HBC223 Analysis for Competitive Advantage Tutorial Topic 3 FINANCIAL PERFORMANCE MEASURES & REWARD SYSTEMS13.2 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. 1 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. 3 Return on sales ROI = = = = profit sales revenue 7.PROBLEMS & EXERCISES EXERCISE 13.31 (15 minutes) Improving ROI: manufacturer 1 Return on sales = profit sales revenue = 100 000* 2 000 000 = 5% * Profit = $100 000 = 2 000 000 – 1 100 000 – 800 000 Investment turnover ROI = = sales revenue invested capital profit invested capital profit invested capital = = 2 000 000 1 000 000 100 000 1 000 000 profit 1 000 000 150 000 = = 2 10% 2 ROI = 15% Profit Profit Profit Expenses = = = = = = = 15% × 1 000 000 sales revenue – expenses = 150 000 2 000 000 – expenses = 150 000 $1 850 000 Therefore.5% × 2 15% = 150 000 2 000 000 = 7.5% Return on sales × investment turnover 2 . If ROI is used. Nor do we know the firm’s required rate of return. ROI may also not provide a good basis for comparison. then the dressmaking division has a higher residual income than furnishing. 15 per cent or 18 per cent. However.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. We do not know what constitutes good performance in the furnishing or the dressmaking industries. then the dressmaking division performs better than the furnishing division. If the firm’s required rate of return is 10 per cent.EXERCISE 13. as the two divisions operate in two different industries. or any ROI or profit targets that management may have set for each division. (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: 2 ________________________________________________________________________________ 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 3 . Motivators are said to provide motivation. so it may be easier to design measures that reflect an individual’s performance. While at this stage ERD is the better-performing division. Both divisions have a negative EVA®. employees need a certain level of hygiene factors to prevent dissatisfaction. instrumentality (performance leads to rewards) and valency (rewards lead to personal goals). Not necessarily. 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. At the same time.08) $22 500 – 26 800 $(4 300) Truck Rental Division ($1 500 000 – 125 000) = $1 375 000 $55 000 / $1 375 000 = 0. the high investment base of TRD leads to a lower ROI.72% $22 500 – ($335 000 × 0. The ROI for both divisions is less than the WACC of 8%.35 (25 minutes) ROI and EVA®: service firm Equipment Rental Division ($375 000 – 40 000) = $335 000 $22 500 / $335 000 = 0.1 times that of the $335 000 invested in ERD. but when the invested capital is brought into consideration. TRD has a much higher profit figure. However.0672 or 6. On the other hand. EXERCISE 13. It states that employee motivation is a function of the strength of expectancy (effort leads to performance). For example.36 (25 minutes) Performance measurement and reward systems 1 False. Many incentive schemes are based on both individual and group efforts. Perhaps.44 times that of ERD ($22 500). 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. Providing rewards for individual performance has both advantages and disadvantages over providing group rewards for team performance. the firm would gain better insight into the performance of each division if comparisons were made with other firms in the same business. True.08) $55 000 – 110 000 $(55 500) 1 ROI Invested capital ROI 2 EVA® 3 The Equipment Rental Division (ERD) has performed better then the Truck Rental Division (TRD) under both measures. when basing rewards on individual performance it may be difficult to determine the effects of individual actions on group or company performance. Expectancy theory does not relate motivation to hygiene factors and motivators. See the ‘Real Life’ information on page 667 in the text for more discussion on this issue. 2 3 4 4 . and so may not encourage improved performance.04 or 4. whereas TRD’s invested capital of $1 375 000 is 4. The employee share plans may award shares to employees based on team-level or individual performance.EXERCISE 13. the “free rider” problem associated with group reward schemes does not exist for individual reward schemes. It seems that many performance-related pay systems are not closely linked to an effective performance measurement system. Herzberg’s theory argued that hygiene factors provide the necessary setting for motivation. 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. However. TRD’s profit of $55 000 is 2.0% $55 000 – ($1 375 000 × 0. False. but do not themselves motivate employees. Using EVA®. When using ROI as a performance measure. Unit contribution margin = total divisional contribution margin ÷ unit sales = $7 420 000 ÷ 1 484 000 units = $5 per unit. total assets: $15 750 000 ÷ 1.5 per cent ROI referred to in the question relates to after-tax ROI. calculated as follows: Divisional profit after tax $1 291 500 Less: Imputed interest charge: Invested capital $15 375 000 × Imputed interest rate × . and marketing effectiveness of Reigis Steel Division in generating a positive contribution per unit sold. efficiency.084 or 8. which would be controlled by Raddington Industries.05 = $15 000 000 ($15 750 000 + $15 000 000†) ÷ 2 = $15 375 000 (b) 3 4 Economic value added. management would accept all investments with a return higher than 10 per cent. Reigis management must control all elements of the business except the cost of acquiring capital. the management of the Reigis Steel Division would have been likely to accept the project whichever method of performance measure had been used.4 per cent: ROI = profit from operations after taxes ÷ average total assets = (1 845 000 x 0.4 per cent).PROBLEM 13.10 Imputed interest charge 1 537 500 Economic value added ($246 000) Assuming that the 11. management’s bonuses. is as follows: Reigis Steel Division Divisional contribution margin for the year ended December 31 (in thousands) Sales Less: Variable costs: Cost of goods sold Selling costs ($2700 × 40%) Contribution margin 2 $25 000 $16 500 1 080 17 580 $ 7 420 Calculations of selected performance measures for 2006 for Reigis Steel Division are as follows: (a) After-tax return on investment is 8. The investment would have increased both the division’s EVA® and ROI. EVA®: manufacturer 1 The calculation of the divisional contribution margin for Reigis Steel Division. The advantage of using the unit contribution margin is that it provides a gauge of the cost control. 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. however.70) ÷ 15 375 000 = $1 291 500 ÷ $15 375 000* = 0.40 (30 minutes) ROI. The per unit measure does not. In this case. a project with an after-tax ROI of 11 per cent would increase the overall ROI and increase bonus rewards. 5 5 . show the overall magnitude of the Reigis Steel Division’s contribution toward covering Raddington’s fixed costs and profit. Reigis’ management is likely to reject any investment that would lower the overall ROI (8. The disadvantage is that this measure is not related in any way to the assets invested in the division. assuming 1 484 000 units were produced and sold during the year. and hence. even though the return may be higher than the required minimum. 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. since these investments would increase the dollar value of EVA®. since this would lower bonus awards.4% * Average total assets: † previous year December 31. this implies that the firm can divest itself of some productive assets without affecting sales volume.SELF STUDY PROBLEMS & EXERCISES EXERCISE 13. Residual income = $8 000 000 – ($40 000 000 × 12%) = = $8 000 000 – 4 800 000 $3 200 000 6 . this implies a cost reduction of $2 000 000 at the same volume.5 = profit invested capital profit sales revenue sales revenue invested capital = $8 000 000 = 8% $100 000 000 = $ 100 000 000 $ 000 000 40 Return on investment = 2 $ 000 000 8 = 20% $ 000 000 40 There are many ways to improve the division’s ROI to 25 per cent.125 = 25% Since sales revenue remains unchanged.5 = 25% Since sales revenue remains unchanged. ROI = (b) ROI Improve the investment turnover to 3. Here are two of them: (a) Improve the return on sales to 10 per cent by increasing profit to $10 000 000: return on sales × investment turnover $10 000 000 $100 000 000 = × $100 000 000 $40 000 000 = 10% × 2. 3.30 (20 minutes) Components of ROI. improving ROI.125 by decreasing average invested capital to = $32 000 000: return on sales × investment turnover $ 000 000 8 $ 000 000 100 = × $ 000 000 100 $ 000 000 32 = 8% × 3. residual income: retailer 1 Return on sales Investment turnover = = = 2. average cost of capital = 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 c od ac 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. service firm 1 The weighted-average cost of capital (WACC) is defined as follows: Weighted . the market value of the company’s equity is $135 million. Therefore. and the company’s tax rate is 40 per cent. The cost of Williamstown Construction Company’s equity capital is 15 per cent.4 per cent.34 (35 minutes) Weighted average cost of capital. ROI.EXERCISE 13. The following calculation shows that Williamstown Construction Company’s WACC is 11. Moreover. 7 . Williamstown Construction Company’s after-tax cost of debt is 6 per cent [10% × (1 – 40%)]. 40) 8 .114 ] $1.624 × = 0.114 ] $6. The EVA® for the two divisions can be calculated as follows.40) Construction $27(1 − – [ ($90 – $6) 0.Weighted.114 cost of capital = $90 000 000 + $135 000 000 2 The economic value added (EVA®) is defined as follows: EVA® = net operating profit after tax – (capital employed x WACC) For Williamstown Construction Company.06)($90 000 000) + (.926 $30(1 − – [ ($150 – × = 0.15)($135 000 000) = . After-tax Current Economic operating Total liabilities value profit assets added (in (in (in (in Division millions) millions) millions) WACC millions) Real estate $9) 0.average (. 9 . 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. bonus schemes: manufacturer Note: In the first printing of 5E. The solution below assumes that the first column of data relates to AUL and the second column relates to FTC.42 (40 minutes) ROI versus residual income. because the residual income of the combined operations would increase. 1 If New Age Industries continues to use return on investment as the sole measure of division performance. 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. The amount charged for funds is equal to an imputed interest rate multiplied by the business unit’s invested capital. (AUL). Seek to reduce the level of assets employed in the business. Avoid profitable opportunities or investments that would yield more than the company's cost of capital but that could lower ROI.6%* * Rounded. EVA® could also be used to measure and reward divisional managers and that would have similar advantages to the use of RI.PROBLEM 13. 2 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. FTC $4 000 000 1 000 000 600 000 $400 000 Residual income AUL $1 600 000* 300 000 240 000 $60 000 Combined $5 600 000 1 300 000 840 000 $460 000 Total assets Profit Less: Imputed interest charge (assets × 15%) Residual income * Cost to acquire AUL. The assumption is that management could provide convincing explanations for the decline in return on investment. because the post-acquisition combined ROI would decrease. Residual income is the profit earned that exceeds an amount charged for funds committed to a business unit. 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. If New Age Industries could be persuaded to use residual income to measure performance. 3. incentives. the two company names that are the headings for the financial data were reversed in error. Fun Times Company (FTC) would be reluctant to acquire Arcade Unlimited Ltd. FTC would be more willing to acquire AUL.