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Chapter 14

Business Unit Performance


Measurement

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Accounting Income

L.O. 1 Evaluate divisional accounting income as a performance mea


Divisional Income:
Division revenues minus division costs
Investors use accounting income to assess
a firm's performance.
Firms use a divisions income to assess
divisional performance.

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LO
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Divisional Income
Mustang Fashions
Divisional Income Statements
For Year 1 ($000)

Sales
Cost of sales
Gross margin
Allocated corporate overhead
Local advertising
Other general and administrative
Operating income
Tax expense (@ 30%)
After-tax income

Western
Division

Eastern
Division

Total

$5,200.0
2,802.0
$2,398.0
468.0
1,200.0
250.0
$ 480.0
144.0
$ 336.0

$2,800.0
1,515.0
$1,285.0
252.0
500.0
227.0
$ 306.0
91.8
$ 214.2

$8,000.0
4,317.0
$3,683.0
720.0
1,700.0
477.0
$ 786.0
235.8
$ 550.2
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LO
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Some Simple Financial Ratios


Mustang Fashions
Selected Financial Ratios
For Year 1
Ratio

Definition

Western Eastern
Division Division

Gross margin percentage


Gross margin sales
46.12% 45.89%
Operating margin
Operating income Sales 9.23% 10.93%
Profit margin
After-tax income Sales
6.46% 7.65%

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Return on Investment
L.O. 2 Interpret and use return on investment (ROI).
Return on Investment (ROI):
Ratio of profits to investment in the asset that
generates those profits

Provides a comparison of different size divisions.

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Return on Investment
Mustang Fashions
Balance Sheets
January 1, Year 1

Assets
Cash
Accounts receivable
Inventory
Total current assets
Fixed assets (net)
Total assets
Liabilities and Equities
Accounts payable
Other current liabilities
Total current liabilities
Long-term debt
Total liabilities
Total shareholders equity
Total liabilities and equities

Western
Division

Eastern
Division

Total

$ 250,000
225,000
250,000
$ 725,000
775,000
$1,500,000

$ 150,000
250,000
150,000
$ 550,000
350,000
$ 900,000

$ 400,000
475,000
400,000
$1,275,000
1,125,000
$2,400,000

$ 125,000
227,000
$ 352,000
-0$ 352,000
1,148,000
$1,500,000

$ 220,000
507,000
$ 727,000
-0$ 727,000
1,673,000
$2,400,000

95,000
280,000
$ 375,000
-0$ 375,000
525,000
$ 900,000

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LO
2

Return on Investment
Mustang Fashions
ROI for Western and Eastern Divisions
For Year 1
Western
Division

After-tax income from income statement


Divisional investment from balance sheet
ROI (After-tax income Divisional investment)

Eastern
Division

$ 336,000 $ 214,200
$1,500,000 $ 900,000
22%

24%

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Residual Income Measures


L.O. 3 Interpret and use residual income (RI).
Residual Income (RI):
This is the excess of actual profit over
the cost of invested capital in the unit.

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Economic Value Added (EVA)


L.O. 4 Interpret and use economic value added (EVA).
EVA is the annual after-tax (adjusted)
divisional income minus the total annual
cost of (adjusted) capital.
It makes adjustments to after-tax income and
capital to eliminate accounting distortions.

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Measuring the Investment Base

L.O. 5 Explain how historical cost and net book value-based accoun
measures can be misleading in evaluating performance.

Performance measures use divisional assets


or investments in the calculation.
How should divisional assets be measured?
Gross book value versus net book value
Historical cost versus current cost
Beginning, ending, or average balance

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Gross Book Value versus


Net Book Value Example

Profits before depreciation (all in cash flows at end of year):


$100 each year for 3 years
Asset cost at beginning of year 1, $500
Depreciation: Ten year life, straight-line, no salvage value
Amounts are in thousand of dollars.

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Year

Gross Book Value versus


Net Book Value Example
Net Book Value

1 ROI =

$100a (0.1 $500)b


$500d (0.1 $500)e

2 ROI =

$100a (0.1 $500)b


$450d (0.1 $500)e

3 ROI =

$100a (0.1 $500)b


$400d (0.1 $500)e

Gross Book Value

= 11.1%

$50c
ROI =
= 10%
$500

= 12.5%

$50c
ROI =
= 10%
$500

= 14.3%

$50c
ROI =
= 10%
$500

The first term in the numerator is the annual cash profit.


b
The second term in the numerator is depreciation for the year.
c
Net income = $50 = $100 ($500 0.1)
d
The first term in the denominator is the beginning-of-the-year asset value.
e
The second term in the denominator reduces the beginning-of-the-year
value of the asset by the amount of current year's depreciation
a

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Historical Cost versus Current Cost


Current cost:
Cost to replace or rebuild
an existing asset

Historical cost:
Original cost to purchase
or build an asset

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Historical Cost versus Current Cost


Operating profits before depreciation
(all in cash flows at end of year):
Year 1, $100; Year 2, $120; Year 3, $144
Annual rate of price changes is 20 percent.
Asset cost at beginning of year 1 is $500.
Straight-line depreciation is used;
the straight-line rate is 10% per year
Amounts are in thousand of dollars.
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5

Historical Cost versus Current Cost


Net Book Value
Year

Year

Historical Cost
$100a (0.1 $500)b
1 ROI =
= 11.1%
$500c (0.1 $500)

Current Cost
$100a (0.1 $600)b
1 ROI =
= 7.4%
$600d (0.1 $600)e

$120a (0.1 $500)b


2 ROI =
= 17.5%
$500c (0.2 $500)

$120a (0.1 $720)b


2 ROI =
= 8.3%
$720f (0.2 $720)e

$144a (0.1 $500)b


$144a (0.1 $864)b
=
26.9%
3
ROI
=
= 9.5%
$500c (0.3 $500)
$864g (0.3 $864)e
Gross Book Value
Year
Historical Cost
Year
Current Cost
$100a $50b
$100a $60b
1 ROI =
= 10.0%
1 ROI =
= 6.7%
$500c
$600d
3 ROI =

2 ROI =

$120a $50b
$500c

= 14.0%

3 ROI =

$144a $50b
$500c

= 18.8%

2 ROI =

$120a $72b
$720f

= 6.7%

3 ROI =

$144a $86.4b
$864g

= 6.7%

Annual operating profit before depreciation. b Depreciation for the year.


c
Beginning-of-the-first-year value of the assets used in the investment base. d Current cost of asset ($500 120%)
e
Accumulated depreciation at the end of the year. f Current cost of asset ($600 120%)
g
Current cost of asset ($720 120%)
a

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Beginning, Ending,
or Average Balance?
Managers can manipulate purchases and
disposition based on which balance is
being used in evaluations.

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LO
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End of Chapter 14

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.