Responsibility Centres

Investment Centre

Investment Centres

Investment Centres
(characteristic features)
Divisional managers considered as profit centres enjoy certain autonomy in directing their responsibility centers within the overall control by the CHQ They use available resources and generate adequate revenues to contribute profits into the profit pool of the company To measure the comparative performance of the divisional managers, some standard or scale is required An investment Centre is a R.C. in which the manager is held responsible for the use of assets as well as revenues & expenses. It is the ultimate extension of the responsibility idea because the manager is expected to earn a satisfactory return on capital employed in the responsibility centre. Here the control system applies monetary measures to both inputs & outputs and the investment used within the R.C. itself. The profits are related to the capital employed during the period & R.O.I. is calculated to ascertain the efficiency of the business unit.

Investment Centres
(characteristic features)
In Profit Centre the focus is on profits. But when the profit is compared with the assets employed in earning it, the RC is referred to as Investment Centre. Thus investment Centre is a special type of profit centre & in real world the companies use the term Profit Centre loosely rather than investment centre. Management Control in Investment Centre, therefore, raises additional problems regarding how to measure the assets employed - specifically which assets to include, how to value fixed assets & current assets, which depreciation method to use for fixed assets , which corporate assets to allocate & which liabilities to subtract. To measure the comparative performance of the divisional managers, some standard or scale is required

Investment Centres
( issues in performance measurement)
The focus on profits without considering the assets used to generate the same is not an adequate basis for exercising control. It is difficult for top management to compare the profit performance of one business unit with that of other units or with similar firms in the industry without considering the assets employed. Comparisons of absolute differences in profits are meaningless if BUs employ different amount of resources. BU managers performance objective generally address to : 1) Generation of satisfactory profits from the resources which are at their disposal. 2) Investment in additional resources provided they are expected to earn an adequate return. 3) Disinvestment where the expected annual profits of any resource after discounting at firms required earning rate, is less than the amount that could be realized from its sale.

Investment Centres
( steps in performance measurement)
Two principal steps are involved in gauging the performance of an investment centre. 1) Measurement of assets employed The aggregate of assets is termed investment base . It helps in measurement of performance of the BU as an economic entity. It also provides useful information for decision making relating to assets employed & motivation of managers in making decisions which are in the best interest of the company. 2) Relating profit to assets employed The methods used for relating profits to assets employed are : a) Return on Investment b) Economic Value Added ( EVA) EVA is a trademark of M/S Stern Stewart & Co. The generic term for this measurement yardstick is Residual Income. Both the terms essentially denote the same entity .

Investment Centres
( steps in performance measurement)
a)ROI It is a ratio of Income / Gross Investment The numerator can be either PBT or PAT & denominator is generally owners investment i.e. Equity + Reserves. b)EVA. It is an absolute amount stated in monetary terms EVA = net operating profit a capital charge & capital charge = Amount of assets employed x rate. When these two measures are to be used for comparative performance measurement, the numerator in ROI concept has to be matching with that used in EVA i.e. PBT. Even though EVA is conceptually superior to ROI , It is the ROI concept that is widely used by Industry and Business. In such absolute workings, without any correlation with EVA, generally PAT is used in numerator of ROI.

Investment Centres
( steps in performance measurement) P & L statement Particulars Sales for the year ended 31.3.2000 Amount (Rs) 500

Expens. (exclu.depre. 350 Depreciation 10 360

Profit before tax

Income tax at 50% Profit after tax

140
70 70

Investment Centres
( steps in performance measurement)
Balance sheet of X Co Ltd as on 31.3 2000

Capital and liabilities Share capital

Amount (Rs)

Assets Fixed assets : cost 500

Amount (Rs)

Paid up
Reserves Current liabilities Sundry creditors Bills payable others

200
80

Less :accumulated depreciation

Current Assets

200

300

150 50 120 600

Cash at bank Debtors Inventories

50 100 150 600

Investment Centres
( steps in performance measurement)
Given Rate to be used for calculating capital charge is 10% flat. 1) ROI = PAT / Gross Investment( equity + reserves) = 70 / 280 = 25% (expressed in percentage terms) This value is for isolated working. However if it is to be used as a comparative measure in conjunction with EVA, the numerator can be PBT which is used as Net operating Profit in EVA calculation below. Then ROI will be 50% 2) EVA = Net operating Profit capital charge = 140 10% of 280 = 140 - 28 = 112

Investment Centres
( performance measurement)
Return on Investment (ROI) ROI is an attempt to express the economic desirability of an investment proposal in terms of a percentage return on the original outlay. Most Investment Centres evaluate the BUs on this basis. It is also called as Accounting rate of return method or financial statement method. It is simple to calculate & easy to understand. It is a comprehensive measure which reflects anything that affects financial statements. It is a common denominator that can be used for any organizational unit, irrespective of size or nature of business, having profit responsibility. It facilitates intra firm & inter firm comparisons because ROI data is readily available.

Investment Centres
( performance measurement) Capital Charge CHQ has the responsibility for establishing the rate which is used for computing the capital charge. It is calculated by considering all the sources of permanent capital viz. equity & debt. Generally the rate is fixed below the firms estimated cost of capital so that the economic value added of an average business unit is above zero. Some firms use a lower rate for working capital compared to fixed assets because the former is less risky owing to its shorter period of commitment. This lower rate compensates for the inclusion of inventory & receivables at the gross value by the firm.

Investment Centres
( performance measurement)
Economic Value Added ( EVA ) This concept has many names & is also called as economic profit, value based management, shareholder value analysis. residual income EVA fulfills the need for a performance measure that is both highly correlated with shareholder wealth & responsive to actions of companys managers. Shareholders are the important stakeholders of the company & shareholder value creation related to companys market value of shares is critical for the firm because - it reduces the risk of takeover - creates currency in aggressiveness in M & A - reduces cost of capital which allows fast investment for future growth. Since shareholders value measures the worth of the consolidated enterprise as a whole , it is nearly impossible to use it as a performance criterion for an organizations individual RCs. The best proxy for shareholder value at BU level is EVA.

EVA
(comparative benefits)
Unlike ROI which is a ratio, EVA is an absolute amount stated in monetary terms which is derived by deducting a capital charge from net operating profit. With EVA all business units have the same profit objective for comparable investments. This contrasts with ROI approach which provides different incentives for investments across BUs. e.g. a BU that is currently achieving an ROI of 30% would be reluctant to expand unless it is able to earn the same or more ROI on additional assets because lesser returns would decrease its overall ROI below its current level. Thus the BU may forego the investment opportunities whose ROI is above the cost of capital but below 30% Similarly a BU that currently is achieving a low ROI say 5 % would benefit from anything over 5 %on additional assets. As a consequence ROI creates a bias towards little or no expansion in high profit BUs while at the same time low profit BUs are making investments at rates of return well below those rejected by high profit units.

EVA
(comparative benefits)
Also decisions that increase a centres ROI may possibly decrease its overall profits e.g. for an Investment Centre where the current ROI is 30 %, the manager can increase its overall ROI by disposing an asset whose ROI is 25%. However if the cost of capital tied up in IC is less than 25%, the absolute profit in rupee terms after deducting capital costs will decrease for the centre. The use of EVA as a measure deals with both these problems which relate to asset investment whose ROI falls between the cost of capital & the centres current ROI. If an ICs performance is measured by EVA, investments that produce a profit in excess of the cost of capital will increase EVA & therefore will be economically attractive to the manger.

Comparative Analysis
(differences between ROI & EVA approaches)
These benefits can be explained with the help of a numerical example given below which highlights comparative analysis of two approaches . Given 1) Companys required rate of return for investing in fixed assets is 10% after taxes. 2) Company wide cost of money tied up in inventories & receivables is 4% after taxes 3) The numerical values relevant for ROI approach ( Refer first table ) 4) The figures required for EVA approach ( Refer second table.) Requirement Highlight relative merits & demerits of two approaches.

Numerical Data for ROI( Rs. 000 )

1
B.U. Cash

4
Fixed Assets

5
Total investment

6
Budgete d profit

7=6/5
ROI objective

Receivab Inventori les es

A B

10 20

20 20

30 30

60 50

120 120

24.0 20% 14.4 12%

C
D E

15
5 10

40
10 5

40
20 10

10
40 10

105
75 35

10.5 10%
3.8 5%

(1.8) (5)%

Numerical Data for EVA ( Rs. 000 )

curr ent 1
B.U.

2 60

3
Rate

ass ets 4 2.4 2.8

fixe d 5 60 50 6
Rate

ass ets 7

1 [(4) + (7)] =

8 15.6 6.6

Profit p- Amount otential

Reqd e- Amount arnings

Reqd e- Budget arnings ed EVA

A B

24

4% 4%

10% 6.0 10% 5.0

14.4 70

C
D E

10.5 95
3.8 35
(1.8) 25

4%
4% 4%

3.8
1.4 1.0

10
40 10

10% 1.0
10% 4.0 10% 1.0

5.7
(1.6) (3.8)

Comparative Analysis
(differences between ROI & EVA approaches) Columns 1 to 5 in the first table show the amount of investment in assets that each business unit budgeted for the coming year. Column 6 is the amount of budgeted profit. Column 7 is the budgeted profit divided by budgeted investment. Therefore this column shows the ROI objectives for the coming year for each of the business units. Only in Business Unit C is the ROI objective consistent with the company wide cut off rate. In no unit is the objective consistent with the companywide 4% cost of carrying current assets.

Comparative Analysis
(differences between ROI & EVA approaches)
Business Unit A would decrease its chances of meeting its profit objective if it did not earn at least 20% on added investment in either current or fixed assets. Units D & E would benefit from investments with a much lower return. EVA corrects these inconsistencies. The investments multiplied by appropriate rates are subtracted from budgeted profit & the resulting amount is the budgeted EVA. Periodically the actual EVA is calculated by subtracting from actual profits the actual investment multiplied by the appropriate rates. For example if B.U. A earned Rs. 28,000-/ & employed average current assets of Rs 65,000-/ & average fixed assets of Rs. 65000-/ its actual EVA would be EVA = 28,000 0.04 (65000) 0.10 (65000) = 28000 2600 6500 = 18900-/ This is better than its objective by Rs 3300 i.e. 18900 15600

Comparative Analysis
(differences between ROI & EVA approaches) If any business unit earns more than 10% on added fixed assets , it will increase its EVA. In the cases of Business Units E & D, the additional profit will decrease the amount of negative EVA. A similar result occurs for current assets. Inventory decision rules will be based on a cost of 4% for financial carrying charges. ( here additional costs for physically storing the inventory are not considered) In this way the financial decision rules of the business units will be consistent with those of company. EVA also solves the problem of differing profit objectives for the same asset in different business units & the same profit objective for different assets in the same unit.

Comparative Analysis
(differences between ROI & EVA approaches)
The method makes it possible to incorporate in the measurement system the same decision rules used in the planning process. The more sophisticated the planning process, the more complex the EVA calculation can be, e.g. the capital investment decision rules may call for a 10% return on general purpose assets & a 15% return on special purpose assets. Business Units fixed assts can be classified accordingly & different rates applied when measuring performance. Managers may be reluctant to invest in improved working conditions, pollution control measures or other social goals if they perceive them to be unprofitable. Such investments will be much more acceptable to B.U. managers if they are expected to earn a reduced return on them.

EVA
( as a performance measurement tool)
Under EVA or Residual Income ( R.I.) method of performance evaluation, divisions are charged with an opportunity cost of capital for the various categories of assets they employ The terminology of Economic Value Added or Residual Income indicates Income after expenses, including the capital charges, Bringing capital costs into the divisional income statement as an explicit expense yields a total cost calculation that is practically identical to the true cost. EVA. then becomes true profit after proper provision for capital cost adjustment for risks associated with assets employed & motivates mangers to increase EVA by taking actions consistent with increasing stock holder value . Under this approach of performance measurement, each division is assigned a budgeted EVA / R.I. & the divisional manger then has to concentrate on decisions that maximize EVA while pursuing goal-congruent behavior

EVA
( as a performance measurement tool)
EVA = Net profit capital charge Capital charge =cost of capital x capital employed. (1) Another way to state the equation (1) is EVA = capital employed( ROI cost of capital) (2) EVA in equation (2) can be increased by one or more of the following actions which are in the best interest of the shareholders. a) Increase ROI through BPR & productivity gains without increasing the asset base. b) Divestment of assets, products & /or businesses whose ROI is less than the cost of capital. c) Aggressive new investments in assets , products & /or businesses whose ROI exceeds the cost of capital. d) Increase in sales, profit margins, capital efficiency ( sales /capital employed) or decrease in cost of capital without affecting other variables in equation (2)

Investment Centre
( measurement of economic performance)
Performance measurement of investment centre manager is different from the evaluation of the economic performance of the investment centre itself. Economic reports are a useful tool in the hands of management. While management reports are prepared on the basis of historic information, economic reports use quite different type of information. The former focuses on what profitability is or has been, the latter deals with prediction of future profitability. Therefore management performance reports use book value of assets for computing depreciation but this information is of no relevance to economic performance report which is more concerned with replacement costs. Economic reports serve as an instrument for diagnosing maladies. The strengths & weaknesses of strategies that are currently being pursued are also revealed.

Investment Centre
( measurement of economic performance - contd.) Whether the current strategies of investment centre are sound or whether a decision should be taken regarding a business unit viz. contraction, expansion, divestment etc. is indicated by such a diagnosis ( Recapitulate different Missions - Build, Hold, Harvest Divest ) It is possible that the economic analysis of an investment centre may show that the existing plans for new products, new distribution channels ,new capital equipment or other new strategies when considered in totality, will not generate a figure of profit which is considered satisfactory, although each separate decision was considered sound when the same were made.

Investment Centre
( measurement of economic performance - contd.)
Economic performance reports have another utility. They are used for deriving the value of the firm as a whole viz. the break up value . The break up value which is also known as shareholder value is the estimated amount that the shareholders are expected to receive if each business unit were sold separately. While considering making a takeover bid, for a company, the break up value proves useful to an outsider. Similarly it is invaluable to the management of a firm in evaluating how attractive the said bid is. The report may come forth with the revelation about the relative attractiveness of BUs. It may also pin point that top management is devoting undue amount of time & energy to investment centres which do not have the potential of contributing significantly to the profitability of the firm . The need for changes may be indicated where there is a gap between existing profitability & shareholder value.