Enhance your sales performance evaluation for Accounting

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now let's talk about how to evaluate the performance of investment centers in many ways an investment center has similar characteristics as an independent company that means that the firm needs to evaluate the investment center in terms of its profitability which can be measured as income from operations but also its efficient use of the assets that it has under its control the two most common ways to do do this our return on investments Roi and residual income Roi is probably the most commonly used measure of a firm's performance in finance this ratio is often expressed as net income divided by average total assets but internally it's more likely that the firm will use income from operations divided by invested assets to assess a division's Roi let's look at an example Acme widgets has two manufacturing division divisions and we have some information about each division their sales their operating income and their invested assets top management wants to decide which divisional manager deserves the big yearend bonus and why based on the formula Roi equals operating income divided by invested assets the RO for division a would be its operating income of $90,000 divided by its invested assets $400,000 when we Crank that out we get a number 0.22 5 or 22.5% and we would interpret that to mean that division a generated 225 cents of income for each dollar of assets that are invested in that division there's no way to tell whether this is good news or bad news unless you have something to compare it to in this case we're going to compare the performance of division a to the performance of division B so we take the operating income for division B $144,000 and divide by its invested asset assets $600,000 and we get an answer of 0.24 or 24% in other words div division B generated 24 cents of income for each dollar of assets that are invested in the division but why is division B's Roi larger it could be that division B is better at generating profit or it may be that the division uses its assets more efficiently or it could be a combination of both let's see if we can figure out the answer there's a well-known method that is used to separate Roi into the part that relates to profitability and the part that relates to asset utilization it's called The Dupont model and you'll probably see it again in an even more expanded form when you take Finance in order to separate Roi into the portion that relates to profitability and the portion that relates to asset utilization we're going to multiply the ROI formula operating income divided by invested assets by one but it's a special form of one and that is sales divided by sales when we do that we get two separate ratios operating income divided by sales and sales divided by invested assets if we're concerned that we might have made a mistake we can cancel out sales in the numer Ator and sales in the denominator and we can see that we would get our Roi formula back that means we didn't make a mistake each of these ratios tells us a different story operating income over sales is called the profit margin ratio and it focuses on the division's profitability that is it tells us how many pennies of operating income the division generates out of each dollar of sales revenue that it earns sales divided by invested assets is called the asset turnover ratio and it focuses on how good the division is at using its invested assets to generate sales revenue by telling us the amount of sales revenue that the division generated for each dollar of assets that are invested in the division let's see how this applies to Acme widgets for division a using the formula for the profit margin ratio operating income div divided by sales we take the divisions operating income $90,000 and divide by its sales5 $100,000 and the answer is 0.18 or 18% in other words division a generated 18 cents of income out of each dollar of sales revenue when we look at the formula for the asset turn turnover ratio sales divided by invested assets we can take the division's total sales $500,000 and divide by the divisions invested assets $400,000 and the answer is 1.25 in other words the division generated a125 of sales revenue for each dollar of assets that are invested in the division these two ratios the profit margin ratio and the asset turnover ratio came from splitting apart Roi so if we m multiply them together we should get our Roi back so we multiply the profit margin ratio times the asset turnover ratio and we get Division division A's Roi so we know we didn't make a mistake now let's look at division B for the profit margin ratio operating income divided by sales we take division B's operating income $144,000 and divide by its total sales revenue $800,000 when we divide that out we get 0.18 or 18% which tells us that division B generated 18 cents of income for each dollar of sales revenue that it earned for the asset turnover ratio sales divided by invested assets we take division B's $800,000 of sales revenue and divide by its $600,000 of invested assets when we Crank that out we get a number 1.33 which tells us that division B generated $11.33 of sales revenue for each dollar of assets that are invested in the division when we multiply the profit margin ratio times the asset turnover ratio we get back division B's Roi which again tells us we didn't make a mistake so what can we learn from this analysis the profit margin is the same for division a and division B 18% that means that each of the divisions generated 18 cents of operating income for each dollar of sales revenue that it earned so where did the rest rest of each dollar go that missing 82 cents out of each sales dollar must have gone to cover the division's expenses it's cost of goods so sold and it's operating expenses but this isn't the source of the difference in the performance of division a and division B when we look at the asset turnover ratio division B has a higher turnover ratio than division a in other words division B generated more sales for each dollar of its assets than division a could so division B used its assets more efficiently to generate sales and that's why division B had a higher Roi than division a of course the results could could be very different for some other firm there are several reasons that that Roi is a popular measure for evaluating the performance of investment centers it allows managers to evaluate the division's profitability and the efficiency of its use of assets at the same time and managers can separate those two components to understand the division's performance better in addition it may give managers an idea of where to invest additional firm funds and it allows managers to compare the performance of Divisions that have different sizes because it gives answers on a per dollar basis however our Roi has one big disadvantage and that is the agency issue if a manager of an investment center is evaluated using Roi the manager will say no to any new project that would lower the division's RO why let me give you an example division a currently has an Roi of 225% Along Comes a project that has an expected return of 177% shareholders would be delighted with a return of 177% on this project because they can't get anywhere near that return on their own but the manager will say no because accepting a 177% project would lower the manager's current Roi in fact managers evaluated with Roi would say no to any project that lowered their own divisions average even if it would increase the firm's overall profitability that's a significant agency issue a much better way to assess the performance of an investment center is to use residual income which represents the difference between the operating income that the division actually generated and some minimum acceptable amount the formula for residual income is operating income minus invested assets times rrr this rrr stands for the minimum required rate of return on projects it's sometimes called a hurdle rate because all projects have to jump that hurdle invested assets times the required rate of return represents the total minimum acceptable income so residual income shows how much this particular investment center enriched The Firm Above This minimum amount let's use residual income to evaluate the performance of the two divisions at Acme widgets we have the information about each division's performance During the period its sales operating income and invested assets and we're told that the firm's required rate of return is 15% for division a its residual income is the difference between its operating income of $90,000 and the required minimum return of 15% on its $400,000 of invested assets comparing the $90,000 of actual operating income to the required minimum of $60,000 division a enrich The Firm by $30,000 more than the required minimum now let's look at division B this division earned $144,000 of op operating income and its required minimum is its $60,000 of invested assets times the required rate of return of 15% when we compare the actual operating income $144,000 to the required minimum return of $90,000 we see that division B enrich The Firm firm by $54,000 so what did we learn from this analysis of residual income division a enriched The Firm by $30,000 after considering the cost of its capital but division B en enriched The Firm by $54,000 after considering the cost of its capital so division B performed better because it made better use of its assets to generate income residual income has a key advantage over Roi for evaluating the performance of investment centers it considers the firm's required minimum rate of return because of that the managers of investment centers will say yes to any project that has a return greater than or equal to the firm's required rate of return so residual income reduces the agency problem and aligns the interests of the managers more closely to the interests of the firm one disadvantage of using residual income to evaluate the performance of managers is that the answer is expressed in dollars not as a percent this makes it more difficult for top management to compare investment opportunities another problem is that a firm may choose an unreasonably High required rate of return the result of this is that it incentivizes the investment center manager to say no to an investment opportunity that might have been very profitable for the firm let's do some practice problems suppose that top management at the drippy faucet company wants to evaluate the performance of its residential faucet division they've acquired information about the divisions net sales operating income and average total assets the firm's policy is to require a minimum rate of return of 18% so what's the division's profit margin ratio think about it the formula for the profit margin ratio is operating income divided by sales when we divide the divisions operating income by its sales we get a number 0.25 or 25% in other words this division generated 25 cents of operating income for each dollar of sales so where did the other 75 cents out of each dollar of sales go the answer is that it was used to cover the cost of goods sold and the operating expenses for the division what is the division's asset turnover ratio take a minute to think about it the formula for the asset turnover ratio is sales divided by invested assets when we take the division sales and divide by its invested assets we get a number 0.80 and we interpret that to mean that the division generated 80 cents of sales revenue for each dollar of invested assets that the division has what is the division's ROI think about it there are two ways to answer this question one way is to take the divisions operating income and divide by its invested assets when we do that we get a number 0.20 or 20% that means that the division generated 20 cents of operating income for each dollar of invested assets another way to answer this question is to remember that the asset turnover ratio and the profit margin ratio came from splitting Roi into its two component parts so we can compute Roi by multiplying the turnover ratio times the profit margin ratio when we do that we get an answer 0.20 or 20% which is exactly the same as the ROI that we computed using the original formula what is the division's residual income think about it remember that residual income is the difference between a division's actual operating in income and some minimum required return on assets the formula for residual income is the actual operating income for the division minus minus its invested assets times the required rate of return we were given the division's actual operating income and we can find the minimum required return on assets by multiplying the divisions invested assets by the 18% required minimum rate of return When We compare the division's actual income to its required minimum return on assets we get a get a number $14,000 this tells us that the residential faucet division of drippy faucets enriched The Firm by $104,000 after considering the cost of capital of course if we wanted to know whether any of these computations represented good news or bad news about the performance of the residential faucet division at grippy faucets we would need some basis of comparison either comparing the performance of this division to another division Vision or comparing it to some predetermined Benchmark in the next section we will be looking at a different Philosophy for evaluating performance