Exercise 23-18 ROI and RIGiven:The Outdoor Sports Company produces a wide variety of outdoor sports equipment.Its newest division, Golf Technology, manufactures and sells a single product, AccuDriver,a golf club that uses global positioning satellite technology to improve the accuracy ofgolfers' shots. The demand for AccuDriver is relatively insensitive to price changes.The following data are available for Golf Technology, which is an investment center forOutdoor Sports:

Total annual fixed costs $30,000,000 Variable cost per AccuDriver $500 Average number of AccuDrivers sold each year 150,000 Average operating assets invested in the division $48,000,000

Required:1.

ROI = Operating Income / Investment

Operating Income = (Selling Price)(Units) - (VC/Unit)(Units) - Fixed Costs

Operating Income = ($220)(150,000) - $30,000,000Operating Income = $33,000,000 - $30,000,000Operating Income = $3,000,000

ROI = $3,000,000 / $48,000,000 = 6.250%

2. If management requires an ROI of at least 25% from the division, what isthe minimum selling price that the Golf Technology Division should charge perAccuDriver club?

(Sales - TVC - TFC)/Average operating assets = ROI

(X)(150,000) - $75,000,000 - $30,000,000 = $48,000,000 (.25)150,000(X) - $75,000,000 - $30,000,000 = $12,000,000150,000(X) = $117,000,000Selling Price = $780

3. Assume that Outdoor Sports judges the performance of its investment centerson the basis of RI rather than ROI. The company's required rate of

charge per AccuDriver if the company's required rate of return is 20%?

Operating Income - Capital Charge = RI

(X)(150,000) - $75,000,000 - $30,000,000 - $9,600,000 = 0150,000(X) - $114,600,000 = 0X = $114,600,000/150,000 Selling Price = $764

Compute Golf Technology's ROI if the selling price of AccuDrivers is $720 per club.

Operating Income = ($720)(150,000) - ($500)(150,000) - $30,000,000

[(X)(150,000) - ($500)(150,000) - $30,000,000] / $48,000,000 = .25

return is 20%. What is the minimum selling price that Golf Technology should

(Sales - TVC - TFC) - (.20)(Average operating assets) = RI[(X)(150,000) - ($500)(150,000) - $30,000,000] - (.20)$48,000,000 = 0

Exercise 23-24 Multinational performance measurement, ROI, RI.Given:The Seaside Corporation manufactures similar products in the United States and Norway.The U.S. and Norwegian operations are organized as decentralized divisions. The followinginformation is available for 2012; ROI is calculated as operating income divided by totalassets:

U. S. NorwegianDivision Division

(in U.S. $) (in kroners)Operating income ? 6,840,000Total Assets $7,500,000 72,000,000ROI 9.30% ?

Both investments were made on December 31, 2011. The exchange rate at the time of

the Norwegian Kroner decreased steadily in value so that the exchange rate on December 31,

1 a. Calculate the U.S. division's operating income for 2012.

X = $697,500 $697,500

b. Calculate the Norwegian division's ROI for 2012 in kroners.

ROI = operating income/total assets9.500%

2. Top management wants to know which division earned a better ROI in 2012.What would you tell them? Explain your answer

We can not tell which division earned a better ROI because the Norwegiandivision's return may have been helped by greater inflation in Norway and a weakening kroner. Need to convert to a common currency.

U. S. Norwegian NorwegianDivision Division Division

(in U.S. $) (in kroner) (in U.S. $)Operating income $697,500 6,840,000 720,000 Total assets $7,500,000 72,000,000 8,000,000 ROI 9.30% 9.50% 9.00%Date of investment 12/31/2011 12/31/2011 12/31/2011Exchange rate 12/31/11 $1 = 9 kroner 9Exchange rate 12/31/12 $1 = 10 kroner 10Average exchange during 2012 is (9+10)/2 = 9.5 $1 = 9.5 kroner 9.5

The Norwegian Division's ROI based on kroners is helped by the inflation thatoccurs in Norway in 2012 (that caused the Norwegian kroner to weaken againstthe dollar from 9 kroners = $1 on 12-31-2011 to 10 kroners =$1 on 12-31-2012).Inflation boosts the division's operating income. Since the assets are acquiredat the start of the year 2012, the asset values are not increased by the inflationthat occurs during the year. The net effect of inflation on ROI calculated in

Seaside's investment in Norway on December 31, 2011, was 9 kroners = $1. During 2012,

2012, is 10 kroners = $1. The average exchange rate during 2012 is (9+10)/2 = 9.5 kroners = $1.

ROI = operating income/total assets = 9.3%.093 = X/7,500,000.093(7,500,000) = X

ROI = 6,840,000/72,000,000 =

kroners is to use an inflated value for the numerator relative to the denominator.Adjusting for inflationary and currency differences negates the effects of anydifferences in inflation rates between the two countries on the calculation of ROI. After these adjustments, the U.S. Division earned a higher ROI than the Norwegian Division.

3. Which division do you think had the better RI performance? Explainyour answer. The required ROR on investment (calculated in U.S. $)is 8%. 8.0%

U. S. Norwegian NorwegianDivision Division Division

(in U.S. $) (in kroners) (in U.S. $)Operating income $697,500 6,840,000 720,000 Total assets $7,500,000 72,000,000 8,000,000 Required return 8% 8% 8%Capital charge $600,000 $5,760,000 $640,000 Residual Income $97,500 $1,080,000 $80,000 ROI 9.30% 9.50% 9.00%

On a comparable basis, after adjusting for inflationary and currencydifferences, the U.S. Division has the higher residual income.

Both the ROI and the RI measures indicate that, afterremoving the effects of any differences in inflation ratesbetween the two countries, the U.S. Division has performed better than the Norwegian Division in 2012.

Exercise 23-22 ROI, RI, EVAGiven:Performance Auto Company operates a New Car Division (that sells high performance sports cars) and a Performance Parts Division (that sells performance improvement parts for family cars). Some division financialmeasures for 2011 are as follows:

Performance Auto CompanyPerformance

New Car PartsDivision Division

Total Assets $33,000,000 $28,500,000 Current Liabilities 6,600,000 8,400,000 Operating Income 2,475,000 2,565,000 Required Return 12% 12%

1. Calculate the ROI for each division using operating income as themeasure of income and total assets as the measure of investment.

Atlantic Division:ROI = Operating income / Total assets = 7.500%

Pacific Division:ROI = Operating income / Total assets = 9.000%

2. Calculate residual income (RI) for each division using operating incomeas a measure of income and total assets minus current liabilities as ameasure of investment.

PerformanceNew Car PartsDivision Division

Operating Income $2,475,000 $2,565,000 Less capital charge $3,168,000 $2,412,000 Residual income ($693,000) $153,000

3. William Abraham, the New Car Division manager, argues that thePerformance Parts Division has "loaded up on a lot of short-termdebt" to boost its RI. Calculate an alternative RI for each divisionthat is not sensitive to the amount of short-term debt taken on bythe Performance Parts Division. Comment on the result.

PerformanceNew Car PartsDivision Division

Operating Income $2,475,000 $2,565,000 Less capital charge $3,960,000 $3,420,000 Residual income ($1,485,000) ($855,000)

Current liabilities represent funds available for use from sources otherthan stock holders. If managers have control over short term debt thenefficient use of creditor generated funds should be taken into account.This was done in question #2.

If managers do note have control of creditor generated funds then RI is best calculated as in question #3.

Note: A negative RI means that the managers were unable to generatethe desired return on invested funds.

4.

cost of capital to both divisions, because each division faces similar risks.Calculate the EVA for each division.

Calculation of weighted average cost of capitalCalculation of the after-tax cost of financing Debt Equity

Cost of equity financing 15%Cost of debt financing 10%Tax savings 4% 0%

After-tax cost of financing 6.0% 15.0%Calculation of the weighting factor

Amount of debt financing $18,000,000 Amount of equity financing 12,000,000

Total financing $30,000,000 0.6 0.4

Weighted cost of financing 3.60% 6.0%

Combined WA cost of capital 9.60%Atlantic Pacific

Calculation of EVA Division DivisionCalculation of After-tax operating income

Operating income $2,475,000 $2,565,000 Less taxes @ 40% 990,000 1,026,000

After-tax operating income $1,485,000 $1,539,000 Calculation of investment charge

Total assets $33,000,000 $28,500,000 Less current liabilities 6,600,000 8,400,000

L/T assets + working capital $26,400,000 $20,100,000 Weighted average cost of capital 9.60% 9.60%Capital investment charge $2,534,400 $1,929,600

EVA ($1,049,400) ($390,600)

Note: EVA is preferred for two reasons:

1. It is a residual income type of measure and does not have the dysfunctionaleffects of ROI-based measures. (ROI as a performance evaluation measurecreates incentives for managers to reject projects that increase the value ofthe firm simply because they may reduce the overall ROI of the division.)

2. EVA calculations incorporate tax effects that are costs to the firm. It provides an after-tax comprehensive summary of the effects of various decisions on thecompany and its shareholders.

5. Use your preceding calculations to comment on the relative performance ofeach division.

Both the residual income and the EVA calculations indicate that the Performance Parts Division is performing nominally better than the New Car Division.

The negative EVA for both divisions indicates that, on an after-tax basis, bothdivisions are destroying value -- the after-tax economic returns from both divisions

Performance Auto, whose tax rate is 40%, has two sources of funds: long-term debt with a market value of $18,000,000 and an interest rate of 10%, and equity capital with a market value of $12,000,000 at a cost ofequity of 15%. Performance Auto applies the same weighted-average

are less than the required returns.

Exercise 23-32Given:Global Event Group has two major divisions: Print and Internet.Summary financial data (in millions) for 2011 and 2012 are as follows:

Operating Income Revenues Total Assets2011 2012 2011 2012 2011 2012

Print $3,740 $6,120 $18,300 $20,400 $18,650 $24,000 Internet 565 780 25,900 30,000 11,200 12,000

The two division managers' annual bonuses are based on division ROI (definedas operating income divided by total assets). If a division reports an increase inROI from the prior year, its management is automatically eligible for a bonus. Themanagement of a division reporting a decline in ROI has to present an explanationto the Global Event Group board and is unlikely to get any bonus.

million in a new computerized news reporting and printing system. It is estimated that thenew system's state-of-the-art graphics and ability to quickly incorporate late-breaking news

1. Use the DuPont method of profitability analysis to explain differences in 2012ROIs between the two divisions. Use 2012 total assets as the investment base.

Profit Investment

Margin Turnover ROI

OI Revenue OI

Revenue TA TA

For 2012:Print 30.00% 0.85 25.50% 25.50%Internet 2.60% 2.50 6.50% 6.50%

For 2011: (not required)Print 20.44% 0.98 20.05% 20.05%Internet 2.18% 2.31 5.04% 5.04%

2012 Results:The Print Division has a relatively high ROI because of its high income margin.

The Internet Division has a low ROI because of its very low income margin(despite having a high investment turnover ratio).

2. Why might Mays be less than enthusiastic about accepting the investment proposalfor the new system, despite her belief in the benefits of the new technology?

ROI2012 ROI before investment proposal 25.50%ROI for investment proposal 15.00%2012 ROI with investment proposal 25.10%

Given the existing bonus plan, any proposal that reduces divisional ROIis unattractive.

Carol Mays, manager of the Print Division, is considering a proposal to invest $960

into papers will increase 2013 division operating income by $144 million. Global EventGroup uses a 12% required rate of return on investment for each division.

3. Chris Moreno, CEO of Global Event Group, is considering a proposal to basedivision executive compensation at each division on division RI. a. Compute the 2012 RI for each division. 12%

Capital DivisionalOperating Charge Residual

Income IncomePrint $6,120 ($2,880) $3,240 Internet 780 (1,440) (660)

b. Would adoption of an RI measure reduce Mays (Print Division manager)reluctance to adopt the new computerized system investment proposal?

Capital DivisionalOperating Charge Residual

Newspapers Income IncomePre-Investment RI $6,120 ($2,880.00) $3,240.00 Investment Proposal $144 ($115.20) $28.80 Post-Investment RI $6,264 ($2,995.20) $3,268.80

Investing in the new computerized system will increase the Print Division's RI.As a result, if Mays is evaluated using a RI measure, Mays would be favorablyinclined to adopting the new proposal.

4. Moreno is concerned that the focus on annual ROI could have an adverselong-run effect on Global Event Group's customers. What other measurementsdo you recommend that Moreno use? Explain.

Moreno could consider using RI which motivates managers to accept anyproject that makes a positive contribution to net income after the cost of theinvested capital is taken into account. Making such investments will have apositive effect on Global Event Group's customers.

Turner may also want to consider nonfinancial measures such asnewspaper subscription levelsinternet audience sizerepeat purchase patternsmarket share data

These measures will require managers to invest in areas that have favorablelong-run effects on Global Event Group's customers.

Exercise 23-33Given:Chris Moreno seeks your advice on revising the existing bonus plan for divisionmanagers of the Global Event Group. Assume division managers do not like bearingrisk. Moreno is considering three ideas.

a. Make each division manager's compensation depend on division RI.b. Make each division manager's compensation depend on company-wide RI.c. Use benchmarking, and compensate division managers on the basis of their

division's RI minus the RI of the other divisions.

at 12%

at 12%

1. Evaluate the three ideas Moreno has put forth using performance-evaluationconcepts described in this chapter. Indicate the positive and negative featuresof each proposal.

Make each division manager's compensation depend on division RI.

Positive FeaturesThe benefit of this compensation plan is that managers would be motivated to put in extra effort to increase divisional RI because managers' rewardswould increase with increases in divisional RI.

Negative FeaturesCompensating managers largely on the basis of RI subjects the managersto excessive risk, because each division's RI depends not only on the manager's effort but also on random factors over which the manager has nocontrol. A manager may put in a great deal of effort, but the division's RImay be low because of adverse factors (high interest, recession) that themanager cannot control.

To compensate managers for taking on this uncontrollable risk, Moreno mustpay them additional amounts within the structure of the RI-based plan. Thus,using mainly performance-based incentives will cost Moreno more money, onaverage, than paying a flat salary. The key question is whether the benefitsof motivating additional effort justify the higher costs of performance-basedrewards.

in compensation plans is to balance the benefits of incentives against theextra costs of imposing uncontrollable risk on the manager.

Finally, rewarding a manager only on the basis of division RI will induce managers to maximize the division's RI even if taking such actions are not in the best interests of the company as a whole. For example, accepting high risk projects.

Make each division manager's compensation depend on companywide RI.

Positive FeaturesRewarding managers on the basis of companywide RI will motivatemanagers to take actions that are in the best interests of the companyrather than actions that maximize a division's RI.

Negative FeaturesEach division manager's compensation will depend not only on the performance

Hence, compensating managers on the basis of companywide RI will imposeextra risk on each division manager, and will raise the cost of compensating them,on average.

Use benchmarking, and compensate division managers on the basis of theirdivision's RI minus the RI of the other divisions.

Positive FeaturesThe benefit of benchmarking or relative performance evaluation is to cancel

The motivation for having some salary and some performance-based bonus

of that division manager but on the performance of the other division managers.

out the effects of common noncontrollable factors that affect a performance measure. Taking out the effects of these factors provides better information about a manager's performance.

Negative FeaturesFor benchmarking or relative performance evaluation to be effective, it iscritical that similar noncontrollable factors affect each division. It is not clear that the same noncontrollable factors that affect the performance of thePrint Division (cost of newsprint paper, for example) also affect the

the same, then comparing the RI of one division to the RI of the other divisionwill not provide useful information for relative performance evaluation.

Also, benchmarking one division against another means that a divisionmanager will look good by improving his or her own performance, or by making the performance of the other division managers look bad.

2. Moreno is concerned that the pressure for short-run performance may causemanagers to cut corners. What systems might Moreno introduce to avoid thisproblem? Explain.

Using measures like RI and ROI -- diagnostic levers of control -- can cause managersto cut corners and take other actions that boost short-run performance but harm thecompany in the long run.

Moreno can guard against such problems by introducing and upholding strong

and codes of conduct expected of all employees, especially actions that areoff limits.

norms of behaviors, and core values of a company intended to inspiremanagers and other employees to do their best.

3. Moreno is also concerned that the pressure for short-run performance mightcause managers to ignore emerging threats and opportunities. What systemsmight Moreno introduce to avoid this problem? Explain.

might cause a myopic disregard for emerging threats and opportunities.

variables that help managers track progress toward achieving a company's

strategic goals. Managers are held accountable for meeting these goals.

focus organizations attention and learning on key strategic issues.

Moreno should not only ask for regular reports on ROI, RI, etc., he should meetregularly with division managers, discuss 5- and 10-year strategic plans, and

performance of the Internet division. If the noncontrollable factors are not

boundary and belief systems of control within the company.

Boundary systems: A method of control that describes standards of behavior

Belief systems: A method of control that articulates the mission, purpose,

Excessive focus on diagnostic control system measures such as ROI, RI, and NI

Diagnostic control system: A lever of control that monitors critical performance

This concern can be minimized with interactive control systems.

Interactive control systems: Formal information systems that managers use to

obtain their field-based inputs. Such regular dialogues will help surface emerging threats and opportunities, and allows for the development of actionplans that need to be taken in response.

Exercise 23-28Given:Nature's Elixir Corporation operates three divisions that process and bottle natural fruit juices.The historical-cost accounting system reports the following information for 2011:

Financial Report Information for 2011 Passion Kiwi Mango(Historical Cost Information) Fruit Fruit Fruit

Division Division DivisionRevenues $1,000,000 $1,400,000 $2,200,000 Operating costs (other than depreciation) $600,000 $760,000 $1,200,000 Plant Depreciation 140,000 200,000 240,000 Total operating costs $740,000 $960,000 $1,440,000 Operating Income $260,000 $440,000 $760,000

Assets:Current assets (expressed in 2011 $) $400,000 $500,000 $600,000 Long-term assets 280,000 1,800,000 2,640,000

Total assets $680,000 $2,300,000 $3,240,000

Age of plant at the end of 2011 (in years) 10 3 1 Built in (at the end of) 2001 2008 2010

disposal value. The straight-line depreciation method is used.

An index of construction costs for the 10-year period that Nature's Elixir has beenoperating (2001 year-end = 100) is

Year 2001 2008 2010 2011Index 100 136 160 170

Given the high turnover of current assets, management believes that the historical-costand current-cost measures of current assets are approximately the same.

Required:1. Compute the ROI ratio (operating income to total assets) of each division using

historical-cost measures. Comment on the results.Passion Kiwi Mango

Fruit Fruit FruitCalculation of Historical Cost ROI Division Division Division

Operating income $260,000 $440,000 $760,000 Total assets $680,000 $2,300,000 $3,240,000

ROI 38.235% 19.130% 23.457%

The Passion Fruit Division appears to be considerably more efficient than the KiwiFruit and Mango Fruit Divisions at using investment dollars to generate operatingoperating income.

2. Use the approach in Exhibit 23-2 (pg. 817) to compute the ROI of each division,incorporating current-cost estimates as of 2011 for depreciation and long-termassets. Comment on the results.

Nature's Elixir estimates the useful life of each plant to be 12 years, with a $0 terminal

gross book value at current cost as of the end of 2011.

The original costs of the plants (gross book values) under historical costs arecalculated as the useful life of each plant times the straight-line depreciation.

Passion Kiwi MangoFruit Fruit Fruit

Division Division DivisionStraight-line depreciation $140,000 $200,000 $240,000 Useful life of plant 12 12 12 Gross book values -- historical cost $1,680,000 $2,400,000 $2,880,000

Construction cost index (CI) in 2011 170 170 170

Construction CI in year of construction 100 136 160

Gross book values -- current cost (2011 $) $2,856,000 $3,000,000 $3,060,000

of 2011.

Gross book values -- current cost $2,856,000 $3,000,000 $3,060,000

Estimated useful life remaining 2 9 11

Estimated total useful life 12 12 12

NBV of L/T assets at current costs as of the end of 2011 $476,000 $2,250,000 $2,805,000

NBV of L/T assets at current costs as of the end of 2011 $476,000 $2,250,000 $2,805,000 Current assets at the end of 2011 (given) 400,000 500,000 600,000 Current costs of total assets in 2011 $876,000 $2,750,000 $3,405,000

Gross book values -- current cost $2,856,000 $3,000,000 $3,060,000 Useful life of plant 12 12 12Current-cost depreciation exp. in 2011 $ $238,000 $250,000 $255,000

Historical-cost operating income $260,000 $440,000 $760,000 Historical-cost depreciation expense 140,000 200,000 240,000 Historical-cost OI before depreciation exp. $400,000 $640,000 $1,000,000 Current-cost depreciation exp. in 2011 $ 238,000 250,000 255,000 OI using 2011 current-cost depreciation $162,000 $390,000 $745,000

depreciation.

OI using 2011 current-cost depreciation $162,000 $390,000 $745,000

Step 1: Restate long-term assets from gross book value at historical cost to

Step 2: Derive net book value of long-term assets at current costs as of the end

Step 3: Compute current cost of total assets in 2011.

Step 4: Compute current-cost depreciation expense in 2011 dollars.

Step 5: Compute 2011 operating income using 2011 current-cost depreciation.

Step 6: Compute ROI using current-cost estimates for long-term assets and

Current costs of total assets in 2011 $876,000 $2,750,000 $3,405,000

ROI using current-cost estimates for L/Tassets and depreciation. 18.493% 14.182% 21.880%

Comment on the results. Passion Kiwi MangoFruit Fruit Fruit

Division Division DivisionROI using current-cost estimates for L/Tassets and depreciation. 18.493% 14.182% 21.880%ROI -- Historical cost 38.235% 19.130% 23.457%

Use of current cost, results in the Mango Fruit Division appearing to be the mostefficient. The Passion Fruit Division's ROI is reduced substantially when the 10year old plant is restated for the 70% increase in construction costs over the 2001to 2011 period.

3. What advantages might arise from using current-cost asset measures as comparedwith historical-cost measures for evaluating the performance of the managers of thethree divisions?

Use of current costs increases the comparability of ROI measures across divisions'operating plants built at different construction cost price levels. Use of current costalso will increase the willingness of managers, evaluated on the basis of ROI, to movefrom divisions with assets purchased many years ago to divisions with assets purchasedin recent years.

Exercise 23-20 Financial and nonfinancial performance measures, goal congruence. (CMA)Given:Summit Equipment specializes in the manufacture of medical equipment, a field that has becomeincreasingly competitive. Approximately two years ago, Ben Harrington, president of Summit,decided to revise the bonus plan (based, at the time, entirely on operating income) to encourage division managers to focus on areas that were important to customers and that added valuewithout increasing costs. In addition to a profitability incentive, the revised plan includes incentivesfor reduced rework cost, reduced sales returns, and on-time deliveries. Bonuses are calculatedand awarded semiannually on the following bases.

Adjustments:Rework

On-time Deliveries

Sales Returns

Note: If the calculation of the bonus results in a negative amount for a particular period, themanager simply receives no bonus, and the negative amount is not carried forward to the next period.

Results for Summit's Charter Division and Mesa Division for 2012, the first year under the newbonus plan, follow:

Charter Division Mesa DivisionFrom 1/1/2012 7/1/2012 1/1/2012 7/1/2012To 6/30/2012 12/31/2012 6/30/2012 12/31/2012

Revenues $4,200,000 $4,400,000 $2,850,000 $2,900,000 Operating income $462,000 $440,000 $342,000 $406,000 On-time delivery 95.4% 97.3% 98.2% 94.6%Rework costs $11,500 $11,000 $6,000 $8,000 Sales returns $84,000 $70,000 $44,750 $42,500

1. Why did Harrington need to introduce these new performance measures?That is, why does Harrington need to use these performance measures inaddition to the operating-income numbers for the period?

Competition!

Operating income is a good summary measure of short-term financial performance. Byitself, however, it does not indicate whether operating income in the short run was earned bytaking actions that would lead to long-term competitive advantage. For instance, qualitycould be ignored.

rewarding managers on the basis of direct quality measures (such as rework, on-time delivery,

Base bonus is calculated at 2% of operating income.

Reduced by excess of rework costs over and above 2% of operating income.No adjustment if rework costs are less than or equal to 2% of operating income.

Increased by $5,000 if more than 98% of deliveries are on time, and by $2,000 if 96% to98% of deliveries are on time.No adjustment if on-time deliveries are below 96%.

Increased by $3,000 if sales returns are less than or equal to 1.5% of sales.Decreased by 50% of excess of sales returns over 1.5% of sales.

In 2011, under the old bonus plan, the Charter Division manager earned a bonus of $27,060 andthe Mesa Division manager, a bonus of $22,440.

The new performance measures take a balanced scorecard approach by evaluating and

and sales returns). The new bonus plan should motivate managers to take actions thatHarrington believes will increase operating income now and in the future.

2. Calculate the bonus earned by each manager for each 6-month period for 2012.

Charter Division Mesa DivisionFrom 1/1/2012 7/1/2012 1/1/2012 7/1/2012To 6/30/2012 12/31/2012 6/30/2012 12/31/2012

Revenues $4,200,000 $4,400,000 $2,850,000 $2,900,000 Operating income $462,000 $440,000 $342,000 $406,000 On-time delivery 95.4% 97.3% 98.2% 94.6%Rework costs $11,500 $11,000 $6,000 $8,000 Sales returns $84,000 $70,000 $44,750 $42,500

Charter Division Mesa DivisionFrom 1/1/2012 7/1/2012 1/1/2012 7/1/2012To 6/30/2012 12/31/2012 6/30/2012 12/31/2012

Base Bonus (2% of OI) $9,240 $8,800 $6,840 $8,120 Adjustments

Rework

Rework $ $11,500 $11,000 $6,000 $8,000 2% of OI 9,240 8,800 6,840 8,120 Excess $2,260 $2,200 ($840) ($120)Adjustment ($2,260) ($2,200) $0 $0

On-Time Deliveries $0 $2,000 $5,000 $0 Sales Returns

1.5% of Sales $63,000 $66,000 $42,750 $43,500 Returns 84,000 70,000 44,750 42,500 Difference ($21,000) ($4,000) ($2,000) $1,000

Adjustment ($10,500) ($2,000) ($1,000) $3,000 Base Bonus + Adjustments ($3,520) $6,600 $10,840 $11,120 Adjusted Bonus New Plan $0 $6,600 $10,840 $11,120

Previous Year's Bonus $27,060 $22,440

3. What effect did the change in the bonus plan have on each manager's behavior?Did the new bonus plan achieve what Harrington desired?What changes, if any, would you make to the new bonus plan?

The manager of the Charter Division is likely to be frustrated by the new plan, as thedivision bonus is more than $20,000 less than the previous year. However, the newperformance measures have begun to have the desired effect --both on-time deliveriesand sales returns improved in the second half of the year, while rework costs improvedslightly.

Bonus earned in 2011 $27,060 Bonus earned in 2012

1st half $0 2nd half 6,600 $6,600

Decreased bonus $20,460

Performance measures 1st half 2nd half Improvement

On-time delivery 95.4% 97.3% 1.9%Rework costs $11,500 $11,000 $500 Sales returns $84,000 $70,000 $14,000

Income as a % of Sales 11.00% 10.00% -1.00%

The manager of the Mesa Division should be as satisfied with the new plan as withthe old plan, as the bonus is almost equivalent. However, on-time deliveries declined considerably in the second half of the year. Rework costs also increased. Sales returns declined slightly in the second half.

Bonus earned in 2011 $22,400 Bonus earned in 2012

1st half $10,840 2nd half 11,120 $21,960

Decreased bonus $440

Performance measures 1st half 2nd half ImprovementOn-time delivery 98.2% 94.6% -3.6%Rework costs $6,000 $8,000 ($2,000)Sales returns $44,750 $42,500 $2,250

Income as a % of Sales 12.00% 14.00% 2.00%

Overall evaluation of bonus plan: Needs improvementSending mixed messages

Suggestions for improvement:

1. Increasing the weights put on on-time deliveries, rework costs, and salesreturns performance measures while decreasing the weight put on operatingincome.

2. A reward structure for rework costs that are below 2% of operating incomewould encourage managers to drive costs lower.

3. The bonus plan should carry forward the negative amounts for one 6-month period into the next 6-month period.

4. Developing benchmarks, and then giving rewards for improvements over priorperiods and encouraging continuous improvement.

5. Change absolute dollar adjustments to % adjustments. Prevents meet and hold tactics.

Exercise 23-21Given:Potomac Electric Company

Geographical Profit CentersAtlantic PacificDivision Division

Total Assets $1,000,000 $5,000,000 Current Liabilities 250,000 1,500,000 Operating Income 200,000 750,000

1. Calculate the ROI for each division using operating income as themeasure of income and total assets as the measure of investment.

Atlantic Division:ROI = Operating income / Total assets = 20%

Pacific Division:ROI = Operating income / Total assets = 15%

2. Potomic Electric Company has used RI as a measure of managementperformance, the variable it wants a manager to maximize. What isthe RI for each division using operating income as the measure of incomeand total assets as the measure of investment? Assume that the required

Atlantic Division:$80,000

Pacific Division:$150,000

3. Potomic Electric has two sources of funds: long-term debt with a market

to both divisions, because each division faces similar risks. Calculate theEVA for each division.

Calculation of weighted average cost of capitalCalculation of the after-tax cost of financing Debt Equity

Cost of equity financing 14%Cost of debt financing 10%Tax savings 4% 0%

After-tax cost of financing 6% 14%Calculation of the weighting factor

Amount of debt financing $3,500,000 Amount of equity financing 3,500,000

Total financing $7,000,000 0.5 0.5

Weighted cost of financing 3% 7%

Combined WA cost of capital 10%Atlantic Pacific

Calculation of EVA Division DivisionCalculation of After-tax operating income

rate of return on investment is 12%.

RI = Operating Income - Capital charge @ 12% =

RI = Operating Income - Capital charge @ 12% =

value of $3,500,000 and an interest rate of 10%, and equity capital witha market value of $3,500,000 at a cost of equity of 14%. Potomic's incometax rate is 40%. Potomic applies the same weighted-average cost of capital

Operating income $200,000 $750,000 Less taxes @ 40% 80,000 300,000

After-tax operating income $120,000 $450,000 Calculation of investment charge

Total assets $1,000,000 $5,000,000 Less current liabilities 250,000 1,500,000

L/T assets + working capital $750,000 $3,500,000 Weighted average cost of capital 10% 10%Capital investment charge $75,000 $350,000

EVA $45,000 $100,000

Which of the measures in requirements 1, 2, and 3 would you recommendPotomic Electric use? Why?

EVA is preferred for two reasons:

It is a residual income type of measure and does not have the dysfunctionaleffects of ROI-based measures. (ROI as a performance evaluation measurecreates incentives for managers to reject projects that increase the value ofthe firm simply because they may reduce the overall ROI of the division.)

EVA calculations incorporate tax effects that are costs to the firm. It provides an after-tax comprehensive summary of the effects of various decisions on thecompany and its shareholders.