Cost Analysis, Profit Planning, and Control

1. Cost Analysis, Profit Planning, and Control MBA 603 Chapter 7 - Measuring and Controlling Assets Employed

2. 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.

3. 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

4. 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.

5. 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).

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.