7

Chapter

Measuring and
Controlling Assets
Employed
In some business units, the focus is on prot as measured by the difference between revenues
and expenses. This is described in Chapter 5. In other business units, prot is compared with
the assets employed in earning it. We refer to the latter group of responsibility centers as in-
vestment centers and, in this chapter, discuss the measurement problems involved in such re-
sponsibility centers. In the real world, companies use the term prot center, rather than in-
vestment center, to refer to both the responsibility centers discussed in Chapter 5 and those in
this chapter. We agree that an investment center is a special type of prot center, rather than
a separate, parallel category. However, there are so many problems involved in measuring the
assets employed in a prot center that the topic warrants a separate chapter.
In this chapter we rst discuss each of the principal types of assets that may be employed in
an investment center. The sum of these assets is called the investment base. We then discuss
two methods of relating prot to the investment base: (1) the percentage return on investment,
referred to as ROI, and (2) economic value added, called EVA. We describe the advantages
and qualications of using each to measure performance. Finally, we discuss the somewhat dif-
ferent problem of measuring the economic value of an investment center, as compared to eval-
uating the manager in charge of the investment center.
Until recently, authors used the term residual income instead of economic value added.
These two concepts are effectively the same. EVA is a trademark of Stern Stewart & Co.

270
 Chapter 7 Measuring and Controlling Assets Employed 271

Structure of the Analysis

The purposes of measuring assets employed are analogous to the purposes we discussed for
prot centers in Chapter 5, namely:
• To provide information that is useful in making sound decisions about assets employed and
to motivate managers to make these sound decisions that are in the best interests of the
company.
• To measure the performance of the business unit as an economic entity.
In our examination of the alternative treatments of assets and the comparison of ROI and
EVA—the two ways of relating prot to assets employed—we are primarily interested in how
well the alternatives serve these two purposes of providing information for sound decision-
making and measuring business unit economic performance.
Focusing on prots without considering the assets employed to generate those prots is an
inadequate basis for control. Except in certain types of service organizations, in which the
amount of capital is insignicant, an important objective of a prot-oriented company is to
earn a satisfactory return on the capital that the company uses. A prot of $1 million in a com-
pany that has $10 million of capital does not represent as good a performance as a prot of $1
million in a company that has only $5 million of capital, assuming both companies have a sim-
ilar risk prole.
Unless the amount of assets employed is taken into account, it is difcult for senior man-
agement to compare the prot performance of one business unit with that of other units or to
similar outside companies. Comparing absolute differences in prots is not meaningful if busi-
ness units use different amounts of resources; clearly, the more resources used, the greater the
prots should be. Such comparisons are used to judge how well business unit managers are
performing and to decide how to allocate resources.
Example. Golden Grain, a business unit of Quaker Oats, had very high protability and ap-
peared to be one of Quaker Oats’ best divisions. It was, however, acquired by Quaker Oats at a
premium above its book value. Based on the assets employed as measured by this premium,
Golden Grain actually was underperforming.1

In general, business unit managers have two performance objectives. First, they should gen-
erate adequate prots from the resources at their disposal. Second, they should invest in addi-
tional resources only when the investment will produce an adequate return. (Conversely, they
should disinvest if the expected annual prots of any resource, discounted at the company’s re-
quired earnings rate, are less than the cash that could be realized from its sale.) The purpose
of relating prots to investments is to motivate business unit managers to accomplish these ob-
jectives. As we shall see, there are signicant practical difculties involved in creating a sys-
tem that focuses on assets employed in addition to the focus on prots.

1
Brian McWilliams, “Creating Value,” an interview with William Smithburg, chairman, Quaker Oats, in Enterprise, April
1993.
272 Part One The Management Control Environment

EXHIBIT 7.1 Business Unit Financial Statements

Balance Sheet
($000s)
Current assets: Current liabilities:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50 Accounts payable . . . . . . . . . . . . . . . . . . $ 90
Receivables . . . . . . . . . . . . . . . . . . . . . . . . . 150 Other current . . . . . . . . . . . . . . . . . . . . . 110
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Total current assets . . . . . . . . . . . . . . . . . 400 Total current liabilities . . . . . . . . . . . . . 200
Fixed assets:
Cost . . . . . . . . . . . . . . . . $600 Corporate equity . . . . . . . . . . . . . . . . . 500
Depreciation . . . . . . . . . . ⫺300
Book value . . . . . . . . . . . . . . . . . . . . . . . 300
Total assets . . . . . . . . . . . . . . . . . . . . . . . $700 Total equities . . . . . . . . . . . . . . . . . . . . $700

Income Statement

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000
Expenses, except depreciation . . . . . . . . . . . . $850
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . 50 900
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Capital charge ($500 * 10%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Economic value added (EVA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
$100
Return on investment ⫽ ⫽ 20%
$500

Exhibit 7.1 is a hypothetical, simplied set of business unit nancial statements that will be
used throughout this analysis. (In the interest of simplicity, income taxes have been omitted
from this exhibit and generally will be omitted from discussion in this chapter. Including in-
come taxes would change the magnitudes in the calculations that follow, but it would not
change the conclusions.) The exhibit shows the two ways of relating prots to assets em-
ployed—namely, through return on investment and economic value added.
Return on investment (ROI) is a ratio. The numerator is income, as reported on the income
statement. The denominator is assets employed. In Exhibit 7.1, the denominator is taken as the
corporation’s equity in the business unit. This amount corresponds to the sum of noncurrent li-
abilities plus shareholders’ equity in the balance sheet of a separate company. It is mathemat-
ically equivalent to total assets less current liabilities, and to noncurrent assets plus working
capital. (This statement can easily be checked against the numbers in Exhibit 7.1.)
Economic value added (EVA) is a dollar amount, rather than a ratio. It is found by subtract-
ing a capital charge from the net operating prot. This capital charge is found by multiplying
the amount of assets employed by a rate, which is 10 percent in Exhibit 7.1. We shall discuss
the derivation of this rate in a later section.
Examples. AT&T used the economic value added measure to evaluate business unit managers.
For instance, the Long-Distance Group consisted of 40 business units which sold services such as
800 numbers, telemarketing, and public telephone calls. All the capital costs, from switching
 Chapter 7 Measuring and Controlling Assets Employed 273

EXHIBIT 7.2 Methods Used to Evaluate Investment Centers

United States* Holland† India‡
Number of usable responses 638 72 39
Companies with 2 or more investment centers 500 (78%) 59 (82%) 27 (70%)
Percentage of companies using Residual Income or EVA
(with 2 or more investment centers) 36% 19% 8%

*Vijay Govindarajan, “Prot Center Measurement: An Empirical Survey,” The Amos Tuck School of Business Administration, Dartmouth
College, 1994, p. 2.
†
Elbert De With, “Performance Measurement and Evaluation in Dutch Companies,” paper presented at the 19th Annual Congress of the
European Accounting Association, Bergen, 1996.
‡
V. Govindarajan and B. Ramamurthy, “Financial Measurement of Investment Centers: A Descriptive Study,” working paper, Indian Institute of
Management, Ahbedabad, India, August 1980.

equipment to new product development, were allocated to these 40 business units. Each business
unit manager was expected to generate operating earnings that substantially exceeded the cost of
capital.
Diageo Plc., whose portfolio of brands includes Burger King, Guinness, and Häagen-Dazs, used
EVA to help make business decisions and measure the effects of management actions. An EVA
analysis of Diageo’s returns from its liquor brands led to a new emphasis on producing and selling
vodka, which, unlike Scotch, does not incur aging and storage costs.2
EVA-based nancial discipline is credited with turning around many companies such as Boise
Cascade, Briggs & Stratton, Baxte, and Times Mirror.3

In a survey of Fortune 1,000 companies, 78 percent of the respondents used investment cen-
ters (Exhibit 7.2).4 Of the U.S. companies using investment centers, 36 percent evaluated them
on economic value added. Practices in other countries seem to be similar to those in the United
States (see Exhibit 7.2).
For reasons to be explained later, EVA is conceptually superior to ROI, and, therefore, we
shall generally use EVA in our examples. Nevertheless, it is clear from the surveys that ROI is
more widely used in business than EVA.

Measuring Assets Employed

In deciding what investment base to use to evaluate investment center managers, headquar-
ters asks two questions: First, what practices will induce business unit managers to use their
assets most efciently and to acquire the proper amount and kind of new assets? Presumably,
when their prots are related to assets employed, business unit managers will try to improve
their performance as measured in this way. Senior management wants the actions that they
take toward this end to be in the best interest of the whole corporation. Second, what prac-
tices best measure the performance of the unit as an economic entity?

2
Dawne Shand, “Economic Value Added,” Computerworld, October 30, 2000, p. 65; Gregory Millman, “CFOs in Tune
with the Times,” Financial Executive, July–August 2000, p. 26.
3
Raj Aggarwal, “Using Economic Prot to Assess Performance: A Metric for Modern Firms,” Business Horizons,
January–February 2001, pp. 55–60.
4
Vijay Govindarajan, “Prot Center Measurement: An Empirical Survey,” The Amos Tuck School of Business Administra-
tion, Dartmouth College, 1994, p. 2.
274 Part One The Management Control Environment

Cash
Most companies control cash centrally because central control permits use of a smaller cash
balance than would be the case if each business unit held the cash balances it needed to
weather the unevenness of its cash inows and outows. Business unit cash balances may well
be only the “oat” between daily receipts and daily disbursements. Consequently, the actual
cash balances at the business unit level tend to be much smaller than would be required if the
business unit were an independent company. Many companies therefore use a formula to cal-
culate the cash to be included in the investment base. For example, General Motors was re-
ported to use 4.5 percent of annual sales; Du Pont was reported to use two months’ costs of
sales minus depreciation.
One reason to include cash at a higher amount than the balance normally carried by a busi-
ness unit is that the higher amount is necessary to allow comparisons to outside companies. If
only the actual cash were shown, the return by internal units would appear abnormally high
and might mislead senior management.
Some companies omit cash from the investment base. These companies reason that the
amount of cash approximates the current liabilities. If this is so, the sum of accounts receivable
and inventories will approximate the amount of working capital.

Receivables
Business unit managers can inuence the level of receivables indirectly, by their ability to
generate sales, and directly, by establishing credit terms and approving individual credit ac-
counts and credit limits, and by their vigor in collecting overdue amounts. In the interest of
simplicity, receivables often are included at the actual end-of-period balances, although the
average of intraperiod balances is conceptually a better measure of the amount that should
be related to prots.
Whether to include accounts receivable at selling prices or at cost of goods sold is debatable.
One could argue that the business unit’s real investment in accounts receivable is only the cost
of goods sold and that a satisfactory return on this investment is probably enough. On the
other hand, it is possible to argue that the business unit could reinvest the money collected
from accounts receivable, and, therefore, accounts receivable should be included at selling
prices. The usual practice is to take the simpler alternative—that is, to include receivables at
the book amount, which is the selling price less an allowance for bad debts.
If the business unit does not control credits and collections, receivables may be calculated on
a formula basis. This formula should be consistent with the normal payment period—for ex-
ample, 30 days’ sales where payment normally is made 30 days after the shipment of goods.

Inventories
Inventories ordinarily are treated in a manner similar to receivables—that is, they are often
recorded at end-of-period amounts even though intraperiod averages would be preferable con-
ceptually. If the company uses LIFO (last in, rst out) for nancial accounting purposes, a dif-
ferent valuation method usually is used for business unit prot reporting because LIFO inven-
 Chapter 7 Measuring and Controlling Assets Employed 275

tory balances tend to be unrealistically low in periods of ination. In these circumstances, in-
ventories should be valued at standard or average costs, and these same costs should be used to
measure cost of sales on the business unit income statement.
If work-in-process inventory is nanced by advance payments or by progress payments from
the customer, as is typically the case with goods that require a long manufacturing period,
these payments either are subtracted from the gross inventory amounts or reported as liabili-
ties.
Example. With manufacturing periods a year or greater, Boeing received progress payments for
its airplanes and recorded them as liabilities.5

Some companies subtract accounts payable from inventory on the grounds that accounts
payable represent financing of part of the inventory by vendors, at zero cost to the business
unit. The corporate capital required for inventories is only the difference between the gross
inventory amount and accounts payable. If the business unit can influence the payment pe-
riod allowed by vendors, then including accounts payable in the calculation encourages the
manager to seek the most favorable terms. In times of high interest rates or credit strin-
gency, managers might be encouraged to consider forgoing the cash discount to have, in ef-
fect, additional financing provided by vendors. On the other hand, delaying payments un-
duly to reduce net current assets may not be in the company’s best interest since this may
hurt its credit rating.

Working Capital in General

As can be seen, treatment of working capital items varies greatly. At one extreme, companies
include all current assets in the investment base with no offset for any current liabilities. This
method is sound from a motivational standpoint if the business units cannot inuence ac-
counts payable or other current liabilities. It does overstate the amount of corporate capital re-
quired to nance the business unit, however, because the current liabilities are a source of cap-
ital, often at zero interest cost. At the other extreme, all current liabilities may be deducted
from current assets, as was done in calculating the investment base in Exhibit 7.1. This
method provides a good measure of the capital provided by the corporation, on which it expects
the business unit to earn a return. However, it may imply that business unit managers are re-
sponsible for certain current liabilities over which they have no control.

Property, Plant, and Equipment

In nancial accounting, xed assets are initially recorded at their acquisition cost, and this
cost is written off over the asset’s useful life through depreciation. Most companies use a sim-
ilar approach in measuring protability of the business unit’s asset base. This causes some
serious problems in using the system for its intended purposes. We examine these problems
in the following sections.

5
The Boeing Company, 2002 Report.
276 Part One The Management Control Environment

EXHIBIT 7.3 Incorrect Motivation for Asset Acquisition ($000)

A. Economic calculation
Investment in machine . . . . . . . . . . . . . . . . . . . . . . . . . . . $100
Life, 5 years
Cash inow, $27,000 per year
Present value of cash inow ($27,000 * 3.791)* . . . . . . . . 102.4
Net present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4
Decision: Acquire the machine.
B. As reected on business unit income statement
First Year
As in Exhibit 7.1 with Machine
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 $1,000
Expenses, except depreciation . . . . . . . . . . . . . . . $850 $823
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 900 70 893
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 107
Less capital charge at 10%† . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 60
EVA 50 47

Note: Income taxes are not shown separately for simplicity. Assume they are included in the calculation of the cash ow.
*3.791 is the present value of $1 per year for ve years at 10 percent.
†
Capital charge on the new machine is calculated at its beginning book value, which for the rst year is $100 * 10% ⫽ 10. We have used
the beginning-of-the-year book value for simplicity. Many companies use the average book value—(100 ⫹ 80) ⫼ 2 ⫽ 90. The results
will be similar.

Acquisition of New Equipment

Suppose a business unit could buy a new machine for $100,000. This machine is estimated to
produce cash savings of $27,000 a year for ve years. If the company has a required return of
10 percent, the investment is attractive, as the calculations in section A of Exhibit 7.3 illus-
trate. The proposed investment has a net present value of $2,400 and, therefore, should be un-
dertaken. However, if the machine is purchased and the business unit measures its asset base
as shown in Exhibit 7.1, the unit’s reported economic value added will decrease, rather than in-
crease, in the rst year. Section B of Exhibit 7.3 shows the income statement without the ma-
chine (as in Exhibit 7.1) and the income statement if the machine is acquired (and in its rst
year of use). Note that acquiring the machine increases income before taxes, but this increase
is more than offset by the increase in the capital charge. Thus, the EVA calculation signals that
protability has decreased, whereas the economic facts are that prots have increased. Under
the circumstances, the business unit manager may be reluctant to purchase this machine. (In
Exhibit 7.3, depreciation was calculated on a straight-line basis. Had it been calculated on an
accelerated basis, which is not uncommon, the discrepancy between the economic facts and the
reported results would have been even greater.)
Exhibit 7.4 shows how, in later years, the amount of economic value added will increase as the
book value of the machine declines, going from ⫺$3,000 in year 1 to ⫹$5,000 in year 5. The in-
crease in economic value added each year does not represent real economic change. Although
there appears to be constantly improving protability, in fact there is no real change in prof-
itability after the year the machine was acquired. Generalizing from this example, it is evident
that business units that have old, almost fully depreciated assets will tend to report larger eco-
nomic value added than units that have newer assets.
 Chapter 7 Measuring and Controlling Assets Employed 277

EXHIBIT 7.4 Effect of Acquisition on Reported Annual Prots ($000)

Book Value Incremental Capital
at Beginning of Year Income* Charge† EVA ROI
Year (a) (b) (c) (b ⴚ c) bⴜa
1 100 7 10 ⫺3 7%
2 80 7 8 ⫺1 9
3 60 7 6 1 12
4 40 7 4 3 18
5 20 7 2 5 35

Note: True return ⫽ approximately 11 percent.

*$27,000 cash inow ⫺ $20,000 depreciation ⫽ $7,000.
†
10 percent of beginning book value.

If protability is measured by return on investment, the same inconsistency exists, as the

last column of Exhibit 7.4 shows. Although we know from the present value calculation that
the true return is about 11 percent, the business unit nancial statement reports that it is less
than 10 percent in the rst year and increases thereafter. Furthermore, the average of the ve
annual percentages shown is 16 percent, which far exceeds what we know to be the true
annual return.
It is evident that if depreciable assets are included in the investment base at net book value,
business unit protability is misstated, and business unit managers may not be motivated to
make correct acquisition decisions.
Example. Quaker Oats discovered it was underinvesting because of the low book value of its 100-
year-old plants. As one executive observed, “We’ve been in the business for over 100 years. As a re-
sult, we have a lot of plants and equipment with a small book value relative to our newer brands.
And just because we’re lucky enough to inherit a 100-year-old business doesn’t mean we are
exempt from substantially improving the controllable earnings of that business from year to
year.”6

Gross Book Value

The fluctuation in economic value added and return on investment from year to year in Ex-
hibit 7.4 can be avoided by including depreciable assets in the investment base at gross
book value rather than at net book value. Some companies do this. If this were done in this
case, the investment each year would be $100,000 (original cost), and the additional income
would be $7,000 ($27,000 cash inflow ⫺ $20,000 depreciation). The economic value added,
however, would decrease by $3,000 ($7,000 ⫺ $10,000 interest), and return on investment
would be 7 percent ($7,000 ⫼ $100,000). Both of these numbers indicate that the business
unit’s profitability has decreased, which, in fact, is not true. Return on investment calcu-
lated on gross book value always understates the true return.

Disposition of Assets
If a new machine is being considered to replace an existing machine that has some undepreci-
ated book value, we know that this undepreciated book value is irrelevant in the economic

6
McWilliams, “Creating Value.”
278 Part One The Management Control Environment

analysis of the proposed purchase (except indirectly as it may affect income taxes). Neverthe-
less, removing the book value of the old machine can substantially affect the calculation of
business unit protability. Gross book value will increase only by the difference between the
net book value after year 1 of the new machine and the net book value of the old machine. In
either case, the relevant amount of additional investment is understated, and the economic
value added is correspondingly overstated. This encourages managers to replace old equip-
ment with new equipment, even when replacement is not economically justied. Furthermore,
business units that are able to make the most replacements will show the greatest improve-
ment in protability.
In sum, if assets are included in the investment base at their original cost, then the business
unit manager is motivated to get rid of them—even if they have some usefulness—because the
business unit’s investment base is reduced by the full cost of the asset.

Annuity Depreciation
If depreciation is determined by the annuity, rather than the straight-line, method, the busi-
ness unit protability calculation will show the correct economic value added and return on in-
vestment, as Exhibits 7.5 and 7.6 demonstrate. This is because the annuity depreciation
method actually matches the recovery of investment that is implicit in the present value cal-
culation. Annuity depreciation is the opposite of accelerated depreciation in that the annual
amount of depreciation is low in the early years when the investment values are high and in-
creases each year as the investment decreases; the rate of return remains constant.
Exhibits 7.5 and 7.6 show the calculations when the cash inows are level in each year.
Equations are available that derive the depreciation for other cash ow patterns, such as a de-

EXHIBIT 7.5 Protability Using Annuity Depreciation—Smoothing EVA ($000)

Beginning Cash Capital
Year Book Value Inow EVA* Charge† Depreciation‡
1 $100.0 $ 27.0 $0.6 $10.0 $ 16.4
2 83.6 27.0 0.6 8.4 18.0
3 65.6 27.0 0.6 6.6 19.8
4 45.8 27.0 0.6 4.6 21.8
5 24.0 27.0 0.6 2.4 24.0
Total $135.0 $3.0 $32.0 $100.0

*Annuity depreciation makes the EVA the same each year by changing the amount of depreciation charged. Consequently, we must estimate
the total EVA earned over the ve years. A 10 percent return on $100,000 would require ve annual cash inows of $26,378. The actual cash
inows are $27,000. Therefore, the EVA (the amount in excess of $26,378) is $622 per year.
†
This is 10 percent of the balance at the beginning of the year.
‡
Depreciation is the amount required to make the EVA (prots after the capital charge and depreciation) equal $622 per year (rounded here to
$600). This is calculated as follows:

$27.0 ⫺ Capital charge ⫺ Depreciation ⫽ $0.6

therefore,

Depreciation ⫽ $26.4 ⫺ Capital charge

 Chapter 7 Measuring and Controlling Assets Employed 279

EXHIBIT 7.6 Protability Using Annuity Depreciation—Smoothing Return on Investment

($000)
Return on
Beginning Cash Net Beginning
Year Book Balance Inow Prot* Depreciation† Investment
1 $100.0 $ 27.0 $11.0 $ 16.0 11%
2 84.0 27.0 9.2 17.8 11
3 66.2 27.0 7.3 19.7 11
4 46.5 27.0 5.1 21.9 11
5 24.6 27.0 2.4 24.6 10‡
Total $135.0 $35.0 $100.0 10%

*A return of $27,000 a year for ve years on an investment of $100,000 provides a return of approximately 11 percent on the beginning of the
year investment. Consequently, in order to have a constant 11 percent return each year, the net prot must equal 11 percent of the beginning-
of-the-year investment.
†
Depreciation is the difference between the cash ow and the net prot.
‡
The difference results because the return is not exactly 11 percent.

EXHIBIT 7.7 Valuation of Plant and Equipment

Percentage of Respondents Using the Method
United States* Holland† India‡
Gross book value 6% 9% 17%
Net book value 93 73 79
Replacement cost 1 18 4
100% 100% 100%

*Govindarajan, “Prot Center Measurement,” 1994, p. 2.

†
De With, “Performance Measurement and Evaluation in Dutch Companies.”
‡
Govindarajan and Ramamurthy, “Financial Measurement of Investment Centers.”

creasing cash ow as repair costs increase, or an increasing cash ow as a new product gains
market acceptance.
Very few managers accept the idea of a depreciation allowance that increases as the asset
ages, however. They visualize accounting depreciation as representing physical deterioration
or loss in economic value. Therefore, they believe that accelerated, or straight-line, deprecia-
tion is a valid representation of what is taking place. As a result, it is difcult to convince them
to accept the annuity method to measure business unit prot.
Annuity depreciation also presents some practical problems. For example, the depreciation
schedule in Exhibits 7.5 and 7.6 was based on an estimated cash ow pattern. If the actual
cash ow pattern differed from that assumed, even though the total cash ow might result in
the same rate of return, expected prots would be higher in some years and lower in others.
Should the depreciation schedule change each year to conform to the actual pattern of cash
ow? This probably is not practical. Annuity depreciation would not be desirable for income tax
purposes, of course, and although as a “systematic and rational” method it clearly is acceptable
for nancial accounting purposes, companies do not use it in their nancial reporting. Indeed,
surveys of how companies measure business unit protability show practically no use of the
annuity method (see Exhibit 7.7).
280 Part One The Management Control Environment

Other Valuation Methods

Some companies use net book value but set a lower limit, usually 50 percent, as the amount of
original cost that can be written off. This lessens the distortions that occur in business units
with relatively old assets. A difculty with this method is that a business unit with xed assets
that have a net book value of less than 50 percent of gross book value can decrease its invest-
ment base by scrapping perfectly good assets. Other companies depart entirely from the ac-
counting records and use the asset’s approximate current value. They arrive at this amount by
periodically appraising assets (say, every ve years or when a new business unit manager
takes over), by adjusting original cost using an index of changes in equipment prices, or by ap-
plying insurance values.
A major problem with using nonaccounting values is that they tend to be subjective, as con-
trasted with accounting values, which appear to be objective and generally not subject to ar-
gument. Consequently, accounting data have an aura of reality for operating management. Al-
though the intensity of this sentiment varies among managers, the further one departs from
accounting numbers in measuring nancial performance, the more likely that both business
unit managers and senior managers will regard the system as playing a game of numbers.
A related problem with using nonaccounting amounts in internal systems is that business
unit protability will not be consistent with the corporate protability reported to sharehold-
ers. Although the management control system does not have to be consistent with the external
nancial reporting, as a practical matter some managers regard net income, as reported on the
nancial statements, as constituting the “name of the game.” Consequently, they do not favor
an internal system that uses a different method of keeping score, regardless of its theoretical
merits. Another problem with using current market values is deciding how to determine the
economic values. Conceptually, the economic value of a group of assets equals the present value
of the cash ows that these assets will generate in the future. As a practical matter, this
amount cannot be determined. Although published indexes of replacement costs of plant and
equipment can be used, most price indexes are not entirely relevant because they make no al-
lowance for the impact of technology changes.
In any case, including the investment base of xed assets at amounts other than those de-
rived from the accounting records happens so rarely that it is of little more than academic in-
terest (Exhibit 7.7).

Leased Assets
Suppose the business unit whose nancial statements are shown in Exhibit 7.1 sold its xed
assets for their book value of $300,000, returned the proceeds of the sale to corporate head-
quarters, and then leased back the assets at a rental rate of $60,000 per year. As Exhibit 7.8
shows, the business unit’s income before taxes would decrease because the new rental expense
would be higher than the depreciation charge that was eliminated. Nevertheless, economic val-
ued added would increase because the higher cost would be more than offset by the decrease in
the capital charge. Because of this, business unit managers are induced to lease, rather than
own, assets whenever the interest charge that is built into the rental cost is less than the cap-
ital charge that is applied to the business unit’s investment base. (Here, as elsewhere, this gen-
 Chapter 7 Measuring and Controlling Assets Employed 281

EXHIBIT 7.8 Effect of Leasing Assets

Income Statement
($000)
As in Exhibit 7.1 If Assets Are Leased
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1000 $1,000
Expenses other than below . . . . . . . . . . . . . . . . . . $850 $850
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 900
Rental expense . . . . . . . . . . . . . . . . . . . . . . . . . 60 910
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . 100 90
Capital charge $500 * 10% . . . . . . . . . . . . . . . . 50
$200 * 10% . . . . . . . . . . . . . . . . 20
EVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 70

eralization oversimplies because, in the real world, the impact of income taxes must also be
taken into account.)
Many leases are nancing arrangements—that is, they provide an alternative way of getting
to use assets that otherwise would be acquired by funds obtained from debt and equity nancing.
Financial leases (i.e., long-term leases equivalent to the present value of the stream of lease
charges) are similar to debt and are so reported on the balance sheet. Financing decisions usually
are made by corporate headquarters. For these reasons, restrictions usually are placed on the
business unit manager’s freedom to lease assets.

Idle Assets
If a business unit has idle assets that can be used by other units, it may be permitted to exclude
them from the investment base if it classies them as available. The purpose of this permission
is to encourage business unit managers to release underutilized assets to units that may have
better use for them. However, if the xed assets cannot be used by other units, permitting the
business unit manager to remove them from the investment base could result in dysfunctional
actions. For example, it could encourage the business unit manager to idle partially utilized as-
sets that are not earning a return equal to the business unit’s prot objective. If there is no al-
ternative use for the equipment, any contribution from this equipment will improve company
prots.

Intangible Assets
Some companies tend to be R&D intensive (e.g., pharmaceutical rms such as Novartis spend
huge amounts on developing new products); others tend to be marketing intensive (e.g., con-
sumer products rms such as Unilever spend huge amounts on advertising). There are ad-
vantages to capitalizing intangible assets such as R&D and marketing and then amortizing
them over a selected life.7 This method should change how the business unit manager views
these expenditures.8 By accounting for these assets as long-term investments, the business

7
Joel M. Stern, “The Mathematics of Corporate Finance—or EVA ⫽ $NA[RONA–C],” pp. 26–33.
8
Shawn Tully, “The Real Key to Creating Wealth,” Fortune, September 20, 1993, pp. 38–50.
282 Part One The Management Control Environment

unit manager will gain less short-term benet from reducing outlays on such items. For in-
stance, if R&D expenditures are expensed immediately, each dollar of R&D cut would be a dol-
lar more in pretax prots. On the other hand, if R&D costs are capitalized, each dollar cut will
reduce the assets employed by a dollar; the capital charge is thus reduced only by one dollar
times the cost of capital, which has a much smaller positive impact on economic valued added.

Noncurrent Liabilities
Ordinarily, a business unit receives its permanent capital from the corporate pool of funds. The
corporation obtained these funds from debt providers, equity investors, and retained earnings.
To the business unit, the total amount of these funds is relevant but not the sources from which
they were obtained. In unusual situations, however, a business unit’s nancing may be pecu-
liar to its own situation. For example, a business unit that builds or operates residential hous-
ing or ofce buildings uses a much larger proportion of debt capital than would a typical man-
ufacturing or marketing unit. Since this capital is obtained through mortgage loans on the
business unit’s assets, it may be appropriate to account for the borrowed funds separately and
to compute an economic value added based on the assets obtained from general corporate
sources rather than on total assets.

The Capital Charge

Corporate headquarters sets the rate used to calculate the capital charge. It should be higher
than the corporation’s rate for debt nancing because the funds involved are a mixture of debt
and higher-cost equity. Usually, the rate is set somewhat below the company’s estimated cost
of capital so that the economic value added of an average business unit will be above zero.
Some companies use a lower rate for working capital than for xed assets. This may repre-
sent a judgment that working capital is less risky than xed assets because the funds are com-
mitted for a shorter time period. In other cases, the lower rate is a way to compensate for the
fact that the company included inventory and receivables in the investment base at their gross
amount (i.e., without a deduction for accounts payable). It recognizes the fact that funds ob-
tained from accounts payable have zero interest cost.

Surveys of Practice
Practices in investment center management are summarized in Exhibits 7.7, 7.9, and 7.10. Most
companies include xed assets in their investment base at their net book value. They do this
because this is the amount at which the assets are carried in the nancial statements and
therefore, according to these statements, represents the amount of capital that the corporation
has employed in the division. Senior managers recognize that this method gives misleading
signals, but they believe individuals should make allowances for these errors when interpret-
ing business unit prot reports and that alternative methods of calculating the investment
base are not to be trusted because they are so subjective. They reject the annuity depreciation
approach on the grounds that it is inconsistent with the way in which depreciation is calcu-
lated for nancial statement purposes.
 Chapter 7 Measuring and Controlling Assets Employed 283

EXHIBIT 7.9 Assets Included in Investment Base

Percentage of Respondents Including
the Asset in the Investment Base
United States* Holland†
Current assets
Cash 47% 59%
Accounts receivable 90 94
Inventory 95 93
Other current assets 83 79
Fixed assets
Land and buildings used solely by this prot center 97 82
Allocated land and buildings used by two or more prot centers 49 47
Equipment used solely by this prot center 96 88
Allocated equipment used by two or more prot centers 48 46
An allocation of assets of headquarters central research 19 16
Other
Investments 53 N/A
Goodwill 55 N/A

*Govindarajan, “Prot Center Measurement,” p. 2.

†
De With, “Performance Measurement and Evaluation in Dutch Companies.”

EXHIBIT 7.10 Liabilities Deducted in Calculating Investment Base

Percentage of Respondents Deducting
the Liability from the Investment Base
United States* Holland†
Accounts payable 73% 91%
Intracompany payables 46 57
Other current liabilities 68 69
Deferred taxes 28 N/A
Other noncurrent liabilities 47 48

*Govindarajan, “Prot Center Measurement,” p. 2.

†
De With, “Performance Measurement and Evaluation in Dutch Companies.”

EVA versus ROI

As shown in Exhibit 7.2, most companies employing investment centers evaluate business units
on the basis of ROI rather than EVA. There are three apparent benets of an ROI measure. First,
it is a comprehensive measure in that anything that affects nancial statements is reected in
this ratio. Second, ROI is simple to calculate, easy to understand, and meaningful in an absolute
sense. For example, an ROI of less than 5 percent is considered low on an absolute scale, and an
ROI of over 25 percent is considered high. Finally, it is a common denominator that may be ap-
plied to any organizational unit responsible for protability, regardless of size or type of business.
The performance of different units may be compared directly to one another. Also, ROI data are
available for competitors and can be used as a basis for comparison.
284 Part One The Management Control Environment

The dollar amount of EVA does not provide such a basis for comparison. Nevertheless, the
EVA approach has some inherent advantages. There are four compelling reasons to use EVA
over ROI.
First, with EVA all business units have the same prot objective for comparable invest-
ments. The ROI approach, on the other hand, provides different incentives for investments
across business units. For example, a business unit that currently is achieving an ROI of 30
percent would be reluctant to expand unless it is able to earn an ROI of 30 percent or more on
additional assets; a lesser return would decrease its overall ROI below its current 30 percent
level. Thus, this business unit might forgo investment opportunities whose ROI is above the
cost of capital but below 30 percent.
Example. Based on ROI, Wal-Mart would have chosen to stop expanding since the late 1980s be-
cause its ROI on new stores slipped from 25 percent to 20 percent—even though both rates were
substantially above its cost of capital.9

Similarly, a business unit that currently is achieving a low ROI—say, 5 percent—would bene-
t from anything over 5 percent on additional assets. As a consequence, ROI creates a bias toward
little or no expansion in high-prot business units while, at the same time, low-prot units are
making investments at rates of return well below those rejected by the high-prot units.
Second, decisions that increase a center’s ROI may decrease its overall prots. For instance,
in an investment center whose current ROI is 30 percent, the manager can increase its overall
ROI by disposing of an asset whose ROI is 25 percent. However, if the cost of capital tied up in
the investment center is less than 25 percent, the absolute dollar prot after deducting capital
costs will decrease for the center.
The use of EVA as a measure deals with both these problems. They relate to asset invest-
ments whose ROI falls between the cost of capital and the center’s current ROI. If an invest-
ment center’s performance is measured by EVA, investments that produce a prot in excess of
the cost of capital will increase EVA and therefore be economically attractive to the manager.
A third advantage of EVA is that different interest rates may be used for different types of
assets. For example, a low rate may be used for inventories while a relatively higher rate may
be used for investments in xed assets. Furthermore, different rates may be used for different
types of xed assets to take into account different degrees of risk. In short, management con-
trol systems can be made consistent with the framework used for decisions about capital in-
vestments and resource allocation. It follows that the same type of asset may be required to
earn the same return throughout the company, regardless of the particular business unit’s
protability. Thus, business unit managers should act consistently when deciding to invest in
new assets.
A fourth advantage is that EVA, in contrast to ROI, has a stronger positive correlation with
changes in a company’s market value.10 Shareholders are important stakeholders in a com-
pany. There are several reasons why shareholder value creation is critical for the rm: It
(a) reduces the risk of takeover, (b) creates currency for aggressiveness in mergers and ac-
quisitions, and (c) reduces cost of capital, which allows faster investment for future growth.

9
G. Bennett Stewart III, “Reform Your Governance from Within,” Directors and Boards, Spring 1993, pp. 48–54.
10
Joel M. Stern, EVA and Strategic Performance Measurement (New York: The Conference Board, 1996).
 Chapter 7 Measuring and Controlling Assets Employed 285

EXHIBIT 7.11 Fortune’s Annual List of Wealth Creators ($ in millions)

2001 Rank Company Name Market Value Added* EVA†
Top 5 in the List
1 General Electric $312,092 $5,943
2 Microsoft 296,810 5,919
3 Wal-Mart 198,482 1,596
4 IBM 142,625 1,236
5 Citigroup 140,426 4,646
Bottom 5 in the List
996 Qwest Communications ($24,919) ($1,800)
997 WorldCom (33,578) (5,387)
998 General Motors (34,456) (1,065)
999 Lucent (41,987) (6,469)
1000 AT&T (94,270) (9,972)

Source: “America’s Greatest Wealth Creators,” Fortune, December 10, 2001.

*“Market value added” shows the difference between what the capital investors have put into a company and the money they can take out.
†
EVA is after-tax net operating prot minus cost of capital.

Thus, optimizing shareholder value is an important goal of an enterprise. However, because

shareholder value measures the worth of the consolidated enterprise as whole, it is nearly
impossible to use it as a performance criterion for an organization’s individual responsibility
centers. The best proxy for shareholder value at the business unit level is to ask business unit
managers to create and grow EVA. Indeed, Fortune’s annual ranking of 1,000 companies ac-
cording to their ability to create shareholder wealth indicates that companies with high EVA
tend to show high market value added (MVA) or high gains for shareholders (see Exhibit
7.11). When used as a performance metric, EVA motivates managers to increase EVA by tak-
ing actions consistent with increasing stockholder value. This can be understood by consid-
ering how EVA is calculated. EVA is measured as follows:
EVA ⫽ Net prot ⫺ Capital charge
where
Capital charge ⫽ Cost of capital * Capital employed (1)
Another way to state equation (1) would be:
EVA ⫽ Capital employed (ROI ⫺ Cost of capital) (2)
The following actions can increase EVA as shown in equation (2): (i) increase in ROI through
business process reengineering and productivity gains, without increasing the asset base;
(ii) divestment of assets, products, and/or businesses whose ROI is less than the cost of capital;
(iii) aggressive new investments in assets, products, and/or businesses whose ROI exceeds the
cost of capital; and (iv) increase in sales, prot margins, or capital efciency (ratio of sales to
capital employed), or decrease in cost of capital percentage, without affecting the other variables
in equation (2). These actions clearly are in the best interests of shareholders.
286 Part One The Management Control Environment

Example. In January 1996, John Bystone, a former General Electric manager, took over as CEO
of SPX, a $1.1 billion maker of automobile parts, such as lters needed to service various models
of engines. The sales revenues of SPX were declining and the company’s stock price was on a
downward spiral by 1995. As part of the turnaround, John Bystone implemented EVA as the basis
for evaluating and rewarding business units, sending a strong signal that managers should build,
hold, harvest, or divest their businesses if the returns exceeded the cost of capital. During the rst
two years of his tenure, SPX’s sales revenues grew and so did its EVA. Between January 1996 and
December 1997, the company’s stock rose from $15.62 to $66.11

Differences between ROI and EVA are shown in Exhibit 7.12. Assume that the company’s
required rate of return for investing in xed assets is 10 percent after taxes, and that the com-
panywide cost of money tied up in inventories and receivables is 4 percent after taxes. The top
section of Exhibit 7.12 shows the ROI calculation. Columns (1) through (5) show the amount of
investment in assets that each business unit budgeted for the coming year. Column (6) is the
amount of budgeted prot. Column (7) is the budgeted prot divided by the budgeted invest-
ment; therefore, this column, shows the ROI objectives for the coming year for each of the busi-
ness units.
Only in Business Unit C is the ROI objective consistent with the companywide cutoff rate,
and in no unit is the objective consistent with the companywide 4 percent cost of carrying cur-
rent assets. Business Unit A would decrease its chances of meeting its prot objective if it did

EXHIBIT 7.12 Difference between ROI and EVA ($000)

ROI Method
(1) (2) (3) (4) (5) (6) (7)
Business Fixed Total Budgeted ROI Objective
Unit Cash Receivables Inventories Assets Investment Prot (6) ⴜ (5)
A $10 $20 $30 $60 $120 $24.0 20%
B 20 20 30 50 120 14.4 12
C 15 40 40 10 105 10.5 10
D 5 10 20 40 75 3.8 5
E 10 5 10 10 35 (1.8) (5)
EVA Method
Current Assets Fixed Assets
(1) (2) (3) (4) (5) (6) (7)
Business Prot Required Required Budgeted EVA
Unit Potential Amount Rate Earnings Amount Rate Earnings (1) ⴚ [(4) ⴙ (7)]
A 24.0 $60 4% $2.4 $60 10% $6.0 $15.6
B 14.4 70 4 2.8 50 10 5.0 6.6
C 10.5 95 4 3.8 10 10 1.0 5.7
D 3.8 35 4 1.4 40 10 4.0 (1.6)
E (1.8) 25 4 1.0 10 10 1.0 (3.8)

11
“Another GE Veteran Rides to the Rescue,” Fortune, December 29, 1997.
 Chapter 7 Measuring and Controlling Assets Employed 287

not earn at least 20 percent on added investments in either current or xed assets, whereas
Units D and E would benet from investments with a much lower return.
EVA corrects these inconsistencies. The investments, multiplied by the appropriate rates
(representing the companywide rates), are subtracted from the budgeted prot. The resulting
amount is the budgeted EVA. Periodically, the actual EVA is calculated by subtracting from the
actual prots the actual investment multiplied by the appropriate rates. The lower section of
Exhibit 7.12 shows how the budgeted EVA would be calculated. For example, if Business Unit
A earned $28,000 and employed average current assets of $65,000 and average xed assets of
$65,000, its actual EVA would be calculated as follows:
EVA ⫽ 28,000 ⫺ 0.04(65,000) ⫺ 0.10(65,000)
⫽ 28,000 ⫺ 2,600 ⫺ 6,500
⫽ 18,900
This is $3,300 ($18,900 ⫺ $15,600) better than its objective.
Note that if any business unit earns more than 10 percent on added xed assets, it will
increase its EVA. (In the cases of C and D, the additional prot will decrease the amount of
negative EVA, which amounts to the same thing.) A similar result occurs for current assets.
Inventory decision rules will be based on a cost of 4 percent for nancial carrying charges.
(Of course, there will be additional costs for physically storing the inventory.) In this way
the nancial decision rules of the business units will be consistent with those of the com-
pany.
EVA solves the problem of differing prot objectives for the same asset in different business
units and the same prot objective for different assets in the same unit. The method makes it
possible to incorporate in the measurement system the same decision rules used in the plan-
ning process: The more sophisticated the planning process, the more complex the EVA calcula-
tion can be. For example, assume the capital investment decision rules call for a 10 percent
return on general-purpose assets and a 15 percent return on special-purpose assets. Business
unit xed assets can be classied accordingly, and different rates applied when measuring per-
formance. Managers may be reluctant to invest in improved working conditions, pollution-con-
trol measures, or other social goals if they perceive them to be unprotable. Such investments
will be much more acceptable to business unit managers if they are expected to earn a reduced
return on them.
Example. In 1996 Mitsubishi Corporation, the Japanese multinational with sales revenues of
$176 billion, employed investment centers as a management control tool. It divided the company
into seven groups and set different targets across the groups. For instance, the Information Tech-
nology Group, which was working in the fast-growing eld of multimedia, had a low target. The
Food Group had a very high target.12

Exhibit 7.13 offers examples of how different companies use EVA in planning and control.

12
Joel Kurtzman, “An Interview with Minoru Makihara,” Strategy & Business, Issue 2, Winter 1996, pp. 86–93.
288 Part One The Management Control Environment

EXHIBIT 7.13 Use of EVA in Planning and Control

Strategic Direction. IBM applied economic value added to evaluate the strategic plans for key Latin
American markets such as Mexico, Brazil, and Argentina.
Acquisitions. In one of the largest acquisitions, AT&T used EVA in deciding on its $12.6 billion purchase
of McCaw Cellular.
Operational Improvements. Briggs & Stratton recognized that its return on capital was poor and
trending lower. Operations were restructured and economic value added was adopted as a way of
focusing managers’ attention on how they were employing capital. EVA became the rm’s benchmark for
product introductions, equipment purchases, supplier arrangements, quality initiatives, and process
improvements.
Product Line Discontinuation. Economic value added helped Coca-Cola identify and sell businesses
that failed to recoup their cost of capital.
Working Capital Focus. Quaker Oats used economic value added to account for the large dollar
amount tied up in nished goods and packaging material inventories.
Cost of Capital Focus. Dow Chemical used economic value added to shed light on what it cost to run
its businesses and return a prot.
Incentive Compensation. At Transamerica, 100 percent of the annual bonuses for the CEO and the CFO
were based on economic value added.

Source: Excerpted from I. Shaked, A. Michel, and Pierre Leroy, “Creating Value through EVA—Myth or Reality,” Strategy & Business, Fourth
Quarter, 1997, p. 44.

Additional Considerations in Evaluating Managers

In view of the disadvantages of ROI, it seems surprising that it is so widely used. We know
from personal experience that the conceptual aws of ROI for performance evaluation are real
and contribute to dysfunctional conduct by business unit managers. We are unable to deter-
mine the extent of this dysfunctional conduct, however, because few managers are likely to
admit its existence and many are unaware of it when it does exist.
We strongly advocate the use of EVA as a performance measurement tool. EVA, however,
does not solve all the problems of measuring protability in an investment center. In particu-
lar, it does not solve the problem of accounting for xed assets, discussed above, unless annu-
ity depreciation is also used, and this is rarely done in practice. If gross book value is used, a
business unit can increase its EVA by taking actions contrary to the interests of the company.
If net book value is used, EVA will increase simply because of the passage of time. Further-
more, EVA will be temporarily depressed by new investments because of the high net book
value in the early years. EVA does solve the problem created by differing prot potentials. All
business units, regardless of protability, will be motivated to increase investments if the rate
of return from a potential investment exceeds the required rate prescribed by the measure-
ment system.
Moreover, some assets may be undervalued when they are capitalized, and others when they
are expensed. Although the purchase cost of xed assets is ordinarily capitalized, a substantial
amount of investment in startup costs, new-product development, dealer organization, and so
forth, may be written off as expenses and therefore will not appear in the investment base. This
situation applies especially to marketing units. In these units the investment amount may be
limited to inventories, receivables, and ofce furniture and equipment. When a group of units
with varying degrees of marketing responsibility are ranked, the unit with the relatively
larger marketing operations will tend to have the highest EVA.
 Chapter 7 Measuring and Controlling Assets Employed 289

Considering these problems, some companies have decided to exclude xed assets from the
investment base. These companies make an interest charge for controllable assets only, and
they control xed assets by separate devices. Controllable assets are essentially working capi-
tal items. Business unit managers can make day-to-day decisions that affect the level of these
assets. If these decisions are wrong, serious consequences can occur quickly: For example, if
inventories are too high, unnecessary capital is tied up and the risk of obsolescence is in-
creased; if inventories are too low, production interruptions or lost customer business can re-
sult from the stockouts.
Investments in xed assets are controlled by the capital budgeting process before the fact and
by postcompletion audits to determine whether the anticipated cash ows in fact materialized.
This is far from completely satisfactory because actual savings or revenues from a xed asset ac-
quisition may not be identiable. For example, if a new machine produces a variety of products,
the cost accounting system usually will not identify the savings attributable to each product.

Evaluating the Economic Performance of the Entity

Discussion to this point has focused on measuring the performance of business unit managers.
As pointed out in Chapter 5, reports on the economic performance of business units are quite dif-
ferent. Management reports are prepared monthly or quarterly, whereas economic performance
reports are prepared at irregular intervals, usually once every several years. For reasons stated
earlier, management reports tend to use historical information on actual costs incurred,
whereas economic reports use quite different information. In this section we discuss the purpose
and nature of the economic information.
Economic reports are a diagnostic instrument. They indicate whether the current strategies
of the business unit are satisfactory and, if not, whether a decision should be made to do some-
thing about the business unit—expand it, shrink it, change its direction, or sell it. The eco-
nomic analysis of an individual business unit may reveal that current plans for new products,
new plant and equipment, or other new strategies, when considered as a whole, will not pro-
duce a satisfactory future prot, even though separately each decision seemed sound when it
was made.
Economic reports are also made as a basis for arriving at the value of the company as a
whole. Such a value is called the breakup value—that is, the estimated amount that share-
holders would receive if individual business units were sold separately. The breakup value is
useful to an outside organization that is considering making a takeover bid for the company,
and, of course, it is equally useful to company management in appraising the attractiveness of
such a bid. The report indicates the relative attractiveness of the business units and may sug-
gest that senior management is misallocating its scarce time—that is, spending an undue
amount of time on business units that are unlikely to contribute much to the company’s total
protability. A gap between current protability and breakup value indicates changes may
need to be made. (Alternatively, current protability may be depressed by costs that will en-
hance future protability, such as new-product development and advertising, as mentioned
earlier.)
290 Part One The Management Control Environment

The most important difference between the two types of reports is that economic reports
focus on future protability rather than current or past protability. The book value of assets
and depreciation based on the historical cost of these assets is used in the performance reports
of managers, despite their known limitations. This information is irrelevant in reports that es-
timate the future; in these reports, the emphasis is on replacement costs.
Conceptually, the value of a business unit is the present value of its future earnings stream.
This is calculated by estimating cash ows for each future year and discounting each of these an-
nual ows at a required earnings rate. The analysis covers 5, or perhaps 10, future years. Assets
on hand at the end of the period covered are assumed to have a certain value—the terminal
value—which is discounted and added to the value of the annual cash ows. Although these es-
timates are necessarily rough, they provide a quite different way of looking at the business units
from that conveyed in performance reports.

Summary
Investment centers have all of the measurement problems involved in dening expenses and
revenues that were discussed in Chapters 4, 5, and 6. Investment centers raise additional prob-
lems regarding how to measure the assets employed, specically which assets to include, how
to value xed assets and current assets, which depreciation method to use for xed assets,
which corporate assets to allocate, and which liabilities to subtract.
An important goal of a business organization is to optimize return on shareholder equity
(i.e., the net present value of future cash ows). It is not practical to use such a measure to eval-
uate the performance of business unit managers on a monthly or quarterly basis. Accounting
rate of return is the best surrogate measure of business unit managers’ performance. Economic
value added (EVA) is conceptually superior to return on investment (ROI) in evaluating busi-
ness unit managers.
When setting annual prot objectives, in addition to the usual income statement items, there
should be an explicit interest charge against the projected balance of controllable working capi-
tal items, principally receivables and inventories. There is considerable debate about the right
approach to management control over xed assets. Reporting on the economic performance of an
investment center is quite different from reporting on the performance of the manager in charge
of that center.

Suggested Additional Readings

Aggarwal, Raj. “Using Economic Prot to Assess Performance: A Metric for Modern Firms.”
Business Horizons, January–February 2001, pp. 55–60.
Len, Kenneth, and Anil K. Makhija. “EVA & MVA: As Performance Measures and Signals for
Strategic Change.” Strategy & Business 24, no. 3 (May–June 1996), pp. 34–38.
Shaked, I., A. Michel, and Pierre Leroy. “Creating Value through EVA—Myth or Reality.”
Strategy & Business 9, Fourth Quarter, 1997, pp. 41–52.
Stern, Joel M. EVA and Strategic Performance Measurement. New York: The Conference
Board, 1996.
Stewart, G. Bennett, III. “EVA: Fact and Fantasy.” Journal of Applied Corporate Finance,
Summer 1994.