Divisional Performance Evaluation Management Accounting Systems Cost Accounting

Divisional Performance Evaluation

Management Accounting Systems Cost Accounting Systems Budgeting Systems Variance Analysis Transfer Pricing Performance Measurement Systems

Agenda • Describe the mechanics of computing accounting-based measures of financial performance – ROI (Return on Investment) – RI (Residual Income) – EVA (Economic Value Added) • Discuss the strengths and shortcomings of these accounting-based performance measures • Example: Ross Parts • Takeaway

Motivating Accounting Performance Measures • The most common accounting measure of performance is income • Since external investors are interested in income, it is an obvious choice for evaluating units of the organization • It also provides a common metric with which to compare different units in the organization

ROI • Return on investment (ROI) or return on assets (ROA) is an accounting measure of income divided by an accounting measure of investment ROI = Income ÷ Investment

ROI Strengths • ROI is easy to compute • ROI is a ratio – Can be compared across divisions

ROI Weakness: Dilution of ROI • A problem with ROI is that it is a ratio rather than a sum • The company’s cost of capital is 15 % – Your division’s ROI is currently 25 % • You see an opportunity that yields 20 % – What does headquarters (if it knew about this opportunity) think about taking on this opportunity? [Yes --- 20% pulls its 15% up] – What do you as a divisional manager compensated on ROI think about taking on this opportunity? [No --- 20% pulls your 25% down] • This organizational inefficiency is called: ROI Dilution Problem

Residual Income (RI) • RI = Income – (Cost of Capital x Investment) • RI is a dollar figure • RI is positive if a project generates income greater than the project’s cost of capital. • Colloquial Interpretation – Suppose cost of capital is 15%. You pay the lender his interest of 15%, and “keep” the rest of the income for yourself.

Strengths of Residual Income Measure • No ROI dilution problem – Suppose the corporate target cost of capital is 15% – The divisional manager compensated on RI will take on any opportunity that generates more than 15% • Taking on such an opportunity can only increase the divisional manager’s RI dollars. – Colloquially speaking, the manager gets to “keep” any income over and above the “interest charge” of 15%.

Different Treatment of Input Resources Division A hires a scientist (input resource) to improve its operations. That scientist costs $100, 000. Division B gets a machine (input resource) instead that also costs $100, 000 and has the same economic impact on efficiency. • RI = Income – (Cost of Capital x Investment) – Because wages are expensed, the entire $100, 000 paid to the scientist hits Division A’s income immediately. – Because machine purchases are capitalized, only the first year depreciation hits Division B’s income immediately.

Economic Value-Added (EVA) • EVA reduces reporting distortions in residual income – Adjust reporting of several income items EVA = Adjusted Income – [cost-of-capital x (Total assets – current liabilities)] NOTE: There are many variations to EVA applied in practice

Agenda • Describe the mechanics of computing accounting-based measures of financial performance – ROI (Return on Investment) – RI (Residual Income) – EVA (Economic Value Added) • Discuss the strengths and shortcomings of these accounting-based performance measures • Example: Ross Parts • Takeaway

Example: Ross Parts North Division Profit South Division $200 $390 $2, 000 $3, 000 Current liabilities $200 Cost of capital 15% R&D expenditure* $500 $0 Investment (Assets) * (Assumed to benefit this period and the following three periods equally – a total benefit period of four years. )

Example: Ross Parts North Division ROI Residual Income South Division ($200 ÷ $2, 000) ($390 ÷ $3, 000) = 10% = 13% $200 – (15% x $2, 000) = – $100 $390 – (15% x $3, 000) = – $60 Note: Residual Income for North Division is negative in part because all the R&D has been expensed, resulting in a low income figure.

R&D Amortization For North Division Amortization Schedule of $500 R&D expenditures over four periods This period +1 This period +2 This period +3 Traditional R&D Expense 500 0 Amortized R&D Expense 125 125 Remaining Capitalized R&D Adjustment to Income Adjustment to Assets 375 +375 250 -125 +375 125 -125 +250 0 -125 +0

Ross Parts Current Period EVA North Division “Adjusted” profit: $200 + $375 = $575 “Adjusted” assets: $2, 000 – $200# + $375 = $2, 175 $575 – (15% x $2, 175) = $248. 75 > 0 EVA: South Division “Adjusted” profit: $390 = $390 “Adjusted” assets: $3, 000 – $200# = $2, 800 $390 – (15% x $2, 800) = – $30 EVA: # $200 is current liabilities that we subtract in our definition of EVA assets

Another EVA Example: Lincoln, Inc 1997 1998 1999 Revenue 50 100 80 R&D Expense (60) Assets (Beginning of year) 100 100 Income (10) 100 80 Residual Income (10) – 15% 100 = ($5) 100 – 15% 100 = $85 80 – 15% 100 = $65

Another EVA Example: Lincoln, Inc Amortization Schedule of $60 R&D expenditures over three periods 1997 1998 1999 Revenue 50 100 80 R&D Expense (20) “Left over” R&D Assets 40 20 0 Assets (Beginning of year) 100 100 Adjusted Assets 100 140 120 Adjusted Income 30 80 60 Residual Income 30 – 15% 100 = $15 80 – 15% 140 = $59 60 – 15% 120 = $42

Takeaway • Some commonly used financial performance measures are – Income – Return on Investment (ROI) – Residual Income – EVA • Organizational Issues: – Each measure has strengths and weaknesses – Effective use requires • Management Judgment and Leadership