ACCT3106 Management
Control
Tutorial Summary on Ch.23
Performance Measurement and Compensation
Financial Performance Measures
• 3 common financial measures available:
1. Return on Investment (ROI): can be broken down into:
• Return on Sales (operating income margin) and
• Operating asset turnover
2. Residual Income (RI)
3. Economic Value Added (EVA)
2
Return on Investment (ROI)
Income
Income before
before interest
interest
and
and taxes
taxes (EBIT)
(EBIT)
Operating income
ROI =
Average operating assets
Cash,
Cash,accounts
accountsreceivable,
receivable,inventory,
inventory,
plant
plant and equipment, andother
and equipment, and other
productive
productive assets (i.e. non-investmenttype
assets (i.e. non-investment typeofofassets).
assets).
3 e.g. a piece of land which is leaving idle.
The firm may wait for the land price to increase
and then sell it at a gain
Regal Company reports the following:
Operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
$30,000 = 15%
ROI =
$200,000
4
DuPont Method – a modified version of ROI
• This modified version of ROI was originated from a company called
DuPont Power Company formed in 1903. Its CEO, Donaldson Brown
extended the value of ROI by decomposing the ROI equation into 2
ratios (margin and turnover) in 1920s.
1.Increasing income per dollar of revenues (operating margin)
2.Using assets to generate more revenues (operating turnover)
5
By introducing sales, the ROI (Operating
income/Average operating assets) formula
can be broken down into two components:
Operating income
Margin = Sales
Sales
Turnover =
Average operating assets
6
• The margin (Operating income/sales) indicates the
income per dollar of revenues.
• It is a measure of management’s ability to control operating
expenses in relation to sales. As the lower the operating
expenses per dollar of sales, the higher the margin earned.
• The turnover is a measure of the sales that are
generated for each dollar invested in operating
assets.
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• When the Margin multiply by the Turnover, the sales will
be cancelled out as follows:
Operating income Sales
Sales x Average operating assets
Margin Turnover
ROI = Margin Turnover
8
Using the DuPont Method to calculate the ROI of Regal Company:
Margin Turnover
ROI =
Sales
ROI = Operating income ×Average operating assets
Sales
$30,000 $500,000
ROI = ×
$500,000 $200,000
ROI =6% 2.5 = 15%
9
3 ways to Improve ROI through DuPont Method:
• Increase sales
• If sales increase at a rate higher than the expense increase, there will be an
increase in operating income, and thereby increasing the margin.
• With increase in sales, the turnover will also increase.
• Reduce expenses
• With decrease in expenses, operating income will increase, and thereby increasing
the margin.
• Reduce assets
• Assuming sales and operating income remain unchanged, reduction in operating
assets will increase the turnover.
Why using DuPont method to analyze ROI?
10 The advantage is that it encourages managers to consider the interrelationships
of sales, expenses and investment.
• Example
Regal’s manager was able to increase
sales to $600,000 which increased
operating income to $42,000. There was
no change in the average operating
assets of the segment.
11
Sales
ROI = Operating income ×Average operating assets
Sales
$42,000 $600,000
ROI = ×
$600,000 $200,000
ROI =7% 3 = 21%
ROI
ROI increased
increased from
from 15%
15% to
to 21%.
21%.
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Problem of using ROI as a performance measure
• It discourages managers from investing in projects that would decrease divisional
ROI but would increase the profitability of the company as a whole
That is, there will be intention of the managers to “reject good projects”
this problem can be overcome by using Residual Income as performance evaluation measure.
13
Residual Income (RI)
• Residual income is the operating income that an investment
earns above the minimum required return on its operating
assets.
When residual income is used to measure performance, the objective is
to maximize the total amount of residual income, not to maximize ROI.
RI = Operating Income – [Min. required return x Avg. Operating Assets]
The cost of capital
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Example
•• A
A division
division of
of Zepher
Zepher Co.
Co. has
has average
average operating
operating
assets
assets ofof $100,000
$100,000 and
and is
is required
required to
to earn
earn aa
return
return of
of 20%
20% onon these
these assets.
assets.
•• In
In the
the current
current period
period the
the division
division earns
earns $30,000
$30,000
operating
operating income.
income.
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Operating assets $ 100,000
Required rate of return × 20%
Required income $ 20,000
O.I. $ 30,000
Required income (20,000)
Residual income $ 10,000
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The $10,000 residual income represents the excess of the division’s
Income over the company’s required amount.
How can RI overcome the problem of ROI?
Example
A division of Wong’s Company has an operating
income of $60,000 and average operating assets of
$300,000. The required rate of return for the
company is 15%. What is the division’s ROI?
ROI = O.I./Average operating assets
= $60,000/$300,000 = 20%
17
If the manager of the division is evaluated based on
ROI, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
(The project’s ROI = $18,000/$100,000 = 18%, which
is lower than the division’s ROI of 20%)
ROI = ($60,000+$18,000)/($300,000+$100,000) =
19.5%
This lowers the division’s ROI from 20.0% down to
19.5%.
Therefore, the manager will NOT make the
investment.
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• So, there is a goal incongruence between the
division and the company as a whole if the
division is evaluated based on ROI.
Division’s Decision Company’s Decision
Not to accept the 18% Company would like the division
project since it’s ROI to take the project since the project’s
is lower than that of the return is already larger than the
division’s average. min. required return 15%.
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How about changing the evaluation base on Residual Income?
The division’s residual income:
Operating
Operating income
income $60,000
$60,000
Required
Required return
return (15%
(15% of
of $300,000)
$300,000) $45,000
$45,000
Residual
Residual income
income $15,000
$15,000
The project’s residual income:
$18,000 – 15% x $100,000 = $3,000
20
After taking the project, the division’s residual income will increase from
$15,000 to $18,000. Therefore, the division would like to accept the project.
Operating
Operating income
income (60000+18000)
(60000+18000) $78,000
$78,000
Required
Required return
return (15%
(15% ofof $400,000)
$400,000) $60,000
$60,000
Residual
Residual income
income $18,000
$18,000
This
This is
is an
an increase
increase of
of $3,000
$3,000 in
in the
the residual
residual income.
income.
No more goal incongruence!
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Economic Value Added (EVA)
• EVA® is a registered trademark of Stern Stewart &
Co.
• You can regard EVA as a specific type of Residual
Income calculation by taking tax and cost of capital
into consideration.
Already taken tax effect
Operating income x (1-tax rate) into account
Long term capital can be used as the capital employed
i.e. Total assets – Current liabilities = LT debt + owners’ equity
EVA
= After tax operating income – [Weighted average Cost of Capital x Total capital employed]
Value is created only if after-tax operating income > the cost of investing the capital
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• EVA substitutes the following specific numbers in the RI
calculations:
1. Income equals to after-tax operating income
2. A required rate of return equals to the weighted-average
cost of capital (WACC)
WACC = Cost of debt (1-tax rate) (market value of debt) + cost of equity x market value of equity
Market value of debt + market value of equity
Example: Assume ABC company has two sources of long-term funds:
a. long-term debt with a market value of $4.8M issued at an interest rate of 10%.
b. Equity capital that also has a market value of $4.8M. Cost of equity capital is 14%
Tax rate is 30% and ABC had after-tax operating income 1.5M last year.
WACC = 10% x (1-30%) x $4.8M + 14% x 4.8M
9.6M
= 10.5%
EVA = 1.5M – 0.105 x 9.6M = 0.492M
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Advantages:
• Division managers find EVA helpful as it allows them to incorporate
into decisions at the division level the cost of capital, which is
generally only available at the companywide level.
• Comparing the actual EVA achieved to the estimated EVA is useful
for evaluating performance and providing feedback to managers
about performance.
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25
ROI of the New Car Division = $2,475,000/$33,000,000 = 7.5%
ROI of the Performance Parts Division = $2,565,000/$28,500,000 = 9%
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2. RI based on total assets minus current liabilities
RI of the New Car Division: $2,475,000 – 12% x ($33,000,000 - $6,600,000)
= - $693,000
RI of the Performance Parts Division = $2,565,000 – 12% x ($28,500,000 - $8,400,000)
= $153,000
3. RI based on total assets
RI of the New Car Division: $2,475,000 – 12% x $33,000,000 = - $1,485,000
RI of the Performance Parts Division = $2,565,000 – 12% x $28,500,000 = - $855,000
No matter the RI is based on total assets minus current liabilities or on total assets,
the performance of the New Car Division is worse than the Performance Parts Division.
Both RIs of the New Car Division are negative, indicating that the division is not earning
27 the 12% required rate of return on their assets.
4. WACC = $18m x 10% x (1-40%) + $12m x 15%
-------------------------------------------------- = 9.6%
$18m + $12m
EVA of the New Car Division
= $2,475,000 x (1-40%) – 9.6% x ($33,000,000 - $6,600,000)
= $1,485,000 - $2,534,400 = - $1,049,400
EVA of the Performance Parts Division
= $2,565,000 x (1-40%) – 9.6% x ($28,500,000 - $8,400,000)
= $1,539,000 - $1,929,600 = - $390,600
5. The ROI, RI and EVA calculations indicate that the Performance Parts Division is
performing better than the New Car Division. However, the EVAs for both divisions
are negative, which indicate that, on an after-tax basis, the divisions are destroying
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value, the after-tax economic returns from them are less than the required returns.
