Exercise 23-18 ROI and RI

Given:
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 of
golfers' shots. The demand for AccuDriver is relatively insensitive to price changes.
The following data are available for Golf Technology, which is an investment center for
Outdoor Sports:
Total annual fixed costs
Variable cost per AccuDriver
Average number of AccuDrivers sold each year
Average operating assets invested in the division

$30,000,000
$500
150,000
$48,000,000

Required:
1. Compute Golf Technology's ROI if the selling price of AccuDrivers is $720 per club.
ROI = Operating Income / Investment
Operating Income = (Selling Price)(Units) - (VC/Unit)(Units) - Fixed Costs
Operating Income = ($720)(150,000) - ($500)(150,000) - $30,000,000
Operating Income = ($220)(150,000) - $30,000,000
Operating Income = $33,000,000 - $30,000,000
Operating 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 is

the minimum selling price that the Golf Technology Division should charge per
AccuDriver club?
(Sales - TVC - TFC)/Average operating assets = ROI
[(X)(150,000) - ($500)(150,000) - $30,000,000] / $48,000,000 = .25
(X)(150,000) - $75,000,000 - $30,000,000 = $48,000,000 (.25)
150,000(X) - $75,000,000 - $30,000,000 = $12,000,000
150,000(X) = $117,000,000
Selling Price = $780
3. Assume that Outdoor Sports judges the performance of its investment centers
on the basis of RI rather than ROI. The company's required rate of
return is 20%. What is the minimum selling price that Golf Technology should
charge per AccuDriver if the company's required rate of return is 20%?
Operating Income - Capital Charge = RI
(Sales - TVC - TFC) - (.20)(Average operating assets) = RI
[(X)(150,000) - ($500)(150,000) - $30,000,000] - (.20)$48,000,000 = 0
(X)(150,000) - $75,000,000 - $30,000,000 - $9,600,000 = 0
150,000(X) - $114,600,000 = 0
X = $114,600,000/150,000
Selling Price = $764

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 following
information is available for 2012; ROI is calculated as operating income divided by total
assets:
U. S.
Norwegian
Division
Division
(in U.S. $)
(in kroners)
Operating income
?
6,840,000
Total Assets
$7,500,000
72,000,000
ROI
9.30%
?
Both investments were made on December 31, 2011. The exchange rate at the time of
Seaside's investment in Norway on December 31, 2011, was 9 kroners = $1. During 2012,
the Norwegian Kroner decreased steadily in value so that the exchange rate on December 31,
2012, is 10 kroners = $1. The average exchange rate during 2012 is (9+10)/2 = 9.5 kroners = $1.
1 a. Calculate the U.S. division's operating income for 2012.
ROI = operating income/total assets = 9.3%
.093 = X/7,500,000
.093(7,500,000) = X
X = $697,500
$697,500
b. Calculate the Norwegian division's ROI for 2012 in kroners.
ROI = operating income/total assets
ROI = 6,840,000/72,000,000 =

9.500%

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 Norwegian
division's return may have been helped by greater inflation in Norway and a
weakening kroner. Need to convert to a common currency.
U. S.
Division
(in U.S. $)
$697,500
$7,500,000
9.30%
12/31/2011

Norwegian
Norwegian
Division
Division
(in kroner)
(in U.S. $)
Operating income
6,840,000
720,000
Total assets
72,000,000
8,000,000
ROI
9.50%
9.00%
Date of investment
12/31/2011
12/31/2011
Exchange rate 12/31/11
$1 = 9 kroner
Exchange rate 12/31/12
$1 = 10 kroner
Average exchange during 2012 is (9+10)/2 = 9.5
$1 = 9.5 kroner
The Norwegian Division's ROI based on kroners is helped by the inflation that
occurs in Norway in 2012 (that caused the Norwegian kroner to weaken against
the 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 acquired
at the start of the year 2012, the asset values are not increased by the inflation
that occurs during the year. The net effect of inflation on ROI calculated in

9
10
9.5

kroners is to use an inflated value for the numerator relative to the denominator.
Adjusting for inflationary and currency differences negates the effects of any
differences 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? Explain
your answer. The required ROR on investment (calculated in U.S. $)
is 8%.
8.0%

Operating income
Total assets
Required return
Capital charge
Residual Income
ROI

U. S.
Division
(in U.S. $)
$697,500
$7,500,000
8%
$600,000
$97,500
9.30%

Norwegian
Division
(in kroners)
6,840,000
72,000,000
8%
$5,760,000
$1,080,000
9.50%

Norwegian
Division
(in U.S. $)
720,000
8,000,000
8%
$640,000
$80,000
9.00%

On a comparable basis, after adjusting for inflationary and currency

differences, the U.S. Division has the higher residual income.
Both the ROI and the RI measures indicate that, after
removing the effects of any differences in inflation rates
between the two countries, the U.S. Division has
performed better than the Norwegian Division in 2012.

Exercise 23-22 ROI, RI, EVA

Given:
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 financial
measures for 2011 are as follows:
Performance Auto Company

Total Assets
Current Liabilities
Operating Income
Required Return

New Car
Division
$33,000,000
6,600,000
2,475,000
12%

Performance
Parts
Division
$28,500,000
8,400,000
2,565,000
12%

1. Calculate the ROI for each division using operating income as the
measure 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 income
as a measure of income and total assets minus current liabilities as a
measure of investment.
Performance
New Car
Parts
Division
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 the
Performance Parts Division has "loaded up on a lot of short-term
debt" to boost its RI. Calculate an alternative RI for each division
that is not sensitive to the amount of short-term debt taken on by
the Performance Parts Division. Comment on the result.

Operating Income
Less capital charge
Residual income

New Car
Division
$2,475,000
$3,960,000
($1,485,000)

Performance
Parts
Division
$2,565,000
$3,420,000
($855,000)

Current liabilities represent funds available for use from sources other
than stock holders. If managers have control over short term debt then
efficient 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 generate

the desired return on invested funds.
4. 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 of
equity of 15%. Performance Auto applies the same weighted-average
cost of capital to both divisions, because each division faces similar risks.
Calculate the EVA for each division.
Calculation of weighted average cost of capital
Calculation of the after-tax cost of financing
Cost of equity financing
Cost of debt financing
Tax savings
After-tax cost of financing
Calculation of the weighting factor
Amount of debt financing
$18,000,000
Amount of equity financing
12,000,000
Total financing
$30,000,000
Weighted cost of financing
Combined WA cost of capital
9.60%
Calculation of EVA
Calculation of After-tax operating income
Operating income
Less taxes @ 40%
After-tax operating income
Calculation of investment charge
Total assets
Less current liabilities
L/T assets + working capital
Weighted average cost of capital
Capital investment charge
EVA

Debt

Equity
15%

10%
4%
6.0%

0%
15.0%

0.6
3.60%

0.4
6.0%

Atlantic
Division

Pacific
Division

$2,475,000
990,000
$1,485,000

$2,565,000
1,026,000
$1,539,000

$33,000,000
6,600,000
$26,400,000
9.60%
$2,534,400
($1,049,400)

$28,500,000
8,400,000
$20,100,000
9.60%
$1,929,600
($390,600)

Note: EVA is preferred for two reasons:

1. It is a residual income type of measure and does not have the dysfunctional
effects of ROI-based measures. (ROI as a performance evaluation measure
creates incentives for managers to reject projects that increase the value of
the 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 the
company and its shareholders.
5. Use your preceding calculations to comment on the relative performance of
each 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, both
divisions are destroying value -- the after-tax economic returns from both divisions

are less than the required returns.

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

Print
Internet

Operating Income
2011
2012
$3,740
$6,120
565
780

Revenues
Total Assets
2011
2012
2011
2012
$18,300
$20,400 $18,650
$24,000
25,900
30,000
11,200
12,000

The two division managers' annual bonuses are based on division ROI (defined
as operating income divided by total assets). If a division reports an increase in
ROI from the prior year, its management is automatically eligible for a bonus. The
management of a division reporting a decline in ROI has to present an explanation
to the Global Event Group board and is unlikely to get any bonus.
Carol Mays, manager of the Print Division, is considering a proposal to invest $960
million in a new computerized news reporting and printing system. It is estimated that the
new system's state-of-the-art graphics and ability to quickly incorporate late-breaking news
into papers will increase 2013 division operating income by $144 million. Global Event
Group uses a 12% required rate of return on investment for each division.
1. Use the DuPont method of profitability analysis to explain differences in 2012
ROIs between the two divisions. Use 2012 total assets as the investment base.

For 2012:
Print
Internet

Profit

Investment

Margin

Turnover

ROI

OI
Revenue

Revenue
TA

OI
TA

30.00%
2.60%

0.85
2.50

25.50%
6.50%

25.50%
6.50%

For 2011: (not required)

Print
20.44%
Internet
2.18%

0.98
2.31

20.05%
5.04%

20.05%
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 proposal
for the new system, despite her belief in the benefits of the new technology?

2012 ROI before investment proposal

ROI for investment proposal
2012 ROI with investment proposal

ROI
25.50%
15.00%
25.10%

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

3. Chris Moreno, CEO of Global Event Group, is considering a proposal to base

division executive compensation at each division on division RI.
a. Compute the 2012 RI for each division.
12%

Operating
Income

Print
Internet

$6,120
780

Capital
Charge
at 12%

($2,880)
(1,440)

Divisional
Residual
Income

$3,240
(660)

b. Would adoption of an RI measure reduce Mays (Print Division manager)

reluctance to adopt the new computerized system investment proposal?

Newspapers
Pre-Investment RI
Investment Proposal
Post-Investment RI

Operating
Income

Capital
Charge
at 12%

Divisional
Residual
Income

$6,120 ($2,880.00) $3,240.00

$144
($115.20)
$28.80
$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 favorably
inclined to adopting the new proposal.
4. Moreno is concerned that the focus on annual ROI could have an adverse
long-run effect on Global Event Group's customers. What other measurements
do you recommend that Moreno use? Explain.
Moreno could consider using RI which motivates managers to accept any
project that makes a positive contribution to net income after the cost of the
invested capital is taken into account. Making such investments will have a
positive effect on Global Event Group's customers.
Turner may also want to consider nonfinancial measures such as
newspaper subscription levels
internet audience size
repeat purchase patterns
market share data
These measures will require managers to invest in areas that have favorable
long-run effects on Global Event Group's customers.
Exercise 23-33
Given:
Chris Moreno seeks your advice on revising the existing bonus plan for division
managers of the Global Event Group. Assume division managers do not like bearing
risk. 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.

1. Evaluate the three ideas Moreno has put forth using performance-evaluation
concepts described in this chapter. Indicate the positive and negative features
of each proposal.
Make each division manager's compensation depend on division RI.
Positive Features
The benefit of this compensation plan is that managers would be motivated
to put in extra effort to increase divisional RI because managers' rewards
would increase with increases in divisional RI.
Negative Features
Compensating managers largely on the basis of RI subjects the managers
to 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 no
control. A manager may put in a great deal of effort, but the division's RI
may be low because of adverse factors (high interest, recession) that the
manager cannot control.
To compensate managers for taking on this uncontrollable risk, Moreno must
pay them additional amounts within the structure of the RI-based plan. Thus,
using mainly performance-based incentives will cost Moreno more money, on
average, than paying a flat salary. The key question is whether the benefits
of motivating additional effort justify the higher costs of performance-based
rewards.
The motivation for having some salary and some performance-based bonus
in compensation plans is to balance the benefits of incentives against the
extra 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 Features
Rewarding managers on the basis of companywide RI will motivate
managers to take actions that are in the best interests of the company
rather than actions that maximize a division's RI.
Negative Features
Each division manager's compensation will depend not only on the performance
of that division manager but on the performance of the other division managers.
Hence, compensating managers on the basis of companywide RI will impose
extra 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 their
division's RI minus the RI of the other divisions.
Positive Features
The benefit of benchmarking or relative performance evaluation is to cancel

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 Features
For benchmarking or relative performance evaluation to be effective, it is
critical that similar noncontrollable factors affect each division. It is not clear
that the same noncontrollable factors that affect the performance of the
Print Division (cost of newsprint paper, for example) also affect the
performance of the Internet division. If the noncontrollable factors are not
the same, then comparing the RI of one division to the RI of the other division
will not provide useful information for relative performance evaluation.
Also, benchmarking one division against another means that a division
manager 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 cause
managers to cut corners. What systems might Moreno introduce to avoid this
problem? Explain.
Using measures like RI and ROI -- diagnostic levers of control -- can cause managers
to cut corners and take other actions that boost short-run performance but harm the
company in the long run.
Moreno can guard against such problems by introducing and upholding strong
boundary and belief systems of control within the company.
Boundary systems: A method of control that describes standards of behavior
and codes of conduct expected of all employees, especially actions that are
off limits.
Belief systems: A method of control that articulates the mission, purpose,
norms of behaviors, and core values of a company intended to inspire
managers and other employees to do their best.
3. Moreno is also concerned that the pressure for short-run performance might
cause managers to ignore emerging threats and opportunities. What systems
might Moreno introduce to avoid this problem? Explain.
Excessive focus on diagnostic control system measures such as ROI, RI, and NI
might cause a myopic disregard for emerging threats and opportunities.
Diagnostic control system: A lever of control that monitors critical performance
variables that help managers track progress toward achieving a company's
strategic goals. Managers are held accountable for meeting these goals.

This concern can be minimized with interactive control systems.

Interactive control systems: Formal information systems that managers use to
focus organizations attention and learning on key strategic issues.

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

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

Exercise 23-28
Given:
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
(Historical Cost Information)
Revenues
Operating costs (other than depreciation)
Plant Depreciation
Total operating costs
Operating Income
Assets:
Current assets (expressed in 2011 $)
Long-term assets
Total assets
Age of plant at the end of 2011 (in years)
Built in (at the end of)

Passion
Fruit
Division
$1,000,000
$600,000
140,000
$740,000
$260,000

Kiwi
Fruit
Division
$1,400,000
$760,000
200,000
$960,000
$440,000

Mango
Fruit
Division
$2,200,000
$1,200,000
240,000
$1,440,000
$760,000

$400,000
280,000
$680,000

$500,000
1,800,000
$2,300,000

$600,000
2,640,000
$3,240,000

3
2008

1
2010

10
2001

Nature's Elixir estimates the useful life of each plant to be 12 years, with a $0 terminal
disposal value. The straight-line depreciation method is used.
An index of construction costs for the 10-year period that Nature's Elixir has been
operating (2001 year-end = 100) is
Year
Index

2001
100

2008
136

2010
160

2011
170

Given the high turnover of current assets, management believes that the historical-cost
and 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
Fruit
Calculation of Historical Cost ROI
Division
Division
Division
Operating income
Total assets
ROI

$260,000
$680,000
38.235%

$440,000
$2,300,000

$760,000
$3,240,000

19.130%

23.457%

The Passion Fruit Division appears to be considerably more efficient than the Kiwi
Fruit and Mango Fruit Divisions at using investment dollars to generate operating
operating 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-term
assets. Comment on the results.

Step 1: Restate long-term assets from gross book value at historical cost to
gross book value at current cost as of the end of 2011.
The original costs of the plants (gross book values) under historical costs are
calculated as the useful life of each plant times the straight-line depreciation.

Straight-line depreciation
Useful life of plant
Gross book values -- historical cost
Construction cost index (CI) in 2011
Construction CI in year of construction
Gross book values -- current cost (2011 $)

Passion
Fruit
Division
$140,000
12
$1,680,000

Kiwi
Fruit
Division
$200,000
12
$2,400,000

Mango
Fruit
Division
$240,000
12
$2,880,000

170
100

170
136

170
160

$2,856,000

$3,000,000

$3,060,000

Step 2: Derive net book value of long-term assets at current costs as of the end
of 2011.
Gross book values -- current cost
Estimated useful life remaining
Estimated total useful life
NBV of L/T assets at current costs as of the end of 2011

$2,856,000

$3,000,000

$3,060,000

2
12

9
12

11
12

$2,250,000

$2,805,000

$2,250,000
500,000
$2,750,000

$2,805,000
600,000
$3,405,000

$476,000

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

NBV of L/T assets at current costs as of the end of 2011

Current assets at the end of 2011 (given)

Current costs of total assets in 2011

$476,000
400,000
$876,000

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

Gross book values -- current cost
Useful life of plant
Current-cost depreciation exp. in 2011 $

$2,856,000
12
$238,000

$3,000,000
12
$250,000

$3,060,000
12
$255,000

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

Historical-cost operating income
Historical-cost depreciation expense
Historical-cost OI before depreciation exp.
Current-cost depreciation exp. in 2011 $
OI using 2011 current-cost depreciation

$260,000
140,000
$400,000
238,000
$162,000

$440,000
200,000
$640,000
250,000
$390,000

$760,000
240,000
$1,000,000
255,000
$745,000

Step 6: Compute ROI using current-cost estimates for long-term assets and
depreciation.
OI using 2011 current-cost depreciation

$162,000

$390,000

$745,000

Current costs of total assets in 2011

ROI using current-cost estimates for L/T
assets and depreciation.
Comment on the results.

ROI using current-cost estimates for L/T

assets and depreciation.
ROI -- Historical cost

$876,000

$2,750,000

$3,405,000

18.493%

14.182%

21.880%

Passion
Fruit
Division
18.493%
38.235%

Kiwi
Fruit
Division
14.182%
19.130%

Mango
Fruit
Division
21.880%
23.457%

Use of current cost, results in the Mango Fruit Division appearing to be the most
efficient. The Passion Fruit Division's ROI is reduced substantially when the 10
year old plant is restated for the 70% increase in construction costs over the 2001
to 2011 period.
3. What advantages might arise from using current-cost asset measures as compared
with historical-cost measures for evaluating the performance of the managers of the
three 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 cost
also will increase the willingness of managers, evaluated on the basis of ROI, to move
from divisions with assets purchased many years ago to divisions with assets purchased
in 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 become
increasingly 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 value
without increasing costs. In addition to a profitability incentive, the revised plan includes incentives
for reduced rework cost, reduced sales returns, and on-time deliveries. Bonuses are calculated
and awarded semiannually on the following bases.
Base bonus is calculated at 2% of operating income.
Adjustments:
Rework
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.
On-time Deliveries
Increased by $5,000 if more than 98% of deliveries are on time, and by $2,000 if 96% to
98% of deliveries are on time.
No adjustment if on-time deliveries are below 96%.
Sales Returns
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.
Note: If the calculation of the bonus results in a negative amount for a particular period, the
manager simply receives no bonus, and the negative amount is not carried forward to the next
period.
In 2011, under the old bonus plan, the Charter Division manager earned a bonus of $27,060 and
the Mesa Division manager, a bonus of $22,440.
Results for Summit's Charter Division and Mesa Division for 2012, the first year under the new
bonus plan, follow:
Charter Division
Mesa Division
From
1/1/2012
7/1/2012
1/1/2012
7/1/2012
To
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 in
addition to the operating-income numbers for the period?
Competition!
Operating income is a good summary measure of short-term financial performance. By
itself, however, it does not indicate whether operating income in the short run was earned by
taking actions that would lead to long-term competitive advantage. For instance, quality
could be ignored.
The new performance measures take a balanced scorecard approach by evaluating and
rewarding managers on the basis of direct quality measures (such as rework, on-time delivery,

and sales returns). The new bonus plan should motivate managers to take actions that
Harrington 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.
From
To
Revenues
Operating income
On-time delivery
Rework costs
Sales returns

From
To
Base Bonus (2% of OI)
Adjustments
Rework
Rework $
2% of OI
Excess
Adjustment
On-Time Deliveries
Sales Returns
1.5% of Sales
Returns
Difference
Adjustment
Base Bonus + Adjustments
Adjusted Bonus New Plan

Charter Division
Mesa Division
1/1/2012
7/1/2012
1/1/2012
7/1/2012
6/30/2012
12/31/2012
6/30/2012
12/31/2012
$4,200,000 $4,400,000 $2,850,000 $2,900,000
$462,000
$440,000
$342,000
$406,000
95.4%
97.3%
98.2%
94.6%
$11,500
$11,000
$6,000
$8,000
$84,000
$70,000
$44,750
$42,500
Charter Division
1/1/2012
7/1/2012
6/30/2012
12/31/2012
$9,240
$8,800

Mesa Division
1/1/2012
7/1/2012
6/30/2012
12/31/2012
$6,840
$8,120

$11,500
9,240
$2,260
($2,260)

$11,000
8,800
$2,200
($2,200)

$6,000
6,840
($840)
$0

$8,000
8,120
($120)
$0

$0

$2,000

$5,000

$0

$63,000
84,000
($21,000)
($10,500)
($3,520)
$0

$66,000
70,000
($4,000)
($2,000)
$6,600
$6,600
$27,060

$42,750
44,750
($2,000)
($1,000)
$10,840
$10,840

$43,500
42,500
$1,000
$3,000
$11,120
$11,120
$22,440

Previous Year's Bonus

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 the
division bonus is more than $20,000 less than the previous year. However, the new
performance measures have begun to have the desired effect --both on-time deliveries
and sales returns improved in the second half of the year, while rework costs improved
slightly.
Bonus earned in 2011
Bonus earned in 2012
1st half
2nd half
Decreased bonus
Performance measures

$27,060
$0
6,600

1st half

$6,600
$20,460
2nd half

Improvement

On-time delivery
Rework costs
Sales returns
Income as a % of Sales

95.4%
$11,500
$84,000
11.00%

97.3%
$11,000
$70,000
10.00%

1.9%
$500
$14,000
-1.00%

The manager of the Mesa Division should be as satisfied with the new plan as with
the 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
Bonus earned in 2012
1st half
2nd half
Decreased bonus
Performance measures
On-time delivery
Rework costs
Sales returns
Income as a % of Sales
Overall evaluation of bonus plan:

$22,400
$10,840
11,120

1st half
98.2%
$6,000
$44,750
12.00%

$21,960
$440
2nd half
Improvement
94.6%
-3.6%
$8,000
($2,000)
$42,500
$2,250
14.00%
2.00%

Needs improvement
Sending mixed messages

Suggestions for improvement:

1. Increasing the weights put on on-time deliveries, rework costs, and sales
returns performance measures while decreasing the weight put on operating
income.
2. A reward structure for rework costs that are below 2% of operating income
would 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 prior
periods and encouraging continuous improvement.
5. Change absolute dollar adjustments to % adjustments. Prevents meet and hold
tactics.

Exercise 23-21
Given:
Potomac Electric Company
Geographical Profit Centers
Atlantic
Pacific
Division
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 the
measure 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 management

performance, the variable it wants a manager to maximize. What is
the RI for each division using operating income as the measure of income
and total assets as the measure of investment? Assume that the required
rate of return on investment is 12%.
Atlantic Division:
RI = Operating Income - Capital charge @ 12% =

$80,000

Pacific Division:
RI = Operating Income - Capital charge @ 12% =

$150,000

3. Potomic Electric has two sources of funds: long-term debt with a market
value of $3,500,000 and an interest rate of 10%, and equity capital with
a market value of $3,500,000 at a cost of equity of 14%. Potomic's income
tax rate is 40%. Potomic applies the same weighted-average cost of capital
to both divisions, because each division faces similar risks. Calculate the
EVA for each division.
Calculation of weighted average cost of capital
Calculation of the after-tax cost of financing
Cost of equity financing
Cost of debt financing
Tax savings
After-tax cost of financing
Calculation of the weighting factor
Amount of debt financing
$3,500,000
Amount of equity financing
3,500,000
Total financing
$7,000,000
Weighted cost of financing
Combined WA cost of capital
10%
Calculation of EVA
Calculation of After-tax operating income

Debt

Equity
14%

10%
4%
6%

0%
14%

0.5
3%

0.5
7%

Atlantic
Division

Pacific
Division

Operating income
Less taxes @ 40%
After-tax operating income
Calculation of investment charge
Total assets
Less current liabilities
L/T assets + working capital
Weighted average cost of capital
Capital investment charge
EVA

$200,000
80,000
$120,000

$750,000
300,000
$450,000

$1,000,000
250,000
$750,000
10%
$75,000
$45,000

$5,000,000
1,500,000
$3,500,000
10%
$350,000
$100,000

Which of the measures in requirements 1, 2, and 3 would you recommend

Potomic Electric use? Why?
EVA is preferred for two reasons:
It is a residual income type of measure and does not have the dysfunctional
effects of ROI-based measures. (ROI as a performance evaluation measure
creates incentives for managers to reject projects that increase the value of
the 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 the
company and its shareholders.