You are on page 1of 8

Explain the concept of ROI. What are its advantages?

Return on investment (ROI) is the ratio of profit before tax to the gross investment.
ROI is calculated with the help of the following formula:
ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)
he numerator is profit before tax as reported in the !"# account. he profit should include onl$ the
profits arising out of the normal activities of the division. %nusual items of receipts and expenses should
be excluded from the profit figure. One should also ignore windfalls and income from investments not
related to the operations of the division. ax is excluded from the numerator because the marginal of
the &'% (&trategic business unit) is not responsible for or in control of the tax paid.
(apital emplo$ed can be ascertained ( ) from the balance sheet b$ including fixed and current
assets. )ssets not currentl$ put to divisional use should be excluded from the investment base. One also
needs to exclude their relative earnings if an$. he compan$ should also exclude intangible assets li*e
goodwill+ deferred revenue expenses+ preliminar$ expenses+ etc.
ROI can be improved b$:
a) Increasing the profit margin on sales.
b) Increasing the capital turnover
c) Increasing both profit margin and capital turnover.
d) Reducing cost as that adds to the total earnings of the firm.
e) Increasing the profits b$ expanding present operations or developing new product line+
increasing mar*et share+ etc.
f) ,iversif$ing+ introducing productivit$ improvement measures+ expansion+ replacement of old
e-uipments
)dvantages of ROI
a) ROI relates return to the level of investment and not sales as the rate of return is more realistic.
b) ROI can be decomposed into other variables as shown. hese variables have tremendous
anal$tical value.
c) ROI is an effective tool for inter.firm comparison.




Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not do
ustice to the evaluation of invest!ent center. Explain this pheno!enon "ith as illustration.
/) 01) does not solve all the problems of measuring profitabilit$ in an investment center. In
particular+ it does not solve the problem of accounting for fixed assets discussed above unless
annuit$ depreciation is also used+ and this is rarel$ done in practice.
2) If gross boo* value is used+ a business unit can increase its 01) b$ ta*ing actions contrar$ to the
interests of the compan$+ as shown in 0xhibit 3.4.
4) If net boo* value is used+ 01) will increase simpl$ due to the passage of time.
5) 6urthermore+ 01) will be temporaril$ depressed b$ new investments because of the high net
boo* value in the earl$ $ears.
7) 01) does solve the problem created b$ differing profit potentials.
8) )ll business units+ regardless of profitabilit$+ will be motivated to increase investments if the
rate of return from a potential investment exceeds the re-uired rate prescribed b$ the mea.
surement s$stem.
3) 9oreover+ some assets ma$ be undervalued when the$ are capitali:ed+ and others when the$
are expensed.
;) )lthough the purchase cost of fixed assets is ordinaril$ capitali:ed+ a substantial amount of
investment in start.up costs+ new product development+ dealer organi:ation+ and so forth ma$
be written off as expenses+ and+ therefore+ not appear in the investment base.
<) his situation applies especiall$ in mar*eting units.
/=) In these units the investment amount ma$ be limited to inventories+ receivables+ and office
furniture and e-uipment.
//) >hen a group of units with var$ing degrees of mar*eting responsibilit$ are ran*ed+ the unit with
the relativel$ larger mar*eting operations will tend to have the highest 01).
/2) In view of all these problems+ some companies have decided to exclude fixed assets from the
investment base.
/4) hese companies ma*e an interest charge for controllable assets onl$+ and the$ control fixed
assets b$ separate devices.
/5) (ontrollable assets are+ essentiall$+ receivables and inventor$.
/7) 'usiness unit management can ma*e da$.to.da$ decisions that affect the level of these assets.
/8) If these decisions are wrong+ serious conse-uences can occur.-uic*l$.
/3) 6or example+ if inventories are too high+ unnecessar$ capital is tied up+ and the ris* of
obsolescence is increased? whereas+ if inventories are too low+ production interruptions or lost
customer business can result from the stoc*outs. o focus attention on these important
controllable items+ some companies+ such as @ua*er Oats+ /3 include a capital charge for the
items as an element of cost in the business unit income statement. his acts both to motivate
business unit management properl$ and also to measure the real cost of resources committed
to these items.
/;) Investments in fixed assets are controlled b$ the capital budgeting process before the fact and
b$ post completion audits to determine whether the anticipated cash flows+ in fact+
materiali:ed.
/<) his is far from being completel$ satisfactor$ because actual savings or revenues from a fixed
asset ac-uisition ma$ not be identifiable.
2=) 6or example+ if a new machine produces a variet$ of products+ the cost accounting s$stem
usuall$ will not identif$ the savings attributable to each product.
2/) he argument for evaluating profits and capital investments separatel$ is that this often is
consistent with what senior management wants the business unit manager to accomplish?
namel$+ to obtain the maximum long.run cash flow from the capital investments the business
unit manager controls and to add capital investments onl$ when the$ will provide a net return in
excess of the compan$As cost of funding that investment.
22) Investment decisions+ then+ are controlled at the point where these decisions are made.
24) (onse-uentl$+ the capital investment anal$sis procedure is of primar$ importance in investment
control. Once the investment has been made+ it is largel$ a sun* cost and should not influence
future decisions.
25) Bevertheless+ management wants to *now when capital investment decisions have been made
incorrectl$+ not onl$ because some action ma$ be appropriate with respect to the person
responsible for the mista*es but also because safeguards to prevent a recurrence ma$ be
appropriate.



Illustration

Q. what are different types of Strategic Missions at SBU level? How do these missions affect
Strategic Planning process and Budgeting at SBU Level?
ifferent !ypes of Strategic Missions"
Business Unit Mission"
In a diversified firm one of the important tasks of senior management is resource deployment, that
is, make decisions regarding the use of the cash generated from some business units to finance
growth in other business units. Several planning models have been developed to help corporate level
managers of diversified firms to effectively allocate resources. These models suggest that a firm has
business units in several categories, identified by their mission; the appropriate strategies for each
category differ. Together, the several units make up a portfolio, the components of which differ as
to their risk/reward characteristics just as the components of an investment portfolio differ. oth
the corporate !office and the business unit general manager are involved in identifying the missions
of individual business units. "f the many planning models, two of the most widely used are oston
#onsulting $roup!s two%by%two growth%share matri& and $eneral 'lectric #ompany/(c)insey *
#ompany!s three%by%three industry attractiveness%business strength matri&. +hile these models
differ in the methodologies they use to develop the most appropriate missions for the various
business units, they have the same set of missions from which to choose, build, hold, harvest, and
divest.

Build"
This mission implies an objective of increased market share, even at the e&pense of short%term
earnings and cash flow -e.g., (erck!s bio%technology, lack and .ecker!s handheld electric tools/.

Hold"
This strategic mission is geared to the protection of the business unit!s market share and competitive
position -e.g., I(!s mainframe computers/.

Harvest"
This mission has the objective of ma&imi0ing short%term earnings and cash flow, even at the e&pense
of market share -e.g., 1merican rands! tobacco products, $eneral 'lectric!s and Sylvania!s light
bulbs/

ivest"
This mission indicates a decision to withdraw from the business either through a process of slow
li2uidation or outright sale. +hile the planning models can aid in the formulation of missions, they
are not cook books. 1 business unit!s position on a planning grid should not be the sole basis for
deciding its mission.

Business Unit #ompetitive $dvantage"
'very business unit should develop a competitive advantage in order to accomplish its mission.
Three interrelated 2uestions have to be considered in developing the business unit!s competitive3
advantage. 4irst, what is the structure of the industry in which the business unit operates5 Second,
how should the business unit e&ploit the industry!s structure5 Third, what will be the basis of the
business unit!s competitive advantage5

%ndustry $nalysis"
6esearch has highlighted the important role industry conditions play in the performance of
individual firms. Studies have shown that average industry profitability is, by far, the most significant
predictor of firm performance. 1ccording to 7orter, the structure of an industry should be analy0ed
in terms of the collective strength of five competitive forces.

8. The intensity of rivalry among e&isting competitors. 4actors affecting direct rivalry are industry
growth, product differentiability, number and diversity of competitors, level of fi&ed costs,
intermittent overcapacity, and e&it barriers.

9. The bargaining power of customers. 4actors affecting buyer power are number of buyers, buyer!s
switching costs, buyer!s ability to integrate backward, impact of the business unit!s product on
buyer!s total costs, impact of the business unit!s product on buyer!s product 2uality/ performance,
and significance of the business unit!s volume to buyers.

:. The bargaining power of suppliers. 4actors affecting supplier power are number of suppliers,
supplier!s ability to integrate forward, presence of substitute inputs, and importance of the business
unit!s volume to suppliers.

;. Threat from substitutes. 4actors affecting substitute threat are relative price/performance of
substitutes, buyer!s switching costs, and buyer!s propensity to substitute.

<. The threat of new entry. 4actors affecting entry barriers are capital re2uirements, access to
distribution channels, economies of scale, product differentiation, technological comple&ity of
product or process, e&pected retaliation from e&isting firms, and government policy.

&e ma'e three o(servations with regard to the industry analysis"
8. The more powerful the five forces are, the less profitable an industry is likely to be. In industries
where average profitability is high -such as soft drinks and pharmaceuticals/, the five forces are weak
-e.g., in the soft drink industry, entry barriers are high In industries where the average profitability is
low -such as steel and coal/, the five forces are strong -e.g., in the steel industry, threat from
substitutes is high/.

9. .epending on the relative strength of the five forces, the key strategic issues facing the business
unit will differ from one industry to another.

:. =nderstanding the nature of each force helps the firm to formulate effective strategies. Supplier
selection -a strategic issue/ is aided by the analysis of the relative power of several supplier groups;
the business unit should link with the supplier group for which it has the best competitive
advantage. Similarly, analy0ing the relative bargaining power of several buyer groups will facilitate
selection of target customer segments.

)eneric #ompetitive $dvantage"
The five%force analysis is the starting point for developing a competitive advantage since it helps to
identify the opportunities and threats in the e&ternal environment. +ith this understanding, 7orter
claims that the business unit has two generic ways of responding to the opportunities in the e&ternal
environment and developing a sustainable competitive advantage, low cost and differentiation.

Low #ost"
#ost leadership can be achieved through such approaches as economies of scale in production;
e&perience curve effects, tight cost control, and cost minimi0ation -in such areas as research and
development, service, sales force, or advertising/. Some firms following this strategy include #harles
Schwab in discount brokerage, +al%(art in discount retailing, Te&as Instruments in consumer
electronics, 'merson 'lectric in electric motors, >yundai in automobiles, .ell in computers, lack
and .ecker in machine tools, ?ucor in steel, @incoln 'lectric in arc welding e2uipment, and I# in
pens.
ifferentiation,
The primary focus of this strategy is to differentiate the product offering of the business unit,
creating something that is perceived by customers as being uni2ue. 1pproaches to product
differentiation include brand loyalty -#oca%#ola and 7epsi #ola in soft drinks/, superior customer
service -?ordstrom in retailing/, dealer network -#aterpillar Tractors in construction e2uipment/,
product design and product features ->ewlett%7ackard in electronics/, and technology -#isco in
communications infrastructure/. "ther e&amples of firms following a differentiation strategy include
(+ in automobiles; Stouffer!s in fro0en foods, ?eiman%(arcus in retailing, (ont lanc in pens,
and 6ole& in wristwatches.
*alue #hain $nalysis,
usiness units can develop competitive advantage based on low cost, differentiation, or both. The
most attractive competitive position is to achieve cost%cum%differentiation.


Q. Discuss and illustrate differences and similarities between
a. Strategy Formulation and Management Control
b. Management Control and Task Control
Some Distinction between Strategy Formulation and management Control

Characteristics Strategy Formulation Management Control
a) Focus of plan On one aspect at a time On entire organisation
b) Complexities Many variables hence
complex
Less complex
c) Nature of information Tailor-made for the issue,
more external and predictive,
less accurate.
Integrated, more internal and
historical, more accurate.
d) Structure Unstructured and irregular,
each problem being different
Rhythmic, definite pattern,
set procedure
e) Communication of
information
Relatively simple Relatively difficult
f) Purpose of estimates Show expected results Lead to desired result
g) Persons involved Staff and top management Line and top management
h) No. of persons involved Small Large
i) Mental activity Creative, analytical Administrative, persuasive
j) Planning and control Planning dominant but some
control
Emphasis on both planning
and control
k) Time horizon Tends to be long Tends to be short
l) End result Policies and precedents Action within policies laid
m) Appraisal of job done Extremely difficult Less difficult

b) Some Distinction between Management Control and Task Control
Characteristics Task Control Management control
a) Focus of plan Single task or transaction On entire organisation
b) Nature of information Tailor-made to operation,
specific, often non- financial,
real time
Integrated, more internal and
historical, more accurate
c) Persons involved Supervisors Line and top management
d) Mental activity Follow directives or none as
in case of machines or set
objectives
Administrative, persuasive
e) Time horizon Day to day Tends to be short
f) Type of cost Engineered- Existence of
objective standard against
which actuals can be
compared makes control
easier.
Discretionary- Control is
more difficult due to
subjective consideration.