Chapter 14 - Business Unit Performance Measurement

14
Business Unit Performance Measurement

Solutions to Review Questions

14-1.
Divisional income is relatively easy to compute because the data exist for financial
reporting purposes. It is related to firm profit, which is of interest to the shareholders. It
makes comparisons easier because it is a summary financial measure. Two
disadvantages are that it is difficult to compare divisions that are different sizes and it
does not include a measure of asset utilization.
14-2.
The basic computations are the same. Because divisional income is not reported, the
firm is free to specify certain accounting policies that might not be consistent with
GAAP. In addition, depending on the decision authority of the manager, some accounts
might be ignored or might be computed using firm-wide averages.
14-3.
ROI-type measures adjust for size. In addition, ROI measures adjust for asset usage.
14-4.
There are two common situations. First, managers might choose not to invest in
worthwhile projects because the ROI is less than the target, even though the net
present value is positive. Second, decisions made based on ROI depend on the current
level of ROI. If the ROI of a project is greater than the ROI of the unit without the
project, the project will increase ROI, regardless of how low it is.
14-5.
ROI is income divided by assets; residual income is income less a capital charge equal
to the cost of capital multiplied by the investment. Residual income is a dollar amount,
not a ratio. It subtracts a capital charge, equal to the cost of capital multiplied by the
assets used.

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Chapter 14 - Business Unit Performance Measurement

EVA makes adjustments to income and investment to correct accounting calculations

that do not reflect the economics of the transaction. Typical examples are capitalizing
expenditures that common accounting practice would expense, such as advertising or
R&D expenditures.
14-7.
Use of net book value will result in the ROI rising as the net asset is reduced through
depreciation. This might be mitigated if ROI is based on gross book value. The problem
is most acute if all depreciable assets in the investment base are the same age.
14-8.
The danger is that you will ignore the interdependence of the business units. No
incentive is given to business unit managers to make them consider the effect of their
actions on other units.

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Chapter 14 - Business Unit Performance Measurement

Solutions to Critical Analysis and Discussion Questions

14-9.
Here the managers are encouraged to include slack in the budget by underestimating
revenues and overestimating costs. The greater the slack, the greater is the division
managers bonus.
14-10.
By maximizing their own divisional income, managers might refuse to sell products to
each other, or might not share information about customers. This statement ignores
interdependencies among business units.
14-11.
Two problems usually arise here:
(a) The division might be encouraged to produce in volumes in excess of sales. In this
way, the fixed production costs would be deferred in inventory.
(b) There could be a great deal of game-playing over how costs are allocated since a
managers performance will depend in part on how few costs get charged to the
division. See the discussion in chapter 12 about allocating corporate costs.
These problems might be greater in new, growing industries than in mature industries
where the accounting and cash flows tend to be more similar.
14-12.
Residual income measures depend upon the rate chosen for charging a division for its
investments. Different rates can yield different residual income rankings. In addition,
residual income measures will tend to favor large divisions over smaller ones since the
measures are based on an absolute dollar value. ROI uses information easily available
from the accounting system.
14-13.
The reason the division manager has been delegated the authority to make investment
decisions is that he or she has better local knowledge of the investment opportunities.
Therefore, if the division manager does not identify the investment project, it is not clear
that the corporate staff will know it exists. If they do not know about the investment, they
cannot direct its adoption.

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Chapter 14 - Business Unit Performance Measurement

Residual Income (RI) is defined as follows:

Investment center operating profits(Capital charge Investment center assets)
The capital charge is the minimum acceptable rate of return, which will likely be
greater than the companys cost of capital.

Economic value added (EVA) is defined as follows:

After-tax (adjusted) operating profits(Cost of capital Capital employed (adjusted))

Comparison:
Investment center operating profits (in the RI formula) can be equated to after-tax
operating profits (in the EVA formula). Investment center assets can be equated to
capital employed. However, the capital charge is not the same as the cost of capital.
The capital charge is the companys minimum acceptable rate of return, and the cost
of capital is the weighted average cost of the companys debt and equity. While it is
possible that these percentages might be the same for a given company, the terms
clearly have different meanings.
More important, EVA calculations adjust the income and capital numbers from the
accounting, or book, numbers to reflect basic differences between economic results
and accounting measurements.
Therefore, although the two methodsRI and EVAhave many similarities, they
are not typically identical.

14-15.
The problem with using the same measure of performance for managers at all levels in
an organization is that managers responsibilities and decision rights differ. For
example, a plant manager might not have the authority to choose where to produce or
what equipment to use. EVA, however, evaluates the manager on how well he or she
uses assets.
14-16.
If the division can rent and the rent does not have to be capitalized for inclusion in the
investment base, the residual income will increase so long as the income from the asset
exceeds the lease payment. If EVA is used, and if these types of transactions are
common, an adjustment will be made to income and assets to treat the leases as if they
are capital leases, even if the company treats the leases as operating leases for
financial reporting purposes.

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Chapter 14 - Business Unit Performance Measurement

ROI does not take the time value of money into account; it is computed based on
annual results. The cost of capital is a measure that does consider the time value of
money. The ROI can be high or low in any one period, while the cost of capital and the
present value of the investment consider return over the life of the investment.
Differences between ROI and the cost of capital are common when assets have
different lives or are purchased at different times. Since the two measures are not
comparable, trying to relate the two will not be meaningful.
14-18.
Residual income divided by divisional assets is just ROI minus the cost of capital (see
below). Therefore, while the measure allows a comparison among divisions, it suffers
from the same problems as ROI.
Residual income
Assets

Income
Assets

Cost of capital x Assets

Assets

= ROI Cost of capital

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Chapter 14 - Business Unit Performance Measurement

Solutions to Exercises
14-19. (10 min.)

Compute Divisional Income: Eastern Merchants.

Operating Income
(thousands)
Eastern
Western
Revenue ............................................................
$1,200.0
$3,800.0
Cost of sales ......................................................769.5
1,900.0
Gross margin ..................................................
$ 430.5
$1,900.0
Allocated corporate overhead ............................ 72.0
228.0
Other general and administration.......................158.5
1,100.0
Operating income ..............................................
$ 200.0
$572.0
Comments:
1. Divisional income is greater in Western.
2. The gross margin percentage is higher in Western.
3. The operating margin is greater in Eastern.
4. Corporate overhead appears to be allocated on the basis of revenues (6% in both
divisions).
Ratio
Calculation
Eastern
Gross Margin percentage ...................................
(Gross margin Sales)
35.88%
Operating margin ................................................
(Operating income Sales) 16.67

14-6

Western
50.00%
15.05

Chapter 14 - Business Unit Performance Measurement

14-20. (10 min.) Compute Divisional Income: Eastern Merchants.

Operating Income
(thousands)
Eastern
Western
Revenue .............................................................
$1,200.0 $2,800.0
Cost of sales.......................................................
769.5 1,400.0
Gross margin ......................................................
$ 430.5 $1,400.0
Allocated corporate overhead.............................
90.0
210.0
Other general and administration .......................
158.5
1,100.0
Operating income ...............................................
$ 182.0
$90.0
Comments:
In addition to the comments for exercise 14-19, nothing changed in Eastern Division.
However, because sales fell in Western Division, the reported divisional income for
Eastern went down. Corporate overhead is allocated on the basis of relative revenues,
not absolute revenues. Thus, the performance of the Eastern Division is affected by the
results in the Western Division.
Ratio
Calculation
Eastern Western
Gross Margin percentage ...................................
(Gross margin Sales)
35.88% 50.00%
Operating margin ................................................
(Operating income Sales) 15.17
3.21
14-21. (10 min.)

Compute Residual Income and ROI: TL Division.

a.

$1,800,000,000
= 12.5% (ROI)
$14,400,000,000

b.

$1,800,000,000 (.08 $14,400,000,000) = $648,000,000 (Residual Income)

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Chapter 14 - Business Unit Performance Measurement

14-22. (25 min.)

ROI Versus Residual Income.

Annual income = $252,000 ($720,000 4 years) = $72,000

Year
1
2
3
4
a

Investment
Base
$720,000a
540,000
360,000
180,000

(a)
RI
$72,000 Base
10.0%
13.3
20.0
40.0

(b)
Residual Income
$72,000 (15% x Base)
($36,000)
(9,000)
18,000
45,000

Base decreases by annual depreciation of $180,000.

14-23. (10 min.) Compare Alternative Measures of Division Performance:

Solomons Company.
a. Using return on investment measures:
*North:
$7,000,000
= 25%
$28,000,000
South:
$39,000,000
= 15%
$260,000,000
b. Using EVA:
North: $7,000,000 (10% x $28,000,000) = $4,200,000
*South: $39,000,000 (10% x $260,000,000) = $13,000,000
c. Using ROI, the comparison is not affected by the cost of capital; the cost of capital
serves only as a benchmark against which to judge ROI.
For EVA, the comparison is affected.
*North: $7,000,000 (20% x $28,000,000) = $1,400,000
South: $39,000,000 (20% x $260,000,000) = ($13,000,000)
*Indicates division with better performance.

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Chapter 14 - Business Unit Performance Measurement

14-24. (10 min.)

Impact of New Asset on Performance Measures: Ocean Division.

a. ROI before:
$780,000
= 20%
$3,900,000
b. ROI after:
$780,000 + $55,500a
= 18.3%
$3,900,000 + $675,000
a

$55,500 = $168,000 ($675,000 6 years)

14-25. (10 min.)

Impact Of Leasing On Performance Measures.

With the lease, the incremental income is the operating cash flow minus the lease
payment or $20,000 = $168,000 $148,000.
The new ROI is:
$780,000 + $20,000
= 20.5%
$3,900,000
14-26. (15 min.)

Residual Income Measures And New Project Consideration.

a. $780,000 (.15 $3,900,000) = $195,000

b. $195,000 + $168,000 ($675,000 6 years)

.15 ($675,000) = $149,250

or
$780,000 + $168,000 ($675,000 6 years) .15 ($3,900,000 + $675,000)
= $149,250
c. $195,000 + $168,000 $148,000 = $215,000
or
($780,000 + $168,000 $148,000) (.15 $3,900,000)= $215,000

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Chapter 14 - Business Unit Performance Measurement

14-27. (20 min.) Impact of New Asset on Performance Measures: Noonan

Division.
a. ROI before disposal:
$330,000
= 15%
$2,200,000
b. ROI after disposal:
$330,000 $28,000
= 15.1%
$2,200,000 $200,000

c. Residual income before disposal:

$330,000 0.12 x $2,200,000

= $66,000

d. Residual income after disposal:

($330,000 $28,000) 0.12 x ($2,200,000 $200,000) = $62,000
14-28. (20 min.) Impact of New Asset on Performance Measures: Noonan
Division.
a. ROI before disposal:
$330,000
= 16.5%
$2,000,000
b. ROI after disposal:
$330,000 $28,000
$2,000,000

= 15.1%

c. Residual income before disposal:

$330,000 0.12 x $2,000,000

= $90,000

d. Residual income after disposal:

($330,000 $28,000) 0.12 x ($2,000,000) = $62,000

14-10

Chapter 14 - Business Unit Performance Measurement

14-29. (25 min.) Compare Historical Cost, Net Book Value To Gross Book Value:
Caribbean Division.

Year 1

a. Net Book Value

b. Gross Book Value

($15,000,000 $6,000,000)
($60,000,000 $6,000,000)

($15,000,000 $6,000,000)
$60,000,000

$9,000,000
$54,000,000

Year 2

Year 3

$9,000,000
= 15%
$60,000,000

($15,000,000 $6,000,000)
[$60,000,000 (2 x $6,000,000)]

($15,000,000 $6,000,000)
$60,000,000

$9,000,000
= $48,000,000 = 18.8%

$9,000,000
= $60,000,000 = 15%

($15,000,000 $6,000,000)
[$60,000,000 (3 x $6,000,000)]

($15,000,000 $6,000,000)
$60,000,000

Year 4

= 16.7%

$9,000,000
= 21.4%
$42,000,000

($15,000,000 $6,000,000)
[$60,000,000 (4 x $6,000,000)]
=

$9,000,000
= 25.0%
$36,000,000

14-11

$9,000,000
= 15%
$60,000,000

($15,000,000 $6,000,000)
$60,000,000
=

$9,000,000
$60,000,000

= 15%

Chapter 14 - Business Unit Performance Measurement

14-30. (25 min.) Compare ROI Using Net Book And Gross Book Values:
Caribbean Division.

a. Net Book Value

Year 1

($15,000,000 $6,000,000)
$60,000,000
=

Year 2

= 15.0%

$9,000,000
$54,000,000

= 16.7%

($15,000,000 $6,000,000)
[$60,000,000 (2 x$6,000,000)]
=

Year 4

$9,000,000
$60,000,000

($15,000,000 $6,000,000)
($60,000,000 $6,000,000)
=

Year 3

b. Gross Book Value

$9,000,000
$48,000,000

= 18.8%

($15,000,000 $6,000,000)
[$60,000,000 (3 x$6,000,000)]
=

$9,000,000
$42,000,000

= 21.4%

($15,000,000 $6,000,000)
$60,000,000
=

$9,000,000
= 15%
$60,000,000

($15,000,000 $6,000,000)
$60,000,000
=

$9,000,000
= 15%
$60,000,000

($15,000,000 $6,000,000)
$60,000,000
=

$9,000,000
= 15%
$60,000,000

($15,000,000 $6,000,000)
$60,000,000
=

$9,000,000
= 15%
$60,000,000

c. Of course, there is no change under the gross book value method. With the net
method, both alternatives (using end-of-year asset values versus beginning-of-year
values) show the same trend of rising ROIs as the assets depreciate. This is to be
expected. The end-of-year value is the next years beginning-of-year value.

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Chapter 14 - Business Unit Performance Measurement

14-31. (30 min.)

Compare Current Cost To Historical Cost: Caribbean Division.

Parts c and d can be solved easier if one first sets up a table showing the change in value of the depreciable assets.
(1)
(2)
(3)
Yearly
Gross Depreciable
Depreciation
Total Depreciation
[col. (1) x 25%]
(1) (Years of life 4 years)
Asset Valuea
Year 1

$24,000,000 x 1.1 = $26,400,000

$6,600,000

$26,400,000 x 1/4 = $6,600,000

Year 2

$26,400,000 x 1.1 = $29,040,000

$7,260,000

$29,040,000 x 2/4 = $14,520,000

Year 3

$29,040,000 x 1.1 = $31,944,000

$7,986,000

$31,944,000 x 3/4 = $23,958,000

Year 4

$31,944,000 x 1.1 = $35,138,400

$8,784,600

$35,138,400 x 4/4 = $35,138,400

a Start

with gross assets = $60,000,000 $36,000,000 salvage value = $24,000,000.

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Chapter 14 - Business Unit Performance Measurement

14-31. (continued)

Year 1

a.
Historical Cost
Net Book Value
($16,500,000 $6,000,000)
($60,000,000 $6,000,000)
=

Year 2

($18,150,000 $6,000,000)
[$60,000,000 (2 x $6,000,000)]
=

Year 3

$12,150,000
= 25.3%
$48,000,000

($19,965,000 $6,000,000)
[$60,000,000 (3 x $6,000,000)]
=

Year 4

$10,500,000
= 19.4%
$54,000,000

$13,965,000
= 33.3%
$42,000,000

($21,961,500 $6,000,000)
[$60,000,000 (4 x $6,000,000)]
=

$15,961,500
= 44.3%
$36,000,000

14-14

b.
Historical Cost
Gross Book Value
($16,500,000 $6,000,000)
$60,000,000
=

$10,500,000
= 17.5%
$60,000,000

($18,150,000 $6,000,000)
$60,000,000
=

$12,150,000
= 20.3%
$60,000,000

($19,965,000 $6,000,000)
$60,000,000
=

$13,965,000
= 23.3%
$60,000,000

($21,961,500 $6,000,000)
$60,000,000
=

$15,961,500
= 26.6%
$60,000,000

Chapter 14 - Business Unit Performance Measurement

14-31. (continued)

Year 1

c.
Current Cost
Net Book Value
($16,500,000 $6,600,000)
($66,000,000 $6,600,000)
=

Year 2

$10,890,000
= 18.8%
$58,080,000

$10,890,000
= 15.0%
$72,600,000

($19,965,000 $7,986,000)
$79,860,000

$11,979,000
= 21.4%
$55,902,000

($21,961,500 $8,784,600)
[$87,846,000 $35,138,400]
=

$9,900,000
= 15.0%
$66,000,000

($18,150,000 $7,260,000)
$72,600,000

($19,965,000 $7,986,000)
[$79,860,000 $23,958,000]
=

Year 4

$9,900,000
= 16.7%
$59,400,000

($18,150,000 $7,260,000)
[$72,600,000 $14,520,000]
=

Year 3

d.
Current Cost
Gross Book Value
($16,500,000 $6,600,000)
$66,000,000

$11,979,000
= 15.0%
$79,860,000

($21,961,500 $8,784,600)
$87,846,000

$13,176,900
= 25%
$52,707,600

14-15

$13,176,900
= 15.0%
$87,846,000

Chapter 14 - Business Unit Performance Measurement

14-32. (25 min.) Effects Of Current Cost On Performance Measures: Upper

Division.
a.

ROI
Year 1:

$225,000 (.25 x $600,000)

$600,000

$75,000
= 12.5%
$600,000

Year 2:

$255,000 (.25 x $600,000)

$600,000

$105,000
= 17.5%
$600,000

Year 3:

$285,000 (.25 x $600,000)

$600,000

$135,000
= 22.5%
$600,000

Year 4:

$300,000 (.25 x $600,000)

$600,000

$150,000
= 25.0%
$600,000

b.

ROI
Year 1:

$225,000 (.25 x $600,000)

$600,000

$75,000
= 12.5%
$600,000

Year 2:

$255,000 (.25 x $660,000)

$660,000

$90,000
= 13.6%
$660,000

Year 3:

$285,000 (.25 x $726,000)

$726,000

$103,500
= 14.3%
$726,000

Year 4:

$300,000 (.25 x $798,600)

$798,600

$100,350
= 12.6%
$798,600

14-16