MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 24
ADVANCED ANALYSIS AND
APPRAISAL OF PERFORMANCE:
FINANCIAL AND NONFINANCIAL
I.

Questions
1. Return on investment (ROI) is the ratio of profit to amount invested for
the business unit.
2. The measurement issues for ROI are:
a. The effect of accounting policies, which affect the determination of
net income.
b. Other measurement issues for income, which include the handling of
non-recurring items in the income statement, differences in the effect
of income taxes across units, differential effect of foreign currency
exchange, and the effect of cost allocation when two or more units
share a facility or cost.
c. Measuring investment: which assets to include.
d. Measuring investment: allocating the cost of shared assets.
3. The advantages of return on investment are:
a. It is intuitive and easily understood.
b. It provides a useful basis for comparison among SBUs.
c. It is widely used.
The limitations of return on investment are:
a. It has an excessive short-term focus.
b. Investment planning uses discounted cash flow analysis while
managers are evaluated on ROI.
c. It contains a disincentive for new investment by the most profitable
units.
4. The key advantage of residual income is that it deals effectively with the
limitation of ROI, that is ROI has a disincentive for the managers of the
most profitable units to make new investments. With residual income, no
matter how profitable the unit, there is still an incentive for new profitable
investment. In contrast, a key limitation is that since residual income is
not a percentage, it suffers the same problem of profit SBUs in that it is
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Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial

not useful for comparing units of significantly difference sizes. It favors

larger units that would be expected to have larger residual incomes, even
with relatively poor performance. Moreover, relatively small changes in
the desired minimum rate of return can dramatically affect the residual
income for different size units. And, in contrast to ROI, some managers
do not find residual income to be as intuitive and as easily understood.
5. Economic value added (EVA) is a business units income after taxes and
after deducting the cost of capital. The idea is very similar to what we
have explained as residual income. The objectives of the measures are the
same to effectively motivate investment SBU managers and to properly
measure their performance. In contrast to residual income, EVA uses the
firms cost of capital instead of a desired rate of return. For many firms
the desired rate of return and the cost of capital will be nearly the same,
with small differences due to adjustments for risk and for strategic goals
such as the desired growth rate for the firm. Also, while residual income
is intended to deal with the undesirable effects of ROI, EVA is used to
focus managers attention on creating value for shareholders, by earning
profits greater than the firms cost of capital.
6. Examples of financial and nonfinancial measures of performance are:
Financial:
Nonfinancial:

ROI, residual income, and return on sales.

Manufacturing lead time, on-time performance, number
of new product launches, and number of new patents
filed.

7. The six steps in designing an accounting-based performance measure are:

a. Choose performance measures that align with top managements
financial goal(s).
b. Choose the time horizon of each performance measure in Step 1.
c. Choose a definition of the components in each performance measure
in Step 1.
d. Choose a measurement alternative for each performance measure in
Step 1.
e. Choose a target level of performance.
f. Choose the timing of feedback.
8. Yes. Residual income (RI) is not identical to return on investment (ROI).
ROI is a percentage with investment as the denominator of the
computation. RI is an absolute amount in which investment is used to
calculate an imputed interest charge.
9. Economic value added (EVA) is a specific type of residual income
measure that is calculated as follows:
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Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24

Economic
value added =
(EVA)

After tax
operating
income

Weighted
Average Cost x
of Capital

Total Assets
minus Current
Liabilities

10. Definitions of investment used in practice when computing ROI are:

a. Total assets available.
b. Total assets employed.
c. Working capital (current assets minus current liabilities) plus other
assets.
d. Equity.
11. Present value is the asset measure based on DCF estimates. Current cost
is the cost of purchasing an asset today identical to the one currently held
if identical assets can currently be purchased; it is the cost of purchasing
the services provided by that asset if identical assets cannot currently be
purchased. Historical-cost-based measures of ROI compute the asset
base as the original purchase cost of an asset minus any accumulated
depreciation.
Some commentators argue that present value is future-oriented and
current cost is oriented to current prices, while historical cost is pastoriented.
12. Special problems arise when evaluating the performance of divisions in
multinational companies because
a. The economic, legal, political, social, and cultural environments differ
significantly across countries.
b. Governments in some countries may impose controls and limit selling
prices of products.
c. Availability of materials and skilled labor, as well as costs of
materials, labor, and infrastructure may differ significantly across
countries.
d. Divisions operating in different countries keep score of their
performance in different currencies.
13. a. Consider each activity and the organization itself from the customers
perspective,
b. Evaluate each activity using customer-validated measures of
performance,
c. Consider all facets of activity performance that affect customers and
are comprehensive, and
d. Provide feedback to help organization members identify problems and
opportunities for improvement.
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Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial

II. Exercises
Exercise 1 (ROI and Residual Income)
Requirement 1
A quick inspection of the data shows mortgage loans with a higher ROI to be
more successful. But see requirement 2 below.
Requirement 2

Total Assets
Operating Income
Return on Investment
Residual Income:
(a) * at 11%
(b) ** at 15%
(c) *** at 17%

Division A
(Mortgage Loans)
P2,000
400
25%
P180
100
60

Division B
(Consumer Loans)
P10,000
1,500
15%
P400
0
(200)

*
P400 (P2,000 x 0.11) = P180 P1,500 (P10,000 x 0.11) = P 400
** P400 (P2,000 x 0.15) = P100 P1,500 (P10,000 x 0.15) = P 0
*** P400 (P2,000 x 0.17) = P 60 P1,500 (P10,000 x 0.17) = P(200)
There is no simple answer to which is more successful in terms of residual
income. Division B is more successful at low rates, while A is more
successful at high rates. This reflects an important limitation of residual
income; larger divisions (Division B in this case) are favored when the desired
return used to determine residual income is relatively low.
Exercise 2 (Return on Investment; Comparisons of Three Companies)

Sales
Income
Investment (assets)
Return on sales
Asset turnover
Return on investment

Companies in the Same Industry

A
B
C
P1,500,000
P 750,000
P3,750,000
200,000
75,000
18,750
500,000
7,500,000
2,500,000
13%
10%
0.5%
3
0.1
1.5
40%
1%
0.75%

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Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24

Exercise 3 (ROI, RI, ROS, Management Incentives)

Requirement 1
If Magic Industries uses return on investment to measure the Jump-Start
Divisions (JSDs) performance, Tan may be reluctant to invest in the new
plant because, as shown below, return on investment for the plant of 19.2% is
lower than JSDs current ROI of 24%.
Operating income for new plant
New investment
Return on investment for new plant

P480,000
P2,500,000
19.2%

Investing in the new plant would lower JSDs ROI and, hence, limit Tans
bonus.
Requirement 2
The residual income computation for the new plant is as follows:
Residual income = Income - (Imputed interest x Investment)
Investment
Operating income for new plant
Charge for funds
(Investment, P2,500,000 x 15%)
Residual income

P2,500,000
P 480,000
375,000
P 105,000

Investing in the new plant would add P105,000 to JSDs residual income.
Consequently, if Magic Industries could be persuaded to use residual income
to measure performance, Tan would be more willing to invest in the new plant.
Requirement 3
Return on Sales (ROS) =

Operating income
Sales

480,000
2,400,000

20%

If Magic Industries uses ROS to determine Tans bonus, Tan will be more
willing to invest in the new plant because ROS for the new plant of 20%
exceeds the current ROS of 19%.
The advantages of using ROS are (a) that it is simpler to calculate and (b)
that it avoids the negative short-run effects of ROI measures that may induce

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Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial

Tan to not make the investment in the new plant. Tan may favor ROS because
she believes that eventually increases in ROS will increase ROI and RI.
The main disadvantage of using ROS is that it ignores the amount of
investment needed to earn a return. For example, ROS may be high but not
high enough to justify the level of investment needed to earn the required
return on an investment.
III. Problems
Problem 1 (RI, EVA)
Requirement 1
Total assets
Current liabilities
Investment
(Total assets current liabilities)
Required return (12% x Investment)
Operating income before tax
Residual income
(Operating income before tax
required return)

Truck Rental
Division
P650,000
120,000

Transportation
Division
P950,000
200,000

530,000
63,600
75,000

750,000
90,000
160,000

11,400

70,000

Requirement 2
After-tax cost of debt financing = (1 0.4) x 10% = 6%
After-tax cost of equity financing = 15%
Weighted average =
cost of capital

P900,000 x 6% + 600,000 x 15%

P900,000 + 600,000

Required return for EVA

9.6% x Investment
(9.6% x P530,000; 9.6% x
P750,000)

9.6%

P50,880

P72,000

Operating income after tax

0.6 x operating income before tax

45,000

96,000

EVA (Operating income after tax

required return)

(5,880)

24,000

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Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24

Requirement 3
Both the residual income and the EVA calculations indicate that the
Transportation Division is performing better than the Truck Rental Division.
The Transportation Division has a higher residual income (P70,000 versus
P11,400) and a higher EVA [P24,000 versus P(5,880)]. The negative EVA for
the Truck Rental Division indicates that, on an after-tax basis, the division is
destroying value the after-tax economic return from the Truck Rental
Divisions assets is less than the required return. If EVA continues to be
negative, Lighthouse may have to consider shutting down the Truck Rental
Division.
Problem 2 (ROI, RI, Measurement of Assets)
The method for computing profitability preferred by each manager follows:
Manager of
S
P
F

Method Chosen
Residual income based on net book value
Residual income based on gross book value
ROI based on either gross or net book value

Supporting Calculations:

Division
S
P
F

Return on Investment Calculations

Operating Income
Operating Income
Gross Book Value
Net Book Value*
P94,700 P800,000 = 11.84% (3) P94,700 P370,000 = 25.59% (3)
P91,700 P760,000 = 12.07% (2) P91,700 P350,000 = 26.20% (2)
P61,400 P500,000 = 12.28% (1) P61,400 P220,000 = 27.91% (1)

Division
S
P
F

Residual Income Calculations

Operating Income 10% Gross BV Operating Income 10% Net BV*
P94,700 P80,000 = P14,700 (2) P94,700 P37,000 = P57,700 (1)
P91,700 P76,000 = P15,700 (1) P91,700 P35,000 = P56,700 (2)
P61,400 P50,000 = P11,400 (3) P61,400 P22,000 = P39,400 (3)

* Net book value is gross book value minus accumulated depreciation.

The biggest weakness of ROI is the tendency to reject projects that will lower
historical ROI even though the prospective ROI exceeds the required ROI. RI
achieves goal congruence because subunits will make investments as long as
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Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial

they earn a rate in excess of the required return for investments. The biggest
weakness of residual income is it favors larger divisions in ranking
performance. The greater the amount of the investment (the size of the
division), the more likely that larger divisions will be favored assuming that
income grows proportionately.
Problem 3 (Multinational Performance Measurement, ROI, RI)
Requirement 1
(a)
Phil. Divisions ROI in 2005 =

Operating income
Total assets

Operating income
P8,000,000

15%

15.3%

Hence, operating income = 15% x P8,000,000 = P1,200,000.

(b)
Swedish Divisions ROI in 2005 in kronas =

9,180,000 kronas
60,000,000 kronas

Requirement 2
Convert total assets into pesos at December 31, 2004 exchange rate, the rate
prevailing when the assets were acquired (8 kronas = P1)
24,000,000 kronas =

60,000,000 kronas
=
8 kronas per peso

P7,500,000

Convert operating income into pesos at the average exchange rate prevailing
when during 2005 when operating income was earned equal to
9,180,000 kronas
8.5 kronas per peso = P1,080,000
Comparable ROI for Swedish Division =

P1,080,000
P7,500,000

14.4%

The Swedish Divisions ROI calculated in kronas is helped by the inflation

that occurs in Sweden in 2005. Inflation boosts the divisions operating
income. Since the assets are acquired at the start of the year on 1-1-2005, the
asset values are not increased by the inflation that occurs during the year. The
net effect of inflation on ROI calculated in kronas is to use an inflated value
for the numerator relative to the denominator. Adjusting for inflationary and
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Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24

currency differences negates the effects of any differences in inflation rates

between the two countries on the calculation of ROI. After these adjustments,
the Phil. Division shows a higher ROI than the Swedish Division.
Requirement 3
Phil. Divisions RI in 2005 =
=

P1,200,000 12% x P8,000,000

P1,200,000 P960,000 = P240,000

Swedish Divisions RI in 2005 (in Phil. pesos) is

P1,080,000 12% x P7,500,000 = P1,080,000 P900,000 = P180,000.
The Phil. Divisions RI also exceeds the Swedish Divisions RI in 2005 by
P60,000 (P240,000 P180,000).
Problem 4 (ROI Performance Measures Based on Historical Cost and
Current Cost)
Requirement 1
ROI using historical cost measures:
Luzon Division

P130,000
P340,000

38.24%

Visayas Division

P220,000
P1,150,000

19.13%

Mindanao Division

P380,000
P1,620,000

23.46%

The Luzon Division appears to be considerably more efficient than the

Visayas and Mindanao Divisions.
Requirement 2
The gross book values (i.e., the original costs of the plants) under historical
cost are calculated as the useful life of each plant (12) x the annual
depreciation:
Luzon

12 x P 70,000
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P 840,000

Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial

Visayas
Mindanao

12 x P100,000
12 x P120,000

=
=

P1,200,000
P1,440,000

Step 1: Restate long-term assets from gross book value at historical costs to
gross book value at current cost as of the end of 2005.
Gross book value of
long-term assets at
historical cost

Construction cost index in 2005

Construction cost index in year of construction

Luzon
P 840,000 x (170 100) = P1,428,000
Visayas
P1,200,000 x (170 136) = P1,500,000
Mindanao
P1,440,000 x (170 160) = P1,530,000
Step 2: Derive net book value of long-term assets at current cost as of the
end of 2005. (Estimated useful life of each plant is 12 years).
Gross book value of
long-term assets at
current cost at the
end of 2005
Luzon
Visayas
Mindanao

Estimated useful life remaining

Estimated total useful life

P1,428,000 x (2 12)
P1,500,000 x (9 12)
P1,530,000 x (11 12)

=
=
=

P 238,000
P1,125,000
P1,402,500

Step 3: Compute current cost of total assets at the end of 2005. (Assume
current assets of each plant are expressed in 2005 pesos.)
Current assets at the end
Net book value of long-term assets at
+ current cost at the end of 2005 (Step 2)
of 2005 (given)
Luzon
P200,000 + P238,000
= P 438,000
Visayas
P250,000 + P1,125,000
= P1,375,000
Mindanao
P300,000 + P1,402,500
= P1,702,500
Step 4: Compute current-cost depreciation expense in 2005 pesos.
Gross book value of long-term assets at current cost at the end of 2005
(from Step 1) x (1 12)
Luzon
Visayas
Mindanao

P1,428,000 x (1 12)
P1,500,000 x (1 12)
P1,530,000 x (1 12)

24-10

=
=
=

P119,000
P125,000
P127,500

Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial Chapter 24

Step 5:
Compute 2005 operating income using 2005 current-cost
depreciation.
Historical-cost
operating income
Luzon
Visayas
Mindanao

Current-cost depreciation

in 2005 pesos (Step 4)

P130,000 (P119,000 P70,000)

P220,000 (P125,000 P100,000)
P380,000 (P127,500 P120,000)

Historical-cost
depreciation
=
=
=

P 81,000
P195,000
P372,500

Step 6: Compute ROI using current-cost estimate for long-term assets and
depreciation.
Operating income for 2005 using 2005 current cost depreciation (Step 5)
Current cost of total assets at the end of 2005 (Step 3)
P 81,000 P 438,000
P195,000 P1,375,000
P372,500 P1,702,500

Luzon
Visayas
Mindanao

=
=
=

ROI: Historical Cost

38.24%
19.13%
23.46%

Luzon
Visayas
Mindanao

18.49%
14.18%
21.88%
ROI: Current Cost
18.49%
14.18%
21.88%

Use of current cost results in the Mindanao Division appearing to be the most
efficient. The Luzon ROI is reduced substantially when the ten-year-old plant
is restated for the 70% increase in construction costs over the 1995 to 2005
period.
Requirement 3
Use of current costs increases the comparability of ROI measures across
divisions operating plants built at different construction cost price levels. Use
of current cost also will increase the willingness of managers, evaluated on the
basis of ROI, to move from divisions with assets purchased many years ago to
division with assets purchased in recent years.
IV. Multiple Choice Questions
1. A
2. B
3. C

11.
12.
13.

B
D
C

21.
22.
23.
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C
D
C

31.
32.
33.

A
A
B

Chapter 24 Advanced Analysis and Appraisal of Performance: Financial and Nonfinancial

4.
5.
6.
7.
8.
9.
10.

C
D
B
A
C
B
A

14.
15.
16.
17.
18.
19.
20.

A
C
C
A
C
B
A

24.
25.
26.
27.
28.
29.
30.

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A
C
D
A
C
D
D

34.
35.
36.
37.

A
C
B
D