Transcript Accounting Based Equity Valuation Model: One Period

ACCT 2302
Fundamentals of Accounting II
Spring 2011
Lecture 15
Professor Jeff Yu
Review: Performance Evaluation
Evaluation Tool
Cost Center
(controls costs only)
Profit Center
(controls costs & revenues)
Investment Center
(controls costs & revenues
& Investments)
Spending Variance;
Standard Cost Variances
Segmented
Income Statement
(Segment Margin)
Return on Investment (ROI);
Residual Income
Review: Standard Cost Variances
Materials Price Variance
Materials Quantity Variance
AQ(AP - SP)
SP(AQ - SQ)
Labor/VOH Rate Variance Labor/VOH Efficiency Variance
AH(AR – SR)
SR(AH – SH)
AP (AR)= Actual Price (Actual Rate): the amount actually paid for
each unit of the materials (labor or VOH).
SP (SR)= Standard Price (Standard Rate): the amount that should
Have been paid for each unit of the materials (labor or VOH).
AQ (AH)= Actual Quantity (Actual Hour): the amount of materials
(labor or VOH activity) actually used in the production.
SQ (SH)= Standard Quantity (Stan. Hour) allowed for the actual output
= actual production in units * standard quantity (hours) per unit
Review: Segmented Income Statement
Sales
- Variable Expenses
Contribution Margin
- Traceable Fixed costs
Segment Margin
 NOI for the company = the sum of segment margins
minus Common fixed costs.
 Important: CVP analyses using the segmented
income statement!
Return on Investment (ROI)
ROI = NOI ÷ AOA

NOI
Sales
Margin

Turnover
Sales
AOA
AOA=Average Operating Assets
=(Beginning + Ending Operating Assets)/2
Thought Question: how will changes in sales, operating
expenses and average operating assets affect ROI?
Example
Holly Company reports the following information in 2009:
Net Operating Income
Sales Revenue
Average Operating Assets
$ 30,000
$ 500,000
$ 200,000
Q:
(1) Holly’s 2009 ROI? Margin? Turnover? Operating Expenses?
(2) How will Holly’s ROI change if sales increases to $600,000 and
both AOA and operating expenses do not change in 2010?
(3) How will Holly’s ROI change if there is no change in sales and
AOA but operating expenses decrease to $458,000 in 2010?
(4) How will Holly’s ROI change if there is no change in sales and
operating expenses, but AOA decreases to $100,000 in 2010?
Summary: Improving ROI
Increase
Sales
Decrease
Operating
Expenses
generate the same NOI
with Less
Operating Assets
DuPont Analysis: ROI = Margin * Turnover
Residual Income (RI)
RI = NOI - Required rate of return × AOA
NOI- Net operating income (profits)
AOA- Average operating assets
Required rate of return × AOA = Required return
Decision Rule: Invest if RI>0.
Practice Problem
At Pitts Co. the required rate of return on
operating assets is 8%. The 2010 sales revenue
for division A is $10 million, NOI is $2 million,
AOA is $2.5 million.
Q: Division A’s 2010 ROI? Margin? Turnover?
Residual Income?
Practice Problem
Given the following information for Division C:
NOI
$560,000
Margin
35%
Turnover
1.6
Minimum required rate of return 12%
What is the division’s residual income?
Example: ROI vs. RI
 Flower Co. Division C has an opportunity to invest $100,000 (AOA)
in a project that will yield NOI of $25,000 for the year.
 Flower Co. has a 20% required rate of return and Division C has a
30% ROI on its existing business.
Q: (1) As a manager at Division C, will you invest in that project if you
are evaluated based on division ROI (the higher the ROI, the bigger
the bonus)?
(2) Is this investment project good for the company?
(3) Will your decision be different if you are evaluated using residual
income?
ROI – A Drawback
Gee . . .
I thought we were
supposed to do what
was best for the
company!
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!
Residual Income VS. ROI
Under ROI, the basic message is:
Maximize rate of return, a percentage.
Under the residual income approach, the basic message is:
Maximize residual income, an absolute amount.
Residual income may encourage managers to make profitable
investments that would be rejected by managers using ROI to
evaluate that same investment.
However, residual income cannot be used to compare the
performance of divisions with different sizes (i.e. different AOA).
The Balanced Scorecard
Management translates its strategy into
performance measures that employees
understand and accept.
Customers
Financial
Internal
business
processes
Performance
measures
Learning
and growth
The Balanced Scorecard: From
Strategy to Performance Measures
Performance Measures
Financial
What are our
financial goals?
Customer
Do customers recognize that
we are delivering more value?
What customers do
we want to serve and
how are we going to
win and retain them?
Internal Business Processes
Have we improved key business
processes so that we can deliver
more value to customers?
What internal business processes are
critical to providing
value to customers?
Has our financial
performance improved?
Learning and Growth
Are we maintaining our ability
to change and improve?
Vision
and
Strategy
The Balanced Scorecard: Non-financial Measures
The balanced scorecard relies on non-financial measures in
addition to financial measures for two reasons:
 Financial measures are lagging indicators that summarize the
results of past actions. Non-financial measures are leading indicators
of future financial performance.
 Top managers are ordinarily responsible for financial performance
measures – not lower level managers.
Non-financial measures are more likely to be understood and
controlled by lower level managers.
Example: The Balanced Scorecard
Profit
Financial
CM per car
Number of cars sold
Customer
Customer satisfaction
with options
Internal
Business
Processes
Learning
and Growth
Number of
options available
Time to
install option
Employee skills in
installing options
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 company’s 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?
For Next Class
 Review for Midterm Exam II
Homework Problem 1
At Davis Co. the required rate of return on
operating assets is 8%.
The 2010 residual income of division B is
$120,000, Margin is 25%, ROI is 20%.
Q: (1) What is Division B’s 2010 Turnover?
(2) What is Division B’s NOI?
(3) What is Division B’s AOA?
(4) What is Division B’s Sales?
Homework Problem 2
DFW Inc.’s required rate of return is 10%. In
2009, its Division A reported the following
performance data: Residual Income = $18,000,
Margin = 20%, Turnover = 1.5.
Q: (1) What is Division A’s ROI in 2009?
(2) What is Division A’s NOI in 2009?
(3) What is Division A’s AOA in 2009?
(4) What is Division A’s sales revenue in 2009?