Accounting Information Systems (9th Edition)

Chapter 8, Problem 14P Bookmark

Problem

CMA-ADAPTED PERFORMANCE MEASURES

The Star Paper Division of Royal Industries is located near Los Angeles. A major expansion of the division’s only
completed in April 2015. The expansion consisted of an addition to the existing building, additions to the product
machinery, and the replacement of obsolete and fully depreciated equipment that was no longer efficient or cost-

On May 1, 2015, George Harris became manager of Star. Harris had a meeting with Marie Fortner, vice presiden
operations for Royal, who explained to Harris that the company measured the performance of divisions and divis
managers on the basis of return on gross assets (ROA). When Harris asked if other measures were used in conj
with ROA, Fortner replied, “Royal’s top management prefers to use a single performance measure. Star should d
year now that it has expanded and replaced all of that old equipment. You should have no problem exceeding th

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historical rate. I’ll check with you at the end of each quarter to see how you are doing.”

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Fortner called Harris after the first quarter results were completed because Star’s ROA was considerably below t

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historical rate for the division. Harris told Fortner that he did not believe that ROA was a valid performance meas
Star. Fortner indicated that she would discuss this with others at headquarters and get back to Harris. However,

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no further discussion of the use of ROA but only reports on divisional performance at the end of the second and
quarters. Now that the fiscal year has ended, Harris has received the memorandum in the figure designated Pro
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Harris is looking forward to meeting with Fortner as he plans to pursue the discussion about the appropriateness
a performance measure for Star. While the ROA for Star is below historical levels, the division’s profits for the ye
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higher than at any previous time. Harris is going to recommend that ROA be replaced with multiple criteria for ev
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performance—namely, dollar profit, receivable turnover, and inventory turnover.

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Required

a. Identify general criteria that should be used in selecting performance measures to evaluate operating manage
b. Describe the probable cause of the decline in the Star Paper Division’s return on gross assets during the fisca
ended April 30, 2007.

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 c. On the basis of the relationship between Fortner and Harris, as well as the memorandum from Fortner, discus
weaknesses in the performance evaluation process at Royal Industries.

d. Discuss whether the multiple performance evaluation criteria that Harris suggested would be appropriate for th
evaluation of the Star Paper Division.

Step-by-step solution

Step 1 of 4

CMA- Adapted Performance Measure :

(a) General Criteria to be used in selecting Performance Measures:

General Criteria that is used while evaluating the performance measures are ROI, ROE, ROCE, ROA etc.

• Each manager objective is to maximize ROI or ROE but when only say ROI or ROE is used as single criteria fo
measuring the performance the sole criterion itself becomes the focus of attention and object of manipulation.

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• Performance measures should not be evaluated based on single criteria but it should be evaluated based on o

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criteria's also so that it gives us clear picture about the health of the company.

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Cause of decline in the star paper Division's return:
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Return on Assets (ROA) gives an idea as to how different management is at using its assets to generate earning
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It is calculated by dividing a company’s annual earnings by its total assets. The formula of ROA is Net Income/To
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• Star paper division measured the company performance on the basis of Return on Gross Assets (ROA).
• A major expansion was completed in April 2007 and value with which the asset got replaced became much hig
the previous one.
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• If for any return which is a function of total assets and lies at the denominator, and there is an increase in deno
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while the numerator is not increased by that proportion then ROA will always be lower. And, this was one of the p
cause which led to the decline in the return on gross assets.
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Step 3 of 4

Weakness in the Performance evaluation process:

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The apparent weakness in the performance evaluation process is top management preference to use single perf
measure which is ROA.

• Further on repeated discussion by H with Fortner regarding only use of ROA for evaluation is not correct but Fo
deferred it and rather at the end of the fiscal year memorandum was issued questioning the weak performance o
paper Division.
• On the contrary, however the division profit was higher than the previous year which itself question the use of R

Step 4 of 4

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Multiple Performance evaluation criteria:
 Multiple performance evaluation which H suggested should be followed since it will not only help to understand t
for fall in ROA but at the same time also evaluate the higher profits is due to better performance or due to excep
income.

• Different criteria used for evaluating the performance also give top management an idea where the company is

• Let say for example net income is 100, gross asset is 1000. Equity is 500 so in such situation. ROA would be 1
whereas return on Equity would be 20%.

• And. let's say capital employed is 2000 i.e. Debt plus Equity, ROCE would 5% so every criteria gives us differen
percentage and allows the management to understand the performance in better manner.

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