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What is a responsibility center?

A subunit in an organization whose manager is held accountable for specified financial results.

What kind of responsibility centers?

- Cost Center/ Revenue Center
- Profit center
- Investment center

Accountability

Authority

Segment

is responsible

for the revenue of a unit.

The Reservations

Department of an airline

Responsibility CentersCost Center

Segment has control over the incurrence of costs.

The Paint Department

in an automobile plant.

Responsibility Centers

Profit Center

Segment has control over both costs and revenues.

Investment Center

Segment has control over profits and invested capital.

Adivision of a

large corporation.

Company-owned restaurant in a fast-food chain.

Center

Profit

Center

Investment

Center

Measuring Management PerformanceEvaluation Tool

Cost

standards

Contribution

income

statement

Rate of return

on invested

funds or

residual income

Investment Center

- Decision rights:
- input mix, product mix, selling prices and invested capital
- Assumes manager has specialized knowledge of investment opportunities
- Performance measure:
- ROI, Residual Income/EVA

Why Relate Profits to Assets Employed?

- To assess if assets are being effectively and efficiently used.
- Shareholders can compare to alternatives.
- Firms can identify and reduce/eliminate (relatively) non-productive use of assets
- To promote discipline in the capital budgeting process.
- Is management accurately estimating future cash flows?
- Are capital budgeting criteria appropriate?

The Big Debate: ROI vs. RI

ISSUE:

What is the best way to evaluate performance of investment centers?

Residual income concepts?

Return on Investment (ROI)

- ROI is an accounting measure of income divided by an accounting measure of investment
- Is a percentage measure
- Puts net income in relation to assets

Average operating assets

ROI =

Return on Investment (ROI)Income before interest

and taxes (EBIT)

Cash, accounts receivable, inventory,

plant and equipment, and other

productive assets.

Return on Investment (ROI)

- Most popular metric for two reasons:
- Blends all the ingredients of profitability (revenues, costs, and investment) into a single percentage
- May be compared to other ROI’s both inside and outside the firm

(ROI intuitive compared to other measures)

- Managers seem to have an affinity for %

Return on Investment (ROI)

Holly Flower Company reports :

Income $ 30,000

Invested Capital $ 200,000

What is the ROI?

Improving ROI

Three ways to improve ROI

2. Decrease

Expenses

1. Increase

Revenues

3. Lower

Invested Capital

Problem:

- Think about the following:
- A department has an IRR of 20%
- The company can borrow money at 10%
- A manager has an opportunity to implement a project that would yield an IRR of 15%
- Would the manager implement the project?
- Should the manager implement the project?

Underinvestment Problem

ROI can be a disincentive to taking on lucrative projects!!!

ROI Advantages/Disadvantages

- Advantage:
- simple
- comparable across business units (because it’s a %)
- Disadvantages:
- Manipulation potential
- of Net Income Calculation
- e.g., Defer R&D expenditures
- of Investment Base Calculation
- e.g., Dispose of assets
- Underinvestment problem

Invested Capital

ROI =

Income

Sales Revenue

Sales Revenue

Invested Capital

ROI =

×

Sales

Margin

CapitalTurnover

Other form of ROIROI Measurement Issues

- Choice of net income:
- Before tax
- After tax
- Choice of investment base:
- Total Assets
- Total Productive Assets
- Net Assets (A-L)
- Controllable Assets
- Gross or net book value

Charge for capital employed

Money costs money!

Residual Income

- Residual Income (RI) is an accounting measure of income minus a dollar amount for required return on an accounting measure of investment
- RI = Income – (RRR X Investment)
- RRR = Required Rate of Return
- Required Rate of Return times the Investment is the imputed cost of the investment
- Imputed costs are cost recognized in some situations, but not in the financial accounting records

Residual Income

(

)

Residual income measures net operating income earned less the minimum required return on average operating assets.

(ROI measures net operating income earned relative to the investment in average operating assets.)

Residual Income

Investment center profit

– Investment charge

= Residual income

Investment capital

×Imputed interest rate

= Investment charge

Investment center’sminimum requiredrate of return

Residual Income

- Flower Co. has an opportunity to invest $100,000 in a project that will return $25,000.
- Flower Co. has a 20 percent required rate of return and a 30 percent ROI on existing business.

What is the residual income?

Investment center profit = $25,000

– Investment charge = 20,000

= Residual income = $ 5,000

Residual IncomeInvestment capital = $100,000

× Imputed interest rate = 20%

= Investment charge = $ 20,000

Investment center’sminimum requiredrate of return

Residual Income

- Disadvantages:
- More complicated(calculating cost of capital)
- Harder to compare (because not a %)
- Arguably, the manipulation potential is the same
- of Net Income Calculation
- of Investment Base Calculation
- Advantage:
- Mitigates the underinvestment problem

ROI Background

- Background:
- CAPM
- Capital asset pricing model
- Computers

What is interest for?

- What would you base interest demands on?
- What would you rather have - $1,000 today or $1,000 in 10 years?
- Would you charge Mr Goodman with a credit score of 740 and MrNogoodman with a credit score 0f 450 the same interest rate?

CAPM

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Also referred to as “beta” – beta is an indicator of how much a stock changes in relative to changes in the overall market

Beta is calculated on historical data

For example: a stock has a beta of 0.5 – this means the stock is less risky than the market; when the market decreases by 10% the stock decreases by 5% - on the same token, when the market increases by 10% the stock increases by 5%

CAPM- Interest rate for equity in RI and EVA is based on the capital asset pricing model (CAPM)
- Interest equity = risk free interest rate + risk return

EVA

- EVA “improvements” marketed by Stern Stewart
- Firm-specific market-based risk assessment based on CAPM (to compute WACC)
- weighted average cost of capital (debt and equity)
- After-tax net income
- Adjusts for distortions introduced by GAAP…

Economic Value Added (EVA)

- EVA is a specific type of residual income calculation that has recently gained popularity
- Weighted average cost of capital equals the after-tax average cost of all long-term funds in use

EVA Net Income “Adjustments”

- Industry specific
- Hundreds are theoretically possible; 10-15 common
- Common adjustments to GAAP income:
- Capitalize and amortize R&D
- Capitalize and amortize marketing costs
- Include leased assets in the investment base
- FIFO inventory accounting
- Substitute economic depreciation for straight line methods
- Adjust for inflation

Weightedaveragecost of capital

(

)

Investmentcenter’s

total assets

Investmentcenter’scurrent liabilities

–

Economic Value AddedInvestment center’s after-tax operating income

– Investment charge

= Economic Value Added

So how to calculate cost of capital?

When both equity and debt are used (which is usually the case) then calculate a weighted cost of capital:

% of debt of total capital

Debt interest rate

Equity interest rate

% of equity of total capital

WACC =

+

x

x

Economic Value Added

The Atlantic Division of Suncoast Food Centers reportedthe following results for the most recent period:

Compute Atlantic Division’s economic value added.

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

= 0.0972

$40,000,000 + $60,000,000

Economic Value AddedFirst, let’s compute theweighted-average cost of capital

Economic Value Added

$6,750,000 × (1 – 30%)

$4,725,000 After-tax operating income

– 4,315,680

= $ 409,320 Economic value added

($45,000,000 – $600,000) × 0.0972 = $4,315,680

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

= 0.0972

$40,000,000 + $60,000,000

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