ACC 222 - Managerial Accounting
Notes For Class 18
Spring 2000

Motivation and Control through Accounting Information
Compute ROI and Residual Income

The Formulas: ROI

  • The basic return on investment formula is:
  • ROI = Profit/Investment
  • The ROI relationship can be divided into two component ratios:
  • ROI = Profit/Sales x Sales/Investments
The Formula: RI
  • The basic formula for residual income is:
  • Operating income less the charge for cost of capital employed = residual income
  • The charge for capital employed is the cost of capital for this division or company multiplied by the investments used to earn this income.
  • Charge for capital employed = invested capital x cost of capital
Relating ROI to RI
The relationship between RI and ROI as simply the difference between the ROI and the cost of capital employed (COC) multiplied by the investment.
  • ROI = Operating income/Investment
  • Therefore:   Income = ROI - investment    (1)
  • RI = Operating income - (Investment x Cost of capital)
  • Therefore:  Income = RI - (investment x COC)    (2)
  • Set (1) = (2)
  • ROI - Investment = RI - (investment x COC)
  • Therefore: RI = Investment (ROI - COC)
Economic Value Added (EVA)
GAAP accounting is much better at measuring short-term rather than long-term company value. By using these measurements, accounting control systems often bias management towards short-term profits. EVA assumes stock market prices approximate long-term value.  Using this criterion, EVA techniques change existing financial accounting data to better measure activities that influence company value.  The economic value added is the adjusted operating income less a charge for the capital employed.  This is similar to residual income except EVA adjusts the financial accounting data to more correctly measure value.  Using this approach, the influence of manager’s activities on stock market values can be estimated.   If EVA is correct, its measures should motivate managers to always increase value by “managing by the numbers.”

19. Why do we use residual income as a performance measurement tool?

  • Residual income gives a different view of the return on invested capital.  The ROI measures the average yield per dollar invested, but does not reflect the size of the monies earned.  RI, on the other hand, measures the contribution to profits in excess of the costs of the investments used.  For example, suppose we have to finance our investments, just like we may a car, then the RI is the money we have earned after we pay interest on the financed assets we used. 
20. Is profit the best performance measure?
  • No.  The best performance measurement is one that measures value.  Profit is based on past operations.  However, profit has the advantage of being hard data, and, thus, is more trustworthy than estimates of future cashflow.  For many investors, profit is considered an important when measure combined with other measures that reflect value.

21. Discuss the differences between EVA and residual income concept.  

  • Both use similar formulas.  The only difference is that Residual income uses GAAP approved reporting measures to determine operating income for the segment measures.  EVA, or economic value added, modifies the GAAP based measures to better reflect the value of these activities.
5 Ethical Concerns with Management's use of Accounting Control Measures

1. Segments may not be comparable.  Different segments may be facing different risk and competitive situations.  Thus, to compare them on profit alone is not appropriate.  These are referred to as “deadly parallel” evaluations.

2. Segment managers may be placed in conflict with each other.  If segments can influence each other’s performance, as in our department store, failure to coordinate efforts could results in lower combined earnings.

3. Comparing last year and this year may not correctly evaluate performance.  Comparing sequential years without considering changes in operating conditions can lead to incorrect evaluations.

4. Managers may be motivated to maximize accounting’s reported profit instead of long-run value.  When only short-term profit is considered to evaluate managers, long-term value may be ignored.  Reductions in maintenance, research and development, and training can reduce short-term expenses but damage long-term value.

5. We may need nonfinancial process measures in addition to the output measures accounting systems usually report.  Long-term value is realized by future cashflows.  Often measures like market share rather than current sales revenue are better indicators of future value.

22. What is a “deadly parallel” evaluation strategy?

  • Parallel evaluations must be applied with care.  Inappropriate evaluations create a deadly parallel problem.  It compares segments and their managers with each other.  This often results in comparing apples and kumquats — comparing two or more segments that are not equal due to location, product, activity, or economic environment.  It also can cause inter-company conflicts and competition by pitting the segments against each other.  This is not the best environment for enhancing long-term value.
P10  --  Return on investment and residual income

a. Calculate the ROI and RI for Commercial Construction.
    Segment margin  =      Sales        -  Variable costs  -   Fixed costs
             $500,000  =  $4,000,000  -    $1,500,000    -  $2,000,000
 Return on Investment  =  Profit / Investment
 ROI  =  $500,000 / $2,000,000  =  25%
 Residual Income  = Investment x  (ROI  -  Cost of Capital)
 $300,000  =  $2,000,000 x  (25%  - 10%)

b. Calculate the ROI and RI for Apartment Construction.

 Segment margin  =      Sales        -  Variable costs   -  Fixed costs
       $1,000,000  =  $6,000,000  -    $2,500,000    -  $2,500,000
 Return on Investment  =  Profit / Investment
 28.6%  =  $1,000,000 / $3,500,000
 Residual Income  = Investment x  (ROI  -  Cost of Capital)
 $651,000  =  $3,500,000 x  (28.6%  -  10%)  

c. Calculate the ROI and RI for the Company.

 Net income   =       Sales         - Variable costs  -  Segment fixed costs  -  Common fixed costs
 $1,000,000  =  $10,000,000  -    $4,000,000   -       $4,500,000         -          $500,000
 Return on Investment  =  Profit / Investment
 16.7%  =  $1,000,000 / $6,000,000

 Residual Income  =  Investment x  (ROI  -  Cost of Capital)
 $402,000  =  $6,000,000  x  (16.7%  -  10%)  

P12  --  Segmented income statements 

 ROI =     Profit     =      Segment margin     x     Segment sales  
            Investment          Segment sales             Segment assets  
 Motors:                          Profit margin                Asset turnover  
 ROI  =  $250,000     =     $250,000         x         $2,000,000  
            $1,000,000         $2,000,000                   $1,000,000  

 ROI  =    25.0%       =      12.5%           x           2.0 times  
 Pumps:                             Profit margin                 Asset turnover  
  ROI  =    $1,000,000  =    $1,000,000          x          $5,500,000  
                 $3,000,000        $5,500,000                      $3,000,000  
 ROI   =        33.3%     =        18.2%            x           1.8 times  
 WRM in total:                           Profit margin                   Asset turnover    
  ROI   =         $1,000,000    =    $1,000,000           x           $7,500,000  
                       $5,250,000          $7,500,000                        $5,250,000  
  ROI   =            19.0%        =       13.3%              x             1.4 times  

P13  --  Ethics and Accounting Control Measures

a. A supervisor lowers the production quota for one shift foreman to increase her bonus.

  • It is unethical to distribute work in a way that favors one employee over another.

b. The company allows a manufacturing division to transfer its costs (which are below market price) to the assembly division.

  • This is an ethical practice.

c. The company has allocated all costs both controllable and noncontrollable into department managers' budgets and issues bonuses as a percentage of savings below budgeted costs.

  • While not unethical this practice is counter productive and confusing to managers.

d. The manager of your department increases the output quota of employee he doesn’t like.

  • It is unethical to establish difficult goals based upon personal likes and dislikes.

e. Production budgets are established using ideal standards.

  • It is unethical to establish standards that are unattainable.

Asset turnover:  This calculation is a short-run measure of how well assets are used in generating sales.  It is the ratio of sales revenues to the investment in assets generating those revenues.

Controllable segment margin:  This information reports the profit resulting from activities under the segment manager’s control.  It is used in evaluating the segment manager’s performance (contrast this subtotal with segment margin).

Cost centers:  These centers are responsible for controlling the costs of their activities.  They do not have profit or investment responsibilities.  Cost variance reports often are used in evaluating their performance.

Economic value added (EVA):  This measure modifies residual income by adjusting profits and investments from the accounting system values to better reflect long-term shareholder value.
Investment centers:  These centers are responsible for their costs, revenues, and investments.  Thus, measures that relate profits to the investments creating them are often used in performance evaluation, such as ROI, residual income, and EVA.

Profit centers:  These centers are responsible for costs and revenues.  They do not have the responsibility for investment decisions.  Segmented income statements and variances often are used in evaluating their performance.

Profit margin:  This calculation is a short-run measure of operating efficiency, which expresses profit as a percentage of sales.

Return on investment (ROI): This calculation is the profit earned on money invested, expressed as a ratio of profit to the investment amount.  ROI is the mathematical product of two ratios:  profit margin (profit as a percentage of sales), and asset turnover (how many sales dollars result from a $1 investment).

Residual income:  This calculation is the remaining profit after deducting the cost of financing an investment.

Segment margin:  This information is the profit contributed directly by a segment to the company.  The sum of all segment margins is used to pay for the company’s common costs, with anything left over being profit.  Segment margin is used to evaluate the profit contribution of the segment (versus evaluating its manager; see controllable segment margin).

Segmented income statement:  This overall statement includes an income statement for each profit center.

In Class  ==>
  • we will focus our discussion on pages 286-295
  • we will discuss problems P10, P12, and P13 from the Student Resource Manual in class

See the PowerPoint slides for Chapter 8 on the Mackey text book web site
under Student Resources for additional notes from Chapter 8

Assignment for Wednesday, April 5th...
  • Begin reading Chapter 9 in the textbook  --  focus on pages 286-305
  • Homework #7 from the Student Resource Manual
  • Note:  HW #7 will be due on Wednesday, April 5th

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last updated March 29, 2000