MANAGEMENT ACCOUNTING - Solutions Manual CHAPTER 24 ADVANCED ANALYSIS AND APPRAISAL OF PERFORMANCE: FINANCIAL AND NONFINANCIAL I Questions Return on investment (ROI) is the ratio of profit to amount invested for the business unit The measurement issues for ROI are: a The effect of accounting policies, which affect the determination of net income b Other measurement issues for income, which include the handling of non-recurring items in the income statement, differences in the effect of income taxes across units, differential effect of foreign currency exchange, and the effect of cost allocation when two or more units share a facility or cost c Measuring investment: which assets to include d Measuring investment: allocating the cost of shared assets The advantages of return on investment are: a It is intuitive and easily understood b It provides a useful basis for comparison among SBUs c It is widely used The limitations of return on investment are: a It has an excessive short-term focus b Investment planning uses discounted cash flow analysis while managers are evaluated on ROI c It contains a disincentive for new investment by the most profitable units The key advantage of residual income is that it deals effectively with the limitation of ROI, that is ROI has a disincentive for the managers of the most profitable units to make new investments With residual income, no matter how profitable the unit, there is still an incentive for new profitable investment In contrast, a key limitation is that since residual income is not a percentage, it suffers the same problem of 24-1 Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial profit SBUs in that it is not useful for comparing units of significantly difference sizes It favors larger units that would be expected to have larger residual incomes, even with relatively poor performance Moreover, relatively small changes in the desired minimum rate of return can dramatically affect the residual income for different size units And, in contrast to ROI, some managers not find residual income to be as intuitive and as easily understood Economic value added (EVA) is a business unit’s income after taxes and after deducting the cost of capital The idea is very similar to what we have explained as residual income The objectives of the measures are the same – to effectively motivate investment SBU managers and to properly measure their performance In contrast to residual income, EVA uses the firm’s cost of capital instead of a desired rate of return For many firms the desired rate of return and the cost of capital will be nearly the same, with small differences due to adjustments for risk and for strategic goals such as the desired growth rate for the firm Also, while residual income is intended to deal with the undesirable effects of ROI, EVA is used to focus managers’ attention on creating value for shareholders, by earning profits greater than the firm’s cost of capital Examples of financial and nonfinancial measures of performance are: Financial: Nonfinancial: ROI, residual income, and return on sales Manufacturing lead time, on-time performance, number of new product launches, and number of new patents filed The six steps in designing an accounting-based performance measure are: a Choose performance measures that align with top management’s financial goal(s) b Choose the time horizon of each performance measure in Step c Choose a definition of the components in each performance measure in Step d Choose a measurement alternative for each performance measure in Step e Choose a target level of performance f Choose the timing of feedback Yes Residual income (RI) is not identical to return on investment (ROI) ROI is a percentage with investment as the denominator of the computation RI is an absolute amount in which investment is used to calculate an imputed interest charge 24-2 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24 Economic value added (EVA) is a specific type of residual income measure that is calculated as follows: Economic value added = (EVA) After tax operating income  Weighted Average Cost x of Capital Total Assets minus Current Liabilities 10 Definitions of investment used in practice when computing ROI are: a Total assets available b Total assets employed c Working capital (current assets minus current liabilities) plus other assets d Equity 11 Present value is the asset measure based on DCF estimates Current cost is the cost of purchasing an asset today identical to the one currently held if identical assets can currently be purchased; it is the cost of purchasing the services provided by that asset if identical assets cannot currently be purchased Historical-cost-based measures of ROI compute the asset base as the original purchase cost of an asset minus any accumulated depreciation Some commentators argue that present value is future-oriented and current cost is oriented to current prices, while historical cost is pastoriented 12 Special problems arise when evaluating the performance of divisions in multinational companies because a The economic, legal, political, social, and cultural environments differ significantly across countries b Governments in some countries may impose controls and limit selling prices of products c Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ significantly across countries d Divisions operating in different countries keep score of their performance in different currencies 13 a Consider each activity and the organization itself from the customer’s perspective, b Evaluate each activity using customer-validated measures of performance, c Consider all facets of activity performance that affect customers and are comprehensive, and 24-3 Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial d Provide feedback to help organization members identify problems and opportunities for improvement II Exercises Exercise (ROI and Residual Income) Requirement A quick inspection of the data shows mortgage loans with a higher ROI to be more successful But see requirement below Requirement Total Assets Operating Income Return on Investment Residual Income: (a) * at 11% (b) ** at 15% (c) *** at 17% Division A (Mortgage Loans) P2,000 400 25% P180 100 60 Division B (Consumer Loans) P10,000 1,500 15% P400 (200) * P400 – (P2,000 x 0.11) = P180 P1,500 – (P10,000 x 0.11) = P 400 ** P400 – (P2,000 x 0.15) = P100 P1,500 – (P10,000 x 0.15) = P *** P400 – (P2,000 x 0.17) = P 60 P1,500 – (P10,000 x 0.17) = P(200) There is no simple answer to which is more successful in terms of residual income Division B is more successful at low rates, while A is more successful at high rates This reflects an important limitation of residual income; larger divisions (Division B in this case) are favored when the desired return used to determine residual income is relatively low Exercise (Return on Investment; Comparisons of Three Companies) Sales Income Investment (assets) Return on sales Asset turnover Companies in the Same Industry A B C P1,500,000 P 750,000 P3,750,000 200,000 75,000 18,750 500,000 7,500,000 2,500,000 13% 10% 0.5% 0.1 1.5 24-4 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24 Return on investment 40% 1% 0.75% Exercise (ROI, RI, ROS, Management Incentives) Requirement If Magic Industries uses return on investment to measure the Jump-Start Division’s (JSD’s) performance, Tan may be reluctant to invest in the new plant because, as shown below, return on investment for the plant of 19.2% is lower than JSD’s current ROI of 24% Operating income for new plant New investment Return on investment for new plant P480,000 P2,500,000 19.2% Investing in the new plant would lower JSD’s ROI and, hence, limit Tan’s bonus Requirement The residual income computation for the new plant is as follows: Residual income = Income- (Imputed interest x Investment) Investment Operating income for new plant Charge for funds (Investment, P2,500,000 x 15%) Residual income P2,500,000 P 480,000 375,000 P 105,000 Investing in the new plant would add P105,000 to JSD’s residual income Consequently, if Magic Industries could be persuaded to use residual income to measure performance, Tan would be more willing to invest in the new plant Requirement Return on Sales (ROS) = Operating income Sales 480,000 2,400,000 = 20% If Magic Industries uses ROS to determine Tan’s bonus, Tan will be more willing to invest in the new plant because ROS for the new plant of 20% exceeds the current ROS of 19% 24-5 = Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial The advantages of using ROS are (a) that it is simpler to calculate and (b) that it avoids the negative short-run effects of ROI measures that may induce Tan to not make the investment in the new plant Tan may favor ROS because she believes that eventually increases in ROS will increase ROI and RI The main disadvantage of using ROS is that it ignores the amount of investment needed to earn a return For example, ROS may be high but not high enough to justify the level of investment needed to earn the required return on an investment III Problems Problem (RI, EVA) Requirement Total assets Current liabilities Investment (Total assets – current liabilities) Required return (12% x Investment) Operating income before tax Residual income (Operating income before tax – required return) Truck Rental Division P650,000 120,000 Transportation Division P950,000 200,000 530,000 750,000 63,600 90,000 75,000 160,000 11,400 70,000 Requirement After-tax cost of debt financing = (1 – 0.4) x 10% = 6% After-tax cost of equity financing = 15% Weighted average = cost of capital P900,000 x 6% + 600,000 x 15% P900,000 + 600,000 Required return for EVA 9.6% x Investment (9.6% x P530,000; 9.6% x P750,000) P50,880 24-6 = 9.6% P72,000 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24 Operating income after tax 0.6 x operating income before tax 45,000 96,000 EVA (Operating income after tax – required return) (5,880) 24,000 Requirement Both the residual income and the EVA calculations indicate that the Transportation Division is performing better than the Truck Rental Division The Transportation Division has a higher residual income (P70,000 versus P11,400) and a higher EVA [P24,000 versus P(5,880)] The negative EVA for the Truck Rental Division indicates that, on an aftertax basis, the division is destroying value – the after-tax economic return from the Truck Rental Division’s assets is less than the required return If EVA continues to be negative, Lighthouse may have to consider shutting down the Truck Rental Division Problem (ROI, RI, Measurement of Assets) The method for computing profitability preferred by each manager follows: Manager of S P F Method Chosen Residual income based on net book value Residual income based on gross book value ROI based on either gross or net book value Supporting Calculations: Division S P F Return on Investment Calculations Operating Income Operating Income Gross Book Value Net Book Value* P94,700  P800,000 = 11.84% (3) P94,700  P370,000 = 25.59% (3) P91,700  P760,000 = 12.07% (2) P91,700  P350,000 = 26.20% (2) P61,400  P500,000 = 12.28% (1) P61,400  P220,000 = 27.91% (1) Division S P F Residual Income Calculations Operating Income – 10% Gross BV Operating Income – 10% Net BV* P94,700 – P80,000 = P14,700 (2) P94,700 – P37,000 = P57,700 (1) P91,700 – P76,000 = P15,700 (1) P91,700 – P35,000 = P56,700 (2) P61,400 – P50,000 = P11,400 (3) P61,400 – P22,000 = P39,400 (3) * Net book value is gross book value minus accumulated depreciation 24-7 Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial The biggest weakness of ROI is the tendency to reject projects that will lower historical ROI even though the prospective ROI exceeds the required ROI RI achieves goal congruence because subunits will make investments as long as they earn a rate in excess of the required return for investments The biggest weakness of residual income is it favors larger divisions in ranking performance The greater the amount of the investment (the size of the division), the more likely that larger divisions will be favored assuming that income grows proportionately Problem (Multinational Performance Measurement, ROI, RI) Requirement (a) Phil Division’s ROI in 2005 = Operating income Total assets = Operating income P8,000,000 = 15% Hence, operating income = 15% x P8,000,000 = P1,200,000 (b) Swedish Division’s ROI in 2005 in kronas = 9,180,000 kronas 60,000,000 kronas = 15.3% Requirement Convert total assets into pesos at December 31, 2004 exchange rate, the rate prevailing when the assets were acquired (8 kronas = P1) 24,000,000 kronas = 60,000,000 kronas = kronas per peso P7,500,000 Convert operating income into pesos at the average exchange rate prevailing when during 2005 when operating income was earned equal to 9,180,000 kronas 8.5 kronas per peso = P1,080,000 Comparable ROI for Swedish Division = P1,080,000 P7,500,000 = 14.4% The Swedish Division’s ROI calculated in kronas is helped by the inflation that occurs in Sweden in 2005 Inflation boosts the division’s operating 24-8 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24 income Since the assets are acquired at the start of the year on 1-1-2005, the asset values are not increased by the inflation that occurs during the year The net effect of inflation on ROI calculated in kronas is to use an inflated value for the numerator relative to the denominator Adjusting for inflationary and currency differences negates the effects of any differences in inflation rates between the two countries on the calculation of ROI After these adjustments, the Phil Division shows a higher ROI than the Swedish Division Requirement Phil Division’s RI in 2005 = = P1,200,000 – 12% x P8,000,000 P1,200,000 – P960,000 = P240,000 Swedish Division’s RI in 2005 (in Phil pesos) is P1,080,000 – 12% x P7,500,000 = P1,080,000 – P900,000 = P180,000 The Phil Division’s RI also exceeds the Swedish Division’s RI in 2005 by P60,000 (P240,000 – P180,000) Problem (ROI Performance Measures Based on Historical Cost and Current Cost) Requirement ROI using historical cost measures: P130,000 P340,000 = 38.24% Visayas Division P220,000 P1,150,000 = 19.13% Mindanao Division P380,000 P1,620,000 = 23.46% Luzon Division The Luzon Division appears to be considerably more efficient than the Visayas and Mindanao Divisions Requirement 24-9 Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial The gross book values (i.e., the original costs of the plants) under historical cost are calculated as the useful life of each plant (12) x the annual depreciation: Luzon Visayas Mindanao 12 x P 70,000 12 x P100,000 12 x P120,000 = = = P 840,000 P1,200,000 P1,440,000 Step 1: Restate long-term assets from gross book value at historical costs to gross book value at current cost as of the end of 2005 Gross book value of long-term assets at historical cost x Construction cost index in 2005 Construction cost index in year of construction Luzon P 840,000 x (170  100) = P1,428,000 Visayas P1,200,000 x (170  136) = P1,500,000 Mindanao P1,440,000 x (170  160) = P1,530,000 Step 2: Derive net book value of long-term assets at current cost as of the end of 2005 (Estimated useful life of each plant is 12 years) Gross book value of long-term assets at current cost at the end of 2005 Luzon Visayas Mindanao x Estimated useful life remaining Estimated total useful life P1,428,000 x (2  12) P1,500,000 x (9  12) P1,530,000 x (11  12) = = = P 238,000 P1,125,000 P1,402,500 Step 3: Compute current cost of total assets at the end of 2005 (Assume current assets of each plant are expressed in 2005 pesos.) Current assets at the end Net book value of long-term assets at + current cost at the end of 2005 (Step 2) of 2005 (given) Luzon P200,000 + P238,000 = P 438,000 Visayas P250,000 + P1,125,000 = P1,375,000 Mindanao P300,000 + P1,402,500 = P1,702,500 Step 4: Compute current-cost depreciation expense in 2005 pesos Gross book value of long-term assets at current cost at the end of 2005 (from Step 1) x (1  12) 24-10 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24 P1,428,000 x (1  12) P1,500,000 x (1  12) P1,530,000 x (1  12) Luzon Visayas Mindanao = = = P119,000 P125,000 P127,500 Step 5: Compute 2005 operating income using 2005 current-cost depreciation Historical-cost operating income Luzon Visayas Mindanao – Current-cost depreciation in 2005 pesos (Step 4) – P130,000 – (P119,000 – P70,000) P220,000 – (P125,000 – P100,000) P380,000 – (P127,500 – P120,000) Historical-cost depreciation = = = P 81,000 P195,000 P372,500 Step 6: Compute ROI using current-cost estimate for long-term assets and depreciation Operating income for 2005 using 2005 current cost depreciation (Step 5) Current cost of total assets at the end of 2005 (Step 3) Luzon Visayas Mindanao Luzon Visayas Mindanao P 81,000  P 438,000 P195,000  P1,375,000 P372,500  P1,702,500 ROI: Historical Cost 38.24% 19.13% 23.46% = = = 18.49% 14.18% 21.88% ROI: Current Cost 18.49% 14.18% 21.88% Use of current cost results in the Mindanao Division appearing to be the most efficient The Luzon ROI is reduced substantially when the ten-yearold plant is restated for the 70% increase in construction costs over the 1995 to 2005 period Requirement Use of current costs increases the comparability of ROI measures across divisions’ operating plants built at different construction cost price levels Use of current cost also will increase the willingness of managers, evaluated on the basis of ROI, to move from divisions with assets 24-11 Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial purchased many years ago to division with assets purchased in recent years IV Multiple Choice Questions 10 A B C C D B A C B A 11 12 13 14 15 16 17 18 19 20 B D C A C C A C B A 21 22 23 24 25 26 27 28 29 30 24-12 C D C A C D A C D D 31 32 33 34 35 36 37 A A B A C B D ... customers and are comprehensive, and 24- 3 Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial d Provide feedback to help organization members identify problems and. .. current ROS of 19% 24- 5 = Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial The advantages of using ROS are (a) that it is simpler to calculate and (b) that it... helped by the inflation that occurs in Sweden in 2005 Inflation boosts the division’s operating 24- 8 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24 income