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Match the responsibility center to the correct responsibility report.
Responsibility Centers Responsibility Reports
14. Cost center a. Includes flexible budget variances for revenues and costs.
15. Revenue center b. Includes flexible budget variances for costs.
16. Profit center c. Includes flexible budget variances and sales volume variances for revenues.
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercise S24-5. MyAccountingLab
HOW DOES PERFORMANCE EVALUATION IN
INVESTMENT CENTERS DIFFER FROM OTHER CENTERS?
Investment centers are typically large divisions of a company. The duties of an investment center manager are similar to those of a CEO. The CEO is responsible for maximizing income, in relation to the company’s invested capital, by using company assets efficiently.
Likewise, investment center managers are responsible for not only generating profit, but
Learning Objective 4
Use return on investment (ROI) and residual income (RI) to evaluate investment centers
Companies cannot evaluate investment centers the way they evaluate profit centers, based only on operating income, because operating income does not indicate how efficiently the segment is using its assets. The financial evaluation of investment centers must measure two factors: (1) how much operating income the segment is generating and (2) how effi- ciently the segment is using its assets.
Consider Smart Touch Learning. In addition to its Tablet Computer Division, it also has an online e-Learning Division. Operating income, average total assets, and net sales revenue for the two divisions for July follow:
e-Learning Division Tablet Computer Division Operating income $ 450,000 $ 975,800 Average total assets 2,500,000 6,500,000
Net sales revenue 7,500,000 5,243,600
Based on operating income alone, the Tablet Computer Division (with operating income of $975,800) appears to be more profitable than the e-Learning Division (with operating income of $450,000). However, this comparison is misleading because it does not consider the assets invested in each division. The Tablet Computer Division has more assets than does the e-Learning Division.
To adequately evaluate an investment center’s financial performance, companies need summary performance measures—or KPIs—that include both the division’s operating income and its assets. In the next sections, we discuss two commonly used performance measures: return on investment (ROI) and residual income (RI). Both measures incorpo- rate both the division’s assets and its operating income. For simplicity, we leave the term divisional or investment center out of the equations. However, keep in mind that all of the equa- tions use investment center data when evaluating an investment center’s performance. Also, each ratio has been rounded to the nearest full percentage.
Return on Investment (ROI)
Return on investment (ROI) is one of the most commonly used KPIs for evaluating an investment center’s financial performance. ROI is a measure of profitability and efficiency.
Companies typically define ROI as follows:
Return on Investment (ROI) A measure of profitability and efficiency. Operating income / Average total assets.
e@Learning Division's ROI = +450,000
+2,500,000 = 0.18 = 18, Tablet Computer Division's ROI = +975,800
+6,500,000 = 0.15 = 15, ROI = Operating income
Average total assets
ROI measures the amount of operating income an investment center earns relative to the amount of its average total assets. The ROI formula focuses on how well the average total assets were utilized to generate operating income (before considering other income and expense items, such as interest expense). Each division’s ROI is calculated as follows:
Although the Tablet Computer Division has a higher operating income than the e-Learning Division, the Tablet Computer Division is actually less profitable than the e-Learning Division when we consider that the Tablet Computer Division does not utilize its average total assets as efficiently.
In addition to comparing ROI across divisions, management also compares a division’s ROI across time to determine whether the division is becoming more or less profitable in relation to its average total assets. Additionally, management often benchmarks divisional ROI with other companies in the same industry to determine how each division is perform- ing compared to its competitors.
To determine what is driving a division’s ROI, management often restates the ROI equation in its expanded form. Notice that net sales revenue is incorporated in the denomi- nator of the first term and in the numerator of the second term. When the two terms are multiplied together, net sales revenue cancels out, leaving the original ROI formula.
Asset turnover ratio = Net sales revenue Average total assets Profit margin ratio = Operating income
Net sales revenue
e@Learning Division’s
profit margin ratio = Operating income
Net sales revenue = +450,000
+7,500,000 = 0.06 = 6, Tablet Computer Division’s
profit margin ratio = Operating income
Net sales revenue = +975,800
+5,243,600 = 0.19 = 19,
e@Learning Division’s
asset turnover ratio = Net sales revenue
Average total assets = +7,500,000 +2,500,000 = 3.00 ROI = Operating income
Net sales revenue * Net sales revenue
Average total assets = Operating income Average total assets
Expanding the equation this way helps managers better understand how they can improve their ROI. The first term in the expanded equation is called the profit margin ratio:
Profit Margin Ratio
A profitability measure that shows how much operating income is earned on every dollar of net sales revenue. Operating income / Net sales revenue.
Why do managers rewrite the ROI formula this way?
The profit margin ratio shows how much operating income the division earns on every $1.00 of sales, so this term focuses on profitability. Each division’s profit margin ratio is calculated as follows:
The e-Learning Division has a profit margin ratio of 6%, meaning that it earns operating income of $0.06 on every $1.00 of sales. The Tablet Computer Division, however, is much more profitable with a profit margin ratio of 19%, earning $0.19 on every $1.00 of sales.
Asset turnover ratio is the second term of the expanded ROI equation: Asset Turnover Ratio
Measures how efficiently a business uses its average total assets to generate sales. Net sales revenue / Average total assets.
The asset turnover ratio shows how efficiently a division uses its average total assets to generate sales. Rather than focusing on profitability, the asset turnover ratio focuses on efficiency. Each division’s asset turnover ratio is calculated as follows:
only $0.81 of sales with every $1.00 of average total assets. The e-Learning Division uses its average total assets much more efficiently in generating sales than the Tablet Computer Division.
Putting the two terms back together in the expanded ROI equation gets the following:
Profit margin
ratio : Asset turnover
ratio = ROI
e-Learning Division 6% * 3.00 = 18%
Tablet Computer Division 19% * 0.81 = 15%
As you can see, the expanded ROI equation gives management more insight into the division’s ROI. Management can now see that the Tablet Computer Division is more profit- able on its sales (profit margin ratio of 19%) than the e-Learning Division (profit margin ratio of 6%), but the e-Learning Division is doing a better job of generating sales with its average total assets (asset turnover ratio of 3.00) than the Tablet Computer Division (asset turnover ratio of 0.81). Therefore, the e-Learning Division has a higher ROI of 18%.
If managers are not satisfied with their division’s asset turnover ratio, how can they improve it? They might try to eliminate nonproductive assets, for example, by being more aggressive in collecting accounts receivables, by decreasing inventory levels, or by dispos- ing of unnecessary plant assets. Or they might decide to change the retail store layout to increase sales.
What if management is not satisfied with the current profit margin ratio? To increase the profit margin ratio, management must increase the operating income earned on every dollar of sales. Management may cut product costs or selling and administrative costs, but it needs to be careful when trimming costs. Cutting costs in the short term can hurt long-term ROI. For example, sacrificing quality or cutting back on research and development could decrease costs in the short run but may hurt long-term sales. The balanced scorecard helps management carefully consider the consequences of cost-cutting measures before acting on them.
ROI has one major drawback. Evaluating division managers based solely on ROI gives them an incentive to adopt only projects that will maintain or increase their current ROI.
Suppose that top management has set a companywide target ROI of 16%. Both divisions are considering investing in in-store video display equipment that shows customers how to use featured products. This equipment would increase sales because customers would be more likely to buy the products when they see the infomercials. The equipment would cost each division $100,000 and is expected to provide each division with $17,000 of annual operating income. The equipment’s ROI is as follows:
Equipment ROI = +17,000
+100,000 = 0.17 = 17,
Upper management would want the divisions to invest in this equipment because the equipment will provide a 17% ROI, which is higher than the 16% target rate. But what will the managers of the divisions do? Because the Tablet Computer Division currently has an ROI of 15%, the new equipment (with its 17% ROI) will increase the division’s overall ROI.
Therefore, the Tablet Computer Division manager will buy the equipment.
However, the e-Learning Division currently has an ROI of 18%. If the e-Learning Division invests in the equipment, its overall ROI will decrease. Therefore, the manager of the e-Learning Division will probably turn down the investment. In this case, goal congruence is not achieved—only one division will invest in equipment. Yet top management wants both divisions to invest in the equipment because the equipment return exceeds the 16%
target ROI.
Next, we will discuss a performance measure that managers can use to help overcome this problem with ROI.
Residual Income (RI)
Residual income (RI) is another commonly used KPI for evaluating an investment cen- ter’s financial performance. Similar to ROI, RI considers both the division’s operating income and its average total assets. RI measures the division’s profitability and the efficiency with which the division uses its average total assets. RI also incorporates another piece of information: top management’s target rate of return (such as the 16% target rate of return in the previous example). The target rate of return is the minimum acceptable rate of return that top management expects a division to earn with its average total assets. You will learn how to calculate target rate of return in your finance class. For now, we provide the target rate of return for you.
RI compares the division’s actual operating income with the minimum operating income expected by top management given the size of the division’s average total assets. RI is the extra oper- ating income above the minimum operating income. A positive RI means that the division’s operating income exceeds top management’s target rate of return. A negative RI means the division is not meeting the target rate of return. Let’s look at the RI equation and then calcu- late the RI for both divisions using the 16% target rate of return from the previous example.
Residual Income (RI) A measure of profitability and efficiency computed as actual operating income less a specified minimum acceptable operating income.
e@Learning Division’s RI = +450,000 - (16,* +2,500,000)
= +450,000 - +400,000
= +50,000
RI = Operating income - Minimum acceptable operating income RI = Operating income - (Target rate of return * Average total assets)
Tablet Computer Division’s RI = +975,800 - (16, * +6,500,000)
= +975,800 - +1,040,000
= +(64,200)
In this equation, the minimum acceptable operating income is defined as top management’s target rate of return multiplied by the division’s average total assets. Therefore,
The positive RI indicates that the e-Learning Division exceeded top management’s 16% target rate of return expectations. The RI calculation also confirms what we learned about the e-Learning Division’s ROI. Recall that the e-Learning Division’s ROI was 18%, which is higher than the target rate of return of 16%.
Now let’s calculate the RI for the Tablet Computer Division:
The Tablet Computer Division’s RI is negative. This means that the Tablet Computer Division did not use its average total assets as effectively as top management expected.
Recall that the Tablet Computer Division’s ROI of 15% fell short of the target rate of
Why would a company prefer to use RI over
as the evaluation tool, we learned that the Tablet Computer Division would buy the equip- ment because it would increase the division’s ROI. The e-Learning Division, on the other hand, probably would not buy the equipment because it would lower the division’s ROI.
However, if management evaluates divisions based on RI rather than ROI, what would the divisions do? The answer depends on whether the project yields a positive or negative RI. Recall that the equipment would cost each division $100,000 but would provide $17,000 of operating income each year. The RI provided by just the equipment would be as follows:
Equipment RI= +17,000 - (16,* +100,000)
= +17,000 - +16,000
= +1,000
If purchased, this equipment would improve each division’s current RI by $1,000 each year. As a result, both divisions would be motivated to invest in the equipment. Goal congruence is achieved because both divisions would take the action that top management desires. That is, both divisions would invest in the equipment.
Another benefit of RI is that management may set different target returns for differ- ent divisions. For example, management might require a higher target rate of return from a division operating in a riskier business environment. If the tablet computer industry were riskier than the e-learning industry, top management might decide to set a higher target rate of return—perhaps 17%—for the Tablet Computer Division.
Exhibit 24-8 summarizes the KPIs for investment centers.
Exhibit24-8 | Investment Center KPIs
Operating income Average total assets Return on Investment
Residual Income Equation
Equation
ROI = Asset turnover ratio
RI = Operating income – (Average total assets × Target rate of return) Operating income
Net sales revenue
Net sales revenue Average total assets
= × =
Advantages • RI promotes goal congruence better than ROI.
• The equation incorporates management’s target rate of return.
• Management can use different target rates of return for divisions with different levels of risk.
Advantages • The expanded equation provides management with additional information on profitability and efficiency.
• Management can compare ROI across divisions and with other companies.
• ROI is useful for resource allocation.
Profit margin ratio×
Limitations of Financial Performance Measures
We have looked at two KPIs (ROI and RI) commonly used to evaluate the financial performance of investment centers. As discussed in the following sections, all of these measures have drawbacks that management should keep in mind when evaluating the financial performance of investment centers.
Measurement Issues
The ROI and RI calculations appear to be very straightforward; however, management must make some decisions before these measures can be calculated. For example, both use the term average total assets. Recall that total assets is a balance sheet amount, which means that it is a snapshot at any given point in time. Because the total assets amount will be differ- ent at the beginning of the period and at the end of the period, most companies choose to use a simple average of the two amounts in their ROI and RI calculations.
Management must also decide if it really wants to include all assets in the average total asset calculation. Many large businesses are continually buying land on which to build future retail outlets. Until those stores are built and opened, the land (including any con- struction in progress) is a nonproductive asset, which is not adding to the company’s oper- ating income. Including nonproductive assets in the average total asset calculation drives down the ROI and RI results. Therefore, some companies do not include nonproductive assets in these calculations.
Another asset measurement issue is whether to use the gross book value of assets (the historical cost of the assets) or the net book value of assets (historical cost less accumu- lated depreciation). Many companies use the net book value of assets because the amount is consistent with and easily pulled from the balance sheet. Because depreciation expense factors into the company’s operating income, the net book value concept is also consistent with the measurement of operating income. However, using the net book value of assets has a definite drawback. Over time, the net book value of assets decreases because accumu- lated depreciation continues to grow until the assets are fully depreciated. Therefore, ROI and RI get larger over time because of depreciation rather than because of actual improvements in operations. In addition, the rate of this depreciation effect depends on the depreciation method used.
In general, calculating ROI based on the net book value of assets gives managers an incentive to continue using old, outdated equipment because its low net book value results in a higher ROI. However, top management may want the division to invest in new technology to create operational efficiency (internal business perspective of the balanced scorecard) or to enhance its information systems (learning and growth perspective). The long-term effects of using outdated equipment may be devastating, as competitors use new technology to produce at lower costs and sell at lower prices. Therefore, to create goal con- gruence, some firms prefer calculating ROI based on the gross book value of assets. The same general rule holds true for RI calculations: All else being equal, using net book value increases RI over time.
Short-term Focus
One serious drawback of financial performance measures is their short-term focus. Com- panies usually prepare responsibility reports and calculate ROI and RI figures over a one- year time frame or less. If upper management uses a short time frame, division managers have an incentive to take actions that will lead to an immediate increase in these measures, even if such actions may not be in the company’s long-term interest (such as cutting back on R&D or advertising). On the other hand, some potentially positive actions considered by subunit managers may take longer than one year to generate income at the targeted level. Many product life cycles start slowly, even incurring losses in the early stages, before
The limitations of financial performance measures reinforce the importance of the balanced scorecard. The deficiencies of financial measures can be overcome by tak- ing a broader view of performance—including KPIs from all four balanced scorecard perspectives rather than concentrating on only the financial measures.
Try It!
Padgett Company has compiled the following data:
Net sales revenue $ 1,000,000
Operating income 60,000
Average total assets 400,000
Management’s target rate of return 12%
Calculate the following amounts for Padgett:
17. Profit margin ratio 18. Asset turnover ratio 19. Return on investment 20. Residual income
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercises S24-6 through S24-9. MyAccountingLab