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MEASURING AND CONTROLING ASSETS EMPLOYED

Purposes of measuring assets employed:

to provide information for decision making

to measure the performance of the business unit

focusing on profits without considering the assets employed to generate those profits is an

inadequate basis for control

unless the amount of assets employed is taken into account it is difficult to compare the profit

performance

business unit managers have two performance objectives

- they should generate adequate profits

- they should invest in additional resources only when the investment will produce an adequate

return

Measuring assets employed:

What practice will induce business unit managers to use their assets most efficiently?

1. Cash: central control

Many 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

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. The usual practice is to include receivables at the book amount , which is the selling

price less an amount for bad debts.

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.

4. Working Capital in General

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 deducted from

current assets.

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5. Property , Plant, and Equipment

If depreciable assets are included in the investment base at net book value, business unit

profitability is misstated. 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.

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

Profit is compared with the assets employed in earning itInvestment centers. Relating profit to the

investment base: (1) ROI and (2) EVA.

ROI is the ratio. The numerator is income, as reported on the income statement. Denominator is assets

employed

Economic value added ( EVA ) is a dollar amount , rather than the 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 the rate.

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 ROImeasure.

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.

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 centre ROI may decrease its overall profits. If an investment centre

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.

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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 company market

value.

EVA v/s ROI

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)

Advantages of using EVA

EVA ranks project on profits in excess of the cost of capital (EVA increases). With EVA, all business units have the same profit objective for comparable investments. EVA permits the use of different interest rates for different investment projects. EVA has greater correlation with a firms market value (it optimizes shareholder value). decisions that increase centers ROI may decease its coverall profits different interest rates may be used for different types of assets lower interest rate for inventories relatively higher rates for fixed assets