Abstract
This paper describes the residual income profile which is a graphical method that summarizes the profitability characteristics of a division of a firm and illustrates the relationship between return on investment and residual income. In addition, the residual income profile shows the sensitivity of residual income to changes in interest rates.
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Managerial and Decision Economics is an international journal of research and progress in management economics. The journal publishes articles applying economic reasoning to managerial decision making. Compared to other journals in economics, the focus of this journal is more normative than positive and the viewpoint is focused on managerial efficiency rather than on social welfare. Managerial and Decision Economics has articles from all of the functional areas of economics, as long as these articles are useful for managerial decision making, and from all the functional areas of business, so long as the articles use economic reasoning. Managerial and Decision Economics is currently published 8 times a year.
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Investment centers are decentralized divisions or sub-units for which the manager has maximum discretion in determining not only short-term operating decision on product mix, pricing and production methods, but also level and type of investment. An investment center extends the profit center concept in that the measured profit is related to the center investment. It may be described as a special form of profit center since a profitability measure is being developed for the center. The concept relating profits to assets employed has an intuitive appeal for it for indicates whether the return for the capital invested in the division and it is important that an evaluation be made the overall company are earning on in elaborate systems for authorizing capital investment center performance can be the aggregation of past and present capital projects each project individually. Such a measurement also provides an incentive for division managers to monitor capital investments carefully while managing their operations. The managers will also be motivated to watch the levels of inventory and receivables since these accounts will almost always be included in that investment base.
Important Methods of Investment Center Performance Evaluation
Some of the important investment center performance evaluation measures are:
1. Return on Investment [ROI]
The most common measure of investment center performance evaluation is the return on investment. It is a better test of profitability and is defined as:
- ROI = Net income/Invested capital
- ROI = [Net income X Sales [Revenue] ]/[Sales [Revenue] X Invested capital]
- ROI= Net profit ratio x Capital turnover
The ROI is the result of combination of these two, items: Net Profit Ratio and Capital Turnover. An improvement in either without changing the other will improve the ROI.
There are many positive aspects of ROI computation. It is generally an objective measure based on historical accounting data. It facilitates a comparison among divisions of different sizes and in different lines of business. It is a common measure, since it is similar to a cost of capital for which external referents exist in capital markets, while evaluating, the overall corporate profitability, the use of this measure for evaluating divisional performance encourages goal congruence between the division and the firm.
Auctions taken by a division to increase its ROI may often increase the overall profitability. Most important, perhaps, the measure focuses’ the division manager’s attention on the assets employed in the division and motivates the manager to invest in, assets only to the extent that an adequate return can be earned on them. If a manager were evaluated only on the level of profits, without regard to assets employed, then the tendency would be to expand assets and thereby increase profits. Such actions will lower the ROI and, therefore, will not take place when ROI is used as a performance measure.
Defects of ROI Measure: Actions that increase the divisional ROI may make the division worse off and, conversely, actions that decrease divisional ROI may increase the economic wealth of the division. A similar problem may arise when two divisions with different investment bases are compared. The ROI of two divisions say, A and B are 25% and 30% with capital investment of Rs. 2,00,000 and Rs. 1,00,000 respectively. It might appear that division B is profitable. But on closer examination we find that the division A has Rs. 10,000 more in assets with an incremental earnings of Rs. 20,000, Its incremental ROI is 20 percent well above the cost of capital of 15 percent. Hence, division A is more profitable, after deducting capital costs, than division B. Unfortunately these things may tempt the divisional manager to manipulate the investment bases in, order to, maximize ROI. This problem is caused by evaluating divisional performance attempting to maximize the ROI ratio.
2. Residual Income [RI]
To eliminate the problems associated with using a ratio as a performance measure, many companies use the RI approach for investment center performance evaluation. RI is the difference between actual income earned by the division on an investment and the desired income on the investment as specified by minimum desired rate of return. It is calculated as, follows:
RI = Actual income- Desired income
Where, Desired income = Maximum desired rate of return x Invested capital
In effect, RI is the excess of earnings above the minimum desired earnings. If the firm sets its minimum rate of return at its cost of capital, it must earn an RI that is at least equal to the cost of funds used in making the investment. Any amount of income earned above the cost of capital, is the profit to the firm. The more the income earned above the capital charge, the better off the firm will be. In short, a firm has to maximize its RI.
Weaknesses of RI Measure: RI is a less convenient measure than ROI because it is an absolute number, not deflated by the size of the division. It is easier for a much larger division to earn a given amount of residual income than a small division. For example, consider two divisions, one with Rs. 5,00,000 in assets and the second with Rs. 10,00,000 in assets; both have a cost of capital of 15 percent. In order to earn a residual income of Rs. 50,000, the first division would need to earn a net income of Rs. 1,25,000 [an ROI of 25 per cent] whereas the second division would have to earn Rs. 2,00,000 [an ROI of 20 per cent, only]. For this reason, most companies using an RI evaluation will not simply direct managers to maximize residual income. Rather they will set budgeted levels of residual income, appropriate for the asset structure of each division, evaluate divisional managers by comparing actual to budgeted residual income. However, this measure also suffers from the same limitation of ROI with regard to the maximization of the economic wealth of the firm.
Return on Investment [ROI] Vs. Residual Income [RI]
Under ROI the basic objective is to maximize the rate of return percentage. Thus, manager of highly profitable division they are reluctant to invest in the projects with lower ROI than the current rate because their average ROI would tot reduced. On the other hand, under RI the manager would be inclined to invest in the projects earn more than the desired rate of return.
3. Present-Value Depreciation Method
The PV depreciation method is derived directly from the cash flow schedule used for the appraisal of capital investments, i.e., from the discounted cash flow approach. In this way, a periodic ROI performance measure can be determined such that when actual cash flows equal forecasted cash flows, then each year’s ROI figure will equal the yield [internal rate of return] of the asset. When asset yields equal cash flows over its economic life the PV depreciation method will be identified to the annuity depreciation method. The PV method while incorporating the RI computation, produces more satisfying results. It also offers significant advantages over the straight line method for investment center performance evaluation.
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