Lecture 3 (Financial Performance Measures - Chapter 10) Textbook Notes

What is the target rate of return?

The minimum acceptable rate of return that top management expects a division to earn with its assets.

What authorities do the investment center manager have?

1. Authority to decide how much inventory to hold 2. What types of investments to make 3. How aggressively to collect AR 4. Whether to open new stores or close old ones

What are the 4 Types of Responsibility Centers?

1. Cost Center 2. Revenue Center 3. Profit Center 4. Investment Center

What is a capital turnover?

1. Focuses on how efficiently the division uses its assets to generate sales revenue. Capital turnover = Sales Revenue/ Total Assets Ex. $14782/5375 = $2.75 This division generates $2.75 of sales revenue with every $1 of assets. Higher number means higher efficiency. To improve statistic, division manager should try to reduce or eliminate nonproductive assets (Ex. By collecting accounts receivables more aggressively or decreasing inventory levels)

How does mgmt. determine what is driving a division's ROI?

1. It often restates the ROI equation in its expanded form: ROI = (Operating Income/Sales) * (Sales/Total Assets) = (Operating Income/Total Assets) Expanding the equation (that includes the sales margin and capital turnover), helps them better understand how they can improve their ROI.

With what ratios can you evaluate Investment centers?

1. ROI (return on investments) 2. Sales margin 3. Capital Turnover

What is the management's target rate of return is based on?

1. Risk level of the division's business 2. Interest rates 3. Investor's expectations 4. Return being earned by other divisions 5. General economic conditions As these factors change over time, mgmt's target rate of return will also change.

What is another way to interpret a division's ROI?

A higher ROI can be achieved because the division is: 1. earning more profit on every dollar of sales 2. generating more sales revenue with every dollar of assets. "Sales Margin * Capital Turnover = ROI" Ex. 29.1% * $2.75 = 80.1%

What is Responsibility Accounting? (Responsibility Center)

A part of an organization whose manager is accountable for planning and controlling certain activities.

What is a Profit Center?

A responsibility center in which managers are responsible for both revenues and costs, and therefore profits. (both generating income and controlling costs)

What is a Revenue Center?

A responsibility center in which managers are responsible for generating sales revenue.

What is an Investment Center?

A responsibility center in which managers are responsible for income and invested capital. (for (1) generating revenues, (2) controlling costs, and (3)efficiently managing the division's assets) Managers are held responsible for generating as much profit as they can with the assets they have.

What is a sales margin?

A sales margin focuses on profitability by showing how much operating income the division earns on every $1 of sales revenue. Sales margin = (Operating income/Sales) "Sales" - Sales Revenue Ex. $4304/14,782 = 29.1% Therefore, this division is earning about $0.29 on every $1 of sales revenue. How to improve Sales margin? Manager needs to focus on cutting costs (but not too much, due to consideration needed for long-term success of division), so that more operating income can be earned for every dollar of sales revenue. (reduce costs to increase profit/income)

What is Responsibility accounting?

A system for evaluating the performance of each responsibility center and its manager. Performance reports compare plans (budgets) with actual results for each center. Superiors then evaluate how well each manager controlled the operations for which he or she was responsible.

Which balance sheet date should we use?

Beginning of the period vs end of the period for total assets. In textbook example, used total assets at "end of year" Some companies use avg. of beg. and end of year.

What is a Cost Center?

In a cost center, managers are responsible for controlling costs. (accountable for costs only)

What are the limitation of financial performance evaluation?

Managers might only strive to increase short term performance, instead of looking long term (and not investing in advertisements or R&D - cutting back)

What is an alternative for using ROI to evaluate performance of investment centers? (RI)

Many companies use "Residual Income - RI". Similar to ROI, the residual income measures the division's profitability with respect to the size of its assets. The calculation is based on both the division's operating income and its assets. (+ mgmt's target rate of return) RI = Operating Income - Minimum acceptable income

What is Return on Investment? (ROI)

Measures the amount of income an investment center earns relative to the size of its assets. - Helpful to have when top mgmt. is deciding how to invest excess funds. (calculate each division's ROI) ROI = Operating Income/Total Assets = Percentage You can't accurately evaluate/compare an investment centers financial performance by simply comparing the operating incomes, etc. You need to consider the size of each division as well. Asses each division's operating income in relationship to its assets. (with ROI or residual income) Higher percentage, means higher return on investments. "Generating more income for every dollar of its assets" Ex. $4304/$5375 = 80.1% = $0.8 "This division earns $0.8 on every $1 of assets."

What is the difference between ROI and RI?

Residual income calculation incorporates one more important piece of information: "management's target rate of return"

Why do some companies prefer using RI rather than ROI?

Residual income often leads to better goal congruence. It depends on what your goal is. Are you looking at the perspective of meeting target rate of return or evaluating an investment based on the current ROI? (If the ROI had been high enough currently, investing in an equipment would "decrease" the division's ROI, therefore the manager probably would not have invested in the equipment. - If the current ROI was low, manager has an incentive to invest in equipment in order to increase division's overall ROI) --> However, considering RI, managers will invest in equipment since if it exceeds target rate/mgmt's expectations, therefore increasing the division's residual income. Therefore, RI enhances goal congruence, whereas ROI may or may not. RI gives a better picture, and enables a clear image of how it's going to affect the division's (profits).) --> Looking (solely) at increase in additional income/profits vs. looking at how it's going to affect ROI (down or up), which considers more than one factor (not just income).

Should we include all assets?

Should we include all assets for the "Total assets"? Ex. If a company has bought land to build future retail outlets, this would be a "nonproductive asset", since it is not generating any operating income. Until these stores are built and opened, the land (incl. any construction in progress) will stay a nonprod. asset. Including this kind of asset will drive down ROI and RI. Therefore, some firms do not include this type of asset into the total asset.

What does a positive RI mean?

The division's operating income exceeds top mgmt's target rate of return. (Negative - division is not meeting the target rate of return) Ex. 1 = Assuming 25% target rate of return, calculate RI for Bev division. (all data stated in millions) Mgmt's actual target rate of return is unknown. Beverage RI = 2785 - (25% * $24,128) = ($4247) million This division's RI is negative, meaning that the division did not use its assets as effectively as top management expected, and therefore was unable to achieve minimum ROI of 25%. (Recall that Bev division's ROI was approx. 10%) Snack RI = $4304 - (25% * $5375) = $2960 million Positive RI indicates that Snack division exceeded top management's 25% target return expectations. The RI calculation also confirms what we learned about the Snack division's ROI. (ROI was 80%, which is higher than the targeted minimum of 25%)

What can mgmt do to a division with a low ROI?

They could try to improve a weaker division by investing in new tech, plants, and equipment. Therefore, division with weaker ROI may also receive an infusion of capital, in order to improve operations.

What is Residual Income? (RI)

This calculation determines whether the division has created any excess (or residual) income above and beyond management's expectations. The RI equation compares the division's actual operating income with the minimum operating income that top mgmt expects, "given the size of the division's assets" 1. RI = Operating income - Minimum acceptable income "Minimum acceptable income" = top management's target rate of return * division's total assets. 2. RI = Operating income - (Target rate of return * Total assets)

Using gross book value vs net book value?

Use "gross book value" 1. Gross book value - historical cost of the assets. 2. Net book value - historical cost of the assets less accumulated depreciation. (Using this has a drawback) Because of depreciation, the net book value of assets continues to decrease over time until assets are fully depreciated. As a result, ROI and RI get larger over time simply because of depreciation rather than from actual improvements in operations. In general, calculating ROI based on the net book value of assets gives managers an incentive to continue using old, outdated equipment because the net book value of the asset keeps decreasing. However, top management may want the division to invest in new technology to create operational efficiency. The long-term effects of using outdated equipment may be devastating as competitors use new technology to produce cheaper products and sell at lower prices. To create goal congruence, some companies prefer calculating ROI based on gross book value of assets or even based on the assets' current replacement cost, rather than the asset's net book value.