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Transcript of Management Control Systems. Responsibility Centers Cost center Revenue center Investment center...
Management ControlSystems
Responsibility Centers
Costcenter
Revenuecenter
Investmentcenter
Profitcenter
Measuring Managers Performance
Cost/RevenueCenter
Standard Cost/FlexibleBudget Variances
ProfitCenter
Budgeted incomestatement
InvestmentCenter
Return on investment,residual income and EVA
Evaluation Tool
Accounting-Based PerformanceMeasure Example
Relax Inns owns three small hotels – one each in Boston, Denver, and Miami.
At present, Relax Inns does notallocate the total long-term debt of
the company to the three separate hotels.
Denver Hotel
Current assets $ 400,000Long-term assets 600,000Total assets $1,000,000Current liabilities $ 150,000
Revenues $1,200,000Variable costs 310,000Fixed costs 650,000Operating income $ 240,000
Relax Inns Balance Sheet
Total current assets $1,350,000Total long-term assets 6,150,000Total assets $7,500,000Total current liabilities $ 500,000Long-term debt 4,800,000Stockholders’ equity 2,200,000Total liabilities and equity $7,500,000
Approaches toMeasuring Performance
Three approaches include a measure of investment:
Return on investment (ROI)
Residual income (RI)
Economic value added (EVA®)
Return on Investment
Return on investment (ROI) is anaccounting measure of income
divided by an accountingmeasure of investment.
Return on investment (ROI)= Income ÷ Investment
What is the return on investment for the Denver Hotel?
Return on Investment
Denver Hotel: $240,000 Operating income÷ $1,000,000 Total assets = 24%
The DuPont method of profitability analysisrecognizes that there are two basic
ingredients in profit making:
DuPont Method
1. Using assets to generate more revenues
2. Increasing income per dollar of revenues
DuPont Method
Investment turnover = Revenues ÷ Investment
Return on sales = Income ÷ Revenues
ROI = Return on sales × Investment turnover
DuPont Method
How can Relax Inns attain a 30% targetROI for the Denver Hotel?
Present situation: Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20
Operating income ÷ Revenues= $240,000 ÷ $1,200,000 = 0.20
1.20 × 0.20 = 24%
DuPont Method
Alternative A: Decrease assets, keepingrevenues and operating income per
dollar of revenue constant.
Revenues ÷ Total assets= $1,200,000 ÷ $800,000 = 1.50
1.50 × 0.20 = 30%
DuPont Method
Alternative B: Increase revenues, keepingassets and operating income per dollar
of revenues constant.
Revenues ÷ Total assets= $1,500,000 ÷ $1,000,000 = 1.50
1.50 × 0.20 = 30%
Operating income ÷ Revenues= $300,000 ÷ $1,500,000 = 0.20
DuPont Method
Alternative C: Decrease costs to increaseoperating income per dollar of revenues,
keeping revenues and assets constant.
Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20
1.20 × 0.25 = 30%
Operating income ÷ Revenues= $300,000 ÷ $1,200,000 = 0.25
Residual Income
Residual income (RI)= Income
– (Required rate of return × Investment)
Assume that Relax Inns’ requiredrate of return is 12%.
What is the residual income from the Denver hotel?
Residual Income
Denver Hotel:Residual Income = $240,000 - ($1,000,000 X 12%)
= $120,000
Economic Value Added
Economic value added (EVA®)
= After-tax operating income
– [Weighted-average cost of capital
× (Total assets – current liabilities)]
Economic Value Added
Total assets minus current liabilitiescan also be computed as:
Long-term assets + Current assets– Current liabilities, or…
Long-term assets + Working capital
Economic Value Added
Economic value added (EVA®) substitutes thefollowing specific numbers in the RI calculations:
1. Income equal to after-tax operating income
2. A required rate of return equal to theweighted-average cost of capital
3. Investment equal to total assets minuscurrent liabilities
Economic Value Added Example
Assume that Relax Inns has two sources oflong-term funds:
1. Long-term debt with a market value andbook value of $4,800,000 issued at aninterest rate of 10%
2. 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 Example
What is the after-tax cost of debt?
0.10 × (1 – Tax rate) = 0.07, or 7%
Assume that Relax Inns’ cost ofequity capital is 14%.
What is the weighted-average cost of capital?
Economic Value Added Example
WACC = [(7% × Market value of debt)+ (14% × Market value of equity)]
÷ (Market value of debt + Market value of equity)
WACC = [(0.07 × 4,800,000)+ (0.14 × 4,800,000)] ÷ $9,600,000
WACC = $336,000 + $672,000 ÷ $9,600,000
WACC = 0.105, or 10.5%
Economic Value Added Example
What is the after-tax operating income for the Denver Hotel?
Denver Hotel:Operating income $240,000 × 0.7 = $168,000
Economic Value Added Example
What is the investment?
Denver Hotel: Total assets $1,000,000– Current liabilities $150,000 = $850,000
Economic Value Added Example
What is the weighted-average cost of capitaltimes the investment for Denver?
Denver Hotel: $850,000 × 10.5% = $89,250
Economic Value Added Example
What is the economic value added?
Denver Hotel: $168,000 – $89,250 = $78,750
The EVA® charges managers for the costof their investments in long-term assets
and working capital.