Management ControlSystems

Responsibility Centers

Costcenter

Revenuecenter

Investmentcenter

Profitcenter

Measuring Managers Performance

Cost/RevenueCenter

Standard Cost/FlexibleBudget Variances

ProfitCenter

Budgeted incomestatement

InvestmentCenter

Return on investment,residual income and EVA

Evaluation Tool

Accounting-Based PerformanceMeasure Example

Relax Inns owns three small hotels – one each in Boston, Denver, and Miami.

At present, Relax Inns does notallocate the total long-term debt of

the company to the three separate hotels.

Denver Hotel

Current assets $ 400,000Long-term assets 600,000Total assets $1,000,000Current liabilities $ 150,000

Revenues $1,200,000Variable costs 310,000Fixed costs 650,000Operating income $ 240,000

Relax Inns Balance Sheet

Total current assets $1,350,000Total long-term assets 6,150,000Total assets $7,500,000Total current liabilities $ 500,000Long-term debt 4,800,000Stockholders’ equity 2,200,000Total liabilities and equity $7,500,000

Approaches toMeasuring Performance

Three approaches include a measure of investment:

Return on investment (ROI)

Residual income (RI)

Economic value added (EVA®)

Return on Investment

Return on investment (ROI) is anaccounting measure of income

divided by an accountingmeasure of investment.

Return on investment (ROI)= Income ÷ Investment

What is the return on investment for the Denver Hotel?

Return on Investment

Denver Hotel: $240,000 Operating income÷ $1,000,000 Total assets = 24%

The DuPont method of profitability analysisrecognizes that there are two basic

ingredients in profit making:

DuPont Method

1. Using assets to generate more revenues

2. Increasing income per dollar of revenues

DuPont Method

Investment turnover = Revenues ÷ Investment

Return on sales = Income ÷ Revenues

ROI = Return on sales × Investment turnover

DuPont Method

How can Relax Inns attain a 30% targetROI for the Denver Hotel?

Present situation: Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20

Operating income ÷ Revenues= $240,000 ÷ $1,200,000 = 0.20

1.20 × 0.20 = 24%

DuPont Method

Alternative A: Decrease assets, keepingrevenues and operating income per

dollar of revenue constant.

Revenues ÷ Total assets= $1,200,000 ÷ $800,000 = 1.50

1.50 × 0.20 = 30%

DuPont Method

Alternative B: Increase revenues, keepingassets and operating income per dollar

of revenues constant.

Revenues ÷ Total assets= $1,500,000 ÷ $1,000,000 = 1.50

1.50 × 0.20 = 30%

Operating income ÷ Revenues= $300,000 ÷ $1,500,000 = 0.20

DuPont Method

Alternative C: Decrease costs to increaseoperating income per dollar of revenues,

keeping revenues and assets constant.

Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20

1.20 × 0.25 = 30%

Operating income ÷ Revenues= $300,000 ÷ $1,200,000 = 0.25

Residual Income

Residual income (RI)= Income

– (Required rate of return × Investment)

Assume that Relax Inns’ requiredrate of return is 12%.

What is the residual income from the Denver hotel?

Residual Income

Denver Hotel:Residual Income = $240,000 - ($1,000,000 X 12%)

= $120,000

Economic Value Added

Economic value added (EVA®)

= After-tax operating income

– [Weighted-average cost of capital

× (Total assets – current liabilities)]

Economic Value Added

Total assets minus current liabilitiescan also be computed as:

Long-term assets + Current assets– Current liabilities, or…

Long-term assets + Working capital

Economic Value Added

Economic value added (EVA®) substitutes thefollowing specific numbers in the RI calculations:

1. Income equal to after-tax operating income

2. A required rate of return equal to theweighted-average cost of capital

3. Investment equal to total assets minuscurrent liabilities

Economic Value Added Example

Assume that Relax Inns has two sources oflong-term funds:

1. Long-term debt with a market value andbook value of $4,800,000 issued at aninterest rate of 10%

2. Equity capital that also has a market value of$4,800,000 and a book value of $2,200,000

Tax rate is 30%.

Economic Value Added Example

What is the after-tax cost of debt?

0.10 × (1 – Tax rate) = 0.07, or 7%

Assume that Relax Inns’ cost ofequity capital is 14%.

What is the weighted-average cost of capital?

Economic Value Added Example

WACC = [(7% × Market value of debt)+ (14% × Market value of equity)]

÷ (Market value of debt + Market value of equity)

WACC = [(0.07 × 4,800,000)+ (0.14 × 4,800,000)] ÷ $9,600,000

WACC = $336,000 + $672,000 ÷ $9,600,000

WACC = 0.105, or 10.5%

Economic Value Added Example

What is the after-tax operating income for the Denver Hotel?

Denver Hotel:Operating income $240,000 × 0.7 = $168,000

Economic Value Added Example

What is the investment?

Denver Hotel: Total assets $1,000,000– Current liabilities $150,000 = $850,000

Economic Value Added Example

What is the weighted-average cost of capitaltimes the investment for Denver?

Denver Hotel: $850,000 × 10.5% = $89,250

Economic Value Added Example

What is the economic value added?

Denver Hotel: $168,000 – $89,250 = $78,750

The EVA® charges managers for the costof their investments in long-term assets

and working capital.