Cost Analysis, Profit Planning, and Control

MBA 603

Chapter 7 - Measuring and Controlling Assets Employed

Overview

• Investment Centers are a key area of many corporations.

• They possess the following responsibility factors:– Revenue– Expenses– Control of Assets

• Profit Centers mainly have responsibility for revenues, expenses, and of course profits.

Overview

• Investment Centers employ assets to generate profits.

• These assets are referred to as the investment base and usually consist of:– Net Fixed Assets– Other Assets– Minus Certain Current Liabilities

• There are two measures of good management we will discuss:– Economic Value Added (EVA) – Return on Investment

Structure of the Analysis

• The theory behind measuring assets employed centers around:– Focus attention on selecting sound assets that will

further the firm’s goals.– Measure the performance of the business unit based

on the amount of assets under it control.

• Manager of “BU’s” have two main performance keys:– Generate adequate resources from the asset base.– Invest in additional assets to increase firm profits -

asset quality comes into question.

Structure of the Analysis

• Return on Investment is one of the most widely employed tools to measure performance of “BU’s”:– Income divided by Assets Employed = ROI (%)

• Economic Value Added is measurement tool that is gaining wide acceptance to measure not only “BU” performance but, as a basis for executive compensation:– Net Operating Profit After Taxes (NOPAT) minus a

capital charge for assets employed ($ Assets X % Corporate WACC).

Measuring Assets Employed

• Before the cost of Assets Employed is computed Corporations need to decide the asset base by:– What will the BU managers use the assets for

effectively to purchase new assets?– What practices do the best job of measuring the BU’s

economic performance?

• Cash is included in the asset base in some firms even though most BU’s do not control a significant cash balance.

Measuring Assets Employed - Continued

• Receivables (net realizable) can be directly influenced by a BU manager and therefore are included in the asset base.

• Inventories are a key ingredient of the asset base and some firms adjust them downward for accounts payable.

• Working Capital as a key function of assets employed is subject to many variations:– Current Assets are included with no offset for current liabilities.– Current assets are included with a deduction for current

liabilities.

Measuring Assets Employed - Continued

• Property, Plant, and Equipment is a controversial component of EVA because of the impact depreciation has on NOPAT.

• Acquisition of New Equipment causes EVA to fall while, BU’s with older assets present a higher EVA value.

• Depending on the treatment by management new asset acquisitions maybe avoided by BU managers because they lower their EVA’s and BONUSES.

Measuring Assets Employed - Continued

• Gross Book Value of Assets Employed is another area of contention because this technique leads understated returns.

• Net Book Value tends to destroy the EVA calculation as depreciation declines with economic life.

• Exhibits 7.3 and 7.4 on Page 293 has some fine examples and calculations of EVA.

Measuring Assets Employed - Continued

• Leased Assets are technically not a part of assets employed because of GAAP and other accounting conventions.

• BU managers usually have restrictions on leasing assets because it is a manner in which they can increase EVA by not incurring a capital charge.

• This maneuver could run contrary to a corporation’s long-term strategy.

• Review Exhibit 7.8 for clarification.

Measuring Assets Employed - Continued

• Idle Assets are often excluded form the assets employed base because they maybe used by other BU’s.

• Intangible Assets such as R and D and huge marketing programs maybe capitalized in some instances which will impact EVA.

• Expensing intangible assets lowers taxable income, capitalizing them will reduce the capital charge on assets employed.

Measuring Assets Employed - Continued

• The Capital Charge is established by corporate headquarters and usually the weighted average cost of capital (WACC) that the firm employs for capital expenditure projects.

• Surveys of Practices for EVA employed assets portray a mixed picture of corporate techniques.

• Refer to Exhibits 7.9 and 7.10 for details.

EVA versus ROI

• Most firms employ ROI as the main measurement tool for investment centers over EVA per the data in exhibit 7.2.

• There are three main benefits to ROI:– It is a comprehensive measure that includes all

aspects of factors affecting financial statements.– It is simple to calculate.– It can be applied to any organizational unit and is

not affected by size or business type.

EVA versus ROI - Continued

• EVA does have some positive aspects and its usage is on the rise:– All business units have the same profit for like

investments.– Decisions that increase a center’s ROI may decrease

its overall performance.– EVA allows a firm the ability to employ different

interest rates for different types of assets.– The final one is key - EVA has a stronger correlation

with changes in a company’s market value.

EVA versus ROI - Continued

• EVA and shareholder return can be increased by the following actions:– Increase ROI by reengineering and productivity gains

without increasing assets.– Divest of assets or product lines that have ROI’s less than

the cost of capital.– Aggressively invest in new assets that have higher ROI’s

than the cost of capital.– Increase efficiency by improving sales, profits margins, and

the quality of the assets employed.

• Refer to Exhibit 7.12 for details.