Measuring The Performance Of Investment Center Presented By: Anurag Sandeep Harshit Sumit

METHODS

 ROI  RI  EVA

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Measuring the Performance of Investment Centers

Return on investment (ROI) is the most common measure of performance for an investment center. ROI = Operating income / Average operating assets = (Operating income / Sales)  (Sales / Average operating assets) = Operating income margin  Operating asset turnover

Margin: portion of sales available for interest, taxes and profit

Turnover: how productively assets are being used to generate sales

Measuring the Performance of Investment Centers Comparison of Divisional Performance

Measuring the Performance of Investment Centers Comparison of Divisional Performance (cont’d)

aOperating

income divided by average operating assets.

bOperating

income divided by sales.

cSales

divided by average operating assets.

Measuring the Performance of Investment Centers Advantages of the ROI measure 1. Helps managers focus on the relationship between sales, expenses and investment. 2. Encourages cost efficiency. 3. Discourages excessive investment in operating assets Disadvantages of the ROI measure 1. Discourages managers from investing in projects decreasing divisional ROI but increasing profitability of the company overall. 2. Encourages managers to focus on the short-term at the expense of the long-term.

Measuring the Performance of Investment Centers

Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:

Residual Operating = Income Income

Minimum rate of return  Operating assets

Measuring the Performance of Investment Centers Residual Income Project I

Residual income = $1,300,000 - (0.10  $10,000,000) = $1,300,000 - $1,000,000 = $300,000 Project II Residual income = $640,000 - (0.10  $4,000,000) = $640,000 - $400,000 = $240,000

Measuring the Performance of Investment Centers

Project I

Project II

Operating assets

$60,000,000

$54,000,000

Operating income

$ 8,800,000

$ 8,140,000

Minimum return*

6,000,000

5,400,000

Residual income

$ 2,800,000

$ 2,740,000

*0.10 Operating assets.

Measuring the Performance of Investment Centers Disadvantages of Residual Income (continued) 1. It is an absolute measure of return which make it difficult to directly compare the performance of divisions. 2. It does not discourage myopic behavior.

Measuring the Performance of Investment Centers

Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.

EVA

After-tax = operating income

-

Weighted average cost of capital  Total capital employed

Measuring the Performance of Investment Centers EVA Example Amount Mortgage bonds Unsecured bonds Common stock Total

After-Tax Weighted Percent x Cost = Cost

$ 2,000,000

0.133

0.048

0.006

3,000,000

0.200

0.060

0.012

10,000,000

0.667

0.120

0.080

$15,000,000

Weighted average cost of capital

$15,000,000 x .098 = $1,470,000

0.098

Measuring the Performance of Investment Centers EVA Example (continued) EVA is calculated as follows: After-tax profit Less: Weighted average cost of capital EVA

$1,583,000 1,470,000 $ 113,000

The positive EVA means that earned operating profit over and above the cost of the capital used.

Measuring the Performance of Investment Centers Behavioral Aspects of EVA 



Tends to focus on long-run Discourages myopic behavior

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