CHAPTER 19: STRATEGIC PERFORMANCE MEASUREMENT— INVESTMENT CENTERS

How does the concept of economic value added EVA compares, as a measure of financial performance, to return on investment (ROI) and residual income (RI)?

Economic value added (EVA®) is a profitability measure that approximates the"economic earnings" of an investment center. Operationally, we define EVA® as a business unit's after-tax cash earnings after deducting an imputed charge of the level of invested capital in the business unit. On the surface, RI and EVA®look confusingly similar. There is a major difference, however. Residual income(RI) is calculated entirely using reported accounting data, for income and for assets (level of invested capital). As such, the resulting measure of profitability suffers from all of the limitations associated with historical-based accounting statements. By contrast, EVA® attempts to approximate economic, rather than accounting, earnings and level of invested capital. Thus, RI and EVA® are similar in form but are strikingly different in terms of measurement. Thus, the overall objective of EVA® is to provide an estimate of the value added to (or destroyed by) each strategic investment unit during a given period. As such, EVA® is one approach to what we call "Value-Based Management."

What is meant by the term investment center? How is the financial performance of investment center is measured ?

Investment centers are commonly used when there are a number of businessunits to be compared, and/or when top management intends to evaluate theeconomic performance of the business unit relative to alternative investments. Bydefinition, managers of these business units exercise control over revenues,costs, and the level of investment in the business unit. The profit per dollarinvested (usually called the "return") can be compared to the rate of return foralternative investments⎯other types of business units or other investmentpossibilities. Commonly, the rate of return is determined by taking the ratio of theamount of profit divided by the amount invested in the business unit.

What is return on investment (ROI), and how is it calulated?

Return on investment (ROI) is the ratio of some measure of Profit to some measure of "investment capital" for the business unit.

What are the advantages and limitations of residual income (RI), and how is each component interpreted and used?

The key advantage of residual income (RI) is that it deals effectively with the limitation of ROI: ROI has a disincentive for the managers of the most profitable units to make new investments. With residual income, no matter how profitable the unit, there is still an incentive for new profitable investment. In contrast, a key limitation is that since RI is not a percentage, it suffers the same problem of using the amount of investment-center profit in that it is not useful for comparing units of significantly different sizes. It favors larger units that would be expected to have larger residual incomes, even with relatively poor performance. Moreover, relatively small changes in the desired minimum rate of return can dramatically affect RI for different-sized units. And, in contrast to ROI, some managers do not find RI to be as intuitive and as easily understood.

What are the advantages and limitations of return on investment (ROI) as a performance measure?

The primary advantages of using return on investment (ROI) as a performance indicator are: 1. It is intuitive and easily understood. 2. It provides a useful basis for comparison among SBUs. 3. It is widely used. The primary limitations of return on investment (ROI) as a performance indicator are: 1. It has an excessive short-term focus. 2. Investment planning uses discounted cash flow (DCF) analysis (Chapter 12),while managers are evaluated on ROI. 3. It contains a disincentive for new investment by the most profitable units. 4. It fails to capture all value-creating activities, such as management of intangible assets.

What are the measurement issues to consider when using return in investment (ROI)?

The primary measurement issues for ROI are:1. The effect of accounting policies, which affect the determination of "income." 2. Other measurement issues for income, which include the handling of nonrecurring items in the income statement, differences in the effect of incometaxes across units, differential effect of foreign currency exchange, and theeffect of cost allocation when two or more units share a facility or cost. 3. Measuring investment: which assets to include. 4. Measuring investment: whether and how to allocate the cost of shared assets.

What are the components of return on investment (ROI), and how is each component interpreted and used ?

We can enhance the ROI measure's usefulness by making it the product of two ratios: ROI = (Profit ÷ Sales) × (Sales ÷ Assets) ROI = Return on Sales × Asset Turnover ROI = ROS × AT Return on sales (ROS) is the firm's profit per sales dollar and it measures the unit manager's ability to control expenses and increase revenues to improve profitability. For divisions (investment centers), "profit" is usually interpreted as"operating profit." For the company as a whole, "profit" can be defined as "netincome." Asset turnover, the amount of sales achieved per dollar of investment, measures the manager's ability to manage both sales and assets, that is, to produce increased sales from a given level of investment in assets. Together, the two components of ROI tell a more complete story of the manager's performance and enhance top management's ability to evaluate and compare the different units.