Cost Accounting (14th Edition)

814 CHAPTER 23 PERFORMANCE MEASUREMENT, COMPENSATION, AND MULTINATIONAL CONSIDERATIONS
Decision
Point
What are the relative
merits of return on
investment (ROI),
residual income (RI),
and economic value
added (EVA) as
performance
measures for
subunit managers?
Learning
Objective 3
Analyze the key
measurement choices
in the design of each
performance measure
. . . choice of time
horizon, alternative
definitions, and
measurement of assets
twice the operating income of the San Francisco hotel—$510,000 versus $240,000—its total
assets are three times as large—$3 million versus $1 million. The New Orleans hotel has a
higher RI because it earns a higher income after covering the required rate of return on investment
of 12%. The high ROI of the San Francisco hotel indicates that its assets are being used
efficiently. Even though each dollar invested in the New Orleans hotel does not give the same
return as the San Francisco hotel, this large investment creates considerable value because its
return exceeds the required rate of return. The Chicago hotel has the highest ROS but the lowest
ROI. The high ROS indicates that the Chicago hotel has the lowest cost structure per dollar
of revenues of all of Hospitality Inns’ hotels. The reason for Chicago’s low ROI is that it
generates very low revenues per dollar of assets invested. Is any method better than the others
for measuring performance? No, because each evaluates a different aspect of performance.
ROS measures how effectively costs are managed. To evaluate overall aggregate performance,
ROI, RI, or EVA measures are more appropriate than ROS because they consider
both income and investment. ROI indicates which investment yields the highest
return. RI and EVA measures overcome some of the goal-congruence problems of ROI.
Some managers favor EVA because of the accounting adjustments related to the capitalization
of investments in intangibles. Other managers favor RI because it is easier to calculate
and because, in most cases, it leads to the same conclusions as EVA. Generally,
companies use multiple financial measures to evaluate performance.
Choosing the Details of the Performance
Measures
It is not sufficient for a company to identify the set of performance measures it wishes to
use. The company has to make several choices regarding the specific details of how the
measures are computed. These range from decisions regarding the time frame over which
the measures are computed, to the definition of key terms such as “investment” and the
calculation of particular components of each performance measure.
Alternative Time Horizons
An important element in designing accounting-based performance measures is choosing
the time horizon of the performance measures. The ROI, RI, EVA, and ROS calculations
represent the results for a single period, one year in our example. Managers could take
actions that cause short-run increases in these measures but that conflict with the longrun
interest of the company. For example, managers may curtail R&D and plant maintenance
in the last three months of a fiscal year to achieve a target level of annual
operating income. For this reason, many companies evaluate subunits on the basis of
ROI, RI, EVA, and ROS over multiple years.
Another reason to evaluate subunits over multiple years is that the benefits of actions
taken in the current period may not show up in short-run performance measures, such as
the current year’s ROI or RI. For example, an investment in a new hotel may adversely
affect ROI and RI in the short run but benefit ROI and RI in the long run.
A multiyear analysis highlights another advantage of the RI measure: Net present
value of all cash flows over the life of an investment equals net present value of the RIs. 8
8 This equivalence, often referred to as the “Conservation Property” of residual income, was originally articulated by Gabriel
Preinreich in 1938. To see the equivalence, suppose the $400,000 investment in the San Francisco hotel increases operating
income by $70,000 per year as follows: Increase in operating cash flows of $150,000 each year for 5 years minus depreciation
of $80,000 ($400,000 , 5) per year, assuming straight-line depreciation and $0 terminal disposal value. Depreciation reduces
the investment amount by $80,000 each year. Assuming a required rate of return of 12%, net present values of cash flows and
residual incomes are as follows:
Year 0 1 2 3 4 5 Net Present Value
(1) Cash flow –$400,000 $150,000 $150,000 $150,000 $150,000 $150,000
(2) Present value of $1 discounted at 12% 1 0.89286 0.79719 0.71178 0.63552 0.56743
(3) Present value: (1) * (2)
–$400,000 $133,929 $119,578 $106,767 $ 95,328 $ 85,114 $140,716
(4) Operating income $ 70,000 $ 70,000 $ 70,000 $ 70,000 $ 70,000
(5) Assets at start of year $400,000 $320,000 $240,000 $160,000 $ 80,000
(6) Capital charge: (5) * 12%
$ 48,000 $ 38,400 $ 28,800 $ 19,200 $ 9,600
(7) Residual income: (4) - (6)
$ 22,000 $ 31,600 $ 41,200 $ 50,800 $ 60,400
(8) Present value of RI: (7) * (2)
$ 19,643 $ 25,191 $ 29,325 $ 32,284 $ 34,273 $140,716