14
Business Unit Performance Measurement
Solutions to Review Questions
14–1.
Divisional income is relatively easy to compute because the data exist for financial
14–2.
The basic computations are the same. Because divisional income is not reported, the
14–3.
ROI = (After-tax income ÷ Divisional assets).
14–4.
14–5.
There are two common situations. First, managers might choose not to invest in
14–6.
14-7.
EVA® makes adjustments to income and investment to correct accounting calculations
14–8.
14–9.
The danger is that you will ignore the interdependence of the business units. No
Solutions to Critical Analysis and Discussion Questions
14–10.
14–11.
14–12.
Two problems usually arise here:
(a) The division might be encouraged to produce in volumes in excess of sales. In this
14–13.
There are two common situations. First, managers might choose not to invest in
14–14.
Residual income measures depend upon the rate chosen for charging a division for its
14–15.
The reason the division manager has been delegated the authority to make investment
14–16.
• Residual Income (RI) is defined as follows:
Investment center operating profits—(Capital charge × Investment center assets)
14–17.
The problem with using the same measure of performance for managers at all levels in
14–18.
If the division can rent and the rent does not have to be capitalized for inclusion in the
14–19.
ROI does not take the time value of money into account; it is computed based on
14–20.
Residual income divided by divisional assets is just ROI minus the cost of capital (see
14–21.
Solutions to Exercises
14–22. (10 min.) Compute Divisional Income: Arlington Clothing, Inc.
Operating Income
(thousands)
Lake Region
Coastal Region
Sales revenue …………………………………………….
$4,080.0
$12,920.0
Cost of sales ………………………………………………
2,616.3
6,460.0
Other general and administration…………………..
Gross Margin percentage …………………………..…
(Gross margin ÷ Sales)
14–23. (10 min.) Compute Divisional Income: Arlington Clothing, Inc.
Operating Income
(thousands)
Lake
Region
Coastal
Region
Sales revenue …………………………………………….
$4,080.0
$9,520.0
4,760.0
Other general and administration …………………..
50.00%
Comments:
In addition to the comments for exercise 14-22, nothing changed in Lake Region.
14–24. (10 min.) Compute Divisional Income: Incomplete Information and Financial
Ratios: Sneaky Pete’s.
a. There are many approaches to solving this problem (although it is likely that the first
step will be to calculate total corporate sales). One approach follows.
14–25. (10 min.) Compute RI and ROI: All-States Bank.
14–26. (25 min.) ROI Versus RI.
Annual income = $700,000 – ($2,520,000 ÷ 4 years) = $70,000
Year
Investment
Base
(a)
ROI
$70,000 ÷ Base
(b)
Residual Income
$70,000 – (8% x Base)
1
2
4
14–27. (10 min.) Compare Alternative Measures of Division Performance:
Solomons Company.
a. Using return on investment measures:
*North:
$6,000,000
= 20%
South:
14–28. (10 min.) Comparing Business Units Using ROI: BMI.
East
West
= 10%
14–29. (10 min.) Comparing Business Units Using Residual Income: BMI.
East
West
Income
$200
$390
14–30. (10 min.) Comparing Business Units Using Economic Value Added: BMI.
In computing EVAs, we need to adjust both income and investment (assets). The
income adjustment is for R&D and the investment adjustment is for R&D and
current liabilities. Because R&D is assumed to benefit two periods, we only
expense 50% of R&D (it is assumed spent at the beginning of the year) each
year.
14–31. (10 min.) Impact of New Asset on Performance Measures: Patio
Enterprises.
14–32. (10 min.) Impact Of Leasing On Performance Measures: Patio
Enterprises.
With the lease, the incremental income is the operating cash flow minus the lease
The new ROI is:
14–33. (15 min.) Residual Income Measures And New Project Consideration:
Patio Enterprises.
$2,340,000 – (.09 $19,500,000)
=
14–34. (20 min.) Impact of an Asset Disposal on Performance Measures: Harbor
Division.
a. ROI before disposal:
14–35. (20 min.) Impact of an Asset Disposal on Performance Measures: Harbor
Division.
14–36. (25 min.) Compare Historical Cost, Net Book Value To Gross Book Value:
Ste. Marie Division.
a. Net Book Value
b. Gross Book Value
Year 1
($20,000,000 – $9,000,000)
($20,000,000 – $9,000,000)
($90,000,000 – $9,000,000)
$90,000,000
Year 2
($20,000,000 – $9,000,000)
$90,000,000
$90,000,000
14–37. (25 min.) Compare ROI Using Net Book And Gross Book Values: Ste.
Marie Division.
a. Net Book Value
b. Gross Book Value
Year 1
($20,000,000 – $9,000,000)
($20,000,000 – $9,000,000)
$90,000,000
$90,000,000
c. Of course, there is no change under the gross book value method. With the net
14–38.
(30 min.) Compare Current Cost To Historical Cost: St. Marie Division.
Parts c and d can be solved easier if one first sets up a table showing the change in value of the depreciable assets.
(1)
Gross Depreciable
Asset Valuea
(2)
Yearly
Depreciation
[col. (1) x 25%]
(3)
Total Depreciation
(1) (Years of life ÷ 4 years)
Year 1
$36,000,000 x 1.1 = $39,600,000
$9,900,000
$39,600,000 x 1/4 = $9,900,000
Year 3
$43,560,000 x 1.1 = $47,916,000
$11,979,000
$47,916,000 x 3/4 = $35,937,000
14-38. (continued)
a.
Historical Cost
Net Book Value
b.
Historical Cost
Gross Book Value
Year 1
($22,000,000 – $9,000,000)
($22,000,000 – $9,000,000)
($90,000,000 – $9,000,000)
$90,000,000
Year 2
($24,200,000 – $9,000,000)
($24,200,000 – $9,000,000)
$90,000,000
Year 3
($26,620,000 – $9,000,000)
($26,620,000 – $9,000,000)
$90,000,000
Year 4
14-38. (continued)
c.
Current Cost
Net Book Value
d.
Current Cost
Gross Book Value
Year 1
($22,000,000 – $9,900,000)
($22,000,000 – $9,900,000)
($99,000,000 – $9,900,000)
$99,000,000
Year 2
Year 3
Year 4
14–39. (25 min.) Effects Of Current Cost On Performance Measurements: Upper
Division.
a.
ROI
Year 1:
$225,000 – (.25 x $600,000)
=
$75,000
= 12.5%
$600,000
$600,000
Year 2:
$105,000
Year 3:
=
$135,000
= 22.5%
Year 4:
=
$150,000
= 25.0%
$600,000
$600,000
b.
ROI
Year 1:
$225,000 – (.25 x $600,000)
=
$75,000
= 12.5%
$600,000
$600,000
Year 3:
=
$103,500
= 14.3%
Year 4:
=
$100,350
= 12.6%
$798,600
$798,600
Solutions to Problems
14–40. (30 min.) Comparing Business Units Using Divisional Income, ROI, and
Residual Income: Colonial Pharmaceuticals.
a. – d. Note that because we ignore income taxes, operating income is the same as net
income.
14–41. (20 min.) Comparing Business Units Using EVA: Colonial Pharmaceuticals.
a.
In computing EVAs, we need to adjust both income and investment (assets). The income
and investment adjustments are for R&D. For AC Division, R&D is assumed to benefit two
periods, we only expense 50% of R&D (it is assumed spent at the beginning of the year)
each year. For SO Division, we only expense (1/9), because it is assumed that R&D
benefits nine years.
AC Division
Adjusted profit ……………….
[$1,500 + (50% x $2,000)] = $2,500
Adjusted investment ………
SO Division
Adjusted profit ……………….
[$6,070 + ((8/9) x $3,600)] = $9,270
Adjusted investment ………
b. Based on EVA, SO performed better than AC. The difference between the EVA result
14–42. (20 min.) Comparing Business Units Using EVA: Colonial Pharmaceuticals.
a.
In solving this problem, we need to recognize that the same proportion of the R&D
investment is added to net (or in this case operating) income and divisional investment.
b. Answers will vary. From the discussion in the problem, it appears that the two divisions
make different products, sell in different markets, perhaps are subject to different
14–43. (30 min.) Equipment Replacement And Performance Measures: Pitt, Inc.
ROI
a.
$3,750,000
b.
c.
$5,025,000b
Costs:
Variable ………………………………………………….
(up 10%)
14–44. (20 min.) Evaluate Trade-Offs In Return Measurement: Pitt, Inc.
b. For the manager, the relevant cost is the lost bonus this year if the machine is
purchased this year versus the effect on the manager’s bonus that would arise from the
increased depreciation charge. If the manager waits until next year, then the return on
investment for this year would be the 60% as indicated in Problem 14-43, part a. For the
coming year, the ROI would be:
$4,700,000a – $3,500,000b
=
$1,200,000
= 18.0%
$4,000,000 – (2 x $1,250,000) + $7,475,000c – $2,325,000d
$6,650,000
assuming that the new equipment is bought at the beginning of the year.
a
$4,700,000 =
$5,025,000 + $2,000,000 – $2,325,000.
d
14–45. (30 min.) Economic Value Added: Pitt, Inc.
(In thousands of dollars)
a.
Residual Income
$3,750 – 0.12 x ($4,000 + $5,000 – $1,500 – $1,250)
= $3,000
c.
$5,025b – 0.12 x ($4,000 – (2 x $1,250) + $6,500 – $2,000)
= $4,305
Variable ………………………………………………….
(up 10%)
14–46. (20 min.) Evaluate Trade-Offs In Performance Measurement and Decisions:
Pitt, Inc.
b. For the manager, the relevant cost is the lost bonus this year if the machine is
purchased this year versus the effect on the manager’s bonus that would arise from the
increased depreciation charge. If the manager waits until next year, then the residual
income for this year would be the $3 million as indicated in Problem 14–45, part a. For the
coming year, the residual income would be (in thousands of dollars):
assuming that the new equipment is bought at the beginning of the year.
14–47. (40 min.) ROI and Management Behavior—Ethical Issues: Asher Company.
a. Most of the specific actions that division managers can take that would result in
b. Asher’s corporate goals and goals for its divisions are not congruent. Improving the
division ROI does not automatically lead to improved corporate ROI. Certain actions
c. The changes should be two-fold in character. The emphasis on a single measure for
performance evaluation should be eliminated. Additional factors important to division
and corporate goals should be included.
One approach would be to establish a target ROI, which would include allowances for
start-up costs of long-term projects. The company could consider the residual profits
14-47. (continued)
d. Answers will vary. Clearly, manipulating numbers at the division level is unethical (and
CMA adapted
14–48. (30 min.) Impact of Decisions to Capitalize or Expense on Performance
Measurement—Ethical Issues: Pharm-It.
a.
ROI
Base Year
This Year
If R&D is expensed:
c. The board should reject the request for a bonus. The purpose of the bonus is to
14–49. (30 min.) Evaluate Performance Evaluation System—Behavioral issues:
Seville Products.
a. An answer that assumed that managers should only be held responsible for what they
control would make the following arguments:
The financial reporting and performance evaluation program of Seville Products is
inappropriate as a measure of the responsibilities of the Salvador Division. Salvador is
b. Following the notion that managers should be held responsible only for what they
control, the answer to requirement b would be:
The following revisions should be made to Seville Products’s financial reporting and
performance evaluation system.
CMA adapted.
14–50. (35 min.) ROI, EVA, Different Asset Bases: Hy’s.
a. and b.
Income statements to summarize the alternatives are as follows:
Regular
Merchandise
Appliances
Total
Sales revenue …………………………..………………..
$4,680,000
$1,350,000
$6,030,000
Cost of sales …………………………..………………….
2,934,000
1,026,000
3,960,000
Gross margin ……………………………………………..
$1,746,000
Operating expense ……………………………………..
Operating profit …………………………………………..
$1,278,000
Investment …………………………………………………
ROI …………………………………………………………..
c. If the floor plan is used, the investment base will be $3,375,000. Total operating profits
14–50. (continued)
e.
Income statements to summarize the alternatives are as follows: ($ in thousands)
Regular
Merchandise
Appliances
Total
Sales revenue …………………………………………….
$4,680,000
$1,350,000
$6,030,000
1,026,000
Gross margin ………………………………………………
$1,746,000
$2,070,000
Operating profit ……………………………………………
$1,278,000
14–51. (35 min.) Economic Value Added: Bisbee Health Products.
After-tax income ………………………………………………………
$7,500,000
Add back R&D expense for year 2 …………………………..…
4,800,000
$12,300,000
Less amortization of R&D:
$1,500,000
Adjusted divisional income ………………………………………..
$8,400,000
$29,400,000
Unamortized R&D at the beginning of year 2:
Adjusted divisional investment …………………………………..
$30,900,000
Calculation of EVA:
Adjusted divisional income ………………………………………..
Cost of adjusted divisional investment (@ 14%) …………..
4,326,000
14–52. (35 min.) Economic Value Added: Biddle Company.
After-tax income ………………………………………………………
$600,000
Add back advertising expense for year 3 …………………….
360,000
$960,000
Less amortization of advertising:
Year 1 advertising: 10% x $150,000 ………………………..
$15,000
Year 3 advertising; 50% x $360,000 ………………………..
180,000
315,000
Adjusted divisional income ………………………………………..
$645,000
Unamortized advertising at the beginning of year 3:
From year 1 advertising: 10% x $150,000 ………………..
$15,000
150,000
Adjusted divisional investment …………………………………..
Calculation of EVA:
Adjusted divisional income ………………………………………..
$645,000
Cost of adjusted divisional investment (@ 10%) …………..
Solutions to Integrative Cases
14–53. (60 – 90 min.) Barrows Consumer Products (A).
a.
There are many possible problems in identifying the “best” performer, but some of the
most commonly cited by students are:
• Different measures can be used in the sector. Different performance measures lead
to different conclusions about the best performer. If different managers use different
14–53. (continued)
b.
(1) Income is given in the case:
County
Indonesia
The Philippines
Vietnam
Income ($000)
Rank
County
Indonesia
The Philippines
Vietnam
Income ($000)
Assets ($000)
ROI
Rank
(2) ROI is computed at Barrows as Operating income ÷ Beginning assets. Notice that
Barrows does not use after-tax income in computing this ratio. This might be a good
time to discuss with students the fact that different companies and different analysts
14–53. (continued)
(3) EVA can be computed in many ways. This is one, in which advertising is amortized
over three years and advertising expenditures are assumed to be incurred uniformly
over the year.
($000)
Indonesia
Philippines
Vietnam
Income ………………………………………………………
$2,065
$1,176
$ 21
Advertising …………………………………………………
5,100
2,955
960
Income before advertising …………………………….
$7,165
$4,131
$ 981
Advertising expense:
$ 850
$ 493
$ 160
From Year 7 (1/3) ………………………………………..
1,700
200
From Year 6 (1/3) ………………………………………..
1,400
183
From Year 5 (1/6) ………………………………………..
Total advertising expense …………………………….
$4,700
$2,577
Modified income ………………………………………….
$2,465
$1,554
Assets b ……………………………………………………..
$7,200
$4,000
$1,880
Less current liabilities …………………………………..
1,255
704
750
Net assets ………………………………………………….
$5,945
$3,296
$1,130
From Year 7 (5/6) ………………………………………..
$4,250
$2,085
$ 500
From Year 6 (3/6) ………………………………………..
2,100
1,200
275
From Year 5 (1/6) ………………………………………..
Capitalized advertising …………………………………
$ 7,100
$3,735
Modified investment …………………………………….
$7,031
$2,000
Cost of capital …………………………………………….
Capital cost ………………………………………………..
2,609
1,406
400
Rank
14–53. (continued)
c.
Answers will vary. Some common suggestions include dividing by population or by
d.
The following items should be included:
(1). The measure you recommend and why. It is important that the measure be one
that the company can actually collect data for use in calculations.
14–54. (60 – 90 min.) Capital Investment Analysis and Decentralized Performance
Measurement: Diversified Electronics.
a. David Parker’s new product proposal was rejected because its ROI was less than 15
percent after tax.
The decision was not correct because it is inappropriate to use a short-term measure
like ROI to evaluate a long-term decision, ignoring completely the project’s cash flows.
b. It appears that Diversified Electronics’ management wanted the focus of division
managers to be on the profitability of their assets, which is why company management
used the investment center concept for performance evaluation. Therefore, Diversified
Electronics’ choice of ROI makes sense because it is a measure of profitability of
assets used. (The company could also have used EVA.) By focusing on ROI,
company management delegates decision rights regarding sales (e.g., product pricing)
and costs to division managers. The benefits of delegation include reduction in cost of
corporate administration, improvement in operational decision making, increased
motivation at division level, and freeing corporate management up for more effective
utilization. However, some unexpected ROI-related pitfalls that the company’s
management apparently did not anticipate are:
1. It may not be appropriate to use one ROI performance standard for all divisions,
14–54. (continued)
14–54. (continued)
Possible Modification to the Present System
1. Within a division there could be a corporate ROI for evaluating the division and