P5 Acca - 11 Divisional Performance Evaluation Becker

Session 11
Divisional Performance
Evaluation
FOCUS
This session covers the following content from the ACCA Study Guide.
D. Strategic Performance Measurement

2. Strategic performance measures in private sector
c) Discuss the appropriateness of, and apply different measures of
performance including:
ii) Return on Investment (ROI)
v) Residual Income (RI)
viii) Economic Value Added (EVA™)
3. Divisional performance and transfer pricing issues
a) Describe, compute and evaluate performance measures relevant in a
divisionalised organisation structure including ROI, RI and Economic
value added (EVA).
b) Discuss the need for separate measures in respect of managerial and
divisional performance.
Session 11 Guidance
Revise divisional performance measurement (s.1) and return measures (s.2); this was covered in
paper F5.
Be aware that annuity depreciation and economic value added are new areas for P5.
Understand the calculation for residual income (s.3), the reason for, and link between annuity-based
depreciation (s.5) and Economic Value Added (EVA) (s.6).
Read the article "Economic value added versus profit-based measures of performance" parts 1 and 2
by Nick Ryan (July 2011).
(continued on next page)
P5 Advanced Performance Management Becker Professional Education | ACCA Study System
Ali ARAJ - [email protected]

VISUAL OVERVIEW
Objective: To describe and apply performance measures in a divisional organisation structure.
DIVISIONAL
PERFORMANCE
MEASURES
• Characteristics of
Appropriate Measures
• Possible Measures
• Managerial and
Divisional Performance
RETURN ON INVESTMENT RESIDUAL INCOME ECONOMIC VALUE

ADDED™
• Calculations • Calculations
• Concept
• Advantages • Advantages
• Rationale
• Disadvantages • Disadvantages
• Accounting
Adjustments
• NOPAT
• Finance Charge
• Advantages
• Disadvantages
ROI/RI AND
DEPRECIATION
• Effect of Depreciation
• Conflict with NPV
ANNUITY BASED COMPARISON

DEPRECIATION
• Evaluation of methods
• Annual Repayment • Summary of
• Annual Equivalent differences
Charge
• Use
© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-1

Session 11 • Divisional Performance Evaluation P5 Advanced Performance Management
1 Divisional Performance Measures

< It is vital that senior management monitors the performance
of divisions and divisional managers.
1.1 Characteristics of Appropriate Measures

< Goal congruence—performance measures should encourage
decisions consistent with company objectives.
< Timeliness—performance reporting must be fast enough to
allow any required corrective action.
< Controllability—evaluation should assess only divisions and
divisional managers on performance under their control.
1.2 Possible Measures

< The measures used will depend on the type of business unit
being monitored.
< It is dangerous to focus on one key measure of performance.
A range of measures should be used to assess all elements
of performance, both financial and non-financial—a "balanced
scorecard" approach.
< The range of measures could include:
= variance analysis—care must be taken in identifying the
controllability and responsibility for each variance;
= ratio analysis;
= return on investment;
= residual income; and
= non-financial measures.
1.2.1 Ratio Analysis
Profitability Measures Liquidity Measures Other Measures
• Net profit margin • Current ratio • Contribution per key factor/

• Gross profit margin • Quick ratio limited resource
• Contribution margin • Receivables days • Sales per employee
• Expenses as percentage • Payables days • Industry specific
of sales cost-related ratios such as:
• Inventory turnover — transport cost per km
— overheads per
chargeable hour
1.2.2 Non-Financial Measures

< Staff turnover (also days lost through absenteeism).
< New customers gained.
< Proportion of repeat bookings.
< Orders received.
< Set-up times (also customer waiting times).
< New products developed.
< % returns.
< % rejects/reworks (or number of complaints received).
< On-time deliveries, client contact hours, training time per
employee.
11-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

P5 Advanced Performance Management Session 11 • Divisional Performance Evaluation
1.3 Managerial and Divisional Performance

The principle of controllability means that when assessing the
performance of the manager of a division, only those items,
which are controllable by the manager, should be included in the
calculation of profit. This "controllable" profit excludes items such
as expenses in respect of agreements that were not made by the
manager (e.g. the annual audit fee agreed by the head office).
When assessing the performance of a division, as opposed to
the manager of the division, central management is interested in
profit that relates directly to the division, so they can ascertain,
for example, how profit would be affected if the division were to
be closed down. This "traceable" profit should exclude allocated
costs, since these costs do not relate directly to the division.
However, traceable profit may include some direct expenses which
are not controllable—so they are not included in the calculation of
controllable profits.
$ $
External sales x
Internal sales x
x
Variable costs x
Controllable by manager
Fixed costs x
(x)
Controllable Profit x
Divisional costs outside manager's control (x)
Traceable Profit x
Allocated head-office costs (x)
Divisional net profit x
< Controllable profit should be used to assess the manager's

performance.
< Traceable profit should be used to assess the division's
performance.
Illustration 1 Controllable v Traceable Profit
In a profit centre, the manager has no authority to make investment decisions. When
calculating controllable profit, therefore, depreciation would be ignored as this is
outside of the control of the manager. When calculating the traceable profit, however,
depreciation would be included, as it is a cost that relates to the profit centre.

2 Return on Investment (ROI)
2.1 Calculations
2.1.1 For Assessing Manager
Controllable profit Profit is before

ROI = × 100
Capital employed interest and tax
because interest is
affected by financing
2.1.2 For Assessing Division decisions and tax is
an appropriation.
Traceable profit
ROI = × 100
Capital employed
Example 1 ROI
Divisional managers are assessed on the value of the return on investment that their division
achieves. The higher the return on investment is, the higher will be their bonus at the end of
the year. The managers of Division X and Division Y are considering two potential projects for
their division.
Details of these, and of the division's current ROI (without the proposed projects) are shown below:
Division X Division Y
Controllable investment in possible project $100,000 $100,000
Controllable profit from possible project $16,000 $11,000
Current division ROI 18% 9%
Company cost of capital 13%
Required:
(a) Determine whether the divisional managers would accept the project available to
their respective divisions.
(b) Comment on whether the manager's decisions are consistent with the overall
objective of the organisation, which is to maximise the wealth of its shareholders.
Solution
(a)
Division X
Division Y
(b) Comment:

2.2 Advantages
Relative measure—easy to compare divisions with different
scales of operation.
Similar to ROCE used externally by analysts.
Focuses attention on scarce capital resources.
Encourages reduction in non-essential investment by:
 selling off unused fixed assets; and
 minimising the investment in working capital.
Easily understood percentages (especially by

non-financial managers).
2.3 Disadvantages
Risk of dysfunctional decision-making (Example 1).
Definition of capital employed is subjective. For example,
should non-current assets be valued using:
(a) carrying amount (i.e. net book value);
(b) historic cost; or
(c) replacement cost?
Should leased assets and intangible assets be included?
If net book value is used, ROI will become inflated over time
because of depreciation.
Risk of window-dressing; boosting reported ROI by:
 under investing; and/or
 cutting discretionary costs (particularly if ROI is linked to
bonus systems).

3 Residual Income (RI)
Residual income—pre-tax profit less imputed interest charge for

capital invested.
3.1 Calculations
3.1.1 For Assessing Manager
$
Controllable profit x
Imputed interest charge (x)
Residual income x
3.1.2 For Assessing Division

$
Traceable profit x
Imputed interest charge (x)
Residual income x
3.1.3 Imputed Interest

< Imputed interest is notional interest charged on the division by
the head office.
Imputed interest = Capital employed × Interest rate
< The company's cost of capital is often used as the basis for the
interest rate.

Example 2 Residual Income
Assume that the divisional managers of Division X and Division Y from Example 1 are now
assessed using residual income rather than return on investment.
The information about the two projects is repeated below:
Controllable investment in possible project $100,000 $100,000
Controllable profit from possible project $16,000 $11,000
Current division ROI 18% 9%
Company cost of capital 13%
Required:
(a) Determine whether the manager would invest in the new project.
(b) State whether the decision-making is consistent with the goal of maximising the
wealth of shareholders.
Solution
(a)
Controllable profit
Imputed interest
Residual income
The manager of Division X will the project.
The manager of Division Y will the project.
(b) Goal congruent?

3.2 Advantages
As an absolute measure it gives more reliable decision-making
than ROI.
A risk-adjusted cost of capital can be used to reflect different
risk positions of different divisions.
3.3 Disadvantages
Definition of capital employed.
Effect of depreciation. As per ROI
Window dressing.
Difficult to compare divisions of different sizes.
Less easily understood than a percentage.

Example 3 RI and NPV
A divisional manager is evaluated by the head office using RI and therefore uses RI to
appraise projects.
Company cost of capital = 10%
New project details: Investment $600,000
3-year life
No residual value
Annual cash inflow $500,000.
Required:
(a) Calculate RI for each of the three years. Use net book value at the start of each
year as capital employed.
(b) Discount RI for each year to present value using 10% discount rate.
(c) Calculate NPV of the project cash flows.
Solution
Calculate RI Year
(a) (1) (2) (3)
$000 $000 $000
Cash flow
Depreciation
Profit
Net book value
Imputed interest
Profit−interest = residual income
(b) Discount RI
10% discount factor 0.909 0.826 0.751
PV



Total PV =
(c) Calculate NPV

Time CF DF PV
0
1–3
NPV

4 ROI/RI and Depreciation
4.1 Effect of Depreciation

If capital employed is defined as net book value at the start of the
year and Straight-line depreciation is used.
< Then, over the life of an investment:
= Capital employed will fall;
= ROI and RI will tend to rise.
< Hence straight-line depreciation inflates reported performance

over time, even if actual performance is constant.
< This can cause dysfunctional decision-making, even if RI is used.
Example 4 RI/ROI and Depreciation
Investment $2.1 million

Life of asset 4 years
Residual value zero
Cash inflows Year 1 $700,000
Year 2 $700,000
Year 3 $700,000
Year 4 $700,000
Capital employed is defined as net book value at the start of each year.
Straight-line depreciation is used.
Cost of capital 10%.
Required:
(a) Calculate:
(i) residual income for each year;
(ii) return on investment for each year;
(iii) NPV of the investment.
(b) Explain whether decision-making will be in the best interests of

the company if RI or ROI is used for investment appraisal.

Example 4 RI/ROI and Depreciation

(continued)
Solution
(a)(i) Residual income
Year
(1) (2) (3) (4)
$000 $000 $000 $000
Cash inflow 700 700 700 700
Depreciation
Profit
Net book value
Interest at 10%
Profit−interest =
Residual income
(ii) Return of investment

(1) (2) (3) (4)
Profit
Net book value
ROI
(iii) NPV
Discount
Time Cash flow Present value
factor
1–4
NPV
(b) Discussion

4.2 Conflict with NPV

Example 4 shows the possible conflict between RI/ROI and NPV:
< Projects with positive NPV increase shareholder wealth and
should be accepted.
< But if RI or ROI are used for divisional performance appraisal,
and therefore divisional investment appraisal, positive NPV
projects may be rejected.
This is because straight-line depreciation causes poor performance
to be reported in early years, and high performance in later years.
Non-goal congruent decision-making is likely to occur if managers
are myopic (i.e. obsessed with short-term performance).
Using annuity-based depreciation can reduce the problem.

5 Annuity-Based Depreciation
5.1 Annual Repayment
Example 5 Annual Repayment
Assume the asset in Example 4 was financed by a bank loan. Interest

on the loan is 10%. The loan is to be repaid over four years by equal
annual instalments.
Required:
Calculate the annual repayment.
Solution
Annual repayment ($000) =
5.2 Annual Equivalent Charge

< The annual repayment is known as the annual equivalent charge.
< It has two components:
Residual income = Cash inflow−Depreciation−Interest charge
= Cash inflow−Annual equivalent

Example 6 Annual Equivalent
Consider again the investment in Example 4.

Required:
Using the annual equivalent charge calculated in Example 5:
(a) Calculate RI for each year. Your solution should show
depreciation and finance charge separately.
(b) Comment on goal congruence.
Solution
(a) Calculation of residual income
(1) (2) (3) (4)

$000 $000 $000 $000
Cash inflow 700 700 700 700
Depreciation (W)
Profit
Imputed interest
Residual income
Working—net book value of investment

(1) (2) (3) (4)
$000 $000 $000 $000
Balance b/f
Depreciation1
Balance c/f
Imputed interest
(= Balance b/f ×10%)
1
Depreciation is equal to the annual charge of $662,500 minus the interest charge.
(b) Comment
5.3 Use
The use of annuity-based depreciation creates a smoother
performance profit profile and reduces the risk of dysfunctional
decision-making.

6 Economic Value Added (EVA)
6.1 The Concept

Economic Value Added (EVA™) is a trademark of the Stern
Stewart & Co. consulting organisation.
EVA is a performance evaluation tool that can be used to appraise
the performance of an organisation. It is similar to residual
income, in that a capital charge is deducted from the profits in
reaching economic value added.
The calculation of EVA can be summarised thus:
Net operating profit after tax x
Finance charge (x)
Economic value added x
6.2 The Rationale Behind EVA

< Many organisations simply use profit as a measure of
performance. However profit does not take into account
the cost of the equity finance required to make the profit;
it only takes into account the cost of debt finance. As one
commentator noted, "until a business returns a profit that is
greater than its cost of capital, it operates at a loss".
< It is argued that the adoption of EVA as a performance
measure for managers aligns the interests of managers with
the objective of the organisation to maximise the wealth of
shareholders. The EVA generated each year shows the amount
of wealth a business has created, or destroyed, during the year.
Illustration 2 EVA
Alpha is 100% equity financed. Its shareholders require a 15%

return on investment. During the year, the company made a profit
of $100,000. The value of equity at the start of year was $1 million.
Although the company made a profit, this profit was not sufficient to
meet the requirements of the shareholders.
The company destroyed value as follows:
$000
Profit after tax 100
Required return of shareholders (1 million × 15%) (150)
Economic Value Destroyed (50)
In this very simplified example, the profits earned by the company

were not sufficient to provide the required return to shareholders on
their investment.
6.3 Accounting Adjustments

In addition to the capital charge, EVA is also based on "Economic
profit" rather than "Accounting Profit". Its proponents believe
that the way financial accountants calculate profit under GAAP
(US GAAP, IFRS and similar accounting systems) does not reflect
the true economic profit. Many adjustments are therefore made
to the accounting profit (and also, therefore, to the equity shown
in the statement of financial position) before EVA is calculated.

6.3.1 Investment in Intangibles

Under GAAP accounting, expenditure on research, advertising,
staff training and similar items are not capitalised, expensed in
the income statement when incurred. Under EVA, such items are
considered to be investments that will bring benefits in the future.
Thus any such items expensed during the year should be added
back to profit for the year and to capital at the end of the year.
Amortisation of such items will also be required in future
accounting periods when calculating EVA. No amortisation would
have occurred in the GAAP profit, as these items were written off
when they were incurred.
6.3.2 Depreciation
Accountants typically use methods such as straight-line
depreciation. These do not reflect the real use of the asset over
the period. Accounting depreciation should therefore be added
It is unlikely that
back to profits and economic depreciation deducted instead. A
you would have to
similar adjustment will be made to the value of non-current assets calculate economic
in the statement of financial position, and therefore to the capital depreciation. In the
employed figure. exam questions on
this topic to date, the
6.3.3 Operating Leases examiner has stated
that accounting
Under financial accounting, leases are categorised as either
depreciation is the
finance leases or operating leases. In the case of finance leases,
same as economic
the value of the assets acquired is recognised in the statement depreciation, meaning
of financial position, and the present value of future payments that no adjustment is
is treated as debt. Operating leases on the other hand are not required.
included in the statement of financial position ("balance sheet"),
and the payments are simply expensed as they are incurred.
Stern Stewart & Co. argues that this inconsistent treatment
should be remedied. Operating leases should therefore be treated
as finance leases. The present value of future lease payments
should therefore be added to capital employed. On the income
statement side, the payments expensed in respect of operating The examiner has not
leases should be added back to profits, and replaced with required calculation of
depreciation of the assets, and interest. (However, as will be seen the value of operating
later, interest is added back to profits in calculating net operating leases in questions
profit after tax.) to date. Instead, he
simply provided the
6.3.4 Allowances and Provisions value of the leases
for adding back to
The creation of allowances for bad and doubtful debts and capital. He also
provisions for deferred tax in financial accounting is too prudent stated that the leases
according to the proponents of EVA. Any increases in such were not amortised
provisions reflected in the income statement during the year and did not provide
should therefore be added back to profit in calculating EVA. any information
Similarly the value of such provisions should be added to the on the operating
lease expenses.
capital employed figure in the statement of financial position.
This meant that
candidates were not
6.3.5 Non-Cash Expenses
required to make any
Non-cash expenses such as impairment of goodwill are not real adjustments to the
expenses according to EVA. They should therefore be added income statement.
back to the income statement and the capital employed in the
statement of financial provision.

6.3.6 Summary of Adjustments

The following table may help you to remember which
adjustments are required. Be aware that for the calculation of
the finance charge, capital employed is taken at the start of the
year, so some of the adjustments to profit in the current year do
not affect capital employed until the following year.
While these adjustments could potentially be complex, the examiner

has avoided requiring detailed calculations in exams. Instead he
has provided the information. He is really interested in whether
you understand the overall calculation of EVA without testing the
intricacies of accounting adjustments.
Change to Profit Change to Capital Employed
Advertising, research Increase current year profits Increase capital employed at

and development items the end of the year
expensed, staff training Amortised previous years
adjustments in respect of Reduce capital employed
these at start of year with
previous years amortisation
adjustments
Depreciation Add accounting depreciation Adjust value of non-current

assets (& capital employed) to
Deduct economic depreciation
reflect economic depreciation
not accounting depreciation
Operating leases Add back lease payments to Add present value of future
profit lease payments to capital
employed.
Deduct depreciation on assets
Provisions Add increases in provision/ Add back the value of

deduct decreases in provisions provisions to capital employed
to/from profits
Non-cash expenses Add back to profit Add to retained profits at the

end of the year.
6.4 Net Operating Profit After Tax

The finance charge in respect of the capital employed is deducted
from profits when calculating EVA. The profit should therefore
be stated before interest, to avoid double counting the cost of
financing debt.
Since the cost of capital used in the calculation of the finance
charge includes on the "after tax" rate of interest, after tax
interest is added back. This has the effect of showing the profit of
the company as if it had no debt.
This profit is referred to as Net Operating Profit after Tax (NOPAT).

Illustration 3 Calculating NOPAT
Eve's income statement for the year just ended showed the following:
$000
Operating profit 1,000
Less interest 200
Profit before tax 800
Tax at 25% 200
Profit after tax 600
In calculating NOPAT the after tax interest charge is added back.* *Although interest
This is interest × (1−tax rate), being $200,000 × 75%, $150,000. charge is added
So NOPAT is $750,000. back net of tax, all
other adjustments to
This is the same as the profit after tax would have been, had Eve not
had any debt finance in its capital structure, and therefore no interest. the profit figure are
before tax.
6.5 Finance Charge

< The finance charge in EVA calculations is the weighted
average cost of capital (WACC) multiplied by the capital of the
division. Here capital is taken to mean equity (net assets)
plus long-term debt.
< WACC is an average cost of capital, which takes into account
the various sources of finance used by the division, including
equity capital and debt. The formula for WACC is as follows:
E D
WACC = Ke × + Kd (1−t) ×
E+D E+D
Where:
Ke = required return on equity
Kd = pre-tax return on debt finance
E
= portion of financing coming from equity
E+D
D
= portion of financing coming from debt
E+D
< It is normal to take capital at the beginning of a financial year,

not at the end.

Example 7 EVA
Extracts from Adam's income statement for the most recent financial
year show the following:
$ million
Operating profits 25
Interest on loans 1
Profit before tax 24
Tax at 25% 6
Profit after tax 18
Included in the calculation of the profit was an expense of $4 million

relating to development costs, which had been incurred during the year,
but were not capitalised because they did not meet the requirements of
IAS 38 Intangible Assets. The development was not complete until the
final day of the financial period.
Accounting depreciation is considered to be the same as economic
depreciation.
In the previous financial year, development expenditure of $10 million
was incurred on another product. This had been expensed in the income
statement when it occurred. Sales of this product began during the
current financial year, and are expected to continue for another three
financial years.
The weighted average cost of capital of the company is 12%. Capital
employed (long-term debt plus equity) per the statement of financial
position was $89 million at the end of the previous financial period.
Required:
Calculate the Economic Value Added by Adam during the current
financial year.
Solution
Economic Value Added
$000
Net operating profit after tax

Finance charge
EVA
Workings

6.6 Advantages and Disadvantages of Using EVA

6.6.1 Advantages of Using EVA
Maximising EVA is consistent with maximising the wealth of
shareholders, since it takes into account not only the profit, but
also the finance charge associated with producing that profit.
Companies that use EVA as a performance evaluation tool
have increased their performance compared to companies that
do not, according to Stern Steward & Co. This is particularly
the case where managers' remuneration packages are linked
to the reported EVA.
Conceptually easy for non-financial managers to understand.
Leads to goal congruence in the same way as residual income.
Encourages managers to take a longer-term view since
expenditure that brings long-term benefits is not treated as an
expense, but capitalised.
Profits are based on economic profits, not accounting profits.
EVA can be used as a single performance measure that
replaces the confusion of multiple goals, such as revenue
growth, profits a growth.
6.6.2 Disadvantages of Using EVA

The adjustments required may become complicated in practice.
As an absolute measure it is not so easy to compare divisions
of different sizes.
It is a short-term measure, so may still encourage managers
to take a shorter-term view.

7 Comparison of Methods
7.1 Evaluation of Methods Be able to compare

and evaluate ROI,
7.1.1 Types of Measures RI and EVA rather
than merely know
< ROI is a relative measure, so it is useful for comparing the their advantages and
performance of different divisions of different sizes. disadvantages.
< Because residual income and EVA are absolute measures,
using these to compare divisions of different sizes is more
difficult. (Two divisions could have identical values for EVA or
residual income, but if one were much larger than the other,
it would be incorrect to conclude that both were performing
equally well.)
< Calculating residual income or EVA as percentages of capital
employed can overcome this weakness (by converting them to
relative measures).
7.1.2 Goal Congruence

< ROI may lead to decisions that are not congruent with the goal
of maximising shareholder wealth. For example, deciding not
to invest in projects that reduce ROI even if they return more
than the cost of capital (see Example 1).
< Residual income and EVA over the longer term should lead
to decisions that are congruent with maximising shareholder
wealth, because projects that return more than the cost of
capital also increase residual income and EVA.
< In the short term, however, there still may be goal
incongruence if a project yields negative residual income or
EVA in its early years (see Example 4).
7.1.3 Overcoming Problems

ROI and residual income are based on accounting profits which
suffer from the following problems:
< Managers may avoid investments in intangibles (research,
marketing, etc) that cannot be capitalised under GAAP to
achieve targets.
< Excessive cost-cutting to improve short-term ROI may weaken
future competitiveness or store up costs for the future:
= Reducing employee numbers may damage product quality
or levels of customer service.
= Deferring training may later require costly recruitment of
more skilled employees.
< Profit has several definitions and also can be manipulated.
EVA seeks to overcome these problems by making the
adjustments detailed in section 6.3 above.

7.2 Differences Between Residual Income

and EVA
EVA is calculated similarly to residual income but constructed in
such a way that maximising EVA can be set as a target. There
are two main differences when calculating EVA and standard
residual income:
< Residual income is accounting profit before interest and tax,
less the finance charge. EVA is NOPAT less the finance charge.
< For residual income, the finance charge is based on the book
values of equity and debt at the start of the year. For EVA,
the finance charge is based on the adjusted values of equity
and debt at the start of the year (i.e. after adjusting for EVA
adjustments of prior years). In both cases, the finance charge
is calculated using the WACC.

Session 11
Summary
< Organisations may be broken down into autonomous decisions, whereby the managers run
the divisions with little interference from the centre.
< Divisional performance measures are required which will ensure:
• goal congruence;
• timeliness of reporting; and
• controllability.
< When assessing the performance of a manager, only the costs and revenues that the
manager can control should be taken into account—controllable profits.
< When assessing the performance of a division, all controllable and uncontrollable costs that
relate directly to the division should be taken into account—traceable profits.
< ROI is a commonly used measure of divisional performance in a cost centre or investment
centre. It is calculated as divisional profits divided by divisional net assets.
< Where managers are evaluated based on ROI, this may lead to dysfunctional behaviour,
where divisional managers reject projects with a return in excess of the companies cost of
capital, but which have a return below the manager's current ROI without the investment.
< Residual income is an absolute measure which is calculated as the net profit of the division
less an imputed interest charge, calculated by multiplying the divisional net assets by the
company's cost of capital. It should overcome the weakness of ROI in that all projects
that generate a return in excess of the company's cost of capital will generate positive
residual income.
< Where projects span many years, the effect of depreciation is to show more favourable ROI
and residual income in later years of the project, as a lower asset base is used. This can
lead to projects being rejected if managers take a short-term view. A solution to this is to
use annuity depreciation.
< EVA was developed as a more sophisticated version of residual income. The calculation of
EVA is similar to residual income, but adjustments are made to accounting profits so that
they reflect the real economic profits.

Session 11 Quiz
Estimated time: 15 minutes
1. List THREE characteristics (objectives) of a good system of divisional performance

measurement. (1.1)
2. Explain whether it would it be appropriate to take the divisional "traceable" profit, or the
divisional "controllable" profit when assessing the performance of a divisional manager. (1.3)
3. Explain whether return on investment is a "relative" or "absolute" measure of
performance. (2.2)
4. List FOUR potential disadvantages of using residual income as a measure of divisional
performance. (3.3)
5. List the TWO components of the annual equivalent charge used for calculating residual
income. (5.2)
6. Describe how the "annual equivalent charge" is calculated for the purposes of calculating
residual income with annuity depreciation. (5.2)
7. List FOUR adjustments made to profit before tax when calculating "net operating profit after
tax" for the purposes of calculating economic value added (EVA). (6.3)
Study Question Bank

Estimated time: 100 minutes
Priority Estimated Time Completed
Q30 Babblings (89) Co 60 minutes
Q32 Toutput 40 minutes

Additional
Q29 Divisional Assessment

Meldo Division
Q31
and Kitbull

EXAMPLE SOLUTIONS
Solution 1—ROI
(a) Division X −
Division Y −
(b) Comment
< The new project available to division X has a ROI above the cost
of capital and should probably be accepted.
< The new project available to division Y has a ROI below the cost
of capital and should probably be rejected.
< The divisional managers are making decisions in their own best
interests, not in the company's best interests.
< Lack of goal congruence.

Solution 2—Residual Income
(a) Division X Division Y
Controllable profit 16,000 11,000
Imputed interest (13,000) (13,000)
Residual income 3,000 (2,000)
The manager of Division X will accept the project.

The manager of Division Y will reject the project.
(b) Goal congruent? Yes
Solution 3—RI and NPV

(a) Calculate RI Year
(1) (2) (3)
$000 $000 $000
Cash flow 500 500 500
Depreciation (200) (200) (200)
Profit 300 300 300
Net book value 600 400 200
Imputed interest 60 40 20
Profit − interest = residual income 240 260 280
(b) Discount RI
10% discount factor 0.909 0.826 0.751

PV 218 215 210



Total PV = 643
(c) Calculate NPV 


RI is
Time CF DF PV consistent
with NPV

0 (600) 1 (600)
1–3 500 2.487 1,243
NPV 643

Solution 4—RI/ROI and Depreciation
(a)(i) Residual income
Year
(1) (2) (3) (4)
$000 $000 $000 $000
Cash inflow 700 700 700 700
2, 100
Depreciation ( ) (525) (525) (525) (525)
4
Profit 175 175 175 175
Net book value 2,100 1,575 1,050 525
Interest at 10% 210 158 105 53
Profit – interest =
(35) 17 70 122
Residual income
(ii) Return of investment
(1) (2) (3) (4)
Profit 175 175 175 175
Net book value 2,100 1,575 1,050 525
Profit
ROI = 8.3% 11.1% 16.7% 33.3%
NBV
(iii) NPV
Time Cash flow Discount factor Present value
0 (2,100) 1 (2,100)
1–4 700 3.17 2,219
($000) NPV 119
Note—NPV could also be found by discounting the residual incomes to
present value.
(b) Discussion
< The project has a positive NPV and therefore should be accepted.
< But if RI is used the manager might reject the project due to the
negative RI in year one.
< If ROI is used the project might be rejected because in year one
ROI is below the cost of capital.
<  Risk of dysfunctional decision-making
Solution 5—Annual Repayment

Loan 2, 100
Annual repayment ($000) = =
4 year 10% annuity factor 3.17
= 662.5

Solution 6—Annual Equivalent
(a) Calculation of residual income
(1) (2) (3) (4)
$000 $000 $000 $000
Cash inflow 700 700 700 700
Depreciation (W) 452.5 497.7 547.5 602.5
Profit 247.5 202.3 152.5 97.5
Imputed interest 210.0 164.8 115.0 60.0
Residual income 37.5 37.5 37.5 37.5
Working – net book value of investment
(1) (2) (3) (4)
$000 $000 $000 $000
Balance b/f 2,100.0 1,647.5 1,150 602.5
Depreciation1 452.5 497.7 547.5 602.5
Balance c/f 1,647.5 1,150 602.5 0
Imputed interest
(= Balance b/f ×10%) 210.0 164.8 115.0 60.0*
1
Calculate the finance charge first, being 10% of the value of the
investment at the start of the year. Depreciation is then calculated
as the annual equivalent (per example 5) less the interest. The
annual equivalent was $662,500.
* In the final year, the interest charge was rounded to $60,000 to
ensure that depreciation in the final year was equal to the net book
value of the asset at the beginning of the year.
(b) Comment
The use of annuity-based depreciation results in a higher value of
residual income in the earlier years of a project, compared to using
straight-line depreciation. The reason for this is that in the early
years of the project, when the finance charge is higher, due to the
higher net book value of the assets, a lower depreciation charge is
made when using annuity based depreciation.
The effect of this is that projects are more likely to be accepted
even by managers taking a short-term view, as even in the early
years of a projects life they are more likely to yield a positive
residual income.

Solution 7—EVA
Economic Value Added

$000
Net operating profit after tax (W1) 20,250
Finance charge 99,000 (W2) × 12% 11,880
EVA 8,370
Working 1 Net Operating profit after tax
$000
Profit after tax per income statement 18,000
Add: Interest net of tax ($1m × (1−25%)) 750
Add: Development costs 4,000
Less: Amortisation of prior year development (2,500)
Net operating profit after tax 20,250
Working 2 Capital employed
$000
Capital employed at start of period 89,000
Add: Development expenditure written off in
prior periods 10,000
Adjusted capital employed at end of period 99,000

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Session 11

D. Strategic Performance Measurement

Ali ARAJ - [email protected]

RETURN ON INVESTMENT RESIDUAL INCOME ECONOMIC VALUE

ANNUITY BASED COMPARISON

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-1

Ali ARAJ - [email protected]

1 Divisional Performance Measures

1.1 Characteristics of Appropriate Measures

1.2 Possible Measures

1.2.1 Ratio Analysis

Profitability Measures Liquidity Measures Other Measures

• Net profit margin • Current ratio • Contribution per key factor/

1.2.2 Non-Financial Measures

11-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali ARAJ - [email protected]

1.3 Managerial and Divisional Performance

< Controllable profit should be used to assess the manager's

Illustration 1 Controllable v Traceable Profit

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-3

Ali ARAJ - [email protected]

2 Return on Investment (ROI)

Controllable profit Profit is before

11-4 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali ARAJ - [email protected]

Easily understood percentages (especially by

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-5

Ali ARAJ - [email protected]

3 Residual Income (RI)

Residual income—pre-tax profit less imputed interest charge for

3.1.2 For Assessing Division

3.1.3 Imputed Interest

Imputed interest = Capital employed × Interest rate

11-6 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali ARAJ - [email protected]

Example 2 Residual Income

Controllable investment in possible project $100,000 $100,000

Controllable profit from possible project $16,000 $11,000

Current division ROI 18% 9%

Company cost of capital 13%

The manager of Division X will the project.

The manager of Division Y will the project.

(b) Goal congruent?

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-7

Ali ARAJ - [email protected]

11-8 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali ARAJ - [email protected]

Example 3 RI and NPV

Net book value

(c) Calculate NPV

© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 11-9

Ali ARAJ - [email protected]

4 ROI/RI and Depreciation

4.1 Effect of Depreciation

< Hence straight-line depreciation inflates reported performance

Example 4 RI/ROI and Depreciation

Investment $2.1 million

(b) Explain whether decision-making will be in the best interests of

• Net profit margin • Current ratio • Contribution per key factor/