Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 16

Management of Division A is evaluated based on residual income measures. The division can either rent or buy a certain asset. Might the performance evaluation technique have an impact on the rent-or-buy decision? Why or why not? Will your answer change if EVA is used?

Step 1 of 2

Divisional performance management

Performance measures are developed to assess the divisional performance. Performance measures should be consistent with authority granted and performance measures should assess the effectiveness of actions. Company should also consider those actions of divisional managers that improve the divisional performance but are unfavorable to organization performance. Divisions are assessed on income earned because divisions have revenue and cost both.

Residual income

This is another measure used to evaluate divisional performance. This is not a ratio. Residual income is calculated by deducting the cost of investment from the amount of income after tax. Cost of investment is calculated by multiplying the cost of capital with amount of divisional assets.

Economic value added (EVA)

This is a performance measure for divisions and firms’ performance. EVA is calculated by deducting the cost of adjusted divisional investment from adjusted income amount.

Adjusted income is calculated by adding the advertising expenses incurred to the income after tax and then deducting the amount of amortized advertising expenses from the sum total. It is believed that advertising expenses shall yield benefit for more than one year and cost of advertising is amortized over the number of years benefit is received.

Adjusted divisional investment amount is calculated by deducting the current liabilities amount from total assets amount and then add the amount of unamortized advertising expense amount to the sum total.

Cost of adjusted divisional investment is calculated by multiplying the adjusted divisional investment amount with cost of capital rate.