ACC702

ACC702 – Management Accounting

Week 7 Tutorial SOLUTIONS – Contemporary Financial Performance Measures
Primary Reference –Text Chapter 13

Discussion questions:

13.4 Outline some of the steps that can be taken to minimise the negative behavioural effects of Return
on Investment (ROI).

There are several ways to minimise the negative behavioural effects of ROI:
• Use a broader set of performance measures which encompass both long-term and short-term measures, and
financial and non-financial measures. This de-emphasises ROI as a performance measure.
• Consider alternative ways of measuring invested capital so that the replacement of an asset does not have
such an adverse effect on ROI. Use of market values or acquisition cost can help here.
• Use alternate profit measures, such as residual income, to minimise some of the investment disincentives
associated with ROI.

13.5 Provide two examples of situations where the use of ROI can lead to decisions which may harm the
further competiveness of a company. (Even though the current ROI is at or above budgeted levels.)

Overemphasising ROI can led to decisions that may be harmful to the future competitiveness of a company. Some
examples follow:
Managers of an investment centre may defer research and development expenditure to improve short-term profit
and hence enhance short-term ROI. However, the lack of R&D may reduce the number of new products under
development that are needed to remain competitive.
Managers may defer investment in new manufacturing plant to reduce depreciation, increase profit, decrease
investment and hence increase short-term ROI. This may reduce the future capacity of the company to produce
innovative products and may lead to inefficient and costly operations.

13.8 Does it matter how invested capital and profit are defined for the purpose of the ROI calculations?
Explain your answer. (Write a paragraph to answer this question.)

In an organisation that has divisions, invested capital and profit must be consistently defined when used in ROI
calculations. However, the advantages and disadvantages of particular definitions must also be considered. For
example, using net book values rather than market values may have certain behavioural consequences. The
investment base used in the ROI calculation should normally include only those assets and liabilities that are
attributable to the division, or controllable by the divisional manager. Similarly, the profit measure should be
either attributable or controllable profit for that division. The ROI used must be capable of measuring the relative
performance of divisions (or managers), or performance of a division (or manager) over time (hence the need for
consistency), and be as ‘valid’ a measure of performance as possible.

Extra Q – What is significant about the Weighted Average Cost of Capital (WACC) used to calculate the
‘capital charge’ in the EVA measurement?

The WACC represents the cost to the company to obtain funds in the market from both equity (share)
holders and debt holders AT CURRENT MARKET RATES. It requires the managers to consider if their
returns are sufficient to justify the performance in current market conditions.

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EXERCISE 13.25 (25 minutes) Comparing the performance of two divisions: retail company
1 A comparison of the profits of the two divisions does not give an accurate picture of the relative performance of
the two divisions as each division derives that profit from different amounts of assets. If ROI is used, then the
Dressmaking Division performs better than the Furnishing Division. However, ROI may also not provide a good
basis for comparison, as the two divisions operate in two different industries. We do not know what constitutes
good performance in the furnishing or the dressmaking industries. Nor do we know the firm’s required rate of
return, or any ROI or profit targets that management may have set for each division.

2 Calculate each division’s Economic Value Add (EVA) under each of the following assumptions about
the firm’s WACC. (Assume the profit shown is AFTER TAX and the Average Invested Capital (shown
above) is the Capital Employed

(a) WACC of 12 per cent:

Furnishing Dressmaking
_____________________________________________________________________________
_______________________________________________________________________
Divisional profit (NPAT) $1 350 000 $300 000
Less: ‘Capital charge’:
Furnishing: $9 000 000  12% 1 080 000
Dressmaking: $1 500 000  12% 180 000
Economic Value Add (EVA) $270 000 $120 000

(b) WACC of 15 per cent:

_______________________________________________________________________
Divisional profit (NPAT) $1 350 000 $300 000
Less: ‘Capital charge’:
Furnishing: $9 000 000  15% 1 350 000
Dressmaking: $1 500 000  15% 225 000
Economic Value Add (EVA) $0 $75 000
(b) WACC of 18 per cent:
_________________________________________________________________________
Divisional profit (NPAT) $1 350 000 $300 000
Less: ‘Capital charge’:
Furnishing: $9 000 000  18% 1 620 000
Dressmaking: $1 500 000  18% 270 000
Economic Value Add (EVA) $(270 000) $30 000

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EXERCISE 13.22 (20 minutes) Components of ROI; improving ROI; residual income: retailer
profit $6 000 000
1 Return on sales = = = 8%
sales revenue $75 000 000

sales revenue $75 000 000

Investment turnover = = = 2.5
invested capital $30 000 000

profit $6 000 000

Return on investment = = = 20%
invested capital $30 000 000
2 There are many ways to improve the division’s ROI to 25 per cent. Here are two of them:

(a) Improve the return on sales to 10 per cent by increasing profit to $7 500 000:
ROI = return on sales  investment turnover
$7 500 000 $75 000 000
= ´
$75 000 000 $30 000 000
= 10%  2.5 = 25%
Since sales revenue remains unchanged, this implies a cost reduction of $1 500 000 at the same sales
revenue.
(b) Improve the investment turnover to 3.125 by decreasing average invested capital to
$24 000 000:
ROI = return on sales  investment turnover
$6 000 000 $75 000 000
= ´
$75 000 000 $24 000 000
= 8%  3.125 = 25%
Since sales revenue remains unchanged, this implies that the firm can divest itself of some productive
assets without affecting sales revenue.

Extension exercise:
1. If in the above exercise, the Weighted Average Cost of Capital for the company was 13% and tax was
30%, would the operation of Zap represent added value for the shareholders? (Note current
liabilities are $300,000 and SHOULD be deducted from Invested Capital to calculate Employed
Capital.)
EVA = NPAT – “Capital Charge”
= [PBT x (1-t)] - [(Capital Invested – Current Liabilities) x WACC)
= $6m x 0.7 - [($30 000 000 - $300 000) x 13%]
= $4.2m - $3.861m
= $0.339m
Therefore the business unit is adding an acceptable return for the shareholders as its return is
greater than the cost of capital.

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EXERCISE 13.23 (15 minutes) Improving ROI: manufacturer
1 Return on sales = profit = 450 000 = 5%
sales revenue
9 000 000
* Profit = $450 000 = 9 000 000 – 4 950 000 – 3 600 000

sales revenue 9 000 000

Investment turnover = = = 2
invested capital
4 500 000

profit 450 000

ROI = = = 10%
invested capital 4 500 000

profit
profit
2 ROI = 15% = =
invested capital 4 500
000
Profit = 15%  4 500 000 = 675 000

Profit = sales revenue – expenses = 675 000

Profit = 9 000 000 – expenses = 675 000

Expenses = $8 325 000

Therefore, total expenses (cost of goods sold and operating expenses) must be reduced to $8 325 000 in order
to raise the firm’s ROI to 15 per cent.

profit 675 000

3 Return on sales = =
sales revenue 9 000 000
Return on sales = 7.5%

ROI = Return on sales  investment turnover

= 7.5%  2

= 15%

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Working Exercise Traditional (Financial) Measures of Performance

Pilot Corporation has established separate business units as investment centres and the manager’s
performance is measured using financial measures. Bonuses of up to one third of the manager’s
salaries are paid for achieving the targets as described below. The following is known about the
Alpha Division’s results:

Profit: $8 000 000

Sales revenue: $100 000 000
Invested Capital $50 000 000
Required:
a) Calculate the Return on Investment (ROI) for the Alpha Division?

ROI = Profit/Invested Capital

= $8m / $50m
= 0.16 i.e. 16%

b) Assuming Sales Revenue is ‘fixed’ by market competition, use the two

component ratios to demonstrate two ways the Alpha Division could improve
ROI, increasing it to 18%.
(Ensure you state the amount of cost cutting or capital reduction necessary and
SHOW ALL WORKINGS and calculations supporting your answer.)

If competition is high in this business then the managers will have little or no
ability to adjust selling prices without affecting sales volume therefore, the
best options are to increase profit BY DECREASING COSTS OR DECREASING the
level of INVESTED CAPITAL REQUIRED:

0.18 = New profit level / $50m

New profit level = 0.18 x $50m
= $9m
Therefore, the manager needs to find cost savings of at least $1m to achieve
the required profit of $9m to achieve an 18% ROI;

OR

0.18 = $8m / New Invested Capital Level

New Invested Capital Level = $8m / 0.18
New Invested Capital Level = $44.44m

Therefore, the manager would have to reduce the Invested Capital (by sale of
surplus assets or perhaps sale and leaseback or outsourcing and/or closing
some underperforming operations until the capital by $5.56m.

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c) Assume a 30% tax rate applied and the Alpha Division had trade creditors (which
was a ‘free finance’ source to the company) of $5 million and the Pilot Company
has a Weighted Average Cost of Capital (WACC) of 12% then:

i. Calculate the Economic Value Add (EVA)

NPAT = PBT x (1-t)

= $8m x (1 – 0.3)
= $5.6m
Capital employed = Invested capital adjusted for trade creditors
= $50m - $5m
= $45m

EVA = NPAT – (Capital Employed x WACC)

= $5.6m – ($45m x 12%)
= $5.6m - $5.4m
= $0.2m
As the EVA is GREATER than zero, the ALPHA Division is still making a
return of value to shareholders. Perhaps the manager would look to make
improvements to the EVA return but currently it is still acceptable.

ii. Recalculate the EVA if the WACC was 15%, would the performance of the
Alpha Division be acceptable or unacceptable, why, or why not?

Using the same numbers from (i) above and recalculating EVA using 15%
WACC:

EVA = NPAT – (Capital Employed x WACC)

= $5.6m – ($45m x 15%)
= $5.6m - $6.75m
= ($1.15m)
As the EVA is LESS than zero. While the WACC is at this higher level, the
ALPHA Division is no longer making a value return to shareholders as it is
not covering the current cost of capital for investments at Pilot. The
company senior management and Board needs to determine if they can
give better after-tax returns, use less capital or dispose of close the Alpha
Division is this is not possible in the foreseeable future.

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