When companies decentralize decision making, they maintain control by organizing responsibility centers, developing performance measures for each, and basing rewards on an individual’s performance at controlling the responsibility center. Performance measures are developed to provide some direction for managers of decentralizedunits and to evaluate their performance. The development of performance measures and the specification of a reward structure are major issues for a decentralized organization. Because performance measures can affect the behavior of managers, the measures chosen should encourage a high degree of goal congruence. In other words, they should influence managers to pursue the company’s objectives. Three performance evaluation measures for investment centers are return on investment, residual income, and economic value added.
Return on Investment
Because each division of a company has an income statement, couldn’t we simply rank the divisions on the basis of net income? Unfortunately, the use of income statements may provide misleading information regarding segment performance. For example, suppose that two divisions report profits of $100,000 and $200,000, respectively. Can we say that the second division is performing better than the first? What if the first division used an investment of $500,000 to produce the contribution of $100,000, whilethe second used an investment of $2 million to produce the $200,000 contribution? Does your response change? Clearly, relating the reported operating profits to the assetsused to produce them is a more meaningful measure of performance.
One way to relate operating profits to assets employed is to compute the profit earned per dollar of investment. For example, the first division earned $0.20 per dollar invested ($100,000/$500,000); the second division earned only $0.10 per dollar invested ($200,000/$2,000,000). In percentage terms, the first division is providing a 20 percent rate of return and the second division, 10 percent. This method of computing the relative profitability of investments is known as the return on investment.
Return on investment (ROI) is the most common measure of performance for an investment center. It is of value both externally and internally. Externally, ROI is used by stockholders as an indicator of the health of a company. Internally, ROI is usedto measure the relative performance of divisions.ROI can be defined in the following three ways:
Return on Investment
Because each division of a company has an income statement, couldn’t we simply rank the divisions on the basis of net income? Unfortunately, the use of income statements may provide misleading information regarding segment performance. For example, suppose that two divisions report profits of $100,000 and $200,000, respectively. Can we say that the second division is performing better than the first? What if the first division used an investment of $500,000 to produce the contribution of $100,000, whilethe second used an investment of $2 million to produce the $200,000 contribution? Does your response change? Clearly, relating the reported operating profits to the assetsused to produce them is a more meaningful measure of performance.
One way to relate operating profits to assets employed is to compute the profit earned per dollar of investment. For example, the first division earned $0.20 per dollar invested ($100,000/$500,000); the second division earned only $0.10 per dollar invested ($200,000/$2,000,000). In percentage terms, the first division is providing a 20 percent rate of return and the second division, 10 percent. This method of computing the relative profitability of investments is known as the return on investment.
Return on investment (ROI) is the most common measure of performance for an investment center. It is of value both externally and internally. Externally, ROI is used by stockholders as an indicator of the health of a company. Internally, ROI is usedto measure the relative performance of divisions.ROI can be defined in the following three ways:
Of course, operating income refers to earnings before interest and income taxes. Operating income is typically used for divisions, and net income is used in the calculation of ROI for the company as a whole. Operating assets are all assets acquired to generate operating income. They usually include cash, receivables, inventories, land, buildings, and equipment. The figure for average operating assets is computed as follows:
Average operating assets = (Beginning net book value + Ending net book value)/2
Opinions vary regarding how long-term assets (plant and equipment) should be valued (e.g., gross book value versus net book value or historical cost versus current cost). Most firms use historical cost net book value.
Average operating assets = (Beginning net book value + Ending net book value)/2
Opinions vary regarding how long-term assets (plant and equipment) should be valued (e.g., gross book value versus net book value or historical cost versus current cost). Most firms use historical cost net book value.
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