Measuring and Controlling Assets Employed

• Profit Centre versus Investment Centre

▫ Profit centres are measured based on profits
which is comparing revenues against expenses.
▫ Investment centres are measured based on the
profitability in which profit is compared to
assets employed (investment).

• Investment centres are beyond the profit centres

▫ Performance is not merely on profits but also
by considering the assets employed.
 Performance Measurement
• Investment Centre could be measured based on:
1. Return on Investment (RoI)
RoI = Profit
Total Assets Employed
2. Economic Value Added (EVA)/Residual
Income (RI)
EVA = Profits – Capital Charge
where,
Capital charge = Cost of Capital Rate x assets employed
 Measuring Assets Employed/Investment
• Cash,
▫ is cash a part of assets employed/invested?
▫ some companies omit cash from investment base
because case is intended to cover current
liabilities.
• Receivables,
▫ is receivable a part of assets employed/invested?
▫ receivable is the effect/result of investment that
was achieved from credit sales.
▫ the real investment of receivable is only the cost of
goods sold and that a satisfactory return of this
investment is probably enough.
 Property, Plant, and Equipment
• Most of a new investment is to finance the fixed
assets.
• What method should applied to measure these
assets employed?
 Illustration
Balance Sheet
Current Assets: Current Liabilities:
Cash $ 50 Accounts Payable $ 90
Receivables 150 Other Current Liab. 110
Inventory 200 $ 200
$ 400
Fixed Assets: Corporate Equity 500
Cost $600 TOTAL LIAB.&EQUITY $700
Depreciation (300)
Book Value 300
TOTAL ASSETS $ 700
• Revenue $ 1,000 - Cost of capital 10%
• Expenses except depreciation $850
• Depreciation $50
 EVA vs ROI
• advantages of ROI
1. it is a comprehensive measure in that
anything that affects financial statements is
reflected in this ratio
2. ROI is simple to calculate, easy to
understand, and meaningful in an absolute
sense.
3. It is a common denominator that may be
applied to any organizational unit
responsible for profitability, regardless of
size or type of business.
 Disadvantage of ROI
• The older a business unit the bigger its ROI
• Under ROI a manager is not motivated to
conduct a new investment
• ROI is merely rely on a short run profitability.
 EVA
• Advantages of EVA
1. all business units have the same profit
objective for comparable investments.
2. decision that increase a centre’s ROI may
decrease its overall profits but not the EVA.
3. different interest rates may be used for
different types of assets.
4. EVA has stronger positive correlation with
changes in a company’s market value.
Example of ROI&EVA see page 302.