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Lecture 9

Management and Organizational Studies 3370A/B Lecture Notes - Lecture 9: Balanced Scorecard, Earnings Before Interest And Taxes, Operating Expense


Department
Management and Organizational Studies
Course Code
MOS 3370A/B
Professor
Laura Timusk
Lecture
9

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Lecture 8
Return on Investment
-   

o Operating income - Income before interest and taxes (EBIT)
o Average operating assets - Cash, accounts receivable, inventory, plant and equipment,
and other productive assets
Net Book Value (NBV) Vs. Gross Costs
- Arguments for Using NBV to measure Operating Assets in ROI Calculation:
o The NBV method is consistent with:
o how plant and equipment are reported on the balance sheet
o the calculation of operating income, which includes depreciation as an operating
expense.
- Arguments for Using Gross Cost to measure Operating Assets in ROI Calculation:
o The gross cost method
o Eliminates both the age of equipment and the method of depreciation as factors in ROI
calculations.
o Does not discourage replacement of old, worn-out equipment.
- Most companies use NBV (Cost accumulated depreciation)
Increasing ROI
- Increase Sales
- Reduce Operating Expenses
- Reduce Operating Assets
ROI = Margin x Turnover
-  
 

Criticisms of ROI
- In the absence of the balanced scorecard, management may not know how to increase ROI
- Managers often inherit many committed costs which they have no control
- Managers evaluated on ROI may reject profitable investment opportunities
Residual Income Another Measure of Performance
- Operating income above some minimum return on operating assets
-  
o   
- This computation differs from ROI.
- ROI measures operating income earned relative to the investment in average operating assets.
- Residual income measures operating income earned less the minimum required return on
average operating assets
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- residual income encourages managers to make profitable
investments that would be rejected by managers using ROI
Divisional Comparison and Residual Income
- The residual income approach has one major disadvantage
o It cannot be used to compare performance of divisions of different sizes
- Residual Income is based on historical accounting data which can lead to inflated amounts for
residual income in periods of rising prices (i.e. values of capital assets)
- RI does not indicate what earnings should be (need comparison of external benchmark or
trends)
- Calculating RI requires numerous adjustments to GAAP increasing the cost of preparing
information
- RI does not incorporate important leading non-financial indicators
The Balanced Scorecard
- Management translates its strategy into performance measures that employees understand and
accept
- Performance measures examples
o Financial
o Customers
o Internal business processes
o Learning and growth
- Relies on non-financial measures in addition
to non-financial
o Financial measures are lag indicators
that summarize the past results of
past actions
o Non-financial measures are leading
indicators of future financial
performance
o Top managers are ordinarily responsible for financial performance measures not lower
level managers
o Non-financial measures are more likely to be understood and controlled by lower level
managers
Balanced Scorecard for Individuals
- Entire organization should have a balanced scorecard and each individual should have a
balanced scorecard
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