Advanced Analysis and Appraisal of Performance

Performance evaluation is the process by which managers at all levels gain information about the
performance of tasks within the firm and judge that performance against pre-established criteria as set
out in budgets, plans and goals. The goal of top management in using strategic performance
measurement is to motivate the managers to provide a high level of effort, to guide them to make
decisions that are congruent to the goals of top management and to provide a basis for determining
compensation to managers.
Financial measures such as return on investment and residual income can capture important aspects of
both manager performance and organization sub unit performance. Increasingly, companies are using
internal financial measures along side with measures based on external financial information such as
stock prices, internal non financial information such as manufacturing lead time and defect rates, and
external non financial information such as market share, and degree of customer satisfaction. Also,
benchmarking against other subunits within the organization and other organizations is done.

Four commonly used measures to evaluate the economic performance of organization subunits are :
1. Return on Investment (ROI)
2. Residual Income (RI)
3. Economic value added (EVA)
= After tax operating income - [ WACC x ( Total Assets – Current Liabilities) ]
4. Return on sales

RETURN ON INVESTMENT
Return on Investment Computation
Based on Operating Income
1. The following selected data pertain to the belt division of Allen Corp. for last year:
Sales $500,000
Average operating assets $200,000
Net operating income $80,000
Turnover 2.5
Minimum required return 20%
How much is the return on investment? (M)
a. 40% c. 20%
b. 16% d. 30%

80,000/200,000 =40% A

2. Harstin Corporation has provided the following data:

Sales $625,000
Gross margin 70,000
Net operating income 50,000
Stockholders' equity 90,000
Average operating assets 250,000
Residual income 20,000
The return on investment for the past year was: (M)
a. 28%. c. 36%.
b. 20%. d. 8%

ROI = 50,000/250,000 = 20% B

3. Apple Division of the American Fruit Co. had the following statistics for 20X4:
Assets available for use $1,000,000
Residual income 100,000
Return on investment 15%
If the manager of Apple Division is evaluated based on return on investment, how much would she be willing to
pay for an investment that promises to increase net segment income by $50,000? (M)
a. $50,000 c. $1,000,000
b. $333,333 d. $500,000

50,000/.15 = 333,333 B

RESIDUAL INCOME
Residual Income Computation
4. REB Service Co. is a computer service center. For the month of May 20X4, REB had the following statistics:
Sales $450,000
Operating income 25,000
Net profit after taxes 8,000
Total assets 500,000
Shareholders’ equity 200,000
Cost of capital 6%
Based on the above information, which one of the following statements is correct? REB has a (M)
a. ROI of 4% c. ROI of 1.6%
b. Residual income of $(5,000) d. Residual income of $(22,000)

OI 25,000
Target income(500,000 x .06) ( 30,000 )
Reidual income ( 5,000 ) B

5. Z Division of XYZ Corp. has the following information for 20X2:

Assets available $1,800,000
Target rate of return 10%
Residual income $270,000
What was Z Division's return on investment for 20X2? (M)
a. 15% c. 25%
b. 10% d. 20%
Residual income 270,000
Target income (1,800,000 x .1) 180,000
Operating income 450,000
ROI = 450,000/1,800,000 = 25% C

6. Pasta Division of We Make Italian, is evaluated based on residual income generated. For 20X2, the Division
generated a residual income of $2,000,000 and net income of $5,000,000. The target rate of return for all
divisions of We Make Italian is 20 percent. For 20x2, what was the return on investment for Pasta Division? (M)
a. 40% c. 20%
b. 13% d. 33%

Net operating income 5,000,000

Less : Residual income 2,000,000
Target income 3,000,000
Average assets 3,000,000/.2 = 15,000,000
ROI = 5,000,000/15,000,000
= 33% D

Target Cost

7. James Webb is the general manager of the Industrial Park Division, and his performance is measured using the
residual income method. Webb is reviewing the following forecasted information for the division for next year.

Category Amount (thousands)

Working capital $ 1,800
Revenue 30,000
Plant and equipment 17,200
To establish a standard of performance for the division’s manager using the residual income approach, four
scenarios are being considered. Scenario 1 assumes an imputed interest charge of 15% and a target residual
income of $2,000,000. Scenario 2 assumes an imputed interest charge of 12% and a target residual income of
$1,500,000. Scenario 3 assumes an imputed interest charge of 18% and a target residual income of
$1,250,000. Scenario 4 assumes an imputed interest charge of 10% and a target residual income of
$2,500,000.
Which of the scenarios assumes the lowest maximum cost? (M)
a. Scenario 1. c. Scenario 3.
b. Scenario 2. d. Scenario 4.
Scenario 1 2,000 + 2850 = 4,850 Operating income
Scenario 2 1,500 + 2280 = 3,780 “
Scenario 3 1,250 + 3,420 = 4,670 “
Scenario 4 2,500 + 1.900 = 4.400 “
Return on Investment & Residual Income & Units Sold
Questions 8 thru 10 are based on the following information.
The Axle Division of LaBate Company makes and sells only one product. Annual data on the Axle Division's single
product follow:
Unit selling price $50
Unit variable cost $30
Total fixed costs $200,000
Average operating assets $750,000
Minimum required rate of return 12%

8. If Axle sells 16,000 units per year, the return on investment should be: (M)
a. 12%. c. 16%.
b. 15%. d. 18%.
120,000/750,000 =16% C

9. If Axle sells 15,000 units per year, the residual income should be: (M)
a. $30,000. c. $50,000.
b. $100,000. d. $10,000.
CM 300,000
FC 200,000
OI 100,000
Target income (750,000 x 12% ) 90,000
Residual income 10,000 D
10. Suppose the manager of Axle desires an annual residual income of $45,000. In order to achieve this, Axle
should sell how many units per year? (M)
a. 14,500. c. 18,250.
b. 16,750. d. 19,500.
Desired RI 45,000
Target income (750,000 x .12) 90,000
OI should be 135,000
Units = 200,000 + 135,000
20
= 16,750 units B

ECONOMIC VALUE-ADDED
11. Watne Company has two divisions, M and N. Information for each division is as follows:
Net earnings for division $65,000
Asset base for division $300,000
Target rate of return 18%
Operating income margin 20%
Weighted average cost of capital 12%
What is EVA for N?
a. $36,000 c. $54,000
b. $29,000 d. $11,000

Net earnings 65,000

Less (300,000 x .12) 36,000
EVA 29,000 B

12. Family Company has two divisions, Ma and Pa. Information for each division is as follows:
Ma Pa
Net earnings for division P20,000 P65,000
Asset base for division P50,000 P300,000
Target rate of return 15% 18%
Operating income margin 10% 20%
Weighted-average cost of capital 12% 12%
What is the Economic Value Added for Ma and Pa, respectively?
A. P20,000, P36,000 C. P12,500; P11,000
B. P14,000; P29,000 D. P20,000; P29,000
Ma 20,000 -6,000 = 14,000
Pa 65,000 – 36,000 = 29,000 B

13. Assume Avionics Industries reported at year-end that operating income before taxes for the year equaled
$2,400,000. Long-term debt issued by Avionics has a coupon rate equal to 6%, and its cost of equity is 8%.
The book value of the debt currently equals its fair value, and the book value of the equity capital for Avionics is
$900,000 less than its fair value. Current assets are listed at $2,000,000 and long-term assets equal
$9,600,000. The claims against those assets are in the form of $1,500,000 in current liabilities and $2,200,000
in long-term liabilities. The income tax rate for Avionics is 30%. What is the economic value added (EVA)? (D)
a. $731,240 c. $1,668,760
b. $948,760 d. $1,680,000

After tax cost of Debt .06 ( 1 -.3) = 4.2%

Cost of equity 8%
Proportion LTD 2,200,000 .2
Equity (11,600,000-3,700,000 =7,900,000 + 900,000 8,800,000 .8
Total 11,000,000
WACC LTD .042 x .2 = .84 %
Equity .08 x .8 = 6.4 %
WACC 7.24 %

EVA = 1680,000 - [ ( 11,600,000 – 1,500,000 ) X 7.24%]

= 948,760 B

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
14. What is the EVA for St. Louis? (M)
a. $255,740 c. $392,540
b. $327,460 d. $720,000
(960,000 x .75) - (3,800,000 x 10.33%) = 327,460

15. What is the EVA for Cedar Rapids? (M)

a. $135,580 c. $234,000
b. $220,000 d. $305,000
900,000 - 764,420 = 135,580

16. What is the EVA for Wichita? (M)

a. $450,000 c. $414,360
b. $1,530,000 d. $1,115,640
1,530,000 -1,115,640 = 414,360

LTD .12 x .75 .09 x 10/18 = .05

Equity .12 x 8/18 = .0533
WACC 10.33 %

Oslo Co.’s industrial photo-finishing division, Rho, incurred the following costs and expenses in 20x2:
Variable Fixed
Direct materials $200,000
Direct labor 150,000
Factory overhead 70,000 $42,000
General, selling and administrative 30,000 48,000
Totals $450,000 $90,000

During 20x2, Rho produced 300,000 units of industrial photo-prints, which were sold for $2.00 each. Oslo’s
investment in Rho was $500,000 and $700,000 at January 1, 20x2 and December 31, 20x2, respectively. Oslo
normally imputes interest on investments at 15% of average invested capital.
17. For the year-ended December 31, 20x2, Rho’s return on average investment was
a. 15.0% c. 8.6%
b. 10.0% d. (5.0%)
CM 150,000 - FC 90,000 = 60,000 NOI
ROI 60,000 /600,000 10% B
18. Assume that net operating income was $60,000 and that average invested capital was $600,000. For the year
ended December 31, 20x2, Rho’s residual income (loss) was
a. $150,000 c. $(45,000)
b. $60,000 d. $(30,000)
60,000 - 90,000 = (30,000) D

19. How many industrial photo-print units did Rho have to sell in 20x2 to break-even?
a. 180,000 c. 90,000
b. 120,000 d. 60,000
90,000 / .5 = 180,000 A

20. For the year ended December 31, 20x2, Rho’s contribution margin was
a. $250,000 c. $150,000
b. $180,000 d. $60,000
300,000 u x .5 = $ 150,000 C
21. Assume the variable cost per unit was $1.50. Based on Rho’s 20X2 financial data, and an estimated 20X3
production of 350,000 units of industrial photo-prints, Rho’s estimated 20X3 total costs and expenses will be
a. $525,000 c. $615,000
b. $540,000 d. $630,000
VC 350,000 x 1.5 525,000
FC 90,000
Total cost 615,000 C

.
Segment A Segment B Segment C Segment D
Net income $ 5,000 - - $ 90,000
Sales 60,000 $750,000 $135,000 1,800,000
Investment 24,000 500,000 45,000 -
Net income as % of sales - - - -
Turnover of investment - - - -
ROI - - 20% 7.5%
Minimum ROI-dollars - - - $120,000
Minimum ROI - % 20% 6% - -
Residual income - -0- $2,250 -

22. For Segment B, net income as a percentage of sales is

a. 8% c. 4%
b. 6.67% d. 10%
30,000/750,000 = 4% C
23. For Segment C, net income as a percentage of sales is
a. 5% c. 4%
b. 6.67% d. 20% 9,000/135,000 =6.67% B
24. For Segment C, the turnover of investment is
a. 3 c. 2.5
b. 1.5 d. 4 135,000/45,000 = 3 A
25. For Segment D, the turnover of investment is
a. 3 c. 2.5
b. 1.5 d. 4 1,800,000/1,200,000 = 1.5 B

26. For segment A, ROI is

a. 6% c. 20.8%
b. 20% d. 7.5% 5,000/24,000 = 20.83% C

27. For segment B, ROI is

a. 6% c. 20%
b. 20.8% d. 7.5% 30,000/500,000 = 6% A