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MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES

 

By Dennis Caplan

 

PART 5: PLANNING TOOLS AND PERFORMANCE MEASURES FOR PROJECTS AND DIVISIONS

 

CHAPTER 22:  DIVISIONAL PERFORMANCE MEASURES

 

Chapter Contents:

-         Divisional Income

-         Return on Investment

-         Residual Income

 

 

This chapter discusses three performance measures used to evaluate divisions and divisional managers. The term “division” in this chapter is shorthand for any responsibility center that is treated as a profit center or as an investment center. Investors and stock analysts use analogous measures to evaluate company-wide performance.

 

 

Divisional Income:

Divisional income is a measure of divisional performance that is analogous to corporate net income for evaluating overall company performance. Similar to related-party transactions in the context of financial accounting, the calculation of divisional income must consider transactions that occur between divisions, and between the division and corporate headquarters. One type of intra-company transaction is the transfer of goods between divisions. These transfers, which represent revenue to the selling division and a cost of inventory to the buying division, are discussed in Chapter 23. Another type of transaction is the receipt of services from corporate headquarters or from other responsibility centers within the company. Examples of such services are human resources, legal, risk management, and computer support. In many companies, these services are “charged out” to the divisions that utilize them. These service department cost allocations were discussed in Chapter 12.  

 

Because divisional income fails to account for the size of the division, it is ill-suited for comparing performance across divisions of different sizes. Divisional income is most meaningful as a performance measure when compared to the same division in prior periods, or to budgeted income for the division.

 

 

Return on Investment:

Return on investment (ROI) is calculated as:

 

Return on Investment

=

Divisional Income

Divisional Investment

 

The same issues arise in determining the numerator in ROI as arise in the previous subsection with respect to deriving divisional income. As regards the denominator, senior management must decide whether and how to allocate shared assets among divisions, such as service departments at the corporate level, or shared manufacturing facilities. Also, management must decide how to value the capital assets that comprise the division’s investment. These assets can be valued at their gross book value (the acquisition cost), their net book value (usually the acquisition cost minus depreciation expense), or less often, some other valuation technique such as replacement cost, net realizable value or fair market value. The calculation of the numerator should be consistent with the choice of valuation technique in the denominator. For example, if divisional investment is calculated using gross book value, then divisional income in the numerator should not be reduced by depreciation expense.

 

One advantage of using gross book value instead of net book value in the ROI calculation is that net book value can discourage divisional managers from replacing old equipment, even if new equipment would be more efficient and would increase the economic profits of the division. This dysfunctional managerial incentive occurs because if the existing equipment is fully depreciated, but is still functional, its replacement can reduce the division’s ROI by lowering the numerator (due to increased depreciation expense) and increasing the denominator (because fully depreciated assets have a net book value of zero).

 

ROI can be broken down into the following two components:

 

 

ROI

 

=

 

Divisional Income

 

=

 

Divisional Income

 

X

 

Divisional Revenue

Divisional Investment

Divisional Revenue

Divisional Investment

 

The first term on the right-hand side is called the return on sales (ROS). It is also called the operating profit percentage. This ratio measures the amount of each dollar of revenue that “makes its way” to the bottom line. ROS is often an important measure of the efficiency of the division, and the divisional manager’s ability to contain operating expenses.

 

The second term on the right-hand side is called the asset turnover ratio or the investment turnover ratio. This ratio measures how effectively management uses the division’s assets to generate revenues. Interestingly, this ratio seems to hover around one for many companies in a wide range of industries, particularly in the manufacturing sector of the economy.

 

Breaking ROI into these two components often provides more useful information than looking at ROI alone, and it is an example of the type of financial ratio analysis that stock analysts conduct in evaluating company-wide performance. In this context, two common specifications for the denominator in the ROI calculation are assets and equity. The resulting ratios are called return on assets (ROA) and return on equity (ROE).

 

At the divisional level, ROI controls for the size of the division, and hence, it is well-suited for comparing divisions of different sizes. On the other hand, similar to the Internal Rate of Return for evaluating capital projects, ROI can discourage managers from making some investments that shareholders would favor. For example, if a divisional manager is evaluated on ROI, and if the division is currently earning an ROI in excess of the company’s cost of capital, then the manager would prefer to reject an additional investment opportunity that would earn a return above the cost of capital but below the division’s current ROI. The new investment opportunity would lower the division’s ROI, which is not in the manager’s best interests. However, because the investment opportunity provides a return above the cost of capital, shareholders would favor it.

 

 

Residual Income:

One way in which financial accounting practice fails to follow corporate finance theory is that the cost of debt is treated as an expense in arriving at net income, but the cost of equity is not. Specifically, interest expense appears as a deduction to income on the income statement, but dividends are shown on the statement of changes in shareholders’ equity. Hence, net income is affected by the company’s financing strategy as well as by its operating profitability, which can obscure the economic performance of the firm.

 

A simple solution to this problem is to add back interest expense (net of the tax effect) to net income, to arrive at operating income after taxes. The performance measure called residual income makes this adjustment, and then goes one step further, by deducting a charge for capital based on the organization’s total asset base:

 

Residual Income = Operating Income - (Investment Base x Required Rate of Return)

 

The company’s cost of capital is often appropriate for the required rate of return.

 

Residual income is probably the closest proxy that accounting provides for the concept of economic profits; hence, residual income probably comes close to measuring what shareholders really care about (to the extent that shareholders only care about maximizing wealth). Residual income can be calculated both at the corporate level and at the divisional level. Many companies that use residual income at the divisional level do so because management believes that residual income aligns incentives of divisional managers with incentives of senior management and shareholders.

 

One type of residual income calculation is called Economic Value Added. EVA was developed by the consulting firm of Stern Stewart & Co., and is a registered trademark of that firm. The calculation of EVA includes a deduction for the cost of capital, and also adjusts accounting income to more accurately reflect the economic effect of transactions and the economic value of assets and liabilities. In general, these adjustments move the income calculation further from the reliability-end of the relevance-versus-reliability continuum, and closer to the relevance-end of that continuum.

 

Since the 1990s, EVA has helped revive the popularity of residual income. However, it should be emphasized that although Stern Stewart has obtained trademark protection on the term “EVA,” the concept of residual income precedes EVA by almost half a century, and it is in the public domain. Anyone can use residual income for any purpose whatsoever without violating trademark, copyright or patent law, and this includes making obvious adjustments to net income to more accurately reflect the underlying economic reality of the firm.

 

 

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