Chapter 14: Business Unit Performance Measurement

Business Unit PerformanceMeasurementChapter 14Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinAccounting IncomeL.O. 1 Evaluate divisional accounting income as a performance measure. Divisional Income: Division revenues minus division costs Investors use accounting income to assess a firm's performance. Firms use a division’s income to assess divisional performance.14 - * Divisional IncomeLO1Mustang FashionsDivisional Income StatementsFor Year 1 ($000)SalesCost of salesGross marginAllocated corporate overheadLocal advertisingOther general and administrativeOperating incomeTax expense (@ 30%)After-tax income$5,200.0 2,802.0$2,398.0 468.0 1,200.0 250.0$ 480.0 144.0$ 336.0$2,800.0 1,515.0$1,285.0 252.0 500.0 227.0$ 306.0 91.8$ 214.2$8,000.0 4,317.0$3,683.0 720.0 1,700.0 477.0$ 786.0 235.8$ 550.2WesternDivisionEasternDivisionTotal14 - *Some Simple Financial RatiosLO1Gross margin percentageOperating marginProfit marginGross margin ÷ salesOperating income ÷ SalesAfter-tax income ÷ Sales46.12% 9.23% 6.46%45.89%10.93% 7.65%WesternDivisionEasternDivisionDefinitionRatioMustang FashionsSelected Financial RatiosFor Year 114 - *Return on InvestmentL.O. 2 Interpret and use return on investment (ROI). Return on Investment (ROI): Ratio of profits to investment in the asset that generates those profits Provides a comparison of different size divisions.14 - *Return on InvestmentLO2Mustang FashionsBalance SheetsJanuary 1, Year 1Assets Cash Accounts receivable Inventory Total current assets Fixed assets (net)Total assetsLiabilities and Equities Accounts payable Other current liabilities Total current liabilities Long-term debtTotal liabilitiesTotal shareholders equityTotal liabilities and equities$ 250,000 225,000 250,000$ 725,000 775,000$1,500,000$ 125,000 227,000$ 352,000 -0- $ 352,000 1,148,000$1,500,000$ 150,000 250,000 150,000$ 550,000 350,000$ 900,000$ 95,000 280,000$ 375,000 -0- $ 375,000 525,000$ 900,000$ 400,000 475,000 400,000$1,275,000 1,125,000$2,400,000$ 220,000 507,000$ 727,000 -0- $ 727,000 1,673,000$2,400,000WesternDivisionEasternDivisionTotal14 - *Return on InvestmentLO2After-tax income from income statementDivisional investment from balance sheetROI (After-tax income ÷ Divisional investment)$ 336,000$1,500,000 22%$ 214,200$ 900,000 24%WesternDivisionEasternDivisionMustang FashionsROI for Western and Eastern DivisionsFor Year 114 - *Residual Income MeasuresL.O. 3 Interpret and use residual income (RI). Residual Income (RI): This is the excess of actual profit over the cost of invested capital in the unit.14 - *Economic Value Added (EVA)L.O. 4 Interpret and use economic value added (EVA). EVA is the annual after-tax (adjusted) divisional income minus the total annual cost of (adjusted) capital. It makes adjustments to after-tax income and capital to “eliminate accounting distortions.”14 - *Measuring the Investment BaseL.O. 5 Explain how historical cost and net book value-based accounting measures can be misleading in evaluating performance. Performance measures use divisional assets or investments in the calculation. How should divisional assets be measured? – Gross book value versus net book value – Historical cost versus current cost – Beginning, ending, or average balance 14 - *Gross Book Value versusNet Book Value ExampleLO5 Profits before depreciation (all in cash flows at end of year): $100 each year for 3 years Asset cost at beginning of year 1, $500 Depreciation: Ten year life, straight-line, no salvage value Amounts are in thousand of dollars.14 - *Gross Book Value versusNet Book Value ExampleLO5ROI= $50c $500=10%Year===ROI= $50c $500=10%ROI= $50c $500=10%Net Book ValueGross Book Value$100a – (0.1 × $500)b$500d – (0.1 × $500)e11.1%ROI=12$100a – (0.1 × $500)b$450d – (0.1 × $500)e12.5%ROI=3$100a – (0.1 × $500)b$400d – (0.1 × $500)e14.3%ROI=a The first term in the numerator is the annual cash profit.b The second term in the numerator is depreciation for the year.c Net income = $50 = $100 – ($500 × 0.1)d The first term in the denominator is the beginning-of-the-year asset value.e The second term in the denominator reduces the beginning-of-the-year value of the asset by the amount of current year's depreciation14 - *Historical Cost versus Current CostLO5 Current cost: Cost to replace or rebuild an existing asset Historical cost: Original cost to purchase or build an asset14 - *Historical Cost versus Current CostLO5 Operating profits before depreciation (all in cash flows at end of year): Year 1, $100; Year 2, $120; Year 3, $144 Annual rate of price changes is 20 percent. Asset cost at beginning of year 1 is $500. Amounts are in thousand of dollars. Straight-line depreciation is used; the straight-line rate is 10% per year14 - *Historical Cost versus Current CostLO5Year=Historical Cost$100a – (0.1 × $500)b$500c – (0.1 × $500)11.1%ROI=1=2$120a – (0.1 × $500)b$500c – (0.2 × $500)17.5%ROI==3$144a – (0.1 × $500)b$500c – (0.3 × $500)26.9%ROI=Year=Current Cost$100a – (0.1 × $600)b$600d – (0.1 × $600)e7.4%ROI=1=2$120a – (0.1 × $720)b$720f – (0.2 × $720)e8.3%ROI==3$144a – (0.1 × $864)b$864g – (0.3 × $864)e9.5%ROI=Year=Historical Cost$100a – $50b$500c10.0%ROI=1=2$120a – $50b$500c14.0%ROI==3$144a – $50b$500c18.8%ROI=Year=Current Cost$100a – $60b$600d6.7%ROI=1=2$120a – $72b$720f6.7%ROI==3$144a – $86.4b$864g6.7%ROI=Net Book ValueGross Book Valuea Annual operating profit before depreciation. b Depreciation for the year.c Beginning-of-the-first-year value of the assets used in the investment base. d Current cost of asset ($500 × 120%)e Accumulated depreciation at the end of the year. f Current cost of asset ($600 × 120%)g Current cost of asset ($720 × 120%)14 - *Beginning, Ending,or Average Balance?LO5 Managers can manipulate purchases and disposition based on which balance is being used in evaluations.14 - *End of Chapter 14LO1Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin