Chapter 19 – Strategic Performance Measurement—Investment Centers
CHAPTER 19: STRATEGIC PERFORMANCE MEASUREMENT—
INVESTMENT CENTERS
QUESTIONS
19-1 Investment centers are commonly used when there are a number of business
units to be compared, and/or when top management intends to evaluate the
economic performance of the business unit relative to alternative investments. By
definition, managers of these business units exercise control over revenues,
amount of profit divided by the amount invested in the business unit.
19-2 Return on investment (ROI) is the ratio of some measure of “profit” to some
19-3 The primary measurement issues for ROI are:
1. The effect of accounting policies, which affect the determination of “income.”
2. Other measurement issues for income, which include the handling of non-
19-4 The primary advantages of using return on investment (ROI) as a performance
indicator are:
The primary limitations of return on investment (ROI) as a performance indicator
are:
1. It has an excessive short-term focus.
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Chapter 19 – Strategic Performance Measurement—Investment Centers
19-5 We can enhance the ROI measure’s usefulness by making it the product of two
ratios:
ROI = (Profit ÷ Sales) × (Sales ÷ Assets)
“operating profit.” For the company as a whole, “profit” can be defined as “net
income.”
Asset turnover, the amount of sales achieved per dollar of investment, measures
the manager’s ability to manage both sales and assets, that is, to produce
increased sales from a given level of investment in assets. Together, the two
components of ROI tell a more complete story of the manager’s performance and
enhance top management’s ability to evaluate and compare the different units.
19-6 The key advantage of residual income (RI) is that it deals effectively with the
limitation of ROI: ROI has a disincentive for the managers of the most profitable
units to make new investments. With residual income, no matter how profitable
the unit, there is still an incentive for new profitable investment. In contrast, a key
19-7 Economic value added (EVA®) is a profitability measure that approximates the
“economic earnings” of an investment center. Operationally, we define EVA® as
business unit’s income after-tax cash earnings and after deducting an imputed
Thus, RI and EVA® are similar in form but are strikingly different in terms of
measurement. Thus, the overall objective of EVA® is to provide an estimate of
the value added to (or destroyed by) each strategic investment unit during a
19-2
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Chapter 19 – Strategic Performance Measurement—Investment Centers
given period. As such, EVA® is one approach to what we call “Value-Based
Management.”
19-8 The three most widely accepted methods are: (1) the comparable uncontrolled
price method, (2) the resale price method, and (3) the cost-plus method. The
profit percentage determined from comparison of sales of the seller to unrelated
parties, or sales of unrelated parties to other unrelated parties.
19-9 The “arm’s-length” standard says that transfer prices should be set so they reflect
the price that would have been set by unrelated parties acting independently. It is
19-10 Expropriation happens when a foreign government takes ownership and control
of assets the domestic investor has invested in that country. When there is a
significant risk of expropriation, the domestic firm can take appropriate actions
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Chapter 19 – Strategic Performance Measurement—Investment Centers
BRIEF EXERCISES
19-11 ROI = Return on Sales × Asset Turnover
19-12 ROI = (Profit ÷ Sales) × (Sales ÷ Assets)
19-13
Return on Sales (ROS) = Profit ÷ Sales
Asset Turnover (AT) = Sales ÷ Assets
Return on Investment (ROI) = Profit ÷ Assets
19-14
NBV ROI = Profit ÷ NBV of Assets
= 5%
19-15 ROI = Return on sales (ROS) × Asset Turnover (AT)
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Chapter 19 – Strategic Performance Measurement—Investment Centers
19-16 Mattress Sets:
ROI = (Operating Profit ÷ Sales) × (Sales ÷ Assets)
Bed Frames:
ROI = (Operating Profit ÷ Sales) × (Sales ÷ Assets)
19-17 Return on Sales (ROS) = Operating Profit ÷ Sales
19-18 Residual Income (RI) = Income − (Required Rate of Return × NBV of average
assets)
19-19 Residual Income (RI) = Income – (Required Rate of Return × NBV of average
assets)
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Chapter 19 – Strategic Performance Measurement—Investment Centers
19-20 Residual Income (RI) = Income – (Required rate of return × NBV of assets)
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Chapter 19 – Strategic Performance Measurement—Investment Centers
EXERCISES
19-21 Return on Investment (ROI); Comparison of Three Investment
Centers (Divisions) (15 minutes)
Answers shown in bold:
X Y Z
Sales $1,500,000 $750,000 $3,750,000i
Income $150,000 $75,000 $18,750h
Investment (assets) $600,000 $7,500,000d$2,500,000
Calculations:
aROS = Income ÷ Sales = $150,000 ÷ $1,500,000 = 10%
bAT = Sales ÷ Investment (assets) = $1,500,000 ÷ $600,000 = 2.5
cROI = ROS × AT = 10% × 2.5 = 25.00%
dInvestment (assets) = Income ÷ ROI = $75,000 ÷ 0.01 = $7,500,000
eROS = Income ÷ Sales = $75,000 ÷ $750,000 = 10%
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Chapter 19 – Strategic Performance Measurement—Investment Centers
19-22 Return on Investment (ROI); Different Measures for Total Assets;
Spreadsheet Analysis (25 minutes)
Note:
Return on Sales (ROS) = Operating Income ÷ Sales
Asset Turnover (AT) = Sales ÷ Assets
Return on Investment (ROI) = ROS × AT (or, Operating Income ÷ Assets)
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Chapter 19 – Strategic Performance Measurement—Investment Centers
19-23 Return on Investment (ROI); Return on Sales (ROS) and Asset
Turnover (AT) (25 minutes)
Revenue 2016 2017 2018
Southwest $ 14,900 $ 22,000 $ 26,000
Midwest 6,700 7,000 7,200
Southeast 12,400 13,000 13,300
Total $ 34,000 $ 42,000 $ 46,500
Net Operating Income
Southwest $ 1,100 $ 1,200 $ 1,350
Midwest 1,250 1,600 1,550
Southeast 1,000 1,200 1,600
Total $ 3,350 $ 4,000 $ 4,500
Average Total Assets
Southwest $ 14,000 $ 14,200 $ 16,800
Midwest 4,700 4,200 4,200
Southeast 5,300 5,600 5,600
Total $24,000 $24,000 $26,600
Return on Sales (ROS)
Southwest 7.4% 5.5% 5.2%
Midwest 18.7% 22.9% 22.5%
Southeast 8.1% 9.2% 12.0%
Firm 9.9% 9.5% 9.7%
Asset Turnover (AT)
Southwest 1.064 1.549 1.548
Midwest 1.426 1.667 1.714
Southeast 2.340 2.321 2.375
Firm 1.417 1.750 1.748
Return on Investment (ROI)
Southwest 7.9% 8.5% 8.0%
Midwest 26.6% 38.1% 36.9%
Southeast 18.9% 21.4% 28.6%
Firm-wide 14.0% 16.7% 16.9%
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Chapter 19 – Strategic Performance Measurement—Investment Centers
Ex. 19-23 (Continued)
Notes:
1. Return on Sales (ROS) = Net Operating Income ÷ Sales
2. Asset Turnover (AT) = Sales ÷ Average Total Assets
3. Return on Investment (ROI) = ROS × AT (or, Net Operating Income ÷
Average Total Assets)