Module 3 Flashcards
(10 cards)
📊 What is ROI (Return on Investment), and how is it used in performance evaluation?
A:
ROI is a widely used performance metric that evaluates how effectively a business unit uses its invested assets to generate operating income. It’s particularly helpful for comparing the profitability and efficiency of divisions of varying sizes.
🧮 Formula:
ROI = Operating Income ÷ Average Investment
Or:
ROI = Return on Sales × Asset Turnover
✅ Advantages:
-Easy to understand and communicate
-Combines profitability and asset efficiency in one metric
-Facilitates inter-division or inter-company comparison
-Encourages responsible use of capital
⚠️ Limitations:
-May discourage new investment (if it lowers ROI, even if NPV-positive)
-Distorted by asset age and accounting method (e.g., historical cost understates asset value)
-Focuses on relative performance (percent), not value created (dollars)
💡 Textbook Insight:
Horngren emphasizes how historical cost ROI can inflate returns for older investments (like Saskatoon Motel), whereas current-cost-based ROI better reflects true economic performance.
Exhibit 23-3 compares both methods to demonstrate the distortion caused by outdated asset valuations.
📊 Q: What is Residual Income (RI), and how is it used in evaluating performance?
A:
RI measures how much income a business unit generates above the required minimum return on its invested assets. It focuses on absolute value creation rather than percentage efficiency.
🧮 Formula:
RI = Operating Income − (Required Rate of Return × Investment)
Where:
RRR = WACC
✅ Advantages:
-Encourages growth and reinvestment (no disincentive like ROI)
-Aligns better with shareholder value creation
-Supports long-term investment decisions, even if they lower ROI
-Simple to understand in dollar terms
⚠️ Limitations:
-Not scale-neutral — larger divisions naturally have higher RI
-Can’t be used to compare divisions of different size without context
-Requires careful selection of hurdle rate (RRR)
💡 Textbook Insight:
Horngren notes that RI overcomes ROI’s weakness by rewarding value above the cost of capital. It shifts focus from relative returns to whether the division actually adds economic value.
📊Q: What is Economic Value Added (EVA), and how does it enhance performance measurement?
A:
EVA builds on residual income by making accounting adjustments to better reflect true economic performance. It subtracts the full cost of capital (debt + equity) from after-tax operating income (NOPAT), delivering a refined measure of value created.
🧮 Formula:
EVA = NOPAT − [WACC × (Total Assets − Current Liabilities)]
Where:
NOPAT = Net Operating Profit After Tax
WACC = Weighted Average Cost of Capital
Total Assets − Current Liabilities = Capital Employed
✅ Advantages:
-Strong alignment with shareholder value
-Reflects long-term economic performance, not short-term accounting profits
-Incentivizes managers to make value-adding investments
-Used effectively in incentive-based compensation systems
⚠️ Limitations:
-Complex: requires accounting adjustments (e.g., capitalizing R&D, adjusting for deferred taxes)
-More useful as a company-wide measurement than for individual business segments
-Demands reliable estimates of WACC and economic capital
-May be difficult to explain to non-financial managers
💡 Textbook Insight:
EVA is presented as a refinement of RI in Horngren’s Cost Accounting, offering greater economic realism through standardized adjustments. It enhances decision quality by addressing accounting distortions.
📊Q: What is Return on Sales (ROS), and how is it used to evaluate performance?
A:
ROS assesses profitability by measuring how much operating profit is generated per dollar of revenue. It’s especially useful for comparing cost efficiency and pricing strategies across similar companies or divisions.
🧮 Formula:
ROS = Operating Income ÷ Sales Revenue
✅ Advantages:
-Focuses directly on profitability from sales
-Useful for analyzing cost control, margin strength, and pricing
-Allows comparison across firms regardless of investment size
⚠️ Limitations:
-Ignores asset usage and investment efficiency
-Can be misleading if sales are high but asset base is inefficient
-Doesn’t capture capital intensity differences across firms
💡 Textbook Insight:
Horngren positions ROS as a valuable ratio for evaluating marketing and cost strategies, but notes its limitations when used alone. It’s most powerful when combined with ROI or asset turnover.
Q: Why must ROI comparisons be made using the same duration of time?
A:
ROI comparisons must use a consistent time frame because ROI is a rate-based performance measure. Both the numerator (Operating Income) and the denominator (Investment) must reflect the same period to avoid distortion. Failing to match durations can lead to misleading results and unfair evaluations.
🧮 ROI Formula Recap:
ROI = Operating Income ÷ Investment (typically Average Total Assets in the Period)
🏗️ Historical vs. Current Cost Implication:
-Older assets measured at historical cost appear cheaper, inflating ROI
-Newer divisions with recent investments may look worse even if equally efficient
-Use current cost adjustments to normalize ROIs across units built in different periods (e.g., Hospitality Inns example in Horngren)
📊 Practical Impact:
-Avoids rewarding divisions for older, depreciated assets
-Ensures that investment decisions are judged on real performance, not timing artifacts
-Makes it fair to compare ROIs across projects, departments, or periods
💡 Key Insight:
From Horngren’s Cost Accounting:
“ROI comparisons should reflect assets evaluated at comparable points in time or on a current-cost basis to avoid performance bias due to asset age or inflation.”
Q: Why does time consistency matter when comparing ROIs?
A:
ROI compares income earned over time to the investment used during that same time. If the time periods don’t match, ROI becomes distorted and misleading.
🧮 ROI Formula:
ROI = Operating Income ÷ Investment
✅ You must match the time periods:
Income = for the year? → Investment should be average assets during the year
Income = for a quarter? → Use quarterly average investment
⚠️ What goes wrong if they don’t match?
-Using full-year income but year-end assets → ROI looks inflated (due to depreciation of NBV)
-Comparing a 3-month project ROI to a 12-month one → short-term ROI looks artificially high
💡 Key Insight:
ROI only makes sense when both the income and the investment reflect the same time duration.
Also, comparing ROIs across divisions built at different times? Adjust for current cost to avoid older assets making ROI look better than it really is.
📘 Why is EVA is more useful for the company as a whole than for individual business segments?
- WACC is a company-wide metric
-EVA relies on the weighted average cost of capital (WACC), which is typically calculated for the entire firm, not individual segments.
-Most business units don’t raise their own capital or carry separate debt/equity — they rely on the parent company’s capital structure. - Capital employed is harder to define segment by segment
-Accurately assigning current-cost-adjusted assets to individual divisions can be impractical or subjective
-Shared resources, centralized functions, and interdependencies blur the lines - Adjustments for economic performance are firm-level
-EVA may involve adjustments for items like R&D capitalization, tax effects, and goodwill — which are firm-wide decisions, not divisional - Risk and hurdle rates vary
-Divisions may operate in very different industries or risk environments
-Using the same WACC for all segments may distort EVA comparisons
🧠 Bottom line:
EVA is best suited for evaluating whether the entire company is creating value above the cost of capital.
It becomes harder — and riskier — to apply meaningfully at the segment level without making simplifying assumptions.
Q: What is Net Book Value (NBV) and how does it affect performance measurement?
A:
Net Book Value is the historical cost of an asset minus accumulated depreciation. It reflects the accounting value of the asset on the balance sheet over time.
🧮 Calculation:
NBV = Original Cost − Accumulated Depreciation
📉 📊 Effect on Performance Measures:
Does not account for inflation.
ROI: Increases over time as NBV shrinks → may overstate performance for older assets
RI: Increases artificially for older assets due to lower capital charge
EVA: Inflated EVA for older divisions because capital employed is understated
ROS: ❌ No effect — ROS is based on income and sales only
📉 Limitations of NBV:
-Distorts comparisons between old and new divisions
-Highly sensitive to depreciation methods
❗ Does not adjust for inflation — asset base remains at old dollar values, making ROI/RI appear higher as real asset values erode
📌 Management Incentives/Behaviour
Incentive to underinvest: As NBV declines over time due to depreciation, ROI and RI increase — making older divisions look better.
➤ Managers may avoid reinvestment to protect high performance metrics (incentive to “coast” on old assets: NBV rewards holding on to fully depreciated assets, even if they’re outdated or inefficient)
Result: NBV-based measures can create short-term thinking and discourage necessary capital upgrades.
🧠 Key Insight:
NBV is consistent with accounting standards but can distort comparisons between old and new investments. Be cautious using NBV alone for performance evaluation.
Q: What is Gross Book Value (GBV) and how does it affect performance measurement?
A:
Gross Book Value is the original acquisition cost of an asset, without subtracting depreciation. It represents the full cost invested, regardless of asset age.
🧮 Calculation:
GBV = Historical Cost (no depreciation applied)
📘 In the textbook:
GBV remains stable over time, which can reduce the distortion caused by depreciation in ROI calculations.
📉 Effect on Performance Measures:
ROI: More stable than NBV, but may understate ROI for older assets with reduced utility
RI: Reduces distortion caused by depreciation, but may still misstate true capital
EVA: Still based on outdated costs — better than NBV but less accurate than current cost
ROS: ❌ No effect
⚠️ Limitations of GBV:
Ignores asset deterioration — overstating value of old assets… This can make older divisions look less efficient or distort ROI comparisons if not adjusted
Does not reflect changes in economic usefulness
❗ Does not adjust for inflation — original dollar values are used even years later
Not aligned with GAAP/IFRS reporting
📌 Management Incentives/Behaviour
More neutral than NBV: GBV keeps the investment base fixed at historical cost, avoiding artificial ROI/RI boosts from depreciation.
Result: GBV reduces extreme distortions, but still allows outdated performance optics if assets are technologically obsolete or underutilized.
This can create a psychological bias: the asset still “looks valuable” on paper.
Managers may still delay replacing old assets because the new asset’s higher cost (from inflation) hurts reported performance, even if the investment is necessary
🧠 Key Insight:
GBV improves comparability across time, but may not reflect actual economic value of aging assets.
Q: What is Current Cost and how does it affect performance measurement?
A:
Current cost is the estimated replacement cost of an asset as of today. It reflects the amount needed to acquire the same or equivalent productive capacity now.
🧮 Calculation:
Current Cost = Historical Cost × (Current Index ÷ Base Year Index)
(e.g., using a construction cost index as in the Hospitality Inns example)
📈 📊 Effect on Performance Measures:
Eliminates distortion caused by inflation or outdated book values
ROI: Decreases ROI for older assets by increasing the investment base → more realistic
RI: Decreases RI unless the division truly outperforms → reflects actual cost of capital
EVA: ✅ Ideal for EVA — matches capital charge to current asset value
ROS: ❌ No effect
Effect on ROI/RI/EVA:
⚠️ Limitation:
-Requires estimates and external data (e.g., inflation index)
-More complex and less commonly implemented in practice
📌 Management Incentives/Behaviour
Aligns incentives with economic reality: Current cost reflects what it would cost today to replace the productive capacity. Managers are judged against real economic capital, not outdated book values.
Encourages efficient reinvestment: Because ROI and EVA based on current cost don’t reward holding old assets, managers are more likely to invest when appropriate.
🧠 Key Insight:
Current cost provides the most economically accurate investment base for ROI and EVA, especially when comparing divisions built at different times.
