.
♦ All accounting-based performance measures (divisional income, ROI, residual income, and
EVA) will have limitations because of the inherent problem of measuring economic performance,
including future opportunities and costs, with accounting systems that rely on observed (past)
transactions.
LO 14-5 Explain how historical cost and net book value-based accounting
measures can be misleading in evaluating performance.
♦ Effective business unit performance assessment requires a measurement of the divisional assets.
• Three general issues are frequently raised in measuring investment bases:
(1) Should gross book value be used?
(2) Should investment in assets be valued at historical cost or current value?
(3) Should investment be measured at the beginning or at the end of the year?
• When ROI is used in conjunction with the net book value method, the ROI increases
each year even though no operating changes take place. The reason is that the numerator
remains constant while the denominator decreases each year as depreciation accumulates.
See Exhibit 14.10 for a comparison of ROI under net book value and gross book value.
♦ Historical cost is the original cost to purchase or build an asset. Current cost is the cost to
replace or rebuild an existing asset.
Chapter 14 – Business Unit Performance Measurement
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• ROI increases each year under the historical cost method even though no operating
changes take place because the numerator is measured in current dollars to reflect current
cash transactions while the denominator and depreciation charges are based on historical
cost.
• The current cost method reduces the effect by adjusting both the depreciation in the
numerator and the investment base in the denominator to reflect price changes.
• See Exhibit 14.11 for a comparison of ROI under the historical cost and the current cost.
• Measuring current costs can be a difficult and expensive task.
• A level ROI is derived in the current cost, gross book value method because the asset
and all other prices increased at the same rate.
• If inflation affecting cash flows in the numerator increases faster (slower) than the
current cost of the asset in the denominator, ROI will increase (decrease) over the years
until asset replacement under the current cost method.
• Surveys of corporation practice show that the vast majority of companies with
investment centers used historical cost net book value.
• In general, how a performance measure is used is more important than how it is
calculated. As long as the measurement method is understood, it can enhance
performance evaluation.
♦ Using the beginning balance of the investment base could encourage asset acquisitions early in
the year to increase income for the entire year. Asset dispositions would be encouraged at the
end of the year to reduce the investment base for next year.
• If end-of-year balances are used, similar incentives exist to manipulate purchases and
acquisitions.
• Average investments would tend to minimize the problem, although it may be more
difficult to compute.
♦ Divisional income, ROI, residual income, and EVA are all financial performance measures that
consider the activities of the business unit independently of other units in the firm.
• Measuring the manager only on the basis of the division’s results risks suboptimal
decision making as the manager ignores the effect of the decisions on other business units.
Chapter 14 – Business Unit Performance Measurement
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• Transfer prices are discussed in Chapter 15 as to how they can help the performance
measurement of business units by signaling the value of the good or service being
exchanged between units to each of the business unit managers.
• Nonfinancial measures of performance are discussed in Chapter 18.
Matching
A.
Cost of capital
F.
Gross margin ratio
B.
Cost of invested capital
G.
Historical cost
C.
Current cost
H.
Operating margin ratio
D.
Divisional income
I.
Profit margin ratio
E.
Economic value added
J.
Residual income
K.
Return on investment
_____ 1. The original cost to purchase or build an asset.
_____ 2. The cost to replace or rebuild an existing asset.
_____ 3. The annual after-tax (adjusted) divisional income minus the total annual cost of
(adjusted) capital.
_____ 4. The excess of actual profit over the cost of invested capital in the unit.
_____ 5. Measures the investment in the division.
_____ 6. Represents the opportunity cost of the resources invested (debt and equity capital) in
the business.
_____ 7. (Divisional revenues – Divisional costs).
_____ 8. The ratio of profits to investment in the asset that generates those profits.
_____ 9.
Sales
margin Gross
.
_____ 10.
After-tax income
Sales
.