Exam 14: Business Unit Performance Measurement

You are the manager of an operating division of a manufacturing company. Your division has $4,500,000 in assets, and your budgeted income statement for the current year follows: Reverues \ 8,000,000 Cash costs: Variable 1,000,000 Fixed 3,750,000 Depreciation 1,375,000 Your company uses a performance evaluation and bonus plan, which is based on return on investment (ROI) computed with end-of-year gross asset balances. In October, you discover that you can purchase a new machine for $3,250,000, which will enable you to expand the output of your division and save costs. The machine would have a salvage value of $250,000 and would be depreciated over 3 years using the straight-line method. It will increase output by 10% while reducing cash fixed costs by 5%. If you accept the machine, it will be installed in late December, but no depreciation will be taken on the new machine this year. If you do buy this machine, you will have to dispose of the machine you are now using, which you just purchased last January. That machine cost you $2,500,000 but has no salvage value. $750,000 of the depreciation on the income statement is depreciation for this machine. In the ROI calculations, the company includes any gains or losses for equipment disposal in income for the year. You may safely ignore all taxes for this analysis. Required: a. What is your division's ROI this year if you do not acquire the new machine? b. What is your division's ROI this year if you do acquire the new machine? c. What is your division's expected ROI next year if the machine is acquired and meets expectations?

The Augment Manufacturing Company has three divisions: X Division, Y Division, and Z Division. Operating results for the three divisions for last year were as follows: Residual income Net operating income Average operating asset: Sales Profit margin Division Division Y Division Z \ 98,400 \2 7,200 \ 12,000 188,600 115,600 76,000 820,000 680,000 400,000 1,640,000 1,445,000 1,040,000 11.5\% 8.0\% 5.0\% Required: a. What is the ROI for each of the three divisions? b. What is the cost of capital for each of the three divisions?

Residual income is a better measure for performance evaluation of an investment center manager than return on investment because: (CMA adapted)

"I think that EVA is the best performance measure. I am going to recommend that we evaluate managers at all levels, including the chief executive officer (CEO), using it." Do you think this statement is appropriate? Explain.

Economic value added (EVA) adjustments are made to both the after-tax income and the capital employed.

The Butyl Division of the Swiss Corporation just started operations. It purchased depreciable assets costing $2,500,000 with an expected life of five years, after which the assets can be salvaged for $400,000. Depreciation is computed for the financial statements on a straight-line basis, using the salvage value. Annual operating cash flows are $1,300,000. Required: a. Compute the division's return on investment (ROI) for each year, using beginning of the year asset values, historical costs, and net book values. b. Compute the division's return on investment (ROI) for each year, using end of the year asset values, historical costs, and net book values.

The following information is available for Kiss Company: Sales \ 100,000 Operating expenses \ 94,000 Operating assets \ 40,000 Stockholder's equity \ 25,000 Cost of capital 10\% What is Kiss Company's residual income?