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CHAPTER 7

MEASURING & CONTROLLING ASSETS


EMPLOYED

INTRODUCTION
In some business units, the main focus is on
profit. In other business unit, profit is
compared with the assets employed.
In real world, companies use the term profit
centre rather than investment centre. But, an
investment centre is special type of profit
centre, rather than a separate, parallel
category.
However, there are so many problems
involved in measuring the assets employed in
a profit centre.

Sagar Manavadariya & Ashish


Babariya

STRUCTURE OF THE ANALYSIS

PURPOSE FOR MEASURING ASSETS EMPLOYED

1. To provide information that is useful in making


sound decision about assets employed and to motivate
managers to make these sound decision that are in the
best interest in the company.
2. To measure the performance of the business unit as
an economic entity.

Sagar Manavadariya & Ashish


Babariya

STRUCTURE OF THE ANALYSIS


In general, B-unit managers have two performance
objectives
1. They should generate profit from the resources at
their disposal.
2. They should invest in additional resources only when
investment will produce an adequate return.
The purpose of relating profit to investment is to
motivate business unit managers to accomplish these
objectives.

Sagar Manavadariya & Ashish


Babariya

STRUCTURE OF THE ANALYSIS


Two ways of relating profit to assets employed
1. Return on Investment ( ROI )
ROI is a ratio. The numerator is income, as reported
on the income statement. The denominator is assets
employed.
2. Economic Value Added
EVA is a dollar amount, rather than a ratio. It is
found by subtracting a capital charge from the net
operating profit. This capital charge is found
multiplying the amount of assets employed by a rate.

Sagar Manavadariya & Ashish


Babariya

STRUCTURE OF THE ANALYSIS


EVA is conceptually superior to ROI. It is clear from
surveys that ROI is more widely used in a business
rather than EVA.
It is found by subtracting a capital charge from the net
operating profit.

Sagar Manavadariya & Ashish


Babariya

MEASURING ASSETS EMPLOYED


In deciding what investment base to use to
evaluate investment maneger, headquarter
ask two questions:
1. What practice will induce business unit manger to
use their assets most efficiently and to acquire the
proper amount and kind of new amount ?

2. What practices best measure the performance of the


unit as an economic entity?

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MEASURING ASSETS EMPLOYED


1.CASH
Most companies control cash centrally because central
control permits use of a smaller balance than would be
the case if each business unit held the cash balancess
it need to weather the unevennes of its cash inflows an
outflows.
Most companies use a formula to calculate the cash to be
included in the investment base.
Some companies omit cash from the investment base.
These companies reason that the amount of cash
approximates the current liabilities.

Sagar Manavadariya & Ashish


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MEASURING ASSETS EMPLOYED


2. RECEIVABLES
Business unit managers can influence the level of
receivables indirectly, by their ability to generate sales,
and directly by establishing credit terms and approving
individual credit account and credit limits, and by the
vigor in collecting overdue amounts.
The usual practice is to include receivables at the
book amount , which is the selling price less an
amount for bad debts.

Sagar Manavadariya & Ashish


Babariya

MEASURING ASSETS EMPLOYED


3.INVENTORIES
Inventories ordinarily are treated in a manner similar
to receivables that is , they are often recorded at end
of period amount even though intra period averages
would be preferable conceptually.

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MEASURING ASSETS EMPLOYED


4. WORKING CAPITAL IN GENERAL
Treatment of working capital items varies greatlt. At
one extreme, companies include all current asset in the
investment base with no offset for any current
liabilities.
At the other extreme, all current liabilities may be
deducte from current assets.

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MEASURING ASSETS EMPLOYED


5. PROPETY, PLANT AND EQUIPMENT
Fixed asset are initially recorded attheir acquisition cost, and this
cost is written off over the assets useful life through depreciation,
if depreciable assets are included in the investment base at net
book value, business unit profitability is m isstated.

The fluctuation in EVA & ROI from year to year can be


avoided by including depreciable assets in the investment
base at gross book value than net book value.
If depreciation is determined by the annuity, rather than
straight line method, the business unit profitability
calculation will show the correct EVA & ROI.
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MEASURING ASSETS EMPLOYED


6. LEASED ASSETS
The business unit managers are induce to lease,
rather than own, assets whenever the interest charge
that is built into the rental cost is less than the capital
charge that is applied to the business units investment
base, because it would increase EVA.

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MEASURING ASSETS EMPLOYED


7. Idle Assets
Business unit has idle assets that can be use by other
units, it may be permitted to exclude them from the
investment base if it classifies them as available.
The purpose of this permission is to encourage business
unit managers to realese undertilized assets to units that
may have better use from them.

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MEASURING ASSETS EMPLOYED


8. Intangible Assets
Some companies tend to be R&D intensive, others tend to be
marketing intensive. There advantages to capitalizing intangible
assets such R&D and marketing an then amortizing them over a
selected life.
9. Noncurrent Liabilities
business unit receives its permanent capital from the
corporate pool of founds. The corporation outained these funds
from debt providers, equity investots, and retained earnings.

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MEASURING ASSETS EMPLOYED


10. The Capital Charge
Some companies use a lower rate for working
capital is less risky than fixed assets because the
funds are commited for a shorter time period, and
the lower rate is a way to compensate for the fact
that the company include inventory and receivable
in the investment base at their gross amount.
11. Surveys of practice
most companies include fixed assets in their
investment base at their net book value. They do this
because this is the amount at wich the assets are carried
in the financial statements.

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EVA v/s ROI


Most of the companies employing investment centers
evaluate business units on the basis of ROI rather than
EVA.
There are three apparent benefits of an ROI measure.
1. Comprehensive measure in that anything that affects
financial statements is reflected in this ratio.
2. It is simple to calculate, easy to understand, and
meaningful sense.
3. It is a common denominator that may be applied to
any organizational unit responsible for profitability,
regardless of size or type of business.

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EVA v/s ROI


The EVA approach has some inherent advantages. There are four
compelling reasons to use EVA over ROI.
1. With EVA all business units have the same profit objective for
comparable investments.
2. Decisions that increase a centres ROI may decrease its overall
profits. If an investment centres 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.
3. Different interest rate may be used for different types of assets.
4. In contrast to ROI, has a stronger positive correlation with changes
in a companys market value.

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EVA v/s ROI


This can be understood by considering how EVA is
calculated. EVA is measured as follows :
EVA= Net Profit Capital Charge
Where;
Capital charge= Cost of capital * capital employed
Another way to calculate EVA
EVA = Capital employed (ROI Cost of capital)
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EVA v/s ROI


The following actions can increase EVA
1. Increase in ROI through BPRE and productivity gain,
without increasing the asset base.
2. Divestment of asset, product and /or businesses whose
ROI is less than the cost of capital.
3. Aggressive new investment in assets, products, and / or
business whose ROI exceeds the cost of capital.
2020
4. Increase in sales, profit margins or capital efficiency or
decrease in cost of capital percentage without affecting the
other variable in second equation.
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Additional Consierations in
Evaluating Managers
We strongly advocate the use of EVA as a performance
measurentment tools. EVA however does not solve all the
problems of measuring profitability in an investment
center.
More assets may be undervalued when are
capitalized, and others when are expense. This situation
applies especially to marketing units.

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Evaluating the Economic


Performance of the Entity
Management reports are prepared monthly or quarterly,
whereas economic performance reports are prepared at
irregular intervals, usually once every several years.
Management reports tend to use historical information on
actual cost incurred, ehreas economic reports use quite
different information.
Concepyually the value of business unit is the present
value of its future earning stream, this is calculating by
estimating cash flows for each future year and discounting
each of these annual flows at a requirted earnings rate.

Sagar Manavadariya & Ashish


Babariya

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