ROI, Residual Income, and
Economic Value Added
ACCT7320
Decentralization in Organizations
Benefits of
Decentralization
Top
Top management
management
freed
freed to
to concentrate
concentrate
on
on strategy.
strategy.
Lower-level
Lower-level managers
managers
gain
gain experience
experience in
in
decision-making.
decision-making.
Decision-making
Decision-making
authority
authority leads
leads to
to
job
job satisfaction.
satisfaction.
Lower-level
decisions
Lower-level decisions
often
often based
based on
on
better
better information.
information.
Lower
Lower level
level managers
managers
can
can respond
respond quickly
quickly
to
to customers.
customers.
Decentralization in Organizations
Lower-level
Lower-level managers
managers
may
may make
make decisions
decisions
without
without seeing
seeing the
the
big
big picture.
picture.
Lower-level
Lower-level managers
managers
objectives
objectives may
may not
not
be
be those
those of
of the
the
organization.
organization.
May
May be
be aa lack
lack of
of
coordination
coordination among
among
autonomous
autonomous
managers.
managers.
Disadvantages of
Decentralization
May
May be
be difficult
difficult to
to
spread
spread innovative
innovative ideas
ideas
in
in the
the organization.
organization.
Cost, Profit, and Investments Centers
Cost
Cost
Center
Center
Cost, profit,
and investment
centers are all
known as
responsibility
centers.
Profit
Profit
Center
Center
Responsibility
Responsibility
Center
Center
Investment
Investment
Center
Center
Return on Investment (ROI) Formula
Income
Incomebefore
before interest
interest
and
andtaxes
taxes(EBIT)
(EBIT)
Net operating income
ROI =
Average operating assets
Cash,
Cash,accounts
accountsreceivable,
receivable, inventory,
inventory,
plant
plantand
andequipment,
equipment, and
andother
other
productive
productiveassets.
assets.
Net Book Value vs. Gross Cost
Definitions/Measurement of Income and
Assets Can Vary
Historical Cost?
Net of depreciation?
Current replacement cost?
Accrual-based, GAAP Income?
Contribution-margin format?
Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales
Sales
Turnover =
Average operating
assets
Turnover
ROI Margin
=
Increasing ROI
There are three ways to increase ROI . . .
Increase
Sales
Reduce
Expenses
Reduce
Assets
ROI and the Balanced Scorecard
It may not be obvious to managers how to increase
sales, decrease costs, and decrease investments in a
way that is consistent with the companys strategy. A
well constructed balanced scorecard can provide
managers with a road map that indicates how the
company intends to increase ROI.
Which internal business
process should be
improved?
Which customers should
be targeted and how will
they be attracted and
retained at a profit?
Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.
Managers often inherit many
committed costs over which
they have no control.
Managers evaluated on ROI
may reject profitable
investment opportunities.
Residual Income - Another Measure of
Performance
Net operating income
above some minimum
return on operating
assets
Calculating Residual Income
Residual
=
income
Net
operating income
Average
operating
assets
Minimum
required rate of
return
This computation differs from ROI.
ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
Residual Income An Example
The
The Retail
Retail Division
Division of
of Zephyr,
Zephyr, Inc.
Inc. has
has
average
average operating
operating assets
assets of
of $100,000
$100,000
and
and is
is required
required to
to earn
earn aa return
return of
of
20%
20% on
on these
these assets.
assets.
In
In the
the current
current period,
period, the
the division
division
earns
earns $30,000.
$30,000.
Lets calculate residual income.
Residual Income An Example
Operating
Operating assets
assets
Required
Required rate
rate of
of return
return
Minimum
Minimum required
required return
return
$$100,000
100,000
20%
20%
$$ 20,000
20,000
Actual
Actual income
income
Minimum
Minimum required
requiredreturn
return
Residual
Residual income
income
$$ 30,000
30,000
(20,000)
(20,000)
$$ 10,000
10,000
Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
Economic Value Added
Economic value added (EVA) is a specific type of
residual income calculation that has recently
attracted considerable attention.
Economic value added (EVA)
= After-tax operating income
(Weighted-average cost of capital) (Long-term assets +
Working capital)
Economic Value Added
Why Long-term assets + Working capital?
Can also be computed as Total assets minus
current liabilities
That is, the investment base is reduced by
current liabilitieslargely Accounts Payable!
Management should utilize this free source of
funds.
Economic Value Added
EVAStern Stewart) substitutes the following specific
numbers in the RI calculations:
1 Income equal to after-tax operating income
2 A required rate of return equal to the weightedaverage cost of capital
3 Investment equal to total assets minus current
liabilities
But use of this definition of investment base is not new
to EVA.
EVA Example
Assume that Resorts Inns has two sources of
long-term funds:
Long-term debt with a market value and book
value of $4,800,000 issued at an interest rate of
10%
Equity capital that also has a market value of
$4,800,000 and a book value of $2,200,000
Tax rate is 30%.
Economic Value Added
What is the after-tax cost of capital?
For debt, 10% (1 30%Tax rate) = 7%
The cost of equity capital is the opportunity
cost to investors of not investing their capital in
another investment that is similar in risk to
Resorts Inns.
Assume that Resorts Inns cost of equity capital
is 14%.
Economic Value Added
What is the weighted-average cost of capital?
WACC = [(7% Market value of debt)
+ (14% Market value of equity)]
(Market value of debt + Market value of equity)
WACC = [(7% 4,800,000)
+(14% 4,800,000)] $9,600,000
WACC = ($336,000 + $672,000) $9,600,000
=10.5%
Economic Value Added
For three of their hotels, assume these values
for the after-tax operating income (NOPAT)
and Investment base for each hotel:
Location
NOPAT
Investment
Chicago
$116,200
$850,000
Dallas
$168,000
$850,000
Miami
$806,400
$5,300,000
Economic Value Added
What is the economic value added?
Chicago: $116,200 $ 89,250 = $ 26,950
Dallas: $168,000 $ 89,250 = $ 78,750
Miami: $806,400 $556,500 = $249,900
Thus EVA charges managers for the cost
of their investments in long-term assets
and working capital.
Companies that use EVA
Mostly large corporations
Costly to implement
Requires consultants
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