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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.
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Chapter Overview
I. DIVISIONAL PERFORMANCE MEASUREMENT
II. ACCOUNTING INCOME
• Computing Divisional Income
• Advantages and Disadvantages of Divisional Income
• Some Simple Financial Ratios
III. RETURN ON INVESTMENT
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
• Gross Book Value versus Net Book Value
• Historical Cost versus Current Cost
VIII. OTHER ISSUES IN DIVISIONAL PERFORMANCE MEASUREMENT
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Chapter Outline
LO 14-1 Evaluate divisional accounting income as a performance measure.
DIVISIONAL PERFORMANCE MEASUREMENT
• “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.
o What to consider when performance measures are developed?
▪ Is the performance measure consistent with the decision authority of the manager?
▪ Does the measure reflect the results of the actions that improve the performance of
the organization?
o No performance measurement system perfectly aligns the manager’s and organization’s
interests. (See Business Application box “What Determines Whether Firms Use
Divisional Measures for Measuring Divisional Performance?”)
▪ Possible dysfunctional decisions made by managers must be considered when
designing the system.
ACCOUNTING INCOME
• Divisional income is an obvious performance measure when divisions have both revenue and
cost responsibility.
o The role of divisional measures decreased with the extent to which the manager’s
decisions affected the performance of other divisions.
▪ Furthermore, divisional income serves as a useful summary measure of performance
by equally weighting the division’s performance on revenue and cost activities..
o Divisional income = Divisional revenues – Divisional costs
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• Computing Divisional Income
o The computation of divisional income follows that of accounting in general.
▪ However, because divisional income statements are internal performance measures,
they are not subject to compliance with generally accepted accounting principles
(GAAP).
▪ Firms might choose to use firm-wide averages for some accounts or ignore other
accounts (taxes, for example).
o Exhibit 14.1 shows an example of divisional income statements.
• Advantages and Disadvantages of Divisional Income
o Advantages of using after-tax income as a performance measure are:
▪ It is easy to understand, prepared in the same way as the firm’s income.
o Disadvantages of using divisional income as a performance measure are:
▪ 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.
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• Some Simple Financial Ratios
o When the divisions are different in sizes, the use of financial (profitability) ratios may
improve comparison. Three profitability ratios are suggested.
▪ Gross margin ratio =
Sales
margin Gross
• Gross margin = Revenues – Cost of goods sold
▪ 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.
▪ Profit margin ratio =
After-tax income
Sales
See Demonstration Problem 1
LO 14-2 Interpret and use return on investment (ROI).
RETURN ON INVESTMENT
• Return on investment (ROI)
=
After-tax income
Divisional assets
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• Performance Measures for Control: A Short Detour
o 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.
• By decomposing ROI, managers can anticipate where problems will occur in
achieving acceptable ROIs and can take actions early.
▪ Declining profit margins suggest the need to implement cost controls; lower asset
turnover suggests the need to review asset utilization.
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• Limitations of ROI include:
o Short-Term Focus (Myopia) From Accounting Information
▪ 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.
• One advantage of using ROI is that the information needed to compute it already exists in the
accounting records.
o Accounting information, however, does not reflect the change in value as a result of the
division manager’s actions because of three general problems.
• 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.
o 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.
▪ 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.
o 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,
ROI Proposal =
$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.
o 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.
o Many companies continue to use ROI despite its limitations.
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LO 14-3 Interpret and use residual income (RI).
RESIDUAL INCOME MEASURES
• 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.
• 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
o Example 2: Operationally, the cost of capital is a weighted average of interest rates from
o 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.
o 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.
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.
• Limitations of Residual Income
o Residual income does not eliminate the suboptimization problem. (See Business
Application box “Does Using Residual Income as a Performance Measure Affect
Managers’ Decisions?”)
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LO 14-4 Interpret and use economic value added (EVA).
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.
o EVA = (After-tax income ± adjustments) – (Divisional investments ± adjustments).
See Demonstration Problem 4
• Limitations of EVA
o Conceptually, EVA addresses problems associated with ROI and residual income.
▪ EVA is not a ratio, so managers are willing to invest in projects as long as EVA is
positive.
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DIVISIONAL PERFORMANCE MEASUREMENT: A SUMMARY
• 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 can
be misleading in evaluating performance.
MEASURING THE INVESTMENT BASE
• Effective business unit performance assessment requires a measurement of the divisional
assets.
• Three general issues are frequently raised in measuring investment bases:
o Should gross book value be used?
• Gross Book Value versus Net Book Value
o 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.
• Historical Cost versus Current Cost
o Historical cost is the original cost to purchase or build an asset. Current cost is the cost
to replace or rebuild an existing asset.
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o 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.
o 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.
• Beginning, Ending, or Average Balance
o 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.
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OTHER ISSUES IN DIVISIONAL PERFORMANCE MEASUREMENT
• 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.
14–15
14–16
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
.
_____ 11.
Sales
income Operating
.
14–17
Matching Answers
Multiple Choice
1. Which of the following is correct?
a. Gross margin ratio =
Sales
margin Gross
.
b. Operating margin ratio =
Sales
income Operating
.
c. Profit margin ratio =
After-tax income
Sales
.
d. All of the above.
2. Which of the following statements is incorrect?
a. No performance measurement system perfectly aligns the manager’s and organization’s
interests.
b. Divisional income serves as a useful summary measure of performance.
c. Divisional income statements are subject to compliance with generally accepted
accounting principles (GAAP).
d. When the divisions are different in sizes, the use of financial ratios may improve
comparison.
3. Which of the following statements regarding ROI is incorrect?
a. Return on investment is the ratio of profits to investment in the asset that generates those
profits.
b. Return on investment is an effective performance measure for managers with
responsibility for asset acquisition, usage, and disposal.
c. ROI can be decomposed into operating margin ratio and asset turnover ratio.
d. Relating profits to investment provides a scale for measuring performance.
The following information is for questions 4 and 5.
Hospitability Inc. has two hotels, Sleep Well and Sleep Tight. The following information is
available.
Division
Divisional assets
Sales
After-tax income
Sleep Well
$1,200,000
$2,000,000
$200,000
Sleep Tight
2,100,000
3,000,000
270,000
4. What is Sleep Tight’s ROI?
a. 9.84%.
b. 10.65%.
c. 11.72%.
d. 12.86%.
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5. What is Sleep Well’s asset turnover ratio?
a. 167%.
b. 154%.
c. 143%.
d. 137%.
6. Which of the following formulas represents the residual income?
a. Residual income = Adjusted divisional income – Adjusted investment base.
b. Residual income = Divisional income.
c. Residual income = After-tax income – Cost of capital.
d. Residual income = After-tax income – Cost of invested capital.
7. A division reports the residual income in the amount of $95,000, after-tax income in the
amount of $410,000, and the investment base in the amount of $2,100,000. What is the cost
of capital used in the calculation?
a. 14%.
b. 15%.
c. 16%.
d. 17%
8. Which of the following statements regarding EVA is incorrect?
a. EVA is a concept closely related to residual income.
b. EVA is a ratio.
c. EVA corrects for many of the accounting distortions that make the other measures
myopic.
d. It is difficult to implement EVA.
9. Which of the following statements is incorrect?
a. Using the beginning balance of the investment base could encourage asset acquisitions at
the end of the year.
b. Measuring the manager only on the division’s results risks suboptimal decision making.
c. In general, how a performance measure is used is more important than how it is
calculated.
d. As long as the measurement method is understood, it can enhance performance
evaluation.
10. Which of the following statements regarding the measurement of the investment base is
correct?
a. Current cost is the original cost to purchase or build an asset.
b. When ROI is used in conjunction with the net book value method, the ROI increases each
year even though no operating changes take place.
c. ROI decreases each year under the historical cost method even though no operating
changes take place.
d. It is easier and less expensive to deal with current costs than to deal with historical costs.
11. Which of the following approaches will improve ROI?
a. Increase sales.
b. Reduce costs effectively.
c. Reduce the assets used to generate income.
d. All of the above.
12. Which of the following statements regarding suboptimization is incorrect?
a. The use of ROI can give incentives to managers that lead to lower organizational
performance.
b. The use of residual income reduces the suboptimization problem.
c. EVA® solves the suboptimization problem.
d. Suboptimization is due to the misalignment of interests between the managers and the
organization.
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Multiple Choice Answers
1. d (LO1)
14–22
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
Total
Sales
$2,800,000
$2,226,000
$3,391,060
$8,417,060
Cost of sales
1,497,000
1,201,000
1,648,059
4,346,059
Gross margin
1,303,000
1,025,000
1,743,001
4,071,001
Operating expenses
503,000
385,000
663,000
1,551,000
Allocated corporate overhead
228,571
182,857
308,572
720,000
Operating income
571,429
457,143
771,429
1,800,001
Income tax (30%)
171,429
137,143
231,429
540,001
After-tax income
$ 400,000
$ 320,000
$ 540,000
$1,260,000
Required:
Calculate the gross margin ratio, the operating margin ratio, and the profit margin ratio for the
three divisions of Health Quest.
14–23
Demonstration Problem 1 – Solution
Western
Division
Midwestern
Division
Eastern
Division
Gross margin ratioa
46.54%
46.05%
51.40%
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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.
Demonstration Problem 2 – Solution
Western
Division
Midwestern
Division
Eastern
Division
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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.
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Demonstration Problem 3 – Solution
Western
Division
Midwestern
Division
Eastern
Division
14–28
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%
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.
Demonstration Problem 4 – 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
