Chapter 16 Performance Evaluation and …s3.amazonaws.com/prealliance_oneclass_sample/xYgd2L56J5.pdfChapter 16: Performance Evaluation and Compensation 175 EXERCISES 16.17 Responsibility

Chapter 16: Performance Evaluation and Compensation 169

Chapter 16Performance Evaluation and Compensation

LEARNING OBJECTIVES

Chapter 16 addresses the following objectives:

LO1 Discuss how decision-making responsibility and authority are related to performance evaluation.

LO2 Explain how responsibility centres are used to measure, monitor, and motivate performance.

LO3 Calculate return on investment, residual income and economic value added and explain how each is used to measure, monitor and motivate performance.

LO4 Discuss how compensation is used to motivate performance.

These learning objectives (LO1 through LO4) are cross-referenced in the textbook to individual exercises and problems.

© 2012 John Wiley and Sons Canada, Ltd.

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QUESTIONS

16.1 ROI is calculated by dividing operating income by average assets, or income/assets. It can be decomposed as follows: ROI = sales/assets x income/sales.

16.2 ROI can be increased by cutting costs or reducing assets. Cost cutting can improve short-term results but harm long-term results if discretionary expenditures such as advertising and research and development are cut. Similarly, reducing investment in new projects could improve ROI in the short term, but harm the organization in the long term.

16.3 Residual income = operating income – (required rate of return * average operating assets). Many organizations have a minimum return that is expected on operations and new investments, this is their required rate of return.

16.4 The size of investment affects residual income less than ROI because it is used only to value the dollar amount of expected return, not as a denominator. Residual income is therefore less influenced than ROI by changes in investment, but it is still subject to the same disadvantages as ROI that affect the operating income – such as cost cutting to discretionary expenditures.

16.5 General knowledge is usually easy to transfer throughout an organization. Specific knowledge is more detailed and is therefore more costly to transfer throughout an organization. General knowledge is needed in the food and beverage manufacturing, in clothing manufacture, and in restaurants and bars, among others. Specific knowledge is important to software companies, bio-tech organizations, and healthcare organizations, among others.

16.6 If general knowledge is required for success within an organization, a centralized form is usually best because knowledge can easily be transferred to headquarters where decision making can be done from the perspective of the overall organization. If specific knowledge is required, it is costly to transfer to headquarters, so a decentralized form is usually best because the decision-making authority lies with the people with specific knowledge to make the best decision.

16.7 EVA is very similar to residual income because both subtract from operating income some measure of interest times investment. EVA is different than residual income because many adjustments are made to all parts of the calculation. For example, after tax operating income is usually used in EVA, whereas before tax operating income is usually used in RI. The assets are also adjusted under EVA, for example long-term leases are usually capitalized. There are over 160 possible adjustments that can be made to RI under EVA.

16.8 The four responsibility centre descriptions and objectives follow.

Cost Centres: In cost centres, managers are held responsible only for the costs under their control. Some cost centres provide support services that are relatively easy to monitor because their outputs are measurable. Cost centres are also used for subunits that



produce goods or services that eventually will be sold by others. Managers in these cost centres are responsible for producing their goods or services efficiently. In discretionary cost centres (marketing, research and development, for example), the output is not easily measurable in dollars or activities. Cost centres are found in for-profit, not-for-profit, and government organizations. Cost centre managers are expected either to minimize costs for a certain level of output or to maximize output for a certain level of cost.

Revenue Centres: In revenue centres, managers are held responsible for the revenues under their control. Revenue centres frequently sell products from manufacturing subunits. Managers are expected to maximize revenues.

Profit Centres: Managers in profit centres are held responsible for both revenues and costs under their control. Profits centres produce and sell goods or services, and may include one or several cost centres. Profit centre managers are responsible for decisions about inputs, product mix, pricing, and volume of goods or services produced. The objective of profit centres is to maximize profits.

Investment Centres: Managers of investment centres are held responsible for the revenues, costs, and investments under their control. Investments include any assets related to the investment centre, such as fixed assets, inventory, intangible assets, and accounts receivable. Investment centres resemble profit centres, where profitability is related to the assets used to generate the profits. The objective of investment centres is to maximize the return on investments made by the organization. This means the most profitable projects must be identified and selected for investment.

16.9 Advantages of decentralization for this company: Because expansion is into other countries, decision making will be timelier and probably more appropriate because local managers understand the local markets. The need to communicate detailed information up and down the organization will be reduced. The people making the decisions have the most knowledge and expertise.

Disadvantagesof decentralization for this company: The decision makers may have objectives that are different from the overall company’s objectives. Decisions need to be coordinated among all of the divisions to reduce non-optimal behavior such as duplication of products or services. Investment in new projects may not reflect the best opportunities, but instead reflect the most persuasive decision maker.

16.10 The span of control is the scope of operations over which an individual has decision-making authority. Manager with a wide span of control, such as CEOS, have extensive authority. Individuals with a narrow span of control, such as bank tellers, have very little authority.

16.11 Residual income is EBIT less ROI * Total Assets. The EBIT budget variance is the sum of sales, COGS, and operating expenses budget variances. On the ROI side the budget variance is the sum of accounts receivable, inventory, other current assets, and long-term asset budget variances. Analysing these variance do determine the effect price,


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efficiency, and volume variance along with collection problems and asset management problems, will provide insight into understanding the residual income variance.



MULTIPLE CHOICE

16.12 Why is residual income a better measure for performance evaluation of an investment centre manager than return on investment?

a) The problems associated with measuring the asset base are eliminated.b) Desirable investment decisions will not be neglected by high-return divisions.c) Only the gross book value of assets needs to be calculated.d) Returns do not increase as assets are depreciated.e) The arguments over the implicit cost of interest are eliminated.

Ans: B

16.13 Robert Motoz is the manager of Division B of a large manufacturing company. Division B purchases all of its direct materials from Division A at a negotiated transfer price. Division B manufactures a product and sells this product on the market. Robert Motoz makes all production efficiency decisions for the division, including replacing and upgrading manufacturing equipment. The above represents which of the following types of responsibility centre?

a) Cost centre.b) Revenue centre.c) Profit centre.d) Investment centre.e) Discretionary centre.

Ans: D16.14 ZIL Inc. operates two divisions, which are treated as investment centres. Data for eachdivision for Year 4 are as follows (in ’000s):

Division A Division BNet income $50,000 $95,000Total assets $300,000 $650,000


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The company’s required rate of return is 12%. The president wishes to evaluate the performance of these divisions and is not sure whether to use return on investment (ROI) or residual income (RI) as the performance measure. Which division performed better based on the ROI and RI performance measures?

a) Division A, because its ROI and RI are higher than those of Division B.b) Division A, because its RI is higher than that of Division B.c) Division B, because its ROI is higher than that of Division A.d) Division B, because its ROI and RI are higher than those of Division A.e) None of the above.

Ans: E Division A ROI is $50,000 / $300,000 = 16.67%;Division A RI is $50,000 – ($300,000 * 12%) = $14,000Division B ROI is $95,000/ $650,000 = 14.62%Division B RI is $95,000 – ($650,000 * 12%) = $17,000

16.15 A small company in Vancouver sold $788,000 worth of its products last year. Net income represents 24% of sales. Net operating profit after tax (NOPAT) and total capital are, respectively, $240,000 and $520,000. The weighted average cost of capital and the required cost of capital were, respectively, 15% and 12%. What is EVA?

a) $111,120b) $126,720c) $162,000d) $177,600

Ans: C EVA = After-tax operating income - [WACC * (Total assets - Current liabilities)]EVA = $240,000 – [15% * ($520,000)] = $162,000

16.16 Which of the following best describes the responsibility of an investment centre manager?

a) Evaluating alternative capital investments the organization must make.b) Achieving a certain target revenue within the manager’s organizational segment.c) Achieving a certain target profit within the manager’s organizational segment.d) Maximizing segment revenues given a predetermined expenses limit.e) Maximizing segment profit while making efficient use of the segment’s

investment in capital assets.

Ans: E



EXERCISES

16.17 Responsibility Centres, ROI, RI – ZIL Inc.

Division B performed better, because its ROI and RI are higher than those of Division A.

ROI Division A = $65,000/$400,000 = 16.3%ROI Division B = $140,000/$850,000 = 16.5%RI Division A = $65,000 - ($400,000 * .15) = $5,000RI Division B = $140,000 - ($850,000 * .15) = $12,500Division B has a higher ROI and RI.

16.18 ROI, Required Rate of Return – An Investor

Net operating income (OI) is $200,000 ($1.2 million – $1 million).A residual income (RI) of $2,000 implies that the return in dollars is net OI – RI = $198,000.The minimum required rate of return is $198,000 / $900,000 = 22%.

16.19 Responsibility Centres, ROI, RI – Spring Bulbs

ROI Division T = $85,000/$255,000 = 33.3%ROI Division I = $210,000/$840,000 = 25.0%Division T performed better based on ROI.

RI Division T = $85,000 - ($255,000 * .12) = $54,400RI Division I = $210,000 - ($840,000 * .12) = $109,200Division I performed better based on RI.

16.20 Responsibility Centres, Performance Measures - Brother’s Coffee Cart Business

A. Each cart is a profit centre because the employees who operate the carts buy baked goods and other items and are responsible for selling them—i.e., they are responsible for both costs and revenues.

B. My brother could use measures that focus on revenues, costs, or profit. Here are some possible measures: total revenue, revenue per hour, revenue growth, cost of goods sold as a percent of revenue, supplies cost as a percent of revenue, and profit margin percent (operating profit divided by revenue).


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C. Number or percentage of return customers is very important because a small cart cannot survive without regular customers. Customer satisfaction is also important. Cleanliness of the cart could be an issue. Students may think of other factors.

16.21 RI, ROI and EVA - Brannard Company

A. Residual income= operating income – (rate of return x average assets)= ($2,000,000 - $1,200,000 - $200,000) – (15% x $3,000,000)= $600,000 - $450,000= $150,000

B. ROI= operating income / average investment= $600,000/$3,000,000= 20%

C. EVA= adjusted after-tax income – [weighted average cost of capital x (adjusted total

assets – current liabilities)]= [$600,000 x (1-0.36)] – [12% x ($3,000,000 - $200,000)]= $384,000 - $336,000= $48,000

16.22 RI, ROI, and EVA – Coburg Company

A. Residual income= operating income – (rate of return x average assets)= ($5,000,000 - $3,000,000 - $500,000) – (15% x $7,500,000)= $1,500,000 - $1,125,000= $375,000

B. ROI= operating income / average investment= $1,500,000/$7,500,000= 20%

C. EVA= adjusted after-tax income – [weighted average cost of capital x (adjusted total

assets – current liabilities)]= [$1,500,000 x (1-0.32)] – [12% x ($7,500,000 - $500,000)]= $1,020,000 - $840,000= $180,000



16.23 ROI, RI, Breakeven Point, Contribution Margin - Oslo Company

[Note: Part C of this problem requires knowledge of breakeven analysis from Chapter 3.]

A. Before calculating ROI, it is first necessary to calculate income:

Sales (300,000 * $2) $600,000Variable costs (450,000)Fixed costs (90,000)

Income $ 60,000

ROI = $60,000/[($500,000 + $700,000)/2] = 10%

B. Residual income:Income $ 60,000Minimum return [($500,000 + $700,000)/2 x 0.15] (90,000)

Residual income $(30,000)

C. Variable cost per unit: $450,000/300,000 = $1.50

Breakeven number of units:Breakeven units = Fixed costs/ CM per unitCM per unit = $2.00 - $1.50 = $0.50BE units = $90,000 / $.50BE units = 180,000 units

D. Sales $600,000Variable costs 450,000Contribution margin $150,000

16.24 EVA for Segments - Fulcrum Company

Segment AEVA = after-tax income – WACC*(assets – current liabilities)

= [€8,000,000*(1-0.30)] – [10%*(€32,000,000 + €8,000,000 – €4,000,000)]= €5,600,000 – €3,600,000 = €2,000,000

Segment BEVA = [€4,000,000*(1-0.30)] – [10%*(€30,000,000)] =

= €2,800,000 – €3,000,000 = (€200,000)

Segment CEVA = [€6,000,000*(1-0.30)] – [10%*€21,000,000]

= €4,200,000 – €2,100,000 = €2,100,000


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Segment C has the highest EVA:

16.25 EVA for Segments – Pyramid Company

Segment AEVA = after-tax income – WACC*(assets – current liabilities)

= [£2,000,000*(1-0.25)] – [8%*(£2,000,000 + £8,000,000 – £1,000,000)]= £1,500,000 – £720,000 = £780,000

Segment BEVA = [£1,000,000*(1-0.25)] – [8%*(£1,500,000 + £6,500,000 – £500,000)]=

= £750,000 – £600,000 = £150,000

Segment CEVA = [£3,000,000*(1-0.25)] – [8%*(£4,000,000 + £8,000,000 – £1,500,000)]]

= £2,250,000 – £840,000 = £1,410,000

Segment C has the highest EVA.

16.26 Residual Income, Solve for Unknown – A Business

Use the residual income formula to solve for the unknown, and assume that “investment” is approximately equal to average assets:

RI = Operating income – (Required return * Average operating assets)$(10,000) = $50,000 – (Required return * $400,000)$(10,000)+ (Required return * $400,000) = $50,000(Required return * $400,000) = $50,000 + $10,000(Required return * $400,000) = $60,000Required return = $60,000/ $400,000Required return = $15%

16.27 ROI, Solve for Unknowns

Unit 1 Unit 2 Unit 3Income $10,000 $50,000 (D) $75,000 (G)Investment $50,000 (A) $250,000 (E) $300,000Sales $150,000 (B) $500,000 $500,000 (H)Return on Investment 20% 20% (F) 25%Return on Sales 6.67% (C) 10% 15%Investment turnover 3.0 times 2.0 times 1.67 times (I)



All answers are calculated using the ROI formula and DuPont Analysis formulas, assuming that “income” is equal to operating income and that “investment” is equal to total assets:

ROI = Operating income / Total assets= Investment turnover × Return on sales= Sales/Total assets × Operating income/Sales

Calculations in order of solving the unknowns:A. ROI = Income/ Investment therefore

Investment = Income / ROI = $10,000 * 20% = $50,000

C. ROI = Investment turnover * Return on Sales therefore Return on sales = ROI/ Investment turnover = 20%/ 3.0 = 6.67%

B. Return on sales = Income / Sales thereforeSales = Income / Return on sales = $10,000/6.67% = $150,000

D. Return on sales = Income / Sales thereforeIncome = Return on sales * Sales = 10% * $500,000 = $50,000

F. ROI = Investment turnover * Return on sales = 2.0 * 10% = 20%

E. ROI = Income/ Investment therefore Investment = Income / ROI =$50,000 / 20% = $250,000

G. ROI = Income/ Investment therefore Income = ROI * Investment = 25% * $300,000 = $75,000

H. Return on sales = Income / Sales thereforeSales = Income / Return on sales = $75,000 / 15% = $500,000

I. ROI = Investment turnover * Return on sales therefore Investment turnover = ROI / return on sales = 25% / 15% = 1.67 times

16.28 ROI, Solve for Unknowns

Unit 1 Unit 2 Unit 3Income $20,000(A) $10,000 $15,000Investment $60,000 $50,000 (D) $60,000 (G)Sales $200,000 $150,000 (E) $300,000 (H)Return on Investment 33.33% 20% 25%Return on Sales 10%(B) 6.67% (F) 5.0% (I)Investment turnover 3.33 times (C) 3.0 times 5.0 times


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All answers are calculated using the ROI formula and DuPont Analysis formulas, assuming that “income” is equal to operating income and that “investment” is equal to total assets:

ROI = Operating income / Total assets = Income / Investment= Investment turnover × Return on sales= Sales/Total assets × Operating income/Sales

Calculations in order of solving:A. ROI = Income / Investment therefore

Income = ROI * Investment = $60,000 * 33.33% = $20,000 rounded

B. Return on sales = Income / Sales = $20,000 / $200,000 = 10%

C. ROI = Investment turnover * Return on sales therefore Investment turnover = ROI / return on sales = 33.33% / 10% = 3.33

D. ROI = Income/ Investment therefore Investment = Income / ROI = $10,000 /20% = $50,000

F. ROI = Investment turnover * Return on Sales therefore Return on sales = ROI/ Investment turnover = 20%/ 3.0 = 6.67%

E. Return on sales = Income / Sales thereforeSales = Income / Return on sales = $10,000/6.67% = $150,000

I. ROI = Investment turnover * Return on sales therefore Return on sales = ROI / Investment turnover = 25% / 5.0 = 5%

H. Return on sales = Income / Sales thereforeSales = Income / Return on sales = $15,000/5.0% = $300,000

G. ROI = Income / Investment therefore Investment = Income / ROI = $15,000 / 25% = $60,000

16.29 Span of Control, General and Specific Knowledge, Performance Measures - Barnett’s

A. In a high end boutique store, salespeople need specific knowledge about the tastes of their clients and also knowledge about styles that are most flattering for each client’s figure. Clients expect to receive phone calls when new items arrive at the store that would be stylish for them. The salespeople might also have general knowledge about fashion trends that could affect decisions such as which items to purchase. However, this type of general knowledge is probably centralized.

B. An advantage of giving salespeople authority to resolve customer problems is that the salespeople have specific knowledge about each customer and probably have a better



understanding of how to satisfy the customer. The disadvantage is that the salesperson may allow the customer to take advantage of the situation, costing the store more money than is necessary to resolve the issue.

C. In most retail stores, salespeople have narrow spans of control. They cannot set prices, cannot resolve problems, and cannot set their own schedules, although they may be able to negotiate schedules with co-workers. However, the information provided about Barnett’s suggests that the salespeople have at least a moderate span of control because they are allowed to resolve customer problems including the return or exchange of merchandise and to hold merchandise for individual customers (which might cause lost sales).

D.1. Total store sales would encourage the employees to work as a team to increase sales

both within and across the men’s and women’s departments. For example, a salesperson is the women’s department might encourage a female customer to purchase clothing in the store for her husband. This measure would also discourage salespeople from setting aside clothing for a particular customer unless they are confident that doing so would increase overall sales. On the other hand, this measure might encourage free riding by salespeople who are not as ambitious as others.

2. Department sales would have the same advantages and disadvantages as total store sales, in that it would encourage teamwork and possibly also freeriding. However, less incentive would be provided for sales across the men’s and women’s departments.

3. Store gross margin would give salespeople incentives to increase sales, similar to points one and two above. This measure would also encourage salespeople to be aware of and focus on selling items that have higher gross margins. However, this measure might discourage salespeople from selling items with lower gross margins, such as clearance items.

4. Department gross margin would have the same advantages and disadvantages as the store gross margin, but as noted in Part 2 above would provide less incentive for cooperation across men’s and women’s departments.

5. Store earnings before interest and taxes (EBIT) would encourage increased sales, increased gross margins, and decreased operating costs. In addition to the issues discussed in Parts 1 and 3 above, this measure would encourage salespeople to reduce operating costs such as tissue paper, clothing bags, and hangers. If these costs are cut too much, customers might perceive a drop in quality, causing sales to suffer. In addition, salespeople might have no control over the largest operating costs, such as store rent, utilities, and advertising. Thus, they might perceive this measure as unfair.


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PROBLEMS

16.30 ROI, Transfer Prices, Taxes, Employee Motivation - Fowler Electronics

A. ROI if the screens are transferred at variable cost:

Windsor DetroitRevenue (10,000 x $2,500) $25,000,000Variable production costs:

(10,000 x $350) $(3,500,000)(10,000 x $110) (1,100,000)

Fixed production costs (2,000,000) (4,000,000)Transfer price (10,000 x $350) 3,500,000 (3,500,000)

Pre-tax income (loss) (2,000,000) 16,400,000Income taxes (a) 0 (7,380,000)

Net income (loss) $(2,000,000) $ 9,020,000

Total assets $20,000,000 $30,000,000

ROI (Net income / Investment) (10)% 30%

(a) Income tax calculations:The Windsor plant has a loss. The problem provides no information about whether Canadian tax law allows companies to carry losses back against prior income or forward against future income. However, if the Windsor plant does not sell to outside customers, then it might always incur a loss if variable cost is used as the transfer price. Therefore, the income tax effect is estimated as zero.

Tax for Detroit plant = $16,400,000 * 45% = $7,380,000

B. ROI if the screens are transferred at market price:

Windsor DetroitRevenue (10,000 x $2,500) $25,000,000Variable production costs:

(10,000 x $350) $(3,500,000)(10,000 x $110) (1,100,000)

Fixed production costs (2,000,000) (4,000,000)Transfer price (10,000 x $750) 7,500,000 (7,500,000)

Pre-tax income (loss) 2,000,000 12,400,000Income taxes (a) (600,000) (5,580,000)

Net income (loss) $ 1,400,000 $ 6,820,000

Total assets $20,000,000 $30,000,000

ROI (Net income / Investment) 7% 23%



(a) Income tax calculations:Tax for Windsor plant: $2,000,000 * 30% = $600,000Tax for Detroit plant = $12,400,000 * 45% = $5,580,000

C. The firm will prefer the market transfer price because it maximizes company income. Total income is increased through tax rate differences between Canada and the United States. In addition, if variable costs are used, then there is a tax loss in Canada for which no tax benefit is received. The net tax advantage of using market value for the transfer price is:

Taxes if transfer price is the variable cost:Windsor $ 0Detroit 7,380,000

Total $7,380,000Taxes if transfer price is the market value:

Windsor $ 600,000Detroit 5,580,000

Total 6,180,000Difference $1,200,000

D. The Windsor plant manager will prefer to transfer at the market price, and the Detroit plant manager will prefer variable cost because these transfer prices make their operations look best.

E. Use of either the dual rate or the negotiation method would give managers the information they need to make the best decisions for the overall corporation. A problem with the dual rate method is that both plants appear to be more profitable than they really are. A problem with negotiating is that manager time can be tied up on activities that do not necessarily add value to the overall firm.

16.31 ROI, Residual Income, Explaining the Better Measure - Prairie Mining

A. ROI = $65,000/$500,000 = 13%

B. Residual income = $65,000 – (0.10*$500,000) = $65,000 - $50,000 = $15,000

C. There are many different ways this memo could be written. However, the memo would need to explain the behavioural implications of ROI: (1) the tendency to forego profitable projects that are less than the current ROI, and (2) that cutting costs that lead to long-term benefit improves the measure. In addition, it does not incorporate any measure of risk.


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16.32 Lease versus Buy Decision, ROI, Residual Income, EVA, Manager Incentives - Prairie Mining (continued)

A. Lease ROINew operating income = $65,000 + $40,000 = $105,000ROI = $105,000/$500,000 = 21%

Purchase ROI(Note: assuming depreciation = lease cost)New operating income = $65,000 + $40,000)= $105,000Total assets including new = $650,000ROI = $105,000/$650,000 = 16.15%

B. Lease residual incomeRI = $105,000 – (0.10*$500,000) = $105,000 - $50,000 = $55,000

Purchase residual incomeRI = $105,000 – (0.10*$650,000) = $40,000

C. If the performance measure causes managers to be indifferent (from the perspective of their compensation) to leasing or purchasing, they are more likely to base the decision on factors that create more value for the firm.

16.33 ROI, Residual Income, Explaining the Better Measure – Far North Logging

A. Return on InvestmentROI = operating income/ average operating assetsROI = $92,000 / $800,000 ROI = 11.5%

B. Residual IncomeRI = operating income – (required rate of return *average operating assets)RI = $92,000 – (10% *$800,000)RI = $12,000

C. There are many different ways this memo could be written. However, the memo would need to explain the behavioural implications of ROI: (1) the tendency to forego profitable projects that are less than the current ROI, and (2) that cutting costs that lead to long-term benefit improves the measure. In addition, it does not incorporate any measure of risk.



16.34 ROI, Residual Income, EVA, Effect on Investment Decision, Performance Evaluation - Strong Welding Equipment Company

A. ROIROI = operating income / average operating assetsROI Brazil = $1,000,000/$4,000,000 = 25%ROI Canada = $120,000/$400,000 = 30%

B. Residual incomeRI = operating income – (required rate of return * average operating assetsRI Brazil = $1,000,000 – (10%*$4,000,000) = $600,000RI Canada = $120,000 – (10%*$400,000) = $80,000

C. EVAEVA = After-tax operating income – [WACC * (total assets – current liabilities)]EVA Brazil = $600,000 – [9%*($4,000,000 - $80,000)]

= $600,000- $352,800 = $247,200EVA Canada = $80,000 – [9%*($400,000 – 10,000)]

= $80,000 - $35,100 = $44,900

D. Current ROI is 25% (see part A)

New ROI = ($1,000,000 + $500,000)/($4,000,000 + $3,500,000) = 20%, which is lower than the current ROI of 25%. Therefore, the division manager would probably forego the opportunity.

E. EVA with appropriate adjustments would be the best performance evaluation measure. EVA overcomes many of the disadvantages of ROI and residual income.

16.35 ROI, Residual Income, EVA, Effect on Investment Decision, Performance Evaluation – BackCountry Hiking Company

A. ROIROI = operating income / average operating assetsROI Germany = $100,000/$400,000 = 25%ROI Canada = $750,000/$2,000,000 = 37.5%

B. Residual incomeRI = operating income – (required rate of return * average operating assetsRI Germany = $100,000 – (10%*400,000) = $60,000RI Canada = $750,000 – (10%*2,000,000) = $550,000


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C. EVAEVA = After-tax operating income – [WACC * (total assets – current liabilities)]EVA Germany = $60,000 – [9%*($400,000 - $8,000)]

= $60,000- $35,280 = $24,720EVA Canada = $300,000 – [9%*($2,000,000 – 40,000)]

= $300,000 - $176,400 = $123,600

D. Current ROI is 25% (see part A)

New ROI = ($100,000 + $50,000)/($400,000 + $350,000) = 20%, which is lower than the current ROI of 25%. Therefore, the division manager would probably forego the opportunity.

E. EVA with appropriate adjustments would be the best performance evaluation measure. EVA overcomes many of the disadvantages of ROI and residual income.

16.36 EVA, Performance Evaluation – A Company

A. Net profit:

Revenues $1,250,000Total cost and expenses excluding interest 630,000 Earnings before interest and taxes 620,000Net interest expense 25,000 Earnings before taxes 595,000Taxes (35%) 208,250 Net profit $ 386,750

B. Weighted average cost of capital

WACC = (cost of debt net of tax benefit * debt %) + (cost of capital * capital %)WACC = (10% * (1 − 0.35) *0.75) + [(10% + 5%)* 0.25]= 8.625%

C. EVA-adjusted net income:

Net operating income before taxes $ 595,000Add: R&D not capitalized under GAAP ($53,825 + $75,700) 129,525Deduct: 2012 amortization of R&D ($15,000 / 5years) (3,000)Deduct: Amortization of R&D capitalized under GAAP ($129,525/5) (25,905)Add: Impairment loss of goodwill included in 2012 GAAP income 22,225 Adjusted net operating income before taxes $717,845



D. EVA:

EVA = Adjusted after-tax operating income – (WACC × total capital)= $717,845*(1 – 0.35) – (0.08625 × $550,000) = $466,599 - $47,438= $419,161

E. Therefore, the EVA for the benefit of shareholders is $419,161. The company has made profits and created value.


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MINI-CASES

16.37 Choosing Type of Responsibility Centre, Support Cost Allocation, ROI - ATCO Company

A. Return on investment is not a good performance measure for the division because division management has very little control over either net income or investment. Sales revenue is totally controlled by central management (they control both prices and quantities). In addition, it appears that division management does not have authority to alter the level of investment in the firm. While one might also mention problems with the allocation of costs and working capital on the basis of sales, and the use of net book value, these problems are trivial relative to the division manager’s lack of authority and lack of control over factors in the performance measure.

B. The division should be treated as a cost centre (it is not a profit centre). Apparently, the division management has control only over providing products at an efficient cost, given timing and quality constraints. The division's performance should thus be measured relative to a well prepared flexible budget. If quality is important, quality performance measures should be included.

16.38 Responsibility Centres, Performance Measures - Peerless Load Levellers Company

A. Four characteristics and requirements for a responsibility accounting system include the following.

• Each level of management is responsible for their department’s operations as well as the employees within their department.

• Costs must be clearly identifiable and controllable by the manager.• Responsibility for performance according to budget must be linked to authority to

do what is necessary to fulfill this responsibility• The system should encourage employee involvement and participation, as well as

improve morale, motivation, and communication.

B.1. The cost centre is an organizational unit charged with achieving its operational

function at a minimum cost. In cost centres, managers have authority over and are responsible for costs incurred. Reports focus on the variance of those costs from the plan or budget. The variances from controllable costs are used to measure the performance of the departmental manger.

2. The objective of a profit centre is to maximize profits. Managers of profit centres are responsible for revenues as well as controllable costs.



3. The objective of an investment centre is to maximize return on investment. Managers in investment centres are responsible for and have authority over costs and revenues as well as investments. Measurement is based on assets employed.

C.1. At least three advantages that may be gained from a responsibility accounting system

include

• Systematic planning and reporting of controllable costs• Budget setting participation that motivates managers to feel ownership, and

increases their accountability and sense of responsibility• Timely reports that allow corrections of difficulties before they affect

financial results

2. A major risk involved in responsibility accounting systems is that managers may focus only on the costs for which they are responsible and not on the overall goals of the organization. The good of the department may be placed ahead of the good of the organization, thus making goal congruence difficult.

D. There are many possible answers to this question. Below are examples of possible operational performance measures that Klein-Robb could implement for each of the three managers.

John Richards, purchasing manager:• Total cash discounts earned, or cash discounts as a percent of gross purchase cost:

This measure would encourage the purchasing manager to negotiate favourable cash discount terms with suppliers.

• Number of purchases rejected from quality inspection: This measure would encourage the purchasing manager to ensure that vendors supply raw materials meeting the company’s quality specifications.

• Price variance for direct materials: This measure would encourage the purchasing manager to seek favourable price changes.

Karl Willis, production manager:• Achievement of budget goals as follows:

• Variances from standard labour and direct material rates: These measures provide incentives to control costs through managing purchase prices and efficiency.

• Average job set-up time: This measure would encourage the production manager to seek ways to reduce the production time lost due to job set-up.

• Percent of production rejected at final inspection: This measure would encourage the production manager to ensure that production quality standards are maintained or improved.


190 Cost Management

16.39 Integrating Across the Curriculum-Business Law: Executive compensation for public companies, CSA disclosures

A. On its Web site, the CSAannounces that it will proceed with requiring companies to disclose various types of information as follows:1

B., C., D., E.,Student answers will vary depending on the report and company they choose.

Information is relatively easy to find once on the Toronto Stock Exchange website. A link is provided to SEDAR.com where all publicly filed documents on public corporations can be found.

Student opinions are likely to vary about whether a company’s information is clear, concise, and understandable. Students who have not previously read these types of disclosures will probably think they are confusing and difficult to understand, partly because of new terminology.

Disclosures are often vague in their explanations of the relationship between pay and performance.

1“Canadian Securities Regulators proceeds with enhanced executive compensation disclosure requirements”, released July 22, 2011http://www.nbsc-cvmnb.ca/nbsc/news_content_display.jsp?news_id=298&id=24&pid=4


22 July 2011CSA proceeds with enhanced executive compensation disclosure requirementsToronto – The Canadian Securities Administrators (CSA) announced today it is implementing amendments to Form 51-102F6 Statement of Executive Compensation , which will provide investors with enhanced information on the key risks, governance matters and compensation practices of publicly listed companies.

A key amendment to the Form, which will come into effect October 31, 2011, is to require public companies to disclose to investors whether their board of directors adequately considered the implications of the risks associated with the company’s compensation policies and practices. Public companies will also be required to provide investors with greater details on the fees paid to outside compensation consultants.

“Greater transparency on the compensation policies of public companies will allow investors to make better informed voting and investment decisions, and will help them determine whether management’s incentives are aligned with their interests,” said Bill Rice, Chair of the CSA and Chair and CEO of the Alberta Securities Commission.

In developing the new requirements, the CSA considered the findings of its 2009 targeted compliance review of a sample of public companies’ executive compensation disclosure. The CSA also considered a number of recent international developments in executive compensation disclosure.

The CSA, the council of the securities regulators of Canada’s provinces and territories, co-ordinates and harmonizes regulation for the Canadian capital markets.

http://www.nbsc-cvmnb.ca/nbsc/uploaded_topic_files/51-102F6-CSAN-2011-07-22-E.pdf


E. Many answers are possible for this question. A student who evaluates the pay a CEO should consider evidence before reaching a conclusion. Potential evidence includes a CEO pay compared to:

• Some measure of reported or adjusted company earnings (e.g., level of income, ROI, residual income, EVA)

• Shareholder stock returns• Earnings and/or shareholder returns relative to one or more other companies • Levels of CEO pay in other companies• Levels and changes in pay for other employee groups

Once students have presented and evaluated evidence, they should identify the criteria/values used to draw conclusions. For example, should CEO pay ever exceed some multiple of pay for the average employee? Should CEO pay include a portion that varies with each year’s company performance or with performance over several years? Should CEO pay remain within some percentage of the CEO pay at other companies?

16.40 Integrating Across the Curriculum - Finance: Calculation of weighted average cost of capital

A. Under generally accepted accounting principles (GAAP), debt and equity accounts are typically recorded at cost and are not adjusted for fair market value. Over time, fair market value can deviate substantially from book values. For a company such as Amazon, whose value relies heavily on intangible assets, the fair market value can be considerably higher than the book value.

B. The weighted average cost of capital computation typically includes only long-term debt and equity. For Amazon, this would most likely include the following:

• 4.75% Convertible Subordinated Notes• 6.875% PEACS• Capital lease obligations• Common stockholders’ equity

Each of the preceding appears to be a source of long-term capital. Excluded from this list are other long-term debt and other long-term liabilities, which are assumed to be simple long-term liabilities rather than sources of capital.

C. Possible sources of information for estimating the weighted average cost of capital are as follows; students may think of additional sources of information.

1. Market value of common shares: Quoted market prices for publicly-traded shares; estimated value using expected future earnings for non-publicly-traded shares


192 Cost Management

2. Cost of equity capital: Long-term rate of return on the stock market for companies having similar risk

3. Market value for each type of debt: Quoted market prices for publicly traded debt; net present value of future cash flows using current discount rates for other forms of debt

4. Pretax interest rates: Effective interest rate imputed from market values of publicly-traded debt; discount rates used to estimate net present values for other forms of debt

5. Income tax rate: Effective income tax rate from income tax footnote


Documents

Chapter 16 Performance Evaluation and …s3.amazonaws.com/prealliance_oneclass_sample/xYgd2L56J5.pdfChapter 16: Performance Evaluation and Compensation 175 EXERCISES 16.17 Responsibility