Measuring and Controlling Assets Employed

Management Control Systems Chapter 7

Purpose
To provide information that is useful in making sound decisions about assets employed and to motivate managers to make these sound decisions that are in the best interests of the company. To measure the performance of the business unit as an economic entity.

The Investment Base

The Investment Base : the sum of the principal types of assets that may be employed in an investment center. An Investment Center : a special type of profit center. 2 methods of Investment Base : ROI & EVA (Economic Value Added)

Methods of Investment Base

Return On Investment (ROI) Income ROI = ----------------- x 100 Investment

Methods of Investment Base

Economic Value Added (EVA)
1. EVA = Net Profit Capital Charge Capital Charge = Cost of Capital x Capital employed

2. EVA = Capital employed (ROI Cost of Capital)

EVA vs ROI
3 Benefits of an ROI measure :
1) It is a comprehensive measure in that anything that affects financial statements 2) Simple to calculate, easy to understand and meaningful in an absolute sense. 3) It is a common denominator that may be applied to any organizational unit responsible for profitability.

EVA vs ROI
Advantages to use EVA over ROI :
1) With EVA all business units have the same profit objective for comparable investments. The ROI approach provides different incentives for investments across BUs.

EVA vs ROI
2) Decisions that increase a centers ROI may decrease its overall profits. If an investment centers 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.

EVA vs ROI
3) Different interest rates may be used for different types of assets, to take into account different degrees of risk. 4) EVA has a stronger positive correlation with changes in a companys market value.

Shareholder Value Creation

Why shareholder value creation is critical for the firm?
a) Reduces the risk of takeover b) Creates currency for aggressiveness in mergers and acquitisions c) Reduces cost of capital, which allow faster investments for future growth.