MANAGEMENT

ACCOUNTING

Lecture 2
Investment Center Evaluation
Measuring the Performance of Investment Centers
Using ROI, Residual Income and Economic Value
Added
Dr. Abdullah Hamoud
Main source: Hansen & Mowen (2007). Managerial Accounting (8th ed.). Thomson.
Measuring the Performance of
Investment Centers Using ROI
Return on Investment (ROI)

3
Divisions that are investment centers will have an
income statement and a balance sheet.
So, could those divisions be ranked on the
basis of net income?
Suppose, for example, that a company has
two divisions, Alpha and Beta. Alpha’s net
income is $100,000, and Beta’s is $200,000.
Did Beta perform better than Alpha?
What if Alpha used an investment of
$500,000 to produce the contribution of
$100,000, while Beta used an investment of
$2 million to produce the $200,000
contribution?
Does your response change?
What is Return on Investment (ROI?
The Return on Investment (ROI) is a
profitability ratio that compares the net
profits received at exit to the original cost
of an investment, expressed as a percentage.
 FORMULA: ROI
The formula for calculating the return on investment (ROI) is as
follows

ROI = (Gross Return – Cost of Investment) ÷ Cost of Investment

The difference between the gross return and the cost of investment is the net return

Thus;

ROI = Net Return ÷ Cost of Investment

For example, if the gross return on an investment is
$100,000 while the associated cost was $80,000 , the net
return is $20,000.

Gross Return = $100,000

Initial Cost = $80,000
Net Return = $20,000
Return on Investment (ROI) = $20,000 ÷ $80,000 = 25%
Suppose an industrial company spent $50 million in capital
expenditures (Capex) to invest in new machinery and upgrade
their factory.
By the end of the anticipated holding period (which in the context
of a company purchasing fixed assets is the end of the PP&E’s useful
life assumption) the company received $75 million.

❑ The net return on the PP&E investment is equal to the

gross return minus the cost of investment.
Net Return = $75m – $50m = $25m
❑ The net return of $25 million is then divided by the cost of
investment to arrive at the return on investment (ROI).
Return on Investment (ROI) = $25m ÷ $50m = 50%
Thus, given the $25 million net return and $50 million cost of
investment, the ROI is 50%
Clearly, relating the reported operating profits
to the assets used to produce them is a more
meaningful measure of performance.
 FORMULA: ROI
ROI relates operating profits to assets
employed.

Return on Investment (ROI) is the profit earned

per dollar of investment

Return on Investment (ROI)

= Operating Income
Average Operating Assets
What is operating income?
What are operating assets?

Operating income is earnings before

interest & taxes.
Operating assets are assets acquired
to generate operate income.
 Operating assets including cash,
receivables, inventories, land, buildings, and
equipment.

Average operating assets=

(Beginning net book value + Ending net book value)/2
ALPHA CO. & BETA CO.
Background

Alpha Beta
Operating income $ 100,000 $ 200,000

Operating assets $ 500,000 $2,000,000

 COMPARING ROI
ROI: ALPHA
= Op. Income / Ave. Op. Assets
= $100,000 / $500,000 = .20

ROI: BETA
= Op. Income / Ave. Op. Assets
= $200,000 / $2,000,000 = .10
MARGIN & TURNOVER: ROI
Another way to calculate ROI is to separate the formula (Operating
income/Average operating assets) into margin and turnover.

Separating ROI into margin & turnover provides better analysis.

Return on Investment (ROI)

= (Op. Income / Sales) x (Sales / Ave. Op. Assets)
 What is margin?

Margin is the ratio of operating income to sales.

It tells how many cents of operating income
result from each dollar of sales.
It expresses the portion of sales that is available
for interest, taxes, and profit.
 What is turnover?

Turnover tells how many dollars of sales results from

every dollar of invested assets.

It is found by dividing sales by average operating assets.

It shows how productively assets are being used to

generate sales.
CELIMAR CO. Background

Sales $ 480,000

Operating income $ 48,000

Operating assets $ 300,000

MARGIN & TURNOVER:
ROI
Separating ROI into margin & turnover
provides better analysis.

Return on Investment (ROI)

= ($48,000 / $480/000) x ($480,000 / $300,000)
= 0.10 x 1.6
= 16%
 EXPLANATION: ROI

The net return on investments is driven

by 2 independent items: the ability to
squeeze profit from sales and the
ability to squeeze sales from invested
assets.
 ADVANTAGES OF ROI

Encourages managers to focus on

Relationship among sales, expenses (& possibility
investment if this is investment center)
Cost efficiency
Operating asset efficiency
Example
Della Barnes, manager of the Plastics Division, is
mulling over a suggestion from her marketing vice president to increase
the advertising budget by $100,000. The marketing vice president is
confident that this increase will boost sales by $200,000. Della realizes
that the increased sales will also raise expenses. She finds that the
increased variable cost will be $80,000. The division will also need to
purchase additional machinery to handle the increased production. The
equipment will cost $50,000 and will add $10,000 of depreciation
expense. As a result, the proposal will add $10,000 ($200,000 - $80,000 -
$10,000 - $100,000) to operating income. Currently, the division has
sales of $2 million, total expenses of $1,850,000, and net operating
income of $150,000. Operating assets equal $1 million.
 Without Increased With Increased
Advertising Advertising

Sales $ 2,000,000 $ 2,200,000

Less expenses 1,850,000 2,040,000

Operating income $ 150,000 $ 160,000

Operating assets $ 1,000,000 $ 1,050,000

ROI 15% 15.24%

The current ROI is the hurdle rate used to make decisions about changes.
Explanation
The ROI without the additional advertising is 15
percent; the ROI with the additional advertising and
$50,000 investment in assets is 15.24 percent.

Since ROI is increase-d by the proposal, Della decides

to authorize the increased advertising. In effect, the
current ROI, without the proposal, is the “hurdle rate.”
This term is frequently used to indicate the minimum
ROI necessary to accept an investment.
 DISADVANTAGES OF ROI
Can product a narrow focus on divisional
profitability at expense of profitability for
overall firm
Encourages managers to focus on short run at
expense of long run
 ALTERNATIVES: ROI

Only Only Both Neither

Project I Project II Projects Project
Op. income $ 8,800,000 $ 8,140,000 $9,440,000 $ 7,500,000

Op. assets $60,000,000 $54,000,000 $64,000,000 $50,000,000

ROI 14.67% 15.07% 14.75% 15.00%

Comparison of Divisional Performance Using ROI
Measuring the Performance of Investment
Centers Using Residual Income
 Residual Income
& Economic
Value Added (EVA)
 Residual Income
▪ Residual income is a calculation that determines how
much money is available after financial obligations
have been met.

▪ Residual income is the income a company generates

after accounting for the cost of capital.

▪ A company's residual income is the capital leftover

after they have completed all their financial
obligations.
 Residual Income
Business Residual Income
▪ Managerial accountants define residual income as the
amount of operating revenues left over from a
department or investment center after the cost of
capital used to generate the revenues have been
paid.
▪ In other words, it’s the net operating income of a
department or investment center.

▪ The amount that a department’s profits exceed its

minimum required return.
 Residual Income
▪ Hurdle rate is a term used to indicate the minimum ROI
necessary to accept an investment.

▪ If residual income is greater than zero, then the division is

earning more than the minimum required rate of return (or
hurdle rate).

▪ If residual income is less than zero, then the division is

earning less than the minimum required rate of return.

▪ If residual income is just equal to zero, then the division is

earning precisely the minimum required rate of return.
 RESIDUAL INCOME

Residual income is the difference between operating income and

minimum dollar return on sales.
It is the difference between operating income and the minimum
dollar return required on a company’s operating assets
RESIDUAL INCOME FORMULA

Residual income = Net income - (Equity x

Cost of equity)

Net income is earnings after all expenses, costs, interest

accrued, depreciations, amortization and taxes.
Equity is the total assets minus the total liabilities enumerated
on the balance sheet.
Cost of equity is the minimum return required on an investment.
 RESIDUAL INCOME

Residual Income = Operating income – (Min. rate of

return x Ave. Operating Assets)

= $48,000 – (0.12 x $300,000)

= $12,000
Calculation of Residual Income
ALTERNATIVES: Residual Income
In 000s

Only Only Both Neither

Project I Project II Projects Project
Op. income $ 8,800 $ 8,140 $9,440 $ 7,500

Op. assets $60,000 $54,000 $64,000 $50,000

Min. return* 6,000 5,400 6,400 5,000

Residual Inc. $2,800 $ 2,740 $ 3,040 $ 2,500

* 10%
Example 1:
Compute for the residual income of an investment
center which had operating income of $500,000
and operating assets of $2,500,000. The cost of
capital is 12%.

Desired income = Minimum required rate of return x Operating assets

= 12% x $2,500,000
= $300,000
RI = Operating income - Desired income
= $500,000 - $300,000
= $200,000

The investment made $200,000 above its desired or minimum income.

Example 2:
Suppose that Company X reported earnings of $100,000
last year and financed its capital structure with $950,000
worth of equity at a required rate of return of 11%.
Its residual income would be:
Equity Charge = $950,000 x 0.11 = $104,500
Net Income $100,000
Equity Charge -$104,500
Residual Income -$4,500

❖ As you can see from the above example, using the concept of
residual income, although Company X is reporting a profit on its
income statement, once its cost of equity is included in relation to its
return to shareholders, it is actually economically unprofitable based
on the given level of risk.
Example 3:
Ethan would like to know how much residual income he’s making from
his meat shop. Ethan spent a total of $250,000 to buy meat-cutting
machines and other equipment. He has a net operating revenue of
$50,000 for the year. He presently earns a return of 10%, so he aims
for a minimum required return of 10%. What is Ethan’s Delicatessen’s
residual income?

Solation
Net operating income: 50,000
Minimum required return:10%
Cost of operating assets: 250,000

We can apply the values to our variables and calculate the

residual income:
RI = 50,000 – (0.10 X 250,000) = $ 25,000

In this case, Ethan’s Delicatessen would have a residual income of

$25,000.

This means Ethan has a remaining net income of $25,000 after the
capital cost has been deducted. This also proves that his
meat shop is earning more than the minimum 10 percent required.
As a result, he can use his excess earnings to fund an expansion,
pay debts, or distribute dividends to any investors.
Measuring the Performance of Investment
Centers Using Economic Value Added
 ECONOMIC VALUE ADDED
(EVA)
▪ Economic Value Added (EVA) is additional value
created above the cost of capital.
▪ A specific way of calculating residual income is
economic value added. Economic value added
(EVA)1 is net income (operating income minus
taxes) minus the total annual cost of capital.
▪ Economic Value Added (EVA), sometimes known as
Economic Profit, is a measure based on the residual
income technique, which measures the return
generated over and above investors’ required rate of
return.
 ECONOMIC VALUE ADDED
(EVA)
▪ EVA serves as an indicator of the profitability of
projects in which a company invests.
▪ It is the excess profit above the cost of capital,
generated by the business.
▪ It represents the difference between the Rate of
Return and Cost of Capital and measures the value
generated by invested capital.
▪ The Economic Value Added (EVA) attempts to
capture the truest economic profitability of the
company. Therefore, we also refer to it as Economic
Profit.
 ECONOMIC VALUE ADDED
(EVA)
▪ A negative EVA means that the business is
generating no value. Whereas, a positive EVA
implies the company is creating value for the
shareholders.
ECONOMIC VALUE ADDED
(EVA)
EVA is net income minus total annual cost of capital.

Projects with positive EVA are acceptable.

Economic value added (EVA) = Net income – (% cost

of capital x Capital employed)
ECONOMIC VALUE ADDED
(EVA)
EVA formula can be expressed as follows:

EVA = NOPAT – (WACC * Invested Capital)

Where:
NOPAT = Net Operating Profit After Tax
WACC = Weighted Average Cost of Capital
Transfer Pricing
TRANSFER PRICING: Definition

Is the price charged for a

component by the selling
division to the buying division
of the same company.
What are the minimum &
maximum transfer prices?

The minimum transfer price would

leave the selling division not worse off
and the maximum would leave the
buying division no worse off than if
sold (acquire) externally.
 TRANSFER PRICE: Choices
Market price
Best choice if there is a competitive outside
market
Cost-Based price
When there is not good outside price
Negotiated price
Useful with there are market imperfections