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LEARNING NOTE 14.1

LEARNING NOTE 14.1. Responsibility accounting in profit and investment centres. LN14.1 (1). Measuring divisional profitability • Ideally focus should be on relative measures (profitability) rather than absolute measures of profit. • Alternative profitability measures:

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LEARNING NOTE 14.1

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  1. LEARNING NOTE 14.1 Responsibility accounting in profit and investment centres

  2. LN14.1 (1) Measuring divisional profitability • Ideally focus should be on relative measures (profitability)rather than absolute measures of profit. • Alternative profitability measures: 1. Return on investment (ROI) 2. Residual income (RI) 3. Economic value added (EVA ™)

  3. LN14.1 (2a) Return on investment Division ADivision B Profit £1m £2m Investment £4m£20m ROI 25%10% • Division B earns higher profits but A is more profitable. • ROI is a relative measure of performance that can becompared with other investments. It also provides a usefulsummary measure of the ex post return on capitalemployed. • A major disadvantage of ROI is that managers may bemotivated to make decisions that make the company worseoff.

  4. LN14.1 (2b) Division X Division Y Investment project available £10 million £10 million Controllable contribution £2 million £1.3 million Return on the proposed project 20% 13% ROI of divisions at present 25% 9% The overall cost of capital for the company is 15% The manager of X would be motivated not to invest and the manager of Y would be motivated to invest.

  5. LN14.1 (3a) Residual income • Controllable residual income = Controllable profit less acost of capital charge on the investment controllable by themanager. • It is claimed that RI is more likely to encourage goalcongruence Division X (£m) Division Y (£m) Proposed investment 10 10 Controllable profit 2 1.3 Cost of capital charge (15%) 1.5 1.5 Residual income +0.5 – 0.2

  6. LN14.1 (3b) • The manager of division X is motivated to invest and themanager of division Y is motivated not to invest. • If RI is used it should be compared with budgeted/target levels which reflect the size of the divisional investment. • Empirical evidence indicates that RI is not widely used.

  7. LN14.1 (4) Economic value added (EVA™) • During the 1990s RI was refined and renamed EVA ™. • EVA ™ = Conventional divisional profit based on GAAP ± Accounting adjustments – Cost of capital charge on divisional assets • Conventional divisional profit based on principles outlined formeasuring divisional managerial and/or economic profits. • Adjustments intended to convert historic accounting profit to anapproximation of economic profit. • Adjustments typically include capitalization of discretionary expenses.

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