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Aligning operations with value-created insights: facilitating the financial-task.

Three organizational issues prompted this article and are addressed by it:

1. The problematic pursuit of ever-better alignment within organizations.

2. The challenge to provide operating managers with pertinent information to ensure there is effective alignment.

3. The need for easily used tools to address the first two issues.

Alignment is often described as "a central theme in the field of strategic management ... (requiring) a shared understanding of organizational goals and objectives by managers at various levels and within various units." (1) The benefit from achieving effective intraorganizational alignment is: "as alignment between manufacturing and business strategies increases, firm performance increases." (2) This is also true for service operations. Yet, "despite ... the importance of alignment in business it remains a difficult concept to implement." (3)

Beneficial alignment "requires information (emphasis added) to ensure there is effective coordination between strategy and manufacturing." (4) The need for aligned information arises on two fronts. Tom Nicholas asserted in 2000, when he was a practice manager with PricewaterhouseCoopers, that many operating managers do "bad things." Among those "sins" is that they often "manage purely to EBIT (earnings before interest and taxes) objectives and ignore the impact on RONA (return on net assets) when developing an asset strategy." (5) As those in the financial arena know, the usefulness of RONA is that it can be used to highlight the "fluctuations in net income or net assets." (6) For an operating manager, EBIT should represent only the starting point of the performance and planning stories. Ascribing EBIT to the assets deployed is an additional, key operating focus that facilitates enterprise-level resource allocations and performance assessment.

The second information-related front galvanizing this article pertains to value creation. Brian Ballou and colleagues pointed out in a provocative 2010 Management Accounting Quarterly (MAQ) article that one of the most common challenges for managers at all levels is answering the question: "How do my actions create value for investors?" (7) This is an important question because: "Firms operate primarily in the interests of the investor (and) seek to eliminate value destroying activities." (8) Information pertaining to a value "focus ... (can be used to) boost productivity and liberate resources that benefit stakeholders of all kinds." (9) Darryl Waldron asserts that "manufacturing outcomes should be judged on the basis of shareholder value (created)." (10) This is certainly true for many other industries as well. More specifically, Karen Kroll, writing in Industry Week, reports that since value-oriented metrics "relate the income statement to the balance sheet (such metrics) are particularly relevant for manufacturing companies." (11) Whether the specific metric used in this regard is called economic value added, residual income, or economic profit (EP), it must quantify the monetary value accruing to an entity's owners after taking into consideration the cost incurred to finance pertinent enterprise assets. Thus alignment of operating managers' mind-sets with the enterprise's strategic financial objectives is fostered by providing those managers with actionable information that pertains to not just earnings (EBIT) or asset performance (RONA) but also to value created and destroyed (EP).

In concert with the foregoing alignment and information motivations for this article is a third and final overarching motivation--the need for useful tools to connect the other two. Indeed, the challenge is to implement "easily understood, operationally meaningful" (12) "analytical decision-making tools" (13) that aid operating managers in making decisions congruent with information focused on earnings, assets, and value creation. This article provides a set of customizable reference table tools to link all three of these financial foci at the operating unit level more closely with corporate finance, thus creating enhanced financial alignment. Moreover, the tables introduced here can be used to operationalize and complement the value-created focus called for in the "Actions-to-Value Framework" described by Ballou and his colleagues in MAQ.

In sum, our objectives are to present, explain, and demonstrate a handy, easily used, customizable, information-rich set of reference tables for operating managers that:

* Helps align operating unit managers' interests with those of corporate finance;

* Facilitates the conversations between those two parties regarding past performance, strategic planning, resource deployment, and future investment;

* Reconciles the difference between targeted and actual earnings due to the effects of changes in a period's investment in net assets (NA), the profit margin earned on those assets (RONA), and the interaction effect of those two factors; and

* Provides easily derived and understood conversions of a familiar EBIT operations-oriented financial metric to a value-created, owners-oriented economic profit (EP) metric.

Management accountants are perfectly positioned to create, communicate, and champion the tools introduced here--tools designed to facilitate the accomplishment of these important enterprise objectives.

GETTING STARTED

The reference tables (Tables 1, 2, 3, and 4) utilize four common financial constructs that have wide applicability to most business organizations. Three have already been mentioned: EBIT, NA, and RONA. The fourth pertains to a company's weighted average cost of capital (WACC). In the reference tables, these financial constructs are used to develop an asset-focused operating earnings variance analysis, as well as an estimation of a fifth value-created financial measure--economic profit (EP).

Envision the following: The typical budgeting process at the operating-unit level (such as for a plant, product line, business unit, program, region, store, etc.) usually begins with the expectation for, and ultimately the establishment of, an earnings target. Depending on the company, targeted operating-unit earnings might be referred to as "operating profit" or EBIT These two financial constructs generally are synonymous and often are used to evaluate operating units and those who manage them.

In addition, the budgeting process may operationalize some notion of net assets (NA), perhaps referred to as capital employed, invested capital, or simply net assets, all of which have a similar operationalization in financial circles. In order to avoid the "sins" and "bad things" mentioned earlier, businesses are well served to have financial managers highlight for their operating unit colleagues those units' respective share of NA, if that is not currently being done. Here we will use the NA terminology, where NA is equivalent to net fixed assets (property, plant, and equipment less accumulated depreciation) plus net working capital (accounts receivable + inventory - accounts payable - accrued expenses).

The third important financial construct is simply the result of linking the first two. Conceptually, EBIT divided by NA results in a generalized, before-tax rate-of-return metric we refer to as RONA. (14) For our purposes here, the RONA metric extends a simple EBIT earnings amount into an asset-based earnings measure.

Next is WACC. All companies incur a cost associated with the funds they invest in operating assets. Just as an individual often finances the purchase of significant personal assets, such as a home or car, with a blend of borrowed funds and personal savings, companies do this, too. The "standard measure of expressing a company's cost of (their blended sources of) capital is the weighted average cost of capital--WACC." (15) Not all operating-level managers in a company may know what that construct means, or, if they do know what it means, they may not know its numeric value or how it pertains to their units. Part of the benefit to be derived from the use of the reference tables presented here is bringing to life the WACC construct for operating managers and providing them with a simple, direct means for appreciating its significance and factoring it into their performance analyses and asset-level decisions.

Together, these four financial constructs--EBIT, NA, RONA, and WACC--provide the foundations for the asset-focused earnings variance analysis and the value-created EP estimate obtainable from using the reference tables. These tables provide interpretable, understandable, important insights for evaluating business-unit performance across time and across units, and they are independent of enterprise size. Once the tables are established and explained by a company's management accountants, operating managers can easily and quickly refer to them to derive the insights they are intended to provide.

FACILITATED TASK #1: DECODING THE ROLE OF NA IN EBIT

Assessing actual earnings delivered by an operating unit at a period's end is critical and a sound starting point for performance assessment. Particularly useful insights pertain to isolating the difference between a period's actual EBIT earnings versus its planned EBIT earnings due to changes in the NA employed, the profit margins earned on the NA employed, and the interaction effect of both factors. Tables 1 through 3 are designed to quantify each of these in sequence.

For discussion purposes, assume the simple, single-period operating-unit data presented in Figure 1.

Step 1

If not currently done at an operating level, planned and actual NA monetary amounts should be ascribed to operating units by corporate finance/accounting. From that information, the two RONA calculations in Figure 1 can be made. Then the first step in using the earnings variance tables is to calculate the percentage change in actual NA in place during the period versus what had been planned. In our example, that percentage change is +25% [($5,000,000 - $4,000,000) / $4,000,000]. Similarly, the percentage change in the period's actual RONA versus the unit's originally planned RONA must be determined. Here that percentage change is +20% [(18% - 15%) / 15%]. Both percentage-change figures will be used as coordinates in Tables 1 through 3.

Step 2

Use of Table 1 enables an operating manager to quantify that portion of his or her total period EBIT earnings variance, which is $300,000 in the example, due solely to more NA in actual use than was planned. Reading across the +25% row and down the +20% column, the Table 1 factor is 0.166667. Multiplying the actual EBIT earnings delivered by the operating unit, which in this case is $900,000, by that factor identifies $150,000 of the $300,000 as due to more NA in use at the initially planned profit margin rate. (See Table 1.)

Step 3

The next step is to ascertain the monetary amount of the total EBIT earnings variance for the period due to the more profitable use of the planned NA. Using the same coordinates as in Step 2, the pertinent factor is 0.133333. Applying that factor to the total actual EBIT earnings amount of $900,000 identifies $120,000 of the $300,000 EBIT earnings variance as being due to higher margins earned on the NA initially planned to be in use. (See Table 2.)

Step 4

The combined effect of having more NA in place and using that higher level of NA more profitably can now be quantified. Employing the same table coordinates, the factor 0.033333 emerges. When that factor is used to multiply the total actual EBIT earnings produced for the period, the interaction variance amount of $30,000 is highlighted. (See Table 3.)

Congruent with the visual representation of classic cost variance analysis posed by Lawrence Vance nearly 70 years ago in a National Association of Cost Accountants Bulletin, the three highlighted parts of this example's $300,000 EBIT variance can be depicted.16 (See Figure 2.)

Here the planned EBIT earnings target of $600,000 is shown as a function of the $4,000,000 NA that was planned to be used, earning a planned 15% profit margin. In this example, the planned EBIT of $600,000 evolved into an actual achieved EBIT of $900,000 due to the three explanations derived from employing the factors from Tables 1 through 3. (17) Specifically, using more NA explains $150,000 of the EBIT variance. The more profitable use of NA as evidenced by a higher actual RONA rate explains another $120,000 of the EBIT difference. Finally, the combination of higher actual margins and higher actual levels of NA explains the remaining $30,000 of the $300,000 increase in EBIT earnings over plan experienced by the operating unit.

FACILITATED TASK #2: CONVERTING EBIT TO EP

The most robust performance management systems are those that "... illustrate an organization's essential means and ends" and provide "predictive capabilities" for operating managers. (18) In a financial performance context, the foregoing discussion provided easily obtained means/ends insights by partitioning the difference between a period's planned EBIT versus its achieved EBIT Was that difference due to a change in the assets (NA) used, the profit margin (RONA) earned, or both? Tables 1 through 3 revealed how each of those potential means gives rise to a period's actual EBIT One additional critical connection remains--extending the analysis to EP, the fifth and final financial construct. Table 4 is the tool for creating and aligning that operating insight with the value-creation focus of the total enterprise and its owners.

Conceptually, two financial deductions are needed to convert an EBIT measure to an EP value-created approximation. Those two adjustments pertain to income taxes and a capital charge on the NA employed. Both are embedded in the Table 4 factors. More precisely, Table 4 assumes the U.S. statutory income tax rate of 35%. A company could craft its own version of Table 4 using its specific, effective income tax rate. In addition, the capital charge deduction is a function of a company's unique WACC, and Table 4 provides several options in that regard. Such a charge must be levied against a tax-adjusted EBIT amount, and, "unless a firm can earn in excess of its cost of capital, it will not create economic profit [EP] or value for its investors." (19) (See Table 4.)

As a demonstration, we will use the data presented earlier. The value-creation question is: For an operating unit that generates $900,000 in actual EBIT with an EBIT-based actual RONA of 18%, did that unit create value (i.e., EP) for the company or not?

Assume the company's corporate financial management derives and imposes a cost-of-capital (WACC) rate of 9%, which is a figure in the realm of current realities. Using Table 4, we go to the 9% column and the achieved before-tax RONA row of 18%, obtaining a table factor of 0.150. When the period's actual EBIT earnings figure ($900,000, as you recall) is multiplied by this factor, we obtain the operating unit's approximate EP value-created amount of $135,000. (20)

To underscore the importance of an EP perspective, assume the company's relevant WACC was 12%, which is at the higher end of today's corporate mainstream. In that case, the Table 4 factor is -0.0167 (read from the 18% row and the 12% column). This factor, because it is a negative number, means the operating unit destroyed enterprise value. In fact, $15,030 ($900,000 X (-0.0167)) of enterprise (owner) value was destroyed in spite of an actual positive EBIT of $900,000 that was an impressive 50% higher than the planned EBIT figure of $600,000.

Clearly, destroying enterprise value at the operating-unit level is a scenario to be avoided if at all possible. This is where the predictive usefulness of Table 4 comes into play. During the budgeting cycle, Table 4 could have been used to signal that the targeted EBIT of $600,000 with a planned NA base of $4,000,000 should not have been approved. Why? Because that original plan was going to destroy enterprise value of $90,000. This would have been easily identifiable by referring to Table 4's 15% row (the originally planned RONA rate), the 12% WACC column, which in tandem then points to the -0.15 factor. When that factor is applied to the planned EBIT figure, a projected $90,000 ($600,000 X (-0.15)) decrease to enterprise value is highlighted. (21)

AN IMPORTANT PURSUIT

As Chee Wong et al. wrote in a 2012 Supply Chain Management article: "There is a need to achieve shareholder alignment so that functional strategies and business processes used to deliver them are compatible with business strategy and shareholder expectations." (22)

Stated simply, shareholders expect sustainable, significant economic value creation. (23) Jacques Bughin and Thomas Copeland estimated that 80 of the 100 largest U.S. companies destroyed enterprise value over a 20-year period and that, on average, the same was true in many of the continental European countries they studied. (24) Operating managers appear to be "driving blind"--not aware of the value (i.e., EP) effects of their operating asset decisions.

To this latter point, "... the relationship between money, interest rates, and returns to invested capital" has been conceptually espoused and discussed in some circles since the 16th Century. (25) Yet barely half of a small sample of 27 companies were found to use the cost of capital concept to evaluate divisional-level performance. (26) Both IMA[R] (Institute of Management Accountants) and the U.K.-based CIMA (Chartered Institute of Management Accountants) have called for enterprise-level, value-creation analysis to be driven down to a company's operating managers. (27) Alfred Rappaport a leading expert on shareholder-value thinking, captures this imperative well: "A sound strategic analysis by a company's operating units (emphasis added) should produce informed responses to three questions: First, how do alternative strategies affect value? Second, which strategy is likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the most likely scenario to ... relevant variables?" (28)

An enterprise's management accountants can easily build, explain, and champion the tables we introduced here to address these questions. In fact, the tables represent enhanced means by which management accountants can "prepare analyses of factors influencing business results" and "support the goals of external parties (e.g., shareholders)"--two important functions of management accountants. (29) Note that the tables are easy to use because of their familiar format and are modeled after those used in such diverse yet common settings as:

* The healthcare industry's tables used to derive a person's BMI (body mass index) based on his or her height and weight (e.g., www.webmd.com/a-to-z-guides/body-mass-index-bmi-for-adults);

* The meteorological charts that convert ambient air temperature and wind speed to a wind-chill factor (www.nws.noaa.gov/om/windchill); and

* The classic present value tables using axes of time and interest rates.

Such familiar reference tables informed the format of those introduced here.

IT CAN BE DONE

Many would agree that "companies with superior performance are characterized by the intensive application of rational data analysis." (30) The reference table tools presented here facilitate that kind of analysis.

Moreover, they are compatible with various asset management frameworks and represent a "sensible integration of business analytics in a performance management framework." (31)

Management accountants' use of these tables can help operating managers translate, quantify, and become better aligned with the financial performance imperatives resident at an enterprise level. Specifically, they help in "tracing the impact of proposed strategic actions on shareholder value." (32) In the end, assets, value creation, and financial alignment are worthy foci for operating managers and corporate finance. Management accountants are perfectly positioned to aid in that pursuit. The tables introduced here present a customizable, useful, sound way to integrate all three foci. (33)

Paul W. Farris, DBA, is Landmark Communications Professor of Business Administration at the Darden Graduate School of Business at the University of Virginia. He can be reached at farrisp@darden.virginia.edu.

Mark E. Haskins, Ph.D., is professor of business administration at the Darden School of Business. He can be reached at haskinsm@darden.virginia.edu.

Endnotes

(1) Ravi Kathuria, Maheshkumar P. Joshi, and Stephen J. Porth, "Organizational Alignment and Performance: Past, Present, and Future," Management Decision, No. 3, 2007, pp. 503, 504.

(2) Ibid., p. 508.

(3) Christopher M. Scherpereel, "Alignment: The Duality of Decision Problems," Management Decision, No. 9, 2006, p. 1259.

(4) Robert H. Chenall, "Integrative Strategic Performance Measurement Systems, Strategic Alignment of Manufacturing, Learning and Strategic Outcomes: An Exploratory Study," Accounting, Organizations and Society, No. 5, 2005, p. 402.

(5) Tom Nicholas, "Bad Things that Operations Managers Do," Industry Week, December 11, 2000, p. 30.

(6) Darrin J. Wikoff, "Financial Planning for Asset Management," Plant Engineering, June 2012, p. 47.

(7) Brian Ballou, Dan Heitger, and Thomas Schultz, "The Actions-to-Value Framework: Linking Managerial Behavior to Organizational Value," Management: Accounting Quarterly, Summer 2010, p. 1.

(8) Cliff Bowman and Veronique Ambrosini, "How Value Is Created, Captured, and Destroyed," European Business Review, No. 5, August 2010, pp. 479-495.

(9) Jacques Bughin and Thomas E. Copeland, "The Virtuous Cycle of Shareholder Value Creation," The McKinsey Quarterly, May 1997, p. 157.

(10) Darryl G. Waldron, "Manufacturing as a Center for the Creation of Shareholder Value," Journal of Business & Economic Research, November 2010, p. 46.

(11) Karen M. Kroll, "Bridging the Earnings Divide," Industry Week, October 2001, p. 28.

(12) Alfred Rappaport, Creating Shareholder Value: A Guide for Managers and Investors, The Free Press, New York, N.Y., 1998, p. 52.

(13) Marten Schlafke, Riccardo Silvi, and Klaus Moller, "A Framework for Business Analytics in Performance Management," International Journal of Productivity and Performance Management, No. 1, 2013, p. 111.

(14) Technically, RONA is widely viewed as determined by NOPAT / NA, where NOPAT is "net operating profit after tax." The difference between NOPAT and EBIT is income taxes. At this juncture in this article, the presumption is that operating managers are not accountable for, or aware of, the income taxes applicable to their operating unit's earnings. In reality, RONA can be customized by a company as long as the numerator is an earnings-type amount and the denominator is an asset or investment-type figure.

(15) Robert F Bruner, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins, "Best Practices in Estimating the Cost of Capital: Survey and Synthesis," Financial Practice and Education, Spring/Summer 1998, p. 15. For an informative discussion of a variety of issues related to the determination of a company's cost of capital, see: Michael T Jacobs and Anil Shivdasani, "Do You Know Your Cost of Capital?" Harvard Business Review, July/August 2012, pp. 118-124.

(16) Lawrence L. Vance, "The Fundamental Logic of Primary Variance Analysis," National Association of Cost Accountants Bulletin, January 1950, pp. 625-632.

(17) The variance discussion to this point presumes a company's preference for, focus on, and use of actual EBIT earnings in deconstructing the EBIT earnings variance. Thus the Table 13 factors are poised as multipliers of an operating unit's actual EBIT amount. In contrast, and perhaps a bit awkwardly, if the EBIT earnings variance analysis seeks to use the initially planned EBIT amount, Tables 1-3 are not appropriate. In that instance, the planned EBIT amount would be multiplied by the period's percentage change in NA (in our example, 25%), the percentage change in RONA margin (20%), and the product of these two percentage changes (25% x 20% = 5%) to arrive at the identical three-part deconstruction of the total EBIT earnings variance of $300,000.

(18) Schlafke et al., 2013, pp. 110, 112.

(19) Bruner et al., 1998, p. 14. Also see Predrag Stancic, Milan Cupic, and Vladimir Stancic, "A Choice of Performance Measurement System in the Shareholder Value Oriented Company," Economic Themes, March 2012, pp. 81-100.

(20) This amount can be verified in the following way: EBIT of $900,000 less income taxes at a 35% rate results in an after-tax EBIT of $585,000 (this amount is often referred to in financial circles as NOPAT--net operating profit after taxes). The capital charge to be levied against the operating unit's $5,000,000 of actual NA in use equals $450,000 ($5,000,000 x .09). Thus the after-tax adjusted EBIT amount of $585,000 less the capital charge of $450,000 results in an EP amount of $135,000--the same figure as derived from using the Table 4 factor.

(21) For those interested in how another set of EP tabular tools can be used in an incentive compensation scenario, see: William J. Branch, Paul W. Farris, and Mark E. Haskins, "Pay for Performance: Keep it Simple and Value Focused," Compensation & Benefits Review, No. 2, 2011, pp. 82-91.

(22) Chee Wong, Heather Skipworth, Janet Godsell, and Nemile Achimugu, "Towards a Theory of Supply Chain Alignment Enablers: A Systematic Literature Review," Supply Chain Management: An International Journal, No. 4, 2012, p. 419.

(23) See Erik Stern and Mike Hutchinson, The Value Mindset, John Wiley & Sons, Inc., Hoboken, N.J., 2004. Also see Andrew Black, Philip Wright, and John Davies, In Search of Shareholder Value: Managing the Drivers of Performance, Financial Times/Prentice Hall, London, U.K., 2001.

(24) Bughin and Copeland, 1997.

(25) Roderick Hewlett, "A Practitioner's Guide to Estimating Weighted Average Cost of Capital and Determining Capital Structure," Journal of Corporate Treasury Management, No. 3, 2008, p. 230.

(26) Bruner et al., 1998.

(27) IMA[R] (Institute of Management Accountants), Measuring and Managing Shareholder Value Creation, Institute of Management Accountants, Montvale, N.J., 1997; CIMA (Chartered Institute of Management Accountants), Maximising Shareholder Value: Achieving Clarity in Decision-making, Chartered Institute of Management Accountants, London, U.K., 2004.

(28) Alfred Rappaport, "10 Ways to Create Shareholder Value," Harvard Business Review, September 2006, p. 69.

(29) Ivo De Loo, Bernard Verstegen, and Dirk Swagerman, "Understanding the Roles of Management Accountants," European Business Review, No. 3, 2011, p. 295.

(30) Tobias Klatt, Marten Schlaefke, and Klaus Moeller, "Integrating Business Analytics into Strategic Planning for Better Performance," Journal of Business Strategy, No. 6, 2011, p. 33.

(31) Khaled El-Akruti, Richard Dwight, and Tieling Zhang, "The Strategic Role of Engineering Asset Management," International Journal of Production Economics, No. 146, 2013, pp. 227-239; Klatt et al., 2011, p. 30.

(32) Eugene G. Lukac and Don Frazier, "Linking Strategy to Value," Journal of Business Strategy, No. 4, 2012, p. 49.

(33) The final formulas (and their derivation) undergirding each of the four tables are presented in the Appendix. Using those formulas along with company-centric values for the variables in those formulas readily leads to a customized set of tables for any company that chooses to do so. Instead of producing hardcopy tables, the final formulas can also be embedded in an Excel spreadsheet used in the normal budgeting, performance measurement, and/or financial reporting processes.

Appendix

Derivation of Formulas Undergirding the Tables

Customized versions of this article's tables, using axis values and granularity set by a company, are easily crafted using the final formulas presented below.

Legend:

EBIT = earnings before interest and taxes

NA = net assets

RONA = return on net assets

WACC = weighted average cost of capital

EP = economic profit

A = actual

P = planned, targeted, budgeted

Table 1 (isolating the effects of a change in NA on the total EBIT
earnings variance) Start with:

1. ([RONA.sub.(P)]) ([NA.sub.(A)] - [NA.sub.(P)]) =
([EBIT.sub.(A)]) (Table 1 factor)

2. Substituting [([RONA.sub.(A)]) (([NA.sub.(A)])] for
([EBIT.sub.(A)] leads to:

3. [([RONA.sub.(P)]) ([NA.sub.(A)] - [NA.sub.(P)])] /
[[RONA.sub.(A)]) ([NA.sub.(A)])] = Table 1 factor

4. [([RONA.sub.(P)]) ([NA.sub.(A)]) - ([RONA.sub.(P)])
([NA.sub.(P)])] / [([RONA.sub.(A)]) ([NA.sub.(A)])] = Table 1
factor

5. Substituting [([NA.sub.(P)]) (1 + %[DELTA] in NA)] for
[NA.sub.(A)] and [([RONA.sub.(P)]) (1 + %[DELTA] in RONA)] for
[RONA.sub.(A)] leads to:

6. [([RONA.sub.(P)]) ([NA.sub.(P)]) (1 + %[DELTA] in NA) -
([RONA.sub.(P)]) ([NA.sub.(P)])] - [([RONA.sub.(P)]) (1 + %[DELTA]
in RONA) ([NA.sub.(P)]) (1 + %[DELTA] in NA)] = Table 1 factor

7 [1 + %[DELTA] in NA - 1] - [(1 + %[DELTA] in RONA) (1 + %[DELTA]
in NA)] =Table 1 factor

8. [%[DELTA] in NA] t [(1 + %[DELTA] in RONA) (1 + %[DELTA] in NA)]
= Table 1 factors

Table 2 (isolating the effects of a change in RONA on the total
EBIT earnings variance) Start with:

1. ([NA.sub.(P)]) ([RONA.sub.(A)] - [RONA.sub.(P)]) =
([EBIT.sub.(A)]) (Table 2 factor)

2. Make the same type of substitutions as performed above for Table
1's factors resulting in:

3. [%[DELTA] in RONA] / [(1 + %[DELTA] in RONA) (1 + %[DELTA] in
NA)] = Table 2 factors

Table 3 (isolating the interaction effect of a change in both NA
and RONA on the total EBIT earnings variance) Start with:

1. ([NA.sub.(A)] - [NA.sub.(P)]) ([RONA.sub.(A)] - [RONA.sub.(P)])
= ([EBIT.sub.(A)]) (Table 3 factor)

2. Making similar substitutions as depicted for Table 1 above,
leads to:

3. [(([NA.sub.(P)]) (1 + %[DELTA] in NA) - [NA.sub.(P)])
(([RONA.sub.(P)]) (1 + %[DELTA] in RONA) - [RONA.sub.(P)])] /
[([RONA.sub.(P)]) (1 + %[DELTA] in RONA) ([NA.sub.(P)]) (1 +
%[DELTA] in NA)] = Table 3 factor

4. [([NA.sub.(P)]) (1 + %[DELTA] in NA) ([RONA.sub.(P)]) (1 +
%[DELTA] in RONA) - ([NA.sub.(P)]) (1 + %[DELTA] in NA)
([RONA.sub.(P)]) - ([NA.sub.(P)]) ([RONA.sub.(P)]) (1 + %[DELTA] in
RONA) + ([NA.sub.(P)]) ([RONA.sub.(P)])] - [([RONA.sub.(P)]) (1 +
%[DELTA] in RONA) ([NA.sub.(P)]) (1 + %[DELTA] in NA)] =Table 3
factor

5. [([NA.sub.(P)]) ([RONA.sub.(P)]) ((1 + %[DELTA] in NA) (1 +
%[DELTA] in RONA) - (1 + %[DELTA] in NA) - (1 + %[DELTA] in RONA) +
1)] / [([NA.sub.(P)]) ([RONA.sub.(P)]) (1 + %[DELTA] in RONA) (1 +
%[DELTA] in NA)] = Table 3 factor

6. [1 + %[DELTA] in RONA + %[DELTA] in NA + (%[DELTA] in NA)
(%[DELTA] in RONA) - 1 - %[DELTA] in NA - 1 - %[DELTA] in RONA + 1]
/ [(1 + %[DELTA] in RONA) (1 + %[DELTA] in NA)] = Table 3 factor

7. [(%[DELTA] in NA) (%[DELTA] in RONA)] / [(1 + %[DELTA] in RONA)
(1 + %[DELTA] in NA)] = Table 3 factors

Table 4 (converting before-tax EBIT to an after-tax,
after-capital-charge EP figure) Start with:

1. [([EBIT.sub.(A)]) (1 - tax rate)] - [([NA.sub.(A)]) (WACC)] =
([EBIT.sub.(A)]) (Table 4 factor)

2. ([EBIT.sub.(A)]) - ([EBIT.sub.(A)]) (tax rate) - ([NA.sub.(A)])
(WACC) = ([EBIT.sub.(A)]) (Table 4 factor)

3. [([EBIT.sub.(A)]) - ([EBIT.sub.(A)]) (tax rate) - ([NA.sub.(A)])
(WACC)] / [[EBIT.sub.(A)]] =Table 4 factor

4. 1 - tax rate - [([NA.sub.(A)] / EBIT (a)) (WACC)] = Table 4
factor


Here it is important to note that the term ([NA.sub.(A)] / ([EBIT.sub.(A)] in equation #4 is simply the inverse of the before-tax RONA rate of return used as an axis in Table 4.

Caption: Figure 2: Highlighting This Example's $300,000 EBIT Variance

Table 1: Factors to Multiply Actual EBIT Earnings by in Order to
Derive the Increase/Decrease from Planned EBIT Earnings Due to a
Change in Net Assets Employed When...

                                  RONA % [DELTA]s

                      -20%        -15%        -10%         -5%

NA           -30%   -0.535714   -0.504202   -0.476190   -0.451128
% [DELTA]s   -25%   -0.416667   -0.392157   -0.370370   -0.350877
             -20%   -0.312500   -0.294118   -0.277778   -0.263158
             -15%   -0.220588   -0.207612   -0.196078   -0.185759
             -10%   -0.138889   -0.130719   -0.123457   -0.116959
             -5%    -0.065789   -0.061920   -0.058480   -0.055402
              0%      0.00        0.00        0.00        0.00
              5%    0.059524    0.056022    0.052910    0.050125
             10%    0.113636    0.106952    0.101010    0.095694
             15%    0.163043    0.153453    0.144928    0.137300
             20%    0.208333    0.196078    0.185185    0.175439
             25%    0.250000    0.235294    0.222222    0.210526
             30%    0.288462    0.271493    0.256410    0.242915

                                  RONA % [DELTA]s

                       0%          5%          10%         15%

NA           -30%   -0.428571   -0.408163   -0.389610   -0.372671
% [DELTA]s   -25%   -0.333333   -0.317460   -0.303030   -0.289855
             -20%   -0.250000   -0.238095   -0.227273   -0.217391
             -15%   -0.176471   -0.168067   -0.160428   -0.153453
             -10%   -0.111111   -0.105820   -0.101010   -0.096618
             -5%    -0.052632   -0.050125   -0.047847   -0.045767
              0%      0.00        0.00        0.00        0.00
              5%    0.047619    0.045351    0.043290    0.041408
             10%    0.090909    0.086580    0.082645    0.079051
             15%    0.130435    0.124224    0.118577    0.113422
             20%    0.166667    0.158730    0.151515    0.144928
             25%    0.200000    0.190476    0.181818    0.173913
             30%    0.230769    0.219780    0.209790    0.200669

                    RONA % [DELTA]s

                          20%

NA           -30%      -0.357143
% [DELTA]s   -25%      -0.277778
             -20%      -0.208333
             -15%      -0.147059
             -10%      -0.092593
             -5%       -0.043860
              0%          0.00
              5%        0.039683
             10%        0.075758
             15%        0.108696
             20%        0.138889
             25%        0.166667
             30%        0.192308

Note: The symbol "[DELTA]" signifies the word "change."

NA = Net assets

RONA = Earnings before interest and taxes/net assets

Table 2: Factors to Multiply Actual EBIT Earnings by in Order to
Derive the Increase/Decrease from Planned EBIT Earnings Due to a
Change in RONA Profit Margin Experienced When ...

                                      RONA % [DELTA]s

                      -20%        -15%        -10%         -5%

             -30%   -0.357143   -0.252101   -0.15873    -0.075188
             -25%   -0.333333   -0.235294   -0.148148   -0.070175
             -20%   -0.312500   -0.220588   -0.138889   -0.065789
             -15%   -0.294118   -0.207612   -0.130719   -0.061920
             -10%   -0.277778   -0.196078   -0.123457   -0.058480
NA           -5%    -0.263158   -0.185759   -0.116959   -0.055402
% [DELTA]s    0%    -0.250000   -0.176471   -0.111111   -0.052632
              5%    -0.238095   -0.168067   -0.105820   -0.050125
             10%    -0.227273   -0.160428   -0.101010   -0.047847
             15%    -0.217391   -0.153453   -0.096618   -0.045767
             20%    -0.208333   -0.147059   -0.092593   -0.043860
             25%    -0.200000   -0.141176   -0.088889   -0.042105
             30%    -0.192308   -0.135747   -0.085470   -0.040486

                                 RONA % [DELTA]s

                     0%       5%        10%        15%

             -30%   0.00   0.068027   0.129870   0.186335
             -25%   0.00   0.063492   0.121212   0.173913
             -20%   0.00   0.059524   0.113636   0.163043
             -15%   0.00   0.056022   0.106952   0.153453
             -10%   0.00   0.052910   0.101010   0.144928
NA           -5%    0.00   0.050125   0.095694   0.137300
% [DELTA]s    0%    0.00   0.047619   0.090909   0.130435
              5%    0.00   0.045351   0.086580   0.124224
             10%    0.00   0.043290   0.082645   0.118577
             15%    0.00   0.041408   0.079051   0.113422
             20%    0.00   0.039683   0.075758   0.108696
             25%    0.00   0.038095   0.072727   0.104348
             30%    0.00   0.036630   0.069930   0.100334

                    RONA % [DELTA]s

                          20%

             -30%      0.238095
             -25%      0.222222
             -20%      0.208333
             -15%      0.196078
             -10%      0.185185
NA           -5%       0.175439
% [DELTA]s    0%       0.166667
              5%       0.158730
             10%       0.151515
             15%       0.144928
             20%       0.138889
             25%       0.133333
             30%       0.128205

Note: The symbol "[DELTA]" signifies the word "change."

NA = Net assets

RONA = Earnings before interest and taxes/net assets

Table 3: Factors to Multiply Actual EBIT Earnings by in Order to
Derive the Increase/Decrease from Planned EBIT Earnings Due to the
Interaction Effect of a Change in RONA Profit Margin and NA Employed
When ...

                                      RONA % [DELTA]s

                       -20%         -15%         -10%         -5%
NA           -30%   0.1071429    0.0756303    0.0476190    0.0225564
% [DELTA]s   -25%   0.0833333    0.0588235    0.0370370    0.0175439
             -20%   0.0625000    0.0441176    0.0277778    0.0131579
             -15%   0.0441176    0.0311419    0.0196078    0.0092879
             -10%   0.0277778    0.0196078    0.0123457    0.0058480
             -5%    0.0131579    0.0092879    0.0058480    0.0027701
             0%        0.00         0.00         0.00         0.00
             5%     -0.0119048   -0.0084034   -0.0052910   -0.0025063
             10%    -0.0227273   -0.0160428   -0.0101010   -0.0047847
             15%    -0.0326087   -0.0230179   -0.0144928   -0.0068650
             20%    -0.0416667   -0.0294118   -0.0185185   -0.0087719
             25%    -0.0500000   -0.0352941   -0.0222222   -0.0105263
             30%    -0.0576923   -0.0407240   -0.0256410   -0.0121457

                                   RONA % [DELTA]s

                     0%        5%          10%          15%
NA           -30%   0.00   -0.0204082   -0.0389610   -0.0559006
% [DELTA]s   -25%   0.00   -0.0158730   -0.0303030   -0.0434783
             -20%   0.00   -0.0119048   -0.0227273   -0.0326087
             -15%   0.00   -0.0084034   -0.0160428   -0.0230179
             -10%   0.00   -0.0052910   -0.0101010   -0.0144928
             -5%    0.00   -0.0025063   -0.0047847   -0.0068650
             0%     0.00      0.00         0.00         0.00
             5%     0.00   0.0022676    0.0043290    0.0062112
             10%    0.00   0.0043290    0.0082645    0.0118577
             15%    0.00   0.0062112    0.0118577    0.0170132
             20%    0.00   0.0079365    0.0151515    0.0217391
             25%    0.00   0.0095238    0.0181818    0.0260870
             30%    0.00   0.0109890    0.0209790    0.0301003

                    RONA % [DELTA]s

                          20%
NA           -30%     -0.0714286
% [DELTA]s   -25%     -0.0555556
             -20%     -0.0416667
             -15%     -0.0294118
             -10%     -0.0185185
             -5%      -0.0087719
             0%          0.00
             5%        0.0079365
             10%       0.0151515
             15%       0.0217391
             20%       0.0277778
             25%       0.0333333
             30%       0.0384615

Note: The symbol "[DELTA]" signifies the word "change."

NA = Net assets

RONA = Earnings before interest and taxes/net assets

Table 4: EBIT Multipliers to Approximate EP When ...

Before-tax                           WACC
RONA
(EBIT/NA)      7%        8%        9%        10%       11%

1.0%         -6.3500   -7.3500   -8.3500   -9.3500   -10.3500
2.0%         -2.8500   -3.3500   -3.8500   -4.3500   -4.8500
3.0%         -1.6833   -2.0167   -2.3500   -2.6833   -3.0167
4.0%         -1.1000   -1.3500   -1.6000   -1.8500   -2.1000
5.0%         -0.7500   -0.9500   -1.1500   -1.3500   -1.5500
6.0%         -0.5167   -0.6833   -0.8500   -1.0167   -1.1833
7.0%         -0.3500   -0.4929   -0.6357   -0.7786   -0.9214
8.0%         -0.2250   -0.3500   -0.4750   -0.6000   -0.7250
9.0%         -0.1278   -0.2389   -0.3500   -0.4611   -0.5722
10.0%        -0.0500   -0.1500   -0.2500   -0.3500   -0.4500
11.0%        0.0136    -0.0773   -0.1682   -0.2591   -0.3500
12.0%        0.0667    -0.0167   -0.1000   -0.1833   -0.2667
13.0%        0.1115    0.0346    -0.0423   -0.1192   -0.1962
14.0%        0.1500    0.0786    0.0071    -0.0643   -0.1357
15.0%        0.1833    0.1167    0.0500    -0.0167   -0.0833
16.0%        0.2125    0.1500    0.0875    0.0250    -0.0375
17.0%        0.2382    0.1794    0.1206    0.0618     0.0029
18.0%        0.2611    0.2056    0.1500    0.0944     0.0389
19.0%        0.2816    0.2289    0.1763    0.1237     0.0711
20.0%        0.3000    0.2500    0.2000    0.1500     0.1000
21.0%        0.3167    0.2690    0.2214    0.1738     0.1262
22.0%        0.3318    0.2864    0.2409    0.1955     0.1500
23.0%        0.3457    0.3022    0.2587    0.2152     0.1717
24.0%        0.3583    0.3167    0.2750    0.2333     0.1917
25.0%        0.3700    0.3300    0.2900    0.2500     0.2100
26.0%        0.3808    0.3423    0.3038    0.2654     0.2269
27.0%        0.3907    0.3537    0.3167    0.2796     0.2426
28.0%        0.4000    0.3643    0.3286    0.2929     0.2571
29.0%        0.4086    0.3741    0.3397    0.3052     0.2707
30.0%        0.4167    0.3833    0.3500    0.3167     0.2833

Before-tax   WACC
RONA
(EBIT/NA)      12%

1.0%         -11.3500
2.0%         -5.3500
3.0%         -3.3500
4.0%         -2.3500
5.0%         -1.7500
6.0%         -1.3500
7.0%         -1.0643
8.0%         -0.8500
9.0%         -0.6833
10.0%        -0.5500
11.0%        -0.4409
12.0%        -0.3500
13.0%        -0.2731
14.0%        -0.2071
15.0%        -0.1500
16.0%        -0.1000
17.0%        -0.0559
18.0%        -0.0167
19.0%         0.0184
20.0%         0.0500
21.0%         0.0786
22.0%         0.1045
23.0%         0.1283
24.0%         0.1500
25.0%         0.1700
26.0%         0.1885
27.0%         0.2056
28.0%         0.2214
29.0%         0.2362
30.0%         0.2500

NOTE: Table factors assume a tax rate = U.S. statutory rate of 35%.

EP = Economic profit

RONA = Earnings before interest and taxes/net assets

WACC = Weighted average cost of capital

Figure 1: Operating-unit Data

             Earnings   Net Assets   Return on Net
              (EBIT)       (NA)      Assets (RONA)

Planned/     $600,000   $4,000,000        15%
  targeted
Actual       $900,000   $5,000,000        18%
Variance     $300,000


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Author:Farris, Paul W.; Haskins, Mark E.
Publication:Management Accounting Quarterly
Date:Mar 22, 2016
Words:6610
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