HBC223 Analysis for Competitive Advantage

Tutorial Topic 3
FINANCIAL PERFORMANCE MEASURES
& REWARD SYSTEMS

13.2 It is useful to examine both components of ROI because they provide additional
insights that can be used to interpret and to improve future ROI. For example, when
comparing ROI over several years examining the two components of ROI can assist
in identifying whether a decreasing ROI is due to a reduction in return on sales or a
reduction in investment turnover. If the reason is a poor return on sales, this can lead
to a search for reasons why profitability has decreased and the formulation of
strategies to improve return on sales and hence improve future ROI.

13.11 ROI or residual income rises over the life of a project, because the carrying amount
of the assets decreases due to accumulated yearly depreciation. This can be avoided
by using the acquisition costs of the assets, not the carrying amount, as the invested
capital in the ROI or residual income calculations.

13.21 Motivation arises from the processes that account for an individual’s intensity,
direction and persistence of effort in attaining goals. Extrinsic motivation may arise
from rewards provided to employees from an external source. This might include a
cash bonus, tickets to a ball game and a holiday. Intrinsic motivation may arise from
the positive experiences of being satisfied with performing well. It can arise when
employees experience the following:
• Choice The employee has the opportunity to select activities that make sense and
to perform these in ways that seem appropriate.
• Competence The accomplishment that follows when activities that have been
chosen by the employee are skilfully performed.
• Meaningfulness The opportunity to pursue a worthy task, which matters in the
larger scheme of things.
• Progress Employees feel that they have made significant advancement in
achieving the task’s purpose.

13.27 The advantages of group-based performance rewards include promoting a team

atmosphere, equality among employees and a reduced focus on competitiveness
between employees. However group-based rewards can reward some employees that
are not contributing positively to the group’s performance. The advantages of
individual-based rewards include: rewarding only those employees that perform well
and there is a clear link between the good behaviour and the reward. As to which
works best depends on a variety of factors including the nature of the team-based
task, existing relationships within the team, and the timing of the recognition and
payment of the reward.

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PROBLEMS & EXERCISES
EXERCISE 13.31 (15 minutes) Improving ROI: manufacturer

profit 100 000*

1 Return on sales = = = 5%
sales revenue 2 000 000

* Profit = $100 000 = 2 000 000 – 1 100 000 – 800 000

sales revenue 2 000 000

Investment turnover = = = 2
invested capital 1 000 000
profit 100 000
ROI = = = 10%
invested capital 1 000 000

profit profit
2 ROI = 15% = =
invested capital 1 000 000
Profit = 15% × 1 000 000 = 150 000
Profit = sales revenue – expenses = 150 000
Profit = 2 000 000 – expenses = 150 000
Expenses = $1 850 000

Therefore, total expenses (cost of goods sold and operating expenses) must be reduced to $1 850 000 in order
to raise the firm’s ROI to 15 per cent.

profit 150 000

3 Return on sales = = = 7.5%
sales revenue 2 000 000
ROI = Return on sales × investment turnover
= 7.5% × 2
= 15%

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EXERCISE 13.33 (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 If the firm’s required rate of return is 10 per cent, 15 per cent or 18 per cent, then the dressmaking
division has a higher residual income than furnishing.
(a) Imputed interest rate of 10 per cent:
Furnishing Dressmaking
________________________________________________________________________________
___________________________________________________________________________
Divisional profit $2 700 000 $600 000
Less: Imputed interest charge:
Furnishing: $18 000 000 × 10% 1 800 000
Dressmaking: $3 000 000 × 10% 300 000
Residual income $900 000 $300 000

(b) Imputed interest rate of 15 per cent:

__________________________________________________________________________
Divisional profit $2 700 000 $600 000
Less: Imputed interest charge:
Furnishing: $18 000 000 × 15% 2 700 000
Dressmaking: $3 000 000 × 15% 450 000
Residual income $0 $150 000
(c) Imputed interest rate of 18 per cent:

________________________________________________________________________________
Divisional profit $2 700 000 $600 000
Less: Imputed interest charge:
Furnishing: $18 000 000 × 18% 3 240 000
Dressmaking: $3 000 000 × 18% 540 000
Residual income $(540 000) $60 000

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EXERCISE 13.35 (25 minutes) ROI and EVA®: service firm

Equipment Rental Truck Rental

Division Division
1 ROI Invested capital ($375 000 – 40 000) = $335 000 ($1 500 000 – 125 000) = $1 375 000
ROI $22 500 / $335 000 $55 000 / $1 375 000
= 0.0672 or 6.72% = 0.04 or 4.0%

2 EVA® $22 500 – ($335 000 × 0.08) $55 000 – ($1 375 000 × 0.08)
$22 500 – 26 800 $55 000 – 110 000
$(4 300) $(55 500)
3 The Equipment Rental Division (ERD) has performed better then the Truck Rental Division (TRD)
under both measures. TRD has a much higher profit figure, but when the invested capital is brought
into consideration, the high investment base of TRD leads to a lower ROI. TRD’s profit of $55 000 is
2.44 times that of ERD ($22 500), whereas TRD’s invested capital of $1 375 000 is 4.1 times that of
the $335 000 invested in ERD. The ROI for both divisions is less than the WACC of 8%.
Both divisions have a negative EVA®. This indicates that the weighted average cost of capital of 8 per
cent is greater than the rate of the return calculated under ROI for both divisions.
While at this stage ERD is the better-performing division, the firm would gain better insight into the
performance of each division if comparisons were made with other firms in the same business. At the
same time, TRD may have invested large amounts of capital in the short term with a view to improving
long term performance and this highlights the dangers of single-period measurements.

EXERCISE 13.36 (25 minutes) Performance measurement and reward systems

1 False. Expectancy theory does not relate motivation to hygiene factors and motivators. It states that
employee motivation is a function of the strength of expectancy (effort leads to performance),
instrumentality (performance leads to rewards) and valency (rewards lead to personal goals). On the
other hand, Herzberg’s theory argued that hygiene factors provide the necessary setting for motivation,
but do not themselves motivate employees. However, employees need a certain level of hygiene
factors to prevent dissatisfaction. Motivators are said to provide motivation.
2 False. Not necessarily. Many incentive schemes are based on both individual and group efforts.
Providing rewards for individual performance has both advantages and disadvantages over providing
group rewards for team performance. For example, when basing rewards on individual performance it
may be difficult to determine the effects of individual actions on group or company performance.
However, the “free rider” problem associated with group reward schemes does not exist for individual
reward schemes.
3 True. It seems that many performance-related pay systems are not closely linked to an effective
performance measurement system, and so may not encourage improved performance. See the ‘Real
Life’ information on page 667 in the text for more discussion on this issue.
4 Perhaps. The employee share plans may award shares to employees based on team-level or individual
performance. Individual reward systems may work better at senior levels as these managers may be in
a better position to take actions that can be directly measured, so it may be easier to design measures
that reflect an individual’s performance.

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PROBLEM 13.40 (30 minutes) ROI; EVA®: manufacturer

1 The calculation of the divisional contribution margin for Reigis Steel Division, assuming 1 484 000
units were produced and sold during the year, is as follows:
Reigis Steel Division
Divisional contribution margin
for the year ended December 31
(in thousands)
Sales $25 000
Less: Variable costs:
Cost of goods sold $16 500
Selling costs ($2700 × 40%) 1 080 17 580
Contribution margin $ 7 420

2 Calculations of selected performance measures for 2006 for Reigis Steel Division are as follows:
(a) After-tax return on investment is 8.4 per cent:
ROI = profit from operations after taxes ÷ average total assets
= (1 845 000 x 0.70) ÷ 15 375 000
= $1 291 500 ÷ $15 375 000*
= 0.084 or 8.4%
* Average total assets:
($15 750 000 + $15 000 000†) ÷ 2 = $15 375 000
† previous year December 31, total assets:
$15 750 000 ÷ 1.05 = $15 000 000
(b) Economic value added, calculated as follows:
Divisional profit after tax $1 291 500
Less: Imputed interest charge:
Invested capital $15 375 000
× Imputed interest rate × .10
Imputed interest charge 1 537 500
Economic value added ($246 000)
3 Assuming that the 11.5 per cent ROI referred to in the question relates to after-tax ROI, the
management of the Reigis Steel Division would have been likely to accept the project whichever
method of performance measure had been used. The investment would have increased both the
division’s EVA® and ROI, and hence, management’s bonuses. Using EVA®, management would
accept all investments with a return higher than 10 per cent, since these investments would increase the
dollar value of EVA®. When using ROI as a performance measure, Reigis’ management is likely to
reject any investment that would lower the overall ROI (8.4 per cent), even though the return may be
higher than the required minimum, since this would lower bonus awards. In this case, a project with an
after-tax ROI of 11 per cent would increase the overall ROI and increase bonus rewards.
4 Reigis management must be able to control all items related to profit and investment if it is to be
evaluated fairly as an investment centre using either ROI or EVA® as a performance measure. Reigis
management must control all elements of the business except the cost of acquiring capital, which
would be controlled by Raddington Industries.
5 Unit contribution margin = total divisional contribution margin ÷ unit sales
= $7 420 000 ÷ 1 484 000 units = $5 per unit.
The advantage of using the divisional contribution margin is that it measures the total contribution of
the Reigis Steel Division toward covering the fixed costs and profit of Raddington Industries. The
disadvantage is that this measure is not related in any way to the assets invested in the division. The
advantage of using the unit contribution margin is that it provides a gauge of the cost control,
efficiency, and marketing effectiveness of Reigis Steel Division in generating a positive contribution
per unit sold. The per unit measure does not, however, show the overall magnitude of the Reigis Steel
Division’s contribution toward covering Raddington’s fixed costs and profit.

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SELF STUDY PROBLEMS & EXERCISES

EXERCISE 13.30 (20 minutes) Components of ROI; improving ROI; residual income:
retailer

profit $8 000 000

1 Return on sales = = = 8%
sales revenue $100 000 000
sales revenue
Investment turnover = =
invested capital
$100 000 000
= 2.5
$40 000 000
profit
Return on investment = =
invested capital
$8 000 000
= 20%
$40 000 000
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 $10 000 000:
ROI = return on sales × investment turnover
$10 000 000 $100 000 000
= ×
$100 000 000 $40 000 000
= 10% × 2.5 = 25%
Since sales revenue remains unchanged, this implies a cost reduction of $2 000 000 at the same
volume.
(b) Improve the investment turnover to 3.125 by decreasing average invested capital to
$32 000 000:
ROI = return on sales × investment turnover
$8 000 000 $100 000 000
= ×
$100 000 000 $32 000 000
= 8% × 3.125 = 25%
Since sales revenue remains unchanged, this implies that the firm can divest itself of some
productive assets without affecting sales volume.
3. Residual income = $8 000 000 – ($40 000 000 × 12%)
= $8 000 000 – 4 800 000
= $3 200 000

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EXERCISE 13.34 (35 minutes) Weighted average cost of capital; ROI; service firm

1 The weighted-average cost of capital (WACC) is defined as follows:

A -t c M a C o Mf x t sf oa e t ar sr k rt k e et t
 od  v +ef  v a q b al u t l ui e t e y
     
Weighted - average
cost of capital
=
 c od  ac oef  pa qf b pi ut i a ti lat y l
M M a a r rk k e e t t
v + v a a l lu u e e
od oe f e qf b u t i t y
The interest rate on the Williamstown Construction Company’s $90 million debt is 10 per cent, and
the company’s tax rate is 40 per cent. Therefore, Williamstown Construction Company’s after-tax
cost of debt is 6 per cent [10% × (1 – 40%)]. The cost of Williamstown Construction Company’s
equity capital is 15 per cent. Moreover, the market value of the company’s equity is $135 million.
The following calculation shows that Williamstown Construction Company’s WACC is 11.4 per
cent.

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 Weighted- average (.06)($90 000 000) +(.15)($135 000 000)
cost of capital = $90 000 000 +$135 000 000
=.114

2 The economic value added (EVA®) is defined as follows:

EVA® = net operating profit after tax – (capital employed x WACC)

For Williamstown Construction Company, The EVA® for the two divisions can be calculated as
follows.
After-tax Current Economic
operating Total liabilities value
profit assets added
(in (in (in (in
Division millions) millions) millions) WACC millions)
Real estate $30(1 − – [ ($150 – $9) × 0.114 ] $1.926
0.40) =
Construction $27(1 − – [ ($90 – $6) × 0.114 ] $6.624
0.40) =

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PROBLEM 13.42 (40 minutes) ROI versus residual income; incentives; bonus
schemes: manufacturer

Note: In the first printing of 5E, the two company names that are the headings for the financial data were
reversed in error. The solution below assumes that the first column of data relates to AUL and the second
column relates to FTC.
1 If New Age Industries continues to use return on investment as the sole measure of division
performance, Fun Times Company (FTC) would be reluctant to acquire Arcade Unlimited Ltd. (AUL),
because the post-acquisition combined ROI would decrease.
Return on investment
FTC AUL Combined
Operating profit $1 000 000 $300 000 $1 300 000
Total assets 4 000 000 1 500 000 5 500 000
Return on investment (profit/assets) 25% 20% 23.6%*
* Rounded.
The result would be that FTC’s management would either lose their bonuses or have their bonuses
limited to 50 per cent of the eligible amounts. The assumption is that management could provide
convincing explanations for the decline in return on investment.
2 Residual income is the profit earned that exceeds an amount charged for funds committed to a business
unit. The amount charged for funds is equal to an imputed interest rate multiplied by the business
unit’s invested capital.
If New Age Industries could be persuaded to use residual income to measure performance, FTC would
be more willing to acquire AUL, because the residual income of the combined operations would
increase.
Residual income
FTC AUL Combined
Total assets $4 000 000 $1 600 000* $5 600 000
Profit 1 000 000 300 000   1 300 000
Less: Imputed interest charge (assets × 15%) 600 000 240 000   840 000
Residual income $400 000 $60 000   $460 000
* Cost to acquire AUL.

3. The likely effect on the behaviour of division managers whose performance is measured by return on
investment includes incentives to do the following:
• Defer capital improvements or modernization to avoid undertaking capital expenditures.
• Avoid profitable opportunities or investments that would yield more than the company's cost of
capital but that could lower ROI.
If residual income were used the likely effect on the behaviour of division managers includes incentives
to do the following:
• Seek any opportunity or investment that will increase overall residual income.
• Seek to reduce the level of assets employed in the business.
EVA® could also be used to measure and reward divisional managers and that would have similar
advantages to the use of RI.