Management Control

Structure UNIT 7 INVESTMENT CENTRES

Objectives

After studying this unit, you should be able to:

 design an investment centre for an organization;

 define the investment base for an investment centre; and

 design appropriate measures for measuring investment centre performance; and

 suggest an appropriate financial control system which can eliminate

investments, over which divisional managers have no control.

Structure
Introduction
Investment Base
Measuring Investment Centre Performance
Measuring the Investment Base
Problems of Financial Control of Investment Centre
Summary
Key Words
Self Assessment Questions/Exercises
Further Readings

7.1 INTRODUCTION
Investment centre is a responsibility centre in which inputs are measured in terms of
cost/expenses and outputs are measured in term of revenues and in which assets
employed are also measured. Thus, the investment centre is responsible for the
assets under its disposal along with the profit. It involves questions related to as to
what assets and liabilities should be included for determining the investment base of
the investment centre.

An investment centre manager is responsible for the production, marketing and

investment in the assets employed on that division or segment of the organization.
He has to take decisions related to credit policy, inventory policy as well as
investment in equipments to be used for production and marketing. That way it may
be taken as extension of profit centre that it covers all the elements relevant to the
measurement of performance of division. As a responsibility centre, the
performance of the division concerned would be measured in relation to the profits
and assets employed in the division concerned.

7.2. INVESTMENT BASE

Investment on asset responsibility implies the authority to buy, sell and use assets.
This involves taking decisions related to identification of the assets and liabilities
for determining, the investment base of the investment centre. It is not a simple
problem, as the accounting theory does not help us in this regard. However, they
should be included in such a manner that would motivate the managers concerned to
take the best possible decision related to buying, selling and using the various
assets. If it is not done, the return on investment in those assets would not be
reasonable or as desirable in the given circumstances.
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The divisional manager has to be motivated to act in the best interest of the Investment Centres
organization while taking such decisions. He is supposed to act, like top
management in this respect. This would, however, depend upon the way the
divisional manager is evaluated by the top management and also the extent of
delegation of authority and resultant decentralisation.

The top management shooud be quite careful while evaluating the divisional
manager's performance. He may depend upon the traditional method of evaluation,
i.e., relating income to assets in terms of return on investment. It may be taken as
Segment Return on investment or SROI. If the return on investment under the
control of division or segment is quite satisfactory or reasonable, the company's
return on investment would also be reasonable and satisfactory.

Activity 1

1) What is the importance of determining the right investment in the investment

centres?

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2) What are the problems in using different investment bases for an

investment centre?

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MEASURING INVESTMENT CENTRE

PERFORMANCE
These are two important and popular methods of measuring investment centre
performance. They are Return on Investment (ROI) and Residual Income (RI).

Return on Investment (ROI)

Return on investment is a popular and easier method of measuring investment

centre performance. ROI is the relationship between return or profit and
investment. It is usually expressed in terms of percentage. The profit here refers to
profit before taxes and interest or operating profit. We take such profit as profit
before taxes and interest is not influenced by extraneous factors such as financing
or taxes over which the divisional manager does not have any control. Similarly,
the investment here refers to operating assets which are available for use in the
operations. Thus,

ROI can be defined as

Profit before Interest and Tax

ROI= Net operating Investment
100

Net operating investment may be in terms of written down value or the gross value
of the fixed assets. The net value of the assets would depend upon the depreciation
method used. It would be better to use, the average value of the fixed assets during 45
their useful life.
Management Control
Structure
An example will explain the computation of ROI. Consider the cases of Ibis
Company presented in Exhibit 7.1, which has a piece of equipment costing Rs.
1,00,000. The equipment has five year life and no salvege value. The equipment can
generate a cash return of Rs. 50,000 per annum. The equipment is depreciated on a
straight-line basis. The company has an expectation of minimum rate of return of
25% on investment.

Exhibit 7.1: Ibis Company ROI Computation Using Net Book Value of Asset

Year
1 2 3 4 5
Net Book Value at Beginning of Year 100 80 6040
20
(Rs. ‘000)
Cash Return (Rs. ‘000) 50 50 50 50 50
Less: Depreciation 20 20 20 20 20
Profit Before Taxes 30 30 30 30
Return on Investment% 30 37.5 50 75
ROI using gross book value of the assets will be 30% for all the five years since
the profit before taxes is the same during all the years. (Profit Before Taxes/Gross
Book Value) x 100%.

= (30,000/1, 00,000) x 100 = 30 %

If we take average investment as book value of the assets at the beginning of the
period plus the book value of the asset at the end of the period divided by two i.e.

(1,00,000 + 0) = 50,000, the ROI on average investment will be:

For measuring divisional performance, ROI method appears to offer several

advantages. They are: (i) this is generally accepted method;l (ii) it is a relative and
not absolute measure; (iii) it is conceptually easy to understand and interpret; and
(iv) it provides incentive for optimum utilization of the assets of the company
concerned.

However, there may be problems related to (a) determination of investment base, and
(b) determination of net income. These problems, however, can be resolved without
much difficulty.

Residual Income

An alternative measure of financial performance of an investment centre is residual

income. It is an amount that remains after deducting an "implied" interest charge
from operating income. In other words, the difference between the actual operating
income of a division and the required/expected income is the residual income. The
expected return on investment is capital charge. The idea is that the division bears a
charge for the assets provided by the company concerned to the division for its use.
The efficiency of the division, on this basis, is to be judged on the contribution
beyond the expected return which may be based on the cost of capital or opportunity
cost of the investment.

Symbolically

SRI=SPC - ( SROI x SR)

Where
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SRI = segment residual income SPC = segment profit contribution
S n

o
SROI = segment Expected RO1 Investment Centres

SR = segment resources.

Following the example given in Exhibit 7.1 we present the residual income
calculation in Exhibit 7.2.

Exhibit 7.2: Ibis Company Residual Income Computations Using Net Book Value

Year
1 2 3 4 5
Net Book Value at Beginning of Year 100 80 60 40 20
(Rs. '000)
Profit Before Tax ( '000) 30 30 30 30 30
Less: Capital Charge 25% of 25 20 15 10 5

Investment Base (Rs. '000)

Residual Income (Rs. '000) 5 10 15 20 25
Other Performance Measure
ROI and RI are the popular methods of measuring performance of investment
centres. However, several firms use other methods or measures also. They
are: growth in market share, sales growth (actual achieved vis-a-vis the
planned or budgeted performance), and profit growth etc. Other factors, such as
new product development and personnel development of the division
concerned may also be considered for such measurement.

Activity 2

Compare ROI and RI as the bases of evaluation of investment centre

performance. Which of these measures will you prefer and why?

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MEASURING THE INVESTMENT BASE

For the performance evaluation of a division as it has been seen, we take ROI,
RI and a few other criteria but the return' or `investment base' can not be
defined without any ambiguity. There are various concepts of returns as well as
investment base. The variables to be included in either of them would
depend upon the management policy.

For measuring investment base, two methods are commonly used. Under one
method, we take total assets and, in other, we take total assets minus current
liabilities. A general condition, however, is that the investment base should include
only those resources which (are used in producing profit for the
decision) concerned. Those assets, which are under construction or which
remain idle should not be included it the investment base.

Total assets imply the fixed assets like, building, furniture and machinery and the
current assets, like cash, receivable and inventory. For the valuation of either
components of the current assets or fixed assets, no common methods are used in
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Management Control
Structure
practice. It differs from company to company and the policies adopted by the
management concerned.
Cash may be controlled centrally or independently by the division concerned. in
most of the companies, the cash is controlled centrally to avoid keeping idle cash.
With the result the divisions normally hold smaller amount of cash. Often the
required cash is computed on the basis of a certain percentage of turnover or
payment requirement for pertain number of days.
While taking amount of receivables, they may be taken at their net values, i.e.
receivable minus provision for bad and doubtful debts. This commonly accepted
method is proper as the divisional managers may influence the amount of
receivable through the volume of sales, proportion of cash and credit sales, the
period of credit allowed and the efficiency of collection policies.
The amount of inventory and its methods of valuation posses more serious
problem, while including it as investment base. A common practice, used by most
of the division, is to include them at their carrying cost. It is necessary for carrying
on smooth operation of the division concerned. However, the fluctuations in
demand for its output or supply of inputs have to be duly considered. Some
companies used LIFO method of taking inventory, but under the inflationary
conditions, its value would be understated. It would be better to use standard or
average cost for the valuation of inventories while including them in the investment
base.

A common practice for valuation of fixed assets is cost less depreciation. Thus,
they are taken at historical cost rather than economic cost of the investment
required in the fixed assets.

If total assets are taken as investment base, it tends to overstate the investment
base. Total assets minus current liabilities may be taken to be a better measure for
the investment base. In case, the division has very little control over the current
liabilities, they should not be deducted from the total assets for the computation of
investment base.

Valuation of Fixed Assets

For the purpose of measuring investment base in the investment centre, valuation of
fixed assets poses the greatest difficulty.

Exhibits 7.1 and 7.2 illustrate the impact of net investment on ROI and RI using the
net book value of the fixed assets. Exhibit 7.1 shows the ROI computations for each
year based on the net book value of the assets at the beginning of the year. In the
first year the ROI is 30% and increases over the five year Iife of the investment in
each year or the accelerated depreciation.

The picture is not different when we used the RI to measure the divisional
performance and use the net book value of the assets as the investment base. The RI
increased over the five year life of the assets from Rs. 5,000 in first year to Rs.
25,000 in the fifth year.
To avoid this artificial increase in the ROI or RI, when profit taxes are constant,
many organizations use the gross book value or the average investment over the life
of the investment to compute the fixed portion of the investment base. We have
seen that the ROI, using gross book value, is 30% in each year. Similarly the RI
will be Rs. 5,000 in each year if we use grow book value of the assets is used as the
investment base.

The use of traditional reliance on historical cost and depreciation methods to

calculate both income and the value of investment base is contributing towards this
confusing picture. A more meaningful approach to solve the problems created by
the gross and net book values of assets in measuring the investment base is to use
48 the replacement cost of the fixed assets for all divisions and use the same for
computation of RO1 or RI
we can obtain more meaningful and comparable ROI and RI figures across the Investment Centres
divisions.
Table 7.3, 7.4 and 7.5 shows result of two studies about industry practices in
calculating the investment base in investment centres. These studies clearly show
that majority of the companies include fixed assets in their investment base at their
net book value.
Table 7.3: Valuation of Plant and Equipment

Percentage of Respondents Uning the Method

Reece & Cool (1978) Govindarajan
459 (1994) 500
Respondents Respondents
Gross book value 14% 6%
Net book value 84 93
Replacement cost 2 1
100% 100%
Sources: Reece and Cool, "Measuring Investment Center Performance," p. 28-49.
Govindrajan, "Profit Center Measurement," p.2
Table 7.4: Assets Included in Investment Base
Percentage of Respondents
Including the Asset in the Investment
Base
Reece & Cool Govindarajan
(1978) (1994)
459 500
Respondents Respondents

Current assets 63% 47%

Cash owned by the profit center
Corporate cash allocated to the profit center n/a 13
External receivables 94 90
Intra company receivables n/a 55
Inventory 95 95
Other current assets 76 83
Fixed Assets
Land & building used solely by this profit center 94 97
Equipment used solely by this profit center 83 96
A portion of land & building used by 2 or more 45 49
profit centers
A portion of equipment used by 2 or more profit 41 48
centers
An allocation of assets of headquarter central 16 19
research or similar units
Other Assets
Investments n/a 53
Goodwill n/a 55
Note: n/a denotes "not asked"
Sources: Reece and Cool, "Measuring Investment Center Performance," p.28-49
Govindarajan, "Profit Center Measurement,"p.2.

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Management Control
Structure Table 7.5: Liabilities Deducted in Calculating Investment Base

Percentage of Respondents Deducting the

Liability from the Investment Base

Reece & Cool (1978) Govindarajan (1994)

459 500
Respondents Respondents
Current external payables 51% 73%
Current intra company 30 46
Other current liabilities 45 68
Deferred taxes n/a 28
Other noncurrent liabilities 20 47
Note: n/a denotes “not asked”

Sources: Reece and Cool, "Measuring Investment Center Performance," p28-

49 Govindarajan, "Profit Center Measurement,"p.2.

Activity 3

Discuss the problem of measurement of investment base. What are the special
problems faced with respect to different elements of the investment base?

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PROBLEMS Of FINANCIAL CONTROL

OF INVESTMENT CENTRE
As there are problems in computations of the investment base, similarly, there are
problems in determining the financial control parameters in the divisionalised
companies. Two most important parameters of financial control in the divisionalised
companies are as follows:

1) Congruity of objectives; and

2) Ability of top management to evaluate performance of managers.

The congruity of objective implies that the divisional manager would take the same
decision which the top management would take the given situation. The top
management should be duly satisfied that the divisional managers would act in the
best interest of the company.
With regard to the second parameter, it is necessary that the top management
would evaluate the performance of the divisional managers keeping in mind the
objectives of the organization. In fact, it is presumed that if the performance of the
divisions is satisfactory, the company's overall performance is also going to be
satisfactory.
There are two issues involved with regard to the effective financial control of
investment centres. Firstly, while imposing financial control, it should be kept in
mind that such investments should not be include over which the divisional manager
does not have any control. Secondly, such control should try to eliminate the
possibility of fluctuation in the investments caused but by the divisional manager's
action. The financial control should not be undertaken in such manner which many
demotivate the manager of the division concerned.
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 Investment Centres
SUMMARY
In the extension of the idea of decentralization and divisionalised control,
investment centre forms one of the higher forms of decentralization. An investment
centre is responsible not only for the revenues and expenses under the control of the
division but also for the investment under the division. In reality we can say that the
investment centre will be almost like a separate organization for the purpose of
control.

The evaluation of financial performance of the investment centres is normally carried

out by using the return on investment or the residual income measure. Return on
investment is the ratio of-the measure of return obtained by the division to the
investment used by the division for achieving the same.

Residual income is the profit before taxes less the capital charge. It is also possible
to use different capital charges for different types of assets thereby influencing the
decision to use the assets. In a capital scare situation it will have the effect of setting
priorities for the use of different type of assets.

in evaluating the performance of managers, the assets or investment over which they
have control alone should be considered in the investment base. The valuation of
assets forms -an important problem in the profit evaluations of investment centres.
Therefore, it is advisable that the measure used should preferably be one not
influenced by the accounting valuations. One of the suggested modes of valuation
can be the current cost of the assets.

Divisional performance should not be evaluated exclusively by the profit measures but
by evaluating the efficiency and effectiveness of the operations of the investment
centres and therefore measures such as market share, sales growth, product
improvements and so on should be taken into account in the evaluations.

Illustration

The average asset balances of the Apparel division's of Ibis for 19XI are given
below:
Cash Rs. 2,50,000
Receiables 3,75,000

Inventory

Raw materials Rs. 2,50,000

Works in process 1;30,000

Finished goods 2,45,000 6,25,000

Gross fixed assets Rs. 2,500,000

Accumulated depreciation 10,00,000 15,00,000

Total: 27,50,000

Current liabilities Rs. 7,50,000

Equity 20,00,000

Total liabilities and equity Rs. 27,500,000

During I9XI the Apparel division earned a profit of Rs. 3, 00, 000 before taxes on
total sale of Rs. 40, 00,000.

1) Compute ROI using net total assets (that is total assets less current 51
liabilities) as the investment base.

2) Compute RI using a capital charge of 10% on net total assets.

Management Control
Structure
3) If the corporate management desires, the division to increase its RO1 by 5%
during19X2, what change in the profit margin on sales or asset turnover ratio would
be required?
Suggested Answer
1) Return on investment = (profit before tax/investment base) x

100% ROI = (Rs. 3,00,000/20,00,000) x 100 =15%

2) Residual Income:

Profit before tax Rs. 3,00,000

Capital charge (Rs. 20,00,000 x .10) 2,00,000

Residual Income Rs.

1,00,000

3) Plan for increasing ROI

Objective: ROI is to increased by 5%

ROI = (profit/sales) x (profit/investment) x 100%

Existing RO1 = (Rs. 32,00,000/40,00,000) x (40,00,000/20,00,000) x 100

= .075x2.0 = 15%
Desired ROI = 20%

Increase in ROI by increase in profit margin:

20 = (profit/sales) x 2.0
21 (profit/sale) = 20%/2 = 10%
22 Increase in investment turnover:
23 20% = 7.5% x (sales/investment)
(sales/investment) = (20%/77.5%) = 2.67
times

KEY WORDS
Asset turnover: The ratio of sales to the investment base. It means the sales rupee
generated for every rupee of investment and will influence the return on
investment.

Capital charge: The charge made to the divisions for the use of assets provided by
the organization and the residual income is computed by setting off this charge
against the income

Gross book value: The historical cost of fixed assets used as investment base by
some organization.

Investment base: The investment taken for the purpose of computing the return on
investment or the residual income. In a ROI computation this is the denominator.

Net book value: This represents the gross assets less accumulated depreciation.

Profit margin: The ratio of profit to sales. It represents the portion of a rupee of
sales which is available as a margin. It can be gross margin when the profit
available after meeting the cost of goods sold is considered or operating profit
margin when the cost of goods sold and all other operating costs of the period are
 considered.

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 Residual income: A measure of divisional performance computed as Investment Centres
the difference between operating profit before taxes less the capital charges.
Return on investment: A measure of the performance of a division calculated as a
ratio of profit to investment base.
SELF ASSESSMENT QUESTIONS/EXERCISES
1) Differentiate between a profit centre and an investment centre. Which one do
you think is a better device from the management control point of view and
why?
2) What are the alternative methods of determining investment base? Bring
out their merits and demerits.
3) What problems are likely to be faced in evaluating the performance
of investment centres? Are the performance of investment centre and
the performance of its manager two different things? Discuss.
4) Do the margins in charge of investment centres, in your opinion, really
have control on the investment in their divisions? What could be the
possible explanations?
5) Ibis Commodities Group is a division of the Ibis Company dealing in food
products. The division is responsible for procurement and distributing of
food products handled by the company. Residual income is used to evaluate
the divisional managers. The company expects a 25% capital charge on
division's investment. The residual income is computed by deducting the
capital charge from the division's contribution towards company's profit
before taxes. The investment base of the division includes closing balance
of receivables, inventories and net fixed assets. Divisional managers have
full control over current assets and current liabilities. Company policy is to
minimize the investment in these assets. Fixed assets are the joint
responsibility of divisional managers and corporate management.
The divisional manager was in the process of preparing the budget for 19X3.
Therefore he wanted the divisional finance manager to review the results of 19X1
and the fist six months of 19X2.
The information relating to performance of the Commodities Group is presented
below:
Ibis Commodities Group

(Rs. `000)
Annual 19X2 2 quarters:Annual 19X1
Budget 2quarters ActualBudget Actual
Budget Results

Sales 2,000 1,000 1,100 1,700 1,680

Expenses:
Direct material 700 350 395 600 590
Wages 200 100 115 175 210
Administration 75 40 40 75 100
Depreciation 100 50 60 90 80
Other expenses 50 25 20 40 40
Total expenses 1,125 565 630 980 1,020
Division's margin 875 435 470 720 660
Allocated Corporate expenses 300 150 120 270 260
Division's Contribution to 575 285 350 450 400
corporate profit
25% Capital charge on 500 75 250 400 375
divisional investment
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Residual income 75 10* 100* 50 25
Management Control
Structure Divisions Investment
(Rs. ‘000)
19X2 19X1

Budgeted Actual
Budgeted Balance Actual Balance 31 Dec
31 Dec 30 June 30 June 31 Dec
Accounts receivable 300 260 250 .200 225
Inventories 400 450 500 350 375
Net Fixed assets 1,300 1,490 1,250 1,050 900
Total 2,000 2,200 2,000 1,600 1,500
Capital Charge (25%) 500 275* 250*, 400 375
Note: Operations are more or less uniformly distributed throughout the years.
* Proportionate capital charge for the period.
Required:

1) Evaluate the performance of the division for the six months ended 30 June 19X2.

2) Critically examine the measurement, reporting and evaluation systems of Ibis

Commodities Group and suggest what changes, if any, should be effected to
reflect the division's responsibilities.

FURTHER READINGS
Bhatia, Manohar L., Performance Measurement of Profit Centres: Practices and
Perspectives, the Chartered Accountant, Vol. XXX, No. 9, March 1982, pp. 586-593

Mauriel, John J. and Robert N. Anthony, 1966, `Misevaluation of Investment Centre

Performance', Harvard Business Review, 44, March-April.

Parker, Lee D., 1979, `Divisional Performance Measurement: Beyond an Exclusive

Profit Test', Accounting and Business Research, 9 Autumn.

Tomkins, Cyril, 1973, Financial Planning in Divisionalised Companies,

Haymarker: London.

Vancil, Richard F., 1978, `Measuring Investment Centre Performance', Harvard

Review. 56, May-June.

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