Measuring The Performance Of Investment Center

Presented By: Anurag Sandeep Harshit Sumit

METHODS

ROI
RI EVA

10-2

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 (contd)

aOperating bOperating cSales

income divided by average operating assets. income divided by sales.

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 companys 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 Operating assets Operating income $60,000,000 $ 8,800,000

Project II $54,000,000 $ 8,140,000

Minimum return*
Residual income
*0.10 Operating assets.

6,000,000
$ 2,800,000

5,400,000
$ 2,740,000

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.
After-tax = operating income Weighted average cost of capital Total capital employed

EVA

Measuring the Performance of Investment Centers

EVA Example Amount Mortgage bonds Unsecured bonds Common stock Total $ 2,000,000 3,000,000 10,000,000 $15,000,000 0.098 After-Tax Weighted Percent x Cost = Cost 0.133 0.200 0.667 0.048 0.060 0.120 0.006 0.012 0.080

Weighted average cost of capital

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

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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