Chapter 13

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Langfield-Smith 7e IRM Ch13
Contemporary Management Accounting (Western Sydney University)
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CHAPTER 13
FINANCIAL PERFORMANCE MEASURES

AND INCENTIVE SCHEMES
ANSWERS TO REVIEW QUESTIONS
13.1 It is useful to examine both components of ROI because they provide additional insights that can
be used to interpret and to improve future ROI. For example, when comparing ROI over several
years examining the two components of ROI can assist in identifying whether a decreasing ROI
is due to a reduction in return on sales or a reduction in investment turnover. If the reason is a
poor return on sales, this can lead to a search for reasons why profitability has decreased and the
formulation of strategies to improve return on sales and hence improve future ROI.
13.2 A responsibility accounting system assigns responsibility to managers of business units for
achieving certain targets. Cost centre managers are responsible for attaining a particular physical
target (such as a certain number of units produced) at an agreed cost. Profit centre managers are
responsible for achieving a certain profit target, but without taking into consideration the capital
invested in the profit centre. Both ROI and residual income are further refinements of the
measurement process, in that they measure the profit made by the investment centre relative to
the capital invested in the investment centre.
13.3 There are many activities that managers in the Business Studies Textbook Division could
engage in to improve ROI. Some are desirable, some are not.
Activity Desirable
 Managing costs more effectively yes
 Increasing sales volume yes
 Increasing selling prices ?
 Decreasing staff numbers ?
 Disposing of unnecessary assets yes
 Deferring the purchase of much needed machinery no
 Delaying research into new markets and publications no
 Deleting unprofitable book titles from the sales list yes
 Disposing of obsolete inventory yes
13.4 There are several ways to minimise the negative behavioural effects of ROI:
 Use a broader set of performance measures which encompass both long-term and short-term
measures, and financial and non-financial measures. This de-emphasises ROI as a
performance measure.
 Consider alternative ways of measuring invested capital so that the replacement of an asset
does not have such an adverse effect on ROI. Use of market values or acquisition cost can
help here.
 Use alternate profit measures, such as residual income, to minimise some of the investment
disincentives associated with ROI.
Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e
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13.5 Overemphasising ROI can led to decisions that may be harmful to the future competitiveness of
a company. Some examples follow:
Managers of an investment centre may defer research and development expenditure to improve
short-term profit and hence enhance short-term ROI. However, the lack of R&D may reduce the
number of new products under development that are needed to remain competitive.
Managers may defer investment in new manufacturing plant to reduce depreciation, increase
profit, decrease investment and hence increase short-term ROI. This may reduce the future
capacity of the company to produce innovative products and may lead to inefficient and costly
operations.
13.6 The chief disadvantage of using ROI as a performance measure is as follows. When there is an
investment centre that earns a rate of return greater than the company’s cost of raising capital,
the manager of that investment centre may have an incentive to reject any new asset or project if
it results in reducing the investment centre’s ROI. This may occur even when the new asset or
project meets the company’s hurdle rate for new investments. The residual income measure
eliminates this disadvantage, as a residual income is a dollar amount that results any time a
project earns a return greater than the firm’s cost of capital.
13.7 ROI or residual income rises over the life of a project, because the carrying amount of the assets
decreases due to accumulated yearly depreciation. This can be avoided by using the acquisition
costs of the assets, not the carrying amount, as the invested capital in the ROI or residual income
calculations.
13.8 In an organisation that has divisions, invested capital and profit must be consistently defined
when used in ROI calculations. However, the advantages and disadvantages of particular
definitions must also be considered. For example, using net book values rather than market
values may have certain behavioural consequences. The investment base used in the ROI
calculation should normally include only those assets and liabilities that are attributable to the
division, or controllable by the divisional manager. Similarly, the profit measure should be either
attributable or controllable profit for that division. The ROI used must be capable of measuring
the relative performance of divisions (or managers), or performance of a division (or manager)
over time (hence the need for consistency), and be as ‘valid’ a measure of performance as
possible.
13.9 The performance of a business unit manager should be assessed differently from the
performance of a business unit, because there are revenues and costs that are attributable to a
business unit but uncontrollable by a business unit manager. The performance measurement of a
business unit manager is meaningful only if the manager has influence and control over the
revenues and costs affecting their performance or else the managers would not be motivated to
achieve the performance target. For example, decisions about corporate advertising expenses and
senior management salaries may occur at the corporate level and these costs may be allocated to
business units, but it might be considered unreasonable to hold business unit managers
accountable for these expenses.

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13.10 There are many definitions of value. The Concise Oxford Dictionary, 9th edn, OUP, 1995, refers
to it as ‘the worth, desirability or utility of a thing’. Michael Porter, Competitive Advantage:
Creating and Sustaining Superior Performance, The Free Press, 1985, p. 3, defines it as ‘the
amount buyers are willing to pay for what a firm provides’. In business, ‘value’ is frequently
related to how somebody outside the firm calculates the worth of the business. Shareholder
value, defined as the worth of the business from the shareholders’ perspective, is often used to
illustrate what is meant by the value of the firm. The rationale behind measuring (shareholder)
value is to determine whether a business is generating value for its owners. The recognised
drivers of VBM are:
Spread: the extent to which the return exceeds the cost of capital
Growth: the increase in funds available to invest in value creating activities
Sustainability: the extent to which these available funds can be sustained over coming years
Cost of Capital.
13.11 Some strategies which, when employed will improve EVA ®, but which are not in the best
interests of the firm include the following:
 Any activity that improves profitability in the short term, but leads to future problems.
This includes reduced expenditure on equipment maintenance, marketing, staff
training, and research and development.
 Reduction of the asset base by disposing of productive assets that are currently not
fully utilised, which may cause capacity constraints in future years.
 Engaging in repairs and maintenance of outdated machines, rather than investing in
new machines.
13.12 The imputed interest charge is the required rate of return that the firm expects of its investments.
This is usually based on the organisation’s weighted cost of capital. The weighted average cost
of capital is the weighted average rate of capital from all sources of borrowings and equity.
13.13 Many companies link achievement of performance targets to employee remuneration as a way of
achieving goal congruence. Goal congruence occurs if managers are striving to achieve, for their
own purposes, objectives that are consistent with the overall company goals. Hence tying part of
their remuneration to achieving performance targets can provide strong incentives to strive for
the outcomes that the company desires. However, this puts the onus on designers of the incentive
scheme to select the most effective performance measures. If the wrong performance targets are
selected, a manager can be motivated toward making decisions that are in their own best
interests but not in the best interests of the company. For example, a water company set targets
for reducing accounts receivable. Performance was measured by reporting the number of
accounts that had been settled. It was easier to collect small amounts from individuals, so that
was where the effort was directed. When the targets were changed to the amount that was
collected from debtors the focus of debt collection changed to the large accounts that were
overdue from companies and large facilities. Far more was recovered from a few settlements
than from many small accounts.
13.14 Motivation arises from the processes that account for an individual’s intensity, direction and
persistence of effort in attaining goals. Extrinsic motivation may arise from rewards provided to
employees from an external source. This might include a cash bonus, tickets to a sports event or
a holiday. Intrinsic motivation may arise from the positive experiences of being satisfied with
performing well. It can arise when employees experience the following:
 Choice: the employee has the opportunity to select activities that make sense and to perform
these in ways that seem appropriate.
 Competence: the accomplishment that follows when activities that have been chosen by the
employee are skilfully performed.
 Meaningfulness: the opportunity to pursue a worthy task, which matters in the larger
scheme of things.
 Progress: employees feel that they have made significant advancement in achieving the
task’s purpose.

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13.15 Herzberg’s theory of motivation is based on the idea that two types of factors affect employee
motivation. First, hygiene factors provide the necessary setting for motivation but do not themselves
motivate employees. The key to hygiene factors is that they must be adequate to avoid dissatisfaction.
Exceeding the level at which satisfaction is achieved will not add further gratification or motivation,
they still only avoid dissatisfaction! Pay levels are normally included in this category of factors.
Second, motivators are factors that relate to the job content or outcomes of that job and will provide
motivation. The examples given in the chapter include achievement and recognition. It is only when
pay carries a message of achievement and recognition that it can motivate. According to this theory it
appears that a very high basic salary will not motivate, whereas incentive payments that reward
achievement can. To take advantage of the hygiene factors and the motivators, a salary package
requires a basic salary adequate to reach satisfaction plus incentive payments for achievements.
13.16 A share option is where an employee has the right to purchase shares in their company at a
specified price at a specified time. Share options can be regarded as a reward that may lead to
extrinsic motivation. It is assumed that if employees participate in a share option plan they will
identify more easily with the company and its goals as they have a stake in the company. This is
thought by many to promote goal congruence and motivate high performance.
13.17 A gainsharing scheme involves distributing cash bonuses to employees when the performance of
their group or business unit exceeds a certain performance target. The performance gain is often
based on exceeding some targeted measures of productivity. The performance pool is shared—
part of the gain accrues to the employees and part accrues to the company. A team-based
incentive scheme rewards employees when the performance of their work team exceeds a certain
performance target. The reward may be cash or non-cash.
13.18 The capacity of profit sharing and employee share ownership in incentive schemes to motivate
employees performance can be explained in terms of expectancy theory.
 Expectancy: employees need to believe that their efforts can lead to achieving a particular
performance target.
 Instrumentality: employees need to have confidence that achieving that target will lead to
the granting of the share of profit or the shares or share options.
 Valence: employees must value the reward that are offered—the cash, share or share option.
13.19 The advantage of basing individual incentives on group performance is that it can help
individuals identify with the group; promote equity among employees; and improve the
performance of group members due to peer pressure. However, it can also encourage excessive
competition between employees; cause individuals difficulty in relating their individual effort to
group outcomes; and reward group members who are not good performers.
13.20 Frequent rewards are often thought to enhance motivation. Timely rewards enable employees to
relate their more recent efforts to performance outcomes and those rewards. There is a danger
that if rewards are very frequent, whenever an employee can see that the bonus cannot be
achieved for this period, they will slacken effort until the start of the next reward period.

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SOLUTIONS TO EXERCISES
EXERCISE 13.21 (20 minutes) Return on investment; residual income

1 False. The two components of ROI are return on sales and investment turnover. The return on
sales measures the percentage of profit generated from each dollar of sales revenue and the
investment turnover measures the utilisation of assets by comparing the revenue generated for
each dollar of capital invested (assets).
2 False. ROI is a financial measurement, whereas customer value is a subjective measure

expressed in non-financial terms. Over a period of time, if customers believe that the firm
provides them with goods or services which they value, the increased sales may well result in an
increase in ROI—but it is by no means certain.
3 True. Residual income increases when assets decrease because the firm’s required return for the
invested capital decreases, which increases the residual income. However residual income may
have increased because of the increase in net income.
4 False. Residual income will encourage managers to replace assets where the projected rate of
return in the replacement of an asset is above the business unit’s required minimum rate of
return. ROI is likely to encourage managers to defer asset replacement if this will result in a
reduction in the business unit’s ROI, even though the return inherent in the new project may be
above the firm’s minimum required rate of return.
5 False. ROI encourages managers to focus on short-term profit improvement by deferring

expenditure on research and development and marketing, even though this may worsen the
firm’s long-term position.

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EXERCISE 13.22 (20 minutes) Components of ROI; improving ROI; residual

income: retailer
profit $6 000 000
sales revenue $75 000 000
1 Return on sales = = = 8%
sales revenue
Investment turnover = invested capital =
$75 000 000
$3 0000 000 = 2.5
profit
Return on investment = invested capital =
$6 000000
$30 000 000 = 20%
2 There are many ways to improve the division’s ROI to 25 per cent. Here are two of them:
(a) Improve the return on sales to 10 per cent by increasing profit to $7 500 000:
ROI = return on sales  investment turnover
$7 500 000 $75 000 000
×
= $75 000 000 $30 000 000
= 10%  2.5 = 25%
Since sales revenue remains unchanged, this implies a cost reduction of $1 500 000 at the
same sales revenue.
(b) Improve the investment turnover to 3.125 by decreasing average invested capital to
$24 000 000:
$6 000000 $75 000 000
×
= $75 000 000 $24 000 000
= 8%  3.125 = 25%
Since sales revenue remains unchanged, this implies that the firm can divest itself of
some productive assets without affecting sales revenue.
3 Residual income = $6 000 000 – ($30 000 000  11%)

= $6 000 000 – 3 300 000
= $2 700 000

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EXERCISE 13.23 (15 minutes) Improving ROI: manufacturer

1 Return on sales = profit = 450 000 = 5%
sales revenue 9 000 000
* Profit = $450 000 = 9 000 000 – 4 950 000 – 3 600 000
salesrevenue 9 000 000

Investment turnover = = = 2
invested capital 4 500 000
profit 450 000

ROI = = = 10%
investedcapital 4 500 000
profit profit
2 ROI = 15% = =
invested capital 4 500 000
Profit = 15%  4 500 000 = 675 000
Profit = sales revenue – expenses = 675 000
Profit = 9 000 000 – expenses = 675 000
Expenses = $8 325 000
Therefore, total expenses (cost of goods sold and operating expenses) must be reduced to $8 325 000 in order
to raise the firm’s ROI to 15 per cent.
profit 675 000

3 Return on sales = =
sales revenue 9 000 000
Return on sales = 7.5%
ROI = Return on sales  investment turnover
= 7.5%  2
= 15%

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EXERCISE 13.24 (20 minutes) ROI as a comparative performance measure
To: The Managing Director

Southern Coast Health Foods
From: Assistant Accountant
Return on investment is sometimes a superior measure of financial performance compared to
profit, as it relates profit to the assets available to generate profits. However a disadvantage of
ROI is that it may not very useful for comparing the performance of divisions where there are
distinct differences in the lives of the assets or where there are different degrees of reliance on
plant and equipment to generate profit.
For the division that has assets that are 10 years old and which are due for replacement, the ROI
generated for that division will be relatively high compared to the second division’s ROI. This
is because the carrying amount of the assets is likely to be very low due to the 10 years of
depreciation. In this case the assets may not be as productive or efficient as they were in their
earlier years, and so may need replacement. (This aspect may not be obvious as the ROI is
high.) However, the high ROI may provide an incentive for the divisional managers to retain
these assets far beyond their optimum time for replacement. Once the assets are replaced the
ROI will dramatically reduce, due to the high carrying amount of the new assets. Exhibit 13.2
shows the changes that can occur in ROI over several years when profits are stable, but the
carrying amount decreases. In this situation the ROI that is reported is not a true measure of the
performance of the division.
The third division has relatively few assets, so its ROI is likely to be high, reflecting a low asset
base. This makes it hard to compare financial performance against the other two divisions
which are more asset intensive.
These limitations must be taken into account when using ROI to compare the performance of
divisions.

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EXERCISE 13.25 (25 minutes) Comparing the performance of two divisions:

retail company
1 A comparison of the profits of the two divisions does not give an accurate picture of the relative
performance of the two divisions as each division derives that profit from different amounts of
assets. If ROI is used, then the Dressmaking Division performs better than the Furnishing
Division. However, ROI may also not provide a good basis for comparison, as the two divisions
operate in two different industries. We do not know what constitutes good performance in the
furnishing or the dressmaking industries. Nor do we know the firm’s required rate of return, or
any ROI or profit targets that management may have set for each division.
2 If the firm’s required rate of return is 15 per cent or 18 per cent, the Dressmaking Division has
a higher residual income than furnishing.
(a) Imputed interest rate of 12 per cent:
Furnishing Dressmaking
_____________________________________________________________________________
_______________________________________________________________________
Divisional profit $1 350 000 $300 000
Less: Imputed interest charge:
Furnishing: $9 000 000  12% 1 080 000
Dressmaking: $1 500 000  12% 180 000
Residual income $270 000 $120 000
(b) Imputed interest rate of 15 per cent:

_______________________________________________________________________
Furnishing: $9 000 000  15% 1 350 000
Dressmaking: $1 500 000  15% 225 000
Residual income $0 $75 000
(c) Imputed interest rate of 18 per cent:
_________________________________________________________________________
Furnishing: $9 000 000  18% 1 620 000
Dressmaking: $1 500 000  18% 270 000
Residual income $(270 000) $30 000

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EXERCISE 13.26 (30 minutes) Weighted average cost of capital; EVA®; service
firm
1 The weighted average cost of capital (WACC) is defined as follows:
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The interest rate on the Constructo Construction Company’s $60 million debt is 10 per cent,
and the company’s tax rate is 40 per cent. Therefore, Williamstown Construction Company’s
after-tax cost of debt is 6 per cent [10%  (1 – 40%)]. The cost of Constructo Construction
Company’s equity capital is 15 per cent. Moreover, the market value of the company’s equity
is $90 million. The following calculation shows that Constructo Construction Company’s
WACC is 11.4 per cent.
Weighted -average (0. 06)($90 000 000)+(0 .15 )($135 000 000)
cost of capital
=0. 114
= $90 000 000+$135 000 000
2 The economic value added (EVA®) is defined as follows:
EVA® = net operating profit after tax – (capital employed x WACC)

For Constructo Construction Company, the EVA® for the two divisions can be calculated as
follows.
Economic
After-tax
Total Current value
operating
assets liabilities added
profit
(in (in (in
Division (in millions) millions) millions) WACC millions)
Real Estate $30(1 - 0.40) – [($150 – $9)  0.114 ] $1.926

=
Construction $27(1 - 0.40) – [($90 – $6)  0.114 ] $6.624

=

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EXERCISE 13.27 (20 minutes) Value-based management
1 False. Value-based management (VBM) is a framework for making key business decisions that
add economic value to the business. Value creation from adopting VBM aims at increasing
shareholder value. It is likely, among other effects, that VBM may increase return on assets, but
it is not a method of increasing any profitability ratio per se.
2 True. Economic value added is a measure of the value created over a single accounting period,
measured by the spread between return generated by business activities and the cost of capital.
3 False. Economic value added (EVA®) is not equivalent to return on investment (ROI). EVA ® is
an absolute dollar figure and is calculated as net operating profit after tax (NOPAT), less an
allowance for investment in assets, which is calculated as capital employed multiplied by the
WACC. ROI is expressed as a percentage, and is calculated as profit divided by invested capital.
4 True. EVA®, ROI and RI are all single period measures of performance and there is potential for
manipulation and short-term focus. The value of a business is really the outcome of several years
of managerial decision making, at both strategic and operational levels.
5 True. Shareholder value analysis (SVA) measures attempt to calculate the present value of
future cash flows resulting from strategic decisions relating to projects, markets, mergers and
acquisitions.
EXERCISE 13.28 (25 minutes) ROI and EVA®: service firm

Equipment Rental Truck Rental
Division Division
1 ROI Invested capital ($750 000 – 80 000) = $670 000 ($3 000 000 – 250 000) = $2 750 000
ROI $45 000 / $670 000 $110 000 / $2 750 000

= 0.0672 or 6.72% = 0.04 or 4.0%
2 EVA® $45 000 – ($670 000  0.06) $110 000 – ($2 750 000  0.06)
=$45 000 – 40 200 =$110 000 – 165 000
=$4 800 =$(55 000)
3 Ready Rentals' Equipment Rental Division (ERD) has performed better than the Truck Rental
Division (TRD) under both measures. TRD has a much higher profit figure, but when the
invested capital is brought into consideration, the high investment base of TRD leads to a lower
ROI. TRD’s profit of $110 000 is 2.44 times that of ERD ($45 000), whereas TRD’s invested
capital of $2 750 000 is 4.1 times that of the $670 000 invested in ERD. The ROI for TRD is less
than the WACC of 6 per cent but ERD exceeds the WACC.
TRD has a negative EVA®. This indicates that the weighted average cost of capital of 6 per cent
is greater than its rate of the return calculated under ROI. With its ROI exceeding the WACC,
ERD’s EVA® is positive.
While at this stage ERD is the better-performing division, the firm would gain better insight into
the performance of each division if comparisons were made with other firms in the same
business. At the same time, TRD may have invested large amounts of capital in the short term
with a view to improving long term performance and this highlights the dangers of single-period
measurements.

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EXERCISE 13.29 (25 minutes) Performance measurement and incentive

schemes
1 False. Expectancy theory does not relate motivation to hygiene factors and motivators. It states
that employee motivation is a function of the strength of expectancy (effort leads to
performance), instrumentality (performance leads to rewards) and valency (rewards lead to
personal goals). On the other hand, Herzberg’s theory argued that hygiene factors provide the
necessary setting for motivation, but do not themselves motivate employees. However,
employees need a certain level of hygiene factors to prevent dissatisfaction. Motivators are said
to provide motivation.
2 False. Not necessarily. Many incentive schemes are based on both individual and group efforts.
Providing rewards for individual performance has both advantages and disadvantages over
providing group rewards for team performance. For example, when basing rewards on individual
performance it may be difficult to determine the effects of individual actions on group or
company performance. However, the ‘free rider’ problem associated with group reward schemes
does not exist for individual reward schemes.
3 True. It seems that many performance-related pay systems are not closely linked to an effective
performance measurement system, and so may not encourage improved performance.
4 Perhaps. Employee share plans may award shares to employees based on team-level or
individual performance. Individual incentive schemes may work better at senior levels as these
managers may be in a better position to take actions that can be directly measured, so it may be
easier to design measures that reflect an individual’s performance.
EXERCISE 13.30 (25 minutes) Incentive schemes: manufacturer

To: The Managing Director
Safety Chemicals Ltd
From: Grant Lawson
Financial Controller
The introduction of a profit-sharing plan is a good idea. However, there are a few issues that
need to be considered before our plans are finalised.
Let us consider the advantages first. Basing individual rewards on group performance can
provide a way of encouraging employees to identify with the company and may lead to
increased motivation. Also, as employee bonuses will all be based on a percentage of base pay,
employees may see this as fair.
Against these advantages, we must consider whether the scheme will encourage ‘free riders’.
That is, some employees may not perform well, but will be given the same rewards as those
employees who have outstanding performance. This may cause high performers to feel
dissatisfied. Closely related to this issue is the difficulty of individual employees not being able
to clearly relate their own effort to improved company performance. This can dampen
employee enthusiasm to perform well.
Another issue relates to the timing of bonus payments. It is often desirable to reward employees
more frequently than once a year. The company could consider paying bonuses six monthly, or
each quarter.

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SOLUTIONS TO PROBLEMS
PROBLEM 13.31 (35 minutes) ROI and performance evaluation: manufacturer

1 Return on sales: $810 000 ÷ $10 800 000 = 7.5%
Investment turnover: $10 800 000 ÷ $13 500 000 = 80%
Return on investment: $810 000 ÷ $13 500 000 = 6%, or
7.5% x 80% = 6%
2 Strategy (1) Profit will be reduced to $675 000 because of the loss, and invested capital will fall
to $13 365 000 from the disposal. ROI = $675 000 ÷ $13 365 000, or 5.05 per cent. This strategy
should be rejected, since it reduces Fletcher Industries’ performance.
Strategy (2) In terms of ROI, this strategy neither hurts nor helps. The acceleration of overdue
receivables increases cash and decreases accounts receivable by the same amount, producing no
effect on invested capital. Of course, it is possible that the newly acquired cash could be invested
in activities or assets that would provide a positive return for the firm.
3 The effect of this strategy would be to increase profits by $337 500. If it had happened in the last
quarter, profit would have increased to $1 147 500 and ROI to 8.5 per cent. However, the
reduction in expenses could have a negative impact on future performance. A drastic cutback in
advertising could lead to a loss of customers and a reduced market share. This could translate
into reduced profits over the long term. With respect to repairs and maintenance, reduced outlays
could prove costly by unintentional shortening of the useful lives of plant and equipment. Such
action could result in an accelerated asset replacement program. In the short term, if lack of
maintenance leads to a major breakdown of equipment next quarter the profits could decrease.
4 Andrews' ROI: ($6 750 000 – $5 400 000) ÷ $11 250 000 = 12%
Brown's ROI: ($10 125 000 – $9 270 000) ÷ $10 687 500 = 8%
Both investments appear attractive, as their ROIs are higher than the division’s current ROI of
6 per cent. However, if Fletcher Industries desires to maximise its ROI, it should acquire only
Andrews; the return from Andrews plus Brown will lie between 12 per cent and 8 per cent. The
risk is that the financial characteristics that are reported for the two companies may not be
typical of future financial results. Of course, when making decisions to acquire other companies
the impact on a company’s ROI is only one of many factors that would be considered!
Current Current + Current +

Andrews Andrews +
Brown
Profit $810 000 $2 160 000 $3 015 000
Invested capital 13 500 000 24 750 000 35 437 500
ROI 6% 8.73% 8.51%

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PROBLEM 13.32 (35 minutes) ROI; residual income: manufacturer

1 Average investment in productive assets:
Last year ending balance $25 200 000
Prior year ending balance ($25 200 000  1.05) 24 000 000
Beginning balance plus ending balance $49 200 000
Average balance (49 200 000  2) $24 600 000
Profit from operations before income taxes

(a) ROI = average productive assets
$ 4 920000
= $24 600000
= 20%
(b) Profit from operations before income taxes $4 920 000
Average productive assets $24 600 000
Imputed interest rate x 0.15
Imputed interest charge 3 690 000
Residual income $1 230 000
2 Yes, Ram’s management probably would have accepted the investment if residual income
were used. The investment opportunity would have lowered Ram’s ROI last year because the
project’s expected return (18 per cent) was lower than the division’s historical returns (19.3 to
22.1 per cent) as well as its actual ROI (20 per cent) last year. Management may have rejected
the investment because bonuses are based in part on the ROI performance measure. If residual
income were used as a performance measure (and as a basis for bonuses), management would
accept any and all investments that would increase residual income (that is, a dollar amount
rather than a percentage), including the investment opportunity it had in last year.
3 Use an Excel® spreadsheet to solve the following:
(a) When profit from operations was $5 400 000

ROI = average productive assets
$5 400 000
= $24 600 000
= 0.2195 or 21.95%
(b) When productive assets at year end were $36 000 000
Average productive assets = $35 142 857*

ROI = average productive assets
$ 4 920000
= $35 142 857
= 0.14%
* recalculate the balance at start of year and find the average, as before.

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PROBLEM 13.33 (45 minutes) ROI and residual income; missing data:
manufacturer
1
Plumbing Industrial Retail

Division Division Division
Sales revenue $40 000 000 $8 000 000e $3 200 000l
Profit 8 000 000 1 600 000 800 000k
Average investment 10 000 000 8 000 000f 4 000 000j
Return on sales 20%a 20% 25%
Investment turnover 4b 1 0.8i
ROI 80%c 20%g 20%
Residual income $7 200 000d $960 000h $480 000
Explanatory notes:
profit
= $8 000000
a
Return on sales = sales revenue $ 40000 000 = 20%
sales revenue
= $ 40000000
b
Investment turnover = invested capital $10000000 =4
c
ROI = Return on sales  investment turnover = 20%  4 = 80%
d
Residual income = profit – (imputed interest rate)(invested capital)
= $8 000 000 – (8%)($10 000 000) = $7 200 000
e
Return on sales = profit
sales revenue
20% = $1 600 000

sales revenue
Therefore, sales revenue = $8 000 000
f
Investment turnover = sales revenue
invested capital
1 = $8 000000
invested capital
Therefore, invested capital = $8 000 000
g

ROI = 20%  1.0 = 20%

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h
= $1 600 000 – (8%)($8 000 000)
= $960 000
i
20% = 25%  capital turnover
Therefore, investment turnover = 0.8
j
ROI = profit = 20%
investedcapital
Therefore, profit = (20%)(invested capital)
= $480 000
Substituting from above for profit:
(20%)(invested capital) – (8%)(invested capital) = $480 000
Therefore, (12%)(invested capital) = $480 000
So, invested capital = $4 000 000
k
profit
ROI =
investedcapital
profit
20% =
$ 4000 000
Therefore, profit = $800 000
l
profit
Return on sales =
sales revenue
$800 000
25% =
sales revenue
Therefore, sales revenue = $3 200 000
2 Three ways to increase the Industrial Division’s ROI:

(a) Increase profit, while keeping invested capital the same. Suppose profit increases to
$2 400 000. The new ROI is:
profit $2 400 000

ROI = investedcapital = $8 000000 = 30%
(b) Decrease invested capital, while keeping profit the same. Suppose invested capital decreases
to
$6 000 000. The new ROI is:

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profit $1 600 000

ROI = invested capital = $ 6000 000 = 26.67%
(c) Increase profit and decrease invested capital. Suppose profit increases to $600 000 and
invested capital decreases to $1 500 000. The new ROI is:
profit $2 400 000

ROI = invested capital = $ 6000 000 = 40%
3 ROI—Plumbing Division = return on sales  investment turnover = 25% 
4
= 100 %
4 ROI does not provide a suitable basis for comparing the performance of the three divisions.
Each division operates in a different industry, has different degrees of dependence on assets,
and manage assets of differing ages. For example, the Plumbing Division is using old
machinery, which may be fully depreciated, so its asset base is low. This would boost the ROI,
making it appear much more profitable than the other two divisions. The Industrial Division is
machine-intensive and has recently acquired expensive computerised machinery. This would
tend to reduce the ROI in the earlier years of acquisition. The Plumbing Division has the
highest ROI of the group. What is not known is whether an ROI of 80 per cent is considered
good performance within its own industry. The Retail Division has the lowest reliance on
assets, and it is difficult to evaluate this division’s performance unless the performance of
similar retail venture within the industry is known.
PROBLEM 13.34 (35 minutes) ROI and residual income; evaluation of new
investment: retailer
1 Current ROI of the Little River Division:
Sales revenue $8 400 000
Less: Variable costs ($8 400 000  70%) $5 880 000
Fixed costs 2 150 000 8 030 000
Profit 370 000
ROI = Profit ÷ invested capital
= $370 000 ÷ $1 850 000
= 20%
Little River Division’s ROI if competitor is acquired:
Sales revenue ($8 400 000 + $5 200 000) $13 600 000
Less: Variable costs [$5 880 000 + ($5 200 000  $9 260 000
65%)]
Fixed costs ($2 150 000 + $1 670 000) 3 820 000 13 080 000
Profit $520 000
= $520 000 ÷ [$1 850 000 + ($625 000 + $375 000)]

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= 18.25%
2 Divisional management will likely be against the acquisition because ROI will be lowered from
20 per cent to 18.25 per cent. Since bonuses are awarded on the basis of ROI, the acquisition
will result in a decrease in salary.
3 An examination of the competitor’s financial statistics reveals the following:
Sales revenue $5 200 000
Less: Variable costs ($5 200 000  65%) $3 380 000
Fixed costs 1 670 000 5 050 000
Profit $ 150 000
= $150 000 ÷ $625 000
= 24%
Corporate management would probably favour the acquisition. Electromart has been earning a
13 per cent return, and the competitor’s ROI of 24 per cent will help the organisation as a
whole. Even if the $375 000 upgrade is made, the competitor’s ROI would be 15 per cent if
past earnings trends continue [$150 000 ÷ ($625 000 + $375 000) = 15%].
4 Yes, the divisional ROI would increase to 21.01 per cent. However, the absence of the upgrade
could lead to long-run problems, with customers being confused (and perhaps turned off) by
two different retail environments—the retail environment they have come to expect with other
Electromart outlets and that of the newly acquired, non-upgraded competitor.
Sales revenue ($8 400 000 + $5 200 000) $13 600 000
Less: Variable costs [$5 880 000 + ($5 200 000 

65%)]
$9 260 000
Fixed costs ($2 150 000 + $1 670 000) 3 820 000 13 080 000
Profit $520 000
= $520 000 ÷ [$1 850 000 + $625 000)]
= 21.01%

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5 Current residual income of the Little River Division:
Divisional profit $370 000
Less: Imputed interest charge ($1 850 000  12%) 222 000
Residual income $148 000
Residual income if competitor is acquired:
Divisional profit ($370 000 + $150 000) $520 000
Less: Imputed interest charge [$1 850 000 + ($625 000 + $375 000)]  12%] 342 000
Residual income $178 000
Yes, divisional management may change its attitude.

Residual income will increase by $30 000 as a result of the acquisition.
PROBLEM 13.35 (30 minutes) Behavioural implications of ROI: computer-

integrated manufacturer
1 The new equipment has not resulted in the expected improvement in financial performance in
the first year of operation, due to the inconsistencies between the way that the capital investment
proposal was evaluated and the way that yearly profit is measured.
When the decision was made to invest in the new equipment, an evaluation was made based on
the present value of the project’s anticipated future cash flows. This method, which is typically
used to analyse cash flows in capital investment decisions (covered in Chapter 21), is not
consistent with the principles used to calculate profit. Profit is not determined by cash flows but
uses accrual accounting principles. Thus, straight-line or diminishing value methods of
depreciation are a yearly expense. The new equipment was expected to save $35 000 per year in
operating expenses. This has occurred. However, in calculating ROI, depreciation of 20 per cent
also reduces yearly profit, and the asset value used in the denominator is reduced by
depreciation. Over the life of the equipment, the ROI will increase as the carrying amount of the
asset reduces. However, in the early years the ROI will be low.
2 The behavioural problem that can result is that the manager of the Sandman Division may have a
disincentive to invest in new equipment in the future, even though the ROI indicates that it is a
sound economic investment. In the early years of an investment the use of ROI can mask
improved financial performance. Also, in this case, as the Sandman Division is a high
performing division, the ROI of 16.7 per cent on the new equipment reduced the division’s
previous high ROI of 20 per cent. The next time such an investment decision arises, the
Sandman Division manager might reject the proposed investment.

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PROBLEM 13.36 (40 minutes) Increasing ROI and RI over time

Average ROI based ROI based on
Profit before Annual Profit after carrying on carrying Acquisition acquisition
depreciation Depreciation depreciation amount* amount† cost cost
Year
($) ($) ($) ($) ($) ($) (%)
1 $150 000 $200 000 $(50 000) $400 000 – $500 000 –
2 150 000 120 000 30 000 240 000 12.5% 500 000 6.0%
3 150 000 72 000 78 000 144 000 54.2% 500 000 15.6%
4 150 000 54 000 96 000 81 000 118.5% 500 000 19.2%
5 150 000 54 000 96 000 27 000 355.6% 500 000 19.2%
* In Year 1, the end of year carrying amount is $(500 000 – 200 000), so the average carrying amount is:
$500 000 + $300 000

= $400 000
2
†
ROI rounded to the nearest tenth of 1 per cent.
1 This table differs from Exhibit 13.2 in that ROI rises even more steeply across time than it does in
Exhibit 13.2. With straight-line depreciation, ROI rises from 11.1 per cent in Year 1 to 100 per cent in
Year 5. Under the accelerated depreciation schedule used here, we have a loss in Year 1 and then ROI
rises from 12.5 per cent in Year 2 to 355.6 per cent in Year 5.
2 One potential implication of such an ROI pattern is an increased disincentive for new investment. If a
proposed capital project shows a loss or very low ROI in its early years, a manager may worry about
the effect on their performance evaluation in the early years of the project. In an extreme case, a
manager may worry that they will no longer have the job when the project begins to show a higher
return in its later years.
3 Profit before Annual Profit after Average RI* based Acquisition RI based on
depreciation depreciation depreciation carrying on average cost acquisition
amount carrying cost
amount†
Year ($) ($) ($) ($) ($) ($) ($)
1 $150 000 $100 000 $50 000 $450 000 $5 000 $500 000 $0
2 150 000 100 000 $50 000 350 000 $15 000 500 000 $0
3 150 000 100 000 $50 000 250 000 $25 000 500 000 $0
4 150 000 100 000 $50 000 150 000 $35 000 500 000 $0
5 150 000 100 000 $50 000 50 000 $45 000 500 000 $0
* Imputed interest rate 10%
† Year 1 $50 000 – $450 000 x 10%
4 The improvement in the RI when based on the average carrying amount is directly due to the reducing
average carrying amount of the assets. It does not reflect improved managerial decisions over the life
of the asset. The result of operating changes will be shown more clearly in the RI based on acquisition
cost. While there is an increase in the RI based on carrying cost, it is not the dramatic increase in Year
5 that we saw with the ROI also based on carrying cost. With both methods using carrying costs, we

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can see that managers are able to get a free ride with regard to their bonuses.
5 Although managers will be less deterred from upgrading equipment when using the RI measure, there
is still likely to be a drop in RI. The greatest incentives for improving performance would come from
basing the calculation on acquisition costs, whether using RI or ROI.
PROBLEM 13.37 (40 minutes) Weighted average cost of capital; EVA®; ROI;
performance report: agricultural company
1 The weighted average cost of capital (WACC) is defined as follows:
After − tax
cos t of
deb t
capital
¿
ri gh
¿
¿
¿
( )
¿
Market
value
of d ebt
¿
ri gh
¿
¿
¿
Co st of
eq uity
capital
¿
ri gh
¿
¿
¿
( )
¿
Market
v alue of
eq uity
Weighted−average ¿
ri gh
¿
¿
¿
( ¿ ) ( ¿ ) ( ¿ ) ¿
costof capital =
¿
¿
¿
¿
The following calculation shows that the company’s WACC is 8.52 per cent.
Weighted - average (.063)($800 000 000) + (.10)($1 200 000 000)

= =.0852
cost of capital $800 000 000 + $1 200 000 000
2 The three divisions’ economic value added measures are calculated as follows:
After-tax
Total Current Economic
operating
Division - assets (in - liabilities  WACC = value added
profit
millions) (in millions) (in millions)
(in millions)
Retail
Plantations $28  (1 - 0.30) - [($140 - $12)  0.0852] = $8.6944
Pine
Forests $90  (1 - 0.30) - [($600 - $10)  0.0852] = $12.732
Large
Growth
Forest $96  (1 - 0.30) - [($960 - $18)  0.0852] = $(13.0584)
3 Overall the company is generating a positive EVA ®. However, the three divisions have very
different levels of performance. While the Retail Plantations Division has the lowest profit
before tax at $28 million, it has the lowest investment in net assets at $128 million. It has a
positive EVA® which indicates that it is returning more than the company’s WACC.
The Pine Forest Division has generated a similar profit to the Large Growth Forest Division, but
due to a more modest net asset base of $590 million is able to generate a positive EVA®.
The Large Growth Forest Division has $942 million in net assets but has generated profits of
only $96 million before taxes. The negative EVA® indicates that it is yielding a return less than
the WACC. More information is needed about the relative age of the assets in each division and
the expected levels of performance for divisions in these types of ventures. (Instructor: Students
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lOMoARcPSD|9693341
need to show an understanding of the relevance of this last statement.)
PROBLEM 13.38 (40 minutes) ROI versus residual income; incentives; bonus
schemes: manufacturer
1 If New Age Industries continues to use return on investment as the sole measure of division
performance, Fun Times Company (FTC) would be reluctant to acquire Arcade Unlimited Ltd
(AUL), because the post-acquisition combined ROI would decrease.
Return on investment
AUL FTC Combined
Operating profit $900 000 $3 000 000 $3 900 000
Total assets 4 500 000 12 000 000 16 500 000
Return on investment (profit/assets) 20% 25% 23.6%*
* Rounded.
The result would be that FTC’s management would either lose their bonuses or have their
bonuses limited to 50 per cent of the eligible amounts. The assumption is that management
could provide convincing explanations for the decline in return on investment.
2 Residual income is the profit earned that exceeds an amount charged for funds committed to a
business unit. The amount charged for funds is equal to an imputed interest rate multiplied by
the business unit’s invested capital.
If New Age Industries could be persuaded to use residual income to measure performance, FTC
would be more willing to acquire AUL, because the residual income of the combined operations
would increase.
Residual income
AUL FTC Combined
Total assets $4 800 000* $12 000 000 $16 800 000
Profit 900 000 3 000 000 3 900 000
Less: Imputed interest charge (assets  15%) 720 000 1 800 000 2 520 000
Residual income $180 000 $1 200 000 $1 380 000
* Cost to acquire AUL.
3 The likely effect on the behaviour of division managers whose performance is measured by
return on investment includes incentives to do the following:
 Defer capital improvements or modernisation to avoid undertaking capital expenditures.
 Avoid profitable opportunities or investments that would yield more than the company’s
cost of capital but that could lower ROI.
If residual income were used the likely effect on the behaviour of division managers includes
incentives to do the following:
 Seek any opportunity or investment that will increase overall residual income.
 Seek to reduce the level of assets employed in the business.
®
EVA could also be used to measure and reward divisional managers and that would have
similar advantages to the use of RI.

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PROBLEM 13.39 (50 minutes) Review of Chapters 12 and 13; ROI and EVA®;
centralised versus decentralised service units: service company
Note that Angler Fisheries is defining invested capital as ‘total assets less current liabilities’ and this
method will be used for all calculations. This definition assumes that investment centre managers have
control (or at least strong influence) over short-term liabilities such as short-term bank loans and
employee entitlements. This approach encourages managers to minimise resources tied up in assets and
manage the use of short-term credit to finance operations.
1 ROI:
Southern Australian Northern Australian Fishing FleetDivision

Division Division
Pre-tax profit $5 400 000 $1 200 000 $900 000
After-tax profit (70%) $3 780 000 $840 000 $630 000
Invested capital $52 500 000 – 12 000 000 $6 000 000 – 3 000 000 $25 200 000 – 2 400 000
= $40 500 000 = $3 000 000 = $22 800 000
ROI $3 780 000/ $40 500 000 $840 000/ $3 000 000 $630 000/ $22 800 000
= 9.3333% = 28.0% = 2.7631%
2 Based on ROI, Northern with 28.0 per cent clearly exceeds the performance of the other two
divisions but, when interpreting the ROI figures, the following should be considered:
 Northern leases its assets, whereas the other divisions own their assets. Thus, Northern has
the use of assets to generate profits, but those assets are not included in its invested capital.
This could be one reason why the ROI of this division is so high.
 Southern Australia is old, and may have older assets that have probably been heavily
depreciated, but the assets of the Fishing Fleet have recently been updated. The ROI of the
Fishing Fleet is penalised by having newer assets.
 The Fishing Fleet is in a different business to the other two divisions. It generates a different
level of profit and return. The ROI may not be comparable to that of the other two divisions.
 Southern’s assets may well be less efficient than Northern’s newer assets (which presumably
will be modern if they are being leased)
One of the advantages of ROI is that it allows comparisons to be made between divisions, but
this case suggests that this is not always valid. Operating a fishing fleet cannot realistically be
compared with operating a restaurant. Whereas all divisions are expected to meet an ROI target
of 10 per cent, only the Northern Division is able to do so. However, this might be partially due
to having leased its assets.
Additional information could include:
 What is the expected ROI for a fishing fleet compared to a restaurant?
 Are the assets of the Southern Division full depreciated?
 What would the ROI of Northern be if the (leased) assets were accounted for in the same
way as in the other divisions?
 Are the lease payments for Northern a similar amount as a depreciation expense?
An important issue when making comparisons is to ensure that the items are actually
comparable.
3 EVA® (using 8 per cent as the weighted average cost of capital)

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Southern Australian Northern Australian Fishing Fleet

Division Division Division
After-tax profit (70%) $3 780 000 $840 000 $630 000
Less capital charge $40 500 000  0.08 $3 000 000  0.08 $22 800 000  0.08
= 3 240 000 = 240 000 = 1 824 000
EVA® $540 000 $600 000 ($1 194 000)
4 When EVA® is introduced into the performance measurement process, Northern still appears to
be the best performer, although the gap between it and Southern has diminished. This is partially
due to the relatively large size of the operations of Northern.
The performance of the Fishing Fleet continues to be poor—going from an ROI of 2.8 per cent
to a negative EVA® figure—because both figures highlight the very high asset base used to
generate only a small profit. Although the divisions are said to operate as ‘stand-alone’
businesses, logic suggests that the fishing fleet may provide at least some fresh fish for the
restaurants. If this is the case, the transfer price charged will affect the profit of both supplying
and buying divisions.
5 In order to make more meaningful comparisons between divisions using ROI and EVA ®, the
following data should be supplied:
 Sales value—this helps to identify whether investment turnover is increasing or decreasing,
and is a part of the Du Pont ratio used to disaggregate the ROI formula. It is also useful in
comparing growth in sales with growth in profit.
 Transfer prices between the Fishing Fleet and the restaurants, if this applies.
 The value of the assets leased by Northern and the value of leasehold payments allowed as
expenses. These could be used to adjust the figures of Northern to be comparable with
Southern.
 The asset values at the beginning of the period, so that average asset values could be used.
In particular, this may be applicable to the Fishing Fleet, since the amount of the fleet
replacement is having a serious affect on the performance of this division.

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lOMoARcPSD|9693341
PROBLEM 13.40 (45 minutes) Performance measures and incentive schemes;

behavioural issues: manufacturer
1 There are several features of the performance-related pay system that are causing problems.
 The performance of teams A and B are not independent. This means that several aspects
of Team B’s performance are dependent on the actions of Team A. Also, the activities of
the purchasing department are also impacting unfavourably on Team B.
 The performance measures may not be appropriate to encourage the correct actions by
teams. Team A can maximise its performance in terms of cycle time, material usage and
production output, by supplying a defective product to Team B. Team B’s performance is
then compromised as it takes longer to process faulty product.
 The use of group performance assessment is allowing at least one team member to free
ride, and receive the same rewards as other members of the team.
 Team D is not participating in sharing the bonus pool and this is creating some
dissatisfaction among the members of Team D.
 There appears to be some tampering with the calibrating machine, which is impacting on
the performance of Team B.
 The bonus pool is fixed, and shared among the three teams. Thus, it is in the interests of a
team to perform well at the expense of the other teams.
2 The three performance measures are cycle time, material usage and production output. These
measures encourage the efficient use of material and speedy manufacturing practices. The focus
on these three measures is having at least one dysfunctional outcome. Team A is providing
faulty output to Team B, who takes much longer to process this product. These measures do not
seem suitable for assessing performance and awarding bonuses as they are allowing Team A to
achieve high-performance outcomes at the expense of Team B.
3 The following changes could be made to improve the system:

 Changes could be made to the selection of performance measures. Either a quality
measure could be introduced, such as ‘percentage of units passing quality inspection’, or
the production output measures could be modified to only record the output of 100 per
cent defect-free production units.
 Performance measures could be introduced for the Purchasing Department to encourage
them to provide material to the teams on time and when required.
 Teams should be encouraged to manage their non-performing team members themselves.
In many companies self-managed work teams are encouraged to manage their own team
members and apply sanctions when necessary.
 Management needs to bring Team D into the scheme, despite the introduction of the new
production technology. Carefully designed performance measures and targets should be
able to be formulated to accommodate their particular production situation.
 There are two choices that could be made to deal with the problem of shared equipment.
Either separate equipment can be purchased for each team (this may be far too costly!)
or, controls or procedures need to be introduced to minimise teams tampering with
equipment/leaving equipment in an unfit state. The calibrating machine could be made
the responsibility of a particular employee or team.
 The use of a shared bonus pool may need to be reassessed, as a team’s share of the pool
is partially dependent on the performance of the other teams. Management could
consider an open-ended bonus pool, so team rewards are not constrained by the good
performance of other teams. However, this could end up being costly for the company.
Alternatively, separate bonus pools could be established for each team, say $2500 per
team, and obtaining the maximum bonus may be dependent on achieving certain
performance targets.

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SOLUTIONS TO CASES
CASE 13.41 (60 minutes) Review of Chapters 12 and 13; divisional performance
reporting and evaluation; ethics
1 Value of the annual performance report.
(a) The major concern is that the Bondi Division is treated as an investment centre when it
appears to sell only to the Bronte Division. The ‘sales’ figure is derived from transfer
prices based on market prices, and is completely beyond the control of the Bondi Division
manager. If Bondi does not sell to the outside market, it should be treated as a cost centre
only and all notions of both profit and ROI discarded. Treating Bondi Division as an
investment centre increases the complexity of accounting and appears to serve no useful
purpose.
If the same accounting techniques are used for the Bronte Division, they appear to be
suitable for an investment centre, with certain improvements desirable.
(b) If the company continues to treat Bondi Division was an investment centre, using a
financial accounting approach to reporting, a number of improvements could be made:
(i) Gross profit should be shown, as it is an important element in any profit-based
measurement system.
(ii) Divisional administration should be shown as a separate cost below gross profit—
not included in manufacturing overhead. This distorts the cost of production and
hides a cost that appears to represent the only administrative cost traceable to the
division. The remaining administrative and financial activities are conducted at
corporate level.
(iii) If the performance of both the division and the manager are being measured, the
report should identify controllable and non-controllable items.
(c) If only two years are being shown in the report, a horizontal analysis such as that is
shown appears adequate. Changes are shown in both dollars and percentages, thus dealing
with the magnitude and relativity of both measures. A $300 change in, say, prepaid
expenses may represent a 100 per cent change, whereas a change of 10 per cent in sales
that amounts to $1 000 000 is far more significant. If the number of years being
considered warranted it, a time series based on Year 1 being 100 may be more
meaningful. A better approach may be to include the current year’s budgeted figure as
well as the last year’s actual figure and identify the ‘off-budget’ items.
2 Specific recommendations:
(a) Continue to treat Bronte Division as an investment centre and use both ROI and EVA ® as
financial performance measures.
(b) Introduce non-financial measures to highlight a more balanced view of divisional
performance (such as customer satisfaction, supplier suitability and quality).
(c) Identify clearly those items which can be traced accurately to the division and which are
controllable by the division manager. For those activities conducted by corporate, costs
should be based on predetermined rates, otherwise there is no incentive for corporate to
attempt to control these costs. The present basis of allocating the costs of personnel,
administration and financing appears equitable, but the rates should be carefully
monitored.
(d) Treat Bondi Division as a cost centre within the investment centre of Bronte Division,
since it appears to supply only Bronte Division. This would eliminate transfer pricing and
any notions of profit and ROI, thereby simplifying the accounting procedures and
obviating the need for asset valuations and so on. It may also mean that many of the
corporate function costs need not be allocated, since they will be carried out for one
division only.

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(e) The reporting of Bondi Division’s performance as a cost centre will be improved by the
following changes:
(i) Introduce budgeting and standard costing and report actual costs against budgets
and standards. As the firm appears to be facing a market where cheaper houses are
becoming more in demand, cost control is vital. Since the kits appear to be a
standardised product, separate standards should be developed for each model.
Calculating the normal costing would be an improvement on using actual costing,
with standard and actual gross profits being prepared and the variances introduced
at gross profit level rather than cost of goods sold.
(ii) The production data in units is too complicated, especially if Bondi was to
become a part of Bronte. Production is triggered by a Bronte order, so output can
be monitored using non-financial measures such as the number of completed
orders, the time taken and so on.
(iii) Any non-production costs incurred by Bondi Division can be shown as actual-
versus-budgeted. Comparisons with the previous year could be shown, if this is
meaningful to the manager.
3 Ethical issues:
Clearly, Thompson should reject the approach of the general manager, since it contravenes
ethical guidelines of the accounting profession. In particular, it contravenes the principles of
objectivity, independence and professional behaviour.
He should explain to the manager that it is against the ethics of his profession and that he must
refuse the request. If he is subjected to further pressure from his divisional manager, he should
approach somebody at a more senior level, presumably in the Corporate Division. If he is still
under pressure to comply, he faces the difficult decision about whether to approach the firm’s
auditors or resign and seek employment elsewhere.

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CASE 13.42 (60 minutes) Financial performance measures and behavioural

issues: manufacturer
1
Outboard Automotive Couch
Profit $2 400 000 $4 400 000 $200 000
Assets 8 000 000 8 000 000 1 600 000
ROI 30% 55% 12.5%
Based on both profit and ROI, the Automotive Division had the best performance, followed by
the Outboard Division and the Couch Division.
2 Bonus pool = ($2 400 000 + $4 400 000 + $200 000)  1/10
= $700 000
$700 000
% bonus = ($4 000 000 + $2 800 000 + $1 400 000)
$700 000
= $8 200 000
= 8.537%
3 The senior managers of the Outboard and Automotive divisions have been participating in the
performance-related pay system for some time. However, the acquisition of Couch by Salt Water
and the entry of their senior managers into the scheme could cause some dissatisfaction among
the managers in the other two divisions. This is because the profitability of the Couch Division is
lower than the other two divisions, so that the inclusion of Couch will effectively lower the per
cent bonus paid to the Outboard and Automotive Division managers. The bonus percentage that
those managers would have been paid had Couch not been included is 10 per cent, close to the
11 per cent and 12 per cent bonuses of the previous two years.
($2 400 000 + $4 400 000)  10%
Bonus % without Couch Division = $4 000 000 + $2 800 000
$680 000
= $6 800 000
= 10.00%
4 Couch Division was a small family-owned company that was noted for its lack of ‘them and us’
attitude between employees and management. Under the previous management all employees
participated in a gainsharing program that yielded equal bonuses for every employee. The
introduction of a performance bonus for the senior managers of Couch and discontinuance of the
gainsharing program is contrary to the culture of Couch, and may cause some dissatisfaction
among those Couch employees who are not senior managers.

28

lOMoARcPSD|9693341
5 There are several possible changes that could be made to the performance-related pay system, to
alleviate some of the potential problems.
 The gainsharing system could be retained within Couch and senior managers of that
division might not participate in the company-wide bonus pool. This will satisfy employees
in Couch, and the senior managers in the other two divisions. However, non-management
employees in the other two divisions may lobby for a similar gainsharing program, so head
office management may need to consider this possibility. Another potential problem is that
the senior managers of Couch may see themselves as not being treated on an equitable basis
with the senior managers in the other two divisions. This may be the case, particularly if
managers are transferred to the Couch Division from the existing two divisions.
 Salt Water may decide that it is preferable to include all the senior managers in a
performance-related bonus scheme, but to have separate percentage bonuses for each
division. This may have the positive effect of having each manager’s bonus dependent only
on their own division’s performance. The one disadvantage for Salt Water is that no part of
the performance bonus is based on company-wide performance. Some managers believe
that it is good practice to have at least some proportion of a divisional manager’s bonus
based on company-wide performance, as this encourages managers to consider the impact
of decisions on both the division and the company. This is a goal congruence issue.

29

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lOMoARcPSD|9693341

Langfield-Smith 7e IRM Ch13

Contemporary Management Accounting (Western Sydney University)

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FINANCIAL PERFORMANCE MEASURES

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EXERCISE 13.21 (20 minutes) Return on investment; residual income

2 False. ROI is a financial measurement, whereas customer value is a subjective measure

5 False. ROI encourages managers to focus on short-term profit improvement by deferring

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EXERCISE 13.22 (20 minutes) Components of ROI; improving ROI; residual

3 Residual income = $6 000 000 – ($30 000 000  11%)

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EXERCISE 13.23 (15 minutes) Improving ROI: manufacturer

salesrevenue 9 000 000

profit 450 000

Profit = 15%  4 500 000 = 675 000

Profit = sales revenue – expenses = 675 000

Profit = 9 000 000 – expenses = 675 000

Expenses = $8 325 000

profit 675 000

Return on sales = 7.5%

ROI = Return on sales  investment turnover

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EXERCISE 13.24 (20 minutes) ROI as a comparative performance measure

To: The Managing Director

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EXERCISE 13.25 (25 minutes) Comparing the performance of two divisions:

(b) Imputed interest rate of 15 per cent:

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2 The economic value added (EVA®) is defined as follows:

EVA® = net operating profit after tax – (capital employed x WACC)

Real Estate $30(1 - 0.40) – [($150 – $9)  0.114 ] $1.926

Construction $27(1 - 0.40) – [($90 – $6)  0.114 ] $6.624

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EXERCISE 13.27 (20 minutes) Value-based management

EXERCISE 13.28 (25 minutes) ROI and EVA®: service firm

ROI $45 000 / $670 000 $110 000 / $2 750 000

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EXERCISE 13.29 (25 minutes) Performance measurement and incentive

EXERCISE 13.30 (25 minutes) Incentive schemes: manufacturer

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PROBLEM 13.31 (35 minutes) ROI and performance evaluation: manufacturer

Current Current + Current +

Profit $810 000 $2 160 000 $3 015 000

Invested capital 13 500 000 24 750 000 35 437 500

ROI 6% 8.73% 8.51%

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