Responsibility Centers

4. Investment Centers –
Output
Inputs
(Money/net profit
(Money spent for RC’s
Earned on account
Starting & running TASK of investment)
the business)

• Objective – Make sound investment decision

• It compares Business units profits with assets
employed to earn that profit i.e. efficiency of assets
employed.
• Performance measure used to evaluate the IC are
Return on Investment ROI and Economic Value Added EVA
• It satisfies both the goals of business organizations
i.e. to earn the profit and
to achieve optimal relationship in profits earned
and assets employed
10/17/08 hmahesh45@yahoo.com; VIM Pune 1
 Investment Center
Decision Rights –
Input Mix – Labor, Material, Supplies
Product Mix
Selling Price
Capital Investment
Performance Measures –
Actual ROI
Actual Residual Income i.e. EVA
Actual ROI & RI in comparison with budgeted ROI & RI
Typically used when –
RC manager has knowledge about correct price/quantity
RC manager has knowledge to select optimal product mix
RC manager has knowledge about investment opportunities
10/17/08 hmahesh45@yahoo.com; VIM Pune 2
 Return on Investment –
Return on Investment-
 Relating the profits of a firm with the
investment made.
 ROI can be computed in many different ways
depending upon the need and relevance.

1. Return on Assets - ROA

2. Return on Capital Employed - ROCE

3. Return on Shareholder’s Equity - ROE

10/17/08 hmahesh45@yahoo.com; VIM Pune 3

 Return on Investment – Return on Assets
Net Profit
1) Return on Assets = --------------- * 100
Assets
ROI terminology would change depending on
what Assets base one takes for computation;
it can be -
 Total Assets,
 Fixed Assets,
 Gross Assets,
 Net Assets,
 Tangible Assets or
 Employed Assets
10/17/08 hmahesh45@yahoo.com; VIM Pune 4
 Return on Investment – Return on Capital Employed

Net Profit
2) Return on Capital Employed = ------------------------- *
100
Capital Employed
 Capital implies the long term
funds
supplied by creditors &
 Alternatively it can be
owners
Net Working Capital + Fixed
Assets

10/17/08 hmahesh45@yahoo.com; VIM Pune 5

 Return on Investment – Return on Shareholders’ Equity

Net Profit
3) Return on Shareholders’ Equity = ---------------- * 100
Equity Capital

Equity includes the preferential capital, however the

ordinary shareholder bears the entire risk.
Net Worth represents the equity capital plus the reserves
and surpluses the portion solely represented by equity
holders’.
Net Profit- Pref. Divi.
Return on Shareholders’ Equity = ------------------- * 100
Net Worth
10/17/08 hmahesh45@yahoo.com; VIM Pune 6
 Responsibility Centers
4. Investment Centers –

Economic Value Added - EVA® (Stern & Stewart)

As lender require certain interest on their money,
owners too expect certain rate of return on their
funds. (taken together both termed as cost of
capital).

Hence no "real" money is made or value is created

until the operating profits exceed the rupee return
required by the owner and the lenders.

 Increase in EVA,  Increase in Market Value of

the firm
10/17/08 hmahesh45@yahoo.com; VIM Pune 7
 Economic Value Added – EVA® (Stern &
Stewart)

• EVA is another of the way to relate profits to assets

employed.
• Economic Value Added = Net Profit – Capital Charge
Capital Charge = Capital Employed * Cost of Capital

• EVA=Net profit – (Cost of Capital * Capital Employed)

• This is nothing but Residual Income which adds to

the value of the firm

10/17/08 hmahesh45@yahoo.com; VIM Pune 8

 Return on Investment V/s
Economic Value Added

1. ROI is a ratio. 1. EVA is Profitability

Simple & easy to measure in money
understand, term. Can not be
Meaningful in used for comparison
absolute sense. with other Business
Being a common Unit or Industries.
denominator of
industries it can used
for comparison.

10/17/08 hmahesh45@yahoo.com; VIM Pune 9

 Return on Investment V/s
Economic Value Added
2. Different ROI % 2. EVA provides an
provides different effective measure
incentives across than ROI. EVA
BUs’ Stresses upon
(e.g. BU having current recovery of cost of
ROI of 30 will be capital. And
discouraged to go for welcomes every
additional investment rupee earned over
giving 25% ROI, even
and above COC.
though the ROI is greater
than Cost of Capital OR
BU mgr can improve its
ROI by just disposing the
assets which give lesser
ROI than current one)
10/17/08 hmahesh45@yahoo.com; VIM Pune 10
 Return on Investment V/s
Economic Value Added

3. ROI does not allow 3. EVA enables to use

different treatment
for different kind of
assets i.e. it treats all
assets/investments
at par.
different rates of
interest for different
types of assets
involving different
risks. e.g. low rate for
inventory investment
whereas higher rate
for fixed investment.

10/17/08 hmahesh45@yahoo.com; VIM Pune 11

 Return on Investment V/s
Economic Value Added

4. It is difficult to EVA has got strong &

define an explicit positive correlation
relationship between with market value of
ROI and Market value the firm.
of the firm. (ROI not
necessarily indicate
the market value of
the firm.)

(shareholders worth maximization may not be suitable measure for RC’s performance evaluation
Because it is consolidated effect of entire company)

10/17/08 hmahesh45@yahoo.com; VIM Pune 12

 Thanks……

10/17/08 hmahesh45@yahoo.com; VIM Pune 13