CONTROLS FOR

DIFFERENTIATED
STRATEGIES
&
MEASURING OF ASSETS
EMPLOYED
 Strategy-describes the general direction in
which an organization plans to move to attain
its goals.
 Strategies at two levels:-

1. For whole organization i.e. at Corporate

Level
2. For Business Units within the organization
Organization Structure

1. Single Industry Firms e.g.

hotels,supermarkets,drugstores.
2. Related Diversified Firms e.g. P&Gs products
like detergent,toothpaste,shampoo,diapers
etc.
3. Unrelated Diversified Firms e.g. Textron
( Bell Helicopter,Utility Vehicles,Golf
Cars,Fin. Corp.,machine tools etc.)
Implications for Organization Structure
CORPORATE SINGLE RELATED UNRELATED
STRATEGIES INDUSTRY DIVERSIFIED DIVERSIFIED
Org. Structure Functional Business Units Holding
Company
Familiarity of High Moderate Low
Mngt.
Decision- More to More
Making Centralized Decentralized
Authority
Size of High to Low
Corp.Staff
Reliance on High to Low
internal
promotions
Implications for Management Control
CORPORATE SINGLE RELATED UNRELATED
STRATEGIES INDUSTRY DIVERSIFIED DIVERSIFIED
Strategic Vertical-cum- to Vertical only
Planning Horizontal
Budgeting Low to High
Imp. to meet the Low to High
Budget
Imp. Of Transfer High to Low
Pricing
Incentive Fin. And Non- to Primarily Fin.
Compensation fin. criteria Criteria
Bonus Basis Overall to Prim. On BU
performance performance
BUSINESS UNIT STRATEGY
Depends on two inter related aspects:
1. Its mission (“what are its overall objectives?”)
2. Its competitive advantage (“how should business unit
compete in its industry ?”)

Four missions could be:

3. Build
4. Hold
5. Harvest
6. Divest

Share building strategy includes:

7. Price cutting
8. Major R & D expenditure (to introduce new products)
9. Major market development expenditure.
 IMPLICATIONS FOR STRATEGIC PLANNING
PROCESS BUILD HARVEST
IMPORTANCE OF RELATIVELY HIGH RELATIVELY LOW
STRATEGIC
PLANNING
FORMAILIZATION OF LESS FORMAL MORE FORMAL
CAPITAL EXPENDITURE DCF analysis; DCF analysis;
DECISIONS LONGER SHORTER
PAYBACK PAYBACK
CAPITAL EXPENDITURE MORE EMPHASIS ON MORE EMPHASIS ON
EVALUATION CRITERIA NON FINANCIAL DATA FINANCIAL DATA (cost
(market share, efficiency; straight
efficient use of R &D cash on cash
dollars, etc.) incremental return)
DISCOUNT RATES RELATIVELY LOW RELATIVELY HIGH
CAPITAL INVESTMENT MORE SUBJECTIVE AND MORE OBJECTIVE AND
 IMPLICATION FOR BUDGETING
BUILD HARVEST
ROLE OF THE BUDGET MORE A SHORT TERM MORE A CONTROL
PLANNING TOOL` DOCUMENT
(“DOCUMENT OF
RESTRAINT”)
INFLUENCE OF RELATIVELY HIGH RELATIVELY LOW
MANAGER IN
PREPARING BUDGET
REVISION TO THE RELATIVELY EASY & RELATIVELY DIFFICULT
BUDGET DURING THE MORE FREQUENT & LESS OFTEN
YEAR
FREQUENCY OF LESS OFTEN MORE OFTEN
FEEDBACK FROM
SUPERIORS ON ACTUAL
PERFORMANCE VERSUS
THE BUDGET
 IMPLICATION FOR INCENTIVE
BUILD HARVEST
PERCENT RELATIVELY HIGH RELATIVELY LOW
COMPENSATION AS
BONUS
BONUS CRITERIA MORE EMPHASIS ON MORE EMPHASIS ON
NON FINANCIAL FINANCIAL CRITERIA
CRITERIA (MARKET ( COST CONTROL,
SHARE, NEW PRODUCT, OPERATING PROFITS
MARKET & PEOPLE AND CASH FLOW FROM
DEVELOPMENT) OPERATIONS)
BONUS DETERMINATION MORE SUBJECTIVE MORE FORMULA BASED
APPROACH
FREQUENCY OF BONUS LESS FREQUENT MORE FREQUENT
PAYMENT
WHILE DECIDING FOR MORE WEIGHTAGE MORE WEIGHTAGE
Competitive advantage.
Differentiated Low cost
player player

Product Primary
innovation is emphasis on
critical. reducing cost.

Broader set of Narrow

products. product line.

Depends on Produce no-

consumer frill commodity
perception. products.
Top management style.
 Management control functions influenced by
senior managers.
 Similarly style of business unit manager,

functional department managers, production

managers affect the management control
work in their particular area.
Differences in management styles.
 Management style is influenced by managers
background and personality like age,
education, experience.
 Implications for management control
 Personal vs Impersonal controls.
 Tight vs loose control.
 Measuring and controlling assets employed

Commonly used measurement method of profitability

–
 Comparison of revenues and expenditures

 Role of investment centers –

 To measure the performance of business as an economic activity
 To measure the performance of the assets employed in the

business.

Modern and effective method of measuring

profitability –
 ROI (Return on investment)
 EVA (Economic value added)
 Return on investment (ROI)
•Percentage return on capital employed (Investment) is referred as
ROI.

Example-
Suppose the total capital employed by a employer in its business is
Rs. 1mn and the profit before tax of company turns out to be Rs. 1
lakh. So return on investment worked out to be-
1 lakh = 10%
10 lakhs

Importance of ROI –
• Before investment employer always consider the ROI which help in
determining the opportunity cost of capital.
• ROI shows the strength of Business unit in real terms.
• Makes the comparison easy
 Economic value added (EVA)

• Economic value added is a dollar amount, rather than a ratio.

EVA = Net profit – Capital charge

Where, Capital charge = Cost of capital * Capital employed
OR,
EVA = Capital Employed (Return on investment –
Cost of capital)

Importance of EVA-
• It shows the real profitability of the business.

• It is one of the method of measuring the performance of the

assets.
Concept of EVA
 EVA emphasize on three things-
 Value Generation
 Value maximization
 Value Sustainability

 Positive EVA indicates value creation.

 Negative EVA indicates value destruction

Current Assets:
Cash……………………………………….$ 50
Receivables …………………………… 150
Inventory………………………………. 200
Balance sheet ($000s)
Current Liabilities:
Accounts payable……………………………………..$ 90
Other current……………………………………………. 110

Total current assets…………. 400 Total current liabilities……………………………. 200

Fixed Assets:
Cost………………… $ 600 Corporate Equity………………………………….. 500
Depreciation….. - 300
Book value…………………….. 300
Total Assets…………………………$700 Total Equities……………………………………….$700
Income Statement
Revenue………………………………………………………………………………………………………………………………..
$1,000
Expenses, except depreciation…………….. $ 850
Depreciation…………………………………………. 50
900
Income before taxes………………………………………………………………………………………………………………..
100
Capital Charge ($500 * 10%)……………………………………………………………………………………………………..
50
Economic value added (EVA)……………………………………………………………………………………………………
50

Return on investment = $100 = 20%

$500
A survey of fortune 1,000 companies
United states Hollland India

Number of usable responses 638 72 39

Companies with two or more 500 (78%) 59 (82%) 27 (70%)

investment centers

Percentage of companies using 36% 19% 8%

Residual income or EVA
(With two or more investment
centers)
 Measuring Of Assets

Cash
 Controlled Centrally
 Some Companies include cash balance at a
little higher amount than normally
required.
 Some Companies even omit the cash from
Investment Base.
 Receivables-
1. Ability to Generate Sales.
2. Establishing Credit Terms.
 Receivables are measured at Book Amount

Selling Price – Allowance for Bad Debts.

 Inventories-Average Costs or Standard Cost.

Working Capital
 All Current Assets with no Offset for Current
Liabilities.

 Current Assets - Current Liabilities

 Property ,Plant , and
Equipment
•Most companies use depreciation
approach for measuring profitability
of the business unit’s asset base.

•Butsome serious problems may be

faced.
1.Acquisition of New Equipment
 Acquiring the machine increases the income
before taxes.
 Increase is more than offset by increase in capital

charge.
 EVA calculation shows profitability has decreased.
 Whereas economic fact is that profitability has

increased.
 Business unit manager may be reluctant to

purchase the machine.

 Business unit with fully depreciated asset will

report larger EVA.

2. Gross Book Value
 Fluctuation in EVA and ROI can be avoided
by taking at gross book value rather than at
net book value.
 Investment= $100,000

Cash flow = $27,000

Depreciation=$20,000
Additional Income=$7000.
 Thus , ROI calculation on gross book value

always understates the true return.

Leased Asset
 Suppose company sold asset with book value of
$300,000.
 Leased back the asset at rental of $60,000 per

year.
 Thus ,business unit’s income before taxes would

decrease.
 As new rental expense would be higher than

eliminated depreciation charge.

 EVA will also increase
 Thus , Business Unit’s manager are induced to

lease.
Idle Asset
 Idle asset that can be used by other unit may
be permitted to exclude them from the
investment base.
 Will encourage business unit managers to

release underutilized asset to unit that have

better use for them.
Intangible Assets
 Some companies are R&D intensive(e.g.
Novartis) and Some are Marketing
intensive(e.g. Uniliver).
 Thus, it’s advantageous to capitalizing

intangible assets like R&D and Marketing and

amortizing them over selected life.
Non Current Liabilities
 Business units receive permanent capital from
corporate pool of funds.
 For business units total amount of these

funds is relevant but not the source.

 Thus ,it’s appropriate to account for

borrowed funds separately and compute EVA

based on assets obtained from general
corporate sources.
The Capital charge
 Corporate headquarters sets the rate used to
calculate capital charge.
 Should be higher than corporate’s rate of

debt financing.
 Rate is set somewhat below the company’s

estimated cost of capital.

 BENEFITS OF ROI
• Reflection of financial statements in the ratio

•Simple to calculate

• Application of common denominator

•Comparison
BENEFITS OF EVA
 Same profit objective for comparable
elements
 Relation to asset investment
 Different Interest rates to different types of

assets
 Stronger positive correlation with company’s

market value
Difference Between EVA AND ROI

ROI METHOD

1 2 3 4 5 6 7
Busines Cash Receivabl Inventorie Fixed Total Budget ROI
s Unit es s Asset Invest ed objectiv
s Profit e

A $10 $20 $30 $60 $120 $24 20%

B 20 20 30 50 120 14.4 12
C 15 40 40 10 105 10.5 10
D 5 10 20 40 75 3.8 5
E 10 5 10 10 35 (1.8) (5)
EVA METHOD

Current Assets Fixed Assets

1 2 3 4 5 6 7
Busine Profit Amoun Rat Require Amoun Ra Require Budge
ss Potentia t e d t te d ted
Unit l Earning Earning EVA
s s
A 24 $60 4 $2.4 $60 10 %6.0 $15.6
%
B 14.4 70 4 2.8 50 10 5 6.6
C 10.5 95 4 3.8 10 10 1 5.7
D 3.8 35 4 1.4 40 10 4 (1.6)
E (1.8) 25 4 1 10 10 1 (3.8)
Uses Of EVA In planning And Control
 Strategic Direction-IBM
 Acquisitions-AT&T
 Operational Improvements-Brrigs & Stratton
 Product line Discontinuation-Coca Cola
 Working Capital Focus-Quaker Oats