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.

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 it Investment 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 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. 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.

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