Management Control System

Presentation Topic
MEASURING & CONTROLLING
ASSETS EMPLOYED
INTRODUCTION
 In some business units, the main focus is on
profit. In other business unit, profit is
compared with the assets employed.
 In real world, companies use the term– profit
centre rather than investment centre. But, an
investment centre is special type of profit
centre, rather than a separate, parallel
category.
 However, there are so many problems
involved in measuring the assets employed in
a profit centre.

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STRUCTURE OF THE ANALYSIS
 PURPOSE FOR MEASURING ASSETS EMPLOYED
1. To provide information that is useful in making
sound decision about assets employed and to motivate
managers to make these sound decision that are in the
best interest in the company.

2. To measure the performance of the business unit as

an economic entity.

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STRUCTURE OF THE ANALYSIS
In general, B-unit managers have two performance
objectives

1. They should generate profit from the resources at

their disposal.

2. They should invest in additional resources only when

investment will produce an adequate return.

The purpose of relating profit to investment is to

motivate business unit managers to accomplish these
objectives.

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STRUCTURE OF THE ANALYSIS
Two ways of relating profit to assets employed
1. Return on Investment ( ROI )
ROI is a ratio. The numerator is income, as reported
on the income statement. The denominator is assets
employed.

2. Economic Value Added

EVA is a dollar amount, rather than a ratio. It is
found by subtracting a capital charge from the net
operating profit. This capital charge is found
multiplying the amount of assets employed by a rate.

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STRUCTURE OF THE ANALYSIS
EVA is conceptually superior to ROI. It is clear from
surveys that ROI is more widely used in a business
rather than EVA.

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MEASURING ASSETS EMPLOYED
In deciding what investment base to use to
evaluate investment maneger, headquarter
ask two questions:
1. What practice will induce business unit manger to
use their assets most efficiently and to acquire the
proper amount and kind of new amount ?

2. What practices best measure the performance of the

unit as an economic entity?

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MEASURING ASSETS EMPLOYED
1.CASH
Many companies use a formula to calculate the cash
to be included in the investment base.

Some companies omit cash from the investment base.

These companies reason that the amount of cash
approximates the current liabilities.

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MEASURING ASSETS EMPLOYED
2. RECEIVABLES
Business unit managers can influence the level of
receivables indirectly, by their ability to generate sales,
and directly by establishing credit terms and approving
individual credit account.

The usual practice is to include receivables at the

book amount , which is the selling price less an
amount for bad debts.

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MEASURING ASSETS EMPLOYED
3.INVENTORIES
Inventories ordinarily are treated in a manner similar
to receivables – that is , they are often recorded at end
of period amount even though intra period averages
would be preferable conceptually.

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MEASURING ASSETS EMPLOYED
4. WORKING CAPITAL IN GENERAL
At one extreme, companies include all current asset in
the investment base with no offset for any current
liabilities.

At the other extreme, all current liabilities may be

deducte from current assets.

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MEASURING ASSETS EMPLOYED
5. PROPETY, PLANT AND EQUIPMENT
If depreciable assets are included in the investment base
at net book value, business unit profitability is misstated.

The fluctuation in EVA & ROI from year to year can be

avoided by including depreciable assets in the investment
base at gross book value than net book value.

If depreciation is determined by the annuity, rather than

straight line method, the business unit profitability
calculation will show the correct EVA & ROI.

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MEASURING ASSETS EMPLOYED
6. LEASED ASSETS
The business unit managers are induce to lease,
rather than own, assets whenever the interest charge
that is built into the rental cost is less than the capital
charge that is applied to the business unit’s investment
base, because it would increase EVA.

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EVA v/s ROI
Most of the companies employing investment centers
evaluate business units on the basis of ROI rather than
EVA.

There are three apparent benefits of an ROI measure.

1. Comprehensive measure in that anything that affects
financial statements is reflected in this ratio.
2. It is simple to calculate, easy to understand, and
meaningful 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.

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EVA v/s ROI
The EVA approach has some inherent advantages. There are four
compelling reasons to use EVA over ROI.

1. With EVA all business units have the same profit objective for
comparable investments.

2. Decisions that increase a centre’s ROI may decrease its overall

profits. If an investment centre’s performance is measured by EVA,
investments that produce a profit in excess of the cost of capital will
increase EVA and therefore be economically attractive to the manager.

3. Different interest rate may be used for different types of assets.

4. In contrast to ROI, has a stronger positive correlation with changes

in a company’s market value.

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EVA v/s ROI
EVA= Net Profit – Capital Charge

Where;

Capital charge= Cost of capital * capital employed

Another way to calculate EVA

EVA = Capital employed (ROI – Cost of capital)

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EVA v/s ROI
The following actions can increase EVA

1. Increase in ROI through BPRE and productivity gain,

without increasing the asset base.

2. Divestment of asset, product and /or businesses whose

ROI is less than the cost of capital.

3. Aggressive new investment in assets, products, and / or

business whose ROI exceeds the cost of capital.
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4. Increase in sales, profit margins or capital efficiency or
decrease in cost of capital percentage without affecting the
other variable in second equation.

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