Transcript
CHAPTER 23: PERFORMANCE MEASUREMENT, COMPENSATION, AND MULTINATIONAL CONSIDERATIONS
TRUE/FALSE
1. Many common performance measures, such as customer satisfaction, rely on internal financial accounting information.
Answer: False
Customer satisfaction would be obtained by surveys that are not in the financial accounting records.
2. Some companies present financial and nonfinancial performance measures for various organization units in a single report called the " balanced scorecard."
Answer: True
3. A major weakness of comparing two companies using only operating incomes as the basis of comparison is this method ignores differences in the size of the investment required to earn the operating income.
Answer: True
4. Return on investment is also called the accrual accounting rate of return.
Answer: True
5. Investment turnover is calculated by dividing investments by revenues.
Answer: False
Investment turnover is calculated by dividing revenues by investments.
6. The three alternatives for increasing return on investment include increasing assets such as receivables, increasing revenues, and decreasing costs. (In all cases assume that all other items stay the same.)
Answer: False
Increasing receivables does not increase return on investment.
7. Imputed costs are costs recognized in particular situations that are not usually recognized by accrual accounting procedures.
Answer: True
8. The objective of maximizing return on investment may induce managers of highly profitable divisions to reject projects that from the viewpoint of the overall organization should be accepted.
Answer: True
9. Goal congruence is more likely to be promoted by using return on investment rather than residual income as a measure of a subunit's managerial performance.
Answer: False
Goal congruence is more likely to be promoted by using residual income rather than return on investment.
10. Economic value added, unlike residual income, charges managers for the costs of their investments in long-term assets and working capital.
Answer: False
Both economic value added and residual income charge managers for the costs of their investments in long-term capital.
11. To evaluate overall aggregate performance, return on investment and residual income measures are more appropriate than return on sales.
Answer: True
Return on investment and residual income are better measures of overall aggregate performance because they both consider income earned and investments made.
12. Companies that adopt economic value added define investment as total assets employed minus current liabilities.
Answer: False
13. Current cost return on investment is a better measure of the current economic returns from an investment than historical cost return on investment.
Answer: True
14. Comparing the performance of divisions of a multinational company operating in different countries is difficult due to the differences in economic, legal, political, social, and cultural environments.
Answer: True
15. One way to achieve greater comparability of historical cost-based ROIs for a company's foreign division is to restate performance in dollars.
Answer: True
16. An important consideration in designing compensation arrangements is the tradeoff between creating incentives and imposing risks.
Answer: True
17. Moral hazard describes contexts in which an employee prefers to exert less effort than the effort that the owner wants because the employee's effort cannot be accurately monitored and enforced.
Answer: True
18. Another term for benchmarking is a relative performance evaluation.
Answer: True
19. Evaluating an executive's performance using the annual return on investment would sharpen an executive's long-run focus.
Answer: False
Using return on investment is a short-run tool.
20. Examples of "cooking the books" are understated assets and overstated liabilities.
Answer: False
Cooking the books is overstating assets and understating liabilities.
MULTIPLE CHOICE
21. A report that measures financial and nonfinancial performance measures for various organization units in a single report is called a(n)
a. balanced scorecard.
b. financial report scorecard.
c. imbalanced scorecard.
d. unbalanced scorecard.
Answer: a
22. Customer-satisfaction measures are an example of
a. goal-congruence approach.
b. balanced scorecard approach.
c. financial report scorecard approach.
d. investment success approach.
Answer: b
23. An example of a performance measure with a long-run time horizon
a. is direct materials efficiency variances.
b. is overhead spending variances.
c. is number of new patents developed.
d. include all of the above measures.
Answer: c
24. Does operating income best measure a subunit's financial performance? This question is considered part of which step in designing an accounting-based performance measure?
a. Choose performance measures that align with top management's financial goals.
b. Choose the time horizon of each performance measure.
c. Choose a definition for each performance measure.
d. Choose a measurement alternative for each performance measure.
Answer: a
25. Should assets be defined as total assets or net assets? This question is considered part of which step in designing an accounting-based performance measure?
a. Choose performance measures that align with top management's financial goals.
b. Choose the time horizon of each performance measure.
c. Choose a definition for each performance measure.
d. Choose a measurement alternative for each performance measure.
Answer: c
26. Should assets be measured at historical cost or current cost? This question is considered part of which step in designing an accounting-based performance measure?
a. Choose performance measures that align with top management's financial goals
b. Choose the time horizon of each performance measure
c. Choose a definition for each performance measure
d. Choose a measurement alternative for each performance measure
Answer: d
27. Which of the following statements about designing an accounting-based performance measure is FALSE?
a. The steps may be followed in a random order.
b. The issues considered in each step are independent.
c. Management's beliefs are present during the analyses.
d. Behavioral criteria are important when evaluating the steps.
Answer: b
28. Managers usually use the term return on investment to evaluate
a. the performance of a subdivision.
b. a potential project.
c. the performance of a subunit.
d. both (a) and (c).
Answer: d
29. The return on investment is usually considered the most popular approach to incorporating the investment base into a performance measure because
a. it blends all the ingredients of profitability into a single percentage.
b. once determined, there is no need to use it with other measures of performance.
c. it is similar to the company's price earnings ratio in that a corporation's return on investment appears every day in The Wall Street Journal.
d. of both (a) and (c).
Answer: a
30. Return on investment can be increased by
a. increasing operating assets.
b. decreasing operating assets.
c. decreasing revenues.
d. both (b) and (c).
Answer: b
31. During the past twelve months, the Aaron Corporation had a net income of $50,000. What is the amount of the investment if the return on investment is 20%?
a. $100,000
b. $200,000
c. $250,000
d. $500,000
Answer: c
0.20 = $50,000/x; x = $250,000
32. During the past twelve months, the Zenith Corporation had a net income of $39,200. What is the return on investment if the amount of the investment is $280,000?
a. 10%
b. 12%
c. 14%
d. 16%
Answer: c
$39,200/$280,000 = 14%
33. The Alpha Beta Corporation had the following information for 20x3:
Revenue $ 900,000
Operating expenses 670,000
Total assets 1,150,000
What is the return on investment?
a. 10%
b. 20%
c. 25%
d. 78.2%
Answer: b
$230,000/$1,150,000 = 20%
34. Wacker Company has two regional offices. The data for each is as follows:
Maryland New York
Revenues $ 580,000 $ 596,000
Operating assets 4,800,000 9,000,000
Net operating income 2,016,000 2,400,000
What is the Maryland Division's return on investment?
a. 0.42
b. 0.54.
c. 0.96.
d. 4.12.
Answer: a
$2,016/$4,800 = 0.42%
35. Thacker Company has two regional offices. The data for each is as follows:
Maryland New York
Revenues $ 580,000 $ 596,000
Operating assets 4,800,000 9,000,000
Net operating income 2,016,000 4,860,000
What is the return on investment for the New York Division?
a. 0.42.
b. 0.54
c. 0.96
d. 4.12
Answer: b
$4,860/$9,0000= 54%
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 36 THROUGH 38.
The Cybertronics Corporation reported the following information for its Cyclotron Division:
Revenues $1,000,000
Operating costs 600,000
Taxable income 200,000
Operating assets 500,000
Income is defined as operating income.
36. What is the Cyclotron Division's investment turnover ratio?
a. 2.00
b. 3.33
c. 2.50
d. 0.80
Answer: a
$1,000,000/$500,000 = 2
37. What is the Cyclotron Division's return on sales?
a. 0.2
b. 0.4
c. 0.5
d. 0.6
Answer: b
$1,000,000 - $600,000 = $400,000; $400,000/$1,000,000 = 0.40
38. What is the Cyclotron Division's return on investment?
a. 0.2
b. 0.4
c. 0.5
d. 0.8
Answer: d
$400,000 / $500,000 = 0.8
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 39 THROUGH 43.
The top management at Munchie Company, a manufacturer of computer games, is attempting to recover from a flood that destroyed some of their accounting records. The main computer system was also severely damaged. The following information was salvaged:
Alpha Division Beta Division Gamma Division
Sales $2,500,000 (a) $1,150,000
Net operating income $1,500,000 $650,000 $ 575,000
Operating assets (b) (c) $ 766,667
Return on investment 0.25 0.15 (d)
Return on sales (e) 0.10 0.5
Investment turnover (f) (g) 1.5
39. What were the sales for the Beta Division?
a. $4,333,333
b. $5,952,380
c. $6,500,000
d. $7,151,800
Answer: c
0.10 = $650,000/x; x = $6,500,000
40. What is the value of the operating assets belonging to the Alpha Division?
a. $4,333,333
b. $6,000,000
c. $6,500,000
d. $7,151,800
Answer: b
$1,500,000/0.25 = $6,000,000
41. What is the value of the operating assets belonging to the Beta Division?
a. $4,333,333
b. $5,952,380
c. $6,500,000
d. $7,151,800
Answer: a
1.5 = $6,500,000/x; x = $4,333,333
42. What is the Gamma Division's return on investment?
a. 0.25
b. 0.42
c. 0.60
d. 0.75
Answer: d
0.5 x 1.5 = 0.75
43. What is the Alpha Division's return on sales?
a. 0.25
b. 0.42
c. 0.60
d. 0.75
Answer: c
$1,500,000/$2,500,000 = 0.60
44. Costs recognized in particular situations that are not recognized by accrual accounting procedures are
a. opportunity costs.
b. imputed costs.
c. cash accounting costs.
d. none of the above.
Answer: b
45. A problem with utilizing residual income is that
a. a corporation with a high investment turnover ratio always has a higher residual income than a corporation with a smaller investment turnover ratio.
b. a corporation with a high return on sales always has a higher residual income than a corporation with a smaller return on sales.
c. A corporation with a larger dollar amount of assets is likely to have a higher residual income than a corporation with a smaller dollar amount of assets.
d. none of the above are correct.
Answer: c
46. A company which favors the residual income approach
a. wants managers to concentrate on maximizing an absolute amount of dollars.
b. wants managers to concentrate on maximizing a percentage return.
c. wants managers to maximize the investment turnover ratio.
d. wants managers to maximize return on sales.
Answer: a
47. Using residual income as a measure of performance rather than return on investment promotes goal congruence because
a. residual income places importance on the reduction of underperforming assets.
b. residual income calculates a percentage return rather than an absolute return.
c. residual income concentrates on maximizing an absolute amount of dollars.
d. residual income concentrates on maximizing the return on sales.
Answer: c
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 48 THROUGH 50.
The Bandage Medical Supply Company has two divisions that operate independently of one another. The financial data for the year 20x3 reported the following results:
North South
Sales $3,000,000 $2,500,000
Operating income 750,000 550,000
Taxable income 650,000 375,000
Investment 6,000,000 5,000,000
The company's desired rate of return is 10%. Income is defined as operating income.
48. What are the respective return-on-investment ratios for the North and South Divisions?
a. 0.110 and 0.125
b. 0.108 and 0.075
c. 0.125 and 0.110
d. 0.050 and 0.150
Answer: c
North = $750,000/$6,000,000 = 12.5%
South = $550,000/$5,000,000 = 11.0%
49. What are the respective residual incomes for the North and South Divisions?
a. $30,000 and $50,000
b. $150,000 and $30,000
c. $150,000 and $50,000
d. $50,000 and a negative $150,000
Answer: c
North = $750,000 - (0.1) $6,000,000 = $150,000
South = $550,000- (0.1) $5,000,000 = $50,000
50. Which division has the best return on investment and which division has the best residual income figure, respectively?
a. North, North
b. South, South
c. North, South
d. South, North
Answer: a
51. After-tax operating income minus the after-tax weighted-average cost of capital multiplied by total assets minus current liabilities equals
a. return on investment.
b. residual income.
c. economic value added.
d. weighted-average cost of capital.
Answer: c
52. The after-tax average cost of all the long-term funds used by a corporation equals
a. economic value added.
b. return on investment.
c. return on equity.
d. weighted-average cost of capital.
Answer: d
53. A negative feature of defining investment by excluding the portion of total assets employed that are financed by short-term creditors is
a. current liabilities are sometimes difficult to define.
b. short-term debt is always more expensive to finance than long-term debt.
c. this method encourages managers to use an excessive amount of short-term debt.
d. this method encourages managers to use an excessive amount of long-term debt.
Answer: c
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 54 THROUGH 56.
Waldorf Company has two sources of funds: long-term debt with a market and book value of $10 million issued at an interest rate of 12%, and equity capital that has a market value of $8 million (book value of $4 million). Waldorf Company has profit centers in the following locations with the following operating incomes, total assets, and total liabilities. The cost of equity capital is 12%, while the tax rate is 25%.
Operating
Income
Assets
Current
Liabilities
St. Louis
$ 960,000
$ 4,000,000
$ 200,000
Cedar Rapids
$1,200,000
$ 8,000,000
$ 600,000
Wichita
$2,040,000
$12,000,000
$1,200,000
54. What is the EVA for St. Louis?
a. $255,740
b. $327,460
c. $392,540
d. $720,000
Answer: b
WACC = [(0.09 x $10,000,000) + (0.12 x $8,000,000)]/$18,000,000 = 0.1033
St. Louis (EVA) = ($960,000 x 0.75) – [0.1033 x (4,000,000 - $200,000)]
= $720,000 - $392,540= $327,460
55. What is the EVA for Cedar Rapids?
a. $135,580
b. $220,000
c. $234,000
d. $305,000
Answer: a
Cedar Rapids (EVA) = ($1,200,000 x 0.75) - [0.1033 x ($8,000,000 - $600,000)]
= $900,000 - $764,420= $135,580
56. What is the EVA for Wichita?
a. $450,000
b. $1,530,000
c. $414,360
d. $1,115,640
Answer: c
Wichita (EVA) = ($2,040,000 x.75) – [(0.1033 x ($12,000,000 - 1,200,000)]
= $1,530,000 - $1,115,640= $414,360
THE FOLLOWING INFORMATION APPLIES TO QUESTIONS 57 THROUGH 59.
Ruth Cleaning Products manufactures home cleaning products. The company has two divisions, Bleach and Cleanser. Because of different accounting methods and inflation rates, the company is considering multiple evaluation measures. The following information is provided for 20x3:
ASSETS
INCOME
Book value
Current value
Book value
Current value
Bleach
$225,000
$300,000
$150,000
$155,000
Cleanser
$450,000
$250,000
$100,000
$105,000
The company is currently using a 15% required rate of return.
57. What are Bleach's and Cleanser's return on investment based on book values, respectively?
a. 0.22; 0.67
b. 0.42; 0.52
c. 0.52; 0.42
d. 0.67; 0.22
Answer: d
Book value ROI:
Bleach: $150,000/$225,000 = 0.67
Cleanser: $100,000/$450,000 = 0.22
58. What are Bleach's and Cleanser's return on investment based on current values, respectively?
a. 0.22; 0.67
b. 0.42; 0.52
c. 0.52; 0.42
d. 0.67; 0.22
Answer: c
Current ROI:
Bleach: $155,000 / $300,000 = 0.52
Cleanser: $105,000 / $250,000 = 0.42
59. What are Bleach's and Cleanser's residual incomes based on book values, respectively?
a. $116,250; $32,500
b. $110,000; $67,500
c. $67,500; $110,000
d. $37,500; $116,250
Answer: a
Book value RI:
Bleach: $150,000 - ($225,000 x 0.15) = $116,250
Cleanser: $100,000 - ($450,000 x 0.15) = $32,500
60. The cost today of purchasing an asset identical to the one currently held is called
a. an actual cost.
b. a current cost.
c. a dual cost.
d. a fixed cost.
Answer: b
61. If a company is a multinational company with operations in several different countries, one way to achieve comparability of historical-cost based ROIs for facilities in different countries is
a. restate the results of operations using the cash basis method of accounting.
b. use GAAP for all reporting and calculations.
c. restate the results of all operations in dollars.
d. all of the above would achieve comparability.
Answer: c
62. Which of the following statements is true?
a. The economic, legal, political, social, and cultural environments differ across countries.
b. Governments in some countries may impose controls and limit selling prices of a company's products.
c. Because of advances in telecommunications and transportation, the availability of materials and skilled labor does not differ significantly across countries.
d. Both (a) and (b) are correct.
Answer: d
63. In performance evaluations
a. the performance of the division prior to the manager assuming control should be considered.
b. economic conditions for the specific industry should not be considered.
c. to have an effective and fair evaluation, a manager should be evaluated over several time periods.
d. both (a) and (c) are correct.
Answer: d
64. A problem with rewarding managers only on the basis of residual income
a. is that residual income is difficult to measure.
b. is that on occasion the items in the residual income calculation are not quantifiable.
c. is that residual income can depend on items over which the manager has little control.
d. include all of the above.
Answer: c
65. _________ describes contexts in which an employee prefers to exert less effort than the effort that the owner wants because the employee's effort cannot be accurately monitored and enforced.
a. Goal congruence
b. Moral hazard
c. Management compensation
d. Incentive compensation
Answer: b
66. Tying performance measures more closely to a manager's efforts
a. encourages the use of nonfinancial measures.
b. results in a strict use of financial ratios.
c. results in the salary component of compensation dominating the total compensation package.
d. includes both (a) and (c).
Answer: a
67. Relative performance evaluation
a. is called benchmarking.
b. filters out the effect of common noncontrollable factors.
c. results in managers having no incentive to help one another.
d. include all of the above.
Answer: d
68. Team incentives encourage cooperation by
a. forcing people to work together on difficult tasks.
b. improving morale.
c. letting individuals help one another as they strive toward a common goal.
d. rewarding all teams the same amount.
Answer: c
69. Many manufacturing, marketing, and design problems require employees with multiple skills; therefore, teams are used and the members have the added encouragement of
a. individual incentives.
b. management incentives.
c. morale incentives.
d. team incentives.
Answer: d
70. Designers of executive compensation plans emphasize which of the following factors?
a. Achievement of organizational goals
b. Administrative ease
c. The probability that the executives affected by the plan will perceive the plan as fair
d. All of the above are emphasized.
Answer: d
EXERCISES AND PROBLEMS
71. Assume you are evaluating a manufacturing company. Match the various organizational activities and concepts with the performance measures listed. Some items may have more than one match.
Activities:
1. Change in revenues
2. Cycle time
3. Economic order quantity
4. Manufacturing defects
5. Market share
6. New products
7. On-time delivery
8. Operating income
9. Product reliability
10. Time-to-market
Performance measure:
_______________ a. Profitability
_______________ b. Customer satisfaction
_______________ c. Innovation
_______________ d. Efficiency, quality, and time
Answer:
1, 8____________ a. Profitability
5, 7, 9__________ b. Customer satisfaction
6, 10___________ c. Innovation
2, 3, 4, 7, 9, 10___ d. Efficiency, quality, and time
72. Designing an accounting based performance measure requires six steps. List each step. For three of the steps, describe a question that must be resolved as part of the implementation process.
Answer:
1. Choose performance measures that align with top management's goals.
Does operating income, return on assets, or revenues best measure a subunit's financial goals?
2. Choose the time horizon of each performance measure.
Should the performance measures be calculated for one year or a multi-year time horizon?
3. Choose a definition for each performance measure.
Should assets be defined as total assets or net assets?
4. Choose a measurement alternative for each performance measure.
Should assets be measured at historical cost or current cost?
5. Choose a target level of performance.
Should all subunits have the same targets such as the same required rate of return on assets?
6. Choose the timing of the feedback.
How often should manufacturing performance reports be sent to management?
73. Museum Corporation uses the investment center concept for the museums that it manages. Select operating data for three of its museums for 20x3 are as follows:
St. Louis
Dallas
Miami
Revenue
$600,000
$750,000
$900,000
Operating assets
300,000
250,000
350,000
Net operating income
51,000
56,000
59,000
Required:
a. Compute the return on investment for each division.
b. Which museum manager is doing best based only on ROI? Why?
c. What other factors should be included when evaluating the managers?
Answer:
a. St. Louis = $51,000/$300,000 = 0.170
Dallas = $56,000/$250,000 = 0.224
Miami = $59,000/$350,000 = 0.169
b. Dallas was doing the best because the ROI was the highest, and compared to Miami, was doing better with fewer assets.
c. At a minimum, the company should consider examining the DuPont method, residual income, and the age of operating assets.
74. Kase Tractor Company allows its divisions to operate as autonomous units. The operating data for 20x3 follow:
Plows
Tractors
Combines
Revenues
$2,250,000
$500,000
$4,800,000
Accounts receivable
800,000
152,500
1,435,000
Operating assets
1,000,000
400,000
1,750,000
Net operating income
220,000
60,000
480,000
Taxable income
165,000
90,000
385,000
Required:
a. Compute the investment turnover for each division.
b. Compute the return on sales for each division
c. Compute the return on investment for each division.
d. Which division manager is doing best? Why?
e. What other factors should be included when evaluating the managers?
For parts (b) and (c) income is defined as operating income.
Answer:
a. Investment turnover:
Plows = $2,250,000/$1,000,000 = 2.25
Tractors = $500,000/$400,000 = 1.25
Combines = $4,800,000/$1,750,000 = 2.74
b. Return on Sales:
Plows = $220,000/$2,250,000 = 0.10
Tractors = $60,000/$500,000 = 0.12
Combines = $480,000/$4,800,000 = 0.10
c. ROI:
Plows = 2.25 x 0.10 = 0.225
Tractors = 1.25 x 0.12 = 0.150
Combines = 2.74 x 0.10 = 0.274
d. Combines' manager had the best performance because he had the highest investment turnover, which offset his second-best return on sales.
e. Residual income should be considered and noncontrollable factors such as the age of the assets.
75. Provide the missing data for the following situations:
Red Division
White Division
Blue Division
Sales
$?
$10,000,000
$?
Net operating income
$200,000
$400,000
$288,000
Operating assets
$?
$?
$1,600,000
Return on investment
0.16
0.10
?
Return on sales
0.04
?
0.12
Investment turnover
?
?
1.5
Answer:
Red Division:
ROI = ROS x IT
0.16 = 0.04 x IT
IT = 4.0
ROS = Income/Sales
0.04 = $200,000/Sales
Sales = $5,000,000
IT = Sales/OA
4 = $5,000,000/OA
OA = $1,250,000
White Division:
ROS = $400,000/$10,000,000 = 0.04
IT = ROI/ROS = 0.10/0.04 = 2.5
OA = S/IT = $10,000,000/2.5 = $4,000,000
Blue Division:
Sales = IT x OA = 1.5 x $1,600,000 = $2,400,000
ROI = 0.12 x 1.5 = 0.18
76. Hargrave Products has three divisions, which operate autonomously. Their results for 20x3 were as follows:
East
West
International
Sales
$30,000,000
$40,000,000
$50,000,000
Cost of goods sold
15,000,000
25,000,000
37,000,000
Operating income
4,500,000
4,750,000
5,000,000
Investment base
30,000,000
30,500,000
31,000,000
The company's desired rate of return is 15%.
Required:
a. Compute each division's ROI. Round to three decimal places.
b. Compute each division's residual income.
Answer:
a. East ROI = $4,500,000/$30,000,000 = 0.150
West ROI = $4,750,000/$30,500,000 = 0.156
International = $5,000,000/$31,000,000 = 0.161
b.
East
West
International
Investment base
$30,000,000
$30,500,000
$31,000,000
Minimum rate
x 0.15
x 0.15
x 0.15
Minimum return
$ 4,500,000
$ 4,575,000
$ 4,650,000
Operating Income
$4,500,000
$4,750,000
$5,000,000
Minimum return
4,500,000
4,575,000
4,650,000
Residual income
$ 0
$ 175,000
$ 350,000
Objectives: 3, 4
77. Batman Abstract Company has three divisions that operate autonomously. Their results for 20x3 are as follows:
Riddler
Joker
Penguin
Sales
$5,000,000
$7,000,000
$10,000,000
Contribution margin
1,440,000
1,700,000
3,500,000
Operating income
1,000,000
1,750,000
2,520,000
Investment base
9,000,000
10,000,000
14,000,000
The company's desired rate of return is 20%.
Required:
a. Compute each division's ROI.
b. Compute each division's residual income.
c. Rank each division by both ROI and residual income.
d. Which division had the best performance in 20x3? Why?
Answer:
a. Riddler ROI = $1,000,000/$9,000,000 = 0.111
Joker ROI = $1,750,000/$10,000,000 = 0.175
Penguin ROI = $2,520,000/$14,000,000 = 0.180
b.
Riddler
Joker
Penguin
Investment base
$9,000,000
$10,000,000
$14,000,000
Minimum rate
x 0.20
x 0.20
x 0.20
Minimum return
$1,800,000
$2,000,000
$2,800,000
Income
$1,000,000
$1,750,000
$2,520,000
Minimum return
1,800,000
2,000,000
2,800,000
Residual income
$(800,000)
$ (250,000)
$(280,000)
c. ROI Rank:
Penguin # 1
Joker # 2
Riddler # 3
RI Rank:
Joker #1
Penguin #2
Riddler #3
77. (continued)
d. As to which division was the best, it is difficult to determine without knowing what the results are being used to evaluate. If management is measuring only the return of capital, the Penguin Division has the highest ranking, although not much ahead of Joker. However, Penguin does have a substantially higher income level. As to meeting management's expectations of residual income, all divisions fall short of the goal with Joker being slightly ahead of Penguin.
Objectives: 3, 4
78. The Coffee Division of American Products is planning the 20x3 operating budget. Average operating assets of $1,500,000 will be used during the year and unit selling prices are expected to average $100 each. Variable costs of the division are budgeted at $400,000, while fixed costs are set at $250,000. The company's required rate of return is 18%.
Required:
a. Compute the sales volume necessary to achieve a 20% ROI.
b. The division manager receives a bonus of 50% of residual income. What is his anticipated bonus for 20x3, assuming he achieves the 20% ROI from part (a)?
Answer:
a. Target operating income = 0.20 x $1,500,000 = $300,000
Operating income
$300,000
Variable costs
400,000
Fixed costs
250,000
Target revenues
$950,000
Sales volume = $950,000/$100 = 9,500 units
b.
Asset base
$1,500,000
Minimum rate
x 0.18
Required return
$ 270,000
Target operating income
$ 300,000
Required return
270,000
Residual income
$ 30,000
Bonus = $30,000 x 0.50 = $15,000
Objectives: 3, 8, 9
79. LaserLife Printer Cartridge Company is a decentralized organization with several autonomous divisions. The division managers are evaluated, in part, on the basis of the change in their return on invested assets. Operating results for the Packer Division for 20x3 are budgeted as follows:
Sales
$5,000,000
Less variable costs
2,500,000
Contribution margin
2,500,000
Less fixed expenses
1,800,000
Net operating income
$ 700,000
Operating assets for the division are currently $3,600,000. For 20x3, the division can add a new product line for an investment of $600,000. The new product line will generate sales of $1,600,000 and will incur fixed expenses of $600,000 annually. Variable costs of the new product will average 60% of the selling price.
Required:
a. What is the effect on ROI of accepting the new product line?
b. If the company's required rate of return is 6% and residual income is used to evaluate managers, would this encourage the division to accept the new product line? Explain and show computations.
Answer:
a.
New investment:
Sales
$1,600,000
Variable costs
$960,000
Fixed costs
600,000
1,560,000
Operating income
$ 40,000
Current ROI = $700,000/$3,600,000 = 0.194
New investment ROI = $40,000/$600,000 = 0.067
Combined ROI = $740,000/$4,200,000 = 0.176
Accepting the new product line will reduce the division's ROI. This would make the manager reluctant to make the investment.
b.
Investment
$600,000
Minimum return
x 0.06
Required amount
$ 36,000
Income
$ 40,000
Required amount
36,000
Residual income
$ 4,000
Manager would accept the investment because income is increased by $4,000.
Objectives: 3, 4, 8, 9
80. Capital Investments has three divisions. Each division's required rate of return is 15%. Planned operating results for 20x3 are as follows:
Division
Operating income
Investment
A
$15,000,000
$100,000,000
B
$25,000,000
$125,000,000
C
$11,000,000
$ 50,000,000
The company is planning an expansion, which is requiring each division to increase its investments by $25,000,000 and its income by $4,500,000.
Required:
a. Compute the current ROI for each division.
b. Compute the current residual income for each division.
c. Rank the divisions according to their current ROIs and residual incomes.
d. Determine the effects after adding the new project to each division's ROI and residual income.
e. Assuming the managers are evaluated on either ROI or residual income, which divisions are pleased with the expansion and which ones are unhappy?
Answer:
a. A ROI = $15,000,000/$100,000,000 = 0.15
B ROI = $25,000,000/$125,000,000 = 0.20
C ROI = $11,000,000/$50,000,000 = 0.22
b. A RI = $15,000,000 - ($100,000,000 x 0.15) = $ 0
B RI = $25,000,000 - ($125,000,000 x 0.15) = $6,250,000
C RI = $11,000,000 - ($50,000,000 x 0.15) = $3,500,000
c. ROI Rank: 1. C RI Rank: 1. B
2. B 2. C
3. A 3. A
80. (continued)
d. A ROI = $19,500,000/$125,000,000 = 0.156
B ROI = $29,500,000/$150,000,000 = 0.197
C ROI = $15,500,000/$75,000,000 = 0.207
A RI = $19,500,000 - ($125,000,000 x 0.15) = $ 750,000
B RI = $29,500,000 - ($150,000,000 x 0.15) = $7,000,000
C RI = $15,500,000 - ($75,000,000 x 0.15) = $4,250,000
e. Everyone would be pleased if residual income was used because residual incomes increase with the expansion. However, it would be difficult to evaluate each division on a comparative basis because each division’s investment base is different.
Only the manager of Division A is pleased with the new investment if ROI is used because that is the only division with an increased ROI. In the case of additional investments that are required by corporate management, residual income may be the best to use for evaluating each manager individually, but not collectively.
Objectives: 3, 4, 9
CRITICAL THINKING
81. The executive vice president of Wicker Pen Company wants to establish an accounting-based performance measurement system for the company's new plant. The company has an accounting information system sufficient to support a fairly sophisticated performance measurement system. The new plant is going to be considered an investment center since its products will be markedly different from others the company currently sells. The new plant will have no internal dealings with other plants within the company.
Required:
What are some of the key steps that should be undertaken in the establishment of an accounting-based performance measurement system?
Answer:
Key steps include:
1. Choose variables that represent the company's financial goals for the plant. They would include those that relate to the plant as an investment center.
2. Define the variables in terms of the company's general goals.
3. Determine how the variables will be measured.
4. Select benchmarks against which the variables will be measured.
5. Select periodicity of reporting for each variable to be measured.
82. Companies are increasingly using nonfinancial measures to evaluate performance. Why? Since these numbers do not come from the company’s financial records, why are they used?
Answer:
The correct answer will revolve around the objective of providing quality goods to the corporation's customers. Quality goods bring repeat business and satisfied customers are a business' best advertisement.
The idea is that these nonfinancial measures concentrate on areas and questions that indicate the quality of a particular corporation’s products. While some of these items do not come from a companies' financial records, such as defect rates, they are quantifiable and can be verified.
83. Bob Cellular Phone uses ROI to measure divisional performance. Annual ROI calculations for each division have traditionally employed the ending amount of invested capital along with annual operating income and net revenue. The Dupont method is generally used. The company's Phone Accessories Division had the following results for the last two years:
20x3 ROI = ($2,000,000/$20,000,000) x ($20,000,000/$10,000,000) = 0.20
20x4 ROI = ($2,400,000/$25,000,000) x ($25,000,000/$15,000,000) = 0.16
Corporate management was disappointed in the performance of the division for 20x4, since it had made an additional investment in the division that was budgeted for a 23% ROI.
Required:
a. Discuss some factors that may have contributed to the decrease in ROI for 20x4.
b. Would there have been any substantial difference if average capital had been used?
Answer:
a. While sales increased by 25%, net income only increased by 20%. This may indicate that expenses increased more than they should have. Apparently, the expected marginal net income from the new investment was $1,150,000 ($5,000,000 x 0.23), and either sales were too low or expenses too high for the new products. But this calculation is somewhat hypothetical since we do not know expected sales. Start-up costs may have also contributed to the increased expenses of the first year's operations. An increase in investment also contributed to the decline in return on investment.
b. Using average capital: = ($10,000,000 + $15,000,000)/2 = $12,500,000
ROI = $2,400,000/$12,500,000 = 0.192
Using average capital would have improved the ROI from 16 to over 19%. This would still have been a disappointment to management because the total ROI fell below expectations. Perhaps it is unreasonable to expect a new investment to achieve its target ROI in the first year of operations.
84. The economic value added concept has attracted considerable attention in recent years. Explain the attractiveness of this number as a measure of performance.
Answer:
The attractiveness of economic value added at the divisional level is primarily the fact that it allows managers to incorporate the cost of capital in decisions at the divisional level.
85. R&D Storage is a small, but diversified, moving and storage company. In recent years, its corporate income has declined to unacceptable levels. To change the direction of the company, the board of directors hired a new chief executive officer. She is currently considering three alternative ways to reward division managers for performance. They are:
1. Give each manager a competitive salary with no bonus for performance.
2. Give each manager a base salary with the largest portion being a bonus based on performance, ROI being the yardstick.
3. Give each manager a base salary with a bonus based on comparative performance with the other divisions.
Required:
Evaluate each of the ideas, giving strengths and weaknesses.
Answer:
1. Opportunities for salary increases might be decided via other means such as improvements in employee motivation, cost savings ideas, or improved management skills. This method will fit some types of situations and managers better than the bonus methods, but should not be used in situations where a high degree of motivation is desired.
2. The second idea is good for motivating a manager to improve the performance of each given division. A weakness in this method occurs when managers make decisions that maximize return on investment in the short run because they have no intent to stay with the company over a long period of time.
3. The third method is great for motivating managers to compete with each other. However, some reward should be available for the lowest rated manager if that manager's performance is, in fact, above the company's standard for performance. Suboptimization is a potential problem with this approach if the winning manager's bonus is substantially above everyone else's bonus.
Objectives: 8, 9
