a manager of an investment center can improve roi by
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A manager of an investment center can improve roi by

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Quiz : Investments, Accounting. Quiz : Financial Statements, Accounting. Quiz : Managerial Accounting, Accounting. Quiz : Cost Accounting, Accounting. Quiz : Budgetary Planning, Accounting. Quiz : Budgetary Control and Responsibility,. Quiz : Standard Costs and Evaluation, Account. Quiz : Budgeting and Analysis, Accounting.

Question: A manager of an investment center can improve ROI by:. A reducing sales. B increasing variable costs. D increasing average operating assets. Saydul Alam Editor, VCampus. Your Name. Many top executives thus want their division managers to focus on ROI performance, since outsiders especially potential investors and their advisers are focusing on it.

Two of these are:. The use of residual income as a measure deals with these drawbacks, both of which pertain to investments—actual or prospective—whose return falls between the cost of invested capital and the centers average ROI. In the first case, then, the manager will probably not be motivated to disinvest; in the second, he will probably want to make the investment. For these reasons, many authorities agree that RI is superior to ROI as a measure of investment center financial performance.

Why, then, the great preference of companies for ROI? Put another way, although their companies may formally use ROI instead of RI to measure division performance, managers realize that assets generating a positive RI should not be scrapped just because ROI measurement has conceptual flaws. Since nondiscretionary projects require capital but do not recover capital costs, they represent a capital cost burden to be earned by those projects that are evaluated on economic grounds.

For the corporation to recover all of its capital costs, then, the discretionary projects must recover their own cost of capital and the capital costs of nondiscretionary projects. Viewed in this light, investments whose return is only between the cost of capital and the current average ROI are probably not desirable after all. This argument, in turn, is based on how investment center ROI targets are apparently set.

Our opinion is that, at least in many companies, the sequence is: 1 budget sales, 2 budget profit, 3 budget assets, and 4 on approval of steps 1 through 3, divide budgeted profit by budgeted assets to arrive at budgeted ROI. The key approvals are in steps 2 and 3, not in step 4. At this point, we want to emphasize that we are not saying that the conceptual weaknesses of ROI that have been so articulately and persuasively pointed out by other authors do not exist.

Both profit center and investment center measurements require specific definitions of what constitutes profit and what constitutes investment. But this, while an obvious alternative, is indeed only one option. The upper portion of this exhibit shows that two out of five companies do define profit to be the same as reported net income.

Exhibit VI reflects the fact that, in the companies which do define profit differently from net income, the variations fall almost entirely in the category of eliminating expenses over which a division manager has no direct control—taxes, interest on corporate debt, and allocated headquarters expenses. A significant finding in Exhibit VI is that most companies attribute interest expense to individual investment centers. Charging interest expense to investment centers serves to remind managers that invested funds are not a free resource.

Conceptually, an investment center should also be charged for equity capital. In the companies not charging divisions with interest expense, the overstatement of profit is, of course, greater. Return on invested capital is of more concern to people in top management—especially the chief financial officer—who are monitoring the return earned on all funds committed long-term to the corporation, whether by creditors including bondholders or shareholders.

For example, the division may have the authority to decide when individual accounts payable shall be paid or may have its own line of short-term credit, especially if it is a wholly owned but legally separate corporation. Of course, such a subtraction alters the investment definition from that of total assets to one more akin to invested capital. There are also investment-base definitional questions on the asset side.

Nearly all companies included receivables, inventories, and fixed assets used solely by the investment center in calculating the centers investment base. Fewer than half felt it useful to include allocations of shared facilities in their calculations, and about half deducted external payables and other current liabilities.

The findings in Exhibits VII and VIII are quite similar to those of Mauriel and Anthony, except ours show significantly fewer companies allocating headquarters assets and more deducting external payables. Asset valuation: What asset categories to include and what liabilities to deduct when one is defining investment is a question quite apart from how to value the assets that are already included.

Asset valuation is an issue especially with respect to plant and equipment, where the obvious valuation alternatives are gross book value undepreciated historical costs , net book value, and replacement costs. However, the use of net book value does have conceptual flaws. The most prominent of the flaws is that, other things being equal, ROI or RI will increase solely with the passage of time as depreciation reduces the investment base.

The concern about this phenomenon is that it may discourage economically sound divisional investments in new fixed assets. Replacement cost valuation and the annuity method of depreciation may be used jointly to overcome this net book value flaw, but companies probably view this combination approach as too complicated to be practical.

Most of the managers we have spoken with do not know what annuity depreciation is. Despite its flaws, net book value is superior to gross book value. The latter creates too great a motivation to scrap older assets that, while still productive, are often idle because of the presence of newer, more efficient assets. Thus, of the currently practicable fixed asset valuation alternatives, most companies are using the best one. Lease valuation: One final investment-base definition issue we researched was the treatment of leased equipment or facilities.

Apparently, then, most companies are not concerned about investment center managers trying to boost ROI by leasing assets that, seen from a purely economic standpoint, should be purchased. Companies may not worry about this because they know that thorough justification procedures and analyses are required before assets can be leased or because they have an overall policy of preparing investment center financial statements in accord with the procedures used for the published corporate statements.

Almost two-thirds set these targets by analyzing the profit potential of the division. This procedure is appropriate since, although the company as a whole has a single profit potential-risk profile, each division considered as a separate entity has its own profile, related to its line of business, the condition of its fixed assets, and so on. Giving every investment center the same ROI target is an unsound procedure, unless the company is in a single line of business and its investment centers are geographical divisions having similarly aged assets.

We were surprised to find that almost one-fourth of the respondents using ROI do not set ROI targets for their investment centers. There are two possible reasons for this. First, not setting a target may be a technique to avoid overemphasizing the ROI percentage at the expense of economic profit.

RI capital charges: One of the advantages of using residual income is that the format of the calculation enables a company to apply a different capital charge rate to each asset category. These differing rates can reflect the fact that some categories of assets are riskier than others e. Of these 26, the majority were using the same capital charge for a given asset type in all investment centers.

In our opinion, the most equitable way to determine such rankings is to compare actual with budgeted performance. Such a budgeted-versus-actual comparison tends to reflect the differing profitability potentials of divisions and does not unduly penalize a manager whose division is in an industry with low profitability.

Note that this actual-versus-budget approach was not the most-used method for financial performance comparisons in either ROI or residual income companies. Each of these has potential weaknesses. Calculating RI as a percentage of investment reflects an apparent desire not only to gain the benefits of RI but also to have the interdivisional comparison property of a percentage which normalizes for size differences.

The use of RI as a percentage of sales for interdivisional comparisons has no conceptual basis unless the divisions have equal investment turnover ratios.

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A manager of an investment center can improve roi by Quiz-2 : Recording Process, Accounting. The potential does exist for ROI as commonly implemented to motivate some investment center managerial decisions which improve the measured divisional ROI yet which are not in the best interests of the company as a whole. Of these 26, the bokf financial were using the same capital charge for a given asset type in all investment centers. Since nondiscretionary projects require capital but do not recover capital costs, they represent a capital cost burden to be earned by those projects that are evaluated on economic grounds. Note that this actual-versus-budget approach was not the most-used method for financial performance comparisons in either ROI or residual income companies. Quiz : Long-term A manager of an investment center can improve roi by, Accounting.
A manager of an investment center can improve roi by Forex content
Forex trading system 96% winning trades The key approvals are in steps 2 and 3, not in step 4. Replacement cost valuation binary option recommendations the annuity method of depreciation may be used jointly to overcome this net a manager of an investment center can improve roi by value flaw, but companies probably view this combination approach as too complicated to be practical. But this, while an obvious alternative, is indeed only one option. It is our premise that most designers of financial control systems are aware of the conceptual flaws in the GAAP-ROI approach, and that these financial managers do not believe that these flaws are more than hypothetical. Revenues and expenses are measured as in profit continue reading, but the assets employed are also measured. Calculating RI as a percentage of investment reflects an apparent desire not only to gain the benefits of RI but also to have the interdivisional comparison property of a percentage which normalizes for size differences.
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A manager of an investment center can improve roi by Exhibit III Extent of use of profit and investment centers by industry. Quiz : Managerial Accounting, Accounting. Quiz : Financial Statements, Accounting. Our opinion is that, at least in many companies, the sequence is: 1 budget sales, 2 budget profit, 3 budget assets, and 4 on approval of steps 1 through 3, divide budgeted profit by budgeted assets to arrive at budgeted ROI. They found that investment centers are in wide use and that ROI is the usual measure of their performance.
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These two equations are equivalent because the sales terms cancel out in the second equation. The first term on the right hand side of the equation is margin, which is defined as follows:. The lower the operating expenses per dollar of sales, the higher the margin earned.

The second term on the right hand side of the equation is turnover, which is defined as follows:. Turnover is a measure of the sales that are generated for each dollar invested in operating assets. The following alternative form of the ROI formula, which we will use here, combines margin and turnover. Both the formulas give same answer.

However margin and turnover formulation provides some additional insights. Some managers tend to focus too much on margin and ignore turnover. Excessive funds tied up in operating assets, which depresses turnover, can be just as much of a drag on profitability as excessive operating expenses, which depresses margin. One of the advantages of return on investment ROI as a performance measure is that it forces the manager to control the investment in operating assets as well as to control expenses and the margin.

When return on investment ROI becomes a very crucial to judge the performance of investment centers managers, managers need to improve ROI of their centers. An investment center manager can improve ROI in basically three ways. To illustrate how an investment center manager can improve ROI by making the use of three methods mentioned above consider the following example:.

The following data represents the results of an investment center of the operations of a company for the most recent month. The rate of return generated by the company for this investment center is as follows:. A profit center is an organizational unit that is responsible to top management for some measure of its own profitability—a measure like net income, pretax income, or net contribution. Revenues and expenses are measured as in profit centers, but the assets employed are also measured.

Thus an investment center is an extension of the profit center idea: profit is measured for both, but only in an investment center is this profit related to the size of the investment base. Designating a division as one of these types of centers, then, is actually deciding between two ways of measuring what the division is contributing to the company. It is the measure of profit in comparison with the amount of capital invested in a division that makes us especially interested in the investment center as an approach to increasing company returns.

In the companies using investment centers, which formula to relate profits to investment does management use—return on investment ROI , which is profit divided by investment, or residual income RI , which is profit before interest expense minus a capital charge levied on investment? How do such companies define profit and investment for measuring investment center performance? In many respects, this study was similar to one conducted in by John J. Mauriel and Robert N.

Nearly three-fourths of the respondents had two or more investment centers. Exhibit II Use of profit and investment centers by sales volume. Exhibit III Extent of use of profit and investment centers by industry. Employing the control-structure device of either profit centers or investment centers was not a new practice for most of our respondents see Exhibit IV. Only 34 companies 5. When compared with what Mauriel and Anthony found, our results indicate that the profit center—investment center concept has gained maturity: they found that over one-third of their respondents using investment centers had begun doing so in the 5 years preceding their study and that over one-half had begun in the previous 10 years.

Although many managers seem to think of using an investment center approach as being synonymous with measuring return on investment, some companies relate profits and the investment base by using the residual income measure. Because each measurement has strengths and weaknesses, many companies make both calculations for their investment centers. ROI makes unlikes comparable. ROI, being a percentage-return measurement, is consistent with how companies measure the cost of capital.

ROI is useful for people outside the company. The ROI measure, unlike residual income, can be calculated by outside financial analysts for purposes of evaluating the economic performance of a company and for making intercompany performance comparisons. Many top executives thus want their division managers to focus on ROI performance, since outsiders especially potential investors and their advisers are focusing on it.

Two of these are:. The use of residual income as a measure deals with these drawbacks, both of which pertain to investments—actual or prospective—whose return falls between the cost of invested capital and the centers average ROI. In the first case, then, the manager will probably not be motivated to disinvest; in the second, he will probably want to make the investment. For these reasons, many authorities agree that RI is superior to ROI as a measure of investment center financial performance.

Why, then, the great preference of companies for ROI? Put another way, although their companies may formally use ROI instead of RI to measure division performance, managers realize that assets generating a positive RI should not be scrapped just because ROI measurement has conceptual flaws. Since nondiscretionary projects require capital but do not recover capital costs, they represent a capital cost burden to be earned by those projects that are evaluated on economic grounds.

For the corporation to recover all of its capital costs, then, the discretionary projects must recover their own cost of capital and the capital costs of nondiscretionary projects. Viewed in this light, investments whose return is only between the cost of capital and the current average ROI are probably not desirable after all. This argument, in turn, is based on how investment center ROI targets are apparently set. Our opinion is that, at least in many companies, the sequence is: 1 budget sales, 2 budget profit, 3 budget assets, and 4 on approval of steps 1 through 3, divide budgeted profit by budgeted assets to arrive at budgeted ROI.

The key approvals are in steps 2 and 3, not in step 4. At this point, we want to emphasize that we are not saying that the conceptual weaknesses of ROI that have been so articulately and persuasively pointed out by other authors do not exist. Both profit center and investment center measurements require specific definitions of what constitutes profit and what constitutes investment. But this, while an obvious alternative, is indeed only one option.

The upper portion of this exhibit shows that two out of five companies do define profit to be the same as reported net income. Exhibit VI reflects the fact that, in the companies which do define profit differently from net income, the variations fall almost entirely in the category of eliminating expenses over which a division manager has no direct control—taxes, interest on corporate debt, and allocated headquarters expenses. A significant finding in Exhibit VI is that most companies attribute interest expense to individual investment centers.

Charging interest expense to investment centers serves to remind managers that invested funds are not a free resource. Conceptually, an investment center should also be charged for equity capital. In the companies not charging divisions with interest expense, the overstatement of profit is, of course, greater.

Return on invested capital is of more concern to people in top management—especially the chief financial officer—who are monitoring the return earned on all funds committed long-term to the corporation, whether by creditors including bondholders or shareholders.

For example, the division may have the authority to decide when individual accounts payable shall be paid or may have its own line of short-term credit, especially if it is a wholly owned but legally separate corporation. Of course, such a subtraction alters the investment definition from that of total assets to one more akin to invested capital. There are also investment-base definitional questions on the asset side.

Nearly all companies included receivables, inventories, and fixed assets used solely by the investment center in calculating the centers investment base. Fewer than half felt it useful to include allocations of shared facilities in their calculations, and about half deducted external payables and other current liabilities.

The findings in Exhibits VII and VIII are quite similar to those of Mauriel and Anthony, except ours show significantly fewer companies allocating headquarters assets and more deducting external payables. Asset valuation: What asset categories to include and what liabilities to deduct when one is defining investment is a question quite apart from how to value the assets that are already included. Asset valuation is an issue especially with respect to plant and equipment, where the obvious valuation alternatives are gross book value undepreciated historical costs , net book value, and replacement costs.

However, the use of net book value does have conceptual flaws. The most prominent of the flaws is that, other things being equal, ROI or RI will increase solely with the passage of time as depreciation reduces the investment base. The concern about this phenomenon is that it may discourage economically sound divisional investments in new fixed assets.

Replacement cost valuation and the annuity method of depreciation may be used jointly to overcome this net book value flaw, but companies probably view this combination approach as too complicated to be practical. Most of the managers we have spoken with do not know what annuity depreciation is.