Learning Objectives 2 Examine accounting-based measures for evaluating a business unit’s performance, including return on investment (ROI), residual income (RI), and economic value added (EVA)
return on sales times investment turnover
income minus a dollar amount for required return on investment
a variation of residual income
Companies commonly use four financial measures to evaluate the economic performance of their subunits. We illustrate these measures for Hospitality Inns.
Hospitality Inns owns and operates three hotels: one each in San Francisco, Chicago, and New Orleans. Exhibit 24-1 summarizes data for each hotel for 2020. At present, Hospitality Inns does not allocate the total long-term debt of the company to the three separate hotels. The exhibit indicates that the New Orleans hotel generates the highest operating income, $510,000, compared with Chicago’s $300,000 and San Francisco’s $240,000. But does this comparison mean the New Orleans hotel is the most “successful”? The main weakness of comparing operating incomes alone is that it ignores the differences in the size of the investment in each hotel. Investment refers to the resources or assets used to generate income. The real question is whether a division generates sufficient operating income relative to the investment made to earn it.
Exhibit 24-1
Financial Data for Hospitality Inns for 2020 (in thousands)
Details as follows:
San Francisco Hotel:
Hotel Revenues: $1,200,000
Hotel variable costs: 31,000
Hotel fixed costs: 650,000
Hotel operating income: $240,000
Chicago Hotel
Hotel Revenues: $1,400,000
Hotel variable costs: 375,000
Hotel fixed costs: 725,000
Hotel operating income: $300,000
New Orleans Hotel
Hotel Revenues: $3,185,000
Hotel variable costs: 995,000
Hotel fixed costs: 1,680,000
Hotel operating income: $510,000
Total (Sum of all above 1's): $5,785,000
Total (Sum of all above 2's): $1,680,000
Total (Sum of all above 3's): $3,055,000
Total (Sum of all above 4's): $1,050,000
Interest costs on long-term debt at 10%: 450,000
Income before Income taxes: 600,000
Income taxes at 30%: 180,000
Net Income: 420,000
Net book value at the end of 2020:
San Francisco Hotel:
Current Assets: $400,000
Long-term assets: $600,000
Total assets: $1,000,000
Current liabilities: $50,000
Chicago Hotel
Current Assets: $500,000
Long-term assets: $1,500,000
Total assets: $2,000,000
Current liabilities: $150,000
New Orleans Hotel
Current Assets: $660,000
Long-term assets: $2,340,000
Total assets: $3,000,000
Current liabilities: $300,000
Total (Sum of all above 1's): $1,560,000
Total (Sum of all above 2's): $4,440,000
Total (Sum of all above 3's): $6,000,000
Total (Sum of all above 4's): $500,000
Long term debt: 4,500,000
Stockholder's equity: 1,000,000
Total liabilities and stockholders’ equity 6,000,000.
Three of the approaches to measuring subunit financial performance include a measure of investment: return on investment, residual income, and economic value added. A fourth approach, return on sales, does not measure investment.
Return on Investment
Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment.
Return on investment is the most popular approach to measuring performance for two reasons: (1) It blends all the ingredients of profitability—revenues, costs, and investment—into a single percentage and (2) it can be compared with the rate of return on opportunities elsewhere, inside or outside the company. As with any single performance measure, however, managers should use ROI cautiously and in conjunction with other measures.
ROI is also called the accounting rate of return or the accrual accounting rate of return (Chapter 22). Managers usually use the term ROI when evaluating the performance of an organization’s subunit and the term accrual accounting rate of return when using an ROI measure to evaluate a project. Companies vary in the way they define income in the numerator and investment in the denominator of the ROI calculation. Some companies use operating income for the numerator; others prefer to calculate ROI on an after-tax basis and use net income. Some companies use total assets in the denominator; others prefer to focus on only those assets financed by long-term debt and stockholders’ equity and use total assets minus current liabilities.
Consider the ROIs of each of the three Hospitality hotels in Exhibit 24-1. For our calculations, we use the operating income of each hotel for the numerator and the total assets of each hotel for the denominator.
Using these ROI figures, the San Francisco hotel appears to make the best use of its total assets.
Hotel
Operating Income
Total Assets
ROI
San Francisco
$240,000
$1,000,000
24%
Chicago
$300,000
$2,000,000
15%
New Orleans
$510,000
$3,000,000
17%
Each manager can increase his or her hotel’s ROI by increasing its revenues or decreasing its costs (each of which increases the numerator) or by decreasing the investment in the hotel (which decreases the denominator). Even when a hotel’s operating income falls, the manager can increase its ROI by reducing its total assets by a greater percentage. Suppose, for example, that the operating income of the Chicago hotel decreases by 4% from $300,000 to $288,000 and its total assets decrease by 10% from $2,000,000 to $1,800,000. The ROI of the Chicago hotel would then increase from 15% to 16%
ROI can provide additional insight into performance when it is represented as two components:
which is also written as
This approach is known as the DuPont method of profitability analysis. The DuPont method recognizes the two basic ingredients in profit making: increasing the income per dollar of revenues and using assets to generate more revenues. An improvement in either ingredient, even without changing the other, increases the ROI.
Assume Hospitality Inns’ top managers adopt a 30% target ROI for the San Francisco hotel. How can this return be attained? Using the DuPont method, the following example shows three alternative ways the managers of the hotel can increase its ROI from 24% to 30%.
Operating Income (1)
Revenues (2)
Total Assets (3)
Current ROI
$240,000
$1,200,000
$1,000,000
20%
1.2
24%
Alternatives
A. Decrease assets (such as receivables), keeping revenues and operating income per dollar of revenue constant
$240,000
$1,200,000
$ 800,000
20%
1.5
30%
B. Increase revenues (via higher occupancy rate), keeping assets and operating income per dollar of revenue constant
$300,000
$1,500,000
$1,000,000
20%
1.5
30%
C. Decrease costs (via, say, efficient maintenance) to increase operating income per dollar of revenue, keeping revenue and assets constant
$300,000
$1,200,000
$1,000,000
25%
1.2
30%
Other alternatives, such as increasing the selling price per room, could increase both the revenues per dollar of total assets and the operating income per dollar of revenues.
ROI makes clear the benefits managers can obtain by reducing their investment in current or long-term assets. Most managers know they need to boost revenues and control costs, but pay less attention to reducing their investment base. Reducing the investment base involves decreasing idle cash, managing credit judiciously, determining proper inventory levels, and spending carefully on long-term assets.
