Management Control Systems
Discussion Question: 5-1
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- Calculate for each division the rate of return on net assets and the economic profit based on historical cost and on replacement cost. For purposes of calculating economic profit, use 10% as the cost of capital.
Capital charge =the cost of capital *average net assets (Horngren, Sundem, Burgstahler, and Schatzberg, 2014).
Economic profit= Net operating income- Capital charge
Rate of return on net assets = [operating income/invested capital] *10
| Divisions | Tools | Appliance | Lighting |
| Historical Cost: | |||
| Operating Income | $2,600 | $6,750 | $5,000 |
| Average net assets | $15,000 | $44,000 | $27,000 |
| Cost of capital (%) | 10% | 10% | 10% |
| Capital charge | ($15,000*0.1) = $1,500 | $44,000*0.1 = $4,400 | $27,000 * 0.1 = $ 2700 |
| Rate of Return on Assets | [$2,600/$1,500] *10 = 17.3% | [$6,750/$4,400] * 10 = 15.3% | [$5,000/ $27,00] * 10 = 18.5% |
| Economic Profit | $2,600 – $1,500 = $1,100 | $6,750 – $4,400 = $2,350 | $5,000 – $2,700 = $2,300 |
| Replacement Cost: | |||
| Operating income | $2,500 | $6,150 | $3,900 |
| Average net assets | $16, 000 | $55,000 | $48,000 |
| Capital cost | 10% | 10% | 10% |
| Capital charge | $16, 000 * 0.1 = $1,600 | $55,000* 0.1 = $5,500 | $48,000* 0.1= $4,800 |
| Rate of return on Assets | ($2,500/ $1,600)* 10 = 15.6% | ($6,150/$5,500)*10 = 11.2% | ($3,900/$4,800)*10 = 8.1% |
| Economic profit | $2,500 – $1,600 = $900 | $6,150 – $5,500= $650 | $3,900 – $4,800 = -$900 |
- Rank the performance of each division under each of the four different measures computed in number one.
| Economic profit Historical cost | Economic Profit Replacement cost | Rate of Return Historical Cost | Rate of Return Replacement Cost | |
| 1st | Appliances ($2,350) | Tools ($9,00) | Lighting (18.5%) | Tools (15.6%) |
| 2nd | Lighting ($2,300) | Appliances ($650) | Tools (17.3%) | Appliances (11.2%) |
| 3rd | Tools ($1,100) | Lighting (-$900) | Appliances (15.3%) | Lighting (8.1%) |
- What do these measures indicate about the performance of the division? Of the division managers? Which measure do you prefer? Why?
The return on assets indicates the profit an organization has generated from its assets. The historical cost indicates the actual cost incurred when acquiring the asset, while the replacement cost is the cost incurred when the asset is purchased today (Lowe, 2019). The four measures have been used to indicate the performance of the division and indicate whether the division managers are using the assets efficiently to generate better earnings. Looking at the information above, the historical costs as the base in return on assets rank lighting first while the economic profit ranks the appliances. On the other hand, the replacement costs rank the tools as the most efficient in terms of economic profit and return on assets.
The replacement cost is the most efficient way to measure the performance of the divisions. Ideally, this is the actual cost that is incurred to replace an asset (Horngren, Sundem, Burgstahler, and Schatzberg, 2014). The replacement cost method will enable the division managers to meet their budget goals since it allows the valuation of the assets and liabilities at their actual costs of replacement. This technique of depreciation can be utilized in regulating the value of the asset over time to estimate the return on the asset over time.
References
Horngren, C. T., Sundem, G. L., & Burgstahler, D., & Schatzberg, J. (2014). Introduction to Management Accounting (16th ed.). Boston, MA: Pearson
Lowe, E. A. (2019). On the idea of a management control system: integrating accounting and management control. Management Control Theory, 63.
