Investment Centre

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Responsibility Centres

Investment Centre


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Investment Centres


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Investment Centres(characteristic features)

Divisional managers considered as profit centres enjoy certain autonomy indirecting their responsibility centers within the overall control by the CHQ

They use available resources and generate adequate revenues to contributeprofits into the profit pool of the company

To measure the comparative performance of the divisional managers, somestandard or scale is required

An investment Centre is a R.C. in which the manager is held responsible forthe 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 theresponsibility centre.

Here the control system applies monetary measures to both inputs & outputsand the investment used within the R.C. itself.

The profits are related to the capital employed during the period & R.O.I. iscalculated to ascertain the efficiency of the business unit.


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Investment Centres(characteristic features)

In Profit Centre the focus is on profits. But when the profit is compared withthe assets employed in earning it, the RC is referred to as InvestmentCentre.

Thus investment Centre is a special type of profit centre & in real world thecompanies 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


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Investment Centres

(issues in performance measurement)

The focus on profits without considering the assets used to generate thesame is not an adequate basis for exercising control.

It is difficult for top management to compare the profit performance of onebusiness unit with that of other units or with similar firms in the industrywithout considering the assets employed.

Comparisons of absolute differences in profits are meaningless if BUs employdifferent amount of resources.

BU managers performance objective generally address to :

1) Generation of satisfactory profits from the resources which are at theirdisposal.

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 thatcould be realized from its sale.


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Investment Centres( steps in performance measurement)

Two principal steps are involved in gauging the performance of aninvestment centre.

1) Measurement of assets employed

The aggregate of assets is termed investment base . It helps in measurementof 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 bestinterest 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 .


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a)ROIIt is a ratio of Income / Gross InvestmentThe 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 termsEVA = 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 thatused 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.


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P & L statement

Particulars

for the year ended 31.3.2000

Amount (Rs)

Sales 500

Expens. (exclu.depre. 350

Depreciation 10 360

Profit before tax 140

Income tax at 50% 70

Profit after tax 70


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Capital and

liabilities

Amount

(Rs)

Assets Amount

(Rs)

Share capital Fixed assets : cost 500

Paid up 200 Less :accumulateddepreciation

200 300

Reserves 80

Current liabilities Current Assets

Sundry creditors 150 Cash at bank 50

Bills payable 50 Debtors 100

others 120 Inventories 150

600 600

Balance sheet of X Co Ltd as on 31.3 2000


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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 EVAcalculation below.

Then ROI will be 50%

2) EVA = Net operating Profit capital charge

= 140 10% of 280

= 140 - 28

= 112


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Investment Centres( performance measurement)

Return on Investment (ROI)

ROI is an attempt to express the economic desirability of an investmentproposal in terms of a percentage return on the original outlay. MostInvestment Centres evaluate the BUs on this basis.

It is also called as Accounting rate of return method or financial statementmethod.

It is simple to calculate & easy to understand.

It is a comprehensive measure which reflects anything that affects financialstatements.

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.


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Capital Charge

CHQ has the responsibility for establishing the rate which is usedfor 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 ofcapital so that the economic value added of an averagebusiness 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 itsshorter period of commitment.

This lower rate compensates for the inclusion of inventory &receivables at the gross value by the firm.


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Economic Value Added ( EVA )

This concept has many names & is also called as economic profit, valuebased management, shareholder value analysis. residual income

EVA fulfills the need for a performance measure that is both highlycorrelated with shareholder wealth & responsive to actions of companysmanagers.

Shareholders are the important stakeholders of the company &shareholder value creation related to companys market value of shares iscritical 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 foran organizations individual RCs.

The best proxy for shareholder value at BU level is EVA.


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EVA(comparative benefits)

Unlike ROI which is a ratio, EVA is an absolute amount stated in monetaryterms which is derived by deducting a capital charge from net operatingprofit.

With EVA all business units have the same profit objective for comparableinvestments. This contrasts with ROI approach which provides differentincentives 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 thesame or more ROI on additional assets because lesser returns woulddecrease its overall ROI below its current level. Thus the BU may foregothe investment opportunities whose ROI is above the cost of capital butbelow 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 investmentsat rates of return well below those rejected by high profit units.


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EVA(comparative benefits)

Also decisions that increase a centres ROI may possibly decrease itsoverall 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 ROIis 25%.

However if the cost of capital tied up in IC is less than 25%, the absoluteprofit 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 & thecentres current ROI.

If an ICs performance is measured by EVA, investments that produce aprofit in excess of the cost of capital will increase EVA & therefore will be

economically attractive to the manger.


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Comparative Analysis(differences between ROI & EVA approaches)

These benefits can be explained with the help of a numerical example givenbelow 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.


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Numerical Data for ROI( Rs. 000 )

1 2 3 4 5 6 7=6/5

B.U. Cash Receivab

les

Inventori

es

Fixed

Assets

Total in-

vestment

Budgete

d profit

ROI

objective

A 10 20 30 60 120 24.0 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)%


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curr ent ass

ets

fixe d ass

ets

1 [(4)

+ (7)]

=

1 2 3 4 5 6 7 8

B.U. Profit p-otential

Amount Rate Reqd e-arnings

Amount Rate Reqd e-

arnings

Budgeted EVA

A 24 60 4% 2.4 60 10% 6.0 15.6

B 14.4 70 4% 2.8 50 10% 5.0 6.6

C 10.5 95 4% 3.8 10 10% 1.0 5.7

D 3.8 35 4% 1.4 40 10% 4.0 (1.6)

E(1.8)

25 4% 1.0 10 10% 1.0(3.8)

Numerical Data for EVA ( Rs. 000 )


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Columns 1 to 5 in the first table show the amount ofinvestment in assets that each business unit budgeted for thecoming year.

Column 6 is the amount of budgeted profit.

Column 7 is the budgeted profit divided by budgetedinvestment.

Therefore this column shows the ROI objectives for thecoming year for each of the business units.

Only in Business Unit C is the ROI objective consistent withthe company wide cut off rate.

In no unit is the objective consistent with the companywide4% cost of carrying current assets.


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Business Unit A would decrease its chances of meeting its profit objective if itdid not earn at least 20% on added investment in either current or fixedassets.

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 theactual investment multiplied by the appropriate rates.

For example if B.U. A earned Rs. 28,000-/ & employed average current assetsof Rs 65,000-/ & average fixed assets of Rs. 65000-/ its actual EVA wouldbe

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


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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 willdecrease the amount of negative EVA.

A similar result occurs for current assets.

Inventory decision rules will be based on a cost of 4% forfinancial carrying charges. ( here additional costs for physicallystoring the inventory are not considered)

In this way the financial decision rules of the business units willbe consistent with those of company.

EVA also solves the problem of differing profit objectives for thesame asset in different business units & the same profitobjective for different assets in the same unit.


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The method makes it possible to incorporate in the measurementsystem the same decision rules used in the planning process.

The more sophisticated the planning process, the more complex theEVA calculation can be, e.g. the capital investment decision rulesmay 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 perceivethem to be unprofitable.

Such investments will be much more acceptable to B.U. managers ifthey are expected to earn a reduced return on them.


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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 variouscategories of assets they employ

The terminology of Economic Value Added or Residual Income indicatesIncome 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 thetrue cost.

EVA. then becomes true profit after proper provision for capital costadjustment for risks associated with assets employed & motivatesmangers to increase EVA by taking actions consistent with increasingstock holder value .

Under this approach of performance measurement, each division is assigneda budgeted EVA / R.I. & the divisional manger then has to concentrateon decisions that maximize EVA while pursuing goal-congruent behavior


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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 whichare in the best interest of the shareholders.

a) Increase ROI through BPR & productivity gains without increasing the assetbase.

b) Divestment of assets, products & /or businesses whose ROI is less than the costof 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)


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Investment Centre( measurement of economic performance)

Performance measurement of investment centre manager is different fromthe evaluation of the economic performance of the investment centreitself.

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 withprediction of future profitability.

Therefore management performance reports use book value of assets forcomputing depreciation but this information is of no relevance toeconomic performance report which is more concerned with replacementcosts.

Economic reports serve as an instrument for diagnosing maladies.

The strengths & weaknesses of strategies that are currently being pursuedare also revealed.


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Investment Centre( measurement of economic performance - contd.)

Whether the current strategies of investment centre are soundor whether a decision should be taken regarding a businessunit viz. contraction, expansion, divestment etc. is indicatedby 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, newdistribution channels ,new capital equipment or other newstrategies when considered in totality, will not generate a

figure of profit which is considered satisfactory, although eachseparate decision was considered sound when the same weremade.


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Investment Centre( measurement of economic performance - contd.)

Economic performance reports have another utility. They are used forderiving the value of the firm as a whole viz. the break up value . Thebreak up value which is also known as shareholder value is the estimatedamount that the shareholders are expected to receive if each businessunit 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 relativeattractiveness of BUs. It may also pin point that top management isdevoting undue amount of time & energy to investment centres which do

not have the potential of contributing significantly to the profitability ofthe firm .

The need for changes may be indicated where there is a gap betweenexisting profitability & shareholder value.

Documents

Investment Centre