Profit / Investment Centres
Overview
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Profit/Investment Centre
Financial Measures
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Return on investment
Residual income
Economic value added
Return on Investment (ROI)
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Most popular approach for two reasons:
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Blends all major ingredients of profitability
(revenues, costs, and investment) into a single
number
Compared to other ROIs both inside and
outside the firm
Return on Investment (ROI)
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ROI is an accounting measure of income
divided by an accounting measure of
investment
ROI = Return / Investment
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ROI may be broken into its two components
as follows:
Income
Investment
=
Income
Revenues
X
Revenues
Investment
ROI = Return on Sales X Investment Turnover
Horngren Motel Example
ROI Comparison
How can Saskatoon get to 30% ROI?
Residual Income (RI)
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Residual income (RI) is an accounting measures of
income minus a dollar amount for required return
an accounting measure of investment.
RI = Income – (Required rate of return × Investment)
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Required rate of return times the investment is the
imputed cost of the investment.
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Imputed costs are cost recognized in some situations, but
not in the financial accounting records.
Residual Income Calculations
ROR x Investment = “Capital Charge”
Saskatoon Expansion ROI vs. RI:
ROR=12%; NI $160K; Assets $800K
Economic Value Added (EVA®)
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EVA is a specific type of residual income calculation
that has recently gained popularity
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Does not use a reported GAAP accrual in the numerator
EVA
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=
After-tax
Operating Income
{
Weighted-Average
Cost of Capital
X(
Total
Assets
Current
Liabilities
) }
Key calculation is the Weighted Average Cost of Capital
(WACC)
Horngren Motel Example:
EVA©
Return on Sales (ROS)
Summary
What conclusions do you draw?
Which method is better?
ROI vs. EVA Example
LARGE Company is a multinational
conglomerate involved in a variety of
businesses. Selected operating data for its
foreign operations in Singapore are as
follows:
Industry
Years of
operation
Sales
Ave. op.
assets
Net op.
income
Division A
Division B
Textile
Industrial
Software
Machineries Development
20
2
10
Division C
$8,000,000 $20,000,000
$3,000,000
$4,000,000 $10,000,000
$2,000,000
$520,000
$2,000,000
$200,000
ROI vs. EVA Example
ROI vs. EVA Example
HANDOUT:
LARGE Company
Work on this on your own or with a
fellow student (~10 minutes)
Slide 13
ROI vs. EVA Example
ROI
EVA
Division A
13%
$120,000
Division B
20%
$1,000,000
Division C
10%
$0
Slide 13; ROI vs. EVA Example
ROI vs. EVA Example
Assume that each division is presented with an
investment opportunity that will cost
$200,000 with a return of $30,000.
If performance is being measured by (i) ROI
and (ii) EVA, which division will probably
accept the opportunity? Reject? Why?
ROI vs. EVA Example
ROI vs. EVA Example
For investment project,
ROI =15%
EVA =$10,000
RI & Economic Value Added, EVA©
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Pros:
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Proper incentive for investment decisions
Different cost of capital for different assets
Useful in comparing business units of similar size
and nature
▪ Cons:
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Difficult in comparing business units of different
size
Subjective choice on cost of capital
Return on Investment (ROI)
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Pros:
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Comprehensive measure
Simple and easy to understand
Easy to use for comparison
Accounted for size effect
Cons:
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Disinvesting profitable investments
Foregoing profitable investments